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Market Wrap

Waiting On The Fed

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I have probably have used that headline a dozen times over the last ten years of commentaries. The FOMC meets an average of 9 times per year so that means I have written about the buildup to FOMC meetings for the week leading up to each meeting for nearly 100 weeks. It seldom changes. The market rallies in anticipation the week before then begins to weaken as traders take profits as the day approaches rather than be caught flat-footed by an unexpected result. This week was no different. Volume has slowed appreciably as the analyst talk increased. Will they cut 25 points or not? Everyone has an opinion and nobody knows for sure. It makes it even more critical this week with the markets struggling to break three months of resistance at 12900, 2400 and 1400.

Dow Chart - Daily

On the economic front Consumer Confidence for April fell to 15-yr lows at 62.3. Actually March 2003 was lower by less than a point but at this level who is going to quibble over a fraction. This drop should be no surprise since the Consumer Sentiment last week fell to 26 year lows. These levels are consistent with a severe recession and not a soft landing. We have seen from recent economic reports that maybe the economic picture is not as grim as most think and the Fed may actually say that in the Wednesday announcement. This suggests both sentiment and confidence could reverse sharply once the newspapers start talking about a recovery in progress rather than a coming apocalypse. The present conditions component was the biggest drag with a drop of -9.8 points to 80.7. The expectations component actually rose .7 to 50.1 and that could be consumers starting to see the economic signs improving.

Consumer Confidence Chart

The monthly S&P/Case-Shiller Home Price Index for February was released today. The trailing 12 month number fell to -13.6% with a -2.9% drop in February according to the 10-city composite index. That was another record for the largest year over year decline since the index began back in 1988. Miami was the largest loser over the last 12 months with a decline of -21.7%. Denver, where we are actually seeing a surge in buying was down only -5.5% for the year and had the least monthly drop at -1.1%. The mortgage reset peak is expected to be in May/June of this year with a gradual decline into 2009. The cheap mortgage boom was 2005/2006 and those ARMS are all rolling over right now. There are reportedly 18.6 million vacant homes in the U.S. and 16 million homeowners are now underwater in their loan to value. By year-end there are expected to be more than one million bank owned homes on the market. To put this in perspective there are only four million homes on MLS. That would mean 25% would be bank owned and selling at a steep discount in most cases. On the bright side 94% of all mortgages are being paid on time.

Case Shiller Table

Wednesday is going to be a monster day for economic events. The Q1-GDP report at 8:30 is going to be closely watched and whisper numbers are creeping up into the +1.0% growth range. Of course this could be anywhere from +1% to as low as -2%. The official consensus is for a small fractional gain of 0.3%. That is a neutral bet by those who don't want to go out on a limb with a bearish forecast. Any number over +0.5% would be greeted warmly by the market.

The April Chicago PMI report at 9:45 is expected to show a bigger drop into contraction territory with a headline number in the 47.5 range. This would be down about a point from March. That would be the third consecutive month under 50. The PMI has a high correlation to the ISM so this should be a preview of Thursday's national ISM report.

Filler reports include the Mortgage Application Survey, Employment Cost Index, NAPM-NY report, agricultural prices and oil inventories.


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The real key for market direction will be the FOMC announcement at 2:15 pm. According to the Fed funds futures there is a 79% chance of a 25-point cut and only a 5% chance of anything larger. The Fed is widely expected to make the cut and change their bias to neutral. Analysts expect a dramatic change in their posture after the rather dire statement last month. The Fed was uncharacteristically negative in the February meeting announcement and analysts are wondering how they are going to do an about face without losing credibility.

Last month's statement said in part, "Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters." Nobody expects the economy to have done a complete about face in only a month but the Fed's liquidity measures have definitely improved the crisis in the financial system. Borrowings through the various Fed liquidity offerings have slowed and although the banks are still posting billion dollar write-downs the situation has improved.

