The next shoe to drop in the Eurozone was a downgrade of Spain's credit rating by Fitch Ratings. We can expect further downgrades of other EU countries in the months ahead.

Market Statistics

The Fitch downgrade of Spain should have come as no surprise to anyone since S&P cut their rating on Spain last month. This should have been pushed to the back pages of the news since the Fitch downgrade from AAA to AA+ was less than the S&P downgrade to AA. Did anyone actually believe that all the angst over the weaker EU countries was not going to lead to downgrades? This is just more proof that a market wanting to decline will always find a reason.

The Spanish government cut its GDP forecasts on Friday and that supposedly triggered the Fitch downgrade. Spain cut its 2012 GDP forecast to 2.5% from 2.9% and 2013 to 2.7% from 3.1%. Did you catch the key point in that least sentence? Spain is predicting 2012 and 2013 GDP not 2010 or 2011. Who really cares today what Spain's GDP will be in 2013?

Spain passed its new austerity program by a margin of only one vote in parliament. With a potential change in the ruling party in the next elections Spain could just as easily dump the austerity vow long before 2012. Citizens are already protesting the austerity program and most analysts expect the programs to fail. Once citizens become accustomed to living off the government dole it is tough to change their habits without a fight.

We should be ready for another wave of ratings cuts since Moody's still has Spain at AAA and there are four other EU countries likely to see their ratings cut. This is a long-term problem that will continue to aggravate markets for many months to come. Until our markets quit reacting to these weekly EU events the volatility will remain.

Adding to the geopolitical uneasiness Friday morning was another warning out of North Korea that they would fire on any South Korean ship found inside North Korean territorial waters. Unfortunately there is strong disagreement about where those waters end so the potential for another attack is strong. The exact maritime border has been in dispute since the war ended in 1953.

North Korea has repeatedly attacked South Korean ships since 1953 and the sinking of the Cheonan in March was simply one more unprovoked attack. South Korea has never retaliated for any attack although there have been exchanges of fire during the attacks. South Korea assembled an international team to examine the salvaged Cheonan wreckage and it was determined with 100% certainty that a North Korean torpedo was the cause of the sinking. They recovered parts of the torpedo including a partial serial number with Korean writing. With this evidence South Korea is heading to the U.N. Security Council in order to increase the sanctions on North Korea.

Several additional countries have now cut ties with North Korea and others have restricted money transfers to NK. The North is strongly expected of providing nuclear technology to Iran, Syria and others and missile technology to numerous countries in violation of existing sanctions. Eventually the North is going to take that one step too far that brings the global community down hard enough on them to force a regime change.

North Korea enjoys being in the spotlight and periodically creates events that catapults them into the news. The NK leader Kim Jong Il believes it raises the status of NK on the world stage. Because of the economic success of South Korea and the military threat of the 1.2 million-man NK army on their doorstep, these news opportunities always put pressure on the equity markets and Friday was no exception.

If that was not enough Iran reported that a U.S. nuclear submarine had entered the Persian Gulf. Western intelligence and naval sources confirmed that a nuclear-armed American sub had entered the gulf. That is sure to escalate tensions in Iran. On May 20th it was reported that the Obama administration had decided to boost U.S. military strength in the gulf and was sending Carrier Strike Group 10, headed by the aircraft carrier Harry S Truman, to the gulf as well. The carrier group left for the gulf on Friday.

The carrier group led by the Dwight D Eisenhower is currently on station in the Arabian Sea just outside the Straits of Hormuz. That puts two carrier groups off the coast of Iran and ratchets up the stakes for Iran's nuclear gamble. It appears President Obama may have decided his failed diplomatic effort needed a little military persuasion to move the talks into a more productive phase.

The geopolitical news overshadowed the economic reports in the U.S. and there were some key numbers released. The ISM Chicago declined by 4.1 points to 63.8 for the May period. Anything over 50 is still in expansion territory and April's reading of 63.8 was a five-year high.

The new orders component fell from 65.2 to 62.7, production fell from 63.1 to 61.0 and backorders fell nearly 10 points from 61.4 go 52.7. Employment fell 8 points to 49.2 from 57.2 and back into contraction territory. This is a new and disturbing trend that has appeared in several of the regional surveys. Employment is supposed to be rising but the regional indicators are slipping and some of them have fallen sharply.

