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Fed Enters Uncharted Territory

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The FOMC entered a new range on interest rates today with a "target range" of 0.0% to 0.25%. This is the lowest interest rate since the Fed began setting an explicit target rate in 1994.

Market Stats Table
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The Fed shocked the market with a very long and comprehensive announcement. The Fed said it was going to target a range of 0.0% to 0.25% for a very long time. The Fed rate was 1.0% going into the meeting but the Fed had been unable to actually hit its target rate. Actual interest rates had been lower than the target but still not getting the job done. By giving the target range with zero on the bottom the Fed is saying they are going to crush rates to the lowest possible level. The Fed said it will "employ all available tools to promote the resumption of sustainable economic growth and preserve price stability."

The FOMC statement noted the problems in the economy including the labor market, consumer and business spending and industrial production were getting worse and the outlook for economic activity has weakened.

Complete FOMC statement:

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

This was the longest statement I have ever seen and it appears the Fed emptied its gun of all available bullets. The Fed can no longer throw rate cuts at the market and short of buying up every mortgage, bond and debt instrument on the continent they are rapidly running out of options and will have to be creative in their next moves. One reporter said the next step could be Bernanke walking the floor of the NYSE with checkbook in hand and stopping at every post to make a stock purchase.

The market celebrated the drop all the way to zero interest in the statement instead of 50 points now and 50 points later. With the economy still in decline there was no reason to wait and prolong the agony. The market had already priced in expectations for zero for sometime in the first quarter and this surprise triggered some short covering. The expanded breadth of the statement also caught some traders off guard and it seemed there was something in it for everyone.

The U.S. dollar dropped like a rock losing -2.49% to 80.68 on the US Dollar Index. (DXY) The Euro spiked by +1.6% as the two currencies moved apart. The dollar index has fallen from 87.7 to 80.68 for an 8% drop over just the last two weeks. Expectations for massive Fed/Treasury intervention in the markets had prompted the decline.

U.S. Dollar Index Chart
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The Fed will have to backup its strong words with equally strong action in order to move the markets from this point forward. They will have to actually buy those mortgage-backed securities they have been threatening to buy for more than a month. Talk is cheap and it has pushed rates lower but the Fed will have to actually buy that $500 billion it has already announced to push rates any lower. Reportedly the Fed is trying to create a 4.5% mortgage rate to induce people to buy homes and revive the sector. I already have solicitors calling every week trying to sell me a refinance and I am holding off for lower rates. When the Fed actually buys those mortgages we should see another dip and that will be my signal to act.

The New Residential Construction report for November was released this morning and the construction rate fell to only 625,000 units on an annualized basis. This compared to 1.1 million as recently as June and 2.26 million in Jan-2006 at the height of the bubble. Even worse the Census Bureau revised downward the October starts by -3%. Permit issuance has also fallen sharply indicating that 625K number is not the bottom. The 19% month over month decline in housing starts was the largest drop since 1981. At current sales rates there is more than 11 months of inventory on the market and the inventory to sales rate is double the normal average. Evaporating home equity has eliminated many of the homebuyers who would normally be trading up. Without any equity today they can't trade up and are locked into their current homes until the market rises again.

There was good news from the Consumer Price Index (CPI), which fell -1.7% in November. The core index was unchanged at 0.1% but key components were dropping sharply. The energy component fell -17% and was responsible for a large portion of the decline in the headline number. With the price of gasoline falling to $1.60 nationwide and expected to continue to decline we should see further declines in both the CPI and PPI for December.

Consumer Price Index Chart
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The other major economic news of the day came from Goldman Sachs rather than the government. Goldman reported a loss of $2.12 billion and the first quarterly loss ever as a public company. Goldman shares rose +14% on the ensuing relief rally because traders had been expecting an even bigger loss. Morgan Stanley (MS) shares spiked +18% in hopes their results on Wednesday will also be better than expected. Goldman's loss was -$4.97 per share and ended its reputation as a company that could do no wrong. They were unable to trade their way out of trouble as they have in the past. The whisper number was for a loss of $6. Write-downs due to troubled loans hit $5 billion. Goldman has converted to a bank holding company to be eligible for additional Fed loans. Goldman already accepted $21 billion in capital from the U.S. Treasury. Goldman is cutting back everywhere possible and slashed its balance sheet by nearly 20% to $885 billion during the quarter. The company also cut 2,500 jobs during the quarter. The CFO told analysts on the conference call, "We were an investment bank for 139 years and a bank holding company for three months. We are still a little new at this game." With mergers and acquisitions almost nonexistent today the big investment banks are going into withdrawal. They lived on the multi-million deal fees like a drug addict on crack. Now they are forced to make money the old fashioned way like a real bank. However, when the economy recovers Goldman will be one of the few left and able to land that business again. Goldman cut full year employee compensation in half to around $10.9 billion to an average of $364,000 per employee. Last year it paid out a Wall Street record of $20.2 billion in compensation. Gee, times must really be tough.

Crude prices declined to $44 before the OPEC meeting on Wednesday. OPEC is widely expected to cut production by at least 1.5 million barrels per day with many estimates up to as much as 3 mbpd. The problem is the urgent need for cash by OPEC countries being complicated by the rapid drop in global demand. Gasoline demand in the U.S. has fallen -5.5% over the last month and -2.5% over the last week. This is the same problem around the world. The recession has overcome the abundance of cheap fuel.

In the chart below the numbers come from Dennis Gartman and show how the OPEC countries and Russia greatly expanded their spending as oil prices rose over the last several years. They quickly became addicted to the excess petrodollars flooding into their treasury and immediately enacted programs to spend the money. Now that the money has stopped the expenses continue. They have to pump as much oil as possible to keep the bills paid but in doing so they are driving down prices even further. It is a vicious cycle and it remains to be seen if they can muster the will to stop it.

Country Budget Requirements
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There are analysts who believe OPEC would have to cut production by as much as 7.7 mbpd in order to really stop the glut from building. Phillip Verleger claims global demand has fallen to 81.6 mbpd from 87 mbpd last spring. That is a monster drop but OPEC production has only declined 1.5 mbpd. Crude tankers are now in short supply because producing nations are renting them to store oil. They have no destination but countries have run out of storage space on land.

All of this is a temporary situation but it could get worse before it gets better if OPEC does not have the guts to take a significant hit in production volumes in order to raise prices. Anything they do on Wednesday should not have a significant impact for several months and this floating storage is consumed. Goldman Sachs said this week they could see oil in the $30s with a target price of $45 for 2009. As you can see by the chart above $45 oil will still not help with the red ink in those budgets. The biggest decline in production could come outside OPEC from companies that can't afford to produce oil at a cost of $60 and sell it for $40. Private companies with high cost fields are facing the same problem as OPEC countries but they don't have the same financial backing. They will be forced to curtail production until it becomes profitable to pump oil again. All of these project cancellations and production curtailments are going to guarantee the return to high prices eventually and those prices could be even higher than we saw last summer.

General Electric (GE) affirmed current estimates and said profits could be flat to +5% in 2009 in a range of $1.78 to $1.84. CEO Jeff Immelt said, "For people of my generation, this is the toughest environment we have ever seen." GE shares rose +6% on the news. GE also broke with prior practices and said they would no longer provide quarterly earnings estimates. We are seeing this more often these days as companies lose sight of what earnings might be in the current environment.

Not all the news was good with Gartner saying semiconductor revenue in 2009 will fall by 16.3% to $219 billion. That follows an expected 4.4% decline in 2008. The 4th quarter of 2008 is now expected to show the worst ever quarterly drop of 24.4%. Gartner said this will produce the first ever back-to-back years of semiconductor decline. This was an update to their estimate cut on PC sales last week. Gartner's warning and an earnings warning from Xlinx failed to hold the sector back. Intel gained +6%, XLNX +5% and BRCM +5.6%. The Semiconductor Index (SOX) rose 6% to a new 6-week high.

The wait for the FOMC and the aftermath of the announcement was really the only news story today. After the announcement the markets exploded as shorts ran for cover. The Fed made it clear they were going to use every available tool to reflate the economy. By mentioning specifically purchasing mortgage backed securities they hit the financials right in the sweet spot. Those are the securities that have been trading as though 50% of all loans would eventually foreclose. If the Fed tells you they are going to buy billions and possibly as much as a trillion in MBS then suddenly those securities don't have the same toxic smell as they did over the last quarter. Instead of write-downs we could be seeing write-ups next quarter.

The Dow rebounded 359 points (4.2%) to close at 8931 and just under strong resistance at 9000. Most of the major indexes looked exactly the same with a rebound right to resistance and then coming to a dead stop. The NYSE Composite was the exception with a +5.6% spike to 5800 and a new 6-week high. The NYA is heavily weighted with financials and small caps and doubly benefited from the short squeeze.

Dow Chart
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Nasdaq Chart
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After last week's consolidation and minor decline on Thr/Mon I was beginning to worry a little more about the health of the markets. Today's rally was a textbook short squeeze and does not really have any bearing on the market direction. The failure at resistance on the Dow, Nasdaq, S&P, Russell, etc, is troubling and indicates sellers were waiting.

The internals were massively lopsided with up volume at 9.5 billion shares compared to only 744 million shares of down volume. Advancers were 4:1 over decliners. However, total volume was just average at 10.3 billion shares. It was not a blowout or a sudden flood of buyers. It was a short squeeze as traders expecting a benign FOMC statement and further decline were caught flat-footed.

S&P-500 Chart
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Russell-2000 Chart
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NYSE Composite Index
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I would not be surprised to see a continued move in either direction. Actually I might be somewhat surprised to see a continued move higher although it is that time of year where the bulls typically outweigh the bears. If we did move over 9000, 1600, 920, 500 I would be a skeptical buyer of the move. There is a volume of data making the rounds suggesting there could be a couple hundred billion in hedge fund lockups that will expire at year-end. I believe that is weighing on the market and even today's positive Fed action may not be enough to push us higher until after those positions are liquidated. However, there are likely quite a few people acting on those rumors by shorting every bounce. It would not take much of a buy program from our current level to create an even bigger short squeeze that could last for days. Short interest is very high and it could be explosive. I would use those index levels I mentioned above as your trading criteria. Longs over those levels and flat/short below those lines. I am moving away from a buy the dip mindset as we approach year-end.

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