---------- Forwarded message ---------- From: Whisper Report <[EMAIL PROTECTED]> Date: 18 Sep 2007 09:09 Subject: The Fed and the Brokers To: Ridwan Musthafa <[EMAIL PROTECTED]>
[image: EarningsWhispers.com] <http://www.earningswhispers.com/> [image: EarningsWhispers.com] <http://www.earningswhispers.com/> Monday, September 17, 2007 *The Fed and the Brokers* ------------------------------ This is week is primarily about the Fed and the big brokers, but FedEx will provide key guidance about the economy, and some other big names could provide some nice surprises while no one is looking. This is the delayed, shortened version of the Whisper Report (r). To view the full issue, which includes a preview of Adobe (ADBE<http://www.earningswhispers.com/stocks.asp?symbol=ADBE>), Oracle (ORCL <http://www.earningswhispers.com/stocks.asp?symbol=ORCL>), Nike (NKE <http://www.earningswhispers.com/stocks.asp?symbol=NKE>), our covered-call trade of the week, and more, please go to <http://www.earningswhispers.com/subwr.asp?artno=165> http://www.earningswhispers.com/subwr.asp?artno=165. We dont want to sound like a broken record by continuing to compare the current market environment to past financial crises, but we simply dont believe that an asset and/or credit bubble can unwind into a soft landing and few people will argue that we have seen a recent asset and credit bubble. The bible on the subject is *Manias, Panics, and Crashes: A History of Financial Crises*<http://www.amazon.com/gp/product/0471467146?ie=UTF8&tag=earningswhcom-20&linkCode=as2&camp=1789&creative=9325&creativeASIN=0471467146>by Charles P. Kindleberger, but we are not going to recommend the book to anyone that doesnt like dusting off an old economics book on a rainy Sunday afternoon. Mr. Kindleberger makes Benjamin Grahams books look like Nick Hornby novels. In our August 27, 2007 Whisper Report (r) we added a brief comparison to the 1907 financial crises, but on August 31, 2007 Robert F. Bruner and Sean D. Carr provided a much better description of the incident with the release of their book * The Panic of 1907*<http://www.amazon.com/gp/product/047015263X?ie=UTF8&tag=earningswhcom-20&linkCode=as2&camp=1789&creative=9325&creativeASIN=047015263X>. This is a much more enjoyable read and a book that we can and do recommend. In this book, the writers outline the elements of the perfect storm that hit in 1907. Our summary is, 1) it started with unprecedented economic growth and an extraordinarily high number of mergers and acquisitions; 2) an earthquake in San Francisco in April 1906 with total damages representing 1.2% to 1.7% of 1906 GNP; 3) a silent crash in March of 1907; 4) a financial shock in the summer of 1907 that started in London; 4) significant speculative losses in the market; and 5) the withdrawal of deposits from the banks that eventual led to actual runs on the banks. These events eventually led to a significant selling of equities in October 1907. A recession didnt follow until 1908. Or maybe we should just say there were excesses in the economy that, once it slowed, caused a tightening in capital, which lead to a selling of equities and an economic decline. Now, fast forward to today and 1) we are (or have been) in an exceptionally strong global economic environment and an even better credit environment; 2) Hurricane Katrina is estimated to be about 0.6% to 0.7% of 2005 GDP half of the San Francisco earthquake on a percentage of GDP basis; 3) we had a correction in late February and March of this year; 4) Bear Stearns (BSC<http://www.earningswhispers.com/stocks.asp?symbol=BSC>), Lehman Brothers (LEH <http://www.earningswhispers.com/stocks.asp?symbol=LEH>), and Goldman Sachs (GS <http://www.earningswhispers.com/stocks.asp?symbol=GS>) have already announced significantly losses either investing in mortgage-backed securities or through quantitative trading during the quarter; and 5) though the days of runs on the bank are probably well past us, recent data has shown during the past few weeks there has been an increase of $44.9 billion of new loans funded by U.S. banks while depositors have withdrawn $30.2 billion from their banks. The result of this $75.1 billion difference over the past few weeks is total loans outstanding are now in excess of their deposits at U.S. banks for the third consecutive month. We believe the authors of the book clearly wrote it with the intentions of making it seem similar to today and, of course, that is exactly what we were looking for as well. So we think it is fair to point out the differences as well. The primary difference is there was no Federal Reserve in 1907, but for the stock market we believe the more important difference is the amount of short interest. If we wanted to go more in depth, we could undoubtedly point out more relevant similarities and differences, but we think weve made our point for what is at risk over the next several weeks. Regardless of what the Fed does on Tuesday and the brokerages report this week and what the market does in response we think there is continued downside risk going forward. This earnings season, when the banks report their results, will tell us more. The consensus of the technicians we follow is that this will be a down week, but it has generally been a bad idea to short before a Bernanke speech or statement. We think the positive rise during the recent week has been short covering for this very reason especially in the financials and the home builders. Regardless, we continue to like volatility and, specifically, the October 25 calls for the VIX, which brings us to the chart on page one of this report<http://www.earningswhispers.com/subwr.asp?artno=165>. When the 24-day percentage rate of change in the VIX crosses the zero line it typically marks a peak or trough in the S&P 500. Yet, since the middle of May, each time it crossed down below the zero line, it immediately jumped higher again, marking a bottom in the VIX and a top in the S&P 500. At the end of last week, the rate of change once again dropped below the zero line. If this is going to follow recent history, it will reverse direction early this week with an increase in the VIX and a decline in the S&P 500. In order for the rate of change to reach above the zero line, the VIX will need to close above 26.57 on Monday, 27.68 on Tuesday, or near 31 later in the week. Also, dont forget triple witching Friday is this week, which means stock index futures, stock index options, and stock options are all expiring this week. So there will be added volatility. Plus, as we pointed out last week, the VIX spiked and the S&P 500 plunged in September 1998 after the Fed lowered the Fed Funds Rate by only 25 basis points. Of course, the big story this week is the FOMC meeting on Tuesday and the expected rate cut announcement at 2:15 PM ET. There are a lot of reasons to support any likely decision, including recent increases in worldwide inflation. But outside of how the market responds this week, we dont believe anything less than a 50 basis point cut will help the issues. The chart on the left shows the Effective Fed Funds Rate since early November 2006. The Fed started injecting money into the system in early August, effectively lowering the Fed Funds Rate below the target price, which is shown by the top blue line. The bottom blue line on the chart represents a 25 basis point rate cut, which is right inline with the average over the past month. However, that still doesnt seem to be addressing the real problem. As we mentioned, depositors have been withdrawing funds from banks, but the banks are still lending money. As a result, U.S. banks have more loans outstanding than they have deposits and it is getting worse. Credit is tightening and simple supply is going to keep a continued tightening of credit. A rate cut is not going to fix this. *Upcoming Earnings* There are more companies reporting this week but, while there are some important names announcing earnings, there arent a lot of good trades. Even those that look like decent risk vs. reward trades will likely be pulled in the direction of the market his week. There are not many weeks that have a whole group of companies reporting earnings with as much anticipation as this week, with Bear Stearns (BSC<http://www.earningswhispers.com/stocks.asp?symbol=BSC>), Lehman Brothers (LEH <http://www.earningswhispers.com/stocks.asp?symbol=LEH>), Morgan Stanley (MS <http://www.earningswhispers.com/stocks.asp?symbol=MS>), and Goldman Sachs (GS <http://www.earningswhispers.com/stocks.asp?symbol=GS>) all reporting together. This group has been at the heart of the financial turmoil in recent weeks. The big brokerages are typically among the most difficult for analysts to estimate earnings and it shows, with reported earnings usually coming in significantly above estimates, but when they miss, they also miss big. The whispers are also typically well above the consensus estimates, which makes the stocks hard to trade as well. This quarter, however, the whispers are well below the consensus estimates and we actually expect the consensus estimates to continue moving down closer to the respective Earnings Whisper (r) numbers as we get closer to each release date. The only analyst weve heard suggest a trade for these companies this week is Michael Hecht at Banc of America, who recommends buying the stocks before their earnings release. Of the four, he likes Morgan Stanley the most. *Lehman Brothers* Lehman Brothers will start the earnings off on Tuesday, September 18, 2007 before the market opens, so well get their earnings and later that day well get the Fed announcement. If you make a trade on the stock, regardless of the position, we think it will be a good idea to close the position before the 2:15 Fed announcement. Earnings estimates for 2008 have come down from $8.34 per share to its current level of 7.76 per share and the stock price has come down from an average multiple of 11.14 and is currently trading at 7.57 times forward estimates. However, the expectations weve heard is that analysts are waiting until after the company reports third quarter results to fully revise their numbers and estimates could be revised down to as low as $6.50. Therefore, with the stock at $59.50 at the close on Friday, it is trading at 9.15 times the potentially revised earnings estimates. For the third quarter, we established our Earnings Whisper (r) number of $1.35 a few weeks ago. Since then, the consensus estimate has been revised down from $1.81 to $1.47 per share. *Bear Stearns* If you compare their charts you'll see Bear Stearns and Lehman Brothers stock price have traded in sync since the turmoil began, and this makes sense since they both have the most exposure to the fixed income market and we see the same expectations for Bear Stearns 2008 estimates. Bear Stearns typically trades at 10.4 times forward estimates, but is currently trading at 8.9 times forward estimates, which suggests that Lehman has either sold off too much or Bear Stearns has not sold off enough. We think it is the later and would suggest shorting Bear Stearns while going long Lehman Brothers might make for a good trade, but believe the reason Bear Stearns has not sold off more is because of the speculation it is an acquisition target. Therefore, we would be afraid to keep a short position overnight or at least for very long. Bear Stearns will report before the market opens on Thursday, September 20, 2007. The consensus earnings estimate is $2.13 per share and the Earnings Whisper (r) number is $1.50 per share. *Morgan Stanley* On Wednesday, before the market opens, Morgan Stanley will report, followed by Goldman Sachs the next morning and neither has as much fixed-income exposure as Lehman Brothers and Bear Stearns. However, while Morgan Stanley has a better product mix, it has still sold off significantly more than Bear Stearns relative to their current earnings estimates. Prashant Bhatia at Citigroup said Morgan Stanleys product mix is the best positioned for the current market environment. While option activity has been mixed for the group during the past week or two, there was a large amount of call buying on Wednesday and Thursday of last week for shares of Morgan Stanley, which suggests to us that many in the market believe it is the most oversold of the group relative to expectations. The consensus earnings estimate is $1.67 per share and the Earnings Whisper (r) number is $1.45 per share. *Goldman Sachs* Of the group, Goldman Sachs is the one that we believe could actually beat estimates, even though the Earnings Whisper (r) number is $4.30 per share nine cents below the current consensus earnings estimate. The company has more fixed-income exposure than Morgan S tanley, but less than the other two. However, despite significantly beating estimates for the past couple of years, its earnings have been kept low due to the companys very costly hedges against a possible market downturn just like we saw in July and August. Then, throw in the sale of Horizon Wind Energy, which is expected to add approximately $1.00 per share to Goldmans bottom line, and we see upside potential for the company. So, to sum all of that up, if the Fed cuts the Fed Funds Rate 50 basis points and cuts the Discount Rate to be below the Fed Funds Rate, then we would instantly buy Morgan Stanley and possibly Goldman Sachs and hold until the close on Wednesday. Otherwise, if the market sells off on the Lehmans earnings and the Fed decision, then the risk/reward may be favorable to buy at the close on Wednesday to hold into the release following Mr. Hechts trade idea. We think the risk is to the downside for Bear Stearns, but wouldnt short on the heels of a market rally following the Fed decision and wouldnt hold it for long due to the take over rumors. We made no changes to our long-term Earnings Whisper #&174; Play Portfolio this week. For the year, the portfolio is up 19.8% - significantly outperforming the S&P 500, which is up 4.7% year-to-date. ------------------------------ Earnings Whispers does not provide recommendations for the companies covered in the Whisper Report (r). The purpose of the Whisper Report is to inform individual traders of the Street's expectations, and to give supporting evidence for this expectation. Fund managers, institutional traders, and other market movers receive similar information and, therefore, the stocks move based on this expectation. Investors should consider the Whisper Report as only a single factor in making their investment decisions. For an academically proven method for trading based on these expectations, please read our free report "How to Make Earnings Whisper (r) Plays.<http://www.earningswhispers.com/report.asp>" This issue of the Whisper Report is sent to [EMAIL PROTECTED] To unsubscribe, please go to <http://www.earningswhispers.com/unsubscribe.asp> http://www.earningswhispers.com/unsubscribe.asp This is the late edition of the Whisper Report available for free. 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