The breakdown in the debt limit talks helped to limit the market gains on Friday as we move even closer to a showdown ahead of the August 2nd default date.

Market Statistics

While nobody actually believes the government will default on the debt the clock is rapidly expiring. Treasury Secretary Tim Geithner reiterated there is no other option and August 2nd is a hard deadline. President Obama claims a deal needed to be concluded by July 22nd to allow time for the appropriate legislation to be passed and signed in order to meet that August 2nd deadline. With no further talks scheduled between the president and congressional leaders it appears the House is going to pass a resolution to try and get something done but it has nearly a zero chance of passing.

This is political theater on both sides of the isle with each blaming the other for the impasse but the curtain is about to go up on the last act. With the uncertainty on the debt limit and some seriously negative economic reports I am surprised the markets closed positive on Friday. I believe it was short covering ahead of the close as options expired along with those debt limit hopes.

Starting the economic reports for Friday was the first reading on Consumer Sentiment for July. The headline number fell sharply to 63.8 from 71.5 in June. The -7.7 point decline knocked it back to levels not seen since March 2009. Since all the normal consumer factors of gasoline prices and stock market gains were both strongly positive in the week this survey was taken the only material factor was apparently worry over the debt limit. As the sound bites increase in hostility and with ratings agencies warning of downgrades the average consumer is begining to worry about the future.

The present conditions component declined from 82.0 to 76.3, a drop of -5.7 points and the expectations component fell from 64.8 to 55.8, a -9 point drop. With jobless claims declining slightly, gasoline at its lowest price in months and inflation seemingly fading and the stock market rallying +6% in nine days there was no real area of concern that would have equated to a -7.7 drop in the headline number other than the impasse in Washington. The market weakness over the last six days was after the initial survey period. The consumer is apparently worried the impasse will lead to a default and while they probably don't know what that means they know it would not be good.

This is even more reason the political theater currently underway in Washington needs to end soon.

Consumer Sentiment Chart

The NY Empire Manufacturing Survey rose slightly from its -7.8 reading in June to -3.8 in July. Unfortunately analysts were expecting a rebound to a +7.0 and not a continued reading in contraction territory. This is the first time in more than two years the survey posted consecutive negative readings.

The internals were ugly. New orders fell to -5.4 from -3.6, down from a high of 22.3 in April. Backorders declined to -12.2 from zero and well off the cycle high of 9.7 in May.

The NY Empire Survey is the first reading on July conditions and this weakness increased concerns about the future regional reports. You may remember that May appeared to be the low of the soft patch and June numbers surprised to the upside. If July is going to show the economy rolling over again after a single month of gains then we are in trouble.

Empire Manufacturing Chart

The Consumer Price Index for June declined by -0.2% compared to a +0.2% gain in May. Analysts expected a -0.1% decline. The majority of the decline was due to the -4.4% drop in energy prices for the month. However, food prices rose +0.2%. Those numbers would appear positive but the core rate, excluding food and energy, rose a strong +0.3% for the second consecutive month.

The year over year rate for the headline number is a gain of +3.4% and the core rate is up +1.6%. This is still below the Fed's inflation target but with +0.3% gains per month it won't remain below that target for long. The biggest impact to the core prices was the +3.9% rise in vehicle prices as a result of the Japanese earthquake.

Consumer Price Index Chart

Industrial production for June rose +0.2% but the major gains were in utility output (hot weather cooling) and mining output (more coal for hot weather cooling). Auto production also rose slightly. Factory utilization remained low at 76.7% so no inflation worries there.

The economic calendar next week only has one major report and that is the Philly Fed Survey on Thursday. That is the second activity report for July so a decline there as in the NY report on Friday would not be good.

In the calendar below I could have put a big DEBT LIMIT line in for every day next week because that will be far more important than any regularly scheduled economic report.

