Crude Rebound?

Summer is almost over

First, we apologize for our long "vacation" from the commentary. Considering the volume shrinkage since the last Fed meeting on 8/8, we are waiting for the big players to be back in business after Labor Day Weekend. But we did see a few key economic data reports this week, such as new home sales, existing home sales, and personal consumption. The bearish mood seems to have picked up in the housing sector, helping out the puts on NEW.

Weekly wrap-up 7-28-06

My sincerest apologies for the tardiness of this missive. Last week saw surprising life in equity markets, and a renewed spark in commodity buying. The Nasdaq and stocks in general closed the week strongly (with 2%+ gains on Friday), laughing in the face of our anticipation of a precipitous decline in the near future. We would like to note the seasonal strength at the turn of the month, to which July proved to be no exception. It may be wise to hedge/cover shorts as the end of the month approaches in the future – we were not aware of this historically persistent phenomenon previously. A valuable lesson learned! We are not concerned that our prediction of the bear market commencing is false. Leadership in July’s rally was concentrated in defensive sectors – healthcare, pharma, oil, etc. These sectors do not lead broad sustainable rallies, they signal a transition to a bear environment.


Moving on to every commentator’s favorite catalyst of the oh-so-hoped-for equity romp: the Fed rate hike pause (and subsequent rate cuts, we presume). How short our fellow market participants’ memories prove to be! A look back to only five years ago shows that the last time the Fed paused after an extended period of rate hikes basically marked the top for the soaring Nasdaq 100 index. The Fed pause, whenever it comes, will probably be the “sell the news” event of the year.


As to whether the Fed pauses or hikes on the 8th, we do not have a strong view. We know that we do not envy Bernanke & Co., who must realize that the US economy is rapidly rolling off a cliff, with housing in the driver’s seat. The sell-off in the dollar will be vicious when it is ultimately sacrificed in an attempt to resuscitate the limp, cold, stick-a-fork-in-it-cuz-it’s-dead US economy. We will carefully observe the various markets’ reactions to gauge prevailing sentiment, which we expect to be quite sour, regardless of the Fed’s actual move.

We took profit on our long in an energy stock index, and have resisted the temptation to pile back in as the leader of the pack, Exxon Mobil, soars to new highs. We don’t trust this rally, especially given the weakness in volume. Nor do we view this as an attractive low-risk entry point, as we note the overbought levels. We are actually tentatively bearish on energy, medium-term. We expect slowing demand from the ailing US consumer to alleviate pressure on supply as spare capacity rebuilds. We note that in the first quarter of 2006 world oil demand shrunk while supply rose relative to the fourth quarter of 2005. This sector is not to be shorted, however, in light of the non-negligible probability of a totally unpredictable geopolitical/supply shock, which would send oil prices rocketing upwards.

Drink a lot of water

It was so hot today that I had to turn back while en route to the driving range. This heat wave has driven up the price of natrual gas during the past week, and our long natty position has benefited greatly. We took profit today, however, and plan on buying into the next sell off. Stocks opened in the red this morning and remained down flat throughout the day. Then during the last half hour of trading, we saw the bulls rush in to close the market with stocks tailing up. With respect to NDX, not only is today's close disconcerting, but I also noticed that the recent parallel downtrend has not been confirmed (at least to our satisfaction) by the RSI or MACD indicators. These factors concern our short NDX position, but we will wait to see further confirmation. We maintain our stop at 1525 and our target at 1400.


Silver had a big rally today, showing what could be a breakout to the upside from its triangle formation. Silver also has a very important resistance level at 11.8, and a break above this level should be a strong buy signal.


Tomorrow Aqua America (WTR) wil be reporting its earnings, and we will be keeping an eye on whether the potential head and shoulders formation will come into play. Looking at various techincals, we hope to see a break above 23. It's really hot out there, so drink a lot of WTR.


The caveat to our forecasts is, of course, the uncertainty of next week's FOMC meeting. Jim will talk more about the Fed in his belated weekly wrap-up.