The inventory component rose from 50.1 to 56.4 and suggests sales are slowing and inventories are beginning to build. This would suggest a slowdown in manufacturing over the coming months in order to prevent a repeat of the large inventory overhang we saw in 2008-2009.

The decline in several regional manufacturing surveys should indicate a decline in the national ISM next Tuesday.

Chicago ISM Chart

In contrast to the Chicago ISM, which is heavily influenced by auto manufacturing, the NY ISM also released on Friday showed a sharp rise to 449.3 from 429.4. More importantly the current conditions component rose to 89.9 and a record high for the index. The employment component rose from 61.8 to 63.3 indicating continued hiring. New York has already regained over 25% of the jobs lost to the recession. However, the public sector is struggling with Mayor Bloomberg announcing the layoffs of 11,000 city workers starting in June. Changes in financial regulations are also expected to be a problem to be overcome as Wall Street firms restructure to deal with the new rules.

ISM New York Chart

The Consumer Sentiment revision for May came in almost unchanged at 73.6 compared to the initial reading of 73.3 for May. All of the gain came from an uptick in the expectations component. Continued weak consumer sentiment suggests consumer spending is not going to hold at the current levels. The Personal Income and spending report for April showed that spending was unchanged for the month after six months of increases.

Inflation was not a problem with the core PCE Deflator rising only a very minimal +0.1%. It has been at that level or lower for the last six months. We are very close to a zero inflation rate at the core level. Wage growth rose +0.4% and the second fastest growth in the last 11 months. The savings rate also rocketed higher to 3.6% and the highest since January.

Next week has some key economic events with the national ISM on Tuesday, ADP Employment on Wednesday and the Non-Farm Payrolls on Friday. Because of declines in the regional manufacturing surveys the national ISM is expected to decline more than a full point to 59.0. Any further decline could roil the market.

The ADP Employment report on Wednesday is expected to show an increase of 150,000 jobs in May. The ADP report only reports on the private sector and does not count government hiring. As such it will not include any census hiring. If the ADP report meets its consensus estimate it would be the largest gain since March of 2007. Recently the ADP report has deviated significantly from the Non-Farm Payroll report due out on Friday. The ADP report fell 199,000 jobs short of the BLS report in April and the second largest deviation in the reports history. The ADP report normally sets the stage for the Friday Non-Farm Payrolls. It provides analysts with the last chance to update their estimates before Friday.

The big report is of course the Non-Farm Payrolls. The consensus estimate will be for a gain of 503,000 jobs of which 250,000 are expected to be temporary census workers. The Census Bureau had planned on hiring 400,000 full time/part time workers in May but a larger number of full time hires reduced the total headcount needed. Secondly hiring was increasing late in the month but the cutoff for BLS reporting is in the middle of the month so the big increase late in the month will not be reported until next month. Lastly the mail-in rate on census forms was higher than anticipated reducing the need for additional personnel. The unemployment rate is expected to decline to 9.8% from April's 9.9%.

Economic Calendar

The FDIC was active again ahead of the holiday weekend. The FDIC closed five banks, three in Florida and one in Nevada and California. This brings the total closures in 2010 to 78. Three Bank of Florida locations were closed along with Sun West Bank in Las Vegas and Granite Community Bank in Granite Bay California. These were all small banks and the total cost to the FDIC was around $315 million. The current pace of closures is twice that of 2009 and expected to peak somewhere around 200-225 in 2010. However the cost of failures over the next four years is expected to be more than $100 billion.

The FDIC reported last week that the list of troubled banks rose to 775 at the end of the first quarter and the most since 1992. That equates to roughly 10% of all the banks the FDIC manages. Total assets of those 775 banks is roughly $431 billion. FDIC head Shelia Bair said overall lending has not increased and lending standards are currently extremely tight. However, loan loss provisions were declining and more bidders with higher bids were showing up at the FDIC auctions.

In stock news Intel seems to be pulling even farther out in front of the competition although there is more competition now than in recent years. Everyone seems to be heading into the computer processor chip manufacturing game including Nvidia, Qualcomm, Apple and several others. On Friday research firm iSuppli predicted that chip sales in the first quarter jumped more than 2%. This spike was powered by things like the iPad, netbooks, Mids, PCs and dozens of other "mobile Internet devices."

