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Market Wrap

Blame It On the VTI

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The elections are over and the president elect is holding meetings and press conferences. Unfortunately they failed to divert the attention of traders away from the horrible economics and the Dow fell over 1000 points from its Tuesday high. At least that is what the media would have you believe.

Market Statistics
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The biggest economic report of the month, the non-Farm payrolls, was released on Friday and it was not pretty. The U.S. economy lost -240,000 jobs in October but that was not the worst news in the report. There was a sharp downward revision to the two prior months. The September job losses of -159,000 were revised lower to a loss of -284,000 jobs and the August loss of -73,000 was revised lower to -127,000. This was the 10th consecutive month of job losses totaling -1.2 million jobs. Half of that decline came in just the last three months. The unemployment rate spiked +0.4 to 6.5% and higher than the levels hit in the last recession. That is a 14-year high.

The job losses are expected to get larger before this cycle is over. The economy is in a negative feedback loop where job losses and fear of losing your job is slowing spending significantly. As spending slows more jobs are lost. We are also expecting a horrible holiday shopping season and further major layoffs in the financial sector. Some analysts are expecting unemployment to rise as high as 8% before we hit bottom.

However, the October job losses were not as large as many traders expected. The estimates two weeks ago were for a loss of 179K. That escalated to 200K by last weekend but by Friday many whisper numbers were over 300K. When the jobs number showed a loss of only 240K a collective sigh of relief was heard in the market and we saw a short covering spike at the open.

Non-Farm Payroll Chart
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The Pending Home Sales Index for September declined 4.2 points to 89.2 after a sharp spike of +6.5 points in August. The major problem was the evaporation of financing opportunities. With foreclosures continuing and financing very hard to get analysts believe home sales will decline over the next several months. This is not unusual even in normal times because homebuyers tend not to shop over the holidays. Buyer traffic will begin to pickup again in February and the bank rescue packages will have had time to be implemented and hopefully financing will be available by spring. Greenspan said at a Friday appearance that home prices should rebound in the first half of 2009.

Next week's economic calendar is fairly bland. The Business Inventories, Retail Sales and Consumer Sentiment are the only material events that might interest traders. On Saturday the G20 will convene in Washington and that could produce some market stimulating news. The G20 is likely to come to grips over a coordinated effort to solve the banking crisis and that could involve some currency intervention. This could produce some serious volatility for Monday Nov-17th.

Saturday is also the deadline for giving notice if you want to withdraw money from hedge funds on Dec-31st. This does not mean Monday will be a big selling day but this is another hurdle the hedge funds will have to cross. Analysts claim the majority of hedge funds have deleveraged and are now net long the market on a level basis. They are sitting on $600-$680 billion in cash and waiting on the Nov-15th notice deadline before putting that cash back to work. If the market would develop a positive trend most of those funds would leverage up again using that $600 billion in cash. Having just been burned they probably would not jump right back in the 8:1 or 10:1 leverage they had before but even 3:1 or 4:1 would be a strong boost for the market. If withdrawals received by the 15th are negligible then I believe we can expect a more bullish outlook for the next couple weeks. Obviously if they are deluged with withdrawals then impact to the markets would continue to be negative.

Economic Calendar
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GM was a news headliner after reporting a $4.2 billion loss for Q3. After one time items that loss was only $2.5 billion on an operating basis but it was still ugly. GM is burning cash at the rate of $2.3 billion per month and they only have $16.2 billion in liquidity. At the current rate they would run out of money in less than eight months. GM is trying to raise additional capital by selling non-core assets like the Hummer division, a plant in France and its ACDelco parts business. It is also trying to trim $10 billion in additional costs and is hoping to get some help from the government. GM warned it had to maintain $11-$14 billion on hand to pay suppliers and handle the float of day-to-day operations. If GM is burning $2.3 billion a month, has $16.2 billion in cash and needs to maintain $11-$14 billion for operations then their life expectancy without a lifeline from the government is measured in weeks, not months. GM bonds are trading at 25 cents on the dollar with a yield of 33.45% assuming they don't default. Auto sales fell to an annualized 10.5 million units in October and the lowest level since Feb-1983. The pace of sales in 2007 peaked at 16.6 million units. Carmakers need an industry pace over 15 million units to remain profitable due to the enormous overhead required to maintain plants, employees and a steady stream of parts and designs. GM saw a -45% drop in sales compared to the same period in 2007. Overall industry sales are down -34% for the same period. Auto dealers are seeing sales constrained due to a lack of financing. Only a very few people have the credit needed to buy a car in today's gridlocked credit markets. S&P cut it's rating on GM to CCC+ with a negative outlook. They also affirmed ratings for Ford at B- despite the Q3 loss and $7.7 billion cash burn for the quarter. Ford has more cash than GM at present and only reported a $129 million loss for Q3.

