General Electric (GE) managed to surpass muted quarterly expectations, but industrial businesses showed signs of weakness and the company issued downside guidance.
Combined earnings at GE’s non-finance businesses fell 8% to $4.16 billion and CEO Jeffery Immelt said the combined earnings of these businesses will come in at the low end of the guidance range (flat to 5% growth) given in December – thanks Jeff, we couldn’t have figured that one out ourselves. The company also adjusted their full-year free cash flow forecast from $16 billion to a range of $14 billion to $16 billion after only generating $7.1 billion in free cash flow from operating activities through the first two quarters of 2009.
GE’s overall order backlog dropped 1.7% from a year ago to $169 billion, but the backlog for higher-margin maintenance and services contracts increased. The company added they are targeting more than 400 stimulus projects valued at $200 billion worldwide. Few of these projects have been realized so far this year, but management expect an increase in the second half of 2009.
Operating margins improved by 140 basis points within the non-finance businesses, primarily due to an increase in services revenue. And with about $2 billion of additional cost reductions under consideration for this year, GE has plenty of levers to pull if revenues continue to plunge.
GE Capital reported profit of $590 million, down from $2.9 billion a year earlier, as consumer credit deterioration weighed on performance. The finance unit’s pretax profits fell 40% from a year ago, but increased 15% sequentially. Pretax profits are important to some investors because of tax credits that often bolster profit. Management reiterated that the finance arm remains on track to be profitable for 2009.
The company has reached its 2009 long-term funding goals for GE Capital and noted that the company has pre-funded about a third of its 2010 target, which means GE Capital could wait almost a year before having to access the capital markets again. This gives them a substantial cash balance right now, which is a positive when you consider the crunch that other wholesale-funded banks like CIT Group have faced.
There is no sugar-coating it: GE had an ugly quarter. Trading just under 12 times earnings, it is hard to imagine that an improvement will justify a higher multiple anytime soon. In the meantime, GE investors need to be patient and hope they continue to receive the 3.5% dividend payout until the economy climbs out of this rut.
--
Peter J. Lazaroff
Friday, July 17, 2009
IBM's earnings smash expectations
IBM’s earnings smashed expectations as margin upside offset weaker revenues, and the firm significantly raised guidance for 2009.
Revenues fell 13.3% to $23.25 billion from a year ago, but only declined 7% when excluding currency effects. With the exception of software, every business segment saw revenues decline versus last year. Hardware sales, which declined 26% from a year ago, and short-term consulting also showed considerable weakness. All geographic areas saw revenue decline, with the Americas down 9%, Europe/Middle East/Africa down 20%, and Asia-Pacific down 7%.
These sales results along with management’s commentary suggest that businesses are not prepared to resume spending.
Although revenues disappointed, the Street totally underestimated IBM’s cost efficiencies. Gross profit margin was 45.5% in the quarter compared to 43.2% last year, and pretax profit margin rose 4.1 percentage points to 18.3% – a level normally reserved for the seasonally strongest fourth quarter. Margin improvement was driven by a more profitable business mix – particularly with software and consulting contracts – and dramatically lower costs from aggressive restructuring and improved labor productivity.
Really juicing investors was the upside guidance from IBM, saying they expect earnings of “at least $9.70” per share. IBM previously expected $9.20 per share while the consensus estimate currently stands at $9.15.
IBM’s business recovery may be more muted than other, more cyclical companies. Still, IBM’s improved signings in the service business, their largest segment, and a near-record backlog bode well for the company’s prospects.
--
Peter J. Lazaroff
Daily Insight
U.S. stocks reversed morning-session losses after Nouriel Roubini, an economist who predicted the financial crisis, stated the recession will end this year. He also stated a second economic stimulus plan may be needed to guarantee a recovery. God help us! I assume he doesn’t mean broad-based reductions in tax rates and higher current-year business-equipment write offs, but rather another $500 billion-$1 trillion in government spending.
The broad-market rally extended to a fourth session as the S&P 500 honed in on its trading-range high of 946-950 (for those keeping count), roughly the post election-day high . Industrial, technology and basic material shares led the indices higher. Financials and telecoms were the laggards – bank stocks were hurt by the news that CIT will very likely go bust today (CIT being the holding company that offers lending to small and mid-sized businesses and to more than half of the “Fortune” 1000 names. The overall market had no problem shrugging it off, instead finding reason to rally on the Roubini comments.
Yesterday’s economic data was really no help. Initial jobless claims posted a substantial decline, but it was met with skepticism as seasonal adjustment factors likely played a major role in the decline rather than some meaningful improvement in the labor market. The latest manufacturing gauge deteriorated.
Volume was pretty soft again, even for this time of year, as just 1.1 billion shares traded on the NYSE Composite – 21% below the three-month average. Advancers beat decliners by a 3-to-1 margin on the Big Board.
On a non-seasonally adjusted basis continuing claims rose 64,000 to hold above the six million mark.
Philly Fed
The Federal Reserve Bank of Philadelphia released their manufacturing survey for July, showing activity fell at an increased rate from the month prior. The Philly Fed index declined to -7.5 from -2.2 in June, which was the best reading since September when Philly posted its last positive reading. Expectations were for the reading to come in at -4.5.
Delivery times picked up to -10.3 from -18.9.
The workweek improved substantially to -15.5 from -26.6 in June.
While all of these readings remain in negative territory, these are nice improvements.
The sub-index that caused the headline figure to worsen was the decline in shipments, which fell to -9.5 in July from +2.1 in June. This reading was surprising since the new orders index improved greatly in June to -4.8 from -25.9 in May – new orders generally portend the direction of shipments. Either the Philly region saw a big cancelation in orders or we’ll just have to wait another month for it to flow to shipments.
On Earnings
IBM blew by their number, reporting really good bottom line results – and the numbers weren’t like many other results of late by which a firm easily hurdles a low estimate but the year-over-year results are down big. IBM’s year-over-year profit rose 17% (operating earnings basis) on massive cost-cutting. They have also moved into markets, specifically consulting within the electric grid market, that will benefit from government spending. However, the company repeated what Intel, among other techies, have stated: businesses continue to delay spending. This has been a concern of ours, as we’ve expressed for a while now, and I don’t see how the direction of policy eases this situation beyond the very necessary equipment purchases.
On the top-line, things were not so rosy as revenue fell 13%. The market is ok for now with cost-cutting as the catalyst for better-than-expected results, but by next quarter investors and traders are going to want to see meaningful improvement in final demand and that means higher revenue numbers.
Google was also out last night, reporting that earnings rose 18% from the year-ago period, but this was below expectations. They predicted that online advertising would decline another 10% this year and that a recovery in technology will take longer than expected.
Bank of America is probably the big earnings news of the morning – at least before the delivery of this letter. The bank reported per share profit that beat expectations by 36% but those results were 66% below year-ago results. CEO Ken Lewis predicted the weak economy will persist into 2010 – he knows what’s coming in terms of commercial real estate defaults.
The bright spots were mortgage lending (big revenues on refi activity) and global markets (trading of stocks, bonds and currencies). The consumer area, just as JP Morgan showed earlier in the week, continues to worsen.
Brent Vondera
The broad-market rally extended to a fourth session as the S&P 500 honed in on its trading-range high of 946-950 (for those keeping count), roughly the post election-day high . Industrial, technology and basic material shares led the indices higher. Financials and telecoms were the laggards – bank stocks were hurt by the news that CIT will very likely go bust today (CIT being the holding company that offers lending to small and mid-sized businesses and to more than half of the “Fortune” 1000 names. The overall market had no problem shrugging it off, instead finding reason to rally on the Roubini comments.
Yesterday’s economic data was really no help. Initial jobless claims posted a substantial decline, but it was met with skepticism as seasonal adjustment factors likely played a major role in the decline rather than some meaningful improvement in the labor market. The latest manufacturing gauge deteriorated.
Volume was pretty soft again, even for this time of year, as just 1.1 billion shares traded on the NYSE Composite – 21% below the three-month average. Advancers beat decliners by a 3-to-1 margin on the Big Board.
Commercial Paper
The commercial paper (CP) market is shrinking at a record pace, as investors demand for all but the top-rated paper dwindles. A proposal from the SEC may worsen the situation by restricting money-market funds (these funds hold roughly 40% of the CP market, according to Bloomberg) to only top-rated debt – anything below A-1, which in short-term credit ratings is equivalent to anything below AAA and AA+ on long-term ratings.
Commercial paper is used by corporations to provide very short –term funding, allowing firms to borrow at cheaper rates. When your CP dries up a firm’s cost of capital rises as the business needs to borrow for longer terms, and that increase is substantial – depending on the credit rating of the firm it may be 4-8 percentage points higher! When borrowing costs rise, it results in less expansion and less jobs than would otherwise be the case. The short-term funding game is over for a lot of U.S. companies.
Maybe this is a good thing over the longer term, certainly CP issuance jumped to levels that were harmful by 2007 – harmful from the respect of when investors flee for safety your funding evaporates; long-term maturities reduce this effect, but the point is this situation is another thing that will affect economic activity over the next couple of years.
Jobless Claims
The Labor Department reported that initial jobless claims plunged 47,000 in the week ended July 11 to 522,000 (a decline of 12,000 was expected). This marks the second week in which we’ve seen a huge decline. Initial claims fell 48,000 in the week ended July 4, which I accounted to the holiday-shortened week and seasonal adjustments due to auto-plant closing.
However, with a second-straight week of huge declines maybe something else is occurring. It’s one of two things: Either the job market is beginning to improve substantially, or we still have this seasonal adjustment thing occurring. (That is, auto plants normally shutdown in July as they retool for new models, the seasonal adjustment factors this in. However, this year, with the GM and Chrysler bankruptcies, they shuttered plants a month earlier than usual so the normal rise in claims is not showing up when it typically does.
I find it very difficult to believe -- with the duration of unemployment making a new record high to 24.5 weeks, another 467,000 jobs slashed in June and the U6 unemployment rate hitting 16.4% -- that the labor market has improved to such a huge degree as this claims data is suggesting. It’s got to be the seasonal distortion. I want to be careful here not to send the wrong message. I’m not stretching to offer a negative view, I don’t want anyone to read it that way – I as much as anyone want the economic scene to improve and improve markedly. But we look at every number that comes across on a daily basis very closely and this large reduction in claims just doesn’t make sense. If the number remained below 600K but rose a bit, or even held steady, I wouldn’t have this level of skepticism, but this degree of decline is not commensurate with the other data.
Now, the rate of job cuts will ease (as we first talked about two months back when estimating that monthly job losses will fall back to the normal recessionary levels of 250K-300K by August) and this is going to have an affect on the claims data, but again this level of decline just seems to not quite jibe with reality. We’ve lost 6.46 million jobs since January 2008 as businesses had been shocked by the degree and quickness of the economic weakness, so we must see some sort of easing simply on a statistical basis. (And just to make something clear, I’ve seen a lot of people state that we’ve lost all of the payroll positions created from the previous expansion. That is not true, we still have a net gain of 1.86 million as 8.32 million were added September 2003-December 2007 and 6.46 have been lost since.
The four-week average on initial claims fell 22,500 to 584,500 – first move below 600K since January.
The Labor Department reported that initial jobless claims plunged 47,000 in the week ended July 11 to 522,000 (a decline of 12,000 was expected). This marks the second week in which we’ve seen a huge decline. Initial claims fell 48,000 in the week ended July 4, which I accounted to the holiday-shortened week and seasonal adjustments due to auto-plant closing.
However, with a second-straight week of huge declines maybe something else is occurring. It’s one of two things: Either the job market is beginning to improve substantially, or we still have this seasonal adjustment thing occurring. (That is, auto plants normally shutdown in July as they retool for new models, the seasonal adjustment factors this in. However, this year, with the GM and Chrysler bankruptcies, they shuttered plants a month earlier than usual so the normal rise in claims is not showing up when it typically does.
