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Market Wrap

Not A Fun Week

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A -561 point loss by the Dow and -108 on the Nasdaq does not qualify for the record books but it does create a lot of pain. For the record the Dow gained +535 the prior week so a dip back to 12150 could qualify as a retracement rather than a new leg down. The economic calendar was very tame with only the normally ignored ISM Services to rock the boat. When it came it was more like a tidal wave than an ignored report. Add in the cautious comments from Cisco and the prior week's rally was scuttled without any material breakout effort. Rallies were sold and despite some Friday afternoon short covering the Dow closed near its lows.

Dow Chart - 60 min

Friday had no material economics and that trend will carry over into next week with only a couple of significant items. The Retail Sales numbers for January will be released on Tuesday and expectations are for a drop in sales of -0.3% as consumers hoard cash to pay for holiday bills. On Friday the Industrial Production for January is expected to be nearly flat with only a +0.1% gain and Consumer Sentiment is expected to decline again to 77.0. It is a stretch to expect the market to really react to any of those reports. The following week will see the economics begin to ramp up again with the CPI and Philly Fed Survey leading the list. Until then it is just another week of filler. I added the various speeches by Fed officials to the calendar since the outlook for the Fed appears to be changing on almost a daily basis.

Economic Calendar

The earnings parade will also slow with only 341 companies reporting compared to more than 700 last week. There are only a couple of brand names that most traders would recognize. Applied Materials and Expeditors International will be watched for news on the chip sector and the shipping sector. There are several energy companies reporting including XTO, TOT, COG, FDG, ECA and PTEN. Abercrombie & Fitch rounds out the list when they report on Friday. The earnings parade is coming to an end with the equine cleanup crew visible in the distance. After the potential droppings from next week's group they are going to need some big shovels.

Earnings Calendar

It was a bad week for AMD. After opening on Monday at a new 6-week high of $8.07 it was downhill from there. On Friday Dell announced it would no longer sell computers on its website with AMD processors. You can still call Dell and request one be built but they will not be advertised on the site. Dell will still market AMD computers through some discount retail outlets where low prices are the only consideration. Any AMD PCs sold there will be the very cheap extreme low margin products. This is a major blow for AMD and their continuing battle for profitability. For the week AMD lost 20% of its value by Friday's close.

MGM Mirage (MGM) now expects Q4 earnings to be in the range of 39-44 cents and well below the consensus estimates of 55 cents. MGM stock fell -5% or -3.88 on the news. MGM actually raised its guidance for Q4 but that guidance included things like hurricane insurance payments in the mix. Minus items it looks grim. UBS said they were even more concerned with softness in Las Vegas revenue for January. Revpar is still expected to have risen in January but much less than prior expectations. UBS lowered their rating on MGM to neutral. All the casinos must be hurting because hardly a day goes by that I don't get 2-3 letters with special offers at various casinos. I don't remember receiving the same volume of advertisements for any period over the last 10-years.

Weyerhaeuer (WY) posted earnings that missed estimates with profits that fell -19% over Q3. The drop came from a significant drop in volume caused by the slowdown in homebuilding. WY said the slowdown in building was not over and they forecast significant losses in Q1.

The fuse is growing shorter at the bond insurers and there is a good chance we could see a tape bomb explode next week. There has been no bailout announced yet and while the participants still believe there is hope everyone concedes the discussions could fall apart at any time. The rating agencies are literally crushing the life out of the discussions with almost daily press releases about the impending downgrade of the companies. This was a major factor in the weakness of the financial sector over the last week. Analysts are afraid a deal will not get done OR that the banks in their desperation will give up the farm to shore up the insurers and avoid another write-down cycle. MBIA managed to float $1 billion in stock at $12.15 on the hopes a deal is going to get done. MBIA stock closed at $14.90 before the announcement. Goldman Sachs was the spoiler and immediately cut its price target to $12 after the announcement. Next week is seen as the make or break week for the three companies under the gun, MBI, ABK and FGIC. If a deal is not completed the rating agencies are expected to follow through on their threats to drastically lower ratings on the three and force write-downs on hundreds of billions in bond/CDO debt. With $2 trillion of this debt as a foundation under the major banks any downgrade will turn that foundation into a house of cards.

Fannie Mae (FNM) is expected to report decaying credit quality in its mortgage portfolio according to Morgan Stanley. In November Fannie said 0.9% of their single family loans were seriously delinquent. That is expected to climb sharply in Dec/Jan despite the falling interest rates. Fannie has $2.4 trillion in mortgage loans on its books. Morgan Stanley said delinquency trends and transition rates have deteriorated over the last several months at an accelerating pace. FNM fell -4% on the news.

While I am on the topic of mortgages I should mention that Friday was the one-year anniversary of the subprime crisis. It was last February when HSBC brought the word subprime into the daily news when they reported write-downs of $10.5 billion due to subprime problems. This started the cascade of announcements from other banks and now a year later those announcements are still occurring. The bond insurer problem is just the last chapter in the subprime saga.

