Daily Insight

U.S. stocks came under pressure yesterday after the latest retail sales report showed the jobless rate will keep consumer activity subdued and foreclosures surged 32% in April (although it shouldn’t be much of a surprise as the moratorium the government placed on foreclosures has ended and the spring is uncoiling).

The data out of yesterday’s Energy Department report, namely the trend among refiners that suggests they don’t currently expect a bounce back in demand, didn’t help matters – we’ll touch on that below.

Financial, basic material and industrial shares took the brunt of the damage.

Mid and small cap stocks got hammered. The S&P 400, a measure a mid capitalization shares, took a 4.38% hit. The Russell 2000 and S&P 600, the main measures of small cap shares, lost 4.72% and 4.73%, respectively.

Market Activity for May 13, 2009


Crude

Crude oil for June delivery remained near the $60 level despite the negative news on the consumer. The weekly Energy Department report showed an unexpected decline of 4.63 million barrels in supplies – inventories were forecast to rise one million barrels. U.S. supplies remain above the five-year average but have come off of the 19-year high that had been hit over the past three weeks.

Domestic demand is not showing signs of a rebound, so the reduction in stockpiles wasn’t a demand-driven event. Rather, oil imports hit a 10-year low as refineries decided to draw down existing stockpiles – unusual activity for this time of year with the summer driving season just around the corner; it suggests refiners are not especially optimistic that gasoline demand is making a comeback anytime soon.

That said, one cannot ignore the fact that production in China has shown signs of life over the past two months and the market is surely focused on the dollar that is trending lower. Then when the economy gets a boost from the inventory dynamic and the fiscal stimulus that has yet to occur (even if the bounce will prove very short term in nature) we could see traders push energy prices higher on rising GDP forecasts. It will probably take some pretty bad news to drive crude below the $50 handle again. Certainly activity out of China, where their stimulus (worth 20% of their GDP) is just starting to kick in, is unlikely to wane.


Mortgage Applications

The National Association of Realtors reported their mortgage apps index fell 8.6% after a 2% rise in the previous week. An 11.2% decline in refinancing activity (it appears we’ve seen most of this activity run its course) pushed the index lower – refis currently make up 72% of the index. However, purchases managed a slight gain of 0.5% after the strong 5% rise in the previous week


Import Prices

The Labor Department reported that import prices for April rose for a second straight month, up a large 1.6% (three times the forecast) after the 0.2% gain for March. This increase was all due to petroleum prices as the oil component jumped 14.6% and petroleum products (lubricants, kerosene, diesel fuels, aviation fuels, etc.) raged higher by 15.4%. Petroleum and petro-related import prices are up 30% over the past three months as they rebound from the plunge of the previous six months.

On a year-over-year basis import prices remain down big at -16.3%. But as commodity prices continue to rise this reading will erase its YOY negative reading and may quite possibly show the extremely elevated readings of summer 2008 by this time next year.

Retail Sales

The Commerce Department reported retail sales declined 0.4% in April, following a downwardly revised 1.3% drop for March. As stated yesterday, I thought the reading would show an increase (the expectation was for no change) as the Easter holiday fell in April this year. This often boosts the number, and quite possibly the reading would have been even worse if not for this calendar event.

Excluding auto sales the figure showed a slightly larger decline, down 0.5%. Auto sales were one of the only bright spots in the report – this component rose 0.2% as dealers, via help from government financing, were able to offer very low rates again after a few months in which they had trouble accessing credit markets.

The sporting goods and books segment also posted an increase, up 0.3% for the month and health stores, which have registered only one monthly decline over the past seven months, saw sales rise 0.4%.

Outside of these areas the rest of the report was ugly, particularly after the previous month’s large declines. The segment weakness we found most interesting was in the grocery store and gas station components.

Gasoline prices were pretty much flat in April, so the significant 2.3% drop within the segment can’t be explained by falling prices. Grocery stores posted a large 1.1% decline in April – considering the Easter holiday had to help the reading somewhat that’s a big decline. Both of these numbers scream joblessness – less driving due to the loss of employment and consumers tightening their belts for even the primary necessity reading of the report, groceries.

