The final curtain in the debt debacle debate slammed down on the U.S. late Friday when S&P cut the U.S. rating for the first time in history from AAA to AA+.
All day Friday there was a threat of a downgrade of U.S. debt by S&P hanging over the market. News that big is very hard to keep secret and that was responsible for the early morning swoon. Late Friday evening news broke that S&P had backed away from a downgrade of the debt after the White House challenged them on the basis for their move. When S&P is going to downgrade somebody they normally supply that entity with their analysis and reasons for the downgrade so the entity can verify all the assumptions are reasonable. Reportedly the White House responded with hostility claiming the agency was "trillions of dollars" off in its analysis, in part because of the complicated "baselines" that are used to compare long-term government spending and revenue projections. The Treasury Dept showed S&P where they miscalculated deficit projections by more than $2 trillion. S&P later admitted the error but said it did not make any difference in their final decision.
The rumored downgrade was blamed for the -416 point Dow decline mid-morning when the Dow declined from a +172 point gain at the open to -245 point decline just before noon. S&P had said he U.S. needed to announce spending cuts of $4 trillion in the debt limit compromise in order to avoid a downgrade. They backed off that position somewhat as the talks continued over the last couple weeks but it was always the elephant in the room. Fitch and Moody's have already affirmed the U.S. AAA rating but they are keeping the U.S. on credit watch negative until they see how the congressional committee works out with the secondary spending cuts.
Later Friday around 9:PM S&P followed through on the downgrade threat and cut the U.S. from AAA to AA+ with a negative outlook. The negative outlook suggests a further downgrade is possible within 12-18 months. This is the first time in history that the U.S. has not had an AAA rating from S&P. The agency said the U.S. did not go far enough to stabilize the country's debt situation. They also cited "political confusion" as part of the reason and they question the ability of the special congressional committee to make any material changes. U.S. bonds are now rated lower than France, Canada, Germany, Netherlands, Australia, Hong Kong, the Isle of Mann and Britain.
Link To S&P Downgrade
Analysts are mixed on what impact this will have on the markets next week. Several analysts said the market decline last week was in expectation of this downgrade. Apparently the rumor had been circulating in the hedge fund community since Tuesday. Analysts are split on what will happen to U.S. bonds because there are few alternatives to the U.S. treasury market in both depth and liquidity. There are $9.3 trillion in U.S. bonds outstanding. More than $580 billion trade every day and far more than the British Gilts at $34 billion or German bunds at $28 billion. Obviously rates on U.S. bonds will change on Monday. SIFMA, a U.S. securities industry trade group, said the down will likely add +0.7% to the rates and cost the U.S. $100 billion a year in additional interest. China holds $1.16 trillion and Japan $912 billion. They will not be selling because they can't without driving the market down and causing themselves a significant loss.
This will ratchet up the ideological issues over spending cuts and tax reform between now and the 2012 elections and you can bet this downgrade will be a hot topic in the election speeches.
The last downgrade threat came while Bill Clinton was president and a similar default scenario loomed. The U.S. debt at the time was $4.9 trillion. Once the limit was raised the rating agencies canceled their warnings.
The downgrade came despite a remarkable Nonfarm Payroll report for July that actually came in well above expectations. The BLS reported a gain of +117,000 jobs in July compared to consensus estimates for a gain of +85,000 and many whisper numbers at zero. Even better the 18,000 jobs created in June were revised higher to 46,000 and the 25,000 new jobs in May were revised higher to 53,000. That was a total gain of 173,000 jobs when most analysts were expecting something closer to zero.
Private sector jobs increased by +154,000 but that was offset by a decline of 37,000 government jobs. Much of that decline came from Minnesota and their government shutdown. More than 30,000 of those jobs losses came from there and they are temporary. They will reappear as job gains in August.
The companion Household Survey, which captures more of the small business trends showed a loss of -38,000 jobs BUT that was significantly better than the -445,000 drop in June and represents a significant reversal.
The jobs numbers suggest the second dip scenario that was so prevalent over the last two weeks may not be as certain as some thought. Yes, there was a new soft patch but maybe the July jobs gain is our evidence it was just a bump in the road and not a detour. If it were not for the S&P rumor early Friday morning the market outcome could have been a lot different.
Nonfarm Payroll Chart
The economic calendar for next week is pretty skinny with only a couple of reports worthy of highlighting. The biggest is the Fed meeting on Tuesday. I can't even imagine what the Fed is thinking this weekend. The market had its worst week in over two years on fears of a double dip recession. S&P downgrades the U.S. credit rating and Europe is on the verge of a meltdown if something is not done this weekend. It would seem like a perfect opportunity to announce some sort of stimulus except the economy added +173,000 jobs in July. The inflation hawks will be holding the line and Bernanke will have to find some way to stimulate without pushing them into a revolt.
