The markets receded to levels not seen since March of 2007 and the Fed failed to ride to the rescue. We know the Fed is not responsible for the equity markets but their economic moves do provide support. That support was sorely lacking and the markets reflected it. The Dow hit 12022 intraday and that represents a drop of -1,758 points from the December highs of 13780 and a -2,176 point drop from the October highs. That is a 15% correction for the Dow but that is not the biggest index loss. The Russell-2000 has fallen -21% from its highs and is now firmly in a bear market. Small caps have the highest risk in a recession and fund managers have been fleeing this risk since late December.
In the correction table below you can see the indexes and sectors most impacted by the drop. Housing, banks, brokers and chip stocks have been decimated. Small caps and transports were the next hardest hit with the large cap indexes generally losing around 15%. Last week was the worst week for the S&P in more than 5-years. It has been the worst start to a new year ever. Just looking at this table you would think we were due for a bounce. It is even more amazing when you realize it occurred in little more than two weeks.
Last week was a busy week for economics and those negative numbers were responsible for much of the market drop in the table above. Next week the economic cupboard is bare with only two reports of minimal importance on Tuesday. Those regional activity reports are not expected to show anything different and would only be noteworthy if they surprised to the upside. Next week will be a very heavy earnings week with close to 450 companies reporting. These earnings reports or more importantly their guidance for 2008 will be critical for market direction. The challenge is the environment. With all the whining about the impending recession there should be a lot of cautious guidance. Think about it. If you are the CEO of a public company with exposure to the U.S. economy then you want to be cautious in your guidance. The street expects it and for you it is a get out of jail free card for the next quarter. If you guide cautiously lower next week then beat your estimates in March you are a hero. It is a win-win scenario. This suggests guidance could be weak and that could weigh on the markets.
The bank stocks continue to drag the overall S&P numbers lower on a daily basis. Q4 earnings in the financial sector are now expecting to fall -99% over the same period in 2007. The entire sector is only expected to post earnings of $586 million compared to $55 billion in Q4-2006. It is hard to comprehend the damage to the financial sector with individual firms losing billions each. Those headliners are erasing the gains by the rest of the sector. Next week the focus will be on the tech stocks led by Apple, Ebay and Microsoft. There are quite a few chip stocks, roughly 10 or so, and that will help tech investors determine the health of the tech sector. On this calendar I put the number of reports at the top of the column and then listed just a few of the higher profile names. I highlighted those I thought would be important to market direction.
Apple reports on Tuesday and analysts are expecting great things. Possibly the expectations are too great as we saw surrounding the MacWorld presentation by Steve Jobs. Analysts are expecting sales of 2.2 million Macs, 24.7 million iPods, 2.26 million iPhones and $1.59 in earnings per share. Apple is expected to crush the earnings number and then give cautious guidance. It is what they always do. However, this time they may have reason to be more cautious. Verizon's iPhone competitor is selling very fast and is lowering the price point for that type of product. Motorola's iPod competitor is also taking market share from Apple. This will only increase as more companies expand their competitive product lines. I think we should expect Apple to guide lower on margins but the products are still too new to guide lower on sales. They are still breaking into new markets and Apple will be the leader in those markets simply due to brand recognition. The other products will come later and eat away at Apple's initial market share.
Microsoft is expected to post earnings of 46 cents powered in part by total sales to date of 17.7 million Xbox consoles with 1.26 million sold in December alone. Software sales are also expected to contribute strongly with more than 100 million copies of Vista already sold. Microsoft is reportedly taking back ground in the piracy battle and all their latest software releases now limit the number of times they can be installed. I got an Office 2007 package this week and it is limited to three installs. That means you will not be loaning the CDs to your brother-in-law or next-door neighbor but keeping them yourself and saving those installs for your next computer upgrade.
