IBM earnings beat estimates, but new business signings slide

IBM beat consensus estimates and raised guidance, but still failed to meet investors’ lofty expectations.

The top and bottom line results revealed IBM’s shifting focus towards software and services from hardware is paying off. Management made specific mention of competitor Oracle (ORCL) when discussing market gains in software. The company also called attention to their reach in the healthcare space, particularly with regard to electronic medical records.

Investors’ main source of concern was the 7% decline in new services business signings – an indicator of future business. The dip in signed service contracts is a clear sign that businesses are delaying spending and purchases. Management said that almost $1 billion worth of contracts were signed during the first two days of October and reminded investors that the company has a $134 billion backlog of already-signed agreements.

Today’s pullback is partially due to the disappointment from those expecting a stronger rebound in demand for IBM’s products, and it is probably warranted considering the run-up following Intel’s earnings. Still, IBM remains a force in the technology space and is well-positioned for long-term growth.

--

Peter J. Lazaroff, Investment Analyst

Harris Corp (HRS) up big after scoring Army contract

Harris Corp (HRS) rose more than 6% after the contractor said it received a $419 million purchase agreement from the U.S. Army to supply advanced tactical radios to combat troops. These radios distribute information in an encrypted form and are used to carry voice-and-data traffic through all government levels up to and including Top Secret classified levels.

The purchase agreement is equal to 8.4% of Harris’ fiscal 2009 revenue.

Following the news, Raymon James analyst Chris Quilty lifted the firm’s rating to “strong buy” from “outperform” and saying the radio “represents a potential multibillion product category for Harris over the next several years.”

We have long felt Harris is undervalued and continues to be one of our favorite defense plays for reasons detailed in this March 24 post.

--

Peter J. Lazaroff, Investment Analyst

GE Capital still weighing down results

General Electric missed revenue estimates and only beat profit expectations because of a tax credit in the company’s financial unit. This is the fifth quarter in a row that GE missed sales estimates, and the third-straight quarter that tax benefits lifted earnings above consensus estimates.

If anyone paid attention earlier this year, I was ga-ga for GE. Today I would argue that GE shares are fairly valued. The industrial conglomerate faces similar problems as the nation’s largest banks – delinquencies on loans to consumers and commercial customers. However, I expect the banks will free themselves from these problems sooner than GE.

This isn’t any reason to run out and sell your GE shares. No, the company’s non-financial businesses still offer strong long-term growth potential. Instead, I’m saying that there is very little reason to be adding to GE at this point – I’d rather buy a real bank.

--

Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks spent most of Thursday’s session in negative territory, but climbed to the plus side late in the afternoon and accelerated to the close. For most of the session energy shares were the only group offering the broad market support, but by the time the closing bell sounded all but two of the 10 major sectors closed higher. Technology and financial shares were the laggards.

Energy shares rallied, by far outperforming the market, as the weekly energy report showed gasoline stockpiles plunged 5.23 million barrels, more than four times the decline expected.

The price of crude for November delivery jumped to $77/barrel and wholesale gasoline extended its four-session increase to close at $1.94/gallon – up 20% over the past three weeks as the wild range of $1.60-$2.08 during the past four months lives on. Refiners have slashed production over the past few weeks and this will eventually lead to an increase in crude purchases in order to rebuild refining product. What refiners receive for refined product relative to the price of their input (crude) is lower than it needs to be to drive production. The crack spread, or the refiners’ margin, is currently 35% below the 10-year average. An increase in gasoline and heating oil prices, or a decline in crude prices, will resolve the lack of refining production issue.

Advancing shares barely edged out the number that declined on the NYSE Composite. Volume was a bit improved as 1.3 billion shares traded, in line with the six-month average.

Market Activity for October 15, 2009
Jobless Claims

The Labor Department reported that initial jobless claims fell for a second week in a row, down 10,000 to 514,000 – lowest level since January. The previous week’s reading of 524,000 was revised higher, initially reported to be at 521,000. This is a helpful move, but anything above 500K is an elevated level from a historical perspective and thus the decline in claims was not a market mover.

The four-week average of claims fell 9,000 to 531,500.

Continuing claims fell 75,000 to 5.992 million. The continued move lower in this data is failing to make anyone hopeful that even a slight return to job creation has occurred as many of these people are simply moving to the extended benefit rolls – between extended benefits and the emergency unemployment compensation (EUC) program, this extends benefit by an additional 33 weeks.

The good news is that the rise in extended benefits was less than the decline in traditional benefits (traditional continuing claims fell 75K and extended and emergency benefit rolls, combined, rose just 16K) so maybe some of these people that came off of benefits were able to find a job.

Emergency unemployment benefits hit a new record (up10K to 3.331 million), and extended benefits to a new high too (up 6K to 471K).

Consumer Price Index (CPI)

The Labor Department reported that headline CPI rose 0.2% in September (in line with expectations), following a 0.4% increase for August. The core rate, which excludes food and energy prices, also rose 0.2% (0.1% was expected) after a 0.1% increase in August. Core CPI is trending 1.5%-1.8%, so this presents no issues right now – I’ll add though that this is not a deflationary environment as many people are still stating. (It would take another leg down in credit activity to make deflation a concern).

Outside of the transportation-related components CPI is not presenting a problem for the Fed. Although, the headline reading is up 3.9% at an annual rate over the past four months – but the Fed can talk this away.

On a year-over year basis headline CPI is down 1.3%. It’s true that CPI rarely posts declines (go back to 1945 and there are only two other periods of this occurrence, 1949 and 1955) but the fact that the reading is being compared to the high mark on the CPI index (not the percentage change figure, but the index itself) due to last summer’s commodity-price spike, down just 1.3% shows there may be embedded inflation out there.


CPI will not begin to pose any problems until November/December when year-over-year comparisons become very easy.