There are things the Fed can do without announcing a QE3 program. I expect them to take some action even if it is only a token move because the wealth effect they worked so hard to create since last August has evaporated. If they can't find some way to shock the market back into rally mode we are likely to see a sharp decline in consumer spending for the rest of the year. The market has a direct impact on consumer sentiment and I suspect that sentiment took a very big hit last week.
This makes Tuesday the pivotal day this week. Monday could be crazy for reasons I will describe later so Tuesday is the Fed's chance to pull us back from the brink.
Friday has the Consumer Sentiment report for August and this month started off really bad. Sentiment declined -8 points to 63.7 in the final reading for July and I would be shocked if we didn't see another large drop. This makes Friday's report critical.
On Friday the Investor's Business Daily Optimism Index dropped -13.5% from July to August to the lowest point in its ten year history. The reading of 35.8 was down from 41.4 in July. It is roughly 20% below its 12-month average. All key components, the six-month outlook, confidence in federal policies and personal finances were also at historic lows. All 21 demographic groups polled showed an increasing level of pessimism over U.S. economics.
The earnings cycle is about over but there are a few big companies left to report. Cisco is probably the most important for the week after Juniper and other networkers disappointed with earnings. Cisco has been in a downhill slide since April of 2010 and every earnings report has caused massive drops in the stock.
MGM reports on Monday but they will probably be overshadowed by the external events in Washington and Europe. Kohl's and JC Penny's report late in the week and will give us another health check on the bargain conscious consumer.
Last but not least we have Europe continuing its meltdown. Italy and Spain both saw their bond yields move over 6% and EU finance ministers and country leaders were holding emergency meetings and conference calls on Friday hoping to find a way out of the quicksand of financial stress. Italy took center stage with 120% debt to GDP and the most urgent of funding problems.
The ECB said earlier in the week it would buy bonds from troubled countries, the European version of QE2, but did not say it would buy bonds from Italy or Spain. This caused the markets to turn on those countries and the ECB was forced to announce on Friday they might buy their bonds but said they would only do it if the countries implemented some tough austerity measures.
Italy's premier, Silvio Berlusconi, told a hastily arranged news conference the government will speed up measures in its budget law approved last month by Parliament with the possibility of reaching a balanced budget by 2013 instead of 2014 as initially planned. He said he met by phone with world leaders and the G7 finance ministers would meet "within days" about the exploding financial crisis. Although that was an exaggeration his spokesman said a meeting was discussed. Italian politicians, normally on vacation in August pledged to keep working in order to respond to the rapidly worsening economic crisis.
It was enough to rescue the U.S. markets from a -245 point decline and produce a +400 point rally in just one hour. The ECB agreeing to buy Spanish and Italian bonds would be a key step in putting an end to the crisis. Buying bonds provides support and keeps rates low. The Federal Reserve had been buying Treasuries in QE2 in the same type of strategy.
The market rallied on the news and all eyes are going to be on Italy and the ECB on Monday. In the U.S. CNBC is going to have special coverage Sunday night on the European crisis when Europe opens the week for business.
If you thought the market was volatile last week just wait until next week. Last week Morgan Stanley released the results of a study on hedge fund leverage. They said funds had been aggressively going to cash over the last several weeks and where the average fund had been leveraged 1.5 or even as much as 2.0 times their capital the average today was only .45%. That means only 45% of their cash is invested. Hedge funds have been struggling to turn a profit in 2011 and the last couple months have been deadly. One noted analyst commented on Friday that the volatility last week could have been related to some hedge funds imploding. Funds behind the curve may have been over leveraged to try and catch up and instead got caught by the market reversal. Volatility is wonderful if you are on the right side of the market.
The volume in the market suggests there is something going on behind the scenes that we are not aware of yet. I am sure everyone remembers big market events with corresponding volume spikes. We have had dozens over the last decade including the Great Recession, bankruptcy of Lehman, the flash crash, etc. However, I don't remember volume suddenly spiking to the extreme we saw last week. Note how the volume spiked on Thursday with the -513 point loss to 13.8 billion shares with up volume almost microscopic. That is what a normal capitulation day looks like.
However, on Thursday night I wrote that I did not think Thursday was a normal capitulation day and I expected it to be Friday. The open on Friday with the big +171 point rally and then crash -416 points from the highs to a lower low was a capitulation event. The up volume in the afternoon was traders buying the dip on the news out of Europe. Friday's share volume was more than double the daily average. More than 36.1 million option contracts traded on Friday compared to a normal day at 4.5 million. That was a new record by nearly 20%. That is a lot of stop losses getting hit.
HOWEVER, I believe the massive amount of volume suggests there may have been something else going on behind the scenes. Hedge funds imploding? Maybe, but a hard leak of the impending S&P downgrade would make more sense. We know now that the story was given to the news networks earlier in the day but was embargoed until 8:30 Friday night. Bloomberg dispatched a news crew to meet with John Mauldin and Nouriel Roubini before it was public news.
