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Market Wrap

Another Fun Day In the Markets

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The normally ignored ISM Services report for January became a market black hole sucking last week's bullish sentiment right out of the market. The ISM services report suffered a drop equivalent to a 10.0 earthquake when it fell from 54.4 to 41.9 for the lowest reading and the first time in contraction territory in 58 months.

What was under reported was a revision in the way the index was calculated with today the first report using the new methodology. I did not hear a single report in the main street press about the change in methodology. Instead the headline number was shouted from the rooftops and the market imploded on the dramatic drop. The internal components were still ugly with employment falling 8 points to 43.9. New orders fell 10 points to 43.5 and order backlogs falling to 46.0. The drop in these forward-looking indicators suggests there could be further weakness ahead.

There was also another reason for the dramatic drop after the release. The ISM is normally released at 10:AM ET. Today the report was released before the market opened because of a breach in security at ISM. Reportedly an individual receiving the data in error on Monday was asking some questions that ISM thought could lead to a possible breach of information on a larger scale. To avoid the data being leaked to the markets in error they released the ISM in full well before the open. This shocked the markets since traders did not have a chance to close any open positions or put on insurance as they would normally do before the 10:AM release. The futures market imploded leading to the gap down open and triggering the massive sell off.

ISM Services Chart

The ISM Services was really the only economic report of consequence for the day. The weekly chain store sales snapshot showed a rebound of +1.7% but this is just noise. The prior week was a loss of -1.2%. This report is ignored by most traders. The sharp increase in Monday's Challenger layoff report was still being felt. Layoffs nearly doubled to 74,986 workers. While that was nearly double the 44,000 in December it is right inline with the prior four months. This report should not have had any impact on the current market but the harbingers of doom were again shouting from the rooftops that layoffs had doubled.

Wednesday is also a light day for economics with Mortgage Applications, Productivity and Costs and Oil Inventories the only reports on the schedule.

There were a lot of earnings reports but few of any importance. Boston Scientific (BSX) posted a $458 million loss or 31 cents per share as it attempts to digest its acquisition of Guidant. Excluding charges BSX posted a profit of $355 million or 24 cents per share. BSX forecasted sales for Q1 lower than street estimates but profits of 15-20 cents compared to street estimates of 12 cents. BSX only lost -8 cents for the day.

The Cheesecake Factory (CAKE) saw net income fall -35% on lower traffic. Earnings were 22 cents and analysts were expecting 26 cents. Net income for the year fell -9%. The company forecast for Q1 revenue was also below analyst estimates. CAKE blamed the Q4 drop in traffic on bad weather so it appears they have turned into weather forecasters with their warning of lower sales in Q1.

The CME Group (CME) posted profits that nearly doubled thanks to its acquisition of the CBOT and higher volume of trades from the combined entity. Profits soared to $3.75 per share in Q4 and topped analyst estimates of $3.62. The strong profits did not help the stock price with CME losing -$30 for the day. CME also confirmed it is considering an offer of $11.3 billion for the Nymex.

Disney (DIS) beat the street on gains in attendance at its parks and strong sales of the High School Musical DVD. Disney said it saw no signs that the current economic downturn had impacted its sales or theme park bookings. The stock rose about 3% in after hours erasing a -2.3% intraday drop. Disney's comments about not seeing any impact from the downturn also helped boost futures after the close.

Tyco (TYC) posted earnings after the close of 74 cents, excluding items, compared to analyst estimates of 57 cents. It was a very strong quarter for Tyco after it divested its healthcare and electronics businesses. Tyco reaffirmed its guidance, which it just raised in January. Despite the strong results the stock fell -1.20 in after hours trading.

Las Vegas Sands (LVS) posted some lackluster numbers on Monday and dropped -12.85 intraday on Monday to $74.95. Despite Tuesday's horrible market the stock rebounded to hit $93.85 intraday on Friday, nearly a $20 bounce before settling at 88.50 and a +7.45 gain for the day. The bounce came on an upgrade from Morgan Stanley saying the decline in U.S. traffic would be made up by their operations in Macau. 65% of LVS earnings in 2008 will come from casinos outside the U.S. market.

