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Market Wrap

Tiptoe To Tuesday

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As the week came to a close the volume slowed significantly with many traders away from the markets. Volatility was subdued and the markets held their early week gains to finish up about +2% for the week. As traders left early for the Jewish holiday those remaining just wanted to tiptoe quietly into the close in hopes of preserving those gains ahead of next weeks heavy economic calendar, FOMC meeting and key subprime earnings.

Dow Chart - Daily

Nasdaq Chart - Daily

Friday saw a flurry of economic reports but none were spectacular. Import prices declined -0.3% in August compared to a +1.3% rise in July. The drop was due mostly to a fall in oil prices in August. Guess where that index is going to be next month? With oil at record levels the import price report for September is likely to show an even stronger rise.

August Retail Sales rose +0.3% and half of the consensus estimates for a +0.6% gain. Ex-autos the headline number would have fallen by -0.4%. End of summer bargains prompted a +2.8% jump in auto sales. Gas station sales fell -2.4% but as we know that will reverse in September. Furniture sales rose +0.5% and electronics continued to show strength with a +0.4% gain. On the surface it appears consumers are still healthy and hoarding of cash has not yet hit the retail sector seriously. Back to school buying was credited with keeping sales in positive territory.

Industrial Production rose +0.2% in August and only slightly below expectations. Output was weak, falling -0.3% with mining output falling -0.6%. Were it not for a monster +5.3% surge in utility output the headline number would have been much worse. Warm temperatures contributed to the rise in electricity output for summer cooling. Capacity utilization at 82.2% was unchanged from the prior month. Auto production fell -2.6% and the largest drop since January.


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Business Inventories rose +0.5% and slightly above consensus with retailers up +1%. This was a July report so it did not have any impact on the markets. Business sales were up a cautious +1.1% with manufacturer sales up +2.6%. The inventory to sales ratio fell to a new cycle low at 1.26% suggesting there is a manufacturing upswing somewhere in our future.

Consumer Sentiment was inline with analyst's estimates with a slight +0.4 rise to 83.8. That surprised me given the negativity in the marketplace over oil and loans. It is still holding at lows not seen since last August. With mortgage resets growing, jobs falling and gasoline prices likely to rise sharply over the next couple weeks it is not likely that sentiment will rise soon.

Next week is a monster week for economics with the FOMC meeting the largest market mover. Earnings from the brokers will also highlight the extent of the subprime damage. The Producer Price Index on Tuesday is expected to show a decline but the Fed will be looking at the inflation rate at the core level to see if producers are going to be passing costs on to consumers. On Wednesday the Consumer Price Index will show the impact of that pass through of producer prices from prior months. The Philly Fed Survey closes the economic calendar for the week on Thursday and is still expected to show an improvement over July. I am not holding my breath on that one. It could very easily surprise to the downside.

Economic Calendar

After two weeks of concentrated Fed analysis in the press and on stock TV the consensus is for a -25 basis point cut in the Fed rate and a -50% point cut in the discount rate. There are some that believe Bernanke could lower reserve requirements for banks to improve liquidity in the system. I am not in that camp and I believe lowering the reserve requirements at a time when banks are under stress and holding bad paper is probably not a good plan. Those requirements are put there to cushion against the impact of bad loans and it sounds like we need a larger cushion today not a smaller one.

The current Fed scenario suggests we will see four 25-point rate cuts by June but analysts are up in arms against that plan. They feel a drawn out rate cut cycle will only prolong the pain and further damage the economy. Most favor a sharper 50-point cut next week followed by another 50 points in October and then a pause. Analysts feel the economics will deteriorate so badly in Sept/Oct that the Fed will be forced to cut 50 points at the Halloween meeting and be another 60 days behind the curve if they wait to make that large cut. By taking decisive action next week they can provide a calming influence into Q4 and help offset the damage of the continuing mortgage reset scenario.

I am not going to beat a dead horse here because I am sure everyone already knows how big a news event the FOMC meeting will be. In reality it is more of a sentiment band-aid than a real economic event. Any cut will help but it normally takes 12-18 months for it to be fully felt in the economy. Mortgages would be the only immediate benefit and the housing sector needs all the help they can get. If by chance the Fed did not cut the market would behave badly and we could easily see a several hundred point contraction. A 25-point cut is already priced in so that may not produce a material move higher. There are signs of inflation coming back to haunt the Fed so their decision is not a slam-dunk. The language is of course the key and the Fed should consider carefully what they say.

