Option Investor
Market Wrap

Bottoms Up?

HAVING TROUBLE PRINTING?
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The Dow rebounded 300 for the week but that does not mean the bottom is behind us. I would love to believe it and some individual stock prices are definitely finding buyers but the volume has been very light. The leaders are definitely stretching their gains but the majority of the pack is still lagging. The Russell 2000, the fund manager sentiment indicator, is very weak and has not been participating in the rebound. Is the bottom in? I believe it is too early to make that determination.

Dow Chart - Daily

Nasdaq Chart - Daily

Friday's economics may have thrown a monkey wrench in the works for a potential Fed rate cut at the September meeting. Neither of Friday's reports were potentially critical reports for the Fed but both were strongly positive and suggest the economy is not as weak as most expected.

The Durable Goods report for July had a headline gain of 5.9% growth in orders compared to estimates for a minimal 1.1% gain. Orders for June were revised up to 1.9% from 1.4%. Shipments also exploded by 3.8% compared to a drop of -1.1% in June. That was the strongest shipping number since early 2004. The gains in orders were the strongest since last September and suggest momentum is building. The numbers were substantially weaker at 3.7% once you remove the high dollar transportation orders but that was still well above estimates. Backorders rose 2.4% and the highest level since last September. The entire report was a strong indicator of underlying economic strength that could give the Fed a reason to not cut rates at the September meeting. However, this was for the July period and the ISM for August will be much more important when it is released on Sept-4th.

The other economic surprise came from the New Home Sales, which rose to 870,000 for July. This compares to estimates for a drop to 825,000 from the June level of 850,000. That 45,000 difference between actual and the estimate and that was a strong surprise. An even bigger surprise was a 3.57% jump in the median home price to $245,668 from the prior months low of $237,208. Sales are still down -10% from year ago levels. Inventory levels fell slightly to a 7.5-month supply. The strength came mostly from the West with support from the South. The Northeast was the weakest region. Months on the market rose to 6.1 months and a high for this building cycle. The higher prices may be deceiving since builders are throwing in every extra they can find to close the deal rather than impact their market by lowering prices. If you sold 250 houses in a subdivision for $125 a foot and then drop prices to $75 a foot to sell the next 250 homes you will have a buyer revolt on your hands. The recent sales at $75 devalue the ones you sold at $125. It also makes it hard to get a higher appraisal once the glut is over and you start raising the price again. Future appraisals will be based on the $75 price not the $125 price. It will take a long time to overcome that price drop. Builders would rather give you anything you can name as a freebie including no payments for a year, decks, pool, landscaping, etc, to entice you to buy at the listed price. Since this was a July report it also captured the last of the summer relocation crowd. August closings should drop since most families want to be moved in well before school starts. I view this as a blip on the screen and expect the new mortgage rules and the change in mortgage availabilities in August to have severely hampered sales.

Last week was a very light week for economics and the market was left to wander on its own driven only by news events. Next week has a heavy economic calendar with several high profile reports. Two Fed surveys, FOMC minutes, NAPM, PMI and Factory Orders will produce plenty of analyst discussions. With only two weeks before the FOMC meeting every report will be weighed against its impact on the Fed rate bias. Currently there is a 100% chance of a rate cut at that meeting based on the Fed funds futures. However, there are a surprising number of analysts now predicting no change in rates. The market has definitely priced in a rate cut and no cut now could be dangerous. With many high profile individuals including the CEO of Countrywide predicting a recession if the Fed does not act fast the analyst community is definitely polarizing. I will wait until next Sunday to provide further rate analysis after the week's heavy economic schedule. Anybody with an opinion today can change it several times before next weekend. Bernanke will speak at the annual Jackson Hole conference next Friday at 10:AM on monetary policy and housing.

