U.S. stocks kept the rally alive, as the broad market added to last week’s gain, up 8% now over the past six sessions. The major indices began the session higher on the news that CIT was able to find a private-sector rescue, and building on this momentum after the June index of leading economic indicators increased for a third-straight month.
Real quick on CIT, basically they are going to need the FDIC and Federal Reserve to offer them an exemption so that they can transfer funds from the holding company to the bank. This $3 billion in financing the company has just received isn’t going to do much good with $8 billion in debt coming due in 2010. With the exemption, CIT will be able to use deposits to fund assets, largely with regard to their factoring business – factoring refers to the receivables that they own; basically, they buy receivable accounts from manufacturers, pay the manufacturer cash and collect the payments when the customers pay, plus the fee from the manufacturer for the immediate cash payment. Funding is needed for this and since their commercial paper funding has dried up, having the ability to use deposits to fund these operations is about the only thing that will keep CIT from bankruptcy. This is where the big bondholders come in. Many of these investors are politically connected, and now that they have even more money at risk with this additional $3 billion in financing they’ve provided. I’m going to bet they’ll convince the Fed and FDIC to offer the exemption – call me a cynic but I doubt this additional money would have been put at risk without the belief that they (the big bond players) would be able to persuade the authorities, if you will.
Also helping to boost prices was Goldman Sachs’ call for 1060 on the S&P 500 by year end – increasing their target from 940. I see that Credit Suisse has also upped their target this morning to 1050. These are very typical target-price increases, the big investment banks have a track record of increasing forecasts when things are running. I recall Goldman’s target price for oil of $200 per barrel last July when crude hit $140. Point is, while 1050-1060 is not out of the question – although I find it hard to believe and also pretty unjustified for the broad market to trade at 19-20 times earnings in this environment – don’t expect it just because the big guys are saying it.
The S&P 500 marched past the 946 hurdle yesterday (which had been a seven-month high) closing within two points of the post-Election Day high of 953. This time around the trailing P/E on the index is a bit richer at 15.3 times vs.13 back in November – although we’re naturally closer to a rebound in profits at this stage. We expect a statistical recovery to begin this quarter, likely the first positive GDP print in a full year by the time it is reported in October, and higher profits should result three-six months later. (My concern is that those results will prove short-lived as the direction of policy will do its best to choke off a nascent rebound). For now though, stock have momentum working, even the Dow Industrials have gone positive for the year.
Consumer discretionary shares led the rally, with basic material and industrial shares close behind. All 10 major industry groups closed to the plus side; the relative losers being traditional areas of safety, namely health care and consumer staple shares – it was only two weeks ago in which these safety trade sectors were in vogue. How quickly things change these days.
Market Activity for July 20, 2009
Early Excitement
This latest rally in stocks is largely on early profit reporting (just 20% of S&P 500 members have reported thus far) as 75% of firms have beat expectations – the longer-term average is closer 65%. But these are very low-quality earnings, the expectations bar is set very low. A couple of examples are yesterday morning’s release out of Johnson Controls (JCI) and last week’s results from Intel.
JCI stated operating earnings per share easily beat the expectation for 19 cents a share as actual results came in at 27 cents. However, this result means profit is down 64% from the year-ago period; revenue was down 30% and missed expectations. In terms of Intel, the chip giant reported earnings per share of 20 cents, which blew by the eight-cent estimate. Still, earnings were off by 31% from the year-ago period. Heck, DuPont’s results are just out this morning and their numbers easily surpassed the estimate by 15%. However, this number is 48% lower from the year-ago and next quarter’s figure is expected to be off by 44%. Revenues were down 22%.
Another thing to consider is a number of important industries that will post the largest profit declines have hardly reported. Energy profits were crushed in Q2, and just one of the 40 S&P 500 members within the industry has reported. Industrials were hit especially hard as well, probably showing 35%-40% decline in bottom line results; just seven of the 58 members in this industry have reported. Then we have basic material shares, hammered by the plunge in commodity prices and very soft mining activity. These firms ramped up production due to the commodity-price spike of last year, but couldn’t possibly adjust to the speed at which activity shut down – that destroys profit growth. Only 15% of these companies have reported. These three industries make up 25% of the S&P 500. Throw in financials (now your up to roughly 40% of the broad market) where only 16% have reported, and with earnings are on pace to decline 45% we’re looking at some real weakness.
