Weekly Research from September 2008

September 22, 2008

The market shook off a tremendous amount of negative news last week. We were looking for support at 1075-1175 and the market split the difference, bottoming on Thursday at 1133 alongside a 42.16 VIX reading. We expect the VIX will remain within a much higher band for the coming 4-6 weeks compared to the first half of 08.

Legislative rallies rarely do more than extend the inevitable. We have been saying the bottom is in process and the market will head higher following Yom Kippur. In the post-regulated world we have question whether 08’s absolute bottom was made last week. Over the weekend the short selling restriction and garbage pail debt entity were discussed ad nausea. There remains a great number of questions, however, its clear the Government is focused on accommodating markets.

On Friday, the SPX and DJIA rallied into their 50dma’s. The DJIA could run as high as 11,900 if it successfully shakes off sellers. If it fails and rolls over on volume, the market will make new lows. The SPX has 3.5-5.5% additional upside if it can continue upward through its 50dma to prior resistance at 1300-1325.

We expect more regional bank failures, as the Government will force weak hands to fold as part of its MBS rescue plan. Sellers will migrate to other hedging strategies, likely in the derivative/debt markets. Unintended consequences will likely create significant volatility and intra-week swings, creating plenty of opportunities to make money by sticking to discipline. Buy high scoring sectors and stocks and avoid companies with risky balance sheets and equity dilution risk. The Gov’t will support large cap financials at the expense of smaller players.

The U.S. equity market may become the only game in town as Treasury yields fail to support principal risk. Global money flows will continue to move into safe harbors as economies slow – benefiting U.S. markets.

Financials opened at their highs and traded lower through the day. A classic regulator inspired short squeeze prompted a narrow but significant market rally dominated by financials. Tech and healthcare lagged throughout the day. Entire prop shops sat Friday out. Going into quarter end, there is little incentive to game markets and a lot of incentive to protect risk.

In healthcare, increased U.S. insurance rolls benefit treatment related stocks. Cost containment continues to support healthcare IT spending. Own healthcare and use sell-offs to add to positions.

In basics, focus on natural gas. Nat gas stocks benefit from utility builds ahead of winter and oversold conditions. On Friday, natural gas stocks were one of the few baskets to trade higher throughout the day rather than open on highs and base.

In technology, build semiconductor positions on down days. They remain oversold and offer upside. Outside of semi’s, stay stock-by-stock using our daily best and worst lists.


September 15, 2008

The market has yet to reach levels consistent with max fear despite wrestling last week with the failure of FNM and FRE, the imminent failure of LEH and the forced sale of MER.

An actionable low is likely in the coming 3-4 weeks. Such a low could cut below the July low (SPX support at 1175 and 1075) and coincide with a +30 VIX. We began to see fear enter markets this week on rising volumes. The VIX has moved from 20 to 25 since August 28th yet remains too complacent.

Healthcare stocks remain top scoring in large and mid cap universes. As elections near, investors digest impacts of each candidate. Under both candidates, more Americans will be covered by insurance, boosting demand for treatment. In the past, healthcare returns outpace the S&P 500 from August through the following December. Use down days to add to leaders.

MER’s self-financed CDO sale upped write-downs, adding pressure to Level 3 assets; which in some stocks exceed market caps. A failure of LEH, and de facto failure of MER, triggers further losses and dominoes through the finance sector (ex. AIG, MS, JPM, GS, WB). Financials have climbed in our rankings as stock-by-stock names have improved and climbed the wall of worry. Investors will embrace legacy leaders post non-Fed supported failures. Avoid the temptation to bottom-fish oversold at-risk brokers/banks and remain focused on owning top scoring leaders. We expect more regional bank failures due to increasing consumer and commercial default rates. We’ll watch small cap financial scores closely and keep you updated.

