Daily Insight

U.S. stocks endured the second 3.00%-plus down day this week as investors are faced with the same concerns that have plagued the market for three weeks now – frozen credit market, the delayed passage of the Treasury’s rescue plan and the likely affect this has had on both the domestic and global economies.

Of the 10 major S&P 500 industry groups, four took a substantial beating – basic materials (-7.67%), industrials (-6.72%), energy (-5.29%) and technology (-4.23%). To no great surprise, all 10 ended the day lower, the best performers being those that traditionally perform well in a down market – health care (-1.12% and consumer staples (-1.10%).

I will add, and we understand it’s tough to see through the fog of pessimism and credit-market troubles, that the market as a whole (as measured by the NYSE Composite) trades at a multiple that is very attractive from a multi-year perspective. Sectors such as industrials, energy and technology are screaming cheap. But patience will be needed for some time still.

Market Activity for October 2, 2008

Credit markets tightened up further yesterday and the develops of the past two weeks, which began when Lehman went down on September 15, have caused corporate short-term borrowing to shrink – this has been the case for several months but the degree of the decline has increased . Commercial paper outstanding tumbled $94.9 billion, or 5.6%, to a seasonally adjusted three-year low of $1.6 trillion for the week ended October 1, according to the Federal Reserve.

Credit is the life-blood of the economy – our economy is all about creating capital and channeling in to where needed. The capital is there – not that much has been created over the past year, but trillions in wealth has been built over the past several years – fear is currently blocking this capital from getting distributed to the areas that need it.

This is what occurs when we’ve had years of mistaken Fed policy and the abandonment of risk-management that followed. When this occurs, the desire to take risk swings from one end of the spectrum (grab all the risk you can) all the way to the other (except none of it). But fears wane and the risk-taking comes back to the middle in time.

In the meantime it is essential to get the Treasury plan approved and signed. And in my personal view it’s time to eliminate, or at least suspend, mark-to-market accounting that is making the situation much worse than it otherwise would be – the rule fails to even make a distinction between noncash-generating assets like equipment and cash-generating assets like securities.. (We’ll note again, FASB rule 157 – mark-to-market – grants the SEC authority to suspend the rule – do it!)

The dollar continues to rebound and has moved through the 80 level, as measured by the Dollar Index, as the ECB (European Central Bank) will be forced to cut rates. They held their benchmark rate unchanged yesterday but the financial crisis has reached another level in Europe and ECB President Trichet acknowledges the risks to growth are mounting even as inflation remains higher than he would like it.


Commodity prices continue to plummet on fears credit issues will substantially slow global growth. We don’t play the game of trading, but simply for illustrative purposes notice how the 50-day moving average has screamed through the 200-day – when a short term average moves through a longer term average it normally means there’s more room to fall.


On the economic front, the Labor Department reported initial jobless claims rose 1,000 to remain at the elevated level of 497,000 – a seven-year high and too close for comfort to the major psychological level of 500,000. Certainly the biggest housing correction in a long time has had a large effect on the figure, but the financial turmoil of late has clearly done additional harm.

There is a silver-lining, however. Much of the rise in claims over the past couple of weeks has been result of Hurricanes Gustav and Ike. For this latest data, the Labor Department states 45,000 in new claims resulted from the havoc created in Louisiana and Texas – more than two million people were evacuated from eastern Texas alone. So if overall claims rose 1,000 even as 45,000 new claims resulted from these weather-related events then there must have been some nice reductions in other states – and yes,36 states and territories reported a drop in claims. Among the 17 states that reported a rise in claims – outside of the Hurricane effect – the damage was due to intense auto industry woes.

The four-week moving average jumped 12,000 to 474,000 in the week ended September 27. We may see this measure ease in the coming weeks as weather-related damage to the figure wanes. Still, this morning’s September job report will likely be the ugliest we have seen thus far in this nine-month labor-market contraction.


In a separate report, the Commerce Department released factory orders for August, which mirrors what the latest durable goods orders and manufacturing data have shown – orders for big ticket items, specifically on the business side (capital spending) have abruptly changed course.

Factory orders fell 4.0% in August and ex-transportation orders were down 3.3%. With the exception of computers and electronics, which jumped 2.0%, every component was down.

Business capital spending fell 2.4% according to this report after the segment had been on the rebound over the previous few months. One hopes the decline in overall factory orders is more a respite after five months of solid gains, but hope is worthless without action. It is difficult to imagine a bounce back when the September data is released due to Wednesday’s weak manufacturing report and significant troubles within the credit markets that have begun to hit small businesses especially hard.



Have a great weekend!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks closed lower Wednesday as the credit markets remained disturbingly locked up, but the major indices recovered from the session’s lows as confidence grew the Senate would pass a “rescue plan” bill that may kick the House into gear to do the same.

Six of the 10 major industry groups lost ground yesterday -- industrial, basic material and information technology shares were hit the hardest. Financials, consumer staples, utilities and telecom shares were the gainers. The 2.15% gain among financial stocks is what held things up. Shares of Bank of America (up 8%), JP Morgan (up 6%) and Citigroup (up 12%) accounted for 68 Dow points – without the jump in these three members the index may have been down triple-digits.


Market Activity for October 1, 2008
And the Senate did pass a bill that has the TARP plan as its primary focus last night by a decisive margin of 74-25. Of course, the bill includes things that have nothing to do with the situation at hand, but that is Washington. However, it does include the extension of certain tax breaks and credits, an AMT patch, an increase in FDIC insurance to $250,000 and reiterates the authority the SEC has to suspend asset-valuing rules (mark-to-market accounting) that has exacerbated the problem to one that was manageable to one that has become a never-ending loop.

Now this moves to the House and I think the AMT patch is probably the component that gives the bill the best shot of passing – no one is going to want to vote against that. We’ll be watching to see what Congressman Shadegg says today, because he’s a very important member of the House and brings many along with him.

We’ll also point out that there’s a shot that this plan will work faster – and when I mean faster we’re talking about getting these assets sold off and resulting in a relatively quick return to the taxpayer (the Treasury Department). There will be an auction process (something the government is quite good at) that will set a price for these assets and once the Treasury take control and a price, or market, has been set we may find firms flow in to buy up these assets as they see the longer they wait the higher the price to acquire them. This would mean less money is made by the Treasury, or it may result in a loss, but it gets the program completed in short order and the cost won’t be anything close to the $700 billion everyone is focused upon. (I do not want anyone to think this commentary sets an expectation that this will occur, I just bring it up as a decent possibility. Further, if the House does pass this thing on Friday, the credit markets will not ease overnight. This will take some time, but the first step is necessary to take right now.)

From there we must concentrate on what got us here, starting with monetary policy mistakes and the Keynesian models that drive the FOMC, causing the Fed to lower fed funds to 1.00% in June 2003 even as the economy began to boom. (One can simply go the Federal Reserve website and read their minutes, they saw the economy rebounding, but simply because employment didn’t begin to bounce back by that point – as if this occurs on a dime anyway – they eased further.) It is these low rates – kept at 2.00% or below for three full years – that encouraged much of what we are now working to correct.

In addition, failure to pass more appropriate regulations on mortgage GSEs Fannie Mae and Freddie Mac certainly didn’t help. This was tried, but it was blocked. And as we’ve discussed many times the Community Reinvestment Act, specifically changes that took place in the mid-1990s – referring to subprime lending and hostile/politically fueled use of the term “redlining” --, has also contributed. Rounding it out are accounting rules that have only done harm. All of these things must eventually be addressed; a move in a different direction – as some are suggesting -- will only lead to more unintended consequences down the road.

Yesterday’s Data

On the economic front, the ADP employment report fell 8,000 for September – this is a preliminary number the market looks to for a sense of what will occur within the Labor Department’s monthly job report. This reading was much smaller than expected as a figure of minus 50,000 was the estimate.

ADP noted that the report does not include the Boeing strike (37,000 machinists) or the effects from Hurricanes Gustav and Ike. Then again, the Labor Department’s strike report showed zero workers for September so Friday’s jobs report won’t reflect that either – the September revision or the October data will reflect this. Surely, the Labor Department’s data will reflect the effect of the Hurricane’s.

Overall though, the ADP readings have not been a good indication over the past couple of years and I wouldn’t be surprised to see the figure dropped as something the market looks to as an indicator Specifically over the labor market contraction of the past nine months, the ADP readings have averaged a gain of 2,000 jobs per month, while the Labor Department’s figure has that monthly average at minus 75,000. Not a very good indication to say the least.

In a separate report, the ISM (Institute for Supply Management) Manufacturing Index fell to 43.5 – a level that reflects significant weakness. This reading marked the lowest level for ISM manufacturing since October 2001.

Heretofore, the manufacturing sector has held up remarkably well considering the double whammy of housing and auto-sector weakness. But it appears that business spending weakness in September has taken away much of the offset to those well-known areas of contraction. (While I was expecting a better ISM reading, we did point to the weakness in business spending in yesterday’s letter that has occurred suddenly. Part of this is due to the direct effects of the credit market trouble with regard to small businesses and the indirect effect regarding large businesses as the situation has increased their level of caution.)

Overall, I believe this can be transitory event as there is decent likelihood businesses are taking a wait and see approach right now. If the credit markets are freed up in quick order, the manufacturing sector will bounce back to something close to or mildly in expansion territory. If not, we will likely see this sector endure several months of meaningful weakness.


Below is a look at some of the sub-indices within the report:

Production was affected by weak metals, machinery and electrical equipment orders, segments that had shown strength over the previous few months. Still, the degree to which production declined is puzzling considering the strength in the Chicago PMI (factory activity in that region).


New orders were down big. Again, I believe this could prove transitory, but depends on the credit markets, and hence the TARP bill passage or elimination of mark-to-market death spiral.


Export orders remained in expansion mode even with European economic weakness of late.

The prices paid index fell substantially, which is quite different from other manufacturing reports and general inflation gauges. The drop in ISM prices paid was due to a 41% plunge in scrap steel prices in the past month.


Lastly, the Commerce Department reported that construction spending came in flat for August – beating the expected 0.5% decline. Although, the July figure was revised lower to show twice the weakness as initially estimated so the two-month look isn’t a good one.

Private residential construction outlays have fallen 27% on a three-month annualized basis – faster than the 15% decline in the second quarter – so housing will again place a significant drag on Q3 GDP. You may be saying, “no kidding,” as if this wasn’t known. I bring this up because housing’s drag on last quarter’s GDP was only half what we’ve seen over the past couple of years, which gave some hope that a flattening out may take place soon. The housing data of late is showing this is a misguided hope.

Now private non-residential spending has shown weakness of late after providing a nice offset to the residential side of things for many months – that offset is over in my opinion. Construction spending is going to remain weak for some time – outside of a catalyst to boost the economy.

In addition to all of this credit-market stuff, and the government proposals to unclog the capital distribution channels, we need to seriously consider a broad look at tax rates. Eliminating or vastly reducing the repatriated tax and lowering the corporate income tax (not to mention cap gain, dividends and labor income rates) can reverse this course and lead us out of the current funk. I realize this may be unrealistic in the current political climate, I’m just stating these actions would provide a big boost to economic growth, the stock market and capital formation – which eventually flows through to construction activity.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks rebounded yesterday – recovering roughly 60% of the prior session’s losses -- as expectations increased that Congress will find the votes to pass the rescue package, there was actual talk of modifying mark-to-market accounting rules and the FDIC is looking to temporarily boost deposit insurance and thus confidence.

Naturally, financial stocks led the gains, jumping 13.09% as measured by the S&P 500 index that tracks these shares. Energy, information technology and industrial shares accounted for the other stellar performers – energy shares jumped 5.80%, tech was up 5.40% and industrials gained 4.23%.

Market Activity for September 30, 2008

The third quarter came to an end yesterday and one may think the declines endured by the benchmark indices were the worst in quite a while, but they weren’t as the past year has been a rough one coming off of the all-time high hit last October.

The Dow Industrials Average lost 4.4% during the July-September period, marking the fourth-straight quarter of decline. The S&P 500 declined 8.88%, which followed a 3.23% drop in the second and a 9.92% plunge in the first quarter of 2008. The NASDAQ Composite fell 8.77%, but little more than half of the first quarter loss.

Among the major domestic benchmarks, the Russell 2000 (small cap stocks) held up very well, falling just 1.46%. The S&P 400 (mid cap stocks) got dinged for 11.20%.

The main international index was thoroughly hammered – down 21.05% during the Q3.

Senate Minority Leader McConnell offered some very encouraging words yesterday, stating they intend to pass legislation – speaking of TARP – and will pass it on a bipartisan basis. At least the Senate has heard Monday’s market message.

We even heard rambling of at least modifying accounting standards away from the pure mark-to-market basis that has proven so pernicious – although one shouldn’t count on this even if it makes as much sense as anything proposed thus far.

Further, FDIC Chairman Sheila Bair, by far the most accomplished player in all of this, announced she is seeking authority to temporarily increase the insurance limit from $100,000 in order to increase confidence. This is important not just for individuals but for small businesses that hold accounts for payroll purposes.

Now we seem to be getting somewhere.

Short-term Economic Outlook

Despite this encouraging news, one has become conditioned to refrain from excitement. You really have to ignore a few years of actions to have any confidence in this group – speaking of Congress – and every day that goes by without the passage of TARP, or some alternative that would be as effective, is another day the credit distribution channels remain blocked.

It is amazing how quickly things have changed. What looked like a 2.0% real GDP third quarter just three weeks back now may turn out to be flat. Credit is in the process of drying up for many small businesses and the costs have risen for those that still have access. For the consumer, those with a top-tier credit score have zero problem receiving a loan, but for anyone else it will become more difficult by the week.

Business sales continue to perform well, but I’ll be very interested to see the August reading, which likely took a substantial hit. And this entire development has caused businesses large and small to become even more cautious – business-capital spending, which was rebounding in strong fashion, looks now to have ceased.

We should not forget that Hurricanes Gustav and Ike will have caused their own damage as Gulf of Mexico energy production was shut down for a couple of weeks, among other things.

All is not terrible. The manufacturing sector remains amazingly upbeat, productivity improvements remain stronger than anytime in history, and personal income growth continues along a healthy pace even if persistent inflation has caused real incomes to flatten out. But we must do something to unlock the credit markets, which are very blocked, and change insane accounting rules that force the financial services industry to endure a death spiral that has forced the hoarding of cash.

Yesterday’s Data

On the economic front, the S&P Case/Shiller Home Price Index showed that home-price declines accelerated in July as the 20-city composite showed a 16.35% drop from the year-ago period. The relative good news is on a three-month annualized basis the declines did ease from 10.03% in June to 8.56% in this latest report.

However, this index has a large lag to it – we are talking about July data here – and from what we’ve seen with the new and existing homes sales figures for August we wouldn’t expect any positive trends to continue in the short term.

As we point out each month, this index does exacerbate the declines as it does not give a very broad look. Yes, it does cover the largest 20 metro areas but there’s a lot that is missed. Further, nine of the cities covered have witnessed the largest prices declines in the nation and that is greatly affecting the overall reading. For instance, Detroit, Tampa, LA, San Diego, San Fran, Phoenix, Washington DC and Miami have posted price declines of between 16% and 30%. In fact, LA and San Fran, which make up 23% of the composite, have registered home price declines of 25% over the past year.

When we average all of the home price data – which covers four main indices including the Case/Shiller -- we see home prices have dropped roughly 8% from over the past year.

In a separate report, the Chicago Purchasing Manager Index (PMI) registered a reading that remained upbeat in September as the survey came in at 56.7 -- a number above 50 illustrates expansion. This is a good sign as the Chicago region represents the largest manufacturing base. We’ll get the national look at the factory sector tomorrow as the ISM report is released. Since Chicago posted a healthy reading it should assure that ISM remains right around the 50 level.

In terms of the internals (the sub-indices of the report), they looked good and point to continued expansion – although with what has occurred in the credit markets doubt has increased.

The production index jumped to 71.4 from 63.4.


New orders fell to 53.9 from 60.2, yet remained in expansion mode.


Order backlogs slipped to 54.9 from 63.0, but again remains nicely in expansion mode.


Unfortunately, the prices paid index remains elevated, which corroborates what various other inflation gauges have shown.


This morning we get the ISM Manufacturing survey for September (the national look at the factory sector) and August construction spending. It is likely ISM held up reasonable well, but the construction number will post a weak reading.

After today, we’ll be looking to Friday, as the September jobs report is released. We’ve endured eight months of declines, but the job losses have been mild relative to the typical period of labor-market weakness.

The concern though is this credit situation. Small businesses (the engine of job creation) have likely been the hardest hit by this reality and this may cause job losses to deteriorate over the next few months. Anyone that thinks the TARP plan is nothing but a life-line to Wall Street is unfortunately unaware of the flow-through effect. If an effective plan is not put in place the employment numbers will get worse, and I believe more people got a sense of this after the stock market sent its message on Monday.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

Rejected!

U.S. stocks plunged yesterday – marking the steepest one-day decline in the S&P 500 since the 1987 crash – after the House rejected the $700 billion plan to unlock the credit markets and keep this situation from becoming an all-out seize up of the financial system. The NYSE Composite Index lost twice that amount yesterday -- $1.5 trillion.

Many wondered what would occur if this bill were blocked, and we’re finding out the market didn’t like that decision very much. We got a sense of this after allowing Lehman Brothers to go down; we now know it would have been better to put them into Conservatorship as well. The day Lehman went down is when the credit markets locked up, and led to AIG’s demise. Fact is the entire financial system is intensely interconnected due to the $60 trillion in derivative contracts. Mark-to-market accounting exacerbates the situation as troubled assets are written down further as these derivatives fall in value – hence the cash hoarding by financial institutions.

While the stock market gets all of the attention, and days such as yesterday are certainly unpleasant events, a decline of this magnitude is not significant over a longer-term perspective – besides this is what markets do on occasion. What is occurring in the credit markets is the main issue at hand; besides, until the credit markets normalize the stock market cannot stage a sustained upswing. The bill to take troubled assets from balance sheets, replace them with capital and sell these assets off in an orderly way is pretty vital to the financial system right now. I assume the members of Congress are getting this message as we speak. I assume all of those calls demanding not to support this bill have reversed course after yesterday’s market message.

Market Activity for September 29, 2008

And allow me to stop for a moment just to put these types of down days in perspective. While I say this is more about the credit markets than the stocks market, the latter is the one that gets the attention and has the most affect on individuals as 60% of the country owns a 401(k) account. Not that it may register very well on a day like yesterday, but we find it appropriate – after a one-day decline of 8.8% -- to illustrate what a one-day shellacking that is nearly three times worse (the 1987 crash) looks like from a long-term perspective.

Below is a 25-year look at how diminished a 20% crash becomes over time. (As an aside, nice double-top there by the way. This is what occurs when stocks go gangbusters as they did in the latter-half of the 1990s, it takes a while to revert to the mean. But over the past several years after-tax corporate profits have significantly outpaced the increase in share prices – up 109% for profits vs. 40% for stocks -- and this sets up for a strong multi-year run.)


And if 25 years is too long for some, here is what the same decline looks like over a 10-year period – the 138% rise over this period does minimize what was a chaotic day back in 1987.


Back to the bill though, it is unacceptable that Congressional leaders on both sides do not have the clout or ability to persuade lawmakers. Of course, the market has taken over as the lead negotiator.

One-hundred and thirty-three Republicans voted against the measure and 95 Democrats shot it down as the bill was blocked 228-204. One has to assume that the TARP is dead, you never know, but that’s what I’m assuming. To get more Rs to g for it, you’ll lose Ds. To get more Ds you’ll lose Rs.

I wouldn’t be surprised to see the Democrats come back on Thursday and pass their version of the bill. Of course this will include another Keynesian-style rebate check scheme, cramdown (allowing bankruptcy court judges to determine loan interest rates) and demanding union members be included on the boards of firms that participate in TARP – these are the things they tried to push into the bill last week. That’s a no go. And for the Republicans, they want to set up some insurance fund for these troubled assets, which I believe would be ineffective for the current situation.

On the bright side, maybe it was saddled with too many restrictions that may have been met with limited participation and we’ll get something better as result. I will state though we didn’t see much good that could come from dragging this bill out – not with these people around, and now we see how the game-playing certainly did not help things.

Moving to the credit markets, the Federal Reserve announced a large increase in its size of the 84-day TAF (Term Auction Facility, or one of the Fed’s tools to inject liquidity that we would prefer over jacking fed funds lower) to $75 billion from $25 billion. This increase will raise the supply of 84-day TAF to $225 billion from $75 billion. Total TAF credit (both 28-day and 84-day) will be increased to $300 billion from $150 billion.

The chart below is one indication that banks are hoarding cash and thus effects credit availability.


The yield on the three-month T-bill hit 35 basis points (one-third of one-percent) yesterday; nothing else explains more clear the level of fear – the massive move to the safety of the Treasury market has been stunning. In fact, the 10-year Treasury note yields just 3.63%. Too bad Congress failed to pass TARP. They could have borrowed the funds needed at sub-4% and over time paid back the Treasury at least what it cost. And this doesn’t even take into account the cashflows that run off of these assets.

Enough of that though; we must get serious. Didn’t like the $700 billion TARP, hey? Ok, here’s the solution. The president needs to come out and say we are moving forward by eliminating the mark-to-market accounting rules that were implemented in November 2007. The new standard will be to a net present value basis that discounts the cashflows of these assets. Or, at the least a five-year rolling mark-to-market – as some have suggested. Hand the SEC Chairman a pen and tell him to sign it. Done.

At the same time eliminate the repatriated tax (the 35% tax levied on foreign income made by domestic institutions when this capital is brought back into the U.S.). It’s an economically inane law anyway. This will bring an enormous level of capital bank into the country. Further, if needed, eliminate the capital gains tax on assets that currently find no bids, such as these CDOs that are clogging the system – this is an idea we raised six months back.

The elimination of mark-to-market (FASB rule 157) does not depend on Congress. This will buy time, as it’s a game changer, for banks while Congress fights it out over the repatriated tax and capital gains tax on troubled assets.

Moving along to yesterday’s economic data

On the economic, the Commerce Department reported personal income rose 0.5% last month and spending was unchanged. The personal consumption expenditures (PCE) index -- the inflation gauge tied to the personal spending report -- showed inflation remains sticky even with energy’s huge move lower. For those readers that understand inflation is a monetary phenomenon you’re surely not surprised.

Let’s look at this data one by one:

The 0.5% rise in personal income last month is a good reading as it was propelled by wage and salary income – a very nice thing to see. Rental income, dividend income and interest income also posted healthy results. Proprietor’s income showed a 0.8% decline last month and this corresponds with what has been hurting the jobs figures of late – after several years of big gains in self-employment we’re seeing the persistence of the housing downturn take it toll on this segment.

From a year-over-year perspective, incomes are holding up much better than we had anticipated. They are being harmed by current levels of inflation, but with the labor market weakness – even though the monthly job losses are relatively mild as we keep discussing – these figures are quite remarkable. Total compensation is up 4.1%, wages and salaries are up 4.2%, dividend income has grown 8.1%. Personal income as a whole is up 4.6% and disposable income (after-tax income) is up 4.8% since August 2007.

On spending, it came in unchanged for August after rising 0.2% in July. The level of real personal consumption (referring to the segment of consumer activity that shows up in GDP) stands 2.7% below the average for last quarter. As we’ve mentioned a couple of times now, consumer activity will remain weak for a couple of quarters and this data backs that up. A decline in employment and lower asset prices are just too much and are affecting the consumer.

On the inflation gauge, again the PCE index, this corroborates what other inflation indicators have suggested – inflation remains sticky and has at least become partially embedded.

The PCE rose 0.2% in August, and from the year-ago period barely budged, coming in at 4.5% after a 4.6% reading for July. The core rate, which excludes food and energy, actually accelerated to 2.6% from 2.5% in July.

The Fed has based their inflation expectations on two things – both are flawed Keynesian models.

One, their Phillips Curve-type analysis tells them that simply because the unemployment rate has risen that inflation must come down. This is not a tautology just as the view that inflation must rise simply because the unemployment rate dropped to a certain level is not a given.

Two, they bet that the price gauges would decline along with energy prices. This has not occurred either. Money supply – whether we look at MZM (money zero maturity) or M2 (which includes bank demand deposits) is growing much faster than output, or nominal GDP. This is inflationary. Now, the growth in these money supply measures have eased over the past three months, but one cannot expect this to effect inflation on a dime. Hopefully it will help to ease price pressures a few months out.

For now, the Fed obviously has other issues and providing liquidity to mostly frozen credit markets is their chief priority currently.

This morning we get the latest manufacturing survey from the Chicago region and the S&P Case-Shiller Home Price index.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ended mixed on Friday as the S&P 500 gained some ground, yet the NASDAQ Composite failed to close on the plus side as shares of RIMM, Apple and Google weighed on the index. The Dow Industrials jumped 121 points as shares of Bank of America and JP Morgan – well-run institutions that have been able to buy assets on the cheap – propelled the move. Those two stocks accounted for nearly half of the Dow’s advance.

Well, what we’ve all been waiting on – passage of TARP – appears ready for a vote today and we should get the plan signed over the next couple of days. The equity markets don’t seem to be interested in applauding the development though as index futures are down big this morning.

The stock market has been very patient as Washington plays politics with this plan. The fact that this plan is focused to deal with some very serious stuff – credit markets that are very clogged up and threaten to do serious economic harm – it’s too bad we have this game playing. Maybe this is what stocks are finally sending a signal over. Maybe the weakness is simply a result of quarter-end window dressing by mutual-fund managers to give the appearance they were heavy cash in this weak market, or to reduce their positions in what was hot, and certainly now is not – energy and commodities. Maybe it’s over the Wachovia development. I don’t know. What we do know is the market is going to open down according to futures.

Market Activity for September 26, 2008

What I really love though is how McCain and Obama are acting as though they bolted over to the Capitol to save this whole situation and forced Congress to pass a better bill. That’s a joke.

Then we have Speaker Pelosi and Congressman Frank. Listening to their comments yesterday was also entertaining, although sad, as they don’t seem to really get the magnitude of the situation. Apparently, they chose to play up for the election and blame this entire event on de-regulation. We’ll point out that the two industries that have been hardest hit by this mess – housing and financial services – are among the most regulated industries out there.

Want to place blame? It is about time we begin to focus at the origin of this situation – Federal Reserve monetary policy mistakes – and that which has exacerbated the problem – FASB Rule 157, “mark-to-market” accounting. You can also add on bad legislation such as the Community Reinvestment Act and Congress hauling banking executives up to Capitol Hill in the 1990s to all but call them bigots for not providing loans to lower income/poor credit score individuals. Now these same politicians castigate the financial industry for doing just that – hence much of the sub-prime problem.

In terms of the proposal, it increased from the four pages that Treasury Secretary Paulson laid out 11 days ago to 110 pages by Saturday night, which is why we’ve been arguing for some speed here as time only gives Washington time to stuff the bill with a bevy of social programs. I will say though it could have been much worse. The executive compensation provisions for those participating in the plan are not austere and House Republicans forced the elimination of a provision to devote 20% profits from the plan to an affordable housing fund. This means ACORN would get that money – and those familiar with this group will understand the importance of this elimination.

Public Angst over the Proposal

We keep hearing how the public is so against this plan. Well, of course they are as it has been presented in exactly the wrong way. When Paulson and Bernanke use terms like “bailout” and figures as large as $700 billion it’s no surprise taxpayers grab their wallet to make sure it’s still there. But this is not a bailout. It is an investment in assets that have a higher intrinsic value than the currently distressed market for these securities is valuing. In fact, there really isn’t a market for much of this stuff anyway, which is why a plan to remove these assets from balance sheets will help to unfreeze the credit markets.

For now, anyone with a 750-plus credit score can access credit in a heartbeat. You want to finance a care purchase? Done. And the cost of money is close to zero. Want to buy a house? No, problem. But the risk is if the credit market remains this clogged – banks continue to hoard cash for fear additional write-downs will affect their capital adequacy ratios – even these top–tier borrowers may be affected. And more importantly, there are many small businesses out there that use credit lines to meet payroll, or buy inventory. These credit lines are in jeopardy of being squeezed and of this credit situation persists, even those who have managed their lives responsibly will be harmed. These are some things that should have been explained.

Further, the entire $700 billion may not even be necessary, as maybe $350 billion is enough to stabilize the market. And even if it takes the entire $700 billion, over the next 5-7 years the Treasury will likely net money off of this deal.

Moving on

On the economic front, the Commerce Department reported real GDP was revised down to 2.8% at an annual rate in the second quarter from the previous estimate of 3.3%. The reason for the lower revision was because personal consumption and net exports (the two catalysts to Q2 growth) were revised down. Inventories were also a larger drag than the previous estimate showed.

Looking to the current quarter, it was shaping up to give us a 2.0% growth quarter (that’s in real terms at an annual rate). Consumer activity was going to be weak, but business spending had rebounded very nicely and the production needed to rebuild low inventory levels looked able to offset this consumer weakness. However, with what has occurred of late – specifically the credit market bottleneck – business spending has reversed the encouraging trend of the past three months and residential fixed investment (housing), which looked much better in the second quarter, will be another big drag to growth for the July-September period.

It is still too early to call current quarter GDP, but if the credit markets are not unlocked quick, it will be quite negative.

For several quarters now we’ve heard from the financial press that consumer activity has been weak – the consumer is “tapped out” as they love to put it. Well, we’re headed into a period where the press will see what weak consumer activity actually looks like – the press is so clueless – and if the business side (capital spending) doesn’t show the August figures to be just a respite – the third-quarter GDP figure will not be a good one.

We’ve got a lot of challenges facing us – both endogenous (domestic economy) and exogenous (geopolitical risks) – the latter was true before the credit market locked up; the former really was not.

The only way to meet these challenges is through growth. I know tax-cutters/supplysiders are gun-shy right now with all that is going on but they shouldn’t be. Proponents of lower tax rates should invite the argument from all of those that want to blame the current situation on lower rates, those with the facts can crush this flawed belief.

The best way to revive things right now, outside of doing what is necessary to free up the credit system, is by reviving the stock market. The quickest way to accomplish this is to drive the capital gains rate down to 5% and the corporate tax rate to 20%. This will spark a renewed optimism and confidence, two things that are desperately needed right now, and we can avoid a downturn, maybe a deep one, as a result. We have people proposing higher tax rates, this will not boost tax revenues – kind of difficult for tax receipts to rise when the economy is held back by lower after-tax profits and returns. Lower these rates and tax receipts will boom. Investors will unlock investment they have been unwilling to sell due to capital gains confiscation and increased after-tax profit growth will funnel right to jobs, increasing the tax base.

Looking Ahead

Stocks will have to endure a period of intense uncertainty, and some of this uncertainty may result in a negative outcome.

However, the housing market will eventually flatten out and then slowing return to normal. The question over tax policy may be answered over the next month as the election takes place – assuming it is not too close and thus dragged out for a month as we count and recount votes. The TARP plan will help the economy avoid a crisis situation and if the operation of this plan is not damaged by political meddling the Treasury will be able to pay back what it borrows and then some.

As these issues wane, stocks are set to provide very nice returns over the next several years. No, we should not expect 15% annualized returns. Those days are gone, and it is a good thing because those levels are not sustainable and lead to years of weakness as the market regresses to the mean. But we’ve got a really good shot of 10% annualized returns over the next several years once we get the realities that follow years of poor risk management behind us.

We believe there is a strong likelihood industrial and technology shares present some great long-term opportunities – don’t mistake this for a walk from diversification; everyone must remain diversified and participate in each of the major sectors and asset classes, I’m just laying out where the potential looks the brightest.

The financial services sector has led the economy for more than a decade, but as independent broker dealers have either been gobbled up by commercial banks or the market forced this upon them as internal funding via deposit bases is the way of the future, leverage is going to move from 30-to-1 to something closer to 10-to-1. This means less growth for the industry, but a more responsible and sustainable growth. As this occurs, the more traditional forms of growth will once again lead the way and this means industrials and technology.

Have a great day!


Brent Vondera, Senior Analyst