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Market Wrap

Global Flu Continues

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Markets around the world fell sharply despite massive stimulus programs like the $585 billion announced by China. The U.S. markets bled points but resisted the urge for a retest of the October lows.

Market Stats Table
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There were not any economic reports of note today. The weekly Chain Store Sales fell -1.0% compared to a gain of +0.6% last week. These weekly numbers have so much noise there is almost no reason to track them. However, last week would have normally been positive as early shoppers try to get a jump on the holiday rush. We also heard that orders from retailers for Q1 are down -6% to -12%. This suggests retailers are not expecting to sell out in Q4 and will have inventory leftovers in Q1. Retailers are expecting the worst holiday shopping period in 22 years.

The economic calendar for Wednesday is even lighter with only the weekly oil and gas inventory report. The International Trade report has been rescheduled for Thursday. The biggest reports for the rest of the week are Business Inventories on Thursday and monthly Retail Sales on Friday.

The biggest events on the calendar are the weekend G20 meeting in Washington and the hedge fund notice day on Nov 15th. The G20 group is expected to make some sweeping recommendations on the currency front and discuss ways to offset the current global flu.

The Nov-15th hedge fund notice day is also going to be a major event. If investors want to withdraw funds on Dec-31st they need to give notice by Nov-15th. Otherwise their next withdrawal window will be March 31st. In recent weeks 21 top funds have closed the gate on withdrawals. Hedge funds have a provision in their agreements that allow them to halt redemptions if they get redemption requests of more than 20% of their capital. This is called gating and is intended to prevent a run on the fund. Another type of gate only allows 20% of the amount you have invested to be withdrawn in a given period. 21 top funds have announced they were gated. There are probably dozens if not hundreds more that did not make pubic announcements. If funds receive a wave of redemption requests by Nov-15th it does not mean selling next week will crush the markets. It means there could be persistent selling through the end of December as funds raise cash. However, funds have already raised a significant amount of cash with an average cash position today at 30% in anticipation of further withdrawals. This suggests a calm notice date without any upsurge in withdrawal requests could actually result in a positive market as that money is put back to work.

The $9 billion Tontine fund group announced it was closing two of its major funds. Investors in the Tontine funds had been rewarded with 37% average annual returns since inception in 1997 but this year was a disaster. The funds were heavily invested in regional banks, steel stocks, homebuilders and commodities. I have heard rumors the funds are off 75% this year. This is the kind of problem plaguing the industry. Years of strong returns built up huge profits but one year of a serious bear market erased those gains leaving investors with a massive tax problem. All gains are taxable but only $3,000 of losses are deductible. If you invested $100,000 in 1997 and received 37% annual returns and never took any money out you would have something around $1.5 million invested after fees. A loss of 75% ytd in 2008 would reduce your gains to less than $325,000 and generate intense animosity toward the fund managers. Remember, a "hedge" fund is supposed to hedge their bets to prevent a material loss of capital in bear markets. I can see why investors would be anxious to withdraw any remaining capital after a year of dismal results. This is why hedge funds are bracing for continued withdrawals.

On a side note the name Tontine came from a type of fund invented in 1653 by Lorenzo de Tonti. The basic concept was simple. Each investor puts in a fixed amount of money. The funds were invested and each investor received dividends. As each investor died their dividends were divided among the remaining investors. This continued until there was only one investor left and he received all the dividends until his death at which point the state liquidated the assets of the fund and used the money to fund public works projects, which often contained the word tontine in their name. In later versions the last surviving investor got to keep all the capital and normally became very wealthy from it. As the practice evolved investors figured out how to game the system by making the investments in the names of their children instead of themselves. In extreme cases the funds saw investments only in the name of young girls since they would historically outlive everyone else in the fund. The use of tontine funds was eventually outlawed since they eventually led to numerous fatal accidents and outright murders as unscrupulous investors sought to reduce the number of survivors in their fund.

