The extreme oversold conditions created a monster short squeeze when economics from China and the U.S. came in not as bad as expected. Are "less bad" results really a reason to rally?

Market Statistics

The basic news thread for the day was based on the "soft landing" scenarios being discussed after China saw decent growth in factory orders of +13.3% in May. That was only 0.1 below the April numbers so no apparent hard landing. China's retail sales rose by +16.9% and fixed asset investment for the Jan-May period rose +25.8%, up +0.4% from the Jan-Apr level. Analysts were worried that China was going to over correct from its blistering pace of growth at 9.7% GDP in Q1 but that does not appear to be happening.

Auto sales in China did decline for the second month but that could have been related to a lack of import models from the Japan parts shortage. China is also trying to slow auto sales somewhat to curb oil demand and limit overcrowding on the streets, which has become a very big problem in the major cities.

China's inflation rate rose to 5.5% in May and well above the 4% target but the increase was minimal and related to a shortage of food due to bad weather. Analysts believe that problem has passed and they are expecting a large harvest to bring down prices and food inflation.

Over all it was a great report from China after several weeks of gloom and doom expectations. After the inflation numbers China did raise the reserve requirement for banks again by another 50 basis points. That is the seventh hike since October. That reduces the amount of money banks have to lend and slows consumption at the retail level and expansion at the business level.

In the U.S. the retail sales for May fell -0.2% and the first decline since last June. The biggest factor in the decline was a -2.9% drop in auto sales, again due to the shortage of models and parts from Japan. Retail sales in March and April were also revised lower. Other sectors losing ground included furniture and home furnishings -0.7%, electronics and appliances -1.3%, sporting goods and food and beverages at -0.4%. Building supply stores saw the biggest gain at +1.2% thanks to the spring weather and sales of materials to rebuild after storms.

Sales at gasoline stations understandably rose +22% year over year but only +0.3% over April. The price of gasoline began to decline on May 3rd so I am surprised there was any gain over April.

Overall retail sales were weaker in May as the impact of those higher fuel prices impacted consumers. Buyers are being selective in their purchases rather than impulse shopping. This is weighing on prices for consumer items since price comparison shopping is so easy in today's smartphone world. The increased take home pay from the temporary social security tax cut has been eliminated by the rise in gasoline prices. When that tax cut disappears in six months there will be another dip in consumption. High unemployment is keeping wages low with 8-10 people available for every job and hundreds applying for anything that is advertised.

On the positive side there is still a pent up demand for products. When the recovery begins to accelerate, employment improves and consumers feel like the worst is over there will be a real buying binge. Hopefully this happens before Q4 begins so the holiday shopping season gets a running start.

Prices at the producer level rose only +0.2% in May and the smallest gain since last summer. The falling fuel prices were again the major driver in the decline. Core prices, excluding food and energy also rose by +0.2%. A +0.5% increase in the price of passenger cars and +1.1% rise in the price of trucks helped to push the core index higher. The Monster Employment Survey for Q3 showed that 12% of respondents were planning on hiring in Q3. That was up from 10% in Q2. However, after seasonal adjustments the Q3 number was only 8% and the same as the adjusted number for Q2. This suggests the hiring plans for major corporations have stagnated. There is too much uncertainty about budgets, taxes and economic strength. Until some of those problems are resolved most companies will be reluctant to increase expenses by hiring employees.

The economic calendar for the rest of the week is busy but only the manufacturing surveys should be market moving. Expectations are low so any bad news may be tempered but any good news could produce another short squeeze. With the FOMC meeting next week there may be less incentive to take any new positions because the Fed is not likely to announce any new stimulus or say anything positive.

Economic Calendar

The big event today was the Bernanke speech on the budget deficit and debt limit. It was anticlimactic to some extent because almost everyone knew what he would say. The limit has to be raised and it should not be used as a bargaining chip to extract massive budget cuts. The economy is too weak to survive another hit from hundreds of billions of dollars in short-term budget cuts. Bernanke would rather see allowances for future cuts over an extended period to achieve the same goals as the economy improves. The markets reached the highs of the day just before his speech but sold off slightly when nothing new was heard.

The FOMC meeting next week will be much more important than today's speech. The Fed will say QE2 is over and give guidance for how much in portfolio payoff proceeds will be used to buy treasuries over the rest of the year. They may or may not mention future stimulus considerations. I expect they will not tease the market with any possible moves. They probably want to see how the market reacts to no QE2 purchases before they decide if something else is warranted. Basically there should be very little in the form of positive statements from the FOMC meeting.

The Greek debt crisis continues to roil the market and a deal for a soft default seems to be taking shape. Nobody believes Greece will ever be able to pay off its debt. The deals just kick the can down the road but every kick increases the size of the can through interest, time and short-term bailouts. The deal being discussed this week would have bond holders agree to roll over their current debts in equal amounts at the end of the original term. If you owned a 3-year bond for $2 million that matured on Jan 1st you would have to agree to roll that over into a new 3-year bond rather than demand payment. It would be essentially the same thing as having Greece arbitrarily extend the maturity dates of all debt by three years but the roll over would not trigger a default and the associated credit default swaps. You still don't get your money and now you have to buy another three years of default insurance.

Most analysts believe this is just a stop gap measure and Greece will eventually have to either cut the principle amounts across the board or lengthen the maturity dates in what would be seen as a hard default and trigger the insurance payments. American banks only own about 5% of the Greek debt but they also own about 6% of the credit default swaps. Essentially they wrote the swaps before the crisis as puts in order to collect the premiums. If a default is triggered they have to eat the debt. If the new deal to roll over debt is successful I believe it would allow the banks to let the swaps expire and then avoid the new debt by not writing any new swaps. It would be a way to escape the noose currently dangling over their balance sheets. Also a delay in the default for those that actually own the debt would give those banks time to prepare their balance sheets for the eventual losses rather than have them suddenly appear and force large losses. Time allows for small regular charges to be passed through the statements without a big impact.

In stock news Nokia (NOK) settled a suit against Apple for what some analysts believe could be for more than $650 million plus future royalties. Apple has sold more than $65 billion in iPhones so far so a $650 million payment is chump change. Nokia sued Apple claiming the iPhone was built using technology patented by Nokia. The suit began in 2009 and with this deal today it was concluded rather quickly as big patent fights go. The agreement settles "all litigation between the two companies" and that suggests Apple saw a long and protracted fight that would not end well. Nokia needed the money after they warned on sales last month. Once the largest cell phone maker they are expected to be beaten by the Android and will be eclipsed by Apple over the next couple months.

Nokia Chart

Apple Chart

Apple also lost Ron Johnson, the head of its retail store division. Johnson was picked to become CEO of JC Penny's (JCP) and the news spiked JCP shares by +17%. Johnson was responsible for Apple's high profile store chain, which was a major factor in Apple's success. Penny's is giving Johnson $50 million in stock to offset his equity awards he will leave behind at Apple. He will get a $1.5 million annual salary. He will also pay just under $50 million of his own money to buy 7.26 million in warrants with a strike price of $29.32. He can't exercise the warrants for six years but he is confident the stock will be well over that level by then. The stock hit a high of $41 in May but dipped to support at $30 on Friday. Today's +17% gain put it back at $35. Johnson has sold more than $300 million in Apple stock and options over the last four years and still owns 232,000 shares.

JC Penny Chart

Pandora, the Internet radio site, prices its public offering for Wednesday at $16 and well over the expected range. Initially Pandora (P) was thinking $7-$9 and estimates rose to $10-$12 on Monday. They priced the 14.7 million shares tonight at $16. The number of shares was increased by +43% last week in order to meet demand. This values the company at $2.6 billion. Pandora has never had a profitable quarter and lost $7 million in Q1 and -$92 million since inception. They are adding one user per second but expenses to gain those users and the pay royalties on music for those listeners is also rising. They are competitors to Sirus XM but they claim their biggest worries are Apple, Google and Amazon as those music platforms surge in popularity. This is probably not an IPO I would hold for more than a few days.

Standard Chartered PLC, a major international bank with a 150-year history and 1,700 offices, blew the doors off the gold market today by predicting gold prices could rise to $5,000 an ounce over the next five years. These guys are not gold bugs or fly by night pump and dump scammers. This is a real bank with $15 billion in earnings in 2010. They did a comprehensive study of 375 gold mines and projected projects over the next five years. They found that production suggested only a +3.6% growth in production over that period. They found that existing projects currently under construction would require $1,400 gold to produce a 20% profit, which is usually the minimum return requirement for new projects. For Greenfield projects where the land still needs to be acquired and financed the minimum price would need to be in the range of $2,000 for the IRR to hit 20%. The recent rise in the price of gold has severely inflated the cost of land and a threshold of $2,000 an ounce to play means many of those proposed projects will be abandoned. This daunting hurdle to new production will serve to severely limit new production. Think about it. If you are a miner today do you want to be buying future reserves at the current $1,500 an ounce price? That would require a lot of faith in the future. You don't want to end up with a mine five years from now with gold selling for only $650 an ounce.

