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Market Wrap

Major Inflection Point

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We saw a once in a decade event last week when the major indexes fell -15% to -17% at their lows. In most years the market only average an 8% move for the entire year and far less than a 15% move in one week. The markets are at a major inflection point and next week will be critical.

Market Statistics
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There were no material economic reports on Friday. Mass Layoffs for October were reported but this is a lagging indicator. There were 2,140 mass layoffs announced involving 232,468 workers. This was down only fractionally from the 235,681 workers cut in September. Last week we saw another round of major layoffs announced in the banking and semiconductor sectors so the November mass layoff report could show a marked increase.

Next week the key reports will be led by the GDP on Tuesday. Estimates are for a revision into slightly negative territory and anything more than -.25% or -.50% could really shake up the markets. Conversely if we got a positive surprise with a revision that keeps the GDP in positive territory or even produces a slight gain it would be very positive for the markets. Of course there is only a very slim chance for a positive surprise.

Following the GDP is the Chicago PMI and the Richmond and Kansas Fed surveys and a current look at manufacturing in those areas. All will probably show continued decreases and none should shock investors. We are only a week away from the next cycle of economic reports beginning in December. The fist week of December has the national ISM, Fed Beige Book ad Non-Farm Payrolls. Those will pretty much determine the investor mindset for the rest of December.

Economic Calendar
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It was an amazing week in the markets. The Dow was down -1048 points for the week at Friday's low of 7449. Three times the Dow broke under support at 7500 and the third time was the charm. Time was running out on the clock on a double witching option expiration Friday. When the third push below 7500 failed to stick the holders of millions of expiring put options decided it was time to cash out. Coincidently the news broke that New York Fed President Timothy Geithner would be named to replace Hank Paulson as Treasury Secretary. The combination of an expiring market and a news generated rebound launched another bear market short squeeze pushing the Dow to a +500 point gain for the day and cutting the losses for the week in half.

The sell off last week was a perfect example of a bear market correction. Most of the major indexes were down 15-17% with banking and broker sectors down well over -20%. With daily market swings of 5-7% it is nearly impossible to be an investor. It is only slightly less difficult to be a trader in those kinds of swings. What set last week's drop apart from the earlier October crash was the support levels reached. The S&P fell to an 11 year low at 741. The Dow at 7449 came within a handful of points of the prior bear market low from March-2003. This is an extremely critical support level.

The Nasdaq nearly completed a retest of its 2003 lows at 1253 with an intraday dip to 1295. In my book that is close enough given the equal performances by the other indexes. The S&P-500 actually broke through its 2002/2003 lows at 768 to hit 741 intraday on Friday. The gloom on the trading floors was so thick you could have could have cut it with a proverbial knife.

However, early in the day all three indexes seemed to find round number support at 7500, 1300, 750 and repeated attempts to break those levels all failed. This is a critical support level on all indexes. If the market is going to hold at these 5-year lows this is where the goal line stand should appear.

Another key point for me was the apparent capitulation trading on Wed/Thr. The internals were the worst I have seen in years and seemed to indicate investors were flushing stocks because of margin calls, triggered stops or just plain frustration. In reality it was probably some funds liquidating based on rumors we heard on Friday. The rumors were probably started by the news the Treasury Dept was going to help liquidate the Reserve Funds U.S. Government Fund. This is a major money market fund and the company was seeing a run on the fund after a sister fund, the $64 billion Primary Fund became the first ever MM fund to break the buck in September. Fears of a similar problem in the Reserve Fund caused investors to swamp the fund with withdrawal requests. The Treasury said it could have exposure of up to $5.6 billion as a buyer of last resort of the remaining securities owned by the Reserve Fund. The fund had previously already liquidated all but $6.3 billion of its holdings to satisfy investors. Under the liquidation plan the fund has 45 days to do an orderly liquidation where it will sell assets on the open market. If the fund can't get what it considers a fair price the Treasury will backstop the fund. The Reserve Fund claims to have invented the money market fund in 1970. The company has now suspended all of their money market funds and is currently liquidating 15 other money market funds. What an amazing time we live in that these innovators find themselves being liquidated by the government instead of leading the pack in returns.

