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Market Wrap

News Overload

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Market reporters are running around in circles with more news than they can report and it is tough to cut down the numerous critical events into a dozen paragraphs. The Fed is in the news every day and we have a new company in the crisis spotlight every morning. Earnings warnings are beginning to fly with the tech sector a highlight. The last week has been a 100-year market event and something you can tell your kids about.

Dow Chart - Weekly

The Consumer Price Index for August was released this morning and was almost lost amid the high profile news events. The headline inflation actually decreased slightly to +5.4% while core inflation remained level at +2.5%. To say inflation had peaked would be premature but it clearly has stalled after oil prices collapsed. The CPI energy component fell by -3.1% but is still up +27.2% over the last twelve months. Gasoline prices fell by -4.2% but are still up +35.6% for the year. The CPI declined in all census regions with the largest decline in the west where the CPI fell -0.5% from July levels. Food prices also appear to have peaked thanks to lower energy prices.

Consumer Price Index Chart

The NAHB Housing Market Index jumped sharply in early September to 18 from 16 in August. The northeast region spiked from 16 to 22 for the biggest gain. Builder sentiment for the next six months rose sharply to 30 from 24. Potential buyer traffic rose for the second consecutive month. Analysts are cautiously saying it appears the demand slump for housing has bottomed. Rates are falling and foreclosures are easing. Buyers who were waiting for a bottom are starting to make offers.

The big economic event of the day was of course the Fed meeting. The FOMC left the interest rates flat at 2.0% with no change in rates. The statement cited the recent turmoil in financial markets and the ongoing slowing of economic growth. The Fed stunned watchers by again saying inflation was a significant concern and did not change the bias toward lower rates. However, the vote to hold rates steady was unanimous with Richard Fisher changing from his hawkish stance of past meetings. The Fed did give a nod to the critical events of late. Here is the entire statement.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

The last paragraph is the action statement where they show a neutral bias rather than favoring one problem over another. Without a rate change traders wanted a bias change to highlight concerns over growth. That would be the first step towards a future rate cut.

Basically the entire statement was neutral. It did not contain any language that suggested the Fed was either more concerned or less concerned about current conditions. Talking about strains in the market is just a statement of obvious fact. They could have written a book on their efforts to mitigate the problems over the last couple weeks.

We know the Fed is working diligently behind the scenes to lessen the problems. The Fed injected liquidity in the market twice on Monday totaling $70 billion. That blunted the spike in real rates but it was not enough bring rates down. They made two more injections totaling $70 billion on Tuesday and the total of $140 billion was finally enough to push real rates down to the Fed target of 2%. Combined injections totaling $140 billion is a massive amount of money in such a short period of time.

By announcing no change in rates the Fed was trying to send a signal that the current financial stress is not an economic problem but a series of individual company problems. Unfortunately some of those companies are the biggest in the world.

Lehman continues to be the second most active news event. The latest chapter in the Lehman saga has Barclay's (BCS) buying the investment banking and trading operations for $2 billion. This would save 9,000 jobs and give Barclay's a stronger foothold in the U.S. markets. Barclay's is the third biggest bank in the U.K. and had balked at an outright acquisition of Lehman last weekend. This week I would expect to see several other vultures picking over Lehman's carcass.

Lehman got another shot of adrenalin when JP Morgan loaned it $138 billion to allow Lehman to continue trading and avoid a disruption of U.S. markets. JP Morgan gave Lehman $87 billion at the request of the Federal Reserve when the market opened on Monday. The Fed later repaid that loan. On Tuesday JPM had to give Lehman another $51 billion. It is surprising to me that that many trades are still going through Lehman after a couple weeks of highly negative press.

The fallout from the Lehman bankruptcy is starting to appear in the markets. Constellation Energy (CEG) dropped -35% or -$16 on fears that the consortium of banks, which included Lehman, would pull its credit line. This came despite assurances from CEG that the Lehman portion of the line was only $150 million and CEG had over $2 billion in excess liquidity. The problem came in the rise of its credit default swap premiums to 478 basis points on fears of the lost credit line. That means it would cost $478,000 per year to insure $10 million in debt for five years. Obviously for debt that is yielding 8% that would be an impossible fee. CEG traded as low as $13 before rebounding to close at $31 and "only" a 35% loss.

There were a steady stream of comments from other companies about their liabilities regarding Lehman. MetLife said they had $800 million in exposure to Lehman and another $10 million in common stock. MetLife had also made secured loans to affiliates of Lehman, which Met hopes are still fully collateralized.

I am not going to bother listing the dozens of companies who talked about Lehman liabilities this week because it is only going to explode in the weeks to come. We can expect quite a few earnings warnings as these liabilities start to be reflected in the third quarter balance sheets.

That trickle of Lehman casualties will turn into a flood the size of the Thailand tsunami if AIG goes under. The market rebounded this afternoon after Bloomberg reported that the Fed was going to reverse its decision to not give AIG a bridge loan. The Dow rebounded +279 points on the rumor as a monster short squeeze was triggered. AIG rebounded from $2.50 to briefly over $5 on the news. After the close shares of AIG collapsed back to $2 when Bloomberg reported the Treasury was considering a conservatorship as an option for AIG. We saw what happened to Fannie/Freddie shares when the government took them over. Shareholders would again be wiped out but the government can't let AIG fail because of all the counterparty risk. There would easily be more than $2 trillion of systemic risk to AIG. As the largest insurance company in the world AIG or an AIG company has monster amounts of counterparty dealings. For instance 1 of every 4 airplanes is insured by AIG. They are the largest private leasing company of aircraft in America. One of eight cars is insured by an AIG company. AIG controls over 240 separate entities. They control 71 independent insurance companies operating at the state level. This independence prevents the sins of the father from contaminating the state chartered insurance companies. They have insured hundreds of billions of dollars of bonds that would immediately be underwater if AIG's credit rating drops one more notch. That could happen before this week is over. If their credit rating is cut again it would begin the AIG death throes. Analysts claim it will take $100 billion to bail them out today. If their credit is cut again it would take over $350 billion in additional capital according to one analyst.

