06-28-07: Market Fundamental Analysis: What is happening?

This is the first blog entry for the fundamental analysis.   I am definitely not the expect in this area.   However, my frien Eric is great at it.    Yesterday, I asked him what he thought was going on in the market.   Here is what he wrote

You’re right, the past two (at least) releases of the Fed statement served as a trigger, firing the markets up.  That could happen Thursday at 2:15, but Wednesday’s move stole some of that thunder.  Wednesday’s action was in part due to a major sell-off in the futures after the close of the cash index Tuesday. Tuesday’s S&P 500 went out 4.85 down for the day, but the futures closing just 15 minutes later were down 15.8.  It put in a bottom and set the stage for the reversal, and made for an interesting open Wednesday.
The last two days of June tend to be strong in the S&P 500, with quarter end window dressing, on top of the last good month for the Turn-of-the-Month (TotM) effect until November. http://www.cxoadvisory.com/blog/internal/blog8-24-06/ , however, the first trading day of July is the third weakest of the 12 months, according to Trader’s Almanac.
Tuesday is a short trading day, Wednesday we’re closed and day after the fourth of July tends to be bearish in the S&P 500.  I wouldn’t expect month end gains to hold.
Wednesday was an outside reversal day up in “candle speak”, but we saw lower lows (by definition) and the S&P 500 failed to regain its 50-day moving average on the cash index, currently at 1507.91.  This had the feeling of bouncing off support. I wouldn’t call it a dead cat, just yet, but something of lower impact, perhaps a sleeping squirrel bounce…
The S&P 500 just completed a bearish intermediate-term formation, what Robert Deel calls a Type II Double Top, and what AJ Monte calls “The Kiss of Death” where we saw lower highs from June 4 at 1557.70 on the Sep future, to June 15 at 1553.90.  We also saw lower lows completed yesterday at 1494.80 breaking below the June 7 low of 1502.  That’s the lowest low since April.
In addition to that, the weekly suggests a pullback as we’ve become very far extended from longer term moving averages, like the 12-month.  The cash index is trading below the 50-day MA which has flattened, and the 20-day MA has rolled over to a negative slope, but not yet crossed the 50-day line.
Implied volatility or option premium as measured by the VIX and VXO made new highs at the open today 18.98 and then trended down all day going out at 15.53, while actual historical volatility as measured by the Average True Range or 20-day statistical has made new highs. These two volatilities have converged, and when statistical vol exceeds implied vol, that can set the stage for a run-up.
All this tells me that we’re range trading, that we reached the bottom of the range and will now move back up to retest 1535 on the cash over the next few days and as early as Thursday on the futures.  As we get to the end of next week, earnings season will be upon us.
Fundamentally, the economy is not poised to spring higher, instead corporate earnings growth are decelerating, and are primarily a function of share buybacks, inflation and currency conversion for global companies. None of those add to on-going operating earnings growth, though they do count in EPS touted by companies.  The Yen hit a wall at 125 to the dollar, and has been strengthening, which unwinds the carry trade and is generally bad for US equities.
Final Q1 GDP comes out Thursday at 8:30am before the bell and unless it is flat or a negative number, is already baked in the cake.  Consensus is 0.8% final, with a range of 0.5% to 1.0%Preliminary Q1 was 1.3% growth, revised down to 0.6% growth.  While I don’t accept government statistics (if the Justice Dept was politicized, then the statisticians probably are too), rumor has it that the Federal Open Market Committee, a collection of the nations’ bankers, pays attention to their preferred inflation measurement, the “core PCE deflator”, looking to keep that under 2% annual rate.  Core PCE is NOT inflation, but a proxy for it.  Anybody that buys food or uses energy, pays taxes or needs healthcare, education, insurance or services knows that actual inflation is much higher.  However, core PCE adjustments or GDP could also set off the markets higher if they are above consensus.  Just triggers, not causes.  
The Fed announcement could surprise, as expectations are for no change, but credit worries are spreading as the market has done the Fed’s job for it and raised rates- yield curve is no longer inverted, the 10-year note yield gaining 68 basis points in a four-week period. 
From assurances that non-performing sub-prime loans wouldn’t spread beyond the companies that offer them (Novastar, New Century, Corrus, Countrywide were wonderful shorts) we see that the entire banking sector($BKX) could join homebuilders and auto companies adding to the roster of zombie (living dead) companies and their stocks.  Now we hear assurances that “there is no contagion- sub-prime loans aren’t affecting the greater economy”.  Give it time.  I hear Bear Stearns is having a sale on their High-Grade Structured Credit Strategies Enhanced Leveraged Fund and that all serious offers will be considered.  Repricing these Collaterallized Debt Obligations is likely to be this decades Savings and Loan debacle, or more familiarly, like the aftermath of giving car keys and alcohol to inmates and turning ’em loose in the parking lot.
Airlines and steakhouses are in downtrends. Transports are sideways.  The long term energy outlook is grim and it’s power outage season.  Producer Prices are up huge this year, with two months coming in with 10% plus annualized rates..
This week marked the third Monday in a row without major PE/M&A (we used to call both of those “Leveraged Buy Outs” – LBOs) activity announced, which had taken shares off market and provided an underlying ask to shares of many troubled companies.
Long story short (too late!) I was a seller of cheap far OTM puts Wednesday and a buyer of fewer longer term ATM puts later in the day, for net credit.  That’s because I expect the S&P 500 to perhaps retest the top of its range, and then come to grips with deteriorating fundamentals, and always want to be paid for my positions… 
Q2 Earnings expectations have been guided low enough to be surpassed, but summer sometimes has some nasty surprises in store for the market.  It would be wonderful if the worst was behind us, and it was ever upward from the double bottom just put in, but I’m a skeptic, and a cynical one as well. 
We could see the market breakdown below the support shown today, but unless the data or the Fed, or the aforementioned nasty surprise arrive, I think it will trade back up in its range and then start looking for corporate earnings to support a new up leg, which I wouldn’t trust, suspecting a bull trap that may take until November to play out.  A few more hedge fund blow ups or other unexpected party crashers could have us test 1463 on the cash index and after that 1425. 
-Eric H”

About the Author Manesh Patel