Daily Insight

U.S. stocks endured another wild day as the benchmark indices traded substantially between gain and loss, but in the end closed the session meaningfully higher. Financial-sector concerns were a major factor again yesterday -- there arel kinds of hypothetical scenarios being thrown around regarding the mortgage GSEs Fannie Mae and Freddie Mac, which is driving this concern. But energy, basic material, industrial and technology shares performed well, driving the benchmark indices to the plus side.

Benflation Bernanke and Treasury Secretary Paulson were on the Hill yesterday talking about regulatory issues. In the meantime, Paulson attempted to dissipate the concerns over the GSEs – another attempt denied – as he repeated that the two mortgage giants were “well-capitalized.” If home prices fall significantly from here and foreclosures ramp up, then this “well-capitalized” position may not hold, but the government will backstop the two from failing.

It’s as simple as this. If the Federal Reserve felt it necessary to assist in keeping Bear Stearns from going down, of course the Treasury and Congress will step in to provide some funds for Fan and Fred to get through the housing woes. The government may very well take the two over if they find if difficult to raise private funds – enough of beating around the bush anyway, they’re not letting the two fail if it came to that. In the meantime the common stock continues to get crushed as these shareholders will endure further dilution if/when they do raise more capital.

Just to clarify, the mortgage-backed securities are a completely different story. These bonds are collateralized by the underlying mortgages. As long as the homeowner makes their payment, the bondholder receives his/her payment. If a mortgage goes delinquent or defaults, then FNM and FRE take the loss and pay the bondholder all principal and interest. These are conventional mortgages.

On the regulatory issues, it appears Paulson would like the Federal Reserve to be granted more oversight authority. Wrong! They are already responsible for banking-industry oversight and dropped the ball in that regard. No, they don’t need any more authority, please.

Market Activity for July 10, 2008

The chart below shows the circuitous path the S&P 500 took on the way to 1253. At one point in the afternoon session the index was just about 2% off the intraday high, but rebounded nicely in the final hour.

In the end, none of this really matters – I show these intraday charts on occasion just to provide a visual. We’re likely in one of those periods where stocks take a while to find the appropriate multiple at which to trade. Additional Fed policy mistakes throw the biggest stock uncertainty of all into the mix – the risk of a harmful bout of inflation – but as we’ve stated before, earnings growth has significantly outpaced stock prices over the past five years. After-tax corporate profits are up 175% since December 2001, while the NYSE Composite is up just 38.8%. Stocks are spring-loaded to deliver outsized returns over the next decade, but we must get past a number of uncertainties first.

General Electric has just released their second-quarter earnings results, which are in-line with expectations. Overall, operating profit was flat from the year-ago period. Flat isn’t great, but I’ll point out that the year-ago period was a strong one – up 22%. So to come in at that level, is not all bad. Sales recorded a nice gain, up 11%. Backlog is looking strong. Their infrastructure business was up 24%. Health-care equipment rose 8% -- the previous quarter’s decline concerned a lot of people, but you may recall we mentioned that decline was a fluke. Overall growth will come around. In the meantime the stock trades at just 12 times earnings and a dividend yield of 4.48%. The company has increased the dividend payout by 10% a year over the past five years.

Moving on to macro issues…

The graphs below, source Credit Sights, shows the percentage change of capital spending activity for 2007. While the risk remains that 2008 spending plans may be reduced, the data of late shows (specifically via factory and durable goods orders) that healthy growth will continue through this year. You can see the number of firms increasing outlays far outweigh those reducing. The same trend is true for 2008.

This is very good news with regard to GDP over the next few quarters. I continue to be concerned over real personal income growth -- particularly in the face of rising commodity costs -- for the next several months as its unlikely we’ll see any job creation for a spell, but this segment (capital goods orders) of the economy will help to keep GDP positive. At this point, I believe GDP will come in at a 2.5% real rate for the second-quarter. This estimate will depend on some of the lagging indicators that we have yet to see for June, but to this point consumer spending, capital investment, exports and inventory rebuilding will overwhelm the continued drag from housing.

In economic news, the labor department reported that initial jobless claims plunged 58,000 in the week ended July 5, falling back to the pretty low level of 346,000. Some of this decline was due to seasonal adjustment issues, but the fact that we have dropped far-below the level of 404,000 reached in the previous week shows the labor market losses will remain tame for now. The four-week average, a less volatile figure, has edged lower. It currently sits at 380,000 – the chart provides the picture.

