About a month ago everyone was hoping oil prices would rise so the energy sector would lift the equity markets. The opposite happened today but we can't blame oil prices. Crude traded as high as $61.10 and the high for the year but it did not help he market. Today economics got the blame along with David Einhorn.

Market Statistics

Oil stocks were down as a result of a presentation by David Einhorn of Greenlight Capital on Monday. His attack on frackers contaminated the entire sector and stocks were down hard despite the new highs on oil. More on this later.

The economic numbers get the lion's share of the blame for today's decline although the market has been showing a lack of conviction for several days. Today's economics simply gave investors a reason to sell. A major sell off in Europe also added to the negativity.

In the U.S. the International Trade numbers upset market. The trade deficit exploded higher from -$35.9 billion in February to -$51.4 billion in March. The estimates were for a rise to -$41.3 billion. To say this was a blowout would be an understatement. This was the biggest trade deficit since October 2008.

Exports rose only +0.9% while imports rose +7.7%. That immediately knocked the estimates for Q1-GDP down 6 tenths of a percent from +0.3% growth to a contraction of -0.3%. It will also weigh on Q2 growth estimates but the range there is so wide (0.8% to 4.0%) that it is hard to know by how much until the new estimates are posted. The last consensus was for +2.9% growth.

The analysts were quick to blame the dollar because the goods deficit rose from -$55.7 billion to -$70.6 billion. They also blamed the port disruption for the inequality between imports and exports. I am sure both of those had something to do with it but you can't get away from the fact that the U.S. economy weakened all through the first quarter.

On the flip side the February trade deficit was unexpectedly low at -$35.9 billion was the lowest since November 2013. That would seem to lend more credibility to the port disruption as a factor in both months.

The market did not care if there was a reason. Futures begin falling as soon as the report was released and it was a steady decline from there.

Moody's Trade Balance Chart

The ISM Nonmanufacturing report for April that came out 90 minutes later managed to stall the decline for about 45 minutes but selling eventually resumed. The ISM services for April rose slightly from 56.5 to 57.8 compared to forecasts for a minor decline to 56.3.

New orders rose from 57.8 to 59.3, backorders from 53.5 to 54.5 and employment from 56.6 to 56.7. It was a solid report but it was not that strong. Some analysts immediately said this pointed to a rebounding economy in Q2. Unfortunately those small gains mentioned above are not pointing to a rebound but more likely to a muddling through until the dollar weakens further.

The first employment report for the week was the Intuit Small Business Employment Index. The index declined from 0.07% to 0.06% and hardly a major move. However, this is down from the recent 0.15% high in November. This reading is the equivalent of adding 15,000 jobs by small businesses in April.

Wages declined -0.2% to $2,774 per month or $33,290 per year. That was the first contraction since July-2013. Average monthly hours declined -0.08% to 108.3 hours or about 25 hours per week. That was the eighth consecutive monthly decline in hours. Small business revenues declined -0.3% for the sixth consecutive monthly decline. All industries posted declines.

This report is normally overlooked but those last two points should not be ignored. Hours and wages have been declining for more than six months. That is a result of the weak labor market and the shrinking labor force participation rate. Unemployed workers can make more by staying at home and collecting benefits than they can by taking a part time job for 25 hours a week or less. The 30 hour workweek in Obamacare is a factor in this decline in hours.

The calendar for the rest of the week is heavily weighted to payroll reports but there is also a full slate of Fed speeches on Wednesday. Coming this soon after the FOMC meeting each will be trying to frame their view of Fed policy and "suggest" their timeline for the coming rate hikes.

Part of the weakness in the market today could have been worry over the coming payroll numbers.

Dow component Disney (DIS) reported earnings of $1.23 that easily beat estimates for $1.11. Revenue of $12.46 billion also beat estimates of $12.24 billion. The company said there was an increase in spending at its theme parks and higher ad sales in its media business. Theme park profits rose +24% to $566 million.

The stronger overall earnings were unexpected since the "Frozen" movie has now run its course. Disney studios saw a -10% decline in profits because they didn't have any blockbuster movies in Q1.

CEO Bob Iger said the expectations for the next Star Wars movie are off the scale. There has not been a Star Wars moving since 2005. There are 14 new Disney movies due out before December 2019. Disney shares rallied more than $2 at the open but faded to close fractionally negative in a weak market.

