Daily Insight

U.S. stocks ended mixed on Thursday as the Dow and S&P 500 gained some ground, while the NASDAQ Composite declined. The broad market managed to move higher as a gain in energy and basic material shares offset a decline among financial stocks. That trend has broken down for two days now (the financial/consumer discretionary/overall market direction correlation).

Information technology shares held back the tech-laden NASDAQ Composite as the S&P 500 index that tracks these shares slipped 0.24%.

Market Activity for August 21, 2008
Seven of the 10 major industry groups rose yesterday with energy, utility and basic material stocks leading the way. Energy shares within the S&P 500 have recorded their biggest three-day advance since 2002 – jumping 8.5% after getting clocked since July 3, down 20% since that date prior to this latest move higher.

Crude-oil jumped $6.20 per barrel, or 5.39%, as Russia’s behavior in Eastern Europe is very likely the reason for this latest move.

On the economic front, first-time claims for unemployment benefits fell 13,000 to 432,000 in the week ended August 16. The four-week average, however, (as illustrated by the chart below) moved to the highest level in seven years.


While this is disturbing, the boost may prove temporary as more unemployed workers apply for benefits due to the Emergency Unemployment Compensation Program. Further, they are allowed to remain on the dole for a longer period than would otherwise be the case – this has moved the continuing claims figure higher.

For now it will be difficult to surmise from this figure the degree of monthly job losses. Claims in this range would normally indicate job losses of over 100,000 per month -- higher than the 66,000 average in monthly payroll declines over the past seven months.

Hopefully, any pick up in job losses will prove temporary but it will take a couple of weeks to get a cleaner look due to the government’s widened safety net – hammock, rather.

Thirty-three states and territories reported an increase in claims, while 20 reported a decrease.

In a separate report, the Philadelphia Federal Reserve Bank’s index of manufacturing activity – known as the Philly Fed survey -- posted its ninth-straight negative reading, but the pace of decline did moderate in August.

I’ll point out, the Chicago PMI (which tracks factory activity within that region – the most active region for manufacturing work) and the nationwide look that comes out of the Institute for Supply Management (ISM) have shown that the manufacturing sector as a whole remains right at the level that separates expansion from contraction – meaning activity is pretty much flat. Point is manufacturing activity is holding up remarkably well considering substantial drags from the housing and auto sectors.

Back to the Philly number, the price indices within the report remain elevated -- two-thirds of respondents reported higher input prices this month. That is down from 77% as energy prices capped their meteoric ascent last month. Regarding prices for their own manufactured goods (prices received as opposed to prices paid), the percentage of firms reporting higher prices in August exceeded the percentage reporting lower prices by a four-to-one margin.

And speaking of which…

MZM (money zero maturity) money supply [this includes checking accounts, savings accounts and money-market funds minus time deposits (CDs)] has soared over the past year rising 14.4%. The rate of growth has cooled over the past few months, but the 12-month rise has enormously outpaced nominal GDP growth of just 3.8% over the same period. The cause of inflation is too much money chasing too few goods and since MZM is money and GDP is goods produced…well, the rise in inflation should come as no great surprise.


We’re without an economic release this morning, but Fed Chairman Bernanke is scheduled to speak on “Financial Stability” at the annual symposium in Jackson Hole. It may behoove him, the market and the rest of society to make some comments on price stability too. I also wouldn’t be surprised to hear from Treasury Secretary Hank Paulson either today or Monday regarding the GSEs -- Fannie Mae and Freddie Mac.

Have a great weekend!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks gained ground yesterday, ending a two-day decline that had erased the previous six-session gain. Energy shares led the way as crude-oil rose for a third-straight day. Financials also enjoyed good results. The S&P 500 indices that track energy and financial stocks rose 2.77% and 1.67%, respectively.

It was interesting to see a trend broken yesterday as the market managed to gain ground even as consumer discretionary shares fell 0.55%. As we’ve been discussing, the direction of financial and consumer disc. shares has determined the path of the overall market on a daily basis for quite a while now.

Now if we can get the indices to gain ground even on days that financial shares fall, we may be moving past fears over the credit markets – maybe, just a thought. That said, credit spreads remain pretty wide and until those narrow, it will be tough for this trend to break. It is becoming easier though as financial shares make up just 14.4% of the S&P 500 Index today, down from 20.7% one year ago.

