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Market Wrap

Danger, Low Volume Week Ahead

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This was not an exciting week. The major averages rebounded to close only slightly negative for the week but the rebound was less than exciting. Support was tested but were it not for the Friday short squeeze I am not sure if that support would have held. I am starting to worry that September may live up to its reputation as a rocky month.

NYSE Composite Chart - Daily

Friday's economics were less than exciting despite a drop in the mass layoffs for July. This is a lagging indicator but still one where the trends can be projected into the current forecast. Mass layoffs in July fell to 1,512 from 1,643 in June. Workers involved fell to 151,171 from 165,697 in June. Layoffs spiked in the auto industry to more than 15,000 and temporary help services at just over 14,000. The transportation sector saw 57,761 layoffs. Manufacturing in general still accounted for the majority of the layoffs at 108,733 workers. Despite the big numbers this was the second consecutive month that mass layoffs declined.

There are quite a few reports due out next week but few of any importance. The highlights include the FOMC minutes on Tuesday, GDP on Thursday and the Chicago PMI on Friday. The FOMC minutes of the August 5th meeting will tell us what the Fed was thinking at the last FOMC meeting. This is key since there is another meeting coming on Sept 16th. The Fed is no longer expected to raise rates at this meeting. The Fed funds futures have fallen to only a 13% chance of a 25-point hike. That was as high as a 120% chance just a few weeks ago.

The second look at Q2 GDP is not expected to change from the +1.89% growth in the first release. Several factors have changed but they should cancel each other out. If the GDP were to surprise significantly to the downside it would produce a negative market. Everybody is assuming we dodged a recession and any evidence to the contrary would be detrimental to our fragile market.

Lastly the Chicago PMI on Friday is expected to decline back into contraction territory after five months of growth and a positive move over 50 for July. Should this indicator surprise to the upside it would be market positive.

The rest of the reports should be market neutral. We will get updates on both sentiment and confidence and another round of bad news on home prices. Bad news on all of those reports should be priced into the market. I also added the OPEC and FOMC meetings to the schedule for the following two weeks.

Economic Calendar

Friday was a strange day in the markets. We opened higher on the strength of comments from Buffett, Bernanke and the potential for a buyout bid for Lehman Brothers. Financials exploded to the upside and a new short squeeze was born. With short interest extremely high after a week of declines in the financials it was a powder keg ready to blow.

Warren Buffett started the rally when he said in an interview on CNBC that he was adding to his stake in either American Express (AXP) or Wells Fargo (WFC). The sly old fox would not say which one and that gave a lift to both. He also said he was seeing better opportunities in the stock market now than he has over the last year. Since stocks are 20% lower now that should come as no surprise. Buffett also said he no longer had any bets against the U.S. dollar. Those comments were enough to get the party rolling but not all of his comments were positive.

Buffett also said he believes the economic downturn will be longer and deeper than many people think. The economy won't be better five-months from now but will rebound within the next five years. He believes inflation will continue to rise. He said he made a mistake in selling BUD before the final deal was done. He thought BUD was going to put up a stronger fight and he sold on the initial pop. He expects the government will have to act to bail out Fannie and Freddie and there is a reasonable chance the shares go to zero. On the political side he suggested contributors to John Edwards file a class action suit seeking the return of their money because Edwards misled them about his extra-marital affair. When you are as old as Buffett with his amount of money you can say what you feel and not worry about the ramifications.


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Bernanke added fuel to the rally when he said the Fed should be able to keep interest rates low for some time because the recent drop in commodity prices coupled with reduced demand should reduce the threat of inflation. "If not reversed, these developments, together with a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year." He also acknowledged slowing growth and rising inflation had combined to create "one of the most challenging economic and policy environments in memory." That is even more difficult because the turmoil in the financial markets "has not yet subsided." His comments were seen as an indication that the Fed would not be raising rates in the near future.

Lehman (LEH) opened with a significant pop to $16 from its close at $13.63 after state-run Korea Development Bank said it might be interested in buying the troubled firm. Lehman was valued at $9 billion at Thursday's close and the Neuberger Berman asset management business Lehman owns is thought to be worth $8-$10 billion. That means everything else Lehman owns is being valued at zero. The KDB news came after a newspaper reported Lehman had approached KDB and CITIC Securities, China's biggest brokerage, about a 50% stake in Lehman. Both reportedly walked away saying the price was too high. The KDP CEO had led local operations for Lehman for three years. The Chosun Ilbo daily cited government sources that claimed Lehman had also approached Korea Investment Corp (KIC), a sovereign wealth fund, about a major stake and the fund turned them down. Any of these foreign entities could write a check for Lehman out of petty cash but they would have a hard time getting it approved by American regulators. An analyst quoted on CNBC Friday morning said he believed Lehman would follow Bear Stearns into oblivion. Dick Bove said Lehman is so undervalued several bidders were likely to appear soon. He values Lehman at $20 per share. Bove felt that KDB was going public with the interest in Lehman in hopes of attracting a U.S. partner. Effectively they were saying we want to buy Lehman but we know the regulators won't let us without a U.S. partner. Lehman lost the majority of its early gains to close up only 69 cents as the various analysts downplayed the KDB chances for a deal. The news was enough to help fire up the rally but the Lehman match burned out quickly. Analysts expect Lehman to lose $4 billion in Q3.

Paul McCauley, from Pimco, said in Jackson Hole on Friday morning that another bank failure, including the GSEs could be imminent. Late Friday the FDIC reported they had shut down the Columbian Bank of Topeka Kansas. This was a small bank with $752 million in assets. The FDIC did not give a reason for the closure but said Columbian reported $92 million in delinquent loans in the second quarter. Columbian said five borrowers represented half of the $92 million problem. It was the ninth bank failure in 2008 compared to three in 2007. The FDIC has been rapidly adding to its staff in order to handle the expected wave of bank failures from the current credit crisis. The biggest failure for 2008 was IndyMac at $32 billion. On Wednesday the FDIC announced a program where thousands of troubled homeowners with loans at IndyMac will be able to switch to a 30-year fixed rate mortgage capped at 6.5%. This will be an important test case for future bank takeovers. If the FDIC can avert bankruptcies and foreclosures by rewriting the loans then it will become a standard practice. There were 90 problem banks on the FDIC list in the first quarter. They do not disclose the names for obvious reasons. Historically only 13% of the banks on the list fail with the rest nursed back to health or taken over by some other bank. Of course the current mortgage crisis is not a historical norm so I expect to see more than 13% fail. The FDIC collected $37.1 billion in the first quarter from the member banks to cover losses from soured mortgages. This bank was not on Paul McCauley's radar when he was speaking Friday morning. He was referring to a major bank default ahead.

There was another set of bailouts discussed on Friday. The big three automakers plan to ask Congress for up to $50 billion in low interest loans over the next three years to help them modernize their assembly plants and develop next-generation fuel efficient vehicles. The loans are twice the amount authorized in the last energy bill and automakers claim they need even more to rapidly change the types of cars they build. The loans would provide for up to 30% of the cost of retooling facilities to build hybrids, electric cars and other alternatives. The automakers said they did not see it as a bailout but a government assistance program.

You probably heard last week that the $2 billion Andor Capital Management hedge fund was going to shut down and return money to investors. The founder is retiring after 24 years in the investment business. Strange that he did not sell the fund rather than shut it down. Quite a few hedge funds are reportedly shutting down and they try to do it quietly. Hedge Fund Ore Hill Partners, $3 billion, was in the news on Friday after they were forced to gate their $1.2 billion Ore Hill International fund after investors tried to withdraw $300 million on the upcoming withdrawal date in September. Hedge fund investors typically have to give a 45-day notice of intent to withdraw funds at quarterly withdrawal periods. Gating is a procedure for limiting withdrawals to prevent a run on the fund. Reportedly this could be the first year where more funds close than new funds open. This has been a very tough year to trade with the volatility extremely high from day to day. Funds trying to trade as they always have using increased leverage were crushed as that leverage turned against them.

With the Q2 earnings cycle over the actual S&P earnings came in with a -22% decline. If you take out the financials, energy and consumer discretionary as sectors with the biggest influence the remaining earnings for Q2 were a positive +4%. That is not exciting but still indicates positive growth. If you do the same for Q3 the estimates don't change much from actual of +2.4% compared to +5% with the exceptions. However, there is a qualification. In Q2 of all the companies that issued guidance only 20% actually hit their guidance leaving a whopping 80% doing worse than they expected. If that same trend carries through Q3 then we could see those positive estimates turn very negative.

If its August it must mean there is a hurricane on the prowl. This weekend we still have Fay to kick around and there are two more tropical depressions heading our way with the potential to turn into hurricanes. Fay completed her reversal and is now over water again in the extreme northeast portion of the gulf and headed towards New Orleans. Fortunately her crisscross of Florida reduced her wind speeds but now over water those winds can increase again. The following chart is a history of Fay's track. I have never seen a storm cross Florida west to east and then return to the gulf. The second chart shows Fay and the two new storms that could turn into problems next week. The red circle is going to move right up hurricane alley between Cuba and Mexico and could be a problem. The yellow circle is headed towards Florida.

Storm track charts

The emergence of Fay back in the gulf had zero impact on oil prices on Friday. In fact oil fell -$6.59 for the biggest one-day dollar drop since 1991. The big gain to $122 on Thursday was completely erased when Russia pulled out of Georgia. Suddenly the threat to the three Georgian pipelines was removed as was support for Thursday's short covering spike. Crude closed at $114.59, -$7.50 from Thursday's high and after the beating the new buyers took the odds are good crude is going lower. Those odds would shrink if Fay suddenly rises to category three and continues to move towards the oil patch. There was also a monster 61-cent bounce in the dollar index and that helped deflate all dollar denominated commodities. That 0.8% spike in the dollar equates to a sharp drop in the number of dollars required to buy a barrel of oil. If this trend keeps up you can count on OPEC to announce a production cut in some form on Sept-9th.

Crude Oil Chart - Daily

After last week I am far less bullish than I was a week ago and I was borderline then. I worried all day Wednesday and Thursday we were going to break support and plunge back to the lows. Fortunately that did not happen but only because of the massive short squeeze on Friday. The Lehman news, Bernanke and Buffett speaking in public and the settlements with the SEC and NY Attorney General on the auction rate security front gave traders a reason to cover shorts ahead of the weekend. This was a prime example of what can happen if the financials finally start to rally. Eventually that will happen but with the daily downgrades and people like Buffett, Bernanke and Milton Friedman and major brokers including Goldman, Citi, JP Morgan and Merrill all saying this week that the banking turmoil will continue the odds of a lasting bounce are slim. Without a financial rally the markets cannot mount a lasting bounce.

Add in the historically ugly month of September and we are treading on thin ice. Volume is extremely thin with volume on Friday just barely breaking the six billion share mark and this was a major short squeeze day. If it takes a 200 point rally to break 6B shares that should be a clue that there was no conviction. The wild card here is the election factor. With the Democratic convention next week I would not expect anything material out of the administration. However once the Democratic convention is over and the Republican convention starts I think we can see some government action on things like Fannie and Freddie and anything else the administration can think of to help make voters think the worst is over. I am not trying to be partisan here but it is a historical fact that whichever party is in power they will pull strings to orchestrate events in hopes of influencing the votes. Part of creating that warm fuzzy feeling for the voter is supporting a bullish market. We are a little early in the cycle but be aware it is coming. Next week is not only a holiday week as the last week of summer but also the airwaves will be filled with convention coverage.

The Dow rebounded to just below prior resistance at 11650 on the opening bounce and then failed to add even a single point the rest of the day. It was a prime example of no conviction on a gap open day. Resistance remains strong at 11650-11700 and it will probably take a major news event to produce a breakout. Support is now 11300 and a break there could easily see 11000 once again.

Dow Chart - Daily

The S&P-500 came to a dead stop at 1290 and a level that has been resistance since late June. Following that level is round number psychological resistance at 1300 that held so strongly a week ago. Support is 1265, 1250 and 1210. The Dow and S&P will be held captive to whatever the financial sector is doing. If oil continues lower that will be a double whammy for the S&P with a large energy component.

S&P-500 Chart - Daily

The Nasdaq and the Russell have been the pillars of the market and they both collapsed last week. The Nasdaq managed to avoid a touch of 2350 and the Russell barely missed a touch at 720. Both of those numbers were levels I said I would buy. While both posted decent rebounds they lagged the Dow on percentages. A quick look at the top ten Nasdaq stocks showed only two still rising at the close, INTC and CSCO. I would be more prone to short this rally than buy it.

Nasdaq Chart - Daily

Russell-2000 Chart - daily

All the negativity in the world could vanish in a heartbeat if a Lehman buyout is announced over the weekend and Hank Paulson announces some kind of Fannie/Freddie solution that does not harm existing equity holders. It won't fix the banking system but it would be a vaccination against a complete breakdown. I would be surprised if the administration would give the Democrats that kind of headline to abuse next week. Instead I believe we are in for a real dose of the summer doldrums with no news and no volume. We know that volume is a weapon of the bulls but I think next week they will be saving their ammunition for a bear hunt later in the quarter. If the market moves higher I will remain long but I am also going to be looking for any signs of a failure to exit. I am no longer recommending buying dips to Nasdaq 2350, Russell 720. I could be completely wrong but the signs are starting to suggest the bulls are leaving the building.

I would like to invite everyone to attend the 2008 Peak Oil Conference with me on Sept 21-23 in Sacramento. About 20 Option Investor subscribers and myself will be attending and it will definitely be fun and entertaining. There are dozens of speakers and all the presentations will have reams of data on Peak Oil and its impact. It is not specifically on investing for Peak Oil although there is a presentation on that in the schedule.

The conference will convince anyone that peak oil is real and give you a countdown calendar for its arrival. I have dozens of people email me every week asking questions about peak oil. This is where to get your answers. The first day is the story and all aspects of the coming problem will be presented. The second day covers the impact. What role will coal play? What is the future for aviation? How will governments react to the changes? What hardships will ordinary people be forced to endure?

I have been to two of these ASPO conferences and it is the only conference I would not miss for the world. This is the definitive answer to all your peak oil questions.

All the Option Investor attendees will sit together so we can talk about the presentations during the breaks. I will be holding an evening session just for OI attendees and it will be Q&A and a general discussion about what we heard that day and how to profit from it. I strongly suggest anyone concerned about their future not miss this opportunity.

Go here to register: http://www.aspo-usa.org/aspousa4/

On the third page of the registration put my name in the "How did you hear" box. That way I can track the registrations and send you emails about meeting times and places.

I guarantee you will not be disappointed with what you learn.

See you in Sacramento!

Jim Brown

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