Stock-index futures jumped in pre-market trading and that flowed through to the regular trading session after Goldman Sachs reported much stronger-than-expected quarterly results. However, stocks struggled to hold those gains after that very weak housing starts reading and a second straight monthly decline in industrial production. When that Goldman analyst’s banking sector prediction hit the press about 10am that was all she wrote and the major indices moved into the red and failed to bounce back.
I wouldn’t put too much into the warning that there is still serious credit-related fallout to come, as that GS analyst stated, as the firm is likely short credit derivative indexes and financial-sector stocks. I’m not saying the issue is completely behind us, but just to keep in mind that GS may have reason to encourage these comments. To be fair, their Basel II risk-adjusted Tier 1 ratio was 10.8% which was stronger-than expected and their principal investing activities – specifically via Chinese bank ICBC – also helped results.
Seven of the 10 major S&P 500 industry groups closed lower for the day, led by financial and consumer discretionary shares. To no surprise, energy shares led the gainers as the index that tracks these shares gained 1.7%.
Decliners beat advancers by a two-to-one margin on the NYSE. Some 1.1 billion shares traded on the Big Board, roughly 25% below the three-month daily average.
On the economic front, the Commerce Department reported builders broke ground on the fewest number of houses in 17 years during May signaling residential fixed investment will remain a large drag on the economy.
This is certainly not a great revelation, as it is expected that housing will weigh on GDP for a few quarters still – which has been the case for nine quarter already. The extent of the weakness though shows the degree to which this segment will subtract from GDP will be substantial – extending the trend of lowering real GDP by more than a full percentage point.
Inventories are simply too elevated and until we get the sales figures to kick up, we’re not going to see the inventory-to-sales figure come much lower. As the graph below depicts, new home inventory stands at 10.6 months’ worth of supply. We need this number to come down to 6 months’ worth before housing begins to add to growth once again. My feel is that housing will flatten out by the second quarter of 2009 and will add slightly to growth by the end of 2009.
In a separate report, Commerce also stated industrial production declined for a second-straight month, falling 0.2% in May. The April decline was 0.7% and the trend is not good. It’s important that we see some rebound for June because we do not want one of these sub-zero gaps to occur – illustrated by the chart --, that would spell trouble.I expect the figure will rebound this month and it is important to note that below average temperatures in May was the main reason for the negative reading.
Utility activity weighed heavily on the reading as it was this industry group that was by far the worst performer, falling 2.7% in May. Capacity utilization fell hard within the utility component, while the other industries were in line with the April reading. Average temperatures were below the historic average, according to the National Climactic Data Center.
Lastly, the Labor Department showed that producer prices jumped 1.4% in May and 7.2% from the year-ago period. This was mostly driven by higher energy prices as the ex-energy reading rose by a much lighter 0.4% in May and is up little more than half as much in terms of the overall reading from the year-ago period.Hello, Fed – anyone home? This is a dollar problem, wake up and get to some mild rate hiking.
Food prices are also contributing to the rise, and while this is partially a function of a lower dollar and aggressive Fed easing of the past six months weather is also playing a role as heavy rains are keeping farmers from getting into the field and planting. What they can do is diminish the energy-related issues, and if food costs come lower too, then that’s an additional plus.
And speaking of the Fed, those WSJ, FT and Wash Post articles we referred to in yesterday’s letter also contributed to Tuesday’s market weakness. These articles suggested that the Fed is not going to raise rates and focused on the point that higher rates erode profits, specifically within industries that rely on short-term financing.
Well excuse me, harmful levels of inflation destroy profit growth for nearly all industries as margins are compressed due to escalating costs. Thankfully, for now, firms have shown an amazing ability to eat these costs and still post good profit results as productivity improvements remain strong. But this cannot go on forever, as the current level of energy prices will eventually erode this ability to manage these rising costs.
Besides, we’re not talking about 6% fed funds, but just getting us back to 3.00% from the current target of 2.00%. This is hardly anti-growth and in fact will boost profits and GDP as the dollar strengthens, oil comes lower as a result and beneficial profit margins remain intact.
We’ll also make this point: As the Fed dithers inflation will accelerate and they will find themselves in a situation where they’ll be forced to jack rates higher next year to a level that will be destructive to growth. There is still time to get it right and I believe they will begin their rate-hiking campaign at the August meeting on their way to 3.00% fed funds by year end. Again, my belief is that this will be a huge positive for the market, the dollar and oil. But Bernanke and Co. need to gets their heads out of their textbooks -- nothing there will direct them in the proper direction -- and pay more attention to market trends, specifically the dollar/oil link.
Have a great day!
Brent Vondera, Senior Analyst
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