Daily Insight

U.S. stocks slid on the first trading session of the fourth quarter after the latest manufacturing report missed estimates, initial jobless claims rose and everyone awaits this morning’s jobs report. The pressure mounted as we headed for the close; the Dow, for instance, fell another 70 points in the final 15 minutes of the session. Not a good sign, but one can’t make too much of one day’s activity, especially after the run we’ve seen.

All major S&P 500 sectors declined, led by financials as the main index that tracks these shares slipped 4.38%. Basic material, tech, energy and industrials also took it on the chin. The relative winner was consumer staples, down just 0.94%.

The manufacturing report seemed to have the most effect on activity, the major indices fell from the opening bell, but the slide didn’t begin in earnest until after that ISM report was released – the market was expecting at least some cash for clunker-related improvement, but instead the rate of growth declined relative to August’s reading.

And then we have that all-important jobs report this morning, which was already in the back of traders’ minds. The increase in jobless claims, and the continued run up in emergency unemployment benefits (showing clear as day that traditional benefits continue to run out as employers remain unwilling to hire – which isn’t much of a surprise at this point of the cycle but expectations were prematurely optimistic) just added another reason for traders to take some off the table. Whether a significant correction has arrived or not will all depend upon this morning’s jobs report. If it comes out better-than-expected, the market will likely catch a bid, if not it could get a little ugly – this is pivotal data.

Decliners smoked advancers by a 17-to-1 margin on the NYSE Composite. Some 1.55 billion shares traded, roughly 20% above the six-month average.

Market Activity for October 1, 2009
Initial Jobless Claims

The Labor Department reported that initial jobless claims remain unhelpfully sticky. Initial claims rose 17,000 to 551,000 in the week ended September 26. So we’re back to the 550K handle after falling to 534,000 in the week prior.

The four week average of initial claims fell to 548,000 from 554,000. This is the first move below 550K for the four-week average since the first week of 2009, but it’s only because of the prior week’s move to 534K, which seems to be a result of some distortion since the rest of the month hovered around 550. What we need is for this reading to plunge through 500K, which is still and elevated historical reading but at least it would provide some evidence of additional improvement.

Continuing Claims fell 70,000 to 6.09 million. This followed a very nice decline of 105,000 in the prior week. Still, it is difficult to get excited about this move because we have all of these benefit extensions in play. Fact seems to be, the decline in continuing claims is merely a function of benefits running out rather than some form of job creation. All that has occurred is that unemployed are being moved from the traditional continuing claims reading to the extended benefits and emergency unemployment benefits (EUC) rolls. (Most of those who extinguish their traditional 26 weeks of unemployment benefits can then move to the extended benefits rolls – another 13 weeks of benefits – and then onto the EUC – which provides another 20 weeks after that for 59 weeks total. Whoa!)

Extended benefits rose 4,650 to another new high of 443,000 and EUC jumped 99,832 (notice this is more than the decline in traditional cont.claims and thus more than offsets that decline) to another new high of 3.275 million. So, continuing claims haven’t really fallen as much as it appears from the Mt Everest peak of 6.90 million as they remain at 6.42 million when you add in the extensions.


Personal Income and Spending

The Commerce Department reported that personal incomes rose 0.2% in August (up $19.3 billion), following an upwardly revised 0.2% increase for July. The increase was driven by a 0.2% rise in both the wage & salary (w&s) and compensation components – both remain down sharply over the past year, w&s is down 4.3% and compensation is off by 5.2%.

A 2.1% rise in the rental component also helped, although this isn’t one of the larger components. Transfer payments are back again, up 0.6% in both of the past two months after a significant 5.4% decline back in June; the rise in government social benefits equaled the gain in the largest private sector gauges (w&s and compensation).

The $12 billion increase in social benefits nearly offset the $15 billion decline in personal income from assets – interest income fell 0.5%, or $6.4 billion and dividend income slid 1.8%, or $9.3 billion.

On the spending side, expenditures jumped 1.3% for August (a 1.1% increase was expected), driven by the clunker-cash program. This marks the largest monthly spending increase since a 2.8% surge in October 2001 as auto dealers offered zero percent interest and the figure rebounded from a large decline in spending due to the 9/11 attacks.

Spending was strong across the board, though, as back-to-school purchases, helped by a sales tax holiday in most states, also brought consumers into stores. We’ll see what happens from here as CFC and sales tax holidays are no longer with us and consumers still need to deal with a 26-year high jobless rates along with high debt burdens that must be managed. (Last night we got the vehicle sales numbers for September showing activity plunged back to pre-CFC levels)

The inflation gauge that accompanies this report rose 0.3% for the month, so on a price-adjusted basis spending was up 1.0% in August and income fell 0.1%

In terms of future consumer activity, the figures will very likely be weighed down by a cash savings rate that must level out at at least 5-6%, and may bounce to something closer to 8% with other savings vehicles lower -- stocks still 32% off of their peaks and home prices down 20% from their apex. The fact that spending outpaced income by seven-fold in August means the cash savings repair has exhibited a setback falling to 3.0% from 4.0% in July. And, this means a sustained expansion in personal consumption, the largest component of GDP, will be delayed.

