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Market Wrap

Volatility Still Increasing

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The CBOE Volatility Index or VIX hit a new historic high of 81.17 on Thursday with the 800-point market swing. Friday's 563-point range deflated that number only slightly to close at just over 70. The Dow traded down -259 and then went positive by +304 before closing with a -127 point loss. It was just another normal day in the current market environment.

Wilshire 5000 Chart

The market opened up to another record drop in an economic report. The Consumer Sentiment report for October showed sentiment fell -12.8 points to 57.5 and the second lowest reading in the last 28 years. The -12.8 point drop was the largest monthly decline on record. The present conditions component fell from 75.0 to 58.9 and that is the lowest level on record. Expectations fell 10.5 points to 56.7. Inflation expectations were mixed despite the drop in gasoline prices. These massive declines should be no surprise given the almost daily crisis in the global financial sector. With the markets off -40% and newspapers full of great depression comparisons I would not be surprised to see consumers spending their last dollar to put bars on their windows and stock up on food and ammunition. Consumer credit has dried up and home values continue to decline. IRA/401K accounts have been cut in half and the damage does not appear to be over. The Dow has only closed positive twice in the month of October. It is not a pretty picture but at least most analysts don't expect it to get worse.

Consumer Sentiment Chart

On the positive side new residential construction permits fell by -8.3% in September and housing starts fell by -6.3%. Permits are down by 38.4% over Sept-2007 and starts are down by -31.1%. One analyst said we have not seen conditions this bad since the 1950s. On the positive side this means there will be far fewer new homes to compete with used homes for available buyers in the spring. With mortgage loans almost impossible to get the current home owner will need all the help they can find in selling their homes in the spring.

Philly Fed Manufacturing Survey Chart

It has been a rocky week for economics with the Philly Fed survey falling to a two decade low of -37.5 from +3.8. Industrial production fell -2.8% in September after a sharp -1.0% decline in August. The NY Empire State Manufacturing Survey fell to -24.6 from -7.4 and the sharpest drop in history. Retail sales fell -1.2% in September and their biggest drop in over three years. The NAHB Housing Market Index fell to 14 and its lowest level since the early 1980s. All these reports are at multi-year or even multi-decade lows and some the lowest on record. The economic drop has accelerated at warp speed over the last 60 days. There appears to be no doubt that we are headed for a sharp recession and moving very quickly in that direction.


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Moody's said credit card charge-offs rose 48% in August, according to the latest data on $435 billion in credit card debt securities that Moody's tracks. That number is misleading as a news headline. The actual charge-off rate jumped from 4.61% to 6.82% or a +48% increase. The headline crossing the wires at 48% sounded like the second great depression had arrived. However, some firms are going to struggle as those rates continue to rise. Friedman Billings Ramsey said charge-offs would continue to rise through 2009 and expected charge-offs at Capital One to jump +25% by year-end and 30% at American Express. Capital One responded saying they expect total charge-off rates to be "only" 7% in Q1-2009. FBR said American Express was experiencing the worst spike in defaults of the entire group. AXP will report earnings on Monday.

The economic calendar for next week is less than exciting. There is only one report that could be called important and that is the Chicago Fed National Activity Index on Tuesday. Everything else is either a routine weekly event or old news.

Economic Calendar

The focal point for traders will be Q3 earnings with numerous companies reporting. So far for Q3 we have seen 82 S&P-500 companies report and the average has been a drop of -33.7% in actual earnings. 59% of companies beat the lowered guidance and 27% missed their lowered estimates. Even the major companies like INTC, IBM and EBAY were sold off after their earnings failed to impress traders. Only Google saw a major bounce after beating the street. This was more of a short squeeze than positive buyer interest. Google is always heavily shorted ahead of their earnings. GOOG closed up +19 on Friday. Thursday is the biggest day of the cycle with more than 325 companies reporting.

