The market suffered through a headline storm last week and survived with mixed results.
Greece voted and traders took profits. They successfully formed a pro-bailout coalition and the market ignored them. The meeting in Moscow between Iran and the six UN nations failed as expected and ensured the oil embargo would proceed as planned on July 1st. Oil prices fell instead of rallied. Spain's 10-year debt yields rose over 7% and the markets sold off again. German, European and Chinese economics all took a turn for the worse and the markets weakened again. On Wednesday the FOMC failed to add any new stimulus and only extended the Operation Twist until year end and the markets churned intraday but ended flat. USA economics fell off a cliff with the Philly Fed Survey on Thursday and the Dow fell -250 points for the worst decline in June. Worries over a Moody's downgrade of the major banks accelerated the selling into Thursday's close. It was a very volatile headline driven week.
Compared to the last seven days the coming week should be a walk in the park even though the economic calendar is full. Earnings are going to start grabbing a larger share of the headlines but that may not necessarily be positive. There are three more regional manufacturing reports and similar declines like we saw in the Philly Fed last week would be very negative for the market. The headline number fell from -5.8 to -16.6 and is now at a nine month low. New orders fell to -18.8 from -1.2, shipments fell from 3.5 to -16.6 and backorders fell from an already negative -9.4 to -16.3.
Philly Fed Chart
Jobless claims hit 387,000 and still rising. The prior week was revised higher to 389,000 and the current week will probably be revised higher as well. Layoffs are increasing as the economy weakens. Look at the trend on the chart since the January low. The gains are not huge but they are definitely consistent. We could see something over 400,000 in the very near future. This is already depressing estimates for the nonfarm payrolls in two weeks. Jobs for May declined to 69,000 and less than half of consensus and some estimates for June are already slipping to the 25-50,000 range.
Jobless Claims Chart
The Fed said they were willing to do more if the economy weakened any further and we could be just two weeks away from that action. If the payroll report does show another sharp decline, possibly turning into job losses and we could see an instant Fed reaction. I seriously doubt it will be another QE program because the problem is not liquidity. The economy is swimming in cash. Pushing interest rates another quarter point lower is not going to solve the problem. This is going to take some really creative action on the part of the Fed. The three manufacturing reports next week are going to be critical as indicators of economic direction. All were still in expansion mode last month so a drop into contraction territory should ramp up the Fed debate.
On Friday St Louis Fed president, James Bullard, said there was a "pretty high hurdle" before the Fed would announce another round of quantitative easing or QE3. The Fed has "done what it can do." He believes another round of QE would be effective but it would mean adding a lot of additional risk to the Fed's balance sheet and risk damaging the Fed's credibility. The Fed already has more than $2.3 trillion in securities on its books and eventually they will have to sell those treasuries. That may not be anytime soon but it will happen. Analysts believe the selling will start in 2015.
Interest rates are going to rocket higher once that selling starts so the economy needs to be moving at a decent pace to absorb the increase in rates. If the Fed were to announce another QE program of $600-$700 billion it would push their holdings to $3 trillion and what some analysts believe is an insurmountable hurdle for the economy once the selling begins. That is one reason the Fed does not want to further extend their ownership. They may end up having to hold them until maturity if the economy does not improve. By extending Operation Twist to exchange another $267 billion of short term securities for longer term securities that just moves their maturity window farther out into the future.
The Fed has kept rates low since late 2008 and they are promising to keep them low until late 2014. Bullard warned this is far "outside of normal business cycle adjustments" and the future implications are unknown and highly unpredictable. If you nurture a generation of new businesses accustomed to rates near zero what will happen when those rates return to normal and business costs rise?
The biggest problem for the Fed is going to be employment. The economy needs to add 150,000 jobs per month to keep up with immigrants and graduates entering the workforce. Add in the number of spouses being forced to go to work to support the family and that number jumps even more. The official unemployment rate is currently 8.2% and the Fed said they did not expect a material change this year. The U6 rate, which includes everyone currently working part time because they can't find a full time job, is now 16% or roughly 22 million people. Creating jobs at only 69,000 a month as we saw in May is going to cause civil problems along with higher costs for support services like unemployment compensation and food stamps. Unemployed youth tend to cause trouble as we have seen in places like Greece, Spain, Italy and the Middle East.
The number of Americans with jobs is at the lowest percentage level (58.5%) since the early 1980s. The chart below is from the St Louis Fed.
