Diamond Slice

Playing With Financials, Not Fire, in 2010

The last week has seen 100 day moving averages torn apart, surprises from economic data reports, and one of the most notable sell-offs for stocks in some time. Recently, many home gamers and pros alike, have put financials out of their purview. The erratic and effectively risky nature of these names are less than inviting, but there are opportunities to profit from what has happened and what will happen next.

Where We've Been

1.) The iShares Dow Jones US Financial Sector Index (DJUSFI) ETF (IYF) has rallied 34% in the last 52 weeks, to 51.51 on February 4, 2010.

2.) The DJUSFI itself, which IYF is designed to mimic, presently totes a 61.07 trailing p/e when accounting for earnings losses.

3.) The DJUSFI's forward p/e appears reasonable at 13.36 when accounting for positive and negative earnings, yet the expectations of future earnings, used to compute this number, are based on a full scale U.S. economic recovery.

4.) Higher p/e ratios are tolerated as upside earnings surprises have helped to keep multiples low throughout the latter half of 2009.

Consider the possibility that your view is now the byproduct of a positive feedback loop, fueled by a bias that is based on a string of positive surprises. Statistics reminds us to rely only on pertinent, non random, past data when forming hypotheses and to discard random events, disguised as oracles.

 

Signal Flares

Looking ahead, we see a trend forming in the very sector which plagued the economy into recession. New home sales have fallen to 342,000 units in December (just above the March 2009 low) after the initial housing stimulus expired and a new incentive package failed to pick up the slack. Simultaneously the Case-Shiller resold home price index stalled in October and November and existing home sales in December tanked to the lowest level since August. Most disconcerting was the jump in months supply of existing homes which jumped almost a full month to 7.2 months worth of housing inventory.

Where the Money Came From 

Banks have profited from three factors in the latter three quarters of 2009 that could actually hurt them in 2010. (1) It's no secret that the Federal Reserve propped up the nations largest banks through the largest liquidity campaign in the history. Mortgages are still being purchased by the Fed, but they have vowed to quit the purchases of MBS from Fannie and Freddie by the end of March. These purchases allowed potential buyers of similar assets on private balance sheets to find a market price and risk taking re-entered the market. (2) Once it was clear that banks weren't going to fail or be nationalized the first leg of the rally carried prices from book values near .50 to levels nearer to fair value. At this point , it was still understood that the "infected" TARP banks would need some wiggle room to begin lending and get their capital requirements up to par. The answer was found in the repealing of "mark to market" accounting (FASB 157), where banks were suddenly able to keep Real Estate Owned (REO) properties, which had been foreclosed and seized by the bank, on their balance sheet at a price estimated by the bank itself. (3) The rally, which resulted from the new found faith in the financial system as a whole, carried confidence and thus risky investments into the market. This return to risk naturally benefited banks through increased fees and expenses from their brokerage arms and increased profits from proprietary trading of their own funds.

Holes in the Cheese

Just as these three factors contributed to the investment in banks in 2009, we see most bank shares at artificially high prices, supported by unsustainable multiples, and several reasons to doubt the foundations of U.S. banks. The 10-year Treasury rate and the 30 year fixed mortgage rate are at historic lows amidst a record U.S. fiscal deficit of 1.4 trillion USD in 2009, insisting that the end game will include higher rates on mortgages in the future. Taking it one step further, we see recent strength in the USD index, and an upward trend in the 10 year Treasury Note yield, forcing borrowing costs to rise in 2010 and decreasing the incentives for home owners to buy and traders to trade risky assets. This shift will be doubly negative for banks as rates chip away new found cash flows from mortgage refinances and profits from proprietary trading. Similarly, higher rates in 2010 will force 2009 refinanced payments higher, where ARM's reset at rates above "teasers", and fixed products will become less attractive to new buyers on the margin. The benchmark Treasury Yield (10 year note) illustrates the bottoming of the yield below.

How to Play It

If you look through our archives you'll see that we held a position in the ProShares Double Short Financials ETF (SKF) earlier in 2009. SKF follows the 2x inverse of the DJUSFI and has been on a wild ride over the past two years. I will be the first to tell you that we did very poorly by holding this position, as our assumption that (a) market handicappers would overstep the obvious but short term increases in profits due to the revision of accounting rules (FASB 147) and (b) that trading fees and proprietary trading gains would be short lived for financial firms, as the market topped and returned to a decline in mid summer 2009. You should know that this did not occur and we ended up closing the position in August for a considerable loss.

While we did take a loss, we see SKF as a crucial element to our financial strategy in 2010. We are bearish on blue chip financial firms in 2010, due to the ramifications of rising interest rates, widespread exposure to mortgage defaults, and a tired equity market. However, it is prudent to hedge where value lies, and in financials we found our protection in the obvious favorite.

We are playing the financial volatility with expectations for weakness, by going long Goldman Sachs (GS) and 2x short the Dow Jones U.S. Financials Index, using an equally weighted long position in SKF. Review the charts below of both names. GS is actually included in the DJUSFI, as the fifth largest holding, yet it's 7.1 p/e and 1.39 price/book make the firm an incredible value, compared to it's DJUSFI peers.

-GS 6 month performance-

-SKF 6 month performance-

 
 
By opening positions in both GS and SKF, with an equal share of capital in each, we are playing a sort of bear biased saddle. While we expect financials to fare badly in 2010, GS has relatively little exposure to mortgage issues and has proved that it's innovation will prevail in any environment. The firm has missed earnings estimates only three times since Q2 of 2001, and has exhibited solid dividend yield and earnings per share growth over a 10 year period. By trading this strategy on a weekly basis, we will sell shares and capture gains from the winning position and add this capital to the other vehicle. Should our thesis prove correct, we expect that losses from goldman sachs will be limited, and that their value relative to the financial sector will support share prices in most environments this year.

