Daily Insight

U.S. stocks closed lower Wednesday as the credit markets remained disturbingly locked up, but the major indices recovered from the session’s lows as confidence grew the Senate would pass a “rescue plan” bill that may kick the House into gear to do the same.

Six of the 10 major industry groups lost ground yesterday -- industrial, basic material and information technology shares were hit the hardest. Financials, consumer staples, utilities and telecom shares were the gainers. The 2.15% gain among financial stocks is what held things up. Shares of Bank of America (up 8%), JP Morgan (up 6%) and Citigroup (up 12%) accounted for 68 Dow points – without the jump in these three members the index may have been down triple-digits.


Market Activity for October 1, 2008
And the Senate did pass a bill that has the TARP plan as its primary focus last night by a decisive margin of 74-25. Of course, the bill includes things that have nothing to do with the situation at hand, but that is Washington. However, it does include the extension of certain tax breaks and credits, an AMT patch, an increase in FDIC insurance to $250,000 and reiterates the authority the SEC has to suspend asset-valuing rules (mark-to-market accounting) that has exacerbated the problem to one that was manageable to one that has become a never-ending loop.

Now this moves to the House and I think the AMT patch is probably the component that gives the bill the best shot of passing – no one is going to want to vote against that. We’ll be watching to see what Congressman Shadegg says today, because he’s a very important member of the House and brings many along with him.

We’ll also point out that there’s a shot that this plan will work faster – and when I mean faster we’re talking about getting these assets sold off and resulting in a relatively quick return to the taxpayer (the Treasury Department). There will be an auction process (something the government is quite good at) that will set a price for these assets and once the Treasury take control and a price, or market, has been set we may find firms flow in to buy up these assets as they see the longer they wait the higher the price to acquire them. This would mean less money is made by the Treasury, or it may result in a loss, but it gets the program completed in short order and the cost won’t be anything close to the $700 billion everyone is focused upon. (I do not want anyone to think this commentary sets an expectation that this will occur, I just bring it up as a decent possibility. Further, if the House does pass this thing on Friday, the credit markets will not ease overnight. This will take some time, but the first step is necessary to take right now.)

From there we must concentrate on what got us here, starting with monetary policy mistakes and the Keynesian models that drive the FOMC, causing the Fed to lower fed funds to 1.00% in June 2003 even as the economy began to boom. (One can simply go the Federal Reserve website and read their minutes, they saw the economy rebounding, but simply because employment didn’t begin to bounce back by that point – as if this occurs on a dime anyway – they eased further.) It is these low rates – kept at 2.00% or below for three full years – that encouraged much of what we are now working to correct.

In addition, failure to pass more appropriate regulations on mortgage GSEs Fannie Mae and Freddie Mac certainly didn’t help. This was tried, but it was blocked. And as we’ve discussed many times the Community Reinvestment Act, specifically changes that took place in the mid-1990s – referring to subprime lending and hostile/politically fueled use of the term “redlining” --, has also contributed. Rounding it out are accounting rules that have only done harm. All of these things must eventually be addressed; a move in a different direction – as some are suggesting -- will only lead to more unintended consequences down the road.

Yesterday’s Data

On the economic front, the ADP employment report fell 8,000 for September – this is a preliminary number the market looks to for a sense of what will occur within the Labor Department’s monthly job report. This reading was much smaller than expected as a figure of minus 50,000 was the estimate.

ADP noted that the report does not include the Boeing strike (37,000 machinists) or the effects from Hurricanes Gustav and Ike. Then again, the Labor Department’s strike report showed zero workers for September so Friday’s jobs report won’t reflect that either – the September revision or the October data will reflect this. Surely, the Labor Department’s data will reflect the effect of the Hurricane’s.

Overall though, the ADP readings have not been a good indication over the past couple of years and I wouldn’t be surprised to see the figure dropped as something the market looks to as an indicator Specifically over the labor market contraction of the past nine months, the ADP readings have averaged a gain of 2,000 jobs per month, while the Labor Department’s figure has that monthly average at minus 75,000. Not a very good indication to say the least.

In a separate report, the ISM (Institute for Supply Management) Manufacturing Index fell to 43.5 – a level that reflects significant weakness. This reading marked the lowest level for ISM manufacturing since October 2001.

Heretofore, the manufacturing sector has held up remarkably well considering the double whammy of housing and auto-sector weakness. But it appears that business spending weakness in September has taken away much of the offset to those well-known areas of contraction. (While I was expecting a better ISM reading, we did point to the weakness in business spending in yesterday’s letter that has occurred suddenly. Part of this is due to the direct effects of the credit market trouble with regard to small businesses and the indirect effect regarding large businesses as the situation has increased their level of caution.)

Overall, I believe this can be transitory event as there is decent likelihood businesses are taking a wait and see approach right now. If the credit markets are freed up in quick order, the manufacturing sector will bounce back to something close to or mildly in expansion territory. If not, we will likely see this sector endure several months of meaningful weakness.


Below is a look at some of the sub-indices within the report:

Production was affected by weak metals, machinery and electrical equipment orders, segments that had shown strength over the previous few months. Still, the degree to which production declined is puzzling considering the strength in the Chicago PMI (factory activity in that region).


New orders were down big. Again, I believe this could prove transitory, but depends on the credit markets, and hence the TARP bill passage or elimination of mark-to-market death spiral.


Export orders remained in expansion mode even with European economic weakness of late.

The prices paid index fell substantially, which is quite different from other manufacturing reports and general inflation gauges. The drop in ISM prices paid was due to a 41% plunge in scrap steel prices in the past month.


Lastly, the Commerce Department reported that construction spending came in flat for August – beating the expected 0.5% decline. Although, the July figure was revised lower to show twice the weakness as initially estimated so the two-month look isn’t a good one.

Private residential construction outlays have fallen 27% on a three-month annualized basis – faster than the 15% decline in the second quarter – so housing will again place a significant drag on Q3 GDP. You may be saying, “no kidding,” as if this wasn’t known. I bring this up because housing’s drag on last quarter’s GDP was only half what we’ve seen over the past couple of years, which gave some hope that a flattening out may take place soon. The housing data of late is showing this is a misguided hope.

Now private non-residential spending has shown weakness of late after providing a nice offset to the residential side of things for many months – that offset is over in my opinion. Construction spending is going to remain weak for some time – outside of a catalyst to boost the economy.

In addition to all of this credit-market stuff, and the government proposals to unclog the capital distribution channels, we need to seriously consider a broad look at tax rates. Eliminating or vastly reducing the repatriated tax and lowering the corporate income tax (not to mention cap gain, dividends and labor income rates) can reverse this course and lead us out of the current funk. I realize this may be unrealistic in the current political climate, I’m just stating these actions would provide a big boost to economic growth, the stock market and capital formation – which eventually flows through to construction activity.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks rebounded yesterday – recovering roughly 60% of the prior session’s losses -- as expectations increased that Congress will find the votes to pass the rescue package, there was actual talk of modifying mark-to-market accounting rules and the FDIC is looking to temporarily boost deposit insurance and thus confidence.

Naturally, financial stocks led the gains, jumping 13.09% as measured by the S&P 500 index that tracks these shares. Energy, information technology and industrial shares accounted for the other stellar performers – energy shares jumped 5.80%, tech was up 5.40% and industrials gained 4.23%.

Market Activity for September 30, 2008

The third quarter came to an end yesterday and one may think the declines endured by the benchmark indices were the worst in quite a while, but they weren’t as the past year has been a rough one coming off of the all-time high hit last October.

The Dow Industrials Average lost 4.4% during the July-September period, marking the fourth-straight quarter of decline. The S&P 500 declined 8.88%, which followed a 3.23% drop in the second and a 9.92% plunge in the first quarter of 2008. The NASDAQ Composite fell 8.77%, but little more than half of the first quarter loss.

Among the major domestic benchmarks, the Russell 2000 (small cap stocks) held up very well, falling just 1.46%. The S&P 400 (mid cap stocks) got dinged for 11.20%.

The main international index was thoroughly hammered – down 21.05% during the Q3.

Senate Minority Leader McConnell offered some very encouraging words yesterday, stating they intend to pass legislation – speaking of TARP – and will pass it on a bipartisan basis. At least the Senate has heard Monday’s market message.

We even heard rambling of at least modifying accounting standards away from the pure mark-to-market basis that has proven so pernicious – although one shouldn’t count on this even if it makes as much sense as anything proposed thus far.

Further, FDIC Chairman Sheila Bair, by far the most accomplished player in all of this, announced she is seeking authority to temporarily increase the insurance limit from $100,000 in order to increase confidence. This is important not just for individuals but for small businesses that hold accounts for payroll purposes.

Now we seem to be getting somewhere.

Short-term Economic Outlook

Despite this encouraging news, one has become conditioned to refrain from excitement. You really have to ignore a few years of actions to have any confidence in this group – speaking of Congress – and every day that goes by without the passage of TARP, or some alternative that would be as effective, is another day the credit distribution channels remain blocked.

It is amazing how quickly things have changed. What looked like a 2.0% real GDP third quarter just three weeks back now may turn out to be flat. Credit is in the process of drying up for many small businesses and the costs have risen for those that still have access. For the consumer, those with a top-tier credit score have zero problem receiving a loan, but for anyone else it will become more difficult by the week.

Business sales continue to perform well, but I’ll be very interested to see the August reading, which likely took a substantial hit. And this entire development has caused businesses large and small to become even more cautious – business-capital spending, which was rebounding in strong fashion, looks now to have ceased.

We should not forget that Hurricanes Gustav and Ike will have caused their own damage as Gulf of Mexico energy production was shut down for a couple of weeks, among other things.

All is not terrible. The manufacturing sector remains amazingly upbeat, productivity improvements remain stronger than anytime in history, and personal income growth continues along a healthy pace even if persistent inflation has caused real incomes to flatten out. But we must do something to unlock the credit markets, which are very blocked, and change insane accounting rules that force the financial services industry to endure a death spiral that has forced the hoarding of cash.

Yesterday’s Data

On the economic front, the S&P Case/Shiller Home Price Index showed that home-price declines accelerated in July as the 20-city composite showed a 16.35% drop from the year-ago period. The relative good news is on a three-month annualized basis the declines did ease from 10.03% in June to 8.56% in this latest report.

However, this index has a large lag to it – we are talking about July data here – and from what we’ve seen with the new and existing homes sales figures for August we wouldn’t expect any positive trends to continue in the short term.

As we point out each month, this index does exacerbate the declines as it does not give a very broad look. Yes, it does cover the largest 20 metro areas but there’s a lot that is missed. Further, nine of the cities covered have witnessed the largest prices declines in the nation and that is greatly affecting the overall reading. For instance, Detroit, Tampa, LA, San Diego, San Fran, Phoenix, Washington DC and Miami have posted price declines of between 16% and 30%. In fact, LA and San Fran, which make up 23% of the composite, have registered home price declines of 25% over the past year.

When we average all of the home price data – which covers four main indices including the Case/Shiller -- we see home prices have dropped roughly 8% from over the past year.

In a separate report, the Chicago Purchasing Manager Index (PMI) registered a reading that remained upbeat in September as the survey came in at 56.7 -- a number above 50 illustrates expansion. This is a good sign as the Chicago region represents the largest manufacturing base. We’ll get the national look at the factory sector tomorrow as the ISM report is released. Since Chicago posted a healthy reading it should assure that ISM remains right around the 50 level.

In terms of the internals (the sub-indices of the report), they looked good and point to continued expansion – although with what has occurred in the credit markets doubt has increased.

The production index jumped to 71.4 from 63.4.


New orders fell to 53.9 from 60.2, yet remained in expansion mode.


Order backlogs slipped to 54.9 from 63.0, but again remains nicely in expansion mode.


Unfortunately, the prices paid index remains elevated, which corroborates what various other inflation gauges have shown.


This morning we get the ISM Manufacturing survey for September (the national look at the factory sector) and August construction spending. It is likely ISM held up reasonable well, but the construction number will post a weak reading.

After today, we’ll be looking to Friday, as the September jobs report is released. We’ve endured eight months of declines, but the job losses have been mild relative to the typical period of labor-market weakness.

The concern though is this credit situation. Small businesses (the engine of job creation) have likely been the hardest hit by this reality and this may cause job losses to deteriorate over the next few months. Anyone that thinks the TARP plan is nothing but a life-line to Wall Street is unfortunately unaware of the flow-through effect. If an effective plan is not put in place the employment numbers will get worse, and I believe more people got a sense of this after the stock market sent its message on Monday.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

Rejected!

U.S. stocks plunged yesterday – marking the steepest one-day decline in the S&P 500 since the 1987 crash – after the House rejected the $700 billion plan to unlock the credit markets and keep this situation from becoming an all-out seize up of the financial system. The NYSE Composite Index lost twice that amount yesterday -- $1.5 trillion.

Many wondered what would occur if this bill were blocked, and we’re finding out the market didn’t like that decision very much. We got a sense of this after allowing Lehman Brothers to go down; we now know it would have been better to put them into Conservatorship as well. The day Lehman went down is when the credit markets locked up, and led to AIG’s demise. Fact is the entire financial system is intensely interconnected due to the $60 trillion in derivative contracts. Mark-to-market accounting exacerbates the situation as troubled assets are written down further as these derivatives fall in value – hence the cash hoarding by financial institutions.

While the stock market gets all of the attention, and days such as yesterday are certainly unpleasant events, a decline of this magnitude is not significant over a longer-term perspective – besides this is what markets do on occasion. What is occurring in the credit markets is the main issue at hand; besides, until the credit markets normalize the stock market cannot stage a sustained upswing. The bill to take troubled assets from balance sheets, replace them with capital and sell these assets off in an orderly way is pretty vital to the financial system right now. I assume the members of Congress are getting this message as we speak. I assume all of those calls demanding not to support this bill have reversed course after yesterday’s market message.

Market Activity for September 29, 2008

And allow me to stop for a moment just to put these types of down days in perspective. While I say this is more about the credit markets than the stocks market, the latter is the one that gets the attention and has the most affect on individuals as 60% of the country owns a 401(k) account. Not that it may register very well on a day like yesterday, but we find it appropriate – after a one-day decline of 8.8% -- to illustrate what a one-day shellacking that is nearly three times worse (the 1987 crash) looks like from a long-term perspective.

Below is a 25-year look at how diminished a 20% crash becomes over time. (As an aside, nice double-top there by the way. This is what occurs when stocks go gangbusters as they did in the latter-half of the 1990s, it takes a while to revert to the mean. But over the past several years after-tax corporate profits have significantly outpaced the increase in share prices – up 109% for profits vs. 40% for stocks -- and this sets up for a strong multi-year run.)


And if 25 years is too long for some, here is what the same decline looks like over a 10-year period – the 138% rise over this period does minimize what was a chaotic day back in 1987.


Back to the bill though, it is unacceptable that Congressional leaders on both sides do not have the clout or ability to persuade lawmakers. Of course, the market has taken over as the lead negotiator.

One-hundred and thirty-three Republicans voted against the measure and 95 Democrats shot it down as the bill was blocked 228-204. One has to assume that the TARP is dead, you never know, but that’s what I’m assuming. To get more Rs to g for it, you’ll lose Ds. To get more Ds you’ll lose Rs.

I wouldn’t be surprised to see the Democrats come back on Thursday and pass their version of the bill. Of course this will include another Keynesian-style rebate check scheme, cramdown (allowing bankruptcy court judges to determine loan interest rates) and demanding union members be included on the boards of firms that participate in TARP – these are the things they tried to push into the bill last week. That’s a no go. And for the Republicans, they want to set up some insurance fund for these troubled assets, which I believe would be ineffective for the current situation.

On the bright side, maybe it was saddled with too many restrictions that may have been met with limited participation and we’ll get something better as result. I will state though we didn’t see much good that could come from dragging this bill out – not with these people around, and now we see how the game-playing certainly did not help things.

Moving to the credit markets, the Federal Reserve announced a large increase in its size of the 84-day TAF (Term Auction Facility, or one of the Fed’s tools to inject liquidity that we would prefer over jacking fed funds lower) to $75 billion from $25 billion. This increase will raise the supply of 84-day TAF to $225 billion from $75 billion. Total TAF credit (both 28-day and 84-day) will be increased to $300 billion from $150 billion.

The chart below is one indication that banks are hoarding cash and thus effects credit availability.


The yield on the three-month T-bill hit 35 basis points (one-third of one-percent) yesterday; nothing else explains more clear the level of fear – the massive move to the safety of the Treasury market has been stunning. In fact, the 10-year Treasury note yields just 3.63%. Too bad Congress failed to pass TARP. They could have borrowed the funds needed at sub-4% and over time paid back the Treasury at least what it cost. And this doesn’t even take into account the cashflows that run off of these assets.

Enough of that though; we must get serious. Didn’t like the $700 billion TARP, hey? Ok, here’s the solution. The president needs to come out and say we are moving forward by eliminating the mark-to-market accounting rules that were implemented in November 2007. The new standard will be to a net present value basis that discounts the cashflows of these assets. Or, at the least a five-year rolling mark-to-market – as some have suggested. Hand the SEC Chairman a pen and tell him to sign it. Done.

At the same time eliminate the repatriated tax (the 35% tax levied on foreign income made by domestic institutions when this capital is brought back into the U.S.). It’s an economically inane law anyway. This will bring an enormous level of capital bank into the country. Further, if needed, eliminate the capital gains tax on assets that currently find no bids, such as these CDOs that are clogging the system – this is an idea we raised six months back.

The elimination of mark-to-market (FASB rule 157) does not depend on Congress. This will buy time, as it’s a game changer, for banks while Congress fights it out over the repatriated tax and capital gains tax on troubled assets.

Moving along to yesterday’s economic data

On the economic, the Commerce Department reported personal income rose 0.5% last month and spending was unchanged. The personal consumption expenditures (PCE) index -- the inflation gauge tied to the personal spending report -- showed inflation remains sticky even with energy’s huge move lower. For those readers that understand inflation is a monetary phenomenon you’re surely not surprised.

Let’s look at this data one by one:

The 0.5% rise in personal income last month is a good reading as it was propelled by wage and salary income – a very nice thing to see. Rental income, dividend income and interest income also posted healthy results. Proprietor’s income showed a 0.8% decline last month and this corresponds with what has been hurting the jobs figures of late – after several years of big gains in self-employment we’re seeing the persistence of the housing downturn take it toll on this segment.

From a year-over-year perspective, incomes are holding up much better than we had anticipated. They are being harmed by current levels of inflation, but with the labor market weakness – even though the monthly job losses are relatively mild as we keep discussing – these figures are quite remarkable. Total compensation is up 4.1%, wages and salaries are up 4.2%, dividend income has grown 8.1%. Personal income as a whole is up 4.6% and disposable income (after-tax income) is up 4.8% since August 2007.

On spending, it came in unchanged for August after rising 0.2% in July. The level of real personal consumption (referring to the segment of consumer activity that shows up in GDP) stands 2.7% below the average for last quarter. As we’ve mentioned a couple of times now, consumer activity will remain weak for a couple of quarters and this data backs that up. A decline in employment and lower asset prices are just too much and are affecting the consumer.

On the inflation gauge, again the PCE index, this corroborates what other inflation indicators have suggested – inflation remains sticky and has at least become partially embedded.

The PCE rose 0.2% in August, and from the year-ago period barely budged, coming in at 4.5% after a 4.6% reading for July. The core rate, which excludes food and energy, actually accelerated to 2.6% from 2.5% in July.

The Fed has based their inflation expectations on two things – both are flawed Keynesian models.

One, their Phillips Curve-type analysis tells them that simply because the unemployment rate has risen that inflation must come down. This is not a tautology just as the view that inflation must rise simply because the unemployment rate dropped to a certain level is not a given.

Two, they bet that the price gauges would decline along with energy prices. This has not occurred either. Money supply – whether we look at MZM (money zero maturity) or M2 (which includes bank demand deposits) is growing much faster than output, or nominal GDP. This is inflationary. Now, the growth in these money supply measures have eased over the past three months, but one cannot expect this to effect inflation on a dime. Hopefully it will help to ease price pressures a few months out.

For now, the Fed obviously has other issues and providing liquidity to mostly frozen credit markets is their chief priority currently.

This morning we get the latest manufacturing survey from the Chicago region and the S&P Case-Shiller Home Price index.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ended mixed on Friday as the S&P 500 gained some ground, yet the NASDAQ Composite failed to close on the plus side as shares of RIMM, Apple and Google weighed on the index. The Dow Industrials jumped 121 points as shares of Bank of America and JP Morgan – well-run institutions that have been able to buy assets on the cheap – propelled the move. Those two stocks accounted for nearly half of the Dow’s advance.

Well, what we’ve all been waiting on – passage of TARP – appears ready for a vote today and we should get the plan signed over the next couple of days. The equity markets don’t seem to be interested in applauding the development though as index futures are down big this morning.

The stock market has been very patient as Washington plays politics with this plan. The fact that this plan is focused to deal with some very serious stuff – credit markets that are very clogged up and threaten to do serious economic harm – it’s too bad we have this game playing. Maybe this is what stocks are finally sending a signal over. Maybe the weakness is simply a result of quarter-end window dressing by mutual-fund managers to give the appearance they were heavy cash in this weak market, or to reduce their positions in what was hot, and certainly now is not – energy and commodities. Maybe it’s over the Wachovia development. I don’t know. What we do know is the market is going to open down according to futures.

Market Activity for September 26, 2008

What I really love though is how McCain and Obama are acting as though they bolted over to the Capitol to save this whole situation and forced Congress to pass a better bill. That’s a joke.

Then we have Speaker Pelosi and Congressman Frank. Listening to their comments yesterday was also entertaining, although sad, as they don’t seem to really get the magnitude of the situation. Apparently, they chose to play up for the election and blame this entire event on de-regulation. We’ll point out that the two industries that have been hardest hit by this mess – housing and financial services – are among the most regulated industries out there.

Want to place blame? It is about time we begin to focus at the origin of this situation – Federal Reserve monetary policy mistakes – and that which has exacerbated the problem – FASB Rule 157, “mark-to-market” accounting. You can also add on bad legislation such as the Community Reinvestment Act and Congress hauling banking executives up to Capitol Hill in the 1990s to all but call them bigots for not providing loans to lower income/poor credit score individuals. Now these same politicians castigate the financial industry for doing just that – hence much of the sub-prime problem.

In terms of the proposal, it increased from the four pages that Treasury Secretary Paulson laid out 11 days ago to 110 pages by Saturday night, which is why we’ve been arguing for some speed here as time only gives Washington time to stuff the bill with a bevy of social programs. I will say though it could have been much worse. The executive compensation provisions for those participating in the plan are not austere and House Republicans forced the elimination of a provision to devote 20% profits from the plan to an affordable housing fund. This means ACORN would get that money – and those familiar with this group will understand the importance of this elimination.

Public Angst over the Proposal

We keep hearing how the public is so against this plan. Well, of course they are as it has been presented in exactly the wrong way. When Paulson and Bernanke use terms like “bailout” and figures as large as $700 billion it’s no surprise taxpayers grab their wallet to make sure it’s still there. But this is not a bailout. It is an investment in assets that have a higher intrinsic value than the currently distressed market for these securities is valuing. In fact, there really isn’t a market for much of this stuff anyway, which is why a plan to remove these assets from balance sheets will help to unfreeze the credit markets.

For now, anyone with a 750-plus credit score can access credit in a heartbeat. You want to finance a care purchase? Done. And the cost of money is close to zero. Want to buy a house? No, problem. But the risk is if the credit market remains this clogged – banks continue to hoard cash for fear additional write-downs will affect their capital adequacy ratios – even these top–tier borrowers may be affected. And more importantly, there are many small businesses out there that use credit lines to meet payroll, or buy inventory. These credit lines are in jeopardy of being squeezed and of this credit situation persists, even those who have managed their lives responsibly will be harmed. These are some things that should have been explained.

Further, the entire $700 billion may not even be necessary, as maybe $350 billion is enough to stabilize the market. And even if it takes the entire $700 billion, over the next 5-7 years the Treasury will likely net money off of this deal.

Moving on

On the economic front, the Commerce Department reported real GDP was revised down to 2.8% at an annual rate in the second quarter from the previous estimate of 3.3%. The reason for the lower revision was because personal consumption and net exports (the two catalysts to Q2 growth) were revised down. Inventories were also a larger drag than the previous estimate showed.

Looking to the current quarter, it was shaping up to give us a 2.0% growth quarter (that’s in real terms at an annual rate). Consumer activity was going to be weak, but business spending had rebounded very nicely and the production needed to rebuild low inventory levels looked able to offset this consumer weakness. However, with what has occurred of late – specifically the credit market bottleneck – business spending has reversed the encouraging trend of the past three months and residential fixed investment (housing), which looked much better in the second quarter, will be another big drag to growth for the July-September period.

It is still too early to call current quarter GDP, but if the credit markets are not unlocked quick, it will be quite negative.

For several quarters now we’ve heard from the financial press that consumer activity has been weak – the consumer is “tapped out” as they love to put it. Well, we’re headed into a period where the press will see what weak consumer activity actually looks like – the press is so clueless – and if the business side (capital spending) doesn’t show the August figures to be just a respite – the third-quarter GDP figure will not be a good one.

We’ve got a lot of challenges facing us – both endogenous (domestic economy) and exogenous (geopolitical risks) – the latter was true before the credit market locked up; the former really was not.

The only way to meet these challenges is through growth. I know tax-cutters/supplysiders are gun-shy right now with all that is going on but they shouldn’t be. Proponents of lower tax rates should invite the argument from all of those that want to blame the current situation on lower rates, those with the facts can crush this flawed belief.

The best way to revive things right now, outside of doing what is necessary to free up the credit system, is by reviving the stock market. The quickest way to accomplish this is to drive the capital gains rate down to 5% and the corporate tax rate to 20%. This will spark a renewed optimism and confidence, two things that are desperately needed right now, and we can avoid a downturn, maybe a deep one, as a result. We have people proposing higher tax rates, this will not boost tax revenues – kind of difficult for tax receipts to rise when the economy is held back by lower after-tax profits and returns. Lower these rates and tax receipts will boom. Investors will unlock investment they have been unwilling to sell due to capital gains confiscation and increased after-tax profit growth will funnel right to jobs, increasing the tax base.

Looking Ahead

Stocks will have to endure a period of intense uncertainty, and some of this uncertainty may result in a negative outcome.

However, the housing market will eventually flatten out and then slowing return to normal. The question over tax policy may be answered over the next month as the election takes place – assuming it is not too close and thus dragged out for a month as we count and recount votes. The TARP plan will help the economy avoid a crisis situation and if the operation of this plan is not damaged by political meddling the Treasury will be able to pay back what it borrows and then some.

As these issues wane, stocks are set to provide very nice returns over the next several years. No, we should not expect 15% annualized returns. Those days are gone, and it is a good thing because those levels are not sustainable and lead to years of weakness as the market regresses to the mean. But we’ve got a really good shot of 10% annualized returns over the next several years once we get the realities that follow years of poor risk management behind us.

We believe there is a strong likelihood industrial and technology shares present some great long-term opportunities – don’t mistake this for a walk from diversification; everyone must remain diversified and participate in each of the major sectors and asset classes, I’m just laying out where the potential looks the brightest.

The financial services sector has led the economy for more than a decade, but as independent broker dealers have either been gobbled up by commercial banks or the market forced this upon them as internal funding via deposit bases is the way of the future, leverage is going to move from 30-to-1 to something closer to 10-to-1. This means less growth for the industry, but a more responsible and sustainable growth. As this occurs, the more traditional forms of growth will once again lead the way and this means industrials and technology.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks swung between gain and loss 22 times yesterday -- but at least didn’t tank in the final hour, ala Tuesday -- as Congress engages in its typical game playing. At times it seemed Paulson and Bernanke were getting through to them, other times it did not. The concern right now though is not really that the plan won’t be approved but that it will become less effective than the originally clean version as everything from executive compensation to offering additional assistance to those that bought more house than they could afford gets added in.


The market has moved to a wait and see mode and Congress better understand that the plan known as TARP needs be finalized by Monday or the reality of the situation will deliver the message in a harsh way. Warren Buffet made a huge bet yesterday (even if the terms of his investment in Goldman Sachs were supreme) that this plan will be implemented soon and one can guarantee he’ll be on the phone explaining the need for speed.

TARP’s original intent was to unclog the credit markets so the situation doesn’t lead to deep and broad implications for the overall economy that will affect even those that manage their lives in a responsible way, not to simply bail out poor decision making – as much of what the majority is attempting to push into this plan seems to think this is about. But this is Congress and it will likely take this give and take to get the deal through. That’s unfortunate because there is a risk to participation in the plan as a result and thus the pricing mechanism for these troubles assets may not work as efficiently.

This entire situation has been exacerbated by accounting standards that make zero sense, but we must first deal with the seized up credit markets and then we can get the accounting back to something that has a glimmer of common sense to it. We’ll also have to finally learn the perils of reckless monetary policy and the flawed Keynesian models that heretofore have driven the Fed’s decision making.

Market Activity for September 24 2008
Credit markets tightened further yesterday as spreads widened to the alarming levels we saw last Thursday that sparked a fire under everyone to implement a strategy that removes troubled assets from the system – the government has the luxury of buying and holding these assets so that something close to a hold-to-maturity value is realized; the banking system does not at this point. Banks continue to bolster balance sheets on concern the TARP proposal won’t happen quickly enough – speed is of the essence; it seems members of Congress have finally realized this.

The charts below show the extent to which the credit markets have tightened.

The first chart, the TED spread, measures the risk-averse nature of the market. A wider spread means the market is running for safety.

The second chart shows one-month LIBOR – LIBOR is the rate that banks in London can borrow from each other. (Important to note, some LIBOR rates are used to set adjustable rate mortgage rates here in the U.S.).

Bottom line, when these indicators shoot up it means the credit markets are not flowing freely – and at these levels that’s an understatement.



The one-week T-bill now yields 12 basis points (or 0.12%), which shows as clearly as anything that cash has run for cover. Return doesn’t matter, so long as you get your dollar back.

Despite the serious nature of this credit-market lock up, stocks have held up very well, and so long as one is properly diversified you can mange the downside. Again, if Congress is going to play around with this, the market will send them a message that will get their attention.

We discussed the TARP (Troubled Asset Relief Program) hearings enough yesterday, but I want to just touch on a comment made by one of the Congressman on Wednesday. He said he has received 200 calls opposing the bailout. (This is not a bailout, this a an attempt to stop a freeze up of the credit markets from reverberating throughout the economy and touching every citizen as a result) He went on to state: if he gathered with his constituents to say the rescue was needed to increase the availability of auto loans, they’d laugh him out of that town-hall meeting.

One could actually feel compassion for a person like this if his ignorance were not so harmful. Um, this is not about making sure some reckless consumer has the credit available to buy that 5 series Bimmer. This is about keeping commercial, mortgage, consumer, and short-term business credit going. If the credit markets are not unclogged, it is not only some foolish consumers desiring to buy something he can’t afford that will be affected. We are talking about stock market savings and home prices. The declines we have seen in these two savings vehicles (the largest savings vehicles) is child’s play if this intervention is not accomplished, which is why it will eventually pass. I’m not trying to alarm anyone, just stating the facts as this letter has always tried to do.

What we have seen late yesterday and into last night is encouraging as it appears things are starting to roll along – I think Congress believed they could drag this process into next week; they are understanding now that that would not be a good choice. The executive compensation limits that Congress is demanding to be added will find compromise and is doable. It doesn’t involve dollar amounts, but removes the “golden parachute ” – common ground is assured on this one. But then there is what’s known as “Cramdown” that some are trying to push into the plan. This grants bankruptcy judges the power to determine interest rates on mortgage loans that are in workout. This is a no go, a terribly bad choice and will not be added in the end.

Back to the normal business of the day

On the economic front, existing home sales fell 2.2% in August to an annual pace of 4.91 million from 5.02 million in July. Home resales were down 10.7% compared to the year ago period.


The median price of an existing home fell 3.4% in August and is down 9.4% over the past 12 months. This is a necessary condition to get sales rolling again. The concern is that the frozen credit markets – and holding up TARP – will cause the availability of credit to decline and cause prices to fall in a disorderly manner.

We’re not talking about those with sketchy credit -- more stringent credit standards should be viewed as a long-term positive coming out of a period with which there were no standards – but considering the way credit is jammed up right now there is the possibility even creditworthy borrowers may have problems getting a loan.


By region, the August home price declines occurred in the Northeast and West regions -- down 6.6% and 5.3%, respectively. Prices actually rose slightly in the South and Midwest -- up 0.5% and 0.9%, respectively.

The supply of exiting homes (this figure measures the number of months it would take to deplete supply at the current sales pace) did ease a bit, but nevertheless remains disturbingly elevated.

The number of existing homes for sale (a different figure that is just a straight number and not relative to the rate of sales) fell 7% in August – falling from 4.57 million units to 4.25 million units. So long as this number continues to decline, or even flattens out, the months’ worth of supply figure can drop quickly once sales ramp up . This will not occur though until the credit markets flow free. Even then, it won’t occur overnight, but will take quite a while still.

This housing data was mostly ignored by the market yesterday as all focus was on Bernanke and Paulson, but I thought it was important to mention.

This morning we get August durable goods orders, initial jobless claims and new home sales.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks declined on concern Congress will hold up a facility to house and patiently sell off troubled mortgage assets, marking the worst two-day slump in six years – this is the message the market will continue to send, and that message may get louder because if the credit markets remain frozen the cost to the economy will be much greater than the $750 billion that everyone is fixated on.

Commodity stocks led the decline as investors worry a sustained credit freeze will reverberate throughout the global economy. Basic material shares declined 3.19% and oil stocks slipped 2.86%. Not far behind were industrial shares, down 2.51%. Health-care shares were the relative winners, down just 0.45%.

Market Activity for September 23 2008
Back to this distressed-credit facility, Bernanke and Paulson were on the Hill yesterday attempting to persuade Congress that this plan – now known as the Troubled Asset Relief Program (TARP), I can see the play on words already from those of whom oppose this idea – needs to get done, but they received the cold shoulder from members of the Senate who have suddenly found reason to protect the taxpayer.

This is laughable to me. These are the same people that seemed all to eager to advance a $170 billion rebate check scheme disguised as a “stimulus” package, which delivered no help whatsoever outside of a two month pop in consumer spending. Members of Congress have also talked about another “stimulus” package that would supposedly cost another $150 billion. So right there you’re looking at $320 billion. And I won’t even get into a welfare system that these individuals hold dear -- a tragedy that costs trillions and has destroyed inner city families, communities and schools. But we are supposed to believe that these people are now the protector of the taxpayer.

Again, everyone seems fixated on this $750 billion figure. What? Are all of these troubled loans worthless? Serious delinquent subprime mortgage loans now total 18%. Assume the number rises to 30% -- heck the government is going to buy these assets at a discount anyway (somewhere between distressed prices and a held-to-maturity value, at least based on the plan that has been proposed).

Personally, I doubt they’ll lose much money at all over the several years they take to sell off these loans. But assume they lose half. Ok, that’s $375 billion, or 2.5% of GDP. In my view, the cost to the economy will be far far greater than that if the credit markets remain frozen -- current accounting rules result in a write-down loop that has banks suddenly unwilling to lend as they hoard cash for fear their capital adequacy ratios will fall.

The major downside is the longer this gets dragged out the more it presents an opportunity for politicians to stuff this plan with all kinds of social projects that have nothing to do with freeing up the credit markets and in fact create impediments to the capital markets

Enough of that for now, there is some good news this morning as Warren Buffet is taking a $5 billion stake in Goldman Sachs via perpetual preferred shares that carry a 10% dividend yield. The deal includes warrants that give him the right to buy another $5 billion worth of stock with a strike price of $115 per share – exercisable any time for five years (the stock currently trades at $130).

It is being reported that Buffet really likes Goldman. Who wouldn’t with these terms? This is something the average investor could only dream off. In any event, it has juiced stock-index futures so it may provide some relief after a two-day beating.

In other news, House Democrats have conceded defeat and will allow the offshore drilling ban to expire – the majority had been blocking even a vote on the issue, but constituents have beat them into submission as gasoline prices remain elevated. Now it goes to the Senate; passage would be huge for energy prices over time and significant from a geopolitical standpoint as it will send a message we have finally begun to get serious.

On the economic front, the Office of Federal Housing Enterprise Oversight (OFHEO) released their latest index on home prices, which showed a 0.6% decline in July. Home prices have slipped 5.4% over the past 12 months, according to this measure.
The hardest hit areas were the Pacific (down 1.0% in July), New England (down 1.0%) and Mid-Atlantic (down 1.1%) regions. Interestingly, the South Atlantic (largely Florida) – one of the hardest hit areas -- has seen prices behave quite well over the past two months. That region saw prices fall just 0.4% in July, which followed a 0.2% increase in June. The Mountain region is also looking pretty good as the larger price declines that have taken place over the last couple of years may have run course – too early to tell, but the trend is looking much better.

Overall, this look at housing is the most broad of all the indicators and is why we believe it gives a more accurate picture than does the S&P Case/Shiller Home Price Index, which has prices down 16% year-over-year (this is the index that gets the headlines). Case/Shiller covers the 20 largest metro areas, half of which have been the hardest hit. While the OFHEO index has its flaws – it fails to capture the higher-end housing market – it does offer a much more diversified look.

Bottom line, when you factor in both of these reports along with the new and existing home sales data, it offers a pretty good feel of what has occurred nationally. Weight all of these indexes equally and prices have declined roughly 8.5% from a national perspective over the past year.

In a separate report, the Richmond Fed Index (manufacturing activity) showed the east coast market continues to see weak factory orders persist as the September reading came in at minus 18. This is quite different from the Chicago region (the largest manufacturing base) and ISM survey (the broadest look) which remains pretty upbeat considering all that is going on.

There was nothing in the Richmond survey to provide any hope over the short term. As most of you know, we focus on the sub-indices within these surveys to offer some insight on how the sector will behave over the next six months. In the case of Richmond, the shipments, new orders and back log indices all posted ugly readings. Even the prices paid index, which has declined a bit among the other factory surveys, remained elevated – actually increased a bit from the August reading.

The charts below show how depressed manufacturing activity is in the Richmond Federal Reserve district compared to the national view. (Remember though, zero marks the line of demarcation between expansion/contraction for the Richmond survey and 50 is the line of demarcation for ISM).




Correction:

Yesterday I stated the following when touching on monetary policy mistakes:
Why did they leave fed funds so low for so long? Simply because the unemployment rate remained below where Greenspan and Co. wanted it. That’s the reason. They ignored that this Phillips Curve mentality has proven feckless, and at times harmful, for 30 years now and continued instead to grasp it no matter how precarious the hold.

I meant to say because the unemployment rate remained above where Greenspan & Co wanted it.

The overall point was that the Fed ignored the reality the economy was booming and inflation was running at a rate that vastly exceeded their fed funds target – real fed funds was negative. This subsidizing of debt encouraged the financial sector to increase leverage and a large percentage of home buyers to move to adjustable rate mortgages – two factors that have caused the current situation to become quite unpleasant.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks erased Friday’s gains as worries mounted that internal conflict will delay a plan to deal with troubled financial assets and thus keep the credit markets frozen. So the S&P 500 is back to where it ended on Thursday, 4.5% above the September 17 multi-year low yet 22.6% below the all-time high hit nearly one year ago.

Of course, financial shares led the indices lower, plunging 8.48% yesterday. Consumer discretionary, industrial and information technology shares also shed 3% or more – all 10 major industry groups closed down on the day.

Monday’s stock-market activity sends the message not to play around with this thing, get it done – cut and dry. It is imperative to get this facility up and going and to completely dismiss some of the Congressional proposals that are delaying the process. We’ll soon find out if Congress is listening.

Market Activity for September 22 2008
And speaking of the government plan, we’ve heard a lot about the financial system and what ails it over the past few days – and a good thing too as the credit markets completely froze up last week. But almost universal among the many proposals to fix this thing is a refusal to lay any blame for who is responsible for this mess, so long as the particular pundit’s solutions are implemented. Well, let’s be clear, we better lay some blame because without it we fail to concentrate on what got us here and thus will not learn from the mistake. So let’s discuss the primary mistakes.

There are two things that brought us to this dead end – and I mean that as credit markets had failed to work of late and the write-down game becomes a never-ending loop; it is Federal Reserve policy and mark-to-market accounting. (Yes, there are many other things that have exacerbated the issue, but these two are the main problems as the former is the root cause, the latter providing the coup de grace).

The FOMC believed – as it still does – they could manage the economy using their flawed Keynesian models and as a result left their benchmark interest rate at 1.25% even as nominal economic growth average 6.5% -- 3.2% in real terms – in the 12 months ending June 2004; that’s running on all cylinders. (In fact, the Fed left fed funds at 2.00% or below for three full years.)

Why did they leave fed funds so low for so long? Simply because the unemployment rate remained below where Greenspan and Co. wanted it. That’s the reason. They ignored that this Phillips Curve mentality has proven feckless, and at times harmful, for 30 years now and continued to grasp it no matter how precarious the hold.

It was the low interest rate environment that encouraged all of the worst things we now know about the credit/housing market situation. We must not allow this to occur again.

The next thing we should learn is not to fall for so-called “sophisticated” models used to price assets – especially for the financial sector where these assets have 10-20 year lives. We were told these models were much more dynamic than the commons sense ways of the past, which used an original cost framework on which the financial sector based capital adequacy ratios.

These new models were developed largely during a period in which asset prices almost only went up -- never tested against what we now face.

Beyond that though the idea never made much sense from the get go. Mark, or price, assets that have 10-20 year lives to a market that is distressed? Not smart.

When asset prices fall firms must raise capital – lest that capital falls below the required level --, they then must sell off more assets to do so, which sends prices even lower, or at least the models that are used to price these assets. The process snowballs and becomes a never-ending loop until a firm is driven out of business. If we only returned to the rules these assets were accounted for just a few years ago, I’m convinced capital adequacy would have never have become a problem and asset prices would reflect a value that is actually close to intrinsic value – right now that is not the case and why an RTC-like facility to house and eventually sell off these assets will not be a losing proposition. (Sure thing, those firms that were leveraged to the hilt would still be in a world of hurt, but I’m talking about the industry as a whole. If we had mark-to-market based accounting during the S&L crisis one only knows how bad things would have become).

So while we listen to all of the solutions – some quite good and some very bad – let us not forget that a recklessly easy Fed and moronic accounting rules are the preponderate mistakes that have led us down this road.

The dollar is getting hit on news that it will take roughly $750 billion to create this facility to house and then sell off troubled assets in an orderly way. This dollar move is both logical and expected based on that number, but without a change in the accounting rules, I’m not sure there is another choice. (Under the Treasury Department’s original intent these assets will be bought at a substantial discount and will come out ahead on the deal – ie. No taxpayer harm, so long as the Congress doesn’t screw the thing up).

Concerns that the cleaner proposal presented on Friday may become saddled with New Deal-type programs likely caused more dollar harm than would otherwise have been the case.


The October contract for crude soared yesterday, jumping $16.37 per barrel, or 15.7%. That contract expired yesterday and it’s pretty obvious the jump was due to the classic short squeeze. Those that remained short had to cover those positions or be force with actually delivering the oil. The November contract rose at only half that amount. You’ll see oil open around $107 per barrel this morning. That’s not because oil has suddenly plunged $13 but because the November contract only rose to $108 yesterday. The two charts below illustrate this point.



We were without an economic release yesterday but get back to it today with the Richmond Fed Index and OFHEO’s Home Price Index. Data on both new and existing home sales, durable goods orders and the final revision to GDP will round out the week.

Thanks to Peter for doing a great job while I was out yesterday.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

Capping off a historic week, stocks rallied sharply for the second-straight day as drastic moves by the government were announced to bail out the banks. Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke announced the removal of illiquid mortgage securities from companies’ balance sheets while the SEC temporarily banned the short sale of 799 financial services companies. As a result, financials led the rally gaining 11.13 percent on Friday.

Market Activity for September 19, 2008
If you were on vacation last week, you might think nothing interesting happened since stocks ended relatively flat for the week. However, the Dow posted triple-digit moves every session in response to a variety of events such as Lehman Brothers filing for Chapter 11 bankruptcy protection, Merrill Lynch and Bank of America’s shotgun wedding, the Fed leaving its target fed funds rate unchanged, the government taking over the world’s largest insurer AIG, two money market funds “broke the buck,” and yields on three-month Treasury Bills rose a few basis points above zero.

On Saturday morning, a three-page bill was delivered to members of Congress asking them to give Paulson unchecked power to buy $700 billion in bad mortgage investment from financial companies in what would be an unprecedented government intrusion into the markets.

The plan would raise the ceiling on the national debt and spend as much as the combined annual budgets of the Departments of Defense, Education, and Health and Human Services. Paulson was asking for the power to hire asset managers and award contracts to private companies. Most provisions would expire after two years from the date of enactment.

On Sunday, the Fed agreed to convert investment banks Morgan Stanley and Goldman Sachs into traditional bank holding companies, thus subjecting the firms to greater regulation and likely lower profitability. (It has become somewhat of a Sunday ritual for me to see what big announcement the government will make on Sundays.)

Goldman and Morgan Stanley have maneuvered through the credit crisis better than other investment banks, but the Fed feared the investment-banking model could not function in these markets for much longer. Investment banks depend on short-term money markets to fund themselves, but that has become increasingly difficult, particularly in the wake of the collapse of Lehman Brothers. As bank holding companies, Morgan Stanley and Goldman Sachs will be allowed to take customer deposits, which are potentially a more stable source of funding.

With the attention focused squarely on the financial crisis and government efforts to unclog the credit markets, the economic calendar will probably take a back seat on Wall Street again this week.

Wednesday we will get the report on existing home sales, which account for about 85 percent of the total home sales and have been at the root of the financial crisis that shook the markets last week. Sales in August are forecast to decline 1.2 percent to an annual rate of 4.94 million units, suggesting that the housing market will get no relief from the uncomfortably high inventory levels and declining home prices.

It is still too early to tell how homebuyers will be affected by the recently-passed housing bill, the bailout of the nation’s largest mortgage buyers Fannie Mae and Feddie Mac, and the monumental developments in the financial markets, but it is crucial for homebuyer confidence to begin to be restored for the economy to gain traction.

Other reports that will be released include durable goods orders, new home sales, and weekly initial jobless claims on Thursday. And, of course, the final 2Q GDP will cap off the week.\

Brent will be back tomorrow and I’m sure he will have plenty to say about these historic events.


Have a great day!


Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks jumped yesterday supposedly on news the government is formulating a “permanent” (run for cover when you hear that one) plan to shore up financial markets. The actual reason stocks reversed course and rallied mid-session on a day that the mood was unpleasant and the credit markets remained frozen is anyone’s guess. One gets a sense it was not this “permanent” plan, at least the Senator Schumer version which was nothing more than re-enacting the New Deal. Lord help us!

This version of the plan was not to set up an RTC-type facility to house troubled paper then to sell in an orderly way, but instead to inject government funds in exchange for equity stakes in financial companies and re-writing mortgages to make them more affordable. We can all discuss whether the efforts heretofore are helpful or not, but fat chance with this New Deal-type plan occurring – the housing/credit market is in a tough state, but I don’t think we’re ready to become socialists just yet.

Certainly helping financial shares rebound, which led the advance as the sector gained 11.73%, was the crackdown on a form of short selling that was suppose to be illegal in the first place but apparently not enforced until now.

Industrial and information technology shares were among the next-best performers, up 3.57% and 3.98%, respectively.

Market Activity for September 18 2008

Monetary authorities also played a role as central banks around the world – US, EU, Japan, Canada and Swiss announced coordinated measures to ad massive amounts of liquidity to the banking system. The Fed doubled its existing currency swap with the ECB and Swiss Bank. In addition, they authorized new facilities with the Bank of England, Japan and Canada.

Bottom line, this measure is aimed at reducing funding pressures in the interbank market and to lower LIBOR rates.

Outside of other major issues, many adjustable rate mortgages run off of LIBOR rates, which has jumped big time over the past couple of days as banks are unwilling to lend to their peers. Overnight LIBOR fell to 3.84% from 5.03% but three month LIBOR actually rose – nice try though. Risk aversion remained extremely elevated – as evidence by the three-month Treasury bill that yields just 8 basis points -- and in my humble opinion I don’t see how the Fed’s action changes this. (No, that is not a typo on the three-month T-bill yield, it really is 0.08% -- investors are paying for the safety and liquidity of the Treasury market.)

On the economic front, initial jobless claims for the week ended September 13 rose 10,000 to 455,000. The Labor Department reported claims were boosted because of the impact of Hurricane Gustav. Claims have been elevated for eight weeks now, but I was comforted to see the figure remain below 475,000 in light of Gulf coast weather. Of course, we’ll see the effect of Ike over the next couple of weeks as Houston was hit hard by this storm.

Continuing claims fell 55,000, which is nice, although you won’t hear it reported. I’m not saying we should get excited about this move lower, but it certainly doesn’t hurt.

The current level of claims does not bode well for the September job report, but I don’t think there was anyone on the planet expecting anything special anyway. While this level of jobless claims is unwelcome, it remains well-below the prior two peaks and continues to suggest monthly job losses will remain in the 60,000-80,000 range and not the 150,000-plus level that we see in the typical period of labor market weakness.


In a separate report, the Philly Fed index – a measure of manufacturing activity in the Philadelphia Fed Bank region – came in much higher than expected, rising to post a positive reading of 3.8, the estimate was for a negative 10. (To offer some clarity to new readers, a reading above zero marks expansion, as opposed to the ISM and Chicago-area manufacturing survey in which a number above 50 marks expansion.)

A couple of the underlying sub-indices within the overall survey improved nicely as new orders jumped to 5.6 from -11.9 in August and shipments posted 2.6 from -3.3 last month. If not for a large drag from the inventory component the total survey would have been stronger. That inventory index came in at -22.9 vs. -6.6 in the previous reading as stockpiles plunged, but this is good for next month’s reading as production will likely kick up to replace inventories.

Lastly, household net worth fell 3.5% in the second quarter, as reported by the Federal Reserve via their flow of funds report. Clearly, falling home and stock prices pushed the figure lower – although, as the chart below illustrates it remains elevated (up 48% since 2002 and 212% over the past 20 years).


I’ll note, household liabilities as a share of net worth rose to a record 25.9%, which is up from 18% in 2001. This corresponds with the easy money policy of the Fed – specifically the duration of that easing campaign even as the economy began to boom in 2003 and was in an all out sprint by 2004.

Have a great weekend!

Brent Vondera, Senior Analyst

Acropolis in the News

Chris Lissner appeared in Jerri Stroud's most recent article in the St. Louis Post-Dispatch.

Click here or on the logo to read the article.

Daily Insight

U.S. stocks tumbled, mirroring Monday’s move, as the credit markets remain largely frozen. Problem is banks continue to hoard cash, as we’ve talked about for a couple of days now, and this causes the whole system to seize up -- we’ll touch on this issue more specifically below.

To no one’s surprise on a day of substantial decline, financial shares took the brunt of the beating – losing 8.94%. Although, the losses were widespread as utilities fell 5.33%, information technology down 4.9%, consumer discretionary shares fell 4.84% and industrial shares lost 4.77%.

On financial shares, we must put an end to what short sellers are doing here. I normally wouldn’t favor such action, but there are times when the authorities have to step up and take Machiavellian action (swift, effective and short-lived). This is one of those times.

The SEC has decided to actually – hopefully this time it’s for real – prosecute those engaging naked short trades (shorting stocks without having the shares to deliver). This will help. They must also reinstate the uptick rule, meaning one must wait for the stock price to tick up before selling short. This rule was eliminated on July 6, 2007. The SEC ran a one-year pilot program, eliminating the rule back in 2004 and all went well, which encouraged them to reverse the rule. However, this is not 2004 and it’s pretty obvious a rolling short is in play -- short one financial stock to zero and move onto the next.

Market Activity for September 17, 2008
For sure, it is the reckless behavior of financial institutions, encouraged by the Fed’s very terrible mistake of keeping rates too low for too long all the way into 2005 (fed funds was kept at 2.00% or below for three full years) even as the economy began to boom in 2003 and was hitting on almost all cylinders by 2004. This reckless behavior by the financial sector is ultimately why the short-trade even got rolling. But we can’t change that now. The raid must be stopped.

In addition, consumers -- specifically many home buyers -- were reckless as well, which is why we’re dealing with this “toxic” paper that no one wants to touch and firms are stuck in a continual write-down loop as a result.

There are people talking about creating a new RTC (Resolution Trust Corporation, which was set up to liquidate assets in an orderly way due to the S&L crisis 20 years ago) to buy up the “bad” paper – sub-prime, Alt-A mortgages etc. – and selling them off in a orderly way. This may be a good idea.

I’d bet a new RTC would eventually make large sums of money off of this because it seems very likely, to me, these assets that continue to be written down are worth much more than currently marked to. And that’s one of the problems.

The mark-to-market accounting seems deeply harmful in my view. Why in the world mark these assets to where they can be sold in a distressed market? In fact, that’s putting it mildly. There is no market for this paper, but the collateral behind it is worth much more than currently assessed. For heaven’s sake, the mortgage market looks ugly, but we’re talking about 93% of mortgage payments are on time. The write-down scenario would make one think this number to be more like 60%. The authorities will eventually get a clue and switch to net present value accounting these instruments that have 10-20 year lives.

That to me is the answer, the accounting standard change.

We’re seeing the farce of the supposedly sophisticated models used to value assets in this mark-to-market accounting rule. As financial firms try to sell distressed assets it lowers the price even more, which makes them even harder to sell – buyers will not step in until they perceive a bottom has been reached. As asset prices fall its causes banks, among others, to raise capital. It becomes self-feeding. And this is why financial institutions are hoarding cash and credit markets are frozen.

The accounting rules must be changed – as former Fed governor Larry Lindsey stated so well yesterday in the WSJ editorial page; I encourage anyone with a WSJ subscription to read it. We must either move to more stable capital adequacy rules – basing capital ratios on original asset values or net present value these longer-term assets. This will put a halt to the capital concern and unfreeze the credit markets. You can’t do this overnight, but changing the rule to take place over the next year will help immensely. As some smart guy from the past said (the name escapes me) the best time to plant a tree is 20 years ago; the next best time is now.

We see this morning that central banks around the world are coordinating to pump $247 billion into the system. This is one of the things central banks are tasked to due and it may help. Then again, it may be like squeezing Silly Putty -- squeeze all you want there will be other areas that stick out. The accounting rules must be changed; this is the ultimate solution for now, in my view.

There are people saying the Fed needs to lower rates – these types think just because the FOMC hasn’t pushed rates lower since March that rates are not low enough. Look, it is not appropriate to view the fed funds rate by itself, but against current levels of inflation (averaging the three major inflation gauges). By this measure, you’re looking at a negative fed funds rate of -3.00%; this is a hugely accommodative stance.

On the Bright Side

The events of late have presented an enormous multi-year stock-market opportunity, but things may very well remain jittery for several months and I am not at all calling a bottom here. Just pointing out that once we get beyond this the attractive nature of the major indices will allow for above normal returns.

The S&P 500 trades at an earnings yield of 7% based on the earnings forecast for the next four quarters, while the 10-year Treasury yields a whopping 3.38% -- even relative to the past 12 months worth of earnings, the S&P 500’s earnings yield remains 101 basis points above the 10-year rate.

The chart below illustrates this point. The series that offers a historic view of the S&P 500 earnings yield was discontinued in October 2007, but the calculation is simply the inverse of the p/e ratio so we can plot where it is today – as represented by the point on the right side of the chart. This presents the largest spread in favor of stocks in at least 30 years. The index also carries the highest dividend yield in 12 years. (Other indices also show favorable ratios as the Dow trades at 13 times earnings and carries a dividend yield of 3.07% and the NYSE Composite – which includes higher growth medium and small cap stocks -- currently trades at 15 times earnings and a 3.40% dividend yield.)

Unfortunately, there are some real disturbances, if I can call it that, in the credit markets, so patience is certainly needed in this environment. And possibly some areas may need to be avoided in the very short term if the credit markets do not improve over the next few days.

On the economic front, the National Association of Home Builders broke ground on fewer homes than forecast in August. Housing starts fell 6.2% to 895,000 at an annual rate.

Multi-family starts plunged 15.1%, while single-family starts fell 1.9% last month.


Also, building permits, a sign of future construction, dropped 8.9% to an 854,000 annual pace. Both of these figures remain at the lowest pace since 1991.


This illustrates the residential housing component of GDP will continue to weigh on economic growth. We were under no illusion that housing would magically begin to support growth again, but figures over the past couple of months did at least begin to show the level of decline had eased – in fact the latest GDP report showed this occur in the second quarter. But the past couple months of data are a pretty clear sign that residential fixed investment will subtract another full percentage point from real economic growth – marking the 10th straight quarter of drag.

Certainly, the degree of decline among multi-family units overstates the underlying weakness in housing; it nevertheless suggests that residential investment is going to be a large drag on third-quarter growth.

Based on the data we have at this point, we still expect the Q3 GDP number to come in better than most expect. The business side of the economy will offset some of the weakness consumer activity will show and export growth may more than offset the housing drag. However, this is based on the assumption export growth remains strong. I think it will for the current quarter, but it seems apparent this segment will slow next quarter based on the slowdown the European economy is now enduring. At that point, if housing doesn’t show a little life, the fourth-quarter GDP reading will likely be flat. One hopes the rise in homebuilder optimism is a sign the degree to which housing activity is declining wanes over the next few months.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks were all over the map yesterday, moving 2.0% to the downside at its lowest point – while the market waited for the FOMC decision and more importantly how authorities would deal with AIG – but rallied hard in the final 90 minutes of trading on word the Fed would provide a loan to AIG and the FOMC held pat as the inflation gauges barely moved even with oil’s large move lower.

The S&P 500 moved between gain and loss at least 10 times yesterday, and the chart below paints the picture as investors weighed the fate of the largest insurer and the cascading effects that would results from an AIG bankruptcy. What occurred in the credit markets yesterday was hugely concerning.

We’ve heard people say credit markets had seized up and for a year now, but this letter has provided evidence that this had not occurred – at least not in a broad sense. Well, over the past two trading sessions it occurred as the credit markets were very much frozen and it definitely had an effect on the Fed’s and Treasury’s decision to take action regarding AIG.


Market Activity for September 16 2008
Financial and energy shares led the indices higher, but the gains were widespread as all but two of the major industry groups gained ground.

On AIG, the Federal Reserve decided to provide an $85 billion loan and in return the Treasury Department will receive warrants representing the right to a 79.9% stake in AIG. AIG would commit to sell a basket of assets (its several business units both insurance and non-insurance) within a certain time frame. The loan has duration of 24 months at a rate of three-month LIBOR plus 850 basis points. That equals 11.25% and one would think guarantees AIG will not play around with getting these businesses sold. This should not adversely affect the taxpayer – outside of unintended consequences that we cannot grasp at this point – as the government will very likely make money off of this action.

In other market news, the $62 billion Primary Fund of the Reserve (a New York money-market firm) broke the buck (NAV went below $1) due to investments in bonds issued by Lehman. It’s been 14 years since a money-market fund has fell below $1 – one has to go back to the Orange County bankruptcy in 1994. This underlines the reckless risk that has been undertaken for amazingly little boost in return.

AIG is Lehman on steroids and it seems a collapse needed to be avoided. The firm was a major seller of credit-default swaps (insurance default on assets tied to corporate and mortgage securities). Bankruptcy would force financial institutions globally to take huge write-downs as a result.

Let’s hope this month marks the bottom in this chaotic situation, but one can’t say so with confidence. One thing is for sure with this whole mess, risk is getting re-priced and it will be a long time before risk management become as reckless as it became over the past several years. Each company and manager is responsible for their own actions, but personally I lay the ultimate blame at the feet of the FOMC.

Gasoline Prices

Wholesale gasoline prices continued to plunge, falling another 4.74% to $2.44 per gallon yesterday, even as the combo of Hurricanes Gustav and Ike have forced 6.3 million barrels a day of refining capacity to shut down in Louisiana and Texas. Gasoline supplies are at their lowest point in eight years, according to the Energy Department.

At some point prices will reflect this situation, or maybe prices are simply returning to levels prior to the Fed’s abrupt easing campaign that caused hedge funds to flow into the energy trade as a way to guard against inflation. I’m skeptical energy prices will remain at these levels considering heightened geopolitical concerns, which have been ignored with all that is going on in the credit markets.

Further, the energy bill working its way through Congress is a sham. It continues to lock up 85% of the outer continental shelf (OTC), restricts oil-shale production and does not offer royalties to states that lie along 15% of the OTC that is available for production. One big joke.


On the economic front, the Labor Department reported that the consumer price index eased in August, but not by much even as the energy component fell substantially. Food prices rose 0.6% in August and accelerated to 6.1% year-over-year (YOY) from 6.0% in July.

For the overall index, (including everything) CPI declined 0.1% in August and decelerated on a YOY basis to 5.4% from 5.6% in July.


The core rate, which excludes both food and energy – a measure the Fed watches closely – remained unchanged at 2.5% on a year-over-year basis.


The Cleveland Federal Reserve Bank’s Mean CPI – this measure takes a weighted mean of the CPI and gives one the sense what inflation is doing outside of wild swings in certain components – remained unchanged at 3.3%.

What does all of this tell us? It shows that inflation remains sticky and is counter to the Fed’s prediction that overall price activity would come lower along with the decline in energy. (This is where their Keynesian models lead them in the wrong direction)

And speaking of the Fed, the FOMC (the group that determines monetary policy) made the correct decision (in my view) yesterday by keeping their fed funds target rate unchanged at 2.00%. Monetary policy needs to be devoted to price stability – and as just mentioned – their assumption that inflation would come lower simply because energy price have plunged has failed to come to fruition. The members of the FOMC have been mugged by reality and this obviously drove their decision yesterday.

Further, jacking rates lower is what got us into this mess in the first place – keeping rates too low for too long subsidized debt, encouraged financial institutions to abandon risk management and created a commodity spike. The Fed has many other tools with which to provide liquidity and it is about time they held the line on fed funds even as the Street was demanding a cut – fed funds futures had the probability of a cut at 80% prior to the announcement.

The central bank added liquidity through their open market operations yesterday morning. This was needed to get the effective fed funds rate to a level that is closer to their target –although it remained above their desired mark for most of the day as banks hoard cash in this uncertain environment.

Also, the Fed auctioned $20 billion in 28-day repos for mortgage-backed securities as an additional way to increase liquidity into the system. (This is part of the TSLF – or Term Securities Lending Facility in which they broadened the types of collateral, in this case mortgage-backed paper, for its 19 primary dealers for a set period. This temporarily raising the amount of money available in the banking system. At the end of this 28-day period they return the securities to the dealers, and they cash to the Fed.)

In the statement that accompanies the rate decision, the FOMC stated they will continue to address market turmoil with emergency lending (noting, “[s]trains in financial markets have increased significantly”) and the prior easing actions should promote moderate economic growth over time. Their statement, “the inflation outlook remains uncertain” clearly illustrates the latest inflation gauges played a major role in deciding to hold their fed funds target unchanged.

The current economic weakness is not due to lack of demand for goods and services, but because of poor risk management. It is a good thing the Fed held the line.

Have a great day!


Brent Vondera, Senior Analyst