Thursday, January 17, 2008

U.S. Stocks Drop on Merrill Loss, Decline in Philly Fed Index

Jan. 17 — U.S. stocks fell for a third day after the Federal Reserve said manufacturing in the Philadelphia region dropped to a six-year low and Merrill Lynch & Co. posted a loss that was double analysts’ estimates.

Merrill, the largest brokerage, slumped the most since September 2001 in New York Stock Exchange trading after writing down $16.7 billion in failed investments. All 10 industry groups in the Standard & Poor’s 500 Index decreased as Fed Chairman Ben S. Bernanke told Congress the outlook for economic growth has worsened. Monsanto Co. posted its steepest decline in almost five years after UBS AG recommended selling the shares.

The S&P 500, which is headed for its biggest three-day drop since 2002, lost 32.15, or 2.3 percent, to 1,341.05 at 2:42 p.m. in New York and is down 8.6 percent this year. The Dow Jones Industrial Average decreased 239.97, or 1.9 percent, to 12,226.19. The Nasdaq Composite Index slid 33.96, or 1.4 percent, to 2,360.63. Almost six stocks fell for every one that rose on the NYSE.

“The market clearly right now is fearing, and trading on the assumption, that there is a significant slowdown going on in the economy and probably a recession on the horizon,” said Dean Gulis, who helps manage $3 billion at Loomis Sayles & Co. in Bloomfield Hills, Michigan. “That’s what’s driving stocks.”

Approaching ‘Bear’ Market

Benchmark indexes are approaching so-called bear markets, or declines of at least 20 percent from highs. The S&P 500 and Dow average have both lost more than 14 percent from their Oct. 9 records, while the Nasdaq composite has tumbled 17 percent from an almost seven-year high on Oct. 31.

Manufacturing in the Philadelphia region contracted more than forecast in January, adding to evidence factories are cutting production as the economy slows. Builders broke ground on the fewest houses since 1991 in December, making last year’s decline in homebuilding the worst in almost three decades.

Merrill retreated $4.57, or 8.3 percent, to $50.52. Goldman Sachs Group Inc. lost $2.04 to $193.48. Bear Stearns Cos. decreased $4.74 to $74.31.

Merrill’s fourth-quarter net loss of $9.83 billion, or $12.01 a share, compared with a $4.82-a-share deficit forecast by analysts in a Bloomberg survey. The decline resulted in Merrill’s first full-year loss since 1989.

Financial companies in the S&P 500 have lost 10 percent as a group this year after tumbling 21 percent in 2007.

Bond Insurers Tumble

MBIA Inc. and Ambac Financial Group Inc., battered by losses from the collapse of the subprime mortgage market, fell the most ever today on concern they will lose their AAA credit ratings.

Ambac dropped as much as 65 percent and Armonk, New York- based MBIA fell as much as 38 percent. Moody’s and S&P said late yesterday they are reviewing the rankings the companies’ depend on to sell bond insurance.

MGIC Investment Corp., the largest U.S. mortgage insurer, declined $1.95, or 12 percent, to $13.82.

First Horizon National Corp., Tennessee’s biggest bank, plunged $2.70, or 14 percent, to $16.20, the third-steepest decline in the S&P 500 after Ambac and MBIA. First Horizon led regional banks stocks lower after posting a fourth-quarter loss and cutting its dividend.

Monsanto, the world’s biggest seed maker, tumbled $12.40, or 11 percent, $100.30. UBS initiated coverage of the shares with a “short-term sell” rating, saying the company could miss second-quarter earnings estimates as farmers plant more acres of soybeans and less of corn. Corn made up 33 percent of Monsanto’s revenue versus 11 percent for soybeans in the fiscal year ended in August, according to Bloomberg data.

‘Devil’s Arcade’

“Right now, this market is the Devil’s arcade,” said Michael Nasto, the senior trader at U.S. Global Investors Inc., which manages about $6 billion in San Antonio. “We’re looking at a possible recession with housing being the drag.”

The Philadelphia Federal Reserve Bank’s general economic index declined to minus 20.9, the lowest reading since October 2001, from minus 1.6 in December, the bank said today. Negative readings signal contraction. The index averaged 5.1 in 2007.

Housing starts decreased 14 percent to an annual rate of 1.006 million, the lowest since 1991, the Commerce Department said. For all of 2007, starts were down 25 percent, the biggest decline since 1980, to 1.354 million.

Lennar Corp., the biggest U.S. homebuilder, fell 38 cents, or 2.7 percent, to $13.87. Hovnanian Enterprises Inc., New Jersey’s biggest homebuilder, dropped 23 cents, or 3.5 percent, to $6.40.

Fed Watch

Bernanke said the Fed is not forecasting a recession for this year and a “temporary” fiscal stimulus would help the central bank to buttress economic growth, while warning against worsening the longer-term outlook for budget deficits.

“Fiscal action could be helpful in principle, as fiscal and monetary stimulus together may provide broader support for the economy than monetary policy actions alone,” Bernanke said in testimony to the House Budget Committee. He repeated remarks from last week that the Fed is ready to take “substantive additional action” to insure against risks of a recession.