Continuing claims remain elevated, but still well-below true job-market weakness, as the chart below illustrates. Also factor in that the workforce is much stronger than those previous periods, so a level of 3.2 million in continuing claims is not what it used to be. Continuing claims being defined as those that have accepted jobless benefits for more than one week.
Finally, we also received chain-store sales for June, which is the growth retail stores open at least one year recorded. The figure for June came in at 4.3%. Naturally, the press and many economists are stating this growth as a one-month blip due to the rebate checks.

First, aren’t these the same people that tried to tell us just how glorious one-time rebate checks are. In reality, they’re a joke compared to the fundamentally sound nature of across-the-board tax cuts that affect behavior in a meaningful way and actually lead to job growth as small business makes up 65%-70% of those within the top federal tax bracket.

Second, the growth we’re seeing on the retail side of things is not a one-month blip at all as this is the third-straight month of nice gains. April same-store sales rose 3.5%; May was up 2.9%; and June we already mentioned as up 4.3%. As we’ve noticed over the past few years, the press says just about anything they like – and let’s be laconic -- a lot of it is mendacity on parade.

Have a great weekend!

Brent Vondera, Senior Analyst

Our view on Freddie and Fannie

As everyone is aware, the Fixed Income markets have been very volatile as panic selling jumps from one corner to another. The most recent episode has ensnared Fannie Mae (FNM) and Freddie Mac (FRE). Fannie and Freddie have seen their common stock plunge over the past week. News outlets all over the place, including the front pages of NYT and WSJ, have been saying that these companies are in major trouble. We do not hold any common stock of FNM or FRE. This does affect our fixed income holdings, mainly our preferred stock holdings of FRE and FNM. This has affected our performance this year and will continue to have a negative impact until the market normalizes. However, I do believe that these are good investments in the long run and that we should continue to hold our positions.

We own several distinct types of bonds issued by Fannie and Freddie. First, and the largest of our holdings, are FNM and FRE backed mortgage backed securities. These bonds are collateralized by the underlying mortgages. As long as the homeowner makes their payment, we receive our payment regardless of the condition of FRE and FNM. If a mortgage goes delinquent or defaults, then FNM and FRE take the loss and pay the bondholder all principal and interest. On these bonds, FNM and FRE are basically acting as insurance. The second type of bond is a Senior Debenture. These are essentially corporate bonds issued by FNM and FRE. They are rated AAA by all the ratings agencies even though they are unsecured senior debt. These are the bonds that FNM and FRE use to fund their operations. It would be unfathomable if FNM or FRE ever defaulted on either of these types of securities. The repercussions on the global markets would be huge.

The last kind of debt that we own is the preferred stock. Even though it is called stock, this is debt of the company that the company can count as capital. FNM and FRE preferred stock is rated AA because in the event of liquidation, it is subordinated to all of the senior issues and MBS guarantees. There is less confidence in the market right now that the preferred stock would be bailed out along with the senior debt. This has caused the preferred stock to slide 25%. However, I am still confident that we will receive our principal and interest payments and that the market price will normalize over time. This current sell-off appears to me to be panic selling and unjustified.

Background—

Fannie and Freddie are government sponsored enterprises. They were created through and act of Congress in order to provide liquidity to the mortgage market and foster home ownership. They were then sold off to private investors and are now publically traded, private enterprises. However, they have their own government regulator, OFHEO, that closely supervises all of their actions and determines adequate levels of capitalization. FNM and FRE also have a line of credit directly with the US Treasury. In the event of a liquidity crunch, these two companies have direct access to the Treasury to meet obligations. This is something that no other company has.

The recent turmoil was sparked early this week when a research report by a Lehman Brothers analyst stated that FNM and FRE may have to raise over $65 billion in capital if a new accounting standard was adopted. This new accounting standard relates to how companies account for mortgage servicing and is still in very preliminary stages. These standards are often radically altered prior to being (if ever) adopted. At the end of the research report, the analyst stated that even if the guideline is adopted as is, FNM and FRE would be exempted. The entire report was a big hypothetical exercise and even the author does not see much chance of it ever coming to reality. However, this was enough to send the stocks in a tailspin that has lasted all week long as every bit of negative information and every doom and gloom scenario has been played out in the press. However, there has been no new material information released about the companies. All that is “news” is rehashed arguments and figures from their last earnings report. Here are a few facts to focus on:

The Bad

• FRE and FNM do need to raise more capital and this is a difficult market to raise capital.
  Foreclosures will remain elevated for at least the next year. This will put pressure on


• FNM and FRE earnings and capital for some time.


• Market is losing confidence in the companies. This is seen in the violent movement of the stock.

The Good

• OFHEO continues to say that FNM and FRE are adequately capitalized.


• FNM and FRE have a history of underwriting higher quality loans. Their foreclosure rate is ~1%. They do have exposure to lesser quality mortgages, but only ~5% of assets.


• Congress is looking to FNM and FRE to help stimulate the housing market. Makes government intervention more likely if needed.


• Have a line of credit with the Treasury.


• While borrowing at highest spreads since 2000, they are still able to issue senior debt at more attractive levels than other US Corporations. This is their primary source of funding.
  

It is my opinion that long term these will be sound investments. I think that they market will regain confidence in the companies, they will raise more capital, and things will normalize. I still believe that we will receive our scheduled principal and interest payments on the preferred stock that we own.

Ryan Craft, CFA

Daily Insight

U.S. stocks got clobbered due to duel concerns over Fannie Mae (FNM) and Freddie Mac’s (FRE) viability and a slowing global economy that many are predicting will hit tech profits, among others.

Never mind that the two mortgage GSEs continue to raise funds at a very low rate – 75 basis points over Treasuries – and delinquent loans remain low relative to total outstanding. Yes, that 75 basis-point spread FNM and FRE have to pay over Treasuries is double the level of a year ago, but it is not a record high, nor is it anywhere near a level that makes doing business a problem.. Their very delinquent single-family loans are twice the level of a year ago too, but account for just 1.22% of total loans outstanding in FNM’s case and 0.81% for FRE.

On tech stocks, the concern that slowing global growth will hurt profits for one of the brightest sectors of late seemed to hit a crescendo – one hopes at least – yesterday, but those advancing this view must have forgotten what Oracle reported little more than two weeks back – operating profit up 25%, with their Americas segment – obviously dominated by the U.S. – up 18% from the year-ago period. If tech earnings were going to fall off a cliff this earnings season, one would think it to have shown up in Oracle’s results.

Market Activity for July 9, 2008

The charts below are intra-day trading for Wednesday.

The flood gates to the river of pessimism have been opened wide and it will just take some time to close them again as virtually everyone ignores any good news and, in my view, overhypes the negatives.

In fact rumors and conjecture rule the environment at the present. Financials took it on the chin over FNM and FRE worries, but also hitting the group was a Credit Suisse report stating 40% of the biggest banks need to cut their dividends. Funny how after the bell yesterday the second-largest bank – Bank of America – mentioned they see no reason to cut the dividend or raise capital. Maybe their management is out of touch with what is occurring, but I doubt such an explicit statement would have been made if they were not very confident this will be the case.

Expanding on this conjecture point, there is supposedly an article in Forbes asking the question: What if FNM and FRE fail?

First, can they fail? Heck yes. Do I think they will fail? No. Fact is this all revolves around the housing market and as down as that market is, it is not as down and out as people are assuming when 92% of mortgages are being paid on time and 95% are either on time or just 30 days past due. If we’re going to go down this road of scary questions, why don’t we just ask: What would happen if we were hit by an EMP attack?

I’ll tell you what would happen; we’d be thrown back to 1870. You want light? Grab a candle. Hot? Can’t turn down the old thermostat; grab a magazine and waive it near your face – where’s that darn Chinese fan? Want to escape reality and listen to some music? That iPod better be charged, and even if it is you’re down to six hours of jammin’. Want some transportation? Get to walking or find a horse – oh my, now this is getting too tough to even contemplate for most Americans Walk? Damn you, you’re saying. But you see my point. We’re trading on conjecture here instead of likely possibilities.

Again, FNM and FRE can and may fail. I don’t think they will based on current delinquency rates and the fact that investors remain quite willing to provide them with capital. Further, if this were really the case, if these two were very likely to fail, you’ll know it because the Dow will lose 2500 points instead of 1/10 that figure, such as yesterday’s loss.

There are challenges, no doubt, and I’m not especially optimistic at the present regarding what may occur with tax rates and leadership that believes the government should get out of the way instead of some nanny state mentality winning the White House. But housing will come back – even if it takes another 12-18 months -- and the mortgage market will be stronger for it. Hopefully, we aren’t burdened with too many additional regulations. There are some that say the free market got us into this mess. Well, they must be forgetting that government meddling has been involved in the mortgage market for a long time – eg. Fannie, Freddie, the Federal Housing Association, the Community Reinvestment Act. They are also forgetting it is monetary policy mistakes that encouraged a rash of bad behavior.

On tax and trade, occasional stints of bad policy will lead to better longer-term polices down the road. Why? Because free markets work and allow economic participants to produce prosperity and socialism does not. Don’t take my word for it, look at the record.

Moving one…

Oil prices actually ended the day flat, reversing course after crude was 2% higher on news stockpiles fell more than expected and Iran test fired several missiles capable of hitting Israel, among other places.

Crude-oil stockpiles fell 5.84 million in the week of July 4, but gasoline supplies did rise 900,000 and sit at the average range for this time of year. The bulk of the decline in crude came from PADD 5 which is the West Coast. (PADD stands for Petroleum Administration for Defense Districts – these areas were delineated during WWII. PADD 1 is the East Coast, PADD 2 is Midwest, PADD 3 is the Gulf, PADD 4 is the Rockies and PADD 5 already mentioned.) I’m not sure what occurred over on the West Coast, but supplies plunged 8.25%, or 4.82 million barrels.

In any event the worries over slowing global growth, which we touched on at the top, overwhelmed the decline in supply and Iran worries.

As you can tell by this point of the letter, we didn’t have an economic release yesterday. Today, we get back at it though with initial jobless claims for the week ended July 4 and chain-store sales for June.

Oh yeah, nearly forgot to mention that optimism over U.S. stocks slid to the lowest level since 1994, according to Investors Intelligence. The share of bullish stock advisers fell to 27.4%. This is actually a very bullish indication.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks rallied yesterday as comments from JP Morgan CEO James Dimon sparked a rally in financial shares and oil continued a two-day slide. Earnings season kicks off this morning, although doesn’t begin in earnest until next week; we’ll have to get better-than-expected numbers for stocks to trend higher in the very short term.

Financial shares led the gains, jumping 5.72%, after JP Morgan’s Dimon stated losses in credit markets will ease. Industrial, transportation and consumer discretionary also enjoyed a nice session as crude futures fell $5.33, or 3.77% -- ending a two-day slide of more than $9.25 per barrel.

On earnings, we expect ex-financial profits to remain positive – although things won’t be strong enough to match the past two quarters of double-digit growth. Tech, consumer staple, health-care and industrial-company profit growth should combine to help ex-financial profits to post 5-6% growth. Financial profits will plummet another 60%, likely, but this is expected and once we get out another couple of quarters this sector’s earnings should rebound in pretty strong fashion as the comps will be easy to beat.

Market Activity for July 8, 2008

It’s been very nice to see oil prices come back below $140, falling to $136.04 as of yesterday’s close. The dollar posted a very nice day too as the G7 members made some very constructive comments on inflation – which means they focused on these two variables and may have sparked some fear in those holding dollar short positions. Alas, crude is up $2 this morning on reports Iran tested a longer-range missile capable of reaching Israel.

On stocks, they’ll remain volatile and will probably find it difficult to gain momentum in the very short term as uncertainties abound. The Fed, with their reckless easing policy of the past several months, has thrown another risk into the mix – inflation concerns – and this makes it increasingly difficult for the market to determine the appropriate market multiple. Other risks are geopolitical events – which is something we’ll have to adjust to for several years –, tax and trade policy, and energy price volatility.

We have heard talk of another “stimulus” plan – but Washington needs to spare us all of their feckless Keynesian shot-in-the-arm rebate check approach and get to making the current rates on income, capital and dividends permanent while also lowering the corporate tax. This is what should be done for now, and will cause the market to rally.

Once we get the election behind us, it will be important to lower all of these rates a bit further. This will cause the dollar to rally, profits to boom, stocks to rise, the job market to expand and disposable income growth to extend upon the very nice gains of the past few years. Enough of the games, it is time to get back into the game and show a very competitive global economy exactly who is king. It is the U.S., and it will remain the U.S. even if we have to deal with politicians that are more inclined to a framework of socialism than capitalism in the short term. Any big mistakes of the next two years will only bring back pro-growth policies and this country will continue to lead the global economic growth. If we escape this tendency – that more government involvement is the answer -- all the better. But mark my words, we will make the correct long-run choices of providing an environment for entrepreneurs and innovators to flourish as common sense policies allow capital formation to build. That is America and will remain that way.

Currently, we are dealing with monetary policy mistakes. As the Fed kept rates too low for too long into 2005. This policy fueled the housing market problems as the FOMC subsidized debt and encouraged some very bad behavior. Now we are working to resolve this issue. Again though, Bernanke & Co. are making the same mistake and this is fueling a commodity boom, and raising inflation expectations. I’m still holding out for the Fed to come around and reverse course. They better get to it. When they wake up the energy problem will ease dramatically. Yes, we have other challenges in this regard, such as pushing aside quixotic tendencies for common sense energy policy, geopolitical risks and the chance a hurricane may take a damaging path. But specifically within the economy, it is all about the Fed and a little tightening will solve the oil/dollar problem.

On the economic front, things were mixed.

The Commerce Department reported wholesale inventories hit the lowest level on record in May even as auto stockpiles remain elevated. Thankfully, most businesses have kept their operations lean and sales remain strong. Sales growth is up 13.6% year-over-year and up 20% at an annual rate over the past three months.

This data indicates two things:

One the economy will not go into recession anytime soon as firms have kept stockpiles lean. Remember, a big contributor to downturns is when firms become bloated and then have to sell off a surplus of goods before ramping production up again. This is certainly not the case today.

Two, underlying growth remains, as evidenced by sales growth. Sales have easily outpaced inflation, so one cannot say this growth is solely a function of rising prices – real sales growth looks good.

That said, we very likely see sales decline when the June data is releases. After three very strong months, a pull-back is a natural occurrence. So be prepared for that as the media will attempt to spread their doom and gloom when it occurs.

Regarding GDP, the large inventory rebuilding of the past two months will result in a stronger-than-expected reading. We’ll see second-quarter GDP come in at 2.5% in real terms by my estimation – assuming nothing huge changes over the next month – the lagging data for June has yet to be reported.

We also had pending home sales, which fell 4.7% for May after large 7.1% rise in April, which was revised higher.

Even with the pull-back last month, the year-over-year trend is looking much better. (The graph below shows the month-over-month change.) In December, the year-over year decline in pending home sales reached 23.9%. As of this latest data, that figure has improved to a decline of 14.6%. Let’s hope we continue to see mild improvement. Still, for things to really turn buyers will have to believe prices have bottomed. Until then, the sales figures will remain weak and supply will remain elevated.

We’re quiet on the economic front this morning, so we’ll have to wait for tomorrow’s jobless claims and chain-store sales data.

Oh, I almost forgot to mention both Fedhead Bernanke and Treasury Secretary Paulson gave speeches yesterday and the market held onto its gains. Let’s hope this is the start of a new trend – talk about quixotic.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

Wow! Market activity was all over the road yesterday as stocks began the day roughly 1% higher on a meaningful decline in oil prices – thanks to some comments from the G7 on Sunday night – and the dollar was up big. But that all changed two hours into the session after a Lehman analyst stated the GSEs Fannie Mae and Freddie Mac may have to raise $75 billion in capital. By noon, the Dow had dropped 278 points from the intraday high and barely recovered from there by session’s close.

These comments on the GSEs (government sponsored entity) received all the press for pounding the market, but an address by San Francisco Fed Bank President Janet Yellen did major damage as well, which we’ll get to below. For now, suffice it to say her statements reversed the dollar’s rally and helped crude futures reverse roughly half of its earlier losses.

In the end, the major indices closed less than 1% lower, with the Dow down just 0.5% and the NASDAQ losing 0.1%, but it was worse than that considering stocks were in rally mode at the open.

Market Activity for July 7, 2008

Not helping the Dow were shares of General Motors, which have declined to the lowest level since 1954. Between GM’s management and the UAW, it’s been very difficult for the firm to compete on a global scale. But Bernanke & Co. have delivered what is very close to a coup de grace with their reckless monetary policy – it is no coincidence that crude oil is up 75% since September, the point at which the FOMC began their rate-cutting agenda. Since becoming absurdly aggressive, kicked off by the January 22 inter-meeting cut, oil is up 60%. GM is not face with a demand problem; they are troubled with having too much supply of trucks and SUVs, while not enough of what the public now desires – more fuel efficient vehicles – after the stunning climb in energy prices in the past several months.

Getting back to the market and investors’ concerns, here’s the kicker regarding the Fannie (FNM) , Freddie (FRE) news: it was all conjecture.

FNM, FRE took a dive after a Lehman Brothers analyst stated accounting rule changes would force the two to raise capital, and thus make it more difficult to buoy the housing market – if you can call it that. But that very same analyst, and naturally not reported on until well-after the close, agreed that such an outcome would not occur. In fact, he stated that he could not “imagine such an outcome occurring.”

So all of this wild ride was over a hypothetical statement. The Dow falls 278 points intra-day, FNM and FRE lose 20% and the market has allowed yet another dark cloud to roll overhead all based on some comments that will likely not come to fruition.

With all of the concerns related to mortgage loans, and the financial sector, the Ted Spread appears to be holding in there pretty well – it is certainly elevated, but no where near the widening that occurred during heightened stints of credit-market concern. This spread is an indication of credit risk as it illustrates the difference between three-month futures contracts for U.S. Treasuries and Eurodollars having identical expiration.

The reasoning: Since U.S. T-bills are considered the risk-free rate, while the rate associated with the Eurodollar is thought to reflect the credit ratings of corporate borrowers, the wider spread is an indication default risk is increasing. Naturally, a narrower spread means default risk has diminished.

But the 30-year mortgage spread does remain wider than usual against the 10-year Treasury. This spread normally runs between 150-180 basis points – that is, the 30-year mortgage rate is usually about 1.5-1.8 percentage points higher than the 10-year Treasury. Currently, the spread is running about 235 basis points as the market demands more via heightened risk. The chart below may look a bit confusing, but focus on the yellow line, which is the spread.

Considering these two spreads, we see that concerns remain heightened, but are lower than the worries of March.

Outside of these housing/credit-market concerns there was also something else that hurt stocks, and that was San Fran Bank President Janet Yellen’s speech. The graphs below show what happened to the dollar and oil when her comments hit the wires.

The address was focused on the current state of the economy but it was her comments on commodity prices, as she explicitly stated there is little monetary policy can do to prevent the rise in oil prices, that did the damage. She also said that the Fed doesn’t have a definitive answer for why food and energy prices have gone through the roof, but suspects it’s resultant of supply/demand. Oh, I see, supply/demand has changed so dramatically in six months that it justifies a 60% rise in crude prices.

It’s true that the rise in food prices is partially due to supply issue as heavy rains have kept farmers from getting into the field to plant. It is true that oil prices had risen from $40 per barrel in late 2004 to $70 per barrel by mid-2007 due to increased demand while we refuse to produce the vast majority of our energy reserves. However, the rise from $70 to $140 in the past 10 months is due to reckless Fed policy. It is amazing that Fed officials continue to tow the line Yellen repeated yesterday. It is not simply chance that energy has risen this much in such a short period of time as the Fed has also jacked rates lower and punished the dollar in the meantime.

I believe when the Fed changes their stance on this issue and signals just mild tightening will take place in order to boost the dollar, lower energy prices and fight inflation, the market will rally hard. It may take a day or two to digest it all, but a major uncertainty will have been removed – the question: is the Fed really focused on curtailing price pressures or will they remain lost in the wilderness of their Keynesian textbooks? – and stocks will find their groove. The search party continues, but I do believe the Fed will be found before we move to a 1970s like situation.

Crude prices are lower this morning, falling below $140 per barrel, and the dollar is lower after some very constructive statements out of the G7 conference last night. (It’s actually the G8, but I don’t recognize Russia’s membership, which is a joke and nothing but a thorn in everyone’s side).

Alas, Bernanke speaks this morning, so don’t be surprised if oil and the dollar reverse their desired direction this morning.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ended mixed in a holiday-shortened session on Thursday as the market had to deal with a job-market report that showed the economy endured its sixth-straight month of jobs losses and a service-sector survey that came in below expectations.

However, the fact that the monthly job losses remain mild did offer some consolation – readings below 100,000 are statistically insignificant for a job market that is nearly 138 million strong – as the broad market hovers very near bear-market territory. The S&P 500 dipped to 20% below the peak reached on October 9, but snapped back very nicely an hour into the trading day. In the end the index closed flat.

Much of our current problem has to do with inflation expectations and a Fed policy that is hurting the dollar and driving energy prices higher. Once they get it right, as I continue to believe they will, the dollar will strengthen and some steam will be taken out of the oil trade. At this point, the market will have an easier time assessing the current multiple in this environment and we can regain some footing.

Market Activity for July 3, 2008
Six of the 10 major industry groups gained ground during Thursday’s session with industrial and basic material shares leading the gainers, while energy and utility shares led the decliners.

For the week, the Dow lost 0.51%, the S&P 500 closed lower by 1.21% and the NASDAQ Composite fell 3.03%.

Getting to the economic data – that after all is what Thursday was all about -- the Labor Department reported that jobless claims, for the week ended June 28, rose 16,000. That moved the four-week average up to 390,000; not a number we wanted to see – optimally, during this period of soft labor conditions it would have been nice to have remained at 375,000 in weekly claims just for assurance.

That said, it is not terribly troublesome, as the chart below illustrates; we remain below the 400k mark and significantly below levels that are seen during substantial labor market weakness. I’ll also add, the work force is much stronger than it was in 1991 and meaningfully higher than the most recent downturn of 2001. For instance, there were 108 million payroll jobs in 1991 and 130 million back in 2001. Today, the there are more than 137 million payroll positions. So, when one adjusts for the increase in jobs, the current level of jobless claims is actually even lower than the periods of heightened job-market weakness that is presented by the graph below.

Nevertheless, based on the latest service-sector report – as we’ll explain below – it does appear we’ll see the claims figure move higher.

And to that report, the Institute for Supply Management’s service sector index (not to be confused with the ISM’s manufacturing survey) declined, moving back below 50 – meaning activity contracted. The reading slipped to 48.2 for June after the May reading printed 51.7.

This is a bit strange considering that personal spending has trended higher over the past few months; what it may be signaling is a pull-back after three fairly powerful months of spending – which rose 6.8% at an annual rate March-May.

The main aspect to focus on within the report was the move on the employment index – a sub-index within the report – which fell 4.9 points to in June. The main culprit was financial and business services, reflecting financial-service woes are beginning to show up in a more meaningful way.

Still, many industries reported employment growth, such as real estate (that’s a surprise), scientific and technical, utilities and recreation and leisure.

Overall, I’m not terribly worried about this reading, but it does suggest, that the job market will remain weak for a while.

Saving the big one for last, we had the employment report for June, which showed another mild loss in payroll jobs. The losses over the past six months now total 404,000, or 5% of the eight million created during the roughly four years that ran September 2003-December 2007.

For June we lost 62,000 payroll jobs, a tepid decline, but the unemployment rate did remain at 5.5% -- I was expecting it to fall after the figure was boosted in May via those 19-24 year olds entering the workforce a couple weeks early and messing with the seasonal adjustment.

However, since the rate remained at 5.5% for a second month, it makes it kind of difficult to blame it on seasonal adjustment factors. Still, even though the jobless rate has risen a full percentage point in the past year, it remains in line with the 20-year average and below the 30-year average of 6.07% -- just to provide some context.

The fact that temporary help fell 30,000 in June – the seventh month of decline – illustrates that we will not see improvement anytime soon. Temp work is a pretty good forward indicator.

For the meantime, we’ll have to contend with a substantial housing correction putting pressure on construction jobs, financial services (namely large brokerage firms and banks) keeping this segment soft and rising costs that keep firms focused on increased productivity out of current workers instead of just adding staff. But the vast majority of firms are slim and streamlined and productivity improvements remain at a historically high level as more efficient plant and equipment allow workers to produce more. This is great news as we look out over the next couple of years. But beware higher tax rates, especially on capital. This is a productivity killer as it results in a lower level of capital formation – the mother’s milk of innovation.

Further, while we all must contend with higher energy prices, the industry is booming as a result. The number of high-paying manufacturing jobs that will come from oil and natural gas production and the necessary nuclear build-out will provide a huge boost to the job market if the government would simply get out of the way and allow it to occur. The industrial sector will take over again as a major job creator if/when Congress removes a number of obstacles.

Have a great day!

Brent Vondera, Senior Analyst