The cash savings rate made great progress last spring, jumping to 5.9% in May from less than 2% in late 2008. This came at the expense of much lower spending figures that weighed heavily on GDP, but this was simply a fact of life with the plunge in payrolls and stock and home prices.

Even with the strong rebound in stocks, the fact that cash savings must go up and debt burdens must go down is a reality the economy still needs to deal with. As a result of high debt levels and tighter credit standards, we cannot rely on increasing consumer borrowing levels to elevate us out of this contraction. When the bulk of the government stimulus plays out and the inventory dynamics runs its course (say six months out) we will still be stuck repairing household balance sheets and this will keep consumer activity bogged down.

ISM Manufacturing

The Institute for Supply Management reported that its manufacturing index showed the rate of growth slowed in September, but remained in expansion mode. The ISM manufacturing reading came in at 52.6 after printing 52.9 in August – a reading above 50 marks expansion. The consensus estimate was 54.0.

Many sub-indices declined relative to the previous month’s reading, but remained in expansion territory. The production index fell to 55.7 from 61.9; the new orders index fell to 60.8 from 64.9 (still a nice reading); export orders fell to 55.0 from 55.5.

The backlog of orders rose to 53.5 from 52.5 and supplier deliveries rose to 58.0 from 57.1 – this is a key indicator as a higher reading means that deliveries have slowed, meaning suppliers are having trouble keeping up with stronger orders. The inventory reading jumped 8.1 points to 42.5. This is a really nice move, still contracting, but the change is helpful. (This gain in inventories helped to offset the easing among other indices).

The employment index remained pretty much unchanged, down just slightly to 46.2 from 46.4.

This is a pretty good report, especially after the Chicago factory survey gave some people a scare when it moved back to contraction mode, but most analysts/economists were expecting more of a boost from the CFC program and the August back-to-school and sales tax holiday.

Construction Spending

Construction spending rose 0.8% in August after three months of large declines – the figure fell at a 14.35% annual rate over that period. The August increase was fueled by a 4.2% bounce back in residential construction. Commercial construction fell for a fourth-straight month, down 0.4% for August.

Pending Home Sales

The National Association of Realtors (NAR) reported that pending home sales (contract signings) jumped 6.4% in August after a 3.2% rise in July. This is a huge move and likely reflects the rush to close on contracts by the tax credit deadline of November 30. The pending home data from here should move lower as purchases have been pushed forward to get the $8,000 offset to taxes owed for 2009 – and since this is a “refundable” tax credit, if a first-time homebuyer doesn’t have $8,000 in federal income tax liabilities then they will receive a spiffy check from the IRS.

Pending home sales were driven by a 16.0% jump in the West region, California offers an additional tax credit for those buying a new home (as opposed to an existing structure) and this is also where most of the foreclosure-driven price declines have occurred, two main catalysts for sales in the region. Pending sales rose 8.2% in the Northeast, 3.1% in the Midwest and 0.8% in the South.

A cautionary note on this data: NAR’s chief economist stated that contracts are not closing because of complex new appraisal rules and that there has also been some double-counting -- buyers whose contracts were cancelled then sign a new contract after finding a different home. So, this pending home data may be overstating the boost that would result in existing home sales (existing home sales are counted when a contract closes).


Have a great day!


Brent Vondera, Senior Analyst

September 2009 Recap

Many investors fretted about September based on its historical record, but the S&P 500 managed its seventh con­secutive monthly gain. Growth continues to outperform Value due to the technology sector, which has been viewed positively through­out the recession thanks pristine balance sheets and historically low inventory levels. Following a sluggish August, Emerging Markets topped all asset classes this month with a gain of 10.2%. Close behind was the Pacific ex-Japan region, which returned 9.69% on the month. Treasury yields held within a tight range and ended the month slightly lower, while credit spreads improved to make corporate bonds the best performing sector in fixed income.

Good news continues to be magnified while bad news is ignored – a drastic change from the beginning of the year. Meanwhile, sell-side analysts are busy raising index targets to catch up to the market level and explaining why they aren’t selling as their existing targets have been reached. With incredible amounts of liquidity sloshing about global markets, the Fed announced plans to slowly pull back on a number of its liquidity programs. The Fed’s purchases of Treasurys are set to end in October and the buying of mortgage and agency debt will cease at the end of the first quarter of 2010. The pull back by the Fed is calming to inflation hawks, but caution still reigns as the economy is weaned off of government support.