The money market funds are not the only ones with redemption problems. Global wealth management company Bernstein surveyed their hedge fund clients to see where they stood. Leverage had fallen to 142% of assets compared to 175% in 2007. 63% of the respondents felt the hedge fund deleveraging process was at least halfway over. Redemptions were also felt to be half done with the remainder in Q4 and Q1-2009. About 10% of the funds were stockpiling cash for known or expected redemptions. Cash as a percentage of assets had risen to 31% compared to an average of 7% over the past two years. The Financial Times said over $40 billion has been withdrawn from hedge funds so far in November. The CEO of Fauchier Partners, a London based fund of hedge funds half owned by BNP Paribas said redemptions would be "much more" that $40 billion. There are still a lot of industry analysts that believe we could see several hundred funds close their doors at year-end. Those funds could be liquidating now without an announcement to avoid having traders front run their sales.

Interesting article from Morningstar about the thousands of layoffs in the mutual fund industry and the closing of some funds. http://biz.yahoo.com/ms/081120/265719.html?.v=1

For whatever reason the selling was extreme on Wed/Thr. It could have been fund liquidations or related to option expiration or both. Either way the massive imbalance of the internals coupled with a dead stop on that round number support from five years ago this could be a perfect spot for a bottom to form.

Market Internals Table
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In the internals table above you can see where the A/D ratio was roughly 10:1 in favor of decliners on Wed/Thr. The volume imbalance was even greater. Note also that the volume was very strong on Thursday and again on Friday's rebound. I harbor no illusions that Friday's rebound was anything but option related short covering but the intraday support hold was critical for bullish sentiment. Thursday's view into the pit of hell was quickly erased with Friday's rebound. We may get a flashback next week but I would rather live it one day at a time rather than focus on the potential for a recurring bearish nightmare.

Like Paulson said on Wednesday we are experiencing a once in a lifetime event. Who would have thought back on January 1st that we would see a failure of Lehman, Bear Stearns, Wachovia, Washington Mutual, AIG, Countrywide, IndyMac, Fannie and Freddie all in a space of a few short months? Those companies had over $5 trillion in assets and it did not save them. Mutual funds have lost up to 50% of their value and $85 billion in deposits. The average hedge fund has lost a range of 16-25% and they were supposed to be "hedged" against a bear market. The market giants have been reduced to midcaps or even small caps. The top ten financial stocks have shifted position and players so often you need a scorecard to keep track. In order of market cap you have Berkshire Hathaway at $84 billion, Wells Fargo $75B, JPM $74B, BAC $51B, USB $36B. Citigroup is down at number 10 with only $20 billion in market cap. That is down from $290 billion a year ago. Goldman dropped from $100B to $20B, AXP from $75B to $20B, AIG $190B to $4B and Wachovia $108B to $8B.

After the bell on Friday the Office of Thrift Supervision closed Downey Savings and Loan (DSL) and put the thrift into the FDIC receivership. Downey stock hit 46-cents on Nov-11th as investors fled the stock fearing the worst. The FDIC sold all of Downey's deposits ($9.7 Billion) and nearly all of its assets ($12.8 billion) to U.S. Bank (USB). The FDIC said the loss to the insurance fund would be $1.4 billion. Regulators also shutdown PFF Bank and Trust or Pomona CA and The Community Bank of Loganville GA. PFF was also sold to U.S. Bank, which picked up 213 branch locations in the deal. PFF had $3.7 billion in assets and $2.4 billion in deposits.

