EquityLetter.com 1/28/08
Note: Event Calendar is located at bottom of page
- General Market Overview
It took global markets on the precipice to finally spur the Federal Reserve to action. Last Tuesday morning traders awoke to find foreign markets in the midst of disturbing decline. The fear of a global market melt down also caused our esteemed politicians in Washington to take notice. The Federal Reserve finally took “substantive” action by slashing interest rates by 75 basis points to 3.50%. The U.S. Congress saw fit to join the party by increasing lending limits at Government Sponsored mortgage lending entities Fannie Mae and Freddie Mac. Congress also proposed tax relief legislation in the form of rebate checks to those within certain income limits. Do any of our esteemed Washingtonians possess the gift of foresight or must an anvil fall upon their skulls before enlightenment? Are these actions too little, too late? It is our view that the typical response from Washington (throwing money at the problem) will provide only short term relief. Yes it will calm nervous markets over the near term; yes it will provide more liquidity as the de-leveraging process continues. What it will not do is correct the massive fraud that occurred throughout our financial system. Whether one looks at the incredible incompetence at bond rating agencies Moody’s, Standard & Poors, and Fitch, or the unscrupulous activities of mortgage lenders, throwing more money at the problem will not prevent similar actions in the future. Just as the executives at Enron were brought to task for their misdeeds, so must the corporate community responsible for our current problems be held responsible as well.
Only time will tell if the current mortgage related credit crisis will spread to other areas such as credit cards and auto loans. Recent signs suggest such is the case. Credit card issuer Capital One, in their recent earnings report disclosed an alarming increase in late payment and default rates.
Just as credit derivatives provided liquidity that enhanced market gains on the upside, so to will the unwinding of said derivatives intensify the losses on the downside. We remain of the opinion that in this de-leveraging environment, investors should abandon the “buy the dip” mentality that is so prevalent and adopt the mantra of “sell the rally”.
II. Sector Analysis
- Financials
The IEF-90.20 (I-share 7-10 year Treasury bond) continued to trend higher last week as the yield on the 10 year Treasury declined from 3.65% to 3.58% on the week. The IEF continues to maintain upside momentum as broad equity market weakness has sent fearful investors fleeing for the safety of U.S. Treasuries. The trend remains to buy dips in the IEF. A weekly closing price below 88.97 would signify a pause to this powerful upside move.
The Financial Select Sector Index (XLF-27.18) posted a 6.59% gain last week. The accommodative actions from the U.S. Federal Reserve spawned an impressive short covering rally. This rally would have been even more impressive had the XLF closed above the 27.90 price resistance level. Despite the strength of the past week we shall remain negative on the banking sector as a whole. The strong rally in the shares of J.P. Morgan (JPM-43.64) and Wells Fargo (WFC-30.66) warrant some attention, as both have generated positive weekly signals. This being stated, we would most certainly not chase these issues to the upside. At best, we would look to buy JPM and WFC upon price declines 10%-15% below current levels. As for Bank America (BAC-39.48), CitiBank (C-26.64), and State Street (STT-78.52), are weekly technical remain to the negative side at this time.
The Brokerage sector (XBD-189.85) benefited from the short covering rally in financials to post a 6.74% gain for the week. Readers should view this rally as an over sold bounce in a sector that remains in the throngs of a problematic downtrend. Market rumors of a potential deal in the making between Swiss banking giant UBS and troubled Bear Stearns (BSC-87.03) helped propel the shares of BSC 20% higher for the week. Although a deal may be very well possible, we would be surprised if it were to occur at a significant premium from current levels. The uncertainty of current legal liabilities combined with the mortgage dominated business model at Bear Stearns give us reason to be circumspect regarding this rumor. Despite the across the board rally in the sector we shall remain negative on the shares of Morgan Stanley (MS-48.89), Merrill Lynch (MER-54.96), Lehman (LEH-57.87) and Goldman Sachs (GS-191.37) as the enormous profits generated from creative financial engineering have come and gone. Use any significant strength in the Brokerage arena to reduce long exposure or initiate short positions.
- Retailers
B. Builders
The combination of an emergency Federal Reserve rate cut and the expansion of loan limits at Fannie Mae and Freddie Mac spawned a sharp rally in the heavily shorted building sector (XHB-19.82,+ 15.23%). Last week we mentioned a potential rally forthcoming in the shares of Pulte Homes (PHM-13.10,+ 31%) and Ryland Group (RYL-29.53, +14.24%). It is our view that the rally of the past week in the builders is an intermediate bounce in an overall long term downtrend. Although this rally may have some further upside from current levels, we would not recommend initiating long positions at current prices. Readers, at best, should look to initiate possible long trades upon a retest of the prior week’s lows. If executed, long positions should be accompanied with protective sell stops below the prior week lows.
