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Market Wrap

Growth, Recession or Inflation?

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You could build a case for all of the above depending on what timeframe you were discussing. Every speaker to the microphone last week was singing a different tune and the market reflected the different notes. Speakers seeing growth instead of recession tended to push the market higher and those calling for tough times ahead greased the skids for a decline. The rise of the inflation discussions helped add speed to that decline on fears that the Fed would not cut rates again. It was a rocky week for the markets with the economic cross currents producing the waves.

Dow Chart - 120 min

Friday's economic reports showed increasing weakness in some areas and increasing inflation in others. The Consumer Sentiment fell to 69.6 for February from a reading of 78.4 in January. This was the lowest reading since Feb-1992. This level of confidence is consistent with past recession levels. The expectations component fell to 59.1 from 68.1 and the present conditions component fell to 85.4 from 94.4. Inflation expectations rose to 3.7% after three months at 3.4%. This was a bearish report since it indicates how consumers will be spending their money.

Consumer Sentiment Chart

The NY Empire State Manufacturing Survey fell -21 points from 9.0 to -11.7 in February. This was a massive drop and completely out of context with the last 12 months. This is the lowest reading since May-2005. New orders dropped 12 points to -11.9 and shipments fell 20.7 points to -4.9. The only component that rose was the prices paid index which rose to 47.4 from 40.2 indicating inflation is still rising. The employment components fell with both the hours worked and number of employees declining. This was also a very bearish wakeup call.

Empire Survey Chart

Inflation is not rising just in the U.S. according to the Import & Export price report. Import prices were up 13.7% year over year in January and the largest year over year increase since 1982. Prices from China were up 0.8% and the 9th straight monthly gain. Petroleum prices rose 5.5% for the month but non-petroleum prices are still up 3.6% for the trailing 12 months. Overall import prices rose 1.7% in January.

The economic calendar for the last two weeks has been light but that is about to change. The critical reports for analysts and the Fed begin on Wednesday with the Consumer Price Index (CPI) and the Philly Fed Survey on Thursday. After the Empire Survey I am afraid to see what the Philly Fed Survey will bring. The consensus is for a rise from the very bearish -20.9 in January to "only" -12.0 in February. I wonder if they are still expecting a snap back in the data after the serious drop in the Empire Survey?

January Philly Fed Chart

The market is closed on Monday for President's Day and there are no economic reports. There are a couple housing reports on Tue/Wed but I doubt anyone expects a miraculous recovery. The biggest event of the week could be the FOMC minutes for the January meeting where the Fed cut 50-points with one dissenting vote. It will be interesting to see how the internal discussions impacted the decisions. Did a couple others vacillate and then cave in at the last minute or was it a unanimous front? I doubt we will actually see any bickering in the minutes but you can bet it is there if you read between the lines. The Fed meets again on March 18th and so far gentle Ben has been indicating another rate cut in his choice of phrases when he testified last week. Greenspan refuses to go quietly into the night and was on the podium again in Houston at an energy conference. He said the U.S. now has better than a 50% chance of a recession. That is up from his 33% call a few weeks ago. I guess sticking with the 33% chance is old news and he needed new headlines to sell his book.

Economic Calendar

In the Business Council CEO Summit Survey last week 81% of CEOs expect "sluggish growth" in the U.S. in 2008. That is still growth and not a recession but the qualifier was for all of 2008. Q1 could recede and the rest of the year rebound. 54% of CEOs expect profits to slow but only 18% expected profits to drop. That is still pretty good news if more than half still expected profits to grow but only at a slower pace.

It is a pretty good bet the banks are still going to see profits fall in Q1 given the rate they are writing down subprime assets. UBS added $13 billion in write-downs when they reported earnings last week and brought their total to $18 billion in subprime write-downs so far. Citigroup said on Friday that UBS could be forced to write off another $18 billion in 2008. UBS still has $30 billion in exposure to subprime. UBS posted a loss of $11.28 billion for the quarter and the first loss since 1997. A Bear Stearns analyst said the UBS earnings raised greater concerns that any further 2008 write-downs could be major.

Fortunately these banks are writing down assets not writing them off. They will eventually see those subprime loans and CDOs recover some portion of their value. With the CDOs trading at 15 cents on the dollar today even a minor recovery to 50 cents would be a 200% rebound. That sets the financials up to post some monster gains late in 2008 and early 2009 with comparison numbers the worst they have been in decades. It would be nearly impossible without a nuclear war for the banks to post any lower earnings in 2009.

The bond insurer saga may have turned positive last week despite an attempted headline grab by Elliot Spitzer. After a week of meetings over the crisis Spitzer said a decision had to be reached within 3-5 days or the State of New York might act to breakup the companies into their component parts. He said the preferred route would be for them to recapitalize but that did not appear to be happening. "Speed is important at this point" Spitzer said and when questioned again later he added the 3-5 day window. On Friday FGIC announced they would split their company into two parts with the bond insurance portion breaking away from the toxic waste portion that guaranteed subprime CDOs. FGIC was downgraded by Moody's to A3 from AAA and said the FGIC balance sheet had materially weakened due to CDO deals. FGIC is owned by the PMI Group and three private equity firms. The top four bond insurance firms, Ambac, FGIC, SCA and MBIA collectively insure $1.7 trillion in debt with the majority of that in municipal bonds.

We heard from the various meetings last week that MBI and ABK were not in danger of going under and were still able to pay their claims. Both disclosed their capital reserves of several billion each but that is not really the problem. The problem is their reserves have fallen to levels that do not support their previously fictitious AAA credit ratings. To regain that rating they would need tens of billions in new capital or to split their business models to allow the low risk bond business to be recapitalized and reviewed by the rating agencies to recover their AAA rating. I said at the beginning of this topic I thought I detected a change in the bias but so far it is just a glimmer of hope and not a groundswell of returning confidence. The XLF actually rose slightly on Friday despite the ugly intraday drop in the major averages. The S&P-500 closed in positive territory thanks to the gains in the financial sector.

Countrywide reported on Friday that delinquency rates rose to 7.47% in January compared to 4.32% in Jan-2007. Countrywide has about $1.48 trillion in mortgages in force. Foreclosures pending rose to 1.48% in January compared to 0.77% in Jan-2007. These numbers continued to spike higher despite the massive effort underway to offer options to those in trouble. Mortgage fundings fell to $22 billion in January compared to $37 billion in Jan-2007. Mortgage loans in the process of being funded rose to $51 billion compared to $35 billion in December. Refinancing applications made up the majority of that increase. Home equity loans fell 93.6% to only $872 million from $3.6 billion a year earlier. Adjustable rate mortgages being processed fell 79.5% to $2.8 billion from $13.7 billion in Jan-2007. Could it be that borrowers have learned their lesson?


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After several weeks of gains coal stocks went from being the new green back to being black dust and unloved on Friday. Goldman kicked the sector back to the cellar with a note to investors and a lowered rating. The GS analyst lowered his rating to cautious from neutral saying the record prices and strong demand will not last as long as Wall Street currently anticipates. He said the perfect storm of winter weather and supply problems was just temporary and the market would return to balance soon. The average share price of coal producers had risen 30% since mid January and the analyst expects a 20% drop as winter eases, supplies rise and prices fall. Prices of coal stocks fell an average of 6% on the news with Peabody the least impacted at -3.6%.

Best Buy (BBY) warned that fiscal 2008 profits would be lower than expected due in part to lower sales in January. BBY now expects to earn $3.05-3.10 compared to $3.10-3.20 in prior guidance. BBY expects sales of $40 billion in 2008 and same store sales growth of 2.5-3.0%. Previously they had expected 4.0%. A BBY customer sued them for $54 million because they failed to protect her laptop when it was in the store for repairs. The laptop was returned for service in May and BBY kept her giving her the runaround about when it would be fixed until they finally admitted on August 9th it had been stolen sometime before May-25th. During that period she could have taken steps to protect herself from identity theft if she had known it was stolen. BBY offered her $2500 if she would agree not to disclose the problem and she refused and took her complaint to court to try and force BBY to change their practices.

Wal-Mart (WMT) reports earnings on Tuesday and analysts are mixed over what to expect. WMT cut prices to the bone in December and the ploy worked with same store sales rising 2.7%. Conditions worsened in January when shoppers redeemed gift cards for necessities and low margin food when they redeemed the cards. Sales rose only 0.5% when analysts were expecting 2.0%. After the bell on Friday WMT announced it was going to support only the Blu-Ray DVD format and phase out any HD-DVD offerings. WMT joined Netflix and Best Buy, which made that same decision earlier in the week. Looks like it is lights out for HD-DVD and higher prices ahead for Blu-Ray now that the competition is over.

Both Wal-Mart and Best Buy are going to see a great second quarter boost. The stimulus package checks are going to be mailed in May and they are already being called the "free TV check." Those two stores will benefit the most from the free money. Those struggling to get by will rush to Wal-Mart to buy necessities and those higher up the food chain will see it as a chance to upgrade their electronics to either a new flat screen TV, Blu-Ray DVD, Xbox, or Sony PlayStation. It is conceivable $50 billion of the payout will end up in the registers of BBY/WMT.

Also on the earnings schedule for Tuesday are HPQ and CROX. Hewlett Packard (HPQ) is expected to report 81-cents for Q4 with revenue of $27.6 billion. Sales of computers were strong going into Q4 but skidded to a halt as the subprime worries put companies on the defensive and froze budgets. However, HPQ does 70% of its business outside the U.S. and may not have been impacted as much as some analysts believe. Goldman Sachs said no tech company is immune from the slowdown but with the greatest geographic diversity and currency exchange benefits HPQ could have greater earnings resiliency. One analyst is calling the earnings report for CROX as the most important in their history. CROX is still oversold and heavily shorted but support is holding at $32. The market is still pricing in a continuation of their problems in the Q3 report of excess inventory and slower sales. The massive sell off has knocked them back to a PE of 12 times earnings and that is very bullish if sales are even minimally decent. The odds are very good there will be a monster move after the event but it is tough to tell in advance which story to believe. Straddle anyone?

I am sure CROX holders are hoping for a PriceLine event next week. PriceLine (PCLN) spiked $21 on Friday after reporting earnings of 96-cents when analysts were expecting only 84-cents. They also raised guidance by about 10-cents for Q1 and 20-cents for the year thanks to a strong 62% jump in bookings. Goldman Sachs raised their target to $140 from $130 and said the global expansion was insulating them from consumer weakness in the USA.

Oil prices continued to rise to close at $95.69 on Friday and traders are talking about $100 once again. The Venezuela crude cut and OPEC sound bites are reportedly putting a floor under prices. In reality I think it is due more to expiring futures next Wednesday and short covering that is pushing prices higher. This is typically a month where crude prices fall as winter demand begins to ease. Cold winter weather, production cuts for various reasons around the world and the Venezuelan embargo of Exxon caused those shorts to run for cover with only a couple days left on the contract.

March Crude Oil Chart - Daily

Rewind to January 21st and our last 3-day weekend. SocGen began dumping $73 billion in futures on the Monday after option expiration with the U.S. markets closed. A monster sell off in the global markets carried over into the U.S. markets when they reopened on Tuesday. Fast-forward to February 18th and the U.S. markets are closed for 3-days once again. While nobody expects the SocGen implosion or something like it to happen again there is no doubt that traders still licking painful wounds from the January event were lightening up on stocks on Friday morning. There were also the option expiration pressures. With the markets trading mostly sideways for the last three weeks there were a lot of options expiring close to where they were written. I scanned a lot of stocks this weekend and quite a few were pinned almost exactly to a strike price with minimal volatility over the last couple days. It appeared market makers and traders were simply content to let February expire calmly and without a lot of drama in the form of volatility.