Percentage of Population Employed
I am afraid the country is heading for trouble. For several months I have pointed out the declining economics but most analysts were blaming the slowdown on Europe and Greece. I believe it is a wider problem and it will continue to fester in the USA as we get closer to the elections and the fiscal cliff at year end.
We are reaching a point where optimism can't continue to prop up the markets. We saw earnings warnings last week from a number of high profile companies. They were mostly multinationals and blamed shortfalls on slowing European sales and the impact of foreign exchange on their profits. The dollar hit a two-year high in May and the euro a two-year low. That means exchanging euros for dollars was a losing proposition.
With economic conditions in Europe worsening the impact is worldwide. Germany reported the worst business sentiment since 2009 and numbers all over the EU are worsening. Chinese manufacturing weakened again in May. What goes around comes around and the Philly Fed report last week showed us it is coming pretty fast.
I don't want this commentary to turn into a gloom and doom session but the forecast is definitely turning to storm clouds. This earnings cycle could be a turning point for market sentiment.
Phillip Morris (PM) warned on Thursday that lower sales overseas and foreign exchange losses could knock 25 cents off its full year earnings. Tobacco companies have normally been immune to economic problems. Nicotine addiction does not respond to economic headlines.
Proctor & Gamble (PG) warned that sales would decline as much as -2% compared to prior forecasts for +2% growth. Organically sales are expected to grow +2.5% compared to prior estimates of 4.5%. Expected earnings are now 75-79 cents compared to prior estimates of 79-85 cents. The reason for the decline was "slowing global economy and sluggish market share growth in developed countries and China."
PepsiCo (PEP) said slowing sales and a sharp impact from foreign exchange rates could reduce earnings by 5% for 2012. When Frito-Lay snacks, Quaker oatmeal and Tropicana orange juice sales are slowing you know there is some cost cutting underway by global consumers.
FedEx (FDX) warned that a slowdown in package traffic from Asia and Europe would depress earnings over the next 12 months. Shipments from Asia fell -3.9% and shipments in the U.S. fell -5% due to the slowdown in the global economy.
United Technology (UTX) warned that the slowdown in Europe was worse than expected in their Q2 guidance and they were "very concerned" about future sales in European countries with an emphasis on Spain and Italy.
Adobe (ADBE) warned of weakening European demand. Earnings expectations were lowered to the 59 cent range and analysts were looking for 61 cents. The declines don't appear to be material but anyone saying "weakness in European sales" is going to be hit by sellers.
Bed Bath and Beyond (BBBY) warned on lower profits after rising expenses to increase sales were offset by consumers moving to lower priced, lower margin products.
Ryder System Inc (Nyse:R) was knocked for a -$5 loss on Friday after they warned earnings would decline to a range of 90-95 cents from prior estimates of $1.07-1.12. They said demand for their rental trucks dropped sharply over the last two months. They said the housing and construction markets, normally big users of rental trucks, remained very weak.
In related news the American Trucking Association said tonnage shipped, the biggest demand metric for the industry, fell sharply in April and May. Consecutive declines in tonnage show the economy is slowing according to Bob Costello, the chief economist for the association.
Analysts are now expecting Q2 profits for the S&P-500 to rise only +6.3% compared to estimates of +9.2% on April 1st. Excluding Bank of America (BAC) and their special loss in Q2-2011 the S&P earnings growth would only be +1.1%. Bank of America had a monster one-time loss in Q2-2011 that will not be repeated this quarter and that makes their comparisons unrealistic. If you remove Apple and BAC the earnings growth for the other 498 companies would be negative.
The slowdown in Europe that is impacting U.S. earnings is best seen in the German statistics. Germany is the strongest economy in the eurozone. Sentiment fell sharply in June. The expectations for the future (orange line) and current business climate (red line) are moving to post recession lows. Germany is dependent on the rest of Europe to buy its goods. Those buyers are drying up thanks to austerity, worries over the financial system and even the fate of the euro itself. Germany was the cleanest shirt in the dirty clothes hamper but apparently the smell from those lower in the pile has finally transferred to top. Associate with the dogs and you will smell like a dog.
