Daily Insight

U.S. stocks jumped yesterday on very positive news out of Citigroup and comments from policymakers the uptick rule will be reinstated and mark-to-market may be modified. The rally was powerful, marking the best one-day advance since back-to-back 6% days back in late November. Still, because of the damage done over the past couple of months, not to mention the last six, only gets us to 720 on the S&P 500 and just over 6900 on the Dow.

Financials led the advance, jumping 15.6% on the uptick and accounting comments. Sure Citigroup’s news helped the rally as well – the firm stated they will achieve an operating profit this quarter, which would be the first since the third quarter of 2007. Still, I’m a bit skeptical that this portends a reversal for the industry in general – I’ll explain why below.

Industrial and information technology shares – two of our favorites for the next decade – also outperformed, up 8.50% and 7.42% respectively.

The key for now is for policymakers to get it done with regard to uptick and mark-to-market. We can’t have more of this talk, only to see no additional comment or action on these topics for a couple of months like everything else they’ve been in involved with lately. There are few reasons for short sellers to run for cover (of course it occurs on days like yesterday, but we need several days of this to get them truly scared and dropping the ball on the reasons the shorts feel safe will prove a huge mistake.

Back to this Citigroup news for a moment, the reason I remain skeptical the industry is not yet ready for a relatively sustained earnings rebound is because there is no sign yet in the coincident indicators that the economy has bottomed, and bank losses generally lag the economy. I find it hard to believe the credit-card side of the business has bottomed since monthly job losses remain large.

Nevertheless, the core business side of the banking industry is looking pretty good – if we can get some work done on mark-to-market banks will begin to lend more freely as they will not be worried about taking on more assets that then will have to be marked to distressed prices and thereby affect their regulatory capital.

If regulators are not going to abolish the accounting standard, they must break the link between mark-to-market and regulatory capital. They can do this by allowing banks to remove these assets from their trading accounts and into their held to maturity accounts. Banks’ core business is essentially a carry trade, borrow low and lend higher, and the strongly positive yield curve makes this possible, but we must at least get the accounting rule modified. Then reinstate the uptick rule, call it a day and watch the market explode to the upside.

Market Activity for March 10, 2009


The Rally

Yesterday we touched on the potential for a market rally from these levels – yesterday’s move was helpful but one day doesn’t matter right now, we need a trend. You can sort of feel a bounce is coming for the following reasons: we’ve been down for 2 ½ weeks straight (and the degree of decline has been harsh); the mood is very dire (and generally when you least expect it, expect it); and again, more and more people (including Bernanke yesterday) are talking about the pernicious aspects of mark-to-market accounting with regard to capital requirements. It’s a start.

Further, there is talk that CDS (credit default swaps -- essentially insurance on default risk) will be required to post margin; amazingly this was not the case heretofore, but then problems generally are not addressed until…well, they become problems. Also, from what I read, the SEC is establishing a futures exchange (the CME and ICE are bidding on the business). This is a big step that will bring transparency and hopefully more appropriate values.

CDS fundamentals seem very much out of line right now as CDS on AAA firms such as Berkshire and GE are trading as if these are non-investment grade firms. This is exacerbating the decline in stock prices – CDS amplify the downside. Say a hedge fund or bank sold CDS eight months back when things were more normal. They are now buying CDS to offset this risk or simply, and more likely, shorting the name for which they sold CDS on. This is why CDS amplifies the downside. Add in pro-cyclical accounting measures (mark-to-market), and we’ve got ourselves two very big issues that are pushing stocks lower than they would likely otherwise have declined. It about time we’re getting the ball rolling on these fronts, now don’t drop the damn thing. (Ok, I promise not to bring mark-to-market up again until they actual take action on it, you must be tired of me brining it up.)

In terms of a rally that turns into a trend, we may have to get around another spate of credit-market fear first. You can see it in the way the corporate-bond ETFs are behaving of late. An investment grade ETF (exchange-traded fund) is down 11% over the past seven weeks and a high-yield ETF is off by 20% over the same period. Outside of the policy front, this is the main impediment to a near-term stock market bounce. If credit spreads widen you can probably forget about any one-two day rally having legs.


The Economy

The Commerce Department reported wholesale inventories fell for the fifth-straight month in January, down another 0.7%.

Sales have been crushed since September, the month everything changed, and they took another beating for January, down 2.9%. This follows large declines over the previous five months – down 2.1% in September, crushed by 4.5% in October, sandblasted by 7.3% in November and creamed by 3.7% in December. This marks the most severe contraction for merchant wholesaler sales since records began in 1967, illustrating businesses went into full-blown survival mode due to the credit chaos that followed the Lehman and AIG collapses.

Most of the damage done to the figure over the past several months has been the collapse in auto sales. Of late though, machinery sales have really plunged – down 3.3% in November, 2.8% in December and a huge 10.8% in January.

The inventory-to-sales ratio, due mostly to the plunge in sales, has moved from just above the record low to just above the average of the past 15 years all in six months time. Inventories in general are not out of control though, much lower than most periods in which the economy has deteriorated to recessionary level. When we do get a bounce back in sales, this inventory-to-sales ratio will come down fast, but we need a rebound in confidence to foment a sales bounce.

This is why we’ve harped on a tax-rate response since the credit crisis began in September. We know it has zero chance due to the make-up of Washington, but that doesn’t mean you stop talking about what best delivers confidence about the future. And that is exactly what we need.

In a separate report, the National Federation of Independent Business (NFIB) released its small business survey for February showing optimism weakened to 82.6 – a record low. The figure posted a reading of 84.1 in January.

The net percentage of firms planning to hire rose to -3% from -6% in January, some improvement there. Amazingly, even in this significantly poor labor-market environment 11% of small businesses surveyed stated jobs as being “hard to fill.” This illustrates the shortage of skilled labor. You wouldn’t think there to be any problem filling positions in this scenario.

Overall, this is a very weak reading from NFIB. “Poor sales” was cited as the single-biggest problem for small business, with taxes running second. I’ll bet 12-18 months out taxes will be the single-biggest problem cited.

The survey showed small firms continue to expect to cut jobs over the near term, but at a slower pace.

Have a great day!


Brent Vondera, Senior Analyst

JCI, WMT, UTX, ACI

S&P 500: +6.37% Dow: +5.80% NASDAQ: +7.07%

Johnson Controls (JCI) -6.87%
Johnson Controls, the largest maker of automotive seats, was left out of today’s rally after it announced plans to sell 8 million equity units with an initial amount of $50 per unit, or $400 million, and $100 million in convertible senior notes due 2012 for a total of $500 million.

Also hurting shares was a negative report from Sterne Agee & Leach, which lowered their expectations for Johnson Controls explaining “How, or to what extent, bankruptcies of U.S. auto manufactures negatively affect Johnson Controls is largely an unknown at this time and presents ongoing risks.”

The analyst note does acknowledge the company is in a better position than United Technologies (UTX) or Ingersoll-Rand (IR) to capture a larger portion of the stimulus spending to improve energy efficiency of government buildings – thanks in large part to an established position with the Department of Energy. However, the stimulus benefit is unlikely to offset contracting new build nonresidential construction.


Wal-Mart Stores (WMT) +2.44%
Citigroup downgraded shares of Wal-Mart on the possibility that legislators will pass the Employee Free Choice Act, which would allow employees to organize without holding meetings and make it more difficult for companies to talk to their workers about unionization.

The report argues that Wal-Mart is directly threatened by this legislation because they are the largest food retailer, a sector that has historically been unionized. Unions would undoubtedly increase labor costs for the company and could be a significant drag to earnings.

The Wall Street Journal reported today that they bill faces opposition in the Senate from several senators – five Democrats and one Republican – which could complicate passage.


United Technologies (UTX) +8.60%
Shares of United Technologies rose despite the company announcing a 5 percent reduction of its work force this year, a reduced buyback program and a decrease in yearly guidance.

Citing a deteriorating outlook for global construction markets and commercial aerospace, the company now forecasts earnings of $4 to $4.50 a share, including restructuring charges, on revenue of about $55 billion. The company had previously projected earnings of $4.65 to $5.15 a share, on revenue of about $57 billion.

Last December, United Technologies predicted an economic recovery in the second half of 2009 which they now say “appears unlikely.”


Arch Coal (ACI) +10.36%
Arch Coal agreed to buy a mine in the Wyoming’s Powder River Basin (PRB) from Rio Tinto for $761 million and integrate it with an adjacent operation.

Arch expects to generate cost savings by combing the purchased mine with its own, while expanding its already large presence in the PRB. This is especially important given the push for “clean coal,” since the PRB coal has emits less toxins when burned than other coal. As a result, Arch is able to charge a premium for this coal.

