It was not a fun day in the market as earnings reports and various news items pointed to the evaporation of liquidity in the financial sector. Worries over a rising default rates in home mortgages and rising interest rates in the corporate sector sent the major averages into a late afternoon spiral. Talk about no rebound in the housing sector until 2009 at the earliest depressed builders and also weighed on financials. It was not a fun day unless you were short.
Dow Chart - Daily
Nasdaq Chart - Daily
The economic schedule was light and none of the reports had any bearing on the market drop. Chain store sales were flat for the week and not a factor. The Richmond Fed Manufacturing Survey was also flat at 4 despite the order backlog component rising to 10 from -5. Declining shipments and slowing of new order growth offset that spike in backlogs.
The real spark for the market downturn came from several earnings reports and comments from analysts on potential problems in the credit markets. Leading the list of negative news items was earnings from Countrywide Financial. Countrywide (CFC) posted a -33% drop in profits and a -15% drop in revenue. They guided materially lower for all of 2007 with a median forecast of $3.00 earnings compared to a prior forecast average of $3.90. This was the second time Countrywide lowered guidance for the year. We all know about the subprime problem and everyone thought Countrywide had it under control. Unfortunately Countrywide said the rising defaults were now coming from prime loans, not subprime or even alt-A credits. Prime lenders with big loans were now defaulting and causing a new round of concerns. Countrywide said falling home prices were the major reason for the defaults. Homeowners, even with prime credit, are no longer able to afford the reset to current interest rates. Normally they would just roll over again with another ARM to escape the reset but with prices falling so drastically and credit terms more strict they can't borrow enough to cover the penalties and interest on the original loan. Homeowner loans have dried up or are being priced at much higher rates so the lender can be assured of being able to resell the loan into the secondary market. Many lenders are not even taking loans today for fear the rates will rise significantly higher before they can resell the loan. This is putting a major squeeze on what few homebuyers are still shopping for a home. Analysts have been worrying the subprime problem would contaminate the rest of the loan sector and it appears that reality has arrived. Countrywide held a three-hour conference call after reporting their earnings and the tone was decidedly bearish. CFC lost -10% and the biggest one day drop in their stock in 15 years.
Accredited Home Lenders (LEND) dropped -15% on the Countrywide news and worries about their current agreement to be bought by Lone Star for $400 million. Lone Star agreed to buy LEND for $15.10 per share and today's drop saw them close under $11. Analysts are concerned that Lone Star may try to walk on the deal now that LEND is worth considerably less. LEND is the target of a Forrest Gump class action suit with investors thinking LEND will be one of the few survivors of the subprime implosion and worth more once the subprime smoke clears. In Forrest Gump, Forrest and Lieutenant Dan buy a shrimp boat but struggle until a hurricane wrecks the competition leaving Bubba Gump owning the last shrimp boat in the area. Without competitors Forrest and Dan become rich.
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I have reported this before but I feel it needs repeating. The total mortgage loan market is just over $10 trillion. Subprime and Alt-A loans only make up $2 trillion of that total. At current default rates assuming further reset foreclosures the maximum loss is expected to be less than $100 billion. That is only 1% of the total loans outstanding and most expect that number to be grossly exaggerated. It will not be a terminal event for the mortgage industry although there will be some serious pain for some and some closings for many. The challenge is the leverage used by the loan re-packagers. 20:1 or even 40:1 leverage is used to increase returns to loan buyers. That leverage works in reverse just as well and those CDO buyers can see their entire investment wiped out by positive leverage turning negative. We saw that happen with the two Bear Stearns hedge funds. Their billions in investments were wiped out. If that default rate is now rising on the CDOs created from prime loans then the pain could get a lot worse.
