Market Commentary - 7.13.2008

July 13, 2008

How low can they go? We’re speaking, of course, about Fannie Mae and Freddie Mac, the two quasi-public government “sponsored” mortgage companies which saw both their stock prices dive into the single digits this week on worries they are undercapitalized and might need a government (taxpayer) bailout sooner rather than later. If you thought the Bear Stearns debacle was scary, consider that these two companies combined either own or guarantee nearly half of the $11 Trillion of outstanding US mortgages, and they are only required to hold $70 Billion in “core” capital, which is significantly less stringent than is required of commercial or investment banks. In addition, because of the 100+ mortgage lenders that have gone out of business over the last year, these firms are being relied on more and more as they accounted for over 81% of home loan securitizations in the first quarter. As you can see, just since May 30th, the stocks of Fannie (top) and Freddie (bottom) have lost 63% and 71%:

Of course, that wasn’t the only excitement for the week. It looks like the action in Lehman Brothers is shaping up eerily similar to what happened to Bear Stearns – market rumors that counterparties have suspended trading with them, the share price plunging on extremely heavy volume, and an explosion in put option activity, and all the while company executives continuing to state that everything is fine and blaming it all on short-sellers. The stock is now at the lowest level since 1999, and as we saw with Bear in March it doesn’t matter whether they are “well-capitalized” or not – if funds start getting really spooked and withdrawing cash, this could create a run on the bank that could wipe Lehman out overnight.

There was some good news earlier in the week for US equities, however, as commodity prices plunged on Tuesday and Wednesday and investors were hopeful this marked the beginning of the “bubble” bursting. Stocks failed to sustain any sort of rally and the good feeling didn’t last as crude oil prices set another record high on Friday. The government is spending an awful lot of time trying to figure out who’s to “blame” for oil prices, yet they refuse to look in the mirror and realize the main cause is all of their own actions with regard to economic, fiscal, and energy policy, in addition to the fact that investors need to find another avenue to park their cash and hedge against inflation since stocks are certainly not the best asset class these days.

For the week, the Dow and S&P 500 both set new intra-day and closing lows for this bear market, and the Nasdaq and Russell 2000 are still down-trending, but showing relative strength as they manage to hold above the March lows. Volatility continued to pick up and the VIX saw a spike up near 30 on Friday – each time we have seen a spike like this it has signaled a medium-term bottom. However we are still well below the volatility levels seen back in January and March:

Friday saw some wild market action as the broader markets gapped down at the open and the Dow was off 250 points by midday and dipped under 11,000 while the S&P 500 touched 1225 which is the low from 2006. After rumors started spreading that the Fed was considering opening the discount window to Fannie and Freddie, and the administration was working on a bailout package, the market staged a stunning rally to get into positive territory. However, the relief rally didn’t last as the Dow still finished down triple digits and the S&P finished just under recent support of 1240.

If you thought last week was exciting, just wait until this week. There will be continued rumor and speculation about Fannie, Freddie, and Lehman, earnings season kicks into high gear with a lot of important companies reporting, there is a wealth of economic data coming out, and it’s options expiration week to top it off. Not to mention that on Friday after the close IndyMac Bank was taken over by federal regulators – this is the 2nd largest financial institution to fail in US history.

In the short term there could be some sharp and quick rallies but we expect the downtrend to continue - we are nearing some key support levels though – on the S&P 500 the intermediate term bottom level we are eyeing is 1170 and on the Dow 11700. Volume has picked up significantly since the start of the downtrend, just as it did in January and March of this year, and there have been some signs that buyers are lurking and ready to pounce on beaten down shares. If the VIX gets over 30 and the indices get near their support levels we would look to pick up some index calls on the IWM (Russell 2000 ETF) since small caps have shown the most relative strength this year.

Earnings

2nd quarter reporting season really gets into full swing this week, as the spotlight will certainly be on financial institutions. While the market has been trading on speculation and rumors around the viability of Fannie Mae, Freddie Mac, and Lehman Brothers, the focus will shift to hard data from Merrill Lynch, JP Morgan, and Citigroup. Technology and Biotech have shown relative strength lately, and both of those sectors will be well represented this week with bellwethers giving investors plenty to digest.

MONDAY – Genentech (DNA), M&T Bank (MTB)

TUESDAY – CSX Corp (CSX), Intel (INTC), JB Hunt (JBHT), Johnson & Johnson (JNJ), Seagate Technology (STX), State Street (STT), US Bancorp (USB), VF Corp (VFC)

WEDNESDAY – Abbott Labs (ABT), Alliance Data (ADS), AMR Corp (AMR), Crown Holdings (CCK), Delta Airlines (DAL), eBay (EBAY), Gannett Co (GCI), Kinder Morgan Energy Partners (KMP), Northern Trust (NTRS), St Jude Medical (STJ), Wells Fargo (WFC), Yum Brands (YUM)

THURSDAY – Advanced Micro Devices (AMP), Bank of New York Mellon (BK), Baxter International (BAX), BB&T Corp (BBT), BlackRock (BLK), Capital One Financial (COF), Gilead Sciences (GILD), Google (GOOG), Harley Davidson (HOG), Illinois Tool Works (ITW), IBM, International Game Technology (IGT), Johnson Controls (JCI), JP Morgan Chase (JPM), Merrill Lynch (MER), Microsoft (MSFT), Nokia (NOK), Novartis (NVS), Nucor (NUE), PNC Financial Services (PNC), Safeway Stores (SWY), Stryker Corp (SYK), TD Ameritrade (AMTD), Coca-Cola (KO), United Technology (UTX)

FRIDAY – Citigroup (C), Honeywell (HON), Manpower (MAN), Mattel (MAT), Schlumberger (SLB), Wipro Limited (WIT)

Economic Data

A whole bunch of data packed into 3 days of reporting this week, as the focus will be on inflation and retail sales. Even with the recent pullback in commodities, food and energy inflation show no signs of abating. While the Fed prefers to look at only “core” inflation, the average American spends a large portion of their incomes on gas, electricity, and food, so while the Fed is hopeful that inflation pressures will ease later this year that will not help the consumer anytime soon. As we saw from retail sales data last week, other than discount retailers like Wal-Mart, Costco, Sam’s Club, etc. the stimulus checks are not being spent on things people want, but rather just on the necessities and only where there are bargains to be had.

TUESDAY – Producer Price Inflation (PPI), NY Empire Manufacturing Index, Retail Sales, Business Inventories

WEDNESDAY – Consumer Price Inflation (CPI), Crude Inventories, Capacity Utilization, Industrial Production, 6/25 FOMC Minutes, Net Foreign Purchases

THURSDAY – Building Permits, Housing Starts, Weekly Unemployment Claims, Philadelphia Fed Outlook Survey

Strategy/Outlook

We expect the next few weeks to continue to be extremely volatile and choppy, with large intra-day swings. As the past few weeks of trading have been based more on technicals, rumors, and sentiment, the next few weeks will be focused on earnings quality, economic data, and some sort of resolution to the Fannie/Freddie crisis.

We believe a short term bottom could be coming in the next couple of weeks – volume has started to pick up, as has volatility, and there is a lot of cash on the sidelines waiting to be deployed. It will all depend on the reaction to earnings and inflation data – the big key will be bank earnings and how much investors are convinced that the worst is behind us as far as write-downs and negative surprises down the road.

As you can see below, by Monday morning we expect to be out of just about all of our open positions, so we will slowly start adding August/September option positions but would rather not overtrade during expiration week as there is always a lot of noise.