Daily Insight

U.S. stocks fell Thursday on a couple of disappointing earnings reports out of the tech sector, sovereign default concerns, and an unexpected increase in initial jobless claims.

So the S&P 500 has slipped 5.7% since touching a15-month high on January 19. This marks only the second 5%-plus dip for this rally – a huge move from the 13-year closing low of 676 that was put in on March 9, recouping 45% of the losses from the all-time high hit on October 9, 2007.

With roughly 40% of S&P 500 members reporting thus far, ex-financial profits are holding onto the 20% increase from the year-ago period. While the percentage of companies beating expectations is surpassing the longer-term average (about 75% of firms have beat expectations, the long-term average is around 60%), we still must get past the bulk of energy, industrial and health-care earnings reports. These groups endured another rough quarter in the final three months of the year, so it will be a challenge to hold onto that 20% growth in ex-financial results – and that rate of growth is going to be what it takes to keep the market at these levels after nine quarters of significant profit deterioration. On the top line, revenues are up 8.8%, but take out financials (a group that has been carried by the Fed as Bernanke has induced a historically positive slope to the yield curve – borrow at near nothing and lend at something much higher, or just buy longer-dated Treasuries), and revenues are slightly negative.

Yesterday’s economic releases also appeared to weigh on investor sentiment. The data was mixed. Durable goods posted a nice number, but the initial jobless claims threw the market for a bit of a loop – as we’ll touch on below.

What’s more, we have these sovereign debt problems continuing to drag on the risk trade – a topic we’ve spent some time on over the previous few weeks and they’re not going away. Greek bonds have really sold off; the yield on their 10-year jumped to 7.18% yesterday from 6.23% at the beginning of the week and 5.98% two weeks back. Last week their finance minister shook off EU bailout speculation by stating the country will handle their financing via the capital markets. Well, while that’s the correct course it is proving to be rather expensive. We’ll watch to see if the EU holds to their statement that they won’t bail the Greeks out. Spain and Portugal, other problems for the Europeans, are also seeing their yields jump. The major debt-financing troubles appear to be confined to these three countries, but it’s another indication of global economic fragility and of course traders wonder that maybe there are more to come.

All of this was good for U.S government bonds and the dollar, which are key safe-havens. The Treasury sold another $32 billion in debt (7-yr notes) and it barely affected rates; this was on the heels of $44B in 2 yrs and $42B in 5 yrs earlier in the week. When it’s all said and done we’ll issue another $2 trillion this year – you may have noticed that the Senate voted yesterday to raise the debt ceiling by $1.9 trillion – they didn’t have much of a choice. This marks the fifth increase in the past two years. Yeehaa boys! Enjoy the low debt servicing while it lasts.

In the final minutes of trading it was reported that the Senate voted 77-23 to end debate and clear the way for a final vote to reappoint Bernanke as Fed Chairman. There was to be no last minute Bernanke bounce though as the market traded slightly lower after the news. After the market closed, the Senate voted 70-30 to officially re-appoint.

Market Activity for January 28, 2010
Jobless Claims

The Labor Department reported that initial jobless claims fell just 8,000 to 470,000 in the week ended January 23. The expectation was for a 32,000 decline after initials jumped to 482K in the prior week. The four-week average rose for a second week to 456,250.

A couple of weeks back it really looked like we were headed for 400K on initial claims, which is a level that almost always suggests at least mild payroll growth. The past two readings have been disappointing.

The continuing claims numbers did offer a glimmer of optimism as both the standard and extended continuing claims data showed a decline. Standard claims, those that provide benefits for 26 weeks, fell 57,000 to 4.602 million. Emergency Unemployment Compensation (EUC) claims also fell, which hasn’t occurred very often since these extensions were implemented in July 2008. EUC claims tumbled 305,000 after the gargantuan increase of 613,000 in the previous week.

This report definitely shifted from the dynamic we’ve seen over the past couple of months. Initial claims had been falling (illustrating the pace of firings has greatly eased), yet continuing claims were rising (suggesting the absence of hiring as the length of unemployment has been extending). But this report shows the opposite. You want to get excited about the drop in continuing claims, but is it simply a function of benefit exhaustion? Certainly with initials hovering well above the 450K level it sure doesn’t suggest hiring has begun just yet, which leads one to believe the decline in EUC claims is either a transitory pullback from the massive increase in the prior week or the expiration of benefits.
Durable Goods Orders

The Commerce Department released a pretty good durable goods report for December. The headline figure rose 0.3%, which followed a downwardly revised 0.4% decline in November. While the December reading was way below the expected 2.0% rise, it was mostly due to a 40% decline in commercial aircraft orders – those orders will probably show a bounce for January after two months of big decline.

The ex-transportation figure, which removes the extremely volatile non-defense aircraft segment, rose 0.9% -- nearly double the expected increase. This marks the second-straight increase for ex-trans durable goods orders.

The segment of the report to concentrate on is the non-defense capital goods ex-aircraft reading, the proxy for business-equipment investment. The figure rose a very nice 1.3% in December after a strong +3.1% in November. The problems on this side occurred within the computer/electronics and electrical equipment components – down 3.0% and 3.9% for the month (although electrical equipment posted two nice increases in the prior months, so nothing to worry about there). The machinery component made up for it though, jumping 6.0%.