Economic Calendar

The various events in the debt market appear to be pointing to an easing of the debt wreck. The Fed's discount rate cut, $2 billion in borrowings from that window and Bank America's $2 billion infusion into Countrywide appear to have had an impact. Corporations sold $23 billion in bonds this week to make it the busiest week since May-2006. The events leading to these sales narrowed the spreads significantly over the prior week and corporations holding off on their planned sales jumped at the chance to collect the money. Elsewhere everything was not as rosy. Over the past two weeks nearly $200 billion in leverage debt sales have been postponed due to no buyers or high rates. Home Depot reported on Friday that it will have to cut the price of its Home Depot Supply unit by -$1.2 billion and guarantee part of the debt in order to obtain financing for the sale to a group of private equity firms. Reportedly three banks were reluctant to fund the debt given the recent credit concerns in the market. Home Depot had already delayed the closing by a week in hopes of finding a resolution. The next big deal in the pipeline is the $28 billion acquisition of First Data (FDC) by KKR with the debt expected to close on Sept-4th. This is considered to be a "covenant light" deal and those will have a much harder time getting funded. Other deals rumored to be in trouble include the $8.2 billion management buyout of Affiliated Computer Systems (ACS) for $59.25 per share. The stock is now trading at $50 and well below the deal price. That suggests there is trouble brewing. Other troubled deals include $5.3 billion for Ceridian (CEN) for $36 with the stock now at $32. Also, United Rentals $6.6 billion sale for $34.50 with the stock at $30.50 today. The $44 billion buyout of TXU by KKR is also thought to be at risk along with the $8.2 billion for Tribune (TRB) and $25 billion for Sallie Mae (SLM). The credit default swaps, insurance on the deal debt, have risen dramatically on SLM to 287 basis points or $2.87 million per year to insure $100 million of debt against a default. This is about twice what the broader market gets for insurance suggesting there is a lot of implied risk in the deal. That is still chicken feed compared to the $8.75 million per year required to insure $100 million of Sam Zell's debt on the Tribune acquisition. This swap is rising fast and signaling the deal may not close despite Zell's claim on Aug-14th that he is committed to the transaction. Citigroup said the major brokers had increasing exposure to unsold LBO debt. According to Citigroup, JP Morgan had $40.76 billion in unsold debt, Goldman $31.88B, Deutsche Bank $27.27B and Credit Suisse $27.16B.

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Countrywide appears to be out of trouble but not yet out of the woods. The CEO was interviewed on CNBC on Thursday and he said all of the right things while denying Bank America was going to buy the company. He admitted to selling 40 million shares for $142 million over the last year saying, "I am getting old and I need to diversify." With BAC now a 16% shareholder and AllianceBerstein 11% and Fidelity, T.Rowe Price, Legg Mason and Vangard other major holders it appears they are in good hands. AllianceBerstein bought 37 million shares on July-31st as the crisis began, bringing their holdings to 64 million shares. The Countrywide CEO said a lot of people volunteered to help and BAC was not the only offer of money. Angelo Mozilo already had a working arrangement with BAC since they loaned him the $75,000 to start CFC in 1969. The conversion price for the $2 billion BAC investment is $18 so the $18-$20 level should be support as the mortgage mess continues to unwind.

After the bell on Friday the Fed clarified that it would accept investment grade asset-backed commercial paper as collateral at the discount window. The Fed also said it would accept subprime mortgages as long as they are performing loans and not in default. They also said they would accept collateralized debt obligations (CDO) containing subprime mortgages. This would be a "get out of trouble free" card if those holding the subprime debt were all banks. Unfortunately most of those financial institutions holding debt that can't be sold are not banks and are not eligible for the discount window. There are plenty of banks that are eligible so the window could be very busy next week. I view this as very market positive and a sign the worst of the debt wreck is probably behind us.

The rescue did not come fast enough for Lehman Brothers. On Wednesday it announced it was shutting down its subprime mortgage unit BNC Mortgage and laying off 1,200 people. Lehman will take a $50 million charge for the closure. Relatively speaking that is chicken feed. When Capital One closed its Greenpoint unit last week they took a charge of more than $800 million. More than 50,000 jobs have been cut in the mortgage arena in the last year with 25,000 of those in August alone. The table below outlines only those big name companies and there were dozens of smaller firms that closed completely.

