It was a tough battle and so far the bulls are leading by a slim margin. The Dow rallied back from last week's -535 point disaster to gain +162 for the week but it was not pretty. The bears mounted a very convincing goal line stand at Dow 12300 and refused to budge on Thursday or Friday. To the Dow's credit it recovered from late afternoon sell offs for three consecutive days. Despite conflicting economics and comments from nearly every Fed member the gains held but so did resistance. Is this the beginning of a prolonged rebound or just a time out while the bears catch their breath?
Dow Chart - Daily
Nasdaq Chart - Daily
The week did not provide much in the way of economic data except for a massive drop in factory orders and a perfectly scripted Goldilocks employment report on Friday. Tuesday's Factory Orders suggested the economy was slowing quickly but Friday's jobs report contradicted that view. The economy created 97,000 jobs in February, slightly more than the 90,000 expected. This was the weakest employment in two years but we did get 55,000 new jobs from upward revisions to December and January. January was revised to a gain of 146,000 jobs from the 111,000 previously reported. December rose to 226,000 from 206,000. The revisions continue to keep gains on track and I am sure the February number will also be revised higher. The biggest hit to the February totals came from a -62,000 decline in jobs in the construction sector, the worst since 1991, followed by a -14,000 decline in manufacturing. The construction decline was attributed to the four weeks of extremely bad weather that shutdown nearly every outside endeavor other than snow plowing in February. Were it not for a very healthy gain of +39,000 jobs in the government sector the headline number would have been much worse. The unemployment rate declined to 4.5% due to a contraction in the labor force. Unemployment for workers with degrees has declined to only 1.9%. Average hourly earnings increased +0.4% continuing their recent trend. Year over year hourly earnings have risen +4.06%. This is slowing somewhat from late 2006 rates but still higher than the Fed would like. With unemployment falling and wages rising this report will likely prevent the Fed from changing their position in the near future. The chances of a Fed rate cut before July fell six points to 30%. Job growth through June is expected to remain under 100K but not fall significantly. This is consistent with a slow growth economy expanding at less than its potential.
Next week's calendar has two reports which should provide us another clue as to the state of the economy and the rate of inflation. Those are the PPI and CPI on Thr/Fri. The Philly Fed Survey on Thursday should tell us if the conditions have improved in the region. The Philly Fed Survey is seen as a proxy for the eastern US economy.
The Employment report had analysts praising the Goldilocks economy but the rise in wages had the inflation hawks circling again. The Fed heads were quick to take to the airwaves with comments about future policy. Jeffery Lacker, a FOMC voting member in 2006, said inflation may not be as stable as analysts think. He said more rapid inflation may mean a tighter Fed policy. Kohn, said those inflation expectations are critical to monetary policy suggesting the optimistic outlook by analysts may be detrimental to future events. Fed Governor Randall Kroszner said currency competition, financial globalization and deregulation is keeping rates low worldwide. This is fighting the Fed's efforts to talk up the real rates. You can bet those conversations will heat up before the PPI/CPI next week.
Kroszner may not have to worry about that global demand for U.S. treasuries for much longer. China announced that it was taking steps to reallocate some of its $1.1 trillion in currency reserves. About 70% of that is in U.S. treasuries. Cheng Siwei, vice chairman of the China National Peoples Congress said Thursday that China only needed to keep $650 billion in reserves and should put the rest to work in more efficient instruments. To read between the lines of the announcement it appears China is going to create an agency to more efficiently invest that $400 plus billion that it has decided to put to greater use. How they will do that remains a mystery but other nations like Singapore have agencies that invest their excess reserves and they do really well. The key here is the automatic investment of future amounts into U.S. treasuries. That equates to about $100 billion a year. If they stop that process it will cause our rates to rise. If they begin selling U.S. treasuries to invest in other areas it will also cause rates to rise. Since China's economy is built upon a strong U.S. consumer base they will not want to upset the status quo but with the majority of their funds invested in the U.S. it may be difficult to make any changes without causing a ripple. Time will tell and it won't be next week or even next month. It takes time to create an agency and for that agency to create a plan and then begin executing that plan.
