Disappointing earnings caused the Dow and Nasdaq to lose ground on Friday but the S&P and Russell 2000 continued their winning ways.

Market Statistics

The Q2 earnings curse is alive and well and there is a long line of companies that have missed on earnings and even more that missed on revenue. The monster miss by Microsoft and Google crushed the Nasdaq on Friday. The severity of the Microsoft miss caused fellow tech stocks IBM and HPQ, also Dow components, to decline significantly and the three removed more than 75 Dow points. With this much negativity I am amazed the Dow only ended with a -5 point loss for the day. The low was set at the open and it was a long slow march higher into the close.

Dow Chart - 5 Min

All the news came from earnings on Friday with no material economic reports.

The economic calendar for next week is going to be led by the HSBC PMI for China on Tuesday. This could be the next shoe to drop in the worry over China. The PMI has been in decline for several months and getting worse.

China's GDP peaked at 11.9% in 2010-Q1 and has declined in all but two of the last 13 quarters.

There are two regional manufacturing reports from Kansas and Richmond next week as well as the Chicago Fed National Activity Index on Monday.

Overall this is a low volatility calendar since most of the reports are not market movers. The home sales reports should show an increase but this is already expected. If sales suddenly declined it might be noteworthy.

Economic Calendar

The earnings calendar for next week does not contain as many big names but overall it is the busiest week of the earnings cycle. More than one-third of the S&P-500 companies report. Some of the most watched companies are NFLX, AAPL, FB, AMZN, SBUX and SWK. Those tend to be actively followed by the largest number of investors.

Apple will be the biggest report for the week on Tuesday. With competition increasing by the day, the odds of an earnings miss are pretty good.

Facebook reports on Wednesday and the biggest question will be the monetization of mobile. Google is struggling with the same problem and they have a lot more money and people working on the problem than Facebook.

Amazon is the preferred stock to hate with ever increasing expenses, more inventory, more distribution centers and less profits. With a negative PE and margins shrinking they could miss estimates again but investors will buy the dip anyway.

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Starbucks should be making money because the price of coffee imploded over the last year but they hedge their coffee costs so they could be on the wrong end of that hedging or so levered into the future that current inventories were bought a couple years ago when prices were high. Eventually they will benefit from the low coffee prices so I believe they should be bought on any dip.

Dow components reporting include MCD, TRV, T, MMM, BA, DD, CAT and UTX. CAT was the recipient of a long term short call by Jim Chanos last week saying the commodity super cycle was over with China in serious decline and that would eventually crush Caterpillar.

Boeing's earnings on Wednesday will be interesting because of the impact of the four month outage of the 787 as a result of the battery problem. That is now fixed but the costs have not worked their way to the financials yet. The recent fire in an unoccupied 787 in London was found to have been caused by the Emergency Locator Transponder or ELT. This device was made by Honeywell and the same design has been in use since the late 1990s. More than 6,000 of them have been installed and this is the first time a unit has failed with a fire. It was traced to the self contained battery and the FAA is recommending these units be turned off or removed until a thorough inspection can be performed on all planes, not just the 787. It appears Boeing is off the hook on this particular problem. We should get some more color on it with the earnings.

Earnings Calendar

There were a bunch of high profile earnings misses last week but the biggest surprise was Microsoft (MSFT). Shares of Microsoft fell the most in four years after the biggest earnings miss in at least a decade. Shares declined -11.4% to close at $31.40. Microsoft posted earnings of 66 cents that missed estimates of 75 cents. On top of that miss they took a $900 million write down on existing inventories of the Surface tablet to compensate for a new fire sale at reduced prices. That knocked another -7 cents off the actual earnings.

The drop in PC sales is killing the manufacturers and software developers. PC sales fell -11% in Q2. However, CFO Amy Hood said consumer PC shipments dropped -20% in the quarter. That hurt sales of the Office software suite and Windows 8. PC shipments have fallen for five consecutive quarters and IDC says that is the worst drop on record.

The Surface tablet only sold 900,000 units in each of the last two quarters. Obviously the product is far from successful.

Revenue rose +10% to $19.9 billion but analysts were expecting $20.7 billion. Sales of Windows were $4.4 billion compared to estimates of $4.8 billion.

Microsoft Chart

Google declined -15 to close at $897 but that was well off the lows. Shares dropped -$50 to hit $859 immediately after the earnings miss but the dip was bought on Friday. Google's cost per click declined -6% after a -4% decline the prior quarter. Cost per click has declined for 8 consecutive quarters. This is a result of higher competition but mostly the shift to mobile computing. Cell phones and tablets don't generate as many clicks as PCs.

Google is also suffering margin compression with its expanding hardware business. Motorola's smart phones, Android tablets and laptops are in a very crowded and competitive field. Operating income came in at 28% of revenues compared with 33% in the year-ago quarter. Revenues rose by +19% but net income declined by -4% to $3.12 billion.

Google is still a growth stock and about the biggest revenue grower so far this quarter. The company can stand to see margins shrink slightly as long as revenue continues to expand at 20% a year. Google reported earnings of $9.56 compared to estimates of $10.80. Revenue, although strong, was -$275 million below estimates.

Google Chart

On Friday GE surprised everyone with surprisingly strong guidance. Earnings declined -5% to 36 cents to beat estimates by a penny. Revenue fell -4% to $35.12 billion and below estimates of $35.6 billion.

GE's backlog of equipment and services rose $7 billion to a record $223 billion. The company said it saw growth in six of its seven industrial businesses. Sales of generators used in power plants and wind turbines declined -6%. This was predicted in late 2012. GE expects to generate 70% of its big ticket turbine sales in the back half of 2013. GE received orders for $26 billion in aircraft engines at the Paris air show in June.

CEO Immelt was very upbeat saying we expect to have a very good year because of the backlog of products that will be delivered over the next six months. GE shares rallied 4.6% to a new four-year high on the news.

GE Chart

Intuitive Surgical (ISRG) fell to $357 at the open on Friday after lowering guidance and saying the sales of its robotic surgery systems will continue to be pressured. ISRG said revenue growth will slow to only about +7% for the year compared to prior estimates of 16-19%. Revenue rose +24% in 2012. The company also said it had received a warning letter from the FDA regarding two problems observed during a recent inspection. Revenue is now expected to be $2.18 billion, down from prior guidance of $2.56 billion. Shares rebounded to close at $393 but that was still a loss of -$29. Shares fell from $499 to $407 on July 9th after an earlier warning.

ISRG Chart

Oilfield services company Schlumberger (SLB) reported earnings of $1.15 that rose +9.5% and beat estimates of $1.10. Revenue rose +7% to $11.18 billion and also beating estimates of $11.11 billion. The profits came from drilling activity at a three decade high outside the USA. The company said oil demand remained stable and high prices enabled companies to make development decisions and move forward with projects.

SLB Chart

Chipotle Mexican Grill (CMG) reported earnings that rose +10.2% to $2.82 on revenue that rose +18.2% to $816.8 million. Earnings were in line with estimates and revenue was a beat. Same store sales rose +5.5%. They opened 44 new stores to bring their total to 1,502 with plans to open 165-180 in 2013. This is a fast food company that is doing everything right.

CMG Chart

So far the Q2 earnings have been weak but slightly better than expected. With 20% of the S&P reported the earnings growth has been +3.7% thanks to the financial sector. Revenues have declined -1%. A common thread in the reports has been "Sorry for the weakness in Q2 but we promise to be better the rest of 2013." There is a huge amount of expectations being pushed into the next two quarters. There is a "hope bubble" forming that everyone wishes will come true.

The earnings beat rate at 70% but as I warned over the last month the bar is so low a snail could crawl over it. As of Friday 97 of the S&P companies had warned about Q2 earnings expectations while only 16 had provided positive guidance. That is the highest rate of negative guidance since 2001-Q1.

The Guggenheim chart below shows the number of negative guidance warnings in gray and the positive guidance in green. Note the broadening divergence that suggests things are getting worse instead of better. Is this the picture of a recovery?

Guggenheim S&P Guidance Chart

Oil prices continued to rise on concerns over Egypt, Libya, Syria and the unrest in the entire MENA region. WTI prices rallied to close at $108.47 and the first time above Brent prices in three years. Brent last traded below WTI in October 2010. Since then the spread had risen to more than $20 on numerous occasions.

The decline in Brent prices is due to a large quantity of nearly 4.5 mbpd that is coming back online after a prolonged shutdown. This is primarily from South Sudan but other fields are coming back online after lengthy maintenance issues and pipeline outages. The return of this crude to the market is depressing Brent as the waterborne crude price index.