Job Cuts in Mortgage Sector

There are still some big problems in the pipeline. Merrill is on credit watch for its exposure to the subprime mess. Merrill bought subprime lender First Franklin late in 2006 and they are expected to confess some problems with their next update. Merrill may have to take a hit on more than $1 billion in subprime loans held by First Franklin. Merrill also has $1 billion in good will on its books from the First Franklin acquisition and analysts expect that to be written off as well. Bear Stearns bought subprime lender ECC Capital in a deal that closed in February. I bet they wish they could do that over again. Morgan Stanley bought Saxon Capital for more than $700 million in December. Subprime loans were hot because of the higher interest rates and fat fees. These loans have now rotted the portfolios of the parent lenders. On Friday S&P slashed the ratings on seven classes of Bear Stearns Asset Backed Securities, citing increasing delinquencies and erosion of credit quality. When the credit ratings are cut it can sometimes force a sale of the securities by the current holders. The vast majority of pension funds cannot hold other than investment grade paper. Once the grade is cut the paper must be flushed. This results in massive margin calls on whoever initially sold the paper to them. The debt wreck may be easing but it is far from over. Earnings from BSC and LEH are Sept-13th and MS on Sept-19th.

The main earnings cycle may be over but there are still a few stragglers. Dell will report on Thursday and has already warned they will miss earnings due to a series of charges for their accounting scandal. They will also have to give an update on the SEC probe and several other legal problems. Meanwhile Hewlett-Packard is beating them like a rented mule in the PC sector. Dell said last week it was having trouble getting parts because Hewlett-Packard was buying them up. What a difference 5-years makes. Dell used to be the PC king using its just in time component acquisition strategy to keep PCs at the lowest cost possible. Now HPQ is buying up the parts and squeezing Dell from both ends.

The rebound for the week came from techs, networkers, energy, materials and metals. The metals and miners rebounded 12% led by BHP Billiton (BHP), Rio Tinto (RTP), Southern Copper (PCU) and Freeport McMoran (FCX). Steel and aluminum stocks rebounded strongly but are still down -20% to -24% from their recent highs. Still plenty of room for the sectors to move higher on the strong global economy.

Energy stocks roared back to life after the post hurricane dip. Dean had not even made it into Mexico before oil dropped to $68.64 on excess supply fears. Inventory levels rose 1.9 million barrels for the first gain in six weeks. That should be bearish but prices rose instead. Feeding the price was a major fire at the Chevron refinery in Pascagoula Mississippi. CVX declared force majeure on its purchase of crude to feed the refinery. Unable to actually refine crude, stockpiles at the refinery quickly became filled to maximum. The 325,000 bpd refinery is only running at 50% and could be offline for many weeks from fire damage. Shell said it would return its Deer Park refinery in Texas to operation this weekend after closing it ahead of hurricane Dean. These refinery outages provided support for gasoline prices but both outages should have added to crude inventories backing up in the system while they are shutdown. This should produce another build in inventory levels for next week, bearish for prices, but low and behold crude was still gaining right into Friday's close. Crude closed at just over $71 for a gain of $1.26. This was powered by short covering after the stronger than expected economic reports suggested growth had not slowed and demand would continue to be robust. I believe it is just a blip in a downward trend while we wait for the OPEC meeting and the peak of hurricane season two weeks from now. OPEC will meet in Vienna on Sept 11th to decide if they need to raise output.

Crude Oil Chart - Daily

There are cracks beginning to form in the coalition's output restrictions given the high price of crude and the special deal given Angola when they joined OPEC a year ago. When they joined OPEC said they were exempt from the quota system until they completed some planned projects. Angola produces about 1.8 mbpd and once those projects are completed they could produce as much as 3.0 mbpd by 2010. This puts them right up there in the top ranks of OPEC producers and they are now saying unofficially now they will never agree to any production quota. This is not setting well with other OPEC members with Nigeria, Libya and Iran already complaining and lobbying for their own quota relief. Since OPEC cheating is a fact of life you can bet cheating will be increasing soon, especially if OPEC decides not to increase production on the 11th.

