Option Investor
Market Wrap

Trapped and Confused

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The markets ended mixed for the week but that was only the result of news-triggered short covering right before the close. It would have been much worse without that news. The Dow was down about 135 points at 3:30 when CNBC broadcast news that an Ambac bailout could be announced on Monday or Tuesday. Financials exploded as shorts covered and the Dow rallied +230 points to end with a 96-point gain. That end of day spike rescued the Dow from posting a losing week but even with a +35 point closing spike on the Nasdaq it still lost nearly 20-points for the week.

S&P-500 Chart - 90 Min

The economy weighed on the markets as well as the continuing bond insurer saga. The inflation monster and his cousin stagflation appear to have awakened and are prowling about like roaring lions looking for investments to devour. The Consumer Price Index last week showed headline inflation rose +0.4% in January and core inflation rose 0.3%. That does not sound like a big jump but taken in context headline inflation has risen 4.4% over the last 12-months and at an annualized 6.8% clip over the last 3-months. Core inflation rose 2.5% over 12 months and annualized at 3.1% over the last 3-months. The energy component to the CPI increased at 2.4% over December and a 19.6% rate for the last 12-months. Dallas Fed President Richard Fisher warned on Friday that the Fed must be wary about feeding inflation as it cuts rates to fight the low growth environment.

This rising fear of inflation put a damper on the expectations for the Fed to continue cutting rates. The Fed Funds Futures still show a 124% chance of a 50-point cut in March but investor sentiment about that cut is falling fast. That sentiment decline is depressing the equities markets on fears the Fed will be hesitant to cut further and even worse hike rates sooner than previously thought to counteract rising inflation. In the FOMC minutes of the January meeting that were released last week the FOMC discussed a "rapid reversal" of existing rate cuts if inflation continued to rise. The Fed is clearly between a rock and a hot place. The rock is the stagnant economy and the heat is the rising inflation. They have to change one of those factors quickly or be faced with an even worse problem down the road.

Next week has a very full economic calendar highlighted by the PPI, PMI, GDP and twin testimonies by Bernanke. The economic roadmap is going to be liberally peppered with land mines in the form of reports that spell out the slowing growth and increasing inflation. It is not going to be very market positive unless the bulls have strapped on their wall of worry climbing apparel. There should be plenty of details to worry about.

On Monday the Chicago Fed National Activity Index (CFNAI) is expected to show a further deterioration from the 12-month low posted in December. The index was already in contraction territory with a -.91 reading and it is expected to show further weakening in January. Existing Home sales are expected to show another decline as willing buyers suffer through the nearly impossible home loan torture test. With bank credit at a standstill and nearly $100 billion in secured loans currently unsold and searching for buyers it is nearly impossible to get a mortgage unless you have perfect credit, cash in the bank, spotless tax returns and a buyer for your old home with the same qualifications. Very few Americans are that lucky.

Economy.com reported on Friday that 10.3% or 8.8 million U.S. homes were now worth less than their mortgage balance. With little in the way of a rebound in values projected over the next two years many of those buyers are electing to walk away from their homes and mortgages rather than continue making the escalating mortgage payments. Many of these people are leaving well ahead of the foreclosure process and further complicating the housing picture. Realty Trac said on Friday that 1.5 million homes are still expected to foreclose in 2008. $2.1 trillion in mortgages or 19% of all mortgages outstanding were sliced and diced into mortgage backed securities (CDO/MBS) and sold all over the world. There were $625 billion in subprime loans written in 2005, four times the rate of 2001, and those loans written in 2005 are the ones resetting today and causing the mortgage problem.


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The S&P/Case-Shiller Home Price Index due out on Tuesday is expected to show another major decline in prices across the nation. The last report covering the November period saw a drop of -2.2% for the month and -8.4% for the trailing 12-month period. This is already the largest drop in the last 50-years. The New Home Sales report due out on Wednesday is expected to see annualized sales fall to the 580,000 range and a continuation of the 4.7% drop seen in December. This is down from the 1.4 million annual rate at the peak in 2005.

