The first week of earnings is over but there are three more just ahead. The Dow managed to post three consecutive weeks of gains for the first time since February but weak earnings could derail future rallies.

Market Statistics

The first week of earnings is behind us with 58 S&P companies now reported. Expectations going into last week were for earnings to decline -5.6% and revenue -1.3%. The actual results have changed the forecast. At the close on Friday, the S&P is now expected to see earnings decline -4.6% and revenue drop -3.2%. Clearly, the revenue side has changed significantly. That is due to the almost constant excuse that the strong dollar ate our sales. If this continues to play out it will be the third consecutive quarter of revenue declines and the first time since the financial crisis.

Honeywell (HON) is a prime example. They said revenue for their automation business rose +3% on a constant currency basis but declined -3% as a result of currency translation. Companies are growing revenue overall but the strong dollar is causing a decline in the accounting process. Even Netflix said the strong dollar reduced its revenue by -$96 million. Without that strong dollar impact, the company would have beaten on revenue. They posted $1.740 billion and analysts expected $1.759 billion. Without that impact revenue would have been $1.836 billion.

Despite a lot of high profile earnings misses the actual S&P earnings to date looks like this. With 58 companies reporting, about 71% beat on earnings, 10% met estimates and 19% missed earnings. Only 50% actually beat on revenue according to The average earnings beat has been +6.6%, which is above the one-year average of +4.4% and five-year average of +4.8%.

The majority of the improvement in the blended earnings results came from GE. Earnings of 32 cents beat analyst estimates for 26 cents. On a weighted basis that is huge. GE also posted revenue of $31.68 billion that easily beat expectations for $28.67 billion. GE is well into its restructuring process to sell $200 billion in financial assets and remove itself as a SIFI (systemically important financial institution) company and all the regulation that entails. GE has sold $126 billion in assets to date. GE is planning on returning $30 billion to investors in stock buybacks, dividends and share swaps for Synchrony (SYF) in 2015. GE still owns 85% of SYF and will be spinning those shares in a swap to shareholders. GE closed at a seven-year high.

Honeywell (HON) posted earnings of $1.60 compared to estimates for $1.55. Revenue of $9.61 billion missed estimates for $9.85 billion because of the strong dollar problem and dramatically declining sales to the oil and gas sector. Shares fell slightly on the news.

There were several economic reports on Friday and the best one was Consumer Sentiment. The headline number rose from 87.2 to 92.1 for October. This was significantly better than expected at 88.7 and the September reading at 87.2. The present conditions component rose from 101.2 to 106.7 and the expectations component rose from 78.2 to 82.7. A rising stock market and falling gasoline prices were credited with the improvement.

Industrial Production for September rose slightly from the -0.4% reading in August to -0.2%. That is hardly a reason to cheer but it was an improvement.

The Job Openings report for August declined from a +3.9% rate to +3.6% but this is old news since we already saw the decline in the August and September payroll reports.

The worst report for the day was the ECRI Weekly Leading Index. I do not discuss this report much because it is a long-term indicator that uses other reports for input. However, the ECRI WLI declined sharply from 132.5 to 128.7 for the week ended October 9th. This was a two-year low and suggests the number of negative economic events are starting to turn into a wave. The economic rebound in early 2015 has been erased and the trend is definitely negative.

This is important. Sometimes the individual economic reports are glossed over or analysts make excuses for individual events. The WLI summarizes all those events and this should make investors cautious about the future.

The Atlanta Fed real time GDP Now forecast is predicting GDP growth of only +0.9% for Q3 compared to the analyst average of +3.2% back in July. That analyst average has now declined to just over +2.0% and dropping fast.

In retrospect, the Fed did the right thing by not hiking rates in September and they are not likely to hike at the October meeting in two weeks. There is only a 17% chance they will hike according to the Fed Funds Futures.

The graphic below shows a summary of the important economic reports for last week. Those in yellow were either lower than last month or less than analyst consensus. Those in green were higher than expected.

On the positive front the weekly jobless claims at 255,000 was a 40-year low and completely unexpected.

Obviously, the weak results greatly overpowered the positive results and this is what we have been seeing for quite a while. It is not an environment where the Fed should be looking to raise rates. In my opinion, we should be more concerned about rising recession risks than hiking rates.

Three of the reports for next week are housing related and they are still expected to show a sector that is growing modestly. The Chicago and Kansas manufacturing surveys on Thursday are likely to show further weakness. Both areas are already in contraction.

The big reports for the week could be from China on Sunday. Because of their recent holiday week, they will announce GDP, Industrial Production and Retail Sales all at the same time on Sunday night. This could definitely set the tone for the markets on Monday.

The Yellen speech on Tuesday is not expected to be a market mover although all of her recent speeches have tended to cause a market bounce.

Watch for another decline on the Weekly Leading Indicators on Friday. Now that the index is at two-year lows, it will receive a lot more attention from investors.

The only split announced last week was actually a spinoff and I did not add it to the calendar. NorthStar Realty Finance (NRF) is going to spin off NorthStar Realty Europe (NRE) on the 31st. Existing shareholders of NRF will receive one share of NRE for every 6 shares of NRF they own. Immediately following the distribution NRF will do a reverse split of 1:2 and reduce the number of shares outstanding from 382 million to 191 million. The implication here is that the removal of the NRE assets from NRF will reduce the share value to single digit levels and the board is planning ahead to keep the share price higher. Since this is not a normal split I did not include it on the calendar.

Skechers (SKX) split 3:1 after the close on Thursday.

Full Stock Split Calendar

Twitter (TWTR) spiked another +5% after former Microsoft CEO, Steve Ballmer, tweeted that he had acquired a 4% stake over the last several months. He praised Jack Dorsey for his efforts to make the company leaner and more focused. On Tuesday, Twitter said it was laying off 336 workers to streamline operations. On Wednesday, Twitter appointed Omid Kordestani, former Google chief business officer, as the executive chairman of Twitter.

Ballmer is now Twitter's third largest shareholder surpassing Jack Dorsey at 3.2%. Saudi billionaire Prince Alwaleed Bin Talal recently increased his position to 5%. Billionaire co-founder Evan Williams is the largest shareholder at 6.9%.

Nike (NKE) surged to a new high two days after raising future revenue targets. The company posted $30.6 billion in revenues in fiscal 2015 and expects to reach $50 billion by 2020. Nike expects sales to China, the emerging markets, central and eastern Europe to grow by low double digits annually through 2020. The company said it expects its ecommerce division to grow from the $1.2 billion in 2015 to $7 billion by 2020. Earnings per share are expected to grow in the mid-teens annually.

Youku Tudou (YOKU) shares rallied +22% after Alibaba (BABA) made an offer to buy them. Youku is the YouTube of China. Alibaba offered $3.6 billion for the 81.5% of Youku that it does not already own. This values YOKU at roughly $26.60 per share or roughly a 30% premium over Thursday's closing price of $20.42. The key shareholders of YOKU already agreed to tender their shares into the deal. That means Alibaba already has 59.3% of the voting rights with Jack Ma already having an 18.5% stake in YOKU. Alibaba will fund the acquisition with cash on hand.

Yum Brands (YUM) shares rebounded +4% after the company said activist investor Keith Meister had been given a seat on the board. Why is this important? Meister has been pressuring Yum to spin off the Asian assets that have been giving them so much trouble. Yum said they were still reviewing the potential spinoff but with Meister added to the board, I would think the odds of a split are very strong. Other investors must have felt the same way and shares rose sharply.

China represents 57.5% of Yum's revenue and 54.2% of the company's profit. Splitting the Asian assets from the U.S. assets would allow each group to manage the businesses differently with a local perspective. KFC, Pizza Hut and Taco Bell are solid businesses in the U.S. and would benefit from a locally focused management. The fast growing KFC and Pizza Hut business in China could be managed better from a Chinese run entity. YUM currently has a 2.66% dividend and a spinoff would generate another profit opportunity along with the potential for a special dividend the parent company receives from Yum China. I think YUM is a buy here with a short fuse into a spinoff announcement.

Wynn Resorts (WYNN) has been crushed by the decline in gaming at the Macau casinos. In their earnings call, Steve Wynn blasted Chinese regulators for irrational gambling rules. The $4 billion Wynn Macau is scheduled to open in early 2016 and they still do not know how many gambling tables regulators are going to allow. This makes it difficult to hire and train employees ahead of the open. China is cutting down on corruption and that means high rollers have been staying away from Macau in order to avoid showing up on a list of visitors that could trigger investigations into their finances.

Regulators have come up with a "table cap" and "employee quota." Half of the VIP market is gone and the Junket operators have gone out of business. The outlook for Wynn is grim. Credit Suisse cut their price target on WYNN by -28% to $76. Shares dipped from $75 on the earnings miss. I would look to short WYNN on the next trade under $70.

McDonalds (MCD) closed at a new high as rumors circulate about a McReit. A board member told the Wall Street Journal that McDonalds has done a lot of due diligence but has not yet made a decision. MGM (MGM) and Macy's (M) are reportedly considering a REIT structure as well.

However, all is not well at McDonalds despite the new highs. According to an article in Business Insider, the McDonald's franchisees believe the brand is in a "deep depression" and could be facing its "final days" according to a recent survey. One franchisee wrote in the Nomura survey that "We are in the throes of a deep depression and nothing is changing. Probably 20% of the operators are insolvent." Another said, "The CEO is sowing the seeds of our demise. We are a quick-serve fast-food restaurant and not a fast casual like Five Guys or Chipotle. The chain may be facing its final days." Management's reaction to the negative comments is for operators to "get out of the system" and quit the business. Several franchisees complained about the all day breakfast saying it has complicated kitchen operations and goes against management promises to simplify the menu.

Another wrote, "The system is very lost at the moment. Our menu boards are still bloated and we are trying to be too many things to too many people. Things are broken from a franchise perspective."

Nomura interviewed franchisees that owned 226 restaurants. McDonalds has more than 14,000 stores and has experienced seven consecutive quarters of declining same store sales.

Crude oil prices declined -$2 for the week but remain stubbornly near $50. There is no fundamental reason for the prices to be moving higher. This is mostly due to the tensions with Russia, Syria, Israel and the Middle East oil producers. With Russia siding with Iran there are worries a conflict with archenemy Saudi Arabia could eventually appear. Bomber videos of an Iraqi oil refinery being bombed on Friday did not help. The refinery was controlled by ISIS but the headline "refinery bombed" was all investors heard.

Oil inventories in the U.S. rose +7.8 million barrels to 468.6 million last week. That is only 22 million barrels below the 40-year high that was set last year at 490.9 million. Between the end of September 2014 and the beginning of the spring demand season on April 24th we added +134 million barrels to inventory. Since that April high inventories have only declined by -45 million barrels. That means we used ONLY ONE THIRD of the inventory buildup from 2014 and there are seven months of inventory builds ahead of us. There is no scenario where we do not exceed the record high at 490.9 million and exceed it by a lot. That buildup caused prices to decline from $92 at the end of September to $42 in March. Why would this year be different except that we are starting from a much higher inventory level and a much lower price level?

Goldman Sachs did say last week that their worst case forecast for oil in the $20s now had a less than 50% chance of coming true. Their rationale was that U.S. production was declining and producers were in crash mode and halting any drilling expenses.

Production declined to 9.096 million barrels per day (mbpd) and a six-month low. That is -514,000 bpd off the peak reached in April. Analysts are calling for production to decline under 9.0 mbpd by the end of December. That seems to be a sure bet but we still added 7.8 million barrels to inventory last week. We would have to see production decline below 8.0 mbpd to really slow the inventory build.

Energy equities are still in rally mode as well. With earnings ahead and the forced restatement of reserves because of the price drop there are going to be some ugly surprises for investors in the earnings reports. I would rather wait for a post earnings decline before adding a bunch of energy stocks to my portfolio.

