Busted Indeed

By David Ott
In mid-May, the New York Times Magazine printed an excerpt from the book, Busted: Life inside the Great Mortgage Meltdown, by Edmund Andrews.

The article is fantastic and gripping because Andrews is a well-educated economics reporter for the Times, but in the article he seems like a true victim of the subprime mortgage crisis. The reader is definitely left with the feeling that what happened to him could happen to anyone.

When I saw the book at the airport, I was caught by the opening pages where Andrews confronts then Federal Reserve Chairman Alan Greenspan about his personal situation. Admittedly, Schadenfreude also played a role in my impulse buy.

The book is much like the article with much greater detail. Andrews describes the divorce of his wife of 21 years and how he sets out to live the American dream with his new wife, Patti. To live that dream, they need a house they can’t afford. As he says early in the book about his new house, “I couldn’t afford it, but that didn’t mean I couldn’t buy it.”

Sure enough, during the housing and credit bubbles, there were plenty of financial institutions willing to lend them money on very easy terms. One of the best characters in the book is his mortgage lender, Bob, who says, “I am here to enable dreams.”

With Bob’s help, Andrews starts with a ‘liar’s loan’ so that he doesn’t have to produce pay stubs or tax returns that would prove that he can’t afford the loan. As their situation deteriorates, Bob is always able to find a creative solution. Five years later, unable to have ever been able to make ends meet, the Andrews become delinquent on their mortgage.

Despite his angry tone, Andrews is straightforward about not being a victim, despite the tenor of the original Times article. He says time and time again that he knew what he was doing; it was a gamble for the love of his life that seemed rational during an irrational time.

Andrews delivers very clear, well-written explanations of the entire mortgage ecosystem, from the mortgage broker to the investment banks. He even uses his investigative journalism skills to figure out which toxic mortgage security ends up owning one of his loans.

The trouble with Busted, though, is that despite being a professional reporter, he fails to mention some key facts. A blogger for The Atlantic, Megan McArdle, found that his new wife Patti had some financial troubles that he didn’t feel were worth mentioning.

In fact, Pattie had declared bankruptcy twice before. At the time of her first bankruptcy, she and her ex-husband had $30,000 outstanding debt on eight credit cards and owed $200,000 in back taxes in addition to the mortgage, car loans and private school tuition bills. The second bankruptcy relieved Patti of an unpaid loan to her sister, who had helped her out after her first divorce and bankruptcy.

It’s impossible to know what happened between Patti, her ex-husband and her sister. Perhaps she did nothing wrong and is horribly unlucky. Or, more likely, she was accustomed to living above her means for decades and encouraged Andrews to do the same.

In another blog, he defends himself, saying that the first two bankruptcies had nothing to do with the financial calamity outlined in the book and he didn’t want to embarrass his wife.

The argument about embarrassing his wife would be more palatable if he hadn’t been so vivid about her role in their personal crisis and the vivid accounts of their marital problems. Although he always writes himself as the bitter villain, the dirty laundry about her inglorious financial past wouldn’t have been any more damaging than what was already in print.

What’s worse though, is that as a reporter, he should have known better. Even though this is a more of a cautionary memoir (a la A Million Little Pieces) and not a newspaper article, her previous dealings were material facts that he should have presented. As they say on Law & Order, “It goes to character, Your Honor.”

Busted goes a long way to show that you shouldn’t buy something just because you can. Andrews wasn’t a victim, he was a participant. To some extent, we all played a role in the crisis and bought into the same dream. In our heart of hearts, though, I think we all knew better just as Andrews did.

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Recommendation: Sell

Busted: Life Inside the Great Mortgage Meltdown

W.W. Norton & Company New York, New York

ISBN: 978-0-393-06794-1 (hardcover)

FedEx lifts guidance

FedEx (FDX) raised its first-quarter earnings forecast, citing better-than-expected international shipments and cost-cutting. The announcement, unsurprisingly, coincides with other recent encouraging economic indicators – FedEx has long been regarded as a proxy for the overall economy.

The world’s second largest-package delivery company said it expects earnings for the quarter ended August 31 of 58 cents a share, down 53% from a year ago but well above the average analyst estimate of 44 cents per share. In addition, the company’s forecast for the subsequent quarter of 65 to 95 cents a share versus the current consensus of 70 cents, leaves some room for upside surprise.

CEO Alan Graf, Jr. said in a statement: “Despite some encouraging signs in the global economy, it is difficult to predict the timing and pace of any economic recovery. Revenue per shipment declined year-over-year in each of our transportation segments, as fuel surcharges declined significantly and we continue to face a very competitive pricing environment combined with significant overcapacity in the LTL freight market.”

FedEx is due to report full results on September 17.
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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks extended the latest winning streak to five-sessions as this peach of a market shows it has some juice left. A larger-than-expected drop in jobless claims, an increased forecast for oil demand and another Treasury auction that went swimmingly all provided impetus for the rally. (On the auction, it appears enough people just can’t keep enough of a 4.2% yield for 30 years – at some point the music’s going to stop but it appears it may be a while still.

Something does appear to be askew. Stock prices are rallying like the economy is out of the woods, yet the bond market is trading like it remains in a dark and dangerous place. Sure the Fed’s QE program (bond purchases) is skewing things, but I’ve got to say the differing outlooks from both of these market is extremely strange to watch.

Telecoms, energy and consumer discretionary shares led the rally.

Telecoms got a boost from an increased demand and sales forecast from Texas Instruments. The energy trade got a lift from the IEA’s boosted forecast for oil demand. Consumer discretionary shares may have been fueled by the initial jobless claims data, but as we’ll discuss below I’m not sure the numbers were suggesting consumer activity will surge any time soon. The index that tracks the group has been hot over the past two months, up 25% -- it now trades at a multiple that is above the long-term average; it seems the bid may have some unjustified euphoria in it with the jobless rate on its way to 10%.

We finally saw some good volume yesterday as roughly 1.5 billion shares traded on the NYSE Composite -- 28% above the three-month average.

Market Activity for September 10, 2009
Jobless Claims

The Labor Department reported that initial jobless claims fell 26,000 for the week ended September 5 – beating the expectation for a decline of just 10K, but the prior week’s number was revised up by 6K so it wasn’t off by quite that much. This is a really nice move lower, even if it is off of an upwardly revised number, after three weeks of averaging above 575K. Don’t get me wrong, as the chart we post each week illustrates, initial claims remain sky high, but this is a welcome decline.

The four-week average fell 2,750 to 570,000.

Continuing claims fell big, down 159,000 to 6.088 million. This is the closest we’ve gotten to the 5 million handle since April.

I still don’t think one can view the decline in continuing claims as a sign that job creation has begun, which believe it or not is what some took from the reading based on headlines. This is more a function of people exhausting benefits – Emergency Unemployment Compensation (an extension of benefits after they are exhausted) rose 73K to a new high of 3.102 million.