The first quarter is normally weaker than the prior quarter but iSuppli had predicted a +1.1% increase in sales. Their new estimate suggests there have been four consecutive quarters of semiconductor revenue growth. That is the first time since 2004 that growth has been this strong. Broadpoint AmTech analyst Dinesh Moorjani said the demand for DRAM chips continues to grow and manufacturers can't keep up leading to continued improvements in pricing. Of the 150 semiconductor suppliers tracked by iSuppli only six reported revenue declines in Q1. Strangely one of those was Intel despite their continued market gains. Intel's sequential revenue declined by -1.4% but Q1 is normally a declining quarter for Intel as the prior two quarters are normally very strong with holiday computer sales.

Intel is going to be a winner in the Google TV project along with Sony. The Google TVs and set top boxes will drive demand for faster ATOM processors made by Intel. The Google TV is expected to be available from Sony in the fall of 2010. Google TV will be a service where viewers will be able to search for websites, watch videos, movies and TV programs through an Internet connected TV. The TVs will run the Android software. Think of the applications available on the Android phone and the iPhone. Now visualize these on your TV on the big screen. Things like Facebook, YouTube, Google Earth, email, games, etc will all be available on your TV. No more squinting at the tiny mobile screen and getting thumb cramps from texting.

Research firm DisplaySearch said 211 million televisions were sold in 2009. They believe this could increase to 228 million in 2010 and 300 million by 2016. By 2016 more than 10% could be compatible with Google TV with the insertion of an Intel chip. That is an additional 30 million chips for Intel and possibly AMD plus the ramp up of production and sales from 2010 through 2015. It will be a major market for Intel and the Intel clones. DisplaySearch estimates that processor sales for Intel in the notebook and netbook market will increase from 150 million units per year in 2009 to 230 million units by 2016. Intel is also branching out into other markets in 2010 and 2011 that could provide explosive growth.

Intel stock performance has been in the tank over the last month but what stock hasn't been in the tank. The expectations for Intel product growth are not being reflected in the stock price. Once the market finds a bottom I believe Intel could find a lot of fund managers loading up for the future. Intel has failed to perform since the crash in 2000 and that trend has got to eventually end. Where would we be without Intel today?

Intel Chart

Oil prices declined slightly but oil drillers and service companies imploded on the six-month moratorium mandated by the president. The president wants to show he is taking charge of the gulf oil spill and he did so by shutting down 33 deepwater rigs operating in the gulf and putting a halt to new drilling permits for six months.

I understand he wants to give the impression he is in charge in order for the Horizon disaster to not become his Katrina. Unfortunately he has no control on stopping the leak so he has to do something else to distract the voters. I completely understand the administration wants to prevent another problem like the Horizon disaster by forcing the industry to implement a tougher set of new standards. It makes a good sound bite for the press and the visit to Louisiana on Friday was another convenient photo op.

However, shutting down all the deepwater drilling in the gulf for six months is not the answer. It is a political statement and another attack on big oil. That is always good for a few votes. It is also the way to insure we pay more money to OPEC in the years ahead.

Deutsche Bank (DB) estimated a six month shutdown would reduce gulf oil production in 2011 by 160,000 to 200,000 barrels per day. Over 80% of gulf oil production comes from deepwater wells along with 46% of gulf gas production.

The deepwater gulf is the major source of new production in the U.S. and a major employer. At any given time nearly 35,000 workers are employed on rigs, platforms and support vessels in the gulf. Most deepwater drilling rigs have a crew of 125-150 always onboard and another crew of the same size in rotation on land. This does not count the number of support services crews that it takes to keep the rigs running. When the Horizon went down there were BP personnel, the Transocean crew, employees from Schlumberger, Halliburton, Baker Hughes and several other firms. There were support ships from several service firms including the ship that was offloading the drilling mud.

