Sustaining the Unsustainable

by David Ott

I read Where Does the Money Go? – Your Guided Tour to the Federal Budget Crisis by Scott Bittle and Jean Johnson last summer before things went from bad to worse.

The U.S. had entered a recession although we didn’t know it yet. The phrase ‘subprime mess’ was creeping out of our lexicon and was being supplanted with the much more ominous term: ‘credit crisis.’

And although I had intended to write this review in the fall of last year, I was taken far off track when the bear market broke into a panic and we graduated from a credit crisis to a full blown global synchronized financial crisis.

Of course, this doesn’t make the contents of the book irrelevant at all – quite the opposite.

As governments around the world attempt to solve the current crisis with massive monetary and fiscal stimulus, it is obvious that the budget problem that we had when this book was authored in 2008 will be stunningly worse as we try to solve the problem.

It is clear in my mind that we will emerge from the current crisis as we always do. It is also clear to me thanks to the work of Harvard economist Ken Rogoff that the budget problem will become substantially worse in the next few years.

Rogoff and his collaborators have looked at financial crises in industrials and emerging nations over the past thirty years and has found striking similarities between them. For example, they have found that home prices typically fall 35 percent on average and stock markets generally fall by 55 percent. So far, the U.S. is right on target.

The combination of policy responses and substantially lower tax receipts lead governments to double the budget deficit within three years of the crisis. Judging from the budget proposals floating around, it would appear that the U.S. is right on track again as the Congressional Budget Office (CBO) estimate that the budget deficit will be $1.7 trillion in 2009.

Even more startling is that the budget deficit will total almost 12 percent of Gross Domestic Product (GDP) – its largest showing since the end of the Second World War. Granted, the CBO estimates that after a $1.2 trillion deficit in 2010, the budget deficit will decline annually to the $300 billion range, which isn’t great, but a lot better than being in the trillion dollar range.

The point, though, in my mind is that we are expecting deficits as far as the eye can see and while a large nation like ours can support deficits and debt, we do seem to be standing on the edge of the Rubicon, as the demography of our spending problems on Social Security and Medicare look less increasingly abstract.

Social Security has been a known problem for decades – President Reagan set up a Blue Ribbon panel in 1983 that included Alan Greenspan to make changes to improve the solvency of the program. And, they did some things that make sense, like increase the retirement age from 65 to 67 for younger people.

Unfortunately, Social Security is less of a problem than Medicare because Medicare is already in trouble. This isn’t a secret, either. The Medicare Trustees told Congress in their 2007 report that their “financial difficulties come sooner – and are much more severely – than those confronting Social Security.”

Biddle and Johnson report that in the respective trustee reports, it is estimated that to fund Social Security for the next 75 years, we would need to cut benefits by 13 percent, raise payroll taxes by 16 percent or do some combination of the two. Using the same metrics with Medicare, it would require a 51 percent reduction in benefits, a 122 percent increase in taxes or some combination thereof.

As bad as that sounds, it gets worse because the authors point out that Medicare’s costs are not as predictable as Social Security. Social Security is mainly about demography, but Medicare costs add ballooning healthcare costs.

Amid all of the interesting statistics, realistic projections and marvelous examples and sidebars, the authors offer only a few solutions. Of course, this isn’t the fault of the authors – it’s that the solutions are so obvious: entitlements have to shrink, taxes have to rise, or, most reasonably, there has to be some combination of the two.

None of these choices are particularly appealing, but preventative changes are required to keep us out of real trouble down the road.

If we wait until 2040, we would have to cut nearly every other government program since Social Security and Medicare would absorb every tax dollar. While we can agree that there is government waste, we can also agree that we need some programs that maintain our dominating position in the world (the military and National Institutes of Health are two of my favorites).

Since it is unreasonable to cut every ounce of spending but Social Security and Medicare, we could raise taxes in 2040. The magnitude of this kind of tax hike is also untenable since raising taxes always puts a strain on growth and economic progress. As undesirable as it is, raising taxes in small increments now would be far better than choking it all down at once, which , which would be crippling.

Unfortunately, given how difficult it is to cut spending and raise taxes in any dose before there is an emergency, it seems likely that nothing will happen for some time to come. The current financial crisis is also a setback since it makes sense to put out the fire that’s currently raging instead of working on long-term prevention issues.

So, we will sustain the unsustainable until it isn’t possible anymore and deal with the problem when the best options are exhausted and have to accept second or third choice options.

Sadly, that’s in some ways what led to this crisis. The housing bubble itself was no surprise – it has been talked about for years. The problem was with the speed and severity of the reversal and the reverberations that came along with it.

Of course, in retrospect it is obvious that we were going down a bad path, but no one wanted to change course because it was easier to keep doing the same thing, even though we knew it couldn’t be sustained.

The book is well worth the read, although it seems like waiting for a second edition may be worthwhile since the fiscal picture has changed so dramatically since the book was published a year ago.

---------------------------

Recommendation: Buy

Where Does the Money Go? Your Guided Tour to the Federal Budget Crisis
By Scott Bittle and Jean Johnson

HarperCollins Publishers, New York, New York 2008

ISBN: 978-0061241871

Daily Insight

U.S. stocks fell yesterday as the March retail sales data disappointed what was a growing hope that consumer activity was rebounding in a sustained manner; excitement over an imminent economic rebound got a bit ahead of itself – more pronounced signs of a rebound will come, but not for a few months still, in my view.

Back-to-back speeches/press conferences from President Obama and Fed Chairman Bernanke didn’t help to turn the market around – in fact stocks moved lower. The president relied upon the typical Keynesian “paradox of thrift” argument as a way of justifying a level of fiscal spending that will prove less than auspicious for long-term growth. Bernanke’s speech showed the Fed continues to grasp to a Philips Curve mentality that has gotten them in trouble in the past, blamed the current troubles on the global savings glut and didn’t spend enough time explaining how they’ll unwind all of this liquidity pumping when the time comes. (I’ll discuss these topics and the end of the letter for those interested.)*

All 10 major industry groups ended the session in the red, led by financials (down 7.68%), telecom (down 2.46%) and consumer discretionary shares ( down 2.23%). The relative winners were health-care, energy and tech shares.


Market Activity for April 14, 2009

Producer Price Index (PPI)

The Labor Department reported producer prices fell big in March, down 1.2% -- the reading was expected to come in flat compared to the prior month. On a year-over-year basis PPI was down 3.5% last month - large deceleration from the -1.3% posted in February (biggest decline since January 1950 in fact.).


The decline in producer prices was largely due to a 1.5% decline in consumer goods (which makes up 73.5% of the index) and this component was driven down by a 13.1% seasonally-adjusted decline in gasoline and a 2.4% drop in residential gas. (Gasoline prices actually rose 10% last month, but since this move was less than it normally is for the period, the seasonal adjustment showed a large decline.)

We’ll note that basically all components of PPI fell last month, I don’t want to create the impression that energy was the only segment that was lower, but we wouldn’t have seen such a significant decline on the overall index if not for the move in energy.

The core rate came in flat for the month and on a year-over-year basis core PPI was up 3.8%, down from the 4.0% posted in February.


Retail Sales

The Commerce Department reported retail sale fell 1.1% in March (a 0.3% increase was expected) and when you exclude auto sales the figure fell 0.9% (expected to come in unchanged from the prior month.)

The prior two months’ data were revised significantly higher. January retail sales was revised to show a 1.9% increase (initially estimated at 1.0%) and February was revised to show a 1.0% increase (initially estimated to have declined by 0.1%). Those gains halted a six-month free-fall.


These revisions do ease the impact of the broad-based March decline, but as we’ve been talking about those two prior months’ worth of data were helped by large increases in government transfer payments, the private-sector income numbers for Jan. and Feb.declined. Since nearly all of the income gains over the past four months have come from the government side of things, we do not see a sustained rise in retail sales taking place for some time.

In terms of major segments, retail sales ex autos and gasoline station receipts fell 0.8% in March, after a 0.7% increase in February and a 1.4% jump in January. Sales excludes gas station, building materials and auto dealers (also known as the core rate) fell 0.9% after a 1.1% rise in Feb.and a 1.9% increase in Jan.

This last figure rolls directly into the personal consumption component of GDP, so the January and February readings will help to offset what will be significant drags on first-quarter GDP via inventory liquidation and overall business spending. Based on this data it appears personal consumption will rise at roughly a 1.0% real annual rate for the first quarter after massive back-to-back declines of 3.8% and 4.3% in the third and fourth quarter’s, respectively – those were the largest back-to-back declines in personal consumption since the 1980 recession.

The three-month annualized decline in retail sales has improved greatly – down 4.9% in March vs. -16.7% in February. That’s great news. Still, the lack of private-sector income growth is the concern regarding the next few monthly readings.