Consumer staples stocks are rallying as investors rotate toward defensive baskets, retail prices remain elevated and input costs shrink. Retail has been improving despite consumer weakness. Top performers this year include WMT, BKE, ARO and URBN. The IndexMetrix Specialty Apparel Index is up 6.71% this year; the RTH is up 5.28%. Since June, the Specialty Apparel Index has moved up 15.62%, the RTH has gained 10.82%. The best YTD performers in the Specialty Apparel Index: PLCE, ROST, GYMB, URBN, ARO. Since June, JNY and MW have performed best. Use weakness over the coming weeks to build positions in leaders. Post Ike, consider the rebuilding demands impact on LOW (131 TX stores), FAST (148 Texas stores) and HD (176 Texas stores).

The XLK has traded to new 2008 closing lows this week. The SMH has also undercut ’08 lows. Techs continue to endure EPS pressure on worries of global economic contraction. An actionable low in the coming weeks presents an opportunity to buy tech on sale. Compile your wish list and target prices and wait for the bottom to be firmly in place.

The Dollar strength and commodity fund withdrawals have pushed basics down sharply this quarter. The Dollar (UUP) moved from $22.10 to a high of $24.83 this week, before retreating on Friday. Most commodities remain under pressure and are due for a bounce. Sellers will likely meet rallies into support while Dollar bulls will only step aside for a brief period while the Dollar digests recent gains. Nat gas is the only commodity basket we’re currently recommending long.


September 15, 2008

The market has yet to reach levels consistent with max fear despite wrestling last week with the failure of FNM and FRE, the imminent failure of LEH and the forced sale of MER.

An actionable low is likely in the coming 3-4 weeks. Such a low could cut below the July low (SPX support at 1175 and 1075) and coincide with a +30 VIX. We began to see fear enter markets this week on rising volumes. The VIX has moved from 20 to 25 since August 28th yet remains too complacent.

Healthcare stocks remain top scoring in large and mid cap universes. As elections near, investors digest impacts of each candidate. Under both candidates, more Americans will be covered by insurance, boosting demand for treatment. In the past, healthcare returns outpace the S&P 500 from August through the following December. Use down days to add to leaders.

MER’s self-financed CDO sale upped write-downs, adding pressure to Level 3 assets; which in some stocks exceed market caps. A failure of LEH, and de facto failure of MER, triggers further losses and dominoes through the finance sector (ex. AIG, MS, JPM, GS, WB). Financials have climbed in our rankings as stock-by-stock names have improved and climbed the wall of worry. Investors will embrace legacy leaders post non-Fed supported failures. Avoid the temptation to bottom-fish oversold at-risk brokers/banks and remain focused on owning top scoring leaders. We expect more regional bank failures due to increasing consumer and commercial default rates. We’ll watch small cap financial scores closely and keep you updated.

Consumer staples stocks are rallying as investors rotate toward defensive baskets, retail prices remain elevated and input costs shrink. Retail has been improving despite consumer weakness. Top performers this year include WMT, BKE, ARO and URBN. The IndexMetrix Specialty Apparel Index is up 6.71% this year; the RTH is up 5.28%. Since June, the Specialty Apparel Index has moved up 15.62%, the RTH has gained 10.82%. The best YTD performers in the Specialty Apparel Index: PLCE, ROST, GYMB, URBN, ARO. Since June, JNY and MW have performed best. Use weakness over the coming weeks to build positions in leaders. Post Ike, consider the rebuilding demands impact on LOW (131 TX stores), FAST (148 Texas stores) and HD (176 Texas stores).

The XLK has traded to new 2008 closing lows this week. The SMH has also undercut ’08 lows. Techs continue to endure EPS pressure on worries of global economic contraction. An actionable low in the coming weeks presents an opportunity to buy tech on sale. Compile your wish list and target prices and wait for the bottom to be firmly in place.