So many stocks have declined in market cap that many mutual funds are prohibited by charter from buying them. In October 1987 only 35 of the S&P 500 were trading for less than $10 per share. After 9/11 there were 59. Today there are over 100 trading for less than $10 and one is less than $1. This is the largest number since records began in 1980. The requirements for a listing on the S&P are a market cap over $4 billion and a reasonable share price. That was typically taken to mean $10 or more. 186 S&P companies have fallen below that minimum $4 billion in market cap and 25 are now less than $1 billion in market cap. Many mutual funds are prohibited from buying small cap stocks or penny stocks. Today Etrade (ETFC) is trading under $1 and has a market cap of $484 million. It is the cheapest stock in the S&P and many funds can no longer buy it. 36 of the S&P-500 stocks are now under $5 and many funds can no longer add to their positions in those companies. Those include GNW, F, THC, AIG, ODP, NCC, DYN, S, SOV, MU, AMD, LIZ, CIT, LSI, JDSU, Q, IPG, GM and TER. Obviously this will reverse explosively once a real bull market begins and those stocks start to climb back out of the depths and become eligible for fund buying again. Given the rapid decline in the global economy that may not be next week.

In this once in a lifetime market are there stocks safe to buy? Hardly a day goes by without several readers emailing me about various stocks now in ranges unheard of just months ago. A couple this week wanted to bet on Citigroup. Surely under $5 they must be a screaming bargain. At their closing price of $3.77 on Friday they are worth $5 billion less than the $25 billion the government invested several weeks ago. Their tangible book to equity ratio is more than 50:1. Their massive amount of consumer debt will force them to write down additional billions over coming quarters. Citigroup execs finally panicked last week and said they were considering selling all or part of the company to get out of trouble. The $25 billion price tag would only pay back the government and investors would be left with nothing. With their stock under $4 they can't sell additional equity without massively diluting the remaining equity to near zero. What buyer could come up with $25 billion and be strong enough to absorb all the write-downs coming in 2009? Only one and it is not a company. It is the U.S. Treasury. The Treasury can't let Citigroup file bankruptcy. Next to AIG they probably have more global counterparty exposure than any company on the planet. Not even Citigroup's Saudi billionaire investor is willing to step up to the plate at $4. The only plausible end to this story is a government takeover of Citigroup with shareholders left holding the bag. Treasury can't let Citigroup fail. They are massively bigger than Lehman or Bear Stearns and the repercussions would be earth shaking. Is Citigroup a buy at $3? I seriously doubt it.

There was a strong rumor under the markets on Friday that the Fed/Treasury would have to do something about Citigroup before the open on Monday. Citigroup is in an apparent death spiral despite the Treasury capital infusion and implicit guarantee. Citi reportedly has $250 billion in distressed assets and they are definitely too big to fail. That suggests the only option is some form of government intervention before Monday's open or Friday's market bounce could quickly be erased. If there is no government action analysts are expecting other major bank stocks to accelerate downward even faster. Bank America is threatening to break under $10 and once under that threshold gravity seems to increase exponentially.

How about Etrade at 90-cents? This is a tough one because Etrade has assets other brokers would kill to get. Customer assets at ETFC fell to $119.38 billion at the end of October. That is down -$100 billion from the end of October 2007. Those assets shrank -16% just in October. Customers are fleeing Etrade as the stock heads for zero. Etrade had some subprime exposure but that is supposedly gone now but they still have a $24 billion mortgage portfolio. However, Etrade's banking arm is weighing on the Internet broker's stock price and that is also what could save them. As a bank they have access to capital a normal broker doesn't. Thanks to their active television adds about claiming the addition of 1,000 new accounts per day they actually added 65,538 new accounts in October. How that offset those accounts fleeing to safety is anybody's guess. If ETFC stock would quit hemorrhaging value there would probably be a lot of people take the $1 bet that Etrade will survive. I believe they will survive but probably as part of some other broker like Charles Schwab or Ameritrade. Sometimes when a company weathers a bad storm like this they are never able to shed the stigma and the stock either takes years to recover or they end up a perpetual takeover target. Etrade just announced they were going to retire $450 million in 2018 debt because it was unable to remarket the notes. They are going to be retired in connection with a new issue of 25 million shares. Etrade has applied for $800 million in TARP funding. Is Etrade a buy at 90-cents? They might be worth throwing a $1000 dollars towards the stock but nothing more. There are far too many unknowns to invest the farm. The stock price is under $1 for a reason and any eventual deal could erase it completely if Treasury suddenly decided they were a risk to account holders.

