So with the unknowns highlighted above, what hints can we look for in the current market that relate to previous markets and their outcomes? Instead of talking about what we think the current dynamics mean to the market as above, let’s focus on how the current market is behaving. Below are the charts of two significant domestic indices, the predominantly large cap S&P 500 and the smaller cap oriented Russell 2000. Both indices experienced a correction in the spring of this year that took them below their 50 day moving average, but not their 200 day MA. These MA indicators are what many market watchers consider support and resistance zones. As you can see the correction the past few weeks has been more severe, especially for the Russell almost 13% compared to an 8¼% decline for the S&P 500 . The 200 day MA for the S&P 500 has mostly held and if the 1425 level, just below last weeks lows, can hold I would consider the Bulls to still be in control. If that level fails look for the Bears to be smiling.

Final Thought

“My doctor gave me six months to live, but when I couldn’t pay the bill he gave me six months more” – Walter Matthau

Last week we wrote about a few of the dynamics that could affect stocks in the coming weeks and how we do not know the true extent of their stats. We watched another equity roller coaster week and listened closely to the news and the commentary on those news events. What jumped out at us is the assuredness many commentators, both bullish and bearish, have regarding their take. Considering the source is always important. For instance have you ever met a Realtor that tells you that it is not a good time to buy real estate? When the market swooned from 2000-03 so did the ratings for CNBC and we have noticed they tend to put a positive spin as much as possible on the market views. We thought it might be instructive to share some of these dynamics that depending on how they play out collectively could have an impact on stocks. Remember these are our thoughts and only our opinion.

1. What is the real number of sub-prime mortgages in the system and how significant is the looming resets on adjustable rate mortgages?

2. Will lenders re-finance these loans rather than foreclose on the mortgage holders?

3. How much did the consumer actually fund their lifestyle with home equity withdrawals and are they now tapped out?

4. Eliminating these sub-prime players from the real estate market and potentially adding their foreclosed homes to inventory is probably not good for the real estate market?

5. How much did the real estate market truly play in the economic recovery of the last few years?

6. How much of these sub-prime loans are buried in AAA paper sold to domestic and foreign institutions and can they be effectively valued?

7. How much leverage have these institutions used in their portfolios and how will margin calls affect the markets?

8. Has a similar issue occurred in the corporate, private equity, and municipal bond arena’s?

9. Will the liquidity the Fed injects solve or exacerbate the current credit problem?

10. What happens to the dollar and our markets if foreigners decide to unload their U.S. assets?

These scenarios playing out poorly are what most Bears are basing their gloom upon. The Bulls have the resilient global economies (although the economy always looks good at the top, remember 2000) and liquidity to hang their hat on. Another factor not mentioned much lately is that it is rare for a financial debacle to unfold in the midst of a Presidential campaign. Take away the performance of the economy and the stock market and the Republicans could struggle even more than they did in the 2006 mid-year elections. This is a good time to put your financial advisor to the test and ask him/her what she thinks about these issues. If you get an answer that we are familiar with, “Stay the course” it might be wise to ask others for their input. What a surprise, huh?

Chart Spotlight

Another precipice? Stocks have had some shaky moments the last few years. Without fail they have been able to pick themselves up, shake it off and move higher. We believe we are now at another precipice and wondering if this time is different. Below are charts of four major indices. So far the pull back looks similar to the spring correction with the Russell 2000 Small Cap Index the only one to violate the March lows. The further we move along the closer we come to the first 10% correction for the S&P 500 since 2003, just 33 points to 1400. As you can see the damage was quickly contained in the spring, we believe we are going to have to get help from the Fed in the way of lowering interest rates and a flood of liquidity to stop this drop. The only problem is… that is what got us into this credit issue in the first place?

Did You Know…

AWFUL AUGUST – Since 1990, the month of August has produced the worst average total return of any of the 12 months for the S&P 500 stock index. The average August has resulted in a loss of 1.0%. Ten of the 12 months have been up on average and only August and September have suffered a negative average monthly total return in the last 17 years. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the US stock market (source: BTN Research).

Final Thought

“Bills travel through the mail at twice the speed of checks” – Stephen Wright

Stocks have had a wild ride the last few weeks, to say the least. It appears equities used every last bit of energy to get to 14,000 on the Dow on July 19^th. In the next eleven trading sessions we have given back over 8% in one of the more volatile periods I have witnessed.

Last Wednesday was the most roller coaster day we can remember. The Dow Jones futures were down over 150 points in pre-market trading as the world indices were roiling. By the time the market had opened, the futures had cut their losses and the Dow opened up over 65 points. Fifteen minutes later we were down over 50 points. Ninety minutes later we were up nearly 100 points for the day. In the next forty minutes the Dow gave up 133 points and we have to admit we were actually a little queasy. With thirty five minutes left in the session the Dow was down over 65 points and threatening to break the lows of the last week. The index rallied 215 points in the last thirty five minutes in what was a perfect finish to the most E-ticket day (we do believe you have to be over forty to know what E-ticket means?) we have ever witnessed. Stomach acid remedy stocks were big winners on the day.

The gyrations in the market appear to be tied to the issues in the credit markets. We all know that the sub-prime mortgage market has had its woes. What we don’t know at this point is the extent of the problem as it relates to the consumer, the hedge funds and their levered positions, the lenders to the mortgage market, and the other related lending players (corporate, municipal, and consumer) outside the mortgage arena.

The Goldilocks economy of not-too-hot-not-too-cold economic growth may be over shadowed by these unknowns, as we believe they will be, and start revealing themselves in the coming weeks. If these revelations turn out to be more serious than many of the talking heads on the tube lead us to believe, and the global economy hiccups simultaneously we could have more E-tickets ahead.

Remember in February when we first learned the term sub-prime? Many said it was just a small piece of an economy that was in good shape. Well it turns out to be a bigger problem than first believed. A Southern California independent broker dealer, Brookstreet Capital, had to close its doors and layoff 650 financial advisors. This because their mortgage desk had too much exposure to the sub-prime mortgage market and the firms equity went negative within a few days. Bear Stearns had its credit downgraded after two of its hedge funds were deemed worthless and that the firm’s profits may be impacted. It will be interesting to see what holders of hedge funds do over the next few months massive redemptions could create margin calls and an inordinate amount of selling, maybe even the good stuff, to meet those calls. In 1998 the market dropped 20% in six weeks when the hedge fund Long Term Capital created a dislocation in the bond market. That slide was stopped when then Fed head Alan Greenspan stepped in and maestroed a bail out of the fund’s upside down positions.

We have been espousing caution in this space for the last couple of years and every time it appears the market may be starting a serious correction, it climbs up off the precipice headed toward new heights. Our technical analysis work gave us two buy signals in the last couple of weeks and they have both failed. We have not seen that happen since 2002, as mostly it has been the sell signals which have not worked the last four years. The buy-the-dip-crowd has been right since 2003, but remember we eventually always run into a dip-not-to-buy. Could this be it? Let’s ask Ben Bernanke.