German Chancellor, Angela Merkel, joined the "Whatever it takes" club on Thursday and the markets celebrated by moving ever closer to new four-year highs.

Market Statistics

Merkel said "European heads of government have a duty to do everything possible to preserve the Euro." With that statement she seemed to back the past statement by ECB head Mario Draghi to do "whatever it takes" to save the eurozone. Unsaid by Merkel but implied is the blessing for the ECB to buy bonds of weak countries like Spain and Italy in order to hold down borrowing costs and prevent a eurozone meltdown. The Spanish market is at four month highs because of the ECB pledge.

Germany has been the sticking point in the ECB plans to buy those bonds. German approval has been lacking with the hawks speaking out against funding the weaker countries. Merkel has not specifically said she supports the bond buying but in politics sometimes what is not said is just as important as what is said.

Merkel has refrained from making negative comments about the ECB plan to buy sovereign bonds. One reporter called it a benign attitude on ECB bond buying because the alternative would be more expensive and detrimental to the rest of the eurozone countries. They have already committed hundreds of billions to the EFSF and ESM so allowing the ECB to buy bonds (QE) is basically a free move and does not require any further donations by member countries.

Merkel will be the center of attention late next week when French President, Francois Hollande, visits Merkel in Berlin on Thursday and Greek Prime Minister, Antonis Samaras, visits on Friday. The result is expected to be a relaxation of the harsh conditions imposed on Greece in the last bailout agreement. There is no upside to not relaxing the conditions. Greece can't meet them and they are going to default regardless of the rules so giving Greece breathing room today is essentially kicking the can farther down the road once again.

At this point the future of Greece in the eurozone appears to be improving. Conditions can't get any worse in Greece and the eurozone has already factored in the prospect of future defaults. It is like finally accepting your weird uncle and realizing he is never going to change. In a Bloomberg survey of 64 economists, 45 of them now believe Greece will still be in the eurozone 12 months from now.

European leaders are giving the outward appearance they have decided to join hands and sing Kumbaya as though all their problems were behind them. That is far from the truth but all the cans have been kicked so far down the road that negative headlines are practically nonexistent or are being ignored. The exception would be Finland. The Nordic state is digging financial moats and strengthening fortifications in anticipation of a breakup of the eurozone. The Finnish Finance Minister, Erikki Tuomioja, said Finland is preparing for the breakup of the eurozone. Finnish officials have warned they will not tolerate further bailout creep or fiscal union by stealth. He said "Finns are not advocating a breakup but we have to be prepared… It is a total catastrophe. We are going to run out of money the way we are going. But nobody in Europe wants to be first to get out of the euro and take all the blame." Finland has risen to be the harshest critic of bailouts and said a future breakup may be preferable to the alternative of continued bailouts and it could make the eurozone stronger by allowing the weaker countries to leave. Other countries may be thinking the same thing but Finland is the only one to express it outright.

The global markets crept higher this week simply because there were no dramatic headlines and everyone is waiting for the ECB announcement on a new bond buying program. That announcement may not come until after Germany votes on September 12th on the constitutionality of the ESM bailout fund.

In the U.S. the economic indicators are actually improving slightly and that "less bad" data helped lift stocks a little higher on the wall of worry. Consumer sentiment for August rose from 72.3 to 73.6 in the first half of the month. Analysts were expecting no change. The rising stock market and better than expected payroll numbers were the likely reasons for the gain.

The present conditions component bore out that theory with a sharp jump from 82.7 to 87.6. The expectations component declined from 65.6 to 64.5. Worry over the fiscal cliff and post election changes could be weighing on expectations.

Inflation expectations rose significantly from 3.0% to 3.6% and that was probably related to higher gasoline prices and the constant warnings about high food prices as a result of the drought. Gasoline prices have risen 45 cents from the year's lows and 29 cents in the last six weeks.

