McMillan Letter

By: Mark McMillan | Wed, Dec 24, 2008
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12/24/2008 10:35:49 AM

This week, we take a look at featured short subjects. That is followed by our Market Outlook and ties off with our conclusion. As always, reader feedback is encouraged.

Home loans at lowest rate in nearly 50 years
Home loans have dipped to a nearly fifty year low with 30-year fixed rates dropping to an average of 5.19% on last Thursday (provided by Freddie Mac). 15-year fixed rates are below 5.0%. These rates don't include the average 0.7% in points charged for the loans.

In addition to actual loans going out for near 5% for 30-year loans, the government is considering having Freddie Mac and Fannie Mae offer 4.5% 30-year fixed rate loans. That will further ease the burden on homeowners who are stretched to make their housing payments. Even Adjustable Rate Mortgages have seen their rates drop to rock bottom as the Fed decreased the Fed Funds rate to between 0% to 0.25% and the prime rate followed it down.

In point of fact, this is good news for an eventual economic recovery. This won't create huge demand yet, even though with home prices down and mortgage rates also down, buyers can more easily qualify for a loan and perhaps more house than they otherwise might have. Hopefully, buyers have learned the peril of using adjustable rate mortgages, as mortgage rates can't fall far from here, and they will begin to move higher when the economy begins to pick up and inflation threatens to steal the show.

Fed Policy
The Fed (Federal Reserve Bank) released its policy statement on Tuesday, December 16th and it was a doozy. The dropped the Fed Funds rate to between 0% and 0.25%. In a related move, the Fed cut the amount it is paying on reserves to 0.25%. In another related move, the discount rate was cut to 0.50%.

The odds were 11% for a Fed Funds rate cut to 0.0% but the most likely cut expected was to 0.50%. The use of a target range rather than a target value was unexpected.

The Fed couldn't actually control the Fed Funds rate so they moved the target to the range it is currently trading in anyway (between 0.0% and 0.15%). The vast sums flowing in from Freddie Mac and Fannie Mae have caused such a surplus that the Fed can't maintain the rate at the 1% target they had set.

The Fed maintains a trading desk. The personnel working the trading desk have a responsibility to ensure that the Fed Funds rate trades at/near a target level. That target level may or may not be the announced Fed Funds rate target. The Fed Funds rate is the target for the rate that the Fed charges banks on overnight lending of funds. The effective Fed Funds rate is the rate that banks actually pay.

Why wouldn't the Fed Funds rate be the same as the target it set? As alluded to earlier, the Fed may have a different target than the announced Fed Funds rate. Assuming that the Fed trading desk is actually targeting the announced Fed Funds rate, what would cause the rate to vary from the target?

The Fed Funds rate is actually derived by trading activity where Federal reserve banks offer overnight loans and banks bid for those funds. If there is insufficient funds in the system to meet the demand for those funds the Fed has to either place additional funds into the system such that supply meets demand or they have to allow the rate to be bid up to where supply will meet demand. In the opposite case, if there is an oversupply of funds in the system, the Fed must reduce the level of those funds or the effective rate will fall. With so much money in the system from Fannie Mae and Freddie Mac, the Fed can not soak up the supply and rates were trading below the target.

Freddie Mac and Fannie Mae are not enticed by the Fed's offer to pay interest on deposits equivalent to the Fed Fund target rate as they are not legally allowed to be paid interest by the Fed on their deposits. The Fed needed to have intermediaries step in to buy the deposits from Fannie Mae and Freddie Mac to remove these funds from the system so they could support the target rate, but haven't been able to put such a large entity together as Fannie Mae and Freddie Mac account for roughly 40% of the funds in the Fed system.

The Fed hasn't yet decided to create another bubble. That bubble would occur in U.S. long term government securities. If the Fed decides to begin buying up the supply of these instruments, it will have to bid prices ever higher and yields ever lower. This is a crowded trade as many of the banks and funds have purchased these in advance with the media claiming it is a flight to quality. In reality, this is a trade betting that the Fed will have to purchase these assets and prices will be propelled higher. If the Fed can resist these purchases, this bubble will be burst before it gets too painful, but yields are already at multi-decade lows.

Financial Bellwether
I have been using Bank of America (BAC) as a bellwether for financial stocks. BofA fell $1.13 for the week to $13.80. Confidence doesn't yet exist that financials are ready to move higher but money is being positioned to take advantage of this possibility. If the TED Spread continues to move lower, I believe that financials will rotate back into favor and will eventually lead the markets higher. There is a lot of fear that financials will enter a prolonged period of poor performance.

I don't dispute that there is still more work to be done to repair damage from home loans gone bad, credit card delinquencies, etc., but the large banks are already discounted significantly. They can certainly move lower, but the question is whether they have weathered the worst of the storm, whether they will survive the difficult times, and how they will perform when they come out the other end.

The current environment is such that the stronger banks and other financial institutions will grow larger as they digest failed banks. The main things required to survive are sufficient cash deposits without significant leveraged liabilities. The large banks have significant reserves and have grown by swallowing up other large financial institutions at bargain prices. Bear Stearns, Merrill Lynch, Countrywide, and Wachovia have all been swallowed up by surviving large banks. It is those assets that will eventually contribute to outperformance by the survivors.