I think the markets did remarkably well on Friday given the horrible recession/inflation data, option expiration and the 3-day weekend. After nearly a 100-point intraday drop the Dow recovered to end down only 28 points and right in the middle of its recent range. No harm, no foul and this was a killer week in the way of news events and high profile speeches. The Fed still appears to be willing to cut rates although reports over the next two weeks could dull that hope. Almost everyone agrees Q1 could be the bottom for earnings and with the Fed's aggressive posture this recession or soft patch should be short and nearly painless relatively speaking. This does not mean the market is about to explode higher and there is still the chance of a retest of the lows. However, with each passing day the chance of that retest dwindles. If the bond problem appears to be finding a solution then the market bottom is behind us. The key there will be the solution.

Friday was also the last day hedge fund investors could request a withdrawal of their funds at the end of March. There is a 45-day notice period ahead of the quarter end and that period began this weekend. If your withdrawal request was not filed by Friday you are out of luck until the end of June. Since the various funds are probably doing better than the individual investor in the current market they were probably able to prevent a mass exodus. Of course any notices received don't need to be acted on for a few more weeks. They have to plan for the withdrawal but not necessarily race for the exits next week.

The Dow traded in a 502-point range for the week (12070-12572) and closed almost in the center of that range at 12350. There is nothing to be determined from this range bound trading except that 12275 appeared as light support on Friday. If traders clearing up some option positions and lightening the load before the weekend were the cause of the minor loss then next week could see us retest the upper end of the range. That assumes there is no meltdown around the world on Monday.

Personally I was not impressed by trader conviction this week. Only one day managed to break 7 billion in volume and the new 52-week lows are starting to climb to 3-week highs. Volume for an option expiration week was extremely light and I think it was because nobody knows where the market is going. Everybody is waiting on the sidelines for a direction to appear. Volume in the high 6-billion range is very anemic for any directional view. It shows an extreme lack of conviction by both bulls and bears.

Internals Table

Tech stocks faired a little worse on the width of their range but still managed to close right in the middle of that range. Hewlett-Packard will be the key for techs next week. Their earnings on Tuesday will be the event that will provide traders with some comfort or smack them right between the eyes if HPQ misses badly. Nasdaq 2310 continues to be support and 2375 resistance as we await that earnings report.

Nasdaq Chart - 120 Min

S&P-500 Chart - 120 Min

The S&P closed nearer the upper end of its range than the Dow/Nasdaq. I believe this was due to the buying in the financial stocks. With financials accounting for 21% of the S&P any gains there are bullish for the index. Initial support at 1340 with stronger support at 1320. Initial resistance at 1365.

The most bullish index was still the Russell-2000 with a decent 4-week higher low trend still in place. The high for the week on Thursday at 721 was above the same relative resistance of the other indexes. Until this uptrend fails I would continue to be mildly bullish. I emphasize "mildly" because the Russell uptrend is only slightly bullish and definitely not a screaming buy. I would continue to watch it as our market sentiment indicator and buy the dips back to 685.

Russell-2000 Chart - 120 Min

The biggest problem facing the markets over the next couple weeks could be rising fears over the return of stagflation. That is rapidly rising inflation and very low economic growth. The Fed becomes trapped between their desire to combat the low growth but can't continue to act aggressively because of rapidly rising inflation. The reports we saw last week definitely showed signs of this condition. The last time we really had serious stagflation was the late 1970s when growth slowed to a crawl and interest rates spiked to 18%-19% and homebuyers disappeared. If inflation in the CPI report next week continues to spike higher we could be looking at another Fed disaster in the making. The market would not look positively at rapidly rising inflation in those critical reports over the next two weeks.

Jim Brown


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