Daily Insight

U.S. stocks continued along the path of vacillation, erasing the last three sessions of gains and returning the broad market to last Tuesday’s level.

The press advanced the notion that yesterday’s existing home data, which showed prices down 7% from the year-ago period, was the culprit for the move lower. But this is what needs to occur in order to reduce home-inventory levels that remain extremely elevated – not to mention that this degree of price decline was expected anyway.

Certainly financial shares put pressure on the market as third-quarter losses are now estimated to be larger than previous expectations. However, the losses were widespread, as every major industry group came under pressure – the best performing sector was utilities and even they were down 1.10%; most sectors lost between 1.50%-2.00%.

So it was not all about financials, it was something more. Iran claiming to do away with Israel, again, and Senator Obama’s economic proposal likely didn’t help things either.

Market Activity for August 25, 2008
On the Obama proposal, it seems now that he will not attempt to raise only the top two income tax rates, but the top three as the WSJ reported married couples with taxable incomes of more than $165,000 will see their marginal bracket raised to 36%. This doesn’t just raise the 33% tax bracket (currently the second-highest rate) but also much of those within the 28% bracket. (The range for the 28% bracket consists of married couples making between $131,451 and $200,300). Of course, the top rate would be raised to 39.6% from the current 35%.

This likely caused the market to believe his plans to raise tax rates will be worse than expected. For instance, if the proposal will now raise rates for more than just the two top brackets – which is bad enough as those within these brackets are the main source of capital supplied to the private sector – what’s to say this potential administration will refrain from raising the rates on dividends and capital gains more than currently proposed?

Of course, the more the Obama camp talks this way the less likely they are to actually win, so maybe we should hope they keep talking. Hopefully, no one clues them in on how politicians are not supposed to talk about raising taxes until after they are actually elected. Talking this way is a mistake on their part, and while harmful to stocks in the short-term, it could turn out to be a plus as this strategy is not one that wins elections. Add in that most other countries around the globe are doing the opposite and lowering tax rates such proposals are not only unacceptable, but illustrate a complete lack of understanding over the importance of global competitiveness in the current epoch. And that is what this commentary is all about. It is not about Senator Obama per se, but the harmful effects to our entire economy that such actions would cause.

Then we had the Iranian comments, which are nothing new but do keep geopolitical risks front and center.

I think one could look at all that is weighing on the market – tax talk, housing correction, inflation rising, Iran/Russia – and be fairly surprised the broad market has held up as well as it has. Surely, we could move another leg lower, but the fact that equity valuations within a number of industry groups appear long-term very attractive may just work as a buoy for stocks.

You say buoy? Values are falling! Yes, but we are just 19% from the all-time high the S&P 500 reached on October 9 – with the short-term headwinds the market faces (much of this uncertainty may never come to fruition but it does weigh down), it could be worse if not for reasonable valuations almost across the board.

On the economic front, the National Association of Realtors (NAR) reported existing home sales rose 3.1% in July to an annual rate of 5.00 million, surpassing the consensus estimate of 4.91 million units. The median home price dropped 7% from July 2007, according to the report. (Single-family home sales are down 12.4% over the past 12 months, but up at an annual rate of 4.7% over the past three months, which is somewhat encouraging.)

The combination of tighter lending standards, an increase in foreclosures and potential buyers waiting for signals of a bottom has pushed prices lower.

This is not something the homeowner likes to hear, but it is a necessary condition to reduce the supply of homes on the market, which sit at a record high. This is evident by what has occurred in the West where the pick up in sales has been most striking – prices are down 22% in that region from year-ago levels. Of course, this is an area where much speculation took place as well.
(Note: This inventory measure that has hit a new high includes both single-family homes and condo sales – an increase in the supply of condos was due to projects started 12-18 months back. In terms of just those defined as single-family homes, the inventory figure did tick down to 10.6 months’ worth – a 3.6% decline from the prior month.)

We’ll point out even as existing home prices have declined 7% over the past year – and will fall at least a bit further as foreclosure rates keep supply elevated – the median price remains 15.5% higher over the past five years and up 5% since July 2004. Point is, with the exception of those that had purchased a home in just the past three years, most are still higher from the point of purchase. Since 1999, the median price for an existing home is up 50.6%.

All that said, this rise in existing home sales is encouraging especially since pending sales have risen 32.2% at an annual rate over the last three months, which may suggest things are beginning to stabilize. We’ll need another couple of months of data still to confirm this, however.



Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

(from August 25, 2008)

U.S. stocks rallied big on Friday, led by financial and consumer discretionary shares, as oil plunged $6.59 per barrel, or 5.44%. That decline erased the prior day’s increase, sending crude back to $115 per barrel.

For the week, the S&P 500 and Dow average slipped 0.46% and 0.27%, respectively. A rally in the back-half of the week nearly erased an ugly start – the broad market lost 2.45% during the first two trading sessions. The NASDAQ Composite was a different story as tech stocks failed to participate in the Wednesday/Thursday upswing – the index fell 1.54% for the week.

Market Activity for August 22, 2008
On Friday, while financial and consumer discretionary shares led the market higher – a trend that broke down the previous three days – there were other bright spots as industrial, information technology and consumer staple shares all rose more than 1.10%.

For the year, the broad market, as measured by the S&P 500, is down 12.00% and we have moved to a lower trading range as uncertainties over future tax rates (and the direct effect this has on after-tax return expectations), inflation, oil/dollar (although this worry has eased), the housing and credit markets and geopolitical risks all put pressure on stocks. We have rebounded more than 6% from the new low set on July 15, but credit spreads remain wide in most cases and until these narrow it will be tough for the market to sustain a rally in the near term. (Thankfully mid cap stocks are down just 5% and smalls are off by just 3.7% -- as measured by the Russell 2000 -- year-to-date)

The November election will also likely keep us in a trading range.

However, the election is just 70 days away, and if the outcome shows tax rates will not change for the worse this market will very likely rally in a significant way. From there it will take an end of the housing correction to get us back to all-time highs. For this all to play out it will take some time, but for now the market is expecting the worse and if that scenario doesn’t play out then things will be looking upbeat for stocks.

From a longer-term perspective, these tough markets create opportunities. Too, if some bad policy initiatives get implemented, it sets the stage for a pro-growth agenda – don’t forget House elections take place every two years. Patience is really the best prescription right now – without it, I think it is easy for people to make some poor decisions regarding longer-term portfolio performance.

We were without an economic release on Friday, so Bernanke’s speech was the big economic-related news of the day (you may remember we mentioned on Friday that the Fed Chairman would be speaking). Below are some key remarks from the speech and my analysis on each.

“In view of the weakening outlook and the downside risks to growth, the Federal Open Market Committee (FOMC) has maintained a relatively low target for the federal funds rate despite an increase in inflationary pressures.”

Comment:
This is a negative with regard to Fed credibility in the future – keeping fed funds this low even though inflationary pressures have increased?

“This strategy has been conditioned on our expectation that the prices of oil and other commodities would ultimately stabilize, in part as the result of slowing global growth, and that this outcome, together with well-anchored inflation expectations and increased slack in resource utilization, would foster a return to price stability in the medium run.”

Comment:
This is a full-fledged Keynesian view and one that history has proven is hardly a foregone conclusion. Further, inflation expectations are not well-anchored as a 20% year-over-year rise in import prices, a 10% year-over-year rise in producer prices, both large and small business surveys show price increases and plans to raise prices are at historic highs, core (ex-food and energy) intermediate goods have jumped 10.2% year-over-year and consumers believe prices will rise at 5-6% over the next year. (I don’t put a lot of faith in this consumer reading, but use it for purposes of illustration nonetheless.)

In addition, while the bond market has not priced in harmful levels of inflation – which is probably what the Fed is referring too when they state “inflation expectation are well-anchored” – we shouldn’t discount the fact that geopolitical and financial-sector risks have the market flooding to this safe-have, which has pushed yields lower. What’s more, there have been periods in the past when the bond market took some time to price in bouts with inflation, such as the mid 1970s even though CPI was hitting double-digit rates. If they are wrong, these yields will reflect the inflation problem soon enough.

That said, I do hope Bernanke and Co. are correct, it’s just that it doesn’t jibe with my study of the historic data. We shall see.