A couple of other quick points on consumer activity:
Yesterday the Redbook retail survey (not a highly watched report, but worth a look) did show sales rose 1.1% during the first two weeks of April, unless things fall apart in the back-half of the month this is a good indication we’ll see a bounce when the official April retail figures are released.

But we have to understand that credit card lines are adjusted by models that run off of overall default rates, which continue to rise. Hence, credit lines will be cut so those that use these lines of credit as a lifeline when things go bad will not have as much at their disposal as they may have expected. This will put additional pressure on consumer activity as will keep the level of caution elevated.

Business Inventories

In another Commerce Department report, business inventories fell 1.1% in January (there’s a huge lag to this data, but it’s important nonetheless) which helps to illustrate the inventory liquidation that occurred last quarter. The three-moth annual change accelerated to the downside, coming in at -$222.4 billion vs. -$197.7 for December.

Unfortunately, the sales data fell as well, falling 1.0%, marking the sixth month of decline. However, since inventories fell more than the decline in sales, the inventory/sale ratio improved slightly.


Stock-Index Futures

Futures are lower this morning in pre-market trading, mostly due to comments out of Intel after the bell yesterday. At first, Intel’s comments were met with optimism as management stated the semiconductor market likely bottomed last quarter. However, the company also specified that this does not mean activity is on the rebound just yet – the global economic environment remains “fragile,” according to CEO Paul Otellini.

So the market, at least at this moment, looks to open lower, (and the first decline in mortgage applications in six weeks won’t help, as that figure has just been released to show apps down 11% -- purchases fell 11.3% and refinancings were down 10.9% -- for the week ended April 10.) If we can get better than expected readings from the industrial production and Empire Manufacturing, due out this morning, we may be able to reverse course, but it’s likely these figures will remain weak for a couple of months still.

*On the two topics from above:
On Bernanke and the Phillips Curve, all this tells the market is that the Fed will not make policy decisions based on forward-looking indicators like commodity prices, but rather keep their reliance on the level of unemployment (a lagging indicator) to guide their hand. That is, the FOMC will continue to base monetary policy on the notion that inflation cannot rise until the jobless rate hits a low enough level that they themselves deem inflationary. This is the exact model that led them to keep rates too low for too long back in 2003-2005 and more importantly led to the policy mistakes of the 1970s. While inflation is not an issue now, there is a very strong likelihood it will be in the not too distant future and the Fed better be on top of it -- much more adaptive than a Phillips Curve model based on the most lagging of indicators allows them to be.

What’s more, Mr. Bernanke, in his speech, also morphed into Mr. Greenspan by blaming the global savings glut for the low interest rates of this decade that encouraged individuals and institutions to move farther out on the risk curve as they sought higher yields, but failed to appropriately price that risk. The failure to state that the Fed’s easy monetary policy earlier in the decade is not the direct cause of that situation is unfortunate. For if they has not kept rates too low for too long, the export driven economies -- such as the Asian economies for whom he blames the savings glut -- would not have exhibited such high economic growth rates, and thus they would not have been left with a flood of dollars with which led them to buy massive quantities of U.S. Treasuries, which helped to push long-term rates so low.

On Obama and Keynes’ “paradox of thrift,” the president didn’t directly mention this Keynesian argument but made indirect overtures to it as he stated the government must spend when the private sector won’t. Of course, individuals are gong to rein things in when debt levels are high and the labor market and income growth are weak. Of course, businesses are going to curtail spending when the economy contracts, which is always the case. But just maybe if policymaker chose to ignite things via the mechanism of tax rates – boosting disposable income and providing incentives for businesses to ramp up production – the pullback effect would not be so pronounced.

One wonders if any of these people ever contemplate that just maybe they are at least part of the problem. Businesses know what follows high degrees of government spending – higher tax rates. And they know that higher tax rates are not conducive to growth (because it removes resources from the much more efficient private sector), which diminished their confidence in future sales potential. This only exacerbates the spending retreat.

Alas, we’re on a path of enormous spending, much of which will make its way to the baseline of the budget, the economy will just have to deal with it – and this is a significant part of the problem.


Have a great one…even if it is tax day. You’ll have fond memories of these rates a year or two down the road.


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries
The two-year finished the day up 3/64, and the ten-year was higher by 41/64. The benchmark curve was 3.5 basis points flatter on the day, and currently sits at +193.5 basis points. A basis point represents .01%.

Today the New York Fed purchased $7.3 billion in Treasury notes ranging in maturities from 9/30/13 to 2/15/16. $5.6 billion of the purchases were in issues maturing in February 2014 and earlier. Despite the shorter buying, the longer end outperformed immediately following the announcement, and the outperformance gained steam as the day wore on, as evidenced by the flattening curve.

Goldman Sachs Equity Offering
Goldman Sachs raised $5 billion by selling common stock today at $123 per share. Shares were trading below 117 by early afternoon on concerns about dilution of common shareholders and a report from S&P confirming their negative outlook on Goldman’s “A” credit rating.

On October 28th of last year Goldman Sachs received $10 billion in capital through the Treasury’s Troubled Asset Relief Program in the form of preferred stock paying a 5% dividend. At first glance this may have looked like a good deal for Goldman. A month before the TARP deal Goldman issued $5 billion of 10% preferred stock to Warren Buffet, so 5% may looked pretty cheap.

However, Goldman, along with other companies receiving TARP funds, soon felt the brunt of the government’s influence as an equity investor. The uproar in the news about compensation for employees at companies receiving government assistance has had its effect at Goldman, who has long had the highest paid employees on Wall Street. Executives have forgone bonuses and with Geithner’s recent threats to mandate the pay across any company receiving TARP, Goldman, along with others, are concerned with their ability to retain and attract talent in the future. Needless to say, the dividend payment was not the extent of the costs associated with accepting aid from the US Government.

With today’s $5 billion equity sale, Goldman claims it now only needs approval from the Treasury to pay back the $10 billion in TARP funds it received and escape the influence of politicians. There’s only one catch. Along with the preferred stock, the government received warrants to buy 12.2 million shares of Goldman Sachs common stock at $122.90 a share at any time before October 28th 2018. If these were exercised today it would amount to a 2.5% stake in the company. These are not surrendered if Goldman gets the ok to redeem the government’s investment, so this would do little if anything to escape government influence.

Goldman may be paving the way for the unwinding of TARP, but a greater question remains to be answered before too much hope persists. What does the government really plan on doing with those warrants?

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

JNJ, INTC, PFG

S&P 500: -17.23 (-2.01%)

Johnson & Johnson (JNJ) +0.43%
A stronger dollar and patent expirations dragged down J&J’s first-quarter profit, but earnings were still above expectations and the company reiterated its 2009 projections.

Revenue dropped 7.2 percent to $15.03 billion, with six percentage points of the decline coming from the stronger dollar. When you consider the stronger dollar and the fact that prior-year revenue was boosted by Zyrtec’s over-the-counter debut, the revenue results are quite impressive.

Consumer products posted particularly strong sales performance and continue to offset the headwinds faced in the pharmaceutical segment. Medical devices yielded mixed results, with particularly weak performance from the vascular group as the company’s drug-eluting stent is losing market share to Abbott’s superior stent.

J&J’s pharmaceutical segment, on the other hand, has taken a substantial hit in recent quarters after losing patent protection for epilepsy-treatment Topamax (the company’s second-largest drug by sales) in March and antipsychotic Risperdal last year.

J&J has multiple new drugs that could offset patent losses awaiting FDA decisions in the next six months including potential blockbusters ustekinumab (biologic drug for sever psoriasis) and rivaroxaban (a pill to prevent blood clots), as well as paliperidone palmitate (schizophrenia) and golumumab (rheumatoid arthritis). The company’s full-year guidance does not reflect the approval of these drugs, which could significantly add to revenues in the second half of 2009.

J&J repurchased $500 million shares as part of the $10 billion program started in 2007. To date, the company has purchased $8.6 billion and expects to finish the buybacks in 2009. I got a bit ahead of myself regarding the company’s dividend, and an increase to the payment will likely be announced sometime in the next two weeks.


Intel (INTC) +0.19%
After the market closed, Intel reported earnings that absolutely crushed estimates. As expected, margins were pressured by lower utilization rates and revenue was lower as PC makers cut back on chip orders to reduce inventory. Still, revenues came in above expectations.

More importantly, CEO Paul Otellini said in the company’s press release: “We believe PC sales bottomed out during the first quarter and that the industry is returning to normal seasonal patterns.”

The initial numbers look pretty good, but we will have more details following the conference call.


Principle Financial Group (PFG) -12.89%
MetLife (MET) said they won’t participate in TARP, seeking to separate itself from rivals in the insurance industry. Judging by the trading activity on other insurers, including Principal Financial Group, it appears they have succeeded in doing so. On the bright side, we can be certain that the insurers in need will be offered assistance from the Treasury.


