MarketView for June 26

MarketView

 

Events defining the day's trading activity on Wall Street

 

Lauren Rudd

 

Thursday, June 26, 2008

 

 

 

 

Summary

  

It was a nasty day on Wall Street with the Dow Jones industrial average dropping almost 360 points to a 21-month low as oil hit a record high and Goldman Sachs writing to clients with the message that they should be selling the shares of the major banks and those of the two domestic automobile manufacturers, especially General Motors. General Motors' stock sank to its lowest level in 53 years, after Goldman warned that the big U.S. automaker could have to raise capital and cut dividends in a brutal slowdown for the auto industry.

 

Goldman Sachs forecast more write-downs at Citigroup and Merrill Lynch. As a result, all 30 stocks making up the Dow ended the trading day in the red. At the same time, the price of a barrel of oil moved above $140 per barrel in intraday trading, compounding fears that soaring inflation will hamper a global economy already on the ropes.

 

Technology shares were hammered after weak profit outlooks from Research in Motion and Oracle, despite both companies turning in excellent earnings for the quarter. Disappointing U.S. earnings from Nike further darkened the mood.

 

The price of oil surged after Libya said it was studying options to cut output in response to possible actions by the United States against producer countries. U.S. crude oil for August delivery settled up $5.09, at a record $139.64 per barrel.

 

Economic data also painted a gloomy picture. The government reported that a four-week average of new jobless claims, a measure of underlying labor trends, rose to its highest level since October 2005 in the aftermath of Hurricane Katrina.

 

Sales of previously owned U.S. homes rose in May and the glut of homes for sale shrank, but prices were off sharply from a year ago, suggesting the housing sector remains a big weight on the economy. The country’s gross domestic product, which measures total output of goods and services within our borders, grew at a 1 percent annual pace in the first quarter.

 

Price Of Crude Oil Hits Record High

 

Oil prices rose nearly 4 percent to a record high over $140 per barrel on Thursday after Libya said it was studying possible options to cut output in response to potential U.S. actions against producer countries. The price of domestic crude settled up $5.09 at $139.64 a barrel, after hitting an all-time high of $140.39 earlier in the trading day, eclipsing the previous record of $139.89 a barrel hit on June 16. London Brent crude settled up $5.50 at $139.83 per barrel.

 

Ghanem, Libya's most senior oil official, said he was studying the possibility of reducing production in response to a bill before the Congress that would empower the Justice Department to sue OPEC members for limiting oil supplies. Libya pumped about 1.71 million barrels per day (bpd) of oil in May, out of 32.12 million bpd pumped by OPEC as a whole.

 

President Bush has said he would veto the legislation if it were passed by Congress. The House of Representatives passed the bill in May, but the Senate has yet to schedule a vote on the measure.

 

Oil prices have rallied over the past six years, supported by surging demand from emerging economies like China. Rising flows of cash into commodities from investors seeking to hedge against inflation and the weak dollar have added to gains in the price of crude oil this year. Meanwhile, the dollar fell broadly on Thursday after the Federal Reserve held interest rates steady on Wednesday and dashed expectations of an imminent rate hike.

 

Rising fuel costs have strained economies and spurred protests around the globe, prompting OPEC kingpin Saudi Arabia to pledge to hike output during a meeting between producer and consumer nations over the weekend. OPEC President Chakib Khelil said that prices could reach $170 a barrel in the coming months, and he reiterated the cartel's position that speculation, not supply, was driving oil to new highs.

 

"I forecast prices probably between $150 and $170 during this summer. That will perhaps ease towards the end of the year," Khelil said.

 

Oil prices fell on Wednesday after government data showed a surprise build in the crude inventories of the world's top consumer as demand continued to drop, while Nigerian oil workers met with Chevron management and the OPEC country's oil minister on Thursday in an effort to avert an all-out strike that could cut output.

 

GM Stock Hits 53 Year Low

 

Shares of General Motors hit their lowest level since 1955 and dragged down the auto sector on Thursday after Goldman Sachs cut its rating on GM’s shares to a "sell and warned it would have to raise capital. The panicky slide in GM capped a period of growing concern about liquidity risk potential facing the automakers and suppliers in a domestic auto market reeling from record gas prices and the impact of a housing slump and tighter credit.

