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Market Wrap

No Sell Off?

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The market has been unable to score two positive days back to back since entering November but we are perfecting the short squeeze to an art form. Shorts went into Monday's close at new multi-month lows with full positions once again. The breaking news on Tuesday morning made them regret that decision one more time and the Dow recovered nearly all of Monday's losses by day's end. Unfortunately, even after strong gains the indexes are still well below Monday's highs.

Dow Chart - Daily

Nasdaq Chart - Daily

In economics the Richmond Fed Manufacturing Survey actually improved slightly to zero in November from a -5 in October. The strength came from an improvement in shipments and new orders although both barely made it back to the flat line. Order backlogs fell another 3 points to -20 and the six-month outlook slipped another 2 points to 34. The gain in the headline number was minimal and while this report was a slight positive there was nothing to cheer about.

The really ugly report for the day was the Consumer Confidence. The headline number fell -8.3 points to 87.3 and the lowest level since Oct-2005 and the post Katrina drop in confidence. There were declines in almost all components but the -11.3 decline in the expectations component to 68.7 was the biggest drag. That is almost a 4-year low for that component. This was the 4th consecutive monthly drop for confidence after hitting a new cycle high at 111.9 in July. Higher gasoline prices and expectations for higher heating bills this winter were given as reasons for the drop as well as the housing crisis and inability to cash in on their home equity. The sharp drop in confidence confirms the sharp drop in consumer sentiment we saw last week and suggests the holiday shopping season is going to be weak.

Consumer Confidence Chart

On Wednesday we will get the Mortgage Applications Survey, Durable Goods, Existing Home Sales, Oil Inventories and the Fed Beige Book. I believe the Beige book is going to be the market mover. With the Fed speakers this week all coming out against another rate cut the report will be another piece of the economic puzzle that could make the FOMC change their mind.

The Fed meeting on rates is only two weeks away on Dec-11th and the Fed Funds Futures are showing a 100% chance of a 25-point cut and a 27% chance of a 50-point cut. The current Fed rate is 4.5% and Goldman Sachs came out today with a 6-9 month forecast of 3%, a full point less than their prior forecast. This is contrary to the party line being put forth by the Fed members. The various Fed speakers are putting up a united front claiming they are happy with the current rate.

Chicago Fed President Charles Evans said on Tuesday, "A continued decline in residential housing, slowing growth, and uncertainty about the impact of financial turmoil resulting from the credit crunch and subprime crisis will continue to challenge the Fed's monetary policy. Though the economy has been able to weather some fairly serious blows, its continued ability to withstand struggles in the housing and financial markets is up for debate." In addition he said, "Housing markets are still weak and will continue to struggle next year," stating specifically "our forecast is looking for another large decline in residential construction this quarter." Even after saying the economy could continue to weaken to growth only in the 1-2% range he repeated that the recent rate cuts of 75-points was sufficient to counter the risks to growth.


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Philadelphia Fed President Charles Plosser said the Fed cannot resolve the current cause of tension in the financial markets with another rate cut. The tension is due to uncertain pricing of complex financial instruments backed with subprime mortgages. "It is important to recognize that the Fed cannot resolve this price discovery problem. The markets will have to figure this out. Arbitrarily lowering interest rates or providing liquidity to the market does not provide the answers the market seeks. Indeed, rate cuts might only delay the painful process." Evans also said, "As of today, I feel that the stance of monetary policy is consistent with achieving our dual mandate objectives and will help promote well-functioning financial markets." He also said he was more worried about the outlook for inflation than he was only a few months ago. Definitely no rate cuts coming from him.

The Fed also released the minutes of the October meeting where they voted on another discount rate cut. Seven banks voted against another discount rate cut while only five voted for a cut. At the same time those in favor of doing nothing had increased concerns the correction in the housing sector might spillover into consumer spending. Based on recent data it appears that is happening. The discount meeting minutes are seen as a proxy for the more critical Fed funds rate meetings. This also suggests the Fed is not going to cut again in December.

Tomorrow Donald Kohn will speak and Bernanke speaks on Thursday. So far the Fed heads are presenting an impressive display of solidarity on the rate front and I do not expect Kohn or Bernanke to break ranks. This solid front in the face of the market expectations for another cut in two weeks is a perfect example of how they tell the market to change its expectations. In October there was no Fedspeak ahead of the Halloween meeting and the Fed was forced to cut because the market had already priced in more than a 100% chance. Rather than face shocking the markets they cut rates. Now as they approach the December meeting every Fed head is on the stump with a no cut speech. This is the last week they can comment before the weeklong quiet period before each meeting. They are all making sure they get the no-cut bias out there but the market does not appear to be listening. This is setting up for a nasty reaction to the Dec-11th meeting if the market does not wake up soon.

When Goldman cut their rate estimates on Tuesday they went against the current Fedspeak bias. I am sure this helped to support the Fed funds futures at a 100% chance but there is definitely a battle brewing. Goldman based their rate call on their new recession outlook. They also upped the chances of a recession to 45% from their previous 40% chance. They are calling for unemployment to hit 5.5% from its current 4.7% and for a prolonged period of sluggish economic performance. They estimate home prices could decline -15% from their peak without a recession but if the country did fall into a recession they estimate home prices could fall as much as 30%. They downgraded multiple sectors ahead of the approaching recession. They cut metals to neutral, cut price targets on the restaurant sector due to stress on the consumer. They cut the hotel sector to "cautious" saying their long running boom may be over. They also cut airlines to "cautious" citing economic woes and rising fuel costs. They also cut the auto sector to cautious due to the growing implications over consumer health and buying power. They also cut office furniture and real estate investment trusts. They upgraded tobacco as a defensive play going into a recession citing Altria's 60% revenue from overseas sources.

Allan Hubbard, economic advisor to President Bush, was interviewed on CNBC today and he also said the risk of recession had risen but were still less than 50:50 but did not give an exact number. Former Treasury Secretary Lawrence Summers wrote in the Financial Times on Monday that the "odds now favor a U.S. recession that slows growth significantly on a global basis."

Setting off the short squeeze this morning was news that Citigroup was getting $7.5 billion from the Abu Dhabi Investment Authority. They will purchase convertible notes with an 11% annual yield. They are mandatory convertible at prices up to $37.24 per share between March 15th, 2010 and Sept-15th, 2011. This is approximately a 4.9% stake in Citigroup. It is supposedly 100% passive and the fund will not be able to name any members to the board. Citigroup said on Monday they could be forced to cut their 300,000-employee workforce by another 45,000 jobs. They announced a cut of 17,000 jobs earlier this year. Their capitalization has been hurt significantly by the subprime problem. They lost $6.5 billion in Q3 and recently announced they will likely write down the value of their portfolio by another $8-$11 billion in Q4. The Abu Dhabi fund is thought to be the largest sovereign fund with assets approaching $1 trillion. The fund typically purchases less than 5% of the companies it owns in order to avoid having to issue an SEC form-13D and disclose their other investments. In the early 1990s Saudi Prince Alwaleed bin Talal bought Citi on the cheap after it made some bad investments and plunged significantly as it has again in 2007. Alwaleed's $600 million investment has grown in value to several billion. I am sure the Abu Dhabi fund is hoping their billions grows by the same scale.

After the bell the beleaguered Freddie Mac (FRE) said it would cut its dividend to 25-cents (50%) and offer $6 billion in preferred stock. The offering is expected to price very quickly. Fannie and Freddie have been under the gun recently and regulators are leaning on them to increase capitalization to cover possible defaults in existing loans. Freddie said its core capital was approximately $34.6 billion on Sept-30th and their minimum capital requirement on that date was $26.2 billion. They also have a mandatory capital surplus target of $7.9 billion. That meant they were right on the regulatory line at the end of September. The additional $6 billion in preferred will give Freddie some breathing room and take the regulator heat off their backs. This move was rumored all day and FRE rebounded +1.23 to $25.73. That is down from their October high of $66. Anyone buying this offering is going to eventually reap some monster rewards. There is really no risk to owning Fannie and Freddie long term since the government is not going to allow them to go under. 2-3 years from now they should both be back to their October highs. This news helped raise the futures after the close.

Chart of FRE - Daily

Also helping the financials today was news from Barclays (BCS) that it was affirming full year earnings inline with analyst's estimates. There was considerable fear that Barclays would announce further write-downs but they killed that rumor today. They are expecting profits of more than 7.09 billion and that was only slightly less than the 7.14 billion they earned in 2006. BCS gained +3.49 in regular trading.

HSBC took a move on Monday that others are being pressured to take. They said they would move two of its structured investment vehicles (SIV) onto its balance sheet and provide up to $35 billion in funding. They said they were making the move to prevent forced liquidation of "high quality" assets. HSBC said without the move the vehicles were at risk of hitting net asset value restrictions that would have forced sales of the debt portfolios. The move won't impact the bank earnings materially since the underlying investors will still have all the economic risk. HSBC said the move would be a giant step in restoring confidence in the SIV sector. By putting them on their balance sheet and showing the assets and their value investors can be assured exactly where they have risk. By providing transparency for the SIVs they are making a bold step that others have been resisting. Citigroup has been under pressure to do the same with $41 billion in off balance sheet securities. Instead Citigroup, JP Morgan and Bank of America are trying to create a superfund to buy these assets and stop the bleeding those holding the assets are experiencing. By moving them into a separate fund they take the implied off balance sheet liability away from the current holders. Citigroup had been pressured to take back those securities after they provided some backstop funding last summer. Complainers said by providing backup funding it changed the hands off relationship and prompted a reconsideration event. Citi said no deal, its accounting practices were in line with applicable rules and regulations.

After the bell today Wells Fargo (WFC) said it would take a charge of $1.4 billion in Q4 for loan losses. WFC will create an $11.9 billion portfolio of the company's riskiest mortgages, which it plans to liquidate. The portfolio will consist of three types of home-equity loans and represents 3% of Wells Fargo's loan balance. WFC also said it was going to tighten lending standards once again. WFC got these loans through an indirect channel that is no longer accepting business. Basically somebody else wrote the loans and WFC bought them under some kind of financing agreement. WFC was buying home equity loans generated by other financial institutions and mortgage companies. Evidently the underwriting criteria for these loans was weak and WFC is going to pay the price. The new criteria requires that any home equity loan be written behind a 1st loan also written by WFC. They also lowered the loan to value percentages.

Not everybody is losing money on the subprime crisis. California's Lahde Capital hedge fund has made more than 1,000% return this year by betting against U.S. subprime loans. This makes it one of the world's best performing funds of all time. A group of fund managers decided to use derivatives to short the subprime loans in late 2006 and have made well over $20 billion for their efforts. New York based Paulson & Co, with $28 billion under management, claims to have already made $12 billion from the trade. They are now returning money to investors claiming the risk/reward no longer justifies the investment. John Paulson just created a new fund to short real estate and the fund is up +42% for the first two months. Paulson has two other funds up over 500% through the end of October. I doubt he will have any trouble raising capital for any future funds.

A glimmer of hope was seen in the housing sector early today. Pulte Home (PHM) made the unexpected decision to affirm Q4 estimates and even project a potential profit. It first made that prediction last month and affirmed it again today. A continued stream of negative housing news had investors questioning if Pulte or any other builder could meet their prior estimates. Just yesterday Citigroup downgraded the sector and issuing a "buyer beware" report. Citigroup said homebuilder valuation metrics were at historic lows and signaling a buy but the broader economic picture was becoming even more perilous for the builders. Citigroup downgraded CTX, DHI and KBH to a hold from a buy. In early October the same analyst had upgraded the sector to a buy. He said the reason he missed the call was because the housing market bottom had not coincided with the economic bottom still ahead. He said there would need to be a modicum of good news before a sustainable rebound in housing stocks can take shape.

Tuesday was not a day of good news for the homebuilders. The S&P/Case-Shiller index for September showed even sharper declines in home prices than in prior months. The Case-Shiller 10-city composite fell -5.5% from year ago levels. This was a new cycle low and the 4th lowest level since the survey began in 1987. The broader 20-city composite fell -4.9% to a record low. The monthly Case-Shiller index is computed on a 3-month moving average and therefore understates the true pricing activity in the current market. The quarterly index of home prices across the nine U.S. Census divisions fell -6.7% on an annual rate in Q3. This was the largest decline in the 21-year history of the index.

Crude oil went on sale today with a drop of -$3.47 on worries over increased recession fears and comments from some oil ministers from OPEC countries that they might be open to another production hike when they meet in December. Oil closed at $94.45 but fell to $93.89 in after hours. The falling oil prices helped the transports somewhat with a +82 point gain but there is still a lot of pain in the sector. Airlines are seeing jet fuel rise sharply and truckers are seeing fuel surcharges rise to new highs. Crude has strong support at $90 but if this is the start of a real correction we could see even lower numbers very quickly. Oil tends not to just drop but to plunge sharply when traders decide the momentum has ended.

CCrude Oil Chart - Daily

In the last four trading days the Dow has been down -211, up +181, -237 and +215 today. To say volatility was extreme would be an understatement. The Dow has had 10 triple digit days out of the 18 trading days so far in November. If you counted intraday swings it would probably be 15 of 18. The Dow has tested 12800 numerous times intraday starting last week and so far has failed to crumble under the strain. Remember last week we had the Dow theory sell signal when it closed at 12799. Friday's short squeeze did not erase the signal but remember it was a low volume day with no funds in the market. Monday's drop of -237 had all the earmarks of a follow through on that sell signal but lo and behold another short squeeze appeared on the Citigroup/BC/Barclays news. Despite the rebound the Dow is still solidly under resistance at 13025 and still at risk. However, the volume was very respectable at more than 7 billion shares and had some decent internal numbers. Volume was nearly a billion shares more than Monday's monster drop. I am not ready to go buy bells for the Santa Claus rally but this was a convincing rebound even if it was originally triggered as a short squeeze.

Intraday we saw the beginning of our now standard end of day sell off when the Dow gave back over 100 points of its intraday gains but thanks to a couple post 3:PM buy programs the pressure continued for the bears right into the close. Not closing at the lows for the day and a better than +135 point closing rebound is not something to sneeze at. Now we have a quandary, conundrum and enigma all wrapped up in a mystery as we try to determine market direction.

SS&P-500 Chart - Daily

NYSE Composite Chart - Daily

Nasdaq-100 Index Chart - Daily

If we use the S&P-500 to avoid the index skewing properties inside the Dow we see that the downtrend is still in place. SPX 1430 is initial resistance followed by resistance at every 10 point spread to 1460. Over 1440 would start to show signs of the down trend ending but we really need to get over 1460 to really put some confidence back into the bulls. Until we can put a couple days of decent gains back to back we are still in sell the rally mode according to the major analysts. Some are starting to call a bottom now that all the indexes have corrected more than 10% but nobody has started to call for a rally just yet. The NYSE Composite is still hugging support at 9400 and the DX is still holding above 2000. Those are both positive sentiment indicators but they have both been holding at those levels for many days now with no rebound. We need to see more than one day in the green and begin extending those gains before Santa's bells will begin ringing.

JJim Brown

When I have to depend on hope in a trade I get out of it!
Jesse Livermore


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