There is no shortage of cheap stocks to play. Just surf that S&P-500 list under $5 I listed earlier and there are quite a few that are not going away. Most will recover. Unfortunately knowing which ones with a great degree of certainty is the problem. Are they value stocks or a value trap? The almost recession we are experiencing has wiped out hundreds of previously profitable companies. I say almost because as long as the GDP for Q3 is positive we are not technically in a recession.

I received a list of retailers this week that are closing their doors or scaling back significantly because of the damage from high oil prices and the recession. We hear every week about a store closing or a chain cutting some stores. The magnitude of the damage is not really seen until you peruse this list. Every location has dozens to hundreds of employees, retail space, warehouses, supply chains, corporate offices, etc. This is a serious recession brought about by high oil prices and financial gridlock and the stock market is reflecting this fact. Fortunately for investors a recession typically brings a major buying opportunity and this is one heck of an opportunity.

Store Closings (unverified)
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The markets rebounded strongly Friday afternoon after Timothy Geithner was named to take over the Treasury leadership from Hank Paulson. There was probably a lot of OpEx involved as well but the market reporters were beating the Geithner news to death. This is a highly positive nomination and could have a positive impact on the markets for the rest of the year. Geithner is the president of the New York Federal Reserve and has been around the block many times. He has a lot of experience in financial events dating back a couple decades. He was involved in the resolution of the Long Term Capital hedge fund problem years ago. He has been heavily involved in the Lehman, Bear Stearns and AIG fiascos. As president of the New York Fed he is involved in the region with the highest concentration of banks and financial companies on the planet. He was actively involved with the actions of the Bernanke Fed and all the recent bailout plans. He is also at the right hand of Paulson and knows and has helped in structuring the current set of bailouts by the Treasury. By all accounts he is the perfect pick to take over from Paulson. The markets should be excited because he will require no training and has in-depth crisis management experience. He gave us early warnings on the subprime crisis, credit default swaps, problems with Fannie and Freddie and dozens of other financial concerns. If the Fed had listened to Geithner years ago we may not be in this situation today.

Timothy Geithner
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The Federal Reserve announced last week they are going to expand their Dec-16th meeting to a two-day event to allow additional time for discussion. They are going to start a day earlier on the 15th and still conclude at the regular time on Tuesday. The Fed is widely expected to cut rates another 50 points to .50% at this meeting and possibly even cut rates again to ZERO at the January 27th meeting.

Late Friday the Obama camp said they were considering Larry Summers as a replacement for Ben Bernanke. This was a very unusual move for Obama since it immediately means Bernanke is a lame duck Fed Head since his term does not expire until 2010. Analysts were very surprised Obama would announce this two years in advance when he really did not have to make a decision for two years. This would appear that Obama is telegraphing to Bernanke he should resign and his replacement is waiting in the wings. This is a very strange development and I am sure we will hear more about this next week. Worries that Obama could ask Bernanke for his resignation while he is right in the middle of the biggest financial crisis in 80 years could weigh on the market on Monday.

Goldman Sachs continued its decline from winner to sinner and there are some who suspect Warren Buffet could be the reason. Warren Buffett has always called derivatives the weapons of mass financial destruction. He is not averse to using them when it fits his needs. Back in 2007 with the Dow at 13,000 he placed a big bet on market direction. Buffett sold $37 billion in naked puts on the Dow and several foreign indexes and received $4.5 billion in premium. Selling a naked put is a bet the markets are going higher. So far that bet is not looking like a winner but he has plenty of time on his side. The puts were written with a 15-year expiration. He sold the puts to an undisclosed group of investors who thought it would be a good way to hedge against a protracted bear market. Goldman was the broker on the deal. Because Berkshire has a platinum credit rating Goldman did not require Berkshire to put up any collateral on the trade and let Berkshire have free use of the premiums received. This was a monster win for Berkshire at the time.