Economic Calendar

The big news for next week is of course the earnings. There are 113 S&P-500 companies reporting and 14 Dow stocks. IBM will kick off the tech week on Monday followed by Apple on Tuesday and Ebay, Intel, F5 Networks and EMC on Wednesday and Microsoft, SanDisk and Western Digital on Thursday. CAT, GE and Honeywell close the week out on Friday. By the closing bell on Friday we will know how the quarter will play out and have a good idea which companies and in what sectors there will be problems and traders will be positioning themselves accordingly for the next several weeks.

Partial Earnings List

Earnings on Friday were led by Citigroup, which posted earnings that rose +24% and beating estimates. However, the earnings came on higher investment banking fees and lower loan loss reserves. The early morning pop in the stock price evaporated after Citi said expenses would be higher than previous forecasts. Earnings were $1.09 per share compared to estimates of 96-cents.

Citi posted a +61% gain in investment banking revenue. Citi lowered its loan loss reserves by $2 billion. Operating costs rose +9% to $12.9 billion and the CFO said that would continue to rise due to legal bills and a weakening U.S. dollar. He predicted between $48 and $50 billion for the year. Citi's revenue declined -7% compared to a +7% rise in revenue at JPM. Citi advised on $98.8 billion in deals for the quarter. That was almost four times the number in Q2-2010.

CEO Pandit told analysts the bank was comfortable with longer-term trends but was worried about the impact of the short-term economic environment. He said the European debt crisis and the current problems in the U.S. had slowed trading significantly. Pandit called it a "challenging trading environment."

Citi disclosed it had $22 billion in risk to Greece, Italy, Portugal, Spain and Ireland. Previously Citi had disclosed a $31.1 billion exposure to Italy in December 2010. No specific mention of that was made on Friday but they could be hedged and the lower net liability is included in the $22 billion total.

Citi said it was selling assets to raise capital for the new Basel rules later this year. Large, too big too fail, banks will be forced to put up more liquid capital to prevent a recurrence of 2008.

Citigroup Chart

Bank of America (BAC) traded below $10 and a new 52-week low on Friday ahead of their earnings next Tuesday. BAC is not expected to post an upside surprise. I heard from an employee at BAC there were wholesale layoffs of quite a few people last week. I would not be surprised to hear BAC tout the layoffs with their earnings as a way to overcome negative sentiment over what traders believe could be some bad numbers. There was news on Friday that six Federal Home Loan Banks may seek to intervene in the $8.5 billion BAC settlement over mortgage-backed securities. These problems may never go away.

Bank America Chart

Mattel (MAT) posted profits that rose +56% thanks to Barbie and Cars 2 merchandise. Mattel reported earnings of 23-cents compared to estimates of 16-cents. Revenue rose +14%. Barbie and friends saw an increase in sales of 22% with Barbie up +12% by herself.

Mattel Chart

Google held its gains from their blowout earnings on Thursday night and contributed more than ten points to the Nasdaq's +27 point gain. The earnings helped garner seven new price target upgrades and 13 earnings estimate revisions. RBC Capital raised their target to $790 and Canaccord Genuity raised their target to $800. Google closed at $597 on Friday.

Google Chart

The Google earnings have put a new spin on the big tech earnings for next week. That is especially for true for Apple on Tuesday. Earnings expectations took a sudden turn higher after the Google beat even though Google earnings are not really relative to Apple's business. This puts a lot of pressure on Apple to put in a strong performance as well. Apple's shares rallied +7 on Friday to close at a new high at $365.

Apple Chart

The big news on Friday was not earnings but news of two high profile buyouts. BHP Billiton (BHP) offered more than $12 billion for Petrohawk (HK) in a deal that paid a 60% premium for the exploration company. BHP will assume $3 billion of HK debt as part of the deal. The deal valued HK at $38.75 per share and HK closed at $23.47 on Thursday. The deal gives BHP more than one million net acres in the Eagle Ford and Haynesville shales. This values HK's proven reserves at $4.50 per MCFE and a very big number considering the price for gas today.

BHP bought HK to get the multi basin access to shale gas. BHP also signed a deal with Chesapeake (CHK) for $4.75 billion in February for shale gas assets. BHP believes HK has significantly more reserves than what has been proven. HK had a chronic cash flow problem because it leased more acreage than it could afford to drill and they were constantly looking for more money. With gas prices still in the tank the new production barely covered the cost to drill. That is based on today's metrics. As demand for natural gas increases and the LNG export activity increases the price of gas will go up. It currently sells for double or even triple the U.S. price in overseas markets.