As I have reported many times before the current stock market boom has been fueled by a flood of liquidity over the last several years. Leveraged buyouts are hitting new records almost on a monthly basis. Buyouts removed $1.2 trillion in stock from the market over the last four years and buybacks have removed another trillion or so. With the liquidity tide receding those market supports are being removed. We are already seeing buybacks being cancelled because the companies were unable to borrow the money at the terms they previously expected. Expedia (EXPE) is a prime example. They initially said they were going to buy back 116.7 million shares. On Monday Expedia said those plans had been cancelled due to unacceptable financing terms. Now we are starting to see leveraged buyouts run into trouble. Some of the debt on the Chrysler buyout is now being quoted at 700 points over Libor (12-13%) instead of the 100-150 points (6-7%) Cerberus expected. GM agreed to sell its Allison unit to the Carlyle Group for $5.6 billion but the deal has been postponed because $3.1 billion in loans for the buyout have been put off due to unacceptable rates. So far $16 billion in leveraged loans/bonds have been cancelled in the last four weeks with more to come.
Bill Gross said on CNBC today that the equivalent of an 8.0 earthquake has occurred in the corporate bond market in the last several weeks. Spreads for prime deals have widened by 250 basis points or more but even worse there is no appetite for deals. Gross said the move in corporate rates over the last two weeks was the equivalent of the Fed suddenly announcing a rate hike to 7% from the current 5.25% level. You can imagine how that would impact the equity markets. This shows why the corporate bond market is in a state of shock. He claims there are several hundred billion in corporate bonds being shopped but there are no takers. Buyers want to wait and see how much worse the problem gets before taking a position. There is $235 billion in already announced LBO deals, which have yet to come to the market. Essentially the credit markets are going into free fall and lenders want to see the sudden splat at the bottom before venturing back into cherry pick the remains. The admission by Citigroup and JP Morgan last week that they have been unable to sell deal debt on multiple deals sent a shock through the sector. That shock continues to reverberate since problems at Citigroup and JP Morgan means the same problem exists at hundreds of second and third tier banks farther down the food chain. None of these banks wants to end up with additional bridge loans they can't sell. It sucks up their liquidity and limits their profits or even worse leaves them exposed for potential defaults.
The bond market is cautiously waiting for the Chrysler deal to get done. With the price on some debt already 3-4 times over what Cerberus was expecting the market is using that deal as a guide to market health. The worst-case scenario would be for a major deal like Chrysler not to get done. If Cerberus walked away from the deal because they could not get financing it would be a very bad sign for the LBO market and the equity markets in general. The last major peak in LBO activity came on October 16th 1989. At 5 min to 3:PM the company buying United Airlines announced it could not get financing for the deal. The markets dropped -7% in the next 65 minutes. That was the peak for LBO deals in that cycle. Investors fear that the failure of a high profile deal today could market the end of this cycle and nobody wants to be left holding bridge loans when the music stops.
There are serious worries about S&P and Moody's ratings of prime debt. If they missed the mark on the subprime debt by such a wide margin then how badly have they missed it on rating prime debt? With Countrywide claiming spiking defaults on prime loans this could cause those credit agencies to rush to revalue their prime ratings. If a debt instrument falls out of the investment grade class as nearly all the classes of subprime debt did then many institutions can no longer hold the paper. They are forced by their bylaws to immediately sell it to protect their investors. This forced dumping in the subprime arena caused untold losses but that would be negligible compared to the potential pain if prime debt gets cut to less than investment grade.
The falling dollar is also putting a strain on the bond market. Overseas investors don't want to put money into dollar denominated investments with the dollar plunging to near record lows. The dollar hit an all time low against the Euro and a 26-year low against the pound. Today the dollar index ($USD) came within .03 of breaking under the 80 mark and a critical level for investor sentiment.
If imploding financials were not bad enough for the market some high profile earnings misses and downgrades were also doing a job on stocks. Texas Instruments (TXN) lowered their guidance to growth of only 2% to 11% for the current quarter saying demand was going to be flat for chips used in cell phones and some consumer electronics. TXN fell nearly -5% and knocked the support from under the chip sector. Nokia, which uses chips from TXN in their cell phones, was also knocked for loss on the TXN news. A Citigroup downgrade on KLAC also contributed to the semiconductor slide.
