A dozen major buyouts by private equity firms and a surprise statement change by the Fed did wonders for the investing climate. A record number of buyouts and potentially the biggest buyout ever helped convince investors the big money is still bullish on the global economy. The Fed addressed the subprime issue very skillfully by not mentioning it at all but with a surprise change of their bias to neutral. Thinking this was a prelude to a future rate cut the bulls stampeded and bears were trampled as the markets raced higher. The end result was the strongest week in the markets since 2003. Gains in the indexes from 3% to more than 6% produced a lot of green on our screens and end of quarter window dressing is just ahead. What a difference a week makes!
Dow Chart - Daily
Nasdaq Chart - Daily
The only material economic report on Friday was the Existing Home Sales for February. That report saw the headline number spike to 6.69 million or a gain of +3.9%. This was a huge jump on top of a +2.7% jump in January. The 12-month chart below shows how sharp a rebound this really is. Sales are still below levels seen in Feb-2006 but they are improving rapidly. Analysts claim this is a weather related rebound due to much warmer than normal weather in Dec/Jan that led to lots of home shopping. That does not explain the +9% jump in housing starts in February. I am sure there was some weather benefit but there was also a continued drop in home prices as the subprime loan problem provided some motivated sellers. The median price of a home fell for the seventh consecutive month with a -1.3% drop to $218,000. This spring is shaping up to be a strong selling season and with inventories at 6.6 months of supply there are plenty of homes to be sold. Friday's existing home sales numbers gave the market a strong opening bounce and continued to ease investor fears that the subprime meltdown was going to sink the economy.
Existing Home Sales
The subprime doomsayers appear to be losing their voice. Buyers have come back into the subprime stocks and deals are getting done again. Fremont General (FMT) said it sold $4 billion in loans at a discount of only 3% off face value. This is nearly business as usual in this sector. Hedge funds and private equity firms are beating the doors down at the subprime firms with handfuls of cash to buy those loans and invest in their assets. Fallon Capital agreed to loan Accredited Financial (LEND) $200 million to help solve its liquidity crisis. Farallon will also get 3.3 million warrants from Accredited with an exercise price of $10 per share.
The biggest lift to the subprime sector came from the Fed. This may surprise everyone since the Fed did not even mention the word subprime. Their only comment was that "the adjustment in the housing sector is ongoing" and that was only a small change from the "tentative signs of stabilization have appeared in the housing market" we saw in the January statement. The Fed instead took the surprising step of removing bias statement even though they said "recent readings on core inflation have been somewhat elevated" and "the high level of resource utilization has the potential to sustain those pressures."
Why would the Fed remove the bias statement and pave the way for a future rate cut while at the same time increase their comments about inflation worry? This move was completely aimed at shoring up the housing sector in light of the subprime meltdown. They know the easiest way to give the housing sector a lift is to lower rates or at least make the market think lower rates are coming. This energizes buyers, raises housing prices, creates jobs and can add significantly to overall economic growth. In this current scenario it could also prevent a large number of foreclosures as rates fall and prices rise. Bernanke is a very smart guy and I warned you last Sunday he might change up the Fed statement to offset the recent Greenspan comments. This was a perfect way to do this and reassure the market without actually mentioning subprime. By restructuring the statement without actually mentioning subprime he avoided giving the doomsayers additional ammo. Had he mentioned subprime in the statement the doomsayers would still be running down the halls screaming "see even the Fed is worried about the subprime meltdown, we must be right! The housing sky is really falling!" I believe the statement was a stroke of genius by Bernanke and a real game changer. It was such a shock it took a few minutes before the market really understood what had happened and I doubt everyone really understands the implications today.
Another wave of positive subprime news is being seen today. It is the wave of quickly commissioned studies to determine exactly what we are going to see in the form of impact from those loans blowing up. In one study they found that subprime loans accounted for only 12.75% of the $10.2 trillion in loans made in 2006. In 2001 those same loans accounted for only 8.5% of the total. Not all of those loans are going to default. Even if the worst case numbers came to pass at 14% it is only a drop in the bucket compared to the total. $10.2T times 12.75% = $1.3 trillion total subprime loans in 2006. If 14% default that is roughly $182 billion but that default could occur over a five-year period. Many loans don't reset to the worst rate until 2010 and 2011. A study by First American says that $370B will reset in 2007, $250B reset in 2008 and 2009 and another $700B won't reset until 2010 and beyond. Any drop in interest rates or rebound in the housing sector could cut that default rate substantially. As one analyst put it the Tsunami of defaults could turn into only a ripple. Another study found that of all homeowners in the US only 5.1% were classed as subprime with fewer than 8% of those loans less than 5 years old. If defaults in that base did occur it would be only 5.1% * 8% * 10% default or .04 out of every 100 loans. This would hardly be a major event.
