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Market Wrap

40 More Years?

HAVING TROUBLE PRINTING?
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We have gone it alone for the last 40 years and we will go it alone for the next 40 years, Angelo Mozilo, Aug-2008. That quote will probably go down in history since only four months passed before the Mozilo had to eat his words to avoid filing bankruptcy. In theory this should have invigorated the markets and produced a monster short squeeze in financials. Even more so since JP Morgan is rumored to be in talks to acquire Washington Mutual (WM) and relieve its pain. Unfortunately the earnings calendar got in the way with Citi, JPM, Merrill and other big financials set to report next week. This is likely to be the "kitchen sink" quarter where every possible charge off is thrown into the write-down stew. Since the quarter is already going to be the worst in years those firms will throw everything into the mix to get it off their books in one big ugly quarter. Some analysts are expecting as much as $40 billion in write-downs to be announced next week. Add in growing recession fears and the markets had another really bad day when they should have been celebrating.

Nasdaq Chart - Weekly

Dow Chart - Daily

There was nothing in the economics on Friday to get excited about. The entire week was very lackluster with the biggest event a speech by Paulson and another by Bernanke. Next week is entirely different economically with inflation reports leading the list. In Bernanke's speech on Thursday he indicated he was not that concerned about inflation and more focused on slowing economic growth. That suggests the Fed is going to be proactive on the rate front and the Bernanke himself already suggested there could be substantive rate cuts ahead. As long as the inflation reports next week (PPI/CPI) show inflation remains tame then the Fed will be free to act. If, as we saw last month, inflation is spiking sharply higher then the Fed will have a tough decision ahead. In November the PPI headline number spiked +3.2% and that was the second highest gain since the PPI began in 1947. The core rate rose +0.4% and that was also well above the recent ranges. The CPI jumped +0.8% in November and that was the largest increase in over two years. These numbers have got to be giving the Bernanke Fed indigestion in the current recessionary environment. I am sure they are waiting to move on rates until they get the numbers from the December PPI/CPI due out next Tue/Wed. Since we are still more than two weeks away from the January 29th FOMC meeting we could see an intermeeting rate cut as early as Monday since the Fed will get an advance look at the PPI/CPI. If inflation cooled in December I would look for a Mon/Tue rate move but that is sheer speculation.

Also out next week is the Fed Beige book, an overall look at all 12 of the Fed districts. This will also give the FOMC a better understanding on the state of the economy. Lastly we get the Philly Fed Survey on Thursday to begin the next series of regional manufacturing reports. The Philly Fed is seen as a proxy for the general economy and is given more credence than the rest.

Bernanke will also testify on Thursday to the House Budget Committee on the economic outlook for the U.S. economy and that is a question and answer session. He will really be on the hot seat this time around and that means it will be even more likely the Fed could move before Thursday. Then Bernanke could say we are taking positive steps, blah, blah, blah. It is easier to face the inquisition if you have an action point to lean on.

Economic Calendar

Alcoa may have been the kickoff to the earnings season when they reported on Wednesday but the vast majority of companies have not yet stepped up to the plate. Next week is financials week with quite a few of the major banks/brokers reporting. This overhang is weighing on the market. Citigroup reports on Tuesday and they are now expected to write-down as much as $24 billion in loans and CDOs. Along with that monster write-down they are expected to report another bailout by a consortium of firms that could be as much as $15 billion. Regardless of how it is structured this will be dilutive to the current shareholders but shares of Citi have been up for the last two days. Still there is a concern that many of the regional banks reporting next week that have been flying under the radar may suddenly rocket into visibility with an unexpected loss. The big boys are still in the crosshairs as well with Merrill expected to announce write-downs could increase to $20-$23 billion from the current $8.5 billion. Morgan Stanley could increase to $9 billion and Bear Stearns another $2 billion. S&P is now expecting financial earnings for Q4 to drop -72%. That will drag the entire S&P earnings to an -11.3% drop. Without the financials the rest of the S&P is expected to post +11.6% earnings growth. Techs are still holding at +22% growth and energy +20%.

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There are two major tech stocks reporting next week and those are Intel on Tuesday and IBM on Thursday. These two companies will either be the tech saviors or the hammers that crush current support. Intel is expected to report earnings of 40 cents and IBM is expecting $2.60 for Q4. Seagate will also report and they were making very bullish comments at CES early last week. Evidently the demand for disk drives is very robust. That suggests overall tech demand is also strong. As long as Intel or IBM does not drop an earnings bomb this could be a turning point for tech stocks. This is also going to be a prime week for determining guidance. The guidance for Intel and IBM will be more valuable than their actual earnings numbers. We also have GE reporting on Friday and their guidance will be seen as a proxy for the U.S. economy.

Earnings Calendar

Stinking up the Dow on Friday was American Express with news it was taking a $440 million Q4 charge due to increased delinquencies and loan write-offs. AXP said it was seeing particular weakness in states with the largest real estate problems like Florida and California. They said they were surprised by the acceleration of the weakness. They expected to see some problems in 2008 but were caught off guard when the credit deterioration accelerated into Q4. AXP will report earnings on Jan-28th and warned those earnings would be around 71 cents and below the prior year's comparison quarter. AXP also warned that further tough times are ahead and growth in cardholder spending will slow. These warnings shocked many investors because they thought the weakness was restricted to the subprime crowd. The higher net worth American Express customers were expected to be mostly immune to the credit weakness. AXP fell -4.92 and was responsible for nearly 40 points of the Dow loss.

Capital One (COF) warned they would take a charge of $1.9 billion for Q4 of which $1.3 billion is loan charge offs. They cut their earnings outlook for the full year to $3.97 from the prior forecast of $5 per share. Capital One was knocked for a $3 loss on the announcement but recovered all of it before Friday's close. Everyone knew COF was going to have problems since they have a large number of lower credit borrowers. Washington Mutual will also have the same problem when it reports next week because they bought Providian last year and Providian was heavily into credit card accounts for low credit borrowers.

Tiffany (TIF) was knocked for an 11% loss of $4.50 after it lowered the top end of its 2007 guidance. Tiffany said it was seeing weakness in its high-end buyers and especially on big ticket items over $50,000. That is definitely big ticket and you would think anyone throwing down an American Express card for a $50,000 trinket would not be hurting in any environment. This further spoiled the idea that the subprime credit crunch only impacted the blue-collar crowd. This problem has risen to the higher echelons of consumers and it does not paint a rosy picture for Q1.

Of course the big news was the Bank America acquisition of Countrywide for $4 billion or roughly $6.90 per share. You may remember BAC paid $2 billion for a preferred stake in Countrywide back when CFC was trading at $18. The press releases and the analyst comments liked the deal with BAC paying roughly 31% of book value or 2.9 times expected 2009 earnings. There are two important points about this deal. BAC not only gets the $1.5 trillion in loan servicing operations from CFC and roughly $40 billion a month in mortgage loan originations but they get hundreds of billions in liabilities from dozens of lawsuits and regulatory challenges. They also added exposure to tens of billions in pending foreclosures they will have to eat when the loans are put back to them. Countrywide loans in default have risen to 7% and foreclosures have doubled over 2006 even with their attempts to rewrite as many as possible. I heard late Friday Countrywide loan-servicing agreements require Countrywide to make the payments on delinquent loans while they are trying to collect from the borrower. That means they have to make monthly payments on 7% of their loan portfolio. Talk about a cash drain! BAC is in a much better position to handle this problem than Countrywide and the acquisition announcement probably prevented a Countrywide bankruptcy. However, there is still the possibility they will let CFC file bankruptcy to limit future liabilities and get rid of some problems they would rather not assume. There was a rumor circulating in the markets on Friday that the Fed was involved in both the CFC and WM deals. Both were headed down a path that would have likely grown progressively worse without a deep pocket acquirer to halt the problem.

Another reason BAC may have taken this leap was to rescue their recent $2 billion investment. Essentially BAC CEO Ken Lewis doubled down on the initial $2 billion investment to roll the dice BAC could turn CFC back into a profit machine. Lewis said he did not plan on Mozilo staying with the merged company. Mozilo's severance package is seen to run from $85 million to as much as $150 million. BAC also said they would move away from the CFC process of buying bulk mortgages from loan originators and would not do subprime loans.

McDonalds (MCD) fell -$4 on fears that the sharp decline in consumer spending would trickle down to big macs and fries. A routine survey of 195 specific stores showed same store sales rose just 1.8% and the lowest increase in six years. Gasoline prices were said to be the culprit with shopper's budgets being squeezed even to budget meals. One obscure analyst downgraded MCD and said the expectations for gains from their big move into the coffee business was already priced into the stock. Almost everyone else disagreed with that prediction and with the worry over a material decline in low dollar fast food. There were several reiterated buy ratings. The -3.85 drop in MCD was responsible for the loss of nearly 35 Dow points.

RF Micro Devices (RFMD) was crushed for a 26% loss after warning that excess inventory and slowing sales would force them to miss earnings. RFMD said customers were reducing orders and overall demand was weak in the infrastructure and broadband markets. RFMD now expects a loss of 4-5 cents per share compared to its prior forecast for a profit of 6-7 cents. The SOX fell to 353 and a level not seen since Sep-2004. Given the Intel earnings next week this may be a pessimistic support level worth buying.

Crude prices fell to $92.69 making the six-day drop -7.36 from the $100.09 historic high hit on Jan-3rd. This may sound strange since oil inventories fell for the 8th consecutive week with a drop totaling 32 million barrels over the eight week period. Inventory levels have now fallen to 9.8% below the year ago level. So why are prices falling? Fears of a recession and a sharp drop in demand for gasoline is putting pressure on crude prices. The sharp drop in gasoline demand is similar to that seen heading into the recession of 2001. Gasoline inventories soared 5.3 million barrels last week compared to an expected rise of only 1.6 mb. Because of high crude prices the cost of gasoline is not declining and this is putting pressure on consumers already hit by the subprime crisis. Secondly, we are in a bear market and everything previously bullish is now being sold. Even a helium balloon goes down in an elevator. We are seeing profit taking in nearly every sector and every individual winner heading into 2008. This will fade and consumers will adjust to paying higher prices. It always happens this way and I would view this as a buying opportunity as we approach $90.

United Airlines (UAUA) said on Friday they were raising the fuel surcharge on tickets to $25 each way up from the current $10. United said they had to do this to survive in an environment where fuel costs had tripled in the last three years. Every penny rise in jet fuel costs the airline sector an extra $195 million per year in fuel expenses. I am telling everyone once again, if there is somewhere you always wanted to go you should schedule that trip soon because once peak oil arrives over the next several years those fuel charges will be significantly higher and be based on miles flown. If oil hits $150 by 2010 (24 months) that is roughly an extra $50 billion in fuel costs annually for airlines. How much will the fuel surcharge be then? On Dec-28th 2006 oil was $66 and jet fuel was $1.78 per gallon. On Dec-28th 2007 oil was $90 and jet fuel was $2.70 per gallon. That is a 51.4% increase in the cost of jet fuel for a 36% jump in oil prices. A crude jump to $150 will seriously cripple airlines and it will be here by 2010.

February Crude Chart - Daily

Elsewhere in the commodity sector gold prices hit $900 for the first time ever and analysts calling for selling began appearing in every sound bite. Corn prices hit an 11 year high on the January crop report Friday morning and went limit up with 18,000 contracts at the ask when the market closed. Soybeans hit a record high at $13 on that same report. Global demand for food is growing rapidly the commodity report showed there was insufficient supply to satisfy demand. This is not going to get better any time soon.

The worst 10 days ever for a new year. More triple digit days. Biggest losses. The records being broken are repeated in nearly every segment on stock TV. Volume is soaring and new lows are well into the quadruple digits. Volatility is huge and nobody knows which way to jump. When will it be over? Nobody knows. It will be over when it is over. I know that is the glib answer but it is true. We have seen a 10% correction in the first eight days of the year and now we are testing those lows.

The news is a lot better than the closing numbers looked on Friday. The Dow was the major loser that was dragging down the other indexes. The Dow was down over 300 points at 3:PM and recovered to hold in very light support at 12600. The Dow was down primarily due to six companies. AXP lost -4.92, MCD -3.85, MMM -2.63, PG -2.30 and IBM -2.25 and BA -1.84. Those six companies accounted for nearly 150 Dow points. AXP and MCD were down on specific news events. I believe the other four, the highest dollar stocks on the Dow, were down on ETF selling. We live in an ETF ruled world today and when those index ETFs are sold it impacts the entire index. Because the Dow is a price-weighted index the highest dollar stocks will be sold the hardest. The top 5 largest weightings in order are IBM, XOM, BA, MMM, MO and PG. Altria (MO) actually rose because they are a defensive recession play. Exxon was down -1.36 but with 6 billion shares outstanding it is tough to move that stock on anything other than a direct news event. I may be full of stuffing but I think Friday's drop was mostly story related on MCD and AXP with a little continuing recession fear thrown in.

If you look at the trend on the internals over the last seven days we saw a ramp up in volume and negativity to what appears to be a capitulation event on Wednesday with nearly 9.3 billion shares traded across all exchanges and a whopping 1530 new 52-week lows. On Thursday we was another 9 billion in volume with a trend reversal in the internals. Friday was a return to selling on a lot of different stories from AXP, TIF to MCD and RFMD. It was the last opportunity for companies to warn before earnings and several took advantage of it. We also had the overhang of increasing expectations for further massive write-downs from the financial stocks reporting next week.

Market Internals

I believe the bad news is priced into the market and while there may be some additional volatility on Monday we "should" start finding a bottom here. If you look at the S&P-500, the index I have been using for market calls for the last two weeks, we had a perfect bounce off 1380 on Wednesday that ran for +59 points. Even with all the negative news on Friday and a Dow dropping -300 points intraday on losses from only six stocks the S&P held its ground at 1400. That appears to me to be traders setting up for a potential rebound next week. We have MacWorld starting on Monday with the Steve Jobs market moving presentation on Tuesday. We have several high profile earnings events with all the bad news in the world already priced in. It would be extremely hard for those financial stocks to surprise to the downside. The odds are better they could surprise to the upside and that would really be a shocker to some traders.

S&P-500 Chart - Daily

Don't get me wrong we could still collapse under any number of news events like even more massive losses than expected in the financial sector or another sharp spike in inflation. Intel could tell us that PC sales have fallen off a cliff but I don't see it. I know distributors in the computer sector currently having a hard time getting components for servers. That is not a sign of slowing demand but it could be sector specific. I don't want to fall into the trap of trying to predict the market direction ahead of an event filled week. I believe we should just stick to the trading plan and let the markets pick the direction. Last week we planned to buy a dip to 1380 on the SPX and we got that on Wednesday. The secondary recommendation was to buy a breakout over 1400. Those would be the same recommendations for next week. With the S&P closing at 1401 I would look to stay long over 1400 and go flat under 1400 to prepare for a bounce at 1380. Should 1380 fail I would go short at 1375 and settle in for a long week. I want to believe Apple and Intel will help turn techs around and I want to believe the worst is for financial expectations. $5 and a belief you are hungry will get you a hamburger a coke at McDonalds but not much else. Let's put my belief on the shelf and let the market lead and we will follow.

Tomorrow is the last day for the end of year renewal special. If you snooze, you lose.

Jim Brown
 

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