“In this regard, the recent decline in commodity prices, as well as the increased stability of the dollar, has been encouraging. If not reversed, these developments, together with a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year. Nevertheless, the inflation outlook remains highly uncertain, not least because of the difficulty of predicting the future course of commodity prices, and we will continue to monitor inflation and inflation expectations closely. The FOMC is committed to achieving medium-term price stability and will act as necessary to attain that objective.”

Comment:
Recall the chart we posted in Friday’s letter illustrating MZM money supply growth. Commodity prices could come down from these levels, but it is not clear to me that overall prices will fall to a level that comes even close to the Fed’s stated comfort zone. Money supply has grown at a rate that has surpassed nominal GDP growth by a long shot over the past 12 months. As Brian Wesbury laid out in a WSJ Op/Ed last week, this excess money creation has been absorbed to some degree by higher energy prices. If those prices fall, that money is still out there – without the necessary production of goods to mop it up. Therefore, demand for other goods may increase and push those prices higher.

Unfortunately, there is nothing in the Fed’s remarks that recognizes their easy money stance has contributed to the rise in commodity prices, nor is there a mention that this type of policy got us into the housing mess in the first place. (I’m not even going to expound on how this policy and the higher commodity prices that have resulted have contributed to Russia’s and Iran’s (oil-exporters) newfound chutzpah)

In the end, the Fed and government policy will choose the correct course – although possibly not before further mistakes are made. But for now things are quite uncertain; I’ll repeat, however, these types of environments do make for great opportunities. On interest rates, if longer-term rates shoot up (to reflect higher inflation expectations) it presents and opportunity to lock in at those higher rates (ala, those that still own 30-year T-bonds from say 1982 that yield 14% -- not saying things will get to that level, but you see the point). Further, stocks behave undesirably during these situations, as we have all seen. But valuations, even if uncertainty over inflation makes valuing equities more difficult, are set up for strong long-term performance and we believe this will pay off in a very nice way for those with patience over the next several years.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ended mixed on Thursday as the Dow and S&P 500 gained some ground, while the NASDAQ Composite declined. The broad market managed to move higher as a gain in energy and basic material shares offset a decline among financial stocks. That trend has broken down for two days now (the financial/consumer discretionary/overall market direction correlation).

Information technology shares held back the tech-laden NASDAQ Composite as the S&P 500 index that tracks these shares slipped 0.24%.

Market Activity for August 21, 2008
Seven of the 10 major industry groups rose yesterday with energy, utility and basic material stocks leading the way. Energy shares within the S&P 500 have recorded their biggest three-day advance since 2002 – jumping 8.5% after getting clocked since July 3, down 20% since that date prior to this latest move higher.

Crude-oil jumped $6.20 per barrel, or 5.39%, as Russia’s behavior in Eastern Europe is very likely the reason for this latest move.

On the economic front, first-time claims for unemployment benefits fell 13,000 to 432,000 in the week ended August 16. The four-week average, however, (as illustrated by the chart below) moved to the highest level in seven years.


While this is disturbing, the boost may prove temporary as more unemployed workers apply for benefits due to the Emergency Unemployment Compensation Program. Further, they are allowed to remain on the dole for a longer period than would otherwise be the case – this has moved the continuing claims figure higher.

For now it will be difficult to surmise from this figure the degree of monthly job losses. Claims in this range would normally indicate job losses of over 100,000 per month -- higher than the 66,000 average in monthly payroll declines over the past seven months.

Hopefully, any pick up in job losses will prove temporary but it will take a couple of weeks to get a cleaner look due to the government’s widened safety net – hammock, rather.

Thirty-three states and territories reported an increase in claims, while 20 reported a decrease.

In a separate report, the Philadelphia Federal Reserve Bank’s index of manufacturing activity – known as the Philly Fed survey -- posted its ninth-straight negative reading, but the pace of decline did moderate in August.

I’ll point out, the Chicago PMI (which tracks factory activity within that region – the most active region for manufacturing work) and the nationwide look that comes out of the Institute for Supply Management (ISM) have shown that the manufacturing sector as a whole remains right at the level that separates expansion from contraction – meaning activity is pretty much flat. Point is manufacturing activity is holding up remarkably well considering substantial drags from the housing and auto sectors.

Back to the Philly number, the price indices within the report remain elevated -- two-thirds of respondents reported higher input prices this month. That is down from 77% as energy prices capped their meteoric ascent last month. Regarding prices for their own manufactured goods (prices received as opposed to prices paid), the percentage of firms reporting higher prices in August exceeded the percentage reporting lower prices by a four-to-one margin.

And speaking of which…

MZM (money zero maturity) money supply [this includes checking accounts, savings accounts and money-market funds minus time deposits (CDs)] has soared over the past year rising 14.4%. The rate of growth has cooled over the past few months, but the 12-month rise has enormously outpaced nominal GDP growth of just 3.8% over the same period. The cause of inflation is too much money chasing too few goods and since MZM is money and GDP is goods produced…well, the rise in inflation should come as no great surprise.


We’re without an economic release this morning, but Fed Chairman Bernanke is scheduled to speak on “Financial Stability” at the annual symposium in Jackson Hole. It may behoove him, the market and the rest of society to make some comments on price stability too. I also wouldn’t be surprised to hear from Treasury Secretary Hank Paulson either today or Monday regarding the GSEs -- Fannie Mae and Freddie Mac.

Have a great weekend!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks gained ground yesterday, ending a two-day decline that had erased the previous six-session gain. Energy shares led the way as crude-oil rose for a third-straight day. Financials also enjoyed good results. The S&P 500 indices that track energy and financial stocks rose 2.77% and 1.67%, respectively.

It was interesting to see a trend broken yesterday as the market managed to gain ground even as consumer discretionary shares fell 0.55%. As we’ve been discussing, the direction of financial and consumer disc. shares has determined the path of the overall market on a daily basis for quite a while now.

Now if we can get the indices to gain ground even on days that financial shares fall, we may be moving past fears over the credit markets – maybe, just a thought. That said, credit spreads remain pretty wide and until those narrow, it will be tough for this trend to break. It is becoming easier though as financial shares make up just 14.4% of the S&P 500 Index today, down from 20.7% one year ago.

Market Activity for August 20, 2008


On oil, crude for October delivery remains well below the peak closing price of $145.29 hit on July 3, but has gained 4% over the past three sessions. Certainly Russia’s Cold War-like activity is not helping in this regard. I see they are calling themselves “peace-keepers” even as they pillage residential areas, destroy infrastructure, block ports and make L.A looters look like amateurs. They have moved well past South Ossetia and Abkhazia and into other cities, such as Gori – it is far from certain they’ll refrain from entering the capital, Tbilisi. I also see they have taken over the hydroelectric plant that provides much of Georgia’s power.


For those that remember the Cold War era, this looks quite familiar to what occurred in the Czech Republic and Poland in the 1960s and 1970s – it is the same playbook and their aim is clear: take over the Baku-Tbilisi-Ceyan pipeline – which is the only regional pipeline supplying Western Europe that the Russian’s do not yet have control over – and determine the future of Eastern Europe. NATO needs to step up or they risk becoming as feckless as the UN. The good news is this may rally support for Eastern European entry to NATO and hopefully sound the alarm to Western Europe to accept this needed result, which they have been blocking.

Moving on…

We were without an economic release yesterday, so I thought we’d touch on a topic that has been plaguing the market of late. There are a number of uncertainties that have hurt investor sentiment – the housing market – and the duration of that correction, inflationary pressures -- and future Fed action to control this situation, and geopolitical risks. The other major concern is the uncertainty over tax rates.

Lower tax rates on capital gains and dividends have been instrumental to the 64% rise of the S&P 500 (9.81% annualized) since March 2003 as it offered a boost to after-tax return expectations and provided the incentive to take on measured risk. The capital gains tax rate reduction -- from 20% to 15% at the federal level -- led to a 6.25% increase in the after-tax return of retained income for an additional dollar put at risk – as Larry Kudlow importantly pointed out a couple of days back.

The dividend tax cut raised after-tax income from this source dramatically as the rate was reduced to 15% from 39.6%, for those in the top tax bracket. Not counting state taxes, this meant an investor kept 85 cents on the dollar, as opposed to just 60.4 cents – a 40.7% incentive boost on an additional dollar put at risk. Needless to say that was enormous and explains why investors have demanded higher dividend payouts and the dividend component of the personal income data has soared. Make no mistake, this extra income does flow through to the rest of the economy by way of higher capital formation and thus higher innovation, productivity gains and jobs growth.

In terms of federal income tax rates on labor, one should know that small business makes up roughly 65% of those within the top tax bracket – this group is the largest job creator in the country. Raise their after-tax income growth (by reducing tax rates) and you get more jobs and higher levels of business investment over the long term.

This is why when a presidential candidate, or members of Congress, talks about raising these tax rates it has a significant effect on investor sentiment and the proclivity of investors to take risk. Raising the capital gains tax rate from 15% to 20% results in a 6% reduction in after-tax retained income for an additional dollar put at risk – from 85 cents on the dollar to 80 cents. Same is true for the dividend tax. Of course, if these rates are pushed even higher, as some have suggested to 28%, that after-tax income number becomes smaller.

In an attempt to justify these tax rate increases, proponents have stated that these rates are the same or less than where they were in the 1990s – most of which were big growth years as everyone knows.

But this not the 1995 global economy, the world is much more competitive today as there are more legitimate players and many countries have slashed their tax rates on income and investment. You try to raise tax rates – and thus lower the after-tax rate on investment and income – in this environment and it means you lose by way of competitiveness. These are the reasons this stuff is so important.

This morning we get initial jobless claims for the week ended August 16. It will be important to see this figure decline; it is not yet known the extent at which the government’s Emergency Unemployment Compensation Program has affected this reading, which has jumped. The BLS (Bureau of Labor Statistics) believes the impact may have peaked. Hopefully over the next couple of weeks we get a cleaner look and can surmise whether the monthly job losses will remain relatively tame or not.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks declined for second day after wholesale prices accelerated from an already hot pace in July – and well-faster than analysts had expected – and housing starts fell to the lowest level in 17 years.

Again, like clockwork, financials and consumer discretionary shares led the market lower falling 3.05% and 2.24%, respectively. As we’ve discussed, one only needs to look at these two sectors to learn the direction of the overall market. When this trend begins to break, it may signal the moment financials and consumer discretionary shares begin their sustained moved higher.

It’s tough when you’ve got these two indicators (inflation and housing) posting bad numbers as higher levels of inflation keep real incomes from rising (amazingly though this figure remains flat, not declining, as the broadest measure of incomes continue to grow at a nice nominal clip) and poor housing market results keep financial-sector concerns alive.

I will point out though that housing construction declines did ease in the second quarter as the drag on the GDP figure was half what it has been of late. It will just take some time to work off the excesses of the previous years; it’s as simple as that. On inflation, the numbers look ugly, and we have our concerns on this front, but the decline in oil prices of late should help inflation pressures ease – that is not a forgone conclusion though as I’ll discuss below.

Market Activity for August 19, 2008

In earnings news, Hewlett-Packard posted another great quarter – releasing results after the bell yesterday – as operating profit jumped 21%, revenue grew 10% and the firm issued strong guidance. Information technology posted the second-best profit performance of the 10 major industry groups for Q2 as operating profit rose 14.8%. This trailed only the energy sector, which posted operating profit growth of 17.9%.

Three of the 10 major industry groups enjoyed double-digit profit growth last quarter – consumer staples being the third. Another three industries posted profit growth in the range of 6%-9.5% -- health-care, industrials and utilities. Three industries reported profits declined in the March-June period – financials (down 94%), consumer discretionary (down 55.8%, much of this due to Ford, GM and housing-related retailers) and telecoms (down 1.9%)

On the economic front, U.S. producer prices (PPI) accelerated in July coming in at twice the rate expected on a month-over-month basis and jumping 9.8% from the year-ago period – fastest rate in 27 years. PPI rose 1.2% in July, an increase of 0.6% was expected, and the year-over-year reading surpassed the expected 9.3% increase. Even excluding energy, producer prices were up 0.6% over the past 30 days and 5% year-over-year.

Most concerning to me is the pace of core intermediate goods, which accelerated to 2.0% on a month-over-month basis and 10.2% year-over-year. (That’s up from the 8.4% pace hit in June.) For clarity, core intermediate goods are those factories use to produce finished product and it excludes energy. There is a real possibility that this segment funnels down to the consumer. If won’t occur in full, as productivity improvements and firms’ desires to keep market share hold consumer prices back, but it may be enough to drive the figure even as commodity prices have declined in a substantial way.

Many were probably looking past this reading as dollar strength and oil’s decline lead most to believe inflation will moderate – the drop in commodity prices, which began to take place in mid-July, did not occur in time to help ease the July PPI reading, but should help the August reading. With energy prices off 22% from the high, it will undoubtedly help. Still, this core intermediate goods segment will be something to watch over the next few months.


In separate report, July housing starts fell to a 17-year low. Building permits, a sign of future construction, also fell.

Starts fell 11% to an annual rate of 965,000, the lowest level since March 1991, followed a 1.084 million pace in the prior months. The report will reinforce the concern that stricter lending rules, rising borrowing costs and foreclosures will keep home sales depressed and cause builders to hold off on new construction. But this is what needs to occur when inventory levels are so elevated – this figure really needs be cut in half from the high hit in March. It will simply take time, but demographics and household formation will eventually take care of this issue.

Construction of single-family homes fell 2.9% in July (down 39.2% from July 2007) to 641,000 at an annual rate – also the fewest since 1991. Work on multi-family homes plunged 24% from the prior month after getting a boost in June from that change in New York City building codes that we discussed yesterday.



Have a great day!


Brent Vondera, Senior Analyst

From Revolution to Evolution

By: David Ott

In his 1992 book, Capital Ideas, Peter Bernstein guides us through the four decades when Modern Portfolio Theory (MPT) revolutionized Wall Street. Now, fifteen years later, Bernstein’s new book Capital Ideas Evolving (referred to as Evolving hereafter) critically examines MPT from three perspectives.

In the first section, he presents the two most substantial academic critiques of MPT that attack some of the underlying assumptions within the theory. For example, MPT assumes that investors are rational. These fictional investors are emotionless automatons that are absolutely capable of making optimal decisions about their portfolio.

This is obviously false. It may make sense with respect to the creation of a theory, but any practitioner will tell you that neither markets nor investors are rational. A whole new field within economics, referred to as behavioral finance, seeks to examine investor behavior in attempt to mitigate some of the frequent problems that arise.

For example, one study looked at how 401(k) participants make decisions about their retirement savings based on the choices that their plan sponsor provides them. The study breaks the participants into three groups and gives each group a choice between two mutual funds.

The first group was given a choice between a stock fund and a bond fund. This group split the money basically down the middle and basically had a 50/50 stock/bond allocation.

The second group was given a choice between a stock fund and a balanced fund that split the money 50/50 between stocks and bonds. Instead of putting all of the money into the balanced fund, the participants split the money between the two funds, which meant that their stock/bond split was 75/25.

The third group was offered a bond fund and the same balanced fund that split the money 50/50 between stocks and bonds. Investors split their money half and half between the two funds instead of the balanced fund and ended up with a portfolio heavily weighted towards bonds.

The researches subsequently interviewed the participants and found that they had wanted to diversify, and since they didn’t understand their options, they just split the money half and half into each option thinking that being diversified into two funds was better than one, even though the results of that simple decision had radically different asset allocation implications for the 401(k) assets.

Whether it is a problem of being uneducated about investments or acting irrationally, this experiment shows that investors are generally not well equipped to make appropriate decisions about their investments. Even Harry Markowitz, the great-granddaddy of MPT says that many of the theories “make unrealistic – absurd – assumptions about the actors.”

In the second section of the book, Bernstein revisits many of the academics that led the revolution to ask if their theories are still relevant. In short, they all seem to agree that the theories aren’t perfect, but are clearly relevant and useful in today’s environment. As Nobel Laureate Robert Merton says, “there is much left to do because so little has been done.”

In the third section, Bernstein describes a variety of practitioners who have put the MPT to work with a great degree of success. The first case is an extension of one of the real world examples in Capital Ideas. In the first book, he describes how Wells Fargo created the first index fund. It seemed odd that they had no visible name regarding indexing in today’s investment landscape.

The answer to that riddle is that Wells Fargo wasn’t making any money indexing, so they sold it to Barclays who – years later – turned their experience in indexing into the dominant player in the exchange traded fund and exchange traded note industry under the successful brands iShares and iPath.

He also describes the Yale Endowments diversification efforts through the extensive use of private equity, long-short and absolute return funds as well as other esoteric strategies like ‘portable alpha.’ The basic idea is use leverage to invest in an equity index like the S&P 500 using futures and invest what you don’t need for collateral into something that will earn interest in excess of your borrowing rate.

The idea was first developed by bond king Bill Gross at PIMCO in a product called StocksPLUS. The result is an investment with the same volatility as the S&P 500, but slightly more return, creating what is known as alpha. The portability refers to the use of capital not used to fund the futures contract in any investment that is likely to earn returns in excess of the cost of capital.

Interestingly, Bernstein mentions that StocksPLUS as an institutional product had earned positive alpha over the S&P 500 in 194 of 195 rolling three year periods from July 1989 through September 2005. For the ten years ending in September 2005, the fund added 50 basis points of performance annually to the S&P 500 with basically identical volatility and nearly perfect correlation.

Since that time, however, it would appear that it has been harder for Gross to find portable alpha since 2005. A review of the data from Morningstar regarding their retail offering of the same name shows that for the three years ending July 31, 2008, the fund has trailed the S&P 500 by 148 basis points per annum and produced negative alpha. This may be a reflection of increased market efficiency.

Additionally, upon review of the mutual fund, the strategy may sound very appealing, but it has some clearly negative implications for taxable investors. According to Morningstar, the fund has had pretax return of 1.41 percent for the three years ending July 31, but the tax-adjusted return is -2.05 percent over the same time frame. One would have done much better to forgo the excess returns and pay less in taxes.

This highlights one my own critiques of the some of the high-minded strategies seem so appealing. While it is amazing what Gross and Swenson have done, it isn’t repeatable for most investors. Of course, we could use StocksPLUS in an IRA or some other deferred account, but how could we replicate Swenson’s ownership of timberlands? Despite the new stream of products, it seems highly unlikely that an individual investor could replicate many of these strategies.

In some respects, the inability to mimic these strategies may be a good thing. All of Bernstein’s examples cover those who were immensely successful at the time he went to print, and a few things have changed since then. The description of Goldman Sachs flagship hedge fund, known as Global Alpha, sounds like investment nirvana. As their chief of quantitative strategies, Bob Litterman says, “We run an alpha factory here.” That was before the fund lost ten percent in 2006 and additional 40 percent in 2007.

Of course, these changes are what keep investing interesting, and Bernstein has enjoyed a front row seat through his career initially as a successful investment manager, then as the first editor of the Journal of Portfolio Management, and finally as a top-tier consultant and critically acclaimed author. As with his other books, this is impeccably written and his direct access to all of the subjects in his book brings you much closer to the story.

Although Evolving isn’t a quite a classic like Capital Ideas, it would be unfair to expect as much since it chronicles a slow-burning evolution rather than an explosive revolution.
_______________________________________________________

Recommendation: Buy

Capital Ideas Evolving
By: Peter L. Bernstein

John & Wiley & Sons, Inc., Hoboken, New Jersey 2007
First Published: 1993

ISBN: 978-0-471-73173-3

Daily Insight

U.S. stocks erased the gains of the previous two sessions as even additional declines in the price of oil failed to offset housing/financial market concerns. Yesterday it was a Barron’s article that raised concerns over the two GSEs Fannie Mae (FNM) and Freddie Mac (FRE), although much of the piece offered nothing new.

I’ve got my issues with Barron’s, and to be honest besides this piece I haven’t read the source in a couple of years simply because I found it a waste of time – personal opinion. But what I fail to understand, regarding the entire GSE capital raising discussion, is why the government would cause harm to the preferred shareholder – which is a hypothetical Barron’s raised in the article.

For one, they would not want to eliminate access to the capital markets, which is what putting these dividends in jeopardy would do. Two, it would worsen the capitalization issues within the banking system as whole – not exactly a desired outcome. Three, why would they change the accounting rules (for those that haven’t kept up on this, it is the hypothetical scenario that the GSEs would have to abide by new accounting rule FAS 140 that would force a capital raise right now) on FNM and FRE at a time when they are currently attempting to bail out the housing market. This would be like performing knee replacement surgery only to then introduce the patient to Shane Stant.. It doesn’t make much sense.

Bottom line, as we’ve talked about for a long time now, any day with which there’s bad press regarding the financials the market’s going down; to no one’s surprise that trend holds true.

Market Activity for August 18, 2008

Financial and consumer discretionary shares led the indices lower – down 3.58% and 1.75%, respectively. In fact, nine of the 10 major industry groups lost ground yesterday – utility shares being the only group that flashed green, up 0.10%.

We were quiet on the economic front yesterday, but did get the National Association of Home Builders/Wells Fargo index for August, which was unchanged from the July reading.

The index remained at a record low; but hey, it didn’t make a new one. Seriously though, the figure is tremendously low, as the graph below illustrates. A reading under 50 marks most respondents view conditions as poor. As the reading came in at 16 again, there aren’t many that view it otherwise.

The survey, first published in 1985, asks members to characterize current sales as “good.” “fair” or “poor” and to measure buyers traffic as well as to assess the outlook six months from now.


Builders are delaying projects as sales drop and home inventory remains hugely elevated. In the meantime, mortgage spreads continue to widen. For clarity, during normal circumstances the 30-year fixed mortgage yields 150-180 above the 10-year Treasury rate. Today that spread sits at 260 basis points, or 2.60 percentage points higher. The chart below shows what has occurred with this spread – the yellow line represents the spread and thus the higher 30-year fixed mortgage rate than would be the case under normal circumstances.


This morning we get producer prices and housing starts for July.

The producer price index (PPI) will post another ugly reading, expected to show an increase of 0.6% for the month and 9.3% on the year-over-year reading. If that expectation holds true it would mark another acceleration -- the year-over-year reading came in at 6.5% in April, 7.2% in May and 9.2% in June.

While much of this increase is due to risings oil prices for the period measured, I’ve noticed that core intermediate goods (those used in early stages of production and excluding food and energy) have jumped 8.4% over the past 12 months. The market will likely discount this July look at PPI considering the dollar strength and decline in oil of late. However, I’m not sure we’ll get a meaningful trend lower based on what has occurred in this core intermediate good number. We could very well see this rise passed along to the consumer level. Thankfully, we’ve got strong productivity improvements that remain and may quell this effect. The next three months of inflation data will be very important.

On housing starts, we should see a meaningful decline as the June figure was boosted by a change in New York City building codes, which spurred a jump in multi-family construction and overshadowed a slide in single-family units. As home inventory levels remain extremely elevated, it may take several months, if not a full year still, before this reading begins to bounce back and trend higher.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks added to Thursday’s gain, rounding the week out on a positive note as the dollar completed a two-week rally and crude moved lower in six of the eight sessions of that fortnight. Again, consumer staples and financials led the way. These are the industries that present the largest concern, and thus they move the most based on wavering investor sentiment. A stronger dollar and lower oil price reduces concerns over the consumer as they are already hit by a housing market correction.

Consumer staples and industrial shares also provided the benchmarks with a boost on Friday. Industrials are enjoying a very nice machinery-orders trend and overall increase in business spending of the past three months – the S&P 500 index that tracks these shares has bounced 10% from the mid-July multi-year low.

Market Activity for August 15, 2008

We’ve talked about how the market is stuck in a trading range as uncertainties over tax rates, housing, inflation and geopolitical risks (now Russia throws another risk in as they attempt to gain control over the Tbilisi pipeline and Eastern Europe as a whole, if allowed). The broad market moved to a new, lower trading range in July but we have bounced nicely from those lows as the dollar/oil trend has offered a concrete boost.

The chart below shows the 22.38% decline from the October 9 all-time high and the 6.85% bounce from that July 15 multi-year low. The shaded area (it’s tough to make out, but it’s lightly shaded in green) illustrates the trading range that formed prior to moving below 1275 on the S&P 500 in July.


From a longer-term perspective, there are many attractive buys out there as an abundance of stocks trade below the market multiple, yet offer market-beating earnings growth. As we have to deal with a bevy of uncertainties at the present it makes for a frustrating time to be invested in stocks. However, whether it takes six months or two years, at some point stocks are going to rebound in strong fashion, in my opinion. While the S&P 500 is up 72.2% since March 2003 (10.5% annualized), the index is essentially flat going all the way back to August 2000. While the market struggles with the uncertainties mentioned above, these risks will eventually wane. (We’ll note that mid and small cap stocks are up roughly 6% and 5% at annualized rates, respectively over the past eight years.)

Outside of geopolitical events, my chief concern is what will happen to tax rates across-the-board. But any mistakes in this regard will lead to a reversal as the House comes up for election every two years. Further, the fact that most developed countries are pushing tax rates lower, it will become quickly obvious (if not painfully so) the decision to raise rates here at home is the wrong prescription.

On the economic front, New York manufacturing conditions improved mildly as the Empire Manufacturing survey advanced to +2.8 – the first positive number for the index in three months. A reading above zero marks expansion, as opposed to the ISM and Chicago manufacturing surveys where it takes a reading above 50 to mark expansion, just for clarification..

However, some of the sub-indices within the report deteriorated as the new orders index fell to -2.2 from 8.3 in July and the shipments index fell to -0.9 from a strong 13.5 reading last month.

Inflation pressures remained elevated and the future prices received index jumped to a record.

On the bright side, the employment index improved, even if it remained below zero. Expectations of business conditions six month out jumped 19 points to 34.6.

In a separate report the Commerce Department reported industrial production rose for the second-straight month in July, increasing 0.2%.


Production of machinery (up 0.7%) and business equipment (up 0.8%) led the figure higher. Even when we exclude motor vehicles and auto parts, as vehicles and auto parts were up a large 3.6% in July simply because the American Axle strike came to an end a couple of months back, the reading remained positive. (Since unit vehicle sales remain weak, one should not expect this segment to help out over the next few months, so the ex-vehicle/parts reading becomes important to watch.)

Many were expecting electrical utility output to lead the production reading higher, but this segment actually declined 2.3% -- which is unusual for July. It is quite telling that the overall, and that ex-auto reading, advanced even with this segment –which accounts for 10% of the total – declining significantly.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks gained ground Thursday despite a rough day on the economic front – and guess which sectors led the way? Yep, financials and consumer discretionary shares as has become the trend on days of strength. As we touched on yesterday, one can look at these two areas and based on their direction you pretty much know whether or not the benchmark indices advanced.

Ugly economic releases from the Labor Department sent the broad market lower at the open, but stocks quickly reversed course gaining nearly 2% from the session’s low – holding onto most of that rally to the close.

Market Activity for August 14, 2008
As financials (up 2.55%) and consumer discretionary (up 1.97%) led the way, most industries participated in the rally as seven of the 10 major S&P 500 groups rose. Information technology and industrial shares gained 0.70% and 0.56%, respectively. Consumer staples, health-care and telecom stocks advanced a bit as well.

The dollar continues to catch fire as evidenced by the Dollar Index, which has moved to the 77 handle. The greenback has jumped 7.30% in the past month – a huge move.


However, the 80 level in probably necessary to escape what many perceive as troublesome levels. I believe we need to see some mild Fed tightening in order to get there, but most seem to disagree with this view due to the credit/financial-sector woes. We shall see where the inflation gauges take us – more on this below.

In any event, it is good to see the greenback rally and it’s helping to push commodity prices lower from the highly pernicious move that took place in the three months ending June.


On the economic front, the Labor Department reported that initial jobless claims dropped 10,000 to 450,000 in the week ended August 9. While a decline is nice, the figure currently hangs at a worrisome range. The chart below shows the four-week average has jumped well above the 400k level – this does not bode well for the August jobs report. As we had discussed for several months, jobless benefit claims held below this 400k level, which gave us confidence the monthly job losses would remain mild. Now that this figure has spiked, it becomes much more difficult top remain sanguine that those losses will remain below 80,000 per month.

That said, due to the government’s Emergency Unemployment Compensation Program it will take a couple of weeks to get a truer reading on claims as a way to gauge the overall job market. (The BLS (Bureau of Labor Statistics) believes the impact of this program has peaked.)

Thirty-five states and territories reported an increase in claims, while 18 reported a decrease.

Continuing claims – those collecting benefits for more than a week – have risen to the highest level since October 2003. The recent government program to extend the length of time one can collect is helping to push this figure higher as those that would otherwise have seen benefits expire, can continue to take the handout.


In a separate report, the Labor Department reported the consumer price index rose 0.8% in July and accelerated on a year-over-year basis to 5.6% -- that’s the highest in nearly 18 years. On a three-month annualized basis the CPI has jumped 10.6%; that’s an acceleration from 7.9% during the previous three-month set.

I’ll note CPI is known to overstate inflation, yet the chained CPI figure – which tracks consumer preferences and the substitution effect more quickly – rose to 4.8% year-over-year after a readings of 4.2% in June and 3.6% in May. This means the Fed’s preferred inflation gauge, the PCE index – will hit roughly that level, which is considerably higher than Bernanke’s stated “comfort zone.”


Over the past few weeks we’ve mentioned the risk of inflation becoming embedded – that is, firms have gotten hammered with higher commodity costs for such a long time they have now begun to aggressively raise prices to compensate for those higher costs. The ISM and PMI (as most readers know these are factory activity indexes) business surveys have been showing this occurring of late; now we have the most-watched small business survey (from the National Federation of Independent Business – NFIB) report a record-high percentage of firms both raising prices and planning to do so in their latest August report.

People look at the lower energy prices of late and expect this to push future inflation gauges lower. I’m just not sure this will occur to the extent they are expecting due to the trends just mentioned. In addition, food prices are also boosting the inflation figures, so energy isn’t the sole reason. On the bright side, the medical care reading within CPI has been nicely contained over the past several weeks and decelerating -- up just 0.1% in July.

There is one group that can essentially make sure the inflation trend does moderate and that is the Fed. Just some mild tightening could go a long way. Yes, this will hurt mortgage resets, but many of these people are in a world of hurt anyway – fed funds could be cut to 1.00% and those that couldn’t afford the initial interest rate on their adjustable mortgage will still find they’re in a bad spot. Besides, those that put little-to-no money down now find their loans are higher than the house is worth. And further, yes, banks need to raise capital and the Fed’s easy policy has this in mind also. But it is a very dangerous game to abandon price stability. Besides, let’s not put undue harm on the entire economy just to help out those that have made poor decisions.

In other news, I see the Europeans have been mugged by reality as the Russians continue to push into the interior of Georgia, well past Ossetia. The Germans had been blocking Eastern European membership to NATO. Now that it has become obvious Russia’s aim is to control the Baku-Tbilisi-Ceyhan pipeline – the only oil flow in the region that Russian does not have control over – and thus block energy to Western Europe, while attempting to dictate Eastern Europe’s future, the Euros seem to be coming around. This is an important and very positive development even if Russia’s actions are troubling.

Have a great weekend!


Brent Vondera, Senior Analyst

Daily Insight

U.S. benchmark indices declined for a second day – led by what else? financial and consumer discretionary shares. These have been the stocks that either push the major bourses higher during rallies or pressure the benchmarks on days of decline as questions over the housing market and consumer are the lead worries. (For the market in total, certainly inflation, tax rate, dollar/oil and geopolitical event uncertainties all currently weigh on investor sentiment. But regarding GDP components, it is housing and the consumer and so long as this is the case financials and consumer discretionary will determine the market’s direction.

The broad market did improve as the day wore on (as the chart below illustrates) thanks to core retail sales growth and business inventories and sales data that indicate the economy is not as weak as many portray. A higher revision to GDP has been our theme for a couple of days now as that’s what the data of the past few days is telling us. The mid and small-cap stock indices bucked the trend to advance yesterday.


Market Activity for August 13, 2008

The best performers of the day were energy, basic material, utility and information technology shares. Energy stocks received a boost, after four-straight sessions of decline, as oil rose 2.65% to $116 per barrel. The weekly energy report showed a larger-than-expected decline in supplies – which was probably a result of Tropical Storm Edouard as it caused rigs to suspend production and halted imports for a couple of days.

On the economic front, overall July retail sales fell for the first time in five months due to weak auto sales – the figure declined 0.1%. Excluding autos, sales rose 0.4% last month and have jumped 10.3% at an annual rate the past three months.

Core retail sales, which exclude autos, gas station receipts and building materials, rose 0.3% in July and are up 10.2% annualized the past three months.

The relevance of this core reading is two-fold:

One looking at this figure minus gas station receipts during a time of high prices helps to reduce the impact of a boost in this figure due to those high prices. Further, subtracting building materials has helped to smooth the data and remove the volatility of a housing market that was boosting the reading to robust levels during the peak of the housing boom that ran 2005-2006 and subtracts from the figure due to the housing correction currently.

Second, this core retail figure is used to calculate the consumer spending portion of GDP – since this reading has advanced at a pace that outpaced inflation during the quarter (thus real consumer consumption was higher) it provides yet another indication Q2 GDP will be revised higher.

In a separate report, the Labor Department reported that import prices jumped 1.7% in July and has accelerated to 21.6% year-over-year. Even excluding oil the figure remains high, up 0.9% in July and 8% from this time last year. The dollar/oil trend of the past few weeks will help to improve this, but we’ll need to see oil and the greenback continue to trend in the desired direction or at least hold here.


Lastly, the Commerce Department released its June business sales and inventory reading. This figure also illustrates GDP will be revised higher. Putting the trade (as discussed yesterday), business inventories and core retail sales data together – all figures that were stronger than initially estimated when the first look at GDP was released – we’re looking at a real rate of growth of at least 2.5% and may be close to 2.8%. That’s not bad considering housing’s drag on the economy. (For context, our long-term average is real annual growth of 3.4%, or roughly 6.5% in nominal terms.)

Anyway, business inventories rose 0.7% in June, beating the expectation of a 0.5% increase. Sales growth was powerful again, jumping 1.7% in June -- up 17% annualized past three months and up 9.2% year-over-year.

I’ll caution, since we’ve had four straight months of robust sales data (up 1.2% in March, 1.5% in April, 1.1% in May and now this big 1.7% increase), July will probably show a natural decline. The economy is weaker-than-normal and this pace will not be sustained. Nothing wrong with that, I’m just preparing everyone for the media hysteria that arises when the number posts a decline as these people are unwilling to put things into perspective.



This morning we get the CPI figure for July and initial jobless claims. Both will be closely watched, but the market will probably focus a bit more on the jobless claims number since it has moved higher over the past two weeks and is showing an ugly trend. The CPI reading looks ugly too but the recent decline in energy prices has eased the inflation worry a bit – for most at least.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. benchmark stock indices declined yesterday, pushed lower by financials shares after JP Morgan warned it may post more credit losses – not sure this was really news as most expect financial losses to drag on for at least another quarter, but there just wasn’t much else to trade on so the market focuses on this negative.

Also putting pressure on bank stocks were comments from Dallas Fed Bank President Richard Fischer who mentioned the current financial turmoil is worse than the savings and loan crisis of the late 1980s/early 1990s. I’m not sure about that one, especially since William Seidman (former chairman of the Resolution Trust Corporation, which was instrumental in cleaning up that mess) has gone on record saying the two are not comparable. But, we shall see. For now, not surprisingly, these types of comments will be met with market downside.

Market Activity for August 12, 2008

As said, financials led things lower as the S&P 500 Financial Index lost 5.19%. Utility and consumer discretionary shares were the other major losers down 2.08% and 1.48%, respectively.

Consumer staples and basic materials were the only two major industry groups to post gains. Commodity prices fell some more yesterday but the declines leveled off, offering some support to the materials stocks – these shares have taken a beating over the past few weeks. The CRB (Commodity Research Bureau) Index has dropped 18.8% from the July 2 high.


On the greenback, the dollar continues to strengthen, which is nice and is a development that was very much needed regarding international-investor perceptions and inflation – particularly with regard to import prices. As we touched on yesterday, I think we’ll need a little Fed tightening to get us to 80 on the Dollar Index – a level that will make those worried about the greenback much more comfortable. For now though, at least we’ve returned to where we were in February and have erased the most recent leg lower.


On the economic data front yesterday, the Commerce Department reported the trade deficit narrowed in June, which was an unexpected move as the estimate was for the figure to widen – although I’m not sure why the narrowing was a surprise as import activity has been lagging export growth for many months now. Nothing of late has shown this trend will end in the immediate future.

Exports rose 4% as imports were up 1.8%. The importance of this narrowing is it will result in a higher revision to second-quarter GDP (the initial estimate to Q2 growth assumed the deficit widened in June). Combine this fact with higher inventory and capital expenditure (capex) figures and we may just see that 2.6%-3.0% real GDP reading we expected a couple of weeks back.

But back to the trade figures for a moment, in real terms (adjusting for inflation) the trade gap narrowed sharply (to its lowest level since December 2001) as real imports declined 0.6%.

U.S. exports have been on fire fueled by sales to South America and OPEC countries. Exports to OPEC countries has jumped 33.7% on a year-over-year basis. I mention this to point out the fact that higher oil prices are not a zero sum game as this flows back in higher export activity.

These comments have in mind all of those that speak of importing oil as a wealth transfer – as if these funds are lost forever. Those that speak of wealth transfers due to trade fail to tell the entire story and are often times either oblivious to how the global economy works or intellectually dishonest. A large degree of the U.S. dollars that move overseas in exchange for goods come back to us in the form of investment. (Before I go on, make no mistake – I do not enjoy being more dependent than needs to be the case on certain regions of the globe for our energy needs. In my world, congressionally built barriers to domestic energy production would be torn down never to be rebuilt. In the end we will accomplish this simply because we’ll have to. The state of the world will marginalize those that believe producing our own abundant sources of energy is a bad thing – a mindboggling stance.

But back to the flow of capital, a large part of it comes back in the form of investment. Some goes to the Treasury market, simply because this is the most liquid and broad market in the world. A significant degree of it though also goes to corporate bonds, equities, mortgage-backed securities, and venture capital. I’ll remind everyone that our long-run return on capital is higher than our cost of capital. Hence, those funds finance future growth, which creates jobs, provides the seed money for innovation and technological advances and leads to higher levels of income growth -- higher levels of productivity, improved living standards, lower inflation and real economic growth are the by-products.

In other news, the Treasury Department reported the July budget deficit widened due to the rebate checks and increased outlays to the FDIC to cover insured deposits at failed backs. The $102.8 billion deficit last month compared to the $36.4 billion in July 2007. Lower tax revenues due to job losses and lower corporate profits – mostly a result of financial-sector woes – has also increased the deficit, but the real damage has come from this Keynesian rebate check scheme.

Too bad because last year we had whittled the budget gap down to just 1.2% of GDP – half the long-term average. This year will be a different story, however. Nevertheless, the deficit will remain manageable for now, but if we do not get a handle on entitlement spending and reform these programs to reflect changing demographics we’ll have a problem on our hands a few years forward.

On the bright side, corporate tax receipts rose 6.6% in July on a year-over-year basis. This marks the first increase in a year.

This morning we get some very important data as July import prices and retail sales will be market movers. Also we get the June business inventories report, which should show the estimated inventory change that dragged so heavily on GDP was flawed. A larger-than-expected reading here will provide additional evidence Q2 GDP will be revised h

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks gained for a second-straight day – up four of the past five sessions – as oil has dropped to a 14-week low, boosting shares in most major industry groups. Consumer discretionary and financial shares led yesterday’s increase. Energy and material shares were the only decliners among the S&P 500’s 10 industry groups. The S&P 500 Energy Index has dropped 20% from its May 20 all-time high.

What has occurred in oil and the dollar since I’ve been out has been pretty amazing and welcome. I’m contemplating taking about six months off – at this pace oil would be down to $10 per barrel, the Dollar Index would hit 100 and even stocks would be higher by 10%. Although at this rate, six months from now Russia would have regained control of the Caucuses and all of Eastern Europe.

Market Activity for August 11, 2008
The decline in oil prices has been very welcome, as we’ll touch on more specifically below. It’s almost hilarious to watch this stuff as the press and energy-industry analysts now talk in terms that make one feel there are no risks that can push prices higher again. For instance, the IEA – International Energy Agency – is now saying that supply will be more than sufficient to meet demand; this is with an increase in their 2009 demand forecast. This is the opposite of what we have heard over the past several weeks as these agencies were stating supply was inadequate. And oil continues to move lower even with the Russia/Georgia conflict and the uncertainties this brings regarding the Caspian pipeline.

Over the past eight trading sessions market activity has continued along its whipsaw path. The first three days of my absence the broad market was down 2.76%; it more than erased those losses jumping 3.21% last Tuesday and Wednesday; gave much of that back on Thursday, but following Friday’s big day, helped by yesterday’s rise has put us up 1.6% since the July 30 close.


We were without an economic release yesterday, so I thought it may be helpful to touch on the economic highlights since I’ve been out. David likely touched on many of these points already, but it is worth reviewing this stuff.

Second Quarter GDP

The economy grew at a 1.9% real annual rate.

The additions to growth were:
Personal consumption (although it added less than what I was looking for as higher inflation reduced real consumption. CPI rose at a 7.4% annual pace in the second quarter.)

Exports provided a large boost, but the degree to which it helped was not from export activity alone but net exports, which jumped due to a decline in real imports – import prices have soared, reaching 20% year-over-year as of the latest data.

The drags on GDP were:

Housing subtracted from growth for the 10th straight quarter, but the decline was much less than it has been averaging. Residential fixed investment declined at a 15% annual rate March-June, much less than the 27% annual rate of the previous quarter. Maybe a portent of good things to come; we shall see.

The change in inventories weighed heavily on the figure. Although, if something is going to weigh on growth, let it be this. Stockpiles are very low and firms will have to increase production, which will keep growth positive in the coming quarters. Friday’s wholesale inventories figure continues to illustrate this fact. Sales continue to rise, jumping 2.8% in June driving the inventory-to-sales ratio to an all-time low.

July Jobs

The labor market remains weak as July marked the seventh month of decline. However, the level of losses remains relatively low compared to normal job-market downturns. Construction and business services continue to weigh on the figure; education and health-care continue to be the bright spots. Youth unemployment also continues to drag the figure lower.

June Factory Orders

This was the best release of the past week-and-a-half. The figure jumped 1.7% for the month and continues to indicate good business spending trends are upon us.
New orders were up for the fourth-straight month; shipments up six months straight (up 1.6% in June to $454.6 billion, the highest since the series began in 1992.)
Unfilled orders up for 28 of the past 29 months to the highest level since the series began.

Non-defense capital spending (a proxy for business spending) was up a strong 1.2% in June. I’ve got to think GDP will be revised higher due to the combination of this data and the June inventory number (which was higher than estimated) -- the May figure was revised higher as well.

The biggest news of all of the past several trading days was undoubtedly the Fed statement and what oil and the dollar have done.

First the Fed

What is going on appears to be an attempt at a “garrulous” form of tightening. That is they are talking tough, but doing nothing even as the inflation gauges rage past the FOMC’s desired levels and they even admit the state of inflation is “highly uncertain.”

The FOMC (for new readers that may not know, this is the committee that determines policy) statement can always be summed up in three paragraphs: Growth, Inflation and Future Stance. The Fed continues to worry about economic growth and credit-market functioning, but has become quite worried about inflation too. Problem is when the FOMC states that inflation is “highly uncertain,” yet they do not raise rates – even mildly – it becomes worrisome. That term “highly uncertain” may be signaling a slight increase in rates quicker than most seem to expect, I may be alone on this thought.

(Look, I realize that it doesn’t make sense to jack rates higher due to credit-market and financial institution issues, but those talking about such action desire a gentle increase. The longer they wait, as inflation becomes embedded, the greater the likelihood they will have to jack rates up to a point that does major economic damage. And there is evidence that price increases are becoming embedded, as the most watched small-business survey along with the ISM and PMI indices show this is occurring.)

Again, as we’ve discussed many times, the Fed does not have a magic wand. There is not much they can do about housing – only time can reverse the excesses of 2005-2006. But they can determine the direction of inflation and it is problematic that they have abandoned price stability as we have been left with both the housing correction and higher levels of inflation.

Now on oil and the dollar

What has occurred here has been huge and is giving Bernanke & Co. some cover -- not that they needed it though, they didn’t seem too eager to quash inflation as oil jumped to $145 per barrel and the dollar was in the dirt, down to 71 on the Dollar Index. In fact, I think they could have pushed oil down to $100 with a 25 basis point cut – hammer it when it’s down.

For now though crude has come down on some very good comments out of Congress – pushed by President Bush – leading the market to believe just maybe drilling restrictions will be removed. This has combined with a reduction in government subsidies in Asian economies (subsidies that have kept demand higher than it otherwise would have been at these price levels.)

It’s tough to read on the chart, but oil is down 7.5% since July 30. Crude has plummeted 22% from the all-time closing high of $145.29 hit on July 3.


On the dollar, I continue to believe it will take some Fed tightening to get us back to 80 on the Dollar Index (a level that is necessary to get us out of the danger zone regarding the greenback) but things have certainly moved in the right direction.


Some of this move has been due to the realization that the Eurozone is weakening and thus a super-strong euro makes zero sense – so traders have moved back to the dollar.

For now though the oil/greenback move is huge. The higher dollar will help ease pernicious import price trends and oil now down 22% from its high will benefit the consumer, GDP, stocks, real income growth and the inflation gauges to some extent if this holds. Huge development.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

The roller-coaster ride continued with the Dow posting its second 300-point move of the week and the sixth move of at least 200 points in the last 10 trading days. Meanwhile the S&P 500 jumped 30.25 points higher to finish the week 2.9 percent higher.

Oil futures slid 4 percent to a three-month low of $115.20 a barrel due to expectations of curbing demand and a sharp rebound in the dollar. After tumbling 7.9 percent this week, oil is nearly 21 percent off its early-July highs.

Retailers, manufacturers and transportation companies rallied the most on speculation lower commodity prices will boost profits by reducing pressure on consumer and corporate expenses.

Market Activity for August 8, 2008

Coinciding with tumbling oil prices was a surging dollar that enjoyed its best one-day performance in more than six years. However, the dollar’s rise against the euro may have less to do with the currency’s fundamental strength than the growing feeling that the European Central Bank will focus their attention to the downside risks to growth.

The dollar was also helped by news that worker productivity in the U.S. grew in the second quarter giving investors (and the Fed) positive encouragement on the inflation front.

While three-quarters of S&P 500 companies have reported results that beat or met the average analyst estimates, the misses have been larger in size, chiefly at automobile companies and consumer finance companies. Despite being the worst performing of the S&P 500’s 10 industries, financial and consumer discretionary stocks have led the market’s rebound since July 15 gaining 25 percent and 13 percent, respectively.

There are a number of things to watch this week to see if we can continue this rally.

• Economic data on retail sales as well as earnings this week from retailers like Walmart, J.C. Penny, Kohl’s and Nordstrom should give us an idea of how the good ole U.S. consumer is doing.


• Wednesday we will get the MBA Mortgage Applications number as well as guidance from homebuilder Toll Brothers, which will give us insight into the housing environment.


• One of the most important numbers this week for the Fed will be the Consumer Price Index (CPI), which surged last month signaling the downside risks of inflation may outweigh the downside risks to growth.


• Other economic news to keep an eye on includes import prices, industrial production and jobless claims.

Brent will be back tomorrow to grace you with his words of wisdom once again.


Have a great day!

Peter Lazaroff, Junior Analyst

Daily Insight

Remember how yesterday, I said that I liked it when the market didn’t lose everything after a big gain like Tuesday’s?

Well, we didn’t quite lose it all, but markets traded lower yesterday to the tune of 224.64 points on the Dow Jones Industrial Average, to close 1.90 percent lower at 11,431.43. A much worse than forecast loss at American International Group (ticker symbol: AIG) was to blame as insurer announced that it lost $5.36 billion on mortgage-related write-downs; shares lost 18 percent of their value.

Oil took an opposite turn, gaining $1.44 per barrel to close up 1.20 percent and close at $120.02 per barrel in New York. It’s too bad, too, since I just filled my tank up today and was thinking how nice it was to be below $60 for a fill-up.

Recently, I read an economist’s take one why we pay such close attention to gas prices: we stand there with nothing to do and stare at the price. Yogurt prices have risen by the same percentage as gasoline prices over the past 18 months, but there isn’t a whole lot of uproar about it (then again, America isn’t addicted to yogurt in quite the same way).

Market Activity for August 7, 2008
This morning futures are basically flat as results from Fannie Mae (ticker symbol: FNM) are reviewed and traders consider oil futures, which are lower again this morning. Right now, oil futures are lower by $2 per barrel suggesting a barrel will trade for under $118 per barrel this morning.

This is no doubt partly a response to the sharply higher dollar, which has moved because China said that it would tighten their currency controls further (is that possible?) and it appears that the European Central Bank will not raise interest rates further. The ECB’s most recent action was to do nothing since it appears that all of Europe is on the verge of a recession/slowdown as well.

As Brent has said many times, at the point when the U.S. dollar stabilizes and begins to recover, the commodity bubble will shrink rapidly (something we have seen in July and August).

With respect to the FNM news, losses were expected and Freddie Mac had already laid the groundwork for some bad results when they posted earnings earlier this week. Therefore, it isn’t likely to have such a negative effect on trading today despite the weak results.

FNM posted a $2.3 billion loss compared to a $1.95 billion positive net income a year ago this quarter. FNM also booked $5.35 billion in credit costs by increasing loss provisions and charge-offs. They also cut their dividend by 86 percent to five cents per share that will save the company $1.9 billion through the end of 2009.

In my personal view, they should have scrapped the dividend on the common stock altogether. I don’t think it makes a whole lot of sense to continue to pay the common shareholder while the government is now officially standing by to rescue the company if they can’t raise enough money to continue independently. Certainly the stocks are so far off (another 11 percent this morning for FNM in pre-market trading) that cutting the dividend to zero wouldn’t likely kill the company. I don’t think anyone still holding the stock is in it for the dividend.

In economic news, U.S. productivity (defined as output per unit of labor) remained strong in the second quarter despite the slowing economy. Non-farm business productivity rose at an annual rate of 2.2 percent in the second quarter. Additionally, labor costs gained only 1.3 percent, below expectations.

This is an important piece of data because labor costs are the largest input in the creation of goods and services. The smaller than expected labor costs suggest that we are not in a 1970’s rerun where higher energy prices spiral into higher labor costs which spiral truly out of control.

Have a great weekend!

Dave Ott, General Partner

Daily Insight

Yesterday the kind of day that I really like: anytime you have a huge up market day like Tuesday, you really expect to give back at least half of it the very next day, so when that doesn’t happen, it feels like a gift.

Despite the far worse than expected $821 million loss for Freddie Mac (plus some write-downs in the billion dollar range), the Dow Jones Industrial Average rose 40.30 points, or 0.35 percent, to close at 11,656.07. The real stock market winner of the day was the Nasdaq, which gained 1.21 percent after Cisco Systems, Inc (ticker symbol: CSCO) announced stronger sales and net income.

Additionally, oil was lower for the third day in a row as inventory data showed that U.S. consumers are changing their driving habits in response to higher prices (kind of like what you would might remember from Econ 101: prices go higher and demand fall leading to lower prices). At the low point, oil had fallen to $117.11 per barrel.

Market Activity for August 6, 2008

At Acropolis, we have had the view that oil was overpriced. That’s the good news. The bad news is that we started saying it before it had crossed $80 per barrel so we’re still way above what we think it ought to be.

Having said that, however, oil has had such a precipitous drop just in the month of July that it does lead one to believe that oil prices are clearly not operating on fundamental factors alone.

Although the U.S. is consuming less crude, Saudi Arabia has increased their deliveries and demand growth in India and China hasn’t changed in the last 30 days. The obvious change was in trader sentiment. It is widely believed that one of the largest trades among Wall Street hedge funds is “long oil and short financials.”

This strategy was no doubt a winner for most of the year – energy prices are still high compared to Jan. 1 and financials have obviously been a disaster. However, in July, when Wells Fargo came out with better than expected earnings and increased their dividend, the trade turned upside-down as financials had a 50 percent rally from their lows, which undoubtedly forced a lot of short covering and unwinding long positions in energy.

This morning, futures are pointing lower this morning as the insurer American International Group (ticker symbol: AIG) posted a worse than expected $5.36 billion loss on even more mortgage related write-downs.

This is the third consecutive multi-billion dollar loss for the insurer related to mortgage investments. Obviously this kind of write-down, along with the news from Freddie Mac yesterday is enough to keep everyone on edge with respect to the bottom in housing.

In similar news, mortgages issues in the first part of 2007 are already going bad a much faster pace than mortgages issued in 2006. The data goes through April 30 of last year and shows that 0.91 percent of prime mortgages from those four months are seriously delinquent after 12 months, which means that they are either in foreclosure or 90 days past due. The data from 2006 shows that 0.33 percent were in serious delinquency.

The only good news on that data is that the lending really did tighten up by the end of the year, so there is some sense that there could be an end point to the lax lending standards.

In semi-related news, July same-store sales fell short of expectations for the second straight month, but discounters like Wal-Mart continued to pick up the slack. Again, this seems like Econ 101 – in tight times, it seems obvious that consumers would forgo $50 jeans at The Gap and buy $15 jeans at Wal-Mart (disclosure: I have no idea what jeans cost at either store, but you get the idea).

Initial jobless claims just came in higher than expected at 455,000. We will get into more specifics of the jobs number tomorrow, but it looks like we may give back some of the gains made in the last two days.

Have a great day!

Dave Ott, General Partner

Daily Insight

As expected, the Fed didn’t adjust their policy interest rates and the market loved it.

The Dow Jones Industrial Average closed 331.62 points higher, or 2.94 percent, to close at 11,615.77. There was only one loser in the Dow today – Chevron, which lost 0.40 percent due to oil prices.

Crude oil fell by 2.77 percent to close at 118.64 per barrel in New York. Oil has now fallen more than 18 percent since is high one month ago.

Market Activity for August 5, 2008

As we have talked about all this week, we knew that the Fed wasn’t very likely to make any changes to interest rates. The question would be what their message would be. Their assessment was towards inflation risk and the key phrase of the day was “significant concern’ regarding inflation.

Markets were strong from the start as oil prices continued their slide. When the market got the announcement, the rally pushed higher as more investors believe that the Fed will tighten later this year to curb inflation.

Right now the market believes that there is a sixty percent chance that rates will rise by either 25 or 50 basis points at the next meeting on September 9th and an 75 percent chance rates that rates will be higher by the meeting in late October. Obviously there is a lot of data that will be released between now and then, but today’s market action reflects this current thinking. In short, it is widely expected that a tightening campaign is forthcoming.


The chart above shows the dramatic shift in the Fed Funds Target rate over the past five years. It’s amazing to look at the steep declines in contrast to the measured pace of tightening in the last campaign.

I mentioned in yesterday’s email that I thought it was likely that there could be three dissenters who wanted to raise rates. Only one dissenter came through, Richard Fisher, who has dissented for the past five meetings.

Here is the statement parsing from the Wall Street Journal.


On the earnings front, Proctor & Gamble (ticker symbol: PG) earned 0.80 cents per share this quarter (on a diluted, continuing operations basis), ahead of the 0.78 cents per share Street expectation. This was a 19.40 percent gain on a year-over-year basis, demonstrating their power to push commodity price input costs along through to the consumer. Surely, this is a mark of their strong brands.

Freddie Mac (ticker symbol: FRE) reported a quarterly loss this morning that was three times wider than analysts’ estimates and wrote down another $1 billion in subprime and low quality mortgage securities. They also announced they will slash their common stock (not their preferred stock) dividend at least 80 percent to raise additional capital. CEO Richard Syron said that the company is still committed to raising $5.5, but many believe these efforts will dilute the value of their common stock. Freddie’s common stock futures are down this morning and could weigh on investor sentiment throughout the day.


Have a great day!

Check it Out!

We are pleased to announce that we have made Wealth Manager Top Dog's list for the 5th year in a row!

Click here to see the rankings.