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Greenspan Warned Us

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Many years ago Allan Greenspan testified before Congress about the dangers of Fannie and Freddie failing and their impact on the global economy. With a combined total of $5 trillion in mortgages on their books they represent a major problem if they fail. That $5 trillion in mortgages have been sliced and diced and resold into the global debt markets. Compared to the impact of the subprime crisis a failure of these government-sponsored entities could be ten times worse. However, they are "government sponsored" and that means the government would support them in some form. What form that will take remains to be seen.

S&P Financial Sector SPDR - XLF

Over the last couple weeks financial analysts have said Fannie and Freddie would have to raise another $75 billion in capital to comply with current equity guidelines. They have already had one capital raise a couple months ago but now it appears the bottom has fallen out of their valuations. Worries were rampant that the government would have to step in and guarantee the debt and convert the companies from public to governmental or at least place them into a conservatorship. Many of the possibilities would include a wipeout of stockholder equity. It would be extremely difficult for FNM/FRE to raise additional capital with worries that any capital infusion could be wiped out.

The problem continues to be the decline in housing prices and rising foreclosure rates. Every foreclosure requires FNM/FRE to raise capital to offset the non-performing mortgage. Since Paulson and crew have said the decline could last well into 2009 the news is going to get worse before it gets better. The problem with the government taking over FNM/FRE is the drain that would place on the government and the economy. Taking on another $5 trillion in debt even if only in name would cause another significant drop in the dollar and a rise in mortgage rates. However, contrary to what some analysts are saying regarding that $5 trillion in debt the government would only have to cough up about $150 billion to guarantee the current and future problem loans not all the loans. Fannie and Freddie "are" the secondary mortgage market today and without them actively buying mortgages the rates on mortgages would move higher and put additional pressure on the housing decline. To whatever extent the government had to fund mortgage defaults it would fall on the taxpayers to make up the shortfall. The combined default rate on that $5 trillion in mortgages is only 1% but that means they currently have only $50 billion in defaults. The combined companies either own or guarantee 70% of all mortgages written in the U.S. but in core capital each has less than 2-cents in capital for every dollar of liability on those mortgages.

There are multiple ways to handle this situation without a government takeover and one of them was rumored on Friday. About 12:45 on Friday Reuters said Bernanke told Freddie's CEO that they would be able to use the Fed's discount window to remove their short-term liquidity pressures. The discount window is normally only for investment banks and opening it to Fannie and Freddie would be a major change in policy and another major cash drain on the Fed. However, it would be an opportunity to ease the current crisis with a minimum of stress. The markets quickly went from down -251 on the Dow to positive territory in just a few minutes. Freddie (FRE) had been down -50% intraday and it quickly returned to positive territory. Shortly thereafter the Fed denied the report and the markets imploded again. As an example of the panic in Freddie nearly 400 million shares traded out of the 646 million outstanding. To say owners were bailing in record numbers would be an understatement. The markets closed sharply negative after the Fed declined to comment on the rumor. Late after the bell the Fed put out a press release saying there were "no" ongoing conversations regarding opening the discount window for FNM/FRE. This carefully worded press release did not say there had not been any conversations only there were no ongoing conversations. These competing press releases were probably just the beginning and I am sure there will be a lot of news over the weekend as the government tries to calm the markets and the rumors. Paulson said the primary government mission would be to support Fannie and Freddie in their current form rather than as government entities. Next week is sure to see continued volatility in these names and in the banking sector as many of the major firms report earnings.

Also late after the bell Fannie said they had raised additional capital of $7.8 billion in May and said their capital levels were substantially above statutory minimums. In fact Fannie claimed it has more core capital and capital surplus than at any time in the company's 78-year history. Fannie said they had access to ample liquidity including the debt markets. Fannie issued $24 billion in debt this week alone including a $3 billion benchmark note sale that was oversubscribed. Freddie also put out a statement after the close saying they were under no mandate to raise additional capital. If the combined companies had made these announcements during market hours the indexes would have closed substantially higher.

Friday's economic reports were not material to market movement and were completely overshadowed by the worries over Fanny and Freddie. Consumer Sentiment was unchanged in July at 56.6 despite the tax rebates. Higher gasoline prices depressed holiday driving and consumer spirits. The current level of sentiment is not only consistent with prior recessions but with severe recessions and that is not yet being seen in the economic numbers. Employment has yet to fall to recessionary norms and that would depress sentiment to even deeper lows.

