WHICH WAY THIS MARKET IS HEADED
The markets on
Friday were hit hard by downgrades on the automakers, financials, bond
insurers, chip stocks and by the quadruple witching option expiration—no
wonder stocks dropped like a rock! The only thing saving this economy up
until this point has been a decent employment picture—but that also
looks to be changing.
The Mass Layoffs
Report for May reported on Friday rose to 1,626 events involving 50
workers or more. The May layoffs hit 171,387 compared to 133,914 workers
in April—an alarming 28% one-month increase. These layoffs will take
place over several months and an increase in these announcements does
not bode well for an already shaky economy. Construction and
manufacturing have plunged the most with a sharp deterioration over the
last two months. Manufacturing is being hurt by the sharp drop in
automobile sales with production falling to 1998 levels. If you think
foreclosures have been high up until this point just wait until
unemployment starts to spike.
The big event on
the calendar for this coming week is the Fed meeting on Tue/Wed. The
rate announcement will be 2:15 ET on Wednesday and will heavily
influence the markets even though most traders are already convinced of
the outcome.
The Fed is caught
between recession and inflation--the ammunition to fight one feeds the
other--cutting rates feeds inflation and raising rates feeds the
recession. Their best alternative is to do nothing and that is what the
market is expecting.
However chances of
an immediate rate hike increased early this past week because inflation
hawks among the FOMC are lobbying for a rate hike regardless of the
impact on the recession. Richmond Fed President Jeffrey Lacker is
adamant that "reversing rate cuts now makes eminent sense." Lacker is a
constant inflation hawk voting against several of the past rate cuts
saying inflation risks were already too high. Other Fed officials have
also been making comments on inflation that were seen as hawkish pushing
the chances of a rate hike higher.
That said the Fed will still probably stand pat--the news items Friday
diminished the chances of a hike significantly. Standard and Poors
warned that it was putting GM, Ford and Chrysler on negative credit
watch because of falling auto sales. Moody's also lowered its ratings on
Ford and Chrysler. Both said the sudden and significant drop in auto
sales, specifically trucks and SUVs, was a bad omen for the automakers.
Sales have fallen to 1998 levels. The downgrade on the automakers and
the negative comments about sales will weigh on any potential rate hike
this week.
Another factor
against an immediate hike is the bearish comments out of the banking
sector. Citigroup fell under $20 on comments that loan losses could
produce significant additional write-downs. Goldman Sachs warned on
Friday that the credit crunch was ongoing and would not peak until
2009--credit losses will increase, loan loss reserves will need to be
increased and raising capital will become much harder. Every capital
deal done over the last three months is now underwater. Merrill said on
Friday that loan losses in the banking sector will materially weaken
earnings and they saw no improvement until 2010. All the major banks
have said the consumer is under serious pressure and future defaults,
foreclosures and bankruptcies are expected to increase. The Fed will
find it very tough to justify raising rates under these conditions.
And if that wasn’t enought the bond insurers are in trouble again.
Moody's downgraded bond insurer MBIA (MBI) by two notches to A2 from Aaa---a
much harsher action than expected. This downgrade literally shuts the
door on new business for MBIA making the company $2.6 billion short of
the capital needed to regain an investment grade rating. MBIA said it
only has $1.1 billion in capital and would probably have to post an
additional $4.5 billion in eligible collateral to satisfy potential
collateral posting requirements under existing contracts. Moody's said
their exposure to mortgage backed securities has risen to $5.9 billion
as of last week. The ratings cut on MBIA will cause the ratings to be
cut on hundreds of billions of bonds MBIA insured. This means holders of
those securities will in some cases be forced to sell them because of
rules regulating the quality of investments they are allowed to hold.
For instance money market funds cannot hold securities that are not in
the top two categories. This would knock those securities out of that
range and force their sale. Moody's also cut the rating on the other
major insurer, Ambac, to Aa3 from Aaa. Just when the Fed thought the
worst was over these rating cuts are putting about $1 trillion in bonds
in jeopardy. It is doubtful the Fed can afford to raise rates in this
environment.
The combination of
all these negative influences is driving a continuing bear market in the
financials. The PHLX Banking Index (BKX) closed at 62.72 and a new
10-year low on a weekly basis. The Merrill, Goldman and Citigroup
comments over the past week suggest there is more pain to come and in
Merrill's view we may not see a rebound until 2010. If that is true
there is almost no way for the broader markets to rise. The financials
are the biggest component of the S&P. And that trillion dollars of bonds
insured by Ambac will cause more write-downs and capital raises all down
the food chain.
In spite of ‘no
rate cut’ this week the Fed will likely claim inflation is now more of a
threat than recession and talk tough about mounting an aggressive fight
but in the end do nothing.
With a large amount
of cash on the sidelines and NYSE short interest at a record high as of
last week at 4.6% of all outstanding shares there is plenty of kindling
for a short-term bear market rally. The NYSE is currently at 17.65
billion shares short compared to the previous record of 16.43 billion on
May 30th. The last three days of a quarter and first four days are
generally bullish as retirement funds are deposited and put to work.
Lastly the Dow is only 102 points away from the March closing low---an
excellent place for a bullish rebound.
The bottom line is we could easily see a reaction
bounce higher this week as the Fed leaves rates alone and the shorts
scramble to cover their positions—but don’t be fooled—this is a bear
market and as soon as the rebound stalls the bears will pile back on and
it would be smart to be among them.
SOUNDS GOOD—SO HOW DO WE MAKE
MONEY ON IT?
We’ve got two plays this week—the first is bullish
and the second bearish.
Our bullish play is on a stock that is
outperforming the market like crazy and just blew away earnings
estimates by a whopping 240%! Fortunately the stock settled down a
little this past week providing an absolutely mouth-watering entry—a
situation we’ll be taking advantage of this week for what looks to be
some outstanding upside profits.
Our second play is bearish—it’s in the financial
sector and it’s on a company that couldn’t hit its earnings targets with
one hand from two inches away! The stock just made some amazingly
damning confessions recently and investors aren’t likely to forgive or
forget anytime soon. This is a solid short and should make us a
bundle—especially if we can catch a reaction bounce this week for an
even better entry.
We’ve got a wildly active market, a Fed meeting to
trade off of, and two super high-potential money makers—so let’s get
going…
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