Standard said sovereign banks had ended their decade old program of selling gold and were now buying gold in large amounts. With the dollar expected to continue to be weak for years to come they are likely to accelerate gold buying as an inflation reserve. China is behind the curve with only 1.8% of their reserves in gold when the global average is 11%. China would have to buy 6,000 more tonnes of gold to catch up and that equates to two years of global production. They recommend purchasing physical gold or shares of junior miners with new production coming online over the next two years. They warn about buying major miners saying the only way they can grow is with expensive acquisitions. Standard expects the major miners to only generate at 4% CAGR over the next five years.

Add in the inflation impact of the lower dollar and the potential for actual hyperinflation to appear within that five-year period and the outlook for gold is pretty favorable. Looking at the chart below should scare most investors away from the play but if Standard is right those who skip the trade will be kicking themselves five years from now.

Gold Chart

Crude prices rallied today on the expectations that maybe China was not headed for a hard landing. Brent spiked to $23 over WTI intraday and a new record for the spread. I could easily see Brent prices move to a new two year higher over $126 in the weeks ahead. Baring a quick resolution to the Libyan problem there will continue to be a shortage of light sweet oil in Europe and Asia. The Brent contract is the true price of oil because WTI is no longer relative due to supply and distribution problems in the Midwest.

I wrote a comprehensive article last night on why WTI is no longer relative and why Brent is the new standard for global pricing. You can read it here: Tale of Two Contracts

Brent Crude Chart

Today's rally was simply another short squeeze from very oversold conditions. Every writer warned about this from last week. The S&P rallied to just short of 1295 and a resistance level that held for the last eight days. The key to determining whether this rally has legs would be a close over 1300. Solid confirmation of the type that fund managers would like to see would be a close over 1325 and the 50-day average.

I am not going to go out on a limb and warn of another decline but that is what I expect will happen. The reason I am cautious on my prediction is the lack of a decline on Monday. We seem to have reached a level where sellers ran out of inventory. They might be just hoping for a bounce so they can sell into strength or maybe the decline is done.

For the decline to be over all the bad news would have to be priced into the market and I don't think that has happened yet. Until we see the Philly Fed report this week I would doubt too many traders would be interested in backing up the truck on long positions. There is still too much uncertainty in the economics. One day does not make a trend. It could be a reversal but until it becomes a trend it remains a risky buy.

There are still a lot of analysts expecting a test of 1250-1257 or even 1225. However, a rally is always accomplished by the bulls climbing over the back of the bears.

In the chart below note the majority of the gains were in the first 30 min and the rest of the day was just passing time waiting for the close. I was encouraged the closing sell off was not stronger. It means the sellers were not convinced either. They were looking for a sign that did not appear.

Look for a more over 1300 or a drop below 1280 for a new directional signal.

S&P-500 Chart - 30 min

S&P-500 Chart - Daily

The Dow rebound stopped exactly where you would have expected it to stop at 12,100. There is no bullish signal here until 12,100 and 12,200 are broken. The short-term downtrend is the dominant trend and it will require a solid breakout to convince traders it is a real move. Every long-term downtrend has many short-term short squeezes. Eventually one of them will be the start of the new bull market but we never know which is the real one and which is a bear trap until several days after they occur.

Dow Chart - 30 Min

Dow Chart - Daily

The Nasdaq actually hit its 200-day average on Monday so you would have expected at least a temporary rebound as some traders bought that support test. The big gain in Apple and Google today, both hit multi-month lows on Monday, helped to power the rebound. Both were very oversold and heavily shorted. A squeeze was only natural on the slightest bit of good news. Google closed -$6 off its high with a gain of only $3. That is not exactly awe-inspiring.

Nasdaq Chart - Daily

The Russell reached its support low at 775 on Monday and came to a dead stop. Sellers lost their conviction after the decline stopped on support. It is not surprising to see the strong rebound today but like the other indexes the rally ended right on strong resistance at 795. A move higher over 805 would be confirmation the rebound had legs but so far what we have seen was just a reactionary short squeeze. I believe everyone loaded up in expectations of a break of that support at 775 and it did not happen on the first test.

However, the negative sentiment so prevalent in the market over the last couple weeks seems to have faded slightly. It will be interesting to see what the rest of the week will bring.

Russell Chart - 30 Min

Russell Chart - Daily

I am neutral for Wednesday. The charts are showing solid resistance and the short squeeze appears to have run its course. If I had to pick a direction I would bet on another decline but negative sentiment appears to have faded slightly. We never know what news from Europe or Asia is going to do to our markets overnight and the rest of the week has a lot of economic reports but only one is critical. (Philly Fed) I would remain cautious on new long positions until the indexes moved over those upside breakout levels I mentioned above. June still has a couple weeks left on the calendar and this is a quadruple witching expiration week.

Definitely, enter passively and exit aggressively.

Jim Brown

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