The major indexes closed mixed for the day and flat for the week as July ends with the biggest monthly gain in a year.
Economics were a market mover on Friday with the GDP revision a major force in the early morning market dip. The headline number on the GDP for Q2 fell to 2.4% compared to prior estimates of 3.0% and the Q1 GDP revised estimate of 3.7%. Dropping more than a full point was a shock to economists but the bigger shock was the revision to the last three years of quarterly GDP estimates.
The BEA revisions show that the recession was much deeper than previously thought. The revision showed that the bottom of the dip was a -6.8% drop in Q4-2008. The revision also moved the severity of the dip backward by a quarter from previous estimates. This discussion is going to be graphic intensive today. The first graphic shows the monthly GDP changes prior to the revision and the revised numbers from the BEA.
GDP Quarterly Revision Table
GDP Annual Revision Table
GDP Comparison Chart Pre/Post revision
The slowing growth in Q2 came from a dramatic increase in imports which produced a -2.8% drag on the GDP estimate. Offsetting that drag was a +2.1% increase in fixed investments including inventories. The improvement in inventories provided only a +1.1% boost compared to the +2.6% and +2.8% boost in the prior two quarters.
Consumer demand slowed to a gain of +1.6% after a +1.9% gain in Q1. The pace of growth in consumer spending is very slow but was still increasing in Q2. Business investment rose at an annualized rate of +17% in Q2. Government spending rose +4.4% and added +0.9% to the GDP number.
The GDP numbers for Q2 are just the first estimate and will be revised monthly. Until the labor market improves and unemployment begins to fall there will only be minor GDP gains. The 16% of U6 unemployment is going to be a drag on growth for at least another year. With this much unemployment the risks are higher for a double dip recession.
Mark Zandi of Moody's is going to revise his Q3 GDP estimates and he may cut them to less than 2%. (Some think it could be as low as 1%) He is worried about the declining inventory cycle and the potential for low job creation now that the stimulus impact is fading. Governments are going to reduce spending by about 1% of GDP in the last half of 2010 as a result of stimulus money drying up. Moody's believes as many as 500,000 government employees could lose their jobs.
GDP Pre-Revision Chart
GDP Post-Revision Chart
There was a small bit of good news in the final Consumer Sentiment revision for July. The headline number was revised slightly higher from 66.5 to 67.8 but that still represented a more than eight point decline from June. This is the lowest level since November. The present conditions component fell from 85.6 to 76.5 in July. The expectations component fell from 69.8 to 62.3.
Because of the slight improvement in late July the researchers are more convinced the decline in the stock market in early July was the main factor in pushing sentiment sharply lower. The key will be the levels we see in the August reports. If sentiment continues lower then it was not the market but the economy.
Consumer Sentiment Chart
The ISM New York improved slightly from 458.9 to 463.1 in July. The recovery is slowing in New York but at least it is still in recovery mode. The current conditions component fell from 69.3 to 58.4. The expectations component fell only 2 points from 69.6 to 67.5. However both of those components are at their lowest levels since August 2009. The Financial Regulation Reform bill could have weighed on sentiment from the New York area.
The Chicago ISM, also released on Friday, showed an improvement in activity. The headline number rose to 62.3 from 59.1 and the highest level since April. Analysts speculate this is only temporary and related to GM's decision to skip the retooling process this year and keep plants open and thereby boosting output. This additional demand probably impacted activity at all the parts suppliers and boosted the Chicago area activity.
This temporary boost in activity is likely to slow as the impact from the stimulus fades as the year progresses. The high unemployment is still going to be a drag on automobile sales as the summer ends.
Chicago ISM Chart
The minor improvements and revisions in various economic reports produced a positive week in the ECRI Weekly Leading Index. The index rose slightly from 120.7 to 121.1. That is not an earth-shaking move but there is a definite uptick in the chart after 16 weeks of a predominately down trend. However, the annualized growth rate ticked lower again to -10.7%. The WLI is likely to make a major move after the jobs report next Friday.
Weekly Leading Index (Moody's)
The economic calendar for next week has two important reports. The ISM Manufacturing is a national report on Monday and that is expected to be flat. A flat report may not produce a market crisis but any material decline or improvement is sure to create a triple digit move.
The big report for the week is the Non-Farm Payrolls on Friday. The official consensus estimate is for a loss of 75,000 jobs. The unofficial estimate today is for a loss of 150,000 jobs. This will have some census data that will cloud the picture again. Morgan Stanley believes the headline number will be a decline of 50,000 jobs but net of the census a gain of +135,000 jobs. That means they are expecting census terminations of 185,000 jobs. They have not been close in recent months but at least they are not afraid to put their estimate out there for the world to see.
