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Market Wrap

Not Over Till Its Over

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It does not make any difference how tired traders are from watching value bleed out of the markets on a daily basis. Despite numerous bottom calls from various analysts and celebrities the pain continues. Asian markets were down over 10% on Friday and European markets were off 4-7%. U.S. futures were lock limit down Friday morning. This is not the sign of an easing financial crisis but worsening global recession.

Dow Chart - 60 min

There was some good news on the economic front on Friday as long as you were not looking overseas. The Existing Home Sales for September rose to 5.18 million units and at the fastest pace since August 2007. It was the fastest one-month gain since Mid-2003. Inventory levels have also improved with only 9.9 months of homes available for sale. This is the first time inventory levels have been under 10 months since January with the peak at 11.2 months in April. The rise in foreclosure sales helped produce buyer interest. Foreclosures were up +71% in Q3 from Q2-2007. Over 765,000 U.S. properties received a default notice, warned of a pending auction or were foreclosed on in the quarter. This was the most since records have been kept. In September one in every 475 U.S. homes received a foreclosure filing.

This report was very positive because it showed that those distressed properties pushing prices lower are being snapped up like Halloween candy and that will support higher prices. On the downside the country is clearly heading into a recession and that will constrain demand somewhat until Q2-2009. Current government programs and those being discussed could also keep prices from declining any further. It will be interesting to see if new home sales also rose in September. Those numbers will be out on Monday.

Existing Home Sales Chart

The economic calendar was relatively light last week but the next two weeks will see the intensity increase. This week the two big announcements will be the FOMC rate announcement on Wednesday and the first look at the Q3-GDP on Thursday. The Fed is expected to cut rates by at least 25-points and many expect a full 50-point cut as a message to the markets. The ECB is also expected to cut rates any day now. This will be a critical FOMC meeting that could have a strong impact on the markets. Most claim the 50-point rate cut is already priced in and a failure to cut rates could be a disaster.

The Q3-GDP is expected to show the economy shrank by 0.5% in Q3 compared to a gain of +2.83% in Q2. We know there was a very sharp turndown in the economic indicators over the last two months so the -0.5% number could easily be wrong by a wide margin. If there is a sharp downward surprise it could definitely impact the markets.

This will be our first look at the Richmond Fed Mfg Survey and the Chicago PMI since the other indicators imploded over the last three weeks. I would expect those to also show sharp declines. The Durable Goods report in September posted the largest monthly drop in nearly six years. Analysts are expecting the decline to continue but hopefully at a slower rate.

Economic Calendar

The Q3 earnings cycle is nearly behind us despite only about 41% of companies reported. The reason I say it is almost over is that nearly all the large and important companies have already reported. There are still hundreds of companies reporting next week but I had a hard time finding 80 companies you would recognize to put in the table below. With the top 200 companies already reported and their average earnings down -21% the potential for any improvement is slim. Typically the quality of earnings declines as the size of the reporting companies decreases. Based on the estimates for the remaining companies earnings would rise to only a -20% decline but the problem with that type of speculation is the major earnings misses we have been seeing. I could see actual earnings decline to -25% before it is over. On January 1st the earnings for Q3 were expected to show a gain of +22%. Even at today's reported average of -20% that is a drop in earnings of more than -40% and that corresponds to the market's -40% drop.

Earnings Calendar

In the energy sector traders spit in the face of OPEC's 1.5 mbpd announced production cut. Crude fell another -3.24 to close at $64.60 after hitting a new low at $62.65. The OPEC agreement was reached quickly and the statement included a rare comment about member commitments. "The Conference has decided to decrease the current OPEC-11 production ceiling of 28.808 million barrels a day by 1.5 mbpd, effective 1 November 2008, with Member Countries strongly emphasizing their firm commitment to ensuring that the volumes they supply to the market are reduced by the individually agreed amounts." It appears there was some harsh language behind closed doors about cheating. The following table shows the new quotas for the 11 member nations that have quotas. Contrast the first table with the second table and the implied cut in production they would have to make to actually hit those quotas. Some countries would actually cut a lot more and Angola could actually raise production. To hit the actual quota OPEC would have to actually cut production by 1.822 mbpd.

