Freddie Mac Roils Market

On Monday, resistance proved futile to downward pressure rather than to upside momentum for a change. The combination of Friday's reversal, Motorola's ( MOT) warning and a shake-up at Freddie Mac ( FRE) sent major stock proxies lower, although traders' propensity to buy weakness surfaced yet again.

The Dow Jones Industrial Average fell 0.9% to 8980, after trading as low as 8945.59 late in the session. The S&P 500 slid 1.2% to 975.93 after trading as low as 972.59, while the Nasdaq Composite shed 1.4% to 1603.97 vs. its nadir of 1597.30.

Although declining stocks led advancers by about 2 to 1 in both Big Board and over-the-counter trading, optimists took solace, because volume was down considerably from last week's levels. About 1.3 billion shares traded on the Big Board and 1.8 billion in Nasdaq trading, indicating somewhat decreased activity on the downside.

All Together, in Opposition

Prices of Treasuries and equities moving in opposition is not unusual, their recent movements in tandem aside. But the catalyst for Monday's action was unique.

News that Freddie Mac's president and chief operating officer, David Glenn, was fired for failing to cooperate with the company's internal audit sent Freddie shares down 16% and weighed on fellow government-sponsored enterprise (GSE) Fannie Mae ( FNM), which lost 4.9%. Two other Freddie Mac executives, Chairman and CEO Leland Brendsel and Chief Financial Officer Vaughn Clarke, resigned.

Earlier this year, Freddie Mac said it would restate results from 2000, 2001 and 2002 after its new auditor, PricewaterhouseCoopers, recommended changes in how the company accounted for derivatives. The changes are expected to "materially increase reported earnings," Freddie Mac reiterated in a press release Monday. But the firm said the restatement process might not be completed until later in the third quarter vs. by the end of the second quarter, as previously forecast.

Over the weekend, Armando Falcon, director of the Office of Federal Housing Enterprise Oversight, which regulates the GSEs, sent a letter to Freddie Mac expressing concern "about evidence that has come to light of weakness in controls and personnel expertise in accounting areas and the disclosure of misconduct on the part of Freddie Mac employees."

In addition to weighing on shares, concerns about Freddie Mac's internal controls caused fixed-income investors to flee so-called agency securities in favor of Treasuries.

The price of the benchmark 10-year Treasury note rose 22/32, to 102 31/32, its yield falling to 3.27%.

The shake-up at Freddie Mac "makes people concerned about GSEs once again, like last year," said Holly Liss, Treasury strategist at Mizuho Securities USA. "It's not the same concern, but there was selling in agencies and stocks of Freddie and Fannie and buying of Treasuries as people moved into safer instruments."

Last year, Hiss recalled, there was concern about the government revoking the GSEs' status, or at least clarifying where the government's implied backing of their securities ends. More recently, there's been concern that large holders of mortgage-backed securities (MBS) were being hurt by the steep slide in Treasury yields and resultant record levels of refinancings. Such activity results in a mismatch of assets vs. liabilities for MBS holders.

Fannie and Freddie "are as good of suspects as any" to be hurt by this so-called prepayment risk, RealMoney.com contributor Howard Simons observed Monday afternoon. "Both firms can be viewed as gigantic bets on a combination of a positively sloped yield curve and modestly falling to flat rates. The recent bull flattening of the yield curve and the hard drop in rates had to wreak havoc with their prepayment expectations and put pressure on their duration gap."

There was tremendous concern about Fannie's widening duration gap last August and September (which the firm subsequently reversed). At that time, the perception was that Freddie Mac was far more conservative with its risk controls and accounting when compared with Fannie Mae. I wrote a story along those lines, and The Wall Street Journal followed suit shortly thereafter.

History may prove otherwise, but at this juncture, it seems the conventional wisdom about which GSE to worry about was misguided. Then again, some have always contended both GSEs posed big risks to the financial market's health.

Monday's action in both stocks and fixed-income suggests that such concerns have not been quelled.

Tide High, This Bull Holding On

I've received quite a few emails recently from readers asking for an update on Bob Brinker, editor of Bob Brinker's Marketimer. Anecdotally, that suggests more interest among retail investors, to whom his newsletter and radio show are geared.

As reported here, Brinker made a staunchly bullish call on March 11, projecting the S&P 500 would rise at least 25% -- nearly exactly the gains registered between March 11 and June 5.

Over the weekend, Brinker issued an update to subscribers, writing: "Monies invested at these levels are subject to increased downside risk in the event a retracement of the market rally occurs."

While that truth is self-evident, it should not be construed as wholesale change. Brinker believes the S&P has the potential to exceed 1000 "by a comfortable margin going forward."

Cyclical bull markets within the secular bear market of 1966 to 1982 lasted from one to three years and produced gains with a median advance of 54%, he wrote. "These percentages leave the door open to significant upside potential in the current environment, depending on the length and breadth of the next economic recovery."

Brinker foresees "moderate" economic growth in 2004, largely on the basis of high levels of fiscal and monetary stimulus, plus "a de facto policy of allowing the U.S. dollar to decline," which should aid U.S. exporters. The market timer took heart that first-quarter GDP and corporate earnings were better than expected, while conceding the economy needs to start adding jobs rather than shedding them and capacity utilization must increase before a "genuine economic recovery" occurs.

Whether merely moderate economic growth will prove sufficient to justify current valuations is subject to debate. Meanwhile, low capacity utilization and low capital expenditures are key reasons why Diane Garnick, chief U.S. portfolio strategist at Dresdner Kleinwort Wasserstein, maintains an "underweight and generally pessimistic view on U.S. equities," as she explained Monday. "Not enough of the underlying fundamental problems facing the U.S. have dissipated for us to be comfortable."

Brinker, however, "will not prejudge the market's full potential, but rather remain vigilant for signs of deterioration in the Marketimer stock market timing model," something he doesn't seem to have spied just yet.

Denouement

Those who are following his recent successes should be aware that Brinker, like all humans, is subject to error.

After making a well-timed "sell" call in early 2000, Brinker recommended that subscribers invest between 20% to 50% of cash reserves in the Nasdaq 100 Unit Trust ( QQQ) in October 2000.

Brinker, who did not return calls seeking comment, "has maintained a hold on those shares ever since," according to David Korn, editor of BeginInvesting.com, where subscribers receive summaries of Brinker's "Moneytalk" radio show, among other investment advice.

Since Brinker's October 2000 call, the QQQs are down over 60% and are off more than 50% since a reiteration in January 2001. Since March 11, however, the QQQs were up 26.6% heading into Monday's action, when they declined 1.4%.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to Aaron L. Task.

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