Option Investor
Market Wrap

"The First Time since the Great Depression"

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The comparison to the Great Depression quoted in the title was excerpted from a MarketWatch article that appeared this week. That article detailed the record amounts of borrowing from the Fed's primary dealer credit facility. For the first time since the Great Depression, the article reminded us, non-bank primary dealers have been allowed to borrow from the Fed's discount window.

Other comparisons to the Great Depression have increasingly surfaced. Another MarketWatch article, also published on Thursday, referenced "Great Depression 2," when discussing how Federal Reserve Chairman Ben Bernanke responded to questions from lawmakers.

One reason for the references to the Great Depression can be found in the TED spread. The TED spread measures default risk. The TED spread's value has soared to levels exceeding those seen during the 1987 debacle. My Trader's Corner article last weekend covered the TED spread, updating an article originally published last May. I suggest you go back and read last weekend's version if you haven't acquainted yourself with the TED spread.

When I conducted the original research for that May article and then began updating subscribers to the Market Monitor daily, I had difficulty finding resource material. Financial presses have in the intervening months exploded with information about the TED spread. Everyone seems to be watching the TED spread because it's been telling us that, despite the government's plan to solve our dilemma and unfreeze the credit markets, little progress has been made.

One Financial Times article, while not specifically discussing the TED spread, nevertheless provided a chart that explains with a quick visual reference what's spreading in the TED spread.

Seizing of the Credit Markets
Source: Financial Times article published 9/24 and updated 9/25

This chart visualizes a flight to the safety of U.S. treasuries, their yields driven down, and a concurrent rise in LIBOR, the rate at which banks lend to each other. LIBOR has been rising. Why does this matter to us? Several reasons. This is the rate that banks loan to each other, but companies pay a certain number of points over LIBOR. With LIBOR rising, even those companies that can secure credit are doing so at higher and higher rates.

Companies may need to borrow from banks. Once again this week, the Federal Reserve's reports on outstanding corporate paper showed a severe drop, of $61.00 billion this week. The financials saw a $50 billion drop in outstanding paper. Corporate paper is the paper that corporations put out in order to finance their short-term needs. If outstanding corporate paper is dropping, either companies suddenly have no short-term needs they need to finance, an unlikely event, or else they're having trouble placing that paper. No one wants to buy it. That forces companies to go to banks for more expensive loans. These days, those bank loans are getting more and more expensive.

Not only that, but also the increasing TED spread points to another difficulty, one that threatens to freeze up the financial system. Several months ago, information was surfacing that banks wouldn't even loan to each other, but were hoarding cash. A rising LIBOR rate shows an increasing unwillingness of banks to provide those loans to each other. The FT article from which the chart was drawn noted another spread that was widening, saying that "the two-year swap spread reached 1.66 percentage points above the two-year Treasury yield--its highest in history."


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By Friday's close, the TED spread had narrowed to 2.92 from its high this week above 3.00. Friday's intraday high had been 3.11 and Thursday's, a whopping 3.37. All these values, even the 2.92 at the close today, remain well above the levels seen in the 1987 debacle..

A CNBC commentator Thursday evening summarized the concern expressed when the TED spread refuses to narrow: either there's uncertainty that the government's plan can be enacted or concern that it won't be effective if it is, or else there's some other big financial institution already in deep trouble and we just don't know about it yet. By Thursday evening, we had some idea that the last supposition at last was right: news surfaced about Washington Mutual being taken over by regulators.

Comparisons to our own Great Depression aren't the only ones being drawn. A spate of articles has compared our current situation to that of Japan, wondering if our government's currently anticipated actions mean we're doomed to follow Japan into a decade of stagnation. Some market pundits say it can't happen here, pointing out differences they consider obvious: claiming that Japan's housing bubble was bigger than the U.S.'s and that the U.S.'s FOMC had responded quicker than Japan's policy makers. An August 21 article found on Economist.com refuted some of those claims, with a chart included in that article concluding that in fact, the U.S.'s housing prices inflated more than Japan's bubble and that Japan acted quicker than our FOMC in the early stages to lower rates.

