Fixed Income Recap

Treasuries began the day lower, on strength in equity markets overseas, but rallied off their lows on an improved, but still negative, Non-Manufacturing ISM.

The Treasury announced $70 billion in refunding with 3-, 10- and 30-year notes coming to market Tuesday through Thursday of next week. It’s odd to think of $70 billion as a small refunding, but it is pretty small. The only problem I see facing next week’s auctions is that the “when issued” period for the three year is essentially one day, thanks to the late Thursday announcement and the Labor Day holiday. The normal period for dealers to search for buyers of the Treasuries to be issued is a week. This may be a non-issue for the market, as most are just concentrating on the small size as a positive for Treasuries.

Bonds opened lower again this morning as traders reduced positions ahead of the announcement of the Change in Nonfarm Payrolls and Unemployment Rate for August. NFP improved from a July Revision of -276k to -216k in August and The Unemployment Rate ticked from 9.4% to 9.7%. Bonds have rallied back from the overnight selloff, lead by the short end that is now positive for the day so far.

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks broke a four-day losing streak, getting a lift from the prior night’s rally in Chinese stocks (as that government tempered concern they would attempt to curb equity and property speculation). A measure of retail sales showed August declines were less-than-expected, which also may have helped the equity markets.

Financials, after leading the indices lower for two days, were the best performing group. Basic material shares recorded another good session as metals prices gained again, led by gold and silver. Silver raged ahead, up 5.17% to $16.15 per oz. Gold came within $2 of $1,000 before pulling back to $993, up 1.64% on the session.

Advancers turned the table yesterday, beating decliners by a five-to-one margin. Volume was typical of this summer’s activity, 1.1 billion shares traded on the NYSE Composite, in line with the three-month average

Market Activity for September 3, 2009
Initial Jobless Claims

The Labor Department reported that initial jobless claims fell 4,000 to 570,000 in the week ended August 29 from an upwardly revised 574,000 (was initially reported as 570,000) in the week prior. The estimate was for a decline to 564K from the initial estimate of 570,000 in the prior week. So, the expectation was close to right on the change (down 4K vs. an expected 6K decline), but missed by a wider margin on the level due to the revision higher from the prior week.

The four-week average, which smoothes out weekly volatility to a degree, rose 4,000 to 571,250. With this being the final week of the month (claims for the week ended Aug. 28) this is the average for all of August, up from the July average of 557K.

Continuing claims rose 92,000 to 6.234 million for the week ended August 22 (there’s a one week lag between continuing and initial claims for those wondering about the different dates). The level is hovering right at the four-week average of 6.216 million.

Emergency unemployment compensation jumped 85,500. This involves the extension of benefits an additional 33 weeks. So, normal benefits period is 26 weeks, plus this emergency extension…some may call this welfare.

This data won’t have a bearing on the first look at the August jobs report, as that will be released tomorrow. However, if claims fail to come lower from this level that is high in the 500K handle it does suggest that the September jobs data will not show much improvement in monthly job losses. Ultimately, we’ll have to wait a couple of weeks to have more confidence in this take, but I bring it up because some (including myself) have believed jobs losses would ease to something closer to 200K by the September jobs release – this level of claims appears to say that monthly losses will remain closer to 300K.

To put this into perspective, while the rate of employment decline has improved big time from the outsized losses of 500K-600K just four months back, 250K-300K in payroll losses is commensurate with the worst levels we seen during the typical recession. If jobless claims fail to ease back closer to 500K (the average over the past two months is 565K) in quick order, we’ll need to delay the expectation that job losses will fall to levels that are below a historically high elevation.

ISM Non-Manufacturing

The ISM non-manufacturing reading continued to improve in August, rising to 48.4 from 46.4 in July, illustrating that business conditions within the service sector declined at a slower rate than in the previous month. This was a bit above expectations for a 48.0 print. The dividing line between expansion and contraction is 50. (Recall, the ISM manufacturing reading earlier in the week surpassed the 50 mark. The fact that this service sector reading failed to do so is an additional confirmation that the rise in factory activity was largely due to what will be a short-term bounce in auto production via the clunker-cash scheme)

The business activity sub-index rose above 50 for the first time since the economy fell apart in September.

Seven of the 18 industries reported expansion, 10 reported contraction and one stated activity was unchanged from July. For perspective, the July data had six industries report expansion, eight reported activity contracted and four said activity was unchanged. On a net basis this indicates deterioration to me, but because there was one more industry reporting growth, it was enough to push the business activity index higher.

The employment index rose two points to 43.5, nice to see improvement but it remains well in contraction mode.

The inventory change index fell four points to 43.0. This is not a good sign. The market is expecting a rebuilding in inventories to help current-quarter GDP. (We will get some help from inventories, specifically due to vehicle assemblies, but it may not be as helpful as many had hoped. Respondents stated that they are “driving managers to reduce and maintain [inventories]at lower level.” I think they meant to say and/or, but that was the quote.

The prices paid sub-index soared 21.8 to 63.1 in August, indicating a substantial jump in prices paid from July. This is a record rise in prices paid, although I need to make note that this data only goes back to 1997. In August, 23% of respondents stated higher prices vs. 13% in July; 71% reported no change vs. 59% in July; and 6% reported lower prices vs. 28% in July. That’s a big shift in one month’s time. Sounds like a slack problem.