As we’ve talked about many times now, earnings are beating expectations as the cost-cutting that has taken place was more massive than analysts calculated. Cost-cutting is a good thing and an essential aspect of economic downturns. Streamlining makes a business more sound and leads to higher profit results over the longer term, but we need to see final demand make a comeback and that means top-line growth, which we are not even close to seeing.
I just don’t think stocks have much more upside potential here (which absolutely does not mean prices won’t go higher, but in my view it will be unjustified) until we see improvement in revenue results and better-year-over-year bottom line growth, which is likely a ways out still. You’ve got to be careful not to chase these rallies, be patient and wait for your spots. High-powered profits may very well present occur a couple of quarters out (and that may be too optimistic) as the degree to which payrolls have been cut almost guarantees it, especially as year-ago comparisons will be much easier to beat. But this market is mercurial to the extreme and if the current earnings season fails to surpass expectations by the time all reports are in… well that’s why its important to pick your spots in these trading-range environments.
Leading Economic Indicators (LEI)
The Conference Board’s LEI index (a gauge that is supposed to predict economic activity six months out) increased for a third straight month in June, up 0.7% after strong readings in the prior two months of 1.3% and 1.0%, respectively. The components that contributed most to the last month’s reading were building permits, interest-rate spreads (the yield curve) and stock prices.
While seven of the 10 components rose in June, just like on earnings, I’d caution from making too much of this trend.
Building permits were the biggest contributor to LEI, accounting for a third of the index’s gain. When one factors in the high level of home supply and the likelihood that home sales (due to tough labor market conditions) are not likely to be sufficient to absorb this supply anytime soon, I don’t think we can count on residential building construction to propel this figure higher in a sustainable manner.
The interest-rate spread (much lower short-term rates than long term) component accounted for half of the gain in June LEI and a third of the May and April gains. The spread we often talk about is that between the 10-yr and 2-yr Treasury notes, which remains near a two-decade high (it may be an all-time high) of 275 basis points hit in late May. The actual spread measured by LEI is that between the 10-year and fed funds, which is ultra wide since the FOMC has pushed fed funds to essentially zero. While this spread is undoubtedly very helpful for growth, it is also a function of the Fed holding the short end very low. This spread is always a function of Fed policy, so no difference in that respect, but I don’t like to see the LEI index as dependent on this one component as it is today. Surely the ability for banks to borrow low and lend much higher is a huge incentive to make loans. But let’s not forget that it’s not only about the supply of loans, but the demand for credit is soft. Firms continue to cancel projects, there are fewer business upstarts and credit standards are much tighter – and appropriately so. Even a massively upwardly sloping yield curve can’t fix this, only time can mend this situation.
Then we have stock prices, which accounted for 15% of the pick up in LEI (so these three components were responsible for 98% of the June increase), and with the activity we’ve seen over the past several months – rallies met by subsequent weakness that has kept us range bound – it’s tough to view stocks as an indicator that economic conditions have changed to an environment in which we’ll see the typical business cycle expansion.
What’s more, what I consider one of the most important components of the index (orders for business equipment) declined in June. As business managers have expressed via earnings reports, firms continue to delay equipment purchases and one should be concerned this trend will continue as economic policy (specifically higher tax rates on small business) is not inspiring the outlook for growth over the next two years. This component has to rise in order to confirm what LEI is suggesting.
All of this said, a rising LEI is certainly better than it declining, as it did in 16 of the previous 18 months prior to this three-month trend higher. However, as we’ve expressed a number of times, one needs to be carful here as the normal indicators may not be as reliable as is usually the case. In a letter back June I stated that June will be the month by which the NBER (official arbiter of the business cycle) marks the end to this recession. We may have to push this up to July or August, but when they do call it one of these months will mark their end date. However, things may remain quite soft even as we do rebound because we see the eventual expansion as a statistical bounce off of very low levels of activity. The economy will have to deal with a few serious drags on growth, specifically consumer activity that will take an extended period of time to come back.
Caterpillar is just out with earnings results as I type. The heavy-equipment maker destroyed the estimate, reporting 72 cents per share vs. the 22-cent estimate. This has turned stock futures to positive territory. Cat’s year-over-year results are down 58% and revenue was crushed, off by 41%.
Have a great day!
Brent Vondera
Real quick on CIT, basically they are going to need the FDIC and Federal Reserve to offer them an exemption so that they can transfer funds from the holding company to the bank. This $3 billion in financing the company has just received isn’t going to do much good with $8 billion in debt coming due in 2010. With the exemption, CIT will be able to use deposits to fund assets, largely with regard to their factoring business – factoring refers to the receivables that they own; basically, they buy receivable accounts from manufacturers, pay the manufacturer cash and collect the payments when the customers pay, plus the fee from the manufacturer for the immediate cash payment. Funding is needed for this and since their commercial paper funding has dried up, having the ability to use deposits to fund these operations is about the only thing that will keep CIT from bankruptcy. This is where the big bondholders come in. Many of these investors are politically connected, and now that they have even more money at risk with this additional $3 billion in financing they’ve provided. I’m going to bet they’ll convince the Fed and FDIC to offer the exemption – call me a cynic but I doubt this additional money would have been put at risk without the belief that they (the big bond players) would be able to persuade the authorities, if you will.
Also helping to boost prices was Goldman Sachs’ call for 1060 on the S&P 500 by year end – increasing their target from 940. I see that Credit Suisse has also upped their target this morning to 1050. These are very typical target-price increases, the big investment banks have a track record of increasing forecasts when things are running. I recall Goldman’s target price for oil of $200 per barrel last July when crude hit $140. Point is, while 1050-1060 is not out of the question – although I find it hard to believe and also pretty unjustified for the broad market to trade at 19-20 times earnings in this environment – don’t expect it just because the big guys are saying it.
The S&P 500 marched past the 946 hurdle yesterday (which had been a seven-month high) closing within two points of the post-Election Day high of 953. This time around the trailing P/E on the index is a bit richer at 15.3 times vs.13 back in November – although we’re naturally closer to a rebound in profits at this stage. We expect a statistical recovery to begin this quarter, likely the first positive GDP print in a full year by the time it is reported in October, and higher profits should result three-six months later. (My concern is that those results will prove short-lived as the direction of policy will do its best to choke off a nascent rebound). For now though, stock have momentum working, even the Dow Industrials have gone positive for the year.
Consumer discretionary shares led the rally, with basic material and industrial shares close behind. All 10 major industry groups closed to the plus side; the relative losers being traditional areas of safety, namely health care and consumer staple shares – it was only two weeks ago in which these safety trade sectors were in vogue. How quickly things change these days.
Market Activity for July 20, 2009
Early ExcitementThis latest rally in stocks is largely on early profit reporting (just 20% of S&P 500 members have reported thus far) as 75% of firms have beat expectations – the longer-term average is closer 65%. But these are very low-quality earnings, the expectations bar is set very low. A couple of examples are yesterday morning’s release out of Johnson Controls (JCI) and last week’s results from Intel.
JCI stated operating earnings per share easily beat the expectation for 19 cents a share as actual results came in at 27 cents. However, this result means profit is down 64% from the year-ago period; revenue was down 30% and missed expectations. In terms of Intel, the chip giant reported earnings per share of 20 cents, which blew by the eight-cent estimate. Still, earnings were off by 31% from the year-ago period. Heck, DuPont’s results are just out this morning and their numbers easily surpassed the estimate by 15%. However, this number is 48% lower from the year-ago and next quarter’s figure is expected to be off by 44%. Revenues were down 22%.
Another thing to consider is a number of important industries that will post the largest profit declines have hardly reported. Energy profits were crushed in Q2, and just one of the 40 S&P 500 members within the industry has reported. Industrials were hit especially hard as well, probably showing 35%-40% decline in bottom line results; just seven of the 58 members in this industry have reported. Then we have basic material shares, hammered by the plunge in commodity prices and very soft mining activity. These firms ramped up production due to the commodity-price spike of last year, but couldn’t possibly adjust to the speed at which activity shut down – that destroys profit growth. Only 15% of these companies have reported. These three industries make up 25% of the S&P 500. Throw in financials (now your up to roughly 40% of the broad market) where only 16% have reported, and with earnings are on pace to decline 45% we’re looking at some real weakness.
As we’ve talked about many times now, earnings are beating expectations as the cost-cutting that has taken place was more massive than analysts calculated. Cost-cutting is a good thing and an essential aspect of economic downturns. Streamlining makes a business more sound and leads to higher profit results over the longer term, but we need to see final demand make a comeback and that means top-line growth, which we are not even close to seeing.
I just don’t think stocks have much more upside potential here (which absolutely does not mean prices won’t go higher, but in my view it will be unjustified) until we see improvement in revenue results and better-year-over-year bottom line growth, which is likely a ways out still. You’ve got to be careful not to chase these rallies, be patient and wait for your spots. High-powered profits may very well present occur a couple of quarters out (and that may be too optimistic) as the degree to which payrolls have been cut almost guarantees it, especially as year-ago comparisons will be much easier to beat. But this market is mercurial to the extreme and if the current earnings season fails to surpass expectations by the time all reports are in… well that’s why its important to pick your spots in these trading-range environments.
Leading Economic Indicators (LEI)
The Conference Board’s LEI index (a gauge that is supposed to predict economic activity six months out) increased for a third straight month in June, up 0.7% after strong readings in the prior two months of 1.3% and 1.0%, respectively. The components that contributed most to the last month’s reading were building permits, interest-rate spreads (the yield curve) and stock prices.
While seven of the 10 components rose in June, just like on earnings, I’d caution from making too much of this trend.
Building permits were the biggest contributor to LEI, accounting for a third of the index’s gain. When one factors in the high level of home supply and the likelihood that home sales (due to tough labor market conditions) are not likely to be sufficient to absorb this supply anytime soon, I don’t think we can count on residential building construction to propel this figure higher in a sustainable manner.
The interest-rate spread (much lower short-term rates than long term) component accounted for half of the gain in June LEI and a third of the May and April gains. The spread we often talk about is that between the 10-yr and 2-yr Treasury notes, which remains near a two-decade high (it may be an all-time high) of 275 basis points hit in late May. The actual spread measured by LEI is that between the 10-year and fed funds, which is ultra wide since the FOMC has pushed fed funds to essentially zero. While this spread is undoubtedly very helpful for growth, it is also a function of the Fed holding the short end very low. This spread is always a function of Fed policy, so no difference in that respect, but I don’t like to see the LEI index as dependent on this one component as it is today. Surely the ability for banks to borrow low and lend much higher is a huge incentive to make loans. But let’s not forget that it’s not only about the supply of loans, but the demand for credit is soft. Firms continue to cancel projects, there are fewer business upstarts and credit standards are much tighter – and appropriately so. Even a massively upwardly sloping yield curve can’t fix this, only time can mend this situation.
Then we have stock prices, which accounted for 15% of the pick up in LEI (so these three components were responsible for 98% of the June increase), and with the activity we’ve seen over the past several months – rallies met by subsequent weakness that has kept us range bound – it’s tough to view stocks as an indicator that economic conditions have changed to an environment in which we’ll see the typical business cycle expansion.
What’s more, what I consider one of the most important components of the index (orders for business equipment) declined in June. As business managers have expressed via earnings reports, firms continue to delay equipment purchases and one should be concerned this trend will continue as economic policy (specifically higher tax rates on small business) is not inspiring the outlook for growth over the next two years. This component has to rise in order to confirm what LEI is suggesting.
All of this said, a rising LEI is certainly better than it declining, as it did in 16 of the previous 18 months prior to this three-month trend higher. However, as we’ve expressed a number of times, one needs to be carful here as the normal indicators may not be as reliable as is usually the case. In a letter back June I stated that June will be the month by which the NBER (official arbiter of the business cycle) marks the end to this recession. We may have to push this up to July or August, but when they do call it one of these months will mark their end date. However, things may remain quite soft even as we do rebound because we see the eventual expansion as a statistical bounce off of very low levels of activity. The economy will have to deal with a few serious drags on growth, specifically consumer activity that will take an extended period of time to come back.Caterpillar is just out with earnings results as I type. The heavy-equipment maker destroyed the estimate, reporting 72 cents per share vs. the 22-cent estimate. This has turned stock futures to positive territory. Cat’s year-over-year results are down 58% and revenue was crushed, off by 41%.
Have a great day!
Brent Vondera
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