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Market Wrap

What Changed?

HAVING TROUBLE PRINTING?
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After six weeks of selling interspersed with several minor rebounds market sentiment changed abruptly. What changed the view from an investor viewpoint? The economy did not change and earnings estimates are still dropping. Bernanke said things were worse than the Fed previously thought and the credit markets were again locked up tight. Despite these events the markets rebounded between 3-5% from the early week lows. As Bugs Bunny would ask, "What's Up Doc?"

Mystery Chart Quiz #1 - Would you buy this stock today?

Mystery Chart Quiz #2 - Would you buy this stock today?

Before I get to the current market hysteria let's get the economics out of the way. The Chicago Purchasing Managers Index (PMI) rebounded to 52.9 in November from a cycle low of 49.7 in October. This confounded analysts who were expecting no change at best and most were expecting a continued drop further into contraction territory. The only components that changed materially were Production to 57.4 from 46.9 and Backorders to 45.9 from 39.9. That jump in production was huge and suggests some noise in the number. There was an unexpected drop in production from 58.3 to 46.9 in October. It appears that statistical anomaly was reversed rather than a flood of new orders hitting the system. New orders did not change at 53.9 yet backorders spiked. Even with the rise in backorders they are still in contraction territory below 50. Inventories remained in contraction territory for the 4th consecutive month. Since these numbers are compiled on a survey basis it is very easy to have erratic results. It is amazing that the numbers correlate as well as they do from month to month. This report is not likely the sign of a rebound, as it would appear in the headline number. This is just a data spike in the series and lower numbers are likely still ahead.

The New York Purchasing Managers report (NAPM-NY) rose for the second month suggesting business conditions are improving in New York. The current conditions component rose to 60.2 and the highest level since April. However, the six-month outlook component fell to 60.5 from 65.0 and the second consecutive monthly drop. This suggests the short-term view was buoyed by holiday preparations and the long-term view is for more weakness ahead once the holidays pass. The New York City government recently announced a hiring freeze and budget cuts of 2.5% for 2008 and -5% for 2009-2010. Wall Street firms have announced layoffs of more than 7,000 investment bankers but some of those will not be in New York City. The financial services industry for the New York area is expected to lose another 10,000 jobs in 2008. Tough to be upbeat with pink slips flying.

Personal Income rose +0.2% in October but that was below the +0.4% gain in September and below expectations for a gain of +0.3%. The savings rate fell -0.5% showing the stress on consumer budgets. Top line inflation rose +3.0% but core inflation remained constrained at +1.7%. The real cost of goods rose due to increases in food and energy and that put pressure on real available income. Inability to borrow against home equities is also impairing available income as expenses mount.

Construction spending fell -0.8% in October hurt by a -2% decline in residential construction. Private construction fell -1.4% overall but public construction rose +0.8%. Total construction spending is down -2.8% YTD to $1.158 trillion and the lowest level since Nov-2005.

Next week's economic calendar has two major releases. The Institute for Supply Management (ISM) will be the major report on Monday with the November payroll report on Friday the clincher for the week. The ISM is officially expected to decline only slightly to 50.4 from 50.9 but there are plenty of whisper numbers in contraction territory under 50. October was the 4th consecutive monthly decline from the cycle high of 56.0 in June. Odds are very good we are going below 50 but end of year activity could delay that for another month or two. Regardless the trend is definitely down.

The Jobs report on Friday is only two days before the next FOMC meeting and could be the deciding factor on whether they cut rates again or not. The estimate is for a gain of only +65,000 jobs and down significantly from last month's +166,000 surprise. The economy needs job creation to be over 100,000 per month minimum and 150,000 is needed just to absorb incoming workers and graduates. The 4-month average before the October surprise was +88,000 and that included some substantial upward revisions. A number next week below 50K would be negative and a number showing jobs were lost in the period would be very bad considering it would be a reversal from the +166K in October. The Fed should consider any number less than 50K another reason to cut rates. If we lost jobs it could change the conversation from do we cut to do we cut 25 or 50 points.

As the week began the Fed was presenting a united front suggesting no more rate cuts until Vice Chairman Donald Kohn began to speak. His tone and content took on a far more agreeable stance towards a potential rate cut and the market roared off to new highs on rate cut hopes. Bernanke also sounded conciliatory when he spoke later in the week and indicated that consumer data had weakened and the rise in food and energy prices were producing growing stress on budgets. He specifically mentioned the financial markets were undergoing renewed turbulence. That stress had resulted in further tightening in financial conditions, which have the potential to impose additional hardships on the housing market and other credit sensitive sectors. The tone of the speech was worried that conditions had worsened and further rekindled new hopes of a December rate cut. The markets again celebrated and for the most part held their gains into Friday's close.

St. Louis Fed President Richard Poole closed the week with a speech that sounded almost like the Fed was promising a cut in December. Poole said, "The Federal Reserve would not hesitate to act to prevent financial strains from damaging the economy and any steps it does take are not made to shield investors. The Fed does not have the desire or tools to prevent widespread losses in a particular sector but should not sit by while a financial upset becomes a financial calamity affecting the entire economy. I would not want people in the markets to believe that I, at any rate, would be so concerned about the moral hazard argument that I wouldn't possibly advocate a 25 basis point or a 50 basis point cut, or whatever might be on the table." Poole also said, "Provided that the central bank does not sacrifice long-term price stability, it can and should respond to new information indicating an increased risk of recession." And, "Likewise, it is a mistake to believe the Fed aims to support a rising stock market with its actions, although it would not refrain from acting if policy adjustments had the effect of boosting stocks. It is a fundamental misreading of monetary policy to believe that the stock market per se is an objective of policy. It is also a mistake to believe that a policy action that is desirable to help stabilize the economy should not be taken because it will also tend to increase stock prices."

The closing tone of Fedspeak heading into Friday's close was far different than the hawkish comments beginning the week. This makes next week's economic reports even more critical as we count down the days until the Dec-11th meeting.

Economic Calendar

The financial markets celebrated on Friday the potential for a short-term resolution of the subprime crisis. Treasury Secretary Paulson met with Federal regulators and bankers on Thursday on the subprime crisis. Attending the meeting were officials from Citigroup, Wells Fargo and Washington Mutual, all major mortgage lenders. FDIC Chairman Shelia Bair also attended. Bair has proposed letting borrowers with adjustable rate subprime mortgages, who are living in their homes and unable to afford resets, get extensions of the starter rate for up to 5-years. They could also be offered 30-year fixed rate deals at bargain rates. Office of Thrift Supervision John Reich also in attendance prefers a three-year freeze. The idea is to make the current mortgages in risk of default more sustainable and take the pressure off the banking system and the housing sector. Over 100,000 subprime loans will reset each month for the next two years according to UBS. The FDIC estimates there are 1.54 million nonprime mortgages valued at $362 billion that will reset by the end of 2008. There are currently $7.1 trillion in securities backed by all kinds of mortgages and all securities are taking some kind of valuation hit due to the subprime contagion. 17% of all adjustable rate subprime loans were in default as of July according to the Mortgage Bankers Association. Fixing the subprime portion would allow the other $5 trillion of greater than subprime credits to return to parity and relieve a lot of market turbulence. The markets cheered the various proposals and the comment by Paulson that a solution could be in place by year-end.

Countrywide (CFC) jumped +16% on the proposals despite news that New York City and State pension funds were named lead plaintiffs in a class action suit against Countrywide for fraud. Countrywide stands to benefit the most from any rescue plan as the largest loan servicer and top loan originator. Fannie (FNM) and Freddie (FRE) exploded off their lows gaining +18% each on expectations that the end of the world has been postponed. Freddie priced its $6 billion offering at $25 per share and the company said it was five times oversubscribed. Given the rebound to $35 in Freddie from its $25.70 close on Tuesday anybody lucky enough to get in on the offering already has a nice profit.

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It has been nearly 10 years since Long Term Capital blew up in 1998 and tanked our markets knocking the Dow back -1900 points (20%) in about five weeks. This was seen as a major catastrophe and had the potential to wreck the entire global financial system. To put this in perspective the LTCM blowup was only a $4.6 billion loss. The subprime crisis has already caused banks to write-down over $120 billion and that amount is expected to double before it is over. That is roughly the equivalent of an LTCM blow up every week. Citigroup alone is proposing write-downs nearing $20 billion or four times the amount of the LTCM loss. LTCM was supposedly such a crisis because of the amount of derivatives they controlled of somewhere around $1.25 trillion. The derivatives impacted by the subprime crisis is reported to be more than $2 trillion since the various CDO, SIV, MBS contracts are sliced and diced in so many ways that nobody knows who owns what or what the risk is on what they own. This crisis was only able to knock 10% off the indexes despite the magnitude of the damage. There may be more to come but it appears there are many solutions in the pipeline and eventually one will stick and while the problem won't go away it will quickly be pushed aside as old news. The financial sector bounced +5.8% this week on hope the solution is near. The BKX rebounded over 10% from its Monday lows. Is the damage over for the banks? I doubt it is over until we get a resolution on the reset problem but it appears fairly certain that will happen over the next 60-90 days. That suggests buying any dip on financials would be a good plan.

The homebuilders index rebounded +10% since Monday's lows on hopes that the end of the subprime crisis and a million fewer foreclosures would benefit new home sales. There was also a report out earlier in the week saying the current homes on the market plus the drastically reduced builder inventories was just about at breakeven with existing demand. They calculated the number of new households entering the market each year and added immigrants and came up with a bottom demand number of people who will buy a home every year regardless of the conditions. That number will consume inventory at almost exactly the same pace as it is currently being created through individual sales, foreclosures and new construction. The report extrapolated that inventory levels could not get much worse although they could languish here for months but this was the bottom in terms of high inventory levels. Now, if the subprime crisis is legislated away by year-end the flood of pent up buyers will come back into the market by spring and assuming they can qualify for a loan under the new guidelines a new housing cycle will begin. I realize this is pure speculation by somebody that is probably long the homebuilders but the report made sense and the timing appears to be right. Interesting that it came only a couple days after Citigroup went negative on the homebuilders again.

The subprime crisis may be nearing an end if you believe the current buzz but the ramifications are expanding. A $27 billion state run investment fund in Florida halted withdrawals after losing $12 billion in deposits over the last two weeks. The fund disclosed it had $900 million in defaulted subprime debt and $2.4 billion in asset-backed paper. Investors quickly began to withdraw deposits and the fund was forced to halt withdrawals to avoid bankruptcy. This quickly spread to other funds as investors researched fund holdings a little more closely. The Montana Board of Investments, which manages the states money, saw $247 million in withdrawals from governments in the last three days. The Montana fund has $90 million in Axon Financial an SIV that has been downgraded and is reorganizing. They have $500 million in other SIVs. A $4.8 billion fund run by King County Washington was warned by S&P that it could be downgraded because of subprime exposure. This type of creeping deterioration of major funds is happening all across the U.S. and much of the damage is still unknown.

On the stock front Dell Computer, now called Dell Inc., (DELL) was hammered by investors after posting earnings that were less than exciting. Dell lost -13% or -3.60 on the news. Hewlett Packard (HPQ) is beating Dell like a rented mule and gaining market share every quarter. Several analysts called this a buying opportunity and noted that notebook sales were rising sharply. Overall sales of their mobility business grew +22% sequentially and 19% year over year to $4.7 billion. Desktop sales fell 5%. Overall gross margin of 18.5% fell short of expectations of 19.1% and analysts said supply procurement was the problem. Last quarter Dell said HPQ was buying up all the components making Dell's component acquisition much harder.

Research in Motion (RIMM) fell -$8 after a Piper Jaffray analyst lowered his price target from $134 to $137 and rated RIMM a "neutral." The analyst said competition is hurting sales of the company's Pearl smart phone. Checks showed a slowdown in sell-through trends of the product in Verizon stores. Sprint store managers noted that the Palm Centro device is selling much better than the Pearl. Despite the $8 drop RIMM closed back right where it traded on Tuesday so no big loss overall for the week. Analysts have tried to call RIMM out many times before and every quarter RIMM surprises with new subscriber numbers and higher profits. Eventually this trend will fade but with RIMM breaking into other markets every month I think the announcement of their demise is premature.

Crude oil continued its decline sinking to close at 88.65 and a loss of $10.65 from its highs of $99.11 on Monday. This was the biggest weekly loss for crude in over two years. The reasons being given included the end of hurricane season on Friday and a quick repair to the oil pipeline out of Canada. We are also expecting much higher imports over the next 4-weeks with Saudi pumping an extra 720,000 bpd headed directly to the U.S. shores. There is also an OPEC meeting scheduled for this week and several ministers have discussed raising production limits. It was the perfect storm for holders of the January contract. Those holding the actual oil have to pay taxes on the quantity they own on Dec-31st and the current crude contract expires on Dec-18th. There is normally a 10% correction in crude between Labor Day and Thanksgiving and that did not happen this year. This is just a catch up correction now that fundamentals suddenly seem to matter once again. Last December this same contract fell from $69.50 on Dec-4th to $56.25 on Jan-17th. That was a -19% drop and that was also the low for the year. Crude has support in the $88-90 range and again at $84-85. A drop back to support at $84 would be a 15% correction and a probable drop for this contract. Ironically most oil companies have been posting gains the last couple days despite the sell off in crude. Most individual energy stocks had sold off in anticipation of the correction and now could be considered buys. Let's hope that trend continues..

The Dow rebounded +743 points from its Monday low of 12724 to its Friday high of 13467. It gave back nearly 100 points before Friday's close despite positive comments from three Fed officials. The majority of those gains were in one giant step on Wednesday. The follow through to Wednesday's rally was almost nonexistent. Bernanke's Thursday night comments sent stocks soaring again at Friday's open but again, follow through was almost nonexistent. Both days of gains were produced by positive Fed speeches moving sentiment from no cut to guaranteed cut and again the shorts were punished without mercy. Now the shorts are scared and they may be unwilling to try another round but what news event could they be scared of? Since the Fed is in their quiet period now there will not be any more comments from Fed heads. About the only news left to print would be the conclusion of a subprime deal. That is not likely to happen next week. There are far too many players to suddenly announce a fix. Any fix will have to evolve over time and Paulson's end of year target may be tough to hit. Either way that should not help us next week.

AAfter the last round of Fed speakers including Bernanke, the grand master himself, the market is already pricing in the next cut. It is actually pricing in more than a cut and more like a 50% chance of a 50-point cut rather than 25 points. Basically with a +650 point Fed induced rally and no improvement in the economics the market has set itself up to fail. Maybe fail is the wrong word since the Fed fix is in but there should definitely be some profit taking as market forces return to a balance. There are plenty of bears out making the rounds of the TV talking head circuit so we have not yet erased that extreme level of bearishness we saw last week. There is still hope for another leg up but it is going to take another news event to power it. On Monday the ISM, even if positive, will probably not provide the power for another move higher. That leaves us coasting towards Friday without any major reports until the jobs numbers on Friday. Should the bulls wish for a job loss instead of a gain to push the Fed to that 50-point level or do they just want a neutral number to signify a slow growth economy rather than one heading for a hard landing? They better be careful what they wish for because it could come to pass. Earnings estimates for Q4 are still falling and now 2008 numbers are weakening. Tough times to build a bullish case but plenty are trying.

In times like these we need to let the charts do the talking and take our individual bias out of the equation. In the chart below the Dow came to a dead stop at 13460 and the resistance created during the crash. Most of the Dow's gains came from the monster Fed change short squeeze on Wednesday the follow through has been weak. Internals on Friday were barely positive and volume was average. Given the week's gains maybe Friday's mixed performance was consolidation in place rather than weakening internals. In the opening paragraph I showed you these charts without any identifying characteristics. Did you decide to buy or sell based strictly on the chart pattern?

Dow Chart - 90 min

Nasdaq-100 NDX Chart - 180 min

If you said buy you are a brave trader. I want to be bullish but I believe the rate rally has now run its course and we could see some weakness next week. I would buy a dip but I would not want to just blindly enter longs on Monday. The Nasdaq big caps were especially weak with a -13 drop on Friday. The bounce was sharp on Wednesday but failed to penetrate 2100 with any conviction. The big caps had been the winning horses in the race higher from early September and the first ones off the cliff in November. They put up a strong goal line stand at 2000 support and were expected to be the leaders on the rebound. There was simply too much indecision on Wednesday afternoon and all day Thr/Fri to make me want to buy them at this level. A dip back to 2050 and a failure to break below that level would be a cautious entry point for me. In times of indecision the big caps are where funds park money. If they are not parking here we don't want to buy the market.

S&P-500 Chart - 180 min

The S&P has a similar chart with strong resistance at 1490 and it was repelled quickly on the near touch on Friday. The S&P is still in a downtrend until we can see some higher highs over 1490 and a break of down trend resistance at 1500 followed by 1520. Without some news event to power buying I think we are going to see additional weakness before additional strength.

The Russell is the weakest link with no movement outside of the opening spike on Wednesday. The small caps are still being sold and that means fund managers have little confidence about the market continuing higher.

Russell 2000 Chart - 180 min

Today I am a closet bull and I am not coming out into the daylight until I see some follow through from last week's gains or at least a minor pullback and rebound. I would look initially for a dip on the S&P to 1460. That would be the first level I would expect buyers to rally. If that does not come then I would look for a move over 1490 to begin adding some long positions. I would add to those over 1520 but that may be wishful thinking. We only have three weeks of trading before Christmas and that means funds will need to be either in or out of year-end positions within that 3-week period. This is also the period where investors sometimes bite the bullet and sell losers to capture a tax loss to offset their gains on other stocks. December has only been strongly positive in three of the last eight years and even in the strong years the early days of December have been weak. This is attributed to that year end portfolio shuffle and funds wanting to get any selling out of the way early in the month when there is still sufficient volume to handle their transactions. They do not want to be sellers in the last two weeks when volume is slim. They would rather be buyers there and help push the indexes higher into year-end.

Once into January there is a quick adjustment of positions in the first week then the longer-term trend regains control. In the last 11 years the first week of January has been down 7 times and up 4. In those 7 years the markets finished January higher six times and only continued down once. Of the 4 times the market opened the New Year higher 3 times January closed lower. Only once did the markets open up and stay up. So, assuming we wander higher into the Fed meeting our December should be done for all practical purposes with their announcement. If they cut rates it is because conditions are getting worse. If they don't cut rates it does not mean conditions are getting better just not getting worse at a faster pace. Either way I would not hold my breath for December gains after the 11th. If funds are playing the "sell January's open" card this year they could be anticipating that by not buying the end of December. It is tough to second, third or even fourth guess what may happen four weeks from now when just predicting Monday is a challenge. This is just idle speculation today based on the facts at hand and it could change by next week as the economic facts change. Trade the market not my speculation. Buy a dip to 1460 or a break over 1490. Sell a break under 1460. It is a simple plan and one even I can understand.

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