German Economic Sentiment Chart
The slowdown in spending is not just overseas. Darden Restaurants (DRI) operates several brands of stores. Overall sales declined -1.9% for the quarter as fewer people opted for an expensive meal at Red Lobster and Olive Garden. Same store sales for Red Lobster were down -3.9% and Olive Garden -1.6%. The vast majority of their sales come from the 704 Red Lobster stores and 792 Olive Gardens. The smaller brands posted slightly better numbers. LongHorn Steakhouse +3%, 386 stores. The Capital Grille +2.8%, 46 stores. Bahama Breeze +2.8%, 30 stores and Seasons 52 +1.9%, 23 stores.
There are a few earnings reports next week but we are still over two weeks away from the start of the cycle. What we are likely to get more of next week are earnings warnings as corporations can now see through the quarter end and realize there is no hope of making their estimates. Analysts have been lowering expectations but I suspect they are still too high. Further warnings will only hasten the revision process and depress the market.
The biggest reports for the week will be Nike and Research in Motion on Thursday. RIMM is heading for a new low and confusion over which new phone will have a keyboard and which ones won't is causing concern among investors. Maybe I should say speculators instead of investors since any buyer of RIMM today has got to be betting on a buyout rather than a recovery. Analysts claim their cash on hand, service business, network and patents are worth about $20 a share but the stock is trading for less than $10. The brand is damaged by the repeated failures to produce a new product that buyers want. How do you win those buyers back once they switch to the iPhone or Android? That is a tough sell.
Volume surged at the close on Friday as the Russell indexes were rebalanced. This happens once a year in June in order to adjust the various indexes for changes in market cap over the prior year. Russell calculates the market cap for the universe of stocks that fit its criteria. The top 3,000 become the Russell 3000 index. The top 1,000 become the Russell 1000 and the next 2,000 stocks become the Russell 2,000 index. As stocks increase in value they can move up from the 2000 to the 1000 and each move higher kicks some other stock back into the smaller cap index.
Worldwide it is estimated there is more than $3 trillion in investments indexed to the Russell indexes.
Volume this year was lighter than normal but still hefty. The Nasdaq said it traded 687.9 million shares of Nasdaq listed stocks at 4:PM, worth $9.5 billion in 1.15 seconds. On an average day the market on close orders run about 50 million shares. Last year there were 750.8 million shares worth $10.6 billion executed in 1.105 seconds.
One noted addition to the Russell 1000 on Friday was Facebook (FB). Facebook shares have rallied for the last week as investors and fund managers bought up FB shares ahead of the inclusion. The prior week FB shares rallied into option expiration as a large volume of options at the $30 strike price pinned the stock at $30.01 on expiration Friday. Settlement day on Monday was also strong. FB shares rallied +4% on Friday to close at $33.00. That just happens to be decent resistance and it will be interesting to see if it can hold the gains as we near their first public earnings report and the first lockup expiration in August.
First Solar (FSLR) shares rallied +9% after LA County Dept of Public Works agreed to approve the solar panels proposed for the 230-megawatt plant in the high desert known as Antelope Valley. The 2100 acre facility is expected to power 75,000 homes. First Solar is building the plant for Exelon Corp (EXC). The project had been delayed when a county inspector refused to certify the electrical connectors for the panels. Since this is the first industrial scale solar installation built by the department they are being very careful about the construction process. First Solar is building two different 550-megawatt plants in other areas of California and a 290-megawatt facility on the Arizona border.
First Solar Chart
For more than a month now investors have been expecting a downgrade to the major banks. On Thursday afternoon Moody's warned again it was going to announce the downgrades after the close. You would have thought the world was going to come to an end with those downgrades. Fortunately the world did not implode and the downgrades did not impact the sector. When investors get a warning a month in advance they are able to price in the risk and position their portfolios. Most of the banks rebounded slightly on Friday as they shook off the downgrades.
What is Moody's thinking? It is more than three years after the financial crisis. Banks have flushed the majority of their nonperforming loans, streamlined their balance sheets and doubled their capital base. They are far better off today than three years ago and Moody's is on the warpath to cut the banks off at the knees. One noted analyst said years ago the job of a ratings agency was to conduct a survey after a battle, point out the winners and terminate the injured. Does anyone actually care what Moody's says about the banks at this point?
Financial Sector XLF Chart
It was a very bad week for oil. WTI has now fallen -$30 from the 2012 highs and Brent is down -$34. The spiking dollar and the plunging economics are driving commodity investors to the sidelines. When commodities correct they do it in style and we have definitely seen a rout over the last month.
