Daily Insight

U.S. stocks rallied yesterday on news that the government will set up a “bad bank” (similar to the original purpose of the TARP) to purchase, house and eventually sell troubled assets. The plan is expected to be officially announced next week, so we’ll have to wait for specifics until then.

The market likes this, for now at least, as it moves us closer to finding a solution to the problem. Banks jumped nearly 13%, although it isn’t totally clear current shareholders will benefit. There has been talk that the government will take common equity stakes in some cases, which will further dilute shareholders.

Consumer discretionary, technology, basic materials, industrials and energy shares also performed well. Energy and tech is up 7% over the last three sessions.


The market in general has bounced nicely, up 9% over the last week, after hitting 800 on the S&P 500 on Inauguration Day. It’s important from a psychological perspective to stay above the 700 handle.

Market Activity for January 28, 2009

Crude-Oil

Oil prices for March delivery rose 1.6% yesterday, ending the 10% slide of the previous two sessions. A large reduction in gasoline supplies offset a larger-than-expected increase in crude supplies.


The Energy Department, in its weekly report, stated crude supplies jumped 6.22 million to 338.9 million barrels – over the past couple of weeks supply has moved meaningfully above the five-year average of $305 million barrels. Analysts expected crude supplies to build by 2.9 million.

However, gasoline supplies fell 121,000 barrels – a two million barrel build was expected – and this interrupted a bearish trend that looked to be setting up over prior two sessions.

Refinery runs have been very light over the past few weeks, so the pick up in demand due to the plunge in pump prices is showing increased production may be in order. Refinery margins have been on the rise from the very low levels of November, which should incentive higher refinery run rates.

The crack spread measures the relationship between crude-oil futures and oil product futures, per barrel. When it rises refining profitability is likely to increase and when it falls… you get the point.


Mortgage Applications

The Mortgage Banker’s Association index of applications fell 38.8% in the week ended January 23 – this marks the largest drop in 16 years as refinancing activity plunged. The 30-year mortgage rate rose to 5.22% on average after hitting 4.89% in the week ended January 9. There are a lot of people waiting to refi, but not at this level. They’ve got things set to hit somewhere in the 4% handle.

Purchases also fell but the decline was mild, down 2.5% for the week. We’ve moved to such low levels regarding home sales let’s hope additional downside is contained.


FOMC Meeting

On Rates
The FOMC decided to keep its target range for the federal funds rate at 0%-0.25% as they anticipate the economy will continue to warrant exceptionally low levels of fed funds for some time.

On the Economy
The members stated that information received since they last met in December suggests the economy has weakened further. (No surprise there as we touch on these things daily) The FOMC noted that industrial production, housing starts and employment have continued to decline steeply as consumers and businesses cut back on spending.
Conditions in some financial markets have improved, yet credit conditions for households and firms remain extremely tight. (This is pretty much how it works when the economy is in downturn)

Policy Direction
The FOMC stated that it is “prepared to purchase” Treasuries if it believes such action would be effective in improving private-sector credit conditions. The lone dissenter was Richmond Fed Bank President Lacker as he favored purchasing Treasuries immediately. (This may suggest the Fed is not terribly close to progressing down this road)

And let’s hope so. They have done what they can to unfreeze the credit markets, some of their programs have worked very effectively and may not have longer-term consequences, but other programs will. If they are truly thinking about printing more money to buy Treasury securities in an attempt to keep market rates extremely low (and not just bluffing to push the market into doing the job for them – a long-held axiom is never fight the fed) this would be one of those decisions that have long-run consequences, namely fueling harmful levels of inflation.

We don’t need more of this printing press mentality. They have done enough. Now the fiscal side must work in cooperation with the Fed and slash tax rates on incomes, capital and corporate profits. This will not only assist the Fed currently, as they jam the monetary easing pedal to the floor, but will help them do their job of taking away this stimulus down the road (as a pro-growth tax environment will help to offset monetary tightening) so to keep inflation from totally raging out of control a year to 18 months out – this the old Reagan/Volcker model.

The markets need to see this type of response because for now investors are assuming we’ll get Fed tightening and higher tax rates 18 months out. That spells economic shutdown. Policy makers need to wake up or we’ll find economic weakness returns just when the economy is regaining its footing.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

General Electric (GE) +3.37%
Moody’s Investors Service said it’s evaluating whether to lower the long-term debt rating for GE and GE Capital, a review that takes about 90 days.

GE expects to generate as much as $16 billion in cash this year after capital expenses, which would be more than enough to pay out roughly $13 billion in dividends (at $1.24 per share). Moody’s is examining the sustainability of GE’s cash flow and, more specifically, wants GE Capital to earn enough to restore a larger payment to the parent company in 2010 – GE is expecting $500 million from a reduced payment GE Capital makes to the parent company.

Under GE’s business model, the finance unit gives the parent a percentage of profit that’s redistributed to all of GE’s businesses. In September, GE allowed GE Capital to cut its contribution to 10 percent of the unit’s profit from 40 percent.

CEO Jeff Immelt and GE’s board consider paying the dividend a good way to return value to shareholders. According to Bloomberg, 40 percent of GE’s holders of its 10.5 billion outstanding shares are individual investors. Immelt explained, “It has just been the judgment that this has been the most investor-friendly use of this capital.”

These days it’s not as essential to have the Triple-A to get funding, but it is an important psychological level. (The difference in cost of borrowing prior to the credit crisis was minor from one level to the next; however, that is not the case today amidst credit market turmoil.) While a cut of the dividend and/or rating may create near-term pressure, ultimately removing these overhangs should be good for the stock.


General Dynamics (GD) +7.70%
General Dynamics said fourth-quarter earnings rose 5.7 percent and made a conservative initial forecast for 2009 earnings. The aerospace group posted the largest quarterly gain among the company’s four units, with ships and information technology also rising, while revenue from combat systems declined.

The company acquired Jet Aviation, for $2.2 billion to expand flight-support into Europe, Asia and South America. The added service revenue will help keep the aerospace unit growing amid a global recession that may weaken demand for Gulfstream jets. The Jet Aviation acquisition helped lift quarterly sales at the company’s aerospace unit by 27 percent to $1.53 billion.

For the full year, operating earnings grew significantly faster than revenue and free cash flow from operations totaled 106 percent of net earnings, showing the strong quality of GD’s earnings.

The company’s total backlog grew by $13.6 billion in the fourth quarter to $74.1 billion. For the full year, company-wide operating margins increased by 110 basis points over 2007, to 12.5 percent.


WellPoint (WLP) +4.41%
WellPoint missed estimates for fourth-quarter earnings and will not give a profit forecast until their investor conference on Feb. 24.

Earnings of $0.65 per share were heavily affected by realized investment losses, which totaled $0.69 per share, or $543.2 million. WellPoint recorded a total of $1.1 billion in investment losses for 2008. Another negative was WellPoint’s membership, which has finally begun to feel the effects of rising unemployment.

The company also laid blame on their computers for their mistakes in setting rates too low and keeping elderly customers from receiving drugs – which ultimately led the government to block WellPoint this month from adding Medicare customers.

WellPoint’s medical loss ratio – the percent of premium revenue paid out to health providers – increased to 83.4 percent from 82.9 percent a year ago. Analysts view this percentage as an indicator of future profit. Although the medical cost ratio deteriorated in each quarter of 2008 compared with the prior year, the relative comparisons improved throughout the year. This indicates that the company was successful in raising prices on renewals as the year went on.


AT&T (T) -0.08%
AT&T said fourth-quarter profit fell 24 percent in the fourth quarter, but sales of the heavily subsidized iPhone exceeded expectations. Net income fell to $2.4 billion, or 41 cents a share, as the company recorded costs of 12 cents a share tied to acquisitions and seven cents for workforce reductions.

The company’s legacy businesses – traditional phone lines and advertising from directories – were particularly vulnerable in a weakening economy. The wireless business, however, added nearly 2.1 million net new customers thanks to strong sales of the iPhone.

The company is increasingly reliant on the iPhone for its growth and subsidizes the device to expand its wireless customer base. This quarter, subsidies paid to keep the iPhone 3G priced at $200 weighed on earnings by five cents a share, but AT&T expects the device to be more accretive in 2009 and 2010 as revenue from the more expensive calling plans offset the subsidies.

There is a growing concern among investors that the wireless business, which has been AT&T’s growth engine with years of rapid expansion, may be near saturation. The company wants to move its traditional phone customers to a more expensive bundled service called U-Verse in order to offset slowing wireless and wireline businesses. AT&T plans for U-Verse to reach 30 million homes by 2011.

Despite the prospects of slower future growth, AT&T’s operations continue to generate solid cash flow and its high dividend yield makes the shares a worthwhile investment.


Dover Corporation (DOV) +5.43%
Dover said its fourth-quarter profit dropped 35 percent, but still beat analysts’ expectations as falling demand in most markets offset growth in its energy segment.

Profitability improved in the quarter, with operating margins up 70 basis points over the prior year period and free cash flow made up 13.2 percent of revenue. The company continues to put emphasis on cash flow, which has been used for add-on acquisitions, share repurchases and investment in their businesses. Dover also increased their annual dividend for the 54th consecutive year.

The company reduced six percent of its headcount worldwide and said in the press release: “Further actions have already been taken in the first quarter and we are fully prepared to take additional steps to address any further deterioration in end-market conditions.”

Looking into 2009, Dover sees a continuation of a weak and uncertain global environment. The company expects decreased demand levels across all end markets to have an adverse impact on revenue, but the company is “very focused on protecting margins.”


Boeing (BA) +0.05%
Boeing posted a loss in the year’s final three months after a strike shut factories and faulty parts slowed efforts to restart production.

Boeing faces a potential increase in canceled or deferred orders this year as airlines cope with a drop in travel demand and tight credit. It also must carry development costs on the delayed 787 Dreamliner, which is now due to reach the first customer in early 2010, about two years later than planned.

CEO Jim McNerney said in today’s statement, “The progress we made in many areas of Boeing during 2008 was outweighed by the impact of the strike and our performance on some key development programs.” The Dreamliner delay drew engineers from other programs, causing slowdowns for other models including the 747-8 freighter and intercontinental passenger jet. Boeing said the 747-related expenses cost it $0.61 cents a share.

Boeing plans to deliver 480 to 485 planes this year, less than its July estimate of 500 to 505, and may have to provide $1 billion in financing to customers. Boeing’s order backlog for commercial planes was $279 billion at year-end.


Southern Company (SO) -1.63%
Southern Company, the largest U.S. power generator, said fourth-quarter profit fell 9.1 percent on costs related to leveraged leases on three international energy projects and as the recession curbed use of electricity.

Utility profit fell 9.4 percent as a decline in power demand because of the recession outweighed an increase in rates. The volume of power supplied to industrial customers dropped 10 percent. Southern added about 25,000 new customers from a year ago, about half the growth of previous years.

The company has budgeted $16.4 billion for capital expenditures through 2011, when it expects to begin expanding its Bogtle nuclear plant in Georgia. That’s up from the previous three-year plan of $14.4 billion. Spending on power lines probably will be cut by $200 million in the period because of slower customer growth.


Quick Hits

• FDIC May Run ‘Bad Bank’ in Plan to Purge Toxic Assets
• REITs in U.S. Consider Paying Dividend in Stock to Save Cash
• Robert Rubin Says Mark-to-Market has Done ‘Damage’
  
  

Peter Lazaroff, Junior Analyst

Fixed Income Recap

Treasuries rebounded, after selling off the past two days. The curve flattened by about 8 basis points in Tuesday’s trading as yields on the longer end of the curve remain much more volatile than the shorter. A basis point represents .01%.

As I’ve said before, supply concerns are in a battle with Fed buying expectations right now. On the days when large Treasury auction announcements dominate the news, supply worries takeover, and investors become concerned with Treasuries finding a bid. On days when it appears as though the Fed is going to continue its trend of keeping rates as low as possible, investors try to ride the wave of increased demand for Treasuries. Bond prices move inversely to yields.

The Fed will announce its target rate for Fed Funds tomorrow, which currently sits at a range of 0% - .25%, the lowest in history. The market expects the rate to remain unchanged but will listen closely to the comments that accompany the rate announcement tomorrow.

Fannie and Freddie
The two Government Sponsored Entities, who were taken into conservatorship in September of 2008, have begun to draw on the $200 billion of aid that was pledged to them by the Treasury. Freddie Mac is asking for $30 to $35 billion in new capital, on top of the $13.8 billion they received last November, and Fannie Mae is now making their first request of $11 to $16 billion. In addition, the FHFA, is proposing new rules that would trim the retained portfolios of Fannie and Freddie to $250 billion each. They currently sit at $782 billion and $804 billion respectively.

Moves such as this are moving the GSEs more towards the business practices they were initially created for, their guarantee portfolio. During the housing boom of 2003-2006 Fannie and Freddie became large buyers of non-conforming loans, both as a result of their desire to increase earnings and regulation that urged them to help previously unqualified buyers purchase homes.

The market isn’t showing any worry about the solvency of Fannie or Freddie as a result of these capital infusions. Credit spreads on longer senior debt of the agencies that still only carries the implied backing of the U.S. Government, as opposed to shorter debt that has an explicit guarantee, remains unaffected. And the Fed continues to take on more and more securitized agency MBS, as those spreads continue to tighten.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks added to Monday’s gain, shaking off another extremely weak Case/Shiller report and a consumer confidence (CC) reading that registered a new low. (Long time readers know I normally don’t spend time focusing on the CC reading, but for now you’ve got to keep some eye on it as this is one of those rare periods in which consumer activity has rolled over – a bounce in CC will offer a good indication on the direction of activity.)

The market was strangely quiet yesterday as the broad market traded very steady the entire session, an anomaly these days. Don’t know if this is telling us anything or not, we’ve seen a number of occasions over the past five months that seemed to offer more normal behavior may be on the horizon, only to see things become crazy again – too much government involvement right now to get excited.

Financials led stocks higher, maybe it was leaked the Obama Administration was about to set up a “bad bank” to house troubled assets – I don’t believe the news was actually released until after the bell. In any event, it’s not even clear this will be a plus for bank stocks longer-term as there’s talk of the government taking common equity stakes. Egad! But the shares seem to like it for now.

Industrials performed very well too. Considering the earnings report DuPont put out, the rise in these shares was surprising.
(That report from the chemical giant was just another sign of how things changed on a dime last quarter; we went from withstanding high energy prices and a nasty housing correction with amazing resilience to a real shutdown following the September 15 Lehman collapse in a flash.)


Market Activity for January 27, 2009

Housing Data

The S&P Case/Shiller Home Price index stated home values for the 20 major metro areas it tracks fell 2.23% in November and are down 18.18% over the past year.


That year-over-year reading continues to deteriorate, although the rate of decline has eased – for October prices were down 18.06% from the year–ago period.

The declines continue to be driven by areas that saw the largest level of speculation during the boom, such as Phoenix and Las Vegas – these are where foreclosures and thus distressed pricing is most evident. Also hurting the figure was increased weakness in Chicago and parts of the Northeast, areas that took a while before things got especially ugly.

Detroit, a special situation, continues to be hammered by the auto-industry malaise and state tax-rate hikes that continue to drive businesses and workers out of Michigan.

So we have existing home prices down 15% over the past year, the FHFA Home Price index down 8% and Case/Shiller down 18%. (Note: Case/Shiller is a month behind as its latest release is for November, the two others have released prices through December). Average the three and you get home prices off by roughly 13% over the past 12 months.

It doesn’t appear home prices will begin to flatten out for several months, especially since we have the weight of the labor market putting an additional drag on the housing market. But mortgage rates are low, and should go lower so long as Treasury Secretary Geithner gets a clue and doesn’t cause Treasury rates to jump via the currency fight he seems to be picking. It may take a 4.50% 30-year mortgage rate to get home sales fired up by the spring/summer, and as we’ve touched on before we think that is the target the Obama Administration will shoot for.

Consumer Confidence

The Conference Board’s index of consumer confidence dropped to a record low in January, falling to 37.7 from 38.6 in December. The present situation index fell to 29.9 from 30.2; the expectations index fell to 43.0 from 44.2.


The good news in the report, and I’m stretching here for a bright side, was consumers’ assessment of the labor market. The percentage of consumers judging jobs as “plentiful” rose to 7.2% from 6.5%, while those viewing jobs as “hard to get” feel to 41.1% from 41.5%. This means the net “plentiful” less “hard to get” index improved to -33.9% from -35.0% in December. This marks the first improvement in a year. The improvement was marginal, but we’ll take it. Now we need to see some help from the ISM surveys and jobless claims.

When consumers are comfortable with their cash savings, as their two major savings vehicles – homes and stocks – have been hit hard, and feel better about the labor market they will increase spending again, but probably not before. This is just one of the reasons we’ve harped on the need of a tax-rate response. Slashing rates on income would immediately drive disposable income higher and speed up recovery. Ignoring this pro-growth response to current economic problems is a big mistake.

Pre-Market Higher

Futures are higher this morning on news the Obama Administration will lay out details of an “aggregator” or “bad bank” with which to buy, house, hold and eventually sell troubled assets. This will remove what’s causing the problems on bank balance sheets. Too bad Paulson chose not to do this even though it was the original plan of the TARP.

I find it hilarious to hear that this “bad bank” will use a net present value accounting, or so it’s being reported. Apparently the government doesn’t want to be hampered by the pernicious mark-to-distressed market accounting that is making things appear worse than they actually are. It is mind-blowing to me that regulators have not yet killed this pro-cyclical accounting standard for one that makes much more sense, such as the standard in place prior to November 2007.

The market will also be watching to see how government Treasury auctions go as they issue close to a trillion in debt over the next several months. Also in focus will be how the commercial paper market reacts as it is weaned from the Federal Reserve CP program and moves back to private investors bidding on this short-term debt. These will be very important develops and we need them to go well.

Have a great day!


Brent Vondera, Senior Analyst

Peabody Energy (BTU) +12.0%
Peabody Energy announced fourth-quarter profit soared sevenfold on higher prices contracted during coal’s record surge to $137.50 a ton. The largest producer of coal in the U.S. said coal demand for 2009 will be impacted by the global pullback in steel production and moderate softness in global electricity generation, offset by growth from new generation and increased market share for coal. In response to current economic conditions, global coal production cuts have been accelerating.

In U.S. spot markets, coal was up 20 percent from a year earlier in Wyoming’s Powder River Basin, where Peabody holds the largest reserves. Although coal prices have outperformed other commodities like steel, copper and oil, there is a lack of upside catalyst in the near future for the industry. A global economic recovery should spur new demand for electricity and steel, driving coal stocks higher.


First Cash Financial (FCFS) +9.91%
First Cash reported its fiscal 2008 earnings grew 35 percent due to a 13 percent increase in same-store revenue and a 38 percent revenue increase from its Mexico pawn operations.

The company projects full-year 2009 earnings growth of eight to ten percent, as it expects significant growth in customer traffic and transaction volumes in 2009, especially in Mexico. Most of the 2009 earnings and revenue growth are expected to occur in the second half, as the significant number of new stores added between June and December of last year become more accretive to earnings.

Quarterly revenue increased 15 percent and same-store sales for the fourth quarter increased 8 percent. Pawn revenue in Mexico during the fourth quarter increased by 31 percent, reflecting new store expansions and strong same-store revenue growth in existing stores. In the U.S., total pawn revenue grew by 13 percent year-over-year.

First Cash said it plans to open between 55 and 60 news stores in Mexico this year, and a limited number new pawn stores in the U.S.


Amgen (AMGN) -2.43%
Amgen reported fourth quarter earnings and revenues that missed estimates, while issuing 2009 guidance that represents roughly flat performance compared with 2008 numbers.

Competitive pressures are preventing Amgen from any substantial growth ahead of the launch of osteoporosis drug denosumab, which could be approved at the end of 2009. Amgen’s high-profile anemia drug Aranesp is losing market share to Johnson & Johnson’s Procrit and competes with biosimilars in Europe. Biosimilars are also launching in Europe that will compete directly with neutropenia drug Neupogen – one of Amgen’s best-selling drugs.

Amgen will rely on its newer drugs to keep earnings steady in the near term, but the company’s more than $5 billion in annual free cash flow gives them plenty of flexibility for acquisitions and share buybacks to further boost growth. The firm had almost $10 billion in cash and about $10 billion in debt at the end of last year.

During the fourth quarter, Amgen repurchased approximately 13 million shares of its common stock at a total cost of $700 million.


St. Jude Medical (STJ) +11.14%
St. Jude Medical reported net sales increased 11 percent to $1.1 billion, which earnings slightly topped analysts’ estimates. The company was aided by higher sales of implantable cardioverter defibrillators, and it said it achieved strong growth across all of its product platforms in 2008.

Quarterly sales in the company’s Cardiac Rhythm Management – the major driver for the company – rose seven percent compared with the same year-ago period to $680 million.


EMC Corporation (EMC) -2.73%
EMC met expectations with 12 percent revenue growth for 2008. Still, normally robust fourth-quarter sales were up only 4 percent from a year ago.

The storage sector has been seen as a safer place than other areas of IT for riding out the economic storm; however, this sector is showing signs that it will succumb to the slumping global economy.

Given that the company chose not to provide any revenue guidance, it is hard to expect the situation to improve in the short term. However, the slowdown represents deferrals of storage purchase decisions rather than permanent cancellations. Long-term, EMC’s position in the highly demanded unified storage and networked storage markets will keep driving profits.

EMC subsidiary VMware, on the other hand, is losing its technological advantage and the landscape for virtualization technologies – which save companies a significant amount in IT expenses – is getting increasingly competitive.


DuPont (DD) +0.39%
DuPont posted a loss in the fourth quarter and trimmed its outlook for 2009, saying it does not “underestimate the difficulties presented by the current environment.”

Revenues fell 16.7 percent year-over-year to $5.82 billion, short of the $6.17 billion consensus. Look ahead to the first quarter, DuPont expects earnings between $0.50 and $0.70 per share, well shy of the $0.72 consensus. DuPont expects global macroeconomic conditions for the first quarter of 2009 to be similar to the fourth quarter, with very weak demand in most of its key markets, excluding agriculture.

DuPont said it will deliver about $730 million in fixed cost reductions in 2009, but expects to continue an appropriate level of spending for high-growth, high-margin businesses, including seed products and photovoltaics.


Quick Hits

• Pfizer Deal to Buy Wyeth Leaves Doubt (online or print subscription required)
• Pfizer’s Kindler Resorts to a Megadeal as Research Falls Flat
• GE Capital Leads Commercial Paper ‘Test’ as Fed’s Buying Ebbs
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks ended the day higher after another volatile session. The broad market began the session with a bang, up 2.5% out of the gate, only to slide 3.0% from the intraday peak to move into negative territory just after lunch. A rally in the final 90 minutes moved the major indices back to the black.

Job cut announcements continue to roll on. This event has accelerated over the past couple of weeks, and generally is something that puts pressure on the market as it has an obvious adverse effect on consumer activity and thus profits. However, the market may begin to gain some ground on this news; while it’s a harsh reality, this is also the benefit of economic downturns as firms come out of it more streamlined and powered for increased levels of growth.

Unfortunately, we also have the government in the mix, and well more than is usually the case, so the market is also struggling with having to deal with the whims of Washington

Most sectors gained ground yesterday, health-care, basic materials and financials were the losers.


Market Activity for January 23, 2009

Pfizer officially announced its purchase of Wyeth for $68 billion in order to boost pipeline potential as their biggest products come off patent 2010-2015, the largest being Lipitor. Wyeth’s promise in Alzheimer drugs, along with pneumonia and depression drugs already on the market, were what Pfizer was after.

This looks like a smart deal for Pfizer, although the stock price didn’t exhibit that yesterday, down 10% on news the company will cut its dividend payout in half to save $4 billion per year

And speaking of cash, Wyeth has a net cash position ($14.1 billion cash - $11.5 billion in debt) and Pfizer will use that cash to help finance the deal. Pfizer already has huge cash reserves of $30 billion, but a lot of this is overseas and they simply won’t repatriate the bread because of the harmful 35% tax incursion on doing so.

This is a topic we’ve spent much time on. Many U.S. firms have substantial cash overseas from international operations, but won’t bring it home because of the tax – they have already paid the corporate tax rate levied in the country in which the business occurred, why would they take another 35% hit on top of it? They won’t.

We’ve got to get serious here. There are responses to the current economic environment that can accomplish both short and long-term good. The repatriated tax should be slashed to 5%. This will bring massive amounts of capital back home, boost the economy and increase government revenues too. Five percent of something is a heck of a lot more than 35% of nothing. The sooner Washington understands this the better it is for everyone.

The Economic Data

The National Association of Realtors (NAR) reported existing home sales unexpectedly rose in December. Total existing home sales increased 6.5% to an annual rate of 4.74 million units from 4.45 million in November. Breaking down the two components, single-family resales rose 7.0% and multi-family increased 2.1%.


The median price for a single-family existing home fell 2.8% in December and has been hammered over the past year, down 15% -- nearly all of this damage has occurred since September.

The rise in sales for December was spurred by a 7.4% increase in the South and a 13.6% jump in the West region – NAR noted that distressed properties accounted for 45% of all sales, particularly true for the West.

The West region saw prices plunge 11.6% in December and the Northeast endured an 8.5% drop (although sales still dropped) – that’s for the month! The median price of an existing home in the Midwest and South held steady – up 3.2% in the South and flat in the Midwest.


The inventory of existing homes, relative to the current sales pace, fell nicely last month, which is a good sign.

However, before we get excited about this move, the figure has to trend down close to six month’s worth. When sales bounce back, which will be delayed now due to the weakness in the labor market, this supply figure will fall fast. Unfortunately, we could be a year from this happening based on what is currently known. What we need to see for now is existing home sales to stabilize around these levels. Let’s accomplish that first and then have some patience, additional patience I should say, regarding the rebound.


Our feel is the Obama Administration may attempt to move the 30-year fixed mortgage rate to 4.0%-4.5% -- maybe by issuing Treasury debt and using Fannie and Freddie to write mortgages in this range. They can finance this via the 30-year T-bond, which currently carries a 3.38%. This could help the housing market bounce faster than it would otherwise occur. The Fed is already engages in pushing mortgage rates lower, but some more could be in the works.

This is not the way I would do it; there is no free lunch and every action has its cost, but then no one is really asking my opinion. In any event, the administration may want to lay off on the China bashing, or they could find out quite quickly that that 3% handle on the 30-year becomes 5%.

The Conference Board’s Leading Economic Indicators (LEI) index rose 0.3%, the first increase in six months – a decline of 0.2% was expected. The positive result was due to an increase in M2 money supply for the month. If this component would have been flat, LEI would have been down 0.4%. This is really not a great indicator right now due to the Fed’s aggressive easing campaign.

Have a great day!



Brent Vondera, Senior Analyst

Afternoon Review

Caterpillar (CAT) -8.38%
Caterpillar, often a barometer of various segments of the U.S. economy, posted disappointing earnings and announced 20,000 job cuts. CEO James Owens, an economist, provided a bleak outlook for the world economy in its earnings release.

The U.S. market, where construction has been weak, saw sales fall four percent while sales outside North America rose 13 percent and made up 64 percent of total sales, up from 60 percent a year earlier. Machinery and engine sales gained 6.7 percent while the company’s financial arm posted a 2.4 percent increase in financial-products revenue despite turbulence in the financial markets.

The financial crisis continues to hinder Caterpillar’s ability to issue corporate bonds. Its finance arm has been driven to offer sharply higher yields on recent bond sales to lure investors

2008 was the company’s sixth consecutive year or record sales and revenue. The company has benefited from a five-year boom led by emerging markets in big need for the heavy construction equipment made by Caterpillar. During that time, the work force rose nearly 50 percent to 101,000 as revenue more than doubled.


Pfizer (PFE) -10.32%
Pfizer agree to pay $68 billion, or about $50.19 per share, to acquire rival Wyeth, in the largest pharmaceutical deal in nearly a decade. Wyeth shareholders will receive $33 a share in cash and 0.985 a share in Pfizer stock. The deal is set to close “no earlier than later in the third quarter.”

Pfizer is paying for the acquisition with roughly one-third in borrowed money, one-third in stock and one-third from cash reserves. Pfizer will borrow $22.5 billion from a number of banks to finance the deal. Under the loan agreement, the banks can withhold financing if Pfizer’s credit rating falls below a certain threshold. If that occurs, Pfizer would have to pay Wyeth a reverse breakup fee of $4.5 billion. That potential penalty is very high by historical norms and underscores the difficulty of completing deals in the current environment. As it turns out, the other big M&A news today was that Dow Chemical won’t close its $15 billion merger with Rohm & Haas on time.

In order to protect its credit rating, Pfizer plans to cut its quarterly dividend, which was 32 cents last quarter, by half. That should save the company more than $1 billion per quarter. Pfizer believes the deal will lead to annual savings of $4 billion by the end of the third year and will be accretive to earnings in the second full year after closing.

The combined company will have 17 products that generate more than $1 billion in annual sales. However, Pfizer has a poor history of large acquisitions that destroyed shareholder wealth. The company’s reliance on growth-by-acquisition instead of strong in-house research and smart licensing could eventually take its toll.

On the earnings front, Pfizer’s fourth quarter net income fell to $26 million, or four cents a share, down from $2.72 billion, or 40 cents a share, a year earlier. Excluding one-time items, earnings rose to 65 cents from 50 cents.


Quest Diagnostics (DGX) +9.85%
Despite slowing revenue growth, Quest beat Wall Street targets in the fourth quarter as operating margins expanded. In efforts increase margins further, the firm is in the middle of a plan to reduce costs by $500 million by the end of 2009.

Clinical testing revenue rose 2.3 percent despite a 0.4 percent decline in volume of drug-abuse testing, which is sensitive to job-hiring volume, dropped. Quest offers a variety of tests, from routine blood work to sophisticated genetic tests, and no one type provides a large portion of its revenue.

Management reiterated that all major managed-care contracts have been renewed or expanded into 2010 and beyond. This is a good sign for Quest, considering the upheaval in managed-care contracting just a couple of years prior.

The company’s shares had been in decline earlier this month, as Quest admitted it provided possibly wrong results for thousands of vitamin D tests in the past two years. The company said it had fixed the problem and is offering free retests, but the incident could raise call for more regulation of diagnostic testing just as it is playing a more important role in guiding medical treatment.


Danaher (DHR) +9.29%
Danaher reported a lower fourth quarter profit, but still topped earnings estimates, as
the manufacturer of bar code readers, medical products and Craftsman tools accounted for restructuring charges related to its acquisition of test and measurement equipment maker Tektronix.

Revenue increased 1.3 percent to $3.18 billion and gross margins rose to 54.3 percent from 53.8 percent.

CEO H. Lawrence Culp expects 2009 to be a difficult year, but anticipates Danaher will outperform given its strong balance sheet and businesses. Danaher is vulnerable to challenges in the retail environment, as shoppers cut back on their discretionary spending. Same-store sales have been steadily falling at stores like Sears and Kmart, with categories such as home appliances and tools feeling the impact of the housing slump.


Kimberly-Clark (KMB) -0.63%
Kimberly-Clark posted an 8.1 percent drop in fourth quarter net income and projected 2009 results below analysts’ expectations. The company also announced that they won’t buy back stock this year because of a quadrupling in 2009 pension costs.

KMB reported fourth-quarter net income of $419 million, or $1.01 a share, down from $456 million, or $1.07 a share, a year earlier. The stronger dollar cut the bottom line by 20 cents a share. On the bright side, gross margin widened to 31.6 percent from 30.7 percent as commodity costs were down “dramatically.”

CEO Thomas Falk said, “Economic weakness impacted our categories more than anticipated, particularly in North America and Europe,” adding the company believes some of the effects are temporary, reflecting inventory reductions by both retailers and consumers.

Trade-down also affected sales. The continuing downturn in the economy has led some consumers to shift to private-label from name-brand goods and to use up products in their pantries rather than spending on new ones.


General Electric (GE) +3.24%
General Electric’s, and finance arm GE Capital’s, AAA debt ratings are not “immediately affected” by the company’s fourth-quarter earnings results, Standard & Poor’s said.

Still, for GE Capital there are signs that 2009 will be even more difficult than the ratings agency assumed when S&P revised the outlook on the both companies to negative on Dec. 18, 2008, S&P said. GE Capital would have reported a significant net loss for the quarter, were it not for a substantial tax credit, the ratings company said.


Quick Hits

• Pfizer-Wyeth: What’s To Keep It From Falling Apart?
• Heard on the Street: GE’s Approaching Date With Destiny
• Bernanke Risks ‘Very Unstable’ Bond Market as He Ponders Buying Treasuries
• In October 2007, Financials made up 22.3% of the S&P 500. Today, they are just 9.7% of the index.
  
  

Peter Lazaroff, Junior Analyst

Fixed Income Recap

Treasuries continued their selloff today, as the curve flattened by about 7 basis points, or .07 percentage points. Bond prices move inversely to yields. Supply concerns will continue to dictate Treasury performance in the near-term. With the plethora of government spending just now beginning to show itself, increased issuance is all but guaranteed to continue.

Only so much paper can be gobbled up at these levels. We saw the yield on the 10 year Treasury, which is tracked closely by the 30 year mortgage, increase by 25 basis points this week. The government must find a balance between funding the stimulus through fiscal spending and promoting economic growth through monetary easing. The Treasury announced $40 billion in two-year notes and $30 billion in five-year notes to be auctioned off next week. The question is, how much of this new supply is the Fed going to have to purchase themselves in order to keep rates low?

The Curve

Also referred to as the term structure of interest rates, curves show what a specific type of bond is yielding across a range of maturities. The graph below shows yield in percent on the vertical axis and time to maturity in years on the horizontal axis. The white line shows the current Treasury curve and the green line shows it as of 12/23/08.





Notice how the two curves in the graph are different shapes. It may be difficult to see from the graph, but since December 23rd the yield on the 2-year has dropped, 11.5 basis points, (or .115 percentage points), from .915 to .80% while the yield on the 10-year has risen 43.2 basis points, from 2.173% to 2.605%. This shift would be considered flattening.

There are curves for municipal bonds, agencies, etc., but in general terms, “the curve” refers to the Treasury curve. Curves are generally upward sloping, although not always. In theory, investors require higher rates of return in exchange for taking more risk. Simply put, the longer the bond, the more risky it is, the higher the yield, which generates the upward sloping curve.

The area of the curve from the 2-year to the 10-year is considered the benchmark curve. When analyzing the shape, (i.e. steepness or flatness) this is area most concentrated on. I plan on discussing curve shape next week.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks ended a pretty good session on Friday, especially after a triple-digit decline in pre-market futures gave the impression things were going to be rough. A couple of good earnings reports out of the tech sector and what appeared to be an increased chance of a decent tax response making it into the stimulus bill helped the broad market rally about two hours into trading.

(Let’s hope Congress gets the message the market is sending, which looked to be the case on Friday. However, what we heard on the Sunday morning talk shows was not altogether helpful. President Obama’s chief economic advisor made pretty clear his disdain for current tax rates, and what they are calling tax cuts in the stimulus bill are mostly government transfer payments to those that escape federal taxes on income.)

At this point, I don’t see even the higher current-year allowances on business spending write-offs in the bill, but there are some good ideas the Senate may be able to force into the legislation. Tax cut proposals from the House were completely ignored last week, but the Senate works a little different and if the Obama Administration wants a bipartisan bill, they’ll have to compromise a bit. The market is showing investors do not like what they have seen thus far – the S&P 500 is down 7.8% for the month.

Most of the 10 major sectors within the S&P 500 managed to gain ground on Friday. Industrials took it on the chin, however, as shares of GE lost 10%.


Market Activity for January 23, 2009

Concentrate on Your Own Currency

We were without an economic release on Friday, so the big news of the day was statements from the soon-to-be Treasury Secretary Tim Geithner. In written comments to members of Congress, Geithner expressed the administration believes China is “manipulating” their currency. A red light goes off in my head when I see politicians and policymakers engaging in this talk.

Look, China is likely to devalue their currency for fear a substantial deterioration in domestic growth will trigger levels of unemployment that result in social unrest. The Chinese government, of course, does not want this to occur. They’ve learned their old ways of tamping uprisings don’t work real well, at least in an overt sense, as it damages economic ties with trading partners and have since used economic responses to quell these events.

What that means is they will devalue their currency to boost exports. The Treasury Secretary can engage in all of the currency rhetoric he wants; what he needs to concentrate on is policy that sends the world the message the U.S. is the place in which capital will remain the most welcome and best treated, to borrow the Walter Wriston adage. He can do this by recommending broad-based tax rate reductions on income, corporate profits and especially capital along with reminding the Fed that sound monetary policy is in our best long-run interest.

For now, he seems set on vilifying the Chinese. (We should recall our trade deficit with China grew so wide over the previous few years not because of Chinese currency manipulation but primarily because the Federal Reserve kept real interest rates negative a few years back that encouraged credit expansion – when the Fed effectively subsidizes debt, you’re going to get more debt and naturally higher levels of consumption.)

Furthermore, one cannot state that they believe in a strong dollar, but in the same breath say China must strengthen their currency. To achieve this China must reduce their foreign currency reserves, much of which is in U.S. dollars. Such action will not boost the value of the dollar, but weaken it. What’s more, when we’re about to engage in $1 trillion in Treasury debt offerings over the next year, picking this fight is that much worse.

In addition, we can call on the Chinese to boost the value of their currency (the Yuan) but even if China becomes less competitive in terms of a manufacturing base, it’s not going to bring certain types of factory jobs back to the U.S. They will simply move to Thailand or Vietnam, not Cleveland or Raleigh.

Don’t do it Geither; you’re playing with fire. A trade war, especially right now is in no ones interest, and that’s putting it mildly. Ignorant politicians have already jumped on Geithner’s comments by stating if we can’t work things out diplomatically we can do it legislatively. Read that as tariffs. Be very careful Mr. Treasury.

Earnings Season

This week marks the heart of fourth-quarter earnings season and will give us a very good sense of how profit results will shape up for what was a horrendously weak period. Forget overall S&P 500 earnings results right now, pro-cyclical accounting rules are in the process of putting the financial sector six feet under. What we should concentrate on are ex-financial results. If we can get past the season with a decline in ex-financial profits that doesn’t exceed 10%, I think the market can rally on the news, all else held constant. We’ll have a good idea by the end of this week.

Today we get back to economic data as the Leading Economic Indicators (LEI) index for December is out and existing home sales for last month too.

LEI is going to post another decline, weighed down by labor market indicators such as jobless claims and hours worked. The housing market will also continue to pressure the number as building permits are very weak.

Existing home sales for December will make another new low.

We need a confidence boost and nothing can accomplish this like immediate and “permanent” reductions in tax rates – investors and consumers need certainty! The Bush Administration failed to include this in their response to the economy’s woes and it doesn’t seem President Obama is too interested either as he’s focusing on public works programs and government transfer payments.

But maybe the market is successful in sending a clear message to policy makers. If this means another move lower, so be it; getting Washington’s attention will be very helpful to stock prices over the next year. To engage in stimulus without driving after-tax returns on incomes and capital higher just doesn’t seem very serious to me. It makes one believe there’s some other agenda in play.

Have a great day!


Brent Vondera, Senior Analyst

General Electric earnings and Pfizer's huge acquisition

General Electric (GE) -10.76%
The best thing about GE’s earnings release is that it contained no surprises, which I thought would be enough to keep shares from dropping further. However, concerns that GE cannot maintain both its Triple-A credit rating and its $1.24 per share dividend payment continues to weigh on sentiment.

The industrial operations showed signs of resilience in the face of a very weak economic environment. The big performance driver continues to be the energy segment, which recorded double-digit growth. Any stimulus package that includes renewable-energy tax credits and production tax credits will continue to drive growth in this segment. Infrastructure orders fell six percent, but backlog rose nine percent. GE said it ended the year with $172 billion of infrastructure equipment and service backlogs.

GE Capital turned in $383 million in profits, but when tax benefits are excluded, the unit lost $1.5 billion. The bulk of this loss is attributable to a $3.1 billion increase in loan loss provisions for financing receivables. The provisions were adjusted higher because of GE’s anticipation of rising delinquencies in the commercial consumer portfolios as higher unemployment levels could hinder consumers’ ability to repay debt.

GE has taken considerable moves to bolster there balance sheet. GE’s cash balance tripled to $48 billion last year, and they have an untapped revolving credit facility of $65 billion. Commercial paper outstanding came in at $72 billion at the end of December, down $16 billion in the quarter, and the company is targeting a cut to $50 billion by the end of 2009. Improvement in GE’s debt should help alleviate concerns regarding the company’s coveted Triple-A credit rating.

GE stressed that their “better safe than sorry” approach is meant to insulate the firm from the uncertainty in the broader financial markets. By making the business model more conservative, the firm has positioned itself to perform well over the long term.

CEO Jeff Immelt restated GE’s commitment to the dividend: “The first quarter dividend is done, and we are committed to our plan for $1.24 per share for the year…We believe the GE dividend provides our investors with a solid return in this uncertain time.” You have to admit, GE certainly deserves some measure of credit for elevating shareholder interest above an agenda growing the business at any costs (see Bank of America, Citigroup, etc).

Looking forward, the company expects 2009 to be “extremely difficult,” but the company has strengthened its cash flow position and taken steps to cut costs. Immelt said the company is position to “return to double-digit growth in a post-recession economy.”

So, are the concerns regarding GE’s dividend and credit rating legitimate or has the company been oversold?

These concerns are legitimate in that one of the two may be cut. The company’s projections for $5 billion profit at GE Capital and five percent earnings growth at the largest industrial and media units are aggressive, and these expectations rely heavily on the economy picking up in the second half of 2009. If these expectations are not met and the current economic conditions persist into 2010, then GE’s dividend or credit rating will likely need to be sacrificed.

However, GE still looks extremely attractive considering their growth potential. The loss of the credit rating or dividend payment would not cripple the company’s prospects for solid post-recession growth.

If the dividend is cut by half, for example, the shares would still be yielding over five percent. This would, in turn, keep their credit rating intact and keep borrowing costs lower than their competitors. Even more, the company could use the additional funds no longer being paid out in dividends to invest in their business for future growth.

If GE instead lost their Triple-A rating, it would lead to greater borrowing costs and put a dent in profitability. In this scenario, GE would maintain their dividend payout, which gives investors a nice return in this difficult market. Standard & Poor’s 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.


Pfizer (PFE) +1.39%
Multiple reports surfaced today that Pfizer is in talks to buy Wyeth (WYE) in a deal speculated to be worth over $60 billion. Some have identified Wyeth as a likely target for Pfizer because of their established foothold in biotechnology, steady consumer-health unit and large cash position.

Pfizer has used big acquisitions in the past as platform for growth, and their reliance on big takeovers over strong in-house research and smart licensing has destroyed an enormous amount of shareholder wealth.

Neither company needs to complete the deal immediately and negotiations could drag on throughout the year. Given the very challenging capital markets, Pfizer’s limited access to major financing may also delay a merger. In the event of a stock deal, the relative cheapness of Pfizer’s equity may prove to be destructive to the value of a merger, and thus lead shareholders to disapprove of the action.

Pfizer has long been expected to make a big acquisition, and it is likely that we will see much more consolidation in the pharmaceutical industry in 2009.


Quick Hits

• Companies Slash Dividends at Fastest Rate in 53 Years
• Citigroup, Bank of America ‘Nationalized’ as U.S. Call Shots
• Bank of America-Merrill Lynch: A $50 Billion Deal From Hell
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks declined Thursday as continued concerns over the future of the banking sector, very weak economic data and downbeat earnings reports combined to erase the prior session’s apparent euphoria.

Microsoft reported an 11% decline in fiscal second-quarter earnings, missing both street forecasts and its own guidance. The company stated it will cut 5,000 jobs over the next year-and-half, the first substantial round of layoffs in its history.

Fifth Third Bancorp apparently threw in the kitchen sink regarding write-downs and provisions jumped – in its latest profit release. We’ve heard that kitchen sink story plenty of times now from the industry only to see substantially higher levels of write-downs in the subsequent quarter, so we’ll see if this is in fact true. The adverse feedback loop due to the current accounting regime makes this an endless story.

The day’s economic reports, which we’ll get to below, offered no help as housing starts fell to another new low and building permits illustrated residential construction activity may make another new low when the January figures are released next month.

Financials led the market lower, falling 5.84% and the tech-sector was the next worst performer, although the hardware and equipment component of the sector gained ground, which cushioned the blow.

Utility and industrial shares performed well on a relative basis; however, if not for a 1.00% gain within the transportation component industrials would have been down more. Health-care was the only positive sector for the session.


Market Activity for January 22, 2009

Jobless Claims

The Labor Department reported initial jobless claims came in well-above expectations, jumping 62,000 to 589,000 for the week ended January 17 – so much for the wish of holding below the 550k level. This is the week that corresponds with the employment survey for January, suggesting we’ll see another big month of payroll losses.

The four-week average of claims was unchanged, at 519,250, but that will rise next week after this latest increase.


Continuing claims jumped 97,000 to 4.607 million for the week ended January 10 (there’s a one-week lag on this data), after falling 102,000 in the prior week.

It will be interesting to watch what occurs within continuing claims as there are reports California and New York are running out of jobless insurance funds. Maybe they should have run things more responsibly when state tax revenues were flooding in 2005-2007. Of course, the federal government will step in to bail them out, which means all of us in other states are bailing them out.


The insured unemployment rate (jobless rate for those eligible for benefits), which generally tracks the direction of the overall unemployment rate, held steady at 3.4%.

Again, this data suggests the January payroll report will post another outsized loss, we’re calling anything greater than down 350,000 outsized.

However, one of the best economists out there – John Ryding – believes the seasonal adjustment factors in retail may provide a boost to the overall jobs report. That adjustment subtracted a large 615,000 jobs from the retail industry to adjust for temporary seasonal hire. Yet, the unadjusted employment for the industry rose by only 381,000 last quarter (compared to a more typical increase of 700,000, meaning less temp.work was employed) so the seasonal adjustment overshot. Still, we’ll likely see a January payroll loss of at least 400,000 as the claims, ISM employment and layoff data all suggest.

Housing Starts

Residential starts plummeted 15.5% in December to 550,000 units – hitting a new low (and a low low it is) – from 651,000 at an annual rate for November. Separating the components, multi-family starts fell 20.4% last month and single-family declined 13.5%. For perspective, single-family starts are down nearly 80% from their January 2006 peak.


Building permits plunged too, down 10.7% in December to 549,000 units (annual rate) from 615,000 in November. This suggests the January starts figure is going to make a new low (the data goes back 50 years). In addition, we endured severe weather across the country this month so that curtailed activity even more. Although, one would think it will provide a nice rebound for February assuming improved weather.


The level of housing construction is now extremely low relative to average activity and by definition below demographic fundamentals. The intensification of the credit crisis, and resultant economic blowback, is also doing a trick on housing. So, as we’ve stated before it appears several aspects of the housing sector are showing the necessary reversion to the mean, and then some, after several years of outsized growth has taken place. The other factors, such as the credit situation and deep economic contraction of the past quarter will not last a terribly long time. When this foot is taken from the throat of the sector the rebound should be strong, but delayed due to the weak labor market.

In terms of GDP, with housing so weak, even this substantial degree of deterioration will not weigh on the figure as it once had. These declines were subtracting a full percentage point from real GDP, now it will be something like 0.5%.

Pre-Market Activity

Stock-index futures are down big this morning after the U.K. economy shrank more than expected and U.S. earnings reports show things really shut-down last quarter – while we all knew this, it still has an effect on sentiment.

Outside of the financial sector, Q4 profits for the S&P 500 are only down 2.4% with 20% of members reporting thus far. This figure will get much worse, probably falling 8-12% when it’s all said and done as the industrial and tech sectors were hit hard, but certainly major issues within financials, exacerbated by accounting standards put in place just 14 months ago, are making the overall profit picture look much worse than it is.

The areas that appear to offer the most promise over the next few years are industrials and tech.. The industrial sector carries a 4.00% yield and trades at a single-digit multiple. The tech sector trades at 13 times earnings, the lowest multiple in at least 16 years, and even carries a small dividend yield of 1.34%.

While we’re on the subject, the broad market, as measured by the NYSE Composite, offers a 4.76% yield and trades at a 12 times trailing earnings. Assuming normal earnings growth over the next five years, the index can rise 40% over this period and the multiple would remain at the currently low level.

But we must get past some real hurdles first. The economy will eventually take care of itself and indeed the private sector will become increasingly streamlined during this downturn. However, since the Fed and Treasury have helped to calm the credit market chaos, at least from levels seen in October/November, they need to lay off now and make sure the unintended consequences of policy actions do no more harm.

Have a great weekend!



Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries continued their selloff today, especially in the longer end, as the curve steepened 10 basis points to +186. U.S. Treasury Secretary-nominee Timothy Geithner announced that the Obama administration believes China is manipulating its currency, and as a result could decrease their demand for U.S. Treasuries in the future. This along with supply concerns drove longer-dated Treasuries slower.

The New York Fed announced $19 billion in MBS purchases for the seven day period ending yesterday. Continuing to stick to 30-year product but making a slight adjustment toward Fannie Mae issued securities. The Fed’s previous buying had leaned more toward Freddie Mac. I’m not sure they truly have a preference. After taking over control of both agencies they act more like one entity than before, and since they are so early into the program, the Fed is more than likely just mopping up whatever they can find at this point.

What is spread?
Spread is the measure of yield differences between two securities. It is usually quoted in basis points, or one-hundredth of one percent, and is used in order to quantify relative risk and return.

Let’s use a simple example. Today you can purchase a 2-year Bank of America corporate bond around a 5.5% yield. Without knowing anything about the current rate environment there is no way of knowing what kind of deal you are getting here. It’s important to consider the return you are getting relative to the market.

We often use Treasuries in calculations of spread because they are the highest quality in terms of credit and liquidity. The goal of any benchmark is to eliminate as many variables as possible, and in bonds nothing is more “Plain Jane” than Treasuries.

A 2 year Treasury bond is currently yielding .72%. So if you were to purchase the BAC bond I mentioned earlier at 5.5% you would be earning 4.78% more than if you bought the Treasury. Therefore, you could say 2 year BAC debt is trading 478 basis points wide of comparable Treasuries (in bond talk). In other words 478 basis points is the “credit spread”.

Since the bonds mentioned here are both 2-year bonds credit worthiness of the issuers is the only major differentiator. According to the market Bank of America is more likely to default on their debt than the U.S. Government. The larger spread over Treasuries, or the higher relative yield, is how an investor is compensated for the added risk.


Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Afternoon Review

Lockheed Martin (LMT) +6.31%
LMT said fourth quarter earnings increased three percent thanks to expanded sales of computer service and support to federal government agencies.

The company raised their 2009 sales forecast, which reflects decreasing expectations for cuts to the defense budget. However, Lockheed lowered its earnings guidance (first given last October) to reflect increased pension costs after declining stock markets eroded plan assets.

Information technology sales, which gained 16 percent last quarter, helped offset sluggish aeronautics revenue, which declined 4.6 percent. LMT expanded sales of computer service and support to federal government agencies.


UnitedHealth Group (UNH) +8.54%
UnitedHealth posted fourth quarter earnings that were in line with expectations and maintained full-year profit guidance. The company generated about $3.4 billion of free cash flow for shareholders in 2008, $2.7 billion of which was used for share repurchases.

Enrollment levels remained relatively stable, but commercial enrollment losses are likely to accelerate in 2009 as members who lost their jobs earlier in 2008 begin to run out of COBRA benefits. However, the company’s diversification paid off, with Medicaid and Medicare enrollment gains more than making up for the losses in the commercial business.

UnitedHealth expects meaningful growth in government-sponsored business in 2009. The company said there is strong interest in its Medicare market offerings and continued expansion from its state and public health program relationships.

The consolidated medical care ratio increased 90 basis points year-over-year to 80.8 percent. This ratio indicates the percentage of premium revenue that gets paid out in medical claims. For the full year, the medical cost ratio was 82 percent compared with 80.6 percent in 2007.

Realized investment losses remained minor, at $0.03 per share in the fourth quarter, which was primarily because of the write-down of a venture capital investment.


Raymond James Financial (RJF) +2.41%
Raymond James reported fiscal first quarter earnings that came in above analysts’ estimates. Although the outlook was grim for most of 2009, the company has been building its bank operations (Raymond James Bank). While many of its peers are cutting expenses, Raymond James has been looking to boost its market share by snagging brokers, traders and bankers from troubled firms.

CEO Thomas James attributed the bank’s improved earnings to interest rate spreads that increased as a result of federal market intervention, a real estate and corporate loan portfolio that is outperforming industry benchmarks and a loan portfolio that was 36 percent larger at the end of December than a year earlier.

In November, the company applied to participate in the U.S. Treasury’s Troubled Asset Relief Program. Still, the company has yet to report write-downs related to subprime mortgages, a sign the company’s balance sheet is relatively strong.


Noble Corporation (NE) -0.82%
Noble’s earnings exceeded expectations with profits growing 20 percent in the fourth quarter thanks to long-term service contracts.

Despite oil declining 35 percent in the fourth quarter, Noble had contracts in place for some time. We are unlikely to see a decline in earnings for a few quarters simply because they have everything locked up near-term. Nevertheless, there are several uncertainties surrounding drillers in 2009 including low commodity prices, weakness in the capital markets, high contract turnover and the expected deliveries of several uncontracted newbuild jack-ups.

CEO David Williams said in the statement, “While we believe the long-term fundamentals of our industry are sound, the condition of the global economic environment is clearly a cause of concern and a reason for caution.”

Spending by companies around the world on oil and natural-gas exploration is expected to drop 12 percent in 2009 to $400 billion, according to a Dec. 19 report by Barclays analysts.


Quick Hits

• GE Sags as Investors Bet Dividend or Rating May Go
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks recovered most of Tuesday’s losses, rebounding off of a two-month low as a 14.6% jump in financial shares led the broad market higher. The major indices began the session higher, gaining momentum mid-morning as it seemed clear Treasury Secretary Nominee Timothy Geithner wasn’t going to be grilled too badly over his tax return issues – the street appears to like Geithner, largely because they don’t want to see time taken to hunt for a new nominee.

After the close it was reported that Bank of America CEO Ken Lewis and five directors bought 500,000 shares and JP Morgan CEO Jamie Dimon purchased 500,000 JPM shares. That’s a big confidence booster, let’s hope it holds.

Technology stocks also jumped yesterday after IBM issued a 2009 profit forecast that topped estimates. Last night’s strong profit release from Apple should help the NASDAQ again today -- at least at the open, from there it’s anyone’s guess.

Energy shares gained good ground as oil prices jumped 12.42% yesterday. This is part of the contango trade, as the February contract expired on Tuesday and crude for March delivery traded higher. There seems to be some flow through there if I gauging things properly.

Looking over the next couple of weeks this trade should wane and crude prices will likely revisit the $30 handle as it’s all about global growth right now. We’ll get some really ugly GDP readings and that’s going to affect demand expectations and thus the price of crude. (Looking out a bit longer, say six months, I wouldn’t be surprised to see oil settle in around $50-$60 as demand rebounds a bit.)


Market Activity for January 20, 2009

Treasury Nominee

While the street seems to like Geithner, after reading his prepared text for testimony before the Senate yesterday, I’m not terribly impressed. What we have hear is another Keynesian, and the economy really needs better than that. He’s certainly very smart, you don’t become President of the New York Federal Reserve Bank (and by definition a permanent member of the FOMC – the monetary policy committee) without real knowledge of financial intermediation. But then this also reinforces the fact that he is a Keynesian, or demand side thinker, as it is tough for those with opposing views to gain high Federal Reserve posts.

His comments involved too mention of what the world thinks of us and the typical utopian view that regulations can make sure the U.S and global economy “never again face a crisis of this severity.”

On the first, this is completely unrealistic, crises are a fact of life. Further, maybe he should look inward, as it was years of Fed monetary policy mistakes that encouraged the event of over-leverage that the market is now working to correct.

On the international view, he mentions caring what the world thinks of our “ideas and actions” from a regulatory standpoint. A Treasury Secretary needs to focus on making sure his/her country welcomes and treats capital well – nothing more.

Look, we are the engine of global growth. The sooner we get back to being the place where capital seeks to reside (this means higher returns and a stable currency), the rest will take care of itself. Let’s not worry what Europe – economies that are smothered by a massive public sector due to their cradle-to-grave entitlement system and therefore higher rates of unemployment and lower rates of growth – thinks of us. We’ll lead and they will follow if they desire to.)

The soon-to-be Treasury Secretary gave no specifics on what needs to be a plan to house “troubled” assets and no mention of mark-to-market. (The reason we have so many “troubled” assets is not because the vast majority fail to produce cash flow, but because of this insane accounting rule.)

Geithner acknowledged that one of the major issues right now is a lack of confidence, but seems to believe that more regulation is what will bring confidence back. This is a huge mistake.

I know, people these days believe we need more regulation. I’d submit, maybe the Fed should have been engaged in the financial-sector oversight for which they are responsible. If our goal is to add on more overlapping regulation for the sake of it, it will only curtail growth and force business to escape this grip – such as off balance sheet entities that banks used to avoid the current regulatory regime. More regulation results in opacity; less, but enforced regulation, means transparency.

With regard to confidence, we need a bold tax-rate response to deal with this issue. You want a higher level of confidence? Give the market a real sense economic growth will have a chance to flourish and higher after-tax return expectations. That’s what gets confidence rolling.

In any event, we wish him luck with getting the economy back on its feet. But I do not wish him luck with regard to demand-side spending initiatives that create work, instead of longer-run job creation, and a level of budget deficits that help tax hikers sell their agenda to the public.

Today’s Economic Data

It’s been a very quiet week but we get back to it this morning with weekly jobless claims, mortgage applications and housing starts.

The claims data is expected to show a rise for the week ended November 17; we’ll be watching to see if the reading holds below 550k.

Claims moved below the 500k level in the previous couple of readings, reversing a trend that had approached 600k just before Christmas. That move lower was due to poorly adjusted seasonal factors (result of the holidays), which was evident by the 54,000 jump in the week ended January 10. It will be important to hold below that 600k mark over the next several weeks, as it may show the major labor market damage has already occurred. Today’s data will give a good indication – holding below 550k will be helpful for stocks.

On housing starts, residential construction plunged 18.9% in November, to a record low of 625,000 units at an annual rate. On an unadjusted basis, only 29,800 single-family homes were started for the month (the average is roughly 130,000). Building permits – a gauge of future activity – dropped 15.8% in November, which is a good indication we’ll make another new record low when the December starts figure is released today.

Mortgage applications for the week ended January 16 are already out this morning. The Mortgage Bankers Association stated total apps fell 9.8% after a 15.8% rise in the previous week. Purchases rose 2.5% and refinancing was down 12.4%, but that does follow a big 25.6% jump in the previous week.


Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

International Business Machines Corp. (IBM) +11.51%
IBM reported another quarter of solid earnings and issued an outlook for 2009 that exceeds current estimates. Even after adjusting for special items such as lower tax rate and fewer shares, IBM’s profit beat expectations.

While revenues slipped across all geographic regions for a total decline of six percent year-over-year, IBM managed to improved gross margins by generating a larger share of its business from high-profit software and services. Even in its hardware business, solid sales of high-margin mainframe computers helped offset disappointing sales of commodity-type servers and a 34 percent sales drop in its semiconductor division.

IBM ended 2008 with $12.9 billion of cash on hand and generated free cash flow of $14.3 billion, up $1.9 billion year-over-year.

This positive earnings release comes as fellow tech-bellwether Intel’s CEO raises the possibility of a loss in the first quarter, ending its more than 21-year run of profitability.


United Technologies (UTX) -0.22%
United Technologies reported results that met expectations and reaffirmed its outlook for 2009. Earnings did include six cents per share in one-time gains, which are typically not included when comparing to the consensus.

Revenues fell 1.3 percent year-over-year to $14.5 billion (consensus called for revenues of $14.8 billion). The company said that solid margin expansion at its aerospace units and at UTC Fire & Security offset the impact of a sharp decline at its Carrier HVAC unit and declines in its Otis elevator unit.

Aggressive share buybacks (over $3 billion worth in 2008 alone) alleviate some of the 2008 headwinds. Looking into 2009, the company expects the global recession to continue through most of this year, but expects a “modest recovery” in the second half.


Wal-Mart Stores (WMT) -2.81%
Wal-Mart was downgraded by several analysts today in response to the company’s December same-store-sales release and guidance revision.

Wal-Mart’s sales fell short of expectations in all three business divisions, illustrating that even Wal-Mart is not immune to the economic slowdown. The company may not realize any benefits in 2009 from consumers trading down as they did in 2008. In addition, price increases drove the majority of Wal-Mart’s sales growth in 2008, not unit growth.

As CreditSuisse notes, Target is focusing on reducing prices to gain market share, which presents an added competitive threat to Wal-Mart. Longer term, Wal-Mart’s sheer size and fewer stores in peak productivity stage (3-5 years after opening) are likely to challenge sales growth expectations.


Bank of America (BAC) +30.98%, J.P. Morgan Chase (JPM) +25.1%
Bank shares soared after regulatory filings showed that Bank of America CEO Kenneth Lewis and five directors bought more than 500,000 shares yesterday. In addition, Bloomberg reported that JPMorgan CEO Dimon bought $11.5 Million of JPM shares last week. Some view this as an act of confidence, while others see this as no more than an expensive PR move.

Bank of America also announced more job cuts.


First Cash Financial Services (FCFS) -4.64%
First Cash reaffirmed its 2009 earnings guidance today, but still saw selling pressure after competitor Cash America International (CSH) reduced its 2009 earnings forecast citing the faltering economy and the effects of store closings.

First Cash has far greater economies of scale than their competitors, plus their growing exposure to Mexico is helping offset weakness in the U.S. First Cash also has a stronger balance sheet than its competitors, which is allowing them to buyback shares and open new stores in Mexico.


Quick Hits

• Blogs Speculate Bank Nationalization
• Madoff Scandal May Lead to New Rules on Adviser Accountability
  
  
  

Peter Lazaroff, Junior Analyst

January 2009 Portfolio Insights

The January 2009 issue of Portfolio Insights has arrived! This expanded addition includes:

• Strategic Reflections
• Madoff
• Inside the Economy
• Equity Markets Activity
• Fixed Income Strategy
• 2008 Review
• Ask Acropolis

Click here or the cartoon to view the issue.

Daily Insight

U.S. stocks failed to abide by the script, we’re supposed to feel a sense of optimism with the changing of the guard, focusing on reality instead as stocks got clocked. The damage done to overall earnings as the fourth-quarter was hit hard by the credit-market chaos is hammering sentiment again. Uncertainty over the direction of government policy is also roiling the market.

The decline on Tuesday added to the market’s worst week (last week) since November and has lopped off two-thirds of the late-November/December rally that shot the NYSE Composite 28% from the November 20 low – we’re now just 8.75% above that mark. Talk of nationalizing banks, while this would be a last resort, is also causing major concern.

Financials led the broad-market’s decline after the largest money manager for institutions – State Street Corp. – announced unrealized bond losses nearly doubled last quarter; the stock tumbled 59%.

Telecoms, utilities and consumer staples were relative winners; none of the 10 major industry groups were positive, as the chart below shows.


Decliners trounced advancers by a 17-to-1 margin on average volume.

Market Activity for January 20, 2009

Mark-to-Disaster

We made mention yesterday of how the Treasury’s decision to guarantee, or backstop, loans at Citigroup and Bank of America was smart by half. If they’re going to do something, they need to remove these assets from balance sheets. The idea of backstopping increases the odds that institutions with this guarantee in place may now dump this trouble at even lower prices, which reverberates throughout the sector. It appears there was significant deterioration in asset-backed securities in December even as some of the credit indicators managed to improve a bit.

It’s important to mention, State Street said none of these securities that are taking write-downs are in default, but that doesn’t matter with mark-to-market; this is why it’s so damaging. My fear is as we continue to watch this insane accounting standard wrought its destruction, it will continue to lead to additional government decisions that bring their own consequences. We’re trying nine-gazillion things (in typical government Rube Goldberg machine fashion) with all of the unintended consequences that result when we could have simply ended an accounting standard that was just put in place a mere14 months ago. This is not just insane, it’s an exhibition in self-flagellation.

And on bank nationalization, no one in Washington has the skills to run the banking system – we only need to look at Fannie and Freddie for evidence of that, or most other government programs for that matter. Nationalization is not an option, such a decision would be ruinous. What needs to be done is elimination of pro-cyclical accounting standards. This will stop the bleeding and buy time for private money to eventually flow in.

This is not a bankrupt society, even if a bevy of government action is doing its best to make it so. Corporate America is as streamlined as ever and flush with cash. On the consumer side, the vast majority of people are not broke, let’s not act like the situation is reversed.

The private sector is the savior here, we mustn’t forget that. Nor should we forget that it has been mistaken Fed policy (keeping real rates negative for two years) and a regulatory regime that put in place mark-to-market that has done the most damage. This country has built a level of prosperity the world had never seen, and done so in a very short time from a historical perspective – it hasn’t been accomplished by regulating the hell out of private industry.

Crude-Oil

Oil futures continue to plunge as the spot price closed in on $30 per barrel yesterday morning. Just two weeks ago crude looked ready to move past $50, but had tumbled in the last 10 sessions as global economic concerns crush demand expectations. The price on the February contract rose mid-day (after falling to $33 early morning) as traders covered their short positions or be forced to take delivery of product as the contract expired yesterday.

Crude is higher today as the market is in contango, meaning subsequent-month contracts trade higher. At this rate, however, it should come down to the mid-$30s within a couple of days.


While oil and stocks trade in tandem for now (yesterday notwithstanding due to the contract expiration) this makes the decline tough to deal it. However, a huge benefit to consumers has resulted

Real incomes have received a large boost over the past six months, something in the neighborhood of $300 billion. This will not be enough to completely offset the deterioration in labor-market conditions, certainly this event is weighing on confidence along with the rout in stock prices, but it is helping consumers rebuild cash savings – something they have been focused on as their two main savings vehicles (stocks and homes) fall in value. The sooner cash savings are rebuilt, the sooner consumer activity can engage in a rebound.

That said, for now the economic picture continues to get worse. However, with production horrendously weak, inventories are being drawn down in a manner that will set the stage for a rebound in output – but we must get past this period of full blown pessimism and caution first. Once we do the combination of a small boost in consumer activity along with higher business spending and production should drive GDP higher two quarters down the road. But we’re also at the whim of government, so gauging things is even more difficult than usual.

Futures Higher

IBM and United Technologies – both Dow components – have posted some decent results since the close of trading yesterday, this is helping to boost stock-index futures. However, the relatively good results were a function of cost cutting, fourth-quarter revenue declined for both firms.

But this is what economic downturns do, they force the strong to become more efficient and weed out the weak, setting the stage for a stronger business cycle upswing. Government meddling will curtail the next expansion – all they need to concentrate on is removing toxic assets from bank balance sheets and eliminating mark-to-market to replace it with cash-flow accounting. If they engaged in nothing more from this point, we could really be onto something six months out. That’s a big if.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries traded wildly today as the curve steepened 7 basis points to +166 basis points. The 2-year ended the day yielding .705% and the 10-year sold off three-quarters of a point to yield 2.38%. The 30-year, traded as low as 127.5 around 8:30 a.m., before rallying back to 130. This volatility in the Treasury market depicts investor’s true uncertainty towards risk

Mortgages
Mortgages underperformed Treasuries today, with 30-year MBS widening out about 6 basis points to the benchmark curve.

The story with mortgages continues to be the same. Reports of banks beginning to see activity in the refi market is most likely contributing to the underperformance of mortgages. Very few in the market are anticipating a refi boom like that of 2003, but even if we see just a small fraction of that activity, mortgages will behave very differently in 2009.

Fannie and Freddie
Herbert Allison, the CEO of Fannie Mae, was quoted in this morning’s Wall Street Journal as saying, "We're not out to maximize profits… We want to promote responsible homeownership.” These are dangerous words coming from the Chief Executive of a publically traded company. A sign that full nationalization doesn’t seem too far off.

The new surcharges introduced by Fannie and Freddie in 2008 in order to cushion losses taken on non-conforming loans they purchased have now been retracted, in favor of further subsidizing home ownership through artificially lower costs.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Afternoon Review

Johnson & Johnson (JNJ) -1.20%
JNJ topped earnings estimates for the fourth quarter, but their revenues and outlook for 2009 were below expectations.

The economic recession, unfavorable currency exchange rates and generic drug competition hurt fourth quarter revenue and factored into the 2009 outlook, which left open the possibility of a decline from 2008 earnings.

The sales decline was led by a drop of 11.1 percent for prescription drugs, in which cheaper copycat pills displaced Risperdal (its top-selling antipsychotic) and Topamax (migraine pill). Also hurting the U.S. pharmaceuticals market was increasing layoffs that left more people without drug-benefit plans.

JNJ noted that consumers and patients are becoming more frugal. Hospitals are chopping purchases and JNJ has seen sales slow on products ranging from contact lenses to diabetes test strips.

The company’s diversified business model has served it well in comparison to rivals more concentrated in the pharmaceutical industry, and the company will exploit cheap market valuations to make acquisitions. CEO William Weldon identified two areas where JNJ are more likely to be acquisitive: health information-technology companies and companies that specialize in wellness and disease prevention.

JNJ’s strength lies in innovation and diversification. JNJ’s strength across diverse health care niches should offset head winds in pharmaceuticals.


Bank of America (BAC) -28.97%, J.P. Morgan Chase (JPM) -20.73%

• U.S. Bank Stocks Decline
• Bank of America Shares Tumble as Analysts’ Worries Grow
  
  
  

Peter Lazaroff, Junior Analyst