What have earnings told us thus far?

S&P 500: +14.31 (+1.68%)

I’ve spent a lot of time talking covering the earnings releases of our Approved List companies. What are some of the things we have learned from earnings thus far?

1. Information technology will lead us out of the downturn. It seems like this sector more than any other thinks that demand has bottomed out. Heading into the downturn with historically lean operations and piles of cash has allowed these companies to invest in future growth while other sectors are scrambling for cash. Even more, businesses will likely loosen the purse strings first for IT spending, which can save money and enhance efficiencies.
   
   
2. Defense firms are not down and out. Several defense firms raised earnings outlooks this week and were optimistic about the changes in U.S. defense spending. A massive stimulus plan along with ambitious healthcare initiatives led many to assume that defense spending would decline going forward. These concerns dragged down valuations across the defense industry; however, these concerns overlook the stability of a U.S. defense budget slated to grow 4 percent in 2010 – a growth rate that would make many industries jealous.
   
   The proposals represent a strategic shift toward enhancing the military’s capabilities to fight today’s wars in Iraq and Afghanistan and future ones like them. Of course, this means there will be winners and losers, some of which are clear at this point, but nothing is certain until the budget is finalized.
   
   
3. Drugmakers face an uphill battle in the near-term. Signs of pharmaceutical sales weakness have been blatantly obvious in earnings reports. People have curtailed visits to the doctor and fewer are starting new therapies for chronic conditions. Increased use of cheaper generic drugs also softened overall sales growth.
   
   A potential economic recovery and changes in U.S. healthcare policies could help bolster demand for pharmaceuticals after this year, but mitigating growth will be another wave of patent expirations for blockbuster brands in 2011 and 2012. In addition, Obama’s healthcare initiatives targeting branded-drugmakers has stoked fears of price control.
   
   
4. Banks’ earnings reports would make Houdini proud. Goldman’s results were boosted by an “orphan” month. Wells Fargo’s earnings were helped by an accounting maneuver used last year that has since been banned. Equally disturbing was their disclosure of a $109.8 billion balance sheet line item called “other assets;” whose largest component was $44.2 billion item ever so eloquently labeled as “other.”
   
   J.P. Morgan, Bank of America, Citigroup, and others all had sizeable trading profits that made them profitable in January and February. Some suspect this was a result of cash-thirsty AIG unwinding their portfolio of default-credit protection. In the process, unwittingly or not, AIG made massively profitable trades to the banks. This is not sustainable.
   
   

Analysts may have finally become negative enough. One problem during the past few earnings seasons has been the unrealistic profit expectations from Wall Street analysts. This week, however, we have seen big rallies on earnings reports that were better than the worst-case scenario. Granted only 35 percent of S&P 500 companies have reported and many of the biggest surprises were in the financial sector.



Quick Hits

• A glimmer of hope?
• Corporate Taxes, and Their Real Impact on Small Business
• Getting Real on Wind and Solar
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks spurred by a late-session financial-sector rally, closed the session higher – it was the opposite of Wednesday’s activity when stocks sank as they headed for the bell. The market was able to push aside economic reports that pretty much hammered any optimism the labor market may be on the mend and housing was rebounding – not to say a bottomed hasn’t occurred because it appears that is the case, but we could struggle at these levels for a while still.

Energy shares also helped propel the broad market higher as results from drilling-services firm Diamond Offshore followed equally good result from Noble Corp. the day before – a dearth of supply remains in the marketplace and rig day rates continue to climb.

The market is treading water right now as investors appear to be pretty much frozen – deer in the headlights analogy applies pretty well. We have earnings season that is shaping up a bit better-than-expected -- profits are down significantly, but results not as bad as the worst-case estimates. But we continue to have an immense level of government meddling that frankly has to be giving investors pause. We also have these stress test results that are expected to be reported May 4, so this may keep some money on the sidelines until results are announced.

The S&P 500 has been stuck right around 850 since April 9. It appeared we were going to break through what many believe is an important resistance level of 875 last Friday when the index closed at 869.6, but fell back to 832 on Monday and have barely moved above 850 with yesterday’s close.

Market Activity for April 23, 2009

Another Sign Inflation is Poised to Roar?

I want to return for a moment to the higher rig rates (oil and nat. gas drilling rigs) touched on above, it reminded me of something I noticed a couple of weeks back regarding the oil tanker market. Oil tanker rates have plunged, and as a result firms have been scrapping ships because between the insurance, labor, maintenance and interest costs, losses are mounting. This is a result of massive swings in commodity prices, energy in particular.

When oil skyrockets to $140 per barrel, shippers can’t build enough vessels, yet when oil summarily plunges they find they have way too much supply. While this pricing environment is not the case for drilling rigs, it means one thing – the supply of ships, just as the supply of drilling rigs, will come up very short of what is needed when oil goes on a tear toward $75, $80, $100 again.

Day rates for jack-up rigs (relatively shallow water drilling) rose to $131,000 last-quarter, up from $102,000 a year earlier; rates for semi-submersibles (used for deep-water drilling) jumped to $283,000 from $249,000. When inflation makes a comeback due to the massive liquidity injections by the Fed and trillions in fiscal stimulus, these rates will move higher – higher energy prices will encourage much more energy production activity and thus greater demand for rigs. And oil tankers, which are being scrapped as we speak, will suddenly find more business than they can handle, which means shipping rates will explode. These costs will be quite something for the economy to deal with. Oh, and Mr. Bernanke, your job won’t get any easier…or, should I say Mr. Summers, as he is next in line for the job. Good luck boys. We’ll need some sort of recovery first though.

Jobless Claims

The Labor Department reported initial jobless claims rose last week, suggesting the substantial decline in the previous week was due to the Good Friday holiday more than an easing in jobs losses.

Initial jobless claims rose 27,000 to 640,000 in the week ended April 18. The good news is we didn’t bounce back to the more than 26-year high hit three weeks back and while we’ll need another week to confirm, this may be a sign that we have seen the worst in initial claims.

The four-week average of initial claims fell 4,200 to 646,800.


Continuing claims (those that remain on benefit rolls) continue to show the labor market is very fragile as the number rose again, up 93,000 to 6.137 million. This marks the 12th straight week in which the figure has set a record.


The insured unemployment rate, a reading that is tied to the continuing claims data, rose to the highest level since January 1983 -- up to 4.6% from 4.5% in the previous week. This number closely tracks the overall unemployment rate and thus suggests we’ll see the jobless rate rise again when the official labor market data for April is released May 8. The overall unemployment rate hit 8.5% in March and we’ll see it move a little closer to 9.0% for April and hit or surpass that level in May if these claims figures do not reverse.


Bottom line, it is a mild positive that initial claims didn’t shoot back up to 670,000, but we’ll need another week worth of data before we get too excited over the prospect that initial has peaked. From there, we will need to see the reading trend into the 500K handle, when this occurs it will offer a very good signal that the worst has been seen regarding the labor market.