Earnings Calendar

Warren Buffett called a bottom on Friday. He did not actually say we were at a bottom but did say he was buying stocks for his personal account this week. He said in an editorial, "Be fearful when others are greedy and be greedy when others are fearful." He said, "Fear is widespread and gripping even seasoned investors." Buffett explained he did not have the faintest idea which stocks would be higher or lower years from now but "what is likely, however, is that the market as a whole will move higher well before either sentiment or the economy turns up." Buffett's opinion piece in the New York Times was repeated about every 30 minutes on stock TV and the news channels. I think the reporters wanted everyone to rush into the market and emulate Buffett. Unfortunately he has deeper pockets than anyone hearing the news and can weather further declines better than most. We will see if his advice was timely when we look back a couple months from now. In the past he has made similar statements and they were not always at market bottoms but generally pretty close.

Meanwhile Carl Icahn put his 177-foot yacht up for sale for $37.5 million. Considering the current financial market and drop in prices for high dollar luxury goods it would suggest Carl needs to raise some money to refill the coffers rather than just deciding to sell. He has taken some sizeable hits on his recent investments. His Yahoo stake is worth about half what he paid for it and the outlook for a quick recovery does not look good.

The retail sales numbers I quoted above paint an ugly picture of the coming holiday season. However, a couple major chains won't live to see those holiday shoppers. Linens and Things was bought by a private equity group a year ago for $1.3 billion. For a year they have been trying to find a way to save the chain of 371 stores. Last month the bankruptcy court said the chain would be sold at auction to benefit creditors. Because there was no financing available in the market there was only one bidder. A consortium of private equity firms bid $470 million. The entire inventory of more than $1 billion in merchandise was put on sale on Friday in a highly publicized event. When that fire sale ends all 10,000 associates will be out of a job. The 371 stores will then be auctioned in December.

Mervyns, also in bankruptcy, said on Friday they were calling it quits and would also have a liquidation sale at its 149 stores before abandoning its remaining real estate. A private equity firm bought Mervyns from Target for $1.2 billion in 2005. Mervyns is suing the private equity firm claiming they forced the firm into bankruptcy by stripping out all their owned real estate and then leasing it back to them at significantly higher prices they could not afford. Sharper Image also filed for bankruptcy and liquidated all its stores. It has not been a good year for retailers and the coming holiday season is not going to help since stores could not buy inventory without financing. Where retailers are normally adding salespeople this time of year many are now trimming staff to offset weaker expected sales.

All day Friday there were sound bites in the news about a potential thawing in corporate debt. Several firms were said to have actually floated loans over the last week. I would urge caution in thinking the credit crisis is suddenly over. Member banks borrowed a record average of $487 billion PER DAY from the Fed discount window last week. That was up from a record of $420 billion the prior week and a record $387 billion the week prior to that. Notice the trend? If the credit markets were thawing I suspect the Fed borrowing would have lessened rather than risen. The Fed and Treasury actually have some programs in the works that will help once they begin operation. One of them will allow companies to go directly to the Fed for corporate loans. That is a scary thought. Reportedly there is about $1.5 trillion in outstanding corporate paper that qualifies for a Fed buy. If you add up the bailout dollars authorized and offered over the last several weeks it is a frightening number. Just in the U.S. it could total more than $3 trillion. While that sounds like a lot that Fed discount window borrowing for last Week was nearly $2.5 trillion. That also sounds like a lot but the majority is refundings from prior borrowings. If the recession is really deep and lasting the Fed/Treasury could end up owning the business sector in the first ever voluntary nationalism program. Obviously I am being dramatic but we are headed into uncharted territory and there are some very big numbers on the horizon. Be very wary if they start offering money to hedge funds to invest in the market.

Hedge funds could use some assistance. TrimTabs said they saw outflows of $43 billion in September. That was seven times the prior record and TrimTabs believes October could be worse. Total capital in hedge funds fell -11% in September to $1.72 trillion. It was also the worst month ever for performance with an average loss of -6.2%. Mutual funds also saw the biggest redemptions in history and October is expected to be worse. TrimTabs said mutual funds were seeing redemptions of $5 billion per day. All funds were hit hard on performance in September with emerging market funds down -15%, equity long funds -11.7% and sector specific funds -7.3%.

Energy funds were down as much as -25% due to the implosion in oil prices. That price hit $68.57 on Thursday and rebounded to $74.30 on Friday. Part of that rebound was due to OPEC moving their emergency production meeting from November 18th to next Friday, Oct 24th. OPEC is expected to cut production and probably sharply by as much as one million barrels. The problem will be policing the quota cut. With cash received for crude off 50% over the last three months many of the OPEC exporters are reeling from the slide. That money received during the spike was easy come and easy go. It was spent almost before it was earned. Now those spending programs are running on empty and the only way to ease the pain is to produce additional oil over quota. OPEC will have a major problem on their hands.

Additional volatility came from crude options, which expired on Thursday, and crude futures expiring next Tuesday.

Crude Oil Chart - Daily

Hugo Chavez has an even bigger problem on his hands. With light sweet crude trading around $70 the price he gets for his oil is closer to $60 because of the poor quality. Venezuela pumps just over 2.36 million bpd and Chavez gives away about half to other Latin American nations to keep them sucking up to him and to subsidize prices inside Venezuela. Venezuela has some of the cheapest gasoline on the planet. That costs Chavez some big bucks to maintain the program. Chavez also announced he was going to implement a six hour workday and enforce severe penalties to employers who violated these policies. This is part of his social programs to stay in office. Many employers said the change from 8 hr to 6 hr plus the mandatory employee benefit programs would drive them out of business. Late Friday we learned that RBS cancelled a $5 billion credit line to PDVSA, the Venezuela oil company. Just over the past couple weeks the interest rate on Venezuelan bonds has jumped from 7% to 15-16% on default fears. The U.S. said on Friday there are indications Venezuela is starting to show signs of financial stress suggesting the country was about to fail. Couldn't happen to a more deserving politician.

The market volatility has prompted several brokers to lower their year-end targets. JPM lowered their year-end target for the S&P to 1125 on Friday from 1375. The last six weeks have forced analysts to rethink the typical year-end rally.

When I sat down to write on Friday I was bearish. I looked at hundreds of charts with many going from just plain ugly to catastrophic. I had already compiled the various economic statistics I reported above and they were not just ugly but simply unbelievable. Then I started to reflect on the various bailout programs heading our way and I could actually see a fundamental reason for hope. Unfortunately fundamentals are sometimes ignored by the markets when in the grip of irrational pessimism.

By the time I got to this point in the commentary several hours of research had passed. While I don't have a magic bullet to use on the markets we are in a repeating cycle that normally prevails. As I reported in prior commentaries the period around expiration week in October is historically a bear killer. More bear markets end between October 10th-22nd than any other period. This is due to mutual fund year-ends, earnings trends, politics and economic cycles. They all seem to converge around expiration week in October.

It is a historical fact that Nov-1st through April 30th are the best six months of the year for investors. In the last 54 years those six months saw a combined gain of 10,599 Dow points while the other six months of the year saw a combined loss of -588 points. $10,000 invested in 1950 for just the six months of the year starting on Nov-1st would have returned $482,000 though 2003. The same $10,000 invested in the opposite six months would have lost $318. This fact is not lost on fund managers and they do game this cycle to some extent. Granted there are other factors and some years there are losses but those losses were minor and occurred in only 12 of the last 54 years. November, December and January are the three strongest months of the year. Fund managers plan their investment buys for October to take advantage of these months. Given the horrible market over the last several months they will need to act aggressively to capture any future rebound and rebuild profits. Many fund managers report being heavily invested in cash as a protection against redemptions and to have ammunition for the eventual rally.

Obviously nobody can call a bottom, not even Warren Buffett. However, this is the first weekend in recent memory where we did not have some crisis that had to be resolved by Monday's open. This was also the first week in recent memory where some corporate paper actually traded. Baring some new revelation on Monday we could be nearing a period of calm in the financial markets. We still have to hold our nose and cover our ears when the banks report earnings over the next few weeks but there is really nobody big left to fail. All the usual suspects have either already been convicted or proven innocent. As each day passes we move closer to those bailout programs actually being implemented and some semblance of normal returning to the credit markets. I could stand some normal days without 500 point swings to take out my stops on both the upside and downside.

As we were strategizing Friday evening the general consensus was for a possible retest of the lows on Monday/Tuesday as the last round of redemptions were removed from the market. Any retest of the lows should be met with some buying as long as a new crisis does not erupt. I would be a buyer of the next dip. I believe we could see 8000 on the Dow, 850 on the S&P and 1600 on the Nasdaq. Since early Q3 earnings have not been a disaster there are actually some fundamentals worth buying.

The wild card here is the election. I am going to try and touch on it gently so as not to anger either side. Most market analysts feel an Obama win would be market negative because of the massive new taxes and large spending programs possible with the democrats in full control of the house and senate. Raising taxes on businesses and redistributing the wealth is not a market friendly policy. It is entirely possible some of the market "adjustments" of late were also influenced by shifting of investments in expectation of an Obama win. For the two weeks after Labor Day when the candidates were running almost even the markets were calm. Once Obama began to stretch his lead again the markets extended their declines. To be fair most of the declines were on financial worries but the chances for an Obama win could have also been a worry. McCain is also not without risk. He is seen as a reformer that could shake up the status quo by use of the veto pen. He is strongly anti-pork and has promised to veto anything that crossed his desk. Those promises rarely mean much because of the way lawmakers structure their bills. The president has to sign bills he does not like in order to get things he does want. His pledge to cut taxes on businesses and capital gains is always market friendly. It is historic fact that cutting capital gains taxes and taxes on business always produces more revenue rather than less. Many politicians have a hard time with this concept but the market always warms to it. The point to this paragraph is that the next three weeks will see the election weigh on the markets in ways we can't quantify and that could easily push them lower. Indecision is a crippling disease and until the election is behind us investors don't really know which way to turn.

The Dow gained +401 for the week but lost -127 on Friday to close at 8852 and under the key 9000 level. The intraday highs on Tuesday and again on Friday were just a continuation of lower highs over the last month. The chart clearly looks like we should expect another retest of 8000 if not something lower. This was option expiration week and we really can't apply much logic to the markets moves ahead of expiration. Next week is when the real market should reappear.

Dow Chart - 30 min

S&P-500 Chart - 30 Min

The S&P-500 is showing the same pattern with initial support at 850. Very long-term support is 800 and while that does not appear likely as a target today it is still a potential bulls-eye on any future sell off. I would be perfectly happy with a touch of 800 by the S&P and 8000 by the Dow with a lasting rebound to follow.

The Nasdaq has initial support at 1550 followed by 1450. With Friday's close at 1711 it is well above those levels. Google has already reported earnings but Apple will report on Tuesday. That will produce a direction for techs. As Apple goes, so goes the Nasdaq.

Nasdaq Chart - Monthly

Russell-2000 Chart - Monthly

The Russell-2000 is floating through the twilight zone at 526. There is minimal support at 500 and decent resistance at 585. Fund managers have abandoned the small caps and until they return to favor any rally is just smoke and mirrors. A move over 600 would be confirmation buyers have returned in volume.

For next week I would key on those support levels above and those earnings reports I highlighted in the table above. We are just a little over a week from another FOMC meeting and odds are good there will be another 50-point rate cut as insurance. Inflation has evaporated along with oil prices so the Fed can continue to act aggressively. The bears should head for hibernation soon so be prepared for a rebound that has legs.

Jim Brown

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