Fixed Income Recap

The curve moved flatter yesterday as large buyers bid up the long end of the curve, moving the yield on the 30-year to 4.243%, its lowest point since July 13th. Despite the move lower in yields on the 10- and 30-year, the 10-year breakeven yield widened out 8 basis points. It seems to me that the long end is trading with every macro factor in mind except inflation, while the TIPS market is focused entirely on expectation for higher consumer prices. The movement the past few days has created a disconnect between the two markets. I know I have concentrated on TIPS a lot this week so I will just leave it at that.

Next week’s supply was announced yesterday and will be just under what the street expected. The Treasury will auction $109 billion in 2-, 5- and 7-year notes, $2 billion less that the $111 billion expected. Bonds rallied on the better than expected supply news but the market still stands to face a few headwinds come next week. The auctions earlier this month were refunding auctions, meaning that the majority of bonds auctioned were just replacing ones that were maturing at the same time, meaning the “net new issuance” was small. That is not the case this week. These are for the most part new bonds that need to find new money. That, coupled with a short staffed street, creates the potential for higher clearing yields, lower bid/covers and longer tails to the current market. Next week may be a wild ride.


Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks advanced on Thursday, pushing back above the 1000 mark on the S&P 500, as a good print from the Philadelphia-area manufacturing gauge and another rise in the leading economic indicators index offset a rise in jobless claims.

Financials led the rally after AIG’s CEO stated he believes the firm will be able to pay back the government. He didn’t give a timeline of course. AIG is on the hook for $182.5 billion and it is unlikely that the bailout money will be repaid in a decade, we’ll see.

Industrial and energy shares were also among the top performers on the news out of the Philly survey. All 10 major industry groups closed higher on the session.

Advancers beat decliners by a four-to-one margin on the NYSE, although volume remains weak with fewer than one billion shares traded on the Big Board. Yes, it’s late August, which is always a light-trading period, but these are below normal levels. This has been an issue with the latest leg of this rally as conviction doesn’t seem robust even though the market has shaken off most of the weak data days.

Market Activity for August 20, 2009
Jobless Claims

The Labor Department reported that initial jobless claims rose 15,000 to 576,000 in the week ended August 15. The previous week’s reading of 550K in initial claims was revised up to 561K. While the level of claims has come down from the 625K average during the first-half of the year, this range is still very high as the chart below illustrates.

This latest claims data coincides with the week the government collects its numbers for the August jobs report, so the boost in claims indicates we’ll see this month’s payroll losses exceed the July reading.

The four-week average of initial claims rose 4,250 to 570K.

Continuing claims rose marginally, up 2,000 to 6.241 million. This number too is nicely off of its peak, but remains extremely elevated. The decline from the apex of nearly 7 million in cont. claims appears to be due to the expiry of benefits rather than a new cycle of job creation – the latest monthly employment report showed jobs losses (while also off of their peak) continue at a level that is at the higher end of what is typically seen during the normal recession.

This chart of the exhaustion rate helps to illustrate the point that the decline in continuing claims is more a function of benefits running out rather than incipient job creation.

A measure of long-term unemployment, those that have been out of work for at least 27 weeks, is another indicator that continuing claims may rise again as jobless benefits are extended, which is coming.

I think it will be a few more months before monthly job losses become mild – by mild we mean less than 100K in monthly losses. We mentioned a few months ago that the job-market weakness will ease to levels that mirror the typical recession, and that appears to be occurring. But the labor market will remain rough for an extended period in my opinion and the unemployment rate will remain near double-digit territory. It takes 140K in monthly job creation to keep pace with population growth and keep the jobless rate from rising.

Leading Economic Indicators (LEI)

The index of leading economic indicators rose for a fourth-straight month for July, up 0.6% -- the expectation was for a rise of 0.7%.

This trend is a very nice sign, and surely many will view this recent rebound as a reason to believe the economy is on the mend. For sure, that notion is largely correct, things have improved markedly from the deep recessionary levels of late/2008-early/2009 but just as I cautioned last month, one has to be leery of putting too much credence in this reading this go around. And yes, things are different this time (heck, look at corporate bond spreads, a chart I’ve put up in prior letters, that remain at previous recessionary levels, even if much narrower than the “Armageddon” spreads of early this year, and this is even with massive government back-stopping within the credit markets – off on a bit of a tangent there but just wanted to point that out).

For instance, the three components of the LEI index that pushed that reading higher for July were the average workweek, jobless claims and Treasury interest-rate spreads.

On the workweek, when this rises it generally indicates job growth is not far behind, but I don’t think job creation is going to make a come back any time soon after what businesses have been through and their concern about the degree of the recovery. Additionally, average workweek rose in July but just barely (up six minutes per week) from the all-time low hit in June. If past is prologue, it takes about a ½ hour increase in the workweek before job creation begins to come back. This time, since we’re coming from an all-time low, it may take a full hour and at this rate that will take a while.

On jobless claims, as touched on above, the August data showed the reading remains extremely elevated and will probably hurt LEI’s August reading.

On interest-rate spreads, this is normally one of the best forward indicators. When the spread between the short and long ends of the Treasury curve widens, and it is very near record wides right now, it indicates that bank lending activity will roar. But this time is a bit different as the demand for loans is depressed due to consumer debt levels in the face of high joblessness and business caution (C&I loan activity continues to decline). Even the most favorable interest-rate dynamics for the banks, borrow near zero and lend at 5-6%, will not change the demand side – only time will fix this issue.

So the overall point is the market should be careful in interpreting this figure, getting too excited could set us up for a significant decline in stock prices if actual economic growth does not improve as directly as LEI appears to be suggesting. Besides, the surge in stock prices from the March lows, at least the back-half of this rally, seems to already price in the boost to GDP by year end due to the inventory dynamic.

Philly Fed

The Philly Fed survey, a gauge of factory activity within the Federal Reserve Bank of Philadelphia’s region, hit positive territory for the first time in 11 months. The reading came in at 4.2 for August vs. the -7.5 for July and has improved massively from the deep contractionary levels of the fall of 2008 through the spring of 2009. The expectation was for the gauge to come in at -2.2, so beating that estimate and moving to expansion mode was big news.

The sub-indices showed nice improvement, although some remain in contraction mode. New orders rose to 4.2 from -2.2; shipments increased to 0.6 from -9.5; unfilled orders rose to -9.3 from -14.6; inventories hit 0.3 from -15.4 (the best news in this report as an increase in stockpiles illustrates at least some degree of confidence regarding the future; it snapped a streak of 22 months of decline); and the average workweek rose to -6.3 from -15.5.

All of the manufacturing figures are pointing higher, with Philly and Empire (the New York factory gauge) rebounding the most. The largest regional factory survey, the Chicago Purchasing Managers Index, remains in contraction mode, as does the nationwide ISM figure, but both are on their way to expansion.

I suspect they’ll hit expansion territory by the September readings, but the bounce may prove short-lived as “cash for clunkers” will boost auto production in a transitory manner. It all depends on the overall inventory dynamic. If firms boost stockpiles for a length of time that last a couple of quarters, it will offset what may be another round of auto production weakness by late/2009-early/2010. If the cautious mindset within the business community remains elevated, however, these factory gauges will retrench. Really too early to tell right now, but it is hardly a given that we’ll soon see a rebound that has the legs that is typical of the normal expansion.

(On the clunkers program, as you probably know, it will come to an end on Monday, I think it was originally planned to expire in November. The government can’t administer the program and dealerships are dropping out for fear they won’t get paid. The administration wants to pull the plug on this thing because it shines a light on the operational incompetence of government and does additional damage to their universal health-care agenda – if so, this is the best $3 billion the government has ever spent. Again, these are my opinions and not the firm’s)

Mortgage Delinquencies

No comment required, see chart.



Have a great weekend!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks, after beginning the session lower following the sell-off overseas, rallied late in the morning session yesterday driven by energy and basic material shares as crude prices rallied. The broad market, as measured by the S&P 500, was able to hold onto most of that momentum to the close. The rise in Exxon and Chevron shares accounted for 33% of the Dow’s move on the day.

So, stocks and oil continue to move in tandem. A couple of months back we talked about that at some point this relationship would turn to one that is inverse in nature as the market sees higher energy prices as just another ballast that will ground the consumer. Well, that hasn’t occurred yet but it’s a matter of time.

Most other commodity prices halted their early-session slide, a move lower that was fostered by fears of weakening demand in China. The reversal pushed most metals and agricultural prices to positive territory on the day.

(On China, even though their stimulus program is robust and specifically targeted to infrastructure projects, analysts are beginning to wonder if that economy can keep growth going at an appropriate pace despite weakness from the most powerful consumers in the world. Export-driven economies in Asia will have a rough time hitting growth levels that a 67% run up in the Shanghai Composite – occurring in five months time -- appeared to price in. China just does not yet have domestic consumer activity that is able to offset reduced U.S. consumer purchases and the 20% decline in that index over the past couple of weeks seemed to be acknowledging that reality. Nevertheless, the Shanghai Composite bounced back last night after Chinese regulators allowed initial public offerings after a nine-month moratorium. That’s what is being reported as the cause for last night’s rally. No one really actually knows as it’s a highly volatile market, sometimes pushed up or down due to cultural superstitions.)

Back in the U.S., there was also speculation that the government will announce an additional stimulus package on top of the $787 billion monstrosity that is currently in play and some pointed to this talk as having an effect on the market’s turnaround. I can’t believe this speculation has much merit considering the uproar that’s begun over current levels of government spending.

Eight of the 10 major industry groups gained ground on the session, financial and industry shares were the laggards.

Market Activity for August 19, 2009
Mortgage Applications

The Mortgage Bankers Association released its weekly mortgage apps index yesterday, which showed a 5.6% rise for the week ended August 14 after a 3.5% decline in the prior week. Refinancing activity led the index higher as refis rose 6.9% after falling 7.2% in the week ended August 7. Purchases, which make up a little less than half of the index right now, also increased, up 3.9% for the week.

The 30-year fixed mortgage rate fell back to 5.15% last week (from 5.37% in the week of August 7) and one would have expected a bit more of pop in the index at this low level of interest – the 30-year mortgage rate has averaged 5.26% over the past month, yet the mortgage apps index is up just 0.2% for the past four weeks. The weak job market is certainly weighing on things.

On Friday we get the actually existing home sales figures for July. There’s roughly a 4-6 week lag between contract closings (the point at which existing home sales are recorded) and applications. Home purchases, as measured by the mortgage apps index, rose about 7% in late-May/June. Pending home sales, an additional figure, rose 3.6% in June. So both of these readings point to an existing home sales number that should rise nicely, that is if contracts didn’t fall apart sometime in the process. Considering the pace of job losses (even if off of their very deep monthly declines) there’s an outsized chance of contract cancelations.

Crude

Oil for September delivery rose back above $72 per barrel after the weekly Energy Department report showed crude stockpiles declined the most in more than a year, plunging 8.4 million barrels – a drop of 1.2 million was forecast.

The biggest factor in the inventory decline was a slide in imports, down 15% to 8.53 million barrels. That marks the largest drop since last September when Hurricanes Ike and Gustav hit the Gulf coast, shutting down the ports. The reason for the reduction in imports was due to nervousness among refiners over the outlook for gasoline demand so they reduced purchases, according Energy Security Analysis.

Nevertheless, crude inventories sit at 343.6 million barrels, which is roughly 6.5% above the five-year average of 320 million.

The Consumer

We’ve spent a good deal of time explaining that consumer activity as a percentage of GDP will move back to its historic average of 65% from the current 71% -- a level of consumer spending that was fostered by very easy credit conditions, a formerly low unemployment rate (averaged just 5.1% 2004-2008), solid real income gains and a wealth effect that steamed along as the stock market hit a record high in October 2007 and home prices were on a tear.

Now, however, all of this has changed as credit standards are tighter (and appropriately so), the jobless rate sits at a 26-year high, incomes are stagnant, and home and stock prices are well off of their peaks -- down 20% for homes on average and the S&P 500 is 36% below its apex, a reverse wealth effect. See chart below. (Household net worth will show some bounce due to the rally in stock prices, the figure will not be updated until we get the final revision to second-quarter GDP).

Certainly the inventory dynamic and massive government spending will offer some boost to the GDP figures a quarter out and this could last for three-four quarters. But the largest segment of the economy will continue to weigh on economic growth, that is just the reality.

The market needs to come to grips with this situation. And then, we’ll have to pay for the way the government has increased debt issuance via massive spending, and monetary policy that has also (even if the Fed really had no other choice) worked to hurt the dollar.

At the current level of interest rates, there is only one direction in which they will move over time. In addition, we’ll have tax rates on labor income, dividends, and capital returns moving higher by the end of 2010. In addition to that, many in Congress are talking about raising the Social Security tax wage base and implementing value-added taxes – talk about concrete boots. Slip the economy a mickey such as this and it will go back to sleep. We shouldn’t lose sight of these very likely headwinds; risk must be properly assessed even if the current level of interest rates encourages the opposite.


Have a great day!


Brent Vondera, Senior Analyst

Quick Hits

• The Greenback Effect
• Disclose the fair value of complex securities
• China? U.S.? Which Might Lead Stocks Higher?

Strong service results and cost cutting lifts Hewlett Packard (HPQ)

Hewlett-Packard (HPQ) reported fiscal third-quarter results that were largely in-line with expectations thanks strong performance from the services unit and effective cost management. The world’s largest PC maker suggested that business is beginning to stabilize and they expect to be an early beneficiary of an economic turnaround.

Revenue for the quarter declined 2% to $27.45 billion. Every business reported steep double-digit declines versus a year ago except the services unit, which increased revenues 93% from a year ago before it had acquired EDS. The way HPQ reports their service unit results makes it difficult to determine how the old EDS outsourcing business is performing, but the 15.2% operating profit is an encouraging sign.

Lower selling prices weighed on revenues in the PC unit as well as the servers and storage division, but strength in areas such as enterprise hardware spending suggest that corporate IT spending may have bottomed. Still concerning, however, are the printer and software businesses, both of which saw sales decline versus last year and last quarter.

Operating profits were mixed by business unit, with improvements in service’s operating margins offsetting declines from servers and PCs. The company generated nearly $4 billion in operating cash, a $500 million improvement from a year ago, as the company benefits from good management of its working capital, particularly inventory. The only red flag with HPQ’s cost cutting is that R&D is only 2.4% of sales, less than half the level five years ago and significantly less than rival IBM’s 6.2% of sales.

The shares declined today as near-term expectations had gotten a bit frothy for HPQ’s upside. Still, the company has successfully managed through the downturn and gained market share in the process. HPQ is trading at 11.5 times forward earnings, a 31% discount to the S&P 500.
--

Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

The recent trend of Treasuries inversely to stocks continued today as some positive retail earnings fueled an rally in equities that lead Treasury prices slightly down.

PPI Down… TIPS Rally?
A .9% month over month decline in the PPI for July was all but ignored by the market – the index was down 6.8% from July of 2008. Consensus was calling for a .3% decline MoM but yields moved higher across the curve despite the deflationary data, and TIPS outperformed nominal Treasuries by 62 basis points. There are a few possible reasons for the atypical TIPS behavior. One is that the market is looking past yesterday’s data, concentrating more on what is to come on the inflation front. Another reason could be energy fears tied to the storm activity in the Gulf of Mexico – oil was up 5% yesterday. 10-year breakevens widened by seven basis points in Monday trading.


Cliff J. Reynolds Jr., Investment Analyst

Morning Reading

• Brokers Aren’t Responsible for Bad Bets (by Charles R. Schwab)
• Buffett Says ‘Gusher’ of U.S. Federal Debt Poses Risks to Economy, Dollar
• Pimco Says Dollar to Weaken as Reserve Status Erodes
• The Economic Recovery: Fast, Slow, or Neither?

Daily Insight

U.S. stock indices gained back about half of Monday’s pullback on better-than-expected earnings out of Home Depot and a measure of European investor sentiment jumped to the highest reading in three years.

The news out of Home Depot turned futures around yesterday morning, although the results were only positive on a relative basis, as we pointed out in Monday’s letter – HD’s 2009 EPS guidance improved as the company now expects earnings to fall in a range of 15-20% vs. the prior forecast of a 20-26% decline; hardly a situation that should get anyone excited but it doesn’t seem to take much these days, my how things change when stocks are on the rise.

It was that European investor confidence reading that likely played a greater role in driving bids higher, specifically German investor confidence, as what is known as the ZEW index jumped well more than anticipated. The ZEW is a gauge that aims to predict economic prospects six months in advance. The figure rose to 56.1 for August from 39.1 in July. (The ZEW’s gauge of current economic conditions rose to -77.2 from -89.3 in July; to offer some perspective, the all-time low of -92.8 was hit in May. Needless to say, views about the current situation remain flimsy).

Market Activity for August 18, 2009
Housing Starts

The Commerce Department reported that housing starts fell 1% in July after a significant bounce during the previous two months – up 6.5% in June and 15% in May, which was off of the all-time low hit in April. Housing starts came in at 581,000 units at an annual pace last month from 587,000 units in June. The market was expecting starts to increase to 599K.

A decline in starts should be viewed as a good thing. While it is true that a rise in residential construction will help GDP in the short term, we don’t exactly need more supply within the housing market. Unfortunately, the decline came totally from the multi-family side of things, down 13.3% in July; single-family construction rose 1.7% after a 17.8% rise in June and a 5.4% increase in May.

I think the trading mentality within the stock market actually liked the pick up in single-family starts as the focus seems to be quite short-term in nature (and on this topic, just listen to how institutional money managers talk, they know this thing in short-lived based on a number of factors; they’re chasing this last hoorah before tax rates on capital returns rise and interest rates go higher – the bill to be paid for all of this fiscal stimulus, not to mention the increase in regulations to come).

But with the job market in the shape it is in, the most important factor with regard to home sales, we could be setting up for additional weakness in residential construction a few months out as the supply figures build from what are still elevated levels. Just as Chairman Bernanke explained in the spring, it takes GDP growth of 2.5% to keep the jobless rate constant. Odds are we won’t hit these levels of growth outside of one-two quarter pops as consumer activity heads back to it historic average. Thus, adding to home supply here will only delay the housing recovery.

Further, foreclosures remain a threat to supply. While a foreclosure-driven decline in prices does help sales, there are estimates that roughly $3.5 trillion worth of home properties are still at risk of default because the owners owe more than the property is worth. This is a double-edged sword that may also add to supply.

It would be much better to continue to allow for the inventory/sales ratio to keep heading south, we’ll be better off 12-18 months down the road

Housing permits, an indication for residential construction over the next few months, fell 1.8% in July after a 10% pop in June. Just as in housing starts, this decline in the permits data for July resulted from the multi-family side as permits for condos, townhouses and apartments fell 25.5%. Single-family permits rose 5.8%.

Producer Prices

On the inflation front, the Labor Department reported that the producer price index (PPI) fell a large 0.9% in July after a 1.8% rise in June. A 10% decline in the gasoline component was responsible for much of the move lower, but even the ex-energy reading dropped 0.4% last month. Basically residential gas and prescriptions were the only components to post an increase.

On a year-over-year basis, PPI posted its largest decline yet, down 6.8% as the figure is being compared to the height of last summer’s commodity-price spike that sent this inflation gauge to the highest level in 27 years. By November this trend will shift as the comparisons will be against flat to declining figures.

“Free to Choose” – never more insightful

Rose Friedman, wife of the late Milton Friedman, died yesterday at the age of 97. The two engaged in copious amounts of economic research and together authored one of the most seminal books of the last century, “Free to Choose.”

The work criticized interventionist government policies (explaining how it does damage to personal freedoms and prolongs economic downturns), explained inflation is not some Phillips Curve based phenomenon that is solely dependent upon a tight labor market but rather the result of rapid money supply growth, and that the welfare system creates “wards of the state” as opposed to “self-reliant individuals.”

Their work lives on.

Futures

We’re in another tug of war here, down Monday, up yesterday and futures are pointing to a lower open this morning. Stock indices are coming under pressure after the Shanghai Composite fell 4.30% last night. This puts the Chinese market down 20% over the past couple of weeks, right in bear market territory. Global stocks have pretty much followed the direction of the Shanghai Composite of late so we’ll see how U.S. markets react to this move in Chinese equities.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

A broad selloff in stocks led to a stronger bond market as the curve was pancaked flatter to 245.8 bps, 6 bps lower on the day. Rates have moved to their lowest point since the end of July, thanks in part to strong Treasury auctions last week, but primarily because of reversal in sentiment over the past 2 weeks or so.

A Treasury market fixated on stocks is a positive for a market that has been looking at every auction with a magnifying glass worried to death that US debt buyers are vanishing. So now that fundamentals are back as the main driver of the market – at least for now – volatility may have a chance to ease a bit. We’ll see how long it lasts.

TALF Extended
In a joint statement with the Treasury, The Federal Reserve announced the extension of the TALF program for newly issued Commercial Mortgage Backed Securities to June 30, 2010. The reason behind the switch is that CMBS deals typically take longer to originate than other TALF eligible collateral such as small business and credit card loans. This extension does not widen the scope of what is considered TALF eligible, although many think that residential mortgages are the logical next step. The Fed Agency MBS purchasing program has been effective at propping up the secondary market for securitized conventional mortgages, but the secondary market for prime jumbo, Alt-A and Sub-Prime mortgages continues to be very illiquid. The question Bernanke is asking himself is, “How much is too much?”

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks endured a broad-based decline on Monday, despite good economic prints on the day, as fear spread that the global economy will remain weaker than expected.

U.S. market sentiment took a hit after the Asian markets dealt with their most pronounced weakness in several months the night before, and the pessimism extended into the official trading session. It will be interesting to watch if buying comes back in after a 5%-10% move lower (if that even occurs yet – there seems to be an awful lot of people waiting for any pullback as a chance to get back in) or we retrench in a more substantive manner after the 52% surge off of the nefarious March 9 low of 666 on the S&P 500.

Indeed, headlines touching on the possibility that stock markets have gotten ahead of economic realities have abounded over the past week after the latest retail sales report showed the “cash for clunkers” spurred bounce in auto sales was not even enough to lift overall sales. A consumer that will need to reduce debt levels as the unemployment rate sits at a 26-year high and incomes remain stagnate for an extended period is a major concern for economic growth prospects.

Health-care stocks were the best performing group on the session as full-blown single-payer healthcare appears dead, for now. The grassroots-driven assault on this treacherous agenda is the best news I’ve seen in nine months. For the record, these comments are purely my own and I do not speak for the firm in this regard.

Financials led all major industry groups to the downside as 30-day credit-card delinquencies remained high. The 30-day delinquency rate did increase at a slower pace (4.2% in July vs. 4.4% in June at AmEx; 8.43% vs. 8.75% at Discover; 13.81% vs. 13.86% at Bank of America) but not enough to help the bank stocks.

Market Activity for August 17, 2009
Empire Manufacturing

New York–area factory activity, as measured by the Empire Manufacturing index, posted some really nice numbers on Monday. The overall index jumped to 12.08 for August after basically flat-lining in July and enduring 15 months of decline.

Among the survey’s sub-indices: New orders moved to 13.83 from 10.42. Shipments came in at 14.11 from 10.97. Delivery times fell at a lower rate, -10.64 vs. -14.58. The average workweek declined at a softer pace as well, -6.38 vs. -19.79 in July.

We should see the factory gauges pick up steam, and the broad ISM figure will even make it to expansion mode, as auto production picks up and that overall inventory dynamic we’ve talked about for a couple of months now eventually occurs. But it may very well slip again after a few months of increase as the car subsidizations expire in December. This is also true for consumer activity as the big rebound in auto sales adds to debt levels and borrows from future spending.

Treasury Inflow Capital (TIC) Report

Longer-term Treasury market inflows for June, a report that is always two months in arrears, showed net foreign inflows rose $90 billion (much greater than the $17.5 billion increase that was expected). Sponsorship in the Treasury market remains very good, as is evident via the very low interest-rate environment (higher bonds prices mean lower yields as the two are inversely related).

Although on the short-term side, inflows into T-bills fell $11 billion in June – maybe a portent of things to come as we look out a couple of quarters.

At some point, it is difficult to see demand for Treasury securities continuing at this pace absent some major geopolitical event or other situation that keeps the safety trade rolling. When the global market is no longer willing to purchase U.S. government bonds at yields of just 1% (on the 2-yr Treasury) to 4.35% (on the 30-year) as investors and governments demand higher protection against future inflation, these inflows will slow substantially. And speaking of dollar-denominated assets…

The Dollar

The greenback rallied yesterday, which is the trend these days when the equity market’s sell off – it’s all about the safety trade, even if that trade is defined differently today with economic “Armageddon” behind us now.
(And on this topic of severe economic weakness, I found a comment from Holman Jenkins in yesterday’s WSJ editorial page apropos to the current environment: “Recall that the deepest damage in the 1930s was not done by a misallocation of capital during the bubble years, but by the destructive political imperatives unleashed in the bubble’s aftermath.” This is certainly a concern that must be acknowledged as we look out over the next couple of years).

But back to the dollar, as we’ve discussed many times before, this is a rather disturbing trend. Under more sound scenarios, the dollar would rally on expectations regarding U.S. economic growth. The fact that the converse is in effect, that it takes a state of concern for the dollar to find a bid, is not a good sign for old green. When the bill for the way we’ve dealt with this credit-market led recession (higher tax rates and the move to higher interest rates – if this combination occurs it will cause the deplorable double dip) the dollar will endure a period of sustained weakness before rising again as those higher interest rates encourage the next phase of demand for dollar-denominated assets.


Fed Extends TALF

The Federal Reserve decided to extend the TALF (Term Asset Backed Loan Facility) for six months as the asset-backed and commercial mortgage-backed markets remain impaired. There is $165 billion in commercial loans that will have to be rolled this year and the Fed knows this will be an issue for the economy. The credit channels would remain very tight if not for government back-stopping and other assistance.

Funny how Bernanke & Co. waited a few days to announce this extension, it’s becoming a trend to omit this stuff from the FOMC meeting comments.

Futures

Stock-index futures are on the rise as I type, reversing early-morning weakness, as Home Depot’s earnings results beat expectations and management bumped its fiscal 2009 guidance. The company now believes adjusted earnings per share from continuing operations to be down in a range of 15%-20%, the prior forecast was for a decline of 20%-26%.


Have a great day!


Brent Vondera, Senior Analyst

Quick Hits

• What’s really different about this recession?
• Reality of Real Economy Overtaking Markets
• The New American Dream: Renting
• Home Prices: There’s No Quick Recovery Ahead
• Pension Funds Paring Stocks Globally, Ignoring Economic Rebound
• Roth IRA Change May Not Be ‘Game Changer’ for Wealthy Investors

Healthcare rises, everything else falls

In a day full of losses, the healthcare sector has managed to stay in positive territory. Managed healthcare providers such as WellPoint (WLP) and UnitedHealth Group (UNH) are providing the biggest boost to the sector as investors hope that a public option for health insurance is not an essential element of reform.

Also providing a boon to the healthcare sector are pharmaceuticals like Pfizer (PFE) and Merck (MRK) and healthcare service companies such as Express Scripts (ESRX) and Quest Diagnostics (DGX). The idea here is that any type of reform that extends healthcare to more people will increase demand for medical treatments, tests, and procedures.

Today's front page article in the Wall Street Journal details the shift in thinking on a national healthcare plan or a nonprofit health insurance cooperatives.

Over the past several months, insurance companies have been dragged down as investors worry that hospitals and doctors would charge private companies more to make up for being underpaid by a government plan. There are also concerns that a public plan would crowd out private options and, thus, lead to nationalized healthcare. A public or co-op plan poses the biggest threat to WellPoint, which operates Blue Cross and Blue Shield plans in 14 states, since they would directly compete in selling individual health policies.

To me, it seems that there would be better ways to lower insurance costs than creating a government-run competitor. The first would be to create incentives for competition among insurance companies by allowing any company to compete in any state. Preventing free competition amongst insurers has certainly contributed to soaring premiums.

Implementing electronic medical records across the country is also a must. Although the cost is substantial, the investment would pay tremendous dividends. Aside from preventing duplicate procedures and costly treatment mistakes, electronic medical records would allow physicians to create and follow a set of “best practices.” “Best practices” would reduce costs by eliminating a physician’s incentive to order a more costly or frequent procedures. Following “best practices” also instills confidence in patients and deters those who seek out treatment regardless of having a legitimate need.

Another important implication of electronic medical records is that they could help identify people who abuse free visits to the E.R. or doctor’s office every time they get a runny nose. Identifying these people and charging them a higher premium could lead to decrease in unnecessary costs.

On a smaller scale, an increased focus on preventative care as well as price transparency would yield benefits and lower our healthcare costs.

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Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

Consumer prices, as defined by the seasonally adjusted Consumer Price Index for All Urban Consumers, were unchanged in July and increased .1% ignoring food and energy. Although the data was in line with expectations, it reassured the market enough to spur buying in longer dated Treasuries – The 30-rallied a point and a half soon after the CPI release. TIPS underperformed comparable nominal coupon Treasuries on the CPI data as 10-year breakeven yields tightened by 8 bps from 1.81% to 1.73%. For new readers of the recap, breakevens are the difference between the yield on the nominal Treasury and the real yield on the TIPS of the same maturity. The difference in the yields is often used in the determination of inflation expectations over the life of the bonds, be it five, ten or twenty years. The Treasury has hinted at expanding TIPS issuance to the 30-year sector, which would give the market a new longer data point for breakevens.

Treasuries are on fire this morning, again with TIPS lagging behind, on weakness in stocks overseas. S&P futures are down 20 points with 45 minutes to go before the market opens. The ten-year is down just under three-quarters of a point to 3.49%.


Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

The S&P 500 posted its first weekly loss in five weeks as an unexpected drop in consumer confidence pushed equity markets lower on Friday. The weaker consumer confidence reading added to concerns that the fastest rally since 1938 has lifted stock valuations too far, too fast – the S&P 500 is currently valued at 18.5 times earnings, the highest level since December 2004. Because consumer spending accounts for about 70% of GDP, a sustainable recovery will be difficult if the consumer remains in the fetal position.

All ten sectors in the S&P 500 declined led by the inflation-sensitive materials, industrials, and energy sectors following reports that the cost of living in the U.S. was unchanged in July. Consumer discretionary shares also faced stiff pressure thanks to the disappointing consumer confidence reading that followed poor retail sales figures the day before.

Market Activity for August 14, 2009
Industrial Production
Industrial production rose for the first time since October 2008, primarily due to the cash for clunkers program which has helped the auto industry recover from sever production cutbacks earlier in the year. Still, excluding motor vehicles and parts, manufacturing climbed 0.2%. As a result of the increase, capacity utilization improved to 68.5% after touching a record-low 68.1% in June. As we have said many times before, depleted inventory levels make an eventual pickup in industrial production inevitable and this is one of the reasons many expect GDP will turn positive in the second half of the year.

Capacity rates gauge factories’ ability to produce goods with existing resources – lower rates reduce the risk of bottlenecks that can force prices higher. The average economy-wide capacity utilization rate in the U.S. since 1967 is about 81.6% according to the Federal Reserve. Rates between 82% and 85% signal price inflation will increase. At 68.5%, the capacity utilization rate does not support the argument that we are currently in an inflationary environment just yet, nor did the Consumer Price Index (CPI) reading.

Consumer Price Index (CPI)

The CPI index was unchanged in July, which matched expectations. The core rate, which excludes food and energy prices, rose just 0.1%. When compared with the same period last year, prices continue to show a deflationary trend – mainly due to the sharp fall in energy prices – as the headline rate fell 2.1%, but the core rate was up 1.5%. As a result, Ben Bernanke and company can put off addressing the weak dollar and inflation for the next few meetings. As long as inflation is restrained, the Fed can take its time in unwinding stimulus, without pressure to act before it feels the economy is ready to stand on its own.

Of course, it is important to note that the inflation data benefited from over a 50% decline in the price of oil compared to last year, and the August data will similarly enjoy a 35% decline in the CRB Index (the widely used benchmark for commodity prices) from a year ago. However, if we assume today’s prices, come December the CRB Index will be up 26%, and the price of oil will be up 100% come Christmas! How important are commodity prices in the CPI calculation? According to the Bureau of Labor Statistics, the relative importance of commodities in the CPI index is 39.5%.

As you can see, inflation will become a bigger concern in late 2009 and early 2010, at which point the Fed will need to decide to either defend the dollar or allow inflation to rise above their target level of 2%. Raising rates would provide a real rate of return for savers, but could short-circuit this recovery. On the other hand, keeping rates low will allow the economy to grow, but will cause inflation and fuel America’s debt addiction. Both scenarios are unpleasant.

Monday morning futures are down
Futures on the Dow Jones Industrial Average are down 190 points as I type on concerns that stocks have gotten a bit ahead of themselves (echoing concerns I raised in last Monday’s post). The credit crisis left our financial system crippled and the government has taken on trillions in debt which will threaten the economy with inflation and higher tax rates. Meanwhile, recent economic data is showing that the consumer is not ready to spend as they contend with weak income growth and balance sheet issues.

A pullback is no real surprise at this point and is certainly no reason to panic. Most pullbacks since March have been short-lived as investors on the sidelines view the declines as an opportunity to buy in. There is no way to tell whether this trend will continue, so a patience and disciplined approach to investing remains essential.


Have a great day!


Peter J. Lazaroff, Investment Analyst

Daily Insight

It looked like markets were going to set aside the Wal-Mart (WMT) earnings surprise yesterday and focus on the retail sales and jobless claims. Futures markets had indicated a positive triple-digit open, but had a tepid open on the economic news only to fall 60 points in the first half hour of trading.

Throughout the day, the Dow and crossed between positive and negative territory almost a dozen times, but ended on a positive note. Just as with yesterday, there was no single defining event to point to, but appears to be nothing more than increased optimism about the economy.

Market Activity for August 13, 2009

On the plus side, there were three pieces of good news to look at. First, the market was happy to see the WMT news. Analysts had expected the retail giant to report earnings of $0.85 per share and instead WMT surprised the market to the upside and announced actual earnings of $0.88 per share. The stock gained $1.37 per share, or 2.71 percent.

I am often asked why the market gets so excited over just a few pennies. The answer is that it is a few pennies per share. WMT has almost 3.9 billion shares outstanding, so this earnings announcement means that WMT’s profit for the quarter was $117 million more profit than analysts had expected. That’s why those pennies are worth so much!

The second piece of good news was that John Paulson of the bought $168 million shares of Bank of America (BAC). Who is John Paulson, you ask? He is a renowned hedge fund manager who not only foresaw the subprime crisis, but turned $2 billion of his client’s money into $15 billion in 2007 by betting against housing. His results were more modest in 2008, earning only 37.6 percent while the market fell 37 percent.

In short, it’s a big deal when he makes a move. Unlike a lot of the bets on the subprime market which were done with securities without much transparency, he had to file his new ownership stake in BAC. He is now the fourth largest shareholder and he has already made a good deal of money on the buy.

Just because he has bought shares, doesn’t mean they are a buy today, though. His purchases were between $6.82 and $14.17 (the high and low during the second quarter) and the stock now trades at $17. That means he has earned between 20 and 150 percent on his trade, which isn’t bad for a $1 billion plus investment.

The third factor in yesterday’s jump was the continued evidence that credit markets are getting back to normal. One of the more technical measures of credit markets is the LIBOR-OIS spread. While it’s probably not critical to explain what these two rates are, suffice it to say that spreads have tightened to what most consider normal levels.

The negative factors weighing on the market were the retail sales and jobless claims data. As we mentioned yesterday, retail sales were expected to be positive, but fell by 0.1 percent instead. Even worse, retail sales ex autos, fell by 0.6 percent. This is considered a broad measure of consumer spending, which, in turn makes up roughly 70 percent of economic activity. Obviously, consumers are still concerned about job losses and stagnant incomes and are continuing to tighten their belt.

The jobless claims showed that 558,000 Americans filed initial claims for jobless benefits last week. While you can’t get more timely than last week, initial jobless claims are discounted to some degree because they can be so volatile. Plus, economists were expecting 545,000 claims, so the number wasn’t too far from expectations. The four-week moving average was 565,000.

Futures are unchanged following the release of the Consumer Price Index (CPI) data, which showed that the cost of living in the U.S. was unchanged month-over-month. Year-over-year the index that tracks inflation fell 2.1 percent, a bigger decline than expected. Peter will pick apart the releases for you on Monday. Until then…

Have a great weekend!


David Ott, Partner

Fixed Income Recap

Treasuries opened mostly flat yesterday, before weak July retail sales data sent bonds higher. The headline number posted -.1% for July, compared to +.8% expected. Stripping out autos the number was still a disappointment, -.6% compared to +.1% expected. The biggest contributor to the upside was from the automotive sector, which was not surprising considering the popularity of the cash for clunkers program, but was more than offset by weakness in gas station and building materials sales.

Bonds leveled off mid-morning before the strong auction results boosted prices going into the afternoon. $15 billion of 30-year bonds were sold at a high yield of 4.541%, with a bid/cover of 2.54. The bid/cover is the ratio of bids to the amount actually sold to bidders, and is used as a gauge of demand. Yesterday’s auction was considered strong compared to an average of 2.43 over the past four 30-year auctions.

As I write July CPI has just posted no change MoM and +.1% Ex Food & Energy, in line with expectations. Bonds have rallied on the news. More on this number on Monday.


Cliff J. Reynolds Jr., Investment Analyst

Wal-Mart beats earnings expectations

Wal-Mart’s earnings beat the consensus earnings view on strong international growth and efficient inventory management.

Excluding currency effects, revenue grew 2.7%, led by the international segment’s 12% increase. This is a trend we can expect to continue as the company penetrates developed and emerging international markets. The company hinted during the conference call that they may continue to be on the prowl for acquisitions that could boost international growth.

U.S. revenue was weaker, with same-store sales falling 1.5%, which was partially a result of stimulus checks the year-ago period benefited from. The third quarter should have an easier comparison and, thus, show some improvement.

Operating margins improved 0.3 percentage points sequentially to 7.6%.

Management said that the Wal-Mart customer is still being pinched by the recession, evidenced by less spending at the end of the month, using more cash than credit, and buying basics and putting off discretionary purchases.

Wal-Mart has gained market share thanks to their low-cost reputation, but it is difficult to know whether or not their new customers will trade up once the economy improves. In attempt to keep customers coming back, Wal-Mart has focused on its shopping environment by remodeling stores with less clutter and better merchandising.
WMT shares finished the day +2.71%
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Peter J. Lazaroff, Investment Analyst

Harris proves analysts wrong

On Tuesday I wrote that several analysts had downgraded Harris because they believed weakness in the company’s tactical radio business would cause the firm to miss earnings estimates and lower guidance.

Turns out these guys were way off and Harris easily beat earnings estimates and also boosted the low end of their full-year earnings forecast. The raised outlook was a very significant upside surprise relative to expectations.

Revenues for the quarter rose 4% to $1.29 billion, compared with the average estimate of $1.21 billion. Orders rebounded significantly in all three businesses and, more importantly, the steep fall-of in orders expected in the high-margin tactical radio unit (RF Communications) did not materialize.

Management said increasing U.S. troop levels in Afghanistan provided RF Communications with the most significant boost in orders across all of Harris’ business segments. This is somewhat ironic because increasing troop levels in Afghanistan was the main reason multiple analysts lowered future revenue forecasts for Harris’ tactical radios.
HRS shares finished the day +12.14%

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Peter J. Lazaroff, Investment Analyst

Daily Insight

Major market indexes broke a two day losing streak with a powerful rally based on … well, it’s hard to say. All of the post-mortem articles about yesterday’s rally attribute the rally to statements from the Federal Reserve, but the Bernanke & Co. didn’t come out with their announcement until 2:15 and the market had been surging since 10 am.

When the rally first got started, the gains were attributed to better than expected earnings from Macy’s. It’s hard to see how this could really push the market, though, since this is a distressed mid-cap stock, the source of improvements were related to cost cutting in spite of weak sales, and it still lost money for the quarter.

In my opinion, a strong rally from a weak data point indicates that markets are not trading on fundamental values at the moment. Just as markets were unjustified in their 25 percent drop earlier this year, the 50 percent rally from the low in March seems to have allowed optimistic euphoria to carry a day like yesterday even when it doesn’t seem well founded.

Market Activity for August 12, 2009

Even though the Fed announcement didn’t end up carrying much weight in the stock or bond market yesterday, the news was good. (There was a rally after the announcement, but it faded back to pre-announcement levels before the end of the day.)

First, it was reassuring to hear the Fed say that “economic activity is leveling out,” which fits with the conventional wisdom that the recession is ending. The bigger news, though, is that the Fed is removing one of the lifelines by announcing that it would not purchase more Treasury bonds after October.

To keep interest rates low across the board, the Fed engaged in a massive buying spree in the mortgage, treasury and agency bond markets. This is known as quantitative easing because it injects liquidity into the economy. They couldn’t push interest rates below zero and this was a strategy that the U.S. had not engaged in before but had it been done in other parts of the world, most notably Japan.

By announcing the end of the Treasury program, the Fed is signaling that they are beginning to withdraw the support that they had put in place during the crisis. This isn’t to say that everything is fine and dandy, though, because many of the lifelines are still in place and the Fed will still own all of the Treasury bonds that they bought, they just won’t be buying any more.

In addition to saying that the economy seems to be stabilizing and that the Treasury purchase program will end in October, the Fed was clear that they do not view inflation as an immediate threat. Their exact language remained unchanged - that inflation will be ‘subdued for some time.’

Markets are set to open higher this morning, though some early enthusiasm has been reduced with the retail sales data from the Commerce Department. Earlier, markets showed a triple-digit rise for the Dow based on earnings news from Wal-Mart.

Retail sales fell 0.1 percent in July, despite the ‘cash for clunkers’ program that was so successful it ran out of money in the first week. Retail sales ex-autos fell by -0.6 percent, well below expectations. Retail sales are an important measure of broad consumer spending patterns, so this may put more of dent on the markets as the bell rings.

Have a great day!


David Ott, Partner

Fixed Income Recap

FOMC
The FOMC pleased the market yesterday with its comments following two days of meetings that concluded Tuesday. The most important topic this time around, which I have touched on pretty heavily this week, is the Fed decision on Treasury Purchases and other forms of quantitative easing. Before yesterday’s comments, the Fed’s Treasury purchases were scheduled to conclude before the end of September. The Fed has decided to extend the purchases to the end of October, while leaving the original $300 billion target unchanged. The other two programs – $1.25 trillion in MBS and $200 billion in agency bonds - will end in December as originally scheduled.

This is a good sign from the Fed. They are reluctant to talk exit strategies at this point, which I think is appropriate, but by coming out and telegraphing how the security programs will end the Fed is taking a step in that direction. In the Fed’s eyes, the US economy is stabilizing enough to not warrant such an aggressive program, so slowing the pace down can be viewed as a type of easing. I know that may be a little bit of a stretch but it’s still a positive sign.

The Fed sees that, “economic activity is leveling out”, a positive change from, “the pace of economic contraction is slowing”, in the June meeting statement. We also got the standard, “The Committee… continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

The Fed pretty much gave the market what they wanted. They outlined the end of the Treasury purchase program, noted that they see the contraction coming to an end and more or less left it at that.


Cliff J. Reynolds Jr., Investment Analyst

Fixed Income Recap

Despite the strong 3-year auction and weakness in stocks the short end was unable to break out of its pre-FOMC deadlock. The 3-year was already a little higher by the time the $42 billion auction drew to a close and was mostly unchanged by the results, but finished the day a few bps tighter than the auction level.

Eyes will be on the Fed today as the market waits for the committee’s comments regarding bond purchases. They will for sure comment on the progress, but the Fed might not be perfectly clear about whether they plan to shutter the Treasury program after the last of the $300 billion is spent in September or extend it to the end of the year. At this point I think the Fed needs to come out and be pretty clear here. People are certainly expecting to hear something meaningful one way or another, so I fear that saying nothing could just throw a wrench into this market, which would not be good.


Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

Following a steep run-up in recent weeks on the strength of better-than-expected earnings, stocks fell for the second consecutive day as investors take pause amid a lull in new economic data and focus attention on today’s Fed policy decision. It is widely expected the Fed will hold interest rates steady at near zero, but the group’s economic assessment will be closely studied to determine the state of the economy.

All ten sectors finished lower with financials dropping the most on concerns that the sector’s earnings may pull back and the possibility of higher interest rates. Volume was relatively low with only 1.2 billion shares trade on the Big Board.


Market Activity for August 11, 2009
Productivity and Wholesale inventories

Productivity surged between April and June, increasing at an annual rate of 6.4%, marking the largest gain in almost six years and easily beating the Bloomberg forecast of 5.5%. The growth was not a result of improving production, but rather a result of employers cutting the number of hours worked faster than the decline in output. These efficiency gains, however, provides the basis for a recovery in corporate profits and investment in the second half of 2009 – aggressive cost-cutting helped many companies exceed earnings expectations last quarter despite weak sales. Solid productivity growth also keeps the lid on prices and inflation, which gives the Fed justification for keeping rates lower for longer.

Meanwhile, unit labor costs fell 5.8%, the biggest decline since 2000 and far more than the expected drop of 2.5%, which may be read as a positive signal for the employment since companies may not need to layoff as many workers as sales stabilize.

Wholesale inventories showed a 1.7% decline in June, larger than the expected 0.9% drop. Durable goods, particularly in the professional equipment sector, led the decline. Total sales rose 0.4% thanks to a 4.5% boost in the automotive sector. The inventory-to-sales ratio – the amount of time it would take to deplete inventories at the current sales pace – improved from 1.28 months in May to 1.26 months in June. No surprise that after ten straight months of decline, inventories sit at the lowest level in more than two year. Companies’ hesitancy to restock in the face of weak demand has added to the severity of the downturn, but retail volumes are showing signs of stabilizing and there is a strong possibility that production will ramp up with even the slightest increase in demand.

Rising productivity and falling inventories fits well with the general consensus that a big inventory rebuild is going to boost both GDP and corporate profits. The inventory destocking in the second quarter took away from GDP, so even if inventories are flat in the third quarter, the drag to GDP would disappear. This idea that the inventory dynamic may mathematically provide a temporary boost to GDP is valid, but the sustainability of such an upturn is seriously questionable because inventory can again be a drag on future GDP if it is slowly depleted. In other words, people won’t necessarily buy stuff just because its there.

In our minds it all still hinges on consumer demand, which will be slow to recover in light of a weak job market, stagnant wages, and falling home values. Without strong consumer demand, any inventory dynamic that boosts third-quarter GDP won’t be lasting, and the odds of a letdown in the fourth quarter or 2010 become greater.


FOMC
The markets will be carefully attuned today to the Fed’s meeting statement, searching for clues regarding how soon and how aggressively the Fed can withdraw its support of the economy. The statement released following the June 23-24 FOMC meeting showed a modest upgrade of their assessment of the economic, which in turn lowered the probability of deflation even though the statement indicated, “Inflation will remain subdued for some time.” Today’s remarks will likely continue to reflect cautious optimistic view so as not to spark inflation concerns.

The first Fed rate increase is not likely to occur until late 2010 or even 2011. Historically, the Fed has never lifted rates when unemployment was rising, it has always occurred when unemployment started to move substantially lower. Despite last week’s July employment report showing improvement, sub-par growth will keep the unemployment rate higher than in a typical recovery. As a result, policy makers are expected to be extremely measured in their removal of policy accommodation.


Have a great day!


Peter J. Lazaroff, Investment Analyst

Amgen (AMGN) trades higher in advance of FDA panel

Amgen (AMGN) shares received a boost just two days before the FDA votes whether to support denosumab as an osteoporosis treatment in post-menopausal women and to help prevent bone loss in treat cancer and prostate cancer patients on hormone therapy.

The shares rallied after a study released showed that denosumab prevented fractures and strengthened bones in men taking hormone therapy for prostate cancer. Almost exactly a month ago, AMGN released encouraging Phase 3 trial results for denosumab in breast cancer patients.

A potential blockbuster like denosumab could eventually generate $2 billion to $3 billion of annual revenues, which could help take the pressure off Amgen’s other drugs, which are facing higher scrutiny from the FDA as well as increased competition from both branded and biosimilar (generic biologic) drugs.

AMGN shares finished the day +2.56%
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Peter J. Lazaroff, Investment Analyst

Analysts get bad signal from Harris (HRS) radio business

Harris Corporation (HRS) is down more than 6% today as analysts anticipate poor earnings results, which are due to be released after the close of trading on Wednesday, and lowered earnings guidance.

The concerns in several analyst reports are centered on the company’s tactical radio business, known as RF Communications. RF Communications’ radios are like the iPhone of walkie-talkies. Mainly used by the military, the radios are encrypted to prevent eavesdropping and have the ability to send data and videos. Aside from working with the military, RF Communications has a public safety and professional communications business.

This high-margin business segment was a major driver of Harris’ earnings for the past several years, but is now faced with order delays that are largely a result of the change in administration and the shift in military focus to Afghanistan from Iraq.

HRS shares finished the day -7.84%

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Peter J. Lazaroff, Investment Analyst

Daily Insight

Stocks got off to a slow start this week as investors questioned the S&P 500’s highest valuation, relative to earnings, since December 2004. Commodity producers and retailers were the main culprits dragging down the S&P 500. Meanwhile, the increasing VIX index showed that options trades are betting that the S&P 500’s rally won’t last through September.

I received a lot of feedback yesterday regarding my discussion on REITs and the accompanying write-up on our blog, some of which were requests to add U.S. REITs to the performance table. Ask and you shall receive…

Market Activity for August 10, 2009



FOMC

The Federal Reserve’s policy makers meet over the next two days and will likely discuss their quantitative easing measures, which helped unfreeze credit markets by holding down yields on Treasuries. When the Fed unveiled its strategy, deflation was the market’s primary concern. Now that credit costs are returning to pre-crisis levels and recovery expectations are growing, the inflationary risk posed by the Fed buying Treasuries is a bigger risk to bond prices than its exit from the market.

The market is concerned that the money printed to fund the program will fuel inflation, and we would likely see a positive reaction to the Fed’s nonrenewal of their quantitative easing program. Exiting this program would provide a clear signal to the world that the Fed is determined to control inflation before it starts. Low inflation makes Treasuries’ coupon payments more desirable, keeping yields in check longer. This is especially important during a period in which foreign buyers, particularly China, are apprehensive about the value of their investments in U.S. debt. We need these foreign buyers to help soak up the record issuance of U.S. government debt to cover the cost of putting a floor under the economy.

While ending the quantitative easing program should calm some of the inflation fears, these purchases could still lead to inflation pressures on a longer horizon and, appropriately, inflation expectations might come earlier.

The other always important topic being discussed will be the Fed’s target for the federal funds rate, which broadly influences borrowing costs. For some of the newer Daily Insight readers, the federal funds rate is an overnight rate banks use to lend to each other. The federal funds rate serves as a benchmark for all other short-term interest rates including the prime rate, the benchmark for most consumer and commercial lending, and short-term Treasuries.


Fed funds rate and stock prices
Over most of the past 50 years, changes in the fed funds rates have been a very good predictor of future stock prices. Using research from Jeremy Siegel’s Stocks for the Long Run, the table below shows the returns on the S&P 500 Index following a change in the fed funds rate over 3,6, 9, and 12 month periods. The benchmark represents an average of all the time periods in each particular sample – for example, the average of every 3-month time period between 1955-2006.


As you can see, the Fed’s actions have a dramatic effect on stock prices. Stock returns following an increase in the federal funds rate are significantly less than average, while stock returns are significantly higher than average when the federal funds rate decreases. Now, I know some people will glance at this table and think they can beat the buy-and-hold strategy by buying stocks when the Fed is lowering rates and selling stocks when the Fed is increase rates. But if you look at the entire table, this trend (like all trends) is hardly foolproof. Since 2000, the impact of the Fed’s interest rate changes on the stock market has been the complete opposite of the historical record.

Why has this occurred? It is possible that investors have become so accustomed to watching and anticipating Fed policy that the effect of its tightening and easing is already priced into the market so that the impact of Fed actions extend over a period of a few days rather than over several months. After all, if investors expect the Fed to do the right thing to stabilize the economy, these expectations will be built into stock prices far before the Fed even begins to take stabilizing actions.

Of course, there is no perfect explanation for the runs of good or bad returns in the stock market. If you spend enough time data mining, then you will find all sorts of apparent trends in historical data. As Burton Malkiel, author of A Random Walk Down Wall Street, so eloquently stated: “Technical results have been tested exhaustively…The results reveal conclusively that past movements in stock prices cannot be used to foretell future movements. The stock market has no memory. The central proposition of charting is absolutely false, and investors who follow its precepts will accomplish nothing but increasing substantially the brokerage charges they pay.”

For more commentary on the Fed funds rate, check out Cliff Reynold's Fixed Income Recap.


Have a great day!


Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

Yesterday was without an economic release resulting in a slow, low volume day in bond land. The snail like pace will continue today as most of the market is waiting to hear if the FOMC will say anything big following the conclusion of their policy meeting on Wednesday.

It’s a foregone conclusion at this point that the Fed Funds rate will remain where it is for this meeting, a target rate of 0-.25%, but futures have shown an uptick in amount of people expecting an increase soon. Current data show that the market is leaning toward an increase in the Fed Funds rate to .50% by the January 27 meeting. If that were correct it would mark the first increase in the rate since June 2006 when it topped out at 5.25%, and would also be the first adjustment to the rate since December 2008 when it was floored.

Shorter-term yields have been on a steady rise since early July when the 2-year reached .904% on July 13. The same bond was yielding 1.222% after yesterday’s rally from 1.302% at the close of last week. While long term yields react more to inflation expectations, short term yields are more sensitive to Federal Reserve policy, and the recent rate movement is showing this increased chance of a Fed policy reversal. It is important to note that the recent selloff in the short end can be partially attributed to poor auctions in late July, but expectations for a reversal in Fed policy coming sooner rather than later made that section of the curve unfavorable at lower yields. The FOMC comments tomorrow, retail sales data on Thursday and CPI on Friday could make for a bumpy ride later this week.

CIT
Just to touch on a brief piece of news from last Friday that I missed in yesterday’s recap, CIT announced that it will be suspending dividends on its preferred stock effective immediately. CIT hasn’t had to pay preferred dividends since June 15, but since one of its issues was due to go ex on Friday they announced the suspension of dividends for all preferred stock. This is no surprise to the market - the market prices for the issues were unaffected by the news – but the move is expected to save CIT $50 million dollars each quarter, a drop in the bucket compared to the $10 billion in debt that is scheduled to come due in the next 18 months. The company currently has no prospects for refinancing their maturing debt, and has also drawn on the final $1 billion of the $3 billion in emergency financing they secured on July 20.


Cliff J. Reynolds Jr.

Quick Hits

• Corporate Earnings Are No Sign of Recovery
• Investing: Hold or Fold, but Don’t Waver
• Fed does not need more powers
• Big Macs and Moving Debt to Asia
• July Jobs Numbers Not All Their Cracked Up to Be

Daily Insight

Stocks finished the week strong as better-than-expected employment data gave investors reason to believe the recession is over. Nine of ten sectors gained, with the only loser in the broad-based rally being the energy sector. As you can see below, all domestic equity asset classes made solid gains but I want to make special note of REITs’ performance since they are not listed in the table.

REITs (real estate investment trusts) had a particularly impressive performance last week (up 16.80%) as investors anticipate some of the financially stronger REITs to shift from defense to offense. Faced with a deteriorating commercial real estate market and hundreds of billions in debt coming due in the next few years, REITs have generally been shunned by investors in 2009. However, REITs have been raising capital by slashing dividends, issuing new equity, and buying back their public bonds at steep discounts. Financially strong REITs have offered attractive yields for several months, but now REITs are getting a boost from investors as they prepare to unleash billion dollar-war chests to fund acquisitions of troubled properties on the cheap. To read more about this, check out my post on our blog from last week by clicking here.

Market Activity for August 7, 2009
Dissecting Friday’s Data

Much to everyone’s surprise, the unemployment rate actually fell in July, hitting 9.4% from 9.5%. Although this report continues to support the view that the recession ended in the summer of 2009, the decline in the unemployment rate was not a product of job creation, but rather due to people dropping out of the work force. If people drop out of the labor force, the unemployment rate can decline because fewer people would be considered jobless.

The July household survey showed the civilian labor force shrinking by 422,000 and employment falling 155,000. That translated into 267,000 fewer people listed as unemployed. The labor-force participation rate fell 0.2 percentage point in July to 65.5%. Once the economy improves, these people will likely return to the workforce, which will result in the unemployment rate climbing higher – for example, people who decided to return to school during the downturn will eventually return to the job search and help push unemployment higher.

Another factor that could keep the unemployment rate elevated is the considerable degree of structural unemployment, evidenced by the 53.5% of those unemployed because they have lost their jobs permanently – the highest figure since this data has been tracked. Structural unemployment, as opposed to cyclical unemployment, is caused by changes in the economy rather than the business cycle. The high number of people permanently laid off reflects the excess capacity that had developed in the economy over recent years in areas such as construction, financial services, retail trade, and auto production/sales. Even as the economy recovers, these displaced workers will likely be unemployed for a prolonged period.

The point to take away here is that we shouldn’t get ahead of ourselves. The improving trend of the labor market cannot be denied, but businesses are not about to start hiring people. Businesses will want to make sure that a sustained economic recovery is here before doing any substantial hiring. For this to happen, demand will need to improve – a process we believe will continue to be a slow one as households contend with weak income growth and balance sheet issues for some time.

Speaking of consumers’ balance sheet issues, the Friday’s consumer credit report showed borrowing by U.S. consumers dropped in June for the fifth straight month, the longest series of declines since 1991. Consumer spending, which accounts for about 70% of the economy, will take time to recover as households put off major purchases in light of a weak job market, stagnant wages, and falling home values.


Where do we go from here?

It seems like a long time ago when stocks were priced for the possibility that the global banking crisis would shut down the world’s financial infrastructure. Being a forward-looking indicator of the economy, stocks rallied since March in anticipation of the end to the recession. But it’s a bit of a head scratcher that stocks are now rallying because the recovery that stocks themselves predicted comes true.

The point I’m trying to make here is that it’s easy to be greedy here and pretend that the crisis never happened. But, it did happen. As a result, the financial system was left crippled and the government has taken on trillions in debt which will threaten the world economy with inflation and higher tax rates. I’m not necessarily saying that stocks can’t continue their progress – although they seem overdue for a small correction following the 50% jump from the March lows – but it would be foolish to think everything is back to normal and stocks will quickly return their 2007 highs.

Patience and discipline is crucial for all investors in this environment.


Have a great day!


Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

Stocks were juiced to new highs for the year on better than expected employment numbers. Nonfarm payroll employment declined by 247,000 in July on a seasonally adjusted basis, much better than the -325k expected. June’s data was revised upward from -467k to -443k.

The main reasons for the better than expected numbers include a 28.2k addition to automotive manufacturing payrolls during a month that historically cuts some due to planned summer shutdowns, this surprise increase is exacerbated by the seasonal adjustment. Federal Government payrolls increased 12k and several service sectors were better than expected but unfortunately too much of the positive surprise compared to what was expected seems to be one time in nature. The auto industry has “cash for clunkers” to thank for the pop last month but that shaping up to be short lived.

Last week was the worst for Treasuries since the March of 2003. Yields were up across the curve every day but one last week to their highest levels since mid-June as investors continue to shed Treasuries in exchange for riskier investments like stocks and corporate bonds. The 5-year credit default swap index, which measures the cost that investors are paying for protection against default for 125 different companies, is at its lowest levels since May 30 2008.

The FOMC will meet this week, and while it is expected to leave the Fed Funds Target Rate unchanged at 0-.25%, a large question mark remains over the future of the Fed’s open market operations. Recent fedspeak has shown some member’s hesitation to increase the amounts dedicated to buying Agency MBS and debentures along with Treasury bonds, fearing the price instability that could ensue if the Fed does too much to keep rates low. Nonetheless it stands to be a heated topic and if the Fed comes out and states that all programs will end as scheduled it will mark the first real tightening of monetary policy during this latest cycle. But that is probably wishful thinking on my part. Something to the effect of, “We will continue to monitor market conditions before making a final decision” is more realistic. Especially considering the next meeting on September 23 will likely be the Fed’s final chance to extend the Treasury program before it completes.

Treasury supply for this week looks like this:
· Tuesday - $37 billion 3-year notes
· Wednesday - $23 billion 10-year notes
· Thursday - $15 billion 30-year bonds


Cliff J. Reynolds Jr., Investment Analyst