Consumer Sentiment Chart

The rising sentiment was not showing in the regional employment numbers on Friday. Unemployment rates rose in 44 states in July. That is the most states to show an increase in unemployment in more than three years. Unemployment rates only fell in two states and were flat in four. Unemployment rose in nine battleground states considered essential for the presidential election. Unemployment increased in Florida, Virginia, North Carolina, Iowa, Pennsylvania, Michigan, Colorado, Wisconsin and New Hampshire.

We had a very weak economic calendar last week and next week is not much better. The FOMC minutes dominate on Wednesday with the home sales the next most watched reports.

The last two major tech companies to report earnings are Dell on Tuesday and Hewlett Packard on Wednesday. Both earnings reports are after the close.

The end of the week has the potential for some headlines out of Europe with Merkel meeting with the French president and the Greek prime minister.

We are moving closer to the Bernanke speech on August 31st and expectations are high. The odds are good the market will be disappointed. The FOMC minutes on Wednesday should give analysts a better clue for what to expect from the Bernanke speech.

Economic Calendar

It was a summer Friday in the markets with volume low at 5.2 billion shares despite being option expiration. Thursday's opex volume of 5.8 billion shares helped raise the average daily volume for the week to 5.06 billion shares. I thought for sure the average would start with a 4 after the slow start this week but Thursday pulled it out. 5.06 billion is still very weak volume. Art Cashin called it "tiptoeing into the weekend."

The Dow traded in a very narrow 36 point range. That is the lowest range for the Dow in more than five years. The S&P traded in a similar 4 point range. The Nasdaq was only slightly better at 16 points. The Nasdaq gained +14 for the day so there was not a lot of room for volatility there. The eight trading days starting on August 6th had the lowest Dow range in more than 60 years of only 128 points.

The Dow actually traded above the high close for the year at 13,279.32 but could not hold that high at the close with a minor slippage to 13,275. The S&P closing high for the year is 1419.04 back in April and it closed on Friday at 1418.16.

The Nasdaq rallied on the strength in Apple. The stock gained +12 points to close right at the high of the day at $648.11. Jefferies raised its price target from $800 to $900 and gave it a buy rating. Peter Misek, an analyst at Jefferies, said the Apple TV product is already in production and could be in stores this fall. He also said a mini iPad is also in production with a 7.85 inch screen. Misek believes the iPhone 5 launch in early September will be the biggest product launch in history. Misek said there are more than 170 million smartphone owners that have expired contracts and quite a few of those are waiting for the iPhone 5. More than 38 million have iPhones with expired contracts and they can upgrade at the subsidized price. The new iPhone is expected to be thinner, taller, faster and with better graphics and run on 4G-LTE. Apple's market cap moved over $600 billion for the first time on Friday.

Apple Chart

Stock news was almost nonexistent but we can rely on Facebook to keep the reporters busy during the day. Facebook (FB) shares declined another -4% to $19.07 the day after a lockup expired for 268 million shares. That increased the number of shares available for trading by roughly 40%. Unfortunately for shareholders there is still another 1.5 billion shares still locked up. I expect we will see a bounce here shortly as the herd starts thinking FB selling is over and it is time for a bounce. Traders paying attention will look for that bounce to fail in order to get short again ahead of the Oct 15th lockup expiration of another 247 million shares and the Nov 15th expiration of 1.3 billion shares. That November lockup is the big one where Zuckerberg will be free to sell his shares. Since he has already lost $10 billion from his $20 billion face value at the IPO you can bet he will be selling some to pay his taxes and raise some money for some new toys.

Troubling for Facebook employees is that the stock is now below the price where they were granted the stock many months ago. Employees that were granted thousands of shares of stock at $20 or $22 or even $25 are now underwater. Since stock based compensation is probably higher than their regular pay they are counting on selling that stock to buy things like houses, cars, boats, etc. Every dollar the stock declines is forcing morale lower for employees. With FB trading at 31 times 2013 earnings it is still expensive. Google and Apple trade closer to 15 times. Even if FB declined to 20 times it would still be expensive for a company where earnings are declining and expenses are rising. We really don't know what FB earnings will be in future quarters and they already warned that expenses would double.

