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Mid-Week Analysis

Mortgage Applications
Natural Gas Futures Prices
Heating Oil Futures

With option expiration week only adding one more complexity to a truly extraordinary financial environment, extreme volatility continues. The NASDAQ100 traded within an 8% intra-day range Monday and 4% both yesterday and today. Over the past six sessions, the NASDAQ100 has experienced intra-day swings of 8% twice, 5% once, and 4% three times. For the week, the Dow has added 1% and the S&P500 2%, reducing year-to-date losses to 7% and 5%. The Transports have jumped 5% and the Morgan Stanley Cyclical index 2%. The Morgan Stanley Consumer index is largely unchanged, while the Utilities have declined 2%. The small cap Russell 2000 and S&P400 Mid-cap indices have both added 2%. Year-to-date, the Russell 2000 has dropped less than 3%, while the S&P400 Mid-cap index has gained 15%. The technology stocks have rallied strongly, with the NASDAQ100 gaining 6% and the Morgan Stanley High Tech index 5% so far this week. Year-to-date, these indices have lost 17% and 6%, respectively. The wild semiconductor stocks have surged 15% this week, pushing year-2000 performance back in the positive column. The Street.com Internet index is unchanged so far this week, while the NASDAQ Telecommunications index has increased 6%. The Biotech stocks have been under pressure. So far this week, the AMEX Biotech index has dropped 6%, reducing year-2000 gains to 70%. The financial stocks have been mixed, with the S&P Bank index dropping 6% on heightened credit concerns, while the AMEX Securities Broker/Dealer index has gained 1%. Year-to-date, the S&P Bank index is unchanged while the Broker/Dealer index has surged 29%.

The Treasury market has rallied strongly as well. So far this week, 2-year Treasury yields have declined 1 basis point and the 5-year note 5 basis points. Further out the curve, yields have declined more dramatically. The key 10-year T-Note has seen its yield drop 8 basis points, while long bond yields have declined 9 basis points. Mortgage-back and agency yields have generally declined 8 basis points. The benchmark 10-year dollar swap spread has narrowed one basis point to 113. Corporate bonds continue to underperform, with spreads widening about 2 basis points for investment grade paper and 3 or 4 basis points for junk. Bank debt spreads have widened more dramatically. The dollar has a slight gain and gold is unchanged.

Although attention is focused overwhelmingly on the Presidential election, there are some significant developments that should be recognized. While the Internet/telecommunications/technology bubble is in the process of collapse, evidence continues support our contention that a dangerous real estate bubble continues to run unabated. Today, the Mortgage Bankers Association reported that their weekly index of mortgage applications increased almost 6% last week to its highest level since June of last year. And while very low mortgage rates and extremely easy availability of credit creates a surge in applications to refinance, purchase applications are strong as well. The index of purchase application rose 5% last week to the highest reading since August, and is now running about 10% above levels from this time last year. Considering the historic mortgage-lending boom, there should be little surprise that home construction remains quite strong and housing inflation continues to accelerate in many markets.

Inflationary pressures are certainly building throughout the energy sector. With extremely tight inventories and strong indications for an early and potentially unusually cold winter, energy prices are actually rocketing higher. Today, the December crude oil futures jumped 71 cents to $35.58. Natural gas prices surged 4% to a record high, and have now jumped 40% so far this month and more than doubled so far this year. The American Gas Association reported that natural gas inventories declined in October for the first time in seven months. U.S. gas supplies are running 9% below year ago levels, and very tight supply and demand conditions are now hitting gas consumers hard. Bloomberg quoted a spokesman from the largest gas utility in Illinois: "Our typical customer should expect what they pay for gas to rise from $400 during the October-to-March heating season last year to $600 or more." According to the American Gas Association, more than 55 million homes use natural gas for heating, with seven out of ten new homes heated with natural gas.

Also today, heating oil prices jumped 3% to the highest level in a month. Yesterday, the American Petroleum Institute reported that heating oil supplies dropped again last month. While expectations were for an increase, heating oil inventories dropped to a level 31% below this time last year. Importantly, the meteorologists that had been warning that a dissipation of atypical weather conditions and calling for an usually cold winter appear to have been accurate. This week much of the nation turned cold and this major cold front is now headed toward the Northeast. Forecasts call for heating energy demands 40% above normal. Bloomberg quoted David Tolleris, a meteorologist and forecaster, "temperatures from the Rockies to the East Coast through the end of the Thanksgiving weekend, and maybe to the end of the month, are going to average 10 to 20 degrees below normal."

