Daily Insight

U.S. stocks closed lower for the first session in three as the market didn’t have much to trade on without a major economic release and the only meaningful earnings release coming from Bank of America (BAC). Earnings at BAC did come in at a better-than-expected rate, but this seemed to be not that surprising after we have already received results that beat expectations from a number of other financial names over the past three days.

The only economic news we had to go on came from the Conference Board’s Leading Economic Indicators Index (LEI); however, this reading doesn’t get much attention these days as it has proven to be fairly worthless. The index has posted negative readings half of the time over the past 3 ½ years – a period with which the economy has averaged 2.5% real annualized growth. While this level of GDP growth is below the long-term average of 3.4%, it isn’t all that bad considering the challenges of the past year and is a far cry from what the LEI has predicted.

Energy, utility and basic material shares led the gainers yesterday. Health-care, consumer discretionary and financial shares led yesterday’s losers. Health-care was hit by a study showing the efficacy of cholesterol-drug Vytorin was less-than-desired regarding valve disease and also showed 9.9% of those in the study developed cancer vs. 7% of those given placebo. This may not seem like a huge risk, given the 7% instance of those taking placebo, but such is the nature of the regulatory environment for the drug industry these days.

Market Activity for July 21, 2008

All and all, the losses among the benchmark indices were mild. Mid and small cap stocks posted nice gains.

Earnings growth is looking better-than-expected – although last night threw us a curveball with American Express, Apple and Texas Instruments all missing; we’ll get to that in a moment. I don’t want give anyone the wrong impression, as a whole S&P 500 profits are down 30% due to the 90% decline within the financial sector. But excluding that currently beleaguered segment of earnings, profits are up 12% and most companies have surpassed expectations – five of the 10 major industry groups have grown earnings at a double-digit rate; six are positive, with two sectors that have yet to report. Seventy-percent of those reporting have beat expectations.

Here’s a quick run down of second-quarter profit results:

Information technology (+26.8%), basic materials (+17%), energy (+15%), consumer staples (+12.6%), health-care (10.7%) and industrials (+2.5%). The downers are financials (-94.3%) and consumer discretionary (-2.7%). Telecom and utilities have yet to report.

And speaking of earnings, stocks look very attractive relative to bond yields. A measure that has been looked upon as one measure of stock-market valuation is comparing the earnings yield on the S&P 500 to the yield on the 10-year Treasury. Unfortunately, the earnings yield index was discontinued in 2007 and I didn’t have time to build my own this morning, but the chart below give a pretty good representation of this relationship even so. I’ve drawn a point on the chart to show where the earnings yield would plot today. (The earnings yield is the inverse of the P/E ratio and at 14 times forward earnings on the S&P 500 this puts the yield at 7% vs. the current yield on the 10-year of 4.03%)

One has to go back 30 years to see the earning yield of stocks this much above the yield on the benchmark bond. One thing to keep in mind is with the uncertainty of inflation rising of late this bond yield could rise abruptly and there goes the positive spread I’m talking about. The overall point though is when we look beyond current challenges/uncertainties, the market multiple is looking attractive here.

We received some earnings disappointments after the bell last night, the largest being poor results from American Express as credit-card defaults rose to 5.3% from 2.9% a year earlier. This is the big one that is sending stock-index futures lower this morning. We’ve had a number of financial names post better-than-expected results, but all it takes is one bad one in this environment and the bears got it in AMEX’s results.

One of the other names I mentioned above, Apple Inc., posted fantastic quarterly results, but the outlook is causing concern, as they forecast current-quarter results will be meaningfully below estimates. One thing to keep in mind though is that tech firms have been low-balling their guidance for four years now. Some of this Apple news is probably a combination of some weakness and low-balling. I’ll note, the current quarter generally sees margins compress a bit as the firm runs back-to-school discounts.

Shifting gears…

I’ve noticed a number of stories out of our beloved financial press over the past couple of months stating that income growth has stagnated and the media’s take has now moved to portray the past few years as a weak period for income growth. This take shows a pathetic level of inaccuracy. While real income growth has flattened out of late due to the 65% jump in the price of oil over the past 10 months, the figure has shown very nice progress over the past several years and remains positive over the past year even with the jump in energy prices. Again, that is over and above headline inflation.

I’m excluding the one-time event the rebate check scheme had on the figure – illustrated by the spike at the end of the series. Since the final quarter of 2001 – which marked the trough of the previous business-cycle contraction, nominal, or unadjusted for inflation, after-tax income is up 40.2%, or 5.5% annually – again, this excludes the May jump that was mostly due to the rebate-check effect. Real after-tax income is up 18.91%, or 2.77% annually. This is not far behind the growth of the 1990s, which didn’t have to deal with exploding commodity prices pushing inflation higher.

My chief concern regarding real income growth is this escalation in commodity prices, namely the energy area. Congress and the White House must follow through on last week’s very good comments on drilling with action. Too, the Fed must focus more on price stability. If crude prices do not stabilize this economy will be in trouble as income growth will not be able to keep up and business profit margins will be squeezed further. There are some things that are out of our control in this regard, but within those areas that we do control this must be dealt with now.

Have a great day!

Brent Vondera, Senior Analyst