Remember this is an active trading strategy and unknown market factors can always drastically change pries over short periods of time. For added protection enable loss stops on both positions to protect yourself from extensive losses.

Disclosure: Long GS, Long SKF

China's Growth: Blessing Or Curse?

On a positive note for Japan, export growth in December surprised economists by growing at 12.1%, compared to the 7.6% forecast, for the first time since the collapse of Lehman in 2008. Breaking down the numbers, analysts were equally unsurprised to learn which market was responsible for the rapid growth. If I'm hitting my target audience, you've already guessed it... (hint: it starts with "Chin")

The half Joseph Stalin half Adam Smith economy continues to roar at 10.7% GDP expansion, in the final quarter of 2009, yet the majority of consumer markets have been slow to follow suit. Chinese stimulus can be thanked for the birth of domestic consumerism in China, as households have been given vouchers to buy specific goods, creating demand in centrally targeted industries. Simultaneously, all levels of government opened the faucet of liquidity, through low borrowing costs and lax loan requirements, which has accelerated the churning out of western style real estate for consumers to fill with all their new stuff. The price tag on China's stimulus so far scans just shy of $600 billion USD, representing 13% of GDP in 2008 and well above spending in the U.S. and Korea, closer to 5% of GDP for each.

As an Expat living in Korea, I can vouch for the tangible business and expansion that has been rumored to have begun in the East. The steady export market in China has buffered job losses and allowed entrepreneurs to take advantage of the record low interest rates which have spanned the globe. The result, through the eye of an American businessman, is a crane filled skyline in motion and downtown retail epicenters furious with life. It all seems eerily familiar to the consumerism evident in the U.S. circa 2004-2006, and is founded on an assumption perhaps less ridiculous than the "forever appreciating U.S. home price" fallacy, but equally as probable. The new assumption serving as the global economic engine, is that China's 10% growth is not only sustainable, but that it will occur for the foreseeable future. 

Let's look at some of this "sustainable" growth more closely: 

- 2008 China GDP = $4,327 Billion (World Bank)

- 2009 Unrevised China GDP = $4,910 Billion (China Daily)

- 2009 Q4 China GDP Growth = 10.7% (Xinhuanet)

- 2009 Outstanding Loan Growth = +$1,400 Billion = 28.5% GDP (2009 Est.) (WSJ)

- 2009 Broad Money Supply Growth = 27.7% (WSJ) 

- 2009 GDP growth = 13.5% (unadjusted for inflation)

Recently markets have operated under an irrational paradigm where prices don't move until the reality of the situation is forced down our proverbial throat. Ironically it seems that the rumors, fears, and speculation about asset bubbles in China are enough for the communist leadership to forcefully hit the breaks on loose liquidity expansion. The ICBC will curb lending in 2010 by 25%, no doubt to moderate the pace of inflation and domestic growth, as it out-paces the anemic recoveries elsewhere across the globe.

This idea that China saw peak economic acceleration in the last quarter of 2009 hasn't sat well with market movers. While stricter borrowing standards may benefit all, helping to avoid a collapse akin to the U.S. real estate failure, the return to reality has traders scratching their heads for reasons to buy. Added stress from a reversal in the U.S. housing recovery and a weak demand forecast from multinational Caterpillar (CAT) have contributed to the past week's decline. 

It's fair to say that the global recovery is fundamentally based on strong growth from China, while there is evidence that GDP growth in the cheap U.S. dollar-tied-Renminbi may be eroding sales from global competitors and misrepresenting global consumer demand. This week's negative outlook on Japan by Standard & Poors and manufacturing woes in Germany, beg that such fears are rooted in truth. Combining these symptoms with an autocratic body of leadership, resistant to allowing its currency to freely appreciate, has exposed the China led recovery to criticism.

It isn't hard to distinguish Asia's beating heart, albeit is any man's guess whether the continent's overall return to growth lives or dies. China is a formidable 1.3 billion strong populace, the world's third largest economy, and yet the IMF ranks the nation's per capita GDP 89th. As blind as justice, markets may now be signalling that the still developing nation cannot lead the globe from the stimulus injected foundations of recovery to global economic expansion. Whether they are right is up to each of us to decide.

Tuesday Earnings Preview

Bernanke and the crew will get started bright and early behind the collasal locked mohagany doors of the FOMC board room Tuesday morning, while traders will ernestly focus on the information at hand. A slew of earnings from Ashland (ASH) (0.71 EPS est.), Corning (GLW) (0.42 EPS est.), Delta Airlines (DAL) (-0.24 EPS est), DuPont (DD) (0.41 EPS est.), and Sherwin Williams (SHW) (0.52 EPS est.) will keep pre-market traders on their toes. ASH will provding insight into managers' expectations of crude oil price strength, based on announcements of layoffs, the effects of an extremely narrow crack spread, and greatly reduced capacity, on the bottom line of this East coast industry player. GLW will add to the demand for consumer electronics conversation, as new orders for screens of computers and hand held devices will be the focal point of this release. To finish a weak year of air travel, DAL will help investors gauge the willingness of consumers to splurge on vacations as we look for spending to recover in 2010. Finally, DD and SHW will combine to tell the story of industrial and consumer growth from a basic materials standpoint. While DD markets polymers to manufacturers of goods, SHW interacts directly with consumers as they make decisions to invest in their homes.

