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Market Wrap

Surprise, Surprise

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The Fed took another step towards stabilizing the financial sector but it was not a rate cut. The Fed said it would lend up to $200 billion in Treasury securities and allow banks to use mortgage-backed securities as collateral. This could be the silver bullet the market was looking for but the amount of the loan guarantee may not be enough. It was enough for the markets and we blasted off to the biggest gain in months. Of course you know what I am about to say. The move caught the shorts off guard and that resulted in a massive short squeeze.

Dow Chart - Daily

The Fed action was the only news in the market if you ignore the continued sound bites about Governor Spitzer's extravagant entertainment budget. The economic calendar was light with only mundane things like International Trade and weekly Chain Store Sales. One minor release was the Manpower Employment Outlook for 2008Q2. The number of employers planning on hiring in Q2 rose to 17% from only 10% in Q1. This may look positive on the surface but it is still slightly below the Q1-2007 at 12% and Q2-2007 at 21%. It is still a seasonal bounce but less than in 2007. I guess we should not question any positive signs regardless of how minor they are.

The big news was obviously the Fed announcement. The new $200 billion Term Securities Lending Facility (TSLF) is an attempt to liquefy the credit markets and especially the mortgage securities market. The Fed move was targeted towards disconnect between reality and the valuations of mortgage securities. We saw how bad it was last week then Thornburg could not make margin calls on $600 million of triple AAA mortgage debt. This are mortgages that are still showing a very low incidence of default as in 1.5% compared to 8%-14% in the subprime sector. The prime debt was sinking to ridiculous levels simply because nobody wanted to buy it. With no market the valuations were slipping into the absurd range of 70-75 cents on the dollar. The Fed wants to give value back to the mortgage securities and they are going to do this by loaning Treasury paper to holders of mortgage paper. Basically if you have $100 million or AAA mortgage paper you can use it as collateral for an equal amount of treasury paper. This effectively revalues your mortgage paper at face value less a few points for interest and shores up your balance sheet. Obviously there are a lot of details and mechanical points I am leaving out but you get the picture. This is the equivalent of the Fed buying mortgages to establish a bottom although technically they didn't buy them only provided a mechanism to solidify their value.


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A more important window into the health of the sector was the release of the results of the latest Term Auction Facility or TAF. You may remember the Fed just raised the auction amount in late February to $50 billion from $20 billion. This week's auction had banks bidding for $92.5 billion, well over the increased amount. There were 82 bidders, up from 72 in the previous auction. The interest rate for the auction came in at 2.8%. The $92.5 billion in bids shows that credit is extremely tight and there is nowhere else to turn but the Fed. This shows the Fed's $50 billion auction target is still too low but they can't afford to simply open the vault and just write a check to everybody that needs cash. They have upped the future TAF offerings to $100 billion. The Fed's balance sheet has only about $880 billion in capital and the TSLF is going to take up nearly 25% of it. These TAF auctions have sucked up another $200 billion or so already. They also added another $100 billion in term repurchase agreements. The Fed is not in danger but they may be reaching their limits of what they are willing to do to shore up the markets and the economy. By the end of March they could end up with more than $400 billion in various mortgage assets on their balance sheet.

After today's Fed action the chance of a 75-point rate cut next week fell to 88% with a 136% chance of a 50-point cut. These numbers are down sharply from the last couple weeks as a result of the recent Fed actions in the credit markets. This clearly shows the Fed is worried about adding too much inflation fuel for the economy in the form of rate cuts when it is the freeze in the credit market that is causing the problems. Given the monster amount of mortgage debt the Fed is assuming through all these vehicles there is a worry that they could be in trouble by year end if the housing sector does not recover. Mark Zandi at Economy.com said Congress and the Bush administration should be planning for the possibility the Fed is not going to be able to steer the financial system and the economy through the turmoil without help. I believe the Fed should continue to cut rates to relieve stress in the housing sector. If homeowners could refinance their mortgages at a low rate and buyers could get financing at a low rate that would go a long way towards putting a bottom under the housing market.

On the stock front WellPoint (WLP) lost -$18 after it slashed guidance. That was a 28% drop to close at $47.50. The sharp drop in guidance to $5.76-$6.01 per share was well below the prior guidance of $6.41. The earnings warning drew a host of downgrades and crushed the sector. Aetna (AET) made a point of coming out in the middle of the storm to affirm their earlier guidance in hopes of avoiding the beating. AET dropped -3.86 for the day. WellPoint said higher healthcare costs and lower enrollment would pressure profits. WellPoint expects the slowing economy to prevent consumers from spending the money on a healthcare plan and opt to tough it out when possible. A Goldman Sachs analyst said WellPoint had also miscalculated prices for 2008 and their competitors have been aggressively cutting.

WellPoint Chart - Daily

Washington Mutual (WM) spiked +18% on rumors that Goldman Sachs or Warren Buffett was going to buy them or at least give them some capital. WM was at decade lows at $10 before the rumor and with an improving credit outlook it might be a good play but analysts said there was no truth to the rumor.

Washington Mutual Chart - Daily

Bear Stearns (BSC) gapped open on the Fed news to $68 and immediately dropped to $55 on rumors they could not make margin calls. BSC has been pressured with these rumors for the last couple weeks but today's was especially violent. The CEO made an unprecedented announcement that there was ABSOLUTELY no liquidity problem at BSC. He as very emphatic and said the rumor mill was complete nonsense. Buyers rushed in at $55 and volume spiked to 55 million shares or ten times normal. We could have seen a bottom in BSC today assuming the CEO does not reverse his statements.

Bear Stearns Chart - Daily

The banking sector rebounded sharply with all the positive news on the credit front. The XLF gained +6.5% for the day as shorts raced to exit the sector. Citi said it was injecting $1 billion in six of its municipal bond funds in order to protect them from margin calls. Citi (C) gained nearly 10% compared to GS +5%, JPM +6% and LEH +8%. Those most heavily shorted showed the strongest gains.

Thornburg Mortgage (TMA) spiked +120% after it restated earnings and said it was working with lenders to meet its margin calls. A +120% gain meant it jumped from 72-cents to $1.56. It has been hammered since the margin calls made the news last week.

Texas Instruments (TXN) fell -3% after warning that a key wireless customer had cut some orders. Although TXN did not say so that key wireless customer was probably Nokia since Nokia is TXN's biggest customer. Nokia said last year that it would broaden its supplier list to include Broadcom and Infineon. Nokia (NOK) dropped slightly on the news.

Despite saying, "I can't say that we are at the bottom, and that it's over and ready for recovery" homebuilder Ara Hovnanian's company HOV spiked +16%. The most positive thing he said was, "the sky is not falling, we will get through this cycle." Net contracts declined -41% and the dollar value -50% to $457 million. He hedged that initial comment slightly with "I have a feeling it is going to settle out soon but I can't say that definitively." The sector SPDR HBM rose +8%. Again, the heaviest shorted rebounded the strongest.

The energy sector celebrated the market rebound with most stocks finishing much higher. Having oil hit $109.70 intraday and close at $108.75 did not hurt. However, we saw the energy sector decline with the market over the last week despite daily gains in the price of oil. There was no specific news in the energy sector although the EIA said the slowing economy would cut another -100,000 barrels per day off of U.S. demand. This was a cut from their estimates just last month. The IEA revised its predictions for 2008 forecasting a drop of 190,000 bpd for the U.S. and Europe but said demand from China and other OECD countries would likely grow by 120,000 bpd. With the two major energy agencies cutting demand estimates you would think oil prices would fall. They rose on the expectations that the Fed move could help shorten the recession and revive growth. Summer gasoline prices are now feared to hit $4 and diesel $4.50 but the EIA estimates are only $3.50 and $3.75. Since it is already over $3.50 in some areas I would not count on their highs being gospel.

Crude Oil Chart - Daily

The Dow rebounded +417 points for the biggest point gain since Jul-2002 and the biggest percentage gain since March 2003. There have been only four 400-point Dow gains in history. This was the smallest of the four but still a great day. Unfortunately it only brought us back to close at 12156. That was only back to level where it failed on Thursday.

The rally was almost entirely on short covering as the indexes fell to the January lows on Monday. The Russell and Nasdaq fell below those January lows. By every indicator the markets were extremely oversold and ripe for this type of short squeeze.

The qualification I would put on this move is the type of Fed action they announced. It was directed at the credit freeze in mortgages and that could have a lasting impact on sentiment. This may have started as a short squeeze but it could turn into a prolonged rebound. The drop in the indexes to the January lows and then today's rebound has put in place a potential double bottom formation and that should be bullish. I am not going to say that we are only going up from here but hopefully the bottom is behind us.

The Nasdaq rebounded +86 points from yesterday's 52-week closing low of 2171 to today's close at 2252. It was the biggest percentage gain since April 2003 and point gain since last November. Like the Dow the rebound only took the Nasdaq back to Thursday's levels. Those stocks with the highest short interest were the biggest performers. GOOG +26, FSLR +21, BIDU +19, AAPL +7, RIMM +7 etc.

Nasdaq Chart - Daily

S&P-500 Chart - Daily

Remember all the worry about the possible S&P break of support last week at 1320? Guess where it stopped today. The rebound of +47 points from Monday's test of the January lows at 1274 took us right back to 1320, which is now resistance. It was the strongest percentage gain since Oct-2004 and point gain since April 2001. It was a strong gain but still well below a breakout.

Analysts were hoping for a 90% day. That means 90% of the volume would be advancing volume. We came very close at 88% so we should be looking for signs of conviction to appear on Wednesday. Because of the size of the short interest I believe analysts were wrong to celebrate the lack of an end of day sell off. That has been the pattern of late and a one-day change is not a trend. With many shorts caught unprepared and hoping for an end of day decline to cover they were disappointed to see that early afternoon decline reversed and the second bout of short covering began. Volume was the strongest since Jan-24th but it was still 2 billion shares below the Jan-24th level.

The Fed meets next Tuesday and expectations for a 50-point cut are now at 136% and 88% for a 75-point cut. The recent Fedspeak seems to indicate the Fed is moving away from a string of further cuts although there are still positive expectations for next week. The markets have been expecting another cut for two weeks and today's TSLF announcement moves the Fed even farther away from a continued rate cut scenario. The Fed has said all along that rate cuts were not the answer for the logjam in the credit markets. Now that they are taking direct action towards the credit markets they are less likely to be aggressive in rate cuts. The market has not yet factored this in and we could see some weakness heading into next week. How much weakness is the $64 question? I would love to see signs of a bottom here because it is exactly the right place on the charts. We retested the January lows and the bulls need that retest to stick. The next major economic report is the Consumer Price Index on Friday. That leaves the market free to determine its own fate. I am neutral here. I suggested buying a dip back to 1275 and we got it now we just need to sit tight and see what happens.

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