The real key to the long-term health of the markets may not be the Fed but the earnings from BSC, LEH, MS and GS next week. The dates appear to have finally been nailed down and I posted them again in the economic calendar above. With Lehman first on the list any positive surprise should translate into a substantial bounce on the rest. Goldman remains my best pick in that sector and I would not hesitate to buy them on positive Lehman news. Bear Stearns is the most feared report but as I said last week I think all the bad news is already priced into the stock.

Merrill Lynch (MER) warned on Friday that the subprime problem and the credit crunch in corporate paper was forcing it to reduce the value of securities on their books. This would force them to post a lower profit in Q3. The earnings warning was made in a SEC filing in regard to a $1.3 billion buyout of subprime lender First Franklin Financial in late December. That deal is expected to close on Sept-21st. Merrill also packaged and sold mortgage backed securities on subprime loans acquired elsewhere. Merrill did not state how much the write down would be and on what assets leaving analysts to wonder if this was the first shoe to drop leaving a larger one for later. If you let the market down in stages it is better on your stock price. If Merrill has to warn on subprime issues you know the other brokers are also going to face the music, possibly in a much harsher fashion.

Goldman announced last week that another of their hedge funds had a significant loss over the last month. I don't think that will impact Goldman Sachs stock next week since the daily hedge fund implosions are hardly making the news any more. I continue to hear that of the 9000 hedge funds as many as 2000 may not be around at year-end. Reportedly many are hanging on to that last thread of hope for a miraculous recovery in the credit markets. The problem here is the lack of a market in debt. Once the major brokers identify debt valuations this week those funds will have to mark to market and many will be underwater.

Bear Stearns (BSC) rebounded about $12 from their lows on Monday at $105. The major mover ahead of next Thursday's earnings was news billionaire Joseph Lewis bought 8.1 million shares in late August and early September bringing his total stake to 7% and making him the largest shareholder. Lewis said he had no activist interest in BSC and just bought the shares for an investment. Lewis currently controls more than 170 companies. Having a knowledgeable multi billionaire invest nearly $1 billion in BSC stock did wonders for investor confidence.

Best Buy (BBY) reports on Tuesday and that could be our window on the current state of the consumer. The retail sales for August showed electronics as one of the few sectors still positive. We should get a better understanding of current conditions and future guidance when BBY reports.

Tech stocks could get a boost when Adobe reports on Monday. The tech sector was stunned into only a +1 point gain on Friday after Intel was downgraded on valuation. The semiconductor sector was also dragging on tech stocks all week after profit warnings in that group. The SOX was the only index to post a loss (-1.16%) for the week. The August semiconductor book-to-bill report is due out Tuesday after the close and it had fallen to .84 in July and a two-year low. That equates to $84 in bookings for every $100 in product shipped. Monthly bookings fell -10.4% in July and YTD bookings have fallen to -17% below the prior year. An increase in production capability has increased the supply of chips in 2007 resulting in excess inventories and a drop in prices. Manufacturers are struggling to overcome this inventory overhang but DRAM and NAND products are beginning to firm. To top it off SanDisk and 23 other companies are being sued in a class action case for allegedly conspiring to fix the price of flash memory. The case is seeking restitution, and triple damages.

FedEx (FDX), the poster stock for dead money in 2007, reports earnings on Thursday. It will not be the earnings that are so important but the guidance about the state of the shipping business. After Bill Zollars from YRC Worldwide (YRCW) came out last week and begged for a rate cut to head off a recession and claimed there was no build up in progress for holiday orders the trucking sector has been under pressure. It will be up to FedEx to come to the rescue. The transports are struggling to hold support at 4700 and positive guidance by FDX would help. Other stocks in the sector are UPS, JBHT and EXPD.

Hovnanian (HOV) is having a fire sale this weekend in all of its communities from coast to coast. They announced they were cutting prices on homes for 3-days only by $75,000 to $100,000 and the goal was to sell 1000 homes. They picked the price cut to specifically put as many homes as possible under the $417,000 jumbo loan limits and allow more buyers to qualify. HOV stock had fallen to $10 and found a solid bottom there over the last week. The news of the sale caused a +10% spike. Reportedly business was brisk in their sales offices with CNBC showing lots of buyer traffic and interviewing people signing contracts as fast as they could to lock in the price and the model they wanted. Hovnanian said they wanted to cut prices sharply enough to push people off the fence and make a buying decision. He said too many buyers were just waiting on the sidelines for a sign the decline in prices was over. This forced them to act quickly or be left out.

