S&P downgraded nine European countries and the Dow only lost -48 points? Obviously the bad news was already discounted and the minimal reaction is bullish.
Regardless of your market bias you have to admit the Dow's rebound from -159 to -48, on a day when all of Europe was expected to be downgraded ahead of a three day weekend, was pretty bullish. Obviously volume was very light but the rebound ahead of the news was astounding. This was the largest single day downgrade of sovereign countries in history.
Clearly the market has already discounted the potential for the downgrades given the last several months of warnings. This rebound on bad news is not going to go unnoticed by those investors on the sidelines. Obviously the full extent of the downgrades was not known until the announcement after the close but many of the individual details were successfully leaked throughout the day.
After the bell S&P cut the ratings of Italy, Portugal, Spain and Cyprus by two notches. That cut Portugal's rating to junk status. They lowered the ratings of Austria, France, Malta, Slovakia and Slovenia by one notch. They affirmed the existing ratings on Belgium, Estonia, Finland, Germany, Ireland, Luxembourg and the Netherlands. All countries were removed from negative credit watch. However, almost all retained a negative long term outlook and S&P said there could be further downgrades in the next 12-24 months.
Just downgrading the countries is not the end of the story. S&P said it would issue separate media statements concerning the affected ratings on the funds, government-related entities, financial institutions, insurance companies, public finance companies and structured finance sectors "in due course." Yes, when a country's sovereign debt is downgraded there are equivalent downgrades on every part of that economy that depends on the country for funding or for income. Insurance companies and banks holding that debt will have their outlooks lowered as well if that is a substantial portion of their holdings.
They also acknowledged the downgrades would likely lead to higher debt costs, which in time could lead to further downgrades. They also cited the risk that "reform fatigue could be mounting." Countries making waves of spending cuts and forcing new and more onerous austerity measures on their citizens were reaching the point where political backlash was weakening the commitment to continue with new measures. That must have been a hard call for S&P when there are open riots and nationwide strikes and two inch headlines in the newspapers calling for no further cuts. The analyst making that call really had to research that topic.
S&P had telegraphed these downgrades for months. They should not have surprised anyone and that is probably the reason the markets recovered so quickly. The morning knee jerk reaction to the pending announcement was met by buyers eager to take advantage of the dip. Let's hope that feeling carries over to Tuesday morning.
The lukewarm reaction all points back to the ECB loaning nearly 500 billion euros to banks for three years at 1% interest last month. They are going to do it again in February. As I have reported before this has eliminated much of the short term downside risk for Europe. As we saw from the debt auctions for Italy this week it has also dramatically lowered the borrowing costs and relieved another stress point for the euro zone. The fix is in even though the plan to implement a new plan by European leaders has not yet been agreed to or signed. As long as the banks are solvent and countries can sell debt at reasonable yields the short term risk has evaporated.
The EU plan to make a new fiscal agreement was cited in the S&P downgrades as being insufficient in size and scope to produce any material changes in the current debt crisis. S&P said the plan did not produce the additional resources necessary to backstop the weaker nations. S&P said the forced austerity was reaching the point where it would be self defeating. New cutbacks strain the economy and lower tax revenues and GDP, which forces the need for additional cuts to stay within the required guidelines. Countries will not be able to exit the crisis through additional spending cuts. The headlines this weekend have Merkel and Sarkozy calling for an even stronger fiscal agreement and rejecting the watered down version currently circulating. Seems many of the EU countries didn't want to have an enforcement mechanism and penalty provision for over spending. Duh!
The one remaining problem is Greece. Talks broke down Friday between the banks and hedge funds holding over 200 billion euros of Greek debt. Reportedly Germany is demanding a 4% coupon on the new debt and the banks are demanding 8%. I can definitely understand the bank's views. They are going to give up 100 billion in principal and get some long dated paper in return. A 4% rate is going to be barely over inflation but an 8% rate will allow them to recover some of their principal over the next twenty years. They will never recover all their money but they will see a significantly better cash flow. The hedge funds are reportedly holding out for an involuntary default so they can execute their credit default swaps and get out with all their principal. The three groups, banks, hedge funds and government negotiators have reached an impasse and the meetings broke up. They "may" resume next week according to one source. However, headlines this weekend suggest Germany is going to press for a 90% haircut. Good luck with that.