There is no denying that this has been a rally of market sentiment rather than pure fundamentals. The one posi­tive factor is the investing community’s reluctance to embrace the rally energetically – inflows into bond funds have been staggering, but those into equity funds have been tepid. When the masses are positioned for a sell-off, it means there’s a lot of ammunition for a rally if the market doesn’t cooperate. The fact of the matter is that investors are more worried today about missing money-making opportunities than about risking any invested capital. It is difficult, however, to ignore the increasingly convincing bear case and we seem well overdue for a pullback. Of course, the market has a history of remaining overvalued for extended periods of time and it is impossible to determine when this turning point might be.

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks failed to close higher on the final session of the second-best quarter in a decade as an unexpected drop in Chicago PMI (factory activity for the region) killed early-session excitement. The reading came in well-below expectations and would have resulted in a significant sell-off in most situations, but not in this market environment.

The broad market vacillated wildly (at least relative to how chilled out volatility has become). Stocks rallied at the open, then retreated 1.6% following that Chicago PMI reading, bounced back to the flat line with just an hour left, slid again and looked headed for session lows, only to rally again in the final minutes – wasn’t enough to get back to the opening price though . This activity was like watching a buy-on-the-dips strategy all packed into one session – the scamper from mutual fund managers to window dress for quarter-end reports went right to the last minute.

The market was also buoyed by Federal Reserve Vice Chairman Kohn’s comments that dispelled opinions from a number of FOMC/Fed members over the past week suggesting the central bank will have to reverse policy in an aggressive manner and possibly sooner than many expect. Kohn explained that the Fed will hold its Keynesian models close to its chest, meaning they are very unlikely to raise rates while the unemployment rate remains elevated. (If the Fed couldn’t raise rates in early 2004 when the unemployment rate moved below 6%, it seems quite difficult to belief they’ll reverse policy when the jobless rate sits in the 8-10% range.) Kohn reminded everyone that the facts on the ground is the FOMC statement, and that statement explains that the Fed will keep fed funds at exceptionally low levels for an extended period. This was the beat down statement to the various Fed officials who have recently stated otherwise. This may be the most confused and conflicted FOMC/Fed in at least 30 years. I’m not an expert on this history, but I know a few things and don’t think this view is a stretch.

The market loves very low interest rates. Despite the fact that the Fed appears to be in disarray, traders only care about the here and now, and for now Fed policy will continue to support the market until a major economic data release, lack of final demand keeps corporate revenues in the tank, or geopolitical development scares the market into correction mode.

For the quarter, the S&P 500 and Dow Average both jumped 14.9%. The NASDAQ Composite gained 15.6%. Mid cap stocks, as measured by the S&P 400 climbed 19.5% and small caps, as measured by the Russell 2000, were up 18.8%.

By sector, financial, commodity-related basic material and industrial shares were the top performers during the third quarter. Financials led the way, for a second straight quarter now, as the index that tracks these shares surged 25%. This group was by far the most beaten down during the height of the credit crisis and still has another 158% to climb back to 2007 highs. Both basic material and industrial shares jumped 21% for the quarter. Industrials still have 61% to go to get back to the high. Basic materials need to jump 50% to climb back to the all-time high.

The laggards for the quarter were utilities (up 5.2%) and telecoms (up 4.2%).

Volume was strong, a rarity for the past three months, as 1.7 billion shares traded on the Big Board – that’s 30% above the six-month average.

Market Activity for September 30, 2009
Energy Report

The Energy Department’s weekly report showed gasoline stockpiles unexpectedly fell 1.66 million barrels last week, a rise of 1 million barrels was expected. While crude inventories didn’t only rise, but rose more than expected – up 2.8 million barrels, a rise of 2 million was expected -- oil prices still rallied 5% to close at $70.25/barrel (retreated to $66 over the previous few sessions) as the decline in gasoline inventories supported the view that oil demand will rise to replenish refined product.

Mortgage Applications

The Mortgage Bankers Association’ s index of application activity fell 2.8% in the week ended September 25, following a strong 12.8% rise in the prior week. Applications to purchase a home fell 6.2% after a 5.6% increase in the week ended September 18 and refinancing activity was essentially flat – down 0.8% -- after a 17.4% surge in the prior week.

The fixed-rate 30-year mortgage remained in the sub-5.00% sweet spot, yet applications to purchase a home couldn’t string back-to-back gains. Is this a sign that sales were pushed forward due to the tax credit – those who applied for a mortgage in the week of September 25 are cutting it close to the meet the closing date deadline of November 30 to capture that credit. Even if the tax credit is extended, and I certainly wouldn’t bet against it, it won’t be a continuous extension and sales will show some weakness again as a result.

ADP Employment Report

The preliminary employment report out of business outsourcing solutions firm ADP had payrolls decreasing 254,000 for September – the expectation was for this reading to come in at -200K, which is roughly the same estimate for the official jobs report that will be released on Friday.