Deepwater drilling is a very labor-intensive business involving dozens upon dozens of companies and thousand of workers. Shutting it down for six months while you develop a new set of rules is a stupid political statement. You can bet that every crew on every rig has read every single report and talked to everyone they have seen about the cause of the Horizon disaster. They have a vested interest in making sure it does not happen to their rig because it is their lives at stake. They do this for a living and you can bet they are treading lightly and double checking the safety measures. The MMS and Coast Guard have already checked every one of the rigs since the accident to insure everything was working perfectly.

This shutdown is even more aggravating to the industry because it has become clear from the weeks of testimony that BP was clearly responsible for the disaster by rushing the well closing process and ignoring obvious problems in the pressure tests after the cementing process. If BP had followed the correct procedures the problem could have been corrected and the Horizon would be drilling at a new location today. Instead the BP manager on the rig was trying to rush the well closure and move to the next site. They were already six weeks overdue because they rushed the drilling, fractured the well, got the drill bit stuck and had to back up and start over. They were trying to make up for lost time and in doing so they ignored maintenance problems like the dead controller on the blow out preventer or BOP, the damaged annular gaskets inside the BOP and the faulty cement job.

This was NOT a technology problem. This was a management problem by BP. Shutting down drilling in the gulf for six months won't fix a serious case of stupidity but it will hurt thousands of workers, dozens of companies, millions of shareholders and cost us up to 200,000 bpd of production in 2011 and beyond.

Over the last 50 years there have been 50,686 wells drilled in the gulf. Interactive Map Through 2007 more than 16.8 billion barrels of oil and 173 trillion cubic feet of gas have been produced. Out of 50,686 wells the number of major spills are in the low single digits. There were 19 blowouts in the last 20 years and none produced a material spill.

The biggest gulf spill came from the Pemex Ixtoc 1 in 160 feet of water in 1979. The exact same circumstances the Horizon encountered were seen in the Ixtoc disaster. The well lost its drilling mud into fractures in the well bore. The engineers chose the wrong strategy to fix the problem and withdrew the drill pipe and bit. Without the pipe and mud in the well the gas and oil surged to the surface where it caught fire. The rig, Sedco 135F burned and sank. The BOP failed to shear the pipe and seal the well because the drill collars between two pipes were too strong for the BOP to slice through. The well flowed an average of 20,000 bpd of oil for 10 months before the leak could be stopped. This was in only 160 feet of water. Over three million barrels of oil were released into the gulf. Pemex spent $100 million to clean up the spill.

Out of 50,686 wells there have been less than five material spills. I would say the offshore drilling industry has been VERY good about their safety record. In the last 30 years there have been dozens of spills related to tanker accidents but nobody put a moratorium on tanker traffic.

As of a couple weeks ago there were 57 active rigs in the gulf. Of those rigs 28 were known to be operating in deep water. The president said 33 rigs were halted so apparently five of those undeclared rigs on the bottom of this list were also deepwater rigs. The moratorium does not affect the shallow water drillers. The upper portion of this chart is the owner of the rig and the bottom portion is the operator of the rig. Transocean was the owner of the Horizon rig but BP was the operator.

Gulf of Mexico Rig List

The moratorium hit the service companies harder than the drillers. A six month shutdown could cost them millions in lost revenues. All the service companies were crushed on Friday and it appears the selling was sector wide even when the service company was not directly related to the gulf drilling.

For instance, Core Labs lost -$4. I can't guarantee it but I doubt Core Labs has an extensive reservoir management base in the gulf. A couple weeks ago the CEO said on CNBC that the gulf spill had "absolutely no impact" on the company. "This has not and will not have an effect on Core Labs revenues or profitability long term." He said that 70% of revenues come from outside North America. The majority of North American revenues come from land based reservoirs. Still, investors sold the stock on Friday in a knee jerk reaction to the moratorium.

Core Labs Chart

BP is not having any luck with the leak and that it probably the worst news for the sector. They thought the top kill process was partially effective on Thursday night but the small decline in output was minimal. They proceeded to load the junk shot and got only partial bridging and almost no reduction in flows. They tried injecting more mud and more junk and nothing changed other than a rising pile of ejected mud around the well. Late Saturday they said the top kill had failed and they were moving to the next plan.

That plan is the most dangerous. There is no room for error. It involves cutting off the crushed riser pipe on the top of the BOP that is currently retarding the flow of gas and oil out of the well. Once the pipe is cut off the well would be 100% open to the sea with nothing to constrain it. BP would immediately try to lower a new containment device onto the top of the BOP. They have already lowered several of the various types of devices to the ocean floor in preparation for this option. The problem is that they can't fail. If the well is 100% open to the sea then the amount of oil flowing into the water could immediately expand by two to three times as much. There is no option of backing away and rethinking the plan once the pipe has been removed.

One of the devices they can use is called a lower marine riser package or LMRP. The LMRP would act as a cap on the BOP and transport the oil to the surface for collection in a tanker. This option requires a pipe from the drillship above and attached to the LMRP. The ice crystal formation would not be a problem because the oil and gas would flow directly from the well into the new riser and not be in contact with the seawater.

If the LMRP effort fails the next option would be to set a new 50-ton BOP on top of the existing BOP. Once securely bolted to the damaged BOP the valves on the new BOP would be closed. The BOP they would use is the one initially put in place to drill the second relief well. That drilling has been halted so that BOP can be used on the damaged well if needed.

BP said it was going to try the LMRP option first. If successful they can collect the 12-15,000 bpd of oil currently flowing from the well. It could be August before the first relief well is completed. That would give BP close to one million barrels of oil before the relief well is completed. At $70 per barrel that would help defray a little of the expenses. Secondly it would free up the second BOP to go back to work on the second relief well.

BP needs to hire a new public relations director. They are not winning friends on land and making quite a few enemies. News broke on Saturday that BP hired a couple hundred temporary workers and bused them to the beach that President Obama was scheduled to tour. Outfitted in coveralls and protective clothing they worked briskly until Obama's helicopter disappeared from sight and then immediately took off their protective clothes, threw them in the trash and left the beach. When questioned as to why they were leaving the supervisor said BP hired them just to work while Obama was there but he said, "I am not supposed to tell you that." They were paid $12 an hour to look busy. Way to go BP, I am sure this story will haunt you forever.

Let's hope BP gets the leak fixed soon so the cleanup crews can get the oil cleaned up before the hurricanes start rolling in. This was hurricane preparedness week and NOAA released its predictions for 2010. They expect 14-23 named storms including 8-14 hurricanes of which 3-7 could be major hurricanes. They give their predictions a 70% chance of coming true. According to NOAA this could prove to be one of the most active seasons on record.

The predictions exceed the averages of 11 named storms, 6 hurricanes and 2 major hurricanes. 2005 was the record with 28 named storms. They are blaming warmer than normal water temperatures this year and a weaker wind shear since El Nino has dissipated in the eastern pacific.

June 1st begins the hurricane season. If a hurricane does appear with the oil slick in the gulf the wind and wave action will oxygenate the oil and speed the dispersal. However, a major storm hitting in exactly the right place could push surface oil deep onto shore in major quantities and contaminate thousands of acres of land. Right on schedule the first tropical storm of the season appeared over the weekend and was named Agatha. The storm was heading northeast over Guatemala. The low intensity storm was not expected to cause trouble in the Gulf of Mexico.

The month of May ended with the worst S&P performance in May since 1962 with an 8% loss. There were a couple of buy programs that kicked off around 2:PM and rescued the Dow from a -155 point loss to push it within 35 points of positive territory. Those were followed by sell program at the close that knocked the Dow back to -122 for the day.

Analysts credit asset allocation funds for the end of day buying. Asset allocation funds are tasked with maintaining a specific ratio of equities to other assets like bonds or commodities. With equities down -8% for the month these funds had to buy some stock before the close in order to close the month with the right ratios. For instance if your fund was targeting 60% equities and 40% bonds that might have fallen to 55/45 because of the market decline. At month end the manager would have sold some bonds and bought more stock to bring the ratios back into balance.

The markets needed a lot more buying to bring them back into balance. There is an increasing fear that European banks are in trouble. Lending has gone to zero and nobody trusts the bank balance sheets. Everyone is afraid banks own too much debt from countries like Greece, Spain, Italy, Ireland and Portugal and everyone expects that debt to be restructured and produce heavy losses. This is a situation that is not going to be healed any time soon. The EU tried to heal it with a $1 trillion dollar loan guarantee package and failed because nobody believes the errant countries will follow through on their austerity programs.