Not surprisingly, officials in Washington are getting increasingly nervous. Energy Secretary Bill Richardson was quoted as saying, "crude and heating oil inventories in the U.S. and Europe are alarmingly and stubbornly low. The U.S. believes that the world needs more production." He also stated: "Politicians and consumers are getting restless. There appears to be growing sentiment for serious government intervention in the oil market." Elsewhere, he was quoted: "I am very concerned by recent talk that the world should get used to $30 a barrel. The ideal price is $20 to $25." Not surprisingly, those countries holding crude oil reserves are becoming increasingly comfortable with "ideal" prices being much higher. Over the weekend, OPEC decided not to raise production, stating it was concerned of coming oversupply and a potential collapse in pricing next year. Yesterday, Saudi Oil Minister Ali al-Naimi stated, "although we desire the price to be less than $30 for continuous growth in demand for crude oil, I believe the world economy can withstand these prices. The economy is resilient enough to withstand this price for a short period." Let's face it; with inventories quite low, the producers have a much stronger hand to play than us energy consumers. There is little we can do today but hope that the winter is not too cold or long.

It's not just the Northeast the must worry. Today, the operator of California's energy grid - the California Independent System Operator - announced a "stage one" emergency as cold weather created an increase in energy demands. It could be a long cold winter with potentially harsh consequences from coast to coast. In Europe, the continent's second-largest oil terminal in is danger of being closed due to a labor walkout at midnight tonight.

The festering issue of deteriorating credit conditions is back in the spotlight this week, with Bank America stating in its 10-Q that it expects a substantial increase in nonperforming assets, loan losses, and loan loss provisions. Yesterday, First Union held an analysts meeting where it acknowledged a "large non-performing credit" and a rapidly worsening credit outlook. The "large non-performer" is generally recognized as Sunbeam, and media attention has quickly focused on those with exposure to this faltering company. BofA, First Union, and Morgan Stanley Dean Witter are the major holders of Sunbeam's $1.4 trillion syndicated loan made in 1998. At the end of June, Sunbeam had $3.2 billion of total liabilities and negative shareholder's equity. This week Sunbeam announced a larger than expected loss of $80 million for the third-quarter, while also stating that lenders have agreed to defer loan payments for 5 months. With Sunbeam's stock trading at 5/8ths, the market is certainly betting that the company doesn't make it.

While Sunbeam is certainly a very poor credit, we see it as little more than the proverbial "tip of the iceberg." Unprecedented reckless lending will haunt the U.S. financial system and economy for years to come. For now, however, there does appear that a significant change in market sentiment is developing. For some time, investors have favored the financial stocks, thinking (through rose colored brain cells…) that they were not only "cheap," but also conveniently bulletproof in this environment. After all, wouldn't the Federal Reserve respond to any sign of financial turbulence, economic weakness or faltering marketplace liquidity by cutting rates and instituting system-wide reliquefication? Well, maybe the combination of rapidly deteriorating credit conditions, surging energy prices, and today's decision by the Fed to maintain their bias and "inflationary focus" will cause some to reassess the risk of holding financial stocks.

Text of today's Federal Reserve Open Market Committee decision on interest rates:

"The Federal Open Market Committee at its meeting today decided to maintain the existing stance of monetary policy, keeping its target for the federal funds rate at 6-1/2 percent. The utilization of the pool of available workers remains at an unusually high level, and the increase in energy prices, though having limited effect on core measures of prices to date, still harbors the possibility of raising inflation expectations. The Committee, accordingly, continues to see a risk of heightened inflation pressures. However, softening in business and household demand and tightening conditions in financial markets over recent months suggest that the economy could expand for a time at a pace below the productivity-enhanced rate of growth of its potential to produce.

Nonetheless, to date the easing of demand pressures has not been sufficient to warrant a change in the Committee's judgment that against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future."

Despite calls from many of Wall Street's best known "market strategists" to increase exposure to the stock market, the signs are everywhere that this is an environment fraught with extraordinary risk.

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