Weekly Roundup: LLL, WLP, CERN, WMT, WAG

L-3 Communications Holdings Inc. (LLL) +3.33%
LLL agreed to buy Insight Technology Inc. to add night-vision goggles and thermal-imaging systems to its already diverse defense portfolio. The acquisition will be completed in the second quarter and will immediately add to operating results. Insight, which also makes laser aiming devices and laser rangefinders, is expected to have about $290 million in sales in 2010.

Just last week, LLL’s CEO Michael Strianese said the company had “plenty of dry powder” for acquisitions with about $1 billion in cash as well as access to credit. The purchase will be an all cash transaction, but the terms are yet to be disclosed.

LLL has a strong history of acquiring cutting-edge technology and his built a stable position in the defense industry thanks to its diversified product portfolio – LLL has about 2,000 contracts with no single contract accounting for more than 3% of total revenue.

The Pentagon’s budget is slated to increase by 3.4%, not including money for the wars in Iraq and Afghanistan. In particular, the Pentagon’s procurement budget is set for a 7.6% increase with command, control, and communications systems expected to see a boost. This will directly benefit firms like LLL and Harris Corporation (HRS).

WellPoint Inc. (WLP) -0.86%
WLP shares fell this week amid the company’s Congressional testimony over proposed premium increases in California. WLP said in a statement the pervious earnings forecast for 2010 is now subject to the “ability to secure and maintain sufficient premium rates.”

The health insurer has postponed premium increases of as much as 39% for two months so that California’s insurance commissioner could review the plan after it was heavily criticized by state officials and the Obama administration.

The recession and difficult labor market is leading younger, healthier individuals to forgo insurance, skewing the mix of policy holders toward the elderly. This dynamic and rising medical costs are the basis for WLP’s premium increases. Insurers were banking on federal legislation to help contain rising healthcare costs, but there is little choice but to raise rates since the healthcare bill has stalled.

Cerner (CERN) +3.00%
After a rough start to 2010, CERN has rebounded a bit in the past few weeks. Some of the bounce may be attributable to investors taking positions after the sell-off in January – the stock fell 8.22% for the month. CERN also reported earnings late last week that should a strong rebound in systems sales during the fourth quarter, which suggest the healthcare IT environment is improving.

Also lifting sentiment was various analyst upgrades for both CERN and fellow healthcare IT firm Quality Systems Inc. (QSII).

Additional content from this week:

• Wal-Mart Stores (WMT) hurt by deflation and lower traffic
• Walgreen Co. (WAG) buys New York drugstore chain

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Peter J. Lazaroff, Investment Analyst

Fixed Income Weekly

The Fed took the market by a bit of a surprise after Thursday’s close when they moved the discount rate higher by 25 basis points to .75%, in addition to lowering the maximum term from 28 days to overnight. Before the crisis the spread between fed-funds and the discount rate stood at 1%, Thursday’s move brings the spread to about .65% if you use the current market fed-funds rate of 14 basis points. The reason for the 100 basis point spread during normal times is to penalize banks for going to the Federal Reserve for funding and encourage banks to get funding from other institutions through the fed-funds market. The spread was lowered in March of 2008 to lessen the strain on banks and provide a cheap source of liquidity for banks unable to obtain funding through fed-funds.

The short end sold off hard immediately after the release, gaining about 10 basis points in yield in the few hours following the announcement, but eased off the lows a bit in Friday’s trading. I don’t think that this move was meaningless, but it’s pretty close. The jump in rates was from the low end of the .8% to 1.1% range on the 2-year that we’ve been in for a while, and should expect to be in for at least the first half of 2010. As far as this move telegraphing an adjustment to the fed-funds rate goes, we still haven’t seen anything substantial from the Fed. Sure, Thomas Hoenig became the first dissenting vote last meeting when he urged to committee to remove the “extended period” language from the statement, but Thursday’s test will be followed by many more before a real move is made.


Have a good weekend.

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks rose on Thursday, staging another nice session and bringing the winning streak to three. A nice headline Philly Fed reading outweighed much worse-than-expected jobless claims data.

