Daily Insight

U.S. stocks declined Wednesday as the market suddenly reversed course with an hour left in the session – completely the opposite of the trend we’ve seen of late – as the Fed’s latest commentary on the economy may have been more pessimistic that some had expected and a major financial-industry analysts rated shares of Wells Fargo a “sell” late in the day.

Stocks had been chugging along for most of the day, appearing to be aloof to Wells’ earnings report that showed profit was boosted by mortgage-servicing fees rather than improving business trends and non-performing loans climbed 28% from the previous quarter. But the comments from Dick Bove, the analyst referred to above, apparently caused the market to take notice. The decline in stocks, relative to the open, was hardly a rout, but the move from the intraday high was fairly substantial – nearly a 2% move.

News that the Pay Master (did you ever think that such a government job would exist in this country – Ok, the official title is Special Master for Compensation, but what’s the difference?) had decided to slash the compensation of the 25 top employees at seven firms that received government aid, probably didn’t help matters. That news was released in the afternoon, and while I’m sure there won’t be a lot of sympathy extended to these employees, it doesn’t exactly juice market sentiment.

How are these firms going to attain top talent if prospects can’t be sure their compensation contracts won’t be torn to shreds by some bureaucrat? All in all, we’re only talking about seven firms here, and a couple may not even be capable of competing in the global market place. But the U.S. does not want to travel down this central-planning path any further than we already have. I see Mr. Geithner wants to take TARP funds and assist small businesses in attaining financing – small business executives will think twice about getting in bed with the devil.

In the end, nine of the 10 major sectors closed lower on the session, utilities being the only sector to close higher. Financials were the worst-performing sector.

Volume came in at 1.35 billion shares traded on the NYSE Composite, in line with the six-month average.

Market Activity for October 21, 2009
Mortgage Applications

The Mortgage Bankers Association reported that their index of applications fell hard in the week ended October 16, down 13.7%. The index was led lower by a 16.8% decline in refinancing activity (which currently makes up 65% of the measure. The 30-year fixe-rate mortgage rose to 5.07% (sub-5.00% has been the sweet spot) from 4.88% two weeks ago.

Purchases fell 7.6%, after a 5.0% decline in the prior week – the first back-to-back declines since mid-April. It appears we’re entering a hangover period as buyers will probably not be able to close on a contract by the tax-credit deadline of November 30. Thus, we’re either seeing a trend lower in home sales due to the front-loading effect of the rush to collect the $8,000 tax credit (which undoubtedly borrowed from future sales to some extent) or potential buyers are anticipating an extension to the credit and for now will simply wait on the sidelines.


Fed Beige Book

The Federal Reserve’s Beige Book -- its survey of economic conditions within each of its 12 districts, released about every six weeks – stated that its regional banks cited “stabilization or modest improvement,” led by housing and manufacturing activity, from depressed levels. All regions reported weak or declining commercial real estate markets. The Fed regional banks observed “little or no” inflation pressures and demand for loans was “weak or declining.” They saw “further erosion in credit quality” across many districts. Reports of gains in economic activity mostly outnumbered reports of decline, but virtually every reference to economic improvement was termed as “small or scattered.”

My main concern with the Fed summary of economic conditions, well I have duel concerns but this one first, is the reference to the housing market as one of the primarily drivers of economic improvement. I feel a number of things may have come together over the previous few months that caused the housing market to rebound from its cycle low hit in the first quarter. There was the tax credit, very low Fed-induced interest rates, and the best seasonal period for home buying that may have caused a very short-lived improvement. I do not think it is out of the question to wonder if we’re headed for another relapse in housing now that the tax-credit has essentially expired and the buying season has passed. Now housing will depend more on it overriding element – the labor market, which needless to saw is very weak.

The second concern is that the report cited manufacturing activity as the other driver. The sector definitely got a pop from “cash for clunkers,” which was a one-and-done event. Most regional factory surveys have remained in expansion mode of late, but we have seen conflicting data on inventory rebuilding. If this rebuilding is not in full effect, manufacturing activity may have a tough time sustaining these gains. As a result, while I do not personally expect the economy to contract again over the next few quarters, the upward trajectory may be extremely weak.

The best news out of the report concentrated on the tech sector. As earnings reports have illustrated, the only area we’re seeing more than scant evidence of revenue growth (the gauge many are using as an indication of aggregate demand) is within tech services and equipment. The Fed stated many districts observed increased demand for high-tech services.

Overall, business spending plans remained subdued as firms continue to conserve, according to the Fed. Employment conditions were generally reported as weak or mixed, but a few encouraging signs were noted as a couple of districts saw some increase in temp. services.

Earnings Season

Third quarter profit results are shaping up much better than expected. In general, firms continue to blow by earnings expectations, but we have yet to see them deliver on the revenue side.

As firms beat expectations, and some are massively surpassing those numbers, all we hear about is the bottom line results. But this earnings season was supposed to be about much more. When second-quarter earnings season came to an end, the market was planning on intensely watching top line growth (evidence of the direction of final demand) and what firms say about capital expenditure plans with regard to this earnings season. There are a couple of reports over the past two days that I’ve found quite interesting in these respects.

The first was DuPont’s results – the chemical giant that the market looks to for evidence of an economic turn as this is one of the most cyclical businesses out there. DuPont stated that they will continue to aggressively cut costs and reduce capital expenditures, and three of four business segments saw revenues get hammered. Ag. & Nutrition down 5%; Coatings & Colors down 16%; Electronic & Communications down 13%; Performance Materials down 24%.

Then there was Caterpillar’s results, which is another major cyclical and a firm we’ve expected to do well since March due to China’ massive stimulus programs (and their commodity purchases in order to hedge against a declining dollar as CAT’s mining equipment benefits greatly from this). Well, CAT destroyed the earnings estimate by a multiple of 10 (recording EPS of 44 cents vs. the 4-cent estimate – although this means profit was still down 68% from year-ago period). But revenue continues to get crushed, down 43% from the year-ago period and if you think that is an unfair comparison due to last summer’s commodity-price spike, revenues are still down 22% comparing all the way back to the same quarter in 2004.

The most important thing I took from the earnings report was the company’s comments on monetary policy support, as mentioned yesterday. They fear that if monetary policy doesn’t remain floored throughout 2010 the economy (it wasn’t totally clear if they were referring to global or U.S.) will relapse.

These are just a couple of looks, but they are looks at the most cyclical of names, which is important to keep one’s eye on at this point in the cycle

With regard to business spending, which is something this economy desperately needs in order to offset some of the weakness from the consumer side, firms are still not showing a willingness to let go of cash. The exception is in the tech industry, where there is a replacement cycle occurring. But among things like plant and heavy equipment, it will just take a while for spending on these items to make a comeback. There is way too much spare capacity out there, as we have illustrated many times by showing the chart of capacity utilization; this reading remains near its 40-year low. Thus, firms can simply rev up currently idled factories and equipment if they need to produce more. This means less job growth as the need to build new plant and equipment is a massive job creator.

From an overall perspective, as we talked about back in June I think it was, looking ahead we expect to see big bang profit results for two quarters, Q4 2009 and Q1 2010 – largely on cost-cutting. (Right now S&P 500 profits continue to endure a postwar record-setting ninth quarter of earnings decline).

The problem is that since firms have cut payrolls so aggressively, it’s highly likely we’ll lack the final demand needed in the quarters ahead to keep the earnings streak going. Oh, and with oil prices now above $80 and gasoline looking like its headed for $3, final demand will be pressured that much more.

Consider these things, in addition to the coming tax hikes, poor credit quality that may just keep loan activity depressed, and the opening of Pandora’s Box due to intense government intervention and maybe you can understand why I’m concerned about the current level of stock prices.


Have a great day!


Brent Vondera, Senior Analyst