Daily Insight

U.S. stocks engaged in another day of wild fluctuations on Friday as the broad market was higher by 4% just after lunch, but we lost it all in the final two hours of trading to close in negative territory. Nevertheless, it was a good week, the first in four, as the benchmark indices closed higher by nearly 5%.

The Dow Jones Industrial Average gained 4.75% over the past five sessions, following the worst week in the index’s history – down 18.15%. Despite the 400-point rebound last week, the Dow remains 2,570 points lower since Lehman Brothers went down on September 15. That marked the point the credit markets became disturbed, to put it lightly.

Market Activity for October 17, 2008
As of the past few days though, the credit markets do appear to be thawing – hopefully the trend continues, but one should not expect to accurately extrapolate based on the trend of the past week – the ride lower will probably not be straight down.

Below are two key indicators the market has been watching, and we’ve spent much time mentioning.

The first is three-month LIBOR, which shows the inter-bank lending rate for the specified period. While it shows banks remain unwilling to lend to one another, or charge a high rate to do so, it’s come down nicely over the past three sessions.


The next is the TED Spread, which illustrates the level of risk aversion in the marketplace. This spread is the difference between the rate on three-month LIBOR and three-month T-bills. The spread shows people continue to run to the safety of the Treasury market. That is, short-term Treasury yields remain very low due to huge demand for these securities. Once this fear wanes, rising T-bill rates will combine with falling LIBOR and this will, obviously, cause the spread to narrow – a clear sign things are normalizing.


Rates for one-month commercial paper also fell to a three-week low.

Friday’s Economic Releases

On the economic front, U.S. housing starts fell more than expected in September as construction of single-family homes plunged to the lowest level in more than 25 years, indicating the slump intensified and will be a larger drag on GDP – residential investment has weighed on economic growth for 10 quarters now; that drag eased in the second quarter, but will get worse again with regard to the final two GDP reports of this year due to the chaotic state of the credit markets.


The only time in the history of this data, which goes back to 1959, single-family starts were this low was in the middle of the 1981-1982 recession.

While this development hurts for now, it is a necessary condition for bringing the housing market back. Inventory levels as a percentage of sales remain at an extreme elevation and a serious reduction in supply is needed. That said, the homes available for sale data (not adjusted for the current sales pace) has plunged. So, when the sales numbers do begin to pick up again, the inventory-to-sales ratio (the supply figure that remains elevated) will come down fast.

It will take some time still, especially as the labor market has deteriorated. Further, demand will not improve substantially until the perception that prices have bottomed takes hold. And obviously, tighter credit conditions – rather, all but frozen credit markets – delay the rebound as well. We do believe though that the next chart illustrates some very important work has been accomplished.


We will have to see the permits reading bounce before housing begins to flatten out.


Digressing

Capitalism is certainly under assault after what’s occurred over the past month – referring to the plunge in stock prices --, but we should be very careful not to throw the baby out with the bathwater. Capitalism, for all of its flaws, remains the best of all of man’s inventions with which to allocate scarce capital, goods and services in order to fulfill unlimited wants. Period. Choose something else and you get lower growth, less prosperity and less choice – such as in Europe for instance. From the perspective of an individual country, tax capital more and it will simply go elsewhere as it seeks out the places where it is most welcome and best treated – to paraphrase the words of the late Walter Wriston.

Policy proposals to raise taxes are harmful. The claim that such an endeavor is necessary to punish the rich is perverse. While it may punish some in the upper class, it truly punishes those attempting to climb the economic ladder. The rich and well-off can shelter their income from onerous tax rates. What it does to other achievers is close the door to wealth – making it more difficult to walk through that door. We should not forget also that the majority of those that make up the top tax brackets are small businesses – the most prolific job creators in our economy.

It is no coincidence why rich Europeans are those that have been wealthy for generations. Conversely, in the U.S. you can run into a multi-millionaire today who didn’t have anything but good ideas and a strong work-ethic 10 years back. This is the key difference between the U.S. and Europe (this is just not a cultural difference but one of tax rates) and those that have the desire to move to the European model are actually punishing those they claim to help far more than those they claim to punish.

And on this claim that de-regulation is what brought us to this point, a topic we spent some time dispelling last week explaining that Congress has net increased regulations over the past several years coming out of the tech bubble and bust, there were two excellent Op/Eds in the WSJ on Saturday. One – the first link below -- explains the regulatory changes that helped deliver us down this path. The other – an interview with the brilliant Anna Schwartz – explains was put us on this path. For those with WSJ subscriptions, these are worth the read.

http://online.wsj.com/article/SB122428201410246019.html?mod=todays_us_opinion

http://online.wsj.com/article/SB122428279231046053.html?mod=todays_us_opinion

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks engaged in another incredibly volatile day of trading as the broad market was down 4.6% at its low point only to rally in the afternoon session to close 4.25% higher. From the day’s nadir, which occurred 90 minutes into trading, that amounts to a surge of 9.4% to the close. The same activity was true for the Dow and NASAQ Composite.

Oil futures price slid another 6.3% yesterday, which fueled buying in sectors such as industrial and consumer shares.

Technology shares enjoyed a very nice session as earnings reports from the group continue to look quite strong. However, some of the high-growth areas of the past couple of years – specifically the Asian economies – are beginning to wane, which was evident by IBM’s results that showed growth in the region decelerated to 6% from double digits in the previous quarter.

This was inevitable as the U.S. consumer has pulled back in a big way. The Asian economies are export-driven and if the largest import market is going to reduce activity then there’s really no way for the region to continue along the growth path of the last several years.

Market Activity for October 16, 2008

The price of oil has come down even faster than it went up; crude per barrel has returned to the level it stood when the Fed began to aggressively cut rates a year ago. A combination of de-leveraging, lower demand, global growth concerns and higher supplies of late have contributed to the move.


The market may begin to pay more attention to this development. A couple of economists have talked about the “tax-cut” effect as oil has moved dramatically lower over the past couple of months. Those comments were a bit early, but now we’re getting somewhere. Now, with crude per barrel back to $70 and the price at the pump below $3 a foot has been removed from the consumer’s throat. We should see gasoline prices move down to $2.50 per gallon within the next couple of weeks – in the aggregate, this is big news.

On the economic front, the Labor Department reported initial jobless claims fell 16,000 to 461,000 in the week ended October 11 – although this data may be subject to a higher than normal revision as some state offices were closed for Columbus Day, causing the government to estimate claims in eight states. (I don’t know why only a few were closed; thought all government offices were closed for that holiday, but apparently not)

The decline in claims was largely due to the bounce back effect from hurricane-related dislocations in the prior four reports. The most telling aspect of the report was that 42 states and territories reported an increase in claims, with just 11 reporting a decrease. This is a very negative ratio and suggests the level of claims will remain elevated, and very likely grow – not a big surprise there with all that has occurred.

The four-week average, which smoothes out volatility, rose to the highest level since the 2001 recession (as the chart below shows). The number of people continuing to collect jobless benefits climbed to 3.711 million in the week ended October 4. Part of this is due to the government extending the duration one can collect benefits. This would not be an incentive to remain on the dole for most, but surely enough will decide to continue to take the handout instead of looking for less than appealing work that is sometimes the case during times of labor-market weakness.


That said, we should remember that the unemployment rate stands at 6.1%, which is exactly the average of the past 30 years – so its not as if the scenario is as pathetic as often reported. But the way things are shaping up here, especially in the last few weeks, we would expect the jobless rate to rise above 7%. The chart below offers some perspective.


In a separate report, the Labor Department stated the consumer price index (CPI) continued to decelerate last month. The month-over-month reading was flat for September and up 4.9% on a year-over-year basis – both were a bit better than expected. That year-over-year reading is down from 5.4% in the previous month.

Large declines in the fuels components offset significant increases in food components during September – the rise in food prices, almost across the board, over the past few months (up 8.7% at an annual rate past three months) is concerning and may keep CPI from falling to the degree that most expect.


However, the decline in fuels is obviously very encouraging (except for the fact that one reason for the decline is serious deterioration in global growth; the other being the de-leveraging process as funds have to sell that which is most liquid to meet redemption calls).

Yet another release, this one from the Commerce Department, showed industrial production plunged in September, declining 2.8%, marking the largest drop since 1974. Thankfully, much of this was due to hurricane-related shutdowns and the Boeing strike. Hurricane Ike, which hit September 13 forced oil production, utility and other facilities to shutdown – this accounted for 2.25 percentage points of the decline. Adjusting for these events, the decline in industrial production was mild, which is good. Still, no matter how transitory the effect, it will weigh substantially on the Q3 GDP reading; we get the first look at that figure on October 30.


