Consolidation Drives Financials & Dow Higher; Nasdaq Sell-off Continues

The major market indices diverged today as the bulls and bears continued to "mark" their territory. In the bear camp, technology stocks were out of favor again, as money rotated into financials and energy stocks. The Nasdaq sold off 129.84 points to close at 4,013.34 on heavier volume of 1.74 billion shares. Breadth was negative as advancing issues trailed declining issues by a 17 to 23 margin.

On the bullish side, the Dow Jones Industrial Average (INDU) showed good relative strength, closing up 50 points to 11,310.64. NYSE volume came in stronger than yesterday at 998 million shares, while advancing issues outpaced declining issues by 15 to 12 margin.

The S&P 500 (SPX) finished lower on the day, despite the positive breadth on the NYSE. The SPX lost 14.82 points to close at 1492.26. Meanwhile, the small-cap Russell 2000 (RUT) moved 2.7 points lower to close at 536.32.

Powering the Dow today were its financial issues. JP Morgan (JPM) moved up $7.81, or 4.88%, to close at $167.75 on a rumor that Deutsche Bank is interested in making an offer for the blue-blooded bank. JP Morgan has been moving steadily higher since CSFB announced its intent to purchase DLJ last week for roughly 3 times book value. That price tag translates to a $210 stock price for JP Morgan. This price represents a fair value given that the Paine Webber (PWJ) acquisition by UBS earlier in the year carried a similar valuation.

Another Dow component, Citigroup (C), also helped to drive the financial sector today, specifically consumer finance companies. Citigroup announced it will be acquiring Associates First Capital (AFS) for $31 billion in stock. The deal values AFS at $42.49/share, nearly a 52% premium from yesterday's close. AFS shares rose $10.63 to close at $38.63. Citigroup stock, as the acquiring entity often does, fell on the day, shedding $2.63 to close at $54.94.

The addition of AFS will significantly alter the revenue mix at Citigroup. Currently, the consumer finance group generates 44% of Citigroup's revenues compared to 47% for the corporate and investment banking arm. The addition of AFS's $7 billion in revenue will tilt the scales in favor of the consumer line of business. AFS, as Japan's fifth largest consumer finance company, will also help to broaden Citigroup's international presence.

The Citigroup announcement helped to lift the entire consumer finance industry today. MBNA (KRB) gained $1 to close at $36.06. Household International (HI)moved up $256 to close at $50.19. Capital One Financial (COF) gained 1.4% and Providian Financial (PVN) moved nearly 4% higher. I bring these companies to your attention because I checked out their trading valuations relative to the AFS deal. The AFS deal was valued at 2x book value, 13.5x earnings, and 1.6x sales. It appears AFS was exceptionally cheap, as most of its peers traded well above these valuation levels. Although these stocks rallied on momentum today, future price appreciation might be minimal given their relative valuations.

In other deals today, Berkshire Hathaway (BRKA) agreed to buy carpet maker Shaw Industries (SHX) for roughly $2 billion. The deal prices Shaw at $19/share, a 56% premium over yesterday's closing prices. Warren Buffett is known as a value investor who favors businesses with good cash flows. Ironically, as a value investor, Buffett often creates many momentum-trading opportunities. He may not be exciting but he makes money and the investing public is in awe of his financial prowess. Shares of Shaw were bid up $6.56 to $18.625 on 10 times normal daily volume. Now that the value is in-line with the offer price, my hunch is that more investors will follow Buffett into the stock, creating additional trading opportunities.

In other sector action, energy stocks continued to outperform the overall market based on the outlook for higher oil prices. Crude oil prices catapulted to a 10-year high, as speculation that additional OPEC output will do little to affect demand and reserve characteristics. October crude oil futures gained $1.07 to $34.90/bbl. The all-time high was set in 1990 during the Gulf War when oil prices hit $41.15/bbl. The Philadelphia Oil Services Index (OSX) surged 3.72% to close at 141.14, a new 52-week high. The outlook for upstream oil service companies, is still very attractive due to an increased number of drilling projects and the long-term nature of drilling rig contracts. The commodity-pricing environment obviously remains positive, although oil doesn't need to remain at these prices to maintain the profits of oil service companies.

Semiconductor stocks led the Nasdaq lower as investors bailed out of Micron Technology (MU) after an analyst downgrade. DLJ downgraded Micron from a buy rating to an under-perform rating, citing less favorable DRAM chip prices going forward. MU fell $8.25 to $70.25 today in response to the downgrade, despite some mid-day analyst support from Joe Osha at Merrill Lynch. Osha believes that a mid-cycle correction has manifested itself and the future outlook for DRAM demand will remain healthy.

Meanwhile, industry bellwether Intel Corp. (INTC) lost another 5% to close at $65.69 a day after it was downgraded. The Philadelphia Semiconductor Index (SOX) lost 5.7% to close at 1057.68.

Also making news in the markets today were Ford Motor (F) and MP3.com (MPPP). Ford's problems are getting worse as documents allegedly indicate Ford and Firestone conspired to keep information regarding tire safety issues in Saudi Arabia from U.S. regulators. This issue was initially thought to be immaterial to Ford's operations, but investor sentiment is shifting sharply to the negative side of the spectrum. Ford sold off $1.31 to close at $26.13. An analyst upgrade yesterday citing a 12-month target price of $46 boosted the stock briefly but has not succeeded in establishing a price floor. Ford is probably getting into bargain territory given GM's recent run-up but I'd wait for the price to re-establish a positive trend on good volume before opening a position in the stock.

As for MP3.com, a federal judge ruled that MP3 "willfully" violated copyrights on music CD's sold by Universal Music Group. The "willfully" is important with respect to damage amounts. Potential damages range from $118 million to $250 million. After being halted in mid-afternoon trading for the judicial decision, MP3 traded down to $5.25 in after-hours trading after closing at $7.88, down $0.69 for the day. If upheld, an award of this size will certainly bankrupt the company.

On the economic front, productivity rose at a 5.7% revised rate in the second quarter. As this report is only a revision from the previously reported 5.4% figure, the markets perceived the news as positive, but generated little excitement on the floor. Treasuries, on the other hand, took the opportunity to sell off in the face of increased corporate and government offerings this month. The 30-year bond traded down 19/32 to yield 5.71 up from 5.67 yesterday. The 10-year note traded down 9/32 to yield 5.72, up from 5.69 yesterday.

As there is little in the way of significant economic news this week, the bulls and bears will receive no additional guidance when duking it out on the trading floor tomorrow. Wait for any positive catalysts from technology players, such as analyst upgrades or acquisition news, before bottom fishing in the Nasdaq. In the meantime, look for continued strength in the financial and energy sectors.

Good luck and trade wisely.

Chris Pikul, CFA
Assistant Editor