Stock Market Review and Analysis for Week of May 18, 2008

WHICH WAY THIS MARKET IS HEADED

As you can see the markets rallied hard this past week with the Nasdaq actually breaking above its simple 200 day moving average for the first time since dipping below it in December. This is a bullish sign because the 200 dma is so closely watched by institutions--but the summer is typically hard on tech stocks and the index is trading very close to resistance.

The SP-500 also traded higher this past week but still hasn’t broken above the 200 dma and has been forming a rising wedge pattern which is typically bearish. There is an old market saying to “sell in May and go away” as the summer months and into October are typically bearish compared to the winter and spring. Perhaps this market can overcome that seasonal disadvantage but there are some tough economic fundamentals right now that the markets are going to have to continue ignoring.

Many analysts have observed that the only reason earnings came in as well as they did is because of overseas sales driven by burgeoning international demand. Essentially companies that sell into strong international markets did great while those confined to the US market did poorly—and all you have to do is look at the latest US Consumer Sentiment figures to understand why.

The Consumer Sentiment report for May was released on Friday with the headline number plummeting to a new 28 year low at 59.5---the lowest reading since June 1980. Since the consumer makes up more than two-thirds of the US economy the report suggests a much more severe recession headed our way than the other economic indicators are showing. Sentiment is already 4.5 points below the lowest level reached in the 1990 recession.

The problem is falling home prices coupled with rising gasoline and food costs. With the majority of most American's wealth tied up in their homes and the current inability to borrow it’s understandable that many consumers are pulling in the reins. Add in gasoline at nearly $4 and rising food prices and the combination is putting a serious crimp on household budgets. That concern can be seen in the numbers--the present conditions component fell -5.3 points to 71.7 and the expectations component fell -1.6 points to 51.7. Inflation expectations rose to 5.2%--the highest level since 1982.

Declining consumer sentiment can most readily be seen in the retail sector. This past week Goldman Sachs downgraded several department stores to neutral from attractive. Goldman said higher gasoline prices should further depress consumer discretionary spending. Goldman cut JCP and JWN to neutral from buy saying expansion efforts and product launches have placed them at a near term disadvantage.

One of the main culprits of a pullback in retail has been the cost of gasoline and this past week the uptrend continued with crude spiking to another new high at $127.82. Goldman Sachs came out with a new report expecting oil prices to average a whopping $141 a barrel in the second half of 2008. Their previous forecast was an average of $107. The analysts at Goldman believe that the oil market is undergoing a structural re-pricing that will continue to play out for some time. That estimate may have some merit—remember Goldman was the broker that originally predicted 100 dollar oil when it was only trading around 60.

Friday was the 8th time in 10 sessions that the crude futures contract set new record highs. The national average for gasoline rose to $3.787 on Friday with diesel rising to $4.482 per gallon. Those prices are likely to rise further because gasoline futures jumped another 6-cents on Friday. The good news is historically gasoline prices are the highest around Memorial Day weekend and then decline through the summer.

However we’ve also got a rapidly approaching hurricane season that officially begins in June. It won't be long before hurricane forecasts begin putting more upward pressure on oil prices. The last two years have been very tame and the law of averages is working against us for another year with no storms in the Gulf.

Despite the record prices in oil the Dow transports continue to hold the high ground with resistance at 5400. Surprisingly the transports have been driving higher in spite of a hurting airline sector. British Airways warned on Thursday that every $1 rise in crude oil costs an extra $31 million in fuel—no wonder so many airlines have been filing for bankruptcy lately. The strength in the transports is coming from the railroads, which are seen to be beneficiaries of the spike in fuel prices as they are the lowest cost ground transportation provider. Fortunately we were able to take advantage of that with a good trade on Burlington Northern this past week.

Amazingly in spite of increasingly negative economics, continued worries about financial write-downs and oil at $127.82 the markets jumped higher for most of last week settling very close to their highs and setting us up for more potential upside this coming week. The major indices are pointing higher in a belief the worst is behind us but the economic fundamentals still pointing to the downside—the question is…

HOW DO WE MAKE MONEY ON IT?

The trick to making money in this kind of market is to take advantage of both directions by going bullish on stocks with great relative strength—and going bearish on stocks with relative weakness. And that is exactly what we’ve done--we’ve got two plays lined up this week—one bullish and one bearish.

They are in roughly the same sector but there is a glaring difference between the two and it reflects a trend that really came out his past earnings season—companies that have good international exposure did really well this past quarter as they took advantage of burgeoning overseas markets. However companies that were confined to the US did relatively poorly—and that is the story of these two stocks.

Our first play is bullish and it’s on a company that grew its earnings a whopping 142% last quarter amid red-hot overseas sales. Not only that but because of a recent over blown melt-down in the stock we can get in at a super discount increasing the probability of some super upside profits on the right calls.

Meanwhile our bearish play is in roughly the same sector with one glaring difference—this company does all of its business in the US market and those markets have been contracting—a fact made glaringly obvious by the company’s recent 125% profit downturn!  Fortunately the stock gave us a great entry point as it bounced off of resistance and began heading lower Friday on big volume. This one looks ripe for some great put profits—puts we’ll be buying first thing Monday morning.

We’ve got two great trades lined up that look to be heading in their respective directions almost no matter what the rest of the market does--so let’s get to them…

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