If this number is accurate in predicting the official reading, which was not the case for August but ADP had been accurate in the previous few months, it means we continue to show improvement from the outsized monthly job losses of a few months back. Still, a number above 200K in payroll declines is elevated from a historical perspective. The job losses remain above the average of the 1981-82 recession (avg. -185K in monthly losses), above the 1990-91 recession (avg. -147K) and above the 2001 downturn (avg. -173K). So improvement, yes, but still very weak.

ADP estimates that service-providing industries shed 103,000, which would be worse than the 80,000 actually cut in August. They estimated that goods-producing industries cut 151,000 positions – 136,000 were actually cut in August, according to the Labor Department’s official data.

Large firms (500-plus employees) cut 61,000 positions in September, as estimated by ADP. This is right in line with August’s 57,000 reduction in payrolls. Medium-sized firms cut 93,000 positions, a 13,000 improvement from August. Small firms (1-49 employees, and the main job creation engine of our economy) reduced payrolls by 100,000, which was better than the 114,000 decline in August, as estimated by ADP.

Final Revision to Q2 GDP

The Commerce Department reported second-quarter gross domestic product fell less than initially estimated, down 0.7% at a real annual rate vs. the 1.0% decline printed from the first revision. The main reason for the improvement was a slight upward revision to personal consumption and business equipment and software. Personal consumption, the largest component of GDP, fell 0.9%, not the 1.0% reported via the first revision. Business equipment and software spending dragged GDP lower by just 0.32% vs. the 0.56% previously reported.

So, the four-quarter contraction, the longest stretch of GDP decline in the post-WWII era ended on a sweeter note than previously thought. The current quarter will post a gain, likely to come in at at least +2.5% and maybe as high as 3.5%, but I’m skeptical of that higher number occurring even with the cash of clunkers-driven boost to auto sales and inventories.

We’ll then probably see a larger jump in economic activity in the fourth quarter as the inventory dynamic will take full effect, but final demand is likely to remain weak as result of continued job losses and a heavy debt burden; the government stimulus spending will not be able to fully offset this drag.

As a result of this reality, which will take time to work through, along with pressure from the reversal of monetary easing, higher tax rates, increased regulations, et al. in the near future this expansion will look nothing like the normal 6-10 year run we have become accustomed to over the past quarter century. No, this one will be different both in degree and duration. In degree, typically coming out of a huge economic contraction we see GDP bounce back as a 6%-8% rate – I think we’ll be lucky to see 4% this time. In duration, I don’t believe more than a four-quarter recovery is possible considering the headwinds we face.

Chicago Purchasing Managers Index

The Chicago PMI (a gauge of factory activity for the largest manufacturing region in the country) unexpectedly fell back to contraction mode in September. The reading declined to 46.1 from hitting the line of demarcation between expansion and contraction (which is 50.0) in August. Expectations were for additional progress – a reading of 52.0.

This is a major setback for the camp that believes we’re on the cusp of a serious expansion and shows that firms remain unwilling to rebuild stockpiles and buy capital equipment as concerns regarding a lack of final demand weigh heavily on the minds of decision makers.

All sub-indices of the index slid back to contraction mode, with the exception being the prices paid component – it accelerated. The forward-looking new orders and supplier deliveries readings fell to 47.2 and 49.3, respectively after hitting expansion territory in August. Order backlogs got clocked, falling to 36.7 from 45.8. Inventories picked up, rising to 38.9 from 27.5 (which was just slightly above the all-time low of 25.4 hit in June).

Everyone, including myself expected the clunker-driven auto assemblies to have a two-three month positive effect on Chicago PMI, only then to fall back again by the end of 2009/early 2010. . If the hangover has begun already, the CFC binge-drinking event was even more worthless than suspected.

Tomorrow we get the national look at factory activity via the ISM reading. This measure will combine the results from all regional manufacturing surveys and the market expects it to accelerate further into expansion mode for September. If it does, it will be the first time in the data’s history, which goes back to 1968, in which ISM posted two months above 50 without Chicago doing the same. If ISM does remain above 50, it will be because of the export component, which Chicago PMI does not include.


Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks slipped on Tuesday as the latest consumer confidence reading unexpectedly declined and tech shares pulled back from a one-year high. The dollar rose for a second day, which put a little pressure on oil prices, sending energy name lower too. All in all though, the broad market’s decline was inconsequential, holding on to almost all of Monday’s strong showing.

Strangely, consumer discretionary shares were the best performing industry, offering the market support. The confidence reading, as we’ll get to below, did not offer a good vibe regarding the direction of consumer activity over the near-term, and frankly the next year, as the jobless rates will remain elevated.

The dollar got decent press yesterday as the Dollar Index posted its first back-to-back rise since early August. It appears some believe recent trends have changed; maybe the dollar has more going for it than just the safety trade. Just maybe stocks and the dollar can rise in tandem, as is usually the case.