The Dollar strength and commodity fund withdrawals have pushed basics down sharply this quarter. The Dollar (UUP) moved from $22.10 to a high of $24.83 this week, before retreating on Friday. Most commodities remain under pressure and are due for a bounce. Sellers will likely meet rallies into support while Dollar bulls will only step aside for a brief period while the Dollar digests recent gains. Nat gas is the only commodity basket we’re currently recommending long.

September 8, 2008

The Treasury will buy $5bn of MBS in the next month as part of its nationalization program of FNM and FRE. The Treasury gets a 10% coupon on $1 bn (each) of preferred and warrants valuing the companies at less than $1 per share. If liabilities exceed assets quarterly, the Treasury will inject up to $100bn (each) in exchange for add’l senior preferred. Clearly, FNM and FRE were facing insolvency, caught between impossible to finance mandates, asset devaluation and sketchy reserve accounting. The MBS market should unlock helping stabilize related valuations. Job loss becomes the next hurdle in stabilizing housing. While fees will shrink and rates drop, borrowers still face strict lending requirements. Further job loss will pressure house values and continue to impair valuations. Clearly, “too big to fail” has helped major finance plays, while small players have been allowed to collapse (re. Silver State this weekend). The boycott threatened by debt buyers is, for now, a memory. We worry; however, about regulator inspired bottoms and question whether the natural selection process of washing out the markets will be pre-empted, similar to regulatory bottoms previously in 08. The market failed to reach levels of max fear and without such fear, represented in this case by VIX, markets still have a lot to prove. Meanwhile, another valve on the liquidity spigot has been opened, as short term funding (LIBOR + 50bps) will also be made available to the 2nd largest U.S. borrower: Federal Home Loan Banks. The Treasury doesn’t want to be in the mortgage business, as evidenced by requiring FNM and FRE to keep mortgage holdings to less than $850bn by the end of 09 and to cut holdings by 10% annually until assets reach $250 billion. They hold $1.58 trn in mortgages, up from $136 bn in 1990. Who will step in to buy these assets remains a mystery, but likely the Treasury is counting on its guarantee enticing foreign investment. Foreigners held $1.3 trillion, or 21.4%, of GSE long-term debt as of the middle of last year (U.S. Treasury) with China owning over $300bn.

The failure of Silver Lake (Nevada), the 11th bank to fail this year, continues to point to risk in states which enjoyed robust development this decade. Mortgages in California, Florida, Arizona, and Nevada accounted for 47% of Fannie’s credit losses in Q2 and 65% of FRE’s losses.

We’re only one step into forming the actionable bottom we expect to see in the coming weeks.

As you know from our comments, we like to track volume alongside price. Volume surges on down days do little to encourage embracing risk.

We fell sharply across just about every basket last week. However, capitulation requires bigger volumes and more put buying. The VIX, which has done an excellent job in helping folks figure out when investors are panicked, still doesn’t reflect max fear.

In fact, a study of past 3% daily declines on the SPX this decade shows 30-day returns following the sell-off are essentially flat when unaccompanied by a +30 VIX. When the VIX does confirm above 30, the return jumps to ~6.5%. Clearly, the market rewards risk when fear is maxxed out – and we argue we’re not there yet. We don’t deny regulator inspired risk will force short sellers to cover. We do, however, question whether a short squeeze will be anything more than an opportunity for mutual and hedge funds to sell into strength to meet redemptions.

Healthcare stocks, one of the only baskets attractive to both technical and fundamental clients, sold off this past week, providing an opportunity to add to leaders. This high scoring basket continues to have its share of 2008 ups and downs, however, the discounts built into them in Q1 and Q2 point toward profits through December 09- in line with historical returns from Election Year August’s through the following year. Pharma is the latest basket to join in on positive Healthcare seasonality. Use sell-offs to up positions.