Official OPEC Quotas

OPEC Production vs New Quota

Oil prices were crushed after the announcement because nobody expects the cuts to actually take place. There may be some token cuts but most analysts expect them to have trouble cutting even a million barrels much less 1.82 million. To put all this in perspective U.S. demand over the last four weeks was -1.7 mbpd lower than the same period in 2007 and a level not seen in the last eight years. Almost the entire 1.8 mbpd production cut would only offset the drop in U.S. demand. Globally demand is only off about one million barrels per day because India and China are still growing. There are fears that the global recession is accelerating and demand could fall another 1.0 mbpd and that would require OPEC to take another million barrels off the market to compensate.

That all sounds drastic in terms of demand destruction and global oversupply but there is a key factor missing. In the U.S. the average price of gasoline has fallen to $2.78 per gallon but in some areas it is already selling as low as $2.15 per gallon. Nothing rebuilds demand as quick as low prices and some analysts believe we could eventually see gasoline under $2 in some U.S. states. You can imagine how fast $1.95 gasoline would spur demand after seeing it at $4.29 just a few months ago. The concept of peak oil has been completely forgotten even though this temporary glut has nothing to do with the real problem. This is just an anomaly and demand will quickly return. The amount of bearishness in the oil market is unprecedented. There is currently a 30:1 imbalance in open interest in crude options. There are 128,000 put contracts and only 4,000 call contracts. This type of imbalance is extremely dangerous for the bears. If we did see something that triggered a reversal it could be explosive and spike back to $100 in mere minutes. Bubbles don't always occur on the upside. The price spike to $147 was event driven and extremely overdone. The drop to $62 is the bubble in reverse. The selling is way overdone and the pendulum always swings in both directions.

December Crude Oil Chart - Weekly

The equity markets opened on Friday with extreme pessimism. The futures were lock limit down based on bad news overseas and huge market drops in Europe and Asia. The Asian markets were hit the hardest with the Hang Seng losing -1,142 points or -8.3% in one day. It is down -30% for the month of October alone. The close at 12,618 was the lowest level in four-years. Japan's Nikkei Index fell -9.6% and the Kospi fell -10.6%. The drops were on fears of a worsening global recession after many foreign firms posted lower than expected earnings and gave negative outlooks. Currencies were hammered with the dollar gaining intraday against the pound with the largest single day gain in 37 years. By the close the pound had recovered to "only" a six-year low. The damage there came after the UK economy contracted by -0.5% in Q3 and the first negative GDP reading in 16 years. The pound has dropped more than 9% in the last week. News of the UK GDP drop crushed weaker economies on recession fears. The UK was supposed to be the stalwart economy overseas and that suggests other lesser economies may be hurt even more. Bank of England governor Charles Bean said on Friday that Britain's economy was in the early stages of a slowdown that could be the largest financial crisis of its kind in history. Those were pretty strong words for an otherwise reserved British chap.

S&P-500 Futures Chart - 5 min

With the futures lock limit down there were fears the Dow could fall as much as 1100 points at the open. Fortunately it did not happen and we ended up down "only" -312 points. Notice how only a 300-point drop seems almost normal? There was a rumor all over Europe that GMAC was going to collapse over the weekend. Iceland has been a problem for the last two weeks and they finally accepted a $2 billion loan from the IMF as a partial solution to their banking problem. Unfortunately the failure of Iceland has brought into focus the potential failure of a dozen other countries and the repercussions from a domino type drop. Instead of just banking risk and investment bank risk we now have country risk and those could evolve into some really big numbers.

The failure of Iceland's biggest banks has had repercussions around the world. Iceland banks were overly aggressive in seeking out business on a global scale and when they failed it impacted thousands of companies worldwide. Lobster prices in the U.S. are down by 50% because the Canadian packagers who consume much of the lobster in the northeast lost their credit lines. No credit, no lobster. Lobsters now cost the same price as bologna because there was an instant glut and nowhere to sell them. Lobsters probably rank right up there on the scale of discretionary spending so the recession was already a problem for sales. Having the food packagers implode on top of the drop in retail sales was a serious blow. http://www.forbes.com/feeds/ap/2008/10/23/ap5594003.html

Chrysler reported on Friday they were going to cut another 25% of their white-collar work force. GM fell another 13% intraday on worries about sales. Reportedly auto sales have not just slowed but come to a screeching halt with no financing available. Volvo reported it received only 115 heavy truck orders in Q3. That was down from 41,970 orders in the same quarter in 2007. Volvo is the world's second largest maker of heavy trucks and they slashed their outlook and said they were curtailing production. I can't even comprehend the severity of that drop. Volvo said it was cutting 1,400 jobs at the truck division in Europe and another 1,350 in America. Volvo said not only had orders dropped significantly but also prior orders were being cancelled at a record pace. Take this downturn in sales that came primarily from global businesses and you get a picture of how abruptly the decline came. Companies can't plan for this type of sharp decline. I have used this word too much lately but this change in the business environment is truly catastrophic.

