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Mid-Week Analysis

Retail Sales
Natural Gas Futures Price

The marketplace has certainly quickly taken on the appearances of a typical year-end period, with strong rallies across most major indices and huge moves by many individual stocks. For the week, the Dow, the S&P500, and the Transports have gained 2%. Year-to-date, the Dow has declined 6% and the S&P500 9%. Defensive stocks continue to shine, while the economically sensitive issues seemingly gather steam. In two sessions, the Morgan Stanley Consumer index gained 4% to close today at a new record, while increasing year-2000 gains to 14%. The Morgan Stanley Cyclical index has surged to its highest level since June, gaining 3% in two sessions. The Utilities also trade to record highs. The small cap Russell 2000 has jumped 8% in four sessions, reducing its year-to-date loss to 5%, while the S&P400 Mid-Cap index jumps 3% to increase year-2000 gains to 16%. Technology stocks came to life today, with the Semiconductors gaining 3%. For the week, the NASDAQ100 has gained 1%, while the NASDAQ Telecommunications index has added 3%. The Street.com Internet index has declined 5% this week. Financial stocks continue to post gains, with the AMEX Securities Broker/Dealer index jumping 7%. This index sports a year-to-date gain of 25%. Bank stocks have added 1% this week.

After last week's dramatic credit market rally that saw Treasury yields sink to 20-month lows, a bit of reality appears to be returning to the market. So far this week, Treasuries between 2 and 10-year maturities have seen yields increase 10 basis points. Five-year yields have jumped back to almost 5%, with long bond yields adding 6 basis points to 5.11%. Agency yields have also increased 10 basis points. Notably, mortgage-backs have under performed, as the yield on Fannie Mae's benchmark mortgage security has surged 14 basis points to 6.95%. The implied yield on the March Treasury bill contract has increased 7 basis points to 5.37%. The 10-year dollar swap spread has increased 5 basis points to 101.

Weaker than expected economic news out of Japan continues to weigh on the yen. The Japanese currency has declined almost 2% against the dollar so far this week to trade at a 16-month low. The yen is actually even weaker against the euro, as the euro continues to rally against the dollar. The euro traded above 93 today after bottoming just above 82 in October. For the week, the dollar index has declined about 1%. With perceptions of dollar vulnerability growing by the week, we do note that gold is quietly trading higher. Other precious metal prices are surging, with shortages sending Palladium up almost 20% this month to record levels. Platinum prices are strong as well.

Today, the S&P Retail Stores Composite index jumped 4% (6% for two sessions), apparently as the marketplace recognizes that Christmas sales were not the disaster some had claimed. According to the Bank of Tokyo-Mitsubishi weekly same-store retail sales report, sales last week were actually 4.4% above year ago levels. This group now expects December retail sales to be 2.5 to 3.0 percent above an exceptionally strong month last year; certainly not the end of the world. Dow Jones ran a story, "Look Beneath Those Retail Sales Headlines: The bad-news headlines about "weak" retail sales since Thanksgiving may actually be masking some basic economic strength, several economists said." Elsewhere, TeleCheck is reporting same-store sales for the holiday season up 3.1%, boosted by a flurry of sales during the final weekend. Interestingly, sales were very consistent throughout the country, with no pockets of alarming weakness in this data. Year-over-year sales were up 3.7% in the Southwest, 3.3% in the West and Southeast, 2.7% in the Midwest, 3.2% in the Northeast and 2.9% in the Mid-Atlantic.

Clearly, many holiday shoppers took advantage of the calendar, waiting until the last minute to purchase final gift items. Shoppers have also been conditioned to expect heavy discounting just before and after Christmas. This evening, Telecheck reported that "same-store retail sales for December 26 also climbed 3.1% nationwide" compared to last year, consistent with continued strong consumer demand. And while some may want to claim that this is a "recessionary" environment, we just don't think we're there yet, at least on the important consumer side. The big problem today is that the retail sector is massively overbuilt. This will keep pressure on margins and profits, despite sales sharply above where they were just two years ago. Come the inevitable major consumer retrenchment, this industry will find itself in the type of trouble that makes today's environment look quite hospitable in comparison.

Speaking of "problems," with much of the country suffering through temperatures significantly cooler than normal, strong demand continues to put acute pressure on energy prices. Natural gas prices for January delivery jumped today above $10 for the first time, after beginning the year below $2.50. With inventories currently running 25% below last year, the situation is becoming quite serious. Many major industrial gas consumers have been forced to switch to heating oil and other energy sources. This afternoon, the American Petroleum Institute reported that both gasoline and crude oil inventories dropped by more than 2 million barrels last week. Distillate inventories declined by almost 2 million barrels.

This afternoon, Dow Jones is reporting the losses suffered by the two largest California utilities could reach a staggering $13 billion by the end of January. Edison International announced losses of $1.4 billion during just the past four weeks. Investors are becoming understandably nervous, as Bloomberg is reporting that Southern California Edison saw its commercial paper borrowing cost surge 85 basis points overnight to 9.08%. Edison has a $1.6 billion commercial paper program. PG&E has a $1.85 billion commercial paper program that they have already exhausted. Both companies are on the verge of losing their investment grade status, which would make their debt offerings unacceptable to many investors, particularly traditional money market funds. If investors lose confidence, there will be few options outside of bankruptcy.

"…unless regulatory actions are taken that restores the confidence of the credit markets in SCE's (Southern California Edison) financial condition, and if SCE is unable to secure additional sources of financing, SCE may have to seek the protection of the bankruptcy court." Southern California Edison 12/22/00 "

The financial survival of PG&E and possibly the survival of the California economy hang in the balance." Roger Peters, PG&E general counsel 12/27/00.

Yesterday, Southern California Edison requested regulatory approval for a 30% increase in utility rates. California's Public Utility Commission is to meet January 4th to decide on customer rate increases. California Governor Gray Davis is in favor of hikes of less than 10%. Such an increase would in no way resolve the utilities' financial difficulties. As the crisis has deepened, Davis has met with Federal Reserve Chairman Greenspan, Treasury Secretary Summers, Energy Secretary Richardson, and with President Clinton. At Gov. Davis' request, the Department of Energy has extended their emergency order requiring out of state energy producers to sell electricity to the California utilities, despite their very dire financial condition. Mr. David was quoted as saying, "I'm confident with more conservation and more supply, we will see this problem through." Unfortunately, there are huge costs to be paid, some directly to consumers through higher electrical bills. Businesses will also be passing along rising costs, and we see today that Federal Express is planning on raising domestic prices an average of 4.9%, this after a 4% increase in April. The U.S. Postal Service is scheduled to raise prices an average 4.6% in January. Inflation is on the rise.

Late this afternoon, Bloomberg ran an article California's Utility Rate Crisis Could Become Fed's Headache. A Wall Street economist was quoted: "This is a credit event. It's not just simply an energy development." From this excellent article written by Bloomberg's Noam Neusner: "A default by the two utilities could make previous credit crises negotiated by Greenspan and Treasury Secretary Lawrence Summers -- who also attended yesterday's meeting -- look like a walk in the park. That's because most major credit problems of the last decade have been overseas, and this one is at home -- and its effect could be felt throughout the U.S. When hedge fund Long-Term Capital Management was on the verge of going under, it threatened its broker-dealer investors. By comparison, the two California utilities count among their creditors money funds used by millions of ordinary investors."

Money market funds own billions of dollars of commercial paper issued by these troubled utilities. A default would hit these funds with losses, something not anticipated by money market fund investors. The article also quoted the publisher of the Money Fund Report: "Any significant damage to one of these companies would reverberate across the capital markets. What you don't want is investors panicking and people asking for their money back." That's right, it is certainly big problems if investors seek liquidity. We also could not agree more with this sentence pulled from Mr. Neusner's piece: "For Greenspan and Summers, two of the three policy-makers once dubbed the 'Committee to Save the World' for their efforts to steer the U.S. economy through financial crises in 1997 and 1998, the California utility rate crisis will require some deft management, economists say." This could get interesting…

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