Weekly Market Summary

Considering the action in the markets this week, it seems appropriate to take a look back at the week to see what happened.

Here's a 5 minute chart that goes back 5 days. Notice the action for the whole week was down.



Here's a 2 day chart. Notice the end of the day sell-off on Friday (today). This shouldn't be surprising. Considering this week's action, no one wants to hold a position over the weekend.



Here's the 3 month chart of the SPYs. Yesterday I noted that a drop to the 200 day moving average would be a drop of about 2%. This would make the total point drop for this sell-off about 10 points (roughly 155 - 145) or a total of 6.45%. This would be considered well-withing the range of a standard market correction.



Let's take a look at the 2 year chart to see how the SPYs have performed when they previously approached the 200 day SMA. Notice it's been awhile since the average was here. Late October 2006 and June July 2006. However, the markets traded around the average for about a month and then rallied.

However, note the increased volume 1.) during the latest rally, and 2.) during the latest top. We could be seeing a selling climax right now, followed by some down time for the average.



There are a couple of problem areas that we're going to look at.

The IWNs (Russell 2000/small cap) are clearly dropping.



People are still bolting from the financials.

Second Quarter GDP Up 3.4%

From the BEA:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 3.4 percent in the second quarter of 2007, according to advance estimates released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 0.6 percent.

The Bureau emphasized that the second-quarter "advance" estimates are based on source data that are incomplete or subject to further revision by the source agency (see the box on page 3). The second-quarter "preliminary" estimates, based on more comprehensive data, will be released on August 30, 2007.

From Bloomberg:

The U.S. economy grew last quarter at the fastest pace in more than a year, propelled by rising exports, commercial construction and government spending.

The 3.4 percent annual pace of expansion followed a 0.6 percent gain in the first quarter, the Commerce Department reported today in Washington. The Federal Reserve's preferred inflation gauge rose at the slowest pace in four years.

Spending on commercial construction projects rose at the fastest pace in 13 years, helping to overcome another drop in homebuilding. Factories ramped up production to fill orders from Europe and Asia that made up for a slowdown in consumer spending. Smaller price increases may be of some comfort to Fed policy makers, who have said inflation is their biggest concern.

From CBS.Marketwatch:

After hitting a pothole in the first quarter, the U.S. economy rebounded in the second quarter, growing at an annual rate of 3.4%, the fastest pace since the first quarter of 2006, the Commerce Department said Friday.

The increase in real gross domestic product was slightly below market expectations for a gain of 3.6%, according to a survey of economists conducted by MarketWatch. See Economic Calendar.

GDP rose just 0.6% in the first quarter.

Let's go a bit deeper into the numbers.

Personal Consumption Expenditures Increased at a seasonally adjusted annual rate (SAAR) of 1.3%. This is the lowest quarterly increase since the fourth quarter of 2005. Consumer purchases decreased across the board -- durable goods, non-durable goods and services. Considering that 70% of U.S. growth comes from consumer spending, this is not a welcome development.

Residential investment decrease 9.3% SAAR. The previous four quarters came in at decreases of 11%, 20%, 16% and 17%. That makes this quarters number a bit of an increase from the previous 4 quarters. Considering the news from the housing sector, I have to wonder if this slower rate of decrease in investment will continue.

Non-residential construction increased at a 22.1% SAAR. This is the biggest increase we have seen this expansion. That means it may be a one time affair. Companies may have decided to make one last push on investment before they shuttered projects for the next few quarters. Whatever the actual reason, this pace is probably unsustainable.

Exports increased 6.4%. Thank-you cheap dollar.

Government spending increased 4.2%.

I think the best way to look at this report comes from CBS. Marketwatch:

Economists said the weakness in the first quarter and the subsequent strength in the second quarter are both overstated, and the best way to understand the economy was to average the growth rate over the past six months. This produces a 2.0% average growth rate in the first half of the year.

What the Hell Happened Today?

Wow -- the trading day is over and it was very bad for the SPYs. Let's take a look at the charts to ses what happened.

Here's a chart of the SPY in 5 minute increments going back 7 days. Notice the market tried to make new highs several times and couldn't cross the thresh hold. Also note the SPYs went through the previous support level and went down quickly from there.



Here's a 5 minute chart going back two days to see today's action in more detail. Notice the average dropped for most of the day. There were simply no buyers in the market until right before 2 PM



Here's the SPYs daily chart. Note there were two previous selling periods in the last 3 months. The first occurred in late May/early June and the second occurred in mid-June. This indicates there has been an underlying skittishness to the markets for awhile.

Note we are still in bull market territory because we are over the 200 SMA. Also note he have about 2% more to go before we hit the 200 day SMA. If the average hits 145, then the correction will be about 6.5%. This would be a standard market correction.

Finally, note the incredibly high action on today's selling. Lots of people were heading for the doors. In the long run, this is a good thing because it clears out the dead wood in the market. Short term, however, it's obviously very painful.



Here are two culprits. The first is the financial sector, which is basically in free fall right now. Investors are concerned about the debt markets. The CDO/CLO markets have gotten hammered lately. However, there is also concern about the health of the LBO market. The Chrysler deal may not go through. Overall financing for the recently announced LBOs is coming into question. Countrywide Financial's latest earnings announcement certainly didn't help. And the ongoing weakness in the housing sector is increasing the concerns related to foreclosures.

Note the average is below the 200 day SMA and the latest volume has been incredibly heavy.



Finally, here is the IWNs -- a proxy for the Russell 2000. Investors are clearly getting out of the small cap game right now.



So -- what does this mean?

1.) The market is clearly correcting. That's a no brainer.

2.) The market sold-off about 5.5% in late February/early March after the China market sell-off. We're 1% below that level right now, so there may be some more downside room.

3.) There are a lot of questions about the health of the financial industry right now. Until those questions are resolved, the markets will be nervous.

4.) There have been some earnings concerns. Exxon's slight drop did not help. However, there have also been some good numbers as well.

5.) Tomorrow's GDP report is now doubly important to the bulls.

Markets Having a Terrible, Horrible, No Good, Very Bad Day

As of this writing, the SPYs are down 2.36% and the IWNs are down 3.14%. By my rough calculation we're down about 4% for the week.

I'll have a market wrap after the close.

New Home Sales Drop 6.6%

Here's a link to the Census report.

From Bloomberg:

Purchases of new homes in the U.S. dropped more than forecast in June, signaling no end to the real- estate slump that's weakened the economy.

Sales fell 6.6 percent, the most since January, to an annual pace of 834,000 last month from a revised 893,000 rate the prior month that was less than previously estimated, the Commerce Department said today in Washington.

Builders may have to cut prices even more and sweeten incentives to turn sales around and trim bloated inventories. Rising mortgage rates and stricter rules to qualify subprime borrowers with poor credit histories will extend the worst housing slump in 16 years and continue to slow growth.

``The subprime debacle is definitely hurting,'' said Zoltan Pozsar, senior economist at Moody's Economy.com in West Chester, Pennsylvania, whose forecast matched the lowest at 850,000. ``This points to further construction drag on growth.''

The South -- which is the biggest region -- saw an increase of 7.6%. This was the only region with good news. The Midwest dropped 17.1%, the West dropped 22.5% and the NE dropped 27.1%. The number of new houses for sale remained the same, but the months supply increased to 7.8%.

These are really big drops and they indicate the correction may be accelerating.

The short version is simple: this report stinks. It confirms all of the bad earnings reports we have been getting from the homebuilders. It also indicates the credit tightening we have been hearing about is probably taking effect and tightening demand.

Ryland Homes, DR Horton and Pulte Post Big Losses

From the Street.com

Pulte reported a second-quarter loss of $507.5 million, or $2.01 a share, compared with profit of $243 million, or 94 cents a share, a year earlier. The loss was in line with the company's projection last week of $2 to $2.10 per share.

...

