Shareholders of Yahoo (YHOO) should be celebrating this weekend after Microsoft offered to acquire the company for $31. For years it has been rumored that Microsoft wanted to acquire Yahoo but millions of option contracts bought on those countless rumors all expired worthless. Yahoo sank to a 4-year low at $18.59 after their disappointing earnings and this may have been the trigger Microsoft was looking for. The stepped up with an offer that was a 62% premium to Yahoo's Thursday night close and virtually guaranteed investor acceptance of the deal. YHOO rebounded +9 on Friday or a 48% gain. With Google taking over the world Microsoft should have no trouble getting the deal approved by regulators but I doubt they will be changing the combined company name to Micro-Hoo.
I am going to add something different this week. Normally I give you the economic calendar for the coming week with a couple bullet points about the more important items. Unless you read the commentary every day of the week you might not know what actually happened. That is like telling you the Giants and Patriots are going to play an important football game on Sunday and then never telling you who won. Last week was such an event filled week I am going to quickly recap the important numbers and how they impact the market outlook.
First up was the New Home Sales, which fell to an annualized rate of 604,000 units and the weakest pace since the spring of 1993. The median price was down by 10.4% from a year ago and inventory of homes on the market rose to 9.6 months of supply. This did not deter the buying in homebuilder stocks with many now on a two-week rally.
New Home Sales
The S&P/Case-Shiller Home Price Index saw home prices fall year-over-year by 8.4% in the 10-city composite and -7.7% in the 20-city composite. The decline in just the last month was over 2% in both indexes. Home sales and prices are still falling but the homebuilders are acting like we have seen the bottom.
The Mortgage Applications composite index soared to a three-year high at 1054.9 as refinance applications poured in at an astounding rate. The index was up +22% over just the past week. The sudden drop in interest rates from the Fed is feeding this sudden rise in refinancing. Loans for outright purchases continued to fall in line with the continued drop in home sales.
Durable Goods Orders exploded +5.2% in December with the help of a +132% jump in defense aircraft orders. Strength in orders was fairly broad based and did not suggest the economy was struggling.
The GDP for Q4 on Wednesday fell to +.64% from the +4.91% rate in Q3. This is a dramatic drop and shows the nearly instant impact from the subprime crisis as it bled over into the corporate bond arena. The 4-point drop in the GDP was a strong incentive for the Fed to cut rates at Wednesday's meeting. The majority of the indicators suggest the economy began dropping even faster in December so analysts worry that the decline into Q1-08 has already put us into a recession.
Another troubling indicator was the sharp spike in initial unemployment claims to 375,000 for the prior week. Rising unemployment is another indicator of a pending recession.
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The Chicago PMI fell to 51.5 from 56.4 showing yet another data point indicating a sharp decline in economic activity in December. Readings below 50 indicate economic contraction. New orders fell to 44.7 from 56.7 and backorders fell to 48.0 from 60.7. Meanwhile prices paid rocketed to 81.7 from an already high 67.4 indicating rising inflation. The Kansas Fed Manufacturing Survey slipped to 7.0 from 12.0 but remains more stable than in other regions.
Global Semiconductor Billings fell -3.6% in December with the decline the 3rd consecutive month of slowing sales. Chip sales were still up +3.2% for the year but slipping fast. Demand for consumer devices remained strong, +14% for PCs, but over capacity problems are flooding the market and forcing prices down.
The Employment report on Friday showed a loss of 17,000 jobs in January. If this is not revised in the March release it will be the first month of job losses since August 2003. Official expectations were for job gains of 75,000-100,000 jobs. January is when the BLS releases its benchmark revision and that knocked -376,000 jobs off the total for the year as reported in December leaving 1.14 million net jobs added for all of 2007. In the table below you can see the revisions over the last 7-months.
Jobs Revision Table
The last item of note for the week was the Institute of Supply Management (ISM) report for January. The headline number came in at a 5-month high of 50.7 and back into expansion territory. The December number had fallen to 48.4 (upwardly revised from 47.7) and a multiyear low. This is probably just a blip in the data and the downward trend will resume next month. There is nothing in the components that suggest a sudden resurgence of activity. New orders and order backlogs remain mired in the high 40 range. Prices paid moved higher to 76.0 from 68.0 and again indicate inflation filtering through the system.
