The latest manufacturing survey from the Institute for Supply Management showed meaningful improvement. It remains in contraction mode, but hit a reading that offers strong evidence we’ve seen the worst in the factory sector. Now we have to get past the latest hurdle, the degree to which auto-plant closings weigh on these factory gauges.
Energy, utility, telecom, industrial and tech shares all outperformed the overall market. The laggards were financial, consumer discretionary and health-care shares.
Market Activity for May 1, 2009
Stress Tests
Well, as everyone knows the stress tests will not be released today as originally planned, but Wednesday now – I wouldn’t be surprised if the results were delayed again.
We’ve talked about how harmful the decision to run these tests can be. If the Fed says every bank tested is ok, then no one believes it. If they identify that 5-6 banks lack the appropriate level of capital (as is expected) then those institutions can forget about having access to private capital, which leaves guess who?
But beyond that, the decision to move away from Tier 1 capital as a way to set capital adequacy to what’s known as tangible common equity (TCE) as the capital measure seems blatantly stupid. (For clarity, Tier 1 capital includes preferred shares along with common shares; TCE on the other hand subtracts preferred shares from the assets available if the bank is liquidated and leaves just common equity as the capital source – common equity being the capital received from shareholders and retained earnings)
The really flawed reasoning behind this decision is that the government capital injections and the shift to TCE may actually make these firms worse off. Here’s why:
By shifting to TCE, the government’s preferred shares must be converted to common equity in order to count as capital, but when they are converted, the common shareholder is now diluted as his stake has been reduced due to the increase in common shares – and massively diluted in some cases.
In addition, the government gains more control over the company as common has voting rights. (Yes, the Treasury may say they will give up voting rights or something similar, but give me a break, they will have enormous control over operations)
So, between the dilution of the common shareholder and increased government control, the share price will fall as one would think an investor exodus is highly likely. Since the equity markets live in a Merton Model world, these decisions will do more harm than good. That is, based on the Merton Model a company’s stock price is one variable in determining default risk – if the common stock is pushed lower by investor fears, then the probability of default increases; when this happens the cost of insuring (purchasing credit default swaps) against default rises and that’s when the short sellers come rolling in again.
Oh, and the already hurting personal income figures will get worse as the dividend income component of the data will erode further as high-dividend paying preferred shares are converted into nil-low paying common.
Just as the prior decisions by the government to inject capital via preferred shares had the market scared stiff over nationalization of the banks, and the accounting standard that is mark-to-market unjustifiably caused capital to evaporate, this too will prove destructive.
We remain in a cautious environment; these rallies may cause people to believe otherwise but when the government becomes this involved, nothing good will come of it. This isn’t merely an axiom, but we have mountains of historical evidence as proof.
Crude Oil
Oil futures for June delivery are well-ensconced in the $50 handle again as the latest manufacturing reading and a consumer confidence survey both bounced to the highest levels since the economy went into a tailspin in September.
Crude rose 3.07% on Friday to close the session at $52.69 per barrel. As we’ve touched on over the past couple of months, crude is generally trading on the outlook for economic growth right now rather than very bearish current supply-demand fundamentals – energy demand is down from the year-ago period, while crude supplies remain at 18-year highs. Sentiment is flowing regarding global growth prospects six months out, and thus so goes the oil trade.
University of Michigan Confidence Survey
Confidence among U.S. consumers, as measured by the University of Michigan’s sentiment survey, rose to the highest level since the economic world changed in September. While the index remains very depressed, much like the confidence reading we received from the Conference Board’s Consumer Sentiment survey a week back (the other major confidence gauge), the fact that it is getting closer to the level prior to the economic shock is a really good sign.
Surely, record low mortgage rates (refi activity has reduced monthly expenses) and the 30% rally in stocks from the nefarious low of 666 on the S&P 500 over the past two months have catalyzed this boost in sentiment. It will be interesting to see how these readings hold up as stock prices fluctuate. Ultimately, we’ll need substantial economic growth in order for job losses to ease and this is what it will take to really set stocks on a more sustained path upward and thus confidence.
ISM Manufacturing (April)
The Institute for Supply Management’s factory activity index climbed to 40.1 in April after being stuck in the lowly 30s since September. This is what we’ve been looking for to confirm evidence that the economy has reached a turning point – certainly not close to a full-fledged rebound to expansion but more than just stabilizing at tremendously low levels.
A reading below 50 illustrates the sector continues to contract, which has been the case for the 15th straight month according to this reading. However, getting to the 40 handle was a major step (and a number of 41.2 is believed to show tepid expansion for the overall economy is possible); now it must march higher – even if this will prove difficult with auto plants being idled. That said, there are many other areas within the manufacturing arena that can offer support.
Respondents were fairly upbeat regarding machinery orders, specifically for agriculture-related products and mining. There was also optimism that orders from the chemical industry would change for the better by the third quarter and orders for electrical equipment were slightly improving.
Most sub-indices of the report were moving in the right direction. New orders, backlog of orders and customer inventories were encouraging. Employment and factory inventories remain very depressed.
New order rose six points and closed in on the 50 mark.
The backlog of orders index moved into the 40s.
Customers’ inventories moved below 50 for the first time since July 2008. (This is not factory inventories, but what suppliers think of their customers’ inventory levels. You want this number to move below 50 as it shows suppliers believe their customers’ stockpile levels are too lean; this may offer evidence production will be needed to boost those levels).
The employment index improved, but only from very low levels – it will take some time for this reading to come around, but we’d like to see a bit more of a pop than we got.
Factory inventories barely moved and continue to contract at a greater rate than they were being trimmed prior to September.
Factory Orders (March)
This figure generally mirrors the results we get from the durable goods orders report, which is generally released a week ahead, and it was right in line this time too. Both reports pretty much showed the prior month’s increase was revised down to show half the rise initially estimated and March orders declined. Since we spend much time on durables, I always question whether to put touch on this report, but it’s worth a mention.
The Commerce Department stated factory orders fell 0.9% in March, more than the expected 0.6% drop, and the February gain was revised down to show an increase of 0.7% (initially estimated at +1.8%).
The most important number here is the business-spending figure (technically termed: non-defense capital goods ex-aircraft) and it showed a second-straight monthly increase – up 0.4% in March, which followed a 4.1% gain in February. Business spending has plunged over the past six months, so the increase is off of very low activity. Extending upon this two-month streak is vital as the economy will not be able to count on the consumer boosting activity (not in a sustained fashion at least) over the foreseeable future.
Have a great day!
Brent Vondera, Senior Analyst
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