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Market Wrap

Eternal Hope

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Hope springs eternal on Yahoo with another nice gain after falling to $23 on Monday. Somebody is making large bets on talks resuming with Microsoft. Large blocks of shares were being purchased suggesting either Microsoft has decided to amass a large position on the open market before getting back into the fight or somebody else is amassing shares in anticipation of a new suitor. Yahoo fell to $23 on Monday after Microsoft walked away from the acquisition. Prices reached $26.24 intraday on Tuesday on huge volume of more than 178 million shares or about 13% of the outstanding shares. Yahoo founder Jerry Yang is in the middle of a firestorm of criticism for letting the Microsoft deal go away. Major shareholders are applying pressure and small shareholders have the opportunity to join one of the many class action lawsuits against Yahoo. Yang may be yielding to the pressure according to some comments he made on Tuesday. Yang told Reuters he had "mixed feelings" about the breakdown in talks and was still open to negotiations. "If they have anything new to say, we would be open. I am more than willing to listen." That willingness to listen may be due in large part to the pressure from major shareholders. Gordon Crawford, the portfolio manager for the largest single shareholder, Capital Research Global Investors, which holds 16% of Yahoo shares said, "I am very angry at Yang and the so-called independent board." The number of major shareholders angry at Yang suggests there could be an opening at the top very soon with Yang being forced out according to an analyst at Sanford Bernstein. It was learned today that Yahoo never even notified the major shareholders that Microsoft had increased its offer to $33. Analysts think that is because those shareholders would have pressured Yahoo to take the deal.

Yang's threats to sell off or contract away parts of Yahoo to thwart any future Microsoft offer did not set well with many investors. Yang's actions and threats suggested a personal emotional reaction and not a reasonable business decision in the shareholders best interests. On the Microsoft side there does not seem to be any remaining interest in the deal. Jean Philippe Courtois, president of Microsoft International, told Reuters that the company has moved on from Yahoo and will focus on its own strategy to be a leader in Internet services. When asked if that was the end with Yahoo, he replied: "Absolutely, that is the end of the story. We are moving on because our strategy is very clear." In a play on words it looks like Yahoo dropped the Ballmer on this deal.

Yahoo Chart - Daily

Fannie Mae (FNM) reported a loss of $2.51 billion or $2.57 per share for the first quarter. This was even worse than even the most pessimistic forecast and follows a record $3.6 billion loss in Q4. In order to save cash Fannie will cut the dividend to 25-cents from 35-cents starting in Q3. Fannie also announced plans to raise an additional $6 billion in capital through common and preferred stock offerings. This news initially caused a sharp drop in FNM shares. However, news that the regulator for Fannie said they were going to drop the capital requirements and lift a consent order that had restricted some of Fannie's lending activities. Fannie's problems are just another step in a worldwide crisis that has seen write-downs of more than $330 billion and new capital raises of more than $200 billion. Fannie's CEO said, "We are in the belly of this housing cycle. The initial period of (disruption) in the marketplace appears to be dissipating. The capital markets are recovering balance." Fannie's total book of business and mortgage market share grew throughout the quarter. Fannie recovered from the opening gap down to $26.25 to trade back over $31 just before the close. Not bad for a $2.5 billion loss and $6 billion dilution announcement.

Goldman Sachs was back in the spotlight on oil prices. Goldman said in a research note that a "super-spike to $150-$200 a barrel is increasingly likely within the next 6-24 months. We believe the current energy crisis may be coming to a head, as a lack of adequate supply growth is becoming apparent and resulting in needed demand rationing in the OECD areas in particular the United States," Goldman Sachs analysts said in a research note Monday. Three years ago Goldman shocked everyone with their prediction of a spike to the then unheard of price of $105. The analyst, Arjun Murti, was highly criticized for his $105 call when oil was only $55 at the time. Goldman's then CEO, Hank Paulson, now US Treasury Secretary, was forced to defend his bullish call. Today Murti said, "We believe we may be in the early stages of having the end game of our 'super-spike' thesis play out, with crude oil prices having risen over $50 a barrel since the U.S. economic crisis began last summer - a remarkable move and one that we think is fundamentally supported by tight global supply/demand balances. On the supply side, spare production capacity from the Organization of Petroleum Exporting Countries would continue to remain tight, with exports likely to be hampered by lackluster supply growth and sharply higher domestic demand," according to Murti. "Meanwhile, non-OPEC crude production would also struggle to grow, particularly in Russia and Mexico. Cost inflation and restrictions on foreign investment in many exporting countries would further limit oil supply growth. On the demand side, a downturn in U.S. and Organization for Economic Cooperation and Development countries consumption would be outpaced by strong demand growth in non-OECD countries, keeping oil market fundamentals tight," according to the Goldman analyst. Last month, Chakib Khelil, president of OPEC, also warned that oil could reach $200 a barrel. Open interest in crude options at the $200 strike has tripled since January. Oil prices hit a new high of $122.73 intraday and closed at $121.83.