Arch’s debt rating was lowered by Moody’s cut its outlook to “negative” from “stable” on the coal company, citing concern that the acquisition would hurt Arch’s liquidity/ S&P said in a statement that it will lower Arch’s credit rating if the U.S. recession persists and demand for coal remains weak.

These credit downgrades are reasonable considering the aggressive nature of this purchase – they are funding it mostly with debt. Still, Arch’s large presence in the PRB is a considerable competitive advantage.


Quick Hits

• Bernanke Urges Rules Overhaul to Stem Risk Build-Ups
• Merck Deal Puts Pressure on Johnson & Johnson and others
• The Challenges to Efficient-Market Theory
• Ten Questions for Those Fixing the Financial Mess
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks continued the trend lower as the broad market fell another 1%. Additional comments from Warren Buffett on the state of the economy combined with the World Bank’s prediction of a total global contraction were reported as the reasons for another sell-off. The actual quote from Buffett was that the “economy fell off a cliff” (I don’t know why this affected things, if indeed it was actually the reason, as we all know this to be the case)

Financial and energy shares were the only sectors to manage a gain yesterday. Telecom, information technology and utility (on cap and trade worries) led the losses.


The pounding seems relentless, but it does feel we’re in store for a bounce. The broad market is down 33% since early November and 28% over the past nine weeks. Bear markets offer the most powerful rallies simply because they also exhibit the largest declines, and all that goes with declines of this magnitude such as short positions that people end up covering when things rally.

What’s more, when no one wants to buy the market, many times that’s exactly when a rally presents itself – when you least expect, expect it. Trouble is we haven’t been expecting it for quite a while now yet still it keeps falling.

This bear has been as harsh as they come (we’re something like 515 days into this bear market and the S&P 500 is down 57%; that’s worse than the -42% 515 days following the 1929 crash). We’re due for a bounce and when it occurs it should be a powerful move. Problem is with the type of policy that’s on the horizon the sustainability of such a move is quite unlikely.

Certainly, elimination of mark-to-mark and the return of the “uptick rule” (having to wait for a rise in price that’s above the preceding sale before implementing a short sale) can foster this rally – and if this is done the rally will be a big one. From there, allowing the market to correct some of the credit excesses (instead of forcing more debt upon the market, this is not September/October when financial collapse appeared possible) can make an upward move sustainable. But we’re a long way from allowing free-market principles to take over – this is simply the cycle we’re in and that must be acknowledged.

Market Activity for March 9, 2009

We were without an economic release yesterday, but that’s ok because there are many others things to talk about these days.

Increased Government Control = Misallocation of Resources

It was reported yesterday morning that Bank of America has become the first U.S. bank to withdraw job offers it had made to foreign MBA students graduating from U.S. business schools this spring. Why? Because banks that had received TARP money are prevented from applying for H1-B visas (visas for those termed to be highly-skilled immigrants) when U.S. workers have been fired.

And you don’t think there’s a protectionist tilt within the current make-up of Congress? Whether its goods or labor no matter, protectionism is protectionism and it ain’t good. Congress can try to block competition all they want, but eventually you must face reality.

That was the Reason?

President Obama was out again this weekend stating they will not repeat the policies that got us into this mess. One assumes he means unsound monetary policy and government intrusion within the arena of lending – specifically the housing market. These are the two primary issues that created a credit expansion that now in hindsight could not last, particularly since the Federal Reserve did not provide the proper oversight for which they were tasked -- one main reason credit standards were so lax for so long. (Oh, and the New York Fed is one of the main overseers of the banking industry – Mr. Geithner was President of the New York Federal Reserve Bank 2003-2009.) Exacerbating it all is the pernicious accounting standard known as mark-to-market (set in place in November 2007) and the removal of the uptick rule, allowing short sellers to drive bank shares into the dirt.

Of course, this is not what he means, as Mr. Obama is in the process of defining what got us into this mess – tax cuts.

I would contend that without the tax cuts of 2003 (capital gains tax rate reduced by 25%, dividend tax rate slashed by 62%, and income tax brackets by roughly 15% -- I would have gone further but these were helpful nonetheless) the economy would not have withstood the higher energy prices of the previous several years. Lest we forget, oil jumped 464% (38%% annualized) spring 2003 through spring 2008. (And not all of that jump was due to the price spike of 2008 as crude rose 200% in the three years ending spring 2006, or 39% annualized).

There is no way in hell the economy could have managed nearly 3% at a real annual rate for the period Q1 2003 through Q2 2008 with this rise in energy prices. Yes, the housing market was on fire for some of this period– but that accounted for just 6.5% of GDP at its peak – so let’s not say the economy grew only because of the housing bubble. Besides, since early 2007 housing has been a drag on GDP and until September 15 2008, when everything changed on the Lehman collapse, the economy still managed 2.1% at a real annual rate despite the nasty housing correction and oil prices that averaged $85 per barrel.

Nevertheless, we’re seeing the reasons for the current woes defined (say it over and over again and people believe it to be fact) and as a result policy will be directed toward removing the current tax rates for a burden that is substantially higher, along with increased government micromanagement. We shall see how the economy and capital react over the next couple of years. (The proposal to raise the FICA tax cap, currently set at $106,800, will create an additional tax burden to bear for both employee and employer at exactly a time in which we need jobs cuts to ease.)

Details? Why Offer Details?

Treasury Secretary Geithner commented last night that next week the administration will roll out a program to offer small business some help. How about starting with refraining from raising marginal tax rates? Roughly 65% of those within the two-top tax brackets are small businesses. No, they’d rather implement policy that hurts the group, only to then offer programs that show they are coming to the rescue, it seems.

(Oh, and speaking of tax rates, when do you think capital gains and dividend tax rates are going higher? At the end of 2010, right? Well, not quite. If President Obama’s fiscal 2010 budget passes, those rates will rise in October of this year – the government’s fiscal year begins in October. That’s nice.)

But back to this small business assistance program…well, never mind; I don’t have anything to say about it because Mr. Geithner’s comments involved zero detail. What’s new? They don’t seem to get it; or maybe they do get it. You with me?

Have a great day!



Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries
Treasuries dismissed the happenings in the stock market today as traders became more concerned with the $63 billion in supply to come this week.

The two-year finished unchanged while the ten-year was higher by about 1/16 of a point. The benchmark curve flattened by 3 basis points on the day. A basis point represents .01%.

The Treasury will auction $34 billion in three-year notes on Tuesday, $18 billion in 10-year notes on Wednesday and $11 billion in 30-year bonds on Thursday.

Corporate Bonds
Credit spreads have taken a beating so far this year. The bond ETF (Exchange Traded Fund) LQD, which follows the iBoxx Investment Grade Corporate Bond Index, is down 11.75% since January 9th, while the S&P 500 is down 24.02% over the same period. The correlation between the two is expected, with corporate debt being less volatile than stocks due to the priority they are given in the capital structure.

A deepening recession and lower expectations for future earnings have hurt stock prices and increased probabilities of default across the board. There is no telling how many defaults will come about through all of this, but staying highly diversified, as opposed to picking just a few names, has its advantages.

LQD is currently yielding 7.12%, while providing exposure to 70 or so different companies across many industries with an average credit rating of A2/A and a 6.7 year duration. The cost of the diversification you get though an ETF like LQD is minimal when considering the unsystematic credit risk you take by building a basket of 7-10 names, in addition to liquidity risk. You may be able to pick up a small bit of yield over the etf by doing so, maybe .5% depending on the execution, but in our view buying the ETF makes much more sense on a risk adjusted basis.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Northrop Grumman (NOC)

Northrop Grumman (NOC) *contact for tearsheet*
Continuing in the aerospace and defense industry, Northrop has been drilled by concerns that defense spending in the U.S. will come under pressure. However, the budget actually calls for 4 percent annual increases in defense spending over the next few years.

Northrop is well diversified and has an order backlog of $78 billion, providing the company with nice visibility into the future. The company also may benefit from a budget provision to spend hundreds of millions on a satellite system to monitor climate change – something the company has been working on for years.

Northrop also hopes to win the Air Force’s $35 billion contract to build aerial refueling tankers – again. Northrop and EADS, actually won this contract in 2008, but Boeing pressed to reopen bidding in 2009 citing unfair practices. Northrop remains convinced it has a better plane and will eventually prevail.

Like other defense companies, shares of Northrop are trading at a significant discount to the market, while sporting an attractive dividend and potential for strong earnings growth.


WellPoint (WLP) -1.21%
Reports surfaced last week that WellPoint placed its pharmacy benefits management (PBM) business up for sale. WellPoint’s PBM business, NextRx, is the fourth largest PBM in the U.S. with 32 million members. NextRx filled about 268 million prescriptions last year, and the business represents about 6 percent to 8 percent of WellPoint’s earnings.

The sale could be valued between $2 billion and $5 billion, depending on how a deal is structured. How long WellPoint would commit to having the PBM continue to manage its members’ prescription-drug benefits, and under what terms, would heavily influence a deal’s value. Discussions are early, but Express Scripts (ESRX) is considered the frontrunner with Medco and Walgreen may also show interest.

Acquiring NextRx would give a big stand-alone PBM like Express Scripts more negotiating power with drug prices and more room to expand its lucrative mail-order pharmacy business. Only about 10 percent of NextRx’s prescriptions are filled by mail order instead of at retail pharmacies, compared with as much as 40 percent of all prescriptions at the bigger PBMs.


General Electric (GE) +4.96%
GE shares were up after analysts said big write-offs are unlikely. The biggest controversy surrounding for the company right now is the fair value of GE Capital’s balance sheet. The company hopes to clear the air when they open up GE Capital’s balance sheet at an investor conference on March 16.

It was reported today that GE is selling $8 billion of government-backed bonds as debt investors speculate the finance unit will need to raise more capital.


Johnson & Johnson (JNJ) -2.86%
Merck's $41.1 billion takeover Schering-Plough seems fine and dandy, but it’s complicated by a long-standing distribution agreement between Schering and J&J. The agreement specifies that if Schering-Plough were acquired, J&J would have the right to cancel the agreement and take full control of the drugs – and the billions they generate.

In Monday’s conference call, Merck said that rights to the two drugs would remain safely with the combined company even though it was Merck that was taking over Schering-Plough and paying a premium to Schering’s shareholders.

Merck is calling the deal a “reverse merger,” so that the surviving parent company will be the existing Schering-Plough corporate entity. That company will be renamed Merck and led by Merck management, but won’t technically be the “old Merck” in the eyes of the law.

The agreement between J&J and Schering-Plough provides for mandatory binding arbitration in the event of a dispute, which means that a court battle is unlikely. Of course, there’s always the possibility that J&J might decide to skip the arbitration and make a play for Schering-Plough itself.


Quick Hits

• Someday, People Will Invest Again
• Depression Dynamic Ensues as Markets Revisit 1930s
• Ivory Tower Unswayed by Crashing Economy
• Credit Conditions
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S stocks, as measured by the S&P 500, erased a 2.3% decline in the final half-hour of trading on Friday to close fractionally higher. The Dow average performed a bit better, propelled by energy and consumer-related shares. The NASDAQ Composite failed to end on the plus side as technology shares close down about a 1%.

Energy, materials and health-care shares led the broad market’s advance.

Health-care stocks have closed lower in 11 of the past 14 sessions on government proposals to change the structure of Medicare Advantage, force pharmaceutical firms to offer more rebates to Medicare recipients and increased talk regarding universal health-care. The shares managed to gain ground on Friday, however, on the news more consolidation will occur, which was exactly right as Merck has agreed to buy Schering-Plough for $41.1 billion in cash and stock – news that broke this morning.

Energy and material shares have caught a little life lately as these industries will be the likely beneficiaries of global stimulus projects; investors may also be gearing up for the inflation trade as this is what will occur via the massive amounts of liquidity the Fed has pumped into the system – the way the government is engaging in stimulus will combine with the Fed’s action to increase the rate of inflation to harmful levels down the road. Still, we’ll see this trade lose steam several times, in my view, as economic issues (to put it mildly) will cause doubt but it’s just a matter of time. The Fed will watch inflation rise and won’t do a darned thing about it for if the housing market is in the early stages of a rebound they won’t want to shut that down via higher interest rates.


For the week, the broad market lost 7%, marking the fourth-straight week of decline that has pushed the S&P 500 down 21%. Financial shares, big surprise I know, led that decline as the index that tracks these shares has plunged another 38% over that four-week period.

Market Activity for March 6, 2009


The Jobs Report

The Labor Department released the February jobs report Friday morning and no one found a silver lining – although we see a possible bright spot. No doubt the vast majority of the report was abysmal, but the whisper number was far worse than printed and the household survey showed a large reduction in the rate of decline. We’ll explain below.

According to the report, payroll positions fell 651,000, smack dab in line with the estimate of a 650,000-position loss. The previous two months were revised down totaling another 161,000 in job losses. Over the past three months, payrolls have fallen at the fastest pace since February 1975.


The unemployment rate jumped to 8.1% in February, which is the highest level since 1983, from 7.6% in January.


There are two separate surveys connected to the jobs data. One is the payroll survey, which shows the headline number of jobs gained or lost – this is the number you read about in the paper or online. This survey includes 400 major businesses, but excludes the self-employed. The other is the household survey, which includes the self-employed and is the number for which the unemployment rate is calculated.

This household survey showed a loss of 351,000 in February, a rate of decline that is substantially lower than the prior three months – down 1239K in January, -806K in December and -799K in November. So that’s one good sign. The other is the fact that the civilian labor force rose, meaning people began looking for work again. While the unemployment rate reflected this, it is much better than what we’ve seen over the past few months, people removing themselves from the labor force (by not looking for work during the four weeks prior to the survey – what’s referred to as “discouraged workers”) and yet the unemployment rate was jumping nonetheless. It is too early to say this with conviction, but just maybe we’re seeing light at the end of the tunnel here. I’m reaching for optimism, but why not – it’s important to acknowledge anything that offers some positive scenario.

(Just to clarify, it would have been far worse to see the unemployment rate rise again even as more workers removed themselves from the labor force because this would mean an additional spike in the jobless rate will be upon us as these workers come back in to look for work. This is not to say the unemployment rate has peaked, because it most surely has not; yet this event does offer some sign the jobless rate will not rise as fast as it has over the past several months.)

According to segment, declines in payrolls were broad based as every category fell, save health and education – the only component of the report that has yet to show a decline during this labor-market contraction.

Service-producing payrolls led the decline as the area shed 375,000 positions – in line with the average of the previous three months. Professional and business services shed 180,000.

Goods-producing payrolls declined 276,000 – an improvement from the 324,000 average decline of the past three months. Manufacturing shed 168,000 and construction lost 104,000.

Hours worked fell 0.7% last month – manufacturing hours were down a significant 2.0%. Average hours worked for the first two months of the year were down 8.2% at an annual rate compared to the fourth-quarter average.

Average hourly earnings rose 0.2% in February; the year-over-year figure slowed to 3.6% from 3.8% in January.

We’ll point out though that real disposable income (after-tax, inflation adjusted) has jumped to 3.3% on a year-over-year basis, which is above the long-term average. As we engage in the policies we are about to embark on, inflation will likely rise to levels that are not helpful and real income growth may very well be lower than we have been accustomed to – so the currently positive rates may not last for long. For now though, it is a major positive for the consumer and we’ll take anything that will help consumer activity rebound.

Unfortunately, what we are doing in terms of policy is not a long-run strategy. We are ignoring the benefit of making hard choices today, choices that may cause the recession to drag on for a few more quarters, yet will put us in a more competitive stance when we come out of this cycle. Instead we are doing the opposite, engaging in plans that will likely give us a short-term boost, but will make us less competitive over the next few years – higher tax rates, more regulations and government spending as a percentage of GDP (moving to 27%-30% of GDP from 18-20% of the past quarter century) are not the best ways to allocate resources and incentive capital (which is extremely mobile these days) to flow into the U.S.

Have a great day!



Brent Vondera, Senior Analyst

General Dynamics (GD)

General Dynamics (GD)
Lots of press from General Dynamics this week. On Wednesday, the aerospace and defense company raised its dividend payment 8.6 percent. Then the next day, GD announced 1,200 job cuts and lowered its profit outlook amid weaker-than-expected demand for the company’s Gulfstream business jets.

The Gulfstream business (18 percent of 2008 revenues) is primarily driven by the health of corporate budgets and it was widely assumed for some time now that GD would reduce Gulfstream production plans – although the size of the reductions seem to have caught some off guard. Even with international orders making up over 50 percent of Gulfstream’s backlog, the global nature of the economic downturn has eliminated the benefit of geographic diversity.

GD now plans to deliver 73 large cabin jets in 2009 (previous guidance 94) and 24 midsize units (down from 30 before). The announcement also implied that 2010 large cabin orders should remain flat at 73, but I think there is potential for further downside in business jets. It will be important to keep an eye the cancellations for large cabin jets where margins are double those in the midsize segment, and thus are far more detrimental to operating profits.

Of course, GD’s defense groups remain strong and are expected to grow revenues by 20 percent from 2008 to 2010, mostly through organic growth (this is important for a company that is known for growth via acquisitions). Combat Systems is expected to increase sharply this year, and would get an additional boost if the administration’s request for over $80 billion in additional funding for Iraq and Afghanistan is granted. Marine Systems should also see good growth as it begins ramping up to double its submarine output through 2011.

GD shares currently trade near the lowest of the major defense-systems integrators – only Boeing (BA) has a lower multiple. This can be attributed to the market giving little value to Gulfstream, declining margins and uncertainty related to the U.S. defense budget. Still, GD’s strong product lineup and existing customer base will drive revenue growth over the long run.


