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Market Wrap

Breakfast At Paulsons

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After another week of declining fortunes and rising revelations in the financial sector it appears we are setting up for another Sunday morning breakfast meeting with Hank Paulson on TV spelling out the terms of another bank takeover. Rumors were flying on Friday of a sale of Lehman to be completed by Sunday. Another rumor had Washington Mutual also being taken over by JP Morgan this weekend. AIG lost another 32% and is rumored to be in trouble as well with a major announcement only days away. Even GE was not immune to speculation over financial weakness from consumer credit transactions and its inability to sell the credit card business. All in all the markets took the news rather well with the Dow the only casualty with a $6 drop in AIG knocking nearly 50 points of the Dow and GE accounting for another -12 points.

NYSE Composite Chart - Weekly

On the economic front the Producer Price Index headline number fell -0.9% and nearly erasing the +1.2% rise in July. The sharp drop was almost entirely due to the fall in the price of oil and gas prices. Prices for finished energy goods fell -4.6% for the month. Core finished goods rose only +0.2% and right inline with the prior trend. If energy prices remain weak we could see a sharp drop in inflation pressures and that would be very Fed positive.

The University of Michigan Consumer Sentiment initial release for September soared to 73.1 and a +10 point gain over the August reading. This is the highest level since January. It was also the biggest monthly increase since Jan-2004. The spike was led by a +13 point surge in the expectations component. It was the biggest increase in that component since 1991 as that recession ended. Inflation expectations also fell sharply due to declining oil prices. The current condition component also rose sharply with a +5.5 point gain. The Michigan Sentiment survey emphasizes consumer finances and therefore the sharp drop in gasoline prices was quickly reflected. However, even at the present headline number of 73.1 it is still below any level seen between 1992 and early 2008. The spike also suggests consumers are expecting the election process to produce change regardless of who is elected and recent events in the news gave them hope on home prices and mortgage rates.

Consumer Sentiment Chart

Retail sales for August did not reflect that rise in consumer sentiment. Sales fell -0.3% and the July number was revised down to -0.5%. Auto sales actually provided a boost in August or the headline number would have been down -0.7%. Other decliners included electronics -1.3%, building material dealers -2.2%, clothing -0.3%, service stations -2.5% and nonstore retailers -2.3%. The drop in sales at service stations was expected given the drop in gasoline prices. Motor vehicles and parts dealers saw a +1.9% gain. The drop in overall sales came from the expiring tax rebates. The money has been mailed and spent leaving consumers with little excess cash for shopping.


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The economic calendar for next week is headlined by the Consumer Price Index or CPI on Tuesday along with the Fed meeting on interest rates. The CPI will tell us how much inflation is filtering down to the consumer level and tell the Fed how concerned they should be about raising rates. There is actually some talk about a potential rate cut in the future given the continued weakness in the banking and housing sectors. Nobody expects that at this meeting but it will be interesting to see what the Fed says in their statement. The Fed Funds Futures are showing a 40% chance of a 25-point cut by December. The next meeting is Oct-28th.

Economic Calendar

The big news for Friday and for next week will continue to be the big names in the financial sector and impending takeovers. Lehman announced on Friday it had put itself up for sale and a deal could be concluded by Sunday afternoon. The two main suitors appear to be Bank of America and Barclay's. According to analysts BAC would be a perfect fit. BAC is seen as a commercial bank but has a huge retail base. Gaining access to the top-notch bond trading division and the Neuberger Berman asset management division would be a perfect fit. BAC would also provide a migration path for employees in Lehman to spread their wings inside the banking giant. A Barclay's deal would be more subdued and is seen as less likely. HSBC was also mentioned but sources feel BAC has the lead.

