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Mid-Week Analysis

US Trade balance - Goods
US Dollar Index
Mortgage Refinancing Applications
AT&T Spread vs US 10-Year Treasury

The unfolding technology collapse has gained momentum this week, with the ramifications becoming increasingly problematic for the rest of the marketplace. For the week, the Dow has dropped 1% and the S&P500 4%. Defensive issues continue to outperform, with the Morgan Stanley Consumer index gaining 2% and the Utilities 4%. The Morgan Stanley Cyclical index and the Transports have gained 1%. The small cap Russell 2000 has dropped 4% and the S&P400 Mid-Cap index has declined 3%. The financial stocks continue to outperform, with the S&P Bank index gaining 4%, while the Bloomberg Wall Street index has declined 2%. The Biotechs have come under increasing pressure, dropping 6% this week. Within technology, an historic collapse is in process. The NASDAQ100 and the Morgan Stanley High Tech index have been hit for 13%, The Street.com Internet index 20% and the NASDAQ Telecommunications index 15%. Gold stocks are actually attracting buyers, with the XAU index gaining 8%.

The collapse in yields continues throughout the credit market. Today, 10-year yields declined almost 16 basis points to 5.04%, while 5-year yields dropped 15 basis points to 4.97%, and 2-year yields dropped 15 basis points to 5.21%. Mortgage and agency yields sank as well, with the benchmark Fannie Mae mortgage-back yield dropping 12 basis points and the implied yield on the agency futures contract declined 9 basis points. Either there is a significant market dislocation pushing rates lower, or the credit market is beginning to discount a very severe recession.

This afternoon, AT&T announced that it would not meet earlier earnings and revenue forecasts. The company also announced a dramatic 83% cut in its dividend. And while it is easy to dismiss this news as just one more in a long list of technology disappointments, it should be noted that AT&T has total assets surpassing $250 billion with total liabilities of more than $125 billion. AT&T has ballooned its debt to finance $100 billion of acquisitions and an aggressive infrastructure build out that now look questionable. The company now faces a significant challenge in completing its capital investment programs, integrating its acquisitions, and servicing its huge debt load. That a company such as AT&T has found itself in a difficult cash crunch should be convincing evidence of the severity and historic nature of the unfolding technology collapse, and the profound financial ramifications.

The global technology rout has certainly taken a turn for the worse, with NASDAQ leading global indices into a tailspin. In heavily tech exposed Asia, the main Taiwan stock index is sporting a 41% decline, with the TAISDAQ losing almost one-half its value. The South Korean Composite has dropped 50%, while the KOSDAQ collapse has seen a 77% evaporation of value. Thailand has dropped 44%, Indonesia 39%, Philippines 32% and Singapore 22%. And while many of these are smaller markets, huge perceived wealth has evaporated with Japan's Nikkei declining 27% to 13,900, while the JASDAQ - TOP 100 index has fallen 48%. And for the proponents claiming that stocks always outperform over the "long-term," it should be recognized that the Nikkei remains about 65% below its record high of 39,957, established almost 11 years ago. Take note that the risk-averse Japanese investor who placed her savings in a bond or interest-bearing account, as opposed to stocks, would now likely have more than 3 times the amount of capital as the "long-term" holder of Japanese stocks.

Elsewhere, the Mexican Bolsa has dropped 27% and the Brazilian Bovespa 14%. Interestingly, European bourses have generally outperformed. Of the largest markets, the U.K. FTSE index has declined 11%, the French CAC40 3%, and the German DAX 10%. The major Italian index has dropped 23%, with 13% losses in Sweden.

This afternoon Bloomberg ran a story "Europe's Stock Funds Lose Most Money in 30 Years." "The average equity fund fell 16% in U.S. dollar terms this year, the steepest drop since 1967 when performance records started being compiled, Standard & Poor's Micropal reported." According to this article, it is the first time since 1992 that equity funds reported losses. A European money manager was quoted as saying, "everyone knew the 'tech' bubble would burst, but it was harder to know when. When it did burst, it was like those cartoon characters that run off a cliff and the legs keep going until they look down." A cute quote, but we don't remember too many expecting a bursting tech bubble - quite the opposite.

And while many investors have been hammered, such a dreadful situation is apparently not going to keep Wall Street employees from big year-end bonuses. Today from BusinessWire: "The Daily Deal reveals…that some of Wall Street's biggest firms are stuffing banker's Christmas stockings handsomely, regardless of the bear market." The median bonus for Senior Managing Directors is between $2 and $3 million, Managing Directors (1-3 years) $1 to 1.75 million, Senior Vice President, Director, Principal $850,000-$900,000, Vice President (class of '94) $750,000- $800,000, Associate (class of '97) $475,000 to $485,000, and second-year Associate $250,000. And while ridiculous compensation was tolerable during the boom, it's hard to believe such pay will garner much goodwill going forward. It is certainly interesting how CNBC now mocks Wall Street analysts on a daily basis.

Despite headlines stating "Trade Gap Narrows," October was another in a long string of disastrous months on the trade front. News accounts stressed the slight decline in both imports and exports as a sign of slowing global growth. Ignored, however, was the continuation of truly unprecedented trade imbalances. During October, we imported $39.5 billion more goods than we exported, a new record. For the month, the U.S. ran record deficits with Canada, Japan and, not surprisingly, OPEC. The $9.1 billion deficit with China during October was the largest ever reported for a month with any country. Our $1.5 billion of exports to China look pretty trivial compared to the $10.6 billion imports. Year-to-date, the U.S. economy has absorbed just over $1 trillion of imports, up a stunning 20% compared to the same period in 1999. October imports were 17% above last October. By country/region, (year-over-year) imports were up 14% from Canada, 27% from Mexico, 24% from France and 15% with the European Union, 21% with Eastern Europe, 21% from the Pacific Rim, 21% from Latin America and 53% from OPEC.

By category, year-over-year imports increased 20% for capital goods, 9% for automobile and automotive, 25% for industrial supplies and 14% for consumer goods. The notion that we export capital goods and import toys and trinkets certainly does not mesh with reality. For the first ten months of the year, the deficit in goods and services has jumped 40% to more than $300 billion. And while there remains this perception that we will be able to help rectify this deficit by exporting "New Age" technology equipment, it is becoming clearer by the month that global demand for such products is waning. For the month of October, semiconductor shipments dropped 5% and telecommunications equipment dropped almost 4%. Looking at inbound shipments, petroleum product imports have increased 85% this year. The harsh reality is that the U.S. economy is hopelessly dependent on imports, and this will remain the case with a strong or weak dollar. It certainly does not take much imagination to envision a scenario where a declining dollar leads to only greater deficits…and a weaker dollar.

And with the confluence of a precarious trade position, U.S. technology stocks in freefall, and the boom-time perception of the "New U.S. Economy" looking increasingly dubious, one cannot overstate the vulnerability of the dollar. Today the euro jumped almost 1 ½% to a four-month high. For European fund managers holding U.S. technology positions, things are turning sour quickly. Bloomberg quoted a currency analyst, "The sentiment is that the U.S. economy and stock market are going to continue south, and European portfolio managers will look to sell U.S. assets." The question then becomes, "who will they sell to?" It is also worth noting that the Mexican peso and Canadian dollar also suffered losses today. These are our two largest trade partners and both economies have huge exposure to the unfolding U.S. economic slowdown. The peso suffered its largest loss in more than two months, dropping more than 1%.

Today, President-elect Bush announced that he would be nominating Paul O'Neill, Chairman of Alcoa, to be Treasury Secretary. And while Mr. O'Neill is quite likely a very talented and fine individual, and certainly a proven executive, we're just not sure that this appointment will instill "warm and fuzzies" to a marketplace increasingly on edge. Mr. O'Neill is not from Wall Street, and the contrast to Robert Rubin could not be more dramatic. Nor does he have the background in economics and financial markets of Secretary Summers. And in the financial storm we see brewing, this could be a major handicap. Our first reaction was to imagine a meeting where President Bush, Vice President Cheney and Secretary O'Neill are interrupted with news of a major unfolding derivatives dislocation, with institutions caught short equity volatility, while counter-party defaults are fostering a domino collapse in the swaps market. After all, during key past episodes of financial distress, the marketplace was comforted with the knowledge that those at Treasury had a pretty good handle on the comings and going of contemporary finance. There was also credibility behind the "Strong Dollar Policy" going all the way to the top. We ponder if this will remain the case going forward, and how this plays with what is increasingly tenuous investor confidence. For sure, it is a particularly precarious environment for a "changing of the guard." "Times they are a changin'…"

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