WEEKLY COMMENTARY - Sept 29 - Oct 3

THIS WEEK’S ISSUE:

• In-Play: $700 Billion Bailout – Deal Reached!
• In-Play: Short-Sellers Report Holdings
• In-Play: Citigroup (C) & Wells Fargo (WFC) Bid for Wachovia (WB)
• Market Commentary: DJIA, S&P 500
• Update: CBOE Volatility Index (VIX)
• Update: NYSE & NASDAQ Hew Highs-New Lows Index (NYHL, NAHL)
• This Week’s Economic & Earnings Reports

U.S. FUTURES (as of 6:15AM EST): DJIA (-1.61%), SPX (-1.80%), COMP (-1.99%)

IN-PLAY: $700 BILLION BAILOUT – DEAL REACHED!

It’s about time! On Sunday, Congress and the White House reached a tentative deal (still needing to be voted on) on the $700 billion bailout. To remind you of the times that we are living in, this bailout is the largest financial bailout in U.S. history. You will never forget this time in our financial history. The plan could provide $250 billion immediately, $100 billion if the president saw it necessary, and the last $350 billion subject to Congressional approval. This means that the full $700 billion may not come for a very long time and both the President and Congress may disapprove of the additional funding. In my opinion, Congress fully understands the implications of putting $700 billion in taxpayer’s funds at risk; therefore, the full amount will not be risked.

Still, $700 billion will not stall the inevitable recession we are about to face. Unemployment is projected to hit 7.5% by the end of 2009, housing prices have yet to stop declining (the root of the MBS/CDO problem), and consumer spending is further restricting. I view this as a compromise between furious taxpayers on Main Street who do not wish for a Wall Street bailout and the Federal Reserve and Treasury’s repeated warnings of “total failure” if action did not occur. A recession, or if you don’t believe we are in a recession – the stock market, cannot be “forced” to improve. This is a natural part of the business (market) cycle. The excesses of our incompetence and the last traces of hubris must be eliminated prior to making a full recovery. That is the nature of any market cycle.

Here are the key provisions of the bill:

• The bill would be disbursed in stages. The authority to use the money will expire on December 31, 2009.
• The assets would be bought at “market value”. I have a hard time believing this as market value for the most toxic real estate assets still cannot be determined. Taxpayers may breakeven or make a profit if the assets appreciate (housing prices must improve for that to happen). If the government overpays for the assets, resulting in a net loss, they may be able to recover the majority of the principal on the open market once they sell the securities.
• If a net loss is evident, the bill requires that the financial industry make up the difference. This will be determined in 5-years, after the bill is enacted.
• The Treasury will have the right to take ownership stakes in participating companies. The firms willing to participate are still to be determined. I and a friend on Wall Street (SB) believe that many of the financial firms will not need to want to participate in this program. Well-capitalized firms have little inceptive to participate.
• The government may purchase non-performing assets directly from banks, giving the government more flexibility in modifying the terms of the loans.
• The Financial Stability Oversight Board (FSOB)and a congressional oversight panel will be established to oversee the program. The FSOB will include the Federal Reserve Chairman, SEC Chairman, FHA Agency Director, HUD Secretary, and the Treasury Secretary. The congressional oversight panel will consist of 5 outside experts appointed by the House and Senate.
• The treasury will establish an insurance program to insure against losses. The risk-based premiums will be paid by the financial industry. This includes MBS’s purchased before March 14, 2008.

The House is expected to vote today and the Senate is expected to vote later this week, or as early as Tuesday.

You and I will patiently wait. If you don’t watch CNBC, this week will be a good time to turn on the tube.

IN-PLAY: SHORT-SELLERS REPORT HOLDINGS

Short-sellers, mainly hedge funds, will have to disclose their short positions to the SEC today. The holdings will reveal the number and value of securities sold short for each day of last week. Although the SEC has good intentions to fight naked short-selling, this presents several problems:

• Other short-sellers may follow and add positions that the funds already have in place. Although this does not apply to financial stocks, this will put pressure on stocks in other industry and sector groups. This could result in an artificial short squeeze for buyers who wish to bet against the funds.
• Hedge funds are most likely to shift their strategies. This presents a special problem for short-biased or short-only funds which have to disclose their entire strategy. With hedge funds providing 25% of the markets liquidity, this will cause a major disruption.
• This puts additional pressure on managers and their staff who must fill out a form that includes short positions placed in the beginning of the day, intraday short positions, and the number and value of the shorted securities at the end of the day.

This information will remain private for two weeks, after which it will be revealed to the public.

