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Market Wrap

Financials Tank Again

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BoI know it is hard to believe but the financial stocks were down again on fears the current financial crisis would cause more write-downs. Obviously unless you live in a cave that should have been common knowledge but evidently some traders did not understand that there was still a risk to the sector. Goldman Sachs dumped on AIG, JP Morgan dumped on Lehman and traders dumped financials. Any question?

Wilshire-5000 Chart - Daily

Economics reports this morning did not help market sentiment either. The Producer Price Index (PPI) jumped +1.2% for July following a +1.8% gain in June. Inflation is positively soaring at the producer level at the fastest rate in 27 years. Even core inflation was stronger than any month over the past year. Over the last 12 months finished goods are up +9.8%, core finished goods +3.6%, core intermediate goods +10.2% and core crude goods +36.9%. Finished energy goods rose +3.1% after a +6% rise in June. I could go on listing line after line of increases but you get the idea. We know much of this inflation is related to energy and energy prices have declined. However there is still plenty of hangover from $147 oil still in the pipeline. Still analysts don't feel this is going to carry over completely to consumer prices with demand so low. It is tough to pass along higher prices when you have excess inventory sitting on the shelves. Until this price inflation starts being passed on to the consumer the Fed can still be patient on raising rates. Several analysts now feel the Fed may actually cut rates as their next move instead of hiking rates.

That rate cut sentiment was not being felt by all Fed officials. Dallas Fed President Richard Fisher was heard trying to make his case for rate hikes sooner rather than later in a speech in Aspen on Tuesday. He said the conventional wisdom that inflation would peak as oil prices decline and the economy slows might turn out to be wishful thinking. Fisher said, "The Fed should remain poised to hike rates if slowing growth fails to contain inflation." Fisher has been agitating for higher rates for months. Richmond Fed President Jeffrey Lacker was giving the same speech in an interview on Bloomberg. Lacker said, "We are still in a fairly risky situation on the inflation front." He said the Fed must not let core inflation settle in at this new higher level and will have to hike rates before the financial markets are tranquil.


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Housing starts for July fell to 965,000 and a 17-year low. Starts were down -11% from June and -36% from July-2007. Permits also dropped back to the cyclical low after a surge in June. The drop in housing starts reflects the decline in purchases and the drop in mortgage availability. The last consumer sentiment report showed consumer interest in buying a new home was rising but without financing that is not going to happen. The only good news in this report was a headline number that did not drop as much as several analysts had expected. The Toll Brothers CEO was on CNBC today and he said the homebuilders were just trying to sell homes at a price that recovered their land costs and try not to go out of business before the cycles reversed. That is a business plan I can understand. Most analysts expect housing starts to continue to decline through October and then increase slowly. That matches the cycle needed for late Q4 starts to be completed by spring selling season.

The bad news in the economic reports was overshadowed by the bad news in the financials. Lehman (LEH) was crushed again after JP Morgan said Lehman was facing "another difficult quarter." This was not unexpected since Merrill, DB and Fox-Pitt have said the same thing over the last two weeks. It was just further confirmation that there was still another shoe to drop. Analysts expect Lehman to write down another $4 billion in mortgage-backed securities when it reports earnings in September. There were also rumors Lehman was looking to sell its Neuberger Berman investment management business in an effort to raise cash. Several private equity firms have reportedly been approached by Lehman on the possible sale. Lehman is trying to retain an equity portion estimated at 20% but still get $8-$10 billion for the sale. Several brokers pointed out that a sale of the profitable Neuberger business would hurt Lehman's earnings in the future because it provides a healthy stream of income and is rated highly by the agencies. Dumping Neuberger may be a last resort play that could have drastic consequences. Lehman lost -13% on the news. There are rising expectations Lehman is becoming a take under candidate like Bear Stearns.

After the bell Goldman Sachs cut earnings estimates on JP Morgan to 40 cents from 64 cents. The Goldman analyst also raised the estimate of losses at Lehman to as much as $3.5 billion. Goldman also cut full year forecasts for Citi, Merrill Lynch and Morgan Stanley. Goldman said "we expect no or negative earnings for the majority of firms in our universe this quarter and for some of our firms it will mark the 4th consecutive quarter of reported losses." Citigroup expectations for this quarter were cut to zero from 17 cents, Lehman to a loss of $2.75 from a profit of 68 cents, Merrill to a loss of $4.75 from $4.40 and Morgan Stanley to 85 cents from $1.10. The analyst also lowered full year estimates on everybody. They recommended buying Morgan Stanley as the best situated for a recovery and shorting Citigroup as the most exposed to mortgages and consumer credit issues.

Dow component AIG lost another 6% to $20 after Goldman Sachs said the potential for another capital raise and ratings downgrade is increasingly likely. Goldman said they expect another $9 to $20 billion in economic losses for AIG from their credit default swaps. This could result in larger cash outlays resulting in a shift in the risk quality of AIG assets and forcing rating agencies to downgrade their paper. This would require large-scale capital raises on the part of AIG. Credit default swaps are essentially a type of insurance on complex financial contracts. In early August AIG reported a worse than expected $5.36 billion loss on mortgage-related write-downs. Goldman cut their price target to $23 from $30.

Fannie and Freddie are not finding any love from analysts this week. A Barron's article over the weekend predicted the government would have to nationalize both companies because of the rising losses in the mortgage market. Jonathan Laing said, "Such a move would almost certainly wipe out existing holders of the agencies common stock." A bailout would also mean losses for holders of the companies preferred shares and $19 billion in subordinated debt. Fannie lost -17% and Freddie -14% on Monday. Today FRE lost another -5% and FNM -2.3%. Both closed at new multi-year lows of $4.16 and $6.01 respectively. Freddie sold $3 billion of 5-year notes to yield 4.172% at 113 basis points above the 5-year treasury. Buyers were counting on government backing of the debt in any takeover.

There is rising fear that another large U.S. bank is going to fail. Former IMF chief economist Kenneth Rogoff said on Tuesday the U.S. is not out of the woods and we are going to see a "whopper" of a bank fail. He said it could be a big bank or one of the big investment banks.

Retailers also disappointed traders with warnings about future sales. Home Depot (HD) reported income that fell to $1.2 billion from $1.59 billion in the comparison quarter. Same store sales fell -7.9%. HD said it expects earnings per share to drop by -24% for the year. HD actually said they felt more comfortable that the loss would not be worse than 24% because homeowners were still making needed repairs while leaving the bigger jobs for later. They projected sales would decline by -5%.

Target (TGT) reported earnings of $634 million, down from $686 million. Sales rose 5.7% but same store sales fell slightly. Profits from its credit card division were $74 million but that was a drop of 65% from the $213 million earned in the comparison quarter. The drop came from larger write-offs of bad loans and larger reserves for future loan losses. Target sold 47% of its credit card receivables to JP Morgan in May for $3.6 billion. Target is expecting same store sales to decline 1-3% in August.

Saks (SKS) said it lost $31.7 million for the quarter and expects same store sales to decline no more than the "low single digits" for the second half of the year. Sales fell -3.5% in Q2. Saks said it experienced "widespread weakness in women's apparel."

SStaples (SPLS) warned that earnings would be below expectations and could fall -15% when it reports on Sept 3rd. Prior guidance was for a breakeven quarter. The company said it was hurt by lower traffic volumes and smaller orders. Same store sales in the U.S. fell about 7% but international sales rose 17%.

Casino stocks crapped out this week on fears China will act to further limit the number of times a citizen can travel to Macau to gamble. In July China imposed a limit on visas to Macau to once every two months. A Portuguese news agency, Lusa, reported on Tuesday that the Chinese government may tighten this even further to one visit every six months. As of September you can no longer travel to Macau from Hong Kong using a Hong Kong visa. The major casino stocks were crushed this week after the rumors broke over the weekend. LVS fell -9, WYNN -10 and MGM -5.50. The Sands Macau casino is the largest in the world as measured by the number of table games. The Venetian Macau is the largest building in the world and opened in 2007. The CEO of the Sands said on Tuesday the Chinese government conned us into building there. Jefferies analyst Larry Klatzkin warned on Tuesday that they were expecting revenue growth of only 9.1% for the second half of 2008 and a decline of 8.3 in the first half of 2009. Morgan Stanley said the selling might be premature because the new regulations have not been issued yet and could be watered down due to the uproar over the move.

It must be wonderful to live in a communist country where all your decisions are made for you. I have a friend who adopted a Chinese girl as a baby. She is now 13 and China keeps sending the girl letters offering her a two-week "visit" to decide if she wants to return to China permanently. This girl was barely alive when she was adopted with numerous diseases and worms so bad she was skin and bones. It took years and tens of thousands of dollars to fix all the problems caused by neglect. I could see her wanting to visit her heritage but there is no chance she would ever take their offer to stay.

After the bell today Hewlett Packard (HPQ) reported earnings that jumped +14% and beat Wall Street's expectations. Earnings of 86 cents beat expectations of 83 cents. HPQ also guided higher for the current quarter to $1.03 per share. HPQ retained its number one position against Dell and Apple and with the EDS acquisition they will take another huge step forward in revenue when that acquisition completes. Revenue rose 10% over the comparison quarter. HPQ rose +1.43 in after hours trading.

September Crude Futures Chart - Daily

Oil prices rallied to $115.76 intraday after trading under $112 most of the night. The rally was blamed on a lot of things but I didn't hear anybody mention the expiring futures. The electronic contract expired at the close today and Wednesday is the last day of trading on the big contract. I suspect the rebound was short covering ahead of expiration after support at $112 failed to crack. Another factor was a female direction change. Tropical storm Fay was headed northeast across Florida when it suddenly appeared she might change direction and head west again. The storm track had been projected to head up the Atlantic coast but as of tonight they are projecting a turn back towards New Orleans. I have never seen a storm go from the gulf across Florida to the Atlantic and back again to the gulf but I guess there is a first time for everything. That sudden direction change put the oil patch back in danger if Fay actually completes the reversal. Several forecasters are projecting a stronger return to the gulf than the NOAA track shown below and a 25% chance she will move back over water and intensify.

Tropical Storm Fay

The Mastercard spending pulse report showed a 17th consecutive week of declines in gasoline demand. The average price of gasoline dropped to $3.74. Believe it or not the buying interest for SUVs has picked up sharply over the last two weeks. Once the price of gasoline started back down the urge to get a bargain on an SUV was too much to bear. Fortunately dealers have plenty of inventory and plenty of incentives to unload them. Days of supply for gas-guzzlers are at decade highs while economical cars are moving briskly.

The markets are on a sell cycle this week and the techs and small caps have not been exempted. The Dow has lost -300 points so far this week and with the Goldman downgrade of the financial sector tonight the odds are good we will see some more red ink at tomorrow's open. The Dow closed under initial support at 11400 and could easily test 11200 or even 11000 if the negative financial news continues. The short-term uptrend on the Dow is still intact but only barely. A move under 11200 would end it. AIG, AXP, JPM and BAC were the biggest losers on the Dow and that trend will likely be repeated. The S&P-500 mirrors the Dow with initial support at 1250 and the end of its short-term uptrend if that level breaks.

Dow Chart - Daily

The Nasdaq gave up 32 points to close at 2385 and still above initial support at 2350. The Nasdaq and Russell are still the strongest indexes in terms of August gains but both suffered the biggest percentage losses today at -1.34% for the Nasdaq and -1.6% for the Russell. If these indexes are going to relinquish their leadership then the market is in trouble. I would like to maintain a cautiously bullish outlook but there is only so much news about the potential failure of a "whopper" bank that the market can take. Bank borrowing at the Fed discount window continues to set new records. That is not a healthy sign. August and September are normally the weakest months for the market and with the financial and economic news turning progressively more negative I am having a hard time retaining a bullish perspective. Below Nasdaq 2350 I would be cautiously bearish and below 2300 definitely bearish.

Nasdaq hart - Daily

Russell-2000 Chart - Daily

The Russell closed at 729 and just above initial support at 720. The Russell tested the June resistance highs above 760 on Friday and it has been downhill ever since. On Sunday I said, "I would look to buy dips to 2350/720 but hope support at 2400/740 holds." Hope failed at 2400/740 and we are looking at a test of primary support at 2350/720. I am going to keep that recommendation but add I would go short under 2350/720. On the Russell we have pretty good support at 700 but if the trend has changed that may only be a pit stop on the way back to 660. The earnings cycle is over and the dump financials cycle has resumed. The economic cycle is turning ugly and the markets could be entering a spin cycle as they spiral down into a normal October low. I hope this is not the case but with multiple downgrades of financials every day there is little hope left if that support breaks.

Jim Brown

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