In addition, nothing in the monthly employment reports suggests such a thing. First, you must see an increase in temporary hirings before more permanent positions are created, and this segment of the data declined for the 20th straight month in August -- although the rate of decline has slowed. Further, you must see the duration of employment make a move lower. Yes, the average duration of unemployment (in weeks) fell to 24.9 in August, but this is just slightly off of the post-WWII high of 25.1 weeks in July.

What’s more, the percentage of those jobless for 52 weeks is still on the rise, as of the latest data.
But what this data does show is the degree of monthly job declines should continue to move in the correct direction. One hopes the monthly decline in payrolls will dip below the 200K level by the next employment report and this will enable us to get back to sub-100K losses (a statistically insignificant level) by early 2010.

The big question is, when will actual job creation occur? This varies by economic expansion. I’ve got a feeling since the bulk of the stimulus spending will arrive in 2010, we’ll see some payrolls added more quickly than is typically the case – largely via the construction industry.

However, the massive increase in government spending does crowd out the private sector (capital is diverted to buy the bonds to finance this spending and higher tax rates that follow damage profits) and also results in a prolonged period of caution among business decision makers. As a result, this largely offsets the short-term boost that will result from public spending and keeps the jobless rates high for a longer period of time than would otherwise be the case. We must remember that government construction jobs are not very permanent. When the road or building project is complete, that worker is out of a job again if the private sector is not there to pick them up. This was the lesson learned the last time we engaged in public projects on this scale. Some lessons need to be relearned apparently.

Trade Deficit

The trade deficit widened in July as the increase in imports outpaced that of exports. The figure widened to $32.0 billion in July from $27.5 billion for June.

Exports were up 2.2% for the month, driven by a 24.5% jump in auto exports, an 8.7% jump in computer-related equipment and an 8.1% rise in commercial aircraft. Imports increased 4.7%, driven by (again) a 21.5% boost in autos – clunker-cash baby, a 17% jump in commercial aircraft and a price-driven 7.6% rise in oil imports.

While these specifics are nice to talk about, and people who watch these things must be aware of what’s driving the figures, there are two main things people should take from this data:

One, you watch the import numbers as a gauge of consumer activity. The fact that autos were the main driver (and will be even more so for the August figure), helped immensely no doubt by Uncle Sugar’s clunker cash, is probably a sign that the boost in import activity will be short-lived.

Two, the direction of the deficit gap has implications for GDP. The trade figure had narrowed in the previous two quarters and that helped to ease the contraction within the GDP readings. Now, the deficit is widening again, and any boost from auto production due to the clunker scheme will be partially offset by imports outpacing exports – one of the components of GDP is net exports (exports – imports). Thus when the deficit widens, it does subtract some from GDP.

We will get the first positive GDP print (third quarter) after four quarters of decline. However, this increase will be held back by the widening in the trade deficit and the relative unwillingness for firms to boost inventory levels, which doesn’t appear likely to really show up in GDP until the fourth quarter.

September 11

It has been eight years now, as time passes are we returning to a 9/10 mindset?


Have a great weekend!


Brent Vondera, Senior Analyst

Afternoon Review: T, PG, MON

S&P 500: +10.77 (+1.04%)
Markets rebounded from its lower open to extend its winning streak on fewer-than-expected jobless claims, rising forecasts for oil demand, and plethora of companies increasing their earnings guidance. The S&P 500 has declined in only 19 out 50 sessions thus far during the third quarter.

The Telecom sector led the pack higher after research firm ISuppli Corp said Apple may extend its exclusive wireless agreement with AT&T (T). The sector is also gaining momentum on expectations that companies will increase spending on communication and mobile equipment as the U.S. economy pulls out of the recession.

Oil prices continue to rise after OPEC left its production targets unchanged, as expected, and the IEA expects global demand to strengthen. Energy stocks were the second best performing sector today.

Procter & Gamble (PG) jumped 4.24% after the company reaffirmed its fiscal first quarter and 2010 earnings outlook. The consumer products company sees fiscal first quarter organic sales growth of zero to down 3%, but PG sees that trend reversing in the second quarter with organic sales growth between 1% and 4%.

The company attributes the stronger sales forecast to new product launches and investments in its portfolio as well as easier year-over-year comparisons.

Monsanto (MON) fell 5.01% as the company reaffirmed fiscal 2009 earnings guidance, but said earnings will fall in fiscal 2010. The company’s gross profit for Roundup and other glyphosate-based herbicides is expected to be lower than anticipated. As I explained in late June, Monsanto’s premium price for Roundup couldn’t possibly be sustainable with such a large supply of generic brands on the market.

On the bright side, the seed and genomics franchise appears to continue gaining market share and trait penetration. Despite near-term concerns about Roundup, there is little reason to believe that the seed business won’t continue its break-neck growth and ultimately increase the bottom line. Check out the earlier post for more on this topic.




Quick Hits

• Understanding the Inflation In the Pipeline
• When Will the Dollar Slide Stabilize?
• Seasonality: S&P 500 Return by Month
  
  

Peter Lazaroff, Investment Analyst

Monsanto (MON) falls on 2010 earnings prospects

Monsanto (MON) reaffirmed fiscal 2009 earnings guidance, but said earnings will fall in fiscal 2010 as the large supply generic herbicides is forcing the company to slash prices of Roundup weed killer. Weed killers generated 32% of 2008 gross profit, but will account for only 11% in 2010.

As I explained in late June, Monsanto’s premium price for Roundup couldn’t possibly be sustainable with such a large supply of generic brands on the market. Monsanto estimated in June that generic inventories would finish the year at a level equal to 40% of next year’s consumption, which puts extreme pricing pressure on both generic and branded products. Further pressuring Roundup’s price is the fact that distributors are slashing prices in order to move this excess inventory and generate cash.

I think there is a very good possibility that Monsanto divests the Roundup business after making it a separate unit and completing restructuring.

On the bright side, the seed and genomics franchise appears to continue gaining market share and trait penetration. Despite near-term concerns about Roundup, there is little reason to believe that the seed business won’t continue its break-neck growth and ultimately increase the bottom line. Genetically modiefied seed is already the standard in corn and soy in the U.S., while Brazil and Argentina are driving a new wave of growth. Don’t be surprised if China, Russia, and Easter Europe provide the next wave.


MON shares finished -5.01%

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Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

A rally in equities couldn’t hold back the second strong Treasury auction in as many days from pushing yields lower. The long bond lagged behind the rest of the curve as it pulled back ahead of today’s 30-year auction.

Credit spreads have enjoyed a very nice week as shown below by the Markit Investment Grade CDS Index. A drop in the index represents a decrease in the cost to insure a broad basket of corporate debt against default.

The reopening of the on-the-run ten-year yesterday was a record setter in both size and performance. It was the biggest reopening ever at $20 billion and was also 55.3% bought by indirect bidders, the best ever by a reopening. The yield blew through the market rate by 2 bps, meaning that the price paid at the auction was higher than the market at the time and set the stage very well for the 30-year auction today. Fears that foreign demand will be missing for longer duration auctions were quieted yesterday so the main challenge facing today’s auction is gone. 30’s have also sold off a good bit since the announcement last week, which may also help them catch a bid today. Yes, believe it or not, many investors think the 30-year looks cheap at 4.3%.

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks showed no desire to pullback just yet as Wednesday’s rally extended the latest winning streak to four days. This move has now erased last week’s decline plus a couple of points.

Stocks got off to a strong start after Goldman Sachs advised buying industrial shares but the broad market pared some of those gains after the Fed’s latest report on economic activity reinforced concerns regarding consumer activity; a final late-session push then got us almost back to the day’s highs.

(That’s really sweet of Goldman to recommend industrial shares, the S&P 500 index that tracks these shares has only bounced 70% since March. While the group remains 40% off its October 2007 high, I’m going to guess the bulk of this current move has been realized – waiting for a pullback at this point seems the appropriate course.)

And speaking of the March lows, yesterday marked six-months since hitting that wicked March 9 nadir of 666 on the S&P 500, we’ve now surged 56% since that (let’s hope) generational bottom.

Industrials (and those who increased exposure to the group early this year thank Goldman for this latest rally), financial and consumer discretionary shares led the rally. The laggards were two of the traditional safe-havens, consumer staples and utilities – the only sectors to post a loss on the day.

Volume was weak again, maybe the vacationers failed to get the memo that the summer holiday season is over, as less than 1.2 billion shares traded on the NYSE Composite.

Market Activity for September 9, 2009
Returning to Risk

I want to preface the following comment by saying that risk taking is generally good and the economy needs a confidence level that allows for this activity. However, there are points in time in which a certain level of risk aversion is appropriate and I’m not convinced that time has passed.

Now that that is out of the way. Investors are definitely returning to risk, and I’m not just talking about the equity markets. Via derivatives such as total return swaps, hedge funds and other investors are going for it again – and banks, the counterparty to this activity, put themselves in a vulnerable position as well.

Total return swaps are a low-cost financing tool that hedge funds use to accomplish leveraged exposure to a particular asset, thereby generating relatively high returns without tying up capital. The hedge fund can use the “purchased” (actually leased) assets as collateral for the loan, which when things go bad means both sides can get burned.

(To keep it simply, a total return swap goes like this: Bank (A) has an asset – a loan. A hedge fund, or other bank for that matter, can sell bank (A) a swap that guarantees against the downside and pays bank (A) LIBOR plus a spread. The swap seller (say the hedge fund) will receive the interest payments that run off of that loan plus any capital appreciation. However, if the asset declines in value the swap seller is on the hook and if that seller goes down as a result of bets gone bad [remember this is a leveraged position], who is there to guarantee the downside protection for the bank?)

Banks have also begun to repackage home and commercial mortgage loans in what some describe as mini CDOs. The strategy of course is to offer securities with a higher yield but also viewed as highly rated. Some of the most explosive land mines of the financial crisis are making a comeback

There’s nothing inherently bad with these instruments, but with the commercial mortgage land mine that has yet to hit (and don’t forget about the $500 billion in interest-only home loans that will reset 2010-2011, according to First American CoreLogic), I’m not sure this story is going to end well.

This is all one consequence of very easy Fed policy, just as we should have learned from the recent debacle. When the Fed pours money into the system and keeps rates very low, that money is going to search for return and the hunt for yield in this low interest rate environment can cause the multitudes to improperly assess the risk that accompanies these securities vehicles. There is a certain déjà vu concern here for those without short-term memory problems.

Mortgage Applications

The Mortgage Bankers Association reported that their mortgage apps index jumped 17% in the week ended September 4, the largest increase since March when the 30-year fixed rate moved below 5.00%. In this latest week, that 30-year rate settled in at 5.02%.

Applications to purchase a home rallied 9.5% as homebuyers rush to get in before that first-time tax credit of $8,000 expires. Applications to refinance an existing mortgage surged 22.5%.

Fed’s Beige Book

The Federal Reserve released their Beige Book – reports on the economic conditions within each of the Fed’s 12 districts, the survey is released about every six weeks.

The Fed stated that economic activity continued to stabilize in July and August. In terms of district, Dallas indicated activity has firmed, while Boston, Cleveland, Philly, Richmond and San Fran mentioned signs of improvement. Atlanta, Chicago, KC, Minneapolis and NY generally described activity as stable or showing signs of stabilization. St. Louis described the pace of decline appeared to be moderating.

A majority of districts reported flat retail sales – helped by clunker-cash. (Note: Odds are retail activity would have been lower without clunker-cash, which begs the question: What will this segment of the Beige Book look like for the current six-week period now that the subsidy has expired and consumers have increased debt levels at the margin – remember, auto loans ran at an LTV of 92% in July).

Downward pressure on home prices continued in most districts – Dallas and NY noted local prices were firming. On the commercial side, all districts suggested demand for space remained weak and rent concessions and the postponement of property improvements were prevalent.

Manufacturing activity improved in most districts. Contacts remain cautiously optimistic but cost control measures would remain in place, according to the report.

Labor market conditions remained weak across all districts. However, several districts did note an increase in temporary hiring – this is what you want to see as it is an early indication of more permanent hiring. That said, contacts in Boston questioned whether these gains will persist. (Note: There was no evidence in last week’s August employment report of temp. hiring as it fell for the 20th straight month.)

Most districts reported loan demand was weak, and one gets the sense that this would have been even weaker if not for the increase in auto loans.


Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review: Industrials, Financials, UNFI

U.S. stocks moved higher for the fourth straight day led by Industrials and Financials.

Goldman Sachs advised buying Industrials, especially multi-industry companies, citing “the historical tendency for meaningful outperformance when the ISM moves sustainably above 50.” As part of its call, Goldman upgraded Illinois Tool Works (ITW) and raised its price target on General Electric (GE), United Technologies (UTX), and 3M Company (MMM).

Financials were boosted by a flurry of analyst upgrades. Citigroup lifted ratings on Capital One Financial and MasterCard explaining that the “big negative adjustment” in consumer spending has already taken place. The analyst also notes “the credit cycle has begun to recover for U.S. credit cards…and an improving U.S. economy will support local bank credit stabilization” in 2010.

Meanwhile, J.P.Morgan upgraded Morgan Stanley citing valuation as the stock has lagged behind investment banking peers. The note added that by the end of 2009, Morgan Stanley will have a core Tier 1 ratio of 12%, which could be enough to support $8 billion of stock buybacks, split between 2010 and 2011.

Oil prices extended their recent gains on the expectation that OPEC will leave production targets unchanged. Ongoing weakness in the U.S. dollar has also helped prop up prices.

The Fed’s Beige Book says economic activity continues to stabilize, but Calculated Risk says it best: “Stabilization is not new growth. Just more beige shoots…”

United Natural Foods (UNFI) earnings beat projections, but sales fell short of expectations. Despite the weak top-line, the distributor of natural and organic foods improved profitability and cash flow due thanks to lower fuel expenses, efficient cost controls, and operational improvements at its distribution centers.

In addition to disappointing revenues, UNFI’s projected 2010 EPS range of $1.48-$1.58 didn’t measure up well to analysts’ forecast of $1.57.

Although UNFI, like its competitors, have been hit as consumers trade down to lower priced groceries, it is clear that UNFI is reaping the benefits of years of distribution-network expansion, as well as its entry into the specialty-foods business in 2007.



Quick Hits

• Finance Overhaul Falters as ’08 Shock Fades
• Inflation Fear Pushes U.S. Endowments Deeper Into Commodities
• Can You Name These 14 Bubbles?
• Walmart’s Project Impact: A Move to Crush Competition

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Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

A strong 3-year auction was outweighed by the rally in stocks yesterday as yields rose across the curve. The curve steepened for the fourth session in a row to 254 basis points, its steepest point since it finished at 256 bps on August 12.

The market was really focused on the rally in risky assets, so the auction wasn’t able to bring Treasury yields lower yesterday. I mentioned last week that Tuesday’s auction could have some difficulties given it’s very short “when issued” period – the auction was just announced Thursday afternoon – but that was no problem at all. Bid/cover was over 3 for the first time since November 2008 – yesterday was 3.02 – and 54.2% of the notes were taken down by indirect bidders, in line with the average.

The Fed took down $4.95 billion in the 7-10 year sector, leaving less than $20 billion to be purchased. The Fed will purchase Treasuries again on Tuesday and Wednesday of next week.

The Treasury will bring $20 billion of the existing 10-year note to market today. Bank demand, both domestic and foreign, has really made for breezy short-duration auctions as of late but longer-duration auctions have had more difficulty establishing a clearing price so yesterday’s success is not guaranteed to carry through to today.

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

Due to technical difficulties, tables and graphs will posted later.

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U.S. stocks engaged in a post-Labor Day rally as traders came back looking to get in on this thing. The market held onto the rally despite a plunge in consumer credit for July, which followed a huge downward revision for June. While this is a backward-looking indicator, credit is kind of a key driver for economic growth, so in that sense it was surprising to see stocks hold momentum – more on this below.

Commodity related shares led the rally as energy and basic materials were the best-performing sectors. Industrial and consumer stocks were close behind. The laggards were the traditional safe-havens, utilities and health-care – the latter being the only of the 10 major industry groups to close down on the session.

Volume was a bit more robust yesterday now that the summer vacation season has ended as 1.275 billion shares traded on the NYSE Composite. While this is fairly weak activity from a longer-term perspective, about 12% below the two-year average, it is nearly 10% above the three-month average. Advancers beat decliners by close to a three-to-one margin.

The latest Treasury auction, this one for $38 billion of three-year notes went off without a hitch. The massive supply that is coming through is not causing any problems yet as the notes came in at a yield of 1.487%, below the 1.493% just before the auction, and the bid-to-cover ratio (the main gauge of demand) was strong, at 3.02 – the average from the past 10 auctions is 2.58.

Market Activity for September 8, 2009
Gold’s Three-Peat

The price on the front month gold futures moved above $1,000 yesterday, before pulling back to $995. For reference, it crossed the four-figure mark for the first time in March 2008 and for the second time during the “welcome to the jungle” period back in late February. While equity traders, always short-term in their thinking, favor easy money Fed policy, gold investors may be looking beyond the here and now to the cost the economy will have to bear as result of another round of prolonged easy money, along with runaway fiscal spending and heightened geopolitical risks (North Korea’s claim to have weaponized plutonium, rough going in Afghanistan and the uncertainties that loom between Israel and Iran).

And speaking of Iran, quickly, I see their president carted himself over to Venezuela this past weekend to cement a deal with Hugo Chavez in which he’ll provide Iran with gasoline. Why is this important? Because it is one of Iran’s major weaknesses; they have loads of oil, but little capacity with which to refine it. That was to be one of the most effective sanctions we had, whenever it is that we were to get around to using it. That one appears to be off the table right now, the options are dwindling. And then in an Op-Ed yesterday, the venerable Manhattan DA Robert Morgenthau suggests that Iran may be building weapons in Chavez country – I’ve got a feeling Mohamad El Baradei and the IAEA aren’t looking there. Sorry for the digression but is kind of an important element in explaining one of the reasons gold is on the rise.

Further, we can see by way of the past couple of TIC reports (data that shows foreign flows into the U.S. Treasury security market) that China is shifting their purchases to the short-end of the curve, buying more T-bills and easing their purchases of T-notes and bonds. While the Chinese must continue to buy dollar-denominated assets for fear their own currency will rally and harm export activity, they can accomplish this and still hedge against dollar weakness by keeping things short. They can go a step further, which I believe they are doing, by also purchasing hard assets, like gold. This will help them to hold down the risk of future dollar damage.


Let me make clear, one can never tell where gold is going – and obviously this is true with everything but especially so on the gold trade. As a result, owning commodity-related stocks (with their earnings streams and dividends) seems like a more reasonable play to us, especially for those that have more than a very short-term trading mindset.

In addition, while one has to acknowledge that things are set up to favor gold over the next two years, there’s always the risk of the trade shifting to oil – it would get the dollar-hedge/uncertainty trade accomplished just the same.

I bring this topic up because gold’s move over the past few sessions seems like an important market development. I’m not specifically advocating a position in gold at this level as it hardly seems practical to chase these things; waiting for pullbacks in this market seems the more appropriate course. That said, at least coming from someone who does have concern over the chances for harmful levels of inflation to result and heightened geopolitical risks, it’s tough to argue against the gold bulls.


Latest NFIB Survey

It’s been a while since I’ve reported on the monthly National Federation of Independent Business survey (small business optimism on economic trends), so long in fact even longer-term readers have likely forgotten it. There have been so many things to talk about and we can only fit so much into this letter on a daily basis.

Anyway, the NFIB’s survey for August showed a slight decline of 1.3 points to 86.5. This marks the second month of decline after the survey rebounded off of its lowest reading for this recession, which was 81.0 in March – the all-time low was hit in 1981 at just below 80.0. The main cause for the August decline was deterioration in expectations that business conditions would improve six months out.

On hiring plans, the net percent planning to hire (firms planning to “increase” hiring minus those planning to “decrease”) over the next three months fell to -3 from -1 in July; prior to this recession, you have to go back to the 1980 recession for the last time this measure recorded a negative reading. Owners stated they are reducing compensation, on average, as well.

These are not good trends for the employment picture since small business is the main engine for U.S. job creation and obviously doesn’t speak well to the chances of consumer activity making a sustained comeback. This is a theme we’ve touched on for some time now.

In another theme we’ve spent time on, the low likelihood that firms will increase capital spending outlays in a manner that is consistent with that seen during the normal recovery, this survey showed capital outlay plans over the next three months was essentially unchanged at 18, just above the all-time low of 16 hit in March. Only 5% of firms characterized the current period as a good time to expand facilities, a very low historical reading.

In addition, NFIB showed small business owners continue to liquidate inventories, this segment of the survey remains at a record low, and plans to increase inventories over the next 3-6 months remains low at -5 (but nothing near the record low of -15 back in 1980 – of course you had more inventory bloat back then).

I continue to believe current-quarter GDP will get a boost from inventory rebuilding (that inventory dynamic we keep referring to) but it may be quite tempered and the more data we view it appears the economy will have to wait until the fourth quarter for the big inventory boost.

The commentary from the survey stated “consumers and business owners’ emergency reserves are depleted, jobs have not returned, and the stimulus seems to have failed on the ground (even if observers agree its effects are yet to come, expectations were set for a quick rescue). The recession is wearing Main Street folks down.”

Small business is very important for our economy and it appears things have yet to improve much for this vital segment.

Consumer Credit

Finally, the Federal Reserve reported that consumer credit took a big hit in July, down $21.6 billion, or 10% at an annual rate. That was more than five times as much as forecast as banks restricted lending and the demand for loans declined due to the labor market conditions and already heightened debt levels.

Revolving loans, such as credit cards, fell $6.1 billion, or 8%, and non-revolving, such as auto loans, fell $15.4 billion, or nearly 12%. (Mortgage loans are not included in this data)

This is something to keep our eyes on, especially considering the shape the labor market is in, and the real possibility that the jobless rate will remain above average for a prolonged period this go around. The fact that we don’t have credit to grease the wheel this time may make it so. This is a harsh, but needed, reality for longer-term stability. In the near term, as consumers reduce debt it will weigh on economic activity.

The whole process of the debt paydown may very much have been delayed by the clunker-cash scheme. I would expect we’ll see the August reading on consumer credit rise on increased car loans (which ran at an average 92% loan-to-value in July – whoa!). This will help in the short term but put back the process needed, which is a reduction in debt levels.


Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review: GE, KFT

U.S. stocks finished followed the rest of the globe’s markets higher on a pickup in M&A activity, higher energy and material prices, and the G20 reiterating their commitment to keep massive monetary and fiscal policies in place.

Kraft Foods made a $16.7 billion bid for Cadbury PLC, which represents a 34% premium for the maker of Dairy Milk chocolate and Trident chewing gum. Cadbury quickly rejected the offer, saying in a statement that the proposal “fundamentally undervalues” the company and its prospects. Conagra Foods (CAG) +4.44% and H.J. Heinz (HNZ) +5.08% rallied along with other packaged foods companies following Kraft’s rejected bid.

High profile deals involving Disney, Proctor & Gamble, and eBay in recent weeks are a welcome sign to investors that the market is recovering and the worst of the downturn could be over.

Meanwhile, energy and materials shares benefited from rising gold, copper, and oil futures. Big gainers on the Approved List included Noble (NE) +3.41%, Transocean (RIG) +4.17%, Peabody Energy (BTU) +6.01%, and Arch Coal (ACI) +3.25%.

General Electric (GE) gained 4.4% after JPMorgan upgraded the shares to “overweight” from “neutral,” saying the stock may be the “last of the low-expectations plays.”

Quick Hits

• Missing Lehman Lesson of Shakeout Means Too Big Banks May Fail
• Anything-But-Treasuries Gains as Credit Rebounds After AIG Death in China
• Stocks Cheapest Since ’89 Show Why Analysts Say Economists Wrong on Growth
• Closely Watched Buffett Recalculating His Bets

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks, after moving into negative territory at the open, rallied to post strong gains on Friday. The broad market’s 1.31% rise pared the week’s loss to 1.22%.

The Labor Department’s monthly jobs report showed payroll declines continue to move in the right direction and I suspect another healthy increase in hourly wages provided the impetus for traders to push prices higher.

There also seemed to be a sense that the jump in the unemployment rate helped the stock rally as well. This seems counterintuitive but what it does is cement in traders’ minds that the Fed is a long way from removing their current easy-money stance.

Normal trading should return today now that the Labor Day holiday and summer vacation run has passed, so we’ll see how investors and traders react to things this week.

Technology, energy, telecom and consumer discretionary shares were the top performing sectors on the session. Financials and utility shares were the laggards, but still posted upticks of 0.83% and 0.34%, respectively.

Market Activity for September 4, 2009
No reason to beat around the bush; let’s get to that August jobs report.

The Labor Department reported that payrolls declined 216,000 in August, beating the consensus estimate for a decline of 230,000 and a nice improvement from the 276K in losses for July.

However, the previous two months of data were revised higher to show 50,000 more job losses than previously reported.

While last month’s level of job losses remains large, we are seeing significant improvement from the sky-high declines that occurred up to just four months back when monthly payrolls were plunging 550K on average. This latest reading sends the monthly losses to levels that are at the low end of the worst we see during the typical recession and makes our call for below 200K in losses by September in play – an estimation I expressed concern over after Wednesday’s ADP report suggested deeper declines may result.

In terms of specifics, the goods-producing industries shed just 136,000 positions, pretty much in line with last month’s losses but much better than the three-month average of 182,000 in monthly declines.

The construction segment of this sector lost 65,000, a bit better than July’s 73,000 decline. The manufacturing segment shed 63,000 positions, worse than the 43,000 lost in the prior month, but a huge improvement from the 104K in average losses for the previous three months and the wickedly deep losses of 170K per month during the first six months of the year.

Service-providing industries shed 80,000 positions in August, jut half the decline recorded for July and that goes for the three-month average as well, which was 165,000.

Again, health care and education services was the only private-sector component to post gains – this segment has not posted a monthly loss during this entire malaise – up 52,000 in August. The three-month average is +35K.

The government cut 18,000 positions, largely due to the branch closings within the postal service. I’m going to bet the government side of the employment picture is not going to post monthly declines for much longer.

The unemployment rate jumped to 9.7% from 9.4% and we are surely headed to 10% and above as there really weren’t many workers returning to the job market. The return of workers looking for work again, as they feel the environment has improved, is usually what pushes the jobless rate higher even as the economy begins to grow again. In August, though, the labor force only increased 73,000 – still 355K below the level of the second quarter. When these unemployed persons come back in to look for work, the jobless rate will move past 10% and give the post-WWII record of 10.8% a run for its money.

The U6 jobless rate (this is the official unemployment rate, plus discouraged workers – those not looking for work during the survey period, plus those working part time for economic reasons – they want to work full time but can only find part time work) hit a new high, up to 16.8% from 16.3% in July.

Those working part-time for economic reasons jumped 278,000 in August to 9.1 million – as a share of the work force this is the highest level since the 1982 recession.

And on part-time work, teenage employment rose to 25.5% last month, I’m sure the boost in the minimum wage that went into effect two months back is not helping the teenage situation.

The duration of long term unemployment (the percentage of the unemployed who have been out of work for over 27 weeks) did decline from a record of 33.8% in July to 33.3%. Good sign, but still very high. The figure remains a large 4.3 percentage points above the record set in June before that July figure surpassed it.

As has been true in so many regards these days, many analysts/economists appear to be getting carried away by extrapolating from the overall decline in monthly payroll losses. Some point to the current trajectory of the slower rate of decline in job losses and state that we’ll have job gains by year end. I would be cautious about accepting this view and the tendency to move farther out of the risk curve by thinking things will move to normal growth mode.

The reduction in the rate of decline has been a function of deep job losses earlier in the year and just because we have seen a 250-300K improvement in the level of monthly payroll declines, I don’t think it is correct to believe that this trajectory will remain in play now that we are back to a more normal level of losses. This assumption appears to be fraught with error in my judgment.
The fact that we continue to shed 200K-plus jobs per month now darn close to two years into this recession (at least as measured by the NBER – the official arbiter in defining business-cycle expansions and troughs) is rather telling; the state of the labor market remains very fragile.

Here’s a picture of this story from Calculated Risk.

We also must take those working part-time for economic reasons and turn them into full time positions before we even begin to send the official unemployment rate lower.

On a brighter note, wages have been ticking higher. Average hourly wages rose 0.3% in August and are up 2.6% year-over-year – that’s a nice move so long as the inflation gauges remain flat. (Overall personal incomes are falling, and the wage&salary component of that overall figure is down 4.7% year-over-year due to the damage done to the salary side of that component).

But the rise in wages -- even though firms continue to hold weekly hours worked at a pathetic 33.1, just above the all-time low (since records began in 1964) of 33.0 hit in June -- is helpful and we’ll take any help consumer activity can get right now.

Today’s Early Trade

Everything is higher this morning, stock-index futures, Treasurys, gold above $1,000 and oil approaching $70 again after last week’s pullback to the $67 handle.

Something will crack; I don’t know what it will be but when you’ve got the risk trade back in the game, yet the key element of the safety trade – Treasury buying – rolling on, it seems something is very much awry. How do you have the risk trade off the bench and a sub-1.00% yield on the two-year and the 10-yr trading at 3.42% at the same time? These are strange days.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries began the day lower, on strength in equity markets overseas, but rallied off their lows on an improved, but still negative, Non-Manufacturing ISM.

The Treasury announced $70 billion in refunding with 3-, 10- and 30-year notes coming to market Tuesday through Thursday of next week. It’s odd to think of $70 billion as a small refunding, but it is pretty small. The only problem I see facing next week’s auctions is that the “when issued” period for the three year is essentially one day, thanks to the late Thursday announcement and the Labor Day holiday. The normal period for dealers to search for buyers of the Treasuries to be issued is a week. This may be a non-issue for the market, as most are just concentrating on the small size as a positive for Treasuries.

Bonds opened lower again this morning as traders reduced positions ahead of the announcement of the Change in Nonfarm Payrolls and Unemployment Rate for August. NFP improved from a July Revision of -276k to -216k in August and The Unemployment Rate ticked from 9.4% to 9.7%. Bonds have rallied back from the overnight selloff, lead by the short end that is now positive for the day so far.

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks broke a four-day losing streak, getting a lift from the prior night’s rally in Chinese stocks (as that government tempered concern they would attempt to curb equity and property speculation). A measure of retail sales showed August declines were less-than-expected, which also may have helped the equity markets.

Financials, after leading the indices lower for two days, were the best performing group. Basic material shares recorded another good session as metals prices gained again, led by gold and silver. Silver raged ahead, up 5.17% to $16.15 per oz. Gold came within $2 of $1,000 before pulling back to $993, up 1.64% on the session.

Advancers turned the table yesterday, beating decliners by a five-to-one margin. Volume was typical of this summer’s activity, 1.1 billion shares traded on the NYSE Composite, in line with the three-month average

Market Activity for September 3, 2009
Initial Jobless Claims

The Labor Department reported that initial jobless claims fell 4,000 to 570,000 in the week ended August 29 from an upwardly revised 574,000 (was initially reported as 570,000) in the week prior. The estimate was for a decline to 564K from the initial estimate of 570,000 in the prior week. So, the expectation was close to right on the change (down 4K vs. an expected 6K decline), but missed by a wider margin on the level due to the revision higher from the prior week.

The four-week average, which smoothes out weekly volatility to a degree, rose 4,000 to 571,250. With this being the final week of the month (claims for the week ended Aug. 28) this is the average for all of August, up from the July average of 557K.

Continuing claims rose 92,000 to 6.234 million for the week ended August 22 (there’s a one week lag between continuing and initial claims for those wondering about the different dates). The level is hovering right at the four-week average of 6.216 million.

Emergency unemployment compensation jumped 85,500. This involves the extension of benefits an additional 33 weeks. So, normal benefits period is 26 weeks, plus this emergency extension…some may call this welfare.

This data won’t have a bearing on the first look at the August jobs report, as that will be released tomorrow. However, if claims fail to come lower from this level that is high in the 500K handle it does suggest that the September jobs data will not show much improvement in monthly job losses. Ultimately, we’ll have to wait a couple of weeks to have more confidence in this take, but I bring it up because some (including myself) have believed jobs losses would ease to something closer to 200K by the September jobs release – this level of claims appears to say that monthly losses will remain closer to 300K.

To put this into perspective, while the rate of employment decline has improved big time from the outsized losses of 500K-600K just four months back, 250K-300K in payroll losses is commensurate with the worst levels we seen during the typical recession. If jobless claims fail to ease back closer to 500K (the average over the past two months is 565K) in quick order, we’ll need to delay the expectation that job losses will fall to levels that are below a historically high elevation.

ISM Non-Manufacturing

The ISM non-manufacturing reading continued to improve in August, rising to 48.4 from 46.4 in July, illustrating that business conditions within the service sector declined at a slower rate than in the previous month. This was a bit above expectations for a 48.0 print. The dividing line between expansion and contraction is 50. (Recall, the ISM manufacturing reading earlier in the week surpassed the 50 mark. The fact that this service sector reading failed to do so is an additional confirmation that the rise in factory activity was largely due to what will be a short-term bounce in auto production via the clunker-cash scheme)

The business activity sub-index rose above 50 for the first time since the economy fell apart in September.

Seven of the 18 industries reported expansion, 10 reported contraction and one stated activity was unchanged from July. For perspective, the July data had six industries report expansion, eight reported activity contracted and four said activity was unchanged. On a net basis this indicates deterioration to me, but because there was one more industry reporting growth, it was enough to push the business activity index higher.

The employment index rose two points to 43.5, nice to see improvement but it remains well in contraction mode.

The inventory change index fell four points to 43.0. This is not a good sign. The market is expecting a rebuilding in inventories to help current-quarter GDP. (We will get some help from inventories, specifically due to vehicle assemblies, but it may not be as helpful as many had hoped. Respondents stated that they are “driving managers to reduce and maintain [inventories]at lower level.” I think they meant to say and/or, but that was the quote.

The prices paid sub-index soared 21.8 to 63.1 in August, indicating a substantial jump in prices paid from July. This is a record rise in prices paid, although I need to make note that this data only goes back to 1997. In August, 23% of respondents stated higher prices vs. 13% in July; 71% reported no change vs. 59% in July; and 6% reported lower prices vs. 28% in July. That’s a big shift in one month’s time. Sounds like a slack problem.

On inflation, I’ve expressed the concern before about the slack in the economy.

First, it’s rather hilarious for me to bring up the term “slack” because it is a total Keynesian take on things. To explain, it goes like this: if the economy has a lot of slack (that is, the job market has shed millions of jobs, and plant capacity sits at a low level (and currently capacity utilization is just off of the all-time lows) then inflation cannot possibly become a problem, according to the Keynesian economist. They believe this because if there is a lot of slack, say in the job market (ie. the unemployment rate is high and firms don’t have to pay up for quality workers) then wages are not rising substantially and thus firms do not have to pass these costs along to consumers.

But that’s their little world. In reality, inflation is more a function of too much money chasing too few goods than it is a function of a tight labor market. As a result, while most economists do not seem to fear harmful levels of inflation to be a possibility in the foreseeable future, I tend to think otherwise.

The massive cuts in employment and idle plant resources can cause prices to rage once even a mild increase in demand presents itself. The productive capacity will not be their right away to meet this demand (even if it is fleeting) and thus prices may jump. I don’t believe troublesome levels of inflation are right upon us, but this unprecedented jump in ISM prices paid may be an early indication of what is possible over the next 12-18 months.

Certainly, the deflation argument seems quite removed from reality – in fact, it will take another financial-sector crisis (banks continuing to sit on massive amounts of cash instead of lending it out) to make deflation a reality.

Chain Store Sales

Well, despite the state sales-tax holidays implemented for the back-to-school (B2S) shopping season, same-store sales (stores open at least a year) fell 2.0% in August, as reported by the International Council of Shopping Centers.

While this is an improvement from the roughly 5% average year-over-year decline of the previous three months, its marks the worst B2S season in a long time. I don’t think anyone should rule out that clunker-cash, at least to some extent, also dragged sales lower – effectively cannibalizing sales from other retail sources. For instance, if the clunker-cash was too enticing to pass up, the consumer is writing a check to the DMV to cover sales tax.

Apparel and department store sales took another beating, down 4.3% and 7.3%, respectively (although the rate of decline eased from the July readings). Luxury store sales continue in the tank, off 12.3% -- the average of the previous two months, but improvement (if you can call it that) from super deep declines of 20% during the spring months. Even discount chains were down 1%.

Year-ago comparables will get increasingly easier once we get into October, but there is little doubt consumer activity will remain depressed for a prolonged period – bouts of rebound, but nothing sustained.


Have a great weekend!


Brent Vondera, Senior Analyst

Quick Hits

• A fair share
• China’s stock market: Another great leap
• Chinese bank lending: Follow the money
• MBS – Fed’s Inflation Fighting Weapon
• Money Fund Floats Plan to Erase $1 Barrier

Baltic Dry Index (BDI) continues to fall

The Baltic Dry Index (BDI), which measures changes in the cost to transport raw materials, continues to tumble and is now down nearly 44% from its June highs. The Baltic Dry Index is often considered a leading indicator, signaling future economic growth when rising and contraction when falling.

The Baltic Dry Index has historically been a good leading indicator for several reasons. First, the index looks at raw materials so it captures activity at the very beginning of the production process. Raw materials are also typically an area with very low levels of speculation. Second, it paints a picture of international trade activity, which is a critical driver of global growth. Finally, the shipping business depends heavily on credit, so the Baltic Dry Index indicates whether credit is tight or loose.

Because the supply of large carriers tend to remain very tight, with long lead times and high production costs, the index can experience high levels of volatility if global demand increases or drops off suddenly. Today, we are seeing excess capacity distort demand as a record number of new shipping vessels, equal to 14% of the existing fleet according to the Financial Times, are due to be delivered by the end of the year.

In addition, China’s reduction in commodity imports has been another key factor affecting demand. As said above, raw materials are typically an area with very low levels of speculation. However, China began hoarding raw materials in light of global economic malaise and the expectation that the declining U.S. dollar would lead to higher commodity prices in the future. The recent easing suggests that the long campaign by China’s Iron & Steel Association to stop speculative hoarding is finally gaining traction. Thus, a working down of stockpiles and fundamentally lower demand will keep a lid on the Baltic Dry Index.

The question now becomes, will this ultimately keep a lid on global economic growth?


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Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

Yields slipped and fell again yesterday as investors shed risk in favor of Treasuries. The two-year fell below .9% intraday but most of the rally was concentrated in the long end. The most recent shift in the curve has been pretty parallel, meaning that even though yields have crashed down in the past few weeks the shape of the curve has remained about the same. While Fed policy expectations have driven the short end lower inflation expectations have taken a step back and lowered longer yields also.

The market carefully studied the August 12 FOMC meeting minutes yesterday, looking for any new information on how the Fed is gauging the recovery, among other things.

Here are some bond market specific highlights from the release:
· The decline in capital investment appears to be moderating. The contraction in industrial production showed signs of slowing and factory utilization recorded a new low in June.
· TIPS liquidity is poor, probably caused by summer holidays, but has resulted in moves in the TIPS markets that may say more about liquidity premium/discount movement than actual shifts in inflation expectations.
· Credit spreads have fallen below the peaks set in the previous recession. It’s pretty incredible to see how well credit has done since March only to now reach normal recession levels.


Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks extended the losing streak to four days, longest since May, as a preliminary employment report suggested job losses in August will be worse than expected – we get the official jobs report tomorrow – and members of the FOMC expressed “considerable uncertainty” over the strength of economic recovery.

Stocks spent most of the day hovering around the flat line. A relatively significant move lower about an hour into trading was quickly erased, but the second move lower occurred in the final 20 minutes as time ran out.

A gain in basic material stocks helped to support the broad market, the group was one of only two of the major sectors to close in the black. Gains in metals prices, driven by a gold price that’s headed back to $1,000 per ounce, led shares of mining companies higher.

There are all kinds of explanations for the current move in gold: the Indian wedding season (I like that one, although I shouldn’t rip on the notion as the final four months of the year are generally good for the metal); China increasing its holding of hard assets to protect against a declining dollar; and investors anticipating a September/October stock-market sell off.

Financials led the decliners again yesterday, down about 1% after Tuesday’s 5.26% slide.

Breadth was ugly for a second-straight day as decliners beat advancers by a two-to-one margin. Volume remained strong, for this summer’s activity that is, as 1.3 billion shares traded on the Big Board.

Market Activity for September 2, 2009
Mortgage Applications

The Mortgage Bankers Association reported its mortgage apps index fell 2.2% in the week ended August 28 after two weeks of big increases – up 7.5% and 5.6%. Purchases fell 1.0% and refinancing activity declined 3.1% even as the 30-year fixed-rate mortgage fell back to 5.15%.

Preliminary Employment Reports

Challenger Job Cuts Announcements

The job cuts survey out of the nation’s premier executive outplacement firm, improved for a sixth month and the year-over-year reading has improvement for three-straight months.

According to the Challenger Job Cuts survey, planned firings fell 21% to 76,456 in August from 97,373 for July. The number improved by 14% on a year-over-year basis from the 88,736 in job-cut announcements in July of 2008. The latter figure is the one to watch as the survey does not adjust for seasonal effects so the monthly change can be deceiving.

The government and non-profit category led the layoff announcements in August. (While non-profits will remain in a world of hurt for a prolonged period, the coming increase in government jobs will make sure this category will not be leading the survey for long – most of the cuts from this category resulted from the U.S. Postal Service slashing 30,000 positions) The auto industry followed with 6,694 layoffs – this was a surprise. The other surprise was the 5,500 job-cut announcements from the health-care industry, the only component of the monthly employment data (the actual component is health-care & education) that has yet to post job losses during this downturn.

ADP Employment Report

The preliminary employment report from ADP Employer Services estimated that 298,000 payroll positions were shed in August on a seasonally-adjusted basis -- the estimate was a decline of 250K. This marks the smallest decline since September 2008 and suggests that the official employment data will remain below the -300K mark.

ADP estimates that the service-providing sector cut 146,000 positions and goods-producing positions to be down by 152,000. These are higher numbers than the improvement we saw in July’s official data. Service industries cut just 128K vs. the 200K+ avg. for the previous three months and goods-producing industries cut just 119K in July, up from the 190K avg. during the previous three months. By way of the ISM and regional factory gauges, many are expecting goods producing to continue to improve. As a result, if this ADP figure is accurate it could be a blow to the market when the official report is released tomorrow.

Small businesses (those with less than 50 employees, and the main engine for job creation) led the declines with a payroll decline of 122,000. Medium-sized firms (less than 500 employees) shed 116,000 payroll positions and large firms cut 60,000. Again, these are estimates.

Final Revision to Q2 Productivity

The Labor Department released their final print to second-quarter productivity, showing the measure surged 6.6% at an annual rate, revised up from 6.4%. This is the fastest move in nearly six years as firms squeezed more out of existing workers in the face of large revenue declines.

Productivity, a measure of output per hour worked, was able to jump last quarter as hours worked (the denominator in the figure) fell much more than output. Hours worked plunged 7.6% (the figure fell to 33.0 hours per week during the quarter, the lowest reading since these records began in 1964). Output fell 1.5%. This is a big decline in output, but obviously not compared to the damage done in hours worked.

What does this mean for corporate profits? As we’ve discussed a couple of times now, this indicates we’re set up for high-powered profit growth a couple of quarters out.

However, one should be careful not to get carried away. The massive reduction in employment and hours worked also means incomes have been drained and the impairment may last longer to reverse than is generally the case. (The productivity boost is not one of an upsurge driven by capital equipment enhancements but rather the abnormal damage done to hours worked and payrolls)

This does not bode well for consumer activity (a consumer that will already be in the process of working down debt levels, now made marginally worse by the clunker-cash program). As a result, aggregate demand may remain depressed. Therefore, we may not see much improvement in corporate top-line growth and thus may see profits turn down again after a two-quarter upswing – again, that upswing is still another quarter out.

This forecast, I must admit, is made all the more difficult due to the government spending that will flow next year. With the bulk of the Obama Dreamliner stimulus plan (the $787 billion in public spending) rolling in 2010, this may help to keep profits moving on an upward trajectory longer than would otherwise be the case in this environment, particularly for the industrial and basic materials sectors. But one should not believe that the normal expansionary path for profits (that typically lasts for years) will occur this time. The consequences of this heightened government spending and very easy monetary policy stance will develop into a large cost for the economy to bear in the not-to-distant future.

The FOMC Minutes

The Federal Reserve released the notes from their August 11-12 meeting, which showed some concern over the pace of economic recovery and discussion of extending the end date for their mortgage-backed security purchase program, much like they announced when the actually meeting adjourned regarding their program to purchase Treasury securities. The strategy behind extending the time frame, not the actual level of purchases, is to smooth out the process as the program approaches completion in order to minimize any distortions.

On the economy, the FOMC was more upbeat in terms of the downturn coming to an end, but their view about the likely degree of recovery was quite cautious and many members agreed the economy remains vulnerable.

FOMC members expressed that conditions in the labor market remain “poor” and that business contacts have mostly indicated that firms would be cautious in hiring even when demand picks up. The members shared a belief that stimulus and monetary policy would lead to economic growth later in 2009 and into 2010, but that “the stimulative effects would fade as 2010 went on and would need to be replaced by private demand and income growth.” (That’s exactly the concern as one would think interest rates to be higher a year from now and tax rates are set to increase – the combination of these two events is like slipping a mickey to the economy, as we discussed last week. Let’s hope the economy is not robbed and thrown into the alley out back).

It was reported that Fed staffers (these FOMC minutes always include economic projections from the central bank’s staff economists) forecast that economic growth will be somewhat above potential for all of 2010 as financial conditions improve. I didn’t read that in the actual text. Instead, what I read was that staffers stated there were a range of views, and considerable uncertainty, about the likely strength of the upturn – was the press padding things a bit? My how things have changed.

On inflation they believe core prices to remain low. Naturally.

Have a great day!


Brent Vondera, Senior Analyst

Defense industry flying under the radar

While the healthcare debate and signals of an economic recovery have dominated the headlines for much of the summer, issues surrounding the Afghanistan war (Operation Enduring Freedom) have been flying under the radar.

Last week brought news that defense needs more than double the place-marker $50 billion estimate for war spending in fiscal year 2011, and perhaps as much as $125 billion. Today there are several reports (see here, here, or here) that Army General Stanley McChrystal may request an additional 21,000-45,000 U.S. troops in Afghanistan, above the 68,000 already there.

Should this large level of troops be needed, the Afghan conflict may begin to resemble the size of the commitment that Iraq had become. Thus defense stocks, especially those with war exposure, could continue double-digit EPS growth beyond the current expectation of slowing growth by 2010. Our Approved List stocks that would benefit the most include Alliant Techsystems (ATK), General Dynamics (GD), and L-3 Communications Holdings (LLL).

Defense companies’ valuations are still far below that of the market because investors have assumed the defense industry would suffer from a U.S. defense-budget squeeze and the market has largely ignored the rising requirement in Afghanistan. However, national security is critical and there is an awful lot going on in Iraq, Afghanistan, and elsewhere.

Uncertainty plays the biggest role in low valuations as the next 18 or so months will have decisions that will shape the industry for a decade or more. Still, these companies are trading just too cheaply to be ignored, especially if the war in Afghanistan continues to grow.
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Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

The market ignored positive economic data for the second day in a row yesterday as stocks sold off and Treasuries rallied. The two-year is to thank for the steeper curve as it has rallied from 1.05% last Thursday to end yesterday at .91%. I usually prefer to show shifts in the curve with a graph, but some seem to have trouble reading them. Below shows the same change, just in table form.

The biggest news of the day will be the release of the FOMC minutes from the Aug 12 meeting. The market will be fixated on the Fed’s comments on the securities purchase programs, prospects for inflation, economic activity and the dollar. More on this in tomorrow’s recap.

The New York Fed purchased $5.6 billion in 3-4 year Treasuries yesterday and has yet to schedule the next batch of operation dates. The Fed has bought $276 million worth of Treasuries to date, so the next announcement will almost surely have to show some sort of slowing down. Most of the speculation is for the Fed to go to one Treasury operation each week, similar to the way they have bought Agency debt throughout the entire quantitative easing campaign.

Cliff J. Reynolds Jr., Investment Analyst