Apple Inc (AAPL) lost -$8.81 on news from AT&T that it only activated 146,000 iPhones in the first two days of sales. Analysts had expected something in the 500,000-700,000 range and traders fled Apple stock ahead of their earnings on Wednesday. Analysts said that activation number was probably misleading since there were activation problems the first couple days and many buyers probably did not rush to activate the phones and deal with the aggravation of setting up a new cell phone account. Apple will face the real test on Wednesday and they really need to announce some blowout numbers or this will be just the start of the drop.
Dupont (DD) posted flat earnings at $1.04 but missed street estimates of $1.06 and was knocked for a -$3.36 loss. Dupont said sales overseas helped blunt serious declines in the U.S. auto and homebuilding markets. Dupont said it did not act fast enough to changing economic conditions in the U.S. or to rising input costs for raw materials. Dupont CEO Charles Holiday said they were not looking for any improvement in the housing market until well into 2008. Based on other forecasts today I think he was being optimistic.
American Express (AXP) reported stronger than expected marketing costs and an increase in loan loss reserves of more than $1 billion. AXP said it expects more customer defaults from its 82 million cardholders most of whom do not fall in the subprime category. AXP also said it expects to pay more for money with rates rising in the corporate sector. This is just one more example of the subprime meltup impacting daily business.
About the only sector doing well today was the defense sector but even those stocks are living on borrowed time according to some. Slowing orders for defense items could be signaling the coming end to the Iraq conflict and companies are pitching their next generation of wares to a deaf administration ear. Ceradyne (CRDN) a maker of ceramic parts for bulletproof gear saw orders fall by more than half and order backlogs fell -21%. They beat the street by 2 cents but the news on falling orders knocked -8% off the stock price. This slowing military procurement phase could be just beginning with the president running out of options to keep the war effort alive and the democrats pushing to bring the troops home. If they can pressure the administration to end it before the democrats take office then the democrats won't have to face the same hard questions Bush is facing today. They don't want the buck passed to them with the administration change and I completely understand.
Amazon reported earnings after the close and the stock produced a Google sized reaction. Amazon beat the street by 3 cents and raised guidance significantly. Their 19 cents of earnings was more than triple the same quarter in 2006 and sales increased 35%. They also nearly doubled their margin to 4%. Amazon received orders for more than 2.2 million of the latest Harry Potter book. The stock was hammered just prior to the close losing -$3 in the last few minutes to close at $69.30. After reporting earnings AMZN soared to close the after hours session at $84 for a post earnings gain of $14.70. This brought back memories of 2000 and the Nasdaq bubble where any earnings surprise produced amazing results. The results here are simply a factor of the amount of shorts in the stock. Since Amazon surprised back in April the stock had risen $30 and was up more than 100% since mid January. The bears thought that had to be a one time event in April and the short interest had been growing over the last couple of weeks. Welcome to yet another perfect example of bears getting roasted in thin trading. The AMZN gains did not carry over into the after hours futures with only a $2 gain on the Nasdaq futures contract.
Oil prices fell to $73.25 with declines accelerating on news that more refineries were coming back online as the driving season comes to a close. Gasoline prices fell over a nickel stretching the loss for the week to more than 11 cents to close at $2.05. Natural gas prices fell to a new two-year low for this contract at $5.86. The end of summer heat may not be here yet but investors can see the cooler temperatures from here and gas supplies continue to build with no hurricanes in the gulf. Energy stocks were hammered with the refiners suffering the most. Positive earnings from several energy companies failed to provide any boost to the sector.
Gasoline Futures Chart - Daily
Where is the market going from here? That is the $64 question and nobody has a clear answer. About the only thing certain is that we have not seen the end of the liquidity drain. The pendulum of market sentiment seldom stops in the middle of a swing. From an almost insane flood of liquidity the odds are good we will swing to an almost insane level of caution before settling somewhere in the middle. The market is looking for that first big name LBO deal to fail and that will be the beginning and the end. The beginning of a serious equity market drop and the end of the current LBO boom as we know it. Expect further declines in financials in the weeks ahead.