A strong earnings report from Hewlett-Packard also helped to boost the market. The largest personal computer maker beat profit and sales estimates during the fourth quarter – although operating earnings (which removes one-time items that either boost or depress profits) did miss estimates by 4.4%; this is the number we watch. Total sales rose 8% thanks to a 41% jump in sales to the BRICs (Brazil, Russia, India and China) – undoubtedly fueled by China and their massive stimulus program.

Hewlett enjoyed increased market share, holiday spending and business outlays as firms had unspent equipment budgets at the end of 2009. This is something we talked about last week, I think it was; firms were unwilling to spend during most of 2009 and as November and December arrived they uses those funds to replace aging equipment. We’ll need to see a comparable follow through in the first quarter to confirm that something exciting is occurring on the business spending front.

Earnings results from Wal-Mart that missed its projection partially offset the good report from Hewlett. Wal-Mart reported that sales for stores open at least a year fell 1.6% in the three months ended January 31. CEO Mike Duke warned that sales will be “more challenging” in the current quarter and. Some people saw the WMT news as a sign consumers are trading up to a higher price point. I’m not sure about that one with 9.8% unemployment and 17% under-employment, but we’ll see.

Basic material shares led the broad market higher, followed by industrials. Nine of the 10 major industry groups closed higher, telecoms being the only loser.

Market Activity for February 18, 2010
Greenback

The U.S. dollar rallied on concerns out of the EU (those sovereign debt issues) and the continued flee from the euro. The situation remains such that the dollar only catches a bid on bad news and investors are certainly fleeing the EU currency, which has gotten smacked by 10% since December. But later in the session the greenback gave up those gains as the euro caught a bit of a bid – speculation that the Swiss engaged in some currency intervention, selling their franc to halt its gains and this meant buying some euros.

While the dollar erased early-session gains it remained above the 80 handle on the Dollar Index (DXY). If it holds here it will help to contain the inflation readings over the subsequent months, particularly with regard to import price inflation that has become a bit frothy of late. After the bell the dollar rallied hard on news the Fed raised the discounts rate, more on this below.

This dollar boost also has ramifications for multi-nationals. Global growth is still not strong enough to boost multi-national company sales without help from a lower currency value – a lower dollar value makes our goods cheaper to overseas buyers. (I am in no way advocating that policy makers move to put pressure on the dollar, they’ve done enough harm to the greenback with an insane level of government spending and the Fed’s ZIRP. You can’t create a prosperous environment by kicking your currency into the dirt, even if it does help in the short term.)

If the U.S. dollar continues to rally on euro woes, and the current belief that Fed tightening is on the way, then this is going to do some damage to profit expectations a couple of quarters out.

Jobless Claims

Well, so much for that decline in claims last week. The Labor Department reported that initial jobless claims rose 31,000 to 473,000 in the week ended February 13 after falling 41,000 to 442,000 in the previous week. Economists had expected claims to fall to 438K.

So you look at the past two weeks and initial claims are down 10,000 but the level remains well above 450K. The previous week’s decline brought excitement that initial claims would crash below the 400K level but that seems a bit premature now. (The 400K level is important because it always signals at least mild monthly job growth.)

The four-week average on initial claims fell 1,500 to 467,500.

Overall continuing claims resumed their move higher too. Standard claims, those that last the traditional 26 weeks, came in unchanged from the week prior.

However, Emergency Unemployment Compensation (EUC) rose 274,000. Over the past six weeks EUC claims have jumped 707,000.

Neither the initial nor the continuing claims data suggest the labor market in improving to a point in which we’ll see job growth, much less statistically significant job growth. I’ve been expecting to see mild job growth beginning in February or March (meaning monthly growth of at least 50K). These numbers aren’t offering much confidence in this call.

We need job growth to keep things going, to get final consumer demand trending higher. Without it, the inventory-led GDP boost we’ve seen is going to fizzle out in short order.

