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Market Wrap

Running Out the Calendar

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For three weeks the markets have traded sideways with only a very small upward bias. Traders have either already quit for the year or are simply hoping to run out the year-end clock and escape with their meager rebound gains.

Market Statistics
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I wish I had a lot to write about this weekend but unless you want 1000 words on the auto bailout plan there really is a lack of newsworthy events. Traders are still in shock from the events of the last three months and those still in the markets are simply trying to get to year-end without any further declines. Rallies are weak, sell offs are weak and volume is already drying up as many traders move to the sidelines for the holidays. The market could have closed on Friday and remained closed until Jan 5th and very few traders would have cared. After a huge bear market drop, the worst financial crisis since the depression and the largest stimulus/bailout program in history, traders are still in shock and emotionally spent. Until the economic news calms and we start seeing some results of the bailout moves the markets are not likely to post major gains.

There was only one economic report on Friday and that was Mass Layoffs for November. We already know unemployment is rising so the news mass layoffs rose to 2,328 events for November should be no surprise. The layoffs involved 224,079 workers compared to 232,468 in October. Manufacturing layoffs accounted for 39% of all events and 45% of initial claims. Transportation equipment (primarily automakers) cut 25,042 workers. Overall layoffs have doubled over the last year. Mining operations are experiencing huge layoffs now that commodity demand and prices have fallen significantly.

The biggest commodity drop has been oil. OPEC met on Wednesday and agreed to cut another 2.2 mbpd of production. January crude prices fell from $44.31 to $32.40 at Friday's lows. January crude prices fell -27% for the week or -$12.71. This entire drop is unprecedented in terms of dollars and percentages since the July high. Actually the problem with the current price is not as bad as it seems on the surface. Friday was the expiration for the current January futures contract. Everybody who was long those contracts in hopes of a major move higher after an OPEC announcement was forced to rush to the exits when that bounce did not occur.

Another reason for the decline was the excess crude currently in storage. Crude inventories have been piling up in record amounts for weeks as refiners, processors, manufacturers, etc, stocked up on cheap oil. Now there is nowhere left to put it. Cushing Oklahoma is the delivery point for the U.S. crude futures contract. The tank farms at Cushing are full and there are few remaining options for delivery other than pay expensive storage while they wait. This means companies long the contract are in panic sell mode instead of being forced to pay for expensive storage. Prices for future months are nowhere near the price on the expiring January contract. The futures are telling us that prices are expected to move sharply higher over the next 12 months. The December 2009 contract at $55.20 is currently trading for more than $20 over the expiring January contract. This is a major premium suggesting investors expect the OPEC cuts and a rebound out of the recession will push prices much higher.

Crude Contract Spreads
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Another problem is the unwinding of hedges by companies like airlines and truckers. When faced with constantly rising oil prices in the first six months of 2008 all of these people put on huge amounts of complicated hedges in order to protect themselves from higher prices. The only way to hedge is to be long the futures and options in some form. Because of the expense of creating longs representing the billion barrels of crude they burn each year they are forced to do this with leverage instead of straight crude futures. We all know how leverage works. It is great if the position is going in your favor but horrible when it turns against you. The losses pile up even faster than the gains. Companies hedging against $100 oil were jumping for joy as prices fell back to $60 and then $50. Thinking they were seeing prices dip back to realistic levels many actually increased their hedges while celebrating their good fortune. As prices fell under $50 and then $45 those long hedges began costing them hundreds of millions in losses. As the losses mount they are forced to liquidate and that means selling their longs with increasing panic as their own selling pushed prices even lower. We saw airlines reporting billions in losses when crude went over $75 and I suspect we are going to see them report monster losses from hedging exposure for the current quarter. Crude prices for the February contract are likely to come under some serious pressure next week as the market begins to factor in the same supply glut for February.

January Crude Contract Chart
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The automakers got their holiday gift from the government but it came with strings. GM will get a loan of $9.4 billion and Chrysler $4 billion. GM could get another $4 billion next year. Ford said it did not need any money now but would be badly damaged if either of the other two makers sought bankruptcy. The government has the option of becoming a stockholder like it did with the banks. Another provision called for wages to be lowered to parity with foreign automakers. That brought a scream of unfair from the UAW and they pledged to have Obama remove that stipulation from the deal in January. The unions were strong supporters of Obama and his share the wealth message. Obama was quick to mention in a press conference on Friday that the bailout would not come on the backs of the working class, meaning he was going to take care of the union workers. The deal also called for the elimination of the "jobs bank" program where laid off workers can receive up to 95% of their pay for years. This was a UAW engineered program with the cost borne by the automakers. Earlier this month the UAW agreed to suspend it after Congress complained so loudly. 95% pay for years to come? No wonder the automakers are in such bad shape. Another point in the deal called for two-thirds of the automakers debt to be exchanged for stock thereby freeing up debt payments to be used for operations. This provision and the addition of new stock for the government will dilute shareholders many times over by quadrupling the shares outstanding.

If carmakers cannot prove viability by March 31st they will be required to immediately repay the loans. Think about that for a minute. They are on the edge of bankruptcy today and this cash is supposed to be a bridge loan to cover operations for the next 90 days. They have no money and they are going to spend the government's money to stay alive. If they can't prove viability are they suddenly going to give the money back? This is insane. That is like giving a poor family a turkey for Thanksgiving and coming back a week after Thanksgiving and demanding the same turkey back. It is not going to happen and the automakers are not going to have the money to repay the loan in 90 days. Viability according to the deal is positive cash flow and the ability to repay the loan. Whoever wrote this provision was dreaming and any automaker that agrees to it is on drugs. This is setting the stage for nationalizing the automakers in March. One analyst said just the unemployment claims from a GM bankruptcy would be more than the $13 billion they will receive under the loan. This is a pay now or pay later deal for the Treasury and there was no alternative. Bush had to swallow another crisis that he did not create in order to avoid future claims that "Bush allowed the automakers to fail." You can bet he is not only counting the days until the inauguration but the hours and minutes as well. Obama's new stimulus plan is moving past $775 billion in the press and before lawmakers get done adding their pork to it the price should be over $1 trillion and has already earned Obama the title of the Trillion Dollar Man.

The Madoff scandal continues to grow and there are rumors circulating it could be a lot more than $50 billion. Major investors are coming out of the closet and admitting billions upon billions in losses. It could be months before the final total is known. Imagine you had invested $10 million with Madoff ten years ago. His average annual return was about 10%. For ten years you got a statement showing you earned $1 million and you had to pay taxes on that amount. By now with compounding your $10 million is supposedly worth about $25 million and your "returns" and taxes have been growing for years. Today you found out that not only have you paid taxes on $15 million in earnings you didn't actually earn but your original $10 million has disappeared. The tax nightmare is going to be horrendous. Apparently there are different qualifications on how the loss can be deducted. If you actually earned money for say 5 years and your balance grew to $15 million and then the theft began then there is a way to deduct that $15 million as a theft loss. The flip side assumes you never actually made any money and only your initial $10 million was stolen and that is all you can claim as a loss. Your taxes on the $15 million in phantom earnings are not recoverable unless you file amended returns with a three-year look back limit on that option. This is crazy. I am sure I butchered the actual remedies and tax law in that brief explanation but you get the picture. I am not a tax accountant and a couple of those I have heard could not even agree on how it would work. I am sure you have heard the new punch line making the rounds but I will repeat it here. It was not the Bernie Madoff fund but Bernie Made Up the Fund.

On the stock front it was a boring day with little of interest. S&P cut its long-term ratings on American Express (AXP) to A from A+ and affirmed the A-1 short-term rating. They cited the deterioration in the credit card portfolio and consumer credit. S&P also lowered its credit rating on 12 major U.S. and European banks citing increasing industry risk and the deepening economic slowdown. They singled out GS for additional criticism saying their core investment banking, trading and asset management business could be significantly weaker than previously assumed. The other banks were BAC, Barclays, C, CS, DB, HBC, JPM, MS, RBS, UBS and WFC. Are you asleep yet? I told you it was boring.

Potash cut its profit estimate for 2008 by -10% citing a sudden sharp drop in demand. They expect 2009 volume levels to be higher than 2008 with a sharp increase in the last three quarters. Their 2008 profits will be more than triple 2007 and 2009 should be higher than that. People still need to eat but there is a big problem in financing fertilizer purchases. Growers can't get letters of credit or loans because of the credit crunch. It is even worse when you are trying to buy a shipload to deliver overseas. The credit markets across countries are even worse than the credit problems inside the US. Potash is still producing a product in high demand but they can't ship the product until somebody can raise cash to pay for it.

Research in Motion (RIMM) had the last word on critics after they reported better than expected earnings and a rosy outlook for the current quarter. Revenues and estimates were surprisingly robust and they even hinted they were "layering in some conservatism" in the forecast. Everyone talking down their products were wrong and RIMM added 2.6 million new customers for the quarter. This was a very strong quarter in a period where everyone else is in a dive. RIMM gained +4.39 on the news.

Credit Suisse gets a gold star for creativity in dealing with its two biggest problems. First they have billions in "illiquid assets." That is Wall Street speak for things you can't sell and are cluttering up your balance sheet with losses. Second they owe a fortune in bonuses to employees that are not going to be fired in the recently announced 5,300 job cuts. They came up with a plan to put the troubled assets into an employee "Partner Asset Facility" and will give employees shares in the fund as a bonus. They get rid of their worthless assets and their cash drain liability for year-end bonuses. Now the employees will take the hit on any further losses. Since they helped put those assets on the balance sheet to begin with this is the perfect solution.

Next week is going to be a sleeper. There are no material economic reports and of course Christmas is Thursday. If there were any material reports there would not be anybody around to see them. The Q3 GDP on Tuesday is not expected to change from the prior reading and it would be no real shock if it did drop. The Q4 GDP is going to be a market mover when it is announced on January 30th. The official estimate is for something in the -5% range but there are highly visible whisper numbers as high as -8%. I actually view that release as a potential surprise if the number comes in less than expected. I think the market would explode. That is still a month away. The only vaguely interesting reports next week are the Richmond Fed Survey and Durable Goods, but again, nobody will be around to listen.

Economic Calendar
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The VIX declined to 41 intraday and a three-month low. This is not the result of the bulls coming back to the market. It is a result of the lower volume and smaller swings in the market. All the bad news is priced in and we have not had a major market sell off in three weeks. The anxiety is slowly bleeding out of the market but it has yet to be replaced by bullishness.

What we are seeing is the process of normalizing from the record volatility resulting from the financial crash. Investors have pulled back from the fear of the last couple months but they are not yet coming back to the market. Most market analysts are expecting a rally to appear by the end of January but most are avoiding discussing the first week of January. I am also afraid of that week.

The markets wandered on Friday as December options expired with barely a whimper. The Dow and NYSE closed down while the Nasdaq, S&P and Russell closed slightly higher. The cheers for the auto bailout plan died before the news alert rolled off the TV screen. It was already baked into the cake and no surprise Bush would get something done. The northeast was being hit by a major snowstorm with 4-5 hour delays at the major airports. Traders were only thinking about closing up shop for a weeklong holiday. Next week will be a ghost town on the market floor and in trading rooms across the country. Money managers will be contemplating a new profession as they review their bonus checks for the year. Most funds have shutdown for the year except for skeleton crews and they are only there in case disaster strikes.

The Dow still has a minor uptrend intact but it appears to be running out of steam. Resistance is rock solid at 9000 and every decent uptick is followed by a couple days of decline. This is not a bullish market despite the lack of losses. Support at 8400 could be deceptive and I could easily see a retest of 8000 around the first of the year.

Dow Chart
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The S&P chart is a clone of the Dow as it has been for weeks. Strong resistance at 920 and rising support at 860. The S&P looks only slightly stronger than the Dow with the trading range shrinking each week. We are definitely setting up for a major move when this range breaks.

S&P-500 Chart
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The Nasdaq is slightly more bullish than the Dow and S&P with the resistance at 1600 being tested more often and the minor dips being quickly bought but on low volume. Tech stocks are shaking off daily earnings warnings with the chip sector seeing 1-2 warnings a day. This is increasingly bullish but until we move over 1600 there is still a lot of behind the scenes worry that the gains are just window dressing. Funds have to be invested in something at year-end and techs are always a crowd pleaser. Support at 1500 was tested hard last week and held. I view that as a positive compared to the brief support tests on the Dow.

Nasdaq Chart
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The most bullish chart remains the Russell with a new 6-week intraday high on Friday. The bulls are chipping away at resistance just under 500 a little more every day. The dips are becoming shallower and there is less hindrance by the actions of the blue chips. The Dow was off -.6% for the week but the Russell was up nearly +4% with a minor new intraday high each of the last three days. It appears fund managers are nibbling at the small caps to keep them moving higher until year-end.

Russell Chart
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I believe conditions are forming where a low volume buy program could appear out of nowhere next week and produce a short covering rally that punches through resistance. I think a buy program in a low volume market could be a major surprise to people like me who think we could see a serious dip the first week in January. I have read/listened to a dozen analysts who claim there are sellers waiting for an end of year rally and that does not surprise me. It would be the perfect time to sell to raise cash for hedge fund withdrawals on Jan-1st. Bottom line, I think we could see a surprise break higher but I would be skeptical of its strength. Secondly I believe the closer we get to year-end the more dangerous it will be for the bulls.

If you have not taken advantage of our year-end renewal special yet I suggest you do so quickly. We were not able to get as many DVDs as we wanted and will be cutting off the special a lot sooner than in prior years. This is the cheapest rate for the entire year and includes $250 in free gifts.

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