The problem with a Lehman takeover is the potential portfolio risk. Nobody wants to take on tens of billions in high-risk exposure to the real estate and mortgage sector and then be forced to take billions in write-downs every quarter as the problems surface. Nobody, including Lehman, knows exactly what the current portfolio is worth. This suggests any buyer is going to be paying pennies on the dollar in hopes the good loans eventually overcome the losses from problem loans. On Friday the Fed and Treasury said they were aware of the negotiations but there would be no government money or guarantees involved. Saturday morning the WSJ reported that the Fed held an emergency meeting late Friday night on the Lehman problem. In attendance were Paulson, NY Fed President Timothy Geithner, SEC Chairman Christopher Cox, Morgan Stanley CEO John Mack and Merrill CEO John Thain. Identities of everyone else were not disclosed other than "senior representatives of major institutions."

Saturday Update: Late Saturday the NYT reported that the heads of the other major banks in the meeting were warned if they did not work together to resolve this crisis with Lehman their banks could be the next victims of the credit crunch. In the Long-Term Capital crisis major banks each contributed to a $3.65 billion bailout of the hedge fund, allowing it to be unwound in an orderly way. The current banking crisis is far worse than the LTCM meltdown. The meeting of all the major bank heads reconvened on Saturday at the offices of the New York Fed. The CEOs from Citigroup, Goldman Sachs, Morgan Stanley, Merrill and JP Morgan were in attendance along with the heads of the SEC, FED, FRB-NY and Treasury but there were no representatives from Lehman.

Lehman Chart - Monthly

The problem with Lehman is not with liquidity. Reportedly they have plenty of liquidity and access to the Fed discount window. The Fed reported they have not accessed the Primary Dealer Funds Facility in 11 weeks. If they needed cash that would be the first place to turn. The problem is the declining balance sheet and capital requirements. As Lehman takes more write-downs it is forced by accounting rules to raise more capital. Lehman does not need the capital to operate, just to remain in compliance with the rules and maintain its credit rating. When it can't raise capital, as is the situation now, the rating agencies cut their rating and their cost of money and insurance goes up. Other firms are reportedly still doing deals with Lehman but analysts wonder at what level. The term used all day Friday was dead man walking. If the markets open for business on Monday without a Lehman takeover they may still be ok financially but without any business or a share price. If they can't get a deal done by Monday the rating agencies have already said they will downgrade them again. Every hour that passes makes it less likely they will pull out of it on their own and nobody wants to do billion or even million dollar deals with a company that may not be around next week. The Bear Stearns debacle is very fresh in the minds of investors and trading partners. Lehman continued to decline losing another 12.5% on Friday to $3.17 at the low for the day. That is down from $66 as recently as February.

Lehman's CEO Dick Fuld has taken home $466 million in compensation since he took office. If the company is sold he will get another $50 million or so as an exit package. Meanwhile employees who own stock have lost over $10 billion in the last year. If I were Mr. Fuld I would be wearing a bulletproof vest to work and be surrounded by armed guards. Fuld is famous for his April 2008 speech where he said the credit crisis was over.

Lehman was started in 1850 and was instrumental in establishing the futures markets in cotton, financed the major railroad expansions across the U.S., took Sears public and had its corporate offices wiped out in the 9/11 attacks. One analyst said on Friday, "The damage is done, the house of Lehman has been burned to the ground and suitors are just picking through the ashes for remains." There is significant doubt that a Lehman deal can get done this weekend without a Fed backstop. Lehman has a $600 billion balance sheet with untold complexity. CEO Fuld just started shopping the firm as a sale on Thursday. How can you perform due diligence on a $600 billion balance sheet over three days and have confidence you were not buying a toxic waste dump that will come back to haunt you? JPM bought BSC over the weekend because the Fed guaranteed $30 billion in debt. There is no Fed guarantee on Lehman. Bids are due for Lehman at 5:PM on Saturday. BAC and Barclays are the lead bidders with JC Flowers fronting for China Investment Company as a remote third bidder. Reportedly BAC and Barclays have both gone to the Fed for help and been turned down.

