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Market Wrap

Betting On A Bailout

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The markets rallied early from a grossly oversold level as comments from lawmakers suggested a bailout will eventually happen. Banks rallied strongly as rumors flew through the market. Expectations for several changes were running very high.

Dow Chart - Weekly

On the economic front the New York Purchasing Manager report (NAPM) fell by -5.5 points to 404. This was the lowest level since July 2006 and was the fourth consecutive month of declines. The six-month outlook plunged from 64.1 to 39.3 indicating a serious decline in market sentiment. That is the second lowest level in the 15-year history of the report. This report was influenced by the Lehman bankruptcy and the takeover of Merrill Lynch by Bank America. The upheaval in the banking industry and a major part of the New York business environment suggests the NAPM report will continue lower in coming months. Layoffs are going to grow as the businesses are consolidated and bonuses are expected to drop sharply for those workers still expecting a bonus. Tens of thousands of employees have seen their bonus hopes evaporate. Over 10,000 workers have already lost their jobs and another 10,000 expect to be terminated. The hefty profits of independent investment banks are unlikely to return. As bank holding companies the survivors will face more restrictions and more competition and profits will be lower. Lower profits means lower bonuses but at least there will be jobs.

The Chicago Purchasing Managers Index fell slightly to 56.7 from 57.9 but was well above expectations for a drop to 53.0. Chicago's economy is more manufacturing than banking and future challenges will come from increasing cracks in the global economy. The financial crisis coupled with the inflation from a year of higher energy prices has caused repercussions around the world primarily in the emerging economies. The Chicago PMI showed a -6 point drop in new orders to 53.9 and an -8 point drop in order backlogs to 54.9. The PMI should be showing a slight gain as we head into the holiday season but the only indication was a sharp drop in inventories from 52.2 to 37.7. Evidently producers are letting inventories deplete but not replenishing them in light of the current economic conditions.


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Retailers are having trouble finding credit for themselves and for their customers. 41% of retailers claim they cannot open new credit accounts for their customers or raise limits because of restrictions from lenders and widening spreads. 37% claim they have been reducing inventory purchasing because of the lack of credit for their customers. With consumers unable to use credit to make holiday purchases 36% of retailers are planning to close stores and 25% will layoff workers before year-end. Retailers do not want excess inventory on their shelves with a weak consumer heading into the holidays. Auto dealers are being hit hard. Dealers claim they have good floor traffic and customers who want to buy but credit is hard and terms are not user friendly. The AutoNation (AN) CEO, the largest U.S. auto dealer, said banks were turning down people with good credit simply because they had no money to loan or did not want to loan on autos with the economy so unstable. The CEO said sales volumes were down as much as -20% due to lack of credit. In normal times dealers are able to finance 95% of buyers. The CEO said approvals of prime customers with excellent credit was down to less than 80% and only after shopping to 5-6 different banks. Approvals of less than prime credits was under 20%. This is causing layoffs by auto dealers as well as automakers and industries that feed directly off of auto sales.

The final reading on Consumer Confidence for September rose to 59.8 from 56.9 and well over expectations for a drop to 55.0. The gain came in the expectations component, which rose +6 points to 60.5. The present conditions component fell -7 points to 58.8 and offsetting the gain in expectations. Analysts had expected a drop in both components. This was the fourth consecutive gain in consumer confidence. Given the market drops of the last several days this is likely to reverse when we get the first October reading.

Consumer Confidence Chart

The rebound in the markets on Tuesday was not due to any economic report but entirely an oversold rebound on hopes for an eventual bailout plan. From the ringing of the opening bell there were rumors that lawmakers were close to another version of the plan that would be approved. The SEC said they were considering a new ruling on the need to mark to market assets on bank balance sheets. Barney Frank said he was working on raising the FDIC insurance limits well above $100,000 to prevent depositors from withdrawing funds from banks. It was a total rumor day that prompted traders to cover shorts and enter new positions ahead of any of those events coming true.

Lawmakers were working frantically to bring competing versions of a bailout bill to a vote. There were as many opinions as to what a bill would look like as there were politicians. Some were conservative and some were exotic but none were seen garnering enough support to come to the floor for a vote. Most analysts believe a bill will eventually be passed and that helped to reduce some of the oversold pressures.

