Hope over a possible resolution of the Greek debt crisis helped push the markets higher on Friday with shorts exiting rather than risk a monster gap higher on Tuesday.
On the surface all the components required to get a positive vote on the second Greek bailout appear to be in place. The EU ministers will meet on Monday and vote to approve the process. There is liable to be some heated differences of opinion but unless they are willing to really roil the markets by restructuring the plan they will probably take the path of least resistance and approve the bailout.
Obviously the market would like to see a simple solution where the bailout was approved, Greece drops out of the headlines and everyone goes back to business as usual. Unfortunately there are other options. The EU Ministers could agree to the bailout but add additional conditions. They could refuse to fund the bailout until certain austerity goals were reached. They could delay the bailout payments until after the April elections. It has already been discussed to do a bridge loan of 15 billion euros to get them past the March 20th debt payment and prevent a default. They could agree to fund that amount and then wait until after the elections and force another Greek vote by the new leaders. Of all the options the bridge loan and delay on payment for the rest until after the elections is getting the most bets this weekend. That would also delay the PSI debt swap deal as well.
The biggest problem for us is that Greece is unlikely to go away as a headline regardless of what option the EU leaders choose. That could set up a sell the news event on Tuesday.
One event agitating EU heads on Friday was news the ECB was going to swap $66 billion in Greek bonds for an equal amount of Greek debt that cannot be subordinated. That means the ECB is exchanging debt that could be restructured for debt that has a guarantee that it won't be restructured. The new debt is exempt from "collective action clauses" (CAC) which exempts them from forced losses. This takes the ECB out of danger of a Greek default and forced write down. The private investors are about to be hit with a 70% cut in the value of their debt. If Greece continues to find itself in trouble it can always default and restructure its remaining debt the same way it is cutting balances from the private sector owners.
The ECB took itself out of that future default risk and that angered many of European leaders. They feel like that sends a bad message to future buyers of debt for any European country. If the ECB is so worried about the future that they go out of their way to exchange their debt should future debt owners worry about the possibility of new debt not being paid? This was not going over well with European officials. Deutsche Bundesbank, Germany's central bank was strongly against the move. The bank believes this will create a two tier market for European debt. Those bonds that have CACs would be worth more than those that don't. Chris Walker, an analyst with UBS London, said "The risk of a voluntary restructuring morphing into a coercive one has arguably increased significantly." Never a dull day in Europe news.
In U.S. economics the Consumer Price Index (CPI) rose by +0.2%. After averaging only 0.033% for the last three months this was a large increase but it was still lower than the +0.3% analysts expected. The bulk of the increase came from rising gasoline prices and higher prices at restaurants. The core rate also rose +0.2% because of rising rents and higher apparel prices.
Compared to the same period in 2011 the headline inflation rate is +2.9% and the core rate, minus food and energy, is +2.3%. The food at home component declined sharply but the food away from home component continued to rise. Fruit and vegetables prices have declined sharply in recent months. Restaurants have been raising prices to compensate for a drop in the number of customers.
Gasoline prices are approaching $3.50 per gallon on their way to as much as $4.50-$5.00 this summer. That is going to be our next economic challenge. Consumers should not be quite so reactive until the price moves over $4 because they have seen prices over $3 for most of the last year. As prices move higher consumption of other products including eating out at restaurants will decline.
Consumer Price Index Chart
The Risk of Recession over the next six months fell to 26% in January from 29% in December. That was the fourth consecutive monthly drop, totaling -19 points, and well below the Q4 average at 34%.
The extension of the payroll tax holiday for the rest of 2012 is a factor in the lowered risk of recession. That was assumed in prior calculations and had it not passed it would have elevated the risk slightly. A resumption of those taxes would have resulted in a -0.4% decline in 2012 GDP. Not extending the unemployment insurance would have reduced GDP by another -0.3%.
The calendar for next week is relatively light with the EU vote on Greece on Monday the biggest event. The two Fed surveys are next in importance with the Chicago Fed National Activity Index the one to watch. The Kansas Fed survey is influenced by the pace of auto manufacturing and can be slightly higher than the rest of the regional surveys.
