The Wall Street Transcript

The Wall Street Transcript interviewed Chris Lissner for the October 2007 issue. This is an excellent read for anyone wanting to learn more about Acropolis, it's investment strategy and security selection process. Click here or the icon below to read the interview.

Daily Insight

U.S. stocks took a beating yesterday as the Fed has created additional problems for equity investors after failing to provide strong and decisive language regarding near-term monetary policy. The lack of conviction is making it difficult to assign an appropriate market multiple to the broad market as inflation concerns increase; oil has gotten back on its horse and seems quite ready to move higher so long as the FOMC remains non-committal.

The Dow Industrial average moved to its lowest level since September 2006 and the Dow Transports have gotten hammered in the past five trading sessions, falling 7.5%. Still the trannies have held up remarkably well, up 7% year-to-date. The S&P 500 has held above the March 10 multi-year low, but just barely as a 1% decline from here will move us through that level.

Market Activity for June 26, 2008
For what it’s worth, the U.S. indices are holding up better than most markets. Year-to-date, Germany is down 14.12%; France is off by 15.57; Britain is down 14%; Spain has declined 14.10% -- and that’s with currency adjustment. In addition, Hong Kong is down 20.7%; China’s major index has plunged 45%; India is off by 32%.

Crude-oil futures, enabled by the Fed and the driver of Benflation, rose 3.78% yesterday and are adding to that move this morning, rising above $140 per barrel. The chart below shows activity for yesterday’s session. Some of this activity includes the previous day’s overnight session, but you can tell by the time on the x axis how momentum began to build early morning and exploded to the upside by the time of our market open. (That momentum actually occurred directly following the release of Wednesday’s Fed decision as crude, which had been lower for most of the day by $4, reversed course and recovered half of that loss.

On the economic front, the data wasn’t too bad really, actually quite good regarding the GDP when considering all of the recession predictions.

Oh, before getting into that, I neglected to mention yesterday that Oracle’s latest earnings results were strong, propelled by the U.S.-dominated Americas region. Overall, quarterly profit advanced 27%, with U.S. sales bouncing back to record 18% growth.

As we’ve talked about many times, there are certainly areas of the U.S. economy that are hurting – housing and autos, namely – but other segments remain quite healthy. This news out of Oracle is just another example. A prime example of this reality, which we touch on each month, is business sales, which are up 6.75% over the past year and have increased at an 8.5% annual pace thus for during 2008. This data does have a big lag to it; the latest data is for April. That said, based on the trends of May and June, I expect this data to remain on an upward trajectory.

But back to yesterday’s economic releases, the Commerce Department reported that first-quarter GDP was revised slightly higher to 1% at an annual pace – that’s in real term, adjusted for inflation.

The drivers of first-quarter activity were personal consumption – always the largest segment of growth --, which added 0.81 percentage point; net exports, which added 0.79 percentage point; and government spending, adding 0.41 percentage point.

The drag continues to be residential fixed investment – housing --, which subtracted 1.12 percentage points from that real GDP figure. This amounts to a 24.6% decline at an annual rate – again, this is for housing construction.

Inventory additions added virtually nothing to first-quarter GDP, after subtracting a large 1.79 percentage points from the fourth-quarter number. Watch as the production needed to rebuild inventories fuels second-quarter GDP. Personal consumption and business spending will also add nicely, and unless the lagging data (mostly for June, but we still have a couple of releases we have yet to see for May) record uglier numbers than I’m expecting, the next GDP report will be stronger than most estimate and will continue to crush the recession predictions.

Growth is certainly weak, but it’s a far cry from recession – traditional definition of which is two-straight quarters of negative readings. My main caveat at this point is the Fed. They are fueling a commodity boom and their latest statements make it appear they are oblivious of this fact. They continue to believe that weak growth will bring these prices lower – I guess we’ll watch this assessment continue to miss the mark. If they don’t wake up, the interest rate increases that will be necessary to regain inflation-fighting credibility will lead to recession in the back-half of 2009.

In a separate report, the National Association of Realtors reported that existing home sales rose 2.0% in May. That’s certainly welcome news, but the inventory levels remain extremely elevated – as the second chart below illustrates -- so it’s tough to get excited about the increase in sales. Fact is this housing correction will be with us for a while. If only the Fed would get it right we will adjust to the housing woes. Assuming Congressional chicanery doesn’t exacerbate the situation, my feel is housing will begin to flatten out a year from now.