Early in the day the SEC said they would have an announcement as soon as today about removing or modifying the mark to market rule that caused this problem in the first place. If this rule was eliminated or set aside for say three years it would erase nearly all the current problems. If a bank is holding a million dollar subprime loan today the current distress in housing and financing is forcing that bank to mark the value of the loan down to 60-75% of value. Multiple this by 1000 loans and this knocks the bank's assets down by hundreds of millions of dollars. This requires the bank to raise additional capital to remain within the reserve guidelines mandated by the FDIC. There is no capital available in the market today. This forces banks to try and sell assets at fire sale prices to bring their balance sheets back into balance. This is the underlying cause of the entire banking crisis today. If the SEC removed the mark to market requirement the banks would be able to carry the loans on their books at a value they are comfortable with and end the crisis. The mark to market rule is a new rule that evolved out of the original subprime crisis. It was supposed to give banks confidence in dealing with other banks because values would not be inflated. Instead it weakened the balance sheets of the entire financial sector and made the problem worse. This led to the Bear Stearns crisis, Lehman bankruptcy, AIG bailout, etc. The prospect of the rule being set aside even if only temporarily was a positive market force. After the close the SEC said FASB could issue a new ruling before the week is out BUT the SEC would accept an owner determination of "fair value" where there was no liquid market for the asset. That would remove some of the pressure from banks until the FASB makes its announcement later this week. The SEC wants to retain the fair market rule but Republicans in the House want to eliminate it to erase the need for a $700 billion bailout.

Another problem hitting the banking sector is a flight to safety by depositors. With major banks failing almost daily, depositors with accounts over $100,000 are withdrawing funds at a rapid rate. This run on the banks causes a bad capital situation to be even worse. Barney Frank said he is trying to get the FDIC insurance cap raised from the current $100,000 level. The FDIC head Shelia Baird said she supported raising the cap. Levels mentioned were $250,000 and $500,000. This would increase the amount banks would pay in FDIC insurance but keep more deposits in place and halt some of the drain on capital.

There are many who feel the FDIC should be left alone. They point to the current "Shelia Bair" trade that should be continued. The FDIC chaired by Shelia is forcing arranged marriages almost daily as weak banks are sold to strong banks. This is how the FDIC has dealt with bad bank management in the past and some see no reason to change. There are quite a few good banks that have no subprime exposure and plenty of money to lend.

Monday's -777 Dow drop has the SEC considering some additional circuit breakers not only for the markets but for individual stocks. Personally I would be against a circuit breaker on individual stocks but they did not ask me. I think individual breakers would be a needless complication for the market. If RIMM shareholders want out of their positions they should be able to exit at any time. If a circuit breaker is tripped and the stock halted it only adds to the anxiety and could increase the number of sellers when the stock reopens. I know several foreign exchanges have individual breakers so it would not be a stretch to see that happen in the U.S. markets. Apple saw its stock fall from $128 to a low of $100 on Monday with a market cap loss of more than $20 billion. Half of that was recovered on Tuesday with a +$8 gain back to $113.68. Would a circuit breaker have lessened that drop or aggravated it?

Tuesday was the end of the month and quarter and many professional traders were claiming the Monday dump was the result of massive redemption requests by hedge fund investors. Hedge funds are seeing a run on the fund similar to the run on the banks by depositors. TrimTabs said hedge funds could have seen $20 billion in redemptions for month end. TrimTabs said regular stock funds were on track for $50 billion in withdrawals for the month and that would be an all time record. TT said investors withdrew $10B on Monday alone. Not even the bond funds are exempt with $8 billion withdrawn last week. With this kind of investor flight at the retail level analysts claim the larger investors are running scared as well. Sept 30th was the last day many hedge fund investors could make withdrawals in 2008. With the markets so volatile it only makes sense that some were running for cover as the quarter ended.

The markets are really confused. Monday was a 96% down volume day with volume of 12+ billion shares. That was the highest volume in over a week but would not even have registered when compared to the 15-18 billion share days of the prior week. Nearly 2100 stocks hit new 52-week lows on Monday. Decliners at 6445 beat advancers of 719 by a mile. It was an ugly day with the VIX hitting 48 and a level not seen since 2002. By all indications the market at the close was the most oversold it had been in years and we should have expected a strong rebound today. By those metrics Tuesday's rebound was anemic at best. It was slow and lackluster other than the opening print. Shorts reluctantly gave up ground until late in the afternoon when the SEC FASB rumors began to surface. That caused many to throw in the towel but most stocks only recovered half of what they lost on Monday. It was the largest gain in six years but it was still lackluster. Contrasting the 12 billion shares traded on Monday only 9.8 billion traded on Tuesday's rebound or nearly 25% less.

The biggest rebounds were in the banking sector with Citigroup gaining +19%, BAC +15%, JPM +15% and WFC +13%. For every bailout deal that gets done and every rule change that occurs these major banks are going to rocket higher. The FDIC has already blessed them by letting them acquire weaker banks over the last couple weeks. These are the new winners in the financial sector and will move higher on any and all news.