Ultimately, we’ll have to wait for the October data to assess the degree to which current credit and economic events have truly affected the reading.

Have a great weekend!

Brent Vondera, Senior Analyst

Afternoon Review

United Technologies (UTX) had 3Q earnings rise 6 percent and the company said 2008 earnings will be 10 cents higher than the lower end of its previous forecast. Profit and sales rose at all six of the main businesses in 3Q. Strength was in demand for elevator equipment and service contracts overseas. Currency translation contributed 3 cents a share. Carrier air conditioner units (26 percent of UTX’s annual revenue) had the slowest growth due to U.S. housing weakness, and sales of Pratt & Whitney aircraft parts may slow because of the Boeing machinists’ strike and global credit crisis. Order rates slowed in 3Q, but backlogs remain strong. UTX’s aggressive cost reductions are evident as its operating margins continue to expand.

UTX has sufficient resources and balance to withstand a significant slowdown in its markets. Boosted its quarterly dividend 20 percent to 38.5 cents a share saying its liquidity and free cash flow remain strong. Current discretionary cash flow of about $5 billion could retire its net debt in under two years. UTX is spending more on buybacks and less on acquisitions as the stock has declined to very attractive levels.

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UnitedHealth Group (UNH) barely beat expectations and reported a 28 percent decline in profit because the company priced some commercial plans too low and lost money on certain policies backed by Medicare.

The biggest risk for UNH is economic conditions that push employers to choose lower-priced insurers, abandon coverage, or trim benefits. Also dampening their outlook is job reductions and health-plan dropouts. On the bright side, risk-based commercial membership grew by 5,000 people in the quarter, reversing the trend of the second quarter, while self-insured membership was down by 25,000 people, most likely a result of rising unemployment. UNH was also hurt by growing medical costs. The medical loss ratio – the percentage of premium revenue paid to health providers – was 81.7 percent in 3Q compared with 79.5 percent a year earlier.

UNH shares have been beaten down this year because of pricing errors, possible future payment cuts from the U.S. Medicare program for the elderly, and the effects of the economic decline and the global credit crisis.

UNH’s financial health is clearly a strong point. The company’s $20 billion investment portfolio only generated about $25 million of capital losses, or $0.02 a share. (You may remember that WellPoint recently estimated a $214 million charge on its holdings in Fannie Mae and Freddie Mac) Today, UNH reported that more than $6 billion of the company’s $20 billion portfolio is cash, with the balance diversified in “investment grade” government and corporate obligations. UNH could afford to write down over $7 billion in assets, or 36 percent of its total cash and investments, and still be in compliance with minimum state requirements.

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Peabody Energy’s (BTU) 3Q profit rose more than 11-fold on increased output and higher prices and boosted expectations citing higher volumes and pricing increases as demand continues to rise. The company increased its 2008 earnings per share target to $3 and $3.25 from a previous range of $2.50 to $3 a share.

From CCO Richard Navarre: “While there is uncertainty in today’s economy, any easing of demand growth is likely to be offset by diminished global coal supply…Supply challenges around the world and lack of capital to respond to market shortages will continue to drive a tight global supply-demand balance for coal.”

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Illinois Tool Works’ (ITW) 3Q profit fell 4.5 percent and the company narrowed its full-year forecast to $3.23 to $3.32 a share, from $3.22 to $3.34 a share. Sales increased 11 percent due to acquisitions and favorable currency translation. ITW acquired 14 companies with total annualized revenue of $847 million during 3Q, boosting its year-to-date total to 40 acquisitions representing $1.4 billion of annualized revenue.

Last week, ITW reduced profit estimates citing a slowdown in industrial production (especially in the U.S.). North American construction base revenue declined 6.2 percent while construction international base revenue fell 3.2 percent. North American automotive base revenue declined 18.1 percent and international base revenue fell 7.3 percent. A 6 percent decline in the number of shares outstanding helped raise the EPS number.

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Citigroup (C) reported a fourth consecutive quarterly loss after at least $13.2 billion of loan losses and securities writedowns. C has now had $61 billion of losses tied to the slumping housing market. C’s Tier 1 ratio fell this quarter from 8.7 percent to 8.2 percent, but it should be noted that the ratio has improved from 7.1 percent at the end of 2007. CEO Vikram Pandit expects the capital ratio to be strengthened more in 4Q with the sale of their German retail banking operations and the investment by the U.S. Treasury. The reserve building was slightly higher than most had expected, which could be a signal for greater loan losses ahead.

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Merrill Lynch (MER) reported a fifth straight quarterly loss and had at least $9.5 billion of 3Q writedowns. Bank of America (BAC) agreed to buy Merrill for $50 billion in an all-stock deal. Each Merrill share will be exchanged for 0.8595 shares of Bank of America. At first glance, it appears writedowns were more aggressive than Morgan Stanley or Goldman Sachs. This could be because of differences in reporting periods, or it could be possible that BAC is hoping to minimize writedowns once Merrill officially becomes a part of BAC.

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Danaher (DHR) said 3Q earnings rose 11 percent as acquisitions helped boost sales. DHR bought 12 companies in the last year to help reduce their reliance on consumer-oriented businesses that are more prone to economic slowdowns. DHR has also expanded sales overseas, and non-U.S. revenue accounted for 51 percent of sales last year compared with 39 percent in 2003.

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Johnson Controls (JCI) held its annual investors on Tuesday to lay out details of its 2009 financial guidance. JCI’s EPS 2009 forecast range works out to a profit decline of 10 percent to 16 percent versus 2008, on sales that are expected to contract by about 3 percent. The company is estimating a 12 percent decline in light vehicle production in North America and a 10 percent decline in Europe. JCI’s outlook for construction spending was a bit more optimistic, expecting international non-residential construction to be up 5 percent in its fiscal 2009, with growth in China and the Middle East offsetting declines in Europe. JCI thinks its diversified business portfolio and ability to improve its cost structure will partially offset the difficult economic environment.

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There was, in fact, other equities news outside of earnings today…

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Wal-Mart (WMT) investors cheered the company’s decision to close a unionized Quebec tire and lubrication shop because of costs tied to the first labor agreement imposed at any of its North American locations. WMT is essentially telling employees that if you join an union, they are going to close your shop.

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Grupo Modelo, the Mexican company that makes Corona and is half-owned by Anheuser-Busch (BUD), said early today that it has filed a notice of arbitration against Anheuser over the InBev deal. Grupo Modelo is arguing that the proposed sale violates a 1993 agreement between Modelo and Anheuser. The agreement includes certain restrictions on when Anheuser’s stake can be transferred to a competing beer maker. Modelo appears to have little leverage in the situation, but the agreement is subject to Mexican law and requires arbitration if there’s a dispute between the two parties. BUD closed the day more than $10 below the deal price is $70.

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In case you missed it, Coca-Cola agreed to distribute Hansen Natural’s (HANS) Monster Energy drink (the largest selling energy drink the U.S., Europe, and Canada). Coca-Cola will expand Monster internationally and boost sales of the drink beyond the more than a quarter of the U.S. energy drink market Hansen already controls. About 50 to 60 percent of Monster’s U.S. distribution is currently handled by Anheuser-Busch.

The agreement states that Coca-Cola will distribute Monster Energy in Great Britain, France, Belgium, the Netherlands, Luxembourg, Monaco, Canada and the U.S. for 20 years. Hansen will record between $110 million and $130 million in pretax expenses for termination fees to distributors that are losing its business. Most of the costs will come in 4Q. Coca-Cola will repay Hansen for the termination fees related to its territory, which Hansen said it will record as revenue over 20 years.

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Medtronic (MDT) was down 2.03 percent after a study linked its drug-coated Endeavor heart stent to more complications than rival devices and found it didn’t reduce the need for future treatment.

Daily Insight

U.S. stocks got clocked again as the broad market posted its largest single-day percentage decline since Black Monday 1987 on an ugly September retail sales report. That economic data possibly kicked off another round of de-leveraging as redemptions caused hedge funds and mutual funds to sell shares.

This latest retail sales report, combined with the negative reading for August, suggests consumer activity may have declined at a 3.0% annual pace in the third-quarter. That would mark the worst consumer retrenchment since the 1981-1982 recession.

