Despite the Dow's loss on Friday the spin control by a large number of Fed presidents succeeded in creating a market rebound.

Market Statistics

The market started off in the dumps on Friday with the Dow down -132 points but it returned to positive territory intraday before succumbing to the negativity of the Russell rebalance to lose -114 at the close. The Nasdaq closed slightly higher with a +1 point gain.

The historical negative bias for the week ahead of the Russell rebalance failed to appear due to an abundance of window dressing and a barrage of positive comments from multiple Fed officials. The Fed speakers were unanimous in saying the FOMC was not going to be tapering QE purchases until it is justified by the economic numbers. This is the same thing Bernanke said but the market heard it differently. The flurry of comments this week stressed the requirement for economic justification and the potential for no QE reductions until 2014. If the Fed did make a change it would be because the economy was improving and the market should embrace that potential.

The combined markets traded 9.7 billion shares on Friday as a result of the Russell rebalance and the biggest volume was at the close. The rebalance will produce a positive bias for next week as the fund managers complete their purchases of those stocks added to the Russell indexes. The first week of July is typically bullish as quarter end retirement contributions hit a market with very light volume.

The pivotal event is going to be the Nonfarm Payrolls next Friday. Coming the day after July 4th and right in the middle of the long weekend the volume is going to be extremely low and the volatility will be huge at the open and quickly dwindle to nothing after the first couple hours.

The payroll report will set the trend for the month since the numbers will be very Fed centric. The consensus estimate is for a gain of +165,000 jobs in June compared to a gain of +175,000 for May. The Fed wants to see an average gain of +200,000 before reducing QE and there has only been one month of more than 200,000 new jobs this year.

Any number lower than 165,000 is going to see the market assuming no end to QE in the near future and equities are likely to go higher. It is back to "bad news is good news" again. If jobs are higher than 165,000 and closer to 200,000 then worries over an early end to QE will immediately return. Bonds will be sold and equities will be sold. I know it is not logical but the stock market is rarely logical. Just look at the chart for the prior Wednesday and see the proof.

Dow Chart - June

If traders would just focus on the current economics they would see the recovery is still struggling. The Fed is not going to reduce QE purchases until there is a positive trend in the monthly economic reports.

The ISM Chicago, formerly Chicago PMI, dropped sharply from 58.7 in May to 51.6 in June. That is just a fraction over contraction territory and the biggest monthly drop in more than four years. New orders fell -4 points to 54.6 and the order backlog positively imploded from 53.1 to 38.4 and deep into contraction territory. The backorders are the window into future production activity. When backorders decline the new orders are processed faster and the plants will begin to run out of work.

ISM Chicago

On Thursday we saw the Kansas Fed Manufacturing Survey for June and it fell back into contraction territory. The headline number declined from +2 to -5 and contraction territory. New orders declined from +6 to -10. The production component declined from +5 to -17. The gap between new orders and inventories declined from +8 to -16. Clearly the manufacturing sector is slowing and that could be reflected in next week's reports.

Kansas Fed Manufacturing Chart

On Monday we will get the national ISM Manufacturing and it may not be positive. The May headline number was 49.0 representing contraction in the sector and estimates for June are for a minor rebound to 50.5. Given the drop in the Chicago ISM and Kansas Manufacturing we could see a downside surprise.

The final headline number on Consumer Sentiment for June declined slightly from 84.5 to 84.1 but it is still a five-year high. The present conditions component declined from 98.0 to 93.8. The expectations component rose from 75.8 to 77.8.

Consumer Sentiment Chart

Other events on the economic calendar for next week include China's manufacturing PMI on Monday. It is expected to decline from 50.8 in May to contraction territory at 49.7. That will be the first time in nine-months for a negative reading. Multiple supporting reports have declined in recent weeks and the initial HSBC Flash PMI was negative at 48.3. New orders are at a ten-month low.

Adding to the gloom over China was weakening exports. China's exports only grew by +1% in May and the slowest rate in a year.

A disappointing PMI number will cause further weakness in commodities including coal. It will also suggest no real improvement in Europe or the USA since the majority of China's manufactured products are shipped to those geographies.

Economic Calendar

Fed officials normally have a one-week blackout period before and after an FOMC meeting in order to avoid saying something that is contrary to the official statement. You can't have a bunch of people spouting forecasts based on their own opinion. The FOMC is supposed to maintain a united front to avoid unexpected market volatility.

That black out concept fell apart last week when every Fed head with a microphone tried to walk back the Bernanke comments. One Fed president even released his own competing press release. To say there was division in the Fed would be an understatement.

