The Break

[Late addition, Friday morning: Great minds think alike.]

Top Line: We call this market a bear market and we should be aware that the tendencies of a bear market are much like those of a bull market, with a little more power due to fear being exhibited versus greed. We here at the Update will promise to be more respectful of the bear market from here on out. Our week has been riddled with whipsaw even though our portfolio remains intact this evening.

More Top Line: Thursday's break of 12,500 in the Dow brings some real trouble to the bulls. The shelf of support revealed a hidden trap door. We need to revisit the numbers we shared in our last post due to the day's action and we are certain that whatever is going on in the after hours is mere noise.

Speaking of the after hours, IBM got to do double duty this week. They preannounced on Monday and tonight they delivered their news. The news was received positively in the thinly traded after hours market and the US futures are up strongly as we write. These are the types of things that are powerful in creating confusion for the participants.

The news of the day has been centered on our FearFul central banker Bernanke and his testimony in front of Congress in the morning. He told them that fiscal stimulus is needed and should be used very soon. If Congress could turn on the fiscal stimulus as the Fed is cranking down the interest rates, Bernanke thought that would be a good preventative dose of medicine to Avoid a recession. (You can only imagine how long it took the politicians to grab onto to that bit of advice.)

Does he seriously think we are Not going to have a recession? That was the question on the traders' minds as stock prices immediately started falling as he was speaking. These helpful hints to Congress to stimulate the economy are not really confidence builders for those who are buying stocks. The US Treasury bonds did do fairly well on the news, thank you very much.

The news on the day was just not very good. Merrill Lynch was the early news and it said they were writing down some more assets. Losses amount to around $10 billion or $12.57 a share. We ask what a company like that is really worth. If the P/E ratio is 10, that would be negative $125, but that's not how it works.

Then there was the Philly Fed's manufacturing report which showed contraction. The housing report that indicated the worst annual drop in 27 years when you now include December's dismal numbers. Washington Mutual, dubbed WaMu, said that it would lose about $1.9 billion.

Then there is the little problem over at the bond insurers, MBIA and AMBAC. These stocks dropped, respectively, 30% and 50% today. This news has brought more energy to the default talk which should appear on the front page of the WSJ on Friday. Inside the article are less than confidence inspiring statements about how the CDS world may have troubles.

CDS's are credit default swaps and the name suggests what they are, swapping the credit defaults of various credit securities. One company owns a bond or mortgage and would like to get "off the risk" so it tries to sell the asset. Some of these assets are so thinly traded that a buyer is difficult to find sometimes. But, in the world of derivatives, this is no problem. An arrangement is made with a speculator who is willing to provide insurance on the asset in the event of default. So, the owner of the asset now is protected from default, right? Not so fast.

This all worked nice and neat over the past several years when defaults were at minimal levels. With all of the losses piling up on various assets, there is a new risk. It is called counterparty risk meaning that the company that provided the insurance may not actually be able to pay for the credit default.

This is quite a predicament for Company A, who buys a security from XYZ but doesn't really like the credit risk of XYZ so it contracts with Company B to provide insurance. If XYZ has a default, Company B is supposed to pay Company A for any loss due to the default. What if the number is so big Company B can't pay Company A? Company A has now lost its "insurance premium" and has lost the value of the asset. Not a pretty picture at all.

Then, after the market closed the Russell 2000, RUT, managed to drop 20% from its 2007 highs. This represents an event known as a confirmed bear market and it will be reported as such in the press on Friday. It was truly a bearish, especially after the market broke through support, or as we call it, the trap door.

Right now it is important to step back and assess the fear of the chairman of the Fed. We think the market has been looking forward to the rate cut in a couple of weeks, and hoping for it early, but now the chairman is explaining why the cuts are necessary and the market does not like it. We think this will continue for a long while.

We received information from our subscription service with Elliott Wave International indicating the break in the market today. They are and have been bearish for a long time and tonight have basically gone red with their bearishness. The market is about to fall a long ways and they think well past the 11,000 we mentioned in our last few posts. Our number is the first in a series of downside targets we expect to hit over the next Five years or so. This will be a painful experience for all. We want to provide some roadmaps for you as we go down this path together. Take the first step slowly and gingerly because it's a doosy.

FSI: 90.20 (not too bad but a new low)