Elsewhere, Ryland posted a loss of $52.4 million, or $1.25 a share, compared with profit of $94.8 million, or $2.03 a share, a year earlier.

From CNBC

D.R. Horton Inc. said Wednesday it posted a deep loss in the fiscal third quarter as the homebuilder recorded one of the largest charges to date to write down the value of unsold inventory.

The Fort Worth, Texas, company posted a loss of $823.8 million, or $2.62 per share, in the period ended June 30, compared with year-earlier net income of $292.8 million, or 93 cents per share.

The most recent quarter included pretax charges of $835.8 million for inventory impairment and $16.2 million to forfeit deposits on land. Horton said the quarter also included a goodwill impairment charge of $425.6 million.

Raise your hand if you're surprised. Me neither.

Fed Releases Beige Book

Here's a link to the whole report

From the WSJ:

The overall economy continued to expand at a moderate pace in the past six weeks, say reports compiled by the 12 regional Fed banks. The Fed typically releases the anecdotal reports, known as its "beige book," two weeks before its policy makers meet to consider interest rates.

In an apparent reaction to the housing slump and rising energy prices, consumer spending rose at only a moderate pace in June and July. Many regions indicated retail sales were below expectations. Five of the 12 said sales of housing-related items, such as furniture or home-repair supplies, were weak or declining.

Here are some key points from the report:

On balance, consumer spending rose at a modest pace, although a number of Districts indicated that sales were mixed or below expectations Cleveland, Chicago, St. Louis, and Minneapolis all shared the general assessment that consumer spending rose modestly, while Philadelphia said retail sales growth was quite strong in May but "closer to trend" in June. New York, Atlanta, Kansas City, and Dallas reported sales as flat and/or below expectations. The remaining regions described sales as mixed

This is not the most glowing statement of consumer spending. It seems the housing slowdown and rising gas and food prices are starting to take a toll on discretionary purchases.

Most Districts said that residential construction and real estate activity continued to decline on balance. Many Districts, however, noted increased activity in some individual market locales or segments.

....

Commercial construction and real estate markets were generally more active than during the previous reporting period.

Over the last year, we've seen commercial/nonresidential construction spending increase. Now this makes up the largest portion of total construction spending. In his Congressional testimony, Bernanke stated residential construction workers had shifted to commercial projects, which explains why construction employment hasn't decreased.

Most District reports indicated that manufacturing activity continued to expand during June and early July.

....

In most Districts, the increases in demand for factory goods were spread across a number of industries.

This jibes with what the industrial production and various Federal Reserve District manufacturing reports have been saying.

Contacts generally reported ongoing input cost pressures, particularly for petroleum-related inputs, while prices at the retail level continued to increase at a moderate rate. Notable exceptions were the Richmond District, which reported faster rates of price increases as local businesses passed along higher input costs, and the Kansas City region, which experienced an easing in overall price pressures. Almost every region said that oil and gasoline prices were either rising, high, or "an issue."

For an organization that focuses on core inflation, the Fed seems to talk an awful lot about energy inflation.

Short version: consumer spending could be an issue in the upcoming GDP report.

Back Up And Running

Hey all --

I had a technical meltdown with Google. They have these things called robots that search the web looking for Spam web sites. They thought I was one, but I guess I'm not.

So, I'm back. Sorry for being away.

A

Debt Market Update

From Bloomberg:

The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners.

Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $3.7 billion in the U.S. this month from $42 billion in June, analysts at New York-based JPMorgan Chase & Co. said yesterday. The market is ``virtually shut,'' the bank said in a July 13 report.

Investors are shunning CDOs after the near-collapse of two hedge funds run by Bear Stearns Cos. that owned the securities. Standard & Poor's downgraded bonds from 75 CDOs as mortgages to people with poor credit defaulted at record rates. Concern about losses on home loans are rattling investors across the credit spectrum.

This slowdown shouldn't surprise anyone. Bear Stearns announced a hedge fund the invested primarily in CDOs and CLOs was essentially worthless. That's enough to get anyone's attention and force a reevaluation of the market.

And other deals are hitting snags:

Allison Transmission, a highly profitable unit of General Motors Corp. based in Speedway, Ind., has gotten stuck in a traffic jam in the debt-financing market.

Wall Street firms postponed a sale of $3.1 billion in loans that would pay for the leveraged buyout of Allison by private-equity firms, said a person familiar with the matter. While the sale of Allison to Carlyle Group LP and Onex Corp. is highly likely to proceed, the trouble raising debt from investors complicates matters for the company and its bankers.

The snag reflects difficult conditions in the market for risky corporate loans and bonds and raises questions about the prospects of other buyout-related debt financings that need to be completed this summer. That includes a $20 billion loan deal for Chrysler Group. Cerberus Capital Management has agreed to buy a majority stake in the auto maker from DaimlerChrysler AG.

While I don't think this mess will blow over, I do think it is overdone. The basic structure of CDOs -- that is grouping assets into a pool and then dividing the unerlying risk across various bonds -- has been around for about 15-20 years. Here's a brief refresher on how this works.

The basic premise of these investments is simple: pool a group of similar assets to diversity the risk and then parcel out the risk to separate investments carved from the pool. Let's create a simple hypothetical deal to explain this concept. We'll start with a $100,000, 30-year five percent mortgage. After the mortgage closes -- that is, after the borrower and lender have signed all of the paperwork and the borrower is "officially" a borrower -- the lender will usually sell the loan to an investment bank. The investment bank will then pool this mortgage with similar mortgages (same interest rate, maturity etc...) and create one giant pool. This process of pooling asserts can occur with literally anything that has a cash flow -- account receivables, loans, bonds -- you name it, and it can be pooled and carved into separate bonds or cash flows.

Suppose the investment bank creates a pool worth ten million dollars. That means there are now 100 mortgages in the pool. The basic investment concept of diversification tells us that a problem with a few of the loans will not impact the overall performance of the entire pool. Suppose five homeowners in this pool eventually default. There are still 95 mortgages that are making payments on time. This limits the problems created by the five loans that defaulted.

Let's add a complicating factor to this scenario. Suppose there is a problem with a larger percentage of the loans -- say 10 percent or higher. This is when the concept of "structured finance" comes into play. The investment back will create different bonds from the large pool and allocate the pool's payments to these different bonds at different times and at different rates.

Here's an example using the previously mentioned pool. Remember, we have a giant mortgage pool worth ten million dollars, and the pool is made-up of 100 mortgages each worth $100,000 that pay five percent interest. The investment bank will "carve" the ten million dollars into three different "tranches." For all practical purposes, each of these "tranches" is a bond.

Investment banks will usually create three types of bonds from these pools. The riskiest bond is usually called an equity bond, and when there are problems with the underlying pool, most of its loses are allocated to this bond. Using our previous, hypothetical example, suppose 10 percent or 10 of the mortgages in the pool are in default. The equity portion of the bond will absorb all of these losses. As a result, the other two bonds are still receiving their regular payments.

Let's suppose the number of defaults increases to 20 percent, so that 20 mortgages in the $10 million pool aren't making payments. The investment bank will now allocate most of the losses to the equity bond, but will also allocate any spillover losses to the mezzanine bond. This is the next riskiest bond in the structure.

Finally, there are investment grade bonds which are the last bonds to be hit by defaults. Because of the concept of diversification, this bond will usually not experience any problems.

One of the central problems with the CDO market is liquidity. Because there isn't a very active secondary market, there is no market pricing mechanism to determine what each bond is worth. Instead, fund managers use various formulas and methods to determine what the value of a security is. That's where the real problem is coming from. Had there been an active secondary market, market participants would have seen a gradual decline in the value of various bonds. Instead to Bear suddenly announcing two funds were worthless, investors in the market would have seen the funds decline in value over a specific period of time. This would have limited the shock from the Bear collapse.