I would say the expectations for the Fed announcement have probably risen to a point where they are too high. Nearly everyone expects one more 25-point cut to take us to 2.0% and then a change to a neutral bias. Traders feel this would be the perfect scenario suggesting the economy was already recovering or at least not getting any worse. The downside to these expectations is the potential for them to not cut again or to raise the inflation warning level to a point where an immediate reversal into a hike scenario is expected.

Just failing to cut again would not be the end of the world. If the reason not to cut is due to an improving economy traders would cringe but then celebrate the end of the recession. The worst scenario is the Fed playing the inflation card. We already had two FOMC members vote against the last rate cut for inflation reasons. If the inflation hawks suddenly outnumber the cooler heads then trader elation over an improving economy will quickly turn into rising fear of an overasctive Fed. Memories of the inflation in the late 70s with rates in the mid teens was forever seared into the investor consciousness. While nobody expects that today the memory always comes back to haunt us whenever the Fed switches to hike mode.

The markets normally do ok when the Fed switches to a hike bias because that means business is booming and profits are growing. It is only when the inflation monster gets up to full speed that rapid Fed rate cuts greases the slide into correction mode.

All of those alternate scenarios will probably not come to pass but depending on Wednesday's Fed statement they will be cussed and discussed over and over in the business news. Most likely the Fed will cut 25, say the economy is no longer weakening, as opposed to recovering, and the Fed does not want to over stimulate inflation by continuing their easing bias. They also don't want to endanger the peak in mortgage resets expected in May/June. Those people need a cheap rate to refi their homes and avoid foreclosure. They will likely mention the success of their various liquidity programs in breaking the logjam in the financial markets. It will be a neutral statement because the Fed will not want to damage the fragile recovery. All the buildup and hype will be forgotten by Thursday morning and traders will be back to the sell in May and go away decision.

I heard a statistic this week that the sell in May strategy has produced winning returns in all but four of the last 27 years. This kind of repeatable low risk return definitely has appeal in normal years. I continue to believe this year is an entirely different ball game. The setup for a recovery rally is almost perfect. I would bet very few institutional investors are willing to miss out on what could be huge gains if the market takes off next week with the Fed's blessing. This could be one of those rare years when the strategy tanks.

The earnings cycle is still in full swing with roughly 1075 companies reporting this week. In the news today BP and Shell both posted strong profits on the rise in oil prices. BP posted a profit of $7.6 billion compared to $4.4 billion in the same quarter last year. Shell reported a 25% rise in profits to $9.08 billion. Shell's profits would have been much higher except for the massive amount of oil production offline in Nigeria. Shell is taking a monster hit with about 600,000 bpd offline on any given week. Some of that has been offline for the last year. Goldman upgraded several of the oil stocks saying they believe oil will continue to rise and with it so will profits. They raised estimates on Exxon (XOM) and Hess (HES) both of which report later this week.

Refiner Valero was not so lucky. Profits fell -85% on record crude oil costs. They have to buy the expensive crude and sell the refined products. Unfortunately despite $3.60 gasoline and $4.10 diesel the price for refined products has not risen nearly as fast as the price of crude. Valero warned several weeks ago that a zero or sometimes negative crack spread would depress profits.

Deutsche Bank (DB) reported its first loss in five years after taking $4.2 billion in write-downs for the quarter. DB ended the quarter with a $220 million loss. This brought their write-down total to $7.8 billion. The banks are still reeling from the total lockdown of the system when Bear Stearns crashed in March.

MasterCard (MA) reported earnings that more than doubled to $3.38 per share, up from $1.57 in the comparison quarter. Cardholder spending rose slightly in the U.S. but grew sharply overseas. That number did have some special items but after items they still earned $2.59 per share and well above the $2 analysts expected. U.S. card purchases rose +8.9%. MA stock rose +$31 on the news. Visa reported earnings on Monday and guided for 20% growth. Analysts were expecting 29% and Visa's stock was punished. It was a quick trip to the woodshed and Visa gained +5.25 today on the positive MasterCard results and guidance.