Real inflation is being seen in nearly every sector as companies report earnings. This is real inflation not the sanitized numbers we get from the Fed. Starbucks (SBUX) is raising the price of coffee 9 cents due to rising costs for milk, coffee and labor. Dominos Pizza (DPZ) reported sharp increases in the cost of cheese, flour and labor. Dupont reported sharp increases in the cost of inputs to its chemical manufacturing business. Almost everyone reporting earnings has said the high cost of energy is cutting into profits. This puts the Fed between a rock and a hard place. Inflation is rising but the negative impact of housing is spreading rapidly. With a FOMC meeting in two weeks this is going to be a definite topic of concern. $2 trillion in mortgage debt remains to be reset in 2007 and 2008. It is going to get worse before it gets better and the Fed has to decide to cut rates and help housing or raise rates to cut inflation.
Since a decline in financials tends to be a precursor to a broader market decline the odds are stacked against us. Since August is typically the worst month for the indexes we are already under a sentiment cloud. Add in the numerous earnings misses, lowered guidance and ratings downgrades and the outlook is not bright. The bulls have climbed walls of worry larger than this in the past but rarely after a rally the size we have seen over the last year.
The Dow has gained 3338 points since the lows in July 2006 at 10683. The low came on July 18th 2006 and the recent high at 14021 was on July 17th 2007 exactly one year later. That is a 31% rally in 12 months and only one major hiccup along the way in February. We are due for a major correction and with all the negative news events and the current credit crunch this would be a perfect time for it to appear. Of course nobody can ever exactly predict the market's future but we can protect ourselves from potential disaster.
The Dow tried really hard not to crack that support at 13800 this afternoon but there was simply too much selling pressure. The S&P was even worse with a late afternoon collapse to 1510 from support at 1530. The S&P lost -30 points for the day and that is not a feat that happens often. The Nasdaq gave up -50 points to halt its slide at 2635 and support from mid July.
SPX Chart - Daily
RRussell-2000 Chart - Daily
The worst performance came from the Russell 2000 which lost -24 points or -2.85% and a new 3-month low. Selling in the small caps ahead of August is a major red flag that there is more weakness to follow.
Market internals were extremely negative with down volume more than 10 times up volume and overall volume at 7.5 billion shares. There were six times more decliners than advancers. To say it was an ugly day would be an understatement. Curbs were instituted on the NYSE for the first time since the market drop last March.
This is where I am supposed to say, "Will the last trader leaving the market
please turn out the lights." If I did it would mark a solid bottom and a 400
point rebound tomorrow. Personally I believe we are in for some further declines
but the bad news bulls have pulled us back from bigger sell offs than this. We
have a solid pattern of lower highs and lower lows on the S&P but a dead stop on
initial support at 1510. We could easily rebound from here or continue down to
stronger support at 1490. Unless that 1490 support breaks we are just trading in
a broader range and the rally is still intact. It may be badly bruised but still
limping along. The S&P was the only average among the big three to break its
50-day average and it did it convincingly. However, the Russell collapsed to
break its 100-day average as well and I view this as a major cause for alarm.
This could easily cause some further stops to be hit and create additional
margin loans were at a record last week and retail traders
rarely go short on margin. That suggests a lot of margined positions will be
closed tomorrow morning if they were not already stopped out today. Watch out
for the Existing Home Sales and Fed Beige Book tomorrow. They could take the
pressure off earnings but could sour sentiment if either takes a sudden turn for
the worst. I have a bearish bias until proven otherwise.
Penn National Gaming - PENN - cls: 58.30 chg: -0.53 stop: n/a
There is nothing new to report on for PENN. There is no change from our weekend comments for PENN. This play seems to be getting more and more speculative as each day passes. We're down to the last nine days before time runs out for PENN to find another bidder. We're not suggesting new positions. If you're willing to gamble on a new offer coming in over the next several days we would stick to the August strikes.