On inflation, I’ve expressed the concern before about the slack in the economy.

First, it’s rather hilarious for me to bring up the term “slack” because it is a total Keynesian take on things. To explain, it goes like this: if the economy has a lot of slack (that is, the job market has shed millions of jobs, and plant capacity sits at a low level (and currently capacity utilization is just off of the all-time lows) then inflation cannot possibly become a problem, according to the Keynesian economist. They believe this because if there is a lot of slack, say in the job market (ie. the unemployment rate is high and firms don’t have to pay up for quality workers) then wages are not rising substantially and thus firms do not have to pass these costs along to consumers.

But that’s their little world. In reality, inflation is more a function of too much money chasing too few goods than it is a function of a tight labor market. As a result, while most economists do not seem to fear harmful levels of inflation to be a possibility in the foreseeable future, I tend to think otherwise.

The massive cuts in employment and idle plant resources can cause prices to rage once even a mild increase in demand presents itself. The productive capacity will not be their right away to meet this demand (even if it is fleeting) and thus prices may jump. I don’t believe troublesome levels of inflation are right upon us, but this unprecedented jump in ISM prices paid may be an early indication of what is possible over the next 12-18 months.

Certainly, the deflation argument seems quite removed from reality – in fact, it will take another financial-sector crisis (banks continuing to sit on massive amounts of cash instead of lending it out) to make deflation a reality.

Chain Store Sales

Well, despite the state sales-tax holidays implemented for the back-to-school (B2S) shopping season, same-store sales (stores open at least a year) fell 2.0% in August, as reported by the International Council of Shopping Centers.

While this is an improvement from the roughly 5% average year-over-year decline of the previous three months, its marks the worst B2S season in a long time. I don’t think anyone should rule out that clunker-cash, at least to some extent, also dragged sales lower – effectively cannibalizing sales from other retail sources. For instance, if the clunker-cash was too enticing to pass up, the consumer is writing a check to the DMV to cover sales tax.

Apparel and department store sales took another beating, down 4.3% and 7.3%, respectively (although the rate of decline eased from the July readings). Luxury store sales continue in the tank, off 12.3% -- the average of the previous two months, but improvement (if you can call it that) from super deep declines of 20% during the spring months. Even discount chains were down 1%.

Year-ago comparables will get increasingly easier once we get into October, but there is little doubt consumer activity will remain depressed for a prolonged period – bouts of rebound, but nothing sustained.


Have a great weekend!


Brent Vondera, Senior Analyst

Quick Hits

• A fair share
• China’s stock market: Another great leap
• Chinese bank lending: Follow the money
• MBS – Fed’s Inflation Fighting Weapon
• Money Fund Floats Plan to Erase $1 Barrier

Baltic Dry Index (BDI) continues to fall

The Baltic Dry Index (BDI), which measures changes in the cost to transport raw materials, continues to tumble and is now down nearly 44% from its June highs. The Baltic Dry Index is often considered a leading indicator, signaling future economic growth when rising and contraction when falling.

The Baltic Dry Index has historically been a good leading indicator for several reasons. First, the index looks at raw materials so it captures activity at the very beginning of the production process. Raw materials are also typically an area with very low levels of speculation. Second, it paints a picture of international trade activity, which is a critical driver of global growth. Finally, the shipping business depends heavily on credit, so the Baltic Dry Index indicates whether credit is tight or loose.

Because the supply of large carriers tend to remain very tight, with long lead times and high production costs, the index can experience high levels of volatility if global demand increases or drops off suddenly. Today, we are seeing excess capacity distort demand as a record number of new shipping vessels, equal to 14% of the existing fleet according to the Financial Times, are due to be delivered by the end of the year.

In addition, China’s reduction in commodity imports has been another key factor affecting demand. As said above, raw materials are typically an area with very low levels of speculation. However, China began hoarding raw materials in light of global economic malaise and the expectation that the declining U.S. dollar would lead to higher commodity prices in the future. The recent easing suggests that the long campaign by China’s Iron & Steel Association to stop speculative hoarding is finally gaining traction. Thus, a working down of stockpiles and fundamentally lower demand will keep a lid on the Baltic Dry Index.

The question now becomes, will this ultimately keep a lid on global economic growth?


--

Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

Yields slipped and fell again yesterday as investors shed risk in favor of Treasuries. The two-year fell below .9% intraday but most of the rally was concentrated in the long end. The most recent shift in the curve has been pretty parallel, meaning that even though yields have crashed down in the past few weeks the shape of the curve has remained about the same. While Fed policy expectations have driven the short end lower inflation expectations have taken a step back and lowered longer yields also.

The market carefully studied the August 12 FOMC meeting minutes yesterday, looking for any new information on how the Fed is gauging the recovery, among other things.

Here are some bond market specific highlights from the release:
· The decline in capital investment appears to be moderating. The contraction in industrial production showed signs of slowing and factory utilization recorded a new low in June.
· TIPS liquidity is poor, probably caused by summer holidays, but has resulted in moves in the TIPS markets that may say more about liquidity premium/discount movement than actual shifts in inflation expectations.
· Credit spreads have fallen below the peaks set in the previous recession. It’s pretty incredible to see how well credit has done since March only to now reach normal recession levels.


Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks extended the losing streak to four days, longest since May, as a preliminary employment report suggested job losses in August will be worse than expected – we get the official jobs report tomorrow – and members of the FOMC expressed “considerable uncertainty” over the strength of economic recovery.

Stocks spent most of the day hovering around the flat line. A relatively significant move lower about an hour into trading was quickly erased, but the second move lower occurred in the final 20 minutes as time ran out.

A gain in basic material stocks helped to support the broad market, the group was one of only two of the major sectors to close in the black. Gains in metals prices, driven by a gold price that’s headed back to $1,000 per ounce, led shares of mining companies higher.

There are all kinds of explanations for the current move in gold: the Indian wedding season (I like that one, although I shouldn’t rip on the notion as the final four months of the year are generally good for the metal); China increasing its holding of hard assets to protect against a declining dollar; and investors anticipating a September/October stock-market sell off.

Financials led the decliners again yesterday, down about 1% after Tuesday’s 5.26% slide.

Breadth was ugly for a second-straight day as decliners beat advancers by a two-to-one margin. Volume remained strong, for this summer’s activity that is, as 1.3 billion shares traded on the Big Board.

Market Activity for September 2, 2009
Mortgage Applications

The Mortgage Bankers Association reported its mortgage apps index fell 2.2% in the week ended August 28 after two weeks of big increases – up 7.5% and 5.6%. Purchases fell 1.0% and refinancing activity declined 3.1% even as the 30-year fixed-rate mortgage fell back to 5.15%.

Preliminary Employment Reports

Challenger Job Cuts Announcements

The job cuts survey out of the nation’s premier executive outplacement firm, improved for a sixth month and the year-over-year reading has improvement for three-straight months.

According to the Challenger Job Cuts survey, planned firings fell 21% to 76,456 in August from 97,373 for July. The number improved by 14% on a year-over-year basis from the 88,736 in job-cut announcements in July of 2008. The latter figure is the one to watch as the survey does not adjust for seasonal effects so the monthly change can be deceiving.

The government and non-profit category led the layoff announcements in August. (While non-profits will remain in a world of hurt for a prolonged period, the coming increase in government jobs will make sure this category will not be leading the survey for long – most of the cuts from this category resulted from the U.S. Postal Service slashing 30,000 positions) The auto industry followed with 6,694 layoffs – this was a surprise. The other surprise was the 5,500 job-cut announcements from the health-care industry, the only component of the monthly employment data (the actual component is health-care & education) that has yet to post job losses during this downturn.

ADP Employment Report

The preliminary employment report from ADP Employer Services estimated that 298,000 payroll positions were shed in August on a seasonally-adjusted basis -- the estimate was a decline of 250K. This marks the smallest decline since September 2008 and suggests that the official employment data will remain below the -300K mark.

ADP estimates that the service-providing sector cut 146,000 positions and goods-producing positions to be down by 152,000. These are higher numbers than the improvement we saw in July’s official data. Service industries cut just 128K vs. the 200K+ avg. for the previous three months and goods-producing industries cut just 119K in July, up from the 190K avg. during the previous three months. By way of the ISM and regional factory gauges, many are expecting goods producing to continue to improve. As a result, if this ADP figure is accurate it could be a blow to the market when the official report is released tomorrow.

Small businesses (those with less than 50 employees, and the main engine for job creation) led the declines with a payroll decline of 122,000. Medium-sized firms (less than 500 employees) shed 116,000 payroll positions and large firms cut 60,000. Again, these are estimates.

Final Revision to Q2 Productivity

The Labor Department released their final print to second-quarter productivity, showing the measure surged 6.6% at an annual rate, revised up from 6.4%. This is the fastest move in nearly six years as firms squeezed more out of existing workers in the face of large revenue declines.

Productivity, a measure of output per hour worked, was able to jump last quarter as hours worked (the denominator in the figure) fell much more than output. Hours worked plunged 7.6% (the figure fell to 33.0 hours per week during the quarter, the lowest reading since these records began in 1964). Output fell 1.5%. This is a big decline in output, but obviously not compared to the damage done in hours worked.

What does this mean for corporate profits? As we’ve discussed a couple of times now, this indicates we’re set up for high-powered profit growth a couple of quarters out.

However, one should be careful not to get carried away. The massive reduction in employment and hours worked also means incomes have been drained and the impairment may last longer to reverse than is generally the case. (The productivity boost is not one of an upsurge driven by capital equipment enhancements but rather the abnormal damage done to hours worked and payrolls)

This does not bode well for consumer activity (a consumer that will already be in the process of working down debt levels, now made marginally worse by the clunker-cash program). As a result, aggregate demand may remain depressed. Therefore, we may not see much improvement in corporate top-line growth and thus may see profits turn down again after a two-quarter upswing – again, that upswing is still another quarter out.

This forecast, I must admit, is made all the more difficult due to the government spending that will flow next year. With the bulk of the Obama Dreamliner stimulus plan (the $787 billion in public spending) rolling in 2010, this may help to keep profits moving on an upward trajectory longer than would otherwise be the case in this environment, particularly for the industrial and basic materials sectors. But one should not believe that the normal expansionary path for profits (that typically lasts for years) will occur this time. The consequences of this heightened government spending and very easy monetary policy stance will develop into a large cost for the economy to bear in the not-to-distant future.