Nouriel Roubini is a noted economist and a professor at New York University. He correctly warned in 2006 about the coming financial crisis. He said the U.S. would enter a recession as a result of the crisis. In February of this year he predicted a "catastrophic (his word not mine) financial meltdown that central bankers would be unable to prevent leading to the bankruptcy of large banks exposed to mortgages and a sharp drop in equities." Obviously he was right on the money there as well. Actually he has been exactly right for the last three years and always well in advance of the projected event. After his February proclamation he was nearly banned from stock TV because broadcasters did not want to start a panic. He was too over the top for the mainstream media and despite his on the mark predictions he was viewed as a crackpot when he said the financial system would fail later in the year. Well, Roubini was proven right and now he is predicting again. On Thursday Roubini spoke at the 2008 Hedge Fund Conference and said "hundreds of hedge funds would fail and policy makers may need to shutdown financial markets for a week or more to avoid dumping of assets." He was joined by Emmanuel Roman of GLG Partners who said 30% of existing funds could close.

Roubini said systemic risk was growing and we were seeing only the beginning of a run on hedge funds that would produce massive dumping of assets. Hedge funds had their worst month in over ten years in September and October is not looking any better. Roubini said they used to say, "When the U.S. sneezes the rest of the world catches cold." "Unfortunately this time around it is not just sneezing, it has a severe case of chronic and persistent pneumonia that is crushing emerging markets." "There are a dozen emerging markets in severe financial trouble and there is not enough IMF money to save them." Roubini was a former senior adviser to the Treasury Dept. Earlier this month he said "the U.S. would suffer its worst recession in 40 years and I fear the worst is ahead of us." I find myself probably in the same camp everyone reading these comments are today. It is the same camp I was in when he made all of his prior predictions. I thought they were extremely bearish and I could not conceive they would come true as predicted. Maybe some things would happen but surely it can't be this bad. Months later I look back and cuss myself for not taking him seriously. Will 30% of hedge funds fail? I doubt it but I have been wrong on all of his other predictions as well. I think the continued forced liquidation in the markets is a symptom of a run on the hedge funds. When does it turn into a disaster instead of just a run? Hedge funds typically borrow 5-8 times their deposits in order to juice results. Those loans are being called and like a margin call they require rapid liquidation to prevent the portfolios from being seized by the banks.

Speaking of funds, 25% of mutual funds have their year end on Oct-31st. It does not sound that bad at only 25%. However those 25% control more than 75% of all mutual fund investments. We know that October is always the most volatile month because funds are trying to shuffle their portfolios to put the best spin on their results and portfolios for the year-end statements. These are the statements that convince people to either stay in the fund or move to a different one. In the fund business it is a life or death event and has a direct impact on year-end bonuses. TrimTabs said in their weekly update that withdrawals from mutual funds had slowed to only $6.47 billion for the week ended Wednesday. That was down from $14 billion the prior week and an estimate of $50 billion for the entire month of October. Mutual funds saw withdrawals of $43 billion in September. So what will funds do to settle the books by Oct-31st? Surely they have already dumped their losers but then what stock is not a loser? They always try to sell some winners to offset their losers and present the best results possible. They try to load the portfolio with the best stocks in the market at the time so investors will be bullish about their fund outlook for the coming year. A lot of them may be holding large amounts of cash so they can claim we are well positioned to pick up bargains when the market turns. A blind monkey throwing darts would have a better chance of picking the option that best describes fund moves over the next week. About the only positive point is that the selling should be over. Why wait until the last minute to sell stock you don't want at month end? If I were going to bet I would think they are biding their time to gauge redemptions and cash flow until the last minute. They are probably hoping to splurge in the last couple days of the month to window dress their portfolios.