UnitedHealth Group (UNH) +9.48%
Bargain hunters snapped up shares of UnitedHealth that were beaten down in previous sessions in response to Obama’s initial budget proposal that cuts payments to Medicare Advantage programs. Compared to its rivals, UnitedHealth has limited exposure to Medicare and enormous scale.

The government won’t finalize the reimbursement rates for Medicare Advantage plans until April, so there is plenty of time for additional fluctuation in sentiment.


General Electric (GE) +6.01%
The Wall Street Journal reported that GE officials, including CFO Keith Sherin, have been meeting daily of late with officials of credit-ratings agencies, who are considering reducing GE's Triple-A rating, the financial chief said. Sherin said the company is unlikely to be downgraded below AA, which would trigger roughly $8 billion in new costs. "I can't imagine it based on the knowledge I have and the reviews we've done," he said.


Quick Hits

• The Financial Wreck Surpasses the Tech Wreck
• Dividend Reductions Surpass 2008’s Record
• To Forecast or Not to Forecast?
• Immelt Meets Buffett in Market Roiled by Credit Swaps
  
  
  

Peter Lazaroff, Junior Analyst

Chris Lissner on municipal bonds

Chris Lissner appeared in the latest issue of the St. Louis Business Journal to talk about the municipal bonds. To check out the article, click here or on the logo below.

Fixed Income Recap

Treasuries
Treasuries again benefitted from a weak stock market. The safety trade was in full effect today, dominated by overseas buyers.

The two-year finished up 1/8 of a point while the ten-year was higher by about 1.375 points as the benchmark curve flattened by 11 basis points today and stands about 12 basis points flatter for the week. A basis point represents .01%.

Today was the biggest compression in spread between the two- and ten-year since February 17th, a day the S&P was down 4.5%.

MBS
Late yesterday Freddie Mac announced it is waving fees for high LTV, low FICO score loans they guarantee. This is no joke. Fannie hasn’t announced such a move, but one is expected considering they have been moving in lock step since they were taken over.

These are the same fees that they were scheduled to increase due to the added risk of guaranteeing riskier loans. Not only is the government forcing extra risk onto Fan and Fred, but they are now prohibiting them from collecting a fee for their services. I just don’t understand it.

Fannie and Freddie Senior debt and MBS on the other hand, are trading as if the standalone solvency of the agencies doesn’t matter. The government is dead set on keeping Fannie and Freddie strong in order to use them to strengthen the mortgage market. These actions will just require more backing from the taxpayer in order to do so.

President Obama’s “Making Home Affordable” Plan
A lot of speculation pertaining to this plan has been making its way around the market, and now that the official plan has been released much of the speculation has been affirmed. The plan has two main parts. The first is aimed at helping homeowners who have no equity, but are still current, refinance their mortgages to take advantage of lower rates. The second plans to modify delinquent loans of borrowers who have mortgage payments greater than 31% of their gross income. Loan value must be under $729,750 in order to qualify for either section of the plan.

The first part of the plan uses 105% LTV as the cap for the loan to qualify for refinancing, but that number ignores what could be borrowed on a second mortgage or HELOC (Home Equity Line of Credit). The secondary mortgage must remain subordinated to the first lien, but there is no cap on total LTV. In other words, a second mortgage cannot be wrapped into the primary under this refinancing program and will largely be ignored when considering whether a borrower qualifies for government assistance.

The second part of the plan uses government subsidies, $75 billion pledged so far, to lower the interest rate and create financial incentives for both the borrower and lender to modify the loan. These loan modifications will bring mortgage payments down to a target level of 31% of gross income for borrowers who are delinquent. Unlike the first part of the plan, there is no cap on LTV for modifications.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks got creamed yesterday -- and the S&P 500 is on its way to an 8% loss this week, marking the fourth-week of decline that has pushed the index down 21% -- after Chinese Premier Wen mentioned nothing of boosting its stimulus program. The market rallied on Wednesday on speculation such a plan was in the works.

Financial shares got sandblasted after Moody’s stated it may cut JP Morgan’s credit rating – of course the market needs to pay attention to what the ratings agencies are saying, but one wonders why as their performance has been pathetic over the past few years.

Energy, industrial and basic material shares also took a beating on that news, or lack thereof, out of China. My take is China will eventually boost their stimulus plans, they’ll have to to tamp citizen uprisings.

As traders geared up for what may be the worst monthly jobs report yet, consumer discretionary shares also took it on the chin.


Market Activity for March 5, 2009

Please Stop (but they’re only just beginning)

We’ve talked at length about how the degree to which the government is involved is causing major issues and making it very difficult, if not impossible, to read the market. Beyond the fact that we’re at the whim of Washington, thereby affecting decision-making capabilities, we have this issue of the $1 trillion stimulus (actually $878 billion for now but it will get to a trillion) and annual deficits that run 10%-12% of GDP (for perspective, the long-run average is 2.4%).

One area that is specifically tough to gauge right now is the bond market. Normally, when the long-end of the Treasury curve rises (yields) during economic duress it signals the business cycle is bottoming, but maybe not this time. Are long-end Treasury yields 75 basis points higher (nearly 100 basis points prior to the past 24 hours) over the past two months because the market believes the business cycle has troughed, or is it solely because of the huge levels of new debt issuance as a result of massive spending? I suppose it is the latter, but the point is the level of opacity has increased due to government involvement.

The same is true for the equity market. You can look at nearly the entire market and witness valuations that are extremely attractive. Even acknowledging that earnings will get worse from here, we are simply trading at ridiculous multiples relative to interest rates, inflation (at least the current rate) and long-run profit averages. But the government is not allowing the market to efficiently allocate resources – or they are signaling a path toward blocking the market’s free choice and stocks trade on expectations.

Take cap and trade proposals for instance. The market will always gravitate toward the most efficient source of energy (or any resource for that matter), yet if the government is going to raise fossil fuel costs by artificially increasing the price due to higher tax rates on these activities it creates distortions. This leads to a less efficient marketplace and thus harms growth potential.

(What I find hilarious, in a sad way, is that the administration understands levying higher tax rates on fossil fuels will result in less use of that source. However, they seem to believe tax rates can be raised on capital and incomes without a reduction in work and investment. Maybe they know this but simply do not care, as they are more interested in ramming through their agenda. Ok, their choice. They have been granted a huge majority by the country and they are absolutely justified (although hugely wrong) in doing so. But the market will continue to beat them – and the rest of us in the meantime – for this obtuse behavior.)

Jobless Claims

The Labor Department reported initial jobless claims fell 31,000 to 639,000 in the week ended February 28. The four-week average of claims rose 2,000 to 641,750.


Continuing claims declined 14,000 to 5.106 million in the week ended February 21 – continuing claims lag initial by a week – and the insured unemployment rate held steady at 3.8%.


The employment survey week (the week in which the initial estimate for the February jobs report, which is out this morning) was February 14. The four-week average of claims rose meaningfully in that week, hitting 620,000 from 543,000 two weeks prior. So, as other employment indicators have shown, we should see another 600,000-plus in jobs losses for the month.

In this latest data, the four-week average is another 22,000 higher from that February 14 level (now at 642,000). There is no sign of a slowing rate of employment contraction just yet and as we’ll explain below the productivity number out yesterday as well helps to confirm this.

Productivity

The Labor Department reported nonfarm productivity fell 0.4% in the fourth quarter, revised down big time from the +3.2% (these are at annual rates) that was initially estimated. This changes things rather dramatically for me at least with regard to the labor market. After that previous 3.2% estimate on productivity I had assumed the degree to which businesses had cuts jobs over the past few months was overdone – largely as they were spooked by the credit market chaos and the plunge in equity values that would clearly affect consumer psyches. Such a strong productivity reading, meant that job cuts had outpaced the degree at which production has dropped, but this latest news of a 0.4% decline in productivity (measured as output/hours worked) shows this is not the case. I am completely confused now as to the direction of the labor market, maybe the February jobs report will not prove to be the worst we’ll see.

Factory Orders and Chain Store Sales

Finally, a couple more reports but we’ll just touch on them briefly.

Factory orders were reported as falling 1.9% in January. This isn’t the big news as we’ve already seen durable goods orders for that month. What’s important to note is the 5.7% decline in non-defense capital goods ex-aircraft – this is the proxy for business equipment. This figure stands 35% below the fourth-quarter average (at an annual rate). Inventories (excluding petroleum inventories, in order to adjust for the decline in price) fell $51 billion at an annual rate compared to $5 billion last quarter, according to RDQ Economics.

