Market action today left no doubt about direction as critical support levels failed.

Market Statistics

The major indexes continued lower once again as conditions in Europe worsened and sellers dumped banks on worries over new regulations in the wake of the JPM trading loss. There was a lack of positive news and that amplified the reaction to the negative news.

Greece failed to form a coalition government and that will force new elections in June. Parties with the majority of votes in the May elections decided to count on gaining even stronger representation in a second election instead of being forced to join together in a watered down coalition. What is really clear is that they are betting on the anti austerity feeling to carry the election and those parties using that platform are sure to gain more votes.

News this afternoon came from the transcripts of the talks with the president of Greece and the top three parties in the last ditch effort to prevent a new election. The transcripts showed Greek banks had seen as much as 700 million euros ($900 million) in deposits had been withdrawn from the banking system since the May 6th elections. The bank run has started to accelerate as depositors worry about Greece leaving the euro. Lines were forming at ATM machines all over Greece.

Greek ATM line

With the majority parties in Greece advocating rejecting the bailout terms and the austerity programs the outlook for future funding for Greece is very grim. Greece is not going to get any further help from the EU until after the June elections and a new government ratifies the bailout. This is not likely to happen. More likely will be a defiance of the bailout deal and an exit from the common currency group. There is a real fear that a Greek exit will eventually lead to an exit by other countries as well.

Regardless of what actually happens in the future it is the fear of contagion that is impacting the markets today. The EU is only one country away from a recession. Germany posted growth in Q1 of +0.5% and Germany accounts for 25% of the 17 nation common currency euro zone. Without Germany the other 16 countries saw GDP decline by -0.25%. Germany only avoided a decline in its GDP because of strength in its auto manufacturing. Mercedes Benz, Audi and BMW sales are very strong globally and that kept Germany from following its peer group into recession.

Of the 17 member countries seven are already in recession and worsening. Those are Ireland, Greece (-6.2%), Spain, Italy, Cyprus, Portugal, Slovenia and the Netherlands. Eurostat is predicting the entire zone will fall into recession in Q2 with a -0.2% decline. The eurozone declined -4.3% during the 2009 recession. European analysts believe the months ahead will be the most difficult for the eurozone since it was established in 1999.

Also complicating the European outlook was the inaugural speech by the new socialist president of France, Francois Hollande. He called for a watering down of German driven austerity measures and a change in the direction of EU economic policy. Immediately after his speech that was critical of austerity efforts spearheaded by Germany and prior president Sarkozy he boarded a plane to fly to Germany to meet with PM Angela Merkel. His plane was struck by lightning and was forced to return to France where he boarded a new plane to continue the trip. Hollande will attempt to convince Merkel to lift Germany's veto on issuing euro zone bonds to harmonize borrowing costs within the euro. He will also lobby for ECB permission to lend directly to sovereign governments. The ECB is prohibited by charter from loaning directly to governments. Germany is strongly against both topics.

The value of the euro fell to a new four month low as European expectations decline. The falling euro is counteracted by the accelerating rise in the dollar. This is crushing commodities denominated in dollars. It will also weigh on earnings by those U.S. companies trying to do business in Europe. More than half of the S&P companies receive a substantial portion of their earnings from Europe. This sudden divergence between the euro and the dollar will make it more difficult to sell into Europe and cause losses due to currency conversion.

Euro Chart

Dollar Index Chart - Daily

Dollar Index Chart - Longer Term

The spike in the dollar is directly proportional to the decline in gold and oil. The moves in the dollar are extreme for a currency, which normally moves in a few hundredths of a point per day.

Dollar vs Oil Chart

The dollar plus the declining economics in Europe have pushed crude prices to a five month low at $93. Crude is extremely oversold and with the Iran summit meeting scheduled for May 23rd we could see a bounce at any time. However, the dollar will have to slow its upward progress for that crude rebound to be significant.

Crude Oil Chart

Gold closed below key support at $1550 and the next major support target would be $1475. There are interim support levels at 1523 and $1533, the lows in December and September respectively. Even with this material decline the gold bull market is still intact. Morgan Stanley issued a report on Monday claiming gold will rebound and set new highs. They said the ECB will have no choice but to support European banks with massive QE programs. Morgan pointed out that central banks are buying gold and the majority of individual investors have held on to their gold ETFs.

Gold Chart

The U.S. economics were positive today but they could not overcome the negativity from Europe. The NAHB Housing Market Index rallied to a FIVE year high at 29.0. This blew past the consensus estimate of 25.0 and a +1 point gain and suggests the housing market is rapidly accelerating. The single-family component rose to 30.0 from 25.0 and is now +15 points over the May 2011 level. Expectations for single family sales over the next six months rose to 34.0 from 31.0. Buyer traffic rose +5 points to 23.0.