In the U.S. there is a growing fear of a double dip recession. Housing prices are expected to decline 5-8% by year-end despite the low mortgage rates. All the buyers were pulled forward into the first quarter and shoppers have all but disappeared today. Jobless claims remain stubbornly over 450,000 per week and sentiment remains weak. The dollar-euro divergence means 50% of the S&P-500 are going to see negative currency translation events in their Q2 earnings.

Multiple investor surveys have shown a growing reluctance to be invested in equities. Through last Wednesday fund flow trackers projected $25 billion in withdrawals from equity funds in May. Personally I would be surprised if it was not $125 billion. Investors were scarred from the flash crash and then the retest of those lows two weeks later. Those who decided to bail on the next move higher were greeted with 12 down days out of the last 15. The technicals are terrible and the internals are confusing. The market hates uncertainty and investors hate volatility and both are in abundance.

The Dow can't seem to move over 10,200 for more than a few minutes at a time and the 200-day average at 10,282 is rock solid. The two short squeezes last week failed to hold and the Dow lost 56 points for the week. Since the low was 9774 on Tuesday we should be glad it only gave up 56 points for the week to close at 10134. That is +360 points off the lows! Investors are fickle. They want V bottoms with aggressive rebounds and that did not happen in May.

The longer the Dow or any index for that matter, remains under the 200-day average the greater likelihood it will decline further. The initial dip below the average is a sell signal for fund managers. But like the rest of us optimists they want to give it a few days in hopes the index will rebound back over the 200-day and keep them from unwinding all those positions they worked so hard to develop. The rebound to the 200-day this week and failure to break over that resistance is another warning sign. The next and final sign would probably be a move below Thursday's low just under 10,000. That would be the lights out signal.

Dow Chart

Like the Dow the S&P-500 failed at the resistance from the 200-day average at 1104 after retesting the May lows on Tuesday. This is a textbook rebound failure point. Confirmation would be a further decline below Wednesday's low of 1065. The 200-day should be our line in the sand for initiating long positions. Once over that level it should return as support on future declines. Likewise falling below 1065 would target much lower levels with a possible bump at 1050.

S&P-500 Chart

The Nasdaq chart is only slightly more positive than the S&P and only because it closed over the 200-day average. The pattern is still the same but the Nasdaq is still above the November resistance. This chart is not a buy in my opinion. Given the picture presented by the other indexes I believe the risk is still to the downside.

Nasdaq Chart

The Russell remains the most positive chart with its rebound from the 200-day average as opposed to sinking below it as the Dow and S&P have done. A reader speculated that the Russell was finding buyers because the small caps were less likely to have exposure to Europe or to currency translation issues. I do believe he was right to some degree. Fund managers are stubbornly refusing to sell the small caps. With cash levels very low they are forced to sell something to raise cash for redemptions and it appears they are targeting the large caps.

I recommended buying Tuesday's dip for a trade because of the Russell's relative strength. I warned that SPX 1085 would be the deciding factor on how long we held that trade. Unfortunately the S&P failed at that level the following day after a strong open. It was a short trade.

Russell Chart

In summary, I don't expect the geopolitical conditions to change materially over the next week. There will continue to be news stories about some country or some bank and Iran and North Korea will fight for the most headlines. The ISM report on Tuesday could be market negative if it falls below 59. The ADP report could be negative below 150,000 jobs. Traders will take positions ahead of Friday's Non-Farm Payroll report based on the numbers from the ADP report.

I was fairly confident in buying the dip from Tuesday but I have no confidence in any further gains until the S&P moves over 1105. That would be a signal to buy. A drop under 1065 would be a confirming sell signal.

This is Memorial Day weekend and the markets are closed on Monday. I know Memorial Day is officially for fallen soldiers but we had some other American heroes fall last week. Art Linkletter, age 97, Dennis Hopper 74, Gary Coleman 42 and Jose Lima 37.

I would be cautious about new positions and try to enter only at the swing highs and lows. I expect the volatility to continue until traders become numb to the daily news from Europe. Sentiment is increasingly negative and the path of least resistance is still down. There is no overriding reason to rush back into the markets. I remain cautious until proven wrong.

Jim Brown