The latest in the parade of speakers was San Francisco Fed President John Williams who spoke Friday afternoon. Williams rocked the boat several months ago when he said the Fed could cut back on QE purchases as early as this summer. He has clearly undergone a conversion experience because on Friday he was repeating the new party line. Now he claims the Fed will not cut back on purchases unless the economic targets are met. "It is too early to slow bond buying." Thank you John for helping to clarify the new Fed communication standards.

Maybe we should petition the FOMC to go back to the Greenspan era methods of no communication and the confusing Greenspeak when Greenspan was pressed for answers in congressional testimony. He admitted after his term ended that he gave long winded confusing answers using words he knew lawmakers were unfamiliar with in order to avoid having to give a truthful response.

All our communication in the Greenspan era came from the FOMC statements. Bernanke's new version of an open Fed has let us see the sausage making behind the scenes and sometimes it is not pretty.

Random comments from this week include Jeffery Lacker, "Not only is the Fed leaving the punch bowl in place it will continue to spike the punch."

William Dudley said the markets were "out of sync" with the Fed. The "reaction of the futures markets for short term rates appears out of keeping with my assessment of the committee's intentions." An increase in interest rates is "very likely a long way off." Bond purchases could be prolonged if economic performance fails to meet Fed forecasts. "I would expect that the asset purchases would continue at a higher pace for longer."

Fed governor Jerome Powell said "I want to emphasize the importance of data over date." And, "In all likelihood, the current" large scale asset purchases "will continue for some time."

Dallas Fed President Richard Fisher had the best quote of the week. He said he still favors a reduction in stimulus but "I am not in favor of going from wild turkey to cold turkey overnight." Fisher said investors overreacted to the Bernanke comments. He also said I agree "we should dial back stimulus" but only if the economy continues to grow as the Fed economic targets are reached.

I suspect the barrage of counterattacks on the Bernanke comments are over. After the holiday the Fed heads will go back to work and try not to ruffle the markets. The next Fed induced headline problem will be the Bernanke testimony on July 17th. Because of the recent market volatility lawmakers are sure to press him in hopes of getting 30 seconds of TV time if they can get him to say something that roils the markets again. It is not what is best for the U.S. but what they think will get them on TV.

The confusion over the end of QE crushed the bond market. said a record $61.7 billion was withdrawn from bond funds and ETFs during June.

Mortgage rates surged at the fastest weekly rate in 26 years.

Ten Year Treasury Yield Chart

Dollar Index Chart

Even if the Fed continues QE4 for another six months the program is not working the way it was intended. Stocks are going higher. Interest rates were low until recently. Unfortunately the economy is still struggling. The Q1 GDP was revised down from +2.4% to +1.78% last week. The odds are good the Q2 GDP will be even less as a result of the Sequestration. The chart below shows the rolling six-month GDP average. This smoothes out some of the seasonal spikes and gives a truer picture of the economic trend. For Q1 that average reached a five year low. If Q2 comes in at less than 1% growth the Fed should be really nervous. The risk of another recession is growing.

GDP - Six-Month Average Chart - Source: MSN Money

The entire taper caper was a serious error on the part of the Fed that I believe was rushed because of Bernanke's impending exit. With the economy so weak I don't understand why the committee would open up this can of worms at this time. They may have wanted to slow the equity market gains but they definitely did not want to see mortgage rates spike the most in 26 years. They effectively gave back three months of QE benefits in only a week and made the committee look like a bunch of amateurs. They have decades of history and experience to draw from and Bernanke himself is a student of the Great Depression. With inflation, as evidenced by the PCE, at 0.7% and falling the risk of deflation is growing not receding. The Fed wants inflation in the 2-2.5% range.

PCE Inflation Chart

In the official outlook that accompanied the FOMC statement the Fed actually cut its growth expectations. If QE is to be reduced based on the health in the economy then tapering should not even be a topic until the growth targets are reached. That could be several quarters from now if not later. Fed President Bullard said, "Policy actions should be undertaken to meet policy objectives, not calendar objectives." I believe that is the crux of the matter. Bernanke wanted to get the taper underway before his term expires in January so his legacy would be protected. Secondly, with the Fed's balance sheet approaching $4 trillion the committee is becoming increasingly aware that exiting this overly accommodative policy without a disaster is going to be an impossible task. The longer they let QE continue the harder it will be to exit. This reminds me of the line in the Twilight Zone movie. "Do you want to see something really scary?" Stay tuned. The climax to the QE movie is still ahead. When it arrives the taper tantrum we saw last week will look like a walk in the park.

Just the potential for the Fed to taper caused investors to withdraw $13 billion from equity ETFs in June. That was a record and the first monthly outflow since December 2011. You can imagine what will happen when the Fed actually begins to really end QE. For reference YTD inflows are just short of $71 billion and less than the $76 billion in the first half of 2012. ETFs saw inflows of $188 billion for all of 2012. Total funds invested in ETFs are $1.437 trillion. As much as 70% of trading on the NYSE is in ETFs and high frequency trading.