Bernanke and Paulson have been summoned to the hill for testimony next Thursday and it is not for a valentine party. They will be grilled on the economy and the health of the banking system. San Francisco Fed President Janet Yellin hinted in a speech on Friday that there could be more rate cuts ahead. She said the U.S. may avoid a recession but more cuts could be necessary. Cleveland Fed President Sandra Pianalto said the "economy is in the midst of some very difficult times." Atlanta Fed President Richard Fisher said the steps already taken are likely to mitigate the downside risks to growth suggesting he would continue to oppose future rate cuts. Fisher was the only dissenting vote on the last rate cut. Fisher believes the risks to inflation remain and should be feared. Richmond Fed President Jeffrey Lacker and Philly Fed President Charles Plosser echoed those same inflation concerns. It appears to me that the Fed is setting the stage for taking a pass on further cuts at the March 18th meeting and the market is also picking up on those clues.

Amazon helped lift the Nasdaq out of a slump on Friday with an announcement it will buy back up to $1 billion of its shares or roughly 3% of the outstanding shares. They probably need some for employee stock options. AMZN, a major Nasdaq component, gained +$2.59 for the day. Apple (AAPL) +4.24 and RIMM +4.76 also contributed to the gain.

CNET rose +8% on a rumor that Google might be interested in acquiring a stake. Google declined comment and Pacific Crest Securities said a Google interest was "highly unlikely." Options volume spiked to 31 times the normal level.

The acquisition of Lucent by Alcatel was supposed to rescue Lucent from the ruins of the telecom sector and create a giant that would have pricing power and plenty of business. The merged company Alcatel-Lucent (ALU) posted a $3.76 billion loss for Q4 and $5.12 billion for the full year. To be fair the majority of that loss was write-downs to the reduced value of the assets acquired in the Lucent deal. I question the rationality of paying $11 billion for a company and then writing off $5 billion in the first year but that is business as usual. Based on recent reports there is a lot more to come. ALU said it will cut 12,500 more jobs, adding to the 6,700 cut in 2007 and bringing the total workforce down to 77,400. On the bright side revenue was up +18% for the quarter to $7.61 billion. Once they fire all the Lucent employees and write down all the assets to zero they should be able to make a profit. It won't be in the first quarter since ALU warned they will lose money in Q1 due to a revenue drop of 20-25%. ALU has fallen from $14.50 back in July to close at $6 on Friday. Lucent closed at $2.55 the day the deal closed on Nov-30th 2006. Each LU shareholder got 0.1952 of an Alcatel share for every share of LU they owned. ALA was trading at $13.25 the day the deal closed. With the merged company now trading at $6 that 0.1952 fractional exchange is worth less than a fountain Coke.

March Crude Oil Chart - Daily

Crude oil exploded for a gain of +3.78 to close at $91.89 on multiple news events. Shell said oil exports from Nigeria could fall by as much as a million barrels per day in February and March due to a deteriorating security situation and planned maintenance. That is an increase of 130,000 bpd from prior outage levels. Total said production from the North Sea was cut by 280,000 bpd due to technical problems. There was also news that output from a Russian field could fall sharply due to rising depletion rates. Exxon won a battle in the war with Venezuela but the war is far from over. Exxon was kicked out of Venezuela last year after Chavez nationalized the Exxon facilities in the Orinoco oil belt. Exxon took Venezuela to court in several countries to recover billions in lost assets. A British high court froze $12 billion in PDVSA assets in England until further notice from the court. Courts in the Netherlands and Netherlands Antilles also issued similar orders for up to $12 billion each. Exxon also has suits in the U.S. against Venezuela assets. A U.S. court froze $300 million in assets in December. Exxon can't go after assets in Venezuela because the government there just levies fines for previously undisclosed offenses or claims previously unknown taxes to offset any asset recovery award. Outside Venezuela they don't have that option. Exxon should eventually be successful in their suit but it could take years. Venezuela knew the freeze was coming and changed the terms of their oil sales two weeks ago to cash in advance instead of the normal terms. If I were going to buy oil from Venezuela I would think twice before laying down $90 million per tanker load in hopes that Venezuela would actually deliver. Chavez is running out of money to fund his programs meant to keep him in office. He has nationalized banks, telecoms, utility companies and just about everything else that generates cash every month. He has run out of nationalism targets and existing cash flow is drying up without the use of operating funds to continue to operate the businesses. If Exxon is successful in getting additional funds and assets seized in the U.S. it could squeeze Chavez and an already unstable country to the point where Venezuela oil shipments are slowed. This potential helped provide the boost to crude on Friday. If the world really had two million barrels per day of excess production capacity like OPEC and the various government agencies claim these types of news events would not cause nearly a $4 jump in crude in one day. Crude prices are volatile because we don't have that spare capacity where all we have to do is turn a valve and let it flow. Get used to the volatility because it will only get worse as we get closer to the peak of production.

