Note for ROI in July 2010, and Analysis for Aug, Sep and Oct

The July cycle is complete and our new July spreads brought in 5%.  As of July 22, 2010, we now like what we see with the current market conditions and we probably will make above average returns over the next 2 to 3 months.  (Average is 4% to 8% per month and above average is 9% to 11% per month)  We are predicting higher returns because we see opposing forces where Q210 earnings are coming in strong, but some of the macroeconomic indicators are weakening telling us that the US economy is hitting a soft patch.  As a result from these opposing forces, we believe that the market is going to trade choppy and sideways for the next few months.  For the non-directional credit spread strategy that we focus on, choppy and range-bound markets create the perfect environment for us to make our best returns. 

Below is a composite of our analysis over the last 2 weeks, as of July 22nd, and we denote each component as either positive, neutral or negative as how it can influence the US stock market.  What you'll notice as you review each item below is that the results are mixed where we do see opposing positive and negative forces, which should keep the major indexes in a choppy and range bound channel.  Again, this is the optimum environment for a non-directional strategy such as index credit spreads.

Positive - Q210 earnings season is coming in strong where 75% of companies, so far, are beating or meeting earnings consensus.

Negative - Even though 75% of companies are exceeding earnings estimates, a lower percentage are beating top line revenue estimates, telling us that the economy is hitting a soft patch.

Positive - S&P 500 earnings are on track to hit $83 in 2010 and are estimated to hit $90 in 2011, according to the VP of equity research in JP Morgan in early July, 2010.  This is consistent with the data that we've seen in the Standard & Poor's website.  They also believe that the S&P 500 will be trading at a "forward looking" 14.5 multiple by the end of the year.  Multiplying $90 of total earnings by a 14.5 price/earnings (P/E) multiple takes the S&P500 index up to 1300 by the end of the year.  This estimate assumes that analysts will not reduce earnings estimates too much from the weakness in Europe and the US, and so far JP Morgan doesn't think that earnings will be impacted too much.

Positive - The 30 stocks that reside in the DOW index are estimated to generate $810 of earnings in 2010, and $930 of earnings in 2011.  Looking at daily DOW chart shown below where the DOW is near 10,200, its trading at a P/E multiple of about 12.5 of 2010 earnings and at a forward looking P/E multiple of 11 for 2011 earnings, which are historically low P/E multiples.  Over time, as the economy improves, the P/E multiples will increase and revert back to the mean closer to 14.5, which will push the markets higher.

Neutral to Positive as of July 22 - The "chatter" from the talking heads on the financial news channels, which influences investor sentiment, has been somewhat positive in the last week where most money managers, economists and investment strategists don't see a double dip even though they predict that the chatter about a possible double dip will resurface.  Most agree that a slowdown is typical when an economy is coming out of a recession, especially a severe recession like what we just had, where growth is initially strong, it then pauses and everyone "flips out" - as one money manager put it, and then growth resumes. 

Negative - On the policy front, a few investment strategists that were interviewed on the financial news stations made the point that economic growth will be slow in the 2nd half because of uncertainty around the following:  1) the fate of the Bush tax cuts won't be finalized until probably December and if they are not extended then personal, corporate, dividend and capital gains taxes are going to increase - and the markets probably are pricing this into stocks since the market looks ahead about 6 months; and 2) even though the Financial Regulations Bill was passed in Congress there still will be uncertainty for many quarters about how the bill will continue to impact Bank and financial institution's earnings, because the bill is broad and far reaching; the bill encompasses 200 new rules that need to be formalized, "interpreted" and then enforced by new government organization that doesn't even exist yet.

Positive - Regarding Financial Reform, some of the uncertainty around Financial reform is already past us and the how the bill will impact the banks and financial institutions is already baked into the markets.

Positive -  At global level, the International Monetary Fund (IMF) raised their 2010 growth estimates for Latin America from 4% to 5%; advertising revenue for US cable and broadcast TV is trending UP nicely according to one analyst, telling us that US businesses are becoming more confident as they increase their advertising budgets;  Greece and several other "at risk" Euro-zone countries had several successful bond offerings telling us that investors believe that their economies are in reasonable shape; Australia, Canada and several other countries are already raising interest rates as they see their economies growing.

Positive, possibly moving toward Neutral -  Headline Retail Sales Number came in weak at -0.5% growth.  However, looking at the more important core retail sales that excludes car dealers, building materials and gas stations, growth was actually respectable at 0.2% growth.

Negative Empire State Manufacturing Survey came in much weaker than expected.  This is not good news and it needs to be monitored.  However, most economists don't pay too much attention to this indicator as they prefer to wait for the National ISM number, which is released on August 2nd.

Negative - The Philly Fed Manufacturing Index disappointed falling for a second consecutive month and confirming that the economy, at least in Pennsylvania, New Jersey and Delaware, has hit a soft patch. 

Positive - While some deflationary pressures exist, Core CPI, the orange line, remained positive increasing 0.2%, telling us that deflation is not currently a concern.

Positive - The headline Industrial Production Number came in with an increase of 0.1%, which was anemic.  However, after digging into the numbers and stripping out a negative oil drilling number caused from the drilling moratorium in the Gulf, and a negative car and car parts number due to typical summer time retooling, the Industrial Production number came in at a healthy 0.5% growth. 

Negative - Aruoba-Diebold-Scotti Business Conditions Index (ADS) -  The ADS Index is a forward looking, high-frequency (i.e. it's updated weekly) macro-level diffusion index composed of a dozen economic indicators that track the overall health of the US economy.  It's pulled back below zero, telling us that the economy has hit a soft patch.  Referring to the 2nd chart, we can see that this indicator periodically crosses below zero, even when the economy is somewhat healthy.  Overall, we are seeing weakness in the economy and we need to tread carefully.

Positive - Below is a big-picture, weekly, technical oriented chart of the S&P 500 index showing the 17 and 43 week EMA (exponential moving averages).  The 17/43 EMAs do a good job of keeping us in the market during bull markets, and out of the market during bear markets.  Right now the 17 week EMA is still above the 43 week EMA, telling us that we should continue to stay "long" in the market.  However, because the market and especially the S&P 500 index have sold off hard, the 17 week EMA is pulling back a lot and it's closing in on the 43 week EMA, so this is something we need to continue to monitor.  But, right now, the market is still in a confirmed, long-term UP trend.

Positive - Wholesale Business Inventories look good, telling us that inventories are lean and any pick-up in business will translate to an increase in production output, which should translate into new hiring.  (Productivity is already maxed out, so companies will have to start hiring if they want to increase production since it's getting difficult to squeeze out any additional productivity from existing workers)

Negative - Consumer Credit continues to be weak where less and less credit, for example credit cards, is being offered to consumers; this will keep negative pressure on consumer spending.

Positive - The ISM Services Index that measures non-manufacturing business activity dropped from 55.4 to 53.8.  The headline number looked negative, reinforcing the fact that the US economy is hitting a soft patch.  However, the Briefing.com analyst noted that after digging into numbers, such as looking at the new orders and backorders sub-indexes, these key sub-indexes are still firmly above 50 and this tells us that the non-manufacturing component of the US economy is still in expansion mode.

Negative - Unemployment came in with the private sector adding 83,000 jobs, lower than the consensus of the creation of 150,000 private sector jobs.  The headline number showed the economy losing 125,000 non-farm jobs, the first decrease since Dec 2009, but this number was skewed by the census bureau laying off 225,000 short-term census workers.  Back to the numbers that matter, and unfortunately even more disappointing was that there was a 0.4% drop in weekly earnings, a 0.1% drop in hourly wages and the number of hours worked dropped from 34.2 to 34.1.  This could be a indication that inventory is building up too fast for current demand and retail sales might be impacted in the coming months.  Overall, the report could have been much worse and several economists and money managers interviewed right after this data was released now believe that because the economy is still adding private sector jobs, albeit at very low levels, there is a low probability of a double dip recession and that economic growth will remain moderate, but consistent.

Positive - The headline number for Factory Orders looked bad coming in with a decline of 1.4%.  However, digging into the sub-indexes show that companies continue to increase their spending on capital goods.  Orders for nondefense capital goods, less aircraft increased by 3.9%, which was a very strong number.

Positive - Personal Income and Personal Spending for May came in strong with all sub-indexes showing strength, comprising wage & salary, disposable income and savings rate.

Positive - The ISM Index came in at 56.2, missing expectations of 59, but still above the neutral 50 level telling us that manufacturing within the US continues to be in expansion mode.   According to the Briefing.com analyst, production, new orders, and backlogs all decelerated during the month of June as the sub-indexes declined by 5.2 points, 7.2 points, and 2.5 points, respectively.  However, Briefing.com's analyst noted that even with the declines, the sub-indexes all held well above 50% and it will take at least three consecutive months of weakening demand before the current expansion in US manufacturing reverses.

Positive - The S&P/Case-Shiller home price index came in showing that home prices continue to climb and stabilize.  However, the report is still cautious saying that the rebound is not yet sustainable.  Overall, housing prices are moving in the right direction since bottoming in early 2009.

Conclusion from the Macro-level Fundamental View of US Economy's Health -  The US economy has hit a soft patch.  However, as of mid July, 2010, most investment strategists and economists do not believe the US economy will go into a double dip recession and think that the US economy will grow at a 2.0% to 3.0% GDP annual growth rate.  Because earnings are reasonably strong, but that some of the economic indicators are weakening, we do have opposing positive and negative forces that should keep the major indices in a sideways & choppy trading range, and this bodes well for our non-directional credit spread option strategy.

Let's look at the charts to see what the potential sideways trading bands look like:

Looking at the daily chart of the DOW, we can see that the DOW remains below its 200 day SMA (simple moving average).  Because it's below the 200 day line, this represents an "unhealthy market" that will have continued high volatility.  On the positive side, however, from the perspective of opening non-directional credit spreads, as long as the macroeconomic indicators don't deteriorate too much, and that earnings results stay strong, there is a high probability that the DOW will trade in a range between 9,700 and 10,500.  (and there's a reasonable chance that it will stay above 9900)

Similar to the DOW shown above, there is a good chance that the SPY will trade sideways between 106 and 113.   If the SPY crosses below 106, then most likely it will retest the 102 low, but as long as we continue to have opposing positive and negative forces, as we discussed above, there is a high probability that the SPY will hold above 102.

Below is the daily QQQQ, an ETF that tracks at 1/40th of the NASDAQ 100 Index - NDX, representing 100 of the largest non-financial companies, many in the technology sector.   The Q's look stronger where it held above the Feb low of 42.6 during the last sell-off in early July.  There is now a high probability that it will trade between 42.6 an 47, as long as the macroeconomic indicators don't deteriorate too badly.  This is why we monitor the economic indicators on a weekly basis.

Conclusion - The US economy has hit a soft patch as shown from the above economic indicators.  However, as of mid July, 2010, most investment strategists and economists do not believe the US economy will go into a double dip recession and think that the economy will grow at a 2.0% to 3.0% GDP annual growth rate.  Because earnings are reasonably strong, but that some of the economic indicators are weakening, we have opposing positive and negative forces that should keep the major indices in a choppy, sideways trading range, and this bodes well for our non-directional credit spread option strategy.  Therefore, we predict that we'll achieve above normal returns in August, September and possibly October of 2010.