The FOMC Minutes

The Federal Reserve released the notes from their August 11-12 meeting, which showed some concern over the pace of economic recovery and discussion of extending the end date for their mortgage-backed security purchase program, much like they announced when the actually meeting adjourned regarding their program to purchase Treasury securities. The strategy behind extending the time frame, not the actual level of purchases, is to smooth out the process as the program approaches completion in order to minimize any distortions.

On the economy, the FOMC was more upbeat in terms of the downturn coming to an end, but their view about the likely degree of recovery was quite cautious and many members agreed the economy remains vulnerable.

FOMC members expressed that conditions in the labor market remain “poor” and that business contacts have mostly indicated that firms would be cautious in hiring even when demand picks up. The members shared a belief that stimulus and monetary policy would lead to economic growth later in 2009 and into 2010, but that “the stimulative effects would fade as 2010 went on and would need to be replaced by private demand and income growth.” (That’s exactly the concern as one would think interest rates to be higher a year from now and tax rates are set to increase – the combination of these two events is like slipping a mickey to the economy, as we discussed last week. Let’s hope the economy is not robbed and thrown into the alley out back).

It was reported that Fed staffers (these FOMC minutes always include economic projections from the central bank’s staff economists) forecast that economic growth will be somewhat above potential for all of 2010 as financial conditions improve. I didn’t read that in the actual text. Instead, what I read was that staffers stated there were a range of views, and considerable uncertainty, about the likely strength of the upturn – was the press padding things a bit? My how things have changed.

On inflation they believe core prices to remain low. Naturally.

Have a great day!


Brent Vondera, Senior Analyst

Defense industry flying under the radar

While the healthcare debate and signals of an economic recovery have dominated the headlines for much of the summer, issues surrounding the Afghanistan war (Operation Enduring Freedom) have been flying under the radar.

Last week brought news that defense needs more than double the place-marker $50 billion estimate for war spending in fiscal year 2011, and perhaps as much as $125 billion. Today there are several reports (see here, here, or here) that Army General Stanley McChrystal may request an additional 21,000-45,000 U.S. troops in Afghanistan, above the 68,000 already there.

Should this large level of troops be needed, the Afghan conflict may begin to resemble the size of the commitment that Iraq had become. Thus defense stocks, especially those with war exposure, could continue double-digit EPS growth beyond the current expectation of slowing growth by 2010. Our Approved List stocks that would benefit the most include Alliant Techsystems (ATK), General Dynamics (GD), and L-3 Communications Holdings (LLL).

Defense companies’ valuations are still far below that of the market because investors have assumed the defense industry would suffer from a U.S. defense-budget squeeze and the market has largely ignored the rising requirement in Afghanistan. However, national security is critical and there is an awful lot going on in Iraq, Afghanistan, and elsewhere.

Uncertainty plays the biggest role in low valuations as the next 18 or so months will have decisions that will shape the industry for a decade or more. Still, these companies are trading just too cheaply to be ignored, especially if the war in Afghanistan continues to grow.
--

Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

The market ignored positive economic data for the second day in a row yesterday as stocks sold off and Treasuries rallied. The two-year is to thank for the steeper curve as it has rallied from 1.05% last Thursday to end yesterday at .91%. I usually prefer to show shifts in the curve with a graph, but some seem to have trouble reading them. Below shows the same change, just in table form.

The biggest news of the day will be the release of the FOMC minutes from the Aug 12 meeting. The market will be fixated on the Fed’s comments on the securities purchase programs, prospects for inflation, economic activity and the dollar. More on this in tomorrow’s recap.

The New York Fed purchased $5.6 billion in 3-4 year Treasuries yesterday and has yet to schedule the next batch of operation dates. The Fed has bought $276 million worth of Treasuries to date, so the next announcement will almost surely have to show some sort of slowing down. Most of the speculation is for the Fed to go to one Treasury operation each week, similar to the way they have bought Agency debt throughout the entire quantitative easing campaign.

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks sold off on Tuesday, extending the losing streak to three sessions as it appears the trend we touched on in yesterday’s letter has shifted. Not only does the famous second-derivative trade appear exhausted, but the broad market fell 2.2% on a day in which the manufacturing index posted its first move into expansion territory in 19 months.

One can never make too much out of two or three days of trading, and we should keep that in mind, but the correction that seemed quite overdue after a tremendous run from the depths of the March 9 low may be upon us.

I see there are money managers out this morning stating stocks can’t fall more than 5-10% simply because ISM has moved to expansion mode. One should remind them of the 2002 market. ISM spent eight-straight months above 50 during 2002, yet coming off of a quick 22% rally the S&P 500 went into a 31% freefall at exactly the same time ISM was hitting expansion mode. How quickly memories are erased.

Also weighing on stocks yesterday was speculation across bond desks that a major bank would fail on Friday. Even if this is baseless, the talk of such an event will certainly bring back the vaunted run for safety back to the Treasury market. The 10-year finished 3.37% -- here we go again?