GM Chart
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Greenspan spoke at a luncheon meeting on Friday and said Q4 GDP was going to be ugly. He said there was no doubt the U.S. and world economy was in a very severe depression and U.S. GDP will decline significantly in Q4. Greenspan said early data for October shows the Q4 GDP falling at more than a 3% rate. "It's important to recognize we are not quite in a free fall but something close to it," Greenspan said. "This economy, and indeed the world economy, has tilted over and is moving down fairly aggressively, pretty much across the board." Greenspan described this as a once-in-a-century event. After 18.5 years as Fed Chairman it appears Greenspan is having trouble staying out of the limelight and needs these monthly sound bites to keep up his book sales.

On a positive note Nvidia (NVDA) gained +14% after posting earnings, which were nearly inline with the estimates and gave a rosy forecast. Nvidia reported earnings of 11 cents after charges compared to estimates of 12 cents without charges but that was not the reason for Nvidia's gain. Nvidia said they expect sales to decline only -5% in Q4. Given the decline in PC sales overall and predictions by their competitors this is very positive. Nvidia is breaking into new markets and just started making video chips for notebooks using an Intel chipset. In a chip market full of bad news Nvidia is standing apart from the crowd.

The current recession is killing Las Vegas as fewer people are finding extra money to donate to the casinos. Las Vegas Sands (LVS) fell -33% on Thursday and another 11% on Friday as bankruptcy rumors swirled. LVS said on Thursday it would likely default on its debt covenants in Q4 as a result of lower traffic. Analysts immediately started thinking this could lead to a bankruptcy by the Sands. The problem is the debt covenants, which prevent them from having a debt to equity ratio above a certain level. Banks normally put these in the loan provisions to prevent the borrower from becoming over committed and unable to pay their debts. LVS stock closed at $6.76 on Friday after trading at over $140 just a year ago. Billionaire Sheldon Adelson controls almost two-thirds of the stock and has lost billions in the decline. Bankers are hoping they will put up some more capital to resolve the problem. The entire casino industry has been aggressively expanding using huge loans to build multi billion dollar properties. When those loans dried up they were forced to use more of their cash flow to keep things moving. When gamblers quit showing up and those who did spent less money it caused a serious cash flow squeeze on the entire sector. Since the casino business is very lucrative in normal times this may be a buying opportunity once the smoke clears and we see who is going to survive. The market cap of LVS stood at only $2.5 billion at Friday's close and that is chump change for the type of people active behind the scenes in the casino sector. Other names in the sector are MGM, WYNN, BYD and PENN. Harrah's, old symbol HET, was bought out and taken private in late 2007 by Apollo Management and TPG Capital. Harrah's was taken out right at the top of the market and they are suffering under $24.2 billion in debt and the cancellation of a $2.9 billion credit line. I would bet there are some interesting discussions going on behind those closed doors.

Wells Fargo (WFC) announced an $11 billion stock offering late Thursday at $27 per share for sale to the public. This was 15% lower than the closing price on Wednesday. The stock dropped to $27.05 on Friday morning before rebounding back to $29. The offering is expected to close next Thursday. The proceeds of the offering are going to complete the $15 billion acquisition of Wachovia (WB). WFC already received $25 billion from the government under the TARP program. WFC is going to take a $60 billion write down of Wachovia loans, $39 billion of that when the deal closes. That allows them to take a substantial tax credit and reduces the exposure to the mortgage portfolio in the future. Wells should be positioned after the deal as a member of the trillion dollar club of large banks and have a tangible common equity to assets ratio second only to Citigroup. They will also have become a member of the "too big to fail" club. I believe that once the smoke clears on the financial sector WFC will be a leader out of the darkness. Bottom fishers should be careful here and I would rather buy a breakout over $35 than take a risk here at $28. There are still too many unknowns until after the Wachovia deal closes. If they had to go back to the government for more money to complete the deal there could be a dilution risk.

Oil prices soared to $71.77 on Tuesday and then plunged back to $59.97 on Friday. Obviously the recent volatility has not ended. There are projections by some analysts for a continued drop back to $50. I am not in that camp. I believe it is possible we could see $55 but the range from $55-$60 is very strong support and a level I expect to hold. One reason is the average marginal cost of a new barrel of oil is over $65 per barrel. Oil companies are not going to pump new oil for a loss. They will do the same thing gas producers have been doing and that is curtail production until prices go back up. This is the same thing OPEC is doing and continued news reports suggest OPEC members are really cutting production this time around and we will see the impact on prices over the next 60 days. Also, the much heralded IEA World Oil Report is due out on Wednesday and the early news releases claim it will be much more bearish on the production outlook than in prior years. Reportedly they are going to say that prices will return to $100 very quickly. I am bullish on oil here.

