Daily Insight

U.S. stocks gained some ground in a holiday-shortened session on Wednesday, halting a two-day decline. Better-than expected economic reports helped the major indices advance.

We’re headed for the worst annual performance on the S&P 500 since 1931 (although I’ll add that the 47% decline that year followed a 28.5% decline in ’30 and a 12% loss in ’29, so the current move is more in line with the 1973-1974 period – down 47% combined – than the years of the last depression. This year’s performance will end a five-year winning streak).

In any event, we may find a rally here in the final four days of the year as tax-harvesting may have run its course. Still, mutual fund managers will want to show high cash balances for quarterly statements, so any gains should be subdued.

Reports on personal spending and durable goods orders, while weak, came in above expectations. The durable goods report showed business spending actually rose 4.7% last month and that helped sentiment.

Market Activity for December 24, 2008

The equity markets have meandered for three weeks now, but at least the moves have been relatively subdued. We have given back a quarter of the 20% rally off of the November 20 multi-year low but that leaves us 15% above that mark. The market appears to be in a feeling out process; no one knows which way things will go but based on similar bear markets – for instance the 1974 bear – there’s a good chance we’ll rally from here.

We may test those lows again, but the de-leveraging event has pushed us below where we should be from a fundamental perspective. For sure there’s a lot of bad news out there, but with the NYSE trading at 13 times trailing earnings with a 4.54% yield (remember the 10-year Treasury carries a 2.16% right now) and the S&P 500 trading at 14 times the consensus estimate for trough earnings (generally the trough earnings multiple is significantly higher than this) stocks have the bad news, and then some, priced in.

Stocks will have to face additional tough forces over the next year – higher regulations, the prospect of higher tax rates, what I believe will be an energy policy that is not conducive to growth, a likely inflation event that will force the Fed to substantially raise rates and will drive long-dated Treasury yields much higher and a new president that may be tested by Islamic radicals, just as the prior two were just months into office – hopefully changes over the past seven years have helped us thwart attacks.

However, we’re trading at very low levels right now and a nice rally is warranted. Further, if any of the stated concerns do not come to pass, stocks will respond positively as a result. Still, without a tax-rate response to the current issues, it is unlikely the next couple of years will be an easy ride. An economy has never spent its way out of a problem and we’re guessing without a reward for success and measured risk-taking (by driving tax rates lower on capital and income) we’re not going to prove history wrong this time.

The government crammed in a bunch of economic releases on Wednesday, some of which would have normally been due out yesterday, so we’ll touch just briefly on each one to keep from getting too long.

Mortgage Applications

The Mortgage Bankers Association’s index of applications to buy a home or refinance a loan rose to the highest level since 2003, jumping 48% in the week ended December 20. The groups’ refinancing gauge rose 63% and purchases gained 11%.

The average rate on the 30-year fixed-rate mortgage dropped to the second-lowest level on record. Let’s hope these rates are low enough to at least partially offset what has become an additional drag on the housing market – a weak labor market.


Durable Goods (November)

The Commerce Department reported that durable goods orders fell 1.0% last month; however, the reading was much better than expected as a decline of 3.0% was anticipated. We’ll note the revision to the October data was revised downward big time, coming in at -8.4%. Significantly lower than an already large 6.2% decline previously estimated.

The ex-transportation reading on durables actually increased in November, rising 1.2%. This is a big surprise and, even if it’s off of a horrible 6.8% drop in October, should be viewed as a good sign.

Non-defense capital goods ex-aircraft, a proxy for business spending within the report, rebounded in November, up 4.7%. However, for the quarter this segment is down 21.6% at an annual rate. A huge reversal from what we saw in the second quarter and first-half of the third as the figure was up 15.25% at an annual pace. This shows how quickly things changed in mid-September.

Overall, for the first two months of the fourth quarter total durable goods are down 41.6% at an annual rate, which puts orders on track for one of the largest quarterly declines ever. The intensification of the credit crunch, the Boeing strike and Hurricane Ike (which made landfall last quarter but affected the first month of this quarter) have combined for the perfect storm to hammer durable goods orders and manufacturing and industrial production in general.

Personal Income and Spending

The Commerce Department also reported that personal incomes fell 0.2% in November, marking only the second monthly decline in the past three years.

So, we’re beginning to see some meaningful deterioration in incomes as the year-over-year reading has dropped below 3.0% -- it came in at 2.5% from the year-ago period for November. Compensation was up just 1.7% in November. The wage and salary segment was up 1.5%. Proprietor’s income fell 1.7%. These are year-over-year readings.

On the positive side, dividend income, while down from high single-digit growth six months back, has held up pretty well, up 3.6%. (The decline in financial-sector payout rates has put pressure on the figure). Rental incomes continue to soar, more than doubling on a year-over-year basis as the housing market correction has fueled rental occupancy rates.

Personal spending fell 0.6% in November, marking the fifth-month of decline -- although, the drop last month was less than estimated. That’s on a nominal basis. Adjusting for inflation, real spending rose 0.6% in November, marking the first increase since May.

We’re looking for the December reading to break this nominal spending trend. Bad weather across the nation over the past two weeks may have held things back a bit, but the 65% decline in gasoline prices has left significant cash in consumers’ pockets and this should show up in the December figure. The plunge in energy prices has brought overall levels of inflation down to almost nothing, so real incomes remain positive, which is meaningful.

Consumer will continue to boost cash savings, as their main savings vehicles – the home and stock market – have endured major damage. Still, the decline in gasoline prices is very powerful and even if the December spending figure fails to show a bounce, it will occur over the next couple of months.

Inflation Trend

Inflation has been led lower by a plunge in energy prices and this should not be confused with what’s known as monetary deflation. While consumer activity must be affected by a deteriorating labor market, the current decline in energy prices is great news for the U.S. consumer and should help to drive spending in other areas over the next couple of months.

The inflation gauge tied to the personal spending data (the PCE Deflator) showed overall price activity came in flat during November (no change from the October reading) and has dropped to 1.4% on a year-over-year basis from as high as 4.5% in July. So this massive deceleration in the rate of inflation should help to augment consumer activity. That said, we do not believe inflation will remain tame; this is a transitory event.


The massive liquidity injections by the Fed will combine with an infrastructure-based stimulus program -- that will likely reach $1 trillion when it’s all said and done -- to kick up commodity prices again and thus overall inflation. But that’s another story and likely several months out.

Jobless Claims

The Labor Department reported that initial jobless claims jumped 30,000 in the week ended December 20 to hit 586,000, remaining at a 26-year high.

While this is a very elevated level, as we continue to point out, claims of nearly 600,000 are not what they were back in 1982 when civilian employment stood at just 99 million, today it stands at 144 million. Adjusting for the increase in employment, we’d need to see claims hit nearly one million to match the 1982 level. We think this perspective is important.
(That 144 million figure comes from the Household Employment Survey, which includes the self-employed. The Establishment Survey, which measure just payrolls and excludes the self-employed, stood at 88 million in 1982 and stands at 136 million today. This does not change the prior point, I just want to clarify that there are two different surveys to view.)

The four-week average of initial jobless claims continues to rise, increasing 13,750 to 558,000 – the eighth week of increase.


We’re without an economic release for the next two business days, so things will be quiet as they normally are in the final week of the year.

On Tuesday, we’ll get some home-price data and manufacturing activity out of the Chicago region. On Wednesday, mortgage apps and jobless claims – again a day ahead of the normal schedule as Thursday is another holiday.

Have a great weekend!


Brent Vondera, Senior Analyst

Fixed Income Recap

Thin Markets Hurt Auction
Today’s $28 billion five-year auction suffered from a thin market and the rest of the Treasury market suffered as a result. However, it is difficult to draw anything meaningful from market movements during the holiday season when most trading desks are half staffed. The 5-year was off about a half point in price after the auction before rallying back in afternoon trading to yield about 1.44% late in the day.

Mortgages have widened to comparable Treasuries over the past week, but again, volatility must be taken with a grain of salt given the thin markets at year end. The spread between thirty-year MBS and the 10-year Treasury has widened about 30 basis points from this time last week.


Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks dropped for the second-straight session (down four of the past five following that 5.1% move on the day of the FOMC meeting) as we’re all but out of time for that Santa Claus rally a number of financial-press articles predicted over the weekend. There are just too many people hiding in cash, and surely mutual fund managers want to show heavy cash positions for year-end reports, while tax-loss trading puts pressure on what is already a light-volume week.

Yesterday’s economic reports didn’t help matters either, as data showed the housing market continues to weaken and the final revision to third-quarter GDP corroborated what the previous estimate told us, the economy contracted during the July-September period.

What’s more, profit reports are illustrating that corporate earnings will have declined substantially this quarter.

While we’ve seen overall S&P 500 profits decline for five quarters now, this has mostly been a financial-sector story. Ex-financial profits have remained positive during this stretch, expanding upon the 20-quarter post-WWII record of double-digit profit growth for total S&P 500 profits. This will not be possible when Q4 earnings season kicks off in a couple of weeks, we’ll see widespread deterioration.

That said, the market has discounted this deterioration in earnings as the conspicuous 46.9% decline on the NYSE Composite illustrates. This is not to say things will be a cakewalk from here, we’re just pointing out that there isn’t much – from an economic perspective -- that should surprise the market at this point.

Market Activity for December 23, 2008

GDP

The Commerce Department reported their final revision to third-quarter GDP came in unchanged from the preliminary revision, showing the economy contracted at a 0.5% real annual rate. The NBER (National Bureau of Economic Research) officially announced the recession began in December 2007, but the contraction truly took hold last quarter.

Real PCE (consumer activity) was downwardly revised to show a very large 3.8% decline at an annual rate. Business equipment spending collapsed, falling 7.5% at an annual pace, much lower than even the meaningful 5.7% drop estimated in the previous revision.

The deterioration in business equipment purchases is the most salient aspect of how quickly things changed when the credit markets froze up. Business spending jumped 10% at an annual rate November 2007-July 2008, but shut down on a dime beginning in September.

Residential fixed investment (housing) declined 16% at an annual rate last quarter. It appeared we had found a bottom in housing during the second quarter as this segment of GDP fell 13.3%, which was a major improvement after falling 25.1% in the prior quarter, and this level of decline had been the trend for the previous several quarters. However, we couldn’t expand on that progress in the third-quarter as credit tightened up and labor-market weakness did additional damage to home sales.

We’ll note a couple of things though. Last quarter’s GDP figure would have still posted a mildly positive reading if not for the Boeing strike, which put additional pressure on durable goods orders, and Hurricanes Gustav and Ike, which did major damage to the Gulf region, shutting down energy and utility production in the Texas and Louisiana. (Gustav made U.S. landfall September 1 and Ike two weeks later – Ike was the third most destructive Hurricane in U.S. history.)

In any event, the report is old news as everyone is focused on the current GDP situation which will be the doozy; we’ll get the advance release (the first estimate) on January 30. Most look for roughly a 6% drop in real GDP, which would mark the worst reading since 1982. The data over the past three months surely bears this out.

Housing

The Commerce Department also reported sales of new homes dropped another 2.7% in November and remained at a 17-year low. Sales came in at an annual rate of 407,000 units. The median price of a new home did rise 2.7% last month, but is off by 11.5% over the past 12 months and down 16.07% from the peak hit in March 2007.


The housing market has hit another snag of late due to the credit event. It appeared as though things had begun to stabilize late-spring/early-summer as the decline in sales eased and we actually saw a couple of months in which sales actually rose; however, the improvement proved short-lived as the combination of tighter credit conditions and a weak labor market have wreaked additional havoc. The unadjusted data showed that just 28,000 new homes sold in November.

The supply of new home, adjusted to the current sales pace dipped slightly, yet as you can see remains very elevated.


On the bright, as we’ve touched on for a couple of months now, the number of new homes available for sale has plunged and when the sale figures do bounce back this shows the inventory-to-sales ratio will fall fast.


In a separate report, the National Association of Realtors (NAR) reported that existing home sales fell a large 8.6% last month (8.0% when taking out multi-family units) to 4.49 million at an annual rate. The median price fell 2.9% last month, down 13.2% from the year-ago period.

Existing home sales are based on contract closing (as opposed to new home data, which is counted when a contract is signed). Thus this November data may be a reflection of the credit crunch that intensified in late September – since there is a 6-8 week lag between the signing and closing of a contract. Let’s hope this data proves the worst has arrived; yet it’s likely the weak job market will be an issue for the housing market for a while still.


The inventory figure, which had shown nice improvement from the peak, has moved higher again.


We really need to see this figure fall to the seven months’ worth of supply level to begin getting excited. The traditional drags on housing – a weak labor market – will cause additional problems for sometime. Mortgage rates have come down nicely over the past three weeks, but we’re not sure this is enough to offset the decline in payroll positions.

The next administration will target mortgage rates (this is our guess, it has not been announced) possibly by issuing long-dated Treasury notes at sub-3.00% -- the 30-year T-bond currently trades at a yield of 2.65% -- and have Fannie and Freddie write mortgages somewhere around 4.25%-4.50%. Depending on how they target this, such artificial meddling within the mortgage market may not have longer-term ramifications. However, if they include those who have been seriously delinquent on their payments (even after prior loans have already been modified) this will certainly cause problems down the road. If they do include these people they better darned make the loans fully recourse.

Such a plan would be a way to take advantage of very low borrowing costs for the government. Problem is there is no free lunch, everything has its cost.

Have a Merry Christmas and a Happy Hanukah!


Brent Vondera, Senior Analyst

Afternoon Review

General Dynamics (GD) -1.35%, Northrop Grumman (NOC) -1.16%
The U.S. Navy awarded a $14 billion submarine contract to a unit of General Dynamics. The contract calls for construction of eight Virginia-class submarines to be built by Electric Boat, a wholly owned subsidiary of General Dynamics, and Northrop Grumman Shipbuilding, a unit of Northrop Grumman (NOC). The companies will construct one ship per year in 2009 and 2010, and two ships per year from 2011 through 2013.


Covidien Ltd (COV) -4.68%
Covidien said it will change its country of incorporation to Ireland from Bermuda. Investors who track stock benchmarks such as the S&P 500 may sell 65 million shares as a result, JPMorgan & Chase estimates.

We are starting to see more companies leaving Bermuda in anticipation of decreased tax benefits once Obama takes office.


Washington Federal Inc. (WFSL) -26.38%
Washington Federal plummeted after it reduced its quarterly dividend by 76 percent to 5 cents a share, citing higher credit costs.


Quick Hits

• 2008 Lookback: Best Calls of the Year
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks began the holiday-shortened week lower as a deteriorating outlook regarding corporate profits and commercial real estate wore on investor sentiment. Year-end tax-loss trades may have also put pressure on stocks, overwhelming what is a low volume week.

Stocks did pare earlier losses though, rallying nearly 2% in the final 30 minutes of trading. What appeared to be heading for a 5% downer mid-way through the afternoon session, turned into a 1.80% drop for the broad market – mild by today’s standards.

Commercial real estate concerns are beginning to rise to the surface and this may be an added issue stocks will have to deal with. It’s pretty clear that lenders used unrealistic estimates, assuming strong rental growth rates to justify high loan payments. As the credit freeze-up that hit in September exacerbates declines in commercial rental rates, borrowers will have a more difficult time meeting payments, driving defaults.

On the bright side, with massive levels of cash on the sidelines, we may be able to rally early next year as the taking of tax-losses will have run its course and that will be one less pressure point on stocks. It’s likely the broad market has priced in a lot of ugly assumptions, like this commercial real estate story.

Market Activity for December 22, 2008


Interbank Lending

Interbank lending rates have eased dramatically over the past couple of months and the TED Spread (an indication of risk aversion – a higher level means investors and institutions are less willing to take risk; lower the opposite) has nearly returned to its level prior to the collapse of Lehman on September 15. Although, the level during more normal times is closer to 0.50, so keep that in mind.


The decline in interbank lending rates has not only declined in the U.S. and London, but across the globe. The Hong Kong interbank rate, HIBOR, has declined to the lowest levels since 2005 and TIBOR (Tokyo interbank rates) sits at the lowest level in a decade, according to Bloomberg.

Global central banks have pumped massive amounts of liquidity into the system and as a result these rates should remain palliative to lending.

The degree to which TED has declined is a bit deceiving, however. The narrowing in the spread between three-month LIBOR (the rate at which banks charge one another for loans of this duration) and three-month T-bills is solely a result of the liquidity injections by central banks that has brought LIBOR down. We really need to see 90-day T-bill yields rise; at current levels it is abundantly clear cash is hiding out for now. When the yields on bills begin to rise again it should signal investors’ willingness to take a dip into the risk pool once again.


Been Waiting for This One

Last week I watched an interview in which a business news journalist asked why everything but tax cuts have been tried in getting us beyond the current mess. The guest responded by stating (paraphrasing): “we tried that in 2003 and look where we are now.”

I’ve been waiting for that comment for three months now, it was only a matter of time and frankly I’m surprised it took this long to hear it.

It’s funny to me how Keynesians, always wanting to keep to the same old flawed game plane, have the temerity to make statements like those that vilify lower tax rates. The journalist should have responded by stating that is has been monetary policy mistakes that have brought us to this economic obstacle. If not for negative real short-term interest rates (for two years) that subsidized debt, we wouldn’t have been caught up in this morass in the first place.

Further, the rejoinder should have involved an explanation that if not for the lower tax rates on capital and income over the past five years it’s highly unlikely we would have withstood a serious housing correction (two years in the making) and a massive energy price shock for as long as we did.
(Remember, the oil shock did not begin in 2008 as oil prices doubled from $70 to $145 in a matter of 10 months, but went from $25 to $45 2003-2004; then from $45-$65 2004-2005; later hitting $70 before dipping to $60 in early 2007 and then the stunning spike to $145 that everyone now remembers. All the way, we heard that $40 per barrel would shut down the economy, but it didn’t. Then $60 would shut it down, but it kept rolling along. Then $70, $90, $100 would cause GDP to collapse, no, no and no. It was not until $145 per barrel combined with a freeze-up in credit that the economy finally succumbed.)

And lest we forget, lower tax rates on capital and income (and it’s important to understand that small business makes up 65%-70% of those in the top federal income tax bracket) enabled the labor market to set a record for job creation (52-straigth months) and corporate profit growth (up at double-digit rates for 20-straight quarters – Q3 2002 through Q2 2007) set a post-WWII era record.

The chart below shows profits with capital consumption and inventory adjustment, so no chicanery in these numbers.


Yes, some of this growth was due to the low interest-rate environment that helped the labor market with regard to construction jobs and the financial-sector post robust earnings. However, the higher after-tax returns on capital, the higher disposable (after-tax) income growth and the massive decline in dividend tax rates had a large hand in allowing the economy to withstand a stunning energy-price shock and a housing market that has been weighing on economic growth since the first quarter of 2006.

And another thing, Keynesians are always the first to complain that U.S. consumers engage in too much credit, yet they want consumers to spend like there’s no tomorrow when it makes zero sense to do so – when savings and overall wealth has declined. This is the dichotomy that confuses the Keynesian mind.

Instead of bowing to the mindset that we must always stimulate the demand side, what we need to do is stimulate the production side of things, that’s where the resources are most prevalent right now anyway -- on the business side.

Thus we must continue to reduce trade barriers, lower tax rates across the board, eliminate overlapping regulations and return society to an ideal of self-reliance – a safety net that has turned into a hammock does just the opposite by increasing a state of dependency. An attempt to spend our way out of this situation may look good in the short term, but it is not a long-run strategy.

As Margaret Thatcher stated: (since the world of economics is dominated by the philosophy of taxing and spending) “economics is too important just to be left to economists.” So true.

Have a great day!




Brent Vondera, Senior Analyst

Afternoon Review

Walgreen (WAG) -4.22%
WAG reported first-quarter profit that trailed analysts’ estimates and said it would spend less on new locations. WAG continues to post solid sales in a difficult retail environment, but costs grew faster than sales and the company plans to further cut back on store openings in 2010 and 2011. The new target growth rate is expected to reduce capital spending through 2011 by approximately $500 million, in addition to the $500 million announced in July.

WAG said it will cut spending on new stores by $1 billion through 2011, double its forecast in July. That will bring the rate of new openings to as much as 3 percent in 2011 from almost 9 percent in the most recent fiscal year.


Caterpillar (CAT) -2.13%
CAT announced new cost saving measures and noted that it is seeing continued deterioration of conditions in many of the markets it serves. The company plans to cut executive compensation by up to 50 percent, and senior managers could see cuts of 5-35 percent. CAT has instituted a hiring freeze and said it is offering an incentive-based voluntary separation program to some of its employees.


St. Jude Medical (STJ) -1.56%
STJ is acquiring MediGuide for $283 million, giving STJ technology to track needles, catheters and guidewires inside the body. STJ will use MediGuide’s technology to help develop products for cardiac ablation, a way to destroy malfunctioning heart cells and correct irregular rhythm without open-heart surgery. The market for ablation equipment could reach $2 billion a year by 2011.

STJ also completed its acquisition of Radi Medical Systems for $250 million. The moves do not alter St. Jude’s outlook.


Quick Hits

• WisdomTree ETFs dropped significantly due to it being their ex-dividend date.
  
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks ended largely higher on Friday as the S&P 500 and NASDAQ Composite gained ground; however, the Dow Industrial Average was held back by shares of Chevron and Exxon – another 6.5% decline in the price of oil put pressure on the group. (The January contract, which expired on Friday, closed at $33.87 per barrel; that backyard storage idea remains in play!)

Basic material stocks also performed poorly, down 1.30%; energy shares lost 0.42%. Industrial, technology, and health-care shares led the board market higher.

We didn’t have much to trade on beyond the Detroit 3 bailout that was officially announced Friday morning. The news may have assuaged some short-term concerns over the issue, which likely provided stocks with a little boost – futures were pointing to a lower open, but reversed course when the news broke.

Market Activity for December 19, 2008

The Bush Administration’s decision to lend GM and Chrysler $17.4 billion so they can avoid bankruptcy was the big news of the day. (The two carmakers are virtually bankrupt as it is, as management has stated they can’t make it through year-end without the funds.) The deal will extend $13.4 billion now and another $4 billion in February. The car makers will provide the government with non-voting warrants, yet the exact amount was unclear.

Ford will not be included, I guess because they haven’t screwed up as royally as the other two. The company has stated its in good enough shape that they do not need this sort of financing. Maybe they’ll learn from this mistake. As former presidential candidate Fred Thompson has put it, “there are strict criteria to receiving taxpayer funds: you must screw up on a monumental scale.” Got that Ford? I’m sure they’ve learned their lesson; they won’t make that mistake again.

Ford is currently seeking a credit line from the government. Management says they may not need to tap it if the government meets this request. I’m guessing that assumes car sales rebound in quick order, which seems pretty unlikely.

Anyway, the deal with GM and Chrysler does have “stipulations.” The companies must show their viability by March 31 by reducing debt and current cash payments for future health care obligations. That’s pretty vague, for a reason I’m sure. In any event, it won’t matter because the stipulations are non-binding, which doesn’t really make them stipulations now does it. Apparently, Washington has re-defined another term for us. We thank them.

It is difficult to blame Bush too much for this decision. What’s the guy supposed to do with the labor market in the shape it is in? He’s kicking the issue down the road for the next administration, that’s when the real checks will begin to rip off.

What the Detroit 3 really need to become viable is to enter Chapter 11 bankruptcy (this is not Chapter 7 liquidation; it’s reorganization). This way they can streamline their primary workforce and dealerships. Currently the three have way too many assembly line workers, far too many dealerships and a layoff structure that makes competiveness impossible.

In term of the workforce and dealer outlets, the firms pretend as if they still enjoy 50% market share when in reality it is 18%.

In terms of the layoff compensation structure, GM pays the difference between their former wages and what jobless benefits pay. Then when the jobless benefits run out GM pays 95% of their wages for two years. Then, if you have the seniority, a former worker has a chance to enter what’s known as the jobs bank, which pay 95% of wages to do crossword puzzles etc., for years This is a joke and not a competitive business model. The government can write them checks until the cows come home, but until the aforementioned issues are dealt with they simply can’t be viable. If the government demands that the Detroit 3 make smaller and smaller cars, in place of producing what the market demands, they’ll simply become even more dependent on government financing. Unless, of course, the government mandates what cars consumers may buy, but that’s getting into another issue.

We’ve got a quiet Christmas-shortened week ahead of us and no economic data releases today.

Tomorrow we’ll get the final revision to Q3 GDP, which should show the economy declined 0.8% at an annual rate – the estimate is for the figure to remained unchanged from the previous estimate, -0.5%. No one will care about this release though as the Q4 reading will be the big one, likely to show the economy contracted at a 6.0-6.5% real annual rate, the worst reading since the spring of 1982.


Tomorrow we’ll also get new and existing home sales (November). Rarely are these released on the same day, but the holiday-shortened week has them crammed into one.

Pending homes sales remained dire in October, so existing sales were surely extremely weak last month, same will be true for new homes.



On Wednesday we get initial jobless claims (a day earlier than usual) and personal income and spending for November.


Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

VIX
The VIX, which measures the cost of using options as insurance against declines in the S&P 500, has dropped over 44 percent since November 20, when it rose to 80.86, the highest in its 18-year history. (The VIX had never closed above 50 before October.)

The VIX measures fear in the market, via the prices investors are willing to pay for protective options. When the VIX hit high levels – such as the high 70s or low 80s – it indicated that there was too much fear and that everyone has already sold. As a result, supply dries up leaving the market susceptible to a rally.

Right now the VIX remains at unusually high levels compared to its historical norm; however, it has fallen quite a bit from where it has been during the past two months. That tells us the fear surrounding stocks has decreased a bit, and demand to actually buy them has crept up a bit.

Volatility may not return to its highs, but it isn’t clear when it will get back to normal, either. Volatility breeds fear, which in turn breeds more volatility. In addition, new leverage exchange-traded funds, off-exchange trading vehicles and other market advancements are adding to the churn. Nevertheless, the lower readings in the past week or two are seen as a positive for the equities market.

--

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks extended upon Wednesday’s decline as concerns over global growth remain in play. Oil’s retreat to $36.85 (so much for those predicting $200/barrel with such certainty just five months back) reinforced the worry due to the stunning degree of decline – crude fell nearly 10% yesterday alone.

This may seem obvious -- you say: “Of course the prospects for global growth are pathetic” – but the concern regarding the extent to which the credit chaos has had on the global economic picture actually ebbs and flows on a weekly, sometimes daily, basis.

Indeed, we do get small indications that the pessimism has gone a bit too far. There is a separation between perception and reality that needs to be addressed – energy demand has actually improved over the past couple of months after falling the most since 1982 for the first 10 months of the year. This is the affect of the price mechanism, but it seems to me we’d see demand continue to decline if the world were as “tapped out” as most seem to assume.


(We’ll note, the January crude-oil futures contract expires today so there was added selling pressure yesterday as those who own contracts simply for financial reasons have to sell to avoid taking possession. Although, at these levels, grab a few galvanized swimming pools and let them back the truck up. Do you think the EPA would have an issue with backyard storage?)

Market Activity for December 18, 2008


In addition, while it’s tough to get terribly optimistic about things right now, the statements that accompany tech-sector earnings in particular show what we’re dealing with is more an issue of confidence than actual economic fundamentals being in the dirt. I can sense the reaction now; you’re thinking I’m off my rocker. But a number of economic data sets show business spending collapsed as if a switch had been flipped (generally we see this kind of grind to a halt as the economy contracts), which proves to me that a lack of confidence/caution is half the battle right now – reverse this mindset slightly and you get a decent bounce in activity from these levels.

Take Oracle’s earnings release yesterday. The company stated they have never seen orders canceled to the extent they did in November -- ever. Apparently, companies had the resources to engage in such spending plans just a couple of months back, but now all of a sudden they are pulling orders. This tells me the dramatic economic retrenchment of the past three months is due more to heightened levels of caution than anything else. This is the obstacle that must be addressed.

Don’t get me wrong, the current quarter’s GDP report is going to make a run at the horrible declines in economic activity seen in 1980 and 1982 (which posted -7.8% and -6.4% readings at their nadirs) but confidence is something that can be returned to the marketplace very quickly if the correct strings are pulled – problem is we’re not pulling the correct strings. You know what I’m referring to.

Ease this current level of caution and a tepid rebound in business spending will combine with a stock market rally and a mild bounce from the consumer. Remember, nearly $4 trillion sits in money market accounts and real incomes have been boosted via the 65% plunge in gasoline prices, offsetting some of the damage due to a weak labor market. The fuel is there, now ignite it.

On stocks, we’re 18% above the November 20 low; if we can manage a rally of an additional 20%, you’ll see caution ease.

Jobless Claims

The Labor Department reported initial jobless claims fell 21,000 to 554,000 in the week ended December 13. While it’s nice to see some easing, the figure remains elevated and the jump in the prior week likely portends the December payroll report will show a decline at least as bad as the 500,000-plus drop in November – possibly worse. Next week’s claims data will correspond with the December job market reporting period and we’ll be better able to assess things then.

Despite the decline last week, the four-week average of claims rose 2,750 to 543,750.


It’s important to watch the ISM (both the manufacturing and service-sector surveys) reports, which have seen their employment gauges slide. The manufacturing survey’s employment index has matched the 1990-91 recession low and we’ll be watching to see if it weakens further and moves to the 1981-82 low. If it holds above that mark, we may see the payroll declines at least stabilize.

We’ll also remind everyone, as touched on a couple of times now, the jobless claims figure would have to approach one million to match what occurred at the high point of 1982 when adjusting for payroll growth. Back in 1982 total non-farm payrolls stood at 88 million; today it is 136 million, so 550,000 in claims is not nearly as harsh as it was back then.

That said, claims have risen significantly over the past three weeks (all due to the December 6 weekly claims report that showed a 60,000 increase) and this is a dismal backdrop for the shopping season. As mentioned above, we expect that the 65% decline in gasoline prices, which has boosted real incomes, will offset some of this labor-market weakness and the December spending numbers will post a better-than-expected reading. But this claims data does cause some doubt.

Continuing claims are approaching the peaks hit in 1974 and 1982, but did fall 47,000 to 4.384 million in the week ended December 6 – there’s a one week lag between initial claims and continuing. .


Philly Fed

The Philadelphia Federal Reserve Bank’s general business conditions index showed activity remains depressed, but not to the degree expected. The index rose to -32.9 in December from -39.3 in November – the number was expected to fall to -40.5. Not exactly an inspiring print but the level remains above even the relatively mild 1990-1991 recession.


The new orders index rose to -25.2 from -31.4; but unfilled orders deteriorated.

The employment index declined to -28.7 from -25.2 last month.


Witching Hour (and no, I’m not referring to Def Leppard lyrics)

We’re without any economic releases this morning, but things will remain exciting (if that’s the correct term) as today marks quadruple witching. This is the quarterly event with which we get the expiration of stock-index futures, stock-index options and single-stock futures and options. As a result, it should be a volatile session, especially in the final hour – unfortunately, nothing new these days.

Have a great weekend!


Brent Vondera, Senior Analyst

Afternoon Review

General Electric (GE) -8.22%
Standard & Poor’s said it has revised its outlook on GE and its units to negative from stable and affirmed its AAA long-term and A-1+ short-term credit ratings. The negative outlook is based partly on the concerns regarding GE Capital Corps’s future performance and funding. Standard & Poor’s said there is at least a one-in-three chance it will cut GE’s credit rating from the top AAA in the next two years.

This announcement comes two days after GE said it could no longer make business decisions that are harmful to its long-term growth prospects for the sole purpose of maintaining their AAA credit rating.

FedEx (FDX) -2.14%
FedEx said its financial performance is increasingly being challenged by some of the worst economic conditions in the company’s 35-year operating history and it expects conditions to remain difficult through 2009.

FDX has already taken actions to reduce over $1 billion of expenses for all of fiscal 2009 and is now implementing a number of additional cost reduction initiatives, including salary decreases, elimination of merit-based salary increases and suspension of 401 (k) company matching for a minimum of one year.

Ingersoll-Rand (IR) -4.65%
IR cut fourth quarter guidance since it has had lower than expected revenues in all business segments, primarily due to softer North American and sharply declining Western European markets (which the company noted was especially severe over the last six weeks).


Quick Hits

• Credit-Card Users Feel Pain as Banks Reap Gain From U.S. Cash
• IBM, Sun Face ‘Reckoning’ in 2009 as Technology Budgets Shrink
• U.S. Spending on Research to Fall
  
  
  
  Peter Lazaroff, Junior Analyst
  

Daily Insight

U.S. stocks fell yesterday, giving back some of Tuesday’s 5% gain as worries over global growth affected investor sentiment. Even a large four-million barrel per day production quota cut by OPEC failed to boost oil prices, illustrating that global growth concerns ruled the session.

Still the decline in the broad market was tepid, for this environment at least. The S&P 500 had been down as much as 1.8% early in the session, bounced to a 0.6% gain in the afternoon but eventually succumbed to the aforementioned concerns falling 1.5% in the final 90 minutes.

Market Activity for December 17, 2008

Utility, technology and energy shares took the brunt of the damage falling 2.92%, 1.73% and 1.59%, respectively. Consumer discretionary and basic material stocks were the only gainers of the 10 major industry groups. (Strange how consumer discretionary shares gained ground on a day global economic worries were the primary concern, but the group was helped by a jump in Macy’s shares after the retailer negotiated a more flexible bank-credit agreement.)

The Dollar

The dollar got clocked yesterday, extending a six-session decline as all of this talk and action of massive fiscal stimulus and the Fed’s latest comments have caused investors to think about fundamentals again. The Fed has flooded the system with dollars, and they signaled they are willing to do much more if they feel necessary. This was setting up for a dollar rout, as much as it pains me to say it, as we’ve touched on for a few weeks now.


The greenback had benefited from the flight-to-safety trade, but it appears some of this trade has moved to gold – up 16% over the past eight sessions. Of course, gold doesn’t pay interest or a dividend, but some don’t seem to care about that right now as the four-week T-bill has traded at a negative yield and 90-day bills trade at 0% -- it’s a crazy world.

Mortgage Applications

The Mortgage Bankers Associations reported their refinancing index rose 6.5% last week. The index has risen four of the past six weeks as the 30-year fixed-rate mortgage has dropped from 6.4% at the beginning of November to 5.18% last week.
The group’s purchases index fell for the second week, declining 4.5% in the week ended December 12, which followed a 17% decline in the prior period.

Crude-Oil

OPEC members agreed to cut production by 4.2 million barrels per day at the cartel’s meeting yesterday. The reduction brings OPEC’s daily production to 24.845 million barrels from 29.045 million which was the official quota back in September. This is a huge reduction and will have on effect on price even with lower levels of demand.

The issue that OPEC generally has to deal with is cheating – individual countries producing more than the quota calls for. When oil prices are rising, especially dramatically like last spring/summer, they have an incentive to keep oil in the ground – it’s free storage and producers are confident a higher price will be captured a month down the road. However, when prices are falling the OPEC members generally produce more than their quota for fear next week will bring less revenue.
(The futures market is currently in contango – future deliveries trade at a higher price than the spot price. This would normally cause producers to allow supplies to build, which is true here in the U.S. but OPEC countries are do dependent and hard-up for oil revenues, they will be cheating.)


Since crude prices have tanked $100 per barrel over the past five months, the members are hurting for revenue – especially countries like Venezuela, Libya and Algeria. The cheating that results will make the reduction less effective. Still, the size of the cut is so large it should push prices higher nevertheless. Not yesterday though.

The market ignored the production cut to focus on the weekly supply report, which was quite bearish and sent crude below $40 per barrel for the first time in four years. It recovered a bit to close above the 40-handle at $40.06.

The Energy Department reported crude supplies rose 525,000 barrels to 321.3 million barrels last week – roughly 5% above the five-year average (effectively more than that considering the drop in demand). Stockpiles have climbed 11% since September 19.

Loans and Mark-to-Market

The Fed continues to pump massive amounts of liquidity into the system, yet banks continue to hoard the cash, unwilling to increase lending. And who can blame them? With mark-to-market accounting rules that determine capital-adequacy ratios, why would they take on assets like car and home loans? Why extend credit lines? Lenders would be holding back in a tough environment already, but even more so due to this rule.

With default rates growing and the housing market showing no sign of reversal just yet, lenders know they’ll just be writing down more assets, which will force them to raise more capital and put up more collateral. This is the insanity of pro-cyclical accounting rules. When asset prices are falling banks have to write-down assets (even those they have no desire to sell), causing them to raise more capital, which forces them to sell more assets, pushing prices down more and thus more write-downs. It’s a death spiral.

Using mark-to-market accounting with which to based capital adequacy ratios was put in place in November 2007; the timing could hardly have been worse. This accounting standard is tantamount to your neighbor having to sell his house today because of special circumstances (and because of the urgency must take a 30% haircut), and you then would be forced you to lower your home’s value by 30%, say from $300,000 to $210,000 – even if you have no desire to sell. Oh, and by the way, you’ll have to come up with $72,000 to keep your LTV at 80%. Wouldn’t that be nice.

If we would have had this standard in place during the S&L crisis we’d still be dealing with the effects. We must return to the former standard, which based capital adequacy on the original cost of an asset; it served us well. Remember, mark-to-market is no better in a rising asset price environment as firms will be required to hold less capital than would otherwise be the case, which obviously carries its own risks.

Sure, if a financial institution is going to sell an asset, then they will have to take the market price and accept the hit to earnings. However, for assets with 10-20 year lives, and most of which continue to kick off cashflows, it makes no sense to continually mark these asset to distressed-market prices. This has greatly exacerbated the current situation.

Have a great day!



Brent Vondera, Senior Analyst

Afternoon Review

Alliant Techsystems (ATK) +0.02% *contact to receive updated tearsheet*
The economic slowdown and subsequent budget constraints by many of the company’s clients has kept ATK’s share price down in recent weeks. Adding injury to insult, funding pressures at NASA and declining satellite activity has brought ATK’s space systems business (36 percent of revenue) into question. Nevertheless, strategic initiatives as well as various recent contract awards should help maintain ATK’s robust free cash flow and profitability.

ATK, the largest supplier of bullets to the U.S. armed forces, raised full-year guidance on October 30 after reporting better-than-expected fiscal second quarter results. The company cited strong armament sales as the primary reason for the outperformance. During the quarter ATK also won many new strategic programs, which led to the signing of several contracts, the largest of which was with the U.S. Navy.


ConAgra (CAG) +7.97%
CAG beat earnings expectations, but operating profits fell by 8 percent to $253 million due to cost inflation. The company reaffirmed its guidance for the full year, which is higher than analysts’ estimates.


Quick Hits

• A 10-point Checklist for Avoiding a Ponzi Fund
• In Spring 2001 Reporter Questioned Madoff Record
• Stock-Picking Dreams Might Pay in Obamanomics
• Companies that May Benefit From Obama Spending Plan (this list gets longer every week)
  
  

--

Peter Lazaroff, Junior Analyst

Fixed Income Recap

FOMC Announces Rate Cut
The Federal Reserve announced a reduction in the Fed Funds Target Rate, the rate at which banks lend to each other overnight, to a target range of between zero and .25%. The market rate has been within this range since the beginning of December, so that part of the announcement was less impactful than the comments that followed.

The Fed announced today that, “The focus of the committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the Federal Reserves Balance sheet at a high level”. Translation, look for expansion of Agency debt and MBS buying by the Fed. The limits currently sit at $100 billion of debt and $500 billion of Agency MBS. Along with other programs aimed at fostering economic growth through lending.

As financial markets remain strained, the Fed is looking for ways to bring liquidity to the system. The Fed’s balance sheet has more than doubled, from about $900 billion to about $2.2 trillion, in the last 6 months, mostly due to the liquidity facilities implemented recently and relaxed standards on collateralized lending to institutions. Today’s announcement foreshadows a future of creative easing by the Fed as they have “thrown in the towel” with regard to the Fed Funds Target.

Treasuries Rally
Treasury yields dropped to record lows across the entire curve today after the Fed made its announcement. The 2-year traded as low as 62 basis points before ending the day at 64.5 basis points while the 10-year ended the day at its low of 2.25%. The shape of the curve remains relatively unchanged from the beginning of the month after the massive flattening that took place in the second half of November. The spread between the two- and ten- year currently sits at 163 basis points.

Mortgages were tighter to comparable Treasuries before the Fed’s announcement this afternoon, after which they rallied along with seemingly every other bond. Thirty-year Fannie 5.5% mortgage pools widened about 3 basis points to Treasuries on the day, while 30-year 5% pools ended the day about where they closed Monday. Investors continue to be worried about accelerating prepays, resulting from rumors of new, more lenient, refinancing programs, causing “up in coupon”, 5.5% compared to 5%, pools to underperform. If there is any truth to these rumors we would expect to see even further underperformance.

Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks jumped yesterday on the Federal Reserve’s version of “shock and awe” as Bernanke & Co. will essentially target fed funds at zero, are willing to sustain the high level of the balance sheet -- and even expand it from here -- and may up the size of their GSE debt and mortgage-backed security purchases. These actions and statements went well-beyond what the market had expected.

Benchmark stocks indices had been up the entire session, despite horribly weak housing data, but the Fed’s afternoon decision provided additional fuel to the rally. The broad market jumped 3.4% in the final 90 minutes of trading.

Market Activity for December 16, 2008

Financial shares led the rally, as the S&P 500 index that tracks the group jumped 11.25%. Basic material, industrial and consumer discretionary shares also outperformed the market.

Economic Data

On the economic front, the Commerce reported builders broke ground on new homes at the lowest level on record – data goes back to 1959. Housing starts plunged 18.9% in November to 625,000 units at an annual pace. Multi-family starts (condos etc.) fell 23.3%; single-family units were down 16.9%.


The degree of weakness was a shock, but the fact that housing starts remained weak was not. Last month’s October building permits figure, showed a 9.3% decline (down 38.2% year-over-year), which was a great indication the reading was going to be very low. Housing starts have declined 72.5% from the January 2006 peak!

Permits for November, which was also out yesterday, do not indicate improvement for December as the figure dropped 15.6% last month to 616,000 – also a record low.

While this news is inauspicious, it is a necessary condition for the housing market to recover. The good news is new homes available for sale have plummeted, so when sales do bounce back the very elevated inventory/sales ratio will fall fast.


In a separate report, the Labor Department reported the consumer price index fell 1.7% in November, the biggest decline in 61 years and follows the 1.0% decline for October. Over the past 12 months, consumer prices are up 1.1% -- that figure was 3.7% in the previous month, 4.9% in September and 5.4% in August – just another illustration how quickly things have changed.


The core CPI was unchanged in November, lowering the year-over-year rate on ex-food and energy prices to 2.0% from 2.2% a month back.


The decline in CPI was virtually completely due to a large 17.0% decline in the overall energy component and a 9.8% in transportation. Gasoline, in particular, plunged 29.5% last month; natural gas was down 5.2%.

This dramatic decline in energy costs is great news for the consumer. As the boys at RDQ Economics point out, energy prices within the CPI fell to their lowest level since February 2007. U.S. consumers spent $670 billion on energy goods and services over the past 12 months – at February 2007 prices, the same level of consumption would have cost just $540 billion. This represents a $130 billion addition to real household incomes. This savings should show up in the December retail sales data.

Energy prices are down some more in December, but the degree of decline will wane and with OPEC planning a production cut oil prices will very likely level out before rising again.

The decline in CPI should not be confused with overall deflation, we’ll point out the food and beverage component rose 0.2% in November and is up 4.1% three-month annualized and 6.0% over the past 12 months. This is an energy-price driven event as we come off of the insanely elevated levels back in the spring and summer of this year.

The Fed has nearly tripled its balance sheet and the trillions in liquidity pumped into the system will combine with an infrastructure-based stimulus package to drive commodity prices and overall inflation higher again.

The price gauges will appear to indicate a deflationary event is upon us for a couple of months still, but it won’t be long before this concern has passed and the Fed will have to start thinking about how they’ll take back some of their easing as the economy slowly and tepidly bounces back. When things do improve, whenever that might be, massive liquidity injections will fire through the system. This is one reason a tax-rate response to the current woes is superior. Such a decision would boost confidence immediately, and offer businesses an incentive to produce over time; we’ll need an increase in goods to absorb all this money that will be flowing. If not, inflation is coming and it will be higher than we’ll like.

The Fed Decision

In a 10-0 decision the Federal Open Market Committee (FOMC) chose to cut the target on the federal funds rate from 1.00% to a range of zero and 0.25% (acknowledging the near-zero effective fed funds rate relative to the target), while stating they will “employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.” Good luck with that ladies and gentlemen of the FOMC.

The group of 10 signaled they’re willing to keep the funds rate low by stating, “the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rates rate for some time.”

Nine rate cuts and nearly $2 trillion in emergency lending via roughly 10 new facilities over the past 12 months have yet to fully reverse the credit situation – although certainly facilities like their commercial paper funding program has certainly kept things from fully collapsing.

The statement also noted the Fed has already announced it will purchase “large quantities” of agency debt and mortgage-backed securities (to bring mortgage rates lower) and they “stand ready to expand these purchases as conditions warrant.” They continue to think about whether or not to buy longer-term Treasuries. (At 2.19% on the 10-year we’re not sure how much further they think the yield should go, so it’s unlikely they’ll engage in this action)

All-in-all, the Fed went well beyond expectations. The target FF cut was larger-than-expected; the establishment of a range for the funds rate and the discussion of quantitative easing (focusing on supporting financial markets and stimulating the economy through sustaining the high level of the Federal Reserve’s balance sheet) all suggest they will throw everything at the current situation. Overall, we knew this but to get explicit statements in their language is big.

The fact that they suggested they may up the size of GSE (Fannie and Freddie) debt purchases, while entertaining the thought of buying long-dated Treasuries really takes their actions to a whole new level.

If we could only get a tax-rate response to the economic distress that truly began to take hold in mid-September, we could spark confidence in a sustained way, which is more than half the battle in my view.

Have a great day!




Brent Vondera, Senior Analyst

Afternoon Review

General Electric (GE) +5.72%
GE, the world’s biggest maker of power-plant turbines, won an order valued at about $3 billion to provide electricity-generating equipment and services to Iraq. It is the largest single order in the history of the GE Energy segment with GE providing 56 of its 9E models turbines capable of supplying 7,000 megawatts of electricity (nearly doubling the country’s generating capacity).

The order comes amid concern the slowing global economy may crimp the pace of deliveries as some utilities struggle for cash for capital investments. In the third quarter, GE Energy had $7.9 billion in orders, up 18 percent. This new award adds to the $4 billion already ordered by countries including Saudi Arabia, Kuwait and Qatar over the past two years.

In separate news, GE reaffirmed its outlook for the fourth quarter and full-year 2008, but said that it will no longer provide specific quarterly earnings guidance. The company also reiterated its dividend, which has been a point of concern for many investors.


ITT Corporation (ITT) +8.88%
ITT reaffirmed its 2008 earnings forecast and said 2009 profit will be higher than the average estimates (according to Bloomberg). Revenue is projected to be down 2 percent to 6 percent from anticipated 2008 sales, including the expected negative impact of foreign currency exchange.

The company said its management will recommend that the board approve a dividend increase of 22 percent to 85 cents for next year at its February meeting. ITT also said the board approved an indefinite extension of the company’s $1 billion share repurchase program that was set to expire in November 2009. ITT has bought back about $431 million of its common stock under this program.


Johnson Controls (JCI) -1.09%
JCI withdrew its 2009 guidance due to “the rapid decline in global automotive production and uncertain industry conditions.” The company’s lowered production estimates for 2009 (made just two months ago) from 12.3 million vehicles to 9.3 million vehicles in North America, and 21.2 million vehicles to 16.2 million vehicles in Europe.

Actions to reduce costs and the performance of its building efficiency and power solutions businesses should keep JCI profitable in 2009, according to the company.


Transocean (RIG) -0.23%
Transocean received approval to change the place of their incorporation from the Caymans to Switzerland. This is likely to result in the company being removed from the S&P 500 and the Russell 2000 indices. This implies approximately 45.1 million shares are to be sold, which may put some near-term selling pressure on the stock.


Bank of America (BAC) +7.02%
BAC traded lower for most of the day (until the Fed’s rate cut decision) in response to an analyst saying the bank will need to raise more capital to offset rising loan losses.


Quick Hits

• Another View: Blaming the SEC (this article was written by a former SEC employee)
• This article shows that not all real estate is depreciating in value.
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks fell for only the fourth time in the past 16 sessions, and even as the indices lost some ground the degree of decline was pretty much a moral victory as the benchmark’s appeared destined for a 5% header with about an hour left. But stocks rallied in the final half-hour to pare earlier losses.

The NASDAQ took the brunt of the damage, falling 2.10%, erasing Friday’s nice move in which the tech-laden index outperformed the broad market.

There was a sense on Friday that technology firms will participate in next year’s stimulus program, which is true, but weak manufacturing and industrial production reports reminded traders of the downbeat business spending environment. New York-area manufacturing showed business spending on tech-equipment contracted significantly over the past month and the industrial production survey drew the same conclusion.

Market Activity for December 15, 2008

Among sectors, financials led the decline, falling 3.99%, after a Merrill Lynch analyst stated credit costs in the U.S. will get worse – not sure this of great surprise. Relative winners were consumer staples, energy and basic material shares – down 0.20%, 0.28% and 0.38%, respectively.

The Economy

The New York Federal Reserve Bank reported manufacturing activity in the region remained very depressed, hitting a record low. (We’ll note the index only goes back to 2001, so when we say record low it’s not saying a lot; still we know other factory surveys that have been around for decades are hitting their lowest levels in nearly 30 years.)

The index known as Empire Manufacturing registered -25.8, the lowest in the survey’s history. Factory activity in the New York-region has been extremely weak for three months now (the global economic situation changed on September 15) – certainly this area of the country is one of the hardest hit as it is home to the financial industry.


Forward looking indicators, like the new orders index of the survey, remain near record lows as illustrated below.


The outlook among respondents did improve a bit, rising to 19.5 – a number around 40 would be seen in more normal circumstances.

The capital spending index held near the November low, coming in at -10.6 for December. The technology spending index hit a new low of -12.8, so no help in this regard.

In a separate report, the Commerce Department reported industrial production slipped 0.6% in November. Manufacturing output, or lack thereof, put the most pressure on the reading, falling 1.4% last month.

(On the chart below we explain the September decline just to clarify why such outsized weakness occurred.)


Utilities and mining production rose 1.6% and 2.5%, respectively. Business equipment was also up, rising 3.2% for the month – this was helped by a jump in aerospace orders.

Consumer goods production fell 0.7%, motor vehicle production fell 2.8% and construction supply output declined 3.3%.

The decline in manufacturing output was actually worse than it appeared because a 12.8% jump in aircraft production helped the reading. That jump in aircraft output occurred as the Boeing strike came to an end. The auto industry continues to weigh heavily on factory output – the segment is down 21.4% year-over-year. Still, excluding autos, manufacturing is down 6.3% YOY.

We believe industrial production will remain weak for a few months still, but do not think a mild rebound should be ruled out. The decline in business spending is due more to caution that a lack of resources and once the current bout of pessimism wanes, even slightly, we should get a bounce in this segment.

Machinery orders are holding in there, but high-tech equipment has been hurt for three months. Firms will look to add more tech equipment as productivity improvement will remain in focus as average selling prices fall.

I may be reaching at optimism here, but do believe a mild rebound is on the horizon.

Going for Zero

The Fed ends its two-day meeting today, which means we’ll get their rate decision this afternoon. I won’t go against the consensus expectation for a 50 basis point (1/2 percentage point) cut by predicting they’ll do nothing – the implied probability of a 50 bps cut is 100%. However, cut right now is meaningless since what the Fed does is set a target for where fed funds (FF) should trade; the actual rate is already close to zero, 0.125% as of yesterday.


Beyond the cut, people will be focused on the language, which will key in on what is called quantitative easing – which is simply providing liquidity in ways separate from traditional FF rate cutting by setting up lending facilities, as they have been engaging in for exactly a year now. They will also mention what Bernanke calls the “second quiver,” which includes options such as buying longer-term Treasuries to inject even more cash into the system.

But again, I don’t see what this does to improve spreads – that’s what they say they’re targeting by executing these purchases. Treasury yields are already near record lows – the yield on the 10-year sits at 2.48% for goodness sakes. The problem is not a high risk-free rate, but an issue of confidence, which has spreads very wide. Ten-year BB+ rated industrials are trading 1100 basis points over Treasuries, that’s higher than typical junk spreads.

Yes, spreads should be wide because default rates are up and the market is going to demand a lot more return to compensate for this risk. However, some of this widening is due to a crisis of confidence and the most efficient way to counter this situation is to slash tax rates on income and capital. This is not the Federal Reserve’s decision to make, of course. The legislative and executive branches need to get this done – it’s been a big mistake by the Bush Administration to ignore this tool.

Is the implementation of broad-based tax cuts realistic with a central-planner entering the White House in 35 days? Certainly not.. But it’s still the correct remedy. Combine this with the elimination of mark-to-market accounting rules with which capital adequacy ratios are based upon (put in place just 13 months back; the timing could have hardly been worse) and I think most would be stunned how far these simple actions would get us in leaving the worst of this mess behind us.

But go ahead and target fed funds at 0.50%, even though the rate trades closer to zero. Go ahead and buy long-term Treasuries. Go ahead and triple the Federal Reserve’s balance sheet, from 6% of GDP a year ago to 17% today. We hope it works.

Have a great day!



Brent Vondera, Senior Analyst

Afternoon Review

AT&T (T) -3.73%
AT&T fell after Goldman Sachs downgraded the company citing the potential for peak dilution from remaining growth initiatives, cyclical exposure in certain businesses and an accelerated pension hit.

JPMorgan Chase & Co (JPM) -7.47%
JPM was downgraded by Merrill Lynch who said the firm may post a fourth-quarter loss and a $2.8 billion writedown.


Quick Hits

• Biotechs With Breakthroughs Can Spurn Product-Hungry Drugmakers
  
  
  

Peter Lazaroff, Junior Analyst

Fixed Income Recap

Agencies and Mortgages Tighten
Yields on Agency debt has tightened dramatically to comparable Treasuries due to recent direct buying by the Federal Reserve Bank of New York. Two-year Agencies are currently at 89 basis points over Treasuries, compared to 120 basis points this time last week.

The Fed has announced they will be buying benchmark Fannie, Freddie and Federal Home Loan Bank issues ranging in maturities from 2012 to 2017. Despite only buying the middle part of the yield curve, spreads have tightened across all maturities, in anticipation of more buying in the future.

MBS has followed agencies by tightening to Treasuries over the past week, again as a result of a buying plan announced by The New York Fed. The Fed has yet to announce specific issues that they plan to buy, but most signs point to fixed rate 30-year MBS pools.

As year end approaches, dealers are avoiding adding to their inventories, leaving the street with little to offer buyers. As a result, bids on odd-lots have continued to deteriorate, beyond what we saw last month, and show no sign of improving before year end.

TARP Money for Autos
The Bush administration announced this afternoon that it is considering tapping into the unused cash from the Troubled Asset Relief Program to rescue GM and Chrysler. The initial plan to allocate $14 billion in money directly from the Treasury failed to pass Congress Thursday night. It seems unclear why TARP money would be easier to allocate than the plan that failed to pass, because the TARP money would also need Congressional approval. Perhaps putting a different label on the same thing is enough to woo decision makers.


Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks, after getting off to a poor start, rallied 3.4% from the day’s low to manage a solid gain. Technology shares led the advance, jumping 5.52% on Friday as the next stimulus plan will not only boost activity within the industrial sector, but tech-equipment too.

The session began lower by roughly 3.0% probably due to pre-market news that the Senate didn’t have the votes to pass the auto bailout.

It came down to Senate Republicans demanding the UAW become competitive with the industry from a perspective of compensation – a “jobs bank” that pays the laid off 95% of wages and zero premium requirement for retirees has total compensation costs among the Detroit Three 52% higher than the transplants, as they’re being called. Frankly, the deal the Senate was working out would have been beneficial to workers relative to the alternative, which is bankruptcy.

But then the President rode to the “rescue” as he commented the administration would find a way to use TARP funds to keep the D3 going for a few months. Stocks often think short-term on a day-to-day basis and bounced from the session’s lows on these comments.

Obviously, the best long-term strategy is to cut dealerships, payrolls, and plants (along with the “jobs bank” and a zero-premium health-care policy, which I believe will change anyway in 2010). The D3 no longer have 50% market share, but something closer to 18%; it’s about time they began to manage the business to reflect this reality. Still, President Bush likely does not want an additional flood of layoffs in his final month in office – one supposes this is why he’s stepping in.

Market Activity for December 12, 2008

Then we had the Bernard Madoff scandal, a Ponzi Scheme, (taking another bite out of confidence). This could have pressured stocks, but didn’t; maybe we’re onto a rally with additional staying power. The broad-market has bounced 18% from the November 20 low; it will be tough to extend this rally through the year but maybe this strength in the face of bad news is telling us something.

Economic Data

The Labor Department reported the producer price index (PPI) for November slid 2.2% for the month and was up 0.4% on a year-over-year basis – that’s a huge deceleration from the prior month, which had PPI up 5.2% YOY.


Core PPI, ex food and energy, rose 0.1% for the month and was up 4.2% year-over-year, down slightly from a reading of 4.4% in the prior month.


This core figure is showing that the plunge in inflation gauges over the past two months is largely due to the rapid decline in energy prices from their Fed-induced heights of July 2008. Oil prices in particular doubled in a 10-month time span, driving crude per barrel to $145. The slide from those heights has brought the inflation indices down with it but there are underlying factors that shows prices will rebound.

Take core intermediate goods for instance. These are goods, ex-fuel, used to make finished product. While these prices are lower, they remain somewhat elevated and sticky.


When banks begin to lend in a more normal way, all that liquidity the Fed has pumped into the system will flow through to the economy. This money will find an environment in which there are less goods out there as production has been cut – to much money chasing too few goods will cause inflation to rise again.

Further, when this combines with an infrastructure-based stimulus program, commodity prices will rebound, making an inflationary event inevitable in my view. Too bad I don’t know whether this will take six, 12 or 18 months to occur – it would certainly be helpful to know this, but it’s pretty much a done deal.

In a separate report, the Commerce Department stated retail sales fell for the fourth-straight month. For November overall sales were down 1.8%, which was less than the expected decline of 2.0%, but still a very significant decline. This follows a very large drop of 2.9% in October.

Certainly, consumer activity is going to remain weak for a while. We have a lot of people that lack the means to expand activity due to a weak labor market and mortgage interest-rate resets for those that chose a lower adjustable rate three years back. That said, the majority of consumers have the means, but have shut down in a spate of caution due to all of the news over the past three months. Surely, a 40% decline in stock prices is having a huge effect on sentiment.

That said when we exclude auto and gas-station sales, activity rose for the first time in three months – up 0.3% in November. This may be an indication retail sales are set to bounce. This is not to say we’ll see a multi-month rebound, but we should halt the four-month decline streak when the December number is released.

One of the factors behind the slump in retail sales has been the dramatic decline in gasoline prices. Gas-station receipts make up 9% of the overall figure, so when this component falls 14.7%, as it did in November, it accounted for 1.3% of the 1.8% drop -- 72% of the move.

Again, under normal circumstances this decline in pump prices would allow for increases in other segments. Things are not normal right now and we’re not trying to say activity will bounce back in a sustained way, but the rise in ex-auto, ex-gasoline retail sales is setting up for a nice month-over-month increase when the December data is released.

This Week

We’ve got a plethora of data out this week, beginning this morning with industrial production (November) and the NAHB (Nat Assc. Of Homebuilders) Housing Market Index.

Later in the week, we’ll get the Fed rate decision, housing starts, CPI, jobless claims (of course) and Philadelphia-area manufacturing.

Have a great day!

Brent Vondera, Senior Analyst

Afternoon Review

Intel (INTC) +5.28%
Intel is not immune to the effects of an economic recession, which now appears to be dragging down microprocessor and PC demand. However, the magnitude of the change in Intel’s forecast seemed to catch the market by surprise. In fact, semiconductors have been among the more pessimistic over the last 30 days, lowering 2009 earnings estimates with an assertiveness that has not been matched by other parts of the market.

While some believe that companies have been too optimistic in earnings forecasts, this cannot be said of chip makers. A report from Citigroup notes that chip companies’ estimates reflect a decline in 2009 earnings of 20 percent or more, “significantly more conservative than other areas of technology or the broader S&P.” In addition, more than 90 percent of the earnings revisions are negative, which suggests “capitulation” among these companies. With those aspects in mind, this sector appears to be attractive.

Today, Nancy Pelosi said the U.S. House is likely to act next month on an economic-stimulus measure that would increase computer expenditures. This certainly will benefit Intel who absolutely dominates the computer processor market with over 80 percent of the market share. (Computer processors are like the brain or nervous system of a computer.)


First Cash Financial Services (FCFS) +6.47%
First Cash announced the acquisition of Presta Max, a privately-held chain of 16 pawn stores located in southern Mexico. The company believes the transaction will be accretive to its earnings in 2009.

CEO Rick Wessel stated, “The 16 Presta Max Stores will further expand our significant Mexican pawnshop operations. These new stores are profitable, provide us a valuable entry point into markets within Mexico and fit well into our long-term strategy for growth.”

First Cash also sold the operations of its Auto Master unit earlier this week, which the company had planned to exit since September. The cash flow and related tax benefits resulting from this transaction will support the continued expansion of First Cash’s pawn operation in Mexico and the U.S. as well as allow the company to reduce outstanding debt.


Harsco (HSC) +4.84%
Harsco said 2008 profit will be lower than it previously projected, but reiterated its 2009 profit forecast. Turmoil and uncertainty has led to Harsco aggressively reducing costs and exiting some underperforming contracts.

The company statement said the 2009 forecast “is based on the assumption that there will begin to be some relief from the current volatility and the beginning of a return of economic confidence by the second half of 2009.


Quick Hits

• Bailout Scorecard (the list keeps getting longer)
  
  

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Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks, after spending most of the session in an usually tight range, slid in the final hour. Traders shook off a really weak jobless claims reading that points to another month of big payroll losses when the December jobs data is released.

We were pretty amazed activity hovered around the flat line for most of the day, particularly on that claims report, obviously it eventually hit sentiment.

Until the final-hour sell-off gains in energy, basic material and industrial stocks were offsetting financial-sector weakness; however, nothing save health insurers and a couple of energy names held up in the end.


Uncertainty over whether the government assistance to the Detroit Three will have the votes to pass the Senate may have also weighed on stocks today, largely because of the additional pressure a GM and Chrysler collapse would put on the labor market – Ford is in a better position; they’ve got liquidity to get them past the next six months at least. What strength.

I’m guessing fears that the government won’t provide some funding are likely overblown. Once January 20 rolls around checks to Detroit will rip off like there’s no tomorrow.

Market Activity for December 11, 2008

Economic Data

The Labor Department reported initial jobless claims jumped to the highest level since November1982, ending a two-week decline. We’ll continue to match 1982 levels as it will take a reading above 700k to make a new high. Claims jumped 58,000 to 573,000 in the week ended December 6.

The four-week moving average, a less volatile measure, rose 14,250 to 540,500, as the chart below shows.


The insured unemployment rate, the jobless rate for those eligible for benefits, rose to 0.1% to 3.2%, the highest since August 1992 – this figure tends to track the overall unemployment rate.

Continuing claims, those taking benefits for longer than one week, jumped 338,000 to 4.429 million – certainly some of this is due to the government extending the period of time one can continue to take benefits, although most is simply due to deteriorating labor market conditions.


It doesn’t take an expert to understand what all this says, the payroll survey is going to register its fourth-straight month of large declines when the December reading is released, possibly a reading over 500k as we saw in the November data.

The unemployment rate will probably hit 7%, unless the number of discouraged workers rises and keeps the figure artificially low. This is why the unemployment rate is a lagging indicator and generally does not peak until 6-12 month after a recession has ended. It takes these discouraged workers to feel better about the environment again before they re-enter the workforce by actually looking for a jobs. (The definition of a discouraged worker is one out of work and has not looked for employment in the past four weeks.)

This labor market data along with what we know about the overall economy means we need to pull the trigger and go with big bang tax rate cuts – across the board, slash rates on income, capital, corporate profits and repatriated income. Anything less signals a failure to understand what gets things going and does so with staying power.

Of course, the Fed must be reigned in too so they are not allowed to make terrible mistakes like the 2003-2005 decisions to keep rates too low for too long. Real interest rates were negative (fed funds lower than the rate of inflation) which means the Fed subsidized debt. When you do this you get more debt, and this is what led to the housing bubble that caused much of the current harm when it popped. It also encouraged the over-leverages stance of institutions that smashed the financial sector and later everything else.

We understand the likelihood of a tax-rate response is highly unlikely with the administration and Congress that is coming in January 20, but it doesn’t mean to forget the government policy that has the most power. Maybe when we get the next payroll report it will begin to wake people up. It’s a real shame the current administration has not even offered such a move, even if the votes do not appear to be there.

Then again, maybe I’m off base; possibly we’ll be able to spend out way out of this situation. If we do, it will be the first.

In another report the Labor Department reported import prices fell hard again in November, plunging 6.7% on a 26% tumble in petroleum prices. On a year-over-year basis import prices have declined 4.4%, what a round-tripper this has made.


Excluding petroleum, import prices fell 1.8% last month and are up 2.6% year-over-year.


While you can see most of the decline was due to the precipitous drop in energy prices, whether including or excluding energy prices fell faster than anticipated. This is going to augment the deflation argument. However, with monetary conditions as they are – the massive easing and liquidity pumped into the system – it makes a sustained deflationary event highly unlikely.

This is certainly a minority view right now, but we believe prices will begin to rise again 6-8 months in a way that will get everyone’s attention. The dollar will have a rough time advancing from here since what we’re getting as stimulus are plans to throw money at the problem – which will push import price alone higher. A more appropriate response would be to provide incentives to produce that would bring more goods to market that absorb these massive money injections. We shall see how it turns out.

Finally, the Commerce Department reported the trade deficit widened to $57.2 billion in October, which was a surprise – a narrowing was expected as import declines were estimated to be larger than the drop in exports. Imports ended up falling 1.3%, while exports fell 2.2%

The real trade gap widened to $46.4 from $42.0 billion in September. Real exports dropped 0.9%; real imports rose 2.8%.

By region, exports picked up a bit in Europe, after a big decline in September; exports to the Pacific Rim fell 0.8%. The biggest export declines came from Japan, down 2.8% for the month, and Asia NICs (Non-industrialized Countries), down a big 9.4%.

Interestingly, exports to South America and OPEC countries, which feel the effects of plunging energy prices as much as anywhere, kept activity upbeat, rising 20% and 36.8%, respectively.

The widening of the real (inflation-adjusted) trade gap means additional pressure will be put on the Q4 GDP report – it’s going to be a doozy. Good news is it shouldn’t take anyone paying attention by surprise when it posts a quite likely negative 6.0% reading – that’s at a real annual rate. If so, it will be the worst GDP reading since the -6.4% posted in Q1 1982.

It is stunning how drastically things change in mid-September and outside of a few areas, we have yet to see any bounce whatsoever.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

Eli Lilly & Co. (LLY) +1.74%
LLY reaffirmed its outlook for fiscal 2008 and raised its targets for 2009 as it expects robust volume growth in sales. While the company expects robust volume growth in sales in 2009, the outlook is dampened by the negative impact of weaker foreign currencies and the impact of generic competition.

LLY is the second U.S. pharmaceutical company in a week – the other being Merck (MRK) – citing slowing demand and international sales declining in value as the U.S. dollar strengthens.

Meanwhile, LLY said it is halfway to meeting its goal of cutting the cost of bringing a new drug to market to $800 million by 2010 from $1.2 billion in 2007.

Drugmakers, which will be subject to continued patent expiration of blockbusters in the next several years, have been looking to cut costs as their pipelines generally aren’t seen as being able to recoup the revenue losses caused by drugs’ generic competition.


Boeing (BA) -3.38%
Boeing said the 787 Dreamliner is now almost two years behind schedule and won’t reach customers until the first quarter of 2010, the fourth delay for the best-selling new aircraft in Boeing’s history.

In separate reports, Boeing plans to offer cheaper weapons systems based on existing technology to counter potential Pentagon budget constraints under the Obama administration. (Related article)


Procter & Gamble (PG) -0.91%
PG said fiscal 2Q sales will rise less than it thought because of the “difficult economic environment,” but reaffirmed its 2Q and full-year earnings guidance. Because of its size, PG has more levers to pull internally to cut costs that other companies may not have.


Quick Hits

• Treasury Bubble Talk Grows as U.S. Gets Free Money
• Level Three Assets Said to Rise at Major Banks
• Bank of America of America to Cut 30,000 to 35,000 Positions
• Auto Bailout Plan Lacks Votes to Pass U.S. Senate

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Peter Lazaroff, Junior Analyst

Fixed Income Recap

Mortgages Continue Tightening
Mortgages rallied strong today, tightening to Treasuries. 15-year collateral outperformed the longer 30-year, while Treasuries were more unchanged on the day.

Mortgages were just slightly tighter before tightening further on news of discussions within Fannie and Freddie of waving new appraisals on refinances to assist homeowners with reducing their mortgage burden. This would allow homeowners who are underwater, and therefore currently unable to refinance, an opportunity to take advantage of today’s lower rate environment. No detail has been given on how lenders would handle the depreciated home values if a plan like this was implemented, but this would obviously be an obstacle.
Prepays on outstanding MBS will accelerate as a result of a plan like this. In an environment where rates are low and new issue is nonexistent, most MBS is priced at a premium. Given this potential risk, we will be very selective as we add new positions.