Market Activity for August 20, 2008


On oil, crude for October delivery remains well below the peak closing price of $145.29 hit on July 3, but has gained 4% over the past three sessions. Certainly Russia’s Cold War-like activity is not helping in this regard. I see they are calling themselves “peace-keepers” even as they pillage residential areas, destroy infrastructure, block ports and make L.A looters look like amateurs. They have moved well past South Ossetia and Abkhazia and into other cities, such as Gori – it is far from certain they’ll refrain from entering the capital, Tbilisi. I also see they have taken over the hydroelectric plant that provides much of Georgia’s power.


For those that remember the Cold War era, this looks quite familiar to what occurred in the Czech Republic and Poland in the 1960s and 1970s – it is the same playbook and their aim is clear: take over the Baku-Tbilisi-Ceyan pipeline – which is the only regional pipeline supplying Western Europe that the Russian’s do not yet have control over – and determine the future of Eastern Europe. NATO needs to step up or they risk becoming as feckless as the UN. The good news is this may rally support for Eastern European entry to NATO and hopefully sound the alarm to Western Europe to accept this needed result, which they have been blocking.

Moving on…

We were without an economic release yesterday, so I thought we’d touch on a topic that has been plaguing the market of late. There are a number of uncertainties that have hurt investor sentiment – the housing market – and the duration of that correction, inflationary pressures -- and future Fed action to control this situation, and geopolitical risks. The other major concern is the uncertainty over tax rates.

Lower tax rates on capital gains and dividends have been instrumental to the 64% rise of the S&P 500 (9.81% annualized) since March 2003 as it offered a boost to after-tax return expectations and provided the incentive to take on measured risk. The capital gains tax rate reduction -- from 20% to 15% at the federal level -- led to a 6.25% increase in the after-tax return of retained income for an additional dollar put at risk – as Larry Kudlow importantly pointed out a couple of days back.

The dividend tax cut raised after-tax income from this source dramatically as the rate was reduced to 15% from 39.6%, for those in the top tax bracket. Not counting state taxes, this meant an investor kept 85 cents on the dollar, as opposed to just 60.4 cents – a 40.7% incentive boost on an additional dollar put at risk. Needless to say that was enormous and explains why investors have demanded higher dividend payouts and the dividend component of the personal income data has soared. Make no mistake, this extra income does flow through to the rest of the economy by way of higher capital formation and thus higher innovation, productivity gains and jobs growth.

In terms of federal income tax rates on labor, one should know that small business makes up roughly 65% of those within the top tax bracket – this group is the largest job creator in the country. Raise their after-tax income growth (by reducing tax rates) and you get more jobs and higher levels of business investment over the long term.

This is why when a presidential candidate, or members of Congress, talks about raising these tax rates it has a significant effect on investor sentiment and the proclivity of investors to take risk. Raising the capital gains tax rate from 15% to 20% results in a 6% reduction in after-tax retained income for an additional dollar put at risk – from 85 cents on the dollar to 80 cents. Same is true for the dividend tax. Of course, if these rates are pushed even higher, as some have suggested to 28%, that after-tax income number becomes smaller.

In an attempt to justify these tax rate increases, proponents have stated that these rates are the same or less than where they were in the 1990s – most of which were big growth years as everyone knows.

But this not the 1995 global economy, the world is much more competitive today as there are more legitimate players and many countries have slashed their tax rates on income and investment. You try to raise tax rates – and thus lower the after-tax rate on investment and income – in this environment and it means you lose by way of competitiveness. These are the reasons this stuff is so important.

This morning we get initial jobless claims for the week ended August 16. It will be important to see this figure decline; it is not yet known the extent at which the government’s Emergency Unemployment Compensation Program has affected this reading, which has jumped. The BLS (Bureau of Labor Statistics) believes the impact may have peaked. Hopefully over the next couple of weeks we get a cleaner look and can surmise whether the monthly job losses will remain relatively tame or not.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks declined for second day after wholesale prices accelerated from an already hot pace in July – and well-faster than analysts had expected – and housing starts fell to the lowest level in 17 years.

