After six days of declines the markets rested. Thank China and JP Morgan for the short squeeze.
A combination of strong oversold conditions and traders not wanting to be short over the weekend combined with good news from China and earnings from JP Morgan to produce another Friday short squeeze. I said on Tuesday "I would be looking to sell any short squeezes and you know there is one in our future somewhere." We have to wait until next week to see if the short recommendation works out but at least the squeeze was right on schedule.
Conditions were very oversold. The Dow and S&P had been down for six consecutive days. Bank America put out a note on Thursday saying stocks were the most hated of any period in the last 15 years. Stocks were selling at the biggest discount to bonds since Bank America/Merrill Lynch began keeping records.
The American Association of Individual Investors (AAII) investor sentiment survey showed bullish sentiment at 30% compared to the long term average of 39%. Bullish sentiment has been below the long term average for 15 consecutive weeks and the last time that happened was in 1993. The S&P only gained +35 points for the entire year but then the S&P was also 435 not 1435.
Year to date global equity funds have only seen net inflows of $1 billion. Global bond funds have seen inflows of $130 billion. That is a lot of money looking for the safety of a guaranteed low single digit yield rather than at risk in the equity market.
The point here is that investors are afraid of the future. For whatever reason including the fiscal cliff, Europe, China, the election, etc, they are moving to cash equivalents in near record numbers.
Those staying in the market are betting on the downside and after six days of declines we were due for a short squeeze. Coming on a Friday the 13th you would probably have been expecting a move in the opposite direction.
Starting out the rally overnight was news that China grew at a rate of +7.6% in Q2 or at least that is what the official GDP release showed. Who knows what the real GDP number was. That was the slowest growth rate in three years and leaves China on track for its slowest full year of growth since 1999. It was the sixth consecutive quarterly decline. Retail sales for June grew by +13.7% compared to May's +13.8%. Industrial production grew by +9.5% compared to estimates of +9.8%.
While the numbers were not great for China they were definitely better than many analysts had expected. China is targeting a full year GDP of 7.5% while some analysts fear growth as low as 6.8% to 7.3%. The consensus back in April was 8.4% so you can see how drastically the estimates have changed. Since China controls what numbers they release and this is a once in a decade transition year for the leadership I suspect they will magically "meet" their targets.
China has cut interest rates twice in recent weeks, cut the reserve ratio three times since November and announced a new loan discount rate for banks in an effort to stimulate the economy. Bank lending rose +16% from May to June as a result of the new discounts. This sudden surge of policy liberalization suggests conditions are worse than the official numbers show. In order to save economic face and avoid massive factory layoffs we may see China announce even further moves in the near future. Turning the giant Chinese economy is like maneuvering an oil tanker. You have to plan your turns well in advance and then wait patiently while the course corrections take effect. You can't afford to act hastily or the result could take years to erase.
The less bad GDP numbers removed a worry component for traders overseas and those market gains carried forward to the U.S. at the open. However, the overall economic numbers from China were still weak and there are some analysts expecting further stimulus from China, possibly as early as Sunday.
Update Saturday afternoon: China announced it would provide $5 billion in subsidies to renovate four million rural homes. Each dilapidated home will be given an average of 7,500 yuan with 130,000 poverty-stricken homes in border areas granted another 2,500 yuan. Besides the stimulus factor of paying for improvements to four million homes this is also a "social engineering" project to keep the poor from causing civil unrest.
The other factors juicing the market were earnings from JP Morgan (JPM) and Wells Fargo (WFC). JP Morgan reported earnings of nearly $5 billion in Q2 thanks to a +29% jump in mortgage originations. Earnings were $4.96 billion or $1.21 per share. This included $4.4 billion in actual losses as a result of the whale trade. Those losses have risen in total to $5.8 billion and JPM said they could rise at most another $1.7 billion but would likely be more in the range of $700 million. The trading losses reduced earnings by 69 cents per share.
Investors were relieved the losses were not worse and amazed by how good the quarter would have been without the bad trade. However, there are some new problems. The bank revealed that traders may have intentionally recorded the value of those trades at favorable prices rather than actual liquidation value in order to avoid reporting paper losses. Since reporting large losses would have been a red flag drawing attention to the oversized positions it appears some traders reported the value of the position when it was entered rather than the fair market value of the position at the end of the quarter.
Jamie Dimon has promised to get to the bottom of the trades and heads will roll. Actually Ina Drew, CIO over the division, has already left and the bank said she would be returning several million in salary as a result of the lax oversight. The actual "London whale" that made the big bets, Bruno Iksil, has also left JPM. The CIO risk officer, Irvin Goldman, has also resigned. The bank only had good things to say about Goldman saying "he behaved with integrity and we wish him well." Archilles Macris, CIO in Europe, and colleague Martain Javier-Artajo have also disappeared from the employee database according to Reuters.
JP Morgan will restate Q1 earnings reflecting a $459 million reduction in income because of the inflated position reports. JPM said the bank combed through more than one million emails, tens of thousands of taped conversations and mountains of other "evidence" to determine how the positions were initiated, valued and who was responsible. At this point you can bet that the regulators will be filing charges or suits over the misrepresentations and lack of oversight. However, anything that happens from this point is just nuisance news. The whale trade is over for all practical purposes even though the story and the regulation aftermath will continue for years. JPM remains hugely profitable and once the stock moves over resistance at $37 the rally will begin.
Also helping the financial sector was earnings from Wells Fargo (WFC). The bank reported earnings of $4.6 billion or 82 cents per share. That compared to 70 cents in the year ago quarter. The +17% jump in earnings came from $2.9 billion in profits from mortgages, up from $1.6 billion. The CEO said the mortgage pipeline was at record levels and Q3 would be very robust in terms of mortgage profits. Total loans increased by $8.7 billion to $775.2 billion. The 82 cent profit compared to analyst estimates of 81 cents. It was not a big beat but the strong guidance helped power the stock to a +3% gain and a new two month high.
Wells Fargo Chart
The earnings news may have helped power the short squeeze on Friday with a couple high profile reports but next week is going to be a real challenge. With estimates declining daily we could see a rolling disaster as each day adds to the prior day's woes. However, since earnings sentiment has been so negative in recent weeks the bar is so low a snake could cross it and not notice the bump.
We are facing the potential for a flurry of "less bad" earnings from some major names that could call into question the impact of Europe's austerity recession. I am not ready to forecast an earnings rally but the sentiment is so negative that it would be hard to miss on the downside. Remember, the sentiment facts I reported earlier. Investors are simply avoiding stocks regardless of the news. The market movement we are seeing is from traders only. Volume was EXTREMELY low at 5.3 billion shares on Friday.
We definitely have some high profile earnings next week with banks Citi, AXP, BAC, MS, GS and USB leading the list. For tech stocks we have INTC, EBAY, IBM and MSFT. The banks should continue to outperform but the tech sector could be a problem. IBM is expected to report only a +10% increase in earnings along with a drop in revenue. Intel is expected to report a -12% drop in earnings on minor gain in revenue. Microsoft is expected to post a -8.7% decline in earnings.
On July 1st 2011 the estimate for Q2-2012 earnings was for +14.15% growth. On October 1st that had fallen to +7.92%. By April 2nd it was down to +1.68% and as of today the S&P earnings are expected to decline -2.12%. That includes a whopping gain by Apple and Bank America. Without those two companies the S&P earnings estimates would be a decline of more than -5%. Why should the market be in rally mode? Currently Q4 earnings are expected to rise by +14%. Where do you think those estimates will be six months from now?
On average there are nearly three companies warning about earnings for every company that is issuing positive guidance. This is the worst pace since the recession.
Declining earnings are never positive unless analysts have over compensated on their bearish estimates and companies surprise with bad but better than expect numbers. If by some remote chance those earnings declines I listed above turned into earnings gains we could be off to the races.
Don't under estimate the possibility that pessimism may now be the base case scenario. With pessimism so high any positive news from any direction, earnings, Europe, economy, etc, could have a bullish impact on stocks. Analysts, writers and reporters have been pounding home the negativity for months now. Eventually investors will become immune to the daily dose of bad news. I seriously doubt there are very many investors that can't list the bullet points causing the current bout of global economic uncertainty.
On the U.S. economic front the Producer Price Index (PPI) for June rose unexpectedly by +0.1% compared to consensus estimates for a -0.6% decline. That was the first gain in four months. Finished energy goods declined -0.9% but the consumer foods index rose +0.5%. Meat prices rocketed higher with vegetable prices not far behind. Crude materials prices declined -3.6% month to month and -9.4% year over year.
Core prices, excluding food and energy, rose +0.2% for the fourth consecutive month. Price increases for trucks and household appliances accounted for the majority of the gain.
Lower commodity prices are a factor throughout the manufacturing sector and will continue to insulate manufacturers against the slowing economy. The European recession and China's manufacturing decline have hurt commodity prices since investors don't want to invest in commodities until demand returns. The PFG Best bankruptcy should continue to keep commodities depressed with hundreds of millions of dollars in commodity traders funds locked up for months to come.
However, corn and soybean prices are soaring because of the drought. If there is no material rain in the Midwest over the next three weeks there could be a serious shortage of soybeans and corn and result in a bidding war later in the summer. The next three weeks are critical for soybean growth and crop yields. Corn and soybean meal are critical inputs to poultry growers and could send price ripples throughout the food chain.
The initial reading for Consumer Sentiment for July declined from 73.2 to 72.0 for the second consecutive monthly decline and the lowest reading since December. The gains for the year that pushed the survey to a high of 79.3 in May have now been erased. That represents a -10% decline in only two months.
Present conditions rose slightly from 81.5 to 83.2 but expectations declined from 67.8 to 64.8. Given the recent improvement in the outlook for the housing sector and the sharp drop in fuel prices it is surprising to see sentiment decline so sharply. Consumers are clearly worried about the slowing job gains, the fiscal cliff and the European debt crisis.
Consumer Sentiment Chart
The June National Federation of Independent Business (NFIB) Sentiment Survey fell 3 points to 91.4. The image below shows the declines in the various components that make up the index. Only one component improved and that was credit conditions. Earnings trends declined -7 and Expect Economy to Improve fell -8. This survey was conducted before the Supreme Court decision on healthcare. With 20 new taxes in the healthcare law the July survey is expected to decline even farther.
The economic calendar for next week contains some high profile events. The Bernanke testimony to the Senate on Tuesday will be the first hurdle. If Bernanke continues the sentiment expressed in the FOMC minutes last week then the market could swoon again. If by chance he decides to tease the market with comments about adding policy to stimulate jobs we could see traders dreaming of QE3 rush back into the market.
Unfortunately the testimony is not likely to give traders that QE tease because many lawmakers are dramatically opposed to further QE. Mentioning the possibility of future QE in any meaningful terms would be inviting some scathing attacks in the Q&A section of the testimony. Lawmakers are going to be posturing for the election so any attack on Bernanke is likely to be seen as free publicity. That suggests Bernanke impact on the market on Tuesday could be limited unless he unexpectedly talks up the economy. That is not likely to happen since the Fed Beige Book, due out on Wednesday, will be the actual recap of activity in every Fed district. Bernanke will have that information on Tuesday and he could color his testimony with positive points from the report but that assumes there are positive points.
He gets to repeat his testimony again on Wednesday in the House. He has changed his House testimony in the past from what he gave in the Senate when he thought the market reporting got it wrong. If the market swoons on Tuesday he could embellish it for Wednesday in an effort to correct the impression. He is pretty good about his phrasing so I would not expect any changes. However, the House has the advantage of seeing the testimony and questions from the day before so they can be better prepared to ask even tougher questions.
Bernanke is more than likely going to complain about the fiscal cliff and plead with Congress to remove problems currently weighing on stocks. He will say the Fed has done all it can do unless the economy weakens considerably. In June he began pushing the economic blame off the Fed and on to Congress in his speeches so we will see if that continues.
Bank of America analyst, Ethan Harris, commented on pending FOMC action. "We expect that the outlook (at the July meeting) will be weak enough to warrant additional Fed easing by the September 12-13 FOMC meeting; we look for Fed officials to both push out their forward guidance on rates until at least mid-2015 and to launch QE3."
The Philly Fed Manufacturing Survey on Thursday is the last major report for the week. This survey is seen as a proxy for the national ISM, which is reported in the first week of the month. That makes the Philly Fed important for sentiment for the rest of the month. It is actually expected to rebound from the -16.6 number in June. The estimate is -6.6 and while a rebound it is still in contraction territory.
Jobless claims on Thursday are expected to rebound to 363,000 from the statistical error last week. Claims declined from 376,000 to 350,000 not because of a sudden hiring spurt. They declined because auto makers did not close their plants for the normal summer model changeover. The 25,000 or so workers that are normally laid off temporarily while the plants are changed over to produce the new models were not laid off. Automakers are experiencing such strong demand for existing models they kept the plants open longer. The Labor Department has a normal seasonal adjustment to accommodate the temporary layoffs only the layoffs did not occur as expected. The seasonal adjustment skewed the numbers and we should not expect the weekly jobless claims to remain at the 350,000 level.
Normally the video game market resists slowing consumer trends. Young people will scrimp, save and borrow whatever is needed to acquire the latest games. That trend has ended in the current environment. Sales of video games and hardware declined in June for the seventh consecutive month. Overall sales fell -29%. Sales of games fell -29% while sales of hardware like game consoles fell -45%. This decline was blamed on reduced discretionary spending and a lack of any new must have titles. While I believe new titles would spur some sales the overall trend is clear and I believe it has to do with lack of employment. With the U6 unemployment rate at 14.9% and youth employment in the same range they don't have the money to spend. What money they do have is being spent on smartphones and data plans, which are rising in cost every quarter. A teenager can do without a video game but they can't live without their phone.
While on the topic of economics I am going to share some random thoughts this weekend. In the process of doing the weekend commentary I easily read well over a hundred articles each weekend. This week I thought several were worth sharing. These are in no particular order.
John Mauldin on growing problems in Europe: The Beginning of the Endgame
ECRI Lakshman Achuthan: The U.S. recession has already started
Nouriel Roubini: 2013 Perfect Storm May Surpass 2008 Crisis
Charles Biderman: Bernanke Put Unlikely to Survive
Moody's downgrades Italy on worries over Greek exit.
Spanish banks borrow record 365 billion euros from ECB in June
Crude prices rallied after Iran bragged on its navy again saying the recently concluded war games showcased missiles with improved accuracy and the ability to hit Israel and U.S. bases in and around the Persian Gulf. The news report put out by the Ministry of Defense said the firing sequence had been improved allowing missiles to be fired in "seconds" if Iran found itself under attack. Iran warned that 35 American military bases in the Middle East are within Iran's missile range and would be destroyed within seconds after any attack on Iran.
The comments came after the U.S. announced new sanctions on Iran on Thursday. The Treasury Dept announced new financial sanctions against 11 companies affiliated with the Iranian Defense Ministry, Revolutionary Guard and the national shipping company. The Treasury Dept said the move was taking direct aim at disrupting Iran's nuclear and ballistic missile programs as well as its deceptive efforts to use front companies to sell and move its oil. Iran announced last week it was allowing private companies to sell its oil in order to avoid the sanctions against the nation of Iran and the government oil company.
Also pushing prices higher was the news from Britain's MI6 spy agency that Iran would have nuclear weapons by 2014. The head of the intelligence service, Sir John Sawyers, said covert British spies had prevented Iran from developing nuclear weapons as early as 2008. He did not say specifically how they did it but he said "without the actions by MI6 you would have had a nuclear Iran in 2008."
He said the threat of a nuclear Iran by 2014 was real and credible and that threat increased the potential for an attack by Israel and/or the U.S. in the near future. He said the threat of a nuclear Iran would create a new nuclear arms race in the region and have serious destabilizing effects throughout the Middle East. A nuclear Iran would force Saudi Arabia and others to go nuclear as a deterrent against aggression by Iran. He said the new Middle East cold war would pose an even greater threat of nuclear conflict than the stand-off between the USSR and the USA because there would be no safety mechanisms in place.
WTI Crude Oil Chart
I am surprised to see gains in any commodities other than grains because of the impact from the PFGBest scandal. It was revealed late Friday that CEO Richard Wasendorf Sr was arrested on charges he stole more than $200 million from clients. He tried to commit suicide on Monday by asphyxiation. He left a suicide note saying he had forged financial documents for 20 years until the losses became too large to hide over the last several weeks. He said in the note, "I have committed fraud. For this I feel constant and intense guilt. I am very remorseful that my greatest transgressions have been to my fellow man. Through a scheme of using false bank statements I have been able to embezzle millions of dollars from customer accounts at PFGBest."
The initial charge was "making and using false statements" but prosecutors said it was just the beginning. Read Article with details Wasendorf was just married on June 30th in Las Vegas. How is that for a honeymoon present?
Richard Wasendorf Sr
Apple shares rebounded after the company said it made a mistake in withdrawing from the Electronic Product Environmental Assessment Tool (EPEAT). The agency is a global registry where consumers can turn for information when shopping for greener electronics. Apple dropped out of the organization after its ratings on some items declined due to the new manufacturing requirements to make them slimmer, faster, cooler, etc. For instance permanently gluing the battery into a laptop made it harder to recycle so the rating declined. Apple apparently thought the agency was not worth the effort but they found out otherwise. Government agencies, colleges and companies like Ford and KPMG require electronics they purchase to be listed on EPEAT. The City of San Francisco has a policy that any electronics they buy have a minimum rating of "gold" on the EPEAT system. Almost immediately after news broke they had left the system the complaints appeared. On Friday Apple SVP Bob Mansfield said "I recognize this was a mistake" in an open letter on the Apple website. Apple quickly rejoined the EPEAT system.
Ford (F) warned that European sales fell -10% in the first half when it decided not to match heavy discounting by rivals as the region fell back into recession. In June alone sales declined -16.1% in its 19 western European markets. The chief of Ford's European sales said, "The economic environment in Europe remains very difficult." In late June Ford said Q2 losses in Europe may have tripled from the -$190 million loss in Q1.
In related news Peugeot announced it was closing some facilities and laying off 8,000 workers. Peugeot said it was losing $245 million a month. On Saturday the new socialist president of France immediately demanded that Peugeot reconsider its plan for the layoffs. Hollande said the announced layoffs are simply not acceptable. He said Peugeot should not be allowed to terminate anyone unless the company has found them new jobs elsewhere or has supplied them with "voluntary" settlement packages. In other words Peugeot would have to offer workers huge cash settlements to leave but workers would not have to accept. Hollande said Peugeot made bad decisions in the past about application of funds to increase profits and benefit shareholders. He would not allow those past decisions to hurt 8,000 workers and would "exert pressure" on Peugeot to keep the plants open. He promised a government rescue plan for the ailing auto sector to be announced by July 25th that would include incentives for purchasing Peugeot cars. Welcome to the new socialist state of France and what may soon be the nationalization of Peugeot.
Volkswagen was at least breaking even with European sales growth of +1.8%. Unfortunately they warned that would change in the second half with a rapidly declining outlook.
A major problem in Europe that has not received much play in the U.S. as yet is the LIBOR scandal. (London Interbank Offered Rate) Reportedly up to 15 major banks may have conspired to manipulate the rate between 2005-2008. The Federal Reserve may have known as early as 2007 that the rate setting process was flawed but probably did not know it was being manipulated. In 2008 Tim Geithner sent suggestions to British banking authorities on how the process could be improved. The CFTC estimates there are more than $800 trillion of financial instruments pegged to LIBOR, including $350 trillion in swaps. Numerous suits have already been filed and hundreds more are expected.
Last week Barclays paid roughly $450 million to settle charges that its traders manipulated LIBOR. That was probably the best decision they have made in years. Analysts believe the eventual fines and awards could be in the tens of billions if not more. Morgan Stanley said a rough calculation could be $14 billion through 2014 but acknowledged the estimate was a crude calculation of regulatory fines and costs. LIBOR has been the base rate in almost every financial instrument for the last 20 years. The potential for damage awards is enormous.
The S&P rebounded +22 points on Friday but that was only about half of the loss since the 1375 high on July 3rd. The S&P declined to 1325 on Thursday. The rebound saw the S&P close within three points of the 100-day average at 1360 and a critical level that has seen repeated tests in June/July. The S&P gained +19 points in the opening spike and then spent the rest of the afternoon consolidating before short covering at the close added the additional three points.
I believe the 100-day will provide strong resistance but a breakout there would encounter even stronger downtrend resistance at 1370 and the July high at 1375. It will not be easy to move higher but not impossible on the right news.
The short squeeze or relief rally, whatever you want to call it, occurred on only 5.3 billion shares. That is very low for 200 point Dow move. Market reporters were bragging on the breadth but I did not see it. Advancers were only a little more than 3:1 over decliners.
However, the actual rebound started on Thursday afternoon. Whether that was just shorts deciding to exit ahead of China and JPM or there was some other reason other than oversold we will never know. With Friday's rally we have gone from oversold to overbought in about 24 hours. Follow through on Monday will be the key to the puzzle but it still may not last without some major headlines to keep the move going.
The Dow may have spiked on the JPM news but it was IBM, CAT, BA and UTX doing the heavy lifting with gains over $1.75 each. Hewlett Packard (HPQ) was the only Dow stock to post a loss. The +200 point gain was only enough to recover half of the prior loss and push the Dow to a +4 point gain for the week.
Techs will rule the Dow next week with the big three, MSFT, INTC and IBM reporting earnings. Financials will help with AXP and BAC reporting. Bank America is expected to post a huge relative gain because Q2 last year contained a monster loss. However, with BAC only an $8 stock the impact on the Dow will be negligible.
Dow 12,900 is the key level to watch. A breakout there could trigger additional short covering. Key support is 12,600.
The Nasdaq lagged the other indexes in relative performance. The +42 point rebound left the index still 80 points from its July highs. It would take two more days like Friday just to recover the losses from the prior week.
Note that all the big caps are represented in the winners list but the amount of their gains was minimal. For Apple to gain $6 after declining nearly $30 in the prior two days was lackluster to put it mildly. Google had declined $38 and gained only $6 on Friday.
Initial resistance is 2930-2935 followed by the 100-day at 2952. Support would be the Thursday low at 2840.
Nasdaq Winners & Sinners
The Russell was 100% a short squeeze. It spiked to 800 at the open and closed at 800.68. There was no further gain and you can tell by the very narrow range after the open that there was no volume and no volatility. Volume in the Russell 2000 stocks was only 729 million shares and the lowest volume day of the week.
Russell 2000 Chart - 30 Min
Next week is option expiration. That means Friday should have been volatile with high volume with most funds closing option positions in the week before opex. Those expiring options were just one more reason why the squeeze was strong. All those puts were flushed when the spike began.
The questions for next week are these. Are negative earnings already priced in? Are expectations too low? What kind of guidance should we expect?
If a small earnings decline is already priced in but companies warn on their second half outlook will that cause a market disruption? If you think about it most companies are probably going to take the "Europe ate my earnings" excuse and use it to hide other problems they want to flush through the books without anyone noticing. If you blame Europe in the headlines you can then blame inventory markdowns on Europe as well. Call it a kitchen sink quarter where everyone can sweep their dirt under the European rug.
In keeping with my prior analysis I would be looking for any pause in the rebound to take profits in longs and establish new short positions. Market visibility is too clouded to suggest the rally continues unless there are some earnings surprises we are not expecting. I would love to be writing this commentary next weekend and talking about the S&P testing resistance at 1425 but I am not expecting that to happen.
The wildcard is the Bernanke testimony. QE addicted traders are wishing for one more fix. If Uncle Ben does not break out the QE commentary we could see some disappointed traders go into withdrawal again.
Enter passively, exit aggressively!
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"I would give my right arm to be ambidextrous."