October 19th is the 23rd anniversary of the 1987 market crash where the Dow lost -508 points for a -23% drop in a single day.

Market Statistics

Today's -165 drop can't compare with the 1987 drop of -23%. Today was only a blink compared to the 1987 heart attack. That does not make today's decline any less painful if you were long going into the open. Numerous earnings reports left investors with an anticipation hangover and the Dow with a -160 point drop at the open.

The Dow drop was fueled by a -$5 decline in IBM. In addition to IBM the drop in oil prices caused a significant decline in CVX and XOM, also Dow components. The Dow was not the only big loser at the open with the Nasdaq tanking on a big drop in Apple, Google, Priceline and Amazon. This is not the way traders were hoping the Q3 earnings cycle would play out.

There was only one economic report of note and that was the New Residential Construction for September. Starts came in stronger than expected with a +.3% gain to an annualized rate of 610,000 units. Starts are up +4% year over year. Unfortunately permits declined by -5.6% month-to-month and -10.9% year over year.

The most important report for the week will be the Fed Beige Book on Wednesday.

Economic Calendar

Economics were not the problem today although currencies were a major weight on the markets. China announced it was raising interest rates by 25 basis points. This was the first rate hike since 2007. China is poised to release its Q3 GDP numbers on Thursday and they are expected to be near 10%. China's growth has caused some serious inflation problems in China. Consumer prices rose +3.5% in August with food prices spiking +7.5%. Real estate prices rose +9.1% in September.

China's action shook financial markets around the world sending equities and commodities sharply lower. The announcement came after China's market closed so the real hit will come tonight when those markets open. The timing of the rate hike should have been no surprise with the G20 meeting this weekend. China's low currency has been a source of concern and the U.S. stopped just short of labeling them a currency manipulator last week. Hiking rates boost your currency value so China will be able to go into the meeting claiming they are working on the problem of a cheap yuan.

The hike in rates prompted a serious round of short covering in various currencies and the U.S. dollar was one currency that was extremely oversold. The short covering prompted a +1.7% rally in the dollar index. That is a massive move in currency terms. That would be equivalent to about a 1,000 point move in the Dow.

Dollar Index chart

The spike in the dollar crushed commodity prices as the stops were hit on the very crowded trade of "short dollar, long commodities." Crude prices fell -4.5% on the increase in the dollar and the worries that China's rate hike signaled a new round of tightening for the Chinese economy. We closed a very nice short in the OilSlick newsletter today that was entered in expectations for a rebound in the dollar.

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Crude Oil Chart

Gold Chart

Copper Chart

A story that was under reported was a halt by China of exports of rare earth minerals to the USA. For the last month China halted shipments to Japan as the two countries fought over jurisdiction of some disputed ocean real estate. Today three industry officials said China had halted shipments to the USA. Our administration needs to be careful what fights they pick with China over currency and trade issues.

You may remember last week that our 30-year treasury auction went badly for lack of demand. That lack of demand was reportedly a lack of Chinese demand for our bonds. They are the largest buyers and a sudden halt to bidding could drive our yields/rates higher very quickly.

The mineral halt was announced on Sunday night to protest U.S. trade actions. American trade officials announced last Friday they would investigate China's violation of international trade rules by subsidizing clean energy industries. The inquiry claims China has been steadily reducing exports in rare earth quotas since 2005 and adding steep export taxes on rare earths. China announced in July it was cutting export quotas by 72% for 2010 and as much as another 30% in 2011. Officials claim this is an illegal effort to force companies to manufacture more of their high tech goods in China. China mines 95% of the world's rare earth minerals. These minerals have very broad commercial and military applications and are vital to the production of things like wind turbines, guided missiles, batteries, semiconductors, etc.

U.S. officials need to be very careful when they pick fights with the sleeping bear. If he wakes up in a bad mood it will be bad for everyone.

Earnings are really the key this week and several big names on Monday night caused havoc in Tuesday's market. Apple reported strong earnings but iPad sales disappointed and profit margins fell to 36.9% from 38.2%. BMO Capital estimated that iPhone margins fell to 45% from 55% in the quarter. Research firm iSupply said the components costs for an iPhone 4 rose to $187.51 from $170.80 for the previous model. Apple shares closed down -$8.51 or $2.7% on the disappointment.

Analysts said the growing competition for the iPhone would probably force some additional price discounting that would impact margins in future quarters. The same problem is true with the iPad, which is being aggressively priced in an effort to control the market ahead of a dozen or so competitors going on sale over the next few months.