I find it very difficult to believe -- with the duration of unemployment making a new record high to 24.5 weeks, another 467,000 jobs slashed in June and the U6 unemployment rate hitting 16.4% -- that the labor market has improved to such a huge degree as this claims data is suggesting. It’s got to be the seasonal distortion. I want to be careful here not to send the wrong message. I’m not stretching to offer a negative view, I don’t want anyone to read it that way – I as much as anyone want the economic scene to improve and improve markedly. But we look at every number that comes across on a daily basis very closely and this large reduction in claims just doesn’t make sense. If the number remained below 600K but rose a bit, or even held steady, I wouldn’t have this level of skepticism, but this degree of decline is not commensurate with the other data.
Now, the rate of job cuts will ease (as we first talked about two months back when estimating that monthly job losses will fall back to the normal recessionary levels of 250K-300K by August) and this is going to have an affect on the claims data, but again this level of decline just seems to not quite jibe with reality. We’ve lost 6.46 million jobs since January 2008 as businesses had been shocked by the degree and quickness of the economic weakness, so we must see some sort of easing simply on a statistical basis. (And just to make something clear, I’ve seen a lot of people state that we’ve lost all of the payroll positions created from the previous expansion. That is not true, we still have a net gain of 1.86 million as 8.32 million were added September 2003-December 2007 and 6.46 have been lost since.
The four-week average on initial claims fell 22,500 to 584,500 – first move below 600K since January.
Continuing Claims fell a massive record-setting 642,000 to settle at 6.273 million in the week ended July 4 (there is a one week lag between initial and continuing claims data).
On a non-seasonally adjusted basis continuing claims rose 64,000 to hold above the six million mark.Philly Fed
The Federal Reserve Bank of Philadelphia released their manufacturing survey for July, showing activity fell at an increased rate from the month prior. The Philly Fed index declined to -7.5 from -2.2 in June, which was the best reading since September when Philly posted its last positive reading. Expectations were for the reading to come in at -4.5.
A number of sub-indices actually improved, but a large decline in shipments made the headline number appear possibly worse than things actually were.
New orders improved to -2.2 from -4.8.
Unfilled orders looked better, hitting -14.6 from -19.6.
Delivery times picked up to -10.3 from -18.9.
The workweek improved substantially to -15.5 from -26.6 in June. While all of these readings remain in negative territory, these are nice improvements.The sub-index that caused the headline figure to worsen was the decline in shipments, which fell to -9.5 in July from +2.1 in June. This reading was surprising since the new orders index improved greatly in June to -4.8 from -25.9 in May – new orders generally portend the direction of shipments. Either the Philly region saw a big cancelation in orders or we’ll just have to wait another month for it to flow to shipments.
On EarningsIBM blew by their number, reporting really good bottom line results – and the numbers weren’t like many other results of late by which a firm easily hurdles a low estimate but the year-over-year results are down big. IBM’s year-over-year profit rose 17% (operating earnings basis) on massive cost-cutting. They have also moved into markets, specifically consulting within the electric grid market, that will benefit from government spending. However, the company repeated what Intel, among other techies, have stated: businesses continue to delay spending. This has been a concern of ours, as we’ve expressed for a while now, and I don’t see how the direction of policy eases this situation beyond the very necessary equipment purchases.
On the top-line, things were not so rosy as revenue fell 13%. The market is ok for now with cost-cutting as the catalyst for better-than-expected results, but by next quarter investors and traders are going to want to see meaningful improvement in final demand and that means higher revenue numbers.
Google was also out last night, reporting that earnings rose 18% from the year-ago period, but this was below expectations. They predicted that online advertising would decline another 10% this year and that a recovery in technology will take longer than expected.
Bank of America is probably the big earnings news of the morning – at least before the delivery of this letter. The bank reported per share profit that beat expectations by 36% but those results were 66% below year-ago results. CEO Ken Lewis predicted the weak economy will persist into 2010 – he knows what’s coming in terms of commercial real estate defaults.
The bright spots were mortgage lending (big revenues on refi activity) and global markets (trading of stocks, bonds and currencies). The consumer area, just as JP Morgan showed earlier in the week, continues to worsen.
Brent Vondera
Fixed Income Recap
Rates settled lower after rising for three days straight on poor economic data. The worsening situation with CIT brought an even stronger bid to the market but we didn’t get the flattening effect along with the rally like we have grown so accustomed to during this past cycle. The middle part of the curve (five-year) outperformed, while the 2-10 spread was unchanged on the day.
The Federal Reserve purchased $1.499 billion in TIPS on $9.188 billion in bonds submitted, a weaker ratio than average. The entire Treasury buying program is very small when considering the size of the Treasury market, and hasn’t made a material impact on anything outside of the initial fury when the program was first announced. The FOMC minutes that were released Wednesday show the committee’s reluctance to increase the number going forward. In my opinion this is a smart move by the Fed.
Cliff J. Reynolds Jr.
The Federal Reserve purchased $1.499 billion in TIPS on $9.188 billion in bonds submitted, a weaker ratio than average. The entire Treasury buying program is very small when considering the size of the Treasury market, and hasn’t made a material impact on anything outside of the initial fury when the program was first announced. The FOMC minutes that were released Wednesday show the committee’s reluctance to increase the number going forward. In my opinion this is a smart move by the Fed.
Cliff J. Reynolds Jr.
Thursday, July 16, 2009
Daily Insight
Stocks rallied again yesterday as the latest reading on industrial production recorded it lowest rate of decline in eight months and New York-area manufacturing activity nearly made it to expansion mode – the new orders index within the Empire Manufacturing survey posted its first month of expansion since September. That Intel news from Tuesday that we touched on yesterday also played a role in the upshot.
The broad market has returned to the high-end of the trading range for the fifth time this year, up 7% since hitting a 10-week low of 870 on July 10. If this morning’s jobless claims data indicates the prior week’s move below 600K was the beginning of a trend rather than a function of the holiday-shortened week of July 4 and seasonal adjustments due to auto plant shutdowns we may have a shot at putting in a higher end to this ambit.
Technology, basic material, energy and industrials led the rally. All 10 major industry groups in fact participated in the move; health-care was the laggard managing a mere 0.8% increase.
Yesterday’s move higher was on the best volume in six sessions, yet still 9% below the year-to-date average on the NYSE Composite. Advancers torched decliners by a 17-to-1 margin.
Market Activity for July 15, 2009
Mortgage Applications
The Mortgage Bankers Association reported that their mortgage apps index rose for a second-straight week, as refinancings remained strong – up 17.7% for the week ended July 10 after a 15.2% increase in the prior week.
Borrowers were attracted to a 30-year mortgage rate that fell back to hover around the 5.00% level. Further, the Obama administration’s decision to allow Fannie and Freddie to refinance mortgages with up to a 125% loan-to-value ratio certainly didn’t hurt this activity. Looking beyond the next six hours, no one can tell me that this is healthy. If home values do not begin to rise I’m going to guess that many of these loans will eventually turn into foreclosures and hence you are just delaying the inevitable, and thus delaying the recovery. But hey, who knows. We’ve got hope, right?
Purchases fell in the week ended July 10, down 9.4% after increasing 6.7% in the previous week. The rate on the 30-year fixed rate mortgage fell to 5.05%, down meaningfully from 5.50% in mid June.
Consumer Price Index (CPI)
The Labor Department reported the CPI rose a bit more than expected in June, up 0.7% vs. the 0.6% estimate. The gain was driven by higher energy prices (a recurring story as this was the case with Tuesday’s PPI reading), which accounted for 70% of the monthly gain. This will not be the case next month as energy prices have declined substantially. The core rate, which takes out the volatile food and energy components, rose 0.2% last month (also more than expected) but up only 1.7% year-over year.
The headline number remains negative on a 12-month basis and this may remain the case until the comparisons become easier by November; these year-over-year numbers are still being compared to last summer’s commodity price spike that pushed CPI up to 5.6%.
Outside of energy (and transportation, which is impossible to hold back when gasoline is up 17% for the month) all other component’s prices remain very tame. Food was flat; housing flat (no surprise there); apparel was up 0.7% for the month, but this followed three months of decline; medical care up just 0.2%.
I do see some concern though within the commodities component of CPI. This segment was up 1.8% in June, again largely due to energy prices. However, when you take out food and energy commodities were up 0.3% last month and 4.1% at an annual rate over the past three months. This is the base we’ve been talking about. While inflation outside energy remains very low, this core commodity reading is starting from a pretty high base considering the weakness of economic activity. Once activity bounces, I believe there is real potential for the inflation gauges to spike. This remains a very early call, but if correct it will be a really tough thing for the economy to deal with as it will be another catalyst for higher interest rates.
Industrial Production
Industrial production fell 0.4% in June, marking the 17th decline in 18 months. This contraction in production is the deepest both in term if degree and duration since the wind down from WWII. Yet the fact that this latest reading marked the slowest rate of decline in eight months (actually, since the figure posted its only positive number over the past 18 months back in October) it led many to believe the worst of the recession is over.
I don’t think this idea that the worst is over is a novel thought as we will soon see a statistical recovery (a boost in GDP simply based on the low levels we’re coming from and the inventory rebuilding that will ensure after the largest inventory liquidation since records began in 1947). I’ve got to say though that the manufacturing component within this data is not showing we’re quite there yet – particularly the machinery data, which posted another large decline of 1.9% in June – down 25.5% year-over-year. If machinery can’t yet muster a rebound as China engages in robust infrastructure-building projects and the U.S. spending begins to get underway, I think that says something.
And in terms of the industry components, manufacturing activity declined 0.6% in May (the eighth month of decline) and is down 15.5% year-over-year. And the woeful situation within the auto sector can’t be blamed for all of this as ex-motor vehicles/parts manufacturing production is down 14% year-over-year. Utility output rose in May for the first time since January, up 0.8% -- it is down 4% yoy. Mining activity dropped 0.5% last month (the seventh month of decline), down 10.4% yoy.
Capacity utilization fell to make another record low (since records began in 1967), down to 68.0% from the 68.2% hit in May. This record low capacity util. reading will cause the economic world to believe inflation cannot rise to troublesome levels – too much slack in employment and thus no wage-related inflation as they say. But our Keynesian world needs to be very careful here for Phillips Curve/NAIRUist models have gotten us in trouble in the past – inflation is more a function of too much money chasing too few goods than a function of wages. And whenever it is that credit begins to flow a bit, and all of that money the Fed has pumped in is no longer fallow, the productive capability will not be there to create the goods in order to absorb all of this money – that’s when inflation hits and teaches us, again, that Keynesian models are quite flawed.
FOMC Minutes
The Federal Open Market Committee (the policy-setting group of the Federal Reserve System) released its minutes (notes) from their June 23-24 meeting. We don’t always report on this news as it pertains to what the Fed saw in the six weeks leading up to that meeting and data we’ve already discussed on a daily basis. However, people were watching this release in particular looking to see what the members said about their quantitative easing (QE) campaign (bond purchases) for clues related to the direction of those actions.
First though, most members “saw the economy as quite weak and vulnerable to further adverse shocks.” Although market conditions had improved, “credit remained tight in many sectors.” They also correctly worried that consumer spending will resume its decline once temporary benefits to household income subsides as the fiscal stimulus subsides. (This is the point we’ve made when explaining that the past two months in which personal income rose was completely a function of government transfer payments – payments that accounted for 97% of the income gain in May.)
The members found conflict with respect to inflation as a few expressed concern the rate could “temporarily rise above levels consistent with their mandate” to keep prices stable. They also raised their 2010 forecasts for both GDP and the unemployment rate.
Uh, someone will have to explain that one to me. It is certainly true that the unemployment rate always continues to rise even as the economy bounces back. However, in a consumer-led and credit contraction, coupled with a plunge in stock and real estate prices, the jobs data should be seen as a more coincident indicator – consumers will not see their optimism increase until they see the job market turn simply because they have less access to credit and stock and house prices have been smashed. I don’t see how you increase your GDP forecast when you believe the jobless rate will get worse than previously expected.
On QE, the Fed appeared to lean toward leaving their program to buy $1.25 trillion in mortgage-backed and $300 billion in Treasury securities unchanged. They stated, “[al]though an expansion of such purchases might provide additional support to the economy, the effects of further assets purchases, especially purchases of Treasury securities, on the economy and on inflation expectations were uncertain.” They are questioning how much this program can boost the economy, while acknowledging the downside of the bond purchases – the actions may have the opposite of the desired effect. Instead of pushing rates lower, the bond market may sell off if it fears this money printing will spark a harmful inflationary event, which means rates will rise.
Futures
Stock-index futures were down big earlier this morning on news the talks to rescue CIT Group have collapsed, but have now reversed course after JP Morgan reported earnings that destroyed estimates.
The bank reported operating profit of 28 cents per diluted share for the quarter, the estimate was for a lowly 4 cents. While the market would certainly not cheer a 28-cent quarterly profit for a firm that made 50 cents in the same quarter during the previous recession, they easily jumped the estimate – a hurdle that was about the height of a speed bump -- as investment banking fees were boosted by big debt issuance and a massive amount of financial-industry stock issuance as the group needed to raise capital. The consumer side of their business continued to deteriorate. Home-equity charge-offs continued to rise and credit card charge-offs rose to 10.03% from 7.72% in the previous quarter and 4.98% a year ago.
Have a great day!
Brent Vondera
The broad market has returned to the high-end of the trading range for the fifth time this year, up 7% since hitting a 10-week low of 870 on July 10. If this morning’s jobless claims data indicates the prior week’s move below 600K was the beginning of a trend rather than a function of the holiday-shortened week of July 4 and seasonal adjustments due to auto plant shutdowns we may have a shot at putting in a higher end to this ambit.
Technology, basic material, energy and industrials led the rally. All 10 major industry groups in fact participated in the move; health-care was the laggard managing a mere 0.8% increase.
Yesterday’s move higher was on the best volume in six sessions, yet still 9% below the year-to-date average on the NYSE Composite. Advancers torched decliners by a 17-to-1 margin.
Market Activity for July 15, 2009
Mortgage ApplicationsThe Mortgage Bankers Association reported that their mortgage apps index rose for a second-straight week, as refinancings remained strong – up 17.7% for the week ended July 10 after a 15.2% increase in the prior week.
Borrowers were attracted to a 30-year mortgage rate that fell back to hover around the 5.00% level. Further, the Obama administration’s decision to allow Fannie and Freddie to refinance mortgages with up to a 125% loan-to-value ratio certainly didn’t hurt this activity. Looking beyond the next six hours, no one can tell me that this is healthy. If home values do not begin to rise I’m going to guess that many of these loans will eventually turn into foreclosures and hence you are just delaying the inevitable, and thus delaying the recovery. But hey, who knows. We’ve got hope, right?
Purchases fell in the week ended July 10, down 9.4% after increasing 6.7% in the previous week. The rate on the 30-year fixed rate mortgage fell to 5.05%, down meaningfully from 5.50% in mid June.
Consumer Price Index (CPI)The Labor Department reported the CPI rose a bit more than expected in June, up 0.7% vs. the 0.6% estimate. The gain was driven by higher energy prices (a recurring story as this was the case with Tuesday’s PPI reading), which accounted for 70% of the monthly gain. This will not be the case next month as energy prices have declined substantially. The core rate, which takes out the volatile food and energy components, rose 0.2% last month (also more than expected) but up only 1.7% year-over year.
The headline number remains negative on a 12-month basis and this may remain the case until the comparisons become easier by November; these year-over-year numbers are still being compared to last summer’s commodity price spike that pushed CPI up to 5.6%.
Outside of energy (and transportation, which is impossible to hold back when gasoline is up 17% for the month) all other component’s prices remain very tame. Food was flat; housing flat (no surprise there); apparel was up 0.7% for the month, but this followed three months of decline; medical care up just 0.2%.
I do see some concern though within the commodities component of CPI. This segment was up 1.8% in June, again largely due to energy prices. However, when you take out food and energy commodities were up 0.3% last month and 4.1% at an annual rate over the past three months. This is the base we’ve been talking about. While inflation outside energy remains very low, this core commodity reading is starting from a pretty high base considering the weakness of economic activity. Once activity bounces, I believe there is real potential for the inflation gauges to spike. This remains a very early call, but if correct it will be a really tough thing for the economy to deal with as it will be another catalyst for higher interest rates.
Industrial Production
Industrial production fell 0.4% in June, marking the 17th decline in 18 months. This contraction in production is the deepest both in term if degree and duration since the wind down from WWII. Yet the fact that this latest reading marked the slowest rate of decline in eight months (actually, since the figure posted its only positive number over the past 18 months back in October) it led many to believe the worst of the recession is over.
I don’t think this idea that the worst is over is a novel thought as we will soon see a statistical recovery (a boost in GDP simply based on the low levels we’re coming from and the inventory rebuilding that will ensure after the largest inventory liquidation since records began in 1947). I’ve got to say though that the manufacturing component within this data is not showing we’re quite there yet – particularly the machinery data, which posted another large decline of 1.9% in June – down 25.5% year-over-year. If machinery can’t yet muster a rebound as China engages in robust infrastructure-building projects and the U.S. spending begins to get underway, I think that says something.And in terms of the industry components, manufacturing activity declined 0.6% in May (the eighth month of decline) and is down 15.5% year-over-year. And the woeful situation within the auto sector can’t be blamed for all of this as ex-motor vehicles/parts manufacturing production is down 14% year-over-year. Utility output rose in May for the first time since January, up 0.8% -- it is down 4% yoy. Mining activity dropped 0.5% last month (the seventh month of decline), down 10.4% yoy.
Capacity utilization fell to make another record low (since records began in 1967), down to 68.0% from the 68.2% hit in May. This record low capacity util. reading will cause the economic world to believe inflation cannot rise to troublesome levels – too much slack in employment and thus no wage-related inflation as they say. But our Keynesian world needs to be very careful here for Phillips Curve/NAIRUist models have gotten us in trouble in the past – inflation is more a function of too much money chasing too few goods than a function of wages. And whenever it is that credit begins to flow a bit, and all of that money the Fed has pumped in is no longer fallow, the productive capability will not be there to create the goods in order to absorb all of this money – that’s when inflation hits and teaches us, again, that Keynesian models are quite flawed.
FOMC MinutesThe Federal Open Market Committee (the policy-setting group of the Federal Reserve System) released its minutes (notes) from their June 23-24 meeting. We don’t always report on this news as it pertains to what the Fed saw in the six weeks leading up to that meeting and data we’ve already discussed on a daily basis. However, people were watching this release in particular looking to see what the members said about their quantitative easing (QE) campaign (bond purchases) for clues related to the direction of those actions.
First though, most members “saw the economy as quite weak and vulnerable to further adverse shocks.” Although market conditions had improved, “credit remained tight in many sectors.” They also correctly worried that consumer spending will resume its decline once temporary benefits to household income subsides as the fiscal stimulus subsides. (This is the point we’ve made when explaining that the past two months in which personal income rose was completely a function of government transfer payments – payments that accounted for 97% of the income gain in May.)
The members found conflict with respect to inflation as a few expressed concern the rate could “temporarily rise above levels consistent with their mandate” to keep prices stable. They also raised their 2010 forecasts for both GDP and the unemployment rate.
Uh, someone will have to explain that one to me. It is certainly true that the unemployment rate always continues to rise even as the economy bounces back. However, in a consumer-led and credit contraction, coupled with a plunge in stock and real estate prices, the jobs data should be seen as a more coincident indicator – consumers will not see their optimism increase until they see the job market turn simply because they have less access to credit and stock and house prices have been smashed. I don’t see how you increase your GDP forecast when you believe the jobless rate will get worse than previously expected.
On QE, the Fed appeared to lean toward leaving their program to buy $1.25 trillion in mortgage-backed and $300 billion in Treasury securities unchanged. They stated, “[al]though an expansion of such purchases might provide additional support to the economy, the effects of further assets purchases, especially purchases of Treasury securities, on the economy and on inflation expectations were uncertain.” They are questioning how much this program can boost the economy, while acknowledging the downside of the bond purchases – the actions may have the opposite of the desired effect. Instead of pushing rates lower, the bond market may sell off if it fears this money printing will spark a harmful inflationary event, which means rates will rise.
Futures
Stock-index futures were down big earlier this morning on news the talks to rescue CIT Group have collapsed, but have now reversed course after JP Morgan reported earnings that destroyed estimates.
The bank reported operating profit of 28 cents per diluted share for the quarter, the estimate was for a lowly 4 cents. While the market would certainly not cheer a 28-cent quarterly profit for a firm that made 50 cents in the same quarter during the previous recession, they easily jumped the estimate – a hurdle that was about the height of a speed bump -- as investment banking fees were boosted by big debt issuance and a massive amount of financial-industry stock issuance as the group needed to raise capital. The consumer side of their business continued to deteriorate. Home-equity charge-offs continued to rise and credit card charge-offs rose to 10.03% from 7.72% in the previous quarter and 4.98% a year ago.
Have a great day!
Brent Vondera
Fixed Income Recap
Rate volatility continued yesterday as yields rose to their highest point in three weeks. The two-year closed above 1% for the first time since July 1, but still far from the recent high of 1.4% on June 8. The curve continues to steepen on higher than anticipated inflation numbers. The 2/10 spread closed yesterday at 259 bps, the steepest it has been since the second week of June.
CPI for June came in at +.7% MoM, a little higher than the +.6% expected, and was dominated by energy (+7.6%) which explains the meager +.1% MoM ex food & energy number. TIPS have enjoyed the past few days. Nominal coupon Treasuries are down 2 points compared to just ¼ of a point for TIPS, translating into higher breakeven yields.
New developments in the CIT saga are pointing toward a bankruptcy filing for the lender soon. According to CIT’s website “it has been advised that there is no appreciable likelihood of additional government support being provided over the near term.”
The market seems alright with letting CIT fail, stock futures are up premarket, but I’m afraid it may be for the wrong reasons. “Let them fail, their business model is broken”, many are saying. Was AIG’s business model not broken? What about Bear Stearns’? CIT has failed to convince regulators that their failure would pose systemic risk to the financial system. Maybe they hired some former Lehman employees to debate on their behalf because they failed to do the same and look where that got us. I agree that Lehman’s bankruptcy was worlds larger than CIT’s would be, but the market is pricing its impact as if the credit market is some well oiled machine. Maybe I’m hanging on to what happened last fall too tight but what happens if CIT’s large CDS counterparties begin to disclose their exposure and we get a another run on the banks? Just because CIT is smaller than Lehman does not mean that it can’t snowball into something much larger.
Cliff J. Reynolds Jr., Investment Analyst
CPI for June came in at +.7% MoM, a little higher than the +.6% expected, and was dominated by energy (+7.6%) which explains the meager +.1% MoM ex food & energy number. TIPS have enjoyed the past few days. Nominal coupon Treasuries are down 2 points compared to just ¼ of a point for TIPS, translating into higher breakeven yields.
New developments in the CIT saga are pointing toward a bankruptcy filing for the lender soon. According to CIT’s website “it has been advised that there is no appreciable likelihood of additional government support being provided over the near term.”
The market seems alright with letting CIT fail, stock futures are up premarket, but I’m afraid it may be for the wrong reasons. “Let them fail, their business model is broken”, many are saying. Was AIG’s business model not broken? What about Bear Stearns’? CIT has failed to convince regulators that their failure would pose systemic risk to the financial system. Maybe they hired some former Lehman employees to debate on their behalf because they failed to do the same and look where that got us. I agree that Lehman’s bankruptcy was worlds larger than CIT’s would be, but the market is pricing its impact as if the credit market is some well oiled machine. Maybe I’m hanging on to what happened last fall too tight but what happens if CIT’s large CDS counterparties begin to disclose their exposure and we get a another run on the banks? Just because CIT is smaller than Lehman does not mean that it can’t snowball into something much larger.
Cliff J. Reynolds Jr., Investment Analyst
Wednesday, July 15, 2009
Asset Allocation Worked in 2008
I’m annoyed.
Last year was a terrible year for investors. Now, the peanut gallery is making the claim that asset allocation failed and diversification didn’t work. That’s bull.
Although there have been several articles from a variety of places, it is this front-page article from the Wall Street Journal that has my blood boiling.
The incendiary title started me off on the wrong foot: Fail-Safe Strategy Sends Investors Scrambling.
Any responsible investor with any appreciation for markets knows that no strategy is fail-safe. The only thing that worked all the time was Bernie Madoff (that is, until it didn’t).
The thrust of the article is that everything went down. It is true that pretty much all stock indexes went down, and diversifying amongst equity asset classes didn’t offer any benefit. However, it is outright false to say that asset allocation didn’t work.
For me, the Ibbotson SBBI Classic Yearbook is like the Rosetta Stone because SBBI was instrumental in developing my thinking about asset allocation and diversification. So, I start there with the six asset classes that Ibbotson lays out in the Basic Series:
Large Cap Stocks - 37.00%
Small Cap Stocks (really Microcap) - 36.72%
Long-Term Corporate Bonds + 8.78%
Long-Term Government Bonds +25.87%
Intermediate Term Government Bonds +13.11%
U.S. Treasury Bills (Cash) +1.60%
At the most basic level, asset allocation worked perfectly well. Stocks went down, but bonds and cash went up.
It is true that pretty much all stocks went down. It didn’t matter if you were large or small, international or domestic, growth or value. All of the subsets and derivations lost big.
As for bonds, I am not sure exactly where Ibbotson gets their Long-Term Corporate Bond data; it isn’t quite what I saw last year. For example, the Barclays US Long Credit A/Better Index lost 0.24 percent. Ibbotson says that their index is based on 20 year maturities, but the current maturity for the Long Credit Index is 24.80 years (11.7 year duration).
Other credit bond indexes were as follows:
iBoxx $ Liquid Investment Grade Index: +0.96%
Barclays U.S 1-3 Year Credit Index +0.30%
Barclays U.S. Intermediate Term Credit Index: -2.76%
Barclays U.S. Credit Index -3.08%
These aren’t exactly eye-popping returns, but they were lowly correlated with U.S. stocks. And, this was the year that credit markets were broken. Take a look at Treasury bond performance:
Barclays U.S. 20+ Year Treasury +33.72%
Barclays U.S. 10-20 Year Treasury +19.69%
Barclays U.S. 7-10 Year Treasury +17.97%
Barclays U.S. 3-7 Year Treasury +13.26%
And, you didn’t have to be solely in Treasuries either. The Barclays U.S. MBS Index gained 8.34 percent, and the Barclays U.S. Agency Index gained 9.26 percent.
Even muni indexes posted positive returns, despite the increasing trouble in many states and municipalities. The Barclays National 0-5 Year Municipal Bond index gained 5.05 percent.
This isn’t to say that all bonds went up – some went down. Preferred stocks, non-Agency mortgage backed securities, high yield (junk) bonds all lost substantially. These are derivations of the credit markets, which had a lot of trouble. They also shouldn’t be in the vast majority of portfolios. Professional investors know, for example, that junk bonds trade like stocks, not bonds.
If you didn’t want to bother with all of the various bond market sectors, just take a look at the Barclays U.S. Aggregate Index. It gained 5.25 percent last year, which is pretty consistent with what you would expect from a long-term bond allocation. In fact, the long-term rate of return for Intermediate Term Government Bonds according to Ibbotson from 1926 through 2008 is 5.24 percent.
Despite one money market mutual fund breaking the buck, all the others held up. It’s true that the government had to come in and lend a helping hand, but cash is pretty much cash. Those who had made sure that their cash didn’t contain undue credit exposure for a little extra yield didn’t have any problems.
If it wasn’t obvious, this article was meant to say that the basic building blocks of asset allocation worked exactly as one would expect. My next article on the subject will look at whether one year is the right time frame to make the statement that asset allocation doesn’t work. I’ll bet you can guess where I come down on that when I say that investing is for the long term…
--
David Ott
Last year was a terrible year for investors. Now, the peanut gallery is making the claim that asset allocation failed and diversification didn’t work. That’s bull.
Although there have been several articles from a variety of places, it is this front-page article from the Wall Street Journal that has my blood boiling.
The incendiary title started me off on the wrong foot: Fail-Safe Strategy Sends Investors Scrambling.
Any responsible investor with any appreciation for markets knows that no strategy is fail-safe. The only thing that worked all the time was Bernie Madoff (that is, until it didn’t).
The thrust of the article is that everything went down. It is true that pretty much all stock indexes went down, and diversifying amongst equity asset classes didn’t offer any benefit. However, it is outright false to say that asset allocation didn’t work.
For me, the Ibbotson SBBI Classic Yearbook is like the Rosetta Stone because SBBI was instrumental in developing my thinking about asset allocation and diversification. So, I start there with the six asset classes that Ibbotson lays out in the Basic Series:
Large Cap Stocks - 37.00%
Small Cap Stocks (really Microcap) - 36.72%
Long-Term Corporate Bonds + 8.78%
Long-Term Government Bonds +25.87%
Intermediate Term Government Bonds +13.11%
U.S. Treasury Bills (Cash) +1.60%
At the most basic level, asset allocation worked perfectly well. Stocks went down, but bonds and cash went up.
It is true that pretty much all stocks went down. It didn’t matter if you were large or small, international or domestic, growth or value. All of the subsets and derivations lost big.
As for bonds, I am not sure exactly where Ibbotson gets their Long-Term Corporate Bond data; it isn’t quite what I saw last year. For example, the Barclays US Long Credit A/Better Index lost 0.24 percent. Ibbotson says that their index is based on 20 year maturities, but the current maturity for the Long Credit Index is 24.80 years (11.7 year duration).
Other credit bond indexes were as follows:
iBoxx $ Liquid Investment Grade Index: +0.96%
Barclays U.S 1-3 Year Credit Index +0.30%
Barclays U.S. Intermediate Term Credit Index: -2.76%
Barclays U.S. Credit Index -3.08%
These aren’t exactly eye-popping returns, but they were lowly correlated with U.S. stocks. And, this was the year that credit markets were broken. Take a look at Treasury bond performance:
Barclays U.S. 20+ Year Treasury +33.72%
Barclays U.S. 10-20 Year Treasury +19.69%
Barclays U.S. 7-10 Year Treasury +17.97%
Barclays U.S. 3-7 Year Treasury +13.26%
And, you didn’t have to be solely in Treasuries either. The Barclays U.S. MBS Index gained 8.34 percent, and the Barclays U.S. Agency Index gained 9.26 percent.
Even muni indexes posted positive returns, despite the increasing trouble in many states and municipalities. The Barclays National 0-5 Year Municipal Bond index gained 5.05 percent.
This isn’t to say that all bonds went up – some went down. Preferred stocks, non-Agency mortgage backed securities, high yield (junk) bonds all lost substantially. These are derivations of the credit markets, which had a lot of trouble. They also shouldn’t be in the vast majority of portfolios. Professional investors know, for example, that junk bonds trade like stocks, not bonds.
If you didn’t want to bother with all of the various bond market sectors, just take a look at the Barclays U.S. Aggregate Index. It gained 5.25 percent last year, which is pretty consistent with what you would expect from a long-term bond allocation. In fact, the long-term rate of return for Intermediate Term Government Bonds according to Ibbotson from 1926 through 2008 is 5.24 percent.
Despite one money market mutual fund breaking the buck, all the others held up. It’s true that the government had to come in and lend a helping hand, but cash is pretty much cash. Those who had made sure that their cash didn’t contain undue credit exposure for a little extra yield didn’t have any problems.
If it wasn’t obvious, this article was meant to say that the basic building blocks of asset allocation worked exactly as one would expect. My next article on the subject will look at whether one year is the right time frame to make the statement that asset allocation doesn’t work. I’ll bet you can guess where I come down on that when I say that investing is for the long term…
--
David Ott
Intel's earnings impress
Intel (INTC) generated a monster reaction to their great second-quarter results, which they reported yesterday after the closing bell. The chipmaker’s reported profits that were nearly double the average estimate.
Second-quarter sales jumped 12% from the previous quarter as PC makers boosted orders for chips in anticipation of increasing demand in the second-half. CEO Paul Otellini explained that businesses probably won’t start buying PCs until next year, but Asia (and especially China) is leading the recovery.
Intel’s Asia-Pacific sales were up 21% from the previous quarter, but still 8.2% below last year’s figures. Sales in the Americas rose 12% sequentially, while Europe dropped 9.4%.
Intel’s guidance for the third-quarter also impressed, with the firm projecting $8.1 billion to $8.9 billion in sales, compared with average estimates of $7.86 billion. Even more, Intel expects gross margin to be about 53%, which is also higher than estimates.
The thing that really caught everyone off guard was how fast Intel was able to shutter capacity and cut workers to drain chips out of the global supply chain, leaving PC makers to scramble for parts.
But what are we really seeing here? Intel is benefiting from a rebound in chip demand because of inventory restocking along the electronics supply chain. The third-quarter guidance suggests that Intel sees this trend continuing for a few quarters. But one must exercise caution.
The company is still not expecting a recovery in business PC demand until 2010, if then. Another sign of uncertainty is that Intel is still not forecasting full-year gross profit. As we have mentioned before, we must see significant increases in the level of global technology spending over the next several quarters for a sustainable recovery.
This message of caution also applies to the entire economy.
--
Peter J. Lazaroff
Second-quarter sales jumped 12% from the previous quarter as PC makers boosted orders for chips in anticipation of increasing demand in the second-half. CEO Paul Otellini explained that businesses probably won’t start buying PCs until next year, but Asia (and especially China) is leading the recovery.
Intel’s Asia-Pacific sales were up 21% from the previous quarter, but still 8.2% below last year’s figures. Sales in the Americas rose 12% sequentially, while Europe dropped 9.4%.
Intel’s guidance for the third-quarter also impressed, with the firm projecting $8.1 billion to $8.9 billion in sales, compared with average estimates of $7.86 billion. Even more, Intel expects gross margin to be about 53%, which is also higher than estimates.
The thing that really caught everyone off guard was how fast Intel was able to shutter capacity and cut workers to drain chips out of the global supply chain, leaving PC makers to scramble for parts.
But what are we really seeing here? Intel is benefiting from a rebound in chip demand because of inventory restocking along the electronics supply chain. The third-quarter guidance suggests that Intel sees this trend continuing for a few quarters. But one must exercise caution.
The company is still not expecting a recovery in business PC demand until 2010, if then. Another sign of uncertainty is that Intel is still not forecasting full-year gross profit. As we have mentioned before, we must see significant increases in the level of global technology spending over the next several quarters for a sustainable recovery.
This message of caution also applies to the entire economy.
--
Peter J. Lazaroff
Daily Insight
U.S. stocks added to Monday’s upshot as a better-than-expected headline retail sales number brought back the view that the economy will soon recover (it seems wishful thinking, and you can’t blame people for this tendency after what we’ve been through, exacerbates these quick and abundant swings in sentiment – recall it was just two sessions back in which the market was concerned activity was not rebounding).
Goldman Sachs knocked the cover off of the ball, blowing by earnings estimates by 35%, but this was expected and failed to help financials, which were the second-most laggard behind telecom shares.
Earnings season in general has just gotten started, we normally don’t comment on things this early as less than 10% of S&P 500 members have reported thus far, but just to give you an idea profits are down 15% overall and -20% ex-financials. The expectation is for S&P 500 profits to fall 35% for the quarter.
Intel reported better-than-expected results after the bell last night and that’s got stock futures juiced this morning. But let’s get real here, when you set the bar low enough it’s pretty easy to hurdle. Intel’s operating earnings fell 31% and revenue was down 15% from the year-ago period. The market will eventually need earnings results to show final demand is improving rather than just the boost from cost cutting and we’re not seeing that yet.
Back to yesterday’s activity, consumer discretionary shares led the market higher on a better-than-expected retail sales report. We’ll get to the internals below, something that is very much out of vogue these days as the press knows only to focus on headline readings.
Industrial shares posted another good day, the second in a row as the 1% increase in the index that tracks these shares followed a 2.7% gain on Monday. Energy shares bounced too even though the price of oil moved below $60 per barrel.
The S&P 500 currently trades at 14.5 times earnings, which makes the current quote of 905 an appropriate top-end of this range in my view. This is an especially uncertain environment and it’s just tough to justify a multiple that is above the long-term average as a result. Some have argued that the market affords a higher P/E simply because the yield on the 10-year Treasury (currently 3.50%) is so low, this security offers the discount rate for most calculations – I’ve made this argument in the past.
However, the Fed is holding rates lower than they would otherwise be (and one cannot expect these very low rates to remain the case with the massive debt issuance that is coming) so the more appropriate rate with which to compare market valuation may be that of AA-rated corporates, which yields 6.15%. This puts the appropriate value for stocks at 16 times (or an earnings yield of 6.25% -- the inverse of the P/E ratio) , which is much more reasonable than the signal the 10-year Treasury yields is signaling of 28 times, which makes zero sense. (A P/E of 28 on the S&P 500 results in an earnings yield of just 3.57%, but it’s doesn’t take much to compare favorably to the very low Treasury yield environment, which is why a different measure, such as high-grade corporate yields, is more appropriate.)
Market Activity for July 14, 2009
Retail Sales
The Commerce Department reported that retail sales rose in June for a second-straight month, up 0.6% last month after a 0.5% increase for May. The ex-auto reading rose 0.3% after a downwardly revised 0.4% rise in May.
The headline reading was pretty much fueled by jumps in auto and gas station sales, up 2.3% and 5.0%, respectively.
Sporting and book-store sales (these two are combined into one component within the data) also posted a nice 0.9% rise; electronic stores registered a 0.9% increase as well. Online sales rose 0.6%, the first increase since January.
The housing-related components remained weak as furniture sales fell 0.2% and building materials were down 0.9%.
The eating & drinking component (largely driven by the relatively recession immune 20 somethings) fell 0.9% in June after two months of gain – 0.9%, either up or down, was a popular number in the June retail data.
The headline increase in retail sales will get people excited, but as we’ve seen with other premature spates of euphoria one needs to spend time on the internals of the data. The ex-auto & gas station number fell 0.2% in June and is down 6% at an annual rate over the past four months. Excluding gas station receipts alone, sales were up 0.3% for the month but are down 7.7% at an annual rate past four months. Retail sales ex gas, building materials and auto dealers, a number that feeds directly into the personal consumption component of GDP (GDP’s largest component), fell 0.1% and is down 1.8% at an annual pace for the second quarter.
While Q2 GDP will get some help from the trade data, as we touched on Monday, the biggest segment of the data (personal consumption) will weigh heavily on the figure.
Overall retail sales are down 9% over the past year and will not be able to sustain a meaningful rebound until the labor market begins to markedly improve.
Producer Price Index (PPI)
The Labor Department reported that producer prices rose at twice the rate expected, up 1.8% for June after a 0.2% rise in May. The figure was driven by a 6.6% pop in the energy component, which makes up 18% of the index – residential gas rose 2.5% for the month and gasoline jumped 18.5%. Energy will have the opposite effect on the data next month as the price of gasoline has dropped 17% over the past three weeks.
Other than energy the data remains tame, passenger car prices rose 2.0% in June, which is a large monthly move, but the three months of gain for this component is unlikely to continue. The one area I’m watching within the inflation gauges is the industrial supplies and machinery figures. We saw industrial supply prices within the import price data post a huge 10.3% increase in June and the capital equipment segment within PPI is one of the few spots that has posted an increase on a year-over-year basis. This is something to watch, at this base when the economy does rebound these areas will see prices explode to the upside.
Business Inventories
The Commerce Department also reported that business inventories fell more-than-expected in May, down 1.0% vs. the estimate for a 0.8% decline. The liquidation of stockpiles will combine with consumer activity to put pressure on last quarter’s economic output (or lack thereof) – the reduction in inventories is not as bad as the previous quarter’s, but then again that was a record liquidation going back to when records began in 1947.
The sales data is beginning to look better though, falling just 0.1% in May, pressured by a 0.9% decline in manufacturer’s sales. Retailer’s sales rose 0.5% and the inventory-to-sales figure within the retail component is beginning to look pretty good again. It still has a little ways to go to get back to the two-decade lows of 1.45-1.48 months’ worth of supply, a level that may be necessary to make retailers more comfortable but the current 1.50 level shows that most of the work has been done in this regard.
On the other hand, manufacturing inventory levels, specifically on the durable goods side, remain too high for comfort in this environment and will continue to put pressure on production for a couple of months if sales don’t summarily bounce back.
Have a great day!
Brent Vondera
Goldman Sachs knocked the cover off of the ball, blowing by earnings estimates by 35%, but this was expected and failed to help financials, which were the second-most laggard behind telecom shares.
Earnings season in general has just gotten started, we normally don’t comment on things this early as less than 10% of S&P 500 members have reported thus far, but just to give you an idea profits are down 15% overall and -20% ex-financials. The expectation is for S&P 500 profits to fall 35% for the quarter.
Intel reported better-than-expected results after the bell last night and that’s got stock futures juiced this morning. But let’s get real here, when you set the bar low enough it’s pretty easy to hurdle. Intel’s operating earnings fell 31% and revenue was down 15% from the year-ago period. The market will eventually need earnings results to show final demand is improving rather than just the boost from cost cutting and we’re not seeing that yet.
Back to yesterday’s activity, consumer discretionary shares led the market higher on a better-than-expected retail sales report. We’ll get to the internals below, something that is very much out of vogue these days as the press knows only to focus on headline readings.
Industrial shares posted another good day, the second in a row as the 1% increase in the index that tracks these shares followed a 2.7% gain on Monday. Energy shares bounced too even though the price of oil moved below $60 per barrel.
The S&P 500 currently trades at 14.5 times earnings, which makes the current quote of 905 an appropriate top-end of this range in my view. This is an especially uncertain environment and it’s just tough to justify a multiple that is above the long-term average as a result. Some have argued that the market affords a higher P/E simply because the yield on the 10-year Treasury (currently 3.50%) is so low, this security offers the discount rate for most calculations – I’ve made this argument in the past.
However, the Fed is holding rates lower than they would otherwise be (and one cannot expect these very low rates to remain the case with the massive debt issuance that is coming) so the more appropriate rate with which to compare market valuation may be that of AA-rated corporates, which yields 6.15%. This puts the appropriate value for stocks at 16 times (or an earnings yield of 6.25% -- the inverse of the P/E ratio) , which is much more reasonable than the signal the 10-year Treasury yields is signaling of 28 times, which makes zero sense. (A P/E of 28 on the S&P 500 results in an earnings yield of just 3.57%, but it’s doesn’t take much to compare favorably to the very low Treasury yield environment, which is why a different measure, such as high-grade corporate yields, is more appropriate.)
Market Activity for July 14, 2009
Retail SalesThe Commerce Department reported that retail sales rose in June for a second-straight month, up 0.6% last month after a 0.5% increase for May. The ex-auto reading rose 0.3% after a downwardly revised 0.4% rise in May.
The headline reading was pretty much fueled by jumps in auto and gas station sales, up 2.3% and 5.0%, respectively.
Sporting and book-store sales (these two are combined into one component within the data) also posted a nice 0.9% rise; electronic stores registered a 0.9% increase as well. Online sales rose 0.6%, the first increase since January.
The housing-related components remained weak as furniture sales fell 0.2% and building materials were down 0.9%.
The eating & drinking component (largely driven by the relatively recession immune 20 somethings) fell 0.9% in June after two months of gain – 0.9%, either up or down, was a popular number in the June retail data.
The headline increase in retail sales will get people excited, but as we’ve seen with other premature spates of euphoria one needs to spend time on the internals of the data. The ex-auto & gas station number fell 0.2% in June and is down 6% at an annual rate over the past four months. Excluding gas station receipts alone, sales were up 0.3% for the month but are down 7.7% at an annual rate past four months. Retail sales ex gas, building materials and auto dealers, a number that feeds directly into the personal consumption component of GDP (GDP’s largest component), fell 0.1% and is down 1.8% at an annual pace for the second quarter.
While Q2 GDP will get some help from the trade data, as we touched on Monday, the biggest segment of the data (personal consumption) will weigh heavily on the figure.
Overall retail sales are down 9% over the past year and will not be able to sustain a meaningful rebound until the labor market begins to markedly improve.
Producer Price Index (PPI)
The Labor Department reported that producer prices rose at twice the rate expected, up 1.8% for June after a 0.2% rise in May. The figure was driven by a 6.6% pop in the energy component, which makes up 18% of the index – residential gas rose 2.5% for the month and gasoline jumped 18.5%. Energy will have the opposite effect on the data next month as the price of gasoline has dropped 17% over the past three weeks.
Other than energy the data remains tame, passenger car prices rose 2.0% in June, which is a large monthly move, but the three months of gain for this component is unlikely to continue. The one area I’m watching within the inflation gauges is the industrial supplies and machinery figures. We saw industrial supply prices within the import price data post a huge 10.3% increase in June and the capital equipment segment within PPI is one of the few spots that has posted an increase on a year-over-year basis. This is something to watch, at this base when the economy does rebound these areas will see prices explode to the upside.Business Inventories
The Commerce Department also reported that business inventories fell more-than-expected in May, down 1.0% vs. the estimate for a 0.8% decline. The liquidation of stockpiles will combine with consumer activity to put pressure on last quarter’s economic output (or lack thereof) – the reduction in inventories is not as bad as the previous quarter’s, but then again that was a record liquidation going back to when records began in 1947.
The sales data is beginning to look better though, falling just 0.1% in May, pressured by a 0.9% decline in manufacturer’s sales. Retailer’s sales rose 0.5% and the inventory-to-sales figure within the retail component is beginning to look pretty good again. It still has a little ways to go to get back to the two-decade lows of 1.45-1.48 months’ worth of supply, a level that may be necessary to make retailers more comfortable but the current 1.50 level shows that most of the work has been done in this regard.
On the other hand, manufacturing inventory levels, specifically on the durable goods side, remain too high for comfort in this environment and will continue to put pressure on production for a couple of months if sales don’t summarily bounce back.Have a great day!
Brent Vondera
Fixed Income Recap
A shift in sentiment moved yields higher and the curve steeper on Monday, however we remain far from the top end of the range on yields, (let’s call it 4% on the ten-year and 1.4% on the two.) Strong Fed buying in Treasury land did nothing to help the selloff even though the $7.5BB in 2-3 year note purchases on $14.73BB submitted for sale was very strong compared to recent history.
PPI (Producer Price index), +1.8% MoM compared to +.9% expected while ex food & energy was +.5% MoM compared to +.1% expected, was the culprit for the steeper curve and the feelings translated into higher breakeven rates on TIPS, a proxy for inflation expectations. Ten-year breakevens were higher by 12 bps to 1.64%, and five-years were higher by 8 bps to 1.14%. The market held off on going crazy, as they waited for today’s CPI release which came in higher than expected but we’ll leave that for tomorrow’s post.
Cliff J. Reynolds Jr.
PPI (Producer Price index), +1.8% MoM compared to +.9% expected while ex food & energy was +.5% MoM compared to +.1% expected, was the culprit for the steeper curve and the feelings translated into higher breakeven rates on TIPS, a proxy for inflation expectations. Ten-year breakevens were higher by 12 bps to 1.64%, and five-years were higher by 8 bps to 1.14%. The market held off on going crazy, as they waited for today’s CPI release which came in higher than expected but we’ll leave that for tomorrow’s post.
Cliff J. Reynolds Jr.
Tuesday, July 14, 2009
CPI and PPI biases
As I mentioned in the most recent Portfolio Insights article titled “Inflation FAQs,” there are a few problems with the Consumer Price Index (CPI) and Producer Price Index (PPI) as inflation gauges.
CPI has an upward bias that is estimated to overstate inflation by about 1 percentage point per year. This can be particularly problematic for employment contracts with cost-of-living adjustments based on CPI as well as for a substantial portion of government spending, such as entitlement payments, which automatically increase with CPI.
The most commonly cited biases that tend to overstate the CPI include:
- New goods. New products that replace existing products are often more expensive at first. This biases the index because some of the newly-available goods perform the same function as different lower-priced goods in the base-year market basket.
- Quality changes. If the price of a product increases because the product has improved, the price increase is not due to inflation, but still causes an increase in the price index.
- Substitution effect. Inflation or not, prices of goods relative to each other are always changing. When two goods are substitutes for each other, consumers increase their purchase of the relatively cheaper good and buy less of the relatively more expensive good. Over time, such changes can make the CPI’s fixed basket of goods a less accurate measure of typical household spending. The chained CPI, however, does adjust to the substitution effect in a timely manner as the basket of goods is “chained.”
- Outlet substitution. When consumers shift their purchases toward discount outlets like Wal-Mart and away from convenience outlets like the neighborhood grocer, they reduce their cost of living in a way the CPI does not capture.
The biases to Producer Price Indexes (PPI) are not quite as extreme and not as important because firms can absorb costs and they don’t get passed on to the consumer. But for educational purposes, here are some of the minor shortfalls of PPI:
- Industry weightings. PPI uses relative weightings for different industries, but these weightings might not accurately represent their actual proportion to real gross domestic product (GDP). As a result, the weightings are adjusted every several years, but small differences still occur.
- Hedonic adjustments. PPI calculations involve an explicit “quality adjustment method,” called hedonic adjustments, to account for changes that occur in the quality and usefulness of products over time. These adjustments may not effectively separate out quality adjustments from price level changes as intended.
- Volatile elements. Energy and food often skew the data because they are so volatile. As a result, the removal of food and energy prices is almost implicit in most media releases. However, the long-term growth rates should not be ignored if these costs grow faster than the core PPI (or CPI) over time because consumers and eventually GDP will feel the pinch.
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Peter J. Lazaroff
Norfolk Southern (NSC) up on competitor's earnings
Norfolk Southern (NSC) jumped 3.5% today as CSX, the third-largest U.S. railroad, beat analysts’ profit estimates due primarily to cost cutting.
As expected among all of the railroads, CSX said the slump in coal shipments widened significantly, falling by 21% in the second quarter from 7% in the first quarter.
Coal is the biggest product category by volume at the four biggest U.S. railroads, which probably were hurt in the second quarter when tumbling natural-gas prices spurred electric utilities to switch fuels. Also impacting coal volumes is reduced coal exports due to lower steel production Europe. Coal volumes have a significant impact since haling coal is a very profitable business for the rails.
CSX expects the coal volume to moderate a bit in the third quarter, but would not predict the trend will improve. Also interesting was that CSX said it has seen “some compression” in prices on new business where the railroad competes with truck and barge transport.
Norfolk Southern is expected to see a 47% drop in earnings from a year ago, according to a Bloomberg analyst survey. I would expect Norfolk to cite similar coal volume declines and it will be interesting to see if they needed to make any price concessions on new business.
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Peter J. Lazaroff
As expected among all of the railroads, CSX said the slump in coal shipments widened significantly, falling by 21% in the second quarter from 7% in the first quarter.
Coal is the biggest product category by volume at the four biggest U.S. railroads, which probably were hurt in the second quarter when tumbling natural-gas prices spurred electric utilities to switch fuels. Also impacting coal volumes is reduced coal exports due to lower steel production Europe. Coal volumes have a significant impact since haling coal is a very profitable business for the rails.
CSX expects the coal volume to moderate a bit in the third quarter, but would not predict the trend will improve. Also interesting was that CSX said it has seen “some compression” in prices on new business where the railroad competes with truck and barge transport.
Norfolk Southern is expected to see a 47% drop in earnings from a year ago, according to a Bloomberg analyst survey. I would expect Norfolk to cite similar coal volume declines and it will be interesting to see if they needed to make any price concessions on new business.
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Peter J. Lazaroff
Dell (DELL) warns of lower profit margins
Dell (DELL) shares are off more than 7% after announcing yesterday that “higher component costs, a competitive pricing environment, and an unfavorable mix of product and business-segment demand” will eat away at its profit margins for its current quarter ending July 31.
On the bright side, Dell did suggest that computer sales may be stabilizing after declining for more than 20 months and they expect a “slight” sequential increase in the current quarter. Still, the comments spooked investors, whose high expectations for technology companies have helped the sector outpace the broad market since the March 9 bottom.
The technology sector benefits from the idea that businesses spend first on technology improvements, which tend to increase efficiency and productivity. Thus, technology improvements allow companies to produce more with fewer workers, which lead to lower costs and expanded margins. Even more, technology companies sport pristine balance sheets, which is especially attractive in this tight credit environment.
It’s true that PC sales have dropped during the recession as consumers have shifted to cheaper netbooks in favor of the more traditional (and more expensive) notebooks and desktops. Not only do netbooks sell for less, but they have smaller profit margins. However, gauging the sector’s health by these statements from Dell’s may be a bit premature, especially when bellwethers like Intel and IBM report earnings later this week.
As for Dell, the company issued longer-term guidance of 5% to 7% annual sales growth and operating margins above 7%. However, these targets have no time-frame and are dependent on a market recovery including higher worldwide IT spending and a sustained double-digit growth rate in demand for computer systems.
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Peter J. Lazaroff
On the bright side, Dell did suggest that computer sales may be stabilizing after declining for more than 20 months and they expect a “slight” sequential increase in the current quarter. Still, the comments spooked investors, whose high expectations for technology companies have helped the sector outpace the broad market since the March 9 bottom.
The technology sector benefits from the idea that businesses spend first on technology improvements, which tend to increase efficiency and productivity. Thus, technology improvements allow companies to produce more with fewer workers, which lead to lower costs and expanded margins. Even more, technology companies sport pristine balance sheets, which is especially attractive in this tight credit environment.
It’s true that PC sales have dropped during the recession as consumers have shifted to cheaper netbooks in favor of the more traditional (and more expensive) notebooks and desktops. Not only do netbooks sell for less, but they have smaller profit margins. However, gauging the sector’s health by these statements from Dell’s may be a bit premature, especially when bellwethers like Intel and IBM report earnings later this week.
As for Dell, the company issued longer-term guidance of 5% to 7% annual sales growth and operating margins above 7%. However, these targets have no time-frame and are dependent on a market recovery including higher worldwide IT spending and a sustained double-digit growth rate in demand for computer systems.
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Peter J. Lazaroff
Johnson & Johnson (JNJ) reports earnings
Johnson & Johnson (JNJ) reported sales and profits that topped expectations and reaffirmed its full-year 2009 guidance. The maker of thousands of healthcare products announced sales decreased 7.4% compared to a year ago, hurt by the stronger U.S. dollar (the negative impact of currency was 6%) and patent expirations.
Drug-patent expirations of migraine treatment Topamax, mood-stabilizer Risperdal, and (to a lesser extent) mild Alzheimer’s treatment Razadyne were the main cause for the 8.5% operational sales decline in the Pharmaceutical segment. Excluding the impact of generic competition on these products, the pharmaceutical segment’s operational sales growth was approximately 9%. Despite patent-expirations and less investment in R&D, J&J’s massive pipeline is near the top of the industry in terms of quality and depth, which should give investors reason to be optimistic for the Pharmaceutical segment.
Meanwhile, Consumer segment operational sales grew 3.1% primarily due to strong results from skincare, driven by new product launches, and oral care, driven by strong growth in sales of Listerine mouthwash. Over-the-counter pharmaceuticals and nutritional products struggled as competitive pressures from private labels impacted growth in this category.
The Medical Device and Diagnostics segment posted operational sales growth of 3% as strong sales in the orthopedics and surgery units offset weakness in the drug-eluting stents unit. Also weighing on the segment were the vision and diabetes units, which typically require out-of-pocket expenditure for items like contact lenses and diabetes strips.
COGS was 30 basis points higher due to unfavorable mix in the pharmaceutical business, but SG&A expenses were down 200 basis points driven by leverage across the businesses. Pretax operating margins improved, which was expected for 2009 when J&J provided annual guidance in January.
All and all, the company remains in solid condition. J&J’s ongoing acquisition program, expansion opportunities in emerging markets, and its promising late-stage pharmaceutical pipeline are the three main catalysts for the company’s longer-term earnings growth prospects.
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Peter J. Lazaroff
Drug-patent expirations of migraine treatment Topamax, mood-stabilizer Risperdal, and (to a lesser extent) mild Alzheimer’s treatment Razadyne were the main cause for the 8.5% operational sales decline in the Pharmaceutical segment. Excluding the impact of generic competition on these products, the pharmaceutical segment’s operational sales growth was approximately 9%. Despite patent-expirations and less investment in R&D, J&J’s massive pipeline is near the top of the industry in terms of quality and depth, which should give investors reason to be optimistic for the Pharmaceutical segment.
Meanwhile, Consumer segment operational sales grew 3.1% primarily due to strong results from skincare, driven by new product launches, and oral care, driven by strong growth in sales of Listerine mouthwash. Over-the-counter pharmaceuticals and nutritional products struggled as competitive pressures from private labels impacted growth in this category.
The Medical Device and Diagnostics segment posted operational sales growth of 3% as strong sales in the orthopedics and surgery units offset weakness in the drug-eluting stents unit. Also weighing on the segment were the vision and diabetes units, which typically require out-of-pocket expenditure for items like contact lenses and diabetes strips.
COGS was 30 basis points higher due to unfavorable mix in the pharmaceutical business, but SG&A expenses were down 200 basis points driven by leverage across the businesses. Pretax operating margins improved, which was expected for 2009 when J&J provided annual guidance in January.
All and all, the company remains in solid condition. J&J’s ongoing acquisition program, expansion opportunities in emerging markets, and its promising late-stage pharmaceutical pipeline are the three main catalysts for the company’s longer-term earnings growth prospects.
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Peter J. Lazaroff
Fixed Income Recap
Treasuries sold off yesterday on light volume as many market participants remained sidelined, waiting for earnings season to get going. Treasuries hovered around unchanged for most of the day, even as stocks were up 1%, but the bottom fell out of bonds as stocks accelerated higher to close up 2.5%.
CIT Group, one of the nation’s largest commercial lenders and a receiver of TARP funds, obtained the services of a bankruptcy lawyer over the weekend raising some concerns over the company’s ability to refinance their $2.5 billion in debt coming due this year. They have applied to issue debt under the Temporary Liquidity Guarantee Program (TLGP), which could be their only shot at survival, but have yet to hear from the government on whether they qualify. The WSJ is reporting this morning that CIT Group, which gained bank holding company status in 2008, is currently discussing their options with regulators.
Many are saying that it is unclear how broad of a threat CIT poses to the broad financial market. The rhetoric sounds far too much like Lehman Brothers in early September, and we all know how that turned out. The market cannot stomach a bankruptcy of this magnitude in my opinion. For a company like CIT to be denied TLGP, a program that was designed solely to help banks refinance their debt, confuses me, considering that is their exact problem. Whether the solution is a FDIC brokered sale of CIT to a larger institution that can take on the balance sheet or just allowing CIT to issue FDIC insured debt through the TLGP, the sooner it is resolved the better. The credit markets are functioning, but are still very fragile. Letting CIT enter bankruptcy would be like taking the stitches out before the wound is fully healed.
Cliff J. Reynolds Jr., Investment Analyst
CIT Group, one of the nation’s largest commercial lenders and a receiver of TARP funds, obtained the services of a bankruptcy lawyer over the weekend raising some concerns over the company’s ability to refinance their $2.5 billion in debt coming due this year. They have applied to issue debt under the Temporary Liquidity Guarantee Program (TLGP), which could be their only shot at survival, but have yet to hear from the government on whether they qualify. The WSJ is reporting this morning that CIT Group, which gained bank holding company status in 2008, is currently discussing their options with regulators.
Many are saying that it is unclear how broad of a threat CIT poses to the broad financial market. The rhetoric sounds far too much like Lehman Brothers in early September, and we all know how that turned out. The market cannot stomach a bankruptcy of this magnitude in my opinion. For a company like CIT to be denied TLGP, a program that was designed solely to help banks refinance their debt, confuses me, considering that is their exact problem. Whether the solution is a FDIC brokered sale of CIT to a larger institution that can take on the balance sheet or just allowing CIT to issue FDIC insured debt through the TLGP, the sooner it is resolved the better. The credit markets are functioning, but are still very fragile. Letting CIT enter bankruptcy would be like taking the stitches out before the wound is fully healed.
Cliff J. Reynolds Jr., Investment Analyst
Daily Insight
U.S. stocks rallied, getting the workweek started on a very nice note after four weeks of losses, as bank, basic material and industrial shares fueled the bounce. Positive analyst recommendations on Goldman Sachs and Best Buy helped kick start investor enthusiasm.
That call on Goldman came from Meredith Whitney, probably the biggest name among bank analysts behind only Dick Bove – nothing like an upgrade after a 90% upshot in the stock in a matter of four months. For Best Buy, I wouldn’t count on anything special. We saw the retailers results for the first quarter: total sales down 15% and same-store comps down 6.2% -- and that was with bankrupt Circuit City out of the game; I don’t see results reversing course anytime soon.
I’m not trying to be overly pessimistic here, just rational. For goodness sakes, sure banks will have a couple of big quarters with the Treasury yield curve positively sloped to a massive degree (the curve has narrowed from the record spread between 2s and 10s hit in June but remains very wide), but I think of Sisyphus when contemplating the banking sector – that rock will come rolling back down as commercial real estate and consumer loans and credit cards bedevil the industry for some time to come. On Goldman, everyone knows they’ll knock the cover off of the ball for another couple of quarters, my six year-old knows that. Heck, their profits tied to massive government issuance (specifically Buy America Bonds) and corporate debt issuance related to maturity rolls will fuel results. But this is kind of what the run from $70 to $150 is about.
Volume was weak as just 1.1 billion shares traded on the NYSE Composite, 26% below the three-month average.
Market Activity for July 13, 2009
That call on Goldman came from Meredith Whitney, probably the biggest name among bank analysts behind only Dick Bove – nothing like an upgrade after a 90% upshot in the stock in a matter of four months. For Best Buy, I wouldn’t count on anything special. We saw the retailers results for the first quarter: total sales down 15% and same-store comps down 6.2% -- and that was with bankrupt Circuit City out of the game; I don’t see results reversing course anytime soon.
I’m not trying to be overly pessimistic here, just rational. For goodness sakes, sure banks will have a couple of big quarters with the Treasury yield curve positively sloped to a massive degree (the curve has narrowed from the record spread between 2s and 10s hit in June but remains very wide), but I think of Sisyphus when contemplating the banking sector – that rock will come rolling back down as commercial real estate and consumer loans and credit cards bedevil the industry for some time to come. On Goldman, everyone knows they’ll knock the cover off of the ball for another couple of quarters, my six year-old knows that. Heck, their profits tied to massive government issuance (specifically Buy America Bonds) and corporate debt issuance related to maturity rolls will fuel results. But this is kind of what the run from $70 to $150 is about.
Volume was weak as just 1.1 billion shares traded on the NYSE Composite, 26% below the three-month average.
Market Activity for July 13, 2009
The Dollar
We like to talk about the old greenback on occasion as one keeps a watchful eye on its value against other currencies. In a time of exploding debt issuance and lower after-tax return expectations you’ve got to think U.S. dollar will have to fight to remain above the recent lows we saw back in June.
For now, the safety trade has made a return – even yesterday on a strong positive session for stocks the long-end of the Treasury market rallied – and the greenback has found some support right around $80 on the Dollar Index. Let’s hope we engage in some policy changes to keep the currency from falling too much, but it is pretty unlikely as $3 trillion in government debt will occur this year and another $2 trillion at least next year. That’s a lot for the debt market to absorb and even though foreign government will not be able to sell the dollar en masse, it’s going to be a tough road for old green. An aggressive reduction in capital gains tax rates (boosting after-tax return expectations and thus dollar demand) could go a long way in mitigating pressure in my view, but that sort of thing is anathema to the current leadership.
Stimulus, the Economy and Patience
There has been a lot of talk recently about the stimulus plan not working. While I in no way agree with the track the administration and Congress have taken in their attempt to boost economic activity let’s be clear that less than 10% of the planned spending has occurred to this point. For all that was said about “shovel-ready” projects, that was just political speak. The appropriations process (as we talked about early this year) makes quick results impossible. Further, most of the money is not spent until 2010 and even the planned spending for 2011 is more than what will be injected during 2009 – that is by design too, we’ve got mid-term elections next year and of course the next presidential race in 2012.
There is little doubt the $787 billion (look let’s call it a trillion for now because that’s what it will end up being) will have an ameliorative effect on GDP. When you throw a trillion dollars into a $14 trillion economy you will have a positive short-term effect – even if muted. However, while this spending will calm such aspects of the economy such as job losses (you’ll have construction and manufacturing firms refrain from laying off workers as they land construction contracts) it only delays the inevitable. We may not see the unemployment rate peak until 2011. I know this sounds shocking but it’s a real possibility.
My expectation has been for the jobless rate to peak somewhere near 10.5% in early 2010, but I’m beginning to think this view needs to be reassessed as we may see the rate begin to flat line at the end of 2009 only to climb again by 2011. Government can’t keep this spending going for long and the massive deficits, higher tax rates (and have you seen the surcharge to income-tax rates many in Congress are pushing?) and the potential for higher interest rates in the not-too-distant future combine to whack economic activity. Anyone who believes that government can boost aggregate demand or that this level of spending (and the more austere tax-rate environment that ensues) doesn’t cause businesses to hold back due to caution is kidding themselves I’m afraid.
What’s more, we have another hike in the minimum wage coming later this month. This will have a disemployment effect on low-skilled labor, which will also shows up in joblessness over time – as the WSJ editorial board states, “those who never get a job in the first place get a minimum wage of zero.” Businesses that have a low-skilled component within their labor force will likely choose to get more work out of existing employees to counter this mandatory increase in wages.
I bring this all up to extend upon a theme of the past month – the investor needs to be careful, don’t let emotions drive you to improperly assess risk merely for the objective of attempting to make up for prior losses, or hunt for yield as the government holds interest rates lower than they otherwise may be.
Policymakers are in the process of prolonging the economic stagnation, but the spending will offer some short-term bounce first. It is then that expectations could begin to run ahead of the realities. Again, investors must pick their spots in this environment. Don’t get sucked into thinking you’re missing out when stock prices move to the high-end of this trading range, you’ve got to have discipline and patience and buy on the meaningful pullbacks – do not chase rallies! We could witness several moves to and from the high-end of this range for a couple of years – have that expectation and you’ll mitigate the damage emotions and performance chasing can do.
Monthly Budget Statement
The Treasury Department reported the fiscal deficit topped the $1 trillion mark for the first, as we’ve blown past the previous nominal-dollar record hit in the 2004 fiscal year. I recall that year vividly as the deficit was all the rage within the financial press – that shortfall was $459 billion. The shortfall for June broke a record for that month as well, coming in at -$94.3 billion (and that’s with $70 billion in TARP pay backs in June) – a month that almost always shows a surplus. We’re up to $1.1 trillion and counting so far this fiscal year, on course for a deficit-to-GDP ratio of 12% -- twice the post-WWII era record of 5.6% hit in 1983.
Corporate and individual tax receipts are off big time, down 57% and 22% fiscal-year-to-date (FYTD), respectively. One wonders how deep the deficit-to-GDP ratio will go in 2010 when the bulk of stimulus spending begins to roll.
Social security outlays led the way on the spending side, up 11% FYTD to $511 billion. Defense spending, one of the few aspects of the budget that was originally enumerated, rose 7.4% to $491 billion. Income security (yes, this is in addition to social security) jumped 17.5% to $403 billion. Medicare outlays increased 10.3% to $315 billion, just to name the big ones. Again, this is hardly sustainable and a certain degree of circumspection should be employed as the road to deal with the ramifications of this spending trajectory will likely be a rough one.
Have a great day!
Brent Vondera
Monday, July 13, 2009
GE trading higher
General Electric (GE) is trading about 6% higher with a few news items lifting sentiment.
GE Transportation announced today that GE’s Evolution Series locomotive has been commissioned and officially released to Egyptian National Railways (ENR) at the end of June. GE’s Evolution Series is the most technologically advanced diesel electric, heavy-haul locomotive in the world. Best-in-class fuel efficiency, higher pulling capability with less wheel slippage, and measurably higher reliability and lower maintenance costs are just a few of the reasons GE’s Evolution Series locomotives are in demand.
The Evolution Series is a global locomotive platform that has had nice success since GE delivered the first 300 locomotives to the Ministry of Railways in China. Other significant orders include forty heavy-haul Evolution Series locomotives to Rio Tinto Iron Ore and Zazakhstan’s 310 locomotive orders.
GE Energy, meanwhile, said in this Bloomberg article that their microgrid power system could pay for itself in four-years.
This is just a small example of what I have harped on in the past (See March 3, March 19, July 7) -- GE’s industrial businesses have tremendous upside because of the demand from developed and emerging nations for their technologically-advanced products. And it's the industrial businesses that will make pay off for the patient, long-term investor.
Also lifting sentiment was reports that Universal Pictures’ Bruno opened a the top film at theaters in the U.S. and Canada over the weekend with the $30.4 million in ticket sales for distributer NBC Universal. Sales should provide a boost to Universal Pictures, which ranked last among the six major studios in 2009 ticket sales with $604.3 million as of July 9.
Adding fuel to GE’s surge was analyst Meredith Whitney’s upgrade of Goldman Sachs, which helped lift sentiment for financials, including GE Capital. This is slightly odd that other financials would benefit because Whitney thesis isn't an improving economy, but rather the weaker economy will boost Goldman who will play a key role in the “tsunami of debt issuance from federal, state and local governments ramping up debt issuance to fund woefully underfunded budget gaps."
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Peter J. Lazaroff
GE Transportation announced today that GE’s Evolution Series locomotive has been commissioned and officially released to Egyptian National Railways (ENR) at the end of June. GE’s Evolution Series is the most technologically advanced diesel electric, heavy-haul locomotive in the world. Best-in-class fuel efficiency, higher pulling capability with less wheel slippage, and measurably higher reliability and lower maintenance costs are just a few of the reasons GE’s Evolution Series locomotives are in demand.
The Evolution Series is a global locomotive platform that has had nice success since GE delivered the first 300 locomotives to the Ministry of Railways in China. Other significant orders include forty heavy-haul Evolution Series locomotives to Rio Tinto Iron Ore and Zazakhstan’s 310 locomotive orders.
GE Energy, meanwhile, said in this Bloomberg article that their microgrid power system could pay for itself in four-years.
This is just a small example of what I have harped on in the past (See March 3, March 19, July 7) -- GE’s industrial businesses have tremendous upside because of the demand from developed and emerging nations for their technologically-advanced products. And it's the industrial businesses that will make pay off for the patient, long-term investor.
Also lifting sentiment was reports that Universal Pictures’ Bruno opened a the top film at theaters in the U.S. and Canada over the weekend with the $30.4 million in ticket sales for distributer NBC Universal. Sales should provide a boost to Universal Pictures, which ranked last among the six major studios in 2009 ticket sales with $604.3 million as of July 9.
Adding fuel to GE’s surge was analyst Meredith Whitney’s upgrade of Goldman Sachs, which helped lift sentiment for financials, including GE Capital. This is slightly odd that other financials would benefit because Whitney thesis isn't an improving economy, but rather the weaker economy will boost Goldman who will play a key role in the “tsunami of debt issuance from federal, state and local governments ramping up debt issuance to fund woefully underfunded budget gaps."
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Peter J. Lazaroff
Expeditors International of Washington (EXPD)
Expeditors International of Washington (EXPD) is trading nearly 6% lower after the third-party logistics firm said second quarter earnings would be 24 cents to 26 cents a share, less than the average estimate of 30 cents a share.
Like most companies related to freight transportation, Expeditors’ performance has been hurt by a steep drop in production across a range of sectors. Encouragingly, the firm noted that volumes improved in late June, but it will be important to see if the company maintained its industry leading profitability. During the first quarter of 2009, Expeditors managed to produce $164 million of free cash flow – a whopping 18% of revenues – despite challenging conditions.
Expeditors’ low-cost business model is behind the firm’s ability to generate strong returns on invested capital (ROIC) of over 30% during the last five years. Expeditors also benefits from a network effect, in which each node in the network becomes more valuable when the firm adds more nodes. As the system grows, shippers gain the ability to ship efficiently to even greater locations.
This network effect along with other competitive advantages like economies of scale and pricing power have historically awarded Expeditor’s a premium. During the past decade, Expeditors traded at rich P/E multiples ranging from 32 to 40. Today, Expeditors’ forward P/E is about 23.
This may not be an absolute bottom, but the low multiples suggest this could represent an opportunity for patient investors.
Click here to read more about Expeditors’ core business and strengths from my March 18 post.
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Peter J. Lazaroff
Like most companies related to freight transportation, Expeditors’ performance has been hurt by a steep drop in production across a range of sectors. Encouragingly, the firm noted that volumes improved in late June, but it will be important to see if the company maintained its industry leading profitability. During the first quarter of 2009, Expeditors managed to produce $164 million of free cash flow – a whopping 18% of revenues – despite challenging conditions.
Expeditors’ low-cost business model is behind the firm’s ability to generate strong returns on invested capital (ROIC) of over 30% during the last five years. Expeditors also benefits from a network effect, in which each node in the network becomes more valuable when the firm adds more nodes. As the system grows, shippers gain the ability to ship efficiently to even greater locations.
This network effect along with other competitive advantages like economies of scale and pricing power have historically awarded Expeditor’s a premium. During the past decade, Expeditors traded at rich P/E multiples ranging from 32 to 40. Today, Expeditors’ forward P/E is about 23.
This may not be an absolute bottom, but the low multiples suggest this could represent an opportunity for patient investors.
Click here to read more about Expeditors’ core business and strengths from my March 18 post.
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Peter J. Lazaroff
Daily Insight
Most U.S. stocks closed lower on Friday but a good relative performance among technology shares resulted in a mixed session for the major indices. We’ve seen a number of mixed results lately; on Friday it was the Dow and S&P 500 losing some ground, while the NASDAQ Composite added a few points.
A lower consumer sentiment reading and weak import data both put the screws to those holding out for a bounce in consumer activity. Another decline in oil prices pressured energy shares, which held the Dow average back as Chevron and Exxon subtracted 20 points from that index.
The broad market has declined for four weeks now, the longest stretch since we’ve rebounded from the lows of early March. We’ve now backed off of the recent highs by 7%, something that should not have been unexpected after the substantial run from those March lows – the investor should be prepared for an additional pullback.
It is quite usual to see at least a 15% retracement in these trading-range environments and one needs to be cautious and pick their spots. No one knows how people will react to a 15% pullback (if we get it) after the shock they endured on the way to the notorious low of 666. If they fear another move to those levels they may just throw in the towel and make the move lower a severe retracement rather than a more moderate correction. (I’m not saying such a move would be justified, just explaining that this is a concern of mine)
Market Activity for July 10, 2009
The Economic Data Front
Overall Friday’s economic releases were not particularly good. The trade data was reported with a lean to the positive side because some of the export numbers were encouraging, but the import side remained very weak and was just another reminder of the depressed nature of consumer activity. The latest confidence reading, if one is to give these surveys a meaningful degree of credence, suggested we’re not ready to see the consumer bounce back just yet.
Import Prices
The Labor Department reported that import prices jumped 3.2% for June and marked the fourth month of increase. While the year-over-year reading continues to post deep negative readings, that will all change by the fall when the comparisons are no longer against the commodity-price spike of last summer.
A 20% increase in petroleum-product prices led the import data to its large gain last month. This got all the news as the financial press suggested that without this run up in petro prices the data would not be on this trajectory. However, a closer look at the data shows that industrial supply prices are on a run, bouncing a huge 10.3% in June and up 64% at an annual rate over the past four readings. Now, this increase has occurred off of large multi-month declines that ran September 2008- January 2009 but the trend is disturbing nonetheless.
On an overall basis import prices are up 18% at an annual rate since March and this is something to watch especially if the dollar weakens – such a scenario will have an even larger effect on import prices as a weaker domestic currency obviously makes imports more expensive.
This trend within some of the inflation gauges, and the pretty high potential for another spike in commodity prices, could spell trouble for corporate profits a few quarters down the road. I think we’ve got a shot at a 2-3 quarter run of high-powered profit results (a couple of quarters out from this point) but higher commodity prices (which is one aspect having an effect on industrial supply costs) could result in a significant margin squeeze quickly thereafter. This will either show up in softer bottom line growth or firms will simply hold off on adding to payrolls for an extended period. Neither issue is a good one.
Trade Deficit
The Commerce Department reported the trade deficit narrowed 9.8% in May to the lowest level in nearly a decade. Exports rose 1.6% (and would have been stronger if not for a 7.6% decline in auto exports) and imports fell 0.6%.
Exports were driven by better results out of Asia , something we’ve talked about a few times now and touched on again in Friday’s letter, as Chinese stimulus spending boosts activity in the entire region. Exports to the Pacific Rim rose 7.3% -- up 10.3% to Japan, up 8.9% to the NICs (newly industrialized countries), and a big 19.4% to Australia. (This is where China gets most of it imports and areas such as Japan the NICs and the Aussies get many of their machinery and industrial goods from the U.S.)
The import numbers illustrate U.S. consumer (and business) activity remains in the dirt, down 31.3% on a year-over-year basis. The monthly number of -0.6% was even worse when you adjust for the price increases – real $ imports fell 2.1% in May, which follows a large 3.0% decline for April.
University of Michigan Consumer Sentiment
As many readers know, there are two major confidence measures. The most watched reading remains the Consumer Confidence survey out of the Conference Board (an independent research organization), but this U. of M. number gets decent attention as well and it showed a decline in June that moved the level back below where it stood in April – the month when we really began to see improvement from the two-decade lows.
The U. of M. survey came in at 64.6 in June after hitting 70.8 in May. Too many people had assumed that consumer activity would make a sustained comeback simply because of better readings of the previous couple of months. This was a misguided view as the fragility of the labor market will keep a lid on consumer sentiment – this move back down should not be a surprise. It will take a full year, at least, for the consumer to get his/her bearings as a weak labor market combines with the reverse wealth effect via the plunge in stock and home prices.
Have a great day!
Brent Vondera
A lower consumer sentiment reading and weak import data both put the screws to those holding out for a bounce in consumer activity. Another decline in oil prices pressured energy shares, which held the Dow average back as Chevron and Exxon subtracted 20 points from that index.
The broad market has declined for four weeks now, the longest stretch since we’ve rebounded from the lows of early March. We’ve now backed off of the recent highs by 7%, something that should not have been unexpected after the substantial run from those March lows – the investor should be prepared for an additional pullback.
It is quite usual to see at least a 15% retracement in these trading-range environments and one needs to be cautious and pick their spots. No one knows how people will react to a 15% pullback (if we get it) after the shock they endured on the way to the notorious low of 666. If they fear another move to those levels they may just throw in the towel and make the move lower a severe retracement rather than a more moderate correction. (I’m not saying such a move would be justified, just explaining that this is a concern of mine)
Market Activity for July 10, 2009
The Economic Data FrontOverall Friday’s economic releases were not particularly good. The trade data was reported with a lean to the positive side because some of the export numbers were encouraging, but the import side remained very weak and was just another reminder of the depressed nature of consumer activity. The latest confidence reading, if one is to give these surveys a meaningful degree of credence, suggested we’re not ready to see the consumer bounce back just yet.
Import Prices
The Labor Department reported that import prices jumped 3.2% for June and marked the fourth month of increase. While the year-over-year reading continues to post deep negative readings, that will all change by the fall when the comparisons are no longer against the commodity-price spike of last summer.
A 20% increase in petroleum-product prices led the import data to its large gain last month. This got all the news as the financial press suggested that without this run up in petro prices the data would not be on this trajectory. However, a closer look at the data shows that industrial supply prices are on a run, bouncing a huge 10.3% in June and up 64% at an annual rate over the past four readings. Now, this increase has occurred off of large multi-month declines that ran September 2008- January 2009 but the trend is disturbing nonetheless.
On an overall basis import prices are up 18% at an annual rate since March and this is something to watch especially if the dollar weakens – such a scenario will have an even larger effect on import prices as a weaker domestic currency obviously makes imports more expensive.
This trend within some of the inflation gauges, and the pretty high potential for another spike in commodity prices, could spell trouble for corporate profits a few quarters down the road. I think we’ve got a shot at a 2-3 quarter run of high-powered profit results (a couple of quarters out from this point) but higher commodity prices (which is one aspect having an effect on industrial supply costs) could result in a significant margin squeeze quickly thereafter. This will either show up in softer bottom line growth or firms will simply hold off on adding to payrolls for an extended period. Neither issue is a good one.
Trade Deficit
The Commerce Department reported the trade deficit narrowed 9.8% in May to the lowest level in nearly a decade. Exports rose 1.6% (and would have been stronger if not for a 7.6% decline in auto exports) and imports fell 0.6%.
Exports were driven by better results out of Asia , something we’ve talked about a few times now and touched on again in Friday’s letter, as Chinese stimulus spending boosts activity in the entire region. Exports to the Pacific Rim rose 7.3% -- up 10.3% to Japan, up 8.9% to the NICs (newly industrialized countries), and a big 19.4% to Australia. (This is where China gets most of it imports and areas such as Japan the NICs and the Aussies get many of their machinery and industrial goods from the U.S.)
The import numbers illustrate U.S. consumer (and business) activity remains in the dirt, down 31.3% on a year-over-year basis. The monthly number of -0.6% was even worse when you adjust for the price increases – real $ imports fell 2.1% in May, which follows a large 3.0% decline for April.
University of Michigan Consumer Sentiment
As many readers know, there are two major confidence measures. The most watched reading remains the Consumer Confidence survey out of the Conference Board (an independent research organization), but this U. of M. number gets decent attention as well and it showed a decline in June that moved the level back below where it stood in April – the month when we really began to see improvement from the two-decade lows.
The U. of M. survey came in at 64.6 in June after hitting 70.8 in May. Too many people had assumed that consumer activity would make a sustained comeback simply because of better readings of the previous couple of months. This was a misguided view as the fragility of the labor market will keep a lid on consumer sentiment – this move back down should not be a surprise. It will take a full year, at least, for the consumer to get his/her bearings as a weak labor market combines with the reverse wealth effect via the plunge in stock and home prices.
Have a great day!
Brent Vondera
Fixed Income Recap
Treasuries ended a strong week with another rally that flattened the curve seven basis points for the day. Looking back, the market as a whole handled the supply relatively well considering the record four days of issuance.
We have a much more active economic calendar this week compared to last, dominated by June CPI and the Empire Manufacturing Survey for the month of July on Wednesday, and Housing Starts for the month on June on Friday. Although from a technical perspective Treasuries look rich, any weakness in the economic data this week could force yields even lower, especially with no supply scheduled for the next two weeks.
Cliff J. Reynolds Jr.
We have a much more active economic calendar this week compared to last, dominated by June CPI and the Empire Manufacturing Survey for the month of July on Wednesday, and Housing Starts for the month on June on Friday. Although from a technical perspective Treasuries look rich, any weakness in the economic data this week could force yields even lower, especially with no supply scheduled for the next two weeks.
Cliff J. Reynolds Jr.
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