The Dow lost 561 points for the week. This was the worst week since March 2003 but that was only a 4.4% drop. The banking sector lost 8% and the homebuilders lost 11%. Those two sectors were responsible for the majority of the market losses. Actually there were a lot of reasons for the selling but nothing we didn't already know about except maybe the Cisco comments. We knew about the bond insurers, subprime mortgage defaults, credit card defaults, recession worries and the Fed decision. Unfortunately those factors have each taken on a life of their own and a bear market mentality has formed. Dips were still being bought the prior week but the trend changed to sell the rallies once that ISM number scared traders with the magnitude of the drop. I still have not heard anyone talking about the new methodology influencing the number but that is water under the bridge today.

The reality of the markets boils down to actual market activity not what traders want to believe. There are a lot of people who still want to be long but Trimtabs.com said on Friday $9.2 billion was withdrawn from mutual funds over the past week. This compared to $1.5 billion in inflows the prior week. Investors are starting to believe the recession worries and money is leaving the market. We know historically that recession bottoms typically lead to monster gains but the key word there is bottom. With the homebuilders, suppliers like Weyerhaeuser, freight companies like YRC Worldwide and now Cisco telling us that the future still looks weak, many investors are suddenly becoming believers. The cult of the recession bear is growing and volume surges are coming on the dips instead of the spikes. This is not a good sign for the bulls.

The Dow failed at 12750 resistance on Monday and found light support at 12125 on Thr/Fri. The key question here is will that support hold or are we looking at a retest of the 11650 lows from January. In round numbers that would be another 500 point drop and take the Dow to -18% off the all time closing high in October of 14,164. We were there just three weeks ago so there is no reason why we can't return to that level. Granted the first trip was induced by the two day $73 billion futures dump by SocGen but that drop did clear out a lot of support on the way down. In reality Dow 12000 is more visible support and a more likely stopping point on any continued sell cycle. The volume has risen but it is only about 65% of the volume we saw on the SocGen futures dump. Bearish conviction may be increasing but the internals are not showing any massive imbalances. We are looking at more of a buyers boycott than a selling frenzy.

The S&P and the Dow are similar in pattern with current weak support around the Jan-22nd congestion at 1320. Both could easily crumble and retest the January lows without much effort. That low on the S&P is 1270.

S&P-500 Chart - 90 Min

Nasdaq Chart - 90 Min

The Nasdaq broke through support at just over 2300 on Thursday and fell to 2250 on the Cisco earnings news. That low is just 45 points above the low set on Jan-23rd at 2205. For all practical purposes Thursday's dip could be considered a valid retest. Or it could just one more interim low on the way to 2200. We won't know until we can look back several weeks from now and see the chart.

For the last week I recommended using the Russell 2000 as our indicator with a dip buy at 685 support. The Russell came very close with a drop to 688 and a nice rebound on Thursday. Friday's loss was a miniscule -4 points. It appears there were some buyers nibbling at support the last 3-days. The loss for the week was the same -4% as the other major indexes but it started from a stronger relative position after the prior week's big gain. My recommendation this week is going to be the same. Buy a dip to 685 and remain flat or short under 685. Add another dip entry buy at 660 just in case 685 breaks. These may only be trades rather than long term holds but any successful trade is still a win.

Russell 2000 Chart - 90 Min

The indexes fell over 4% over the last four days. You would think that would produce perfect conditions for an oversold bounce. However, the slowness of the drop except for Tuesday really kept the oversold conditions from building. From where we are sitting this weekend anything is possible. I personally believe the bond insurer scandal is the biggest pressure on the market. Everybody got excited a couple weeks ago when it appeared a deal might get done. All that excitement has turned to fear with insiders being quoted on Friday as saying it may not ever happen. All the major banks have tens of billions in additional write-down exposure if no deal appears.

Goldman Sachs thinks the total write-down exposure is over $400 billion. Fitch warned in the Wall Street Journal on Friday that there could be $139 billion in additional losses from individuals walking away from mortgages even before foreclosure because the homes had dropped in value. Fitch expects 26% losses on all subprime loans written in 2007. Defaults on credit cards rose to 7.6% in December. Credit card debt is bundled and sold in CDOs just like mortgages. The $2 trillion CDO market is in lockdown. Nothing is being traded and these were as liquid as cash in the past. The following chart tracks the value of a group of BBB CDOs. These CDOs in this index were written by companies including Morgan Stanley, JP Morgan, Merrill Lynch, Bear Stearns, Carrington, Citigroup and others. These CDOs are currently worth roughly 14 cents on the dollar. This is an example of how the $2 trillion CDO market is being valued. The possibility of massive additional write-downs is guaranteed unless a miracle occurs in the CDO market. It also illustrates the challenges of trying to construct as bailout of the bond/CDO insurers. Who in their right mind would want to take on that exposure?

Markit.com ABX Chart

This makes the bond insurer bailout problem even more critical.

Investors are selling the banks like the outcome was already known. Given the loose lips inside that community it may already be known and they just have not told us yet. Regardless of the outcome the markets are going to move by hundreds of points when it is announced. Hopefully with all the interested government agencies a deal will be forced rather than allow a melt down of the system. While a bailout would be the desired result we have to be ready for either eventuality. Actually regardless of whether they announce an outcome next week or not we need to trade what the market gives us and not what we want to see. Watch Russell 685 for directional guidance with 660 as a secondary support level.

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