"A Tale of Two Bubbles" from Economist.com, August 21

Those were the comparisons being drawn this week, the worries exposed as Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, and SEC Chairman Christopher Cox first crafted a plan and then spent days trying to convince lawmakers to pass it. By Thursday morning, lawmakers reportedly had cobbled together a version of a fundamental bipartisan plan that would be presented in a meeting with President Bush that afternoon. That plan would not hand over the full $700 billion the government estimates as the ultimate cost all at once, but would provide $250 billion at once, with the rest available later, if needed. Both presidential candidates were invited to the meeting, under the premise that one of the two would be dealing with the economy within a few months. Lawmakers spoke of finishing their work by Friday or Saturday, before recessing.

That Thursday afternoon meeting proved contentious, however, although it doesn't serve the purposes of this article to repeat salvos that each party lobbed at the other. I want to cover this as basically as possible without injecting any wording that would convey an opinion one way or another. Opinions among the public and presumably among our readership, too, have already polarized and I don't want to add to that polarization. The basics: a group of House Republicans presented an alternative plan.

The new plan proposed by House Republicans would insure all mortgage-backed securities, expanding the coverage from the half of such securities now covered, with the Treasury collecting premiums from the holders of those assets. According to press coverage, the House Republicans who presented the bill feel that it transfers the burden from the taxpayers to private capital.

Meetings took place. Press conferences were held. Assurances were made that a resolution would be found. The latest headlines late Friday afternoon have President Bush assuring the public that a deal will be reached by Monday.

Our country isn't the only one dealing with these issues. The U.K.'s Prime Minister Gordon Brown addressed the U.N. General Assembly saying that the crisis requires an international solution. Markets should first be stabilized and then the globe's international institutions should work toward transparency, regulation and responsibility, including "global oversight of international capital flows," according to an AP article by Michael Astor. While some might wince at the thought of an "international solution," the point of this comment is to note that the whole disconnect theory of last year has been proven wrong. We're all in this together.

All week, however, that TED spread was showing increasing danger that credit markets would freeze altogether. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson kept reminding lawmakers of the urgency of a quick decision, and SEC Chairman Cox and his employees kept adding names to the list of no-shorts companies, ranging far from the trouble financials originally covered. By Thursday, companies such as Zale Corporation and Autonation were on the list.

As if to emphasize the need for a quick decision, Federal regulators seized Washington Mutual late Thursday in the largest ever failure of a U.S. bank. The takeover of WaMu, with its $310 billion in assets, dwarfed the failures of Continental Illinois National Bank in 1984 and IndyMac this year, with their assets at $40 and $32 billion, respectively. Late Friday, another impending failure, covered in the last section of the Wrap, was to be characterized as a merger, and it was to be bigger than Washington Mutual.

Suddenly, the worries batted about last week about the FDIC running out of money assumed greater importance, but the FDIC announced that the WaMu seizure would not require the FDIC to dip into its insurance fund. As it had with Bear Stearns, JPMorgan Chase (JPM) took over WaMu, and all depositors and customers were assured of a seamless transition. JPM agreed to purchase certain of WaMu's assets, deposits and liabilities for a cost of $1.9 billion.

Last weekend, when I also substituted for Jim, I worried about submitting the article Friday evening, afraid that a resolution would be reached Saturday morning and the information I presented in the Wrap would be incomplete when it appeared in mailboxes Saturday evening. Here we are again at the same place, but this time, I have less worry that I'll turn in an article and that all parties will come to agreement minutes after I submit it. I've heard estimates that an agreement will be reached by the end of the weekend and avowals that it will take a week or two. You'd still be waiting for last weekend's Wrap if I'd tried to hold up its submission until an agreement was reached. This will be submitted Friday evening, so I urge subscribers to watch news reports Sunday evening for further developments.

The earlier optimism that markets will rebound immediately when an agreement is reached, having put in "the" bottom week before last, has waned, too. It wasn't an optimism that I personally shared, based on the monthly charts I included in last weekend's Wrap and will update in this one.

Ultimately, we could debate for hours the merits of what government agencies have done and will do in attempts to resolve this crisis. Politicians have been debating the merits, economists are, and Mom and Pop on Main Street are doing it, too. People whose only use of the word "swap" had previously been linked to the word "meet" are now debating why AIG used a faulty insurance-based assumption that because one institution failed did not mean that others would and why AIG failed to understand that each subsequent failure made those swaps in which they were counterparties more dangerous. In fact, who except a few Harvard attorneys and Wharton Business School graduates even discussed counterparties? We may discuss these terms and study them, trying to learn as much as we can as quickly as we can, but most of us can still empathize with policy makers and especially with lawmakers not well versed in the financial realm suddenly trying to understand the impact of the decisions that they'll make.