However, despite the strong increases in the headline number it should be noted that 50.0 is considered neutral. Over 50 is an expansion and under 50 represents contraction. Compared to the component numbers in the teens just six months ago the numbers today are significantly better but still not in boom mode. The headline number was 13.0 last June. The sector is recovering and accelerating but it has a long way to go.

NAHB Chart

The New York Empire State Manufacturing Survey rebounded sharply from the prior month's decline. The headline number rose to 17.1 for May compared to 6.6 in April. The consensus estimates were for a gain to 9.0. Analysts believe the dip in April was due to business being pulled forward into Feb/Mar by the warmer weather. That dip was more than corrected in May.

New orders rose slightly to 8.3 from 6.5 but backorders remained in contraction territory at -4.8. That was an improvement from the -7.2 in April but only slightly. Back orders have not been in positive territory since May 2011. However, it appears the low backorder rate is due to accelerated production. Shipments spiked from 6.4 to 24.1. Employment rose from 19.3 to 20.5 and hours worked from 6.0 to 12.1. That suggests companies have hired some additional workers but are still increasing hours on existing workers to get orders out the door faster.

The worst component was the expectations. The six month expectations component declined from 43.1 to 29.3 suggesting companies are expecting business to slow ahead of or immediately after the elections. Factors in Europe could also be weighing on expectations.

Empire Manufacturing Survey

Retail sales for April slowed to only a +0.1% increase and the lowest level since December. Analysts again blamed the decline in April on the pull forward of sales into Jan/Feb/Mar due to the warm weather.

The Consumer Price Index for April was flat at zero on the headline number and +0.2% on the core rate. The biggest gains were in food and energy which the government ignores. Food prices rose +3.1% year over year and energy rose +0.9%. However, with the core rate flat at +0.2% or less for the last twelve months the inflation rate is still well within the Fed's comfort zone at +2.3% per year. The recent decline in energy prices will filter through the CPI headline number in the months ahead.

The economic calendar for the rest of week will be dominated by the FOMC minutes on Wednesday. Analysts will use those minutes to decide on the Fed's next course of action. Based on Fed member comments since the meeting most analysts believe the Fed is on hold and will not announce any new QE programs. Pimco may be an exception and they believe there is still a 50% chance or better the Fed will announce something at the June meeting.

Economic Calendar

Everybody love clear pricing and everyday low prices, right? Apparently not at JC Penny. Bargain shoppers are sending a clear message they like blockbuster bargains, weekly sales and advertised specials. JCP reported a larger they expected loss for Q1 because shoppers did not like the everyday low price presentation. Shoppers appear to be addicted to saving money or at least the appearance of saving money with large highly visible ads.

JCP historically offered as many as 600 special sales every year. When they dropped those promotions in favor of the everyday low price program, shoppers dropped them.

My wife came into my office while I was writing this commentary. On a whim I asked her if she ever went to JC Penny. She said and I quote, "No, they quit having sales so I quit going there. I know they are supposed to have low prices but I like the sales." Her favorite store of that type is Kohl's. She said, "They have sales every day."

Apparently the new CEO, Ron Johnson, failed to survey women shoppers before changing the company's sales program. America's Research Group, a consumer research firm said, "When you train shoppers for years to shop at big discount sales, that customer is not going to change."

JCP reported a Q1 loss of $163 million or -25 cents per share for the quarter. Revenue declined to $3.15 billion and far below estimates of $3.43 billion. Same store sales fell -18.9% and mush more than the -11.4% analysts expected.

JCP said it was canceling its 20 cent dividend to save $175 million on an annual basis. Shares of JCP fell -13% in afterhours trading.

JCP Chart

Patriot Coal (PCX) tanked the coal sector again after cutting its outlook for metallurgical coal sales. The company cited a customer, which it did not name, that had defaulted on a contract to buy coal. The price of high-volatile met coal had fallen to between $25 to $35 a ton and significantly below the contracted price. High-volatile met coal is a low quality coal. The higher grades of met coal continue to rise in demand and price. Patriot said the decline in price was crimping sales.

This is yet another example of Patriot blaming slowing sales on the coal sector rather than on their product mix and customer base. They have tanked the sector quarter after quarter with high profile headlines warning of slowing coal sales when it was actually only slowing sales at Patriot. In a week or so Peabody will get around to putting out a press release on how the sales of their met coal is increasing and how China is sucking up all the coal Peabody can mine but the damage will already have been done.

