Daily Insight

Markets closed lower yesterday after a see-saw ride that lifted the Dow Jones Industrial Average as high as 55.85 points (0.49 percent) and as low as -104.79 points (-0.93 percent). Ultimately, the index closed down 42.17 points (-0.37 percent) as major oil stocks fell along with oil and investors await word from the Fed.

Crude oil dropped $3.69 per barrel or -2.95 percent to close at 121.41 in New York trading. Since the peak of 145 early last month, crude prices have dropped slightly more than 16 percent – a correction, but not yet a bear market (one that we can all enjoy). Still, oil is up more than 25 percent for the year and is only back to prices seen in May.

Market Activity for August 4, 2008

Both personal income and personal spending were higher than Wall Street expected. As noted yesterday, personal income was expected to be lower by -0.20 percent, but actually came in positive at 0.10 percent. Personal spending registered a greater than expected 0.60%, versus the anticipated 0.40 percent.

As mentioned yesterday, one of the key considerations was whether or not consumers were spending their stimulus checks and the data bore that out. I don’t know how I failed to mention it (Brent will have my head), but along with the personal income and spending data came the personal consumption expenditures (PCE) that are considered a key measure of inflation.

The PCE is an index that measures the average increase in price for all domestic personal consumption. If you thought that this would be identical to the Consumer Price Index (CPI), you would be fooled by those tricky economic data collectors.

The CPI uses one set of expenditure weights for several years, where as PCE uses expenditure data from only the current and the previous period. In short, it looks at price changes from one period to another rather than looking at the most recent period compared to some predetermined base period.

The PCE index rose by 0.80 percent in June and gained 4.10 percent from the same month one year ago. Like its ugly cousin CPI, PCE also has a less volatile ‘core’ rate that excludes food and energy. The core PCE rate rose 0.30 percent in June, or 2.3 percent for the year ending in June. The Fed would like the core PCE rate below two percent.

Brent will also be aghast that I forgot to provide any guidance on productivity – one of the favorite measures of our nation’s great fortune. Despite the economic weakness, productivity has grown at an average annual rate of 2.50 percent. For those of you who don’t remember productivity rates in the 1970’s, it was around 0.80 percent.

Set your alarm clock for 2:15 pm EST, when the Fed announces their inaction. As stated yesterday, very few people believe that there will be any change in Fed policy. The key will be the statement. It is widely expected that rates will be unchanged, but that there will also be several dissenters instead of just one. That alone is a signal that rates are headed higher later this year, but the generally fragile nature of the financial system right now is a paramount consideration.

Have a great day!

Dave Ott, General Partner

The Housing and Economic Recovery Act of 2008

The housing bill President Bush signed into law last Wednesday, officially called The Housing and Economic Recovery Act of 2008, looks more like a transcription of the Odyssey in Homeric Greek than it does an attempt to help the everyday American homeowner manage the current mortgage crisis.

However, after reading through the bill itself and listening in on multiple analyst conference calls I will attempt to explain some of the contents of the bill, where it helps the current housing environment and where it falls short.

Government Purchasing GSE Securities

• GSE’s are the Government Sponsored Enterprises, known more commonly as Fannie Mae and Freddie Mac. These organizations were created by congress but are privately owned by common stockholders. Since their inception, they have had a unique, hybrid role between the public and private sector that is at the heart of today’s crisis.
• In order to prevent a widespread deterioration of the market for Fannie Mae and Freddie Mac debt, the government has been given the ability to buy any GSE security issue, whether it is debt or equity, by either agency.
• This announcement has shored up the market prices of the senior debt of both agencies and increased the confidence in their subordinated debt.
• If the government takes an equity stake in either company, it is unclear what effect this will have on the existing common and preferred shareholders.
• Treasury Secretary Paulson has said many times that he orchestrated the purchase plan as a confidence booster and doesn’t foresee the need to use it in the future.

Rising Rate of Foreclosures

• If a particular homeowner is at serious risk of default, they can apply for participation in the refinance program with the Federal Housing Administration (FHA).
• The FHA will refinance the home up to 85 percent of the newly appraised value as long as the current loan servicer agrees to forgive the outstanding principle balance above and beyond the FHA refinance.
• To qualify as seriously delinquent, the homeowner must prove that at least 31 percent of gross income is allocated to servicing mortgage debt and loan-to-value (LTV) must be greater than 90 percent.
• The FHA underwriting standards will remain strict. Therefore, jumbo loans and homeowners who cannot prove the proper documentation of income will not qualify for this program.
• By participating in the FHA program, the homeowner will sacrifice a portion of the future appreciation of the home, up to 50 percent in certain cases. This, along with a fee paid by Fannie Mae and Freddie Mac on the new securitization business, leaves some hope for this portion of the program to pay for itself.

Government Buying Homes

• A large amount of funds, about $4 billion, will go to purchasing the glut of already foreclosed homes that currently sit unoccupied.
• The future for the homes purchased by the government is still unclear. Most home purchases will be in urban areas and will most likely be refurbished and turned into government subsidized housing or simply bulldozed.

First Time Homebuyer Credit

• A credit for first time homebuyers of ten percent of the value of the home, up to $7,500, will be offered until the end of 2009.
• Although called a credit, it can be more accurately described as an interest free 15 year amortizing loan.
• For example, a $7,500 credit will be repaid with $500 added to the homebuyer’s federal tax bill every year for the next 15 years. This can be considered a small incentive at best.

New GSE Regulator

• In order to police Fannie Mae and Freddie Mac, the government has created a new regulator, The Federal Housing Finance Agency.
• In addition to assuming all of the responsibilities of its predecessor, the Federal Housing Finance Agency will have fairly open ended discretion over dividend payments, executive compensation and various other aspects of the business.

Problems and Risks with Plan

• Participation in this program is voluntary. The potential problem with this deals with the shocking number of homeowners that simply walk away from their mortgage without a single call to the lender. The lack of participation in programs for distressed borrowers that already exist poses a challenge for this new program.
• It will be important to see the principle amounts that loan servicers are willing to forgive. If they are too stringent it may be hard for this plan to get off the ground. It is the responsibility of the loan servicer to maximize the present value of the loan so this will be a difficult decision on their part. It is scary to think that 30 to 40 percent or more principle forgiveness is needed for some borrowers to qualify for this program.
• Although $4 billion will go towards converting foreclosed property to government subsidized housing, the bulk of the problem lies in suburban homes that are much larger and were purchased by people who couldn’t afford the homes and relied too much on the expectation of continued appreciation. These borrowers won’t qualify for the FHA refinance program because their home value exceeds the limit or they can’t document the level of income needed (or both).

The Long and the Short

The Housing and Economic Recovery Act of 2008 should not be looked at as a “cure all” for the problems that plague the current housing market. If participation in the program goes well it could help to create a bottom for declining home values and reinstate traditional liquidity in housing.

How do currency differences affect investing?

Click here or on the icon below to see David Ott's most recent ASK THE EXPERT column in the St. Louis Post-Dispatch.

Daily Insight

Markets ended the day lower Friday on the larger than expected losses from General Motors (ticker symbol: GM) and rising oil prices. The employment data was relatively mixed and was generally greeted with a sigh of relief even though the headline number went up by one tenth of one percent.

For the day, the Dow Junes Industrial Average (DJIA) closed down 51.70 points to close at 11,326.32, or -0.45 percent. For the week, the Dow lost 0.40 percent, but you would hardly know it as the gyrations were wild – at least 185 points one way or another each day through Thursday.

Crude prices went up by $1.02 per barrel, or 0.80 percent to close at $125.10 in New York. For the week, oil gained 1.50 percent, the first rise over a week for three weeks.

Market Activity for July 31, 2008

Today, we have June Personal Income and spending data at the market open and June Factory Orders at 10:00 a.m. Eastern Standard Time. Personal income is expected to be -0.30 percent and personal spending is expected to be +0.50 percent. The big question will be whether not there is a continued boost from the stimulus checks.

