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Mid-Week Analysis

Freddie Mac 15-Year Mortgage Yields
Mortgage Refinancing Applications
Consumer Credit

We are in the midst of another particularly unsettled week, as a hopelessly momentum/speculation-driven marketplace jockeys to pounce on what is believed will be the hot sectors for the New Year. Clearly, sentiment is building that Federal Reserve accommodation will again work its magic, and that the risk of buying stocks has been significantly reduced ("Greenspan Put"). And with money supply again exploding, liquidity does appear to be making its way back into the financial markets. This is particularly the case in the beleaguered junk bond market that has suddenly come back to life. The marketplace greeted debt offerings by McLeod, XO Communications and Charter Communications enthusiastically last week. As a gauge of investor sentiment in the junk bond arena and leveraged companies generally, we keep a keen eye on closed-end high-yield ("junk") bond funds. Interestingly, for the past month or so these funds have quietly posted strong gains. Moreover, almost all have gone from trading at a discount to net asset value to selling for a premium. Many are even trading at the highest premiums in over a year, some as much as 20%! And now it appears that the underlying junk bonds are strongly outperforming Treasuries, quite a change from most of last year. We are certainly not advocating junk or these funds, but are compelled to highlight this development and stress how quickly sentiment can change in this most unsettled financial environment.

A recovering junk bond market is beautiful music to the ears of stock investors/speculators, at least for today. During the session, the NASDAQ Telecommunications index surged better than 5%, with large numbers of individual stocks making explosive moves. Many equities in this sector have experienced huge rallies in the first seven sessions of 2001. WorldCom sports a 50% gain so far this month, Level 3 Communications 36%, McLeodUSA and XOXO Communications 44%, and Metromedia Fiber Network 52%. On the NYSE, AT&T has jumped 34%. Month-to-date, the Philadelphia Semiconductor index has posted a 13% gain, the Morgan Stanley High Tech index 8%, The Street.com Internet Index 9%, and the NASDAQ Telecommunications index 7%. What does this mean? Well, for now the market is back buying the speculative names.

For the week, the Dow has declined 1%, while the S&P500 has gained 1%. The Transports have declined 1% and the Morgan Stanley Cyclical index has dropped 2%. The Morgan Stanley Consumer index has gained 2%, while the Utilities are unchanged. The small caps came to life today, pushing the Russell 2000 to a 3% gain for the week. The S&P400 Mid-Cap index has added 2% this week. Technology stocks have definitely come to life, with the NASDAQ100 gaining 6%, the Morgan Stanley High Tech index 7%, and the Semiconductors 6%. So far this week, The Street.com Internet index has jumped 13% and the NASDAQ Telecommunications index 7%. The Biotechs have added 3%. With buyers returning to the technology sector, financial stocks are lackluster. So far this week, the S&P Bank and the AMEX Securities Broker/Dealer indices have declined 1%.

Instability also reins in the credit market, as last week's collapse in interest rates abruptly reverses into significant increases so far this week. After dropping a stunning 54 basis points last week, 2-year Treasury yields have jumped 19 basis points so far this week to 4.76%. Five and 10-year yields have increased about 17 basis points, while long-bond yields added 9 basis points. And while agency yields jumped 12 basis points today, they continue to outperform generally. It is a much different story, however, in the chaotic world of mortgage-backed securities. Chaotic trading continues, with yields on the benchmark Fannie Mae securities surging 24 basis points in three sessions. Last week, mortgage-back yields dropped 33 basis points in just three sessions. Amazing. In just six weeks, Freddy Mac's posted 30-year mortgage rates dropped almost 70 basis points to just over 7%. Fifteen- year rates are now below 6-¾%. These are the lowest mortgage rates since May of 1999. Not surprisingly, we are in the midst of a major refinancing boom as the Mortgage Bankers Association refinancing index surged 65% last week to the highest level since March of 1999. For perspective, last week's level on the refinancing index was 259% above year ago levels. Wall Street Computers are certainly being kept busy calculating the expected average lives of mortgage paper.

Consistent with the firming of stock prices, the dollar has seemingly regained its footing this week. The dollar index has added about 1%, with somewhat stronger gains against the euro. And while little mention is made, it is interesting to note that commodity prices have generally come on strong after beginning the year with significant selling. Led by a 10% gain in crude oil prices, both the CRB and the Goldman Sachs Commodity index have posted better than 1% gains thus far.

Our nation's unfolding energy crisis is becoming more apparent by the week. In its biggest move since October, Crude oil (February futures contract) today jumped $1.84, or almost 7%. There was quantification of the sharp December pullback in OPEC production. For the month, OPEC pumped 5%, or 1.53 million barrels less than November, largely due to cutbacks by Iraq because of their dispute with the United Nations. In what should be disconcerting to U.S. energy consumers, Saudi Arabia, Iran and other OPEC members have been calling for a 5% cut in production to support prices. The oil producers sure look determined to make what most believe has been a temporary spike in crude prices into something much more permanent. There was further bullish news of a draw down of heating oil inventories after a very cold week in much of the country. Heating oil inventories dropped almost 5% for the week and remain almost 20% below last year's levels. OPEC ministers meet next Wednesday in Vienna to set new production quotas. Yesterday, OPEC's Secretary-General was quoted as saying "if we don't cut production, there will be an uncontrollable plunge in prices."

There is certainly a steady stream of ugly news coming out of the California utilities. This afternoon PG&E announced that it would be eliminating its dividend, as it struggles with a rapidly depleted cash position. PG&E ended the year with power losses of $6.6 billion, while losses at Edison International increased to $4.9 billion. PG&E has stated that it "may be forced into bankruptcy" as it is in danger of not being able to pay its power bills, with $583 billion million due February 1st and $1.6 billion due March 2nd. The company has cash on hand of about $500 million. Interestingly, the recently approved 10% pay increase will provide only about $70 million extra each month for PG&E. The proverbial "drop in a bucket." Yesterday, the company sent California Governor Gray Davis an ominous letter including the following: "Without the gas supplies currently under contract, gas available to serve high-priority customers will be depleted within several weeks, and possibly sooner if temperatures fall below normal. At that point, home gas furnaces, stoves and water heaters would go off." "The question of the day is how long these companies have," a Wall Street analyst was quoted by Bloomberg.

Meetings that include the power generators, California Governor Davis, Energy Secretary Richardson, and Treasury Secretary Summers were held yesterday in Washington. Some type of solution is likely forthcoming.

And as buying returns to NASDAQ, it appears that the perceptions of the economy "falling off a cliff" are due change as well. Market News International ran a story yesterday high-lighting the BTM-UBSW weekly U.S. chain store sales index. On a year-over-year basis, sales for the first week of the year are up a strong 5.7% over 2000. Since one week is not exactly a statistically significant sample, we looked at monthly sales from our basket of retailers that we discussed here on August 16th. To refresh your memory, we follow a group of retailers that report monthly sales greater that $100 million. Total sales are then compiled monthly.

$ in millions Dec Nov Oct Sept Aug July
Total Sales $69,110 $40,503 $33,974 $48,954 $36,490 $30,948
Y-o-Y Growth 4.6% 7.7% 7.8% 8.1% 16.5% 13.2%

The results certainly confirm that the US economy is slowing from an unsustainable - "white hot" - environment. However, let's not get carried away and forget that December 1999 was an extraordinary month for retail sales. Not only was the stock market-driven economy booming, there was also the uncertainty raised by the Y2k scare. Consumers stocked up in December. Actually, our above group of retailers actually enjoyed total sales growth of over 15% last December! The fact that last month's sales increased at all over 1999 hints at the underlying strength, or resiliency, of the US consumer. Interestingly, while total sales increased 4.6%, same store sales fell by 0.2%. The problem is enormous overcapacity. With weak same-store-sales combined with reports of deep discounting by retailers, we doubt retailers will be consoled by this analysis. Profits in this sector will only become harder to come by.

Obviously fueling retail sales, the consumer continues to take on more debt. November consumer credit increased a much stronger than expected $12.9 billion, an annualized 10.7% gain. Total consumer credit now stands at $1.53 billion. Remember, this does not include loans secured by real estate, another category of debt expanding at an alarming rate. Clearly, the consumer has had no problem increasing its use of credit while interest rates increased. With the recent rate-cut and mortgage refinancing boom, we wonder how much fuel will be thrown on the fire. Until something changes, we see a continuation of problematic over consumption and massive trade deficits, as well as acute financial instability.

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