If Greece can't get the 50% haircut done soon they will likely default on their next debt payment. That payment is 14.4 billion euros and they don't have the money. The troika will not give them any more money until the haircut has been concluded. That is a precondition for the continued loans. That makes Greece the focus of attention again next week. However, I seriously doubt anyone has not factored in an eventual resolution whether it is voluntary or involuntary.
In my opinion Greece will default. You can't solve a massive debt problem with more debt. I have said that from the beginning. Slashing government spending sharply reduces GDP, cuts jobs, raises unemployment payments and reduces taxes, which forces more spending cuts and the cycle repeats as the country falls even further into recession. With Greek debt at 160% of GDP they are growing debt payments at a far faster rate than they will ever be able to grow the economy. If your debt payments increase by 10% a year (you have to sell more debt to make interest payments on the old debt) and your tax receipts are growing at 5% a year, or in the case of Greece declining by 5% a year, there is no way to escape the debt trap but to default.
Even getting private lenders to go along with the 50% haircut on more than 200 billion in debt only reduces the total outstanding debt to 120% of GDP by 2020. Greece is on a collision course with destiny. The only question is how long it will take before the house of cards collapses and will the European banking system collapse with it.
Reportedly the IMF is ready to pull the plug on Greece saying the conditions are deteriorating rapidly. Supposedly IMF head Christine Lagarde has warned the second 130 billion euro bailout agreed to on Oct 26th needs to be expanded by "tens of billions." German officials are adamant about not contributing any further funds. Michael Fuchs, deputy leader of Merkel's CDU party said last week, "There has to be a line somewhere. This cannot be a bottomless barrel. I don't think that Greece, in its current condition, can be saved."
Fitch said earlier last week there was still a reasonable chance Greece would leave the euro by year end. Fitch also warned last week they could downgrade several European countries by the end of January. That shoe has yet to drop.
The downgrade of France from AAA to AA+ could be seen as a failure by Sarkozy within the euro zone. His party is facing elections in April and the opposing party could use this downgrade against him. If his party was to lose the election the result would mean France would be far less agreeable to the demands of Germany. Should Germany and France end up disagreeing on future policy it could halt further euro zone reforms.
Spain and France have debt auctions on Thursday and the results of those auctions will be critical.
Germany's AAA rating was not changed. However, the downgrade of AAA rated France and Austria as well as cuts to the other seven nations, lowers the credit rating for the European Financial Stability Fund (EFSF) which is backstopped by the credit of the euro zone nations. That means the EFSF may have to pay more to sell additional debt. The EFSF sold three billion euros of debt last week.
The euro fell to a 17 month low at 1.2623 when the first news of the pending announcement was leaked at the open. The dollar spiked nearly 1% and that weighed on stocks and commodities alike. Nearly all analysts are looking for the euro to return to at least 1.20 over the next six months and possibly to parity at 1.0 over the next two years. This means the dollar will remain strong and continue to weigh on equities.
Since the euro is extremely over shorted today there is always the potential for a bounce to 1.30 in the short term. The short interest in the euro futures is at record levels of more than 155,000 contracts. On the bright side a lower euro is the equivalent of a weaker monetary policy for the entire euro zone. Exports are cheaper and tourist travel will increase.
Dollar Index Chart
On the U.S. economic front the Consumer Sentiment for January rose sharply for the fifth consecutive month. The headline number rose to 74.0 from 69.9 and the third month of strong gains. This is the highest level since May. The present conditions component rose from 79.6 from 82.6 and the highest level since February. The expectations component rose from 63.6 to 68.4 and the highest level since May.
Consumer Sentiment Chart
Import prices declined -0.1% in December and the fourth decline in five months. Imported food prices declined by -0.4%. This suggests inflation pressures are nonexistent. Export prices declined -0.5% and the second decline in three months. This report was ignored.