Facebook Chart

Groupon (GRPN) lost another 5% so investors interested in a real discount special could pick up a few shares here. That would be a bad idea according to Evercore Partners. They put an underweight rating on the stock with a price target of $3. Evercore is concerned Groupon is facing some "working capital" problems and was burning through available cash. Consumers are being bombarded with dozens if not hundreds of discount deals from anyone with access to a mailing list. Banks, AAA, insurance companies and anyone else with an email list for routine customers is mailing discount offers. They see it as a way to generate some additional revenue and offer a service to their customers. Unfortunately the consumer is flushing the deals and sending them straight to the spam folder.

I have an email screening program that compares email I receive to a databank of emails that thousands of other users have reported as spam. If the email matches a database entry that email is routed straight into the spam folder. I never see it until I scan the spam folder before I delete the messages about once a week. I am seeing more and more of discount offers showing up in the spam folder, which means other customers are clicking "spam" when the email shows up in their inbox. After enough customers click the spam button the software starts to assume it is spam for everyone.

That automatic flush to the spam folder is a sign the discounting companies are in trouble. Subscribers are not reading their email offers. Companies like Groupon are also finding that merchants are no longer interested in doing deals. They have to discount too heavily and then Groupon gets a portion of the remaining price. If a business has a $100 service and they have to discount it to $25 to get any takers they only get $12.50 after Groupon takes their cut. If they have any cost in the product then odds are good the seller is losing money. Secondly offering a Groupon at a highly discounted price cheapens the value of that service. Customers who paid $25 today will not want to pay $100 a month from now if they liked the service. They will want to pay $25 again.

Groupon shares are down -77% since the IPO. Facebook is catching up fast at -50% below the IPO price.

Groupon Chart

Some retailers reported earnings on Friday and the results were surprising. Ann Inc (ANN) reported earnings that rose +27% and same store sales that increased +4.7%. Earnings were 63 cents compared to estimates of 51 cents. Ann's CEO said the chain had moved to smaller stores with less expensive clothing and the formula was working. The company raised full year guidance and shares rallied +20%.

ANN Chart

Gap (GPS) reported a 29% rise in earnings to 49 cents that beat estimates by a penny. New merchandise and marketing in North America produced the best first half sales since 2003. Same store sales rose +5.6% to $3.58 billion for Q2 and the best in five years. Gap raised its forecast to $1.95-$2.00 from $1.78-$1.83. That was still below analyst estimates of $2.08. Gap shares rallied +5% on the news.

Gap Chart

Other retailers posting gains included Ralph Lauren (RL) +5%, Abercrombie (ANF) +1.5% and Foot Locker (FL) +1.74%. I am surprised Foot Locker did not do better. They increased their Q2 profits by 59% to 38 cents. Analysts were expecting 33 cents. Same store sales rose +9.8% and inventory declined -3%. Shares only gained 60 cents but they are up more than 100% since last August.

Foot Locker Chart

Not all retailers were in rally mode. Aeropostale (ARO) pulled another guidance warning out of inventory and reported earnings that were a breakeven on a +4% increase in sales. ARO has a long track record of guidance warnings. Just to keep that record intact they cut guidance for Q3 to a range of 25-30 cents and analysts were expecting 38 cents. With such a history of warnings and missing earnings I don't understand why anyone would want to own this stock. Shares declined -11% and would have gone lower but the market closed.

ARO Chart

In an example of political electioneering the White House said it was considering releasing oil from the Strategic Petroleum Reserve. Quite a few analysts called this press release what it is and that is an excellent use of the bully pulpit and all the tools at the president's disposal to win an election. Just to recap, the strategic petroleum reserve is a "strategic" stockpile of 727 million barrels of crude oil stored underground to be used in case of an emergency like war, hurricanes or a disruption of supplies. An emergency is NOT an average gasoline price of $3.71 two months before an election.