Unfortunately, continuing claims are shouting the job market is extremely tenuous right now and this will keep economic activity very soft. The economy will likely already have begun to rebound before continuing claims show real improvement (it is more of a lagging indicator, the initial claims figure is the more leading indication) but this reading must halt the march to new weekly highs in order for one to have conviction economic activity has truly bottomed out.

Existing Home Sales

The National Association of Realtors announced that sales of previously owned homes fell in March after jumping in February by the most in five years. As we touched on at the time of that February release, the jump in sales appeared to be more a function of weather-related events than anything else – terrible weather in January that depressed home sales more than otherwise would have been the case and then very mild weather in February helped sales bounce back substantially.

Existing home sales fell 3.0% to 4.57 million units at an annual rate from the 4.71 million hit in February – this is just 1.7% higher than the 12-year low hit in January and confirms the above commentary. That said it does appear the figure has bottomed; however, the labor market will likely hold activity near this bottom rather than allowing for housing to rebound, at least regarding the next few months.

Distressed properties made up 50% of all sales; this bottom-fishing has put a floor on sales. When the data shows other-than-distressed purchases moving to 70-75% of sales this will be another sign we’re onto something.

Looking at just single-family units, the overall reading includes multi-family (apts. and condos), the data shows the same. We want to be aware of this single-family figure because activity in condo units, in particular, appear to be lagging the single-family environment and we’re watching singles for some sign of improvement that the overall reading may not show. But evidence of a bounce has yet to present itself, as the chart below shows. Again, we’ll very probably have to see some easing in monthly job losses before home sales begin to recover a bit.


The number of existing homes for sale remains elevated.


And the inventory/sales ratio remains stuck too.


The rate of year-over-year decline in prices has eased for the second-straight month, which appears to be the only positive aspect of the report.


Have a great weekend!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries traded around unchanged the whole day on below average volume. The two-year finished up 1/16, and the ten-year was higher by 11/64. The benchmark curve was 1.5 basis points steeper on the day, and currently sits at +199 basis points. A basis point represents .01%. We are close to the 200 bps mark on the benchmark curve, a level we haven’t been at since March 4th.

Volume likely suffered from traders waiting for tomorrow’s announcement from the Treasury detailing the preliminary results of the stress tests that will include some of the guidelines that are being followed. Some remain skeptical of the validity of the stress tests, but they stand to make a decent impact regardless.

The Treasury auctioned $8 billion of a new five-year Treasury inflation-protected note that came in at 1.278%, well under the yield prevailing in the market before the auction. The issue was bid well, with a bid-to-cover ratio of 2.66, much better than the results of the last two TIPS auctions. The Treasury will auction $40 billion in two-year notes, $35 billion in five-year notes and $26 billion in seven-year notes next week. The new supply, in addition to the stress test announcement tomorrow, could threaten the 3.05% resistance on the ten-year.

The Fed purchased $7 billion in Treasuries with maturities ranging from 5/31/12 to 8/15/13, bringing the total cumulative purchases to $66.7 billion. The Fed again stayed away from benchmark Treasury issues, but successfully bought bonds across the entire range of maturities as planned.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Earnings: GR, NE, EMC, UPS, HSC, LLL

S&P 500: +8.37 (+0.99%)

Goodrich Corp (GR) +10.02%
Goodrich beat expectations with first-quarter net income rising 6.7 percent despite weak demand from aircraft makers. Management cited increased productivity and cost containment initiatives as reasons for strong results.

Goodrich lowered the top end of its earnings guidance to reflect lower commercial equipment sales due to less travel as well as production delays at Boeing (BA). Still, shares rallied sharply since some analysts were expecting a worse outlook.

Although commercial demand is slowing, Goodrich’s defense and space business is growing sales faster than expected. Management expects this trend to continue and believes the defense budget will continue to emphasize investments in areas which benefit Goodrich.


Noble Corp (NE) +3.07%
Noble easily surpassed consensus estimates as explorations contracts went into effect that were signed before the economic downturn. Earnings quality was strong with the bulk of the positive earnings surprise coming from higher contract drilling margins.

Companies like Noble or Transocean (RIG) are less affected by sharp declines in oil and natural gas prices because they depend on long-range contracts with exploration giants such as Petrobras, which limits their downside even as commodity prices decline.


EMC Corp (EMC) -4.17%
EMC became the latest technology company to call a bottom in demand for information technology, saying customers would start spending more in the second half of 2009.

Storage remains an essential component of the IT infrastructure where purchases can be delayed, but rarely avoided – which explains why everyone (IBM, HPQ, CSCO, DELL) is clamoring to gain a bigger presence in this market.

EMC’s first-quarter results were hurt by more stringent corporate procedures for IT purchases as well as willingness by its customers to trade down to inferior products – EMC’s storage products and services are considered to be the best, but are also the most expensive.


United Parcel Service (UPS) -2.59%
The report didn’t contain any surprises. Lower volume led to lower margins, and revenues declined as pricing trended lower due to lower shipping weights and reduced fuel surcharges. UPS did note that the exit of rival-shipper DHL from the U.S. market helped improve revenues from their premium domestic next-day-air service.

UPS hesitantly suggested an economic recovery might begin late this year, but felt more confident that a rebound wouldn’t occur until next year. UPS is considered a barometer for the U.S. economy because it transports from mortgage and banking documents to auto parts and building materials to pharmaceuticals and consumer electronics.


Harsco Corp (HSC) +0.06%
Harsco’s results topped expectations, but the company slashed its full-year earnings guidance in light of unfavorable exchange rates, the global credit squeeze, and unprecedented weakness in the steel market.

The stronger U.S. dollar accounted for almost half of the sales decline and it also accounted for a substantial reduction in operating income and margins – about 70 percent of Harsco’s sales are outside the U.S.

Harsco will benefit from global stimulus- related infrastructure spending, but will continue to struggle until the global economy rebounds. However, a healthy balance sheet along with strong cash flow generation is allowing Harsco to invest for the future and we expect them to emerge from this economic downturn stronger than before.


L-3 Communications (LLL) +1.73%
L-3’s first-quarter profit beat estimates and lifted the low end of its full-year outlook. Like Lockheed Martin and Northrop Grumman, which both raised guidance this week, L-3 appears to be well-positioned for changes in the defense budget.

Higher sales and orders drove first-quarter profit 5.3 percent higher, led by increased sales of military communications gear. L-3’s funded backlog finished the quarter at a record $11.7 billion.

The company continued to deploy its increasing cash flow to increase shareholder value by acquiring Chesapeake Sciences Corporation for $87 million, repurchasing $232 million of common stock, and paying $42 million in dividends. L-3 also increased their dividend payment 17 percent.


Quick Hits

• A glimmer of hope?
• Muddy Waters
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks, after spending the vast majority of the session in positive territory, slid 2.1% in the final 30 minutes of trading on news the Obama administration may reveal each bank’s capital needs when the result of the stress tests are revealed on May 4 – prior to this announcement, it was believed they would reveal the results of how many of the 19 largest institutions passed but not specifics.

