Daily Insight

U.S. stocks built upon Wednesday’s rally, sending the broad-market higher by 3.71% over the past two sessions. Financial and consumer discretionary shares once again led the indices higher, with technology and industrial stocks helping out nicely.

Again, just as on Wednesday, earnings results and a decline in oil prices were the spark. We saw a number of Dow components report very healthy profit growth and the financial sector is delivering results that are surpassing expectations – still weak, but we’ll take what we can get right now.

I’ve got to think the initial jobless claims number, showing claims remain well below the 400K level., also helped to keep things going. The four-week average remains well-below troublesome levels and we just won’t see significant job losses so long as this remains the case – more on that below.

Market Activity for July 17, 2008

Earnings are looking good, outside of the financial sector – and this morning’s releases have turned stock-index futures around. Dow futures were down 100 points a few minutes ago, but have reversed course, down just eight points as I type thanks to additional better-than-expected results. Citigroup has just reported results that beat expectations and Honeywell has knocked the cover off of the ball – 24% operating profit growth, beating their number by 16% and raising full-year guidance. This follows a very nice report from United Technologies yesterday.

A couple of tech names missed their mark yesterday – Google and Microsoft reported income that missed estimates – but the growth rates were stellar. Microsoft reported 25% operating profit growth and Google 33%. Merrill Lynch reported a horrible number last night, losing $4.66 per share, but the rest of the universe is overwhelming their troubles.

To this point, with one-fifth of S&P 500 members reporting, profits have declined 21.4% as financial-sector net income is down 78.8% for the second quarter. However, ex-financial results look ready to record another quarter of double-digit growth, up 12.7% to this point.

The other catalyst over the past two trading sessions has been a welcome decline in oil prices. If we can move down to $125 per barrel that will provide a huge boost to stocks. Personally, I don’t see it happening just yet, although we are finally getting some good comments out of Congress regarding the removal of drilling restrictions – follow this talk up with action and we’re onto something. If not, it will take some mild Fed tightening to really cause a rotation out of the oil trade, in my view.

On the economic front, the Commerce Department reported housing starts jumped 9.1% in June, but that was only because of a change in New York’s building code. That change resulted in a large jump in multi-family units in the Northeast, but excluding this jump starts would have declined 4%.

As the chart below illustrates, starts remain at a lowly level, and it’s tough to picture a sustained bounce until the supply of homes come off of these extremely elevated levels. It will simply take time to reduce this supply, hopefully over the next 12 months we’ll see sales rebound – once they do, the supply figures will fall in pretty quick order.

Residential fixed investment has been a drag on GDP for 10 quarters now. Single-family homes fell 5.3% in June, down 43% year-over-year, but the monthly declines have eased of late. We are probably close to seeing the worst, but foreclosures are the pig still moving through the python, so I’m not sure the bottom in housing can be called just yet. Again, these things just take some time – hopefully we don’t get anymore harmful legislation out of Congress, the more they attempt to be the savior of all of those who made poor decisions the more unintended consequences will result and extend this housing correction.

In a separate report, the Labor Department showed initial jobless claims rose 18,000 in the week ended July 12, but this was less than the 32,000 expected. Remember, the week prior showed a huge decline in claims that was a likely a result of having to adjust to the July 4 holiday. Based on this, there was a concern we’d get a big bounce back to the 380,000-390,000 range. We didn’t though as claims sit at 366,000. The chart below is the four-week average and so long as this reading remains below 400,000, it is very likely job losses will remain tame.

We really need to see things turn a bit and move to mild additions, but this is going to be tough to accomplish until the housing sector comes around – construction-job losses are really weighing on the figure. One glimmer of hope over the short term is what appears to be a rebound in capital spending, which has rebounded, but the jury is out whether it will become a trend. The smart part of the “stimulus” package was the increase in current-year write-down allowance and 50% bonus depreciation for business. This should spark capex and may boost jobs as a result.

In addition to better-than-expected profit results, we’ve received official announcement this morning that Teva Pharmaceuticals, an Israeli company and the world’s largest generic-drug maker, will buy Barr Pharmaceuticals for $7.46 billion in cash – a 41% premium over Barr’s closing price on Wednesday. The deal is helping to boost stock-index futures, so hopefully another nice day is in store.

Have a great weekend!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks rallied, sending financial shares to their best one-day performance ever – up 12.3% -- after Wells Fargo posted operating earnings that beat expectations and posted overall stunning results – the firm even raised their dividend. In an environment in which everyone has been expecting the worse out of this sector, the Wells news was more than enough to rally stocks.

Adding to the rally was another significant drop in crude-futures. Oil prices have declined nearly $11 in two days and this helped to ease concerns regarding the consumer; the index that tracks consumer discretionary shares jumped 4.38%.

Industrial and technology shares also enjoyed a nice day, up gained 3.18% and 2.30%, respectively.

Market Activity for July 16, 2008

Oil prices are a bit lower this morning, after falling 7.42% over the previous two sessions, as crude for August delivery stands at $134.06. Yesterday’s weekly energy report showed crude supplies rose 2.95 million barrels; a decline of 2.2 million was expected.

We saw a similar decline during last week’s first two trading session when oil prices fell $9, or 6.5% only to see a rebound back to $145. Hopefully, we have a sustained dropped occurring that gets us close to $125 for now. This would help stock prices out big time and cool the inflation gauges over the next month.

I see many in Congress continue to vilify speculators, citing their behavior as the main reason oil prices have shot up so dramatically. Certainly no one likes it when the market pushes commodity prices higher, but one can’t wish away realities by regulating vital commodity trading markets. I wonder if anyone in Congress happens to ask exactly why market participants have speculated oil prices will go higher. Of course they haven’t – most at least – because they never blame themselves for their own ridiculous policies.

Maybe if there were a sensible energy policy in place, traders wouldn’t bet prices would go meaningfully higher. I doubt anyone would be complaining if speculators were betting prices will fall.

And on the Fed, maybe if the FOMC wouldn’t have implemented such a reckless monetary policy stance, the dollar would be a bit stronger and oil, which is priced in dollars, would be closer to $90 instead of $135. The Fed has thrown the dollar under a bus. But we are trading lower for now, and if Congress removes all restrictions on drilling, we can get a trend started here. I’m not holding my breath, but stranger things have happened.

On the economic front, the Labor Department reported that the consumer price index (CPI) jumped 1.1% in June – that’s on a month-over-month basis – and 5.0% over the past 12 months. We’ve been warning that the consumer-level inflation gauges will rise to 5% before the Fed knows it and here we are. Consumer prices jumped at a seasonally adjusted annual rate of 7.9% in the second quarter and all Benflation Bernanke could say yesterday was that inflation is too high – as if he has zero control over this situation.

Energy accounted for two-thirds of June’s large 1.1% increase, but this didn’t have to be the case if the Fed hadn’t jacked fed funds lower in such an aggressive way. The CPI’s index of energy soared 29.1% at an annual rate in the first-half of 2008. The food component rose 0.8% in June and that specific index within the CPI has risen 6.8% annualized in the first half.

To be fair, the regular CPI does overstate inflation a bit as the index is not capable of quickly adjusting to consumer preferences and the substitution effect – the tendency of consumers to buy more of those goods with which prices are rising more slowing and curtailing consumption of those goods that have prices rising more quickly. Further, the owner’s equivalent rent (OER) segment boosts the housing component as it factors in the cost of renting one’s home instead of owning it. Thus, when the housing market is hurting and more people rent, that results in higher rental prices and pushed the CPI’s housing component higher even when we know home prices are falling. However, there are legitimate segments of this housing component that are pushing CPI higher, such as utility and insurance costs.

Personally, I prefer the chained CPI figure, which we do mention each month, even as the financial press totaling ignored the figure. The chained reading had inflation up 0.8% in June and 4.2% on a year-over-year basis. Certainly higher than we’d like but better at least than the regular CPI reading. Still, if the Fed continues to ignore price stability we will see all of the inflation gauges hitting 5%.

In a separate report, the Commerce Department reported that industrial production rose 0.5% in June after two months of decline. Some of this increase was due the American Axle strike coming to a close, and the negativists obviously suggested that this was a one-time thing and therefore the gains in production will not last. One could also say that the strike, which went on for several months, kept industrial production lower than it otherwise would have been over previous periods.

Other segments boosting industrial production last month were utility output, high-tech production, consumer goods, business equipment and mining activity.

Stock-index futures have done a 180 and are up strong right now after some very good earnings results from Coca-Cola, Untied Technologies and better-than-expected earnings from JP Morgan.

In economic news, we’ll get housing starts for June, the weekly jobless claims figure and manufacturing activity out of the Philadelphia region.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks were all over the map yesterday as the dynamic duo (Fedhead Bernanke and Treasury Sec. Paulson) were on the Hill – which almost always results in market volatility – and a big drop in oil prices helped stocks erase much of a 2.3% early-session decline.

Also we had a slew of economic data out yesterday, and while the inflation data was disturbing – and Bernanke’s dithering, non-committal behavior only causes inflation expectations to erode -- the retail and business sales data were market positives.

Nevertheless, those two economic gauges were not enough to keep stocks positive by session’s close as the S&P 500 closed at its lowest level since late 2005. I’ll repeat though, even if stocks are laggards right now – much of this due to the fact the Fed has created additional uncertainties, in my view – the economy continues to show an awesome level of resilience and I’m not sure our call for a 2.5% second-quarter GDP reading won’t be a bit shy of reality; we may very well get a reading that is closer to 3.0% (in real terms) as core retail sales have risen at a 7.5% annual rate over the past three months – a figure that flows right into GDP.

Market Activity for July 15, 2008

In addition to the Capitol Hill appearance by the dynamic duo, SEC Chairman Chris Cox was also testifying. Of his statements, his comment that naked short-selling would be outlawed regarding financial-sector shares probably garnered the most attention. Naked short-selling is supposedly when someone borrowers the same stock from the same brokerage firm multiple times. What this means is that the person selling short has no intention, or ability, to deliver the shares. I’ve got to be honest, not even sure how this works in reality, but I was under the assumption it was already illegal; it certainly sounds illegal. Maybe what Chairman Cox was saying is now it is really really illegal. Or maybe he found it appropriate to voice the term “naked shorts” in front of members of Congress based on their indecorous behavior.

Moving on…

Crude-oil futures plunged $6.44 per barrel, or 4.44%, yesterday. When this drop occurred at 9:15CT it perfectly coincided with the rally in stocks that brought them back from what looked to be shaping up as an ugly day. President Bush was on the mark yesterday. He was awesome – without tripping himself up even once – on the economy, spelling out a number of positives while acknowledging there are some major challenges that must be dealt with. He was clear, straightforward and on message. Same was true for his statements on the necessity of removing restrictions on domestic energy production.

Naturally, according to the press, it was not Bush’s comments on domestic production that caused crude prices to decline, but the rumor that a bank was failing and had to liquidate their oil positions. So typical. There are a lot of people saying we can’t drill our way out of this situation. I don’t agree. Yes, even if we removed all restrictions on domestic production it would not result in one additional drop of oil, or cubic foot of natural gas, today. But, if the statements are followed with action, it sends a signal and futures prices will respond. Besides, if these restrictions has been removed a decade ago, the energy market would likely not be so uptight.

All of that said, we’ll point out that the crude contract for August delivery expires this week, so this likely has something to do with the precipice drop as well. Crude is down another 1.25% this morning.

On the economic front, the Commerce Department reported that June retail sales rose 0.1%, but excluding autos the figure jumped 0.8%. Core retail sales, which takes out gas station receipts, autos and building materials, rose 0.3%.

We’ve seen consumer activity bounce back very nicely over the past four months, and the rise since April will help to boost Q2 GDP.

In a separate report, Commerce also released business inventories and sales data for May. Inventories rose 0.3% and sales jumped 0.8%, which sent the inventory/sales ratio back to the record low of 1.24 months’ worth of supply.

As the chart below illustrates, business sales remain on a respectable trajectory, up at a 6.3% annualized pace over the past six months – this is not something one sees in an overall weak economy, underlying strength is there. I’ll caution, this sales figure will likely decline when the June figure is released but this will be a very natural occurrence following three months of big gains. Since March, business sales have increased at a 14% annual rate.

Finally, we had the Labor Department’s report on wholesale inflation via the producer price index for June. I’ll let the chart speak for itself.

Despite the troublesome pick up in producer and import prices – import prices are up 20.5% over the past year due to the weak dollar – Bernanke offered nothing that would lead one to believe he is focused on price stability. But reality will continue to ask ol’ Ben how many lumps he wants as it continues to beat him over his Keynesian skull.

In his defense, the consumer-level inflation gauges have remained somewhat tame, although we’ve seen CPI hit 4.2% and this morning’s data is expected to show CPI rose 4.5% year-over-year for June. I find it hard to believe that at least half of the rise in producer prices will not flow to the consumer readings. Inflation works with a lag and I believe the Fed is going to find the inflation gauges hit 5% before they know it. At that point, they’ll be forced to say their Phillips Curve models are flawed – well no, they won’t explicitly admit it – and begin to raise rates. This will actually be a positive event if it occurs, because the sooner they get to it the less aggressively they’ll have to hike.

For now the Fed Chairman is dreamin’ as he continues to state “longer-term inflation expectations remain well anchored.”

On earnings news, Intel reported last night that that operating earnings jumped 45% in the latest quarter as the chip-giant posted record unit shipments of chips for laptops, record shipments for wireless communications and gross margins rose to 55.4% from 53.8%. So that’s good news and provides additional evidence tech-sector profits will record another strong quarter. Recall, Oracle’s 25% rise in operating profit a couple of weeks back that showed the U.S. segment rebounded by 18%.

On a lighter note…

We’ve heard a lot about the “staycation” over the past couple of months. For those not familiar with the term, as it suggests, this is when you can’t afford to actually travel anywhere so you just stay home – as if no one ever stays home when they take time off from work. Anyway, there’s an article in the WSJ touching on how some are pretending to travel – they stay home, but create itineraries for themselves that make it feel like they have gone somewhere. One example was this woman in New York who could not afford a trip to Japan. Instead, she is going to Japanese restaurants, the Bonsai Garden and speaking Japanese for a week. Articles of this type prove there are too many journalists in this country, when you’re struggling to write something and this is what one comes up with it’s pretty clear evidence. We’ve known for some time America has too many lawyers; now it’s clear there are too many journalists too.

Have a great day!


Brent Vondera, Senior Analyst

July 2008 Portfolio Insights

The newest issue of Portfolio Insights has just arrived!

To view the new issue click here or on the cartoon on the right.

Topics include:

• What We Do in Bear Markets
• Investing with Clients
• Fixed Income Strategy
• Equity Markets Activity
• Inside the Economy
• The 2002 Bear Market

Daily Insight

U.S. stocks were dragged lower by financial stocks yesterday on heightened concern bank failures will spread – the S&P 500 index that tracks these shares fell to its lowest level since October 1998, a period which marked the previous financial debacle.

The major indices began the day on a high note, after the Treasury and Federal Reserve stated they’d provide capital to the mortgage GSEs, if needed, but things deteriorated quickly after concerns grew over the status of the banking industry.

Considering the beating the financials endured, down 5.1% yesterday, the benchmark indices held in there pretty well as consumer-staple and energy shares recorded pretty nice results. Health-care, basic material and many industrial shares performed well on a relative basis.

Market Activity for July 14, 2008
Fact is the big banks are very likely well capitalized, in fact they are “well-capitalized” as defined by regulations, but they are also prepared for further deterioration in housing and on the consumer front, such as credit-card defaults – they’ve raised large sums of capital to guard against this likely scenario. However, there will be smaller banks that do go under; although, this is not something to panic over. (Of course, one can’t rule out one of the larger ones taking a header as well if depositors overreact.)

To provide some context, during the S&L crisis of the late 1980s-very early 1990s close to 800 banks and financial institutions failed and the system hardly crashed – this didn’t even push the economy into recession, it took an aggressive Fed tightening campaign in1989 to do that; credit continued to flow. (To this point, I think a grand total of eight banks have gone under thus far – six of those with deposits of less than $60 million in assets –very small players.)

During that financial crisis the bulk of failures occurred 1988-1990, yet consumer loans rose at a 7% annual clip and business loans at a 6% pace. Now, we have the doomsayers – likely holding short positions, I’ll add – stating that the few failures we’ve had thus far will lead to a shut down in credit. Only if people disregard the current state of the economy to focus more on the hyperbole of the moment will credit availability truly crumble.

The charts below show loan activity for consumer and business loans.

Consumer Loans

Business Loans

One of the main problems right now is the way the press, and many analysts, frame things. They act as though depositors will make a run on banks, and that’s trouble enough, but keeping to this rhetoric things can become self-fulfilling. Overall though, we have been through much much worse that this and it’s rather pathetic that we have those of supposed credibility scaring the heck out of people.

Kicking these new concerns off was the seizure of Indymac Bancorp by U.S. regulators on Friday afternoon. But this is not your typical bank as it is a hybridthrift/mortgage bank that specialized in Alt-A mortgages – mortgages that do not require borrowers to document income. The hyperbolic press reporting over the Indymac situation resulted in large banks like Washington Mutual and National City feeling it necessary to release statements that “no unusual depositor or creditor activity” had occurred. And none will unless people become unjustifiably hysterical and cause it to occur. More banks will fail, no doubt about it, but as usual, the press seems to hold context in contempt.

We’ll get through this period, but it will take some time. The economy will have to deal with quarters of weakness squeezed between quarters of pretty decent growth over the next 12 months as I see it. But housing will end its correction at some point and a huge drag on the GDP readings will have passed.

For stocks, there are a lot of names out there that are trading at very low multiples, P/Es that are extremely attractive relative to long-term earnings growth. But one has to be patient as the Fed is not helping things. The administration carts out temporary rebate check schemes instead of jamming a stake in the ground and pushing for more appropriate tax reform and dollar intervention. Yes, Bush’s term is near its end, but one would be amazed at what can be accomplished in an election year. Simply forcing another extension to the current rates on capital, dividends and income – and lowering corporate tax rates, as most of the rest of the world has done – would propel stocks.

Moving on…
I noticed a quote from Senator Obama on Sunday stating, “there is little doubt the U.S. economy is in recession.” To be fair Senator McCain has made similar statements, although I believe he’s refrained from using the “R” word.

Well, that has yet to materialize – recession, that is, as most readers know. Yes, the unemployment rate has risen and corporate profits have been hit by a couple of industries that are in a world of hurt. But real business sales continues to rise, productivity levels remain elevated, the manufacturing sector remains remarkably resilient in the face of housing and auto-industry problems, and, most important, GDP remains positive.

I really don’t get all of the pessimism – I’m speaking of future growth perspectives, surely there are consumers feeling the pain of high energy prices and some pessimism is understandable. But beyond the here and now, all it takes is some policy tweaks, and a couple of industries to turn around slightly and this economy will roar. On a global scale, unless we make some really dumb choices, we will continue to blow everyone else out of the water over the longer-term. But it takes setting in place an appropriate tax policy that boosts after-tax return expectations, instead of an environment in which those that provide the system with capital expect tax rates to harm after-tax returns. It takes a Federal Reserve that actually cares about price stability.

And on this recession speak, which continues in a tone that seems the press actually desires this to occur, watch Q2 GDP hit 2.5% (real terms) as a rebound in consumer activity during April, May and June, strong export growth, decent capital spending increases and the production needed to rebuild low inventory levels overwhelm the drag from the housing sector. Sorry, but this is not recession. Challenges abound, but this amazing and dynamic economy is adjusting to these challenges quite well.

Now, if the market can get a signal tax rates will not change on them, a sensible energy policy is presented and the Fed can get back to focusing on price stability, the stock market will take off and so will the economy. Until then, we’re stuck.

A big day on the economic front this morning as we get producer prices – which will continue to jump to troublesome levels --, June retail sales, and business inventories. That inventory report should show the underlying business sales data remains on an upward trajectory.

The dollar is getting crushed this morning as Bernanke and Paulson will be on the Hill again this morning. Bernanke and the other members of the FOMC. need to signal some gentle rate hiking is coming in order to turn the dollar around and put a lid on oil prices – I sound like a broken record, sorry. Problem is, the market is pretty sure he won’t signal such a move. In short order, he will be forced to as all members of the FOMC are mugged by reality. Their Keynesian-textbook mentality had gotten us into this mess and their errors will be the cudgel with which beats them into submission to hike rates – gently.

Have a great day!

Brent Vondera, Senior Analyst

Fannie & Freddie Update

Fannie and Freddie are still the leading headlines in the news. On Sunday, the Treasury made a major announcement that is positive for the long run viability of the two companies. While Paulson’s recommendations need approval from Congress, it appears that it will get done this week. Once completed, the implied government guarantee that was always attached to Fannie and Freddie is now an explicit guarantee. Here are the main points:

The FOMC approved access for Fannie and Freddie to the Federal Reserve Discount Window. This erases liquidity concerns for the two companies as they can go directly to the Fed to borrow short term cash. Since it has been reported that Fannie and Freddie have a combined $1.5 trillion in unpledged assets, this removes concerns about a short term liquidity crunch.

The Treasury wants to expand its line of credit to the agencies. Fannie and Freddie both currently have a line of credit with the Treasury that they can use for emergency needs. However, this is currently just a $2.5 billion line. This line was established when Fannie held just $15 billion in assets and has never been increased. Speculation is that the line may be increased to $200 billion or more.

The Treasury has asked Congress for the ability to purchase equity in both Fannie and Freddie. There is not yet an actual plan to purchase equity and the form any purchase would take is still in the air. However, if approved, concerns about Fannie and Freddie becoming insolvent and unable to raise capital are eased. The US Treasury is now the backstop, able to provide an unlimited amount of capital to keep the two companies afloat.

The market has applauded this news so far this morning. Investors have renewed confidence in Agency debt as spreads are tightening on both the debt and guaranteed MBS. Freddie Mac auctioned $3 billion worth of discount notes this morning. The auction went very well with the spread tighter than recent issues and strong demand for the issue. Now that it is evident that the government will stand behind the Agencies’ debt, there is little concern for senior debt holders. Most of our fixed income holdings are senior debt issues of Fannie or Freddie.

Fannie and Freddie stock continues to be volatile as shareholders are uncertain about the dilutive affects of any capital injected by the Treasury. This will not be known unless it gets to the point of the Treasury needing to purchase equity. It was reported that Fannie and Freddie would have to agree to terms with the Treasury before any capital injection.

The preferred stock has rallied significantly off of its lows last week. It is still trading at a significant discount and will continue to be volatile until the form of any additional capital is resolved. Any solution that indicates Fannie and Freddie can raise capital and continue to pay dividends on preferred stock will be very beneficial for the preferreds.


Ryan Craft, CFA

Daily Insight

Stocks stormed back from the depths of the intraday low – jumping 2.7% from that nadir – when Reuters reported Fed Chief Bernanke told the mortgage GSEs (Fannie and Freddie) they would have access to the discount window. This way, specifically with regard to Fannie, they could use its $1.5 trillion in unpledged assets as collateral to provide necessary funding, if needed. But minutes later Bernanke denied comment on the news. Stocks summarily lost momentum, but held onto half of the gains from the session’s low.

Benchmark indices began Friday trading lower and were down 2.3% at the lowest point, reached just after noon, as hypothetical situations had taken over and overwhelmed the current state of capital and liquidity positions at Fan and Fred. As three different financial analyst firms stated on Friday morning, home prices would have to decline 40% nationally and delinquency rates would need to rise ten-fold for the two to reach critical capital levels. One assumes it wouldn’t take this level of housing-market deterioration for the two to runs into capital constraints, but the overall point is salient – to this point there isn’t an issue.

The main concern was that hysteria would take over and a state of panic could set in. In light of this, the administration and Federal Reserve decided it important to get a plan out in order to quell this hysteria and to stop short-sellers in their tracks. The Treasury stated they would increase their credit lines to Fan and Fred, and would take an equity stake, if necessary, to inject a level of capital that would get them through a period of trouble. The Federal Reserve also stated they would open the discount window to the two GSEs, again if necessary. So it appears that Reuters’ story was correct.

These statements have calmed the market immensely, for now, as stock futures are up big and common shares of Fan and Fred are up 20% and 30%, respectively in pre-market trading.

Market Activity for July 11, 2008
In other news, the board of Anheuser-Busch agreed to the $50 billion ($70 per share) takeover from InBev last night, so the situation will go to shareholders for approval, which will undoubtedly get the green light.

I seem to be the only one talking about anti-trust issues, and maybe I’m in left field on this one, but I wouldn’t be surprised to see the political landscape attempt to block the deal. I don’t think there are realistic anti-trust problems, but we’ve seen the Justice Department block deals that were less compelling than this one. Antitrust blockage would simply be a pretense for politicians’ desire to keep their constituents happy. Bottom line, if Bud had run their business more efficiently, they’re stock price would have made a deal prohibitive – and of course some of this falls on the Fed for driving the dollar into the dirt, which also made the deal financially appealing to InBev.

Getting to Friday’s economic releases:

First, the Treasury Department reported the monthly budget surplus for June came in at a larger-than-expected level thanks to a 16% decline in spending. On the revenue side, things continue to deteriorate as financial-sector woes have hurt overall profit growth. Yes, several industries continue to post higher year-over-year earnings but the drag from the financial sector is too much for corporate tax receipts to remain positive from year-ago levels.

In addition, we have endured 438,000 payroll job losses since January, and while this is not a large number in a market with 137.6 million payroll positions, it does have an effect on individual tax receipts as the year-ago comparison enjoyed healthy job growth and an expanding tax base.

In a separate report, the Commerce Department stated the trade deficit narrowed in May and illustrated that strong export growth will continue to provide a boost to GDP. Exports rose 0.9% in May and have jumped 25% at an annual rate for the quarter. (This is for the second quarter which has passed, but we must frame it in a sense that it is still ongoing because the data has a large lag to it. We’ll get the June figure next month.)

Finally, the Labor Department reported that import prices for June jumped 20% from the year-ago level – up 2.6% from May alone. Both of these figures were higher-than-expected and the May data was revised higher as well.

Unfortunately, this received zero attention as everyone focused on the Fan/Fred story, but one has to worry that this level of price increases will funnel to the consumer level – as energy is already a major issue for consumers. The Fed continues to clinch, precariously, to their Phillips Curve models. These are Keynesian-economic teachings that state; so long as wage pressures do not present themselves, one doesn’t have to worry about inflation. Problem is, as is the case with most other Keynesian type beliefs, they are often removed from reality.

To my dismay, it doesn’t appear the Fed will raise rates any time over the next several months with all that is occurring related to the housing market, but they better get to some mild tightening regardless of this situation. They can begin by gently raising the fed funds rate 25 basis points at a time, until they get to 3.00% -- I don’t see how this will hurt things regarding the overall economy. In terms of mortgage resets, keeping the rate at 2.00% won’t do any good anyway for all of those that failed to put money down as their home value is currently less than what they own on the mortgage. Benflation Bernanke can push fed funds to zero and these people will still just walk away from their obligation.

The thing that worries me is the longer they ignore inflation and energy price realities, we’ll move to a situation where the Fed will have to jack rates to a level that will be economically harmful in order to get inflation back in its box. They still have time to avert such a scenario in my view, but must get to it.

Have a great day!


Brent Vondera, Senior Analyst

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

Daily Insight

U.S. stocks ended a two-day winning streak on Wednesday after some really thoughtless comments from Treasury Secretary Hank Paulson sent the indices lower. Crude prices, which also moved on those comments, hit a new high and as crude gained momentum in the afternoon session stocks continued to slide.

The benchmark indices began the day on a positive note after a better-than-expected factory orders report, but Paulson’s comments over in Europe threw a wet blanket on any momentum.

We’ll get to the specifics of his remarks below, but for now let’s just say that his comments were unwise in the environment with which we find ourselves. The commodity is priced in dollars for heaven’s sake and Paulson is Numeral Uno when it comes to comments on the greenback. He’s essentially stated, I’m going to nothing to boost the dollar value and thus bring crude lower – a killer in this environment. As I type, crude is making a new high, hitting $145.50 per barrel.

Market Activity for July 2, 2008

Basic material stocks led the broad market lower as these shares got thumped, plunging 5.25%. Such a move is strange on a day with which commodity prices were higher. The CRB Index, which tracks the prices for a basket of commodities rose 1.04% -- three days up and three new highs. But worries that the emerging-market economies will slow put pressure on the material stocks -- another indication the rise in commodity prices right here is not so much a function of supply/demand fundamentals as it is speculators being driven to this trade based on what the Fed and Treasury Department are indicating.

Relative strength was found in consumer staples and health-care shares – the indices that track these sectors fell 0.10% and 0.45%, respectively – a pretty good session considering the S&P 500 lost 1.82%.

Getting to Paulson’s statements, which were meant to address the state of housing and the economy in general, he mentioned three headwinds: capital markets turmoil, high energy prices and a continued housing correction.

On two of those topics, nothing but time will ameliorate these issues. The more government planners try to do, the more they will just prolong the situation – just as the Community Reinvestment Act helped to get us into this housing situation. Of course, the Fed’s mistake of keeping rates too low for too long into 2004-early 2005 was the major issue. That’s for another day.

But on oil prices, as mentioned, the Treasury Secretary was quoted as saying “there doesn’t seem to be any obvious short-term solution.” In other words, he is telling traders and speculators to sell the dollar and continue on with the oil trade. (That is how traders interpret these comments in the current environment.)

He’s got to understand a stronger dollar will put a lid on oil prices -- I’m speaking within the policy framework, surely the Israel/Iran thing or a hurricane that makes a direct hit on Gulf of Mexico infrastructure would counteract dollar intervention.

But by refusing to acknowledge this, and thus blocking the G7 from intervening to boost the greenback, it gives a green light to the current dollar/oil positions. Between this guy and Bernanke, I don’t know what to think. They should be working in conjunction to stamp out inflation and give the dollar some life, but their words and actions are delivering the opposite result.

Crude, which had pared pre-market gains, was flat prior to the Paulson comments. However, as the charts below illustrate, oil shot up shortly after those comments hit the wires. The dollar, which was already down, went lower too.

This really is mind-boggling. We could have a concerted effort by Treasury and the Fed – a little intervention from the G7 and mild tightening from the Fed – and oil and the dollar would very likely move in the desired directions again; but, alas, no help. Big policy blunders.

On the economic front, the ADP and Challenger jobs surveys (two preliminary looks at the job data, which about half the time are not even in the ballpark) indicate this morning’s monthly jobs report will show a decline of 80,000 payroll positions. There’s a good chance it may be a bit worse than that as financial service-sector woes will begin to show up in a meaningful way.

If we do get at least an 80,000 decline in payrolls, this will bring the six-month total of job losses to 404,000, or 5% of the eight million jobs created September 2003-December 2007 – a 52-month streak that set a new record for job creation. (You heard virtually nothing of this record streak of job creation as it was occurring, but we’re all bombarded on a daily basis with news of the current job losses.)

In a separate report, the Commerce Department reported that factory orders rose 0.6% in May – marking the third-straight month of increase. The April reading was revised higher to show a 1.3% pick up in activity after being previously estimated at 1.1%

The highlights of the report were computer and electronics orders, up 2.9% in May and shipments of capital goods, up 0.5% That increase followed a nice 1% rise for April.

The capital goods shipments component feeds right into the GDP calculation and will offer a nice boost to second-quarter economic growth so long as June doesn’t show a meaningful decline. As of the data we have currently, we’ll see second-quarter GDP come in at a 2.5% real annual rate – pretty darn good considering housing continues to subtract a full one percent from this reading.

Recession? Certainly things are ugly for the housing and auto industries. Consumer sentiment is reportedly in the dirt – a direct result of sky-high oil prices. But the economy continues to show amazing resilience. We have yet to see one quarter of negative GDP, much less two – the traditional definition of recession. If we get the 2.5% real GDP figure we expect for the second quarter, it will mean the economy grew at an inflation-adjusted rate of 2.25%. That is well below our long-term growth rate of 3.4%, but further from recession that it is from trend growth.

All eyes will be on this morning’s employment report, which will determine the market’s direction. We’ll also get the ISM service-sector index for June. The reading should show the service economy remained in expansion mode for the third-straight month. The January-March period – all registering readings of contraction -- ended a 57-month expansionary streak.

Have a great July 4th – greatest country in the history of the world; thank you Founding Fathers (and the Good Lord for placing them here) – and a great weekend!

Brent Vondera, Senior Analyst

2Q 2008 Participant Insights

Hot off the press is this quarter's issue of Participant Insights. In this issue, Debra Moran explains why Acropolis Retirement Solutions plans use index funds and Mona Gooden reviews some important definitions.

Click here to access this quarter's issue.

Click here to view archived issues.