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Market Wrap

Subprime Returns To Haunt

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The morning started out great with the Dow rebounding to 13500 and 140 gain but it ended ugly with a -146 loss. Subprime returned again to plague traders much like Freddie Kruger returned time and time again to wreak havoc in the Friday the 13th movies. We keep beating this dead horse but it keeps coming back from the dead to trample the financial sector and the broader market.

Dow Chart - Daily

Nasdaq-100 Chart - Daily

It was a very busy day economically with 9 different reports. Chain store sales rose 1.1% for the week, a very strong showing and the best week since Feb-3rd. Reportedly the gains were due to back-to-school demand. Declining gasoline prices also helped consumer sentiment. Personal income rose 0.4% in June and that also helped fuel additional spending. This was the second consecutive month of gains but still below expectations for a 0.5% gain. The core PCE deflator, an indicator of real inflation at the consumer level, came in at 0.1% pushing the year over year inflation rate down to 1.9% from 2.0%. Inflation, ex-food and energy, is still falling although very slowly. Ironically consumer confidence shot up to 112.6 in the final July reading from 105.3 in June. The present conditions component shot up 10 points to 139.2 to lead the charge. That is the highest level since 9/11.

The Employment Cost Index (ECI) for the second quarter rose 0.9% and slightly more than the 0.8% Q1 rate but less than the 1.0% expected rate. The gain was right inline with the average for the last four quarters. Employee benefits rose sharply but growth in wages slowed preventing a sharp uptick in overall compensation. This was a positive event for inflation watchers with wage inflation pressures easing.


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On the downside the business conditions in New York City weakened in July with the NAPM-NY headline number slipping to 446.4 and a 6-month low falling -5.1 points from the June level of 451.5. Nearly all components showed declines with a notable drop in the current conditions component to 39.7 from 52.5 in June. A level under 50 denotes contraction. The outlook component, which measures sentiment for the coming six months, fell to 62.5 from 66.7 and the lowest level since July 2005.

Confirming the drop in the NAPM-NY was a sharp drop in the Chicago Purchasing Managers Index (PMI) to 53.4 in July from 60.2 in June. The internals fell sharply and this is a major red flag that the economy may have reversed directions. New orders fell to 53.4 from 65.7, order backlogs fell to 37.4 from 50.8 and production fell to 59.0 from 66.5. The prices paid component is the only component steadily rising, now at 73.1, and indicating inflation growing at the wholesale level. The sharp drop in order backlogs was another key indicator of a slowing economy.

Construction spending fell -0.3% with a -0.7% drop in residential construction leading the headline drop. This was the biggest drop in 5-months. Agricultural prices spiked 2.2% in July with livestock prices gaining 2.2% and crop prices adding 1.4%. Food commodities rose 2.9% for the month being pushed up by higher prices for milk and eggs. Farmers paid higher prices for feed and fertilizer. Most people don't realize that nitrogen based fertilizers, by far the largest in use, are petroleum based and derived primarily from natural gas. Since oil and gas prices are linked as the price of oil rises so does the price of fertilizer. Many U.S. fertilizer companies have already gone out of business or have moved overseas where large supplies of natural gas are cheaper. The cost of fertilizer and the eventual shortage in years to come is going to have a serious impact on the eventual carrying capacity of the planet. Without nitrogen fertilizers the vast nutrient depleted farmlands in the U.S. would not even grow weeds. More on this subject in future commentaries.

Earnings tried to move back to the forefront of investor interest today but were overshadowed by the subprime news making the rounds again. Sun Microsystems (SUNW) posted another quarterly profit and gained 21 cents. GM posted its first profitable quarter in two years and lost -21 cents. After the close today Whole Foods (WFMI) beat the street on earnings and spiked sharply gaining 10% in after hours. That after hours news failed to produce even a slight uptick in futures.

Apple (AAPL) lost -9.67 on an erroneous report from TheStreet.com that iPhone production had been cut in half. TheStreet attributed the report to a trader at Miller Tabak. However the spokesman for Miller Tabak said TheStreet called them and asked if they had heard the rumor. When they answered yes they had heard a rumor TheStreet reporter then attributed the rumor to Tabak. Tabak does not even have an analyst that follows Apple or follows tech in general and denied ever releasing any comments on Apple stock. TheStreet ended with egg on their face and Apple shareholders lost over $8 billion in market cap. Another Street.com writer interviewed after the close and after the news on the erroneous story broke, ignored questions about The Street's error and blamed the stock drop on the market and overbought conditions in AAPL.

September Crude Chart - Daily

Oil prices closed at an all time record of $78.21 today and well over the prior $77.03 record seen on July 14th 2006. The intraday high of $78.27 came very close to the historic intraday high of $78.40 on that same day in 2006. Helping to push oil prices higher was more violence in Nigeria and news of new refinery problems. The appearance of the 3rd named storm of the season, Chantal, also spiked prices even though Chantal is off the coast of Canada not Florida. Just the appearance of another named storm reminds traders that the peak of the hurricane season is only 40 days away on Sept-10th. The National Weather Service also highlighted the potential formation of another storm over the next 48-hours just southeast of Cuba and that one would be a major problem if it tracks between Mexico and Cuba and the normal launching ramp into the Gulf oil patch.

Linda lives in Texas and they have been inundated in rain for the last couple months. This prompted several forecasters to dig into historical records to research hurricane patterns after summers of record rainfall. Linda sent me some results of those searches. There was a good correlation of major storms making landfall later in the summer after record rains. Since this summer could be the wettest on record for Texas those on the Gulf coast should be prepared.

The two biggest challenges to traders today were the closing of the $3 billion Sowood hedge fund and the warning from American Home Mortgage. Sowood sent a letter to investors yesterday saying losses in the credit markets driven by exposure to the subprime meltdown had forced the closing of the fund. The $3 billion fund was managed by an individual that helped build Harvard's endowment fund to nearly $30 billion. Sowood had leveraged the $3 billion invested into $15 billion in positions. When those positions turned against them they could not exit fast enough. Once bids evaporate it makes no difference what the collateral is really worth.

I wrote about this several times over the last few weeks. Leverage works both ways and those leveraged to the credit markets are getting killed. Sowood said they were ok last week but the sudden deterioration in the credit markets after Countrywide warned of defaults moving up the credit scale knocked -$1.5 billion off Sowood's positions. The "mark to model" method for valuing positions has been coming under increasing pressure over the last few weeks. Every time the value of these credit instruments takes another hit the model weakens. I have mentioned this many times before that the degree of decline in the value of these credit instruments was going to eventually force a "mark to market" valuation rather than mark to model. That is beginning to happen across the sector and as we have seen in the case of Sowood and AHM the results are disastrous. Sowood's lenders forced a mark to market valuation on Sowoods credit investments and that produced a monster margin call that Sowood could not meet. In the letter to investors Sowood said it had sold nearly all its assets to Citadel resulting in a 53% loss in capital and the closing of the firm. Citadel is a $14 billion hedge fund and a known purchaser of distressed assets. Citadel joined with JP Morgan to purchase the distressed energy assets of Amaranth late in 2006.

AAmerican Home Mortgage (AHM) said today that it can no longer fund home loans and may be forced to liquidate its assets. AHM said lenders cut off access to credit on Monday leaving it unable to fund $300 million in mortgage closings. AHM said it may be unable to fund an additional $450-$500 million in loans on Tuesday. AHM hired Milestone Advisors and Lazard to evaluate options and advise on the orderly liquidation of assets. AHM is not a small company. It holds about a 2.5% share of the U.S. mortgage market. Contrary to popular belief AHM does not deal in subprime mortgages. They specialized in Alt-A mortgages, which fall between subprime and prime. This is another confirmation of the warning given by Countrywide last week on rising defaults in prime loans. The default rate across the entire spectrum of the mortgage market is causing serious problems for those exposed to credit risk. AHM shares fell -90% to close at $1.04 on fears that any liquidation of assets would wipe out shareholder equity. AHM owes money to almost every major banker including $2 billion to UBS, $2B BSC, $1.3B BAC and $1B to Barclays. These major banks took another major hit to their stock prices on losses to the credit sector. Goldman Sachs lost -$7.40, BSC -$6.03, LEH -$2.80 and MER -$2.51.

AHM Chart - Weekly

Since HM did not have any subprime exposure this collapse will cause another round of concerns about those stocks involved not only in subprime but all the way up the credit ladder. MGIC Investment (MTG) and Radian Group (RDN) said they might have to write off a combined $1.03 billion invested in C-Bass, a joint venture related to subprime mortgages. MTG fell -15% and RDN -16% after the announcement.

TThe market was doing well until AHM reopened for trading after a 2-day halt and dropped -90%. At the same time St Louis Fed President William Poole said the Fed will not come to the rescue of the stock market. Poole warned that should the Fed be overactive in responding to the current crisis it would set a precedent for future market events. Poole said Bernanke is trying to move away from the "Greenspan Put" and let the markets move on their own rather than always depend on the Fed to bail them out. The phrase was coined after the Fed under Greenspan pumped up the money supply in order to stabilize the markets after the 1987 and 1989 crashes, the Long Term Capital Management implosion and the tech bubble bursting back in 2000 and the post 9/11 crash. Poole said the Fed must wait and react over time to changing economic conditions rather than run when somebody yells fire.

With new damage from the credit crisis breaking out all over and a Fed President saying the Fed was not going to ride to the rescue the impact to the market was an immediate sell signal. The morning's 140 opening bounce turned into a -146 point rout and there was not any uptick at the close. The Dow ended at another new 2-month low at 13211 and just 39 points over the 100-day average at 13172. This was the second time in 3-days the Dow has closed at the low. The Nasdaq fell farther and faster losing -37 points to close at 2546 and UNDER its 100-day average at 2551.

Rick Santelli, CNBC anchor on the bond floor in Chicago pointed out a critical technical event on the S&P-500 that could be predicting a major reversal in equities. He pointed out that the S&P created what is called an "outside month", a higher high and lower low, with a close under the prior months low. This is a technical sell signal that is widely followed by many fund managers. The S&P at 1455 also closed well below its 100-day average at 1488.

With sell signals breaking out all over on the technical side and financial companies going under almost daily the outlook for the equity market is turning darker. You could make a case that today's drop was a needed retest of the prior low but it would be a very weak case. The market appears to be setting up for a full -10% correction if not more. Bulls keep reminding everyone that earnings are growing not shrinking and the market will move higher. Buy the dip. The bears are reminding the bulls that the market lost -50% in 1973/74 and earnings continued to climb. The 1987 crash also occurred on no decline in earnings. Sell the rallies.

I think it is simpler than that. It is clear that the financials can't free themselves from the subprime slime and now it is turning into a prime slime with the accelerating defaults in prime loans. Some analysts are now saying we could see as many as half of the loans made in 2006 default. That would be a monumental number and produce losses well over the $100 billion risk limit quoted by Bernanke and others. Even worse it would force home prices even lower with that many foreclosures and forced sales hitting the market. This would impact consumer spending as the value of their equity falls and send the economy into recession if it plays out as some are suggesting today. It is not a pretty picture and funds did the only thing they could do to raise cash to cover their sinking credit investments and that is sell equities. Add in oil at record levels pushing costs higher for everything made from oil and the economy is under increasing pressure.

S&P-500 Chart - Weekly

Russell-2000 Chart - Weekly

Everyone thought Monday's rebound was the beginning of a recovery after indexes touched new intraday lows at the open. The increasing buying as the day continued suggested the sellers have finished. Unfortunately it appears they were just regrouping and today's bad news was all they needed to start another wave of selling. I would be bearish until we see if the market shakes off today's financial news but late Tuesday evening Bear Stearns said a third hedge fund was in trouble. The Bear Stearns Asset-Backed Securities Fund speculates in subprime mortgage loans and was worth $850 million in March. Bear Stearns announced late today the fund had suspended redemptions and expects losses for July. BSC said this fund was not leveraged and would not be susceptible to margin calls like other funds are now seeing. Bear said the fund was well positioned to wait out the market uncertainty. But, well positioned or not, BSC lost -$6 in after hours trading to $115 before buyers appeared cutting losses in half to $118. It does not bode well for Wednesday's open.

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