This gets us to what we were discussing yesterday, one day they can say something that juices the market, the next day they create concern – we’re at the whim of Washington and that’s no way to enable a secular bull market. Nothing good can come of these tests, it creates the perception that a bank is insolvent even if the worst-case scenario that deems that institution insolvent never comes to fruition. In addition to that, the Treasury says it may force those firms the government has targeted to be in need of capital to announce whether the source of that capital will come from the private sector or the government. Well, you can forget about the private capital injections once this announcement is made, which makes the whole thing one giant farce – say hello to even more government involvement.

The day’s economic data probably offered a bit of support to stocks and buoyed the indices from an even greater freefall at the end of trading. Futures were meaningfully lower in pre-market trading and that negative sentiment spilled into the official trading session, but the indices rallied after the latest housing price gauge showed an increase for February – the first back-to-back monthly gains since early 2007. While the late-session news erased the rally, it may have been worse if not for that housing report. The NASDAQ Composite did manage to close higher as tech shares held onto their gains.

Financials led the declines, falling 4.6% in the final half-hour, ending the session lower by 3.82%. Industrials led the gainers, up 1.14% on better-than expected results and guidance from Ingersoll-Rand.


Market Activity for April 22, 2009


Crude Oil

Crude for June delivery continues to hold up even though the supply figures have increased for the sixth-straight week. The weekly Energy Department report showed a build of 3.9 million barrels in the week ended April 17 – estimates were for an increase of 2.5 million units.

Total stockpiles stand at 370.6 million barrels, the highest level since September 1990. The large contraction within the manufacturing sector alone has crimped demand, and now we’ve got GM idling 15 plants. Nevertheless, the price of oil continues to hold up as it is trading with stocks for the time being – when investor sentiment is on the rise you just don’t have the concerns over global demand, at least not in a heightened sense, and thus oil holds above the $45 per barrel mark.


Mortgage Applications

The Mortgage Bankers Association’s mortgage applications index rose 5.3% for the week ended April 17, after falling for the first week in six in the previous period. The index rose 5.3%, propelled by a 7.7% increase in refinancing activity – refis continue to make up 80% of the reading.

Unfortunately, purchases fell for a second-straight week, down 4.2% after the 11.3% decline during the previous week. The 30-year fixed mortgage rate remains in sub-5.00% territory, which will keep refi activity going, but purchases will remain sketchy as the weak labor-market conditions will continue to weigh on the figure. Hopefully, we’ll begin to see the degree of monthly job losses wane a couple of months out; I really doubt the current rate of losses is sustainable past June, and just maybe this will offer enough confidence for some buying to begin a slow trend upward in sales.


FHFA Home Price Index

The Federal Housing Finance Agency stated its index of home prices rose 0.7% in February after a downwardly revised 1.0% increase for January (initially estimated at a 1.7% gain). For the past 12 months, this index has home prices down 6.5% -- this is one of the broadest gauges of home prices, but does miss the high-end market.

The regions that helped push the index higher were the Pacific (HI, AK, WA, OR and CA) and New England (ME, NH, VT, MA, RI and CT) areas of the report. The Pacific region showed home prices jumped 3.8% in February after a series of large monthly declines. Home price in the index’s New England region rose 2.2%, marking the second month of increase.

The report’s West N. Central region (ND, SD, MN, NE, IA, KS and MO) showed prices rose 1.5% and West S. Central (OK, AR, TX and LA) was up 1.9%. The South Atlantic (DE, MD, VA and WV) registered a 0.8% decline.

The Earnings Front

First-quarter earnings season is proving to be a tough one; however, results are coming in better-than-expected. With 25% of S&P 500 members reporting thus far, overall operating profits are down 18.6% and ex-financial results are down 21.5% -- expectations averaged about -20% on the overall reading and -30% on ex-financial.

Basic material (-65.1%), industrial (-42.9%), energy (-26.0%) and information technology (-24.2%) lead the sectors to the downside. Financials, after four quarters of the most horrible of horrible results, is among the two sectors reporting positive results – up 1.6% for the quarter. The health-care sector has posted a 3.6% increase thus far.

There’s little doubt we’ll have another two quarters of negative earnings seasons to content with, but one has to think – even for people like me who worry very much about how government actions will keep businesses cautious – that the bounce back in profit results will be dramatic. Firms have engaged in a massive round of cost cutting. This is always the case during a downturn, but the level of job-reductions this go around has been the most dramatic since the early 1980s. As a result, sales won’t have to bounce much in order for bottom lines to show significant upswings.

I remain concerned that when the economic rebound does occur, it will not be sustainable. It will not come close to the duration of the last expansion and in absolutely no way be comparable to the 1980s and 1990s expansions that both lasted a full decade – there is way too much government involvement, way too much capital that will be removed from the private sector as public-sector spending will be on parade, and the actions by the Fed (while they have had little choice) will have ramifications the economy will have to deal with in the not-to-distant future. Nevertheless, based on the significant round of cost-cutting within the business community over the past several months, it shouldn’t take much to fire profit growth two-three quarters out. It will come, the duration of the event is the question at this point.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries finished down for the day, sending the yield on the ten-year to upper part of the 2.5% - 3% range it has been in since mid January. Treasuries rallied off their lows from the early afternoon as stocks dipped into negative territory in the last 30 minutes of trading. The two-year finished down 3/64, and the ten-year was lower by 11/32. The benchmark curve was 1.5 basis points steeper on the day, and currently sits at +197.5 basis points. A basis point represents .01%.

Today was without a Fed purchase or a Treasury auction. Tomorrow the Treasury will auction $8 billion in five-year Inflation protected Securities.

Mortgage Rates
Rates on 30-year fixed rate mortgages rose last week to 4.73% from their all time low of 4.7% reported the week before. Loans originated for purchases were down 4.2% week over week (-29.1% from a year ago) but refinances were strong (up 7.7% for the week – up 186.1% for the year) and continue to dominate loan origination with 80.2% of the total dollar amount of loans originated last week.

The story with mortgages has changed very little in the past month. Rates may have a little farther to drop, but mortgage originators are still struggling to meet demand. Fed purchases continue to artificially prop up the market for MBS but risk premiums in the securitized market remain higher than usual due to the big question of prepays. We can look back to other prepay booms, (2003 for example) and begin to get an idea of how things may really start to heat up as the summer moving season begins. However, LTV problems for some homeowners may or may not stand in the way of a 2003 type prepay environment. For those of you who don’t remember see this previous post on the President’s “Making Home Affordable” plan.

I say “may or may not” because the plan has been a complete flop so far. The plan aimed at helping 400,000 homeowners has seen 312 applications since October, due largely to the complete lack of incentives for lenders to participate in the program. Secretary of Housing and Urban Development Steve Preston, who heads the operation that is partnering with Fannie and Freddie, blames congress for “Dotting the I’s and crossing the T’s for us, [making] this program tough to use.” Pretty much in line with any other case of government involvement in activities that should undoubtedly be left to private enterprise.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Earnings, earnings, and more earnings

S&P 500: -6.53 (-0.77%)


SunPower Corp (SPWRA) +7.91%
Before we all get lost in the earnings madness, SunPower announced a joint venture with Exelon Corp to develop the nation’s largest urban solar power plant at a former industrial site on Chicago’s South Side.