The second topic of the day was Washington Mutual (WM) and their prospects. WaMu has been under pressure since taking a $5.9 billion loss reserve and $2.7 billion bad loan write off in Q2. WaMu said on Thursday it was setting aside another $4.5 billion for credit losses in Q3. They made the disclosure six-weeks early in an effort to calm investors and depositors. WaMu said loan losses through 2011 could reach $19 billion. All of these losses may force WaMu to raise additional capital or sell itself as Lehman is trying to do. WaMu has already been forced to raise $7 billion in capital in 2008. Late Friday the American Banker trade paper said WaMu was in advanced talks to be acquired by JP Morgan. WaMu is the nations largest savings and loan and JPM is the third largest bank. Before the day was over there were several denials of any "current" talks but traders were placing side bets there was something past or present in the works.

Washington Mutual Chart - Monthly

WaMu is a monster thrift with $60 billion in home equity loans, $50 billion in option ARMs and $16 billion in subprime mortgages in addition to untold billions in higher quality loans. With WaMu stock at $2.75 the market cap of WaMu is only $4.6 billion. Compare that to their $143.6 billion in deposits and claimed $50 billion in available liquidity from "reliable funding sources." You may remember that Countrywide claimed $46.2 billion in available financing from "highly reliable" funding sources only two weeks before it was forced to draw down an $11 billion bank line when those sources dried up. Bear Stearns claimed they had $20 billion in liquidity only a week before they went under. It is not hard to understand that traders and counterparty firms are a little leery when they hear the same comments coming from WaMu. The more you have to reassure the markets that things are fine the more likely they are not fine.

Lastly AIG caused a major hole in the market with a -31% drop. After the close the drop continued with another -2.7% drop to $11.81. As a Dow component this was a major hit to the Dow and kept the Dow in negative territory at the close. S&P put AIG on CreditWatch negative saying it may lower it's rating by as much as three notches because of worries over liquidity and capital. The worry over AIG is concern that its financial position is deteriorating rapidly because of the gridlock in the credit markets and rising mortgage defaults. Analysts also worry about guarantees by AIG on billions in structured investment vehicles or SIVs. As more home mortgages default the risk of defaults on SIVs grows. Every time they are downgraded they have to immediately put up billions more in capital to cover their credit default swaps. Over the past three quarters AIG has lost about $25 billion in the value of their credit default swaps and lost about $15 billion on other investments. AIG stock has already lost 80% of its value since January and AIG is having the same liquidity/capital problems as Lehman and WaMu. AIG is the largest insurance company in the world and is planning on updating investors on Sept-25th on its financial condition. Hopefully they will still be around on that date. AIG has lost nearly $200 billion in market cap since last October. AIG has $40 billion in debt coming up for renewal over the coming months and analysts estimate they need to raise $15 billion in capital to meet obligations. It was announced well after the close that AIG had hired JP Morgan to advise them on how to raise new capital in the current market. AIG is now expected to announce its plan to raise capital by Sunday evening and the option being tossed around is an investment by Blackstone and/or Blackrock.

Chart of AIG - Monthly

Merrill Lynch (MER) was also under pressure with another -12% drop on fears that bad news from Lehman, WaMu and AIG are just flu symptoms that have yet to come to the surface on Merrill. Increasing fears over problems at Merrill also include counterparty risk to Lehman and AIG. If Merrill has deals with those companies then a failure there could explode back at Merrill. What started out as a problem in the subprime mortgage market has now translated to a crisis of confidence in the credit markets. That is now moving into a crisis of confidence in the equity markets for the investment banks. However, large retail banks like Wells Fargo (WFC) and US Bank (USB) are doing fine with WFC hitting a new high on Friday.

U.S. Dollar Index Chart - 15 min

The U.S. dollar was positively crushed on Friday with a -1.47% drop in the dollar index. Thursday saw a new 52-week high at 80.37 but Friday saw a -1.19 drop. In currency terms this is a monumental move. The problem is our weakening financial markets and fears that the government will be forced to bail an increasing number of companies. The automakers were pleading their case on Friday for a $50 billion bailout. There is an increasing feeling overseas that the U.S. will also have to bailout individual homeowners and the numbers begin heading off the scale when economists start trying to tally the potential liability. They could be completely wrong in their assumptions but the impact on the dollar was huge.