VVery late this evening CNBC broke story saying the Fed and Treasury were about to reveal a $85 billion secured bridge loan that would NOT be a conservatorship takeover. Reportedly the government would receive AIG warrants for 80% of its equity and severely dilute existing shareholders. However, if AIG was successful in liquidating its assets the loan could be repaid and shareholders would be restored. Reportedly Bernanke and Paulson are actively involved in the talks. AIG management would be fired as part of the deal. Futures rose sharply when the news broke. Several analysts were saying that an AIG failure could come as soon as Wednesday so the Fed action needs to be announced before tomorrow's open or this positive sentiment would evaporate quickly.

If AIG is bailed out this should be the end of the current crisis. We still have lingering problems like Wachovia and WaMu but a failure of those companies would not be any where near the severity of AIG or Lehman. Given the strong touch of multiyear support in the markets today an AIG fix would definitely trigger at least a short-term rally. AIG traded over 1.23 billion shares on Tuesday.

AIG Chart - Daily

Not all the news was negative. Morgan Stanley posted better than expected earnings of $1.32 per share or $1.4 billion. Analysts had only expected earnings of 79-cents. CEO John Mack said the company was in great shape to profit from the current environment. Morgan Stanley was 75 years old today.

Goldman Sachs (GS) also posted better than expected earnings of $1.81 per share compared to estimates of $1.71. It was the worst profit slump since the company went public in 1999 but it was still a profit. Morgan Stanley and Goldman Sachs are the only two major independent investment banks left in America. Goldman was slammed at the open to a low of $116 but rebounded to close with a +2.50 gain at $135.

Dell Computer (DELL) warned this morning that softness in global sales had softened significantly in just the last three weeks. The Dell CFO said the slowdown is broad based and not tied specifically to Dell or it's pricing. Dell hit a ten year low on the news. IBM, HPQ and CSCO were up suggesting the market still believes this is a Dell only problem.

Hewlett-Packard (HPQ) said it was cutting 26,400 jobs as a result of the acquisition with EDS. This is far in excess of the prior expectations and suggests HPQ is trimming staff overall because of softening conditions. However, the CFO said he was "very confident" HPQ would hit or exceed its current earnings and margin targets.


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Oil prices plunged again to $90.50 intraday and closed at $91.50. However, once the potential AIG bridge loan news hit the wires crude spiked +$2 to $93.50 in after hours. This simply emphasizes what I said in last night's email that the current drop was simply funds trying to raise cash to cover margin calls and redemptions. When major events are forcing everything to new panic lows you have to sell whatever has value and oil futures and commodities in general are extremely liquid. Nobody believes the fundamentals in the coal sector changed suddenly on Monday but coal stocks dropped sharply. For instance ANR dropped from $70 to open this morning at $50. There was no news to cause a -30% drop the major coal stocks. This is simply commodity dumping to raise cash.

The internals were obscene today. Volume was off the scale thanks to AIG, WM, WB, GS, etc. If I only looked at the internal picture it would be a screaming buy today. Monday appeared to be a capitulation day with 12:1 decliners to advancers on volume of 13 billion shares. Today's short squeeze produced a 2:1 upside volume day on 15.5 billion shares. That may be an all time share record. At the close I was not convinced this was a potential bottom. I thought it was just a news squeeze on the potential AIG bailout. If the Fed does announce a $85 billion loan to AIG by tomorrow morning I think the bottom was today. If AIG is not bailed out and is forced to file bankruptcy then we will see new lows.

Market Internals Snapshot

The volatility is huge with a spike today to 33.70. That is in the normal capitulation range and it was completely news related but fear was evident in the morning market. This is a level where people should be getting long in normal markets in expectations of a rebound. This is not a normal market but an AIG bailout would remove a monster amount of fear from the markets.

Volatility Index Chart - Daily

The Dow hit 10750 this morning and that is support from July 2006. This should be strong support and a level to be bought if AIG survives. The S&P-500 also hit multiyear support at 1170. If this level does not hold we are in serious trouble.

S&P-500 Chart - Monthly

Nasdaq Chart - Monthly

The Nasdaq rallied to a +27 point gain after temporarily breaking support on the Dell news. The Nasdaq chart is still ugly but the levels reached today have not been seen since mid-2006. While I want this 2150-2200 level to hold that may be wishful thinking if we get no help from an AIG bailout.

The biggest plus for me today was a sharp rebound in the Russell-2000 to 708 after hitting 680 intraday. The Russell was showing signs of fund buying before the rumors began to hit the wire. It is entirely possible the Russell is about to take back the leadership and that would be very positive for the markets. Resistance is still 740-750.

Russell-200 Chart - Weekly

In case I was not clear I believe that the failure of AIG is the only major cloud over the market. Economics are improving. The housing sector is improving. Mortgage rates are improving. Oil prices are down and car buying is up. Everything would be rosy were it not for the AIG cloud. I know we are going to have a flood of Lehman induced counterparty earnings charges but once traders have heard 20-30 it will be old news. This is a quadruple witching expiration week and the market activity over the last two days has surely flushed any expiration activity early. Keep your fingers crossed that AIG gets a big check and the market will reap the benefits.

Jim Brown

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