There were a couple of important economic events last week. The weekly jobless claims fell under 350,000 for the first time since April 2008. The pace of new claims has been declining steadily and that is very positive for the labor market.
The Philly Fed Manufacturing Survey for February came in at 10.2 and the second highest reading since April 2011. October was slightly higher at 10.8. This was a very good reading compared to January at 7.3 and consensus estimates at 9.5. New orders rose from 6.9 to 11.7 and backorders rose from -4.1 to +2.2. The negative component was a drop in employment from 11.6 to 1.1. However, this was a strong report and further confirmation the economy is improving.
Philly Fed Survey
One event that did not get much press in the U.S. was the -2.3% GDP for Q4 in Japan. Analysts were expecting a -1.3% decline. They posted a trade deficit of $32 billion for the year. That is the first deficit in 31 years. Exports were crushed by the impact of the earthquake and nuclear disaster. They are expecting 2012 to be better with a +1.7% GDP thanks to the rebuilding efforts around the quake zone.
The real problem for Japan is the mountain of debt and the potential for an earthquake under that debt mountain. Greece has 350 billion euros of debt. That is huge for Greece but compared to Japan is does not even register. Japan has more than $10 trillion in debt. This is more than 200% of Japan's GDP. The government borrows annually more than it receives in taxes. Half of Japan's revenues go to pay on the debt. Each year Japan borrows more than the combined GDP of Greece and Portugal.
Fortunately for Japan about 95% of its debt is held by Japanese. They are very frugal savers and investors. If the trend of citizens and institutions buying Japan's debt ever changed the country would have a very tough time selling $500 billion a year in debt to the international markets. With a debt load that massive any minute change in trends could send interest rates rocketing higher and Japan would not be able to service the debt. Every 1% in interest adds one trillion yen to the annual debt payments, currently 22 trillion yen annually. Japan is not too big to fail it is too big to save.
The Bank of Japan established a QE program in 2010 to buy 20 trillion yen in bonds annually. With that kind of central bank buying they can keep the bond rates low and protect the mountain of debt. The government is planning on raising sales taxes from 5% to 10% and that is expected to create significant hostility from citizens. That plan is due to be debated in March. Analysts estimate the tax would have to go to 25% to close the financing gap built up over the last 20 years.
Whenever the European debt crisis is discussed the Japanese debt crisis is the elephant in the room. Analysts claim Japan only has a couple years before the mountain of debt will begin to dissuade even the Japanese from investing. The European crisis has made the world more aware of debt levels and the impact of that debt. It is only a matter of time before Japan becomes the focus and the bond vigilantes take aim at that debt pile. Negative GDP and negative trade deficits as a result of the quake can be explained away but the long term effect of that rising debt will eventually be a crash. You can't add $500 billion in new debt every year to the $10 trillion in existing debt forever. There will come a point where that mountain will erupt and the Greek crisis will be a firefly by comparison.
James was proofing my commentary this weekend and after reading that last paragraph he asked, "If Japan's debt is the elephant in the room then what would the roughly $80 trillion in U.S. debt be?" Good point!
One last piece of depressing news. Art Cashin pointed out this week by way of a JP Morgan report that as unemployment goes down disability goes up. The reported unemployment at 8.3% is only the tip of the iceberg. When a person's unemployment benefits expire they fall off the unemployment rolls and are considered "discouraged" workers. The total unemployment including these discouraged workers and those working part time because they can't find a full time job is closer to 16.5%.
However, the point of the JP Morgan article was the rise in people on disability. Apparently the JP Morgan report estimated that nearly 25% of those whose unemployment benefits had expired had applied for and been accepted for disability payments. According to JPM as of January 8.5 million individuals were receiving federal disability payments along with another two million spouses and children of disabled workers. Since the recession and spike in unemployment the pace of filings for disability has grown faster than the overall size of the labor force. Currently 5.3% of the population aged 25-64 is on federal disability, up from 4.5% when the recession began.
