T-Waves Weekly Thoughts

by Stephen Tetreault, T-Waves | May 26, 2009

Our economic calendar for this shortened holiday week is a little more robust with several key manufacturing reports and we get the next look at the 2009Q1 GDP revision. The manufacturing and economic conditions reports include the Richmond Fed Survey, Chicago Fed National Activity Index, NAPM New York and the Institute of Supply Management (ISM) for Chicago; these reports will provide some crucial insight into the deteriorating manufacturing sectors. They are all about as boring as a hair cut but a necessary evil. All are expected to show slight increases in activity. They will be the preview of the national ISM due out the following Monday. This is the key gauge of national economic activity as reflected by purchasing manager trends. The national ISM has risen for four consecutive months and I now expect a pull back (though many expect another small increase). The 2009Q1 GDP revision on Friday is expected to show continued improvement with an upward revision to -5.6 to -5.2% from the previous reading of -6.14% (so a beneficial increase due to inventory manipulation is likely already baked into the proverbial cake…these are horrible numbers but way so many talking butt-head analysts believe the worst is behind us; though many expect the rebound to be long and treacherous.

We will also get another look at the volatile housing number that can and often do drive market sentiment the existing home sales (due out Wednesday) and new home sales (due out Thursday) for April. These will be the most current numbers available and will provide us an in depth real look into the spring selling season. Since the homebuilder stocks have rallied significantly from the March lows this will be test for these stocks (will they find fuel for additional move higher or will it be a sell the news event); many have retrenched in the past few weeks on fears the continued credit crunch has restricted buyers.

Traders and investors are still worried and concerned about the potential impact of a prospective downgrade on the UK and the possibility of a similar downgrade on the USA debt ratings. Both are in danger of eventually losing their AAA credit ratings as a result of the deepening recession and the unprecedented mega Tsunami waves of government-led taxpayer bailouts; that they claim is highly needed. In order to finance the massive bailout of the lecherous banks, lenders and other corporate firms with their hands held out needing what they claim are bailouts to foster growth…as such our government is being forced to sell nearly $2 trillion in debt in the next 12-16 months and worse yet the buyers for our debt are shrinking and interest rates are on the rise. We saw the markets react badly to the weak bidding on U.S. debt and yet there is still $2+/- trillion in the pipeline; this could be a huge looming contagion yet to be factored into the mix. The amount of U.S. Treasuries sold by the Treasury on behalf of others rose by 20% this week; and instead of selling into the open markets other countries have asked the Treasury to sell their notes for them (sort of masking the true sellers); also this allows the Treasury to manage the sale rather than just having the other country dump them into the market and impact prices; this 20% jump in sales is disturbing in that other countries are starting to decide they no longer want to hold our debt…but I’m in the minority in this assessment, as others on CNBC and other bubblevision networks as still talking about green-shoots. Bill Gross warned this past week that the U.S. will eventually lose their precious AAA credit rating; he claims this fear is now being felt seen in the bond markets with lower prices, higher yields and fewer bidders. It is also being seen in the value of the dollar as it continues to press downward to another new multi-month low on Friday.

I believe that bonds and the equity markets will be negatively impacted by the Wednesday release of the FOMC minutes; as in those minutes the Fed-heads lowered their expectations for the rebound compared to their prior estimates. Geithner also sounded the alarm on the growing budget deficit and its impact on the dollar this past week but he has been all over the map lately…he stated that “We must get our fiscal house in order or risk having government borrowing crowd out productive private investment.” Moody's said it was still comfortable with the U.S. AAA rating (but they were also comfortable with AIG, LEH and BSC’s ratings as well). S&P was questioned about downgrading the U.S. rating like they are in the process of doing with the UK and S&P said they affirmed the U.S. rating in January “despite our judgment that fiscal risk has noticeably increased” but they stated that they saw that deterioration as only temporary (then again they said the same thing about AIG, and other firms as well). As I’m so fond of saying…why should we believe or even care about what these rating agencies says after they gave AAA ratings to hundreds of billions in toxic products that were at the center of this credit/debt debacle!

