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Market Wrap

More Pain, No Gain

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The markets may have closed off their lows on Friday but only barely. The average loss for the week for the major indexes was about 3% with banking, brokers and homebuilders doubling that loss. Even with the end of day short covering the major indexes ended at new 52-week closing lows. We have traded lower in 2008 but never closed there. The week was filled with negative economics and major disappointments. Is the pain over or do we have further to fall? The answers to that are mixed and I will try to touch on as many as possible in this commentary.

Dow Chart - Daily

There was only one major economic report on Friday and it was a killer. The Employment report for February showed a loss of 63,000 jobs. I reported last weekend that the official consensus had fallen to a gain of only 25,000 jobs, down from estimates of 40,000 the week before. By Thursday night that consensus estimate had fallen to a gain of only 5,000. The whisper numbers had been negative for nearly two weeks but nobody wanted to pin their company credibility on a negative jobs forecast. February's 63,000 job loss was the second consecutive month of losses. January's 17,000 loss was revised lower to -22,000.

The charts below show the monthly job creation and a 3-month moving average. Job creation numbers are prone to major swings as the government adjusts jobs for seasonality and for the birth/death factor as small companies startup and others fade away. The 3-month average for February is -1,000 and due to scale does not show on the chart.

MMonthly Jobs

3-Month Moving Average

Employment at companies that produce goods saw a decline of -89,000 jobs and was again the biggest loser. If you remove the +38,000 jobs added to government payrolls the private sector lost over 101,000 jobs for the month if you don't count those self employed and those working at home. Payrolls in the household survey declined by 450,000 and the number of unemployed workers rose +195,000. The unemployment rate actually fell to 4.8% for the second month of declines but not because of additional hiring. As workers exhaust their unemployment claims they fall off the rolls and are no longer counted. Because of the sharp drop of 450,000 workers being removed from the list the actual percentage of unemployment declined. Obviously those workers are still unemployed but are simply no longer drawing unemployment. That is a flaw in the system but it has been this way for decades.

The odds of the U.S. being in a recession are nearly 100% and those who claim it is only going to be a soft patch of slowing growth are rapidly losing their conviction. The decline in jobs is a clear signal of the onset of recession and one that has been nearly flawless for the last 60 years. We have never escaped a recession after three months of job losses. That is two months down and one to go.

The only thing that kept the markets from imploding was the action by the Fed just as the report was about to be released. The two-step approach reflected the Fed's efforts to break the currently frozen credit markets. The first step was to increase the Term Auction Facility (TAF) to $100 billion from $60 billion. They also committed to extend the TAF for an additional six months. They relaxed the rules to cover any bank and almost any collateral. In step 2 they will offer $100 billion in 28-day repos. Normally a repo is an overnight loan for those that need immediate cash as they juggle funding and payment events. By increasing the amounts and extending the term to 28-days it takes the pressure off to repay the loan the next day. Instead of only one type of collateral they increased it to three types to broaden the scope. It is still a tool for primary dealers only and requires the best collateral they have. The market initially rallied on the news despite the drop in the jobs numbers but as the day wore on the real impact became clear. The majority of stress in the credit market is due to mortgages, subprime and otherwise, and majority of those loans are held by mortgage companies and secondary institutions, not banks. The new deal would only be a minimal help to that sector. Secondly by announcing the new enhanced TAF it soon became clear that the Fed was not going to cut rates before the March 18th meeting. That was a secondary blow to the market, which had been expecting an intermeeting cut last week. Fed funds futures immediately begin to price in a reduced chance of future rate cuts. There is still a 100% chance of a 75-point cut at the next meeting according to the futures but the real odds of that occurring are slim. A 50-point cut is all analysts are expecting today. More on the Fed later.

The economic calendar for next week is full but mostly with economic filler. The only really important report is the Consumer Price Index (CPI) due out on Friday. The rest of the week is a repeat of the same information we have been seeing for the last month.

Economic Calendar

The CPI is important because of the sudden uptick in inflation talk among Fed officials. The CPI gives us a look at the rate of inflation at the consumer level. Fed speakers have been hitting the podium all week with warnings about the potential rise in inflation brought on by aggressive rate cuts. It was as if the Fed was trying to warn investors that the pendulum was swinging back to inflation fears and away from worries about slowing growth AND the resulting halt to the current rate cut bias. Kansas City Fed President Thomas Koenig said in a speech on Friday that, "excessive rate cuts risk adding to inflation and create further asset bubbles." Not exactly rocket science but indications the Fed may be rethinking its position. Fed Vice Chairman Donald Kohn said at a Bank of France seminar in Paris, "Policy-makers must be mindful of the uncertainties surrounding the outlook for commodity prices and the risk that past or future increases in these goods could yet embed themselves in higher long-run inflation expectations and a persistently faster rate of overall price increases." San Francisco Fed President Janet Yellin said the U.S. economy is particularly exposed to risks from the unwinding of the housing bubble and disruptions in the financial market. This seemed to indicate the Fed would still have to take steps to alleviate the problem. Noted inflation hawk Dallas Fed President Richard Fisher told the markets not to expect continued rate cuts saying the Fed needs to be careful and take a steady measured approach to the new economic events. Fisher is a voting member of the FOMC. Earlier this week the futures were showing a strong chance of rates cuts totaling 100-points by April 1st. With the Fed's action on Friday those chances have now dropped to only 50-points. The market has yet to price in this change in bias despite the -146 drop in the Dow.

The lockup in the credit markets is due to reluctance of anyone to hold mortgage paper. With delinquencies and foreclosures at an all time high even triple AAA mortgages are being dumped. Thornburg Mortgage, a company with no subprime debt at all is on the verge of bankruptcy because of margin calls by their major lenders. Thornburg has billions in AAA or prime mortgages, which according to Thornburg and nearly every analyst currently have nearly zero risk of default. These are high dollar loans to very high credit individuals. Unfortunately for Thornburg they sold off these loans in packages to investors with the qualification if the value of the packages declined they would buy them back. The investors theoretically had very little risk. Triple AAA prime loans are typically traded around 94-96 cents on the dollar and previously traded like cash. With no buyers in the market for any kind of mortgage paper those trying to sell or in a cash crunch are bidding down the price in hopes of finding a buyer. According to Bill Gross these prime loans are now trading in the 70-78 cents on the dollar range. This is forcing a mark to market by anyone holding the loans whether they want to sell them or not. Pension funds are big buyers and they have little leeway in their rules. If the value declines they must put a call on the originator to buy them back. Thornburg is sitting on billions of prime mortgages with very little chance of a default but because of market prices they are being hit with massive margin calls or demands to buy the mortgages back. On Friday Thornburg said it could not meet $610 million in margin calls and the continued drop in value and increased calls have raised substantial doubt about Thornburg remaining a going concern. This is being repeated in dozens of mortgage companies and at holders of mortgage debt all around world. Thornburg shares fell -90% over the last two weeks to close at $1.79.

Late in the day Pimco's Bill Gross said on CNBC they had bought hundreds of millions of dollars of Thornburg paper at very good prices over the past week. He expected to get a double-digit return off his investment. Everyone claims this hysteria in the higher-grade paper has no basis in fact. Until the Fed can come up with some plan to bring liquidity back to the credit markets the stock market is doomed to further selling. The news that Citigroup was going to lighten its mortgage portfolio by $45 billion over the next year did not help. Citi also said it was going to reduce by 50% the number of new mortgages it would keep. Continued news from around the world like the $2 billion UBS write-down on $26 billion in mortgage loans is evidence of how massive the problem really is. The major global banks each have tens of billions in mortgage exposure and it is no longer only subprime in trouble. Other mortgage companies like Washington Mutual and Countrywide have been on a steep decline all week. Bank America's planned acquisition of Countrywide did not prevent a -28% drop in CFC over the last week or so. Fannie (FNM) and Freddie (FRE) also hit new 52-week lows on thoughts that this mortgage paper will eventually wind up in these government-sponsored entities.

There is a growing consensus that the only way out of this credit crunch is for the Fed to step in and buy mortgage paper to put a floor under the market. They don't need to buy the subprime but only the high quality mortgages. They can sell treasuries to offset the investment in mortgages and could actually make a profit on the deal. Buying at today's distressed prices and selling back into the market at normal prices once the crisis has passed would make it a perfect way to support the economy today.

The increasing chances for a recession continue to push the US Dollar to new lows. Every Fed rate cut will push it even lower. This drop in the dollar is continuing to power commodities and oil rose to another new intraday high at $106.54.

U.S. Dollar Chart

Those armchair analysts on TV continue to blame the rising cost of oil on the falling dollar. Maybe if you repeat it enough times it will become true. While I think there was some impact I do not believe it was a material force. The chart below or ones like it are showing up in financial newsletters everywhere as the cause of high oil prices. Just looking at the chart it appears to be an obvious correlation. However, what they are not showing you is the relative scale of moves. Against a basket of currencies the dollar fell from .85 back in early 2007 to .73 in March-08. That was a 12 point drop or -14% in value (left scale). During the same time oil prices rose from $50 to $105 or +110% (right scale). Does it make sense to you that oil prices rose +110% on a 14% decrease in the dollar? It shouldn't because a direct currency correlation on oil would be a 14% rise from $50 or an increase to $57. Even allowing for a few points of slippage between currencies that would only take us to a maximum of $60. Next time you see somebody blaming the drop in the dollar for the rise in oil prices you can comfortably assume they don't know what they are talking about. Some impact yes but not 110%.

Oil Vs Dollar

Every $1 increase in oil is an additional $5.23 billion energy tax on U.S. consumers. Get ready for some additional taxes. Goldman Sachs raised its average expected price to $95 for all of 2008, $105 in 2009 and $110 in 2010. Those are averages for the full year but their high end of the range is now expected to be $135 with possible spikes to $150-$200 if additional supplies do not come to market or we suffered a major disruption in some producing country. You may remember that Goldman shocked everyone two years ago with their $105 super spike projection. Looks like they were dead on with that projection and odds are good they are going to be dead on with their new projections. UBS said on Wednesday they could see oil prices over $150 by 2010 due to rising decline rates in older fields offsetting oncoming new production. Goldman, UBS, looks like I am in some good company with my views on oil. I was criticized last week for being too bearish on my outlook for the impact of high oil prices. Everything I have projected has come to pass and we are not even into the big numbers yet. You tell me if I am off the mark. Would $150-$200 oil change your everyday life? Jim at OptionInvestor.com

Oil Chart - Daily

For three weeks we have been discussing the Ambac bailout and how it would positively impact the market. The bailout failed and Ambac disappointed investors with a Band-Aid solution. For three weeks Gasparino has been grabbing headlines with the imminent announcement of a deal. Private equity including Cerberus and Blackstone were said to be putting substantial amounts of money into the firm. It never happened. A consortium of banks was said to be arranging infusions of cash with numbers making the rounds of as much as $10 billion in an effort to maintain their AAA rating. It never happened. In the end nobody wanted to touch the toxic paper that Ambac is holding. Everybody walked except for some participation in the Band-Aid share offering. Ambac had 100 million shares. They offered 171 million shares at $6.75 per share to raise $1.5 billion and effectively diluting the prior shareholders by 63% with the new addition. To avoid this dilution Ambac said existing shareholders were buying a substantial amount of the new shares. Ambac carved out about $100 million of the new capital to pay some expenses and a fat dividend to existing shareholders. Goldman Sachs said the capital raise was about $1 billion short of what was needed to provide sufficient liquidity. This was the equivalent of Ambac passing the hat among its shareholders and debtors when it could not get the money from the consortium of banks. Reportedly that consortium agreed to buy as much as $500 million of the new shares IF the offering could not be fully sold. The capital raise was enough to hold off the rating agencies temporarily but their ratings are still in danger over the next few months if conditions don't improve. The problem for the market was the lack of a backing by the consortium. The market wanted some deep pockets to step up and provide equity so those holding the $620+ billion in Ambac insured bonds could breathe easier. It just did not happen and everybody immediately saw through the charade and realized their insurance could still be worthless if the current credit crunch continued. After waiting for three weeks and being promised almost daily a deal was imminent the markets sold off on the news. ABK stock sold off from last week's "imminent deal" high of $12.75 to close at $7.40 on Friday. There was a bad tick at the close so some charts may say $9.50. The 42% drop for the week was an indication of how displeased investors were on the news. This was still better than what would have happened if they just said deal discussions had broken down and we are going to batten down the hatches and weather the storm. It would have been a monster storm. The Ambac CEO was on CNBC again on Friday saying, "there was no possibility of Ambac not being able to pay claims" regardless of how bad the market got. He claims the worst-case estimate of exposure by outside analysts was $12 billion and Ambac reportedly has $16 billion in resources to pay those claims. If that was the case why did Ambac have a market cap of only $860 million as of Wednesday according to the CEO himself? Let's see $860 million guaranteeing payments on $620 billion. What's wrong with this picture? Time will tell on this boast.


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Bucking Friday's decline was the semiconductor sector. The SOX posted a nominal gain on the strength of earnings from National Semi (SM). National Semi gained +12% after beating estimates by 3-cents. It was all short covering since brokers were quick to downgrade and cut estimates for future quarters. NSM projections were far from exciting. Bank America cut their target to $16 from $17.50 with NSM at $18.23 and reiterated their sell rating. The analyst said, "the lack of growth is increasingly obviousand is likely to get even more evident through the course of the current slowdown." National Semi did say the semiconductor business seems to be finding a bottom and that was enough to provide lift in the form of short covering for the sector.

It was an ugly week in the markets and were it not for Bill Gross of Pimco talking about buying hundreds of millions in Thornburg paper on CNBC it would have been worse. The Dow was down about 220 points when Gross made his comments about Thornburg. Knowing that Gross is a savvy buyer it relieved some of the stress in the markets and a flurry of short covering began. Still the Dow closed at a new 52-week low at 11893. Support at Dow 12000 broke and we could easily see the January intraday lows at 11635 tested next week.

YYou would think from looking at the charts that the markets were under extreme stress bordering on free fall. That is not the case. We are oversold but there is little stress. The VIX only rose to 28 on Friday and a level it has seen many times over the last four months. It is far from an extreme like the 37 we saw back in January. Volume was far from high with only a slight gain over the prior week. Friday's volume was 8.2 billion and well below the 12 billion or so we saw back in late January. The advance decline line was less than 2:1, actually 8:5, in favor of decliners. There was an imbalance but definitely no market stress. The biggest red flag in the internals was the new 52-week lows compared to new 52-week highs. Of course with the indexes at 52-week lows we should expect a large number of stocks to be at those same lows. Without duplication there are roughly 7000 stocks across all the major exchanges. Only about 12% were at 52-week lows on Friday. The internals snapshot is not a pretty picture but it is far from dire. There has been no capitulation and no extreme increase in volume. The sell off has been orderly and more like a buyer boycott than a seller party. I have been telling you for over a week I was an observer of this market and not a participant and I think that virus is contagious given the mediocre volume.

Market Internals

There could be a bounce waiting at the January intraday lows, Dow 11635, but I would be surprised if it stuck. Even being very oversold does not guarantee anything but a strong short squeeze. We are in a recession, the Fed has significant challenges and the credit markets are locked up tight. The Thornburg margin call is a wet blanket for the markets. Until this type of problem is resolved the financials are not going to recover and there is a good chance we are going to see lower lows ahead. If the indexes do fall below those January lows we could see a whoosh as institutional buyers move to the sidelines just to see how far it will fall. We need a capitulation event and I am not sure that would even stick today. br>
TThe Nasdaq has already traded below its January lows at 2202. The low on Friday was 2186 and the rebound was anemic although it was a +30 point gain. Shorts came in quick and the Nasdaq closed with a loss at 2211. If the 2200 level cracks for good next week then the next target is 2000. Five leaders of the Nasdaq MSFT, INTC, AMZN, EBAY and GOOG look really weak. Cisco is the only major tech stock that is holding its ground. Apple and RIMM are trading jabs and both appear punch drunk and unable to produce a trend.

Nasdaq Chart - Daily

S&P-500 Chart

The S&P-500 broke below January's low close of 1310 and sellers quickly appeared in volume. The dip was bought as traders waiting for that break took advantage of the dip. Like the other indexes the minor rebound was quickly sold and the S&P closed at 1293 and well under the 1310 threshold. The next support and likely light support would be the 1275 intraday lows from January. Under that would be the support at 1225 dating back to Jun/Jul 2006. I would be willing to place a small wager that we see that 1225 level tested. br>
RRussell-2000 Chart - Weekly

The market has many problems and I spelled out several in the pages above. We also have the next round of financial earnings due out the week of the 18th. Odds are very good there will be more write-downs. If they are small and the companies give decent guidance then maybe there is a rebound in our future. If they are large and the future is bleak then we will need our parachutes. The Fed also meets in seven days to discuss rate cuts. With a 75 point cut priced into the market there is plenty of opportunity to be disappointed. We are also closing in on earnings warning season. Based on recent reports from everybody but Cisco there are likely to be some sizeable warnings that could disrupt the market even further. Nobody expects Q1 earnings to be anything to brag about and that could work in our favor. If the warnings turn out to be less dire than expected we could see some bargain hunters appear. The biggest problem as I see it will be the CPI next Friday and the FOMC meeting the following Tuesday. Immediately after the meeting the earnings warning period will begin. Let's take these hurdles one at a time and try not to worry about them as a group.

Sunday is daylight savings time and you need to set your clocks ahead an hour. Daylight savings time was originally created to save energy but a recent study found that it costs an extra $3.15 a year to observe it today. It would be worth $3 to me not to change all the clocks and watches in the house and cars twice a year. br>
Jim Brown

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