Friday morning, I read two articles, both by learned men. One applauded the firm stance the government had taken in the Freddie/Fannie solution and in letting Lehman sink. The other, Michael Kao, CEO and portfolio manager of Akanthos Capital Management, decried those same actions. Kao, writing as a RealMoney guest commentator, claimed the Fannie/Freddie action "eviscerated the preferred markets." Since I have little experience in the preferred markets, I'll let his words speak. Formerly AA-rated securities dropped to "mere cents on the dollar overnight," he said, adding that, "this market was one of the only capital markets that remained open to financial institutions in the last eight to nine months, and it raised $80 billion during this period from straight and convertible preferred issuance." He warned that allowing Lehman to fail "severely eroded confidence between counterparties."

Kao blamed these actions and others, such as the no-shorts rules, for the "harrowing near-deaths" of Goldman Sachs and Morgan Stanley. We options traders have worried about what that no-shorts rules mean to our options trades, and Kao warns that the convertible bond/preferred market is being adversely impacted "because its main participants are arbitrageurs who require the ability to short out their equity exposures for bona fide hedging purposes."

He echoed a warning that others have increasingly mentioned, that we look to Pakistan's example if we want to see what banning short-selling can do. After Pakistan banned short selling, equity markets experienced a massive short-covering rally, but when that was finished, equity markets quickly dropped 26 percent in the following weeks and month, he says.

So, while we all want a quick solution and I personally worry about the consequences of no quick solution, we also all must worry about the effects--especially the unintended ones--of the actions taken. Few of us can understand all the implications of the actions, and we should perhaps exercise some understanding toward those who are working so hard to do so. While I expressed worries last week about the unintended consequences to options market makers and traders, some of which are being realized in wider spreads in some options series, I never thought about that convertible bond/preferred market because it's not a market in which I'm active.

So, we must voice our concerns but also exercise patience for those whose opinions or experiences differ from ours. As options traders, I suggest we exercise something else: caution. We don't know how our trades will ultimately be impacted. This is not the time to plunge into new trades or employ unfamiliar strategies.

And then I suggest that we allow ourselves to hope. We've been in tough places before, and we're a resourceful people. The fact that we are so passionate about our views and so willing to voice them perhaps increases the possibility that a resolution will be cobbled together, that some voice somewhere will propose a workable solution that others will embrace.

Let's look at charts. As was true last weekend, I want to look at monthly charts so we get a better perspective on what's going on. Then we'll look at intraday charts in the last section, to give us a close-up view.


Annotated Monthly Chart of the SPX:

Vulnerability to the bottom of the channel must be factored into trading plans, providing the background against which shorter-term action takes place. There's no guarantee that the SPX will slide lower, but the possibility certainly exists.

The weekly chart's (not shown) candle showed the lowest weekly close since October, 2005. That's obviously bearish. Couple that news, however, with the realization that weekly candles have been springing up from support, leaving lower shadows behind. If in bearish positions, I usually start getting nervous when I see a number of candles in a row with long lower shadows, as someone is doing some buying as prices probe those lower values, sending prices back up again. If only candle bodies are considered, then the SPX this week broke below the support that it had been forming with all weekly closes above 1239.49 in the last few months. If one looks at those lower shadows, though, bears would be advised to keep updating their just-in-case profit-protecting plans. That leaves chartists with some difficulty interpreting the charts, but that's not unexpected. We're in a situation in which big money doesn't know what's going to happen next, and trying to read the tracks they've left behind provides little help since they, too, seem to be running in circles.

The daily chart unfortunately provides little clarity. That chart suggests that a climb toward 1249 appears about as likely as a drop toward 1175, and vice versa. Think in terms of vulnerabilities to certain levels, consider lowering the risk you're willing to take in trades and well as, in some cases, the time frame you'll stay in a trade.

I'll say this: nothing on those charts can yet prove to me that we can't have another sharp downturn in a typical September/October pattern or at least to test the previous low.