Buffett wrote in his annual report that Berkshire would get to use the $4.5 billion for 15 years and regardless of the outcome of the bet shareholders could make a lot of money off that $4.5 billion in invested cash over the life of the puts. Unfortunately the bet has gone horribly wrong for Berkshire and is significantly underwater. Rumors are flying on Wall Street that the investors are demanding Goldman force Berkshire to put up normal collateral for the trade. Given the amount the trade is underwater it would be a massive amount of money somewhere in the range of $10-$20 billion. Some feel the $5 billion Berkshire investment in Goldman at $125 per share was not really an investment but a creative way to provide Goldman money to use as collateral. Obviously Goldman cannot come up with $20 billion for collateral and Berkshire would do everything possible to avoid having to come up with the money. The foreign investors are concerned with the health of the U.S. financial sector and that Goldman will go under without putting up the collateral for the trade leaving the investors exposed.

If I was an investor holding $37 billion in puts on the global markets I would be hysterical on fears Goldman was about to go under. As part of the deal the puts cannot be exercised until 2022. That means the entire trade could easily reverse and the puts expire worthless but a continued global crash into another great depression would be a major windfall for the investors only as long as there is somebody standing behind the puts in 2022. Buffett has acknowledged in his report that Berkshire will take a write-down of roughly $1 billion a quarter as they amortize the risk on this position. Warren may not even be around to pay up in 2022 and that would be even more reason I would want collateral behind my puts. This collateral shortage is reportedly looming large over Goldman and that is why the stock is tanking. Personally I believe it is simply tanking with the sector since the Banking Index dropped -24% for the week.

Stranger than fiction. The big three automakers were asked by lawmakers last week if they flew to Washington by commercial airlines or private jet. All three flew by private jet. They were soundly criticized for asking for a bailout when they were still living the high life in a private jet. On Friday GM announced they were returning 2 of their corporate jets as part of a cost cutting measure. They denied the announcement had anything to do with the harassment by lawmakers. "It was simply part of a larger plan to cut travel costs." If you believe that then you probably still believe in Santa Claus and the Easter Bunny. Don't you think CEO Rick Wagoner would have taken the opportunity when he was criticized by lawmakers to say they were plans in the work to drop the jets instead of sitting there blank faced and silent? To GM's credit they had 7 leased jets at the beginning of the year and they returned 2 more back in September. On Friday Ford also said they were considering selling some of their jets. Don't you think this is an amazing coincidence? The automakers all said they required their executives to fly on the private jets for security reasons. I did not realize auto execs were in such danger.

Dow Chart - Monthly
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SPX Chart - Monthly
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It is time to wake up now. The last five years have just been a dream and it is time to return to the real world. The S&P is still under 800 and the Dow bounced off 7500 last week. This is exactly where they were five years ago in the 2002-2003 bear market. The entire rise to Dow 14,000 was just a dream. Your home did not double in value and then lose all those gains over the last five years. On the bright side you don't owe any taxes on all those market gains you made before the market imploded. I say all this in jest but I have seen movies with the same story line. Unfortunately the markets did return to their 2003 lows and all the gains are gone. Instead of crying we should be buying. I know that is an old refrain but it is true. We should be sifting through the rubble to find those puddles of melted gold that will remake themselves into the leaders of tomorrow. It could be IBM, HPQ, COP, RIMM or all of the above.

Hundreds of stocks are going to survive this bear market and they are all a lot closer to a bottom today than they have been over the last four years. You should buy when there is blood in the streets and the internals from Wed/Thr showed copious amounts of bleeding. The financial crisis might not be over and the recession may not officially start until the Q4 numbers show up in early 2009 but market rebounds typically begin six months before the end of a recession. Most analysts are predicting Q3-09 or before as the recovery quarter. That suggests we are moving through the worst of it now. Most secular bear markets average 45% to 50% drops and we are there now. I believe we should be taking partial positions now even if it is just with a few ETFs. The majority of trading gains happen in the first couple weeks of a rebound. From that point on it becomes a buy and hold market. Now is the time to nibble so you can capture those gains whether the rebound begins next week, next month or next quarter. The risk reward ratio is extremely high at this level. Risk is minimal and the eventual reward could be great. Next week is black Friday and the biggest shopping day of the year. The market is open, shop for some stocks as well.

Jim Brown

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