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EBAY reports on Wednesday and although it has been posting some strong results most analysts only expect Ebay to meet estimates and possibly tighten forward guidance. The slowing economy could prompt more people to try and raise cash by selling on Ebay but it also reduces the number of buyers willing to take your junk off your hands. Expectations are for earnings of 41 cents. I am an active Ebay power seller and I have noticed a slowing of bid traffic and a lower ticket price for things that have been selling. Ebay also ran several special promotions late in Q4 to try and pump up auction listings. Things like free gallery pictures and drastically reduced insertion fees. I don't recall the same frequency of special deals over the last several years so they may be seeing a slide in traffic and revenue and need to induce sellers to list more items. Ebay is facing increased competitive pressure by Amazon and Google. The Google checkout process is stealing business from PayPal. Google is not currently charging a fee for that service compared to a roughly 3% fee on PayPal. This is a promotional move by Google to build market share and will switch to fee based on Feb-1st. Ebay is expected to announce lower fees to offset these competitive pressures when they report earnings. I would be concerned about holding any Ebay position over their earnings report.
GE reported earnings on Friday that were basically inline with estimates although the revenue number was a little lighter than expected. GE is seen as a proxy for the economy and GE chief Jeffery Immelt said the U.S. was a tough market. GE said the global infrastructure was very strong and would help smooth out any weakness in the U.S. economy. GE affirmed guidance for 2008 of $2.42 per share but it was slightly less than what analysts had expected. Still, the affirmation allowed GE stock to post a $1.10 gain for the day.
Ambac (ABK) received another blow on Friday that could impact not only its survival but also cause further pain in the financial sector. Ambac is a bond insurer that guarantees payment to bond holders in case of default. Fitch Ratings cut it's rating on Ambac on Friday to AA from AAA. This downgrade likely means Ambac is out of the underwriting business. The reduction in rating under AAA causes a revaluation problem for any institution, especially banks, that currently holds this paper. These assets have already been eroded by the market and now with the insurance dropping out of investment grade status their value will erode even further. Some banks have bylaws that will require the bonds to be sold and in the current market it would be a fire sale prices. Merrill took a $3.1 billion write down after ACA Capital Holdings was similarly downgrades to junk status. Competitor MBIA (MBI) currently has an AAA rating and after Friday's move on Ambac it could be in for a downgrade of its own.
The downgrade of these underwriters means many municipalities will no longer be able to sell bonds at a competitive rate to finance projects. Many smaller entities like schools and hospitals rely on these underwriters to provide them respectability and access to capital markets. If you have weak credit you could pay a company like Ambac to insure your bond. With their AAA credit behind your bond you got AAA rates and ready buyers. The difference in rates more than offset the cost of the insurance so everybody was happy. Basically they were renting their AAA credit rating. Now their ratings are falling off a cliff. ACA has already been cut to CCC and junk status and nobody will pay to use their credit. Warren Buffett is looking to ride to the rescue of those municipalities with his new AAA rated insurance business. I believe he saw the handwriting on the wall for ABK and MBI and jumped into the sector. Buffett's new firm has the added benefit of having no bad loans on the books and that is something the others can't say. His new company should be very busy for the foreseeable future.
There is a serious concern that should these insurance firms go under, and that is clearly possible over the next few weeks, the financial sector could lose another 50% in value due to devaluation on their bond investments. This is going to be a serious factor to watch next week. ACA has only $425 million in capital left to cover $69 billion in bonds they insured. They are already under state control and will likely go out of business. Ambac has fallen from $95 per share to $6 and a market cap of $629 million. They were planning on doing an equity offering to shore up finances but the $1 billion they were planning to sell became too costly and too dilutive for existing shareholders. The plans were canceled last week. Ambac has insured $556 billion in debt. The odds of any of it actually being paid in the event of a default are zero. Now more than 137,000 institutions that insured their bonds through Ambac will see their interest rates rise significantly because of the ratings cut on Ambac.