Annotated Monthly Chart of the Dow:

The Dow did not close the week below the weekly low reached on the week of July 7, but it wasn't far off it, either. The narrower Dow is easier to prop up or even send higher than a broader-based index such as the SPX or especially the NYSE, so its out-performance on the daily chart (not shown) should be taken with a grain of salt. That chart gave a slightly higher chance of the Dow reaching toward 11,330 than of dropping toward 10,590, but only a slightly higher and not quite trustworthy greater chance. RSI on the daily chart has been squiggling along either side of the neutral 50 most of the week, and the chart pattern defies definition. Is the Dow chopping out the parameters of a big triangle at the bottom of its decline? Is it instead forming up a wide channel of higher highs and higher lows, a possible bear flag but a wide one in which it might retrace a significant portion of the decline from last year's high before dropping lower again? Pick your bias, but be aware that nothing seen on that monthly chart yet negates the idea that Dow could slide back down to retest that big channel's support.

Annotated Monthly Chart of the Nasdaq:

The Nasdaq closed its week at its lowest weekly close since 2006 (weekly chart not shown). Weekly candles are sliding lower along the midline of its descending price channel. It's been piercing that midline, however, with the candle bodies closing at or above it and with long lower shadows left below, so bounce potential must be considered here, too. Vulnerability to the lower support of the channel must be factored into trading plans, but bears should also be factoring in the possibility that the Nasdaq will either slide lower along the midline rather than drop all the way to the lower red trendline or bounce. If the Nasdaq scrambles above about 2185 early Monday morning and maintains a daily close above that, then its daily chart (not shown) presents the possibility that the Nasdaq could climb toward 2281. Remember the possibility that an early morning climb could be quickly reversed back below about 2185, too, however.

Annotated Monthly Chart of the SOX:

The SOX's weekly chart (not shown) illustrates that since breaking below the 335-ish support on weekly closes about a month ago, the SOX has been churning just below that. It hasn't fallen away steeply but neither has it scrambled back above that former support. That chart shows that it's as likely to find resistance on weekly closes at about 341.50 as it is to find support on weekly closes at above 311 or perhaps 297. The daily chart (not shown) sets up a similar tale, although it would lower the likely resistance level on daily closes to about 338-339.

Annotated Monthly Chart of the RUT:

The RUT's weekly candle (not shown) was an ugly one, a bearish engulfing candle that threatens to send the RUT lower, but there's a caveat. It occurred in the middle of a months-long choppy consolidation zone and it stopped right at the weekly 72-ema. Although there was a spring off that weekly candle, too, as well as the daily one, the daily candle formed beneath likely strong resistance. The daily Keltner chart suggests that unless the RUT can produce daily closes above 710.50 and perhaps not even unless it can produce daily closes above about 720, it's vulnerable to another drop, perhaps toward 671.

Annotated Monthly Chart of the TRAN:

The TRAN is obviously in a chop zone. It's holding up near its high, at least when viewed on a monthly or weekly (not shown) chart. The possibility of a double-top formation exists, but it requires a drop below 4032.88 before it's confirmed. The possibility of an upside break also exists, but I would suggest you require at least a weekly close above previous highs before you believe too strongly in any upside breakout. The weekly and daily charts present the possibility that the TRAN could be trending down toward 4546 or perhaps even its weekly 200-sma, now at 4476, but perhaps not until another pop up toward 4843.

Why is the TRAN important? In past times, the TRAN has been important because it's sensitive to both crude prices and economic outlook. It tends to lead the SPX, OEX and Dow, and it's obviously not leading to the downside.

While I would never utter those dreadful words "it's different this time," some special considerations should be noted here. In this case, I'm not so sure of the importance of the TRAN's leading or not leading. Although some economic releases are disappointing and showing the possibility of increasing weakness, both here and abroad, others are not so conclusive and the TRAN may be reacting accordingly. However, our greatest immediate danger currently is a crisis in credit, not recessionary fears. When those fears fully assert themselves, we may find the TRAN tumbling down, or, if the credit crisis is resolved, we may find it breaking higher after a period of stabilization. For now, it's diverging and that should be watched. It's not giving us a lot of information now, but it may provide more when it finally breaks one direction or another.