Last Week's Economic Results Summary
For the coming week there is almost nothing of importance on the calendar. The Factory Orders for December are due out on Monday and they are expected to show the same type of positive blip as we saw in durable goods last week. This blip is thought to be replenishment orders for items sold during the holidays. Because this is a lagging report it is not normally a market mover.
The ISM Services is due out on Tuesday and there are not expected to be any material changes. The ISM Manufacturing last week showed a slight bounce back into expansion territory but the services sector has not yet dipped below 50.
Other than those two reports the rest are just filler and just smooth out the reporting schedule. The economic schedule does not intensify again until the week of the 18th.
On Friday we also heard from the automakers about their January sales and it was not a pretty picture. Sales sank to a seasonally adjusted annualized rate of only 15.2 million units. This is the lowest pace of sales since after the employee sales promotion in 2005. Of the top five companies only GM posted a sales gain for the month of 2.8%. Toyota sales fell -2.3%, Honda -2.3%, Ford -4% and Chrysler sales fell -12% for the month. On the bright side GM did say they did not expect a recession.
Google (GOOG) was hammered on Friday for a -$48 loss to close at $515 after disappointing on earnings Thursday night. The news of the MSFT/YHOO deal just added to the Google drop. Google earnings and revenue growth slowed more than analysts had expected. They posted earnings of 4.43 per share compared to analyst expectations for $4.44 per share. For a company used to beating estimates by a mile the fall from grace was a shock for investors. Downgrades flowed like Saudi oil with new price targets in the $600 range the norm.
The combination of Microsoft and Yahoo will create a serious competitor for Google. Yahoo claims over 500 million unique visitors and over 4 billion page views per day. Another source claims the global audience for actual users of each site breaks down to 265 million for Google, 198 million for MSN and 182 million for Yahoo. Those are users that set the sites as their home page or have some other connection like email or instant messaging. That would give Microsoft a lead over Google in eyeballs and potential advertising audience. Yahoo just finished spending a fortune on recreating their backend advertising model and Microsoft can take advantage of that new system almost immediately. Reportedly Microsoft and Yahoo have been in discussions for the last 14 months and Microsoft described them as frustrating. When Yahoo declined to a 4-year low Microsoft decided to go hostile and made them a bear hug offer. That is a price that is high enough to prevent anyone from bidding higher and with enough premium that current shareholders can't afford to pass it up. Yahoo claims they will review the offer in light of their future plans and the benefits of staying independent. Translated that means "guys we are screwed so let's see if we can negotiate for another couple of bucks before we throw in the towel."
Merrill Lynch is getting no love these days and Friday was no different. Massachusetts securities regulators filed fraud charges against Merrill for selling the city of Springfield $13.9 million in CDOs. Those CDOs have declined in value to $1.2 million. Merrill announced on Friday they had repurchased the CDOs from Springfield at the original $13.9 million price they paid. When the value of the CDOs began to fall Springfield told Merrill they wanted to sell them but Merrill said there were no buyers. There are still no buyers for CDOs and that is hampering efforts for banks to unload paper they took in over the last six months.
It would not be an update for the week without an update on the bond insurers. The major rating agencies reiterated their current negative outlook on Friday. That was their way of warning the current crop of negotiators that time was rapidly slipping off the clock. The current consensus of opinion suggests a settlement needs to be reached on ABK/MBI before the end of February or the sky is going to fall in on them. There were several good discussions of potential damage if their credit ratings do plunge and I think that is why 8 banks are still in talks to bail out the insurers. Reportedly a downgrade to junk status on MBI/ABK would cause between $75 billion and $150 billion in further write downs by the major banks. Reportedly the majority of that would be in the top five banks. That brings up a serious conflict of interest for those banks. They either come up with $20-$30 billion in capital to keep the monoline insurers liquid or take a paper hit of as much as $150 billion over the next 12-18 months. That is not much of a decision for me. The initial cost to keep the insurers afloat was estimated to be $15 billion but as more problems appear that number continues to rise.