Actually the Goldman call is contrary to reality over the next 18 months. We are actually going to see a supply surge from a flurry of major projects coming online through 2009. The gains in 2008 and 2009 are expected to be close to 7 million barrels per day. It takes 6.1 mbpd of new production each year to offset declines in existing fields and an average of 1.6 mbpd of new demand. After 2009 the cupboard is bare. New production coming online is less than that 6.1 mbpd and significantly less beginning in 2013. Major new finds take 5-7 years to bring online in any type of quantity. Dozens or even hundreds of new wells must be drilled. Infrastructure as in pipelines, storage, processing plants, etc, need to be built before production can begin. For an offshore find in deep water it can take 7-10 years for full production to begin. As an example the new Tupi field offshore Brazil is not expected to be in production until 2018-2020. That means EVERY major field scheduled to come online in the next 5-10 years has ALREADY been discovered and production planning is in progress. As you can see in the new supply additions chart below there is hardly any new production scheduled past 2012. Some smaller fields will eventually be added because the lead-time from discovery to production is much quicker. Unfortunately the world needs that 6.1 mbpd of new production each year to stave off disaster. It is simply not going to happen.

Megaprojects Chart

Countrywide (CFC) continued its decline although only fractionally. The worries are growing that the acquisition by Bank America (BAC) may not happen. With hundreds of federal fraud, racketeering, truth-in-lending and other claims pending there are increasing expectations that Countrywide may end up in bankruptcy. The need to go through bankruptcy is growing. That may be the only way to limit the growing liabilities. BAC has already warned they might not guarantee any of Countrywide's debt. This is a clear warning that trouble is brewing. There are rumors making the rounds that the acquisition does not make sense at any price. BAC recovered from Monday's drop on hopes that they would walk on the Countrywide deal. If Countrywide does head into bankruptcy the Countrywide bank would be split out and sold through the FDIC system rather than continue as a part of the parent company. This reduces the value to Bank America. The bank unit has about $120 billion in assets and those will go to secure the bank's liabilities. They will probably not be available to help the Countrywide parent cover its increasing problems. The Countrywide parent has roughly $50 billion in debt, vendors and other liabilities. This is turning into a real can of worms for BAC and the outcome is definitely in doubt. BAC is liable for a $160 million breakup fee if they walk and that has got to be looking like chump change compared to their possible loss if they try to conclude the deal.

On a side note the announcement by BAC about not backing the $50 billion in CFC debt could have been the reason for the surprise announcement by the Fed of the increased Term Auction Facility debt limits and the acceptance of much weaker securities as collateral. Are they giving Countrywide and/or BAC a way out of the mess?

Builder D.R. Horton (DHI) posted a loss of $1.31 billion or $4.14 per share. This loss included a pretax write-down charge of $834 million on the value of land and homes. They had 15,100 homes in inventory at the end of the quarter. That has got to hurt!

After the bell Disney (DIS) reported earnings of 58 cents compared to estimates of 51 cents. Revenue jumped almost a billion dollars from $7.95B to $8.71B. Disney said its theme parks had not seen any material decline from the high gas prices or economic decline. Revenues at theme parks rose +11%. Disney is offering vacations for families of four for $1,600 and has priced 75% of its hotel rooms in the medium value range that compares to only 50% in the 1990-1991 recession. They benefited from several major movies and DVD sales including National Treasure, Hannah Montana's Best of Both Worlds, Enchanted, Game Plan and No Country For Old Men. Disney spiked $1 in after hours.


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Also reporting Cisco Systems (CSCO) had earnings of 38-cents that were 2-cents above analyst estimates. Revenue at $9.79 billion was nearly a billion over the comparison quarter but only slightly over analyst estimates. Cisco guided investors towards 9% to 10% sales growth for the current quarter and roughly inline with estimates. Normally bullish CEO John Chambers said he expects companies in the U.S. to remain cautious through the end of 2008. Cisco spiked a buck on the initial report but gave it back with the cautious guidance comments. Chambers said Cisco was seeing some orders delayed and that is normally what happens in weak economic times. On the conference call Chambers said, "Overall I wouldn't say yet that there is a turn. I would say it feels pretty steady in terms of business momentum." CFO Frank Calderoni urged analysts to "model on the conservative side due to macro-economic challenges."