December Crude Chart
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I was out of town on business on Wed/Thr and did not watch the markets other than logging into get the closing print late in the evenings. With no idea what had transpired in the news you have to move into a forensic investigation to try and find the clues. First I looked at the internals. Volume was strong but not exceptionally so it did not look like a panic sell off. On both Wed/Thr the volume imbalance was huge at better than 10:1 in favor of declining volume both days. I looked at a couple hundred charts of high profile stocks and they all looked the same. All had a straight drop from Wednesday morning until early afternoon on Thursday. After doing the research I believe the evidence was clear. It was program driven liquidation by fund(s).

I don't know if it was hedge funds or stock funds or both but I have no doubt it was program driven. It was also index based. They sold the various indexes, futures and or ETFs covering very large baskets of stocks. Because of the very large breadth of the declining stocks with every sector seeing the same basic decline I checked the Vanguard Total Market ETF, the VTI. (When investors buy a large number of shares of an ETF over the amount that is normally traded the "Authorized Participant" or market maker for that ETF has to buy/borrow a corresponding number of shares of the underlying stocks/futures to produce a creation unit consisting of a new block of ETF shares. This is typically done in 10,000 to 50,000 share blocks. When there is a large imbalance on the sell side the market maker will have to redeem that creation unit and sell the same stocks that make up the ETF. This is done to keep the net asset value of the ETF in line with the actual stock prices. In practice this is done by computer and occurs almost instantly.) The creation unit for the VTI is 50,000 shares. For a market maker to create 50,000 new VTI shares he must deliver to Vanguard shares of each individual stock in the "Portfolio Composition File" in the quantities listed. There are 1664 stocks in the VTI PCF today. The graphic below is just the first 14 stocks in the creation unit. Basically every time a market maker creates or redeems a 50,000-share creation unit he has to either buy and supply shares of all 1664 stocks to Vanguard or redeem and sell shares in those same 1664 stocks. The value of those shares in all 1664 stocks was approximately $2.5 million per creation unit last week.

VTI Holdings Table Page One
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The average daily volume on the VTI over the last 12 months is about 3.2 million shares. On Wednesday nearly 23 million shares were traded and another 21.5 million on Thursday with over 90% down volume. This was record volume for the ETF and nearly three times the volume leading into the Oct-10th bottom. (For every million shares the market maker had to eat he had to redeem/sell 20 of the creation units described above at $2.5 million in underlying stock for each.) In the chart below you can clearly see the average volume leading up to the October decline was minimal. We saw a slight jump in volume around Oct 10th but still nothing major. Then, as we headed into the October 31st year-end for mutual funds the volume rose to a peak of 19 million and six times the average on exactly Oct 31st. This was clear evidence of a fund or funds capitalizing on the year-end window dressing using the VTI.

On Mon/Tue volume dropped sharply as the fund(s) waited for the election results. When the market opened up on Wednesday and then failed they started selling and did not stop until 1:PM on Thursday. On Friday we saw the same thing with a large volume of five million shares sold after Obama's press conference ended. It appeared they were still looking for the Obama bounce they didn't get on Wednesday. The volume patterns of the VTI over the last week clearly show it was not a market sell off. It was a fund or funds dumping the VTI ETFs they had accumulated going into the October 31st fund year-end. This was NOT a market event where millions of investors dumped stocks because Obama won the election. If you compare the volume for the same period on the QQQQ you will see exactly the opposite evidence. Even with the Cisco earnings volume was much lower than the prior four weeks with no spike on Wed/Thr. If it were a broad market event where millions of traders dumped stocks the QQQQ would have shown a corresponding jump in volume. Even the S&P-500 ETF, the SPY, showed only a minimal increase in volume for those two days.

Conspiracy theorists could make a convincing case that somebody wanted to make it look like Obama's election killed the market. I prefer to think that a major hedge fund was playing the year-end window dressing and hoping for a major market spike on election results and bailed when that spike did not occur. It would have taken less than $500 million in margin to accumulate enough VTI shares to produce the event we saw. Had we seen a major rally occur on the election results it could have been a very profitable play. With hedge funds sitting on $600 billion in cash today the odds are good somebody was rolling the dice on the election results. I doubt the selling in the VTI was the only security being sold but I could not find any corresponding track on any other index/ETF. I am sure there were plenty of sell stops hit by the decline since the prior week's rally was weak at best. The severity of the selling and the 10:1 down volume suggests there was more than one selling vehicle. I checked the volume on the various futures contracts but they traded less than on Monday or Friday. If you know of any irregular trading patterns on those day let me know and I will pass it on to all the readers.

Vanguard Wilshire 5000 ETF - VTI Chart
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Nasdaq QQQQ Chart
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S&P-500 SPY ETF Chart
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If you agree with my analysis the market crash last week was caused by program selling by hedge funds on an election bet gone bad then the next conclusion should be that the market is not as weak as it appeared. I am sure the drop scared many traders who had just turned bullish the week before but a couple days of gains should bring those recent converts back into the corral. I read a lot of commentary this weekend suggesting we are going to retest the lows. The bears are adamant we are going back to 7400 on the Dow. I wrote last Tuesday night I was skeptical of the rally but I was long. We saw in the description above how buying the VTI shares helped push the indexes higher in the closing days of October so in reality the gains were as artificial as this week's selling. So where does that leave us?

I think there are some pretty smart people out there and I bet many of the fund managers saw the same thing I did. I would like to think the positive news on the bailout front and a potential bailout to GM that could happen any day would be motivation to continue buying the market. We knew the jobs number was going to be bad. We knew the GDP was going to be negative. I think all the bad news is baked into the cake. Obama said another stimulus package would be his first priority after his inauguration if the current batch of lawmakers did not act on it sooner. Countries around the world are cutting rates on almost a daily basis. The election is behind us and the world seems happy with our choice. Countries are proclaiming national holidays in honor of Obama. Antigua and Barbuda are going to rename their highest mountain as Mount Obama in his honor. Obama himself appears to be turning away from his announced tax hikes as prospective cabinet members have helped him to see the light. Wall Street should be celebrating rather than selling. We have entered the best six months of the year cycle and oil prices are at an 18-month low. Most analysts claim markets bottom 6-9 months before the recession ends. With expectations for a new growth cycle to begin in Q2 or possibly early Q3 of next year this is the time for the market to bottom. I could go on but you get the picture. I am not seeing a credible rally yet but I believe it is close. Next week is going to be the key. Whatever direction the market picks next week in the absence of election news, very little material economic news and almost nothing on the earnings calendar is going to likely be the real deal.

The Dow returned to 8700 on Thursday and found support after the two day beating for -900 points. On Friday that support rose to 8800 and the Dow closed at the high of the day. Technically it is stuck in the middle of a huge range from 8150 to 9600. I can't really point to anything on the Dow chart to support a bullish outlook. The two-day sell off knocked the Dow back into congestion and we just need to wait for a new direction to appear. Hard support is 8200 and hard resistance at 9600.

Dow Chart
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The S&P-500 looks just like the Dow only the support and resistance lines are a little more pronounced. Resistance at 1010 held solid last week. The sell off knocked us back below 985, which was interim resistance in late October. I don't believe it is relative after last week's move higher.

S&P-500 Chart
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The Nasdaq is laboring under a heavy load. Continued drops in guidance by tech companies had already soured sentiment but it was inching higher until Wednesday. It has yet to really attempt a breakout over 1800 but did manage to string six consecutive days of gains together just before Wednesday's decline. With Apple trading under $100 and RIMM under $50 and Google looking like a short at $330 I am surprised it managed those six days of gains. Looking at the Nasdaq chart does not inspire any confidence in a future rally until we see a move over 1800.

Nasdaq Chart
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I pointed out on Tuesday that the Russell gains had stalled at resistance at 550 and it appeared fund managers were waiting for the election results to determine their small cap plans. The two-day sell off knocked it back to 500 where it held for two days. This has been weak support in the middle of its recent range but I am not convinced it will hold. If it does hold this would be a higher low and a decent launch point for another attack on 550. As I have stated many times the Russell is a sentiment gauge for fund managers. If they believe the market is going higher and the risk of another crash is low they will favor the small cap stocks over the blue chips. A little money going into a low volume stock can make a lot of difference where a lot of money moving into a high volume stock can go unnoticed. Fund managers have to be making plans for investments now that will reap rewards and generate bonuses in 2009. This greed factor will make them move back into small caps as soon as they think the bottom is behind us.

Russell 2000 Chart
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Thomson financial put out the following data on Friday. In years where there were net job losses for the entire year the following year was very profitable for the markets. Since 1950 only one year with net job losses failed to be followed by a stronger market. That year was 2001 and we all know why that year was different. We are on track to lose more than 1.5 million jobs in 2008 making it the third worst year since 1950. Hopefully the historical trend is still with us.

Gains from Net Job Loss Years
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I am still long the broad market but even more skeptical than last week. I want to believe the scenario I outlined above but that view through the keyhole may not be the entire picture. I think we are at the point where we have to take a chance that the next move will be higher. The cycle is right, the bad news is priced in and there are changes on the horizon. I think we need to be long but with decent stops. If stopped we need to buy support at the prior lows and try again. The majority of bull market gains are made in the first two weeks of a real rally. Those of us long from late October have our fingers crossed that everyone else joins us only at a higher level.

Jim Brown

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