One study suggested that we could see one million subprime foreclosures over the next four years. Another study predicted 2.2 million. These numbers sound horrendous but remember they will be spread over the next four years. To put this into perspective there were 1.2 million foreclosure actions in 2006 and the economy did not implode. When the next wave of foreclosures hits the pain will be felt in places where the most subprime loans were written. California heads that list and yet prices are still rising in California. We forget that over 8 million homes are sold in the U.S. each year with 1.6 million of those being new homes. America creates 200,000 new households every month from graduations, marriages, divorces, etc and we see our population swell by 2.25 million immigrants each year. This consumes a lot of housing production and there are no signs of these trends slowing. Unless the subprime problem suddenly spikes well above current estimates we are likely to see only a small slowdown in the housing sector with the worst likely behind us. I admit I bought into the original fear factor when subprime loans took center stage earlier this year but I believe that was in error. Employment is still growing and the economy is still progressing. This is a far more positive time than what we saw post 9/11 when 3 million workers lost their jobs and foreclosures hit 10%. We weathered that bust and the resulting housing boom was one of the greatest booms on record. There is nothing like that on the horizon and the Fed could erase the weakness in housing with one simple rate cut any time they feel it necessary. Bernanke winked at the economy on Wednesday and told us not to worry without actually using the word subprime. Good job, Ben!
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KeyBanc Capital Markets analyst Brett Hoselton said on Friday that auto parts maker Magna International was preparing an unsolicited bid of $4.7 billion for Chrysler. He said they were being aided an unnamed private equity firm and Magna would only retain 25% of Chrysler. Cerebus Capital and Blackstone were seen as possible players in an eventual deal. Unfortunately the Magna bid is seen as way too low to have a chance. It was also viewed negatively since it would put Magna in the position of competing with their customers primarily Ford and GM. GM is also seen as a potential bidder for Chrysler. The final value of a winning bid is seen as something north of $6 billion. Daimler Chrysler (DCX) gained +4.76 on the news.
After the bell on Friday Discover Financial Services filed with the SEC to spin itself off from parent Morgan Stanley. The ticker symbol would be DFS and be listed on the NYSE. The long awaited spinoff will include a generally tax-free distribution of its shares to Morgan Stanley shareholders. Morgan said earlier in the week that the spinoff was on track for the 3rd quarter. Since shares of MasterCard nearly tripled after its IPO this seems to be the right time for Discover to make the break. Visa is also rumored to be planning an IPO later this year. Visa has 1.5 billion cards, MasterCard 750 million, American Express 78 million and Discover 50 million cardholders. Obviously the Visa IPO will be eagerly awaited.
PALM gained fractionally even after posting disappointing earnings. Palm received downgrades from UBS and Banc America Securities. UBS went from hold to sell and BAC from buy to hold. Palm had been trading higher in March on takeover speculation. RIMM, MOT and NOK all have deep pockets and have been suggested as potential buyers. Citigroup analyst Daryl Armstrong wrote on Friday that while he still expects Palm to be sold it is difficult to expect anyone like MOT or NOK to justify purchasing the company at current levels. The company CFO dodged acquisition questions on the earnings call saying, "All you need to know is that we are 100% focused on running an independent supplier of mobile computing products. End of story."
Kronos, (KRON), always a company that conjured up visions for me of a fictional computer in a SciFi movie, agreed to a $1.74 billion buyout led by Hellman & Friedman and JMI Equity. The 30-year old software company accepted an offer of $55 per share or about a $9 premium over Thursday's closing price.