CNBC reported on Friday that eight banks were working on a bailout for Ambac. Those banks are Citi, Barclays, BNP Paribas, Allianz, Dresdner, RBS, SocGen, UBS and Wachovia. Moody's said on Thursday that some bond insurers would likely NOT be able to raise their finances to levels that would repair their credit ratings. Another report hitting the wires on Friday spelled out there were $1.3 trillion in CDOs written over the last 3-years. There was no number given for their value today but based on the Merrill CDO buyback they could be worth less than 50% of their original value. Since banks have only written off about $100 billion in value this suggests a failure to rescue the insurers could result in much more massive write-downs in the future.
Rating company Egan-Jones, which was ahead of the crowd with downgrades on New Century, Enron, Worldcom and Global Crossing, also has warned on Ambac and MBIA. Egan rates them either a B+ or BB- with negative implications. Egan believes the other rating companies will eventually match his ratings.
In the various news articles out on this topic this week it appears the problem has drawn the help of several agencies, not just the lone New York insurance regulator trying to patch a deal together. The Washington Fed is involved along with the New York Fed, the Presidents Working Group on Financial Markets otherwise known as the Plunge Protection Team (PPT) started by Reagan after the 1987 crash, and the Treasury Dept. This bond insurer problem has the potential to be worse than the Long Term Capital blowup in the late 90s.
Motorola (MOT) rallied 10% on Friday on news that the company may be broken up to release value. The company hinted it might be preparing to sell its handset business. One of the companies rumored to be in the running to buy the handset business is Dell Computer. Personally I think that would be a major mistake for Dell but they did not ask me. If Motorola can't make their own division fly when they have major market share already then why would Dell, already struggling with their own problems, want to put another millstone around their neck? Carl Icahn nominated four new members to the board and increased his stake to 5%. Motorola said that Greg Brown would become the new CEO of the handset unit while they explored strategic alternatives.
Miner BHP woke up with a headache on Friday after a dawn raid by competitors on Rio Tinto (RTP). Alcoa (A) and Aluminum Corp of China (ACH), a Chinese aluminum company, joined together to spend $14 billion for 12% of RTP's London listed shares in a move designed to block a BHP bid for RTP. The investment gave them a 9% overall stake in RTP. The dilution came from the dual listing RTP enjoys on both the London and NYSE exchanges. BHP was expected to launch a formal offer of 3 BHP shares for each RTP share next Wednesday. That was the deadline set by the UK Takeover Panel for BHP to either launch a formal bid or drop its acquisition plans for a minimum of six months. Aluminum Corp of China officials said the move was to diversify outside of China but the real reason Alcoa gave was to prevent BHP from gaining a virtual monopoly on iron ore supplies into China. BHP would also have garnered over a third of global aluminum supplies with a RTP takeover. The move by Alcoa and Aluminum Corp of China put BHP on notice that there were some deep pockets ready to assist RTP should BHP continue its takeover plans. RTP surged +$34 on the news and BHP gained $6 on thoughts that the acquisition was dead. BHP had been depressed for several months as it considered its options for upping it's bid for RTP. Aluminum Corp of China paid $119 per share for the London shares, a 21% premium over the prior close. Alcoa was a minor player in the $14 billion deal contributing only $1.2 billion to the purchase.
The rapid drop in interest rates has killed the value of the dollar with the low on Friday very close to the 40-year low of 74.48 we saw back in November. Both rallies have failed and with our rates heading for the cellar the dollar had no chance.
Dollar Index Chart
After the Fed announcement the Dow rose +200 points then collapsed to close negative for the day. On Thursday the Dow fell -186 at the open then rebounded to close +200. On Friday the morning was volatile but buying began about 1:PM and never let up. I believe both days were signs the bear market may be over. Every major selling attempt since the Jan-23rd post SocGen low has been met with strong buying. The pessimism is being peeled away layer by layer and all the signs suggest there could be a lasting rally ahead.