Picked on June 17 at $ 62.12
Bear Stearns - BSC - cls: 129.85 chg: -4.40 stop: 142.55
The broker-dealers continued to get crushed today. Countrywide's negative comments about the housing market and sub-prime loans was bad enough. Yet PIMCO's Bill Gross had to issue negative comments calling an end of the easy money leveraged buyout boom. The XBD index sank 3.7%. Shares of BSC fell 3.2% to a new relative low. More conservative traders may want to take some profits here. We're sticking with our target in the $125.50-125.00 range.
Picked on July 22 at $134.72
Harley Davidson - HOG - cls: 58.27 change: 0.59 stop: 60.26
Today was not a day we wanted to see relative strength in shares of HOG. Unfortunately the stock managed to close up with a 1% gain after being upgraded this morning. Watch for a failed rally near the $59.00-60.00 zone as a new entry point for bearish positions. Our target is the $52.50-50.00 range. The P&F chart already points to $42.00.
Picked on July 23 at $ 57.75
Ryanair Holdings - RYAAY - cls: 38.72 change: -0.45 stop: 40.15
RYAAY slipped about 1.1% but overall the airline sector was higher. The XAL index rose 0.3%. We remain bearish on RYAAY and the airlines but have to keep a careful eye on the price of oil. We're expecting oil to correct two or three weeks from now and that will probably lift the airlines. In the meantime the trend in RYAAY is bearish. We'd use a failed rally under $40.00 or a new relative low under $37.40 (maybe under $38.00) as a new entry point for puts. Our target is the $35.05-34.00 range, which is near the November 2006 gap. The P&F chart is already bearish with a $26 target.
Picked on July 22 at $ 38.13
(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)
Advanced Micro - AMD - cls: 15.21 chg: -0.15 stop: n/a
It was a rough day for tech stocks. The SOX semiconductor index broke down under short-term support with a 1.9% decline. AMD lost just under 1% as it clings to potential support near $15.00. We're not suggesting new strangle plays at this time. The August options we suggested were the August $16 call (AMD-HQ) and the August $15 put (AMD-TC). Our estimated cost was $1.18. We want to sell if either option hits $1.85 or higher. Aggressive traders could aim for $2.40.
Picked on July 15 at $ 15.43
Amazon.com - AMZN - cls: 69.25 chg: -2.49 stop: n/a
Be prepared to exit tomorrow! Shares of AMZN managed to churn sideways for the first half of the day as investors waited for the company's earnings report. Unfortunately for shareholders the stock eventually gave in to the market-wide sell-off and shares of AMZN lost 3.4%. In the process of pulling back AMZN provided us an entry point near $70.00. After the bell today AMZN reported earnings. The company beat estimates by 3 cents and raised its 2007 guidance. This news has propelled AMZN to a 19% gain in after hours trading with the stock near $84.00. At this point, if AMZN can open near $84, then the August $75 calls (ZQN-HO) should open in the $10-13 range. We are adjusting our suggested target price from $7.45 to $9.95. More aggressive traders may want to aim higher. We are no longer suggesting new positions on the stock. The options in our suggested strangle were the August $75 calls (ZQN-HO) and the August $65 puts (ZQN-TM). Our estimated cost was $4.75.
Picked on July 22 at $ 71.63
DaimlerChrysler - DCX - cls: 89.45 chg: -2.50 stop: n/a
DCX pulled back toward $90.00 again providing us another great entry point to open strangle positions. We are not suggesting new plays at this time. We're expecting the company to present its preliminary Q2 earnings numbers tomorrow. We were suggesting the August $95 calls (DCX-HS) and the August $85 puts (DCX-TQ). Our estimated cost was $3.70. We want to sell if either option rises to $6.45.
Picked on July 22 at $ 89.75
Intel - INTC - cls: 24.52 change: -0.19 stop: n/a
INTC produced another bearish failed rally today. We are no longer suggesting new strangle positions. The August options we suggested were the August $27.50 call (INQ-HY) and the August $25.00 put (INQ-TE). Our estimated cost was $0.96. We want to sell if either option hits $1.65 or higher.