The White House said they were monitoring gasoline prices to see whether they fall in September before making a decision to release oil from the reserve. Since crude oil supplies in the U.S. are currently more than 366 million barrels and +3.4% higher than this time last year and considerably higher than the five year historical average, any release of oil would have zero impact on prices. The red line in the chart below is the current inventory level. The blue shaded area is the five year average.

Crude Oil Inventory Chart

The International Energy Agency (IEA), the agency responsible for the reserves of the 28 member nations, immediately rejected the possibility. The Executive Director said bluntly the IEA "bases its actions on data and reality. The market is sufficiently supplied. There is no reason for a release." A Japanese official said, "Stock releases are not done when the price is high but when supply is inefficient. Supplies are sufficient now." Officials in South Korea said basically the same thing.

The director of the IEA said the U.S. had "excess oil in storage" and nothing prohibited the president from acting unilaterally to release any excess oil. When asked if any other IEA members were considering tapping their supplies as a result of the president's comments she answered a simple "No." Going against the IEA recommendations would subject the president to more political trouble. This was clearly election year politics.

The last time the president released oil from the SPR the price dropped -$4 on the announcement but returned to trade higher only a week later. The markets understand supply and demand and politics. Even if a release was approved it would be a couple months before that oil actually got into the supply chain. Bids have to be requested from refiners interested in purchasing the oil. The bidding process takes several weeks. Once bids are presented, analyzed and then awarded the payment and delivery process has to be worked out. You can't just open a valve and have a million barrels flow into refiner storage. The refiners can be hundreds of miles from the SPR. Arrangement have to be made to pipe the oil from the SPR to the refiner. Since there are no empty pipelines just waiting to take SPR oil somewhere the delivery has to be scheduled by the pipeline operators. All of these processes each take weeks to be completed.

Since crude prices and fuel prices normally decline in late August and early September as the driving season ends the prices would probably be significantly lower by the time any SPR oil was delivered. This announcement from the White House is simply election year politics.

Crude prices have rallied over the last six weeks on expectations for new QE programs from various central banks including the ECB and the Fed. Prices rallied on the increased violence in Syria and the potential for that violence to spread across the Middle East and northern Africa. Syrian operatives have been captured in Lebanon trying to incite civil war. Syrian troops have crossed the border into Jordan and fought with Jordanian troops. Analysts worry that the sectarian violence that has erupted from the Syrian civil war could spread to oil producing nations like Saudi Arabia.

Lastly there are increasing tensions over Iran and the potential for an Israeli attack. Recent news reports and comments from Israeli officials suggest an attack will occur in the next six weeks if it is going to happen. Israeli officials have said any attack should take place before the U.S. elections. There is also a timing issue based on weather patterns and Israel would want to attack before the weather declines in the fall months.

There were a couple of news threads that suggested the presidents SPR announcement could have been a trial balloon ahead of a coordinated attack in the near future. I completely discount that train of thought. If the president was planning on assisting in an Israeli attack I seriously doubt he would deplete the SPR ahead of what could turn into a really messy oil supply problem. Iran has pledged to block the Strait of Hormuz choke point for oil shipping if they are attacked.

This was announced for political gain with the president's advisors knowing full well that prices would decline anyway over the next four weeks due to the end of the driving season. This was a free throw and they took it knowing in advance there would never be a release. Nobody ever said politics were fair.

Crude Oil Chart

I wrote the last couple weeks about the non-confirmation of the rally by the Russell 2000 and the Dow Transports. That situation has changed dramatically. The Russell gained +2.3% for the week when the Dow only gained +0.5%. The Dow Transports gained +2.6%. There was a sudden shift in small cap sentiment as though fund managers finally came to a realization there was a real rally in progress. We could debate until Christmas on why that rally exists but it does exist.

The Russell 2000 catapulted from 791 on Monday to 819.89 on Friday and it closed at the exact high for the day. Whatever happened to shift sentiment on the Russell started at the open on Wednesday. It was straight up from that point forward.