GM announced on Friday it had borrowed another $4 billion from the Treasury and was planning a bankruptcy before the month is over (but the markets ignored this disclosure). That raises the bailout funds received by GM to $19.4 billion and GM said that total would rise to at least $27 billion after the government imposed deadline to restructure on 6/1/2009. GM will require the government to provide debtor in possession financing once they file for bankruptcy. This past week GM reached a tentative agreement with the Canadian Auto Workers union, which would reduce wage costs by 28% if ratified by the rank and file members; while GM got a similar sell-out agreement from the UAW earlier in the week. GM Bond holder’s reps on Friday they solidly oppose the $0.10 on the dollar ownership offer for their $24-$26 billion in debt; and they will likely let bankruptcy resolve the stalemate. This cram down of 10% ownership for the bondholders is seen as a war on capitalism by the Obama administration; the bondholders are being called speculators by the administration where in the past they were called investors. Calling them speculators or capitalists, now a dirty word, allows our government to vilify them in the press; they forget that many of these bonds are held in pension trusts and retirement accounts. By cramming down a this 10% ownership plan they will be essentially be wiped out; the retirees will likely pass on long before that measly 10% ownership position yields any significant gain. I do not believe that the markets are not going to react well if the shareholders and the bondholders are wiped out in the GM bankruptcy.

The 2009Q1 earnings cycle is over and S&P announced on Friday that actual earnings for the entire SPX were better than expectations; and that it was the first time in seven quarters that earnings exceeded estimates, and the cheerleaders on CNBC were all over this statement. Of course everyone should realize that the bar was so low a snake could have jumped over the vastly reduced estimates.

The SPX closed Friday at 887 and when we divide 887 by 28.50 we get a historically high P/E of 31+/- a very rich price to earnings ratio for real investors, so we would have to increase earnings next quarter by 70% or better to come in at $48.50 which would be more in line for a relatively high range P/E ratio of 18+/- at current levels. A bear market P/E is typically 9-12 and we never even came close to this valuation (666/28.5 = 23.4+/-). So the $64,000 question remains what should investors be expected to pony up for 2009/2010 earnings and beyond....its important to not that most of these earnings were related to energy and commodities and unless oil prices explode upward we may not see $50.00+/- earnings again for quite some time.

And the Fed-heads agree as they downgraded their estimates in their minute’s release that a booming economy by year end was probably not in the cards. The Fed was somewhat more optimistic than in prior meetings as they see the pace of the contraction slowing…its important to note that they downgraded their GDP growth estimates which also suggests SPX earnings are going to rebound any time soon. I believe that the recent relief rally assumed the economy would begin to recover in 2009Q3 and accelerate into 2009Q4; as GDP estimates were projected to be 2.8% to 3.2% in 2009Q4…but I believe this is just wishful hoping/praying. With the new estimates it may not reach that point until the second half of 2010; so this rally is likely way early.

This past week that noted bear Gary Shilling and Pimco's Mohamed El-Erian are suggesting the recent rebound in the economy is a normal head fake and we should expect another dip in the economy and the as such the markets. Shilling pointed out that GDP growth in 8 of the 11 recessions since WW-2 has seen a quarter of positive rebound followed by another drop. This is a false rebound in economic activity and is not met with a rebound in consumer spending. Evidently it takes substantial proof of a real and significant economic rebound underway before consumers begin to loosen their tight grips on their wallets. If this is true then the coming regional economic reports this week could be key-market drivers. If we begin to see a dip in activity instead of the expected continued rebound then investors will probably run for the exits…hopefully a fat-rat will not get caught in the porthole of the sinking ship before everyone has a chance to escape! This makes holding equities during the remaining weeks a risky proposition. I fear that news flow is going to turn into a drought and the so called green-shoots will turn into scorched weeds.

