Daily Insight

U.S. stocks gave back most of a pretty strong morning session rally – actually moving to negative territory late in the day – but managed to close on the plus side, ending a two-day losing streak.

Stock-index futures were nicely above fair value in pre-market trading and the momentum continued into the trading session after the Commerce Department showed retail sales for May easily beat estimates. But a weaker-than-expected jobless claims number, sky-high import prices and a management shakeup at Lehman Bros. were likely the culprits that took some steam out of the rally.

Six of the 10 major industry groups closed higher, with financials and information technology shares leading the way. Energy shares led the laggards lower even as crude prices shook off morning session weakness to close higher.

On the economic front, it was a mixed bag.

On the positive side:

The Commerce Department reported May retail sales jumped 1.0% and the April figure was revised up to show a 0.4% gain after the initial estimate stated sales fell 0.2%. Excluding auto sales, the retail figure rose 1.2% and the April reading was revised to show double the increase that was previously estimated, up 1.0%.

Even when excluding gas station receipts, sales were very solid, rising 0.9%. A number of people have attempted to suggest the rise in retail sales of the past few months has come from gas stations receipts as pump prices accelerate. But excluding gas station and auto sales, retail activity is up a powerful 10% at an annual rate over the past three months. Great news!

Commerce also reported that business inventories rose 0.5% in April and, importantly, business sales jumped 1.4% which followed a strong 1.2% rise the month prior.

The trend in business sales looks very good and has driven the inventory-to-sales ratio very near the all-time low hit in January 2006. The importance of this, as most readers know, is the production needed to rebuild stockpiles will not only keep the economy from contracting, but will lead to acceleration in the back-half of 2008.


On the negative side:

The Labor Department reported import price jumped 2.3% in May and 17.8% from the year-ago period – no, unfortunately this is not a typo. This move is a result of the declining dollar, at least prior to the greenback stabilizing over the past couple of weeks. A little Fed tightening will fix this problem – if they would only get to it.

In a separate report, Labor also reported that jobless claims for the week ended June 7 rose 25,000 to 384,000. That’s the highest level we’ve seen of late outside of the blip above 400,000 back in March. But we do remain below that 400,000 level and so long as we hold here it will suggest labor market weakness will remain mild.

This recent jump does have me a bit concerned, but we’ll really have to wait to see what occurs over the next couple of weeks – the May 26 Memorial Day holiday does make seasonal adjustments difficult, so the prior week’s decline and this latest jump may be a result of the problems related to adjusting for the holiday.

In a week we’ll have a better sense of what is occurring. I suspect claims will trend around this 370,000 level and we’ll get a scare sometime in the near future that we’ll push above 400,000 but won’t actually occur. The trend in business sales is way too strong and this will help growth accelerate and the job figures, which do work with a lag, will slowly strengthen a few months down the road.

Have a great weekend!

Brent Vondera, Senior Analyst

This Bid's (Not) For You!

As a lifelong St. Louisan, it is hard to objectively evaluate the proposed takeover of Anheuser Busch (ticker symbol: BUD) by Belgian brewer InBev (ticker symbol: INB BB). That said, as a fiduciary for our clients, we have a responsibility to put client interests above all else as we consider our options in the takeover with respect to the 25,000 shares that our clients own.

We have been asked by several clients what we should do. Right now, the answer is that we shouldn’t do anything except see how the deal plays out. There are really only two potential outcomes: the deal goes through, in which case our clients will get $65 dollars in cash for their shares held, or, the deal fails and BUD likely drops in price down to the pre-rumor levels between $45 and $50 per share.

The case for the merger is that the ‘transformational deal’ would create the largest brewer in the world with 300 brands across six continents (no word on who controls Antarctica), sales in excess of $36 billion and production of 10 billion gallons of beer per year. There has been a lot of consolidation already in the beer business and INB probably feels like this is their time to may hay since a substantial portion of their recent growth has been due to strong performance in emerging markets.

The case against the merger (beyond my personal antipathy towards losing a hometown favorite) is fairly strong as well. Given that there is relatively little geographic overlap between the two companies and the promises to keep the existing U.S. breweries, it’s hard to imagine that there are a lot of cost savings to be had, despite INB’s notorious penny pinching and ‘zero-based budgeting.’

As for whether the deal will get done, it may be fairly tempting for a lot of shareholders. The stock has languished over the past five years and the $65 buyout is nearly 20 percent higher than the all time high for BUD stock several years ago. It may be hard for management to argue that they can improve the company enough to justify a $65 price given that they haven’t done so in the years since the high while the market was generally rising.

That said, there is a lot going against the deal. First of all, you have a foreign buyer looking at an iconic American brand. This would be the third largest foreign purchaser deal in U.S. history, and while there is no national security risk like some of the other failed bids, it may be hard for shareholders to stomach a Belgian King of Beers. It’s possible that there could be anti-trust issues as well, since the combined company would be 50 percent larger than the current number one company, SAB Miller.

On the financial front, it won’t be easy for INB to get the deal done. For one thing, they aren’t substantially larger – the market capitalization for INB is approximately $47.5 billion compared to BUD’s $44.1 billion market capitalization. Furthermore, while INB has put together some preliminary debt financing, consummating the $40 billion in loans may still prove difficult in today’s credit environment.

BUD could also throw a wrench into the deal by purchasing the remaining 50 percent of the Mexican brewer, Grupo Modelo, which would raise the price tag beyond what INB could afford. And, although BUD let their poison pill lapse three years ago, they could reinstate it quickly if there is board support.

It’s well known that the Busch family opposes the deal, but they only own four percent of the outstanding stock, which probably isn’t enough weight to throw around. The hidden block of shares, though, is among the distributors. We don’t know how many shares they control and they want to keep the current regime in place since they are hugely profitable entities and large recipients of the marketing dollars. IBB would want to make cuts here, so it would probably take a price of $70 or above to get the distributors on board.

So far, Wall Street seems to like the deal. Usually when a merger is announced, the stock price for the buyer falls and the price for the target goes up. Today, INB’s price rose, although it could be a red herring since the price has fallen since the deal rumors emerged a few weeks ago. While BUD has risen, there is still a five percent premium between where it is trading today and the takeover price, suggesting a fair amount of uncertainty.

Given what we saw with the recent Microsoft/Yahoo imbroglio, this deal may be tough to swallow.

Meet Me In St. Louie!

One of the immediate reactions to the Budweiser deal around town was general sadness about losing another corporate headquarters. Here is a look at the ten largest publicly traded companies headquartered in St. Louis by market capitalization:

1. Monsanto ($73.7 billion)
2. Anheuser-Busch ($44.0 billion)
3. Emerson Electric ($42.9 billion)
4. Peabody Energy ($20.9 billion)
5. Express Scripts ($17.1 billion)
6. MEMC Electronics ($14.3 billion)
7. Arch Coal ($10.0 billion)
8. Ameren Corp ($9.1 billion)
9. Sigma-Aldrich ($7.4 billion)
10. Energizer Holdings ($4.5 billion)

Daily Insight

U.S. stocks fell for the second-straight session – although yesterday’s decline was slight – as global inflation fears grow. Central banks are either raising rates or signaling rate hikes are part of near future realities. Financial, industrial and information technology shares took the brunt of the beating. For the broad market overall, the S&P 500 slipped 1.69%.

It will take some time for the equity markets to adjust to this new reality, but it will and I believe this situation will be a positive for investors. Certainly leaving rates where they are and either ignoring the commodity inflation that will surely begin to seep into other areas or pretending that just because growth is weak harmful price increases won’t result is not good for stock prices – outside of higher tax rates, a major market killer is a pernicious bout of inflation.

Nine of the 10 major industry groups lost ground yesterday, as energy was the sole bright spot – the S&P 500 index that tracks these shares gained 0.77%.

Yesterday’s weekly energy report showed crude stockpiles fell well-more than expected, pushing crude futures prices higher and hence the gain in energy producing stocks. I was hoping for a build in inventories, as the previous week’s decline was, at least partially, due to port problems which are now resolved. Alas, this failed to occur.

Crude supplies fell 4.56 million barrels – a decline of just 1.8 million was expected – and this is what shocked the market resulting in the $5 jump in crude for July delivery.

Still, levels aren’t looking bad, as the current inventory of 302.2 million barrels is just slightly below the five-year average and refinery utilization is high, pushing close to 90%, which is nearly full output. Gasoline and distillate (heating oil and diesel) inventories actually rose thanks to refineries banging out product. Fuel consumption was down 1.3%, but electricity use rose 4%, so those pretty much canceled one another out. Electricity production is only partially an oil story as natural gas, coal and nuclear are other sources of this energy, but a 4% increase is pretty big, so it did have its effect on prices.

Too, as we constantly mention, investors/speculators are using oil to guard against a falling dollar and inflation worries. When the Fed begins to hike rates – and they will begin to gently push fed funds higher until they hit 3.00% -- this oil trade will come off, the dollar will strengthen, inflation concerns will wane and stocks will rally. (For sure, there are many uncertainties outside of oil prices and overall inflation, as we’ve exhausted much time touching on, but with crude at these levels any meaningful decline will rally stocks in my opinion. Thankfully, a thoughtless and harmful energy bill failed to achieve the votes needed on Tuesday, so we’ve got that going for us. This would have driven crude futures prices much higher if passed as it focused only on hitting energy producers and forcing utilities to use sources that are not even yet viable, making no mention of increased production.)

These are frustrating times for stock-market investors and tries one’s patience, but these are situations that must be dealt with – they are a reality of investing in stocks. This up and down activity weighs on people – although it is better than moving straight down – but you stay in the game, buying here on the dips. That said, your allocation to stocks must follow your long-term goals and ability to deal with risk.

The graph below shows activity on the S&P 500 since December 2005. We enjoyed the powerful rise to 1550, hit in October 2007, and after dealing with roughly a 20% drop from that top we’ve been range bound.

On the economic front, the Federal Reserve released its latest Beige Book survey (a look at economic conditions within their 12 regional districts every six weeks) and it showed economic activity is muddling around at levels that are just slightly above last year’s.

Much of this data is already known – this report was for the back-half of April and May –but the report is worth a read.

A few interesting points:

• Retail sales were pretty decent in most districts. (We’ve seen evidence of this via last week’s same-store sales data and receive more clues by this morning’s retail sale report.
• Manufacturing continues to hover right around the dividing line between expansion and contraction as housing drags on the sector. While we would like activity to be stronger, we’re not looking too bad considering the housing construction correction and auto industry woes.
• Residential construction remained very weak, but some regions did report buying has picked up as prices have declined. Commercial construction was mixed.
• The energy industry continues to drive growth. The number of active drilling rigs surged, even as a couple of districts stated a bit of constraint due to a slight shortage of equipment. Dallas noted activity reached its highest level in 20 years.
• Labor market conditions loosened a bit but skilled positions remained tight. This corresponds to the small business survey we cited a couple of days back that mentioned the availability of skilled labor is among their top concerns.

In a separate report, the Treasury Department reported the May budget deficit jumped to $165 billion due to the Treasury sending out those rebate checks -- a completely stupid idea that will do little to boost economic growth – it would have been far better to pass current tax rate permanence, which would have moved stocks higher. In addition, consumer consumption patterns are determined more by their longer-term after-tax income expectations than by transitory changes.

The May deficit was larger than the entire 2007 shortfall. Last year’s deficit was essentially non-existent thanks to soaring tax receipts, and is probably a reason we didn’t here the press talking about it. One can be sure much attention will be given to this year’s shortfall.

Anyway, what I found interesting was that when you adjust for the $50 billion in rebate checks that went out individual tax receipts were 5% higher than the year-ago period. This signals the job market, while soft, is not terribly weak or this would not have been the case.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ended mixed on Tuesday as the S&P 500 and NASDAQ Composite lost some ground, while the Dow average managed a small gain thanks to a big day from Coca-Cola shares – financials such as AIG, JP Morgan and Citigroup also rose, helping to offset losses from Chevron and Exxon.

The broad market was pushed lower by basic material and energy producing stocks as Fed comments sent the dollar higher and commodity prices lower.

Health-care, information technology and industrial shares also slipped. Utility, financial, consumer discretionary and consumer staple shares closed higher for the session.

More than four stocks fell for every three that rose on the NYSE. Some 1.35 billion shares traded on the Big Board, about 10% lower than the three-month daily average.

Oil prices fell for the second-straight day, slipping 2.26%, following a 3.02% drop on Monday. Still, this pullback has come about $4 short of erasing Friday’s $10.75 per barrel jump. Crude is higher this morning on speculation that supplies will decline for the fifth week in a row as Wednesdays bring the weekly energy report.

I think it was last week that some port issues caused havoc with imports, so there is a decent possibility this will reverse the trend and we may actually see a build in crude and gasoline supplies. We’ll find out at about 9:30 this morning.

In any event, the Fed has recently done some good work in keeping some pressure on crude prices by boosting the dollar, but these words must turn into action and as the FOMC moves fed funds back to 3.00% by early next year (my opinion), the course of these two items should go in our favor.

It’s been interesting to watch the Fed reverse their language on rates and inflation. Until recently, Bernanke and Co. were sticking, precariously I’ll add, to their flawed Keynesian models that led them to believe commodity prices would fall simply because growth had slowed. For months they based their assumptions on this idea and delivered many speeches on how sub-par growth would bring energy prices down. In fact, their aggressive rate cutting, and the damage it has done to the dollar, helped energy prices to explode upward; thankfully they seem to be acknowledging this.

I’m beginning to think the Fed is preparing us for a higher-than-expected CPI report on Friday and the monetary tightening that may result. If the headline figure moves above 4% and the core rate pushes to the 2.5% level this may spark a mild rate-hiking campaign.

These are not horrible rates of inflation, especially since CPI overstates price activity a bit during most periods – averaging the three major gauges and overall inflation is running at roughly 3.5% year-over-year. However, remember that the April CPI figure didn’t seem to match reality as the energy component was basically flat due to seasonal adjusting. That energy component will drive the index higher on Friday and the Fed may be realizing this – hence their newfound hawkishness. If a move above 4% on CPI gets the job done its fine by me; as we’ve explained for a while now, some mild tightening will actually boost activity via lower oil prices that should result.

On the economic front, the trade balance for April widened a bit due to higher crude prices – the higher price per barrel caused import growth in nominal dollar terms to exceed the growth in exports.

However, when we adjust for the move in price the trade figures actually narrowed in real terms – the deficit in trade fell to the lowest level since August 2003. As long-time readers know, I’m not one to get all worked up over a trade deficit, so the fact that it is narrowing doesn’t make much difference to me. Whether we import more bananas or capital, one or the other doesn’t spell impending economic demise.

Personally, I’d rather have the capital and that is what results as more dollars are put into the hands of foreigners via robust trade. What’s important is growth expectations. Embrace the right polices and those dollars moved over seas via high U.S. import activity (and remember there is a huge benefit to living standards by this trade via lower prices) will come back home in the form of investment. Beware of poor tax policy decisions though (especially on investment), and that is one of the uncertainties currently as the November elections are upon us.

Anyway, the point that needs to be made about the real-term trade gap narrowing is that it will help boost GDP. The March figures narrowed more than expected, so when the first-quarter GDP is revised it will be higher and this April figure isn’t going to hurt the second-quarter reading either.

Exports are exploding – up 19% year-over-year and this is good for our industrial sector – more specifically it is helping our manufacturing sector remain very near expansionary levels even as housing and auto industry woes drag on factory activity.

But imports have bounced back strong too after a couple months of weakness. This is a very important signal as it suggests economic activity is stronger than many currently proclaim. And not all of this import growth is a result of crude imports – imports ex-petro were up 2.6% in April. I didn’t see anyone mention it, but capital goods imports were up 3.5% in April and 8.5% year-over-year. These are good numbers that suggest businesses are spending. Factoring in the period of overall weakness we’re working through and this capital goods activity is quite strong.

I notice this morning that it appears certain political organizations are disseminating comments on the labor market, stating that the unemployment rate has hit the highest level in 22 years. Here we go again. This reminds me of the 1992 campaign when some were saying the economy was in the worst state in 50 years – suggesting it was the worst economic period since the Great Depression. That claim was hugely false as the economy rose at a robust real rate of 4.1% during 1992.

This claim on the jobless rates is equally false. What occurred was the unemployment rate’s rise in May was the largest jump in 22 years, but the jobless rate itself is not at its highest level in 22 years. In fact, the current rate of 5.5% is below the 20-year average and was higher just three years ago.

Have a great day!

Brent Vondera, Senior Analyst

The Little Book that Tells Half the Story

By David Ott

The “Little Book” series launched with a short book about a magic formula that promised an easy way to find would beat the market. Normally, this premise would be enough for me to pass right by, but it was authored by a highly respected hedge fund manager who had racked up more than a decade of annualized performance of around thirty percent (before incentive allocation, of course).

The sixth installment in the series is The Little Book That Builds Wealth, by Pat Dorsey, the director of stock analysis at Morningstar, Inc. Although the title is shockingly disconnected with the contents of the book, it is an insightful review of competitive strategy with a remarkable number of real world examples that support his analysis.

This book is not about building wealth (the word wealth is used a scarce three times throughout), but about identifying whether or not a company has an ‘economic moat.’ An economic moat is the homespun name that Warren Buffet uses to describe whether or not a company has a sustainable competitive advantage.

As Morningstar and Dorsey see it, there are essentially four sources of competitive advantage (or an economic moat in their parlance):

• Intangible Assets such as brand names and patents.
• High Switching Costs like the cost of purchasing new equipment or software.
• Network Economics, which refers to a ‘closed loop’ business that builds on itself. For example, telephones aren’t very useful without other people who use telephones.
• Cost Advantages that can come from scale, processes, legacy or geography.

Each one of these moats is described in terrific detail with plenty of examples. While Coca-Cola is an obvious example of a successful business built on a strong brand name and everyone knows that Wal-Mart typifies cost advantages through their vast scale, Dorsey provides multiple real world examples for each kind of competitive advantage and how it translates into business success.

Generally these are all considered barriers to entry under Porter’s five forces analysis. Morningstar generally neglects other some of Porter’s forces like the intensity of competitive rivalry, the bargaining power of customers and the bargaining power of suppliers. Instead, they choose to focus on the threat of new competitors and the threat of substitute products and services. This seems like a reasonable choice on their part, since they don’t want to simply repeat Porter’s work and they can make the argument that some of these unmentioned forces fall under their more broad definitions.

While the descriptions and examples are all very good, the book stops short of being great since it really only describes what to look for in a business. It doesn’t offer much in the way of figuring out whether or not a good company will make a good investment. For example, we can use this book to determine that McDonalds is a great ‘wide moat’ company, but obviously, it makes a huge difference what price we pay to become a part owner in this enterprise.

Dorsey makes this point at the outset of chapter twelve and dedicates a only 27 out of 200 pages to outlining the basics of valuation. Valuation is one of the most important and difficult aspects of investing, so it’s a disappointment that there is such scant coverage of the topic in the book. It’s a shame since Morningstar has a detailed valuation methodology that they have created for their stock star ranking system that could have filled another book of the same length, leading me to argue that they only told half of their story. I suggest that this book be re-titled to “The Little Book of Identifying Economic Moats.”

One of the nice things about reviewing a book like this is that there is real performance based on the strategy. Cranking out investment platitudes is easy, but backing it up with actual results is far more useful and interesting.

The table shows the performance of buying stocks with a five star rating (usually a wide moat company trading with a substantial margin of safety) and then sold when the stock becomes a three star holding (the moat may still be intact, but the stock is trading at or around ‘fair value.’ Morningstar presented their results using three methods for buying and selling and the table reflects the data with the best results. Additionally, the table only reflects full year data.
Although Morningstar deserves high praise for beating the S&P 500 for the six complete years available, it wasn’t a free lunch and it would be hard to argue that this strategy alone builds wealth. Although the Morningstar returns are about 15 percent higher than the S&P 500, the volatility, or risk, was about 75 percent higher. This disparity is reflected in the Sharpe Ratio, which shows that the S&P 500 had better results on a risk adjusted basis.

It is also important to note that we can’t see the details of how these results were generated. We can’t tell if it was an overweight in energy stocks which have been extremely good over the past five years, or if they had substantial investments in mid and small cap stocks, in which case the S&P 500 may not be the best benchmark. We also can’t see other characteristics like turnover, which appears high based on the fact that I receive an email nearly every day with between two and eight new five star stocks. On an after tax basis, these results are likely to be far worse than the S&P 500.

So, we know that Morningstar hasn’t found the magic bullet for investing – no surprise there. With that said, the book is worthwhile as it helps develop a framework for identifying good businesses, which is a critical component of successful investing. I commend Morningstar for putting together a solid process and laying out the results for the world to see and wish that more firms were willing to do this with such thoroughness and integrity.

June 10, 2008
____________________________________________
Recommendation: Market Perform

The Little Book That Builds Wealth:
The Knockout Formula for Finding Great Investments
By: Pat Dorsey, CFA

John Wiley & Sons, Inc., Hoboken, New Jersey 2008
ISBN: 978-0-470-22651

April 2008 Portfolio Insights

The April 2008 issue of Portfolio Insight is now available here.

Topics in this issue include:

• The fall of Bear Stearns
• The Federal Reserve
• Fixed Income Strategy
• Equity Markets Activity
• Inside the Economy
• Commodities

Daily Insight

U.S. stocks bounced around yesterday, beginning the day higher after traders had a chance to give Friday’s employment report additional consideration, but we lost ground mid-day after Fed Bank President Tim Geithner stated the Fed very likely needs to tighten monetary policy. It may take some time for the market to come to grips with these sorts of comments, which we’ll get to in more detail below, but over the next few weeks I think such action will be a market positive.

The broad market did shake off the mid-day weakness as the S&P 500 rose nearly 1% from the day’s low in the final 90 minutes of trading to close positive, just barely.

Financials and health-care stocks were the worst-performing sectors of the day. Energy, utility, basic material and industrial shares enjoyed a nice day. Overall, six of the 10 major industry groups gained ground for the session.

As stated above, stocks began the day on a good note, as people had a chance to push aside emotional reactions to Friday’s employment report, which showed a jump in the unemployment rate, and acknowledged a couple of things.

One, monthly job losses remain very mild – as stated yesterday, the losses of the past five months are usually what we see in one month’s time during the typical job-market downturn.
Two, two-thirds of the increase in job-market entry came from the 16-19 age group – it’s that entry, as opposed to serious job losses, that caused jobless rate to rise. This entry usually occurs in June so the increase played havoc with the seasonal adjustment and probably means we’ll settle in at 5.5% unemployment for now instead of seeing the figure climb.
Three, a jobless rate of 5.5% is hardly something to get concerned over and since the seasonal adjustment process should keep the rate at this level, or even tick a bit lower next month, there’s nothing to get hysterical over.

The graph below shows yesterday’s intra-day activity on the S&P 500. The yellow line illustrates the opening price.


On the economic front, the National Association of Realtors announced the number of Americans signing contracts to buy existing homes unexpectedly rose in April as lower prices lured buyers back into the market. Let’s hope we’re onto something here. I suspect we’ll see the index bounce around for several months still, but no one expected a rise of this strength so maybe something has changed.

The index of pending resales rose 6.3%, which followed a 1.0% decline in March. By region, April resales jumped 13% in the Midwest, 4.6% in the South, 8.3% in the West and were down 1.9% in the Northeast.

As touched on at the top, New York Fed Bank President Tim Geithner stated the Fed needs to give much consideration to raising rates as commodity prices threaten overall prices, which may begin to flow into the core rate, even if as this has yet to occur.
(As a personal aside, the FOMC needs to forget about the core rate right now and realize that energy prices are causing not only consumer pessimism to rise but the latest small business survey cited these costs as one of their main concerns. The core rate remains extremely benign and while this is a benefit of strong productivity increases it is also a result of businesses eating costs, instead of passing them along, That hurts profit margins.)

The market didn’t seem to appreciate these comments from Geithner but I think more investors will over time. It is vitally important for the Fed – which did great work via comments last week – to work on inflation expectations and the dollar. Friday’s job-market data and ECB (European Central Bank) President Trcihet’s comments didn’t help the greenback at the end of last week, but the Fed seems to be determined to work this strategy. For now these are just words, but this will be followed by action and as they gently raise fed funds back to 3.00% the dollar will strengthen and oil will come off.

Bernanke followed up on Geithner’s comments last night in Boston as he stated the central bank “will strongly resist an erosion of longer-term inflation expectations.” Again, the market is not enjoying this news for now, futures are down on the comments, but if they follow through on these comments with action, I believe it will be a major plus.

The graph below shows the implied probabilities of a rate hike by the September 16 meeting. Fed funds currently sits at 2.00%.

And speaking of energy costs, the dollar and overall inflation, we often talk about energy policy – ie, drilling for vastly more of our abundant resources – and tax policy that remains accommodative to growth.

It is a real shame, especially at a time when many consumers are feeling a bit pinched by high energy costs and a meaningful housing correction that these policies have not been brought to the table in a earnest way. I believe one would be amazed at what could pass in an election year.

You want to manage energy costs over the long term, the answer is diversification. Diversification regarding geographic placement of our infrastructure so a single hurricane cannot knock a high degree of transmission off line for several weeks. Diversification in terms of sources: more coal, crude and nat gas production. In addition, building more nuclear power plants is essential. Solar and wind are fine for where they work.

Regarding nuclear, some worry about waste. OK, simply revoke the Carter-era policy that outlawed nuclear recycling. France for heaven’s sake has produced 80% of its electricity with nuclear power for 25 years and since they recycle nuclear fuel they store all of their high-level waste in a 3500 square foot space. Recycling seems to be all the rage regarding everything else under the sun, but not for nuclear. This is pathetic.

Want to strengthen the dollar via the best way possible. Send a signal to investors -- not just domestic risk takers but global risk takers too -- that tax rates are not going to rise on them and erode after-tax return expectations.

But if this is not going to occur, as it surely seems it will not in the near term, then there is something that can be done -- now. Something that can immediately bring crude prices lower via a strengthening of the dollar and that is intervention. Treasury Department intervention, with cooperation of other G7 members, and at a time when it appears the Fed has seen the light and just may begin to mildly raise fed funds back to 3.00% over a series of meetings, will do the trick.

This will jolt an economy that is already poised to accelerate and provide further strength to the greenback to get us back to the 85 level on the Dollar Index, which in my mind is the optimal level. Optimal for trade and a level that will bring oil – which is priced in dollars – lower.

Have a great day!

Brent Vondera, Senior Analyst

Does the mortgage mess affect my mutual funds?

David Ott appeared in the ASK THE EXPERT column of the St. Louis Post-Dispatch on February 24, 2008. Click here to read David Ott's take on how the mortgage mess affects your mutual funds.

January 2008 Portfolio Insights

In case you missed it, click here to view the January 2008 issue of Portfolio Insights.

Articles in this issue discuss:

• Stock market performance this decade
• Sovereign Wealth Funds
• Fixed Income Strategy
• Equity Markets Activity
• Inside the Economy
• Changes in the world's 10 largest companies

Daily Insight

As everyone knows by now stocks took a hit on Friday following the Labor Department’s release of the May job-market figures and oil’s record one-day rise of $10.75 per barrel, or 8.41%.

It was really that jump in crude prices that pushed the market down 394 points – on the Dow average. The three major indices were lower by roughly 1.5% around lunchtime, but as oil got on its horse and rocketed up to nearly $140 in the afternoon session stocks doubled their morning-session losses.

As an aside, the price for a barrel of oil prior to the 9/11 attacks and aggressive Fed easing that ensued was only $11 more than the change of the past two trading sessions – crude has risen $16.24 since Wednesday’s close. The price of barrel of crude was $27.63 on September 10, 2001.
But it wasn’t only oil that pushed stocks lower, a jump in the jobless rate stunned traders, who sent the indices lower in the morning session. We’ll get to the specifics of that jobs report below.

On Tuesday we mentioned that a 134-point move on the Dow was nothing, those comments followed Monday’s media response which acted as if this is a big deal. With the Dow above the 12,000 mark, that level of decline is nothing and we wrote that one should be prepared for 3% down days in this market, which is what we got on Friday.

It was just an ugly day as all 10 major S&P 500 industry groups declined. Financial, industrial, information technology and consumer discretionary stocks led the move lower. While there are a number of uncertainties equity investors are burdened with at the moment – as we’ve touched on many times (the election, and thus tax and trade policy; the housing correction, geopolitical events, sky-high oil) the one thing many people aren’t talking about is the boost stocks would get from a large decline in oil prices.

It seems difficult to comprehend right now, but with crude up this big, it means there is a long way for the price to fall and still factor in geopolitical risks and a domestic energy policy that is removed from reality.

What was behind oil’s climb on Friday? Well, first it was another day of dollar decline as the employment report pushed the greenback lower. This move caused traders to increase their position in oil.

Then word came out that Israel is looking to strike Iran as they continue to restrict weapons inspections while stating Israel “is about to die and will soon be erased from the geographical scene.” This prompted a number of Israeli officials to state they will go after Iran’s nuclear program as the threat becomes too pronounced. Prime Minister Olmert also stated he’d had enough of Hamas lobbing bombs out of Gaza and time has come to do something about it. Comments like these cause anyone with a short positions to ask whether they want to go into the weekend with this trade, and hence the additional rally in the afternoon took place.

We were looking so good too. The dollar had gained nice ground after Bernanke’s much desired comments had given a boost to the greenback and sent oil lower earlier in the week. But ECB president Trichet stabbed the Fedhead in the back on Thursday – as we touched on in Friday’s letter – and then the job market data and Israel/Iran thing reversed all of that.

OK, let’s get to the job report, which was the major news of the day before oil’s meteoric rise.

The stunner was the jump in the unemployment rate, rising to 5.5% from April’s 5.0% reading. This marked the largest monthly rise in the jobless rate since February 1986. The major reason for the move was not a meaningful decline in jobs, but a huge rise in job market entry of 577,000 participants.

The net job losses for May actually came in lower-than-expected as we lost 49,000 payroll jobs – the market was expecting a decline of 60,000. Either one of these figures is statistically insignificant for a labor force of 138 million and doesn’t even come close to explaining the ½ percentage-point rise in the unemployment rate. Rather, it was a huge rise in 16-19 year olds entering the labor force that sent the rate higher – this segment accounted for 66% of new entries and since it occurred in May, when June is typically the month in which we see students enter, it created havoc in seasonally adjusting the figure.

I’m not trying to say that net job losses are a good thing, it’s clearly a bad situation whenever this occurs. But what led the unemployment rate higher needs to be explained and the reasons for the move higher suggest to me that we’ll see the rate hold there in the following months or actually decline due to the seasonal adjustment as student entry will be lower than is normally the case for June. The unemployment rate for teens jumped to 18.7% from 15.4% in April.

Also, think about it. If we’re going to be in a period of job-market weakness, trust me, this is what you want to see. There have been a net 324,000 jobs lost during the past five months, that’s can be one month’s worth of declines during the typical period of significant job-market weakness. We’ve only lost 4% of the 8 million positions created in the 4 ½ years prior to this five-month down trend. While the change is often more important that the level, one finds it difficult to become too concerned over a 5.5% jobless rate – which is below the 30-year average of 6.07% and right on top of the 20-year average of 5.42%.

The job losses came from construction (-34,000), manufacturing (-26,000) and business services (-39,000). The largest increases, which has been the trend for several months, came from health-care (+42,000) and education (+12,000). The public sector added 17,000 jobs.

In a separate report, the Commerce Department reported that wholesale inventories jumped 1.3% and sales rose a strong 1.4%. This data is for April and fairly outdated, but it does suggest that inventory re-building will help boost second-quarter GDP – assuming we don’t get declines in May and June. The 1.4% rise in sales means the inventory-to-sales ratio has moved to an all-time low of 1.09 months’ worth of supply. Production will catalyze growth in the months ahead and lead to higher GDP readings in the third and fourth quarters.

Some, the typical economists that we hear from month after month, attempted to say that the rise in sales came only from petroleum activity. But the wholesale business sales ex-petro rose 1.5%, so the negative spin hardly adds up.

For an economy that is supposed to be so down and out, a number of data points are just not showing it, including the business and wholesale sales data.

Have a great day!

Brent Vondera, Senior Analyst