Remember the Fed meets next week and the country is in a recession, declared or not. Bernanke knows the only way out of this scenario is to inflate his way out of it. They call him helicopter Ben after he referred to a Milton Friedman statement about a "helicopter drop of money to stimulate the economy" in a 2002 speech. If the Fed makes money so cheap that my blind monkey could run a business and turn a profit then the country will quickly rebound out of almost any economic scenario. At least under normal conditions it would reflate the markets. We still have the election cloud over the markets and despite the difference in the polls there is still a lot of indecision hanging over the markets. If capital gains are going to double then the time to sell things at the lower tax rate is running out. I suspect Ben is aware of how the election may complicate his job and has plans to work around it.

The easiest way to get out of the housing crisis is for the Fed to create inflation. Rising home prices would be very beneficial to the economy and consumers. Freddie Mac (FRE) said mortgage delinquencies on their portfolio had risen to an all time record high. That is another one of those news headlines that should be ignored. Freddie currently has $736.9 billion in mortgages on the books and ONLY 1.22% are delinquent. That is still $8.99 billion in delinquent loans but only a drop in the $736 billion bucket. If inflation returned and prices began to rise it would stimulate buyers to return quickly before the bargains disappeared. Inflation would heal a lot of problems.

After a quick glance at the market internals and I was actually pleasantly surprised. Down volume is winning the battle but it was not as lopsided as I would have thought. Volume is rising after the calm reversal on Monday/Tuesday but still not capitulation levels. It is almost as though we are seeing a calm decline. The VIX hitting 89 on Friday would be contrary to that calm appearance but that was on the gap down open. Other than the severe volume imbalance on Wednesday the real point that stands out is the new 52-week lows. However, Friday's 2227 new lows were dwarfed by the 5007 we saw back on Oct-10th. Volume on the 10th was 19.5 billion shares. Even though the market is slowly slipping back to those Oct-10th levels the internals are actually not that bad. Of course bad is relative these days.

Market Internals Table

When I started this commentary I was bearish. When the markets collapsed at Friday's open on global economic news after rebounding from Thursday's lows I started reconsidering my outlook. The Nasdaq is positively ugly. It traded under 1500 on Friday and although it rebounded from its lows still close down -52 points. Every day last week was a lower low, lower high. The Dow appeared to want to rebound but every move higher was met with heavy selling. They hammered the close again with a -200 point drop in the closing minutes. It is not pretty.

Nasdaq Chart - Daily

S&P-500 Chart - Monthly

The S&P actually respected the 860 low from Thursday and managed to recover significantly from the opening drop. Still more and more technicians are talking about 840 as real support they are expecting to see tested. After listening to all the bears talk and scanning a hundred articles I was about to throw in the towel.

However, there are some material events coming our way. The Fed meeting should provide a little uptick in sentiment as long as Ben does not turn into a raging bear in the statement and cuts 50 basis points. Friday is month end and year-end for those funds I mentioned. I can't help but think they should be done selling and looking for window dressing material. The drop in oil prices on the OPEC announcement was a classic sell the news event by the bears. Eventually that 30:1 imbalance in puts to calls is going to reverse. We got some positive news Friday evening that PNC Financial Services was buying National City Corp for $5.6 billion. That would not otherwise be news except that PNC sold $7.7 billion in preferred shares to the U.S. Treasury under the new TARP program, (Troubled Assets Relief Program), making it the first bank to participate in the program. This should encourage others to start thinking out of the box and join in the fun. It should also provide some positive sentiment to the banking sector.

My outlook for the week is mixed. I do believe we are at or near a bottom. However that depends on the forced liquidation by funds. All the positive fundamentals in the world can't fight a hedge fund implosion. That is the real unknown, unless of course you are Roubini. Baring selling from further hedge fund liquidations I expect mutual funds to be dressing up their books and actively buying the market. I expect the Fed to cut rates and I think the bad news bulls are itching to get back in the fight. We may not have seen the lows yet but I think we are very close. However, projecting market directions and distance in a 100-year event is a fool's errand. I want to think November 1st will see us higher than we are today but that may only be wishful thinking. I stepped up to some long 2009 calls on the Russell Proshares ETF last week and I plan to hold them through whatever happens next week. I am not going to speculate on the various indexes today and leave that up to Leigh in his Index Trader commentary in this newsletter. I am already well over my commentary size limits. I heard Carter Worth and Jeffery Weiss, both excellent technical analysts expressing bullish opinions on Friday and I respect them both. Bill Gross of Pimco also said a bull market was imminent. In his context he was not referring to next week but "soon." That puts me in good company and hopefully they are right.

Jim Brown

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