Exxon paid a whopping $41 billion for XTO back in June 2010 to get access to their large lease holdings of natural gas. XTO had a resource base of as much as 45 trillion cubic feet of gas. That is roughly double the U.S. annual consumption. That made Exxon the largest natural gas producer in the USA. Exxon holds millions of acres of gas leases around the world and needed the shale gas technology and expertise from XTO. For instance Exxon has 3.2 million acres in Germany and an XTO technical team recently visited there.

Obviously Exxon management is not stupid and you can bet they did their homework before buying XTO for $41 billion. BHP is also a very large oil and gas producer with a market cap of $150 billion and decades of experience in the field. They are one of the most active drillers in the Gulf. These companies are looking into the future and visualizing the need for more oil and gas production that sells for much higher prices. Chevron has also been active in the space and closed its acquisition of Atlas Energy in February for $3.58 billion, a 37% premium to the prior closing price. Atlas had 622,000 acres in the Marcellus Shale.

The HK transaction has raised the bar for other players in the space. There are a dozen companies that could be acquisition targets now and it appears the majors are now in a race to see who can acquire the most acreage and reserves. It is easier for a major company to acquire an existing company like HK than try to locate and acquire premium leases in a vastly overbought space. Every acre that has any promise has already been locked up or will be soon. The inventory of available contiguous acreage is no longer in private hands but now is on the balance sheets of those companies. The only way to get the acreage is to buy it from these companies OR buy the companies and get their rigs and technology as well.

The HK purchase has put some amazing valuations on some of these potential acquisition targets. For instance if valued at $4.50 per MCF Pioneer Natural Resources, currently $96, would be worth $174 a share. EOG Resources would be worth $160 not the $101 where it closed today. Chesapeake would be $89.

I seriously doubt there will be any more deals in the next several weeks because everyone in acquisition mode will be choking on the HK price. However, they will realize that the days of buying for $2.00 or $2.50 per MCF are over and if they wait any longer someone else could swoop in and steal their target.

We have been taking positions in these acquisition targets in the Oil Slick newsletter so the big gains in the energy sector on Friday were very nice to see. We did not own Petrohawk because of their chronic cash flow problems but we do own several other targets that are better companies with more impressive lease portfolios. You should consider adding some of these companies to your portfolio while they are still cheap.

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Petrohawk Chart

Petrohawk was not the only buyout announced on Friday. Clorox (CLX) is the target of another takeover play by Carl Icahn. The billionaire offered $76.50 for the company saying it was very undervalued. Unfortunately this is a Trojan horse rather than a serious bid. Why Clorox? Why would Icahn want a bleach company? Don't let the name fool you. Clorox has a varied portfolio of dozens of name brands. For instance they own Liquid Plumr, Formula 409, Pine-Sol, Armor All, S.O.S., Tilex, Hidden Valley, KC Masterpiece, Glad, Kingsford, Brita, Fresh Step and many others. Clorox has added names to its portfolio whenever the opportunity presented itself over the years.

However, the Icahn ploy is not really a buy out. Icahn has a large position (9.4%) in Clorox and he is trying to pump up the price in hopes somebody like Procter & Gamble or Unilever will over bid him. The letter to Clorox offers $12.6 billion consisting of $4.8 billion in equity of Icahn Enterprises and $7.8 billion in financing arranged by Jefferies & Company. This would be a 21% premium to the pre announcement price. Icahn is also offering a $100 million breakup fee if the board accepts his offer and he fails to close the deal. Icahn owns 12.8 million shares of Clorox. Just announcing the bid made the value of his shares rise by about $85 million. He probably owned a lot of call options as well.