Half of the recipients suffer from mental disorders, mood disorders or musculoskeletal disorders such as back pain. Those three reasons accounted for 54% of all claims in 2009. That is nearly double the rate of 1981 at 28%. Mood disorders alone accounts for 10% of the group. Once on disability it is almost impossible to be taken off. Only 1% lost their benefits in 2011 because they were no longer disabled. The report suggested 25% of the people whose unemployment insurance expired simply filed for disability insurance instead. Annual applications over the last ten years have increased by more than 123% to 2.9 million. More than 50% are declined but as many as 75% are approved on appeal with the lawyers receiving up to $6,000 (25% of back benefits) for taking the case. An entirely new breed of ambulance chasing lawyer has evolved. This is costing the government (you and I as taxpayers) more than $200 billion a year. That is more than the budgets of the Commerce Dept., Energy Dept., Homeland Security, Interior Dept., Justice Dept. and State Dept. combined.
There is a paradox here. Hard labor jobs like manufacturing and construction declined sharply over the last three years. You would have expected disability from those jobs to decline since the jobs no longer existed. Instead disability claims skyrocketed higher. More people were becoming disabled from the arduous task of cashing their unemployment checks and supposedly looking for work. Who knew filling out job applications could be so physically demanding?
In stock news it was a rather dull Friday ahead of a three-day weekend. Shares of Gilead Sciences (GILD) lost -14% after the company said many patients relapsed after receiving a combination of its experimental hepatitis C drug and the antiviral ribavirin. Six of eight patients receiving ribavirin relapsed after 12 weeks of treatment. However, patients in that group were those who had no prior responses to other regimens. That means they were drug resistance. Ordinarily this small a trial would not be big news but Gilead had said earlier this month that another group of the same type of patients were cured after just four weeks of treatment. Oops! The $7 spike in GILD shares from the earlier announcement was subtracted on Friday.
Baidu (BIDU) was the unwelcome recipient of a short call by Morgan Stanley. The company posted earnings that rose +77% on revenue that rose +82.5%. Baidu said there were more than 513 million people online in China at year end. Morgan Stanley said Baidu's growth was slowing and suggested this was a shorting opportunity. BIDU guidance was seen as lackluster although it was in line with analyst estimates. Chinese portal Sohu.com gave guidance for Q1 that was only about half of what analysts expected. Ads are apparently slowing for everyone in China except BIDU at least on published guidance. This is why Morgan Stanley thinks there is a shorting opportunity as guidance catches up at BIDU. Baidu only posted a +7% rise in ad revenue quarter over quarter. Shares declined -$5 on the downgrade.
First Solar (FSLR) rallied after the Antelope Valley Solar Ranch One plant in Los Angeles County received permit approval. This $1.36 billion power project had been on hold after regulators froze its permits. The solar plant will receive $646 million in loan guarantees from the Energy Dept. First Solar sold the project to Exelon Corp (EXC) for $75 million in September. Exelon is going to invest $713 million in the project. First Solar shares have been on the skids all last year with a decline from $170 to $38. The permit news gave shares a +7% lift on Friday.
However, there may be more trouble brewing overseas. Deutsche Bank (DB) said Germany's next cut on solar subsidies could be worse than previously expected. The bank said a cabinet meeting had been called to discuss major cuts to the subsidy policy. Sources now expect a 15% cut in April followed by a monthly 2% cut. They are also considering a 900 KWh subsidy cap on new installations. That would mean that large installations would have to foot the entire bill over 900 KWh and that would reduce the size of future installations. Most solar projects around the world would not be built without significant government subsidies. Germany is the largest consumer of solar products with 7 gigawatts (GW) of installed capacity. In December alone nearly 4 GW of capacity came online.
First Solar Chart
The DNA mapping world just got a lot faster. Oxford Nanopore just announced two products that could dramatically change the field of DNA mapping. They announced a new DNA sequencer that may be able to handle a human genome in 15 minutes and a USB thumb drive DNA sequencer that can read DNA directly from blood without any preparation work. The device will cost $900 and be able to read DNA in 10,000 letter stretches compared to only a couple hundred in current technologies. This was the equivalent of a nuclear bomb in the DNA mapping sector. Life Technologies (LIFE) fell -8%, Illumina (ILMN) fell -4%, Pacific Biosciences (PACB) lost 8%.
