Daily Insight

U.S. stocks gained ground yesterday, extending the rally from the multi-year low hit about a week ago, as earnings reports continue to stream in at better-than-expected rates of growth and oil prices continued to fall.

Consumer discretionary and financials shares led the way again as the drop in energy prices boosts sentiment regarding future consumer activity and their ability to pay bills. The housing-market woes, which have brought higher foreclosures, job losses within the construction sector and an increased level of caution are the largest reasons behind the consumer worries, but higher energy prices are an additional challenge.

Market Activity for July 23, 2008

The laggards were energy, basic materials and utility shares. The CRB Index, which measures a basket of commodity prices has dropped 12.5% over the past eight trading sessions and oil alone has fallen $20 from the all-time high of $145.29. The S&P 500 Energy index has plunged nearly 17% from its high hit in mid-May and 15% this month. The group has likely been oversold as they’ll continue to make great money at these levels and continue to boost dividend payouts.


Crude-oil prices fell another 2.74% yesterday, to $124.44 per barrel, even as the weekly energy report showed supplies fell 1.56 million barrels – a decline of 675,000 barrels was expected. Pushing crude lower was builds in gasoline and distillate fuels (heating oil and diesel), which rose more than expected. Information on gasoline demand showed a decline of 2.2% from the year-ago period, which is in line with what we’ve seen over the past four weeks.

I do think that hawkish comments from Fed officials of late has helped push crude lower as the dollar has gained some ground over the past week. There has been talk the collapse of oil-marketing firm SEMGroup is behind oil’s decline as they had to unwind long positions. I don’t know, maybe this has some validity, but it doesn’t explain the decline within almost all commodity prices of late.

Earnings continue to beat expectations by-and-large – 75% of S&P 500 members that have reported thus far have beat expectations. Ex-financial profit growth remains in double-digit territory, up 10.5% with about 40% of members reporting. Even overall earnings, punished by a 97% decline in financial-sector profits, have improved. Overall, second-quarter S&P 500 profits are down 27%; that figure was a negative 35% two days ago. (One of the exceptions within the ex-financial space is Ford, which has just stated their second-quarter loss came in at 62 cents a share – a decline of 27 cents was expected. Ouch. Also just out is 3M’s second-quarter results, which easily beat their number as operating income rose 13%)

On the economic front, the Fed’s Beige Book release showed most of what we already knew occurred during the six weeks that ran early June – mid July. (This report is a survey of economic conditions within their 12 regional districts – the survey is released every six weeks.)

• Consumer Spending
  Reported as sluggish or slowing in all districts –not terribly surprising considering retail sales x autos jumped 11.5% at an annual pace past four months. You can bet there will be some slowing after that robust pace.
  
• Real Estate
  Residential remained weak across the country. A few districts did show improvement on the commercial side, but Boston reported “over-built” conditions.
  
• Manufacturing
  Remained subdued, but did show activity increased in Cleveland, St. Louis and San Francisco districts. Understandably, producers of energy equipment enjoyed increased demand.
  
• Prices
  All districts reported price pressures as elevated or increasing. Input prices continued to rise, particularly for fuel, metals, food and chemicals. Many districts reported on manufacturer’s plans to raise prices as a result of higher input costs. (Hopefully the FOMC is reading their own report.)
  
• Labor Market
  Job market was reported as unchanged or slightly weaker in most districts. Demand remained high for skilled workers in most industries.

The Fed continues to focus on wages, as any good Keynesian/Phillips Curver/NAIRUist would, and since wage pressures are not elevated they continue to expect inflation to cool. We hope they’re right, but as most of you know I’m skeptical. The ISM and regional manufacturing surveys suggest inflation is becoming embedded due to the abrupt jump in input costs over the past 10 months. However, the decline in oil and other commodity prices over the past several sessions is very welcome news and if this trend continues – or at least do not jump again – it will help in calming import, producer and consumer-level inflation.

Yesterday I mentioned Fed Vice Chairman Kohn and Governor Mishkin were scheduled to speak, but I must have had my dates wrong. The Federal Open Market Committee (FOMC) website didn’t have anything on this. However, Philadelphia Fed Bank President Plosser was out making comments and they were somewhat hawkish. He stated that policy maker must increase fed funds before inflation expectations become unhinged. He joins Minneapolis Fed Bank pres Stern and Dallas pres Fischer in this sentiment. They are all voting members, so there is dissent building and will result in pressure for the group to gently increase their benchmark rate.

The table below shows the probability of Fed moves over the next three meetings. The first segment shows the probability of a change at the August 5 meeting. To no real surprise, the market believes there’s a 90.5% chance that the FOMC will keep fed funds unchanged at 2.00%. Notice though how things have changed over the past month – a month-ago the market believed a 42.1% chance of a 25 basis point hike to 2.25%. This helps to illustrate how the Fed has changed its language and has been all over the map, thus confusing the rest of the market with regard to their direction.

You can then move down to the September 16 meeting table where a month ago there was a 56% chance the Fed would go to 2.25% by then and a 37% shot of hiking to 2.50% for a combined 93% chance of raising rates whether it be 25 or 50 basis points. Now that chance is just 60%, and a week ago it was as low as 24.6%.

Oil and the dollar trade are based on a variety of factors, but a major variable is the Fed’s direction. The sways in the table above helps to explain the ups and downs in the dollar and oil prices off late. As the market increases its expectation the Fed will hike, oil will continue to move in the right direction – of course hurricane activity and geopolitical events will have their own effect on price. If they send market expectations on another wild goose chase by becoming more dovish on the inflation front again, oil and the dollar may just return to an undesirable direction.

This morning we get initial jobless claims for the week ended July 19. It will be very important to hold below the 390,000 level. The last two weeks we’ve seen claims trend lower. I expect to see the figure begin to trend upward slightly, but if we remain in a range of 375,000-390,000 on the four-week average – which is the graph we’ve been posting on Friday’s for a few months now – it will signal monthly job losses to remain mild.

We’ll also get existing home sales for June, which are expected to decline 1% after recording a 2% rise in May.

Have a great day!

Brent Vondera, Senior Analyst