This payroll report is going to be critical for market sentiment for the rest of the quarter. It will be looked at as a true read on whether the economy is improving or declining. Most of the weekly regional reports have seen the employment components improving even as the overall production components decline. This is going to be a tough report to predict and the market will probably be hesitant ahead of the news. There is a Fed meeting two days after the payroll report so another reason for the market to worry.
Jobless claims continue to hover in the 460,000 range and while down from the peak over 640,000 in early 2009 they are stubbornly refusing to return to normal in the 320,000 range. This suggests a high level of terminations are still ongoing.
Weekly Jobless Claims (Moody's)
The Dow dropped -120 points in the first few minutes of trading on the downgrade to the GDP or at least it was blamed on the GDP. This was of course month end and the last days for mutual funds to adjust their portfolios. July is not a big adjustment month but some funds have a trading plan that forces them to maintain certain ratios of stocks and bonds and that forces some portfolio shuffling at the end of each month.
The markets rallied strongly in July with gains in the 7% range across the board. This was possible because the markets hit eight-month lows on July 2nd. Yes there was a rebound but most of it came in the first ten days of the month.
The rebound was due to the oversold conditions of the market heading into the earnings cycle. Now that the earnings cycle is nearly over and the market is struggling at resistance the outlook is not as positive. The focus is going to turn from earnings back to economics and the big reports next week will be a jumping off place for the August market.
Based on the yield of the U.S. treasuries it appears investors are not expecting the economy to rebound. The two-year note yield fell to an all time low of 0.5493% on Friday. The yield on the ten-year note fell to 2.91% and is very close to lows not seen since April 2009 with the recession in full bloom. There are 110 stocks on the S&P-500 that have dividend yields that are higher than the ten-year note yield. This is helping consumers refinance their homes and stimulating continued purchases. The weekly mortgage applications index has been over 700 for the last four weeks. This is near a 52-week high.
Ten-Year Treasury Yield Chart
The dollar has fallen to a three month low and showing no sign of improvement. This is a combination of our weakening economy and signs of improvement in Europe. It is not necessarily negative for the stock market but more of an indicator of economic conditions relative to Europe. The dollar has declined -6% against the euro but only -3% against the yen.
Dollar Index Chart
Despite the negative economics I am seeing signs of improvement, faint but they are there. We saw guidance upgrades from FedEx, UPS and Expeditors (EXPD) and they are all reporting rising prices. That is not a sign of a declining economy.
Ethan Allen's CEO said high-end furniture is beginning to sell again. Fortune Brands (FO) posted earnings that more than doubled at 98-cents and beat estimates of 76-cents by a wide margin. They posted a 9.1% increase in revenue and raised their guidance for the full year.
Travel companies are seeing a boom in vacation travel. Hotels are seeing higher occupancy with a +6.2% increase in Q2 and AAA reported a 20% jump in bookings for cruises. Royal Caribbean spiked $5 last week on better than expected profits and bookings. Smith Travel Research said corporate travel was up 7.5% to 9% in Q2. Airlines are soaring with full planes and Travelocity says summer airfares were up +20% in Q2.
Granted these are anecdotal indicators but it appears the economy is going through a stealth improvement cycle. We are not seeing a rush to buy everything in sight but consumers are spending some money. They are just doing it selectively. The chain store sales report for July due out next Thursday could be a interesting indicator if it shows a gain rather than a decline.
I have not turned into a bull but to use an overworked term there are some green shoots sprouting up all around us. I still believe we are going to see some further market weakness this summer but I think we are going to see a big rally in the fall. We just need to see these green shoots mature into thriving plants and not die in the heat of the dog days of August.
In Europe we are seeing declining credit default swaps on every country but Greece. This is evidence of more confidence that the sovereign debt crisis has passed. Greece is still in trouble and will probably restructure their debt in the months to come but the worry over the other EU nations like Spain and Portugal has diminished completely. Jimmy Rogers says the EU stress test for banks was strictly a publicity move and should not be taken seriously but that is the same thing I said when the results were released. The banks passed if you don't discount their sovereign debt so this exercise is now over and they did not find any problems. Surprise, surprise.
China appears to be headed for a soft landing with the Shanghai market up 11% in July. That is good for everybody on the planet because the worry about a hard landing is fading. This was a big deal for the U.S. markets a month ago but now nobody is worried about China.
All around the world there are growing economies. Nearly a dozen countries have raised rates recently to slow growth. That is a clear sign the global recession is over. Even Mexico reported on Friday that its GDP grew by +7.0% in Q2 after a +4% gain in Q1.
Unfortunately back in the U.S. the Fed is worried about a deflation cycle. St. Louis Fed president James Bullard was on CNBC on Friday and he was very free with his comments. He is worried a Japanese style deflationary decade may be in our future. Fortunately he is speaking out to try and convince others that the Fed needs to take action now rather than wait until it has arrived. Bullard is a voting member of the FOMC this year and has been known as an inflation hawk in years past. He said on Friday the Fed does not need to worry about inflation but instead take action to head off deflation. He does not specifically want the Fed to take action today but he wants an emergency plan in place in case conditions worsen.