FreightCar America (RAIL) blew away estimates with earnings of 71-cents compared to estimates of 13-cents. Revenue of $187.1 million was well above estimates of $126.8 million. Revenue rose +250%. New builds, sales and leasing revenue almost tripled. Full year revenue more than tripled to $487 million from $142 million. The company has large order backlogs for cars to transport coal, ore and other bulk commodities. The company delivered 2,489 railcars in Q4 compared to only 694 in Q4-2010. More than 4,481 units were ordered in Q4, up from 331 in the prior quarter.
Rackspace (RAX) was hit by a Merrill Lynch downgrade at the open from buy to neutral. The cut was based on valuation and the +27% year to date gains. The analyst said the market opportunity was becoming fully valued and in line with consensus estimates. Analysts are expecting +28% revenue growth. The outlook remains solid but the upside was limited with risk and reward evenly balanced. He raised his target price to $58 from $56 with the stock at $54. Shares spiked on earnings earlier in the week. The chart does look a little optimistic.
Apple (AAPL) shares took a breather this week after hitting a new high at $526. Of the 57 analysts that cover Apple 26 of them have a strong buy and 26 have a buy. That means 91% of the analysts covering the stock still think it is going higher. The median price target is $600. Oppenheimer raised their target from $510 to $570 on Friday. Channel checks suggest the iPhone sales in January were strong but iPad sales slowed in advance of an expected iPad 3 announcement in early March.
Apple now has more than $100 billion in cash if the $3 billion a month in free cash flow continued through Jan and Feb. The company shareholder meeting is next Thursday and there are rumors Apple could announce a dividend. I would not hold my breath but Tim Cook did say he had no specific reason for holding on to the cash and the board was researching ways to use it. They could also do a stock buyback. Shareholders cannot force Apple to issue a dividend. That is up to the board and shareholders would have to replace the board with people favorable to a dividend. Without a concentrated effort by a large number of shareholders that is not going to happen.
Apple is facing a challenge in China where Shenzhen Proview Technology has asked regulators to seize iPads in China because Apple does not own the iPad trademark. Apple claims it bought the name from a Proview affiliate in Taiwan in 2009 for $55,000. Proview registered the name in China in 2001. Proview went to court to have the sale voided and a mainland court ruled in December it was not bound by that sale agreement. Proview is broke. It has been suspended for trading on the Hong Kong market since August 2010 and will be delisted in June if it can't show it has sufficient assets, business operations and working capital. Proview has filed a trademark violation suit that goes to court next Wednesday. Clearly they are looking for a big payment from Apple to revitalize the company. Apple is likely to settle rather than risk the unknowns of a Chinese court. Would the court side with the nearly bankrupt Proview or with Apple, which employs hundreds of thousands in China? In communist China where there is no real rule of law you never know.
BP shares rose after their minority partner in the Macondo well disaster agreed to settle with the U.S. for $90 million. Mitsui through its MOEX Offshore 2007 LLC partnership owned 10% of the Macondo well. The company agreed to pay $45 million in civil penalties under the Clean Water Act and $25 million to the Gulf States affected by the spill. They will also pay $20 million for coastal protection projects. The judge said this was the largest civil penalty ever recovered by the Clean Water law enacted in 1972. That record will only be on the books for a matter of days before BP and others settle as well. MOEX already agreed to pay BP $1 billion to settle all claims between the companies.
The trial to asses liability for the disaster will begin on Feb 27th and there is a very good chance that BP and others will settle with the government before that trial. They would rather know in advance what the price will be rather than wait for a court to assign blame and possible prove gross negligence, which quadruples the damages.
Also on Friday BP and M-I LLC, a Houston based drilling mud company used at the well, dropped claims against each other in federal court. BP had accused M-I of several missteps in removing the mud that accelerated the blowout. M-I said it was shielded from responsibility because of the indemnification clause in the BP contract and accused BP of causing the blowout. Both companies said the terms of the settlement were confidential.
