MarketView for May 9

MarketView

Events defining the day's trading activity on Wall Street

Lauren Rudd

Friday, May 9, 2008

Summary

Trading on Wall Street continued to follow the pattern of up one day and down the next with declining share prices taking the lead on Friday as the price of oil set another record and concerns regarding the financial sector continued  after American International Group reported a massive loss after the close on Thursday. All three major equity indexes ended the week lower: The Dow was down 2.4 percent for the week, the NASDAQ fell 1.3 percent and the S&P 500 was down 1.8 percent.

The NASDAQ fell less than the other indexes. Its losses were kept in check by stronger-than-expected earnings from Activision and upbeat comments on Nvidia. Activision shares ended the day up $3.94, or 14.22 percent, to close at $31.64, while Nvidia's stock closed up 58 cents, or 2.64 percent, at $22.53.

AIG's dismal results raised doubts that the end of the credit crisis was near. The world's largest insurer wrote down assets linked to subprime mortgages and said it would need to raise $12.5 billion to boost its balance sheet. Its shares ended the day down $3.87, or 8.77 percent, to close at $40.28. AIG was the heaviest drag on both the Dow Jones industrial average and the S&P 500. Also in the financial area, Citigroup has made it clear that it intends to shed roughly $400 billion of non-core assets in a bid to become more competitive. Citigroup’s shares ended the day down 67 cents, or 2.76 percent, to close at $23.63.

Oil rose above $126 a barrel, raising concerns over the possibility that inflation will continue to rise and worries that consumers will pare back their spending as higher prices at the pump cut into discretionary income. Oil has risen sharply since slipping as low as $110.53 per barrel on May 1. Speculators have seized on disruptions to crude oil supplies in the North Sea and Nigeria, as well as galloping demand for distillate fuels, a category that includes diesel fuel and heating oil.

Strong demand for diesel fuel in Europe, along with the growing use of distillates for generators to supplement strained power grids in fast growing emerging markets, have cut into stocks of distillate fuel and pushed up prices sharply. Crude oil futures hit a record $126.25 per barrel in post-settlement trading, before pulling back somewhat to $126.17. On the New York Mercantile Exchange, June crude settled up $2.27 per barrel at $125.96.

The steady rise in crude oil prices once again has turned the spotlight OPEC, which for months has insisted it has no control over the factors it blames for pushing up the price of oil, including speculation and the weak U.S. dollar.

Despite the rise in oil, Exxon Mobil was among the day’s losers on both the Dow and the S&P 500, most likely as a result of profit-taking. Exxon closed down $1.11, or 1.23 percent, at $88.82.

Pharmaceutical companies added to the gloomy picture. Mylan posted a wider loss, while Bristol Myers fell on the threat of generic competition in Europe for its top-selling blood thinner. Mylan ended the day down $1.04, or 8.35 percent, to close at $11.42, while Bristol Myers stock fell $1.08, or 4.74 percent, to close at $21.71.

A record drop in domestic imports because of slowing domestic demand took a big bite out of the trade deficit in March despite record high oil prices. The trade gap shrank 5.7 percent in March to $58.2 billion, the Commerce Department reported; a figure was considerably smaller than expected.

Will Bank of America Walk

Countrywide Financial saw its share price fall nearly 6 percent on Friday on renewed speculation that Bank of America will renegotiate or cancel its agreement to buy the largest U.S. mortgage lender. Bank of America agreed in January to pay $4 billion for Countrywide, swapping 0.1822 of a share for each Countrywide share. That valued Countrywide at the time at about $7.16 per share. The value of the merger has since fallen to about $3.9 billion because Bank of America's stock has fallen. However, Countrywide, however, has long traded well below the exchange rate, suggesting that investors expect a lower price.

Bank of America also spooked investors last week by saying it had not decided whether to guarantee all of Countrywide's debt. Friedman, Billings, Ramsey analyst Paul Miller wrote to clients on Monday that Bank of America should walk away from the merger.

With put options overwhelming call options by over 7 to 1, the thought is that the increase in put activity is due to persistent conjecture in the market that Bank of America may either secure a lower price for its Countrywide takeover, take on less Countrywide debt, or walk away from the deal completely.

Outlook is not good say Goldman Sachs

Goldman Sachs economists expect a total of $500 billion in residential mortgage credit losses, a renewed slowdown in economic activity after the near-term boost from fiscal stimulus, and no monetary policy tightening in 2008 or 2009, according to a research note from the firm.

Despite a setback in recent days, many financial market indicators have recovered substantially since the Bear Stearns/JPMorgan Chase & Co deal in mid-March, Goldman Sachs chief U.S. economist Jan Hatzius wrote. Still, "we think that overall mortgage credit losses will end up being larger than generally believed," Hatzius wrote.

"Excess supply in the housing market is still growing; home prices are already falling at rates that are very rapid by the standards of previous housing downturns around the world; and U.S. loan-to-value ratios are much higher than in those previous downturns," he said.

"Ultimately, a painful adjustment needs to take place, certainly in the housing and credit markets and likely in the broader economy as well," Hatzius wrote.

Even if the shock is moderate, it can have large multiplier effects if it reduces the equity capital of highly leveraged financial institutions that mark their balance sheets to market, he said. Although the leveraged losses story sounds dire, its implications for the U.S. economic outlook are actually somewhat encouraging at present.

Reduced selling pressure or outright purchases of beaten-down assets will eventually support asset prices, this will push down leverage, and the resulting balance sheet relaxation will facilitate further asset purchases.

"This means that good news can continue to feed on itself," he wrote, with "positive spillover effects on sentiment and activity in the broader economy."

Still, the increase in mortgage credit defaults is large and has further to go and the "locus of pain" tied to losses related to further mortgage credit defaults is likely to shift away from subprime mortgages, where the markets are already discounting very large losses, to other residential mortgage debt, including prime mortgages.