Meanwhile WTI prices have been rising as producers find new ways to ship crude oil to the coasts where it is priced comparably with Brent. Five years ago there were 50,000 bpd shipped from the Bakken by rail. Today there is nearly 700,000 bpd and growing plus an additional 200,000 bpd shipping from other shale oil fields. New pipelines are being completed and the Seaway pipeline from the Gulf of Mexico to Cushing Oklahoma was reversed to drain the glut of oil flowing into Cushing from the Midwest.

WTI was expected to catch up to Brent prices but not until the next major pipeline is completed in 2014. Once the equalization of supply began the closure rate was very rapid.

WTI Chart

Detroit became the largest city to file bankruptcy just one year after President Obama vowed, "I will not let Detroit go bankrupt." Reportedly 54% of Detroit's $18 billion in debt is related to pension funding. More than 40% of their street lights were out and 66% of their ambulances were not working. Detroit's problems have been increased by population flight. In the 1950s there were nearly two-million people in Detroit. That has declined to around 750,000 today. The lack of jobs and decaying infrastructure in the rust belt drove people to other states in search of a new beginning. I was in Detroit a couple years ago and some areas looked like something out of a Walking Dead episode.

Other cities likely to file in the coming months include Philadelphia, Houston, Los Angeles, Baltimore, Miami, Chicago, Scranton and Oakland. Having Detroit lead the way establishes a large city precedent that will make it more likely for those other cities to file. The equity market ignored the Detroit headlines.

$20 billion flowed into to equity funds last week for the largest inflow since June 2008. Another $1 billion flowed out of bonds but that was reserved compared to the $80 billion in outflows in June.

This liquidity driven exuberance could keep the equity markets irrational far longer than fundamentals, technicals or simple logic would suggest. The VIX collapsed to 12.54 and a two month low on Friday. There is no fear in the market. The only fear is that investors will miss further gains by not being in the market.

The broadest measure of the market, the Wilshire 5000, has broken out to a new high and appears unstoppable. The RSI and MACD are showing no weakness.

However, note the steady decline in volume since the 2009 low despite the extreme increase in algorithmic trading. Market sentiment changed after the recession. Individual investors began to withdraw from the markets. After watching their accounts shrink by 50% as they headed towards retirement they began pulling money out rather than risk another hit when the Fed ends QE.

I suspect we are seeing some of that money come back because new highs are a very powerful motivator. Fear of missing out on a big bull market probably overcame some fear of a future loss. Note the slight pickup in volume in Q2-2013.

Wilshire 5000 Chart

In theory we should be approaching a period of market weakness after a month of almost solid gains. Theory rarely works in practice and the $20 billion in new cash that flowed into the market last week is proof that investors either don't understand market theory or they believe this time is different.

The Dow, S&P and NYSE posted gains last week but the rate of climb slowed appreciably. The Nasdaq lost a little ground because of the hit on Friday by Microsoft, Google and Intuitive Surgical.

The Dow only gained +79 points for the week after averaging +275 points the prior two weeks. The S&P continued undaunted to draw ever closer to 1,700. This is the new Holy Grail for traders and the odds are good it will be hit. The key of course is what happens next. We are so far above the average estimates we started the year with we would need a -112 point decline to 1580 to hit that target.

The table below was estimates as of December 29th with the exception of Goldman and Morgan Stanley, which were revised up as of March 31st.

Year End Targets as of December 29th.

Many analysts have increased their estimates but even those increased year end estimates are only in the 1700-1725 range and we are basically there now. So what happens if we punch through 1,700 next week? Does everyone increase their estimates another 100 points and we continue on our merry way? I doubt it. There are some major analysts turning negative on the markets.

Carter Braxton Worth, chief market technician at Oppenheimer, pens a weekly research note called "Money in Motion" and at the end of June his only comment in the note was "We have no new thoughts. Sell." View Money in Motion

In a note this week he compared the 2003-2007 rally with the 2009-2013 rally and said it had a 95.5% correlation. The current bull is 1,096 trading sessions old. Out of the 20,383 rolling 1,096 sessions periods dating back to 1927 the period with the highest correlation is the one that began on March 10, 2003 and ended on July 17th, 2007. He said humans tend to recognize patterns and once they are recognized they tend to repeat.

Oppenheimer Chart

While I like to point out historical trends and semblances there is never any guarantee of future results. Each market is unique and there is a myriad of factors creating the current market sentiment. That sentiment today is very bullish as evidenced by the $20 billion in inflows into equities last week.

