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Market Wrap

Hangover Week Ahead

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Friday's closing swoon my have indicated the rate cut party is over and the hangover is about to begin. The enthusiasm traders exhibited to the stronger than expected cut carried over for three days after the Fed meeting but on Friday you could clearly tell the buzz was fading along with premium values in expiring options. Volume on Friday was strong but that was mostly related to options expiration and the S&P rebalance. Monday will be a key day for the markets. Do traders head to work on Monday ready to charge higher or do they grab a bottle of aspirin and amble into work in a fog in hopes of a flat market and no need to trade? It appears the fear of earnings is beginning to edge out the rate cut euphoria as a market mover next week. That could restrict any further gains until earnings warning season passes.

Dow Chart - Daily

Nasdaq Chart - Daily

Friday was lackluster in terms of economic reports with the Mass Layoffs report showing a small drop in layoffs to 118,120 workers in August from 124,835 in July. This is still elevated from earlier levels and it is not expected to decline materially until 2008. Manufacturing still produced the most layoffs by sector with a loss of 23,361 jobs. Credit and mortgage services also made the leader board clinching the 3rd and 7th largest loser spots. Ironically mortgage applications hit a six-week high this week led by a +4.6% increase in refinance applications.

Next week we have a full economic calendar but there are only a couple reports that could move the market. Those are durable goods on Wednesday, our last look at Q2 GDP on Thursday and the Chicago Purchasing Manager Index (PMI) on Friday. There are several housing reports with existing home sales on Tuesday and new home sales on Thursday. Everyone expects home sales to be even lower than before so any positive news could produce an unexpected market bounce.


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The S&P/Case Shiller Home Price Index on Tuesday showed a -0.9% drop in prices from Q1 to Q2 when it was last released on August 27th. That was also a -3.2% drop from Q2-2006. This was reflected in the national index, 10-city composite index and the 20-city composite index. At the time Shiller said the drop in real estate prices was showing no signs of abating. Now that the prime selling season has passed it will be interesting to see if the trend is continuing or has gotten worse. Detroit was the biggest loser in the August report with prices falling -11% year over year. Seattle was the biggest gainer at +7.9% year over year.

Last week we saw the number of nationwide foreclosures climb to 243,947 for August. This was up +36% over July and +115% over August 2006. The top three states showing increases from July to August were Florida +77%, California +48% and Nevada +21%. Rising foreclosures are pressuring home prices as banks try to quickly flush the foreclosed homes to free up cash. I was talking to a realtor here in Denver on Friday and the inventory of bank owned homes is increasing rapidly but there are plenty of active bidders locally. Investors are stepping up with offers at about 80% of value with plans to either fix and flip or fix and rent. With so many homeowners losing their homes the rental markets are getting stronger.

Economic Calendar

The biggest loser on Friday was Harman (HAR) with a -27.25 drop (-21%) after KKR and Goldman Sachs pulled out of their deal to buy Harman for $8 billion. Harman said they were notified on Friday morning that the firms were not going to complete the deal due to a supposedly material adverse change in Harman's financial condition. Harman claimed no such change and blamed the cancellation on the buyer's inability to finance the deal. The deal included a break up fee of $225 million but I am sure Harman will have a fight to collect it. The deal was supposed to pay shareholders $120 per share and far more than Friday's $88 closing price. Nobody will say what the adverse change was so details remain sketchy. An analyst at RiskMetrics said inventories were rising at +40% while sales were only rising +11%. This could be a factor of the credit crunch on consumers who are no longer buying high dollar speakers at the same time they are paying $3 for gasoline. There was also a filing showing 25% of Harman's sales through June-30th were to DaimlerChrysler. Since Chrysler has been taken private and cost cutting will be of primary importance it may have been concerns that the new Chrysler will cut back on purchases of expensive speakers and GPS devices from Harman. Regardless of the reason for the break up shareholders saw a nice payday at $120 collapse and Friday's close at $88 is not likely to be the bottom.

The problem for the market was not the 21% haircut in the Harman stock price but the appearance of a large LBO deal gone bad. KKR and GS can claim it was a change in conditions at Harman but suspicious traders will be focusing on the bigger picture and suspect it was a breakdown in funding instead. Since the credit markets were thought to have been improving this will be a negative blow for the week ahead. Until a major deal or two closes there will be a shadow over any pending transaction. The brokers reporting earnings last week admitted to writing off $4 billion in loan losses and having to eat tens of billions in hung loans until conditions improve. There are also reports of banks asking LBO firms to postpone or breakup deals rather than be forced to carry the loans on their books. Some were even reported to be offering to pay the breakup fee. This is not a positive sign for the credit markets.

BEA Systems (BEAS) is still under attack by Carl Icahn. The billionaire raised his stake this week to 9.88% or 38.72 million shares. This is an addition of 5.3 million shares from the prior week. Under pressure from Icahn to sell the company it was reported that the two sides would likely meet over the next two weeks to try and come to some agreement. BEAS said last week it is not for sale and felt it could continue to innovate better as an independent company. Hedge funds are starting to smell a deal and have begun accumulating shares in BEAS. J&W Seligman accumulated 10.7 million shares and Third Point 9.7 million. The largest shareholder is activist investor Bruce Sherman with 41.4 million (10.6%) but he has been a silent owner for some time. Looks like a food fight brewing among billionaires as BEAS share price nears 52-week resistance at $14.25.

BEAS Chart - Daily

Texas Instruments announced plans to buy back another $5 billion in shares bringing its outstanding buyback plans to about $9 billion. TXN also raised its dividend 25% to a dime. Since 2004 TXN has authorized $20 billion in share buybacks including this latest authorization. They reduced their outstanding shares by 17% through June 30th. Last week they raised their earnings guidance to the high end of the previous range. Fewer shares produces higher earnings per share without any increase in earnings. This is a common trick by large companies when earnings are under pressure. Friday's announcement pushed the stock over resistance at $36 but the current uptrend is still lagging the market.

Oracle (ORCL) turned in another strong quarter with +25% growth and investors finally found the story positive enough to break through resistance at $21. Oracle has been on the ignore list for so long there was probably a large number of shorts hoping for another sell the news event. Oracle's license growth was strong enough to attract some buyers and the resulting post earnings squeeze pushed the price past resistance.

Oracle Chart - Daily

Morgan Stanley (MS), Lehman (LEH), Bear Stearns (BSC) and Goldman Sachs (GS) finally reported their long awaited earnings. Overall they were better than expected and after Lehman reported on Tuesday the sector saw a strong bounce. BSC was the stinker as expected with a -88% drop in profits. The punctuation mark for the week was the Goldman Sachs earnings where they earned a whopping $2.85 billion for the quarter. This was after a charge for $1.48 billion in losses on mortgages and broken LBO agreements. They beat the street by $1.78 because of their diverse business segments and their trading book. Apparently they bet against their own hedge funds and shorted mortgage instruments to capitalize on the mortgage problem. In theory any trading business is lucky to get by with 55% or maybe even 60% wins. With hundreds of traders placing thousands of trades the law of very large averages should produce an average won/loss ratio of roughly even. Goldman has the cream of the crop of traders and managed a 75% win ratio quarter after quarter. Unfortunately they don't give that same trading benefit to their hedge funds with many of them down 25% for the year. Evidently betting against your own fund strategies is an acceptable game plan. Remind me not to subscribe to any Goldman funds. Also, Goldman raised their set aside for bonuses to $16.9 billion for the first three quarters. This is 21% over 2006 levels and represents a bonus of $565,000 per employee. Of course those traders and partners will get the majority of the bucks and not the rank and file employee. The punch line here is "work for Goldman but don't let Goldman work for you." If you bought GS on that breakout over $180 you were rewarded with a touch of $210 on Friday.

Goldman Sachs Chart- Daily

FedEx (FDX) needs more than a buyback to rescue its shares after warnings this week that earnings would be well under street expectations and cut its full year forecast. The FedEx CEO has been on CNBC several times in recent weeks whining that the slumping economy was worse than the economic numbers showed and the Fed had to act quickly to rescue the economy from a recession. FDX has lost $7 from its $111 level when the CEO became a regular complainer on CNBC.

FedEx Chart - Weekly

The FedEx warning is a critical warning for the market. Comments about a nonexistent holiday shipping bounce suggest this retail season will be terrible. Retail analysts are already saying sales will be the worst in five years and possibly even ten. If you follow this train of thought through the economy is suggests earnings for Q3/Q4 are not going to be exciting. So far this quarter we have seen mixed earnings guidance but we are just now entering into the critical warnings cycle for Q3. Analysts will be shifting their estimates based on this warning cycle and that hits high gear next week.

Believe it or not we are only one week away from the 4th quarter and less than 100 days until Christmas. The year is rapidly drawing to a close and mutual funds, hedge funds and analysts have yet to agree on a direction. The post Fed honeymoon is over and now the focus will turn back to the economy and the coming end of quarter reports. We are only a week or so away from the ISM on Oct-1st and the next Jobs report on Oct-5th. The current forecast for new jobs is for a gain of 120,000 in September. That is very optimistic in my view today. If it does come to pass that jobs are revised upward and we are back in the +100,000 range for September the market would go crazy. These are major economic milestones in the Fed's next decision at the Halloween meeting.

There is an increasing feeling among analysts that the Fed scared the bond market by moving out of character with the larger than expected 50 point cut. What do they know that the bond market didn't? There is lots of head scratching in progress and now analysts don't know what to wish for at the Halloween meeting. Of course the Fed said future moves were data dependent so the next cycle of economic reports will be crucial. Add in the earnings warning cycle over the next two weeks and the picture should become clearer. Data from the business sector suggests the economy is still slowing despite the relatively tame economic reports. It will be interesting to see how this plays out in the markets.

Gold seems to be predicting a recession as it reached 27-year highs this week at $746. The gold bugs are all a twitter with projections of a retest of the Jan-1980 high of $850 if the dollar continues to weaken. Inflation adjusted that would be over $2000 an ounce but nobody seems to be keeping track. I am hearing opinions that the dollar may have run its course for this dip and is currently oversold. That could slow any attempt at that $850 level for gold.

The various market internals have reversed substantially over the last week. TrimTabs reported that more than $13.6 billion flowed into mutual funds over the last week ending on Wednesday. That was five times more than the prior week and showed how investors were playing the Fed announcement. Global funds saw inflows of $4.76 billion. Inflows on Wednesday at $8.49 billion were the largest single day inflows since Jan-4th 2001. This compares to only $568 million the prior week.

Margin loans fell by -$51 billion to $331 billion while the short interest dropped by -5%. That was the largest monthly drop in short interest in years and suggests retail investors either closed short positions or were blown out on Tuesday by the monster post Fed short squeeze. I am assuming that margin drop was due to short positions because traders long on margin over the Fed meeting would likely still be long. Did those short on margin decide not to reverse to longs on margin? Are they not convinced the bounce will hold? Are they planning on going short again when this bounce begins to fade? Nobody knows but a drop in short interest does remove some of the bounce potential from the market. Strong short interest makes rallies explosive, as we have seen many times recently.

Friday's quadruple witching produced record volume at the NYSE with 704 million shares in the first 30 min and 805 million for the first hour. That rate declined for the rest of the day until the market on close option settlements and S&P rebalance volume hit at the close. Overall there were 6.5 billion shares across all exchanges and that is far below the recent record of 11.769 billion hit on August-16th but still a decent day. Now that those option positions taken out during the August crash have expired traders will be entering a new series of trades to take them through this earnings cycle. Are they going to be longs are shorts? Next week's earnings warnings should determine that direction.

The Dow rallied +377 points for the week or +2.81%. Most of those gains came with the +335 post Fed short squeeze to 13865 but we have not been able to hold that Tuesday high. After a Thursday decline the post Goldman/Oracle open on Friday saw another retest of that 13865 high but the Dow closed back at 13818. To be fair it was an expiration Friday and traders were just content with holding over 13800 and not give back its gains for the week. They were successful and they escaped the week with their gains. Next week could be a different story. Those expiring option positions will not be there to support the indexes and a new series of positions will be entered. The Dow looks vulnerable here without a material bout of profit taking. Funds will not want to buy here but they should be willing to buy any material dip. Don't fight the Fed and the Fed appears to be on the side of the market.

The Nasdaq ran headfirst into apparent resistance at 2675 and valiantly held at that level. The Thursday decline was bought and the Nasdaq closed the week only about 10 points off its high. Google set a new high at $560 after gaining +35 points from its pre Fed level. EBAY ran to a new 52-week high at $39 on a sharp increase in listing volume. Yahoo hit a new 2-month high at $26 and Cisco hit a new multiyear intraday high at $32.56 on John Chambers continued comments that the global economy is the strongest he has ever seen. Intel is within 75 cents of a new high and AAPL is closing in on a new high as well. The bullishness is breaking out all over on the Nasdaq and that should help keep the broader market rally alive.

The S&P-500 rallied to 1540 on Wednesday and could not hold it. That was the resistance high set back in June and it was too strong to conquer on the first attempt. There was an extreme amount of open interest on both the calls and puts and 1530 appeared to be a solid top on Friday. Next week the index will be free to move again and direction will be dependent on the earnings warnings making the news. The S&P could pull back to something in the 1500 range and still manage a bullish trajectory. Assuming there is not a deluge of negative news I would continue to buy the dips.

S&P-500 Chart - Daily

Russell-2000 Chart - Daily

The Russell sprinted over 800 on Tuesday and continued to 823 on Wednesday before running out of steam. Now at 821 and over the 200-day average at 807 that should become support. This is still our fund manager sentiment indicator and I would continue to be long over that 200-day average. If it slips back below that average at 807 it could be trapped again by the undertow and be doomed to repeat the 780-800 range bound trade for a few more weeks. I sincerely hope this does not happen but hope has never been a credible market mover.

Watch the earnings news next week for warnings and the Russell-2000 200-day average at 807. Those are the only two indicators you need to follow the market action. Everything else is just smoke and will cause you to become distracted if you start worrying about it. The Russell direction will tell you what the big fund money is doing and you can never go wrong following the money.

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