GM fell to a low of $2.75 intraday and a low not seen since 1943. GM and the other U.S. automakers are seeking up to $50 billion in aid. GM fell -12% after a Deutsche Bank analyst downgraded the stock to a sell with a price target of ZERO. Rod Lache said GM could run out of cash before year-end if they don't get a bailout. Barclay's has a price target of $1. Obama is pressuring the Bush administration for a $25 billion bailout but lawmakers are resisting for multiple reasons. Some say the current business model is flawed and giving them cash now will only perpetuate that flaw. GM announced 22 new models for 2009 even though they can't sell the models they have. They fear giving the automakers money will open the door for dozens of other industries to come begging to the Fed for a bailout. GM announced today they were suspending production at five plants in South Korea for two weeks in December. This is yet another indication the recession has spread around the world. The South Korean plants and products form one of GM's best performing business units. Demand had been strong for Korean built Chevrolets, Pontiacs and Buicks. With three million U.S. jobs dependent on the auto industry and 4% of our GDP I doubt the U.S. is going to let GM fail.

Starbucks (SBUX) reported earnings that disappointed investors. After charges Starbucks only earned $5.4 million for the quarter compared to $158 million in the comparison quarter. Same store sales fell -8% due to slower traffic and a decline in total ticket price. Starbucks is closing 600 stores to reduce costs. CEO Howard Schultz said same store sales had improved in October and was confident the worst was over. Starbucks is planning on opening 700 new stores over the next 12 months, 200 fewer than prior plans. They currently operate 16,680 stores worldwide. SBUX stock closed at $10, down -2%.

Toll Brothers (TOL) warned that estimated Q4 income could fall 41% from the year ago period after October's economic meltdown wiped out any hope of stabilization in the housing market. The financial crisis and lack of financing has pushed up cancellations and driven traffic to record lows. Toll said it would book impairment charges of $120 to $220 million for the quarter ended Oct-31st. Toll's orders have fallen for 13 consecutive quarters. Toll said it was expanding its rent to own program until the crisis eases. Despite the negative news Toll closed flat for the day. Toll still has one of the strongest balance sheets in the sector.

Goldman Sachs gained +$3 to $75 despite a downgrade from a noted analyst. David Trone of Fox-Pitt Kelton said Goldman would likely post a loss of -$1.55 per share for Q4 compared to his prior profit estimates of $2.59. The consensus estimates are still for a profit of $1.16 per share. Just a month ago consensus estimates were for a profit of $2.71 per share. Goldman is expected to mark down its investment portfolio by $2.7 billion because of declines in global markets over the quarter. They are also expected to take losses of $2 billion in write-downs on their mortgage-backed securities and leveraged loan portfolio. This is definitely a dramatic event because Goldman was considered the best of the best over the last decade and their decline into the abyss has been striking.

Financial Sector ETF Chart
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The Las Vegas Sands (LVS) lost another 17% today to close at $5.26 after it announced a $1 billion capital raise from billionaire Sheldon Adelson. The overall plan is for an infusion of $2.14 billion through an investment by Adelson and a new stock offering. Adelson is going to invest another $525 million and convert a $475 million convertible note they purchased just a month ago into stock. Another 460.5 million new shares will be issued on top of the 355.7 million already in circulation. 181.8 million shares will be sold at $5.50 per share. This will dilute Adelson to just over 50%, down from his 67% stake earlier this year. His total stake after the capital raise will be worth $2.2 billion. That is down substantially from their value in Sept-2007. His $28 billion net worth as late as Sept-2007 when he was considered the 3rd richest man in America by Forbes. LVS shares were worth $145 when that article was written. The Sands said it was suspending development on the $600 million St Regis condo project in Las Vegas and two sites on the Cotai Strip in Macau.

Chipmakers and major PC manufacturers fell hard after Barclay's Capital cut forecasts for their products. Barclay's cut HP's 2009 estimates from $4.08 to $3.80 saying HP would be hurt by falling server demand as well as a shift towards low priced networks. They also cut estimates on Dell saying the Dell business model is at risk in a weak economy. Channel checks indicated Dell was suffering significant losses of market share, negative product mix and exposure to retail financing risks. FBR Capital cut earnings on Intel and AMD citing weak PC demand. Piper Jaffray and Barclay's also cut estimates on Intel. Dell lost -5%, HPQ -2.5%, INTC -3.6% and AMD -2.6%. Sun Micro (JAVA) closed at a new multi-year low of $4.