Producer Price Index (PPI)

Producer prices rose 1.4% in January according to the Labor Department, which outpaced the 1.0% rise that was expected. The increase was mostly due to the fuel components as the ex-energy reading rose just 0.3%. But energy sort of matters as it makes up between 8-12% of disposable income for most households. It’s ridiculous for the Fed to use an inflation gauge that excludes food and energy as their desired tool for tracking price activity.

The overall energy component rose 5.1% for the month, boosted by an 11.5% jump in gasoline. Overall consumer goods rose 1.8% in January and are up 18.4% at an annual rate over the past three months. Gasoline and residential electricity are two components within the consumer goods segment.

Over the past 12 months the PPI is up 4.6%, quite a turnaround just three months removed from an 11-month streak of PPI decline.
Philly Fed

The Philadelphia Federal Reserve Bank’s gauge of factory activity within their district rose to 17.6 in February (in line with expectations) from January’s 15.2. This follows a good headline figure from the Empire index (New York-area manufacturing) so the month is off to a good start. Like Empire though, some of the sub-indices suggest factories aren’t going to be quick to hire workers.

The new orders index jumped to 22.7 from 3.2 in January – this is the highest reading since April 2006. Inventories rose to 3.2 from -1.6 -- a similar level of improvement showed up in Empire. The employment data was mixed as the number of employees gauge rose to 7.4 from 6.1, yet the average workweek index fell to 1.6 from 4.2 – that divergence doesn’t make sense and one questions which reading is providing the right picture.

Among the components we’re watching most closely for clues of future hiring, the readings weren’t quite as good. The unfilled orders index fell big time, dropping to -7.5 from 3.6; the delivery times index declined to -2.1 from 6.6. We need these reading to trend in positive territory for several months as it would show that factories are having difficulty keeping up with orders. So long as they are not, which is what negative readings suggest, manufacturing employment is unlikely to move higher.

Maybe the big new orders reading will provide the work needed to stretch current workers and send the unfilled orders and delivery times gauges higher over the next couple of months. Households are saddled with high debt levels and those liabilities have to be paid down to some extent before this economy can return to normal – to state the obvious, that takes employment growth.

For now manufacturing activity is looking good, a rebound that began 5-6 months back, as inventories had been slashed at record levels and firms are rebuilding those stockpiles a bit.

Fed Timing Surprises the Market

The Fed chose to raise the discount rate by 25 basis points to 0.75% last night after the market closed. (This is the rate banks are charged to borrow directly from the Fed.) They also returned the term of these loans to overnight from 28 days. This move gets the discount rate closer to its normal 100 basis point spread over fed funds

This move by Bernanke is not a surprise as there has been talk of such action for a couple of months and they laid this out in their minute release on Wednesday. The timing is a bit interesting though. This change is intended to encourage financial institutions to rely more on money markets rather than the central bank for short-term liquidity needs.

It will be interesting to watch how the market perceives this move, possibly expecting the total exit strategy to occur sooner than formerly expected. This is a test by the Fed, testing to see how the market reacts; I still think they’ll be slow to move with regard to actual tightening – raising the fed funds rate. Former Fed Governor Laurence Meyer is predicting fed funds won’t rise for the first time until mid-2011.

For past issues of Daily Insights and other daily publications please visit: www.acrinv.com/blog

Have a great weekend!


Brent Vondera, Senior Analyst

Wal-Mart Stores (WMT) hurt by deflation and lower traffic

Wal-Mart Stores (WMT) dropped 1.09% today as fourth-quarter revenues missed expectations and soft guidance left investors unenthused.

The impact of deflation on operations is becoming increasingly obvious for a company that has traditionally been a back-door dollar play – WMT buys goods from foreign countries where the dollar is strong and sells them in the U.S. The company spent a good part of last year downplaying the impact of deflation in food and in other areas such as consumer electronics, but deflation cannot be ignored. Still, WMT has not publicly addressed with how it is dealing with this issue.

A decrease in traffic during the quarter was also responsible for disappointing results. I can’t help but assume some of the traffic decline is due to consumers trading. WMT’s low price advantage has been crucial in attracting recession-stricken consumers, but increasing signs of stabilization threaten to reverse this trend. Comparing WMT’s results to those from high-end grocer Whole Foods (WFMI) earlier this week makes the trade-up case even more compelling. WFMI raised its full-year forecast amid more store traffic and increased number of items per sales ticket.