The International Trade deficit rose to -$47.8 billion from -$43.5 billion for November. Slower growth in Europe and China is weighing on our exports and this trend is not likely to change in the near future. This report was also ignored.
The economic calendar for next week has some high profile reports with the Philly Fed Survey the most important. That is a preview of the national ISM released in two weeks. The home construction and sales reports will also be noteworthy with the current signs of improvement in the sector.
France and Spain have debt auctions on Thursday and this will be the first major euro event since the downgrades. Sharply higher interest rates on those auctions would be very negative for the market and the euro.
The real calendar that matters for next week is the earnings calendar. Monday is a market holiday so there are limited reports worth watching. The pace begins to quicken as the week progresses with Goldman Sachs and US Bank on Wednesday. Thursday should be called Super Thursday with a major string of reports. Intel, Microsoft, IBM and Google highlight the tech side and AXP, BAC and MS highlight the financial sector. GE and SLB close the show on Friday.
By the end of this week we will know how this earnings cycle will end. The biggest banks and techs will have reported and we can extrapolate the results for the rest of the cycle. The only major sector not represented is the energy sector. That will come later but after the Chevron warning last week we know how that is going to play out for the energy majors.
The limited earnings we have had so far have been less than exciting with misses and warnings the predominant theme. Surprisingly investors have ignored the bad news except for those in the individual stocks.
Dow component JP Morgan (JPM) missed earnings estimates on Friday when they reported a -23% earnings decline. That is the first quarterly earnings miss from JPM since Q4-2007. Since JPM is considered to be the best managed the earnings miss is very troubling for the other banks reporting next week. If you see one cockroach there are probably a lot more.
JPM reported earnings of 90-cents compared to $1.12 in the year ago quarter. That was in line with official estimates but the whisper numbers were slightly higher. Dimon had warned on Dec-7th that investment banking was not improving and analysts lowered their estimates. They missed on revenue at $22.2 billion compared to estimates of $23 billion. Investment banking revenue fell -30% to $4.36 billion due to a -39% drop in underwriting and advisory fees. The bank had to book another $500 million in expenses for mortgage litigation expenses.
Earnings would have been worse but JPM bought back 4% of its stock during the quarter and that makes earnings per share higher when there are fewer shares outstanding. Shares of JPM declined about 5% at the open but rebounded to a loss of only -2.5% and a close at $36.
CEO Jamie Dimon was upbeat about the future but admitted there were risks. He said credit quality was improving as well as loan demand from corporations and consumers. "We see a mild recovery which actually might be strengthening and it is broad. Hopefully it will add to jobs. We have seen jobs growing, not enough, but it could be self sustaining." He said he was becoming "increasingly worried" about Europe.
In an interview with an Italian newspaper on Saturday Dimon said JPM had $15 billion in exposure to the five weakest European countries. (PIIGS) "We fear we could lose up to $5 billion. We hope the worst won't happen but if it did happen, I would not be pulling my hair out." To put that $5 billion in perspective JPM bought back $8 billion in stock in 2011 and plans to do the same in 2012.
JPM was the only major earnings even on Friday but there were other stocks in the news. Patriot Coal (PCX) declined -13% after it announced it was closing five facilities due to weak demand for its West Virginia coal. The company said weak demand for metallurgical coal used to make steel caused it to idle the "higher cost" facilities. The CEO said declining U.S. coal exports have hurt demand. However, it will bring those idle facilities back online once demand resumes. Patriot is facing three problems. Peabody is ramping up exports and stealing their market share. Secondly rising coal exports from Australia (Peabody, BHP Billiton and MacArthur) are also reducing demand from the U.S. because the shipping to China from Australia is cheaper. Lastly China's economy has slowed and that weakened the demand for met coal. Patriot pulled this same "weak demand" excuse back in July and tanked the coal sector when it was really just a Patriot problem.
