I predicted this market correction a week or so before it happened in July, which subsumes the fact that I consider it a correction - meaning that the market will find the July highs again and go on to higher ground. I’m not always right, so it feels good. 336 points on the DOW today; biggest one-day gain in five years or so.

To recap, I’ve been saying for a while that we’re in the waning stage of a bull market, that a correction was due, that the summer sell-off was a correction only, and that the market will recover to the July level and new highs. Sometimes we really have no clue what comes next, but - love me or hate me - I was rock-solid on this call.

So we recover; but then what?

The bull doesn’t have a whole lot farther to run, that’s what. I’m guessing the stumble will come by next summer, if not sooner. Like a doctor examining a terminal patient, I cannot say the date, but like the doctor, I have no doubts, either. With nearly five years under its belt, how much longer can the bull run, with a global credit crisis occurring and housing dragging our economy down further by the day? I’ve written about this extensively, so I won’t regurgitate it here.

I get emailed newsletters DAILY urging me not to panic, not to lose faith in the market, that the powers-that-be have the potential economic crises well in hand, and that the market will go on to incredible new highs. We’ll see some new highs, yes (barring the other economic shoe dropping too soon), but the market’s end is in sight; get serious. I’m not selling this blog or any newsletter, nor do I market hot stock picks, so these are my actual, unexpurgated thoughts. It’s not about faith or reading the tea leaves, it’s about applying common sense to the data.

When corporate profits start to falter, the market will go bearish for real. Actually, the market will turn south before the cascade of bad earnings, because certain forces always are, shall we say, ahead of the economic curve. But even these “forces” don’t know the “date.”

If you were on the fence whether we’re just having a correction or the bear market had begun, does the resurgence of the brokers like Lehman (LEH) in the last few days provide any reassurance? They have some of the largest credit-crunch and mortgage-meltdown exposure of any, other than mortgage and directly housing-related companies. Yet the brokers are soaring. This would not be happening if the bull were not getting back on its legs. Even Lowes (LOW) and Home Depot (HD) have been showing strength lately, not exactly a bearish sign for the near term.

I know, sigh, we had an artificial boost today from the FOMC, and the Fed can’t cut rates every day. But the market wants to go back up, and this provided a terrific morale boost. The bets placed on a rate cut are winning big.

We’ll probably have a hiccup or two on the way back to the market top, but I am bullish now for the medium term. The market may pull back again one or more times on the way back uptown, and I won’t panic if it does. The market usually surges in November (Halloween Effect), and may well surge earlier this year. Even at new highs, expect a lot of volatility - think of it as lots of chances to trade the calls!

TRADING:
Covered calls have been tough in the last two months for straight writers, though not bad for those adept at trading calls. But better times are a’coming. I think it’s about time to get long, actually. Buying calls or writing covered calls will work for a while yet, as will naked puts. In fact, OTM covered calls should be very productive in coming months as the market gathers its last strength. However, the real gainers, the safer stocks, are the large caps.

If you are not a well-practiced covered call writer, stick with the S&P 100 and Nasdaq 100; or at least the top half of the S&P 500. Quality, quality, quality.

Covered writers and naked put writers should in my opinion avoid small caps and all but the strongest mid-caps with the least exposure to housing woes, because if they fall it could be hard and fast. The market is cutting these stocks VERY little slack any more. A few will be great, yes, but you’d better be able to pick them. You will have a greater comfort level with covered calls on these if buying a cheap, long-term protective put.

The big brokers Morgan Stanley (MS), Lehman Brothers (LEH), Bear Stearns (BSC) and Goldman Sachs (GS) all report earnings next week for the quarter. Merrill Lynch (MER) reports in October. These are all important players on the world financial stage. Their financial results will be a good barometer of how bad the credit crunch in past months actually has been. Bear and Lehman have the most exposure to the credit crunch, since they rely more on fixed income sales, which means they heavily sold collateralized mortgage products, but all of them have substantial fixed income sales. The merger and buyout deals generate gigantic fees for these chaps, and the deals have slowed to a crawl as a result of the meltdown. Here’s where the brokers stood as of 9/7/07:

MS - 62.50, down from 90.00 (-30.5%)
MER - 73.20, down from 95.00 (-22.9%)
GS - 179.00, down from 233.00 (-23.1%)
BSC - 105.00, down from 172.00 (-39%)
LEH - 53.00, down from 86.00 (-38.3%)

Several hedge funds have collapsed, notably two run by Bear Stearns. Even Goldman had to pump $2 billion of its own money into one of its big hedge funds after losses in August. Brad Hintz of Bernstein Research (and former Lehman CFO) notes that the big brokers have substantial exposure to subprime because they securitize mortgage loans by cutting them up into tranches and selling the tranches. But the brokers wind up having to take the riskiest tranches that are exposed to the first losses (growing, and they will become gargantuan in 2008), known as residuals. BSC, LEH, GS, MS and MER have as much as $11 billion of these “residuals” on their balance sheets. They also get stuck with leveraged notes and other assets that no one wants now, because one of the ways they get underwriting deals is to take the paper and gamble on being able to resell it.

The market is waiting to see how much effect the crunch will have, how much their asset holdings (which are marked to market) will be devalued, how recent volatility has affected trading profits (they should be up) and how much the slowdown in M&A activity has hurt profits.

Many financial pundits are starting to say that the big brokers are so devalued that they are bargains. Maybe so, but they may be more of a bargain after next week… unless you think they have not been affected by the sheer immensity of the summer’s crunch and the fact that some of their most profitable activities have been virtually stopped dead in their tracks.

Trading and Call Writing
There will be lots of people shorting these stocks (many already have), though it may not be easy. When short interest gets large enough, where will you find stock to borrow? But even your Aunt Mabel can buy puts or place a bear put spread.

Anyone with a covered call on these stocks and who has not purchased a multi-month put to protect the position might consider doing so. Putting a covered call on these stocks requires such a put at this point. If the stock pulls back and catches support convincingly, the put (which will have increased in value with the stock’s drop) can be sold at a profit. Or the put can be exercised if necessary. Unprotected covered calls simply will have to ride it out, although the calls can be traded with the stock’s movement to produce trading profits.

These brokers are some of the most important financial companies in the world, so they are unlikely to vaporize. Bear Stearns is the greater risk and has been scaring people, Lehman is the next most likely to take a large hit. But the problems affecting the brokers are not resolved and not at a crescendo yet, either.

The AUG non-farm payrolls report showed a loss of 4,000 jobs. That might not seem like much, but 1) it was the first negative month in four years, and 2) it was expected that as many as 155,000 new jobs would be added. Thus viewed, AUG showed a rather breathtaking shortfall.

Housing-related industries have lost at least 80,000 jobs this year, and Countrywide (CFC) will itself cut another 10,000 to 12,000 jobs. In fact, the AUG jobs report probably will, more than any other single factor, weigh in the Fed’s decision to cut the fedfunds rate from 5.25%, should they decide to cut it at the September 18th FOMC meeting.

The AUG jobs shortfall is an “economic earthquake” that will dramatically change the Fed’s perspective on the economy, and data to come should start to reveal “how big the ripple effect will be on the economy,” according to Doug Roberts, Channel Capital Research, referring to expected oncoming job losses. Political pressure is mounting on the Fed to cut the fedfunds rate (it only cut the discount-window rate, where non-banks and weaker banks borrow). Federal Reserve Governor Frederic Mishkin recently said that the Fed possesses the “tools to limit the negative effects on the economy from a house-price decline.” Feel better, now?

I for one certainly don’t buy into the notion that the Fed is an all-seeing body (like the Greek gods of antiquity) that can micro-manage human affairs. Notice that Mishkin is not talking about the subprime mess; he specifically limited the Fed’s ability to help to the “house-price” decline. I’m not trying to be niggling, but Mishkin does well to carefully limit his words. Economic tides are too big to be contained by central bank policies, though central bank actions can obviously help or hurt.

A cutback in consumer spending has not yet appeared in corporate earnings. What I really want to see are September jobs reports and Q3 corporate earnings. We’ll have a better handle on things then. If the economy and the credit crunch are in fact derailing consumer spending, then it has to show up in corporate earnings.

DUE NEXT WEEK:
Several reports for AUG are due next week: retail sales, business inventories and industrial production. All are expected to be up 3-5% over July, and shortfalls will be ugly.

Stock futures are down this morning before the stock market’s open, signalling losses today in the stock market. S&P 500 futures declined 5.7 points Nasdaq 100 futures declined 11.75 points. Dow industrial futures fell 39 points. This may not signal a triple-digit pullback in the market, but today is extremely unlikely to be anything but another down day, unless news comes out that moves the market.

For those of you playing volatility, today might provide a chance to profitably close bearish positions recently put on, and you might be able to put them on this morning (buy puts, etc.).

Covered call writers: be alert for a chance to close short calls profitably if the underlying stock pulls back with the market.

The title quote is from a Marketwatch.com article by Steve Goldstein this morning noting that Wednesday morning stock futures are signalling losses today in the stock market. S&P 500 futures declined 11.9 points at 1,477.60 and Nasdaq 100 futures declined 7 points at 2,017.75. Dow industrial futures fell 80 points.

As Goldstein points out, investors may well be pulling back ahead of key economic data due out later in the week, such as the Beige Book and pending-home sales for August. We could well see a retreat in the stock market, which had the Dow within spitting distance of 13,500.

Until this volatility settles down, we will continue to have the market advancing in fits and starts (due to the core of bullishness remaining, based upon still-decent corporate earnings) and then pulling back, just when it seemed safe to go back in the water. The market cannot play keepaway forever, though, and these tremors should subside.

The older I get, the weirder life seems to get… Early in 2007, I was talking about the subprime problems and their severity, and most people (including Bernanke) snickered at the economists making such Cassandra warnings. Well, maybe not snickered, but Bernanke in particular predicted in March 2007 that the subprime problems would not significantly impact the “broader economy.” Right, that’s why in August, European central banks pumped an aggregate of nearly $300 billion of liquidity into their economies to save big banks getting a giant wedgie from all the profligate credit extended. When German banks are being bailed out, brother, there is much to be concerned about.

Now everyone is taking the problems deadly serious, though a real panic has not yet bloomed. Taking them so seriously, in fact, that I now seem like Pollyanna for saying we still are in a correction and that the bull has farther to run, as newsletter publishers increasingly turn bearish.

But if markets are the result of economic fundamentals, and I’m confident they remain so, then the market should get back on its feet. But this would also mean that before long, probably before the halfway point in 2008, the bear really is going to be large and in charge.