It’s important to point out that real economic growth has increased 2.5% over the past four quarters. That’s with housing subtracting more than one percentage point during three of those quarters and high fuel prices that continue to rise. For perspective, the long-term average for real U.S. growth – or what is referred to as “trend growth” – is 3.4%.

Lastly, the Labor Department reported that initial jobless claims came in flat from the previous week’s reading. For the week ended June 21 claims remained at 384,000, which is a bit higher than we would like. In the currently soft job market environment, we’d like to see claims hovering around 365,000-375,000 – this level would give us confidence that the monthly job losses would remain very tame. The current level of claims is not terrible, so long as we remain below 400,000 it is unlikely we’ll see a sharp monthly decline in payroll jobs, but still a small decline from here would make me more comfortable especially regarding the outlook for income growth.

This morning we get the May figures for personal income and spending, along with the inflation gauge tied to it all.

It will be tough for the equity markets to advance today, as traders will not want to go into the weekend long with the uncertainties that surround. But if the income and spending numbers come in at a healthy pace, stocks could get a boost. The inflation gauge tied to personal spending – known as the personal consumption expenditures index, or PCE – will show consumer-level inflation remains fairly tame. But this will change if the import and producer price figures remain at current levels and the Fed fails to put the hurt on the oil trade. If they fail to get it right, we’ll see the inflation gauges hit 4.5%-5.0% and then the bozos will be forced to act.

Have a great weekend!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ended the session higher, but traders appeared confused during the hour of trading subsequent the Fed’s rate decision – and just as importantly the statement, which was extremely non-committal – as the major indices gyrated more than 1%, as the graph below illustrates. In the end the indices held onto to most of the pre-announcement gains.

During the morning session, stocks shook off another very weak new home sales number – this time for May – as a pretty good durable goods report helped investor optimism. That report showed orders were flat for May, but electronics, computer products and telecommunication equipment showed nice gains and shipments of capital goods, which flows directly to the GDP figure, gave good indication second-quarter growth will be stronger than expected. More on this later.

Market Activity for June 25, 2008
Crude oil futures fell roughly 4% as the weekly energy report showed supplies rose 803,000 barrels – the forecast was for a decline of 1.1 million barrels. Fuel demand averaged 20.2 million barrels per day during the past four weeks, down 2.3% from a year earlier. Crude recovered half of this decline after the Fed’s comments showed they still don’t get it, which we’ll also get to below.

Eight of the 10 major industry groups gained ground for the day; energy and industrials were the losers. Energy was down on the decline in crude futures and industrials were pushed lower by a nearly 7% decline in Boeing shares, which sent many of the aircraft suppliers down in sympathy. But this concern was overplayed and the suppliers, especially those with strong defense contracts, are looking quite attractive here. The decline in Boeing shares subtracted 41 Dow points from the index, which is why it lagged the performance of the S&P 500.

Getting to the economic data, new home sales fell 2.5% in May, brining sales to 512,000 at an annual rate. There’s not much more to say about this situation, you’ve all heard it before. Supplies are terribly elevated and buyers simply will not come back to the market in earnest until they get a sense that prices have bottomed.

Expect housing – residential fixed investment in technical terms – to continue to weigh on the GDP figures, which has been the case for nine quarters now. During eight of these quarters, housing has subtracted at least 1.25 percentage point from real growth, yet economic growth has still measured 2.35% in real terms during this nine quarter period. Add in the 1.25 percentage point and you’ve got above trend growth even with sky-high energy prices – that proves underlying strength remains.

I’m guessing housing will bottom sometime in mid-2009, but this assumes Congress doesn’t do anything stupid to prolong the correction, which is a big assumption.

In a separate report, the Commerce Department reported that May durable goods orders came in flat. What kept the figure flat from the April reading was a big drop in machinery orders, down 5.3%. Strong orders in April and March – up 5.1% and 8.5%, respectively – caused the machinery orders respite. Vehicles and parts also weighed on the figure, which as been a reality for several months now. Those orders were down 3.5% and many auto plants remain idle.

