Option Investor
Market Wrap

Waiting For What?

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The markets have been moving sideways for a week as if they are waiting on something to provide direction. Is it earnings, Fed action, the appearance of more subprime problems or just for assurance that the bears have run out of ammo? Whatever the reason there has been no shortage of news events and the market seems to be taking them in stride.

Dow Chart - Daily

The morning opened with the Pending Home Sales report and a drop of -1.9% in February. January's number was revised higher to 86.2 in contrast to February's drop to 84.6. This was probably not as negative a report as some were expecting despite the bulls being disappointed. The housing sector is still in recession and February is still a little early for the summer sales bounce to show in the numbers. We have been seeing in the very short-term reports a pickup in buying but it is still minimal since getting a mortgage is about as hard as getting elected to public office. Home sales in the west and north east actually improved and that suggests at least the rate of the overall decline is slowing. Lawmakers are trying to come up with an incentive program to stimulate home buying but the competing factions cannot agree on how that should be done.

The Job Openings and Labor Turnover Survey (JOLTS) declined -8.4% in February. This sounds bad but it is simply a continuation of a slow decline in employment over the last six months. August was the last month with a gain. The number of advertised jobs has been slowing but the hiring rate remained at 3.4% for the 4th consecutive month. Job openings remained at 2.7% with the separations rate at 3.3%. Without a surge in separations there is no evidence that the recession is accelerating. However, hiring is at a 4-year low. The non-farm payrolls last Friday showed a loss of 80,000 jobs but that is also not a serious drop. In times of serious economic decline job losses can reach 250K to 350K per month. This report was only slightly negative and it is not widely watched so the impact to the market was minimal.

The biggest report for the day was the release of the FOMC minutes for the March-18th meeting. They cut interest rates by 75-points to 2.25% at that meeting. In the minutes the tone of the FOMC outlook changed. The party line has been "the country is not in a recession" and that changed to "the country will contract in Q1/Q2 but recover in the second half of the year." The FOMC staff revised down significantly the estimates for GDP in Q1/Q2 into negative territory and only a slight improvement in Q3/Q4. FOMC members agreed that monetary policy changes would not be enough to halt the recession and they decided to launch new initiatives like the Term Securities Lending Facility (TSLF) and increase their various auction efforts. The members noted that since their prior meeting in late January homebuilding continued to contract, consumer spending was softer and the labor market was deteriorating. FOMC members were concerned that the inability by financial institutions to price mortgage instruments was a serious constraint.


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There was increased fear about rising inflation in the short-term but nearly all expected that inflation to ease late in 2008 and early 2009. I wonder, since they have been wrong on just about every other point in this economic decline what makes them think they are right on inflation? There was an argument among the members that on one side inflation could become "unanchored" from current expectations and begin a cycle of much higher inflation. The other members continued to believe that recessionary pressures would keep inflation in check as excess capacity and low demand kept prices low. The wild card that worried everyone was the rise in energy prices and its impact on food and transportation expenses.

The minutes and the economic reports since March 18th suggest the Fed will cut rates again at the April 29th meeting and probably by another 25 points. They are running out of room with what would be a 2% fed funds rate after the April meeting. They are going to have to continue to be creative in alternate solutions other than rate cuts. The biggest change in stance remains the move from "not in a recession" to "economy will contract in first half of 2008." That is Fedspeak for a recession. That change in bias should keep the Fed on the offense for the next couple of quarters.

The remainder of the week has few reports with the only one likely to influence the markets being the Consumer Sentiment on Friday.

On the stock front Alcoa (AA) disappointed with lower than expected earnings of 44 cents compared to 79 cents in the comparison quarter. Revenue fell 6.7%. This was not expected given the rally in metals and commodities over the last six months. Analysts were expecting earnings of 48 cents. Alcoa said higher costs were to blame in both the metals and energy expenses. The CEO said prices were holding near their historic highs and sales would continue to rise around 6% per year over the next decade. The earnings were especially worse since they bought back 14 million shares during the quarter and that actually increases the earnings per share on the remaining shares. Analysts were still upbeat about their earnings in coming quarters saying the blizzard in China had impacted prices and a new smelter coming online in Iceland would help. AA lost only 26 cents in trading but the market negativity from the earnings miss was quite evident.

Advanced Micro Devices (AMD) warned it was continuing to face problems with current product cycles, would miss current estimates and layoff about 10% of its workforce. AMD was a year late on being able to deliver quantities of its quad core chip code named Barcelona. Jeffries said AMD fundamentals are continuing to unravel with product delays, formidable competition and a weak cash position. A Goldman Sachs analyst was even more to the point. "AMD's business model remains structurally broken." AMD stock remains broken as well with a 5% drop today to $6.

Novellus (NVLS) warned this morning that earnings would be lower than expected due to significant price drops in DRAM memory chips. NVLS dropped -8% on the news. Novellus said earnings would be at the low end of its prior range. Income is now expected to be in the 15-17 cent range compared to estimates of 21-24 cents.

Goldman Sachs Japan was also a pressure on the chip sector after cutting estimates on the chip equipment makers.

Washington Mutual (WM) served up a cold dish to investors after they announced they were selling 805 million shares at $8.75 to raise $7 billion in additional capital. WaMu had 882 million shares outstanding so this basically doubles the number of shares outstanding at a price $3 below current market. You would have expected the stock to behave badly after the announcement. On Monday rumors of a new capital deal added $3 to the stock price to close at $13.13. After the actual announcement today the stock declined only $1.34. Obviously there was more to the story than just a stock sale as most of it ($5.5B) was convertible preferred shares. WaMu needed the additional capital because of rising losses from mortgage defaults. As part of the deal WaMu will close all of its freestanding home-loan centers and cut 3,000 jobs. They will exit the wholesale mortgage business by June and only accept retail mortgage applications at its retail bank branches.

WaMu is not the last cockroach in the pantry. There is still expected to be another round of write-downs when the financial sector reports for Q1. The International Monetary Fund is now projecting losses from the mortgage crisis to exceed $1 trillion. That is still less than several major companies like Goldman Sachs have been projecting for months. There are more roaches in the pantry but at least we know they are there and should not be too surprised when they crawl out.

After the bell UPS warned that Q1 profits will be lower than expected citing lower volume and higher fuel costs. Earnings are now expected to be 86-87 cents compared to prior guidance of 94-98 cents. UPS said lower volume trends in February continued in March making it impossible to high prior guidance. UPS said customers were shifting away from premium products in favor of lower cost shipping methods. UPS warned last month that it might not meet guidance due to deteriorating conditions. UPS said they were going to concentrate on China, India and Europe for growth and said it could no longer rely on U.S. package volume growth. Rival FedEx (FDX) reported lower than expected earnings also citing lower package volume and higher fuel costs. FDX also said earnings for the full year would be under pressure.

Countering the negativity from the UPS news after the close was a WSJ online article that said Citigroup (Nyse:C) is close to selling about $12 billion in leveraged loans and bonds to a group of private equity firms. The sale would be made to Apollo Group, Blackstone Group and TPG and could be final before Citi reports earnings on April 18th. Citi would sell the debt slightly below 90 cents on the dollar. Citi ended 2007 with $43 billion in leveraged loan exposure and this would significantly decrease that exposure. This could be the deal that puts a bottom under the credit crunch. Once private equity is confident enough to step under the declining value of a significant amount of debt the worst may be over. There will still be paper for sale without buyers but the bargain hunters will begin circling like sharks looking to grab the few remaining quality morsels. Citi was up +4% in after hours but the news did not really hit the wires until just seconds before trading ended. As the news became more widely distributed the futures began to climb. Is this the "what" I mentioned in the title for this commentary?

Crude Oil Chart - Daily

Oil prices rebounded on Monday to $109.64 and almost a perfect double top to the resistance high just over $110 from mid March. The gains came on news from OPEC sources they would not discuss production again until September. They are convinced there is enough oil in inventory to cover demand. On the same day the Dubai Gulf News posted an article that said OPEC exports from the Persian Gulf region would drop one million barrels per day during July and August due to higher energy use within the gulf region. This seasonal cycle has been increasing in recent years as the region added skyscrapers at the rate of dozens per year. The primary fuel for generating electricity in the area is natural gas. As demand increases in July/August there is less gas to reinject into the oil wells to maintain pressure. This results in less oil flowing to the pumps until the gas demand eases.

The U.S. Energy Information Agency (EIA) said the average price of oil would be around $103.67 in Q2 and over $100.61 for the entire year. They are normally the more conservative of the group in their estimates. They also lowered their demand growth estimate for the various fuels.

The problem is the disconnect between the current demand and the current price. National gasoline prices hit a record of $3.33 on Monday despite demand being 7% below year ago levels as reported in the weekly MasterCard survey. U.S. gasoline inventory is currently 224 million barrels. That is 23 million above a year ago, 19 million above the 5-year average and a 15-year high. Prices should be going down, not up. AAA said the average price in California on Monday was $3.70, NY 3.42, DC 3.41, FL 3.38 and TX 3.26. That is an average of 60-cents higher than the same period in 2007.

Circuit City Stores (CC) reports earnings on Wednesday and expectations are not good. According to various consumer reports the sales of consumer electronics are way down. That covers DVD players, flat panel TVs, satellite radios, audio equipment, etc. Margins on flat panels have fallen below 20% and are dropping fast. LG said today they were considering pulling out of the ultra competitive U.S. LCD market due to shrinking margins. Mirae Asset Securities said there was still room to ramp up production even though the U.S. market was slowing. The rest of the world has yet to reach the saturation level seen in the U.S. but after the Olympics analysts expect demand to slow. With Wal-Mart and the other discount chains willing to sell for profits in the low single digits the squeeze on CC and BBY profits is going to be tough.

Apple Inc (AAPL) was cut to underperform or basically the equivalent of a sell rating at Morgan Keegan on worries that consumer spending in a weak economy could impact revenues. AAPL fell -3.05 on the news and the weak market. The analyst at Keegan said he based his call on "mounting evidence of broad-based weakness in consumer technology spending" in the U.S. and Europe. He used the 2001 recession and slowdown in consumer discretionary spending as a model. He also believes Mac sales will slow and the availability of music without digital rights management (DRM) software will erode the popularity of iTunes. Keegan is the only bearish analyst on Apple with 24 rating it a buy, two neutral and Keegan the only sell. AAPL was up +$2.89 on Monday on an upgrade to you be the judge.

To further complicate tomorrows trading S&P announced late tonight that they were cutting ratings on MGIC Investment (MTG), Old Republic (ORI), PMI Group (PMI) and Radian Group (RDN). S&P cited continued deterioration in key variables surrounding the mortgage insurance business. S&P said worsening conditions prompted them to project a 20% drop in home prices, much lower than their 11% estimate back in November. That means the mortgage insurers will not post a profit again until 2010 according to S&P. The ratings cut puts in jeopardy the firms ability to sell insured mortgages to Fannie and Freddie because the ratings are below the minimum AA- rating. S&P said replacing this insurance would be nearly impossible since these insurers account for 58% of the market. This follows a move by Fitch last Friday to downgrade Ambac (ABK) and MBIA (MBI) to AA and trigger another round of worries about counterparty guarantees.

The various earnings stories above are probably just a taste of what is to come. S&P earnings are now expected to fall -11.8% from the year ago quarter and that is worse than the -8.1% estimate just one week ago. Financials are the anchor dragging them lower with expectations for a -61% drop. Only energy is expected to show a gain but that has been dimmed by the higher costs being seen in that sector. $108 oil is great for them but bad for refiners and oil at those levels triggers higher royalty payments in many countries. No single sector seems to be immune to the earnings plague and that could be the biggest weight on the market over the next week. The big techs begin reporting next week with Intel on the 15th and IBM on the 16th. Those two will likely set the standard and the direction everyone else will follow.

The Dow has gone nowhere for a week. The April Fool's Day breakout rallied to about 12700 and there it stopped. Monday's attempted breakout was hammered back and Tuesday's earnings related decline pushed the Dow back to support at 12550. While this is a decent support level it would not be the end of the world if we dropped back to retest 12200. I would hate to see it but it is always possible and would not specifically negate the rebound off the March lows.

The Nasdaq is a mirror image and even with a -16 point drop today the initial support at 2340 still held. The Nasdaq could decline to 2300 and not raise any eyebrows. With the major tech earnings still a week away there is no way to accurately predict the rest of this week. The internals are mixed but the Nasdaq has already withstood multiple hits and survived. Until it finds traction and moves over 2400 anything is possible.

Nasdaq Chart - 120 Min

S&P-500 Chart - 120 Min

The S&P-500 actually looks a little stronger than the Dow/Naz and appears to be respecting initial support at 1360. Stronger support remains 1320 and well under the current level. The Russell-2000 has the same chart pattern and suggests some accumulation occurring on the dips.

The best indicator I can find tonight is the volume. It has declined every day since the April 1st rally and failed to break the 6 billion market today. At 5.8 billion shares traded that is the lowest volume we have seen in 2008. This suggests this is simply a buyer boycott rather than a reload by the shorts. The bulls are just waiting for a signal to run again. The bears were crushed by monster short squeezes on March 24th and April 1st and they appear reluctant to jump back into the battle despite the ugly earnings picture.

I seriously doubt any investor who has been in the market for more than six months actually expected earnings to be better than expected for Q1. Everyone is expecting them to be worse and the real surprise would be better than expected results. This suggests the warnings and misses may have little impact on the market unless it turns into a flood of really negative guidance. I believe investors are waiting for more earnings clarity from the financials. We have firms predicting over $1 trillion in losses and others saying the worst is over. This extreme divergence in opinions can only be resolved by the majors reporting Q1 earnings and confessing their current holdings and outlook. Eventually some of these write-downs will become write-ups and the market will immediately forget the multiple quarters of gridlock and pain. That may not happen until Q4 but they could start making positive statements as soon as next week. If the credit markets are loosening up as evidenced by the $12 billion Citigroup deal then we could easily return to business as usual over the next couple of months. Business as usual in the credit markets would mean a strong rally in the equity markets. I am still in dip buy mode over S&P 1320. My concern from last Tuesday has eased and my recommendation has not changed.

Jim Brown

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