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Market Wrap

Traders Leap Into Abyss

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Friday was the worst leap day of trading since records were begun back in 1896. Leap year babies have to wait for years for their birthday to roll around again. Traders would probably not mind waiting 4 more years before seeing a repeat of Friday's selling. A tsunami of economic news was flooding Wall Street with analysts and economists warning that things could get worse before they get better. At least five Fed speakers made comments, sometimes conflicting, that suggest the Fed may still be ready to cut rates again but are already preparing to remove those cuts the instant conditions show signs of improvement. There was evidence the municipal bond sector was imploding with massive amount of selling by hedge funds. The news was ugly on every front and the market reflected this sentiment. Selling in the dollar increased sharply on increased recession fears. It is now trading at all time historic lows.

Dollar Index Chart

The economics were headlined on Friday by a sharp drop in the Purchasing Manager Index or PMI. The headline number fell to 44.5 for February from 51.5 in January. This is the lowest reading since Dec-2001 and well below expectations for a drop to an even 50. This put the PMI into contraction territory and increases the likelihood that we are in a recession. As you can see in the table below the employment component fell sharply by nearly 16 points to a multi year low at 33. Shipments and order backlogs also declined sharply to settle in the 30s. This index suggests we will see an equivalent drop in the national ISM when it is reported on Monday. Some analysts are now projecting a negative GDP for both Q1 and Q2 and that is the textbook definition of a recession.

Chicago PMI Four-Month Table

Chicago PMI Chart

The economic calendar for last week was crowded but next week has the two most important reports for the month. Those are the ISM and Payroll reports. The ISM is expected to fall into contraction territory and the PMI on Friday has analysts lowering their expectations to something in the mid 40s.

The jobs report on Friday was expected to show a gain of 40,000 jobs based on reported estimates as of noon on Friday. After the close that estimate had fallen to a gain of only 25,000. If the ISM does come in at a mid 40 level that jobs estimate may fall into negative territory. The rising jobless claims in Q1 suggest that employment has fallen significantly and we could see a second month of job losses when Friday's number is revealed.

Jobless Claims Chart 2008

The other three economic reports of interest are Factory Orders, ISM Services and the Beige Book. Factory orders are expected to drop sharply and the ISM services report is expected to post its second month in contraction territory. The Fed Beige Book will be released on Wednesday and that will give investors a look by region at the current economic conditions.

Economic Calendar

The selling on Friday was triggered by the drop into contraction territory by the PMI but also by bad news in stocks. AIG reported earnings before the open and reported substantially bigger losses than previously expected. AIG posted a loss of $5 billion for the quarter due mostly to losses in the credit markets. Credit default swaps owned by AIG fell by more than double the estimates made just two weeks ago. AIG owned credit default swaps on $579 billion in debt and those swaps lost more than $11 billion in value on worries that the debt will not be repaid. AIG also lost $3 billion in its investment portfolio because of "significant, rapid declines" in the value of mortgage debt. Because of the continued high exposure to mortgage debt and various bond investments the downgrades were flying fast. AIG said it also had $42 billion in bonds insured by those insurers trying to construct a bailout and there is indecision in the market on whether that insurance will be paid. AIG said 84% of the bonds were "A" rated or higher with only 2% considered junk credits. AIG stock lost $3.29 or 6.5% on the news. As a Dow component that equates to a loss of nearly 30 Dow points. The real damage to the market was much worse since it suggests the damage is still growing and when the brokers report earnings again in mid March it is going to be ugly.

Dell lost a buck after reporting earnings on Thursday night but the ugly results knocked the support from under the tech sector. Dell reported an unexpected drop in earnings, missing estimates by a nickel and sales that were substantially below consensus estimates. All the news was not bad with overseas sales rising +16% with sales to BRIC countries rising +36%. Sales in the U.S. were disappointing and again point to sharply slowing economics. This was the equivalent of finding cancer in the tech sector. Expectations for sharply lower spending in Q1/Q2 pushed all the major techs lower.

There were numerous events in the financial sector other than the AIG implosion. Three hedge funds, Duration Capital, 1861 Capital and Blue River were forced to dump billions in municipal bonds due to margin calls. As the bond insurer bailout continues to drag on with no signs of a solution the value of those bonds has fallen. Friday was the day the rating agencies had originally given as the deadline to do a deal or be downgraded. That deadline may have been unofficially extended after the Ambac consortium actually provided a deal framework to the agencies. Those agencies said no deal to the proposed plan without a substantial increase in the capital portion and kicked it back to the consortium with some additional demands. That may have given the consortium another week before the hatchet falls but the market did not wait around for the conclusion. With the value of bonds dropping like a rock there were plenty of bonds for sale. Pimco was reportedly in the market making ridiculous offers simply because they are the biggest buyer and nobody else was willing to jump into the alligator pit. On a normal day reportedly there are portfolios of $20-$30 million seeking bids. On Friday there were portfolios of $500 million to more than $1 billion being offered. There was definitely blood in the streets in the bond market and the flight to quality was huge. The yield on the ten-year treasury fell to 3.534% at the close as buying in treasuries exploded. That was more than .400 points below the 3.932% yield we saw as recently as Tuesday. That may not sound like much but in the bond market it is huge.

Ten-Year Yield Chart

UBS announced early Friday there could be at much as $600 billion in write-downs by financial firms. Goldman Sachs said write-down exposure could be in excess of $400 billion. According to Bloomberg total write-downs to date are $181 billion. If the Ambac bailout never comes those numbers could be worse. The news of the deal refusal by the rating agencies caused all the financials to be sold hard and this could continue next week. With financials 21% of the S&P this was very bad news for the overall market. The bond margin selling on Friday could be a sign of what is ahead. Volume dumping depresses values and that could trigger margin selling in other portfolios next week. Hedge funds had been loading up on depressed muni bonds in anticipation of an eventual insurer deal that would send the value of those bonds back to normal. Instead of rising in value those bonds have continued to decline. With $2.4 trillion of those bonds in the market there is plenty of pain to go around. Friday's margin selling was not even a drop in the bucket compared to the amount of bonds outstanding.

In another hedge fund development six banks seized the assets of hedge fund Peloton Partners. The firm announced on Thursday it was shutting down its ABS Master Fund. The fund made 87% on accurate subprime bets in 2007 but got into trouble in 2008 when their bets on highly rated securities went wrong and the value of those securities plunged in the current credit crunch. Apparently the banks decided to take action to protect their investments in a rapidly declining bond market. Funds typically raise money and then borrow against that money to produce leverage of 600% to 1000%. Get a billion, borrow $7 billion against it and go buy leveraged assets on margin to push your risk/returns even higher. According to various hedge fund managers this leverage is being removed from the markets as more banks revise their risk exposure in the face of declining asset values. Several managers have said in private that the quickness of the leverage removal (loans from banks) is making it nearly impossible to make an orderly withdrawal from the hedge funds investments. You get a notice that says we are calling your loan and you have only days to exit investments, sometimes illiquid investments, before the loan has to be paid. This forces dumping of other assets and that dumping forces other funds into a similar problem as the value of the asset class diminishes. If this turns into a self-replicating feedback loop within the industry then declines like we saw on Friday could become worse.

There was a major financial conference in New York and there was a report making the rounds analyzing the expected damage of the subprime crisis. The report claimed there would be $2 trillion less lending as the credit crunch continued. $900 billion of that reduced lending would be to homeowners and small business. This would subtract up to 1.5% from GDP in 2008 and possibly 2009. This is just more reinforcement that the markets could be under pressure for many months to come.


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The parade of Fed speakers to the podium on Friday seemed to indicate the Fed was open to cutting rates again at the March 18th meeting. Unfortunately there were several references to the need for a rapid reversal of any rate cuts the instant the economy appeared to finding traction. The prospect of a rapid reversal lessens the implied impact of any rate cut. It is like telling your kid they can have a hot fudge sundae and then taking it away after the 3rd bite. This should invoke tantrum images if you are a parent. They are diluting the potential impact of future cuts before they even happen.

Friday's trading was the worst leap day trading since records began in 1896. The Dow lost -315 points on Friday but only -115 for the week. The low on the prior Friday was 12155 and the high on Wednesday was 12756 or a +601 points. Even at the low this Friday of 12224 we have not yet retraced that 601-point move. Yes, it was a bad day in the markets but it did not change the recent market trend. I cautioned on Tuesday night that the +600 point move was the result of anticipating of an Ambac bailout, hopes that Bernanke would make some market moving statement and the guidance upgrade by IBM. Basically all the expectations had been priced into the market in advance of the events. The Ambac deal died, Bernanke disappointed the markets and Dell killed the outlook on techs. The AIG earnings after an $11 billion write-down and forced margin selling by hedge funds was icing on the cake for the bears.

Despite Friday's drop the Dow continues to trade in its recent range. I agree that it looked ugly but volume was still relatively light at only 7.7 billion shares. It was far from a washout even though the A/D line was negative 10:1 over advancers. The decline was predominantly in financials although all sectors saw profit taking. All 30 Dow components were down but only AIG was down significantly. On the Nasdaq 100 only six stocks finished in the green. Only 62 of the Russell 3000 were up more than 50 cents. It was an ugly day but it was just a day with several news events providing the motive power.

For next week the Dow still has support in the 12100-12200 range and the January intraday lows are well below at 11634. The Dow can continue to wander for hundreds of points without any serious damage. Many analysts this weekend are renewing their calls for a retest of the January lows. If it did happen I believe it would be good for the markets since there has been plenty of advance warning. Traders have already been beaten senseless and are far less likely to hold long positions in a falling market. Any retest could easily clean house and have an entirely new set of holders rush into the dip to establish new positions. This is what is needed to provide a firm bottom.

Dow Chart

The qualification here is the margin selling by hedge funds. If this increases we could see a really high volume market event that could endanger the prior lows. I view it as a slim chance but still a chance. The Fed is watching the bond insurer saga and they will be forced to consider what a cascade of bond selling would mean to the broader market. Over the weekend the Fed could lean on the parties involved and press for a resolution. They could also throw a surprise rate cut into the mix next week if it appears the markets are about to fall off a cliff. I still believe the key is Ambac. If a deal appears that will allow them to maintain their AAA rating then sellers will evaporate and a real rally begin.

Everyone believes we are in a recession. We should not get any news next week that can increase that possibility other than maybe a big job loss. The CPI on Friday was a preview to the ISM so without a bigger implosion in the ISM it should not be a major market mover. All the smaller economic reports have shown falling employment so a minor job loss on Friday should not be a major news event. It would just be confirmation of the current recession. A major job loss approaching 100,000 jobs or more could prompt fears of a deeper recession and possibly cause another sell cycle. It would also provide the Fed with another reason to cut rates.

Nasdaq Chart

Because of the Dell shortfall the Nasdaq looks a little worse than the Dow but is still within its 6-week trading range. Friday's close was a new 17-month closing low but there were four days over the prior six weeks where the Nasdaq traded lower but recovered to close higher. Currently 2260 is initial support and 2365 initial resistance. 2202 was the intraday low back on Jan-23rd and theoretically the point we could test before a new rally appears. Nothing says we need to go there but it is always a possibility.

The S&P-500 also made a complete round trip from the bottom to the top and back to the bottom of its range. The bounce on last week's expectations was erased and the S&P returned to retest initial support at 1320-1325. We could easily return to the January lows at 1285 but there would need to be a buyer boycott to do it. Plenty of buyers still remain at the bottom of the range as evidenced by the prior rebounds. It may take another bloody nose and a dip back to 1285 to bring in the really big money and that possibility always exists. The Dow and S&P have declined for four consecutive months and that has not happened since the last bear market bottom in 2002. The Russell-2000 chart mimics the S&P so I will skip it today.

S&P-500 Chart

Russell-2000 Chart

One negative point I have not yet discussed was the news from Thomson Financial. They calculated that the final earnings tally for Q4 showed a drop in earnings of -25% and a number that we have not seen since they began keeping records in the mid-90s. With profits in Q1 expected to be worse we could be nearing a bottom in the cycle. Q1 only has a month to go and then estimates for the rest of the year begin to explode higher. This is of course due to the meager comparisons with Q3/Q4 of 2007. It would not be hard for Q4-2008 earnings to be better than Q4-2007 at -25%. When does an earnings bottom begin to produce speculation in stock prices? Normally when investors actually see those earnings start to improve. We are not there yet we can probably see it from here. When companies begin to give guidance for Q2 we will quickly know if the bottom is behind us or still in our future. That early guidance is about six-weeks away. Odds are good that institutions will begin to speculate on that guidance being positive sometime over the next 2-4 weeks. Assuming an Ambac deal is finally announced that would be the all clear signal and investors would come back to the market. Those stocks with the best outlooks would be the first to be bought. The caution here is that the next couple of weeks could be rocky and volatility will likely increase as we try to find a bottom in this market. If more hedge funds find their leverage cut and are forced to liquidate the odds are very good the January lows will be tested. I would be a cautious buyer of any dip to that range. Until then I am an observer rather than a participant. Trying to pick a trend in a range bound market is a fool's game. You can scalp the reversals if you are quick and nimble but a position older than two days is a huge risk.

Jim Brown


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