Daily Insight

U.S. stocks rallied Friday despite another really rough jobs report as traders anticipated the announcement Geithner was supposed to deliver today regarding the bank rescue. Apparently, they had high hopes on the direction the administration would take -- too bad the market will have to wait another day as the announcement has been delayed; they’re paying with fire in this market environment.

The financial press reported the depressing jobs report sparked the rally as this would force Congress to pass the stimulus package. I’m not sure about this one as the market understands what we’re getting doesn’t exactly inspire the equity investor. Besides, the Senate is still working to pass the thing and then it will move on to the House to be worked some more.

More likely, traders didn’t want to be out of the market, or short, just ahead of the Geithner announcement.

From a more fundamental aspect – unfortunately we don’t hear that much these days as everyone is focused on government’s response (which is exactly the problem) – longer-term investors may have stepped in simply as a result of the magnitude of job losses last month. We lost 598,000 payroll positions in January and this marks the third-straight month of darn-near 600k declines. Such outsized losses should not continue for much longer, and some of the buying may have been driven by this thought.

As we mentioned on Friday, it will take additional mistakes out of Washington to keep this level of job losses going. The trade fight some politicians, ignorant of history, seem to be sparking could certainly do it but we’re not there yet.

Financials led the market higher as concerns over bank nationalization eased. Technology and consumer discretionary shares were among the other strong relative performers.


Market Activity for February 6, 2009


The Jobs Report

Well, so much for that quirk in the seasonal adjustment I was expecting. The Labor Department reported payroll positions were slashed by 598,000 in January. Over the past 12 months 3.5 million jobs have been lost, with 70% occurring since September and 50% in the past three months. No other data set shows more clearly the degree to which things changed since the day Lehman went down – September 15.

Goods-producing industry job losses led the declines, shedding 319,000 positions in January – 111,000 construction jobs and a massive decline of 207,000 manufacturing positions.

Service-producing industries lost 279,000 jobs, although the degree of decline has eased relative to the previous two months – professional and business services led the industry, shedding 121,000.

Education and health services continue to buck the trend, adding 54,000 positions last month – this segment has not shown a month of decline during this period of labor-market malaise.

The unemployment rate jumped to 7.6% -- the highest since September 1992 -- from 7.2% in December. The Household Survey (separate from the payroll survey as it includes the self-employed) showed a decline of 1.239 million jobs last month. It is this survey the Bureau of Labor Statistics uses to calculate the unemployment rate.

On the bright side, hourly earnings continue to show remarkable resilience, up 0.3% last month and 3.9% over the past year. Real wages, as we touched on in Friday’s letter, have exploded to the upside as the plunge in energy costs drive inflation to zero.


The labor market continues to shed jobs at an alarming rate and the streak of monthly declines has extended to 13 months – although the vast majority of this damage occurred in the last five months. The credit event that occurred with the collapse of Lehman sent the equity markets plunging and business financing – especially for small businesses – into chaos. As a result, the consumer pulled back with stunning quickness as their savings (in stocks) plunged and businesses canceled spending plans as they saw the economic contraction that would ensue.

The focus should be set on returning confidence to the consumer, business and investor – anything less will be a failure.

Another Delay

Stock-index futures are lower today after the Senate delivered a bill Friday evening that is junk. This doesn’t surprise the street as Congress has signaled the direction for some time now, but confirms what’s being presented as stimulus is laden with entitlement spending and transfer payments – programs that can have a lasting affect on suppressing growth as it will be very difficult to take them away; those that try to make them temporary will be demonized.

Stocks are also trading lower this morning as the administration has delayed Geithner’s official announcement on their bank rescue plan until tomorrow. This is the second delay now, and one wonders what’s going on. They say they are focused on the stimulus plan today, but I don’t know how a 30-minute press conference limits focus on getting the spending spree passed. They’ve got it passed anyway; it just won’t be a bipartisan event.

On the bank rescue, if it’s even correct to call it that, word is Geithner will propose incentives to encourage private money to buy troubled assets. That means government guarantees protecting against a certain amount of losses will be their tool.

Geez, why don’t they just eliminate mark-to-market, since this is what’s exacerbating the problem. And you want incentives? Place a five-year moratorium on capital gains taxes related to these specific investments – that will bring bids in and the government won’t have to keep printing money to backstop losses. We are wasting so much time and money just to keep a flawed accounting standard in place it makes one wonder…I’ll refrain from writing what I’m thinking right now.

The Geithner plan is also expected to include the “bad bank” idea and more capital injections – it’s pretty clear the government is enjoying the increased control these injections bring.

In the meantime the market has to deal with more uncertainty. The administration should have learned from the previous occupants not to wave proposals in the market’s face only to delay or change plans. Stocks may just offer them another lesson today. We shall see.

Have a great day!

Brent Vondera, Senior Analyst

Afternoon Review

LMT, NOC, ITT, LLL, CW, ATK left out of rally
A few defense stocks were left out of today’s rally following reports that the Obama administration has told the Pentagon to pare its next budget request to the level it projected a year ago, down nearly $60 billion from a more recent Pentagon wish list.

It has long been suspected that weapons and war equipment spending are first in line for budget cuts. Areas that are likely to be safe from budget cuts include intelligence, communications, and surveillance.

The Obama administration plans to present an overview of its fiscal 2010 budget request by the end of this month, followed by a detailed proposal by April.


Caterpillar (CAT) +5.28%
Moody’s Investors Service said Caterpillar will be in a better position to cover $14 billion of debt coming due in the next 12 months after making its largest bond sale. The slump in demand for Caterpillar’s products and the amount of debt coming due over the next 12 months led Moody’s to lower its rating outlook to negative from stable on Jan. 26.

Caterpillar paid spreads about a percentage point narrower than in its last sale in December; however, the spreads on the notes sold yesterday were still about a percentage point higher than similar bonds sold in September.

Moody’s comments seem to have quelled concerns that Caterpillar would have to cut their dividend.


General Electric (GE) +2.30%
GE shares struggled for much of the day after a JPMorgan analyst said GE’s AAA Rating "Unsustainable."

Then, of course, General Electric said they will keep their 31-cent dividend, but will review the payout for the second half.


Procter & Gamble (PG) +1.28%
Bloomberg reports that PG’s pharmaceutical unit may fetch as much as $billion from its bidders. PG is looking to exit the drugs business since sales have been declining for several years in the face of generic competition, and PG is not willing to spend the kind of money on pharmaceutical R&D to remain competitive.


Johnson Controls (JCI) +10.53%
First, shares are definitely benefiting from news that the U.S Auto Suppliers’ Industry aid request may reach $25 billion.

In other news, Johnson Controls was added to the Calvert Social Index, a broad-based, rigorously constructed benchmark for measuring the performance of U.S.-based socially responsible companies.

Finally, Barron’s ran a special report on the very significant stock purchases by Beda Bolzenius, corporate vice president and president of automotive experience business.


Quick Hits

• Bank of America Rejects Nationalization, More U.S. Funds, Lewis Tells CNBC
• Obama Names Advisory Panel
• Senate Seeks to End Impasse, Vote on Stimulus This Evening
  
  

Peter Lazaroff, Junior Analyst

Fixed Income Recap

Treasuries traded higher today as the two-year rallied 1/32 of a point in price while the ten-year traded higher by about a quarter of a point. The benchmark curve was mostly unchanged on the day, and stands 6 basis points steeper for the week. A basis point represents .01%.

The supply concerns that dominated Treasuries last week have abated. The payroll number we are scheduled to get tomorrow is propping up the market up for now. A big downside surprise in that number could send investors fleeing for the safety of Treasuries.

Fed MBS Purchasing
The Federal Reserve announced $22.3 billion of agency MBS purchases for the seven day period ending yesterday. A considerable jump from their average of $18 billion per week.

The Four Primary Risks of Bonds

Credit
Duration
Liquidity
Structure

Duration measures a bond’s price sensitivity to interest rate movements. The higher the bond’s duration the more volatile the price of the security will be when interest rates change. Bonds with higher durations carry more risk as a result of this volatility in price.

Duration is often confused with time to maturity. Although it is usually true that longer bonds have higher durations, duration and time to maturity are not one in the same. Only in the case of zero coupon bonds (bonds that do not generate any cash flow until maturity), is the duration and time to maturity the same number.

Another name for duration risk is interest rate risk. Thirty-year Treasury bonds are very volatile securities, even though they are risk free from a credit standpoint. The risk lies in what can happen to the general interest rate environment during the time one has their money invested. A newly issued thirty-year Treasury has a duration of about 17, meaning that a 1% change in the yield on the thirty-year Treasury will result in a 17% change in the price in the opposite direction. Remember bond prices move inversely to yields. The same 1% change in yield on the two-year Treasury results in less than a 2% change in price. The two-year experiences considerably less volatility than the thirty-year due to a much smaller duration.

