Market updates

This past week the markets leaped in both directions and this time the volatility worked against us…

The only good thing you can say about getting stopped out is that our losses were limited and now we’re on the sidelines safely back in cash. If we are going to bet with the opportunity of winning the tide is occasionally going to go against us—the key is to learn and improve.

One of the things I’ve noticed is that trying to time a reversal—like this past week on the XLF and the USO–is much more demanding than just jumping on board an existing trend and riding it. However when your timing on the reversal works the rewards can be greater.

With two losses this past week it’s important that we get positioned for winners this coming week—which is why our two new plays have extremely high odds of making us money no matter which way the market goes. You’ll see what I mean when you take a look and I’m really excited to show them to you—but before we do let’s take a good peek at…

WHICH WAY THIS MARKET IS HEADED

As you can see we’ve got two different stories going on right now. The SP-500 is weighed down by the financial sector and the recent drop in oil prices has brought energy down as well. Energy and the financials are by far the two biggest groups in the SP-500.
The Nasdaq on the other hand rallied +30 points on Friday bouncing off of its new uptrend support line. This is a bullish chart even after the mid-week drops in AAPL, RIMM, GOOG—and those stocks have already started to recover.

The bounce we saw at the beginning of last week can be attributed to relief that earnings have been better than expected–over 45% of the S&P has reported so far and 75% of those reporting beat estimates.

That is pretty good news on the surface but keep in mind earnings have still declined 17.8% for the quarter. And if you eliminate the energy sector earnings have fallen a very bearish 25.8% for the quarter.

And in spite of the rally in the XLF early last week the financial sector was expected to report an earnings decline of -60% but instead the bottom line dropped a mind-numbing 90%. Guidance has also been worse than normal with an almost unanimous view across all sectors that Q3 and Q4 will see lower profits. It is not surprising that the rebound failed on Thursday.

Lowered forward guidance brings into question the whole “the bottom is behind us” mentality that is currently keeping a bottom under share prices. Probably the biggest key is the labor market which so far has held up pretty well. We’ll get another look this Friday when the Labor Department reports on employment in July. In June, nonfarm payrolls fell 62,000, while the unemployment rate held at 5.5%.

Credit Suisse analysts expect a July decline in payroll jobs of 75,000. They forecast continued deterioration, and cited indicators such as a trend in initial jobless claims remaining at elevated levels and June’s decline in the ISM Non-Manufacturing Employment Index.

Plus the financials have not hit bottom regardless of any temporary jump in the XLF. S&P placed Fannie and Freddie on negative credit watch which is a pretty good indication they will lower their rating soon. With mortgages failing in record numbers Fannie has already raised $7 billion in capital and Freddie $5.5 billion. The government has pledged to help them and the Fed said it would open a special lending option to provide further support. Congress is expected to pass the housing bill including guarantees of up to $100 billion for the pair. Over the last year the government–along with Fannie and Freddie–have already put $1.43 billion of support into the mortgage market. As a result of the subprime crisis banks have already written off $880 billion and expectations are for that to climb to $1.5 trillion by the end of 2009—so by those estimates we’re little more than half-way through this mess.

One big indication that banks are still having problems is the Fed reported that bank borrowings at the discount window rose to an average of $16.38 billion per day in the latest week–the highest level ever. This is a strong indication banks simply cannot raise money in the private sector which means the credit markets are still locked up.

The Fed seized two more banks after the close on Friday and immediately sold them to Mutual of Omaha Bank. The two failing banks were the First National Bank of Nevada with assets of $3.4 billion and $3 billion in deposits. The second was First Heritage with assets of $254 million and $233 million in deposits. The FDIC said the estimated cost of the transactions to its insurance reserve account would be $862 million. Expect more bank failures to come.

In spite of a pretty serious situation there are signs of hope. The Durable Goods report for June rose by +0.8% when analysts were expecting a decline of -0.7%. This was the second month of positive growth. Unfilled orders also rose and the orders to shipments ratio is near its all time high. The inventory to shipments ratio is at its highest level since 2001. This was a very positive surprise.

Plus Consumer Sentiment for July spiked to 61.2 from June’s 56.4 reading–the first move higher since January. Analysts credited the tax rebate checks and a firming of home prices in many states. A reading of 61 is not great but it beat the tar out of expectations in the low 50s. Current conditions rose +6 points to 73.1 and expectations rose +4 points to 53.5. Inflation expectations remained high at 5.1% but appear to have eased somewhat from the first July reading at 5.3%.

The third positive report on Friday was the New Home Sales for June. New sales totaled 530,000 units–much better than the 501,000 analysts expected and better than the previously reported 512,000 in May. However, the Census Bureau revised the May numbers up to 530,000 as well as the April numbers to 540,000 from 520,000. This surprising improvement in sales was super news for a horribly beaten down sector. New home prices rose slightly to $237,871 from $231,087 in May for a +2.94% gain. Months of inventory decreased slightly to 10.0 from 10.4. Sales in the second quarter declined only 17% over Q1 compared to drops of nearly 40% in the prior three quarters.

The bottom line is we have data coming out heavily in both directions. If energy prices continue to slide for a few more weeks we could see more optimism in the consumer sector. However this economy is still in tough shape–the index of leading economic indicators, which attempts to forecast turning points in the economy–declined 0.1% in June with six out of the ten indicators falling. Until we see some growth this economy has not bottomed.

However the keys to market direction this week will still be earnings with nearly 750 companies reporting. This will be the heaviest week of the Q2 cycle although most of the largest companies have already reported. Earnings quality will continue to decline as we move farther into the cycle with the smaller companies reporting. This will also be a heavy week for energy earnings and those should be very strong.

So we’ve got the SP-500 looking bearish—although it may be helped by energy this week—and the Nasdaq looking bullish. The banks are still in trouble and crude has been falling—with so many counter-trends…

Trade with close stop next week everyone.

Andy Huang