Option Investor
Newsletter

Daily Newsletter, Tuesday, 5/25/2010

Table of Contents

  1. Market Wrap
  2. New Plays
  3. In Play Updates and Reviews

Market Wrap

Massive Rebound But Still A Loss

by Jim Brown

Click here to email Jim Brown

After the Dow gave up -292 points at the open there was a massive rebound at the close that pushed the S&P back into positive territory.

Market Stats Table

It appears multiple hundred point drops and reversals have become the norm. Tuesday's -292 point opening drop to a seven month low at 9,774 was almost erased by the rebound to close at 10,045 but the dip buyers lost traction at the close. The spreading contagion in Europe continues to be a problem for the markets along with talk of war in Korea and worries over declines in the global economy.

The markets had priced in a robust global recovery in 2010 but the problems in Europe and China have soured that optimistic outlook and produced a blue light special buying opportunity in equities. At today's lows the Dow had declined by -13% in less than a month from the 11,258 high on April 26th. The S&P has declined -14.6% and the Nasdaq -16%. These types of declines combined with a dip to critical support levels produced the +271 point Dow rebound.

Today was a busy day for economics but the reports were mostly ignored. The Consumer Confidence report for May came in at 63.3 and a new cyclical high. This compares to 57.7 in April. The biggest gains came from the expectations component, which jumped from 77.4 to 85.3. Those planning on buying a car rose from 5.4% to 6.0% but those planning to buy a home fell to 1.9% from the 2.8% cyclical high in March. Those expecting an increase in income rose nearly a full point to 11.3%. Those expecting more jobs within six months rose to 20% and the highest percentage since 2003. Confidence would really have moved higher were it not for the sharp decline in expectations for the stock market after the peak in April and began to move lower. Market pessimism increased through early May as the flash crash on May 6th rocked investor accounts.

Consumer Confidence Chart

The Case Shiller home price index posted a +2.3% increase in prices for March but the lagging report was ignored. We are already hearing anecdotal reports about the dramatic decline in housing activity now that the tax credit has ended. Starts have died as builders cut back significantly on the number of homes they are willing to build for late summer delivery. Lumber companies report a sharp decline in orders due to the cutback in building. Cement prices are also falling. Realtors are reporting a complete lack of shoppers. Moody's said they believe home prices will decline for the rest of the year although the rate of decline will be slower than the prior decline with a 5% drop through year end. Last week we saw a record rate of foreclosures and distress sales are expected to rise.

May housing reports are going to be extremely negative once into the June reporting period and they are only going to get worse as the summer buying season ends. Be prepared for the news and the negative market reaction. Everyone should already know it is coming but the lagging nature of these reports tends to let investors forget the problem until the report appears.

There has been an increasing worry that the U.S. could slip back into a double dip recession because of the housing decline and now because of the impending decline in global growth. U.S. economic reports have gone from a solid improvement to a mixed bag with some indicators beginning to weaken. The Richmond Fed Manufacturing Survey today declined from 30 to 26 and the first decline since December. Any number over zero still indicates growth but that growth is slowing in the Richmond region.

New orders declined to 36 from 41 and employment declined to 4.0 from 13.0. Capital expenditure plans decreased as manufacturers started pulling back again.

Richmond Fed Survey Chart

The drop in the employment component in the Richmond Survey corresponded with the spike in new jobless claims to 471,000 last week and the spike in mass layoffs on Friday. The Mass Layoff report showed the number of events involving more than 50 workers rose to 1,856 events in April from 1,628 in March. The number of workers involved rose to 200,870 in April from 150,864 in March. This is not the directional trend investors want to see.

Economic reports due out on Wednesday include the Mortgage Applications survey, Durable Goods, New Home Sales and Oil Inventories.

The market depression is not coming from our economics but from the increasing worries over Europe. Italy and Spain are now the focus and a bank closure in Spain over the weekend plus some sudden mergers of others prompted more concern. European finance ministers appear clueless as to how to end the contagion.

Italy will attempt to sell €8 billion of six-month bills on Wednesday and there are worries over what rate they will have to pay to borrow the money. In April they paid .81%. Spain paid .79% to sell debt in April and 1.2% to sell new debt in May. Rates are rising across the Eurozone and many of those economies can't afford to pay progressively higher rates. The credit default swaps are rising dramatically. Libor rates, the rates banks charge each other, are rising sharply and hit a new 10-month high overnight. This suggests European banks are becoming more reluctant to loan to each other just like countries are becoming more reluctant to buy sovereign debt from others.

