Daily Insight

Stocks slid yesterday led by energy, basic material and financial shares as the Dow erased just about all of Monday’s gain and the S&P 500 was pushed back to a level that is just above the July 15 multi-year low – the index endured its steepest drop since Feb 2007.

Financials led the declines, falling 6.6% yesterday, as a 45% drop in Lehman Brothers shares led the index that tracks these stocks lower.

Energy shares fell 6.4% as the decline in oil continues to punish these shares. I guess many have forgotten that these firms will continue to post strong profit results – oil trades at $103 per barrel for goodness sakes. These stocks trade between 5-8 times earnings and are posting high double-digit profit growth.

In fact, there are a number of stocks and entire sectors that trade at attractive valuations, it’s just investors must have a great deal of patience and resolve during times such as these.

Market Activity for September 9, 2008

Oil touched $102 per barrel yesterday, before closing at $103.26 – down 2.90% -- as concern over a global economic slowdown has increased in recent days.

OPEC’s spokesman -- contradicting yesterday’s comments from the Saudi Oil Minister who stated inventories are “healthy” and the market is “well balanced” – is saying this morning that there is a “huge oversupply” and they’ll cut production by 500,000 barrels per day. They have obviously succumbed to pressure from Iran and Venezuela – two of whom are at the least proxies for a Russian voice within the cartel. In reality, Russia should have been granted membership this indecorous group long ago as they run things much like a mafia anyway..

And one more point on crude and the market, I doubt anyone would have thought stocks (as measured by the S&P 500) would be down 3.3% (and barely above the multi-year low set on July 15) as the price of oil has plunged 31% since July 3 and the dollar has rallied big time -- even if the current price of crude remains elevated. But while it looks like all hell has broken loose we have to acknowledge to some extent that heretofore commodity-heavy hedge funds are causing some adjustments.

Hedge funds were riding the commodity gravy train, and who could have blamed them; the Fed’s easy money policy was signaling to those with a traders’ mentality to do just that. But now that the CRB is off by 24% and oil down heavily from the peak, the unwinding of those trades are causing havoc.

Look, we are not out of the woods yet, and maybe quite a way from it; there are a plethora of uncertainties out there – as we talk about nearly each day – and a number of them are capable of creating troubles at any time. But we could also find, a few weeks out, that stocks begin to climb as investors turn their attention to attractive long-term valuations and away from focusing on the anticipation of a potential train wreck.

On the economic front, the Commerce Department reported wholesale inventories rose 1.4% in July and as expected sales declined; they slipped 0.3% in July.

This decline in sales is very normal as activity was robust over the previous four months – up 26% at an annualized rate.

Further, sales were largely hurt by petroleum sales. Excluding petro, merchant wholesaler sales climbed 0.8% in July and are up 12.8% over the past six months at an annual rate – 12% three-months annualized.

We’ll note that machinery sales were also weak, falling 3.7% in July. However, this segment had been on fire, up 22% annualized over the previous three months, and these big-ticket items are volatile. One has to expect a decline in machinery sales after this activity. I suspect they’ll bounce back as the energy industry continues to hum and incentives to increase business equipment remain in effect through year end.

With regard to the impact on GDP, the rise in wholesale inventories – twice as much as expected – offers good evidence business-retail inventories will be stronger-than-estimated (we get that number next week) and we may see this result in another upward revision to the Q2 GDP report.

The inventory-to-sales ratio did move up but remains at an extremely low level historically, as the chart below illustrates.

Important point, automotive inventories alone rose 2.3% in July, but last week’s auto sales data showed inventories were trimmed substantially due to incentives that helped August sales activity. I’d look for wholesale and overall business inventories to move back to a record low when the August number is released, which provides a strong indication the production needed to rebuild stockpiles will keep overall economic growth positive.


In a separate report, the National Association of Realtors stated pending home sales for July fell 3.2%, breaking a very nice trend that had this figure up 32% at an annual rate over the previous three months. Pending sales in the West plunged 10.6% and 7.5% in the Northeast. The South region was unchanged from the prior month and the Midwest posted an increase of 2.8%

Mortgage spreads, until the past couple of days, remained historically wide and this hasn’t helped the housing market. After the Treasury Department’s decision to take the mortgage GSEs into conservatorship that has changed as spreads have narrowed and mortgage rates will fall substantially next week. Still, this won’t solve things as those that put little-to-no money down, or do not have a meaningful down payment will find little help outside of the FHA program.

The big issue with housing is a speculative bubble has been burst in many regions and the decline in prices will simply run its course until the overhang of home supply is absorbed. Once buyers get a sense that prices have bottomed, sales will begin to ramp up in a consistent manner. It will just take time, there is nothing the government or anyone else can do about it.

What can be done for the economy as a whole is for Congress and the next administration to reduce tax rates on incomes and business, make permanent increased current-year write-down allowances and bonus depreciation schedules, and keep the rates on capital and dividend returns unchanged at the least. This will do three things:
One, it will restore investor confidence and thus drive equity prices higher.
Two, it will keep the boost we’ve seen in capital spending over the past few months alive, which will boost GDP and drive future productivity gains via the new equipment.
Three, it will lead to job creation as small business is this economy’s largest job creator – remember than two-thirds of those in the top federal tax bracket is small business. All three of these factors will have a beneficial effect on housing, over time.

It will also help if the Fed learns from this harsh lesson not to recklessly push interest rate to levels that encourage the behavior that led to the housing excesses we are now watching correct. Keeping fed funds at 2.0% or below for the three years that ran November 2001 – November 2004 was a grave mistake. Hindsight is 20/20, but we were calling for the Fed to raise rates at the end of 2004, as longer-term readers may recall, as it was evident the economy was running on most cylinders by the end of 2003.

We’re without an economic release today, but will get back to it tomorrow with the July trade balance, August import prices and initial jobless claims.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks climbed yesterday, on the view that the government takeover of the mortgage GSEs (government sponsored entities) will stabilize the global financial system battered by half a trillion in write-downs since August 2007.

The market actually held onto most of the early session’s gains – although it didn’t look that way by midday as the chart below illustrates – all sectors but energy and basic materials enjoyed a nice day with financials, consumer discretionary and industrials jumping between 2.4% and 4.7%.


Market Activity for September 8, 2008

Advancer whipped decliners on the NYSE by a 30-to-1 margin and volume was pretty strong as 1.7 billion shares traded on the Big Board.

The S&P 500 is still 19% below the October 9 all-time high, but we’ve bounced back to 4.5% above the multi-year low set on July 15 – it will be important to remain above that mark. Even if we do, investors will likely need to lean on patience as the next short-term event is Hurricane Ike and longer-term the election.

Oil prices have moved back to the $104 per barrel handle this morning (for the first time since April) on news the Saudi Oil Minister stated inventories are “healthy” and the market is “well-balanced” at the cartel members’ meeting. OPEC is expected to keep production unchanged. While this is a big plus, weather-related events do threaten the welcome trend in crude prices. If Hurricane Ike maintains its current speed it is expected to keep south of major oil production facilities in the Gulf of Mexico and we could test $100 per barrel. If it does not, all bets are off.

On the economic front, the Federal Reserve reported that consumer credit rose half as much as expected in July rising $4.6 billion for the month, which represents the smallest increase this year – the financial press will focus on this point.

However, while the media will cite stricter lending conditions, leading one to believe credit is hardly available, we’ll note a reading of this nature is not unusual especially following several months of strong increases – which was the case in the prior six months of the year. What helped to drag the figure lower was the slump in July auto sales as gasoline prices jumped and consumers shunned SUVs and trucks.

For sure credit standards have tightened, but is this a bad thing? – especially in light of the fact that there have been little-to-no standards at all over the previous couple of years. I saw one report quote someone as saying the consumer is “stuck between a rock and a hard place,” but it is not because the availability of credit has disappeared, but more because real income growth has been hurt by accelerating rates of inflation and the ancillary effects of higher energy prices, even if those costs have come down of late.

Credit spreads have widened, thus the cost of money is higher than it otherwise would be with benchmark interest rates at their currently low levels but this latest report on consumer credit showed the cost of money actually fell for car loans – the average interest rate for new car loans fell to 3.31% in July from 5.49% in June as dealers offered incentives. For those with strong credit scores sub-1% financing is available. The loan-to-value ratio rose, not exactly a situation that takes place in an environment with which credit is scarce.

While financial institutions have become more cautious from an overall perspective, things have hardly progressed to the point that we need to worry credit has dried up and thus the economy will grind to a halt as a direct result.

In fact I would take a more optimistic view – and I’m not being Pollyannaish here as you all know I’ve got my concerns – as we’ve seen the consumer credit-to-disposable income ratio ease slightly even as the Fed continues to subsidize debt via their easy money policy. It’s saying something when this figure flattens out or dips slightly even as interest rates remain historically low – it’s a long-term plus that credit standards have become more reasonable.

So we have the media that is not happy when credit expands “too much,” for fear the consumer is spending beyond his/her means. Yet, when the borrowing figures rise less-than-expected, that isn’t good either. I would say the economy is adjusting to the realities of the economic environment just fine overall, even if is unpleasant during such periods as stocks struggle to gain ground and these adjustments make for trying times.

Mortgage Spreads Narrow

The temporary government take-over of Fannie and Freddie certainly helped stocks yesterday, as it also helped to bring mortgage rates lower. The yields on Fannie Mae mortgage-backed securities fell 40 basis points, narrowing to 150 basis points over the 10-year Treasury – that spread was 190 basis points on Friday and widened to 212 basis points in early August. This means the 30-year fixed mortgage rate will come down to a level that more closely mirrors the historic average, relative to Treasury rates. When these rates adjust to this reality next week we’ll be able to provide a chart of this picture.

Looks Like We Have a Race

Game on in the race for the White House as both the polls and pay-to-play Intrade has either McCain pulling away or the race narrowing.

Polls (of likely voters) show McCain is up by 5-10 points over Obama. But forget these polls; they can be wrong up to the final day as we found out in 2004. Pay-to-play Intrade betting has McCain gaining momentum, making a game of it. Obama remains in the lead according to this source, but the McCain surge is significant and one person is directly responsible – Sarah Palin.

The charts below show you pay 46 cents and get a buck if McCain wins. Pay 53 cents and get a buck if Obama wins.

Hard telling how things will play out, but the important thing with regard to the market and economy is that this tightening has helped ease the worry over tax rate changes, even if just slightly. This new surge, if you will, has caused the Obama campaign to state they may just defer their plan to raise taxes on income, capital and dividends. While politicians say a lot during a campaign, and do something entirely different when in office (no matter the party), this change may give investors a little solace – now that gives me something to believe in.

This morning we get pending home sales for July and wholesale inventories. Pending home sales will likely show a decline as the figure has jumped 32% at an annual rate the past three readings.
On wholesale inventories, we’ve got to expect the underlying sales data will slip after four months of huge sales growth that has sent the inventory-to-sales ratio to an all-time low. Merchant wholesaler sales jumped 26% at an annual pace over the past four readings and one should expect a pull-back in sales as a result.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks didn’t take kindly to the large increase in the unemployment rate as the benchmark indices began the morning session down roughly 1.5% across the board. However, the market reversed course in the afternoon as people realized, while the economy has lost jobs for eight-straight months, the losses remain mild relative to the typical labor-market downturn.

In addition, most of Thursday’s decline a significant move, was in anticipation of this employment report as the jobless claims data offered an indication losses would continue. Point is most of the damage due to this event occurred on Thursday.

Also, possibly helping to spark the reversal was a report from Barton Biggs – a well-known market strategist – that stocks are “pretty close to a bottom” and can mount a “powerful” rally from here. Although, we’ve heard this from Mr. Biggs before, only then to see stocks make new multi-year lows. (This is not meant to disparage Biggs, whom I admire, just stating the fact.)

Market Activity for September 5, 2008
The chart below shows the strong rebound from the day’s low point – up 2.00% from that intraday bottom.


Financial, consumer staple and basic material shares led the rally – financials were up 3.23%, consumer staples added 1.00% and materials 1.13%. The worst-performing group was utility shares, down 1.75%.

On the economic front, the Labor Department reported the economy shed 84,000 payroll jobs in August, which was a bit higher than expected but meaningfully less than the whisper range of between a 100,000 -110,000 decline.


That said the previous months’ job-loss figures were revised up. Prior to these revisions the monthly job-loss average year-to-date was 66,000. That average has moved to minus 75,000 per month due to these adjustments.

Again, the economy lost 84,000 payroll positions in August – according to the initial estimate at least – as the majority of these losses where in manufacturing and business services. Manufacturing, lost 61,000 and business services shed 53,000. (I’ll note, most of the manufacturing decline came from the motor vehicle and parts segment of goods-producing industries as auto-land employment declined 39,000 last month.)

Interestingly, construction lost only 8,000, which is a major improvement relative to the past few months – we’d averaged a decline 41,000 monthly construction jobs prior to this report year-to-date. The bright spots remained education and health services, adding 55,000 combined (38,000 pick up from health services and 16,000 in the education sector).

The unemployment rate jumped to 6.1% from 5.7% in July and is higher by a full 1.7 percentage points since hitting a multi-year low of 4.4% in March 2007. Although, I think it is safe to say that that low-point for unemployment was a bit artificial as it was the former (as opposed to the current easing campaign) very easy monetary policy stance by the Fed that led to housing-industry excesses and the big jump in construction employment as a result. It is more appropriate in my view to gauge the current increase in unemployment to the 5.00% level reached prior to those excesses totally taking hold – which is still a significant rise that amounts to roughly 1.6 million in jobs losses – this includes the self-employed.

The civilian labor force (those currently employed or looking for work) rose 250,000 in August, while household employment declined 342,000. So, we had 250,000 new entries – those looking for work – which is why the unemployment rate shot up to 6.1% as the labor market lost jobs in addition to those new entries. To add, much of the rise in the unemployment rates over the past few months was due to the teenage segment of the report. Not so in August as it was all adults.

(Just to clarify for new readers, there are two reports that encompass the monthly jobs figures. One is the establishment, or payroll, survey. This is the number you see in the headlines and this is where the 84,000 jobs lost in August came from. It is a survey of 400,000 businesses. The second is the household survey, this is the figure that is used to calculate the unemployment rate – it’s a survey of 60,000 households and includes the self-employed.)


Average hourly earnings accelerated to 3.6% on a year-over-year basis, from 3.4% in July. This is quite helpful and good to see a slight acceleration. Another positive from the report, and not touched by most, was the percentage of private companies adding jobs rose to 48.9%, the highest in many months. Not sure this is the start of a trend, but it’s something to watch for indication the labor market scenario may flatten out in the coming months.

What does this job’s report say for monetary policy? It increases the likelihood Bernanke and Co. will actually cut their benchmark fed funds rate – that’s right, I said cut. This would prove to be a very large mistake if in fact they do so – in my personal opinion --, but their flawed Phillips Curve models will point them in that direction with the unemployment rate jumping to 6.1%. (For additional perspective, the current unemployment rate matches the 30-year average, but the Fed will take notice to the jump from 4.4% last year and possibly think they have a green light to reduce rates without sparking inflation. Not saying this will happen, just that it wouldn’t surprise me if it did.)

The economy is not in terrible shape even though these jobs reports are less than encouraging. A number of sectors continue to show nice progress and from an overall perspective just look at business sales (a chart we show regularly), which remain on an upward trajectory rising 6.5% year-over-year. What we are seeing within the labor market is a housing and auto sector drag that is causing firms to cut jobs within goods-producing industries – that’s where the pressure is coming from.

However, for the auto-sector at least, the latest auto report showed incentives are clearing inventories and leading to a mild increase in sales – even if they remain depressed from a historical perspective. There is evidence however, that auto production will extend upon August’s increase (the data we saw on Wednesday has changed my mind in this regard). Housing will remain weak for sometime, but a little boost from the auto sector will do a lot to keep manufacturing activity near or slightly above the expansion/contraction cut line. Many segments within the industrial sector remain upbeat. The Fed’s models though will likely push them in the wrong direction in my view at this time. We shall see.

Fannie and Freddie

The big news of the weekend came from Hank Paulson and the Treasury Department, stating the two housing GSEs Fannie Mae and Freddie Mac would be placed in conservatorship – which means the government, via the Federal Housing and Finance Agency (FHFA), will take them over and shore them up until the housing market stabilizes. This was not triggered for fear of imminent collapse – both have capital that is above the requirement, but further housing-sector losses would test that capital position in time and this was the furthest point from the election, yet after the conventions, to take such action. Prior to this, Paulson’s hope was that simply talking of a government backstop would calm markets; alas, that strategy only made things worse.

The terms of the plan will be to eliminate dividends on common shares and at least suspend dividends on the preferred. Interest and principal will continue to be paid on the subordinated debt and one would expect over the next few days for mortgage-backed bonds to perform well.

The Treasury will extend their credit facility to both Fannie and Freddie to $100 billion each in order to make sure they maintain a positive net worth. The Treasury will also receive $1 billion of senior preferred stock and 10% interest on the stake. As a condition, the two GSEs will have to shrink their portfolios, not to exceed $850 billion as of December 31, 2009 and shall decline 10% per year until it reaches $250 billion. (Currently, Fannie’s portfolio stands at $758 billion.) The point of the December 2009 timeline is that this is a relatively safe bet the housing woes will have run their course by this point. Longer-term this will be a very good thing because if they are currently too big to fail, then the logical solution would be to shrink these behemoths. I do believe this plan to shrink their portfolios must first be approved by Congress, so it’s not official just yet.

Stock futures are up big on the news so the effort by Treasury will result in at least short-term market strength.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks tumbled yesterday after the weekly report on jobless claims showed the figure is not abating; some had hoped once adjustments to the government’s program to extend benefits began to set in the reading would ease. Now that the figure remains above the 400k level, even as the Bureau of Labor Statistics says the response to that government program has peaked, it’s leading many to believe claims are simply rising because job losses are accelerating, not solely because of the increase in eligibility.

This morning we get the jobs data for August – a decline will mark the eight-straight month of losses, although they have been mild to this point averaging just 66,000 per month. The jobless claims numbers offers pretty good evidence those losses will move to 80,000-100,000 per month.

Up to now the labor market weakness has been more about the lack of new openings rather than layoffs on a large scale. I think the situation will remain that way, but it does look like we’ll get a couple of months here and there that cause people to worry layoffs will rise substantially.

Market Activity for September 4, 2008
All 10 major industry groups got hammered yesterday, with financial and basic material shares performing the worst down 4.69% and 3.83%, respectively. The best performers, of course on a relative basis, were consumer staple and utility shares, which lost 1.13% and 1.21%, respectively – no surprise that those sectors were pressured the least when concerns over global growth arise.

It’s been interesting to watch commodities – as measured by the Commodity Research Bureau – fall 21% since July 15, yet stocks have remained essentially flat. The CRB is down 8% since August 21 and the broad market has down as well, off by 3.2% since that date. Ask someone two months ago how stocks would perform with this level of decline in commodity prices and there’s little doubt most would say a rally would ensue – myself included. But global growth concerns have taken over, which makes it tough for stocks to catch a bid. The S&P 500 remains 2% above the July 15 multi-year low.

And speaking of commodities, crude-oil price fell yesterday even as the weekly energy report showed stockpiles decreased by 1.9 million barrels in the week ended August 29. Again, worries over global growth have now taken over to offset supply concerns, hence the dip in prices even though crude inventories are now six million barrels below the 12-month average.

Expectations were for a 450,000 barrel increase in supplies. I’m not sure what logic drove that estimate, but one wonders where these analysts have been over the past week – maybe they believed Mr.Gustav would be kind enough to deliver supplies to the ports and terminals.

In international news, both the ECB (European Central Bank) and the Bank of England decided to keep their benchmark interest rates unchanged (4.25% for ECB and 5.00% for BOE) even as EU growth has flat-lined and many call for them to cut. Yet, inflation remains elevated in the Eurozone – close to a 16-year high – so they are holding steady for now.

The relevance of this weak EU growth with regard to the dollar is that caused traders to question why exactly they had pushed the euro to such a lofty level – some of those funds have flowed into the dollar as a result. Still, the interest rate differential remains in the EU’s favor, but many assume it is just a matter of time until the ECB does in fact cut their benchmark rate and thus narrow that differential.

Still, as we’ve talked about for a couple of weeks now we need to see the Dollar Index hit 80 before getting to excite. For now, we’ve got a great trend going.


On the economic front, the Labor Department reported that Q2 productivity surged 4.3% at an annual rate, revised up from the previous estimate of 2.2%. A large upward revision in output combined with a downward revision to hours worked led to the significant upward revision to productivity. (Productivity measures the increase in output per hour worked.)

Just to put this reading into perspective, a number above 2.5% is considered large. Non-financial sector productivity came in at a rip-roaring 5.6% annual rate. That reflected a 3.8% rise in output and a 1.7% fall in hours worked.

These levels of productivity are hugely beneficial, especially now as we deal with energy prices that have climbed roughly 50% across-the-board over the past 12 months. U.S. productivity has increased a powerful 3.38% over the past 12 months.

Unfortunately, within the manufacturing sector, productivity declined 2.2% at an annual rate as output fell 3.7%, while hours worked dropped just 1.5%. This marked the largest quarterly decline in manufacturing productivity since a 2.5% decline in Q2 1989. Unit labor costs in the sector jumped 6.2% -- boosted by a 9.0% rise within the durable goods sector.

In total, compensation per hour has increased 4.0% over the past 12 months, which is helpful but lags the current pace of inflation.

In a separate report, the Labor Department reported that initial jobless claims for the week ended August 30 rose 15,000 to 444,000. For the reading to remain at these levels, it obviously points to more job losses ahead. Some, including myself, were anticipating this figure to fall as the government’s program to increase unemployment assistance wore off, or at least that the response from this program had peaked. The fact that the reading has not come lower illustrates there’s a good possibility we’ll see monthly job losses increase to 80-100k over the next several months. (In the seven months in which the job market has shed positions, we’ve averaged 66,000 monthly losses.)

The four-week average of jobless claims did tick down, but just barely, and remains elevated. I will point out, however, that when you view the chart below keep in mind that the labor market is 12 million stronger than it was 10 years ago and 32 million stronger than it was 20 years back. Point is, jobless claims of 445,000 is not what it used to be at lower job-market levels. Nevertheless, this is well-higher than we want it to be.


Lastly, the Institute for Supply Management issued its latest look at the service-sector as its nonmanufacturing composite index (which equal weights the survey’s business activity, employment, new orders and supplier delivery indexes) showed activity accelerated a bit. The reading rose to 50.6 in August from 49.5 in July. Over the past six months the index has averaged 50.3 – 50 is the cut line between expansion and contraction.


The business activity index rose nicely to 51.6 from 49.6 in the previous month.


The employment index fell to 45.1 from 47.1, which is another sign today’s jobs report may come in weaker than expected.


The prices paid index fell to 72.9 from the extreme level of 80.8 yet remains higher than the average of the past two quarters. A year ago the prices paid index was running in a range of 60-65.


All eyes will be on the August jobs report, released at 7:30 CT. We’ll also get the mortgage delinquency figure for the second quarter at 9:00.

Have a great weekend!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ended mixed as the S&P 500 and NASDAQ Composite fell for a third-straight session, while the Dow Industrials managed to close higher helped by shares of Home Depot, United Technologies, Proctor & Gamble and Chevron.

Information technology shares put pressure on the tech-laden NASDAQ and basic material, energy and those tech shares kept the S&P 500 down.

We’ve been trapped in a trading range between 1215 and 1450 on the S&P 500 since the beginning of the year and over the past month stuck between 1250 and 1300. The market doesn’t know what to do. Multiples are not high enough to send us much lower – based on what is currently known – and there are simply too many uncertainties lurking to propel the index out of this range.

The nearest term event will likely be the election. At least then we’ll have a good sense of where tax rates are going as after-tax return expectations on capital, dividends and labor income (small business consists two-thirds of the top federal income tax bracket) are necessary to assess the correct market multiple. Disposable, or after-tax, income growth is also hugely important right now, and the tax-rate uncertainty raises an issue here as well. Until then, we’ll just have to lean on patience.

Market Activity for September 3, 2008

That said, there are many individual stocks that trade at attractive P/E levels, but uncertainty is a terrible thing for stocks and these opportunities often get ignored in such an atmosphere. There are also entire sectors that look cheap in my view, as the S&P 500 index that tracks tech shares trades at 19 times earnings and industrials trade at 15 times. Energy stocks are back down to 10 times trailing earnings and 9 times this year’s profit expectations as many focus on oil’s recent decline and forget that these firms will make a lot of money at $110/barrel oil. The good news is the major indices seem to have found a bottom – knock on wood.

Yesterday we mentioned how all will be focused on the direction oil trades as the weekly energy report will surely show a big drop in inventories due to Gulf-rig shutdowns and closure of the LOOP. In addition, 13 refineries in the area were shut down completely and 10 others ran at reduced rates due to Gustav. The problem is I forgot that due to the holiday the weekly energy report, which is usually released on Wednesday, will be pushed back by a day. So, we’ll have to wait a couple of hours still for that report.

In any event, it does seem that production will resume quickly as the hurricane did very little damage to production infrastructure -- we should see stockpiles rebuilt in short order.

On the economic front, the Commerce Department reported factory orders rose 1.3% in July, beating the 1.0% estimate. This followed a large 2.1% increase in June that was revised up from the initial estimate of 1.7%. That’s a meaningful revision and may push the second-quarter GDP reading a bit higher when we get the final revision at the end of this month.

For this quarter, the July reading puts the period off to a good start and reinforces our view that business spending (capital expenditures) will provide an offset to what will likely be weak consumer activity (in real terms) during the third quarter. For instance, the non-defense capital goods, ex-aircraft, component of this report – which is the business capital spending number – jumped 2.5% in July.

It will be very interesting to watch the trend in capital spending as this is on top of three months of pretty strong growth for this component. I’ll note: the rebound in capital spending corresponds directly to the increase in current-year business write-off allowance and bonus depreciation the president signed into law back in May. Unfortunately, the way I understand the legislation, this will expire in 2009 as he had to drag Congress kicking and screaming to add it to the tax-rebate bill and could only manage a very short-term incentive boost as a result.

In terms of overall factory orders, they have risen for five-straight months now and in dollar terms stand at the highest level since the series began on an NAICS (simply put, a new classification system) basis in 1992.

Importantly, the unfilled orders figures is up 29 of the past 30 months and also stands at the highest level since the series began reporting on an NAICS basis. One would expect, outside of normal fluctuations, orders will remain on an upward trajectory for at least the next few months based on this heightened unfilled orders figure.

The weakness within the report came from high-tech equipment, specifically computer orders -- down 11% in July and 4.8% from July 2007.

In a separate release we received Challenger’s Job Cut Announcement survey (this is comprised by the executive outplacement firm Challenger, Gray and Christmas), which stated that the rate of layoffs slowed in August as they reported 88,730 job cuts were announced -- 103,312 were announced in July. However, while that number was lower than their July figure, job cut announcements were nearly 12% higher relative to August 2007. This is not seasonally adjusted data.

According to this report, one-third of the 88,736 in August came from the automotive and government sectors.

In other news the Fed released its regional economic survey known as the Beige Book. This report is released every six weeks and to be honest is a bit outdated, but is worth a read nonetheless. It found:

• Consumer spending was slow in most districts and many districts showed a pattern toward discount stores and lower-priced brands. (I think we should expect consumer activity to exhibit a two quarter respite after pretty good numbers over the past few months and inflation has cut into real income growth)
  
• Manufacturing was weak and declining in most districts, but improved in KC and Minneapolis (this doesn’t totally match with the ISM reports, which show things are a bit more optimistic within the sector)
  
• Residential real estate remained soft in most districts, save KC (no surprise there)
  
• All districts reported continued upward price pressures, with Boston, New York, Philadelphia, Atlanta and Dallas indicating businesses have stepped up the pass-through of higher costs. (This matches with what both small and large business price surveys along with the ISM and NAPM (factory surveys) reports have shown. Further, the Cleveland Fed’s Trimmed-Mean CPI, which takes out the most volatile components, and non-energy CPI are both at 17-year highs)
  

One obviously hopes the large and rapid decline in energy prices will ease price pressures, but the more data one studies the more it paints the picture that the 48.5% rise in crude, the 41.5% in gasoline and the 45% in diesel prices over the past year have become at least partially embedded.

This morning we get a number of data releases, with the final revision to Q2 productivity, weekly jobless claims and the ISM service index for August receiving the most attention.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks reversed course as a substantial early-session rally fizzled, succumbing to losses within the energy and basic material sectors; driving the broad-market into negative territory by mid-day was deterioration within the tech-sector. With all three of those sectors losing between 1.4% and 4.6%, and no real help from anywhere else save financials and consumer discretionary shares, the market could only go lower.

Energy stocks got drilled, pun intended, as oil prices shed $5.75, or 4.98%, to close the session at 109.71. Crude had been down as much as 8.8% yesterday, but a roughly 5% decline ended up being plenty to clock the sector. Oil is down to $108.32 this morning, the lowest level since early April.

Energy, basic material and information technology shares combine to make up 33.2% of the S&P 500.

Market Activity for September 2, 2008
As the chart below depicts, stocks started the day much higher after Hurricane Gustav’s impact proved to be much less than initially feared, sparing drilling platforms in the Gulf of Mexico and the New Orleans’ levees mostly held. However, things nonetheless fell apart as information technology, industrial and health-care shares erased early gains providing zero offset to the basic material and energy stock woes.

The S&P 500 began the session up 1.6% at the get go, but ended up losing 2.0% from that intraday high. The broad market declined 0.41% relative to the opening price. (The yellow line represents that opening mark.)


This morning, as the day progresses, it will be interesting to see how the oil market prices things in as we get the weekly energy report. Supplies will surely drop as the LOOP (Louisiana Offshore Oil Port) remains closed and Gulf production was shut down. Too, we have Hurricane Ike that looks to be making its way to the area.

On the economic front, the Institute for Supply Management (ISM) reported that manufacturing activity (on a national level) remains right at that dividing line between expansion and contraction. The reading came in at 49.9 for August and has hovered there for six months as the average for this period is 49.5.

The fact that the survey failed to show a pick up is decent proof the large acceleration in the Chicago-manufacturing reading (which we touched on yesterday) was mostly due to an increase in auto production – U.S. auto production is a large component within that regional survey. Normally, this would be fine, but since vehicle sales remain subdued, one shouldn’t expect auto production to have much staying power. That said, it is remarkable the manufacturing sector – from a national perspective -- remains solidly at the 50 level even as housing weighs heavily on the sector. (Again, above 50 marks expansion and below that mark, contraction – a reading very close to 50 on either side is a push.)

In terms of the sub-indices, which are hugely important to watch as they give evidence of future ISM readings, most remain subdued but a couple did improve from the July readings. For instance, the new orders index rose to 48.3 in August from 45.0 in July. Backlogs of orders increased slightly to 43.5 from 43.0.

The production index did slip from the July reading but remained in expansion mode, coming in at 52.1 in August after 52.9 in July. Inventories remained below 50 for the second-straight month, but did rise, coming in at 49.3 after July’s 45.0 – one watches this reading to gauge the effect inventories have on GDP. However, the customer inventory reading hit 54.5 – a 7.5-point jump from July. A reading over 50 for this index shows that respondents believe their customers’ inventory levels are too high. (This illustrates the cautious nature of business more than anything else as we know that inventory levels in a broad-based sense are at historic lows)

New export orders jumped to 57.0 from 54.0 in July.


The prices paid index has decelerated nicely, yet remains elevated.


Bottom line: the report was a decent one as the headline ISM reading remained very near the 50 level, yet it doesn’t give us a sense the manufacturing sector is ready to engage in rip-roaring activity anytime soon. That big increase in new export orders is a great sign though as many have worried economic weakness in Europe will cause export activity to ease. This reading shows other regions of the globe are filling the void.

It is good to see the prices paid reading come lower, but we’ll need to see continued deceleration to ease broad-based inflation concerns.

In a separate report, the Commerce Department reported that construction spending fell 0.6% in July after two months of gains. A 2.3% decline in private residential construction in the month led the overall figure lower. Non-residential private-sector construction (commercial) was also lower, falling 0.7%, marking the first decline for this figure in more than a year. (Private-sector residential construction is down 27.5% year-over-year. Commercial construction is up 16.0% since July 2007, just to mention the contrast)

July marked the first month since January 2007 in which private-sector commercial construction has not helped to offset residential weakness.



The public-sector did help to prop up the overall reading as public-sector residential construction rose 3.4% in July and non-residential (boosted by transportation and schools) rose 1.4%.

I’ll note, however, even though residential construction remains mired as inventory levels are hugely elevated, we have seen some encouraging signs as the degree of decline has waned over the past three months. For instance, single-family new homes sales fell at an 18.5% annual pace over the past three months – about half the 35.3% decline of the past 12 months. Pending home sales – those existing home sale contracts that have been signed, but not yet closed -- have jumped 32.2% at an annual rate since April, compared to the 12.1% decline over the past 12 months.

The pig in the python is foreclosures, as it will take some time still for this figure to peak. U.S. loans past due have increased to 6.35% of the total mortgage market vs. 4.84% a year ago. (These will not all turn into to foreclosures as this reading accounts for all mortgage loans just 30 days past due, but the number is nonetheless higher) Prime loans past due hit 3.71% as of the latest data. Subprime loans past due hit 18.79% for that universe. That is up from 2.58% and 13.77%, respectively.

This morning we get the latest factory orders report, which should show business spending continued to trend higher. This is the big bright spot from a domestic GDP standpoint (outside of trade) as we’ve seen signs that the business side will offset any consumer weakness in the current quarter.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

• U.S. stocks ended a three-day winning streak on Friday as the Commerce Department showed personal spending was weak during July and incomes declined for the first time in three years. More than anything though, Friday’s down market was more a function of traders’ unwillingness to take on additional long positions considering the increased uncertainty that Hurricane Gustav wrought.
  
  That personal income figure was really more a function of the government’s rebate check program coming to an end as this caused government transfer payments to fall substantially. The fundamental components of the data continue to look pretty good, as we’ll touch on below. (Real income growth remains a chief concern, but the income data looked much better in July than the headline number would lead one to believe.) Further, it’s tough to blame economic data for Friday’s stock-market decline considering the most important regional manufacturing survey showed activity was just shy of robust last month.
  
  Market Activity for August 29, 2008
  

All 10 major industry groups ended the week on a down note, with information technology, utility and industrial shares leading the declines. Financials were the best-performing sector on a relative basis, falling just 0.59%.

Crude-oil prices have plunged this morning, falling 6.30%, or $7.27 per barrel, as Hurricane Gustav failed to strengthen to the level many had feared and thus oil and gasoline production should resume in pretty quick order. We won’t know the extent of the damage until tomorrow – firms will get out and assess rigs today – but there’s a strong possibility we escaped major damage. That said, the Louisiana Offshore Oil Port (LOOP) has been closed for a few days and likely won’t be able to begin taking shipments again until Thursday, so this will have a meaningful effect on stockpiles in the very short term.

As the chart below illustrates, we’ve enjoyed a welcome 25% decline in oil prices over the past six weeks, yet remain 43% higher from the this time last year and 24% higher from date the Fed began to aggressively ease with their January 22 inter-meeting cut. (The annualized figures are meaningless for the purposes of this graph, so pay not attention to those readings, if you can even read them.)

It’s been amazing to watch how emotion-driven trading has turned. Just six weeks ago the slightest disturbance would lead to large moves higher as crude hit $145 per barrel in mid July. Now, even when a large production disturbance occurs, so long as it doesn’t reach the worst-case assumption, traders push crude down 4-7%. This is a huge development for the consumer and profit margins.

Helping this trend out is some encouraging signs from Congress regarding the removal of energy production restrictions; let’s hope the recent decline in prices doesn’t cause a reversal. Further, the pro-drill candidate continues to make progress in the polls, which likely has an effect on traders’ mentality as well.

I’ll caution though, OPEC meets next week and you know what that means with crude 25% off its high. Yep, they’re likely to push through a production cut, especially since Russia will put pressure on them to do so. (Russia is not a member of OPEC, but they do have strong, and concerning, ties to Iran and Venezuela – regimes that very much depend on the high price of oil to remain relevant.)

On the economic front, the Commerce Department reported personal income fell 0.7% in July. This decline was due to the rebate-check effect. Recall back in June how we explained the big jump in May income growth was due – largely – to government payments and that there would be some blowback effect as the numbers were adjusted to this one-time situation. Well, here it is.

The large 17.6% decline in the “other” component of government transfer payments moved the overall figure lower. However, the components that really matter – compensation, wage and salary, proprietor’s income, rental income and dividend income all posted decent-to-strong results.

Compensation was up 0.3% in July and 4.0% year-over-year (YOY)

• Compensation was up 0.3% in July and 4.0% year-over-year (YOY)
• Wage and salaries gained 0.3%, up 4.1% over the past 12 months
• Proprietor’s income rose 0.4% -- nonfarm proprietor’s income up 3.2% YOY, accelerating to 8.9% at an annual rate last three months
• Rental income jumped 7.2% in July and has soared 50.6% YOY
• Dividend income was up 0.6% in July and up 8.2% YOY
• Disposable (after-tax) income is up a very healthy 5.8% YOY

So the income components that matter show pretty nice trends, although for the labor-income related segments the growth has not been enough to keep up with elevated inflation rates. Broadly speaking, disposable income does continue to outpace inflation, which is good.

On the spending side, personal consumption rose 0.2% last month and is up 5.1% YOY and just a bit more six-month annualized. One should expect the pace of spending to ease as inflation eats into the growth of income. Lower commodity prices of late will help, but as we’ve touched on in past letters there is a risk that inflation has become embedded. We’ll just have to see how the data turn out over the next two months.

And speaking of inflation, the gauge tied to this personal spending data showed the PCE deflator (one of the big-three inflation gauges) has increased 4.5% over the past 12 months – a large acceleration from the June year-over-year figure of 4.0%.

The core rate also edged up, coming in at 2.4% YOY – well-above Bernanke’s stated comfort zone of 1%-2%. We’ll admit, as this letter has stated before, a comfort zone of below 1.50% is rather ridiculous as some pricing power is important, but I believe it is worth mentioning that the actual readings continue to blow past his comfort level even if the lower end of the range is silly.


Lastly, the Chicago Purchasing Manager’s survey (tracks Chicago-area manufacturing) came in much stronger than expected, jumping to 57.9 in August from 50.8 in July – a reading above 50 marks expansion and a reading approaching 60 borders on robust.


The sub-indices within the survey were extremely encouraging. The production index jumped to 63.4 from 49.2 in July. New orders rose to 60.2 from 53.5 last month. The order backlog reading rocketed to 63.0 from 45.7.

While these are all very good readings, we’ll need the national reading to confirm this strong rebound before getting too excited – and we’ll get that with the ISM report this morning. Stronger auto production of late likely helped to push this figure higher and since auto sales are relatively weak…well, that’s where the caution comes in. Overall, though the manufacturing sector has remained largely upbeat despite housing’s woes -- and the heretofore drag from the auto sector -- and this reading does offer optimism that the sector will remain in expansion mode. That order backlog reading is also very encouraging.

The prices paid index pulled back, falling to 80.6 from 90.7 in July, but remains very elevated.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks rallied, pushing the broad market higher for the third-straight day, after the Commerce Department reported second-quarter GDP was revised significantly higher. This followed a durable goods orders report, the first look at this segment of the economy for the current quarter, that offered a reasonable indication the business side of the economy will offset potential consumer weakness as inflation has put a halt to real income growth.

The caveat is that after three days of stock-market gains, we have a pretty good idea of what’s to follow in this market. We’re in a trading range, as we’ve explained for some time now; there is no reason to ignore it. A multitude of uncertainties reign down and will affect the market for a while still. These range from questions over the duration of the housing market; to inflation, and thus what Fed policy will look like if this trend does not abate; to across-the-board tax rate uncertainty, weighing heavily on investor sentiment; and geopolitical risks, which will be with us for a long time.

But these situations present opportunities. There are a number of sectors that currently trade at attractive valuations – in addition both large and mid-cap indices will trade at very low levels once the financial sector flattens out --, and thus present strong multi-year return potential. However, we should all be prepared for continued sideways trading and possibly further declines. Patience will eventually pay off though.

Market Activity for August 28, 2008
Back to yesterday’s activity, nine of the 10 major industry groups gained ground; energy shares were the only loser. Financials, industrials, consumer discretionary and basic materials lead the way – health-care and information technology shares also posted nice increases.

Crude-oil prices fell $2.42, or 2.05%, to close at $115.73 yesterday even as TS Gustav (soon to be a hurricane, but now only expected to make it to category 2) appears on track to hit Gulf of Mexico energy infrastructure. One reason for the decline was a statement out of the IEA (International Energy Agency) that they would supply strategic stockpiles if needed. This would include the release of stockpiles from European gasoline supplies. The downgrade to cat. 2 also helped a great deal.

On the economic front, GDP was revised much higher, showing the economy grew at a 3.3% real annualized rate – the initial estimate had the figure at 1.9%. We’ll get another revision to the number next month, but it shouldn’t change much from here as all data for the quarter is in by this point.

The components that led to the higher revision were personal consumption, net exports and the change in inventories.

• Personal consumption was revised to show a 1.24 percentage-point contribution to real growth from 1.08 initially.
  
• The change in inventories subtracted less-than-initially estimated taking 1.44 percentage-points from growth vs. the 1.92 percentage-point drag initially.
  
• Net exports exploded, offsetting the drag from inventories, adding 3.10 percentage-points vs. the 2.42 contribution estimated last month
  

Residential fixed investment (housing) was unchanged. This component subtracted 0.62 percentage-point and the main point here is that this is half the average drag of the past nine quarters when the segment was subtracting more than a full percentage point.

Many continue to say current quarter growth will be a payback period for this much stronger-than-expected reading – meaning third-quarter GDP will be very weak if not negative. They cite the fact that the end of rebate checks will cause the personal consumption component to ease. While this may be true, not so much because the ridiculous rebate check scheme comes to a close but simply because income growth has not outpaced the jump in inflation of late (real income growth is flat as both year-over-year income and inflation have risen at roughly the same rate). Thankfully, strong productivity improvements have held back consumer-level inflation more than otherwise would be the case as import, producer and intermediate goods prices soar.

What those predicting a weak Q3 GDP reading may be missing is strong business spending trends and the likelihood this will offset the weakness on the consumer side. Further, even though the drag from inventories was less than first expected in the second quarter, it still posted a large weight on GDP. As business sales continue to rise and inventory-to-sales ratios sit at record low levels, an inventory boost should also help to keep third-quarter GDP somewhat upbeat.

Real year-over-year GDP has increased 2.2% even as residential construction has declined 22.2% -- this illustrates the breadth and dynamism of the U.S. economy.

I’ll note that real final sales (GDP minus inventories) jumped 4.8% last quarter, which followed a 3.9% reading in the first quarter. This final sales figure will ease over the next couple of quarters as inventories rise, and this production will push the headline GDP figure higher.

In a separate report the Labor Department reported that initial jobless claims fell 10,000 to 425,000 in the week ended August 23. This number remains elevated and it’s not good that it remains above the 400k level, but we are seeing some signs that the effect of the government’s program to extend unemployment benefits is waning.

The four-week average for jobless claims did tick down ever so slightly and I think there’s a good chance we’ll see a mild trend lower over the next few weeks. Thirteen states and territories reported an increase in jobless claims, while 40 showed a decrease.

Unfortunately, continuing claims (those on the dole for longer than one week) will remain elevated for a while as the government’s assistance program extended the time (normally 26 weeks) one can collect the hand out.

I’ll leave you today with graphs of real (inflation-adjusted) GDP and after-tax income per capita of the past quarter century.

The charts below are quite enlarged but it was necessary in order to read the percentage increase figures.

Disposable (after-tax) income on an inflation-adjusted basis up 3.0% per year since 1981 – that is huge and explains the level of prosperity we enjoy today.

Have a great weekend and holiday!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks rose yesterday after durable goods orders unexpectedly rose in July and concerns over Fannie Mae and Freddie Mac waned for a second day – for now at least, who knows when the next article comes out that causes investors to concentrate more on hypotheticals than current realities and thus swing perceptions back in the other direction.

The durable goods news, which we’ll touch on below, was great to see and may be illustrating – as we’ve mentioned for a couple of months now – that the business side of things will help to offset future weakness that may arise on the consumer side as real (inflation adjusted) income growth has flattened of late and housing prices continue to decline.

All but one of the 10 major industry groups gained ground yesterday – health-care was the laggard. Financial, energy, basic material and information technology shares led the way.

Market Activity for August 27, 2008
The U.S. Federal Deposit Insurance Corporation (FDIC) stated a couple of days back that its “problem list” of banks increased 30% in the second quarter – the figure rose from 90 to 117, marking the highest level since mid-2003. “Problem” institutions are those under closer regulatory scrutiny, meaning their capital cushions are weak.

The media has jumped all over this, but it is hardly an issue at this point – it’s not like we’re talking about the highest level in 20 year, far from it. And think about it, do you even recall hearing about the FDIC “problem list” in 2003? I don’t, which shows this is a relatively low level. In terms of actual failures this year, the figure sits at nine. There will be more to come, but we shouldn’t get carried away.

What this does illustrates is that strong bank earnings may not return anytime soon – it had been expected banking-sector profits would rebound in the fourth quarter; the return of much better results won’t be seen until next year.

But back to actual failures, for now these are being reported over weekends. When bank failures begin to get reported on Tuesdays and Wednesdays, that’s when you’ll know the FDIC pipeline is filling up. It’s been reported that to this point 99% of banks and thrifts remain “well-capitalized.”

On the economic front, the Commerce Department reported durable goods orders unexpectedly rose in July as overall orders increased 1.3%. The ex-transportation figure rose 0.7%. The expectation was for overall orders to come in unchanged from June and ex-trans to decline 0.7%.

These are very healthy increases especially considering orders have trended higher for three months now – total orders are up 11.3% at an annual rate since April and ex-trans up 11% annualized for the same period.

The component that we watch most closely is non-defense capital goods, ex-aircraft (a proxy for business capital spending). The figure jumped 2.6% in July and is up 14.4% at an annualized rate over the last three months – so the nice bounce we’ve seen in business spending continues. This reading is being helped by the increased current-year write-off allowance and bonus depreciation schedule that President Bush demanded to be added to the government’s “stimulus” package back in May – these policy decisions provide meaningful incentives.

Capital spending will help to keep GDP positive this quarter as other components may weigh on growth. The trend in capital goods orders is encouraging -- the segment continues to be driven by industrial machinery orders.

Shipments have outpaced inventories for two months now, pushing the I-S (inventory-to-shipments) ratio lower, which is a good sign for future orders growth. That said we should expect to see durable orders decline when the August number is released simply because of the strength over the past three months – a respite over the next month or two would be quite natural as orders for these big ticket items can fluctuate wildly. The media would use it to spread their proclivity toward hyperbole and typical gloom and doom prose, but we should all be conditioned for this by now.

More economists are coming around to the notion that the credit-market troubles are not having an adverse effect on capital expenditures – this is why we’ve spent several letters over the past few months explaining that corporate cash levels are at or near an all-time high; firms have the resources to engage in projects and large equipment purchases without necessarily borrowing to do it. This is the power of the double-digit profit growth that took Q3 2002 through Q2 2007 – that period of 10%-plus earnings increases marked a post-WWII record and we continue to see feel the benefits today.

This morning we get the first revision to second-quarter GDP, which will be revised higher. Back in July we estimated that GDP would post 2.5%-3.0% real growth at an annual rate, which looked pretty much off the mark when the number came out at 1.9%. This revision should show that estimate was pretty close after all as the figure is expected to be revised up to show 2.7% real growth. A narrower trade gap, stronger-than-initially estimated business spending and better-than-expected inventory data will be the reasons for the upward revision.

The latest durable goods orders figure has also led to higher third-quarter GDP estimates.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ended mixed on Tuesday as the Dow and S&P 500 closed a bit higher, while the NASDAQ failed to gain ground as information technology shares struggled.

Analysts’ comments on Fannie Mae and Freddie Mac – explaining that the two GSEs have enough capital to withstand losses through the end of the year and still keep a capital cushion above their requirement – helped financials shares gain ground. Energy shares also helped the broad market close higher as oil prices rose for a third-straight session as what is now Tropical Storm Gustav is on a projected path to threaten the Gulf.

Market Activity for August 26, 2008
All in all, seven of the 10 major industry groups closed yesterday’s session higher. Consumer staples, information technology and telecom shares were the losers.

The dollar has staged a very welcome rally of late as it has become evident the super-strong euro made zero sense considering the Eurozone economy has weakened considerably. This may force the European Central Bank to lower interest rates – they had been increasing rates even in the face of weakness as unions (which are much more powerful in Europe than here in the U.S.) force wages higher. The liklihood that the interest rate differential between the EU and U.S. will move in our favor has been one reason for dollar strength.


Oil prices have also moved substantially lower, as everyone knows – falling 20% from the all-time high hit on July 3. This trend is in jeopardy though as Gustav tracks toward Gulf of Mexico energy infrastructure. Evacuations of oil and natural gas production facilities are scheduled to begin as early as today.

In addition, Russia continues their disruptive behavior (which appears to be the correct term for now, their actions could escalate into something worse if not confronted) as they see how far they can push things. Their immediate objective: Gain control of the Tbilisi pipeline – the only Caspian-region oil flow to Western Europe that they do not have control over – and determining the future political environment of Eastern Europe. NATO needs to step up; this is their backyard; this is their reason for existence. Problem is European militaries have been so degraded that the Euros seem to have neither the will nor the ability to commit troops.

So we’ll see we’re these issues take the price of oil. For now, let’s hope Gustav misses major oil infrastructure – good news is the industry caps rigs very effectively these days and can get up and running again very quickly.

On the economic front yesterday housing data dominated.

First, we had the release of the S&P Case/Shiller Home Price Index and its tracking of 20 major cities showed prices declined 15.92% from the year-ago period. That’s quite a large drop and much worse than the National Association of Realtors, Commerce Department and OFHEO surveys have shown.

We’ll note that this survey’s reading (Case/Shiller) has been dragged lower by six cities – L.A., San Diego, Las Vegas, Miami, San Francisco and Phoenix – all down at least 25% year-over-year. These were the areas that exhibited the largest price spikes over the previous three years. As a result of its narrow reach, this survey does not show the true picture for home values across the nation as the aforementioned areas were where the most speculation took place.

On the bright side, the survey does show that price declines are waning from a three-month annualized perspective, decelerating to a decline of 10.05% vs. price declines of 15.87% in May, which followed a 21.73% hit in April and 24.98% in March.

Shortly after the release of Case/Shiller, we received the OFHEO Home Price Index. (OFHEO stands for Office of Federal Housing Enterprise Oversight and is a much broader-based survey. This survey’s main fault is that higher-end homes are not included, yet it does offer a better look at the housing situation from a national perspective.)

The OFHEO survey showed prices fell 5% from the year-ago period, coming in flat for June (meaning zero change) relative to the May figure.

Lastly, the Commerce Department reported that their new home sales report showed prices declined 6.3% from the year-ago period.

So we put the existing home sales data (which we touched on yesterday), the new home data and the OFHEO survey together and it shows home prices are down 6.1% on average over the past 12 months. This is quite different from the degree to which Case/Shiller is showing values declined and I think closer to the truth from a national perspective.


In terms of new home sales, they rose 2.4% in July, halting a two-month decline, to 515,000 at an annual rate -- new home sales have declined during 12 of the past 15 months. Lower prices may be starting to work, but I’m not convinced we’ve stabilized just yet – more data will be needed to confirm this.


The best news within the report was that the supply of new homes on the market fell a meaningful 5.2% to 10.1 months’ worth of supply at the current sales pace (as the chart below illustrates). While this level of stockpiles remains very elevated the trend is moving in the correct direction at least -- off from 11.2 months’ worth in March.


Important: The number of unsold new homes on the market has declined for 15-straight months. The problem is when the figure is matched against the sales rate (which is that 10.1 months’ worth of supply number mentioned above) supply remains very elevated. However, when sales do bounce that months’ worth of inventory figure should drop very quickly.

We need to see the above chart get to nine months worth before we get too excited and then work its way down to six months’ worth before home construction will begin to add to GDP again – this whole process will likely take another year to play out and we can’t rule out two-full years before this occurs. In any event, it will be a very nice plus when housing merely flattens out; at which point it will no longer subtract from GDP and this will be a substantial positive.

Have a great day!


Brent Vondera, Senior Analyst

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