The impending GM bankruptcy and news surrounding GM is going to be increasingly negative for investors. Earnings for the first quarter are over and the second quarter is normally a rough period for technology stocks ahead for the third quarter back-to-school uptick, so it appears to me that unless conditions suddenly get remarkably better then the majority of the upcoming news could be negative and the path of least resistance would be to hit the sell button (sell-in-May). If the economic data and global economies suddenly turn down again then it would be a rush to the proverbial exits.

Our friendly 30-component benchmark Dow made a clear lower high this past week and then it closed below its recent uptrend support line, not a very bullish development, and as such the only remaining material support level comes into play at 8,155-8,170 before we have to face a potential retracement to 7,800+/-. The 7800 level is a 38% Fib retracement of the March to May highs. This would be the logical place for any major decline to stop to take on passengers (that the bull-train left behind); there are still a lot of long only funds that failed to catch the departing train the last time and many are praying for a decent dip to buy and they may get their chance at this level (see full technical assessment below). I believe that we could see a distinct pull-back continue this week...Once again we saw a very small change in the McClellan OscillatoronFriday, suggesting a large price move is coming early this week. On an Elliot Wave analysis equities look like they completed wave 2-up of (C ) down, Friday. That suggests wave 3-down is about to start, and that leg should be a sharp move, also the 3rd wave's are usually the longer moves in the usual five wave sequence.

I cautioned on several times this past week that volume was extremely anemic the previous week and Monday/Tuesday only to see an up-thrust in volume on Wednesday/Thursday; and it’s this volume increase that is a negative as both days we saw heavy selling and downside volume. This raised a caution huge flag for me and makes me bearish this week. With lighter volume any negative news could accelerate any selling. Now according to the stock-market almanac here is the wild card for this week; as the week after Memorial Day historically we get a light-volume bullish-trend as seven of the past ten years we have seen gains. I want to point out that none of the past 10 years have we been embroiled in such deteriorating negative global economic conditions as we have now so historical norms for trading this week are practically useless.

Fitch Ratings stated this past week that China's banks are showing early signs of asset quality deterioration amid a torrent of new lending to help fund government stimulus projects. New loans totaling 5.17 trillion yuan (about $$757 billion) in the first four months of this year have already exceeded the 4.91 trillion yuan in loans made in all of 2008. Amid the credit surge, government officials have warned of rising financial risks and earlier this week announced rules to ensure money is going to the real economy, after concerns were raised that some loans were being diverted into the asset markets instead (this helped fuel their market-bubble).

In a report on China's banks published Thursday, Fitch said it's seeing early warning signals from the Chinese banking system. Chinese lenders have been downgrading more “special mention” loans credit that is considered about to default to bad debt, or nonperforming, status, said Charlene Chu, a senior director at Fitch Ratings.

Chinese banks also have been provisioning more capital for unimpaired loans, indicating that the banks themselves see greater losses down the line in loans that are currently marginally performing, according to Chu. The report added to earlier warnings from the agency that lending quality in China is weakening. Fitch has long argued that figures like low levels of non-performing loans compared with total bank assets don't tell the full story.

Fitch said any impending credit crisis will be hard to spot in the short term given the high volume of lending. Yet over time the global economy's continuing weakness and China's nascent domestic demand will take a toll on the banks, as their corporate borrowers report lower profits and the likelihood of defaults rise, Chu said.

“At the heart of these concerns is the recent steep rise in corporate exposure amid a concurrent decline in enterprise profits,” she stated. Ordinarily falling corporate earnings are met with tightened lending, but in China precisely the reverse is evident, illustrating that despite years of reform Chinese banks still retain an important policy function in upholding local firms!