Again, like clockwork, financials and consumer discretionary shares led the market lower falling 3.05% and 2.24%, respectively. As we’ve discussed, one only needs to look at these two sectors to learn the direction of the overall market. When this trend begins to break, it may signal the moment financials and consumer discretionary shares begin their sustained moved higher.

It’s tough when you’ve got these two indicators (inflation and housing) posting bad numbers as higher levels of inflation keep real incomes from rising (amazingly though this figure remains flat, not declining, as the broadest measure of incomes continue to grow at a nice nominal clip) and poor housing market results keep financial-sector concerns alive.

I will point out though that housing construction declines did ease in the second quarter as the drag on the GDP figure was half what it has been of late. It will just take some time to work off the excesses of the previous years; it’s as simple as that. On inflation, the numbers look ugly, and we have our concerns on this front, but the decline in oil prices of late should help inflation pressures ease – that is not a forgone conclusion though as I’ll discuss below.

Market Activity for August 19, 2008

In earnings news, Hewlett-Packard posted another great quarter – releasing results after the bell yesterday – as operating profit jumped 21%, revenue grew 10% and the firm issued strong guidance. Information technology posted the second-best profit performance of the 10 major industry groups for Q2 as operating profit rose 14.8%. This trailed only the energy sector, which posted operating profit growth of 17.9%.

Three of the 10 major industry groups enjoyed double-digit profit growth last quarter – consumer staples being the third. Another three industries posted profit growth in the range of 6%-9.5% -- health-care, industrials and utilities. Three industries reported profits declined in the March-June period – financials (down 94%), consumer discretionary (down 55.8%, much of this due to Ford, GM and housing-related retailers) and telecoms (down 1.9%)

On the economic front, U.S. producer prices (PPI) accelerated in July coming in at twice the rate expected on a month-over-month basis and jumping 9.8% from the year-ago period – fastest rate in 27 years. PPI rose 1.2% in July, an increase of 0.6% was expected, and the year-over-year reading surpassed the expected 9.3% increase. Even excluding energy, producer prices were up 0.6% over the past 30 days and 5% year-over-year.

Most concerning to me is the pace of core intermediate goods, which accelerated to 2.0% on a month-over-month basis and 10.2% year-over-year. (That’s up from the 8.4% pace hit in June.) For clarity, core intermediate goods are those factories use to produce finished product and it excludes energy. There is a real possibility that this segment funnels down to the consumer. If won’t occur in full, as productivity improvements and firms’ desires to keep market share hold consumer prices back, but it may be enough to drive the figure even as commodity prices have declined in a substantial way.

Many were probably looking past this reading as dollar strength and oil’s decline lead most to believe inflation will moderate – the drop in commodity prices, which began to take place in mid-July, did not occur in time to help ease the July PPI reading, but should help the August reading. With energy prices off 22% from the high, it will undoubtedly help. Still, this core intermediate goods segment will be something to watch over the next few months.


In separate report, July housing starts fell to a 17-year low. Building permits, a sign of future construction, also fell.

Starts fell 11% to an annual rate of 965,000, the lowest level since March 1991, followed a 1.084 million pace in the prior months. The report will reinforce the concern that stricter lending rules, rising borrowing costs and foreclosures will keep home sales depressed and cause builders to hold off on new construction. But this is what needs to occur when inventory levels are so elevated – this figure really needs be cut in half from the high hit in March. It will simply take time, but demographics and household formation will eventually take care of this issue.

Construction of single-family homes fell 2.9% in July (down 39.2% from July 2007) to 641,000 at an annual rate – also the fewest since 1991. Work on multi-family homes plunged 24% from the prior month after getting a boost in June from that change in New York City building codes that we discussed yesterday.



Have a great day!


Brent Vondera, Senior Analyst

From Revolution to Evolution

By: David Ott

In his 1992 book, Capital Ideas, Peter Bernstein guides us through the four decades when Modern Portfolio Theory (MPT) revolutionized Wall Street. Now, fifteen years later, Bernstein’s new book Capital Ideas Evolving (referred to as Evolving hereafter) critically examines MPT from three perspectives.

In the first section, he presents the two most substantial academic critiques of MPT that attack some of the underlying assumptions within the theory. For example, MPT assumes that investors are rational. These fictional investors are emotionless automatons that are absolutely capable of making optimal decisions about their portfolio.

This is obviously false. It may make sense with respect to the creation of a theory, but any practitioner will tell you that neither markets nor investors are rational. A whole new field within economics, referred to as behavioral finance, seeks to examine investor behavior in attempt to mitigate some of the frequent problems that arise.

For example, one study looked at how 401(k) participants make decisions about their retirement savings based on the choices that their plan sponsor provides them. The study breaks the participants into three groups and gives each group a choice between two mutual funds.

The first group was given a choice between a stock fund and a bond fund. This group split the money basically down the middle and basically had a 50/50 stock/bond allocation.

The second group was given a choice between a stock fund and a balanced fund that split the money 50/50 between stocks and bonds. Instead of putting all of the money into the balanced fund, the participants split the money between the two funds, which meant that their stock/bond split was 75/25.

The third group was offered a bond fund and the same balanced fund that split the money 50/50 between stocks and bonds. Investors split their money half and half between the two funds instead of the balanced fund and ended up with a portfolio heavily weighted towards bonds.

The researches subsequently interviewed the participants and found that they had wanted to diversify, and since they didn’t understand their options, they just split the money half and half into each option thinking that being diversified into two funds was better than one, even though the results of that simple decision had radically different asset allocation implications for the 401(k) assets.

Whether it is a problem of being uneducated about investments or acting irrationally, this experiment shows that investors are generally not well equipped to make appropriate decisions about their investments. Even Harry Markowitz, the great-granddaddy of MPT says that many of the theories “make unrealistic – absurd – assumptions about the actors.”

In the second section of the book, Bernstein revisits many of the academics that led the revolution to ask if their theories are still relevant. In short, they all seem to agree that the theories aren’t perfect, but are clearly relevant and useful in today’s environment. As Nobel Laureate Robert Merton says, “there is much left to do because so little has been done.”

In the third section, Bernstein describes a variety of practitioners who have put the MPT to work with a great degree of success. The first case is an extension of one of the real world examples in Capital Ideas. In the first book, he describes how Wells Fargo created the first index fund. It seemed odd that they had no visible name regarding indexing in today’s investment landscape.

The answer to that riddle is that Wells Fargo wasn’t making any money indexing, so they sold it to Barclays who – years later – turned their experience in indexing into the dominant player in the exchange traded fund and exchange traded note industry under the successful brands iShares and iPath.

He also describes the Yale Endowments diversification efforts through the extensive use of private equity, long-short and absolute return funds as well as other esoteric strategies like ‘portable alpha.’ The basic idea is use leverage to invest in an equity index like the S&P 500 using futures and invest what you don’t need for collateral into something that will earn interest in excess of your borrowing rate.

The idea was first developed by bond king Bill Gross at PIMCO in a product called StocksPLUS. The result is an investment with the same volatility as the S&P 500, but slightly more return, creating what is known as alpha. The portability refers to the use of capital not used to fund the futures contract in any investment that is likely to earn returns in excess of the cost of capital.

Interestingly, Bernstein mentions that StocksPLUS as an institutional product had earned positive alpha over the S&P 500 in 194 of 195 rolling three year periods from July 1989 through September 2005. For the ten years ending in September 2005, the fund added 50 basis points of performance annually to the S&P 500 with basically identical volatility and nearly perfect correlation.

Since that time, however, it would appear that it has been harder for Gross to find portable alpha since 2005. A review of the data from Morningstar regarding their retail offering of the same name shows that for the three years ending July 31, 2008, the fund has trailed the S&P 500 by 148 basis points per annum and produced negative alpha. This may be a reflection of increased market efficiency.

Additionally, upon review of the mutual fund, the strategy may sound very appealing, but it has some clearly negative implications for taxable investors. According to Morningstar, the fund has had pretax return of 1.41 percent for the three years ending July 31, but the tax-adjusted return is -2.05 percent over the same time frame. One would have done much better to forgo the excess returns and pay less in taxes.

This highlights one my own critiques of the some of the high-minded strategies seem so appealing. While it is amazing what Gross and Swenson have done, it isn’t repeatable for most investors. Of course, we could use StocksPLUS in an IRA or some other deferred account, but how could we replicate Swenson’s ownership of timberlands? Despite the new stream of products, it seems highly unlikely that an individual investor could replicate many of these strategies.

In some respects, the inability to mimic these strategies may be a good thing. All of Bernstein’s examples cover those who were immensely successful at the time he went to print, and a few things have changed since then. The description of Goldman Sachs flagship hedge fund, known as Global Alpha, sounds like investment nirvana. As their chief of quantitative strategies, Bob Litterman says, “We run an alpha factory here.” That was before the fund lost ten percent in 2006 and additional 40 percent in 2007.

Of course, these changes are what keep investing interesting, and Bernstein has enjoyed a front row seat through his career initially as a successful investment manager, then as the first editor of the Journal of Portfolio Management, and finally as a top-tier consultant and critically acclaimed author. As with his other books, this is impeccably written and his direct access to all of the subjects in his book brings you much closer to the story.

Although Evolving isn’t a quite a classic like Capital Ideas, it would be unfair to expect as much since it chronicles a slow-burning evolution rather than an explosive revolution.
_______________________________________________________

Recommendation: Buy

Capital Ideas Evolving
By: Peter L. Bernstein

John & Wiley & Sons, Inc., Hoboken, New Jersey 2007
First Published: 1993

ISBN: 978-0-471-73173-3

Daily Insight

U.S. stocks erased the gains of the previous two sessions as even additional declines in the price of oil failed to offset housing/financial market concerns. Yesterday it was a Barron’s article that raised concerns over the two GSEs Fannie Mae (FNM) and Freddie Mac (FRE), although much of the piece offered nothing new.

I’ve got my issues with Barron’s, and to be honest besides this piece I haven’t read the source in a couple of years simply because I found it a waste of time – personal opinion. But what I fail to understand, regarding the entire GSE capital raising discussion, is why the government would cause harm to the preferred shareholder – which is a hypothetical Barron’s raised in the article.

For one, they would not want to eliminate access to the capital markets, which is what putting these dividends in jeopardy would do. Two, it would worsen the capitalization issues within the banking system as whole – not exactly a desired outcome. Three, why would they change the accounting rules (for those that haven’t kept up on this, it is the hypothetical scenario that the GSEs would have to abide by new accounting rule FAS 140 that would force a capital raise right now) on FNM and FRE at a time when they are currently attempting to bail out the housing market. This would be like performing knee replacement surgery only to then introduce the patient to Shane Stant.. It doesn’t make much sense.

Bottom line, as we’ve talked about for a long time now, any day with which there’s bad press regarding the financials the market’s going down; to no one’s surprise that trend holds true.

Market Activity for August 18, 2008

Financial and consumer discretionary shares led the indices lower – down 3.58% and 1.75%, respectively. In fact, nine of the 10 major industry groups lost ground yesterday – utility shares being the only group that flashed green, up 0.10%.

We were quiet on the economic front yesterday, but did get the National Association of Home Builders/Wells Fargo index for August, which was unchanged from the July reading.

The index remained at a record low; but hey, it didn’t make a new one. Seriously though, the figure is tremendously low, as the graph below illustrates. A reading under 50 marks most respondents view conditions as poor. As the reading came in at 16 again, there aren’t many that view it otherwise.

The survey, first published in 1985, asks members to characterize current sales as “good.” “fair” or “poor” and to measure buyers traffic as well as to assess the outlook six months from now.


Builders are delaying projects as sales drop and home inventory remains hugely elevated. In the meantime, mortgage spreads continue to widen. For clarity, during normal circumstances the 30-year fixed mortgage yields 150-180 above the 10-year Treasury rate. Today that spread sits at 260 basis points, or 2.60 percentage points higher. The chart below shows what has occurred with this spread – the yellow line represents the spread and thus the higher 30-year fixed mortgage rate than would be the case under normal circumstances.


This morning we get producer prices and housing starts for July.

The producer price index (PPI) will post another ugly reading, expected to show an increase of 0.6% for the month and 9.3% on the year-over-year reading. If that expectation holds true it would mark another acceleration -- the year-over-year reading came in at 6.5% in April, 7.2% in May and 9.2% in June.

While much of this increase is due to risings oil prices for the period measured, I’ve noticed that core intermediate goods (those used in early stages of production and excluding food and energy) have jumped 8.4% over the past 12 months. The market will likely discount this July look at PPI considering the dollar strength and decline in oil of late. However, I’m not sure we’ll get a meaningful trend lower based on what has occurred in this core intermediate good number. We could very well see this rise passed along to the consumer level. Thankfully, we’ve got strong productivity improvements that remain and may quell this effect. The next three months of inflation data will be very important.

On housing starts, we should see a meaningful decline as the June figure was boosted by a change in New York City building codes, which spurred a jump in multi-family construction and overshadowed a slide in single-family units. As home inventory levels remain extremely elevated, it may take several months, if not a full year still, before this reading begins to bounce back and trend higher.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks added to Thursday’s gain, rounding the week out on a positive note as the dollar completed a two-week rally and crude moved lower in six of the eight sessions of that fortnight. Again, consumer staples and financials led the way. These are the industries that present the largest concern, and thus they move the most based on wavering investor sentiment. A stronger dollar and lower oil price reduces concerns over the consumer as they are already hit by a housing market correction.

Consumer staples and industrial shares also provided the benchmarks with a boost on Friday. Industrials are enjoying a very nice machinery-orders trend and overall increase in business spending of the past three months – the S&P 500 index that tracks these shares has bounced 10% from the mid-July multi-year low.

Market Activity for August 15, 2008

We’ve talked about how the market is stuck in a trading range as uncertainties over tax rates, housing, inflation and geopolitical risks (now Russia throws another risk in as they attempt to gain control over the Tbilisi pipeline and Eastern Europe as a whole, if allowed). The broad market moved to a new, lower trading range in July but we have bounced nicely from those lows as the dollar/oil trend has offered a concrete boost.

The chart below shows the 22.38% decline from the October 9 all-time high and the 6.85% bounce from that July 15 multi-year low. The shaded area (it’s tough to make out, but it’s lightly shaded in green) illustrates the trading range that formed prior to moving below 1275 on the S&P 500 in July.


From a longer-term perspective, there are many attractive buys out there as an abundance of stocks trade below the market multiple, yet offer market-beating earnings growth. As we have to deal with a bevy of uncertainties at the present it makes for a frustrating time to be invested in stocks. However, whether it takes six months or two years, at some point stocks are going to rebound in strong fashion, in my opinion. While the S&P 500 is up 72.2% since March 2003 (10.5% annualized), the index is essentially flat going all the way back to August 2000. While the market struggles with the uncertainties mentioned above, these risks will eventually wane. (We’ll note that mid and small cap stocks are up roughly 6% and 5% at annualized rates, respectively over the past eight years.)

Outside of geopolitical events, my chief concern is what will happen to tax rates across-the-board. But any mistakes in this regard will lead to a reversal as the House comes up for election every two years. Further, the fact that most developed countries are pushing tax rates lower, it will become quickly obvious (if not painfully so) the decision to raise rates here at home is the wrong prescription.

On the economic front, New York manufacturing conditions improved mildly as the Empire Manufacturing survey advanced to +2.8 – the first positive number for the index in three months. A reading above zero marks expansion, as opposed to the ISM and Chicago manufacturing surveys where it takes a reading above 50 to mark expansion, just for clarification..

However, some of the sub-indices within the report deteriorated as the new orders index fell to -2.2 from 8.3 in July and the shipments index fell to -0.9 from a strong 13.5 reading last month.

Inflation pressures remained elevated and the future prices received index jumped to a record.

On the bright side, the employment index improved, even if it remained below zero. Expectations of business conditions six month out jumped 19 points to 34.6.

In a separate report the Commerce Department reported industrial production rose for the second-straight month in July, increasing 0.2%.


Production of machinery (up 0.7%) and business equipment (up 0.8%) led the figure higher. Even when we exclude motor vehicles and auto parts, as vehicles and auto parts were up a large 3.6% in July simply because the American Axle strike came to an end a couple of months back, the reading remained positive. (Since unit vehicle sales remain weak, one should not expect this segment to help out over the next few months, so the ex-vehicle/parts reading becomes important to watch.)

Many were expecting electrical utility output to lead the production reading higher, but this segment actually declined 2.3% -- which is unusual for July. It is quite telling that the overall, and that ex-auto reading, advanced even with this segment –which accounts for 10% of the total – declining significantly.

Have a great day!

Brent Vondera, Senior Analyst