The combination of Fed events, rising equities, falling treasuries and the feeling of impending doom in China helped push gold to its worst quarterly loss in 45 years. Gold ended the first quarter at $1596 and closed Q2 at $1227 for a -23% decline. At one point on Friday the yellow metal traded as low as $1179.40. The $1200 level is seen as serious psychological support and coin and bullion buying around the world soared as the price dropped.

At $1200 it is below the cost to produce it at many mines and production from those mines will be halted until prices rise. Newmont (NEM) said it was cutting 33% of its staff in an effort to lower production costs. Barrick (ABX) said it was considering a $5 billion write down on the Pascua-Lama mine because of the decline in asset value. Newcrest Mining (NCM) is writing down the value of its mines by $5.5 billion and be the biggest one-time charge in gold mining history. Gold Fields (GFI) CEO Nick Holland said "The industry is not sustainable at $1230 an ounce. We need at least $1500 to sustain the industry in any reasonable form." With marginal mines being shutdown and major projects being written down the gold miners are still not a buy. Once the write downs occur I would not hesitate to speculate on a major miner like Newmont. Gold supplies are going to dwindle as production slows and the miners will recover.

Gold Chart - Weekly

Gold is not the only commodity falling. The Commodity Index (CRB) is at a 52-week low and were it not for the same decline in June 2012 it would be at a three-year low. Precious metals, grains, coffee, coal, iron, lumber, etc are dropping although gold is getting all the attention. This is another warning sign we could be heading closer to a depression.

Commodity Index Chart

In stock news rare earth miner Molycorp (MCP) rallied +10% after the SEC completed an investigation into their public disclosures and accounting and recommended no enforcement action against the company. The SEC announced the probe last August and that weighed on the stock along with the decline in rare earth prices.

Molycorp Chart

BlackBerry (BBRY) fell -28% to close at $10.45 after reporting earnings that were a disappointment. BlackBerry said it lost 16 cents per share on revenue of $3.1 billion. This compares to a loss of -99 cents on revenue of $2.8 billion in the year ago quarter. It was a decent improvement but analysts were expecting a profit of +5 cents on revenue of $3.37 billion.

The company said it shipped 6.8 million phones compared to 7.8 million in the year ago quarter. More than 2.7 million of those were BB10 models. The Z10 was late into the U.S. market and that slowed sales early in the quarter. The Q10 went on sale in the U.S. in early June.

BBRY said it was going to halt development on new versions of the slow selling Playbook tablet. The company said total users declined by 4 million to 72 million.

Many investors had expected this to be a turnaround quarter for Blackberry but this is a very competitive space. The smartphone market is very crowded but Blackberry has a diehard following. The company is not in danger. CEO Thorsten Hines reminded analysts that "turnarounds take time."

Revenue in North America rose +30%, Asia Pacific +35% and EMEA +9%. Revenue in Latin America declined -9% due to a currency devaluation in Venezuela cutting into sales.

Blackberry is worth more than $10 because of the sum of their parts. Did you know every Ford has Blackberry software? The enterprise technology portion of the business is worth nearly as much as the entire company at $5 billion today. Also, 50% of their market cap is in cash. This company is either going to be split up or acquired.

Short interest is 41% and quite a few will be covering those shorts if there is no further decline.

BlackBerry Chart

Accenture (ACN) was a market killer on Friday. The company posted adjusted earnings of $1.14 and analysts were expecting $1.13 so where is the beef? Revenue was $7.2 billion compared to expectations of $7.43 billion. The company also projected revenue for the current quarter to be $6.7-$7.0 billion compared to analyst estimates of $7.36 billion. Accenture said customers were putting off decisions on short term projects but continuing to plan for longer term business. This results in higher bookings for Accenture but lower revenue in the short term. The weakness in the European economy is also forcing companies to postpone projects and that delays sales.

Accenture is the second largest consulting company behind IBM. The -10% drop in Accenture shares was followed by a -2.3% drop in IBM shares. The $4.50 drop in IBM knocked -35 points off the Dow.

Accenture Chart

IBM Chart

The first half of the year is over and the Dow gained +13.78%, S&P +12.62% and Nasdaq +12.71%. Gold lost -26% and silver 35%. Brokers were the big winners at +33%, biotech +26% and semiconductors +22%. It was a good year that lasted only six months. With the consensus estimates for the year end S&P at 1654 and Friday's close at 1606 there is some room for movement.