The markets, with the exception of the Russell-2000, rallied into Friday's close to cap a decent week after the Fed's discount window move. With the Fed funds futures pointing to three cuts by year-end it appears traders are already pricing in those cuts starting with the meeting on Sept-18th. A 300 point gain by the Dow and 71 on the Nasdaq compared with a miniscule 12 point move on the Russell. Small cap buyers, primarily funds, are nowhere to be found. Those betting on the Fed are doing it with the highly liquid large caps where a quick exit is guaranteed. The various ETFs are booming because they are also liquid and you don't have to go through the brain damage of picking a specific stock. These things make me think investors are not convinced the bottom is behind us but don't want to miss the move just in case the rally continues. September is normally a bad month in the market and that is weighing on market sentiment.

Internals for the week were mixed with very low volume. Friday's volume at 4.6 billion shares across all markets was the lowest volume since the Memorial Day holiday. This is well below the record of 11.769 billions shares set on the prior Thursday's drop. The Commodity Futures Trading Commission (CFTC) reported on Friday that short interest in the S&P futures hit record levels again on Tuesday. According to several hedge fund traders many of the funds shorted the 50% retracement of the July drop at roughly 13250 on the Dow, 1460 on the S&P. We saw the markets come to a screeching halt early in the week after the big rebound. The indexes barely moved as the week progressed but did maintain a slight upward bias. On Friday sellers tried to take the market down at the open but when it became obvious the market was not going to crumble the short covering began. That short covering lasted right into the close taking us roughly 100 points over that 50% retracement level. Shorts were throwing in the towel ahead of the weekend and what could be the lowest volume week of the year next week.

Dow Chart - Daily with Retracement

S&P-500 Chart - Daily with Retracement

The last week of August is vacation week. Everyone who did not take a vacation while the markets were imploding and volatility was hitting 4-year highs will try and squeeze in a vacation next week. It is a holiday week ahead of the Labor Day weekend, non-Farm payrolls and the FOMC meeting. With September normally a bad month in the markets this is the last week for traders to take time off. There is a lot of anguish in the fund community about bonuses. With the markets flat for the year and many positions blown out in July/August there are a lot of managers under pressure to find some profits as the year comes to a close. This is going to increase trading and increase volatility.

Barton Biggs was asked last week if the markets were going to retest their lows in September as everyone expected. He said, the market is a very mean master and it could easily just crawl higher while giving signals that it might roll over at any time. This would have 25% of the funds trying to short it and 25% of funds waiting in cash for the dip that never comes. All will eventually end up chasing prices higher. Unfortunately nobody knows what scenario to pick in advance of the event.

After the Fed news on Friday offering to accept subprime paper and CDOs at the discount window I feel market sentiment, especially in the credit markets, will improve even further. If the Fed does cut rates on the 18th it will improve even further. However, no rate cut would be a disaster since the markets are already pricing in more than one cut. Traders will be focused on the Bernanke speech on monetary policy next Friday. Hopefully this will give the markets a clue as to Fed direction two weeks before the meeting. Personally I would not hold my breath. I believe Bernanke will not give any clues OR guide to a continued no cut bias. The Fed is making it clear they will provide liquidity to anyone in need with almost any kind of paper for collateral. Bernanke might see this as all that is needed to fix the debt wreck and the Fed can remain neutral on rates. Contrary to this view was the statement by the Fed last week that the risk to the economy had changed significantly. Traders are hanging on each of those words as a guarantee the Fed is going to cut rates. This makes any Fedspeak next week very critical for market sentiment.

Russell-2000 Chart - Daily

I have been recommending readers wait for the Russell 2000 to break resistance at 800 before racing back into long positions. After spending all week in the 790-800 range the Russell closed on an uptick at 798.93 and right at that resistance line at 800. If we do move over 800 next week I would definitely be a buyer. It is going to be a low volume week and the shorts will likely be on vacation. Longs play all the time but shorts do take vacations. At this point on the calendar I would have a long bias over 800 and a short bias under 790. We saw a week of consolidation on the Russell and the shorts were unable to knock it down. That is slightly bullish. I believe fund managers will jump on board the 850 express once 800 is broken. You can play this directly with the Russell ETF (IWM). Calls are cheap with strikes at every dollar increment. Just be faithful to the 790/800 suggestions above.
 

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