As each day passes the odds are getting better that the bond insurer problem will be solved. A week ago I did not believe it but I am coming around given the continued news about Federal agencies taking an active part in the solution. The financial sector rallied +11% for the week and the housing sector gained +13%. This suggests traders also believe there is a bailout in the future.
The Fed has already bailed out homeowners and CDO owners. Their unprecedented 125 basis point cut in just over a week is a clear sign they are trying to rescue the economy by bailing out homeowners. I mentioned this a week ago that by cutting rates to the bone it would allow all those homeowners in serious trouble with resetting ARM loans to quickly escape the debt trap and convert to a low interest conventional mortgage. 30-year rates were down at 5.15% last week although the surge in loan applications pushed rates slightly higher this week. Since most of the ARMS were resetting in the 7%-8% range this is a windfall for beleaguered homeowners. Many of the 1.2 million homes expected to foreclose in 2008 may now escape that plight. The Fed is not done according to the futures, which are now close to pricing in another 50-point cut when they meet again on March 18th. A 2.5% Fed Funds rate would put mortgage rates under 5% and complete the rescue of the housing sector, mortgage sector and the economy. That $1.3 trillion in CDOs written over the last three years would suddenly recover in value and help solve the problem of the bond insurers. It is a win-win scenario and for whatever reason the Fed has decided to power flush rates it was the right thing to do.
The market has finally figured it out and the only cloud still making visibility questionable is the bond insurer challenge. If there is an announcement that a solution has been reached to liquefy the insurers and indemnify holders of those bonds then the market is going to explode. There is so much money on the sidelines that we were seeing the overflow trickle back into equities all week. With the ten-year treasuries yielding 3.6% at Friday's close there is a big incentive to go back to equities. If the Fed can cut rates fast enough and revitalize the housing sector in the process then the recession potential should be limited to Q1 and possibly erased completely. Once it appears the recession has been avoided the global economy will catch fire again. The only reason there is a global slowdown today is because of the U.S. subprime crisis and the resulting slowdown in the States. Reflate housing, solve the bond crisis and we will be off and running once again.
I believe part of the rally from the last two days was short covering in case a monoline insurer solution is announced over the weekend. It helped that January was the worst January in 17 years and the Dow came close to losing 2000 points from the December highs. We were extremely oversold going into the earnings cycle and now that cycle is almost over. Over 700 companies report next week but that will raise the total of reporters to something over 80%. Those remaining 20% will trickle in over the next month. The earnings for the S&P for Q4 now stand at a negative -20.5% as of Friday. On October 1st the estimate was for a gain of +11.5%. Financials are continuing to drag on the S&P with a -104% drop in earnings for the quarter and a loss of $2.5 billion compared to sector gains of $55 billion in profits in Q4-06. Tech stocks have been the strongest sector with earnings gains of 25%. Overall companies have been reporting earnings about 26.6% below estimates, again mostly due to the financials.
On Friday the jobs report was ugly but buyers still showed up. That is a key sign of a change in sentiment. On the internals table below the new highs have risen slightly but the key is the drop in new lows. You may remember in the prior week there were 4 days with more than 1000 new lows and Jan-22nd had 2,389 new lows. Notice the volume as well. We started the week very cautious ahead of the many economic reports and the FOMC meeting. Only one day saw declining volume beat advancing. Notice also that the overall volume is rising. It is still not overly bullish but rising volume in a rising market is also a positive sign.
The gains for the week surprised many. The bears were so thick the prior week no bull dared venture into the daylight. Last week we saw many tentative buyers tiptoe back into the fray with cautious entries. The bears were unable to dent the sentiment even after a -200 post FOMC drop and nearly a -200 drop the next morning. The dip buyers rushed back into the market on Thursday filled with confidence the Fed was going to make the recession go away. The key now will be to keep that sentiment all next week.
