MP 5/29/08

Traders,

While we didn’t see big moves in the market yesterday – no doubt volatility played a part as oil rallied back up putting the squeeze on the market – until in the late trading session we saw the market recover. We are hovering back up towards resistance levels and looking (and almost needing) something to punch through and push this market higher – however it’s as if this economy is a rag doll being tossed from one side to another. If it is not oil, it is housing, if it is not housing, it is inflation, etc.

All investors and even those that are not in the market are taking notice to the daily economic news waiting with baited breath for something to happen. It is an interesting environment as consumers not in the market are starting to take notice of financial products like futures, commodities, metals, and inflation. Consumers are feeling the economic forces squeeze them (higher gas and food prices, the housing bubble, etc.) – they are starting to take notice. As the general election draws near we will probably hear more about the economy than anything else – because everyone is feeling it at some level.

For now – we wait and cling to each bit of data that befalls us ready to “knee jerk” as if that one piece of data is the confirmation that the worse is behind us or the next shoe to drop.

With uncertainty comes volatility.

______________________________________________
10 year bond yields climb – as inflation creates weak auctions

The 2 year note auction yesterday meet very weak demand as the government is trying to raise money (no doubt to justify the printing of billions of dollar – thus and added pressure of inflation). The $30 billion auction was tepid at best – and the weak auction also saw a decrease in the 10 year bond which rose to 4.05% (the highest since last year).

China had mentioned in Jan of 2007 that they would not be renewing up to $1 trillion in U.S. treasuries as they came due and several other countries have been following a similar course (but for different reasons). While Bernanke initially tried to serve two masters (the banks during the initial stages of the credit crisis and the economy) he moved slowly with 25 bps cuts – hoping not to create inflation (and scare away large foreign buyers of U.S. treasuries) while at the same time do his best to offer relief to the banks strapped for cash as overnight lending tighten. But the slow 25 bps cuts (one after another didn’t help) and he was faced the fork in the road – either cut rates hard and fast, pour money in the system, narrow the spread between discount and target, and allow investment banks to borrow at the discount window to keep banks from failing (thus not serving the economy or the dollar) OR not cut rates and let the banks sort themselves out and instead try to keep inflation at bay and strengthen the buying power (which is what the ECB did). We know his choice and the outcome has been an increase in inflation.

Currently there is no incentive for China or for that matter any nation to purchase large sums of U.S. treasuries – the reason is simple, why would you want to buy a financial product (treasury) were the underlying asset (the dollar) is losing value (via inflation) and for that assumed risk get only paid a paltry 2%? If the dollar is weak and getting weaker isn’t the whole function of interest rates is to off-set credit risk? Needless to say as long as the dollar remains weak and as long as interest rates are very low – there is really no incentive to buy them – not for foreign nations – but guess what not even for U.S. investors.

While the CPI (as you know I take with a grain of salt) is reporting inflation over 4%, why would you buy a interest rate product (2-year treasury) that is yielding 2-2.5%? At the end of the year – you actually lost money (via the loss of buying power). I would argue that the situation is much worse, because if we use pre 1990 methodology for CPI calculation we are running closer to 8% inflation – but that is just math.

Today the government is trying to raise $19 billion in the 5-year debt instrument – will it be as weak as the 2-year? Probably.

The dollar is seeing some strength in the early morning – but we are still way above that 1.30 mark against the Euro - which was a serious spot last year for the currency swap forwards.

The dollar needs strength and interest rates need to go up to attract investors to pay down the government debt – until then…..well…..

_______________________________________________
U.S. economy grew more than previously estimated

U.S. economy grew in the first quarter as the trade deficit shrank. The weak dollar has helped the trade deficit and several economist would argue that shows that the economy is strong – but I would argue that is only one piece of the puzzle. Ask the question, Why did the trade deficit shrink? and you quickly see that a very weak dollar is the reason. Is that a good thing? Some would argue yes and traditionally in a manufacturing and industrialized country it is great, but we have over the last several decades have become a consumer nation – we rely MORE on imports from energy (oil), food, even durable goods. And the weak dollar is a double edge sword.
While the trade deficit maybe good and several companies are doing very well – it does not mean a rosy picture for consumers – but rather just a result of a very weak dollar (and their unfortunate loss of buying power). Sure – some jobs maybe created as certain companies expand to meet overseas demand – but we are not that manufacturing country of yester-year where a boom in exports means jobs for everyone. We are a service / consumer nation.

I will take my observation one step further – those companies that are doing well with overseas sales (a decrease in the trade deficit) – take a look were they ACTUALLY manufacture their products! They maybe head-quartered in the U.S., but where are they doing their manufacturing? I would argue that politicians are right and there is something to cheer about with job creation – if you live in Mexico or many other nations that manufacture the products we sell. Apple maybe a U.S. company – but if you look at all the parts in a IPhone – you quickly realize that almost everything about it is built overseas.