In the letter to the board Icahn urged the company to seek other bids from potential strategic buyers such as P&G, Unilever, Colgate, Reckitt Benckiser, Kimberley Clark and Germany's Henkel. He suggested those companies could offer up to $100 per share based on the synergies of scale. Analysts are not buying the deal. Since 1996 Icahn has made 15 unsolicited or hostile bids for companies whose shares he held in his portfolio. NONE of them resulted in an actual acquisition by Icahn. Analysts believe only Kimberley Clark could be a real suitor. Most of the other companies mentioned already have competing products and brands and would face anti-trust issues if they tried to make a play. The company could be split up with the different brands going to different buyers but there would be tax implications to that kind of sale. Analysts feel the Icahn proposal was just another attempt to profit from his activist mentality and it will fail. Almost all said sell Clorox now because this is a fair price. Sounds like a good short target to me.

Clorox Chart

The Chicago Mercantile Exchange closed trading on pork bellies on Friday. Not just intraday but forever. The exchange began trading pork bellies in 1961 and trading peaked at 2.8 million contracts in 1982. The contract was used to lock in prices on frozen pork in storage. Traders no longer use that contract. Only 185 contracts have traded since July 2010 and no trades have occurred since January. This is the end of an era and it passed with barely a mention.

Italy's lower House of Parliament passed the €48 billion austerity package by a vote of 314 to 280. The austerity package has some severe cuts and lawmakers are aiming at balancing their budget by 2014. That was a milestone in the European debt crisis but it is far from the end of the story. It was amazing that the parliament was able to pass the measure in less than a week. It showed what motivated politicians can accomplish.

It was a busy week in Europe with Moody's cutting Ireland's debt to junk and Fitch cutting Greece to CCC. There was no surprise to either of those moves since the agencies were playing catch up.

The results of the stress test on the European banks were reported on Friday and only eight banks out of 90 failed to pass. That ratio should be a clue to the quality of the testing. Analysts were calling it a stressless test since the European banking sector is in serious trouble. There was no allowance in the test for a soverign default. They were only graded on their personal and corporate loan portfolios. Since the problem with the European debt crisis is country oriented and not corporate the exclusion makes no sense.

The eight banks, five in Spain, two in Greece and one in Austria, were found to have a combined capital shortfall of 2.5 billion euros. That is a relative drop in the bucket compared to the 100 billion shortfalls of the individual countries. S&P analysts suggested in March those same 90 banks could need $250 billion in additional capital in the event of a serious crisis. The European Banking Authority (EBA) said as a result of the tests any bank with certain sovereign debt risk should increase their capital. Duh!

S&P increased the pressure on U.S. lawmakers to get a debt deal done quickly by threatening to slash the credit rating of insurers, securities clearinghouses, mortgage agencies and a list of other names if there is not a deal very soon. S&P warned it would cut the ratings of these companies because they either have direct links or rely on the Federal government in their business. Some of the companies put on notice included a Goldman Sachs subsidiary, New York Life, Depository Trust Clearing Corp, Depository Trust Company, Freddie Mac, Fannie Mae, Federal Home Loan Banks, Farm Credit System Banks, Northwestern Mutual, Teachers Insurance & Annuity Assoc (TIAA), USAA and others. This warning is a way to ratchet up the pressure on the U.S. lawmakers and the president to get something done quickly.

Pimco's Bill Gross said in a Bloomberg interview "Lawmakers really do not get the implications going forward." "The U.S. has a $60 trillion net present value liability burden and that constitutes Medicare, Medicaid and Social Security in combination. That is 4-5 times GDP and it certainly exceeds the combined liabilities of Greece, Portugal and Spain. The U.S. has a big, big problem and it can't be solved by cutting $2-$3 trillion in spending over a year or two and expect the economy to survive."

The longer it takes to get a deal done the more damage will accrue to the U.S. on a reputational context and a credit context. How many billions in treasuries will not get sold because the overseas buyers will start to be concerned about our future ability to pay our bills? Political risk is just as troublesome as credit risk for buyers. Every sound bite that hits the wires warning about financial Armageddon is another wake up call to overseas investors who were clueless about our real financial condition.

You may remember the weeks of debate that occurred prior to the passage of the TARP program. After a deal was finally worked out and congress voted on it the first vote did not pass and the market immediately crashed. The Dow lost over 700 points in one day because the situation had become dire and action needed to be taken. The market was very unhappy when it did not happen as expected.

We could reach that point next week. The debt limit discussion is already priced into the market but nobody believes a deal won't get done. The market may be weak but at least it is not crashing. If we get closer to the deadline (July 22nd for action) and nothing happens we could see a market implosion. Just let S&P or Moody's or Fitch actually start cutting ratings on the U.S. or some major financial institutions in anticipation of a botched deal and all heck will break loose.

I believe we have reached an inflection point in the markets. We have reached the point where political banter is no longer going to be accepted in lieu of action. Investors are going to begin voting with their money by exiting long positions and shorting the market and bids are going to disappear if something does not happen early next week. The parade of major earnings may keep traders occupied until Wednesday evening but after that the atmosphere could become toxic.

The debt limit problem, the stressless test for European banks, rising inflation on the CPI, record highs for bond yields on the European PIIGS and weak U.S. economics pushed gold prices to another new high. Gold closed at $1594.50 and a gain of $52 (+3.3%) for the week. Silver rallied to just under $40 and a +7% gain. It is very likely we will see $1600 on gold next week or even higher if the debt limit problem does not go away. Central banks are starting to hoard gold as a reserve currency. The World Gold Council said on Thursday that central banks have bought more gold in the first six months of 2011 than in all of 2010. Normally the second half of the year is when most reserve purchases of gold are made and that suggests the price is going higher.

Gold Chart

Silver Chart

Stocks narrowly missed having the worst week in a year but the late day short covering rescued the indexes from that fate. The S&P was down -2.6% for the week at 2:30 and that would have made it the worst weekly percentage decline since August. At the close the S&P cut its losses to -2.1%. You can thank BHP for the rescue and the positive gains on Friday. The Oil Service Index gained +2% but the S&P Exploration SPDR spiked over 6%. More than 30 energy stocks rallied over $3 and another 20 more than $2. The energy sector is 13% of the S&P-500 and made up the majority of Friday's S&P gains.

The S&P seems to have found support at the 50% retracement level from the June 17th lows. The short-term trend is still down but the 1307 level was solid support on Friday. Unfortunately the S&P traded under the 100-day average at 1316 all day until the closing spike put it back over the average for a technical save.

If I only had the chart to look at and no context to apply to the overall picture I would probably say the S&P was going back to 1270 soon. However, applying a news filter and including the heavy slate of earnings and the probability of a debt limit deal I would expect the 1307 level to hold. I know market technicians claim a chart is all you need to trade any market because the news is already priced in. While I agree to some extent I believe the news is not always accurate or timely. Was Google's earnings news priced in on Thursday? The simple answer is no.

S&P Chart - 90 Min

S&P Chart - Daily

The Dow did not retrace as much as the S&P and found support at the 38% Fib retracement level, which just happened to be just over 12,400 and decent support. It always helps to have more than one support type converging at a given level. The Dow did not decline as much as the S&P because the blue chips act as a safe deposit box in times of market stress for extra cash fund managers need to have invested but want to be able to extract quickly. Secondly blue chips are not as susceptible to general news events because of their global earnings power and dividends.

The Dow could be ready to move higher but with 14 Dow stocks reporting next week there is a very large amount of event risk. While IBM will probably start the week off with a gain there are always a risk some other stock will miss the target.

Dow Chart - 60 Min

Dow Chart - Daily

The Nasdaq rally on Friday was guaranteed by 4:15 Thursday afternoon. When Google spiked nearly $60 after earnings that guaranteed a +10 point gain in the Nasdaq on Friday. The power of indexing and ETF baskets did the rest. When a single stock in an ETF rockets higher by that much of a spike it triggers short covering or outright buying in the ETF and by association all the stocks in that ETF. A $68 move in one stock is a market mover by the time the ripples are felt in the ETFs.

The Nasdaq also had the support at the 100-day average at 2759 as a launch point for Friday. The index had penetrated the 38% Fib retracement level but came back to it as support on Friday. With IBM, AAPL, MSFT, INTC, FFIV and others reporting next week the Nasdaq could be very volatile.

Nasdaq Chart - 60 Min

Nasdaq Chart - Daily

There is nothing to be learned from the Russell this weekend. The rebound from the 100-day average was lackluster because all the motive power was in big cap techs not the small cap Russell. The trend here is still down until we can see a few more days of activity. One day does not make a rally. The small caps are more sensitive to the debt limit discussions because of their low liquidity and economic sensitivity.

Russell 2000 Chart

I believe the overall market was led by Google on Friday and helped by the rush into stocks like Apple in hopes of scoring a similar earnings win. Sentiment was negative going into Thursday's close so short exposure was high. Next week we won't have that same negative sentiment heading into the IBM or APPL earnings so any beats will likely be far less reactive on the stock price than Google.

The debt limit resolution is going to be the key. The first three days of the week will probably be supported by those major earnings reports but no resolution on the debt limit by Thursday could produce a sell off on the chance lawmakers fail to act in time.

I believe Friday's closing spike was short covering and option expiration. Few traders would want to go into the weekend short when a deal announcement could cause a triple digit spike at Monday's open. I think that would have a very slim chance of happening but anything is possible and I am not confident enough to bet my trading account on being right.

Focus on earnings but be aware of the storm clouds building in Washington.

Update: On Saturday the European debt crisis took a serious turn for the worse. The Greek deputy finance minister announced the country would fall far short of the revenue targets in planned asset sales. In the austerity plan just approved a couple weeks ago Greece was supposed to raise up to 80 billion euros by selling things like government buildings, roads, bridges, tourist attractions, etc. No big surprise here since the government did not really want to sell them anyway. It is just a surprise that the announcement of the failure came so soon after the agreement in June. Still, this is only part of the problem.

The Greek prime minister sent an open letter to Eurogroup Chairman Juncker warning that Greece has done all it could and there will be no further austerity deals or agreements. Papandreou went on to say that the responsibility is now on the EU to either pay up or else. "It is time for Europe to wake up and make some brave decisions."

It appears Greece is issuing an ultimatum to the EU, ECB and Germany to either bail them out completely at the expense of several hundred billion euros in addition to those previously spent or Greece will go its own way and leave the EU. He said Greece is no longer prepared to make any further concessions and will withdraw from the EU if subjected to any further pressure. Since a withdrawal means no more loans it would also mean all the existing loans would be defaulted. If Greece withdraws it would have to go back to its own currency and default on all its debt. Basically they would wipe the slate clean and start over and all the creditors would end up holding worthless paper. Of course it would also take Greece out of the public debt market for a very long time so this decision would have a lasting impact on both Greece and the EU.

The suddenly stubborn Papandreou has crossed a line in the sand and is now in control of the future events. No longer is Greece begging the EU and ECB for bailout money. They are now demanding it with no strings attached because they realize they are now in the drivers seat. They can almost single-handedly destroy the EU if they defect. A default on the 110 billion euros in existing bailout loans and the 370 billion euros in sovereign debt would be enough to take down much of the European banking system.

The balance of power has shifted from the EU to the debtor nations. Bail us out or we leave the union and you will suffer the consequences. The European debt crisis has actually turned into a real crisis that could have far reaching effects and begin almost immediately. Almost all analysts believed Greece would eventually default. They just did not expect it to happen so quickly. If Greece gets its way then the rest of the PIIGS will suddenly find a backbone and they will also demand unconditional bailouts. The tide has turned and the EU and ECB are facing a serious dilemma.

There will be another emergency meeting on Thursday and this time it is a real emergency. In order to finance Greece the EU would have to come up with 2-3 times more than the 110 billion euros currently being discussed for the second round of bailouts. With Greece going hostile in the negotiations will the EU member countries want to throw good money after bad with little or no hope of ever seeing it return? The odds are very good the European debt crisis will be weighing on our markets next week.

This news could cause a serious drop in the euro next week and a sharp spike in the dollar. That would pressure commodities as well as equities. Plan accordingly.

Jim Brown

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