Also hit in the coal sector in a guilty by association trade was Alpha Natural Resources (ANR). Share of ANR declined -10%. The railroads, CSX, UNP and NSC all declined on worries that weak coal demand would cut into revenues. Analysts were quick to counter that view saying the amount of coal Patriot was cutting back was "insignificant" to the volume of coal shipped by railroad. This would be a buying opportunity for the railroad stocks but those three above all have earnings over the next week or so.
Video game maker Electronic Arts (EA) declined -7% on news video game sales fell by -21% in December. The decline was led by a drop in the purchase of hardware such as consoles and handheld players. Hardware declined -28% and software sales fell -14%. Accessories lost -27%. Part of the decline in sales was due to the early release of titles like Call of Duty in November. That spiked sales in November and left a void in December. Another factor was the NPD survey does not take into account digital delivery of games, downloads, and that is a growing part of their sales. EA also suffered from news Barry Cottle, head of EA's interactive business was leaving to join Zynga. He followed EA's COO, John Schappert, who recently left for Zynga. Cottle will answer to Schappert at Zynga. Mark Skaggs, now senior VP at Zynga and developer behind FarmVille and CityVille was a game producer at EA. Bing Gordon, a board member at Zynga was once EA's creative officer. Maybe Zynga should just buy EA and solve the employee poaching problem all at once.
EA - ZNGA Comparison
EA is not the only company with employee flight causing problems. Tesla Motors (TSLA) fell -19% on Friday after news broke the VP and Chief Engineer, Peter Rawlinson, had decided to step away to tend to personal matters in the UK. Nick Sampson, supervisor of vehicle and chassis engineering also left the company last week. With the new Model "S" scheduled to be delivered later this year investors were apparently concerned why two high profile executives would leave so abruptly. The company said Sampson had already "fully transitioned off the S model at the time of his departure." Still, for an up and coming company with two new products in the pipeline it does seem suspicious.
Shares of Shutterfly (SFLY) fell -6% after news broke the CFO, Mark Rubash, was leaving next month. Shutterfly is fighting a tough battle in a hostile pricing environment and the CFO has inside information on financial health. Unexpected CFO departures tend to make investors nervous. The current CEO and Chief Accounting Officer will both handle the CFO duties until a new person can be hired. Time will tell if there were problems developing inside SFLY.
There was an interesting story out of China on Friday. China imported the most gold ever and investors bought U.S. bullion coins at the fastest pace in more than two years. Mainland China imported 102.8 metric tons of gold in November. It was valued at $5.4 billion. Analysts believe China is adding to its reserves ahead of an inflationary cycle expected later this decade.
The U.S. Mint said it sold 85,000 ounces of American Eagle gold coins in the first 12 days of January. If that pace continues the sales for January would reach 213,750 ounces and the most since December 2009.
Holdings at exchange traded gold funds are poised for the biggest weekly expansion of assets since mid November and are within 2% of an all time high according to Bloomberg. Holdings at the funds reached 2,357.3 tons on Thursday and were valued at $124.1 billion. That exceeds the reserves of all but four central banks.
Of the 23 analysts surveyed by Bloomberg, 18 expect gold prices to rise next week, 3 were bearish and 2 were neutral.
Analysts say the massive Chinese buying has caught investor attention. China beat out India for second place in the gold jewelry market in Q3 according to the World Gold Council.
The gold options market is showing a little irrational exuberance with more than 8,000 July call options trading on Thursday with a $2,200 strike price. Gold closed today at $1,640. Put options on the GLD ETF are at their lowest level in the past 20 months.
While I applaud the thought process that gold will go higher, much higher, I think they got the timeframe wrong. As long as the euro is falling and dollar rising the price of gold should be stable. Once the euro finds support and investors believe the worst is over for Europe the euro will rise and the dollar will drop like a gold brick. Unfortunately for those July $2200 calls they may be a couple years early. I do believe gold will see $2,500 over the next several years but not by July.
Professional investors, hedge funds and institutions, are not so bullish. They cut their longs to 110,954 contracts as of Jan 3rd and that is the lowest level since January 2009. HOWEVER, as I have written before there is a history for managed commodity funds and money managers to take profits on gold before year end and then launch new positions in January. The last time net longs were this low gold rose +17% over the next four weeks. I certainly do not expect that with the soaring dollar but anything is always possible.
I would be thrilled to see it because silver would follow along for the ride and I am long silver for the long term. I believe this is a buying opportunity for silver and we will probably get to buy it cheaper as the euro nears 120.
Crude prices declined slightly on the pending downgrades in Europe but still held the majority of their December gains. The problems in Iran and Nigeria will continue to provide support. It was reported on Friday that two U.S. Navy ships were harassed by Iranian gunboats in the Strait of Hormuz this week. The high speed gunboats appeared to be trying to spark a confrontation and the skippers of the Navy ships videoed them as they circled and then pulled into the wake of the bigger ships to follow them with their guns manned.
The Navy is not going to fire the first shot so the Iranians have room to run and taunt the bigger ships. However, it was also reported a second carrier task group arrived on station in the Arabian Sea and a third one was en route. A Pentagon spokesman said it was "not unusual" to have multiple carriers in the region.
It was also reported that U.S. troops in Kuwait had risen to 15,000 including two combat brigades. The spokesman said he was not aware of any decision to "permanently" increase the number of troops in Kuwait. Sounds like a politically correct answer to both questions.
Defense Secretary Leon Panetta said the U.S. would have about 40,000 troops in the area at the end of 2011 after the withdrawal of forces from Iraq. The spokesman specifically declined to say where they were located today. The sabers are rattling on both sides this week.
The administration said late in the week they had advised Iran through political and civil channels not to try and close the Strait or risk repercussions.
These little tidbits of data paint a picture of an increased chance of a conflict of some kind in the months ahead. The U.S. has denied they had anything to do with the assassination of the nuclear scientist last week but Iran will always believe the U.S. and Israel orchestrated it. It was the fourth such assassination in recent months.
Oil prices are not likely to fall very far with the risk of an altercation breaking out at any minute. The only factor holding Iran back is that they use the Strait for oil transport as well. Iran said on Friday they were NOT storing oil on tankers in the Persian Gulf as had previously been reported. Due to risks of a blockade those tankers are moving outside the Gulf and closer to their intended buyers.
EU leaders are still discussing their embargo and they will meet on Jan 23rd on the topic. However, it appears there could be a delay of as much as six months in implementing it. The reason is the large amount of oil bought from Iran. Arrangements must be made for alternative sources. Europe gets 18% of its oil from Iran, China 20%, Japan 17%, India 16% and Korea 9%. You can't just cut them off. Plans have to be made. That gives Iran a six month window before the cash flow declines to a trickle and the regime begins counting down the days until its end. There is no need to fire a single shot if the majority of countries honor the embargo. Iran's current regime will die of financial starvation.
Crude Oil Chart
The S&P futures rose +6 points after the close to 1289 on what appeared to be a strong case of sell the rumor, buy the news. They sold the open to knock the futures back to 1272 (1277 cash) and then bought them again starting at 1:45 when news broke that France was only downgraded one notch instead of two.
Overall the downgrades had been expected and when Germany escaped without a cut and France only lost the one notch the buyers came back. There was enough indecision and lack of volume to keep the indexes from returning to positive territory but the sentiment was encouraging. However, as one analyst said "would you want to go into the long weekend short?" What we saw could have been simply short covering in a thin market. Volume was barely six billion shares.
Next week is option expiration and the bias appears to be to the upside. S&P 1295 is still strong resistance with 1280 the new initial support followed by 1260. The problem will likely be a strong pattern of disappointing earnings. Overall estimates continue to decline and every earnings warning has the European component in the press release. I view it as the kitchen sink excuse. When the quarter didn't go as planned you throw all your accounting problems into Q4 and then blame it on Europe. If nobody looks too hard they won't see the drop in sales in Oshkosh or the higher expenses in Peoria. They will see "Europe" in the headline and immediately ignore the rest of the data. That may not work for a company with limited international exposure but those can always blame the weak consumer and U.S. unemployment.