Financials shrugged off a lot of the pain this week (the XLF finished up on the week) ahead of the Treasury’s busy weekend. Broker eps kicks off this month and post MER firesale level 3 valuations will be a topic of discussion (albeit far less of one given the FNM/FRE bailout). Writedown risk is arguably priced into bank valuations and any retest of prior lows in financials will likely be tied to loan demand destruction and defaults caused by job loss and declining personal income. So far in 08, small cap finance has been a safe spot. Given the willingness of Government to bail out big caps and let small caps fold, we may see a shift in investors willingness to support smaller regionals. Watch scores closely for any declines. More aggressive investors can begin to traffic in larger cap financials, stock-by-stock, strongest scoring only.

Technology stocks bore the brunt of selling this week with the XLK down 5.4% and the SMH down 7%. Investors are increasingly pulling money out of foreign markets (Russia had to stabilize the Ruble last week), including domestic multinationals such as big cap tech stocks. As a result, money from tech has flowed to Treasuries (the TLT gained 1.7% last week). Our expectations remain for an actionable low in the coming 4-5 weeks, providing significant upside. Volumes to support a sustainable run are most likely to come by mid October, following Yom Kippur.

The basics continue to weaken under the weight of global slowdown. The USO broke down through its 200dma on rising volumes. The IYM put in a new 2008 low. The UNG traded slightly higher despite market weakness, reversing early day losses on both Wed and Thursday. We continue to recommend buying natural gas only at this stage, preferring to wait for additional conviction in underlying commodities before re-embracing producers and related suppliers.

Services, specifically retailers, tend to put in actionable entry points in September. Use mid to late month to begin acquiring leading retailers for upside through next February.



September 1, 2008

Healthcare, industrials and tech score highest across our entire universe. Services, Financials and consumer are weakest.

Sectors offer solid seasonality across the board in the 3 months beginning August 31 and ending November 30th. Conglomerates, Ute’s and Financials have done the best in this coming 3-month span over the past 5 years.

An actionable low is likely in the coming 4-6 weeks. The July low, sparked by regulation and a +30 VIX, failed to offer follow through in August. Financials, which bounced sharply in July, lost ground this month. Historically, Q3 is the most troublesome quarter for the markets. As we move into October/November, historical seasonality begins to reward buyers of risk in September/October. Watch closely for pullbacks. Compile a list of favorite names and entry points.

Q4 and Q1 traditionally reward September buyers of retail. Use sell-offs in the next 4-weeks to build positions in leading retailers.

Pharmaceuticals become the next healthcare industry to move into seasonal strength, kicking off a multi month run beginning early September. Political risk is historically priced into healthcare stocks in the first half of Election Years. In the past 5 Presidential Election Years, a basket of widely traded large cap healthcare stocks outperformed the SPX in 4 of the periods beginning Aug 31 and ending the following year. Use political inspired volatility to build positions in healthcare.

Tech remained hit-and-miss most of the quarter with a narrow basket of stocks accounting for the bulk of returns. As we move into September, however, we should be presented with opportunities to be rewarded for buying by the time we close November.

Purchases rose 0.2% in July, down from 0.6% in June. Services spending was unchanged. Inflation adjusted spending fell 0.4%. Inflation adjusted disposable income fell 1.1% marking back-to-back declines (June fell –1.9%).

The 4-week moving average of jobless claims is 440,250, up from 324,750 YoY. There are 1.6mn more unemployed people YoY.

Personal Income fell 0.7%, the first fall since August 05 (est. were -0.2).

PCE rose 2.4%.

The basics remain under pressure as global GDP risk contagion spreads. Typically, nat gas rises through November from the end of August. Hurricane risk has moved the basket in the past week adding some speculators. Use their unwinding to buy. The DBA has yet to support owning risk in ag supply. Remain on the sidelines until the DBA re-exerts itself. Coal stocks depend on Australia price strength. U.S. spot prices peaked for No Appalachian coal on August 1st. Watch for price stability and improvement and own top scoring coal stocks only.

India’s economy grew 7.9% in Q2, the slowest since 04, down from 8.8% in Q1. India inflation has tripled to 12.4%.

The TLT has risen from $90 to $94 in August.

The VIX remains overly