The Russell rallied to exactly the resistance high from early July at 820. A break over that level targets 832 but once over 820 the bull run could turn into a stampede. Support is now well back at 800 so you could make a case for overbought.

Russell Chart

The Dow Transports made the low for the week on Monday's dip and never looked back. Even with oil prices rising daily the Transports made a vertical run to higher ground. The Transports have not yet broken out to new highs and they have reached downtrend resistance so next week will be critical.

Dow Transports Chart - 15 Min

Dow Transports Chart - Daily

The S&P emerged from more than a week of horizontal consolidation to ease above the high close from May at 1405. The spike higher on Thursday came on the Merkel comments apparently backing the ECB on buying sovereign bonds, comments from China on stimulus and the better than expected earnings from Cisco. The sudden spike higher simply confirmed the old adage about never shorting a dull market. Up until Thursday the market had been exceedingly dull for over a week.

The strong move over 1405 coupled with the Dow's touch over 13,279 seems to suggest the S&P will test stronger resistance at 1422-1426 next week. That four year high on the Dow and S&P will be a critical test of the rally's staying power. There is always the potential for a double top at those levels and a decline into October but so far that possibility looks slim. If we do breakout to new highs in an election year we could see a serious move higher.

There have been several commentaries by analysts lately suggesting this was the most hated rally in recent memory. Retail investors are almost all afraid of it because of the looming fiscal cliff and weak economy. They have been burned so many times that they don't want to trust it in a month known for big declines.

If we do move higher it will have to be due to the retail investor coming back into the market. Equity funds only have a 3.7% cash position according to David Darst from Morgan Stanley. The record low cash position is 3.3% so they are very close to record levels. They have to keep some cash on hand for withdrawals and clearing purposes. With only 3.7% on hand that means their buying power is nearly gone. It also means they may be a little nervous if it looks like a double top is forming. If they have positions they bought last August on that big credit downgrade dip then they are up 40% or better and they should be thinking about taking profits ahead of their fiscal year end, which is not far away.

It has been over three weeks since we saw a decent dip. Nothing goes up forever but in some cases we can see streaks that seem to defy the law of gravity.

I can't tell you how many times I have said next week will be a pivotal week but this will be a pivotal week. If the indexes fail at the new high resistance then we could have a textbook double top and we could see a significant decline. If the indexes manage to break through that resistance to new four-year highs then we could see a race to much higher levels on short covering and price chasing. Anyone not in the market at a new high will immediately buy something. Nobody likes to be left behind.

From Friday's close every point higher will be critical as the S&P nears that 2008 high.

S&P Chart - Daily

The Dow completed six consecutive weeks of gains and it has not done that since January 2011. It also touched that May closing high at 13,279 and closed just below it but the resistance still exists. If we move over that level next week by a couple dozen points we could be off to the races. New Dow highs will attract new buyers like a moth to a flame.

If we do move higher the next material resistance is 14,164 and the all time closing high from October 9th, 2007. There is a lot of air between 13,279 and 14,164 so the monthly high close at 13,924 will probably be a decent target and a staging area for any attack on the 14,164 summit.

Talking about new historic highs is a long way from actually getting there. A lot of things have to go right and very few things go wrong for this to happen. I am not convinced it will happen but it is a possibility to be considered. First we need to get over 13,279 with authority and volume in order to cement that milestone and then focus on the next targets. Every journey consists of a lot of small steps.

Dow Chart - Daily

Dow chart - Monthly

The Nasdaq blasted off from the support at 3,000 thanks to a $27 gain in Apple and a $35 gain by Google. Those two stocks accounted for the majority of the Nasdaq rally but the higher the index went the broader the rally became.

The next resistance level at 3,085 is only +9 points higher and then we start targeting the 3,122 high close from March 26th. The Nasdaq posted the majority of its gains over the last two days just as the Russell sentiment changed.

