The Dow lost -199 points for the week to stretch the current decline to six consecutive weeks. That is the longest losing streak since October 2002 when the Dow lost -15%.

Market Statistics

It was not an economic report that knocked the market for a loss on Friday but a resurgence of worry over the second bailout for Greece and new worries about a decline in exports from China. China reported that imports accelerated in May suggesting the economy might not be slowing as much as regulators had hoped. Worse for the global economy their exports weakened and suggested slower global demand. Imports rose +28.4% over the same period in 2010 and up from the 21.8% rate in April. Export growth slowed to +19.4% from +29.9% in April. However, 19% growth is still growth.

The combination of China's numbers is like a good news, bad news joke. The increase in imports suggests China is not headed for a hard landing from its four rate hikes and seven reserve hikes over the last year. That was the good news. The bad news is a slowing pace of global consumption of Chinese exports. China's economy grew at a +9.7% rate in Q1. Their CPI for May is due out on Tuesday and it is expected to rise to 5.4% according to the consensus estimates. The PPI is expected to decline slightly to +6.5%. The recently released Purchasing Managers Index declined from 66.2 to 60.3 and a significant decline by Chinese standards. If the CPI rises China is expected to raise interest rates again in June or July. That would be the fifth hike since October.

The worries over slowing exports from China coupled with another round of worries over the second bailout for Greece combined to push our markets lower or at least that was the theory being put forth in the press. The Euro collapsed and the dollar rallied sharply for the third consecutive day. A spiking dollar means lower commodities and equities.

The economic reports in the U.S. were mostly ignored with Import and Export prices for May basically flat at +0.2% compared to +2.2% in April. The ECRI Weekly Leading Index declined slightly from 128.3 to 127.7. Unfortunately the implied economic growth rate fell to +4.1% and has been declining steadily since mid April's 7.7%.

Next week is a busy week for economic reports with the PPI, CPI and Philly Fed Survey headlining the list. The price indexes are not expected to show any material gains since energy prices have declined for more than a month. Grain prices have been rising due to the floods and fewer acres planted. These reports should give the Fed some comfort if they decide to continue some form of stimulus in July.

Economic Calendar

The euro collapsed after Germany's Finance Minister defied Trichet, the president of the ECB, when he said a restructuring of privately held Greek debt would be a requirement for a bailout. Trichet said the ECB would unequivocally deny the possibility of an ECB sanctioned debt restructuring for Greece. Many analysts believe Greece will never be able to pay off its debt and they will eventually have to either default or restructure. Most believe a restructuring where the principal is lowered or term is lengthened is just another form of default. Credit default swaps for Greek debt rose to a new record high. Trichet said the ECB would not accept Greek bonds as collateral for future loans.

The continued on again, off again agreement over the Greek problem has been roiling the currency markets for over a year now. Getting a dozen finance ministers from different countries with vastly different economies and balance sheets to agree on anything is next to impossible. The countries with a strong economy and finance system see loans to Greece as a handout and a reward for running their economy into the ground. Those debtor nations who depend on outside funding can't afford to donate billions to the Greek problem when they know Portugal, Italy, Ireland and Spain are lining up behind Greece. The U.S. may have some serious financial problems but at least we are not dependent on a dozen misfit countries controlling our fate. Expect this problem to continue to cause volatility for months to come.

Leigh Stevens was in Spain last week and he said a hedge fund manager in his party had called on several large banks to question them about their portfolios. Apparently the Spanish banks have not written off their portfolio of bad real estate loans left over from the 2008 crisis. They are using the "pretend and extend" policy where they pretend the borrower/collateral is better than it is and extend the loans hoping the economy recovers along with real estate prices. If they had to write down the value of their loans to a market value basis many of the banks would be underwater. The manager said Spain has accepted a big austerity package but unemployment is so high the youth are in revolt. Leigh said he saw large abandoned housing projects in the south where construction funds dried up. Spain is the largest of the "PIGS" and will be far worse for the EU than Greece if they can't get their act together soon.

Euro Chart

Dollar Index Chart

The nearly 2% spike in the dollar over the last three days finally crushed the commodity markets on Friday. Gold was down $21 off the Thursday high and silver -$1.30. The biggest decline came in light sweet crude which fell -$3 on Friday due to the dollar spike and news that Saudi Arabia would increase production by July to 10.0 million barrels per day. At least that is the theory why oil prices fell but I think it was bogus.