Back to where we are now. Credit terms have been very lax for the last 2-3 years. What we are seeing now is a backlash against easy credit terms -- in essence, a massive tightening of credit standards. My guess is we will start to see the pendulum start to swing back within the next 12-18 months to a point between easy and tight.

When Will the Dollar's Decline Stop?

From the Financial Times:

How long before the dollar hits $1.40 to the euro? That is the question many analysts are asking after a week when the US currency struck a new low of $1.3843 to the euro and fresh multiyear lows against a range of currencies, including sterling.

The US currency has fallen 4.5 per cent against the euro this year and 4 per cent against sterling, hitting a new 26-year nadir against the pound last week. The trade-weighted dollar index dropped to its lowest since 1992.

The dollar exchange rate is important because the US relies on hefty foreign purchases of securities and other assets to fund its current account deficit.

“At some point, the fall in the dollar will translate into foreign investors no longer buying US assets and selling their existing holdings,” said William Strazzullo, chief market strategist at BellCurve Trading.

The last paragraph states a really important question: when will the dollar's value decline to a level that makes investing in US debt securities a bad idea? There is no answer for that. However, consider the following chart from the St. Louis Federal Reserve which shows total foreign holdings of US debt securities. Notice the amount has more than doubled in the last 7 years.



How long will this trend continue when the dollar's chart looks like this?

Earnings Growth Pretty Good

From Bloomberg:

More than one-quarter of S&P 500 companies have posted second-quarter results. Their average profit growth was 8.1 percent. Analysts estimate index members will post average quarterly profit growth of 5.8 percent, up from a 4.8 percent estimate a week ago, according to data compiled by Bloomberg News.

It's not double-digit growth, but 8.1% isn't bad.

Metals Still A Buy?

From CBS MarketWatch:

"The long-term story for the base metals remains the same: Demand for metals continues to increase steadily," said Lawrence Roulston, editor of Resources Opportunities. Meanwhile, "production growth is constrained by the long lead times to develop new production and by the shortage of high-quality development projects."

"All metals have small inventories, which means any supply disruption can lead to a price bump," said Dr. Harlan Meade, president and chief executive officer of both Selwyn Resources Ltd. (CA:SWN: news, chart, profile) and Yukon Zinc Corp. (CA:YZC: news, chart, profile).

Base metals are even likely to find support from the rally in oil prices, "since the principle in economics is simply supply/demand fundamentals," according to Cary Pinkowski, chief executive officer of Vancouver, Canada-based CP Capital Group and director of Centrasia Mining

This has been a constant theme of the last few years. With China growing at high rates and India not far behind, demand for metal and other raw materials continues to increase. Here are some charts from Futures Charts.

Copper

Copper sold off at the end of 2006. However, demand pick-up again in 2007, and the metal has been rallying since. Since April it has been consolidating in a triangle formation.



Palladium

Palladium has had a slow and steady price increase since October of last year. That's a 10-month rally, which indicates the strength of the underlying increase in demand



Gold

Gold had a 6 month rally starting in October of last year. For the last three months it has been consolidating in a triangle formation.



Keep an eye on the dollar's level. As the dollar approaches the $80 level it may apply upward pressure to gold.



Silver

Silver rallied starting in June of last year. Since April it has been consolidating in a slightly downward forming triangle pattern.



Aluminum

Aluminum is the one metal that hasn't had a strong rally. Instead, it's price has been near constant for the last year or so. However, note that it's price is still high on the chart, indicating demand is still higher now than it was a year or so ago.

Health Care Jobs

This chart is from Business Week. The author argues:

Basically, the non-health job market is in free-fall. I suspect that when the BLS issues the next round of revisions to the job numbers, the picture will look even worse.

The S&P 500 Going Into Next Week

First, here is a chart of the S&P 500



Here are some notes from my trading journal. They are in no order of importance.

-- The trend started in late June is still intact.
-- Daily MACD = +
-- Daily CMF = +
-- Daily OBV = Neutral
-- NYAD and NASDAQ AD = Bearish
-- NY and NASDAD NHNL = Fair
-- Subprime is still a problem.
-- Energy is good
-- Industrials are good
-- Tech to the rescue?
-- Financials are a big problem, and will probably continue in that vein
-- Friday market sentiment = Bearish (contrary indicator)
-- M&A is getting hit with stricter loan terms. But, I think this is more a return to prudent lending terms. Conditions have been incredibly lax and lenders have let borrowers get away with murder.
-- Zach's says earnings are good. Thompson says they're not:

Following a heavy week that saw 125 companies of the S&P 500 reporting, earnings growth for the second quarter is so far pegged at 5.2%, an improvement from 4.2% last week, according to Thomson Financial.

Financials Are Still Under Pressure

Remember that financial stocks are the largest percentage sector in the S&P 500, coming in at a little over 20%. Last week there was a ton of bad news in the sector.

Bear's two funds are worthless.

S&P downgraded over 400 bonds.

Several financial institutions increased their loan loss reserves.

As a result, investors are nervous about what will happen to various financial companies.

That means they are selling financial shares. Also note the increased volume in this sector over the last three days. The selling is accelerating.

Weekend Weimar

The markets are closed.

Get off your computer.

See you tomorrow.

Great Paper on the Housing Market's Problems

Mike Larson -- who writes on the blog Interest Rate Roundup -- has written a paper titled How Federal Regulators, Lenders, and Wall Street Created America’s Housing Crisis Nine Proposals for a Long-Term Recovery. While the title is less than exciting (when will economists learn to get great titles to their papers?), the paper is very good and I highly recommend it.

So Far, Earnings Look Good

From Zack's

Through the close of Tuesday, Jul 17, a total of 55, or 11.0% of the S&P 500 firms have reported their second-quarter results. So far the results look very encouraging with positive surprises outpacing disappointments by a ratio of nearly 4:1. The median year-over-year growth rate is a very healthy 11.7% and the median surprise is 3.7%. Seven sectors have had at least one firm report, and of those, five are seeing double-digit median growth rates. There are only three sectors which have yet to have any firms report.

While it's too early to draw firm conclusions, the trend is promising.

Borrowers Are Sweetening Deals

From the WSJ:

Banks raising nearly $40 billion in buyout-related debt for Chrysler Group and the United Kingdom's Alliance Boots PLC are being forced to sweeten terms for investors and face delays in their sales, in another sign of turbulence in global debt markets.

Chrysler is being taken over by Cerberus Capital Management, a New York hedge fund, and is raising $20 billion in loans as it separates from DaimlerChrysler AG. Alliance Boots, a chain of U.K. drug stores and a wholesale pharmaceutical-distribution firm, is being taken over by Kohlberg Kravis Roberts & Co. and is raising the U.S. dollar equivalent of $18.4 billion.

In both cases, bankers are shopping interest payments to investors that are around a half percentage point more than originally planned. And in both cases, they're putting off plans to close the deals in the next few days. The Alliance fund raising might be delayed by months, people familiar with the situation said. The Chrysler debt sale is expected to close next week.

This is far from the end of the world for the M&A market. Credit terms have been incredibly lax for the last few years. A better description of events would be a "return to prudent lending standards".

As an example, here is a chart of the daily baa yield for the last 10 years. While rates have increased, they are still below the levels at the end of the 1990s.

Fed Still Focused on Inflation

From the Federal Reserve

At its May meeting, the Federal Open Market Committee (FOMC) maintained its target for the federal funds rate at 5-1/4 percent. The Committee’s accompanying statement noted that economic growth slowed in the first part of the year and that the adjustment in the housing sector was ongoing. Nevertheless, the economy seemed likely to expand at a moderate pace over coming quarters. Core inflation remained somewhat elevated. Although inflation pressures seemed likely to moderate over time, the high level of resource utilization had the potential to sustain those pressures. The Committee's predominant policy concern remained the risk that inflation would fail to moderate as expected. Future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

The Fed has been saying the same thing for about 6 months now. No one should be surprised by this statement.