Market Outlook
I made it through the first week of the seasonal effect known as the Santa Claus rally. This appears to have provided impetus for an upward move but has, thus far, only resulted in a sideways move. There are another two weeks of Santa Claus rally left, but the coming week is a holiday shortened week, as is the week of New Year's Day.

Examining earnings results and outlooks I see a mixed bag. While the majority of companies are removing guidance, lowering guidance, or providing in-line guidance, there are a minority of companies that are raising guidance.

The automakers are receiving a bailout from the Federal government to attempt to adjust capacity to demand. With the precipitous drop in oil prices, they will likely be able to sell the gas guzzlers they have emphasized for years, even as some forward planning provides more fuel efficient vehicles down the line. With the significant drop in demand for new vehicles there will be fallout for workers on the payrolls of the big three as well as the numerous companies that provide them with parts. Much of this is already priced into the market.

Let's look at interbank lending rates which have dropped significantly in the last week.

The TED Spread fell thirty-three basis points since last Friday, closing at 1.58. I had been waiting for the TED Spread to drop below 1.80 and it has finally occurred. The Fed's attempts to get credit flowing again are meeting with success. More money will come off the sidelines to propel equities higher when the Spread moves below the lower uptrend line.

The importance of the TED Spread isn't a secret and the smart money watches it all the time as a barometer of the health of the credit markets. I will continue to cover it until the credit crisis has subsided and a sufficient thaw has occurred in credit markets that I can focus on the early stages of an expansion, rather than worries about a contraction.

For the week, the yield on the 10-year note collapsed forty-six basis points to close at 2.13%. The media has suggested this represents a flight to quality. I believe it is simply front running the Fed.

Last week the near term futures contract for a barrel of oil collapsed 27% to close at $33.87. This is the lowest price in five years.

I believe that the rally seen since the low before Thanksgiving will fail in the short term and I are looking for a test of the bottom to occur. Given the sideways moving during the seasonally strong Santa Claus rally, the odds have shifted to an earlier retest of the lows, rather than a further move upward into January.

Let's take a look at all the daily charts and offer comments on them as a group. First, let's take a look at the QQQQs (NASDAQ:QQQQ), as they are the ETF that mimics the NASDAQ-100.

The NASDAQ is in the lead, either up or down, for the major indexes. The NASDAQ-100, as modeled by the QQQQs, have traded mostly sideways through the week coming down from resistance and are training between a supporting uptrend and horizontal resistance. A break outside of either of these constraints is coming by the beginning of the New Year which will see a more dramatic move take place.

I would look for a break below the 20-day or the uptrend line or a break above the horizontal resistance to cause more money to come off the sidelines to try to chase a trade up or down.

Next, let's take a look at the DIAmonds (Amex:DIA), as they are the ETF that mimics the Dow Jones Industrial Average.

The DIAmonds have the same sort of important support and resistance levels as the QQQQs, so we are looking at a similar scenario.

Let's take a look at the chart of SPYders (Amex:SPY) since they mimic the S&P-500.

The SPYders are mimicking the other indexes with the same sort of move projected.

The week in Review - Events & Fundamentals:

Monday, December 15th:
There were four economic reports of interest released:

All the reports were released before the open and weren't major movers, although they contributed to a positive open.

Most of the day's mood was contributed by the lack of details about plans by the White House to aid the struggling Big Three auto makers.

The alleged fraud perpetrated by the Madoff fund is apparently having widespread ramifications among many of the financial elite. Madoff apparently had $17B under management but losses to investors are projected to be $50B. How this is possible is unclear, but it is apparent that there was little/no oversight of the actual performance of Madoff investments with the accountant being obscure and difficult to locate.

The dollar fell as currency traders rotated out of it due to an imminent rate cut by the Fed when they release their policy statement at 2:15pm EST Tuesday. Projections are for a rate cut of fifty basis points to 0.50%.

The fall in the dollar prompted a rally in dollar denominated commodities, including oil and metals. However, oil, which had been up nearly 9% during trading, actually closed lower. OPEC is expected to cut production by two million barrels per day which would more align supply to demand.

Financials were hit hard as Morgan Stanley (MS) and Goldman Sachs (GS) sold off as they will release earnings results which are expected to show significant losses. In addition, Meryll Lynch downgraded JP Morgan Chase (JPM) due to exposure to lending markets. Bank of America (BAC) fell in sympathy to JPM.

Tuesday, December 16th:
There were four economic reports of interest released:

All the reports were released an hour before the open. Building permits for October were revised from 708K to 730K, but housing starts were revised from 791K to 71K. These reports were largely ignored while investors awaited the Fed's release of its policy statement and a half point reduction of the Fed Funds rate. Dutifully, the Fed released it's policy statement at 2:15 with a seventy-five to one hundred basis point cut to have the Fed Funds rate trade in a 0.0% to 0.25% interest range.

In point of fact, the Fed Funds rate has been trading in the range that the Fed lowered rates to, and there was little the Fed could do to control that rate at this time, due to the amount of liquidity they pumped into the system to keep Fannie Mae (FNM) and Freddie Mac (FRE) afloat. That in turn left the spigot open for them to place funds in the system which drove rates down to the current range.

The Fed has pulled out the stops in an effort to provide a stimulus to the economy in light of data that indicates the economy is in recession. A weak economy and a further drop in interest rates caused the dollar to weaken dropping 1.9% on Tuesday.

The widespread nature of the alleged fraud perpetrated by Bernard Madoff underlined a lack of appropriate regulation and oversight of the financial services system. Madoff apparently "cooked his books" and even advisors that recommended his fund are being investigated due to the steep commissions it paid to bring clients under management.

Earnings were announced by Goldman Sachs (GS $76.00 +$9.54) and they were worse than the consensus estimate. The stock had fallen in value for the previous five sessions so apparently that news was priced in. Best Buy (BBY $27.68 +$4.21) reaffirmed its 2009 guidance and reported better than expected income. General Electric (GE $17.92 +$0.92) reaffirmed its outlook for FY2008 and maintained its dividend but indicated it would no longer provide quarterly guidance.

Financials led the markets higher illustrated by GS rally cited earlier. The rally was huge as the likes of Morgan Stanley rose 18% during the session even through MS announces earning on Wednesday. Bank of America (BAC $15.10 +$0.99) is the bellwether for the sector and rose 7%.

Wednesday, December 17th:
There were now economic reports of interest released. Instead, there was essentially a lack of sector leadership. Tech (-1.7%) and financials (-1.3%) shared the spotlight as the worst performing sectors. Tech was anchored by Apple (AAPL $89.16 -$6.27) sliding on news that CEO Steve Jobs no longer attending MacWorld and on a decision that Apple must end its exclusive deal with a French network operator. Financials were a mixed bag as Morgan Stanley (MS $16.63 +$-.50) and Goldman Sachs (GS $78.78 +$2.78) rose as Morgan Stanley reported worse than expected earnings following similar earnings results at Goldman reported a day earlier. The traditional large banks led financials lower as Citigroup (C $7.83 -$0.40) as the Wall Street Journal reported that regulators were scrutinizing Citi due to increased concern regarding its financial status.

Thursday, December 18th:
There were three economic reports of interest released:

The jobless claims came out before the open while the other reports came out a half hour into the session which caused the market to lift. That wasn't enough to sustain a rally, however, as investors focused on a lowered credit outlook for economic bell whether General Electric (GE $15.96 -$1.43). S&P didn't reduce GE's AAA credit rating but gave 1:3 odds that it may reduce that credit rating in the next two years.

The dollar strengthened some 0.7% causing metals, including gold and silver to fall. Mining companies fell with those declines including Freeport McMoRan (FCX $23.32 -2.69).

President-Elect Barach Obama intends to put forward a $775B stimulus package that will put people to work during these difficult times. Although $100B of the package may be used for Medicare, the majority is intended to improve infrastructure for schools, broadband, etc. It would be implemented over two years and is being prepared to be in Congress for debate at the open of the 2009 session on January 6th. Obama's goal is to have legislation passed such that he can sign it into law shortly after his inauguration on January 20th.

The White House intends to offer aid to ailing automakers by Christmas with Treasury Secretary Henry Paulson leading the effort. The rumor of a merger between GM and Chrysler persists but has been denied by GM.

Friday, December 19th:
There were no economic reports of interest released. Instead the focus was on the automaker bailout that will be provided with TARP funds. $13.4B will be provided to GM and Chrysler with another $4B when Congress approves the appropriation of the second $350B for the fund. Ford has indicated it does not need financing at this time.

In financial news, Standard & Poor's cut its rating outlook on twelve major international firms, with the U.S. market headliners being Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), J.P. Morgan Chase (JPM), Morgan Stanley (MS), and Wells Fargo (WFC). Shares of these companies traded in mixed fashion with some closing higher and some lower for the day.

As seen last week, equities have moved up to resistance as volume decreased (a bearish sign). I see the potential of a Santa Claus Rally diminished as the move has been primarily sideways. A break out is imminent either upward or downward. For a trade, traders may enter long or short positions on a break upward through resistance or downward through support. A downward move could take prices all the way back down to challenge the November lows. A move higher would likely run out of steam by the beginning of January so would be a short term trade. There is also a potential for an intermediate term sideways move, which in effect breaks down through support.

As stated last week, for now, there is little advantage to tying up a large amount of cash in the market. The important thing is to have cash when probabilities of return are highest.

Oil prices have broken to new five year lows and are trading around $40 per barrel. This is a five year low. Even OPEC's continued reduction in supply hasn't yet halted the fall in the price of oil. Part of this is because of the strengthening in the U.S. dollar. As the dollar strengthens, the dollar denominated price of oil falls. Oil is likely to hit a floor soon as demand in developing nations is still growing even as demand in developed nations is falling due to the state of their economies.

It is a good time to have the majority of your position in cash, waiting to catch a high probability move. That move is coming and I will alert you to it as it develops.

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Mark McMillan

Author: Mark McMillan

Mark McMillan
The McMillan Portfolio

Mark McMillan

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