Don’t bet on it though. The greenback was supported by lip service, talk coming from the heads of the European Central Bank and World Bank. Just words, and not even from members of our own Fed. No, nothing has changed; the dollar’s rise was only on the hope of supportive policy. Sorry, I wish the dollar would find a little strength, and most importantly stability, but I’m not interested in wishful thinking – it will only bring one trouble in this environment.

Decliners just barely outnumbered those that advanced on the NYSE. Volume was weak again, with just 1.1 billion shares traded on the Big Board, 15% below the six-month average.

Market Activity for September 29, 2009
S&P Case/Shiller Home Price Index

The Case/Shiller Home Price Index, not the most geographically diverse but certainly the most watched housing market survey, showed home prices in the 20 U.S. metro area tracked rose 1.61% in July. This marks the third-straight month of gains, following 33 months of decline. The index remains down 13.3% from the year-ago period – it was expected to decline 14.2%.

L.A., San Diego and San Francisco accounted for 40% of the July price increase – these three cities make up 27.4% of the index. California offers a tax credit for new home purchases that is in addition to the federal tax credit, which has definitely helped sales in the state.

Eighteen of the 20 cities tracked registered an increase in prices, the same as June. Las Vegas and Phoenix were the only cities to show a monthly decline for July, in June it was Vegas and Detroit.

On an annualized basis, home prices have jumped 15.21% over the past three months – this data is not seasonally adjusted so this traditional peak period for home buying has influenced the sales data, and thus prices within Case/Shiller. For perspective, it would take a 43% surge in home prices to return to the peak hit in Case/Shiller, which occurred in July 2006

Foreclosure-driven price declines, a new homebuyer’s tax credit of $8,000 and fed-induced rock-bottom interest rates have helped sales, which have allowed overall housing-market prices to rise from the cycle-low hit in January (the Case/Shiller cycle low was hit in April). Problem is it has front-loaded buying, so the market will have to deal with a decline in sales and a little more pricing pressure in the months ahead. Foreclosure rates are likely to pick up gain, as all state moratoriums on the foreclosure process have expired, and this will put pressure on prices again also.

Below is the individual city break down:


Consumer Confidence

The Conference Board’s consumer confidence reading unexpectedly declined in September, coming in at 53.1 after an upwardly revised 54.5 for August. This missed the expectation for a rise to 57.0.

The fact that we can’t get above even the lowly level of 60 (a level where the index had settled during previous recessions) is quite telling. The drag the largest component of GDP will put on economic growth does not seem to be factored into the market right now.

The present situation index fell to 22.7 from 25.4 – the cycle low is 21.9 touched in March and the all-time low is 15.8, touched in December 1982.

The expectations reading (view of economic prospects six month out) came in at 73.3, down slightly from August’s 73.8 – the cycle low is also the all-time low, 27.3 hit in February.

The most important aspect of this report, in my opinion, is the jobs “plentiful” less jobs “hard to get” figure; this is likely the best indication of future consumer activity trends. This reading fell to -43.6 from -40.0 in August.
The share of consumers stating jobs are plentiful fell to 3.4% from 4.3% and those stating jobs are hard to get increased to 47% from 44.3%

The cycle low is -44.1, which was hit in March. The all-time low for this reading is -58.7, recorded in November 1982 when the unemployment rate hit 10.8% -- the post-WWII peak. We are going to test that number sometime over the next six months.

The reasonable probability that aggregate demand will remain weak (as mentioned yesterday, today’s very aggressive corporate cost-cutting, mostly via payroll slashing, is tomorrow’s lack of final demand) does not seem to be factored into the equity-market valuation equation right now. Rather, particularly regarding the latest leg of this rally, the attraction to stocks seems to more a function of a run for money while the gettin’ is good type of behavior.

If policymakers’ belief in an economic “escape velocity” doesn’t occur – that is, a sufficiently high and sustained level of growth that enables the economy to shed its supportive crutches and keep on running (think of a young Forrest Gump) even as tax and interest rates rise and the government regulates… well, let me say: I wish the market and policymakers luck with that fantasy http://www.youtube.com/watch?v=7_nwbTeIN4Y.

If history is any guide, for policymakers who find it fancy to borrow phrases from Newton, it seems his laws of motion (specifically the third law, “to every action there is always an equal and opposite reaction”) would be more apropos.


Have a great day!


Brent Vondera, Senior Analyst

Walgreen (WAG) shares up 9.24% on earnings

Walgreen (WAG) shares soared as the drugstore chain reported a 7.6% increase in revenues with same-store sales improving 2.4%. Total prescription sales rose 9% and accounted for 66.5% of the firm’s total sales in the quarter. Walgreen’s prescription sales growth follows competitor CVS Caremark’s (CVS) statement in August that it saw no recession in its prescription-drug business. Pharmacies are also expected to benefit from a cold-weather return of the H1N1 virus in the U.S.

In addition to increased pharmacy sales, Walgreen said savings associated with the “Rewiring for Growth” initiative boosted earnings by 17.5%. As part of Walgreen’s “Customer Centric Retailing” initiative, the drugstore chain will start selling beer and wine in a majority of its 7,000 stores. (You can read more about Walgreen’s initiatives in this June post).

The most impactful news is that Walgreen will start offering 90-day prescriptions of maintenance medications to all payers, not just its own pharmacy benefit manger (PBM) customers. This is a direct hit to CVS Caremark’s integrated value proposition and should make it more difficult for CVS to win PBM customers. It’s also bad news for independent PBMs (like Express Scripts) if the market share gains of mail-order pharmacies begin to reverse, and thus eliminate a key component of PBMs’ value proposition to customers. Even more, 90-day retail scripts could serve to accelerate the decline of independent pharmacies to the benefit of large chains, given the increased importance of scale under this model.

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks rallied Monday, breaking a three-session losing streak as investors sidestepped heightened geopolitical risks, focusing on the day’s acquisitions as a reason to bid prices higher. The broad market is in route to its best quarterly performance in 10 years, bouncing 15%-plus for the past two three-month periods. The S&P 500 declined for six straight quarters prior to this surge, falling 48% during that stretch and 57% peak to trough.

The market likes to see firms put money into the market, so gets juiced on the merger and acquisition (M&A) activity from the tech and pharmaceutical industries (the Xerox and Abbott Labs deals). If only this were true for business-equipment spending; there are few things more powerful for job creation than a plant and equipment spending binge. Of course, such activity takes confidence and it appears the business community is just fine with lying low right now.

Many people believe a surge in M&A activity will present itself as firms go hunting for profits as final demand remains weak, cost cutting gets you only so far and firms have slashed to the bone. But today’s degree of cost cutting means tomorrows lack of demand -- if the jobless rate remains at 26-year highs it’s kind of tough to see demand dynamics improving much. I’m not sure firms will go on buying sprees with demand where it is.

Friday’s biggest losers, financial and basic material shares, led Monday’s advance. The traditional safe-havens – health-care, utilities and consumer staples – were the laggards on the session, although they did move higher as well.

Volume was dirt, the lowest level since the holiday weekend of September 4, nearly 30% below six-month daily average.

Market Activity for September 28, 2009
Fed Bank Economic Conditions Gauges

We received two rarely watched business surveys yesterday, readings we generally do not report on but since these were the only two releases yesterday…well, it’s time to talk about them.

The first was the Federal Reserve Banks of Chicago’s national index, which draws on such indicators as industrial production, capacity utilization, the jobless rate, consumer spending and housing starts, to name a few – 85 economic indicators in all. The survey came in at -0.90 for August, only mildly in contraction mode, but the reading was worse than July’s -0.56.

The Chicago Fed stated that they believe a three-month average of greater than 0.20 needs to be achieved following a period of economic contraction to provide a significant likelihood that the recessions has ended. We have yet to see this occur as the three-month average is -1.09. Still, I think it is safe to say that the recession has ended.

The second was a reading out of the Dallas Federal Reserve Bank, which also stated activity continued in contraction mode, but this reading was for September. The trend is looking good though as the chart below illustrates. (This reading is specific to the manufacturing sector)

All sub-indices within the report remained in contraction with the exception of new orders and volume shipments. New orders rose to 8.0 from -1.7 in August. Volume shipments posted 0.3 after a -11.2 in August.

The finished goods reading remained deeply weak though, coming in at -21.3 from -23.2. This indicates the region fails to show improvement in final demand, a topic of concern we’ve had for some time. If final demand doesn’t rebound here these improvements seen in the factory surveys over the past four months are unlikely to continue.

Further, as the other factory gauges have shown, this survey’s prices paid index posted another month in expansion mode – came in at 9.8 after hitting 9.9 in the prior month – while the prices received index recorded another negative reading, -17.9 vs. -21.4 in August. This does not bode well for profit margins.

Failing to Learn from History’s Guide is Unwise

Last week we focused on a new protectionist precedent taking hold in Washington with the Obama Administration’s decision to levy a 35% tariff on Chinese manufactured tires. This action went beyond WTO anti-dumping rules, citing simply that these imports were harming the U.S. tire industry. (I’ll remind everyone that the recent inflow of imported tires was fostered by the CFC program. The auto industry saw annual car sales fall to nine million from 16 million in a matter of one year. As a result, tire plants were idled and when the CFC-driven sales meant vehicle assemblies had to speed up…well, you had to get the tires from somewhere.)

Now, the paper and steel industries have gotten into the mix, yeah they’re being “harmed” by competition too, by lobbying the administration to place tariffs on these imports. You can bet there will be more industries that will do the same.

Further, in a recession, and a labor market that is likely to remain weak for an extended period, it is very easy for the populace to see the “harm” that certain industries endure via intense globalization and trade, while ignoring the benefits society in general enjoys from free trade. This makes a trend of protectionism even more likely; there may be no stopping it until time enough passes to make clear the perils of trade barriers.

The sparks of protectionism can quickly turn into a raging forest fire, this is what history teaches. When one side sets up trade barriers the other side is very quick to counter, this leads global economic activity to deteriorate and obviously does damage to living standards.

Thankfully, there is a higher degree of interdependence within the global economy today (due to freer trade over the past 25 years) and this may keep trade wars at bay longer than has occurred in the past. But that fire will eventually rage if smarter heads do not prevail.

The Market and the Fed

On this day last year the Dow plunged 778 points, or 7%, as Congress failed to pass the TARP. Still, the Dow closed 576 points higher than its current quote. The S&P 500 got nailed by 107 points, or 8.8% -- 43 points higher than yesterday’s close.

I bring this up not because of why the market plunged, but only as a reminder of how volatile things can get. We shouldn’t forget these wild swings because there’s a high likelihood we’ll see more of it over the next several months, likely driven by central bank actions.

As Mohamed El-Erian recently wrote, central bank synchronization is coming to an end. We’ll begin to see some parts of the globe begin to tighten just a bit and this may very well result in another wave of high volatility as global markets begin to reassess things; the equity markets are currently very cozy with the massive easing and liquidity pumping measures of central banks, specifically policy from our own Federal Reserve. (There’s little doubt a main element of the Bernanke strategy is to repair household balance sheets by pumping up the stock market – all of this liquidity must go somewhere as the Fed holds to its zero interest-rate policy, thereby removing the bond and money markets as an alternative to stocks.)

Indeed, we see this occurring already, if only via words for now – in time not to distant this will become action if the current path of fiscal and economic policy doesn’t cause an additional period of significant weakness.

European Central Bank President Trichet was out yesterday harping on the importance of a “strong” dollar. Trichet is worried that the strength of the euro vs the dollar will hurt EU export markets, so that is one reason for his statements on dollar weakness. But when the head of a foreign central bank becomes outspoken about the dollar’s value -- at a time in which our own Fed, the only party that has a monopoly on dollar creation, refuses to even mention the greenback in their meeting statements – you know monetary policy synchronization will soon come to an end.

Trichet, and other central banks, may remain moored to Bernanke’s easy money ways for a while as they fear hiking interest rates will only further strengthen their domestic currencies against the dollar. But it won’t be long before they realize that capital inflows, promoted by sound money policy, will offset the hit to export markets and at that point, if the Fed remains easy for a prolonged period, they’ll separate from the Fed’s hitch. That will send a strong signal that the stock-market pumping activity from the Fed will begin to unwind. The easy-money trade will end in anticipation of this shift; it won’t wait for implementation of the unwind.

(This whole process will result in a major conundrum – to use a Greenspan term – for the Fed. If other central banks begin to raise rates, while our Fed remains near zero, you’re looking at significant dollar weakness even from these levels. But, if the Fed begins to raise rates, then the $500 billion in IO resets coming in 2010-2011, the commercial real estate default rates and overall bank-industry woes become an even larger problem for the economy to handle. This will be very interesting/troubling to watch play out. The Fed has backed itself into a corner and there is no easy way of returning to the center of the ring.)

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

S&P 500: +18.60 (+1.78%)

“Merger Monday” sparked a big rally, with Xerox Corp’s acquisition of Affiliated Computer Services, Abbott Laboratories (ABT) buying Solvay to gain a stronger emerging markets presence, and Johnson & Johnson (JNJ) buying an 18% stake in biotech firm Crucell to develop a universal flu vaccine.

Despite the today’s gains, volume on the NYSE fell to its lowest level in one month, coming in below one billion shares.

The Wall Street Journal ran an article (see abbreviated version here) that said earnings could surprise to the upside, this time as a result of stronger sales rather than cost cutting. Still, the vast majority of columnist and opinion articles floating around carry a negative tone regarding the market rally’s sustainability.

Our concern about the market outpacing fundamentals has been well-documented at this point. The one positive factor, in my mind, is the investing community’s reluctance to embrace the rally energetically. As I said repeatedly, the market has a history of remaining overvalued for extended periods of time and it’s impossible to predict when the market will correct.

While it’s anybody’s guess as to the timing of a pullback – it could be two weeks or two years – there is no denying the bear case is stronger the bull case at this juncture.


Quick Hits

• The rally in financial markets: Liquid fuel
• Can Irrationality Be Rational?

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks fell for a third-straight session, sending the broad market to its worst weekly decline since early July. Since mid-July the S&P 500 has recorded weekly gains of 2.2% or more in six of those 11 weeks. One has to go back to right around the July 4 holiday to see even a meager pullback of 7%; it’s unusual to see a move to the upside we’ve witnessed since early March without a pronounced correction. We will get that correction, there is no way around it and the higher we go without one occurring, the deeper it will be.

The market ran into another slight roadblock as Friday’s weak durable goods orders report and new home sales failed to meet expectations (and the prior month’s reading was revised lower). This data offset an improvement in a consumer confidence survey.

Friday morning’s news out of Iran, confirming that they have a second uranium-enrichment facility, didn’t help investor sentiment either. However, I’ve got to say, the market’s resilience is remarkable. This is big news and yet investors hardly flinched.

One has to assume any chance at sanctions on Iran is off of the table now – even if our Congress is unwilling to admit it. The mullahcracy has cemented a deal with Venezuela to supply the regime with gasoline and it is highly likely that Russia will truck refined product into Tehran simply to put a thorn in our side. Since Iran has very little refining capabilities, this was what many saw as their main non-military weakness, but that has now changed. The options are becoming a heck of a lot more concerning. It seems a lot of people continue to hold out for concrete measures from the UN and G-20 on getting Iran to change course, but only a sucker would expect anything of substance out of these two organizations as China and Russia can block anything that has bite to it.

Basic material, financial and industrial shares led Friday’s decline. Energy and health-care shares were the relative winners, even though they too closed lower.

Market Activity for September 25, 2009
Durable Goods Orders

The Commerce Department reported that durable goods orders fell 2.4% in August (much less than the 0.4% rise that was expected) after the CFC–driven jump of 4.8% in July. Ex-transportation orders, durables printed a big goose egg after rising 0.8% in July.

The headline reading was led lower by transportation orders, which fell 9.3%. Vehicle and parts orders did rise a bit, up 0.4% (although this number was probably expected to be much stronger as most thought vehicle assemblies to be robust after CFC-driven sales). The incredibly volatile commercial aircraft component led the transportation reading lower as this segment plunged 42.2% after surging 98.2% in July.

So this brings us to the ex-trans number, which came in flat -- unchanged. Orders for both primary (cars) and fabricated metals rose 1.9% and 0.8%, respectively. Machinery orders gained 0.7% after a 7.9% drop in July. Computer and electronics and electrical-equipment orders put pressure on ex-trans as these components fell 0.7% and 0.5%, respectively.

The very important business spending reading (technically, non-defense capital goods ex-aircraft) fell 0.4% after a 1.3% decline in July. Businesses remain cautious and will continue this stance so long as an over-bearing government keeps the private sector uneasy.

Shipments of durable goods orders fell 1.4%. This number flows directly to GDP, so it won’t be helpful for the third-quarter reading. And speaking of GDP, it appears that the biggest boost from the inventory dynamic will occur in the fourth quarter, not the current quarter as many had expected.

U of M Confidence

The final reading for September consumer sentiment out of the University of Michigan’s survey showed a three point increase to 73.5 from the initial reading of 70.2 and up from 65.7 for August.

Both the Current Conditions and Economic Outlook (six months out) surveys were revised higher from the preliminary readings. Inflation expectations for the next year fell to 2.2% from 2.8%.

New Home Sales

The Commerce Department reported that new home sales rose 0.7% to 429,000 at an annual rate (a bit below the expectation for a 1.6% rise). By region, sales fell in the Northeast (smallest market for new homes) and Midwest and rose in the South (largest market for new homes) and the West.

The inventory/sales ratio made additional progress, falling to 7.3 months worth (lowest since January 2007) from 7.6 months in July.

The median price of a new home got slammed last month, down 9.5%.

The August number may be beginning to show the signs of the front-loading effect due to the tax credit. I suspect the September reading will begin a trend of falling sales as those who sign a contract struggle to close by November 30 – even if that credit is extended we should see sales decline again as the extension will hardly be perfectly continuous.

Fed’s Eventual Direction

Other big news on Friday was Fed Governor Warsh’s comments via an Op/Ed on how the FOMC will have to aggressively raise rates (much more than is customary) when the time comes, whenever that may be.

We’ve discussed this topic for some time now. It’s pretty simple, based on their extraordinary/ unprecedented level of easing the other side of this will be harsh. This is the main reason no one should expect this expansion to be long-lasting. The crutches that currently support the economy will turn and whip it when they are reversed – combine this with higher tax rates and protectionist policies (pray this doesn’t occur) at the same time and you’re looking at massive economic headwinds.

Futures

Stock-index futures have reversed coarse, after being meaningfully lower early this morning they are now pointing to a higher open. International bourses were supported by electoral victories for Germany’s pro-business government, allowing most overseas indices to pare earlier losses and offering support to the U.S. trading session. M&A activity is also offering support as Xerox stated it will pay $6.4 billion for Affiliated Computer Services and Abbott Labs will buy Solvay’s pharmaceutical unit.

Still, with all of the uncertainties, which have now just increased as we can’t make light of the fact that Israel’s trigger finger just got itchier, one has to be cautious with the market at this level. It seems unwise to increase equity exposure, but that is the tendency when stocks are in rally mode and the impulse to win back losses overtakes common sense.


Have a great day!


Brent Vondera, Senior Analyst