These two aspects of the factory orders report show that the first-quarter GDP reading is going to be just as bad as the last. It appears, the consumer side of things will not be as bad as last quarter but the inventory liquidation is going to be a huge drag on GDP. The business spending numbers show how necessary it is to deliver incentives back to the market. This can only be done by slashing tax rates on corporate profits, capital and incomes in general. Further, we must make permanent bonus depreciation and write-down allowances. The fact that policy is pointed in the opposite direction is very damaging.

The good news is the inventory dynamic (falling at these levels) will catalyze growth when we do rebound. (Firms will have to increase production to boost stockpiles even on a slight boost in sales).

In that chain-store sales report (based on the year-ago levels) the data showed consumer activity remains depressed in a number of areas – apparel store sales were down 7.9%; department stores down 9.8%; luxury continues to get hammered, down 19.2%. However, discount stores and wholesale clubs (ex-fuel sales) showed another month of life, up 3.1% and 5.0%, respectively.

While it is not good to see the components outside of discounters so depressed, the figures for the discount group have improved. This may be a sign consumer activity has troughed. It’s a stretch for now, but we shouldn’t ignore glimmers of optimism.

Have a great weekend!


Brent Vondera, Senior Analyst

Lockheed Martin (LMT)

Lockheed Martin (LMT)
Lockheed’s strategy of snapping up logistics and government services companies seems to be paying off. In September, Lockheed won a 10-year Army-focused vehicle maintenance contract worth up to $5.6 billion. Yesterday, Lockheed announced they won a similarly lucrative contract to supply U.S. military commandos with logistics support – the contract was previously considered one of L-3 Communication’s most prestigious lines of business.

Lockheed and defense companies in general, have been hit hard in recent weeks due to concerns of a U.S. defense-budget squeeze. More than 80 percent of Lockheed’s revenues come from the U.S. government. Trading at just 8.5 times 2009 EPS estimates (the S&P 500 trades at 11.6 times forward earnings), some of the discount is reasonable in the face of general uncertainty, but the market seems to be overlooking the stability of a U.S. defense budget slated to grow 4 percent in fiscal 2010.

Weapons and war equipment are likely to be cut first from the budget, thus the future of Lockheed’s F-22 fighter jet tops investors’ list of concerns. The program contributes about $2.8 billion in annual revenue, but is only a fraction of the company’s $43 billion 2008 sales. The other program in danger of cuts is the VH-71 presidential helicopter program, but this no-margin program is immaterial to Lockheed’s bottom line.

Longer-term, Lockheed’s F-35, known as the Joint Strike Fighter, should be a key growth driver that more than replaces F-22 revenues. This plane is in the preproduction phase and is expected to replace eight different aircraft types for the U.S. Air Force, Navy and Marine Corps, as well as eight other nations.

Lockheed is poised to generate $3 billion-plus in free cash flow in 2009 and has two years of growth locked in with its $81 billion backlog. Management is also returning value to shareholders by recently authorizing a $2 billion buyback and paying a secure dividend that is yielding 3.8 percent.


Wal-Mart Stores (WMT) +2.60%
Wal-Mart reported February sales growth that outpaced its forecast after consumers battered by unemployment bought more groceries.

Same-store sales in the U.S. advanced a whopping 5.1 percent last month, more than double analysts’ estimates, helped by an increase in the number of customers. The company predicts sales will rise 1 percent to 3 percent in the quarter ending May 1.

Gasoline prices have retreated from a record high in July, spurring more visits to Wal-Mart by people staying home for food and entertainment. February’s results were primarily driven by the grocery, entertainment and health-and-wellness segments.


Quick Hits

• Wells Fargo, BofA Loan Values Are a Scary Sight
• Concerns About GE’s Finance Arm ‘Overdone’
• Hewlett-Packard (HPQ) CEO Says Demand Won’t Improve in 2009
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks snapped a five-day losing streak yesterday, a streak that sent the broad market 10% lower, on news China may be planning on substantially increasing its stimulus program. This allowed traders to get past preliminary labor-market reports that pointed to another large loss in payroll positions – the official jobs report for February will be released tomorrow.

Commodity prices, as measured by the Commodity Research Bureau (CRB), jumped the most this year on that speculation out of China – energy and basic material shares led the broad market as a result.


Market Activity for March 4, 2009

Crude oil jumped 8.5% to $45.16 per barrel, again as a result of the China story. However, that speculation has been dashed this morning as Chinese Premier Wen didn’t mention a word about increasing their stimulus plans in his address on the economy last night.


This China stimulus talk reminds of something we discussed a couple of weeks back. If Geithner was thinking more clearly, he would cut a deal with the Chinese – it seems the administration likes cutting deals, or at least attempting to; the effort to offer a deal with the Russians on Iran didn’t go over so well for those that have kept up on the issue.

Anyway, its seems that offering to stop calling China a currency manipulator (and I’m no Chinese apologists, I feel compelled to state this each time we talk about the Chinese, but look we live in a world of fiat money, all central banks are currency manipulators) in exchange for them upping their infrastructure stimulus package three-fold is a worthwhile action. This way we all benefit from the stimulus. We in the U.S. don’t have to engage in this exorbitant level of fiscal spending (and the damage this will do to the private sector as it saps resources), and by the way is scaring the heck out of business and capital as they know the result of all of this spending is higher tax rates. The Chinese may just be more than happy to play along as this means they are not pressured to take their currency completely off of the dollar peg and watch their exports fall as the production is moved to Vietnam or Thailand. Besides, they are likely to increase their stimulus plan anyway as they’ve got a citizen uprising issue that is growing.

Opportunity missed Mssrs. Geithner and Obama -- or maybe not deliberately, if you know what I’m saying.

Mortgage Applications

Mortgage apps fell for a second-straight week as home-owners wait for sub-5.00% to refi and purchases remain subdued, to put it mildly – this is a weak period for home purchases anyway, we’ll have to wait for May/June for a real sign of whether sales will bounce or not. The labor market will keep it depressed, but hopefully we see some rebound.

Refinancings will drive overall mortgage apps over the next several months as we think there’s a good shot the 30-year fixed mortgage rate will move below 5.00%. If it doesn’t occur more naturally, the Fed (whether right or wrong) will engage in activity to attempt to bring this to fruition.


Challenger Job Cuts Survey

The layoff report out of the nation’s premier outplacement consulting firm stated announcements of job cuts slowed in February, coming in at 186,350 from 241,749 in the prior month. Still, job-cut plans were 158.5% above the year-ago level.

The auto, industrial goods, retail and electronics sectors led the layoffs, or planned layoffs I should say.


ADP Employment Report

In another preliminary jobs report, the ADP employment survey anticipated that 697,000 payroll positions were shed in February – larger than anticipated and meaningfully lower than the January decline of 614,000. (The official number of job losses, as estimated by the Bureau of Labor Statistics, showed 598,000 jobs were lost in January – so ADP seems to be tracking the government’s figures closely).

Service-producing employment fell 359,000 last month, followed by a 338,000 decline in goods-producing industries – manufacturing job losses led the segment, falling 219,000, the worst monthly decline yet in this recession, and construction was down 144,000.

Employment was hardest hit in small and medium-sized businesses (those with fewer than 500 workers) as these firms slashed 576,000 jobs compared to a 121,000 decline at larger firms. Small-to-medium businesses are the main job creator in this economy and some of the policies that appear to be on the horizon will not treat this group kindly – this will make it more difficult, naturally, for the labor market to rebound.

Overall, the ADP report is just an estimate as to what we’ll see on Friday when the official numbers for February are out. Other indicators are also pointing to another large decline in payrolls though, probably the largest decline we’ve seen yet. That’s saying something since we’ve shed 2.4 million positions over the previous five months.


ISM Service Sector

The Institute for Supply Management’s service-sector index remained weak for February, coming in at 41.6 from 42.9 in January. The business activity index (which measures general sentiment among respondents) fell to 40.2 from 44.2 – while down, it is slightly above the fourth-quarter average of 38.9. (For clarity, the headline number – the 41.6 number – equally weights business activity, employment, new orders and supplier delivers; all sub-indices of the overall survey)


The especially important employment index rose to 37.3 from 34.4 (this is above the fourth-quarter average of 35.8).


The fact that this employment number improved is a good sign, although we have so many other indicators going against it – jobless claims, the two reports mentioned above and ISM manufacturing – it’s tough to find a silver lining. In any event, just maybe service-sector employment contraction has begun to slow. We’ll have a better idea of this on Friday when the big numbers are reported.

Have a great day!


Brent Vondera, Senior Analyst

INTC, ACI, BTU, CAT, JEC, GE

Intel (INTC) +3.91%
Semiconductors got a boost from Goldman Sachs Group saying the group will continue to outperform the S&P 500 Index and profits are likely to start improving, now that the companies have pared back inventory.


Arch Coal (ACI) +4.50% and Peabody Energy Corp (BTU) +7.62%
Coal producers rallied as China considering new stimulus measures. China gets 80 percent of its electricity from coal.


Caterpillar (CAT) +13.22% and Jacobs Engineering Group (JEC) +8.72%
Caterpillar and Jacobs jumped after Transportation Secretary Ray LaHood said there are an ‘enormous number’ of highway jobs coming.

Some of Caterpillar’s gain can be attributed to anticipation of a new stimulus plan in China.


General Electric (GE) -4.56%
GE dropped for the fourth straight day, driven down by selling by sovereign wealth funds anticipating a downgrade of the company’s AAA credit rating, according to PIMCO’s Bill Gross. GE said claims that it needs to raise capital in the near term are “pure speculation.”


Lockheed Martin (LMT)
LMT won a 10-year contract worth up to $5 billion to supply U.S. military commandos with logistics support, a contract that L-3 Communications Holdings (LLL) held for more than 20 years and considered among its most prestigious lines of business.

I will have more on Lockheed and the defense industry tomorrow.


Quick Hits

• More Than 8 Million U.S. Mortgage Holders Are Under Water as Prices Tumble
• Berkshire Hathaway Credit Swaps Rise to Record, Imply ‘Junk’
• Short-Sale Rule Undermined by SEC Data After Bernanke Urges Review
• Trading Tax to Fund U.S. Bailout Would ‘Decimate’ Markets, NYSE Chief Says
• Defense Firms Look to Fill Gaps as U.S. Policy Shifts

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks bounced between gain and loss yesterday, eventually closing lower on comments from Fed Chairman Bernanke and Treasury Secretary Geithner. The former stated the banking system has yet to stabilize and the latter talked about things like raising tax rates and the increasing costs of getting out of this mess – at least as he sees it.

On the banking system, it is certainly more stabilized than it was back in the fourth quarter when it could only be described as chaotic – inter-bank lending rates were sky-high, illustrating the unwillingness of banks to lend to one another; this is not the case today. We shouldn’t confuse lower lending activity with instability; banks always tighten lending standards in a downturn and this was certainly needed coming out of the past few years when there really were no standards.

On the Geithner comments…well, let’s just say he bombed. More on that below.

Basic material, energy and technology shares gained ground yesterday. This is a good thing as we need the commodity players (materials and energy) to pick up as a sign things are reflating. I’ve got a feeling we won’t be worrying about basic material and energy stocks a year down the road as fiscal/monetary policy will spark an inflationary event that will cause its own issues. For now though the market will view signs of reflation as a good thing.

It was also nice to see technology shares gain ground on a day in which most sectors were down. This group has huge cash positions, low debt levels, and is poised to rock when the economy does turn. Now we need to see industrial shares rally, which is another industry we think will outperform over the next few years.

On the downside, utility shares led the declines as the administration seems dead set on cap and trade. I’m laughing as I type this, but I shouldn’t be. This is an inappropriate response to energy efficiency and it will cause home-energy costs to jump 40%-50% at least over the next couple of years if it is eventually passed.


Market Activity for March 3, 2009

So Bernanke and Geithner were on Capitol Hill again yesterday. They talked about several topics, but we found it strange neither touched on one of the biggest news items of the day, which is the latest Fed program – the lack of clarity, or willingness to expound on the various programs Treasury and the Fed are rolling out is one of the main problems right now.

TALF (yet another acronym)

The Fed will finally roll out the Term Asset-Backed Loan Facility (TALF) on March 25 – they’ve been working on this since November. It will be a $1 trillion (we’re seeing a lot of that number lately) program to prop up the market for consumer and business loans.

The TALF will start by offering $200 billion in loans to hedge funds and other investors aimed at jumpstarting lending for consumer-related and small business loans. The program will also help auto dealers finance inventory.

This will target the securitization market, a huge source of credit that is outside of the traditional banking system – a credit source that has basically shutdown following the Lehman shock. Personally, I’m not sure this is the best route as consumer credit simply needs to contract for a while still. And this program may have some difficulty as a result; the consumer has pulled back for a reason. If they are not willing to borrow, you can open up the pipeline all you want but it won’t have the intended efficacy.

Geithner Comments

And then we have the Treasury Secretary. In his testimony to Congress yesterday, explaining to the members of the Spend-Freely Club how the $1.5-$1.75 trillion deficit we’re going to run this year (as he vilifies other economies for being currency manipulators at the same time – governments we’ll need to buy this debt), that the financial-system rescue will cost more than $700 billion. Well, hell yeah it will. The way they’re laying waste to the market by crushing investor psychology, disparaging the holders of capital and scaring the tar out of the business community – the very people we’ll need to bring things back – no amount of government spending will do the trick.

Mr. Geithner also mentioned he would crack down on companies and individuals who try to avoid paying taxes -- now that’s a real peach of a comment coming from him; I’m sure you all remember the FICA tax fiasco. Besides, avoidance is not evasion – the former is legal – and maybe if we were to implement a tax structure that made sense, economic participants wouldn’t find it worthwhile to incur the costs of finding legal ways to avoid tax rates. But no, they will raise tax rates. Well, guess what pal, you’re going to be chasing a lot of people because I’ve got a feeling tax avoidance is going to make a big comeback.

And get this one, the Treasury Secretary also mentioned the administration plans to propose rules that would curb companies’ ability to delay paying U.S. corporate tax on foreign earnings. Um, the issue he is talking happens to be a current law, U.S. firms that have subsidiaries overseas are allowed to defer U.S. corporate tax until they bring the money home – and guess what? The money doesn’t come home, its stays put.

Why do you think this deferral is law right now? Anyone? It’s because no other OECD economy levies their home tax on business done overseas. You see, U.S. firms already pay the country’s corporate tax in which the sales are made, by forcing them to pay the U.S. tax as well means they become unable to compete. Now it seems they will eliminate this rule. That’s grand!

This letter has been calling for the abolition of the “repatriated tax” as the above deferral is often called. Instead though, they seek to make it overtly onerous. These people are like a financial hurricane, destroying anything in its path. One has to believe, for those giving this much thought as have I, that they are purposely attempting to drive the stock market and the economy into the dirt simply so they can control more of it via their highfalutin “fixes.” These people are not idiots, maybe incredibly naïve, but not completely stupid. What else is one supposed to take from the path they are on? It makes zero economic sense.

Pending Home Sales

Pending home sales fell 7.7% for January after the December increase was downwardly revised to show a 4.8% increase, it was initially estimated to have risen 6.3%. Three of the four regions dropped, led by a 13% drop in the Northeast. The South saw a drop of 12% and in the Midwest pending sales were down 9%. Pending sales rose 2.4% in the West.


Pending home sales are considered a leading indicator because they track contract signings. Although, lately an upswing in pendings hasn’t been a great barometer of existing home sales for the subsequent couple of months as there has been a trend of mortgage contracts being signed but then falling apart when it came to closing – existing home sales are not counted until the contract is closed.

It appears we’ve got a while before we find a bottom in housing. We’ve got to be close, but troubles within the labor market will delay the rebound.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries
Treasuries started March in rally mode, benefitting from a pause in supply and a weak stock market. Bonds pulled back today, but yields are still down for the month. Bond prices move inversely to yields.

Treasuries struggled hard out of the gate, but rallied to recover most of their losses at the end of the day as stocks lost their momentum and ended the day in the red. The two-year finished down 1/16 of a point while the ten-year was lower by about 3/8 as the benchmark curve steepened by 1.5 basis points today but stands 3 basis points flatter for the week. A basis point represents .01%.

MBS
Mortgages outperformed Treasuries today, trading around unchanged as U.S. Government bonds were down. MBS widened yesterday but tightened back in today to remain about where they closed before the weekend. FNCL 5s (Fannie Mae 30 year 5% Pools) currently sit at 142 basis points over comparable Treasuries. Just 3 basis points higher than the low we hit on February 8th.

TALF
Today the Treasury announced adjustments to the Term Asset-Backed Securities Loan Facility. The terms were extended to include such things as CDOs collateralized by subprime credit card loans and auto leases. The government won’t be purchasing these assets from institutions, but giving them a loan for up to three years and requiring them to post these assets as collateral. The Treasury will use sizable haircuts, (some as high as 15%), in addition to backing from the Fed to the tune of $100 billion, (increased from $20 billion today), to try and insulate the taxpayer from loss.

These assets that will be used as collateral are not stable by any means. The posted assets could lose significant value in three years, and in the event of default, the Treasury will be left with only the collateral. If the assets have lost value beyond the level of the initial haircut the Fed backstop will kick in.

The Fed backstop is being funded with TARP money. This is the same TARP money that was initially intended to buy bad assets from the struggling banks and hold them indefinitely. There are approaching that model with this version of TALF, but I still don’t understand the Treasury’s disgust with the original TARP. They are putting the taxpayer at no less risk with this program, (they are stilled exposed to the performance of these assets), but they are limiting the benefits. If they just purchased these assets outright, they could leave the banks with the mindset to make valuable long term investments, instead of making them repay the loan in the three years.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

GE oversold?

