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Mid-Week Analysis

Retail sales - Durable Goods
Mortgage Purchasing Index
Mortgage Refinancing Applications
California Electricity Prices

It is but another in a long string of weeks with volatile and unpredictable market swings. So far this week, the Dow has gained 1%, cutting its year-2000 loss to 6%. The S&P500 and the Transports have declined 1%, while the Morgan Stanley Consumer index is unchanged. The Morgan Stanley Cyclical index has declined 2% and the Utilities have added 1%. The small cap Russell 2000 has declined 2% and the S&P400 Mid-cap index has declined 4%. The technology rally appears to have come to an abrupt halt, with the NASDAQ100 index dropping 5% and the Morgan Stanley High Tech index falling 4%. The Semiconductors have sunk 6%, with The Street.com Internet index declining 2% and the NASDAQ Telecommunications index 1%. The Biotech stocks have come under pressure. The AMEX Biotech index has dropped 5%, reducing year-to-date gains to 66%. The financial stocks continue to outperform, with the S&P Bank index adding 2% and the Bloomberg Wall Street index with a small decline. The gold stocks have come under heavy selling pressure, dropping 6% so far this week.

The extraordinary rally continues in Treasuries, agencies, and mortgage-back securities. So far this week, 2-year Treasury yields have declined 1 basis point, while 5, 10 and long-bond yields have declined 4 basis points. Ten-year yields have dropped 21 basis points so far this month to 5.26%, the lowest yield in 19 months. Mortgage-backs continue to perform exceptionally well; with Fannie Mae benchmark yields dropping 5 basis points to 7.03%. The implied yield on agency securities has dropped 6 basis points so far this week and 28 basis points so far this month. The corporate market has seemingly stabilized this week, with junk spreads narrowing somewhat from last week's historic extremes. Government bond markets have rallied throughout Europe as well. The dollar has a slight gain for the week against most currencies. The dollar has benefited from a 1% decline in the Japanese yen, which now trades at a 16-month low versus the dollar.

Business conditions are continuing to deteriorate rapidly throughout Techland. Yesterday, Compaq announced it would significantly miss fourth-quarter earnings estimates and guided forecasts considerably lower for 2001. On the heels of the other PC makers' warnings, this should have come as no surprise. Adding to the bleak outlook was today's news that two Wall Street firms lowered their 2001 capital expenditure forecasts for Intel, actually forecasting that Intel would reduce 2001 capital expenditures. Interestingly, this comes immediately after Intel announced that it plans on increasing 2001 expenditures by $500 million. Semiconductor equipment makers were all impacted, with the Philly Semiconductor index falling over 6% today. Wall Street is finally recognizing the unfolding industry slowdown that is causing a dramatic reduction from previous ambitious growth plans. The degree of retrenchment is in dispute, with Wall Street all over the map for total semiconductor capital spending in 2001. Although most of the street is forecasting 5%-10% growth, one of the more bearish views calls for an actual decline of 7% to $48 billion. Of course, all the Wall Street firms are looking for the second half of 2001 to save the industry. Wall Street continues to believe that the Windows 2000 and P4 upgrade cycle will save the day.

Coming as a great shock to the bullish contingent, technology has experienced a "rolling" demand problem. It first started with cell phones, moved into PCs, and now it has hitting the massive telecommunications sector. And instead of one sector improving as another falls victim to slowdown, weakness is begetting weakness throughout the entire technology industry. We see a major credit crunch developing throughout the corporate sector, while also being quite skeptical that consumer cell phone demand will reach the lofty projection that the bulls continue to champion. And in light of some of the latest fiascoes in the 3G auctions, we see little chance that the rollout will continue as planned.

Over the past eighteen months or so there have been two major events to spur demand, beyond just a booming general economy and surging stock market. The first was the Y2K situation. The most convenient mechanism for corporations to become Y2k compliant was to upgrade their equipment and systems. This resulted in an extraordinary spike in demand last year. All the same, Wall Street was apparently surprised when the year-over-year growth slowed down. Another major factor was aggressive marketing aimed at the retail consumer. Prodigy started the promotion of rebating computer buyers $400 on the purchase of PCs when they signed up for Prodigy Internet service. Several other ISP jumped on the bandwagon, which spurred demand for the retail consumer last year. This was an obvious bubble, and now Wall Street is caught ill prepared for what should have been seen as an unavoidable year-over-year slow down in growth. Going forward, we do not see any significant catalyst for either consumers or corporations to upgrade PCs in the near future. Intel's new P4 chip is not significantly faster than its PIII and the Windows upgrade cycle has not been a significant event since Windows95. On the corporate side, we expect a dramatic retrenchment going forward.

Yesterday, the American Petroleum Institute (API) reported a sharp decline in distillate supplies. Inventories dropped more than 5%, with heating oil inventories contracting 2.7 million barrels. Distillate inventories are now 27% below last year, while demand rises sharply to the strongest levels since last February. According to API, there are 47 million barrels of heating oil inventories, with recent demand jumping to almost 500,000 barrels a day. Bloomberg quoted an analyst: "There isn't as much heating oil out there in secondary storage as previously thought."

Out in the "Golden State," things are going from bad to worse, as the largest utilities racked up billions in losses from surging energy prices. Twelve hour spot rates surged above $1,300 a megawatt yesterday (compared to about $30 this time last year!), before reversing sharply today. This afternoon, Dow Jones ran a article by Mark Golden, "PG&E: Will Keep Borrowing Until Lenders Say 'No More'." "How long can PG&E Corp. continue to buy power at $500 a megawatt-hour and sell it at $54? As long as banks continue to say it can, according to the spokesman for PG&E's regulated utility… 'That decision belongs to the lending institutions. They have to make the decision if lending us money is a prudent investment for them,' utility spokesman Ron Low said…From May through November, the utility spent $4.6 billion more to buy electricity in skyrocketing bulk power markets than it can charge its customers, who have frozen rates. And December purchases so far have been more expensive than those of any previous month….PG&E is left to borrow about $750 million a month to fund the electricity losses."

The article concluded with some interesting comments: "Enron Corp, as one of the big beneficiaries of the higher prices for bulk power supplies, has some concern about the credit strain, 'but I can't imagine the state letting the utilities go into bankruptcy,' Enron Chairman Kenneth Lay said Wednesday. 'The utilities will have a difficult time raising the funds unless the state gives a guarantee,' Lay said."

A Bloomberg article added another twist to this unfolding problem: "California is facing rolling blackouts today because electricity providers in the Northwest don't want to ship power into the state over concerns that utilities won't be able to pay their bills. Officials from the Federal Energy Regulatory Commission and the U.S. Energy Department have been making calls on California's behalf in an attempt to bring power into the state…PG&E Corp.'s Pacific Gas and Electric Co. and Edison International's Southern California Edison, the state's two largest utilities, have racked up more than $7.2 billion in power-buying losses." This week Fitch cut debt ratings on these two Utilities. This afternoon, Edison's CEO stated that it might "soon be compelled to take drastic measures…that could include rationing electricity." Bloomberg quoted him: "The new market structure is broken and must be discarded. We need to reform and, where necessary, re-regulate California's electric system."

Also, this afternoon Secretary of Energy Richardson invoked "emergency powers" to have the Department of Energy set rates for California power, while also forcing out of state generators to send power to the state. "I will use the emergency authority of the Federal Power Act to require generators and marketers that refuse to supply power to California because of credit issues to send power into the state to keep the lights on. I can order a power plant to send power where it is needed. The department can and will set the rates. We will ensure that the generators receive a fair return." This could get interesting…this evening the California Independent System Operator is declaring another "Stage Two" emergency.

Elsewhere, the Mortgage Bankers Association reported this morning that their weekly index of mortgage applications jumped to the highest level since April 1999. The purchase application index gained 3% to 344, a record for this index and 20% above levels from this time last year. The refinancing application index surged 14% to 758, the highest since June of 1999. Mortgage refinancings are currently running 124% above year ago levels.

Today, the Department of Commerce reported that retail sales declined during November for the first time in seven months. However, total sales of $272 billion were 5.2% above year ago levels. This weaker than expected report was led by weak purchases of durable goods that declined 1.1% from October, and were only about 1% above last year. Yet, with the housing market's continuing strength, furniture sales bucked the trend rising 6.3% versus last year. Driven by a 15% year-on-year increase in gasoline sales, nondurable goods sales were up 8.4% from a year ago. Helped by rising prices, drug store sales increased 10 from last year. "Eating Places" saw sales jump by 10% from last November.

Personal spending is on course to rise by less than 3% this quarter, the slowest growth since 1999's second quarter. Bloomberg quoted a Wall Street economist: "Retail sales have suddenly fizzled out as worries over heating costs this winter and a stock market decline have suddenly made Americans very cautious." The decline in general merchandise sales (.02) was the largest since May of last year. Clearly, the high-flying automobile marketplace is slowing rapidly, with auto dealer sales dropping 2.2%, the largest decrease (according to Bloomberg) since July of 1998. The suddenness of the downturn appears to have caught the U.S. automakers flat-footed, now dealing with unusually large inventories of unsold vehicles. General Motors, DailmlerChrysler and Ford have all announced production cutbacks and this will reverberate throughout the automotive supplier industry, with GM planning to cut production 14% during the first quarter. And while much is made of the retail sales slowdown, keep in mind that same-store sales are expected to run 4% above an exceptionally strong 1999 holiday season.

Deteriorating business conditions were certainly evident in the National Association of Purchasing Manufacturers (NAPM) bi-annual business survey released yesterday. Sixty-five percent of manufacturers reported that they were "concerned" or "worried" about business for next year, compared to 44% during the May survey. According to NAPM, "purchasers are now facing higher interest rates, higher energy costs, a stronger dollar, slower growth in the U.S. and Europe, excess capacity in the basis materials segment, more foreign competition and inflation." ("But other than that, how did you like the play Mrs. Lincoln?) The survey saw 58% of respondents expecting to pay higher prices, with only 29% expecting prices to decrease. And for business outside of manufacturing, fully 71% expect higher prices next year. Eighty-two percent of respondents expect to pay higher wages next year. Only 22% expect to hirer fewer workers next year.

As we have written repeatedly, what we are dealing with is a highly unstable financial system and a deeply maladjusted economy. What is truly amazing, however, is that somehow everything looks just wonderful to most investors. According to Bloomberg, Market TrimTabs is reporting that $20 billion flowed into mutual funds during the first two days of the week, "the most ever for a two-day period since TrimTabs began following money flows in 1994." As we said, amazing...

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