It may have been July 24th for traders but it was an unlucky Friday the 13th for the Nasdaq. The streak of consecutive daily gains was snapped at 12 after Microsoft and Amazon cursed the Nasdaq with a -7 point loss.
Despite the -7 point decline in the Nasdaq the markets remained bullish after a week of conflicting earnings. Various resistance levels were broken and the major indexes were up over 4% for the week. For the second and busiest week of earnings season so far it was a resounding success.
On Friday there were little in the way of economic reports to subdue the bullish enthusiasm of traders. The only report of note was the Consumer Sentiment Survey for July with a headline number of 66.0. This was +2 points better than the first reading for July but still -5 points below the 70.8 reading in June. The biggest decline came in the expectations component, which fell to 63.2 from 69.2. The present conditions component fell to 70.5 from 73.2. The 66.0 headline number was the lowest reading since April.
Factors causing the decline included larger job losses in June, continued house price declines and foreclosures, the rise in interest rates cutting off refinancing efforts and worries over the change in Washington. The growing fight about the health care reform along with the rising expectations for cost and taxes needed to pay for it has soured the outlook for American taxpayers. For generations politicians have been claiming new programs would not raise taxes and eventually they always find a way to tax somebody for the new benefit.
The new health care plan has polarized the nation with 57% now strongly against it, 33% for it and 10% with no opinion. The numbers opposed are growing because of the taxes being discussed but more importantly the details of the plan. There is a rapidly rising backlash from the retiring boomer generation who are being told the government is no longer going to approve the expensive drugs or operations needed to keep them alive. The thought of being "counseled" every five years as called for in the plan on how to die early and gracefully is not being met with open arms. This sounds more like a science fiction plot than a new health care plan for America.
The worries over the plan details and how to pay for it have taken on a life of their own in the press. Consumers feeding on those rumors and then passing them on to others with their own embellishments are compounding the problems and weighing on consumer sentiment. Most analysts believe a lot of the market rally this week had more to do with the apparent slowing of the plan than with the earnings being released. On Friday the Dow shot up +25 point when the leader of the blue dog democrats, Mike Ross, said the plan was dead and there was no chance for a deal. Unfortunately Ross appeared again later and said talks would resume on Monday.
Consumer Sentiment Chart
The economic calendar for next week has a couple of high profile events in the Beige Book and the GDP report for Q2. The Fed Beige Book on Wednesday is an update on the economic conditions in all 12 Fed regions. We would hope to see another uptick in conditions heading into Q3. This is a preview of the two-day Fed meeting in two weeks.
The second quarter GDP report on Friday is the critical report for the week. The last reading on the Q1 GDP was a drop of -5.49%. The estimates for the Q2 GDP range from -1.6% to +1.8%. Any reading in positive territory would prompt a monster rally in the market. The consensus opinion is closer to a -1.5% decline, which would be a major improvement but still in a recession and inline with what the market is expecting.
Next week will be a major debt auction by the government. $205 billion in various notes and short-term bills will be auctioned starting on Monday. This is a massive amount of supply but because it is mostly short term notes all the auctions are expected to succeed. The 2-5-7 year notes will be the largest ever auctions of these notes on record. However, as I have cautioned before, the more debt the government is forced to sell the better the chance for an auction to eventually fail. Even if there is no failure the sheer volume of supply is going to force interest rates higher. I added the various auctions to the calendar in green.
Until the GDP report on Friday the focus will be on earnings with over 500 companies reporting. This is the busiest week of earnings season but there are only a couple dozen companies you would know. Out of the 500+ reporting I had a hard time filling the graphic below with symbols I thought everyone would recognize.
There are five Dow components reporting (those in green) and by the end of the week 70% of the S&P will have reported. Currently the stats are 77% have beaten earnings per share estimates, 14% have missed and 9% reported inline. Those statistics are misleading.
In the first graphic below are the 30 Dow stocks. Those with a colored background have already reported. The ones in green beat the earnings per share estimates, yellow reported inline and red missed the estimates. Based on this graphic and the +77% statistic above it looks like a blowout earnings season.
Dow Components By Estimate Result
However, the graphic below tells a much different story. Those stocks in green beat their revenue numbers and those in red missed estimates on revenue. Boeing was inline. This graphic is telling us the real story. The majority of companies are beating estimates per share because of dramatic cost cutting measures. Laying off tens of thousands of workers, forcing vacations, cutting salaries, closing plants and slashing advertising budgets allowed them to beat the earnings per share estimates. Unfortunately the gains are not repeatable unless you can make the same cuts this quarter.
For earnings to be investor worthy they must come from rising revenue in the form of increased sales. Obviously we are in the middle of a recession and sales for nearly everyone are down across the board. Those that did beat the lowered estimates did not do so without a lot of pain and their management should be commended. The key for investors at this point is the outlook. Quite a few companies have guided lower and a rare few have guided higher. Those that guided higher should be the leaders when the rebound really catches fire.
Dow Components By Revenue Result
There is a bright side to this story. As we have seen in prior recessions those companies that really cut the fat to trim down to a fighting weight will see earnings explode once the real recovery begins. They have cut millions if not billions in salaries, sold off non-core businesses, closed high cost facilities, etc. Now that expenses are dramatically lower they are poised to really dish out the profits when sales pick up again. A deep recession is good for business balance sheets because they can flush bad decisions and hide the losses in the negative recession earnings.
Government Motors is a prime example. They cut 1000 dealerships, laid off tens of thousands of workers, cancelled unfavorable contracts and eliminated debt through bankruptcy. They don't have to sell nearly as many cars in 2010 to break even as they did in 2008. Obviously this is an extreme example but you get the picture. Their problem in 2010 will be selling go-kart sized economy cars to a consumer that wants a SUV. The new government appointed board with many non-auto members will be hard pressed to force a profit if the "green cars" turn to rust brown on the dealer lots while buyers move to SUVs produced by non governmental companies. But, as they say, that is another story.
The bottom line to the earnings story is that corporate America has completed the normal recession downsizing and is ready to go forth and do battle again on the global stage and retake market share when the recovery really begins. This is a bullish event and something that many money managers were anticipating in their purchases last week.
In the Dow table above you probably noticed that Microsoft (Nasdaq:MSFT) missed their earnings estimates on Thursday night. Microsoft stock was crushed for an 8.25% loss to $23.44 on Friday. This equated to about 17 Dow points. Microsoft revenue fell -17% to $13.1 billion. This was $1 billion less than analyst estimates. Microsoft lost almost $20 billion in market cap on Friday alone. Microsoft said their revenue declined because of an overall shift toward cost-conscious purchasing. However, they said PC sales had flattened in recent months suggesting the worst was over.
There is light at the end of the tunnel for Microsoft. They are going to release Windows 7 in October and this should be a very strong release and a cash cow for Microsoft. They are also seeing a rise in interest for Windows Server 2008. Many IT departments had not upgraded from Server 2003 to 2008 because of the Vista problem. There was some hesitancy to upgrade before the recession hit and during the recession nobody was spending money on upgrades. That is changing now and this is likely to be a low point for Microsoft. I would be thrilled to see a further decline to $22 for a long entry point.
Amazon (Nasdaq:AMZN) was the other stinker on Friday after their earnings report failed to impress investors. Amazon earned 32-cents per share and analysts expected 31-cents. That was a -10% decline from the year ago quarter. However, the revenue number was a little light at $4.65 billion compared to $4.69 billion. Amazon guided inline for Q3. Basically sales were flat on books, CDs and DVDs while overall sales rose +14% thanks to sales of the $299 Kindle book reader. At least one analyst theorized that Amazon's margins declined because they were selling fewer paper books because they had sold so many Kindles. I question this theory. To sell a paper book they have to order it, store it while they wait for a buyer then a person pulls it from inventory, packs it using costly supplies and ships it by USPS to the buyer. All of these things are margin intensive.
I have a series of paperback books I have been reading for years. They cost $6.99 at Amazon plus $3.99 for shipping. The Kindle version is $5.04 with instant availability and no shipping charges. A Dale Brown hardcover is $19 plus shipping while the electronic version is $9.99. I don't know what Amazon pays for each electronic version they deliver but you can bet it is a lot less than the paper books they buy. I am sure Amazon makes a profit on the paper book shipping but I doubt it is very much and on orders over $25 shipping is free so they are eating that cost. Personally I think Amazon is poised for the future with the Kindle and I doubt Jeff Bezos would have gone to all the effort for a break-even product. I have also heard from Kindle users that they buy more electronic books than they ever bought paper books simply because of the convenience and the reduced cost.
Amazon dropped -$7.38 on Friday but that came after a +5.22 gain the day before. Several analysts upgraded Amazon and some downgraded it so the community is split on Amazon's future. With the Zappos.com acquisition they are proving they will remain the web's number one retailer. I was a bear on Amazon for a long time but I have switched sides over the last year. I would love to see a bout of Nasdaq profit taking so I could get long AMZN closer to $75-80. Resistance is strong at $88 but long term I think it is going higher.
CIT Group (Nyse:CIT) completed its fall from grace when it was removed from the S&P-500 at the close on Friday. It was replaced by RedHat (Nyse:RHT).
The FDIC closed seven banks on Friday bringing the total for the year to 64. Six of the banks were in Georgia and were subsidiaries of Security Bank Corp. State Bank and Trust of Pinehurst Georgia assumed the deposits of all six banks. The FDIC will lose $807 million on the deal. State Bank received $300 million from a group of 26 investors to help the bank make the acquisition. In New York the Waterford Village Bank was closed. It only had assets of $61 million and will cost the FDIC $5.6 million to close. So far in July there have been 19 bank failures.
Guaranty Financial Group Inc, (Nyse:GFG) the second largest publicly traded bank in Texas with 150 branches, said on Friday it will probably fail after loan losses and writedowns left it "critically" short of capital. If it fails it will be the largest bank failure so far in 2009. GFG said it had turned over control to the Office of Thrift Supervision (OTS) until the final resolution. However, Carl Icahn owns 17% and Robert Rowling of Omni Hotels owns 19%, both through companies they control. With those heavyweights involved the outcome is not certain and you can bet they are negotiating with the FDIC for a bargain settlement. Last September Washington Mutual with $307 billion in assets was closed for the largest U.S. bank failure.
The +947 point Dow gain over the last two weeks is the best two-week gain for the Dow since 2000. There seems to be no stopping it after it moved over resistance at 9000 on Thursday. Friday would have been the perfect day for profit taking after Dow component Microsoft tanked both the Dow and the Nasdaq. Microsoft was responsible for about -17 Dow points and UTX another -10. However, the -65 point drop at the open was quickly erased and the Dow closed at another new seven-month high.
How much longer can this rally continue? It depends on whom you believe. Technicians are conflicted about the breakout versus future resistance. Some believe it could run for several more weeks and of course there are others who believe it won't last until the August 7th Jobs Report.
I heard an interesting report from Mary Ann Bartels, Chief U.S. Market Strategist and hedge fund tracker for Merrill Lynch. She publishes a weekly report of hedge fund trends. Bartels claimed on Friday that hedge funds were still net short Nasdaq stocks and were selling their S&P longs. She said there were continued outflows in Q2 but Q3 could see inflows of $40-$65 billion. She said for Q2 hedge funds will likely post their best quarterly gains since early 2000. Investors are moving back into hedge funds now that the market bottom is behind us and the financial system is intact. Hedge funds will need to put that money to work and that suggests they will have to close their Nasdaq shorts. Those Nasdaq shorts were planned to take advantage of the normal Aug-Oct Death Valley Days of summer for tech stocks. I would say that is not working out well for them this year.
Bartels said there was $3.65 trillion in cash in money funds, $1.21T in uninvested cash in brokerages accounts and another trillion or so in miscellaneous accounts. The combined buying power in the equity market was roughly $16 trillion and once the tide turned and hedge funds decided to go long again it was going to be a strong rally. Heck, if the events worked out as she expects we will be dusting off those Dow 10,000 hats again soon.
It is very hard for me to recommend anyone go long today. With the Dow up 10% in the last two-weeks it would seem to be the worst possible time. That is the way many rallies actually occur. They are unexpected and run much farther than anyone expects because the shorts just keep feeding the flames. It is not logical but it happens.
The advance/decline chart below was making the rounds on Friday in an attempt to illustrate the absurdity of going long the current market. (Must be those hedge fund guys trying to rescue their Nasdaq shorts) The S&P-500 10-day Advance/Decline line rose to its highest point in over a year. This is the same level where the advance failed after the end of December rally and the initial March rebound. Just reaching this point does not guarantee a correction but it does suggest that we have reached a market extreme that should require a pause.
S&P A/D Chart (Red overbought, Green oversold)
For chartaholics you can easily find your choice of oversold charts or charts showing breakouts and be content that your bias is still intact. Unfortunately your bias does not count. I have been expecting a short-term break in the upward trend for over a week. It didn't do me a lot of good because the market does not care what I think.
The market consists of millions of investors buying and selling stock based on their individual ideas of a stocks future. Most individuals don't try to time the markets. They just buy something that attracts their interest and then watch it every day for several weeks then they forget it. Fortunately the market is not driven by individuals or it would be very boring.
The market is driven by hedge funds, mutual funds and by Goldman Sachs. 25% of market volume is routinely attributed to program trading at Goldman Sachs. I have no idea if that GS claim is true or not but like an urban legend the story continues to make the rounds. On Monday they called for the S&P to rally 15.5% so they must have been long. Goldman said the forecast was due to better than expected Q2 earnings and the likelihood this trend will sustain itself through an economic rebound in the second half of 2009.
A noted insider trade tracker Jonathan Moreland said Goldman was full of hot air. According to Moreland insider buying over the last week fell to the lowest level since July 2002. If conditions were improving insiders would know it first and be loading up on stock. Maybe Goldman's hot air was actually smoke to pump up the market for their existing longs. TrimTabs Research agreed with Moreland and released their own list of statistics. This insider tracking is key because historically insiders are right about stock direction about 80% of the time. Both trackers are warning that the rally won't last.
You have to wonder if hedge funds really have any control of the market if they have been short the Nasdaq for the last month. If they are truly short as much as Bartels claims then we have them to thank for the rally but not because they got it right. Because they got it wrong we benefited from the monster short squeeze.
That leaves mutual funds as the balancing factor in the market. In theory they don't trade and purchases are driven by deposits into retirement accounts. Despite 10% unemployment the vast majority of those deposits are still flowing into mutual funds. Those investors who self direct their retirement accounts are seeing the markets rally and I would bet they are shifting some of that money from the safety of bonds and money markets and back into stock funds. These funds have to put the money to work. Most don't have the luxury of sitting on the cash until they feel the time is right. Some funds do but most do not. They have to invest the money within days of its receipt.
We know the average individual is not a market timer. Their idea of market timing is seeing a headline in the Saturday paper about the 5% Dow gain for the week. Gee whiz Mabel, the market is hot again. I am going to move that money back into stocks so we don't miss out. That is how a rally continues unexpectedly. There are roughly 140 million people in the U.S. with retirement accounts. If only a million people had this same thought that equates to a lot of money appearing in fund accounts over the next week.
I know this is true from past experience but I had it vividly brought to my attention on Friday. I was in a restaurant at lunch on Friday and the big screen TV was set to CNBC. I was watching one of the market reporters talking about the stocks higher for the day when an unknown male alone at the next table interrupted my thoughts with "Those solar stocks are hot but so is the entire market. I just transferred all my money back last week. I think we will be back over 12,000 by year-end." I never saw the guy before and that was the first and only words spoken between us. The dumb look on my face after his statement probably scared him off.
The point I am trying to make here is that market experts and technicians can chart and plot and predict until hell freezes over but it all boils down into cash flow. If John Q Public is moving money back into his stock funds and the top 5% of the tax paying public is buying back into hedge funds then the bottom is definitely behind us but that does not mean the economy has recovered. The market will recover well before the economy. The Dow has already rallied +2600 points off the Market lows but that does not mean it can't go higher.
In March stocks were priced for Armageddon. Today, even after the rebound they are only priced for today's less bad earnings. If the economy is going to be significantly better six months from now with GDP at +2.4% then the current rally is just the beginning. Remember most companies have cut the fat and trimmed down to their fighting weight. Once the economy finds traction the earnings are going to explode and stock prices will follow.
That brings me back to next week. After a +10% to +15% rally over the last two weeks I would have a hard time going long almost any stock. That is like watching red come up on roulette 10 consecutive spins and saying I am not going to bet on red because it has to be black soon. The law of averages says it should be black but nothing says it has to be black. The longest run I have ever seen was 27 reds in Mesquite NV 14 years ago. Tens of thousands of dollars were being lost on every roll because nearly everyone at the table along with every bystander who could throw down a bet were betting on black. After 27 rolls black did come up but most bettors had already busted out.
James and I were talking Friday night about Option Investor plays for the weekend. The conversation was something like "how can I suggest going long after the last two weeks?" There is no right answer. Just like red in the story above the market can remain irrational far longer than an investor can remain liquid. Sometimes you just have to wait and the right answer is to do nothing. I am having the same problem this week trying to find plays for Option Writer. My preferred strategy is to write puts but who in their right mind would write at the money puts on a stock today? Volatility is so low that only options at the money have any value. Go one strike in either direction and options are worth pennies. The VIX is now 23 and in full retreat. There is absolutely no fear in the market.
The Relative Strength (RSI) on the Dow chart hit 71.62 on Friday and the highest level since June 2007. This is extremely overbought but does not guarantee a bout of profit taking. For instance in the second chart from 2007 the RSI hit 81 followed by one day of profit taking and then five more days of gains. In 2006 the RSI hit 81 and saw four days of profit taking and went right back to rally mode for four more months. Nothing guarantees a bout of profit taking regardless of how badly traders want it.
Dow 2007 Chart - RSI 81
Dow Chart 2006 - RSI 81
The Dow has rallied past 9000 and right to the extreme upper limit of what could be considered resistance from January at 9088. That would be stretching to accurately call it resistance but then rally failures have occurred on less resistance than that.
While I believe that we are over due for profit taking I believe it would only be a pause in the continued uptrend. On the Dow the next resistance is 9635 and well over the current 9088 level. A positive GDP on Friday could power that rally.
The ideal market move for next week would be a three-day pause before the Beige Book on Wednesday and then a light "preparation" rally into Thursday's close on hopes of a decent GDP on Friday. With that kind of setup any decent GDP number could kick start the next move higher. Likewise a depressing GDP could poison market sentiment again with worries about a double dip recession.
A double dip recession is one where the economy recovers into positive territory and then immediately falls back into recession. This is normally caused by a lack of consumer demand for goods and services due to a lack of jobs and tight money/credit. Sound like where we are today? I would rather not go there but several noted analysts are predicting this to happen.
Dr Doom, (Roubini) is predicting a long climb out of the current recession or a double dip if our current recovery loses traction. Economist Martin Feldstein, Professor of economics at Harvard, is predicting a double dip where the economy drops back into recession in Q4. There are several others circulating on the talking head circuit but you get the idea.
What the market does next week is not dependent on the double dip scenario. Next week the markets will be driven by cash flow into funds and continued Nasdaq short covering by hedge funds. The Dow will be looking to add one more day to its string and hopefully close over 9100 and then higher.
The S&P is showing the same chart pattern as the Dow only the S&P has resistance at 1005. The S&P has rallied +109 points since July 8th and only has the 1005 hurdle to cross before setting up for a long road higher, economy permitting. Like the Dow the RSI is climbing off the scale.
The ideal scenario for the S&P would be a pause early in the week and a rally to just below 1000 then a monster spike over that 1005 resistance on a positive GDP number. That is probably like wishing for 15 reds in a row but at least it gives a trader something to wish for.
The Nasdaq hit 13 days and got a double dose of bad luck. The double earnings whammy of a Microsoft miss and an Amazon disappointment combined to keep the Nasdaq 7 points in the red and snap the winning streak at 12. The +12% gain over those 12 days was not even close to the gains made in prior 12-day streaks. There were nine 12-day streaks since the Nasdaq began trading. The biggest gain was +29.31% that ended on 4/20/01 followed by 22.45% on June 9th, 2000 and 21.55% on Oct 26th 1998. The longest Nasdaq streak was 19 days ending on August 31st 1979 but the gain was only +5.64%.
I believe the Nasdaq took a well-deserved day of rest. Neither Microsoft or Amazon are going to remain down for long and the damage they caused was temporary. Monday will be a new day and a new chance for redemption. There is no material resistance until 2000 and again at 2200. However the biggest resistance may simply be the built up profit that needs to be equalized before it can go much higher.
The two biggest gains last week from primary indexes came from the Russell at +5.63% and the Dow Transports at +6.71%. Both of these outsized gains are providing confirmation of a major market move. The Russell lagged many times over the last couple months but caught fire last week and rebounded to close exactly at critical resistance at 550. The outsized gain suggests money managers are putting money to work despite the short term overbought conditions. Long term we are not even close to overbought. A breakout over 550 would be a major confirmation of bullish sentiment and fund manager involvement.
Dow Transports Chart
There is no sure answer for next week. We are due for profit taking just like black eventually follows red. It could be Monday or two weeks from Monday, nobody knows for sure. When it does come I would view it as a buying opportunity. Unless the economy begins to weaken I believe the worst is over and any pauses will be to reload for the next push higher rather than the start of a new leg down. Beware the Beige Book and the $205 billion in debt for sale. Let's all keep our fingers crossed for a GDP surprise to the upside.