Is a bottom in or do we have more downside to go?
To get an idea let’s take a hard look at…
WHICH WAY THIS
MARKET IS HEADED
As you can see the
markets were poised to break support heading into the close Friday on
some pretty determined downward momentum---but a half hour before the
bell news hit that a deal was being finalized on Ambac and the markets
shot through the roof.
CNBC announced that
"significant progress" had been made and a bailout could be coming as
soon as Monday or Tuesday. The bailout would be a recapitalization of
Ambac by a consortium of banks and would save the AAA rating for the
bond insurer—EXACTLY what investors wanted to hear. Reportedly the banks
would provide a credit line and actual investment into Ambac-- enough
hope to bounce the markets straight up in a huge relief and
short-covering rally.
The fuse has been
burning increasingly quickly on the bond insurance bomb as the various
credit rating agencies have given regulators until Feb-29th to produce a
solution or ratings on MBIA and Ambac will be downgraded sharply.
For the bulls it
was good the rescue rumors came in the last half-hour because it was
only about an hour later that news began to break from Ambac that a deal
was NOT imminent. Ambac said they were in talks with numerous parties
and exploring all options including capital raises—and that there was no
bailout. The New York Times reported in its early Saturday editions that
Ambac plans to split itself in two and hopes to raise $3 billion to
bolster its finances according to a person who saw the plans on
Friday—so much for a ‘big bailout’ by a consortium of banks.
Meanwhile in other
areas of the credit arena the mortgage sector took a hit when Merrill
Lynch cut Fannie Mae (FNM) and Freddie Mac (FRE) to a "sell" on Friday
warning that the mortgage entities still did not reflect the severity or
duration of the financial crisis. "Specifically, we think further
deterioration in financial market conditions and worsening credit
performance will undermine fundamentals and likely lead to further
valuation compression." "We think Fannie and Freddie could retest 2007
lows and possibly incur new troughs as the cyclical downturn appears
more acute."
OUCH!---Both stocks
were knocked for big losses on the downgrade.
And the big brokers
aren’t faring much better---Oppenheimer banking analyst Meredith Whitney
said Citigroup had insufficient reserves and would be forced to cut its
dividend again. Whitney also warned that financial stocks could fall as
much as 15% to 50% in 2008. Bernstein cut estimates for BSC, LEH, GS and
MS saying the brokers had significant further exposure to depreciating
asset classes.
A big chunk of
those ‘depreciating assets’ appear to be linked to housing. The
S&P/Case-Shiller Home Price Index due out on Tuesday is expected to show
another major decline in prices across the nation. The last report
covering the November period saw a drop of -2.2% for the month and -8.4%
for the trailing 12-month period. This is already the largest drop in
the last 50-years. The New Home Sales report due out on Wednesday is
expected to see annualized sales fall to the 580,000 range and a
continuation of the 4.7% drop seen in December---down substantially from
the 1.4 million annual rate at the peak in 2005.
On Friday a report
hit that wires that 10.3% or 8.8 million U.S. homes were now worth less
than their mortgage balance. With little in the way of a rebound in
values projected over the next two years many of those buyers are
choosing to walk away from their homes and mortgages rather than
continue making the escalating mortgage payments. Realty Trac warned
Friday that 1.5 million homes are still expected to foreclose in 2008.
There were $625
billion in subprime loans written in 2005, four times the rate of 2001,
and it’s becoming painfully obvious many of those loans should never
have been made. Approximately $2.1 trillion in mortgages or 19% of all
mortgages outstanding were packaged into mortgage backed securities
(CDO/MBS) and sold all over the world. Market watchers are beginning to
realize we’re likely to see more billions in write-downs in the coming
months.
The Fed would love to keep cutting rates to remedy
the problem but inflation keeps lunging at its chain like a rabid dog.
The Consumer Price Index released last week showed headline inflation
rose +0.4% in January and core inflation rose 0.3% capping an annualized
6.8% clip over the last 3-months. Core inflation rose 3.1% over the last
3-months with the energy component alone blasting higher by a whopping
19.6% over the last 12-months. Crude prices closed the week at $99 after
a record run, and natural gas just hit a nine month high.
This is massive inflation no matter how you slice
it and the Fed is reluctantly taking notice--Dallas Fed President
Richard Fisher warned on Friday that "We have to be very careful in
terms of accommodation with monetary policy in order to get the economy
to pick back up again," Mr. Fisher pointed out that the central bank
must be wary of "stirring the embers of inflation."
This rising fear of
inflation is putting a damper on expectations for the Fed continuing to
cut rates. The Fed Funds Futures still show a 124% chance of a 50-point
cut in March but investor sentiment about that cut is falling fast. That
sentiment decline is depressing the equities markets on fears the Fed
will be hesitant to cut further. Some investors are already looking at a
potential rate hike scenario to counteract inflation if the CPI keeps
rising.
In the FOMC minutes
of the January meeting that were released last week the FOMC discussed a
"rapid reversal" of existing rate cuts if inflation continued to rise.
Uh-Oh. The Fed is caught between a stagnant economy and rising inflation
and it’s becoming apparent there is no easy way out.
Fed Chairman Ben
Bernanke will give testimony on Wednesday and Thursday in his semiannual
report to the House and Senate on the state of the economy. This
testimony is coming just a little over two weeks ahead of the next FOMC
meeting on March 18th. The key phrases analysts will be looking for are
the ones indicating the Fed's plan to cut rates again at that March
meeting---should his testimony lean more toward inflation than growth
look out for falling markets!
So—we’ve got market
buoying rumors that may turn out to be false in the cold gray light of
Monday morning, inflation ticking ever higher, a big jump in energy
costs and a continuing downtrend in housing. Plus the market is
compressed like a coiled spring after six weeks of sideways action—the
question is…
HOW DO WE MAKE MONEY ON IT?
We’ve got two
really nice looking plays lined up this week—the first is bullish and
the second bearish.
Our first play is a
standout in the energy sector—the company recently announced a 30% jump
in earnings, increased guidance and beat analysts’ expectations. The
chart is coming off a strong ‘V’ bottom and looks poised to rocket
higher this coming week—a trip we’ll be jumping on for what looks to be
a very profitable ride!
Our next play is
bearish and it’s in the hard-hit retail sector. When the CEO comes out
and says the current year will be ‘challenging’ investors better take
notice—and they have been. The stock has been tracing a path of
continuous new lows but it’s still got plenty to fall—a fall we’ll be
taking advantage of with some well placed puts first thing Monday
morning!
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