The Dow was off more than 300 points at the low of the day but rallied back to flat after Fannie and Freddie announced a plan to halt foreclosures on their 31 million outstanding loans. Fannie and Freddie own 58% of all U.S. mortgages. Under the plan borrowers who were more than 90-days past due could qualify for a modified loan with lower interest and lower payments. Excess principal would be deferred into a balloon payment. The new modified loan program would only apply to people who could make payments up to 38% of their gross monthly income. That is still a high ratio of payment to income but better than some adjusted rate loans require today. Federal Housing Finance Agency Director James Lockhart said the private industry should adopt the same industry standards to modify mortgage loans. The announcement produced a temporary bounce in the market but sellers returned before the close. Blackstone's CEO Stephen Schwartzman also made positive comments about the same time. Speaking at a Merrill Lynch conference he noted that Blackstone's private equity portfolio was performing pretty well and he would be a buyer of distressed real estate.

In the weekend newsletter I reported I was still long the broad market but more skeptical of the month end rally than the week before. After the Dow spiked +350 points at Monday's open and then gave it all back to end with a -73 point loss my hopes for a November rally faded even further. Today's +300 point rebound off the bottom and resulting -175 point decline is even more proof that sellers have not left the building. The Dow respected its interim support at 8600 all day but the lack of a credible rebound makes it look more like the next failure point rather than a goal line stand. The more analysts increase their projections for a retest of the October lows the more likely it becomes a self-fulfilling prophecy. When I say the October lows I am referring to the multi-day support lows we saw on the late October dip at 8200 rather than the intraday dip to 7882 we saw back on Oct-10th. It is entirely possible we could see 8000 tested so I would not rule that out either.

The problem remains a lack of any sustained buying activity. We have had several oversold rallies but nothing credible and definitely nothing of note in November. I was hoping November would prove to be the beginning of the normal best six months cycle but the Dow is down over 600 points since the calendar turned over. The global markets continue to fall with most of Europe down -4% to -5% last night alone. China's $565 billion stimulus package and market rally was completely forgotten within 24 hours. It appears there is more pain ahead for the bulls.

Dow Chart
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Because of the downgrades on the chip and PC sectors the Nasdaq was the weakest link on Tuesday. Nasdaq 1500 appears to be calling our name and none of the big tech stocks are showing any signs of buyer interest and that suggests the tech bulls are afraid to come back to the market.

Nasdaq Chart
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The S&P-500 honored tentative support at 865 all morning but still ended with a loss of 20 points at 898. The banks are still not lending and the Fed TARP well is running dry. The financial sector is the largest sector in the S&P. Energy stocks are also slipping into a hole with crude prices falling to $58.32 intraday. Energy is the second largest component of the S&P. With both of those components trading lower the S&P has a major anchor preventing any material gains. Support is 885 and again at 850.

S&P-500 Chart
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December Crude Chart
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The Russell was the lone performer intraday. Support held at 480 and the Russell actually turned positive late in the afternoon while the other indexes remained negative. This suggests there were some fund managers nibbling at the small caps in hopes a rally would eventually appear. If support at 480 breaks the next level to watch is 450. The 480 level is an exact 61.8% Fibonacci retracement of the October bounce. That will make no difference if the bulls fail to show up on Wednesday.

Russell-2000 Chart
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One positive for the markets on Wednesday could be the IEA World Outlook report on oil. It has been widely summarized in pre publication press releases as laying the groundwork for a return to $100 oil. Unfortunately you have to wonder if the weekly pre-releases have not already told the story and the news is priced into the market. If oil does manage a rebound on the report release it might infect the broader market with a case of bullish sentiment. I am not holding my breath but it deserves watching. I would be neutral to bearish for the rest of the week until proven wrong. Oversold conditions are building again but volume has been very light at 7.7 billion shares on Monday and 8.7 billion today. This is not a conviction level for either camp. It is more of a wait and see level where the majority of traders are simply passing time while they wait for a direction other than down.

Jim Brown

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