Daily Insight

U.S. stocks slid in the final hour of trading yesterday as concern grew the credit-market situation, which tightened further, will spread into other industries, according to the financial press. I believe that was a concern already, if fact we all know it was the case. The sell-off was more a function of de-leveraging and growing fear, which drives things well-below justified valuations.

The fact that things fell apart to such a degree in the final hour likely suggests the plunge was due to hedge-fund deleveraging. Look at the most liquid stocks, many of which took the worst beating; those that had to sell when redemptions flooded in sold whatever they could. It’s quite likely in my view large-cap stocks will show the largest bounce when the indices rally again.

The Dow moved to the 8,000 handle, closing at 8579 for the first time since May 2003 – the index has lost 16% this week, which I believe is on pace for the worst weekly performance ever. The broad market, as measured by the S&P 500, has plunged 27.4% since September 19 – down 17.2% for the week.

First chart represents yesterday’s session; the second shows the last 18 months.

So much for the thought that removing the short-sell ban would push the indices higher, that was a moronic statement. (The logic was that hedge funds may come back to the market as they would now be able to put on the appropriate hedge – can scrap that idea).

Market Activity for October 9, 2008


I don’t know call me crazy, but maybe the charts below (pay-to-play odds on the election outcome) have something to do with the pummeling too. When investors, especially those of whom may not have a multi-year time horizon, fear that capital gains and dividend tax rates may be jacked higher, I’m going to guess it doesn’t exude a pleasant feeling to say the least.

I’m going to guess, with all that is occurring, specifically the credit markets shutting down and the economic contraction that is quite likely to ensue, investors probably aren’t getting a great feeling about a filibuster-prove Senate either.

The activity in the stock market over the past three weeks and specifically the past seven trading sessions, seems to be pricing in a serious recession. We’re are not headed for a downturn that is worst that anything we’ve seen in 30 years – the typical recession seems about impossible to escape though the longer credit markets remain this locked up; heck, the stock market activity alone will surely push spending lower, whether it be the consumer or business as caution is heightened. However, if the market is pricing in an Obama victory – and much worse an Obama/Reid/Pelosi run government – it means it is pricing in higher tax rates and tariffs (major changes in our international trade agreements). That would mean an economic coma in this environment.

And before any Obama lovers send me hate mail, I’m going to rip on the current administration below – this is not about whom I want to win in this election, it’s about policy and it’s about proper communication.

Another Treasury Proposal

The Treasury Department reported they may begin a program to inject capital into banks, much like the UK plan announced the day prior. The TARP plan includes the ability to do this – using some of the $700 billion to directly inject capital in exchange for currently traded preferred shares to protect the taxpayer. These positions must be sold back to the private sector once the crisis passes, that’s imperative.

As the Editorial Board of the WSJ stated yesterday, when the private sector won’t provide the capital in this current period of fear public-sector funds must be used to throw the life-preserver.

As we touched on yesterday, it is better for Hank Paulson to wait until something is put in place before making statements. The market could give a damn about talk, it wants action.

Besides, everyone knows that I believe a couple of the Treasury’s major plans will work quite well. But they have a problem with communication – a contagion within the Bush Administration. It’s quite likely poor communication has meant a 2,000-point swing in the Dow – instead of losing 1,000 from 9500 it very well should have rallied 1,000 to 10,500.

Take this capital injection, for instance. Do not state such a plan without specifics, the market will think they’re going to bring out the hatchet. Moral hazard? This is something many have worried about with all of this government intervention. Not with these guys.

This capital injection plan can work very well, but Treasury must make it clear that they won’t do what they did with Fan and Fred – destroying the preferred shareholder, many of which were the very banks that need help. Lay the plan out when you bring it, and it must state three things loud and clear with regard to government stakes in preferred stock:

• No voting rights
  
• Not senior to any other preferred series (so the currently held shares won’t be blown out – don’t penalize shareholders here; support them)
  
• Get out ASAP (as soon as this crisis has waned)
  

Commercial Paper

Total commercial paper (CP) outstanding fell $56 billion in the week ended October 8, which puts the total decline over the past four weeks at $264 billion -- total outstanding is $1.55 trillion.

Financial company CP fell $42 billion and is down $175 billion over the past month – financial CP stood at $825 billion a month ago, that $175 billion decline marks a 21% plunge. Non-financial CP outstanding rose $3.6 billion in the past week to a total of just over $200 billion, that’s the bright side.