The strength came from electronic, computer products and telecommunication equipment, which all posted really nice gains. Electronics orders were up 2.0%; computer products orders were up 10% and telecom orders rose 2.4% for the month.

Non-defense capital goods ex-aircraft – a proxy from business spending -- slipped 0.8% in May due to that drop in machinery orders. The decline followed a 3.1% rise in April. Importantly, shipments of business equipment rose 0.6% last month, which was on top of a 0.9% increase for April. This number is a component of GDP and thus will help the Q2 reading.

Finally, getting to the big news of the day, the FOMC (Federal Open Market Committee) kept their benchmark interest rate unchanged and the statement that accompanied the decision was non-committal.

The Fed mentioned overall economic activity continues to expand, reflecting some firming in household spending. However, they also mentioned that labor markets remain soft and that the housing correction and high energy prices will likely weigh on economic growth.

This latter statement was damaging. We already know this and all stating it does is send a signal that they may not raise rates in August. This is bad for the short-term price of oil – we needed a strong statement proving Bernanke and Co. understand that a mild boost in fed funds will bring crude futures lower.

The Fed certainly stuck to their Keynesian roots by mentioning they expect inflation to moderate later this year simply because growth is weak. This has been their line for six months now, only to be way wrong as their easy money campaign has hit the dollar and boosted commodity prices.

I’ve got to say my initial reaction to the statement was that it did signal the rate-hiking will begin in August – basically because of the “economic activity continues to expand, reflecting some firming in household spending” comment. Alas, the market didn’t see things the same way.

I lament, the language was not nearly strong enough – they needed to be much more hawkish towards commodity-price inflation. This was evident shortly after the comments were released as the dollar declined – after being flat-to-higher prior to the statement; oil reversed course – erasing half of it earlier losses – and the probability of a rate hike in August (their next meeting) declined.
Overall, the FOMC release was a big let down and we’ll likely have to deal with a dollar that struggles to gain ground and thus oil prices that remain above $100 per barrel, possibly above this $130 mark as the Fed is directing short-term traders to stick to the commodity trade.

There will be a new Fed Chief by the end of 2009. Bernanke is a fumbler and fails to get what will actually help economic growth in the relative short term.

This is a confused Fed. They certainly have a tough job in front of them, but they must understand that 2.00% fed funds will not magically solve the housing and credit issues and concentrating on the dollar and commodity prices is their best lever at this point. Mild tightening, beginning with what should have been strong and decisive comments yesterday, is the best way they can boost growth over the near term.

Have a great day!

Brent Vondera, Senior Analyst

Bernstein's Gale

By David Ott

In 1942, economist Joseph Schumpeter wrote The Process of Creative Destruction that argued that new machines, methods and ideas destroy the existing ones and bring about new and improved systems. In the book Capital Ideas, Peter Bernstein chronicles this process on Wall Street from his perspective as the old guard.

The story begins with a relatively unknown French mathematician named Louis Bachelier in 1900 and ends up covering the titans in modern finance: Markowitz, Sharpe, Fama, Modigliani, Black, and Sholes, among others. Throughout the journey, the prevailing market conditions and technological advances are seamlessly woven into the story, not to mention terrific personal antidotes from Bernstein’s five decade career on Wall Street.

Although the book is divided into six sections, there are really three stories. The first describes the evolution of the theories that revolutionized investment management. Prior to the 1950’s, it appears that there was little attention paid to investment theory beyond fundamental analysis of individual securities. While this is a worthy endeavor, it isn’t enough to appropriately balance the delicate risk and reward equilibrium.

Portfolio investing techniques that are now considered basic like asset allocation were inconceivable to the broker, analyst or portfolio manager in the 1950’s. As a portfolio manager at that time, Bernstein relates this with a funny personal story about how in his view, a portfolio was nothing more than “a fancy leather folder with a sheaf of papers inside.”

The first section takes you from Markowitz’s efficient frontier to Sharpe’s capital asset pricing model (CAPM), and Bernstein slowly but surely builds the case for Modern Portfolio Theory and the Efficient Market Hypothesis. The clarity of his writing, his own personal evolution over the years and his one-on-one conversations with those that originated each theory make you want to accept the totality of all of the arguments presented.

The second part gently guides us through how the academics transformed securities valuation. Bernstein starts with the origins of William’s Dividend Discount Model, then walks through Merton Modigliani’s bombshell assertion that a company’s capital structure is independent of it’s market value, and ends with the creation of the Black-Scholes model for pricing options – one of the fundamental building blocks of modern finance.

The last section is comprised of three case studies where some of the first professionals put the theories into practice, or as Bernstein calls it, taking the ideas “from gown to town.” At first, this seemed to be the least interesting part, but it turns out to be as illuminating as the preceding pure theory.

The 1970’s were the tipping point for putting the ideas into practice for two major reasons. First, the bear market of 1973-74 sent everyone back to the drawing board and opened doors to those with new ideas. Second, there were major advances in computing power that allowed for substantial calculations that the new theories required.

The first case study is Wells Fargo’s creation of the index fund. The second case study is a thorough discussion of a successful pension consultant Barr Rosenberg, founder of BARRA, who took the ideas to Wall Street. Perhaps the most interesting case study, however, is the birth of portfolio insurance.

Theoretically, portfolio insurance is essentially the equivalent of a put option. Because index options didn’t exist yet, two professors from Berkley started a management firm that used computer programming to adjust an allocation between stocks and cash depending on market conditions that acted like a put option. The insured portfolio was designed to be 100 percent cash at a predetermined percentage loss. As conditions changed, the computers were programmed to make additional buys or sells.

Although the strategy was in application for nearly a decade, the day of reckoning came on Black Monday, in October 1987, when the market dropped by 22.6 percent. This was the critical test for portfolio insurance and it failed. In fact, many have argued that portfolio insurance contributed to the losses rather than ameliorated them.

One of the critical assumptions built into portfolio insurance was that there would always be sufficient liquidity to execute any trades that the programming required. Despite all of the modeling and programming that had been done, this was a fatal assumption, because even though the computer may have been ‘right’ to sell, there were no buyers which caused the program to sell more, creating a vicious cycle.

This seems like an interesting choice of topics to end the book since it clearly suggests that while the young turks from the ivory towers had succeeded in breaking down the old system that was firmly entrenched on Wall Street, the new system was far from perfect. The models that had been created were immensely useful, but they tend to create the illusion of precision and somehow urge users to focus more on the output rather than the value and assumptions of the inputs.

In the case of portfolio insurance, the models assumed that there would be sufficient liquidity to execute the waves of orders, but the human element crept in and the system locked up, creating a free fall in prices. Of course, this would seem obvious to an old time floor trader, but to an academic buried in equations and proofs, it was an overlooked factor (one of the inventors went on to argue that the insurance had worked, it was the market that failed).

Bernstein is an incredibly thoughtful writer. The tenor and flow of the book is easy even when the concepts are not. There is plenty of humor and delightful sideshows to keep the reader fully engaged. Most importantly, given Bernstein’s stature in the field, he has the opportunity to interview nearly all of those that he covers in the book and you feel like you know who they are as people, which is fascinating. Bernstein strikes a perfect balance between interesting story and technical description.

Bernstein is still active and recently published Capital Ideas Evolving, the subject of the next review. As the gales of creative destruction continue to reinvent Wall Street, it is easy to appreciate a writer with as much access, curiosity and lucidity as Mr. Bernstein.


June 25, 2008
_____________________________________________________

Recommendation: Strong Buy

Capital Ideas:
The Improbable Origins of Modern Wall Street
By: Peter Bernstein

John & Wiley & Sons, Inc., Hoboken, New Jersey 2005
First Published: 1992

ISBN: 13 978-0-471-73174-0

Defining Your Legacy: Exit Planning for the Business Owner

Extra! Extra! Read all about it!

Chris Lissner writes in the Wealth Management section of the Saint Charles Business Magazine about exit planning for business owners.

"One out of two businesses will change hands in the next ten to fifteen years."

- Chris Lissner, President & General Partner


Click here or on the logo below to access the article.

Daily Insight

U.S. stock market activity resembled a seesaw yesterday as we began the morning session lower, moved the plus mid-day only then to slip back into the red by the session’s close. Three ugly readings from the day’s economic releases were the culprit as we had to contend with data sets that have been directly harmed by the housing correction.

Home prices, Richmond-area manufacturing and consumer confidence all posted pretty horrendous results, which we’ll get to below, making it very difficult for the indices to gain ground, especially ahead of today’s Fed rate decision and the comments that accompany that stance.

Market Activity for June 24, 2008

Seven of the 10 major industry groups closed lower yesterday – financials, consumer staples and telecoms were the three that ended on the plus side.

In addition to weak data releases, traders also has to deal with seemingly incessant comments of how we’re headed for recession, with some going as far as stating there isn’t any question that economic contraction is just ahead.

Outside of the data that is acutely tied to the housing woes, the majority of economic indicators are not pointing to this situation, as we’ve talked about for many months now. You simply do not have inventory levels (as a percentage of sales) near record lows, business sales that are on an upward trajectory, jobless claims below the 400,000 level and the overall manufacturing reading hovering very close to the line of expansion when recession is right around the corner.

In fact, so long as the Fed gets to it and begins to raise rates a bit – and it wouldn’t; take much in my view – the economy will escape recession even in 2009. If they do not get to it, and instead continue to dither, recession will be upon us late next year as their rate increases will need to be harmfully abrupt in order to squelch what will become a troublesome bout of inflation.

Getting to yesterday’s economic data releases, it began with the Richmond Fed index for June – a survey of factory activity within that Fed district – which posted a reading of negative 12. A number below zero marks contraction.

All broad indicators of activity within the index – shipments, new orders and employment – were in negative territory and lower than the previous month. District contacts reported that readings on order backlogs and capacity utilization narrowed and delivery times, although in positive territory, moved lower as well.

The silver lining, and ignored by the press, was the readings on capital expenditures. This segment increased, registering a four-point gain, coming out of two-straight months in which it registered zero.

This is important because it – along with other indications like the past two months of durable goods data – helps to validate our assumption that business spending will catalyze economic growth in the back-half of the year. Of course, the Fed cannot allow concerns to spin out of control with regard to soaring commodity prices. They must act now. So long as they do, concerns over fuel prices in particular will wane and businesses, which have vast resources as their disposal, will boost spending.

The second piece of data we received pertained to home prices. The S&P/Case-Shiller Home Price Index reported that home sales fell 1.36% in April and 15.3% from the year-ago period.

This index does overstate the declines by my judgment at it only captures 20 U.S. cities. They are the largest cities, but many of which have registered the most dramatic declines. Nine of these cities – Detroit, Las Vegas, Tampa, Minneapolis, L.A, San Fran, San Diego, Phoenix and Miami have all registered at least a 15% price decline in the past year, with seven of these areas falling at least 20%.

But this is not the situation for the country as a whole, as the geographically broader OFHEO (Office of Federal Housing Enterprise Oversight) home price index shows prices down by just 4.9% over the past year. Not that that’s good, but it’s not 15.3%.

Lastly, the Conference Board’s Consumer Confidence reading for June fell to the lowest level in 16 years. I normally do not report on this reading as it has proved to be a worthless indication of actual spending trends – long-time readers may recall this letter spending plenty of time explaining this reality back in 2002-2003. In any event, since the reading has declined to such a low level I feel compelled to touch on it for now.

The precipitous decline of the past eight months is undoubtedly due to housing-market woes and conspicuously irritating gasoline prices for many and financially painful for plenty. In addition though, a constant drumbeat of media pessimism has also contributed and I’d be remiss to leave out that the declines began at the very same time the Fed began to lower rates. The confidence numbers continued to slide as the Fed became irresponsibly aggressive with their rate cuts and oil shot even higher as a result.

I will point out though, again, that this survey is a poor indicator of what consumers actually do, which is apparent even in the past couple of months as spending has rebounded in pretty strong order even as confidence has plunged. The degree to which this reading has declined is disturbing, but those that filled out these surveys (mailed out to homes) should call Bernanke’s office if they’d like to vent some frustration. It was the Fed mistakes of keeping rates too low for too long into 2004 and 2005 that led to home prices to explode to levels that made zero sense, and hence the correction the market is currently dealing with. Now, it is their mistake of becoming way too easy that has pushed the dollar lower and oil prices higher by 70% in the last nine months alone.
The graphs below show both the confidence readings and retail sales (ex-auto sales). Retail sales (x autos), has increased at a 12% annualized pace over the past three months even as this confidence survey has moved to very low levels. Even including auto sales, which have been weak, retail sales have advanced at a 7.6% annual pace since March. Reason is, income growth is the single-largest determent of spending, and disposable income (after-tax income) is up 5% year-over-year. While this increase is not enough to keep up with raging energy prices, it’s still a darn good number.



This morning we get new home sales and durable goods orders for May, but everyone will be waiting for that Fed decision – the comments actually – that is released this afternoon.

I don’t think anyone believes they will raise rates today, although I wish they would send a strong message and begin to boost by 25 basis points. Inflation is becoming a problem and while it hasn’t yet shown up, in a really nasty way at least, within the consumer-level price gauges it will.

Statistical inflation lags by 7-8 months; there is nothing stopping the inflation gauges from hitting 4.5%-5.0% by year end. CPI is close to that point, but the others are still registering roughly 3.5%. Bernanke can save his job by beginning his rate-hiking campaign today, as they need to move fed funds by 3.00% by year end – it needs to be a mild move higher, but the move has to take place or crude prices will not come lower anytime soon.
He will not choose this course, but the second-best thing will be to offer strong language that signals the hiking will begin at the August meeting. If he does not, we’ll be talking about a new Fed Chairman within a year.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stock indices bounced around between gain and loss on several occasions yesterday, but in the end closed roughly flat. The NASDAQ took the brunt of the damage, closing lower by nearly 1% as most technology shares were pressured by investors’ concern over the consumer as crude prices gained more ground.

Financial shares were the worst-performing sector, but the broad market managed a fractional gain thanks to a big day from the energy group -- industrial, basic material and utility shares also closed higher.

Volume was weak as just 1.1 billion shares traded on the Big Board, the lowest activity in about five weeks as investors seem willing to wait on the sidelines for tomorrow’s Fed announcement. The three-month daily volume average is roughly 1.5 billion shares.

UPS came out yesterday and lowered their earnings guidance for the second quarter ala the FedEx announcement last week. The two statements read the same as the dramatic jump in energy prices was too quick for the two logistic firms to match with fuel surcharges. They also both reported customer cutbacks in air shipments, which is their most profitable unit.

General motors also came out and stated -- as they too get crushed by higher fuel costs; their most profitable unit, truck and SUV lines, find very few buyers as gasoline has moved to $4 per gallon – that plant closings will be prolonged by an additional couple of weeks. This won’t help the manufacturing figures, but the sector is holding up relatively well nonetheless.

Manufacturing has been dealt a nasty combination from the housing correction and low auto sales environment, but factory output remains very near the expansionary level. This is a reality we’ve pointed out for months now, underlying economic strength remains, for if this were not the case the manufacturing readings would be pushing 45 on the ISM index rather than hovering right at the dividing line between expansion and contraction. Thankfully business sales remain on an upward trajectory and this has driven inventory levels near record lows. The production necessary to keep stockpiles from moving to new all-time lows (as a percentage of sales) is keeping factory activity from slowing too much. Still, if fuel prices are allowed to rise like this, you can bet this index will move to the mid-40s.

And speaking of higher costs, we’re seeing trends continue to point to a situation that the Fed may lose control of if they don’t take their heads out of their Keynesian textbooks and focus more on market realities.

We’ve talked about higher import prices for five months now. While consumer-level inflation remains somewhat tame, one cannot expect this to last forever, there is only so much strong productivity improvements can do to quell inflation as import and producer price gauges remain at harmful levels.

And it’s not just the goods’ prices that are rising but service costs, namely transportation costs, have soared as well as one would expect. The expense of shipping a standard 40-foot container from Asia to the U.S. has jumped 50% on average over the past 14 months. Air freight costs are up 16% in the past year, and that’s before surcharges have been tacked on to reflect the recent jump in energy prices. This is why consumers are pulling back from this form of shipping and UPS and FedEx feel the pain.

In terms of goods, iron ore and steel imports were up 46% in May (on a year-over-year basis), which is allowing domestic producers to raise prices by 36% -- according to Bloomberg News – without having to lose market share.

Meanwhile, the Fed fiddles. The irony is that a mild boost in the fed funds rate (the Fed’s benchmark rate) can actually fuel growth by lowering transportation costs via lower fuel prices. That’s opposite the conventional wisdom (higher rates boosting economic activity) but watch it work…if the Fed would only get to it.

They end their two-day meeting tomorrow. It would be great to see them begin to gently increase fed funds – the longer they wait the more abrupt and thus painful the rate hikes will be – but they won’t. They’ll ramp up the rhetoric in their statement tomorrow and then begin to boost fed funds in August on their way to 3.00% by year-end – that’s my call at least. If they do so, the dollar will get a boost, oil prices will come lower and a huge weight will have been lifted from the consumer, producer, and the market.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks slid Friday, sending the broad market to a three-month low, and within 3% of the multi-year low hit on March 10, as higher oil prices heightened concern – again – that consumers will pull back on electronic and most other discretionary goods.

Consumer discretionary and information technology shares were the hardest hit, with financials not far behind. All ten major industry groups closed lower – no surprise there on a day when the major indices lost roughly 2%. Energy stocks, or the S&P 500 index that tracks these shares, was the only group that lost less than 1% as crude futures rose 2.04% on news that Israeli military exercises were meant to mimic an attack on Iran’s nuclear installations.

For the week, the Dow declined 3.78%; the S&P 500 was lower by 3.10% and the NASDAQ Composite dropped 1.97%.

Well, I guess the story that China’s fuel subsidy reduction – allowing the market price to float a bit more free – caused crude prices to fall lasted all of about 12 hours. That was the storyline on Thursday. The single-largest determinant of oil’s direction remains the dollar’s value and thus Fed policy. (Although, if a showdown between Israel and Iran materializes that will take over, but until then it is the Fed. A little tightening please; the longer they wait the more it shows the members of the FOMC fail to get it.

No doubt, allowing the price mechanism to work in places like China and India will cause demand to compress but to really break this trade – speculators’ bidding crude higher – it will take a fed funds boost. I don’t believe it will take much to do the trick, 3.00% by year end and the first 25 basis point hike will send a huge signal.

Crude futures are higher this morning and it’s telling considering the develops over the weekend. The Saudi’s reiterated that they’ll boost daily production by 200,000 barrels, which is on top of last month’s 300,000 barrel boost, bringing the daily boost to 550,000 in just a month’s time. In addition, they said daily production will move to 12.5 million barrels per day, from the current 9.5 million. That’s huge, and the fact that crude is trading higher this morning corroborates the trade is waiting for explicit Fed action before reversing, in my view.

The market really needs oil to come off, falling to $120-$125 per barrel will be a good start, before we gain some traction. We have several uncertainties to deal with, as we’ve spent much time focusing on, but with energy prices at these levels it adds just another obstacle for stocks to shake this range.

There are a number of positives that continue to receive little attention from the press – business sales remain upbeat, inventory levels are low, the labor market is holding up pretty well, income growth looks decent (although its impossible to keep up with oil’s rise), consumer spending has rebounded over the past two months and durable goods orders of late are showing business spending has some life. I feel the need to express these positives when talking about the uncertainties. Things are holding up much better than is being reported but when there are questions over tax and trade policy, the duration of the housing downturn and geopolitical events it is tough for stocks to break out. Then add in these energy costs.

More than 2 billion shares traded on the Big Board on Friday, the most since March 20, as the expiration of futures and options on indexes and individual stocks took place – known as quadruple witching. Quarterly re-structuring of the S&P 500 also boosted volume as the funds that mimic the index implemented the necessary trades to reflect these adjustments.

We’re without an economic release this morning, and will have to wait a couple of days for something meaningful. Starting Wednesday, we hit it hard as the Fed adjourns one of its two-day meetings. (The FOMC – the rate-setting committee – meets eight times a year, usually for one day. The meetings in January-February and June-July are two-day events.)

Unfortunately, they’ll leave rates unchanged, but will be forced to acknowledge their errors and will begin to gently raise rates by at the August 5 meeting – that’s my guess at least.

By the back-half of the week we’ll also get May durable goods orders, new home sales, the final revision to Q1 GDP, existing home sales and personal income and spending for May. So lots of good data and they’ll all be market movers.

Stock index futures have just reversed course; we were up nicely for most of the morning but have now gone negative as it’s being reported Goldman Sachs just downgraded the financial sector. These big brokerage calls kill me – it’s almost comical how they are so momentum based.

Have a great day!

Brent Vondera, Senior Analyst