The tightly controlled Saudi newspaper Al-Hayat reported Saudi officials were going to raise production unilaterally from 9.3 mbpd to 10.0 mbpd in July. That additional oil would go to China and Asia. The price of WTI crude declined -$3 to close at $98.92.

If you believe that drop was a reaction to the Saudi news then I have a bridge in New York I want to sell you. Saudi already said on Wednesday they, along with Kuwait and the UAE were going to raise production by 1.5 mbpd despite the quotas. Why didn't WTI decline then? The Friday announcement was only half the quantity of the Wednesday announcement and basically just a repeat of that announcement.

Secondly, why did WTI (light sweet crude) in the U.S crash? The crude Saudi is going to produce is heavy sour crude that is not interchangeable with light sweet. Thirdly they said all the oil was going to China and Asia and not to the USA. If any contract should have crashed it would have been the Brent contract, still a light sweet crude, but it is the contract the European and Asian heavy crudes are indexed to. Brent only fell 90-cents.

Saying the WTI light sweet contract crashed because Saudi is going to sell an extra 700-Kbd of heavy sour to China is like blaming falling milk prices on orange trees freezing in Florida. There is no direct correlation.

I believe WTI crude collapsed because speculators in all investments were running for cover. Our equity markets were in the tank with the Dow down -187 points at midday. The dollar was spiking and commodities in general were declining. Plus this is a quadruple option expiration month. Everything expires next Friday. If a fund had some big option bets on oil ahead of the OPEC meeting then Friday would have been the time to close them. Funds normally close positions the week before expiration. Traders got the big OPEC spike in crude on Wed/Thr and it was time to take profits. Nobody would want to carry profits on an expiring contract over the weekend in this environment.

Lastly the USO ETF rolled over their July WTI futures into Aug futures. The posted forward roll dates for June were the 7th-10th. Friday was the 10th. The USO sells 4,000 to 6,000 contracts of the current expiring month and rolls the proceeds into the next month. That is $400 to $600 million in contract value. With oil so volatile after the OPEC meeting they probably waited until Friday to sell the majority of those contracts and that helped push the current WTI price lower. According to the USO website they had pending sells for 3,333 July contracts on Friday morning and they were going to buy 3,590 of the August contracts.

I think the news crews simply report on whatever headline happens to scroll by and then ignore everything else.

WTI Light Crude Chart

Brent Chart

Late Friday an Ohio judge issued a ruling calling for Ford to pay $2 billion in damages to thousands of dealerships in a 2002 class action lawsuit. The court found Ford had over charged dealers under their agreements and awarded $781 million in damages and $1.2 billion in interest. Apparently Ford billed all the dealers based on unrealistically high published wholesale prices but used a series of unpublished "secretive" discounts to shift revenue from the dealerships to Ford. Under the dealership agreements Ford was required to sell the trucks to the dealers at prices and discounts published in accordance with all dealer Terms of Sale Bulletins. Ford gave favored dealers unpublished discounts while making others pay the published price. Ford has maintained a liability warning on this case in its financial statements for years but at a microscopically lower level. There are 3,000 dealerships in the suit covering purchases of 474,000 trucks. Ford said it would appeal the verdict.

Auto production for 2011 could decline by 2.8 million vehicles as a result of the Japanese earthquake. So far Japanese manufacturers have lost production of 2.3 million vehicles though June 3rd and all manufacturers are not yet up to full production. The 2.8 million loss also accounts for declines at automakers outside of Japan that saw production slow due to a lack of parts.

Ford Chart

The market attempted to rebound in the middle of the day after CNBC reported the biggest banks, considered too big to fail, would have to put up less capital than previously thought. The Basel accords have raised the basic capital requirements of banks to a minimum of 7% but the big banks are going to have to put up additional capital in order to avoid any future bailouts for systemically important banks.