Subprime Problems Not Over

From Bloomberg:

Subprime mortgage defaults will increase this year and holders of securities linked to those home loans may experiences losses well into 2008, JPMorgan Chase & Co. analysts said.

``The worst is not over in the subprime mortgage market,'' analysts led by Chris Flanagan, the head of structured finance strategy, said in a report today. ``We expect continued deterioration in subprime loan performance through the balance of this year, and it is likely to be well into 2008 before the problems in securitized portfolios begin to abate.''

Home price declines will lead to ``substantial increases in subprime mortgage defaults and losses,'' Flanagan, who is based in New York, said in a report titled ``Subprime Meltdown, the Repricing of Credit and the Impact Across Asset Classes.'' Borrowers of as much as 50 percent of the $500 billion of mortgages that will reset in the next 18 months may not be able to refinance, Flanagan estimates.

Mortgages defaults at 10-year highs have reduced prices of some bonds backed by home loans to people with poor or limited credit by more than 50 cents on the dollar. The increased risk of default prompted Moody's Investors Service, Standard & Poor's and Fitch Ratings to begin cutting credit ratings on hundreds of bonds last week.

Nobody should be surprised by this. The Fed's most recent Monetary Report to Congress stated:

Delinquency rates on subprime mortgages with variable interest rates -- which account for about 9% of all first lien mortgages outstanding, continued to climb in the first five months of 2007 and reached a level more than double the recent low for this series, which was recorded in mid-2005.

Here's a chart of the result -- an increase in foreclosures from the blog Interest Rate Roundup



And don't expect this stop in the near future. One of the reasons for the financials poor performance (see post just below) is concern over foreclosures and an increase in loan loss reserves at financial institutions.

Financials Still Hurting S&P

Remember that financials are the largest sector of the S&P 500, comprising about 20% of the average. Yesterday the sector dropped because of issues in the subprime market:

Bear Stearns fell 0.4% after reports that investors in two of the investment bank's hedge funds that made big bets on subprime mortgages have been practically wiped out, in more evidence of the turmoil in that corner of the bond market. Dick Bove, an analyst at Punk Ziegel, said the Bear Stearns woes are likely an industrywide problem and cut his ratings on eight top banks and brokerages.

The news and the downgrade were felt throughout the sector and the broader market. Goldman Sachs Group fell 2%, and Merrill Lynch was off 3.3%. Dow component Citigroup declined 1.6%, and Bank of America fell 0.8%. Even J.P. Morgan Chase, which reported a better-than-forecast 20% profit rise, was down 2.4%. Shares of Lehman Brothers, meanwhile, fell 1.9% amid those market rumors of losses from its subprime business.

Here's a chart of the sector. Notice that all short-term moving averages are headed lower. Also note the shorter-term SMAs are below the longer term SMAs. This pulls the longer term SMAs lower, adding to bearish pressure in the sector. Finally, the index is below the 200 day SMA, another bearish signal.

JP Morgan Triples Loan Loss Reserves

From Reuters:

JPMorgan Chase & Co. (JPM.N: Quote, Profile, Research) said on Wednesday it tripled the amount set aside for loan losses as even borrowers with good credit defaulted on home equity loans, hurting the bank's quarterly profit.

.....

But the bank set aside $1.53 billion for loan losses, up from $493 million a year earlier. About a one-third of the increase resulted from higher loss estimates on home equity loans in which borrowers had little equity in houses with falling values.

This is something to keep an eye on going forward.

Bernanke's Testimony

Here is the complete opening statement

Here are the highlights.

Despite the downshift in growth, the demand for labor has remained solid, with more than 850,000 jobs having been added to payrolls thus far in 2007 and the unemployment rate having remained at 4-1/2 percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the past decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors, but the underlying pace of productivity gains may also have slowed somewhat.

There is controversy about the labor picture. Some economists have argued the BLS' birth/death model has skewed recent numbers higher. Here is a full explanation of the problem. While statistic issues are not my strong suit, the previous link provides a convincing argument that current employment numbers are too rosy.

To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales and construction have slowed substantially and house prices have decelerated. Although a leveling-off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders’ inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent below the pace in the second half of last year.

Notice that Bernanke is finally admitting the housing market is a bigger problem than currently thought and is largely responsible for the current economic downturn. However, it's also important to remember the Fed Chair is in a difficult position. He can't simply come out and say housing is dropping like a stone; part of his job is to offer assuring statements and a calm outlook. But considering the length of the housing downturn and the severity of the inventory overhang, I personally think Bernanke has understated the problem to a larger degree than prudent.

Real consumption expenditures appear to have slowed last quarter, following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace, aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year, and barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases.

This statement slightly contradicts Bernanke's "the employment outlook is good" statement. If job growth were as robust as the numbers illustrate -- and if wage growth were as strong as indicated by the low unemployment rate-- then consumer spending would probably be stronger.

In the business sector, investment in equipment and software showed a modest gain in the first quarter. A similar outcome is likely for the second quarter, as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories. Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year, motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth.

Business investment will help, but not in as large a degree as we would like. In other words, the bullish argument's belief in a strong business sector may be overshooting the mark.

The global economy continues to be strong. Supported by solid economic growth abroad, U.S. exports should expand further in coming quarters. Nonetheless, our trade deficit--which was about 5-1/4 percent of nominal gross domestic product (GDP) in the first quarter--is likely to remain high.

Exports should grow, but not enough to tame the trade deficit.

So here's his conclusion:

Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.

Housing Starts Up 2.3%

From the Census

Housing inventory is at inter-generational highs, home builders are reporting terrible earnings and credit is tightening.

This is a great time to add to inventory.

CPI Up .2%

From the BLS:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.2 percent in June, before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The June level of 208.352 (1982-84=100) was 2.7 percent higher than in June 2006.

There are a couple of interesting points in this report.

1.) For those of you who consume food and energy, those prices are up Y/Y on an unadjusted basis of 4.1% and 4.6%, respectively.

As CBS Marketwatch noted:

Energy prices fell 0.5% in June after surging the previous three months at an annual rate of more than 70%. In June, gasoline prices fell 1.1% and natural gas prices fell 0.1%.

Gasoline prices have inched higher in recent weeks, however.

Food prices continued to climb, rising 0.5% in the month. Dairy prices rose 3.2%, and poultry prices rose 2.1%, on higher prices for corn as a feed for poultry and livestock. Fresh fruit and vegetable prices fell.

Food prices are up at an annual rate of 5.1% in the past three months, driven higher by adverse weather, strong global demand and the diversion of much of the corn crop and the nation's arable land into the production of ethanol for fuel.

2.) From the BLS report:

Consumer prices increased at a seasonally adjusted annual rate (SAAR) of 5.2 percent in the second quarter after advancing at a 4.7 percent rate in the first three months of 2007. This brings the year-to-date annual rate to 5.0 percent and compares with an increase of 2.5 percent in all of 2006.

Those are not happy numbers for the Fed.

3.) The unadjusted 12-month core rate of change is 2.2% which is still above the Fed's comfort zone of 1% to 2%.

Pulte Homes Reports Big Loss

From the Street.com

Pulte Homes (PHM - Cramer's Take - Stockpickr - Rating) projected a hefty loss for the second quarter and posted a 20% drop in orders for the period, joining other homebuilders in reporting still-dismal conditions for the housing market.

The Bloomfield Hills, Mich.-based builder said Tuesday that it expects to report a second-quarter loss of $2 to $2.10 a share due to numerous charges. The company expects land impairment charges of $1.85 to $1.92 a share, as well as 10 cents a share in charges for a previously announced restructuring.

Previously, Pulte predicted results ranging from break-even to a loss of 10 cents a share, before any charges. Analysts, on average, forecast a loss of 17 cents a share, according to Thomson Financial.

