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Market Wrap

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Last Sunday I said if the Fed only cuts 25-points and keeps the inflation paragraph in the statement then we should beware the PPI and CPI reports. The Fed has this data ahead of the release date and they clearly considered it relative when they cut rates. They knew the market would tank even worse than it did if the did not cut at all given their pre-meeting Fedspeak. Now we know why they were so wimpy in their actions. The inflation monster is back and he is very hungry.

Dow Chart - 180 min

Nasdaq-100 NDX Chart - Daily

On Thursday the Producer Price Index (PPI) headline number spiked +3.2% and that was the second highest reading since the inception of the report back in 1947. You can try to spin this any way you want but the bottom line is the return of much stronger inflation. The YOY inflation rate spiked from 6.0% to 7.7% and the highest level since 1981. The largest contributor to this spike was a 14.1% jump in energy prices. The core rate, even after taking out food and energy, rose by +0.4%. The jump in inflation was not limited to producer prices. The Consumer Price Index headline number on Friday spiked +0.8% and the largest increase in more than two years. This compares to only a +0.3% rise in October. Even the core index rose +0.3%, after 5-months of +0.2% gains, and the biggest rise since January. Over the last 3-months the top-line CPI has risen at an annualized rate of 5.6%. It would be impossible for the Fed to not react to this sudden return of inflation. The Economist's food-price index is now at its highest since it began in 1845, having risen by one-third over the past year.

CPI Chart

The biggest problem for the market late last week was the new inflation revelations. Since the Fed can't ignore the signs they are nearly locked out of any future rate cuts if the current trends last through January. The next meeting is Jan-29/30th and the Fed will have nearly two months of additional data before they have to decide again. This makes the inflation component in any future economic report very key for Fed direction.

There are only a couple of material reports next week but they are likely to be ignored as we head into the holidays. The Risk of Recession update is due out on Monday then we get two activity reports on Thursday. The Chicago Fed National Activity Index and the Philly Fed Survey will probably be the two most watched reports and both are expected to show declines in activity.

Economic Calendar

Next week will be notable because of the earnings reports by the major brokers. Goldman Sachs reports earnings on Tuesday, Morgan Stanley reports on Wednesday and Bear Stearns on Thursday. Actually for an off week before the holidays there are quite a few major earnings report on tap. Besides the financials there ADBE, ORCL, PALM and RIMM. Those could be some volatile events.

Earnings Schedule

RIMM rebounded from my buy call at $100 last week to $109 but faded into Friday's close at $106. If you took that suggestion you should remember that RIMM has earnings on Thursday. They are expected to have sold 1.65 million BlackBerry phones for the quarter. Some analysts are still saying that RIMM is losing ground in the smart phone market but I am still a believer. I would not recommend holding over earnings but I know many traders do. I still think $100 is decent support but even good stocks sink in a down market. Use your own judgment.

Citigroup finally caved into pressure to take responsibility for their troubled investment funds. Citi had been pressured to take the troubled SIV funds back in house after they broke the arms length rule by putting $10 billion additional capital into them to keep them operational. Investors were suing Citi to recover losses from the subprime funds. On Friday Citi said it would move its seven SIVs back onto its balance sheet. The SIVs have $62 billion in assets or $49 billion excluding cash and cash equivalents and $58 billion in debt. By taking them back onto their balance sheets it guarantees the funds will probably not go under and help create transparency for future dispositions. The new CEO, Vikram Pandit, probably got a blank approval from the board on almost any amount of housecleaning needed to bring Citi back into favor on Wall Street. Taking responsibilities for the SIVs could put Citi into a capital squeeze. Bank America analyst John MacDonald warned Citi capital reserves could drop to 6.8% by year's end. Regulators like banks to remain above 6% and a level they feel is safe. Citi has $2.36 trillion in assets and while a failure is not expected there is concern. Besides the SIVs Citi has $55 billion in direct exposure to subprime mortgages. $43 billion of that is exposure to CDOs. Citi has already said they would write down $11 billion of this debt in Q4 due to decaying credit quality. CIBC World Markets said Citi would have to sell about $100 billion in assets to raise cash and probably cut its 54-cent dividend. The dividend cut is already being priced into the stock. Citi (NYSE:C) lost nearly 10% for the week.

Bank America helped spoil the bounce in bank stocks back on Wednesday when they said the end of year results would be "quite disappointing." The CEO said announced write-downs of $3 billion from bad debt would not be enough and larger losses were still ahead. BAC lost 6.5% for the week despite being named by Inside Mortgage Finance as the largest mortgage loan originator for the first nine months of 2007. BAC originated $110 billion in mortgage loans for the first nine months and that beat Countrywide and Wells Fargo. In just Q3 BAC loans jumped +27% over the same period in 2006. This was mostly due to the problems at Countrywide and people looking for a secure lender to handle their loan. BAC is not nearly as large as Citi but they have 57 million customers. That is a pretty strong ace in the hole when it comes to generating new business.

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All the good news was not enough to rescue traders who bought the end of November dip. Like the housing market traders have been trying to pick a bottom in financials for the last four months to no avail. The XLF fell -8.5% just since the Fed announcement on Tuesday. Once traders figured out the Fed was not coming to their rescue the financials were sold hard.

Black and Decker (BDK) also helped spoil the party on Friday after it warned that earnings would be well below expectations. BDK said it would earn $1.03 after special items and analysts were expecting $1.61. BDK said business conditions had been weaker than expected and sales to home improvement centers had slowed. BDK said they what they were seeing indicated a slowdown in remodeling as well as a slowdown in new home construction. Sales will decrease in the low single digits according to the company spokesman. BDK also said they would take a $25 million charge for a recall on certain DeWalt cordless drills. Brokers fled from BDK leaving estimate cuts in their wake. BDK lost 8.5% on Friday. Whirlpool lost another $2 on the BDK warning and that added up to a -$8 loss from the week's highs.

Oil prices fell a buck on Friday but the big move was a +$4 spike on Wednesday leaving it up +3.10 for the week. There is no reason and worries over rising inflation and gains in the dollar should have held it back. Support is holding at $87 as we await the news of the next cold wave. The U.S. is going to update the long-term weather forecast next week and that could add a little more volatility but the big event will be the expiration of the current January contract on Tuesday. At Friday's close we have moved back into contango meaning the futures contracts for future months are trading at higher prices than the current month. That suggests fears of a winter oil shortage are dissipating. That is somewhat surprising since inventory levels have declined sharply over the last eight weeks. Fog shutdown the Houston ship channel for several days last week so inventory levels could fall even further in Wednesday's report.

The U.S. dollar continued its rebound despite nearly every analyst including Jim Rogers telling traders this is a shorting opportunity. Friday's close was a new 6-week high. This should have some impact on oil prices but a 3-cent move in the dollar is not an earthshaking change in dollar valued oil.

FedEx said Monday would be the biggest shipping day of the year for them. FedEx is expected to haul 10.4 million packages through the system on that day. That is a 6% increase over the 9.8 million shipped on the busiest day in 2006. It is the last day you can ship by FedEx ground and expect it to arrive by Christmas. UPS expects to handle more than 22 million packages with the help of an additional 60,000 seasonal workers. Those workers will be picking up their last paycheck in two weeks and along with retail layoffs putting about 200,000 workers back on unemployment in January. My UPS driver has been coming about 6:PM and he still has a truck full of boxes.

Friday was not a good day in the markets. Actually the last three days have not been exciting for the bulls. When the Fed failed to cut 50 points and failed to issue a strongly worded statement the market support evaporated. Add in the earnings warnings, sector wide downgrades, additional subprime write-downs, recession warnings and sharply rising inflation and there was no reason to buy stocks. In fact there were a lot of reasons to sell stocks rather than buy them. The bulls are still hanging on to their SPX 1550-1600 year-end hopes tighter than a lifejacket on the Titanic. Unfortunately even good people drown when a ship or market sinks.

There are basically eight trading days left in 2007 plus a couple half days of no consequence. Volume is going to continue to decrease and mutual funds are going to quit trading as volume slows. About the only people left in the market are those taking care of tax selling. This means loser stocks are going to be sold even lower as investors sell losers to offset profits from winners. Other tax sellers will be selling winners to offset losses. It is not a pretty picture now that the rebound appears to be dead. As long as there was hope of a year-end rally there were people hanging on to shares. If current support levels break next week it could be an ugly week. November lows could be tested again.

The post Fed volatility and especially volatility into Friday's close could have been accelerated by next week's quadruple witching. Since volume will slow to a crawl next week the big option positions were probably closed over the last couple days. Positions were taken ahead of the Fed and those positions are now being unwound.

A slim positive for Friday was the low volume. Friday's volume was only 5.8 billion shares and nearly 2 billion under a good day's totals. This will shrink even further as next week progresses.

The Dow dropped back to 13400 after Tuesday's Fed announcement. Wednesday's bizarre Fed auction announcement caught all the shorts leaning to the downside again and the +271 point opening spike was a monster short squeeze but traders reloaded again at the top and the indexes have been under pressure ever since. On Friday that 13400 support failed with a -178 drop and a close at 13337. The last material support before retesting the 12800 November lows is 13250. That is only about 80 points under Friday's close and in this market that is about a 15 min move. The volatility has been huge and multiple triple digit moves in opposite directions have been as frequent as Britney's visits to rehab.

The Nasdaq-100 (NDX) has declined to initial support at 2075 and appears to be trying to hang on to that level. With Oracle, Adobe, RIMM, PALM and a handful of chip stocks reporting earnings next week any further weakness in guidance and this support could fail. Next support is 2050 followed by the November lows at 2000. If any tech stocks were going to be bought it would be the big caps in the NDX. Check for weakness here before going long anything else.

S&P-500 Chart - Daily

Russell-2000 Chart - Weekly

The S&P-500 failed at 1490 on Tuesday after the Fed announcement. That was a clear sell signal. The Fed auction spike on Wednesday morning was just another opportunity to get short at a higher level but 1490 was the key. The S&P failed to regain 1490 on either Thursday or Friday and each intraday failure below that level was another sell signal. 1460 is now the target. I said on Tuesday I would look to buy a dip to 1460 on a short-term trade only and we could easily see that on Monday. Under 1460 the same recommendation stands to double up on your shorts with 1420 as a target.

The Russell-2000 is leading the major indexes lower with a 4.1% drop for the week compared to 2+% drops for the other majors. There is no reason to buy small caps ahead of year-end. There was no material Q4 bounce and what little bounce we did see was sold hard after the Fed announcement. With the country headed into recession you don't want to be in small caps. That should be a clear indicator for us for next week. Any continued weakness in the Russell should be copied by the S&P.

The wildcards are going to be the low volume, quadruple witching, tech and financial earnings. The economic reports will be watched by the few traders still showing up for work but there is not likely to be much reaction. Remain short under SPX 1490 and double up under 1460.

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Jim Brown

"Averaging down in a down market is tantamount to taking a seat on the down escalator at Macy's."
Richard Russell (Dow Theory Letters 1984)

 

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