I will note that the Owners Equivalent Rent component in CPI (which makes up 24% of the index) fell 0.1% -- only the second decline in 17 years. This number is calculated in what seems to be a counterintuitive fashion (not getting into that now), but it does seem to be working for the current environment. Take a drive around and notice all the “for rent” signs. Rental rates have to be getting hammered by the 10% unemployment world we find ourselves in.

Empire and Philly

The manufacturing surveys out of both New York and Philadelphia were out yesterday, showing the two remain in expansion mode. Empire soared, hitting 34.57 (twice the forecast) for October, after September’s reading of 18.88. Philly remained in expansion, but the rate of growth decline a bit to 11.5 (slightly less than forecasted) from 14.1 in September.

On Empire: new orders, unfilled orders and employment (first positive in the number of employees gauge since June 2008). The average workweek jumped to 20.78, the highest level since October 2007. Inventories remained negative though, but 7 points better than the previous month. This is a very good report overall – with the exception of inventories, which we’ll touch on below – but we need to see it confirmed by the broad ISM reading as Empire is particularly volatile.

On Philly: the numbers were so-so. The headline number posted a reading in expansion mode, but prices paid vastly outpaced that of prices received (not good for margins); the number of employees improved but remains in contraction mode; delivery times sped up (you want to see this slow); and inventories were horrible, falling 13.7 points to -31.8 (barely better than the average during the height of the crisis).

The inventory data increases doubt that a full-blown rebuilding of stockpiles will occur even in the fourth quarter. This manufacturing data (for October) gets Q4 started off on a bad note in this regard.

FOMC Minutes

This text from the latest FOMC meeting was released on Wednesday, but I ran out of time to touch on the comments in yesterday’s letter – so here we go.

Overall, the minutes didn’t reveal anything terribly new. The consensus was to hold the Fed’s benchmark interest rate at rock-bottom (full-blown emergency) levels for an extended period. (It doesn’t appear the Fed is as quite as sanguine as that of the stock market – understatement!). The only new comments were that some FOMC members expressed a desire to increase their mortgage-backed security purchase program for fear of a housing market relapse.

In terms of their comments on the overall state of things:

• Industrial production (IP) has increased from very low levels thanks largely to auto assemblies
• Business spending has stabilized (transportation equipment rising, investment in equipment and software stabilizing after falling sharply)
• Vacancy rates in commercial real estate continue to rise and property prices fell further (this is for August-September)
• Firms reducing inventories at a slower rate
• Business contacts expressed relief that the most severe economic outcomes have been avoided, but remain cautious about recovery
  

After the release of these minutes, and comments from Fed Vice Chair Kohn earlier this week that there is no need to even mildly shift rates higher, it is no surprise that the dollar continues to decline against a basket of other currencies. We’re in danger-zone territory here and I peg 70 on the Dollar Index (DXY) as the alarm bell that eliminates the current luxury of keeping fed funds floored. The safety trade rescued the dollar in 2008 when it approached 70 on DXY, but of course the events that caused investors to run for safety smashed everything else. Seems like a precarious situation, but this is obviously a minority view at the present.

Futures

Futures are lower this morning after the latest earnings reports fail to show final demand is coming around – a necessary condition for higher revenue growth.

IBM’s earnings release after the bell showed operating earnings jumped 17% from year-ago results, gross profit margin rose 180 basis points to 45.1% (up 20 of last 21 quarters) and services backlog up 4%. The company raised its full-year 2009 earning forecast. All good right? Problem is revenues fell 7% from the year-ago period. That’s not bad, but does show final demand has yet to arrive. Geographically, the Americas third-quarter revenue fell 5%; Europe/Middle East/Africa fell 12%; and Asia-Pacific revenues were flat. The other issue within the report was a 7% drop in signed services contracts – this is an indicator of future business.

Google also reported last night after the bell and showed the ad market is beginning to recover. Third-quarter profit was up 27%. Revenue rose about 10% from the year-ago period, boosted by a surge in mobile searches (smart phones). This is going to be a nice driver for Google’s results over the next couple of quarters, but Google’s revenue results are an isolated case.

Bank of America’s results are out too, but I haven’t had a chance to look over the report. Consumer defaults continue to rise, and this surely is what led to their earnings miss. I see old Ken Lewis got smacked by the government’s Pay Master. I’m sure Mr. Lewis isn’t going to find much sympathy, he’s not going away a poor man, but the government’s dismantling of contracts (and this is not the first case, remember the way senior bond holders of GM and Chrysler were treated) is not the American way. Oh, I’m sorry; it’s the new American way.

So futures are lower on the revenue concerns via the IBM report, and just released results from GE (also showing bottom line is still being boosted by aggressive cost cutting and no help from revenue, which was down 20%). But the direction of futures has shown little bearing on final results as the market has the easy-money/zero-interest rate trade going for it.


Have a great weekend!


Brent Vondera, Senior Analyst

Afternoon Review

U.S. stocks spend most of the day in negative territory before climbing in the final hours of trading. Energy producers gained after oil jumped above $77 a barrel, the highest price in a year, while Citigroup and Goldman Sachs Group led banks lower on earnings that disappointed some investors.

The rally continues to be one of sentiment rather than one based on fundamentals, which means it will take a big disappointment to hold stocks back for now. Investors seem increasingly willing to view results through rose-colored glasses. It would be nice to see more companies beat revenue expectations. Cheering companies for beating estimates via cost cutting will only make firms more reluctant to reinvest profits to growth their business.

Gluskin-Sheff's David Rosenberg notes this trend and explains that: “This strategy is being deployed by so many firms that it is having a broad-based dampening effect on private aggregate demand and hence corporate revenues – enticing firms to take even more costs out of the system.”