Countrywide (CFC) posted a loss of $893 million for the quarter due to sharply rising loan loss provisions and deliquent loans. Bank America is buying them for $4 billion in stock. The loss equated to $1.60 per share and revenue fell to $679 million from $2.4 billion in the comparison quarter. Countrywide took $3.05 billion in credit related charges. Chargeoffs rose to $606 million compared to only $39 million in Q1-2007. Deliquencies rose to 9.3% with 4.8% more than 90 days behind. In separate news BAC said it sold $6 billion in debt in an effort to increase capital to cover loan losses. BAC said profits declined -77% due mostly to real estate loans to developers and consumer mortgage problems. On the bright side Countrywide said applications jumped 27% in Q1.

High profile earnings due out tomorrow include PRU, PG, SBUX, TWC, FSLR, GRMN, GM, SYMC, JDSU and CMI.

Crude oil finally lost its traction. The price of oil fell over $3 to close at $115 after spiking to $119.93 on Sunday night. Reportedly this was due to the end of the strike in Scotland that shut down the 700,000 bpd Forties pipeline. Unfortunately that is not the whole story. The strike is over but it could take weeks to get the entire system back up again. The Grangemouth refinery was nearly 100 years old and had not been shutdown completely since World War II. To say there may be problems restarting all that old equipment would be an understatement. They should be able to get the power and steam process running quickly and that is what caused the pipeline shutdown. Yes, the strike is over but some problems may linger. Since the market runs on news events and not reality it was no surprise to see oil finally correct. It will only be temporary but hopefully we will see it drop significantly to provide all of us who did not want to buy energy stocks at $120 oil a chance to enter some new positions.

Crude Oil Chart - Daily

The markets ended the day mixed and still within striking distance of their recent highs. The Dow lost -39, S&P -5 and the Nasdaq gained nearly 2. Both days this week have been lackluster to say the least. Volume on Monday was only 5.8 billion and the lowest day in 2 weeks. Today was only marginally better at 6.2 billion shares. The markets are clearly waiting on the Fed.

The Dow traded over 12900 twice in the last several days only to retreat at the close to its current comfort zone around 12835. I actually think this is bullish. The minor retreat suggests nobody wants to sell and there are plenty of dip buyers waiting in the wings. One analyst said last week there was $3.5 trillion in cash that was earmarked for stocks once a recovery begins. If the Dow can move over 12900 with conviction after the Fed meeting then some of that cash will be put to work.

Nasdaq Chart - Daily

The Nasdaq has become the leading index of late. It has been comfortably over 2400 for a week now although never straying far from that prior resistance. The big cap momentum techs consisting of APPL and RIMM refuse to slow down and they are dragging the Nasdaq higher. Even the chip stocks are creeping higher. It is a clear sign that bargain hunters are getting antsy as they wait for the Fed.

The S&P spent most of Monday just over strong resistance at 1400 but caved in to selling at the close. It did not retreat far to close at 1391 and well within striking distance if the Fed does not spoil the party. The Russell actually broke out slightly yesterday to hit 728 but sellers hit it hard this morning and it closed with a 6 point loss. I believe this was just profit taking ahead of the Fed because exiting on the news from a small cap stock can be painful. This was caution in motion rather than any change in sentiment.

S&P-500 Chart - Daily

I would plan not to be in the market over the Fed announcement but assuming they don't rain on our parade I would continue to buy the dips or any breakout over SPX 1400. The next economic trap is the non-farm payrolls on Friday but assuming the Fed is neutral tomorrow the jobs won't matter unless there is a monster surprise. Please excuse any typing/spelling errors tonight. My spell check in Word suddenly quit working today. You forget how much you rely on it to correct those errors where your brain is thinking one thing and your fingers another.

Jim Brown

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