Disclosure: Long Gold Futures; Short NDX

Natural Gas Explosion

Stocks opened lower this morning, following a 2 day rally, but were lifted temporarily after today's Fed Beige Book report of regional economic conditions. The report showed slowing growth in the economy, and the market interpreted this as another indication that the Fed will pause or even cut in August. However, I keep stressing that the bottom line of that report, including Bernanke's comments last week, is the fact that the economy is slowing. A slowing economy is not good for stocks. I wonder when this Fed rate bias will end and bad economic data will start sending stocks lower, instead of higher. With respect to yesterday's new short position on BIDU, the stock opened in the red, but rallied hard to close at a gain of 2.5%. Similar to PHM, I took this opportunity to build more shorts on BIDU. Tomorrow we will see earnings from both BIDU and PHM (also new home sales figures).

We expect this week's 3 day rally to have come to end, as evidenced by a very weak closing today accompanied by light volume. This is supported by the doji that formed today in the S&P and Dow.


We are re-entering our short in the Nasdaq 100 (NDX). Although there is a possibility that there may be a follow through rally until the end of the week, the technicals for NDX do not agree. Today's internal technicals showed just 65 new highs compared to 125 new lows in the Nasdaq. One factor that concerns us is the NDX making a new low on 7/23, while the RSI failed to follow suit, indicating divergence. Our stop for NDX is at 1525, and our target is at 1400.


Today's most exciting activity came from natrual gas, which rallied very hard to close with a gain of nearly 9%! We feel very fortunate to have went long natrual gas futures yesterday as part of our relative value trade against crude oil. Frank Barbera's chart from Financialsense provides a great depiction of the historical relationship between natural gas and crude oil. As Barbera's indicator shows on the chart, a peak in the crude:natural gas ratio has coincided with important bottoms in natural gas. Indeed, today we saw natural gas break out of its downtrend, indicating that a bottom may have been forming.


Disclosure: Long BIDU, PHM Puts; Long NatGas/Short Crude; Short NDX Futures

Great Expectations

As I mentioned on yesterday's post, the data for existing home sales today showed further meltdown in the housing market. However, the drop in sales was small compared to expectations and forecasts. The market took this to mean some sort of stabilization in housing sales and real estate stocks rallied hard. But I do not buy this rally. We took this opportunity to build up our short position in PHM (Pulte Homes, Inc). Furthermore, we decided to hedge our long gold futures position by shorting a basket of gold stocks (NEM, AU, ABX). This hedge is supported further by a potential head and shoulders forming in gold stocks.

BIDU will be releasing its earnings tomorrow after the market closes, and I expect it to test the completion of a potential descending triangle. Today AMZN took a big hit due to poor earnings and I don't think the outlook for BIDU looks any brighter.


Disclosure: Long Gold Futures/Short NEM, AU, ABX; Long NatGas Futures/Short Crude Futures; Short BIDU

Will The Rally Continue?

Today we saw a sharp rally in all indices, while shorts scrambled to cover...boosting the rally further into the late afternoon. Of course, sharp rallies are not unusual during beark markets. But considering the overwhelmingly bearish sentiment within the mainstream, we take this as a contrarian indicator of a continued rally in equities. Therefore we have closed our shorts and will remain on the sidelines until further confirmation. Meanwhile, we expect oil producers to come out with strong earnings in the coming weeks due to the price of crude which hovered above $70 throughout this year. As for tomorrow's data, BP will be reporting its earnings and we are long BP calls. Furthermore, data on consumer confidence and existing housing sales will be released tomorrow. We expect both data to reflect the lagging drag of the Fed rate hikes, and we also expect the data to show further slowdown in the housing market. PHM has been forming a descending triangle, which is a continuation pattern of a downtrend. We took today's massive rally as an opportunity to build a short position. The falling volume indicates the near completion of the pattern and we expect PHM to break below $26 accompanied by heavy volume.

Disclosure: Long MSFT (Stop revised to $23.7), Long BP Calls, Long PHM Puts

Weekly wrap-up 7-21-06

This week saw a lot of action and clowns jumping up and down on CNBC with Wednesday’s “Fed-is-done” rally. Commentators took Bernanke’s claim that the FOMC expects moderating growth to contain inflation as a confirmation that inflation is under control and the interest rate outlook is benign, a view we do not endorse. Investors may have realized that slowing growth implies slowing earnings – so although second quarter earnings have been largely in-line with and even exceeding expectations, stocks were broadly not rewarded. We wonder how many of these “Fed-is-done” rallies are left… but would not be surprised to see more and more sharp rallies as this bear market really takes hold. We saw Wednesday’s action as a short-covering rally, motivated by the fears of short-sellers of missing the next leg up, perhaps triggered by Bernanke’s new seemingly dovish stance. The fact that buyers failed to materialize, as evidenced by the various indices surrendering most of Wednesday's gains, confirmed our view. The higher-than-expected core CPI number and the growing signs that Israel plans a full-scale invasion of Lebanon were mostly ignored.

The outlook for gold and silver this week is sunny with a chance of rain. We look for rallies off forming trendlines to confirm their importance. If those rallies successfully penetrate some resistance overhead, we look to get long these metals again. If no rally is mounted, however, we expect trading down to support and possibly 200-day moving averages. If those levels are seen we will be aggressive buyers. For now we are on the sidelines.


The Nasdaq 100 crumbled some more this week as tech industry bellwethers INTC, DELL, and AMD saw their stocks trampled, countering the mid-week rally that saw a test of 1500 above. In bear markets, oversold conditions are the norm, so the low RSI does not bother us that much. Excusing sharp intermittent rallies like the one we saw on Wednesday (which we used as an opportunity to add to our short), we expect the NDX to continue disintegrating for a test of 1400, and ultimately 1300. The SOX semiconductor index hit new lows, violently. We remain short NDX, and look to add to our position on large rallies.



We noted that copper has failed to make new highs on its latest rally. It is now below its 50-day MA again, which previously provided support. The 200-day MA remains far below. Our growing bearishness on copper, coupled with the PD chart, motivates our desire to sell rallies in that stock.

Important Earnings Tomorrow (7/20)

Today (7/19) the markets bounced back much stronger than I anticipated yesterday. This is because the market decided to pop the champagne cork to Bernanke's testimony today. Even though the core CPI came out higher than expected, Bernanke commented that he expects inflation to retreat due to a slow-down in the economy. It seems like the current upward bias in the market welcomed Bernanke's comment on moderating inflation, but missed out on why that may be: a recession? The Dow is near its 50-day MA and I don't expect it to break above that resistance. With major earnings being released tomorrow (Ford, Google, Pfizer, Microsoft...), it will be interesting to see whether equities will continue their rally. Looking at Microsoft, I expect tomorrow's earnings (after market close) to help confirm whether there is a head and shoulders bottom. Strong earnings and a break above the neckline would be a confirmation, and it should be accompanied by heavy volume. But given the current bear market, there is a chance that it may turn out to be a failed head and shoulders.

Rec: Long MSFT (Stop at 22.2)

MC Hammer

As trading began this morning, equities continued to bleed from yesterday's plunge. But as I mentioned yesterday, most indices are near very important long term trend lines, so it seemed too much to ask for the market to continue its relentless dive - a breather seemed to be in order. Then surprisingly (or I guess not so surprisingly), the markets started turning green around 2pm and managed to close above their open. Consumer staples (food, beverages, tobacco...) and non-cyclicals led today's afternoon rally. But, the H/L differentials of each index depicts continued interior weakness in the market, despite what the averages said today. The Nasdaq, for example, made only 28 new highs compared to 251 new lows today. However, I cannot ignore the hammer that formed today for NDX, and thus cannot rule out a mild bounce (although a similar hammer back in June turned out to be a false signal). Moreover, I expect the Dow to rebound as well from its support level (tested today) of 10700. However, looking at the very weak volume for the Dow today, I am not sure how strong the rebound may be. Moreover, there will be important data released tomorrow such as the core CPI and Bernanke's testimony at Congress that may depress many assets. Finally, I checked out the chart for Google and found that it made an Evening Doji Star (bearish reversal pattern, but based on weekly candlesticks) earlier this month. Moreover, it is very clear that the uptrend from the 340 level in March has not been supported by strong volume. Instead, a descending triangle has been forming (volume heavier on the downside and lighter on the upside), and while the descending triangle is a continuation pattern usually found at downtrends, they can also be found at market tops signalling a reversal. I can't see Goolge holding its 400 level for long (by the end of the week), and we may easily see a drop back to 340 or even 275 in the coming weeks. This breakout to the downside should be accompanied by heavy volume.

