Market Commentary - 7.20.2008

Once again government intervention was the catalyst for the latest rally –1) government officials and the Fed announced a backstop plan in case of Freddie Mac or Fannie Mae should need emergency capital, 2) Securities regulators have banned “naked” short selling on shares of 19 of the financial companies whose stocks have seen the worst deterioration this year, as well as investigating if hedge funds and broker dealers were responsible for spreading rumors about Bear Stearns, Lehman Brothers, etc. Whether or not naked short selling and rumor-mongers were responsible for plunging share prices, the government actions certainly had the desired effects. Short covering began in earnest on Wednesday morning, and almost every financial institution regardless of their condition saw double digit gains. After earnings reports which showed huge losses, write-downs, and credit loss reserves, the banks continued their rally through the end of the week as investors were once again hopeful that the worst is behind us.

The biggest news of the week was the plunge in oil prices – US inventories were higher than expected and there are worrying signs of a global growth slowdown which is driving down demand. Oil prices were down over $15 dollars on the week, and energy stocks were absolutely pummeled, with many wiping out all of their gains from 2008 in just a few weeks. Only time will tell if this is just a much-needed pullback in the context of a still robust bull market for crude oil, or whether we have seen the top – either way, expect the volatility in energy prices to continue for the rest of this year.

Besides financial companies, the biggest winners for the week were the most heavily shorted and beaten down shares – homebuilders, transportation, and consumer discretionary companies – it was a combination of a relief rally and short covering in response to the large drop in oil prices. As has been the case with the last 2 counter-trend rallies in late January and mid-March, expect these sectors to the lead a new rally over the next month or so.

So where are we in the scheme of things? If we look at the S&P 500, the latest downtrend lasted roughly 240 points – from 1440 to 1200 – we wouldn’t be surprised to see a sharp and relatively short-lived rally into August that will retrace roughly half of this decline, or to around the 1315-1330 area. All of the “tells” that were in place in the end of January and mid-March such as sentiment levels, the VIX spike we saw, and bullish divergence on technicals, along with an extreme amount of short interest which needs to be covered, suggest a good chance of this rally. Technology and small-caps have shown relative strength all year, and we expect that to continue, so look for the Russell 2000 and Nasdaq to outperform the Dow and S&P 500.

Earnings

This week picks right where we left off, with big names in banking, tech, healthcare, and transportation all reporting on Monday. As long as there are no big downside surprises, we expect investors to start buying again in earnest as the companies that have been beaten down the most will most likely be the biggest beneficiaries.

MONDAY – American Express (AXP), Apple (AAPL), Bank of America (BAC), Boston Scientific (BSX), Canadian National Railway (CNI), Merck (MRK), Schering Plough (SCG), Texas Instruments (TXI), Weatherford Int’l (WFT)

TUESDAY – Baker Hughes (BHI), Biogen (BIIB), Caterpillar (CAT), Chicago Mercantile Exchange (CME), DuPont (DD), Fifth Third Bancorp (FITB), Freeport McMoran (FCX), Haliburton (HAL), Intuitive Surgical (ISRG), Lockheed Martin (LMT), SunTrust Banks (STI), United Parcel Service (UPS), United Health Group (UNH), Wachovia Bank (WB), Washington Mutual (WM), Yahoo (YHOO)

WEDNESDAY – Allstate (ALL), Aflac (AFL), Alcon (ACL), Amazon (AMZN), AT&T (T), Boeing (BA), Conoco Phillips (COP), EMC Corp (EMC), General Dynamics (GD), Genzyme (GENZ), GlaxoSmithKline (GSK), McDonald’s (MCD), New York Times (NYT), PepsiCo (PEP), Pfizer (PFE), Phillip Morris (PM), Qualcomm (QCOM), SLM Corp (SLM), Travelers (TRV), Wyeth (WYE)

THURSDAY – 3M (MMM), Bristol-Myers Squibb (BMY), Burlington Northern Santa Fe (BNI), Canon (CAJ), Celgene (CELG), Credit Suisse Group (CS), Dow Chemical (DOW), Eli Lily (LLY), Ford Motor (F), Juniper Networks (JNPR), Kimberly Clark (KMB), Occidental Petroleum (OXY), Potash (POT), Raytheon (RTN), Southwest Air (LUV), Suncor Energy (SU), Union Pacific (UNP), Wynn Resorts (WYNN), Xerox (XRX)

FRIDAY – Arch Coal (ACI), Black & Decker (BDK), Ceradyne (CRDN), Coventry Health (CVH), Fortune Brands (FO), Honda Motor (HMC), ITT Corp (ITT), Legg Mason (LM), Netflix (NFLX), T. Rowe Price (TROW)

Economic Data

The calendar is pretty dead this week, and the only data that will really move the markets is crude inventories.

MONDAY – Leading Indicators (June)

WEDNESDAY – Crude Inventories, Fed Beige Book

THURSDAY – Weekly Unemployment Claims, Existing Home Sales

FRIDAY – Durable Goods Orders, New Home Sales, Michigan Consumer Sentiment

Strategy/Outlook

Last week, we talked about crucial support levels on the Dow (11700) and S&P 500 (1170) that were we were approaching – we nearly got there – 11827 and 1200 – before government intervention stopped the downtrend dead in its tracks. We believe that was the low for the downtrend, and we will see a sharp rally over the next month or two which should retrace roughly half of the decline we saw since May. However, we need to see some follow through as options expiration Friday showed lackluster action. Also, the rally wasn’t really broad-based, as besides the extremely beaten down sectors there wasn’t a lot of participation.

With that being said, we still believe any sharp rally should be sold into – there are a large amount of stocks which broke long-term support levels and are set up for much better entries on the short side upon a retest than trying to find a bottom. This week will be very telling as far as what the near term holds, as there has been a lot of sector rotation as energy positions are sold and investors find new trades on the long side. If the S&P can get close over the 1275-1280 area this bounce is for real and we’ll likely see the 1315-1330 range. However, if this rally has no follow through we could see some range-bound trading for the next few weeks.

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