Consumer sentiment won’t be going gangbusters until the unemployment rate moves significantly lower, but still investors should be less focused on WMT’s low-cost position and pay more attention to the company’s international sales.

Much of the company’s future leans on their international success. International operations have grown to roughly $100 billion in annual sales from nothing 20 years ago, but much of that growth came from directly acquisitions. And while international sales are growing faster than those in the U.S., profitability is lower – international operating margins are 5% and 7% in the U.S. An even bigger concern is that WMT has not been able to show the economies of scale or explicit synergies that were always the rationale for such expansion.

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks closed higher on Wednesday after a better-than-expected industrial production reading offered evidence that the global recovery in gaining momentum.

Earnings results from Deere & Company whipped very weak estimates and this was also portrayed as having a positive effect on the market. Deere’s revenues did fall 6% for the quarter but the company also upped its revenue forecast for all of 2010. Still, overall S&P 500 fourth-quarter profit growth actually dipped a bit to 12.4% from 12.6% as of Tuesday so I’m not sure that one company truly had much impact on the market.

The broad market fluctuated during the 30 minutes that followed the release of the FOMC minutes from their January 26-27 meeting, but returned to the pre-release level an hour later – so those comments had zero effect. The same can’t be true for the bond market, which sold off – the yield on the 10-year Treasury rose 7.75 basis points.

The industrial production number surely was the primary driver. Certainly, the mortgage applications and import price data didn’t help and I really doubt housing starts, which remain floored, offered much impetus either.

Even if housing starts were flying high, I don’t see how it excites investors as housing market demand/supply is far from equilibrium. While higher home building would boost GDP in the current quarter, it would only subtract from growth in subsequent periods as the coming shadow supply (seriously delinquent loans that are being held from the foreclosure process) will eventually hit the market and drive construction down again…unless the government just buys these mortgages and allows the delinquent borrowers to remain in the home, which I lament isn’t such an outrageous statement these days.

Market Activity for February 17, 2010
Mortgage Applications

The Mortgage Bankers Association reported their applications index fell 2.1% for the week ended February 12 after the 1.2% decline in the week prior. Both purchases and refinancing activity dragged the index lower.

Purchases fell 4.0% after dropping 7.0% in the week prior. Refinancing activity slipped 1.2% following a 1.4% pick up in the prior week. The rate on the 30-year mortgage remained unchanged, averaging 4.94% for the week.


Import Prices

The Labor Department reported that import prices jumped 1.4% in January (and increase of 1.0% was expected) largely due to energy prices, but ex-petro import prices rose 0.6% for the month so it was more than just fuels driving the reading higher.

The petroleum segment jumped 4.8% in January and has nearly doubled over the past year, up 95.5%. Food and beverage was up 1.3% and these import prices have begun to get juicing over the past three months, up 11.3% at an annual rate. Industrial supply prices jumped 3.8% in January and have rocketed 31% past three months at an annual rate.

For import prices overall, the index is up 11.5% from depressed levels of a year ago. The index is still down 15% from the peak hit in July 2008 (driven by that summer’s commodity price spike -- oil at $145/barrel) and is back to levels just before that period.

Housing Starts

Builders broke ground on 591,000 units at a seasonally-adjusted annual rate in January following an upwardly revised 575,000 in December. The January results were pretty much in line with expectations.

We don’t exactly need more housing units coming onto the market; it would be nice to see job growth come back, debt levels paid down and income growth take place first. This would set up for better conditions within the housing market. That said, roughly 600K units at an annual rate is close to zero in relative terms as the readings remain near record lows – the data goes back to 1959.

Recall the foreclosure figures we touched on again yesterday – 300K foreclosure filings a month, 2.8 million in 2009, another 3 million in 2010, a current distressed loan balance of $450 billion. We’re talking about three years before this inventory (both actual and shadow) clears, according to S&P. So any home building only extends the time to which the housing market can normalize.

Building permits, a gauge of construction over the next few months, fell 4.9% in January after a 10.9% jump in December.

Industrial Production

The Federal Reserve reported that industrial production (IP) rose 0.9% in January (an increase of 0.7% was expected), marking the seventh month of increase. The manufacturing segment, which accounts for 80% of the IP index, drove the figure this time – last month IP only rose thanks to a historically outsized 6.3% jump from the utility segment, a function of colder-than-normal weather.

The manufacturing segment looked strong in January as production rose 1.0% after a -0.1% slip in December. Motor vehicle and electronics production drove the segment.

Utility production rose 0.7% last month. The mining component rose 0.7% after a 0.2% production decline in December.

Industrial production is up 0.9% over the past year thanks to this seven-month streak. Prior to this rebound, IP fell in 17 out of 18 months.

Capacity utilization rose to 72.6% from 71.9% in December, marking the seventh month of improvement off of the record low of 68.3% in June -- the 40-year average is 81%. We’ll watch for the reading to hit 78%, which has taken between 12-24 months to rebound to depending on the recession -- this is the level that accompanies significant job growth. It took capacity utilization 12 months to hit 78% from the cycle low of 70% following the 1982 recession; it never dipped below 78% during the 1991 recession; and took nearly 24 months to accomplish from the cycle low of 73.5% following the 2001 downturn.

FOMC Minutes

The minutes from the January 26-27 FOMC meeting revealed that policy makers debated how and when to shrink the central bank’s $2.26 trillion balance sheet , with some pushing to start selling assets in the “near future.” (Just for clarity, when we talk about the Fed’s balance sheet it refers to the securities they hold as they purchased various assets in order to pump money into the system and create a lower interest-rate environment.)

I’ll believe that they’ll sell assets, like longer-dated Treasury bonds and mortgage-backed securities (MBS) when I see it – the discussion probably took place as lip service to the market as an attempt to keep inflation expectations moored. They can’t even find the muster to raise the fed funds rate to 0.75%-1.00% and we’re supposed to believe a debate took place on asset sales, please. Gradual asset sales would risk a significant jump in mortgage rates and crush the housing market. (These comments, even if actual asset sales are unlikely anytime soon, will likely push forward the markets tightening expectations, as evidenced by the pop in Treasury yields after the minutes were released.)

The FOMC declared the economy was in “recovery” for the first time and affirmed it would end liquidity backstops and MBS purchases.

On the FOMC’s signal as to how long the fed funds rate would remain floored, we knew there was a lone dissenter via the statement following the conclusion of the late January meeting, but the minutes repeated that KC Fed Bank President Hoenig opposed keeping the phrase “an exceptionally low level of federal funds…for an extended period” for something that suggests they may raise rates soon. The market believes that the fed funds target will not rise a smidge for another six months so long as they keep this phrase intact. Hoenig wanted the Fed to be more flexible, give themselves a little more leeway with adjusting the rate gently higher.

On their forecasts, policy makers also raised the low end of their 2010 economic growth range to 2.8%-3.5% from 2.5%-3.5%, but raised the low-end of their unemployment range to 9.5%-9.7% from 9.3%-9.7%. They believe that core inflation (which excludes food and energy prices) will range 1.1%-1.7%.

For past issues of Daily Insights and other daily publications please visit: www.acrinv.com/blog

Have a great day!

Brent Vondera, Senior Analyst

Walgreen Co. (WAG) Buys New York Drugstore Chain

Walgreen Company (WAG) announced that it will acquire New York-based Duane Reade, giving WAG a leading position in the nation’s biggest pharmacy market. At a price of $1.075 billion, including the assumption of Duane Reade’s debt, WAG will acquire Duane Reade’s 257 stores, which generate the highest sales per square foot in the retail drugstore industry nationwide.

WAG expects the transaction to be dilutive to earnings in the first 12 months after closing before becoming accretive going forward. WAG anticipates meaningful distribution and purchasing efficiencies as well as back-office synergies that could amount to $120 million and $130 million in the third year after closing.

The true value of Duane Reade is their presence around the lucrative New York City market – no doubt about it. From what I have read, everyone seems to hate Duane Reade’s staff and customer experience, but the chain also seems to carry to unambiguous title of most convenient drug store in the market place. This makes the company a perfect fit for WAG’s strategy.

WAG has used its free-standing stores in prime locations as the backbone of their growth strategy for over the past decade – WAG has a store within five miles of 70% of U.S. households – benefiting from the fact that people fill their prescriptions where it is most convenient. Because New York real estate is difficult (expensive) to obtain, an acquisition like this is the only way to build a powerful position in New York.

It’s also worth noting that the acquisition represents another step away from its historical focus on organic growth. After years of rapid expansion, WAG has significantly slowed new store openings to focus on remodeling and scrutinizing its merchandise to enhance consumer experience and convenience. Management’s goal is to increase their customers’ average basket size by one item.

I think this is a nice move by WAG, but it doesn’t dramatically change my opinion of the company. If they ever consider purchasing or signing a long-term deal with a pharmacy benefit manager (PBM), then that would be a different story.

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks gained good ground, although the market remains stuck below the midpoint of the latest range, after the NY Fed Bank reported faster-than-expected factory activity in February. Commodities rallied, with oil jumping the most in four months; the dollar declined.

I came in yesterday morning thinking dollar strength (on euro concerns) would cause pre-market enthusiasm to evaporate as the day wore on. But the opposite occurred, as the dollar weakened and stocks gained momentum as the day progressed.

Energy, basic material and financials shares led the advance. All 10 sectors were up on the session, even the worst-performer – health care – gained nearly 1%.

With roughly 80% of S&P 500 members reporting fourth-quarter profit results to this point, ex-financial operating earnings are up 12.3%. Top line growth, revenues, were up 3.8% for the quarter.

We’ll need to see 5-7% revenue growth for an extended period if we’re going to get both job and profit growth; if firms don’t see top line improvement they won’t hire. Remember the only reason profits are up is because of the slashing of costs via massive payroll cuts. We’ll need big monthly job growth to get this unemployment rate down to even the heightened level of 8% over the next 15-18 months.

Market Activity for February 16, 2010

Empire Manufacturing

The New York Federal Reserve Bank’s factory activity gauge posted the highest reading since October (and the best print since October 2007 outside of that more recent high).

The Empire Manufacturing index accelerated in February, posting a reading of 24.91 (a reading of 18 was expected) after January’s 15.92. The sub-indices of the report were mixed.


This was a strange report. The big increase on the headline reading and you’d expect to see all of the sub-indices posting significant acceleration, but it wasn’t the case.
It was almost completely boosted by the inventory gauge. While this is good, as we’ve been worried that business caution will keep firms from rebuilding stockpiles and therefore hold economic growth from a level that gets some job creation going, it is also important to see the other components follow suit.

That inventory gauge rallied big time, posting a reading of 0.00 for February after -17.33 in January – this ends 17-straight months of negative readings.

The average workweek also posted a nice gain, accelerating to 8.33 from 5.33 in January. Again, this is good news. While it will take larger average workweek readings to get job growth going, the trajectory is helpful. The number of employees rose to 5.56 from 4.00, so a little help there.

Unfortunately, the new orders index (indicator of future factory activity) decelerated to 8.78 from 20.48.

Further, the unfilled orders gauge rose only slightly to 2.78 from 2.67 and the delivery times gauge fell to -6.94 from 6.67; the former remains stuck in lackluster territory and the latter is not even close to where we need it to be. These are very important gauges, as we’ve been talking about for some time, as it shows that factories are still not having trouble meeting orders. It is essential for orders to overwhelm the much lower level of labor resources due to the slashing of payrolls, until it does you can forget about a meaningful increase in employment.

So, the headline reading is very good, but all due to the inventory gauge. While we need inventory rebuilding to catalyze growth, we also need job growth in order for final demand to take hold. Without final consumer demand the economic boost from the inventory dynamic fizzles out two-three quarters down the road and that means economic growth does too.

Treasury International Capital, or TIC, Report

The Treasury Department reported that foreign purchases of U.S. securities during December came in at half the level of the previous month, but that previous reading was one of the largest ever.

Net foreign security purchases rose $63.3 billion in December after November’s $126.4 billion increase. Net purchases of Treasury securities rose $70 billion, following November’s $118.3 billion increase; net buying of agency paper came in flat, no change, after a $5.6 billion increase in the previous month; net buying of corporate bonds fell for a fifth-straight month, down $7.9 billion after -$4.6 billion in November; buying of U.S. equities rose $20.1 billion after a $9.7 billion increase in the month prior.

These numbers are outdated, as it takes time to compile the data. Still, it is important to watch the trend – particularly these days as we’ll need big foreign demand for Treasury securities as we’re issuing record levels of debt -- $2.4 trillion in debt issuance this year alone, yow!.

The December data showed that China was usurped as the largest foreign holder of Treasury securities, Japan has returned to being the largest holder. China reduced their Treasury holdings by $34 billion, while Japan picked up an additional $11.5 billion. In the months ahead, we’ll see if China picked up more Treasuries in January and February due to the European debt and currency markets getting hit.

NAHB Housing Market Index

The National Association of Home Builders gauge of builder sentiment rose to 17 in February from 15 in the previous month. Readings below 50 means most respondents consider conditions as poor.

Rising foreclosures are adding to inventory and are do so in an aggressive manner at some point in the not-too-distant future. The government is offering lenders cash incentives to modify loans, but this is only delaying the inevitable – as we’ve talked about for several months now – as a very high percentage of those modified mortgages are back in default 2-3 months later, as you can see via the “recidivism” chart below. (S&P calls modified loans “cured” loans)

A record 3 million homes will be repossessed this year, according to RealtyTrac, up from 2.82 million in 2009 . Foreclosure filings rose 15% in January and have exceeded 300,000 per month for 11-straight months.

The NAHB’s gauge of prospective buyers held at a reading of 12 last month. Continued low interest rates, meaningfully lower home prices, and the home buyers’ tax credit are not enough to get things moving for the market. It will ultimately take significant job growth to propel the housing market into a durable rebound, and even then it will still have to contend with coming supply from all of these foreclosures.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

I wasn’t in on Friday so I don’t know what drove the market throughout the session. What did occur is the broad market closed the session lower, but just mildly as the S&P 500 recouped nearly all of its early-session losses. The NASDAQ Composite along with mid and small cap indices closed higher.

The day’s economic releases probably has a net positive effect on investors after the early losses, the session’s low point was put in just an hour into trading. Things began to improve by late-morning and more or less held that mid-day momentum.

Information technology was the only sector of the 10 majors to close higher on the day. Industrials and utility shares led the market lower as they were the worst performing sectors.

The un-Summit

I think the market was expecting the typical conclusion following the EU’s summit – discussions on how to provide aid to Greek’s budget problems. But that’s not what they got as the Euro-zone’s finance ministers stated there wouldn’t be an announcement of a detailed bailout. The market could begin to question the EU commitment over the next couple of weeks.

We’ll watch as this plays out. Frankly I like that the EU is holding Greece accountable for its reckless budget decisions – they have to do the heavy lifting here. But the Greeks, specifically the public unions, are not going to take this lying down, they’ve become too accustomed to government largess, handouts and public-sector wage growth that is likely significantly disconnected from market realities.

I really hope the EU isn’t attempting to play a game of chicken with the markets, thinking that just because they are talking about the subject public sector funding problems won’t arise; they’ll end up losing if they do. And this is about much more than just Greece as the political response to the very tough 2008-09 recession has heavily strained budgets for most Western countries. This is a bailout crazed environment, traders want to see anything that extends the rally in the short term; if they don’t get it, things may get ugly.

However, if they are serious about playing hard ball with Greece, the EU finance ministers that is, things may still get sketchy in the short term, but at least it should set up for government budget improvements that make a heck of a lot more sense for long-term economic growth potential. One thing that is for sure is the issue isn’t going away.

Retail Sales

On Friday, the Commerce Department reported that retail sales rose 0.5% (+0.3% was expected) in January. Ex-gasoline was up the same and core sales (ex gas, autos and building materials) came in at a hot 0.8% - this even as building materials got hammered, down 1.2% for the month; the figure is off by 9.9% over the past 12 months.

The furniture and aforementioned building materials segments were the only components of the report to post declines in January. Food & beverage was up 0.8%; gasoline stations up 0.4% (probably all price driven though); sporting goods sales advanced 1.0%; general merchandise was up 1.5% (after getting hit by 1.1% in December due to weather); non-store retailing jumped 1.6% after high-powered advances in December and November of 2.2% an 2.5%, respectively.

The non-store retailing results do make it difficult for one to argue that the December decline in overall retail sales was due to winter weather. The strong results show that online purchases picked up a lot of the slack. BTW, I forgot to mention above that the December decline was upwardly revised to show sales slipped 0.1%, not the 0.3% initially estimated. Notwithstanding that upward revision for December, the December-January combination is still weak from the perspective of the past several years.

This is a good report considering income growth has been flat-to-weak as the jobless rate sits at 9.8%. I do caution though that pretty decent spending over the past several months, really going back to May with a couple of weak numbers thrown in, has gotten ahead of household cashflows. The growth in government transfer payments, still hovering at the record percentage of total personal income, cannot continue. These payments are helping to drive consumer spending, but also driving deeper federal budget deficits.

We’ll see the savings rate dip in January from December’s 4.8% as result of this retail spending. Since this figure has to get to the long-term average of roughly 6.5% (this is a reality due to high joblessness and the evaporation of $12 trillion from household net worth) we’ll see weak personal consumption trends over the next year at least – but not without a big quarter here and there, remember those homebuyers tax credits will be going out over the next few months.

Consumer Confidence

The latest confidence reading came from the University of Michigan’s poll on the subject. The headline reading dipped to 73.7 from 74.4 in January – the long-term average is 88.0.
Consumers’ view of the current economic situation improved to 84.1 from 81.1, this is the highest reading since March 2008. However, the expectations reading (consumers’ take on things over the next six months) got crushed, falling to 66.9 from 70.1 – a reading of 66.9 is about the average of the past two recessions. (I’m talking about 1982 and 1991, the 2001 downturn was just that, it was not a technical recession in my view.)

The improvement in the current situation figure is probably due to the decline in the jobless rate last month. Consumers see this and believe the jobless rate will continue to decline, but it doesn’t exactly work this way, as we’ll see in the coming months.

Business Inventories

The Commerce Department reported that business stockpiles fell in December after the first back-to-back gains since July-August 2008. In fact, those increases in the previous two reporting months were the first positive readings at all since August 2008.

Business inventories fell 0.2% in December, but it did result from higher sales as they advanced a very nice 0.9%. One would like to see a little more confidence among business managers (but who can blame them) but this is better than inventories falling even as sales collapse, which is what occurred in the 10 months that ran November 2008-August 2009.

The inventories-to-sales ratio has nearly returned to the all-time low of 1.24 touched in January 2006, coming in at 1.26 months’ worth in December.

One can take both good and bad messages from this report.

The good is that the inventory-to-sales ratio is rock bottom. Firms have slashed stockpiles like never before, at least in the postwar era, and sales have begun to bounce. We’ll watch to see if this sales trend has the juice to keep going, but the combination of super-low stockpiles and increasing sales suggests the next two GDP quarters will be good, catalyzed by the inventory dynamic we been talking about for a long time now. (First-quarter GDP is shaping up to post another reading in the 5% handle.)

The bad is that even though inventories are near record lows it has not yet compelled firms to aggressively rebuild stockpiles; this is a result of high levels of uncertainty – doubts that consumer spending will continue to trend higher and worries of higher tax rates and an increased regulatory environment. If sales keep improving, then firms will be forced to rebuild inventories – that means more production. But if they don’t, then the catalyst the rebuilding process offers to economic growth will not fully take hold.

Have a great day!

Brent Vondera, Senior Analyst