Brent declined to $88.50 before rebounding. This is a critical level for OPEC. They were producing about 2.5 mbpd over their official quota in early June. After the OPEC meeting they announced the over production would stop. Personally I had serious doubts about their sincerity but after the decline to $90 I would be very surprised if they did not stop. It is not that $90 is so bad for them but if they don't put a bottom under $90 they could see the slide continue. It is easier to stop the drop now than wait and hope prices firm on their own.
WTI Crude Chart
Brent Crude Oil Chart
Oil could see a bounce on Monday after Syria shot down a Turkish fighter plane on Friday evening. Syria said the fighter intruded into Syrian airspace and was shot down by coastal air defense batteries. Turkey vowed retaliation but did not say how they would retaliate. As of late Saturday both sides have signaled they don't want to escalate the incident and that is dramatically different from Friday night's headlines. Still, there could be a bounce in Brent prices if the war of words is still in progress on Monday.
Gold dropped -$62 from Monday to Friday's low at $1558. With no QE from the Fed and no countries leaving the EU this week the spiking dollar took its toll.
Silver declined nearly 9% from Monday's highs to $26.50 at Friday's lows. The drop over the last two days was dramatic. However, support at $26 held. The problem for silver is that it is not used as a reserve currency by central banks. It is the poor man's gold but it is also a manufacturing staple. It is used in everything from cell phones and tablets to solar panels, electric cars and guided missiles. When silver is used in manufacturing it is seldom recovered when that product reaches end of life. Once used, silver is gone forever.
The decline supposedly occurred because of the bad manufacturing numbers out of China, Europe and the USA. If manufacturing of any electronic commercial product slows then demand for silver slows. However, it will NOT decline below current mine production. Silver is being consumed at a rate of 150 million ounces more than is being mined every year. With less than 900 million ounces in global inventories that means there will be a shortage of silver by the end of the decade. If/when the economic cycle kicks back into high gear the consumption of silver will accelerate.
I could be completely wrong but I believe this is a fantastic buying opportunity for silver in any form. You can use the SLV ETF or simply buy circulated silver coins or silver eagles.
I will give everyone a word of caution. During the financial crisis silver declined to a low of $8.50. While I don't think we are about to go through another Great Recession there is a good possibility we could see a normal recession on a global scale. How that will impact silver is unknown. Could we see $20 again? That is entirely possible depending on what happens to the economy. For me I am going to be adding to my silver stash with every drop in price. I firmly believe we will see $50 silver by 2020 if not higher.
Commodities are now in a bear market as represented by the Goldman Sachs Commodity Index ($GSCI). The index has fallen from its high of 717 in February to a low of 558 on Thursday. That is a drop of 22%. This is a challenge for the Fed although it is keeping inflation in check. Unfortunately it could be a sign of deflation and the Fed will do anything to keep that from happening. Commodities are declining because manufacturing is declining as a result of the global economic slowdown.
Commodity Index Chart
An article by Keith Bradsher in the NY Times on Friday suggested China may be lying about the drop in manufacturing activity. That should come as no shock to our readers since the possibility has been mentioned in these pages many times. Bradsher said local and provincial officials in China are hiding the depth of the slowdown but they can't hide the physical signs. Record setting mountains of excess coal have accumulated at the country's biggest storage areas because power plants are generating less electricity to meet demand. According to Bradsher, power sector executives claim Beijing has forced plant managers not to report the full extent of the manufacturing decline. Corporate officials are urged to keep two sets of books, showing improving business results and tax payments that do not exist.
Electrical usage is considered the gold standard for measuring what is really happening in a country's economy. Since China's track record of reporting of economic numbers is highly questionable analysts must turn to the fundamentals behind the numbers for the real picture. Even Li Keqiang, expected to become China's premier this fall, said in 2007 that he regarded China's measures of economic growth as "man made and therefore unreliable."
A chief executive in the power sector said "government officials don't want to see negative numbers." They tell power managers to report usage declines as "no change." A different official with access to grid data for two provinces with heavy industry said power consumption had fallen -10% in May from the year ago period. An analyst at Wood MacKenzie said coal stockpiled at the port of Qinhuangdao reached a record 9.5 million tons in early June. That surpasses the prior record of 9.3 million tons in November 2008 at the bottom of the financial crisis. Three other large storage areas in Tianjin, Caofeidian and Lianyungang are also at record levels. HSBC and Markit released their independent survey of Chinese purchasing managers on Thursday and the 48.1 headline number was the second lowest since March of 2009.