We also know that when bullishness becomes irrational the potential for a climactic spike increases and will be followed by a period of correction and consolidation. To be valid that spike needs to occur on a sharp increase in volume.

On Thursday we traded 6.0 billion shares, which for a summer Thursday was above average but it was expiration week and a big earnings day so with those qualifications I would say it was only mediocre. Friday traded 5.9 billion, which was also above average but with the same qualifications it remains mediocre as well. We have not seen a climatic spike. The ratio of up to down volume has been tame except for the 11th when it was 6:1 in favor of advancers. That was a Bernanke headline driven rally.

Bernanke has gone out of his way to smooth over the June comments that tanked the market and done a good job of it. However, we have to wonder what else could the Fed pull out of its hat to push us higher? The doves have stated their case and the hawks other than Ester George have toned down their comments in order to avoid roiling the bond market and killing the real estate market. That means the Fed is likely to be quiet this week and with the July 31st FOMC meeting they are entering their quiet period anyway. That means no Fed headlines for the next 10 days.

What do we have left to spur the market forward? Economics are back in the good news is bad news cycle so any good news next week would suggest an earlier end to QE. More bad economics are not likely to be ugly just weak and that would be neutral for the market.

That leaves us with earnings and the Q2 earnings cycle has not worked out well so far. As we move into the third week of earnings the number of companies reporting increases to the busiest week of the cycle but the size of the companies also declines and normally so do the earnings. However, this quarter may be different.

Smaller companies are normally less exposed to Europe and China and those are the regions that have been giving the big blue chip companies the most trouble. Maybe the U.S. focused companies reporting next week will report better earnings. Either way the bar is set so low we should continue to see a high beat rate.

Will it be enough to push the S&P well over 1,700? That remains to be seen and the rubber band is starting to look like it might be reaching its limits. The S&P has gained +132 points in the 18 trading days since June 24th. That is an average of 7.3 points per day with only a couple pauses on the way up.

Initial support is 1672 and resistance at 1700, 1715 and 1725.

S&P Chart - Daily

The Dow was handicapped by MSFT, INTC and IBM on Friday with those three stocks costing the Dow -75 points. However, it almost made it back to positive territory. I view that as bullish and I don't need to belabor the point.

The Dow set a new high on Thursday and after five days of consolidation just above 15,400 it could be set to move higher. That 15,400 level has turned into decent support and resistance is well above in the 15,750 range with round number resistance at 15,600. It is hard to accurately plot resistance points when the markets are making new highs.

Dow Chart

Like the Dow the Nasdaq was severely handicapped by Microsoft and Intel with an assist by Google. The index never had a chance. The bearish sentiment from the tech earnings misses was a lot to overcome. However, the index gapped down to 3581 at the open and closed at 3586. The sellers were unable to push it any lower. This was purely a knee jerk reaction and there was no follow on selling. I view this as bullish as well even though the rebound was lackluster.

Resistance is 3610 and the Thursday close. The Nasdaq consolidated at the 3610 level all week ahead of the tech earnings. Now that those big names are out of the way we could see a direction appear this week.

Initial support should be the 3581 low from Friday. We would have to decline significantly below that level to find the next support level about 100 points down. That would be a major sentiment change.

Nasdaq Composite Chart

The Russell 2000 succeeded in making a new closing high by two-tenths of a point. Yes, 0.2074 to be exact with a close at 1050.47. That 1050 level is current resistance. The Russell has gained +108 points in the last 18 days or roughly +10%. Since the small caps rarely do well in the summer this suggests fund managers have thrown the seasonal cycles out the window.

Support is 1035 and upper resistance at 1075.

Russell 2000 Chart

Sentiment will remain bullish until suddenly it isn't. The market will find an excuse to go down when it is ready. All the charting and posturing in the world will not prevent that event when it appears. Seasonally the market typically weakens after the Q2 earnings cycle. With a third of the S&P reporting this week we will know beyond a doubt by Friday's close how the quarter will finish. That is usually the starter's bell for the August decline. It can vary by several weeks depending on headlines and sentiment but we need to watch for the signs of instability forming.

Enter passively and exit aggressively!

Jim Brown

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"When they call the roll in the Senate the senators do no know whether to answer 'present' or 'not guilty.'"
Theodore Roosevelt


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