Next week we will get the Producer Price Index and the Consumer Price Index and the latest inflation information. On Tuesday the FOMC minutes for June will be released on Wednesday and everyone will want to know what the Fed really thought when they met and kept rates level last month. On Thursday we will get the Philly Fed report for another look at manufacturing conditions.

Economic Calendar

Other than Fannie and Freddie the markets next week will be controlled by earnings news rather than economics. Many of the major market moving companies will report next week and their results will determine the market bias for the rest of the summer. Overall S&P earnings are expected to drop by -12.8% according to Thomson Financial. If you remove the banking sector the S&P would see a rise of +8.7%. If you remove energy the decline would be -20.3%. Nine of the top ten sectors have had their expectations cut and 60% of all the preannouncements have been negative. 10% of the S&P announces earnings next week but nearly all of the critical benchmark stocks are reporting. Those include INTC, EBAY, IBM, MSFT, GOOG, MER, JPM and Citi. Add in JNJ, UTX and HON and you will have a very good picture of Q2 and of the overall guidance for the rest of the year. After next week you could actually cancel the rest of the earnings calendar and nobody would notice. The market bias for Q3 and the year will be set in concrete by next Friday's close.

Earnings Calendar

GE reported earnings on Friday that were inline with estimates at 54 cents per share. Revenue rose +11% to $46.89 billion. GE ended the day flat after giving guidance that many analysts thought was light. GE predicted a rough Q3 with its commercial finance profits down 10-15% and profits at GE Money flat to down 5%. Full year profits for all of GE were expected to be flat to up +5%. That is a far cry from the mid teens Jeffrey Immelt promised investors a couple years ago. GE posted a surprising drop in profits for Q1 due mostly to the Bear Stearns implosion and the impact on the credit markets. Analysts were not impressed with GE's tepid forecast saying their core business sectors were outperforming at other companies and GE was not keeping up with those other companies in their group. It appears GE simply grew too big to manage and GE is trying to narrow its focus. GE announced on Friday a sale of its Japanese consumer finance business to Shinsei Bank for $5.4 billion. GE is also going to spin off to shareholders its consumer and industrial operations in the first half of 2009 and is trying to sell its U.S. private label credit card business but is finding no takers. GE shares are down 24% YTD.

Apple shares took a $4 hit on Friday after software glitches hampered the sales of its new iPhone. After waiting in line for hours buyers were frustrated they could not activate their phones or could not access Apple services like iTunes. AT&T said the problem was too many people trying to access iTunes and the Apple software store at the same time. Since Friday sales were expected to be nearly 400,000 units I could see why the circuits would be busy. One buyer said he spent 4-hours in line and 1-hour in the Apple store and still could not activate his phone several hours later. This will pass and Apple will rise again.

The long lines at the Apple stores caused investors to sell RIMM stock but that is a misdirected trade. RIMM dropped -$7 on the idea that the new iPhone would slow BlackBerry sales. They are not the same. Forget it. Buy RIMM on dips and the Friday dip to $110 is a gift.

Cisco was pulled from the Goldman conviction list and replaced with Qualcomm. QCOM gained +16 cents, CSCO declined 31-cents. Yawn!


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Rupert Murdoch, chairman of News Corp (NWS) said on Friday he does not expect News Corp to be a part of any Yahoo buyout. He went even farther and said there will not be a Microsoft deal saying in six months Microsoft will tire of the chase and walk away. According to Murdoch Yahoo's largest shareholder Gordon Crawford of Capital Research Global Investors was upset that he did not get $33. Microsoft offered $33 in May but Jerry Yang would not budge from $37. YHOO is $23 today. Reportedly Microsoft advances to News Corp and Time Warner have come up short in trying to find a partner for a Yahoo deal. Nobody wants to touch the company in its current state of lockdown. Yahoo will eventually learn that resistance is futile and the company will either be sold to Microsoft or decline to such low levels that some lesser desirable entity comes knocking with a $10 offer.

The Wall Street Journal's Dennis Berman theorized that a deal will happen at $33 before the August 1st shareholder meeting. He believes the impending board takeover by Carl Icahn will put the fear of God in the current Yahoo management and they will take a known offer for the entire ball of string rather than risk being sliced and diced to different buyers after Icahn gets control. Several major shareholders have said they will back Icahn but there is still some indecision on whether he has enough votes. Lastly what happens to Yahoo if Icahn gets control and Microsoft lowers its offer significantly knowing there are no other suitors and Icahn went though the battle just to complete a sale to Microsoft? Congratulations Carl on your Yahoo victory, enjoy the company as it spirals down to single digits with no Microsoft deal. Reportedly despite several long phone calls between Ballmer and Icahn there is no deal and Ballmer does not like Icahn. Icahn can't talk to Yang so the trio is left playing passing cryptic notes implying possible offers and rejections. Microsoft is clearly in the drivers seat and they are in no hurry to play let's make a deal.

August Crude Oil Chart - Daily

Oil prices hit another new high on Friday at $147.27 as worries over Iran, Nigeria and Brazil hit the tape. After the -$10 drop the first two days of the week nearly every oil bear had loaded up on shorts thinking the bubble was finally bursting. Then Condelezza Rice and Iran got into a war of words on Wednesday and Iran started firing off missiles to punctuate their claims of massive retaliation for any attack. On Friday there was another round of Iran worries after the Jerusalem Post said Israeli planes were practicing in Iraq for an attack on Iran. The paper said the planes were using U.S. controlled airfields in Iraq and were establishing forward supply bases for the coming attack. Iraq, Israel and the U.S. all made strong denials saying the newspaper claims were utterly baseless. It was still enough to squeeze the shorts once again to a new high over $147. Later in the day various sources were claiming that the pictures of missiles being fired in Iran had been altered, were all the same picture from different angles and were of outdated rockets and the actual test could have occurred years ago.

Nigeria said the MEND rebels were canceling their ceasefire as of midnight Friday and to expect new rounds of violence against the oil infrastructure. Violence has kept over one-third of Nigeria's oil off the market for the last year. In Brazil Petrobras said workers were going on a 5-day strike starting on Monday. Workers said they would allow minimal production unless Petrobras tried to send in their own teams. If that happens the strikers vowed to disconnect and disable the equipment. Workers on the 42 Petrobras oil platforms in the Campos area are demanding an extra day off each month. Personally I think they already have it great with 14 consecutive days of work followed by 21 days off. The Campos area represents 80% of Petrobras daily production of 1.8 mbpd. Since the strike is limited to 5-days this should not create any impact to the market other than some news ripples.

Matthew Simmons was interviewed on CNBC again on Friday and was again adamant that this price hike was just another step higher towards $200 oil and higher. He said as long as so many people continue to expect a return to lower prices nothing will really change. Consumers will drive less in the short term but not really change their consumption habits. He thinks the government should be worried about how to limit consumption and increase production rather than focusing on a witch-hunt for whatever demon caused the problem. He believes the U.S. is on a dangerous spiral where inventory levels continue to decline until some geopolitical event causes a severe shortfall in imports. When that happens there will be a shortage of gasoline and diesel and the country will see severe civil unrest from the lack of fuel and food. I know this sounds dire but I have been preaching this for several years. All of my predictions have come true as many of our readers know. This is just another step in the process of peak oil and while we have not seen the top in production yet it is expected to be in 2009. Once that occurs there will be a serious downward economic spiral not just in the U.S. but around the world. Peak oil does not mean the end of oil, just the end of cheap oil. Every barrel from that point forward will be fought over either by bidding or shooting or both.

On the market front the steep -251 point Dow drop at the open was just another drop in a long slide over the last two months. By any metric the market is grossly oversold. We saw the short squeeze on Tuesday get sold hard on Wednesday when the Dow hit 11400. At Friday's low the Dow fell under 11000 and a level not seen since July 2006. You may remember a couple weeks ago I was targeting 10700 for the Dow and Louise Yamata was targeting 10000. She was on TV again on Friday and she has not changed her bear coat or her predictions. Actually four high profile technicians were interviewed Friday and all four were predicting lower lows. What we are facing today is a crisis of confidence in the banking system, housing sector and the economy along with $4 gasoline, $5 diesel and rising inflation. The headline number on the Consumer Price Index next Tuesday is expected to be +0.8%. The economy appears to be headed for a severe bout of stagflation, a period of no growth and high inflation, like we saw back in the 1970s. Whether it comes to pass or not remains to be seen but we are definitely setting up for that possibility.

With that potential in focus the markets will probably be neutral next week as we await the earnings and more importantly guidance from the big firms I highlighted on the earnings list above. The earnings outlook is pessimistic so there is the potential for a positive surprise but as we saw in the GE earnings on Friday their outlook was gloomy. There is a real possibility that we could have more negative than positive news. Couple bad earnings with all those symptoms in the prior paragraph and the path of least resistance is still down. Dow 10700 is only 400 points lower and appears to be an easy target. However, in any bear market there is always the potential for multiple 3-5% rebounds and even rallies for up to 10%. I am not predicting just explaining. The average bear market peak to initial trough is nine to twelve months. This is the 9th month already so the normal bottom could be anywhere between here and October.

According to analysts the markets have plenty of firepower on the sidelines. Reportedly 23% of money normally allocated to equities is in cash on the sidelines. Think about that number. That is 23% of normally invested cash and a massive amount of money. Short interest continues to be at record highs. New lows hit their second highest level for the year on Friday at 1215. The prior high was 1381 back on March 17th. The combination of available cash, record short interest and grossly oversold conditions have the explosive force of a nuclear explosion if the all-clear signal was suddenly given in the market place. We could easily be up several thousand points over a couple weeks but nobody is even close to giving that all clear signal. There is probably a tradable bounce in our future but I thought that was possible back on Tuesday and it failed miserably. Until something significant changes in the marketplace we will continue to be in sell the rally mode. Negative internals continue to suggest more pain ahead.

MMarket Internals

It is possible that better than expected earnings next week could produce a rebound. I believe it is more likely that any bounce will be sold and we will see Dow 10700 if not Louise mata's 10000 target. The Dow has no visible support between here and 10700. It does have highly visible resistance at 11400. Any bounce should stop there until those broader market issues I mentioned above are resolved. They say the market climbs a wall of worry but this wall is still so clouded in unknowns the bulls can't find a foothold. Until greed overcomes fear the path of least resistance is down.

DoDow Chart - Daily

The Nasdaq tested 2200 again on Friday and that is current support. Under 2200 the next targets are 2050 and 2000. If we hit 2050 I would expect us to retest 2000 since it is so close. Like Dow 10700 Nasdaq 2000 is strong multiyear support. With INTC, MSFT, EBAY, GOOG and IBM reporting next week the tech stocks will become market leaders. The direction they will lead is still unknown but gloomy words from any of them could just accelerate the downtrend. Currently the tech sector is second only to the energy sector in terms of earnings expectations. If they can pull off a positive surprise it would go a long way towards healing market sentiment but I would doubt it could heal the unknowns in the financial sector.

Nasdaq Chart - Daily

S&P-500 Chart - Weekly

The S&P-500 is where technical analysis and fundamental analysis are about to do battle. The S&P hit it's two-year support low at 1225 on Friday. If it were solely up to the charts the S&P would be ready to rally. Unfortunately the financials are the largest sector in the S&P and they are nowhere near a bottom. There have been plenty of bottoms called but none have held. The financial PDR the XLF hit a historic all time low on Friday at 18.29. The unknowns in the sector are simply overpowering the indexes. Bill Gross of Pimco said on Friday he was 100% sure there will be another major bank failure in our future. Lehman, -26% this week, continues to be the one traders point to but there are dozens of others just below the radar. Wachovia (WB) fell -22% for the week.

LLiterally as I was writing the last paragraph the Federal Government announced they have closed the $32 billion IndyMac bank and transferred its assets to the FDIC. This is the largest regulated thrift to fail and the second largest financial institution to close in U.S. history. The largest was the Continental Illinois National Bank with assets of $40 billion when it failed. The Office of Thrift Supervision said IndyMac failed on Friday when it was unable to cover depositor withdrawals. The bank will reopen on Monday as the IndyMac Federal Bank FSB. The FDIC will begin the process to clean up the portfolio and sell the bank to a healthy buyer. Last Monday IndyMac quit accepting loan applications and announced plans to slash 3,800 jobs. The announcement along with a letter to regulators by Sen. Charles Schumer urging them to take action to prevent the banks collapse caused a run on the bank and depositors withdrew $1.3 billion over the last week. The bank's problems came from massive mortgage loan losses and the collapse of the real estate market.

IndyMac Bank Chart - Daily

That should start the markets off on the downside on Monday. Nothing like the second largest bank failure ever to further spoil market sentiment already worried about potential bank failures. I don't know if there is any way the markets can rebound next week given the ugly financial news. Of course things are always darkest before the dawn and it is getting pretty dark on Wall Street. Sell the rallies until something changes.

Jim Brown

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