I noted several months ago that China was probably very glad Greece was hogging the headlines because it kept the focus off the slowdown in China. The government's sudden rate cut in June and increase in loan authorizations suggests China is moving aggressively to combat the slowdown but until the European economy begins to recover and consumers buy more goods there is little the Chinese government can do. They already built enough ghost cities to last the next 20 years.
Next week is healthcare week. The Supreme Court has run out of time. They can't procrastinate the announcement any longer. This week is the last week they are in session until October if I remember correctly. That means they have to render their verdict on the Affordable Care Act. In theory that will happen on either Monday or Thursday. The Senate has asked the court to televise the proceedings because of the impact on everyone in the USA. That means we should have a little warning before the decision is released. Regardless of the decision is will be a market mover in the healthcare sector.
The leaders in Europe meet again on Thr/Fri to discuss the financial crisis. I have lost count but this is like the 29th summit on the problem and it is still a problem. One analyst said it was time for the EU to either go big or go home. They need to announce a major program and be in agreement on getting it done. This monthly meeting to agree to put more money in the pot is like a death by 1000 cuts. It is the nightmare that never ends. They need to step up and take their medicine and put a sweeping and costly program in place to avoid repeating the process again in July. I doubt this will actually happen but every armchair commentator in America knows this is what needs to be done. Expect more talk and less action from the summit.
The markets continued to rally early in the week but then faded as the headlines became more negative. The S&P punched through 1325 last week and then returned to test that level on Thursday. That is currently initial support followed by 1307 and then 1285. A break below 1325 is troublesome but a break below 1285 is a disaster. Resistance is now 1362 and the 100-day average at 1360. That gives the market a wide range to navigate without traders needing a lot of conviction. A move out of the current range could trigger a material move and right now I would bet on the downside.
On March 21st Goldman Sachs announced that it was the best time to buy equities in a generation. Goldman's Chief Global Equity strategist Peter Oppenheimer said stocks were cheap relative to bonds and the anticipated economic growth rate. The report was titled "The Long Good Buy." The S&P at the time was 1,405. Maybe Peter was referring to a generation of something other than humans. On Thursday Goldman's head of the Macro Equity team issued an email advising clients to short the S&P-500 citing economic weakness. In fairness they are only looking for a -5% decline (1285) and they probably already have the Long Good Buy Part II email already to send.
S&P Chart - 120 Min
S&P Chart - Daily
The Dow failed at exactly the 61% Fib resistance level after testing it three times last week. The Dow also bounced at exactly 12,575, prior resistance now support. This was a perfect test in both directions. Should initial support at 12,575 break the secondary levels are 12,400 and 12,325. A decline below the 12,325 suggests we will see a new low for the year.
The large multinationals in the Dow are all going to be impacted by Europe and the dollar. IBM will be a key indicator when they report earnings. That assumes they don't warn in advance.
Dow Chart - 120 Min
Dow Chart - Daily
The Nasdaq managed to close with a gain for the week thanks mostly to the biotechs and chip stocks. Apple and Google did manage to make it into the top 20 on Friday with low single digit gains. The Nasdaq only managed to retrace to the 50% level from the June lows compared to the Dow's 61% Fib spike.
Tech stocks do not normally perform well in the summer months so I would continue to be wary of the tech sector. Resistance is now 2930 and support 2860.
Nasdaq Chart - Daily W/Fibs
Nasdaq Chart - 120 Min
Nasdaq Chart - Daily
The Russell indexes are not relative this weekend because of the rebalance impact. The NYSE and Dow 5,000 are carbon copies of the S&P so no reason to show the charts.
The focus next week should be regional manufacturing reports, earnings warnings and the EU summit on Thr/Fri. It is time for the EU to either go big or go home. The monthly summits have accomplished nothing other than to prolong the pain. Rip the band-aid off and get it over with.
Italy's new Prime Minister, Mario Monti, warned on Friday of the apocalyptic consequences of failure at the coming summit. He warned, "We have only a week to save the eurozone." That is very strong language and he went on to detail the problems confronting the EU leaders. This is going to be the headlines all week. With Spain now saying they only need 62 billion euros to save their banks instead of the 100 billion the EU promised, the focus will shift to Italy and the next target in the shooting gallery for the bond vigilantes.
If the EU does not pull out the bazookas at this meeting we could see some marked deterioration in the European outlook.
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