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Market Wrap

Calm Before the Storm

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Today's rally on calm economics was equivalent of moving your boat from an ocean front harbor to one well up river from the coast ahead of a hurricane. The first three days this week have minimal economics but the last two days are chock full of critical data that could roil the markets. The rally today was blamed on the Merrill Lynch news but I believe that blame was misplaced.

Wilshire-5000 Broad Market Index Chart - 90 Min

The economics today consisted of another dreary Case-Shiller Home Price update and Consumer Confidence. The home price index showed that prices fell to another 12-month low but the rate of decline was slower at about -1% from April to May. This was a report for the May period so it was a lagging indicator and nothing new for investors to absorb.

Consumer Confidence for July rebounded only slightly from 51.0 to 51.9 with the expectations component rising +1.6 to 43.0 after setting a record 30-year low in May. The present conditions component fell fractionally from 65.4 to 65.3. Dragging on the current conditions component was deteriorating labor markets. Those who think jobs are plentiful fell to 13.5% and the lowest level since December 2003. Those finding jobs hard to get rose to 30.3% and the highest since May 2004. Those consumers expecting jobs to become harder to find rose to 35.7% and the highest level since 1980. Those planning on buying autos and appliances fell but those planning on buying a home rose +10% over the prior month. Lower gasoline prices and tax rebates were credited with the minor bounce in the headline number.

Today's rally was blamed on the drop in oil prices and on the changes announced by Merrill Lynch. In case you missed it Merrill said two weeks ago they had no need to raise additional capital. Last night Merrill announced they sold $8.55 billion of common shares at $22.50 each. That represents more than 380 million new shares. Merrill also reported they sold $30.6 billion of CDO debt to Loan Star Funds for 22 cents on the dollar or more than $6 billion. They will take a $5.7 billion write down in Q3. By selling the CDOs they turned a liability into cash and reduced their leverage. Merrill shares dropped sharply at the open on the huge dilution from adding 40% more outstanding shares. Shares dropped to $22 before rebounding sharply on heavy volume to close at $26.30 for a gain of +1.96. Considering Merrill traded as high as $37 just four days ago it has been a rocky five days.

It was also reported that Singapore sovereign fund Temasek was going to invest another $3.4 billion in the new Merrill stock offering. That was a misrepresentation of the facts. Temasek invested $4.4 billion in Merrill at $48 several months ago. As part of their deal they had a price-reset clause that lowered their price if anybody else bought stock at a lower amount. As part of this reset clause Merrill owed them a refund of $2.5 billion of their prior investment. Temasek agreed today to convert that $2.5 billion into new stock at the $22.50 price. As part of the conversion they agreed to invest another $900 million at the $22.50 price. So Temasek did not really write a check for $3.4 billion in new stock as the press reports would have you believe. They just benefited from new Merrill offering by having their basis cut by more than half. Basically they got a 2:1 stock split on their original $4.4 billion investment. They put out very little in additional cash but doubled their shares. Of course if you loved Merrill enough to invest $4.8 billion at $48 then you should really be ecstatic about buying it again at $22.50. Merrill now has the largest investment by sovereign funds of any U.S. company at $14.5 billion.


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Lone Star Funds bought $30.6 billion in collateralized debt obligations or CDOs from Merrill for $6.7 billion. It was their third large purchase of this junk debt. They bought $1.5 billion from CIT and several billion more from Accredited Lending and a monster chunk of the Bear Stearns portfolio. While it sounds on the surface like Lone Star was stepping up to a major high-risk purchase the truth is always stranger than fiction. It turns out Merrill loaned Lone Star $5 billion to make the purchase. Hey, Lone Star, I have this $31 billion pile of crap on my books and I need to dump it. I will loan you $5 billion to take it off my hands. Yes, I know it is only worth 10 cents on the dollar today but it could be worth 50-cents in a couple years. Come on buddy, I know you like bargains and this is a really valuable asset that is why we are dumping it. All joking aside this is a sweet deal for Lone Star. These mortgages are being valued so low because nobody knows what they are really worth until the sub prime housing crisis goes away. Even if 25% of the loans go into foreclosure the sale of the properties will eventually cover the majority of the debt on those loans. If the other 75% end up paying as agreed then Lone Star would get 100-cents on the dollar for those. That would easily cover any shortfall in the distressed sales. Lone Star is not a public company so they don't have all the accounting rules about fair market value and they can wait for the loans to recover.

Here is the real kicker. By selling this highly visible chunk of CDOs it establishes a true market price for this kind of distressed debt. Banks with this debt in their portfolio now have to write down that debt to this valuation or have a very good reason why not. For Goldman, Lehman, Morgan Stanley and JP Morgan it is not a problem because their exposure to CDOs is around $1 billion each. However Citigroup has exposure of about $18 billion and Bank America $4.5 billion. Several analysts immediately hit the news wires with expectations of another $8 billion write down by Citi due to the Merrill sale. Sometimes you just can't get a break. Deutsche Bank estimated the Citi write down at $7 billion. Several analysts said the odds of another capital raise at Citi just went up substantially. Citi has already gone to the well more than once so any new raises are going to be a challenge. Odds are better that Citi will accelerate sales (dumping) of its non-core assets to raise capital. Regardless of what Citi does the sale of the CDOs should start another wave of write-downs by all the major financial institutions still holding that toxic debt.

The bond insurers MBIA and SCA saw some strong gains on the sale of the Merrill CDOs. Merrill announced it was cutting the obligations from SCA as part of the CDO sale. As these problem loans are taken off the books the risk to the bond insurers drops. This suggests they will eventually escape much of the pain that had been forecasted for them. MBIA (MBI) gained +16% today.

The financial sector gained on the Merrill news because many analysts now believe the worst is almost over. There will still be further downgrads, write-downs and capital raises but at least the end is in sight or so they think. After three days of strong selling in financials and increasingly dire predictions each day the Merrill news was another shock to the shorts. They probably thought when they heard the news Monday night that the markets would gap down a couple hundred points today. You can imagine their surprise when the financials rallied instead and producing another textbook short squeeze. Jon Najarian said on CNBC that shorts in the financials were at 19.6% of the float last week. That was a huge pile of dynamite just waiting to explode.

Crude Oil Chart - Daily

Falling oil prices also helped stocks rally with oil falling to $120.14 intraday before closing back above support at $122. This is a critical level for oil prices and a break below $122 targets $110. The antagonistic comments from Iran's president on Monday pushed oil back to $125 but a later speech was seen as conciliatory. Ahmadinejad seems to be playing tough in speeches his people will hear and soft in those heard only by the outside world. The lack of any high profile speeches by Ahmadinejad today, no attacks in Nigeria and no storms on the horizon helped depress prices. The MasterCard spending pulse report showed gasoline demand was down for the 14th consecutive week in the U.S. but it was the strongest week in the last two months.

BP PLC (BP) posted a 28% rise in profits in Q2 or $9.47 billion. Revenue was $110.9 billion or more than the GDP of Kazakhstan. BP's new CEO has been on a restructuring binge and it appears to be working. Of course the price of oil helped the most. BP warned that refining margins so far in Q3 were running below normal. They announced a quarterly dividend of 84 cents per share. The good news was not enough to shake off the drop in oil prices and BP closed down -1.56. BP is also at war with Russia over the fate of the TNK-BP joint venture. That has been dragging its share price down for weeks.

Yahoo (YHOO) broke under $20 this morning after Boone Pickens ridiculed Yahoo management over their bungled deal with Microsoft. Pickens said he sold his entire stake of 10 million shares at a loss. He would not say how much he lost but he acquired the stake back in mid May when prices were $24-$28 a share. His "friend" Carl Icahn suggested he buy the shares with expectations he could renew a $33 sale to Microsoft. That never worked out for Icahn and now that he has a seat on the board he is less able to agitate for change or speak negatively about the board. Kind of a tough pill to swallow but once your short-term trade turns against you in many cases it becomes a long-term investment. Note to Boone, - with friends like Carl Icahn you don't need any enemies. Heck, what is a $50 million loss among friends? Icahn is down about $350 million so far so Pickens deal could have been worse. Reportedly there is a new word making the rounds. When a deal goes bad you no longer say "I got screwed." Now the term is "I got Yanged" as a reference to how Yahoo founder Jerry Yang botched the Microsoft deal and cost shareholders billions. The Yahoo shareholder meeting is this weekend. Mr. Yang, if you see shareholders carrying ropes and torches you should leave quickly.

Ford warned its dealers it was raising the prices on leasing for its most profitable trucks and sport utility vehicles due to "extreme losses" it was incurring. GMAC, the lending arm of GM, has decided to stop extending lease deals to customers with weak credit. Reportedly this applies to the bottom third of acceptable credits. According to a dealer briefed on the Ford move the higher prices will make Ford trucks and SUVs "lease proof." In other words the prices will be so high that consumers will not be willing to agree to the terms. The new Ford rates will begin on August 1st. Ford said auction values for off lease 2-3 year old trucks and SUVs had fallen $2,400 to $2,700 per unit compared to July of 2007.

StarBucks (SBUX) announced it was cutting 1,000 non-store jobs and eliminating the COO position. It is also closing 61 stores in Australia. The announcement came just a day before SBUX is scheduled to report earnings for the second quarter.

Metlife (MET) dropped -$6 in after hours after posting earnings that fell -19%. Operating income came in at $1.30 a share when analysts were expecting $1.51. MET said they took more catastrophe losses from tornados, hail and flooding in Q2. MET also reported losses of $233 million in its $350 billion investment portfolio. The losses were said to be due to the credit crisis.

The markets sprinted higher at the open and in the case of the Dow and S&P they never looked back. That was because of the short covering in the financials. The Nasdaq and Russell sprinted higher at the open but lagged in the afternoon with minimal additional gains. Obviously they lacked the financial components. The Dow rebounded +266 points to a dead stop at resistance of 11,400. This would be a perfect place for a failed rally. You have to wonder if the bearishness in financials will return once investors realize this means another round of write-downs and capital raises to dilute their holdings? Based solely on the Dow I would be neutral tonight. The S&P chart looks exactly like the Dow with a stop in the middle of its recent range.

Dow Chart - Daily

S&P-500 Chart - 60-Min

Fortunately the Nasdaq is projecting a more bullish picture. The index regained everything it lost on Monday and added more to close at 2319. This is also exactly resistance for the last month but we saw strong gains in chip stocks and that typically is a leading indicator of Nasdaq performance. Even Intel shook off news that the next generation of Mac laptops would not be powered by Intel chips. The Nasdaq appears poised to move higher but we tried that once last week and failed at 2350. That will become the next target if the Nasdaq can move over 2320 tomorrow.

Nasdaq Chart - 90 Min

Russell-2000 Chart - 90 Min

The Russell was also bullish but ended the day unable to move back over its 1:15pm high. Russell 715 appears to be a pause point in the move higher. It is not really a defined resistance point but close. Currently 718 to 721 is the clear hurdle to cross. The Russell dipped as low as 697 this morning but still well above my projected dip support level of 690.

Unfortunately today was just a short covering day on only moderate volume of 8.9 billion shares. Volume the prior two days was only in the mid 7 billion range, which is good if the markets are moving lower. You want the markets to go down on low volume and up on strong volume. Volume of 8.9 billion is not strong volume. It was just concentrated in the financial shares and those are the largest sector in the Dow and S&P. I would remain cautiously bullish for Wednesday with today's Russell low of 697 as the new decision point. I would buy dips to 697 but if we move under that level I would go short or flat. Remember this is the calm before the storm of economic data due out on Thr/Fri. On Thursday there is the Employment Cost Index, GDP, NAPM-NY, Kansas Fed Survey and PMI. On Friday we get the ISM and the Non-Farm Payrolls. Next Tuesday is the FOMC meeting and the Fed is likely to raise rates. All of those reports are going to impact the market in some way. Buckle your seatbelt.

Jim Brown

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