 

The Goldman Sachs warning, including the unusual "sell" call on the auto industry's largest player after a period of sharp stock price declines just ahead of the close of the second quarter, prompted selling across the sector. GM Chief Executive Rick Wagoner said the embattled automaker had enough liquidity to carry it through the year and had financial flexibility beyond that.

 

"We've got a very good, solid funding base under any scenario we see, solid through the end of this year," Wagoner said after an economic event hosted by U.S. presidential candidate Barack Obama. "We have a lot of options to fund beyond that."

 

Chrysler LLC, for its part, denied rumors it was facing a cash crunch or that it had been driven to filing for Chapter 11 bankruptcy. Those rumors had driven down loan prices for the privately held automaker. "The rumor is without merit," Chrysler spokesman Dave Elshoff said. "There is no basis for the rumor."

 

Debt and equity markets were affected by growing concern for the deepening risks for the auto sector. The cost to insure the debt of GM and Ford hit record highss.

 

Major GM suppliers were also hammered. Shares in American Axle & Manufacturing, which supplies axles for GM trucks, dropped 12 percent. Lear, downgraded to a "sell" rating by Goldman, fell 18 percent. Shares of Ford, which had its price target cut by Goldman, fell almost 5 percent.

 

With the Thursday price fall, GM's market cap fell to less than $6.5 billion. The company has the smallest market capitalization in the Dow Jones industrial average, of which it has been a component since 1925.

 

Next above GM in terms of market value in the Dow is Alcoa with a market cap of about $30 billion. Walt Disney’s cap is 10 times GM's at about $60 billion and Exxon Mobil is the leader at about $460 billion.

 

GM shares have lost 38 percent over the last month as more evidence has piled up that sales weakened further in June, raising doubts about the prospect for the second-half recovery that GM and other major automakers had anticipated. Fitch Ratings on Wednesday cut debt ratings on GM and Chrysler ratings deeper into the "junk" category," citing the fallout from weaker sales and high gas prices. Fitch also said it would review Ford ratings over the next six weeks, which could also result in a downgrade.

 

All three U.S. automakers, which have been hardest hit by the collapse in demand for pickup trucks and SUVs, have faced scrutiny in recent days over whether they have sufficient liquidity to ride out the current downturn. Billionaire investor Kirk Kerkorian, who has invested about $1 billion in a contrarian bet on Ford, has offered to provide more capital to support the automaker's turnaround.

 

Earlier this week, Chrysler drew down a $2 billion credit line from Cerberus and Daimler AG, the German car maker that sold off a roughly 80 percent stake in Chrysler to Cerberus last year. Under terms of the sale, Chrysler had until August to draw on the credit line, which included $1.5 billion from Daimler. The credit line pays interest fixed at 7 percentage points above the London interbank rate, Daimler has said.

 

Chrysler, which lost $1.6 billion in 2007, has said it ended the year with $9 billion in cash. Its domestic sales are down 23 percent so far this year.

 

Analysts have also fixed their sights on GM, which ended the first quarter with $31 billion in cash and undrawn credit. Deutsche Bank and JP Morgan both warned last week that GM would be forced to borrow heavily to shore up its liquidity position.

 

Goldman Sachs analyst Patrick Archambault cut his six-month price target on GM stock by $8 to $11. "We think GM's automotive cash flow burn this year and next is likely to lead it to look to raise capital, which we believe could lead to significant shareholder dilution and/or a cut to the company's dividend," Archambault wrote to clients.

 

Inflation Major Role Player In Fed Decisions

 

The Fed has indicated that inflation expectations will play a much bigger role in future decisions about interest rates. Like many policy-makers around the world, Fed officials have been taken aback by the relentless surge in oil prices. They are hoping such spikes will not make Americans too accustomed to faster price increases. If consumers and businesses begin to take such inflation for granted, the Fed fears, they might set off a self-reinforcing cycle of demands for better wages and costlier products.

 

"The upside risks to inflation and inflation expectations have increased," the policy-setting Federal Open Market Committee said as it wrapped up a two-day meeting on Wednesday, at which it decided to keep its benchmark interest rate steady. For now, the U.S. central bank appears to hope tough talk can help tamp down these tendencies, avoiding the need for a near-term increase in borrowing costs.

 

While expectations are seen as a key ingredient in the future rate of inflation, economists caution a policy that relies heavily on measuring them has its perils.

 

Because gauging consumer and business psychology is difficult, the Fed risks either underplaying or overstating the case for higher rates. In either instance, the repercussions could be costly.

 

Investors need not look too far to see why the Fed is worried. No matter how you measure them, inflation expectations are moving higher, although some barometers are flashing more urgently than others. Spreads between regular U.S. government bonds and their inflation-protected cousins are at their highest levels since early May, even if they have receded considerably from highs seen during the turbulent markets of last summer.

 

Household surveys, too, have captured a much less sanguine consumer. The Conference Board's index of one-year inflation expectations is stuck at an all-time high of 7.7 percent, while its Reuters/University of Michigan counterpart remains near its highest since the early 1980s.

 

Yet so far, both the economy and credit markets have remained weak enough to support the central bank's prediction that inflation will eventually come down, despite skyrocketing prices for oil and other commodities. However, the sheer persistence of the rise in crude oil prices, which hit a record above $140 a barrel on Thursday, has prompted a pause among policy-makers. Indeed, Richard Fisher, one of the Fed's more hawkish members, voted for an interest rate increase this week.

 

Goldman Says Sell Citigroup Short

 

Citigroup saw its share price hit its lowest level in nearly a decade after a Goldman Sachs said that investors should sell the stock short as losses mount from troubled debt. They also touched their lowest level since October 1998, the month that Sanford "Sandy" Weill merged his Travelers Group with Citicorp to create Citigroup.

 

William Tanona, the Goldman analyst, added Citigroup to Goldman's "Americas conviction sell" list and cut his price target on the stock to $16 from $20. He recommended a "paired" trade in which investors sell Citigroup shares short, betting on a decline, and buy Morgan Stanley shares.

 

The analyst said Citigroup might take $8.9 billion of write-downs for the April-to-June period, leading to its third straight quarterly loss. He also said the bank might need to cut its quarterly dividend for a second time this year, after lowering it 41 percent to 32 cents per share in January.

 

Tanona's forecast suggests deeper problems for Citigroup Chief Executive Vikram Pandit, who is trying to turn the bank around after nearly $15 billion of losses in the last two quarters, and more than $46 billion of credit losses and write-downs since the middle of 2007.

 

"We see multiple headwinds for Citigroup including additional write-downs, higher consumer provisions as a result of rapidly deteriorating consumer credit trends, and the potential for additional capital raises, dividend cuts, or asset sales," the analyst wrote to clients.

 

Tanona said Citigroup might write off $7.1 billion related to collateralized debt obligations and associated hedges related to monoline insurers, $1.2 billion for other asset classes and $600 million for structured note liabilities.

 

He now expects Citigroup to lose 75 cents a share this quarter, compared with his earlier forecast of a profit of 25 cents. He also expects a full-year loss of $1.20 a share, compared with his prior view for a profit of 30 cents.

 

Tanona said the bank may now need to issue common stock or sell assets to raise capital, because regulators may forbid it from issuing more preferred or convertible securities. He also said halving the dividend could preserve $3.5 billion a year.

 

"Given the firm's current level of earnings power, we do not believe the dividend is safe," Tanona wrote.

 

Tanona also downgraded the brokerage sector to "neutral" from "attractive," saying deteriorating fundamentals will likely prolong any recovery from the credit crunch. He projected a $4.2 billion second-quarter write-down for Merrill Lynch, leading to a quarterly loss for the brokerage.

 

"We expect write-downs for Citigroup and Merrill to outpace what we saw from Morgan Stanley and Lehman Brothers Holdings recently, due to Citigroup's and Merrill's large exposures to ABS CDOs (asset-backed security CDOs) and associated hedges with the monolines," Tanona wrote.