Something changed in the mindset of fund managers for the Nasdaq and Russell to both sprint higher on almost no news. Cisco and the retailers were the only material stock news in that period. I doubt that Merkel's comments turned our market around that strongly but then her support of the ECB buying Spanish bonds is critical. That may have been the green light for some funds to take the plunge.

Nasdaq Chart - Daily

While the markets may continue higher next week there are still a lot of factors that investors need to take into account. Bernanke is not likely to promise QE3 in the August 31st speech. The Nonfarm Payrolls for July rose to 163,000. He will probably want to see the August report on Sept 7th before making a QE decision. The market will not be happy if his speech is devoid of any QE tease. Goldman Sachs said last week they believe the economic data is not weak enough to justify a new QE program in September. Retail sales showed a dramatic improvement and GDP estimates for Q3 have risen from +1.5% to +2.3% over just the last two weeks. Bottom line, don't bet on the Fed.

NYSE trading volume last week declined to average 2.9 billion shares compared to the 3.3 billion average for the entire month. That is the lowest volume for August since 2006 when volume averaged 2.2 billion shares. New highs on six year lows in volume should be viewed with caution. There is nothing that says markets can't make new highs on low volume and then trigger a larger volume follow through but the low volume is a reason to be wary.

NYSE Average Daily Volume

Aug 2006 2.2 billion
Aug 2007 4.1 billion
Aug 2008 4.2 billion
Aug 2009 5.8 billion
Aug 2010 4.0 billion
Aug 2011 5.7 billion
Aug 2012 3.3 billion
Last week 2.9 billion

The market is ignoring bad news. The Philly Fed survey was negative for the fourth month. The NY Empire survey was negative for the first time since October. The MBA Mortgage Purchase Index declined for the fifth consecutive week and dropping -8.6% in just the last four weeks. Home purchases are declining rapidly. The fiscal cliff moves closer as each day passes. China's Q2 GDP was reported at 7.6% but numerous analysts believe it is a lot worse. Electricity usage has fallen off a cliff in a country where brownouts are a fact of life. Now plants are running at minimum levels and unused coal is piling up so fast at the plants there is no place to store it. The UK GDP fell -0.7% and the Eurozone GDP declined -0.2% in Q2.

Some would call this a wall of worry while others could call it denial.

On the positive side the risk of a Lehman event in the European sovereign debt crisis appears to be fading. Public debt is slowly moving from the private sector to the public sector. Over the next couple of years the toxic debt will continue migrating to the EFSF, ESM and ECB leaving the weaker countries in a more stable condition. Without the cloud of a potential Lehman event we should see European economics and outlook begin to improve. There are still more than one trillion euros of bad loans held by banks in Europe according to a study last week by Price Waterhouse Coopers. Those will eventually have to be written off.

Interest rates are at a three month high and rising. This would seem to suggest the Fed would take additional action in the months ahead. After all the FOMC statement claims rates will be kept low until 2014. What is "low?" Most would think 1.8% on the ten year note was still low. When will the Fed decide rates are higher than desired and take action? Will that anticipation counteract the negative factors I mentioned above?

10-Year Yield Chart

The Volatility Index closed at a six year low at 13.45 on Friday. Investors are unusually complacent and that is never a good sign. Long term lows are usually followed by abrupt moves to the upside and sharp market declines. It does not happen like a sudden reaction to touching an electric fence but more like the increasing tension in a coiled spring. The VIX can stay low for some time as the tension on that spring increases but when it finally releases it can be dramatic.

Volatility Index Chart

I tried to point out some of the factors on both sides of the market argument. It would appear the trend will attempt to move higher next week but the complacency is extreme. That is strange since this is being called the most hated bull market in recent years but you can't argue with the result. Somebody is buying equities or maybe a better excuse would be that nobody is selling equities. The trend is your friend until it ends and the Russell 2000 and Dow Transports suggest that trend may be ready to accelerate.

Enter passively, exit aggressively!

Jim Brown

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