Additionally – energy and fuel prices may squeeze growth growing forward, while we may not be in a recession (yet) – I think the National Bureau of Economic Research has a better definition (rather than having to be negative) – they define it as “contractions as a significant decrease in activity over a sustained period of time.”

No doubt expansion is slowing – but this report will be the discussion of talking heads all morning and I am sure both sides will be able to justify their belief that we are in a recession, heading into a recession, avoiding a recession, recovering, etc. For now it just academics.

________________________________________________
Sears reports an unexpected loss

As Wal-mart and Target have been gearing up for the slow-down offering all kinds of incentives and moving into other markets (pharmaceuticals and food) to off-set the retail demand – their older mentor Sears is stuck doing it the old school way. The largest U.S. department store chain reported a UNEXPECTED loss of $56 million (.43 a share). The problem with Sears is unlike Wal-mart and Target that have expanded their offerings or on deep discounters like Costco – they are squarely in the middle of the economic slowdown in the retail sector.
Costco, the biggest warehouse deep discount chain saw an increase in net income and a profit. People are becoming conscious buyers and looking for savings – Costco also offers bulk and a expanded product line beyond what traditional retailers like Sears offer.

While consumer confidence continues to fall (the lowest levels since 1992) and the housing decline looks to continue through 2008 – they still need food and the basic staples. Going to Sears to buy clothes and appliances is not something on their mind.

Sears did fall in early trading down to $86 (down $3 points) but for some reason it has rallied back to unchanged? Expect volatility in Sears – and the retail sector. Buying Sears at these levels is risky and the economy looks to be slow through 2008.

________________________________________________
Other News

Jobless claims are up this week.

Royal Bank of Canada’s profit dropped as they write-down more debt ($436 million C)

GM looking to revise their business model and cut truck and SUV production and look to build smaller “gas friendly” vehicles.

________________________________________________
Futures Pre-Open

The futures got hit going into the opening and is front running the cash by a couple of points, which will put pressure on the cash basket as Arb traders sell the basket at the opening.

________________________________________________
Support / Resistance

We saw a couple of indices get up to those resistance levels or close to it yesterday on a small move at the close, but they look like they are giving up strength if the pre-market futures are an indication. However – we don’t have a confirmation one way or another and are still range bound.

INDU 12400 / 12800 (As I mentioned yesterday the 12600 level – a previous very short-term support could be short-term resistance but is more of a pivot point than anything else. It is not a place to get long or short – but rather neutral with gamma. The index is waiting for news to “knee jerk” up or down and as long as we stay between 12400 and 12800 it is just a volatility band with no confirmation – rather we are a ship in irons flogging about.)

NDX 1950 / 2000 (We got a good jolt at the close to 2000 – but are we going higher – if AAPL and the brethren over weights push higher – it is a sure bet we will. But these stocks have had a significant rally already over the last couple months – will they push higher? For now 2000 is a place of short-term resistance – but with a couple ticks could be a support. Treat it as a pivot point. Futures are showing a pull back in the morning – watch the close.)

SPX 1380 / 1400 (we moved higher but are still short of the 1400 level we need to break through to give the broader 500 stocks the confirmation that we can go higher. As long as we stay between 1380 and 1400 – just expect whipsaw volatility.)

RUT 720 / 740 (We ALMOST got to 740 – just shy. Again – like with the INDU and SPX we need to get out of this band to get some confirmation – in the range expect volatility and “knee jerk” moves as news stories come out.)

____________________________________________________
Conclusion

We are just in this whipsaw range – people are waiting to hear the R-word and while we may NOT be in a recession in the 1st quarter and with the stimulus package in the 2nd quarter – we may not see a negative 2nd quarter. However, inflation is on everyone’s mind – and the CPI over 4% is causing concern (imagine if they went back to the pre-1990 method and saw inflation at 8%?). There is already talk among a couple of the Fed reserve members of a possible rate HIKE. However, that may just be talk – the rumors and option action in Lehman Brothers is indicating that the credit problem is still VERY REAL, add in another $500 million write down from Royal Bank of Canada – we are not close to resolving the problems.

The other issue is the renewed attacks on the Libor method – and I think changing any method such as Libor in the middle of a credit crisis could spell disaster – so many products are based off Libor. I am not saying it should not be looked at or even addressed – but let’s not panic and make some major change in some used to price the majority of the world’s debt instruments. Of course – politicians and regulatory bodies unspoken duty is to blame someone – so after they have chewed up the CEO of the Oil Companies they are not aiming their sites at Libor. Keep an eye on this story as it could be the center story on CNBC and Bloomberg in weeks to come.

Oil is coming off again this morning and we are seeing some big volatility up in these ranges as it has become the center of attention – the market will “knee jerk” to every tick in oil.