Companies still in the hunt for a settlement before the court trial begins on the 27th are BP, Transocean Offshore (RIG) and Halliburton (HAL). Any settlement between these firms removes a cloud that has been weighing on their stock prices over the last year. Transocean shares have already rallied after the court ruled BP must indemnify RIG as specified in the contract.
Transocean Chart - Weekly
Transocean Chart - Daily
While on the topic of oil the U.S. WTI crude contract is breaking out over eight months of resistance at $103. The +1.75 gain came as a result of the improving economics and the challenges in the Middle East. Syria, Egypt and Nigeria are seeing lower production because of internal strife. Iran is actively talking up prices and warning daily about the risk of following through on the various sanctions and embargos. It is in Iran's best interest to talk up the price of oil so they can raise more money before their oil exports are cut in half.
The former president of Shell Oil was making the rounds on the speaking circuit last week and warning about the possibility of $5 gasoline this summer. When the president of a top five oil company is warning about higher prices people tend to listen. He said $4 gasoline is a given and there is a 50% chance we will see $5 along with the sharp drop in economic activity that will bring.
Several analysts in recent months have predicted a return to $60 oil prices. I have never wavered on my projections of much higher oil prices not only this year but in the near future. Unless we have another recession I think WTI will be $150 by 2015 if not higher. Much of the quoted production numbers for shale liquids in the U.S. is not oil. It is natural gas liquids and that does not translate into gasoline or diesel. We hear constantly about the increase in production from the Bakken and the other shale oil fields but the increase is only about 100,000 bpd per year. We lost more production than that from the Gulf drilling moratorium and it will take us several years to regain that lost momentum.
Last week the U.S. produced 5.819 million barrels per day. In that same week a year ago we produced 5.610 mbpd. Despite all the hoopla about shale drilling, liquids production, etc and drilling of thousands of new wells our production increased only 200,000 bpd. We consume about 21.0 mbpd. That +200,000 bpd is less than 1% of our consumption. Everything is relative. When people tell you there is plenty of oil ask them where it is. If we had plenty of oil the price of gasoline would not be approaching $4 a gallon.
WTI Crude Chart
Brent Crude Chart
The S&P has started off 2012 with the best YTD performance since 1987. In that year through Feb-17th the S&P had rallied +17.9%. This year the S&P is up +8.2%. It seems like more because the lows were set in October at 1075. If you count from that low the S&P is up +26.6%. If you skip the November dip and start from the December dip at 1202 the gain to date is +12.2%.
Many investors are looking at those various statistics and at the strong resistance and calculating a pending decline. I have been in that category several times in the last two weeks. On the two days the market tested support I was pretty convinced we could trade lower. Much of that was probably due to wishful thinking in hopes of a decent dip to buy. So far no dip.
A one-day wonder of -10 points does not qualify given the magnitude of the gains and the severity of resistance. I am beginning to wonder if there is no dip in our future. I know as soon as I start believing that the bottom will fall out.
The resistance at 1350 finally broke and the next target is the April closing high at 1363.61. A breakout there puts the S&P at a three year high. New support has formed at 1340 so now a dip could cover -20 points and still not be a danger to the rally. I would really like to see a return to that level.
I said on Tuesday night I would be cautious about committing new money to longs without a decent dip or a break over 1350 on strong volume. It took two days for the market to move over 1350 and the gain was only +6 points. That is a definite lack of conviction and consolidated volume was only 6.5 billion shares. Hardly strong volume and hardly a real breakout. This inch by inch creep higher is frustrating for market technicians especially given the weak earnings with 64% of companies lowering guidance. If we do close over 1363 we have to hold our noses and remain long.
The S&P 100, the largest 100 stocks in the S&P, have already broken out to a three year high. Like the Nasdaq 100 the primary reason for this gain has been Apple with help by IBM, PCLN, etc. Apple is 12% of the index and tech stocks in general are 20% of the S&P. The top five constituents in order are Apple, Exxon, Microsoft, IBM and Chevron. The S&P 100 is the largest market cap and highest liquidity stocks. It makes a perfect hiding place for fund managers who want to benefit from any future gains but want the capability of an instant exit if disaster strikes.