The Baker Hughes active rig count declined -8 rigs to 787. Oil rigs declined -10 to 595 and gas rigs rose +3 to 192. Offshore rigs rose +1 to 33. To put this in perspective in 1981 there were roughly 4,500 active rigs in the U.S. and that declined to less than 500 in 1999 after Saudi Arabia pushed oil prices to less than $10 in 1998. While oil prices are not going to $10 again the active rig count for oil wells could easily decline back to 500.

With rigs counts in free fall we are going to see some dramatic declines in production in the months ahead. Without the strong flows from new wells the rapid decline rates from existing shale wells is going to be dramatic. The CEO of Core Labs said it could be as much as 10% per month.


The major indexes closed above recent resistance and appear to be poised to move higher. Investors, or maybe I should say portfolio managers, shrugged off negative economics and crummy earnings and every dip was bought. I have stated over the last couple weeks that fund managers are fully engaged in window dressing for their fiscal year end on October 31st. This is their last chance to grab some performance and put some well-known names into their portfolios before time runs out.

The S&P moved comfortably over resistance at 2,020 and the Dow extended its gains to close at 17,251. The Nasdaq pulled ever closer to 5,000 with a close at 4,886. However, the Dow Transports, Russell 2000 small caps and the biotech index were still weighing on the market.

Monday will be a critical day for market direction with the three major economic reports from China. If the reports are less than dire then the U.S markets have a good chance to extend their gains.

The S&P has resistance at 2,040 and then enters into a solid congestion range from 2050-2130. We spent six months in that range from February through early August and I seriously doubt we are just going to punch through it to a new high without a struggle.

Support is now 2,020 and 1,990, which were both resistance on the way up.

The Dow got some help on Friday from a broad range of companies. Caterpillar and Apple were the only major losers. Nike and McDonalds led the charge with JNJ and GE getting a positive bounce from their earnings reports.

Dow components reporting next week include IBM, UTX, AXP, BA, CAT, MCD, MMM, KO, VZ and MSFT. The risk for Monday is IBM. They have had a tough time over the last several years with international revenue trending lower. China has recommended companies not use their systems on fears of hooks in the hardware to allow the NSA to spy on China. I would be very surprised if IBM was up after earnings.

The Dow edged over resistance at 17,130 to close at 17,215. Starting at 17,500 the Dow has the same wide band of congestion as the S&P up to 18,165. This could be a struggle. Support is now 16,700.

The Nasdaq was helped by Amazon, Priceline and a cluster of biotech stocks to gain a minimal 16 points on Friday. The Nasdaq still has some near term resistance at 4888-4900 before dealing with psychological resistance at 5,000 and the beginning of congestion from 5000-5175. Assuming the biotech sector does not implode again I think the Nasdaq will retest that 5,000 level and above. Apple does not report until the following Tuesday so it should not be a negative influence this week. Netflix is due to rebound next week and the big caps of Amazon, Google/Alphabet and Microsoft do not report until Thursday.

The 4,775 level is now support and it would take a severe direction change to test that level again.

The Dow Transports slammed into resistance at 8,260 again and it was a dead stop. Despite weak oil prices, they cannot seem to mount a credible rally and with the U.S. economics weakening, we could see a decline back below 8,000.

The Russell 2000 small caps also came to a dead stop at resistance at 1,165. However, at least they appear to be trying to chip away at that level. Small caps are normally favored in Q4 but the weak economics may be causing fund managers to go to big caps instead for their window dressing. If the market rally does fail, they would be able to exit quicker and with smaller losses.

This week I would watch the Russell for market direction. If it cannot move convincingly over that 1,165 level then sentiment will remain weak and the big cap rally could fail. However, window dressing into month end could support the market somewhat but look for trouble in early November.

Any tax loss selling should be over and managers should be concentrated on putting extra cash to work rather than saving it for the next dip.

We are well over that solid resistance at 2,020 and that was a critical level. Watch the Russell 2000 for market sentiment and buy the dips until proven wrong.

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Random Thoughts

Bearish sentiment sank to a three-month low at 27.1% but strangely, bullish sentiment declined -3.4% to 34.1% after three weeks of gains. Neutral sentiment is rising again so it appears investors are skeptical of this rally continuing.

Hedge funds are disappearing almost weekly. Fortress Investment Group (FIG) said it was closing its flagship hedge fund following heavy losses and investor withdrawals. The fund had more than $8 billion in assets in 2007 but they declined to $3.2 billion by the start of 2015 and only $1.6 billion last week. The fund bet on macroeconomic trends and lost more than 17% through September.

Bain Capital said it was closing its multibillion dollar Absolute Return Capital fund that also bet on macroeconomic trends after three consecutive years of losses. The fund was down -14% though August.

In 2014, the hedge fund attrition rate was an unprecedented 26%. A survey found that 30% of new funds do not make it past 36 months. Almost half never reach their fifth anniversary and only about 40% survive for 7 years or longer. Hedge Funds Disappearing

I wrote in my Tuesday commentary about the potential for a black swan event because of the rapid buildup of out of the money puts on the S&P. On Thursday somebody bought 70,000 out of the money puts on the Russian ETF (RSX) and almost immediately another 30,000 put contracts appeared at various other OTM strikes for November.

This could be somebody protecting a position in Russian stocks or somebody speculating that a Russian plane will take a shot at a U.S. plane in Syria. We never know why these big positions appear but it is not likely because somebody knows something we do not. They just fear something that might happen.

On Friday, NATO forces shot down a Russian Orian-10 surveillance drone flying over Turkey. In typical Russian fashion, the Russian military replied "what drone." "All of the airplanes in the Russian aviation group have returned to their bases." The more important fact is that NATO forces actually shot it down. That suggests a greater threat of a bigger event in the future.

Iran tested a ballistic missile on October 10th that was "inherently capable of delivering a nuclear weapon" and therefore in direct violation of a UN Security Council resolution. There are resolutions banning Iran from "any activity related to ballistic missiles capable of delivering nuclear weapons, including launches using ballistic missile technology." The U.S. is preparing a position paper to submit to the Security Council on the event.

The real question here is about Iran's clear violations of EVERY UN resolution ever levied regarding its nuclear activities. If Iran will launch an "in your face" missile test that is clearly a violation, why would we expect them to honor the recent nuclear agreement? The answer is that they will not honor the agreement and to believe otherwise is complete stupidity. They are testing the waters to see what they can get away with ahead of the implementation of the new agreement. Iranian Missile Test

What is the big deal about China? Why is every analyst projecting gloom and doom over the decline in China's economy? The decline in China has created a flood of money out of emerging markets. Something close to $500 billion will leave China and the other markets in 2015. Here is a great article on what is happening to China's economy and why we should worry. 30 Years of Chinese History

Leon Cooperman is bullish. On Bloomberg, he gave five reasons why he expects the market to continue higher.

1. This would be the first time the market has peaked before a Fed tightening since 1950.

2. Bear markets are usually caused by recession, overvaluation, hostile Fed or geopolitical event. The risks for all of those are overblown.

3. Individual investors are not bullish enough. There is not enough euphoria.

4. We just had a correction with the "average" common stock down -20% over the last 52-weeks.

5. There are no good alternative investment options relative to stocks.

Bank repossessions spiked 66% in Q3. Apparently, the financial crisis is not yet over. That is the largest spike ever recorded by RealtyTrac. Couple that with rising requirements to get a conventional loan and the housing sector could be headed for a decline. Bank Repos up 66%

Reuters built a computer model to predict the outcome of the presidential election. The answer, a republican will win. Taking in all the historical factors it is three times harder for a candidate to win if they are in the same party as an exiting two-term president. The computer did not pick a specific candidate. Next Presidential Winner

With inflation falling to the lowest rate since 2009 the Fed is not likely to hike rates. If we get another month of economic declines there is a far better chance that they will be forced to take further stimulative action in the months ahead. The current economic cycle is 77 months old and the median economic cycle is 50 months. We are actually closer to a normal recession than we are to some surge in growth that gives the Fed a reason to hike. Inflation at 2009 Lows


Enter passively and exit aggressively!

Jim Brown

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