Herbalife (HLF) reported earnings of $1.29 compared to estimates for $1.11. The company raised guidance for the current quarter to a range of $1.05 to $1.15 and analysts had been expecting $1.06. Full year earnings are now projected by Herbalife to be $4.30 to $4.60, up from $4.10-$4.50. Bill Ackman will not be happy. Shares of HLF rallied $6 in afterhours trading.

SolarCity (SCTY) reported earnings of $1.52 compared to estimates for $1.60. However, revenue of $67.5 million beat estimates for $57.8 million. The company guided for a loss of $1.60-$1.70 for the current quarter. Shares declined $1 in afterhours.

Mylan (MYL) reported adjusted earnings of 70 cents that missed estimates by a penny. Revenue of $1.87 billion also fell short of estimates at $2.05 billion. The company blamed the miss on the strong dollar that lowered revenue by -$93 million. The company reiterated its target of $6 in earnings by 2018. Mylan offered $32.7 billion for Perrigo (PRGO) last month. Teva Pharma (TEVA) offered $40.1 billion for Mylan on the condition it dropped its bid for Perrigo. Mylan shares were unchanged after earnings.

Electronic Arts (EA) reported earnings of 39 cents that beat estimates of 25 cents. Revenue of $896 million also beat estimates of $838.8 million. The company raised guidance for revenue in the current quarter to $1.14 billion and analysts were expecting $752 million. EA guided to full year earnings of $2.75 and revenue of $4.4 billion. Shares rose +$2 in afterhours.

The earnings calendar for Wednesday is going to be focused on Tesla, Whole Foods Market, Trip Advisor and Green Mountain Coffee. The biggest event for the rest of the week will be Alibaba on Thursday. Expectations are dropping fast and there could be a big disappointment. However, with a 37% short interest any surprise is going to create a rocket ride higher.

Bank of America (BAC) upgraded NetFlix (NFLX) to a buy from underperform. The move shocked numerous analysts because BAC had been negative on the stock for so long. BAC said the fast growing portfolio of original content will extend the saturation point in the USA and fuel long term subscriber growth in the international market. The original content will also provide a barrier to entry and reduce other competitive threats. The bank said Netflix had a total addressable market today of about 330 million broadband connected households and that would rise to 480 million, excluding China, as the international roll out continues in the coming years. BAC raised the price target from $350 to $722. The stock closed at $565. That was a major change of heart by Bank of America. Netflix has said it is going to split its shares once shareholders approve the new shares at the June meeting.

Amazon and JetBlue (JBLU) announced free in-flight streaming of Amazon movies to Amazon Prime customers. The service will operate over JetBlue's free Wi-Fi and will be called Fly-Fi for Amazon Prime. Members will be able to stream any Amazon content including movies and streaming TV, plus they will be able to rent or buy other titles from Amazon's instant video store. Amazon shares were up early but ended down -$2 for the day.

Salesforce.com (CRM) spiked again as rumors spread that Microsoft (MSFT) was mulling a bid for the company. Shares spiked as much as 6.4% intraday and caused a volatility halt in trading. The report came from Bloomberg. Reportedly Microsoft began considering making a bid after news broke last month that someone else had approached Salesforce about an acquisition. That was widely thought to have been Oracle. Salesforce is now working with two investment banks to formulate a response to the two suitors. People reportedly having inside information on the matter said Microsoft was NOT in talks currently but "might" compete for the company if it was for sale. Shares declined to a +1.6% gain as the new faded.

Golar LNG (GLNG) shares soared +20% on news the company had commissioned the third floating LNG liquefaction vessel. Golar is a transporter of LNG with numerous transport vessels of various sizes. They have recently begun moving towards offering a floating liquefaction vessel that can be moored offshore near the wells and convert the natural gas into LNG for transport. This is less expensive than laying pipelines to shore and be forced to construct a $5-$8 billion facility to convert it to LNG. There are no permitting issues with an offshore LNG facility. They can be built in a couple years and be flexible to move to where there is the most need or the most profitability. They will also feed the transport division with gas that can be shipped to the most desirable location.