Vonage (VG) suffered a major blow on Friday after it was hit by a restraining order calling for it to halt any use of technology related to patents held by Verizon. Vonage has already been found in violation of 3 of the 5 VOIP patents Verizon holds and was just waiting on the next phase in the suit to transpire. The unexpected restraining order was a major blow although they claim they will win in the end. Any win for Vonage is going to be a major uphill battle from here and investors were not betting on Vonage at the close. After being halted for trading for most of the morning VG closed down -25% at $3.00 and I doubt the selling is over. There is speculation that any deal with Verizon will be too expensive and any work around will be far too bulky and cumbersome. That leave Vonage with a serious challenge that it may not be able to overcome and analysts were already talking about a potential business closing. Vonage has turned into the worst IPO of the decade with its fall from the IPO high of $17.25 last May to Friday's close at $3.00.
Vonage Chart - Daily
In a week led by a strong flurry of M&A deals there was news on Friday that Citigroup may be considering a bid for ABN Amro. ABN has already agreed to be acquired by Barclays for $80 billion and would be one of the largest deals ever. Insiders at Citigroup are said to be pushing management to make a rival bid for ABN.
May Crude Oil Chart - Daily
Oil prices returned to their recent highs on Friday at $62.65 before seeing some profit taking at the close. This was well above the lows of $56.10 we saw on Tuesday. I told everyone in these pages to buy the dip and I hope you took my advice. There were multiple reasons for the dip, mostly profit taking post OPEC and some futures expiration pressures. The rebound needed no reason since the fundamentals did not change. Inventory levels were falling, gasoline prices were rising and refineries were either down for maintenance or suffering from various outages. VLO, COP and Shell (RDS) all saw outages this week from power problems. Exxon also had problems and lost production. However, Friday's gains were also prompted by new concerns over Iran. Iran patrol boats captured 15 British naval troops in Iraqi waters while they conducted a search of a private vessel. The British personnel and boats were then taken back to Iranian waters and to an Iranian base in the Shatt al Arab waterway. This attack on British personnel in Iraqi was witnessed by various military patrols in the area and was a blatant move into Iraqi waters. Considering the capture came only one day before the UN Security Council is set to vote on new sanctions against Iran it is even more puzzling. After a week of posturing by Iranian officials the act showed even more defiance than normal. Iranian President Mahmoud Ahmadinejad called off his visit to New York to address the Council on Saturday and blamed the cancellation on the lateness of getting Visas for his trip to the US. Others said it was likely he would find it difficult to claim to be peaceful after seizing British troops in Iraqi waters.
There were also the strong words by the supreme leader earlier in the week. Supreme Leader Ayatollah Ali Khamenei warned again on Wednesday that Iran would strike back at anyone who attacked them and would exact a terrible price. He also said UN sanctions would have no impact because Iran would continue its nuclear efforts illegally until it was successful. I believe Iran caught the British and US forces off guard with its dash into Iraqi waters to capture the British personnel. Both the British and US commanders in the area have demanded the immediate return of the personnel and equipment. I believe it will happen eventually and once they are returned the rules of engagement for allied forces will be raised significantly. The next Iranian ship that ventures towards an allied force in Iraqi waters may quickly find itself a permanent obstacle to shipping from its resting place on the bottom of the channel. This is exactly the kind of head busting confrontation the allies will be looking for to prove Iran is not immune to hostile fire. Trick us once, shame on you. Trick us twice and lose your ship. The low-key confrontation may have occurred without any shots being fired but the ramifications to the oil market were clear. The escalation of tensions between the US and Iran is drawing ever closer to a real confrontation and with two carrier battle groups in place there will only be one winner. Analysts are starting to talk about $70 oil again before summer is over and the target price rises with every Iranian news item.
London based storm forecaster Tropical Storm Risk (TSR) said on Tuesday the six-month season, which begins on June 1st, was expected to bring 17 tropical storms, of which nine will strengthen into hurricanes. Four of those nine are expected to become more destructive or intense storms. The long-term average is 10 storms with 6 reaching hurricane strength. TSR said current climate signals indicate land-falling hurricane activity will be 75% above the 1950-2006 averages. Back in December that estimate had been only 60% but the sudden dissipation of El Nino in February raised the risk. The Colorado State University forecasters have also warned the 2007 season is likely to be busier than normal. In 2005 there were a record 28 storms and 15 hurricanes and following only a slightly less active season in 2004. Everyone agrees the very calm 2006 season was a statistical fluke and is not likely to happen again in 2007.
Last Sunday the Dow was resting on support at 12100 and that support looked poised to break. I speculated that odds were high it would break and we would see a new low under 12000. While I had a fever of 103 when I wrote it I am not claiming it influenced my thinking. The charts show what they show and last Sunday they were showing a greater chance of decline than rally. That all changed on Monday when a flurry of M&A deals, including the record breaking $80 billion ABM Amro deal, sent the indexes on a short covering ride higher. The start of the FOMC meeting on Tuesday and the +9% jump in housing starts applied even more fuel to the fire. The Dow leveled off at just below resistance at 12300 to wait for the Fed announcement. Surprise, surprise, surprise as Gomer Pyle would say. The unexpected removal of the tightening bias caught everyone off guard and the rest as they say is history. Friday saw the Dow bumping its head on 12500 and +400 points off last Friday's support.
In only a few short hours the game has changed substantially. The bulls no longer have a wall of worry to climb but an interstate highway paved with gold bricks stretches out before them. There are only five days left in the quarter and earnings warnings have been suspiciously absent. With all the stars in alignment it is entirely possible we could be back at new highs before the quarter ends. What a picture perfect scenario that would be for fund managers! New highs at the end of a messy quarter. Retail investors confident the correction was behind them would be pouring money into funds. What is wrong with this picture? Frankly I can't see anything wrong with it today. The summer doldrums lay ahead but Q1 earnings are about to begin. According to the bean counters the earnings estimates for Q1 have declined from just over 8% growth two months ago to only about 5% growth today. I doubt most investors have come to that realization yet. The string of double-digit quarters has run so long that everyone just expects them to continue. 5% growth may suddenly cause investors to jump back in alarm even though 5% is still decent for the long term. Nearly 70% of companies have been beating estimates recently and investors will expect that to continue. We all know that is from managing expectations but what happens when those expectations shrink to only 5% growth. Will investors suffer sticker shock when the numbers begin two weeks from now? Who knows but I suspect they will be more focused on the perception that the Fed is going to cut rates later this year and that will blot out a few earnings disappointments. It will be several weeks before we get enough announcements for the reality to sink in and reporters to polish their sound bites discussing the earnings decline. Until then the punchbowl has just been refilled courtesy of the Fed and the revelers are going to drink themselves giddy.
The Nasdaq closed at 2449 and almost exactly where it closed for the prior two days. Nasdaq 2455 appears to be strong resistance but there has been no credible effort to sell it off. The index is pinned to 2450 and several less than exciting tech events late this week failed to have any impact. There were some bad trades posted at 1:55 on Friday that spiked the index from 2450 to 2457 but those trades were corrected at 3:20 and the print returned instantly to the same level it was holding prior to takeoff. Donegal Group (DGICA) had several trades cross at $1,999 instead of the $18 level where it was trading when they were entered. The Nasdaq immediately cancelled the trades once they were located and the index values were corrected.
S&P-500 Chart - Daily
Russell-2000 Chart - Daily
The S&P-500, like the Nasdaq, found itself pinned to 1435 and the level reached after Wednesday's Fed announcement. Moves over that level were very limited and very brief but like the Nasdaq there was no concentrated effort to sell it off. Both indexes appeared to be exactly where the fund managers wanted them to be ahead of quarter end window dressing. Friday's volume was negligible at 4.6 billion shares and the lowest level since Feb-12th. Internals were strongly positive but given the very light volume but there appeared to be no conviction.
That conviction came from the Russell. The Russell closed at 810 and a new 4-week post crash high. That is only 20 points from the all time high set on Feb-22nd. This is all the conviction I need to believe we are going higher next week. Fund managers are buying small caps ahead of quarter end and that suggests we will see plenty of tape painting next week. It is entirely possible we will see new highs. The NYSE Composite also closed at a new post crash high to confirm the move in the Russell.
The economic calendar for next week will give us another look at home sales and several regional Fed surveys. The GDP revision for Q4 should not be earth shaking since the major revision from 3.5% to 2.2% was seen last month. The expectations for next week are for a flat revision to a nominal +0.2% rise to 2.4%. The PMI on Friday could be the big report for the week since the last two reports showed contraction. A rebound above 50 would be very positive for the market although potentially troubling for the Fed. The Fed would like to see a couple more months of contraction to keep inflation pressures under control. This is even more important now that they have removed the tightening bias. We don't need any sudden rebound in the economy to upset their plans.
As traders we need to stick with the trend and that trend should last through Friday. Fund managers are in control and they will be trying to keep the rebound going through quarter end if at all possible.