Daily Insight

The S&P 500 made a run for positive territory several times yesterday but to no avail, until the final push of the session moved the broad market fractionally to the plus side; the Dow and NASDAQ Composite managed slightly more substantial gains.

A strong manufacturing report out of the Chicago region appeared to do more harm than good as it led to some speculation the Fed will withdraw stimulus measures sooner than previously believed. I don’t know how many times Bernanke & Co. have to explicitly state that they’ll keep monetary policy floored for a while still, but we remain in this what’s-bad-is-good environment (bad is good because it means the easy money trade rolls on) so I guess the reaction, stocks struggling to move higher on a strong report, shouldn’t be terribly surprising.

Tech was the leading sector on the session; consumer discretionary shares the worst performing group. The 10 major sectors were spilt, with five in the green and five in the red.

The seven-year Treasury auction was well–received, as the rise in yields of late seemed to support this week’s $118 billion in debt sales.

We’ve got one session left before getting this decade in the market behind us. The S&P 500 has fallen 23% since the end of 1999 (that’s on a simple-price basis, not including dividends), the first decline for a decade since 1930-1939. Including dividends, the index lost roughly 10% since 1999 (0.9% per year), the first negative annualized return over a 10-year stretch in the index’s history, which goes back to 1927, according to S&P’s Howard Silverblatt.

Market Activity for December 30, 2009
Chicago Purchasing Managers Index

The Chicago PMI (a gauge of manufacturing activity from the nation’s largest factory region) jumped to 60.0 in December, the highest level in nearly four years, from 56.1 in November. The reading easily surpassed expectations, which had the figure slipping to 55.1. The Chicago region is the main factory corridor for the auto sector, so vehicle assemblies to restore what have been low inventory levels for this segment of manufacturing was likely the catalyst. Chicago does involve a good level of electronic-goods production also, the holiday shopping season surely played a supporting role as well.

Nearly all of the sub-indices of the report looked really good, The new orders index remained hot, hitting 63.5 (highest level since May 2007) after 62.8 in November; order backlogs entered expansion mode for the first time since August 2008, hitting 53.0 after 46.5 in the previous month – this is an important gauge to watch, if it remains above 50 for several months it’s one signal current workers are getting stretched and new hires will be necessary; the employment figure jumped to 51.2 from 41.9, the first move into expansion since November 2007; and supplier deliveries remained at a good level, slipping but just slightly to 56.2 from 57.4 in November – this is another key gauge as a sustained stay above 50 will also signal workers are stretched by new orders.

Unfortunately, the inventory reading remained in contraction mode, but it improved and that is all it takes to offer a boost to GDP. The reading rose to 39.4 from 34.9 – this is a depressed level, remaining below the average since the recession officially began (40.3) and below the average for the decade of 45.9.

So, we now have two of the major regional factory gauges that have posted strong results (Chicago and Philly) for the month of December, while two have shown deterioration (New York and Richmond). Now we wait for the nationwide look at manufacturing via the ISM data, which arrives on Monday. The market expects a reading of 54, which would be good. Chicago is predicting something more, but it hasn’t been the best indicator of late – normally it is an excellent signal for what’s to come from ISM.

Ticking

Last week, I think it was, we talked about the trouble brewing within the Chinese real estate market. Over the past 12 months apartments in Beijing have more than doubled in price and speculators have driven the high-end market up by 55% in the nine months ended September in Shanghai; housing starts have nearly tripled over the past 12 months.

It will be interesting to watch when exactly the Chinese banking bomb blows, they’ve had problem loans on their books for a while but nothing like the problems that arise when their real estate bubble pops. The escalation in Chinese RE prices appears to dwarf what occurred here in the U.S.

One indicator of economies becoming overheated, not a great one for those serious about this issue but interesting nonetheless, is the Skyscraper Index put together by Andrew Lawrence of Dresdner Kleinwort (it follows through on the Skyscraper Indicator, created by Ralph Elliot in the 1930s). The index holds that the impulse to build the world’s tallest structures is a strong indication that an economy is about to run into deep trouble. As Lawrence states, the planning for the Singer and Met Life buildings foretold the Panic of 1907; the Chrysler and Empire State buildings, the Great Depression; the Petronas Tower in Malaysia, the Asian Crisis. The tallest building in the world at the present is the Burj…in Dubai.

Next on the list? The Shanghai Tower, currently under construction. Heads up!


Have a great day and Happy New Year!


Brent Vondera, Senior Analyst

PEG ratio

The P/E ratio (or price-to-earnings ratio) is one of the most well-known valuation tools, but some people neglect to consider the impact of future earnings growth on this ratio.

The price/earnings-to-growth ratio (or PEG ratio), provides a forward-looking perspective and allows investors to compare the relative attractiveness of a stock in the context of the firm’s earnings growth outlook. Similarly to the P/E ratio, a lower PEG ratio means that the stock is more undervalued.

Calculating the PEG ratio is quite simple – divide the P/E ratio by the three- or five-year earnings compound annual growth rate. To better understand how to use the PEG ratio, consider these two technology firms.

• Hewlett-Packard (HPQ) has a P/E ratio of 13.82 and a growth rate of 11.8%
  
• Apple (AAPL) has a P/E ratio of 33.70 and a growth rate of 18.8%
  

Hewlett-Packard is clearly the cheaper company based on P/E ratio alone, but an investor might argue that Apple’s high P/E is justified by its superior growth. Apple has gained a reputation for introducing cutting-edge products and, accordingly, Apple is projected to grow earnings at an annual rate of 18.8%. Hewlett-Packard, on the other hand, is projected to grow earnings at 11.8% rate.

But after calculating both firm’s PEG ratios (Hewlett-Packard is 1.17 and Apple is 1.79) we discover that that Apple’s growth rate, although higher than Hewlett-Packard, does not justify its higher P/E. In other words, Hewlett-Packard’s stock is a better value (even if Apple makes better computers).

As you can see, the PEG ratio is useful for determining whether a firm’s high growth potential justifies their valuation.

--

Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks bounced between gain and loss on several occasions yesterday, but unlike Monday when a late session move higher delivered the broad market to the upside a move lower in the final minutes ended a six-day winning streak. Overall, the beginning of this holiday-shortened week has turned out as uneventful as maybe it was expected to as the last two sessions canceled one another out.

The day’s economic data was really not enough to push stocks higher. The latest housing report showed prices rise month-over-month in October, but it was a negligible gain and too many cities continued to show no durable recovery in prices is yet upon us. The latest consumer confidence reading showed a nice improvement in households’ expectation of the future, but even that reading remains quite depressed and if jobs growth fails to get rolling in substantial fashion a few months down the road, even expectations may get smacked down again. The present conditions index of the report made a new cycle low.

Really the only excitement yesterday was the ubiquitous internet photos of the “Great Balls of Fire” underwear, the clandestine means for the failed explosive device via al Qaeda’s latest human mule.

Seven of the 10 major S&P 500 industry groups closed lower on the session, led by energy and financial shares. The three sectors that gained ground were led by consumer discretionary and industrial shares – consumer-staples being the third of those sectors ending in the black.

The $42 billion five-year Treasury auction went well as the yield was 1.4 basis points lower than the when-issued were trading prior to the auction. The bid-to-cover (gauge of demand) was 2.59, lower than the previous two auctions, but in line with the four-auction average. The indirect bid (gauge of foreign buying) was the worst aspect of the auction, coming in at 44%, down from 60.9% in November and below the 54.2% of the past four auctions. Today’s seven-year auction will be the test for the week.

Market Activity for December 29, 2009
S&P CaseShiller Home Price Index

The CaseShiller HPI (which tracks home prices for the 20-largest metro areas) extended its streak to five months as the measure showed October prices advance 0.37% from the prior month. From a year-over-year perspective, the improvement extended for a seventh month – relative to October 2008 prices were off by 7.28%, which follows a 9.27% decline in September (from the year-ago period).

Nine of the 20 cities tracked registered price declines for October, the same number as last month. Tampa led the declines, where prices were down 1.19% for the month, followed by Chicago (down 0.98%), Miami (down 0.48%), Cleveland (down 0.40%), Las Vegas (off by 0.28% and has never shown an increase since the market collapsed); Boston, NY, Atlanta and Dallas also registered price declines.

For the 11 cities that gained ground, San Francisco led the way (up 1.73%), followed by Detroit (up 1.23%), San Diego (up 1.11%), LA (up 0.69%). Seattle, Portland, Denver, Minneapolis and Washington DC and Charlotte rounded out the positive contributors.

Since hitting its cycle low in May, the CaseShiller HPI has rebounded 3.4%. The current level was first hit in September 2003. Peak-to-date, CaseShiller has home prices down 29.55% -- April 2006 was when prices peaked, according to this index.


Consumer Confidence

The Conference Board’s consumer confidence reading for December improved to 52.9 from an upwardly revised 50.6 (previously reported at 49.5) for November – basically in line with the expectation of 53.0. For perspective, the long-term average is 94.1. The reading averaged 103.4 in 2007 and 60.5 in 2008.