Before the market re-opens tomorrow, we will have earnings results from several technology firms including IBM, Google, and Advanced Micro Devices. These companies should give us further color following Intel’s results on Tuesday. Intel results showed PC demand may be returning to pre-crisis levels. While Intel seems fairly priced, the market may be underestimating the strength of the corporate PC replacement cycle in 2010 and the resulting benefits for PC makers such as Hewlett-Packard and Dell.

Other companies that will surely catch morning headlines are General Electric and Bank of America. GE lowered guidance last quarter, so a significant miss would result in big downside. As for Bank of America, expectations were lowered today after traders realized that today J.P. Morgan’s monster results won’t necessarily trend across all banks.


--


Peter J. Lazaroff, Investment Analyst

Daily Insight

Wall Street is partying like it’s 1999, the only problem is that this isn’t the second or third time the Dow is flirting with the 10K mark, but the eighth (in terms of closing price). Oh, and differences to the first time we crossed 10K abound: the Dollar Index stood at 101 (now 75 and falling), oil was below $20/barrel (now $75) and the jobless rate stood at 4.4% (now 9.8% and rising). Back then, the Fed was in the process of flooding the financial system with dollars, ahead of the perceived Y2K problem, (just as they have done over the past year) – although interest rates were well-more investor friendly: fed funds at 4.75%; 2-yr Treasury at 4.70%; 10-yr at 5.50%. Such yields would crush this economy and likely send the housing market back to cycle lows.

To be fair, the longer we remain stuck in this stock-market trading range, the more sense the market makes from a longer-term perspective. Dow earnings are 50% higher than in 1999; S&P 500 earnings are 35% higher than 10 years ago. Prices have gone everywhere, but in the end no where over the decade and that means multiple compression. But we still have much to get through before the economy’s issues are resolved and who knows what an overly interventionist government will do before we get there. If past is prologue regarding crises, we have yet to see the extent of the damage Washington can do.

Yesterday’s rally occurred on the heels of Intel’s better-than-expected earnings report and was certainly juiced by a good, solid (and also better-than-expected) retail sales report for September. This move across the 10K mark is certainly a heck of a lot more pleasant than the last time we were crashing through the level (a 370-point plunge on October 6, 2008).

The broad market was driven by shares of financials and industrials. Basic material and energy shares also outpaced the session’s broad-market performance -- oil and metals prices rose again, as the U.S. dollar has gotten clobbered every day this week.

Advancers whipped decliners on the NYSE Composite by an 8-to-1 margin on decent volume (at least by today’s standards) of 1.29 billion shares changed hands – still not much by way of conviction. We’d have to see 1.7-2.0 billion in volume to illustrate conviction. We continue to move higher nonetheless.

Market Activity for October 14, 2009

Mortgage Applications

The Mortgage Bankers Association index of applications fell 1.8% in the week ended October 9 after a large 16.4% increase in the prior week. Purchases fell 5%, driving the index lower as the rush to get in before the first-time homebuyers tax credit has run its course (the contract needs to close by November 30 and that is probably not possible for last week’s signings). We’ll see if Congress extends the credit or not over the next two months. My bet is they will, and they will also extend it to all home buyers. Still, it will have a disruptive effect on home sales activity even if it is extended as it will not be continuous. .

Refinancing activity slipped just 0.1% last week, as the 30-year fixed mortgage rate continues to hover around the 5.00% level – averaging 5.02% last week. Refi activity made up 67.4% of the mortgage apps index as of this latest reading.


Retail Sales

The Commerce Department reported retail sales in September came in much better-than-expected. The headline readings fell 1.5% (a 2.1% decline was expected) after a downwardly revised 2.2% increase in August.

The payback for the cash-for-clunkers program is what pushed overall retail sales lower as motor vehicles & parts fell 10.4% last month. Clunker-cash provided a one and done boost to the auto industry, just as common sense would have led one to believe. The month’s decline in auto sales erases the prior two month’s gains and takes the level of auto sales below the that seen before cash-for-clunkers was implemented.

Excluding autos, retails sales rose more than expected, up 0.5% after a 1.0% rise in August. This is good to see as the previous reading was boosted by back-to-school buying and the sales tax holiday most states had implemented – there is some follow through here.

Furniture (up 1.4% after a falling 0.8% in Aug.), food & beverage (up 0.7% after a 0.8% rise in Aug.), clothing (up 0.5% after a 1.1% rise in Aug.) and general merchandise (up 0.9% after a 1.2% increase in Aug.) all contributed to the ex-auto sales increase.

The electronics component failed to show follow through off of August’s back-to-school bounce. This is not what Intel’s numbers suggested on the surface, but a significant degree of the Intel boost in chip deliveries was due to sales in China – China’s stimulus has not only been infrastructure based but they have also instructed banks to lend; bank loans in China have soared 76.5% over the past year. There has also been a substitution effect occurring, replacing higher-priced laptops with cheaper netbooks (which didn’t hurt Intel as their Atom chip sales soared but does tamp down overall electronics sales).

Excluding autos and gasoline, retail sales rose 0.4% after a 0.6% pick up in August. Removing the distortions clunker-cash had on the reading and gas station receipts (which is always appropriate to remove from the retail sales figures in order to get a better sense of things) retail sales are up 2.4% over the past three months at an annual rate. Not bad but somewhat of a weak bounce from the significant 5% decline in this figure on a year-over-year basis as of June 2009.

Now, a number of segments of the retail sales data have posted nice gains over the past two months, and I’m not trying to take away from that, but a boost in consumer activity does not pass the smell test based on the headwinds the consumer faces. It will take a sustained rebound in the labor market, household incomes and the resultant decline in default rates to push consumer activity higher in a consistent manner. Recall, that we saw a big bad bounce in core retail sales in the beginning of the year off of the cycle low (hit in December). This provided hope for the market, only to deflate again. I would be careful not to replace reality with hope. Nevertheless, consumer activity will offer a nice help to the third-quarter GDP reading.

Business Inventories

The Commerce Department stated that business inventories fell 1.5% in August, marking the 12-straight month of liquidation. This shows the inventory dynamic did not take place in the third quarter so we should expect some actual replacement of stockpiles to boost fourth-quarter GDP in a substantial manner.

Still, inventories will add to GDP when the Q3 report is released as stockpiles are on pace to fall at close to half the rate of decline of that in the previous quarter. (The inventory component to GDP involves the change in inventories. Thus, you do not need an increase in inventories, or non-fixed investment as it is technically known, but they only need to decline less than that of the previous quarter to contribute to growth.

Business inventories were dragged lower by a huge 7.9% reduction in auto stockpiles (down 31.1% y/o/y). Ex-autos, inventories fell just 0.3%, the smallest since March – which I guess isn’t sayin’ all that much. I would expect the September inventory data to show an increase, the first since August 2008.

Business sales rose 1%. As a result, the inventory-to-sales ratio fell to 1.33 months worth from 1.36. The reading has now moved meaningfully below the 15-year average for the first time since the chaos began with the Lehman collapse.


Correction, and Commentary on Option Adjustable Rate Mortgages:

In yesterday’s letter I stated: 46% of IO (interest-only) mortgages are at least 30 days delinquent, even though just 12% of these loans have reset. That is wrong. The correct figure is 46% of option ARMs are 30 days late, as of the September data, according to Fitch Solutions.

Interest-only loans make up just one of the choices in the option ARM market. The choices are: make a full payment of principal and interest, a payment equivalent to interest only, or a payment less than the total amount of interest due (Pick-A-Pay).

Payment-option mortgage loans are heavily concentrated in the worst-hit regions of the housing market (75% of these loans are on collateral located in California, Florida, Nevada and Arizona), making these loans much more vulnerable to declining property values. Since these were the heaviest areas of speculation, many of these borrowers are likely just walking away. Many of these loans have loan-to-value ratios of 126%, according to Fitch, meaning a significant number of these borrowers will be unable to refinance to avoid the rate shock – until the government comes in to rescue them. .

Option ARM loans are a much smaller percentage of the total mortgage market than subprime loans, but the point of discussing this topic is that it adds incrementally to the headwinds consumer activity faces.



Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks failed to extend upon the six-session rally, although the decline was inconsequential, as JNJ posted better-than-expected bottom line results on lower research and marketing costs but revenue declined more than analysts has forecasted. The NASDAQ Composite bucked the trend in the Dow and S&P 500 as the tech-laden index managed a fractional gain.

Intel reported strong results, beating both on the top and bottom line estimates, but that news came after the bell so no help to yesterday’s trade. Gross margins blew past estimates of 53%, coming in at 57.6% for the quarter. The forecast for the current quarter is a big bang margin expansion to 62%. The results seemed to be fueled by Chinese demand that has been augmented by that government’s stimulus programs and PC makers placing orders on expectations Microsoft’s Windows 7 operating system (to be formally released on October 22) will get customers buying. Intel’s enterprise business remained weak.
As has been abundantly reported over the past 12 hours, Intel’s sequential (quarter-over-quarter) earnings results jumped 17%, the most in 30 years.

(I love watching the mercurial nature of the market, sequential comparisons have suddenly become all the rage. You couldn’t get anyone excited about year-over-year results back in 2002 (the correct way to compare earnings results) when corporate profits had begun the record-setting 20-quarter period of double-digit growth. Now, year-over-year results can fall against weak 2008 Q3 comparisons, revenues can remain punk and all anyone needs to get excited is sequential results these days. The ever-changing behavior of the market is quite the thing to chronicle.)

The major 10 sectors were spilt between gain and loss yesterday as basic material, consumer discretionary and telecoms led the five sectors that gained ground; financials, health-care and utilities led the losers.

The U.S. dollar was down again yesterday even as the ZEW (German investor confidence) unexpectedly fell and a member of the ECB (Europe’s central bank) stated there is no reason to change monetary policy. Both of these events ease any near-term pressure over interest-rate differential between the U.S. and Europe and should have been dollar positive. The fact that it wasn’t means we may be headed for 70 on the Dollar Index (DXY) – a level that would begin to sound the red alert signal to members of the Fed.


For now, the 75 handle on the DXY doesn’t have the bond market concerned. Bonds rallied, sending yields lower, on expectations that the Fed will remain on hold for a while – you have to go out to June 2010 for a majority opinion that the Fed will raise rates to a range of just 0.50% - 1.00%, according to fed funds futures. If this dollar trend continues, those expectations will change even as the nascent economic rebound remains soft – the economy won’t have the luxury of pedal-to-the-metal monetary policy, Bernanke and Co. will have to shift focus to rebuilding the perception of longer-term dollar stability.

Market Activity for October 13, 2009
Consumer Hindrance

The press is finally beginning to accept the fact that the consumer is going to be a major drag on the GDP figures over the next couple of years, and stricter and possibly less innovative credit products will exacerbate the situation – an article from the WSJ entitled “The ‘Democratization of Credit’ is Over – Now It’s Payback Time” offered an in depth account of this scenario (of course the piece includes the goofy anecdotals that always accompany financial articles but the overall point is spot on). The press also seems to be coming around to the reality that a prolonged period of payroll cost-cutting means a lack of final demand.

A consumer drag is simply the reality when the unemployment rate explodes to 10% (9.8% as of the latest reading but it will go above 10%). This is especially damaging at a time in which we’re coming off of a debt binge, fostered by a prolonged easy-money policy by the Fed. These debt levels were manageable at 5-6% unemployment, but at 9.8% and rising, well there will be a period of repair that will bring personal consumption as a percentage of GDP back to the historic average of 65.2% from over 70% at present.

