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Market Wrap

Freaky Friday

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Friday's 1,018-point range on the Dow was a fitting end to a very scary week. It was the worst week ever for the Dow. Worse than 1987 and worse than 1929. The Dow lost -18.15% for the week and at the low it was down -3601 points or -31% in just the last three weeks. Friday's opening dip hit a low of 7882 and a level not seen since March of 2003. Ugly does not even begin to describe the market action over the last week.

S&P-500 Chart - Monthly

There were no material economic reports on Friday but after the Dow gapped down 700 points any reports would have been ignored. The global markets imploded on Friday and the U.S. markets followed suit. A large Japanese insurance company filed bankruptcy and Iceland's banking crisis worsened. Those were just two examples of negative news impacting global market sentiment with losses for the week of more than -20% not uncommon. The Indonesian markets were closed to avoid further panic and several other countries considered that option.

The Dow fell over 700 points at the open and quickly rebounded into positive territory on hopes the dip to 7882 was a climax bottom. The rebound was quickly sold and another -600 point drop appeared. When there was no crush of selling at 3:PM and the Lehman auction closed successfully traders decided to cover some shorts and the Dow quickly rebounded +870 points to +322. As traders held their breath ahead of the close we saw the sellers reappear again and knock -450 points off the bounce to close down -128. It was the biggest intraday range ever for the Dow and the biggest weekly loss.

The problem continues to be fund liquidations to cover record redemptions and margin selling by retail investors. For instance the CEO of XTO was forced to sell $101 million in company stock when he received a margin call he could not make. The CEO of Chesapeake (CHK) and the largest individual shareholder with 33.5 million shares (5.8% of outstanding worth nearly $1 billion at his cost but only $500 million today) was forced to sell all of his position to meet margin calls. Aubrey McClendon had been a constant buyer of CHK stock for cash and then on margin as Chesapeake's future brightened. The sudden collapse of the energy sector and the markets in general produced margin calls on nearly every margined stock over the last three weeks. He is just one individual out of millions that was forced to sell.


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Investors receiving margin calls were forced to sell other positions in addition to the ones being hit by calls. This domino effect squeezes investors in stages. First there is denial of the initial drop and some minor covering to rebalance the portfolio. Traders then double down in an attempt to recover losses from this "obviously oversold" dip. Next comes shock that the market continued down and the dip was a crash and they have to rebalance again. Then comes realization that the sell off was worse than they expected and could get worse. The pain threshold increases and some positions are liquidated. As the selling continues eventually you get capitulation as dejected and broken investors dump remaining positions either in disgust or by forced margin selling. We are nearing the capitulation phase and the -700 point Dow drop on Friday was initially thought to be that capitulation spike. The NYSE said margin debt had fallen by 25% during the third quarter. I would bet it has dropped a lot more since October 1st. The last week has seen more margin selling than any prior week but the actual numbers wont be out for some time.

The liquidation has been extreme. TrimTabs said funds saw record outflows in September of $72 billion. In just the first week of October another $50 billion was withdrawn. That was $43 billion from stock funds and $7 billion from bond funds. Since many funds are leveraged from 2:1 to 8:1 that is a lot of buying power leaving the market.

The forced liquidation was extremely evident in the markets. In the first 20 minutes of the futures market crude prices fell -$5 on 10 times the average volume. It was clearly a major position dump by a major fund(s). When the equity markets opened any stock with a high stock price was crushed. Exxon (XOM) dropped another $10 to $56 and this was on top of a -$9 drop on Thursday. The same was true for Chevron and Conoco. Google lost $20 intraday before rebounding to close positive. Rio Tinto (RTP) lost -$25 before rebounding. Gold lost -94 intraday before rebounding at the close. Goldman Sachs dropped -26 to $74 before rebounding and this was on top of a -$20 drop on Thursday. Part of Goldman's problem was fear over the Lehman auction and another downgrade but the trend was clear. Prior winners and places where funds thought they could safely store money while waiting for the market to recover were sold hard to raise cash. There are no favorites left and no safe place for hiding cash.

Chevron Chart - Daily

Crude Oil Chart - Daily

The Volatility Index (VIX) hit a new record high of 76.94 on Friday as the market volatility hit extreme levels. The 1000-point swing in the Dow and going from sharply negative to sharply positive twice was unheard of in market history. The current VIX or "new" VIX is based on the SPX where the "old" VIX was calculated on the OEX. The old VIX hit a high over 100 in the 1987 crash. The old VIX had fewer stocks (100) and according to the CBOE the new VIX on the SPX should be less volatile. I would equate Friday's VIX at 77 to be equal to the 100 in the 1987 crash.