General Electric (GE) -7.76%

GE touched below $7 for the first time since 1993 as investors expect GE Capital will need more capital injections. Some estimates see GE’s balance sheet absorbing more than $10 billion in rising consumer credit delinquencies and falling real estate values outlined by the company.

GE Capital has a tangible common equity ratio (a measure of its ability to withstand losses against its total assets) of about 5.3 percent, which is at the high end of ratios amongst large commercial banks. GE Capital’s balance sheet would make the segment the 7th largest U.S. bank measured by assets. This is one reason investors are shorting the stock like other banks.

At least GE’s shareholders (40 percent of which are individual investors) don’t need to worry about the threat of nationalization like the nation’s large commercial banks. GE had $48 billion in cash on its balance sheet at the end of 2008 and can provide additional funds to GE Capital as needed. Of course, dipping into their giant cash pile increases the chance of credit rating downgrades. (Losing the AAA credit rating would not materially impact the company’s profitability, but the rating still carries tremendous psychological weight.)

While shareholders don’t need to worry about being diluted by government ownership, they will take a back seat to GE’s balance sheet when it comes time to decide where to allocate cash flow from operations – a big change from the recent past.

In just 2006 and 2007, GE repurchased $20.9 billion of stock and paid out $21.9 billion in dividends. This $42.8 billion in total value returned to shareholders is more than half of GE’s current market cap. Total GE buybacks and dividends over the past five years amount to over 100% of GE’s current market cap. The fact that such activity will now necessarily be greatly diminished has been weighing on shareholders.

Still, let’s not forget that GE has strong industrial business to offset its financial woes. A recent Credit Suisse report estimates that GE’s manufacturing business (in which they included infrastructure, industrial, and healthcare segments) alone is worth $14 to $15 a share. Given the current stock price, this implies losses at GE Capital would be at least $5 billion to $6 billion. This number seems excessive, especially when you consider that the company expects GE Capital to turn a $5 billion profit in 2009 (although it would not surprise me if this estimate is too high).

Looking into the future, GE’s manufacturing businesses are positioned for solid growth when the economy turns up. They are good franchises with leading market positions and many have high margin aftermarket revenue streams.

--

Peter Lazaroff

Daily Insight

U.S. stocks slid yesterday, extending the post-Election Day rout to 30% (for the S&P 500), after comments from Warren Buffet over the weekend obviously affected investor psyche and a $62 billion loss at AIG reminded everyone what a mess the CDS (essentially insurance on default) market is. It’s not like investor sentiment had been on the rebound, but when you’ve got headlines of an “economy in shambles” from someone with which most people give a lot of credence, such as Mr. Buffett, you’ll see this sort of affect. Buffet’s comments were optimistic from a long term perspective, but these days no one reads the story, they only view the headline.

This move has done additional psychological damage and it may just take some time for the market to form a base as a result.

We’ll open today with the S&P 500 at it lowest level since October 1996, which puts the index at an extremely low P/E of 9.8 based on trailing earnings. This would normally be a level stocks should not move down to, especially with interest rates and inflation this low (even if the levels on both will not remain this low for too very long), but government policy has investors throwing in the towel as it becomes extremely difficult to evaluate shares when we’re all so intensely at the whim of Washington.

Compounding the whole thing is a complete lack of clarity with regard to the plan that would remove toxic assets from bank balance sheets. Dang, get to it! Eliminate mark-to-market, supply low-cost funding to purchase, corral these troubled assets (until the real estate market rebounds and they can then be sold at a level much closer to intrinsic value) and for Heaven’s sake do not punish the very people you’ll need to facilitate these trades. The administration is in the process of raising tax rates on private equity firms, this is just dumb. We need to incentivize these people to come in and buy these assets, lowering their after-tax return expectations will only keep them on the sidelines.

Every major industry group got wacked yesterday, the relative winners were technology and consumer staples, down 3.22% and 2.62% respectively.


The price of crude got clocked as well, down 10.52% to $40.05 per barrel on concerns global demand will remain depressed. As we’ve touched on a couple of times now, domestic demand is not all that bad as we’ve seem it stabilize, according to the latest Energy Department report, but things are trading on perceptions as well as actual economic deterioration. When stocks slide like this, and we’re now 7% below the former multi-year low hit on November 20, few people care about any positives that are out there, they sell out of fear.

The really sad thing is we do have positives like high levels of productivity, enormous levels of cash on the sidelines, businesses that are streamlined and poised to dominate on the global stage and a plunge in energy prices that has caused inflation to flat-line thereby boosting real income growth. If we could just get a couple of policies out of Washington that are somewhat kind to the private sector we could be onto something. But that’s the problem; investors are saying all they see is destructive policy.

Market Activity for March 2, 2009


The Economy

The Commerce Department reported on it personal income and spending figures for January, both of which came in at better-than-expected rates.

Personal income rose 0.4% in the first month of the year, posting the first gain in four months. Although, the increase came solely from the government as transfer payment jumped 3.5% for the month.

Most private-sector segments were flat to down – excluding government payments personal income fell 0.2%. Compensation came in flat, unchanged from December; wage and salaries fell 0.2% -- the third month of decline; proprietors’ income was down 0.7%; rental income (one of the bright spots of the last three months) fell 0.4% and interest income dropped 0.7%. Dividend income was the only private-sector segment that rose, up 0.1%.

Again though, the flat inflationary environment has allowed real incomes to jump, and that’s a good thing.


Personal spending gained 0.6% in January, posting the first gain in six months. The level of real spending stands 0.8% above the fourth-quarter average at an annual rate. We’ll need to see spending rise again in February to offer a more concrete view that the consumer side of things will contribute to GDP this quarter. I suspect we’re a little early here, that boost from the consumer will likely have to wait until the second quarter. We shall see.

The personal savings rate (cash savings) hit 5% a couple of months faster than we thought would occur (something we’ve been watching for as a signal consumers feel better about spending given the decline in asset prices). Although again, the boost to income last month was due to government transfer payments, not private-sector dynamics, so I’m not sure the higher cash savings rate will flow into confidence and thus boost spending in a sustained manner just yet.


The inflation gauge tied to personal spending, the PCE Deflator, continues to pretty much flat line. Core PCE, which excludes food and energy, rose 0.1% in January – the year-over-year core rate slowed to 1.6% from 1.7% in December.


However, I would not expect the inflation figures to remain low for long. Soon enough inflation rates will spike as the Fed has pumped massive amounts of money into the system and huge levels of government spending will combine to send enormous amounts of money into the economy. The Fed’s action has not shown up totally as the velocity of money (the number of times it turns over) has been held back as banks have eased lending. But when lending returns to more normal levels, we will have the classic scenario of too much money chasing too few goods.

Remember, as if you need reminding, production has been weak. What’s needed to absorb all of this money is an upshot in production and the best way to do this is by slashing tax rates, thereby incentivizing producers. Without this action, which we are not getting, troublesome levels of inflation are inescapable, in my view, due to monetary and fiscal policy actions.

Manufacturing Sector

In a separate report, the Institute for Supply Management showed its manufacturing index improved ever so slightly from the month prior, posting a reading of 35.8 last month from 35.6 in January. February’s reading is basically unchanged from last quarter’s average of 36.0. ISM figures are one of the best economic indicators, so what we saw in the fourth quarter is shaping up for this one, according to this measure.


The various sub-indices were not much changed either, although the important employment index fell further, hitting 26.1 from 29.9 in January – for newer readers I should mention that 50 is the dividing line between expansion and contraction.

On a brighter note, this is the second month in which ISM has improved, the problem is the index remains well in contraction mode and the improvements have been very slight. Look for the index to move into the 40s and initial jobless claims to fall back to 500,000 and this should signal we’ve seen the bottom. Until then, those calling a bottom are probably just going on hope. The theme we keep touching on is inventory liquidation, and it is this dynamic that will require higher levels of production that will catalyze economic growth, maybe by next quarter.

Construction Spending

In yet another release, Commerce announced construction spending fell 3.3% in January, marking the fourth month of decline. The public sector will begin to take over during the next…well, I don’t know how long frankly. The public sector numbers have declined for a couple of months now as state and local tax revenues have dried up, but this segment will kick back up when the infrastructure programs begin to take affect.

So, over the next year one should expect the pubic sector side of things to push overall construction spending higher, or at least largely offset declines from the private side. But as we get into 2010 we’ll see private residential construction begin to rise again, if the response we’re seeing from the government doesn’t distort economic decision making and cause the private sector to hold off. The commercial side (or non-residential as it’s technically termed) should remain depressed for some time as this is the last thing firms engage in after the economy rebounds.