Traders increased bets for a bigger interest-rate cut at the Fed’s meeting at the end of January. Fed funds futures trading indicates a 46 percent chance of a 0.75 percentage point reduction in the benchmark rate to 3.5 percent, up from 40 percent odds yesterday. The rest of the bets are for a 0.5 percentage point cut.

Harley-Davidson Inc., the biggest U.S. motorcycle maker, dropped $2.15 to $37.48. Analysts at Citigroup Inc. said slower U.S. sales growth may hurt earnings and downgraded the stock to “sell” from “hold.”

Where Do We Go From Here?

There has been a great reluctance to let go of the bull market. It’s understandable as we like to see increases, forward motion, and positive news. But, there are those times when one can search for the silver lining and only find the cloud. The macroeconomic outlook is not good, but it is not the end of the world. The market is dealing with the questions of how much will the Fed’s cut interest rates and whether or not we are going into a recession. From government officials to economists to fund managers to traders, everyone is split as to whether we are in a recession or just in a slow growth period? Will the Fed’s cut enough, are they too late, and are the Fed’s concerned more about economic growth or inflation? Does the market go up from here or do we have significant downside, because we’re already in a bear market?

As traders, the question is “What do we do now?” The answer is: we trade! It is certainly more challenging to trade in this type of market environment, but if one isn’t willing to wait it out, then one must be as prepared as possible. We prepare by doing fundamental research, keeping up with current news, and using our technical analysis. We must do our best to understand the environment in which we are trying to earn a living, regardless of our business. It may be difficult to have a successful tanning salon in the Sahara or a bikini shop in the Antarctic, for instance (not impossible, but difficult)! What we have in our environment is a financial crisis. When a financial crisis occurs, it can be dealt with in many ways. What makes it worse, or prolongs the problem, is a crisis in confidence. A lack of confidence in “the other guy”. That’s why people have been talking about the need for transparency concerning the balance sheets of financial institutions. It’s why we all shake our heads when our government officials come out with yet another “bail-out” plan that would make even a first year accounting major laugh. No confidence. Low interest rates are important, but let me ask a question. Pretend you are a bank, and the bank to bank lending rate was cut to 0.5%. ABC Bank wants to borrow from you, but his collateral is commercial paper that no one can really put a price on. How much are you willing to lend when you aren’t even sure whether his collateral is worth enough to cover the loan should he default? That’s why it was so ridiculous for any lender to lend more money to a home buyer than the home was worth. Could they get their money back if the borrower defaulted? When the borrower was required to have an adequate income-to-debt ratio and was required to put down 20% on a home, the bank had a better chance of recouping a larger part of their investment, should the borrower default. But, once all of those practices were tossed out the window, the banks took on huge risks. They tried to mitigate those risks by bundling those mortgages and selling them to investors, which would have worked out for everyone (and did for awhile) as long as the borrower kept paying and the underlying asset (the home) didn’t lose value. Now those underlying assets are losing value and no one knows how much lower they will go. For homeowners/consumers there is no more equity to be extracted and credit lines are maxing out. The fact is that American’s are drowning in debt, due to no-to-low wage growth and rising real expenses, and now they are defaulting on all those loans they’ve taken out. Many of those loans were in the form of second mortgages and credit card purchases. It’s time to pay the piper and the money just isn’t there.

We can’t forget the other “credit” factor affecting our markets, either. Margin, or borrowing to buy equities.

Alan Kohler at Businessspectator.com says:

“Housing is not the only asset against which banks have been making sub-prime loans, there’s shares as well.”

“After a long period of cheap money and an unusually long and very strong bull market in shares there is now a large but unknown amount of leverage in the share market and the derivatives connected to it. And shares are now doing what the housing market did – that is, falling.”

“Unlike shares, residential real estate is an illiquid market, so any price contagion is slow moving. Nevertheless rising delinquencies and foreclosures are driving US property values lower and creating a slow-moving, self-reinforcing downward spiral. In the very liquid stock market, this process is much faster and much more dangerous. Margin calls force highly leveraged investors to sell shares, driving prices lower quickly and sparking more margin calls. An avalanche can develop, as happened in October 1987.”

“The stock market is falling around the world as US banks confess to the bad loans they made against housing. But how many bad loans were made against shares? What about the leverage inherent in many stock market derivatives such as warrants and CFDs – to what extent will losses on these instruments cause defaults on others loans?”

The politicians and “news” anchors will be on TV speaking about an economic stimulus package. We’ll leave them to talk about tax cuts, interest rate freezes, etc. What is disheartening to hear from these people is that they think the consumer needs to spend, so whatever the government does, it needs to put money in the pockets of the people. I’m all for that, but it will help to pay that rising cost of living, and not to pay for more discretionary retail goods. The Federal Reserve can cut rates, but rate cuts will not restore the enormous amount of capital that has been lost by financial institutions and investors or help them with margin calls. Rate cuts will not pay the rising costs for our food and heating oil. Rate cuts will not restore the confidence which is necessary for our markets to function properly.

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