All 10 major sectors declined on the session, led by a 5.26% slide in financial shares. Utility shares were the best performing group on a relative basis, down just 0.72%.

Volume blew by the three-month average. Roughly 1.6 billion shares traded on the NYSE Composite, 33% more than the average for this summer. Sixteen stocks fell for every one that rose on the Big Board.

Market Activity for September 1, 2009
ISM Manufacturing (August)

The Institute for Supply Management’s manufacturing gauge for August jumped to 52.9 (a reading above 50 marks expansion) from 48.9 in July. This marks the first time the nationwide factory index has moved to expansion in 19 months (January 2008). (Yesterday, in getting everyone ready for this reading, I stated the last time it hit expansion territory was September 2008, sorry about that error I was thinking about the Chicago manufacturing reading).

Eleven of the 18 manufacturing industries reported growth last month, that’s up from seven in July.

New orders jumped 9.6 points to 64.9 – a reading that is well-above the 30-year average of 53.8. This sub index was the main driver for the overall ISM number.

The employment index ticked up slightly but remains in contractions mode. I noticed a comment from PIMCO’s Tony Crescenzi yesterday, in which he pointed to the jump in supplier deliveries (another sub-index of ISM) to 57.1 from 52.0 in July – this component of ISM works in the opposite direction, a reading above 50 means slower delivery times.

Crescenzi states that this may mean manufacturing job growth is on the horizon. That would be nice. No doubt the jump in orders has caused some potential bottleneck issues. One can see this in the new order less inventories figure, which jumped to the highest reading since June 1975. But manufacturers understand that the jump in orders is largely driven by the auto sector, and to a lesser extent apparel as the fall line ups roll out. Neither of these factors spells sustained orders growth though, and thus factories are more likely to boost hours worked for current workers than to add to payrolls at this time.

The prices paid index surged. Early inflation signal? We shall see.

Some of this rebound in ISM manufacturing is due to the inventory dynamic. As we’ve talked about for a few months now, the very low state of inventories will encourage firms to boost production in order to rebuild those stockpiles.

But the surge in the new orders index does not jibe with aggregate demand, which has yet to rebound. What is occurring is more than just the inventory dynamic, a function of all business cycle upswings. The boost in vehicle orders is the primary contributor. One can see this by way of the “what respondents are saying” section of the ISM report. The transportation and fabricated metals sectors were clearly the most upbeat, other industries stating activity is on the rise struck a rather cautious tone. Comments from the fabricated metals industry even explicitly stated that manufacturing has increased “thanks to cash for clunkers.”

I noticed an often-quoted economist state, “that the pieces are falling in place for a recovery to take hold.” I wouldn’t get too carried away here. This move in ISM is very welcome, but clunker-cash is over. I wonder if car dealers appreciate people calling this clunker-cash. Since most are still waiting for their government payments, maybe we should call it clunker IOUs.

Prior to this government subsidization, car sales had been in the tank for nine-straight months. This was due to the reverse wealth effect, very weak job market and tighter credit conditions. What occurs once the auto makers have replenished stockpiles? One would think dealer inventories will swell again. Does anyone really believe that car sales will follow a path that is unlike what had occurred before cash for cars?

Unfortunately, instead of a prolonged expansion in factory orders that generally lasts several years in the typical economic recovery, my view is that this one will last only a few months.

In the short-term though, GDP for the current quarter will mark the end of the four-quarter contraction. The latest two readings on ISM average 50.9. I’m guessing economists are upping their third-quarter GDP estimates as we speak.

Construction Spending (July)

Construction spending fell 0.2% in July, following a 0.1% increase for June. The index is down 10.5% year-over-year.

The residential side of things was robust in July as private-sector home construction jumped 2.3% and public-sector outlays for housing rocketed up 3.6% -- that is a huge one month move. (This is a great start to the quarter and suggests housing will lift Q3 GDP, marking the first positive impact from this component in 13 quarters. Again, those GDP estimates are on the rise)

The increase on the residential side, however, was not enough to offset the private sector weakness in commercial construction spending, which was down 1.2% -- down 8.3% y-o-y and lower by 15.8% past three months on an annualized basis.

Looking out over the next several months, private sector commercial construction will remain in the tank, I’m not sure what will happen on the residential side, but it would be a surprise to see a complete recovery in this segment as the inventory/sales ratio for new homes, while much lower, remains elevated. The public sector will take over though and boost this overall reading as the bulk of the government’s stimulus spending has yet to roll out.

Pending Home Sales (July)

Pending home sales continue to roll, up 3.2% for July – the sixth month of increase. Contract signings were fueled by a 12.1% jump in the West (where California’s state tax credit on new home purchases combines with the federal government credit and foreclosure-related price declines) and a 3.1% increase in the South. Pending home sales fell 3.0% in the Northeast and 2.0% in the Midwest.

This data suggests we’ll see another nice month for existing and new home sales when the July data is released. We’re heading for that tax credit expiration, have to close by November 1; we’ll see what happens to sales after that – unless it is extended, which some have speculated.

Another Big Find

BP has reported a giant discovery at the Tiber Prospect in the Gulf of Mexico that may hold more than 3 billion barrels of oil. The well is located about 250 miles southeast of Houston. Between this and the huge find off of the coast of Brazil not that long ago, the “peak oil” crowd is really taking some blows.