Peabody needs to buy Patriot just to keep them from poisoning the well with their blame shifting headlines. PCX shares fell 18% to $3.93. Their market cap fell to $366 million compared to Peabody's at $8 billion. Acquiring PCX would be chump change for Peabody and at this point it would be a mercy killing.

PCX Chart

The Facebook countdown clock is winding down. Many of the underwriters announced on Monday they were closing their order books because the offering was already oversubscribed. You have to wonder if those announcements were not a sales ploy. However, Facebook did raise the anticipated pricing to $34-$38 from $28-$35 so there must be some buyers.

The requirements to get in on the Facebook IPO are very steep. Fidelity customers were required to have $500,000 in their account and made 36 trades in the past year in order to be eligible. Ameritrade was requiring $250,000 and 30 trades in three months.

An AP poll out this week found that 50% of Americans said Facebook was just a fad. Only one third thought the IPO valuation was reasonable and more than 50% thought it was too high. I still have not seen a single analyst that suggests buying shares in the open market at the open. Tech guru Dan Niles said he would sell any IPO shares at the open as most analysts are recommending. Facebook will have a valuation that is roughly six times the same metric as Google on a sales/earnings basis. Facebook could trade at a PE of 100 based on expected earnings of 35 cents.

Just last week Facebook said sales in Q1 declined -6%. Today GM said it was not going to buy any more Facebook ads because they were not worth the money. More than 83% of Facebook users polled had "rarely or never" clicked on an ad in Facebook. The company is going to have a rough time building ad revenues in that kind of environment.

Market Outlook

Crystal clear is sometimes too obvious. In the S&P chart below the failure of support at the 100-day average and 1,340 would appear to be a crystal clear indication the market is headed lower. The trouble with crystal clear pictures in the market is that they seldom see any follow through. If the roadmap is so clear that everyone can see it then something is wrong. The counter trend traders will instantly begin to build massive positions in expectations of a rebound. Oversold suddenly becomes the buzzword of choice and rather than watching the index slide mindlessly down to the next support level the move is interrupted by short squeeze after short squeeze.

I am not going to bet on a short squeeze appearing on Wednesday but anything is always possible. Every bear worth his coat should already be short and the only traders joining the trade at this point are those who just woke up from a long winters nap.

The markets have declined for nine of the last ten days and even in a bear market that is a streak looking to be broken. That does not mean any rebound is headed back to new highs but it just means there could be a counter trend rally in our near future. I believe it would simply be an opportunity for those already wishing they were short to get in at a higher level.

The S&P failure at 1,340 should now be targeting a return to 1,275 and the 200 day average and a 10% correction. I seriously doubt we will continue in a straight line to that level but the odds are good we will get there.

Not once in the last 33 years has the market failed to retrace to its closing print for the year. That would be 1,257 on the S&P. That is also a very long and recognizable streak looking for an end. I would not bet on it this year. There are far too many global problems to suggest sudden market strength in our future. The only reason I can think of would be the U.S. as the dog with the least fleas. Nobody wants to invest in Europe or China and South America is questionable. That makes U.S. equities a safe haven of sorts as long as you don't expect too much in the way of earnings over the next three months.

At the risk of being overly obvious the S&P appears poised to move significantly lower. At this point I am not sure even QE3 could reverse this slide but anything is always possible.

S&P Chart

Like the S&P the Dow has also broken below critical support at 12,750. Dow blue chip stocks get a significant portion of their earnings from Europe and the social and economic breakdown in progress will not be good for business. The divergence of the euro and dollar will also lower earnings for Q2.

Dow Chart

The Nasdaq is struggling to cling to support at 2900 but the close today was slightly below that level. Apple closed at a new two month low at $553 on news several major funds had sold shares over the last reporting period. Some of that news came after the bell so there may be more "follow the funds" selling on Wednesday.

The Nasdaq closed -36 points off its high. The index rallied before lunch but could not hold those gains with the selling accelerating into the close. Ending at 2,893 is still close enough to suggest support is a factor but any move lower on Wednesday will sever that support connection and target the 200-day at 2,740.

Nasdaq Chart

Market sentiment has definitely taken a turn for the worst. The FOMC minutes on Wednesday may not be market positive since they are likely to show a deeply divided Fed and no prospect for QE3 in the near future. That does not mean the market won't find some scrap of hope to cling to but it will be slim.

I would hesitate to jump into the market with bearish positions on Wednesday because of the increasingly oversold conditions. I would prefer to wait for the inevitable short squeeze for a better entry point.

The bearish trade is very crowded at present. Sometimes when everyone is leaning in the same direction a counter trend move can be explosive. Beware the herd. They tend to be wrong.

Enter passively, exit aggressively!

Jim Brown

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