The Systemically Important Financial Institutions or SIFIs will be charged another 3%. At least it was thought to be 3% up until Friday afternoon. After a secret meeting of regulators the capital surcharge is now expected to be 2.0% to 2.5%. That may not seem like a large amount but a bank as big as Bank America with $2.3 trillion in assets and $165 billion in tier one capital, one percentage point is a huge amount of money. Having to put 9% aside under the new Basel rules is going to be very painful. This is why the banking sector has been in the tank for the last three months.

When the news was announced the entire banking sector rocketed higher. It went from the worst performing sector for the day to the best performing in about an hour. The market would have finished significantly lower without the bounce in the banks.

KBW Banking Index

Bank America Chart

Travelers was hit by a tornado. Actually several tornados. The company said it was cutting back on a stock buyback program and would probably post a loss for Q2 as a result of more than $1 billion in insured losses from the tornados in Joplin and Tuscaloosa. The said normal insured losses are less than half that amount. According to risk modeler AIR Worldwide the insured losses for all carriers will be in the range of $4 to $7 billion for the May storms and $3.7 to $5.5 billion for April storms. There have been 1,439 tornados so far in 2011 compared to 1,282 in all of 2010.

Travelers Chart

The major indexes (Dow, S&P) are down -7% since the first of May. It has been a long slow grinding decline with three material rebounds but all posting lower highs. The Dow closed under 12,000 at 11,952. Since the May high that equates to an $855 billion decline in household net worth.

The top ten percent of households with the highest incomes account for more than 20% of all spending. Those are also the households that invest the most. Seeing nearly a trillion dollar decline in their investment accounts is going to produce a big hit to consumer sentiment and consumer spending.

According to fund tracker EPFR Global the bond funds saw $6 billion in inflows for the week and the fastest rate in nearly a year and equity funds saw outflows of $7.7 billion. Investors are seeing the signs of economic stress and running back to the safe haven of bonds even though the ten-year yield is under 3%.

The American Association of Individual Investors (AAII) weekly survey of members on their outlook for the next six months found 48% bearish, 24% bullish and 28% neutral. The bearish group rose +14.2% and the bullish group declined -5.8% from the prior week. The neutral fence sitters declined by -8.5%. The long-term normal ranges are bullish 39%, neutral 31% and bearish 30%.

Other red flags include a sharp sell off in the junk bond market plus an increased amount of options activity. The put call ratio hit an 18-month high last week. Did anyone notice how easily major support levels were broken? The indexes barely slowed as they passed through levels thought to be strong support like 1295 on the S&P or 12,200 on the Dow. That suggests further selling ahead when the buyers are not even making a halfhearted attempt to buy the dips.

Over the last few weeks IPOs were making headlines and people were talking about a new bubble forming after stocks like Linkedin opened with big numbers. On Friday another IPO made big news. Ally Financial announced it was delaying its $6 billion IPO because of bad market conditions. The target date was to IPO before July 4th. Now they are talking late August depending on the market.

The Dow and S&P have now been down for six consecutive weeks. That is the worst performance since 2002 when the Dow lost -15%. The Nasdaq has lost -191 points (-7%) in just the last 10 days and is now negative for the year along with the Russell 2000, Dow Transports, Semiconductors, Banks, Brokers and Housing. The S&P-500 is only 12 points away from a low for the year.

The slow decline we saw for the entire month of May turned into a steep dive in June. It would appear we are going to target a true -10% correction and it could come next week. For the S&P that would be 1225 but I am betting we find some bargain hunters in the 1250 range assuming the economics don't suddenly turn worse.

We have been seeing quite a few more earnings warnings BUT we are still on track for the S&P to earn between $95 and $100 for the year and that would be record earnings. Using those numbers we are currently undervalued and oversold. The problem is not that investors don't want to buy something. The problem is the economic uncertainty. The drop from "decent but slow" growth to "barely growing if at all" occurred so quickly it caught everyone off guard.

Personally I believe it was $4 gasoline that shocked consumers into a buying halt. They remember the pain from 2008 and immediately changed their spending habits. Fool me once shame on you, fool me twice shame on me. Now we will have to rest awhile and let prices decline so consumers will feel comfortable opening their wallets again. Look at the decline in same store sales for the lowest common denominator retailers like Wal-Mart for the proof. Those are the retailers who were hurt the worst by the sharp spike in gasoline prices. Moody's claims gasoline prices will have to decline by 90-cents from the highs to rebuild that confidence. That would put it back to a national average of roughly $3.05. Don't hold your breath.