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The big dog for earnings on Wednesday is Cisco. The stage was set on Tuesday with Citigroup cutting estimates and price targets on Cisco to earnings of $1.55 and a target of $28. Pacific Crest wrote that they expect orders will be soft but earnings will be inline. You may remember that CEO John Chambers said last quarter that sales to the financial sector were soft as the big banks cut corners to preserve capital. Orders were being pushed out rather than cancelled and everyone will be looking to see if those orders are still sliding or firmed up by year-end. Many large companies have been postponing capex spending and Chambers is expected to talk about this problem in his guidance. However, overseas sales have pulled Cisco earnings out of the fire several times over the last couple years and some analysts expect that to happen again for Q4. Earnings estimates are for 38 cents and revenue of $9.8 billion. Cisco closed at a new 52-week low ahead of their earnings.

The CEO of Centex (CTX) helped kill the two week homebuilder rally with comments about the continuing bear market in home sales, no end in sight and potential for it to get worse before it gets better. The CEO said this was his 6th cycle in the business and the worst since World War II. The Housing Index lost -3.5% on his comments and the market sell off.

In the continuing bond insurer saga the Wall Street Journal said there were actually several bailout attempts underway at the same time involving multiple players and multiple methods. Most include a new line of credit by the major banks and some equity participation by those banks. Hurdles include a continued reluctance by the current shareholders of the insurers to give up any equity. I view that as a very narrow mindset but I am not privy to the inside details. According to those inside the situation is very fluid. A bailout on Ambac is said to be the farthest along in the process. S&P said late in the day that a failure of the process could result in a downgrade of ratings on multiple banks because of CDO hedges they put in place using guarantees from the insurers. Rating agency Fitch warned today that they "may" cut the ratings on MBIA from the current AAA level. The constant stream of news from the rating agencies is meant to stimulate greater urgency in the bailout meetings. One inside person speaking anonymously said the chances for a successful conclusion were increasing daily. Any announcement of a deal could produce a major rally in the financial sector.

Moody's announced today a change in the way they will rate CDOs and the delay in making the change appears to be due to the amount of profit they were making. In 2006 Moody's derived nearly 50% of its profits from rating CDOs. The profit margin on rating a CDO was nearly three times higher than that of a regular municipal bond rating. They had a huge incentive to continue rating CDOs and no incentive to crack down on the CDO writers who were taking triple BBB subprime paper and magically get a AAA rating. Those CDO writers included JP Morgan, Lehman, Citigroup, Morgan Stanley, etc. Ticking them off would have been detrimental to future business for the rating agencies unless they all took a stand at the same time. Unfortunately the profit motive is very strong and nobody wanted to risk making the writers mad or giving up those massive profits. Structured finance was a huge money maker and odds are good the implied conflict of interest of the rating agencies and their profits will eventually come back to haunt them. Regulators are bound to make the connection eventually and see deep pockets that need to be emptied.

The ISM Services number, even flawed as it was by the change in methodology, rekindled recession fears and brought the bears back out of hiding. Fed heads sought to calm the market with random comments. Richmond Fed President Jeffery Lacker said there was a possibility of a mild recession and further easing may be warranted. Lacker said home construction is unlikely to bottom in 2008 and there is further risk that the 10-year housing bubble still has further to unwind. He also warned that inflation both overall and excluding food and energy prices has increased.

Jeffery Lacker

Merrill Lynch told clients that there was a strong chance of another intermeeting rate cut. The Fed Funds Futures are now projecting a 168% chance of a 50% cut at the March 18th meeting. The Fed is already in record territory with the sudden rate cuts of 125 points and another intermeeting cut of 50 points would be nearly unthinkable outside of the current crisis.

It was announced today that Bernanke will testify before a Senate panel on Feb-14th regarding the economy and the markets. Bernanke will also give his semi-annual testimony on Feb-27/28th.

Crude Oil Chart - Daily

Crude sank with the market posting a -1.52 loss for the day. This came despite calls from several OPEC members for cuts in production at the March 5th meeting. Iran and Venezuela have already petitioned for a cut so the matter will be considered before the full OPEC body in March. We are also entering a weak demand cycle as winter fades and summer driving has yet to begin. I expect further declines without any news event to bolster prices. Oil closed at $88.50.

