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Mixed Economics, Mixed Markets

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It was a week of heavy economics but the numbers were mixed. GDP was up but still disappointed and jobs improved but only slightly. The ISM was better than expected but still lower than June. Jobless claims spiked to a 5-year high. New mortgage applications fell to a 7-year low. Overall it was not a good week for economics but given the recession outlook 60-days ago I think we should be counting our blessings.

Wilshire 5000 Broad Market Index Chart - 60 min

The big report for Friday was the Non-Farm Payrolls for July. The economy lost 51,000 jobs and right inline with the prior three months. Analysts had expected job losses of 70,000 to 80,000. The unemployment rate increased by 20 basis points to 5.7% and the highest level in four years. Manufacturing continued to lead the list of job losses with a loss of 35,000 jobs. June job losses of 62,000 were revised lower to 51,000 and May losses of 62,000 were revised to only 47,000. Overall it was a good report for a depressed economy. Losses were less than expected and prior losses were revised lower. We should be celebrating except that the rising unemployment claims to a five-year high suggest that next months report could be more negative.

The average workweek fell to 33.6 hours meaning employers are cutting back on employee hours as a way to trim payrolls without necessarily cutting employees. This was the seventh consecutive month of job losses but those losses have been minimal. Normal job losses in a recession run in the 250,000 to 350,000 per month range. The unemployment rate at 5.7% is considered a lagging indicator and is expected to top out around 6% in mid-2009. The recently approved extension of unemployment benefits will provide support for the economy by giving aid to those who have been out of work for an extended period.

Non-Farm Payroll Chart

The ISM Index for July declined fractionally to an even 50.0 from 50.2 in June. The move was insignificant but positive. Several analysts had speculated it would fall back in contraction territory around 49. The index is consistent with a struggling economy that has avoided a recession. Manufacturing output is muted but still functioning normally. New Orders fell to a new six year low at 45.0, down from 49.6. On the bright side the employment component rose sharply to 51.9 from 43.7 and the prices paid component fell to 88.5 from 91.5. These internal components suggest the August report could be a little stronger as manufacturers gear up for the holidays. Evidence of the global slowdown was seen in the drop of export orders to 54.5 from 58.5. Still in expansion territory but cooling.

IISM Chart

The economic reports for next week are mostly filler with the FOMC meeting on Tuesday the only possibility for fireworks. For next week's FOMC meeting the Fed is faced with an economy that pulled back from the brink but is still peering over the cliff. Manufacturing firmed but only barely. Jobs firmed in that they are not declining into normal recession ranges but are still weak. The financial sector is facing another round of write-downs and recapitalization. There were record borrowings at the Fed's discount window for each of the last two weeks. The Fed may have been considering fighting inflation with a rate hike at this meeting but economic indicators last week have cooled that need. The price of oil eased and as we saw in the ISM the prices paid weakened. There is suddenly no urgency for the Fed to raise rates in this volatile environment. With three Fed members already on the record for wanting to hike rates it should be a volatile meeting and although analysts are now favoring a no hike decision anything is still possible.

Economic Calendar

In stock news GM led the list with a monster $15.5 billion Q2 loss from huge restructuring costs, labor problems and sales declines. The loss per share was -$27.33. That sounds like a lot of money but it only ranked as the third largest quarterly loss for GM. Revenue fell to $38.2 billion, a drop of $8.5 billion from Q207. Analysts were only expecting a loss of $2.62 per share on revenue of $44.57 billion. To say it was a disaster would be an understatement. Any other company would already be in bankruptcy or closing their doors. GM ended the quarter with $26 billion in cash and credit and they only burned through $2.9 billion in cash for the quarter. Analysts believe that without further significant weakening of demand GM has enough liquidity to make it through to 2010. GM dropped to $10 on the news but the real damage was to market sentiment. With July auto sales coming out later in the day the expectations were very low.

Turns out there were good reasons to be worried. Autodata reported late in the afternoon that vehicle sales dropped nearly a million units from the June level to an annualized rate of 12.55 million vehicles in July. This is down from 16.3 million as recently as December. The sharp increase in fuel prices produced an equally sharp decrease in vehicle sales. GM reported a -32.4% drop in sales for July, Chrysler -34.2%, Ford -21.5%, Toyota -18.7% and Honda -9.2%. The last time sales were this low was April 1992 during the recession of the early 1990s. Sales of only the big three fell to an annualized rate of 5.4 million units with market share of imports climbing +29%. When this decade began the big three were selling about 12 million units annually. They only account for 43% of U.S. market share today. Toyota sold 30,000 more vehicles than Ford for the quarter. Analysts claim that consumers have always reacted to previous fuel spikes with a temporary slowdown in buying but always expected normal prices to return and flocked back to trucks and SUVs when prices dropped. They claim this time is different and most consumers surveyed now expect fuel prices to remain high and eventually move higher. Evidently the hundreds of hours of TV news and countless pages of print have finally impressed on Americans that oil will not last forever and it is time to rethink their love for SUVs.

The Yahoo shareholder meeting passed quietly and all the board members were reelected. Jerry Yang retained his position with 85% of the votes cast. Most everyone angry with Yahoo management have already dumped their shares in disgust and those currently holding are expecting somebody to perform a miracle and resurrect Yahoo's stock price. Carl Icahn took the fight out of the remaining shareholders when he agreed to take three positions on the board in lieu of open warfare at the meeting. Icahn was losing support for his board slate after his potential deal with Microsoft failed despite his best efforts. Some shareholders were angry that Yahoo did not allot enough time for shareholder questions. Yahoo's leaders spent an hour defending the Microsoft decision then only allowed 30 minutes for shareholder questions. One shareholder said "it appeared they were more interested in going to lunch than hearing from shareholders." Chairman Roy Bostock staunchly defended the board's actions by listing numerous points regarding the Microsoft negotiations. Microsoft said after the meeting this was "Yahoo attempting to rewrite history yet again with statements that are not supported by the facts." Eric Jackson, a shareholder representing 150 other shareholders, called on Bostock to resign because he overplayed his hand in the negotiations. Another shareholder criticized Bostock for spending so much time defending the handling of the Microsoft negotiations, likening him to a spurned lover in a broken romance trying to "save face." Obviously there were still some hard feelings despite the overwhelming election of the board. YHOO closed at $19.80, just 72-cents over where the stock was trading when Microsoft made the first offer. I am sure there is a number where Microsoft will take another run and this time Icahn will be ready to beat the board into submission. $15 a share, $12, who knows but with every dollar of decline the urge to accept the next offer will be growing. If Microsoft will just keep quiet for a couple months they could get a bargain.

YHOO Chart - Daily

Citigroup got some bad news on Friday from the New York Attorney General. The AG is going to charge Citi with fraudulently marketing and selling auction-rate securities and destroying documents that had been subpoenaed. Reportedly Citi destroyed tapes of phone calls concerning sales of the auction debt. Cuomo's office also sued UBS on July 24th calling it a multi-billion fraud in steering customers into the debt. Merrill is also under attack for the same reasons. The letter from the AG office said any settlement would require Citi to buy back the debt at face value, pay damages to investors and incur a "significant penalty" for its misconduct. I would not hold my breath about a quick settlement. Citi also disclosed it had received subpoenas from the SEC about the sale of the securities. Citi also disclosed subpoenas from state regulators in New York, Texas and Massachusetts and said some of its hedge funds were also targets.

The FDIC announced on Friday it had issued warnings to four U.S. banks that lacked sufficient reserves to cover potential loan losses. The warnings told the banks to raise more capital, expand their loan loss reserves and diversify their loan portfolios or risk being shutdown. Eight U.S. banks have been shutdown so far including First Priority Bank, which was closed on Friday. Sun Trust Banks agreed to take over First Priority and reopen the bank on Monday as Sun Trust. Every Friday now as I start to write the weekend commentary I have a check off list that includes "what bank got shutdown today." You may remember IndyMac Bank was closed two weeks ago and taken over by the FDIC and not another bank. On Friday IndyMac Bancorp, the holding company, filed for Chapter 7 bankruptcy and will be liquidated to pay its creditors. IndyMac Bank was severed from the holding company when the FDIC took over, leaving the holding company without any material assets to repay its liabilities of as much as $500 million. The FDIC is estimating it will cost the FDIC fund up to $8 billion to cover the losses in IndyMac.

Elsewhere in the financial sector you have probably seen the press increasing on the Merrill CDO sale to Lone Star Funds for $6.7 billion. Merrill initially said it was $30.6 billion of CDOs. However, Merrill only carried them on the books for about $11 billion just a couple weeks earlier. Either way they sold them for $6.7 billion but had to loan Lone Star $5 billon to take them. Merrill claimed this cleared the books of billions in risk when actually it just shifted the risk from one category into another by using a $5 billion loan against collateral they already admitted was crap. I described this last week when it happened and as the week progressed several of the major papers have started exposing the ugly details. The latest rumor at the WSJ on Friday had Merrill coming clean with all the details on Monday to shutdown the rising criticism. Should be interesting. Remember you heard it here first.


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Sun Microsystems (JAVA) posted profits that fell -73% due to slumping sales to big U.S. companies. Sun also announced a $1 billion buyback saying the 50% drop in shares has made them a value. Wall Street did not agree and JAVA fell -12% to $9.30. Sun had been riding a wave of profitability of six quarters out of the last seven. Sun still posted profits of 35 cents per share and that beat analyst estimates of 25 cents. Nearly every point in Sun's report including guidance was interpreted as negative by analysts and suggests major companies are withholding purchases until they see the economy recover.

The biggest loser for Friday was Elan (ELN) with a -$10, -50% drop that followed a -39% drop on Wednesday. Its partner Biogen Idec (BIIB) followed with a -$20, -28% drop on Friday. Elan and Biogen Idec were being crushed after two new cases of a potentially fatal brain disorder were reported. The MS drug Tysabri was originally taken off the market in 2005 but reintroduced in 2006 under restricted sales conditions. Patients have to sign a statement acknowledging the risks. 32,000 patients are on the drug with a target of 100,000 according to Biogen. Sales of Tysabri tripled in Q2 to $200 million. Biogen said they did not believe the drug will be withdrawn but they did expect investors to panic. I would say that was an understatement with ELN down -70% in two days and BIIB down 28%.

Oil prices continued to firm around $125 after several attempts to move in either direction. It appears there is plenty of support at $122 but still plenty of sellers waiting at $127. This stalemate will eventually end and I am starting to hear more bullish scenarios than bearish. Crude closed at $125.10 but not before trading at a range from $122 to $128.60 on a flurry of sound bites over Iran. Israel caused a major spike when deputy Prime Minster Shaul Mofaz warned, "Iran is continuing to advance toward a military nuclear capability and is heading towards a major breakthrough." Also, "For Israel, Iran as a nuclear power is an existential threat - and is unacceptable." Mofaz warned that they estimate Iran will reach military enrichment capability as soon as 2010. He warned that Iran is just playing for time as they continue to delay the U.N. group while they continue making strides in their technology. Mofaz said time was a decisive element and the window of influence was becoming smaller and about to close. It is a race against time and with no action time is winning.

Crude Oil Chart - Daily

The deadline for a decision to the U.N. committee is this weekend and Iran stepped out in front of the deadline with tough words. Iran's President ahmoud Ahmadinejad said, "the nuclear issue is just an excuse for the country's foes" and, "Iran will stand against its enemies with its power." The White House was quick with a negative reaction along with spokesmen from other U.N. nations. All were quick to emphasize this weekend was the deadline for a "clear answer" from Iran. Iran replied that there was no deadline but they had "already replied." Given the sharp rhetoric from the P5 nations they failed to get the reply. The P5 are the five permanent members of the U.N. Security Council. Reportedly one idea the P5 nations are discussing is to target Iran's gasoline imports with sanctions. Iran imports a lot of its fuel and shutting that down would cause some serious pain in Tehran. I would worry that civilian hostility towards the U.S. would increase and actually might increase the support for Ahmadinejad.

Oil prices appear to be firming as the deadline approaches. There is also a new tropical depression forming east of the Caribbean and heading in our direction. Forecasters believe this depression has a moderate chance of turning into a storm as it moves over warmer waters but it is still several days away.

The markets were as mixed as the economics and about as exciting as trip to the dentist. Volatility was very strong but only in index movement not in the VIX. Friday saw a little spike in the VIX but it quickly diminished. There is no conviction in the market in either direction and no real movement. The Dow continued to trade in its two-week range from 11200 to 11600 with no surprises. This equated almost exactly with the two-point range in the XLF over the same period. The markets rallied off the financial lows on July 15th but then ran into some serious doubt the rally was going to stick as bank failures increased, write-downs increased and discount window borrowing hit record highs the last two weeks. I keep hearing the bottom is in for financials but then other analysts are heard saying there is another $500 billion in write-offs ahead. Then Greenspan takes to the tube in an interview and says a recession is still more likely than not and home prices could lose up to 35%. It is tough to believe in a bottom with those factors in play.

Dow Chart - Daily

I believe Friday's lack of a rebound was due to anxiety over the FOMC meeting next Tuesday. There are about equal reasons for a hike as there are for a continued pause. Despite late week analysts now saying there is no way they will hike, one said it would be suicide, there is always a chance of a surprise. I actually heard one analyst on Friday saying they should cut rates to give the economy another boost. Even if they don't hike the statement could be detrimental. Don't forget there is an election in 90 days and a convention in three weeks. Politics are definitely in play and every time Obama finds another tax to propose the market is going to stumble. His proposal on Friday to tax oil companies to fund a $1000 emergency energy rebate for consumers did not go over well.

Nasdaq Chart - 90 Min

The Nasdaq faired only slightly better and gaining less than a point for the week. The lack of financials was a positive but several tech disasters did not help. Next week is Cisco's turn in the earnings confessional. They scheduled their earnings for Tuesday and I can't help but wonder if they did it in hopes to get by unnoticed while everyone is talking about the Fed decision. Nortel reported earnings on Friday and lost more than expected and guided lower for the rest of 2008. Nortel said they faced a tough economic environment ahead and lower spending by major customers. Cisco is not Nortel and commands a much stronger share of their market but it will be interesting to see if John Chambers can remain upbeat when the rest of the tech sector seems to be guiding lower. The Nasdaq managed to peek over 2325 more than once but was knocked back to 2300 both Thursday and Friday. The Nasdaq has a feeble uptrend in progress but Cisco could end that trend if they disappoint on guidance. The uptrend can also be viewed as a bearish flag pattern that normally resolves to the downside.

Earnings Calendar

The S&P chart looks slightly better than the Dow this weekend as though it is finally going to break ranks and move higher. I suspect it was the firming in the energy sector that helped provide the lift since the financials have given up the lead. S&P 1285 remains resistance and 1240 support.

S&P-500 Chart - 90 Min

The Russell is still confounding logic with the strongest chart in a seasonal period where it should be lagging. The Russell is still wedging up to resistance at 720 and a breakout could come any day if only it could get some help from the other indexes. A large number of earnings reporters next week are in the Russell-2000 but that is a double-edged sword. The smaller companies don't have the breadth to prosper in a weak economy and we have been seeing some weak results. Fortunately the Russell is broad enough to be able to absorb some hits and keep moving. Resistance is still 720 and support is 697.

Russell-2000 Chart - 180 Min

For next week the Tuesday Fed meeting is the key along with the Cisco earnings. Nothing material should happen before the Fed announcement and the Cisco earnings after the announcement should seal the deal for techs. Just looking at the Dow I would be neutral to bearish with that lower high and routine end of day selling. The asdaq uptrend coupled with the tight wedge forming on the Russell give me a cautiously bullish view as long as I focus on just the charts. Fundamentally I am expecting a retest of the lows. August and September are the two worst months of the year for the stock market. With the record borrowing at the Fed's discount window for the last two weeks I believe there is something happening in the financials that we don't yet know about. If the credit crunch had seen its worst days then the amount of borrowing would be slowing. The rising unemployment claims are also troubling and you have Greenspan on TV saying a recession is still likely. He may not have a clue but his comments still carry weight. When fundamentals and technicals conflict we should go with the charts because they represent the votes of the investing public. However, we should always leave an escape route whenever the outlook is confusing. Custer thought he would win that last battle and he did not plan for things to go bad. My plan is to continue buying the dips as long as the Russell-2000 is above 697. Under 697 we pull the ripcord and bail out of any longs. Under 690 we want to be short. Fund managers tend to clean house after Labor Day and August markets tend to reflect that expectation. Hope for the best but be prepared for the worst.

Jim Brown

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