The Case Shiller price index of resold homes in the 20 largest metro areas should grab attention at 9:00 AM, since recently we've seen a stabilization of home prices by this metric. Later at 10:00 AM, Consumer Confidence measured in January is expected to nudge higher from 52.9 to 53.5, while the measure of consumer appetites has wavered around the break-even point since May. Keep an eye on the 4-week bill (11:30 AM) and 2-year note (1:00 PM) auctions, where demand will likely strengthen as the relative safety of Treasury debt becomes more attractive to equity holders following last week's decline.

Monday's recovery on the S&P 500 saw the index stablize at 1096, a technically insignificant level, while the WTI continuous crude oil spot ended the day just above $75/barrel, the U.S. Dollar index held it's ground, Gold failed at $1100, and the 10 Year Treasury yield paused higher to 3.63%. Despite solid numbers from Apple's laptop sales, markets found little comfort on a day more reminiscent of a technical pause than a reversal higher. The absence of upside surprises on Tuesday will leave financial markets lower.

Crude Oil: The Path to $70

Supporting our highest conviction trade yet, we now see fundamentals, sentiment, and technicals aligned for a significant correction in Crude Oil prices. While DS partners already hold a position in DTO, we are moving to formally call a short term WTI Crude Continuous Spot price target at $70. Below we explain in detail our thesis supporting this trade strategy.

Fundamentals 

Crude supply rose by 5 million to 330 million barrels in the past two weeks, still above average market high water mark levels. Despite a large draw from the 375 million barrel supply peak in May 2009, refiners are voicing their concern by halting production capacity just above 81%. Crack spreads are increasingly narrow as weak consumer habits choke the profitability of refiners and discourage production managers from adding to the more costly finished good stockpiles (i.e. gasoline, distillates, etc.). When crack spreads rise alongside prices, refiners benefit from higher gas prices by increasing their margins. However, stagnating crack spreads near all time lows signals weaker consumer demand for final petroleum products, forcing refiners into slowing production to keep spreads at current levels. In short, higher oil prices are hurting refiners and consumers in an environment where end demand for energy is not responsible for price gains. 

 

The fundamental global price function of supply and demand should be respected, but IEA have recently been misstated by oil hawks. The International Energy Agency has predicted global demand for oil to begin at 86 million barrels per day (mb/d) in Q1 2010 and finish Q4 near 87 mb/d. While these estimates may have risen from earlier expectations for weaker demand, the upward price momentum has been baked into stocks.

The 2010 mean demand estimate of 86.3 mb/d compared to December global supply of 86.2 mb/d, on an unexpected rise of 270 kb/d, suggests that supply is gaining while demand growth, rooted in non-OECD developing Asian countries, is less than stable. Also important are upside supply surprises from the OPEC 12, which prove that there are incentives for the cartel member states to raise production levels at these prices.

Sentiment

Rooted in U.S. equity values lie traders' economic sentiment. Crude oil prices are historically volatile during periods of uncertainty, where the commodity reflects market participants' confidence in the economy as a whole. Bullish sentiment has been on the rise for much of the previous year, as traders have been talking up the potential for crude to hit $90 per barrel. This optimism has been rooted in the manufacturing expansion in the second half of 2009, GDP expansion in Q3 and expectations of expansion in Q4, and global demand upgrades by the IEA mentioned above. Though mainly, there is the $144 per barrel price hemorrhage of July 2008 fresh in traders' minds and expectations for a lasting economic recovery in 2010. These factors have combined to create a short averse commodity trader's market, where resistance levels have remained weak as rallies occur. 

As you may have already guessed, we consider prices to be floating on a thick layer of froth, aided by the mentality that oil will continue a sustainable rise, despite the 130% rally from February '09 to January '10. The catalysts necessary to cause this confidence shift are simply the reverse arguments of price inflating factors that are now being proven overblown. 

First, the manufacturing recovery has outpaced most expectations, as ISM Manufacturing Surveys show positive forward indicators of growth, inflating expectations to levels where the probability of upside surprises is greatly reduced. Second, the manufacturing sector has contributed largely to GDP expansion in Q3 and is expected to carry the U.S. economy towards +3% growth in 2010. Future disappointments from the goods producing sector would not only implicitly hurt oil, but would indirectly lower crude prices as the forecasts for broad based economic growth are revised lower. Third, the IEA estimates for Global demand for crude oil are overblown and supply is increasing more rapidly than predicted. All the while, a public announcement from China proclaimed that QE in response to the economic recession is now being reversed, causing the market's expected rate of energy consumption to be revised lower. 

Wrapping up, Q4 earnings results seem to be less positive than Q2 and Q3, where specific results from financials and transports have so far bode badly for animal spirits. Further write downs from JP Morgan (JPM) & Citi (C) on credit card defaults and foreclosures have pushed the consumer's recovery further down the time line, while CSX Corp. (CSX) reported lower transport volume, dampening the spirits of bulls citing manufacturing growth during the period.

Technicals

While fundamental analysis and sentiment shifts are both worth pointing out, the technical support to one's argument is always most crucial to a high conviction trade. Glance over the visual below, then we will discuss the technical signals in more detail.

 
 The bearish wedge pattern is a classic technical pattern, where market prices for an underlying security increase over a period of time, but growth between peaks shrinks while growth between troughs is sustained. In this cycle, the Moving Average Convergence to Divergence (MACD) graph and histogram show weakening moving average momentum, as depicted by the downward sloping trend between peaks on the MACD sub-chart. While the wedge has been forming for some time, two further technical signals support now as the turning point for crude prices. The first signal comes from the 50 day simple moving average (sma) at $77.50, which prices broke beneath more than once in futures markets on Monday, before the WTIC closed higher at Tuesday's close. The second and most convincing sign came when the MACD histogram broke below zero, marking a bearish cross. Had trading momentum led to higher price levels and an MACD reversal above the most recent rally peak in late October, the bearish wedge would not have formed and crude prices could have consolidated to move higher. Instead, we saw a perfect lower peaking reversal to complete the bearish wedge and seal this call.