The quarter ended with monster losses in some major sectors. Energy lost -25%, materials -23%, semiconductors -17% and cyclicals -10%. The Dow lost -4.6% for the month, S&P -9% and Nasdaq -8.9%. The +5% rebound in the S&P on Tuesday lessened the damage but it was still a horrible month. The S&P closed -17% under its 200-day average on Monday. By any metric this was grossly oversold. The Nasdaq lost -199 points on Monday and only recovered +98 points today. This was hardly a bullish day despite the gain. The VIX closed just fractionally under 40 and a level we would have called a major buy point any time over the last five years. Few were calling it that today.

Everything hinges on some change in the financial environment. A bailout deal of some kind needs to be completed by Friday. A FDIC insurance change would help as would a new FASB interpretation. However, today's gain was in hopes of all three of those events coming to pass. We saw what happened on Monday with the bailout deal failed. I believe we are setting up for another decline if those events don't happen. This was a "betting on a bailout" rebound and nothing else.

Nobody in their right mind expects a strong earnings cycle ahead. Earnings warnings are growing in numbers and intensity and Alcoa will lead off the Q3 earnings cycle with their earnings next Tuesday. Any deal rally this week will face an ugly earnings cycle starting next week. I am not specifically bearish but I am skeptical of any bullish rebound this week. I would rather than late to a rally then early for the next decline.

In stock news Google was the headliner today with some monster volatility at the close. Google saw some huge volume in the three minutes before the close with a print down to $210 and a close at $341. Nasdaq investigated the trades and busted those responsible for the volatility. The official close was adjusted up to $400.52 from $341. The Nasdaq said it busted every trade below $400.52. The Nasdaq also said the trades in error were routed from another exchange but did not identify the exchange. Celgene (CELG) recovered +13% to $63 after trading as low as $56 at the closing print on Monday on unusual volume. Nasdaq did not bust those trades. Dr Pepper Snapple (DPS) spiked +9% on news they were being added to the S&P 500.

Crude Oil Chart - Daily

Crude prices recovered from the -$11 drop on Monday and the dip to $93 this morning to close at $102 today. 48% of gulf oil production and 47% of natural gas is still offline. Wednesday's inventory report could show a sharp spike in inventory levels as a result of the backlog of supertankers offloading at the LOOP after hurricane Ike passed. The offset to those deliveries would be those refineries currently operating running at full speed to overcome the gasoline shortage in the southeast. It should be interesting to see what they numbers will show.

The Dow rebounded +485 points to close at 10850 and right at initial resistance. That resistance range runs from 10850 to 11150 and will be tough to cross without a major change in the banking environment. The S&P failed to return to the same relative resistance range as the Dow. The +5% S&P rebound stopped at 1168 with the equivalent resistance range at 1175-1215. The S&P is greatly impacted by financials and they were up big on Tuesday but not enough to erase the -9% S&P drop on Monday.

Dow Chart - Daily

Nasdaq Chart - Daily

The Nasdaq hit a low of 1983 on Monday and temporarily broke strong support at 2000. The Nasdaq is where Main Street trades while Wall Street trades in the blue chips. Main street traders were scared on Monday but there was some serious bottom fishing on Tuesday. Apple gained +8%, RIMM +10%, MSFT +7%, QCOM +7% and ORCL +8%. Unfortunately the resistance at 2100 held firm.

I could go on but the answer is clear. This was a weak rebound on hope that a bailout deal would be done as well as the possible FDIC/FASB changes. I believe that it will take a strongly positive deal to really push the markets higher. Those potential deals are already baked into the cake. Profits are going to be ugly regardless of whatever deals are announced. I would be cautious about longs on anything but those top four financial stocks and look for a retest of the lows on any deal disappointment. Late news suggests a new bailout plan could be brought to a vote on Wednesday. Others with a competing bill are saying Thursday for a vote. As long as the competing groups are involved in a tug of war I doubt nothing positive is going to happen soon. One view is the lack of a financial collapse on Monday and the rebound today as indications that the market will not implode if the deal goes away completely. That would be a bad assumption.

Jim Brown

Correction: In last nights Market Wrap I somehow made a typographical error in the spelling of Senator Obamas name. Sometimes when typing quickly, we can make mistakes and rely on Microsofts spell check to correct it later. Originally I incorrectly spelled the Senators name Obama in the first draft. Then somehow the spell checker automatically switched Obama to that other name. I meant no ill will toward the candidate or his supporters. My intention was to give a portfolio managers perspective of the days occurrences without political bias. Unfortunately, my typographical error ended up being disrespectful to a strong and influential man. On behalf of myself and OptionInvestor.com, I am deeply sorry to those that I have offended. In the future, we will provide market commentary relative to option investing and trading. Please accept my apology.

Robert Ogilvie

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