This is simply another announcement from the housing sector that shows housing is nowhere near a bottom in any way shape or form. Expect more of the same as other builders make their respective announcements.

Pay particular attention to the announcement that came with the announcement:

"The difficult conditions that plagued the homebuilding industry in the first quarter of 2007 worsened in the second quarter, with increased competitive pricing pressures, elevated levels of new and resale home inventory, and weak consumer sentiment for housing affecting the entire industry," said Richard Dugas Jr., president and CEO of Pulte Homes, in a press release.

Note the statement "worsened in the second quarter." This is not a cheery report and indicates management is extremely concerned about the market right now.

This Is Not Good

From the WSJ

Weeks after the meltdown of two prominent Bear Stearns Cos. hedge funds that bet heavily on the market for risky home loans, the brokerage has told the funds' investors that the portfolios' assets are almost worthless, according to people familiar with the matter.

The assets in Bear's more-levered fund, the High-Grade Structured Credit Strategies Enhanced Leverage Fund, are worth virtually nothing, according to people familiar with the matter. The assets in the larger, less-levered fund are worth roughly 9% of the value since the end of April, these people said. The April valuations were not immediately available, but in March, before their sharp losses, the enhanced leverage fund had $638 million in investor money, while the other fund had $925 million.

The two funds have been in the spotlight for weeks after suffering heavy losses in the subprime market. Late last month, Bear helped stabilize the less-levered fund with a $1.6 billion secured loan; the enhanced fund began trying to unwind its remaining $1.1 billion in debt.

Bear disclosed this information to investors earlier today and is expected to make a statement this evening, these people said. A spokeswoman for Bear did not return calls for comment.

These losses, which took more than two weeks to calculate because of the fluctuating values in the market for risky, or subprime, mortgage securities, came amid another tumultuous day for the broader mortgage market. One particularly wobbly slice of the market tracked by a closely watched index called the ABX fell to an all-time low of 44.

Homebuilder Confidence Drops

From Bloomberg:

Confidence among U.S. homebuilders fell this month to the lowest level in 16 years, signaling the housing market continues to tumble.

The National Association of Home Builders/Wells Fargo sentiment index declined to 24 this month, the lowest since January 1991, from 28 in June, the Washington-based association said today. Readings less than 50 mean most respondents view conditions as poor.

Builders are pulling back on construction of new homes as inventories remain high as sales haven't recovered. Housing probably will be a drag on economic growth the rest of this year, economists said.

``Higher inventory levels would suggest that builders are going to have slow down their activity,'' said Jeffrey Roach, chief economist at Horizon Investments in Charlotte, North Carolina, before the report. ``We still expect to see, for the next couple of months, building being a drag on economic growth.''

This should surprise no one. Consider the following recent housing news.

M/I Home warns on earnings

M/I Homes Inc. warned investors Thursday to expect as much as $75 million in charges to snag its second quarter results.

M/I Homes said it expects to record up to $70 million in pretax asset impairment charges and write-offs related to its homebuilding assets and investments. Another $5 million charge will come from writing off intangible assets related to the 2005 acquisition of Orlando, Fla.-based Shamrock Homes.

Realtors forecast weak housing market into 2008:

he slump in home sales and prices will be deeper and last longer than previously expected, according to the latest forecast Wednesday by the National Association of Realtors.

The trade group is now looking for flat prices for existing homes in the first quarter of 2008 compared to the first quarter of 2007, and a more year-over-year declines for new home.

DR Horton sales down:

The traditional spring home-selling season was a bust for D.R. Horton Inc., one of the biggest nationwide homebuilders. Horton said Tuesday it will post a loss from operations for its latest quarter after net orders fell 40 percent and it wrote down the value of unsold houses.

Ryland expects loss:

Luxury homebuilder Ryland Group Inc. said Tuesday its expects to post a second-quarter loss as a result of the continued slump in the housing market.

According to preliminary figures, Ryland expects to report a loss of $1.25 to $1.35 per share for the quarter.

The news has been uniformly bad. Considering that inventories are at inter-generational highs, credit is tightening and the subprime financing market is experiencing problems, there is no reason to expect this trend to reverse anytime soon.

Industrial Production Up

From the Federal Reserve:

Industrial production rose 0.5 percent in June after a decrease of 0.1 percent in May. At 113.4 percent of its 2002 average in June, total industrial production was 1.4 percent above its year-earlier level. Manufacturing output moved up 0.6 percent in June; excluding motor vehicles and parts, factory output increased 0.4 percent after having been unchanged in May. In June, the output indexes for mining and utilities registered gains of 0.5 percent and 0.3 percent respectively. For the second quarter as a whole, total industrial production advanced at an annual rate of 2.9 percent after an increase of 1.1 percent in the first quarter. Capacity utilization for total industry moved up to 81.7 percent in June; the rate was 0.6 percentage point below its level in June 2006 but 0.7 percentage point above its 1972-2006 average.

This jibes with yesterday's Empire State manufacturing report, which showed gains as well.

There were increases across the board: consumer goods, business equipment and construction all saw gains. Business equipment is up 3.4% Y/Y. However:

The index for business equipment was unchanged in June for a second consecutive month, but it advanced at an annual rate of 3.6 percent in the second quarter

Automotive production is ramping up:

After little change in the first quarter, the production of automotive products surged at an annual rate of 20.7 percent in the second quarter.

The housing slowdown is clearly having an effect:

The output of home electronics recovered 2.6 percent in June after a decline of the same amount in May. The index for appliances, furniture, and carpeting fell 0.5 percent in June; production increased at an annual rate of 0.8 percent in the second quarter after declines in each of the preceding six quarters.

One of the central themes of the bull's argument going forward is an increase in manufacturing capacity and activity. So far this month, we are getting a decent confirmation of that trend.

PPI Down -.2%

From Bloomberg:

Prices paid to U.S. producers unexpectedly dropped for the first time in five months, restrained by declines in fuel and food costs.

The 0.2 percent fall followed a 0.9 percent increase in May, the Labor Department said today in Washington. Core prices, which exclude food and energy, rose 0.3 percent, reflecting a jump in automobile prices. Excluding passenger cars, core prices were up 0.1 percent.

The figures, coming a day before Federal Reserve Chairman Ben S. Bernanke testifies to Congress on the economy, would be welcome news for policy makers. Central bankers last month said a pickup in inflation remained the biggest risk and more evidence of a slowdown in prices would be needed before concern eased.

From the BLS:

The Producer Price Index for Finished Goods decreased 0.2 percent in June, seasonally adjusted, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. This decline followed advances of 0.9 percent in May and 0.7 percent in April. At the earlier stages of processing, prices received by producers of intermediate goods rose 0.5 percent in June after increasing 1.1 percent in the prior month, and the crude goods index moved up 0.3 percent following a 2.0-percent advance in May.

According to the BLS, energy prices decreased 1.1% in June and Food prices decreased .8% in June.

However -- consider the following charts:

The Goldman Sachs Agricultural futures index:



Light Sweet Crude Oil



However, also consider that gas prices decreased in June:

Rail Volumes Down in June

From the American Association of Railroads:

U.S. freight railroad carload traffic fell 2.7 percent in June 2007 compared with June 2006, while intermodal traffic fell 1.8 percent compared with the same month last year, the Association of American Railroads (AAR) reported today.

Overall, U.S. railroads originated 1,344,296 carloads of freight in June 2007, down 37,679 carloads (2.7 percent) from June 2006. U.S. railroads also originated 961,545 intermodal units in June 2007, a decrease of 17,956 trailers and containers (1.8 percent) from June 2006.

“Rail volumes remained relatively soft in June, though they are up against some very strong comparisons from last year,” noted AAR Vice President Craig F. Rockey. “Most economists are fairly upbeat about economic growth in the second half of this year, and when the economy does pick up, we can expect rail volumes to rise commensurately,” Rockey added.

Once again, Bonddad returns to the old Dow theory -- transports an transportation have to perform well for the economy to be doing well. The reason is simple -- goods have to be shipped somewhere. Declining rail traffic indicates the manufacturing expansion isn't happening as strongly as we would like.

Empire State Index Shows Strength

From the NY Fed:

The Empire State Manufacturing Survey indicates that conditions for New York manufacturers continued to improve in July. The general business conditions index held near its June level, at 26.5.

The new orders index climbed for a fourth consecutive month to its highest level in more than a year, while the shipments index remained near its June level. The inventories index tumbled sharply into negative territory. The prices paid index, although elevated, eased modestly, as the prices received index held steady. Employment indexes were modestly positive. Future indexes conveyed significant optimism, with notable improvements in the outlook for employment and capital spending.

I'm a big fan of these regional Federal Reserve reports. They give us a nice regional picture of good, general business information.

This release gives us further confirmation of a strengthening manufacturing sector. However, the inventory questions could indicate a period of slowing activity in the next few months. That situation -- as with most in the economics realm -- will have to play out.

I should add that I am not a big fan of the future outlook question because it's really easy for those being polled to be really optimistic.

Higher Energy Prices Are Here to Stay?

From the WSJ:

World oil and gas supplies from conventional sources are unlikely to keep up with rising global demand over the next 25 years, the U.S. petroleum industry says in a draft report of a study commissioned by the government.

In the draft report, oil-industry leaders acknowledge the world will need to develop all the supplemental sources of energy it can -- ranging from biofuels to nuclear power to oil extracted by unconventional means from the oil sands of Canada -- to meet soaring demand. The surge in demand is expected to arise from rapid economic growth in such fast-developing countries as China and India, as well as mounting consumption in the U.S., the world's biggest energy market.

This is a good time to look at the daily and weekly oil charts to see how they are performing.

Here's the daily chart. Notice that prices consolidated for about two months between $61 and $67. As a rule of thumb, when prices move within a roughly 10% range, it's usually a consolidation pattern where traders are either selling old positions and taking profits or buying new positions and betting on higher prices. Because oil prices typically increase during the summer, traders were buying contracts in April and May betting on a summer rally.



From the weekly perspective, we have prices bottoming in a classic head and shoulders formation and rallying from that base.



From both a daily and weekly perspective we have a strong reason to expect the rally to continue and for prices to remain high. From the daily perspective we have a solid two month base. From the weekly chart we have a classic reversal.

From the fundamental perspective we have India and China growing at high rates creating an additional 2 billion people demanding energy. Increased demand = higher prices.

In addition, there is the peak oil argument which states oil supplies are already at or near their highest levels and will only decrease from here. I can't speak to the veracity of that claim, but if it's true then we have a big problem on our hands.

The Upcoming Week

It's going to be a busy week in the markets.

1.) It's earnings season. 'nuff said.

2.) There are three manufacturing reports. The Empire State survey on Monday, Industrial Production on Tuesday and the Philly on Thursday. Remember that manufacturing/exports are supposed to be a big reason for the US not entering a recession soon, so these numbers are crucial.

3.) PPI is Tuesday and CPI is Wednesday. But remember -- food and energy don't count at all in these numbers.

4.) Housing starts are on Wednesday. Just when the market doesn't need more bad housing news.....

The Employment Numbers and the Birth/Death Model

There has been a lot of commentary among economists about the effect of the BLS' birth/death model on employment numbers. However, most of these discussions have been annoyingly wonky in my opinion and difficult to understand.

John Mauldin has provided an excellent analysis of exactly what the controversy is and more importantly provides a very readable explanation.

To start with, let's dissect the employment numbers. The official headline number for June was 132,000 new jobs. Since we need about 150,000 new jobs just to stay even with population growth, that is hardly a robust number, but not too far off from what would be a good number. Except that there are some problems with the headline number.

The employment numbers come from a survey of established businesses. But obviously the Bureau of Labor Statistics (BLS) cannot call every business in the US, so they simply survey the larger businesses. But that means they miss the growth in the small-business sector of the economy, which is where the largest amount of new jobs are created.

The BLS surveys about 160,000 businesses in its sample model. There is an unavoidable lag between an establishment opening for business and its appearing on the sample frame and being available for sampling. Because new firm "births" generate a significant portion of employment growth each month, non-sampling methods must be used to estimate this growth. To make up for this, they add or subtract a certain number of jobs, called the birth/death (of new businesses) ratio.

They use the actual births and deaths of real businesses for the last five years to make their estimates of new jobs created from new business. This is quite a legitimate methodology, but it does have one problem. It is backward-looking data. BLS knows that and states the following on its web site:

"The most significant potential drawback to this or any model-based approach is that time series modeling assumes a predictable continuation of historical patterns and relationships and therefore is likely to have some difficulty producing reliable estimates at economic turning points or during periods when there are sudden changes in trend. BLS will continue researching alternative model-based techniques for the net birth/death component; it is likely to remain as the most problematic part of the estimation process."

Remember the jobless recovery of the first Bush term and the constant criticism about the poor economy? Why was the economy doing so well and yet job creation was so poor? It turns out that a great deal of the explanation is that the BLS underestimated the number of new jobs being created by small business. In the early years of the recovery, rather badly.

Likewise, the BLS data will overestimate jobs when the economy is slowing down. Is there some evidence that may be the case today? I think there is.

To the credit of the BLS, they are very transparent about their data. There are massive amounts of data available at www.bls.gov and the data on the birth/death ratio is at http://www.bls.gov/web/cesbd.htm. Now, let's examine the contribution of the birth/death ratio to the employment numbers.

Last month, the BLS estimated that there were 156,000 new jobs in the birth/death ratio category, which was 24,000 more jobs than they estimated were created for the month. OK, maybe no problem. Looking back over five years, the economy has created about that many new jobs during the month.

Except that they estimated 26,000 new small-business construction jobs. With home construction dropping, do we really think that the same number of new jobs was created in construction as in June of 2006 and 2005? Or that 153,000 new jobs in small-business construction have been created this year? Really?

In fact, since January, the BLS estimates for the birth/death ratio have added 747,000 new jobs of a total projected growth of 871,000 jobs, or 86% of the total of the jobs estimated supposedly created for the first half of the year.

Is there any other reason to believe that the birth/death ratio may be overstating employment as the economy slows? The always astute Paul Kasriel of Northern Trust thinks there is. He notes that in 2005 the contribution of the birth/death ratio (12-month average) to the overall employment numbers was well under 35%. Today it is over 56%. Given the recent numbers, that ratio is likely to rise.

"What has been happening to the relative contribution of birth/death estimates as the economy has slowed in the past year? The chart below shows that it has been rising. In the 12 months ended March 2006, the birth/death adjustment was contributing only 30.9% of the jobs to the change in nonfarm payrolls. The birth/death relative contribution has been trending higher since then. Notice that as the birth/death contribution to nonfarm payrolls has been trending higher, the percentage of small businesses saying that now is a good time to expand their operations has been trending lower. If existing small business managers do not think now is a good time to expand their operations, does it make sense that there are a lot of new small businesses starting up and hiring?

Weekend Weimar

The markets are closed. Stop thinking about economics. Go do something else.

How Stupid is the Fed's "Core Inflation" Obsession?

Core inflation doesn't include food and energy prices. So -- here are charts of some raw food and energy prices from the future's markets.

Cattle prices:



Corn



Gas



Oil



Soy Beans



Wheat



Notice how little these prices have moved over the last few years....

Import Prices Increase

From the BLS:

Import prices rose 1.0 percent in June, the fifth consecutive increase for the index. Petroleum prices were also up for the fifth month in a row, increasing 4.7 percent in June after a 3.7 percent advance the previous month. After declining at the end of 2006, the price index for import petroleum rose 28.1 percent from January through June. However, the index was only up 2.1 percent over the past year compared to a 33.7 percent increase over the previous 12 months. Nonpetroleum prices also advanced in June, rising 0.2 percent after advancing 0.5 percent in May. Prices for nonpetroleum imports increased 2.6 percent for the year ended in June, while overall import prices rose 2.3 percent for the same period.

Once again, a report brings into focus the ridicules obsession with core inflation at the expense of the whole picture. Import oil prices are up 28.1% this year. But according to the Fed, this increase is not important.

Retail Sales Drop

From the Census Bureau:

The U.S. Census Bureau announced today that advance estimates of U.S. retail and food services sales for June, adjusted for seasonal variation and holiday and trading-day differences, but not for price changes, were $373.9 billion, a decrease of 0.9 percent (±0.7%) from the previous month, but 3.8 percent (±0.7%) above June 2006. Total sales for the April through June 2007 period were up 3.9 percent (±0.5%) from the same period a year ago. The April to May 2007 percent change was revised from +1.4 percent (± 0.7%) to +1.5 percent (± 0.3%).

All areas of retail sales declined -- motor vehicles and parts, general merchandise, gas stations, apparel, electronics and appliances and health stores.

However:

Retail sales decreased 0.9% last month, the Commerce Department said Friday. The drop followed a big, 1.5% increase in May, revised up from an originally estimated 1.4% jump. Demand dropped 0.3% in April, the first month of the second quarter.

Economists have been predicting consumer spending would soften after its first-quarter surge, and they expected a drop in June sales. But the 0.9% fall was much bigger than forecast; the median estimate of 27 economists surveyed by Dow Jones Newswires was a 0.1% decline.

In fact, the 0.9% decrease was the largest since a fall of 1.5% in August 2005. Still, the decline wasn't broad, with demand among some retailers, including general merchandise stores, rising. The decrease among all retailers except the auto and gasoline sectors was a much smaller 0.3%.

In other words, the auto sector was a pretty big reason for the large drop.

Yesterday's Rally In Perspective

Here is a chart of the SPYs. Before we get too excited about yesterday's rally, let's put it in perspective.

In index broke through the upward band of a downward channel which is bullish. But the index is barely above resistance a bit above $154. If the index holds at this level a further upward move is more probable. But the index has had trouble maintaining gains recently, so don't be surprised if it pulls back.

Trade Deficit Widens

From the BEA:

The U.S. Census Bureau and the U.S. Bureau of Economic Analysis, through the Department of Commerce, announced today that total May exports of $132.0 billion and imports of $192.1 billion resulted in a goods and services deficit of $60.0 billion, compared with $58.7 billion in April, revised. May exports were $2.9 billion more than April exports of $129.2 billion. May imports were $4.2 billion more than April imports of $187.8 billion.

An increase in the price of oil was the primary reason for the increase.

This is one of the underlying reasons for the decrease in the dollar's value.

Economists Predicting Stronger 2Q Growth

From Bloomberg:

The economy probably expanded at an annual rate of 3.6 percent last quarter, rather than the 3.2 percent rate Global Insight had forecast prior to the trade report, Gault said.

Economists at HSBC Securities USA Inc. and Morgan Stanley in New York were also among those raising their second-quarter estimate.

In a Bloomberg News survey of economists taken July 2 to July 9, economists expected the economy to expand at a 3 percent rate in the second quarter, based on the median of 69 estimates. That compares with a 0.7 percent rate in the first quarter.

There are a few points I would like to address from the above referenced predictions.

1.) Currently, most economists are looking at the first quarter as a brief slowdown in a otherwise long expansion. In other words, there is a consensus that things are getting better.

2.) Let's say the number comes in below expectations. That could create a big problem for people because it would shock the regularly held consensus view.

3.) I would personally be far more comfortable if the median was say 2.3% - 2.5%. Going from .7 to 3% is a big jump whereas moving from .7% to the mid 2% range seems far more possible.

Bank of Tokyo Mitsubishi's Retail Sales Stronger Than Expected

Here's the link to the report (PDF)

Specialty and Apparel Store Sales Increased 3.4%.
General Merchandise increased 2.4%
Home Supply Decreased (this does not include Home Depot or Lowe's) -15.5%
Drug Store Sales Increased 4.8%.

The annual total for 2007 so far is 2.8%. This is the lowest total since 2001. However, we still have 7 months to go until the end of the year.

Wal-Mart was up 1.3%. Because Wal-Mart is by far the largest retailer in the US, their sales figures are closely watched.

Target was up 5.8%.

Overall, this report is fairly solid. While the low annual rate should raise a yellow flag, the strength of this number should console the bulls.

Foreclosures Increasing

From Bloomberg:

he number of U.S. properties in foreclosure climbed 87 percent last month from a year earlier as home prices fell and lending standards tightened, making it harder for borrowers to sell homes and refinance mortgages.

There were 164,644 loan default notices, scheduled auctions and bank repossessions in June, led by filings in California, Florida, Ohio and Michigan that together accounted for half the total, according to RealtyTrac, a seller of foreclosure data.

The June foreclosure figure was 7 percent lower than in May, when filings reached a 30-month high, Irvine, California-based RealtyTrac said today. ``Still, rates in most states remained substantially above last year's levels,'' James Saccacio, the company's chief executive officer, said in the statement.

Recent housing news has been incredibly bearish. Two ratings agencies have announced a downgrade of CDO/CLO deals. Homebuilders have announced lower earnings, higher cancellation rates and stated the current environment is difficult. Now we learn that while forclosures decreased from last month, they are still far higher than last year. It's also important to remember foreclosures are coming off of record lows, so they really only have one way to -- namely, up.

A Look At the 5 Largest S&P Sectors

According to S&P, the 5 largest sectors of the S&P 500 are financials (20.77%), information technology (15.45%), health Care (11.67%), industrials (11.43%) and energy (10.79%). Here are the industry charts for those sectors from the largest to the smallest.

The financials are getting hit by the subprime issue in a big way. Notice the 10, 20 and 50 day SMA are all heading lower. The 10 day SMA is below the 20 day SMA, which is below the 50 day SMA. As a result, the smaller duration moving averages are pulling the longer duration averages lower. Finally, the index is trading below the 200 day SMA.

In short, 20% of the S%P 500 is in a terrible technical position.



Technology is heading higher, although it's not the strongest rally; the upward trajectory is weak. However, a weak upward rally is better than nothing. Also notice that all the moving averages are heading higher. If this index continues on its current trajectory it will help to stabilize the downward pull of the financials.



Health care sold off in early June and has trended down since then. However, it appears to be stabilizing. The 10 day SMA is heading higher. However, the shorter term SMAs (the 10 and 20) are still below the 50 which will pull the longer term SMAs lower. Short version: health care is struggling.



The industrials mirror the technology area. While this index is heading higher, it's not the strongest rally we've seen. However, the larger industrials have good international sales exposure and a very cheap dollar. This should help earnings reports giving this sector a lift.



Energy is in good shape. It has rallied since the end of June. All the SMAs are heading higher. Also, oil is trading above $70/bbl. Assuming oil continues at current prices we should see this sector do well.




1.) Two sectors -- financials and health care -- are languishing. Health care is trying to make a comeback, but the jury is still out. These sectors comprise 32.44% of the S&P.

2.) Two sectors -- technology and industrials -- are rallying, but the rally's trajectory is weak. These sectors comprise 26.88% of the S&P.

3.) One sector -- energy -- is doing well. It comprises 10.79% of the index.

Gas Prices Now Near Last Year's Levels

From This Week In Petroleum:

For the first time since May 21, the U.S. average retail price for regular gasoline rose, increasing 2.2 cents to 298.1 cents per gallon as of July 9, 2007. Prices are 0.8 cent per gallon higher than this time last year. Regional prices were mixed with East Coast prices dropping 0.1 cent to 292.4 cents per gallon. The largest rise was in the Midwest, where prices jumped 9.1 cents to 304.5 cents per gallon. Prices for the Gulf Coast increased 0.7 cent to 285.8 cents per gallon. In the Rocky Mountain region, prices fell 3.1 cents to 306.6 cents per gallon, although they remain 17.9 cents per gallon above last year. West Coast prices were down 2.6 cents to 308.0 cents per gallon. The average price for regular grade in California was lower by 2.1 cents to 313.6 cents per gallon.

Here is a chart of gas prices from the same report:



Note that prices increased at the same time this year as last year. But, this year's prices were consistently higher than last years prices. This year's prices continued to rise into May, decreasing to current levels starting in about June.

In other words, the economy has now had about 6 months of gas prices that were higher than last year's prices, although year to year comparisons are currently near parody.

How has this impacted wages? According to the Bureau of Labor Statistics, the average hourly earnings of production workers increased from $17.16 to $17.29 from January to June, or an increase of .75%. Over the same period, the overall inflation level increased from 202.416 to 207.949 or an increase of 2.73%, for an overall drop of 1.98%.

Here's a chart of energy prices from the St. Louis Federal Reserve.



It looks like energy prices hit earnings pretty hard.

Bear Stearns Selling Bonds

From The Street.com

Bear Stearns (BSC - Cramer's Take - Stockpickr - Rating) is set to offload about $450 million of securities tied to one of its failing hedge funds.

The offering consists of securities from a cash collateralized debt obligation tied to a credit from debt backed by subprime mortgages. The CDO debt list is peppered with fixed- and floating-rate junk debt but includes primarily securities that carry higher-credit quality as rated by Standard & Poor's and Moody's Investors Service.

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It's hard to say how the debt might trade in the market in light of all the distress in subprime, one CDO manager says, noting that previous offerings from Bear have fared "OK." He was unable to provide pricing on past Bear deals.

This could create a big problem. Depending on which bonds Bear is selling, it may be selling very illiquid securities. If this is the case, then bids for the bonds might come in lower than Bear would like. This could lead to a wave of similar debt being written down, which could impact a lot more funds.

Dollar Still Falling

The S&P downgrade story really hit the dollar yesterday. Notice the drop below key support levels.



The weekly chart looks terrible. Notice the downtrend is still firmly intact and all of the moving averages are still headed lower.

Was Yesterday A Turning Point?

I have been moderately bullish for the upcoming quarter. I have thought that earnings would come in above the 4% level. I have also argued that the structure of the CDO/CLO deals would mitigate the impact of decreasing

Consider the following news items which came out yesterday:

Sears (NasdaqGS:SHLD - News), which operates both Sears and Kmart stores, blamed slow home appliance sales for its big warning. Shares fell 10%.

Home Depot, the No. 1 home improvement retailer, trimmed its 2007 forecasts. Shares edged higher on its buyback plans.

Major home builder D.R. Horton (NYSE:DHI - News) warned of a loss, too. Orders fell 40% in its fiscal third quarter and cancellations rose thanks to the glut of homes on the market.

Meanwhile, Standard & Poor's said it may cut ratings on some $12billion worth of bonds backed by subprime assets. It announced tougher standards for evaluating mortgage-backed securities.

In addition:

Hours after S&P's move, Moody's Investors Service said it was downgrading 399 mortgage-backed securities issued in 2006 and reviewing an additional 32 for downgrade, affecting $5.2 billion of bonds. It also downgraded 52 bonds issued in 2005.

"The level of losses continues to exceed historical precedents and our expectations," said Susan Barnes, an S&P managing director, in a conference call with investors to discuss the looming downgrades.

Also add:

LOS ANGELES, July 10 (Reuters) - The Ryland Group Inc. (RYL.N: Quote, Profile, Research) warned on Tuesday that it expects to post a second- quarter net loss of $1.25 to $1.35 per share due to continued deterioration in the housing market.

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Analysts, on average, had been looking for the company to post a second quarter profit, excluding items, of 46 cents per share, according to Reuters Estimates.

And finally:

The Home Depot Inc., the world's largest home improvement store chain, on Tuesday cited continued weakness in the housing market and the sale of its wholesale distribution business as it issued a bleaker-than-expected financial outlook for the year.

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Home Depot said it now expects its earnings per share to decline by 15 percent to 18 percent for fiscal 2007. In May, the company had projected an earnings per share decline of 9 percent for the year.

So --

1.) The primary method of financing the housing market expansion -- mortgage backed securities -- takes a major hit with a huge wave of ratings downgrades. This will dry-up funding for the more speculative elements of this market, as well as increase funding problems across the board for all mortgages.

2.) 2 major retailers are reporting the consumer is not spending as much as we would like. Remember that consumer spending is responsible for 70% of economic growth.

3.) The homebuilding sector is still experiencing some really big problems. Sales are down, cancellations are up and the business environment is "challenging."

This is a deluge of bad news in one day that has hit literally every possible spectrum of the housing market. Wall Street reacted with a big wave of selling.

Days like yesterday can have a profound impact on market psychology. The breadth of the negative news was profound.

Homebuilder's Report Lousy Quarter

From The Street.com

Homebuilder Ryland (RYL - Cramer's Take - Stockpickr - Rating) projected a loss for the second quarter and reported a 17% drop in new-home orders for the period.

The company said late Tuesday that it expects to report a loss of $1.25 to $1.35 a share for the quarter ending June 30. Analysts had been expecting a profit of 32 cents a share, according to Thomson Financial.

The expected loss stems from $145 million to $155 million of charges related to inventory impairments and write-offs, Ryland said.

As prices fall for new houses, builders are finding previous land investments are no longer profitable, forcing them to record impairment charges. Ryland said its impairments were associated with projects in Arizona, California, Florida and Nevada.

From CBS.Marketwatch:

Home-building bellwether D.R. Horton Inc. early Tuesday said quarterly orders for new homes fell 40% from a year earlier and that it expects to post a loss after impairment charges.

The Ft. Worth, Texas-based company said net sales orders for its fiscal third quarter ended June 30 dropped to 8,559 homes valued at $2 billion, compared with 14,316 homes or $3.8 billion in the year-ago period.

"Market conditions for new home sales declined in our June quarter as inventory levels of both new and existing homes remained high, and we expect the housing environment to remain challenging," said D.R. Horton Chairman Donald Horton in a statement.

He said the builder lowered its prices in response to sagging sales. The company expects to see a loss for both the third quarter and the nine months ended June 30, after charges. Analysts polled by Thomson Financial had been looking for net income of 7 cents a share in the latest quarter, on average.

I would expect more news like this from the homebuilders for the foreseeable future.

Big Bond Downgrade

From CBS MarketWatch:

Influential rating agency Standard & Poor's said on Tuesday that it may downgrade $12 billion of subprime mortgage-backed securities because losses in this low-end part of the home-loan market have increased and will probably get worse.

Credit ratings on 612 classes of residential mortgage-backed securities (RMBS) backed by U.S. subprime collateral have been put on CreditWatch with negative implications, S&P said. Beginning in the next few days, the agency said most of these classes will be downgraded.

That covers about $12.078 billion in rated securities, or 2.13% of the $565.3 billion in U.S. RMBS rated by S&P between the fourth quarter of 2005 and the fourth quarter of 2006, the agency noted.

The agency said it's also reviewing ratings of Collateralized Debt Obligations (CDOs) that invested in the RMBS that could be downgraded. (CDOs are a bit like mutual funds that hold asset-backed securities. Many CDOs bought subprime RMBS, helping to fuel the housing boom earlier this decade.)

This is a really big story. I would add the following points:

1.) S&P is downgrading the underlying mortgage pools of certain CDOs. We have yet to see how this will effect the actual CDOs. While I don't think the implications are good, we'll have to see how this plays out.

2.) I would like to see a diffusion index of where these bonds are. If owership is spread out or concentrated.