Carl Icahn filed a notice on Friday that he had acquired an 8.5% stake in BEA Systems (BEAS). He said Icahn Capital Management had acquired 33.4 million shares and call options representing another 16.1 million shares. That would be the vast majority of the open interest in BEAS calls and a slick move. You buy a pile of calls at for the $12.50 strike for pocket change with BEAS languishing at $11.50-$12. That does not directly influence the stock price. After your announcement sends BEAS to $13.50 and probably higher next week since the announcement was late in the day, you can either exercise the calls locking in the stock at a cheaper price or simply sell the calls for a nice profit on news you generated. A very nice trick if you have the bucks and name to pull it off. Icahn said an acquirer could make better use of BEAS technology and he would lobby for the company to be sold using his own slate of directors. BEAS issued no comment on the news. BEAS is currently in danger of being delisted from the Nasdaq for failure to file reports for several quarters while doing a stock options probe. BEAS did confirm it received another delisting notice from the Nasdaq on Friday.

British bank Northern Rock, the 4th largest mortgage issuer in England, had to be bailed out on Friday by the Bank of England. Stock in the bank fell 31% when the news broke. Depositors stood in line for hours to withdraw their money. The bank said it had been unable to raise funds since last month when the global credit markets froze up. The amount of the bailout was not disclosed and the BOE said Northern Rock was in no danger of collapse. The bank said there was no sign of easing in the credit markets and conditions could continue to be grid locked through year-end. Just last week a Bank of England big wig derided the American banking crisis saying the Fed should not bail banks out and should let U.S. banks fail for making bad decisions. It is funny how high profile statements have a way of coming back to haunt you. British analysts warned about comparing Northern Rock to Countrywide saying NR was more diligent in its lending practices, no longer has a subprime book and has a repossession rate of less than 1%.

Countrywide (CFC) can't say that but it is trading more than $3 off its lows for the week after saying it lined up another $12 billion in borrowing capacity from new or existing credit facilities. They also reported that loan fundings for August were $34 billion, down 17% from August 2006, but still a respectable number in a tough environment. There were $52 billion in the pipeline at the end of August, down from $64 billion at the same time last year. That should put a lot of skeptics to rest with news that business as usual is not as bad as everyone thought.

Alan Greenspan will be interviewed on 60 minutes this Sunday and the interviewer has a definite edge in her voice. Gone is the fear and awe that reporters expressed when they interviewed him as Fed Chairman. It is scoop time and the sharks smell blood. In an excerpt making the rounds on Friday Greenspan denies any knowledge or control over the subprime problem. He said he "didn't really get it until late 2005 or early 2006." Sure Alan, and I guess you want us to believe in the tooth fairy as well. In the interview he stumbles all around the subject before admitting he didn't get it. That is a heck of an admission by the guy everyone thought was infallible. One analyst called it "an incredibly disingenuous, if not cowardly, attempt to weasel out of responsibility for the current economic mess." Catch the interview on Sunday night.

Merger and acquisitions hit the low for the year this week with only 135 deals announced totaling $5.9 billion according to Thomson Financial. This was the lightest volume and the lowest dollars for the year. The next lightest weeks were August 19th with 154 deals and $12.1 billion and January 6th with 235 deals for only $6.9 billion. When you can't be assured of funding it makes it a lot tougher to sign those contracts including a breakup fee if the deal does not close.