Apple Chart

Dow component IBM reported earnings that beat the street and raised full year guidance but plunged more than $6 intraday after service contract signings fell by -7% to $11 billion in Q3. Sales were brisk on hardware and software but corporations were holding back on large contracts until the economic outlook improves.

IBM said one deal worth $1.8 billion with ABN Amro slipped until October 8th and would have pushed the services total to $12.7 billion and higher than expected. Investors were already running for cover and ignored the excuse.

IBM Chart

Bank of America reported earnings of $3.1 billion or 27-cents per share before the open and that was well ahead of analyst estimates of 16-cents. After a list of charges relating to the new federal regulations that limit fees and some other items BAC lost $7.3 billion. This came from a $10.4 billion write-down in the value of its bankcard unit. The bank said credit quality improved significantly in the quarter. This allowed them to set aside only $5.4 billion for credit losses and $2.7 billion less than the prior quarter. It was $6.3 billion below the reserves for the same quarter last year.

BAC shares did ok at the open but took a sizeable tumble to lead the market down after news broke that Blackrock, Pimco and the NY Federal Reserve was preparing to sue BAC to buy back $47 billion in mortgage securities. The news sent BAC to a new 52-week low and the Dow to a -230 point intraday loss late at 3:30 PM.

Bank of America (Countrywide) sold roughly $750 billion in mortgage-backed securities between 2004-2008. Of that total $3.9 billion have been involved in repurchase requests for various reasons. $500 million were declined and $1 billion have been approved for repurchase with $1 billion still outstanding. Those are manageable numbers. If the $47 billion action now underway is the first of a new wave of repurchase actions then BAC and other banks like JPM, WFC, etc could be in trouble. This was a major weight on the market.

A bank can be forced to repurchase the loans if the purchaser can prove they were misrepresented in the original sale. This is covered by the representations and warranties clauses in the contracts. For instance if the bank represented the average credit score was 725 and it was found out later to be 685 they could be forced to repurchase. If the homes were represented to be owner occupied and later investigations found that many were actually rented they could be forced to buy back the loans. With the number of RMBS loan defaults the purchasers of these mortgages are trying every conceivable way to force a buyback. They have hired auditing firms to investigate tens of thousands of loans/properties in hopes of finding a pattern of misrepresentation that will give them a reason to go to court.

The action in progress by Pimco, Blackrock and the NY Fed is alleging that Countrywide failed to service the loans properly. Bank America and Countrywide collectively service more than 14 million mortgages worth more than $2.1 trillion. About half are owned by Fannie and Freddie and 30% are owned by institutions. Bank America said it would resume foreclosures in 23 states this week and the rest of the states next week.

Bank of America owns 34% of Blackrock so it is suing itself in a sense.

Goldman Sachs reported earnings of $1.74 billion and easily beat analyst estimates. Debt underwriting rose +59% during the quarter but trading revenue fell -40% from earlier in the year. The $2.98 per share in earnings from $3.03 billion and $5.25 per share during the same period in 2009. The decline was due in part to large dividend/compensation reserves for shareholders and employees. Goldman set aside $3.83 billion and benefits during the quarter. That brings the set aside for year-end compensation to $13.12 billion for the first nine months.

Goldman's CFO said trading revenue was down because of lower volatility and traders were skittish since the flash crash and worried about economics.

Goldman Sachs Chart

Harley Davidson (HOG) reported earnings of 40-cents that missed the street estimates of 44-cents due to a 7.7% drop in sales. Harley CEO Keith Wandell said "the economy as yet to turn around in a convincing way and many consumers remain on the sidelines." Harley narrowed its forecast for 2010 shipments. Shares of HOG gave up -7% on the news.

Harley Davidson Chart

Juniper Networks reported earnings that matched street estimates but revenue was light. The stock declined -10% in after hours before positive comments on the conference call produced a rebound. Juniper spokesmen said the company was on track for a revenue growth rate of 20% or higher for the full year and predicted higher than expected revenue in Q4. The CEO said global economic growth recovery was still patchy and slow but was very encouraged by recent discussions with large service providers. After closing at $30.54 shares briefly touched $27 before the conference call news.

EMC posted strong earnings that rose +58% due mostly by a surge in cloud computing. EMC is the majority owner of VMWare and VMW reported earnings that doubled. The U.S., Asia and Latin America markets saw sales increases over 20% while Europe lagged with a 14% increase. Earnings of 30-cents matched analyst estimates but EMC did not decline as other reporters today. EMC posted a fractional gain but it was a gain in a bad market. EMC said they were hiring again and added 1,700 people in the quarter.