Quick Hits

• Bernanke’s Response to Four Questions at Morehouse College
• How to Puff Up Earnings, Goldman Sachs Style
• Analysts See Weak Spots in Goldman’s Results
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks looked ready to take a breather (after running hard over the past five weeks) in early trading yesterday, but pared those losses after lunch and had enough momentum going into the final hour for the broad market to end higher.

The trend of the previous 24 sessions has pushed the S&P 500 27% above the nefarious low of 666 hit on March 9 and it may prove tough to keep this going without some abatement. There has been increasing talk that this upswing is getting a bit long in the tooth, which may have had some effect on overall sentiment – while the S&P 500 closed to the upside, six of the 10 major industry groups closed lower and mid and small cap indices end in the red as well. The Dow average was held back by shares of Exxon, Chevron, Boeing and IBM.

More than anything the market didn’t seem to have the alacrity to take on a decisive position ahead of this morning’s retail sales figure. This retail number will be the big news of the day, maybe the week, and the market may have too much riding on it. Our take is that many market participants have put misguided hope in the fact that consumer activity began a sustained rebound in January and that could kick off the pullback that should be expected after a run like the one we’ve seen over the past month - more on the retail sales report below.

In terms of sector performance, financials and material shares alone pushed the S&P 500 higher yesterday. Goldman Sachs knocked the cover off the ball after the bell, posting operating profit that doubled expectations -- maybe this is enough to for financials keep it going, but considering the bounce over the last five weeks (Goldman shares are up 76% and the sector 85%) the good first-quarter results are likely priced in.

Utilities, energy and telecom shares were the biggest drags on the index. (Energy share were hit by an IEA report that predicted 2009 demand for crude could be cut to the lowest level in five years on lower factory production.) Tech and consumer-related shares also closed lower.

Utility stocks have been the biggest laggard during this five-week upswing. While it’s not surprising to see utilities lag during this abrupt rally, considering the sector’s safe-haven status, one shouldn’t ignore the impact the cap and trade bill that is in the works has had on the shares – if this gets through, or is even implemented piece-meal via executive order, it will hit power-plant margins hard. I prepared a commentary on cap and trade a couple of weeks ago, but there have been so many other things to talk about haven’t had a chance to fit it in. I’ll try to do so when Congress comes back from Easter recess and the topic gets more attention.


Market Activity for April 13, 2009


This Week’s Data

We didn’t have an economic release scheduled for yesterday, but get back to it today with retail sales and PPI.

Producer Price Index (Today)

PPI is expected to come in flat for the month. Core prices, which exclude the food and energy components, are expected to rise 0.1% for the month and remain at 4.0% on a year-over-year basis.


The fact that core PPI is running at this rate on a year-over-year basis at this point in the business cycle shows we’re starting from a high base. When the commodity explosion occurs, and I don’t know how we escape it as global monetary and fiscal policies flood the system with trillions of dollars, the inflation that will ensure should come faster than I think most expect.

Retail Sales for March (Today)

Retail sales are expected to rise 0.3% for March, after a 0.1% decline in February. The ex-auto reading is expected to show a 0.1% increase after rising 0.7% in February. I think there’s a good chance this reading will disappoint, and it will be very important to watch how the market deals with this if indeed it doesn’t meet expectations. There has been a lot of optimism that consumer activity is on the rebound after the 1.0% gain in January, followed by a 0.7% gain on the ex-auto reading for February (even as the overall number showed a 0.1% decline). I’m just not sure we’re back on the road to a sustained consumer upswing as the private-sector components of income remain in decline.


Consumer Price Index for March (Wednesday)

Consumer prices as measured by the CPI are expected to rise 0.1% for both the overall number and the core rate. Core CPI on a year-over-year basis is expected to remain at 1.7%.


Industrial Production for March (Wednesday)

Industrial production (IP) has been in the tank for seven months and the degree of decline for five of the past six months has been unusually pronounced. This number must return to positive territory to offer signs that an economic rebound in upon us. We’ll note, this data has a decent lag to it, so we’ll see evidence that IP is bouncing back in the manufacturing surveys first, as they are more real time releases.


Housing Starts for March (Thursday)

Housing starts showed a strong 22% rebound in February. What the market will be watching for is evidence that at least some of this move was part of a fundamental turn in housing rather than just a rebound from the extremely depressed levels of January, which were weather-related (tough weather conditions across the country in Jan. halted construction projects and better-than usual weather in Feb. helped activity snap back. I don’t think we should expect an increase in March, but if the decline is a mild one it will likely prove a positive for stocks.


Initial Jobless Claims week ended April 11 (Thursday)

Claims are expected to come in at 660,000 for the latest week. This will be an especially important report as it is for the week that corresponds with the April jobs survey. Overall, we need to see jobless claims trend back to the 500K level, which is still an elevated position but moving out of 600K territory will be a very clear sign the worst for the labor market is over – we’re likely weeks away from this move. In addition, continuing claims need to halt making record highs.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries
The two-year finished the day up 9/64, and the ten-year was higher by 19/32. The benchmark curve was unchanged on the day, and remains at +197 basis points. A basis point represents .01%.

The market will get a break from auctions this week. Next week will be a large week for incoming supply with two-, five-, and seven-year auctions being announced.

Today the New York Fed purchased $7.37 billion in Treasury notes ranging in maturities from 3/31/11 to 4/30/12. They will purchase 4.5 to 7 year notes tomorrow and Treasury Inflation-protected bonds on Thursday.

The Fed is $43.9 billion into a $300 billion Treasury purchasing campaign that is scheduled to be completed by August. With the Treasury curve essentially where it is was before the program (10 yr 2.845% as I write, was 3% before the 3/18 announcement) was announced, much of the street is beginning to feel that more will be needed in order for the Fed to achieve its ultimate goal of lowering rates.

MBS
Lower coupon collateral outperformed by 4/32 on the day with very light trading due to the holiday weekend. Prepayments continue to be volatile and unpredictable, but the market remains fixated on how successful the government’s programs turn out to be.

The national average for a 30-year fixed rate mortgage, as defined by the Mortgage Bankers Association, currently stands at 4.73%. That number could easily be 4.6% or 4.55%, but as I have said before, rates being offered to borrowers are slightly higher due to understaffed mortgage brokers and warehouses not being able to keep up with the added demand for refinancing.

Credit
Corporate bonds performed well today despite equities being relatively flat, (Dow -.32% S&P 500 +.25%). CSJ and LQD were up .43% and .96% respectively today.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

ESRX, WLP, CVX, GE, earnings season

S&P 500: +2.17 (+0.25%)

Express Scripts (ESRX) +15.54% and WellPoint (WLP) +8.03%
Express Scripts will purchase WellPoint’s pharmacy benefits management (PBM) business NextRx for $4.68 billion. The deal includes a 10-year contract for Express Scripts to provide PBM services to WellPoint, the biggest health insurer with 35 million members. According to the Wall Street Journal, Express Scripts is buying the business with a mixture of cash and up to $1.4 billion in stock.

NextRx is the fourth largest PBM in the U.S. with 32 million members. NextRx filled about 268 million prescriptions last year, the business represents about 6 percent to 8 percent of WellPoint’s earnings. The acquisition boosts Express Scripts’ prescription volume by about 50 percent, putting the company at comparable volumes as its rivals CVS Caremark and Medco Health Solutions. Express Scripts’ increased size should allow them to bid for contracts to manage major companies’ employee drug benefits.

Acquiring NextRx will give Express Scripts more negotiating power with drug prices, plus more room to its lucrative mail-order pharmacy business. Currently, 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 bigger stand-alone PBMs.

WellPoint benefits from the deal because they monetized a business that could not compete with larger stand-alone PBMs and may use the proceeds to enhance shareholder value by repurchasing shares or paying out a special dividend.


Chevron (CVX) -1.81%
Chevron said it expects first-quarter 2009 earnings to be “sharply lower” than in the fourth-quarter 2008 due to lower prices for crude oil and natural gas as well as narrower margins on the sale of refined products.

Chevron’s upstream business (exploration and production) likely faced higher costs, while the company’s downstream business (refining, marketing, and transportation) is expected to hurt earnings due to weaker international margins and negative timing effects.

A higher effective tax bracket, which ConocoPhillips and Hess Corporation have mentioned, might also weigh on Chevron’s results.


General Electric (GE) +7.06%
The Wall Street Journal reports that GE increased its stake in car-battery maker A123 to 10 percent, but the big move upwards may be more related to the fact that GE shares are trading more like a bank than an industrial company.


Earnings season on its way
Earnings have already begun to trickle in, but things are really getting started this week. Tomorrow we get our first look into the technology and healthcare sectors as bellwethers Intel (INTC) and Johnson & Johnson (JNJ) report. I should note that Goldman Sachs (not on our Approved List) will be reporting, which should have implications for the financial sector.

