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Fleck Rap

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Note: Professor Fleckenstein provides his commentary for educational purposes - his insights are not intended as investment advice. You can find his daily comments at www.fleckensteincapital.com

Please note that this is Prof. Fleckenstein's Rap that was published yesterday afternoon, however given Fleck's focus/expertise in the area, we still find it helpful.


Connecting the Dots


Overnight markets were slightly soggy, as were our equity futures. The big news from my vantage point began last night, when Xilinx (XLNX:NASD) surprised the it's-the-bottom-because-it's-only-a-one-quarter-problem bulls. Specifically, the company took guidance down further than expected, and shocked the wide-eyed by announcing that inventories had gone up from around 140 days to 155 days -- during a period when they were supposedly working down inventory.


CLS Radios an SOS


But the real shovel to the face was delivered by Celestica (CLS:NYSE), which said, via PR Newswire: "The revision in revenue is due to recent order reductions from some of its largest communications and IT customers." For folks who don't know, Celestica's largest customers in those areas are Cisco (CSCO:NASD) and IBM (IBM:NYSE). (Much more about this and related dot-connecting below.)


To my mind, Celestica's news swamped the fact that last night Oracle (ORCL:NASD) made the number as it was supposed to. I don't believe there's any information to derive about other companies based on what Oracle had to say or delivered, but that was one port in the storm early this morning.


Shifting to the preopening news, the macro data were about as expected and really not worth commenting on. In the glad-tidings department, Best Buy (BBY:NYSE) said that everything continues to be just fine, thank you very much, and pricy doodads continue to sell well, as we've seen from some other high-end retailers. One of these days, the whole consumer-electronics arena will take a breather, though thus far it hasn't.


Things Go Bitter with Coke


Additionally, Coca-Cola (KO:NYSE) preannounced, which obviously has nothing to do with the supposed one-quarter chip-inventory correction. (KO's news saw the stock "correct" to the tune of down 5% in the early going.) Similarly, Tribune (TRB:NYSE), the big media company, announced lowered expectations, though its stock price was not impacted much.


In any case, that was the scene as the casino opened for business. There was an attempt at stabilization right off the bat, but that kind of fell apart. A couple hours into the day, all the indices were down 0.75%, plus or minus. Housing stocks were slightly red, but the mighty, mighty Sox was unequivocally red, down a quick 4%.


Away from chips, other tech stocks were under pressure, as people digested not only the news from Celestica but also the less-than-bullish results of a regular IT-spending survey done by a leading dead-fish house. Just as noted in their June survey, they basically said that the sentiment of the chief information officers polled had turned more negative. Around late August, in other words, these CIOs had lowered their tech-spending projections yet again.


Semis in Scarlet, Subprimes in Shamrock


The early-morning weakness carried on until about midday, and then a rally began that took us not far below the opening, which of course was still negative on the day. From there, the market sank again in the last half hour, to finish essentially on its lows. Not surprisingly, the Sox -- where a tremendous amount of speculation and short-covering has just occurred on the back of a dubious premise -- remained the biggest area of pain, closing down 4%. Internet stocks had tried to fight the tide, turning green for a while, but they gave up and were slightly red as well. Housing stocks took on a little more water over the course of the day. About the only place I saw much green was in a smattering of subprime financials, which looked most likely to be short-covering.


After the five-week or so rally we've seen in the S&P (punctuated recently by an epic three-day 15% rally in the Sox), I believe the tape is now poised in precarious fashion, in that if we start to get the sort of bad news that I am anticipating, it will occur at a time when everybody is on the wrong side of the boat. That's exactly how you get a dislocation, even if it only turns out to be a small one. As I said the other day, I think the bulls picked the wrong moment in time to try to stage this chip-buying party, which was really just the culmination of the prior rally, not the start of a whole new leg up, and therefore doomed to failure.


Away from stocks, fixed income was down modestly. The dollar enjoyed a nice bounce, with most major currencies down 0.75% to 1%. That pressured gold, which was down about $2 initially, before closing down just 50 cents. But silver bucked the trend, up 1%. Oil was up 1% before closing down 2%. (Inventories were drawn down once again, this time to the tune of about 7 million barrels.)


A Chorus to Drown Out the 'One-Quarter' Tune


Now let's turn to the connect-the-dots department, for some thoughts on my recent favorite subject -- chip land and its fabled one-quarter problem. Beginning with last night's data, Xilinx has almost two quarters of inventory. Obviously, it would be a near impossibility for them to work this off in just one quarter.


To further compound their problems, Celestica saw cutbacks, most likely from Cisco. Cisco is not only Celestica's biggest customer but also a very large Xilinx customer. (Celestica builds products for Cisco, using parts from Xilinx and others, and said on the call that its inventories were going higher this quarter again, since the deterioration just accelerated.) So, to think that Xilinx is going to get out of two quarters' worth of inventory this quarter when its major customers are cutting back doesn't seem very likely.


In addition, Xilinx will probably have to cut its wafer starts at the foundries (think United Micro Electronics (UMD:NYSE) and Taiwan Semiconductor (TSM:NYSE)). Now if this goes on very long, the foundries will need to re-evaluate their capital-spending plans. That's how this news will ultimately affect semiconductor-capital-equipment companies.


If this were just one isolated incident, that forecast regarding the equipment arena might be a bit of a stretch. But besides Xilinx and Celestica, let's take a look at some other companies that have preannounced, which also happen to count Cisco as their largest customer: Altera (ALTR:NASD), Cypress Semiconductor (CY:NYSE), and Integrated Device Technology (IDTI:NASD). In all probability, Cisco is cutting back orders to the vendors it buys parts from, in addition to its contract manufacturer, because it has excess inventory on its books, and is seeing orders that are less than were expected.


Big and Blue and Vulnerable All Over


We could go through this same analysis on the IT side. Quite likely, Celestica is referring to IBM (which I believe is uniquely positioned to begin hitting on no cylinders, but that's a story for another day). While IBM tends to make more of its own product than do some of the other companies, the point survives that this is more than a one-quarter problem. Note that Celestica said some of its largest customers, implying that it was more than just one each.


This sort of digging can only lead to conjecture (not certainty), but just from what happened last night one can start to see that this problem in all likelihood will be far more severe than the whistling-past-the-graveyard crowd had wanted to believe. As I was saying yesterday, there are too many problems in too many places for this to be a short-term problem.


As we've seen with Alcoa (AA:NYSE) recently, and then Coca-Cola and Tribune today, problems appear to be more than just chip-related. The fact that volatility measures are this low to me is just staggering, in view of the problems we face on an earnings, as well as a macro front. I can't see how people selling volatility at this level can possibly win, and in all likelihood, this will exacerbate any problems that do arise.

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position in altr, csco, ibm, xlnx

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