The Biotech Index ($BTK) corrected from a high of 4,144 to a low of 3,278 in only five days for a -10% drop last week. After rebounding about 2.5% on Friday the index opened significantly higher on Tuesday and then declined -3.8% from those highs to give up -2% for the day. This bio-wreck is killing the Nasdaq, which lost -77 points today alone.

There is no specific reason for the biotecks to implode except that they were the strongest sector in Q1 with a +25% gain from the end of December to the high on March 20th. It was time to take some profits and rotate those funds elsewhere. Since March 16th the energy sector was up +13% at today's highs. Apparently that is where they were putting the money. David Einhorn's presentation on Monday may have changed that idea.

David Einhorn took on the energy sector at the Ira Sohn conference on Monday. Specifically he attacked the frackers as a sector with never ending negative opportunities. He singled out Pioneer Natural Resources (PXD) as the MotherFracker of all frackers. Link to presentation slides in PDF Basically he contends that they raise tens of billions of dollars and pour every dollar back into drilling more holes. Along the way their "profits" have so many exclusions and footnotes that any sane investor would run for the hills.

The easiest point to understand from the entire presentation is the difference between reserves and proved reserves. In theory "reserves" mean all the oil that is thought to be underground and potentially recoverable. "Proved reserves" is the oil and gas under existing wells that is currently being produced. Sometimes this is also called developed reserves.

In theory the more money you spend drilling wells the faster your proved reserves should rise. If you drill 500 wells a year you should be able add all that newly found oil as reserves. The problem is that the shale wells you drilled 3 years ago have already produced 85% of the recoverable oil. The new reserves from 3 years ago are now depleted. A producer would hope that the total reserves would continue to grow, which means you are finding oil faster than you are producing oil.

Unfortunately in the case of Pioneer they spent roughly $16 billion in capex for drilling since 2006 and their proved reserves are less today than they were in 2006. Along the way they produced about 470 million barrels of oil but the money they got for that oil they put right back into the ground in the form of new wells.

Einhorn slide, page 34.

I have been writing about this for the last six years. Shale drilling is a treadmill that runs faster every day. Shale wells deplete about 75% in the first year and another 25% in the second and third years. A well coming online at 1,000 bpd is producing only 250 bpd at the end of the first year, 187 bpd at the end of the second year and 140 bpd at the end of the third year. The well may produce at a trickle for many years thereafter.

If a company drills 100 wells per quarter they have to keep drilling 100 wells per quarter in order to keep up with the depletion from the wells they drilled 4 quarters ago. They cannot rest. The instant they stop drilling their production will begin to decline and their reserves will shrink. They have to spend every dollar they can scrape together to keep the treadmill oiled and running at full speed. The problem is that the more wells they drilled over the last several years they more wells they have to drill this year to offset the decline in those older wells. There is no escape from this treadmill. This is why U.S. production is going to fall off a cliff later this year now that drilling has reached a six-year low.

In Q4 Baker Hughes said there were about 9,350 wells drilled. That probably dropped to about 5,000 in Q1 and probably to 4,000 in Q2 because of the drop in active rigs. Currently only about 30% of the wells being drilled are being completed. The rest are being put into inventory now called the "fraclog." That means they have been drilled but not fracked and completed. About 50% of the well's cost is in drilling the hole. The other 50% comes from fracking the well, installing the pumps and producing equipment and connecting it to a pipeline. Producers today are saving that second 50% and are waiting for oil prices to rise before they begin to complete the wells in their fraclog.

Einhorn has figured out what everyone else has known for the last six years. There is no future in shale production unless oil prices are well over $75 per barrel. However, Pioneer and EOG Resources both plan on adding additional rigs this summer if prices reach $65 and remain stable. Both have wells and leases in the Permian and that is the cheapest shale field to develop today. Einhorn also figured out that shale production will peak in 2017 although he did not realize it. His charts and graphs paint the picture of slowing production but he is looking at it from the viewpoint of an investor looking at a fracking company. What he did not factor into his short thesis is that the sharp drop in shale production over the next year is going to lift oil prices significantly because it all boils down to supply and demand. Demand is rising because fuel is cheaper. Currently it is rising 1.0 to 1.5 million barrels per year. Supply at $65 oil is going to decline about 1.0 to 1.5 mbpd in the USA. There is currently a global surplus of about 1.5 mbpd. Do the math.

Einhorn may be right in the long term about the frackers but they have several years to run and when they restart their drilling programs this time around they are going to be a lot more conservative. They now know there is no reason to race to produce all their oil at low prices. They can take their time and prices will rise and they can actually make a profit for a few years before they run out of drilling locations. Just my two cents.

Crude oil rose +$1.47 in the regular session and is up to $60.75 in the evening session. Also helping to push prices up was a report that protestors in Libya had shutdown a major pipeline forcing the closure of several oil fields and effectively closing the port of Zueitina. Pipeline and port closures have reduced Libyan exports to about 400,000 bpd, down from 800,000 bpd several months ago. Before the ousting of Qaddafi Libya produced about 1.6 million barrels per day.

AAA said the national average for gasoline has risen to $2.63 per gallon.


The S&P closed within 3 points of a historic high on Monday. Today's close was -28 points from a historic high. The S&P lost -1.2% compared to -0.8% on the Dow, -1.5% on the Nasdaq and -1.4% on the Russell 2000. The biotechs and chip stocks sunk the Nasdaq and the rising interest rates tanked the small caps.

The blowout in the trade deficit sent the yields on the ten-year treasury soaring by almost +2% for the day to close at 2.176%. The selloff in treasuries seems counterintuitive since bad economic news would push the Fed rate hikes farther out into the future. However, once an idea has taken hold as it did last Wednesday when the Fed said all meetings are now on the table for a rate hike, it is hard for investors to shift gears. They know rates are going to rise and they are fleeing treasuries.

There was also a meltdown overseas. The Shanghai markets fell -4% and the Hang Seng -1.3%. The European markets were down -2% or more. The bleeding overseas translated into a weak open in the U.S. and everything worsened from there.

The S&P retreated from overhead resistance at 2120 and plunged to initial support at 2090. Despite the 25 point drop the index remains inside its recent trend and nothing has really changed. A decline below 2075 would be required to change the trend.

Support is 2090, 2080, 2075 and resistance 2117, 2120.

The 18,100 resistance level on the Dow is still holding firm. The index was dragged down by Apple's -$3 loss or -22.50 Dow points. Goldman and Home Depot accounted for another -16 Dow points each.

The Dow was down -164 at the lows and closed down -142. Despite the big move it remains in its sideways trend and inside the 17,800-18,100 trading range. Today was just a volatility day and unless the Dow tacks on a couple more days in the same direction it was just noise.

The Nasdaq may have started a new pattern. On Thursday the index had a high of 5015 and closed at 4941. On Monday the high was 5043 but closed at 5016. Today the high was 5008 and closed at 4939. That is the lowest close since April 17th. The 5000 level has reasserted itself as strong resistance and the two big red candles with the spinning top between them is a sign of a topping pattern. The spinning top or doji on Monday was formed when the open at 5018 and close at 5016 were only 2 points apart on a day with a 30 point range. That means the buyers and sellers were closely matched and when followed by a big down day it suggests further weakness to follow. The lower close is another confirmation signal.

The small cap Russell 2000 is in full breakdown mode. The attempted rebound back over support at 1230 failed and light support at 1208 is the only thing between us and a drop to 1150. Conventional wisdom suggests the small caps are declining because higher interest rates will impact their ability to be profitable. I think that is a stretch when we are talking about a 2% rate on the ten-year but anything is possible. I believe they are falling because they are normally weak over the summer doldrums and investors are exiting to avoid the rush later.

The break below the 100-day average is a clear sell signal. If there is no material rebound on Wednesday we could be in for a change in the overall market direction.

The market is weak. There is no denying it. While the S&P may have come within rock throwing distance of a new high the Dow has been fighting overhead resistance at 18,100 since mid March. There is no conviction to the upside rallies and there is no conviction to the selling. We are trapped in a range until one side of the other can manage a breakout.

Today's decline could be seen as a failed rebound. However, the S&P futures are up +3.50 as I write this. The dip buyers are alive and well.

I would continue to be cautious in holding too many longs and I would keep my stop losses in place. Eventually the market is going to pick a direction and the pace could be very fast given the length of time we have spent trapped in the range. This is coiling the spring and when it releases it could be violent.

Enter passively, exit aggressively!

Jim Brown

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