Yahoo reported earnings after the close and earnings doubled. Unfortunately it was due to the sale of HotJobs.com and not a significant improvement in advertising revenue. Without the HotJobs sale earnings were 16-cents and only a penny above analyst estimates. Revenue was $1.6 billion, an increase of only 2%. You may remember Google posted a 23% increase in revenue. It appears Yahoo may not be spiraling down the drain but it is definitely takeover bait. CEO Bartz has had two years to turn the company around with not much luck. Google and Bing have passed Yahoo by and captured the search market. Yahoo's search revenues fell -7% for the quarter. After some serious volatility YHOO closed flat in after hours.

Major earnings reports due out on Wednesday include Boeing, Ebay, Morgan Stanley and Wells Fargo.

Earnings Calendar

The volatility today was nowhere near that seen on Oct 19th 1987 but it was still ugly. The Dow declined -230 at its lows and the Nasdaq was off -59 points. The Dow closed back below 11,000 but just barely.

The negative earnings, currency challenges and the Bank America mortgage problem were too much for the dip buyers to overcome. I believe they are still there but reeling from the morning body blow.

Wednesday will be a key inflection point. If the dip buyers return then it is back to business as usual with QE2 in the headlights but we are rapidly approaching that November 3rd FOMC meeting and analysts are starting to express skepticism.

There could be too many "perhaps, could and might" words in the recent speeches. Maybe the Fed is getting cold feet about charging off on another stimulus venture despite what the market thinks.

You may remember 2-3 weeks ago when the subject first appeared. Market pundits were talking $500B to $5T in future QE purchases. That is an amazing amount of money to float the economy and the market raced higher in anticipation. Now we are hearing numbers like $100 billion in an initial buy sometime in January. That is a drop in the bucket and 90 days away. The market is beginning to second-guess itself and we could see some backing and filling while we wait for the actual FOMC announcement.

That means the onward and upward market may turn into more of a trading range over the next two weeks.

The earnings parade has done little to power us higher other than the Google earnings last week. That pushed the Nasdaq higher but the Dow lagged in negative territory. Without any really key Nasdaq earnings other than Ebay and Amazon left this week there is little to create excitement.

We also have the Fed Beige Book economic update on Wednesday. That has the power to heal or kill the market. If conditions have improved the markets will not be so dependent on QE2. If conditions declined we will be entirely dependent on news of QE2. That 2:PM report will be critical.

The S&P pulled back to support at 1160 and saw a decent rebound on short covering just before the close. Volume was strong today at 9.65 billion shares but heavily skewed to the downside as stop losses were hit in volume. Resistance is now 1185 and real support 1150. That gives us a wide range to wander until November 3rd.

S&P-500 Chart

The Dow tried to push over 11,100 for a week and failed to hold its gains. The expectations for strong earnings did not last and the weakness in the financial sector weighed it down.

On the positive side the uptrend resistance from June (blue dashed line) has turned into support. The trend is intact as long as that support holds. A break there targets 10,700 and that would be a serious decline on top of our 165-point loss today.

Seven Dow stocks lost more than a buck with IBM -4.80, CAT -1.69, CVX -1.69, BA -1.18 and XOM -1.16 the biggest decliners. I doubt IBM will continue its decline and crude prices should recover when the dollar loses traction. That will give the Dow some support but other than short covering I don't see any big market moving events pushing it higher. Earnings from Dow components BA, AXP, MCD, HON and VZ will not have the same dynamic pop for the Dow as BAC, JPM and IBM.

Dow Chart

A -44 point loss on the Nasdaq is a lot but we should look at the glass as half full and be thankful prior resistance at 2435 returned as support for the third time in the last five days. We should view that as initial support and 2400 as the next level to test.

With the major big cap techs all severely negative we should be glad that 2435 held. Unfortunately there are not a lot of high profile tech earnings left this week. We need the dip buyers to come in at the open and then hope for positive news from Ebay, SanDisk, Amazon and a couple others to keep the rally alive.

Personally the way the big caps have been pummeled on various aspects of their fairly decent earnings does not give me much hope that scenario will come true. I would like to believe the QE2 story will overcome various deficiencies in future earnings but this week has not been a prime example of that thesis. I believe a break back below 2400 could lead to a significant decline.

Nasdaq Chart

In summary I believe market sentiment took a serious blow this week. The shorts are probably recovering some of their confidence while the dip buyers are questioning the reasoning of buying the QE2 rumor. Today's decline was steep but it was not a major problem. This rally has overcome several major declines in its six weeks of gains.

The market was severely overbought and needed a good face slap to wake it up. It depends now on whether traders decide enough is enough and start taking profits or they suck it up and race back in to buy the dip. Time will tell. I am still a dip buyer today but a further material decline on Wednesday could quickly change my mind.

Jim Brown