C. Semiconductors
The SMH (28.02) continues to act poorly as the prior week earnings report from Intel Corp. continues to cast a cloud over the sector. A somewhat upbeat report from Texas Instruments (TXN-29.79) was unable to light a fire in a sector that remains under the pressure of distribution. We continue to believe that the shares of Applied Materials (AMAT-17.42) have the potential to be a positive outlier in a negative sector. Any weekly close below the 16.50 level for AMAT would abort our near term bullish view. If long the shares of AMAT, we would look to take profits around the 19.50-20.00 price area. Readers should take note that SMH component Novellus Systems (NVLS-24.23) is due to report quarterly earnings in the coming week. Although an over sold bounce is a distinct possibility, we remain negative on the shares of INTC (20.00), TXN (29.79), Micron (MU-6.53), SNDK (25.62), and ADI (27.72).
This sector (RTH-90.27) managed to post a second consecutive week of gains by advancing 2.81% this past week. The government proposal of fiscal stimulus in the form of tax rebate checks has provided short term relief for the battered sector. The shares of Home Depot (HD-28.53) rallied an impressive 8.56% in the past week but ran in to a wall of price resistance at the 30.00 level. The 25.00 price level appears to be an important support level for HD at this time. The charts of Sears Holdings (SHLD-99.00) and Kohl’s (KSS-41.84) merit attention as price action is indicating potential near term strength for deeply oversold conditions. WalMart (WMT-48.09) displayed strength early in the week but was unable to close out the week above our key 48.09 price resistance level. A weekly closing price above 48.09 could signify a move to the 51.00-52.00 area for the shares of WMT. The shares of Walgreen’s (WAG-34.28), Target (TGT-51.60), and BestBuy (BBY-45.28), although advancing for the week, have yet to display the positive technical characteristics that would signify an end to negative price trends.
E. Steels
After an early weak collapse that accompanied extreme weakness in foreign markets, the Steel sector (SLX-73.46) recovered smartly and gained 1.66% for the week. Despite the recovery from the depths of despair, this highly volatile sector is (in our view) technically damaged. We would use any further upside strength in the shares of U.S. Steel (X-108.99), Nucor (NUE-54.97), Mittal (MT-62.98), and Steel Dynamics (51.44) as an opportunity to reduce long exposure. It is our view that the glorious growth story of foreign markets will no longer insulate investors from the domestic troubles in the United States.
F. Pharmaceuticals and Healthcare
Although supposedly “defensive” in nature, the Pharmaceutical sector gave investors an important lesson on “event” risk this past week. In two weeks the PPH (73.12) has collapsed an astounding 15%. The shares of drug giant Merck (MRK-47.79) have plunged 20% in that same two week period after an FDA study questioned the efficacy of their cholesterol drug Vytorin. This “event” has sent the sector as a whole in to a dizzying downward spiral. It seems that fund mangers that rotated assets in to the pharmaceutical space as a defensive play amid general market turmoil, have discovered an unintended mayhem. We shall remain on the sidelines in this sector until the extreme volatility subsides.
We went long AMGN on 1-17-09 at 47.40. Although the stock closed the week at 48.14, we were stopped out of our long position on 1-23-08 at 44.49, for a loss of 6.14%. We must respect our stop discipline, but may revisit the shares of AMGN from the long side in the near future.
G. Internet
The Internet sector (HHH-51.13) continues to remain in corrective mode. In this past week they finally carried the proverbial piano player out of the burning building, Google (566.40), traded as low as $525.00, before recovering to close the week at 566.40. Earnings reports will dominate the sector in the coming week as GOOG, YHOO, and AMZN are all scheduled to disclose results. Despite continued market rumors of a potential merger, the shares of Yahoo (YHOO-21.94) remain under heavy selling pressure. We shall also remain negative on AMZN (77.60) and EBAY (26.83) as they both remain in “sell the rally” mode.
Take note that the VIX-29.08(CBOE Volatility Index) increased from a reading of 27.18 the previous week. After spiking as high as 37.50 early in the week, matching the August 2007 high, the VIX eased after the Federal Reserve emergency rate cut. A weekly close under the 22.00 level would indicate a near term easing of the current heightened volatility. We shall continue to look for a spike to 40.00 level or higher before the current chaos subsides.
III. Gold
- Energy- (Oil, Oil Service, Nat’l Gas, Coal)
- Underline names have changed from previous week*
GLD (streetTracks gold index) – The GLD-(90.30) advanced $2.88 or 3.29% for the week. Year to date the GLD is up a sparkling 9.27%. While we have stated in previous letters that the GLD appears poised for a corrective pause, that pause has not materialized. At this time GOLD appears to be the only place to hide from market turmoil. While the trend remains to the upside our worry here is that the GLD has become a “crowded” trade. It remains our opinion that the risk reward from current price levels is slanted to the risk side. Readers should be aware that commodity price corrections can be quite fast and quite furious.
From a technical standpoint the weekly trend for the GLD is to the upside, with the 86.32 price level being key weekly closing price support. We continue to view the weekly chart as in a short term overbought stage and would only look to initiate long positions upon price declines to around our weekly price support level. Any weekly closing price below the 86.32 will signal a near term price correction to the 80.00-82.00price area.
We currently have no position in the GLD.
The Large-Cap Integrated Oil space continued to descend along with the price of crude. The sharp four week price correction has shaved 15% off the XOI since the beginning of 2008. Could it be that the elevated price of crude oil has reached the point of demand destruction? We believe that the price correction has more to do with hedge funds selling what they can, while they can. Just as leveraging up caused prices to rise, de-leveraging will cause prices to fall. Although somewhat deeply over sold in the near term, the shares of Exxon (XOM-83.94), Chevron (CVX-81.82), British Petroleum (BP-63.27), and Conoco Phillips (COP-74.13) are all technically damaged goods. Readers should use any significant market rallies to reduce long exposure.
The Oil Service (OIH-163.49), managed to squeak out a 1.17% gain for the week after surviving intense early week selling pressure. The sharp decline of the OIH has left the index vulnerable to further declines to the 140.00 price support area. We would use any significant bounce in the OIH to the 175.00-180.00 price resistance area as an opportunity to reduce long exposure. Whichever individual company chart we view, we see a similar picture, near term over sold, longer term major over head price resistance.
Natural Gas (XNG-519.82), after reaching new all time highs just three weeks ago, has suffered a 10% downside correction. If the 200 day moving average of 513.08 is violated on a weekly closing basis the XNG could quickly slide to the major price support area of 450.00-475.00.
The Coal sector experienced some amazing upside moves in the past week. Consol Energy (CNX-73.01) up 22.09%, Arch Coal (ACI-41.23) up 15.75%, Peabody Energy (BTU-56.07) up 13.62%, and Massey Coal (MEE-34.63) up 21.59%. These companies have all rallied back to areas that are weekly price resistance. If they can somehow follow through on the upside in the coming week, the coal stocks may be headed much higher. If not, it will be a one-week wonder, and recent lows will be revisited. If trading this sector, one should have a bottle of Pepto Bismol readily available.
V. Dow 30 Analysis
Our Weekly Trend Indicator (WTI) measures in at -18, a slight increase from the previous week reading of -20. The Dow Jones Industrial average advanced 0.89% for the week to 12207.17 and is currently showing a negative return for 2008 by 7.95%. The S&P 500, as measured by the SPY (133.04), advanced 0.69% for the week and is currently 9.23% to the downside year to date. Small caps issues, as measured by the IWM (IShares Russell 2000 Index Fund- 68.47), continue to under perform large cap issues. The IWM rose 1.86% this past week and is in the red by 10.04% year to date.
The emergency Fed rate cut of this past week seems to have temporarily stemmed the precipitous waterfall decline in the DIA. After plunging below the 120.00 price support level intra-week, the DIA managed to close the week ay 122.19, a slight 1.34% gain. Despite the rally, the technical picture remains that of distribution. We remain of the opinion that the DIA faces significant over head price resistance at the 128.00-130.00 price levels. Any subsequent rally to said price resistance levels should be used to reduce existing long exposure or to institute short positions.
On a positive note, the shares of General Motors (GM-25.79), which rallied 9.65% last week, are signaling the potential for further upside. While we understand that this is a counter-trend idea, we would only look to initiate a long position in GM upon a price decline to the 22.00-23.00 price support area. Any weekly closing price below 22.00 would cause us to abort this tenuous bullish stance. It is our view that the shares of GM could potentially rally to the 30.00-32.00 price resistance area.
Readers should take note that Dow Jones Industrial components AXP, BA, MCD, MMM, MO, MRK, PG, and VZ are scheduled to report quarterly earnings this week.
Dow 30 stocks with positive weekly signals:
GM, HD, IBM, JPM, MO, UTX
Dow 30 stocks with negative weekly signals:
AA, AIG, AXP, BA, C, CAT, DD, DIS, GE, HON, HPQ, INTC, JNJ, KO, MCD, MMM, MRK, MSFT, PFE, PG, T, VZ, WMT, XOM
VI. OPEN POSITIONS
VII. CLOSED TRADES
AMGN- 1-17-08 Long @ 47.40, stopped out 1/23/08@ 44.49-Loss 6.14%
2008 NET RESULTS ON CLOSED TRADES ASSUMING EQUAL DOLLAR AMOUNT INVESTED IN EACH TRADE: (6.14%)
VIII. KEY EVENTS IN THE WEEK AHEAD:
Monday, January 28
Economics
10:00 New Home Sales: 649k cons.
Earnings
Before: BOH, BDK, GLW, HAL, MCD, NTY, ROH, SWK, SYY, TSN, VZ, YRCW
After: ARG, AXP, AMLN, CX, EEP, JBHT, MTH, STLD, SSCC, SNDK, VMW, VLTR
Events
Tuesday, January 29
Economic
8:30 Durable Goods Orders: 1.9% cons.
9:00 S&P/CaseShiller Index
10:00 Consumer Confidence: 87.5 cons.
2:15 FOMC Meeting
Earnings
Before: MMM, AAI, AEP, AXE, ARM, BNI, CP, CAH, CRS, CHTT, CNX, CVG, CFC, DOW, LLY, EMC, ENR, ETR, FSRV, GKSR, GYLT, GNTX, JBLU, KCI, LXK, NWA, OXY, PCAR, BTU, PPC, SMG, SHW, SLGN, SII, TROW, TRV, X, VLO, ZMH
After: ALL, AJG, BBOX, CTX, EGLT, FDRY, HLIT, HPC, IPSU, JLL, RHI, TRMB, TUP, PAY, YHOO
Events
Wednesday January 30
Economic
7:00 MBA Mortgage Applications: 8.3% prior
8:15 ADP Employment Change: 40k prior
8:30 GDP Annualized: 1.2% cons.
8:30 Personal Consumption: 2.8% cons.
8:30 GDP Price Index: 2.6% cons.
8:30 Core PCE: 2.5% cons.
Earnings
Before: AMG, AGN, MO, AUO, BHI, BA, BOBJ, CEG, D, DOV, DSPG, EK, FTD, HES, HOLX, ITW, IMN, IFF, K, KFT, LM, MRK, NCR, NI, OSTK, PAS, PNW, SAP, SO, STE, UGI, UMC, WWW, XEL
After: AFL, ADS, AMZN, CDNS, CVD, CCK, CTS, CYT, DNB, EXP, RE, ESLR, FNF, FBN, GIL, HRS, HSTX, JDSU, MUR, NVLS, PHM, OI, SBUX, TTEK, TSCO
Events
Thursday, January 31
Economic
8:30 Personal Income: 0.4% cons.
8:30 Personal Spending: 0.1% cons.
8:30 PCE Deflator: 3.5% cons.
8:30 PCE Core: 0.2%; annual 2.2% cons
8:30 Initial Jobless Claims: 301k prior
8:30 Employment Cost Index: 0.8% cons.
9:45 Chicago Purchasing Manager: 52.0 cons.
Earnings
Before: ATK, AZN, ALV, BPHX, BMY, BC, BKC, CAM, CELG, CVS, DCP, RDEN, GR, HBI, HSC, HHS, HP, HMC, IMCL, RX, ICE, IVC, LLL, LEA, ERIC, MRO, MA, MAT, MBI, MEH, MYL, NDAQ, NYT, NWL, NCX, ODFL, OPXT, PTRY, PDC, BPOP, PG, RTN, SAF, TSM, HOT, TSO, TKR, UA, WU, WYE, BUD
After: ACS, ALTR, BEBE, CA, ELY, CHRT, CSR, CLM, DLLR, ERTS, FMD, GOOG, INFN, ISRG, MEE, MCK, MNST, ZZ, SXE, STAR, SYMM, TSRA, TRID, VRSN, ZHNE, ZIGO
Events
Friday, February 1
Economic
8:30 Nonfarm Payrolls: 65k cons.
8:30 Unemployment rate: 5.0% cons.
8:30 Avg. Weekly Hours: 33.8 cons.
10:00 U. of Mich. Confidence: 79.0 cons.
10:00 ISM Manufacturing: 47.5 cons.
10:00 ISM Prices Paid: 68.0 cons.
10:00 Construction Spending: -0.5% cons.
Earnings
Before: AXL, ACI, ADP, CVX, CMI, EL, XOM, GCI, MAN, MWV, MF, NMX, OSK, PEG, R, SPG, TDW, VVI
After:
Events