He believes the economy is on course for a gradual recovery but wants a backup plan in case it stalls. He believes that keeping the rates "exceptionally low" is counter productive because it fosters the belief that rates will be low for a much longer period. He favors further quantitive easing rather than keeping rates artificially low. Bullard's two-hour appearance on CNBC is a major change in the policy of Fed presidents to hold the party line and not rock the boat. However, Kansas Fed President, Thomas Hoenig, has also spoken out recently as well as Dallas Fed president Richard Fisher.
Fisher warned that regulatory uncertainty will make further monetary accommodation from the Fed ineffective. "No amount of further monetary policy accommodation can offset the retarding effect of heightened uncertainty over the fiscal and regulatory direction of the country. Businesses and consumers are being confronted with so many potential changes in the taxes and regulations that govern their behavior that they are uncertain about how to proceed. Until business operators are provided the clarity they need, they will continue to hoard their cash, limit their payrolls and constrain investment in new plant and equipment - none of which provides hope for the unemployed or will put us on a more forceful path to recovery." He said businesses were taking defensive positions until after the elections. These frank and potentially combative comments suggest the atmosphere in the Fed meetings is growing rather hostile. Bernanke may have his hands full in keeping all the chiefs in line.
The various Fed comments suggest there is a growing frustration level with the administration and lawmakers in Washington. The Fed is tasked with keeping the economy growing and lawmakers are working against this goal. Several Fed members have spoken out against letting the tax cuts expire in January. Letting the tax cuts expire is the Holy Grail for the democrats and now the Fed is preaching against it. Bullard was specific on Friday saying that raising taxes in a weak economy was not the right thing to do. Even a staunch liberal democrat like Paul McCauley at Pimco who has been advocating letting the tax cuts expire has now switched sides claiming they should be extended for two years. Most people don't realize that the top 5% of wage earners account for 33% of all spending and they are the largest creators of new businesses and new jobs. If you raise their taxes there is a multiplier effect on their spending reductions. Even Bernanke alluded to the need to extend the tax cuts when he testified last week.
I would bet that there is a major announcement a few weeks before the elections about extending the tax cuts. It will be the ultimate Hail Mary pass for democrats facing tight elections. I think it will be interesting to see how it will be phrased since letting the cuts expire was a major campaign platform plank in the last election.
Seventy five percent of the 336 S&P-500 companies who have reported earnings beat the street on earnings per share. Only 64% beat on revenue expectations but that is still a strong number. Q2 profits have risen more than 45% from those who have already reported. Obviously that number will go down as the smaller companies report but it is still light years ahead of the 26-30% that was being predicted just four weeks ago. This has been a very strong earnings cycle. Unfortunately that early cycle boost to the market has run out of steam.
The earnings calendar for next week is still busy with more than 350 companies reporting. However the quality of those reporters is declining. The list below is the highlights and I would bet 50% of those symbols are unknown to most investors.
Making news next week is a new announcement from Research in Motion. There is a high profile press conference setup for August 3rd and rumor has it that they will announce a new touch screen Blackberry. The model number is expected to be 9800 and the code name is "torch slider." This version has been widely speculated for some time.
RIMM is also rumored to be preparing an announcement on a new tablet PC called the Blackpad. It will have a 9.7-inch touch screen and start at $499 with WiFi and Bluetooth. It will not have its own cellular interface but will share a connection with a companion Blackberry. The device is rumored to be loaded with business applications and will be targeted to corporations rather than individuals. RIMM bought the domain BlackPad.com but nothing has appeared there yet.
In the housing market there are a growing number of reports that claim there will be a housing shortage in 2012. JP Morgan is adamant that the current annual production rate of 500,000 is not sufficient to keep an adequate inventory level once demand begins to return. Over 300,000 homes are destroyed each year for various reasons including fire, highway right of ways, etc. Over 150,000 new households are created each month by marriages, graduations, legal immigration, etc. Once the surplus of distressed homes is absorbed there will be a housing panic until builders can ramp back up to the two-million plus rate prior to the recession. Since their crews have been laid off and land holdings cut to the bare minimum it will take 24-36 months to regain the ability to build a lot of homes. After being burned so badly in the crash many builders will not want to leverage up so quickly and be content to keep inventory low and raise prices. I sure hope JPM is right because my home is still 25% below its peak appraisal back during the boom. I could sure use a housing shortage. I scanned the homebuilders with an eye towards a long-term position and I think we are still early but just after the year-end holidays I think we could start adding them to our portfolio. That will get us past any potential second dip and through the next wave of foreclosures.
The House voted on Friday to end the drilling moratorium in the gulf. Of course that has zero to no chance of going anywhere because the Senate would also have to vote to end it and President Obama would have to sign it. We know that is not going to happen but it was a nice gesture on the part of the House.