(Dates are tough to read, data runs 12/1947 – 6/2009)

The government hasn’t helped things either. The vast majority of decisions that come out of Washington carry unintended consequences and the new credit-card laws will intensify the cutting of credit lines that accompany any period in which default rates soar. Congress is imposing a number of new rules on credit-card issuing companies, in the name of consumer protection, and as a result banks are slashing lines for those that need it the most right now.

We talked about this several months ago, models are already set up to cut credit lines based on overall default rates and this takes away the safety net that many had used credit cards for when they get into a bind. Those that need it most right now, those with weaker fundamental credit situations, will be at least marginally and at the worst totally locked out of the credit arena and this will show up in consumer spending over the next year. When the government puts more restrictions on banks it creates an environment in which it is not profitable to extend credit to those with lower credit scores. This may be a good thing longer term, the access to credit was way too loose anyway, but it does mean that we’ll have to endure of period of slower growth rates as a result. It’s important to understand this.

In addition to this, we may see continued troubles via the higher ranks of the consumer segment. We have another wave of foreclosures to get past and the upper tiers of the housing market are beginning to show the cracks are widening.

The top third of the housing market now accounts for 30% of total foreclosures, up from 16% when the housing recession began three years ago. The bottom third, which has been the main problem thus far, accounts for just 35% of all foreclosures, down from 55% in 2006, as reported by the WSJ. What’s even more troubling is that 46% of IO (interest-only) mortgages are at least 30 days delinquent, even though just 12% of these loans have reset. Most of these will reset in 2011, when rates may just be much higher. If we don’t get policies that help to turn this economy around a high level of joblessness is going to keep foreclosure rates elevated for some time to come and that cannot be helpful for consumer activity.

A move to keep tax rates at current levels (rate reductions are needed but we can’t expect that now) and an aggressive and permanent policy shift that allows businesses to write-down capital equipment purchases in the current year will give firms the confidence in the future to let go of some of their cash to engage in capital expenditures. This would be a huge job creator that would not only drive aggregate income but would also provide a windfall to the Treasury via a larger tax base. Slashing the corporate tax, which only hurts employment and is passed on to the consumer via prices, would also offer a big boost to job creation.

Conditions within the labor market will keep consumer activity mired and business spending delayed for a prolonged period if a sustained economic revival doesn’t occur. Consumer headwinds abound.

Economic Data

We haven’t had a major release for two days, but the rest of the week will bring some important numbers.

The monthly budget statement for September has been flashing on the economic calendar since Friday, but the deficit figure for the final month of the government’s fiscal year has yet to be released. The Treasury Department is expected to show a budget deficit of roughly $34 billion for the month. September closes out the government’s fiscal year and the deficit for 2009 will come in right around $1.5 trillion, or 11% of GDP – the previous postwar record is 5.6% hit in June 1983. The release is flashing on the screen again today, maybe the fourth time is the charm and we’ll get the official reading.

The big release today will be retail sales for September. The headline figure is expected to show a 2.1% decline. This will be the fallback from August’s big 2.7% increase that was sparked by clunker-cash auto sales and a back-to-school/sales tax holiday boost to clothing and electronics sales. The retail sales increase for August was the largest monthly reading since October 2001 when auto dealers offered zero-percent financing following the 9/11 attacks.

Thursday we’ll get initial jobless claims and CPI. Claims are expected to hold at last week’s level of 520K – a move back to 550K will likely spell trouble for stocks; conversely, it will probably take a significant move below 520K for this data to help stocks as readings above 500K are extremely elevated levels from a historical perspective. CPI is expected to show no problems. This reading will be for September consumer prices, it won’t be until November when the year-over-year comparisons start to show some problems for CPI and the monthly number illustrate some effect from the rebound in commodities.

Finally, on Friday we’ll get industrial production for September. IP has rebounded somewhat off of its worst contraction, both in terms of degree and duration, since 1946 when the economy was making the shift back from purely war-related production. The reading for September should show IP rose for a third-straight month, but over the following couple of readings production may prove to be choppy. The mining component may look good, boosted by higher selling prices – higher commodity prices. But manufacturing could very well slump again and the utility component, while helped by colder weather, will continue to show the effects of higher residential and office vacancy rates.

Futures

Stock-index futures are up big this morning on the Intel news and now JP Morgan’s results, just out as I type, destroyed the estimate. S&P 500 earnings results will still post another 20%-25% decline for the quarter when it all said and done. The Intel story was a special case as they received a boost from back-to-school, Chinese stimulus and the coming Windows 7 release. With regard to JP’s earnings, all banks in fact, the zero-interest rate policy by the Fed is helping to mask record loan default rates. When the Fed has to raise rates (and this is the dichotomy, if they raise rates to a more normal level it all falls apart; if they don’t the dollar continues to get hammered, which makes the necessary degree of rate hikes more severe and likely to arrive sooner than the market currently expects) the banking industry will show the continued troubles in loan quality.

As we’ve mentioned for a couple of months, we will get a two-quarter jump (I’ve actually referred to this as a big bang) in corporate profits due to massive cost-cutting. This move in year-over-year profit growth will begin in the current quarter (fourth-quarter earnings season – the current earnings season is for the third quarter, just to clarify things). But the Fed’s unwind of aggressive monetary easing, coupled with a lack of final demand (as the jobless rate remains high and consumers engage in more balance sheet repair) will bring a quick end to the profit revival.

For now though, the “let the good times roll” trend continues. We’ll be watching for that “psychological” level of 10,000 Dow to be hit, which will mark the eighth time we’ve moved past the 10,000 mark since initially doing so in January 1999. After eight moves back in forth, I’m not sure how psychological 10,000 actually is anymore.


Have a great day!


Brent Vondera, Senior Analyst

Kicking off earnings season

S&P 500: -3.00 (-0.28%)

We are entering into the thick of third quarter earnings season, with stalwarts such as Johnson & Johnson (JNJ), Intel (INTC), General Electric (GE), J.P. Morgan (JPM) and Goldman Sachs (GS) reporting this week. It will be particularly interesting to see Citigroup and Bank of America’s earnings, as they were the most troubled of the banks.