The Dow rebounded from 11,645 on Jan-23rd to a high of 12,766 on Feb-1st. This was over 1100 points in only 7-days. The Dow held at that 12700 level for two days before beginning Monday's decline. The Dow lost -370 points on Tuesday returning to nearly 12250 at the close. That was nearly -500 points off the Feb-1st high. The volatility in 2008 has been extremely high with nearly every day a triple digit day. It has been the most opening year volatility ever. Traders are calling this the hardest market to trade in the last 10-years. The VIX hit 36.48 back on Jan-22nd when the SocGen futures sell was tanking the markets. It has been holding just under 30 for the last two weeks and inflating option premiums. The Dow has decent support at 12150-12200 and odds are very good we will test that at the open on Wednesday. This could be seen as a successful retracement of the January gains. The bottom is about 550 points below 12200 but technicians are saying they do not expect a complete retest of all the gains.

DDow Chart - 60 Min

S&P-500 Chart - 60 Min

The S&P lost 58 points since Friday's close and that was the worst 2-day loss in 5-years. The S&P is down -8.9% for the year and according to S&P that is the worst year-to-date decline in the history of the index topping the 7.95% drop in 1939. The S&P closed at 1337 and has decent support at 1335 and the Jan-25th low. If the S&P holds this level it would also be seen as a successful retest. The 2-day lows from January were right at 1275. A retest there would involve significantly more pain. One technical factor that deserves a mention is the 50% close on the S&P. The close at 1337 is almost exactly a 50% tracement of the gains made from the January lows. A 50% retracement is sometimes a launch point for a continued rebound.

TTThe Nasdaq failed to rally as high as the Dow and S&P and has already declined back to initial support just over 2300. The Cisco earnings will have a large bearing on Nasdaq performance but they won't be announced until after the close on Wednesday. A quick review of the Nasdaq majors shows most of them at support or very near it and a break of 2300 would only occur if those major stocks suffered significant breaks of their own. The big cap Nasdaq 100 closed at a new 52-week low at 1775. It has traded below that level twice in January but never closed there. 1700 would be the intraday support low.

Nasdaq Chart - 60 Min

Russell-2000 Chart - 90 Min

On Sunday I suggested using the Russell-2000 as our benchmark index for the week. The Russell had outstripped the big cap indexes with its gains over the prior week. With the Russell closing at resistance of 730 I suggested entering longs over 732. That did not happen and we declined from the open on Monday. I suggested buying a dip to 715 and remaining flat or short under 715. Since the Russell gapped down to 711 at the open today that short or flat under 715 recommendation would apply. I discussed that 685 was the next serious support level but I did not expect it to occur. After looking at the chart again today I still do not expect that 685 level to be broken. The Russell ran ahead of the other indexes and then lagged on today's decline. As long as that 685 level is not broken my market bias is still positive. br>
II wanted to believe all day that we were seeing some kind of retest capitulation event but the volume did not support it. Volume did not break 8 billion shares and there was no material change in new highs/lows. This was just a mediocre sales day according to the internals with an imbalance in the A/D volume. Tomorrow could be different. If this is just a retest event then the open could be negative as those long on margin dump positions. That could easily produce a retest of the initial support. If that test fails then all bets are off. The TRIN numbers in the market stats graphic at the start of this commentary show extreme oversold conditions as the market closed. That may not reverse immediately but it is a factor to watch.

Market Internals

At this point I believe we are setting up for a retest of some sort of the January lows. How extensive that retest will be is anybody's guess. I would still be a buyer of a bounce from Russell 685 but I believe we need to wait for the market to steady before making any move. The triple digit reversals in both directions are making it an impossible task to buy and hold anything. Eventually this will calm and the markets will begin to trend once again. You may remember the markets last summer when we were topping and changed directions almost daily. That same process can happen as we try to find a bottom. Once that bottom is behind us the resulting rally could be very long and strong. Rallies out of recessions, real or imagined, tend to run for double digits and for many months. We just need to be ready when it finally comes. Letting the market subtract money from our account every time we try and buy a dip reduces our available investment cash once a real rebound appears. Be patient and let's watch the gyrations from the safety of cash. We can still play the dips and spikes with a token amount of money but keep your Scrooge McDuck fortunes locked safely in reserve for the eventual charge higher. There will be plenty of time to hop on the train as it leaves the station. There is always the chance that this could turn into a full-blown recession and this market dance at these levels is just the prelude to a much larger drop. Until we know for sure we need to be cautious about loading up with longs until it is clear the bottom is behind us.

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Jim Brown
 

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