Daily Insight

U.S. stocks endured another wild day as the benchmark indices traded substantially between gain and loss, but in the end closed the session meaningfully higher. Financial-sector concerns were a major factor again yesterday -- there arel kinds of hypothetical scenarios being thrown around regarding the mortgage GSEs Fannie Mae and Freddie Mac, which is driving this concern. But energy, basic material, industrial and technology shares performed well, driving the benchmark indices to the plus side.

Benflation Bernanke and Treasury Secretary Paulson were on the Hill yesterday talking about regulatory issues. In the meantime, Paulson attempted to dissipate the concerns over the GSEs – another attempt denied – as he repeated that the two mortgage giants were “well-capitalized.” If home prices fall significantly from here and foreclosures ramp up, then this “well-capitalized” position may not hold, but the government will backstop the two from failing.

It’s as simple as this. If the Federal Reserve felt it necessary to assist in keeping Bear Stearns from going down, of course the Treasury and Congress will step in to provide some funds for Fan and Fred to get through the housing woes. The government may very well take the two over if they find if difficult to raise private funds – enough of beating around the bush anyway, they’re not letting the two fail if it came to that. In the meantime the common stock continues to get crushed as these shareholders will endure further dilution if/when they do raise more capital.

Just to clarify, the mortgage-backed securities are a completely different story. These bonds are collateralized by the underlying mortgages. As long as the homeowner makes their payment, the bondholder receives his/her payment. If a mortgage goes delinquent or defaults, then FNM and FRE take the loss and pay the bondholder all principal and interest. These are conventional mortgages.

On the regulatory issues, it appears Paulson would like the Federal Reserve to be granted more oversight authority. Wrong! They are already responsible for banking-industry oversight and dropped the ball in that regard. No, they don’t need any more authority, please.

Market Activity for July 10, 2008

The chart below shows the circuitous path the S&P 500 took on the way to 1253. At one point in the afternoon session the index was just about 2% off the intraday high, but rebounded nicely in the final hour.

In the end, none of this really matters – I show these intraday charts on occasion just to provide a visual. We’re likely in one of those periods where stocks take a while to find the appropriate multiple at which to trade. Additional Fed policy mistakes throw the biggest stock uncertainty of all into the mix – the risk of a harmful bout of inflation – but as we’ve stated before, earnings growth has significantly outpaced stock prices over the past five years. After-tax corporate profits are up 175% since December 2001, while the NYSE Composite is up just 38.8%. Stocks are spring-loaded to deliver outsized returns over the next decade, but we must get past a number of uncertainties first.

General Electric has just released their second-quarter earnings results, which are in-line with expectations. Overall, operating profit was flat from the year-ago period. Flat isn’t great, but I’ll point out that the year-ago period was a strong one – up 22%. So to come in at that level, is not all bad. Sales recorded a nice gain, up 11%. Backlog is looking strong. Their infrastructure business was up 24%. Health-care equipment rose 8% -- the previous quarter’s decline concerned a lot of people, but you may recall we mentioned that decline was a fluke. Overall growth will come around. In the meantime the stock trades at just 12 times earnings and a dividend yield of 4.48%. The company has increased the dividend payout by 10% a year over the past five years.

Moving on to macro issues…

The graphs below, source Credit Sights, shows the percentage change of capital spending activity for 2007. While the risk remains that 2008 spending plans may be reduced, the data of late shows (specifically via factory and durable goods orders) that healthy growth will continue through this year. You can see the number of firms increasing outlays far outweigh those reducing. The same trend is true for 2008.

This is very good news with regard to GDP over the next few quarters. I continue to be concerned over real personal income growth -- particularly in the face of rising commodity costs -- for the next several months as its unlikely we’ll see any job creation for a spell, but this segment (capital goods orders) of the economy will help to keep GDP positive. At this point, I believe GDP will come in at a 2.5% real rate for the second-quarter. This estimate will depend on some of the lagging indicators that we have yet to see for June, but to this point consumer spending, capital investment, exports and inventory rebuilding will overwhelm the continued drag from housing.

In economic news, the labor department reported that initial jobless claims plunged 58,000 in the week ended July 5, falling back to the pretty low level of 346,000. Some of this decline was due to seasonal adjustment issues, but the fact that we have dropped far-below the level of 404,000 reached in the previous week shows the labor market losses will remain tame for now. The four-week average, a less volatile figure, has edged lower. It currently sits at 380,000 – the chart provides the picture.

Continuing claims remain elevated, but still well-below true job-market weakness, as the chart below illustrates. Also factor in that the workforce is much stronger than those previous periods, so a level of 3.2 million in continuing claims is not what it used to be. Continuing claims being defined as those that have accepted jobless benefits for more than one week.
Finally, we also received chain-store sales for June, which is the growth retail stores open at least one year recorded. The figure for June came in at 4.3%. Naturally, the press and many economists are stating this growth as a one-month blip due to the rebate checks.

First, aren’t these the same people that tried to tell us just how glorious one-time rebate checks are. In reality, they’re a joke compared to the fundamentally sound nature of across-the-board tax cuts that affect behavior in a meaningful way and actually lead to job growth as small business makes up 65%-70% of those within the top federal tax bracket.

Second, the growth we’re seeing on the retail side of things is not a one-month blip at all as this is the third-straight month of nice gains. April same-store sales rose 3.5%; May was up 2.9%; and June we already mentioned as up 4.3%. As we’ve noticed over the past few years, the press says just about anything they like – and let’s be laconic -- a lot of it is mendacity on parade.

Have a great weekend!

Brent Vondera, Senior Analyst

Our view on Freddie and Fannie

As everyone is aware, the Fixed Income markets have been very volatile as panic selling jumps from one corner to another. The most recent episode has ensnared Fannie Mae (FNM) and Freddie Mac (FRE). Fannie and Freddie have seen their common stock plunge over the past week. News outlets all over the place, including the front pages of NYT and WSJ, have been saying that these companies are in major trouble. We do not hold any common stock of FNM or FRE. This does affect our fixed income holdings, mainly our preferred stock holdings of FRE and FNM. This has affected our performance this year and will continue to have a negative impact until the market normalizes. However, I do believe that these are good investments in the long run and that we should continue to hold our positions.

We own several distinct types of bonds issued by Fannie and Freddie. First, and the largest of our holdings, are FNM and FRE backed mortgage backed securities. These bonds are collateralized by the underlying mortgages. As long as the homeowner makes their payment, we receive our payment regardless of the condition of FRE and FNM. If a mortgage goes delinquent or defaults, then FNM and FRE take the loss and pay the bondholder all principal and interest. On these bonds, FNM and FRE are basically acting as insurance. The second type of bond is a Senior Debenture. These are essentially corporate bonds issued by FNM and FRE. They are rated AAA by all the ratings agencies even though they are unsecured senior debt. These are the bonds that FNM and FRE use to fund their operations. It would be unfathomable if FNM or FRE ever defaulted on either of these types of securities. The repercussions on the global markets would be huge.

The last kind of debt that we own is the preferred stock. Even though it is called stock, this is debt of the company that the company can count as capital. FNM and FRE preferred stock is rated AA because in the event of liquidation, it is subordinated to all of the senior issues and MBS guarantees. There is less confidence in the market right now that the preferred stock would be bailed out along with the senior debt. This has caused the preferred stock to slide 25%. However, I am still confident that we will receive our principal and interest payments and that the market price will normalize over time. This current sell-off appears to me to be panic selling and unjustified.

Background—

Fannie and Freddie are government sponsored enterprises. They were created through and act of Congress in order to provide liquidity to the mortgage market and foster home ownership. They were then sold off to private investors and are now publically traded, private enterprises. However, they have their own government regulator, OFHEO, that closely supervises all of their actions and determines adequate levels of capitalization. FNM and FRE also have a line of credit directly with the US Treasury. In the event of a liquidity crunch, these two companies have direct access to the Treasury to meet obligations. This is something that no other company has.

The recent turmoil was sparked early this week when a research report by a Lehman Brothers analyst stated that FNM and FRE may have to raise over $65 billion in capital if a new accounting standard was adopted. This new accounting standard relates to how companies account for mortgage servicing and is still in very preliminary stages. These standards are often radically altered prior to being (if ever) adopted. At the end of the research report, the analyst stated that even if the guideline is adopted as is, FNM and FRE would be exempted. The entire report was a big hypothetical exercise and even the author does not see much chance of it ever coming to reality. However, this was enough to send the stocks in a tailspin that has lasted all week long as every bit of negative information and every doom and gloom scenario has been played out in the press. However, there has been no new material information released about the companies. All that is “news” is rehashed arguments and figures from their last earnings report. Here are a few facts to focus on:

The Bad

• FRE and FNM do need to raise more capital and this is a difficult market to raise capital.
  Foreclosures will remain elevated for at least the next year. This will put pressure on


• FNM and FRE earnings and capital for some time.


• Market is losing confidence in the companies. This is seen in the violent movement of the stock.

The Good

• OFHEO continues to say that FNM and FRE are adequately capitalized.


• FNM and FRE have a history of underwriting higher quality loans. Their foreclosure rate is ~1%. They do have exposure to lesser quality mortgages, but only ~5% of assets.


• Congress is looking to FNM and FRE to help stimulate the housing market. Makes government intervention more likely if needed.


• Have a line of credit with the Treasury.


• While borrowing at highest spreads since 2000, they are still able to issue senior debt at more attractive levels than other US Corporations. This is their primary source of funding.
  

It is my opinion that long term these will be sound investments. I think that they market will regain confidence in the companies, they will raise more capital, and things will normalize. I still believe that we will receive our scheduled principal and interest payments on the preferred stock that we own.

Ryan Craft, CFA

Daily Insight

U.S. stocks got clobbered due to duel concerns over Fannie Mae (FNM) and Freddie Mac’s (FRE) viability and a slowing global economy that many are predicting will hit tech profits, among others.

Never mind that the two mortgage GSEs continue to raise funds at a very low rate – 75 basis points over Treasuries – and delinquent loans remain low relative to total outstanding. Yes, that 75 basis-point spread FNM and FRE have to pay over Treasuries is double the level of a year ago, but it is not a record high, nor is it anywhere near a level that makes doing business a problem.. Their very delinquent single-family loans are twice the level of a year ago too, but account for just 1.22% of total loans outstanding in FNM’s case and 0.81% for FRE.

On tech stocks, the concern that slowing global growth will hurt profits for one of the brightest sectors of late seemed to hit a crescendo – one hopes at least – yesterday, but those advancing this view must have forgotten what Oracle reported little more than two weeks back – operating profit up 25%, with their Americas segment – obviously dominated by the U.S. – up 18% from the year-ago period. If tech earnings were going to fall off a cliff this earnings season, one would think it to have shown up in Oracle’s results.

Market Activity for July 9, 2008

The charts below are intra-day trading for Wednesday.

The flood gates to the river of pessimism have been opened wide and it will just take some time to close them again as virtually everyone ignores any good news and, in my view, overhypes the negatives.

In fact rumors and conjecture rule the environment at the present. Financials took it on the chin over FNM and FRE worries, but also hitting the group was a Credit Suisse report stating 40% of the biggest banks need to cut their dividends. Funny how after the bell yesterday the second-largest bank – Bank of America – mentioned they see no reason to cut the dividend or raise capital. Maybe their management is out of touch with what is occurring, but I doubt such an explicit statement would have been made if they were not very confident this will be the case.

Expanding on this conjecture point, there is supposedly an article in Forbes asking the question: What if FNM and FRE fail?

First, can they fail? Heck yes. Do I think they will fail? No. Fact is this all revolves around the housing market and as down as that market is, it is not as down and out as people are assuming when 92% of mortgages are being paid on time and 95% are either on time or just 30 days past due. If we’re going to go down this road of scary questions, why don’t we just ask: What would happen if we were hit by an EMP attack?

I’ll tell you what would happen; we’d be thrown back to 1870. You want light? Grab a candle. Hot? Can’t turn down the old thermostat; grab a magazine and waive it near your face – where’s that darn Chinese fan? Want to escape reality and listen to some music? That iPod better be charged, and even if it is you’re down to six hours of jammin’. Want some transportation? Get to walking or find a horse – oh my, now this is getting too tough to even contemplate for most Americans Walk? Damn you, you’re saying. But you see my point. We’re trading on conjecture here instead of likely possibilities.

Again, FNM and FRE can and may fail. I don’t think they will based on current delinquency rates and the fact that investors remain quite willing to provide them with capital. Further, if this were really the case, if these two were very likely to fail, you’ll know it because the Dow will lose 2500 points instead of 1/10 that figure, such as yesterday’s loss.

There are challenges, no doubt, and I’m not especially optimistic at the present regarding what may occur with tax rates and leadership that believes the government should get out of the way instead of some nanny state mentality winning the White House. But housing will come back – even if it takes another 12-18 months -- and the mortgage market will be stronger for it. Hopefully, we aren’t burdened with too many additional regulations. There are some that say the free market got us into this mess. Well, they must be forgetting that government meddling has been involved in the mortgage market for a long time – eg. Fannie, Freddie, the Federal Housing Association, the Community Reinvestment Act. They are also forgetting it is monetary policy mistakes that encouraged a rash of bad behavior.

On tax and trade, occasional stints of bad policy will lead to better longer-term polices down the road. Why? Because free markets work and allow economic participants to produce prosperity and socialism does not. Don’t take my word for it, look at the record.

Moving one…

Oil prices actually ended the day flat, reversing course after crude was 2% higher on news stockpiles fell more than expected and Iran test fired several missiles capable of hitting Israel, among other places.

Crude-oil stockpiles fell 5.84 million in the week of July 4, but gasoline supplies did rise 900,000 and sit at the average range for this time of year. The bulk of the decline in crude came from PADD 5 which is the West Coast. (PADD stands for Petroleum Administration for Defense Districts – these areas were delineated during WWII. PADD 1 is the East Coast, PADD 2 is Midwest, PADD 3 is the Gulf, PADD 4 is the Rockies and PADD 5 already mentioned.) I’m not sure what occurred over on the West Coast, but supplies plunged 8.25%, or 4.82 million barrels.

In any event the worries over slowing global growth, which we touched on at the top, overwhelmed the decline in supply and Iran worries.

As you can tell by this point of the letter, we didn’t have an economic release yesterday. Today, we get back at it though with initial jobless claims for the week ended July 4 and chain-store sales for June.

Oh yeah, nearly forgot to mention that optimism over U.S. stocks slid to the lowest level since 1994, according to Investors Intelligence. The share of bullish stock advisers fell to 27.4%. This is actually a very bullish indication.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks rallied yesterday as comments from JP Morgan CEO James Dimon sparked a rally in financial shares and oil continued a two-day slide. Earnings season kicks off this morning, although doesn’t begin in earnest until next week; we’ll have to get better-than-expected numbers for stocks to trend higher in the very short term.

Financial shares led the gains, jumping 5.72%, after JP Morgan’s Dimon stated losses in credit markets will ease. Industrial, transportation and consumer discretionary also enjoyed a nice session as crude futures fell $5.33, or 3.77% -- ending a two-day slide of more than $9.25 per barrel.

On earnings, we expect ex-financial profits to remain positive – although things won’t be strong enough to match the past two quarters of double-digit growth. Tech, consumer staple, health-care and industrial-company profit growth should combine to help ex-financial profits to post 5-6% growth. Financial profits will plummet another 60%, likely, but this is expected and once we get out another couple of quarters this sector’s earnings should rebound in pretty strong fashion as the comps will be easy to beat.

Market Activity for July 8, 2008

It’s been very nice to see oil prices come back below $140, falling to $136.04 as of yesterday’s close. The dollar posted a very nice day too as the G7 members made some very constructive comments on inflation – which means they focused on these two variables and may have sparked some fear in those holding dollar short positions. Alas, crude is up $2 this morning on reports Iran tested a longer-range missile capable of reaching Israel.

On stocks, they’ll remain volatile and will probably find it difficult to gain momentum in the very short term as uncertainties abound. The Fed, with their reckless easing policy of the past several months, has thrown another risk into the mix – inflation concerns – and this makes it increasingly difficult for the market to determine the appropriate market multiple. Other risks are geopolitical events – which is something we’ll have to adjust to for several years –, tax and trade policy, and energy price volatility.

We have heard talk of another “stimulus” plan – but Washington needs to spare us all of their feckless Keynesian shot-in-the-arm rebate check approach and get to making the current rates on income, capital and dividends permanent while also lowering the corporate tax. This is what should be done for now, and will cause the market to rally.

Once we get the election behind us, it will be important to lower all of these rates a bit further. This will cause the dollar to rally, profits to boom, stocks to rise, the job market to expand and disposable income growth to extend upon the very nice gains of the past few years. Enough of the games, it is time to get back into the game and show a very competitive global economy exactly who is king. It is the U.S., and it will remain the U.S. even if we have to deal with politicians that are more inclined to a framework of socialism than capitalism in the short term. Any big mistakes of the next two years will only bring back pro-growth policies and this country will continue to lead the global economic growth. If we escape this tendency – that more government involvement is the answer -- all the better. But mark my words, we will make the correct long-run choices of providing an environment for entrepreneurs and innovators to flourish as common sense policies allow capital formation to build. That is America and will remain that way.

Currently, we are dealing with monetary policy mistakes. As the Fed kept rates too low for too long into 2005. This policy fueled the housing market problems as the FOMC subsidized debt and encouraged some very bad behavior. Now we are working to resolve this issue. Again though, Bernanke & Co. are making the same mistake and this is fueling a commodity boom, and raising inflation expectations. I’m still holding out for the Fed to come around and reverse course. They better get to it. When they wake up the energy problem will ease dramatically. Yes, we have other challenges in this regard, such as pushing aside quixotic tendencies for common sense energy policy, geopolitical risks and the chance a hurricane may take a damaging path. But specifically within the economy, it is all about the Fed and a little tightening will solve the oil/dollar problem.

On the economic front, things were mixed.

The Commerce Department reported wholesale inventories hit the lowest level on record in May even as auto stockpiles remain elevated. Thankfully, most businesses have kept their operations lean and sales remain strong. Sales growth is up 13.6% year-over-year and up 20% at an annual rate over the past three months.

This data indicates two things:

One the economy will not go into recession anytime soon as firms have kept stockpiles lean. Remember, a big contributor to downturns is when firms become bloated and then have to sell off a surplus of goods before ramping production up again. This is certainly not the case today.

Two, underlying growth remains, as evidenced by sales growth. Sales have easily outpaced inflation, so one cannot say this growth is solely a function of rising prices – real sales growth looks good.

That said, we very likely see sales decline when the June data is releases. After three very strong months, a pull-back is a natural occurrence. So be prepared for that as the media will attempt to spread their doom and gloom when it occurs.

Regarding GDP, the large inventory rebuilding of the past two months will result in a stronger-than-expected reading. We’ll see second-quarter GDP come in at 2.5% in real terms by my estimation – assuming nothing huge changes over the next month – the lagging data for June has yet to be reported.

We also had pending home sales, which fell 4.7% for May after large 7.1% rise in April, which was revised higher.

Even with the pull-back last month, the year-over-year trend is looking much better. (The graph below shows the month-over-month change.) In December, the year-over year decline in pending home sales reached 23.9%. As of this latest data, that figure has improved to a decline of 14.6%. Let’s hope we continue to see mild improvement. Still, for things to really turn buyers will have to believe prices have bottomed. Until then, the sales figures will remain weak and supply will remain elevated.

We’re quiet on the economic front this morning, so we’ll have to wait for tomorrow’s jobless claims and chain-store sales data.

Oh, I almost forgot to mention both Fedhead Bernanke and Treasury Secretary Paulson gave speeches yesterday and the market held onto its gains. Let’s hope this is the start of a new trend – talk about quixotic.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

Wow! Market activity was all over the road yesterday as stocks began the day roughly 1% higher on a meaningful decline in oil prices – thanks to some comments from the G7 on Sunday night – and the dollar was up big. But that all changed two hours into the session after a Lehman analyst stated the GSEs Fannie Mae and Freddie Mac may have to raise $75 billion in capital. By noon, the Dow had dropped 278 points from the intraday high and barely recovered from there by session’s close.

These comments on the GSEs (government sponsored entity) received all the press for pounding the market, but an address by San Francisco Fed Bank President Janet Yellen did major damage as well, which we’ll get to below. For now, suffice it to say her statements reversed the dollar’s rally and helped crude futures reverse roughly half of its earlier losses.

In the end, the major indices closed less than 1% lower, with the Dow down just 0.5% and the NASDAQ losing 0.1%, but it was worse than that considering stocks were in rally mode at the open.

Market Activity for July 7, 2008

Not helping the Dow were shares of General Motors, which have declined to the lowest level since 1954. Between GM’s management and the UAW, it’s been very difficult for the firm to compete on a global scale. But Bernanke & Co. have delivered what is very close to a coup de grace with their reckless monetary policy – it is no coincidence that crude oil is up 75% since September, the point at which the FOMC began their rate-cutting agenda. Since becoming absurdly aggressive, kicked off by the January 22 inter-meeting cut, oil is up 60%. GM is not face with a demand problem; they are troubled with having too much supply of trucks and SUVs, while not enough of what the public now desires – more fuel efficient vehicles – after the stunning climb in energy prices in the past several months.

Getting back to the market and investors’ concerns, here’s the kicker regarding the Fannie (FNM) , Freddie (FRE) news: it was all conjecture.

FNM, FRE took a dive after a Lehman Brothers analyst stated accounting rule changes would force the two to raise capital, and thus make it more difficult to buoy the housing market – if you can call it that. But that very same analyst, and naturally not reported on until well-after the close, agreed that such an outcome would not occur. In fact, he stated that he could not “imagine such an outcome occurring.”

So all of this wild ride was over a hypothetical statement. The Dow falls 278 points intra-day, FNM and FRE lose 20% and the market has allowed yet another dark cloud to roll overhead all based on some comments that will likely not come to fruition.

With all of the concerns related to mortgage loans, and the financial sector, the Ted Spread appears to be holding in there pretty well – it is certainly elevated, but no where near the widening that occurred during heightened stints of credit-market concern. This spread is an indication of credit risk as it illustrates the difference between three-month futures contracts for U.S. Treasuries and Eurodollars having identical expiration.

The reasoning: Since U.S. T-bills are considered the risk-free rate, while the rate associated with the Eurodollar is thought to reflect the credit ratings of corporate borrowers, the wider spread is an indication default risk is increasing. Naturally, a narrower spread means default risk has diminished.

But the 30-year mortgage spread does remain wider than usual against the 10-year Treasury. This spread normally runs between 150-180 basis points – that is, the 30-year mortgage rate is usually about 1.5-1.8 percentage points higher than the 10-year Treasury. Currently, the spread is running about 235 basis points as the market demands more via heightened risk. The chart below may look a bit confusing, but focus on the yellow line, which is the spread.

Considering these two spreads, we see that concerns remain heightened, but are lower than the worries of March.

Outside of these housing/credit-market concerns there was also something else that hurt stocks, and that was San Fran Bank President Janet Yellen’s speech. The graphs below show what happened to the dollar and oil when her comments hit the wires.

The address was focused on the current state of the economy but it was her comments on commodity prices, as she explicitly stated there is little monetary policy can do to prevent the rise in oil prices, that did the damage. She also said that the Fed doesn’t have a definitive answer for why food and energy prices have gone through the roof, but suspects it’s resultant of supply/demand. Oh, I see, supply/demand has changed so dramatically in six months that it justifies a 60% rise in crude prices.

It’s true that the rise in food prices is partially due to supply issue as heavy rains have kept farmers from getting into the field to plant. It is true that oil prices had risen from $40 per barrel in late 2004 to $70 per barrel by mid-2007 due to increased demand while we refuse to produce the vast majority of our energy reserves. However, the rise from $70 to $140 in the past 10 months is due to reckless Fed policy. It is amazing that Fed officials continue to tow the line Yellen repeated yesterday. It is not simply chance that energy has risen this much in such a short period of time as the Fed has also jacked rates lower and punished the dollar in the meantime.

I believe when the Fed changes their stance on this issue and signals just mild tightening will take place in order to boost the dollar, lower energy prices and fight inflation, the market will rally hard. It may take a day or two to digest it all, but a major uncertainty will have been removed – the question: is the Fed really focused on curtailing price pressures or will they remain lost in the wilderness of their Keynesian textbooks? – and stocks will find their groove. The search party continues, but I do believe the Fed will be found before we move to a 1970s like situation.

Crude prices are lower this morning, falling below $140 per barrel, and the dollar is lower after some very constructive statements out of the G7 conference last night. (It’s actually the G8, but I don’t recognize Russia’s membership, which is a joke and nothing but a thorn in everyone’s side).

Alas, Bernanke speaks this morning, so don’t be surprised if oil and the dollar reverse their desired direction this morning.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ended mixed in a holiday-shortened session on Thursday as the market had to deal with a job-market report that showed the economy endured its sixth-straight month of jobs losses and a service-sector survey that came in below expectations.

However, the fact that the monthly job losses remain mild did offer some consolation – readings below 100,000 are statistically insignificant for a job market that is nearly 138 million strong – as the broad market hovers very near bear-market territory. The S&P 500 dipped to 20% below the peak reached on October 9, but snapped back very nicely an hour into the trading day. In the end the index closed flat.

Much of our current problem has to do with inflation expectations and a Fed policy that is hurting the dollar and driving energy prices higher. Once they get it right, as I continue to believe they will, the dollar will strengthen and some steam will be taken out of the oil trade. At this point, the market will have an easier time assessing the current multiple in this environment and we can regain some footing.

Market Activity for July 3, 2008
Six of the 10 major industry groups gained ground during Thursday’s session with industrial and basic material shares leading the gainers, while energy and utility shares led the decliners.

For the week, the Dow lost 0.51%, the S&P 500 closed lower by 1.21% and the NASDAQ Composite fell 3.03%.

Getting to the economic data – that after all is what Thursday was all about -- the Labor Department reported that jobless claims, for the week ended June 28, rose 16,000. That moved the four-week average up to 390,000; not a number we wanted to see – optimally, during this period of soft labor conditions it would have been nice to have remained at 375,000 in weekly claims just for assurance.

That said, it is not terribly troublesome, as the chart below illustrates; we remain below the 400k mark and significantly below levels that are seen during substantial labor market weakness. I’ll also add, the work force is much stronger than it was in 1991 and meaningfully higher than the most recent downturn of 2001. For instance, there were 108 million payroll jobs in 1991 and 130 million back in 2001. Today, the there are more than 137 million payroll positions. So, when one adjusts for the increase in jobs, the current level of jobless claims is actually even lower than the periods of heightened job-market weakness that is presented by the graph below.

Nevertheless, based on the latest service-sector report – as we’ll explain below – it does appear we’ll see the claims figure move higher.

And to that report, the Institute for Supply Management’s service sector index (not to be confused with the ISM’s manufacturing survey) declined, moving back below 50 – meaning activity contracted. The reading slipped to 48.2 for June after the May reading printed 51.7.

This is a bit strange considering that personal spending has trended higher over the past few months; what it may be signaling is a pull-back after three fairly powerful months of spending – which rose 6.8% at an annual rate March-May.

The main aspect to focus on within the report was the move on the employment index – a sub-index within the report – which fell 4.9 points to in June. The main culprit was financial and business services, reflecting financial-service woes are beginning to show up in a more meaningful way.

Still, many industries reported employment growth, such as real estate (that’s a surprise), scientific and technical, utilities and recreation and leisure.

Overall, I’m not terribly worried about this reading, but it does suggest, that the job market will remain weak for a while.

Saving the big one for last, we had the employment report for June, which showed another mild loss in payroll jobs. The losses over the past six months now total 404,000, or 5% of the eight million created during the roughly four years that ran September 2003-December 2007.

For June we lost 62,000 payroll jobs, a tepid decline, but the unemployment rate did remain at 5.5% -- I was expecting it to fall after the figure was boosted in May via those 19-24 year olds entering the workforce a couple weeks early and messing with the seasonal adjustment.

However, since the rate remained at 5.5% for a second month, it makes it kind of difficult to blame it on seasonal adjustment factors. Still, even though the jobless rate has risen a full percentage point in the past year, it remains in line with the 20-year average and below the 30-year average of 6.07% -- just to provide some context.

The fact that temporary help fell 30,000 in June – the seventh month of decline – illustrates that we will not see improvement anytime soon. Temp work is a pretty good forward indicator.

For the meantime, we’ll have to contend with a substantial housing correction putting pressure on construction jobs, financial services (namely large brokerage firms and banks) keeping this segment soft and rising costs that keep firms focused on increased productivity out of current workers instead of just adding staff. But the vast majority of firms are slim and streamlined and productivity improvements remain at a historically high level as more efficient plant and equipment allow workers to produce more. This is great news as we look out over the next couple of years. But beware higher tax rates, especially on capital. This is a productivity killer as it results in a lower level of capital formation – the mother’s milk of innovation.

Further, while we all must contend with higher energy prices, the industry is booming as a result. The number of high-paying manufacturing jobs that will come from oil and natural gas production and the necessary nuclear build-out will provide a huge boost to the job market if the government would simply get out of the way and allow it to occur. The industrial sector will take over again as a major job creator if/when Congress removes a number of obstacles.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

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

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

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

Market Activity for July 2, 2008

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Brent Vondera, Senior Analyst

2Q 2008 Participant Insights

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

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Daily Insight

U.S. stocks ended a pretty wild session in the black as investors pushed aside another day of speculation regarding the likelihood of an Israeli attack on Iran’s nuclear installations and higher oil prices to focus on better-than-expected manufacturing and construction spending reports.

Stocks gained some steam early in the session when the ISM (Institute for Supply Management) survey showed factory activity expanded in June, but gave it back quickly as oil prices jumped on the Middle East news. The Pentagon released a statement mid-day dismissing the news and oil prices pulled back; stocks gained ground as crude fell from the session’s highs.

(With all of this talk of a strike, and Israel’s military exercise last month preparing for what may be the inevitable, Iran is suddenly inviting the idea of talks over their nuclear activities. Of course, this is what Iran does; they act as though they are serious about keeping to their end of the bargain, while they buy time and continue to enrich uranium to weapons grade status. The Israeli’s understand this and prudently prepare for action considering the regime continues to makes statement such as “Israel will be wiped from the map.” The market is currently trying to assess the appropriate multiple due to this uncertainty, among others.)

Market Activity for July 1, 2008

The S&P 500, as the chart below illustrates, had been down as much as 1.5% from the opening price, but jumped nearly 2% from those lows to close the session meaningfully higher. Financial, consumer discretionary and energy shares led the broad-market’s advance. The Dow’s gain was propelled by shares of American Express, Proctor and Gamble, McDonalds and Wal-Mart.

Advancing stocks just about matched decliners on the NSYE. Some 1.58 billion shares traded on the Big Board, slightly more than the three-month daily average. For this July 4th holiday-shortened week, volume is usually much lower, but with the June jobs data release coming on Thursday, traders likely delayed vacation to be around for this all-important report.

On the economic front, the latest manufacturing report showed factory activity expanded in June, marking the first move above 50 (the level that divides expansion and contraction) since January. Even so, during the previous four months of contraction, the index was just barely below the line of expansion and no where near the level that indicates trouble.

The Chairman of the Institute for Supply Management explained in the report, as we’ve touched on in the past, that when the survey averages 50 it corresponds to roughly 2.8% real annualized GDP growth. During the second quarter ISM averaged 49.4, so we’re looking at a GDP reading of about 2.6% by this indication.

(I believe we will see a number in that range as increased capital goods shipments, higher personal consumption numbers and the production needed to rebuild low inventory levels will catalyze growth. Housing will continue to subtract a full percentage point from the reading; if housing were merely flat, GDP would come in at 3.5% for Q2, but this flattening will not take place until the supply of homes comes down significantly – which will probably take another year, hopefully.)

In a separate report, the Commerce Department reported that construction spending fell less-than-expected in May, declining by 0.4% -- the consensus estimate was for a 0.6% decline. The April reading was revised higher to show a 0.1% drop, after previously estimated at a 0.4% decline.

Two months of declines surely doesn’t give one a sense of full-flowing optimism, but considering the residential component – which makes up 40% of this reading – was down 1.6% in May (and off by 26.9% year-over-year) these mild declines are relatively good news. Strength came from lodging construction (up 2.6% for the month), schools (up 1.6%), power plants (up 1.5%) and manufacturing facilities (up 0.9%).

Lastly, the auto industry released its sales data for June, and the turn down of the past three months continues. But lower sales volumes are not the result of a lack of credit availability or even demand. Instead, according to the report, there is just too much supply of trucks and SUVS and not enough of what consumers currently desire during this period of high fuel prices – more fuel efficient vehicles.

Over the next several months manufacturers will undoubtedly ramp up production of the cars people want in this environment and unless something changes with regard to the job market – which is currently soft but not showing statistically significant declines – sales should rebound several months out.


Have a great day!

Brent Vondera, Senior Analyst

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Daily Insight

U.S. stock indices ended mixed on the final day of the second quarter as the Dow and S&P 500 managed small gains, while the NASDAQ Composite closed lower. The opposite was the case for the quarter, however, as the Dow and S&P 500 ended the period lower – the third-straight quarter of losses – and the NASDAQ managed a fractional gain.

The Dow closed the quarter down 7.44%; the S&P 500 declined 3.23%; the NASDAQ Composite gained 0.61%

The Dow’s string of three consecutive quarterly losses has not occurred since 1977 when the index recorded losses in each of that year’s four quarters. (For the S&P 500 we have had two other occasions since 2000 when the measure was off for three straight quarterly periods – first nine months of 2002 and the final nine months of 2000.)

We don’t want to get ourselves into a situation where comparisons to the 1970s become relevant, especially with regard to inflation. And on that topic, Bernanke & Co. better well get a handle on benflation expectations or stock prices may just begin to price in harmful levels of price activity – even as the consumer-level gauges remain pretty tame for now. One cannot ignore the jump in energy prices, and commodities in general, or suggest that these costs will come lower simply because economic growth is weak. This is what the Fed has been saying, and the thought has been terribly wrong to this point; I’ve got a sense they’ll be forced to throw their Keynesian-style thinking aside in the very near term.

Market Activity for June 30, 2008
The financial sector, to no one’s surprise, led the broad market lower for the quarter as the index that tracks these shares tumbled 19.01%. The next worst performer was the industrial group. Six of the 10 major industry groups declined during the prior three months.

Energy, again no surprise, led the gainers, jumping 16.92% for the three months ended June 30, as oil jumped 38%. Such a quarterly increase (in percentage terms) has not occurred since 1999, but back then oil per barrel was trading at $12-$16 per barrel, so it was just a touch easier to deal with. The lunatic fringe may begin to surmise that Bernanke has some family members with oil-company interests if this pace continues. This would be an illogical view, but there’s little arguing his easy money ways hasn’t had adverse effects on the dollar and the price of oil.

Interestingly, removing the financials from the S&P 500 the index was basically flat during the prior three months, down just 0.38% -- financials were responsible for 285 basis points of the 3.23% decline. I’m not sure if thinking of things this way makes much sense, but thought it was worth pointing out. Financials make up 14.2% of the S&P 500 at present, which is down from 16.8% when the quarter began and 21.42% just two years ago.

I look at the benchmark indices, and many of the stocks that make up these measures, and see a lot of value. There are an abundant number of stocks trading at multiples that have compressed to levels that make very little sense based on their current earnings growth and potential of the next several years. In time the equity indices will explode to the upside as stocks are spring loaded after several years of earnings growth far outpacing the rise in share prices.

But for now, investors will simply have to be patient because uncertainties abound and the Fed has thrown one more in with their easy money policy. Maybe I’m way off base here, but as most readers know, my belief is oil will fall back to the $100-$110 level if Bernanke would just mildly raise rates. This would bring inflation expectations lower and remove a major risk (not just on an expectations level but will relieve some pressure on the consumer) as we deal with the current housing-sector woes and concern over tax and trade policy – a concern that increases each day Senator Obama makes a speech about how he’s going to jack rates up on the people that provide our economy with capital, which is about every day by my count. In addition, placing windfall” profit taxes on oil producers (more production is something we can really use right now) won’t be kind either as this will increase out dependence on energy imports, just as the same scheme drove the industry to other areas of the globe during the late 1970s.

Enough of that. On the economic front, the Chicago Purchasing Manager’s report – factory activity for the most important manufacturing region – showed mild improvement within the sector continues, as the index crept even closer to the expansionary mark.

The reading came in at 49.6; a reading of 48 was expected. As we’ve stated for a few weeks now, it does appear the manufacturing sector is poised to record expansionary reading once again – it’s been six months since we’ve been solidly above the line of expansion, which is 50 on these indices.

Yes, it will take a flattening out in housing before factory activity moves markedly into expansion mode – by markedly we mean readings of 55-56. However, we are already right at the line of demarcation and should mover above the 50-mark within a couple of months – even with current housing and auto-industry challenges.

We’ll get a better look this morning when the national factory index – known and ISM Manufacturing – is released. We’ll have to deal with another reading that remains just barely in contraction mode, but should see some signs that things continue to slowly improve as underlying strengths help the sector fight through the areas of weakness.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks fell on Friday, adding to Thursday’s rather large declines, even as the day’s economic data looked quite healthy. But the typical pessimistic tone related to those economic releases, which always seem to tell only part of the story (funny how it’s always a negative commentary), and another day of higher oil prices – as the Fed remains lost in the wilderness of their Keynesian textbooks – was too much for investors to bid the indices higher.

As a result of Friday’s nearly 1% decline on the Dow, the index has virtually moved to bear-market territory. The S&P 500 remains roughly 2% from bear-market levels – which are defined by falling 20% from the top. That top was reached on October 9. The graphs below illustrate was has occurred over the past two years, and specific to this discussion over the past nine months.

Market Activity for June 27, 2008

Today marks the final day of the third quarter and things aren’t looking real nice as the broad market is set to decline 3.4% for the past three months. The poor quarterly results are due to the worst June performance since 1930 – down 8% this month with the final session to go. We were off to such a good quarter too as April was up 4.75% and May add another 1.07%. But oil prices have proven to be too much for the market to handle. Sure, we have a soft labor market and the questions as to the duration of the housing correction, but let’s face it the job-market declines have been mild and housing has been baked in for a while. It’s mostly about the direction of energy prices at this point.

Crude-oil futures picked up another 60 cents on Friday, closing the session above $140 per barrel. Crude has jumped 2.2% thus far this morning, moving above $143. I simply don’t see this situation changing until the Fed gets a clue and begins to overtly signal, and then follow words with action, they will begin to raise rates. As we’ve touched on many times, they do not need to raise their benchmark fed funds rate much, just a gentle climb to 3.00% by year end. This will take the steam out of the oil trade and do some amazing things in terms of causing the inflation gauges to decelerate. (Remarkably, the consumer-level inflation indicators remain remarkably tame. This is not so for the producer price and import price gauges, which are through the roof and the worry is that these levels will eventually end up moving to the consumer level. But this has not yet occurred.)

But back to the Fed for a moment, their current decisions are causing traders to keep their long positions regarding the oil trade and have led others to move in as well. According to Bloomberg News, net long positions in New York oil contracts jumped 90.5%. Long positions had touched a five-week low a week earlier as many believed the Fed would make a strong statement that the rate-hiking campaign would begin at their August meeting. Now that another meeting has come and gone, and they were pathetically non-committal with regard to policy, the oil trade goes on.

In addition to all of that, we also have geopolitical concerns pushing oil futures higher this morning, as worries about Iran pick up. Still, I don’t think I’d want to be long oil futures right now. It is a matter of time before the Fed begins to raise rates, they’ll be forced to, and oil should come off big when they do. Geopolitical concerns will remain, but this is why one keeps an allocation to energy and the stocks that provide the equipment to the industry.

On the economic front, the Commerce Department reported that personal incomes shot up in June, jumping 1.9% and sending the year-over-year increase to 6.4%. But much of this was due to rebate checks and the government transfer payments that also went out but were not officially termed “rebate” checks.

During June, $48 billion of rebate checks were delivered so when we adjust for this one-off incomes rose 1.3% last month, still a huge reading. However, there was a purely Keynesian aspect to this “stimulus” program that resulted in people getting checks that were actually more than their actual federal income tax liabilities for 2007. Part of the program was to essentially eliminate the 10% bracket, that’s how they came up with the $600 rebate for most individuals and $1200 for most couples. But others got money as well – a handout is the appropriate term.

You see anyone with income of at least $3,000 in 2007 got at least $300, and since federal tax rates have been driven to zero for individuals making up to $10,000 and couples making up to $20,000, their checks amounted to more than they paid in taxes and those payments were termed “social benefit” outlays. Put all of this together and there were $176.5 billion in government payments that boosted the June income figures. Still, what the media failed to report was that even when you adjust for all of this, June incomes still rose $49 billion, resulting in a 0.4% pick up in incomes for the month. That’s a healthy reading.

I’ve expressed some concern over income growth, especially with energy prices pushing higher, but even when we adjust for the government handouts, June looked good.

Spending jumped 0.8% in June, and has been quite strong from three months now – up 6.8% at an annual rate --, bouncing back very nicely from the respite consumers took during the first couple months of the year. Interestingly, there was $226 billion in income last month when adding in the government handouts, but spending rose just $77.4 billion. Hence, the majority of the “stimulus” handouts were saved, or used to pay down debt.

Overall though, the income (adjusted for the government checks) and spending figures looked good in June and remain on a solid trajectory. Unfortunately, the pace at which energy prices are rising is impossible for income growth to match. In time, very near term in my opinion, the Fed will do its part and this will not be the worry it is today. Their action is belated, but they will be forced to raise as oil will not begin a downtrend until they do.

We’ve got a huge week regarding economic releases. Today we begin with the most important regional factory index – that being Chicago. Tomorrow we get the national reading, which should show manufacturing activity remains very close to expansion mode even as housing and auto-industry woes weigh on the figure. Construction spending for May will also be released on Tuesday. On Thursday we round out the holiday-shortened week with the all-important jobs data for June.

Have a great day!

Brent Vondera, Senior Analyst

The Wall Street Transcript

The Wall Street Transcript interviewed Chris Lissner for the October 2007 issue. This is an excellent read for anyone wanting to learn more about Acropolis, it's investment strategy and security selection process. Click here or the icon below to read the interview.

Daily Insight

U.S. stocks took a beating yesterday as the Fed has created additional problems for equity investors after failing to provide strong and decisive language regarding near-term monetary policy. The lack of conviction is making it difficult to assign an appropriate market multiple to the broad market as inflation concerns increase; oil has gotten back on its horse and seems quite ready to move higher so long as the FOMC remains non-committal.

The Dow Industrial average moved to its lowest level since September 2006 and the Dow Transports have gotten hammered in the past five trading sessions, falling 7.5%. Still the trannies have held up remarkably well, up 7% year-to-date. The S&P 500 has held above the March 10 multi-year low, but just barely as a 1% decline from here will move us through that level.

Market Activity for June 26, 2008
For what it’s worth, the U.S. indices are holding up better than most markets. Year-to-date, Germany is down 14.12%; France is off by 15.57; Britain is down 14%; Spain has declined 14.10% -- and that’s with currency adjustment. In addition, Hong Kong is down 20.7%; China’s major index has plunged 45%; India is off by 32%.

Crude-oil futures, enabled by the Fed and the driver of Benflation, rose 3.78% yesterday and are adding to that move this morning, rising above $140 per barrel. The chart below shows activity for yesterday’s session. Some of this activity includes the previous day’s overnight session, but you can tell by the time on the x axis how momentum began to build early morning and exploded to the upside by the time of our market open. (That momentum actually occurred directly following the release of Wednesday’s Fed decision as crude, which had been lower for most of the day by $4, reversed course and recovered half of that loss.

On the economic front, the data wasn’t too bad really, actually quite good regarding the GDP when considering all of the recession predictions.

Oh, before getting into that, I neglected to mention yesterday that Oracle’s latest earnings results were strong, propelled by the U.S.-dominated Americas region. Overall, quarterly profit advanced 27%, with U.S. sales bouncing back to record 18% growth.

As we’ve talked about many times, there are certainly areas of the U.S. economy that are hurting – housing and autos, namely – but other segments remain quite healthy. This news out of Oracle is just another example. A prime example of this reality, which we touch on each month, is business sales, which are up 6.75% over the past year and have increased at an 8.5% annual pace thus for during 2008. This data does have a big lag to it; the latest data is for April. That said, based on the trends of May and June, I expect this data to remain on an upward trajectory.

But back to yesterday’s economic releases, the Commerce Department reported that first-quarter GDP was revised slightly higher to 1% at an annual pace – that’s in real term, adjusted for inflation.

The drivers of first-quarter activity were personal consumption – always the largest segment of growth --, which added 0.81 percentage point; net exports, which added 0.79 percentage point; and government spending, adding 0.41 percentage point.

The drag continues to be residential fixed investment – housing --, which subtracted 1.12 percentage points from that real GDP figure. This amounts to a 24.6% decline at an annual rate – again, this is for housing construction.

Inventory additions added virtually nothing to first-quarter GDP, after subtracting a large 1.79 percentage points from the fourth-quarter number. Watch as the production needed to rebuild inventories fuels second-quarter GDP. Personal consumption and business spending will also add nicely, and unless the lagging data (mostly for June, but we still have a couple of releases we have yet to see for May) record uglier numbers than I’m expecting, the next GDP report will be stronger than most estimate and will continue to crush the recession predictions.

Growth is certainly weak, but it’s a far cry from recession – traditional definition of which is two-straight quarters of negative readings. My main caveat at this point is the Fed. They are fueling a commodity boom and their latest statements make it appear they are oblivious of this fact. They continue to believe that weak growth will bring these prices lower – I guess we’ll watch this assessment continue to miss the mark. If they don’t wake up, the interest rate increases that will be necessary to regain inflation-fighting credibility will lead to recession in the back-half of 2009.

In a separate report, the National Association of Realtors reported that existing home sales rose 2.0% in May. That’s certainly welcome news, but the inventory levels remain extremely elevated – as the second chart below illustrates -- so it’s tough to get excited about the increase in sales. Fact is this housing correction will be with us for a while. If only the Fed would get it right we will adjust to the housing woes. Assuming Congressional chicanery doesn’t exacerbate the situation, my feel is housing will begin to flatten out a year from now.

It’s important to point out that real economic growth has increased 2.5% over the past four quarters. That’s with housing subtracting more than one percentage point during three of those quarters and high fuel prices that continue to rise. For perspective, the long-term average for real U.S. growth – or what is referred to as “trend growth” – is 3.4%.

Lastly, the Labor Department reported that initial jobless claims came in flat from the previous week’s reading. For the week ended June 21 claims remained at 384,000, which is a bit higher than we would like. In the currently soft job market environment, we’d like to see claims hovering around 365,000-375,000 – this level would give us confidence that the monthly job losses would remain very tame. The current level of claims is not terrible, so long as we remain below 400,000 it is unlikely we’ll see a sharp monthly decline in payroll jobs, but still a small decline from here would make me more comfortable especially regarding the outlook for income growth.

This morning we get the May figures for personal income and spending, along with the inflation gauge tied to it all.

It will be tough for the equity markets to advance today, as traders will not want to go into the weekend long with the uncertainties that surround. But if the income and spending numbers come in at a healthy pace, stocks could get a boost. The inflation gauge tied to personal spending – known as the personal consumption expenditures index, or PCE – will show consumer-level inflation remains fairly tame. But this will change if the import and producer price figures remain at current levels and the Fed fails to put the hurt on the oil trade. If they fail to get it right, we’ll see the inflation gauges hit 4.5%-5.0% and then the bozos will be forced to act.

Have a great weekend!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ended the session higher, but traders appeared confused during the hour of trading subsequent the Fed’s rate decision – and just as importantly the statement, which was extremely non-committal – as the major indices gyrated more than 1%, as the graph below illustrates. In the end the indices held onto to most of the pre-announcement gains.

During the morning session, stocks shook off another very weak new home sales number – this time for May – as a pretty good durable goods report helped investor optimism. That report showed orders were flat for May, but electronics, computer products and telecommunication equipment showed nice gains and shipments of capital goods, which flows directly to the GDP figure, gave good indication second-quarter growth will be stronger than expected. More on this later.

Market Activity for June 25, 2008
Crude oil futures fell roughly 4% as the weekly energy report showed supplies rose 803,000 barrels – the forecast was for a decline of 1.1 million barrels. Fuel demand averaged 20.2 million barrels per day during the past four weeks, down 2.3% from a year earlier. Crude recovered half of this decline after the Fed’s comments showed they still don’t get it, which we’ll also get to below.

Eight of the 10 major industry groups gained ground for the day; energy and industrials were the losers. Energy was down on the decline in crude futures and industrials were pushed lower by a nearly 7% decline in Boeing shares, which sent many of the aircraft suppliers down in sympathy. But this concern was overplayed and the suppliers, especially those with strong defense contracts, are looking quite attractive here. The decline in Boeing shares subtracted 41 Dow points from the index, which is why it lagged the performance of the S&P 500.

Getting to the economic data, new home sales fell 2.5% in May, brining sales to 512,000 at an annual rate. There’s not much more to say about this situation, you’ve all heard it before. Supplies are terribly elevated and buyers simply will not come back to the market in earnest until they get a sense that prices have bottomed.

Expect housing – residential fixed investment in technical terms – to continue to weigh on the GDP figures, which has been the case for nine quarters now. During eight of these quarters, housing has subtracted at least 1.25 percentage point from real growth, yet economic growth has still measured 2.35% in real terms during this nine quarter period. Add in the 1.25 percentage point and you’ve got above trend growth even with sky-high energy prices – that proves underlying strength remains.

I’m guessing housing will bottom sometime in mid-2009, but this assumes Congress doesn’t do anything stupid to prolong the correction, which is a big assumption.

In a separate report, the Commerce Department reported that May durable goods orders came in flat. What kept the figure flat from the April reading was a big drop in machinery orders, down 5.3%. Strong orders in April and March – up 5.1% and 8.5%, respectively – caused the machinery orders respite. Vehicles and parts also weighed on the figure, which as been a reality for several months now. Those orders were down 3.5% and many auto plants remain idle.

The strength came from electronic, computer products and telecommunication equipment, which all posted really nice gains. Electronics orders were up 2.0%; computer products orders were up 10% and telecom orders rose 2.4% for the month.

Non-defense capital goods ex-aircraft – a proxy from business spending -- slipped 0.8% in May due to that drop in machinery orders. The decline followed a 3.1% rise in April. Importantly, shipments of business equipment rose 0.6% last month, which was on top of a 0.9% increase for April. This number is a component of GDP and thus will help the Q2 reading.

Finally, getting to the big news of the day, the FOMC (Federal Open Market Committee) kept their benchmark interest rate unchanged and the statement that accompanied the decision was non-committal.

The Fed mentioned overall economic activity continues to expand, reflecting some firming in household spending. However, they also mentioned that labor markets remain soft and that the housing correction and high energy prices will likely weigh on economic growth.

This latter statement was damaging. We already know this and all stating it does is send a signal that they may not raise rates in August. This is bad for the short-term price of oil – we needed a strong statement proving Bernanke and Co. understand that a mild boost in fed funds will bring crude futures lower.

The Fed certainly stuck to their Keynesian roots by mentioning they expect inflation to moderate later this year simply because growth is weak. This has been their line for six months now, only to be way wrong as their easy money campaign has hit the dollar and boosted commodity prices.

I’ve got to say my initial reaction to the statement was that it did signal the rate-hiking will begin in August – basically because of the “economic activity continues to expand, reflecting some firming in household spending” comment. Alas, the market didn’t see things the same way.

I lament, the language was not nearly strong enough – they needed to be much more hawkish towards commodity-price inflation. This was evident shortly after the comments were released as the dollar declined – after being flat-to-higher prior to the statement; oil reversed course – erasing half of it earlier losses – and the probability of a rate hike in August (their next meeting) declined.
Overall, the FOMC release was a big let down and we’ll likely have to deal with a dollar that struggles to gain ground and thus oil prices that remain above $100 per barrel, possibly above this $130 mark as the Fed is directing short-term traders to stick to the commodity trade.

There will be a new Fed Chief by the end of 2009. Bernanke is a fumbler and fails to get what will actually help economic growth in the relative short term.

This is a confused Fed. They certainly have a tough job in front of them, but they must understand that 2.00% fed funds will not magically solve the housing and credit issues and concentrating on the dollar and commodity prices is their best lever at this point. Mild tightening, beginning with what should have been strong and decisive comments yesterday, is the best way they can boost growth over the near term.

Have a great day!

Brent Vondera, Senior Analyst

Bernstein's Gale

By David Ott

In 1942, economist Joseph Schumpeter wrote The Process of Creative Destruction that argued that new machines, methods and ideas destroy the existing ones and bring about new and improved systems. In the book Capital Ideas, Peter Bernstein chronicles this process on Wall Street from his perspective as the old guard.

The story begins with a relatively unknown French mathematician named Louis Bachelier in 1900 and ends up covering the titans in modern finance: Markowitz, Sharpe, Fama, Modigliani, Black, and Sholes, among others. Throughout the journey, the prevailing market conditions and technological advances are seamlessly woven into the story, not to mention terrific personal antidotes from Bernstein’s five decade career on Wall Street.

Although the book is divided into six sections, there are really three stories. The first describes the evolution of the theories that revolutionized investment management. Prior to the 1950’s, it appears that there was little attention paid to investment theory beyond fundamental analysis of individual securities. While this is a worthy endeavor, it isn’t enough to appropriately balance the delicate risk and reward equilibrium.

Portfolio investing techniques that are now considered basic like asset allocation were inconceivable to the broker, analyst or portfolio manager in the 1950’s. As a portfolio manager at that time, Bernstein relates this with a funny personal story about how in his view, a portfolio was nothing more than “a fancy leather folder with a sheaf of papers inside.”

The first section takes you from Markowitz’s efficient frontier to Sharpe’s capital asset pricing model (CAPM), and Bernstein slowly but surely builds the case for Modern Portfolio Theory and the Efficient Market Hypothesis. The clarity of his writing, his own personal evolution over the years and his one-on-one conversations with those that originated each theory make you want to accept the totality of all of the arguments presented.

The second part gently guides us through how the academics transformed securities valuation. Bernstein starts with the origins of William’s Dividend Discount Model, then walks through Merton Modigliani’s bombshell assertion that a company’s capital structure is independent of it’s market value, and ends with the creation of the Black-Scholes model for pricing options – one of the fundamental building blocks of modern finance.

The last section is comprised of three case studies where some of the first professionals put the theories into practice, or as Bernstein calls it, taking the ideas “from gown to town.” At first, this seemed to be the least interesting part, but it turns out to be as illuminating as the preceding pure theory.

The 1970’s were the tipping point for putting the ideas into practice for two major reasons. First, the bear market of 1973-74 sent everyone back to the drawing board and opened doors to those with new ideas. Second, there were major advances in computing power that allowed for substantial calculations that the new theories required.

The first case study is Wells Fargo’s creation of the index fund. The second case study is a thorough discussion of a successful pension consultant Barr Rosenberg, founder of BARRA, who took the ideas to Wall Street. Perhaps the most interesting case study, however, is the birth of portfolio insurance.

Theoretically, portfolio insurance is essentially the equivalent of a put option. Because index options didn’t exist yet, two professors from Berkley started a management firm that used computer programming to adjust an allocation between stocks and cash depending on market conditions that acted like a put option. The insured portfolio was designed to be 100 percent cash at a predetermined percentage loss. As conditions changed, the computers were programmed to make additional buys or sells.

Although the strategy was in application for nearly a decade, the day of reckoning came on Black Monday, in October 1987, when the market dropped by 22.6 percent. This was the critical test for portfolio insurance and it failed. In fact, many have argued that portfolio insurance contributed to the losses rather than ameliorated them.

One of the critical assumptions built into portfolio insurance was that there would always be sufficient liquidity to execute any trades that the programming required. Despite all of the modeling and programming that had been done, this was a fatal assumption, because even though the computer may have been ‘right’ to sell, there were no buyers which caused the program to sell more, creating a vicious cycle.

This seems like an interesting choice of topics to end the book since it clearly suggests that while the young turks from the ivory towers had succeeded in breaking down the old system that was firmly entrenched on Wall Street, the new system was far from perfect. The models that had been created were immensely useful, but they tend to create the illusion of precision and somehow urge users to focus more on the output rather than the value and assumptions of the inputs.

In the case of portfolio insurance, the models assumed that there would be sufficient liquidity to execute the waves of orders, but the human element crept in and the system locked up, creating a free fall in prices. Of course, this would seem obvious to an old time floor trader, but to an academic buried in equations and proofs, it was an overlooked factor (one of the inventors went on to argue that the insurance had worked, it was the market that failed).

Bernstein is an incredibly thoughtful writer. The tenor and flow of the book is easy even when the concepts are not. There is plenty of humor and delightful sideshows to keep the reader fully engaged. Most importantly, given Bernstein’s stature in the field, he has the opportunity to interview nearly all of those that he covers in the book and you feel like you know who they are as people, which is fascinating. Bernstein strikes a perfect balance between interesting story and technical description.

Bernstein is still active and recently published Capital Ideas Evolving, the subject of the next review. As the gales of creative destruction continue to reinvent Wall Street, it is easy to appreciate a writer with as much access, curiosity and lucidity as Mr. Bernstein.


June 25, 2008
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Recommendation: Strong Buy

Capital Ideas:
The Improbable Origins of Modern Wall Street
By: Peter Bernstein

John & Wiley & Sons, Inc., Hoboken, New Jersey 2005
First Published: 1992

ISBN: 13 978-0-471-73174-0