The increase was driven by a nice move within the expectations index (consumer’s view of things six months out), which rose to 75.6 from 70.3. That’s the highest since the recession officially began in December 2007. The cycle low, which is also the all-time low, of 27.3 was touched in February.

The present situation index weighed on the headline reading, slipping to 18.8 (a new cycle low, the all-time low of 15.8 was hit in December 1982) from 21.2 in November. With the present number falling, we’ll have to see a marked pick up in economic activity, and thus job growth, or that expectations number is going to get hammered again.

As we explain each month, the most important reading is the jobs “plentiful” less jobs “hard to get” reading. This is the confidence index’s best indication of future consumer activity trends. The measure made a new cycle low of -46.6 in November, but improved ever-so-slightly in December to -45.7. The all-time low is -58.7, hit in December 1982.

The share of respondents stating jobs are “plentiful” fell to 2.9 from 3.1 in the previous month, but those stating jobs are “hard to get” improved to 48.5 from 49.2, more than offsetting the decline in the plentiful reading.

The readings on plans to buy a car or a home six months out continued to decline. Plans to buy a car fell to 3.8 from 4.5 and the plans to buy a home hit a new 27-year low, falling to 1.9 from 2.1.

Subsidize It

The Treasury Department will throw another $3.5 billion GMAC’s way so that the financial-services firm can keep their mortgage arm, ResCap, out of bankruptcy as loan losses continue to mount. This is on top of the $12.5 billion Treasury has already thrown down this rat hole. We likely haven’t seen the extent of this bailout story as GMAC’s loan portfolio will record additional losses down the road – what’s going to happen when home prices slip just another 5% over the next 6-12 months? With the way that banks have delayed the foreclosure process, there’s little doubt these distressed properties will add significantly to home supply.

The government will hand the 90-year old lender all the money they need to cover losses as the auto market can’t afford GMAC going down, or even slow their financing activity.


Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks bounced around the flat line for most of the session, ending in positive territory thanks to a tick higher in the final minutes. The gain extended the broad-market’s winning steak to six sessions. We didn’t have a major economic release to trade on, and with most traders out until next week it was overall a quite session.

This time of year is almost always subdued, although things can get interesting on occasion due to the lack of volume; the market can become especially news-driven when there is an event with which to trade on. Thankfully, the failed act of terrorism, the targeting of civilians by an enemy combatant, didn’t offer such a scenario. (But I’ve got to say, and long-time readers know that I’ve been very concerned about our security efforts for a long time, when you have someone go from Nigeria to Amsterdam to the U.S. without luggage -- and on top of that our unwillingness of inability to revoke the visa even after his own father warned that his son may have been radicalized -- we don’t seem terribly serious about this problem; a problem that will grow over time if not properly checked. When one thinks about risk-management within the investment world, this issue has been and must remain a serious element of that risk assessment.)

Telecom shares, the worst-performing sector for the year, led the advance. In fact, all seven of the 10 major industry groups that rose on the session outperformed the broad market. The three that failed to close in positive territory were consumer discretionary, financials and industrials – ranked 3, 4 and 5 in terms of 2009 performance

The $44 billion Treasury auction went fine, not as well as previous auctions but ok. The rate was pushed higher, 1.089% (what a wonderful yield for two years) compared with the 1.077% at which the when-issued was trading just ahead of the auction. The bid-to-cover ratio (measure of demand) came in at 2.91, the previous auction had a bid-to-cover of 3.16 and the four-auction average is 3.07. The indirect bidding (foreign buyers, including central banks) came in at 35%; it had averaged 43% over the past four auctions. In general though, no big deal. Tomorrow’s $32 billion seven-year auction should be the tougher test, but we shouldn’t run into too much trouble, not yet at least. If inflation concerns arise, or the bond market begins to believe that this expansion is for real, that’s when the market will fully shun these levels of interest rates and trouble in financings this deficit spending may begin.

Market Activity for December 28, 2009
Holiday Sales

MasterCard Advisors’ SpendingPulse has holiday sales up 3.6% from the year-ago period – their definition of the shopping season is the timeline Thanksgiving-Christmas, others extend it out to year end. This look by MasterCard does include food and health-care expenditures, which means there is some H1N1 vaccine in the number. There was also an extra shopping day this year (28 days between Thanksgiving and Christmas vs. last year’s 27), adjust for that and sales rose 1%. Severe winter weather across most of the country also helped to boost sales – while many concentrated on how this event hurt in-store traffic, it surely boosted online sales of winter apparel enough to offset the physical-store weakness.

According to SpendingPulse, E-Commerce sales are up 15.5% since Black Friday (day after Thanksgiving), relative to the year-ago period; electronics sales are up 5.9%; jewelry sales higher by 5.6%; footwear up 5.0%; luxury (ex. jewelry) is up 0.8%; apparel down 0.4% and department stores down 2.3% -- again, clearly this is a function of online activity stealing some sales due to the weather. Last year’s holiday shopping season was the worst since 1970, according to the International Council of Shopping Centers.

The final week of the year is also an important one as it accounts for roughly 15% of total holiday sales, according to Dana Telsey of Telsey Advisory Group.

China Watches Inflation, But It’s Just Talk for Now

Chinese Premier Wen Jiabao, in a rare interview, discussed inflation risks over the weekend – pointing to a surge in real estate prices and credit expansion (doubling over the past year as virtually every other economy shows credit is contracting). Wen stated that the Chinese government will address the issue before it becomes a problem. That’s what everyone always thinks, but it is too late by the time politicians begin to address it, at which point the measures necessary to ultimately tamp harmful levels of inflation are intensely detrimental.

We’ll watch for the Chinese to clamp down on credit by tightening standards. For now, they explicitly state that aggressive stimulus measures will remain in place, which propelled the Shanghai Exchange and other Asian markets over the past two sessions.

The Chinese leader also expressed that they will not cede to foreign pressure and allow their currency to appreciate – meaning they will not remove the peg to the U.S. dollar. So much for Mr. Mandarin himself (Tim Geithner) going over to China last month to smooth over the Chinese – nice try. Maybe they allow the currency to float for other reasons, but by explicitly stating that foreign governments’ calls to do so will have no bearing on their decision-making process Wen makes quite the public political statement.

Government Still Can’t Pull Back, But Will Have to Eventually

The Treasury Department has removed a $200 billion limit on aid to Fannie and Freddie and promised to cover their losses through 2012. So, just as the Federal Reserve plans to end it purchases of mortgage-backed securities by the close of first-quarter 2010, Treasury will be their to pick up the slack. Washington is extremely concerned that higher mortgage rates will result when the Fed exits from their purchase program, and the damage this will do to a housing market that has become conditioned to sub-5.00% rates, as well they should be.

The two government agencies underwrite nine out of every 10 new residential mortgages, twice the level prior to the crisis. The housing market may still be in decline if not for the government backing, but such actions carry their own risks. You can’t attempt to backstop everything, sometimes you just have to let the market find the bottom. Increased government involvement has done more harm within the labor market than may have otherwise been the case. Firms know what follows this level of deficit spending – higher tax rates.

As Lender Processing Services (a major provider of mortgage data) has been explaining for a while now, the mortgage delinquency problem is moving upstream. The level of deteriorating loans with credit scores above 680 are making up a larger percentage of all defaults. It’s no longer about sub-prime, but the traditional drag on housing (high unemployment) is now becoming a larger problem for the market. Of the loans that were current at the end of the prior year but now 60 days-plus delinquent as of September of the following year, > 680 FICO mortgages made up 40% of that number (750,000 of the 1.831 million loans). This is up from 35% in the prior year

It seems that the cost of this government support is going to be very costly. It masks the problems in the short term, but they will become evident over time.

Week’s Data

We were without a major data release Monday, but get back to it this morning with the S&P CaseShiller Home Price Index (October) and the Conference Board’s consumer confidence reading (December). CaseShiller is always a heavily watched release; we’ll see if the index can manage a fifth-straight monthly increase and continued improvement on the y/o/y figure, expected to be down 7.15% after September y/o/y decline of 9.36%. The confidence reading is expected to improve to 53.0 for December from 49.5 in the prior month. The figure needs to break above a reading of 60 in order to move past recessionary levels – the 40-year average is 95.8.

On Wednesday we get the Chicago Purchasing Manager Index, the gauge of factory activity out of the largest manufacturing region. The number is expected to slip from November’s reading, but remain in expansion mode nonetheless. It will need to meet expectations as two of the three regionals we’ve gotten for the month thus far have not been good.

We’ll round it out on Thursday with the weekly jobless claims data. The figure is expected to hover around the 450K level, and it should. The problem for claims at this point is the continuing numbers, which continue to rise.

Other Notes

Today marks 20 years since the Nikkei 225 (Japan’s main stock exchange) hit its all-time high of 38,915. Currently that bourse resides at 10,638. This is what can happen when an economy, still the world’s second-largest but probably not for long, implements terrible policy for an extended period of time. For sure Japan has structural issues, namely birthrates that are close to non-existent – not even close to replacement levels. But strong economic and monetary policy would have sparked economic growth, jobs, and encouraged immigration, thus easing or even completely offsetting the population problem.

GM is offering Saturn and Pontiac dealers $7,000 to clear these closed-out models from inventory. This will certainly boost December auto sales but is nothing more than another round of front-loading sales. Just as the clunker-cash program stole sales from the future, this program – although necessary to get discontinued models out the door – will do the same.


Have a great day!


Brent Vondera, Senior Analyst

Stock performance following a bad decade

The new year is approaching and soon investors will be scouring over year-end performance reports. Sadly, one of the most common mistakes investors will make is using past performance as the basis for their investment decisions.

Those that harp on past performance may find it difficult to invest in equities following a decade that was plagued by two brutal bear markets. But shunning equities may be a mistake.

Consider the table below.

Each time the average ten-year return of the S&P 500 was below 6%, the following ten-year period has been very good to investors, with an average return of 13.14%. The following 20-year period is even more impressive, averaging 14.82% per year.

There are no guarantees this trend will continue going forward. After all, it’s impossible to consistently predict the direction of the market (see my June 30, 2009 post: Are you chasing performance?).

Still, the table above should at least make you rethink shunning equities for emotional reasons.

--

Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks added to a nice holiday-shortened week (S&P 500 gained 2%) as traders were determined to push the indices higher. Thursday’s economic releases were certainly a help as initial jobless claims fell more than expected and durable goods orders, excluding transportation, also came in much better than was anticipated.

Information technology shares led the broad market higher, with financials and basic material shares also posting market-beating gains.

Volume was about as flat as it gets with just 300 million shares traded. It was a half-day session and thus expected for activity to be light, but this Christmas Eve was about 50% lighter than what we’ve seen over the previous four years.

Interest rates continued their march higher on Thursday, particularly on the long-end as the 10-year Treasury is now yielding 3.80% (spiking from 3.20% as of November 30) – up another 4 bps to 3.84% this morning. We’ll get another $118 billion in government debt auctions this week ($1.4 trillion for all of 2009) so we’ll see how they go, and the direction that rates take.

Market Activity for December 24, 2009
Jobless Claims

The Labor Department showed that initial jobless claims fell 28,000 (a 10,000 claim decline was expected) to 452,000 in the week ended December 19 – nice to see initials back to the 450K level after bouncing back to 480K over the previous two readings. Initial claims are now back to the level of September 2008. The four-week average (chart below) of initial claims fell 2,750 to 465,250.

Continuing claims also fell, down a meaningful 127,000 to 5.08 million -- that is for the standard 26 weeks of benefits. However, claims for EUC (Emergency Unemployment Compensation), which kicks in to provide up to another 73 weeks of benefits, added another 142,000. So, again, this suggests that the decline in standard continuing claims is more a function of those benefits running out rather than a resurgence in job growth. (That said, as I’ve been mentioning since the October jobs report was released, we should begin to see some job growth arise over the next couple of months, it’s just that the increase is likely to be quite mild.)


Until we see EUC begin to trend lower, or at least halt it’s consecutive-week increase, the evidence is just not there that statistically significant job growth will take place anytime soon. And frankly it is unreasonable to expect this to occur just yet. These things take time to materialize even during a normal expansion, which this is not. This time we must contend with very low capacity/resource utilization rates. Therefore, those resources have a longer distance with which to be stretched, if you will, before firms begin to aggressively add to payrolls – average hours worked per week continues to hover near the all-time low and until these hours pick up for existing workers, should one expect much by way of new hires?

Durable Goods Orders

The Commerce Department reported that durable goods orders rose just 0.2% in November (+0.5% was expected), but this seemingly weak headline reading off of a 0.6% decline for October was affected by a large drop in commercial aircraft orders. The report was actually well-balanced and quite strong.

Excluding transportation orders, and thus removing the 32.6% decline in the commercial aircraft segment, durable goods orders jumped 2.0% (nicely outpacing the expectation for a 1.1% increase), which follows a 0.7% decline in October. Total orders are down 6.0% on a year-over-year basis and ex-trans are down 4.9%.

Overall transportation orders fell 5.5% -- vehicle and parts orders declined 0.2% and, again, nondefense aircraft plunged 32.6% after a 39.3% jump in October. The rest of the report looked really good though. Computers, electronics orders rose 3.7%; electrical equipment orders increased 3.2%; machinery orders rose 3.5% (following a large decline of 7% in October).

Those components of the report pushed non-defense capital goods ex-aircraft higher by 2.9% after a 2.0% drop in October. This is the reading we like to watch most closely as it is the proxy for business-equipment spending. This segment is down 8.9% y/o/y, but the last three months have been positive, up 5.5% at an annualized rate.

We need to see this segment, as I’ve been saying for a while now, trend higher; this economy desperately needs help from the business side. One hopes for this to occur, but U.S. corporations appear to be managing capital expenditures to maintenance levels as they manage around lower sales. This will help profits in the short term but will not be helpful for overall economic activity if this process extends for a while – it will keep final demand depressed; business-equipment spending is a huge job creator.

The inventories segment of the report showed that firms continue to reduce stockpiles, which is quite strange based upon the record pace of liquidation of the previous few quarters. The largest inventory liquidation on record occurred in the second quarter, and the third-quarter liquidation only looked good compared to that historic reduction – firms remain abnormally cautious. Durable goods inventories fell 0.2% in November, but the three-month annualized change is half that of the prior month – and that is all it takes to boost GDP. We are still waiting for actual re-stocking to begin, but firms continue to hold off.

Expectations for the fourth-quarter GDP reading are definitely going to be boosted by this report. Shipments of durable goods, which gets plugged into GDP, rose 0.3% following a 0.7% rise in October. That’s a great start to the quarter and will help to offset what may be a drag from the housing component. Housing construction was up in November, but on a quarter-over-quarter basis is down. If the December housing starts reading (which we’ll get in three weeks) falls, this segment won’t contribute to GDP.

Reminded, Yet Again

Everyone probably expected the health-care debate to dominate the Washington storyline for a while, but a little event on Christmas reminded (or re-reminded) us that something else looms larger – no matter how badly we’d like to ignore it, there are people, organizations and regimes that want to do us grave harm. Thankfully, the terrorist’s device failed, buy they’ll keep coming; their desires are surely not contained to taking down airplanes, but much more. As I have written for the last eight years, security is key. Obviously now, we have major economically endogenous issues to also deal with but if we don’t get security right, and the overall policies that greatly diminish the chance of major attack, it makes it that much harder for a normal business cycle expansion to take hold.

Futures are higher this morning. Quite the opposite would be the case if it were that explosive device, rather than the terrorist’s leg, that had ignited.


Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks shook off two ugly housing reports to extend the recent winning streak to four sessions. A good headline personal income number helped traders look past the housing data. Even though the income figures are being propelled by government transfer payments, which can only be transitory in nature, the wage and salary component did register a nice increase and that offered stocks a little boost. Money was most focused toward mid and small capitalization indices as the broad large-cap market was only slightly higher.

Basic material, tech and energy shares led the advance. Financials were the worst-performing sector; health-care stocks slipped also as these were the only sectors of the major 10 that closed in negative territory.

Volume was extremely weak, which is always the case for the session prior to Christmas Eve, but even more so than is typical as just 740 million shares traded on the Big Board – something closer to 900 million has been the norm. Today is a holiday-shortened session and most traders are long gone so we’re likely to just go through the motions unless the day’s economic releases (jobless claims and durable goods orders) print readings that are far from expectations.

The U.S. dollar ended a six-day rally.

Market Activity for December 23, 2009
$80 Looks to be Back in Play

Crude-oil for January rose 3% to $76.67/barrel yesterday after the weekly energy report showed supplies fell more than expected. Crude stockpiles slid 4.84 million barrels last week, a fall of 1.6 million was expected, as consumption of gasoline rose 0.9% from the prior week to 9.05 million/day and distillate fuels (diesel and heating oil) rose 5.2% over the previous week – some of this was obviously due to colder weather, especially in the Northeast.

Not all of the decline in stockpiles was a result of increased demand, though it is nice to see gasoline consumption 2% higher than the ultra-weak levels of a year ago. While refinery utilization rose to 80%, this is still rock-bottom as 88% is the long-term average and 83% was viewed as the floor prior to the beating the economy’s taken over the past year. Also, oil imports fell another 0.8% in the latest week to 7.71 million barrels, the lowest level since September 2008 when Hurricanes Gustav and Ike punished the Gulf Coast and shut down the ports.

Mortgage Applications

The Mortgage Bankers Association reported that applications fell 10.7% in the week ended December 18, the first decline in four weeks. Both purchases and refinancing got clocked, down 11.6% on purchases and 10.1% for refis. The 30-year fixed rate mortgage rose to 4.92%.

The rate will move above 5.00% next week as Treasury yields have jumped, which means the Fannie and Freddie commitment rates also rose. Based on those moves the 30-year mortgage rate is going to 5.20% next week. This will be a nice little snapshot to show how housing will react to just marginally higher rates. It does not seem likely that a sustained move higher will present itself, in my opinion – not yet at least. But the housing market has become conditioned to 4.70-5.00% rates and thus the reaction will not be kind to 5.00%-plus, and higher, that is inevitable over time.

Personal Income and Spending

The Commerce Department reported that personal income rose 0.4% in November (a bit below the expected 0.5% increase), which marks the fifth-straight monthly increase. Over the past year, overall personal income is down 0.3% -- although that has been helped by a 15% rise in government transfer payments. Total compensation (which excludes rental, dividend, interest and proprietors income) is down 2.2% y/o/y, but off by 5.6% when we exclude transfer payments.

All of the components looked good in November. Compensation was up 0.3%, same for wage & salary. Proprietors income rose 1.2%, boosted by another huge bounce on the farm side – up 23.0%; non-farm proprietors income rose 0.5% for the month. Rental income added 0.6% in November. Interest income rose 0.2% and dividend income was higher by 0.9%. Government transfer payments rose 0.5%. On a year-over-year basis, rental income and government transfer payments are the only segments that are positive.

On this transfer payments situation, we have seen massive increases in both actual $ amounts (as the social safety net has become larger, we’ve seen two rounds of stimulus checks, and higher SS outlays due to an aging population) and as a percentage of personal income. The spike over the past year is largely due to the French-style extensions of unemployment benefits that now extend to as much as 99 weeks.


In summary, the 0.3% bounce in the wage & salary component was welcome news and let’s hope this is the start of something good. Even if firms are unlikely to add aggressively to payrolls (and aggressive additions is what it will take to move the unemployment rate meaningfully lower over the next year), some decent increases to existing workers’ paychecks is not out of the question. Still, the overall figures (total income and compensation) are looking better than would otherwise be the case due to the transfer payments. Such activity, government spending at these levels, is not sustainable and that does boost the risk that we face another disappointing trend a few months out. The “Gods of the Copybook Heading” will prevail as they always do. Bret Stephens of the WSJ Editorial Board brought this up earlier in the week and reflecting on Rudyard Kipling’s poetic reminder that common sense always prevails is all the more apropos today.

On the spending side, personal expenditures rose 0.5% (also below the expectation, which estimated a 0.7% increase) as outlays for goods rose 1.4% (holiday shopping) and service rose 0.4%. The cash savings rate held steady at 4.7%.

University of Michigan Confidence

The U of M consumer confidence reading for December was revised down to 72.5 from the preliminary print of 73.4 that was release two weeks ago. Still, this shows that confidence did improve from November’s weak 67.4.


The economic outlook reading (expectations six months out) was also revised down to 68.9 from 69.7.


New Home Sales

New home sales tumbled 11.3% in November (a 1.7% increase was expected) after a big downward revision for October (up just 1.8% vs. the 6.8% rise initially reported last month) to 355,000 units at a seasonally-adjusted annual rate. This is the lowest level since April and erases most of the bounce from the January low of 329,000 units. On a year-over-year basis, new home sales are down 9%.


This offers us a glimpse of what will occur when the tax credit expires. (Unlike existing home sales that are counted when a contract closes, new home sales are counted when a contract is signed. That is, while existing sales are effectively counting activity a month or two in the past when the purchase process began, the new home sales figure measures what actually occurred in the reporting month. Since buyers in November largely believed the credit had essentially expired – had to close by November 30 – this offers a glimpse of what things may look like without the subsidy.)

By region, sales were flat in the Northeast, up 21% in the Midwest, down 21% in the South (this region makes up over half of the new-home market) and off by 10% in the West (the West and South together make up 73% of the new-home market).

The median price actually rose 3.8% in November to $217,400, which was quite unhelpful.

The supply of new homes, as measured by the inventory-to-sales ratio (the number of months it takes to sell off existing supply at the current sales pace) rose to 7.9 from 7.2 in October.

Yesterday I mentioned that we should be careful in our expectations regarding the supply of homes when referring to the previously-owned home figures. The supply of existing homes fell substantially and has returned to a level that is pretty close to the longer-term average. However, when foreclosures begin to hit the market that supply number will rise again. But that’s not all as the market is likely to be hit by a double whammy – more houses hitting the market due to foreclosures along with a decline in sales. If what has occurred in new home sales shows up in existing (although unlikely to fully occur until the tax credit expires in April) then it will boost the inventory/sales ratio that much more.

Futures

Stock-index futures are higher this morning. We await the jobless claims and durable goods orders reports. Unless these numbers are much worse than expected, traders appear determined to push prices higher. We continue to hold above that 50% retracement level we’ve referred to over the past two days.


Merry Christmas!


Brent Vondera, Senior Analyst

Santa Claus Rally

In the past, the stock market has made modest gains in late December into the beginning of early January. Widely recognized as the Santa Claus rally, this time period has quite the track record. Since 1950, the S&P 500 has increased an average of 1.5% during the seven trading days that start with Christmas Eve and end with the first two days in January. Stocks have gone up during this period in 12 of the last 15 years.

Other interesting facts (complements of InvesTech Research):

• December is the best single month for stocks, with the S&P 500 index averaging a 1.6% gain. The first December after a bear market ends performs even better, averaging 3.1%.
  
• November through January has historically been the best three-month span for stocks. The average gain over the last four decades from Nov. 20 through the end of January has been 4.2%, or an annualized rate of 23%.
  

There are several factors that people theorize are responsible for the Santa Claus rally such as peak retail season (due to holiday shopping), tax considerations, upbeat year-end investment reports (many of which have “top stocks for the next year”), happiness around Wall Street, people investing their Christmas bonuses, and vacationing Wall Street workers.

A prudent investor knows the Santa Claus rally is not an opportunity to make a quick buck (because that would be market timing!), but it’s difficult to ignore all together. After all, the lack of a Santa Claus rally in recent years has signaled turmoil lies ahead. The market tanked in 2000 when there was no Santa Clause rally in 1999 and a late-year drop two years ago preceded a disastrous 2009.

Is Santa Claus coming to town this year?

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Peter J. Lazaroff, Investment Analyst

Economy or Quadruple Witching?

S&P 500: -13.10 (-1.18%)

Market participants scrambled for safety, pushing the dollar to the highest level in three months. On cue, stocks and commodities traded lower.

Several factors sparked fear in markets. Greece’s second credit rating downgrade this month certainly kept government debt concerns in focus. Also, initial jobless claims unexpectedly increased, reminding everyone that the road to recovery will be bumpy. The lack of jobs was one reason the Fed plans to keep interest rates low for an extended period.

A disappointing profit forecast global shipping company FedEx (FDX) also made market participants question the strength of the economic recovery. Many use FedEx’s earnings and projections as an indicator of the nation’s economic strength since the firm transports a wide range of business and consumer goods such as auto parts, real estate documents, and toys.

It was clear from FedEx’s earnings call that the company still lacks clarity on the end demand picture. The firm says the economy is approaching a turning point, but a full recovery appears a way off. In the long run, the firm sees strong demand in Asia and Latin America leading the way to global economic recovery.

Trading volume on the NYSE hit its highest level in nearly three months. One could argue that such volume is signs of conviction behind the selling effort, but it’s important to note that tomorrow is a quadruple witching day.

Quadruple witching is a day when contracts for stock index futures, stock index options, stock options and single stock futures all expire. This occurs on the third Friday in March, June, September, and December. The name may sound scary, but it simply means there is some extra volatility as large funds and traders cover any remaining open positions before they expire and settle on Saturday.



Quick Hits

• Santa Claus’s Trade Infractions
  
  

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Peter J. Lazaroff, Investment Analyst

Exxon Mobil makes a splash in natural gas

Exxon Mobil (XOM) rarely makes major acquisitions. Today, the oil-giant announced the acquisition of XTO Energy for $31 billion, representing a 25% premium over XTO’s closing price on Friday.

Exxon played the last cycle better than any of the other oil majors. As energy prices rose during the last three years, Exxon patiently committed just 40% of earnings to capital investment while Shell, BP, and Chevron committed between 85% to 100%. Today’s deal is notable because it marks a change in strategy. Exxon’s move is a bet that gas demand is going to outpace oil and coal over the next decade, in part due to tighter emissions standards.

Staying true to their financial conservatism, Exxon is doing an all-stock deal rather than dipping into its healthy cash pile. At the end of the third quarter, XOM had a net cash position (cash less debt) of $2.9 billion. Meanwhile, the company converts roughly 10% of revenue to free cash flow meaning that the company may generate roughly $8 billion in free cash flow in the fourth quarter alone.

Some investors were disappointed Exxon didn’t offer a cash-stock combination, but this concern overlooks the fact that Exxon will assume about $10 billion of XTO’s debt. If you include XTO’s debt obligations in the cost of the acquisition, then Exxon is actually using cash to fund about one-fourth of the XTO purchase.

One could also argue that future share buybacks will reduce the new outstanding shares, effectively “paying” for the acquisition. Exxon has reduced total outstanding shares by 25% since the end of 2004 and has repurchased $17 billion in stock this year alone. I admit this is a bit of a stretch, but it’s worth considering.

Exxon’s acquisition is clearly a wager that depressed gas prices will improve in the coming years, but I wonder if there are any other factors at work.

How much does the Fed’s zero interest rate policy (ZIRP) play into these decisions?

Cash-rich corporations, like individual investors and savers, aren’t earning any return on their cash and equivalents. But until there is concrete evidence that the economic recovery is sustainable, businesses may be hesitant to add to capacity. As a result, mergers and acquisitions present a more attractive use of capital.

Does expected inflation create a greater sense of urgency for firms to put cash to use?

In Exxon’s case, higher inflation means higher natural gas prices and higher revenues. So it’s obvious that expectations for higher inflation would create a greater sense of urgency for an acquisition in this case. Still, it would also be in a non-energy firm’s best interest to purchase assets that can enhance growth if the firm believes that inflation will diminish their purchasing power in the future.


Quick Hits

• Fastest Food Inflation Since ’08 Riots Means Milk Costs 39% More Next Year
• Volcker: We Need to Think More Boldly

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks held onto most of the session’s early gains, fighting off a move into negative territory about midday to close higher for a third day in a row. The gains just barely erased pre-hump day losses – the S&P 500 closed fractionally higher for the week.

A well-balanced retail sales report and a higher-than-expected University of Michigan consumer confidence reading for December both helped to boost stocks. (This UofM confidence reading is a preliminary number, we’ll get the final reading later in the month. I’ll note that the trend over the past two months has been a downward revision. Plus the reading remains at past recessionary levels. So, the increase in stocks was likely all due to the retail sales reading.)

Utilities was the best-performing sector. Consumer discretionary and industrials were not that far behind. Tech and health-care were the only two of the major 10 groups that closed lower on the session.

Utility shares continue to enjoy a momentum trade that began in early November; what kicked it off were events that virtually happened in succession. First was the G-20 meeting at the end of October in which the members pledged to keep government stimulus plans in play, which was followed by the same pledge from APEC (Asian governments), followed by the Fed’s November 4 meeting and the FOMC’s statement that ZIRP will remain in place for an extended period. All of these comments showed that rock-bottom interest rate will remain in place – and there was some uncertainty in this regard by in mid-October – and that drove money into higher-dividend paying utility shares. The index that tracks utility shares is up 12% since November 4, double the move for the broad market.

Advancers beat decliners by a two-to-one margin. Volume was punk again as just 950 million shares traded on the NYSE Composite.

Market Activity for December 12, 2009
Retail Sales

The Commerce Department reported November retail sales rose 1.3% (double the expectation) after October’s 1.1% increase. That’s a strong two-month rise; it is unusual to see back-to-back 1%-plus readings. That said, the October reading was all auto-related (strip out autos and the figure was virtually unchanged, up just 0.01% -- as we commented on when it was released last month) and hardly an impressive report. However, this report for November was impressive, showing widespread gains – every major component with the exception of furniture and clothing was up nicely.

The ex-auto reading for November jumped 1.2%; excluding autos & gas, spending rose 0.6%; ex-autos, gas, and building materials (the figure that flows straight to the personal consumption reading of GDP) rose 0.5% - and is up 5.1% on a three-month annualized basis, which means we’re going to see Q4 GDP estimates boosted.

The caveat: this retail sales report was based upon a new sample – the sample is changed every 2 ½ years in an attempt to more closely reflect buying preferences. So, GDP estimates are being boosted and rightly so. We’ll see though if this new sample resulted in an overstatement of activity when the revision is released next month and more closely reflects what actually occurred rather than substantial estimations which are present in this first look.

Unless the spending figures are revised much lower, or the December reading is a complete flop, we can now expect a 3.0% GDP reading for Q4 even if the inventory segment doesn’t help out much. If inventories provide a good boost, we’ll probably see 4.0%.

This is what we’ve been talking about, even as my pessimism on several other fronts has surrounded these moments of optimism. A couple of months back we talked about the high possibility of above-average GDP readings for a couple of quarters, but the numbers won’t be as strong as they are historically coming out of a severe contraction, nor are they likely to be sustainable. (Recall, as we’ve explained, the economy has averaged growth of 7.8% in the year following the worst recessions in the post-WWII era – actually, to be specific this is true for the year following one quarter removed from the end of those recessions. So, if we are to get a couple of quarters of 4% growth it is still weak by comparison. We’ll take 4% though considering the headwinds the economy continues to face.)

By segment, autos were up 1.6%; electronics up 2.8% (boosted by post-Thanksgiving weekend door-buster sales, we’ll watch for follow through in December); building materials up 1.5% (I don’t believe this segment has a prayer at sustainability); food & beverage up 1.0%; health & personal care up 0.6%; gasoline stations up 6% (strange reading as this is not what the weekly energy reports have shown, some of it may be due to price increase, but most of that occurred in October); general merchandise up 0.8%. Again, furniture and clothing (each down 0.7%) were the only components to register a decline.

Import Prices

The Labor Department report November import prices jumped a higher-than-expected 1.7% -- up 3.7% year-over-year and the first positive y/o/y reading in 13 months. We have been expecting the inflation gauges to exhibit a pronounced change beginning in November, as the y/o/y comparisons become very easy -- heretofore, the year’s price-level readings have been matched against the highs in the inflation indices that resulted from that commodity-price spike back in the summer of 2008 -- $140/barrel oil etc. That has now changed.


I have begun to reassess my inflation expectations over the past couple of months, however. We should still expect relatively high y/o/y readings for a few months based on year-ago low levels, but banks are in bad shape (much more troubled than the market currently seems to acknowledge.) and if credit continues to contract a sustainable pick up by way of harmful levels of inflation could still be a another year to 18 months off. We’ll continue to keep a close eye on this story. The main point I want to get through here is while the inflation trade (commodities and commodity-related stocks) has proven a successful one for those who got in at the right entry point – had to be ahead of the momentum trade – I would caution against myopically charging at this trade right now.

Business Inventories

Business inventories rose 0.2% in October (a decline of 0.2% was expected, so this jibes with the larger-than-expected increase by way of that wholesale inventory figure on Wednesday) – this is the first increase in 14 months. Although, the increase was largely boosted by autos and thus still shows some clunker-cash boost. I bring up the clunker program because stockpile increases driven by this program don’t exactly offer the suggestion that firms are re-stocking as a result of a boost in confidence but rather via the large car sales that resulted in August – it’s fantasy to believe car sales will return to 14 million units at an annual pace, as occurred in August; something closer to 10 million is more likely and that means auto production can’t be leaned upon for too much longer. Excluding autos, business inventories fell 0.2%, down for the 13th month.

On the more positive side, business sales have increased for the fourth-straight month – up 1.1% in October. As a result, it shouldn’t be too long here before we see at least a mild trend higher in inventory levels.

The business inventory-to-sales ratio slipped to 1.3 months worth (the time it would take to sell off all stockpiles at the current sales pace) from 1.31 in September. This is a vast improvement from just nine months back when the reading hit 1.46 months worth. The inventory slashing of the two quarters that ended June 2009 were without precedent in the postwar era.


On a three-month annualized basis, business inventories are down $101.2 billion. That’s an improvement from -$174.1 billion in September and -$224.5 billion in August. All it takes is for stockpiles to fall at a slower rate in order to add to GDP. Again, based on the violent slashing of stockpiles earlier this year we should see some actual rebuilding. If we fail to see even a mild level of absolute re-stocking over the next couple of months, it will provide a clear signal that businesses remain very cautious and confidence has yet to improve.

Futures

U.S. stocks futures are up strong this morning, fueled by the news that Abu Dhabi will send Dubai a $10 billion check, $4.1 billion of which will be used to avoid defaulting on a bond payment that is due today. When this news was hitting the headlines around Thanksgiving we stated that December 14 will be the date to watch. That’s because Dubai World’s real-estate arm Nakheel has a bond coming due (Dubai World is the emirate’s corporate flagship). Well, what this shows is just another sign that things are not in the shape that equity markets world-wide appear to be pricing in. Another government bailout means that the global economy is far from out of the woods. Nevertheless, stocks look ready to revel.


Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

S&P 500: +4.06 (+0.37%)

The S&P 500 managed to finish the week with a small gain after better-than-expected retail sales and consumer confidence offset concerns regarding sovereign government debt. Also lifting sentiment was bullish data from China (larger-than-expected increase in industrial production and new lending) as well as a bullish 2010 forecast from J.P. Morgan.

November retail sales signal the holiday shopping season got off to a nice start, with strength in electronics and “nonstore” (i.e. internet) retailers. It appears consumers can continue to spend during the deleveraging process, but a challenging labor market and tightening credit should restrict the pace at which spending will rebound in 2010.

The U.S. Dollar Index again made gains along stocks, gaining 0.7% today and now up 3.1% since November 25.

During the past several months, stronger economic data caused risk aversion to fade, pushing stocks higher and the greenback lower. This trend may be changing, though, with the market increasing bets on interest rate hikes in 2010.

If the dollar continues to rally, we should see a shift in outperformance from the companies that derive a large portion of their revenues internationally to those that derive the most of their revenue domestically.

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks pared their early-session gains but spent the entire day in positive territory and, most importantly, closed on the plus side. The financial press pointed to a jobless claims report that showed initial claims remained below 500K, as the main reason behind the market’s advance. I’m not buying it though as the continuing claims number suggested that labor-market troubles continue to lurk.

A more likely impetus behind the advance was day’s other economic release, the October trade figures, which, beyond showing that energy demand remains very weak, did illustrate pretty good discretionary spending.

Another factor may have been near-record wides in the yield curve (274 basis points between the 2s and 10s– just shy of the 275 record – and 355 bps between 2 and 30 – close to the record wide of 368). This spells continued strong interest income for the banks, and boy do they need all the help they can get by the way the coverage ratio looks – provisions set aside are hugely inadequate for the level of non-performing loans. According to the FDIC, that coverage ratio sits at 60%; the 15-year average is 140%.

Consumer discretionary shares led the gains, which gives at least some credence to the thought that the trade numbers helped investor sentiment. Utilities, health-care and energy shares were the other out-performers. Financials and basic material shares were the losers on the session.

Small caps continue to lag the broad market, which is usually a sign that a rally has become winded. The smalls peaked on October 14, about six weeks before the S&P 500 hit its post-March lows high-point. Since mid-October, the smalls are down 4.5%, while the S&P 500 is about flat.

Market Activity for December 10, 2009
Jobless Claims

The Labor Department reported that initial jobless claims rose 17,000 last week, rising to 474,000 – the reading was expected to fall by 2,000. This ends a five-week streak of decline but the reading remains nicely below 500K so that’s something to take a little comfort in. The four-week average fell 7,750 to 473,750.

Continuing claims slid 303,000 to 5.157 million, but the decline is meaningless as EUC (Emergency Unemployment Compensation – the jobless are moved to this program when their standard 26 weeks of benefits run out) claims more than offset that move by jumping 327,729. This shows that the move lower in standard continuing claims is more about the expiration of benefits (see chart immediately below) rather than from some level of job creation occurring.

The claims numbers continue to exhibit that the pace of firings has substantially slowed (as exhibited by the initial claims readings – possibly confirmed by the third month below 500K), yet firms are not yet adding net jobs (illustrated by the jump in EUC).

Trade Balance

The trade deficit narrowed in October by 7.6% to $32.9 billion from $35.7 billion in September. Exports rose 2.6%, while imports increased just 0.4%. I can hear it now, there will be economists exhorting that the lower value of the dollar is the reason and thus we should applaud the erosion in our currency. (A lower dollar means that U.S. goods are cheaper to the rest of the world and hence exports outpace imports. However, this doesn’t exactly work out in the longer term as well as the text books teach us because a weaker dollar causes a higher price of oil over time – and with our restrictions on domestic energy production we import a lot of petroleum products; this segment makes up 30% of imports.)

The narrowing appeared to be more of a domestic energy demand problem – not a surprise as office vacancy rates are on the rise and less people are driving to work. And the decline in crude imports, down 12% for the month, was not a function of a decline in prices – the price/barrel was down just 1.1%. In terms of barrels, we imported 32 million less barrels for the month of October – a 19.2% drop from the year-ago level. From the year-ago period crude imports are down 38.5%, even as the price of crude us up 48%.

Many categories posted some pretty good monthly readings though. Capital goods exports rose 3.7% -- fueled by an 8.9% increase in semiconductors, a 10.8% jump in computer accessories and a 2.2% rise in telecom equipment. On the import side, consumer goods were up 2.8% -- boosted by an 8.5% in pharmaceuticals. While this is more of a necessity product, clothing imports rose 5.5%, so there was a decent move from the discretionary aspect of consumer purchases. Autos also climbed 2.6%.

Outside of the significant drop in energy demand that continues the 14-month trend lower, U.S. consumer demand for other goods has shown decent improvement from very low levels.

Around the World

Australia reported that payrolls rose for a third-straight month, up 31,200 for November. Adjusting for population, this amounts to a 450,000 increase in U.S. terms (and payrolls are up roughly 1.4 million past three months). Last week we saw that Canada – another commodity-rich nation, particularly with regard to energy – posted a 79,000 increase in payrolls last month. Adjusted for population that’s a 790,000 increase in U.S. terms. This continues the theme that the commodity-laden economies of the world continue to post the best results

These countries can thank the Federal Reserve as it is their zero-interest rate policy that has the U.S. dollar just 6.5% above its all-time low; the path of the dollar both directly and indirectly is a major determinant of the price of commodities. Too bad we don’t aggressively remove production restrictions on our own energy holdings. This would be the most direct and effective way to create high-paying manufacturing jobs here at home.

Futures

Stock-index futures are up strong this morning on the heels of a higher than expected industrial production reading out of China. The figure jumped 19.2% in November on a year-over-year – the November 2008 reading it’s being compared to marked the cycle low. Even so, this is a large increase.

The growth in Chinese production over the past couple of months is commensurate to levels seen during 2003-2007; a period of robust consumption. Production is being driven by what is largely still a command-and-control government structure and history has shown, on several occasions, that such a political-economic system can lead to big trouble. I do wonder where exactly China is going to find the consumer activity to absorb all of these goods with global jobless rates double the levels they were just two years ago. Unemployment rates are still pretty low in Asia, but the region doesn’t have the domestic consumption to absorb this level of production as Asians’ propensity to save remains very high.


Have a great weekend!


Brent Vondera, Senior Analyst

Afternoon Review

S&P 500: +6.40 (+0.58%)

An unexpected narrowing of the trade deficit and favorable components of the jobless claims report helped the S&P 500 finish higher despite global government debt concerns. Volume was lacking for most of the day as stocks traded sideways for most of the session.

It’s also worth noting that the broad-based gains were made in the face of a stronger dollar, bucking the recent trend. Dollar gains have most often led to selling in the stock market due to the drag of a stronger dollar on commodity prices and repatriated profits from multinationals.

Small cap stocks finished lower today and continue to lag behind larger capitalization stocks this quarter. This trend is typical of a rally that is entering a later, more mature phase. The high beta stocks often see some of the sharpest rallies off the market bottom start to slow down.


Quick Hits

• The dollar’s fall reflects a new role for reserves
  
  

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks bounced into positive territory on two separate occasions Wednesday after beginning the session lower on sovereign credit concerns. However, the final push above the cut line occurred in the final hour of trading so the numbers posted a resplendent green by the close.

A bounce in basic material and technology stocks led the market higher. A turn down in the U.S. dollar helped the commodity-related material shares. Technology shares seemed to get a boost from Hewlett-Packard shares as the company announced it will cancel its normal two-week holiday break for the sales staff (normally begins December 21) in order to spend the time closing deals – obviously this it the kind of alacrity investors like to see.

Advancers just edged out decliners on the NYSE Composite by a margin of 9-to-8. Volume was weak at just over one billion shares traded.

The 10–year Treasury auction, a re-opening of the November issue, was a bit weaker than we’ve seen as the yield was about 4 basis points above where the when issued was trading and the bid-to-cover of 2.62 was below the 2.80 average of the last four auctions – not concerning though. The weakest aspect of the auction was that just 32.9% went to indirect bidders (a gauge of foreign central bank demand), meaningfully lower than the recent average of 45.6%. Tomorrow we get a $13 billion 30-year re-open and we’ll see if the heightened concerns that a sovereign default will occur (troubles in Dubai and Greece have garnered the headlines but Spain and Italy have been included in the mix – frankly I could see Russia as the next default; Abu Dhabi will bail out Dubai and the EU will make sure one of their members doesn’t actually default) may make for a more difficult auction.

For the U.S. no one has to worry about default, but higher interest rates are bound to become an issue with all of this debt issuance. Those lending money for 10 and 30 years at 3.4% and 4.4%, respectively, is where the major risk lies. Then again, if the economy runs into trouble in short order (and lower coverage ratios even as non-performing loans continue to grow has me quite concerned about another wave of bank trouble), 3.4% for 10 years may not look all that bad.

This is a strange environment, a tough environment – one can see several situations affecting rates, in either direction. Still, this is no time to increase risk levels whether it be by becoming more aggressive on the equity side of things or extending out in an attempt to reach for a little more yield.


Mortgage Applications

The Mortgage Bankers Association reported their application index rose for a second-straight week, up 8.5%. This follows a 2.1% increase in the week ended November 27 and broke a string of six weeks of decline. Applications to purchase a home rose 4.0%, just about matching the previous week’s 4.1% rise. The difference this week was that refinancing activity picked up, jumping 11.1% after a very mild 1.7% rise in the previous week. The 30-year fixed-rate mortgage held below 5% for a sixth-straight week, averaging 4.88% for the week ended December 4.

We saw the purchases index decline for six weeks that ended November 13 as potential buyers were uncertain as to whether the tax credit would be extended. Now that it has officially been extended to April 30 (and beyond just first-time buyers as those who have owned a home for five years will be offered a $6500 credit to buy a new or existing home) sales have picked up again. I continue to believe that the affect the credit has on sales will be less robust than it was back during the traditional buying season, but we will see. No matter how it turns out, the home-buyers tax credit will expire and at that point it is likely sales will retrench.

Wholesale Inventories

Distributors’ inventories rose for the first time in 14 months, increasing 0.3% in October from September’s 0.8% decline – the estimate was for a 0.5% decline. The increase was boosted by higher stockpiles of motor vehicles, nondurable goods (such as clothing) and petroleum products (recall the weekly energy reports we’ve been touching on in which very low demand has pushed crude and gasoline stockpiles higher – and yesterday’s report showed no sign of improvement has presented itself). Stockpiles of durable goods ex-autos were down 0.4% for the month. From the year-ago period, total wholesale inventories are down 13.5%

So while there is some evidence that this overall inventory rebuilding is a function of the affects from clunker cash sales and low energy demand, this does get the first month of the final quarter of 2009 off to a good start – we’ll need to see some inventory building in order to get the next GDP reading above 2.5% in my view, based on what we currently know for the quarter. (For clarity on the clunker-cash comments, auto inventories fell for eight straight months, but began to build again in September following the big August sales gain related to the clunker program.)

Even if a full-blown inventory dynamic does not ensue, this segment of the economy will at least add somewhat to GDP as the three-month annualized change has moved to -$27 billion from -$56.8 billion in the prior month – and all it takes is a slower rate of decline to add to GDP.

The sales data within the report showed its sixth month of increase, up 1.2% for October – down 9.6% from the year-ago period. This is a nice trend we’ve got going here and it will have to be maintained to keep factory production on an upward trajectory.

The inventory-to-sales ratio has come crashing lower, down to 1.16 months worth (this measures how long it would take to sell off all inventories based on the current sales pace) from 1.34 months worth in January – the cycle high.

This shows just how effectively the private sector adjusts to new economic realities. While it is an unpleasant process, to say the least, the adjustment occurs quickly and fosters an environment in which we can begin producing goods again, on a net basis of course. Again, sales will have to remain on the current glide path or firms will simply keep stockpiles at rock-bottom levels.

We’ll receive the broader business inventories report for October tomorrow.

The Un-stimulus

Everyone is talking about Britain’s decision to slap a 50% tax rate on bank bonuses above $41,000 – Chancellor of the Exchequer Alistair Darling explained to Parliament that this tax will be borne by the banks, not the employees. You’ve got to be kidding; are these people really this clueless?

But the big news is Britain’s decision to raise income tax rates on bank employees making over $240,000 -- a 10 percentage points increase to 50%. Add this to the national insurance tax and the London city income tax and you’re honing in on 55%. (The 50% tax on bonuses is only in effect until April 5, 2010 so banks will either defer bonuses or come up with some other way around this onerous tax, which is why the top income-tax rate hike is the larger issue.) Keep in mind that the financial services industry is the best thing London has going for it –for now at least. In many Asian financial centers, tax rates on incomes of similar size are set around 20%. What do you think is going to happen?

Now we have Prime Ministers Brown (Britain) and Sarkozy (France) in an Op/Ed this morning explaining how economies across the globe need to increase regulations and tax rates. These are about the only two things a Frenchman and a Brit can ever agree upon.

Well, Messrs Brown and Sarkozy, at least here in the U.S. we’re importing enough of your Western European socialism. Those Americans that will be looking for work or fighting to move up the economic ladder don’t need anymore of it, thank you.


Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks declined Tuesday as a number of issues caused investors to flee for a little bit of safety – Treasury securities and the dollar rallied – but the equity market’s move lower was a mild one. Stocks have traded sideways for seven weeks now, moving as low as 1035 on the S&P 500 and topping out at the 13-month high of 1110, but overall no where since October 14.

This latest bought of weakness all started off with Bernanke’s speech on Monday in which, among other things, he mentioned that the economy faces “formidable headwinds.” A decline in German industrial production, a credit rating downgrade of Greek debt (which highlights government deficit risks) and a decline in small-business optimism, all occurring yesterday, put additional pressure on stocks. The budget problems in Greece, which is hardly the only nation with issues right now, follows the troubles out of Dubai that surfaced in late November.

Energy, basic material and industrials shares – all early business-cycle plays – led the broad-market’s decline. All 10 of the major industry groups lost ground on the session.

As a result of the dollar’s climb, back up to the 76 handle on the Dollar Index, commodities sold off. Gold fell for a third-straight session, down 7% over this stretch, and oil is back down to $72/barrel after holding in the high $70s since mid October.

Outside of some geopolitical event or a sovereign default it is tough to imagine the dollar breaking its downward trend – especially as the Fed continues to signal their zero interest-rate policy will remain in place.


Market Activity for December 8, 2009
Too Big Too Fail Fix – Give Me a Break

The House Financial Services Committee voted 31-27 last week to approve legislation that would augment government authority to police large firms that pose risks to the economy. Debate on the House floor will begin this week to create a council of regulators that monitor financial industry risks and impose costs (funds that would bail out reckless firms) on the largest firms within the industry. The legislation would grant the Treasury Secretary, among others, the authority to dismantle healthy, well-capitalized firms whose size threatens the financial system. It also removes a 30-year ban on audits of monetary policy – it’s not clear to me whether this pertains to just the Fed’s balance sheet or interest-rate policy as well; this is a treacherous road if it includes the latter, the Fed has made large mistakes this decade but you can expect plenty more if Congress and the GAO are allowed to get involved.

If this is passed, we may all watch firms take on even greater risks over time as healthy firms will see their costs rise, effectively backstopping those that get themselves in trouble – this has a certain moral hazard problem attached as far as I’m concerned.

Giving the government the ability to dismantle healthy and well-capitalized financial firms carries its own problems -- more government involvement in the private sector has never been long-run helpful and its not going to be this time. Further, it will eventually have to be acknowledged that we wouldn’t have had a credit bubble, and thus this de-leveraging process that ensued, if the Fed would not have kept fed funds below the level of inflation (negative real fed funds) for three full years earlier in the decade. Firms wouldn’t have been lured, taunted and encouraged to take on stupid levels of leverage in the first place -- implement insanely low levels of interest rates and you’re going to get more debt and whacky 30-to-1 leverage, unless of course the economy is so crushed that both the supply of and demand for financing craters, as is currently the case.

Rather than going down this road, imposing costs on the industry at this time of distress and possibly encouraging reckless behavior down the road, what we need is to allow the market to determine interest rates (not the Fed) and the Federal Reserve need only be there as a lender of true last resort. If the period we’ve just been through doesn’t wake everyone up to this reality, the high-probability that current monetary policy will engender new problems should do it.

Another key point is when new costs are imposed on industry those costs are passed through to the consumer. If the government decides to add on new fees to the largest banks in the financial sector, and they’re already looking at imposing much higher costs on all banks via the FDIC funding agenda, then we’ll see consumers face higher financing costs. This will add another impediment to credit expansion and thus increases the velocity of the headwinds confronting the economy.

NFIB Small Business Economic Trends

The National Federation of Independent Business (the largest small-business organization) stated that their economic trends index fell in November to 88.3 from 89.1 – the lowest level in four months. The six-month average is 88.2. The cycle low of 81.0 was touched in March; the all-time low of 80.1 was hit in April 1980, but just four months later the index was back to 94 and never returned to the 80 handle until this latest recession.

The report showed that six of the index’s 10 components registered negative responses – the key gauge being the hiring figure, which decelerated to -3 from -1. The six-month avg. is -2. As we’ve been talking about, this report is another indication that small businesses will be slow to hire – small firms account for at least 60% of job creation.

Another key reading is the measure of capital spending plans, this is important as an increase in plant and equipment outlays is a major job producer. The gauge fell to 16% from 17% in October –- this matches the lowest point on record; the first time this low was put in was March. The six-month avg. is 17%.

The share of executives expecting better business conditions six months out dropped to 3% from 11% in October. The six-month avg. is 6%

The NFIB’s chief economist stated that “sales are not picking up, so survival requires continuous attention to costs – and labor costs loom large.” He also stated that reductions in stockpiles (the gauge of executives expecting to increase inventories was unchanged at -3; the all-time low of -13 was put in in March and the six-month avg. is -5) “sets the stage for support for new orders in future periods.” This is something we’ve talked a lot about, but firms must first gain confidence in the future.

“New” Stimulus

President Obama, in a speech at the Brookings Institute yesterday, unveiled some “new” ideas – many of which aren’t exactly new. The administration continues to rely on additional extensions to unemployment benefits, food stamps, this idea of providing $250 payments to seniors and veterans and subsidizing health insurance costs for the unemployed – none of which fires up economic activity or job growth, but they’ll seek to spend another $100 billion on these programs. Yes, jobless benefits are the countercyclical programs that put more money than would otherwise be the case in the pockets of the unemployed. But look, benefits already extend out to 99 weeks and each dollar spent by government simply takes a dollar away from the private sector -- either in future taxes or currently as funds are needed to finance this deficit spending.

He also explained that the administration will seek to add $70 billion to infrastructure spending.

However, Mr. Obama did offer some things that actually work. He stated that they would push to extend the higher current-year expensing on business equipment and bonus depreciation schedules through 2010 – such initiatives have a track record of incentivizing business-equipment spending as it allows a business to quickly recover the cost of major asset purchases. (Why does it take a 10% unemployment rate to drag policymakers toward implementing efficacious polices?)

Still, this program that is held over from the Bush years is only effective so long as other government decisions don’t smother its otherwise beneficial effects. I applaud him for offering something here that makes sense.

In all, any stimulus plan that is not simply a function of government getting out of the way of private industry only drags out the adjustment process, elongating economic weakness. Sure it may offer the appearance that improvement has arrived, but in actuality results in weaker levels of growth and more frequent business-cycle contractions. Capitalism is about creative destruction, tearing down old industries that no longer compete and replacing them with more innovative ones that provide for higher living standards in the future. It is also about washing out excesses. While the adjustment process is unpleasant, it does allow for a more fundamentally sound and longer-lasting recovery to ensue. We seem to be forgetting this.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

The S&P 500 closed out with its second straight loss and its fourth decline in eight sessions. Continuing the recent trend of correlation, the dollar rose as crude, gold and stocks all dropped.

In focus today was sovereign debt related news, including a downgrade in Dubai and Greece as well as a warning to the U.S. and U.K. None of these countries debt problems are new, but they give market participants a perfectly good reason to sell a top-heavy market.
--

Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks slipped a bit on Monday, led by a decline in financial shares after Fed Chairman Bernanke gave a speech explaining that credit continues to contract and suggested delinquency rates will remain elevated as he cited the employment situation several times. Interestingly, consumer discretionary shares were among the top-performing sectors. Telecoms and utility shares were the leaders on the session.

In one relatively short speech Chairman Bernanke dispelled any idea that the Fed is about to even mildly remove its unprecedented level of monetary easing (recall this was the topic yesterday) by stating that the economy faces formidable headwinds, has some way to go before a self-sustaining recovery is assured, and questioned whether growth will be strong enough to materially bring down the unemployment rate. As a result, the dollar dropped like a rock from its early-session gains and the price of gold came off if its lows.

Funny thing that occurred though was stocks turned lower about two hours after the Bernanke speech and the dollar bounced off of its speech-driven plunge. I call this funny because the trend that’s been in place has been stocks rally when the Fed makes negative remarks (and signals ZIRP’s life expectancy has increased) – this trend has signaled the easy-money trade remains in the game. However, this late-session move lower in stocks, and up from the day’s low point in terms of the dollar, may now indicate a little safety trade in back on. We’ll have to watch this week’s activity to confirm a new trend but for what its worth (which probably isn’t much) it felt like things changed a bit.

Volume turned back down yesterday after Friday’s more normal levels (only the second session out of the past 20 in which we broke the 1.2 billion mark) as activity came in below one billion.

Market Activity for December 7, 2009
Stimulus Rolls On, But Other Actions May Smother

As we were just talking about Friday’s trade in yesterday’s letter, specifically the concern that the Fed will remove their aggressive level of accommodation sooner than previously believe, the Chinese government came to the rescue. That government stated early Monday morning that they will maintain “moderately” loose monetary policy and “proactive” fiscal policies through 2010. This helped to ease pressures on pre-market futures trading and flowed into the trading session. Stocks were set to move much lower when I came in on Monday morning.

The market continues to depend on stimulus programs (I’m shifting back to the domestic front) because the data shows that this nascent recovery is weak, at least to this point. While things are lackluster right now even with stimulus efforts (literally more than half of the 2.8% increase in third-quarter GDP was due to clunker-cash driven auto assemblies and fed-induced ground-level interest rates and tax credits that helped home sales and thus a bump in home building) there are a lot of economists that believe the expansion will soon turn robust.

Historically, it is true, the deeper the contraction the stronger the expansion that follows. We’ll find out if the current environment will prove consistent with this history when the fourth-quarter GDP reading is released. The historical record shows that coming out of the deepest postwar recessions –1958, 1974 and 1982 – that two quarters after the final negative GDP print the economy began to surge at a 7.8% pace in the following year, on average. (That two-quarters-removed reading begins in the current quarter.) Yet I feel many people seem to be forgetting that expansions are generally helped by the Fed lowering rates and the increase in household debt levels that ensue. That expansion of credit allows for spending to offset general economic weakness. This time though, while the Fed has certainly floored interest rates, households are not in a position to increase debt loads -- not with the jobless rate in double-digit territory and consumers flush with debt; the two have never occurred simultaneously in the postwar era.

And there is another thing: the EPA slipped an “endangerment” finding on carbon dioxide in April and declared it a health hazard yesterday, which set the stage for President Obama to formally declare CO2 a dangerous pollutant. (Offers the president some bargaining power at the Smokenhagen conference) The promulgation is expected this week, as the WSJ reported yesterday. Yes, that’s right; CO2 will be considered a pollutant – you now must refrain from exhaling. Quiet though, we don’t want to alarm the plants.

What this means is that it doesn’t take passage of a cap-and-trade system (officially, the Waxman-Markey bill), this allows Washington the power to regulate all production in the U.S. – all without a vote. This will only increase uncertainty regarding future business costs and thus takes away another historical driver of expansions – business-investment spending.

It apparently isn’t enough that firms must attempt to manage their businesses unaware and trepidatious as to just how the health-care legislation will come down and to what extent tax rates will be increased. I guess Washington feels the private sector needs yet another burden to work around. The result will be a heightened level of business caution – and that caution will show itself in lower job growth and much less private-sector activity in general. (This is showing up in the monthly NFIB Small Business Confidence Survey, which is just out for November. The reading, which would normally begin to rise by this point remains stuck – we’ll touch on this reading in tomorrow’s letter.)

Of course, there are many among us that do not at all believe this is by accident or a complete ignorance as to just how our economy works, but rather by design. I’ve got to say, based upon the way that the current congressional leadership believes an increased government role in the economy will prove beneficial it’s pretty difficult to argue with them. Bottom line is that this all increases the headwinds that the early-stages of expansion must endure – these headwinds appear to be picking up speed.

Conference Board’s Employment Trends Index (ETI)

The Conference Board (a 90-year old independent economic research group) stated its ETI rose to 90.8 for November from October’s reading of 89.2. The reading is the highest since March, but remains nearly 10% below that of a year ago. A year ago the economy was shedding 650,000 jobs per month.
(The reading is well below that of a year ago probably because two of the indicators that comprise the index continue to pressure. These are: respondents who say jobs are “hard to get” and the number of people working part-time because they cannot find full-time work. The Conference Board doesn’t give the specifics on these readings, so I’m guessing here based upon other economic readings that suggest these two areas continue to fall. People saying jobs are “hard to get” continues to make new highs as shown by the consumer confidence survey and the monthly jobs report shows that the number of people working part-time for economic reasons remains at extreme elevations.)

The improving indicators were jobless claims, the number of temporary workers, industrial production, job openings and real manufacturing and trade sales. The index is released the Monday following a monthly jobs report.


Consumer Credit

The Federal Reserve reported that consumer credit contracted in October for the 10th month in a row, which extends the record (data goes back to 1943). The figure is being pressured by a significant decline in credit card lines. The drop in overall credit was well-below what was expected though, contracting just $3.5 billion vs. the $9.4 billion that was expected. The September data was revised up also, showing credit declined $8.8 billion instead of the $14.8 billion initially estimated.

Revolving credit (credit cards) continues to plunge -- down $7 billion, or 9.3% at an annual rate -- as lines are being slashed due to eroding credit quality and consumers cut back. Fitch Ratings stated that more consumers fell behind on credit-card payments in October and several banks reported their highest delinquency rates for 2009. Such is reality with 10% joblessness and 17.2% underemployment.

Non-revolving credit (basically car loans) rose $3.4 billion, or 2.6% at an annual rate. The average maturity on an auto loan stretched out to 64.4 months in October and the loan-to-value increased to 93%.

We’ll be without a major economic release until Wednesday. The big event of the week will be the October retail sales data that is due out on Friday.


Have a great day!


Brent Vondera, Senior Analyst