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Mid-Week Analysis

Mortgage Refinancing Applications
Mortgage Purchasing Index
California Electricity Prices

It is certainly not hyperbole to make the claim that "we are now living financial and economic history on a daily basis." With the California utilities on the brink of bankruptcy, power blackouts in California, production cuts by OPEC, a new administration, and wild price volatility endemic to the energy, credit and equity markets, every day is certainly an "adventure." As for this chaotic stock market, at one point today the NASDAQ100, the Morgan Stanley High Tech, The Street.com Internet and the NASDAQ Telecommunications indices had all achieved 6% intra-day gains. This morning, the Semiconductor index was sporting an 11% intra-day rise. Many individual stocks surged wildly, with key stocks such as JDS Uniphase, Siebel Systems, Applied Micro Circuits, Linear Technologies and Maxim Integrated circuits (to name just a few) all ending the day with gains of at least 10%. Once again, it has developed into another one of these episodes of "buyers' panic," certainly with aggressive stock purchases by the derivative players and those caught short these rapidly rising stocks. Whether today's reversal marked what traders refer to as "capitualation," only time will tell, although these types of situations can often last longer than one would imagine. All the same, the numbers are rather impressive, with year-to-date gains of 25% for The Street.com Internet index, 18% for the NASDAQ Telecommunications index, 17% for the Semiconductors, 13% for the Morgan Stanley High Tech index, and 9% for the NASDAQ100 9%. Not bad for 11 sessions.

So far this week, the Dow and S&P500 have gained 1%, while the Transports and Morgan Stanley Cyclical index have gained 2%. The Morgan Stanley Consumer index is unchanged, while the Utilities have declined 1%. The small cap Russell 2000 and the S&P400 Mid-Cap indices have gained 1%. The NASDAQ100 and the Morgan Stanley High tech index has gained 2%, while The Street.com Internet index has gained 4%, NASDAQ Telecommunications index 3%, and the Semiconductors 1%. The Biotechs have declined 3% and the gold stocks have dropped 2%. The S&P Bank index has added 2% and the Securities Broker/Dealers have gained 1%.

Likely augmented by California utility woes, the Treasury market rallied strongly today. So far this week, 2-year Treasury yields have declined 8 basis points to 4.83%, 5-year 11 basis points to 4.84%, and the 10-year 8 basis points to 5.17%. Long bond yields have declined 10 basis points to 5.52%. Agency securities have preformed comparably to Treasuries, with yields dropping about 8 basis points. The benchmark 10-year dollar swap spread has widened about 1 basis point to 90. After last week's drubbing, the yield on the benchmark Fannie Mae Mortgage-back has dropped 8 basis points.

The unfolding California energy debacle took a troubling turn this afternoon. First, it is being reported that PG&E has defaulted on commercial paper, only the third commercial paper default in the past four years. While PG&E is claiming $700 million of "cash reserves," it nonetheless defaulted on $43 million of commercial paper, while also failing to make a $33 million debt payment. PG&E also stated that this default could force it into bankruptcy. According to Bloomberg, "Pacific Gas & Electric, California's largest investor-owned utility, has $837 million of a $1.85 billion commercial paper program outstanding, with $437 million maturing before the end of the month. PG&E Corp., the parent, has $501 million of its $935 million program outstanding, with $263 million maturing by Jan. 31." PG&E's filing with the SEC stated that this default was prompted by its failure to secure additional funding from its bankers, including Bank of America and JP Morgan Chase.

All eyes will now be focused on Southern California Edison with $1.85 billion outstanding commercial paper. Today's PG&E default follows yesterday's failure to make $230 million of scheduled note payments. Not surprisingly, the rating agencies are now racing to lower PG&E and Edison debt to junk status, with Moody's this afternoon stating that "California's escalating energy crisis has increased the probability of bankruptcy for both Southern California Edison and Pacific Gas and Electric which, in turn, places the financial guaranty industry's exposure to these utilities at greater risk…Among the primary guarantors, MBIA's exposure is by far the largest…"

Also this afternoon, the California Independent System Operator ordered its first rolling electricity blackouts for Northern California, a move necessary to avoid a complete system breakdown. While about 4.6 million customers were at risk of losing power, the blackout was canceled after about 2 hours with only 200,000 effected. The outage was ended when electricity was routed to California from Canada. Officials are, however, warning that further blackouts are possible.

Dow Jones is reporting that "officials representing the administration of President-elect George W. Bush said Wednesday that it is up to California state officials to resolve the state's electricity crisis." We are not sure if Bob Rubin or Larry Summers would have made such an announcement, considering the widespread financial ramifications of what would be major bankruptcies. With the utilities having burned through their cash and power generators refusing to continue selling electricity to the state, California legislators are rushing to pass a bill that would allow the state to purchase power directly and sell it at cost to the utilities. This comes quite late in the game to help these troubled utilities. To appreciate the severity of the crisis, spot power prices today in California were about 22 times higher than this time last year. Yet, even if the state does step in to purchase electricity, this doesn't do much for past utility losses. Bloomberg quoted the California assemblyman who is sponsoring the bill as saying, "I think bankruptcy is the more likely outcome." Story to continue…

Elsewhere, in what is truly an extraordinary environment throughout the entire "energy complex", OPEC agreed today to cut production by 1.5 million barrels, or 5%, its first reduction in two years. From the OPEC press release: "…this step is being taken in recognition of the fact that current crude oil supplies far exceed demand, a situation exacerbated by the slowing growth in key economies. With the approach of the seasonally lower demand in the second quarter, unchecked production could precipitate a price collapse, serving the short- and longer-term economic interests of neither producer nor consumers." It is clear the ministers are determined to keep prices high and are apparently prepared for further cutbacks, if necessary, at its next meeting in March. Crude oil dropped 79 cents today as energy prices moved sharply lower generally. Natural gas prices plunged almost 15%, the largest decline in the 11 years of trading. This drop comes despite a continued depletion of inventories. Inventories dropped by almost 6% last week (less than expectations of a 9% decline) and are 34% below year ago levels. Again, these are truly astounding market conditions.

And in another situation indicative of this highly unusual financial and economic environment, this morning the Mortgage Bankers Association reported that their weekly mortgage application index surged to the highest level since the collapse in rates back in 1998 (Russia, LTCM collapse). Not surprisingly, the index of mortgage refinancing applications jumped 78% to the highest level since October 1998, and were up 617% from year ago levels. Interestingly, even the index of purchase applications has bounced back strongly after dropping precipitously over three weeks during December. After posting one of the highest levels ever (344) during the first week of December, the index then sunk to 219 over the following three weeks. Over the past two week, however, this index has jumped all the way back to 333, fully 14% above where it stood this time last year.

Adding to the intrigue, we are now in the heart of earnings seasons. Clearly, companies (particularly in the technology sector) are encouraging investors to look past the valley of deteriorating fundamentals and onto what is being sold as a positive outlook for the second half of the year. And with the consensus now taking for granted that the economy is slowing it is apparently okay for companies to report what in another environment would be considered horrible results (Intel!). Companies are hoping that forgiving investors will allow them a couple quarters to improve operations and repair financial statements.

And as we get further along in this earnings season, it is becoming clear that companies are adopting a much more optimistic "spin" for the future than is justified by current results and business and economic trends. Last week, Gateway announced a major corporate restructuring that is to sharply cut costs and improve profits. These savings are to be realized beginning in the second half of the year. During today's conference call, 3M stated that the benefits of its cost cutting programs would also materialize during the second half of 2001. Eastman Kodak, as well, announced their own cost cutting plans, also indicating the bulk of its forecasted 4-6% earnings growth will be realized in, you guessed it, the second half of the year. President, CEO, and Chairman, Daniel Carp bluntly stated "as we told investors last month, our business plans assume a stronger economy in the second half of 2001."

Rockwell's CEO and Chairman, Don Davis, was just as direct in his short-term forecast, "For the next two quarters, we are not going to see any growth." Rockwell, and many others, is counting on the Federal Reserve's interest-rate cut and future cuts to "start kicking in during the second half of the year." Yahoo's Susan Decker, chief financial officer, also expects the advertising market to improve in the second half.

However, the real story today is out of Intel, which, of course, released fourth quarter results yesterday afternoon. With the help of non-operating income, Intel just beat significantly reduced Wall Street expectations. Yet, the market moving news rested on Intel's aggressive capital expenditure plans for 2001. Certainly this move helps trumpet a future industry recovery and throws some gas on this tech rally, in the face of a dreadful warning that first quarter revenue could be 15% lower sequentially. Intel announced it has increased its planed capital expenditures for 2001 to $7.5 billion, a 15% increase over the $6.5 billion spent in 2000. This announcement worked wonders, as almost every major analyst commented on how this demonstrates Intel's faith in the future. It also sent capital equipment stocks into orbit.

Adding to this new round of "optimism" was a bubbling appearance this morning on CNBC by GE's Jack Welch. Welch was commenting on GE's results, which conveniently led to a discussion regarding Information Technology spending. Welch proclaimed that "we are driving the hell out of IT spending." He continued by declaring "you won't see one ounce of slowdown in tech spending from us." Welch finished the topic by smugly adding, "Frankly, I hope our competitors do [cut IT spending]."

Well, isn't this interesting. On all fronts, this is a simply fascinating environment and all we can say is that it will be something to watch how events play out. Clearly, there is one heck of an effort being made to get a sustainable rally going, but poor fundamentals are not helping things along. So the question becomes: How long will investors look over the valley and choose to give these companies the benefit of the doubt? How long will investors ignore what is conspicuous heightened financial instability? Only time will tell, but one thing is for sure, we have all the makings for another very interesting year.

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