It was the best yearly percentage start for the Dow since 1999 and best since 1998 for the S&P. As any sports fan knows it is not how you start but how you finish that counts and there are six more months of volatility ahead.

The general consensus for the rest of the summer is a retest of 1540-1555 and then a rebound as the economy improves later this year. Of course that is a flawed assumption since the economy is struggling just to stay afloat rather than accelerate. The Fed expects the full year GDP to be in the range of 2.5%. That would require Q3 and Q4 to average 3.3% growth. With the Sequestration expected to remove -1.5% to 1.9% that suggests the Fed's targets are not going to be hit. Whether the market continues to see the bad news of a weak economy as good news for QE remains to be seen.

Earnings begin in two weeks and the growth estimate for Q2 is +3.3% with a revenue increase of +0.5%. The majority of those earnings are going to come from the financial sector and everyone else is going to be fighting to reach their estimates. In January the S&P was expected to see earnings growth of +9% in Q2. Somewhere along the way the expectations eroded. Q2 earnings warnings have been 7:1 over positive guidance. That is the worst since 2009.

The expectations for Q3 are currently +6.9% earnings growth followed by +11.1% in Q4. The odds are very good those estimates are going to erode as well.

If the Q2 earnings surprise to the upside then we could be looking at something closer to 1700 on the S&P by year end. However, if the earnings play out as the warnings project we could see the markets fade into August/September while investors wait for Q3 guidance.

For next week the bias "should" be bullish due to money flows, rebalance leftovers and general relief that the Fed is back on hold. The following week should be slightly bullish as investors come back from the holiday and launch their earnings positions. Once the earnings begin to flow all bets are off. We will be in the summer doldrums period where volume is light and interest is low. Depressing earnings could prompt traders to close up shop and head for the beach to escape the heat.

The S&P is in a dangerous position. The rebound from 1560 screeched to a halt at the 50-day average at 1620. This was strong support over the last six months and should now be strong resistance. That level also held on Friday but given the Russell rebalance at the close there was little interest in buying the market. I am surprised the S&P did as well as it did and only lost -7 points.

If we were to push higher the next material resistance would be the June high at 1650.

S&P Chart

The Dow has the same resistance problems. The 50-day is now resistance at 15,040 followed by the early June resistance at 15,300. The Dow is likely to retest 14,400 at some point later this summer before moving higher later in the year.

Dow Chart

The Nasdaq squeaked out a small gain on Friday but remained stuck to the resistance at 3400 and downtrend resistance from May. I was encouraged by the Nasdaq performance since Accenture and IBM were down so hard. The semiconductor index was also positive. Intel had some bullish comments about the future of chips and that helped the sector. Support is now 3300 and the 100-day average at 3310.

In the winners list below we actually see Apple on the left side of the board. That is unusual and at 11.1% of the Nasdaq those +3.32 points do count. Google was also mildly positive along with ISRG, PCLN and BIIB. All of those big caps being positive on the same day make it tough for the Nasdaq to be negative.

Winners and Sinners

Nasdaq Chart

The Russell rebalance is history except for the cleanup next week. When the index following funds have to buy and sell hundreds of stocks at the close on Friday they rarely get it exactly right. There is always some position shuffling in the days that follow as they attempt to get the weightings correct. At the same time they have large inflows of new money from the quarter end. This produces a slight upward bias over the next several days. These position adjustments are small but there are thousands of funds making them. Russell claims there is more than $7 trillion indexed to their funds so that is a lot of money sloshing around in the system when these changes take place.

The Russell 2000 traded to a draw on Friday with a loss of only -2.45. That was based on the indexes with the old stocks. On Monday they will be valued including all the new additions. The Russell 2000 gained +20 points in the first two days of last July during the adjustment period. If that were to happen this year it would put the Russell 2000 right at 1,000 and the historic closing high. I would short that event.

The Russell 2000 has support at 950 with the 100-day average. Resistance is 980 and 1000.

Russell 2000 Chart

In theory the Russell rebalance cleanup plus the $61 billion that came out of bond funds should give the markets a positive bias next week. However, funds that window dressed into the quarter end may be thinking about capturing some of the big profits so far this year and looking to get back in on the late summer dip.

Predicting market direction is impossible with any degree of accuracy. There are simply too many variables. We can pick a general direction based on the factors that are known but as Donald Rumsfeld said "There are known knowns; there are things we know that we know. There are known unknowns; that is to say, there are things that we now know we don't know. But there are also unknown unknowns – there are things we do not know we don't know." Market direction for the rest of July is a one of those things we do not know.

I personally expect a short bounce followed by extreme volatility surrounding next Friday's Nonfarm Payrolls and then a direction should appear.

Enter passively and exit aggressively!

Jim Brown

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