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Market Wrap

Russia, Japan, Banks and the Fed, Have we been here before?

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         WE 1-5         WE 12-29         WE 12-22         WE 12-15
DOW    10662.01 -124.84 10786.85 +151.29 10635.56 +200.60  -277.95
Nasdaq  2407.65 - 62.87  2470.52 - 46.50  2517.02 -136.25  -264.16
S&P-100  681.71 -  4.74   686.45 +  2.22   684.23 -  5.25  - 37.58
S&P-500 1298.35 - 21.93  1320.28 + 14.33  1305.95 -  6.20  - 57.74
W5000  11872.50 -294.50 12167.00 +185.50 11981.50 -112.40  -572.60
RUT      463.14 - 20.39   483.53 + 20.54   462.99 +  4.96  - 21.04
TRAN    3113.99 +167.39  2946.60 + 96.67  2849.93 +151.25  -181.27
VIX       32.03 +  1.80    30.23 -  1.29    31.52 +   .32  +  5.07
Put/Call    .63              .67              .61              .94

Just when traders felt it was safe to go back in the markets the investing climate took a serious hit. Beginning with a ghost from the past, Russia announced that it would not make the first quarter debt payment to a group of nations called the Paris Club which includes the United States. Russia said it was not a "declaration of default" but whatever you call it the results are the same. The debt is over $48 billion and the interest payment for the quarter is over $1.5 billion. This is not a material event in itself but raises questions about their future economic liquidity. They have defaulted on this debt twice in the past in 1991 and 1998. Another major pre-market problem was a rumor that Bank of America had suffered significant trading losses and/or material credit quality issues. The stock did not open for trading until 10:30 after BAC asked the exchange to halt the stock until they could put out a press release rebutting the rumors. They did issue the release saying things were fine and affirming estimates for the year but the damage had already been done. BAC dropped about -$5 but the impact to other financial stocks as investors fled in defense was more of a problem with Dow component JPM losing over -$3. Japan became a problem once again as the Yen lost ground closing at 116.56 Yen to the dollar. Investors in Japan have been pulling out of stocks with the Nikkei falling in tandem with the Nasdaq. Business bankruptcies, restructuring and slowing corporate spending are taking a toll on their fragile economic recovery. Analysts are worried that Japan is on the verge of another period of volatility with non-performing assets at banks mounting again. The Japanese central bank cannot rescue their economy like our Fed since interest rates are barely above zero already. Sounds like a great way to start a trading day!

Is the Fed honeymoon over or are investors worried that the Fed knows something really scary that we don't? Many analysts were blaming Friday's drop on the worry that the Fed had reacted so quickly and drastically that there must be something on the horizon that we have not seen yet. With every new news event Friday they tried to point to it as a possible factor but there was no smoking gun. The Jobs Report was benign with only +105,000 new jobs and 4.0% unemployment. Analysts were expecting a real disaster after the unexpected rate cut and the benign report was a surprise. They then pointed to the energy problem in California and the rumor of BAC losing billions in trading energy derivatives as the hidden reason. When BAC denied the rumor and affirmed estimates that balloon burst. With no obvious scapegoat event, traders were looking behind every news article for the "hidden" reason. The Russian default, the weakening Japanese Yen, even the weakness in the Mexican economy and possible impact of a U.S. recession was mentioned. The bullish sentiment from Wednesday has evaporated and severe pessimism has returned.

Give those boys and girls a tranquilizer, please! Yes, the Jobs report was benign on the surface. Only +105,000 new jobs but half (56K) of those jobs were government jobs leaving only +49,000 private sector jobs. Now factor in the 133,000 layoffs announced in December which have not yet taken effect and you have a good chance for negative job growth in January. The number of layoffs announced in December was an eight year high. The problem with the headline number was that it was just not bearish enough to justify the -.50% rate cut inter-meeting. However, it was still a market friendly report. The economy is still slowing and the manufacturing numbers show the sector to already be in a recession and getting worse AND fairly broad based. About the only strong points were financial services, transportation and utilities.

The energy problem in California is now bleeding over into other states and impacting the market. Possible bankruptcies by the leading energy suppliers are putting pressure on banks which have loaned money to the utility companies. Huge layoffs have been announced in an effort to stop the bleeding. The rising energy costs and losses are expected to filter through the entire industry since many of these companies cover multiple states. Losses in California could be felt in higher rates in other states. Traders feel that the government relief in California was insufficient and will only delay the eventual bankruptcies of several huge energy companies and that is undermining the market. Many think this was a factor in Greenspan's decision. I think the problem is serious but I also think they are grasping at straws.

I am more concerned with the huge outflows of cash from equity funds. With the expectation of a market bounce after the rate cut, and another cut almost a sure thing three weeks from now, why did $13 billion in cash flow out of stock funds in the week ended on Wednesday? I justify the number as Christmas bills, year end spending, taxes and the fact that the Nasdaq hit a new 52-week low on Wednesday morning. That low was before the rate cut and before any money transfer decisions could have been made as a result of the cut. Pessimism was very negative and investors were shuffling funds to start the new year. Sounds logical to me but it is my daydream.

If you read my commentary on Thursday you know that I think the .50% rate cut was a message to Bush. I don't think it was related to any "hidden" disaster like the Long Term Capital problem or any global currency problem. Maybe the market drop on Friday was just the last gasp of the tax selling before the historical January rally start next week. I think if you take into account that tax selling, another flurry of a dozen or so earnings warnings, several high profile downgrades, the huge BAC rumor, the Russian debt default and the persistent CSCO earnings warning rumor you have a very good reason not to hold over the weekend. Traders simply decided that discretion was the better part of valor and they went home flat. Compared to Wednesday and Thursday the volume was positively wimpy. After turning in a two billion share day on Thursday the NYSE only managed 1.4 billion. The Nasdaq volume dropped by one third from 3 bil on Wednesday to barely 2 bil. on Friday. There was no huge rush to the exits. Down volume however did swamp up volume by 2:1 on the NYSE and 5:1 on the Nasdaq. That does concern me but at -250 on the Dow and -159 on the Nasdaq you would expect it to be lopsided.

The earnings warnings are almost over but you could not tell from Friday. Delta warned that weather and pilots had forced the cancellation of 7500 flights and earnings would drop drastically. Tech stocks FCS, IOM, NXTV, CMTN and NEON all warned as well as GDT, MNY and BGP. BAC downgraded AMCC from a target of $160 to only $120 and AMCC lost -$10. Lehman downgraded SAPE, NXTV, AA and MMM saying Dow component MMM was fully valued. 3M lost -3.50. Robertson Stephens cut estimates on Wal-Mart but Prudential raised estimates. UBS Warburg and Goldman Sachs downgraded estimates for Hewlett Packard. CSFB cut IBI to hold from neutral and LTD to hold from buy. With only one week left in warnings season traders are hoping the big caps everybody has been dreading, IBM, CSCO, JDSU, etc, are not going to warn. IBM was actually up on Friday as investors breathe a little easier the closer we get to the actual earnings date. Investors in PVN and COF got hit with a downgrade from Morgan Stanley on fears that a hard landing would impact repayments and increase bankruptcies by credit card holders. Several analysts rushed to their defense pointing to their excellent track record during previous down turns. Both stocks lost but PVN took the biggest hit at -4.50. Much of the Nasdaq loss Friday was due to CSCO which lost -12% or -$5.25 on continued fear of a pending earnings warning. They announce a month later than most other companies, Feb-6th, so they are just now approaching their warnings period. The rumors were very specific that CSCO would warn after Friday's close. Since they didn't those rumors will probably shift into next week. It is doubtful they will go away.

Pessimism to irrational exuberance and back to extreme pessimism in only three days. Dizzy yet? Got your motion sickness pills ready? While it would have been nice to believe the massive record setting rally on Wednesday was a result of millions of buyers rushing into the market on the news of the rate cut, it appears it was simply a mad panic by shorts covering after being blindsided by the Fed. Still, I believe it is immaterial. Over the last 12 years the first week of January has normally been flat or down. 1999 was the exception with the S&P rising +3.7%. In 2000 the S&P dropped -6% in the first four days before rebounding. The true test will come on Monday. Historically a rally day but we may be held hostage by speculation and worries about earnings. There are no material economic reports on Monday or Tuesday so the focus will be on news from the weekend and any earnings stories from next week. Wednesday we will see Wholesale Inventories, Thursday Import/Export prices and Friday the PPI and Retail Sales. Earnings will start to trickle out and hopefully a brighter outlook for the first quarter. Companies will be giving guidance for coming quarters and First Call is projecting only a +4% growth rate. If the guidance from the early announcers is higher then investors will start to feel more confident that a recession has been avoided. Conversely if the outlook is negative then the market may tend to trade down until the outlook improves.

With a slow earnings week and dwindling warnings the hope will be for a bounce from the current oversold conditions on positive investor expectations. Any negative news that blunts this expectation could void a repeat of the week as a historical rally. The Dow has given back almost all the gains from the short covering rally on Wednesday and the Nasdaq has lost over half. The Nasdaq came to a screeching halt at 2400 in the last hour of trading on Friday. This is -235 points from Thursday's high and +156 points from Wednesdays low. Volatility anyone? At this point 2400 is only psychological and offers no real support. Still the Fed is on our side. Even if we retest 2300 again on Monday there is very strong sentiment that the 2300 area is the bottom and we should trade up from there. There are no guarantees in life but once the Fed starts cutting rates the market normally goes up. Mutual funds cannot make money by sitting on the sidelines and they will have to eventually buy stocks. Our task next week is to look for these buyers coming into the market on heavy volume and then join them. I am more cautious today than I was on Thursday night after only a minor drop on the Nasdaq of -2% following the +17% jump. The drop on Friday could have just been further profit taking prompted by all the negative factors I mentioned above BUT as traders we need to go with the trend not try to force our bias on the market. My bias may be up BUT until the market reverses to the upside I will lose money just like everyone else that buys too soon.

The Fed gave us a present yet traders are treating it like a bomb squad would treat an unattended suitcase in an airport. Until somebody opens it and finds only a message to Bush the buyers may not come out of hiding. My suggestion is to wait patiently and see what the market gives us on Monday. Treat any rally as a trading rally and keep your stops close to avoid giving back your profits.

Trade smart, enter passively, exit aggressively!

Jim Brown

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