I don’t think one should dismiss that the market is also currently pricing in fears of impending regulation, not to mention an Obama/Pelosi/Reid government that has opposed free trade pacts and proposed higher tax rates.

The good news is the market seems to have priced in an awful lot – a significant U.S. recession, possibly a global recession, policy concerns and a credit market freeze up that is making things much worse. (I’m not saying we’ll see the global economy actually contract, certainly very weak growth will occur, just that the market seems to have priced this event in)

This is a bargain-hunters dream, but patience remains and will continue to be the theme for several months. Those with a longer-term view have had to deal with a decade in which stock-market returns have been non-existent for large-cap stocks. Thankfully, a diversified portfolio would have provided some boost as mids and smalls are up at 7%-8% annualized rates over the past 10 years.

These events of stock-market stagnation occur on occasion; the good news is large returns follow – although things may remain sketchy for a while still.

Market Activity for October 15, 2008
Oh, and I’ve got to touch on this de-regulation claim we keep hearing about – you know, the exhortation that de-regulation has caused the current crisis. Someone tell me where net de-regulation has occurred over the past seven years. In fact, the last round of de-regulation occurred in the late 1990s. Have people forgotten about Sarbanes-Oxley and all the regulatory requirements that accompanied that legislation?

While the current crisis results from years of monetary policy mistakes, keeping rates too low for too long, (and all of the leverage, poor risk-management, scurry for yield and overall bad behavior that these policy mistakes encouraged) it has been a regulatory regime that’s sent public offerings to the London and Dubai Exchanges as the comparative cost of going public on the NYSE has risen.

For the record, I am for de-regulation, but it is a specious claim to state that this is what has brought on the current situation.

It appears the credit markets are beginning to unlock. It is really too early to tell, but three-month LIBOR (inter-bank lending rate) has come down a bit – although it remains at an extreme elevation. The overnight LIBOR rate dropped 20 basis points this morning to 1.94% -- the lowest level since late 2004. We’ll need to see that three-month rate come much lower.


On the economic front, the Labor Department reported that producer prices fell 0.4% in September, marking the second month of decline – the August reading fell 0.9%. The core rate, however, accelerated, rising 0.4% on a month-over-month basis and up 4.0% year-over-year – that’s up from the previous reading of 3.6%.


For the overall reading it remains elevated, up 8.7% from the year-ago period, although it has come down from 9.8% in July – not much considering energy price have moved much lower, but the direction is encouraging – oil has come crashing down from $145 per barrel in July to $72.57 this morning, which brings it back to the level just prior to the Fed’s latest aggressive monetary easing (interest-rate cuts).


More specifically, we’ve been watching prices of core intermediate goods – the goods used to produce finished product and excludes energy – which does remain stubbornly high. Although, on a three-month annualized basis we have seen the degree of decline has been substantially up 14.2% vs. 21.7% in the previous reading – this will show up in the year-over-year figure next month.


In a separate report, the Commerce Department stated retail sales fell for the third-straight month, and core retail sales – which exclude gas station receipts (which have put pressure on the overall reading as prices have declined) and auto sales – fell for the second-straight month. So we can’t blame this on weak auto sales and declining gas prices.

Overall retail sales fell 1.2%, core sales fell 0.7% and the figure that funnels directly to the GDP report (sales ex gasoline, autos and building materials) fell 0.6%. That last figure has collapsed on a three-month annualized basis, down 3.8% -- that number was up 4.8% as recently as July.


For nearly three months now we talked how consumer activity was going to decline for a while as the job market remains weak, inflation keeps real income growth flat and an intense level of caution has set in due to falling home and stock prices. Up until the credit markets locked up a month ago business spending was on fire, but that all changed over the past six weeks. The economy will falter so long as capital distribution lanes remains blocked – the length of this situation will determine the duration and severity of the economic downturn. That downturn will begin to show up in the next GDP reading.

The Commerce Department also reported business inventories rose 0.3% in August, following a 1.1% jump July – these figures suggest inventory investment will offset some of the fall off in domestic final demand, and thus temper the decline in GDP.

However, the sales data dropped a significant 1.8% in August. Most of this was expected, after five months of very strong gains, but the September figure will surely mark the second-straight month of decline based on all that has occurred. Thankfully, the inventory-to-sales ratio remains low and the fact that firms have kept things very lean should help to manage this downturn. (Again though, all bets are off the longer credit remains frozen.)

Finally, the Federal Reserve issued its regional economic survey, which stated the following:

• Economic activity weakened across all 12 districts
  
• Consumer spending was weaker in many districts. Boston and New York were the exceptions – that’s interesting with the financial-sector fallout. Many districts stated consumers were more price conscious, shifting to cheaper brands
  
• Several districts reported capital spending decisions were being delayed due to economic uncertainty
  
• Manufacturing declined in most districts; several stating credit conditions were contributing to a high level of caution
  
• Real estate and construction weakened or remained low in all districts. However, the inventory of unsold homes was reported to have declined in Boston, Atlanta, Cleveland and Philly. Cleveland and St. Louis reported commercial construction was steady
  
• Price pressures have eased, but remained sticky and elevated in a number of districts
  

Hang in there and have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

Bloomberg reports the U.S. Securities and Exchange Commission agreed to back an effort by banks that may delay writedowns on some securities tied to losses that have cost companies more than $640 billion.

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JPMorgan Chase & Co. (JPM) managed a profit of 11 cents a share, down from 97 cents a share a year earlier. JPM’s Tier 1 ratio – which gauges a bank’s ability to withstand loan losses – was $112 billion, or 8.9 percent of risk-weighted assets (the minimum for a “well-capitalized” rating from regulators is 6 percent).

The bank’s retailing unit profits fell 61 percent as revenue rose 16 percent, while commercial banking earnings rose 21 percent amid an 11 percent rise in revenues. Big earnings drops were also seen at JPM’s asset-management and credit-card segments. It is not surprising at all to see the asset-management arm struggle amidst falling equity markets. JPM expects credit-card charge offs to gradually rise during the rest of the year and they plan to set aside additional reserves as the economy slows.

JPM is adding about $600 million to reserves due to charge-offs in its retail and credit-card businesses, as well as $2 billion to loan-loss reserves because of accounting issues in the WaMu deal. JPM also showed a $642 million loss on Fannie Mae and Freddie Mac preferred stock.

Revenue growth in many of its businesses is being driven by customers leaving banks perceived as weaker than JPM. With rapidly evolving banking landscape, JPM has been able to capitalize on the crisis’ victims at basement prices. After WaMu purchase, JPM is the biggest bank by domestic deposits.

CEO James Dimon said this about the company’s future: “Given the uncertainty in the capital markets, housing sector and economy overall, it is reasonable to expected reduced earnings for our firm over the next few quarters.”

Meredith Whitney is REALLY enjoying her 15-minutes of fame; the analyst is featured in this article that spotlights her questions and remarks during JPM’s conference call.

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St. Jude Medical (STJ) posted a 20 percent rise in third quarter net income, helped by strong sales of defibrillators as well as pacemakers and cardiovascular products as margins improved.

STJ narrowed its full-year forecast, projecting earnings of $2.30 to $2.32 compared with an earlier forecast of $2.28 to $2.33. STJ sells products usually covered by insurance and that treat serious problems and thus its business is less affected by swings in the economy and discretionary spending.

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The credit crunch, declining air traffic and the Boeing (BA) strike are likely to hurt earnings for the suppliers of aircraft parts including United Technologies (UTX) and Goodrich (GR).

Aerospace companies are in some ways better prepared for the current economic woes than they might have been in the past. Having survived the crisis of the 2001 terrorist attacks and subsequent wars and epidemics that damped demand for new planes, most aerospace companies now have terrific balance sheets with plenty of cash and not much debt. Fitch Ratings say that BA and Airbus (their biggest competitor) have the capability to provide several billions of dollars of their own financing if customers need help, without affecting their credit ratings.

BA machinists are still demanding that the company guarantee it will outsource less, but BA needs flexibility to react quickly to market changes by outsourcing some jobs. Considering the state of the global economy, these workers should be happy that they have jobs. When they finally do return to work, they’ll have more than seven years worth of orders to keep them busy (and then they will probably strike again). I don’t blame BA for not wanting to make any guarantees about work orders that are more than seven years away and don’t even exist yet.

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The CRB Index of 19 commodities is down nearly 40 percent from its May 2008 record as falling equities, tighter lending conditions and slowdowns in manufacturing and construction are signaling a drop in demand.

Energy was the worst performing sector today. Overseas, there were reports of demand weakening which has hurt the space in general and the coal names in particular. Refiners still cannot catch a bid despite crude falling below the $75 level as fears that consumer demand destruction will outweigh crude’s price drops. Exxon Mobil (XOM) and Chevron (CVX) both fell 13.95 percent 12.49 percent, respectively. Arch Coal (ACI) lost 17.99 percent and Peabody Energy (BTU) finished 20.65 percent lower. Drillers, Transocean (RIG) and Noble (NE), were each down about 20 percent.

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InBev’s $52 billion deal to buy Anheuser-Busch hit another snag when the InBev announced it was forced to postpone a $9.8 billion rights offering intended to help fund the purchase. InBev said that the delay would have no impact on the deal and that it still expects to close the acquisition by the end of the year. The postponed offerings are more of a speed bump than a signal that the deal may be in trouble; however, the stock price still reflects a degree of uncertainty as BUD closed today at $62.20.

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Intel (INTC) projected a larger than normal range for the fourth quarter and scheduled a rare midquarter update for December. In explaining the large guidance range, CEO Paul Otellini said, “It is clear that the financial crisis is creating some signs of stress that may impact our business, but the extent of that is difficult to quantify.”

Demand patterns were mixed due to the volatile macro environment with weakness in corporate (especially U.S.) off-set by strength in notebooks/netbooks and emerging markets (especially China). The most important number in regards to INTC’s business is their gross margins, which were strong for 3Q (58.9% from 55.4% the previous quarter). 4Q gross margin guidance seems fine, but the lack of projectability makes the number less useful. Many questions during the call were related to INTC’s new ultra-small chip called Atom, which is intended for low-end laptop and portable internet devices. The major concern with this product is that it will cannibalize sales of higher-end portables that use more expensive chips and have better profit margins.

In my opinion, these lower cost chips will allow INTC to maintain (and possibly expand) their market share in this challenging economic environment. In addition, the future of computers lies in very portable devices that perform basic computing functions and surf the internet on the same browsers as a desktop computer uses (think iPhone and, even more so, iTouch). Expect to see more of these devices released as companies try to grab market share of this growing division of computers. Because 3Q margins increased and 4Q margins are projected to be higher, Atom margins are likely better than people are estimating.

Prepared by:

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks began the day substantially higher on Tuesday, but quickly reversed course as the market looked beyond the global push to unlock credits markets and turned focus on earnings expectations. The broad market began the session up 4% but that didn’t last long, as the chart below illustrates.


People look around and probably wonder why stocks are so depressed – even with Monday’s huge rally – since the market continues to get what it wants. It wanted TARP, and got it. It demanded a coordinated central bank effort to cut short-term interest rates, and got it. The market wanted capital injections into the financial sector, and is getting it. Why haven’t we at least returned to 10,000 on the Dow?

Markets don’t always move on a dime, exactly when it may be expected after a series of intervention. Certainly, moves can be quick and substantial, but patience is needed, especially when we’re talking about rebounds from aggressive moves lower. When you least expect it, it will occur.

The major indices trade at multiples not seen in over a decade and dividend yields are too. Regarding the S&P 500 one has to go back to 1992 to see a yield of 3.00% and back then the 10-year Treasury yield was 7% -- today we’re looking at 4%, making that S&P 500 yield that much more attractive. The yield on the Dow is 3.48% and 3.96% on the NYSE Composite – these are very attractive levels. Patience will pay off, but one must have a multi-year view, we’ve got some issues to work through first and if tax rates are increased a sustained rebound will be delayed.

Only two of the 10 major industry groups managed to gain ground yesterday and financial shares were one, jumping 6.41%. This is important as it shows how much smarter the latest plan to inject capital into the sector is than the decision to obliterate the Fan and Fred shareholder.

That decision was very damaging as banks held preferred shares in those GSEs (one of the few preferreds by regulation they can own) – beyond the additional pressure this put on capital ratios, financial-sector preferreds have been damaged big time as a result of this mistake. The new plan is investor-friendly and the sector is responding to the upside, bouncing 27% from the October 9 bottom. Interesting how the sector that has put the most pressure on the market bottomed exactly one year after the broad market made its all-time high. Don’t’ know if it means anything, I just find it of interest.

Market Activity for October 14, 2008


For now, we’ll have to see the credit markets begin to flow again and get past earnings season -- especially fourth-quarter outlooks that will certainly be lower-than-expected – the four-week lock up of
credit markets have done significant damage.

Yesterday’s pessimistic tone seemed to result after PepsiCo Inc. delivered a forecast that was below expectations – although the lower forecast was only 1.3% below the original guidance and represents a 9% improvement from 2007 results. Further, the reduced outlook was largely due to a stronger dollar, which doesn’t mean things deteriorated in an overall economic sense – this isn’t like demand was significantly weaker. Coca-Cola has just reported third-quarter results and operating profit was up 16.9%, which corroborates that last statement.

After the bell, Intel reported that operating profit advanced 12.9% as sales remained strong for notebooks and other electronic goods made with their chips. This has to be somewhat encouraging. Point is at least the turmoil that has hit the financial sector didn’t do damage to this sector, and this probably means the rest of the tech-sector will report pretty good results. The concern is that the current quarter will show weakness – probably a sure thing as businesses have become increasingly cautious after all that has occurred.

We’ll all be watching fourth-quarter guidance for clues as to the degree the credit-market chaos has hit not just tech’s but other sectors as well. One should keep in mind though that firms have been low-balling guidance for five years now, so any negative comments should be viewed as worse than they actually are – I think that’s a logical concept. Nevertheless, the market may not respond too kindly to the likely pessimistic tone from corporate America -- for those with the patience to see past the current situation it means additional longer-term opportunities.

On the economic front, the Treasury Department reported that the 2008 fiscal budget deficit ballooned to $455 billion – the government’s fiscal year ended last month. This amounts to a deficit-to-GDP ratio of 3.2%. In 2007 that ratio was reduced to just 1.2% -- the 30-year average is 2.4%. For the month of September, the government recorded a surplus, which is not unusual due to quarterly tax payments.

For the year, tax receipts fell 4.5% and outlays jumped 30% -- not a good combination. On the revenue side, receipts were hurt by a weak job market (smaller tax base) and a decline in corporate profits due to financial-sector weakness. On the spending side, a 144% jump in Social Security payments and the $175 billion rebate check “stimulus” program did significant damage.

In terms of total national debt as a percentage of GDP, the figure runs about 68%. This stacks up well against other major industrial regions as the EU debt-to-GDP stands at 75% and Japan 180%. Nevertheless, we need to be very careful here, current entitlement programs are not sustainable and if not modified to come in line with demographics it will cause problems. Pro-growth policies are also a necessary condition to keeping this figure under 70%.

This morning we get a number of important economic releases as the Labor Department releases September producer prices, Commerce releases retail sales and August business inventories/sales and New York manufacturing is also released.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

The government is expected to invest up to $250 billion in the banks via preferred stock, with about half of that going to nine major banks. The FDIC will temporarily provide unlimited insurance on non-interest bearing accounts, bringing the U.S. in line with guarantees offered by several European governments. The U.S. will also guarantee most new debt issued by banks for up to three years.

******

Johnson & Johnson (JNJ) beat earnings estimates thanks to strong sales in their consumer-products and medical device divisions. JNJ reported 3Q sales grew 6.4 percent to $15.9 billion, and EPS increased 10.4 percent to $1.17. The improvement in the consumer segment is all the more impressive given the problems in the economy. Increased generic competition is slowing growth in JNJ’s pharmaceutical unit, but their diverse revenue base and robust research pipeline has the company optimistic about the future. JNJ boosted its full-year 2008 earnings forecast to a range of $4.50 to $4.53 a share, from a previous range of $4.45 to $4.50 a share.

******

Intel (INTC) beat earnings estimates and met gross margin targets despite selling cheaper computer processors (Atom). INTC’s processors are a key component of more than 75 percent of the world’s PCs, making its financial performance an indicator of global technology demand. We will have to wait for INTC’s conference call to get more details.

******

Johnson Controls (JCI) slid 6.98 percent after saying that full-year profit will fall as much as 16 percent as carmakers worldwide slow production. JCI’s CEO says he plans to leverage their strong financial position to wrestle away contracts from weaker suppliers, as well as making $950 million in capital investments during 2009 and hiring more sales staff.

******

Boeing (BA) failed to reach an agreement with their machinist union in negotiations that have spanned six weeks. Analysts estimate the work stoppage is costing BA more than $100 million in lost revenue a day since they usually get paid upon delivery. New 787 Dreamliner, which is at least 15 months behind schedule and was supposed to fly for the first time next month, is expected to experience further delays. Job security is the main conflict between BA and their machinists, but BA feels that outsourcing is an integral part of their business strategy. BA faces the additional threat of a strike by its 21,000 engineers, who have likewise listed outsourcing as a chief complaint. Final talks begin October 28.

******

JPMorgan (JPM) was left out of the financial rally and declined 3.05 percent. Investors may also be concerned about JPM’s next earnings report, which is scheduled to be release on Wednesday morning. A Citigroup analyst cut his estimates for JPM and suggested that future quarters could be weak: “We believe the near- to intermediate-term outlook remains challenged in light of higher credit costs in card and the retail bank, as well as the increasing likelihood of sustained lower revenues from JPMorgan’s capital markets business.”

******

Principal Financial Group (PFG) gained 7.71 percent today and 49.07 percent in the last three sessions. Credit Suisse notes: “One positive for PFG is that much of its separate account/equity market related exposure does not have living benefits guarantee risks, since it is predominantly a 401(k) provider versus a retail variable annuity company. Thus the risks of asymmetrical earnings leverage, hedge breakage, and substantive capital charges in a declining market are less than they are for companies with large variable annuity franchises.” Part of the reason PFG’s earnings held up better than expected is because they didn’t take sizeable variable annuity DAC adjustments as some peers have done. With equity markets remaining very weak, it is possible that this will be a source of future earnings pressure.

Prepared by:
Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks rallied, ending a tumultuous eight-session decline in which everyone watched the Dow Industrial Average and S&P 500 plunge more than 22% -- that was on top of an already 20% decline from the peak set last October. The surge marked the fifth-largest percentage gain for both the Dow and S&P 500. The NASDAQ Composite has rocketed 20% from Friday’s intraday low!

It was nice to see the strength build at the end – the opposite had become the norm.


While the degree of the response was not usual, yesterday’s market bounce was bound to occur and is quite typical -- looking back at history, powerful rallies follow aggressive moves lower whether it be the various points during the 1929-1948 period, the 1968-1982 epoch or the 1987 crash. Surely, the market also responded kindly to proposals from European policy makers over the weekend – all will be waiting to hear what our own Treasury Department has to say today on the subject of freeing up the credit markets – which we’ll get to below.

Market Activity for October 13, 2008
Obviously, on a day of such strength, all 10 major industry groups jumped in the session. Energy and basic material stocks – the hardest hit over the past couple of weeks – led the surge, rising 18.48% and 13.28%, respectively. Utility, healthcare and information technology shares were the next in line – up 13.52%, 12.43% and 12.14%, respectively. The remaining five rose between 7.28% and 10.23%.

We should be under no illusion though that this will be a V-shaped event. For sure, what has occurred over the past three weeks especially, has presented an awesome opportunity – one that does not come around often.

However, even if common sense valuation analysis has been abandoned as the de-leveraging process takes place and moves valuations below longer-run intrinsic fundamentals there are potential challenges on the horizon. Some of these challenges are things we talk about all the time, others are related to possible policy changes from a new administration and the regulations that always follow these types of events. The point of this comment is not to push people away from the equity markets, but rather to reinforce that investing is a longer-term proposition. Setting these expectations to a reasonable level actually encourages stock-market investing, for it is the unreasonable ideas that cause people to flee when their scurry for return fails to pan out.

On the credit markets, the three-month LIBOR rates and the Ted Spread came off of their highs a bit, but the bond market was closed yesterday due to Columbus holiday so it’s difficult to get a good read. The next couple of days will be telling and the market will be intensely focused on how three-month LIBOR and the TED Spread react.


These indications, in addition to the spreads between high-yield corporate debt and Treasury bonds, suggests economic weakness for at least a couple of quarters. The longer the credit markets remain locked up, to no surprise, it only extends the duration and severity of the downturn.

Over the past year we’ve heard many calls of recession, but it never came to pass, even as the housing market weighed heavily on overall growth. However, everything changed when Lehman went down one month ago tomorrow, and some level of contraction will occur as an unwillingness to lend has hit certain industries directly. Even for those somewhat immune from this situation, the caution that ensues will have a meaningful effect on GDP.

This morning the big news will be the Bush/Paulson/ Bernanke press conference to lay out the latest plan to unlock the credit markets. What we know at this point is this:
Ø The government will guarantee inter-bank lending and debt issuance. (What this does is hopefully take away some of the unwillingness to lend to one another as the measure means banks will not have a problem rolling debt.)
Ø Non-interest bearing accounts will be insured (this is huge and something former Fed Governor Larry Lindsay suggested a month ago as these are small business accounts. These accounts are used to meet payroll, and often amount to more than the $250,000 currently insured. This takes away a bank run concern because if businesses believed a bank was going down they wouldn’t hesitate to pull funds.)
Ø They will buy bank preferred shares to inject capital into the financial system. (These will be non-voting shares and have a 5% yield that will move to 9% after five years if a bank does not raise private capital and call those shares – that’s good news and will get the government back out one hopes. $250 billion of the $700 billion TARP plan will be used to fund this – and yes, this was an original option within that plan)

These plans seem to have widespread backing as even people such as William Poole from the Cato Institute – a libertarian think-tank -- are in favor of the idea. Poole has been one of the most out-spoken opponents to what Treasury has proposed heretofore.

The really important aspect of this last point is that the Treasury’s terms seem to be friendly with regard to private investment. It is essential that these measures do not scare away private capital – or obliterate it like what occurred with Fan and Fred – a terrible mistake.

Overall, the great unknown is will all of this intervention only prolong the problem – surely a very significant problem – and have unintended consquencs that make things even worse or will it be successful in averting something that is terribly severe. This is the great question that will only be known after the fact.

Futures are nicely higher on the news, but with government officials talking today let’s hope we hold onto early gains – it has become the trend for the market to sell off just about every time these people step to the mic. and begin speaking. Let’s hope it’s different this time.

Have a great day!



Brent Vondera, Senior Analyst

Afternoon Review

Markets rallied on a Fed-led plan to flood the global financial system with dollars, as well as reports that government equity injections will be aimed at “healthy” firms, will be voluntary and have attractive terms to encourage participation.

Japan’s biggest lender, Mitsubishi UFJ, purchased $9 billion of Morgan Stanley preferred stock (with a 10 percent dividend) and will now own 21 percent stake of the investment bank. Moody’s Investors Service said the investment from Mitsubishi UFJ is “critical” for Morgan Stanley to keep its current credit ratings (A1 long-term debt rating was on review for downgrade on October 9). This is the second overseas investor to take a significant stake in Morgan Stanley. China Investment Corp. paid $5.58 billion for equity units in MS that pay 9 percent a year and convert to common stock in 2010, granting CIC about 10 percent of MS.

Principal Financial Group (PFG) surged over 26 percent after reassuring investors by saying it sees operating profits in 3Q of $0.92-0.97 per share, versus the Reuters forecast of $0.93. PFG called the results “very solid,” particularly in light of weakness in the economy and extreme market conditions, and said its capital position improved from 2Q to about $375 million in excess of levels needed to maintain a AA rating. PFG cut its annual dividend in half to $0.45 per share and will suspend its stock buyback, which it termed as prudent capital management in the volatile environment.

AT&T (T) rose 16.28 percent. AT&T, fighting cable companies for customers, announced that it will sell its U-verse high-speed Internet service at Wal-Mart Stores and Circuit City Stores, the first national agreements to sell the products at retailers.

Total System Services (TSS) earnings came in short of estimates, but weren’t disastrous (due to recurring revenue model) considering the challenging operating environment. Revenues were slightly higher, but margins were notably weaker. Card accounts were down due to client purges of inactive accounts and the loss of a $12 million pre-paid account from Nordstrom. Potential client losses ahead as WaMu (WM) and Wachovia (WB) represented roughly 4.5 percent of revenues for TSS, and could potentially be absorbed by JPMorgan (JPM) and Wells Fargo (WFC). TSS’s processing contracts with WM and WB haven’t been made yet, but JPM does most of their consumer card processing in-house, while WFC processes with FirstData. The combination of potential client losses, purging of accounts, and continued weakness in financials and the global economy appears to have kept investors cautious.

United Technologies (UTX) said today that it has withdrawn its $2.6 billion offer for Diebold, the maker of automated teller machines and electronic voting machines. UTX had offered $40 a share after having pursued Diebold for two years. In Diebold, UTX sought to expand its electronic security business with on of the field’s largest players. Last year, UTX bought Initial Electronic Security Systems for about $1.2 billion.

Great article in the Deal Book, about the large deal spreads (current price vs deal price) that has some good insights the InBev – Anheuser-Busch deal and includes some possible obstacles to such deals. InBev’s $50 billion acquisition of Anheuser-Busch (BUD) has with a deal spread of about 10.8 percent, down from 19.4 percent on Friday. Dow Chemical’s (DOW) $15 billion acquisition of Rohm and Haas (ROH) has a deal spread of about 20.4 percent, down from 28.5 percent on Friday.

Last week, Controladora Comercial Mexicana SAB, the third largest retailer in Mexico, filed for bankruptcy reorganization after defaulting on 400 million pesos in commercial paper. Likely a positive for Wal-Mart (WMT), which has seen a slowdown in Mexican business of late. WMT believes it could benefit by gaining additional market share. Approximately 25 percent of the total square footage of Wal-Mart International is in Mexico. Wal-Mart International contributes roughly 26 percent of total company sales and 21 percent of total company operating profit.

Lots of big earnings reports this week…

Tomorrow we will get a first look into the technology sector with Intel (INTC) reporting earnings. The most watched aspect of the report tomorrow will not be the 3Q results, but the 4Q and forward outlook. Many expect to see tech spending weakness. This is a good article from Bloomberg on tech budget cuts. As for INTC, they have one of their strongest product lineups in years. Their microprocessors serve as the “brain” for most personal computers. INTC has done particularly well in portables, which to little surprise has began to outsell desktop models on a global basis. INTC trying to expand by promoting low-end laptops called netbooks and new pocket-sized devices for surfing the Web (think iPhone-like browsing ability).

Also reporting earnings tomorrow is Johnson & Johnson (JNJ), who should serve as a good indicator for health care markets.


Prepared by:
Peter Lazaroff, Junior Analyst

Buying where others fear to tread

Chris Lissner appeared in David Nicklaus' Sunday column in the St. Louis Post-Dispatch.

Click here or the logo to see the article.

Daily Insight

U.S. stocks ended a horrible week on a down note Friday; however, the late-session rally was encouraging as the pressure the market has endured over the past three weeks has normally been met with late-session deterioration.

Friday’s session was a wild one, as illustrated by the chart below. The Dow Industrials, for instance, began the day down 700 points, bounced all the way back to positive territory 40 minutes later, languished for a while, moved back down to that intra-day low, roared back – gaining 1022 points from that low --, then down 5.1% from that peak in the final 30 minutes. (The chart below shows the broad market – S&P 500 -- was down 7.7% at its worst, rallied 10.9% from trough to peak and then down 6.8% from that high in the final minutes. However, to end down just 1.1% after getting off to such a horrid start is a major victory in our view)


The indices settled at 8450 on the Dow and 899 for the S&P 500, which brings us back to May 2003. The first time we crossed these levels was August 1997 for the Dow figure and November 1998 in terms of the S&P 500’s current quote.

Market Activity for October 10, 2008
As we mentioned last week, the G7 convened this weekend in an attempt to coordinate a strategy for unlocking the credit markets by getting banks to lend to one another for a period longer than just overnight. They failed to get a unified strategy together, which with credit this frozen is pretty much a joke in my view.

The three-month LIBOR chart illustrates the unwillingness to lend.

The TED Spread illustrates heightened aversion to risk. This is the spread between the rates on three-month LIBOR and three-month T-bills. LIBOR rates are high because banks do not know which will be the next to go down and T-bill rates are super low as investors flood to the safety of the Treasury market. That three-month T-bill currently yields 0.18%, which shows many do not care to get paid on this money, so long as they get their dollar back.



On this G7 action, there are plans being discussed but it has been a lack of very specific details that has done more harm than good to this point – investors, specifically private equity, will not step in until they have a good sense what will actually occur. Why step in if you’re going to be wiped out by government capital injections – much like what occurred to Fan and Fred shareholders. Thankfully, we have heard comments that capital injections will not be punitive to current investors, which is huge – although the market will want to see promulgation.

The Europeans – while unable to find unity (you think there’s a lack of unity in the U.S. try throwing 27 different nations into the mix) -- did get some piecemeal responses accomplished and the market seems to like it as futures are up big – although one never knows if this is simply a bounce back from last week’s plunge.

The EU laid out four main points:
1. Rescue banks when needed, which will mean nationalization in most cases
2. Inject capital in other instances
3. Loosen mark-to-market rules (unfortunately, I don’t see anything concrete here. And this goes for the U.S. as well – no official decree)
4. Guarantee bank debt issuance and inter-bank lending.

For the U.S. there’s word the Treasury will lay out their overall strategy tomorrow, but it better include specifics – let’s see if Treasury has learned from the mistakes of the past couple of weeks; the details must be crystal clear.

Moving on to Friday’s economic releases

The Commerce Department reported the trade gap narrowed 3.5% in August to $59.1 billion as export activity fell less then imports declined. Adjusting for inflation, which are the figures used to calculate GDP, the trade deficit shrank to the lowest level since December 2001.

We’ve talked about the trade deficit figure many times over the past several years, as long-time readers know well, and have often stated to those that desire a narrower trade gap to be careful for what you wish – it takes economic weakness to accomplish this in a global economy that offers the free-flow of goods, services and capital across borders. Now, we have that weakness and like clockwork the trade gap narrows. It’s important to point out though that the current economic weakness is not due to the trade deficit – as Keynesian economists attempt to portray it -- the cause and effect is flipped in reality.

Exports declined 2.0% in August as overseas economies weakened – this marks the largest monthly decline in four years for exports. Imports fell 2.4% in August, largely due to falling oil prices. Excluding petroleum, imports rose slightly, up 0.9%. Still, import activity was weak across the various segments, the only bright spots were telecom equipment, pharmaceuticals and apparel.

In a separate report, the Labor Department stated import prices fell the by the largest margin since April 2003 – falling 3.0% in September. Although, that is a decline from a peak that marked the highest rate of import price growth since 1982 just two months back. The year-over-year change remains at an extreme elevation, but a stronger dollar value will assist this figure in coming lower.


A 9.0% drop in energy prices led the overall decline. Excluding petroleum, import prices dropped 0.9% and are not off the high by all that much on a year-over-year basis, as the chart below illustrates.


As stated above, stock-index futures are up big this morning. The first step will be to see the market hold onto early-session gains, and then we’ll see if we can get a multi-day rally going.

One can see a huge bounce back from the damage that has occurred in just a three week period – the broad market is down 28% over the past three weeks – 18% of which occurred over the previous five sessions. Those declines are on top of the 20% fall from the peak (hit in October 2007) that took roughly a year to play out.

But the next clues will be the credit markets – spreads, such as the TED and LIBOR charts posted above will have to come lower – and fourth-quarter earnings guidance. That guidance will be very important in assessing how the credit-market chaos of the past three weeks has hurt expectations for the non-financial sectors of the economy. Even then, things won’t be completely clear. We’ve had firm’s low-balling guidance for five years now and one has to expect, even if they see things are not terrible, they’ll certainly be very cautious with their forecasts in this environment.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks slid in the final hour of trading yesterday as concern grew the credit-market situation, which tightened further, will spread into other industries, according to the financial press. I believe that was a concern already, if fact we all know it was the case. The sell-off was more a function of de-leveraging and growing fear, which drives things well-below justified valuations.

The fact that things fell apart to such a degree in the final hour likely suggests the plunge was due to hedge-fund deleveraging. Look at the most liquid stocks, many of which took the worst beating; those that had to sell when redemptions flooded in sold whatever they could. It’s quite likely in my view large-cap stocks will show the largest bounce when the indices rally again.

The Dow moved to the 8,000 handle, closing at 8579 for the first time since May 2003 – the index has lost 16% this week, which I believe is on pace for the worst weekly performance ever. The broad market, as measured by the S&P 500, has plunged 27.4% since September 19 – down 17.2% for the week.

First chart represents yesterday’s session; the second shows the last 18 months.

So much for the thought that removing the short-sell ban would push the indices higher, that was a moronic statement. (The logic was that hedge funds may come back to the market as they would now be able to put on the appropriate hedge – can scrap that idea).

Market Activity for October 9, 2008


I don’t know call me crazy, but maybe the charts below (pay-to-play odds on the election outcome) have something to do with the pummeling too. When investors, especially those of whom may not have a multi-year time horizon, fear that capital gains and dividend tax rates may be jacked higher, I’m going to guess it doesn’t exude a pleasant feeling to say the least.

I’m going to guess, with all that is occurring, specifically the credit markets shutting down and the economic contraction that is quite likely to ensue, investors probably aren’t getting a great feeling about a filibuster-prove Senate either.

The activity in the stock market over the past three weeks and specifically the past seven trading sessions, seems to be pricing in a serious recession. We’re are not headed for a downturn that is worst that anything we’ve seen in 30 years – the typical recession seems about impossible to escape though the longer credit markets remain this locked up; heck, the stock market activity alone will surely push spending lower, whether it be the consumer or business as caution is heightened. However, if the market is pricing in an Obama victory – and much worse an Obama/Reid/Pelosi run government – it means it is pricing in higher tax rates and tariffs (major changes in our international trade agreements). That would mean an economic coma in this environment.

And before any Obama lovers send me hate mail, I’m going to rip on the current administration below – this is not about whom I want to win in this election, it’s about policy and it’s about proper communication.

Another Treasury Proposal

The Treasury Department reported they may begin a program to inject capital into banks, much like the UK plan announced the day prior. The TARP plan includes the ability to do this – using some of the $700 billion to directly inject capital in exchange for currently traded preferred shares to protect the taxpayer. These positions must be sold back to the private sector once the crisis passes, that’s imperative.

As the Editorial Board of the WSJ stated yesterday, when the private sector won’t provide the capital in this current period of fear public-sector funds must be used to throw the life-preserver.

As we touched on yesterday, it is better for Hank Paulson to wait until something is put in place before making statements. The market could give a damn about talk, it wants action.

Besides, everyone knows that I believe a couple of the Treasury’s major plans will work quite well. But they have a problem with communication – a contagion within the Bush Administration. It’s quite likely poor communication has meant a 2,000-point swing in the Dow – instead of losing 1,000 from 9500 it very well should have rallied 1,000 to 10,500.

Take this capital injection, for instance. Do not state such a plan without specifics, the market will think they’re going to bring out the hatchet. Moral hazard? This is something many have worried about with all of this government intervention. Not with these guys.

This capital injection plan can work very well, but Treasury must make it clear that they won’t do what they did with Fan and Fred – destroying the preferred shareholder, many of which were the very banks that need help. Lay the plan out when you bring it, and it must state three things loud and clear with regard to government stakes in preferred stock:

• No voting rights
  
• Not senior to any other preferred series (so the currently held shares won’t be blown out – don’t penalize shareholders here; support them)
  
• Get out ASAP (as soon as this crisis has waned)
  

Commercial Paper

Total commercial paper (CP) outstanding fell $56 billion in the week ended October 8, which puts the total decline over the past four weeks at $264 billion -- total outstanding is $1.55 trillion.

Financial company CP fell $42 billion and is down $175 billion over the past month – financial CP stood at $825 billion a month ago, that $175 billion decline marks a 21% plunge. Non-financial CP outstanding rose $3.6 billion in the past week to a total of just over $200 billion, that’s the bright side.

The dark side is that financial and asset-backed CP continues to decline rapidly and signals the need for the Fed to get its Commercial Paper Funding Facility operating in quick order.

On the economic front, the Labor Department reported initial jobless claims fell 20,000 in the week ended October 4 – although, the figure remains elevated due to the hurricanes that tracked through the Gulf in September. The report showed these weather-related events added 17,000 in jobless claims so adjusting for this claims would have dropped substantially.

The four-week average of claims rose 8,250 to 482,500.

The hurricanes resulted in an increase of 50,000 in claims in last week’s data, but the overall figure only rose 2,000 – so plenty of distortions then as well. This is good news but we should be prepared for claims to remain elevated as small business in particular has been hurt by the credit market freeze up.

Continuing claims remain elevated, the highest level since June 2003 – which was three months before the labor market began to turn around coming out of the 2001 downturn. Thirty-five states and territories reported an increase in new claims, while 18 reported a decrease. These aspects of the data likely underscore the deterioration in the job market we’ve seen of late.

The G7 will convene this weekend and I’ll go out on a limb and say they’ll come back and have decided on two things:

One, they;ll state global governments will guarantee lending between banks.
Two, there will be a coordinated effort to suspend mark-to-market accounting for securities that currently have no market. (The U.S. has proposed this but I do not believe it has become offical. Besides the standard needs to be change on a global scale for conformity’s sake)

These two events should bring inter-bank lending rates lower and a willingness to lend to one another. At which point businesses, specifically small business, will begin to see capital and credit flow in their direction again. I’m still waiting for a tax-rate response as well, which would provide a big boost to confidence – to offer nothing in this regard is a major mistake in my view

Hang in there and have a great weekend!

Brent Vondera, Senior Analyst

Daily Insight

What a difference a year makes. It was a year-ago today the Dow Industrials Average and S&P 500 indexes touched their all-time high – 14,164 on the Dow and 1565 on the S&P 500. Nine-trillion dollars in stock-market value was created during the bear market that began in the spring of 2003 to that peak, as measured by the NYSE Composite – today that rise in stock-market wealth stands at 44% of that figure, 4.16 trillion.

U.S. stocks bounced around again yesterday – and the swings were significant – but we gained momentum going into the afternoon session and appeared poised to close strong. But then Treasury Secretary Paulson stepped to the microphone and…well, the same thing happened that occurs just about every time a government official open his mouth, the rally fizzled. (And no, I’m not being sexist here because the pronoun is correct; I won’t disparage the other gender because when FDIC Chair Sheila Bair speaks the stocks market does not retreat.)


I’ve been pretty hard on Paulson in the past – he’s weak on the dollar, failed to convene the G7 as the FOMC was digging a larger hole for the greenback and has offered zero with regard to a tax-rate response to this entire mess – big mistake.

But what he’s proposed with the TARP plan has a great shot of freeing up the credit markets – assuming the auction does not end up being rigged, can’t rule that out; this is the government we’re speaking of. Really though, you’ve got TARP passed and signed, please don’t step to the mic. again until you’ve got something constructive to say and your ducks are in a row to buy, buy, buy.

Market Activity for October 8, 2008 At midnight the short-selling ban expired, that ban pertained to something like 800 stocks, and conventional wisdom may assume this will result in more pressure for stocks. Not sure about that though, the indices may rally on the news as hedge funds come back in to buy now they have more freedom with putting proper hedges in place. These market participants may have sat out while the ban was in place.

IBM announced quarterly results earlier than expected, stating operating earnings rose 22% last quarter and margin growth was strong, widening to 43.3% from 41.3 a year ago. Revenue growth was a little light, surely the woes in the financial sector have caused some issues, but it was a good decision to pre-announce in this environment lest rumors take over and crush your stock.

Overall earnings will be weak for the quarter, no getting around that, but maybe tech-land will be stronger than most expected.

On the economic front, the National Association of Realtors (NAR) stated pending home resales unexpectedly rose 7.4%, as the median price of existing homes fell sharply in August.

One has to expect home sales to fall further, especially with how locked up the credit markets are, but mounting foreclosures are helping the sales data and this may help to offset the credit-market issues – pending home sales are an arbiter of the direction sales will take over the subsequent two months when these contracts close.

By region, pending sales were up 2.3% in the South, 3.6% in the Midwest, 8.4% in the Northeast and soared 18.4% in the West.

Digressing

I ran across an article Monday night that stated how the slide in home prices has left nearly 16% of homeowners with a higher mortgage than the home is currently worth. (I’m not sure all of this is because of the fall in home prices, as a decent percentage of these people have been in their current home for several years – and home prices are higher going back to mid-2004 --, but rather because they took advantage of home-price gains in previous years to refinance and take cash out. Others of course put no money down and so it doesn’t take much to go underwater – it is pathetic though to see so many just walk away, not even trying to make the payment – as if the price of the property will not rise over the longer-term)
Anyway, the article points to the need to offer programs to these individuals to keep them in their homes.

No. What we have here is a total neglect of obligations – complete irresponsibility.

These people must not be bailed out in a direct way – of course a series of government action will bail those that made really bad decisions in an indirect way, but it may also insulate the rest of us from going down with them. The Treasury’s TARP program will offer indirect assistance to those that made bad choices, but this program is essential so that those that have lived their lives responsibly are not harmed by a bevy of mistakes made by the Fed, Congress and individuals themselves.

The most effective solution to this situation is three-fold as I see it:

• One, TARP is essential. These troubled assets must be removed from bank balance sheets.



• Two, the SEC and FASB must at least modify mark-to-market accounting – and hopefully kill the wretched rule, that is FASB rule 157.



• Three, broad-based tax cuts are imperative. Reductions in capital gains, dividends, labor income, repatriated income and corporate earnings will spark growth, increase earnings and after-tax income, rally stocks, bring more capital home, boost tax receipts, and promote jobs.

Many continue to miss the fact that broad-based reductions in tax rates do result in more tax revenue – the evidence is there; one only needs to review what occurred in the 1960s, 1980, late 1990s and the current epoch, save the last year as corporate profits have been hurt by financial-sector woes, a rebate check scheme immediately added $175 billion to the 2008 deficit and everything that has occurred since.

But we shouldn’t forget that the three fiscal year running 2005-2007 saw the largest rise in tax revenue ever, jumping $785 billion in that three-year period. Let’s not forget, the 2007 budget saw the deficit narrowed to just 1.2% of GDP from 3.9% in 2004 after the downturn of 2001 and trillion dollar hit to the economy from the 9/11 attacks.

Cutting tax rates in a broad-based way increases revenue for two main reasons:

One, with regard to capital gains more investors are willing to pay the tax at a lower rate – we all know this story. Further the after-tax return expectations that result push stock prices higher, which results in additional gains – lower dividend tax rates have the same result.

Two, lowering income tax rates means higher after-tax income, which promotes growth. Also, and what many fail to acknowledge, is that two-thirds of the top tax bracket is made up of small businesses, and as after-tax profits rise for the largest job creator within our economy they hire more – thus increasing the tax base.

So lower tax rates are vital to growth, both for the private sector and in terms of tax revenue. We face many challenges over the next couple of decades and growth will be essential to meet those challenges.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks endured another harsh session yesterday after beginning the day up 170 points (for the Dow), but plunged from that intra-day peak by 680 points. We talked about a coordinated rate cut by various central banks yesterday, many seem to be blaming yesterday’s weakness on the fact that this did not occur.

Well, literally as I type, the Fed, Bank of England and ECB (European Central Bank) have just done so – all cutting their benchmark rates by 50 basis points, or one-half of one percent. Frankly, I’m not sure what a rate cut does, if banks are unwilling to lend credit spreads will not ease. As I look, these spreads remain wide and in fact the TED Spread, three-month LIBOR and LIBOR OIS are all wider, or higher in terms of 3 mos. LIBOR, than yesterday.

However, stock-index futures have turned around nicely; let’s hope we can hold onto those gains as the actual session progresses.

Market Activity for October 7, 2008

Another Fed Facility

The Federal Reserve continues to add liquidity and shoot it to where they see its most needed. Yesterday they announced creation of the Commercial Paper Funding Facility (CPFF) in which to purchase commercial paper (CP) and create a liquidity backstop for U.S. issuers. The facility will directly purchase three-month unsecured and asset-backed CP through April 30, 2009.

Outstanding CP has shrunk to a three-year low, interest rates on this short-term funding used by businesses has risen substantially and an increasingly high percentage of outstanding paper must be re-financed daily, according to the Fed.

The CPFF should help to improve confidence in this very important segment of the credit markets since CP investors will know the Fed stands as the purchaser of last resort in event an issuer has difficulty rolling paper.

Yields on top-rated overnight CP dropped 0.74 percentage point to 2.94% on the news – this is used to finance day-to-day operations.

On the economic front, the Federal Reserve released their minutes from the September 16 FOMC meeting. These are things we talk about each day, and since the minutes pertain to what occurred largely in July and August it’s a bit outdated, but worth mentioning nonetheless.

• Economic activity decelerated considerably in recent months.
  (Actually, I would re-phrase this. The economy was rebounding pretty nicely. Consumer spending was weak, but the business side of things looked very capable of offsetting this reality – business spending was on the rebound. However, business expenditures came to a halt in the back-half of August after three-months of nice gains. September, even though we do not have the data yet, will surely prove to be very weak as credit conditions locked up and firms either became cautious or saw funding dry up.)
• The job market declines accelerated, according to the Fed.
  (And it got worse in September, which the Fed minutes did not cover. Prior to September the job losses were mild, but moved to a level that is more in line with the typical job-market downturn.)
• Consumer spending has weakened.
  (And we can expect this to remain the case for a couple of quarters. The numbers may appear flat, but adjusted to inflation they will very likely remain soft).
• Inflation rose rapidly in July, but edged lower in August.
  (The Fed has bigger problems right now, but they should be careful with these comments. Inflation remained elevated in August by a variety of measures. The PMI and ISM surveys (factory-sector indices) and consumer level gauges remained high – even if down from extreme elevation. Plus, despite a dramatic decline in energy prices, producer prices rose 9.6% year-over-year in August (latest data) and core intermediate goods – goods excluding energy that go into producing finished product -- accelerated in August to 12.5% year-over-year).
• Credit conditions deteriorated
  (We know this all too well).

And speaking of credit, the Fed reported that consumer credit declined in August for the first time since 1998 – the previous period of credit-market chaos.
Credit by this measure, which includes both revolving (credit cards) and non-revolving (auto loans) fell $7.9 billion in August, or 3.7% at an annual rate. (This data does not include mortgages or home-equity loans).

This reduction illustrates the credit crunch that truly began that month, one wonders how much the figure will contract when the September data is released. Some of this isn’t all that bad as certain aspects of debt need to come down, as consumer credit growth has outpaced the rise in disposable income by eight percentage points since the end of 2002. Not a terribly big deal, but you really don’t want credit outpacing income growth. I think it’s safe to say this game is up for a long time.

Further, in light of all that has occurred, it is safe to say it’ll be a long time before investors take on substantial levels of risk without correctly pricing it in. This of course is a result of monetary policy mistakes as a lot of investors sought extra yield as Fed policy was recklessly easing even as the economy was hitting on darn-near all cylinders – we’re talking about the mid 2003-2005 period. When the history is written the Fed will bulk of the blame for this one.

Downward Pressure

The downward pressure on stocks weighs heavily on everyone. Since hitting an all-time high a year ago tomorrow, the broad market is off 36% -- 20% since September 19.

A couple of things on this:

One, we’ve got to suppose that many understand things have shot well too far to the downside. One looks around and sees an ocean of stocks that offer healthy-to-strong earnings growth (this comment is not based on expectations but on many years of bottom line growth) and trade anywhere between 8-12 times earnings. And look at the indices here and the dividends yields that are offered. The S&P 500 carries a yield of 2.99%; the NYSE Composite carries a yield of 3.92% at yesterday’s closing price; the Dow Average yields 3.36%. These are not only strong yields for entire indices to offer in a very very low interest rate environment, these yields help to boost annual returns for those interested in looking past the current mayhem.

But most do not seem willing to remain invested – and I’m talking about money managers; it’s difficult to explain to clients why they shouldn’t be at 50% cash in this environment; it’s much easier just to sell – as they worry more about their jobs than doing what is right for clients’ long-term perspective. But this is a sprinter’s view; investing is a marathon.

Two, the S&P 500 is back to its October 2003 level, yet the index is still higher by 24% since March 2003. The NYSE Composite is back to its August 2004 price, yet up 43% since March 2003.

You see where I’m going here. This points out that when stocks swing back they do so in a dramatic way. Even when the S&P 500 hit its peak a year ago -- it was up 95% from when the market turned around in March of 2003 coming out of the tough 2002 period – half of that gain occurred in the first 11 months of the new bull market. And I can tell you from memory even well into 2003 there were a lot of people hesitant to step in. Point is you wait for when it feels good and you miss out on a lot.


You don’t sell on panic here; you remain invested, and for the current situation it does make some sense to wait and watch for what the credit spreads signal – when they narrow, that should be a green light to step in with money on the sidelines.

Of course compounding the market’s issues are two presidential candidates that find it easier to castigate capitalism – as if distortions are never supposed to occur – than to offer fundamental solutions. Instead, they should lay blame with the Fed, government policies that demanded more sub-prime lending, individuals that made poor decisions and insane accounting rules and offer solutions such as growth-inspiring tax rate responses, as we touched on in Monday’s letter.

Hang in there and have a great day!

Brent Vondera, Senior Analyst