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Not to miss her 5 min of airtime Susan Bies warned the Fed has been monitoring the U.S. subprime mortgage market for several months. Bies has been the Fed's top banking policy official during her tenure at the Fed. She said the current subprime problem is only the beginning of a wave as the low entry loans reset into full rate loans and payments increase 25% to 50% in some cases. She said this was only the beginning and the real impact was yet to be seen. She said many borrowers were locked into these loans as rates spiked sharply due to large prepayment penalties from the initiating lender. She said the Fed was concerned about the rapidly rising rate of defaults on regular bank residential loans, which reached a 4-year high last month. The Fed also warned on Thursday that subprime mortgages, 20% of loans during the bubble, represented 50% of foreclosures in 2006 and that number would rise.
Everyone has heard repeatedly about the New Century Financial (NEW) problem. They are the largest independent subprime lender with $28 billion in loans last year. They ceased funding loans on Thursday after their credit lines were frozen and many expect them to file bankruptcy. A mortgage banker sent me a copy of a letter New Century sent to bankers on Friday saying they had reached an agreement with a major financial corporation to solve their problems. The letter said they could not give the name today but the agreement would be announced next week. Since their market cap has shrunk from $3 billion or so to $127 million over the last few months it would not surprise me if somebody stepped up to the plate with a take out offer. New Century has zero options and with no credit lines the returning defaulted loans will force them into bankruptcy very quickly. Someone like Goldman Sachs could step up and buy them with pocket change and then manage their way out of the problem using their piles of cash and credit to remove the stigma attached to New Century loans.
New Century Financial Chart - Daily
Of the top 25 subprime lenders at the start of 2006, 11 have already filed bankruptcy or closed their doors. Over 34 companies in the sector have closed their doors in the last few months. Next week we will get earnings from Bear Stearns, Lehman and Goldman Sachs. Analysts expect them to confess any subprime problems. Citigroup released some estimates on Friday for earnings exposure for the top five sub prime securitizers. Citigroup said Bear Stearns had risk to 6.5% of their earnings. Lehman was 5.8%, Merrill 2.6%, Goldman 2.4% and Morgan Stanley 2.0%. These are miniscule numbers relative to the huge earnings for these companies but it still represents risk. Each of these companies take the debt from sub prime originators and consolidates those loans and sells them into the investor market. Each company keeps some of the loans for their own portfolio. Earnings next week should let us see inside this evolving problem. Bear Stearns held an investor conference on Friday where 1100 subprime investors met to discuss the problem. Nothing earth shaking made the news wires.
In 1998, the last time there was a loan crisis, the subprime market represented only about $100 billion in annual loan volume. In 2006 there was more than $600 billion in subprime loans and that was the end of the bubble. According to Mark Zandi at Economy.com as many as 2.25 million homes were bought using some form of subprime mortgage product. With the new rules starting Sept-1st of this year and with so many lenders halting subprime loan applications already that suggests quite a few homes will not be sold in 2007-2008. If only half of those loans were not made over the next 24 months it would mean two million home sales transactions would not take place. Add in the current 15% to 19% default rate on loans less than two years old and that adds another 750,000 homes to existing inventory by the end of 2007 at foreclosure prices. This is not a good sign for the housing sector. Ironically the subprime implosion may be doing much of the Fed's work for them. The housing sector provided 25% of U.S. job creation and nearly a full point of GDP during the bubble. The cooling of the housing sector is helping the Fed by slowing the economy. Everyone hopes it does not turn from a cool breeze into a blizzard.
Even GE is having trouble with its subprime unit. WMC Mortgage, a subsidiary of GE, announced on Friday it was laying off 460 staffers. That is 20% of its workforce. The company also tightened loan requirements and said it was no longer writing some types of loans. Numerous lenders have announced restrictions on loan types over the last week.
The CEO of Hovnanian Enterprises (HOV) said on Friday there were signs of stability in their various markets but it did not yet indicate a recovery. They were seeing a normal seasonal pickup as spring home shopping began but they did not expect a rapid recovery. Given the items I reported above it may be a very slow recovery. His comments depressed the housing sector with most builders posting losses for the day.