One analyst said credit is the blood flow of commerce. As long as banks are lending money corporations can buy inventory, raw materials, fund employees and make investments to expand their businesses. European banks are already in trouble because of loans to Eurozone countries. Those loans have been written down to the point where the banks are under capitalized and every day the sovereign debt worries continue those banks will be reluctant to make business loans as they try to conserve cash and rebuild their reserves.

On Monday Treasury Secretary Geithner was pushing the idea of a stress test for European banks. The possibility of a stress test at a time that banks are under stress is realistic BUT it means banks are going to restrict lending even more than before in order to raise cash. It is a serious situation where banks are stressed but the potential for a stress test could actually cause an even sharper decline in economic activity. When the U.S. conducted stress tests they said any bank that needed additional capitalization as a result of the stress test results would be given TARP funds to keep them afloat. European bankers claim the EU does not have the capital to support thousands of banks if they are found to be undercapitalized because they own millions or even billions in questionable EU debt. Therefore a stress test would point out the problems but offer no cure.

A new ruling in Italy cast more suspicion on Italian banks. The government said Italian banks no longer have to recognize market to market losses on government debt. That means Italian banks can report profits but don't have to recognize losses or raise capital to offset those losses. This also means Italian banks can no longer be trusted because their balance sheets are bogus.

Spain was the topic of the day because of the bank closure and sudden bank mergers. Spain has one trillion euros in foreign debt while Greece only had €300 billion in foreign debt. A debt problem in Spain would be much worse than Greece. All of the stock markets for the weaker EU nations, Italy, Portugal, Ireland, Spain and Greece are experiencing bear markets of more than 20% declines.

In addition to the European problem we had an escalation of the situation in Korea. U.S. lawmakers voted overwhelmingly by a 411-3 margin to approve a resolution condeming North Korea for sinking the ROKS Cheonan and called for an apology by NK. Earlier in the day North Korea put its 1.2 million man army on the highest possible war footing alert. NK has said it will react with total war to any provaction by South Korea. There are calls for new U.N. sanctions and South Korea has severed all ties with NK and prohibited NK ships from entering NK waters and ports. NK also severed all ties with SK and prohibited any SK ships and planes from transiting NK airspace or waters.

SK and the U.S. navy are conducting joint exercises off the coast of SK as a warning to NK to not do anything stupid. Maybe I should say "more stupid" since Kim Jong Il has not been a model of intelligence. SK said it would resume radio broadcasts and use of loud speakers along the border as well as large billboards urging North Koreans to defect to the south. The worry over a possible Korean conflict helped to depress futures overnight but the U.S. military said late in the morning that no troop movements or war preparations had been seen in the north despite what Kim Jong Il said in the press. The U.S. announcement calmed nerves and eased the pressure on the equity markets.

Another plus for the equity markets came when Barney Frank said a provision in the Senate version of the financial reform bill could be cut from the final version. The provision requires banks to spinoff their derivatives businesses and was intensely disliked by Wall Street. Frank said the provision went too far and would likely be cut. However, the provision that prevents banks from trading with their own money would likely remain in the committee version.

The dollar rallied again to touch the 52-week high set last week at 87.45 on the dollar index. The euro lost ground again overnight to trade under 122. This is setting up a very negative earnings warning cycle. We are nearing that cycle again for Q2. With less than six weeks until the first Dow component reports on July 12th we are only two weeks from the start of the earnings warning cycle. Any company that receives a large portion of its revenue from Europe is going to be forced to report some serious currency translation losses. Unless your hedging department is doing an outstanding job the 20% decline in the euro over the last six months is going to be painful. Add in the decline in economic activity in Europe and those multinational companies are going to disappoint.

You may think there are only a few companies that fit this model but more than 50% of the S&P derive more than 50% of their earnings from overseas. For instance Intel gets 77% of their revenue from overseas sales. The strong global recovery that was priced into over the last nine months is going to be removed as estimates for global growth are reduced significantly.