The dark side is that financial and asset-backed CP continues to decline rapidly and signals the need for the Fed to get its Commercial Paper Funding Facility operating in quick order.

On the economic front, the Labor Department reported initial jobless claims fell 20,000 in the week ended October 4 – although, the figure remains elevated due to the hurricanes that tracked through the Gulf in September. The report showed these weather-related events added 17,000 in jobless claims so adjusting for this claims would have dropped substantially.

The four-week average of claims rose 8,250 to 482,500.

The hurricanes resulted in an increase of 50,000 in claims in last week’s data, but the overall figure only rose 2,000 – so plenty of distortions then as well. This is good news but we should be prepared for claims to remain elevated as small business in particular has been hurt by the credit market freeze up.

Continuing claims remain elevated, the highest level since June 2003 – which was three months before the labor market began to turn around coming out of the 2001 downturn. Thirty-five states and territories reported an increase in new claims, while 18 reported a decrease. These aspects of the data likely underscore the deterioration in the job market we’ve seen of late.

The G7 will convene this weekend and I’ll go out on a limb and say they’ll come back and have decided on two things:

One, they;ll state global governments will guarantee lending between banks.
Two, there will be a coordinated effort to suspend mark-to-market accounting for securities that currently have no market. (The U.S. has proposed this but I do not believe it has become offical. Besides the standard needs to be change on a global scale for conformity’s sake)

These two events should bring inter-bank lending rates lower and a willingness to lend to one another. At which point businesses, specifically small business, will begin to see capital and credit flow in their direction again. I’m still waiting for a tax-rate response as well, which would provide a big boost to confidence – to offer nothing in this regard is a major mistake in my view

Hang in there and have a great weekend!

Brent Vondera, Senior Analyst

Daily Insight

What a difference a year makes. It was a year-ago today the Dow Industrials Average and S&P 500 indexes touched their all-time high – 14,164 on the Dow and 1565 on the S&P 500. Nine-trillion dollars in stock-market value was created during the bear market that began in the spring of 2003 to that peak, as measured by the NYSE Composite – today that rise in stock-market wealth stands at 44% of that figure, 4.16 trillion.

U.S. stocks bounced around again yesterday – and the swings were significant – but we gained momentum going into the afternoon session and appeared poised to close strong. But then Treasury Secretary Paulson stepped to the microphone and…well, the same thing happened that occurs just about every time a government official open his mouth, the rally fizzled. (And no, I’m not being sexist here because the pronoun is correct; I won’t disparage the other gender because when FDIC Chair Sheila Bair speaks the stocks market does not retreat.)


I’ve been pretty hard on Paulson in the past – he’s weak on the dollar, failed to convene the G7 as the FOMC was digging a larger hole for the greenback and has offered zero with regard to a tax-rate response to this entire mess – big mistake.

But what he’s proposed with the TARP plan has a great shot of freeing up the credit markets – assuming the auction does not end up being rigged, can’t rule that out; this is the government we’re speaking of. Really though, you’ve got TARP passed and signed, please don’t step to the mic. again until you’ve got something constructive to say and your ducks are in a row to buy, buy, buy.

Market Activity for October 8, 2008 At midnight the short-selling ban expired, that ban pertained to something like 800 stocks, and conventional wisdom may assume this will result in more pressure for stocks. Not sure about that though, the indices may rally on the news as hedge funds come back in to buy now they have more freedom with putting proper hedges in place. These market participants may have sat out while the ban was in place.

IBM announced quarterly results earlier than expected, stating operating earnings rose 22% last quarter and margin growth was strong, widening to 43.3% from 41.3 a year ago. Revenue growth was a little light, surely the woes in the financial sector have caused some issues, but it was a good decision to pre-announce in this environment lest rumors take over and crush your stock.

Overall earnings will be weak for the quarter, no getting around that, but maybe tech-land will be stronger than most expected.

On the economic front, the National Association of Realtors (NAR) stated pending home resales unexpectedly rose 7.4%, as the median price of existing homes fell sharply in August.

One has to expect home sales to fall further, especially with how locked up the credit markets are, but mounting foreclosures are helping the sales data and this may help to offset the credit-market issues – pending home sales are an arbiter of the direction sales will take over the subsequent two months when these contracts close.

By region, pending sales were up 2.3% in the South, 3.6% in the Midwest, 8.4% in the Northeast and soared 18.4% in the West.

Digressing

I ran across an article Monday night that stated how the slide in home prices has left nearly 16% of homeowners with a higher mortgage than the home is currently worth. (I’m not sure all of this is because of the fall in home prices, as a decent percentage of these people have been in their current home for several years – and home prices are higher going back to mid-2004 --, but rather because they took advantage of home-price gains in previous years to refinance and take cash out. Others of course put no money down and so it doesn’t take much to go underwater – it is pathetic though to see so many just walk away, not even trying to make the payment – as if the price of the property will not rise over the longer-term)
Anyway, the article points to the need to offer programs to these individuals to keep them in their homes.

No. What we have here is a total neglect of obligations – complete irresponsibility.

These people must not be bailed out in a direct way – of course a series of government action will bail those that made really bad decisions in an indirect way, but it may also insulate the rest of us from going down with them. The Treasury’s TARP program will offer indirect assistance to those that made bad choices, but this program is essential so that those that have lived their lives responsibly are not harmed by a bevy of mistakes made by the Fed, Congress and individuals themselves.

The most effective solution to this situation is three-fold as I see it:

• One, TARP is essential. These troubled assets must be removed from bank balance sheets.



• Two, the SEC and FASB must at least modify mark-to-market accounting – and hopefully kill the wretched rule, that is FASB rule 157.



• Three, broad-based tax cuts are imperative. Reductions in capital gains, dividends, labor income, repatriated income and corporate earnings will spark growth, increase earnings and after-tax income, rally stocks, bring more capital home, boost tax receipts, and promote jobs.

Many continue to miss the fact that broad-based reductions in tax rates do result in more tax revenue – the evidence is there; one only needs to review what occurred in the 1960s, 1980, late 1990s and the current epoch, save the last year as corporate profits have been hurt by financial-sector woes, a rebate check scheme immediately added $175 billion to the 2008 deficit and everything that has occurred since.

But we shouldn’t forget that the three fiscal year running 2005-2007 saw the largest rise in tax revenue ever, jumping $785 billion in that three-year period. Let’s not forget, the 2007 budget saw the deficit narrowed to just 1.2% of GDP from 3.9% in 2004 after the downturn of 2001 and trillion dollar hit to the economy from the 9/11 attacks.

Cutting tax rates in a broad-based way increases revenue for two main reasons:

One, with regard to capital gains more investors are willing to pay the tax at a lower rate – we all know this story. Further the after-tax return expectations that result push stock prices higher, which results in additional gains – lower dividend tax rates have the same result.

Two, lowering income tax rates means higher after-tax income, which promotes growth. Also, and what many fail to acknowledge, is that two-thirds of the top tax bracket is made up of small businesses, and as after-tax profits rise for the largest job creator within our economy they hire more – thus increasing the tax base.

So lower tax rates are vital to growth, both for the private sector and in terms of tax revenue. We face many challenges over the next couple of decades and growth will be essential to meet those challenges.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks endured another harsh session yesterday after beginning the day up 170 points (for the Dow), but plunged from that intra-day peak by 680 points. We talked about a coordinated rate cut by various central banks yesterday, many seem to be blaming yesterday’s weakness on the fact that this did not occur.

Well, literally as I type, the Fed, Bank of England and ECB (European Central Bank) have just done so – all cutting their benchmark rates by 50 basis points, or one-half of one percent. Frankly, I’m not sure what a rate cut does, if banks are unwilling to lend credit spreads will not ease. As I look, these spreads remain wide and in fact the TED Spread, three-month LIBOR and LIBOR OIS are all wider, or higher in terms of 3 mos. LIBOR, than yesterday.

However, stock-index futures have turned around nicely; let’s hope we can hold onto those gains as the actual session progresses.

Market Activity for October 7, 2008

Another Fed Facility

The Federal Reserve continues to add liquidity and shoot it to where they see its most needed. Yesterday they announced creation of the Commercial Paper Funding Facility (CPFF) in which to purchase commercial paper (CP) and create a liquidity backstop for U.S. issuers. The facility will directly purchase three-month unsecured and asset-backed CP through April 30, 2009.

Outstanding CP has shrunk to a three-year low, interest rates on this short-term funding used by businesses has risen substantially and an increasingly high percentage of outstanding paper must be re-financed daily, according to the Fed.

The CPFF should help to improve confidence in this very important segment of the credit markets since CP investors will know the Fed stands as the purchaser of last resort in event an issuer has difficulty rolling paper.

Yields on top-rated overnight CP dropped 0.74 percentage point to 2.94% on the news – this is used to finance day-to-day operations.

On the economic front, the Federal Reserve released their minutes from the September 16 FOMC meeting. These are things we talk about each day, and since the minutes pertain to what occurred largely in July and August it’s a bit outdated, but worth mentioning nonetheless.

• Economic activity decelerated considerably in recent months.
  (Actually, I would re-phrase this. The economy was rebounding pretty nicely. Consumer spending was weak, but the business side of things looked very capable of offsetting this reality – business spending was on the rebound. However, business expenditures came to a halt in the back-half of August after three-months of nice gains. September, even though we do not have the data yet, will surely prove to be very weak as credit conditions locked up and firms either became cautious or saw funding dry up.)
• The job market declines accelerated, according to the Fed.
  (And it got worse in September, which the Fed minutes did not cover. Prior to September the job losses were mild, but moved to a level that is more in line with the typical job-market downturn.)
• Consumer spending has weakened.
  (And we can expect this to remain the case for a couple of quarters. The numbers may appear flat, but adjusted to inflation they will very likely remain soft).
• Inflation rose rapidly in July, but edged lower in August.
  (The Fed has bigger problems right now, but they should be careful with these comments. Inflation remained elevated in August by a variety of measures. The PMI and ISM surveys (factory-sector indices) and consumer level gauges remained high – even if down from extreme elevation. Plus, despite a dramatic decline in energy prices, producer prices rose 9.6% year-over-year in August (latest data) and core intermediate goods – goods excluding energy that go into producing finished product -- accelerated in August to 12.5% year-over-year).
• Credit conditions deteriorated
  (We know this all too well).

And speaking of credit, the Fed reported that consumer credit declined in August for the first time since 1998 – the previous period of credit-market chaos.
Credit by this measure, which includes both revolving (credit cards) and non-revolving (auto loans) fell $7.9 billion in August, or 3.7% at an annual rate. (This data does not include mortgages or home-equity loans).

This reduction illustrates the credit crunch that truly began that month, one wonders how much the figure will contract when the September data is released. Some of this isn’t all that bad as certain aspects of debt need to come down, as consumer credit growth has outpaced the rise in disposable income by eight percentage points since the end of 2002. Not a terribly big deal, but you really don’t want credit outpacing income growth. I think it’s safe to say this game is up for a long time.

Further, in light of all that has occurred, it is safe to say it’ll be a long time before investors take on substantial levels of risk without correctly pricing it in. This of course is a result of monetary policy mistakes as a lot of investors sought extra yield as Fed policy was recklessly easing even as the economy was hitting on darn-near all cylinders – we’re talking about the mid 2003-2005 period. When the history is written the Fed will bulk of the blame for this one.

Downward Pressure

The downward pressure on stocks weighs heavily on everyone. Since hitting an all-time high a year ago tomorrow, the broad market is off 36% -- 20% since September 19.

A couple of things on this:

One, we’ve got to suppose that many understand things have shot well too far to the downside. One looks around and sees an ocean of stocks that offer healthy-to-strong earnings growth (this comment is not based on expectations but on many years of bottom line growth) and trade anywhere between 8-12 times earnings. And look at the indices here and the dividends yields that are offered. The S&P 500 carries a yield of 2.99%; the NYSE Composite carries a yield of 3.92% at yesterday’s closing price; the Dow Average yields 3.36%. These are not only strong yields for entire indices to offer in a very very low interest rate environment, these yields help to boost annual returns for those interested in looking past the current mayhem.

But most do not seem willing to remain invested – and I’m talking about money managers; it’s difficult to explain to clients why they shouldn’t be at 50% cash in this environment; it’s much easier just to sell – as they worry more about their jobs than doing what is right for clients’ long-term perspective. But this is a sprinter’s view; investing is a marathon.

Two, the S&P 500 is back to its October 2003 level, yet the index is still higher by 24% since March 2003. The NYSE Composite is back to its August 2004 price, yet up 43% since March 2003.

You see where I’m going here. This points out that when stocks swing back they do so in a dramatic way. Even when the S&P 500 hit its peak a year ago -- it was up 95% from when the market turned around in March of 2003 coming out of the tough 2002 period – half of that gain occurred in the first 11 months of the new bull market. And I can tell you from memory even well into 2003 there were a lot of people hesitant to step in. Point is you wait for when it feels good and you miss out on a lot.


You don’t sell on panic here; you remain invested, and for the current situation it does make some sense to wait and watch for what the credit spreads signal – when they narrow, that should be a green light to step in with money on the sidelines.

Of course compounding the market’s issues are two presidential candidates that find it easier to castigate capitalism – as if distortions are never supposed to occur – than to offer fundamental solutions. Instead, they should lay blame with the Fed, government policies that demanded more sub-prime lending, individuals that made poor decisions and insane accounting rules and offer solutions such as growth-inspiring tax rate responses, as we touched on in Monday’s letter.

Hang in there and have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks took a beating, even as they pared losses in the final hour of trading, as global equity indices were pounded the night before and that flowed into our trading session. Concerns that the credit market seizure will continue to spread and have larger ramifications than just the typical economic downturn continue to grow.

I’m not willing to share this belief just yet, but we have to get these troubled assets out of the way, or banks will continue to hoard cash. Personally, removing current accounting rules that make zero sense, and in fact results in a death spiral we’re watching play out, would do the trick but apparently not all share this view. As a result, the assets must be removed and housed by an entity that has the resources to hold these assets through the current crisis – and obviously that is government – I’m not one that normally embraces intervention, but in this case it seems very much necessary.

The broad market, as measured by the S&P 500 was down 8.3% at it worst level yesterday but stocks rallied 4.8% from that nadir in the final hour of trading. The NYSE Composite plunged 9.12% with an hour to go, but jumped 5.0% in the final 60 minutes – the index lost $760 billion in market value.


Market Activity for October 6, 2008

This latest decline has sent the Dow Industrial Average back to where it traded in the spring of 2005. The S&P 500 hasn’t seen this level since December 2003 – ouch!

Credit markets remain extremely frozen. As most readers know, the following charts illustrate this point. These graphs show the level of risk aversion in the marketplace – put simply all you really need to know is when they jump to this degree, it ain’t good.

For new readers, the TED Spread is the difference between three-month LIBOR rate (an interbank lending rate) and the rate on three-month Treasury bills. (Banks are charging more as they are unwilling to lend for anything longer than overnight and three-month T-bill yields have plunged as many run for the safety of the Treasury market.



And speaking of the credit markets, we’ve talked about how everything suddenly changed on September 15 when Lehman went down; this is the date credit markets tightened up, and outside of a two-day blip when the TARP plan was initially laid out, hasn’t eased.

For instance, business spending had been on a very nice upswing for three months, but came to a screeching halt in September. Firms obviously have the resources to continue to buy equipment, but a high level of caution has caused a respite.

A prime example of this is SAP AG’s latest earnings report. The software giant had offered bullish comments up until two weeks ago, but yesterday explained that things changed dramatically in the back-half of the month. The firm cited that customers have put orders on hold amid the global financial crisis. The good news is this is not for lack of capital, but credit markets have to free up or activity is going to remain subdued at best.

Another good indication of how quickly things have changed is news Bank of America cut its dividend by 50% after the bell. One can only trust these managers as far as you can throw them these days, but CEO Ken Lewis has been pretty straight up over the past year. The fact that he stated there was not reason to cut the dividend just a couple of weeks ago when they bought Merrill Lynch shows how quickly things have deteriorated within the financial markets

On Fed Action

One reason being given for yesterday’s dramatic sell-off – prior to that late-session rally – is the market had expected a coordinated rate cut by the various central banks and when there was not an announcement of such a plan by mid-day, the market came under intense pressure.

What the Fed did announce is that they will be doubling their TAF (Term Auction Facility) program to $900 billion. This is a new program put in place last December that allows the Fed to accept a wider range of collateral and provide increased liquidity. This is a good step, although it didn’t do much to unfreeze the flow of credit. It’s a step though.

On this topic of a coordinated rate cut by several central banks, I wouldn’t hold your breath. For one, our Fed has tried to bring the ECB (European Central Bank) along on this before and they’ve been obstinately opposed. Secondly, the Fed is now offering interest on deposits at the Federal Reserve – this is what many term quantitative easing. It’s essentially a stealth rate cut.

Banks must keep a required level of reserves with the Fed and sometimes there is an excess amount. Banks will now be paid interest on both required and excess reserves – interest on those excess reserves will be the targeted fed funds rate (2.00%) minus 0.75 on those excess reserves. So, what they have done is effectively moved fed funds down to 1.25%.

This serves two purposes. One, it gives the Fed greater scope to use its lending programs by expanding its balance sheet. They will have more firepower to shoot liquidity to where it is most needed. Two, it keeps a floor on fed funds. (During times of big liquidity injections, such as now, banks are left with excess reserves and thus are willing to lend this money overnight for an amount that is often much lower than the target the Federal Reserve sets – this is why we’ve seen the rate trade at 0.50% on occasion over the past three weeks. See below:


By paying interest on excess reserves at the Fed it sets a floor on fed funds – why lend it out overnight at 0.50% when the Fed is going to pay you 1.25%? Now the Fed is free to pump massive amounts of liquidity without pushing fed funds to levels that would spark inflation – well, at least not as severe as would be the case otherwise. I still believe we’ll have an inflation problem to deal with when things return to normal, but it is obvious that’s a secondary concern right now.

On a more optimistic note, there are some really compelling valuations and opportunities in stock-land – if anyone cares to hear about it in this environment.

There seems to be a marvelous opportunity in energy here; many names in this group are trading at lower multiples than they did in 1998 when oil was $10 per barrel.

Same is true for defense, industrials and medical equipment markers in most cases – awesome opportunities. Same can be said for technology shares.
Of course, we may have to wait a while for these opportunities to result in a sustainable upswing, but patience is key for stock market investing – a reality that has become obvious to all over the past several years.

While diversification is key – one must not abandon positions in many economic sectors and asset classes, stocks in the aforementioned industries may lead the economy once again. We are coming off of a 10-15 year period in which financials led the economy, now that leverage within the industry will move from 30 times to a level that is more appropriate and sustainable the more traditional industries appear positioned to lead the way

Patience will be needed though as locked up credit markets cause quick deterioration and some pretty substantial damage to both domestic and global growth has occured.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks dropped Friday after a wild ride that saw the broad market advance 3.4% during the morning session only to fall 4.7% from that intra-day peak – as the chart below illustrates.

The morning session’s euphoria was based upon the strong likelihood the TARP plan would pass the House, but once it did the benchmark indices fell sharply as the market focused on the September jobs report and the fact that there is no way to prevent a recession at this point. The effectiveness of the TARP plan, along with more traditional policy responses, will determine whether the downturn is mild or severe – more on that below.


The S&P 500’s performance last week was the worst since the 2001 terrorist attacks – the index lost 9.3%. The NYSE Composite – one of the broadest looks at U.S. stocks – fell 10.16% last week, also just slightly less than 11.24% decline the week stocks opened after the 9/11 attacks. People are beginning to realize that the TARP plan is not about “bailing out Wall Street” – as so many in the press have led people to believe – but about stopping the damage from spreading to everyone else, most of whom have lived their lives in a responsible way.

The credit markets remained locked up Friday, but we didn’t expect this to turn on a dime simply because the government’s rescue plan was passed and signed. It will take some time, but as the assets that are clogging things up come off of the balance sheets, things should improve. The extent of the improvement will determine the degree and duration of the downturn.

Market Activity for October 3, 2008
The Citigroup/Wachovia news got interesting Friday as Wells Fargo offered to pay $15.1 billion for Wachovia, or $7 per share. This gets tricky because Citigroup supposedly has an exclusivity agreement that forbade Wachovia from talking to another firm.

Wells clearly saw the TARP plan was on its way to passage and since they would be able to unload the troubled assets of Wachovia as a result, decided to throw in their bid – a far superior deal to botht he shareholder and the government. Under the Wells deal shareholders would get $7 per share (clearly still largely wiped out from where the stock had come from but a major improvement to the $1 per share from the Citigroup deal. Further, the FDIC wouldn’t be on the hook, which was not the case with the Citigroup workout.

Where it seems to stand now is some sort of split up between Wells and Citigroup based upon geographic lines.

On the economic front, the Labor Department reported 159,000 payroll positions were lost in September, which is a figure that is more in line with the typical labor market downturn – prior to this latest number, as most readers know, the monthly job losses had been mild from a historical perspective.

As the chart below shows, we normally see monthly jobs losses that move below the 200,000 level and while September’s data remained above this mark, it’s the closest we’ve come to that level of deterioration thus far.


Year-to-date, the economy has shed 760,000 payroll positions, or 9.5% of the total created since 2003. This is beginning to become significant and considering how locked up the credit markets have become over the past three weeks, one must expect this figure to get worse.

Basically every industry of last month’s employment report looked bad, except – as has been the case throughout this downturn in jobs --, education and health services. These segments have added 451,000 positions year-to-date.

Construction and transportation have been among the hardest hit as the unemployment rates for these two industries jumped from the year-ago period. For construction, the unemployment rate increased from 5.8% in September 2007 to 9.9% currently. The unemployment rate for the transportation industry increased from 3.9% a year ago to 5.8% last month.

The segments (not to be confused with industries) that have been hardest hit are teenagers – where the unemployment rate has risen from 16.0% a year ago to 19.1% and the self-employed – where unemployment has increased from 2.8% to 3.9%,

Overall Economy

In terms of the overall economy, everything has changed over the past three weeks – the turning point was when Lehman went down on September 15; the credit markets froze up.

We’ve gone from a situation in which things were significantly stronger than most had portrayed -- credit continued to flow (of course, less available than before but with much more appropriate standards), business spending had bounced back in strong fashion, factory activity remained upbeat and incomes were rising at a nice clip all things considered -- to an environment where most of these things have shut down. (Income growth remains on a nice trend – although flat in real terms due to high inflation --, but these other aspects have reversed course.)

Now we have job losses picking up to recessionary levels and what appeared to be shaping up as a 2.0% real growth quarter just three weeks back has changed to something flat or worse currently.

Government policy needs to go on the attack both from a perspective of dealing with the troubled assets that have led to the freeze up of credit distribution channels and purely from a framework of economic policy.

The TARP plan has now been passed and signed and if done right, and relatively free from Congressional intrusion, this auction process should work to create a market and pricing mechanism for these assets. We’ll note, while the government is pretty inept at managing just about everything, they are very good at holding auctions and have a good history of the type of auctions that will be held for these assets, from what I’ve learned about the issue. Moreover, they will be able to finance this plan at very low interest rates, increasing the likelihood Treasury will make money off of this plan.

Along with that plan, we must eliminate FASB rule 159 (mark-to-market accounting) especially with regard to the basis of capital adequacy ratios – and the TARP plan does have a provision to look at this and modify it. From here, we must net present value these assets. This will include in the valuation process the cashflows that run off of these assets, something rule 159 ignores.

(We see news broke last night that Europe is beginning to take action as well. They are now providing blanket guarantees on deposits and are looking at doing away with mark-to-market as well. Just to clarify, mark-to-market is used in many circumstances, what we’re talking about here is the appropriate basis with which to determine capital adequacy for financial firms. On this topic, mark-to-market is nothing but harmful.)

On the economic policy front, it’s time to stop playing around and drive tax rates down across-the-board. In basketball terminology, it’s time for “40 minutes of hell.” Cut fed funds further? Please. We’re talking about substantive action here and only tax policy can deliver the big-bang boost that is needed.

I do not express the urgency of this because of the 159,000 job losses for September, but rather because the frozen credit markets will cause this figure to become much worse. Small businesses will be eliminating many more jobs – there is no getting around this for now. What we must thwart is a spiral of job-market deterioration that will ensue if the flow of capital and credit is not freed.

In order to spark activity in the face of current caution with regard to large businesses and lack of short-term credit for the small businesses we must drive down the income tax rates – two-thirds of the top tax bracket is made up of small business – and the corporate tax. Drive these rates lower and you expand after-tax profits, which leads to more jobs and a larger tax base – more government revenue. (The benefit to the private sector would occur very quickly. In terms of government revenues, it will take a year to begin funneling in, but this will result in substantially more receipts that if we were to do nothing in this regard.)

Further, the repatriated tax must be eliminated. This will bring capital that is currently residing overseas to escape this tax to come back home. After a year or so we can get this rate back to 5% or so, but the 35% that is currently levied on these funds is not helpful.

The capital gains rate must at least be halved. Igniting the stock market right now is essential both from the standpoint of confidence and from an overall net worth scenario. It will take some time for the job market to improve again, but by igniting a stock market rally consumer activity will begin to pick up as both confidence and wealth are boosted. In terms of government revenues, this tax rate change will be felt immediately as investors unlock old investments – willing to pay this lower tax – and will move those funds into new investments.

If these actions are taken, we can thwart what a reckless monetary policy has wrought – particularly speaking of the FOMC’s decisions during the 2003-2005 period – and we can escape the worst of this situation. And once we get past this, tax rates and overall policy will be positioned to help the U.S. economy reach its intrinsic growth potential.

I realize this all seems unrealistic at this time. During this election cycle class warfare has hit a crescendo, but as more and more people see how this situation affects everyone, now is exactly the time to propose such measures.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks endured the second 3.00%-plus down day this week as investors are faced with the same concerns that have plagued the market for three weeks now – frozen credit market, the delayed passage of the Treasury’s rescue plan and the likely affect this has had on both the domestic and global economies.

Of the 10 major S&P 500 industry groups, four took a substantial beating – basic materials (-7.67%), industrials (-6.72%), energy (-5.29%) and technology (-4.23%). To no great surprise, all 10 ended the day lower, the best performers being those that traditionally perform well in a down market – health care (-1.12% and consumer staples (-1.10%).

I will add, and we understand it’s tough to see through the fog of pessimism and credit-market troubles, that the market as a whole (as measured by the NYSE Composite) trades at a multiple that is very attractive from a multi-year perspective. Sectors such as industrials, energy and technology are screaming cheap. But patience will be needed for some time still.

Market Activity for October 2, 2008

Credit markets tightened up further yesterday and the develops of the past two weeks, which began when Lehman went down on September 15, have caused corporate short-term borrowing to shrink – this has been the case for several months but the degree of the decline has increased . Commercial paper outstanding tumbled $94.9 billion, or 5.6%, to a seasonally adjusted three-year low of $1.6 trillion for the week ended October 1, according to the Federal Reserve.

Credit is the life-blood of the economy – our economy is all about creating capital and channeling in to where needed. The capital is there – not that much has been created over the past year, but trillions in wealth has been built over the past several years – fear is currently blocking this capital from getting distributed to the areas that need it.

This is what occurs when we’ve had years of mistaken Fed policy and the abandonment of risk-management that followed. When this occurs, the desire to take risk swings from one end of the spectrum (grab all the risk you can) all the way to the other (except none of it). But fears wane and the risk-taking comes back to the middle in time.

In the meantime it is essential to get the Treasury plan approved and signed. And in my personal view it’s time to eliminate, or at least suspend, mark-to-market accounting that is making the situation much worse than it otherwise would be – the rule fails to even make a distinction between noncash-generating assets like equipment and cash-generating assets like securities.. (We’ll note again, FASB rule 157 – mark-to-market – grants the SEC authority to suspend the rule – do it!)

The dollar continues to rebound and has moved through the 80 level, as measured by the Dollar Index, as the ECB (European Central Bank) will be forced to cut rates. They held their benchmark rate unchanged yesterday but the financial crisis has reached another level in Europe and ECB President Trichet acknowledges the risks to growth are mounting even as inflation remains higher than he would like it.


Commodity prices continue to plummet on fears credit issues will substantially slow global growth. We don’t play the game of trading, but simply for illustrative purposes notice how the 50-day moving average has screamed through the 200-day – when a short term average moves through a longer term average it normally means there’s more room to fall.


On the economic front, the Labor Department reported initial jobless claims rose 1,000 to remain at the elevated level of 497,000 – a seven-year high and too close for comfort to the major psychological level of 500,000. Certainly the biggest housing correction in a long time has had a large effect on the figure, but the financial turmoil of late has clearly done additional harm.

There is a silver-lining, however. Much of the rise in claims over the past couple of weeks has been result of Hurricanes Gustav and Ike. For this latest data, the Labor Department states 45,000 in new claims resulted from the havoc created in Louisiana and Texas – more than two million people were evacuated from eastern Texas alone. So if overall claims rose 1,000 even as 45,000 new claims resulted from these weather-related events then there must have been some nice reductions in other states – and yes,36 states and territories reported a drop in claims. Among the 17 states that reported a rise in claims – outside of the Hurricane effect – the damage was due to intense auto industry woes.

The four-week moving average jumped 12,000 to 474,000 in the week ended September 27. We may see this measure ease in the coming weeks as weather-related damage to the figure wanes. Still, this morning’s September job report will likely be the ugliest we have seen thus far in this nine-month labor-market contraction.


In a separate report, the Commerce Department released factory orders for August, which mirrors what the latest durable goods orders and manufacturing data have shown – orders for big ticket items, specifically on the business side (capital spending) have abruptly changed course.

Factory orders fell 4.0% in August and ex-transportation orders were down 3.3%. With the exception of computers and electronics, which jumped 2.0%, every component was down.

Business capital spending fell 2.4% according to this report after the segment had been on the rebound over the previous few months. One hopes the decline in overall factory orders is more a respite after five months of solid gains, but hope is worthless without action. It is difficult to imagine a bounce back when the September data is released due to Wednesday’s weak manufacturing report and significant troubles within the credit markets that have begun to hit small businesses especially hard.



Have a great weekend!


Brent Vondera, Senior Analyst

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