I am on the list for numerous market newsletters and it was not even an hour after Friday's close before I started getting emails about the return of the bear. As much as I would like to discount those ramblings as lingering negativity we still have to be wary of this fledgling rally. Every newborn walks on wobbly legs until it has mastered the art of balance. The volatility all week was the newborn rally trying to acquire that balance. We also know that many a toddler loses his balance as he is learning and suffers a painful fall. This rally may be no different. We need to monitor it carefully until a real trend develops. If the bottom really was Dow 11,634 on Jan-22nd then there are plenty of profits left to capture on any continued move. Normally a 24-hour retest of a bottom is not considered a valid retest and that leaves the technicians wanting to see another drop. This is a good thing for the bulls because it means many traders a going to be waiting on the sidelines for that drop and get left behind if it never comes. Once they realize this they race to catch up and that frantic buying helps push the market higher. The remaining shorts are also unbelievers and will be waiting at the overhead resistance to load up again. A surprise rally like we saw last week can last for weeks if the conditions are right.
Before you start charging to your broker screen to place buy orders you should be aware that we are approaching strong resistance. The ideal scenario would be a bounce off that resistance to give latecomers a chance for an entry and then a breakout that catches the bears holding their shorts. The Dow has a 100-point resistance range from 12800-12900. Over 12900 it should be clear sailing for several hundred points.
Dow Chart - 90 Min
Nasdaq Chart - 90 Min
The Nasdaq has the same resistance range as the Dow but the Nasdaq is starting next week from a lower level. The major earnings problems on the Nasdaq slowed its rebound. This should give tech traders an extra day of gains before running into that resistance.
The resistance range on the S&P is a little wider than the Dow and by definition less precise. That suggests there is no single point of potential failure other than the top at 1425. This could allow the indexes to creep up for a stealth test rather than a sudden sprint. Either way I would expect a pause somewhere between now and 1425 if this rally continues.
S&P-500 Chart - 90 Min
I left the best chart for last. The Russell-2000 is the most bullish of the major indexes. It has already surpassed the corresponding resistance ranges I drew for the other indexes. It is right on the verge of a major breakout and a run to 800. This is a clear sign that fund manager sentiment has changed. Sure part of this rebound was short covering since the Russell was heavily shorted but this has progressed beyond short covering and you can tell from the rate of climb that something else is juicing the Russell from the prior week's lows. The Russell posted gains of 6.08% for the week and the second largest gain of the major indexes.
Russell-2000 Chart - 120 Min
Dow Transport Chart - Daily
The largest gain of the major indexes was the Dow Transports with a +7.43% rebound to 4807. The rebound in the transports came on the drop in oil prices and on the expectations for a Fed produced economic recovery. The Transports rallied to close at 4800 and just slightly below major resistance at 5000. Should that 5000 level be broken the markets would see it as a strong sign of confidence and odds are good the other major averages would charge ahead as well.
I should also note that the SOX posted a better than 7% gain but the SOX is considered a sector index. The SOX rebound was confined to a nearly 6% gain on Friday alone. It was not a weeklong event but a party over the joint announcement by Intel and Micron of a NAND chip that was five times faster than current models.
For the watchdog index for next week I am choosing the Russell-2000. It closed on Friday right at the upper limit of its resistance range at 730. I would look to enter the longs of your choice with a confirming move over 732 and buy a dip back to 715. Should we retrace under 715 I would remain flat unless the bottom fell out under 685. I am not expecting a retracement of that magnitude but we always have to be prepared for any potential possibility. For the more passive traders I would simply look for a more over 732 and don't try to game any dips. The economics for the week are slim and although there are over 700 earnings reports there are probably less than 10 that anybody cares about. Cisco on Wednesday would be the highlight. Based on guidance from Intel and Microsoft I expect good news from Cisco. That does not mean they are going higher since the their earnings late in the cycle are often anticlimactic. With only two weeks until option expiration there are probably some good earnings plays using front month options but you need to be selective on the expectations for the company. Look to trade against any existing trend into their earnings report. Rarely do companies surprise enough to produce a continued spike in the same direction. For broad market direction focus on Russell 732 and everything else will be easy.