When the markets want to go down they will always find an excuse. Last week there were plenty excuses to choose from.
There are some ugly numbers in those statistics above. The Nasdaq has entered correction territory with a 10.3% decline since the April 23rd close at 2529. The Dow is down -7.4% for a total of 830 points from the April closing high. The damage for the week was bad and it came on top of a significant decline in the prior week. Volume has been extreme with Thursday trading almost 19 billion shares and Friday was 17.5 billion. The bears have forsaken the elevator down in favor of a bungee plunge.
The Dow's spike into positive territory from the jobs report had a hang time that could have been measured in milliseconds. Almost immediately the Dow rolled over to sink -279 points to 10,241 before any buyers appeared. This was probably forced margin selling by those who saw their positions implode on Thursday. When the opening spike did not hold there was no option but to sell and raise cash. Dip buyers appeared at 10,240 and they managed to push the Dow back into positive territory but that brief green candle was immediately sold again. The bullish payroll report was unable to support the market.
The Jobs report showed the economy added 290,000 jobs in April. The consensus estimates were for a gain of 200,000 jobs compared to the 162,000 jobs added in March. April was the best month for jobs since November 2005 when there was a gain of 354,000 jobs.
Also positive was a revision for March from +162,000 to +230,000 and a revision for February from -14,000 to +39,000 jobs. I know you are waiting for the census shoe to drop. Actually the census only added 66,000 jobs and much less than expected. Government hiring actually declined and the private sector added 231,000 jobs. This is very bullish.
Manufacturing has been a drag on employment for several years and that sector added an astounding 44,000 jobs in April. Construction added 14,000, business/professional +54,000 and leisure/hospitality +45,000 jobs. The percentage of industries adding jobs jumped from 48.9% in November to 64.3% in April and the highest since March 2006.
The unemployment rate rose +0.2% to 9.9% but that comes from an increase in the labor force participation rate. More people were looking for jobs. Many of those who had given up on looking for a job have started looking again.
The separate Household Employment report showed a gain of 550,000 jobs for April and the most in almost three years.
This was a very strong report. After including the revisions and the household survey the economy added 962,000 jobs and only 66,000 of those were census workers. This should have been a very strong boost to the markets but the market was focused elsewhere.
The markets were a prisoner of the events in Europe. The civil breakdown in Greece was setting the stage for a potential economic breakdown in the rest of Europe. Various countries and organizations still have to approve the potential $140 billion bailout of Greece. They watched as the riots grew in intensity in protest of the required austerity programs. Greek airports, trains, schools and many businesses were shutdown.
Countries and institutions that were due to vote on the Greek bailout were expressing concerns that Greece would not be able to enforce the austerity programs. Did they really want to be part of a $140 billion loan package if Greece was simply going to take the money and then default on the austerity deal?
The market hates uncertainty and the three-ring circus that is the Eurozone last week is uncertainty squared. Analysts are claiming the breakdown in Greece could lead to a contagion that spreads across the zone and lead to future chapters with a different country failure in each chapter.
Analysts were comparing Greece to Lehman and how everyone thought Lehman would be ok until suddenly it was gone. Within days Merrill Lynch was also gone and there were rumors of others ready to fail.
The problem in the EU has been explained many times in these pages so I am not going to repeat that detail. The worry is simply that Greece is going to default and restructure its debt and possibly exit the Eurozone. Once an EU country defaults and/or exits the union then other countries like Ireland, Italy, Portugal and Spain would also find themselves without funding on fears they would follow Greece back to a country currency.
The EU was supposed to be this collection of strong countries with rigid financial guidelines and they had the implied guarantee of being part of the bigger financial unit. Greece has proven the model is not working and analysts are worried there will be a Lehman like disaster any day now.
Until the EU and the IMF actually provide cash to Greece this day-to-day news driven market is going to continue to worsen. Greece has an $11 billion payment due on the 19th and various EU officials have promised Greece will have cash before that date and Greece will not default. Those promises are falling on deaf ears since there are so many pieces to the approval puzzle that have not fallen into place. We have had a dozen or more agreements in the last 90 days and all have either failed or changed materially. Greece was found to have been lying about their debts and habitually understating their cash requirements.
Last weekend we were told that Germany would approve the deal on Thr/Fri of this week. The EU would hold another financial summit this weekend to approve the final deal and work out the funding details. The IMF was supposed to give its final approval this weekend. All the details were to be released on Sunday in order to calm the global markets on Monday.
As of this weekend French President Nicolas Sarkozy and German Chancellor Angela Merkel said early Saturday that Europe would setup an intervention mechanism before Monday to calm the markets. The pair also said the EU leaders would have a plan in place before Monday to defend the Euro against speculation. They pledged to stave off attacks on the financial systems of weaker nations including Spain and Portugal. "The euro is an essential element of Europe. We cannot leave it to the speculators." The EU finance ministers are scheduled to hold an emergency meeting on Sunday to work out the details of the anti-speculator plan. Merkel said, "We will make use of the EU mechanism to protect ourselves against speculation."
Sarkozy warned that the crisis had gone beyond Greece and was now focused on the very roots of the euro currency. President Obama and Canadian Finance Minister Jim Flaherty urged the EU on Friday to resolve this quickly to avoid further global contamination. I believe the crisis has gotten to the point where the EU countries have to quit bickering and get something done or the collapse of the euro is going to cause them more pain than having to give money to Greece that they may never get back.
If further squabbling prevents a concrete solution before the markets open on Monday we are probably going to see another triple digit decline. If the finance ministers can present a concrete plan by Sunday night then the global markets should rally on Monday. Until the problem is resolved we are going to remain a prisoner of Europe.
Most readers are probably wondering why Greece is so important. It is because Greece is the canary in the EU coal mine. Of the five weakest EU countries Greece is the smallest by a wide margin. Whatever happens to Greece could easily happen to the other five only there is no possibility of a bailout except for the possibility of Portugal. The others are simply too large. Greece has roughly $236 billion in debt. The other four countries, Italy, Ireland, Spain and Portugal have $2.6 TRILLION in debt. Spain has $1.1 trillion in debt, 20% unemployment and one of the weakest economies in Europe. Greece is the first and probably the smallest of the EU debt problems. It has taken three months to get the other EU countries to agree to invest a few billion each to bail out Greece to protect the euro. It would be impossible to get them to spend $100 billion each to bailout Spain. Check out this graphic: LINK
The euro sank to 124.88 on Thursday and a level not seen since January 2009. This is strong support but only if the EU acts quickly. The 125 level has been support but another failure to act this weekend could cause that support to be broken under a global speculative onslaught.
The +6.2% spike in the dollar over the last four weeks is a direct result of the crisis in the euro and our recovering economy. It was probably the reason for the -998 point crash in the Dow on Thursday. It has crushed commodities with crude prices falling -13% in a single week and copper prices losing 15%. For stocks with a substantial amount of their business coming from overseas the spike in the dollar is going to seriously impact earnings in Q2. Intel receives 70% of its revenue from overseas.
Dollar Index Chart
While nobody knows exactly why the market imploded on Thursday there is a very good chance it was a capitulation event by somebody that was deeply underwater in the currency carry trade. Hedge funds around the world had been shorting the dollar when it plateaued around 80 on the dollar index and using the cash to buy commodities and equities. When the big spike came last week these funds were in serious trouble. Currencies don't move in 5% increments per week but the dollar did last week. These funds construct highly leveraged trades and then they go bad they go really bad. The Yen carry trade also unraveled last week.
My guess, and it is just a guess since nobody really knows for sure except for the trader who pulled the trigger, is that a fund or funds were really upside down in a currency trade of some sort. They finally reached the point where they were forced by their clearing broker to liquidate. Since the market was already in a downward spiral the addition of a major sell program was more than the system could bear.