Yahoo lost 5.2% on Friday after news broke that it was negotiating sweeping changes with AT&T over its broadband partnership. The sagging alliance was started in 2001 and Yahoo has been reaping from $210-$290 million in annual revenue from the deal. Yahoo gets $3 per month from each AT&T DSL subscriber. Unfortunately that business model may no longer work for AT&T with its stronger footprint and reduced need for Yahoo to sell its service for them. In 2001 broadband, especially the DSL lines which AT&T sells, were much less popular than they are today. Unfortunately cable broadband has surged in prominence and is the real competitor for AT&T DSL.
National Semi (NSM) posted earnings that fell -45% but said bookings were strong and guidance was better than expected. NSM gained +1.14 on the news. Texas Instruments (TXN) rose +0.76 after being upgraded by Stifel Nicolaus analyst Cody Acree saying the inventory build had ended and TXN shares had fully reacted to the surplus. He projected a price target of $44 with TXN at $32 today. This helped give the semiconductor sector two consecutive days of gains.
President Bush kicked off his anti-Chavez Latin America tour with a stop in Brazil and a token agreement to join forces on ethanol. There was no talk of canceling the 54-cent per gallon duty on imported ethanol from Brazil. Since Brazil can make it from sugar cane for less than $1 per gallon and the current U.S. price is $2.17, a removal of the duty would be an open door to undercut the fledgling U.S. industry. This tour is widely seen as an anti Chavez campaign and an attempt to give Latin American countries someone to turn to besides Venezuela for their needs. Not to be out done Chavez began a five-nation tour to lead anti Bush rallies and call for demonstrations against Bush in those countries he was visiting. This is producing some interesting sound bites and videos but little relation to real news.
Warmer weather and next week's 144th OPEC meeting in Vienna helped push the price of oil back to $60. The range is clearly defined from $60-$62.25 and we are visiting both extremes each week. The OPEC meeting next week was called the most important event of the quarter but I see it as a non-event. Nobody expects them to do anything. $60 oil is right inline with their expectations ahead of the summer demand and prices are expected to rise without any further cuts. Bank of America expects oil prices to be $68.50-$70 by June. Why should they cut any further? Refinery runs are well off their norms as an early maintenance schedule has taken its toll. Inventory levels of gasoline and diesel ahead of summer demand are below their 2006 levels. Gasoline prices are already moving higher well ahead of that summer demand. Let somebody say hurricane on the nightly news and the race will be on to higher prices. Tuesday we will get the monthly IEA report on demand and supply and no major changes are expected.
Solving Bush's Chavez problem, deciding how to invest China's $400 billion and giving the Fed advice on its inflation expectations would all be easier than deciding the fate of the markets for next week. After a monster weeklong crash all the major indexes rebounded just enough to reach strong resistance and then stalled for the last two days. Volume has declined for four consecutive days as the rebound progressed. Friday's volume was only 4.8 billion shares compared to more than 8.3 billion shares on the 27th. This suggests there is decreasing interest in buying the rally. This was also the week prior to a quadruple expiration week and the last two days should have seen very strong volume. It did not happen and that leaves us with two options. Either everybody was blown out of their open positions last week or they are still holding those option positions and hoping for another major move next week.