The volatility hounds will be howling next week. With the S&P downgrade, an all night Europe watch Sunday night and FOMC on Tuesday the week could start out in dramatic fashion. It is hard to know for sure but the conventional wisdom would expect the U.S. market to plunge at the open on Monday thanks to the downgrade. However, since there were rumors the last several days we don't know if the downgrade is already priced in or not. I am betting NOT. This is a major event at least psychologically. Since Moody's and Fitch have already affirmed the AAA rating at least for August that may take some of the sting out of it. However, now that S&P has taken the plunge does that mean the other two will follow suit at the end of August? You know S&P is now going to be grabbing headlines every week now with downgrades of related agencies and corporations that depend on the government for their existence.
The wild card here is the Europe mess. If the ECB announces Sunday night they are going to backstop Italian bonds no matter what then the markets could rally on expectations for a final (really?) resolution to the European crisis.
Regardless of the reason for the crash last week there was some serious damage done to the technicals. This was the equivalent of a reboot of the markets. The Dow "only" lost -5% for the week but the Russell lost more than 10%. This was an instant correction.
Despite the broken technicals the S&P performed exactly as it should have with the dip to 1175. Two weeks ago that was a level we would have never believed we would see again in 2011 with the S&P trading over 1350 as recently as early July. The panic dip Friday morning traded down to 1168 purely on momentum as millions of stop losses were hit. Within minutes the dip was bought and the rebound began. This preserved 1175 as short-term support. I could easily see this level tested again at the open on Monday. I would be a buyer if that level is tested again. If this level eventually breaks the next support is 1050.
S&P Chart - Daily
The Dow fell -1,612 points from the high on July 21st to the low on Friday. That has to rank right up there with one of the fastest declines in recent history. The Dow failed to drop to 11,000, which would be the equivalent level to S&P 1175. That does not mean it won't go there but the big cap blue chips are seen as safe deposit boxes in times of market stress so fund managers were more concerned about bailing from the small and mid caps than the Dow's blue chips.
I would be a buyer to any dip to 11,000 but that is 444 points away. (Oh, I forgot, we already had 400-point moves three times in the last three days.) If we are lucky enough to test 11,000 I would be a buyer of the DIA or SPY at that level.
Nasdaq, different index, same story. Support at 2500 was tested with a dip all the way to 2465 thanks to the high velocity plunge after the open. Buying was pretty strong at that level and that would suggest there is a point where traders are willing to take a risk. Apple traded as low as $362 with support at $360. If you want a position in Apple or Amazon but always thought they were too high dollar then this may be your chance.
I like tech stocks but I would key any purchases on Monday based on the support levels for the S&P and Dow. The Nasdaq ended the day negative with the Dow up +60 so key on the stronger index.
Nasdaq Chart - Daily
The Russell has declined -18.6% from the 860 high on July 7th to Friday's 700 low. The Russell has long passed correction territory at -10% and is rapidly approaching bear market territory at -20%. Fortunately traders defended strong support at 700 and only allowed a 1.1 point incursion below that level. They clearly had their buy orders ready. If that level is tested again I would be a buyer of IWM calls for a trade.
Russell 2000 Chart
Last weekend we were watching the 200-day average on the S&P at 1284 as critical support. This weekend we are watching 1175. What a difference a week makes!
I have read dozens of articles on what to expect when the market opens on Monday. While nearly everyone expects a drop at the open, most believe the dip will be bought. Of course we will not know until 10:AM who was right. The Europe watch on Sunday night will complicate the issue. I am sure the newspaper headlines around the world telling of our rating downgrade could cause some knee jerk selling. However, I would expect that to be in treasuries not equities. Secondarily, strong selling in equities could actually promote strong buying in treasuries as a flight to quality. Yes, an AA+ rating is still quality.
I would use any weakness on Monday morning as a buying opportunity for a trade. We don't know how the long-term scenario is going to play out so I would want to grab a few points and then move to the sidelines later in the week if the market begins to weaken again. We are extremely oversold and it is only a matter of time until we get a real short squeeze.
You have to ask yourself if the economy and financial system is worse today than in 2008 or is it significantly better? Despite the weak reports over the last month we don't have any major U.S. banks failing, the TARP loans have been paid, 73% of S&P companies beat earnings, jobs were better than expected, the debt debacle is behind us and gasoline prices are falling. That would seem to indicate there is no real macro reason for the markets to be crashing. This is a political event roiling the markets. I think a lot of others will see it that way as well but since we have never had a ratings downgrade before there is no precedent in the USA. Other countries have been downgraded and nobody noticed. Of course the hype in the weekend news is going to create some selling from the nervous Nellie's and we just have to let it play out and then pick a spot to jump in.
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