The WTI continuous spot, charted above, closed at $79.32 on Tuesday and will allow for a better entry point for oil shorts on Wednesday. We own the PowerShares Double Short Crude Oil ETN (DTO) and added to our position at $79 dollars. The vehicle attempts to provide 2x inverse price movement compared to the WTI crude oil spot.

We are setting a price target for the WTI spot at $70, where we will take profits from our DTO position and reassess our position. 

Disclosure: Long DTO

Weekly Spectrum: Short Week, Housing & Earnings Focus

The January 18 - 22 business week will begin one day late, due to Martin Luther King Jr holiday, leaving only Tuesday to Friday for market action to be staged. The most notable economic data releases will be the Housing Market Index (HMI) and Housing Starts numbers; while Treasury International Capital data, the Producer's Price Index (PPI), a Philadelphia Fed report, Leading Indicators and Jobless Claims will fill the docket. 

Combine the absence of economic indicating data on Friday and a hand full of releases spanning Tuesday to Thursday, and the spotlight turns squarely on the weeks earnings reports listed by day below...

Tuesday: Citigroup (C), CSX Corp. (CSX), McMoRan Exploration Co. (MMR)

Wednesday: Bank of America (BAC), Ebay (EBAY), Logitech International (LOGI), Morgan Stanley (MS), Starbucks (SBUX), U.S. Bancorp. (USB), Wells Fargo & Company (WFC)

Thursday: American Express (AXP), Burlington Northern Santa Fe (BNI), Capital One Financial (COF), Fifth Third Bancorp (FITB), Freeport-McMoRan Copper & Gold (FCX), Goldman Sachs (GS), Google (GOOG), Southwest Airlines (LUV), Union Pacific (UNP), Xerox (XRX)

Friday: BB&T (BBT), General Electric (GE), McDonalds's (MCD), Schlumberger (SLB), Suntrust (STI)

(Scroll down to find the Economic Report or Earnings Details of your choice)

Tuesday 

The late trading week will start in a hurry Tuesday morning as C and MMR are scheduled to announce earnings before the market open. Citigroup has been plagued by sub par lending standards and may miss the expected -0.33 EPS due to higher defaults and weaker Commercial Real Estate fundamentals, cited in JP Morgan's results on Friday. MacMoRan will likely have benefited from higher oil prices over the quarter, perhaps beating the -0.26 EPS consensus, yet the forward momentum for drilling and exploration of crude oil could be dampened by the recently wavering price of the commodity. The Treasury's International Capital report will hit wires at 9:00 AM, and should give some clarity to the Treasury market that has moved inversely with equities as investors seek safety and speculators look to capitalize on future supply-demand gaps of the U.S. debt. At 1:00 PM home builders' sentiment will be judged by the results of January's Housing Market Index, which weakened from 17 to 16 in the previous month. Following the close, rail carrier CSX Corp. will announce earnings, where the estimated result stands at -0.76 EPS. 

Wednesday 

The usual weekly suspects MBA Mortgage Applications (7:00 AM), ICSC Goldman Store Sales (7:45 AM), and Redbook Sales (8:55 AM), may be overshadowed by financial earnings this Wednesday. Wells Fargo (WFC) (-0.02 EPS est.) and Morgan Stanley (MS) (0.36 EPS est.) will announce Q4 results at 8:00 AM, U.S. Bancorp (USB) (0.29 EPS est.) will release numbers before the open, and Bank of America (BAC) (-0.52 EPS est.) will keep traders guessing, but vow to show their grades by day's end. While BAC and WFC expect losses, USB has the most to lose if results miss the optimistic estimates. In a quarter where JP Morgan announced an additional $2 billion of loan loss provisions for 2010 Q1 and Q2, The financial sector may reveal some skeletons. US Bancorp. doesn't have the trading arm to profit from market movement fees like BAC, MS or JPM and share a closer fate to their loan portfolio. The PPI and Housing Starts data will cross tickers at 8:30 AM, and are expected to show virtually no change in either statistic, suggesting that any big moves from these reports will impact markets. Consumer names EBAY (0.40 EPS est.), LOGI (0.27 EPS est.) and SBUX (0.27 EPS est.) will announce and be judged in after hours trading; begging attention to after-market consumer goods, communication tech spending, and consumer discretionary outlays, respectively. 

Thursday 

While Jobless Claims will demand an audience at 8:30 AM, following an unexpected 11,000 jump in initial claims to 444,000 last week, earnings reports will steal the pre-market show. First by Fifth Third Bancorp (FITB) (-0.31 EPS est.) at 6:00 AM, second with Xerox (XRX) (0.22 EPS est.) at 7:00 AM, and accompanied by Goldman Sachs (GS) (5.19 EPS est.) and Union Pacific (UNP) (1.04 EPS est.) some time before the opening bell. FITB will add clarity to consumer lending and commercial real estate, XRX will mirror businesses investment, GS will tell how well the best traders on the planet fared, and UNP will keep tabs on the manufacturing sector's recovery via transportation of goods. 

The Leading Indicators report, due at 10:00 AM, is expected to ease from the 0.9% November growth to 0.7% growth in December but may be weakened by recent negative surprises from labor and spending in the tail end of 2009. Simultaneously the Philadelphia Fed will release their survey of economic conditions within their respective district, which is also expected to show decelerating growth as the indicator drops from the previous high of 20.4 in December, to 18.0 in January. The EIA Petroleum Status report has been pushed from Wednesday to Thursday this week, and will be closely watched for total supply changes (currently 330 million barrels) as well as distillate stock draws and refinery capacity rates.

Reporting after the close are Burlington Northern Santa Fe (BNI) (1.22 EPS) at 4:00 PM and Capital One Financial (COF) (0.45 EPS est.) at 4:05 PM, while American Express (AXP) (0.55 EPS est.) and Google (GOOG) (6.43 EPS est.) will release earnings sometime after the bell. BNI will be an interesting post-close story to compare to UNP as traders look for moves in the transport sector, just before Capital One walks investors through an average U.S. credit portfolio. Amex will unveil the strength of their high end consumer credit book and small business arm, while Google will most definitely stomp estimates, as on-line advertising continues to gain traction. Finally, Southwest Airlines (LUV) (0.06 EPS est.) will announce results at an unknown time; a testament to consumers' marginal propensity to fly rather than drive.

Friday

On a day where there is literally no economic data to be released, Friday's market action will be acutely focused on earnings. Before the market open BB&T (BBT) (0.21 EPS est.), General Electric (GE) (0.27 EPS est.), McDonald's (MCD) (1.02 EPS est.), and SunTrust (STI) (-0.69 EPS est) will make highlights. Most of the banking sector will have reported at this stage, however results from BB&T and SunTrust will reflect loan quality and economic activity in the South Eastern states where these banks have a dominant presence. Similarly, GE and MCD will boast or bleed by changes in consumer demand for household appliances and premium priced meals at fast food restaurants. Capping off the list of noteworthy market moving events, Schlumberger (SLB) (0.63 EPS est.) will announce their Q4 2009 earnings as the only scheduled release on Friday, while it happens to be the earliest at 6:00 AM. The strength of the offshore oil explorer and driller will be influenced by spiking crude prices throughout the quarter, yet expectations for the price/barrel moving forward could have a greater effect on the stock than the corporate track record. 

Keep a close eye on earnings and economic data in this short yet furious week of market moving events. Oil is moving lower and the MACD is showing a bearish cross, leading us to make a high conviction call in our next piece that you won't want to miss. 

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In this piece we experimented with different font color for our readers' increased utility when referencing the Weekly Spectrum and would appreciate any feedback you may have

Thank you and as always... Happy Trading

Trading Notes: Crude Oil, Consumer, Financials

Crude Oil

The oil issue has been speculative to this point. It's hard to argue against 90 dollar oil when we saw 145 in July 2008, but the fundamentals aren't congruent with the price growth we've seen and this trader finds it easier to argue FOR $60/ barrel oil. Crude supply in the U.S. remains high, at 330 million barrels, while gasoline demand remains week and imports are rising. Crack spreads for refiners are reflected in their output averse management of facilities, where capacity utilization rates have stagnated at 81.3%. Refiners are the effective buyers of crude and the capacity numbers are sending signals of distress. The IEA's world demand predictions for 2010 were recently raised from the current 2009 level of 84.9 Million Barrels / Day (mb/d) to nearly 87 mb/d by 2010 Q4. (It should be noted that predictions for Q4 2009 global demand at 85.5 mb/d overshot the actual level of 84.9.) Rate hikes in China this week will calm the giant and should increase the likelihood of U.S. rate hikes in the first half of 2010.

Rate hikes will cool speculative trades and pull a significant amount of upward speculation out of Crude, as they increase capital holding costs and the risk of trading on margin. Softening Chinese growth will also cool global supply and demand speculation, with respect to crude, in an equally bearish development for the commodity.

The Consumer

Earnings season may present upside risk to short positions, which is why our stops have been tightened on our SDS and SCC positions. SPX might make it's way to 1200 where a lot of traders are calling the next Fibonacci resistance level, but momentum seems to be sputtering as earnings have begun.

The December Retail Sales report showed -0.3% growth combined with the revised higher 1.8% November rate, and makes it difficult to gauge buying sentiment moving into 2010. However the negative growth in the month of Christmas will leave many scratching their heads, and suggest that energy prices are playing a bigger role in retail sales than previously thought.

All in all, crude seems to be weakening, even on the backs of solid earnings from Intel, which should have been interpreted as positive to the overall economy. In after hours trading Intel traded up around 0.8% on a 0.55 EPS report vs. 0.34 EPS expected. Granted the day saw some sour economic fundamental data from the previous mentioned reports, but the market response was weak for a 62% profit beat.

Financials

Markets are becoming tougher to surprise at these levels and we could see more weakness from the banks. Soc Generale (SCGLY.PK) had an awful quarter in France and the U.S. regional First Midwest Bancorp (FMBI) missed the -0.07 EPS consensus by 76 cents, at -0.83 EPS. If regional financial problems due to MBS and the potential for more mortgage pain continue to show their fangs, financials could sell off through earnings.

Financials are the guts of the recession and will surprise many at how fast they can lower the tide for all. JP Morgan (JPM) will answer questions in this category on Friday, where weakness from the best in breed lending giant would create malignant concern in the banking sector at large. 

Disclosure: Long SDS, Long SCC, Long DTO (see: DS Portfolio)

Alcoa Miss Spells Trouble for Q4 Earnings

Earnings season officially began, as the first member of the S&P 500 and Dow Jones Industrial Average to grab Q4 2009 earnings headlines, Alcoa (AA), reported a net profit of $0.01 EPS on Monday, January 11. The shortfall to the $0.06 EPS market consensus was explained by CEO Klaus Kleinfield by the unexpected weakness in the dollar, combined with higher energy prices.

