Daily Insight

U.S. stocks engaged in an afternoon rally that sent the benchmark indices to a positive close, breaking a two-day losing streak.

The broad market began the session higher as investors liked the fact that weekly jobless claims dropped a bit and remained nicely below the 400,000 level, but quickly lost ground as the latest regional manufacturing survey showed continued weakness. Stocks then reversed course as oil prices moved lower, fueled by technology, transportation and consumer discretionary names.

Energy stocks were the worst-performing group yesterday as crude price closed lower by 3.36%.

Oil prices slipped $4.59 per barrel yesterday, to close at $132.09, as the Chinese government announced it will curtail fuel subsidies and price caps. By rolling back these command-and-control policies one can expect demand to respond.

In addition, the crude market will hopefully come under pressure over the next month as China reduces production activity in an attempt to clear the air of substantial smog problems ahead of the Olympic games.

I still think the crude trade – in the very short-term – is more a function of Fed policy and the dollar than anything else, but these developments should have us come off the highs. We shall see.

Onto the market in general, the WSJ is calling the stock market a pinball, bouncing between technical levels. We’ve talked about this for some time, being stuck in a range as uncertainties keep the S&P 500 (SPX) between 1275 and 1430. Currently, we’re at the mid-point of this range – 1342 on SPX.

It will likely take some time to break out of this range – I’m talking about upside break-out. In the short term, once the Fed gets it right and the market’s current concerns over the Presidential election are allayed (Intrade – pay to play betting – has the relative free-market candidate down by 30 points) we’ll gain some strength. After that it will depend on longer-term policies.

The graph below is an update to the one posted last week.

In the meantime, it will prove beneficial to stick to the allocation that best meets your risk tolerance and goals. One never knows when the rally – a sustained rally -- will come, but it generally arrives when least expected. Again, pro-growth polices are key, and I believe this is the road the U.S. will choose, outside of our typical swerves off of the prosperity-producing path on occasion. We have not swerved just yet, but the uncertainty of such action is one concern that has investors a bit wary.

On the economic front, jobless claims for the week ended June 14 declined 5,000 to 381,000. As touched on yesterday, I was looking for this figure to come back to the 375,000, but a decline is good and continuing claims fell to the lowest level in six weeks.

We remain meaningfully below the 400,000 level – hitting 400k would indicate statistically significant monthly job losses – and well below levels of the typical recession/downturn. Notice, as most readers are aware, that we have yet to even hit the mid-1990s slowdown level, which was a period of extremely transitory slowing that saw economic growth bounce back with much force.

Finally, the Philly Fed index – a gauge of factory activity compiled by the Philadelphia Federal Reserve Bank – showed that manufacturing activity continues to weaken. Most regions in fact have shown weaker factory activity over the past few months, but the Philadelphia region has been particularly hard hit as it is more dependent on the housing sector than any other.

Most of the sub-indices were ugly as well, with new orders and shipments moving lower. Unfilled orders and delivery times were also negative, but improved from the May readings.

Importantly, the largest manufacturing region, the Chicago-area – is holding up pretty well as it hovers around the break-even point that divides expansion from contraction. The nation-wide survey looks pretty much the same, as we’ve depicted with graphs over the past few months.

I do believe the sector as a whole will improve and move back to expansion mode sometime in the next couple of months, as business spending and the production necessary to rebuild inventories take hold. That said the regional surveys will likely remain shaky until housing finally bottoms.

Have a great weekend!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks extended upon Tuesday’s losses after FedEx posted quarterly results that were lower than expected and Fifth Third Bancorp cut their dividend by 65% -- a dividend that they had just boosted three months back.

Stocks began the day lower and never looked back. We bounced around in negative territory, looking like some momentum may get the broad market to the plus side, but it failed to materialize and we ended lower by roughly 1%.

The FedEx news showed how higher energy costs – and Fed mistakes, in my view – are having some widespread effects. The company stated that while activity was relatively weak (largely in terms of the higher cost Express Air deliveries), the big issue for the quarter was their inability to keep up with rising energy costs. FedEx does have to deal with a two-three month lag when it comes to increasing fuel surcharges and when crude prices rise so abruptly this reality exacerbates the issue. They also mentioned full-year guidance will be in a range of $4.75-$5.25 per share, well below the estimate of $6.00.

To no surprise, financial shares pushed the broad market lower on the Fifth Third news, but the group was not the worst performer as consumer discretionary shares held that unwanted position. All 10 major S&P 500 industry groups declined.

A number of uncertainties are keeping stocks range-bound, as we’ve mentioned for some time now. Some of these questions are economically endogenous, such as future tax and trade policy, the price of energy and the duration of the housing correction, and some are exogenous, such as geopolitical risks, namely Iran and their terrorist-group proxies.

But we shouldn’t forget that a number of economic indicators remain quite upbeat, while others have shown signs of improving of late.

For instance:

• Retail sales have rebounded nicely after a few months of lackluster activity. Retail sales ex autos and gas stations receipts (adjusting for the rise in pump price and showing that consumers have the aggregate resources to purchase other items) are up a powerful 10% at an annual rate over the past three months.
• Business sales remain on an upward trajectory, rising at an 8% annual pace over the past six months. As a result, inventory levels remain very near record lows. The production needed to increase stockpiles will catalyze growth in the back-half of the year, in our view.
• The labor market is holding up quite well and even though we’ve lost jobs over the past five months, just 4% of the 8 million jobs created during the previous five years have been erased. We’ve lost a net 324,000 payroll jobs since January; during the typical economic downturn we see this amount of losses in one or two months’ time.

In addition, once the Fed gets it right and boosts their benchmark rate to 3.00% by year end – that’s my personal call at least – oil will come off these highs and stocks, the economy and the consumer will receive a substantial boost.

We were without a major economic release yesterday, but get back to it this morning with the weekly jobless claims figure. Recall, last week we saw a boost to the 380,000 level – for new readers we want to get back to 365,000-375,000 for now. Any sign that we are trending toward 400,000 in weekly claims will be troubling. Last week’s jump may have resulted from the issue of seasonally adjusting for the Memorial Day holiday as it pushed the prior week’s data meaningfully lower and hence we got that boost last week – which was actually for the week of June 7. This morning’s data will give us a cleaner look as the adjusting process to that holiday will have passed.

Moving along to energy policy, CNBC had analysts and commentators on all day long yesterday talking about whether or not to open up restricted federal lands along the outer continental shelf, et al., that have proven oil and natural gas reserves. Literally, all day they went round and round as if this is a tough call. For the love of God, just drill.

Ronald Reagan, in his epic 1964 speech “A Time for Choosing” stated: “They say the world is too complex for simple answers. They are wrong. There are no easy answers, but there are simple answers.” He was of course referring to the Cold War.

In this case though, we have the best of both worlds. The answer is both easy and simple, especially with energy prices perched at these lofty levels and regimes that hold vast reserves hell-bent on the destruction of the West. As Daniel Henninger has so forthrightly put it: drill, drill, drill!

And while we’re on the subject, those opposed to increased levels of production have come out with a new claim: energy producers are sitting on 68 million acres of leased land that they are not currently drilling on and thus they should not be allowed to lease additional areas. This has become the new talking point as I heard it verbatim from three different politicians within an hour’s time last night

But let’s inject a few realities:

• First energy companies must engage in geological/seismic testing to find where the oil – if any – is on a given parcel of land (there are no proven reserves when the leasing process begins regarding many of these areas)
• Then they must move through the long process of local, state and federal permit approvals – and the lawsuits that pop up from environmental groups which delay work for years in many cases
• Lastly, this claim that government will take the land back (part of this new “use it or lose it” threat) if production or the processes necessary to get to that stage is not occurring is already law. If nothing is being done, then there is no argument; the oil companies lose that land. But why would they pay the lease if they were not going to do anything with it? Some of these parcels are “dry” and they must move on to another site

Finally, beyond the fact that more production is necessary, we shouldn’t neglect the reality that this new approach will create thousands of high paying manufacturing jobs. We often hear how productivity increases and global competition have reduced U.S. manufacturing positions. Well, this is one way to boost jobs within the sector in a big way.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks fell on Tuesday, led by financial shares after a Goldman Sachs analyst predicted banks will have to raise $65 billion in new capital and the economic data of the day was less than inspiring – an appropriate statement for the industrial production number, but a clear understatement regarding May housing starts, which remained ugly. We’ll get to these topics below.

Stock-index futures jumped in pre-market trading and that flowed through to the regular trading session after Goldman Sachs reported much stronger-than-expected quarterly results. However, stocks struggled to hold those gains after that very weak housing starts reading and a second straight monthly decline in industrial production. When that Goldman analyst’s banking sector prediction hit the press about 10am that was all she wrote and the major indices moved into the red and failed to bounce back.

I wouldn’t put too much into the warning that there is still serious credit-related fallout to come, as that GS analyst stated, as the firm is likely short credit derivative indexes and financial-sector stocks. I’m not saying the issue is completely behind us, but just to keep in mind that GS may have reason to encourage these comments. To be fair, their Basel II risk-adjusted Tier 1 ratio was 10.8% which was stronger-than expected and their principal investing activities – specifically via Chinese bank ICBC – also helped results.

Seven of the 10 major S&P 500 industry groups closed lower for the day, led by financial and consumer discretionary shares. To no surprise, energy shares led the gainers as the index that tracks these shares gained 1.7%.

Decliners beat advancers by a two-to-one margin on the NYSE. Some 1.1 billion shares traded on the Big Board, roughly 25% below the three-month daily average.

On the economic front, the Commerce Department reported builders broke ground on the fewest number of houses in 17 years during May signaling residential fixed investment will remain a large drag on the economy.

This is certainly not a great revelation, as it is expected that housing will weigh on GDP for a few quarters still – which has been the case for nine quarter already. The extent of the weakness though shows the degree to which this segment will subtract from GDP will be substantial – extending the trend of lowering real GDP by more than a full percentage point.
Inventories are simply too elevated and until we get the sales figures to kick up, we’re not going to see the inventory-to-sales figure come much lower. As the graph below depicts, new home inventory stands at 10.6 months’ worth of supply. We need this number to come down to 6 months’ worth before housing begins to add to growth once again. My feel is that housing will flatten out by the second quarter of 2009 and will add slightly to growth by the end of 2009.

In a separate report, Commerce also stated industrial production declined for a second-straight month, falling 0.2% in May. The April decline was 0.7% and the trend is not good. It’s important that we see some rebound for June because we do not want one of these sub-zero gaps to occur – illustrated by the chart --, that would spell trouble.

I expect the figure will rebound this month and it is important to note that below average temperatures in May was the main reason for the negative reading.

Utility activity weighed heavily on the reading as it was this industry group that was by far the worst performer, falling 2.7% in May. Capacity utilization fell hard within the utility component, while the other industries were in line with the April reading. Average temperatures were below the historic average, according to the National Climactic Data Center.

Lastly, the Labor Department showed that producer prices jumped 1.4% in May and 7.2% from the year-ago period. This was mostly driven by higher energy prices as the ex-energy reading rose by a much lighter 0.4% in May and is up little more than half as much in terms of the overall reading from the year-ago period.

Hello, Fed – anyone home? This is a dollar problem, wake up and get to some mild rate hiking.

Food prices are also contributing to the rise, and while this is partially a function of a lower dollar and aggressive Fed easing of the past six months weather is also playing a role as heavy rains are keeping farmers from getting into the field and planting. What they can do is diminish the energy-related issues, and if food costs come lower too, then that’s an additional plus.

And speaking of the Fed, those WSJ, FT and Wash Post articles we referred to in yesterday’s letter also contributed to Tuesday’s market weakness. These articles suggested that the Fed is not going to raise rates and focused on the point that higher rates erode profits, specifically within industries that rely on short-term financing.

Well excuse me, harmful levels of inflation destroy profit growth for nearly all industries as margins are compressed due to escalating costs. Thankfully, for now, firms have shown an amazing ability to eat these costs and still post good profit results as productivity improvements remain strong. But this cannot go on forever, as the current level of energy prices will eventually erode this ability to manage these rising costs.

Besides, we’re not talking about 6% fed funds, but just getting us back to 3.00% from the current target of 2.00%. This is hardly anti-growth and in fact will boost profits and GDP as the dollar strengthens, oil comes lower as a result and beneficial profit margins remain intact.

We’ll also make this point: As the Fed dithers inflation will accelerate and they will find themselves in a situation where they’ll be forced to jack rates higher next year to a level that will be destructive to growth. There is still time to get it right and I believe they will begin their rate-hiking campaign at the August meeting on their way to 3.00% fed funds by year end. Again, my belief is that this will be a huge positive for the market, the dollar and oil. But Bernanke and Co. need to gets their heads out of their textbooks -- nothing there will direct them in the proper direction -- and pay more attention to market trends, specifically the dollar/oil link.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks bounced around as offsetting economic reports and a fairly dramatic turnaround in crude prices left traders unsure of the position to take during the session.

Stocks began the day lower as oil per barrel shot up $5, coming just 20 cents shy of the $140 mark and the two economic releases of the day canceled one another out – New York-area manufacturing posted a weak reading, but foreign security purchases show there is plenty of appetite for U.S. securities. But energy traders, after brushing off the Saudi announcement to increase production by 550,000 (formerly 300,000, boosting that by 250,000 this weekend) per day beginning next month, shifted their positions. As a result, crude dropped $6 and stocks rebounded to the highs of the day before closing flat. The chart below illustrates the day’s activity.

Of the 10 major S&P 500 industry groups, financials were the best-performing area, adding 1.05%. Energy and information technology shares also gained some ground, while consumer staple and health-care shares led the laggards lower. By the close, six of the 10 ended in the red.

On the economic front, the Empire Manufacturing survey showed New York-area factory activity contracted in June – this marked the second-straight month of decline and the fourth in the past five. Fortunately, the New York region is not a terribly significant portion of total U.S. factory activity, as one might expect. The national reading is hovering right at the expansion/contraction mark of 50 and has shown mild improvement over the past couple of months.

But regarding the Empire number, clearly financial-sector woes are hurting activity in the region. Businesses have to contend with both higher costs and increased layoffs/smaller bonuses at the large brokerage firms. This doesn’t affect manufacturing in a direct sense, but does flow through to orders as the weakness trickles down.

A couple of the key sub-indices within the report were ugly as new orders came in at -5.5, shipments posted a -6.5 reading and unfilled orders posted -10.5 – all lower from the previous month. On the bright side, the index that measures the outlook for the next six months jumped to the highest level this year, coming in at 32.3 from 23.9 in May and 19.5 in April.

Note, on the Empire Index, a number above zero marks expansion; the national factory index – the ISM reading we talk about each month – marks expansion by anything above 50.

In other news, the Treasury Department reported that foreign security purchases jumped $115 billion in April – there’s a pretty large lag to this data as it takes times to compile. We’ve heard a lot about how the trade deficits are the reason for the falling dollar, but the value of the greenback in actually driven more by Fed policy than anything else, especially in the relative short term.

If perhaps, most of the dollars foreigners held via trade were converted into other currencies to buy assets outside of the U.S. then, yes, trade deficits would lead the dollar lower. However, so long as these governments and investors return most of these dollars to the U.S. via security purchases then the old Keynesian argument doesn’t hold up. For instance, the U.S. trade gap over the past 12 months has run about $692 billion, while foreign security purchases over this period have registered $772 billion. The trend is true for the past few years.

Moving along to the Fed, it appears the press – the WSJ, FT and Washington Post – are attempting to walk the market down from their fed funds expectations. Fed funds futures were showing a pretty good indication that the FOMC would begin to gently raise rates by the August meeting – holding steady at next week’s get together. But some comments from Richmond Fed President Lacker seem to have confused some people. He did mention that the Fed may hold pat, but I believe he was referring to the June 25 meeting. He also raised serious concerns regarding inflation and it seemed fairly clear to me he was signaling a hike in August. The press saw it differently, and the possibility of the FOMC holding off for an indefinite period led the headlines last night.

As a result, expectations of some tightening have come off a bit. The bar chart shows expectations for the June 25 meeting, and no change in policy is largely expected. But notice how things have changed from the “1 day ago” reading, as shown in the table (top table to the left). And importantly, notice how expectations for a hike in August have come off (second table). There was a 68.5% chance of at least a 25 basis point hike in August yesterday. Today that expectation has dropped to 56.5%.

I think the view regarding some tightening will increase again this morning after the producer price index for May is releases at 7:30CDT. This number is trending 6-7% year-over-year and unless it returns to the 4-5% range, the Fed will feel pressure to do something – at least I hope they will for the dollar’s sake and the price of oil.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks gained some nice ground Friday, as oil decline a bit and the latest consumer-level inflation report posted a number that was pretty much in line with the officially stated expectations. While the core rate remains remarkably tame in the face of higher food and energy prices, to have the headline number pushing above 4% is not great news but I think there was a whisper number expecting something worse. As a result, the market found reason to rally.

Consumer discretionary shares led the advance as oil prices declined and investors pushed these shares higher after Thursday’s very good retail sales report. The group didn’t gain much ground in the previous session even though that May retail report justified a nice move higher; what we saw on Friday was likely some flow through there.

Energy, basic material, financial and technology shares also performed very well. All 10 major S&P 500 industry groups ended the session higher.

Oil prices declined on Friday, not by a lot but we’ll take what we can get for now. We have received some nice comments from G7 members this weekend as their main focus was commodity prices. So long as the group focuses on rising energy and food prices as their major concern regarding future economic growth I think we may see a lid put on oil prices as the dollar will get some support. In the end, either the Fed will have to begin to gently raise rates, the G7 will have to back their words up with action of intervention, or a combination of the two before the dollar can get back to 80 on the Dollar Index (currently it stands at 73.75 – the 80-85 range is the optimal dollar level in my view) and oil goes meaningfully lower. We need to see the G7 take charge here for once. While the dollar has stabilized of late, it would be very harmful for both the U.S. and global growth if the greenback were to test the 70 handle again as it did in mid March.

The dollar posted its biggest weekly climb since 2005 as more expect the Fed will need to tighten policy a bit and on those G7 comments. I should note that the group meeting these days is actually the G8, but I choose to go by the G7 still as Russia, the latest entrant, is nothing but a thorn in everyone’s side and brings virtually nothing to the table – nothing productive at least.

This weekend we also saw that Saudi Arabia has chosen to boost production by 550,000 barrels per day beginning next month. This will bring their daily production to roughly 10 million barrels. It appears that Bush trip a couple of weeks back actually was effective – it was reported at the time that he went hat-in-hand to the Saudi’s and came back with nothing. I don’t think it is a coincidence that they are suddenly announcing a boost to production as the President likely reminded the Saudi Family it is the U.S. that stands between them and an Iranian regime that would love to invade as Mideast hegemony is their primary goal.

Another key factor is also that OPEC fears the fact that crude prices have remained at these lofty levels. They know if crude in the $130 range is sustained for a meaningful period of time that alternatives will eventually account for a larger percentage of our sources of energy. As they see it, better for them to lower the price a bit via higher production then allow alternatives to bring prices crashing lower.

This is one reason why many of the alternatives that are looked upon as the panacea for our energy issues are simply difficult to bring to market in a cost effective way. This is not the way the world is currently set up. For alternatives such as solar, geothermal and coal-to-gas, we need the current price of oil to remain at these levels or the capital simply won’t be there to bring it to market in a way that significantly lowers the price. Fact is fossil fuels are still the cheapest source. The really unfortunate thing is that we could break the back of OPEC if we only had the will to drill for all known reserves within our own land and engaged in a policy to power the “grid” solely with nuclear and coal. This would bring crude and natural gas prices much lower, and these are the sources with which OPEC currently provides roughly 40% of world supply.

On the economic front, the Labor Department reported the May CPI (consumer price index) reading came in at 4.2% from the year-ago period – CPI has been hovering around 4% since December. For the month, the reading showed no sign of abating, rising 0.6% in May alone. The core rate, which excludes food and energy, does remain tame, rising just 0.2% in May and 2.3% from the year-ago period.

I’ll note, when we average all three major inflation gauges overall inflation is running at 3.5%.

The Fed continues to focus on the core reading. We have argued they need to drop this look and focus only on the headline figure as food and energy prices are the real issue. The significance of the core rate is that it shows high energy prices are not fully flowing through to the costs of other items. We can thank strong productivity improvements for this, but the Fed ought not expect either energy prices to come lower simply because growth is weak or that these higher energy prices do not cause other problems. Firms are eating these higher costs and this could hurt profit growth down the road. A little rate-hiking could go a long way, and outside of the conventional wisdom may just be quite positive for both economic and profit growth.

As the whole point of this morning’s commentary suggests, higher energy prices were the driver of the CPI report. The energy component jumped 4.4% in May as gas and electricity was up 2.3% and gasoline up 5.7%.

On the optimistic side of things, medical care costs have really stabilized rising just 0.1% each month since February, which is nice. Most of the other components don’t look bad either; it’s just the energy side of things and some food prices. Fed can take care of this energy move, just do it.

Have a great day!

Brent Vondera, Senior Analyst