If you check the open interest on the S&P options the largest open interest is on the 1300 and 1340 puts at more than 174,000 contracts each. Total put open interest from 1230-1575 is more than 2,740,345 puts but only 1,710,573 calls. More than a million more puts contracts than calls are still outstanding. Narrowing the range from 1300-1500 still results in an imbalance of 2,330,745 puts to 1,364,275 calls. This is portfolio insurance and speculation but how much of each remains to be seen. One third of those puts are in the money compared to only 23% of the calls. In the money or not there is still substantial premium at risk with only 4 trading days left. Just to put it into perspective at Friday's closing prices that represents $1.527 billion in call premiums and $2.321 billion in put premiums that needs to be resolved next week. Some will expire and some will be cash settled but a lot of those contracts will need to be closed early in the week to salvage any remaining out of the money premium. When a contract is closed that frees up the underlying hedges put on by the market makers and option writers. I should stress this is only one index. Multiply this across all the indexes, ETFs, holders and stocks and you get an idea how volatile next week could be. Normally a quadruple witching produces volume in the week before expiration and that did not happen either from trader shock or speculators wanting to hold those bearish positions a bit longer to capture any further declines. It appears to me that the sudden down draft last week produced some strong option volume and that volume was bearish in nature. If much of that open interest is closed early in the week it could produce a high volume bounce. We could also see the hedge funds try to play games on Monday and try to shock the market in a particular direction favorable to their positions. If a large hedge fund is underwater in a bunch of options they can try to move the underlying in their direction with strategic orders. With thousands of hedge funds I would not be surprised to see quite a few line up on the same side on Monday morning. If I had to pick a day for a major move it would be Monday. Once Monday is over any remaining out of the money premium will evaporate to the point of worthless and that takes the motive out of the market. It then reverts back to the market makers to try and pin the price of the underlying to whatever strike price that makes the most of those remaining options expire worthless. They will try to hold the underlying at that price the rest of the week. Sometimes they are phenomenally successful and prices close within pennies of the target strike. These expiration games should cause a dormant market late in the week with the only exception being the open on Friday when the S&P settlement price is calculated. SPX options cease trading on Thursday night. The Friday opening price on each S&P stock is used to calculate the settlement value. This allows the market makers to play additional games at Friday's open but once all the stocks are open and that settlement value calculated there is no further reason for the SPX market makers to play with the price. Options on individual S&P stocks are still based on Friday's closing price.
The Dow rebounded from Monday's low of 12039 to hit 12300 by 10:15 on Thursday morning. It hung there without any further gains until the closing dip. On Friday the jobs report caused an opening spike to 12330 but it was very short lived. The retracement was almost immediate and 12300 became the ceiling once again. This appears to be strong resistance and a level that will require an external event to cross given the rapidly slowing volume.
On a side note you may have noticed that there was an afternoon dip each day this week during the last hour. One analyst pointed out that the strong stock buyback cycle was the cause. Those companies doing buybacks are taking advantage of the depressed prices. However, they are prohibited from buying back their own stock in the last 30 min of trading. Since they want to err on the side of caution this translates into a halt some minutes before that cutoff time. With buyback programs at all time record levels across hundreds of major companies it is not surprising that their buying is providing support for the market. It also provides a nice timing play for shorting futures ahead of the afternoon drop.
The Nasdaq performed the same sprint to resistance but with far less consistency. Wednesday saw an early fade and a lower close but Thursday's gap open tagged resistance at 2400 and that was the end of the advance. It was very solid with Friday's jobs gap to 2404 lasting only seconds before the decline began. The chip news from NSM and TXN failed to support the Nasdaq and that is troubling to those hoping for a continued rebound.
The S&P struggled with 1400 through Wednesday then found a second wind to move the resistance bar to 1407 but like the other indexes it closed the week off its highs. The 1400-1410 range could be difficult and I expect strong volume on Monday to test those levels again.
Russell 2000 Chart - Daily
NYSE Composite Chart - Daily
Wilshire 5000 Chart - Daily
The Wilshire 5000 is showing the most clear-cut resistance test of the broader averages with Friday's close at the 100-day average. This resistance test for the broadest index is crucial to the rebound's continued success. Aiding the Wilshire on Friday was the Russell. The Russell was showing some strength along with the NYSE Composite and based on those alone I am leaning slightly bullish for next week. The Russell futures saw a strong sprint higher into the close and came very close to ending at their high for the day. This was a nice recovery off their afternoon lows and suggests we could see a move higher on Monday. Coupled with the relative strength in the NYSE Composite I could see a pre-expiration move higher on Monday. After Monday all bets are off.
For trading ideas I think this may be the last dip in oil prices ahead of summer and your last chance to pick up an energy stock cheap. Other than that I am skeptical of next week for anything but a short-term trade. I would rather wait until the following week to see what direction the post expiration market decides to take. Overall skepticism is still very high and we are approaching the beginning of the warning cycle for Q1. Watch BSC, LEH and GS for subprime news when they report earnings. Look for NEW to announce a new lending partner, a buyout or a bankruptcy or maybe even all three. Stifel Nicolaus said on Friday that an acquisition is a growing possibility with fair value at $13.50 a share. Could be a trade there!