S&P 100 Chart
The Dow is an even smaller subset of the highly liquid blue chips and that is why it is also moving higher. Liquidity is a major factor because of the low volume, lack of conviction rally. The Dow is only 51 points away from Doe 13,000 and the media is making a big deal of the large even number. It is only a big deal in their eyes. It is just another number on the way to the next resistance level of 13,100. The number I would really worry about is 14,000-14,100. That is the 2007 highs and a lot of traders are going to want to escape with their principal intact after being relegated to the status of "accidental investor" when the Oct-2007 crash began. They lived through the recession and the flash crash and once stocks return to that level they will take the money and run.
The Dow has now established strong support at prior resistance of 12,750. That should protect the bulls from anything but a concerted onslaught of selling. It is 200 points away and we have yet to have a triple digit loss day in 2012. If we did break that support level I think it would cause a system reset on investor sentiment. Investors have become so accustomed to buying every dip a break of major support could be traumatic.
The Nasdaq lost ground on Friday thanks to a minor decline in Apple and large declines in GILD, BIDU, LIFE, JAZZ, MSTR, etc. The entire biotech sector was down and that weighed heavily on the index without Apple tacking on any gains. The Nasdaq is over extended and it really needs to rest. The aftermath of the Apple shareholder meeting on Thursday could be the trigger for some profit taking.
Nasdaq Composite Chart
The Russell has moved sideways for the last ten days. It topped out at 833 on Jan 27th and has failed to reach that level again over the last two weeks. Support formed at 813 and it was tested twice. That gives us the range to watch and at 20 points there is plenty of room to run. A break below 813 should test 790.
A break over 833 still has a long way to go before strong resistance at 860 and the potential for a new high. Fund managers appear to have cooled on the small caps and the higher the blue chip market goes without a decent bout of profit taking the less likely they will shift their bets to small caps.
Russell 2000 Chart
Trouble on the tracks with the Dow Transports. They began topping out on Jan 26th and rolled over on Feb 6th. Dow Theory needs the transports to be making new highs at the same time as the Dow to confirm the rally and the transports are weakening. It may be simply a case of high oil prices and the anticipation of losses in the airline community.
However, if you go back and look at the charts late February is normally a particularly rough time for the transport sector. There have been some major February declines in past years so it could be a seasonal factor such as post holiday slowdown syndrome. After shipping tens of millions of packages a day in Q4 the decline to low single digit millions in Q1 could have institutional investors cycling out of the sector and into tech stocks or energy stocks. With February normally the seasonal lows for oil prices it would make perfect sense to exit transports and move into oil stocks. When oil begins to decline in August that would be the key to switch back into the transports to catch the holiday shipping season.
Whatever the reason the transports are no longer confirming the Dow rally and that should have institutional traders worried.
Dow Transport Chart
S&P Capital IQ warned on Friday that bullish sentiment was getting worrisome. While bullish sentiment hit 51.6% in the prior week on the AAII survey the number of traders betting against the market declined sharply. TrimTabs said NYSE short interest decreased -6.7% to 12.5 billion shares in early February. That is the lowest level on record and down from the record high of 16.1 billion shares on Sept 30th.
The Investment Company Institute (ICI) said retail mutual funds saw inflows of $1.9 billion for the week ended Feb 8th. That was the largest inflows since April 20th 2011, which was the week the market topped in 2011. This is even more unusual because funds have only had positive inflows for three weeks of 2012. Bond funds and fixed income funds have been receiving all the new money. Here we are at new market highs and retail investors are suddenly flocking back into the market. If you are a contrarian investor this has got to be a warning sign.
Need another reason to vote contrarian? The Barron's cover last week headlined Dow 15,000. That type of headline bullishness typically signals trouble ahead.
I have run a lot longer than usual this week. I hope I did not bore you. I can't emphasize enough the pivotal nature of the Greek vote by the EU on Monday. There are many ways it can go and all will impact our market in some form. The U.S. markets are not running on fundamentals so headline risk is the primary market mover. We have been waiting for a resolution on Greece for so long that a sell the news event is possible regardless of the outcome. However, with our positive economics and zero interest rates the path ahead is still promising for equities. That means we need to continue to buy the dip until proven wrong.
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