I have to admit I am impressed with the slow meltup of the market. So far nothing has phased it in 2012. Some event will eventually appear to knock out the props but until then you can't afford to be short. This stealth meltup could suddenly turn into a real rally and blow through 1300 on its way to 1350. That is the resistance level I don't see breaking.
S&P Chart - Weekly
S&P Chart - Daily
The S&P chart above and the Dow chart below are identical in their resistance despite being totally different indexes. The Dow has already eased through the 12,285 resistance equivalent to the 1,295 on the S&P but the pattern is still the same.
IBM and UTX were the two biggest losers on the Dow and Chevron, the poster child for energy earnings warnings, was the biggest gainer. Investors really have short memories when their bias is bullish. Five Dow components report earnings next week. AXP, BAC, IBM, MSFT and GE. BAC and IBM could be the big disappointments. MSFT has already warned that PC sales slowed worse than expected in December. That probably means they will not post strong earnings.
With the Dow only 300 points from major resistance at 12,750 and the level some see as the high for the year there will be some serious reluctance at being long at that level. Initial support is 12,300 and initial resistance 12,500.
The Nasdaq paused on some minor profit taking after six consecutive days of gains. The dip to support at 2700 was uneventful and the month long uptrend is still intact.
AAPL, GOOG and FFIV were slightly negative but PCLN, AMZN, NFLX, SODA, AMZN and OPEN made up for those declines. I was surprised the Nasdaq did not recover to positive territory given the strength in those six stocks.
Initial support is prior resistance at 2700 and resistance at 2730.
The Nasdaq 100 declined -10 points but that was merely a stutter step as it continues its approach to strong resistance at 2400. That will be the real test and likely the high for Q1 if it makes it that high. A breakout over 2400 would be very bullish.
Nasdaq Composite Chart - 90 Min
Nasdaq Composite Chart - Daily
Nasdaq 100 Chart - Weekly
The Russell 2000 gave back -6 points to close at 764 but that was very minimal when it could have easily dropped back to 750 and its breakout level from Tuesday. Given the huge European downgrade risk on Friday the decline could have been a lot worse.
This would appear to be even further proof that fund managers are feeling better about the future despite the earnings disasters. Small caps should have cratered on the negative news and they barely dipped.
Thursday's high at 770 remains resistance and a breakthrough there would be very bullish.
Russell Chart - Daily
The Dow Transports dipped sharply on the Patriot Coal warning about reduced production. Analysts said the drop was minimal and the railroads immediately rebounded. The Transports are in breakout mode and I believe the sudden dip buying was bullish confirmation.
Dow Transport Chart
The January curse has failed to appear but we are just now at mid month so anything is still possible. With the potential for negative earnings ahead I would normally say the odds are good for a decent decline. However, the market action on Friday, given very bad news, was a wakeup call for the bullish doubters. If they can overcome negative earnings next week and the possibility of another round of downgrades from Fitch, then I will officially be a convert.
This is going to be a rocky week if the earnings turn out as expected. It will take a cast iron stomach for any bulls to tough it out and celebrate the bad news. If they do succeed in moving the markets higher then I would expect a move to the next resistance level at the July highs. (Dow 12,750 and SPX 1,350)
If the Fitch downgrades appear they will likely be overlooked as repetitive unless they are much worse than S&P. Since they already said they were not going to downgrade Germany and France the rest do not matter than much at this point. We can mark Fitch off as a step in the wall of worry.
You can bet there will be plenty of news from Europe about the S&P downgrades but fortunately our markets are closed on Monday and we will miss the flood of headlines. It will be old news by Tuesday. The fly in our soup is Greece. If that situation deteriorates any further it could be a sticking point for the market. However, does anyone really care about a default in Greece today? That news is two years in the making and we might be surprised to see the markets have already priced it in as well.
Buckle your seatbelts. We could be in for a wild ride next week.
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