Sunday, July 29, 2007

Rising volatility at market peaks is never a good sign.

- No one wanted to hold stocks ahead of the weekend
- Some serious issues: Volatility, Frequency of the corrections, and key sector struggles (Financials, cyclicals, and transports struggling together)
- Rising volatility at market peaks is never a good sign.
- GDP solid, inflation low, consumer confident, but credit squeezes the financial markets.
- The key test for this correction is after the relief bounce to come runs its course.

Stocks try a weak rebound, get dumped late ahead of an uncertain weekend.

Futures were lower but the strong GDP coupled with low core inflation gave the pre-market a bracer, turning stocks higher on the open. Almost immediately, however, the market was sold as sellers used the bounce to move in. That rebound enjoyed a half-life of about 30 minutes. Michigan sentiment was released and it blew past the June reading, but it did not help the market. Another bounce over lunch into the last hour, another run by sellers sent the indices negative as NASDAQ peeled off 45 points from its early high, SP500 reversed 30 points, DJ30 260 points into the close.

Credit crunch fear piled on top of mortgage fears on the week, and that ignited the selling. The market held the sellers at bay even with the mortgage worries as it waited for earnings to come out better than expected. When that did not happen there was nothing to hold back the other problems from bubbling up. When the credit issues hit Wednesday and Thursday it was too much to hold back. Earnings finally came around (AMZN, AAPL, WFR, BIDU, CVX, etc.) but it was too late. The contagion fever infected the market and when that emotion laden virus hits, as with its human infecting cousins, it simply has to run its course.

A perfect selling storm.

It wasn't just credit contagion and mortgages, however. There was something of an induced unwinding of the carry trade. The New Zealand central bank raised rates with the primary goal of driving those using the NZ dollar as part of the trade out of the NZ currency. When you look at the action of the yen (the other part of the trade), treasuries, and gold, you could tell there was massive unwinding of this play. In the earlier correction this year there was a partial unwinding and that caused the market to struggle in the spring. This is a much more dramatic unwinding and it further undermined the market weakness.

That put the hammer to the market. Since the recent peaks DJ30 is down 5.3%, NASDAQ 5.9%, and SP500 6.2%. In the spring correction they fell 6.6%, 7.9%, and 6.7% respectively. The losses from the prior correction were hit on the second leg. If we get the bounce this coming week as we anticipate, we could have a very similar pattern to the spring correction in terms of the overall losses. That would also set up some great shorts for the next leg lower. How great depends upon how much of an upside rebound we get.

In the aftermath of the week we heard the usual from both sides of the fence. The bears were calling for more downside while the bulls were saying it was no time to panic. As for the bears calling for more downside, well that tells us this leg is getting close to its bottom. As for not panicking, are you supposed to wait for another 6% down and then panic? Ha! The idea was right though the delivery was less than artful. There is never a time to panic.

You always have to fight that urge, and as always, wait for the right moment and make your move. With the gaps lower last week there was not a lot you could do with some plays. Instead of bailing out on those at the bottom we are playing the percentages, i.e. looking for the rebound that typically lasts from 3 to 5 sessions. If a stock is holding a support level after this week, even a lower support level, it is likely to put in a good bounce on a market relief rally. That will at a minimum give us a better exit point, and some stocks will continue right on up, forming a good base and moving higher. That is why when we have this kind of volatile action we have seen we take interim gains on the way up. Indeed, we always like to take interim gains after a strong run, but when things are choppy there is all the more reason.

Technical issues.

Technically the action was grim once more. Volume was lower but after that huge Thursday selling spike anything seems lower. It was still well above average on both NASDAQ and NYSE. Breadth was still poor at -2:1 and better though that was way off the -13.5:1 seen intraday Thursday on NYSE. Stocks gave up a rebound attempt in the afternoon and closed at the session low. SP500 cracked the February peak as it dove lower again while SP600 broke the 200 day SMA on the close.

Beyond the session there are some disturbing features to this pullback that the prior corrections have not shown.

Volatility is rising at market peaks. After a long dormant period volatility jumped during the spring selling. No big deal there. It fell back but landed in a higher range. It rose modestly with the market as it recovered and then jumped again in the June turbulence. The market recovered and broke higher again and volatility dropped but it also moved higher with the market's gain.

We talked early in the year about volatility and when it becomes an issue warranting concern. We said to watch for rising volatility as the market rises as a sign of a more significant top. With volatility on a slow rise with the market and then shooting past the spring levels we have to watch closely how this next rally and subsequent down leg play out. It will likely be a good time to go to cash on the upside and then look for downside shots if we see volatility continue its trend higher during the next upside bounce.

Frequency of corrections is another issue. There was the summer 2006 correction and then the run into the spring where there was no correction, hiccup or otherwise. Two months later the June double bottom and a convincing looking breakout just over two weeks back. Then in July a sell off that quickly reversed the breakout and in its first week is already matching the spring downside fling. The market is having a harder time making upside moves stick, and a big breakout that is reversed in short order is never a good sign.

Leadership. There are still strong stocks across the market in excellent shape even after a week of heavy market selling. It is always a good sign when there are stocks that shrug off selling and go about their business such as CELG, NVDA, BG, etc. At the same time, however, financials are in the toilet and have been for all of July; some of them longer than that. Cyclical stocks (e.g. raw materials, durables, autos) are in the tank as well, starting their selling well before the past week's downside romp. When those two sectors decline in tandem history says beware as there may be something more serious ahead even if GDP looks good. Throw in some reports we are hearing from the truckers that tonnage never really picked up through the holidays after starting to decline in late summer 2006 (as we reported at the time) and indeed that some are saying there is a freight recession over the past six months, and you have some serious issues that historically do not bode well for the economy and thus the market. And of course, the market prices it in ahead of the economic news.

That said, after this week of selling, the size of the losses to this point, and the weak, disappointing close, the downside actually looks about tapped out on this leg. Another push down Monday and that would likely bring in some covering and a relief bounce. When that runs its course after roughly a week then we need to batten down the hatches and see how these massive undercurrents swirling through the world economies and markets plays out. Of course we will play the downside on that move and if it really breaks we will be able to take the rest of the summer off and then play the upside run on the backside of the year.


Q2 GDP as solid as expected.

At 3.4% the first iteration of the second quarter output was better than the 3.2% expected, and blew away the meager 0.6% bump higher in Q1. Fastest growth since Q1 2006, not surprising since the economy suffered that mid-cycle slowdown the second half of that year.

There was some bad news in the report, however. Personal spending slowed to 1.3%, well off the 3.7% in Q4 2006 and Q1 2007. Even that 3.7% was revised lower. Government spending jumped to 4.2% from 1% in Q1, and government spending is not really a positive for GDP growth given government spending is inefficient to begin with and is made from tax dollars that were taken from the private economy. Moreover, exports jumped and imports fell, pumping up the GDP number but also underscoring the slowing consumption at home.

Offsetting the consumer slowdown was the continued rise in business investment. After slowing to end 2006 and the start of 2007, businesses started buying again, showing an 8.1% gain in the quarter, easily topping 2.1% in Q1 and -1.4% in Q4 2006. Indeed, those Q4 and Q1 readings really look to be the outriders because before that Q4 decline business investment rose 5.1% in Q3 and 4.2% in Q2.

In addition, inflation, at least at the core level, remained under control in Q2. Indeed, it improved over Q1. In Q1 the year/year core PCE was 2.4%, well out of the Fed's 1% to 2% 'comfort zone.' That hurt. The economy was slower with its 0.6% growth rate and yet inflation jumped. Stagflation comments were heard as Phillips Curve worshippers were dazed and confused. Then Q2 with its 3.4% growth rate and the core PCE fell to 1.4% year/year. How is that possible? We have covered this before: growth resolves inflation issues because supply is humming along and it is able to meet demand where it rises. When you have a slowdown in supply as seen in Q4 and Q1, that is when inflation pressures rise. That is why it is absurd for the Fed to try and slow the economy as a way of curbing inflation.

Sentiment rises but not as much as anticipated.

Michigan sentiment (final) for July clocked in at 90.4, down from the 92.4 originally reported but still a significant improvement over June's 85.3. This is the best showing in 5 months, reflecting a 9% jump in expectations and a more modest 2% increase in the present situation measure. The improvement is attributed to a bit lower gasoline prices, a solid labor market, and a better economic outlook versus the housing market slowdown. Interestingly, expectations are holding their trend higher, resuming the move after a June slowdown. Of the two components, it is always good to have a consumer looking for better times down the road.

Of course if the housing market was the drag in July, it will be a drag in August as well given the market worries related to it. On top of that the credit issues will be on consumers' minds. Not in the sense they understand that there is a worldwide credit squeeze right now, but more in the general sense that the stock market is selling as a result of that issue. That creates uncertainty in the consumer, and as with the investor, uncertainty tends to discourage buying.

By: Jon Johnson, Editor

Jon Johnson is the Editor of The Daily at

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