The big story this week will be tomorrow, when the Federal Reserve Open Market Committee (FOMC) announces their Fed Funds Rate and the Discount Rate. The Fed Funds Rate is the interest rate that banks charge each other for overnight loans. The current rate is 2.00 percent. The Discount Rate is the rate that the Fed charges for lending directly to banks and other depository institutions. The current discount rate is 2.25 percent.

Right now, the market expects no change in actual interest rate policy. Any major news will come from their position and comments. Their position refers to the statement that accompanies the interest rate policy decision that describes gives the Fed view on which is worse: inflation or general economic weakness (we long for the days of the third option: a balanced view).

Parsing the statements is a favorite Wall Street pastime. The image may be hard to read, but below is a copy of the most recent statement along with comments about what changed and what stayed the same from statement to statement.

Generally, the Street picks out a few key words to focus on. Last time, for example, when the Fed kept steady for the first time since the credit crunch began, The Street focused on the use of the phrase “uncertainty remains high” when the Fed referred to inflation.

These statements will give clues about whether or not the Fed will begin raising rates by the end of the year. Currently, markets believe that there is a 50/50 chance of a rate hike in October, but those numbers could change quickly depending on what happens tomorrow.

Have a great day!

David Ott, General Partner

Daily Insight

Markets ended the day lower on weaker economic news. For the day, the Dow Junes Industrial Average (DJIA) closed down 205.67 points to close at 11378.02, or 1.78 percent.

On the New York Stock Exchange (NYSE), there were 571 stocks advanced, 1,279 stocks declines and 23 stocks remained unchanged. There were also 33 new highs and 39 new lows.

Market Activity for July 31, 2008
As reported in yesterday’s Insights, the Gross Domestic Product (GDP) figures did not meet expectations for the second quarter and were reduced in the fourth quarter from expansion to contraction. The main contributors were personal consumption (added 1.08 percent), exports (added a huge 2.42 percent) and government consumption (added 0.67 percent). Housing continued to weigh on GDP with residential fixed investment subtracting 0.67 percent, but the big factor was the large subtraction from inventories that dragged down GDP by 1.92 percent.

Additionally, the Labor Department announced that the number of people seeking jobless benefits rose to the highest level in five years, although as Brent has established many times before, this weekly data is very volatile and is generally used as part of a four-week moving average instead of looking at each week independently.

In addition to the economic news, the market also responded to lower than expected earnings from ExxonMobil (ticker symbol: XOM). Although the company reported higher earnings in a single quarter in the history of corporations (a truly remarkable figure – nearly 11.7 billion of profit in a single quarter), it was less than Wall Street had expected (the thought almost 12.9 billion was on deck). The stock fell by 4.86 percent, leading the whole energy sector lower.

In addition to lower profits from XOM, crude oil fell by 2.19 percent or 2.77 per barrel to 124.09 per barrel in New York. This drop extended losses for oil to 11.4 percent for the month of July, making it the largest drop in percentage terms in the 25 year history of the New York Mercantile Exchange.

Wild-man Alan Greenspan hit the airwaves on CNBC just as the bell was about to ring. He told Maria Bartiromo that the U.S. is “nowhere near the bottom” of the housing slump. It’s funny because, two years ago I went to a conference in Washington D.C. where he was a speaker and at that time he told the audience that the worst was nearly over in housing. So much for the maestro –

Today we have what an old colleague of mine referred to as the “jobs jamboree.” The employment report is actually two separate reports that are taken from two separate surveys. The first report is the household survey looks at the employment data by reviewing 60,000 households.

The second part is the establishment survey looks at 375,000 businesses and looks at nonfarm payrolls, the average workweek and average hourly earnings. Generally the market focuses on the establishment survey given the relative size and data dependability.

The unemployment number came in a ticker higher than Wall Street estimates at 5.7%, but this is not terribly surprising after yesterday’s jobless claims number. Nonfarm payroll data came in slightly better than expected this morning and average hourly earnings matched the Street’s expectations, but average weekly hours fell slightly below expectations.

Additionally, we just got earnings from General Motors (ticker symbol: GM) and they are as disappointing as we expected – $15.5 billion second quarter loss. Don’t worry – we weren’t looking to buy – but we were looking at some GM bonds today for the fun of it. Right now issues maturing in 10 years or more are trading at 50 cents on the dollar, which would mean yields of 18 percent per year, assuming all of the payments are made along with getting your money back (obviously, a huge assumption!).

Last but not least, I saw this picture on Greg Mankiw’s blog. He is a professor at Harvard and keeps a timely blog. I thought the picture was great even though Pick n Pay’s are mostly in South Africa and New Zealand.



Have a great weekend!

Dave Ott, General Partner

Daily Insight

Please accept my apologies for the extremely late Daily Insights this morning. As Brent mentioned the other day, he is on vacation and I plum forgot until I walked in the door.

Market Activity for July 30, 2008

Markets were strong yesterday which was particularly refreshing because it built on the rally the previous day. The S&P 500, the broadest measure of large cap activity, gained 0.80 percent, adding to the 2.30 percent advance on Tuesday.

Instead of a single factor, there were several issues driving the market higher. First, the ADP Employer Services report showed that payrolls had grown by 9,000 jobs this month, while most economists were expecting a loss of 60,000 jobs. This survey isn’t the most important jobs picture, but any good news on employment is greeted positively these days.

Second, the Federal Reserve announced that it would maintain the emergency borrowing plan extended to Wall Street firms through January. 30 of next year. The program was established in March during the most acute phase of the credit crisis when Bear Stearns collapsed and was scheduled to end in mid-September. Other programs were also extended through January that should encourage lending between investment banks.

Third, energy shares were helped by rising oil prices, but those prices didn’t extend to losses on other stocks. Oil gained 4.58 a barrel to 126.77, or 3.75 percent. Large integrated oil companies like ExxonMobil and Chevron gained 4.30 percent 5.34 percent respectively.

Finally, financial shares continued their rally with Bank of America gaining 4.31 percent on top of the 14.83 percent gain on Tuesday. Financial stocks have had an amazing rally since July 15th. Bank of America, for example, has gained more than 80 percent since the low only 15 days ago. This is remarkable rally for a two week period. Obviously, the stock is still well blow prices from even at the beginning of the year, but it does seem to suggest that there is a bottom for financial companies. For the year the stock remains down 15 percent including dividends through yesterday.

Of course, all of this is yesterday’s news. Today, the focus is entirely on the GDP report that shows that the economy grew at an annualized rate of 1.90 percent in the second quarter. While that may seem like good news, it was less than the forecasted growth rate of 2.30 percent and the gains can largely be attributed to the one-time federal stimulus check sent out during the quarter. Housing continues to take its toll on the overall economy.

Whenever a new GDP figure is released, the government also puts out revisions to the previous two quarters. Markets right now are focusing on the revision from the fourth quarter of last year that was revised from a positive figure to a negative number. The first quarter still shows a gain of 0.90 percent, though it is subject to one more revision.

Classical definitions of recession are based on two consecutive quarters of contraction in GDP. However, the organization that now calls recessions, the National Bureau of Economic Research (NBER), now defines a recession this way:

The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. For more information, see the latest announcement on how the NBER's Business Cycle Dating Committee chooses turning points in the Economy and its latest memo, dated 07/17/03. (Source: http://www.nber.org/)

Therefore, although we haven’t yet experienced two consecutive quarters of recession, the NBER may still call one in the coming months. Generally, the NBER makes their official announcement well into or even after the recession itself.

Stocks opened lower on the news but are now heading back to neutral. If there is anything to be learned by the volatility we have seen this year, though, intra-day movements can be all over the board.

I promise to get Daily Insights out much earlier tomorrow. Also, we now publish Insights along with other articles on our blog, http://www.acropoblog.com/.

Best,


David Ott, General Partner

Daily Insight

U.S. stocks rallied yesterday, more than erasing Monday’s declines, as the market continues to be whipsawed. A nice move by the dollar, which helped to push oil prices lower, combined with what may have been a favorable view of Merrill Lynch’s decision to unload mortgage-related securities at a fire-sale price sparked the rally. More on that Merrill news below.

The price of crude for August delivery moved to its lowest level since May, which sent consumer discretionary shares higher – this is the theme these days. When the market rallies, financials and consumer discretionary shares generally lead the way.

Information technology and industrial shares enjoyed a nice day too as better-than-expected earnings results sent the sectors higher.

Market Activity for July 28, 2008

Information technology profits are up 21% with 60% of those names reporting. The capital goods segment of the industrial sector looks good too and may just return to double-digit growth if the business spending trends of the past couple of months continues.

Profit results for eight of the 10 major industry groups remain in positive territory – three have recorded double-digit growth, two have posted 9% or better and another three have recorded earnings growth in a range of 4%-7%. The weakness has occurred in financials and consumer discretionary, down 86.8% (no that’s not a typo) and 21.7%, respectively.

The dollar gained good ground yesterday after the latest home price index showed price declines eased and the July consumer confidence reading improved slightly. Neither report was good, but both were better-than-expected. The dollar’s gain likely was due more to the home price data, which we’ll get to below, than the confidence number, which has proved to be a worthless indicator of future spending for a long time, but I mention it nonetheless.


Oil prices dropped 2.04%, or $2.54 per barrel, to $122.19. With the exception of constructive action out of Congress regarding the self-imposed barriers to production, we need the dollar to rally in order for crude to fall back to desired levels. Fed and tax policy can go a long way in pushing the dollar higher, but this looks quite unlikely for now. So we just have economic data that will drive the $ and oil in the meantime – Thursday’s GDP number will beat current estimates, and the dollar should rally. However, we get non-farm payrolls (NFP) on Friday, which may put pressure on the greenback. So we may be looking at offsetting effects. This increases the importance of the August 5 FOMC meeting; the Fed has a major opportunity to put a dazed oil trade on the mat.


In other news, Merrill Lynch announced they’ll take another $5.7 billion in write-downs in the third quarter – largely from selling $30.6 billion of bonds at a fifth of their face value. This follows $9 billion in write-downs just three weeks ago when they reported second-quarter results. (Merrill had previously valued the $30.6 billion (face value) in bonds at $11 billion. This sale brings the value down to roughly $6.8 billion.)

While these are huge numbers, and carry tremendous costs to existing shareholders, this is a good sign. Merrill is taking their medicine and getting this stuff behind them. One shouldn’t miss that for every loser, there is a winner -- the buyers of these mortgage-related bonds should make out big over time, picking these positions up at 22 cents on the dollar. Absent these fire-sale prices, the losses would have only dragged on.

On the economic front, we received the latest figure from the S&P Case/Shiller Home Price Index for May, which showed a year-over-year decline of 15.78%. On a monthly basis, the index showed prices fell 0.86% (that’s for May from the April reading) and 15.91% at an annualized rate for the three months ended in May.

While these are large declines, the index did offer evidence the degree of price declines may be decelerating. For instance, the three-month annualized figure has eased from down 25% in March and the month-over-month decline has eased from -2.63% in February.

Further, keep in mind that this Case/Shiller index only captures activity among the largest 20 U.S. cities. The largest price declines have taken place in what we’re referring to as speculative areas -- San Diego, LA, Phoenix, Las Vegas and Miami. Detroit has been another major decliner, but this is due to other factors such as auto-sector woes and higher tax rates that have pushed businesses out of Michigan.

Seven of the 20 cities actually showed home price rose in May – Boston, Dallas, Charlotte, Denver, Atlanta, Minneapolis and Portland. So, there was some good news, but the overall point is that Case/Shiller is not a broad index. It does a good job of showing the direction of home prices, but exacerbates the degree to which prices have moved.

The broadest home price index is the OFHEO (Office of Federal Housing Enterprise Oversight) index, which shows home prices are down 6% over the past year. This index has its limitations too, as it captures only conforming loans, leaving out the upper-end of the housing market.

So we must factor in all of the data, it is a mistake to look at just one indicator. For a longer-term perspective I’ll leave you with charts of new and existing home prices. Notice that prices remain nicely positive going back to 1999. It’s tough to read on this graph, but existing home prices are 51.82% higher and existing home prices are up 46.7% from the summer of 1999. (I could only go back to 1999 as the existing median home price index began in that year.) Existing home prices are down 6.41% from the peak and new home sales are down 12.12% from the all-time high.



I’ll be on vacation through August 11 so David Ott, among others, will be filling in until then.

On economic watch over the next week will be the first look at Q2 GDP tomorrow and the July jobs report on Friday. Monday, personal income and spending for June will receive focus and then the FOMC meeting on August 5. For new readers, the FOMC stands for Federal Open Market Committee – the group that sets the Fed’s key interest rate.

We have seen some dissent within the FOMC of late. That is, more members have expressed the need to raise fed funds, gently for now – 20% year-over-year increases in import prices, a 10% jump in producer prices and 5% CPI will have that effect. Anyway, with oil $24 off its record high the Fed may have been lulled into a false sense of security regarding price stability and their comments on August 5 may turn dovish. If so, I believe they’ll be making a huge mistake and oil may rise again. (There are several other factors that determine the price of oil, but one thing at a time for now.)

However, if they show they’re serious about price stability – even with the credit-market challenges that confront the group – we may just see crude forced closer to the $110 level. This presents an awesome opportunity for the Fed and could bring with it a stock market rally, increased consumer consumption numbers and one serious risk removed from the market. It will be interesting to watch this play out.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks began Monday’s session lower but looked to reverse course as the indices quickly popped to positive territory in the first 30 minutes of trading; that was until a dire IMF (International Monetary Fund) statement was released about 9:30CT. That release stated there was no end in sight to the housing woes and warned deteriorating credit conditions for consumers and banks may prolong a period of slow growth. (Interesting how they are now reframing their negative predictions as “slow growth” rather than “recession.”)

On this point for a moment, there is no doubt the credit markets are going through a period of trouble, but let’s not act as though things are worse than they actually are. I’ll point out that commercial and industrials loans have risen 18% over the past year and at a 9% annual rate over the past six months. The pace has slowed, but comments that credit has slowed to a halt are removed from reality. Below is a chart of C&I loans.


Losses among the benchmark indices increased in the afternoon after Treasury Secretary Paulson held a press conference that failed to address the market’s chief concerns – we’ll touch on this below.

Market Activity for July 28, 2008
To no surprise, financials and consumer discretionary shares led the market lower – these are the pressure points on days of weakness as concerns over housing, tax rates, price stability and the job market effect these sectors more than any other.

The good news that people should have been focused on yesterday was exactly that IMF report, as this organization’s predictions are rarely accurate. While we expect housing to remain weak for some time still, likely another year due the elevated nature of home supply and higher foreclosure rates, the fact that the IMF has predicted no end in sight may be the best indication the worst is over.

While financials and consumer disc. shares led the indices lower, nothing really helped as all 10 major industry groups were down yesterday. Industrial and information technology shares got wacked with the rest of the market. Utility, energy and basic material shares were the relative winners down 0.19%, 0.46% and 0.58%, respectively.


On the earnings front, outside of the financial sector, things continue to look quite good. Ex-financial profits are up 12% with 55% of S&P 500 members reporting thus far. Seventy-percent of those reporting have beat expectations. Still no one cares right now.

Take Verizon’s results as an example. The phone giant reported Q2 operating profit rose 15.5% as their wireless business was strong. Yet, all people could focus on was their weaker-than-expected landline business. Now, which segment is the growth story? Bad news would have been weak wireless activity, not the case though. So you have a stock that offers a 5.12% dividend yield and is delivering high single-digit profit growth trading at 12.8 times 2008 earnings. And this isn’t even one of the more compelling buys out there. The problem is investors may have to wait a while for attractive returns to materialize, but when they do, it will be big.

For now there are plenty of uncertainties in front of us. The shame of it is policy makers have created most of these uncertainties. A Fed that left rates too low for too long into 2004 and 2005 encouraged the mortgage mess we find ourselves in. The economy was rolling along at a very nice pace, yet they waited until June 2005 to get fed funds above 3.00%. Heck, they were still easing in the back-half of 2003, cutting fed funds to 1.00% in June of that year even as the stock market was signaling a boom and their own June 11 Beige Book report showed things were turning. Now, the same reckless easing policy is on again. Yes they must ensure liquidity and they are doing that via their lending facilities, but to jack their benchmark rate down 325 basis points in nine months (225 of that in six months) is reckless.

And then there is the Treasury Secretary.

Paulson Tries Again

Treasury Secretary Hank Paulson held a press conference yesterday afternoon -- in an attempt to reassure the markets I presume – explaining the virtue of “covered bonds” and the beneficial affect such debt instruments would have on the credit markets. However, while this may be the direction the industry goes over the next several years, it doesn’t do much for now because banks are still set up under the securitization framework – hence, many times they do not hold the assets that back these debt instruments on the balance sheet.

(The way I understand it: Covered bonds are securities issued by a bank and backed by a dedicated group of loans – a “covered pool.” If the issuing bank becomes insolvent, the assets in the covered pool are separated from the issuer’s other assets solely for the benefit of the covered bondholder. This is the major difference between covered bonds and asset-backed securities. Loans backing a covered bond remain on the balance sheet and should the originating bank fail to make payments, interest payments from the underlying mortgages would go to investors.)

Anyway, Paulson’s attempt whiffed, reminiscent of a Dave Kingman strikeout – for you 1970s and 1980s baseball fans, because this is not that which market participants are currently concerned – at least regarding the here and now.

At risk of sounding repetitious, it is the uncertainty over the housing market and its effect on consumer behavior, questions over tax rates, and the possibility/likelihood that the Fed is ignoring price stability.

The housing market will simply take time to correct; after several years of outsized gains, there is nothing Congress or anything other than time can do to fix it. The Fed will do what they are going to do; this is not Paulson’s turf, so nothing he can really do there either. But this is the Treasury Secretary we are talking about, the appropriate person (after the President) to offer tax rate proposals.

What he should be doing is demanding that Congress make the tax rates on capital, dividends and income permanent – as permanent as Washington gets anyway. Follow that up with a proposal to cut the corporate income tax -- which has become one of the highest rates in the world as virtually every other serious country has cut this rate -- and vastly reduce the tax on repatriated income. (This income earned overseas will stay there so long as it is taxed at a 35% rate) You want to bring it home, cut this rate down to single digits; it will come home in droves.

This would combine beautifully with the increased current-year business equipment write-off allowance and bonus depreciation that was delivered in May, and by the way has kicked started business spending as we discussed yesterday. This combination would be a big job and productivity producer, but Paulson doesn’t get it, and thus the market will continue to send the message that he is not delivering what it wants.

Look, these are times the equity investor must deal with on occasion. But this economy is fundamentally sound; allow the housing correction to run its course, get monetary policy back in order and simply do not damage after-tax return expectations by driving tax rates higher and the market will get back on its horse We only need a little tweaking, U.S. businesses are more streamlined than anytime in history, able to compete and dominate on a global scale, but bad policy should not get in the way. Raise tax rates in this environment of intense global competition and you get your hat handed to you.

As of the latest count, there was $3.5 trillion sitting in money-market funds – plenty of capital out there. Give it a reason to come out of hiding and you’re looking at a powerful market run – long-lasting. That said, the equity investor will need patience here, but when things turn, it will make it all worth it.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks gained ground on Friday after better-than-expected economic reports showed a bounce in business spending will help catalyze growth and new home sales rose in two of the four regions. The gains helped the major indices pare weekly losses on the Dow and S&P 500, while the strong 1.33% rise on the NASDAQ Composite moved the tech-laden index to a gain for the week.

The Commerce Department reported durable goods whipped the consensus estimate, with the business spending component jumping 10.4% at an annual rate since March. This number will push the second-quarter GDP figure to a level that easily surpasses the current estimate. The new homes sales number, while weak, didn’t hurt either. The supply of new homes fell, but remains extremely elevated.

Market Activity for July 25, 2008

Information technology shares led the advance, which was nice. Earnings growth has outpaced the rise in share prices for several years with regard to the overall market, but increasing so for the tech sector. Energy and material stocks also helped the benchmark indices bounce back from Thursday’s pummeling after a multi-session pull-back for these shares. Industrials and health-care stocks also rebounded.

On the earnings front, S&P 500 profits remain in negative territory for the second quarter and nothing is going to help this figure move to the positive side with the financial sector weighing so heavily. Financial-sector profits are down 94% for the three months ended June 30 – that’s from the year-ago period. Yet, ex-financial earnings remain in double-digit territory – up 12.1% thus far; roughly 40% of S&P 500 members have reported.

Five of the 10 major industry groups have recorded 10%-plus growth – consumer discretionary (+20.1%), consumer staples (+10.5%), energy (+27.0%), health-care(+10.1%) and information technology (+20.9%). The industrial, basic material, telecom and utility sectors have posted results in a range of 2%-6.8%. Financials is the only sector that’s negative.

In economic news, the Commerce Department reported new home sales dropped at half the expected rate in June and the supply fell for the second month in three. We’ll note that sales have declined 33.2% over the past 12 month, but have increased 13.9% at an annual rate over the past three months.

That last comment is encouraging, but the report does not account for cancellations of previously signed contracts, so the new home sales data is not the most reliable. (Existing home sales, although working with a bigger lag that new homes is probably a better indicator as sales are not counted until the closing, rather than when signed like new homes sales.)

Too, this figure is quite volatile and the next couple months of data can pull the rug from any optimistic thoughts – just something to keep in mind. If this trend of the past quarter continues, however, it may signal the housing sector is beginning to stabilize, but it will take more data to make this conclusion realistic. That said, I think the non-speculative regions of the market – those excluding California, Arizona, Nevada and Florida – may be showing a bottom in prices. Those four states are big ones though, five of the biggest 20 cities reside in California and Florida alone, which will weigh on the overall figure.

In terms of region, the Northeast saw new home sales increase 5.3% in June; sales rose 2.5% in the Midwest. The South and West regions showed declines of 2% and 0.9%, respectively.

In a separate report, Commerce showed durable goods orders for June easily surpassed the consensus estimate, rising 0.8% overall and the ex-transportation number, which has posted a gain in three of the past four months, jumped 2.0%. The estimate was for a 0.3% decline on the overall reading and a 0.2% decline in the ex-trans number.

Total durable goods orders have fallen 0.3% at an annual pace since March. Excluding transportation – which takes out the extremely volatile commercial aircraft orders and a beleaguered auto sector – orders have jumped 13.5%.

As mentioned in Friday’s letter, we were focused on the business spending figure and it didn’t disappoint -- up1.4% in June and 10.4% at an annual rate for the last three months. The shipments of this segment – technically known as non-defense capital goods ex-aircraft – increased 5.9% at an annual rate during the second quarter. This number feeds right into the GDP figure and we’ve got a great shot at seeing a 3.0% real rate of growth for Q2. This would be huge considering housing continues to subtract a full percentage point from the figure.

Big gains in electrical equipment and machinery orders were the catalyst for the capital goods segment. Industrial machinery orders were up 13.8% annualized past three months and 11.8% over the past year. Electrical equipment more than doubled, up 150% over the past three months – again that’s annualized – and 8.4% past 12 months.


In other news, the Senate passed the housing bill, which the President Bush will sign this morning I suppose. The bill involves the Fannie Mae and Freddie Mac provisions that would allow the Treasury Department to increase its credit line to the two GSEs, Treasury to take an equity stake if needed, and raise the size of loans eligible for purchase to $625,000 – that ceiling will depend on the region.

The centerpiece of the legislation is the program of $300 billion of FHA-insured mortgages to help refinance loans for those who cannot afford their current situation. The way I understand it, lenders would have to get a new appraisal on the property and then write it down by 15% from there for the homeowner to qualify. In return, the homeowner will have to share, equally, future price appreciation with the FHA. And if home values go down before they go back up, and the borrower goes under, then of course the taxpayer is on the hook.

Also, in the legislation is up to a $7500 tax credit for first-time homebuyers. They would have to buy between April 2008 and June 2009. That’s a big credit and may just kick sale up a bit; we shall see.

Have a great day!

Brent Vondera, Senior Analyst

100 Minds is Investment Grade

By David Ott

When I think of Ken Fisher, I think of junk. Not junk bonds; junk mail.

Fisher is the Chairman of Fisher Investments, a long-time columnist for Forbes Magazine, a best-selling author, and, last but not least, a billionaire. He is also a “proud junker,” and argues that his aggressive direct marketing campaigns merely “cut out the middleman.” [1]

But before Fisher became a marketing juggernaut he wrote 100 Minds That Made the Market, a delightful book with 100 three or four page chapters chronicling the men and women that – for better or for worse – built Wall Street.

In addition to the standard, though necessary, fare like Alexander Hamilton and J.P. Morgan, Fisher includes far lesser known but equally interesting personalities like Thomas Ryan and Floyd Odlum.

If these names don’t ring a bell, you’re not alone. Their lack of name recognition belies their important contributions as Ryan is the creator of the first corporate holding company and Odlum is the original corporate raider (pictured on the phone, poolside).

Clearly, heroes like Hamilton and Morgan deserve their place, but their name and influence is so well known that it is particularly enjoyable learning more about the smaller, yet still important players.

In addition to the famous and the unknown, there are many that fall in between. Famous names that you know today for one reason or another, although you probably don’t know the history.

For example, Charles Dow, (creator of the Dow Jones Index), started the Customer’s Afternoon Letter that ultimately became today’s venerable Wall Street Journal. Charles Merrill, founder of Merrill Lynch, started out as a semi-professional baseball player before famously bringing “Wall Street to Main Street” and started Family Circle magazine on the side.

It’s also easy to see how Main Street developed a healthy skepticism for those on Wall Street. Some of the juiciest stories are of the many criminals that have made their mark on Wall Street and Fisher makes the case that “crooks, scandals and scalawags” offer some virtue as a “sort of perverse” education. Fisher is right, although no one else seems to be getting the message since many of these crimes are still prevalent today despite the mountains of regulation that have been created to prevent history from repeating itself.

Consider Richard Whitney, one of the bluest blue-bloods on Wall Street in the 1920’s, serving top-tier clients like J.P. Morgan. It is said that his personal order to purchase 10,000 shares of U.S. Steele on Black Thursday helped stabilize the market.

His bold action provided him instant notoriety and propelled him to the president of the New York Stock Exchange (NYSE), where he presided until his demise in 1937. It was ultimately revealed that he lost millions of dollars in the Crash, his firm lacked profitability despite its high profile status and he continued to spend lavishly throughout the Depression.

He was able to keep up appearances for years by borrowing $27 million in 111 different loans from his also-prominent brother, acquaintances who knew him by reputation, and from creditors from some of his business dealings.

When all of his borrowing sources dried up, he turned to crime by taking stealing from his clients and the NYSE. He was sentenced to five to ten years in Sing Sing and was banned from the securities industry for life – not to mention suffering the media frenzy covering his fall from grace.

For every devious character, though, there is an inspiring story as well. Amadeo Giannini, for example, was a banker in San Francisco during the 1906 earthquake. The earthquake caused major fires throughout the city and as they encroached on his bank, he loaded the cash, securities and gold onto vegetable wagons and bravely walked the bank’s assets out of the city.

When the city was safe and the funds could be secured, he was the first banker to begin lending in an effort to rebuild the city. By 1929, he had 400 branch locations and over $1 billion in capital. His bank today is Bank of America.

Fisher makes a point of only including those who have passed away. He writes in the forward that his was partly due to his reluctance to write about his father, the famous practitioner who also wrote the classic book, Common Stocks and Uncommon Profits.

This viewpoint also ensures that only the truly great make the list avoids those who may just be a flash in the pan. Only after the final chapter is written can history appropriately be judged. In due time, there will be many more pioneers to write about, like the legendary international investor Sir John Templeton who passed away this month.

As Fisher brings the dead to life with interesting stories and antidotes, he is also tells an even more remarkable story: the creation of the most powerful and far-reaching capital markets system in the history of mankind. Wall Street is the nexus of global capital and each of the innovators outlined has a unique story of contribution worthy of telling.

In some ways, their stories also tell a broader story about America. Although Fisher doesn’t dwell on factors like heritage or religion, these he does describe how these were definitely challenging factors for many of the greats who were of Italian decent or Jewish faith.

Without a doubt that the next 100 minds will include a far more diverse group who will have overcome many of the same obstacles that unfortunately still persist in similar forms today.

Despite the obstacles, however, many of the next 100 will have worked their way to the top through the right combination with drive, determination and, most importantly, transformative ideas.

Based on this excellent book, I wish Fisher would spend less time on “Eight Investing Mistakes” or “Ten Predictions for 2009” and make the jump from junk to investment grade writing about America’s great financial history.

July 21, 2008
_________________________________________________________________
Recommendation: Market Perform

100 Minds that Made the Market
By: Ken Fisher

John & Wiley & Sons, Inc., Hoboken, New Jersey 2007
First Published: 1993

ISBN: 978-0-470-13951-6

[1] Fisher regularly discusses his use of junk mail at industry conferences. The first quotation refers to conference held by Tiburon Advisors, one of the largest consultancy firms for the financial advisory industry. http://www.tiburonadvisors.com/06.11.03_Release_Highlights11th.html
The second quote refers to a statement from a 2004 Wall Street Journal article.
http://www.latrobefinancialmanagement.com/Research/Money_Management/Define%20Aggressive%20Fisher%20Sales.pdf

Daily Insight

U.S. stocks got clocked Thursday after the latest housing data showed existing home sales down and supply up, while bond-maven Bill Gross put the hurt on the financial sector with an extremely gloomy prediction.

The market is dealing with a bevy of uncertainties, but chief among them for now is the housing market. Stocks do not need housing to have completely turned in order to stage a sustained rally – stocks generally turn on anticipation, prior to actual results – but when you get a well-known name stating things like the situation will cost banks and brokerages $1 trillion the equity market will get hit. Currently, housing-market related losses stand at roughly $500 billion.

I’ll add Bill Gross may just have ulterior motive here, why would he wait until now to make such a statement? He has certainly been paying close attention to what is occurring within housing and the financial sector throughout this process, yet the $1 trillion number has suddenly dawned on him? Bill Gross is also no stranger to dire predictions, such as his call back in 2002 that the Dow would fall to 4500.

Market Activity for July 24, 2008

Financials led the market lower, as the S&P 500 index that tracks these shares plunged 6.75% -- the group had caught fire over the previous six trading sessions, jumping off a 10-year low, up 30%. Consumer discretionary, the other catalyst behind the market’s recent multi-day rally, lost 2.81%; industrials also took it on the chin, losing 2.51%.

Of the 10 major industry groups, none were up. The relative winners were health-care, down just 0.16%, and energy, off by 0.58%.

Getting to the economic data, the National Association of Realtors (NAR) reported existing home sales fell 2.6% in June to a lower-than-forecast 4.86 million units at an annual rate. Purchases declined in three of the four regions led by a 6.6% drop in the Northeast. The West posted an increase in sales of 1%, but also showed a 17% decline in the median price year-over-year, according to NAR. This marked the fourth-straight increase for the West, which could be a signal to the rest of the country that sellers, whom remain somewhat stubborn, need to lower prices a bit further in order for sales to kick up.

Certainly not helping sales is a wider-than-normal 30-year fixed mortgage spread. As the chart below illustrates – depicted by the yellow line – even though the 10-year Treasury sits at the very low level of 3.99%, the 30-year mortgage rate is higher than it otherwise would be due to increased risks. The current spread has widened to 260 basis points, from its normal range of 150-180 basis points. (We’re referring to the spread between the 30-year mortgage and the 10-year Treasury it runs off of.)

On supply, the number of existing homes on the market rose 0.2% in June, resulting in the months’ worth of supply figure increasing to 11.1 – likely double where we need to be. Exacerbating this situation is rising foreclosures, which have doubled over the past year. As of the latest data, foreclosures have risen to 2.5% of the total mortgage market. Roughly 11% of sub-prime loans have entered the foreclosure process and 1.25% of prime loans are in foreclosure.

The median home price dropped 6.1% last month compared to June 2007 – although that figure is up 10% since hitting a multi-year low in February. As of June, the median price of an existing home came in at $215,000.

In a separate report, the Labor Department reported initial jobless claims jumped to 406,000 in the week ended July 19 from a revised 372,000 the previous week.

We saw claims trend lower the past couple of weeks after hitting 404,000 at the end of June; now we’ve seen an expected increase from those levels, as we discussed yesterday.

The four week average, which smoothes the data out, remains below the 400k mark, as the chart below illustrates. Continuing claims, those receiving jobless benefits for more than one week, has trended lower the past two readings, falling to 3.107 million from 3.202 million in the final week of June, which is good.

But back to the four-week average, so long as we remain below 400k, the monthly job losses will remain relatively mild.

This morning crude-oil prices are extending upon yesterday’s gain. Oil hit the $124 handle on Wednesday, but has moved up a bit to $126.33 as I type.

We’ll also get durable goods orders for June, which are expected to decline 0.3% as the housing and auto industries continue to hold this reading down. The ex-transportation reading is expected to post a 0.2% decline after two months of strong positive readings. What we’ll be focused on is the non-defense capital goods ex-aircraft reading – a proxy for business investment – which has rebounded of late. It will be important to see this segment increase -- specifically the shipments, which flow right to the GDP reading. If the figure gains ground for June, I’ll expect to see a 2.8%-3.0% real GDP reading for the second quarter. If not, we’re probably looking at something like 2.0% when the reading is released on Wednesday.

Have a great weekend!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks gained ground yesterday, extending the rally from the multi-year low hit about a week ago, as earnings reports continue to stream in at better-than-expected rates of growth and oil prices continued to fall.

Consumer discretionary and financials shares led the way again as the drop in energy prices boosts sentiment regarding future consumer activity and their ability to pay bills. The housing-market woes, which have brought higher foreclosures, job losses within the construction sector and an increased level of caution are the largest reasons behind the consumer worries, but higher energy prices are an additional challenge.

Market Activity for July 23, 2008

The laggards were energy, basic materials and utility shares. The CRB Index, which measures a basket of commodity prices has dropped 12.5% over the past eight trading sessions and oil alone has fallen $20 from the all-time high of $145.29. The S&P 500 Energy index has plunged nearly 17% from its high hit in mid-May and 15% this month. The group has likely been oversold as they’ll continue to make great money at these levels and continue to boost dividend payouts.


Crude-oil prices fell another 2.74% yesterday, to $124.44 per barrel, even as the weekly energy report showed supplies fell 1.56 million barrels – a decline of 675,000 barrels was expected. Pushing crude lower was builds in gasoline and distillate fuels (heating oil and diesel), which rose more than expected. Information on gasoline demand showed a decline of 2.2% from the year-ago period, which is in line with what we’ve seen over the past four weeks.

I do think that hawkish comments from Fed officials of late has helped push crude lower as the dollar has gained some ground over the past week. There has been talk the collapse of oil-marketing firm SEMGroup is behind oil’s decline as they had to unwind long positions. I don’t know, maybe this has some validity, but it doesn’t explain the decline within almost all commodity prices of late.

Earnings continue to beat expectations by-and-large – 75% of S&P 500 members that have reported thus far have beat expectations. Ex-financial profit growth remains in double-digit territory, up 10.5% with about 40% of members reporting. Even overall earnings, punished by a 97% decline in financial-sector profits, have improved. Overall, second-quarter S&P 500 profits are down 27%; that figure was a negative 35% two days ago. (One of the exceptions within the ex-financial space is Ford, which has just stated their second-quarter loss came in at 62 cents a share – a decline of 27 cents was expected. Ouch. Also just out is 3M’s second-quarter results, which easily beat their number as operating income rose 13%)

On the economic front, the Fed’s Beige Book release showed most of what we already knew occurred during the six weeks that ran early June – mid July. (This report is a survey of economic conditions within their 12 regional districts – the survey is released every six weeks.)

• Consumer Spending
  Reported as sluggish or slowing in all districts –not terribly surprising considering retail sales x autos jumped 11.5% at an annual pace past four months. You can bet there will be some slowing after that robust pace.
  
• Real Estate
  Residential remained weak across the country. A few districts did show improvement on the commercial side, but Boston reported “over-built” conditions.
  
• Manufacturing
  Remained subdued, but did show activity increased in Cleveland, St. Louis and San Francisco districts. Understandably, producers of energy equipment enjoyed increased demand.
  
• Prices
  All districts reported price pressures as elevated or increasing. Input prices continued to rise, particularly for fuel, metals, food and chemicals. Many districts reported on manufacturer’s plans to raise prices as a result of higher input costs. (Hopefully the FOMC is reading their own report.)
  
• Labor Market
  Job market was reported as unchanged or slightly weaker in most districts. Demand remained high for skilled workers in most industries.

The Fed continues to focus on wages, as any good Keynesian/Phillips Curver/NAIRUist would, and since wage pressures are not elevated they continue to expect inflation to cool. We hope they’re right, but as most of you know I’m skeptical. The ISM and regional manufacturing surveys suggest inflation is becoming embedded due to the abrupt jump in input costs over the past 10 months. However, the decline in oil and other commodity prices over the past several sessions is very welcome news and if this trend continues – or at least do not jump again – it will help in calming import, producer and consumer-level inflation.

Yesterday I mentioned Fed Vice Chairman Kohn and Governor Mishkin were scheduled to speak, but I must have had my dates wrong. The Federal Open Market Committee (FOMC) website didn’t have anything on this. However, Philadelphia Fed Bank President Plosser was out making comments and they were somewhat hawkish. He stated that policy maker must increase fed funds before inflation expectations become unhinged. He joins Minneapolis Fed Bank pres Stern and Dallas pres Fischer in this sentiment. They are all voting members, so there is dissent building and will result in pressure for the group to gently increase their benchmark rate.

The table below shows the probability of Fed moves over the next three meetings. The first segment shows the probability of a change at the August 5 meeting. To no real surprise, the market believes there’s a 90.5% chance that the FOMC will keep fed funds unchanged at 2.00%. Notice though how things have changed over the past month – a month-ago the market believed a 42.1% chance of a 25 basis point hike to 2.25%. This helps to illustrate how the Fed has changed its language and has been all over the map, thus confusing the rest of the market with regard to their direction.

You can then move down to the September 16 meeting table where a month ago there was a 56% chance the Fed would go to 2.25% by then and a 37% shot of hiking to 2.50% for a combined 93% chance of raising rates whether it be 25 or 50 basis points. Now that chance is just 60%, and a week ago it was as low as 24.6%.

Oil and the dollar trade are based on a variety of factors, but a major variable is the Fed’s direction. The sways in the table above helps to explain the ups and downs in the dollar and oil prices off late. As the market increases its expectation the Fed will hike, oil will continue to move in the right direction – of course hurricane activity and geopolitical events will have their own effect on price. If they send market expectations on another wild goose chase by becoming more dovish on the inflation front again, oil and the dollar may just return to an undesirable direction.

This morning we get initial jobless claims for the week ended July 19. It will be very important to hold below the 390,000 level. The last two weeks we’ve seen claims trend lower. I expect to see the figure begin to trend upward slightly, but if we remain in a range of 375,000-390,000 on the four-week average – which is the graph we’ve been posting on Friday’s for a few months now – it will signal monthly job losses to remain mild.

We’ll also get existing home sales for June, which are expected to decline 1% after recording a 2% rise in May.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks began the session lower yesterday on a disappointing profit report from American Express that was released after Monday’s close, but the benchmark indices reversed course, gaining momentum throughout the day to end meaningfully higher.

Financial shares led the advance, jumping 6.59%, even after a couple of ugly profit – lack of profit rather – reports from Wachovia and Washington Mutual. Despite these harsh realities, we have had a number of bank names post better-than-expected results and investors may see some light at the end of the tunnel with regard to write-downs. The entire group has also stated there is no need for additional capital which may be the main catalyst for this sector’s rally. The S&P 500 financial index has rallied 27.8% in five trading sessions.

Market Activity for July 22, 2008
Of course, the very welcome decline in oil prices has also helped the market over the past five sessions – actually four of the past five sessions as we were fractionally lower on Monday. Yesterday oil prices closed in on the $125 per barrel handle, pushing stocks higher in the afternoon session.

The chart below shows the reversal in stocks yesterday – the orange line, it’s difficult to see, marks the opening price.

Oil prices have plunged $20 over the last seven sessions as we have hit the $125 handle this morning – falling another 1.59% to $125.92. We began to come off the all-time high closing price of $145.18 hit last Tuesday and estimations, and now the reality, that Hurricane Dolly will remain West of the major energy infrastructure in the Gulf has certainly helped things. Program trading has likely kicked into gear due to the degree of the decline, pushing the price of oil even lower.

I shouldn’t leave out that we have received a number of hawkish comments from Fed officials since Friday (focusing on the need to raise their benchmark rate) which certainly hasn’t hurt the dollar and scared some out of the oil trade. It will be interesting to see how oil prices react throughout the day. We’ll get speeches from Federal Reserve Vice Chairman Kohn and Governor Mishkin today. These are the so-called academics of the group – along with Bernanke – and thus the Phillips Curve addicts. Their comments will very likely have a more dovish tone – not at all ready to increase rates even mildly if their past comments are any indication – but will surely pay lip service to inflation as import prices have jump 20.5%, producer prices have hit 9.2% and CPI 5% -- all on a year-over-year basis.

And speaking of inflation, it’s been interesting to watch bond yields remain so low. Yes, yield have risen of late but we sit at 4.15% on the 10-year Treasury as we speak, which is still one of the lowest levels of the past 40 years.

This move in oil, if sustained, will certainly help out regarding the inflation figures. Still, with headline consumer-level inflation running at roughly 4.5% [the average of the regular CPI (5% YOY), chained CPI (4.2% YOY) and PCE (which will probably rise to 4.2% when released)] one would think investors to demand a yield on longer-term rates that compensates for this price action. Even the 10-year TIPS/conventional 10-year Treasury spread sits at just 245 basis points, as the chart below illustrates, which does seem a bit removed from reality. (TIPS are the Treasury Inflation Protected Securities.)

On the chart below, it is the yellow line that is the focus. The white line is the conventional 10-year Treasury yield, the orange line is the inflation-protected 10-year yield, and the yellow is the spread -- or the market’s inflation expectation.

Maybe inflation will come crashing lower and this spread, which is probably the most accurate high-frequency market indicator we have, is gauging things correctly. Of course, some of the low-interest rate environment is due to risk concerns, thus investors have fled to the Treasury market for safety – so there’s a possibility this market has not fully accounted for future inflation expectations. We shall see, but I would expect yields to rise some from here.

On the economic front, we received the OFHEO Home Price Index for May, which showed a decline of 0.3%. (OFHEO stand for Office of Federal Housing Enterprise Oversight.) On a year-over-year basis, the index has home prices down 5%. The largest declines have occurred in the West and South Atlantic regions – California, Nevada and Florida, place where the most speculation took place.

This index has prices declining at a much lower rate than does the press’ favored Case/Shiller Home Price Index that has prices down 16% year-over-year. This OFHEO index provides a much broader look as Case/Shiller only tracks the largest 20 cities – about half of which have witnessed the biggest declines. Factor both and we probably have home prices down 10-12% since the declines began to take hold in the fall of 2006. No one likes this situation, but this is what needs to occur for the home-supply figures to come off of very lofty levels.

We have a plethora of earnings results out this morning and virtually all have either met or outpaced estimates. As a result stock-index futures are nicely higher. We’ll wait for the Fed’s Beige Book – regional economic survey for the past six weeks – release later this afternoon and the Kohn/Mishkin comments, which will surely be market movers.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks closed lower for the first session in three as the market didn’t have much to trade on without a major economic release and the only meaningful earnings release coming from Bank of America (BAC). Earnings at BAC did come in at a better-than-expected rate, but this seemed to be not that surprising after we have already received results that beat expectations from a number of other financial names over the past three days.

The only economic news we had to go on came from the Conference Board’s Leading Economic Indicators Index (LEI); however, this reading doesn’t get much attention these days as it has proven to be fairly worthless. The index has posted negative readings half of the time over the past 3 ½ years – a period with which the economy has averaged 2.5% real annualized growth. While this level of GDP growth is below the long-term average of 3.4%, it isn’t all that bad considering the challenges of the past year and is a far cry from what the LEI has predicted.

Energy, utility and basic material shares led the gainers yesterday. Health-care, consumer discretionary and financial shares led yesterday’s losers. Health-care was hit by a study showing the efficacy of cholesterol-drug Vytorin was less-than-desired regarding valve disease and also showed 9.9% of those in the study developed cancer vs. 7% of those given placebo. This may not seem like a huge risk, given the 7% instance of those taking placebo, but such is the nature of the regulatory environment for the drug industry these days.

Market Activity for July 21, 2008

All and all, the losses among the benchmark indices were mild. Mid and small cap stocks posted nice gains.

Earnings growth is looking better-than-expected – although last night threw us a curveball with American Express, Apple and Texas Instruments all missing; we’ll get to that in a moment. I don’t want give anyone the wrong impression, as a whole S&P 500 profits are down 30% due to the 90% decline within the financial sector. But excluding that currently beleaguered segment of earnings, profits are up 12% and most companies have surpassed expectations – five of the 10 major industry groups have grown earnings at a double-digit rate; six are positive, with two sectors that have yet to report. Seventy-percent of those reporting have beat expectations.

Here’s a quick run down of second-quarter profit results:

Information technology (+26.8%), basic materials (+17%), energy (+15%), consumer staples (+12.6%), health-care (10.7%) and industrials (+2.5%). The downers are financials (-94.3%) and consumer discretionary (-2.7%). Telecom and utilities have yet to report.

And speaking of earnings, stocks look very attractive relative to bond yields. A measure that has been looked upon as one measure of stock-market valuation is comparing the earnings yield on the S&P 500 to the yield on the 10-year Treasury. Unfortunately, the earnings yield index was discontinued in 2007 and I didn’t have time to build my own this morning, but the chart below give a pretty good representation of this relationship even so. I’ve drawn a point on the chart to show where the earnings yield would plot today. (The earnings yield is the inverse of the P/E ratio and at 14 times forward earnings on the S&P 500 this puts the yield at 7% vs. the current yield on the 10-year of 4.03%)

One has to go back 30 years to see the earning yield of stocks this much above the yield on the benchmark bond. One thing to keep in mind is with the uncertainty of inflation rising of late this bond yield could rise abruptly and there goes the positive spread I’m talking about. The overall point though is when we look beyond current challenges/uncertainties, the market multiple is looking attractive here.

We received some earnings disappointments after the bell last night, the largest being poor results from American Express as credit-card defaults rose to 5.3% from 2.9% a year earlier. This is the big one that is sending stock-index futures lower this morning. We’ve had a number of financial names post better-than-expected results, but all it takes is one bad one in this environment and the bears got it in AMEX’s results.

One of the other names I mentioned above, Apple Inc., posted fantastic quarterly results, but the outlook is causing concern, as they forecast current-quarter results will be meaningfully below estimates. One thing to keep in mind though is that tech firms have been low-balling their guidance for four years now. Some of this Apple news is probably a combination of some weakness and low-balling. I’ll note, the current quarter generally sees margins compress a bit as the firm runs back-to-school discounts.

Shifting gears…

I’ve noticed a number of stories out of our beloved financial press over the past couple of months stating that income growth has stagnated and the media’s take has now moved to portray the past few years as a weak period for income growth. This take shows a pathetic level of inaccuracy. While real income growth has flattened out of late due to the 65% jump in the price of oil over the past 10 months, the figure has shown very nice progress over the past several years and remains positive over the past year even with the jump in energy prices. Again, that is over and above headline inflation.

I’m excluding the one-time event the rebate check scheme had on the figure – illustrated by the spike at the end of the series. Since the final quarter of 2001 – which marked the trough of the previous business-cycle contraction, nominal, or unadjusted for inflation, after-tax income is up 40.2%, or 5.5% annually – again, this excludes the May jump that was mostly due to the rebate-check effect. Real after-tax income is up 18.91%, or 2.77% annually. This is not far behind the growth of the 1990s, which didn’t have to deal with exploding commodity prices pushing inflation higher.

My chief concern regarding real income growth is this escalation in commodity prices, namely the energy area. Congress and the White House must follow through on last week’s very good comments on drilling with action. Too, the Fed must focus more on price stability. If crude prices do not stabilize this economy will be in trouble as income growth will not be able to keep up and business profit margins will be squeezed further. There are some things that are out of our control in this regard, but within those areas that we do control this must be dealt with now.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks halted a six-week losing streak as better-than-expected earnings from the banking industry and ex-financial S&P 500 profit growth remains in double-digit territory has helped the benchmark indices to rebound the past three sessions.

For the week, the Dow gained 3.57%; the S&P 500 rose 1.71% and the NASDAQ Composite added 1.95%.

Financial-industry giants Citigroup, Wells Fargo and JP Morgan continue to post relatively weak results but the numbers have come in much better-than-expected. Bank of America has extended the trend this morning, whipping their estimate by 40%. Their second-quarter net income was 42% below the year-ago number, but it appears we may be on pace to get most of these write-downs behind us by the time the fourth-quarter rolls around – which would be huge.

Excluding financial-industry results, S&P 500 profits are on their way to posting another double-digit quarter; the figure is up 12.7% with about 25% of members reporting thus far.

Market Activity for July 18, 2008

We have to get several uncertainties out of the way still, inflation concerns are now another issue equity investors must deal with, making the task of assigning the correct market multiple very difficult, so one should be prepared for stocks to continue within this trading range. But we’ll eventually break out to the upside. Several positives that no one seems to be talking about is the awesomely streamlined nature of most industries – it is absolutely amazing how many sectors continue to record decent-to-healthy profit growth even as most input costs have risen in such a quick fashion.

And there is certainly no lack of capital as a record $3.5 trillion sits in money–market funds just waiting to get in. Corporate cash levels remain high as well.

It’s true a lot of wealth has been lost, more than $10 trillion in global market value since October, according to Bloomberg News. However, we’ve held onto to a lot of the gains of the past few year – the NYSE Composite Index, for instance, remains 88% higher from the March 2003 multi-year low and is up 56% since 1998. That 10-year return is relatively weak when annualized, just 5%, but there has been a lot of wealth created over the past decade as U.S household net worth has jumped 60%.

In terms of housing, the 30-year fixed mortgage spread – as indicated by the thick yellow line in the chart – has narrowed nicely. Hopefully, it will continue to trend lower as this will show credit availability is improving. Credit remains very much available for those with strong credit scores (although at a higher price), but sketchy for those with questionable histories. In any event, it will be a big market plus to see some of these spreads narrow, and this mortgage spread is one of the important ones. I do have my concerns though.

The spread between the 10-year Treasury and the 30-year mortgage rate remains much higher than normal, as you can see – currently running at 210 basis points, the normal range is 150-175. The Fed can keep rates very low – thus keeping the 10-year probably lower than it otherwise would be – but the market is saying, I don’t think so; we’re not originating mortgages at normal spreads due to increased risks.

What the very low fed funds rate does help is adjustable mortgage resets, but still the FOMC can push fed funds to 1.00% and those that had no skin in the game and now have mortgages that are higher than the home’s value will simply walk, as they have been doing.

The overall point, the Fed does not have a magic wand that solves everything. It seems to me they need to raise rates mildly, show the market that they’re still serious about price stability, and let the housing market adjust as it will. At least this way we won’t have multiple things to deal with down the road – a weak housing market and harmful levels of inflation.

Keep in mind, if inflation becomes embedded, the Fed tightening that will take place will be substantial and abrupt. At which point, the economy could be pushed into a serious recession and housing won’t be able to rebound. This doesn’t have to be the case. If the FOMC realizes there is no silver bullet and deals with that which they are tasked, time will take care of the rest.

There are signs inflation is becoming imbedded, which is my chief concern here and now (our other concern, and the market’s in general, is the uncertainty of tax policy as higher capital and dividend tax rates will be crushing for stocks, but that takes a back seat right now). The ISM surveys along with some of the regional manufacturing indexes are showing the jump in energy prices have flowed through to other prices.

In the latest regional manufacturing survey a special question was asked on price behavior and found that 60.5% of respondents have increased base prices to pass on energy and other cost increases. Of these, 29.1% have instituted price surcharges. Looking ahead, 32.6% of respondents stated they were more likely to institute escalation clauses incorporating price adjustments; 31% were more likely to use surcharges to offset higher costs.

So manufacturers have and plan to pass price increases down the pipeline, with a number of them contemplating automatic price escalation agreements. The Fed needs to get a handle on energy prices and further dithering on this issue will not prove beneficial. For sure, there are many variables that go into the price of oil, it is not only the Fed’s reckless easing campaign – a hurricane that tracks through the Gulf of Mexico, OPEC stating they’re contemplating a production reduction, the weekly energy report showing supplies fell, geopolitical risks, etc. But it doesn’t seem to be happenstance that crude has jumped 65% since the Fed began to ease last September and 40% since the January 22 inter-meeting cut that kicked off this aggressively Fed action. Some mild tightening may go a long way in removing inflation concerns.

Moving on…

I see this morning the NABE (National Association of Business Economists) is now saying the U.S. will avoid recession, but growth will remain weak. We welcome the NABE to reality along with the other recession promoters that seem to be dropping like flies. We’ll likely see the second-quarter GDP figure come in at a 2.5% real rate of annualized growth – even as housing continues to subtract a full percentage point from the reading. There’s even an outside chance Q2 GDP will post a 3.0% reading.

Still, until housing flattens out, we’ll have to deal with weak readings that surround some of these stronger posts. But so long as inflation risks are quelled, real incomes will rebound a bit from here and we’ll have the consumer helping out the business side, which seems quite capable of boosting capital outlays with their huge cash positions and profit growth that remains intact for many industries.

Futures have turned around this morning and are now nicely positive thanks to the better-than-expected Bank America results.
Have a great day!

Brent Vondera, Senior Analyst