Crude prices rallied back to $79 on the slightly better than expected ISM reports from New York and Chicago and the upwardly revised consumer sentiment. Demand did not pickup but the support under oil prices is amazing.
There is still no answer about the Japanese tanker that was attacked in the Straits of Hormuz on Wednesday but evidence is mounting that is was an attack rather than a freak wave or a collision. Windows were blownout on the bridge and rear of the ship but there was no water in the bridge or dining rooms where the windows were blown out. If there was a freak wave that knocked out windows 50 feet above the waterline then there should have been water in those rooms. Also waves don't leave dark smudges where the side of the tanker was damaged in a 25x25 foot area above the waterline. This mystery along with the falling dollar are helping keep support under oil prices.
Japanese Tanker Damage
Crude Oil Chart
We are headed into the dog days of August and volume is going to drop even more than we saw in July. There were only 7.5 billion shares traded on Friday and just barely 7.06 billion on Wednesday. This was a month end week and there should have been more volume from funds squaring positions. This suggests we could see some days below 7 billion in the near future. Low volume means higher volatility so be prepared.
The China PMI on Sunday night could be a market mover. The consensus estimate is for 51.1 with 11 estimates from 50.0 to 51.7 according to Reuters. The whisper number is below 50 and into contraction territory. The June number declined to 52.1 from 53.9 in May. You may remember the major market decline when that big June drop was announced. China's Shanghai Composite index closed at a nine-week high on Friday so their market is primed for a big move if the number disappoints.
The S&P did exactly what we expected last week. The rally to major resistance at 1113-1115 stalled at that resistance and the index retreated to 1100 to rest over the weekend. Since it was month end this was a good round number for support ahead of the China PMI and the U.S. ISM on Monday. This could be a launch point or a pause point for a breakdown.
I have been expecting further weakness into August but we have to recognize the potential for a rebound as well. The +18 point rebound on the S&P is clearly evidence that fund managers are not giving up hope. At least not prior to month end. Next week could be different. The potential for a breakout would occur if the 1115 level was tested again next week. This would be a retest from a higher low and technically the test should provide a breakout if it occurs. Nothing is set in concrete but a retest from the pullback to 1100 would have a good chance of success.
However, a break back below 1100 on something other than an opening gap would suggest a failure of support and a return to 1060.
The China PMI is the wildcard for Monday. We may not trade on our own merits if the PMI is significantly different than the expectations. To simplify the decision process I would consider being short under 1100 and long over 1115 next week.
The Dow was unable to move over resistance at the 100-day average at 10,525 and hold its gains. For five days it moved over 10,500 intraday but fell back below that level on increasing volatility. The last two days showed triple digit moves that ended with losses.
The majority of the Dow components have reported earnings and there is little in the way of news to push the Dow stocks higher. The excitement is dwindling and the Dow will have to depend on external news next week for motive power. The China PMI, U.S. ISM and the payroll report are sure to be big events but it will take a big surprise to push it over the 100-day with conviction. Initial support is the 200-day average at 10,400.
The Nasdaq dropped back to support at 2225 on Thursday and Friday and rebounded both days to the 2250 level. This was impressive given the multiple downgrades to the chip sector. The SOX declined -6.2% from its Tuesday high thanks to the downgrades and guidance issues from several chip companies. The SOX came to rest on its 200-day average at Friday's close but I have no confidence it will hold as support. It has been violated repeatedly over the last three months. The summer is not normally kind to tech stocks and the chips are leading techs lower.
If the Nasdaq were to rally, a move over the 100-day average at 2325 would be a buyable event. Nasdaq 2300 is now resistance.
Semiconductor Index Chart
The Russell 2000 is stuck between support at 640 and resistance at 670 and the 100-day average. This is perfect set of signals for August. A decline below 640 would be a short and a breakout over 670 would be bullish. Traffic between those level could be easily tradable in a nice 30 point range using the IWM ETF or the Russell futures.
Small caps are not likely to do well in August but the closer we get to October the better chance we have of starting what could be a very nice move higher.
In summary our markets on Monday will be controlled by the China PMI on Sunday night. Odds are every good that the number will be significantly different than expectations and a major move will result. Should that not occur the U.S. ISM on Monday will be our own version of economic motivation.
We saw some market weakness as I expected and I still believe we will trade lower in August. There are quite a few people who believe that way so a counter trend move could be violent and we do not want to miss it. If the S&P moves over 1115 traders should adopt a bullish bias. Conversely I would adopt a short bias under 1100. Of course maintaining those signals in a low volume volatile market could be tricky. We saw the S&P on Friday trade down to 1088 before rebounding to 1100. We need to be prepared for this volatility and use it to our advantage. Choose your entry and exit points in advance and stick to your plan.