SunPower wants to construct more power-plant sized solar parks to profit from rules that require utilities to buy a portion of their electricity from renewable sources.


T. Rowe Price Group (TROW) +0.77%
T. Rowe’s earnings came in above expectations and CEO James Kennedy said, “financial certainty around the globe is beginning to stabilize,” but added, “we are not expecting a recovery any time soon.”

T. Rowe had net inflows of $4.5 billion in the first quarter, an encouraging improvement from net outflows of $2.4 billion in the previous quarter. T. Rowe’s target-date retirement funds accounted for “substantially all” of new money flowing into mutual funds during the first quarter.

Despite the inflows, assets under management (AUM) fell 3 percent during the first quarter to $268.8 billion, down from their peak of $400 billion at the end of 2007. Still, this is an improvement compared to the 20 percent decline in AUM in the fourth quarter of 2008.

T. Rowe was one of the few fund firms that had not announced layoffs during the current downturn, but today said it would reduce its staff by 5.5 percent – the majority of layoffs in the phone, processing, and technology areas where lower volumes of work led to overcapacity.


St. Jude Medical (STJ) +3.38%
Medical device company St. Jude beat expectations amid solid sales for its heart-rhythm and cardiovascular businesses. The company lowered the top end of its 2009 sales outlook to reflect a stronger dollar – nearly half of their revenues come from outside the U.S. – but maintained its full-year earnings outlook.

More importantly, St. Jude reported market share gains in several key product categories, which they attribute to aggressive research and development spending in the higher-growth areas like atrial fibrillation and neurostimulation.

CEO Daniel Starks said today’s results reflect the “resilience of St. Jude Medical’s growth program in an environment of global economic recession. Growth dynamics in our core markets are remarkably stable.”


WellPoint (WLP) +0.53%
WellPoint’s first-quarter profit fell 1.3 percent on investment losses and enrollment declines. The largest U.S. health insurer by membership also lowered its 2009 projections.

WellPoint’s medical-loss ratio – a key indicator of profitability calculated as the percentage of premium revenue used to pay patient bills – fell 3.5 percentage points to 81.6 percent, which shows nice operating improvements.

Volatile financial-markets, unexpectedly high medical-cost increases, and service and pricing problems created significant challenges last year. Even more, margins are weakening after years of solid growth amid intense competition in the shrinking pool of corporate business.

Health insurers so far have avoided the string of profit warnings seen last year, but rising unemployment and uncertainty about the effects of a healthcare overhaul continue to weigh on sentiment.


Ingersoll-Rand (IR) +15.66%
Ingersoll recorded a smaller loss than anticipated and provided a much more optimistic outlook than analysts expected. Ingersoll’s businesses are particularly exposed to suffering sectors such as housing construction, the trucking industry, and retailing.

The company said the operating loss resulted from a rapid drop off in end-market orders caused by the downturn in the global economy and a reduction in business capital spending. Operating margins plunged during the quarter to 1.7 percent from 9.3 percent, mostly from lower production volumes.

The company said it’s aggressively shrinking operations to align production with end-market demand and paying down its heavy debt load from the Trane heating and air condition systems acquisition last June.

In addition to a better forecast than expected, investors were excited by the fact that savings from the restructuring program and the integration of Trane, which was purchased in June 2008, are finally adding to the bottom line.


Norfolk Southern Corp. (NSC) +0.35%
Railroad operator Norfolk Southern reported earnings that missed expectations after the market closed Wednesday. Investors had high expectations following solid results from competitor CSX.

The largest transporter of metals and automotive products in North America said the slow economy was evident across all of its business segments, with total volume falling 20 percent year-over-year. The company also brought in less money from fuel surcharges as the price of diesel fell sharply.

The company expects its intermodal business (transfers between trucks and trains) will be hurt soon by weak international business, and coal transports will be dragged down by an increase in natural gas use and weak demand for the kind of coal used to make steel. Norfolk expects general merchandise shipments will be helped by higher municipal waste and ethanol carloads, but the sharp drop-off in transports of cars, car parts and lumber will continue to hurt that segment.

On the bright side, Norfolk expects shipping demand to bottom in the second quarter and improve as early as the second half of 2009. The company also cited the U.S stimulus package as a catalyst for shipping demand.


Northrop Grumman (NOC) -0.21%
Northrop, the third largest U.S defense contractor, beat earnings expectations and said full-year profit will exceed their prior forecast because of a legal settlement.

Northrop is the second of the Pentagon’s five biggest supplier to raise its forecast for 2009 profit, the other being Lockheed Martin (LMT).

Revenue and profit rose at all five of the company’s divisions, led by growth in sales of electronic systems, such as the anti-missile defense for military planes, and technical services, including training and simulation programs.


Boeing Co. (BA) +1.77%
Boeing missed earnings estimates due to lower airplane prices and charges related to the delayed delivery of the new 747-8 jumbo jet.

The company lowered its 2009 outlook to reflect a surge in deferred orders due to weak airline traffic and tight financing for customers, but the outlook was cut less than expected. This caused shares to rally because the low valuation makes it hard to be more negative on a company with such a massive backlog.

Boeing’s backlog for 3,589 planes is valued at $266 billion, or about 7.5 years of manufacturing. Going forward, the key for Boeing will be keeping the backlog intact in this tough economic environment.


AT&T (T) +1.82%
AT&T reported first quarter earnings that topped consensus estimates and said that it achieved solid wireless subscriber gains. Growth in wireless and wireline data services in large part offset declines in wireline voice access lines and business voice revenues.

Although total wireline revenue fell, AT&T reported that revenue per household was slightly higher thanks to strong additions to its high-speed Internet and television businesses.

The wireless business remains the primary growth engine for AT&T, but after years of rapid expansion, investors worry that the market may be nearing saturation. The iPhone remains a significant boost to this business and the company is seeking to extend its exclusive deal to carry the phone, which expires next year.


Other Approved List earnings reports
Kimberly-Clark (KMB) -0.34%
Dover Corp (DOV) +0.66%



Peter Lazaroff, Junior Analyst

Fixed Income Strategy - Municipal Bonds

With investors seeking yield in this low rate environment and the expectations for tax rates to increase, we are often asked about municipal bonds (muni’s). Historically, retail investors purchased very long maturity muni’s because they offered an attractive after-tax yield in a relatively safe investment.

Changes in the market dynamics today make investing in muni’s a more difficult task. It used to be that investors would just look at the rating and make certain that it was not subject to AMT. After all, we have all been told before that muni’s have a very, very low historical default rate and therefore they bear little credit risk. However, the same was said about real estate until 2007. In today’s environment, one must really dissect a bond based on the four primary risk factors of all bonds: credit risk, term/duration, structure, and liquidity.

Credit
Historically, most muni’s came to market with very high ratings with many qualifying for the coveted AAA. The vast majority of AAA rated bonds achieved this status because an insurance wrapper was purchased for most issues.

When a muni is insured, the insurance company guarantees the timely payment of principal, so the muni assumes the same rating as the insurance company. This process allowed poorly rated issuers to issue AAA rated debt. In early 2008, the financial stability of the insurance companies came into question and nearly all of them lost their AAA rating. As a result, many muni’s were severely downgraded. The downgrade was not a direct reflection of the credit quality of the issuer, but a result of the insurance being downgraded.

Regardless, the investor who purchased an insured AAA-rated muni is now left with a lower rated muni (or in some cases, non-rated). The downgrading of a vast number of bonds that were previously rated AAA has adversely affected market prices of the entire muni market and lowered the liquidity of many issues.

Today, investors must perform a thorough analysis of each municipal issue. It must be assumed that the insurance attached to each deal is worthless and one must evaluate each issuer’s ability to service their debt on its on merits. After all, if the issuer can service the debt, then the fate of the insurance wrapper is irrelevant.

Term
The maturity of a bond affects your exposure to changing interest rates and inflation. If you expect rates to decrease, it makes sense to purchase longer maturity bonds to lock in the higher rate. The opposite is true as well. When an investor expects rates to rise, shorter term bonds are a better investment as they will depreciate less and the shorter maturity will grant the investor the opportunity to reinvest at higher rates in the future.

The traditional retail investor has always purchased longer maturity municipals. By purchasing bonds in the 10-20 year maturity range, the investor is able to achieve a higher yield. There is no free lunch, as the higher yield is simply a trade-off for a higher level of market risk. With today’s rates at historic low yields and potential for inflation, we do not think that it makes sense to extend maturities very far into the future.

Structure
Structure refers to the timing of cash flows along with any optionality that is embedded into a bond. Muni’s are typically straightforward bonds that pay interest on a set interval and pay back principal at maturity. However, many muni’s also have embedded call options that give the issuer the opportunity to retire the bond prior to maturity. Since the bond will only be called if it is advantageous for the issuer to do so, calls typically work against the investor. This is referred to as optionality since the issuer has the option to call the bond.

The structure will also affect the liquidity and market price of an issue, so one must fully understand the structure of the bond they are purchasing. Many older outstanding bonds have call dates that are very close or are even callable today on a continual basis. If an investor does not know about this feature and only looks at Yield to Maturity or Current Yield, they could earn significantly less than expected (or even lose money) if the bond is called away early. An investor must understand the structure and always evaluate a bond based on a Yield to Worst scenario.

Liquidity
Liquidity is defined as the ability to buy and sell a bond. If a bond is very liquid, there will be an efficient market and the bond can be purchased or sold quickly with a minimal bid-offer spread (low transaction costs). Unfortunately, the municipal market has historically been a rather illiquid market. This is one reason that muni’s have provided above market yields as investors must be compensated for the loss of liquidity. In the muni market, it is common for there to be a wide price difference between where you can buy a bond and where you can sell it.

Beginning very early in 2008, liquidity in all markets became a hot topic. Certain types of muni’s enjoy ample liquidity, however, many have nearly no liquidity at all. The maturity, credit, structure, and even block size all contribute to the ability to buy and sell a particular issue. These criteria have always been the same, but were often overlooked leaving investors holding bonds that they would have difficulty selling today if needed.

***

The current market inefficiencies do provide opportunities in certain sectors of the municipal market. However, they are not for everyone. An investor must be able to separate the good from the bad to determine value. Muni’s remain exposed to credit risk, are less liquid than many other forms of fixed income, and may not be the best relative value for all investors. For example, depending upon your marginal tax rates, you may be able to realize a higher after-tax return in taxable bonds versus tax-free muni’s.

With all of the new spending coming out of Washington, the muni market is only going to become bigger and more complex. A new category of muni’s was just created: Build America Bonds (BABs). These are bonds that support infrastructure projects, but will often be subject to income taxes.

Protecting your assets begins with understanding all of the underlying risks. The next step is to have the tools to evaluate them and determine the true relative value before investing.


Ryan Craft, CFA
Senior Fixed Income Analyst

Daily Insight

U.S. stocks ended higher yesterday in what looked to be shaping up as additional weakness following Monday’s meaningful sell off. The major indices began the session lower on downbeat earnings guidance from a couple of big industrial names, but reversed course mid-morning after positive comments from Treasury Secretary Geithner regarding the capital positions of most financial institutions; stocks never looked back, holding momentum to the close.

Geithner’s key statement was that the “vast majority” of U.S. banks have more capital than required. I wasn’t sure at first why this had such a profound impact on investor sentiment, which was certainly low in pre-market trading, since the more than “well-capitalized” position of most banks has been a known. I ran this thought by Ryan Craft (our senior bond analyst) who correctly stated, “It’s not about the reality of the banks being more than “well-capitalized,” but rather whether or not the Treasury Department deems them ‘well-capitalized,’ and thus Geithner’s statement sends the signal that the government won’t take them over.”

And this is exactly the case, for today at least -- one day Geithner and Co. make statements that push stocks lower (such as the need to convert the gov’t’s preferred shares to common) and the next day they say things that juice the market (such as suggestions that remove nationalization concerns.) We are indeed at the whim of Washington and one only knows what they can say, or do, tomorrow or the next day to shift sentiment back in the other direction; this must change.

Stocks were also helped by technology shares after Texas Instruments offered guidance that was well-ahead of expectations. The second-largest U.S. chipmaker stated that semiconductor orders recovered and customers have begun to increase orders after finishing inventory liquidations plans. (We’ve spent plenty of time talking about how the inventory dynamic can catalyze growth in the not-to-distant future. While there are many other challenges for the economy to deal with, many of which originate from the political class, this is great news and hopefully signals a trend regarding overall inventory rebuilding.)

Financial shares led the charge. Basic material, industrial and consumer discretionary shares also outperformed the market. The consumer discretionary sector received a boost from Coach Inc. as the company stated sales trends are encouraging.


Market Activity for April 21, 2009


Just as stocks rallied on the Geithner statement, Treasurys declined (yes, this is the correct plural spelling in case you were wondering.) Bonds were in rally mode for a second-straight session before reversing course; the yield on the 10-year Treasury note was pushed higher by six basis points to 2.90% (the price of a bond and its yield are inversely related – price goes down, yield goes up and vice versa).

The 10-year seems to have found support at 3.00%, which seems to be viewed as the trader’s attractive entry point as the market knows the Federal Reserve is a buyer of Treasurys – as part of their quantitative easing plans.


One may wonder if this will prove an unintended consequence of quantitative easing. Will this place a burden on stock prices as money flows out of the equity markets and into Treasurys as traders see a 3.00% approach on the 10 as an easy opportunity to make a quick profit? (The magic number seems to be 1.00% on the 2-year, just for clarity.) We don’t know, certainly it’s dangerous to think the trade is a no brainer each time the note approaches 3.00% as the government is going to issue $2.5 trillion of debt this year and something like $1.7 trillion next year – I don’t think one can take for granted that bond prices will rebound off of certain levels for very long as massive supply will eventually put pressure on those prices. In any event, I thought the support level of 3.00% on the 10-year was interesting enough to mention.

One thing is apparent, when prices do fall as this enormous level of supply (debt issuance due to the massive deficit spending plans) comes to market, the move will be severe – yields will rocket higher. As the Fed focuses on keeping rates lower than they otherwise would be, they may be engendering the conditions for just the opposite -- an abrupt rise in interest rates. You get to a point in which there are no more rabbits to pull from the hat.

While this event would create a shock to an economy that may be in the midst of an expansion’s early stages, say a year out, it will be welcome news for the fixed income investor. Patience.

Stress Tests

Even with Geithner’s helpful comments yesterday, the administration’s actions continue to be perplexing. For the life of me, ignoring my skeptical side that sees ulterior motives that I won’t get into, it’s difficult to understand why the White House/Treasury has chosen to go down the road of the stress tests. (For those who may not know, stress tests are being conducted on the 19 largest U.S. banks to determine solvency based on a worst-case scenario economic conditions and loan quality.) What good can come of it? Say they deem a financial institution as insolvent under the worst-case scenario, which in terms of these government tests assumes something like 10.5% unemployment and significant and prolonged GDP contraction. What will follow is a perception of insolvency even if economic conditions do not deteriorate to the worst-case scenario inputs of the model. As a result of this perception, do you have runs on particular banks at that point – if not on deposits, then certainly on the stocks?

This whole exercise seems quite dangerous. Not to mention that they may use these tests to force banks to participate in the unnecessary PPIP (Geithner’s Public-Private Investment Program scheme) and as a way to disallow repayment of TARP funds.

(And on this last point, heck if you’re dead set on keeping TARP in place you should at least except the repayment -- without conditions -- from those strong enough to return it and use it for those institutions that need it. I’m not advocating this as the TARP has transformed into a beast that in no way resembles its original purpose, just acknowledging the fact that the administration isn’t letting go of TARP and touching on a better way. For goodness sake, at this point if a bank is actually insolvent, send it to the FDIC for clean up and sell it off to the private sector in quick order – a system that has worked quite well for decades. But this group demands the control, so you can forget about that idea.)

Economic Data

We’ve been without a serious economic release for a couple of days but get back to it this morning with mortgage applications (for the week of April 17) and one of the major home price indexes.

Then on Thursday things get very interesting with the weekly jobless claims number and existing homes sales data for March; we round the week out on Friday with durable goods orders and new home sales.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Comments from the Treasury Secretary and less than stellar Fed buying pushed Treasuries lower today. The two-year finished down 3/64, and the ten-year was lower by 33/64. The benchmark curve was 4 basis points steeper on the day, and currently sits at +196 basis points. A basis point represents .01%.

Today the Fed purchased $7 billion in US Treasuries with maturities ranging from 2/29/16 to 2/15/19. Although the range of buying went into to the 10-year area, the Fed again concentrated on the shorter end of the announced range while buying $3.99 billion of notes maturing in 2016. $130 million of the on-the-run 10 year was purchased in today’s activity, but the market was expecting more in terms of that specific bond, causing the longer end of the benchmark curve to suffer.

Geithner Goes Green
Bonds sold off from their highs of the morning as the Fed announced their purchases, but that probably had more to do with stocks moving into the green as Treasury Secretary Geithner began his testimony on Capitol Hill. Geithner’s comments were seen as a positive as he backed off his previous comments hinting at converting the Treasury’s existing preferred stake into common stock. I use the word “comments” but yesterday the market saw them more as “threats”.

Geithner indicated in an interview yesterday that the health of individual banks won’t be the sole criterion for whether the Treasury will permit the repayment of TARP funds. Today’s testimony improved on yesterday’s interview, as he noted that a lower demand for credit is the major reason for the lack of lending currently and not simply liquidity being selfishly hoarded by financial institutions. I give him some credit for this because many lawmakers just continue to ignore this fact. However, Geithner is still doing his share of ignoring.

Government involvement is currently the biggest deterrent of private capital. Why would a private investor ever risk his or her own capital in an environment where the government can just change the rules? Geithner cites the need to make sure banks have enough capital to lend when the demand for credit does come back, and therefore will determine a bank’s ability to boost lending if the government’s infusion was paid back. The fear of mass dilution, government appointed board of directors, and other disturbing consequences of government meddling in private enterprise would begin to subside if the government loans were paid back in full. Private investors would be much more willing to supply that much needed capital with the government out of the mix.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Earnings galore

S&P 500: +17.69 (+2.13%)

International Business Machines (IBM) +1.87%
Revenues fell 11 percent due to a stronger dollar (down only 4 percent when adjusting for currency), but net income was down less than 1 percent thanks to improving margins in services and software. $1.8 billion in share repurchases helped earnings per share rise 4 percent.

Software held up the best of IBM’s key businesses, with revenue down 6 percent and pretax income up 5 percent. Services revenue was down 10 percent but would have been down only 2 percent without currency fluctuations. Services contract signings, down 1 percent, would have been up 10 percent at constant currency, with longer-term contracts growing. Hardware revenue fell 23 percent from a year earlier, hurt by a 36 percent decline in semiconductor sales.

Regarding the Oracle acquisition of Sun Microsystems, management said they see no practical change in the competitive landscape as a result of the deal. With $12.3 billion of cash on hand and free cash flow in the first quarter of $1 billion, up $450 million year-over-year, IBM will remain active on the acquisition front.


Lockheed Martin (LMT) +0.41%
The world’s largest defense company said first-quarter profit fell 8.8 percent as higher pension costs weighed on results that were otherwise relatively positive. Net income came in at $1.68 a share, with pension costs resulting in a negative impact of 19 cents a share. Pension problems will be evident with several of the defense firms that report this week including Boeing and Northrop Grumman.

Sales and operating profit gained at three of Lockheed’s four business units led by strong performance in computer services and defense electronics. The only segment with a decrease in sales was Lockheed’s aeronautics unit, with sales declining less than 1 percent.

The 2010 Pentagon budget will likely terminate and wind down some Lockheed projects like VH-71 presidential helicopters and the F-22 Raptor fighter jet. Still, those budget dollars are being reallocated to areas like the F-35, which is the Defense Department’s biggest contract and stands to be a cornerstone of Lockheed’s future sales. Lockheed also stands to benefit from being the largest supplier of information technology and electronics to the U.S. government.

The company raised full-year profit guidance because of share repurchases.


Quest Diagnostics (DGX) +5.80%
Quest’s first-quarter net income jumped 20 percent on strong demand for healthcare tests, and the company boosted its 2009 earnings forecast while reaffirming its revenue growth target of 3 percent.

Quest said demand for cancer diagnostics and other tests has made them more recession-resistant than most healthcare providers who have been squeezed as increased unemployment and rising costs sap demand.

Clinical-testing revenue rose 2.2 percent despite a 1.7 percent decline in volume as drug-abuse testing, which is sensitive to job-hiring volume, dropped 25 percent.

Quest also mentioned their joint venture with Walgreen (WAG) last month to provide free healthcare services to patients who lost their jobs on or after March 31 and have no health insurance. Quest is providing free lab testing for common respiratory ailments, allergies, infections and skin conditions that are ordered through Walgreen clinics.


United Technologies (UTX) +4.76%
United Technologies reported a 26 percent drop in first-quarter profit on restructuring charges and weak demand across most of its businesses, but expects earnings growth to resume in 2010.

Profit and sales declined in five of six units, the exception being the Sikorsky helicopter unit. In response to lower demand, United Technologies plans to spend $750 million this year to reduce costs so that they are positioned to resume earnings growth in 2010.

Although the company no longer expects an economic recovery this year, they reaffirmed its full-year outlook and highlighted profit-margin expansion from improved productivity as well as a slowdown in demand erosion.


Caterpillar (CAT) +2.99%
Caterpillar beat its earnings target of 6 cents a share, but cut its earnings forecast for the year in half to $1.25 a share. The heavy-machinery maker expects the global economy to contract 1.3 percent and remain in recession for most of the year, amid continued tight credit.

The company cited the pullback in commodities prices as a primary cause for waning global demand for their heavy machinery. Caterpillar is responding to conditions by eliminating nearly 25.000 jobs while also cutting pay, closing plants, and shortening workweeks. A dividend cut could be the next move if more cost-cutting is required or sales continue to deteriorate.

The disappointing results were not surprising since the company had reduced its quarterly guidance from $1.02 a share to $0.06 a share just a little more than a week ago. Some had projected losses of more than $0.20 a share. Judging by today’s activity, it seems that investors took comfort in the fact that the earnings weren’t as ugly as some expected.


First Cash Financial Services (FCFS) +1.13%
First Cash beat expectations, helped by higher revenue from its Mexico pawn operations. The company plans to open 55 to 60 new stores in Mexico and a limited number of new pawn stores in the U.S.

U.S. payday lenders, who make small, short-term loans against the borrower’s next pay check, are investing more in their pawn operations as stricter regulations and rising unemployment make their primary business less attractive.

First Cash said its objective is to become substantially debt free under its bank credit facility in 2010. It also reaffirmed its 2009 outlook and expects to generate “significant” free cash flow.


Johnson Controls (JCI) +8.55%
Weak auto production and hefty restructuring charges caused Johnson Controls to post a quarterly loss, but the company expects its core auto parts unit to break even by year-end. Investors also seemed please to know that Johnson Controls will participate in a government payment guarantee program. (Program details in paragraph 7)

Revenue fell 47 percent in the automotive segment, which supplies parts for almost every major automaker, including General Motors, Toyota, Honda, BMW, and Hyundai. The auto segment makes up nearly half of the company’s revenues. Sales for its power-solutions unit, which sells car batteries, fell 38 percent. The building efficiency unit’s revenue declined 10 percent due to weakness in the global new construction market.

CEO Steve Roell said they haven’t seen a bottom in the auto and housing sectors, and the company will continue slashing jobs and closing plants to control costs.


UnitedHealth Group (UNH) -5.82%
UnitedHealth’s profit beat estimates and sales reaffirmed its 2009 earnings forecast, but shares declined as the company said growing unemployment would keep stripping Americans of health coverage this year.

Management said better results were partly because of a mild flu season and revenue from prescription-drug refills that are likely to decline. Higher revenue growth was also a result of price increases as well as an increase in enrollees in government-funded plans. Although better than expected, commercial sales were down as the recession has reduced the number of people obtaining coverage through employers.

UnitedHealth’s medical-loss ratio (the percentage of premium revenue used to pay patient bills) remained at 82.4 percent, which is particularly encouraging since costs were expected to rise as they picked up more expensive Medicare patients.


Other notable earnings releases:
Merck (MRK) -6.66%
DuPont (DD) +4.94%


Quick Hits

• U.S. Regulators Put Emphasis on Loan Quality in Tests
• Geithner Says Most U.S. Banks Have Enough Capital
• A Backdoor Nationalization
  

Peter Lazaroff, Junior Analyst

Fixed Income Recap

Treasuries
Weakness in equities helped Treasuries recover from last week’s selloffathon. The two-year finished up 4/32, and the ten-year was higher by 15/16. The benchmark curve was 5 basis points steeper on the day, and currently sits at +192 basis points. A basis point represents .01%.

Tuesday will bring another round of Treasury buying by the Fed. Tomorrow they will purchase Treasury notes ranging in maturities from February 2016 to February 2019, and May 2012 to August 2013 on Thursday.

The Treasury will auction $8 billion in 5-year TIPS on Thursday.

Yield Curve Shape
A few people have had questions about what I am trying to show in the area of the table labeled “2 to 10 bps”. The label is an abbreviation for the difference in yield between the 10-year and 2-year Treasuries. This number describes the current shape of the yield curve. A steep yield curve would be characterized by a large 2- to 10-year spread. The current yield curve is considered relatively steep.

The Term Structure of Interest Rates, as it is sometimes called, is a snapshot of what investors require from Treasuries with varying maturities. Investors usually demand a higher return for longer dated bonds in order to be compensated for the additional risk. Because of this the yield curve is almost always upward sloping, but the degree to which it is, otherwise known as its steepness, varies greatly depending on the environment. Factors such as expectations for future inflation, liquidity preferences of investors as a whole and expectations for future Fed policy determine the shape of the yield curve.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

BAC, LLY, IBM

S&P 500: -37.21 (-4.28%)

Bank of America (BAC) -24.34%
Bank of America reported profit that topped estimates, but the focus was on its comments that “credit is bad and we believe credit is going to get worse before it will eventually stabilize and improve.”

The bank’s net income tripled, but most of the revenue came as a result of its Merrill Lynch acquisition. The company posted worsening ratios in terms of charge-offs (rose to 2.85 percent from 1.25 percent), credit-card losses (rose to 8.62 percent from 5.19 percent), and nonperforming assets (rose to $25.7 billion, up 41 percent).

Bank of America isn’t the first bank whose earnings were of low quality (see Wells Fargo and Goldman Sachs). As we have said before, these earnings are simply not repeatable and the financial sector still faces obstacles on its road to recovery.

On the bright side, fears that the government will nationalize troubled banks and wipe out existing shareholders have subdued. For this reason it seems unlikely that the major banks will revisit their recent lows. Of course, Uncle Sam continues to be a very active shareholder and it’s hard to see that changing anytime soon.


Eli Lilly & Co (LLY) -2.25%
Eli Lilly beat profit expectations and reiterated its 2009 earnings target. The main driver of the earnings upside was a nearly 700 bps increase in gross margins to 83.8 percent of total revenue, helped by a stronger dollar. Revenue increased 5 percent on higher volumes and higher prices.

Lilly’s long-term future is uncertain as the company faces U.S. patent expirations early next decade on two of its top selling drugs Zyprexa (antipsychotic) and Gemzar (cancer). At this point, the pipeline is does not have enough late-stage drugs to offset these patent losses, but the company wants to avoid large-scale acquisitions.


International Business Machines (IBM) -0.83%
After the market closed, IBM reported earnings that beat estimates and reiterated 2009 guidance. It looks like IBM’s mix of services contracts and wide-margin software business largely offset slumping sales of servers and a strong U.S. dollar.

The conference call is just getting started, so I will get you more details in my next post.



Quick Hits

• Don’t Bank on It
• Inflation Is Looming on America’s Horizon
  
  

Peter Lazaroff, Junior Analyst

Best Places to Work

Acropolis Investment Management appeared in the St. Louis Business Journal's "Best Places to Work" feature. In fact, Acropolis was awarded 3rd place in the Extra-Small (less than 50 employees) category!

Click here or on the logo to read the story.

Daily Insight

U.S. stocks finished higher on Friday, marking the sixth-straight week of gains – the S&P 500 is up 28.5% from the March 9 low – and the third consecutive session in which the indices closed higher after beginning lower.

The major indices reversed course after starting the session lower when news broke that BB&T Corp. stated they have seen declines in past due loans regarding some portfolios. The positive headlines that ensued help to lift investor sentiment. (We’ll note that BB&T’s CEO Kelly King also mentioned they expect “continued increases in nonperformers in this difficult environment” and one can be sure we’ll see delinquencies and defaults rates rise in commercial real estate loans and credit card accounts.)

We’re closing in on the top-end of the five-month trading range of 666-935 on the S&P 500 and it will be a big test this week as we get something like 35% of S&P 500 members reporting first-quarter profit results. I’ve got a feeling we’ll have a tough time extending this weekly winning streak to seven as the industrial and tech sector profit reports will mirror the plunge in sales and business spending that occurred last quarter. The fact that the broad market has jumped 30%, even if it is off of what was clearly an oversold low, in just six weeks will make extending this streak tough enough on its own.

Financial and consumer discretionary shares led Friday’s advance. Telecoms and information technology shares were the only losers on the day. Telecoms have had a rough two weeks, falling 3.4% as the broad market is up 3.15%.


Market Activity for April 17, 2009

We’re without a major economic release until Wednesday so this gives us time to talk about some things on the policy front – namely the flawed economic models that will engender a harmful bout of inflation over the next year to 18 months, if government policy even allows the economy to bounce back. We’ll deal with this caveat tomorrow; for today the flawed models.

The Prevailing Economic Thought and Its Effect on the Business Cycle

Policy makers continue to insist that deflation poses the largest risk to the economy. This view is giving them (in their minds) the green light to engage in an economic philosophy that has proven to be quite harmful with regard to the duration of business cycle expansions, the level of employment, real wages and the economic distortions that result from intense government involvement.

And indeed, one doesn’t see the present current of economic thought changing anytime soon. Many economists, and importantly those who receive much attention from the press, continue to cling, however precariously, to their Keynesian/Phillips Curve/Output Gap models. That is, for economists within the Obama Administration and throughout academia, there is the overt belief that the federal government (via fiscal policy/government spending) and the Federal Reserve (via monetary policy) can continue to put the pedal to the floor without concern of sparking a nasty inflationary event. FOMC Vice Chairman Donald Kohn, New York Fed Bank President William Dudley and the White House’s chief economist Larry Summers were all out this weekend attempting to explain why high levels of inflation will not become a problem

Why are they so confident? Because there is a lot of excess capacity out there (plant and equipment and also within the labor markets – although not true for highly skilled labor) – ie. the “output gap.”

This way of thinking surmises that because excess capacity remains, right now at least, we can jack any level of money into the system and have little fear of inflation rearing its ugly head. However, this is a terribly flawed concept because it ignores that inflation is a monetary phenomenon, as a plethora of empirically evidence has shown. One would think this abundance of historical evidence over the past 30 years would have changed minds within the Keynesian camp – alas, they remain lost in the wilderness of their Phillips Curve/Output Gap textbooks. (And this was very obvious by way of Larry Summers’ appearance on Meet the Press yesterday morning. Mr. Summers is living in a fantasy world.

As they wander aimlessly (and we mustn’t forget that this type of economic thought is conducive to a big government agenda, which is why pedal-to-the-medal spending types love it) they forget that production has contracted substantially over the past seven months. In the meantime money supply growth and government debt-driven stimulus has (and will continue to) skyrocketed. This sets up for the classic situation of too much money chasing too few goods – the result of which is inflation, and based upon the level of money pumping activity that policy is exacting this inflationary event could be very large.

While no one can predict what will occur in the future, the chances of very high inflation rates, and thus the economically crushing monetary tightening that would eventually be applied to quash this event, are running high.

The main focus of this discussion is not a lesson in Keynesian economic thinking but to caution investors from becoming too excited after this significant move higher in stock prices; there will be additional economic challenges to address even when it initially appears we’re out of the proverbial woods. The way we are dealing the current situation is not favorable to sustained economic growth.

When the business cycle does turn up it will act as the spark to this inflationary event and the monetary tightening that will ensue, although it will be delayed as the Fed is not currently independent of the political class (as they should be) and will be pressured not to act on this inflation right away for fear of shutting down what may be a nascent housing rebound, will act as another economic problem that will very likely keep stocks in a trading range. That tightening process will cause the economy to contract again – I’m not smart enough (or dumb enough) to attempt to predict the timing --, and maybe profoundly, and thus investors should not be taken to move further out along the risk curve in an attempt to quickly make back the losses of the past seven months, in particular. It’s a natural human reaction to try and do so.

The caveat to this inflationary event occurring is that government screws up so royally that the economy does not rebound in a meaningful way. When Washington gets increasingly involved with regard to the allocation of resources this does cause the private sector to hold back. We can talk to this topic tomorrow, specifically what the administration wants to do regarding interest-rate ceilings on credit cards and regulations within the energy sector that has power plant companies holding off on building new plants until they see what Congress does in this regard. My view is the economy will rebound and that inflation event will occur, but this is the caveat… more on that tomorrow.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries
Treasuries sold off heavily for the second consecutive day. The two-year finished down 4/32, and the ten-year was lower by 31/32. The benchmark curve was 4 basis points steeper on the day, and currently sits at +197 basis points. A basis point represents .01%.

Interest rates moved higher today on a strong equity market and a rush of shorts coming in to hedge against next week’s corporate bond supply. Bond issuers often short Treasuries when they announce an upcoming bond issue to hedge against rates moving higher before the issue is priced. Higher rates mean higher debt servicing costs (making coupon payments), so if rates move higher before their issue is priced by the market they will be at least be partially compensated for the fall in bond prices through the hedge. Remember bond prices move inversely to rates.

Next week will be big in terms of Treasury auction announcements so some rate volatility can be expected.

Fed Agency Purchases
The Fed purchased $3.07 billion in Fannie Mae, Freddie Mac and Federal Home Loan Bank debentures today ranging in maturities from 10/15/15 to 7/15/32. The auction met the market’s expectations and agencies more or less tracked Treasuries downward throughout the day.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst