Daily Insight

U.S. stocks fell for the first session in four as concerns over corporate-profit growth (fourth-quarter earnings season kicks into gear next week) outweighed encouraging statements from the Treasury Department regarding bank rescues and talk of some tax cutting within the Obama stimulus plan.

Financials and telecoms led the market lower on analyst downgrades of telecommunication firms and the likelihood of higher default rates put pressure on bank stocks.

Energy and utility shares were the only bright spots, adding 1.36% and 0.72%, respectively. Energy is a great way to at least partially hedge against geopolitical risk, which isn’t going away anytime soon unfortunately.

Besides the Israel/Hamas conflict, Russia has now shut off shipments to Ukraine and that affects much of Western Europe as well. While $50 per barrel oil is not a major issue – after coming from $145 just six months ago – crude is up 40% over the past seven trading sessions. These big swings makes it difficult for businesses to manage, and nearly impossible to hedge, around the issue and that’s the problem.

Market Activity for January 5, 2009

Economic Data

The Commerce Department reported that overall construction spending fell 0.6% in November, following a 0.4% decline for October -- a number that was revised substantially higher from the estimated 1.2% decline reported last month. Over the past year overall construction spending has fallen 3.3%.

Gains in commercial and government building helped to offset weakness from the private residential component of the report, which continues to fall at a substantial rate.

Private residential construction fell 4.2% in November and is down 23.4% from the year-ago period. For additional context, the three-month annualized decline in private residential construction has worsened, down 8.1% for November, compared to -5.5% for October. Public-sector residential construction spending rose 1.4% and is up 7.9% over the past 12 months.

On the commercial side, private nonresidential construction rose 0.7% in November and is up 10.3% since November 2007. This segment is holding up pretty well, but we expect the year-over-year rate to continue to decline, which has been occurring. (Private commercial construction was up 13% year-over-year back in August.)

Public sector nonresidential spending rose 1.4% -- boosted by school and highway construction – and is up 7.8% over the past 12 months.

At some point private residential spending will begin to rise again as it has been declining every month since March 2006, save August 2008. (In August the figure jumped 5.5%, causing many to believe the housing contraction had run its course, but then September followed with its collapse of Lehman Brothers and the credit-market freeze up.)

But housing will rise again. Looking at the annual increases in home prices going back to 2000, it appears we’ve fully reverted to the mean, and in fact may have gone too far. Lower mortgage rates should boost home sales, even as the weak labor market curtails this boost.

As the inventory/sales ratio moves lower home building will resume, but this does not work on a dime and will take a year or more to occur based on what we currently know – and this is more a guess than anything else, there are too many variables to call it with any confidence. Over the next several months we won’t need residential investment to add to GDP, if it only flattens out and is no longer a drag on growth it will be a big plus.

In the meantime the public sector will take over as the next administration is focused on traditional Keynesian-style public works programs.

Tax Cut in the Works

There is talk that the Obama Administration is crafting a plan to offer as much as $310 billion in tax cuts. (These costs that CBO and other assign to tax cuts are generally well off base as it does not take into account that when correctly targeted the Treasury enjoys large windfall over the ensuing years – they employ static analysis instead of the appropriate dynamic type. So we wouldn’t put much credence in the size, hopefully it’s targeted in the right way, which is what matters.)

Anyway, among the business tax cuts being discussed, one is to allow firms to write-off large losses incurred in 2008 and 2009 to retroactively reduce tax bills dating back five years. What this means is that the government will be replacing losses with current-year government spending.

That’s all fine but it does not boost government revenues (which is kind of important right now) or provide longer-lasting incentives, incentives that eventually drive jobs and productivity higher via increased business-equipment spending and higher profits. Tax policy that is longer-lasting in nature provides higher revenues two, three and four years out and thus offsets the higher deficit spending in the first year of implementation.

However, there is talk that something else is being crafted that would offer a longer incentive cycle. Word is they’ll extend the 2008 legislation that increased current-year business spending write-off allowances into 2009 and 2010.

This plan, according to press reports, offers powerful incentives to boost business equipment outlays, which boosts jobs (more workers are required to produce this equipment) and has long-lasting productivity benefits. This plan would also extend the bonus depreciation provision, which allows an additional 50% of the cost of an asset acquired and placed into service this year and next to be depreciated immediately.

This would be big and we should applaud such a move if they do it. However, as they plan to permanently boost the size of government, they should at least make these private-sector incentives permanent as well. Permanence brings the most bang for the buck as certainty makes life much easier for business decision makers and you don’t get this front-loading phenomenon only to see business-equipment spending fall off when the legislation expires.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Long-Dated Treasuries Drop
The curve steepened 15 basis points today to 170 basis points as the 2-year rallied 3/32 of a percentage point in price to yield .77% and the 10-year sold off about one percent to yield 2.48%.

There are multiple factors negatively effecting Treasuries on a broad scale, I will try to touch on a few of them here.

Obama’s stimulus plan will leave the government hungry for cash, thus increasing the supply of Treasuries coming to market. Even with the Federal Reserve increasing its purchases through open market policy, the demand for the paper just doesn’t seem to exist at these yields. The yield on Treasuries, and the cost for financing the stimulus will go up as a result.

Treasuries are beginning to look rich to other markets around the world as foreign investors continue to become a lower percentage of the bidders at Treasury auctions. Over the past month the dollar has weakened 5.15% to a basket of global currencies according to the DXY Index and the CRB Commodity Index is down 45% from June 30th of last year, while gold is down less than 9% over the same period. If these factors draw more foreign investors away from US Treasuries, via a weakening dollar, demand for U.S. Government debt will continue to struggle to find a buyer.

If, or when, depending on who you ask, rapid inflation from excessive easing comes about, it will drive people even further from long bonds. Increasing concerns about inflation can cause large swings in the price of loner dated Treasury bonds. Although they are considered riskless from a credit standpoint, long duration bonds can be very volatile securities, as can be seen by the 3.7% drop in the thirty-year Treasury today.


Cliff J. Reynolds Jr.
Junior Analyst

Afternoon Review

Pfizer (PFE) -0.06%
CEO Jeff Kindler said in this interview with The Financial Times that the company is open to acquisitions, big or small.

Pfizer’s cholesterol drug Lipitor, with sales of $12 billion a year, is expected to encounter stiff competition in 2011 when generic versions hit the market. Kindler said any new acquisitions will be designed to “generate new and diverse sources of revenue growth and cost structures to position us to be strong after Lipitor.”

The article also raises the possibility of Pfizer acquiring Amgen (AGMN) to strengthen its biological medicines by purchasing Amgen, which has developed a range of promising medicines.


Walgreen (WAG) +5.05%
Walgreen said that sales increased 10.8 percent in December and same-store sales rose 4.9 percent in December in the face of challenging retail headwinds. Comparable pharmacy sales increased 8.5 percent in December. The company said that comparable pharmacy sales were negatively impacted by 2.5 percentage points due to generic drug introductions. Meanwhile, competitor Rite Aid said same-store sales fell 0.2 percent.

U.S. drugstores are feeling the effects of the recession as more customers seek cheaper alternatives to prescriptions and other medical items. In addition, prescription drug sales are slowing as consumers skip doses of medicine to reduce their medical costs.

Walgreen is a leader in what is generally viewed as a lucrative industry. The company’s strong cash flow generation should help them remain active on the acquisition front, adding smaller, less traditional businesses to the mix until a better opportunity arises. Walgreen’s strong sales numbers are encouraging and the company appears to be well-positioned for growth once the economy recovers.


General Electric (GE) -2.58%
GE Capital, the lending arm of General Electric, plans to raise $10 billion in the biggest offering of debt backed by the FDIC since the program began. The sale will be split between $2 billion of two-year notes, $5.5 billion of 3.5-year debt and $2.5 billion of 18-month securities.

Today’s offering would put GE Capital halfway toward its goal to “pre-fund” $45 billion in debt that the company plans to refinance this year. GE Capital sold about $12.5 billion of FDIC-backed notes last year.


AT&T (T) -3.37%
Bernstein Research analysts downgraded AT&T to neutral today. The analyst report acknowledges that the company is more recession-resistant than most, but the U.S. recession and saturation of the wireless market will make it tougher to find new mobile customers and will accelerate losses of home phone customers.

AT&T is solidly profitable and recent cost cutting should boost profits over the next couple of years. The company’s debt load remains very manageable relative to the firm’s cash flow and their nice dividend (yielding 5.77%) is in no danger.


Quick Hits

• Obama Said to Push for Tax Cuts in U.S. Stimulus Plan
• Investing Experts Urge ‘Do as I Say, Not as I Do’
  

Peter Lazaroff, Junior Analyst

4Q 2008 Participant Insights

Bear Market Spooking You? That is the question Debra Moran tackles in the most recent issue of Participant Insights. If you haven't seen it yet, it's just a click away!

Click here to view the 4Q 2008 Participant Insights

Daily Insight

U.S. stocks continue to advance, adding to a rally that has brought us 24% above the November 20 low. The broad market added roughly 3% on Friday, brushing aside a very weak manufacturing report to focus on New Year optimism.

The gains came on very light volume and we’ll see how traders react to geopolitical events that have intensified over the past week. Some are suggesting we can jump to the pre-Lehman collapse levels, which would be nice (1260 on the S&P 500) but is highly unlikely with events we face – both inside and outside of the economy. We think 1050 on the S&P 500 is quite possible, but probably not without another move lower. From there is all depends on how geopolitical events unfold, and we remain in a secular bear market so we shouldn’t expect stocks to magically move higher without bouts of weakness.

Also helping the benchmarks advance was a statement out of the Treasury Department that a Citigroup-style rescue package would be used to help other financial institutions if needed – this is a confidence booster for investors.

Many, including us, had assumed this to be the case but the government has been so capricious regarding its decision-making process it has caused additional uncertainty over the financial markets.

Bank preferred shares rallied on the statement as it signals the government will not render these shares worthless in place of new super-senior government securities if some assistance is required.
(The Citigroup plan involved pumping liquidity into the bank and backing potential losses. This too can bring problems down the road, obviously the government can’t back everything, but at least investors can have a little more certainty their positions will not be driven worthless if some assistance is deemed necessary.)

Again, today will be an important one as traders come back from vacation and we see how they react to Israel’s incursion into Gaza, Iran’s call to cut oil exports to the West and Russia feeling things out to possibly do the same regarding Europe.

Market Activity for January 2, 2009

And speaking of oil, prices extended upon Wednesday’s 14% advance, adding 3.7% on Friday. Wednesday’s gain was on the heals of the weekly Energy Department report that showed stockpiles rose less than expected.

On Friday, the price began the session lower after the release of that very weak manufacturing report, which we’ll get to below, but reversed course as stocks gained ground on supply concerns related to the Russia-Ukraine dispute. Crude is up another 1.2% this morning, and looks headed for $50 per barrel. Not a big deal whatsoever, but the issues driving the price higher are.


Economic Data

The Institute for Supply Management (ISM) reported their manufacturing index continued to slide in December, blowing past the 1982 nadir to hit the lowest reading since June 1980. The December reading came in at 32.4, down from an already very weak 36.2 in November.

None of the 18 manufacturing industries surveyed reported growth in December, which is down from 11% for November and October and 33% in September. The ISM stated that based on the historical relationship between the manufacturing data and the overall economy the average readings for 2008 – 45.6 – suggests a 1.4% real annual increase in GDP. If activity for December were annualized it would correspond to a 2.7% decline in real GDP annually.

I don’t like annualizing extreme lows as it is unlikely activity will remain this soft for long; nevertheless, found it worthwhile to mention the comment from the ISM Chairman


All of the sub-indices within the report deteriorated, which isn’t a surprise based on the weakness of the overall survey. However, the degree to which some indices fell, from already low levels, took me by surprise.

The new orders index dropped to 22.7 from 27.9 – remember a reading below 50 marks contraction; the production index hit 25.5 after posting 31.5 in November; the export index came in at 35.5 from 41.0; the employment index hit 29.9 from 34.2 in November.

And it is this employment index that most are focused on considering the state of the labor market. People are looking for clues of a bounce, but they may need some patience as this is unlikely to occur for a few months.


The report in total shows that the recession continued to deepen in December and the forward-looking sub-indices suggest more of the same for January.

This report is going to augment what’s going to be a massive stimulus program, and it will approach $1 trillion. My wish is for a tax-rate response that provides incentive effects to producers and kicks disposable income higher for consumers, but this is not in the cards as politicians are myopically focused on a government spending related response. That’s what we’ve got to go on for now. The goods news is the next administration is considering higher current-year write-off allowances on business equipment purchases. This would be a very smart decision, let’s see if they do it.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries Trade Lower
After three straight days of strong rallying in stocks, the flight to quality trade had a bit of a reversal on the first trading day of 2009. In late trading the two-year was down 6 ticks to yield .86% and the ten-year traded almost two points lower to yield 2.4%. A tick represents 1/32 of one percentage point of a bond’s price.

Attention turns to supply next week when the Treasury plans to auction another $30 billion of three-year and $16 billion of ten-year notes. Most trading desks will be back to full strength next week, as a result we look for liquidity to improve. If investors fail to absorb the new auction supply don’t be surprised to see a real jump in yields come Wednesday and Thursday. On the other hand, the employment numbers that are planned to be released on Friday could disappoint, and bring back the flight to safety trade.


Cliff J. Reynolds Jr.
Junior Analyst

Afternoon Review

December Recap:

Markets rallied in December as governments around the world responded aggressively to the global fallout and investor appetite for risk edged higher. The widely publicized VIX index, a measure of fear in the market, has declined over 50 percent from its November 20 high, which suggests that the fear surrounding stocks has dissipated somewhat and demand for risk-taking increased. Another indication of an increased demand for risk-taking is evident in the S&P 500’s lagging performance compared to riskier asset classes.

While the S&P 500 posted a modest return of 1.06 percent, the S&P 400 Mid Cap Index and S&P 600 Small Cap Index climbed 4.85 percent and 6.10 percent, respectively. Meanwhile, international equities surged with the iShares MSCI EAFE (EFA) climbing 8.88 percent and the iShares MSCI Emerging Markets (EEM) up 10.35 percent. Even more impressive were the returns on REITs, which had been smashed in the prior two months by investors’ preference for businesses that don’t require debt. The Vanguard REIT ETF (VNQ) gained 16.68 percent in December and global REITs increased 10.14 percent.

Most sectors posted gains with the exception being energy stocks. The main culprit for the sector’s poor performance is commodity prices that have plummeted in response to a global recession that has created expectations for decreased global demand. S&P GSCI Commodity Index Fund (GSG), which is about 75 percent devoted to energy with the bulk of that focused directly on crude oil, fell 11.18 percent this month. Greenhaven Continuous Commodity Index Fund (GCC), which tracks an equal weighted basket of 17 commodities, increased 0.64 percent.

The record low yields seen in November were surpassed in December with the two-year falling 21.5 basis points on the month to yield 0.76 percent, and the ten-year fell 70.5 basis points to yield 2.12 percent at the end of 2008. Yields on MBS ended the month flat to Treasuries on a spread basis, after widening out in early December only to snap back in the final week of the year.

The iShares Barclays Aggregate Fund (AGG) was up 6.65 percent due to considerable tightening of credit spreads, the continuing rally in Treasuries and the fund itself moving from a discount to a premium. iShares TIPS fund (TIP) also enjoyed some nice price appreciation as the deflationary scare that hurt TIPS the past two months proved to be short lived.


--

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks ended the market’s worst year since the 1930s on a positive note, rising roughly 4% over the final two trading sessions of 2008. Wednesday’s gains may have been helped by a much-better-than expected reading on initial jobless claims, although continuing claims jumped, honing in on the high point reached during the 1981-82 recession.

More likely investors and traders were positioning for the so-called January effect, the tendency of the stock market to rise in the first week or month of January – the definition is not concrete. I don’t buy into this idea, since it seems to occur largely in up markets. In any event, positioning for the New Year is likely what drove stocks higher.


The benchmark S&P 500 declined 38.49% in 2008, resulting in the first 30% slide since the 38.59% plunge in 1937. There have been just two years that exceeded 2008’s decline -- 1931, when the S&P 500 lost 47.07% and 1937 when the index slid 38.59%. The 1931 debacle followed an 11.91% decline in 1929, a 28.48% drop in 1930 and preceded a 14.78% drop in 1932. So I wouldn’t go comparing what occurred in 2008 to the early years of the Great Depression years just yet.

Most other large annual declines in stock prices were followed by strong upside activity. The slide in 1937 was followed by a 24.55% rise in 1938. In 1974 – which we think is a more appropriate comparison -- the broad market fell 29.72% and was followed by a 31.55% surge in 1975. In 2002, the broad market lost 23.37% and was followed by a 26.38% jump in 2003, a year that kicked off the five-year bull market that saw the S&P 500 rise 77% by the time it peaked in October 2007.

That said, investors will be faced with plenty of headwinds this year. If the economy, not just domestically speaking but globally as well, does snap back and lending activity turns a bit more normal we’ll have an inflationary event on our hands as the Fed is printing dollars like mad. The Fed will then have a choice. Stamp out the inflation by raising interest rates, or ignore it for fear that higher rates will push the cost of money to levels that impede corporate profit growth. And even if the Fed doesn’t raise short term rates, one would think the long end to rise, which will affect corporate borrowing costs, and mortgage rates as well.

If inflation does not rise, it will probably mean that the banking system remains in disarray and lending has not returned to normal, which will also be a drag on equity prices.

The likely scenario, based on what is currently known, is that we will rally from these levels, but then run into some trouble a few months later as the previous concerns arise.

There are positives, however – as long-term readers know I do not enjoy this tone of pessimism.

Fed stimulus, fiscal stimulus, trillions in cash on the sidelines, very low gasoline prices and very low mortgage rates should help out. In addition, U.S. businesses are very streamlined these days; inventory levels are much lower than normal heading into recession and that will help to ease the duration of the downturn (less goods to sell off before production ramps up again) – so long as government policy mistakes don’t work against this private-sector efficiency.

But back to last year, if you thought it was a rough year for the U.S. market, it was worse for most overseas bourses. Overall, international stocks within developed markets fell 45.09%, led by a 42% decline in the Nikkei 225 (Japan). Emerging markets got hammered, losing 54.48%, led by a 72% in Russia’s main index.

Jobless Claims

The Labor Department reported initial jobless claims fell 94,000 to 492,000 in the week ended December 27. That’s a very big decline and the first time since October initial claims have moved below the 500k mark. While this decline is very welcome, most of it was likely due to the seasonal adjustment as the week covered the Christmas holiday. The unadjusted level of first-time claims fell only 2,000. Additionally, some suggested winter storms prevented people from filing. We’re not sure of the extent this may have played, possibly government offices closed down as a result.

The four-week average of claims fell 5,750 to 552,250.


Continuing claims jumped 140,000 to 4.506 million in the week ended December 20 – there is a one-week lag between initial and continuing claims data. Continuing claims are closing in on the 1982 peak, but as we’ve touched on many times now, this level of continuing claims is not nearly as bad as it was back then when payroll employment stood at 88 million; today that figure is 136 million, so that context is important. Nevertheless, this high level of claims illustrates labor market conditions are very weak.


In terms of the December payroll survey (job losses for the month), we look for another big decline, maybe another 500,000, as the previous jobless claims reading hit a 26-year high. That previous reading was for the week that corresponds with the December payroll reading – the Bureau of Labor Statistics defines as unemployed those persons who didn’t work in the week of the monthly employment report.

It’s too early to tell, but if I had to throw a guess out there, we should expect the monthly job losses to ease over the next three months. The job market lags the overall economy, so the labor market will remain weak for even after the economy rebounds (although the type of stimulus the Obama Administration will implement will give jobs a short-term boost) but we should see the degree of decline level off by late spring.

Russian Revanchism and Energy Supply Threats

The Russian economy has been hit exceptionally hard as global growth wanes, oil prices have plummeted (they’re economy is heavily dependent on oil revenue) and the ruble continues to get crushed and will very likely slide further. GDP trends will reverse, from growing 6-7% over the past few years to contraction.

As a result, the Russian populace will become increasingly perturbed and the number of demonstrations will rise. The regime has already countered by expanding the definition of treason (endangering order as they define it) and punishable by up to 20 years in prison. The riot police will be cracking down in force.

In order to take the citizens’ minds off of their eroding circumstance one should assume they’ll seek to reclaim former Soviet satellites, much like the conflict with Georgia last summer. Propaganda will increase to foment anti-American/anti-Western ideology. Further, as the WSJ pointed out last week Russian authorities have rewritten the constitution to grant the president 12-year consecutive years in office. They point out that current President Medvedev will take the fall for the ailing economic state to usher in Putin’s return.

This will likely become quite problematic and the Obama Administration will need to remain on top of things. Over the past couple of days, Russia has cut off gas supplies to Ukraine and threatens to extend this action. This does not only affect Eastern Europe but Western Europe as well. For now, natural gas supplies are well built, so this action by the Russians does not harm energy requirements in the near term, but it is a concerning indication of how Putin and Co. will roll over the next few years.

The West needs to get off of its environmental concerns and think much more logically by increasing energy production. This is serious stuff. We also need to dramatically expand nuclear energy capabilities, which is extremely clean energy production and should be embraced whether you believe in anthropogenic climate change or are more concerned from a national security perspective.

Have a great weekend!


Brent Vondera, Senior Analyst

Afternoon Review

Spotlight: Transocean (RIG) *updated tearsheet attached*
Two weeks ago, I mentioned that Transocean may have some near-term selling pressure following their approval to change the place of their incorporation to Switzerland and their subsequent removal from S&P 500 and the Russell 2000 indices. Transocean tumbled more than 26 percent in the seven trading days following the decision, and today trades at just more than three times earnings (the company’s has typically traded between 12 and 15 times earnings).

Also fueling the share price meltdown was CEO Bob Long’s comment last month that deepwater projects need $60-a-barrel oil to be economic. With oil hovering around $40-a-barrel, fears have grown that projects may be canceled. However, this is not a valid concern for Transocean since only 1 to 2 percent of their contracts can be canceled by client termination, and those particular contracts contain day rates far below market rates.

The deep-water market is positioned to expand substantially in coming years because of large deep-water discoveries, and Transocean has positioned itself as the prime beneficiary. The company’s $41 billion backlog (nearly three times its current market capitalization) and orders extending out to 2020, provide stability for the business and nice visibility into the future.

Noble (NE) is will likely be the next driller to change the place of their incorporation to Switzerland, and thus will be removed from the S&P 500 and Russell 2000 indices as well. Though much smaller than Transocean and less leveraged to the deepwater market, Noble’s $12 billion backlog (double the company’s current market capitalization) gives revenue visibility out to 2016. About 88 percent of Noble’s business is with national oil companies, giant public firms and large independents, thus the risks of customer financing issues are low.

Noble also provides engineering and consulting in addition to contract drilling services, giving the company a diversified revenue stream. Noble is contracted to build the largest ultra deepwater drill ship to be put into service in 2011, for $585 million. Out to 2011-2013, the deepwater market will become a larger proportion of Noble’s revenues, which should allow them to maintain wide margins.


Quick Hits

• Tallying the Trillions in Bailouts to Bankruptcies
• The Deals and No-Deals of 2008
• VIX Declines Below 40 as ‘Sheer Panic’ on Wall Street Recedes
  
  

Peter Lazaroff, Junior Analyst

Fixed Income Recap

Treasuries Rally
U.S. Treasuries were higher across the board today on thin trading, despite the gains in the stock market. The two-year ended the day at .73% while the ten-year closed at a yield of 2.06%.

The yield curve has steepened 9 basis points this week to 179 basis points, after flattening considerably over the last month. Like stocks, Treasuries continue to be range bound in an environment where volume is very light and most desks are waiting out the end of the year.


Fed MBS Purchasing Program
Goldman Sachs, Blackrock, PIMCO and Wellington Management were announced as managers for the Federal Reserve’s $500 billion MBS buying program. Actual purchases are expected to start in early 2009 and be completed by June. Only, Fannie Mae, Freddie Mac and Ginnie Mae fixed-rate mortgage-backed securities are eligible for the program.

The market has already begun to price these purchases in, which has significantly lowered fixed rate mortgage yields over the past few weeks. The market is hopeful that the demand from the Fed will spill over to new mortgage originations and continue to re-establish confidence in the overall mortgage backed securities market.

Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks managed some nice gains on very light volume yesterday, brushing aside manufacturing data that showed activity within the sector remained very weak and housing data showed price declines accelerated in October.

The news that the lending arm of GM will receive $5 billion in TARP funds (at a cost 8%) likely helped the indices advance. While bankruptcy is the best path to viability for the Detroit Three, the market probably doesn’t want to contemplate the ramifications to an already weak labor market that would result.

We’ll note the dire predictions that an additional three million workers will be thrust into the unemployment rolls are a bit hyperbolic; nevertheless, such an event would cause the unemployment rate to jump. Re-organization is a necessary condition to get GM, Chrysler and Ford streamlined for the future, but the marketplace doesn’t want to deal with this reality right now, so stocks get a short-term boost on news of government-assistance.

Unfortunately, the rally in stocks was not accompanied by a decline in Treasuries. We’ll really need to see some money come out the Treasury market as this will signal an easing in risk aversion. So long as money continues to hide under the Treasury market rock, it’s tough to get too excited.

The goods news is intraday swings have become much milder, so we may have entered into this feeling out process, as we’ve termed it – a period in which the market determines which way it wants to go after a serious plunge, such as the 40% slide in the two months that ended November 20. During the 1974 bear market a similar period of relative calm ushered in a powerful rally.

Many seem to believe a robust rally will come in January. We’re not so sure as the de-leveraging event may have not yet fully run its course. The Middle East is also heating up, which won’t help things. Based on what is presently known, we do believe a powerful bear-market rally is on the horizon, but may have to wait a few weeks still. It’s impossible to time.

Market Activity for December 30, 2008

U.S. stocks are headed for their worst year since 1931 as things fell apart when Lehman went down on September 15; the event roiled the money markets and caused the overall credit market to freeze up. The following chart of the S&P 500 Index shows what has occurred from the peak hit in October 2007. It took us basically a year to fall 20% from that peak, but prices began to plunge in the third week of September.


Economic Data

The S&P Case/Shiller Home Price Index, a gauge of the largest 20 metro areas in the U.S., posted its largest decline yet in October.

Case/Shiller recorded home prices fell 18.04% on a year-over-year basis. As you can see via the table below, the most significant damage continues to occur in the West, although Miami, Detroit, Tampa and Minneapolis also continue to see exceptionally large declines. This home price index has values down 23.4% from the peak.


We’ll note, as long-term readers know, that this gauge is not a broad representation of what is occurring nationwide. The FHFA (Federal Housing and Finance Agency) offers the broadest measure of home prices. This measure has home prices down 10% from the peak hit in early 2007 (the exact time of the peak depends on the gauge). This measure also has its flaws though. Where Case/Shiller is not a broad index, and subject to a number of cities that saw the greatest speculative fervor at the height of the housing euphoria, the FHFA index fails to cover high-end homes.

In our view averaging the four main home price measures, the two just mentioned along with price data from the new and existing home sales figures, offers the best look at what prices in general have done. This shows average home prices are down roughly 16% from the peak.

For a longer term perspective, home prices in generally are up about 35% since 2000. That means home prices have grown about 3.4% annualized, which is slightly below what I believe to be the long-term average of 5%.

The decline in home prices has been a harsh reality; however, it is a necessary condition to bring sales back. It appears the process of reversion to the mean has run its course, in fact may have moved beyond what is justified. This does not mean prices will bounce back over the next couple of months, we do have a weak job market to contend with, which is the more traditional drag on housing. Nevertheless, we may be very close to the bottom.

In a separate report the Chicago Purchasing Managers Index (PMI), which measures factory activity in the region, edged slightly higher from the prior month’s depressed reading.

The overall activity index came in at 34.1 after posting 33.8 in November – the weakest readings since the spring of 1982. A reading of 50 is the line of demarcation between expansion and contraction.

(For context, Chicago-area manufacturing showed activity expanded 54 of the 55 months that ended in February 2008, which marked the longest run in the survey’s history. In February the index contracted mildly, but bounced back July-September as business spending accelerated. Things collapsed though beginning in October as the credit event caused businesses to cancel spending projects when the credit markets froze up.)


The new orders index moved up to 29.4 from 27.2 last month, while production fell to 31.7 from 34.3. The employment index rose nicely to 39.6 from 33.4; however this level still represents a significant decline in manufacturing jobs. For new readers, these are the sub-indices of the overall report.

Nothing in this report offers an indication the nation’s largest manufacturing region in on the verge of a rebound. The next reading on factory activity comes on Friday via the ISM survey (manufacturing activity for the entire nation).

The US Dollar

The greenback has given up much of the gains recorded in summer and fall and will very likely take a beating in 2009 as the combination of the Federal Reserve’s massive liquidity injections pumps more dollars into the system and the government’s spending spree will cause budget deficits to soar. And we’re not talking about deficits the media has harped on over the past several years, those were child’s play, extremely manageable levels that ran 1.2%-4.0% of GDP. No, the deficits that the government will record for 2009 and 2010 will hit $1 trillion plus, or more than 7% of GDP.

Last spring, the Dollar Index (DXY) hit the very low level of 71 but rallied beginning in July as it benefited from a flight to ultra-safe investments such as Treasury securities. Now though with yields at record lows, that money may move to other currencies, or more likely gold as the safety trade moves to this hard asset. We’d look for, as much as it pains us to say it, the DXY to return to the lows we saw in mid 2008.


This morning we get initial jobless claims for the week ended December 27, a day earlier than usual due to the New Year’s holiday.

Have a great day and happy New Year!


Brent Vondera, Senior Analyst

Afternoon Review

Spotlight: General Electric (GE) *contact for updated tearsheet*
On December 18, S&P cut the outlook for GE to negative and gave the company a 1-in-3 chance of losing its top grade within two years. This announcement came one day after GE’s investor presentation, which suggested that the company’s AAA credit rating could be sacrificed in the name of the dividend.

This does not mean that GE has completely given up on maintaining its top rating. GE plans to shrink GE Capital from 50 percent to 40 percent of total profit. Even more, the company plans to issue $45 billion in long-term debt in 2009, less than the $66 billion it has maturing, and to reduce commercial paper to $50 billion, less than the $75 billion they had planned before.

Bloomberg ran this article today, which showed that the gap between bonds rated AAA and those three steps lower, at AA-, averaged a record 1.12 percent in December as the credit crunch deepened. Before credit markets began unraveling 16 months ago, the difference averaged about 0.06 percent. Insert GE as an example, and an extra percentage point in interest would have cost the company $233 million more in annual payments on the $23.3 billion they raised in the bond market in the first half of 2008.

Despite the increased borrowing costs, shareholders should be pleased with GE giving priority to the dividend and future earnings growth instead of their credit rating. If GE decided to do the opposite, they would be forced to focus on raising capital by selling business units or forgoing opportunities that would benefit the company in the long term.

The financial crisis has called into question the balance sheets of even the most creditworthy institutions. Consequently, GE’s valuations are at multi-decade lows.
With a recent capital infusion as well as government loan and guarantee programs, GE Capital’s funding position appears stable. In addition, strong cash flows are expected from GE’s industrial businesses, enabling the company to maintain its current dividend through the end of 2009.



Quick Hits

• The Financial Crisis Timeline
• GMAC Adds Loans as U.S. Injects $6 Billion to Aid GM
• Billionaire Blowups of 2008
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks fell on concern merger and acquisition (M&A) activity will continue to slow after Dow Chemical’s deal to sell half of its plastics unit to Kuwait was canceled. The funds were slated to help fund Dow’s $16 billion purchase of specialty chemical firm Rohm & Haas. The deal would have provided Dow with $9 billion.

The fact that M&A activity will continue to slow in the current environment is obviously not of great surprise, but the market still comes under pressure each time investors are reminded of this fact.

Kuwait’s decision to pull out means the Dow acquisition is much less likely and this has larger ramification for the market in general as it illustrates the problems related with funding deals right now. Kuwait’s issue was not from a financing perspective so to speak but rather the 75% plunge in the price of oil has them reigning things in. Nevertheless, it keeps the issue in the back of investors’ minds, adding just another concern tugging at sentiment.

Dow shares slid 21% as the failure to sell part of the plastics unit may put the dividend in jeopardy. Most people own the stocks for the dividend. The company will now try to re-negotiate the R&H purchase, probably attempting to shave 10%-15% off the original purchase price. R&H shareholders will likely do the deal at the lower price as they will have a rough time finding other bidders for a while and a price of $70 (original deal was set at $78 per share) is suddenly looking pretty darned good.

For the market in general, the goods news is major indices pared earlier losses. The S&P 500, for instance, was lower by nearly 2% when the afternoon session began, but a late-session rally erased most of those losses. Still nine of the 10 major industry groups lost ground. Energy shares gained ground as the Middle East heats up, pushing oil prices higher.

Market Activity for December 29, 2008

Interestingly, the rally in crude prices early yesterday morning fizzled just after stocks opened yesterday – the spot price jumped nearly 7.7% in pre-market trading but gave most of those gains back by lunch.
However, crude rallied again in the afternoon session to close the day up 6.13%.


They’re a Bank!

Last night it was reported that GMAC will get $5 billion in TARP funds in exchange for super-senior preferred shares yielding 8% to the Treasury Department. GM will get another $1 billion that is supposed to help them finance the lender’s (GMAC) reorganization as a bank holding company – so I guess they got the TARP money before they were officially in a position to be called a bank holding company. That’s what you call making up the rules as you go along.

So GMAC gets $5 billion, GM get $1 billion, which is on top of the roughly $7 billion they received earlier in the month. Maybe this will get GM through the spring. Isn’t that grand?

Some were saying without the TARP funds GM would be forced to eliminate 40% of its 6,500 U.S. dealerships. Yeah, that’s what’s going to occur anyway in time as the GM model pretends as if they still enjoy 50% market share when in reality it’s below 20%.

GM has too many dealerships, too many assembly-line employees and a compensation and layoff structure that makes zero sense in today’s highly competitive world. The checks will fly as the 111th Congress rolls in, but it won’t do a darn bit of good in terms of viability until the firm is forced to streamline

Cash Galore

A story ran yesterday explaining that $8.85 trillion currently sits in bank deposits and money-market funds, which is equal to 70% of the market value of U.S. stocks as measured by the NYSE Composite.

This is a theme we’ve touched on for a couple of months now, yet we focus specifically on money-market funds as this is a more natural area for cash to flow into equities.

Logically, bank deposit accounts are higher as households increase cash savings after the stock market has gotten crushed by 45% (from the October 2007 peak) and home prices are down roughly 15% on average – these are the two largest savings vehicles for U.S. residents. As those savings vehicles have declined people have chosen to boost cash savings and I’m not sure this money should be included among the funds that will potentially move to stocks any time soon.

Still, specifically regarding money market funds there is $3.8 trillion in cash, which could theoretically by 48% of the S&P 500.


Of course, this money needs a compelling reason to enter the market, and with concerns heightened right now it may take a little while to flow into stocks. Once we get a couple of months out and the Obama stimulus plan begins to get off the ground, we should see these funds seek some risk -- the market is cheap from both an earnings-multiple standpoint and a dividend-yield perspective, especially compared to rates along the Treasury curve.

This is one of those rare occasions in which the investor can pick up shares at prices that offer superior long-term returns – December 1974 is probably the last time such an opportunity presented itself. However, over the short term things will remain highly precarious.

We’re not at all convinced a rally from these levels, whenever it happens, will have sustainability however (talking months not years) – the market will need to see concerns ease over future trade pacts, tax rates, how the Fed is going to deal with eventually removing some of the liquidity it’s pumped in and the degree to which regulations will increase, among other things. But the cash is available to spark a rally and as this occurs it should remove some of the caution currently in the marketplace and bring with it a bit of optimism.

It’s a crisis in confidence that needs to be addressed, which is why a tax-rate response could go very far in building optimism as it would spark a stock market rally as quick as anything can. However, this does not seem to be in the cards (ok, it’s not at all probable) considering the make up of Washington after January 20. The policy that will be put in place over the next few months is all we have to go on right now.

Economic Data

We’ve had a couple of quiet days in terms of economic reports, but get back to it today with the S&P Case/Shiller Home Price Index (October) and Chicago-area manufacturing activity. Tomorrow we get initial jobless claims for the week ended December 27 – a day ahead of the normal schedule as Thursday is a holiday.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

Spotlight: 3M Company (MMM) *contact for updated tearsheet*
3M’s highly diverse business portfolio, healthy international mix, continuing commitment to R&D and an intensive focus on productivity has contributed to the company’s high profitability and strong cash flows.

Considered a highly reliable barometer of the general health of the economy, 3M stock has fallen in tandem with the market. However, 3M has historically turned crisis or recession into opportunity by utilizing its very solid finances (currently almost $3 billion in cash) to buy quality companies at low valuations.

3M generates significant free cash flow and has plenty of financial flexibility to continue to invest for organic growth, concurrently still pursue business portfolio realignment activities and also reward shareholders materially.


Dow Chemical (DOW) -20.79%, Rohm & Haas (ROH) -16.08%
Dow’s acquisition of Rohm & Haas hit a major snag as a Kuwait backed out of a deal in which a state-owned petroleum company was to pay Dow $7.5 billion for a 50 percent stake in several chemical plants. The deal was to become effective in less than a week, and Dow had intended to use the money to help finance its $15.3 billion purchase of Rohm & Haas.

Kuwait’s decision is a result of significantly lower energy prices compared to when the deal was struck about one year ago, making the deal less attractive. The deal would have given Dow much needed access to low-cost natural gas, which they consume in huge quantities to make its chemicals.

In July, Dow offered $78 per share for Rohm & Haas in an $18 billion deal, but Dow is coming under pressure from lenders and shareholders to renegotiate its offer price in light of the current situation. For years, Dow has been trying to reposition itself, moving away from producing low-margin commodity chemicals and into the higher-margin specialty chemicals business. These events present a major setback for Dow’s plans.



Quick Hits

• Democrats May End Minimum Tax on Municipal Bonds to Spur Market
• Cash at 18-Year High Makes Stocks a Buy at Leuthold
  
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks gained additional ground on Friday, extending upon the market’s Christmas Eve advance to mark the first back-to-back gains in three weeks. The broad market, as measured by the NYSE Composite, now stands 19% above the five-and-half year low hit on November 20. The S&P 500 is roughly 16% above the November 20 close, which was a six-year low for that measure.

Energy shares led Friday’s advance as Middle East tensions heat up to drive crude prices higher. Basic materials also performed well with industrial and consumer discretionary shares helping the benchmark indices as well.

Market Activity for December 26, 2008

We were without an economic release on Friday, and absent one today also. Trading activity is also subdued as many take the final few days of the year off and have probably accomplished most or their end-of-year positioning and tax-loss harvesting. Nevertheless, there is still plenty to talk about.

Lending and FASB No.159

Government officials continue to state that they want banks to make more loans, yet they fail to pull the correct strings. The government’s unwillingness to suspend mark-to-market accounting rules with which to base capital adequacy ratios (officially FASB rule159 put in place November 2007) is one of the major reasons their pleas are being ignored.

Mark-to-market is a reason banks have halted lending as the accounting change carries elevated write-down risk. Make no mistake, we’re not ignoring the fact that falling asset prices and rising default rates are playing a role, but based on the former standard the seemingly endless write-down cycle would not be occurring and thus affecting capital adequacy is such a pernicious manner. (We’ll add, this rule is just as harmful in a rising asset-price environment as it would encourage firms to hold less capital.)

Another issue is how the Treasury has changed the TARP, using the funds to inject capital into banks, rather than buying up “troubled” assets. The original plan would have allowed the government to house those assets – removing them from bank balance sheets -- until the market returns to normal and can then be sold at prices that more closely align to intrinsic value rather than distressed price levels that currently have little if any bids coming in. Changing the plan was a big mistake in my view as the decision does not address that which has firms so fearful.

The idea to inject capital assumed that banks would increase lending activity as they would be able to withstand current asset write-downs with these additional funds. However, as banks increase loans obviously they’re taking on more loan assets, assets that are subject to huge write-downs even if the institution has zero desire to sell the asset and the asset is producing cash flows. This is what the capital injection plan misses. So long as mark-to-market instructs that banks continually write-down assets in this distressed asset-backed market banks will simply hoard the cash, as they are doing.

In the meantime, the Treasury and the Federal Reserve continue to target housing in a very circuitous manner. The various Federal Reserve facilities (while some have worked quite well) and Treasury Department programs that have been implemented make the government even more the Rube Goldberg machine that it always has been than and entity that efficiently attacks the issue – an endless cycle of write-downs and capital raises that cause banks to become increasingly cautious.

We must allow the housing correction to run its natural course, reverting to the mean after years of outsized growth – in terms of both credit and prices. What we must attack is that which has exacerbated the painful process of reversion – the accounting change. By eliminating mark-to-market, specifically with regard to basing capital adequacy ratios, and returning to the original cost model banks will not have this incessant capital-eroding write-down problem and lending, while remaining logically subdued, will increase from these very low levels of activity.

Gold and Oil on the Run

Gold prices have rallied 4% the past two sessions as Middle East tensions rise again. Concerns of an inflationary event over the next 12 months may also be playing a role as the metal has jumped 15% since December 5.

Normally gold has to compete with interest paying assets but with Treasury rates so low, in fact non-existent on the short end, we’ve got money flowing into the hard-asset safe-haven once again. The price of gold has been surprisingly held back considering all that has occurred.


Oil prices have also found some life, jumping 6.7% on Friday and up another 7.7% this morning as Israel attacks the Gaza Strip, which is where Hamas’ second favorite weapon, Katyusha rockets, are being fired.

This back-to-back rally in crude is pretty meaningless relative to the 75% plunge over the past five months, as the chart below illustrates.


Still, as things heat up in the Middle East especially if Iran gets involved via its proxy Hezbollah, the crude trade may have some staying power -- too early to tell just yet.

In any event, Middle East tensions are not going away and when you combine geopolitical risks with the massive liquidity injections via the Fed (causing an inflationary event when lending begins to increase) we find it hard to believe oil will stay at these levels for an extended period of time.

Friday’s Letter

I went back and read Friday’s letter to notice I rambled on there in the first half while talking about short-term equity-market trends – accept my apologies for the complete lack of brevity.

A much better way to deliver the point is to say we believe there’s a heightened potential for a strong bear-market rally to occur. Although, I’m not convinced it will happen in January as many seem to be predicting. The de-leveraging process has probably not yet played out, so we may have to wait until February/March for a potential spike.

Certainly, there are many concerns tugging at investor sentiment. Indeed, there are a number of issues on the horizon as well. However, as the de-leveraging process runs its course, a spike from these levels is likely in our view.

What’s more, rallies are typical after sharp dives in equity prices such as the two moves we endured in October in November.

Have a great day!



Brent Vondera, Senior Analyst

Fixed Income Recap

Mortgage Refinance Applications Highest Since 2003
The Mortgage Bankers Association reported a 62% increase in refinance applications for the week ending December 19th to 6,758 applications, on a seasonably adjusted basis, from 4,156 the week prior. However, the number of actual refinances resulting from the applications remains to be seen.

The capacity for banks to lend is very constrained, 1 in 5 homeowners are under water on their mortgage (although appraisals may be waived later), and the market’s appetite for securitized mortgages remains thin. These factors point to a refi-boom less than that of 2003, where applications peaked at 9,977 the week ending May 30th.

Nonetheless, Bloomberg consensus speeds, which are the benchmark models for estimating individual prepayment characteristics of a mortgage backed security, have been revised aggressively, and likely have farther to go. As refinances increase and prepays speed up, MBS shortens as principle is paid back to the bondholder sooner.

As I have noted before, times of heavy refinancing reward those who avoid high coupon (high premium) MBS and stick to dependable structure in CMOs. We have been selective in buying MBS and have stayed away from this type of paper.

Cliff J. Reynolds Jr.
Junior Analyst

Afternoon Review

AT&T (T) +0.40%, Wal-Mart (WMT) -0.16%
Wal-Mart Stores (WMT) will start selling Apple’s iPhone on December 28 in almost 2,500 U.S. stores to bolster its offering of consumer electronics. A partnership with Wal-Mart brings the iPhone to the world’s biggest retailer, building on a deal Apple made in September with Best Buy, the largest U.S. electronics chain.

Wal-Mart’s customers can be seen as the average American, and it appears that Apple hopes Wal-Mart will help the iPhone go mainstream. While it is highly unlikely that the iPhone will control the market the way iPods control the MP3 player market, Apple will likely see its smartphone marketshare grow.

AT&T should reap the benefits of new customers buying iPhones, and thus switching to their network. Increasing the number of current customers using smartphones would provide AT&T with a boost since smartphone customers tend to have higher monthly bills.

By carrying the iPhone Wal-Mart continues to build its reputation as a consumer-electronics destination. The company’s 3,000 U.S. supercenters and discount stores have improved displays and given more space to Sony Corp. flat-panel televisions, Dell Inc. laptops and other electronics in the past year to spur sales.

Eli Lilly & Co. (LLY) +0.48%
Lilly signed a $497 million licensing and development agreement for BioMS’s dirucotide, potentially the first treatment for advanced forms of multiple sclerosis to come to market.

Lilly faces the possible loss of more than half of last year’s revenue when patents on its top-selling drugs – Zyprexa, Cymbalta, Gemzar and Humalog – expire by 2013.

In mid-2009, BioMS will hand off dirucotide to Lilly so it can complete clinical testing and eventually sell the product. At any time during testing, Lilly can break its agreement with BioMS, which has no other drug in its pipeline.


Quick Hits

• Pawn Shops Lead China Small-Business Loans as Bank Credit Wanes (Ok FCFS, time to go to China)
• Rail Takes Back Seat as States Target Obama Stimulus for Roads (St. Louis is the article’s first example)
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks gained some ground in a holiday-shortened session on Wednesday, halting a two-day decline. Better-than expected economic reports helped the major indices advance.

We’re headed for the worst annual performance on the S&P 500 since 1931 (although I’ll add that the 47% decline that year followed a 28.5% decline in ’30 and a 12% loss in ’29, so the current move is more in line with the 1973-1974 period – down 47% combined – than the years of the last depression. This year’s performance will end a five-year winning streak).

In any event, we may find a rally here in the final four days of the year as tax-harvesting may have run its course. Still, mutual fund managers will want to show high cash balances for quarterly statements, so any gains should be subdued.

Reports on personal spending and durable goods orders, while weak, came in above expectations. The durable goods report showed business spending actually rose 4.7% last month and that helped sentiment.

Market Activity for December 24, 2008

The equity markets have meandered for three weeks now, but at least the moves have been relatively subdued. We have given back a quarter of the 20% rally off of the November 20 multi-year low but that leaves us 15% above that mark. The market appears to be in a feeling out process; no one knows which way things will go but based on similar bear markets – for instance the 1974 bear – there’s a good chance we’ll rally from here.

We may test those lows again, but the de-leveraging event has pushed us below where we should be from a fundamental perspective. For sure there’s a lot of bad news out there, but with the NYSE trading at 13 times trailing earnings with a 4.54% yield (remember the 10-year Treasury carries a 2.16% right now) and the S&P 500 trading at 14 times the consensus estimate for trough earnings (generally the trough earnings multiple is significantly higher than this) stocks have the bad news, and then some, priced in.

Stocks will have to face additional tough forces over the next year – higher regulations, the prospect of higher tax rates, what I believe will be an energy policy that is not conducive to growth, a likely inflation event that will force the Fed to substantially raise rates and will drive long-dated Treasury yields much higher and a new president that may be tested by Islamic radicals, just as the prior two were just months into office – hopefully changes over the past seven years have helped us thwart attacks.

However, we’re trading at very low levels right now and a nice rally is warranted. Further, if any of the stated concerns do not come to pass, stocks will respond positively as a result. Still, without a tax-rate response to the current issues, it is unlikely the next couple of years will be an easy ride. An economy has never spent its way out of a problem and we’re guessing without a reward for success and measured risk-taking (by driving tax rates lower on capital and income) we’re not going to prove history wrong this time.

The government crammed in a bunch of economic releases on Wednesday, some of which would have normally been due out yesterday, so we’ll touch just briefly on each one to keep from getting too long.

Mortgage Applications

The Mortgage Bankers Association’s index of applications to buy a home or refinance a loan rose to the highest level since 2003, jumping 48% in the week ended December 20. The groups’ refinancing gauge rose 63% and purchases gained 11%.

The average rate on the 30-year fixed-rate mortgage dropped to the second-lowest level on record. Let’s hope these rates are low enough to at least partially offset what has become an additional drag on the housing market – a weak labor market.


Durable Goods (November)

The Commerce Department reported that durable goods orders fell 1.0% last month; however, the reading was much better than expected as a decline of 3.0% was anticipated. We’ll note the revision to the October data was revised downward big time, coming in at -8.4%. Significantly lower than an already large 6.2% decline previously estimated.

The ex-transportation reading on durables actually increased in November, rising 1.2%. This is a big surprise and, even if it’s off of a horrible 6.8% drop in October, should be viewed as a good sign.

Non-defense capital goods ex-aircraft, a proxy for business spending within the report, rebounded in November, up 4.7%. However, for the quarter this segment is down 21.6% at an annual rate. A huge reversal from what we saw in the second quarter and first-half of the third as the figure was up 15.25% at an annual pace. This shows how quickly things changed in mid-September.

Overall, for the first two months of the fourth quarter total durable goods are down 41.6% at an annual rate, which puts orders on track for one of the largest quarterly declines ever. The intensification of the credit crunch, the Boeing strike and Hurricane Ike (which made landfall last quarter but affected the first month of this quarter) have combined for the perfect storm to hammer durable goods orders and manufacturing and industrial production in general.

Personal Income and Spending

The Commerce Department also reported that personal incomes fell 0.2% in November, marking only the second monthly decline in the past three years.

So, we’re beginning to see some meaningful deterioration in incomes as the year-over-year reading has dropped below 3.0% -- it came in at 2.5% from the year-ago period for November. Compensation was up just 1.7% in November. The wage and salary segment was up 1.5%. Proprietor’s income fell 1.7%. These are year-over-year readings.

On the positive side, dividend income, while down from high single-digit growth six months back, has held up pretty well, up 3.6%. (The decline in financial-sector payout rates has put pressure on the figure). Rental incomes continue to soar, more than doubling on a year-over-year basis as the housing market correction has fueled rental occupancy rates.

Personal spending fell 0.6% in November, marking the fifth-month of decline -- although, the drop last month was less than estimated. That’s on a nominal basis. Adjusting for inflation, real spending rose 0.6% in November, marking the first increase since May.

We’re looking for the December reading to break this nominal spending trend. Bad weather across the nation over the past two weeks may have held things back a bit, but the 65% decline in gasoline prices has left significant cash in consumers’ pockets and this should show up in the December figure. The plunge in energy prices has brought overall levels of inflation down to almost nothing, so real incomes remain positive, which is meaningful.

Consumer will continue to boost cash savings, as their main savings vehicles – the home and stock market – have endured major damage. Still, the decline in gasoline prices is very powerful and even if the December spending figure fails to show a bounce, it will occur over the next couple of months.

Inflation Trend

Inflation has been led lower by a plunge in energy prices and this should not be confused with what’s known as monetary deflation. While consumer activity must be affected by a deteriorating labor market, the current decline in energy prices is great news for the U.S. consumer and should help to drive spending in other areas over the next couple of months.

The inflation gauge tied to the personal spending data (the PCE Deflator) showed overall price activity came in flat during November (no change from the October reading) and has dropped to 1.4% on a year-over-year basis from as high as 4.5% in July. So this massive deceleration in the rate of inflation should help to augment consumer activity. That said, we do not believe inflation will remain tame; this is a transitory event.


The massive liquidity injections by the Fed will combine with an infrastructure-based stimulus program -- that will likely reach $1 trillion when it’s all said and done -- to kick up commodity prices again and thus overall inflation. But that’s another story and likely several months out.

Jobless Claims

The Labor Department reported that initial jobless claims jumped 30,000 in the week ended December 20 to hit 586,000, remaining at a 26-year high.

While this is a very elevated level, as we continue to point out, claims of nearly 600,000 are not what they were back in 1982 when civilian employment stood at just 99 million, today it stands at 144 million. Adjusting for the increase in employment, we’d need to see claims hit nearly one million to match the 1982 level. We think this perspective is important.
(That 144 million figure comes from the Household Employment Survey, which includes the self-employed. The Establishment Survey, which measure just payrolls and excludes the self-employed, stood at 88 million in 1982 and stands at 136 million today. This does not change the prior point, I just want to clarify that there are two different surveys to view.)

The four-week average of initial jobless claims continues to rise, increasing 13,750 to 558,000 – the eighth week of increase.


We’re without an economic release for the next two business days, so things will be quiet as they normally are in the final week of the year.

On Tuesday, we’ll get some home-price data and manufacturing activity out of the Chicago region. On Wednesday, mortgage apps and jobless claims – again a day ahead of the normal schedule as Thursday is another holiday.

Have a great weekend!


Brent Vondera, Senior Analyst

Fixed Income Recap

Thin Markets Hurt Auction
Today’s $28 billion five-year auction suffered from a thin market and the rest of the Treasury market suffered as a result. However, it is difficult to draw anything meaningful from market movements during the holiday season when most trading desks are half staffed. The 5-year was off about a half point in price after the auction before rallying back in afternoon trading to yield about 1.44% late in the day.

Mortgages have widened to comparable Treasuries over the past week, but again, volatility must be taken with a grain of salt given the thin markets at year end. The spread between thirty-year MBS and the 10-year Treasury has widened about 30 basis points from this time last week.


Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks dropped for the second-straight session (down four of the past five following that 5.1% move on the day of the FOMC meeting) as we’re all but out of time for that Santa Claus rally a number of financial-press articles predicted over the weekend. There are just too many people hiding in cash, and surely mutual fund managers want to show heavy cash positions for year-end reports, while tax-loss trading puts pressure on what is already a light-volume week.

Yesterday’s economic reports didn’t help matters either, as data showed the housing market continues to weaken and the final revision to third-quarter GDP corroborated what the previous estimate told us, the economy contracted during the July-September period.

What’s more, profit reports are illustrating that corporate earnings will have declined substantially this quarter.

While we’ve seen overall S&P 500 profits decline for five quarters now, this has mostly been a financial-sector story. Ex-financial profits have remained positive during this stretch, expanding upon the 20-quarter post-WWII record of double-digit profit growth for total S&P 500 profits. This will not be possible when Q4 earnings season kicks off in a couple of weeks, we’ll see widespread deterioration.

That said, the market has discounted this deterioration in earnings as the conspicuous 46.9% decline on the NYSE Composite illustrates. This is not to say things will be a cakewalk from here, we’re just pointing out that there isn’t much – from an economic perspective -- that should surprise the market at this point.

Market Activity for December 23, 2008

GDP

The Commerce Department reported their final revision to third-quarter GDP came in unchanged from the preliminary revision, showing the economy contracted at a 0.5% real annual rate. The NBER (National Bureau of Economic Research) officially announced the recession began in December 2007, but the contraction truly took hold last quarter.

Real PCE (consumer activity) was downwardly revised to show a very large 3.8% decline at an annual rate. Business equipment spending collapsed, falling 7.5% at an annual pace, much lower than even the meaningful 5.7% drop estimated in the previous revision.

The deterioration in business equipment purchases is the most salient aspect of how quickly things changed when the credit markets froze up. Business spending jumped 10% at an annual rate November 2007-July 2008, but shut down on a dime beginning in September.

Residential fixed investment (housing) declined 16% at an annual rate last quarter. It appeared we had found a bottom in housing during the second quarter as this segment of GDP fell 13.3%, which was a major improvement after falling 25.1% in the prior quarter, and this level of decline had been the trend for the previous several quarters. However, we couldn’t expand on that progress in the third-quarter as credit tightened up and labor-market weakness did additional damage to home sales.

We’ll note a couple of things though. Last quarter’s GDP figure would have still posted a mildly positive reading if not for the Boeing strike, which put additional pressure on durable goods orders, and Hurricanes Gustav and Ike, which did major damage to the Gulf region, shutting down energy and utility production in the Texas and Louisiana. (Gustav made U.S. landfall September 1 and Ike two weeks later – Ike was the third most destructive Hurricane in U.S. history.)

In any event, the report is old news as everyone is focused on the current GDP situation which will be the doozy; we’ll get the advance release (the first estimate) on January 30. Most look for roughly a 6% drop in real GDP, which would mark the worst reading since 1982. The data over the past three months surely bears this out.

Housing

The Commerce Department also reported sales of new homes dropped another 2.7% in November and remained at a 17-year low. Sales came in at an annual rate of 407,000 units. The median price of a new home did rise 2.7% last month, but is off by 11.5% over the past 12 months and down 16.07% from the peak hit in March 2007.


The housing market has hit another snag of late due to the credit event. It appeared as though things had begun to stabilize late-spring/early-summer as the decline in sales eased and we actually saw a couple of months in which sales actually rose; however, the improvement proved short-lived as the combination of tighter credit conditions and a weak labor market have wreaked additional havoc. The unadjusted data showed that just 28,000 new homes sold in November.

The supply of new home, adjusted to the current sales pace dipped slightly, yet as you can see remains very elevated.


On the bright, as we’ve touched on for a couple of months now, the number of new homes available for sale has plunged and when the sale figures do bounce back this shows the inventory-to-sales ratio will fall fast.


In a separate report, the National Association of Realtors (NAR) reported that existing home sales fell a large 8.6% last month (8.0% when taking out multi-family units) to 4.49 million at an annual rate. The median price fell 2.9% last month, down 13.2% from the year-ago period.

Existing home sales are based on contract closing (as opposed to new home data, which is counted when a contract is signed). Thus this November data may be a reflection of the credit crunch that intensified in late September – since there is a 6-8 week lag between the signing and closing of a contract. Let’s hope this data proves the worst has arrived; yet it’s likely the weak job market will be an issue for the housing market for a while still.


The inventory figure, which had shown nice improvement from the peak, has moved higher again.


We really need to see this figure fall to the seven months’ worth of supply level to begin getting excited. The traditional drags on housing – a weak labor market – will cause additional problems for sometime. Mortgage rates have come down nicely over the past three weeks, but we’re not sure this is enough to offset the decline in payroll positions.

The next administration will target mortgage rates (this is our guess, it has not been announced) possibly by issuing long-dated Treasury notes at sub-3.00% -- the 30-year T-bond currently trades at a yield of 2.65% -- and have Fannie and Freddie write mortgages somewhere around 4.25%-4.50%. Depending on how they target this, such artificial meddling within the mortgage market may not have longer-term ramifications. However, if they include those who have been seriously delinquent on their payments (even after prior loans have already been modified) this will certainly cause problems down the road. If they do include these people they better darned make the loans fully recourse.

Such a plan would be a way to take advantage of very low borrowing costs for the government. Problem is there is no free lunch, everything has its cost.

Have a Merry Christmas and a Happy Hanukah!


Brent Vondera, Senior Analyst

Afternoon Review

General Dynamics (GD) -1.35%, Northrop Grumman (NOC) -1.16%
The U.S. Navy awarded a $14 billion submarine contract to a unit of General Dynamics. The contract calls for construction of eight Virginia-class submarines to be built by Electric Boat, a wholly owned subsidiary of General Dynamics, and Northrop Grumman Shipbuilding, a unit of Northrop Grumman (NOC). The companies will construct one ship per year in 2009 and 2010, and two ships per year from 2011 through 2013.


Covidien Ltd (COV) -4.68%
Covidien said it will change its country of incorporation to Ireland from Bermuda. Investors who track stock benchmarks such as the S&P 500 may sell 65 million shares as a result, JPMorgan & Chase estimates.

We are starting to see more companies leaving Bermuda in anticipation of decreased tax benefits once Obama takes office.


Washington Federal Inc. (WFSL) -26.38%
Washington Federal plummeted after it reduced its quarterly dividend by 76 percent to 5 cents a share, citing higher credit costs.


Quick Hits

• 2008 Lookback: Best Calls of the Year
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks began the holiday-shortened week lower as a deteriorating outlook regarding corporate profits and commercial real estate wore on investor sentiment. Year-end tax-loss trades may have also put pressure on stocks, overwhelming what is a low volume week.

Stocks did pare earlier losses though, rallying nearly 2% in the final 30 minutes of trading. What appeared to be heading for a 5% downer mid-way through the afternoon session, turned into a 1.80% drop for the broad market – mild by today’s standards.

Commercial real estate concerns are beginning to rise to the surface and this may be an added issue stocks will have to deal with. It’s pretty clear that lenders used unrealistic estimates, assuming strong rental growth rates to justify high loan payments. As the credit freeze-up that hit in September exacerbates declines in commercial rental rates, borrowers will have a more difficult time meeting payments, driving defaults.

On the bright side, with massive levels of cash on the sidelines, we may be able to rally early next year as the taking of tax-losses will have run its course and that will be one less pressure point on stocks. It’s likely the broad market has priced in a lot of ugly assumptions, like this commercial real estate story.

Market Activity for December 22, 2008


Interbank Lending

Interbank lending rates have eased dramatically over the past couple of months and the TED Spread (an indication of risk aversion – a higher level means investors and institutions are less willing to take risk; lower the opposite) has nearly returned to its level prior to the collapse of Lehman on September 15. Although, the level during more normal times is closer to 0.50, so keep that in mind.


The decline in interbank lending rates has not only declined in the U.S. and London, but across the globe. The Hong Kong interbank rate, HIBOR, has declined to the lowest levels since 2005 and TIBOR (Tokyo interbank rates) sits at the lowest level in a decade, according to Bloomberg.

Global central banks have pumped massive amounts of liquidity into the system and as a result these rates should remain palliative to lending.

The degree to which TED has declined is a bit deceiving, however. The narrowing in the spread between three-month LIBOR (the rate at which banks charge one another for loans of this duration) and three-month T-bills is solely a result of the liquidity injections by central banks that has brought LIBOR down. We really need to see 90-day T-bill yields rise; at current levels it is abundantly clear cash is hiding out for now. When the yields on bills begin to rise again it should signal investors’ willingness to take a dip into the risk pool once again.


Been Waiting for This One

Last week I watched an interview in which a business news journalist asked why everything but tax cuts have been tried in getting us beyond the current mess. The guest responded by stating (paraphrasing): “we tried that in 2003 and look where we are now.”

I’ve been waiting for that comment for three months now, it was only a matter of time and frankly I’m surprised it took this long to hear it.

It’s funny to me how Keynesians, always wanting to keep to the same old flawed game plane, have the temerity to make statements like those that vilify lower tax rates. The journalist should have responded by stating that is has been monetary policy mistakes that have brought us to this economic obstacle. If not for negative real short-term interest rates (for two years) that subsidized debt, we wouldn’t have been caught up in this morass in the first place.

Further, the rejoinder should have involved an explanation that if not for the lower tax rates on capital and income over the past five years it’s highly unlikely we would have withstood a serious housing correction (two years in the making) and a massive energy price shock for as long as we did.
(Remember, the oil shock did not begin in 2008 as oil prices doubled from $70 to $145 in a matter of 10 months, but went from $25 to $45 2003-2004; then from $45-$65 2004-2005; later hitting $70 before dipping to $60 in early 2007 and then the stunning spike to $145 that everyone now remembers. All the way, we heard that $40 per barrel would shut down the economy, but it didn’t. Then $60 would shut it down, but it kept rolling along. Then $70, $90, $100 would cause GDP to collapse, no, no and no. It was not until $145 per barrel combined with a freeze-up in credit that the economy finally succumbed.)

And lest we forget, lower tax rates on capital and income (and it’s important to understand that small business makes up 65%-70% of those in the top federal income tax bracket) enabled the labor market to set a record for job creation (52-straigth months) and corporate profit growth (up at double-digit rates for 20-straight quarters – Q3 2002 through Q2 2007) set a post-WWII era record.

The chart below shows profits with capital consumption and inventory adjustment, so no chicanery in these numbers.


Yes, some of this growth was due to the low interest-rate environment that helped the labor market with regard to construction jobs and the financial-sector post robust earnings. However, the higher after-tax returns on capital, the higher disposable (after-tax) income growth and the massive decline in dividend tax rates had a large hand in allowing the economy to withstand a stunning energy-price shock and a housing market that has been weighing on economic growth since the first quarter of 2006.

And another thing, Keynesians are always the first to complain that U.S. consumers engage in too much credit, yet they want consumers to spend like there’s no tomorrow when it makes zero sense to do so – when savings and overall wealth has declined. This is the dichotomy that confuses the Keynesian mind.

Instead of bowing to the mindset that we must always stimulate the demand side, what we need to do is stimulate the production side of things, that’s where the resources are most prevalent right now anyway -- on the business side.

Thus we must continue to reduce trade barriers, lower tax rates across the board, eliminate overlapping regulations and return society to an ideal of self-reliance – a safety net that has turned into a hammock does just the opposite by increasing a state of dependency. An attempt to spend our way out of this situation may look good in the short term, but it is not a long-run strategy.

As Margaret Thatcher stated: (since the world of economics is dominated by the philosophy of taxing and spending) “economics is too important just to be left to economists.” So true.

Have a great day!




Brent Vondera, Senior Analyst

Afternoon Review

Walgreen (WAG) -4.22%
WAG reported first-quarter profit that trailed analysts’ estimates and said it would spend less on new locations. WAG continues to post solid sales in a difficult retail environment, but costs grew faster than sales and the company plans to further cut back on store openings in 2010 and 2011. The new target growth rate is expected to reduce capital spending through 2011 by approximately $500 million, in addition to the $500 million announced in July.

WAG said it will cut spending on new stores by $1 billion through 2011, double its forecast in July. That will bring the rate of new openings to as much as 3 percent in 2011 from almost 9 percent in the most recent fiscal year.


Caterpillar (CAT) -2.13%
CAT announced new cost saving measures and noted that it is seeing continued deterioration of conditions in many of the markets it serves. The company plans to cut executive compensation by up to 50 percent, and senior managers could see cuts of 5-35 percent. CAT has instituted a hiring freeze and said it is offering an incentive-based voluntary separation program to some of its employees.


St. Jude Medical (STJ) -1.56%
STJ is acquiring MediGuide for $283 million, giving STJ technology to track needles, catheters and guidewires inside the body. STJ will use MediGuide’s technology to help develop products for cardiac ablation, a way to destroy malfunctioning heart cells and correct irregular rhythm without open-heart surgery. The market for ablation equipment could reach $2 billion a year by 2011.

STJ also completed its acquisition of Radi Medical Systems for $250 million. The moves do not alter St. Jude’s outlook.


Quick Hits

• WisdomTree ETFs dropped significantly due to it being their ex-dividend date.
  
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks ended largely higher on Friday as the S&P 500 and NASDAQ Composite gained ground; however, the Dow Industrial Average was held back by shares of Chevron and Exxon – another 6.5% decline in the price of oil put pressure on the group. (The January contract, which expired on Friday, closed at $33.87 per barrel; that backyard storage idea remains in play!)

Basic material stocks also performed poorly, down 1.30%; energy shares lost 0.42%. Industrial, technology, and health-care shares led the board market higher.

We didn’t have much to trade on beyond the Detroit 3 bailout that was officially announced Friday morning. The news may have assuaged some short-term concerns over the issue, which likely provided stocks with a little boost – futures were pointing to a lower open, but reversed course when the news broke.

Market Activity for December 19, 2008

The Bush Administration’s decision to lend GM and Chrysler $17.4 billion so they can avoid bankruptcy was the big news of the day. (The two carmakers are virtually bankrupt as it is, as management has stated they can’t make it through year-end without the funds.) The deal will extend $13.4 billion now and another $4 billion in February. The car makers will provide the government with non-voting warrants, yet the exact amount was unclear.

Ford will not be included, I guess because they haven’t screwed up as royally as the other two. The company has stated its in good enough shape that they do not need this sort of financing. Maybe they’ll learn from this mistake. As former presidential candidate Fred Thompson has put it, “there are strict criteria to receiving taxpayer funds: you must screw up on a monumental scale.” Got that Ford? I’m sure they’ve learned their lesson; they won’t make that mistake again.

Ford is currently seeking a credit line from the government. Management says they may not need to tap it if the government meets this request. I’m guessing that assumes car sales rebound in quick order, which seems pretty unlikely.

Anyway, the deal with GM and Chrysler does have “stipulations.” The companies must show their viability by March 31 by reducing debt and current cash payments for future health care obligations. That’s pretty vague, for a reason I’m sure. In any event, it won’t matter because the stipulations are non-binding, which doesn’t really make them stipulations now does it. Apparently, Washington has re-defined another term for us. We thank them.

It is difficult to blame Bush too much for this decision. What’s the guy supposed to do with the labor market in the shape it is in? He’s kicking the issue down the road for the next administration, that’s when the real checks will begin to rip off.

What the Detroit 3 really need to become viable is to enter Chapter 11 bankruptcy (this is not Chapter 7 liquidation; it’s reorganization). This way they can streamline their primary workforce and dealerships. Currently the three have way too many assembly line workers, far too many dealerships and a layoff structure that makes competiveness impossible.

In term of the workforce and dealer outlets, the firms pretend as if they still enjoy 50% market share when in reality it is 18%.

In terms of the layoff compensation structure, GM pays the difference between their former wages and what jobless benefits pay. Then when the jobless benefits run out GM pays 95% of their wages for two years. Then, if you have the seniority, a former worker has a chance to enter what’s known as the jobs bank, which pay 95% of wages to do crossword puzzles etc., for years This is a joke and not a competitive business model. The government can write them checks until the cows come home, but until the aforementioned issues are dealt with they simply can’t be viable. If the government demands that the Detroit 3 make smaller and smaller cars, in place of producing what the market demands, they’ll simply become even more dependent on government financing. Unless, of course, the government mandates what cars consumers may buy, but that’s getting into another issue.

We’ve got a quiet Christmas-shortened week ahead of us and no economic data releases today.

Tomorrow we’ll get the final revision to Q3 GDP, which should show the economy declined 0.8% at an annual rate – the estimate is for the figure to remained unchanged from the previous estimate, -0.5%. No one will care about this release though as the Q4 reading will be the big one, likely to show the economy contracted at a 6.0-6.5% real annual rate, the worst reading since the spring of 1982.


Tomorrow we’ll also get new and existing home sales (November). Rarely are these released on the same day, but the holiday-shortened week has them crammed into one.

Pending homes sales remained dire in October, so existing sales were surely extremely weak last month, same will be true for new homes.



On Wednesday we get initial jobless claims (a day earlier than usual) and personal income and spending for November.


Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

VIX
The VIX, which measures the cost of using options as insurance against declines in the S&P 500, has dropped over 44 percent since November 20, when it rose to 80.86, the highest in its 18-year history. (The VIX had never closed above 50 before October.)

The VIX measures fear in the market, via the prices investors are willing to pay for protective options. When the VIX hit high levels – such as the high 70s or low 80s – it indicated that there was too much fear and that everyone has already sold. As a result, supply dries up leaving the market susceptible to a rally.

Right now the VIX remains at unusually high levels compared to its historical norm; however, it has fallen quite a bit from where it has been during the past two months. That tells us the fear surrounding stocks has decreased a bit, and demand to actually buy them has crept up a bit.

Volatility may not return to its highs, but it isn’t clear when it will get back to normal, either. Volatility breeds fear, which in turn breeds more volatility. In addition, new leverage exchange-traded funds, off-exchange trading vehicles and other market advancements are adding to the churn. Nevertheless, the lower readings in the past week or two are seen as a positive for the equities market.

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Peter Lazaroff, Junior Analyst