Our strategy tends to lean toward the shorter end of the curve. Rarely is one rewarded for taking the extra risk of longer duration bonds. By staying on the short side we receive the principal of our investment back sooner, and therefore have the ability to reinvest where we believe the best opportunities are.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S stocks rallied on better-than-expected earnings out of Mastercard and word that Goldman Sachs and Morgan Stanley will repay their TARP money – that executive compensation cap had some affect on these two – which helped to turn around financials after starting the session lower.

There seems to be a bit of a reflation trade occurring too as basic materials and energy shares have gained nice ground over the past three sessions – this is a really good sign, let’s hope it has legs.

Also helping stocks rally was a retail sales report that showed a decline in January same-store sales was not as bad as expected. Sales at retail stores open for at least a year fell 1.6% last month -- a 2.2% drop was expected. Apparel, department and luxury sales remain in the dirt, but discounters and wholesales clubs helped to ease the decline.


Market Activity for February 5, 2009


Economic Data

The Labor Department reported initial jobless claims breached the 600K mark for the first time in 26 years as claims rose 35,000 to 626,000 in the week ended January 31.

The four-week average jumped 39,000 to 582,300, the highest reading since December 1982.


Continuing claims rose 20,000 to 4.788 million – a new high. Everyone knows the labor market remains very weak and we should expect this reading to make new highs over the next couple of months as workers have a rough time finding new jobs.


Putting this into perspective however, as we’ve mentioned for the past month, when you adjust for the rise in payroll positions continuing claims would have to hit 7.5 million to match the peaks hit in 1974 and 1982. So while this is a rough situation, it is not nearly as bad as those past periods when adjusting for the rise in employment.

In a separate report, Labor reported worker productivity rose 3.2% in the fourth quarter, twice as much as expected. Over the past four quarters, nonfarm productivity has risen 2.7% -- a pick-up from the 2.2% reported in the third quarter.

Normally, an increase above 2% is considered good and anything above 2.5% is stellar. But the rise last quarter was largely due to rapid losses in employment (60% of last year’s job losses took place in the final three months) rather than gains in output. Worker productivity is measured by taking output per hour over hours worked. Hours worked fell 8.4% in the fourth quarter, outpacing the 5.5% decline in output (this decline in output was the largest since 1982). Thus, productivity is largely reflecting substantial weakness in the labor market than anything else.

The report mentioned an interesting point on real hourly wages. Hourly pay, adjusted for inflation, surged 15.6% at an annual rate in Q4 – this is the largest increase since records began in 1947 and is the result from the massive decline in energy prices. While consumers are in the process of rebuilding cash savings and dealing with a tough job market for now, this rise in real wages will drive activity a few months out. We think there’s a good chance the consumer spending figures will begin to show some life by late spring.

Our Choice

We need a confidence boost and by slashing tax rates on income, capital and corporate profits (thereby increasing disposable income, stock-price and profit growth) we can get things going in a much quicker way than all of the goofy Keynesian ideas floating through Congress combined. In addition, a move toward a tax-rate response will result in higher capital gains, corporate income and individual tax receipts to the Treasury.

In case you’re not following, lowering the tax rate on capital will boost after-tax return expectations and thus bring some excitement back to stocks as investors are willing to accept risk again and see a future environment that is much more certain. The cut in the corporate income tax – currently the second-highest among OECD members – will boost profits, which will drive stock multiples lower, offer increased return potential, jumpstart business spending and lead to more hiring several months down the road. The cut among all income tax brackets will immediately raise disposable (after-tax) income and help restore consumer confidence. All of these improvements will spark economic growth and within two years result in a massive rise in tax receipts.

The current proposals being bandied about will only leave us with more permanent government programs and increased deficits. At which point, the tendency will be to increase tax rates, which will extend the economic malaise. On top of that, the proposal that came out of the House last week risks sparking trade wars, which we’re seeing develop under the surface.

As I mentioned a few months ago, this is a “time for choosing,” borrowing the phrase from Reagan’s well-known 1964 speech. Well, in November, whether voters understood it or not, we chose a move toward a Western European-type system. You can see it in the House bill: a huge increase to Medicaid; granting part-time workers jobless benefits; government payment of 65% of COBRA premiums, adding adults to the S-CHIP program. Only 12% of that bill was focused on infrastructure spending, 60% of which would not be spent until 2010 and 2011. This is not stimulus – just the opposite in fact as a move towards increased dependency reduces longer-term growth rates and increases joblessness -- and if the Senate gives us anything similar today, it must be rejected. The choices made today will have an effect for years to come; there are two sides to change.

Jobs Report

This morning we get the January employment report, and by the looks of the indicators it’s going to be another very bad one. The expectation is for payroll positions to decline by 525,000, which would mark the third-straight month of losses in the 500k handle. Our feel is we’ll get something in the 400k range due to quirks in the seasonal adjustment – less workers than usual were hired for the holiday shopping season in December, so less were there to fire in January.

I think we’re still months away from a turning point, but if Congress doesn’t screw things up too badly we should see the degree of labor market weakness begin to ease three-four months out. We have seen outsized monthly jobs losses for five months now and this trend will not naturally extend for much longer. However, if Washington makes the wrong decisions and scares business, 400,000-500,000 monthly jobs losses could continue for some time and we will eventually see a double-digit unemployment rate – but it will take large mistakes to get us there. This economy is too dynamic for that to occur on its own.

Have a great weekend!

Brent Vondera, Senior Analyst

Afternoon Review

Cisco Systems (CSCO) +3.22%
Cisco reported a 27 percent drop in fiscal second-quarter earnings that exceeded estimates, but signaled that conditions had worsened.

Year-over-year order growth declined 9 percent in November and 11 percent in December, but deteriorated significantly in January, falling 20 percent. Approximately 80 percent of Cisco’s business is non-recurring each quarter, and thus is a reasonably good indicator of spending patterns. Using January’s numbers to construct revenue guidance for the coming quarter, the company projects a revenue drop of 15 percent to 20 percent from a year earlier.

Demand for routers and switches, which account for the majority of Cisco’s revenue, has dried up. Given AT&T’s and Verizon’s plans to reduce capital equipment spending in 2009, a rebound in carrier router demand should not be expected anytime soon. Longer term, however, router demand is primarily a function of network traffic growth, which is unlikely to subside. Similarly, enterprises are pushing out new equipment purchases, but they must eventually upgrade their networks to accommodate traffic growth.

In discussing the expected length of the economic downturn, CEO John Chambers said that the majority of Cisco’s customers are guessing 2010 while a smaller group sees the upturn toward the end of 2009. When asked for his opinion Chambers added, “I tend to be a little more optimistic than most of my customers.”

Cisco generated 3.2 billion in cash flows in the quarter, up from $2.4 billion in the same period a year ago and higher than the $2.7 billion in the company’s fiscal first quarter. With $29.5 billion in cash, Cisco sees the downturn as a chance to expand and has continued to move into new markets.

Cisco is also believed to be developing a server system that would take it into the computer business for the first time. Cisco will likely require an acquisition (I’m looking at you EMC) if they want to be real player in that competitive market.

Looking at the big picture, Cisco is very comfortable long-term growth goals of 12 to 17 percent due to “favorable long-term secular trends including cloud computing/data center build-outs, unified communications, web-based video and Telepresence.”


Harris Corporation (HRS) +0.98%
Harris revenue was up 16 percent in the second quarter of fiscal 2009 as strong international sales and healthy government contracts boosted results.

The company had strong growth in its military radio and government communications sectors. Second-quarter sales of military radios in the RF Communications segment were up 23 percent. International revenues made up 40 percent of RF Communications revenue, with orders from the Philippines, Mexico, Iraq, Algeria and Afghanistan.

Total orders in the second quarter were lower than expected because of delays of several large orders. On the bright side, no orders were lost or cancelled, “they just simply moved to the right.”

Contracts with the U.S. Census Bureau provided important revenue, as did multiband satellite communications terminals, avionics shipments for the F-35 Joint Strike Fighter program, an information technology services program for the Air Force Weather Agency and various classified programs.

Also during the second quarter, Harris completed the first phase for the U.S. Department of Health and Human Services' Nationwide Health Information Network. The software will allow federal agencies and regional health care providers to share information. It also positions Harris for growth.

Full-year, Harris is forecasting annual profit growth of 17 percent to 20 percent compared with last year and a revenue increase of 8 percent to 9 percent. CEO Howard Lance added, “We are well-positioned in the intelligence market, which ought to receive priority funding,” (from the government over tanks, planes, missiles, etc).


Wal-Mart Stores (WMT) +4.61%
Wal-Mart said January sales exceeded its projection after consumers bought more discounted groceries and $4 medicines. Same-store sales advanced 2.1 percent last month, beating Wal-Mart’s forecast of no change to a 2 percent increase. Same-store sales fell for the whole industry fell for the fourth straight month.

The company also announced they will provide quarterly sales guidance, rather than monthly guidance due to “volatile times when consumer swings are more difficult to predict.” During the period from January 31 through May 1, Wal-Mart projects an increase between one and three percent in U.S. same-stores sales excluding fuel.

Retailers continue to underperform and may continue to lag even on rebounds until there’s an anticipation of a bottom in housing prices.


Johnson Controls (JCI) +4.82%
Bloomberg reports that Ford Motor Co. selected Johnson Controls-Saft, a U.S.-French joint-venture, to supply batteries for a plug-in hybrid auto coming in 2012.

Johnson Controls-Saft, which makes batteries for Mercedes-Benz and BMW hybrids, will provide lithium-ion battery systems for a car that can get as much as 120 miles per gallon of fuel, Ford said in a statement. The car will have an electric range of 30 miles before a gasoline engine takes over.

In addition to the five-year deal they received on the Ford plug-in, Johnson Controls-Saft is also bidding on a contract to provide batteries for an all-electric Ford small car due in 2011.

These are key contracts for Johnson Controls battery business since they missed out on contract with GM and Toyota to supply their hybrid batteries.


Boeing (BA) 1.96%
Bloomberg reports that Boeing lost a $2.4 billion order for 16 Dreamliner 787 planes from Dubai-based leasing company LCAL, the second cancellation for the model in a week. Boeing has delayed the Dreamliner 787 introduction four times, but cancellations remain low. With 900 orders for the 787 and the eventual production rate of about ten a month, cancellations by smaller buyers who need more financing are not concerning to the long-term outlook for the company (or those who will supply parts like Goodrich).


eResearch Technology (ERES) +16.78%
Standard & Poor’s announced that eResearch Technology will join the S&P 600 small cap fund.


General Electric (GE) -3.73%
GE’s Immelt Prepared to Run Company with AA Rating


Chevron (CVX) +2.20%
Chevron Reports New Discovery Similar to Jack Field


Quick Hits

• In Merrill Deal, U.S. Played Hardball
• Goldman, JPM Won’t Feel Effects of Executive Salary Caps
• Lower Earnings, at Higher Prices
• Volcker Chafes at Obama Panel Delay, Strains With Summers Rise
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks resumed their latest losing streak – down four of the past five sessions – as disappointing earnings results from Kraft Foods and Walt Disney sent consumer-related stocks lower. Concerns that Bank of America will need additional government assistance, even as CEO Ken Lewis stated January results were encouraging, sent financial shares lower.

The market got off to a strong start yesterday, up 1.6% from the get go, but the erosion began as President Obama’s news conference related to capping executive pay got underway – he obviously learned nothing from watching the Bush/Paulson press conference effect. Even consumer-related shares were holding up pretty well despite the misses from Kraft and Disney; however, by the time the afternoon session got underway most major industry groups were lower.


At 10ET we got the ISM service-sector index, as we’ll touch on in depth below, which offered its first sign of a bottoming since the mid-September collapse of Lehman that seemed to change the world. While it is too early to get excited about a bottoming in service-sector activity, the fact that this ISM measure improved should have helped stocks hold up. Since things began to break down you’ve got to say that press conference is what did it – and who can blame the market; enough is enough when it comes to government involvement. And who’s going to be screaming when financial-services jobs move overseas?

Market Activity for February 4, 2009


During that press conference President Obama stated the government will cap top executive pay at $500,000 for firms that have taken “significant” TARP funds.

What this means, of course, is the few large institutions that have not received significant (however that term will be defined) funds will be able to attract the top talent. Private equity firms will also be able to lure the best and brightest. This also increasing the likelihood talent will be moving overseas, much as the Sarbanes-Oxley regulation has driven IPOs away from the New York Stock Exchange and to the London and Dubai exchanges over the last few years.

In addition, we shouldn’t forget that it is regulators and the Federal Accounting Standards Board that has delivered the coupe de grace to the financial sector via fair value, or mark-to-market accounting rules. Banks would not have needed TARP funds in the first place if pro-cyclical accounting standards were not in place.

I understand the topic of executive compensation is a touchy one. Many people wonder how some in the industry are awarded such high compensation during a period when many terrible mistakes were made. But when the government gets involved in determining these things, it puts us on a dangerous course. As Justice Brandeis wrote, “the greatest dangers to liberty lurk in the insidious encroachment by men of zeal, well-meaning but without understanding.” Same is true when it comes to the economy.

It is also true that in many cases financial industry bonuses for the previous year’s results are paid in the first three months of the following year. So, some of what we’ve seen in 2008 pay was based on 2007 performance. There is no doubt that 2009 would have already shown a massive decline in compensation (2008 was down 40% from 2007 and the trend will continue in 2009), but now the government is involved in another market-price mechanism and I can’t view this as a good thing even if the vast majority of people are likely outraged by what they hear about executive pay. In its current form the caps are not a huge deal, but government intervention has a history of snowballing, which rolls us down a prosperity-killing path, and that’s the real concern. Watch, we’ll all be getting the bill for the New York bailout.

Preliminary Employment Reports

First, we had the Challenger Job Cuts survey (January), which tracks the number of announced layoffs for the month. The report estimated the number of layoff announcements picked up significantly last month – 241,749 vs.166,348 for December. Layoff announcements in January were 224.4% higher than January 2008’s level.


The bulk of the layoff announcements came from retail, industrial goods and computer & electronics sectors.

We’ll note that job-cut announcements are a lagging indicator; they generally peak after a recession has technically ended. We should expect that this data will be a good indication to the degree of official monthly job losses calculated by the Bureau of Labor Statistics for the next few months, but several months out it will not.

Second, we received the ADP employment report, which showed private payrolls fell 522,000 in January. This survey, via the largest employer services firm, had not been a great indication of what actually occurred in the labor market prior to the past few months, but its methodology has been changed to more closely mirror the way the government calculates things, so it has been close lately.


ADP stated service-producing employment fell 279,000 in January. Goods-producing jobs dropped 243,000 -- manufacturing shed 160,000 and construction down 83,000.

Small and medium-sized firms (defined as those with fewer than 500 employees) cut 430,000 positions, compared to a 92,000 decline for larger firms.

So, Friday we get the official monthly job report for January, and these data suggest (along with jobless claims and ISM employment) that it’s going to be another ugly one. We’re likely to see another 500K-plus drop in monthly payroll positions, although some expect it to be closer to 400,000 due to technical issues related to seasonal adjustments. (The retail industry added fewer holiday season jobs than usual, which may play havoc with the adjustment).

In any event, we will see a few more months of outsized monthly declines – outsized defined at a number greater than a 325,000 decline) but this deterioration should ease after that. Unless some sort of government response really backfires and causes major alarm within the private sector, we just won’t see the current level of weakness extend beyond another 3-4 months, in my view.

ISM Service Sector Index

The Institute for Supply Management stated its non-manufacturing index rose to 42.9 for January from 40.1 in December. (This is a composite index that equally weights business activity, employment, new orders and supplier deliveries).

The rise in the index is quite welcome, even if the level is nothing to get excited about just yet.


Both the ISM surveys (manufacturing and this service sector look) point to continued contraction in economic activity. However, if we can build on these mild improvements it may be signaling a turning point. We’ll be watching for ISM service to make its way closer to 50 and ISM manufacturing to inch its way to the mid 40s. If that occurs by April, an economic bounce may be in the cards by the third quarter.

For now we remain concerned regulators’ obstinance regarding pro-cyclical accounting will keep lending activity stagnant (see chart below) and the government spending spree will keep the private sector concern over future tax rates heightened, and their level of caution as well. We shall see.

(On the chart below, notice the spike in activity that took place August-October. This resulted from firms accessing credit lines for fear they would be taken away; it was not due to increased project activity – credit lines are set to models, when default rates rise banks almost universally pull back on lines of credit and firms got out in front of this move. During November and December we saw lending activity fall as the credit-line phenomenon ran its course. I’m expecting this contraction will be more pronounced as we get the January and February figures. Some of this will be part of the re-adjustment process, no problem there, but the accounting regime will exacerbate the situation and that is a problem.)


Have a great day!

Brent Vondera, Senior Analyst

Afternoon Review

ITT Corporation (ITT) -0.29%
ITT’s fourth quarter earnings came in above expectations as benefits from recent acquisitions and operational improvements offset higher costs from aggressive restructuring and realignment activities.

Fourth-quarter revenue for the Defense Electronics and Services segment was up 39 percent, led by growth in ITT’s Advanced Engineering & Sciences and Night Vision businesses. At the close of 2008, the Defense segment had a funded backlog of $5.24 billion, providing good visibility into the year ahead. Like other defense companies that have reported earnings thus far, ITT is predicting there will be no defense cuts by the new U.S. administration.

Sales in ITT’s Fluid Technology segment were roughly flat in the quarter, but saw significant growth in international and emerging markets on higher demand for their water and waste water management. The Motion and Control segment revenues fell 12 percent in the fourth quarter as demand the segment’s end markets, including marine and automotive, came to a grinding halt.

ITT’s full-year results were impressive, as revenues increased 30 percent on strong organic growth across all of its business segments. ITT’s free cash flow grew 33 percent to $871 million, representing a 112 percent conversion of income from continuing operations. (Growing free cash flow is frequently a prelude to increased earnings.)

ITT maintained earnings guidance for 2009, but sales guidance was lowered from the forecast made in December. Higher margins are expected to compensate for the lower revenues. First-quarter earnings guidance was a disappointing 53 cents to 63 cents, well below the 82-cent consensus estimate.

ITT is hopeful that they will benefit from the forthcoming U.S. stimulus package, although they did not include any stimulus money in their forecast due to a lack of visibility of Washington. Management said they could potentially benefit from water and wastewater treatment plant construction, and they mentioned talks with the Secretary of Transportation about infrastructure development with respect to next generation FAA technology.


Goodrich Corp (GR) +0.77%
Goodrich, a leading aerospace parts supplier, topped projections as fourth-quarter earnings rose 29 percent on higher business-jet and defense sales. However, the company reduced its 2009 guidance (originally given in Oct. 2008) to reflect updated expectations for 2009 pension expense and the uncertainty of the global economic environment.

In the fourth quarter, higher revenue from defense and corporate-aircraft customers helped overcome a 40 percent decline in sales to Boeing after an eight-week machinists strike at the planemaker resulted in fewer parts shipments.

Goodrich expects global airline capacity to contract slightly in 2009, but remains confident their aftermarket sales will perform above market trends because of their “excellent product positions on the newer, more fuel-efficient airplanes that are least likely to be removed from service.” In addition, Boeing and Airbus are expected to deliver more new airplanes in 2009 than they delivered in 2008, which will boost original equipment sales.

Goodrich makes a number of the products for the highly demanded planes of the future, the Boeing 787 Dreamliner and Airbus A350, which are expected to generate “significant revenues for Goodrich for many years to come, and will help Goodrich sustain its position as an industry leader in its commercial aerospace markets.” Both Boeing and Airbus hope to deliver their first planes by early 2010.


Cisco Systems (CSCO) +1.41%
After the closing bell, Cisco announced posted fiscal second-quarter profit that topped analysts’ estimates. We will go through the details tomorrow of what should be a very interesting report. Because Cisco’s quarter ended on January 24, this will be our first taste of 2009’s business climate.

Cisco is a barometer for the technology industry because it is the dominant seller of routers and switches, which both direct and control the flow of data. Bloomberg acknowledges that large companies account for most sales of switches, which they use to run their corporate networks. Phone carriers and Internet service providers mostly purchase routers.


Quick Hits

• Bond Yields Rise – But Will It Last?
• Will swallowing Wyeth cure Pfizer?
• U.S. Stocks Retreat, Led by Consumer Companies, on Earnings
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks gained some nice ground yesterday, sending the Dow above the 8000 mark, again. The index was propelled by shares of IBM and Merck.

Tech shares have put together nice back-to-back gains as more people may be seeing this area of the market will lead the way, along with industrials in our view. Merck shares helped the health-care sector post are strong 2.44% rise yesterday after the company beat profit expectations.

The broad S&P 500 index rallied a solid 1.58% after a rough couple of sessions; nine of the 10 major industry groups gained ground – the financial sector was the sole loser.


Market Activity for February 3, 2009

It was reported the market also received a boost as Treasury Secretary Tim Geithner stated the government will step up efforts to fight recession. We’ll see if their actions actually help things. Based on what we’ve seen from the stimulus program there’s zero chance the economy will respond kindly – it will have to be completely re-worked. I’ve got a feeling Geithner may have be referring to proposed program that brings mortgage rates down to 4.00%-4.50%.

Geithner also mentioned, after watching Japan sink in the 1990s if there is one thing he learned it is not to dither. This is what was learned? What he should have come away with is throwing money (for a full decade) at the problem does nothing but leave a nation with many more government programs and massively in debt. They don’t call it the “lost decade” for nothing. But our Treasury Secretary learned not to dither; that’s nice.

Pending Home Sales

The National Association of Realtors announced pending home sales rose 6.3% in December -- the first increase since August. On an unadjusted basis, pending sales are 6.0% above the year-ago levels; seasonally adjusted, pending sales are 2.1% above the December 2007 level.


By region, pending home sales rose 1.7% in the Northeast (down 14.5% YOY), jumped 12.8% in the Midwest (down 1.2% YOY), up a similar 13% in the South (up 1.6% YOY) and fell 3.7% in the West (up 17.5% YOY). So, despite the decline for the month, you can see things have stabilized nicely in the West region.

As a result of the rise, we’ve got a pretty good indication existing home sales will show an increase when the January data is released at the end of the month. That will be nice, but we’ll have to see some easing in job-market losses before a sustained rebound in home sales presents itself.

That said, you can see the desire building for some sort of government action with regard to mortgage rates. The Fed is certainly engaged, buying roughly $15 billion per week in mortgage-backed securities. This has done a lot to narrow spreads, now much closer to the historic average of 180 basis points – the spread between the 30-year fixed mortgage rate and the 10-year Treasury had hit 290 basis points back in November. But the Treasury may begin to issue Treasury debt, yes on top of the rest, and use Fannie and Freddie to bring fixed rates down to 4.00%-4.50%. That would provide a huge boost to both refis and purchases – with the 30-year Treasury priced at a yield of 2.82% this is certainly doable; the question is how long that window will remain open. There’s also talk the Senate may propose a $15,000 tax credit for new home buyers.

Earnings, Valuations and Policy

Fourth quarter earnings season is shaping up pretty much as we figured. Overall S&P 500 profits have been crushed due to a massive 340% decline within the financial sector. You may ask how something can fall by more than 100%. Huge losses make it possible, and the collapse will continue so long as pro-cyclical accounting rules remain in place.

Digressing for a moment, with each new loan the industry makes, they take on additional assets that must be marked down to distressed-market prices – regardless of whether principal and interest payments remain uninterrupted. This also of course ignores the fact that there is underlying collateral – a house and land with regard to mortgage-backed assets. Give me a break. Say you have an asset that is actually in default and it is already marked down to 40 cents on the dollar. In most cases, the house and land, even if the bank needed to sell that asset within a month, is worth more than that. And we wonder why lending activity is stagnant? It is no wonder spreads became prohibitively wide.

I was unaware that we’ve used market value accounting before this stint, but after reading comments from former FDIC chairman William Isaac last night learned we had. The period was the 1930s and it took eight tortuous years before it was abolished for historical-cost accounting. Let’s hope it doesn’t take so long this time – at the current pace of financial-sector deterioration it won’t, if you know what I mean

Anyway, we had no idea how badly financial sector earnings would deteriorate last quarter, but our assumption of mid-$40 per share for trough earnings on the S&P 500 was not terribly far off. The actual number is $42.05 per share with 60% of firms reporting.

The ex-financial figure, which is the one to watch as the 15-month accounting regime greatly exacerbates financial sector results, is down 15.5% for the quarter, which is in line with our expectation. This shows that profits deteriorated substantially last quarter, but it certainly is not the collapse that justifies the decline in the market, in my opinion. A decline of 30% on the S&P 500 from the peak seems justified (which would result in a trailing earnings P/E of 25 times – pretty normal if not a bit on the low side for a trough earnings multiple, currently it’s very low at 19 times) but the 47% plunge that has occurred seems quite gratuitous.

Surely, the deleveraging event and uncertainty regarding the whims of Washington are playing a role here. The forward P/E sits at a low 12.5 times expectations. Even if profits bounce just two-thirds the normal rebound coming out of trough results you’re still looking at a forward market multiple of 16.5 times expectations (and the index carries a 3.40% to boot).

But think about it, and I’m certainly not saying we’re headed for a sustained rally as the level of uncertainty over government responses weighs heavily on investor sentiment, what if policymakers get a clue and demand regulators return us to the old accounting standard, or a net-present value accounting that takes into account cash-flows? You will see financial earnings flatten out, thus no longer weighing upon overall S&P 500 earnings per share, and suddenly the already low market multiple will be pushed even lower. If it is not, it means stock prices have bounced meaningfully from current levels, and indeed I would think stocks rally hard if mark-to-destruction is abolished.

And this is the point, policymakers don’t have to do much to spark a rally. They just need to engage in some common sense and refrain from programs that do nothing but leave us further in debt two years down the road. This is quite a lot to ask from Washington I grant you, but it’s possible. One thing I am confident of is the current accounting rule is making things appear far worse than they actually are.

Have a great day!

Brent Vondera, Senior Analyst

Afternoon Review

Emerson Electric (EMR) +5.99%
Emerson posted fiscal first-quarter profits that beat analysts’ projections and predicted 2009 profit in line with estimates.

Underlying sales (which exclude acquisitions, divestitures and foreign currency translation) were essentially flat. Declining sales in the U.S. were offset by strong international and emerging markets sales that increased 7 percent and 10 percent, respectively.

Technology leadership continues to drive global sales in the company’s Process Management were strong, with underlying sales growth in the U.S. of 10 percent and international growth of 16 percent. The company made special mention of its multiple awards for technologies including a first-place award for Wireless Infrastructure.

The company said that cost reduction initiatives and restructuring benefits mitigated deterioration of the operating profit margin in a challenging environment of increased commodity inflation and volume deleverage.

Emerson’s cash flow to total debt provision remains strong at 60 percent, allowing for continued investment in the business and support of the dividend. The company is targeting a strong year in free cash flow at 11 to 11.5 percent of sales for fiscal year 2009.

“We’re positioning Emerson for a strong breakout when the global economy recovers,” CEO David Farr said. “Our ability to generate cash demonstrates the underlying strength of the business and enables us to fund growth, both organic and through acquisitions.


Hologic (HOLX) +6.93%
Hologic reported fiscal first-quarter revenues increased 16 percent from the same period a year ago.

The company attributed the increase primarily to the inclusion of 13 weeks of revenue from the diagnostics, surgical and MammoSite product lines acquired in the merger with Cytyc. Also contributing to the increase in revenues was a 34 percent increase in service and other revenues primarily related to their Selenia full field digital mammography units sold.

Hologic reiterated full-year guidance, which was lowered on Jan. 12 to reflect that hospitals are responding to tightening access to capital by restricting capital expenditures, implementing tight spending controls and reducing personnel.

The company has three new products submitted to the FDA for approval that could significantly enhance revenues; however, Hologic could not estimate with any certainty if or when they may begin to market these products in the U.S.


United Parcel Service (UPS) +6.08%
UPS fourth-quarter earnings declined, but topped analysts’ expectations.

In response to the “severe decline in economic activity,” UPS has consolidated operating districts, reduced air segments and eliminated some package handling operations. The company also announced it is freezing management salaries and suspending the match for its 401(k) plans.

Revenue per piece growth was constrained by a lower average weight per package and a continuing shift away from premium products and services. These trends, along with lower volumes, more than offset the benefits from reduced fuel cost and competitive wins.

During the quarter, UPS expanded its presence in China by opening a new hub in Shanghai, the first hub constructed by a U.S. carrier in that country. In addition, UPS began building a new intra-Asian hub in Shenzhen (expected to open in 2010) to expedite service within the region.

UPS ended 2008 in a strong financial position with $1 billion in cash on their balance sheet after repurchasing 53.6 million shares for $3.6 billion and paying $2.22 billion in dividends with declared dividends up 7 percent. The company’s free cash flow remained solid at $5.7 billion.


Northrop Grumman (NOC) +4.23%
Northrop reported a fourth-quarter loss on a $3.1 billion goodwill write-down, but its 2009 forecast came in above expectations.

The aerospace, electronics and information systems company turned record results in 2008, with $33.9 billion in sales and $2.4 billion in free cash flow. In addition, the company’s total backlog grew 23 percent to a record $78 billion, representing a book-to-build ratio of 143 percent.

Sales rose at all of Northrop’s business segments except shipbuilding, which posted a decline of 3.4 percent. During the quarter, the U.S. Navy awarded Northrop and its partner, General Dynamics, a $14 billion contract for eight more Virginia-class submarines over the next ten years.

Northrop also noted newly elected President Barack Obama doesn’t look to be scaling back defense spending anytime soon.

Quick Hits

• Obama’s Foreclosure Plan May Back Rewritten Loans
• Schumer Sees Momentum for Guaranteeing Toxic Assets
• Citigroup Leads Tumble in Hybrid Bonds as Bank-Nationalization Bets Surge
• Where the Financial Gurus Are Putting Their Own Money
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks ended mixed Monday as the Dow and S&P 500 ended lower, while the NASDAQ Composite closed strong to the plus side – strong by normal measures at least.

The Dow was pressured by shares of 3M, Boeing and Proctor & Gamble as the day’s economic data showed manufacturing and consumer activity remain in the doldrums. Among the 10 major industry groups, industrial shares led the losers, falling 2.51%.

The NASDAQ Composite was bolstered by a strong showing among telecom, information technology and biotechnology shares, up 2.02%, 1.48% and 0.95%, respectively.

The S&P 500 ended the day just fractionally lower.


Market Activity for February 2, 2009

Economic Data

The Commerce Department reported that personal income fell for the third-straight month in December. While the declines in this data, the broadest measure of income, have been mild considering the degree of labor-market weakness, the fact that we have a series of declines means the year-over-year readings have deteriorated substantially.

Personal income fell 0.2% in December and is up only 1.4% year-over-year, which is down from +3.8% as recently as August. Real disposable (after-tax) income rose 0.3% for the month. The savings rates increased to 3.6% in December from 2.8% in November. This traditional measure of savings has jumped over the past few months as the two main savings vehicles (stocks and homes) continue to fall.

The compensation and wage and salary components of the report had been holding up remarkably well, but not so for the past two months – both fell 0.3% in December.

Proprietor’s income fell 0.6%, marking the second month of decline – the figure fell 1.6% in November. The year-over-year figure is down 2.0%.

Interest and dividend income were also lower, down 2.1% and 0.5%, respectively. On a year-over-year basis interest income is down 7.2% as interest rates have been very low for some time. Dividend income was up only 0.1% from December 2007, down from the robust year-over-year rate of 5.5% in August. The dividend cuts within the financial sector have caused this erosion.

On the spending side, personal spending fell a large 1.0% in December, marking the sixth month of decline – and substantial declines they have been. The level of real spending in December was down 2.8% from the fourth-quarter average at an annual rate, according to RDQ Economics. This compares to the 3.5% decline in personal consumption we saw in Friday’s GDP, so we wouldn’t expect this component of the report to be revised.

The consumer is simply not going to increase activity until they are comfortable with the level of cash savings. If we don’t get policy out of Washington that can ease some concerns and spark a sustained stock market rally, then we may need a savings rate close to 5% before consumer activity rebounds. Obviously, the deterioration within the labor market has caused issues, but it’s our feel the degree of decline in stock prices – along with continued home price contraction – has dealt the largest blow. It’s a confidence thing.

This personal spending data has an inflation gauge linked to it (known as the personal consumption expenditures, or PCE, deflator). This gauge, along with the chained CPI report, is immensely more accurate than the regular CPI figure and garners the most focus from economists.


The month-over-month reading showed prices fell 0.5% in December. On a year-over-year basis, the PCE Deflator is up 0.6%, that’s down from 1.4% in November. The core rate, which is the Fed’s favored inflation gauge, has price activity up 1.7% year-over-year, which is a deceleration from 1.9% for the previous month.


Energy prices have turned the inflation gauges lower and this pushed real disposable income up a sharp 6.7% at an annual rate last quarter. This will help the consumer bounce back several months down the road.

Combine this improvement in real incomes with strong corporate cash positions and massive monetary easing that will explode through the economy once lending normalizes and we could see a powerful rebound in economic growth a couple of quarters down the road. The concern is that government is so involved at this point, the unintended consequences of their actions makes this rebound a short-term event. We shall see. It’s vitally important we shift some of the stimulus plan to an incentives-based framework; if done it will help to offset the consequences that always follow government “fixes.”

In a separate report, the Institute for Supply Management announced factory activity improved in January, although it remains at a weak level.

The ISM manufacturing index rose to 35.6 last month from 32.4 for December, which marked the lowest reading since 1980. ISM is a diffusion index, which means it attempts to measure the percentage of firms experiencing an improvement in factory conditions. Therefore, only 35.6% of firms experienced improving conditions last month; 64.4% saw conditions deteriorate.


The more forward-looking sub-indices of the report did show some life for February as production, new orders, orders backlog and inventories all moved in the right direction. However, the improvement is from terribly weak levels. One would think we can get some bounce over the next couple of months, simply based on the levels we’re coming off of, but there just isn’t a compelling reason to expect a sustained rebound just yet.

If we’re going to see the economy begin its recovery by the summer, we’re going to have to see ISM move into the mid-40s by March. This is one of the best indicators of when the economy has begun to turn.

In the final release of the day, Commerce also reported construction spending fell 1.4% in December. The November decline was revised downward to show a 1.2% drop (double last month’s estimate). This marks the third-straight month of decline, but unlike the previous months every component was down.

Private residential construction continues to the lead the move lower, falling 3.2% (down 22.9% year over year); private nonresidential fell 0.4% (up 8.9% YOY) -- it remains remarkably resilient, I’ve got a feeling we’re about to see this one begin to post substantial declines. Public residential construction spending dropped 2.5% (up 9.1% YOY) and public nonresidential fell 0.8% (up 6.9% YOY).

The December construction spending decline was larger-than-expected, and in addition to the downward revision for November, this data will have a negative effect on the revision to Q4 GDP.

The driver for construction spending will come from the public side of things over the next year, at least, as it is obvious government will play a larger economic role.

Have a great day!

Brent Vondera, Senior Analyst

Fixed Income Recap

With the record large auctions of last week behind the market, Treasuries traded higher Monday as buying was dominated by foreign accounts. The two-year was up 3/32 of a point in price while the ten-year traded higher by just more than a point. The benchmark curve flattened by 6 basis points on the day. A basis point represents .01%.

TLGP Update
$145 billion has been issued to date under the FDIC insured corporate debt program. Demand for the issues has improved significantly since the program was implemented. Current issues are trading about 30 basis points, or .30% over Treasuries.

The FDIC announced last week that it was considering extending the term of the program to cover newly issued debt maturing in ten years. It was indicated that the program for insuring longer debt would differ from the existing program. The debt would need to be collateralized, perhaps in a way similar to a covered bond, and the issuer would have to prove the money was being used to support consumer lending. The current program covers debt maturing as late as June 2012 and has no such stipulations.

Last Thursday, in the face of this announcement, Goldman Sachs issued $2 billion in ten-year debt without any guarantee from the FDIC. The issue came in at 7.5%, or 500 basis points over the ten-year Treasury.

Current FDIC insured corporates are trading right on top of agency debt. Ten-year Fannie and Freddie debentures currently trade around 3.6%, considerably more than the 7.5% that Goldman will be paying on their newly issued bonds. However, credit spreads are much tighter than they were last fall, and as Goldman exhibited, along with several others who issued a total of $8 billion in longer term deals last Thursday, the market does not need the subsidization.

In my opinion, the FDIC should make bank deposit insurance their top priority. The original Term Liquidity Guaranty Program helped resuscitate the credit markets that seized up after the collapse of Lehman Brothers, and the assistance proved to be very effective. However, the current environment does not warrant further assistance from the government in this form, especially not at the expense of the depository base.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Afternoon Review

January Recap *please contact for full monthly report*

In January, equity markets moved lower in response to more bad news from major banks, gloomy economic data and disappointing earnings reports reflecting the difficulties ahead. The Dow lost 8.65 percent, its worst January in 113 years. The S&P 500 gave up 8.43 percent this month, eclipsing the 7.36 percent drop at the start of 1970 and adding to last year’s 37 percent plunge.

As more financial institutions required additional government assistance, investors found themselves in the same unfortunate position as in November, depending on solutions from Washington. The uncertainty over the government’s role in the U.S. financial system, use of TARP funds and details of the stimulus bill was detrimental to confidence. Also weighing on sentiment were poor job reports and GDP data suggesting even greater production drops in the current quarter are likely. The buildup of unsold inventory shows that businesses could not slam on the brakes fast enough when demand dried up late in the quarter. As a result, many companies are withholding earnings guidance and hoping that visibility improves as the year progresses.

Utilities outperformed all other sectors, with investors seeking safety in their attractive yields and relatively stable revenues. Other strong performers included health care, energy and information technology. The health care sector, which is generally considered a defensive sector, benefited from Pfizer’s acquisition of Wyeth and expectations for increased consolidation. Crude oil’s 20 percent rally from its lows and positive reports from bellwethers Chevron and ExxonMobil helped buoy the energy sector. The technology sector’s pristine balance sheets and solid cash flows have earned these companies a premium among investors looking for less risky assets.

Treasuries suffered from fears of oversupply with various U.S. stimulus plans in need of funding, causing prices to drop and yields to rise. Yields on the two- and ten-year notes rose 0.19 percent and 0.65 percent, respectively, steepening the benchmark curve by 46 basis points.

The Federal Reserve Bank of New York began their agency MBS purchasing program in January, purchasing $70 billion dollars of the securities so far. The plan aimed at lowering borrowing costs for homeowners, helped mortgages outperform comparable Treasuries for the month.

--

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks slid for a second-straight session, capping the worst January on record for the S&P 500. The index fell 8.6% last month, surpassing the previous record of -7.6% in January 1970.

Weak economic reports put pressure on the indices as the preliminary fourth-quarter GDP report showed the economy endured its worst three-month period since the first quarter of 1982. While the report, which we’ll touch on below, didn’t show the decline that was expected, adjusting for a build in inventories (what’s known as real final sales) activity was weaker-than-expected at -5.1% at an annual rate.

The Chicago PMI reading, which tracks factory activity in the region, didn’t help matters as the gauge posted its weakest reading since 1982.


Market Activity for January 30, 2009

Amazingly, the Dow held above the 8000 mark, which is a psychological level. Today though we may break that mark, again, as comments out of Washington over the past few days have further damaged investor sentiment. We’re talking about the currency fight Treasury Secretary Geithner seems ready to pick with China and failure to understand the mistakes the previous Treasury Secretary made regarding the TARP.

The administrations needs to learn that flaunting a “bad bank,” RTC-style solution, only to pull it back is not at all constructive. The market seems to like the idea of setting up a facility to house troubled assets and holding them until intrinsic value can be realized, so investors get juiced when the idea is brought up but then we have these sell offs when policymakers raise doubts and euphoria deflates.

They must be forgetting what occurred November 19 and 20 (back-to-back 6% declines that established a new multi-year low – 752 on the S&P 500 and 7552 on the Dow) when Paulson changed the TARP from an RTC-style plan to the hugely inferior capital injection route.

On top of it all we’ve got rhetoric over Chinese currency manipulation and tariffs. What is it with this protectionist nonsense? Have people forgotten this is one of the main elements that made the Great Depression possible?

Geithner got this rhetoric kicked off in his written answers to the Senate Finance Committee’s questions (as part of his confirmation process) when he stated the administration believes China is artificially keeping its currency undervalued to boost exports. Someone who is supposed to be so smart should understand this would just present fodder for politicians and that is exactly what has occurred. I’m certainly no China apologists, there are some real military concerns over the longer term but the best way to avoid this is via economic cooperation and trade. In any event, to blame the Chinese for currency manipulation ignores the fact that we manipulate our own – our Fed has a monopoly on the U.S. dollar.

The Chinese yuan has been pegged to the U.S. dollar since 1994, it’s how they escaped the Asian contagion of 1997-1998. Washington didn’t seem to care that they were pegged to the dollar when the greenback was strong.

We need to focus the blame in the right direction, it’s with our own Federal Reserve, they are the ones that have caused the greenback to fall in value over the past decade. The silliest aspect of these comments is that Geithner – just as the previous administration stated – says he desires a strong dollar, yet wants the Chinese to strengthen their currency too. Um, if the Chinese are going to strengthen their currency they’ll need to decrease foreign currency reserves, which means they will sell dollars. This is not going to make the greenback stronger. We need to worry about ourselves. Sound monetary policy and lower tax rates on profits and capital will deliver a stronger dollar over time.

What makes these comments all the more mind-blowing is the fact that this administration is going to be issuing trillions in Treasury debt over the next couple of years in order to finance all of this spending – a trillion here, a trillion there. Don’t poke a stick in the eye of one of the largest foreign purchasers of this debt; we’ll quickly find out much higher servicing costs ensue (via substantially higher interest rates) if Geithner and Congress are not extremely careful here.

So there are some major issues tugging at the market here. The unfortunate thing is we’re beating ourselves up; it doesn’t have to be this bad. Pro-cyclical accounting rules are exacerbating the credit market problems by artificially eroding capital adequacy ratios and protectionist comments are scaring the hell out of equity-market investors – as if they need another concern.

Fourth Quarter GDP

The Commerce Department reported fourth-quarter GDP fell only 3.8% at an annual rate as inventory growth added 1.32 percentage points to the figure. It seems strange to use the word “only” on a 3.8% decline in GDP, but as we’ve been discussing a 5.5% decline was expected. In any event, the reading was the worst since the 6.4% decline in the first quarter of 1982.


Private sector final demand was extremely weak as personal consumption slid 3.5% (real terms at an annual rate) – this largest component of GDP subtracted 2.47 percentage points from the Q4 figure. This follows a 3.8% drop in the previous quarter. These are huge declines in consumer activity and it will just not come back until consumers are more comfortable with cash savings as their two main savings vehicles (homes and stocks) have been ravaged.

Residential investment sank another 23.6%, but only took 0.85 percentage point from GDP as residential home construction is just 3.0% of GDP these days. Go back a year and a decline of this degree was subtracting 1.50 points from economic growth.

Business spending declined 19.1% -- spending on structures fell 1.8% and equipment spending plunged 27.8%. (Adding higher current-year write-off allowance and bonus depreciation, as we’ve discussed, to a stimulus plan is essential right now. We should raise the amount with which small businesses can write business spending down in a given year to $250,000 and allow larger businesses to write-down 50% of equipment purchases in the year bought, instead of forcing them to depreciate the entire cost over time. The current depreciation policy creates distortions anyway. It understates cost due to inflation over time and overstated earnings, and thus overtaxes.)

We still feel the Q4 GDP report will be revised down (we’ll get two revisions to this figure), the way things shut down last quarter anything above -4.5% doesn’t seem right. However, inventory levels are low; no where near the heights they generally climb to at this stage in a business cycle, and this could be the bright spot.


Some expect inventories to be drawn down this quarter, and drive first-quarter GDP much lower as a result. But maybe at these levels we’ve seen stockpile curtailment largely run its course. If so, this will keep the GDP readings over the next couple of quarters from falling to levels that compare to the rough 1981-82 recession.

Chicago PMI

The Chicago Purchasing Managers’ index (for new readers, this is the gauge of factory activity out of the largest manufacturing region) fell slightly in January to 33.3 from 35.1 for December. This is the lowest reading since March 1982 (we’re seeing a number of comparisons to that period).


The forward-looking indicators continued to slip from already very low levels – the new orders index fell to 30.7 from 31.5 and production fell to 29.7 from 32.4. Order backlogs inched higher to 26.5 from 26.3, but this degree of improvement is worthless.

The employment index within the report, something we’re all keeping a close eye for any sign the job market is improving, dropped back to 34.8 in January from 39.2 for December.

So this data offers no hope that we’ll see any improvement in the labor market for this month -- although that’s not much of a surprise as jobless claims have painted a clear picture substantial weakness continues --, and shows industrial production will contract at another substantial rate for January. The forward-looking indices also portend factory activity will remain low for February. The only thing that may give us some boost next month is the fact that auto production will rise as idled plants came back on line a couple of weeks ago – but this will prove to be a temporary boost if it does materialize.

We need to get serious here. Attack the crisis in confidence by driving tax rates lower. We’re going to find out, unless this stimulus bill is changed to something that is more constructive, that ignoring the most potent ammunition policymakers have is a grave mistake.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

**Earnings release was yesterday

T. Rowe Price Group (TROW)** -7.60%
TROW’s fourth quarter earnings fell 87 percent, the second straight decline, as market losses reduced asset-management fees and the company wrote down the value of investments in its own funds.

Assets under management fell 20 percent to $276.3 billion in the quarter. Net outflows from mutual funds were $2.2 billion in the quarter, including $1.4 billion from stock funds and $1.5 billion from bond funds. The company’s target-date retirement funds drew $700 million in net inflows, about half the previous quarter.

On the bright side, T. Rowe is on of the few major U.S. asset managers not to eliminate jobs to compensate for the steep drop in fees.

Despite the negative effect the bear market has on asset managers, T. Rowe’s well-respected brand, solid fund performance, high customer switching costs and scale positions the company well when global markets rebound.


3M (MMM)** -4.88%
3M posted better-than expected earnings for the fourth quarter, but moved its guidance down in anticipation of a steeper decline in sales.

3M’s international sales fell 14 percent and U.S. sales fell 6 percent. Asia-Pacific sales dropped 18 percent and European sales fell 13 percent, while Latin America and Canada dropped 9.2 percent.

CFO Patrick Campbell said the first quarter “will be by far the most difficult quarter we have. As we work through the inventory correction, later in the year, we will see the recovery.” 3M is cutting capital expenditures by 30 percent and it will cease stock buybacks until the “environment improves.”

On the bright side, 3M produced solid free cash flow and returns on invested capital that widely exceeded its estimated cost of capital. 3M faces the same challenges as everyone else, but their pristine balance sheet and prudent cost control will help them


Illinois Tool Works (ITW)** -3.37%
Illinois Tool Works fourth-quarter results came in slightly above their reduced guidance given in December, but the company provided a dismal outlook for 2009.

As cited by most industrial companies, the markets deteriorated considerably throughout the fourth quarter. The company expects its revenue from business acquisitions, ITW’s main growth driver, to fall by more than half this year.

Despite their grim outlook for the U.S. and Europe, the company remains optimistic about its positioning in Asia. In countries such as China and India, the company has heavy exposure to infrastructure projects in its welding and construction units.


Alliant Techsystems (ATK)** +2.16%
Alliant Techsystems said fiscal third-quarter sales rose 11 percent on higher sales of commercial and military ammunition.

The company sees this fiscal 2009 profit coming in at the top of the company’s forecast range, but pension costs and a change in accounting rules for convertible debt put Alliant’s 2010 forecast well below consensus estimates. Although these factors have no real impact on the core and growth operations of Alliant, they are likely to lead to a flat year for earnings in 2010.

In the long-run, Alliant’s competitive advantage from low-cost production and its industry’s high barriers to entry should continue to generate impressive profitability and robust free cash flow.


L-3 Communications (LLL)** +0.86%
L-3 said fourth-quarter earnings rose 29 percent, exceeding estimates, thanks to a gain from a divestiture. The company‘s 2009 outlook trailed its previous forecast because of an increase in pension expenses.

Total revenue for the quarter increased 5 percent due to strong growth in aircraft modernization and maintenance as well as specialized products. The operating margin for the quarter increased from last year in every segment expect for the C3ISR (command, control, communication, intelligence, surveillance and reconnaissance) unit.

Full-year revenue increased 7 percent, driven by double-digit growth in C3ISR and specialized products. These segments should continue to fuel total revenue growth in coming years because the global political landscape and unchanged, if not increasing, U.S. defense budget.


Arch Coal (ACI) -9.53%
Arch Coal’s earnings beat analyst estimates because of higher prices on long-term contracts for the fuel.

Coal companies benefited last year from locking contracts for the fuel as it surged to a record $137.50 a ton for Eastern supplies before the U.S. recession curtailed demand. Arch plans to slow production growth until the economy rebounds. Cash prices for coal in Wyoming’s Power River Basin, where Arch gets about three-fourths of its production, rose 20 percent from a year earlier.

Like rival Peabody Energy (BTU), Arch discussed its expansion into the Asia-Pacific rim, which they expect will “set the stage for increased participation when global economic growth resumes.”

Although coal prices have outperformed other commodities, it is unlikely coal companies will rebound until the oil prices move higher and expectations for the global economy become more optimistic.


Chevron (CVX) -0.14% , ExxonMobil (XOM) -0.68%
Earnings from Exxon and Chevron both exceed expectations largely because of widening margins on refined fuel.

Both companies experienced significant declines in revenue as a global recession eroded fuel demand, spurring a 56 percent drop in oil futures. Still, Chevron and Exxon capitalized from significant overseas refining operations because diesel demand outside the U.S. has remained relatively strong.

While other large oil companies like ConocoPhillips and Occidental Petroleum are cutting their capital budgets, Exxon is increasing their capital spending this year and Chevron plans to maintain their current levels.

Chevron said stock buybacks will be suspended in the current quarter after the company bought back $8 billion in stock last year. Exxon, who has far deeper pockets than their competitors, plans to repurchase $7 billion in shares during the current quarter after spending $32 billion on buybacks in 2008.

Chevron and Exxon’s ability to generate robust cash flows in this difficult environment is very positive sign that both will be able to weather the storm in coming quarters.


Fortune Brands (FO)** -5.07%
Fortune Brands reported disappointing fourth quarter earnings and cut its 2009 earnings forecast well below estimates.

Declining home prices, rising unemployment and tight credit caused consumer confidence to drop to record lows during the quarter. This resulted in consumers purchasing fewer of the company’s discretionary brands including Titleist Golf, MasterLock padlocks, Moen faucets, Jim Beam, etc.


Procter & Gamble (PG) -6.39%
P&G reported revenue that fell more expected and lowered its annual forecast as consumers spent less and the dollar’s gains hurt overseas sales where they get more than half of their revenue.

The company’s revenues were hurt by consumers trading down and buying less expensive versions of necessary items, such as P&G’s Gain laundry detergent instead of Tide. The company also saw consumers purchasing fewer discretionary hair-care products and fine fragrances.


Qualcomm (QCOM)** -1.65%
Qualcomm reported disappointing earnings despite higher revenues that were driven primarily by the mix of higher-end chipsets and higher priced data capable (web browsing, text messages, etc) devices.

The company said it saw “healthy demand” for 3G as CDMA-based device shipments in the quarter were at the high end of its expectations.

Qualcomm did not issue earnings guidance “due to the volatility of financial markets and the impact it has had and may have on our investment portfolio and net income.” They did, however, provide revenue guidance for their second fiscal quarter that translates to a year-over-year revenue decline between 6 and 14 percent.


Eli Lilly (LLY)** -3.03%
Eli Lilly reported earnings that topped expectations and reaffirmed its outlook for 2009. Revenues were basically flat, but fell shy of consensus estimates.

The company said it expects volume growth in sales again in 2009, driven by Cymbalta, Alimta, Cialis, Humalog and the anticipated launches of prasugrel, as well as the Elanco animal health division. However, the negative impact of weaker foreign currencies and the impact of generic competition in certain markets for Gemzar are anticipated to partially offset these positive impacts.



Peter Lazaroff, Junior Analyst

Fixed Income Recap

Supply pressures crushed Treasuries in trading Thursday. The five-year was off 20/32 of a point in price while the ten-year traded lower by almost 2 points by late afternoon. The benchmark curve steepened by 14 basis points, a large move even by today’s standards. A basis point represents .01%.

The seven-year Treasury Note will likely be brought back after a 16 year hiatus according speculation. Just showing how the Treasury is trying desperately to squeeze all demand out of the market by filling every gap along the curve.

The Fed announced $16.8 billion in Agency MBS purchases for seven day period ending yesterday. At this point the Fed appears to have settled into a steady range of $15 to $18 billion per week in purchases.

The Four Primary Risks of Bonds

Credit
Duration
Liquidity
Structure

Credit Risk
Perhaps the most straightforward of the four risks of fixed income investing, credit risk has the potential to be the most severe.

Credit risk, also known as default risk, is the risk that the borrower will not be able to make principal and interest payments in a timely manner. The market prices the risk of default by demanding a higher return for lending money to companies or individuals who are more likely to default.

“High Yield Bonds”, otherwise called “Junk” bonds, are traditionally those who are issued at a higher yield relative to the market, usually by companies with poor credit ratings.

I will talk about the other primary risks of bonds in upcoming issues.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks ran into a wall yesterday, halting a four-session advance, due to an especially harsh day on the economic data front and the fact that fourth-quarter ex-financial sector profits moved to -14.5% with 50% of S&P 500 members reporting thus far. News out of Washington probably had an effect on the broad market as well.

Financials got clocked, as you can see below, on news the “bad bank” idea is running into snags. This is ridiculous. As policymakers focus on their brainiac fixes they are incapable of seeing the simple solution that’s slapping them in the face – end mark-to-market rules with regard to establishing capital adequacy ratios.

Additionally, comments from the White House that sounded like they came from a Russian oligarch rather than a U.S. president didn’t help matters. You want to demand that private-sector firms halt bonuses? Maybe we should understand how our market works first. While there are economic problems right now, we should not forget that top talent is performing well in many cases; if you punish this talent it will move on. And if they can’t move on under the current labor market conditions, these people won’t forget, and they’ll say sayonara the moment they get the chance.

Fire those that have made grave mistakes and reward those that continue to bring value – that’s how we’re set up to prosper. If the government believes it is justified in managing businesses because they have provided taxpayer funded capital, they need to be reminded that beyond the mistakes financial institutions have made the regulatory decision to implement mark-to-market accounting rules just 14 months ago is that which drives the industry, and the economy, into the dirt.

Market Activity for January 29, 2009

Yesterday’s Economic Data

First, the Labor Department reported initial jobless claims rose 3,000 to 588,000 for the week ending January 24. So, we held below the 600k mark that everyone expects the reading to eclipse, but that level will probably be breached within the next couple of weeks as layoff announcements continue to climb.

The four-week average rose for the first time in five weeks, up 24,250 to 542,500. This measure is now nearly back to its mid-December high and as the lower readings of mid-January drop out over the next three weeks you can bet it’s going higher.


Continuing claims rose to a record high of 4.776 million, increasing another 159,000. Although we’ll note that when one adjusts for the size of payroll employment, continuing claims would have to hit 7.5-8.0 million to match the highs of 1974 and 1982. So the current labor market issues are hardly as rough as those past periods.

That said, we better get our priorities straight on attacking the problem, or it will reach those levels.

We must attack the crisis in confidence by slashing tax rates on incomes, capital and corporate profits. The immediate boost to after-income and after-tax return expectations would be the greatest stimulus we can implement right now. Spending much of the stimulus plan on government transfer payments and allowing laid off workers entry into the Medicaid program will not do – this is what passed the House Wednesday night.

Even the infrastructure plans (and one can argue whether or not this is beneficial but at least it is some form of stimulus) make up only 12% of the total package, and even then 80% of which would not be implemented until 2010 and 2011. As former Fed Governor Larry Lindsey summed it up yesterday, we’ll look back a couple of years from now and all we’ll find is we’re two years older and saddled with much more debt by the looks of this current bill.


Back to the labor market, the insured unemployment rate (the jobless rate for those eligible for benefits) rose 0.2% to 3.6%. This reading generally corresponds with a directional move in the overall unemployment rate, so we’ll probably see the jobless rate hit 7.4% when the January data is released early next month.

Next, the Commerce Department reported that durable goods orders fell hard in December, down 2.5% on the headline reading and 3.6% excluding transportation. This report shows as clearly as anything that businesses are in capital preservation mode, unwilling to engage in business equipment plans until they see something that offers some sense of confidence over the foreseeable future.

Every aspect of the report was down, save electrical equipment and military aircraft. Primary metals were down 6.9% for the month, industrial machinery orders fell 5.0% and computers and electronics orders dropped 7.2%. Orders for these three components of the report are down 70%, 53.2% and 27.5%, respectively at an annual rate for the past three months.

And if these two reports weren’t bad enough, the Commerce Department also showed news home sales plunged 14.7% in December to 331,000 units at an annual rate – that’s the lowest level since records began in 1963.

The good news is at these levels it is tough to believe we haven’t bottomed out. Further, the drag this data has on the economy has eased as residential construction makes up just 3.0% of GDP, down from 6.0% three years ago.


In terms of region, sales were weak across the board. The Northeast endured the largest decline, down 28.2% -- although this is a bit deceiving as the prior two months saw strong sales growth. The West region saw sales fall 20.2%; the South was down 12.1% and Midwest new home sales fell 5.6%.

The median price of a new home fell 9.3% on a year-over-year basis. So we add this into the other three major housing indicators and home prices are down 12% on average over the past year.

Despite the decline in home prices, the inventory-to-sales ratio rose to a new high.


Yesterday was indeed a particularly harsh day on the economic data front. Today won’t be much better, although it is expected (so long as it’s not worse than -6.0%), as the preliminary fourth-quarter GDP report registers its weakest reading since 1982.

We’ll get through this, but it would be nice to see a strong, pro-growth agenda that attacks the problem. We don’t need the economy to turn on a dime, recessions are important events that eliminate the weak and provide a stronger base with which to grow when the business cycle begins to expand.

However, if we choose to support businesses that cannot compete on the global stage, and expand transfer payments to the point that government spending reaches 25%-30% of GDP, then one should not expect the economy to rebound with the vigor we’ve become accustomed to.

What we can do immediately is return a higher level of confidence to the market place, but that will take the correct policy response.

Have a great weekend!


Brent Vondera, Senior Analyst

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