While Alcoa is only one company, the firm is symbolic of the U.S. manufacturing sector as a whole and it's profits are directly affected by the prices of input commodities, primarily petroleum products and aluminum ore.  Below is a 1-year chart of the S&P 500, annotated according to AA earnings results vs. estimates. (Click chart to expand in a new window)

 

As shown above, the S&P 500 has rallied from the announcement of AA earnings following each of the past three quarterly announcements. The once discarded industrial giant has found new importance over the past year in financial markets as it foreshadows the industrial earning power of the U.S. The recent two quarterly results beat estimates, while the Q1 2009 results were very near the street's consensus at the end of a period wrought with massive earnings let downs. All in all we see the first three AA quarterly results of 2009 as better than expected.

Naturally, Alcoa can't dictate the earnings of an entire economy, but the two factors causing the firm to miss earnings will be applied to bottom lines as earnings season picks up in the following weeks. These factors were higher energy and aluminum ore costs combined a weaker U.S. Dollar. The macro economic message heard on Wall Street highlights real revenue destruction from a weaker domestic currency and the negative cost effects of higher oil.

The following two charts show the trend of these two factors of production below in the form of the USD index and the WTI Continuous contract. 

 Referring to the charts, the cost of petroleum based inputs to production and the devaluing of the U.S. dollar during the months of October to December 2009 are both evident. Immediately, traders and investors have begun applying heavier weights to these parameters when running their earnings models. Will this trend be the thorn in the side of earnings to bring the first season of the recovery where earnings miss more than beat estimates?

In our opinion the dollar has held it's ground fairly well over the past month and may see a short term appreciation on interest rate concerns, while we view crude oil as overbought and due for a pullback. We follow the Moving Average Convergence Divergence technical series, as it has been highly predictive of price cycles in the many securities, mainly crude oil, over the course of the recovery, and see crude oil particularly overbought with respect to this statistic.

Whether earnings season is a make or a break for stocks relies on more than the results of just one firm, yet the manufacturing recovery story has remained the golden goose of 2009 and will not benefit from the implications derived from a negative AA earnings card. 

Disclosure:

Currently we are short Crude Oil (DTO), short Consumer Services (SCC), and short the S&P 500 Index (SDS). 

(By Clicking on the DS Portfolio tab in the navigation bar above, readers can follow the current portfolio held by Diamond Slice partners in real time.)

Weekly Spectrum: Life After -85k December Jobs Lost

The January 11-15, 2009 week will be crucial to the movement of equities and commodities over the next month. This addition of the Weekly Spectrum will recap the December Employment report and explain which economic reports will affect U.S. financial markets in the week ahead.

The December Non-Farm Payroll report dropped traders' jaws as if they had witnessed a clown showing up to their eight year old's birthday party slurring and cursing through rosy cheeks soaked in cheap bourbon... not a pretty picture. The news on the street last week was that non-farm payrolls could end up in positive territory for December, yet they fell 85,000 from the revised 5000 gain in November. The headline unemployment rate remained at 10.0% for the month, due to 650,000 job seekers giving up the hunt and thus decreasing the total size of the labor market. Had those 650k continued their job search, the unemployment rate would have reached 10.4%. While the U.S. equity market initially sold off in reaction to the data, the day ended in positive territory as markets continued data mining for positive news. This tells us that now may be the perfect time to start adding to your short positions... or the worst. Crude oil has hovered at a major crossroads for the last three sessions and will have to make up it's mind this week to continue a rally past its previous highs or retreat back into the $70/barrel range. Perhaps even Mr. Wizzard Blankfein is rethinking the situation heading into week 2 of 2010. 

Monday

-Demand for 3-Month and 6-MonthTreasury bills will be closely watched during the 11:30 AM auction, but debt markets will certainly wait to make a call on the day until the 10 Year TIPS bids begin flying at 1:00 PM.

-The 10-Year TIPS are "Inflation Protected Securities", which do basically what they say they do. An interest rate is derived when they are issued and the principle on the obligation is adjusted for inflation over it's life. These investments become popular with institutions and individuals during times of expected inflation and will be closely watched. The last 10 Year TIPS auction on October 5, 2009 saw the high yield at a record low of 1.510%, reflecting the record bid/cover demand ratio of 3.12. Demand for most longer maturing Treasuries has been weakening in recent auctions and may lift yields of the TIPS above the previous record low. A higher yield on the 10-Year TIPS will signal that lessened demand for treasury debt has outweighed inflation fears, while sustained low yields will argue the case of inflation hawks.

Tuesday

-Store salesreports from ICSC Goldman at 7:45 AM and Redbook at 8:55 AM will begin foreshadowing where sales are headed in the post-holiday season.

-The International Trade report at 8:30 AM is forecast to show a widened November trade deficit at -35.0 billion USD in November, from -32.9 billion USD in October, corresponding to recent reports from china that trade to and from the communist giant is improving.

-In debt markets, we will also see Treasury auctions of the 4-week Bill and 52-week Bill at 11:30 AM, and the 3-year Note at 1:00 PM.

Wednesday

-MBA Purchase Applications at 7:00 AM will start the day, as the previous 3.6.% weekly gain will be the number to beat. Last week 30 year prime mortgage rates rose to 5.18% and muted the mortgage application strength rooted in refinances, as widespread rate hike speculation intensifies.

-The EIA Petroleum Statusreport will get a lot of attention this week as oil finds its way above the high water $83/barrel mark or below the psychologically significant $80/barrel level. Distillate inventories have begun falling due to cold snaps in the U.S., while the IEA has upped OECD global consumption forecasts for 2010, supply shipments to the Cushing, OK continue to rise, and refiners keep capacity below %80. The Moving Average Convergence/Divergence technical indicator (MACD) and corresponding histogram is signaling that the price/barrel of crude will pull back from these levels, but a big draw in inventories would give the price a further boost higher.