Moody's said it was going to review MBIA and you can bet their credit will be cut as well. MBIA (MBI) recently raised $1 billion from Warburg Pincus and sold another $1 billion in notes at 14%. They have fallen from $70 to $8 since October and now have a market cap of only $1 billion. Their exposure to mortgage backed bonds, CDOs and CDO derivatives is more than $68 billion. Those notes they sold last week are already trading at 70 cents on the dollar. It is almost a certainty that Ambac, MBIA and ACA will go under and any bond insured by them, over $656 billion in total, will have to be written down by the bondholders. Let's see, we have already seen about $60 billion in write-downs by the major firms. Once these insurers actually go under that number could quadruple very quickly. Since most of those bonds will eventually pay out it is not a 100% write-off but they must write down the value to whatever level the credit of the underlying borrower will bear. If they are a junk credit then the bonds go to junk and get valued at something around 35-50 cents on the dollar or worse. This is a story that will be around for a long time.
Under Armour (UA) lost 35% over the last two days after saying on Wednesday they purchased a full 60-second commercial during the Super Bowl. The nearly $5 million cost for the ad equates to a majority of their advertising budget of 12% of annual revenues and the cross trainer shoe they will advertise will not even be available until May. Downgrades were flying with the majority of comments as "bad timing in a weakening retail environment." This is a huge risk for a product that will not be out for months after the ad runs. The next day UA warned that their profits for the first half of 2008 would be in the range of 3-5 cents when analysts were expecting 39 cents.
The various economic events of the week combined to make bonds the preferred investment and push the yield on the ten-year note to 3.65% and a new 4.5-year low. The recession fear is spiking almost daily with Intrade.com seeing their recession contract rising to 73% chance of a recession in 2008. Volume was very strong with over 10,000 contracts traded on Thursday. The Fed Funds Futures are still showing better than a 136% chance of a 50-point rate cut at the January 29th meeting. Quite a few analysts expected that rate cut last week but so far it has failed to appear. Bernanke appears to be playing chicken with that recession locomotive headed straight for him and he is putting off the rate cut until the last possible moment. The Fed still believes the U.S. will avoid a recession but that is definitely a minority view. The inflation numbers for the week saw the Consumer Price Index (CPI) rise another +0.3% to an annualized headline rate of 5.6%. The core rate increased slightly to 2.4% and right at the upside edge of the Fed's comfort envelope. However, the risk of recession should be outweighing the risk of inflation and Bernanke has no reason not to cut rates quickly. It appears he is using the tried and true tactic of talking the real rates down without actually rushing to lower the actual Fed rate. With the yield on the ten-year at 3.65% and the current Fed rate at 4.25% that tactic appears to be working. Unfortunately it is not helping the market.
Volatility is spiking back into the upper 20s and levels seen in the August and November bottoms. The market is running on fear and we know these things tend to get overdone before they end. The option expiration on Friday helped to increase the volatility and there is the potential for it to climax on Tuesday. Monday is a market holiday. With the expiration of options on Friday all those traders holding January puts for insurance are now uncovered. According to Jon Najarian the number of puts being purchased in the February strikes was far outweighed by the expiring puts in January. This means traders will have to do a gut check on Tuesday morning and decide if they want to be long or short and if the market is going up or down. If they think the market is going lower then they are more likely to sell on Tuesday rather than buy more puts. This could be the selling climax we need to see to create a new buying opportunity. There will also be a lot of put writers who will wake up with new stock in their accounts on Tuesday morning from exercised puts. Those traders will hit the sell button at the open to unload that unwanted stock.
The internals are getting progressively worse and suggest we are building to a selling climax. It should also be noted that option expiration also impacted the negative internals so we can't apply too much weight to the data but it is very negative. Note the rising number of 52-week lows and the extreme volume levels. Regardless of the reason this is a very oversold picture and suggests at least a temporary relief bounce soon.
The Dow lost -507 points for the week and came to rest right above the support at 12,050 dating back to March 2007. In theory this should be a decent support point and the launch point for a potential rally. Unfortunately the rest of the indexes are not in agreement. The Dow may be the most visible index but it is not the most representative of the broader market. We normally use the S&P-500, NYSE Composite and the Russell 2000 for market direction predictions. Were it just up to the Dow I would be calling for a rebound today. The dead stop at 12,050 support is exactly where you would expect a rebound to appear. If that level fails it is going to get very ugly very quickly. The market takes the stairs when moving up and the elevator when moving down. If the Dow breaks 12,000 it could be the express elevator to the basement at 10,700.