EExpiring October Crude Oil Chart - 30 min

Oil prices hit yet another new high on Friday at $80.35 before succumbing to selling that knocked the price back to $79 at the close. The quick appearance of Humberto caught traders leaning the wrong way and shorts were again massacred. Fortunately the three refineries knocked offline by storm related power outages will all be back online by Saturday. There was no material disruption and no refinery damage. Tropical storm Ingrid is now wandering around east of Puerto Rico and tracking northward toward Bermuda. It is very slow moving and it could be Wednesday before we know for sure it is not going to take a left turn into the Gulf. That is cutting it very close for holders of the October futures contracts. The October contracts, the ones that hit $80.35 on Friday, cease trading on Wednesday and anyone not wanting to take delivery will need to exit before then. Add in the normal weekly inventory numbers on Wednesday morning and the stage is set for a massive sell off next week. I suppose that was part of the crash in the last 30 min of trading on Friday. With open interest so high in this contract there are going to be a lot of exits next week. How many will wait until the last minute on hopes of another inventory drop or a left turn by Ingrid is anybody's guess. I loaded up on shorts at $80 so I hope there is a stampede for the exits and no weekend bombing of Iran. Analysts claim Iran could be part of the high prices. The UN Security Council group dealing with Iran over the nuclear issue is scheduled to meet again next Friday to discuss a third round of sanctions. I doubt further sanctions will be approved until 2008 because Russia and China are against further actions. With the U.S. stonewalled in causing Iran further grief and Bush running out of time in office many think the U.S. or Israel will take action to destroy the nuclear sites. That would of course send oil prices through $100 within seconds.

Were it not for the Fed meeting clouding the horizon I would again be on the verge of switching to a bullish bias in the broader markets. The shorts have been unable to capitalize on numerous events and even the approach of the earnings warning cycle and some high profile warnings already announced has had little impact on the markets. The Dow is slowly creeping up on resistance at 13500 and a break over that level could trigger a rush of buying. I have begun to believe that the August crash has cancelled the potential for a further drop in September and the bottom is behind us. What the Fed does, while maybe not material for the economy in the short term, is critical for short-term market sentiment. Any kind of cut at the Tuesday meeting should result in further bullishness even if there is a sell the news reaction.

The markets will still be hostage to the financial earnings next week but if Lehman does not disclose disastrous results on Tuesday the rest of the club will be expected to do the same. That could be the first step on the wall of worry the bulls will use to reach higher ground. The S&P has strong resistance at 1490 and that was evident again on Thursday when 1489.58 was the intraday high. However, with the financials the largest component of the S&P and the reason it has been held back for weeks, a rebound in financials after this week's earnings will definitely aid in any breakout.

The Nasdaq has strong resistance between 2610-2635 and it is knocking on the door. With Adobe and Oracle announcing earnings next week we could have the software sector lead the techs over the roadblock. The problem for techs will be the semi book-to-bill on Tuesday and any new tech warnings. Summer is not normally a bullish quarter and earnings estimates have been moving progressively lower. That could be a bad sign or the potential for some positive surprises.

SS&P-500 Chart - Daily

Russell 2000 Chart - Daily

Russell 2000 Chart - 15 min

The flaw in the bullish argument is still the Russell-2000. While big cap stocks are making new highs on decent volume the small and mid caps are just doing good to tread water. The Russell posted the smallest gain (+0.9%) of any major index for the week. While it appears 775 has emerged as decent short-term support the Russell has not been able to move more than a few points over that level all week. This is way below the even stronger resistance at 800. Fund managers are still avoiding risk and more importantly avoiding liquidity issues. They are favoring the big caps where a quick exit is always possible. For instance GE traded over 35 million shares on a lazy Friday and well over their average volume. The QQQQs traded 100 million and Intel nearly 70 million. With total volume across all exchanges only 4.6 million, the lowest since 8/27, those individual volumes are huge.

I have been recommending a neutral or bearish position under 790 on the Russell and we have been pinned just above support at 775 for a week. Some may see it as a glass half full and support at 775 ready to act as a springboard for the next attack on 800. Others may see it as glass half empty and support about to break. I am with the half full crowd today and think we are about to see an end to this consolidation. I am changing my market bias to a long over 775 and short under 770. There are a great number of events next week that could scuttle any rally attempt but they could also provide fuel for a takeoff. Those events are the Fed, financial earnings, tech earnings, PPI, CPI, BBY/FDX earnings, etc. They can paint a positive picture contrary to that portrayed by the Jobs report or they can confirm the economic decline. I believe we are either going to rally hard or crash hard next week but the risks to the upside is greater. All the bad news should be priced in or at lease very close to it. Of course as soon as I make that statement some new revelation will appear to take us down another notch. I saw the Northern Rock bailout on Friday as market negative and after an opening dip it was quickly ignored. The bears have run out of ammo and may be ready to hibernate for the winter. It will all depend on the events for the week and the severity of any that turn negative. Otherwise I am going to maintain a long bias over Russell 775 and a short bias for energy unless Ingrid turns west. It should be a full week! Good luck!

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