The Durable Goods report on Wednesday is expected to show a drop in new orders of -3.5% and a reversal of the +5.2% spike in December that was powered by a +138% jump in orders for defense aircraft. Unless the government bought another $50 billion in fighters in December the new durable goods orders are expected to plunge sharply. The next Q4 GDP revision will be out on Thursday and is expected to erode and possibly show a contraction. In the initial report growth for Q4 was seen as only +0.64% or extremely anemic. It would not take a very big revision to push it negative and increase recession fears.

The Chicago Purchasing Manager Index (PMI) for February will be announced on Friday and official expectations are for a drop to 50 and a level of zero growth. A reading under 50 would represent contraction and most whisper numbers are in the 47-49 range. Coming the day after the GDP revision it will be viewed as a more current look at Q1 economic activity. The following Monday the national Institute of Supply Management (ISM) Index will be released and expectations are also for a drop into contraction territory under 50.

Lastly Fed Chairman Ben Bernanke will give what was previously called the Humphrey Hawkins testimony on Wednesday and Thursday. This is the semiannual report to the House and Senate on the state of the economy. Whenever Bernanke has spoken in front of a microphone in recent weeks the market has paid close attention. This testimony is coming just a little over two weeks ahead of the next FOMC meeting on March 18th. The key phrases analysts will be looking for are the ones indicating the Fed's plan to cut rates again at that March meeting. Should his testimony focus more on inflation than growth the market will not react positively.

Given the increasing negativity in the recent economic reports I would say there was a greater potential for a negative result next week than a positive surprise. However, since everyone is so bearish ANY positive economic news could be followed by a short covering rally. Any positive news would have to be balanced with the likelihood of that "rapid reversal" of the Fed rate cuts so a rally is not a sure thing on positive news. It depends on what the news was and how it was presented.

Economic Calendar

The news rescuing the markets from a multi-week closing low on Friday was the announcement by Charlie Gasparino on CNBC at 3:30 that a deal was being finalized on Ambac. Gasparino said "significant progress" had been made and a bailout could be announced on Monday or Tuesday. The bailout would be a recapitalization of Ambac by a consortium of banks and would save the AAA rating for the bond insurer. The consortium of banks includes Dredsner, WB, UBS, RBS, C, SocGen, BNP and Barclay's. Reportedly the banks would provide a credit line and actual investment into Ambac. However, Gasparino stressed that the deal could blowup at any time. It was enough to move the market given the stress the bond insurer problem has been. Gasparino also reported that Channel RE, the reinsurance company for MBIA, had been downgraded by Moody's to less than AAA status. That puts more pressure on MBIA and its battle with the rating agencies. Reportedly the rating agencies have given regulators until Feb-29th to produce a solution or ratings on MBIA and Ambac will be sharply lowered. It may be this deadline that finally got everyone to get serious. However, it was only about an hour later that news began to break from Ambac that a deal was not imminent. Ambac said they were in talks with numerous parties and exploring all options including capital raises. An Ambac spokesman said we have no comment on a deal or the timing of a deal. They also said they did not see any deal as a bailout. The New York Times reported in its early Saturday editions that Ambac plans to split itself in two and hopes to raise $3 billion to bolster its finances according to a person who saw the plans on Friday. That does not sound like a bailout by a consortium of banks. Late Friday Citigroup said it had $4.02 billion in exposure to the monoline bond insurers. That would be a significant incentive for Citigroup to get a deal done.

The bond market has begun to freeze on another level according to recent reports. There are numerous instruments that banks, funds and institutions use to park money or guarantee yields. Some are called auction rate preferred securities and others are called variable rate notes. These securities are normally traded like cash and required only a phone call to liquidate. Reportedly there are over $100 billion of these securities that have gone off the grid. Dealers are refusing to buy them back and owners are being told to contact the tender agent to discuss repurchase. This has severely crimped liquidity in the marketplace and dealers have begun serving notice that transactions will be on a "best efforts" basis. For trading notes previously considered as liquid as cash this is a stark change. Yields have fallen from 2.5% to less than 1% while rates have spiked to 6% or even higher for debt backed by faltering insurers. American's typically take cash out of money market funds to pay taxes by April 15th. Same with corporations who file by March 15th and analysts claim there is an increasing liquidity problem in these notes used by money market funds to park money. If they can't resell them the money markets are going to be in trouble. Morgan Stanley said on Thursday there was $60 billion in failed auction rate debt that needed to be liquidated quickly but there were no takers. Northern Trust (NTRS) said it would provide $229 million in support to money market funds it advises that have exposure to notes issued by firms that have been downgraded. This is going to be a continuing pattern if something does not change soon.

We also heard on Friday that over the last 48 hours the major money center banks had suddenly begun calling buyers of debt and trying to unload tens of billions in leveraged debt at a loss. These banks had been reluctant to take a loss on the debt over the past couple months and preferred instead to keep it on the books rather than get killed in the frozen market. Something happened in the last 48 hours that changed that scenario. Now it appears they are in dump mode and it is not just one or two but all the major players suddenly are trying to unload failed debt. An example of this debt would be the $20 billion leveraged buyout of Clear Channel (CCU). Nearly all of the LBO debt incurred over the last six months is still on the books of the originating banks because there were no buyers once the credit markets locked up. If the banks are suddenly calling debt buyers and offering it at a substantial discount of as much as 60-75 cents on the dollar then what changed? Why the sudden rush by the majors to take additional losses. 99% of the debts will eventually payout so why rush to take a monster loss unless the liquidity crisis is deepening.

Merrill Lynch cut Fannie Mae (FNM) and Freddie Mac (FRE) to a "sell" on Friday saying the mortgage entities still did not reflect the severity or duration of the financial headwinds facing the companies. "Specifically, we think further deterioration in financial market conditions and worsening credit performance will undermine fundamentals and likely leading to further valuation compression." "We think Fannie and Freddie could retest 2007 lows and possibly incur new troughs as the cyclical downturn appears more acute." Both stocks were knocked for steep losses on the downgrade. Oppenheimer banking analyst Meredith Whitney said Citigroup had insufficient reserves and would be forced to cut its dividend again. Whitney also warned that financial stocks could fall as much as 15% to 50% in 2008. Bernstein cut estimates for BSC, LEH, GS and MS saying the brokers had significant exposure to depreciating asset classes.

Fannie Mae Chart - Daily

The cold front sweeping from the Midwest to the Northeast has been responsible for huge draws of natural gas from storage. That pushed prices on gas to $9.15 and a new 9-month high. With winter quickly drawing to a close this commodity may be running on borrowed time. Options on natural gas futures expire next week so expect continued volatility in those prices. Crude prices closed the week at $99 after a record run. You have probably heard the Boone Pickens quotes from Wednesday suggesting crude will decline to the mid $80 range as we approach the second quarter. High gasoline prices and slowing demand are contributing to the expected decline in crude prices. Pickens is a noted energy bull but he admitted he was currently shorting both natural gas and crude. OPEC meets on March 5th to discuss production quotas but no changes are expected. Once that event occurs the support for crude should evaporate. Several prominent analysts including Pickens are expecting $107-$120 by year end so this is just a temporary decline if it appears at all.

If your electricity is costing more this winter you can expect it to go up even more next summer. Coal accounts for 49% of the electricity generated in the U.S. and coal prices are exploding. In an interview with a coal executive on Friday who also agreed with comments from Boone Pickens the demand for electricity and coal was going to continue. It appears to be a consistent fact that we need to add 15% additional electrical generating capacity by 2020 and much of that capacity will be coal whether we like it or not. There are a number of nuclear plants being discussed but extremely high costs, long lead time and availability of fuel for those plants is a serious problem. Coal continues to get a bad wrap for pollution but when the rolling blackouts begin because of insufficient generation capacity it is always coal that jumps to the front of the discussion. Coal plants can be built from scratch in about 2 years and even at the 80% increase in prices per ton it is still cheaper per watt. Coal companies you might consider include Peabody (BTU), Foundation (FCL) and Walter (WLT). Peabody would be my choice for a long-term hold because of their dominance and global footprint.

Coal Prices

By 2:PM on Friday afternoon I had already started to think about how I was going to explain my bearish bias. The Dow had declined to 12155 and appeared right on the verge of a collapse below critical support at 12100. A retest of the January lows at 11650 appeared to be all but guaranteed. Suddenly the long awaited news about a bond insurer bailout hit the wires and a nearly 250-point rebound appeared. Hardly an hour had passed before denials began to flow and had the markets been open the odds are good we would have retested the lows for the day.

That leaves us with a really confused market for Monday. If a real Ambac bailout appears then we could continue to see the financials rally depending how the bailout was structured. If no bailout appears over the weekend or on Monday then the market will return to its funk and hunker down in an attempt to survive the week's heavy economic calendar. In fact, not having a bailout after getting its hopes up could cause an even deeper swoon.

For the week the Dow continued to be trapped in a range from 12500 to 12150. We did see a series of lower highs and lower lows over the last ten days. To me the Dow was setting up for a breakdown below 12100 and a retest of the January lows at 11650. Friday's spike failed to reverse that trend and based on the Friday evening comments on the wires it could be just one more lower high on what could be negative news on Monday. I would be hesitant to buy a dip to 12100 and I would look to short any break of that level.

DDow Chart - Daily

Nasdaq Chart - Daily

The Nasdaq was equally as bearish as the Dow and the big cap techs were getting crushed intraday on Friday. Apple set a new relative low at $116 to cap a week of declines. Microsoft set a new 10-month low at $27.20. Resistance is very strong at 2350 and the Nasdaq would have closed at two week low without the Ambac news.

The S&P has been the calmest of the three major indexes with a much tighter range from 1340-1365. That range was broken on Friday with a drop to 1327 and technicians were holding their breath that critical support at 1320 would hold. The closing spike put the index back at 1350 and dead center in the middle of the range. It is clear that 1320 is the critical level that must hold or the sentiment of the last four weeks is going to change. A break there could easily retest the January lows of 1275. The Russell-2000 uptrend broke and the index returned to initial support at 685 on Friday and was holding its own until the news broke. Unfortunately I think sentiment is turning against the small caps and I am switching to the S&P as the market indicator for this week.

S&P-500 Chart - Daily

Russell-2000 Chart - Daily

A key point here is still the lack of volume. For the last two weeks the total volume has been in the mid 6 billion range and very anemic. This is a buyer boycott rather than a crush of sellers. In reality there has not even been an imbalance of sellers. The internals are very choppy and change directions almost daily. This would suggest neither side has any conviction and everyone is just waiting to see if a recession appears. Traders don't know which way to trade although we were just starting to see an imbalance to the downside when the news broke.

Market sentiment is more neutral than bearish and we have every reason to be headed for the cellar. You could make the case that the lack of serious selling in the face of all the current problems is actually bullish but that would require a leap of faith greater than I have today. The lower highs and lower lows of last week have me worried. I said on Tuesday I was losing any enthusiasm for buying the dips. If we get a bond bailout on Monday the key market indicator will be how aggressively the bears sell the rally and if the S&P can break resistance at 1365 and again at 1395. If we don't get a bailout and news suggests nothing is imminent then the key will be S&P 1320. Between 1320-1360 is the Twilight Zone of confused sentiment and a good place to waste money trying to force a trade. Wait for a breakout or a breakdown and go with the trend.

Jim Brown


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