Orders for vehicles and parts rose 3.6% for the month and have increased seven of the past eight months. Auto assemblies will play a key role regarding the inventory boost to GDP, but I question whether it is lasting (a theme I keep returning to) as auto sales are very likely to remain choppy.

This is good news but we need this trend to extend for several months. My belief is that firms are going to keep their cash held close and not take any big bets with regard to future activity. That is, they will manage business-equipment purchases to maintenance levels. This will be helpful based on where we’re coming from, as business spending had collapsed with a swiftness and degree never before seen in the postwar era, but such caution will not allow for the normal rebound in capital expenditures – it’s the uncertainty, stupid.

By the time we get into late-spring/early-summer we’ll have a good sense as to whether this view proves accurate or something larger, and hopefully more substantial, is occurring. It all depends on Washington clearing uncertainties regarding future tax rates and coming regulations.

Today’s Data

Today’s focus will be on the fourth-quarter GDP report and Chicago PMI (factory survey).

The consensus estimate for GDP is 4.6%, but most expect a reading closer to 5%. The average for this quarter (Q4 GDP) should be in a range of 6%-9% -- this is the average one-quarter removed from the three-worst prior recessions in the postwar era. But a print around 5% will be good enough, particularly since the previous reading was revised down in such a dramatic manner – originally printing 3.5%, but revised down to 2.2% by time all the revisions were in. The welcome durables goods data of the past two months is going to help us get that fiver; GDP is going to be fueled by some inventory rebuilding.

The Chicago PMI data is always heavily watched, maybe more so today as the two regional factory gauges we’ve received thus far for January have been conflicting – one good and one not so.


Have a great day!

Brent Vondera, Senior Analyst

Fixed Income Weekly

Greece
With a budget deficit of 13% of GDP and a rapidly maturing debt load, Greece is in a little bit of a pinch. I think I mentioned this briefly last week but sovereign debt is becoming more of a global problem, and all eyes are have been on Greece the last few weeks to gauge how other countries will deal with the issue.

Much was made last week when Greece announced they would price €8 billion in 5-year debt in their first bond sale since mid December, but the market initially priced in the concerns accurately when the bonds came to market on Tuesday in a relatively clean auction. But news since then has sent yields on Greek debt higher, including the bond sold in Tuesday at a 99.34 price. That same bond closed at 96.34 today, and it doesn’t even settle for the first time until Feb 2. OUCH!! I heard CDS on 5-year Euro denominated Greek debt quoted at 420 basis points as of this afternoon, up from 324 basis points two days ago when the 5-year priced.

The skittish market comes after comments from Greek Finance Minister George Papaconstantinou, (his close friends call him “Papa”), denying that there is any bailout assistance coming from the ECB or IMF. He also denied any talks with China over a deal to sell a special debt issue to them, which wouldn’t be a bailout per say, but not exactly something a healthy Greece would necessarily have to do.

The near future looks rough for Greece, as half of the bond issuance for 2010 is slated for Q2 to refinance maturing debt. Officials seem confident that fiscal reform will be the answer, but days like today lead me to believe that the market does not share their confidence.


Have a good weekend.
Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks recouped the prior session’s losses, reversing course following the Federal Open Market Committee’s meeting after spending most of the day in negative territory. And the S&P 500 breached that 1090 level we’ve been talking about, without causing additional deterioration as it closed meaningfully above that mark.

The market’s about-face occurred shortly after the release of the FOMC statement. The Committee’s comment on how employers remain reluctant to hire suggested the Fed will keep rates floored into 2011. However, there was a change in the language that also implied they may move to slightly tighten on a faster timeline – we’ll touch on this below. I doubt this will be the case, but if you’re really looking for something, it seems to be there. Further, one member of the Committee did dissent, so we’ll watch to see if these voices in the wilderness build.

I also notice people were talking about the possibility that the President will ditch the populism and private-sector bashing that has clearly increased since the MA election results and turn to talking about increasing jobs and the economy via his State of the Union address. As a result, this may also have helped the turnaround as some may have seen a buying opportunity.

Now that the SOTU has been delivered, we see that this view didn’t exactly come to fruition, particularly clear to those who stuck around for the entire 90-plus minute speech. I’m not going to comment further on the SOTU address. We’ll watch and see how things turn out.

Financials and tech led the advance. The S&P 500 index that tracks telecom shares also performed well thanks to the boost AT&T shares received from the unveiling of the iPad. I don’t know, maybe pants will be redesigned to offer just one humongous back pocket with which to carry this oversized iPhone. Oh gosh, I’ve done it now. How dare I trespass upon the sacrosanctity of this new religion.

Market Activity for January 27, 2010
Mortgage Applications

The Mortgage Bankers Association reported that its applications index fell 10.9% in the week ended January 22 after a 9.1% increase in the prior week that was fueled by both purchases and refinancing activity. In this latest week, both aspects of the report weighed on the index as purchases fell 3.3% and refis dropped 15.1%. The average rate on the 30-year fixed mortgage was 5.02% last week, basically unchanged from the prior week.

As you can see, the purchases index remains pinned. The rebound in sales during the spring and summer were helped by a variety of government support, which we’ll get into below. However, as we’ve talked about, that activity was short-lived as policy cannot completely overcome a double-digit unemployment rate and historically high debt burdens.

New Home Sales

The Commerce Department reported that new home sales tumbled for a second-straight month in December, falling 7.6% to 342,000 units at a seasonally-adjusted annual rate (SAAR). That follows a 9.3% decline in November (which was revised higher from the previously reported 11.3% decline) and completely erases the bounce in sales that ran May-October. The current level of new home sales now stands just 4% above the cycle and all-time low hit in January.