-At 1:00 PM the 10-Year Noteauction will confirm or dis-confirm speculation that interest rates are beginning to rise with the market rate yield on the Note finding support at 3.8% as of Friday's close. We predict that coupon rate will be higher than the past two 10-Year Note auctions' 3.375% coupons, while the high yield "tail" on the auction will foreshadow demand for Thursday's 30-year Bond offering. In December the high yield tail was 3.448% compared to the 3.375% coupon, showing that demand for the debt weakened as the secondary market began trading the contracts.

-The Fed's Beige Bookwill get a lot of attention on CNBC and in headlines, as unfortunate interns pour through the minutia of economic window dressing, already released to the public through economic data reports. This report at 2:00 PM should be expected to provide an optimistic boost to U.S. markets.

-The Treasury Budget, also at 2:00 PM, is expected to show a $-92 billion deficit, down from the $-120 billion in November, and suggests that Treasury support programs may be receding. A deficit greater that $-92 billion will suggest that the Treasury is not withdrawing from support roles, as they have announced is their intention.

Thursday

-Retail Sales will steal the limelight Thursday at 8:30 AM, with a consensus estimate of 0.4% growth for December compared to a 1.3% gain in November. This is a number which could get beat, since vehicle units sold in December grew, chain stores posted gains and rising fuel prices will give a boost to the statistic. Be careful of where you stand ahead of this number if you have short positions exposed to retail names.

-Jobless claims(8:30 AM) should stabilize near the 435,000 initial claims level, according to Bloomberg economists, and will hold more significance following the surprisingly negative Non-Farm payrolls drop in December.

-Import and Export prices (8:30 AM) will add color to Tuesday's U.S. Trade Deficit report, but will mainly be watched for signs of inflation in the domestic market.

-In October, Business Inventories rose by 0.2% for the first time in 14 months, and are expected to have risen at a similar rate over the November 2009 period, in the report released at 10:00 AM. Rising inventories are a positive sign that retailers are more confident moving into a recovery cycle, but foreshadow an end to the higher profits from low inventory carrying costs.

-At 1:00 PM the most important, but perhaps least publicized, 30-Year Treasury Bond auction will commence. The pricing of this security, which is most closely tied to the 30 year Prime Mortgage rate, will define investors appetite for long term government obligations and the expectations for mortgage rates moving forward. The market priced this Bond's Yield at a recent high of 4.7% at the close on Friday, and suggests that the previous two month's 4.375% coupon at auction will be forced to rise. The high yield tail on this security has averaged above the coupon over the past two auctions, and should be closely watched in relation to the auction coupon here as a gauge of 30 year interest rate sentiment.

Friday

-Kicking off a big day of data, the Consumer Price Index (CPI) is expected to show barely 0.1% m/m change in consumer prices at 8:30 AM, compared to the 0.4% growth in November. Yet gains in commodity prices over the month and reports from the ISM Manufacturing survey, suggest that input prices surfaced as price increases for consumers in December.

-Empire State Manufacturing cooled towards the zero growth mark in December but is expected to grow at the 13.0 level in January at 8:30 AM. A disappointment in this figure will be negative for goods producing firms with business in New York.

-Industrial Production (9:15 AM) is forecast to show a 0.6% increase in December, compared to 0.8% growth in November. Given strength from the ISM Manufacturing report, this number will likely meet its estimate.

-Finally capping off the week, Consumer Sentiment for the first half of January (9:55 AM) will show just how confident individuals feel moving into the new year. The statistic measuring consumer spirits is expected to rise to the 74.0 level after falling to 72.5 at the end of December, which would mark the highest level since January 2008.

Recapping the forecast for the week, we see potential for this rally to roll over and correct given the gains we've seen, but we are suggesting that stops on short positions are tightened as there has clearly been a desire to buy companies throughout the first major week of trading in January 2010. Crude oil is overbought according to technicals (RSI and MACD) at the $83/barrel level and looks to be meeting resistance as the dollar has found support amidst the gains on the S&P 500. Generally the only names pushing markets higher over the past week were energy names and a pullback in Crude this week would greatly weaken all asset prices. However, we see several upside risks to short positions this week as economic data continues to show moderate levels of growth as explained in this Weekly Spectrum outlook.

Manufacturing Not Enough For U.S. Recovery

The Institute for Supply Chain Management surprised the world on Monday morning, as they announced the results of their manufacturing managers survey. The report is essentially a survey where every manager is asked to respond to his own experience. Each manager states whether they see conditions improving, deteriorating or remaining constant, with respect to thirteen main criteria. The December survey's headline number at 55.9%, tells us that when all criteria responses were averaged, that 55.9% of respondents saw conditions as favorable. Take a look at this recap of the December 2009 report which we can refer to in more detail below.

The consumption of manufactured goods represented 1.59%of the revised 2.2% U.S. GDP growth in Q3 2009 and thus remains the center point of the economic recovery as we have known it thus far. The growth indicative ISM report booned U.S. markets in the first 2010 trading session, as the seemingly unbeatable 60.3 November New Orders component was crushed by a 65.5 stat in December. New Orders are the single most telling economic reading of future conditions in Manufacturing, perhaps making this month's strength unbeatable in January and ironically a curse on the effects of less positive results moving forward. Less discussed but also important, are increasingly slower deliver times that, if sustainable, should have positive effects on both transportation carriers' top lines and jobs in the industry.

Standing on the shoulders of a massive rally to start 2010, it's safe to say that the environment is still a wash of confusion. Inventory numbers from the report show that clients of manufacturers are becoming increasingly skeptical, where the Customers' Inventories number at 35 perpetuated a nine month trend of contraction during one of the highest consumer demand months of the year. These results suggest that inventory rebuilding hasn't occurred on par with headlines, and that instead the entire production chain has become extremely lean and risk averse. Should confidence return and consumers loosen their wallets, this would be a prime area of growth in the new year, but headwinds to such spending remain significant and could intensify. Partly frightening, is the component of higher input prices, continuing a six month trend of appreciation that is reflective of the commodity rally and U.S. Dollar weakness. While input prices have helped to raise the ISM headline number in recent months, U.S. Dollar strength will be discounted as having a negative effect on future reports. 

Kicking the mud from our boots, let us shed the stats from our purview and think logically about the chances for economic success in the U.S. over the next year. 2010 estimates for U.S. GDP growth are floating in the mid 3% range, but where can we expect to find growth summing up to this handsome rate of expansion? 

In the U.S. 24% of annual GDP dollars are rooted in manufactured goods, while the service industry brings in nearly twice that figure. In Q3 of 2009 we lost about 3% to our trade deficit, which should grow if consumers spend more, and the remaining 30% is split into one part domestic investment, two parts government expenditures. We can expect that the government isn't going to muster much more growth in 2010, due to it's bureaucratic inefficiencies and the Q3 2009 0.5% annual contributed GDP growth, despite $700 billion (5.3% x GDP) of stimulus.

For all intensive purposes we're left with the manufacturing and service industries to get us most of the way to 3% growth. "We did it in 2003, so it's just a matter of animal spirits... right?" Unfortunately, in our opinion, the game has changed significantly, making 2009 anything but 2003 . First, there is not an abundant supply of new homes, and the supply we have aren't being bought, so the big new houses of Super Sized Suburbia30 miles from town won't have the same magnetic effects on consumption as were present in 2003-2006. Instead we're seeing strength in existing home sales and less confident buildersrealizing that bigger isn't better. Second, unemployment is expected to average 10% in 2010, according to Bloomberg economists, landing well above the worst case scenario for financial institutions outlined under the Stress Tests in April of 2009 and crippling to the financial strength of the government, as Washington continues to roll over benefits and pay to jobless individual. Third, the shadow inventory of homes, as described by Robert Shiller, will flood the market with more defaults as teaser rates reset higher, even as rates are low, while weakening bonds will inevitably send mortgage rates higher.

Some of the smartest guys in the room are beginning to make calls that hold viral ramifications for the economy. Robert Shiller is predicting higher rates of defaults in the prime mortgage category, while Bill Gross is liquidating most of his exposure to bonds, and still many see this scenario as a victory on il-applied grounds of historical market recoveries. Perhaps confident retailers and mid-chain distributors could lift inventory levels as consumers spend more of what they've saved, but there must be widespread consumer spending on services as well as goods, at magnitudes congruent with a boisterous labor market, for 3% GDP to become a reality. At minimal, do your homework before placing your bets on a recovery founded in manufacturing, and at best keep limber to capitalize on the self fulfilling prophecy that equity markets have become when sentiment changes yet again.

Construction and ISM Prelude December Employment

While the long weekend has hosted more than several 2010 financial outlook articles, the rubber will hit the road as the first week of actual trading commences this morning. Ahead of the bell it's Oil and Equities back on the offensive in U.S. markets after Nikkei and Kospi exchanges closed with solid gains and European equities charged higher in early action. The story remains focused on Chinese manufacturing growth as a driver in 2010 and a rebounding U.S. labor market to consume more of the manufactured goods being produced. While the dollar trade has taken a back seat and bond yields are beginning to rise, there remains downside risk in equities if the Construction Spending, ISM reports, and December Employment Situation disappoint optimistic expectations.

Monday

The ISM Manufacturing survey (10 AM) is predicted to rise from 53.6 to 54.8, by Bloomberg economists, yet the figure surprised to the downside in November. Manufacturing holds a large percentage of the recovery as inventories were brought up to par, but be floated by forces of consumer demand at the other end of the pipeline. The second 10 AM report of the day, construction spending, may cite a drop of 0.5% in capital allocated to new projects. While the number was flat in November, it's clear that new housing start weakness of the past few months shows a reluctance among contractors to take excessive risk in the current environment, which may be reflected on today.

Tuesday

The elusive Motor Vehicle Sales report will appear sometime Tuesday, and while it's expected to show growth from November's 8.2 million annual sales rate, holiday spending could weigh on demand for big ticket vehicle purchases. The November rate of Factory Orders, a leading indicator which has lead the manufacturing sector towards growth, will be revealed at 10 AM. Economists see orders in November increasing less than the prior period at 0.4% compared to 0.6%. Year over year orders are showing a sharp rebound, yet the comps over the next few months will fall precipitously and cause the month over month figures to be watched more closely.

Wednesday

Highlights mid-week will center on the ISM Non-Manufacturing report at 10 AM, which gauges the strength of many white collar and service industry jobs. The report fell hard in November but is expected to nose just above break even to 50.4. The petroleum report at 10:30 AM could pour cold water on high flying oil prices, now opening above $80/barrel for the February contract, should inventories grow from the current 325 million barrel mark.

Thursday

Thursday should prove anticlimactic for most, while government debt handicappers may be hungry for volumes announced for future Treasury auctions. The Jobless Claims at 8:30 AM may foreshadow Friday's report and make a few waves in equities on Thursday if claims astonish economists, but the real deal is in the December monthly stats.

Friday

The high point of the week and perhaps an omen of what may come in 2010, the December Employment Report at 8:30 AM could easily daunt both bulls and bears. Optimists suggest that December will mark the turnaround month for labor markets in the U.S. and that jobs were actually created during the period. While less rosy estimates indicate that jobs continue to be lost and that perhaps the household survey statistic will show a greater percentage of the workforce without jobs. Keep an eye on the number, despite the roaring masses, because a peak in unemployment will undoubtedly spur some magnitude of rally in U.S. equities.