Dow Chart - Weekly
Nasdaq Chart - Weekly
The Nasdaq chart also came to a dead stop on substantial support at 2340. Were it up to just the charts of the Dow and Nasdaq the odds would be good for a rebound next week. Should the Nasdaq break support here it could be a long drop to something in the 2000 range. That would be a whopping 30% drop from its highs. With potential earnings problems from AAPL, EBAY, QCOM and a dozen chip stocks next week it will be up to Microsoft to hold the line. I am not sure Microsoft can pull it off and they don't report until Thursday night so the week will be 80% over before they can help. To put it bluntly I am afraid we could see some lower lows for tech stocks.
The S&P-500 chart clearly shows the support break at 1380 and a potential target of 1225. This chart is more bearish than the Dow and Nasdaq and is colored by the 21% weighting of the financial sector in the S&P. With the rating downgrade on Ambac and the likely downgrade on MBIA the financials are going to be in the house of pain. That will make it tougher for the techs to mount any kind of S&P rally.
Russell-2000 Chart - Weekly
The small caps have been decimated over the last two weeks and there appears to be no end in sight. The small caps are the sentiment indicator for recession fears. Their liquidity limitations and tendency to perform poorly in recessionary conditions have fund managers fleeing them in large numbers. As a sentiment indicator for the economy and the market this is a flashing warning that the bear is not dead. If current support at 675 fails we could easily hit 600 and that would be a 30% correction from the highs.
The NYSE Composite is composed of just over 2000 stocks that trade on the NYSE. That includes 1600 U.S. stocks and 360 non-U.S. companies and a large number of ETFs. This index is highly correlative to the overall market although the inclusion of the non-U.S. components tends to make the NYA outperform the other indexes in times of U.S. market stress. The index components have more than $18 trillion in market cap. The $NYA (ETF is NYC) has returned to initial support at 8800 but the odds are very good that support will not hold. The Dow, S&P and Nasdaq have already broken through their corresponding levels and any further decline should push the NYA into free fall to retest 7800.
NYSE Composite Chart - Weekly
Wilshire 5000 Chart - Weekly
Moving out to the broadest measure of the market the Wilshire-5000 we see that the corresponding support levels on the NYSE Composite have already been violated on the Wilshire. Using the Wilshire as a market guide suggests we could see lows somewhere in the 12300-12400 range.
It is tough to read those charts above and not let your bias color the outlook. The bears would be convinced that every current support level is about to be crushed by the next negative news event next week. The bulls believe that Dow 12,000 is going to hold and the mother of all rebounds is about to appear. This is why we let the markets tell us where they are going. Last Sunday I suggested putting your market bias on the shelf and going long over 1400 and short at 1375. That short was 50 points higher than Friday's close and would have been a great trade. The S&P has risk to 1225 and that is another 100 points lower. The Dow and the Nasdaq are resting on critical support at 12050/2340 and while I would like to believe they will rebound from there I think there is more pain in our future. Again, like last week we need to let the market dictate direction.
One point in the bulls favor is the Russell at 675. I mentioned about 3-weeks ago that 675 would be a buy level for me on the Russell using the IWM ETF. So far we have not seen any signs of bottom fishing at that 675 level and a break there would target 600 and that would be a screaming buy assuming the economy was not in a full-blown recession. How the overall market reacts next week will depend a lot on how the Russell handles that support level at 675. With the S&P well away from any material support/resistance level I am going to use the Russell at 675 as our key indicator for the week. You should already be short from SPX-1375 and we should remain short on any continued drop below that Russell-675 level. However, if a bounce develops on the Russell we want to reverse to a trading long over 675. We could see a lot of post expiration volatility on Tuesday so be prepared for some market indecision around that level. There is a strong possibility of a market drop at the open as option exercises are resolved. I know more than one analyst was suggesting any opening dip on Tuesday would be a buying opportunity. I would go along with that theory simply because we are so oversold but it would only be a short-term trade. We need to focus on Russell-675 as our key indicator. Let the market pick the direction and you pick the trade.