Today’s Data and News

This morning we get pending home sales for January, which is a closely watched reading these days for obvious reasons. We’ll also get some testimony from Treasury Secretary Geithner; it will be very important for him to perform better than the last time we heard from him.

Have a great day!



Brent Vondera, Senior Analyst

Afternoon Review

February Recap

The S&P 500 and Dow Jones Industrial Average both posted double-digit monthly declines in February. Lackluster corporate earnings and a sharp downward revision to fourth-quarter 2008 GDP, which declined 6.2 percent, show that the economy deteriorated much faster than previously thought. Still, policy decisions remained the primary force driving the market.

Attractive valuations and defensive reputation helped telecom stocks outperform other sectors. The technology sector was also a relative outperformer. Technology companies are viewed as having relatively solid balance sheets with good cash positions, which is certainly an attractive quality in this tight credit environment.

Again, the financial sector was the weakest performer in the S&P 500 as investors mulled over the possibility of some large banks becoming nationalized. There is still a great deal of uncertainty with regard to the government’s plan for troubled banks. The Federal Reserve, Treasury and White House all tried to squash nationalization rumors, but there is a growing feeling that at least temporary nationalization may be necessary.

Despite a pick up in merger and acquisition activity, the historically defensive healthcare sector felt some pain after the Centers for Medicare and Medicaid Services said private Medicare plans would see a modest 0.5 percent increase in the 2010 fiscal year – a growth rate well below industry estimates of 2 percent to 4 percent. Also hurting the sector was fears that President Obama’s reform plans may carve into the profits of drug makers, medical devices and insurers.

Given the poor performance of the financial and healthcare sectors, it is not a big surprise that growth outperformed value. More surprising was the fact that emerging markets were the best performing asset class this month. The worst asset class was REITs, with the Vanguard index tracking REITs losing over 20 percent this month.

Record issuance during the month of February drove prices down and yields up in the Treasury market. The market weathered the large increase in supply very well, thanks to the large flight-to-safety trade. The benchmark curve was 11 basis points steeper for the month as the longer end of the curve underperformed the shorter.

Quick Hits

• Buffett Says Economy ‘In Shambles,’ Promises Best Days Ahead
• ‘Leave It to Beaver’ Savings Lifts U.S. Bond Holdings
• Decremental? Fitting Word for Ugly Times
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks fell for a third-straight session on Friday as a bevy of government action continues to damage investor sentiment and the latest revision to fourth-quarter GDP showed the economy contracted at the fastest pace since 1982 -- the S&P 500 fell below what many see as a key level, the 2002 low.

Friday’s decline pushed the broad market down for the third-straight week – down 4.54% last week, which followed declines of 6.87% and 4.81% in the prior two weeks, respectively. The S&P 500 closed below the Asian Contagion low, hit in May 1997, to the lowest level since December 1996.

There are undoubtedly awesome long-term opportunities out there in the stock market, as valuations sit at the lowest levels in more than 20 years. However, investors remain spooked as the Obama administration has an overt disdain for business, makes clear they will raise tax rates – and in some ways has already begun to do so, continues to engage in policy that freezes private capital and sends signals regulations are going to much higher – instead of simply enforcing current regulations. The equity investor will need a lot of patience, but patience will pay off – in the meantime caution is the rule.

Financial and health-care shares got drubbed again on Friday as the latest government “help” to Citigroup simply put the “short banks” trade back in place and the Obama health plan puts the screws to private care and drug discovery.

The relative winners were consumer discretionary, technology and consumer staple shares.


Market Activity for February 27, 2009

On the Citigroup news, the Treasury Department will convert as much as $25 billion of preferred shares into common stock as long as private investors agree to the same terms. The government does not currently intend to inject additional money.

So let me get this right. Bernanke comes out and assuages concerns on Tuesday by saying nationalization is not in the cards. Then Geithner does an interview on PBS stating the administration has no intention of nationalization. Now, just two days later, the Treasury effectively makes a move in that direction – the decision to convert Treasury’s preferred shares to common is more an accounting change than anything (why not just eliminate mark-to-market?) -- but what if investors do not want to tender their shares, will the government force it upon them. And even if they do not need to force investors’ hands, you’ll still have the government holding nearly a 40% stake in the bank and in the meantime “encourage” them to do things like suspending foreclosures. And people wonder why the market is in disarray; there’s little wonder why capital is on strike.

And speaking of government rescues, the Treasury Department is into its fourth rescue plan for AIG, as the insurance giant will receive another $30 billion in TARP funds and interest rate modifications on government loans will ease borrowing costs.

On the Economic Front

The Commerce Department reported fourth-quarter GDP was revised down big to show the economy contracted at a 6.2% real annual rate – it was initially estimated to decline 3.8%. This figure is much closer to the -6% we were expecting when the initial reading was released a month ago as personal consumption showed a very big decline and inventories building was revised substantially lower.


The 4.3% decline in real PCE (personal consumption adjusted for inflation) occurred at the fastest pace since the 1980 recession, business fixed investment fell 21.1% (specifically, business equipment fell 28.8%, the most since 1958), residential fixed investment (housing) fell 22.2%. These are all quarter-over-quarter at an annual rate.



The main reasons for the large downward revision came from the personal consumption decline, originally estimated at -3.5%, and the change in inventories, down $19.9 billion -- originally estimated to have increased $6.2 billion. This downward revision in inventories accounted for 1.2% point of the 2.4% points of the revision to overall real GDP.

So what we have here is the worst decline since the spring of 1982 (a period with which the Volcker Fed was quashing the insidious inflation of the 1970s by the necessary jack-up in rates). We are indeed looking for GDP to contract at a 5% pace this quarter, although it is too early to truly gauge, which will make this the deepest recession since the 1957-58 contraction (a 4.2% decline in Q4 1957 followed by a massive 10.4% contraction in Q1 1958).

The export data shows the nature of the global downturn (yes, global growth remains dependent upon U.S. activity – those piping about “decoupling,” or how the emerging markets do not need U.S. growth need a lesson in how the global financial and economic world works, to say the least). U.S. exports declined at a 24% annual rate.

Such large back-to-back declines (fourth and first quarter GDP) should signal a bottoming out process. Personal consumption should begin to rebound, a bit, by the second quarter (we may be a bit optimistic here) as we see the cash savings rate approaching 4.5% by that time. As we’ve discussed for a couple of months now, since the two primary savings vehicles (homes and stocks) have been hit hard consumers will need this level of cash savings to feel better about spending.

Also, the inventory liquidation dynamic should provide a production boost by late spring/early summer and housing activity has become so weak it should stop subtracting from GDP – at the least it will not cause such a drag on the figure as this segment makes up just 3% of GDP, down from just about 7% back in 2005.

In a separate report, we also received the Chicago Purchasing Managers’ Index (the most important regional manufacturing gauge that gives us a look at what nationwide ISM will post) and the index improved a bit to 34.2, but only from the very weak level of 33.3.

We really need to see the index rise to the 40s before feeling strong that the economy will bounce by mid-year. ISM and these PMI indices (again ISM is the manufacturing gauge for the nation and PMI surveys should be viewed as preliminary report for ISM) are great initial indicators as to the direction of economy activity so we’ll continue to watch them closely.



This morning we get personal income and spending for January and the ISM manufacturing reading for February. The previous ISM report led many to believe the economy had hit bottom – and who isn’t looking for evidence of a bottoming process – as the figure improved mildly. However, the preliminary factory reading (figures such as the Purchasing Managers’ indexes – like the Chicago survey touched on above) show we’re not there yet. This morning’s ISM number should take another turn down.

Again though, inventory levels went into this recession at a low level and businesses have scaled back stockpiles even more over the past two quarters. It should not be long before this inventory dynamic offers a boost to growth as firms must ramp up production. However, the government has to stop scaring the tar out of the private sector, and unfortunately we see no evidence of this waning just yet.

Have a great day!

Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries
February was a huge refunding month and the market is certainly taking a depth breath as it all comes to an end. Concerns over supply should subside for now as March’s schedule appears relatively light.

Treasuries were mixed today as the long end of the curve underperformed the shorter. The two-year traded up one-eighth of a point while the ten-year was lower by about a quarter as the benchmark curve steepened by 11 basis points today and stands 17 basis points steeper for the week. A basis point represents .01%.

MBS
Mortgages continued to outperform comparable Treasuries today, tightening 2 basis points.

Higher coupon MBS are outperforming lower coupons as many analysts are paring back their expectations for refinance activity. The programs established by the Obama administration, (easier LTV standards and subsidized rates), are certainly going to speed things up, however some analysts on the street believe the boost to refinancing will be short lived. Higher coupon mortgages, which trade at high premiums, underperformed lower coupons a month ago when the market expected prepays to skyrocket. Now that expectations are reversing a little, the market is just adjusting.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst