Daily Insight

U.S. stocks halted a six-week losing streak as better-than-expected earnings from the banking industry and ex-financial S&P 500 profit growth remains in double-digit territory has helped the benchmark indices to rebound the past three sessions.

For the week, the Dow gained 3.57%; the S&P 500 rose 1.71% and the NASDAQ Composite added 1.95%.

Financial-industry giants Citigroup, Wells Fargo and JP Morgan continue to post relatively weak results but the numbers have come in much better-than-expected. Bank of America has extended the trend this morning, whipping their estimate by 40%. Their second-quarter net income was 42% below the year-ago number, but it appears we may be on pace to get most of these write-downs behind us by the time the fourth-quarter rolls around – which would be huge.

Excluding financial-industry results, S&P 500 profits are on their way to posting another double-digit quarter; the figure is up 12.7% with about 25% of members reporting thus far.

Market Activity for July 18, 2008

We have to get several uncertainties out of the way still, inflation concerns are now another issue equity investors must deal with, making the task of assigning the correct market multiple very difficult, so one should be prepared for stocks to continue within this trading range. But we’ll eventually break out to the upside. Several positives that no one seems to be talking about is the awesomely streamlined nature of most industries – it is absolutely amazing how many sectors continue to record decent-to-healthy profit growth even as most input costs have risen in such a quick fashion.

And there is certainly no lack of capital as a record $3.5 trillion sits in money–market funds just waiting to get in. Corporate cash levels remain high as well.

It’s true a lot of wealth has been lost, more than $10 trillion in global market value since October, according to Bloomberg News. However, we’ve held onto to a lot of the gains of the past few year – the NYSE Composite Index, for instance, remains 88% higher from the March 2003 multi-year low and is up 56% since 1998. That 10-year return is relatively weak when annualized, just 5%, but there has been a lot of wealth created over the past decade as U.S household net worth has jumped 60%.

In terms of housing, the 30-year fixed mortgage spread – as indicated by the thick yellow line in the chart – has narrowed nicely. Hopefully, it will continue to trend lower as this will show credit availability is improving. Credit remains very much available for those with strong credit scores (although at a higher price), but sketchy for those with questionable histories. In any event, it will be a big market plus to see some of these spreads narrow, and this mortgage spread is one of the important ones. I do have my concerns though.

The spread between the 10-year Treasury and the 30-year mortgage rate remains much higher than normal, as you can see – currently running at 210 basis points, the normal range is 150-175. The Fed can keep rates very low – thus keeping the 10-year probably lower than it otherwise would be – but the market is saying, I don’t think so; we’re not originating mortgages at normal spreads due to increased risks.

What the very low fed funds rate does help is adjustable mortgage resets, but still the FOMC can push fed funds to 1.00% and those that had no skin in the game and now have mortgages that are higher than the home’s value will simply walk, as they have been doing.

The overall point, the Fed does not have a magic wand that solves everything. It seems to me they need to raise rates mildly, show the market that they’re still serious about price stability, and let the housing market adjust as it will. At least this way we won’t have multiple things to deal with down the road – a weak housing market and harmful levels of inflation.

Keep in mind, if inflation becomes embedded, the Fed tightening that will take place will be substantial and abrupt. At which point, the economy could be pushed into a serious recession and housing won’t be able to rebound. This doesn’t have to be the case. If the FOMC realizes there is no silver bullet and deals with that which they are tasked, time will take care of the rest.

There are signs inflation is becoming imbedded, which is my chief concern here and now (our other concern, and the market’s in general, is the uncertainty of tax policy as higher capital and dividend tax rates will be crushing for stocks, but that takes a back seat right now). The ISM surveys along with some of the regional manufacturing indexes are showing the jump in energy prices have flowed through to other prices.

In the latest regional manufacturing survey a special question was asked on price behavior and found that 60.5% of respondents have increased base prices to pass on energy and other cost increases. Of these, 29.1% have instituted price surcharges. Looking ahead, 32.6% of respondents stated they were more likely to institute escalation clauses incorporating price adjustments; 31% were more likely to use surcharges to offset higher costs.

So manufacturers have and plan to pass price increases down the pipeline, with a number of them contemplating automatic price escalation agreements. The Fed needs to get a handle on energy prices and further dithering on this issue will not prove beneficial. For sure, there are many variables that go into the price of oil, it is not only the Fed’s reckless easing campaign – a hurricane that tracks through the Gulf of Mexico, OPEC stating they’re contemplating a production reduction, the weekly energy report showing supplies fell, geopolitical risks, etc. But it doesn’t seem to be happenstance that crude has jumped 65% since the Fed began to ease last September and 40% since the January 22 inter-meeting cut that kicked off this aggressively Fed action. Some mild tightening may go a long way in removing inflation concerns.

Moving on…

I see this morning the NABE (National Association of Business Economists) is now saying the U.S. will avoid recession, but growth will remain weak. We welcome the NABE to reality along with the other recession promoters that seem to be dropping like flies. We’ll likely see the second-quarter GDP figure come in at a 2.5% real rate of annualized growth – even as housing continues to subtract a full percentage point from the reading. There’s even an outside chance Q2 GDP will post a 3.0% reading.

Still, until housing flattens out, we’ll have to deal with weak readings that surround some of these stronger posts. But so long as inflation risks are quelled, real incomes will rebound a bit from here and we’ll have the consumer helping out the business side, which seems quite capable of boosting capital outlays with their huge cash positions and profit growth that remains intact for many industries.

Futures have turned around this morning and are now nicely positive thanks to the better-than-expected Bank America results.
Have a great day!

Brent Vondera, Senior Analyst