Volatility Index Chart - Daily

Weighing on the markets Friday morning was the Lehman CDS auction. Lehman had over $400 billion in debt covered by credit default swaps. In order for debt holders to exercise the default insurance a value on the debt needs to be set. This is done by an auction. Lehman's debt was auctioned for 8.625 cents on the dollar. That means a $100 in debt was sold for $8.65. The debt holder can now bill the writer of the default insurance for the difference or $91.35 per $100 of debt. This means insurers will have to pay $365 billion to holders of the debt. The International Swaps and Derivatives Association (ISDA) has only had to run nine of these auctions since 2005 but has five this month alone including WaMu. Traders were worried that the size of the insurance payments would cause further bankruptcies when the writers of the swaps were unable to come up with the billions in cash. After the auction the ISDA said it was successful and there were no failures. All insurers had put up collateral to cover their liabilities. In fact the ISDA said after taking into account the offsetting positions only about $8 billion in actual payments would change hands. Insurers had been very active in offsetting and hedging their positions. The feared disaster had been averted and the market rallied +800 points off the lows.

On the earnings front you have to look hard to get any earnings news. Since all the earnings news is negative the market reporters are ignoring it to focus on the market drop. GE reported earnings on Friday that fell -22%. The earnings of 43 cents hit GE's own lowered forecast and they blamed the drop on its struggling finance division. Even GE has had to raise capital by selling $15 billion in stock and an additional $3 billion in preferred shares to Warren Buffett. GE rose +2.49, mostly at the close, as traders breathed a sigh of relief and shorts covered their positions. Several analysts expressed concern that GE was likely to lower their earnings forecast again once the smoke clears. They still have $88 billion in commercial paper and even with their AAA rating this expense is weighing on their results.

The Nasdaq managed to bounce back to positive territory mostly on the back of a +$12 rebound in Apple. The chip sector plus Microsoft was a major drag after the Micron warning on Thursday. Micron said it was cutting its global workforce by 15% and said it was slashing output of NAND chips in its joint venture with Intel because of weak demand. Most of the 2,800 jobs to be lost will be in Boise Idaho. Micron said customers were calling and saying they could not pay for chips already shipped because they can't access their lines of credit. Micron said selling prices for chips had fallen significantly below the manufacturing cost. This is not good news for the tech sector and suggests tech earnings could be weak. Intel will report earnings on Tuesday and there are numerous other chip stocks reporting.

Financials are still struggling despite weeks of different bailout plans. As Micron reported many companies are facing a cutoff of capital as bank funding dries up. American Express said on Friday that 18% of small businesses were in danger of failing due to a sudden lack of financing. A survey out Friday showed that banks making loans had dropped by -60% over the last six months and were at levels not seen since the Carter administration. Money is drying up at a faster rate than ever before in this crisis. The FDIC announced on Friday they closed the Meridian Bank in Illinois and Main Street Bank in Northville Michigan. The FDIC has 117 banks on its danger list but that may only scratch the surface. RBC Capital said they expect 300 banks to be closed over the next three years. Bauer is tracking 426 banks in danger. Weiss Research says 1479 banks and 158 thrifts with $3.2 trillion in assets are in danger. That equates to 1 in every 9 banks. Obviously the problem is probably worse than the low FDIC estimates but probably not as bad as Weiss claims. Somewhere in the middle is where everything will settle but unless banks raise capital and are able to make loans the rest of the economy will crash before the banks fail. Most banks have raised interest rates and lowered credit lines on credit cards. Home equity mortgages are almost impossible to get and business loans are extremely tight. A reader told me this week a high net worth friend with a 750 credit score tried to get a car on a 3-year lease. He was denied even though he offered to pay the entire three-year lease in advance. A GM car dealer in the business for 30 years reported on Friday that business was down 50% from August levels because he could not get financing for customers and shoppers did not want to commit to a big debt on a car in this economy. There is simply no money in the market and things may get worse before they get better.

Countrywide notified one million customers last week that their home equity line of credit had been canceled. Despite the bailout Washington Mutual is notifying customers that they will not have access to any unused credit on their cards or home equity loans. If you had a card with $10,000 in credit and a $4000 balance then your new credit line is $4000. This is then reported to the credit bureau and it shows up as a maxed out credit line and that lowers your credit score even though you did nothing wrong.

Another problem is the failure of the Letter of Credit market. Suppliers require a letter of credit from a purchaser before they load the goods for a global shipment. This assures them they can get paid when the goods arrive. At least that was how it worked in the past. The system has broken down with banks refusing to issue letters of credit or worse, refuse to accept them as collateral for payment because they are not confident in the issuing banks ability to pay. According to Commodity Information Systems there are all kinds of stuff stacked up on docks right now that can't be shipped because the buyers can't provide an acceptable letter of credit. If this continues for another 2-3 weeks the global economy will begin to slow rapidly from lack of inventory and components.

Iceland moved one step closer to having to ask the IMF for a bailout. Iceland shutdown the last of three major banks on Thursday. The top three banks had liabilities of $140 billion and 10 times the GDP of Iceland. The Icelandic stock exchange was shutdown and trading in the Icelandic krona ceased with no foreign banks willing to take the currency. Without an IMF bailout Iceland will be bankrupt. The three banks had been paying very high yields and had attracted deposits from all over the world. They had more depositors than citizens. Under the government takeover only individual accounts of Icelandic citizens were protected. Foreign accounts were not protected. Numerous EU organizations, city councils, even Scotland Yard lost millions in the failures. England and the Netherlands have already gone to court. The UK is freezing assets of Iceland in the UK.

After the bell on Friday Hank Paulson announced that the G7 had decided on a comprehensive program to help with the financial crisis. The details were sketchy but it appears the Treasury will buy non-voting stock in financial institutions in an effort to shore up the banking system. The lack of details in the official announcement suggests the group is not yet clear on the details but knew everyone had been waiting on news all afternoon on Friday. This was an announcement to calm traders ahead of the three-day weekend for banks. Monday is Columbus Day and a bank holiday. I expect further announcements before Monday. We desperately need a positive announcement because the IMF issued a warning on Saturday that the world was on the brink of a global financial meltdown. The U.S. appealed for patience but the IMF said there was no time after the G7 failed to present a comprehensive plan on Friday. The IMF said the potential failure of several global institutions had pushed the global financial system to the brink of a systemic collapse. The G20 was scheduled to meet on Sunday. There is also a meeting of the Euro Zone nations on Sunday.

Not all the news was bad. Art Hogan at Jefferies called Friday a bottom. Unfortunately he was the only one and there were plenty of other analysts suggesting a far different scenario. The general consensus felt the afternoon rebound and then failure of that rebound was just short covering ahead of the weekend and an entry point for sellers on Monday. Market bottoms rarely come on Fridays. Bottoms are typically formed on Mondays and Tuesdays after an ugly week of selling. The consensus appears to be expecting another washout next week that knocks the Dow back to 7500-7700 and the support lows from 2002-2003. That is seen as major support and a level where reluctant buyers venture back into the market. Unfortunately until investors quit taking money out of funds the selling will not be over.

Also after the bell news broke that GM and Chrysler were in talks over a possible merger. Analysts aware of the deal said chances were better than 50:50 it would happen. GM originally approached Ford about a deal but the two companies could not come to terms. GM and Ford both denied bankruptcy rumors last week. The reasoning behind the GM Chrysler deal is massive cost cutting for the combined entity and regain market share against foreign rivals. It was thought the combined entity could garner further concessions from the government after they showed billions in reduced costs. It is easier to bailout one entity than two. It is also well known that Cerberus is willing to try anything to rid itself of Chrysler. They bought the troubled carmaker just before oil prices rocketed from $60 to $147. Chrysler lost $1.6 billion last year and sales are down 25% in 2008. GM is burning cash at the rate of $1 billion per month and has only $16 billion in reserve. Sales are down 18% and GM has lost $57.5 billion in the last 18 months, primarily due to tax accounting changes. The WSJ said on Friday that Cerberus might trade Chrysler to GM for the 49% stake in GMAC that it does not already own.

I really wanted to believe that the -700 point drop at Friday's open and rebound back to positive territory was a capitulation bottom. When sellers returned to push the Dow back to 7973 jut before 2:PM I realized it was just wishful thinking.

This is not an average bear market but a bear caused by the collapse of the global financial system. There have been 12 bear markets since 1890. An average bear market falls -33.8% but the worst went to -60%. October 10th was the one-year anniversary of the market high in 2007 at 14167 on the Dow. Over the last 12 months the Dow has declined -39.6% to Friday's close at 8551. On an average basis we should be near a bottom but the cause of the problem has not been fixed. Investors typically come off the sidelines before the economy recovers but nearly everyone believes the economy has fallen off a cliff over the last month. We are far from an economic bottom and that suggests there could be lower lows ahead. October is known as the bear killer month because of the number of bear market bottoms in October. I would love to believe we will see a bottom next week but that will not happen until redemptions stop and reverse into deposits. Money market funds actually saw a rise in deposits last week so maybe that crisis has finally ended. Reportedly investors are moving money to checking accounts and money markets rather than leave funds in brokerage accounts that may be in danger of failing. If funds are waiting patiently in money markets they can be put back into brokerage accounts rather quickly.

The economic calendar for next week contains several key reports but I doubt the markets will be listening. Inflation has eased significantly so the PPI/CPI reports will be less important than normal. The Beige Book and Philly Fed Survey will be of interest since they show the level of economic activity and provide clues about recession possibilities. Traders will be more focused on earnings and the credit crisis but the economics will provide some noise to confuse the analysts.

Economic Calendar

More important than economics will be the earnings from the major tech leaders and a few financials. Intel reports on Tuesday followed by Ebay, IBM and GOOG. Key financials reporting will be JPM, WFC, MER, C and COF. I doubt anyone will beat estimates and we are probably going to see quite a few reporters miss their targets. IBM would be the exception since they already preannounced earnings last week in the range of $2.05 and +4 cents ahead of analyst estimates. Unfortunately they will miss the revenue number by about a billion dollars.

Earnings Calendar

I have already exceeded my word count today so I will keep the outlook brief. The Dow tested support at 8000 twice on Friday with the initial gap down to 7882 lasting only four minutes below 8000. This may look like support but it is simply a round number with no significance. Real support is just below at 7500-7700 and the 2002/2003 lows. As long as local banks don't start failing on a daily basis I would expect the 7500 level to hold. If we are really lucky and the market continues higher on something concrete out of the G7 meeting I won't complain.

Dow Chart - Monthly

The Nasdaq dipped to 1542 on Friday and that is not support either. Real support is well below at 1250 and what would seem like scorched earth selling. With tech stock earnings likely to disappoint the path of least resistance is still down. Just bear in mind we are very oversold.

Nasdaq Chart - Monthly

The S&P-500 came the closest to real support with a drop to 840. Strong support is just below at 800. I can't believe those numbers as I typed them. I expected lower numbers when I last wrote a weekend wrap three weeks ago but I never expected the S&P to go this low. I would be a strong buyer of index calls if the S&P trades near 800.

The Russell-2000 was even more surprising. The index lost almost 300 points from 751 to 467 in only three weeks. Once funds started getting volume redemptions the flight out of the Russell was immediate and drastic. That is a -38% drop in only three weeks. The Russell has strong support at 520 and that is exactly where it closed on Friday. The intraday low was -53 points lower and the Russell rebound was the strongest with a +23 point gain for the day. I would like to think it was fund buyers returning but common sense tells me it was just short covering in the low volume stocks.

Russell-2000 Chart - Monthly

Friday was an all time record for volume at 19.6 billion shares across all markets. Because of the rebound advancing to declining volume was 2:3 and not a clear lopsided capitulation event. Thursday was 1:13 in favor of decliners and could have been the perfect setup for a capitulation event on Friday. I was not convinced but that does not mean next week won't confirm with another move higher.

We are suffering from irrational pessimism and the only cure for that is a suddenly positive market. The doomsayers and media bears are having a field day and you are probably thinking I am in their camp from the negative news I listed above. The difference is that I want the markets to rebound. I want to buy a strong rally if only one would appear and last more than 30 minutes. Once the bad news bulls return to the market the daily dose of negativity will only be stepping stones in the wall of worry they climb. Unfortunately they are still on vacation and waiting for a sign to return. Saturday's urgent IMF warning of an imminent global financial collapse could have negative implications for Monday's open if there is not a comprehensive announcement from world powers before Monday's open.

Jim Brown

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