Picked on July 15 at $ 25.97
Lexmark - LXK - cls: 44.85 change: -0.70 stop: n/a
LXK reported earnings this morning but it appears the market did not know how to digest them. The stock bounced around in a relatively wide $2.85 range. Considering the company's bearish comments about their ink jet business we're expecting the next move to be down. We are no longer suggesting new positions. The options in our strangle were the August $50 calls (LXK-HJ) and the August $40 puts (LXK-TU). Our estimated cost was $0.75. We want to sell if either option rises to $1.50.
Picked on July 22 at $ 45.43
Manpower - MAN - close: 88.60 chg: -2.80 stop: n/a
MAN lost another 3% and produced another bearish failed rally pattern. Shares look poised to drop toward the $85.00 level. More aggressive traders may want to raise their target on the strangle exit. We are no longer suggesting new strangle positions. We were suggesting the August $100 call (MAN-HT) and the August $90 put (MAN-TR). Our estimated cost was $3.35. We want to sell if either option hits $5.75 or higher.
Picked on July 15 at $ 94.60
Boeing Co - BA - cls: 103.80 change: -0.24 stop: 99.75
BA rallied to a new all-time high today at $105.67 but eventually succumbed to the broad-market weakness. It was our plan to exit today at the closing bell to avoid holding over BA's earnings report due out tomorrow. Wall Street expects BA to report earnings of $1.16 a share. We would not be surprised if BA announced a stock split. They last split their shares 2:1 in June 1997.
Picked on July 13 at $101.55
FedEx - FDX - cls: 113.39 change: -2.24 stop: 114.42
A relatively positive earnings report from UPS was not enough to lift shares of FDX. Shares of FDX sold off today breaking support near $115 and the $114 levels. The stock hit our stop loss at $114.42 early this morning. Technicals have definitely turned bearish and volume on today's 1.9% decline was above average, which is bearish.
Picked on July 12 at $114.42
GulfMark - GLF - cls: 54.85 change: -0.90 stop: 53.74
Oil and oil service stocks were not safe havens during today's market-wide sell-off. The OIX oil index sank 3.2% and the OSX oil services index sank 2.3%. Shares of GLF under performed them both with a 4.4% decline. Shares hit our stop loss at $53.74.
Picked on July 09 at $ 55.05
Helmerich Payne - HP - cls: 34.00 chg: -1.31 stop: 33.95
HP is another oil service stock that hit some heavy profit taking. Shares dipped to $33.75, hitting our stop loss at $33.95. The move today broke multiple levels of support.
Picked on July 15 at $ 36.30
Joy Global - JOYG - cls: 59.56 chg: -2.71 stop: 59.75
Bulls rushed to lock in profits across the market sectors today and JOYG was hit with some heavy selling. Shares lost 4.3% on big volume and broke down under multiple levels of support. The stock hit our stop loss at $59.75.
Picked on July 11 at $ 62.05
PACCAR - PCAR - close: 92.71 change: -4.51 stop: 93.77
It was an ugly day for PCAR. First and foremost the company released earnings. We had been trying to avoid holding over earnings but couldn't find a confirmed date. We had planned to exit today because sources suggested PCAR would not announce until the 25th. Instead PCAR reported this morning and beat market estimates by 8 cents but that wasn't enough. The stock has produced a bearish reversal with today's bearish engulfing candlestick pattern. More importantly, we raised our stop loss to $93.77 yesterday and PCAR hit that stop today.
Picked on July 15 at $ 93.77
MGIC Invest. - MTG - close: 49.27 change: -3.32 stop: n/a
Target exceeded. The negative earnings news from Countrywide (CFC) helped drive MTG to new lows. MTG closed with a 6.3% loss even after bouncing from its intraday low at $48.46. Our suggested exit price was at $5.95. The August $55 put (MTG-TK) traded at $6.50 today.
Picked on July 15 at $ 56.98
Today's Newsletter Notes: Market Wrap by Jim Brown and all other plays and content by the Option Investor staff.
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