Rec: Short GOOG (Stop at 400)

Testing the Trends

This week will be a major test for the long term trend for the Dow, S&P, and Nasdaq. There will be key economic data released this week, such as the core CPI and housing starts. Moreover, Bernanke will be addressing Congress on Wednesday, and he will most likely explain his interpretation of the latest inflation figures. As the Fed made clear that they will be more data driven, this week's hearing at Capitol Hill and data release will be pivotal to guage how the Fed may move in August. As for today's broad selling in PM, it confirmed short-term technical weakness. Silver has failed to break above both its resistance level of 11.8 and the 50-day MA for over two weeks. Assuming a mild correcting for PM is in progress, silver, as with gold, will probably slide back down to the 200-day MA. Hopefully this is when I will get back into PM. Note: Tomorrow, look out for earnings from Coca-Cola and Intel as the market will probably react sensitively to their releases.

Bounce

As morning trading began today, it seemed like the broad selling in Asia and Europe was going to continue into the U.S. market. The bulls kicked in, however, late afternoon to enable the major indices to close in the green. The NDX failed to break below its support level, and the Dow maintained its short-term uptrend line. But all this could very well turn out to be noise as we head into earnings season. As for tomorrow, there are no major earnings release but the government will be reporting on the past week's crude inventory and the trade balance for the month of May. I am not sure how equities will react to tomorrow's data, but gold and silver are likely to use tomorrow's data to test their resistance levels. Note the bounce of gold and silver off the 200-day MA, compared to the Dow's diving plunge...

P.S.

While people are still finger pointing at Zidane for France's lost, I still believe that he is one of the greatest football players of our era. He should have received a yellow card, just like Figo did after he similarly headbutted a Dutch player.

Tech Weakness

Today (Mon. 7/10), the short-term trend line for NDX (Nasdaq 100) was broken. NDX closed just above last month's low of 1516. With earnings reports due, it wil be interesting to see whether NDX holds its current support level, which also marked the start of a major rally in October 2005. This week we could see a mild bounce off this level, but weak earnings can very well cause a break below, indicating a strong bear signal.

Sweet Crude

As the price of crude started cooling off from its post-Katrina high of $70, many people predicted crude to sink below $50. Indeed crude briefly fell below $60, but as we predicted at the end of last year, crude has climbed back above $70. Subsequently, the $70 level has become a very strong support for crude. While other assets, including precious metals, went under steep correction, crude remained resilient, consolidating within a tight range between $69 and $75. This week, as the Fed storm cleared away, crude is back to challenging $75. Until the next August FOMC meeting, at least, we expect crude to break out of its current range (maybe even beginning next week) and find a new high. We expect the ever-present global political fear and high summer demands to support crude's strength in the coming months. Clearly, the long-term trend in crude is still very much intact, bouncing off the 200-day MA.

Divergence

Since the broad correction across all assets began in mid-May, precious metals and equities have been moving in unison. Despite the traditional negative correlation between PM and equities, uncertainty of the Fed's interest rate decisions and fear of liquidity drainage affected both assets equally. As PM investors, we have been looking for indications that signal a break from this trend. The first indication came when PM stocks led the rally in response to the Fed's dovish meeting in 6/29. As Wall Street begins talking about the Fed game being over, we expect PM to stop being dragged by broad selling and buying in equities. Of course, we don't expect there to be perfect negative correlation between PM and equities. But today marked the first day since May when PM rallied against a poor performance in equities. Indeed, today's PM rally was supported by the missile launching of North Korea and a rally in crude oil past $75. But the importance of today's divergence lies in our expectation that the froth in PM has been cleared, setting the stage for a new uptrend.

As for technicals, gold is near a resistance level at $640, so a break above that level this week would be a strong buy signal. As for silver, we see a resistance at $11.5-$11.75 and we expect silver to rally quickly from it's current $11.4 and test its resistance level. If both metals fail to break their resistance, we could see a pull back to $580 and $11 respectively. As for equities, we continue to see whether the Nasdaq will break above the resistance level of 2200-2225. We expect economic data to begin showing clearer signs of stagflation in the economy (high energy costs, lagging wages, weak (and yes, even strong) employment, debt, housing meltdown...), so even though equities may break its immediate resistance levels, we don't expect them to make a new high past April's high. Again, we will keep our eyes on how PM and equities each react to future data. As for tomorrow, we expect a mild bounce in equities (as investors perhaps realize the empty threat of the "Type-Of-Dung" missile), and a continued rally in PM.

Prudent Observer Suggested Trade (POST)

It has been a while since our last entry. As part of our comeback, we decided to start a new series called POST (Prudent Observer Suggested Trade). We initially began testing our investment ideas by building a small index back in November of last year. POMP (Prudent Observer Model Portfolio) has returned more than 130% over the past 5 months. The purpose of POST, however, is to test our trade ideas in a more short/mid-term and leveraged setting. Our goal is to manage a small list of trades through a paper trading account, and to update their performance on a regular basis (MWF). More trades will be added to this list.

- Silver/Gold
- Short-Term Silver/Long-Term Silver
- Nikkei/JGB
- GE/GOOG
- Bottom 10% P/E in S&P 500/Top 10% P/E in S&P 500

(Note: the unit size of each trade represents a suggested ratio for each pair of contracts)

1. The Core: Long Silver Futures (+3 ZI APR06), Short Gold Futures (-2 ZG APR06)

Here we want to take advantage of silver's relationship with gold. Historically, the ratio between the spot price of silver and gold has been 1:15. Right now this ratio is at 1:55, so silver has a lot of catching up to do. Moreover, the silver market is about 7 times smaller than the gold market, so any bullish sentiment in precious metals is likely to have a greater impact on silver prices. As for the specifics of the trade (silver bias), we are long 3 silver futures and short 2 gold futures. Although the two metals provide a natural hedge for each other, this is not true all the time. As evident last Friday when gold futures rallied a whopping 1.8% while silver futures gained only 0.5%, a proper stop on both ends of the trade is necessary. For now, we have a stop on long-silver at 10.610, and a stop on short-gold at 562.70. Note: The official launch of the silver ETF will be a crucial point for this trade. According to our view in Quicksilver below, we will temporarily close this trade or even temporarily reverse it once the ETF begins trading.

2. Quicksilver: Long Short-Term Silver Futures (+1 ZI JUL06), Short Long-Term Silver Futures (-1 ZI JUL07)

Now that the Silver ETF is a 90% reality, we expect the silver market to react by moving from a contango market to a backwardation market, where the price of futures contracts is less than the current spot price. The reasoning here is that the silver market has been tightening up due to the expectation of the silver ETF (contango market), and that once the ETF begins trading the silver market will loosen up due to realized expectations (backwardation market). We are assuming that the silver ETF will begin trading before the end of this year. We are not so sure whether a stop is necessary for this particular trade. We will decide on possible stops once we have a chance to monitor this trade.

3. Sushi Roll: Long Nikkei Futures (+1 NIY APR06), Short JGB Futures (-5 SJB JUN06)

Japan has finally been picking up some momentum. Consequently, the BOJ believes that the Japanese economy no longer requires "quantitative easing." We believe that much of this monetary easing in the past two decades has been trapped in the Japanese bond market, where 10-year JGB's have been yielding a mere 1%. We expect the BOJ, however, to raise rates by very predictable baby steps, so we do not necessarily see a downturn in Japanese equities (similar to US equities during recent rate hikes). Instead, we expect a transfer of liquidity from JGB's to Japanese stocks. As for the specifics of the trade, we are long 1 Nikkei 225 futures and short 5 JGB mini futures (Singapore Futures Exchange). This trade is denominated in JPY in order to take advantage of a potentially decpreciating USD against the JPY over the long run.

4. G Money: Long GE (+10), Short Google (-1)

The reason here is simple. In an inflationary market, especially when the Fed is trying to recoil the market for yet another reflation, it is crucial to hold cheap stocks and dump expensive stocks. GE currently has a P/E of 22, while Google has a P/E of 73. GE has strong tangible assets with a patent portfolio life of over 20 years, while Google relies on advertisement revenue based on free products on the Internet that merely improve upon other freely available products (i.e. very weak assets).

5. Lava Lamp: Long Bottom 10% P/E in S&P 500, Short Top 10% P/E in S&P 500

The reasoning behind this trade is simliar to G Money - hold cheap stocks and dump expensive stocks. We are long a basket of 10% of S&P 500 stocks with the lowest P/E, and short a basket of 10% of S&P 500 stocks with the highest P/E. Our view is that over the course of several rate hikes and the subsequest reflation by the Fed, the cheaper stocks will appreciate while the more expensive stocks will depcreciate in value. More details on this trade will be updated once we are able to properly monitor its performance.