More of this to come, technological improvements will lead to additional finds. Despite what many would like everyone to believe, we are not even close to running out of oil; we should be more focused our own preservation.


Have a great day!


Brent Vondera, Senior Analyst

August 2009 Recap

The S&P 500 chalked up its sixth consecutive monthly gain as stocks continue to climb a wall of worry. Domestic mid-cap stocks outperformed its large and small counterparts in August and have a sizeable lead in year-to-date performance. REITs topped all asset classes this month with a gain of more than 14%. Emerging markets and commodities were the only asset classes posting negative monthly returns.

While breadth has been very strong during the rally from March lows, it was very weak in August with only two of ten outperforming the S&P 500 as a whole. Financials drove the entire market in August with a gain of 12.99%. The Industrial sector was the only other one to outperform the S&P 500 with a gain of 4.53%.

There is still a considerable amount of skepticism about this rally and many investors are still sitting on the sidelines. As of August 31, 90% of stocks in the S&P 500 are now trading above their 200-day moving averages – a signal to some that prices have risen too far, too fast. Consumer Discretionary and Industrials have the highest percentage of stocks above their 200-day moving averages at 95%, followed closely behind Financials (94%), Technology (92%), Energy (90%), and Consumer Staples (90%). Utilities rank second to last at 83%, and Telecom is dead last at 67%.

Meanwhile, disappointing retail sales, consumer confidence, and initial unemployment claims readings show that consumers are still holding back, which could dampen the prospects of a rapid recovery. In addition, while the extremely low levels of business inventories are expected to lead to increased activity in the near future, companies may not increase spending for fear of a reversal in demand.

There is little doubt that the rebound in the Chinese market helped to fuel the U.S. market rally, but its stock market has recently declined into bear territory, which raises the concern that other markets might follow. Chinese markets have slid in response to regulators tightening lending standards and taking action reduce soak up excess liquidity.

The yield on the two-year Treasury, a rate tied closely to Fed policy, reached a high of 1.30% on August 7, but fell steadily through the month to finish at 0.96%, a sign the Fed is far from hiking its target for overnight lending. MBS spreads continue to tighten as the general rate environment remains low.

Fixed Income Recap

Treasuries posted gains yesterday despite positive economic data that tried its best to overcome weakness in stock overseas. The two year finished the day at .97%, its lowest yield since mid-July, thanks to New York Fed President William Dudley’s comments the quelled speculation from last week that the Fed was nearing the beginning of its formal exit strategy.

Last week two separate Fed presidents, Richmond’s Lacker and Saint Louis’s Bullard, spoke out on the possibility the Fed may not have to purchase the entire $1.25 trillion in MBS. Dudley definitely leans more toward the majority within the FOMC than Lacker (the only FOMC member who has voted against expanding the monetary base through targeted credit programs), and didn’t seem as confident that things are improving enough to warrant such an aggressive action. MBS didn’t seem to take last week’s comments too seriously, so there wasn’t any real correction to be made on Lacker’s counter argument for the continuation of the program. But still, it was a smart move to come out and say something.


Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks declined on Monday as the Sunday night (our time) sell off in China caused investors to rethink the rally. Speculation that the Chinese government will implement lending curbs resulted in a nearly a 7% decline in Shanghai, pushing that country’s main bourse into bear territory – down 22.8% since August 4. The Shanghai Composite bounced back a bit last night, up 0.6% after China’s main factory gauge posted a sixth-straight month of expansion.

One would have thought the encouraging economic data in the U.S. (Chicago manufacturing on the cusp of expansion mode, which we’ll get to below) to have offset the overseas event and provide a boost to our market. Is this a shift, or just a one day event?

The trend over the past few months has been that only a mild boost in economic data, off of very deep levels to boot, was needed to spark equity-investor euphoria. We’ll find out over the next couple of days whether or not something has changed here. This morning we get the ISM number for August, it will very likely move to expansion mode for the first time since last September. If this occurs and stocks don’t respond in kind, it will be a clear sign that something has changed.

Yesterday’s decline reduced the August gain, the sixth-straight monthly advance; still the S&P 500 added 3.4% last month. That followed a 7.41% advance in July; a virtually flat June, up just 0.2%; a May gain of 5.31%; and romps of 9.39% and 8.54% for April and March, respectively.

All but one of the 10 major industry groups declined yesterday, consumer staples being the lone sector to buck the trend.

Volume was actually pretty strong, by the standards of the past three months anyway, as more than 1.3 billion shares traded on the NYSE Composite – 13% above this summer’s average. Declining stocks whipped advancers by a five-to-one margin.

Market Activity for August 31, 2009
Chicago PMI

Chicago-area manufacturing activity for August, as measured by the Purchasing Managers Index, moved to the line of demarcation that divides expansion from contraction. The reading jumped to 50.0, following 43.4 in July. The reading for August is the highest since September, when Chicago PMI stood at 55.9.

The reading beat the expectation of a move to 48.0 and I certainly thought it would be another month before we got back to 50, which we stated after the latest factory reading out of Philadelphia on August 20. One would have thought this move to spark a rally in stock prices, but the market actually traded lower on the news before regaining some of those losses later in the session.

A boost in auto production will keep the Chicago reading going for a couple of months. The Chicago factory gauge is highly exposed to the auto sector and the increase in vehicle assemblies coming off of the plant shut downs that followed the GM and Chrysler bankruptcies is playing a significant role (big inventory reduction after “cash for clunkers” kicked car sales higher) However, after a couple of months, as we move to year end, the factory sector will need to find support elsewhere.

The boost in the new orders index to 52.5 from 48.0 was surely driven by the auto sector – first move above 50 in a year. Order backlogs also looked good, not yet in expansion mode coming in at 45.8 for August, but marking nice improvement from a very low reading of 32.1 in July.

The employment index remains in deep contraction, hitting 38.7, but has improved significantly from the cycle low of 25.0 in May. (And on employment, we get the August payroll data on Friday. While the weekly jobless claims data suggest monthly job losses will be worse than what we saw in July, the firming in the auto sector should keep factory employment losses milder than was the case just two months back – this sector showed the rate of decline in jobs losses slowed meaningfully during July and that should continue in August.)

The Commercial Hurt

Investors’ concerns seem to be growing regarding the impact commercial real estate losses will have on the banking system (this time more so with community and generally smaller banks than the big guys). Just as in the residential lending standards when credit was offered to just about anyone based on the assumption that home prices would rise without interruption, commercial lending standards appeared to assume occupancy and rental rates would not abate.

The commercial side always erodes, with a significant lag, when the economy turns down. You have manufacturing properties that go bust due to reductions in output, office properties that see both rental and occupancy rates head in the wrong direction and mall properties take a beating due to a higher level of joblessness. If this situation doesn’t go well it will erode bank-industry earnings power, offsetting the hugely positive impact of a massively upward sloping yield curve (a situation that allows banks to borrow near zero and lend money at much higher rates, effectively helping to offset mortgage and consumer credit woes). According to the FDIC, banks have $1.1 trillion in core commercial real estate loans on their books (and another $590 billion in construction loans); it’s likely the downturn in commercial real estate will be the next hurdle for the economy.

I should make it clear though that trouble in the commercial side of real estate does not have quite the economic impact a downturn in the residential side does as the latter can have a profound impact on consumer activity. Still, losses in commercial loans does affect the availability of credit as capital ratios are diminished.

FDIC “loss shares” – Another Crutch

And speaking of the banking industry, through deals known as loss shares the FDIC is agreeing to absorb losses in portfolio loans of banks that have gone under in order to encourage other banks and private equity firms to come in and buy up the failed lenders. As the WSJ reported, the FDIC is agreeing to pick up more than 80% of future losses for most assets and 95% of losses on the rest – that is, it will cover 80% on the first $xx billion of losses (the actual amount depends on the institution) and 95% of losses above that given threshold. The loss exposure the FDIC will assume may skyrocket due to commercial real estate losses touch on above.

This means you’ll have private equity (PE) investors (also encouraged now that regulators have reduced capital standards on private-equity purchases of failed banks) willing to come in and take over a bank, buying up the assets and capturing potentially large profits over time. As the FDIC will assure against most losses, it’s a great risk/return picture for PE investors. But this is not the way the game is supposed to be played and something will crack. We continue to prop up an array of markets and that just cannot go on without cessation.

(I want to make clear, the FDIC will never have a funding problem, simply because if things get bad enough, Congress will inject as much cash that is needed into the agency – and Congress has already passed $100 billion in emergency funding for the agency.)

Taxpayers will be on the hook for these losses and that very likely means much higher tax rates to come. Also, there is a moral hazard issue if the industry cares little to rework troubled loans because the government is massively subsidizing the losses, making the potential losses even greater. It all comes down to how long it takes the economy to bounce back in a sustained manner. My concern is that increased government involvement delays a sustained economic expansion. We shall see.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

The Personal Consumption Expenditures Price Index fell .9% in July from a year ago, slightly lower than the -.8% expected, but a little exaggerated compared to +.1% when food and energy is stripped out. The data was more or less a non-event as far as bonds were concerned, which can be expected since the data was right in line. The ten-year sold off on the data but quickly bounced back as equities opened lower. The morning volatility subsided soon after and bonds cruised toward the week’s close to end just slightly higher on the day.

Tomorrow we will get the minutes from the August 12th FOMC meeting. The market will be focused on any new mentioning of an exit strategy for the Fed, a major factor driving rates as of late. The two-year ended last week at 1.02% and has rallied more this morning to yield .992% as I write this. If more talk about an exit strategy is exposed in this week’s minutes the short end will certainly feel the pain, if not, stocks may feel it instead.

The employment report for the month of August will be released on Friday. The consensus forecast is for unemployment of 9.5%, .1% higher than the initial July number.

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks ended mixed on Friday as the Dow and S&P 500 closed lower, while the tech-laden NASDAQ Composite managed a slight gain after better-than-expected earnings results from Dell and a boosted forecast from Intel. Weighing on the broad market was data that showed personal incomes were flat in July, following a decline in June, and traders wondering what will happen to the spending side after August as the “cash for clunkers” program has come to an end.
Despite the mixed results on Friday all three major indices gained ground for the week. The Dow gained 0.27%; the S&P 500 added 0.40%; the NASDAQ Composite rose 0.39%. Among smaller capitulation stocks, the S&P 400 (mid cap stocks) gained 0.50%; the Russell 2000 (small caps) fell 0.28%.

Basic materials, tech and financial shares led the broad market higher. Health-care shares, down 0.91% for the biggest loser on Friday, led the decliners.

Volume remained pretty weak for Friday’s session (1.2 billion shares) and all of last week (an average of just 1.1 billion). We’ve had trading volume average less than 1.2 billion shares over the past three months, that’s roughly 15% lower for this time of year.

Market Activity for August 28, 2009
Personal Income and Spending
The Commerce Department reported that personal incomes were unchanged in July (missing expectations for a 0.1% increase) after a 1.1% decline in June, a number that was revised higher from the 1.3% drop initially estimated. Personal income has dropped 2.4% from the year-ago period.
While the headline figure didn’t show it, the internals of the income data were a vast improvement from what we’ve seen over the past several months. Compensation and wages & salaries (two of the three largest components of the data, personal income from assets being the third) both rose 0.1% in July; this follows eight month of decline. So, even though the 0.1% increase is paltry and won’t do much to help elevate consumption, it’s something. These key components have gotten shellacked over the past 12 months, down 4.2% and 5.1%, respectively.

Regarding other segments: proprietor’s income gained 0.6%; rental income jumped 3.3% (the only private-sector component that has looked good over the past year – up 26.4% past 12 months); personal income from assets fell 1.0%, with a 2.6% decline in dividend income (down a massive 23% y-o-y) and interest income lower by 0.3%; government transfer payments declined 0.2%.

On the spending side, activity rose 0.2%, which was in line with expectations following a 0.6% pick up in June – revised up from 0.4%. Spending was helped by the “cash for clunkers” program, offsetting continued weak results from most retailers. This is evident by way of the internals as non-durable goods consumption (things like clothing, electronics, etc.) fell 0.3% in July, while durable goods (items meant to last at least three years (like cars and appliances) jumped 1.33%. The CARS program should have a larger positive effect on August’s spending activity, but this will be borrowing from the future as income growth will remain weak.

As spending outpaced incomes in July, the personal savings rate (cash savings) slipped back to 4.2% from 4.5% in June and off of its 11-year high of 6% hit in May.

This is what I mean by borrowing from the future. The CARS program is just delaying what needs to occur, a cash savings rate that needs to settle in at roughly 8% in order to get consumers feeling right again – based on current realities within the home, stock and labor markets.

Normally, I don’t make a big deal about the personal savings rate, as the two major savings vehicles (homes and stocks) are generally on an upward trend. But this is not the trend today as both have been hit hard, stocks down 34% from their peak and homes off by 20%. Also, with the unemployment rate at a 26-year high (and likely to move higher before it comes lower) a boost to cash savings is essential. The CARS program also encourages the addition of debt to households and this too will delay a sustained spending rebound.


PCE Deflator
The inflation gauge tied to the personal spending data remained unthreatening in July. The core rate, which excludes food and energy (I’ll predict right now that consumers will become really tired of hearing about inflation gauges that exclude these components a year to 18 months out) rose 0.1% for the month and is up 1.4% year-over-year The headline number (includes every component) fell 0.8%.

This is the situation now, but things will change come November. This is when the year-ago comps becomes very weak. Right now, by contrast, the inflation gauges are being matched against numbers that were very high due to last summer’s commodity-price spike ($145 per barrel oil and $4 gasoline – just to mention the commodities that I’m sure you remember). I’m not saying inflation will rage come November, but it will very likely begin to tick higher. There is some embedded inflation right now, the core rate, while tame, is showing the deflation talk is bunk. Over the past four months, the core rate is up 2.1% at an annual rate.

Again, nothing to get terribly alarmed about in the meantime, but as the economy begins to rebound, even if that progression is a very slow one from a historical perspective, this embedded inflation as I’m calling it will feed more quickly into higher prices. As the Fed keeps rates very low, and there’s a heightened probability they won’t have the will to reverse the current course of monetary policy (when needed) due to a jobless rate that remains high, the inflation gauges will begin to show life again.

No one envies Mr. Bernanke’s position, he will have to work magic in order to allow the economy to strengthen while keeping inflation subdued. The Fed has backed itself into a corner, in my opinion, after several years of misguided policy decisions.

Japan’s Electoral Shift
An electoral landslide occurred, if the polls are correct, in Japan this weekend. The DPJ will take over from the LDP, ending just about 50 years of rule. The Japanese economy will need more than a change in the political leadership; they’ll need to completely change policy, shifting from high tax rates and what has become annual government stimulus spending programs to very low tax rates across the board.

Japan’s main obstacle is one of demographics, the most aged population in the world and getting worse due to very low birthrates. They need an immigration jolt to change things and an aggressive shift in their tax regime will encourage businesses and labor capital to flow into the country. Japan’s GDP has literally gone no where since 1996 and has barely increased since 1992. If this isn’t enough to foster a complete change in their economic policy, nothing is.


Have a great day!


Brent Vondera, Senior Analyst