At one point today only one S&P company was in positive territory. That company was Autozone and it closed the day with a +$10.32 gain. The company reported earnings after the close on Monday that beat the street by a mile. Earnings of $4.12 per share beat street estimates of $3.59 per share. This was a 17% jump in net income. Autozone (AZO) said it opened 21 new stores to bring its total to 4,521. The company said parts sales had been brisk as consumers tried to lengthen the life of existing cars rather than trade up to a new one. Sears Chairman Eddie Lampert owns 40% of Autozone.

Autozone Chart

You can pay them millions but you can't force them to be polite. Yahoo's CEO Carol Bartz dropped the F*bomb in another TV interview. Her foul mouth has made her a target by reporters as they try to get her to unload on them so they can write her up for the use of profanity rather than the progress Yahoo is making under her guidance. Personally I think it shows a lack of character when a professional can't control her words in a public interview. This has become a rather routine event for Carol and I wonder how her shareholders feel about he spewing profanity on TV.

Yahoo CEO Carol Bartz

I was in Michigan for much of last week for my son's wedding. Michigan needs to spend a few million more dollars on those TV ads by actor Jeff Daniels on what a great place Michigan is for businesses. Every block was littered with boarded up buildings with sale/lease signs in the parking lot. You can tell they are getting no lookers because the signs themselves were in a serious state of disrepair. If you need to move a business or start one I bet you can get some killer deals on real estate in Michigan.

The CBO said today that the $893 billion stimulus package raised the GDP by +4.2% in the first quarter and put 3.4 million people to work. Obviously Michigan was standing in the wrong line when the money was doled out. Since the BLS only reported job growth of 573,000 jobs in the first four months of the year you have to wonder where those 3.4 million jobs reported by the CBO were created. The Bureau of Economic Analysis, the agency that reported the official GDP numbers only reported a +3.2% gain in GDP for Q1. I suggest we create a new job and hire a person that can coordinate all the government releases and keep them on the same page.

Crude prices dipped with the equity market and sank to a low of $67.15 intraday before rebounding to $70 at the close. Crude prices are falling due to the rising dollar, expectations for slowing demand in Europe and the potential for the 16th weekly increase in inventories over the last 17 weeks when the EIA reports on Wednesday. After the bell today the API reported a 616,000-barrel increase in crude inventories but a -3.19 million barrel decline in gasoline supplies.

Crude Oil Chart

BP has relented and agreed to broadcast the Wednesday attempt to halt the leak with a "top kill" procedure on the Horizon well. At the request of the administration BP already broadcasts a live video feed of the leak at Video Link Here but they had warned the video would be shutdown during the top kill procedure on Wednesday. Their reasoning was that since the mud would be injected into the well under extreme pressure it could flow in both directions up and down and it would give the impression that the procedure was not working. The administration requested the feed be kept live and BP relented.

The market volatility continues to increase in terms of point swings and internals but the VIX posted a lower high on Tuesday. The VIX hit 48.20 on Friday but only managed to hit 43.74 on Tuesday despite the lower lows on the indexes and the huge 292-point range. The VIX closed at a five day low of 34.61 thanks to the end of day rebound in the markets. One analyst pointed to the lower high as evidence the sellers could be nearing exhaustion and a bottom near.

The market internals are off the scale in terms of reversals and volume. The average daily volume over the last five days was 12.73 billion shares. This is nearly five billion shares per day over the 7-8 billion shares days we had during the market rally to the April highs. Volume today was 12.96 billion shares. The number of new 52-week lows today was 373 and that is the highest number since the February drop.

Normal investors can't trade in this kind of volatility. If you have a day job the concept of putting a trade on at the open and then checking on it when you get home at night is suicidal. Regardless of the direction of the trade a 300-point Dow range is sure to cause you grief. This is the kind of market where you either watch from the sidelines or day trade only. It will eventually pass but we could see additional volatility for quite some time. When it ends we will have seen some excellent long term buying opportunities.

Today was probably one of those days. The S&P traded to 1040 and slightly below the February low at 1044 and that could have been the signal traders were looking for. After pausing under that 1044 level for several hours the buyers started to appear and eventually erased the entire 35-point intraday decline.

If you are a technical trader looking for an entry point the prior material low, in this case the February low is a key point. The flash crash low of 1065 did not count because it was an artificial low created by some random computer generated bids and not real trading. The real low for the retest was February's.

Now that the low was tested the next key will be the 1085 resistance from the prior three days. A rebound that takes out that resistance has a good chance of ending the decline although it may not produce a V bottom recovery. I believe the market is still reeling from the volatility hangover and the daily confusion from Europe. Add in the weakening in the U.S. economics and the potential for a harsh warning cycle and it may take many weeks before the market is healthy again.

The "sell in May and go away" crowd had it right this year. However, whenever May experiences more than a -5% decline there is normally a rebound in the June-August timeframe. In recent history there have been nine May's with better than a 5% decline and the average rebound was +12% over the next three months. There were only two years where the markets continued lower. Past performance is no guarantee of future results and we definitely have our share of problems weighing on the markets in 2010.

The S&P is trading well below the 200-day average at 1103 and that could weigh on market sentiment for weeks to come. As long as that 1044 low holds we have a good chance the bulls will return to the market. However, a break of 1044 suggests a much lower event well under 1000.

S&P-500 Chart

The Dow traded below both the February low and the May-6th low and should have put in a tradable bottom but the conditions in Europe, China and Korea will be the determining factors. Investor flight from equities is in full swing and it may take positive news from the Q2 earnings cycle to restore investor confidence. Investors have been bitten by the volatility virus and the only cure is a return to a bull market trend. That could take many weeks if not months before the trend returns.

Dow Chart

The Nasdaq is not as clear as the S&P and Dow. The tech index did not return to its February lows and stubbornly clings to the 2200 support level. The big cap tech stocks tend to derive most of their revenue overseas so the currency translation problem is going to be severe for tech earnings. We could have a flurry of warnings 2-3 weeks from now and tech investors may want to see how bad the warnings are before moving back into the market. However, the fact the Nasdaq did not return to the same Feb levels suggests there are still buyers lurking just under the market.

Nasdaq Chart

The S&P was a picture perfect chart where support was respected. The Russell is also a picture perfect chart and taken by itself would definitely be a bullish sign. The Russell declined to exactly where it should have stopped and then rebounded back over the 200 day average at the close. This is the perfect spot for a strong rebound to begin IF there were no external problems overseas governing our market direction. I am amazed that fund managers are not showing any fear by dumping the small caps. To the contrary they appear to be holding their small cap positions despite the rockets red glare overhead. I would buy this chart for at least a rebound trade. Whether or not that support at 620 will continue to hold on a retest is a different question where the answer depends on the external forces in play.

Russell Chart

In summary, over the past several weeks I have told you that the path of least resistance was lower. That definitely proved to be true. I wrote that there was no compelling reason to risk new money until the various global forces faded. With the summer doldrums ahead and the potential for Q2 earnings warnings I felt there was no urgency on buying the dips.

Based on the levels reached today and the relative bullishness in the Russell I would buy Today's dip as a trade in hopes the near term overhead resistance on the S&P at 1085 would be broken. If that resistance fails I would go back to cash and wait for the smoke to clear.

As I wrote earlier I was attending my son's wedding in Michigan last week and was unable to write on Tuesday and Saturday. I appreciate Todd filling in for me and I appreciate your patience in my absence.

Jim Brown


New Plays

Countertrend Play on Energy

by Scott Hawes

Click here to email Scott Hawes


NEW BULLISH Plays

Console Energy - CNX - close 34.81 change +0.84 stop 32.95

Company Description:
CONSOL Energy Inc. (CONSOL Energy) is a multi-fuel energy producer and energy services provider primarily serving the electric power generation industry in the United States. During the year ended December 31, 2009, the Company produced high-British thermal unit (Btu) bituminous coal from 16 mining complexes in the United States. CONSOL Energy has two principal business units: Coal and Gas. The principal activities of the Coal unit are mining, preparation and marketing of steam coal, sold primarily to power generators, and of metallurgical coal, sold to steel and coke producers. The principal activity of the Gas unit is to produce methane gas for sale primarily to gas wholesalers. All Other segment includes terminal services, river and dock services, industrial supply services and other business activities, including rentals of building and flight operations. Its subsidiaries include CNX Gas Corporation (CNX Gas), Fairmont Supply Company and CNX Marine Terminal Inc. (source: company press release or website)

Target(s): 37.50, 38.80
Key Support Areas: 33.90
Key Resistance Areas: 35.75, 37.55
Time Frame: 1 to 2 weeks

Why We Like It:
I believe the sell off in coal stocks was overdone and they appear to be building momentum for a move higher. CNX double bottomed with lows on Friday and Monday and has responded nicely. The stock also has longer term support dating back to resistance in late 2008 (see weekly chart below). I would like to see some retracement in the recent gains and use $34.05 as a trigger to enter long positions. Our initial stop will be $32.50 which is just below 5/20 and 5/24 lows (pull up a daily chart). Our targets of $37.50 and $38.80 are both below the stock's 20 and 50-day SMA's and also below the recent downtrend line. This is a countertrend trade that has potential but I also view it as aggressive and quick so please use small position size to manage risk.

Suggested Position: Long CNX stock if it trades down near $34.05

Option Traders:
Suggested Position: Buy July $35.00 CALL, current ask $3.20, estimated ask at entry $2.80

Annotated Weekly Chart:

Entry on May xx
Earnings Date More than 2 months (unconfirmed)
Average Daily Volume: 7.0 million
Listed on 5/25/10, 2010


In Play Updates and Reviews

Our Portfolio has +8% Gains

by Scott Hawes

Click here to email Scott Hawes

Editor's Note:

Good evening. As I suspected in yesterday's updates we were forced to use our gap rule again today. It worked perfectly on Friday and also today as the none of the first 15 minute bars were taken out and the stocks rallied to close their gaps. All things considered, our positions have performed well. Current positions in our model portfolio have gained a combined +8% as of today's close. GE is the laggard but we're still alive. I have offered multiple targets and support/resistance areas to help guide you when exiting positions.

I remain in the camp that we will most likely consolidate at these levels for several weeks until a larger move to the downside comes later. However, I also believe that a geopolitical event could be a catalyst for a larger move down sooner rather than later. Picking a range has been tough but 1,040 to 1,100 on the S&P 500 seems logical. The problem is that we moved from 1,040 to 1,075 today. These extreme price swings are creating difficult conditions to manage swing trades. Using proper position size and having access to trade intraday makes a big difference. Lastly, taking profits when you can is a must. Please email with any questions.

Current Portfolio:


BULLISH Play Updates

Dr. Pepper Snapple Group - DPS - close 37.11 change +0.28 stop 35.95

Target(s): 36.80 (hit), 37.00 (hit), 37.50, 37.95
Key Support Areas: 35.75, 34.40, 32.70
Key Resistance Areas: 36.93, 37.15
Current Gain/Loss: +4.23%
Time Frame: 1 to 2 weeks
New Positions: No

Comments:
We were forced to use the gap rule on DPS today just like GE. DPS never took out the first 15-minute low and it was off to the races. The stock is currently above our first and second target and we have gained +4.23%. Considering the turnaround this afternoon I think it is prudent to see if we can squeeze more out of this trade tomorrow, but I don't want too get too greedy. I am going to keep our stop at $35.95 and also provide a new target at $37.50, which is just below the highs from May 20th. The stock also still has good support with its 20-day and 50-day SMA's below.

Current Position: Long DPS stock at $35.50

Entry on: May 21
Earnings Date: More than 2 months (unconfirmed)
Average Daily Volume: 1.9 million
Listed on: May 8, 2010


General Electric - GE - close 15.94 change -0.06 stop 15.94

Target(s): 16.25, 17.00, 17.45, 18.25
Key Support Areas: 16.00
Key Resistance Areas: 16.25, 16.80, 17.20, 17.80, 18.00
Current Gain/Loss: -5.82% Time Frame: Several weeks
New Positions: No

Comments:
Our gap rule worked perfectly with GE again today and kept us living another day in the stock. We'll see if there is any follow through to this afternoon's strength in the market, or will it be a dud similar to the Friday/Monday craziness. As I write this the ES futures are +11 points higher so it appears we may even gap higher tomorrow. Regardless of how we open, we will use the same rule to manage exiting the position. When there is an opening gap up or down through, or very close to stops/targets I have a rule for exiting positions. For long positions here is my rule of thumb: If a stock gaps down below the stop that has been established, wait for the first 15 minutes of trading before doing anything. Then place a new protective stop just under the low of that first 15 minutes of trading. Reverse the entire scenario for shorts. The reason I do this is because I want to measure the real strength or weakness in the stock. I don’t want a Good Til Cancelled (GTC) stop to be unnecessarily triggered at the open because often times stocks gap and reverse immediately, which keeps us in the position and looking for a better exit. In GE’s case this worked perfectly today and on Friday and kept us in the position. The targets listed above are areas to consider exiting or tightening stops.

Current Position: Long GE Stock at $17.00.

Entry on May 19, 2010
Earnings Date More than 2 months (unconfirmed)
Average Daily Volume: 88 million
Listed on 5/18/10, 2010


Kinross Gold Corp - KGC - close 16.96 change +0.32 stop 16.06

Target(s): 17.25, 17.75
Key Support Areas: 16.25
Key Resistance Areas: 17.25, 17.95
Current Gain/Loss: +3.41% Time Frame: 1 to 2 weeks
New Positions: Yes, if there is a pullback

Comments:
KGC traded down to our trigger to enter long positions at $16.40 so we are now long the stock. My technical comments have not changed from the trade set-up. KGC has been trading in a sideways channel between $16.25 and $19.25 for over 3 months. The stock is near the bottom of that channel and I believe the stock is ready to move higher in the coming days along with other gold miners. KGC is also testing the backside of its broken downtrend line from December. I believe KGC should easily trade up to its 50-day SMA which is also above our target of $17.75. I suggest readers initiate long positions if the stock trades down near $16.40. Our stop is below the recent channel at $16.05. This sets up more than a 3:1 risk/reward trade: we are risking $0.35 to make $1.35. Gold stocks tend to be volatile so please use proper position size to limit risk.

Current Position: Long KGC stock at $16.40

Option Traders:
Suggested Position: Buy JUNE $16.00 CALL

Entry on May 25, 2010
Earnings Date More than 2 months (unconfirmed)
Average Daily Volume: 7.2 million
Listed on 5/22/10, 2010


MetroPCS Communications - PCS - close 8.44 change +0.00 stop 7.80

Target(s): 9.00, 9.25
Key Support Areas: 8.18, 8.05, 7.85
Key Resistance Areas: 8.62, 8.90
Current Gain/Loss: N/A Time Frame: 1 to 2 weeks
New Positions: Waiting to be triggered

Comments:
PCS hit our trigger to enter long positions at $8.20. My technical comments from the trade set-up have not changed. PCS has shown relative strength while the overall market has declined in recent weeks. There was major volatility during the flash crash in this stock which appears to have shaken out the weak hands. The stock has responded nicely since and bounced off of its 20-day SMA on Friday. I'm playing for a bounce in PCS along with the overall market and I suggest readers initiate long positions if PCS retests its lows from Friday near $8.20. If the market bounces from here I think PCS is poised to retest its recent highs, which are near our targets of $9.00 and $9.25. We'll use tight a stop at $7.80, which is below a gap fill from 5/10 to 5/11. I also like the 2:1 risk/reward set-up of this trade: we are risking 40 cents to make 80 cents, and possibly $1.05.

Current Position: Long PCS stock at $8.20

Entry on May 25
Earnings Date More than 2 months (unconfirmed)
Average Daily Volume: 9.6 million
Listed on 5/22/10, 2010


BEARISH Play Updates

Royal Caribbean - RCL - close 27.74 change -0.17 stop 31.50

Target(s): 27.80
Key Support Areas: 27.38, 25.00
Key Resistance Areas: 28.00, 28.85, 29.80
Current Gain/Loss: +3.68%
Time Frame: 1 or 2 days
New Positions: Yes, with a tight stop

Comments:
RCL traded down to its 200-day SMA today and bounced nicely today. Although the stock closed only -0.61% on the day, it closed +6.2% off of its lows. I'm sure short covering had something to do with this but how things can change so drastically in a matter of hours is beyond me, so we must deal with the circumstances. I suggest readers be cautious and prevent this trade from turning into a loser. My fear at this point is that RCL may rally all the way up to fill the gap down between 5/19 and 5/20. I suggest we place a tight stop at $28.45 and just get out of the way for a small profit if this is hit. I also want to list a lower target at $27.80 which is just above today's close.

Current Position: Short RCL stock at $28.80

Option Traders:
Suggested Position: Buy JUNE $28.00 PUT

Entry on May 24
Earnings More than 2 months (unconfirmed)
Average Daily Volume: 4.5 million
Listed on May 22, 2010