I am not going to repeat it all here but global oil demand is rising and production is not despite the minor increase by Saudi Arabia. Prices will decline slightly but nowhere near $3.05 without another recession. That means the slow growth economy is going to continue growing slow if at all. There are still more than 16 million people unemployed and more than two million homes still in the foreclosure process. This is not an economy that inspires investors to buy the dip.

While I expect the S&P to find some buyers at 1250 I think it is going to require some better economics to keep them in the game. The reports this week are more inflation oriented (CPI, PPI) but the Philly Fed could be a turning point. Estimates are for a rebound from the seven month low of 3.9 in May. The cycle high was 43.4 in March. That is how fast things turned to crap. March was when oil prices first rallied to $110. Economic activity crashed almost immediately.

If the S&P fails to hold 1250 or even the 10% correction level at 1225 the next target would be 1175 and the lows from November. However, a break below 1250 would have analysts racing to lower their year-end forecasts and that would further sour investor sentiment. We need to pray that 1250 level holds. Better yet we need to pray all the manufacturing reports post rebounds this month that prove the damage to the supply chain from Japan is over.

S&P-500 Chart

The Dow is in free fall mode with the close under 12,000 and the last level of material support before the March lows at 11,600. The 200-day at 11,687 may not hold since 11,600 is such a clear target. Like the S&P if the Dow breaks below the March lows it could be a very quick trip to stronger support at 11,000.

Dow Chart

I wish I could skip the Nasdaq this week. This is the definition of an ugly chart. The possibility of a miraculous rebound at the March low at 2610 is practically zero. The damage to the Nasdaq in June has been dramatic. All the big caps are imploding. Google closed at a new eight month low on Friday at $509. Cramer's $675 or is it $750 price target is not going to happen this summer. Apple hit a six-month closing low at $325. Unless some seriously dramatic tech news breaks next week the Nasdaq appears destined to fall below 2600. That would be a critical breakdown in sentiment that could cause an even further decline.

Granted tech stocks are supposed to decline in the summer but this is a little worse than normal. I keep hearing brokers pounding the table to buy tech stocks but I don't see it. I would want to see a decent bounce off 2600 that lasts more than 48 hours before taking a chance at a long position.

Nasdaq Chart

The Russell, like the Nasdaq, has gone negative for the year. It is on the verge of a potentially horrendous breakdown should support at 775 fail. This is going to be a critical test of fund manager sentiment and it would have to be a Jekyll and Hyde transformation to make me a believer of any rebound.

Russell Chart

Next week is the proverbial "pivotal" week. The indexes should all reach critical support levels and how they react to those levels will be the key. If they break it will be like the groundhog seeing his shadow and doom us to six more weeks of pain. If they hold on support long enough for a couple of positive economic reports to arrive them we have a chance this correction will fall just short of a -10% drop.

That is a couple of very big "IFs." More than likely the economics will improve slightly as the impact of Japan fades but I would be surprised if slightly will be enough. The next big turning point for the market is more than likely the second week of July when the Q2 earnings begin to appear. If earnings are decent they may overpower the weak economics.

This is a quadruple witching expiration week but most of the associated volatility likely played itself out on Friday with the big drop. Moves like that are either caused by expiration or they eliminate expiration pressures by blowing through the stop losses. Regardless of the reason on Friday the move was enough to spike volume by 1.3 billion shares to 7.4 billion. That was 1.4 billion more than I was expecting. Summer Fridays are normally very quiet so that is even more confirmation for me it was option liquidation rather than just a market dump on mediocre news. Declining volume was 5:1 over advancing. Before the banking rebound it was much worse. However, it was not bad enough to be a capitulation day. I would love to see one on Monday with volume 10:1 negative and taking us right to those critical support levels. I would be very surprised if it happened. I have never found wishing to a particularly effective trading strategy.

There is one significant caveat. With six consecutive weeks of losses we are very oversold. However, the minor short squeeze on Thursday was sold hard so any new short squeeze would require some follow on confirmation before I would jump on board.

I would continue to be very cautious. Enter passively, exit aggressively.

Jim Brown

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