Doubts about the vigor of China's recovery deepened on Thursday as two senior officials and a pair of international banks highlighted the risks still facing the world's third-largest economy. Vice Premier Li Keqiang said that while the government's 4 trillion yuan ($585 billion) stimulus plan had yielded initial results, it was too early to hail an economic recovery. “The international financial crisis is still spreading, and its impact on the real economy is deepening,” Li stated. “There are still huge uncertainties, and the process of economic recovery may be tortuous and complicated, he added.

Li's cautious comments are striking because Premier Wen Jiabao has repeatedly said that confidence is more important for China as it strives to pull out of its downturn. Annual gross domestic product growth in the first quarter slowed to 6.1% from 6.8% in the final three months of 2008. Zhu Hongren, an official with the ministry, stated this week that weak economic activity, especially reduced external demand, may exacerbate industrial overcapacity. “Caution is needed before we can say that the Chinese economy has bottomed out,” Zhu said.

Credit Suisse said this past week in a report that economic activity appeared to have softened in the second half of April and that the trend was more pronounced in May, with weakness in the materials sector and power consumption spreading to retail sales. “We argue that the recovery in China is still ongoing, but that the pace may not be as strong as many have hoped and prayed for recently,” Dong Tao, Asia economist at Credit Suisse, said in a report. He forecast that the Purchasing Managers' Index might slip below the watershed of 50 over the next few months, suggesting that the Chinese manufacturing sector was contracting.

ENERGY-Corner

The SPX is heavily weighted with the energy-sector/components….this is a drag in the energy sector and SPX as we saw a report this week from the IEA that stated Oil consumption will this year drop at the sharpest pace since 1981 due to the crisis afflicting world economies. In its closely watched monthly survey, the IEA stated that it now expects global oil demand to fall 3% to 83.2 million barrels a day this year, or 2.6 million barrels a day less than in 2008. This was the ninth consecutive monthly reduction that the IEA has made to its oil demand forecast…..not very bullish for energy stocks or ancillary stocks like drillers and tankers.

The International Energy Agency (IEA), forecasted this month that world oil demand this year will post the sharpest annual fall since 1981; also pledges by the Organization of the Petroleum Exporting Countries to cut production has also taken its toll on supplies. The IEA has said the recent rise in oil prices was due to sentiment rather than evidence of higher consumption.

Weaker freight rates have also meant oil companies have resorted to leasing ships to store both crude oil and products. An oil market trading structure known as Contango, when oil for prompt delivery is cheaper than oil for later delivery, has made it profitable to buy oil for storage which has helped take many vessels out of circulation. Estimates have ranged from 120 million to 140 million barrels of crude oil stored at sea in 53 to 55 vessels.

This current commodities led rally is a function of a very-weak dollar and rally a giddiness of seeing some green-shoots associated with macro economic hopes/prayers over the harsh realities of poor demand. Global commodities benchmark CRB index hit six month highs this past week. U.S. crude futures have surged about 21% in May to a six-month high as they pushed above $62 a barrel this past week. Gains so far this month surpass a 12% rise in May last year when crude was marching toward a record high above $147 hit last July….so the magnitude of this trading manipulative gain is huge!

From my vantage point this current rally has shown a disjunction between prices and fundamentals (except for the deterioration of our greenback). It reflects significant optimism, mainly with regard toward equity markets, that the world economies have bottomed and the worse is now in the rearview mirror!

Certainly things are a tad bit better than they were but it does not mean we are out of the woods yet. We are in the midst of a very serious crisis and deteriorating economic environment. Global oil consumption has not recovered since the price drop we saw to a five year low of around $32 this past December. And The International Energy Agency expects oil demand will post the sharpest yearly plunge since 1981. Crude inventories in the United States remain close to a 19-year high; and we have approximately 120-150 million barrels of oil are in floating storage with inventories ashore brimming. This move is again being fueled by speculators who switched to net longs for many commodities; as such prices could rise further, although the global economy is forecast not to recover until early next year. Investors, however, are finding tentative evidence of a narrowing gap between fundamentals and prices.