Crude Oil Chart - Daily

Normally when the dollar tanked the price of oil exploded. Normally when a hurricane blows through the oil patch and shuts down 20% of the nations refining capacity for a week oil prices explode. Normally no longer works. Texas Governor Rick Perry was on CNBC doing his imitation of Ray Nagin's "storm of the century" warning on Gustav. Perry was warning Ike could cause $100 billion in damage and be the most expensive natural disaster ever seen in the states. There was no bounce in oil and it fell to trade under $100 for the first time since April. Early Saturday morning officials said damage was much lighter than feared with mostly downed trees and broken windows although low lying areas were flooded. Valero said they were inspecting their refineries and were restarting one and waiting for power to be restored on another. Shell, the largest gulf oil producer, said they were already doing over flights to check for damage and starting to put crews back on the platforms.

With all the negative points this weekend if Ike did NOT cause significant damage to the oil infrastructure we could easily see oil trade down to the mid $90s next week. I have never seen oil trade lower as a major hurricane arrived. 20% of the U.S. refiners or 4 mbpd were shut down ahead of the storm. 96% of gulf production is offline and has been most of the week. Gasoline supplies were already depleted at eight-year lows and last week's shutdown from Gustav and this weekend's shutdown for Ike is only going to make it worse. Based on this week's price action on crude I could see gasoline rising and crude falling next week if there is only manageable damage. I am not even sure oil will go up if there is damage. Russian long-range Backfire bombers landing in Venezuela and Hugo Chavez threatening again to cut off oil shipments to the U.S. had zero impact. Funds are still liquidating oil positions and until that ends normal conditions do not apply.

Ike Making Landfall In Houston Friday Night

Chart of Gulf Production Shut In for Hurricanes Gustav & Ike

There was some positive news on Friday. Karl Case co-inventor of the Case-Shiller Home Price Index released every month believes it is time to be optimistic. In a paper presented at the Brookings Institute he laid out his "case." He feels there are plenty of reasons why we are nowhere near the end including high inventory levels of unsold homes and home still underwater with high mortgage balances. He also believes there could be legal delays in unraveling the credit derivatives associated with the initial sale of the mortgages to investors. He also warned that tighter credit could make it tougher to buy homes. However, he noted that in almost all areas foreclosures have dropped and the Case-Shiller index for those regions has moved higher. He also believes as California goes so goes the rest of the nation and California sales are rebounding. Prices are falling at a much slower rate and foreclosures have fallen to less than a third of total sales. He said the real gross residential investment hit 3.5% of GDP at the bottom of previous cycles. It is currently 3.1 and suggests California is at a bottom. Also, historically when housing starts fell under 1 million the cycle has rebounded quickly. As of July 2008 starts dipped to 965,000. In the Case-Shiller report 9 of the 20 regions reported are already rebounding. Mortgage rates fell under 6% last week and that is also historically stimulative to buyers. Based on his decades of analyzing the housing market he believes these are clear signs of a rebound.

Next week could be crazy. We have the LEH, WM, AIG, MER saga and there are some worries about Citigroup and Goldman Sachs. Citi has seen huge put buying over the last week on fears there is something they are not telling us. Goldman Sachs was crushed by almost daily downgrades on earnings estimates started by Meredith Whitney on Monday. GS traded in a $22 range with every bounce drawing another downgrade. They report earnings on Tuesday and they can either emerge as a zero or hero depending on what they report. Other reporters on Tuesday include AIR, ADBE, BBY and DRI.

We are also heading into the earnings warning cycle. It seems like we just finished Q2 earnings but we are only a week away from the Q3 warning cycle heating up. I would bet that the ratio of negative warnings moves substantially higher for Q3 and that could impact the markets. This is also a quadruple witching week with everything expiring by Friday. I watched the interaction between volume, volatility and the markets last week and even though there was high volume there was very little indication that we were seeing expiration moves. I believe the deck is stacked so heavily that funds are waiting until next week to roll out of their positions. Most of the high volume has been in those key news event stocks. On Friday there were nearly 1.2 billion shares traded in just five stocks, LEH, AIG, MER, WM and Citi.

Despite all the volatility in the indexes the volatility index (VIX) was rather tame. It has been hovering in the 24-26 range all week. That is far from a level over 30 that would indicate a bottoming process. The last three days the internals have been evenly split with upside volume slightly over downside. The market appears scared. Several sectors are rising but the overall market is struggling. With the major indexes finishing close to neutral on Friday I was shocked to see the NYSE Composite up strongly at +80 points. I could not find a specific reason other than a strong showing by energy stocks. That is even more confusing with oil prices declining.

Volatility Index Chart - Daily

I had a reader whose opinion I respect email me on Friday saying hedge funds had been heavily into a pairs trade of long financials and short energy for the last two months. With financials up +47% from the July lows and energy stocks down over 30% in some cases it is time to unwind those trades. With oil at support and the financial sector showing cracks again they may want to unwind it quickly. He also pointed out that Sept-30th is the last day this year that most hedge fund investors can withdraw funds. He was suggesting the need for month end cash could accelerate the unwinding of the pairs trade. Obviously that is just speculation on our part but a possible explanation why energy stocks had been up for the last 2-3 days with oil trading under $100.

Twice this week the Dow tested support at 11000 and both times it was quickly bought. Unfortunately the rebounds ran out of steam below 11500. The Dow is going to remain hostage to the financial mess with Monday having the potential for another gap open. The only question is up or down. If Lehman and AIG report deals by Sunday night we could move higher even if it is only temporary. The financial sector has been moving from event to event at a leisurely pace since the Bear Stearns, Countrywide takeovers. Conditions have now deteriorated to where we now have a hand full of major companies in crisis all at the same time and we may be nearing a point where investors don't want to be in any major investment institution for fear of another LEH/AIG/WM problem. On the bright side the FDIC did not announce any bank closures this Friday. Bottom-line the Dow and S&P are going to remain hostage to the financial news.

Dow Chart - Daily

Nasdaq Chart - Daily

The Nasdaq tested 2200 on Thursday and managed a +70 point rebound but like the Dow ran out of steam at initial resistance and faded into the close. With AAPL down -3.71 and RIMM off -3.53 it was amazing the damage was not worse. Were it not for the solar stocks it would have been very different. Most of the Nasdaq point gainers for Friday were names most people probably would not recognize. That would be a positive for next week if I really thought the rebound was broadening but I suspect it was just a statistical anomaly. Resistance is 2270 and support 2200. That support at 2200 should be relatively strong but this is a pivotal week.

The Russell touched support at 700 on Thursday but the rebound failed at 720. The Russell has given up its role as sentiment leader and I fear that 700 level could be broken.

Russell-2000 Chart - Daily

S&P-500 Chart - Monthly

The NYSE Composite tested support at 7875 four times over the last week and gapped down to 7800 on Thursday only to instantly rebound sharply. I hesitate to say the NYA has a bullish chart but it appears it is trying to put in a bottom. Unfortunately we need a lot more confirmation before calling anything a bottom ahead of next week.

The coming week is quadruple witching. That normally produces huge volume and huge volatility. Add in the FOMC meeting on Tuesday and the financial news events scheduled for Monday and toss in a couple earnings warnings and we could be in trouble. It is impossible for anybody to accurately pick a direction in this market for more than 30 minutes. There are too many cross currents and lots of white water between here and next Friday. This is historically the worst week in September and the worst month of the year for the markets. Let's hope whatever happens next week marks a turning point towards an end of year rally. That may be too much to wish for but it is a good start.

Jim Brown

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