Two days of declines is not the end of the world. This was the first time on over a month that the S&P has ended with back-to-back losses.

Market Statistics

Despite two days of declines the Dow is still +248 points over last Wednesday's low at 11,097. That should put today's minor 60-point decline in context. After a seemingly unstoppable rally over the last couple months a couple days of profit taking have energized the bears but have barely fazed the bulls. I am glad to see some selling because it provides a buying opportunity for the next move higher.

Today was a slow news day for economics with no important releases. The Job Openings and Labor Turnover Survey (JOLTS) showed that job openings declined to 2,929,000 in September from 3,092,000 in August. This is a lagging report since we are already midway through November. The pace of job creation rose only +11.6% in September and separations barely offset hires. We already know September was not a good month for jobs with the Non-Farm Payroll report showing we lost -41,000 jobs. I do expect this report to improve in October and move up sharply in November.

The Wholesale Trade report for September showed a +1.5% surge and more than twice what analysts expected. The August numbers were revised up to +1.2% from +0.8%. Nondurable goods orders spiked a very strong +2.8%. The rapid increase in goods inventories is expected to push the Q3 GDP slightly higher in the next revision. That assumes other factors don't produce additional drag. That could be a bad assumption.

Weekly Chain Store Sales rose +1.3% as retailers began their pre Black Friday marketing programs. The firm BDO did a survey of retailers and consumers and projected 2010 holiday sales could climb by +3.5%. Apparently there is a lot of pent up buying that will be released this holiday season.

Wednesday also lacks any critical economic reports but we do have Cisco earnings after the close. This could be the next market-moving event. If John Chambers says business is improving briskly then the market could find some traction. Conversely if he warns that conditions are not yet indicating a recovery then the profit taking could continue.

Economic Calendar

Tivo fell 15% when the U.S. Court of Appeals posed some negative questions to the firm in its fight with Echostar and Dish over the DVR patents. Tivo has repeatedly won judgments that bar Dish and Echostar from using the patents and won multi million dollar judgments but the companies continue to appeal. The Federal Circuit court ruled that the companies were still infringing but the decision was set aside so that a full panel of judges could rehear the case. ran out of answers, at least answers on searches. is dropping the search engine portion of its business due to lack of interest by the browsing public. Ask will cut 130 engineering jobs and outsource its searches. Ask realized it could not keep up with Bing, Google and Yahoo and threw in the towel. Ask had only 3.7% of the search market in September while Google had 65%. Ask will keep and expand its question driven answer service.

Goldman Sachs disclosed it lost money trading on only two days in Q3. It made between $75M and $100M on 24 days and mode over $100 million on seven days. Bank America disclosed it made a profit every day. On 25 of those days they made between $25M and $50M and more than $100M on five days. JPM reported they had no losing days and made more than $200 million on 12 days. You wonder how the new financial reform laws are going to impact this kind of trading profits. Goldman has already started closing its proprietary trading business.

Yahoo rallied +3% on news that KKR added their name to a list of firms that want to take the company private. Yahoo has lost more than half its value since Microsoft withdrew its $44.6 billion bid in 2008. Goldman Sachs is working with Yahoo to find an acquirer and/or arrange financing to take them private. Reportedly the private equity group approached AliBaba Group, which is 40% owned by Yahoo, about taking Yahoo private. Yahoo shares traded under $13 as recently as August.

Boeing took another hit today after a 787 Dreamliner was forced to declare an emergency and land in Laredo Texas. Smoke filled the rear cabin and the source was not immediately known. The plane made an emergency landing at the closest field and the crew evacuated.

Chevron announced it was buying Atlas Energy (ATLS) for $3.2 billion to gain a position in the Marcellus Shale gas field. Other majors buying into the Marcellus this year include XOM, RDS, TOT, BP and STO. The deal valued the Marcellus acreage at $9,000 per acre. That is down from $14,000 earlier this year so maybe there is something to be said for waiting for a pullback. Chevron will gain access to as much as 9 TCF of gas. Atlas has 850 BCF of proved reserves but much more than that in suspected reserves. Until they drill additional wells they can't call it proved. The Chevron offer was $43.34 for each share of Atlas. That was a 37% premium.

Atlas had previously sold 40% of its Marcellus acreage into a partnership with Reliance Industries of India. Chevron will take over the Atlas position. As part of that sale Reliance has to fund all the drilling costs so Chevron gets a free ride on that portion.

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Crude oil hit a two-year high at $87.55 early this morning before the spike in the dollar knocked out support. Crude declined a buck on the dollar spike.

Oil Chart

A report out today from the Kaufman Foundation claims ETFs pose a systemic risk to the market and could cause disruptions larger than the flash crash. You may remember after the flash crash more than 70% of the trades that were busted were on ETFs. Mutual funds and hedge funds are now using ETFs as a proxy for stock investing. The ETFs have significantly higher volume than individual stocks and they are easier to short.

They are so easy to short that back in June there were six major ETFs that had a short interest of more than 100%. How is that possible you ask? It is the miracle of blind borrowing. If you have shares of the ETF in your account and you have not told your broker he can't lend them then the next time somebody shorts those shares it could be your shares he is borrowing. If the person buying the shorted shares holds them in a margin account then the broker can lone them out for someone else to short.

ETFs With High Short Interest - June

My question is simply, what happens if suddenly everyone wants to cover and there are no shares available to be purchased? That seems like a reasonable question. In the chart above the S&P Retail ETF had 16.9 million shares outstanding and 94.9 million shares short. That sounds like a recipe for a serious short squeeze. That was a question posed in the ETF systemic risk report.

Another problem they highlighted was the lack of a requirement for ETF managers to actually own the shares they are indexing. If you look closely at the prospectus of some ETFs they specifically allow the manager to retain a portion of the money invested and use that money for anything they want and for buying and selling securities not indexed by the fund. Hypothetically you could be invested in an energy ETF that has a portion of its funds invested in Apple or gold, tulips or pork bellies.

So what happens if the fund sees a significant short squeeze and the manager is holding cash or other securities that is not participating in the squeeze? For instance, if you held an energy fund and Iran dropped its first nuke on Saudi Arabia you would hope your ETF manager was 100% invested in oil stocks and not some pet side project where he was trying to scalp a couple dollars off an airline stock.

If an ETF has 100% of its shares shorted it would imply a negative leverage of about 50:1. Rules state that there must be 102% collateral against all short sales of any stock. That collateral is covered by your margin account when you sell short.

Without going into great detail about this report I think you can see why they feel the market risk is growing. That risk is not just to the downside but there is also risk to the upside. If something happened to start a serious generic short squeeze in the market it could become positively explosive as those ETFs with monster short interest all tried to cover at once. An ETF manager has to cover redemptions with the actual shares of the stocks in the index not with something he may be holding that is not relative to the ETF.

In 1995 there were FOUR ETFs with $2.3 billion in assets.
In 2000 there were 106 ETF/ETP with $74.3 billion in assets.
In 2005 there were 525 ETF/ETP with $412 billion in assets.
In 2010 there are 3257 ETF/ETP with $1.2 trillion in assets.
There are currently 972 ETF and 878 ETP in the pipeline to market.

An Exchange Traded Product (ETP) can be in the form of an exchange traded note or exchange traded commodity. These are backed by the sponsor, like Barclays, which promises to guarantee the value of the ETP. In a major market meltdown the impact of an imploding ETP could be more than the guarantor could cover.

Lastly, with the thousands of products there are hundreds of cross collateralizations. That means a company with 25 million shares outstanding could be represented in the index list for a couple hundred ETFs representing more than a billion shares.

It smells a lot like a CDO or Mortgage Backed Security. Each ETF represent slices of tens to hundreds of individual stocks. In theory there is no way for a default but we saw how that theory broke down in real life in 2008. The homes still exist and many of the owners are the same but the CDOs and MBS products all caused significant losses for the purchasers. In a major market event will the ETFs implode from the leverage and take everyone's retirement down the tubes with them?

Here is the link to the report: ETF Systemic Risk

Debt concerns in Europe created another day of currency problems for the market. Worries that Ireland and Portugal may need a bailout or they will default on debt sent the Euro plunging more than 1% and the dollar up more than 1%.

Gold prices rallied to a new high at $1,424 before rolling over on the afternoon rebound in the dollar. Gold was also supported by the World Bank president suggesting that leading economies should consider readopting a modified gold standard.

The G20 meeting that starts on Thursday has also increased hostility and volatility over currencies. The extreme volatility in currencies is causing havoc in commodities and metals. Today that volatility crossed over into equities as well.

Dollar Index Chart

Euro Chart

Gold Chart

Twice now the S&P has reached 1227 and stalled. This is not a problem, yet. The S&P rallied nearly 50 points from last week's lows and a -10 point decline is just a blip. It will be a bigger problem if we start stringing several days of declines together. This was the first time the S&P has had back-to-back losses in 24 trading days. It is due for a rest.

I mentioned last week that I wish we could get a decent decline so those still on the sidelines would feel comfortable joining the crowd at the table. I could easily see a decline to 1200 or even 1190 to erase last Thursday's big spike. I do not see any potential drop below 1190. Remember, we have the Fed put to protect the market. The S&P stalled exactly where it should have stalled at just under 1228.

This profit taking is simply that, profit taking from the pre FOMC rally. The indexes were up 14% to 18% over the prior two months. Once the pressure eases we should continue moving higher.

S&P-500 Chart

The Dow has the same challenge as the S&P. The big gain from last week was unsupported and needed to back fill before moving higher. There is significant support at 11100 and we could easily test that level if the G20 currency battle heats up. That will give traders the excuse they need to take profits.

Dow Chart

The Nasdaq came very close to testing uptrend support at 2550 late this afternoon. The dip to 2552 was instantly bought and on heavy volume. I believe this support should hold and provide a launching point for the next bounce. The Cisco earnings on Wednesday evening will be the major test. That needs to be a good news only report because the bad news bulls are taking the week off.

Nasdaq Chart

In summary the markets are taking a rest. Traders needed to take profits from the two-month rally now that all the announcements and monthly economics are behind us. They needed a reason to justify taking profits and the debt/currency issues were blamed.

This is the week before option expiration and this is when the expiration volatility normally occurs. Don't get shaken up by the declines unless support at S&P 1190 and Dow 11100 are broken. It is a buying opportunity not the start of a new bear market.

Jim Brown