If the dollar starts to rebound, energy players (especially futures players) will be quick to book profits as the rally of nearly 50% has been built on a fundamental house of cards, we could easily see a pull back in the related ETF's and stocks...OIH, XLE, HES, XOM, CVX, OXY, SLB, HAL, RIG etc.) we could see a rally in SCO and DTO, ERY !

This week CRUDE what I so often refer to as black-gold Texas-"T" traded up $0.65 on Friday on the continuous contract.....the contract gained 4.67-points on the week or 8.19% to finish the secession/week at $61.67 *weekly range was moderately wide 56.76-62.26 The (Daily crude chart) appears to be setting up to roll over again after reaching an a high of 62+/-....and the downside could be extensive as I have written previously we will need to watch SUPPORT at 42.50-44.25+/- a level where I will be a BUYER...I REPEAT-BUYER on a short-term basis. The (weekly crude chart) is indicating that we are looking like we are very over-extended in this move and that we might have one leg higher into the 63.75-65.00 range before we post another exhaustive top and likely roll-over (unless we run into a wave of geopolitical crap....if we break below 59.00 and then 54.50 I believe we see a retest of the $42.50-45.00 level... The chart is very overbought!

On a technical basis we have seen a significant drop in the number of outstanding crude futures contracts as they have plunged to the lowest level in over seven months signaling that this year’s crude rally could be on its last leg. Open interest on the NYMX has dropped 13-14% in the past week to 1.094 million contracts. This indicates that a 20% surge in crude this month that has pushed prices above $61 a barrel is likely to end, and we could see crude dropping back towards $40.00-45.00 I’m not sure at this point due to the huge inventories that the crude market is necessarily buying into the green shoots premise as the number of short positions to be covered is usually finite, so support for prices isn’t as strong as when you’re adding new positions. [Open interest is defined as the quantity of contracts bought that have not been cancelled by corresponding orders to sell; and the open interest level for crude on the Nymex is at its lowest since 10/29/08]. Crude has recovered from a four-year low of $32.40 a barrel in December as rebounding equity markets foster speculation that government stimulus measures will spur economic activity and as such demand for energy will increase as well; and this flies in the face of data where U.S. crude oil inventories remain near their highest in nearly 19 years because of lower demand from consumers. In addition to the stockpiles held in the U.S., traders are storing 102 million barrels of crude and 19 million barrels of refined fuels on tankers, according to London-based shipbroker E.A. Gibson. Given the high level of crude inventories and contraction in activity in advanced economies, I am still expecting a large correction from these levels in crude. And a pullback to the low $40s is quite possible if crude held in floating storage is released back onto the markets, due to the increase in storage prices!

Not very consumer friendly (good for refiners and energy firms though) With the Memorial Day weekend and summer driving season upon us, motorists are facing a familiar trend surging gasoline prices….as pump prices have increased nearly 20% over the past month, and are likely to go even higher over the coming weeks, we are a tad bit relieved that many experts don't foresee anything like the record levels of 2008. The national average price for a gallon of regular unleaded gasoline increased Friday to $2.41, in a survey compiled for motorist group AAA. But the surge in prices is somewhat relative. The average price is down 38% from the $3.88 per gallon AAA reported one year ago. And it's down $1.72 or 41.8%, from the record high of $4.114 set last July 17…thank good ness for small favors. Gas prices could increase to $2.45 this weekend, said Tom Kloza, publisher of Oil Price Information Service. That would be an astounding 52% increase from November, he noted. He noted that we have never seen a similar percentage increase from winter to spring. Barring major hurricanes or other unforeseen events, many experts expect the average price to peak around $2.75 by Labor Day; California and other West Coast states could see prices spike as high as $3.10..

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Stephen Tetreault | Southern Maine, USA | Email | Website

The opinions of FSU contributors do not necessarily reflect those of Financial Sense.