Daily Insight

U.S. stocks rallied in the afternoon session on Friday to erase what was a 1.6% decline just before lunch. A very weak industrial production report, which followed an outsized decline for November, was said to have driven stocks lower in the morning session.

We don’t agree with that assessment as the production data, even as it was worse than expected, is hardly a surprise after all other data sets have clearly shown a shutdown occurred last quarter. Rather, the market doesn’t know what to do as investors are attempting to gauge government action instead of focusing on fundamentals. The government is capricious, and thus trading will continue to exhibit quick fluctuations as well.

It was talk that the FDIC and Treasury are going back to the future, as we’ll touch on below, by removing troubled assets from banks’ balance sheets that got things rolling in the back-half of trading.

Market Activity for January 16, 2009

Advancers ended up beating decliners by a two-to-one margin on the NYSE. Roughly 1.5 billion shares were traded, in line with the three-month daily average.

Original TARP Redux

Absent a tax rate response focused to bring in bids for toxic assets and an elimination of pernicious mark-to-market accounting standards, we were proponents of the original intent of the TARP – buying up troubled assets, RTC-style, and holding them until the housing market and investors’ willingness to take risk return to somewhat normal behavior.

Engaging in such action removes assets that are causing the mayhem from bank balance sheets and provides a return to the Treasury as the vast majority of these assets have a higher intrinsic value than the depressed market prices currently assigned to these positions. In a way the latest Citigroup and Bank of America rescues, which include the government backstopping troubled assets, are close to the original TARP proposal -- but not enough; it was smart by half.. These assets must be removed in a way similar to what was done during the S&L crisis of the late-1980s/early-1990s.

Now, Treasury Secretary Paulson and FDIC Chairman Bair have come up with what they are calling an “aggregator bank” to buy and house these assets based on the aforementioned purpose.

Well darn, wish they would have begun this process last year instead of ditching it for lack of timeliness in favor of cash injections – a strategy that has not helped as banks hoard the cash in this highly uncertain environment. All we did was waste time

Hopefully, since our most desired way to attack this problem doesn’t have a chance with Congress, they get to it and begin the RTC model; it might actually work.

In the meantime, mark-to-market accounting requires that institutions continue to write-down assets (even those in which institutions had no prior intention of selling), which means the endless circle of cash injections continues. And expect it to get worse. Since Citigroup and Bank of America have government backstops on troubled assets, they’ll unload these positions at horribly low prices, which forces the rest of the industry to mark assets even lower – far below intrinsic values. While this means we’re getting closer to the problem running its course, it also means mark-to-disaster accounting wreaks even more harm.

Economic Data

The Labor Department reported the headline consumer price index (CPI) for December fell 0.7% (-0.9% was expected), marking the third-straight month of decline. The year-over-year (YOY) rate rose 0.1% for December (a decline was expected, which would have marked the first YOY decline in CPI since August 1955).

The decline in the month-over-month reading was largely due to the plunge in energy prices (as we’ve talked about via the other inflation gauges). When you remove just the energy component, CPI was flat last month and up 2.4% year-over-year.


The core rate, which excludes food and energy items, came in flat last month (a decline of 0.2% was expected) and was up 1.8% on a year-over-year basis.


In a separate report, the Commerce Department announced industrial production slid 2.0% last month (double the expectation) -- a huge move, which follows a statistically large 1.3% decline for November.


Consumer goods production fell 1.7%, construction-supply production declined 3.4% (down 32.6% at an annual rate last three months) and computer and office equipment output fell 3.8% (also down more than 30% at an annual rate last quarter). Business equipment did rise (largely machinery and electrical equipment) for the second straight month. Let’s hope a trend has begun.

This decline in overall industrial production marks the fourth monthly drop in the past five and all of those four negative readings were large. That said, the August and September declines (represented by the sharp negative move on the chart above) were a result of Gulf-coast hurricane activity (back-to-back storms) and the Boeing machinist strike. So, the true weakness within this figure began to take hold in November as it occurred without an exogenous event.

For the quarter, manufactured output fell hard, down 13.8% at an annual rate. This is in volume, so it takes out the price-related declines within other data. This is yet another indication the Q4 GDP reading will be the worst since the 1981-82 recession.

On the bright side, the bounce in business equipment may be signaling there’s some life out there. We know the vast majority of businesses have the resources, it is a high level of caution we need to conquer, which is why we’ve spent so much time talking about a tax-rate response to the current woes – nothing can kick start stocks, economic activity and confidence like bold across-the-board tax-rate reductions.

Don’t think we can move rates lower? I think we can reduce capital gains and dividend tax rates to single-digits, move the corporate tax below 30% and do a lot of good by reducing six federal income tax brackets down to two and making sure the top rate does not exceed 25%. Let’s not pretend these changes are static; there is a huge economic boost that results, and as the tax base and entrepreneurial spirits explode, flows to the Treasury will follow.)

Morning Activity

U.S. stock-index futures are lower this morning, showing the affect of overseas financial woes that sent international bourses lower yesterday. But today is Inauguration Day, so maybe some optimism will follow as incoming President Obama will give an uplifting address and get right to work.

We need good policy and we need it fast. An RTC-type response to troubled assets will do a lot of good, but my fear is neglecting (actually abusing) the private sector will only cause Atlas to shrug. That cannot be allowed to occur.

Capital is already on strike; innovators, the providers of seed capital and the engines of production must be incentivized by higher after-tax returns. In terms of infrastructure programs, it must be focused on productive sources such as rebuilding the energy grid, enhancing broadband, improving air-traffic control and restoring vital defense equipment after several years of wear and tear. The current stimulus package appears to be tilted toward entitlement programs; this will not do.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

Bank of America (BAC) -13.70%
In advance of their scheduled earnings release date, Bank of America reported terrible fourth quarter results and received an additional $20 billion from the U.S. government under the TARP. The government will receive preferred stock carrying an eight percent dividend rate and has agreed to a loss sharing program on $118 billion in selected capital. Under the agreement, Bank of America would cover the first $10 billion in losses and the government would cover 90 percent of any subsequent losses.

Revenues rose 22.5 percent year-over-year to $15.68 billion, but were well short of the $20.72 billion consensus. Credit costs were steep for BAC at $8.54 billion, which includes boosting its reserves by $3 billion – nearly double estimates as the consumer credit environment continues to deteriorate. Bank of America ended 2008 with a Tier 1 capital ratio of 9.15 percent.

Bank of America said that fourth quarter results were driven by escalating credit costs, including additions to reserves, and significant write-downs and trading losses in the capital markets businesses.

In light of continuing severe economic and financial market conditions, Bank of America slashed its dividend to $0.01 per share from $0.32 per share.


Intel (INTC) +3.39%
The cyclical slowdown in business conditions in the chip sector clearly weighed on Intel’s results in the quarter. Volume was significantly lower as the health of the computer industry has been deteriorating with cutbacks in spending from consumers and corporations.

Sales of Intel’s Atom chips, which are targeted at the rapidly emerging netbook segment of the PC market, grew 50% sequentially, to $300 million. The growth in sales of Atom chips directly affected Intel’s profitability, as the gross margin came in at 53.1 percent versus 58.9 percent in the third quarter.

There is a lot of concern that the Atom processor may cannibalize demand for Intel’s mainstream processor products, which are more profitable for the company, as consumers opt for low-cost netbooks over notebooks and desktops in the PC market. However, these fears are overblown since netbooks offer limited processing power and less functionality, and thus are not a viable substitute for PCs. This is not to talk down the importance of these chips to a huge new market for Intel, as the lower price points for netbooks and Atom processors allow the firm to sell chips to a significantly larger portion of the worldwide population that presently cannot afford mainstream computers.

Intel did not repurchase any shares during the quarter as the company focused on preserving cash in the current challenging environment. However, dividends remain untouched and management expects to continue using share buybacks as part of the company’s long-term capital structure strategy.

While a supply chain correction, inventories, utilization levels and slowdown in PC demand will dominate near-term concerns, the company remains well positioned structurally to benefit from:

• Accelerating PC growth especially in emerging markets;
• Market share gains in entry level PCs (Atom) and high-end servers (Nehalem);
• Higher margin 32 nm products in 2010; and
• Manufacturing, cost and competitive advantages over competition.
  

Johnson Controls (JCI) -5.04%
Johnson Controls reported disappointing results for its first fiscal quarter and issued an outlook that expects the trouble to continue. The loss was $1.02 a share for its first quarter ended in December, but the company said its first quarter is typically the weakest and generates the smallest portion of annual earnings.

Johnson Controls, with about 58 percent of revenue from automotive products in the quarter, booked fewer orders as automakers cut output in North America, Europe and Asia to cope with a worldwide recession. Softness in the global construction markets reduced sales for the supplier’s building division, which makes heating and cooling equipment and contributed 42 percent of sales.

Johnson Controls is working to close 21 plants this year to counter global auto production cuts that include a 23 percent reduction in North America in the final three months of 2008.

Johnson Controls said its first quarter is typically the weakest and generates the smallest portion of annual earnings.


Quick Hits

• U.S. ‘Bad Bank’ Plan Gets Momentum to Revive Lending
• Creative TARP Counting and the BAC Bailout
  
  

Peter Lazaroff, Junior Analyst

Fixed Income Recap

The curve has flattened 17 basis points this week to 147 basis points from 164 at the close of business last Friday. The 2-year was mostly unchanged on the day to yield .715% and the 10-year rallied slightly to yield 2.19%.

Mortgages
Mortgages continue to be volatile during this period of Fed induced liquidity. The 10 year Treasury has rallied while mortgages have sold off. This inverse movement has resulted in yields on mortgages being 20 basis points wider on the week.

The New York Fed announced today that it bought $23.4 billion in mortgages during the period from January 8 to January 14. Considering that the Fed plans on buying $500 billion before the end of June, this is closer to the expected average than the $10.2 billion reported last period.

Treasuries
The main concern with Treasuries deals with the possibility of the Fed buying them in order to push yields lower. Current Fed-speak is leading the market to think that they will likely exhaust other options before accelerating their buying of Treasuries in the open market, but uncertainty remains. They appear to be content with waiting to see how the current programs, (i.e. commercial paper, Freddie and Fannie debentures and MBS), may help lower rates.

Friday is a half day in the bond market.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks endeavored upon a wild ride yesterdsay, reminiscent of the volatility that took hold back in October and November, as uncertainty over government action can only cause investor sentiment to waver. There is less to go on these days from a fundamental perspective; it is all about the whims of Washington right now – making it virtually impossible to value assets.

Stocks began the session lower and the selling accelerated to round out the morning session, but an afternoon rally allowed the broad market to close slightly to the upside. The tech-laden NASDAQ Composite posted a more meaningful gain.


The main news of the day was that Bank of America is seeking more TARP funds and loan guarantees, specifically related to the Merrill Lynch acquisition since its is those assets that are taking the brunt of the write-downs.

On a larger scale, there was a general concern that certain banks could be nationalized. This, of course, would be highly unlikely as the entire system could not be nationalized, and if the government took control of just a few of the big names, then it would basically wreck the rest of the industry as you’d have runs on banks as individuals and small businesses shifted deposits to the government entities. But when people begin to raise the subject, it just adds one more uncertainty into the mix. So this is part of what was going on yesterday to cause a wide swing between peak and trough.

By the back-half of the session, as the chart illustrates, it became clear the likely action would take place – the government would assist BofA by using a Citigroup-type takeover – and stocks rallied. The fact that this needs to be done is not good, but it’s by far better than some of the alternatives.

Market Activity for January 15, 2009


The government will give BofA $20 billion in TARP funds – in exchange for preferred shares yielding 8% -- and guarantee $118 billion of assets. The bank will cut their common dividend to a penny per share.

So, we continue to count the number of times the government will offer assistance (remember though these are investments, so from a taxpayer perspective there will be a return here) to the same institutions. Say what you want about BofA’s purchase of Merrill – yes, they should have demanded Merrill enter receivership before taking them over, which would have cleansed the investment bank of troubled assets. That notwithstanding, until mark-to-market accounting is eliminated the risk remains that these institutions will need assistance again. This accounting rule, put in place little more than a year ago, makes stability impossible whether assets prices are moving up or down. Banish it!

Crude-Oil

Crude price tumbled another 5% yesterday to close the session at $35.64. This is great news for consumers as real incomes are boosted by the continued move lower. However, everyday crude decline it also illustrates the market’s view that global economic activity is in trouble, and based on what we see in the trade figures that’s a reality.


Jobless Claims

The Labor Department reported initial jobless claims rose 54,000 to 524,000 for the week ended January 10. A 36,000 increase was expected.

This followed two weeks in which claims fell below the 500k mark, which seemed to be due to a number of factors – seasonal adjustments, winter weather that closed unemployment offices and several states that saw their electronic filing systems crash. The Labor Department called last week a “straight forward” week, referring to the inadequate seasonal adjustments to the holiday shortened weeks of the prior two readings, and therefore that those declines in unemployment claims could not be trusted.

Still, we had all but hit the 600k mark in the week prior to Christmas as claims touched 589K, so the fact that we’re in the low 500k handle may be some sort of silver lining.

The hardest hit state was New York, reporting 24,000 initial claims – this illustrates the retail and financial sectors are currently driving job losses.

The four-week average of initial claims, a less volatile measure, fell for the third-straight week to settle in at 518,500.


Continuing Claims, those accepting jobless benefits for more than a week, fell 115,000 from a 26-year high to come in at 4.497 million in the week ended January 2. The insured unemployment rate (the jobless rate for people eligible for benefits) – which tends to track the overall unemployment rate – held at 3.4%. Both of these readings have a one week lag to the initial claims figure.

I’m going to assume the decline in continuing claims was due benefits expiring.


Next week’s claims data will be the most important of the month as it aligns with the employment survey week. The Labor Department will count those that are not employed next week (and were actually looking for a job) as unemployed for the month. Initial indications are that January will post another large job loss; the next jobless claims number will help to confirm or deny that.

Producer Price Index

In a separate report the Labor Department announced producer prices slid 1.9% in December and moved to negative territory on a year-over-year basis, coming in at -0.9% after a reading of +0.4% in November.

The index has been driven lower by declines in the price of energy, which has plunged from the spike we endured last summer – oil, gasoline and natural gas are all down roughly 65% from the July peak.


The PPI core rate (which excludes food and energy) actually accelerated in December, up 4.3% from the year ago period following the November reading of 4.2% -- and remains elevated.


This is why we continue to caution against the conventional wisdom that believes we’re in a deflationary cycle. We are not. It can always turn into one, but based on the data we’ve seen over the past few months and the huge degree to which the Fed has injected money into the system -- using both conventional and quantitative easing techniques – the chances of an inflationary event occurring several months down the road is much greater than prices continuing to spiral lower.

Empire Manufacturing

The NY Federal Reserve Bank’s index of factory activity within the region improved during December to post a reading of -22.2 after a downwardly revised -27.8 for November. A reading below zero represents a contraction in activity, so even though the survey improved, one can see things remain depressed. (The fact that a reading below zero marks contraction is intuitive, but we mention it because there are factory surveys, such as the ISM indexes, in which the line of demarcation is set at 50).


Stock Futures
Stock-index futures are up this morning on the heels of the BofA news and a statement out of Intel that profitability may rebound.

The House also unveiled the details of its stimulus package, and while we’re going to assume there will be a lot of senseless spending in the program higher current-year write-off allowances and bonus depreciation remained in the plan. This should boost business spending once things calm down. That is so long as firms do not hold off on spending plans for fear higher deficits give politicians an easier sell at raising tax rates and thus curtails economic growth. If firms do not feel a sustained rebound is likely, they will remain very cautious.

Have a great weekend!


Brent Vondera, Senior Analyst

Afternoon Review

J.P. Morgan Chase (JPM) -6.06%
JPM managed to squeak out positive fourth quarter earnings of seven cents a share after several one-time charges and gains, but CEO Jamie Dimon said the results were “very disappointing.” Without the gains, JPM lost 28 cents a share.

The addition of Washington Mutual was a definite positive for JPM’s fourth quarter, boosting income and resulting in one-time gains. JPM also indicated that deposits at WaMu were basically flat, which a huge positive since there was some concern that WaMu customers would move their assets in response to the bank’s failures. But the acquisition wasn’t all warm and fuzzy. In fact, the WaMu deal may end up costing JPMorgan billions down the line.

For the second consecutive quarter, JPM did not earn enough to cover its dividend payment, but the company does not appear to be concerned and remains committed to paying it. The company was able to strengthen their capital position, and their Tier 1 capital ratio now stands at 10.8 percent. Tier 1 capital is a metric of a bank’s ability to sustain future losses. Regulators consider a bank to be well-capitalized with a Tier 1 ratio of at least 6 percent.

Looking into 2009, Dimon said, “If the economic environment deteriorates further, which is a distinct possibility, it is reasonable to expect additional negative impact on our market-related business, continued higher loan losses and increases to our credit reserves.”


Bank of America (BAC) -18.43%
Bank of America was slaughtered on news that they are close to receiving billions more from the government to help it absorb Merrill Lynch. Reports indicated the arrangement might protect BAC from losses on Merrill’s bad assets. According to The Wall Street Journal, BAC told the government in mid-December that it was unlikely to complete its purchase because of Merrill’s larger-than-expected losses in the fourth quarter.

It looks like Bank of America may have bit off more than it can chew. In Bank of America’s defense, they had very little time to look over Merrill’s books before their shotgun wedding, and other banks received government aid for rescuing failing banks – JPMorgan had assistance from the government in its purchase of Bear Sterns as did Citigroup in their attempt to buy Wachovia. So why shouldn’t Bank of America get some help as well? It is unlikely that the government would allow such a big bank to fail, but the future for these banks is anyone’s guess when the government is controlling the financial markets.

Full-disclosure of the arrangement will be given with company’s earnings report next Tuesday. Regardless of the government’s potential involvement, Bank of America is expected to cut their dividend to at least two-thirds of the current payout.


Intel (INTC) +1.61%
Intel reported a fourth quarter profit decline of 90 percent after the markets closed. The recession curbed demand and forced the company to write down the value of its investments. Intel’s earnings call should provide some good insight into the technology sector and I will address the comments tomorrow.


Quick Hits

• FDIC’s Bair Says She’d Be ‘Very Surprised by U.S. Bank Nationalization
• I highly recommend this financial bailout game (make sure sound is on)
  
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks slid to a six-week low after a dismal retail sales report extended the record of monthly declines in consumer activity to a sixth month.

Nearly half of the decline in overall retail sales during December was due to a 16% decline in gas station receipts (largely price-related) but that didn’t do much to assuage investors’ concerns. Every component within the report showed a decline, even the eating, drinking component – an area heretofore that had been upbeat during this period of substantial consumer weakness.

The broad market has now given back half of the rally that drove the S&P 500 24% above the multi-year low hit on November 20. So much for the so-called January Effect and the supposed euphoria over the much talked about stimulus proposal.

Decliners whipped advancers by nine-to-one margin on the NYSE Composite; volume was somewhat light with 1.3 billion shares traded.

Market Activity for January 14, 2009

We did talk about an expected pullback in the January 5 letter as predictions that the S&P 500 was going hit pre-Lehman collapse levels (1250 on that index) hit a crescendo. There was just too much data we had to get through. Besides, the market was destined to take a breather after the December run.

We’ll be stuck in a trading range for some while (wish I could define that in actual time), based on what is currently known. However, we do have a decent potential of hitting 1050 on the S&P 500 – that would get us to a market multiple of 22 times what we see as trough earnings on the index.

Such a multiple is at the low-end for a trough earnings P/E, but one should not expect a mid or high range level based on the challenges we face now that the government is so involved and both economic and geopolitical risks abound.

I suppose it will take a hugely positive financial sector event to free us of this range-bound scenario, or a bold tax-rate strategy – yes, I’ll keep dreaming.

In the meantime, we’ll count the number of times the same financial institutions must be rescued before regulators decide to eliminate mark-to-market accounting standards. It was an enormous mistake to implement this accounting rule in November 2007; it has greatly exacerbated the current situation.

Mortgage Applications

The Mortgage Bankers Association reported mortgage applications jumped 15.8% in the week ended January 9 as the 15-year fixed mortgage rates fell to 4.63% and the 30-year fell to a record low of 4.89%.


Refinancing activity drove the index higher as this segment jumped 25.6% last week. Unfortunately, home purchasing activity didn’t follow the trend, falling 14.1% -- ending three weeks of increase.

A wave of refinancing will help to put more money in consumers’ pockets, which appears to be very much needed as we’ll discuss another ugly retail sales report below. However, we need purchases to make a comeback in order to boost investor sentiment. Lower mortgages rates will undoubtedly help, but the tough labor market conditions will delay a sustained rebound in home sales.


Retail Sales (December)

U.S. retail sales fell twice has hard as expected in December as job losses combined with a desire among consumers to boost cash savings (as their two primary savings vehicles, homes and stocks, decline) to crush activity.

Overall sales fell 2.7% in December, which follows a downwardly revised 2.1% decline in November – originally reported as a 1.8% decline. This marks the sixth month of decline for overall retail sales, which has not been seen since these records began in 1992. Prior to this stretch of weakness, the previous record was two months of decline.

Excluding auto, retail sales fell 3.1%, which follows a 2.5% drop in November and a 2.9% in October.

Falling prices are certainly playing a role here, especially with regard to pump prices (gasoline station sales were down 15.9% in December, some of which was price-related). However, the weakness was broad-based with every major category posting a decline.

Over the past three months, retail sales have collapsed, plummeting 28.35% at an annual pace. While gasoline sales account for much of this decline (gas station receipts plunged 87.3% three-months annualized) retail sales ex gasoline is still down 13.9% at an annual rate for the quarter.

Sales less autos, gasoline and building materials – the figure that flows directly into the personal consumption component of GDP – fell 1.4% in November and is down a massive 8.8% for the fourth quarter. A GDP reading of as least -5.5% (that’s at a real annual rate) seems assured based on this rate of decline.

Import Prices

The Labor Department announced import prices posted another big decline, down 4.2% for the month and 9.3% over the past 12 months.


The sharp decline in this data has been driven by petroleum-price activity; this component of the report fell 21.4% in December and 47% for the past year. This is a massive shift as the component was up 47% on a year-over-year basis as recently as September.

Excluding petro, import prices fell 1.1% in December and are up 0.9% year-over-year.


While the Fed seems confident, based on the latest meeting’s notes, that inflation will remain tame, we do not agree. Some even fear a sustained deflationary event. If this were the case all components of the data would be showing large negative readings, which is not the case – instead it is petroleum prices coming off of the spike that occurred last summer that is causing the large negative reading for the overall inflation gauges.

Once banks begin to push Fed cash injection into the economy via increased lending activity (whenever that may be) this will combine with a fiscal stimulus that will reach $1 trillion ($500 billion in the first year of implementation) to drive commodity prices higher and thus overall rates of inflation. While the Fed is focused on other things, if they do not confront this threat in its early stages, our expectation is we’ll then have a longer-term inflation problem to deal with. But that is down the road.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

Principal Financial Group (PFG) -11.31%
Principal moved lower amid concerns that losses on fixed-income investments will deplete capital. Life insurers are facing an increase in defaults on corporate bonds and commercial mortgages as the U.S. recession depends. The carriers cut jobs, asked regulators to ease reserve standards and applied for government aid in the fourth quarter to replenish their dwindling capital cushion.

The biggest risk, at this point, is a new wave of credit defaults that would undermine these companies’ capital adequacy.


Caterpillar (CAT) –4.95%
Caterpillar fell on speculation that the government stimulus spending plans may not give the company a boost. In addition, a Morgan Stanley report said the company faces a “steep fall” in sales from emerging markets. Bets against shares of Caterpillar reached their highest level since April.



REITs
Our REIT holdings (VNQ, ICF, IYR) all fell more than five percent today and are down over 15 percent YTD. After three quarters on flat returns in 2008, our REIT holdings fell between 38 and 40 percent in the final quarter.

The biggest concern surrounding REITs is liquidity. REITs carry high debt levels and most will need to repay or refinance obligations in the year ahead. Securing capital at attractive terms should remain challenging, which will squeeze companies with large development pipelines that rely on banks to provide funds for construction.

It is likely that several REITs will need to issue new equity or reduce dividend payments to improve liquidity. While this may provide some relief, it hurts investors’ confidence and further reduces share prices.

The main reason Acropolis invests in REITs is because of their relatively low correlation with the stock market, and thus it diversifies away from some of the risk inherent in the stock market. Rather than investing in individual REIT companies, we use the following ETFs to get diversified real estate exposure:

VNQ (Vanguard REIT ETF) boasts a relatively broad-based domestic portfolio, making it a suitable choice for one-stop, no fuss real estate exposure. The biggest risk the fund carries is that more than 40% of assets are in its top ten positions. If one or more of these names falter, the fund’s performance will suffer. VNQ carries a 0.12 expense ratio, which ranks as the cheapest real estate ETF on the market.

ICF (iShares Cohen & Steers Realty Majors Index Fund) has solid exposure to the biggest, best-managed public landlords of the major property types – office, retail, industrial and multifamily. ICF carries a 0.35% expense ratio, which is cheaper than most, but not all REIT mutual funds and ETFs.

IYR (iShares Dow Jones U.S. Real Estate Index Fund) has exposure to the largest biggest, best-managed public landlords of the major property types – office, retail, industrial and multifamily – as well as some more exotic corners of the REIT world like timber and brokers. IYR carries a 0.48% expense ratio, which is cheaper than most, but not all REIT mutual funds and ETFs.



Quick Hits

• Economic Stimulus Package May Reach $850 Billion
• Greenhouse-Gas Limits Proposed by Industry Would Raise Coal Plant Costs
  
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

Most U.S. stocks gained ground yesterday, helping the S&P 500 and NASDAQ Composite end a two-day slide. However, the Dow Industrial Average failed to close in positive territory, held back by shares of Untied Technologies, Boeing and Hewlett-Packard.

Energy share helped the broad market manage a slight gain, as the price of crude rose for the first day in six. Shares of Microsoft and the biotech sector pushed the NASDAQ higher.

News floating around for a couple of months now that Citigroup will end its financial supermarket model began to take shape this past weekend and we received further indication yesterday the diversified banking institution will return to a model that looks more like the old Citicorp. The company will officially announce its plans next week; it’s been reported Citi will sell a majority stake in Smith Barney to Morgan Stanley and will likely spin-off its CitiFinancial consumer-lending unit. The new firm will focus on providing services to large corporations and affluent individuals.

Market Activity for January 13, 2009

It is also being reported Citi will set up a “bad bank” to house troubled assets and attempt to sell that unit off at some time.

That’s interesting since this is essentially the original purpose of the TARP, but for the banking industry in general. Too bad they chose to ditch this idea in favor of injecting capital into banks, which has really done nothing but allow banks to remain afloat. They won’t increase lending in this environment so long as mark-to-market accounting standards remain in place; they will simply continue to hoard the cash.

It would be highly preferable to see tax rates slashed across the board, a five-year moratorium on federal and state capital gains taxes on investments in troubled assets (which should bring the bids the market needs) and of course elimination of mark-to-market accounting in terms of basing capital adequacy ratios. But with Washington remaining obstinate, the original TARP proposal was the next best thing.

Crude-Oil

Oil futures slid 11.89% last week and fell another 8% on Monday, before rebounding 3.5% yesterday and into this morning’s trading. In the previous week crude was bid higher due to the heating up of Middle East conflicts and the game Russia continues to play with European energy supplies, but that gave way to global economic concerns and reduced demand forecasts.

Crude touched $50 on January 6, but has returned to the $30 handle, trading at $38.97 per barrel as I type.


It seems quite likely that oil prices will remain depressed so long as traders’ primary concern remains global economic contraction. In the meantime, the silver-lining is that money remains in consumers’ pockets via this low cost of energy, boosting real incomes.

Although for stocks, low oil prices currently work as a two-edged sword as we really need global economic worries to ease for stocks to resume the rally that’s brought us nicely off of the November 20 low. Oil and stocks may move in tandem for some time still.

But don’t expect energy prices to remain low as we look out over the next few months. For one, the massive amounts of liquidity the Fed has pumped into the system will explode throughout the economy whenever lending activity becomes normalized and risk aversion wanes even the least bit. This is going to push commodity prices higher and oil will certainly participate.

Another thing is the fact that energy policy over the next couple of years may not quite work the way some in Washington hope. We’ll see a focus on alternative sources, which is a good thing – especially if nuclear power is allowed to escape an onerous and inefficient permit process that delays production and drives costs far higher than they would otherwise be.

But we cannot abuse traditional energy sources, pretending as if they do not offer serious benefits both in cost to individual consumers (particularly those at the lower rungs of the economic ladder) and the economy in the aggregate.

To this point, I noticed the Senate advanced a $10 billion conservation plan last week that would set aside over two million acres among eight states. The Bureau of Land Management estimates the legislation would take nearly nine trillion cubic feet of natural gas and 300 million barrels of oil out of production in Wyoming alone.

The U.S. uses 21 million barrels of oil per day, so the 300 million figure is not huge (although we are talking about just one state), but anything other than a boost to supplies is not helpful over the long term. In terms of natural gas, the amount taken off line is equivalent to removing annual production levels of the two-largest NG production states – Alaska and Texas, according to the Energy Information Administration.

The irony here is that those most vocal on the topic of energy independence are also the primary proponents of this legislation. We have a 30 year history of voluntarily curtailing domestic energy production, which has made us increasingly more dependent on foreign energy sources.

Economic Data

The Commerce Department reported the trade gap narrowed by an enormous margin in November coming in at $40.4 billion from $56.7 billion in October. Imports plunged 12% for the month and exports were down 5.8%. The enormous decline in energy prices was a primary factor for the decline in import activity; significant weakness in consumer activity obviously played a role too.

The real trade gap, adjusting for prices, narrowed to $39.5 billion in November from $45.6 billion in October. Real exports declined 3.3%, real imports dropped 6.8%.

The export data within major regions indicates the degree of the global slowdown as year-over-year U.S. exports to China fell 10.7%, 18.9% to Asian NICs (newly industrialized countries), 15.2% to Canada and 1.1% to the European Union. This shows a synchronized global recession has occurred; so much for that “decoupling theory.”

Amazingly, U.S. exports to OPEC countries remains very strong, up 22.7% in November, although we’d expect this to grind to a halt due to the collapse in the price of oil.

(In terms of fourth-quarter GDP, this significant narrowing means trade will be less of a drag on the figure than expected. Still, we’re likely to see at least a 5.5% real rate of decline in economic growth when the reading is released on January 30, and may be solidly in the -6% handle.)

Real goods exports fell a huge 39.7% at an annualized rate over the past three months; this number was up 11.3% in the 12 months ended August 2008. This shows as clearly as anything does just how quickly things changed globally.

Real goods imports dropped 29.3% at an annual rate over the three months ending November; this figure down just 2.11% in the 12 months ended August 2008. And this shows how dramatically things have change domestically since September.

We often warn those who desire a very narrow trade balance to be careful what you wish for, you may not like it. No doubt, the degree to which import activity outpaced exports by 2005 had gotten out of control. This was due to the Fed’s mistaken monetary policy that sent real short-term interest rates negative, and thus subsidized debt. The credit expansion that ensued did have a lot to do with how wide the trade gap had become.

Yet, the gap was narrowing in 2006 and 2007 as the Fed removed that easing policy that kept rates too low for too long. In an event, a U.S. economy that had been in growth mode for the vast majority of the past 25 years resulted in a powerful and prosperous consumer base – which is still the case in the aggregate even with our current troubles. Thus trade deficits will result.

Overall, we shouldn’t fear trade deficits. This is not 18th century mercantilism. So long as we engage in pro-growth polices many of those dollars used to purchase imports come back home in the form of investment, which is what the trade-deficit curmudgeons never factor.

What we should fear are Federal Reserve monetary policy mistakes; the harm rendered by these mistakes is widespread and extremely damaging.

Let’s learn from this situation. Instead of castigating capitalism – for all of its faults it is undoubtedly the most efficient allocator of resources – we need to focus the blame on the FOMC and their Keynesian models.

For sure, an out of control Fannie and Freddie, supposedly sophisticated accounting standards that were never modeled against a full-blown decline in asset prices and congressional demands to extend credit to those with very low credit scores or be accused of “redlining” are also serious contributors to the current problem. However, none of those are large issues if the Fed doesn’t push real fed funds negative for two full years as was the case October 2002-March 2005.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

General Electric (GE) -5.62%
Barclays said in a research note that General Electric’s fourth-quarter profit may be at the low end of its forecast. The note also predicted that tax benefits at GE Capital will contribute a “substantial” portion to per-share results, and thus earnings quality will be weak.

Also hurting sentiment for the company was news that Vivendi SA, NBC Universal’s 20 percent venture partner, said it may write down its stake in the company because of declining media values. GE does not expect to take a writedown on its majority stake of NBC Universal.

S&P cut GE’s outlook on Dec. 18, giving the company a one-in-three chance of losing its top rating over the next two years. S&P said an example that would lead to the re-examination of their opinion would be if GE failed to generate free cash flow after dividends and assets sales in 2009 or 2010. Moody’s may follow suit and cut their outlook on GE’s AAA credit rating if earnings results disappoint. Both ratings companies are unlikely to base any change on the fourth quarter itself, unless, of course, there is a material change in GE’s outlook.


Pfizer (PFE) +1.32%
Bloomberg reports that Pfizer wants to sell 100 experimental medicines to rivals as it shifts its research efforts to medicines to treat cancer, brain disorders and pain. The report also notes that Pfizer will fire 800 researchers, eight percent of its scientists, as part of a research reshuffling.

There is wide speculation that Pfizer is hunting for acquisitions that will help replace revenues from products losing patent protection in the next several years.


J.P. Morgan Chase (JPM) +5.78%
JPM’s announcement that it would move up its earnings release to Thursday from a scheduled report next week has created a minor stir in amongst the media. This normally would not be a big deal, but any unforeseen event – no matter how big or small – in the financial industry is going to cause a bit of commotion.

Some are taking it as a sign that they have bad results and need to raise more capital, while others see it as a sign that JPM has great earnings that they can’t wait any longer to tell the world about. There is also growing speculation that JPM has gotten involved in the bidding for Smith Barney, Citigroup’s brokerage unit, either with the intent to buy the unit or just get involved in the joint venture.


Energy
Oil gained on Saudi Arabia’s plan to make deeper production cuts, lifting energy shares including:

• Chevron (CVX) +1.41%
• ExxonMobil (XOM) +1.80%
• Transocean (RIG) +2.93%
• Noble (NE) +2.61%
• Arch Coal (ACI) +5.00%
• Peabody Energy (BTU) +4.90%
  

Quick Hits

• Bernanke Says Stimulus May Be Inadequate, Signals Asset Buying, Guarantees
• Bank of America to Use Merrill Lynch Name, Bull Logo
• From Advisors’ Perspectives: Our examination of the 69 naming deals by publicly traded companies shows that the performance of companies that purchase naming rights trails the S&P 500 index by 4.7% over the course of the deal. If you invested in a company the day it announced a naming agreement and sold when the agreement was done (or still held onto it for current name holders), your portfolio would be down 9.1%, as compared to -4.5% for the S&P 500.
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks began the session lower on earnings concerns – Q4 earnings season begins to roll this week – and downward pressure increased as the day progressed as more people begin to realize that infrastructure-based stimulus has a large lag to it.

In terms of profit worries, one has to believe equity values have lower earnings priced in; it’s not like a profit decline of 20-25% comes as much of a surprise after the economic data we’ve been battered with over the past three months. So we’re not sure this was the primary concern yesterday.

It’s more likely stocks had a rough session due to growing concerns over the efficacy of the stimulus proposals, a topic we touched on last week. Those crafting the plan can say the proverbial shovels are already in the ground, waiting for the nod to begin projects, all they want. The reality is there are federal and state appropriations that must be dealt with first and the typical infighting over prioritization.

Then there is the issue of the private sector delaying spending plans as they may be expecting higher government spending will be followed by tax hikes, which will only curtail growth just when it seems things have turned. Maybe intertemporal economic decisions are not quite this lucid within the business community, but it’s a concern nonetheless.

Market Activity for January 12, 2009

Also delivering a blow to investor sentiment was news Larry Summers (Obama’s top economic advisor) sent a letter to Congress outlining onerous conditions on financial institutions.

Bank stocks got hammered, leading the losses as the sector shed 5.7%, The only good news here is maybe banks will pay the TARP money back as quickly as possible so to get out from under these damaging conditions, such as limits on executive compensation, banning dividend payouts beyond de minimis amounts, and limits on stock buybacks and acquisitions.

(Certainly, these institutions are not raising dividends and buying back stock anytime in the near future, but these restrictions may prove quite damaging for their stock prices two-three years from now. On executive compensation limits, at a time when a firm needs to acquire top talent those that can deliver most effectively will simply look in another direction if their pay is going to be held back – these demands are very near-sighted and quite hostile to relatively free market principles. But that has been one of the concerns all along.)

So the market is still assessing all of these things. We may very well extend upon the rally that has given us a 16% boost from the multi-year nadir hit on November 20, but not without a pull-back period of assessment as we’re finding.

The broad market’s 8% decline over the past four sessions comes as some credit spreads have narrowed significantly. The TED Spread (as most readers know is a measure of the market’s willingness to take risk – a wider spread means risk aversion) has narrowed the most since this whole fiasco truly began in September.


Further, the spread on top-rated credit card-backed debt and similar bonds backed by auto loans have also narrowed thanks to the Fed’s Term Asset Backed Lending Facility (TALF). These spreads moved to historic wides as investors fled to the safety of U.S. government bonds. Now with the Fed beginning to step in, these loans will come off of more prohibitive levels for consumers.

That said, no one can make consumers borrow, the large issue of a deteriorating labor market will keep activity subdued. Personally, while the Fed is the lender of last resort, I don’t believe them stepping into the consumer-loan market is part of their job, but mention it just to explain what’s occurring.

Commercial Paper issuance has also rebounded. This source of short-term funding that businesses use to meet payroll and purchase inventory was in the process of collapsing in September and October. The Fed attacked this problem via its Commercial Paper Funding Facility (CPFF), one of its most successful moves yet.


Now, the levels CP issuance hit in 2007 and into 2008 where not sustainable, so the goal wasn’t to get this activity back to those levels. Instead, the objective was to halt a very troubling slide that resulted in credit access being shut off to even fairly well-positioned small businesses as investors fled for safety when the Lehman collapse occurred on September 15.

Part of what’s occurred in the labor market has resulted from firms having to close their doors as funding shutdown. And we’re not talking about businesses that were poorly managed – that is what recessions are about, killing off these unfit firms – but rather those that were pretty well managed but merely not ready for a credit freeze-up that has not been seen for a very long time.

So while financial stability has improved, investors are still leery of additional fallout.

This morning will be another quiet one on the economic front. We do get the November trade balance and the monthly budget statement for December; however, we already know what these two are going to look like.

The trade gap will very likely narrow as the plunge in energy prices and very weak consumer activity caused imports to trail export activity for November. Both will be weak, but imports likely more so.

The monthly budget statement will show the government ran another huge deficit in December, but this is no surprise. Government spending has exploded, while the weak economy has caused revenues to decline.

The first-half of the TARP money makes up much of this spending explosion, but remember that these funds were issued via preferred shares yielding 5%. One can argue about the terms, and of course the plan in general, but the vast majority of these funds will be paid back with interest.

More concerning to me is the spending that will occur this year and next (and the overall permanence of government programs) as the funds go to who knows what with little chance of much of these projects delivering productivity enhancements down the road. This spending will massively increase the deficit, which is expected to come in at $1 trillion for fiscal year 2009. It will also crowd out private-sector activity if history is any guide.

I laugh at all of those in the press that have made a big deal about budget deficits over the past three decades – deficits that were quite manageable, averaging 2.4% of GDP. A deficit of $1 trillion amounts to 7% as a percentage of GDP, and won’t be any smaller for 2010 in my view.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

The curve flattened 7 basis points today to 156 basis points as the 2-year was mostly unchanged on the day to yield .74% and the 10-year rallied about three-quarters of a point in price to yield 2.3%.

Mortgages Widen
New-issue 30-year Agency MBS widened out to begin the week at 107 basis points over comparable Treasuries from just 78 basis points late last week. This is likely a correction to the market overreacting with regards to the impact of the Fed buying MBS. The impact is likely to be great, but it will take a few weeks in order for the market to gain more insight into what the exactly the Fed is looking to buy.

The New York Fed reported $10.2 billion of Agency MBS purchases from January 5th through the 7th, while concentrating on 4.5% and 5% coupon 30 year pass-throughs, as we expected. This is perhaps a slower start compared to what the market expected, causing the considerable widening today. We will continue to get a report on their purchases every Thursday for as long as the program is in effect.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Afternoon Review

Hologic (HOLX) +13.12%
Hologic – a leading developer, manufacturer and supplier of premium diagnostics, medical imaging systems and surgical products dedicated to serving the healthcare needs of women – announced preliminary first quarter fiscal 2009 earnings that exceeded the company’s initial guidance. The company’s revenues, however, are now expected to be three percent below their previously issued guidance.

Hologic lost nearly 62 percent in 2008, 32 percent of that decline coming in the fourth quarter. Companies within the medical equipment industry saw an unprecedented decline in hospital spending due to the severe and rapid economic downturn. Hospital systems across the country have responded to tightening access to capital by restricting capital expenditures, implementing tight spending controls and reducing personnel.


Bank of America -12.01%
A Citigroup analyst issued a report today suggesting that Bank of America may post a loss of $0.75/share, compared with his earlier estimate of a $0.02/share profit, and they may reduce its dividend to $0.05/share from $0.32/share.

Bank of America raised $10 billion in October in a share sale, received $25 billion from TARP and halved its dividend to prepare for a slower economy. However, the analyst report estimates that Bank of America may have cumulative losses of $165 billion between 2008 and 2011. “So far about 33 percent have been taken either through loan loss provision or purchase accounting marks.” About a third of the expected losses, or $57 billion, are likely from credit-card lending, with about $29 billion from home loans made by Countrywide Financial Corp.

Also hurting financial shares was a statement from President-elect Obama that companies who receive TARP money should face restrictions with their dividend payments and share repurchases.


Principal Financial Group (PFG) -11.41%
Principal, as well as other life insurers tumbled on news that the National Association of Insurance Commissioners rejected an industry plea to loosen reserve standards after investment losses depleted capital across the industry.

Financial stocks were battered after news reports that Obama would limit dividend payments and share repurchases for institutions that receive TARP funds.


Seagate Technology (STX) -15.60%
Seagate, the world’s biggest maker of hard-disk drives, replaced CEO William Watkins and said it will cut 10 percent of its U.S. workforce as sales and profit drop amid the recession. The new CEO will be Chairman Stephen Luczo, who ran the company for six years before Watkins was in the position.


Earnings Season
The big market declines today is evidence that investors are bracing for a grim earnings season, which began this afternoon after the close with Alcoa posting disappointing results.

Analysts are expecting to see a decline of more than 15 percent in aggregate fourth-quarter earnings at S&P 500 companies, once all the reports are in hand. Such a decline would represent the sixth straight quarter of falling S&P profits. However, there is increasing sentiment that earnings expectations are still too high.

Two of the more interesting companies set to report earnings this week are JPMorgan (JPM) and Intel (INTC). The market will be paying close attention to their comments on the outlook for future quarters, looking for hints about when the long-running U.S. recession will wind down as well as the general health of the financial and technology sectors.


--

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks moved lower on Friday, marking the worst weekly performance in seven weeks, after the December jobs report showed the economy shed 1.5 million payroll positions last quarter. While the December employment reading was not as bad as the whisper number, back-to-back monthly losses of more than 500k makes it about impossible for stocks to shake off the pessimism that results.

I think there is a positive view we can take from these job-loss numbers, however. The speed at which firms have cuts jobs is commensurate with the speed at which economic activity ground to a halt and as a result we may see the worst will have occurred when look back two months from now. Its possible firms may be close to meeting their headcount objectives and the degree of monthly losses may ease faster than most currently anticipate.

For now, the high number of job cuts only increases global-recession concerns and with earnings season kicking off this week – surely posting the worst decline since the second-quarter of 2001 and possibly the worst since 1991 – all of those expecting the so-called “January Effect” to boost stock prices, without an additional pullback, may be disappointed.

Market Activity for January 9, 2009

The broad market, as measured by the S&P 500, remains 18% above the November 20 low even after last week’s 4.45% decline. The even broader NYSE Composite remains 22.5% higher than that November low.

The Economy

The Labor Department reported the number of job losses last month was pretty much in-line with the overt expectation, shedding 524,000 payroll positions. This marks the fourth-straight month in which nonfarm payrolls fell by more than 400,000.

Seventy-five percent of the job losses for all of 2008 occurred in the final four months, so maybe this helps to explain our sentiment that the economy truly didn’t move into recession until September. Payrolls dropped 1.5 million in the fourth quarter, the largest quarterly decline since 1945.


In any event, the unofficial number circulating among traders – the whisper number -- was for something much larger, closer to 650,000. So in this regard the actual reading was viewed with some optimism when released. Unfortunately, a reading of -524,000 (on top of downward revisions for the past couple of months) weighed on investor sentiment and this showed up in the final hour of trading.

All but two sectors/industries shed positions last month. Education and health services remain the bright spots, adding 7,000 and 38,000, respectively. Neither of these areas has recorded a decline in this downturn.

Goods producing industries lost another 251,000 in December (accelerating from the 182,000 lost in November), 101k coming from construction and 149k from manufacturing. The service sector lost 273,000 (an improvement from the 402,000 plunge in November, but I guess anything would be from that level). Trade and transport shed 121k, while retail trade eliminated 67k positions.

The unemployment rate jumped to 7.2% -- the highest level since 1993 -- from 6.8% in November. Household employment, the unemployment rate runs off of the household survey, plunged 806,000 in December. The difference from the payroll survey (which is the job change number represented in the chart above) and the household survey is the latter includes the self-employed.


Hours worked fell a massive 7.7% at an annual rate in the fourth quarter, offering a clear indication we’ll get a 5%-plus decline in real GDP for the fourth quarter. The figure is released on January 30.

The bright side of the report was the earnings figure, which remains remarkably strong.

Average hourly earnings came in at 3.7% on a year-over-year basis. While this is down slightly from 3.8% in November, hourly earnings have bounced over the past three months and with the inflation gauges posting very low readings due to the plunge in energy prices real (inflation-adjusted) incomes are very positive – up 2.6% on a year-over-year basis. This is a significant benefit to the consumer.

Now, I must make it clear, a very weak job market and the drop in hours worked (which has caused an index of hours worked multiplied by average hourly earnings to deteriorate in a meaningful way -- down 5.6% at an annual rate over the last three months) will weigh on consumer activity.

Further, consumers are building cash savings due to the substantial decline in equity and home prices, so this should keep activity depressed for a little while still.

But because of the fact that real wage growth is substantially higher than the historic average of 0.6% it isn’t crazy to assume consumer activity may bounce more quickly than many currently believe. (I’ll note the long-term average for real disposable income growth – after-tax, inflation-adjusted income – a much broader measure than the rather narrow hourly wage data, is 3.15% per year -- that’s important perspective especially since the press only reports on the lower figure.)

This quicker-than-expected bounce assumes that we will have seen the worst the labor market has to offer over the next two months. We’ll have to wait for a couple of jobless claims readings and another ISM report for a better indication, but one has to assume much work in reducing headcount has been accomplished.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks began yesterday’s session lower after Wal-Mart stated fourth-quarter profit will miss its forecast and predicted January sales may not grow at all. If any retailers seemed safe in this environment it was the discounters, so this news out of Wally world is a surprise. Most indices, however, rallied in the back-half of the day, led by energy and technology shares.

The Dow Industrial Average failed to participate in the rally, held back by shares of Wal-Mart – the most hated retailer on the planet subtracted 33 points from the index.

Bloomberg reported that stocks were also helped by news that Citigroup agreed to back legislation allowing bankruptcy courts to modify mortgage contracts.

We’re not so sure. This may be one of the early signs that government has greater power to force the private-sector’s hand -- after all, Citigroup was opposed to this legislation when it was initially proposed just a few months ago; it didn’t have the numbers to pass Congress back then. If you accept money from the government (such as TARP funds and the rescue package Treasury came up with in early December) then you’ll find the government has more sway in determining business decisions.

I’ll note, these institutions didn’t have much choice in the matter, without the government assistance firms like Citigroup would have gone down as mark-to-market accounting rules greatly exacerbate their over-leveraged troubles. Oh, and that increased degree of leverage was encouraged by a Federal Reserve that kept real short-term interest rates negative 2003-2005, which essentially subsidizes debt

But back to the topic, I don’t necessarily view what’s known as cram down as a good thing, particularly with regard to borrowers that put little if any money down.

For instance, the FDIC’s plan to modify loans is showing that 50% of those with no skin in the game simply live rent-free for another three months only to walk away later. Why would Citigroup’s borrowers be any different? Sure, bankruptcy courts will be able to reduce the principal amounts of mortgage loans along with the rate of interest, which will be helpful to those that put little money down. Nevertheless, I don’t think we should have much confidence in these derelicts (people who simple walk away from their largest financial obligation) to do what it takes to stay in their homes no matter how the loan is modified. Well see.

Market Activity for January 8, 2009

Economic Front

The Labor Department reported initial jobless claims unexpected fell last week, declining 24,000 to 467,000 – three-month low. This was quite a surprise and marks the second week in which first-time claims remained below the 500k level, two weeks ago the number looked as if it would soon blow through the 600k level.

Many seemed to believe the previous week’s decline was due to seasonal adjustments and winter weather that closed unemployment offices. For this latest week, there are reports from several states that electronic filing systems crashed due to volume, so we’ll really need to wait another week to see what is truly going on.

Considering the data we’ve received from a number of economic surveys – ISM , ADP, Challenger and the Conference Board’s net “plentiful less “hard to get” (pertaining to jobs) index – it is very difficult to believe the past two initial claims readings are pointing to an improving employment market. It’s just too early for improvement to occur – in my view we’re still several months away from meaningful reductions in the level of job losses.

The four-week average of initial claims fell for a second week as well.



The continuing claims data, those that remain on jobless benefit rolls for longer than a week, does jibe with other job-market indications. Continuing claims rose 101,000 to 4.611 million in the week ended December 27. This figure is just barely below the 1982 high and more closely resembles the nature of the job market.


This morning we get the official jobs report for December and expect payroll positions to decline 600,000 – the unemployment rate will likely hit 7.0%. If we get a decline of 600k, the economy will have lost 2.5 million jobs in 2008 (75% of which occurred in the final four months of the year). The job losses last year erased 30% of the 8.2 million jobs created 2003-2007.

In a separate report, the International Council of Shopping Centers (ICSC) announced same-store sales fell 2.7% in November from a year earlier. This marks the third-straight month of decline – since the ICSC began reporting on same-store retail sales there has never been back-to-back declines much less three in a row.

Drug and discount store sales have been the least affected, naturally, by the three-month pullback in consumer activity as was the also the case in November falling 0.6% and 1.0%, respectively. Department, luxury and apparel stores were the hardest hit as sales fell 10%-13%.

This is all part of consumers adding to cash savings as the major savings vehicles, homes and stocks, have been hit hard. It has been the damage in the stock market in particularly that has really caused consumers to retrench. No doubt the decline in the labor market has had an affect as well, but in the aggregate most of the damage to confidence has resulted from the plunge in equity prices October-November.

This is why a tax-rate response is the most efficient, and least burdensome to the budget, prescription to the current weakness. Legislation that drives disposable incomes immediately higher via substantial bracket cuts and boosts after-tax return expectations by halving the capital and dividend tax rates would do more than the panoply of programs and facilities delivered by the Treasury and the Fed – and without the unintended consequences. (Although, some of what the Fed has done, such as the commercial paper funding facility, has worked very well and reduced damage immensely. However, in the aggregate their decisions will leave us with an inflation issue to deal with, and I’m not talking 5% on the CPI if they’re not acutely responsive.)

We can engage in $800 billion, $1 trillion, or more in public works programs but this type of stimulus does not only lack staying power it takes 12-18 months to get off the ground. I don’t care how many times politicians state that shovels are already in the ground, they still have to go through federal and state appropriations. While this is good government, it causes a huge lag affect. It may very well prove to be the case that just when the bulk of the public spending is flowing through to the economy the business cycle will have already turned. We shall see.

Correction:

Yesterday, in an attempt to put the labor-market weakness in perspective, I stated the 500k in job losses that occurred in February 1958 accounted for 9% of payroll positions and the 600k in jobs losses that occurred in December 1974 accounted for 7.5% of total payroll positions. Today 600k in losses accounts for just 4.3%.

Those figures are actually 0.9%, 0.75% and 0.43%. Dan Esser informed me of this mistake. I apologize for the carelessness.

Have a great weekend!


Brent Vondera, Senior Analyst

Afternoon Review

Wal-Mart (WMT) -7.49%
Wal-Mart shares weighed on sentiment after the retailing giant cut profit guidance and reported lower than expected December same-store sales. The company said the difficult economy and severe winter weather in some regions hampered the holiday seasons at Wal-mart Stores, with softness in apparel and jewelry. Looking ahead, Wal-Mart said customers are focused on “value and necessities” and it expects same-store sales to be flat to up two percent.


Peabody Energy (BTU) +4.71%
Peabody announced it is cutting its expected 2009 production targets in response to the current weak U.S. thermal and global steel markets. To address excessive inventories in the Power River Basin (PRB), Peabody plans to reduce targeted 2009 PRB output by 10 million tons (approximately five percent of their total U.S. output). Following the cuts, Peabody’s U.S. production is essentially fully priced.

To address weak global steel demand, Peabody plans to reduce targeted Australian metallurgical coal (coal used in the steelmaking process) production by two million tons (approximately 20 percent of Peabody’s Australian metallurgical coal production).


EMC Corp (EMC) +6.35%
Data storage company EMC reaffirmed its fourth quarter earnings and revenue guidance and announced a program to cut costs. As part of its restructuring program, EMC plans to cut 2,400 jobs, or about seven percent of its workforce. EMC expects the program to reduce costs from its 2008 annualized rate by approximately $350 million in 2009, increasing to approximately $500 million in 2010.


Quick Hits

• Credit Downgrade Hits Bank of America’s Debt, Equity
• Citigroup Supports Letting Bankruptcy Courts Reset Mortgages
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks began the day lower, a typical breather after rallying six of the past eight sessions, and the downward pressure accelerated after Kansas City Fed Bank President Thomas Hoenig delivered a rather gloomy picture of the economy and preliminary employment reports indicated the December losses will likely eclipse what we saw in November. News out of Intel explaining how business equipment production collapsed in the back-half of the fourth quarter didn’t help matters.

Technology shares took a lot of the damage, but energy stocks endured the biggest hit as oil prices slid – so much for those worries over Russia and the Middle East. Traditional safe-havens, health-care, utilities and consumer staples were the relative winners yesterday, but even these shares traded lower.

While the press focused on the Intel, Thomas Hoenig and employment report news as the reasons for the sell-off, those realities are not unexpected as a stock market that is down 42% from the peak suggests. Market participants know full-well that the fourth quarter was a disaster; the worst quarter in at least 26 years.

In terms of the Hoenig speech, the Fed member stated a recovery may not emerge until the third quarter. Now I know the NBER (the arbiter of business cycle peaks and troughs) officially announced the recession began in December 2007, but come on most know it truly began in September 2008. What? Is the press acting as if this is some revelation? There’s little doubt economic growth will remain depressed in the first half of 2009; the KC Fed Bank president’s comments on this topic are in line with overall expectations

Stocks were destined to give back some of the rally that had brought us 24% above the November 20 low, such rallies rarely occur without some sort of pullback; the Intel and Hoenig news just offered a more concrete reason to explain the declines.

Market Activity for January 7, 2009

That said, Hoenig did warn against trying to mitigate what naturally needs to occur in the economy by making too many attempts at mollifying recessionary effects. By trying too much (pumping massive amounts of liquidity into the system that will cause inflation to rage if not taken back properly) or implementing plans that have a history of doing more harm than good in the long run (such as public works programs, and the way it crowds out private sector activity) we put future stability and growth at risk.

Indeed, he has a concerning point there. As we discussed in yesterday’s letter, there is not free lunch, every action has its cost. In terms of the market, however, it is not necessarily focused on these risks right now as getting things up and running is the primary agenda.

We too were concerned about the deterioration that resulted back in October/November, but some of the most troubling issues – the growing risk of runs on banks and a total shutdown of credit -- are no longer a major concern. But make no mistake, from where I sit, these were very real concerns and we were staring down the abyss at the beginning of the fourth quarter. Now that those risks have eased, however, the government needs to lay off a bit and allow things to run their course.

Crude-Oil

Oil futures prices plunged 12% yesterday after the weekly Energy Department report showed supplies of crude and gasoline rose more than expected.


Inventories of crude rose 6.68 million to 325.4 million barrels in the week ended January 2 – supplies were forecast to increase just 800,000 barrels. While the jump was large, supplies are in line with the five-year average.

Gasoline inventories jumped by triple the amount expected, yet stockpiles are only hitting the May levels.

On the demand side, activity actually increased last week and is just 1.4% below the May level, according to the American Petroleum Institute. It appears to me that the price of oil and its derivatives are artificially low, just as they were artificially high back in July.

Gasoline demand is a mere 1% below the 200-day moving average; for all we’ve heard about demand destruction (one of the favorite new phrases of our beloved press corps) activity isn’t terribly depressed.


The Housing Market

The Mortgage Bankers Association announced its mortgage applications index fell 8.2% for the week ended January 2 after no change in the previous week and a huge 48% bounce the week ended December 19.

On the table below the Market Index represents total mortgage applications.


While the overall index declined due to a 12.3% drop in refinancing activity, the purchase side of the index rose 7.3%, marking the third week of increase -- much lower mortgage rates has begun to fuel sales, let’s hope the trend holds.


Employment Reports

The Challenger Job Cuts report showed layoff announcements nearly quadrupled in December from a year earlier. The declines were driven by job cut announcements in the East, which means the financial sector led the overall figure higher.

Firing plans jumped 275% to 166,348 last month, according to the nation’s premier outplacement firm Challenger, Gray & Christmas. The firm expects the job-cutting to continue through the first-half of 2009.

In yet another jobs report, the ADP Employment Change survey estimated that December job losses will approach 700,000 – the official Labor Department report is released on Friday and a loss of 500,000 jobs is expected.

We’ll note ADP isn’t the most reliable indication of what actually occurs, which is strange considering they’re a major payroll-service firm. ADP has made methodological revisions to their survey in an attempt to more closely fit the employment data, so we’ll see if it is more accurate this go around. In any event, it does offer a good indication that the official job losses for December will be a large number, which is corroborated by the initial jobless claims figures and the ISM surveys that have printed very weak employment readings.


Friday’s jobs report is going to be ugly, and we’re thinking the number will be worse than expected, possibly approaching 600,000.

Monthly job losses of 500,000 or more are rare and one has to go back to the deep recessions of 1957-58 and 1973-74 to see such declines. That said we need to provide some context, especially since no one else seems to be doing so. The job market is obviously much larger than it was in 1974, and nearly triple the size of the 1958 economy.

Back in 1958, a decline off 500,000, which occurred in February of that year, accounted for 9% of all payroll positions. Back in December 1974, when payrolls declined 602,000 it accounted for 7.5% of total payroll positions.

Today, there are 137 million payroll positions, so a decline of 600,000 accounts for just 4.3% of the job market. To hit the degree of job losses in those past periods, adjusting for job growth, we’d have to see a monthly job loss of more than one million. While the current levels of job losses are harsh – I’m not trying to downplay it – we need to keep things in perspective.

Just out, the Bank of England has cut their key interest rate (the bank rate, which is their version of our fed funds rate) by 50 basis points. The bank rate now sits at the lowest level on record at 1.50%.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

Monsanto (MON) +17.29% *updated tearsheet available*
Monsanto reported strong earnings and revenues for its first fiscal quarter and raised its full-year outlook. The company continues to benefit from market share gains due to the quality of its portfolio.

With the most significant part of its business cycle still to come, the first quarter results signaled a good start to the year, though it primarily reflects the impact of its Latin American businesses. The company said its second and third quarters are expected to be the primary drivers for full-year results since they reflect the relative size of its U.S. businesses and the importance of its seeds-and-traits business.

Monsanto is exceptionally well positioned, the balance sheet is strong and competitors are struggling to keep up, much less narrow the gap. While profitability in the agriculture sector is clearly important for Monsanto, the value proposition in the products and the near-global political focus on agricultural output positions the company for strong growth.

Monsanto has a strong record of buybacks, but pays a relatively tiny dividend considering the strength and likely longevity of profitability. As markets become more restive, a higher dividend might be more beneficial for the stock’s valuation than continued buybacks.


Intel (INTC) -6.05%
Intel said it expects fourth quarter revenue of about $8.2 billion, down 20 percent sequentially and 23 percent year over year, and below its previous guidance of $8.74 billion. Intel’s fourth-quarter gross margin, the percentage of sales left after production costs, was at the lower end of the range it had predicted. Intel also wrote down the value of its investment in Clearwire Corp by $950 million.

Intel cited the weakness in end demand and inventory reductions by its customers in the global PC supply chain as causes for the shortfall. Global PC production fell 15 percent from the previous quarter with PC companies making 3 percent fewer notebooks and 27 percent fewer desktop machines.

The earnings warning from Intel was not entirely surprising given the other semiconductor warnings that have stacked up in recent weeks. Intel’s smaller rival, Advanced Micro Devices (AMD), cuts its sales forecast on December 4, saying it expected revenue to decline about 25 percent.

Much of the upside for Intel is dependent upon a new chip called Atom, designed specifically for simple, inexpensive mobile machines such as netbooks. The problem is that Intel has traditionally commanded a premium for its processors, but it’s not clear the company can continue to command that premium given that vendors such as Hewlett-Packard seem willing to choose chips from rival Advanced Micro Devices (AMD) for these simple machines.


Quick Hits

• Commodity Rebalancing Rally Tails Off
• PG Fights for Cash Amid $2 Trillion U.S. Borrowings
• Pawn Shop Borrowing: The Upside

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks ended a bouncy session higher as President-elect Obama explicitly stated his stimulus plan will reach $775 billion. (These budget and cost assumptions are never accurate, so give zero credence to this number; what it shows is the plan will be massive). On Monday corporate profit concerns seemed to outweigh any excitement over government stimulus, yesterday it was the reverse.

Stocks have gained ground in four of the past five sessions. More likely than some shifting in sentiment between the stimulus plans and what will be a very weak earnings season is that money managers are stepping into the market after stocks have rallied nicely off of the November 20 low.

We are now 24% above that multi-year low on the S&P 500 and 28% for the NYSE Composite and should expect the market to take a breather after a run of this magnitude.

Real estate and financial shares (the sectors that have endured the deepest losses) benefited on the news firms will be able to take losses incurred in 2008 and 2009 to offset tax bills dating back five years. I suppose this means they’ll be refunded, if indeed the plan is implemented as we discussed yesterday.

The tech-sector jumped 3.3% as the group will be a primary beneficiary of higher business-equipment write-off allowances, the most constructive aspect of the Obama overall stimulus proposal.

Market Activity for January 6, 2009

Economic Data

The Institute for Supply Management announced their survey on the service-sector contracted in December for the third-straight month as consumers continue to build up cash savings in the face of a continued decline in home prices and the October/November plunge in stock prices. While the broad market has bounced nicely off of the November 20 low the psychological blow remains in place.

The ISM non-manufacturing index posted a reading of 40.6, a mild improvement from the 37.3 low hit in November. That November reading was the lowest in the survey’s history; although, it only goes back to 1997, so not much history here. The December reading was better-than-expected as further deterioration was anticipated. Still, 50 is the threshold between expansion and contraction, so a reading of 40 illustrates activity remained very weak.


The more forward-looking sub-indices within the report showed a little improvement as well. The new orders index rose to 39.9 from 35.4 in November. The orders backlog index hit 42.5 after 39.5 in the previous month.

We expect the overall reading to improve over the next couple of months. The bounce in stocks, if it holds, should help to relieve some anxiety. Plus, the 65% plunge in gasoline prices has left billions in the pockets of consumers and this extra money should find its way to retail stores. Taking a longer view though, it will be a while (only wish I knew what a while means in months) before we can get to a situation in which the service sector shows sustainable growth as a deteriorating labor market weighs on consumer activity. Mining and utility activity is also part of the index and these sectors should remain depressed for some time still.

On the bright side, the government’s stimulus plan (while I’ve got major issues with its short-term nature and inefficient use of capital) will boost public-sector construction activity, which is also part of the ISM non-manufacturing index. As we head into the third quarter, this segment of the report should offer some life to the index’s readings.

In a separate report, the Commerce Department reported that November factory orders declined 4.6% after plunging 6.0% in October. The back-to-back declines were the largest since records began in 1992.

The business-equipment spending component of the report bounced, rising 3.9% in November after declining for three months – mirroring what the durable goods orders report showed just before the Christmas holiday.

The downside is a 7.4% decline in nondurable goods fully offset the rebound in business spending. This was related to a substantial drop in the price of petroleum products as petro and coal products fell 21% in November.

Finally, in a separate report Commerce reported that pending home sales fell a larger-than-expected 4.0% for November and the October reading was revised much lower to show a 4.2% drop instead of the mild 0.7% decline estimated last month. This large downward revision explains the 8.0% decline in existing home sales for November, a reading we received several days ago.

This data continues to show there is little evidence housing activity has hit a bottom. However, we do believe reversion to the mean (erasing the outsized growth in home prices that occurred 2002-2006), has occurred and may have moved beyond the longer-term average for home prices. Since 2000, the median price of an existing home is up 3% at an annual rate – the long-run average is closer to 5%.

No one should expect the housing market to bounce back quickly as we have foreclosures and a weak labor market to deal with still, but the market has done much work in removing past excesses. Another thing is the meaningful decline in mortgage rates. This should boost sales over the next few months.

The Fed is currently working to lower mortgage spreads (the spread between the 10-year Treasury and the 30-year fixed mortgage rate is traditionally 180 basis points, today that spread is very wide at 250 basis points). The Federal Reserve began to attack this head-on yesterday by buying mortgage-backed securities.

The plan is part of a $600 billion plan that also includes buying GSE (Fannie and Freddie) debt. Mortgage rates would be in the low-to-mid 4% range if spreads were normal and this is the level the Fed will try to bring the fixed rate down to. The downside is they are printing money to fund the plan, which will kick inflation higher 8-12 months down the road – everything has its cost.

Fed Minutes

The Fed released its minutes (notes) yesterday from the previous FOMC meeting. In short, they stated the credit markets have improved but remain under severe stress, the downside risks to economic activity were a serious concern and they will remain very aggressive with regard to their policy.

Their key interest rate is virtually zero, so there’s no firepower left regarding traditional monetary easing. What they’ll do is continue to engage in aggressive quantitative easing, which means they will continue to engage in lending facilities to pump liquidity into the system. Problem with this is they can’t force banks to lend or consumers to borrow. However, when this does begin to occur in a more normal way that liquidity is going to rage throughout the economy.

The FOMC will also continue to print money in order to fund programs like buying mortgage-backed securities we touched on above.

This brings us to the most interesting aspect of the minutes. The Fed seems to think that their decision to pay interest on bank deposits at the Fed will allow them to take back this liquidity quickly so to avoid a troubling inflationary event. They’ll simply increase the interest rate on Fed deposits, which will cause banks to keep a higher level of deposits at the Fed, thus removing money supply from the system.

Problem is it will be difficult to pull this trigger as these higher rates will mean the longer-end of the Treasury curve will sell off, sending those rates higher as well. At which point, what may be a nascent housing market rebound will run into the road block of higher rates, making it very difficult for the Fed to do what it takes to keep inflation in check. But the Fed seems confident they can pull it off.

Good luck with that one.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

There was no major news that specifically moved any of our Approved List companies today. The markets continue to move higher on speculation that the U.S. economic stimulus plan can help the country out of recession. Barack Obama told House Speaker Nancy Pelosi he favors a price tag of about $775 billion for the stimulus, and pledges “unprecedented transparency” including publishing online “very detailed information about all the projects that are taking place.”

At this point, Obama is trying to provide the markets (both domestic and global) with what they need most: confidence. The stimulus itself is unlikely to make the economy turn around any faster, but the speed and efficiency with which the government implements the funds will have a large effect on confidence.

Rewind to 9/29/2008 when Congress could not agree on the Economic Stabilization Bill. The government’s perceived uncertainty transferred directly to the stock markets, which fell nearly 9 percent that day.

I personally think economists are kidding themselves if they believe this stimulus package will create long-term jobs; however, the country’s rising unemployment could benefit if short-term employment opportunities prop up the work force until the economy reverses course.

I also think that the personal tax cuts will provide little aid to the economy. Look no further than the Bush tax refund in 2008 to see that most people pocketed the money and the temporary increase in spending simply delayed the inevitable. The business tax cuts, on the other hand, are more likely to have a positive effect on the economy. Either way, the tax cuts are crucial to the acceptance of a plan that is based on building confidence.

Spending nearly $800 billion on a short-term fix does seem a bit irrational, but if the money is spent in areas that will improve U.S. productivity and competitiveness then we can truly view this package as an investment rather than spending. This isn’t like the taxpayer’s investment in the financial system – which someday in the future will be viewed as genius or asinine – in that the dividends and returns will be far more difficult, if not impossible, to measure.

But, few can argue with long-term vision for the stimulus plan. Our internet infrastructure is embarrassing, our healthcare sector wastes billions of dollars a year due to record keeping mistakes and our transportation system leaves much to be desired, just to name a few.

How can the government can possibly allocate resources better than the free market? They probably can't. I am sure that there will be projects receiving funds that don’t deserve it, and contracts will not always be awarded as they might be on the free market, but that is not what a stimulus is about. This stimulus should serve as a kick in the butt to our country to tackle projects that wouldn’t be touched for years, while instilling much needed confidence in our country.

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Peter Lazaroff, Junior Analyst