Apple Inc (AAPL) hit a new 4-month high at $186 after announcing a deal with Vodafone Group (VOD) to distribute the iPhone in 10 countries. Telecom Italia (TI) also announced it was going to distribute the iPhone in Italy. Italy is the largest prepaid phone market in the world. 91% of Vodaphone users in Italy have prepaid cellular. Apple reiterated its goal of selling 10 million phones in 2008. Apple has been struggling in the U.K. and Germany where users have been slow to convert to the big screen iPhone rather than the heavily subsidized phones from rivals.

Merrill Lynch (MER) dropped about $3 at the open on new revelations about their subprime holdings. They recovered all but a nickel before the close. Merrill disclosed that their level III assets rose by $28 billion over the quarter. Level III assets are those, which are valued using management's own assumptions rather than market prices. Assume you have a house that was worth $500K in 2006 but only $400K today. If you continue to value it at $500K just because you think it is worth that then it would be a level III asset for you. Jerry Yang is valuing Yahoo at $40 because that is what Microsoft offered for the company in early 2007. The market is valuing it at $26. Who is right? If a company has massive level III assets would you believe those valuations? Merrill's level III assets rose from $41.4 billion to $69.9 billion. Does that give you much confidence in the value of Merrill?

Dow Chart - Daily

The markets shook off the morning earnings shocks to move higher by the close. The Dow was down triple digits at the open but recovered to close +51. That was +169 points off its lows. With Disney up in after hours the gains should continue on Wednesday. Strong support is still 12800 but that is more than 200 points under the close. For the last four days the Dow has bumped up against the 200-day average at 13040. Once over that resistance the next level of concern is around 13500. The Dow is in breakout mode and built a solid base over the last the weeks around that 12800 level.

The Nasdaq is performing very well led by Apple, RIMM, Microsoft, Cisco and Intel. I am unsure how Cisco will trade on Wednesday given their cautious comments. There was a strong ramp into earnings and we could see some post earnings depression. Still the Nasdaq is pressing resistance at 2500 and that is tremendously better than the 2200 lows we saw in March. Support is still 2400 and well below our 2483 close. This is a bullish tape and a move over 2500 should attract a lot of new money.

Nasdaq Chart - Daily

S&P-500 Chart - Daily

The S&P has finally broken the 1400 resistance level with conviction. After spending two days above 1400 the decline on Tuesday saw 1400 act as support rather than resistance and this is a very positive sign. It is not going to be a cakewalk higher but the forward motion should continue.

The Russell is still the drag on sentiment. The 730 level is holding as resistance and there is no conviction being shown by fund managers. The Russell needs to breakout with conviction to really confirm the rally.

Fund managers are only buying the highly liquid big caps where they can exit in an instant if something goes wrong. Until that changes the market will remain highly volatile. According to an analyst at Merrill the hedge funds are sitting on $116 billion in cash and are still heavily short equities. A Merrill survey found that the majority were still expecting a retest of the March lows for an entry point. This is a very strong contrarian indicator. If they are short and in cash a continued move higher will force a continued short squeeze and those who are paid to perform will end up chasing prices higher with their available cash once the pain of lost profits becomes too great.

We had some terrible news from the financial sector this morning and the markets shook it off before noon and returned to their recent highs. When bad news is met with a bullish tape the bottom is likely behind us. However, 77% of the S&P-500 stocks and 85% of the S&P financials are now above their 50-day averages. This is the highest reading since October. Analyst Bennet Sedacca notes that a combination of annual, decennial and presidential cycles gives a potential market top date for the S&P as May 8th. These were the same cycles that predicted a market bottom on March 15th. FYI, the low came on March 10th and the retest was March 17th. Pretty good call on that cycle work. The key now as I have been saying is the sell in May cycle. Now that Cisco has reported the last big dog has left the building. By the end of the week 90% of the S&P will have reported. If the sell in May event is going to occur it should happen over the next 10 days with options expiration on the 16th a key inflection date. So, watch the Russell for conviction, the calendar for timing and S&P 1400 for direction. Long over 1400, short below it.

Jim Brown

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