Intel’s results will be closely watched for clues on corporate and consumer technology spending since Intel controls more than three-fourths of the microprocessor market – microprocessing chips serve as the nervous system for computers. Revenue is expected to be lower, reflecting a supply chain correction as companies pared back inventory; however, it will be more important to hear where Intel thinks demand is trending.

Profitability margins – often considered the most important metric of semiconductor earnings – were likely pressured by rapid growth in sales of lower-cost Atom chips and lower utilization rates. Future declines could be offset by higher-margin products introduced this quarter, like Nehalem, and ULV chips for ultra-light laptops. In addition, Intel is making some of its largest investments ever for a new manufacturing process, which will allow them to build faster, smaller chips that consumer less energy and cost less to produce.

What to look for from INTC: (1) outlook for corporate and consumer IT spending, (2) profitability margins, and (3) product mix

Johnson & Johnson provides a diverse look across the healthcare sector, with leading positions in medical devices, over-the-counter medicines and several pharmaceutical markets. Despite its diverse product portfolio, the economy likely weighed on operating results. Last quarter, the company noted that consumers and patients were becoming more frugal, with hospitals chopping purchases and slowing sales on products ranging from contact lenses to diabetes test strips. Pharmaceutical sales were particularly weak due to generic drug competition as well as increasing layoffs that left more people without drug-benefit plans. I suspect these trends continued into the first quarter of 2009.

I am expecting J&J to announce an increase to their dividend, which they have increased annually at a double-digit rate over the last five years. I won’t be disappointed if the increase is less than 10 percent, but I will be disappointed if there is no increase at all. Most importantly, I will be listening for any updates on the company’s 10 potential blockbusters in late-stage development. The company faces roughly $6.3 billion (10 percent of sales) in patent exposure through 2009, but patent exposure significantly lessens going forward. Growth in J&J’s other businesses are expected offset the loss of patent protection.

What to look for from JNJ: (1) pipeline updates, (2) dividend increase



Quick Hits

• Bernanke Bet on Keynes Has Meltzer Siding With Friedman on Inflation Risks
• Wall Street in Wells Fargo Moment as Obama Stress Tests Earnings Euphoria
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. markets were closed for Good Friday. Today will likely be a relatively light session as European bourses are closed, which may keep some overseas investors on the sidelines even regarding their U.S. trading activity.

Market Activity for April 10, 2009

Ahoy, Miscreants!

The pirate encounter ended successfully as everyone knows by now; one couldn’t have hoped for a better conclusion, at least regarding this specific incident – certainly we have much work to do still in deterring this activity from taking innocent people hostage and keeping the shipping lanes free-flowing.

The whole incident was becoming worrisome as it looked as if we’d refrain from using our overwhelming power in this confrontation and the messages the wrong decisions would send to our enemies, who were surely watching.

No one knows the extent to which a bad outcome would have had on the economy, it may very well have given certain regimes the confidence to challenge us, which lead to events that diminish confidence in the future and hence results in both businesses and consumers reigning in spending plans to an even greater degree than has already occurred. Of course, the higher insurance costs and likelihood that ships would choose more circuitous routes are the direct economic burdens to bear. A serious effort to make pirates pay for their decisions via direct and harsh confrontations instead of simply surrendering and paying ransoms will diminish the increased costs that piracy puts on the global economy – a number of historical events shows us to path to defeating this problem.

But whether it be how the crew of the Maersk Alabama largely thwarted the pirate attack, to the bravery and wherewithal of the captain, to the U.S. Navy’s operations, the message to the world regarding every aspect of this encounter was very American – exceptional in every degree.

Chinese Stimulation

China is in the process of massively stimulating their economy. There is the much talked about $600 billion stimulus over the next two years (which will end up being far more than that as they use their state-run banks to offer easy credit – probably spells trouble for them down the road but for now will provide a huge boost). This level of stimulus amounts to 18% of their GDP, which would be the equivalent of us engaging in a $2.5 trillion stimulus program – and all infrastructure-based. Chinese demand for raw materials (base metals, oil etc.) are showing signs of life again.

We have previously talked about how Geithner should offer a quid pro quo to the Chinese – we will stop calling them a currency manipulator, which is a waste of time anyway since we’re all currency manipulators in a world of fiat money – and in turn they are to triple their stimulus plans. This way we get the economic benefit, but without driving debt levels even higher than they are already going.

But it appears the Chinese are engaging in this anyway, not to the extent that it triples the program but they are using their banks to really foment a boom – loan activity was up six-fold from the year-ago period, according to Bloomberg News.

This means we should see an export boost (exports to China were strong in the latest trade figures and there should be more of this to come) and thus the economy should show life more quickly. This event may just ease the degree of GDP contraction in the first-quarter – it looked like we were headed for another decline of 6%-6.5% at a real annual, the latest trade figures may help that contraction a bit, something closer to 5% may be the reading. And for the current quarter we may even see a slight increase, another decline has been the consensus view. (The caveat is the consumer, which I think will continue to put a drag on GDP as the private sector components of personal income are showing significant declines, but we shall see.)

Economic Data

We don’t have a release today, but get to it tomorrow with producer prices and retail sales (both March data).

PPI is expected to come in flat for the month. Core prices, which exclude the food and energy components, are expected to rise 0.1% for the month and remain at 4.0% on a year-over-year basis.


Retail sales are expected to rise 0.3% for March, after a 0.1% decline in February. The ex-auto reading is expected to show a 0.1% increase after rising 0.7% in February.

I think there’s a good chance this reading will disappoint, and it will be very interesting to see how the market deals with this if indeed it fails to meet expectations. There has been a lot of optimism of late that consumer activity is on the rebound after a 1.0% gain in January, followed by a 0.7% gain on the ex-auto reading for February – after a significant retrenchment during the previous six months, notice the gap in negative territory as identified by the green circle (chart below). It is unusual to see such a gap in negative territory, normally a decline in retail sales is quickly followed by an increase. Unfortunately, this data only goes back to 1992, we would have to go back to the 1980 recession to get a comparable contraction in consumer activity.

I’m just not sure we’re back on the road to a sustained consumer upswing as the private-sector components of income remain in decline. We’ll see months of nice gains simply as we come off of these weak levels, but it won’t be consistent for quite a while still in my view. .


Have a great day!


Brent Vondera, Senior Analyst

April 2009 Portfolio Insights

Click here to read this quarter's Portfolio Insights. This issue includes:

• Getting It Right Twice
• Does It Pay to Diversify?
• New at Acropolis
• Inside the Economy
• Bailout Scorecard
• Equity Markets Activity
• Fixed Income Strategy
• Ask Acropolis
• Big Picture

Click here or on the cartoon to access the issue.

Fixed Income Recap

Treasuries
The two-year finished the day down 3/64, and the ten-year was lower by 35/64. The benchmark curve was six basis points steeper on the day, and currently sits at +161 bps, a basis point flatter for the week. A basis point represents .01%.

$17.8 billion of the on-the-run ten-year Treasury note was auctioned today with a bid to cover ratio of 2.49 and a yield of 2.95%. The ten-year finished the day up 1/4 from the close of the auction to yield 2.92%.

MBS
The Federal Reserve Bank of New York announced $30.4 billion in agency MBS purchases for the seven day period ending yesterday. The Fed has purchased a total of $333 billion in agency MBS to date with a daily average of $4.75 billion. Wow!

Credit
Credit spreads moved tighter today on positive earnings guidance released by Wells Fargo (ticker WFC). The better than expected news from the financial sector helped the overall market for credit today. Wells officially announces earnings on the 22nd, but today’s earnings guidance (55 cents per share) was more than double the streets estimate. The company sighted better than expected loan performance and increased activity in their mortgage refinancing business; signs that credit conditions may be turning and people are taking advantage of the lower mortgage rates. With prices down all across bondland CSJ (1-3 year IG credit) and LQD (Intermediate IG Credit) were up .47% and .67% respectively.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks rallied, ending a two-session respite to an upswing that has now pushed the S&P 500 higher by 26.6% from the March 9 wicked low of 666. Yesterday’s move was broad-based with really nice volume, especially for the session prior to Good Friday (normally light) – 1.7 billion shares traded on the NYSE, 20% above the three-month average.

The market didn’t get any help from the day’s economic data as jobless claims remain very elevated, same-store retail sales fell 2.1% for March and the trade figures showed consumer activity remained subdued as U.S. imports fell for a seventh-straight month in February.

However, Wells Fargo pre-announced that profit would easily surpass expectations, fueling a 15.5% rise in financial shares and a 24% jump in bank stocks, in particular. We should see more of this to come. As we mentioned earlier in the week, rising interest margins will help bank results this quarter – borrow near zero and lend at 5-6%. Mortgage originations also helped Wells during the quarter; they dominate California, which has seen bargain hunting increase over the past couple of months due to a 40% average decline in home prices in the state – refinancing activity nearly doubled last quarter thanks to ultra-low mortgage rates.

Investor optimism returned after a couple of days in which doubt had set in (positive comments on the economy yesterday from WH chief economic adviser Larry Summers and Fed official Gary Stern helped that sentiment turn), helped propel industrial and basic material stocks. Energy names in general under-performed, but the sub-sector energy equipment & services shares rose in line with the overall market.

Consumer staples and utilities, the typical safe-havens, were the only sectors that failed to close on the plus side.


Market Activity for April 9, 2009

Latest Retail Sales Data

The same-store retail sales figures (when you read same-store sales it refers to the year-over-year change) were not very good for March, which follows with my assumption that the March retail sales report will decline. We’ll note, however, that Easter fell in March last year, so this does have on effect on comparisons – we’ll likely see some make-up in the April data.

The International Council of Shopping Centers’ (ICSC) index fell 2.1% for March based on the year-ago period – a 0.8% decline was expected. Four of the six segments of the index showed a decline, the drug and wholesale clubs ex-fuel components were the two in the black.

The luxury segment led the declined for the seventh-straight month, down 20.3%; department-store sales fell 10.9%; apparel sales declined 8.4%; discount-store sales slipped 0.6% wholesale club sales fell 2.3% (again, when you exclude fuel sales from this segment’s sales rose, up 4.6%); drug-store sales rose 0.9%.

Jobless Claims

Initial jobless claims fell 20,000 to 654,000 for the week ended April 4 – the previous week’s reading was revised higher by 5,000 for what it’s worth. Initial claims have exceeded the 600K level for 10-straight weeks. The four-week average was effectively unchanged, falling less than 1,000 to 657,250.


Continuing claims rose another 95,000 to a new record of 5.84 million in the week ended March 27 (continuing claims lag initial by one week, that’s not a typo). The insured unemployment rate, which is tied to the continuing claims data and closely tracks the direction of the overall unemployment rate increased to 4.4% from 4.3%, and remains at a 26-year high. This insured jobless figure give us an indication the overall unemployment rate will move higher from the 8.5% posted as of the March employment report). We’ll get a better look next week as that’s the week that corresponds to the April jobs survey.


Bottom line is we’ll need to see the initial claims figure trend back to the 500K level. The overall unemployment rate is a lagging indicator, meaning it will continue to rise even as the economy rebounds, but initial claims is one of the most reliable real-time indicators we have. Until this trend to 500K begins, we should not expect much regarding the degree of an economic bounce. As most readers know, the ISM numbers are key to watch also as these are the other real-time indicators -- ISM manufacturing will need to hit the 40 handle (last reading was 36.3) and ISM service-sector will need to improve (it has dropped the past two months).

Import Prices

The Labor Department reported import prices rose for the first time in seven months as the petroleum products component jumped 10.5% in March, coming off of previously depressed levels.


Most other components continued to decline as a stronger dollar and weak demand kept prices down. The fuels component (which excludes petro and involves just coal and natural gas prices) continues to fall at massive rates – the price of imported coal fell 14% and natural gas was down 15.8% last month, according to the report. But those segments aren’t that meaningful as we don’t import much of these products. Paper and metals prices were the main reasons for the year-over-year decline. These two segments fell 2.4% and 1.8%, respectively for the month and their 12-month declines accelerated based on the prior months figures.


Trade Balance

The Commerce Department reported the U.S. trade deficit narrowed for the seventh–straight month to the lowest level in nine years. The gap shrank 28%, the largest decline since October 1996, to $26 billion in February from $36.2 billion in January.


Imports fell 5.1% in February, down 28.8% over the past 12 months, as both consumers and businesses pull-back. On the business side, capital goods (down 6%) and industrial supplies (down 9.3%) led the decline in import activity. On the consumer front, apparel imports slipped 6.5%, automotive was down 8.2% and food and beverage down 2.0%.

Exports did rise, up 1.6% for the month -- the first increase in six months. Consumer goods, semiconductors and telecom equipment drove exports higher.

By country, U.S. exports to Australia jumped 16.4%; export to China were up 12%; exports to Europe rose 6%; Canada up 5.9%; and to OPEC countries up 10%.

While it is nice to see the export data show an increase, the import side of the report illustrates that consumer and business spending remains in the tank. We’ll want to see imports trend higher (that is, we’ll want to see a multi-month increase), which will be another indication that the economy is on the rebound.

Have a great weekend and a Happy Easter and Passover!


Brent Vondera, Senior Analyst

WMT, WFC, the Fed

S&P 500: +31.40 (+3.81%)

The biggest news story of the day was Wells Fargo reporting a first-quarter profit that beat even the most optimistic estimates, sparking a rally in financial shares. Adding to the positive sentiment were reports that banks are holding up in the government's stress tests, but some still may need aid.


Wal-Mart Stores (WMT) -3.71%
Wal-Mart again posted revenue gains in the month of March, but they fell short of lofty expectations. Same-store sales (stores open at least 12 months) rose 1.4 percent, again driven by the health and wellness, and home and grocery segments. The world’s largest retailer projects its sales growth will be at the high end of its 1 to 3 percent guidance for the quarter ending May 1.

Wal-Mart continues to focus advertising on dinnerware and drapes while slashing prices on staple food items to appeal to consumers entertaining more at home. The company expects Easter to drive April sales performance.

Other retailers reported mixed results as many are still struggling with waning consumer confidence. While some retailers cited the shift in Easter this year out of March and into the April reporting period as a reason for weakness, others noted a gain from having an extra day in the reporting period, since stores didn’t have to close for Easter Sunday in March.


Quick Hits

• How Bernanke Staged a Revolution
• The Federal Reserve: Sacred Territory
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks gained ground yesterday on M&A activity within the home-building sector, another nice mortgage application report and the first decline in the wholesale inventory/sales ratio in eight months. Oh, and insurance shares also helped out on news that the Treasury will give them Troubled Asset Relief Program (TARP) funds.

Egad! TARP the insurance companies? Following other actions, such as forcing TARP funds on some banks, a proposal to make Treasury Secretary Geithner the official arbiter of “appropriate” compensation, and now appearing to use the government’s bank stress tests to force the selling of “troubled” assets this gives the impression that one big power grab is the agenda. If you’re an insurance company that is in trouble – its receivership for you. This process works just fine; besides, we need to get a grip, polices aren’t paid out all at the same time and most never need payout at all. Let’s not go overboard here, especially since many insurance profits are only back to 2005 levels – we don’t need to bailout insurance companies’ investment portfolios.

Back to yesterday’s trading, the economic data drove the market higher, reversing what looked to be a down session as futures were meaningfully lower in pre-market. The fact that the purchases segment of the mortgage apps data showed a nice increase and wholesaler sales rose for the first time since the economy hit the dirt late last summer, which is why the inventory/sales ratio improved, was big news.

The gains were broad-based, as nine of the 10 major industry groups gained ground – led by consumer discretionary and tech shares. Telecom was the only group to remain below the flat line.


Market Activity for April 8, 2009


Crude

The price of oil for May delivery rose for the first session in four after the Energy Department’s weekly inventory report showed stockpiles rose less than expected. Crude supplies rose 1.65 million barrels to 361.1 million last week. Even though this is the highest level since July 1993 stockpiles were forecast to jump 6.94 million barrels. Crude had declined the past few days on the assumption of a much higher inventory build and even though stockpiles are at a 15-plus year high, and demand is down, the much lower than expected build ruled the day.

Mortgage Applications

The Mortgage Bankers Association reported their mortgage applications index rose for the fifth-straight week – this time though the rise in purchases surpassed the increase in refinancings. Purchases jumped 11.1% in the week ended April 3 and refis rose 3.2%. The 30-year fixed mortgage rate fell below 5.00% during the week of March 6 and the index has gained ground ever since.


Refinancing activity remains the driver of the index as this segment makes up 78% of mortgage-loan activity, but the double-digit rise in purchases is a very welcome sign – it will be interesting to watch if the very low mortgage rates will be enough to offset the drag a bad labor market has on sales.

Wholesale Inventories

The Commerce Department reported that wholesale inventories fell at double the rate expected, declining 1.5% in February. The sales data recorded the first increase in eight months, a very good sign that may provide evidence the production needed to rebuild stockpiles is not far down the road – this will work as a nice catalyst to GDP growth by the third quarter if the sales pick up becomes a trend.

Durable goods inventories plunged 2.4% for February, the largest decline on record (the record isn’t that long though, just back to1992) led by a large 7.9% drop in automotive stockpiles.


While the very large inventory declines (down $62.6 billion over the past three months at an annual rate, which means the larger business inventories figure will show a $250 billion decline when we get that reading on April 14) will weigh heavily on the first-quarter GDP reading, this is very good progress for subsequent quarters. Again, we need to see the sales data trend higher.

Inventory Dynamic (but is a sustained economic rebound likely?)

And speaking of inventories, the WSJ ran a good piece yesterday morning touching on how inventories have been liquidated to the point that they’ll need to be boosted fairly soon – that means more GDP-enhancing production as stated above.. This is a topic long-time readers of this letter are familiar with as we have talked many times of inventory trends over the past several years and specifically of the inventory dynamic over the past couple of months.

It’s important to realize that we went into this downturn with a much lower inventory-to-sales ratio than is typically the case. The amount of inventory bloat generally determines the duration of an economic contraction as excess stockpiles must be sold off prior to production ramping up again. The fact that we began at low inventory levels at this point in the business cycle (not to say the inventory-to-sales ratio hasn’t sky-rocketed over the past several months as sales plunged due to the credit event that began in September, because it has as the above chart shows) will help to make this downturn less severe than it otherwise would be,

That said, the problem with this recession is that it is led by a credit event and a very serious contraction in consumer activity as very low interest rates encouraged too much debt – a situation that will take time to work off. And the policy decisions of late do not address this issue -- in fact what we’re doing will only compound issues over time. Simply because overall stockpiles have come down in a large way, it is not a sufficient condition for sales to bounce back in a way that normally occurs to drive the inventory-to-sale ratio much lower. (The most abrupt decline in stock prices since the 1974 bear market may also keep consumer activity somewhat subdued – call it the reverse side of the wealth effect. This move in equity prices has even more meaning today; most consumers did not have their savings in the stock market back then; same is true for the 1987 market crash.)

We’ve spent so much time harping on the need for broad-based reductions in tax rates because this is the surest way to fire up investors’ animal spirits – especially via tax rates on capital. And as goes the direction of the stock market, so goes consumer and business optimism. What’s more, lower taxes on income will drive disposable income higher as we wait for business spending to come back around – and we need businesses to be confident about the future because the business spending segment of GDP will be relied upon to drive things as consumer activity will not be as robust as it had been over the past several years.

We can’t stress this enough – confidence is key. I’ll remind you that during the previous expansion firms managed their businesses in a pretty cautious manner (likely because of heightened geopolitical risks and high energy prices). This will be the case this time as well, but intensified, as firms are surely watching what the government is doing and therefore may lack the confidence that is needed for a serious production ramp up. This caution from business is not all bad as firms will remain extremely streamlined and at some point things will flow again. However, the point in the shorter term is that this is just another reason (along with the time consumers will need to get things right again) the expansion that will eventually come may prove to have a much shorter life than the previous three business-cycle upswings; caution among businesses will have a negative effect on job growth and production.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries
The two-year finished the day down 1/32, and the ten-year was higher by 15/64. The benchmark curve was seven basis points flatter on the day, and currently sits at +191 bps. A basis point represents .01%.

$35 billion of three-year Treasury notes were auctioned today with a bid to cover ratio of 2.42 and a yield of 1.385%. The yield on the three-year dropped 10 bps after the rally in stocks was erased by the release of the FOMC minutes at 1pm Saint Louis time. Although equities rallied to end the day up 1%, Treasuries remained strong throughout the afternoon.

FOMC Minutes Released
The minutes from the Federal Open Market Committee’s March 18th meeting were released this afternoon. The minutes detail the discussions behind the Fed’s decision to boost purchases of agency Mortgage Backed Securities from $500 billion to $1.25 trillion, purchase $200 billion in agency debentures (up from $100 billion), and $300 billion in US Treasuries.

The committee’s projections for GDP growth were reduced “with real GDP expected to flatten out gradually over the second half of this year and then to expand slowly into next year.”

The Fed’s decision to buy Treasuries to bring rates down further was not a unanimous one. Some members voted for “very substantial” increases in open market operation, while others recommended less of an increase. The $300 billion allocated to Treasury purchases was probably on the more conservative side of the discussions, but with rates just about where they were before the announcement on March 18th an increase doesn’t seem out of the question.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

PFG

S&P 500: +9.61 (+1.18%)

Principal Financial Group (PFG) +21.28%
The Wall Street Journal reports that the Treasury Department has decided to grant TARP funding to life insurers. No details have been released regarding which companies will receive aid. Life insurers argue that federal capital injections would allow them to buy more bank bonds and stimulate lending – the industry owns about $1 trillion in corporate debt.

AIG’s expanded and drawn-out rescue has played a big role in the delay of a decision on the insurance industry’s requests for aid. Principal Financial Group filed their TARP application back in November 2008. The insurance industry shouldn’t have been as aggressive – hindsight is 20/20 – but that won’t be a problem once the government gets involved and insurance profits are tamed for a long time.

In Principal’s case, the Life and Health insurance segment accounted for 45 percent of operating revenue in 2008. Like their peers, Principal has sizeable losses in its investment portfolio that back their policies. Principal, however, avoided guaranteeing minimum returns in their variable annuity business, which is a practice that has exacerbated problems for their peers.

Still, the bigger reason we continue to hold Principal (aside from the tremendous upside) is their Asset Management segment, which accounts for well over 50 percent of operating revenue. The bread and butter of this segment is Principal’s 401(k) business, which is a dominating player in the small to medium-size business market.

Because less than 20 percent of companies with fewer than 100 employees have 401(k) plans, Principal has plenty of opportunity to grow through this underpenetrated market. What may prove to be more important to Principal’s growth is their growing presence in several emerging markets such as Chile, Mexico, Hong Kong, Brazil, India, China and Malaysia.



Quick Hits

• ‘I Want You,’ Uncle Sam Says to Wall Street’s Jobless Financial Analysts
• Energy Prices May Rise on ‘Slingshot’ Effect After Credit Chills Drilling
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks declined yesterday as a pull-back was bound to occur after another strong rally last week, which marked the fourth weekly gain.

As mentioned yesterday, stocks may have a rough patch to get through as we’re heading into what will be the worst ex-financial earnings season we’ve seen during this contraction. Bank profits should help overall S&P 500 earnings as interest spreads (borrow near zero and lend at 5-6%) could help this segment post an actual profit increase, which would be the first since Q3 2007 for the group.

But ex-financial S&P 500 profits, which posted their first quarterly decline (since this mess began in September) during Q4 earnings season, will likely fall 30%. This will be difficult for the market to deal with following the strong upswing that took place off of the wicked 666 low of March 9 – up 25% prior to the past two sessions. Since we’re range bound, it will be important to make the necessary pull back short and sweet. If we keep it to a 10-12% decline, our guess is we’ll re-rally in quick order. (This view is somewhat supported by activity during the equally nasty bear market of 1974.) If it’s more than that, it may invoke enough fear to make a quick resurgence difficult.

In terms of economic data, the market will be focused on Thursday’s jobless claims figure and next week’s retail sales number for March. We’ll probably need to see some improvement in jobless claims – at least some sign we’ll trend back to the 500K handle – and it will be imperative for March retail sales to post a gain – too many people are riding on the assumption that consumer activity can rebound in a sustained way so if this number disappoints it may be a rather tough blow for market psychology to absorb.

In terms of the sector trade, the cyclicals took the beating yesterday– industrials, telecom, basic materials, consumer discretionary. The relative winners were the typical safe-havens – utilities, health-care and to a lesser degree, staples.

Financials held up relatively well for the vast majority of the session, but plunged 2% in the final 20 minutes of trading – possibly on news that the Manhattan DA uncovered an Iranian/Chinese money laundering scheme in which they used fake companies to facilitate the purchase of banned materials to make missile systems and nuclear weapons.


Market Activity for April 7, 2009


Crude

Crude oil moved below $50 per barrel yesterday, falling 3.2%, (and off by 10% over the past four sessions) as traders anticipate this morning’s Energy Department report will show stockpiles remain at a 15-year high, or 13% above the five-year average – this is something that has occurred very quickly as stockpiles were in line with the five-year average just three weeks back. Daily fuel demand appeared to be on the rise as the prior four-weeks showed demand increased 1.2% from the year-ago period. However, last week’s report showed demand fell a pretty substantial 4.4% for the latest four week based on year-ago levels.
.
Until global demand picks up oil will continue to trade on the dollar and stocks (that is when doubt begins to rise regarding a global economic rebound, the dollar – the crisis/safe-haven currency – value rises and stocks sell off, in which case oil comes under some pressure, and vice versa).

Some traders hopped onto the oil train as a way to hedge against the inflationary event that is likely to come as the Fed and Treasury (along with other governments) are pumping trillions into the system. This is what made it look like we were headed for $60. However, between pessimism over earnings season and recent predictions that the rally won’t last, that hedge has come off a bit. (Last night’s earnings results out of Alcoa won’t help the commodity trade over the short term either.)


The Old Washington 180

In a dramatic, but typical, political reversal (“Who me, I never advocated that?”) House Financial Services Committee Chairman Barney Frank has proposed legislation prohibiting lenders from extending mortgage loans to those who can’t afford them – one assumes Mr. Frank determines the parameters, which is scary enough. What’s amazing about this is that Mr. Frank was one of the most vocal members of Congress over the past decade demanding that banks offer credit to low-income households – some of you may recall he is also the person quoted as saying, “I want to roll the dice” with Fannie and Freddie. What we’re going through today is yet another serious consequence of government’s social engineering plans –specifically the 1995 modification of the Community Reinvestment Act. (And we shouldn’t let the Fed off the hook by blaming only the members of Congress, for it is their massive monetary policy mistakes that made the whole leverage issue and housing bubble possible.)

As is typical, Congress is behind the curve as the market is already well into this process --- those with low credit scores have largely been shut out of the credit markets for the past six months. The shift in credit standards (and the lack of private sector financing as a result of default rates) has been so dramatic in fact that the Fed has rolled out a series of facilities to address this issue.

Second Thoughts?

In other news involving the government and their attempts to ameliorate credit conditions, Treasury Secretary Geithner seems to be running into some difficulty finding participation in the Public-Private Investment Program (PPIP). The fact that Geithner hasn’t been able to officially announce the participants (which was only five based on the restrictions they place on participation) spells trouble. Now they have come out and extended the time with which to apply, stating the reason for the extension is to allow smaller and minority-led firms into the PPIP.

Call me skeptical, but this looks like a way to disguise a lack of alacrity to participate – gee, the populist wave Congress is fomenting can’t be a cause of this possible hesitation could it? On the current political trajectory, firms can’t be sure they’ll be able to keep the potential profits – especially when the press starts reporting on the degree of profits made and the very attractive terms with which the government extended them loans.

Same is true for the Federal Reserve’s TALF program (a program that is largely focused at reducing consumer-lending costs). The goal of TALF is $1 trillion in activity, yet in its first week investors applied for only $4 billion in loans and the Fed received applications for just $1.4 billion in last week’s round – at this rate the $1 trillion goal will be reached by the year 2200. It’s not difficult to understand why investors have become wary of dealing with the government.

Consumer Credit

The Federal Reserve reported that consumer credit fell $7.4 billion in February, or 3.5% at a seasonally-adjusted annual rate, to $2.56 trillion. The decline marks the fourth decline of the past five months. The January reading was revised higher to show a $8.14 billion increase.

This report on consumer credit involves both revolving (such as credit cards) and non-revolving (fixed payment loans such as auto and student loans) – mortgage loans are not included in this data. Revolving credit continues to retrench (down 9.7% at an annual rate), while non-revolving credit was virtually unchanged.

The plunge in the stock market, the continued decline in home prices (for most regions) and rising unemployment have sent a clear signal to consumers to reduce credit card balances, or at least reduce transactions. This is an event that simply needs to run its course. Over the next several months, it means a sustained rebound in consumer spending is unlikely.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries
The two-year finished the day up 1/16, and the ten-year was higher by 7/64. The benchmark curve was unchanged on the day, and remains at +198 bps. A basis point represents .01%. Treasury prices traded within a tight range throughout the day but ended higher on the weakness in equities.

$5.7 billion of ten-year Treasury inflation-protected securities were auctioned today with a bid to cover ratio of 2.25 and a real yield of 1.589%. TIPS are purchased with a fixed coupon that pays interest on a principal amount that is adjusted every month for inflation.

The Fed will buy 1-2 year Treasuries tomorrow.

FDIC Expansion
If the Public-Private Investment Program (PPIP) ever gets off the ground, and that is still a pretty big “if”, the FDIC may begin to look a lot like Fannie and Freddie. The FDIC is being summoned by the Treasury to provide guarantees for the leverage used in the PPIP; a situation similar to Fannie Mae and Freddie Mac being used by the government to absorb the risk that private investment is currently shedding in the housing market. A PPIP refresher.

Sheila Bair, chairwoman of the FDIC, was quoted in Monday’s NY Times estimating “Zero risk for insuring the PPIP.” That’s an interesting viewpoint considering that they are providing non-recourse leverage for the purchase of securities collateralized with auto and credit card loans on a 6-to-1 debt to equity basis while splitting the profits down the middle with the private investor. “Zero risk”? Not exactly the words I would use to describe such a plan.

As if the risks (sans reward) associated with the government’s involvement in PPIP aren’t alarming enough, it’s difficult to listen to the person at the helm of it all flat out denying any risk. Mispricing of risk (think Angelo Mozilo), and in some cases flat out denial of it (think Jimmy Cayne), are at the heart of the credit crisis. It’s astonishing to me that decision makers still believe that wishing risk away is the answer.

The deadline for private institutions to apply for participation in the PPIP was extended yesterday to April 24th and many are speculating the Treasury is struggling to find participants. This is thanks in large part to a change in FASB guidance on mark-to-market accounting that makes the program much less effective. Maybe the Chairwoman was referring to the program never really coming to fruition when she described the FDIC’s commitment as “zero risk”.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

EMR, WLP, UNH, earning season will be the X-factor

S&P 500: -19.93 (-2.39%)

There seems to be a bit of profit taking ahead of profit season. Corporate earnings are the big X-factor in determining the sustainability of the most recent rally. The first quarter was likely a huge stinker and earnings will likely carry less weight in the market than the outlooks companies are giving. Are things the same, getting worse or getting better? What are companies saying about jobs? Are there any real surprises? While there are some big names releasing earnings this week, next week is when things really start getting interesting.

Emerson Electric (EMR) unch
Emerson cut its profit forecast for the year, citing falling demand and inventory reductions by customers. The company now expects earnings between $2.40 and $2.60 per share, down from $2.70 to $2.95 per share.

The company said the weak economy has taken a toll on Emerson’s residential, nonresidential and capital businesses.


WellPoint (WLP) +2.27% UnitedHealth Group (UNH) +6.93%
Insurers with U.S. Medicare-backed health plans for the elderly and disabled advanced after Centers for Medicare and Medicaid Services announced a rate increase of 0.8 percent in 2010, higher than originally proposed.


Quick Hits

• Gates Cuts to Boeing, Lockheed Spur Fight in Congress
• Cisco Forges Ahead With Acquisitions as Technology Companies Cut Spending
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks broke a four-day winning streak as traders took some profits ahead of today’s kickoff to first-quarter earnings season – although a nice move in the defense sector helped the Dow and S&P 500 pare losses (aerospace and defense shares jumped 3.6%.)

Frankly, I thought yesterday would prove to be a rough session following the North Korean launch of a multi-stage rocket. Not only because North Korea showed they’re inching closer to a long-range deliver system, but also because of the known relationship with Iran and knowledge (no matter how far behind industrialized nations) sharing between the two. And we propose cutting slashing our missile-defense budget a day later? It’s very dangerous to send the wrong messages. Traders totaling brushed it off, however.

Banks took the brunt of yesterday’s losses following comments from Treasury Secretary Geithner on Sunday. He makes these statements about being prepared to force the removal of bank executives and boards – even if some should be removed all it does is increase doubt over how far they’ll go or what ruse they’ll use to invoke more power within the banking system. As if the government is capable of finding competent replacements anyway. What’s their goal; to overtly direct lending to the channels of the economy that they see fit? It’s troubling to think of the direction they’re taking.

A pessimistic report from a major bank analyst also pushed the shares lower -- financials fell 2.93%.

Basic material, energy and consumer discretionary stocks were among the other drags, as is generally the case on these days in which the market wonders that maybe the economy has yet to bottom. (Odds are it has, but to say so with conviction is not possible at the present. Even if it has it’s difficult to see a sustained expansion – consumer activity as a share of GDP will be curtailed for quite a long time and policy isn’t exactly giving businesses the confidence to boost expenditures, which is already weak simply because of the languid economy.
(What’s needed is policy that fires up business optimism. Policymakers need to acknowledge that it will take some time for the consumer --in the aggregate -- to become healthy/comfortable again. This is why they should be focusing on the business side instead of vilifying the private sector.)

The breakdown of the deal between IBM and Sun Microsystems, as Sun did its best impersonation of Yahoo! by demanding a higher bid among other things, hurt the tech sector. Sun shareholders will wish they took IBM’s price.


Market Activity for April 6, 2009


Even though we lost a little ground activity certainly seemed to be quite positive yesterday – rallying in the afternoon session in front of today’s start to first-quarter earnings season; however, one should not expect this rally to continue unabated and big down days are probably going to with us for an extended period. Yes, stocks typically rebound 4-5 months ahead of an earnings recovery but we have at least two really tough quarters to get through first and we may have to wait until the fourth-quarter to see a meaningful profit rebound.

Financial-sector profits should be much improved for Q1 earnings season – thanks to rising interest margins – but we’ll have to endure depressed results from industrial, technology and consumer-related sectors that will push S&P 500 profits down between 30-35%. And the profit improvement within the financial sector may prove short-lived as a nicely positive yield curve, which is what delivers higher interest income, may not be able to offset rising credit-card delinquencies (simply a result of rising unemployment) and an acceleration in commercial real-estate default rates. Thus the sector may not offer the help some expect regarding Q2 and Q3 overall earnings results. It may take another nine months for the overall profit rebound to unfold.

So, this rally has been a very welcome event, and one could certainly feel it coming as we mentioned in the March 5 letter, but it’s been a strong upswing and traders will eventually look around and find stocks nicely higher from the low, yet many of the same macro (along with economically exogenous) problems remain in play. A degree of caution and a refrain from chasing these rallies is probably the main thing to keep in mind. During normal downturns you don’t want to have these shorter-term tendencies, but this is not normal and we could be range-bound for an extended period; buying at the higher-end of this range should be accompanied by a willingness to accept several stints of continued weakness.

The Week’s Economic Data

We will have to wait another day for a meaningful release. This afternoon we do get consumer credit for February, but this is not one of the big readings.

Tomorrow we get mortgage apps and wholesale inventories. We’ll look for mortgage apps to rise for the fifth-straight week, fueled by refi activity. Wholesale inventories will likely provide additional evidence that the degree of inventory liquidation last quarter was significant. I think we also get the minutes from the Fed’s last meeting – although Bernanke has been so vocal lately I’m not sure there will be anything new to take from the minutes.

Thursday we get the trade balance for February, import prices for March and initial jobless claims. On Friday markets are closed.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries
The two-year finished the day flat to where is ended last week, and the ten-year was lower by 3/8. The benchmark curve was 4.7 basis points steeper on the day, and remains at +198.7 bps. A basis point represents .01%.

Treasury prices see-sawed throughout the day but were mostly down by the end of the afternoon. Concerns over this week’s coming supply ruled the day, but a small rally appeared late in the morning after the Fed announced the results of their Treasury bidding. The Treasury will auction $6 billion of the 10-year TIP on Tuesday, a new 3-year issue on Wednesday and reopen the on-the-run 10-year nominal note.

The Fed purchased $2.53 billion of Treasuries today in the 10-17 year area. As expected, buying was concentrated in the shorter end of the maturity range with 65% of the buying in 2019 and 2020 maturities. The Fed will buy more Treasuries on Wednesday.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks were able to shrug off another bad employment report (largely because the numbers came in at expectations and the prior month’s reading was not revised lower) to extend the weekly rally. The 3.26% rise on the S&P 500 last week marks a month of gains that has moved the broad index 26.5% above the March 9 low.

Stocks did begin the session lower Friday but rallied mid-morning following Fed Chairman Bernanke’s comments explaining their programs to unfreeze credit markets is working.

(Now let’s hope that Treasury Secretary Geithner doesn’t use their bank stress tests as a way to force financial firms to participate in the PPIP (Public-Private Investment Program). For new readers who may not know, this is the Treasury plan to remove toxic assets from bank balance sheets. The PPIP is not needed now that FASB has voted to allow modification to mark-to-market – banks can hold these assets on their own balance sheets now that those that do not have the liquidity to make a market, and thus are trading at distressed prices even if they are performing on time, wont’ necessarily have an effect on regulatory capital. If Geithner chooses to use the stress tests as a cudgel I don’t see how this doesn’t completely offset the beneficial effects of the accounting change.)

Most of the 10 major industry groups gained ground on Friday with financials leading the way. The only two that declined were health-care and consumer staples.


Market Activity for April 3, 2009

Economic Releases

The Jobs Report

The Labor Department reported that 663,000 payroll positions were lost last month, which was in line with expectations. While the whisper number expected a loss of more than 700,000 it’s still tough to see a bright spot – the March reading marks the fifth-straight month in which we’ve lost at least 600,000 payroll positions; 5.1 million jobs have been lost over the past 15 months, 73% of which have occurred in the past six months (as we often state, everything changed in September.)

Goods-producing payrolls shrank by 305,000 in March, a slight acceleration from the -285,000 for the prior month. Construction lost 126,000 (slightly worse than the 107,000 decline in February) and manufacturing lost 161,000 (a slight improvement relative to the 169,000 decline in February).

Service-sector payrolls sank by 358,000, a bit less than the -366,000 in the prior month. Trade and transportation payrolls fell 112,000, slightly better than February’s reading of -121,000. Business services lost 133,000, meaningfully better than the 178,000 decline in February. Job losses in the leisure and hospitality segment accelerated, which is what kept total service-sector job declines pretty much in line with the previous month’s decline.

Health-care services remains the only employment segment that has yet to show a monthly decline during this contraction, adding 14,000 jobs last month.


The unemployment rate jumped to 8.5% (as expected) from 8.1% in February. The unemployment rate runs off of the household employment survey (the number mentioned above, and the figures you read and hear about in the news come from the payroll survey – also called the establishment survey).

The household survey includes the self-employed and we mentioned last month that we saw a silver lining with regard to this figure as losses eased substantially, down 351,000 in February compared to a 1.24 million decline in January. Well, that appeared to be wishful thinking as the household survey showed another big job loss of 861,000 in March.


The average duration of unemployment rose to 20.1 weeks in March from 19.8 in February. The median duration of unemployment rose to 11.2 weeks from 11.0.

It will really be tough to see consumer activity rebound in a sustained way so long as this level of labor-market deterioration continues, especially since the availability of credit is not there for those with less than auspicious credit scores, as it had been for a number of years. While more appropriate credit standards are helpful for the longer-term health of the economy, in the short run the degree with which the consumer has catalyzed GDP over the past several years will diminish.

This is yet another reason we advance the notion that broad-based tax cuts are key to getting the economy back on its feet in a sustained manner. What this does for the consumer is boost disposable income as we wait for the business side of things to kick in again. And on the business side, slashing tax rates boosts their confidence in the future and provides the incentives to produce. Substantial reductions in the corporate tax -- along with a huge reduction in the repatriated income tax rate, currently set at 35%, (the tax that must be paid when U.S. firms with overseas subsidiaries bring that capital back home – which means it doesn’t come back home ) would boost corporate profits and provide a huge capital boost that would fuel business-equipment spending. Alas, such proposals are anathema among the current political class.

ISM Service Sector

The Institute for Supply Management’s service sector index fell in March to 40.8 from 41.6 in February – a reading of 42.0 was expected. (The index tracks service industries such as real estate, wholesalers trade, management and support services, education, professional and scientific, utilities, health-care, fishing and hunting, transportation and finance and insurance.)


The business activity sub-index (this is a general sentiment index – and for clarity, the headline number cited above equally weights the sub-indices business activity, employment, new orders and supplier deliveries) rose to 44.1 in March from 40.2 in February, bringing the reading almost back to where it was in January. A pick up in sentiment in the real estate sector pushed the sub-index higher.

New orders contracted for the sixth-straight month, registering 38.8 in March from 40.7 in February and the degree of contraction increased for a second-straight month.

The employment sub-index fell to 32.3 from 37.3.


We have seen the manufacturing sector improve ever-so-slightly, which is hopefully a sign this segment of the economy has bottomed. Cautious optimism is the appropriate approach as we do not yet know the extent to which the auto sector will continue to weigh on this sector. The service sector though is not showing signs of a bottoming. Possibly, the Fed’s work in reducing mortgage rates will incrementally boost the real-estate segment of this ISM report and we will see some mild improvements from here.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries
The two-year finished the day down 1/8, and the ten-year was lower by 1&1/8. The benchmark curve was 7 basis points steeper on the day, and remains at +194 bps. A basis point represents .01%.

Although the employment numbers were ugly, Treasuries were down at the open and got worse as the day wore on due to renewed concerns over next week’s supply. The Treasury will auction $6 billion of the 10-year TIP on Tuesday, a new 3-year issue on Wednesday and reopen the on-the-run 10-year nominal note.

The Fed will purchase 10-17 year notes on Monday and 1-2 year notes on Wednesday of next week.

Fed Purchase Programs
The Fed purchased $32.9 billion in agency MBS during the period ending Wednesday April 1st. The weekly average has moved to about $32 billion since they announced the increase a few weeks ago, from about $18 billion before the increase.

Fed Chairman Bernanke spoke today about how the Fed purchase programs are having their desired effect. Something that was not possible through the traditional method of lowering the Fed Funds Target Rate.

The Fed’s balance sheet, which stood at $870 billion before the collapse of Lehman Brothers, currently stands at $2 trillion with 45% of that being short term liquidity programs implemented by the Fed. Five Percent of the Fed’s balance sheet consists of loans to AIG and Bear Stearns. The Chairman noted that although some portions of the balance sheet carry more risk than others, the Fed intends to be made whole on all its outlays.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst