Mauled

By David Ott

For 85 years, Bear Stearns was one of the most storied, venerable investment banks on Wall Street.

In 2008, Bear found itself at the center of an old-fashioned bank run and was forced to sell itself to J.P. Morgan in a nearly overnight deal engineered by the Federal Reserve. Many financial institutions were already under stress during this early phase of the crisis, but Bear was the first major domino to fall.

The final days of Bear are told in a riveting narrative by Kate Kelly in Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street. This is her first and it reads with the pace and excitement of a John Grisham legal thriller, but with the facts and authenticity of a Wall Street Journal article, where Ms. Kelly works as a journalist.

Bear was as a tough-guy’s firm, always on the hunt for employees who were poor, smart and a deep desire to be rich; known simply as PSDs. Unlike many white shoe firms, Bear was less interested in pedigree and more focused on profits.

The old regime run by Alan ‘Ace’ Greenberg had a reputation for strong risk management along with those profits, believing it was better to serve as a casino and let the customers do the betting.

This attention to risk deteriorated under CEO Jimmy Cayne, who seemed less interested in managing the day-to-day management of the firm and more concerned about playing bridge or golf and smoking pot. The book paints a portrait of an out-of-touch manager who maintained power by installing weak lieutenants and an even weaker board of directors.

While the actual demise was swift, it was a long time in the making. The origins of Bears problems begin with policy changes from Congress and the SEC.

In 2000, Congress passed legislation that allowed financial derivatives like credit default swaps (CDS) to escape oversight by the SEC, the Federal Reserve, and state regulators, leaving the Commodity Futures Trading Commission (CFTC) with very limited supervision.

Then in 2004, the SEC waived its leverage rules for the top five investment banks. Goldman, Morgan, Merrill, Lehman and Bear could go from a maximum 12:1 debt-to-net capital ratio to whatever the market would allow. By the end of 2007, Bear was leveraged 35.5:1.

These policy changes along with record low interest rates and the associated housing bubble, paved the way for Bear to maintain a highly leveraged balance sheet with illiquid and low quality assets as collateral.

This strategy can be a very profitable mechanism, but any disruptions can derail the profits and lead to disaster. In the summer of 2007, Bear hit a major speed bump when two of its hedge funds that invested in subprime mortgage related derivatives lost nearly all of their value.

Although Bear pumped $3.2 billion of its own capital into the fund and persuaded high profile investors like Eli Broad to invest, confidence in Bear was shaken. These hedge funds invested in the same securities that Bear had bought the same securities with its own capital.

With the fire sale going on in the funds to meet investor redemptions, Wall Street realized that Bear would have to mark down the value of their own collateral taking the leverage even higher. These concerns were solidified when Standard & Poor’s cut their rating from AA to A. Over the next few months, the investment banks and hedge funds that did business with Bear started pulling their cash out in droves.

Perhaps Goldman’s decision to stop trading with Bear because of the counterparty risk was the final blow. That same day, newly installed CEO Alan Schwartz seemed caught off guard on the Goldman issue during an interview with CNBC, further eroding confidence.

When it became clear that Bear might not be able to open their doors and execute trades with their clients, everyone realized that it was over.

That weekend, with the aid of the Federal Reserve, J.P. Morgan bought Bear for $2 per share. Little more than one year before, the stock had traded at $172 per share. At $2 per share, Bears market value was less than the value of their headquarters.

One of the more visually stunning images of the entire financial crisis is the photo showing a $2 dollar bill taped to Bears front door.

Ms. Kelly does an excellent job filling out the central characters and giving details about the chaotic final days. Sometimes it feels over dramatic and the steadfast adherence to chronology instead of storyline can be unnecessarily confusing, but the inside story combined with the broader implications makes Street Fighters thoroughly interesting and enjoyable.

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Recommendation: Buy

Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street
By: Kate Kelly

Penguin Group (USA) Inc. New York, New York 2009

ISBN: 978-1-59184-273-6

Daily Insight

U.S. stocks ran into a bit of trouble yesterday as the latest housing figures gave the heretofore euphoric equity-market investor a little pause. The Dow average held up the best, while the NASDAQ took the biggest hit of the three most widely known indices.

Existing home sales fell in August, which probably took even the skeptical by surprise. This event offset a jobless claims reading that showed pretty nice improvement, even if initial claims remain at peak levels relative to three of the past five recessions and continuing claims sit in the nosebleeds.

The housing number may have been driven by nothing more than a longer process to close loans, but it likely reminded people that the economic state of things remains precarious. The Federal Reserve’s decision to begin to slow a couple of its liquidity programs (which are providing funds to the market on the cheap) next month probably had an effect on trading as well. Still, I wouldn’t make much of the session’s decline as a 1% move on the S&P 500 (following Wednesday’s similar drop) is hardly noticeable after a 60% sprint from the March 9 low.

Basic material, financial and industrial shares led the decline. A downtick in commodity prices led the sell-off in material shares, and to a lesser extent energy names. An important gauge of commodity prices fell 2%, led by copper, oil and gold. Crude has moved back to the mid-$60s from $71.55 per barrel just two days back.

Another huge Treasury auction went off without a hitch yet again – hey, maybe we can continue to issue massive amounts of debt, an additional $1.5 trillion per year, without consequence. This time it was $29 billion of 7-yr notes met by strong demand – completing a week of $118 billion issuance.

Market Activity for September 24, 2009
Initial Jobless Claims

The Labor Department reported that initial jobless claims fell 21,000 to 530,000 in the week ended September 19 – the reading was expected to print 550K. This is the lowest level in two months (and when you exclude the distortions in July is the lowest level since January). The prior week’s reading was revised higher by 6,000 to 551,000, so this latest reading is the first move below the 550K level in eight months, again excluding a one-week blip below this level in July.

The four-week average of initial claims fell 11,000 to 553,500.

Continuing claims fell too, down 123,000 to 6.138 million. That’s a nice move that nearly erases the damage done from the prior week’s 158K increase.

Emergency Unemployment Compensation (EUC) jumped 82,364 to 3.223 million -- new high. This is another indication that the decline in continuing claims is not due to job hiring but from the expiration of benefits. (Those who have extinguished their normal 26 weeks of benefits and then their 13 weeks of extended benefits move over to EUC (EUC gives them another 20 weeks).

Overall, initial and continuing claims combined, the data suggests firms have slowed the pace of firings, but are unwilling to add to payrolls.

Existing Home Sales

The National Association of Realtors (NAR) reported that existing home sales unexpectedly fell in August, down 2.7% to 5.1 million units at an annual rate. The market was expecting sales to rise 2.1% to 5.35 million units, or 250,000 units more than we got.

This marks the first decline in four months and surprised even those, such as moi, expecting home sales to roll over again in a couple of months. And the decline was not due to the volatile multi-family component of the data, but resulted from a 2.8% decline in single-family unit sales.

Single-family sales came in at 4.48 million units, down from 4.61 million in July (again, this is at an annual rate) – still meaningfully above the cycle low of 4.05 million touched in January, but we’re not supposed to see a decline with full-blown housing stimulus still in effect and an economy that is supposed to be improving.

We shall see if this decline was due to a longer loan-closing process or the upward trend in home sales is getting exhausted as even massive stimulus (fed-induced rock-bottom interest rates, the tax credit, Fannie/Freddie accounting for 80% of originations), along with foreclosure-driven price declines, are no longer enough to offset a very weak labor market.

NAR stated 30% of buyers were first timers (encouraged by the tax credit) and 31% of sales were of distressed properties. The median price fell 2.1% for the month and is down 12.5% from the year-ago period.

The bright spot in the data was the continued decline in the inventory/sales ratio of single-family units, falling to 8.2 months worth of supply from 8.5 in July. The total number, which includes multi-family units, fell to 8.5 months worth from 9.3 in July.

One has to be aware, though, that foreclosures are not likely to slow, particularly since state moratoriums (which have now expired) have only delayed this process. This will work against the supply figures that are currently moving in a beneficial direction.

The homes available for sale figure, which is not adjusted for the pace of sales, remains elevated from a historical perspective but has come down from withering heights.


Have a great weekend!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks fell as the Federal Reserve’s statement that accompanies the close of their FOMC meetings failed to augment confidence that the economy is capable of strengthening on its own. Still, the market loves easy money and the Fed definitely reinforced that they will keep the policy as loose as it gets, so even with the lack of self-supporting confidence in the economy its was kind of surprising to see stocks decline nearly 2% in the final hour of trading.

Then again, until yesterday, we haven’t had a daily decline of more than 0.34% in the S&P 500 since September 1 so I guess it shouldn’t be all that surprising to see a buy on the rumor (hitting a multi-month high on Tuesday) and sell on the news event in the stock market.

The broad market hovered around the flat line for most of the session, rallying immediately after the Fed’s statement was released. However, a closer view of the statement (when people actually took time to read it) showed the Fed remains quite concerned about the prospects for economic growth and what the market’s reaction will be when the QE (bond buying) campaign comes to an end.

Nine of the 10 major industry groups closed lower, telecoms being the only one that gained ground. Financial, basic material and energy were the worst performers.

Market Activity for September 23, 2009
Mortgage Applications

The Mortgage Bankers Association’s applications index jumped 12.8% in the week ended September 18 after falling 8.6% in the week prior. Purchases rose a strong 5.6% and refinancing activity ran up 17.4%. Applications to purchase a home are down 14.9% from this time last year, yet refis have soared by 41%. Refinancing activity accounted for 63.8% of all applications in the week.

The 30-year fixed mortgage rate fell below 5.00% late May, ending the latest week at 4.97% -- this sub-5.00% level is the sweet spot for refis and needless to say doesn’t hurt purchases either. The first-time home-buyers tax credit and foreclosure-driven price declines have also fomented the rebound in sales.

The questions from here is what happens to mortgage rates when the Fed’s bond purchases come to an end (currently they have bought $810 billion of the $1.45 trillion in mortgage-backed and agency debt scheduled) and whether or not the tax credit will be extended past November.

Crude

Crude oil for October delivery moved back above the $70 per barrel mark Tuesday, but dipped early-morning yesterday after a preliminary energy report showed stockpiles increased. When the official Energy Department report was released at 9:30 CT, oil continued its move lower as that report showed crude inventories rose 2.86 billion barrels to 335.6 million – inventories were forecast to fall 1.4 million. Crude settled in to close at $68.97 for the session.

This keeps the current level of crude inventories about 5% above the five-year average, which is telling considering the daily average of crude imports remains 10% below year-ago levels – this shows fuel demand remains weak.

Refiners idled some plants for seasonal maintenance reasons, which also played a role in the demand dynamics.

So between the low demand/elevated inventory situation, it makes it kind of tough to justify $70 per barrel oil, maybe a number closer to $50 makes more sense from a supply/demand basis. But the reality is the dollar continues to get blasted and individual investors and governments are looking for alternatives to currencies as a way to guard against their declines. When this is factored in…well, $70/barrel doesn’t seem all that out of line – oil has become quite the dollar hedge over the past couple of years, supplanting gold to a degree.

FOMC Meeting

The Federal Open Market Committee stated:

On the economy:

“[E]conomic activity has picked up following its severe downturn. Conditions in financial markets have improved and activity in the housing sector has increased. Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.”
(This statement changed vs. their statement following the August meeting from: “economic activity is leveling out” and “household spending has continued to show signs of stabilizing”)

“Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.”
(The previous statement was the same expect for they did not mention “at a slower pace.”)

“[A]lthough economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.”
(The previous statement was, “the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.”)

I also have to add my own comment to this segment of the statement. It really is a nice thought, but I don’t see how policy takes this direction, and is effective in bringing growth back, without a heightened inflation consequence – that’s a pretty little world to live in. Further, and this is very important, notice how they dropped the sustainable growth phrase. They know that the massive easing campaign they have engaged in has brought the economy out of trough levels for now, but it cannot contribute to sustained economic growth because when this aggressive policy is reversed it will cause the economy to retrench.

On interest rate policy:

“The Committee will maintain the target range for the federal funds rate in a range of 0-0.25%and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

On quantitative easing (QE):

“To provide support to the mortgage lending and the housing markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt.” The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.”
(The previous statement was, “the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion in agency debt by the end of the year”)

They left some leeway in the previous statement, implying they may not buy all $1.25 trillion in mortgage-backed securities. Now they state they will gobble up the entire $1.25 trillion – not unexpected, but it is a change in the language. The extension of this program from the end of the year to the end of first-quarter 2010 was a very good decision. It’s already going to be a tough thing for the market to deal with when this buying come to an end as bond prices have adjusted to the current policy. They will need all the smoothing out they can muster, and the extension allows them this luxury.

Some additional comments on these statements:

I’ve got so much to say, but I’ll keep it concise. Simply put, the economy remains in a precarious and fragile position. The very fact that the Fed will continue to support the economy with an unprecedented level of monetary policy easing makes this abundantly clear.

I also found it strange, not surprising but strange, that the members of the FOMC appear almost ebullient on their inflation outlook as they believe the output gap (low capacity labor and utilization rates) will keep a lid on inflation pressures. Interesting how they ignored the increase in commodity prices – quite convenient.

What’s more, since they are intensely focused on the output gap, they are signaling policy will remain very easing for quite a while still – capacity utilization rates are just above their record low, currently at 69.6% (these records go back to 1967). It will likely take a long time to get it back to the long-term average of 81%. For context, it took nearly two full years for capacity utilization to go from 71% in 1982 to 81% by 1984, and that was with one of the most powerful periods of growth in the history of the United States – the economy grew at a 7.75% real rate in 1983 and 5.6% in 1984.

And on the duration of this easing, the Fed is focused on repairing household balance sheets by using an extreme easy money stance to encourage an equity market surge from the March lows. They accomplish this by reducing alternative investments, such as fixed income investments as yields remain very low. But they forget about the alternative they cannot control – commodities. The risks of another fed-induce bubble remains very much in play.



Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review: T, DELL, HPQ

S&P 500: +7.00 (+0.66%)

The S&P 500 made new 2009 highs immediately following the release of the Fed statement, but stocks continued their early day move lower. The Fed reiterated the October end of its Treasury purchase program and extended purchases of mortgage-backed securities to the first quarter of 2010. The announcement showed that the Fed intends to exit the market, but wants to give the markets time to adjust to their exit.

Crude oil dropped 4.89% on the New York Mercantile Exchange (NYMX) after a U.S. Energy Department report showed an unexpected increase in stockpiles as refineries idled units for seasonal maintenance and fuel demand dropped. Energy and Material shares were the worst performing sectors, excluding Financials. Adding pressure to commodities was the U.S. dollar, which rebounded from new 2009 lows to finish the day with a small gain.

The only sector to finish in the black was Telecom, led by AT&T’s (T) 2.38% gain. A buy recommendation from Jim Cramer (of all things) pushed AT&T’s shares higher as Cramer said the company offers a “nice, safe” way of making money off the rise in the mobile Internet market.

Dell (DELL) shares moved higher for the first time since announcing their acquisition of Perot Systems. The acquisition left investors scratching their heads for several reasons, which I will detail on the blog hopefully by tomorrow.

Something to chew on while waiting for tomorrow’s post: Hewlett-Packard (HPQ) shares are cheaper on a price-to-earnings basis despite higher profitability, more diversified and stable revenue sources, and greater market share in the markets they serve.


Quick Hits

• Bullish Wall Street Estimates Fail to Keep Up With S&P 500 for First Time
• Fed Says Mortgage-Backed Purchases Will Slow, Sees Economy Strengthening
  
  

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks returned to rally mode on Tuesday as the broad market is now just 16% from the pre-Lehman/AIG collapse level – basically two month’s worth of work in today’s market. The S&P 500 remains 31.5% below its all-time high hit on October 9, 2007, however. Another day of analysts’ upgrades of financial, consumer discretionary and technology shares fomented the move.

Financials led the rally, with energy and basic material shares also among the best performing groups – another dollar rout, hammered back down to a 13-month low, sent commodity prices like gold (back to $1015 per oz.) and crude (back above $70 to $71.55 per barrel).

The traditional safe-havens – consumer staples, utilities and health-care -- along with telecoms were the downers on the session.

Advancing stocks beat decliners by more than a two-to-one margin, but it occurred on yet another day of unimpressive volume as 1.2 billion shares traded on the Big Board, roughly 16% below the five-year average.

Market Activity for September 22, 2009
Richmond Fed

Manufacturing activity in the Central Atlantic region remained in expansion mode during September, according to the Federal Reserve Bank of Richmond’s factory index. The index reading came in at 14 for the third-straight month and has been in expansion mode for five straight. This is now the third regional factory gauge we’ve received for the month, all showing activity continues to expand.

But just like the other readings for September (the others being the New York and Philly regions) the sub-indices suggest some deceleration in the pace of activity. For instance, new orders volume slipped to 13 from 18 – still a good number though. The order backlog figure fell to contraction mode, coming in at -5 for September vs. 4 in August – needless to say that’s not a good sign. Also, as component of these regional surveys we have talked about lately, the vendor lead times (or supplier delivery times) fell to contraction mode as well, hitting -3 from the 2 posted for August – this means supplier deliveries sped up, you want to see them slow as it shows orders are coming in faster than they can easily handle.

On the bright side, the average workweek remained elevated, coming in at 15 – basically unchanged from August’s reading of 16. The wages component accelerated to 9 from 6, which will be a helpful event if it is sustained and proves true for the entire factory sector. And, while hiring plans among respondents were mixed, the overall employment gauge rose to 5 from 0 in August – the first positive reading since December 2007, which is the month the NBER says was the “official” start of the recession.

Home Price Index

The Federal Housing Finance Agency’s (FHFA) home price index rose 0.3% for July -- an increase of 0.5% was expected. The June reading was revised substantially lower to show a 0.1% rise vs. the initial reading of 0.5%. This puts home prices down by 4.2% year-over-year and just 10.5% from the April 2007 peak, according to this measure. By contrast, the existing home sales data has the median price of a home down 15% y/o/y and 22.5% from its peak hit in July 2006. The FHFA reading is geographically diverse, but does not include properties with jumbo mortgages.

This reading breaks prices down into eight different regions. Here are the results:

FOMC and Overall Policy Direction

The Federal Open Market Committee (FOMC) began their two-day meeting yesterday. Today, while there is no doubt the FOMC’s current interest-rate policy stance will remain unchanged, market participants will be focused on the statements from the members as that meeting comes to a close. What will they say on quantitative easing, the duration of their current policy stance and any shift in key phrases with respect to the economy?

The truly concerning aspect of current policy, and this involves fiscal and trade policy too (tax rates and protectionist trends – and if you think I’m sounding a false alarm here there are studies stating protectionist policies have jumped 31% since this time last year), is that it is intensely focused on the consumer while ignoring business and fails to understand the damage that results from higher tax rates and tariffs.

To concentrate solely on the Fed for a moment, while it is true consumer activity is the largest segment of the economy, currently making up 70% of GDP, policymakers must allow this percentage to revert to the long-run average of 65%, even if it means additional economic hardship in the short term -- this adjustment will work as a large drag on growth, but by attempting to impede this adjustment all you do is delay the inevitable and set up other challenges for the economy.

There must be a focus on policies that allow, or incentivize, other parts of the economy to take over as the consumer engages in a, let’s call it two year, period of repair.

For the record, I must admit a failure to see what was occurring a couple of years back – solid income growth, a very low unemployment rate that averaged 5.1% in the five years that preceded the crisis, and a massive wealth effect as both home and stock prices were elevated caused me to believe debt levels were quite manageable. Indeed, they were, until these events changed to a situation of falling-to-stagnant income growth, a 9.7% jobless rate and a crushing blow to home and stock prices.

It’s quite clear that part of the Fed’s strategy is to juice the stock and housing markets. Very low interest rates and a flood of liquidity will naturally result in money flowing into stocks as investors see little by way of FI yields. The Fed’s purchases of Treasury and mortgage-backed securities (part of this quantitative easing campaign we keep referring to) keeps mortgage rates down, which clearly is also helping the housing side of things.

Simply put, Bernanke and Co. are targeting household wealth as a way to combat consumer debt levels in the hope they will begin to borrow again and spend. This is a primary reason I believe the economic expansion will be relatively shallow and short in duration – this approach will cause other problems for the economy over the next 12-18 months, the reduction of household credit must take place. Those who expect the normal business-cycle expansion, which have lasted between six and 10 years over the previous quarter century, are fairly removed from reality in my opinion. In addition, current policy works as an assault on the dollar and no society has devalued their way to prosperity. We won’t be the first.

It would be much better for the Fed to keep some of their programs in place, programs that ease the adverse effects of declining loan activity, but get rates to a more appropriate level – uh, something above zero at least as this only causes investors to improperly assess risk in their hunt for yield. We saw this result from their 2002-2005 policy mistakes and it is happening again. And the QE aspect of the easing campaign must come to an end, they should have never gone down this road. Now to take it away will cause even more harm as the market has come to expect it, adjusting price levels to the Fed’s bond purchases.

Where the problem of a lackluster economy should be aggressively addressed is through tax policy. (And no, the current tax-rate policy did not fail. How does allowing people to keep more of their income, leaving more capital within the resource-allocating private sector and incentivizing business to engage in productivity-enhancing capital expenditures hurt the economy? It was a careless Fed that provided the oxygen for an over-leveraged system. That over-levered state of things is what got us here to begin with. The Fed is one of the primary origins of the crisis, yet they escape much of the criticism.) The correct response, going back to the Bush Administration in 2008, should have been to slash income, capital, dividend, and corporate tax rates. This would have likely placed a higher floor on equity prices and corporate profits, and just as importantly put disposable income on a more beneficial path.

In addition, they should have made permanent the very successful program of higher current-year write-down allowance and bonus depreciation schedules. This is the most powerful way to get businesses to spend, and it is also a huge job creator as the plant and equipment orders spur employment.

But we failed to take this path, instead deciding to go down a road that is reminiscent of the policy decisions that caused havoc for economic well-being in the past – a combination of decisions, some that mirror steps taken in the 1930s and some that are similar to policies of the 1970s. As a result, expectations must be pared and a heightened level of caution is appropriate.

This is the world we are currently in and it is best to recognize it even as the stock market goes on a tear.


Have a great day!


Brent Vondera, Senior Analyst

BTU, ACI, DGX, repo agreements

S&P 500: +7.00 (+0.66%)

It appears that yesterday was just a pause because today markets resumed trekking higher. Meanwhile, the U.S. dollar weakened to nearly a 12-month low, which sent commodities and related investments higher.

A weaker U.S. dollar is great news for gold, commodities, resource-based economies (like Australia or Canada), basic material stocks, and U.S. large cap stocks with large proportions of revenue derived from overseas.

It’s worth making note of the first quick hit, which discusses the Fed’s use of reverse repurchase (repo) agreements. Repo agreements would involve the Fed issuing collateralized short-term debt that third-parties could purchase. The Fed hopes repo agreements will help soak up some of the excess liquidity in the system.

Peabody Energy (BTU) gained 5.34% following an upgrade from Citigroup. The upgrade came on the expectation for higher prices for coking coal (used in making steel) as global steel production rebounds and supply lags. Demand for U.S. thermal coal continues to wane due to demand for substitute forms of energy and a drop in industrialized power; however the Citigroup analyst anticipates an improvement in U.S. thermal coal demand in 2010. Other coal companies gained including Arch Coal (ACI) jumping 4.28%.

Quest Diagnostics finished 3.36% higher as Moody’s Investors sServices raised its rating outlook on the diagnostic-testing companies. Moody’s attributed the change to DGX’s better-than-expected results in recent quarters, as well as its higher margins and continued improvement of its financial leverage since its 2007 acquisition of AmeriPath. Quest’s ratings were also affected by its aggressive approach toward acquisitions and continued share repurchases.


Quick Hits

• Fed Is Said to Starts Talks With Dealers on Using Reverse Repo Agreements
• Budget Chief Orszag Sees Health-Care Legislation Passing Within Six Weeks
  
  

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Peter Lazaroff, Investment Analyst

Daily Insight

The broad U.S. market followed most international bourses lower on Monday, but the NASDAQ Composite bucked the trend as the Dell acquisition of Perot Systems increased the belief that M&A activity will jump next year. An increased likelihood of acquisitions, or at least the perception that M&A activity will rebound in 2010, is one factor that helps to push stock prices higher as purchases generally occur at levels that are well-above normal valuations.

The Dow struggled along with the S&P 500 to fight back to the plus side; it made two attempts to get back to the opening price, but failed.

For the past four weekends the financial press has run pieces suggesting that stocks have gotten ahead of economic prospects, but these articles had zero effect on investor sentiment over the last three Mondays. The fourth time seemed to have some influence on things, at least for one day. That said, yesterday’s decline was mild and the market continues to show remarkable resilience as the degree of decline in futures trading (pre-market open) suggested the broad market would get hit by 2%-3%.

There is no doubt the market will pullback though after a run of this magnitude, even if it is from a very very low level. This has been what I’ve tried to prepare people for over the past couple of months – it’s too much about momentum and too little about fundamentals, which have been overshot. The more we run to the upside, the deeper the correction will be. There still seems to be a lot of money waiting for a pullback to get back in. This means the first pullback may be a mild 5%-10% move, at which point we’ll test the recent highs again. But the following pullback, which may result from a failure to meet expectations (bottom line growth failing to meet the expected timeline, home sales and consumer activity rolling over again, continued bank issues via commercial real estate and consumer default rates, and the opening of Pandora’s box from too much government involvement) is likely to be more pronounced – this is inevitable after a run of this magnitude if history is any guide.

Naturally, as has become the trend, the dollar rallied on a down market day as the greenback has only the safety trade going for it. Under normal circumstances, the USD would trend higher with a rising stock market or improved economic growth prospects. This is not the case these days and it’s not a good sign for old green. It will take much higher interest rates to get our currency moving in the right direction again, and that won’t be good for economy, one of the main reasons I do not expect the economic upturn to be long-lasting – there is a lot of stimulus that will have to be removed.

Financial, energy and basic material shares led the losses. Lower commodity prices put pressure on the latter two sectors, while financials were led lower by shares of American Express.

Volume returned to its weak-is-normal ways of the past few months as just 1.1 billion shares traded on the Big Board – that’s in line with the three-month trend but about 13% lower than the six-month average.

Market Activity for September 21, 2009
Treasury Auctions

We’ve got another record week of government debt issuance coming with $112 billion of 2, 5 and 7-year note auctions. Demand remains strong, although we have seen some decline in the level of purchases from the Chinese. Still, based on the mere size, these auctions have resulted in a higher level of anxiety than is generally the case.

At some point the music is going to stop, investors and governments will eventually demand higher interest rates to continue to absorb this level of issuance. And China (and it’s hardly one sided as the Chinese are more dependent upon us than we are on them) can always send shockwaves throughout the bond market by sitting out an auction or two. As we get into 2010 some trouble may arise in the bond market as we will issue another couple trillion dollars in public debt and the inflation gauges begin to show the inflation picture is not as benign as many currently believe.

To expand on the parenthetical statement, China cannot allow their currency to substantially increase in value as this will hurt their vital export market. Thus, they must continue to buy dollar-denominated assets. To this same point, their export markets need the U.S. consumer and if U.S. interest rates go higher this makes life even more difficult on consumer activity – that doesn’t help the Chinese much now does it. But the Chinese cannot be expected to buy dollars to the degree they have in the past. If this occurs, rates will begin to creep higher, especially once the Fed stops manipulating the bond market with their quantitative easing campaign.

The bond market is much larger than just Chinese buying though, whichever direction that government takes with regard to their dollar exposure. You cannot expect interest rates to remain at these levels for a prolonged period. Even a move to 5.5%-6.0% on the 10-year (hardly close to the super elevated rates of the very early 1980s and lower even than the 8% hit on the 10-year in 1995) will make things difficult for the economy considering the state of things. What’s more, it will exacerbate a number of things coming down the pike, such as $500 billion in IO (interest-only mortgages) resets scheduled for 2010-2011. Higher interest rates will make this reality intensely harsh for the banking industry to endure as they deal with commercial real estate defaults too.

The most troubled areas of the economy are currently being propped up by short-term policy decisions, and as these policy crutches that currently support growth are removed (whenever that may be) they will turn from support to something that more closely resembles an Andrew Jackson wielding his hickory cane and begins to beat the economy with a vengeance. While this may be a little bit farther down the road than most economic commentators seem to be willing to look, it’s careless to ignore.

LEI Index

The index of Leading Economic Indicators rose 0.6% for August, marking the fifth-straight monthly increase, which is the most since 2004. (Prior to this rebound in LEI it had declined for 20-straight months, the longest stretch since the 1970s). This is signaling the recovery is under way, and indeed activity has increased from the depths of the previous three quarters. But as implied above, the concern is that we’ll fail to enjoy the normal business-cycle upturn – the duration and sustainability of this move is a big question

As we touched on yesterday, and when talking about the previous LEI release for that matter, people need to be careful not to put too much into this indicator as it is being driven by stock prices, cash for clunkers (CFC) and the Fed’s zero-interest rate policy, rather than an economy that is rebounding on its own. Stock prices, the pace of supplier deliveries and an aggressively sloped yield curve (short-term rates much lower than the long end of the curve), all components of LEI, were by far the main drivers for August. Here are some things to think about regarding these components.

Stock prices are not always the best leading indicator, and this time it is especially suspect as one must acknowledge the possibility that Fed interest-rate policy is goosing the market (this enables banks to borrow at zero and lend much higher, leading to strong interest income – those profits then move to the stock market).

This aggressive positive slope of the yield curve, the spread between two-year Treasury yields and that of the 10-year, currently sits very near record wides. This steep slope, as the Fed keeps short-term rates near zero, was the second biggest contributor to LEI – this situation cannot last

And finally, the pace of supplier deliveries (slower deliveries means this segment adds to LEI as it suggest suppliers cannot keep up with orders) clearly got a boost from CFC and the 700,000 vehicle sales in July and August. This clunker-cash program has now ended and we’re seeing the regional factory readings that are out for September show supplier deliveries have sped up again, which suggest orders have slowed.



Have a great day!


Brent Vondera, Senior Analyst

DELL, WMT, GE, AMGN, CERN, QSII

S&P 500: -3.64 (-0.34%)

A bit of profit taking occurred today amid light volume on speculation that markets have rallied too quickly. Not much has changed except that investors seem more aware of the market’s vulnerabilities. News outlets are littered with stories suggesting markets have gotten ahead of themselves and that rallies like this most recent one have little staying power. I expressed similar concerns last week.


Dell (DELL) declined 4.07% after the company announced the $3.9 billion acquisition of Perot Systems Corp.

Wal-Mart Stores (WMT) gained 1.6%, the biggest gain in the Dow average, after HSBC initiated coverage of the world’s largest retailer at “overweight,” citing its expansion in emerging markets.

General Electric (GE) rose 1.58%, the second-biggest gain in the Dow average, after Morgan Stanley raised its GE’s target price to $19, citing an improvement in the company’s risk profile. (See quick hit below.)

Amgen (AMGN) finished 2.48% higher following positive test results for it’s bone-strengthening drug, denosumab.

Cerner (CERN) and Quality Systems (QSII) both gained more than 4% as it becomes increasingly clear that electronic medical records will be part of the U.S. health reform efforts.


Quick Hits

• Ratings Downgrade
• GE: ‘Not Just About Credit Anymore’
• IMF: Securitization Is Necessary, but Must Be Reformed
• Economy on upswing, durability and sustainability in doubt
  
  

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Peter Lazaroff, Investment Analyst

Daily Insight

U.S stocks moved higher on Friday after Thursday’ respite from the up, up and away trend of the past two months. This latest leg of what has been an amazing seven-month rally off of the damnable March lows has seen the broad market surge 22% in just 10 weeks. Analysts’ upgrades of consumer discretionary, energy and tech shares sparked Friday’s advance – funny how these upgrades come out of the woodwork after massive upswings; their absence when the market tanked and valuations were much more attractive is telling.

Market activity was mild even as the third Friday of September (and true for March, June and December as well) brings quadruple witching, the expiration of stock-index and single-stock futures and options. This usually makes for pretty large swings at different parts of the session, but not so on Friday, not by today’s measures anyway.

Volume, as a result of these expirations, was the strongest since late June as 2.22 billion shares traded on the NYSE Composite, 66% more than the six-month daily average.

For the week, the S&P 500 gained 2.45%; the Dow Average added 2.24%; and the NASDAQ Composite rose 2.50%. Mid cap stocks, as measured by the S&P 400, rallied 3.26% on the week and the Russell 2000 (small cap stocks) jumped 4.09% -- smalls by this measure have soared 80% since early March.

Market Activity for September 18, 2009
More “Fixes” to Come

Regulators are working on rules that would require bank-company policies that set pay for employees to receive Federal Reserve approval in an attempt to reign in risk taking. This means for the first time in U.S. history the Fed could reject any compensation decisions that heretofore were up to the boards and executives. The topic of compensation decisions having to abide by government approval isn’t new, we’ve all heard of the “pay czar” for some time. But having to get Fed approval is a new one, as the degree and scope – previously regulators were focused on just the largest 25 banks and the top executives – has increased to include all banks and most employees.

You see the irony here. The focus is to set compensation in a way that does not incentivize excessive risk taking, but it is exactly Fed policy that encouraged excessive risk taking, as it will do again with the Fed’s current zero-rate stance. Yet policy makers want to put this same Fed in charge of even more oversight.

And digressing for a moment, what sort of compensation is it that can exactly keep top trading/investment banking talent from engaging in shorter-term actions while also allowing firms to hold onto that talent? Will traders have to now wait five years to find out if their strategies continue to hold up in order to get paid? Will their best employees stick around even as their strategies funnel into big profits for the firm, yet are not promptly compensated for this contribution? I doubt it. Then you have places like Hong Kong where such regulations on salaries and bonuses will be shunned. The areas of the globe that refrain from this policy will magnetize the best talent. This used to be what the U.S. was all about.

But back to the focus on the Fed, they continue to escape criticism while the industry absorbs all of the blame. What exactly are firms supposed to do when the Fed pushes real short-term rates below zero (fed funds below the rate of inflation) for three full years? This encourages leverage, and you can be sure to see more of it, just as we had. If the Fed would concentrate on getting policy right instead of taking on more jobs (many of which they have zero experience in implementing) I don’t think we’d be talking about any of this in the first place; the over-leveraged state of financial institutions and the market meltdown would not have occurred. Alas, we’re headed in a very different direction.

In addition, the regulators are looking at increasing capital requirements within the banking industry. Probably not a bad idea, but if policymakers want credit to start flowing a bit (currently it is declining), well they better watch their timing of these stricter standards. Again though, so long as the Fed gets its policy largely right you don’t have much of a problem. If very easy money policy remains in play for an extended period this go around (which seems likely), regulations have no chance at efficacy as banks simply move more leveraged positions off of the balance sheet to escape oversight – exactly what happened during the previous few years.

Indeed this is occurring again. I see that Barclays is about to engage in some window-dressing by deciding to move some of their riskier assets to a hedge fund – oh, and they’ll provide a loan for the hedge fund to “purchase” and manage these assets. (Here we go again.) There are two primary reasons for this move:

1. Barclays knows more trouble is coming and they want to get these assets off of the balance sheet so they don’t have to mark them and take a hit to their capital ratios.


2. They see the stricter capital standards coming that would force them to raise funds because of the nature of these riskier assets.
   

Neither one is a particularly good sign.

The Week’s Data

We were without an economic release on Friday but get back to it today with the LEI (Leading Economic Indicators) index for August – although this has been a deceiving indicator of late as the government’s prop job of the bond, housing and stock markets (the aggressively sloped yield curve, rebound in housing starts and surging stock prices have been the main contributors) is juicing this data set.

Later in the week we get more important things like the FOMC meeting (there will be no surprise by way of policy decisions as they will keep monetary pedal floored, but we’ll be waiting for their comments), the weekly jobless claims reading, both existing and new home sales and consumer confidence readings.

To touch on a couple of these releases:

Initial Jobless Claims
Market participants will be watching to see if initial claims can hold below the 550K level (came in at 545K in the latest week). The last time we were below 550K was in the week ended July 10, which was another period in which a holiday distorted the data (Labor Day holiday may have affected the latest reading). If we can hold below this mark, and then make progress toward sub-500K, it will offer a strong sign we can get to monthly job losses in a the range of 80K-100K in pretty quick order – while still job losses, these are statistically insignificant levels.

Durable Goods Orders (August)
It will be important to build upon the strong 5.1% increase seen in July, and we should get it as once again the data may be driven by auto assemblies. We’ll need to see this data get some boost from business spending (capital equipment and software expenditures), which heretofore has been AWOL.

Home Sales (both existing and new homes for August)
The data for August will very likely continue to build on the nice trend we’ve seen over the past couple of months as very low interest rates and the first-time homebuyers’ tax credit has helped to offset the damage done by a weak labor market. For obvious reasons, the market has been acutely focused on these number, but the readings near the end of the year will be the more important figures to watch as there’s an outsized chance home sales will roll over again as the tax credit expires. (Even if Congress extends the credit for another six months to a year, which is probably inevitable, there will be some break in the continuum. Also, we shouldn’t forget that the past three months are historically the strongest for home sales so there will be some easing simply from a seasonal perspective.)


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Without any economic data on Friday, dealers concentrated on building concessions ahead of this week’s supply. Yields traded higher during four of the five sessions last week, but thanks to Thursday’s rally in Treasuries, yields were only slightly higher for the week. The yield on the two-year rose 8.8 bps last week to finish at .992% while the ten-year yield was higher by 11.6 bps to yield 3.463% after Friday’s session.

The Fed statement that we will receive on Wednesday is the talk of the market this week as traders wait for how they balance comments on the economic recovery with those justifying the continuation of current monetary policy. As I said in Thursday’s write up, there is no real possibility of a rate change this time around, but the chances improve as we move toward Q2 2010.


Cliff J. Reynolds Jr., Investment Analyst