They could have been leveraged to S&P futures, crude futures or any combination of dollar denominated instruments. With those going south at a high rate of speed their problems were growing worse by the hour. Eventually their leverage capability was exceeded and the computers hit the sell button.
The CME said there were $16 billion in E-mini futures traded in a 20 min period. This was four times their previous record volume. When futures contracts are sold there is a computer somewhere that is tracking those contracts and selling the equivalent S&P stocks. That is an incredible simplified explanation but you get the picture. The same is true with ETFs.
The SPY ETF is the most heavily traded ETF on any exchange. The SPY traded 637 million shares on Thursday and most of that was down volume with 60 million shares sold in a 15 min period. That means the fund manager was deluged with ETF shares coming back home to roost and he had to redeem those shares and sell the corresponding shares of the S&P-500.
The SPY is only ONE of more than 1,000 ETFs. Some analysts claim that more than 40% of all trading volume is ETF related. ETFs have become the trading vehicles of choice because they are highly liquid and regardless of what you want to trade there is probably more than one ETF that fits the scenario.
The NYSE and Nasdaq put out a list of 296 stocks where the trades were canceled on Thursday's drop. 69% of those stocks were ETFs. The NYSE list of 173 tickers had 111 ETFs. The bids for those ETFs disappeared during the drop and were responsible for shares being traded for as little as a penny. Market makers were so deluged with sell orders they could not supply quotes. When you consider all the things going on behind the scenes it is not surprising.
The largest ETFs with canceled trades were the Vanguard Total Stock Market Index (VTI), iShares Russell 1000 (IWB), iShares Russell 3000 (IWV), iShares S&P-500 Growth (IVW) and iShares S&P-500 Value fund (IVE).
The vast majority of the selling on Thursday was related to equity futures and index ETFs. As sell volume on those products increased by several hundred percent the associated computer related selling of the baskets of stocks related to the ETFs also exploded.
The NYSE said the sudden crash tripped the Liquidity Refreshment Point or LRP on many of the stocks traded on the exchange. The LRP works like a time out switch when it slows trading but it does not stop trading. When a stock price suddenly drops the LRP kicks in to short circuit the electronic trading and revert to a manual auction process where trades are matched to orders rather than continue electronically at the bid. The process is designed to prevent unreasonable price swings. Trades can take more than a minute rather than the milliseconds electronic trades require.
The LRP prevented Proctor & Gamble (PG) from trading below $56 on the NYSE but it traded as low as $40 on other exchanges. The LRP is triggered on a few stocks every day as news events cause price fluctuations. The NYSE prides itself on the "human factor" that limits errors like we saw on Thursday.
Unfortunately the Nasdaq blamed the NYSE for the problem. For stocks that are listed on the NYSE that is the primary exchange where the vast majority of shares are traded. Some trades are routed to the other exchanges when there is a better price. The NMS rules put in place a couple years ago requires trades to be routed to the lowest price regardless of what exchange is showing the price. There are some qualifications but that is the general idea.
For a NYSE listed stock like PG that trades nine million shares a day the vast majority of those shares would be routed through the NYSE. That is especially true of the large institutional orders. They could also trade on the Nasdaq but prices can be slightly higher than the NYSE because of the much lower volume.
When a large number of NYSE stock tripped the LRP at the same time in response to the computer generated futures and ETF sell orders the LRP stopped the trades to allow a human to respond to the price imbalances. When the orders were halted and sales were not being executed in the normal electronic time the computers instantly looked for another bid. The bids it found were on the thinly traded "alternate" exchanges.
Hypothetically if the NYSE handled nine million shares of PG every day then the NYSE market depth of the open bids hoping to get a better price could total a couple million shares. On the alternate exchanges that may handle less than a million shares of PG per day the order depth could have been only in the tens to hundreds of thousands.
When the program selling began there may have been millions of shares of PG suddenly looking for a bid. PG actually traded 28.5 million shares on Thursday, three times normal. The computers found bids on the Nasdaq and instantly routed those sell orders for millions of shares to the Nasdaq and other exchanges. If the market depth on the Nasdaq was only 500,000 shares then the next order found no bid. The order routing system instantly tested all the other exchanges and found that all their bids had disappeared as well. All of this happened in milliseconds while the NYSE specialist was still waking up the fact that his board was suddenly filled with sell orders for millions of shares and the LRP process was asking him what to do.
Because the market depth away from the NYSE was so small and instantly absorbed by the order routing system there were several stocks that actually returned a no-bid condition while others actually sold for as little as a penny because somebody had a dormant order lingering in the system.
It is a common practice for many traders to park orders for a stock they want with a ridiculous price just in case somebody enters a crazy price. Many times I have seen fills well away from the market price simply because the bid was left open. When markets are really volatile this happens a lot with options. If your sell stop is hit during a crash the market order that is triggered can be filled several dollars away from the listed price.
To summarize, I suspect the market crash was triggered by a fund liquidation because of an extremely overleveraged position with a dollar denominated component. With fund leverage as much as 20:1 a rogue position can be unwound by the clearing broker with serious consequences. Since the main trade for last couple months has been long oil and commodities, highly leveraged trades, the explosion of the dollar and implosion of commodities could have been a toxic mix.
The sell program is triggered in an already seriously bearish market and stop losses begin to be hit by the millions. Since all the volume is on the sell side the bids dry up, the prices dip sharply and the LRP halts trading for 90 seconds or longer. That is an eon of time when computers are making ten thousand trades a second. The system short circuits when the NYSE trades fail and these billions of shares for sale are suddenly dumped off to the alternate exchanges with no fail-safe for excessive volume. Prices go to zero with no bid and the computers calculating the value of ETFs based on the value of the S&P or Russell 1000 are suddenly launching sell programs of their own in an effort to adjust to market prices.
It is a wonder the system did not crash completely. Many people have reported they tried to sell stocks when they saw the crash beginning and they could not get a bid. They were probably lucky when you consider that bid could have been pennies on the dollar.
Fortunately the greed factor quickly rectified the problem. Within minutes of the crash trading floors were literally filled with traders screaming, "buy anything." When prices are suddenly being quoted 20-25% off the price five minutes earlier that is a major incentive to buy something. Over 18.8 billion shares were traded and the highest volume day ever.
We may never know what started the dominoes falling on Thursday but once the cascade began it was astounding to watch. I can't tell you how many people initially though a nuclear bomb had gone off. I heard that several times. For the Dow to drop 998 points, 700 in less than five minutes, it had to be a terrorist attack with a nuclear component. Not even another 9/11 style attack would have had the same immediate impact.
To say that bullish sentiment was damaged would be an understatement. It was the proverbial perfect storm. A market already trending sharply lower on geopolitical events most traders don't understand was hit by a complex convergence of seemingly unrelated computer programs, which I guarantee 99% of traders don't understand.
The system broke in a way nobody expected and it may have broken the back of the bulls.
Once sentiment is broken it may be very difficult to recover. Equity funds are up strongly from the March 2009 lows. People were feeling a little more confident about their finances and suddenly the system let them down. The Greece problem had already blunted the market advance and now Dow is down -800 points in little more than a week. The sell in May strategy is suddenly looking a lot better.
For those in taxable accounts the capital gains tax is going up at year-end as well as higher income taxes for 2011. This may be the perfect time to take those gains and move to the safety of tax-free bonds. What happens if Greece really does default? What happens if China's slowing growth suddenly turns into a bursting bubble as many have predicted? Is the U.S. really going to avoid the double dip recession? There are dozens of questions plaguing investors and few answers.
We know that Q2 earnings are going to be weaker than Q1 but still decent. The suddenly stronger dollar is going to apply additional pressure to those Q2 earnings. Unfortunately Q3 and Q4 are going to be even weaker because of tougher comparisons from last year. The market tends to discount six months in advance and that means it is looking at Q3 earnings today.
I don't want to be the voice of gloom and doom but I think once in a while we need to look farther ahead than next week. Personally I think the economy is going to continue growing at roughly a 3% clip. I think the addition of more than 900,000 jobs in April is far more than we could have hoped and very bullish. The Fed is still on hold today but with jobs numbers like that they may not be on hold much longer.
If the Greek problem is resolved this weekend I think the markets will rebound but I doubt they will begin a new bullish trend. It will be like the quarterback that gets sandwiched between two tacklers and carried off the field on a stretcher. He may be walking under his own power at Monday's practice but he is probably not going to be strapping on pads for several more days. Investors were blindsided on Thursday and the weekend papers are going to be full of negativity. It is not an atmosphere conducive to adding to positions on Monday.
A market looking for a reason to go down will always find one. Once that profit taking process has begun it almost always ends up overdone. We have already seen the momentum stocks get crushed over the last two weeks. PCLN, GOOG, AAPL, FLS, WLT, FSLR, BIDU, etc. Did the fundamentals change for those stocks? No, market sentiment changed.
The Nasdaq has already moved into correction territory with a -10.3% decline. The Russell fell -12%, the Dow is close at -7.5% and the S&P at -8.8%. Volume is off the scale and severely imbalanced. In theory this is capitulation volume but without the corresponding trend. Eight days of declines is painful but not really a trend. I suspect there is more pain ahead.
For next week the economic calendar is fairly bland until Friday. The biggest event for next week is the Cisco earnings on Wednesday. That could help rekindle interest in tech stocks.
There are several business metrics on Friday including production, orders and inventories. I don't believe Friday will be material for market direction. Whatever is going to happen will be over long before Friday.
Nobody was really paying attention to stock news last week but news on Friday that Nokia was suing Apple for patent infringement on the iPhone and iPad was good for a headline. An initial suit by Nokia was updated to include the iPad. Nokia claims the devices infringe five Nokia patents related to the technology that allows the devices to be more compact.
Apple has already responded with its own suit against Nokia claiming Nokia's products infringe on 13 Apple patents. Apple claims Nokia chose to copy the iPhone in order to recapture some high-end market share. Apple has also sued the HTC Corporation, a leading producer of the cell phones that run on Google's Android software.
This will probably turn into a case where the company with the highest priced lawyers will prevail but not until several years have passed and the technology is no longer relevant. Apple shares lost $10 on the news but it is hard to say is was the news or just the weak market.
Friday was not a good day for BP. The hastily constructed 74-ton containment structure is now resting on the ocean floor in the gulf beside the leaking well. The box is designed to sink 15 feet into the ocean floor in order to provide additional stability when the floating rig a mile above attempts to attach the two pipes that extend to the surface. The box was lowered into position on Friday and BP said as soon as it was in place over the leak the frozen gas hydrates immediately clogged the pipe out of the top of the box. The hydrates formed so quickly and so aggressively that they were starting to add buoyancy to the 74-ton box. BP had to quickly remove the box from over the leak and move it off to the side while they figure out what to do next.
When methane gas is released from the well it quickly freezes into ice crystals at the extreme pressure and cold under a mile of water. The original plan was to pump warm water and antifreeze into the box to keep the gas and oil in a liquid state for its trip to the surface. They said the ice crystals formed so quickly that the pipe out of the box was immediately clogged and the box began filling up with ice. BP said they have not given up on the project but said it could be 48 hours before they will be ready to try a different approach. Before they can try again they have to remove the ice from inside the box.
BP says the device could begin capturing the leaking oil within 48 hours of finding a solution to the frozen gas. The rig on the surface can process 15,000 bpd of oil and water and separate the components. The rig can also store 139,000 barrels of oil while waiting for a tanker to take the oil to the BP refinery in Texas City.
BP is unsure they can get this to work since it has never been successfully tried at these depths. They have nearly 100 scientists and engineers working on multiple approaches to stopping the smaller leak at the blow out preventer. The third leak was halted when it was capped on Thursday by a remote sub.
Containment box being lowered into the water
The Dow has lost -837 points since the high close on April 26th. This chart shows the 200-day average at 10192 but the stronger support is the 10300 level where the Dow consolidated in November and December. Who would have thought last weekend that we would have seen a cascade decline of this magnitude? I have been predicting market weakness but this far exceeded my expectations.
Now the focus shifts to pinpointing where the decline will end. The Thursday decline stopped at almost exactly the support from February at 9900 but I don't think Thursday was a valid print. That was a system failure and not normal investor selling. Friday's decline was about half of the day's intraday loss but there was no buying at the close. Shorts did not attempt to cover and longs did not appear interested in adding to positions ahead of the decision on Greece.
If there was no geopolitical component and we had arrived here from the normal selling process I would expect 10250-10300 to be tested again on Monday and a possible rebound on Tuesday. Since we are a prisoner to the drama playing out in the EU I don't think there is a coherent scenario unless the EU suddenly gets motivated and actually follows through with a plan.
The S&P is more likely to respect the 200-day average than the Dow. The Dow is too dependent on individual stocks to respect moving averages. The S&P typically responds to the 50 and 200 day as support. Fund managers use a cross of the 200-day as a major buy/sell signal. Should the 200-day fail to be support I would expect managers to look for confirmation with a break of 1085 before pulling the exit trigger.
The S&P has lost -105 points over the last two weeks for an 8.8% decline. A 10% correction would take the S&P to exactly 1095 and the 200-day average. The convergence of the 10% decline at the 200-day and the horizontal support from November should provide a strong base if the bulls have any fight left.
The Nasdaq has strong convergence at 2200. The 200-day and the prior support stopped the Thursday decline exactly where it should have been halted. The Nasdaq is suffering from big cap flight as the high dollar momentum stocks like Apple, Priceline and Google seem to have lost their leadership ability. In reality those big cap techs are quick cash for funds that are trying to stave off margin calls. In times of crisis, taking profits in multi hundred dollar stocks has always been a valid strategy to raise cash. Until these stocks begin to find a bid the Nasdaq should remain weak.
After a -12% decline the Russell found support at 650 and exactly where it should have paused. A break here targets the 200-day at 620. I am concerned that the small caps have suddenly surged to the top of the losers list but that is what happens in bear markets. Low liquidity small caps find themselves being tossed overboard in order to reduce the clutter and lower risk. Exiting small caps in heavy traffic is always a problem.
I always recommend watching the small caps for market direction. This week is no different. I don't expect them to lead on a rebound but they could easily lead us lower. A break under 650 should be a signal to remain in cash.
In summary, the initial market direction on Monday will be based on the weekend news concerning Greece and the euro defense plan. Greece is the key. No firm plan, no firm market. I would love to never have to write about Greece and the EU again this year but I doubt I will be that lucky.
The earnings are basically over with Cisco on Wednesday the only major report that could impact the market in a material way. Chambers is always bullish and based on the other tech earnings he should give positive guidance. Whether it will make any difference is unknown.
I don't think the market decline is over. Even if we rally on Monday I would be surprised to see it last. I believe investor sentiment has been damaged and at a bad period for the market. When traders are trying to decide whether or not to "sell in May and go away" it is not a good time for a major sell off. If you step out on the front porch to see if the weather is good for golf and narrowly miss getting hit by lightning it may not be a good idea to head for the course. Investors dodged a lightning bolt on Thursday but were still pummeled by the hail. I doubt they will be rushing back into long positions.
Last week's crash may have created a buying opportunity but it may take a few days for that to be come clear for most investors. I am not convinced that a buy here would be anything more than a short-term trade. I remain cautious until proven wrong.