General Electric earnings and Pfizer's huge acquisition

General Electric (GE) -10.76%
The best thing about GE’s earnings release is that it contained no surprises, which I thought would be enough to keep shares from dropping further. However, concerns that GE cannot maintain both its Triple-A credit rating and its $1.24 per share dividend payment continues to weigh on sentiment.

The industrial operations showed signs of resilience in the face of a very weak economic environment. The big performance driver continues to be the energy segment, which recorded double-digit growth. Any stimulus package that includes renewable-energy tax credits and production tax credits will continue to drive growth in this segment. Infrastructure orders fell six percent, but backlog rose nine percent. GE said it ended the year with $172 billion of infrastructure equipment and service backlogs.

GE Capital turned in $383 million in profits, but when tax benefits are excluded, the unit lost $1.5 billion. The bulk of this loss is attributable to a $3.1 billion increase in loan loss provisions for financing receivables. The provisions were adjusted higher because of GE’s anticipation of rising delinquencies in the commercial consumer portfolios as higher unemployment levels could hinder consumers’ ability to repay debt.

GE has taken considerable moves to bolster there balance sheet. GE’s cash balance tripled to $48 billion last year, and they have an untapped revolving credit facility of $65 billion. Commercial paper outstanding came in at $72 billion at the end of December, down $16 billion in the quarter, and the company is targeting a cut to $50 billion by the end of 2009. Improvement in GE’s debt should help alleviate concerns regarding the company’s coveted Triple-A credit rating.

GE stressed that their “better safe than sorry” approach is meant to insulate the firm from the uncertainty in the broader financial markets. By making the business model more conservative, the firm has positioned itself to perform well over the long term.

CEO Jeff Immelt restated GE’s commitment to the dividend: “The first quarter dividend is done, and we are committed to our plan for $1.24 per share for the year…We believe the GE dividend provides our investors with a solid return in this uncertain time.” You have to admit, GE certainly deserves some measure of credit for elevating shareholder interest above an agenda growing the business at any costs (see Bank of America, Citigroup, etc).

Looking forward, the company expects 2009 to be “extremely difficult,” but the company has strengthened its cash flow position and taken steps to cut costs. Immelt said the company is position to “return to double-digit growth in a post-recession economy.”

So, are the concerns regarding GE’s dividend and credit rating legitimate or has the company been oversold?

These concerns are legitimate in that one of the two may be cut. The company’s projections for $5 billion profit at GE Capital and five percent earnings growth at the largest industrial and media units are aggressive, and these expectations rely heavily on the economy picking up in the second half of 2009. If these expectations are not met and the current economic conditions persist into 2010, then GE’s dividend or credit rating will likely need to be sacrificed.

However, GE still looks extremely attractive considering their growth potential. The loss of the credit rating or dividend payment would not cripple the company’s prospects for solid post-recession growth.

If the dividend is cut by half, for example, the shares would still be yielding over five percent. This would, in turn, keep their credit rating intact and keep borrowing costs lower than their competitors. Even more, the company could use the additional funds no longer being paid out in dividends to invest in their business for future growth.

If GE instead lost their Triple-A rating, it would lead to greater borrowing costs and put a dent in profitability. In this scenario, GE would maintain their dividend payout, which gives investors a nice return in this difficult market. Standard & Poor’s cut GE’s outlook on Dec. 18, giving the company a one-in-three chance of losing its top rating over the next two years.


Pfizer (PFE) +1.39%
Multiple reports surfaced today that Pfizer is in talks to buy Wyeth (WYE) in a deal speculated to be worth over $60 billion. Some have identified Wyeth as a likely target for Pfizer because of their established foothold in biotechnology, steady consumer-health unit and large cash position.

Pfizer has used big acquisitions in the past as platform for growth, and their reliance on big takeovers over strong in-house research and smart licensing has destroyed an enormous amount of shareholder wealth.

Neither company needs to complete the deal immediately and negotiations could drag on throughout the year. Given the very challenging capital markets, Pfizer’s limited access to major financing may also delay a merger. In the event of a stock deal, the relative cheapness of Pfizer’s equity may prove to be destructive to the value of a merger, and thus lead shareholders to disapprove of the action.

Pfizer has long been expected to make a big acquisition, and it is likely that we will see much more consolidation in the pharmaceutical industry in 2009.


Quick Hits

• Companies Slash Dividends at Fastest Rate in 53 Years
• Citigroup, Bank of America ‘Nationalized’ as U.S. Call Shots
• Bank of America-Merrill Lynch: A $50 Billion Deal From Hell
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks declined Thursday as continued concerns over the future of the banking sector, very weak economic data and downbeat earnings reports combined to erase the prior session’s apparent euphoria.

Microsoft reported an 11% decline in fiscal second-quarter earnings, missing both street forecasts and its own guidance. The company stated it will cut 5,000 jobs over the next year-and-half, the first substantial round of layoffs in its history.

Fifth Third Bancorp apparently threw in the kitchen sink regarding write-downs and provisions jumped – in its latest profit release. We’ve heard that kitchen sink story plenty of times now from the industry only to see substantially higher levels of write-downs in the subsequent quarter, so we’ll see if this is in fact true. The adverse feedback loop due to the current accounting regime makes this an endless story.

The day’s economic reports, which we’ll get to below, offered no help as housing starts fell to another new low and building permits illustrated residential construction activity may make another new low when the January figures are released next month.

Financials led the market lower, falling 5.84% and the tech-sector was the next worst performer, although the hardware and equipment component of the sector gained ground, which cushioned the blow.

Utility and industrial shares performed well on a relative basis; however, if not for a 1.00% gain within the transportation component industrials would have been down more. Health-care was the only positive sector for the session.


Market Activity for January 22, 2009

Jobless Claims

The Labor Department reported initial jobless claims came in well-above expectations, jumping 62,000 to 589,000 for the week ended January 17 – so much for the wish of holding below the 550k level. This is the week that corresponds with the employment survey for January, suggesting we’ll see another big month of payroll losses.

The four-week average of claims was unchanged, at 519,250, but that will rise next week after this latest increase.


Continuing claims jumped 97,000 to 4.607 million for the week ended January 10 (there’s a one-week lag on this data), after falling 102,000 in the prior week.

It will be interesting to watch what occurs within continuing claims as there are reports California and New York are running out of jobless insurance funds. Maybe they should have run things more responsibly when state tax revenues were flooding in 2005-2007. Of course, the federal government will step in to bail them out, which means all of us in other states are bailing them out.


The insured unemployment rate (jobless rate for those eligible for benefits), which generally tracks the direction of the overall unemployment rate, held steady at 3.4%.

Again, this data suggests the January payroll report will post another outsized loss, we’re calling anything greater than down 350,000 outsized.

However, one of the best economists out there – John Ryding – believes the seasonal adjustment factors in retail may provide a boost to the overall jobs report. That adjustment subtracted a large 615,000 jobs from the retail industry to adjust for temporary seasonal hire. Yet, the unadjusted employment for the industry rose by only 381,000 last quarter (compared to a more typical increase of 700,000, meaning less temp.work was employed) so the seasonal adjustment overshot. Still, we’ll likely see a January payroll loss of at least 400,000 as the claims, ISM employment and layoff data all suggest.

Housing Starts

Residential starts plummeted 15.5% in December to 550,000 units – hitting a new low (and a low low it is) – from 651,000 at an annual rate for November. Separating the components, multi-family starts fell 20.4% last month and single-family declined 13.5%. For perspective, single-family starts are down nearly 80% from their January 2006 peak.


Building permits plunged too, down 10.7% in December to 549,000 units (annual rate) from 615,000 in November. This suggests the January starts figure is going to make a new low (the data goes back 50 years). In addition, we endured severe weather across the country this month so that curtailed activity even more. Although, one would think it will provide a nice rebound for February assuming improved weather.


The level of housing construction is now extremely low relative to average activity and by definition below demographic fundamentals. The intensification of the credit crisis, and resultant economic blowback, is also doing a trick on housing. So, as we’ve stated before it appears several aspects of the housing sector are showing the necessary reversion to the mean, and then some, after several years of outsized growth has taken place. The other factors, such as the credit situation and deep economic contraction of the past quarter will not last a terribly long time. When this foot is taken from the throat of the sector the rebound should be strong, but delayed due to the weak labor market.

In terms of GDP, with housing so weak, even this substantial degree of deterioration will not weigh on the figure as it once had. These declines were subtracting a full percentage point from real GDP, now it will be something like 0.5%.

Pre-Market Activity

Stock-index futures are down big this morning after the U.K. economy shrank more than expected and U.S. earnings reports show things really shut-down last quarter – while we all knew this, it still has an effect on sentiment.

Outside of the financial sector, Q4 profits for the S&P 500 are only down 2.4% with 20% of members reporting thus far. This figure will get much worse, probably falling 8-12% when it’s all said and done as the industrial and tech sectors were hit hard, but certainly major issues within financials, exacerbated by accounting standards put in place just 14 months ago, are making the overall profit picture look much worse than it is.

The areas that appear to offer the most promise over the next few years are industrials and tech.. The industrial sector carries a 4.00% yield and trades at a single-digit multiple. The tech sector trades at 13 times earnings, the lowest multiple in at least 16 years, and even carries a small dividend yield of 1.34%.

While we’re on the subject, the broad market, as measured by the NYSE Composite, offers a 4.76% yield and trades at a 12 times trailing earnings. Assuming normal earnings growth over the next five years, the index can rise 40% over this period and the multiple would remain at the currently low level.

But we must get past some real hurdles first. The economy will eventually take care of itself and indeed the private sector will become increasingly streamlined during this downturn. However, since the Fed and Treasury have helped to calm the credit market chaos, at least from levels seen in October/November, they need to lay off now and make sure the unintended consequences of policy actions do no more harm.

Have a great weekend!



Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries continued their selloff today, especially in the longer end, as the curve steepened 10 basis points to +186. U.S. Treasury Secretary-nominee Timothy Geithner announced that the Obama administration believes China is manipulating its currency, and as a result could decrease their demand for U.S. Treasuries in the future. This along with supply concerns drove longer-dated Treasuries slower.

The New York Fed announced $19 billion in MBS purchases for the seven day period ending yesterday. Continuing to stick to 30-year product but making a slight adjustment toward Fannie Mae issued securities. The Fed’s previous buying had leaned more toward Freddie Mac. I’m not sure they truly have a preference. After taking over control of both agencies they act more like one entity than before, and since they are so early into the program, the Fed is more than likely just mopping up whatever they can find at this point.

What is spread?
Spread is the measure of yield differences between two securities. It is usually quoted in basis points, or one-hundredth of one percent, and is used in order to quantify relative risk and return.

Let’s use a simple example. Today you can purchase a 2-year Bank of America corporate bond around a 5.5% yield. Without knowing anything about the current rate environment there is no way of knowing what kind of deal you are getting here. It’s important to consider the return you are getting relative to the market.

We often use Treasuries in calculations of spread because they are the highest quality in terms of credit and liquidity. The goal of any benchmark is to eliminate as many variables as possible, and in bonds nothing is more “Plain Jane” than Treasuries.

A 2 year Treasury bond is currently yielding .72%. So if you were to purchase the BAC bond I mentioned earlier at 5.5% you would be earning 4.78% more than if you bought the Treasury. Therefore, you could say 2 year BAC debt is trading 478 basis points wide of comparable Treasuries (in bond talk). In other words 478 basis points is the “credit spread”.

Since the bonds mentioned here are both 2-year bonds credit worthiness of the issuers is the only major differentiator. According to the market Bank of America is more likely to default on their debt than the U.S. Government. The larger spread over Treasuries, or the higher relative yield, is how an investor is compensated for the added risk.


Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Afternoon Review

Lockheed Martin (LMT) +6.31%
LMT said fourth quarter earnings increased three percent thanks to expanded sales of computer service and support to federal government agencies.

The company raised their 2009 sales forecast, which reflects decreasing expectations for cuts to the defense budget. However, Lockheed lowered its earnings guidance (first given last October) to reflect increased pension costs after declining stock markets eroded plan assets.

Information technology sales, which gained 16 percent last quarter, helped offset sluggish aeronautics revenue, which declined 4.6 percent. LMT expanded sales of computer service and support to federal government agencies.


UnitedHealth Group (UNH) +8.54%
UnitedHealth posted fourth quarter earnings that were in line with expectations and maintained full-year profit guidance. The company generated about $3.4 billion of free cash flow for shareholders in 2008, $2.7 billion of which was used for share repurchases.

Enrollment levels remained relatively stable, but commercial enrollment losses are likely to accelerate in 2009 as members who lost their jobs earlier in 2008 begin to run out of COBRA benefits. However, the company’s diversification paid off, with Medicaid and Medicare enrollment gains more than making up for the losses in the commercial business.

UnitedHealth expects meaningful growth in government-sponsored business in 2009. The company said there is strong interest in its Medicare market offerings and continued expansion from its state and public health program relationships.

The consolidated medical care ratio increased 90 basis points year-over-year to 80.8 percent. This ratio indicates the percentage of premium revenue that gets paid out in medical claims. For the full year, the medical cost ratio was 82 percent compared with 80.6 percent in 2007.

Realized investment losses remained minor, at $0.03 per share in the fourth quarter, which was primarily because of the write-down of a venture capital investment.


Raymond James Financial (RJF) +2.41%
Raymond James reported fiscal first quarter earnings that came in above analysts’ estimates. Although the outlook was grim for most of 2009, the company has been building its bank operations (Raymond James Bank). While many of its peers are cutting expenses, Raymond James has been looking to boost its market share by snagging brokers, traders and bankers from troubled firms.

CEO Thomas James attributed the bank’s improved earnings to interest rate spreads that increased as a result of federal market intervention, a real estate and corporate loan portfolio that is outperforming industry benchmarks and a loan portfolio that was 36 percent larger at the end of December than a year earlier.

In November, the company applied to participate in the U.S. Treasury’s Troubled Asset Relief Program. Still, the company has yet to report write-downs related to subprime mortgages, a sign the company’s balance sheet is relatively strong.


Noble Corporation (NE) -0.82%
Noble’s earnings exceeded expectations with profits growing 20 percent in the fourth quarter thanks to long-term service contracts.

Despite oil declining 35 percent in the fourth quarter, Noble had contracts in place for some time. We are unlikely to see a decline in earnings for a few quarters simply because they have everything locked up near-term. Nevertheless, there are several uncertainties surrounding drillers in 2009 including low commodity prices, weakness in the capital markets, high contract turnover and the expected deliveries of several uncontracted newbuild jack-ups.

CEO David Williams said in the statement, “While we believe the long-term fundamentals of our industry are sound, the condition of the global economic environment is clearly a cause of concern and a reason for caution.”

Spending by companies around the world on oil and natural-gas exploration is expected to drop 12 percent in 2009 to $400 billion, according to a Dec. 19 report by Barclays analysts.


Quick Hits

• GE Sags as Investors Bet Dividend or Rating May Go
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks recovered most of Tuesday’s losses, rebounding off of a two-month low as a 14.6% jump in financial shares led the broad market higher. The major indices began the session higher, gaining momentum mid-morning as it seemed clear Treasury Secretary Nominee Timothy Geithner wasn’t going to be grilled too badly over his tax return issues – the street appears to like Geithner, largely because they don’t want to see time taken to hunt for a new nominee.

After the close it was reported that Bank of America CEO Ken Lewis and five directors bought 500,000 shares and JP Morgan CEO Jamie Dimon purchased 500,000 JPM shares. That’s a big confidence booster, let’s hope it holds.

Technology stocks also jumped yesterday after IBM issued a 2009 profit forecast that topped estimates. Last night’s strong profit release from Apple should help the NASDAQ again today -- at least at the open, from there it’s anyone’s guess.

Energy shares gained good ground as oil prices jumped 12.42% yesterday. This is part of the contango trade, as the February contract expired on Tuesday and crude for March delivery traded higher. There seems to be some flow through there if I gauging things properly.

Looking over the next couple of weeks this trade should wane and crude prices will likely revisit the $30 handle as it’s all about global growth right now. We’ll get some really ugly GDP readings and that’s going to affect demand expectations and thus the price of crude. (Looking out a bit longer, say six months, I wouldn’t be surprised to see oil settle in around $50-$60 as demand rebounds a bit.)


Market Activity for January 20, 2009

Treasury Nominee

While the street seems to like Geithner, after reading his prepared text for testimony before the Senate yesterday, I’m not terribly impressed. What we have hear is another Keynesian, and the economy really needs better than that. He’s certainly very smart, you don’t become President of the New York Federal Reserve Bank (and by definition a permanent member of the FOMC – the monetary policy committee) without real knowledge of financial intermediation. But then this also reinforces the fact that he is a Keynesian, or demand side thinker, as it is tough for those with opposing views to gain high Federal Reserve posts.

His comments involved too mention of what the world thinks of us and the typical utopian view that regulations can make sure the U.S and global economy “never again face a crisis of this severity.”

On the first, this is completely unrealistic, crises are a fact of life. Further, maybe he should look inward, as it was years of Fed monetary policy mistakes that encouraged the event of over-leverage that the market is now working to correct.

On the international view, he mentions caring what the world thinks of our “ideas and actions” from a regulatory standpoint. A Treasury Secretary needs to focus on making sure his/her country welcomes and treats capital well – nothing more.

Look, we are the engine of global growth. The sooner we get back to being the place where capital seeks to reside (this means higher returns and a stable currency), the rest will take care of itself. Let’s not worry what Europe – economies that are smothered by a massive public sector due to their cradle-to-grave entitlement system and therefore higher rates of unemployment and lower rates of growth – thinks of us. We’ll lead and they will follow if they desire to.)

The soon-to-be Treasury Secretary gave no specifics on what needs to be a plan to house “troubled” assets and no mention of mark-to-market. (The reason we have so many “troubled” assets is not because the vast majority fail to produce cash flow, but because of this insane accounting rule.)

Geithner acknowledged that one of the major issues right now is a lack of confidence, but seems to believe that more regulation is what will bring confidence back. This is a huge mistake.

I know, people these days believe we need more regulation. I’d submit, maybe the Fed should have been engaged in the financial-sector oversight for which they are responsible. If our goal is to add on more overlapping regulation for the sake of it, it will only curtail growth and force business to escape this grip – such as off balance sheet entities that banks used to avoid the current regulatory regime. More regulation results in opacity; less, but enforced regulation, means transparency.

With regard to confidence, we need a bold tax-rate response to deal with this issue. You want a higher level of confidence? Give the market a real sense economic growth will have a chance to flourish and higher after-tax return expectations. That’s what gets confidence rolling.

In any event, we wish him luck with getting the economy back on its feet. But I do not wish him luck with regard to demand-side spending initiatives that create work, instead of longer-run job creation, and a level of budget deficits that help tax hikers sell their agenda to the public.

Today’s Economic Data

It’s been a very quiet week but we get back to it this morning with weekly jobless claims, mortgage applications and housing starts.

The claims data is expected to show a rise for the week ended November 17; we’ll be watching to see if the reading holds below 550k.

Claims moved below the 500k level in the previous couple of readings, reversing a trend that had approached 600k just before Christmas. That move lower was due to poorly adjusted seasonal factors (result of the holidays), which was evident by the 54,000 jump in the week ended January 10. It will be important to hold below that 600k mark over the next several weeks, as it may show the major labor market damage has already occurred. Today’s data will give a good indication – holding below 550k will be helpful for stocks.

On housing starts, residential construction plunged 18.9% in November, to a record low of 625,000 units at an annual rate. On an unadjusted basis, only 29,800 single-family homes were started for the month (the average is roughly 130,000). Building permits – a gauge of future activity – dropped 15.8% in November, which is a good indication we’ll make another new record low when the December starts figure is released today.

Mortgage applications for the week ended January 16 are already out this morning. The Mortgage Bankers Association stated total apps fell 9.8% after a 15.8% rise in the previous week. Purchases rose 2.5% and refinancing was down 12.4%, but that does follow a big 25.6% jump in the previous week.


Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

International Business Machines Corp. (IBM) +11.51%
IBM reported another quarter of solid earnings and issued an outlook for 2009 that exceeds current estimates. Even after adjusting for special items such as lower tax rate and fewer shares, IBM’s profit beat expectations.

While revenues slipped across all geographic regions for a total decline of six percent year-over-year, IBM managed to improved gross margins by generating a larger share of its business from high-profit software and services. Even in its hardware business, solid sales of high-margin mainframe computers helped offset disappointing sales of commodity-type servers and a 34 percent sales drop in its semiconductor division.

IBM ended 2008 with $12.9 billion of cash on hand and generated free cash flow of $14.3 billion, up $1.9 billion year-over-year.

This positive earnings release comes as fellow tech-bellwether Intel’s CEO raises the possibility of a loss in the first quarter, ending its more than 21-year run of profitability.


United Technologies (UTX) -0.22%
United Technologies reported results that met expectations and reaffirmed its outlook for 2009. Earnings did include six cents per share in one-time gains, which are typically not included when comparing to the consensus.

Revenues fell 1.3 percent year-over-year to $14.5 billion (consensus called for revenues of $14.8 billion). The company said that solid margin expansion at its aerospace units and at UTC Fire & Security offset the impact of a sharp decline at its Carrier HVAC unit and declines in its Otis elevator unit.

Aggressive share buybacks (over $3 billion worth in 2008 alone) alleviate some of the 2008 headwinds. Looking into 2009, the company expects the global recession to continue through most of this year, but expects a “modest recovery” in the second half.


Wal-Mart Stores (WMT) -2.81%
Wal-Mart was downgraded by several analysts today in response to the company’s December same-store-sales release and guidance revision.

Wal-Mart’s sales fell short of expectations in all three business divisions, illustrating that even Wal-Mart is not immune to the economic slowdown. The company may not realize any benefits in 2009 from consumers trading down as they did in 2008. In addition, price increases drove the majority of Wal-Mart’s sales growth in 2008, not unit growth.

As CreditSuisse notes, Target is focusing on reducing prices to gain market share, which presents an added competitive threat to Wal-Mart. Longer term, Wal-Mart’s sheer size and fewer stores in peak productivity stage (3-5 years after opening) are likely to challenge sales growth expectations.


Bank of America (BAC) +30.98%, J.P. Morgan Chase (JPM) +25.1%
Bank shares soared after regulatory filings showed that Bank of America CEO Kenneth Lewis and five directors bought more than 500,000 shares yesterday. In addition, Bloomberg reported that JPMorgan CEO Dimon bought $11.5 Million of JPM shares last week. Some view this as an act of confidence, while others see this as no more than an expensive PR move.

Bank of America also announced more job cuts.


First Cash Financial Services (FCFS) -4.64%
First Cash reaffirmed its 2009 earnings guidance today, but still saw selling pressure after competitor Cash America International (CSH) reduced its 2009 earnings forecast citing the faltering economy and the effects of store closings.

First Cash has far greater economies of scale than their competitors, plus their growing exposure to Mexico is helping offset weakness in the U.S. First Cash also has a stronger balance sheet than its competitors, which is allowing them to buyback shares and open new stores in Mexico.


Quick Hits

• Blogs Speculate Bank Nationalization
• Madoff Scandal May Lead to New Rules on Adviser Accountability
  
  
  

Peter Lazaroff, Junior Analyst

January 2009 Portfolio Insights

The January 2009 issue of Portfolio Insights has arrived! This expanded addition includes:

• Strategic Reflections
• Madoff
• Inside the Economy
• Equity Markets Activity
• Fixed Income Strategy
• 2008 Review
• Ask Acropolis

Click here or the cartoon to view the issue.

Daily Insight

U.S. stocks failed to abide by the script, we’re supposed to feel a sense of optimism with the changing of the guard, focusing on reality instead as stocks got clocked. The damage done to overall earnings as the fourth-quarter was hit hard by the credit-market chaos is hammering sentiment again. Uncertainty over the direction of government policy is also roiling the market.

The decline on Tuesday added to the market’s worst week (last week) since November and has lopped off two-thirds of the late-November/December rally that shot the NYSE Composite 28% from the November 20 low – we’re now just 8.75% above that mark. Talk of nationalizing banks, while this would be a last resort, is also causing major concern.

Financials led the broad-market’s decline after the largest money manager for institutions – State Street Corp. – announced unrealized bond losses nearly doubled last quarter; the stock tumbled 59%.

Telecoms, utilities and consumer staples were relative winners; none of the 10 major industry groups were positive, as the chart below shows.


Decliners trounced advancers by a 17-to-1 margin on average volume.

Market Activity for January 20, 2009

Mark-to-Disaster

We made mention yesterday of how the Treasury’s decision to guarantee, or backstop, loans at Citigroup and Bank of America was smart by half. If they’re going to do something, they need to remove these assets from balance sheets. The idea of backstopping increases the odds that institutions with this guarantee in place may now dump this trouble at even lower prices, which reverberates throughout the sector. It appears there was significant deterioration in asset-backed securities in December even as some of the credit indicators managed to improve a bit.

It’s important to mention, State Street said none of these securities that are taking write-downs are in default, but that doesn’t matter with mark-to-market; this is why it’s so damaging. My fear is as we continue to watch this insane accounting standard wrought its destruction, it will continue to lead to additional government decisions that bring their own consequences. We’re trying nine-gazillion things (in typical government Rube Goldberg machine fashion) with all of the unintended consequences that result when we could have simply ended an accounting standard that was just put in place a mere14 months ago. This is not just insane, it’s an exhibition in self-flagellation.

And on bank nationalization, no one in Washington has the skills to run the banking system – we only need to look at Fannie and Freddie for evidence of that, or most other government programs for that matter. Nationalization is not an option, such a decision would be ruinous. What needs to be done is elimination of pro-cyclical accounting standards. This will stop the bleeding and buy time for private money to eventually flow in.

This is not a bankrupt society, even if a bevy of government action is doing its best to make it so. Corporate America is as streamlined as ever and flush with cash. On the consumer side, the vast majority of people are not broke, let’s not act like the situation is reversed.

The private sector is the savior here, we mustn’t forget that. Nor should we forget that it has been mistaken Fed policy (keeping real rates negative for two years) and a regulatory regime that put in place mark-to-market that has done the most damage. This country has built a level of prosperity the world had never seen, and done so in a very short time from a historical perspective – it hasn’t been accomplished by regulating the hell out of private industry.

Crude-Oil

Oil futures continue to plunge as the spot price closed in on $30 per barrel yesterday morning. Just two weeks ago crude looked ready to move past $50, but had tumbled in the last 10 sessions as global economic concerns crush demand expectations. The price on the February contract rose mid-day (after falling to $33 early morning) as traders covered their short positions or be forced to take delivery of product as the contract expired yesterday.

Crude is higher today as the market is in contango, meaning subsequent-month contracts trade higher. At this rate, however, it should come down to the mid-$30s within a couple of days.


While oil and stocks trade in tandem for now (yesterday notwithstanding due to the contract expiration) this makes the decline tough to deal it. However, a huge benefit to consumers has resulted

Real incomes have received a large boost over the past six months, something in the neighborhood of $300 billion. This will not be enough to completely offset the deterioration in labor-market conditions, certainly this event is weighing on confidence along with the rout in stock prices, but it is helping consumers rebuild cash savings – something they have been focused on as their two main savings vehicles (stocks and homes) fall in value. The sooner cash savings are rebuilt, the sooner consumer activity can engage in a rebound.

That said, for now the economic picture continues to get worse. However, with production horrendously weak, inventories are being drawn down in a manner that will set the stage for a rebound in output – but we must get past this period of full blown pessimism and caution first. Once we do the combination of a small boost in consumer activity along with higher business spending and production should drive GDP higher two quarters down the road. But we’re also at the whim of government, so gauging things is even more difficult than usual.

Futures Higher

IBM and United Technologies – both Dow components – have posted some decent results since the close of trading yesterday, this is helping to boost stock-index futures. However, the relatively good results were a function of cost cutting, fourth-quarter revenue declined for both firms.

But this is what economic downturns do, they force the strong to become more efficient and weed out the weak, setting the stage for a stronger business cycle upswing. Government meddling will curtail the next expansion – all they need to concentrate on is removing toxic assets from bank balance sheets and eliminating mark-to-market to replace it with cash-flow accounting. If they engaged in nothing more from this point, we could really be onto something six months out. That’s a big if.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries traded wildly today as the curve steepened 7 basis points to +166 basis points. The 2-year ended the day yielding .705% and the 10-year sold off three-quarters of a point to yield 2.38%. The 30-year, traded as low as 127.5 around 8:30 a.m., before rallying back to 130. This volatility in the Treasury market depicts investor’s true uncertainty towards risk

Mortgages
Mortgages underperformed Treasuries today, with 30-year MBS widening out about 6 basis points to the benchmark curve.

The story with mortgages continues to be the same. Reports of banks beginning to see activity in the refi market is most likely contributing to the underperformance of mortgages. Very few in the market are anticipating a refi boom like that of 2003, but even if we see just a small fraction of that activity, mortgages will behave very differently in 2009.

Fannie and Freddie
Herbert Allison, the CEO of Fannie Mae, was quoted in this morning’s Wall Street Journal as saying, "We're not out to maximize profits… We want to promote responsible homeownership.” These are dangerous words coming from the Chief Executive of a publically traded company. A sign that full nationalization doesn’t seem too far off.

The new surcharges introduced by Fannie and Freddie in 2008 in order to cushion losses taken on non-conforming loans they purchased have now been retracted, in favor of further subsidizing home ownership through artificially lower costs.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Afternoon Review

Johnson & Johnson (JNJ) -1.20%
JNJ topped earnings estimates for the fourth quarter, but their revenues and outlook for 2009 were below expectations.

The economic recession, unfavorable currency exchange rates and generic drug competition hurt fourth quarter revenue and factored into the 2009 outlook, which left open the possibility of a decline from 2008 earnings.

The sales decline was led by a drop of 11.1 percent for prescription drugs, in which cheaper copycat pills displaced Risperdal (its top-selling antipsychotic) and Topamax (migraine pill). Also hurting the U.S. pharmaceuticals market was increasing layoffs that left more people without drug-benefit plans.

JNJ noted that consumers and patients are becoming more frugal. Hospitals are chopping purchases and JNJ has seen sales slow on products ranging from contact lenses to diabetes test strips.

The company’s diversified business model has served it well in comparison to rivals more concentrated in the pharmaceutical industry, and the company will exploit cheap market valuations to make acquisitions. CEO William Weldon identified two areas where JNJ are more likely to be acquisitive: health information-technology companies and companies that specialize in wellness and disease prevention.

JNJ’s strength lies in innovation and diversification. JNJ’s strength across diverse health care niches should offset head winds in pharmaceuticals.


Bank of America (BAC) -28.97%, J.P. Morgan Chase (JPM) -20.73%

• U.S. Bank Stocks Decline
• Bank of America Shares Tumble as Analysts’ Worries Grow
  
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks rallied in the afternoon session on Friday to erase what was a 1.6% decline just before lunch. A very weak industrial production report, which followed an outsized decline for November, was said to have driven stocks lower in the morning session.

We don’t agree with that assessment as the production data, even as it was worse than expected, is hardly a surprise after all other data sets have clearly shown a shutdown occurred last quarter. Rather, the market doesn’t know what to do as investors are attempting to gauge government action instead of focusing on fundamentals. The government is capricious, and thus trading will continue to exhibit quick fluctuations as well.

It was talk that the FDIC and Treasury are going back to the future, as we’ll touch on below, by removing troubled assets from banks’ balance sheets that got things rolling in the back-half of trading.

Market Activity for January 16, 2009

Advancers ended up beating decliners by a two-to-one margin on the NYSE. Roughly 1.5 billion shares were traded, in line with the three-month daily average.

Original TARP Redux

Absent a tax rate response focused to bring in bids for toxic assets and an elimination of pernicious mark-to-market accounting standards, we were proponents of the original intent of the TARP – buying up troubled assets, RTC-style, and holding them until the housing market and investors’ willingness to take risk return to somewhat normal behavior.

Engaging in such action removes assets that are causing the mayhem from bank balance sheets and provides a return to the Treasury as the vast majority of these assets have a higher intrinsic value than the depressed market prices currently assigned to these positions. In a way the latest Citigroup and Bank of America rescues, which include the government backstopping troubled assets, are close to the original TARP proposal -- but not enough; it was smart by half.. These assets must be removed in a way similar to what was done during the S&L crisis of the late-1980s/early-1990s.

Now, Treasury Secretary Paulson and FDIC Chairman Bair have come up with what they are calling an “aggregator bank” to buy and house these assets based on the aforementioned purpose.

Well darn, wish they would have begun this process last year instead of ditching it for lack of timeliness in favor of cash injections – a strategy that has not helped as banks hoard the cash in this highly uncertain environment. All we did was waste time

Hopefully, since our most desired way to attack this problem doesn’t have a chance with Congress, they get to it and begin the RTC model; it might actually work.

In the meantime, mark-to-market accounting requires that institutions continue to write-down assets (even those in which institutions had no prior intention of selling), which means the endless circle of cash injections continues. And expect it to get worse. Since Citigroup and Bank of America have government backstops on troubled assets, they’ll unload these positions at horribly low prices, which forces the rest of the industry to mark assets even lower – far below intrinsic values. While this means we’re getting closer to the problem running its course, it also means mark-to-disaster accounting wreaks even more harm.

Economic Data

The Labor Department reported the headline consumer price index (CPI) for December fell 0.7% (-0.9% was expected), marking the third-straight month of decline. The year-over-year (YOY) rate rose 0.1% for December (a decline was expected, which would have marked the first YOY decline in CPI since August 1955).

The decline in the month-over-month reading was largely due to the plunge in energy prices (as we’ve talked about via the other inflation gauges). When you remove just the energy component, CPI was flat last month and up 2.4% year-over-year.


The core rate, which excludes food and energy items, came in flat last month (a decline of 0.2% was expected) and was up 1.8% on a year-over-year basis.


In a separate report, the Commerce Department announced industrial production slid 2.0% last month (double the expectation) -- a huge move, which follows a statistically large 1.3% decline for November.


Consumer goods production fell 1.7%, construction-supply production declined 3.4% (down 32.6% at an annual rate last three months) and computer and office equipment output fell 3.8% (also down more than 30% at an annual rate last quarter). Business equipment did rise (largely machinery and electrical equipment) for the second straight month. Let’s hope a trend has begun.

This decline in overall industrial production marks the fourth monthly drop in the past five and all of those four negative readings were large. That said, the August and September declines (represented by the sharp negative move on the chart above) were a result of Gulf-coast hurricane activity (back-to-back storms) and the Boeing machinist strike. So, the true weakness within this figure began to take hold in November as it occurred without an exogenous event.

For the quarter, manufactured output fell hard, down 13.8% at an annual rate. This is in volume, so it takes out the price-related declines within other data. This is yet another indication the Q4 GDP reading will be the worst since the 1981-82 recession.

On the bright side, the bounce in business equipment may be signaling there’s some life out there. We know the vast majority of businesses have the resources, it is a high level of caution we need to conquer, which is why we’ve spent so much time talking about a tax-rate response to the current woes – nothing can kick start stocks, economic activity and confidence like bold across-the-board tax-rate reductions.

Don’t think we can move rates lower? I think we can reduce capital gains and dividend tax rates to single-digits, move the corporate tax below 30% and do a lot of good by reducing six federal income tax brackets down to two and making sure the top rate does not exceed 25%. Let’s not pretend these changes are static; there is a huge economic boost that results, and as the tax base and entrepreneurial spirits explode, flows to the Treasury will follow.)

Morning Activity

U.S. stock-index futures are lower this morning, showing the affect of overseas financial woes that sent international bourses lower yesterday. But today is Inauguration Day, so maybe some optimism will follow as incoming President Obama will give an uplifting address and get right to work.

We need good policy and we need it fast. An RTC-type response to troubled assets will do a lot of good, but my fear is neglecting (actually abusing) the private sector will only cause Atlas to shrug. That cannot be allowed to occur.

Capital is already on strike; innovators, the providers of seed capital and the engines of production must be incentivized by higher after-tax returns. In terms of infrastructure programs, it must be focused on productive sources such as rebuilding the energy grid, enhancing broadband, improving air-traffic control and restoring vital defense equipment after several years of wear and tear. The current stimulus package appears to be tilted toward entitlement programs; this will not do.

Have a great day!


Brent Vondera, Senior Analyst