The ubiquitously talked about rebound in housing was phantasmal -- boosted only by a multitude of government intervention: rock-bottom interest rates, the buyers tax credit, an enormously increased role by the FHA (guaranteeing many more mortgages at their harmfully low 3.5% down payment standard). The existing home sales data do not look much better as they have been slammed back down as well, but that was Monday’s discussion.

The only pure market force that took place was the decline in price, which also played a role in the transitory rebound in home sales – distressed and foreclosed on properties made up 33% of sales during the period.

The problem is that this intervention could not ultimately overcome the troubled labor market, the double-digit jobless rate, and it has surely prolonged the housing correction as it interfered with the proper liquidation of homes and allocation of resources. (Should first-time homebuyers have been buying homes, often times with very little money down, taking advantage of that tax credit, when the foundation would have been better off renting and saving for a period of time). This intervention has not allowed supply and demand to find its necessary equilibrium and hence the rebound is not durable. It is important to understand that this is true for the economy as a whole as well.

In terms of region, the Northeast and West saw new home sales increase, up 42% and 5%, respectively – the Northeast accounts for just 10% of the new-home market, so its not significant. The Midwest and South (the largest aspect of the new-home market) saw sales fall 41% and 7.3%, respectively.

The median price of a new home rose 5.2% in December, which proved to be quite unhelpful. We saw the same occur within the existing home data. Sellers improperly assessed the market conditions, thinking they could boost prices; they were wrong.

The supply of new homes at the current sales pace rose back to 8.1 months’ worth. That figure got down to 7.1 as of October as the temporary increase in sales combined with what has been a 60% decline in new homes available for sale. The figure is still well-off the highs, but since the sales were not durable the supply figures were destined to rise again. The 40-year average is 6.3 months’ worth.

FOMC Meeting – The Lonely Voice

The FOMC did massage their latest statement, and the statement is the only thing that matters since they continue to keep the fed funds rate floored. As everyone expected, they held to the phrase “economic conditions…are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

The members stated the following. I’ve put the key changes from the prior statement in parentheses:

• “Information received since the December meeting suggests that economic activity continued to strengthen”
  
• “Household spending is expanding at a moderate pace but remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit”
  
• “Business spending on equipment and software appears to be picking up, but investment in structures is still contracting and employers remain reluctant to add to payrolls” (Prior statement: business are still cutting back)
  
• “Firms have brought inventory stocks into better alignment with sales”
  
• “While bank lending continues to contract, financial market conditions remain supportive of economic growth”
  
• “Although the pace of economic recovery is likely to moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability” (prior statement concentrated on fiscal and monetary actions as the key contributions to the strengthening of economic growth) My note: this was the biggest change in the statement. This could be viewed as an indication they are thinking about a mild rate increase. Why would they drop the key point that monetary stimulus is a necessary condition to the economic improvement if they didn’t mean to float this message?
  
• “And finally, in usual Keynesian form, they mentioned that substantial resource slack continues to restrain cost pressures and with longer-term inflation expectations stable, inflation is likely to be subdued for some time” (Prior statement: inflation will remain subdued) My note: this also subtly points to the thought of some tightening. Additional note: While inflation is likely to remain subdued for a while, as we’ve been talking about, the Fed better take the focus off of resource slack and focus more on commodity prices and bank credit. When bank credit begins to expand, inflation will roll in short order, regardless of the unused plant, equipment and labor resources.)

There was a dissenting vote this go around with KC Fed Bank President Thomas Hoenig believing the time has come to stop promising ultra-low rates. It would have been a shock to the market if the Committee would have stated this in unison as they have not telegraphed the move via speeches -- even though I agree with Hoenig’s point of view, the emergency level of rates must be removed.

They stuck to their March 31 timeline of ending the MBS and agency debt purchase program, just as expected.


Have a great day!

Brent Vondera, Senior Analyst

Take Quality Over Quantity When It Comes To Earnings

Quality doesn’t get much attention in the financial headlines or from investors for that matter. The quality rather than the quantity of earnings is a much better gauge of future performance. Firms with high-quality earnings typically generate above-average P/E multiples – they give investors a good reason to pay more – and tend to outperform the market for a longer time.

There is no perfect definition for earnings quality, but understanding the degree of conservatism within a firm’s income statement is crucial. The best way to accomplish this is to review the firm’s revenue recognition, inventory valuation, and depreciation method – all of which can be found in the Management Discussion & Analysis section of the firm’s 10-K.

Recognizing that most readers lack the time or motivation to make such an assessment about an income statement – that’s what you hire Acropolis for – I won’t get into the gritty details. Instead, you simply need to remember that high-quality earnings are repeatable, controllable and bankable.

Let’s start with repeatable. It’s common to see a brief boost to earnings from a one-time event such as a tax-benefit or the sale of assets, both of which investors can’t rely on to be repeated. For example, the earnings pop a healthcare company gets from selling animal care unit can only happen one time. Sales growth or cost cutting, on the other hand, has a positive effect on earnings that can be repeated. Sales growth in one quarter is normally, but not always, followed by sales growth in future quarters. And cost reductions are not typically reversed quickly, thus investors can expect earnings to benefit from the operating leverage in future quarters.

One-time earnings surges can also be attributable to items out of a firm’s control. Take currency fluctuations for example. A U.S. company with large international operations would benefit from a falling dollar against international currencies since international profits are converted back into dollars. Unfortunately, management has no control over exchange rate fluctuations – this blends in with the previous point in that uncontrollable items cannot be assumed to be repeatable. Other examples of items out of a firm’s control include inflation or deflation – falling jet fuel prices can improve earnings at transportation companies like UPS. Even weather can boost earnings – utilities and coal companies enjoy extra profits when temperatures are unusually hot or cold.

The most important characteristic of quality earnings is that they are bankable. By this I mean that investors should seek firms with earnings figures that closely resemble the cash flow they generate. Cash flow, which firms can control and repeat, is the source of the highest-quality earnings. A company that recognizes revenue before cash is received (using account receivables) faces large uncertainties since customers may cancel or refuse to pay. In this case it is easy to identify the lower earnings quality because the amount of actual cash flow the company generates will be lower than the earnings number (since all of the revenue has not been collected).

The point to take away from all of this is that the earnings number itself isn’t always the best indicator of a successful company. When it comes to earnings, investors should seek out quality over quantity.

--

Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks fell on Tuesday and if you fell asleep just an hour into the session and awoke with 30 minutes left you wouldn’t think much occurred. But stocks did rally off of an opening sell off, following a better-than-expected consumer confidence reading.. It looked like we were going to hold the gains too, but traders backed off ahead of today’s FOMC meeting and the SOTU address.

The U.S. market followed international bourses lower after China began to engage in policy steps to restrict loan growth – which has reportedly been torrid, more than doubling over the past year. The Asian markets led the declines as the Shanghai Composite fell 2.4% and has backed off by a bit more than 9% since December. The Hang Seng Index (Hong Kong) fell a similar amount and is off by 10% over the past two weeks.

Financials led the declines, with telecom and basic material shares close behind. The utilities and consumer discretionary sectors were the only of the 10 major groups to close on the plus side.

Remember we talked about that 1090 level the S&P 500 has bounced off of several times over the past three month…check out the chart below. Let’s see how long it remains a level of support.

Market Activity for January 26, 2010
S&P CaseShiller Home Price Index

The S&P CaseShiller HPI rose 0.24% for November, marking the sixth month of increase -- that’s on a seasonally-adjusted basis. Unadjusted, the home price index fell for a second-straight month. From a year-over-year perspective, CaseShiller has prices down 5.32%, which missed expectations just a bit but is the smallest y/o/y decline since September 2007. The y/o/y single-digit price decline has been in play for three months now; it follows 20 months of double-digit percentage declines.

This measure tracks 20 major metro areas and for November six cities registered a month-over-month decline, which is an improvement from October’s nine cities that posted a negative reading. Miami, Tampa, Chicago and New York were the cities that posted recurring price drops. Washington DC and Detroit registered price declines in November after posting positive reading in October.

Of the 14 cities that registered an increase in November (four of which were cities that showed a price decline in the previous month), Phoenix led the way with a monthly increase of 1.56%. That was followed by San Francisco (up 1.47%), San Diego (up 1.02%) and L.A. (up 0.97%). These are some of what were the hardest hit metros.

Four cities registered y/o/y price increases: Dallas (up 1.4%), San Francisco (up 1.0%), Denver (up 0.49%) and San Diego (up 0.38%).

Since hitting the cycle low in April (and this is on a not seasonally-adjusted basis as this is the primary way the index has been presented, it just started providing seasonally-adjusted readings a few months back), the index has rebounded by 5%. This puts the index down 29.2% from the peak hit in July 2006. The current level was first touched in September 2003.

Consumer Confidence

The Conference Board’s reading on consumer confidence for January came in at a better-than-expected 55.9 (53.5 was expected) after 53.6 in December (a number that was revised up from the initial print of 52.9). The January reading is the highest since September 2008, yet barely above past recession lows. The 40-year average is 95.6.

The January increase was driven by the present conditions segment, which pulled itself off of the mat by rising to 25.0 from the cycle low of 20.2 in December. This is the first real increase in the present conditions reading since August so maybe there’s a little something happening here – likely due to some stabilization within the job market. Still, the measure remains pretty much floored, as the chart below shows. The long-term average is 99.5.

The expectations index provided little help to the overall reading, rising just a bit to 76.5 from 75.9 in December. The long-term average is 92.98.

The key reading for gauging future consumer activity remains the jobs “plentiful” less jobs “hard to get” index. That reading improved for a second straight month but only gets us back to the level of September. Those respondents seeing jobs as “plentiful” rose to 4.3 from 3.1, while those that see jobs as “hard to get” fell to 47.4 from 48.1. This number has to get back to around the -20 level before we even begin to get excited about the consumer. At that point, there is probably enough job growth occurring so that households can begin to meaningfully reduce debt burdens. This is the first order of things to eventually get consumer-activity growth to levels we’ve become accustomed – this will probably take a couple of years to accomplish though as activity will be meaningfully lower as the process works its course.

Richmond Fed Survey

The Richmond Federal Reserve Bank’s measure of factory activity for January (within the fourth Fed district) was pretty much a dog, remaining in contraction mode for a second-straight month. Its rebound from prior contraction lasted seven months. The index came in at -2, which was an improvement from December’s -4.

The new orders and vendor lead times were the only sub-indices to print positive readings – up to 1 from -4 for new orders and a nice bounce to 5 from -2 for vendor lead times. (Vendor lead times is simply delivery times. You want this number to post positive readings, which means lead time have slowed; thus, deliveries are having a difficult time keeping up with factory production.)

However, orders backlogs fell to -13 from -12; capacity utilization remained unchanged at -3; the average workweek fell to -6 from 2,

So we now have two regional manufacturing reports for the month, one good and one not so good. The Empire Manufacturing survey (factory activity within the Fed’s second district – New York) provided us with a well-balanced report a week ago. Now we wait for the number out of Chicago, which will be released on Friday.

The Fed

The Federal Open Market Committee (FOMC – the policymaking arm of the Federal Reserve) began their two-day meeting yesterday. We’ll get the statement that follows the close of the meeting at 1pm CST. Don’t expect anything different from the prior meeting’s statement – not yet at least; changes should begin to make things interesting a few months down the road.

I see the UK economy has halted a six-quarter contraction, but just barely as fourth-quarter GDP came in at +0.1%. Such a paltry gain hardly illustrates that that their recession has ended and increases the likelihood that the Bank of England will extend and expand their QE program (bond purchase program).

What will our Fed do? They currently plan on ending QE on March 31. (The Fed’s QE program has involved buying $1.25 trillion of mortgage-backed securities (MBS) and has driven both mortgage and Treasury rates lower – the buying of MBS has directly pushed mortgage rates lower and indirectly kept Treasury yields lower than they otherwise would be as private investors sell the Fed MBS and buys Treasury securities with the proceeds, as firms like PIMCO have explained.) Bernanke & Co. have signaled on more than one occasion that this program will indeed close on that date, so don’t expect them to extend it…not yet. But if we get to mid-2010 and the housing market runs into trouble, they’ll probably be back in the game of buying bonds to push rates lower in an attempt to induce sales.

Home sales should show some life again in March and April as home borrowers rush in before the tax credit expires April 30 (contract has to be signed by that date), which means May, June and July may be ugly – especially on a seasonally-adjusted basis as this is normally the key buying season.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

Stocks shook off a worse-than-expected decline in home sales to get back some of last week’s declines, but did pare about half of the day’s peak increase in the final hour of trading. I say the market shook off the housing, but what’s bad is good, right? I don’t know how long this philosophy will prevail but for now the market still wants to see pedal-to-the-metal monetary policy.

There was a little Monday combebacker mentality in pre-market trading yesterday that flowed into the official session, but as touched on above traders hesitated a bit with such a huge week ahead – 136 S&P 500 members reporting, a slew of big economic releases and the State of the Union address.

Japanese policy makers may have also helped out a bit. Not that Japan monetary policy matters much these days, but they did state a possible increase in their quantitative easing (QE) program is on the horizon if the economy slips again – which means they will step up their QE program.

Last week’s performance certainly suggested the market is not going to react well when copious and aggressive varieties of stimuli are removed – and soon enough at least some of this unprecedented level of coordinated global accommodation will have to be removed. There is little evidence to this point that the global economy will be able to foster much growth on its own – without the benefit of either time or a more permanent incentives-based growth policy in the U.S..

Along these lines, we see the Chinese are sticking their path of reining in some of their very aggressive stimulus measures. I was beginning to think statement from the Chinese were nothing but a trial balloon -- see how the market responds. Well, they appear to be serious as they’ve instructed the Bank of China Ltd. and China Construction Bank (huge lenders that are major sources of infrastructure-based lending) to restrict new loans and build reserves. This has the international bourses down this morning – obviously, Asian markets are leading the declines. U.S. stock-index futures are under pressure as a result.

Market Activity for January 25, 2010
Earnings, Data Releases and SOTU

The battle between economic headwinds and improved bottom-line corporate results continues and this week should enlighten us as to which side will prevail in determining the market’s direction. We’re into the heart of earnings season now and it will also be a huge week on the economic data front.

As of this morning, about 20% of S&P 500 members are in and operating profits are up 374% -- up 22% excluding financials. As that comment illustrates, total results are being fueled by the banking sector (the big names in this sector are always early reporters) as they set aside lower levels of loan-loss provisions and results are compared to the as-bad-as-it-gets quarter of a year ago. But banks will still have to deal with future headwinds and I expect they’ll be setting aside more provisions over the next couple of quarters. So, we focus on ex-financial results to help smooth out results and one hopes we can hold onto this 20% increase. Oh, and we’ll be watching the top line as well; the market will want to see some increase in sales. Lets’ hope we can manage a mild increase as these results are against the revenue collapse of the year-ago period.

What we do know is we’ve seen the trough in earnings, it occurred in the third quarter. For Q3 2009, S&P 500 operating earnings per share (EPS) totaled about $40 on a trailing twelve-month basis (TTM), down 56% from the peak of $91 hit in Q2 2007. If we assume the expected $17 in S&P 500 fourth-quarter earnings comes to fruition, we’ll end 2009 at about $57. Most seem to expect total 2010 S&P 500 EPS to come in around $77; we’ll see if that happens.

When it comes to building a valuation analysis I find it appropriate to assume $65 as the basis to evaluate the market – I see the payroll reduction-driven profit story as short lived and so it makes sense to use a more normalized number. So assuming $65 on total S&P 500 earnings, the market currently trades at roughly 17 times. This is a reasonable valuation, but it is slightly above the long-term average of 15-16 times. Considering the headwinds we face (the macroeconomic, populist and geopolitical challenges), it is difficult to afford the market a multiple that is even in line with the LT average much less above it. Sales will have a rough time mustering steady improvement due to a 10% unemployment rate and heightened business caution; this increases doubts that the profit bounce will be lasting. Margins will continue to look good thanks to the super-aggressive cost cutting. But it cuts both ways as the slashing of payrolls will hurt final demand.

The week’s economic data may prove quite challenging, particularly from the standard point of additional housing data, consumer confidence and jobless claims. In addition, the Chicago manufacturing reading – a big market-moving release – may struggle to print a number in line with expectations after December’s robust print of 60.

The big positive reading (not necessarily on an expectations basis but just because we haven’t seen a good GDP print in eight quarters) will come on Friday via the Q4 GDP reading. The first look (there will be two additional primary revisions) at GDP is going to be good, something around 4.5%. But if it disappoints by coming in shy of expectations, worries about a pace of recovery that’s necessary to move the jobless rate lower may ensue – we’ll need at least four-quarters of 4.5%-5.0% growth to get us down to 9.0% by year end and I think there is little chance of this happening.

I’m having a hard seeing how the market responds well to any GDP print below say 6.0%. (Why do I pick 6%? It certainly isn’t an arbitrary number. This level is the low-end of the averages growth performance coming out of the worst recessions in the postwar era – a level that would indicate the economy may be able to withstand some very mild tightening.) If GDP disappoints, it will offset the improvement in corporate profits. But even if the number surprises to the upside, one can see renewed concerns that policymakers will remove stimulus sooner than currently expected. (There is zero chance even slight policy accommodation will be taken away before the market expects, which is currently sometime between June-September, but with the easy-money/fiscal stimulus “sugar high” the government has engendered the market is intensely sensitive to any signs of reversal.)

And then we have the SOTU address tomorrow night, which brings yet another factor the market must consider this week. If the President’s tenor resembles the rhetoric expressed in his speech on Friday, things will get even more interesting.

Existing Home Sales

The National Association of Realtors illustrated what the pending homes sales have suggested earlier in the month: the extension of the home-borrowers tax credit will not have the same affect as it did initially, at least not until spring arrives.

Previously-owned home sales got whacked by 16.7% (-16.8% for single-family only) in December, falling back to 5.45 million at a seasonally-adjusted annual rate (SAAR). This the largest monthly decline since records began in 1968. The expectation was for a decline of 9.7%. For all of 2009 though, existing home sales rose 4.9%; the first annual gain since 2005.

Foreclosures and other distressed properties continue to make up about a third of total sales. For December, that percentage was 32%, according to the National Association of Realtors (NAR).

Above I referreed to the pending sales data because existing home sales are not counted until the contract is closed. Since contracts take 4-6 weeks to close, the 16% slide in signings via the November pending sales data signaled what was about to occur. (For clarity, new home sales are not counted this way, they are official sales at signing.) Those buyers in November knew what was going on with the tax credit as the extension was announced on November 4, so one cannot blame the decline on buyers’ uncertainty as to the extension of that credit.

I want to concentrate on the single-family numbers, which make up nearly 90% of all previously-owned home sales. The 16.8% decline in single-family units marks the first monthly drop in three months and only the second in nine. There is indeed more than just a hangover that’s following the antecedent three-month surge in sales – fostered by buyers rushing to get in before what was perceived to be the expiration of the tax credit, which was originally slated to expire November 30. The December results were a complete purging as the decline erased the sales increases of November and October. From here, we’ll watch to see if the extension of the borrowers subsidy offers a similar effect as we get closer to spring. A contract must be signed though by April 30 to still get the tax credit.

The months’ worth of supply for all existing homes rose to 7.2 months from 6.5 in November – up to 6.9 months from 6.2 for single-fam. only. (This means at the current sales pace it would take 6.9 months to sell off all currently available supply – the 20-year average is 6.4 months.)

The number of homes available for sale fell and is getting closer to a level that makes more sense as the chart below illustrates. The caveat is that estimates of foreclosed, or soon-to-be foreclosed on homes, that have yet to hit the market range from 3-7 million properties -- taking the low-end of this estimate the number of previously-owned homes available for sale doubles.

The median price of an existing home rose 4.8% during December to $177,500 from $169,300 in November – this proved quite unhelpful and is yet another example of the economic distortions that occur when the government gets intensely involved. They have done nothing but extend the period of time with which the market must accomplish supply/demand equilibrium.

I don’t think we’ve seen the extent of the downside. When more foreclosures (which are running at 300,000-plus per month) hit the market, prices will fall if the sales are not there to support this coming supply. With the jobless rate at 10% and the under-employment number at 17.3%, sales are unlikely to be there. It will take either lower prices or a sudden boom in job creation to boost sales in a durable manner. I’m betting the former is more likely to occur – not exactly going out on a limb with that one.


Have a great day!


Brent Vondera, Senior Analyst

Pharmaceuticals in 2010: JNJ, PFE, LLY

Last week I spoke of the general attractiveness of the healthcare sector, and today I want to focus particularly on pharmaceuticals. The most visible positive catalyst for the industry is that the worst-case reform scenarios – a single-payer system or a public plan with a Medicare-linked fee schedule – are no longer a threat.

Another boon to the industry could be the significant number of late stage product results are due in 2010 and 2011. In 2008 and 2009, there were very few Phase III drugs completing clinical trials that were viewed as significant improvements in the standard of care. Consequently, the news surrounding the industry had low emphasis on sources of future revenue growth and high emphasis on generic erosion. The game-changing clinical data on tap for 2010 and 2011 could help reverse investor skepticism on the industry’s pipelines – a very substantial factor in the group’s deeply discounted valuations.

Also working in favor of pharmaceuticals is that mega deals have improved the patent cliffs, and thus the industry has a better outlook to longer-term earnings than a year ago. There is also reason to believe that some additional upside could surface over the next few years for deals involving emerging markets and biologic capabilities.

As the above dynamics generate investor interest, I expect to see the valuation gap between the S&P 500 and Pharmaceuticals contract.

Here are a few of the pharmaceuticals currently on our Approved List.

Johnson & Johnson (JNJ)
It’s hard to find a higher-quality healthcare firm than JNJ. The firm’s AAA credit rating is rare among its pharmaceutical competitors. With nearly $15 billion in annual cash flow from operations, JNJ has plenty of financial flexibility to continue making strategic acquisitions, increasing their dividend, and buying back stock.

One of the more expensive healthcare companies (as measured by P/E ratio) on our Approved List, JNJ still trades at a 25% discount to the S&P 500 and about a 37% discount to its 10-year average valuation.

The firm trades at a premium to the healthcare sector because investors value its diverse revenue base (in which JNJ controls the #1 or #2 leadership spot in 70% of its products), robust drug pipeline (with 10 potential blockbusters in Phase III development), strong brand names (Tylenol, Band-Aid, Listerine, Splenda, Neutrogena, Acuvue, Audafed, Rolaids, just to name a few), and exceptional free cash flow generation. Furthermore, JNJ’s patent exposure was more prominent in the last two years than it will be in coming years.

2010 will bring clinical trial data from two of JNJ’s Phase III drugs. In the hepatitis C market, JNJ and Vertex (VRTX) are expected to report strong pivotal Phase III data on protease inhibitor telaprevir. The firm’s cardiovascular drug Xarelto is also expected to post solid data, demonstrating its ability to prevent strokes in patients with atrial fibrillation.


Pfizer (PFE)
PFE completed its acquisition of Wyeth last quarter, dramatically altering the trajectory of PFE’s patent cliff, while expanding PFE’s geographic reach (particularly in emerging markets) and other strategic (e.g. biosimilar) possibilities. Revenue will still be substantially lower in 2015 than it is in 2010, but PFE plans to use large amounts of cost-cutting to EPS basically flat across this period. If EPS is, in fact, roughly flat through 2015, then the PFE looks inexpensive compared to its peers (32% discount) and the broader market (55% discount).

PFE trades at a nearly 60% discount to its 10-year average, which is reflective of the fact that PFE is no longer the growth story it was in the past. Still, the company generates significant amounts of free cash flow and will continue to do so. PFE’s long trend of paying a growing dividend will also continue as well as their robust cash flows quickly work down debt during the next few years.

Whether or not PFE returns to their growth-glory-days will depend on their management of a massive pipeline that is heavily-weighted towards early-phase drugs. In the arthritis market, we will likely see data this year from JAK inhibitor, currently in a Phase III program – the drug has already established strong efficacy so safety will be the focus. Based on Phase II data, analysts expect the drug to make a significant dent in the rheumatoid arthritis market. Investors should also watch for data on dimebon, PFE’s Alzheimer’s treatment.

My longer-term concern with PFE is their tendency to use big acquisitions as a platform for growth. The company’s reliance on big takeovers rather than strong in-house research and smart licensing has destroyed an enormous amount of shareholder wealth.

Nevertheless, PFE is a great way to get exposure to the undervalued pharmaceutical sector and seemingly provides more sustainable dividend income than the next company of topic.


Eli Lilly (LLY)
LLY is set for decent EPS growth through 2011, but then will begin to fall sharply for what could be a multi-year period due to the loss of several major, high-margin products to generic competition. There are some regulatory and commercial concerns about several pipeline drugs in the latest stages of development, but the pipeline may still be incapable of replacing revenue from drugs losing patent protection.

While LLY looks inexpensive on a P/E basis when using 2009 or 2010 estimates, it looks expensive when evaluating the longer-term earnings trend that is substantially lower. The patent cliff loss is similar in magnitude to Pfizer’s before their Wyeth acquisition.

Thus, LLY may be forced to do a sizeable acquisition. The immediate question then becomes whether such an acquisition would lead LLY to cut the dividend, to which management persistently denies would happen. LLY management did provide a worst-case-scenario for long-term earnings in December, but the outlook remains cloudy.

So LLY is the wild card here, but contrarians may piece together an intermediate-term investment case. The company is the cheapest among its peers, sports the highest dividend yield, and has the most negative analyst sentiment, yet there is no easily identifiable sources of downside risk in the near-term.
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Peter J. Lazaroff, Investment Analyst

Daily Insight

More of the same hit stocks on Friday as concerns about Chinese tightening and increasing regulations in the U.S. caused a shift in what has become a very high level of complacency. Now add uncertainty over the Bernanke confirmation and we had some real doubts over this rally roll in.

The median forecast of 17 economists surveyed by Bloomberg has China raising interbank rates and reserve requirements by June and the Obama regulatory plan has people worried about earnings and the fragile and incipient economic rebound. Certainly, traders had no desire to go into a weekend with the increased uncertainty in the air, made worse by the possibility that a politician may say something that brings a Bernanke confirmation even further in doubt – this concern has now dissipated, more on that below

As I stated yesterday, I think this regulatory proposal is more talk than anything else. It’s difficult to see the thing passing in the current economic environment, but Congress has been known to do things that are rather unwise (to put it kindly) and horribly ill-timed. Because of the lack of specifics in the proposal, some are wondering if this plan would limit balance sheet expansion. That gets to the credit contraction issue. This isn’t a campaign, and the President can’t go out there as if he’s on the stump; this is for real and this market surely doesn’t need additional uncertainties spooking it.

Speaking of regulations that are more certain, the Credit Card Accountability Responsibility and Disclosure Act (no wonder it goes by the easier name: CARD Act) is beginning to present some issues for certain aspects of the market – frankly, the market should have begun pricing this in a couple of months back. The latest comes via analysts’ downgrades of the major card issuers as proposed changes to credit-card regs. will damage margins. American Express and Capital One were hit by 8.5% and 12%, respectively. Beginning next month the group will have to deal with new provisions via the CARD Act.

Tech, financials and basic material stocks were the worst performers on the session. Two of the traditional areas of safety, consumer staples and health-care, were the best performers. That was true for the week as health-care shares actually rose, up 1.5%, and staples fell just 2.1%. The broad market lost 3.9% for the week, led by a 6.3% slide in basic material shares. This marks the third-worst week for the broad market since March lows.

With about 30 minutes left in the session I noticed the S&P 500 was managing to hold above 1090, which may be a level technicians are keeping an eye on as that’s right about the number the market has found support on several occasions. It looked like we were going to dive past that mark but it held. We’ll see this week if that level continues to be supportive.

Market Activity for January 22, 2010
Populism’s Engulfing Wave Hits Bernanke Beach

The swell of populism, that has undoubtedly been fomented by politicians, looks to be headed straight for Fed Chairman Bernanke. The Fed head is up for confirmation and that means he must garner 60 votes in the Senate. But the members of Congress are running for cover ahead of the November mid-term elections and that means Bernanke is caught in the middle of it.

I’ve been critical of the Fed; plain and simple they are the origin of the credit/debt bubble that the economy will continue to work off for some time still. There were many things that caused consumers and institutions to take on dangerous levels of leverage: years of social-engineering from Congress that targeted putting as many people as possible in houses, at any cost; an erosion of credit standards; and a lack of personal responsibility, to name the big ones. But none of this would have gotten rolling if the Fed had not kept rates too low for too long – a three-year period of holding the real fed funds rate negative. When you hold short-term interest rates below the rate of inflation you subsidize debt, which means you will get more of it – and boy did we. It also engenders a mispricing of risk. Fed policy earlier in the decade was the incendiary device that lit the bomb.

That said, you can’t exactly go and change the Fed Chairman without telegraphing it to great extent. Besides, it’s not like we’re going to get a Dick Fischer, a John Taylor, a David Malpass, a Glenn Hubbard as the alternative – and certainly not Paul Volcker; that would demolish the easy-money trade in a millisecond. These are strong dollar, sound money economists that understand you just can’t keep jacking interest to rock-bottom levels and pumping massive amounts of money into the system without perilous consequences on the other side. At some point you have to do some things that may make life more difficult in the meantime, but puts things on a more solid footing for the longer term. (And I’m not saying the Fed should not have responded to what happened in the back half of 2008, just that they caused the issue in the first place and have yet again sent fed funds too low – coupled now with a quantitative easing program that will be tough for them t completely rein in.)

No, the replacement we’ll get if Bernanke can’t get the 60 Senate votes required for confirmation is Donald Kohn, the Vice Chairman of the Fed. He is of the exact same mold as Bernanke, so the change could do significant damage to the market, but without actually changing the policy direction in a way that makes us better off in the longer-term. It’s the worst that can happen.

So, we don’t know yet what will happen to Bernanke. Certainly, things were looking much more precarious Friday afternoon than they are right now after a few Senators decided to signal they’ll back the Chairman Friday evening following the stock-market reaction. Senate Minority Leader McConnell stated on “Meet the Press” that they’ll have the 60 votes. Even if he gets 60, that means 40 nay votes. To this point, the most nays a Fed Chairman has ever received is 16 when Volcker was re-confirmed in 1983. The big difference was Volcker had jacked the fed funds rate to the politically abhorrent double-digits, while Bernanke is at the politically harmonious rate of zero.

If it wasn’t hard enough, Bernanke’s job is going to get even tougher if he is confirmed. The lack of support means he’ll have an exceptional level of politicization to work through in getting policy right. As a result, it’s even more likely the FOMC will make mistakes that cause significant problems down the road.

Huge Week

It will be a big week on every front as we get a slew of economic data, the heart of the earning season, the Fed’s latest meeting and the State of the Union address.

On the economic front we’ll get several releases on housing, consumer confidence, durable goods orders, the first look at fourth-quarter GDP and comments from the FOMC as they’re two-day meeting closes on Wednesday.

For earnings, 136 S&P 500 members will report so we’ll have nearly 50% in by the end of the week and a great sense of how the quarter will wrap up.

The State of the Union will be quite enlightening. If it looks anything like President Obama’s speech on Friday from Ohio, things are about to get even more interesting.

Have a great day!

Brent Vondera, Senior Analyst