IN-PLAY: CITIGROUP (C) & WELLS FARGO (WFC) BID FOR WACHOVIA (WB)

Wachovia, the 6^th largest U.S. bank with $40 billion in deposits, is currently locked in a bidding war between Citigroup (C) and Wells Fargo (WF). If WB fails, this would be the 2^nd largest bank failure in U.S history, tied with Continental Illinois National Bank in 1984. This would mean that the top 3 largest bank failures in the U.S. would all have taken place in 2008. But, let’s not speculate.

The Federal Reserve and the Treasury are involved in facilitating the deal and both remain adamant about not providing public capital in guaranteeing WB’s assets or taking over WB, unless the company deteriorates more rapidly.

Shares were down 15% on Friday, after-hours. I don’t expect both Citigroup and Wells Fargo to pay close to WB’s closing price of $10 on Friday.

MARKET COMMENTARY -- INDU 11,143.13, SPX 1,213.01

There are two things that are important for this week: 1) the direction of the triangles that are forming in the market and 2) volume. Notice the symmetrical triangle in the DJIA and the ascending triangle in the S&P 500. Just because we made a higher short-term low does not mean we are out of the woods yet. Any breaks above of below the triangle’s boundaries should be considered.

Observe the volume since the short-selling ban occurred. This is amazing. Hedge funds make up over 25% of the trading volume in the markets and if you get rid of a primary aspect of their trading (in financials), then it is no surprise that the volume has completely dried up. A well-functioning and liquid market should see increasing volume, not volume that is cut more than half! Volume has increased on Thursday and Friday, however, they still remain at ‘average’ levels. This is very discouraging because trading activity has dried up to point where it has discouraged many participants in the market. If there is a rally, it cannot and will not be sustained with volume at these levels. Volume confirms price action – that’s a fact!

UPDATE: VOLATILITY INDEX (VIX)

I want to point out the significance of the VIX at the stage it's in. The VIX is actually consolidating in a high-and-tight flag pattern. If you check the past 3-years, you'll see that the VIX has never done this. This means that the fear is still at elevated levels and probably won't be coming back down anytime soon. This pattern indicates that a breakout higher should occur imminently. But, the bailout could change all of this and the flag pattern could breakdown, sending the VIX into the 20s, but I doubt it. Note any bounce off the 15-day MA.

The VIX is likely to hit the 40s again and stay there.

UPDATE: NYSE & NASDAQ NEW HIGHS-NEW LOWS INDEX (NYHL, NAHL)

What’s important here is that the NYSE and NASDAQ issues are still making new lows! In fact, we’ve continued to make new lows all last week while the short-ban was in effect. We did get a slight rebound as I mentioned in last week’s commentary, but it was only temporary. As the market consolidates in their respective triangle formations, we should see both NH-NL indices remain steady at this level; however, I do not expect many new highs to be hit. On Friday, only 9 new highs were made on the NYSE and NASDDAQ (total) and 263 new lows have been hit. This is a clear indication that the market will most likely make a new low.

Remain vigilant and be aware of any sudden changes in these two indices. The market cannot rally if the ratio between new highs and new lows is only 3%! Be a realist, not an optimist or pessimist, and make note of any increases or decreases in the number of issues making new highs or new lows this week.

THIS WEEK’S WATCH

• House and Senate vote results on the bailout package
• NYHL & NAHL indices
• VIX – possible breakout to the upside
• This week’s economic & earnings reports

Noteworthy Economic Reports: Mon. (Personal Income, Personal Spending, PCE Core – 8:30AM), Tues. (S&P/Case Schiller HPI, Consumer Confidence – 10:00AM, NAPM – 9:45AM, Weekly Retail Sales – 7:45AM), Wed. (Total Vehicle Sales, Weekly EIA Energy Inventory – 10:35AM, Weekly MBA Mortgage Applications – 7:00AM, Challenger Job Cuts – 7:30AM, ADP Employment Change – 8:15AM, ISM Manufacturing – 10:00AM, Construction Spending – 10:00AM), Thurs. (Initial Jobless Claims – 8:30AM, Factory Orders – 10:00AM, Monster Employment Index – 6:00AM), Fri. (Unemployment Rate - 8:30AM, ISM Non-Manufacturing Composite – 10:00AM).

Noteworthy Earnings Reports: Mon. (CC, SCS, WAG), Tues. (PBG), Wed. (BLUD, ATU, MU, ZZ, WWW), Thurs. (STZ, MAR), Fri. (FDO).

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