If revenues come in above expectations, and the economic indicators (retail sales, jobless claims, NY and Philly manufacturing indexes, U of Michigan sentiment index) come in strong, stocks could stage a big rally. I expect more stocks will beat earnings estimates than will not.

In the limited number of companies that have reported so, we have seen two major themes. The first is corporate cost-cutting, which has allowed firms to boost margins. This is not sustainable – eventually firms will have to spend to expand – but it is helping results in this quarter.

The second major theme has bee the continued reawakening of international markets, notably China. The Chinese desire for raw materials and other goods is helping plumb up global demand. With other countries in the region showing stability or even growth, it’s possible to see the region as an engine for global growth, as the U.S. and Europe deal with continued economic woes.

Intel will be reporting any minute now. I posted earlier today about Johnson & Johnson’s quarterly result, and I examine what their results tell us about healthcare companies that report next week.

--

Peter J. Lazaroff, Investment Analyst

Johnson & Johnson (JNJ) misses revenue estimates

Johnson & Johnson (JNJ) topped earnings estimates on cost cuts, but reported lower revenues than analysts had expected. The pharmaceutical business was the main drag on revenues due to a couple big patent expirations (Risperdal and Topamax). Partially offsetting weakness in the pharmaceutical division was slight operational gains in the consumer division as well as the medical device and diagnostics groups.

The pharmaceutical business will likely be hindered by patent losses until mid-2010, but will then return to solid growth with the launch of several new drugs. J&J is widely believed to have one of the best late-stage pipelines in the industry.

On the cost front, J&J is making impressive strides in increasing efficiency. Operating margin improved 260 basis points from a year ago, and it appears that the company is cutting expenses more aggressively than they have let on.

Management conservatively raised its full-year EPS estimate by about 1%.

J&J is a decent proxy for the healthcare sector due to its diverse health operations (drugs, consumer, devices, diagnostics, etc). Cost cutting will obviously be a common theme across the healthcare sector, but J&J’s results may give us some insight into results due next week.

• Big Pharma companies, such as Pfizer (PFE) and Eli Lilly (LLY), will likely see revenues impacted by a stronger U.S. dollar compared to the same period a year ago, just as J&J did.
  
• Impressive growth in J&J’s DePuy unit, which makes replacement hips and knees, suggests that Zimmer Holdings (ZMH) could surprise to the upside next week. Zimmer faces several near-term pressures including hospital budget cuts, healthcare reform, and individuals delaying elective procedures in light of economic difficulties.
  
• J&J’s strong growth in their diagnostics business might be a positive omen for other diagnostic companies like Quest Diagnostics (DGX). Quest has seen significant volume growth due to the outbreak of the swine flu and the growing demand for esoteric testing for advanced diseases. What will drag on Quest’s results will be drugs-of-abuse testing, which falls in tandem with the unemployment rate.
  

Hopefully we will see more healthcare firms beat revenue expectations. The market would likely be happier with firms beating bottom-line estimates by less as long as revenue exceeds expectations.


--

Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks extended the winning streak to six days on Monday as investors shook off what looked to be playing out as a mid-afternoon rout. Roughly an hour into the afternoon session the broad market tanked, erasing earlier session gains, after Homeland Security Secretary Napolitano told Bloomberg News that it was “fair to say” terrorists with al-Qaeda-style beliefs are in the U.S..

This is hardly news as everyone should assume we’ve got all kinds of terrorist cells in the U.S.– I guess the remarks must have been initially interpreted as the government saying they believed an attack was imminent. Stocks rebounded an hour later, able to hold onto about half of the early-session gains

The economic and earnings calendars were light as yesterday was Columbus Day so the only thing that really drove things was optimism about earnings season, which gets rolling in earnest later this week. The market will be particularly attentive to what executivessay in addition to results; investors will want to hear some willingness to grow capital expenditures. Intel will report after the bell and may help in shedding light on this subject.

My concern is that firms will remain extremely cautious and keep their cash held close as they understand the government will be on the hunt for revenue in 2010. I often find Thomas Paine’s “Common Sense” coming to mind, specifically these comments: “we still find the greedy hand of government thrusting itself into every corner and crevice of industry, grasping the spoil of the multitude. Invention is continually exercised, to furnish new pretenses of revenues and taxation.” Business is very concerned about the direction of tax rates.

The bond market was closed for the holiday.

Commodity prices rallied too. Gold hit $1,055 per oz. (and is up another $13 this morning), oil surpassed $73 per barrel (and has moved onto $74 this morning), and copper hit $2.85 per lb.(an elevated level even if the global economy were humming, which it is not). The dollar continues to get wacked, and that’s what’s driving these prices higher.

A former Federal Reserve researcher stated global central banks continue to diversify away from the greenback and the trend accelerated in the third quarter – the U.S. dollar’s share of new reserves fell to 37% from 63% on average over the past decade. This spells trouble, as we’ve been discussing, if the trend holds. It also means it could force the Fed to hike rates much quicker and more dramatic than the market currently expects – if this trend does not reverse, a significant move in rates will be the life preserver necessary to rescue a drowning dollar.

Considering this stock rally is based upon the easy-money trade, this also spells trouble for stocks if investors begin to grow concerned a quick strike from the Fed is necessary – for now they don’t seem concerned about anything. If the Fed lets this one get away from them, it will really screw up the luxury of being able to keep monetary policy floored.

Volume was weak again, with just barely more than 900 million shares trading in the NYSE Composite – the six month average is 1.3 billion. Although, I guess relative to last week’s average volume of little more than one billion shares per day, 900 million shares ain’t bad for a holiday.

Market Activity for October 12, 2009
Second Stimulus? (actually the third, counting Bush’s failed rebate-check scheme in 2008)

Worried that job growth won’t be significant enough (when it arrives) to lower the unemployment rate to a level that is even close to the long-term average, Congress is now in the process of devising a another “stimulus” plan. Lord help us.

There are a number of things being contemplated right now, so no idea on what will prevail, but the leading ideas are as follows:

• Extending subsidies to laid off workers, paying for up to 65% of their COBRA premiums
• Sending checks of $250 to more than 50 million Social Security recipients and railroad retirees to make up for the lack of cost-of-living (COLA) increase in 2010 – CPI has been printing negative-to-flat y/o/y readings so no COLA increase was scheduled for next year
• Reviving the “net operating loss carryback” plan, which died in Congress last year when the previous “stimulus” plan was being devised
• Awarding tax credits to companies that add jobs. This too failed to make it into the previous “stimulus” plan as Congress couldn’t figure out how to implement it. One of the proposals is to provide a $4,000 tax credit to be paid out over two years for each new employee.
  

Oh my, let’s look at these one at a time.

Ok, sending more checks out. Not only has Friedman’s Permanent Income Hypothesis been proven via several rebate-check schemes over the past few decades. We have the luxury of not having to go back and study the effect of those in the past, although it’s easy enough to do with the right resources, since we have recent memory to go off of via the 2001, 2008 and 2009 rebate-check plans.

In 2001 the checks provided a little help to GDP the quarter in which they were received. It was a one-and-done event. In terms of Bush’s second rebate check attempt to revive the economy, personal consumption rose 0.1% in Q2 2008 and was followed by a collapse in spending in the following two quarters.

Fact is not even all of this money is spent, as several academic studies have shown. When consumers see this as a one-time event, instead of a more permanent increase in disposable income via reductions in tax rates, consumers choose to either pay down some debt or save it.

The 2009 rebate-check plan, as a result, attempted to trick consumers into spending the money as it dribbled something like $25 per paycheck until the amount reached the intended $400. One could obviously argue that the economic troubles mask the effect of the plan, but let’s get serious, this is not a real stimulus agenda.

On extending COBRA subsidies: This is a typical countercyclical response. The government makes payments to laid off workers, which allows them to keep more money in their pockets to spend on other things. Fine, but we have all kinds of programs like this, extending them or creating even more turns our economy into something that looks more like Western Europe than that of the USA. Time and money would be better spent on firing up business optimisms, which will get them to spend and the jobs will soon enough come along for the ride.

On the net operating loss carryback to five years: This means the government will send out checks to firms that have reported losses the last two years, refunding taxes paid over the previous five years. Oh, that’s nice. Not only will this balloon the deficit, but if firms are uncomfortable with the direction of policy and thus remain cautious, then why would they spend this money? It seems to me this would only exacerbate the cautious nature of business as they will expect higher tax rates to follow as this adds onto an already heavy budget deficit.

On the tax credit to businesses that add jobs: Maybe we don’t have to waste time on discussing this one. Two-thousand dollars a year for two years? – maybe members of Congress should bring themselves up to speed on how much it costs to add a worker. This is a flat out joke, just as it was the last time it was tried – 1977.

And this brings us to how Congress plans to pay for this stuff. The idea that seems to have the most support would be to apply the Social Security payroll tax to incomes between $250,000 and $359,000 – currently the 12.4% tax caps out at $106,800. This is a huge job killer. It is a growth killer in general as it would suck $24,000 out of the private sector on average for the segment of workers that drives consumer spending, not to mention the reduced level of investment that would result. Further, it raises the cost of employment as employers pay half of the Social Security tax – making the temporary tax credit “reward” for adding to payrolls all that more laughable.

They don’t get it, and I don’t think they care to.

Have a great day!


Brent Vondera, Senior Analyst

Treasury Inflation Protected Securities

Real Yield – measured by subtracting inflation from nominal yield – is an extremely important factor in fixed income investing. High inflation not only destroys purchasing power but is also greatly influences investor behavior. Traditionally investors will demand higher rates of interest as inflation creeps higher in order to preserve their purchasing power. However, as the graph below shows, negative real interest rates are not impossible.

click to enlarge

While year-on-year inflation, as measured by the Consumer Price Index, was 12.3% in December of 1974, the prevailing yield on the ten-year Treasury was at 7.4%, a real yield of -4.9%. A similar situation happened again just a few years later. By the mid-80’s inflation had calmed down, but Treasury yields remained elevated. Real yield on the Ten-year Treasury reached a record 9.5% as investors sought revenge for the past decade of poor inflation adjusted returns. This all happened without the presence of TIPS.

When they were introduced in 1997 Treasury Inflation Protected Securities changed the landscape of investing. While still maintaining the full faith and credit of The US Government, investors are now given the option of accepting a lower coupon in exchange for future adjustments to principal based on CPI. TIPS trade on a yield basis, just like any other bond, but if you assume CPI accurately measures inflation, the quoted TIPS yield is a real yield. If you don’t, please take a number… the Bureau of Labor Statistics will be with you shortly.

click to enlarge

The first few years of TIPS data isn’t very reliable. In December 1997, after one full year of TIPS issuance, the total market value of TIPS was $33 billion, less than 1% of the $3.5 trillion Treasury market at the time. By 2000 the value was still only at 3.5% of the market. TIPS have ballooned to $551 billion (about 8%), and now that it has been around for a while, it operates much more efficiently. This is the main explanation for the elevated yields from 1997 to 2000.

Some argue that TIPS won’t provide the inflation protection they advertise when the Fed moves to nip inflation in the bud, saying that when inflation begins to go away, the absolute return of TIPS (real yield + inflation) will be diminished. But is that important? If you buy TIPS, do you necessarily want runaway inflation? If you are looking to spend the dollars you are investing on real goods at some point in the future, the inflation portion of your return will be offset by the run up in prices of real goods. Leaving you with an effective hedge against what would otherwise hurt your return.

Secondly, a certain author of a certain Wall Street Journal article argues that a shift toward tight money from the Fed will move so many investors out of TIPS, driving prices for the securities down, that any benefit will be negated. The graph above shows the movement in TIPS yield that happened as a result of the world moving from $150 per barrel oil in the summer of 2008 to the largest deflationary scare in the Post WW2 era. (A pretty serious adjustment) This movement from 1.5 to 3% in TIPS translates into a 14% decline in the price of the 10-year TIP, while the nominal 10-year was up about 16% over the same period. So that means we should all load up on ten year Treasurys at 3.30% right?

Diversification is key to any sound investment strategy and the correlation of TIPS with other asset classes is attractive to investors. It is the unique characteristics of TIPS compared to other asset classes that provide this benefit, along with unique risks.

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks rallied again on Friday, that’s five days in a row that now completely erases the losses of the previous two weeks, as Wall Street analysts’ bandwagon mentality rolls on as usual. The Dow Average closed at it highest level in a year; the S&P 500 just barely shy of that mark.

Another day of analyst recommendations, this time suggesting investors buy tech and health-care stocks, pushed the broad market higher. This is about the third time in five sessions that buy recommendations have spurred a rally. Earlier in the week it was recommendations to buy industrial and basic material shares that helped to get the week started. These two sectors have jumped nearly 80% since the March 9 lows.

As we discussed at the beginning of the year, industrial and tech shares present the greatest opportunity over the next decade and commodity-related basic material shares are the place to be in the shorter-term as the dollar gets hammered. Back then you couldn’t find analysts’ buy recommendations, but now that the market has surged 60%, and some of these sectors even more, they abound. This is quite typical. But those just getting in should beware, especially with regard to the sectors that have run up the most; they are likely to pull back substantially before resuming an upward trajectory over the longer term.

Advancers beat decliners by a two-to-one margin on the NYSE Composite. Volume was very weak, as less than one billion shares traded on the NYSE Composite – roughly 27% lower than the six-month average.

Market Activity for October 9, 2009
Trade Figures

The Commerce Department reported that the U.S. trade deficit narrowed in August as exports rose (in nominal terms) and oil, consumer goods and industrial supplies weighed on imports. The gap fell 3.6% to $30.7 billion ($2.3 billion tighter than forecasted) from a revised $31.9 billion for July. The trade deficit hit its widest level in August 2006 at -$67.7 billion.

The trade deficit is generally a vey good indication of U.S growth. When growth is strong, and thus consumer and business activity is on a roll, imports soar and the deficit widens. When growth is weak, and consumer and business spending retrenches, the gap narrows. The wides on the trade deficit were also caused by a Federal Reserve policy that encouraged consumers to take on more debt (and high oil prices also had an effect, also a result of easy Fed policy as it had a weakening effect on the dollar). But in general, even though trade deficits are often vilified, it does reflect what is going on in the economy.

The rise in exports, although a mild rise of just 0.2%, was helped by another big month for automotive deliveries and to a smaller extent industrial supplies and telecom equipment. Computer accessories, a huge decline in civilian aircraft deliveries and consumer goods weighed on the figure.

Imports were disappointing, falling 0.6% in August after two months of increase that gave some the incorrect sense that the U.S. consumer was making a comeback. It was reported that a large decline in oil imports (a decline that was actually worse than the number relays since petroleum prices rose during the month) was the cause of the drop in imports, but this isn’t the entire story. Significant declines in consumer goods and industrial supplies also weighed meaningfully on imports.

When we adjust for prices, both sides of the trade numbers fell in August. Real exports fell 1.5% and real imports declined 1.9%. No matter though for GDP as that needs to occur for the trade figures to boost the reading is for exports to fall less than the degree to which imports do. The inflation-adjusted trade gap fell to $37.70 billion from $38.75 billion in July.

All in all, what should be taken from the reading is that trade remains imperiled. Export orders do not suggest (although this data is a bit outdated as it is for August) global growth is back in the swing of things and the import numbers continue to paint the picture that businesses remain on the sidelines and the consumer is still in balance-sheet repair mode – hardly a surprise though.



The Commodity Trade

Following Australia’s better-than-expected jobs report on Thursday, 40,000 jobs were added in September and the unemployment rate ticked down to 5.7% (30-year average is 7.8%), the Canadian government reported Friday morning that payrolls rose 30,600 last month after a 27,100 pick up in August. The Canadian jobless rate fell 0.3% to 8.6% (perfectly in line with the 30-year average). In contrast, our jobless rate remains 3.6 percentage points above the 30-year average of 6.2%, and it ain’t coming down anytime real soon – it is on its way to test the post-WWII high of 10.8%.

The rise in commodity prices -- fostered by a positioning among investors and foreign governments to protect against a declining dollar and China’s stimulus plans that are focused upon building factories and roads like mad – has allowed the basic material/natural resource-rich regions like Canada and Australia to perform relatively well.

(The U.S. is rich in natural resources as well, but in the name of “environmentalism,” we place huge restrictions on our production of these resources. This will eventually change as lower growth will trump misplaced priorities over time – it won’t take more than a couple years of this and citizens will say enough is enough and the focus will turn to augmenting growth again. But we erred big time in failing to exploit huge technological improvements within the energy sector. The focus should have been to create high-paying manufacturing jobs in the natural gas/oil exploration, coal and nuclear arenas. The opportunity remains, but it appears priorities will remain misplaced for some time before we get things right.)

We have been in front of this trade with our push to commodity-related stocks and an increased weighting to the Australian market within the international asset class. For people who are late to the game in this trade, I would caution against a major push here now at these levels. But for those who have been here a while, buying at very low prices and valuations at the beginning for the year, it’s working out well and the actual figures out of Canada and Australia support the view.


Have a great day!


Brent Vondera, Senior Analyst