Annotated Monthly Chart of the NYSE:

The NYSE is the broadest of our indices and it's taken over a leading role from the TRAN. It's been leading down. The weekly chart (not shown) shows that its weekly close was the lowest since late '05, but it, like some of the other indices, has been producing weekly candles with lower shadows. While a slide lower along that lower red trendline not only is possible but may in fact be likely, bears should be aware of the possibility of a break up toward the weekly 9-ema, now at 8221.60. The NYSE has not produced a weekly close above that 9-ema since the week of May 28, 2008, so a weekly close above it would be a short-term change in tenor. Until that happens, watch for likely resistance on a weekly close at that level. The daily chart gives about equal likelihood that the NYSE will climb to test 8160 as that it will drop toward 7684.

Length requirements don't allow a presentation of all charts that might be important and my personal area of expertise might vary from that of other commentators. However, it's important to note that worries about the bailout that have spread across the globe have sent some investors rushing into the perceived safe haven of gold while some other commodities sink amid worries about demand.

This Week's Developments

For the second week in a row, so many events have occurred so quickly that developments that would have been considered extraordinary and worthy of whole articles in themselves must be brushed aside. That includes some of this week's economic releases. The Richmond Manufacturing Index, House Price Index (HPI), Existing Home and New Home Sales, Durable Goods Orders, and the Final GDP all disappointed.

Friday's revision lower of the GDP resulted at least in part from a lower personal consumption reading. The Price Index component eased to 1.1 percent from the prior 1.2 percent.

Friday's revised University of Michigan Consumer Confidence came in on or near target, but below the prior 73.1. The expectations component rose to 4.3 percent.

Research in Motion (RIMM) also reported this week, with the company's outlook and results disappointing, despite revenue and net income growth that was solid.

Other developments on Friday included a speech by President Bush, a brief talk in which he assured the public that the country would find some consensus on the method by which financial companies would be funded. Other press conferences occurred with other speakers assuring the public that an agreement could be reached while warning of significant consequences if one was not. Democrats and Republicans agreed to postpone their recess and returned to negotiations to complete a plan.

Next Week's Economic and Earnings Releases

What about Next Week?

As I warned last weekend, developments this weekend will likely trump anything shown on these short-term charts or any scheduled events listed on that calendar. In addition, market participants appeared to fear some settlement of the crisis and bailed from bearish positions into the close, with the last-minute positioning somewhat untrustworthy and distorting the chart action. Still, let's see what we can see.

Annotated 30-Minute Chart of the SPX:

Choppy price action is apparent with most of the week spent chopping between a 38.2 percent and 61.8 percent retracement of the rally from the 9/18 low into the 9/19 high. Friday's action in particular took the choppy back-and-forth action of a bear flag climbing off support, with the SPX then stopping short of besting Thursday's high.

For the sake of the clarity of this short-term chart, I have not drawn the flag, but the SPX needs to sustain values above Friday's high to avoid the possibility of falling back toward the flag's support. If the OEX does sustain those higher values, first resistance on 30-minute closes is now near 1225, but would be shoved higher by any strong rise early in the day. Therefore, I would be careful of any early punch higher to the 23.6 percent Fib level that then falls back beneath about 1225 and maybe even 1230 by the end of the first 30-minute period.

If the SPX drops immediately Monday morning, as is at least possible, watch for potentially strong support on 30-minute closes near 1203-1205.80. If that support doesn't hold, and particularly if 30-minute closes are beneath 1199, then vulnerability to 1187 and perhaps 1175.63 must be considered. As long as the SPX chops between about 1175 and 1225, it's in a chop zone, and technical indicators may be less and less predictive of what happens next. Breakouts above or below those levels, sustained on 30-minute closes, could result in strong moves either up to the 9/19 high and beyond or down to the 9/18 low and beyond.

Annotated 30-Minute Chart of the Dow:

Similar setup. As long as the Dow maintains 30-minute closes above about 11,085, it maintains a possible upside target of 11,202, but that will get shoved higher by any early climb. Watch for potential resistance on 30-minute closes beginning about 11,200 and extending up to about 11,240. Be wary of an early breakout toward 11,270 that is quickly reversed back below 11,200 and particularly below the rising red 9-ema. If an early breakout were maintained, however, a retest of the 9/19 high might be possible, although I would watch for potentially strong resistance there.

If the Dow descends immediately Monday morning, as could happen, watch for potentially strong support on 30-minute closes first near 11,080-11,090 and then near 10,980-11,020. A failure to maintain 30-minute closes above that zone could set the potential for a drop toward 10,900 or even 10,700. A breakdown there, confirmed by a 30-minute closes beneath that support, suggests a potential drop toward the 9/18 low.

Annotated 30-Minute Chart of the Nasdaq:

The Nasdaq climbed in a formation that looks like a bear flag and stopped cold at the 120-ema as well as gap resistance. A breakout above that resistance, confirmed by 30-minute closes above it, targets black-channel resistance, which is likely to be shoved toward the 38.2 percent Fib level shown above. Watch for likely strong resistance there. A breakout there suggests a move toward 2260 and perhaps even the 9/19 high.

But the Nasdaq looks weaker than some other indices, with those others looking neutral while the Nasdaq remained in the lower half of the Keltner channels shown here. Sustained 30-minute closes beneath the 9-ema and particularly below about 2164, it sets a potential downside target near 2135.65 and perhaps down to 2128 by the time it's tested.

Annotated 30-Minute Chart of the Russell 2000:

The RUT, like the Nasdaq, spent the end of the week in the lower or bearish half of these Keltner channels and, also like the Nasdaq, stopped at the top of its gap from Friday. The possibility of another pullback exists, perhaps not until a bump up to test 708-710. If the RUT does pull back, watch for potentially strong support on 30-minute closes at its 30-minute 9-ema, now near 701, as this average sometimes has special relevance for the RUT. Sustained 30-minute closes beneath it, however, would suggest a drop down to 693-694. A breakout above 708 on 30-minute closes, suggests a test of 715-717, where next resistance might be strong.

In other words, the RUT may be setting up a pattern similar to the SPX's, in which it chops between two Fib levels before deciding next direction. Breakouts above or below black-channel resistance or support, confirmed by 30-minute closes, suggest moves up to or down to the next Fib levels, where chop might resume.

Taken all together, we must cast anything seen on short-term charts in the light of monthly ones that show all these indices firmly ensconced in descending price channels or patterns. That hasn't changed from last week. Until they break to the upside out of those channels or price patterns, nothing has changed, as simplistic as that sounds, and resistance at the top of those channels must be presumed to remain resistance. Further downside potential and perhaps sharp downside potential remains and must be factored into trading plans without counting on it happening. I hope it doesn't happen.

Cast against that, we have short-term action that shows that mostly spent the week chopping between certain Fib levels. The longer they chop there, the more indicators and moving averages and Keltner channels will flatten. Bollinger bands will narrow. Little guidance will be offered. Charts are in waiting patterns. We're in waiting patterns. The financial sector is, big money is, and the whole world is.

Of course, big events--resolution of the crisis, failures of other banks, news of big investments by other tycoons and any number of as yet-unforeseeable events--could break the indices out of those chop zones. Don't assume that you know the direction they'll break, however, piling on more risk than is optimal for you, your personality and your trading account. Big negative news could send markets reeling only to have that trigger buying the bottoms of those channels are hit again. News of the resolution could result in a bounce that's promptly sold into in a buy-the-rumor, sell-the-fact reaction.

In the old world paradigm, before sending my articles off for publication, I used to check afternoon news sources to make sure some company had not warned or else announced upbeat news that would change the landscape the next days. It's a sign of our new financial world that Friday evening, before submitting this article, I checked financial print and television sources to make sure that no bank failure had been announced.

What did I find? Wachovia (WB) was in talks with Citigroup (C), and perhaps also Santander and Wells Fargo, with those early stage discussions centering on a merger, but being called another bank failure (of WB) by some sources. Wachovia is bigger than Washington Mutual, and the FDIC wants a deal like Washington Mutual's to be put into effect, so that it doesn't have to pay claims from its funds.

As I have urged so many times lately, spend time with those people and activities that renew you. Relish your part in making history, as difficult as that can be, as we're all taking part. Educate yourselves about the candidates and exercise your vote to change what you want changed. Have hope, but don't hope yourself into more risk than is optimal for you. Standing to the side and watching can be a wise action these days.

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