(Digressing for a moment, policy makers may have been able to stem this surge in the jobless rate if they had aggressively cut tax rates on capital, labor income, corporate taxes and repatriated income when it became apparent the economic world had changed last fall. This would have boosted disposable incomes, created incentives for businesses to boost capital spending, eased job cuts to some extent, and offered a higher floor for stock prices. But the Bush administration chose to return to the rebate check strategy, which never works, and the Obama administration explains that they will raise tax rates and create entire new entitlement programs, thus boosting government spending and driving massive deficits for years to come. I’m not saying all would have been right with the world, there was a major credit event that took place, but the policy direction chosen is clearly not the correct prescription and lower tax rates would by definition have boosted after-tax incomes, profits and capital return expectations. It would also have been dollar supportive, which is not the case right now; when run for the safety of the Treasury market comes off, the dollar will be in big trouble because of higher tax rates on capital and the massive debt issuance that will result over the next few years)

Department and clothing store sales fell 0.5% and 0.2%, respectively. These declines are logical, if consumers are going to reduce groceries, they’re surely not buying that new spring line of clothing; especially since credit-card lines have been cut (and you can bet that legislation to restrict interest rate changes on credit-card balances will result in even less availability). Electronic store sales fell 2.8% after a large 7.8% decline in March – massive discounting is likely playing some role here, it’s not totally a volume thing.

Looking out over the next year, we’ll see months in which consumer activity pops, which is likely to occur to some extent for May after two months of decline. This may cause the so-called pundits to believe the consumer is back, again. However, the need to boost cash savings, as the two major savings vehicles (stocks and houses) have taken a pounding, will weigh on activity for an extended period of time – and if energy prices surge again, that will act as yet another drag on the retail figures.

The consumer makes up 70% of GDP (that number is clearly going back to 65% over the next year or two), so as this segment remains weak we will greatly depend on the business side to boost economic growth. Of course, government is moving in to take a much larger role, but it can provide only a short-term boost, and over the longer-term this government spending will depress growth as it saps capital from the private sector. Washington needs to be very careful in its vilification and crowding out of the private sector; policymakers must tread with caution with regard to higher tax rates and regulations. If they choose to progress down the current path, they’ll find the business side will remain very cautious and continue to reign in its capital spending projects.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Investors rushed toward the safety of Treasuries today on retail sales data that came in weaker than expected. The two-year finished up 1/32, and the ten-year was higher by 29/64. The benchmark curve flattened by 4 basis points, and currently sits at +224.5 bps. A basis point represents .01%.

Credit

While stocks have pulled back over the past few days, corporate bonds have been doing the opposite. Comparable Treasuries are up a little over the same period, but not nearly enough to justify how credit has outperformed stocks this week. The following graph compares the performance of CSJ (1-3 Year Credit ETF) and SHY (1-3 Year Treasury ETF) month to date.

And this graph shows CSJ and the S&P 500 over the same period.

Successful non-guaranteed bond offerings from Morgan Stanley and Bank of America and upcoming issues from American Express and J.P. Morgan are likely to blame for this outperformance. These companies have benefitted from the Temporary Liquidity Guarantee Program, which allows banks to issue corporate debt with a guarantee from the FDIC. In order to repay TARP, the Treasury is requiring banks to show the ability to issue debt without the guarantee, which has prompted several to do so.

Although debt costs will increase without a backstop from the FDIC, this new issuance shows that the credit markets have come a long way since last fall.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

No worries at Intel

S&P 500: -24.43 (-2.69%)

Intel (INTC) -0.53%
Nearly a full decade after Advanced Micro Devices’ first complaint about its larger competitor, EU regulators laid a record $1.45 billion fine on Intel for abuse of a dominant market position. This decision follows a 2005 ruling in Japan and another in Korea last year, both of which determined Intel was abusing its dominant market position.

But shareholders don’t care much for the opinion of government officials, and the share price of Intel barley moved today on the news. Investors are far more interested in Intel’s attempts to cut costs, improve margins, and control inventories – the main focus of its analyst day on Tuesday.

The ruling is more of a positive for AMD than a negative for Intel since any form of settlement would help AMD with its debt load. In terms of the market for microprocessors, however, little will change.

The practice in question is allegedly restrictions attached to volume rebates, not the principle of rebates themselves. Intel holds over 70 percent of the market for all microprocessors (the central engine of every computer) and benefits from a self-reinforcing scale advantage that allows them to outspend AMD on research and development by more than four to one.

In short, Intel’s fines are nothing to worry about.


Quick Hits

• Taylor Says Fed May Not Have Much Time Before Rate Rise Needed
• Putting GE Capital Through Its Stress-Test Paces

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks pared earlier session losses after former Federal Reserve Chairman Greenspan stated the housing market may be on the verge of recovery and financial markets should continue to improve. The comments, part of a speech to the National Association of Realtors, helped the broad market rally in the final hour of trading – although some weakness in the final minutes drove the S&P 500 and NASDAQ Composite back into the red. The Dow Industrials did, however, close to the plus side thanks to shares of Coca-Cola, Exxon, Chevron and IBM.

The Transportation Average, as we talked about yesterday is an important indicator to watch right here, slid for a second-straight session and has appeared exhausted over the past week. This is a reliable gauge for the entire market and may be suggesting the nine-week long rally is nearing an end. We may see a bit more upside as investors who have been on the sidelines and missed out on this surge from the wicked depths of 666 on the S&P 500 look for any pullback as a chance to get back in. Beyond that we’re probably very close to some degree of retracement after the 39.6% rally from the March 9 low, as of Friday. Whether this will be a 10%-15% pullback to be followed by another surge forward or a move back the middle of this trading range…we’ll just have to wait to find out.


Market Activity for May 12, 2009


A Tough Road for the Greenback

The dollar has had a rough run after hitting a multi-year high in early March. If the safety trade continues to recede the greenback will no longer benefit from the rush to own Treasury securities, but will be left to fundamentals -- and those fundamentals are ugly with a very easy Fed and massive levels of debt issuance coming down the pike. (There are only two ways to build a healthy and stable dollar value in a post gold standard world: there must be low tax rates on capital and monetary policy must be sound; the latter is not in play right now and the former will soon change for the worse)

As the greenie declines in value commodity prices will rise. As a result, the road to harmful levels of inflation may be shorter than most believe. Keeping an eye on the value of the dollar is essential and will prove to be one of the most accurate indicators of future inflation levels.

Trade Figures

The U.S. trade deficit widened a bit in March, but not because imports bounced back to positive territory (which would illustrate U.S. consumer and business spending have markedly improved); rather imports into the U.S. declined at a slower pace than U.S. exports declined during the month.

For the month, the deficit rose 5.5% but remains at a very low level, especially when one looks at the real (inflation-adjusted) figure excluding petroleum. (Funny how the same people who rail about trade deficits are many of the same who say we must continue to place restrictions on domestic energy production. If we didn’t need to import 70% of our petroleum-related energy needs, trade deficits would have been much narrower a few years back when the price of crude hit $145 – I’ve got a feeling we’ll have a date with déjà vu a year, 18 months outs; when economic activity bounces, the price of crude will push to $80, then $100)

U.S. exports fell 2.4% in March, following a 1.5% increase in February, and imports fell 1.0%, after a 5.1% decline in Feb.

While imports fell in March, the degree of decline was a huge improvement from the mid-to-high single digits of the previous five months. Nevertheless, a decline in imports, as mentioned above, means that consumers and businesses remained reluctant to spend in March – but no surprise there. The capital goods component of this data (business spending) fell another sharp 5.2% in March.

In terms of U.S. exports to regions and countries:

Export to Europe fell 17.8%, to Mexico down 14.5%, to Brazil down 18.4% and to the Pacific Rim down 25.4% -- China down 12.3%, Japan down 20.5% and Asia NICs (newly industrialized countries) down 34.5%. All of these numbers show trade activity remains very depressed, not the implosion of the previous several months but still extremely weak.

I put the China figure is bold because the rate of decline showed the largest improvement, coming off of 25% declines (again in terms of U.S. exports to the country) of the previous three months. China’s stimulus, virtually completely infrastructure-based in nature, will push commodity and overall U.S. exports to China higher over the next several months.

Budget Statement

The Treasury Department reported the first monthly budget deficit for April in 26 years, stating the shortfall came in at $20.9 billion, compared to a $159.3 billion surplus for the same month a year earlier – April, obviously, is usually a month in which the government books a surplus due to the jump in tax payments.

Fiscal-year-to-date (FYTD) the budget deficit sits at $802.3 billion, expected to hit $1.8 trillion, or 13% of GDP, when the fiscal year comes to a close in September – that will be more than double the previous post-WWII highs hit in 1983 and 1992. (The all-time high budget deficit-to-GDP ratio is 33.5%, which occurred in 1942 as we were financing the war)

Federal spending jumped 17.5% in April based on the year-ago period, while revenue (tax receipts) fell 34.1%. Corporate tax receipts, totaled $70.8 billion, a 58.6% decline from a year ago. Individual receipts came in at $566.4 billion, a decline of 24.2% from the April 2008.

I’m generally not a deficit hawk, simply because the budget shortfalls of the past 30-40 years have been completely manageable, averaging 2.4% of GDP – one only needs to look at average long-term interest rates during the last 40 years for evidence that our deficit spending has not been harmful. But when you get into the 10% deficit-to-GDP ratio range, harm will be done. These levels are not sustainable; they certainly are not conducive to a healthy dollar value.

And I don’t buy the argument that these deficits are short-term in nature, too much of the current stimulus spending will work its way into the budget baseline. In addition, there is an attempt to add a $1 trillion per year national health-care program – forget about the drug rationing and decision making by the government with regard to who gets care and when, we’re watching the Social Security and Medicare systems crumble right in front of our eyes, and still Washington wants to progress further along this entitlement road?

Eventually reality is going to confront Washington’s fantasy view of how the world works, particularly with regard to the affect massive increases in government spending has on the dollar, interest rates and economic growth. If we pass the next exit on this “Road to Serfdom,” it’s not going to be pretty.

Today’s Data

This morning we get mortgage applications for the week ended May 8, import prices and Retail Sales (both for April).

Retail sales will get the most attention as the market is intensely focused on consumer activity. The figure is expected to come in flat after a 1.2% decline in March. Watch for the number to beat estimates as Easter fell in April this year.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasurys were little changed today on mixed equity markets and Fed buying that went as expected. The two-year finished up 1/64 on the day, and the ten-year was lower by 2/32. The benchmark curve steepened by 2 basis points, and currently sits at +228.5 bps. A basis point represents .01%.

Fed purchased $6 billion in Treasuries maturing from 5/31/12 to 8/15/13. Cumulative purchases stand at $101.7 billion.

Inflation Expectations
Treasury Inflation Protected Securities (TIPS for short) are used by investors to hedge against the risk of inflation. They are backed by the full faith and credit of the US Government, just like regular (nominal) Treasurys, but instead TIPS pay a fixed real rate of interest on principal that is adjusted for inflation as defined by the Consumer Price Index (CPI). So when inflation increases so does the investor’s nominal return.
TIPS also play an important role in Inflation expectations. As investors become more concerned about inflation, the gap between the yields on TIPS and nominal Treasurys widens out. This gap is called the “Breakeven Rate”. The graph below shows the ten-year breakeven for the past 12 months.

The rate is forward looking, meaning that the 10-year breakeven is an estimate for average inflation over the next 10-years.

Notice that on 11/20/08 the 10-year breakeven actually went negative. Oil had dropped from $145 to below $50 a barrel, the credit markets had seized up following Lehman’s bankruptcy which halted production activity and the Fed had yet to begin its long-term securities purchases. As evidenced by the graph, deflationary concerns that were unreasonable even given the circumstances, have since been squashed.

I think TIPS remain a good buy. The quantitative easing efforts by the Fed have begun to work, but if we continue to be truly forward looking we can’t ignore the red flags. Congress would rather solve the problem by re-inflating the housing bubble instead of allowing the market to correct itself to a healthy sustainable level, and they appear to have the Fed’s services at their disposal in order to do so. Fed/Politician interconnectedness spells danger when it comes time to removing liquidity from the system and the result will likely be inflation.

I could definitely be wrong. If the Fed can return to a state of independence, and pull the extra liquidity from the market at the appropriate time, then above average inflation could not happen. I’m certainly not wishing for any monetary policy failure, but judging by what breakevens have done so far this year, I’m not the only one with these concerns.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

PFE, PFG

S&P 500: -0.89 (-0.10%)

Pfizer (PFE) +5.51%
Pfizer jumped on speculation the drugmaker may increase its dividend by mid-2010 and seek lower financing costs for its purchase of Wyeth. Pfizer’s stock had fallen 19 percent before today, in large part due to the dividend cut.

I am not entirely sure how Pfizer will get lower financing costs, but I do agree that a dividend increase is a strong possibility 12 to 18 months after Wyeth deal closes. Providing support for this argument is solid cost-cutting execution in Pfizer’s latest quarterly results, the expected revenues from the Wyeth acquisition, and robust cash flows.

Regardless of when Pfizer increases its dividend, the company is trading at a very attractive valuation with a dividend yielding over 4 percent. Pfizer’s valuation is well below its historical average, trading at just 7.7 times estimated earnings, which reflects the fact that Pfizer is no longer the growth story it was in years past.

Still, I expect Pfizer’s long trend of paying a growing dividend to continue as their robust cash flows quickly work down debt during the next few years. Whether or not they return to their growth-glory-days of the 1990s will depend on their management of a massive pipeline that is heavily-weighted towards early-phase drugs.


Principal Financial Group (PFG) -2.95%
There are few reasons to believe the investors’ appetite for exposure to the insurance industry is growing. First, Principal was able to price its shares at just a 3 percent discount, compared with the double-digit percentage discounts offered by lenders such as J.P. Morgan, Wells Fargo, and J.P. Morgan. Second, Principal managed to boost the size of the offering to just over 50 million shares from its original intention of pricing 42 million shares.

Credit Suisse estimates the $1 billion offering will dilute earnings per share by 15 percent, but the bolstering of the balance sheet is likely enough to keep any long-term overhang from inhibiting the stock.


Quick Hits

• Social Security Fund Will Be Depleted By 2037, Earlier Than U.S. Forecast
• Questions About Consumers
• Stress-Test Countdown: The Race to Market
• Soda Tax Weighed to Pay for Health Care
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks pulled back, unwilling to push above that 930 mark on the S&P 500 (the top end of this trading range is 930-935), as the market took an appropriate breather. The broad market had jumped 39.5% from the nefarious March 9 low of 666 after another powerful move last week, so we’re watching to see whether or not we remain capped in this range or break to higher levels; we should expect some sort of meaningful pullback no matter which scenario turns out to be the case simply following the degree of this now nine-week long rally.

Also hurting stocks is the fact that the broad market has moved to the highest valuations in seven months; the press was all over this story over the past couple of days and it no doubt increased concerns things have gone too far too fast.

We’ll add, the valuation on the NYSE has gone from what seemed to be a very opportunistic 10 times earnings back in March (and a dividend yield of 5.50%) to a very rich (especially for this market) 21 times trailing 12-month profits, at the present -- the yield does remains attractive at 3.99%. Stocks should, and no doubt will, pull back very soon as we’ve returned to levels that have removed worst-case economic and profit scenarios. Further, the Dow Transportation Average appears exhausted here, after a 60% jump from the low. This is an important index to watch as the overall market is unlikely to trade much higher if the trannies don’t.

Friday’s leadership were Monday’s laggards as financials, energy and industrial shares led the market lower. Telecom and information technology shares were the only two major S&P 500 industry groups to close higher, also a reversal from Friday.


Market Activity for May 11, 2009


Interest Rates and Fed Purchases

The yield on the 10-year Treasury note has blown through 3.00% (this support level broke down after the Fed decided to leave its planned purchased of Treasury and mortgage-backed bonds unchanged at $300 billion and $125 trillion, respectively). Many of you may recall our discussion explaining how the Fed’s planned purchases had placed a ceiling on rates as investors flooded back into the Treasury market each time that note hit a yield of 3.00%(and since the price of a bond and its yield are inversely related this level offered price support); based on those planned purchases, traders saw a quick and easy way to make some profits as prices would rally off of those levels.

Well, since rates have been heading higher over the past three weeks, don’t be surprised to hear the Fed announce it’s stepping up its purchase plans. We’ll watch the 30-year fixed mortgage rate for an indication that they’ll be moving in this direction. If that yield moves in on the 5.00% level and threatens to blow through it, they’ll very likely do so in order to move the rate back below 5%.

This will make it difficult for those who have made big bets that rates are going higher, at least over the next 12 months. But the Fed won’t be able to play this game for very long as they will eventually be over-whelmed by the market.

This action will also increase the odds that they, the FOMC, will not be able to manage policy around inflation trends. If inflation does become a problem (and I certainly believe the environment is set up for this scenario) they will hold off from attacking it – what does one expect them to do (especially since they are hardly independent of Capitol Hill right now), start taking away the quantitative easing by selling Treasury and mortgage-backed bonds? If they do rates will jump and it will not only shut down what may be a nascent housing rebound but also a rebounding economy by that time – quite unlikely that they’ll do so. Although, such action would be appropriate as we’ll at some point need to take our medicine, it’s only a matter of time. The economic recovery on the other side of this very likely double-dip will then have a shot at sustainability, but the not without additional trouble first.

For those confused by these remarks, what I’m saying is the economy will rebound, but will run into a wall of reality shortly thereafter – based on what we now know about policy (both monetary and fiscal). At which point, we should be prepared to deal with another downturn before the business cycle is allowed to expand with both vigor and endurance.

The Week’s Data

We were without a data release yesterday but we’ll get back to it this morning and round out the week with important figures.

Today: Trade Balance and Budget Statement.

We know things were weak as the first quarter came to a close, but it’s still worth viewing export and import trends within that trade balance figure – although next month’s release of the April figures will be much more important as it will set the stage for the current quarter’s trade picture.

We’ll also receive the monthly budget report for April, which is expected to show a pretty mild deficit. Good things too as we’re on pace to hit a $1.8 trillion shortfall for fiscal year 2009. If so, it will mark a deficit-to-GDP of 13%, more than double the prior post-WWII record of 5.6%.

Wednesday: Mortgage Applications, Import Prices and Retail Sales.

We’ll need to see another increase in mortgage apps and hopefully another increase in purchases – we don’t want it all coming from refis. If purchases pick up in this latest week, it will mark the first back-to-back increases since late March when the fixed rate made its move below 5.00%.

Import prices will be a non-event. It’s likely we’ll see another meaningful monthly increase (expected to come in at 0.5% after the same reading last month) but no one is paying attention until the main inflation gauges like CPI and PCE begin to head higher.


Retail sales will be a hugely watched number. We’ll need to see a positive reading after the March report and latest chain-store sales data pretty much crushed the thought that consumer activity was back.


Thursday: Initial Jobless Claims and PPI

PPI (producer price index) won’t get much attention, as touched on above, but the normal Thursday ritual that is jobless claims is one of the most important indicators right now. We need to see this reading move into the 500K handle – came close last week as the figure hit 610,000.


Friday: CPI, Empire Manufacturing and Industrial Production

CPI will get some attention as this is one of the main inflation gauges. We expect this reading to begin to slowly tick higher and accelerate by year end, driven by the energy component.


Empire manufacturing, while showing New York area factory activity contracted again in April, the pace of decline slowed substantially. We’ll need to see these manufacturing figures continue to progress to expansion mode, this will give the market some hope business equipment spending is on the rebound. The problem is the auto-sector woes will put pressure on the readings, thus we’ll need to pay more attention to what respondents are saying that the overall readings, which will be affected by the idling of auto-production and parts plants.

Industrial production had declined in 14 of the past 15 months, and the degree of decline over the past seven months has been one of the most severe moves in the post-WWII era – industrial capacity in use (utilization) fell to the lowest level since 1967. This number must show a rebound to positive territory or the equity markets will respond adversely.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasurys rallied today on a selloff in equities and some encouraging long-end buying by the Federal Reserve. The two-year finished up 11/64 on the day, and the ten-year was higher by 1&3/64. The benchmark curve flattened 3.5 basis points on the day, and currently sits at +226.5 bps. A basis point represents .01%.

With no new supply coming this week, Fed purchases stand to bring the market a little closer to equilibrium during the next few days. Treasury prices have been beaten down badly over the past two weeks – mostly due to investors stepping out and taking risk in other asset classes (corporate debt, stocks). However, if more money continues to flow out of the Treasury market, the Fed’s quantitative easing campaign won’t be nearly enough to absorb the rest of this year’s supply.

Fed purchased $3.51 billion in maturities ranging from 8/15/26 to 2/15/39. Cumulative purchases stand at $95.73 billion.

Credit
Microsoft sold corporate bonds today for the first time in the company’s history. The market for corporate bonds has followed stocks higher the past 2 months, while credit spreads tightened in, but Microsoft is a different animal. Microsoft’s $3.75 billion in five-, ten- and thirty-year bonds are expected to price at 95 to 105 basis points over Treasuries, or about 2.97%, 4.22% and 5.23% respectively. Microsoft currently has no debt outside of a $2 billion bank loan that comes due this year, and has a AAA rating. The rates Microsoft will pay on these bonds are just 40-50 bps more than Fannie Mae and Freddie Mac, who benefit from an explicit guarantee from the US Government.

According to data compiled by Bloomberg, $498.9 billion of investment grade debt has been issued so far this year, 25% more than the previous record for the same period set in 2007. Low absolute yields certainly make this market attractive to issuers. Investment grade spreads still remain pretty wide, but issuing debt at these interest costs can prove to be very advantageous for the long term. Especially for a company like Microsoft, who with this bond offer, will greatly diversify their capital structure. Whether they choose spend the cash to expand their business or to buy back stock at cheap level, this is a positive for Microsoft.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

INTC, PFG

S&P 500: -19.99 (-2.15%)

There was a lot of bearish (or less bullish) commentary today, which is appropriately reflected in today’s Quick Hits section. Obama’s proposed budget that projects a $1.841 trillion (!) deficit and changes to tax code also weighed on sentiment.


Intel (INTC) +0.52%
The Financial Times reports that Intel is on the verge of receiving one of the largest penalties in Europe for anti-competitive behavior after a near-decade long investigation into the group’s marketing practices.

The charges accuse Intel of abusing its dominant market position by offering illegal rebates to computer manufacturers, shutting rival Advanced Micro Devices (AMD) out of the market.


Principal Financial Group (PFG) -14.10%
Principal Financial announced it will be selling 42.3 million shares of its common stock. The offering will be worth about $1 billion, compared with the company’s current market cap of approximately $5.5 billion, and will be used for “general corporate purposes.”

CFO Terrance Lillis said investment losses in coming quarters will be “higher than normal,” as borrowers struggle to repay debts. Still, Lillis and several analysts have argued that market declines are overstating future losses on Principal’s fixed-income portfolio.


Quick Hits

• By Most Measures, Stock No Longer Look Cheap
• Merrill’s Rosenberg: Goodbye, Thank You, Yes It’s Just A Sucker’s Rally
• Sorry, We’re Still Screwed
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks gained ground on Friday after the official announcements on bank stress tests suggested the capital needs were not as bad as believed and the Labor Department stated fewer jobs were lost than expected.

I’m not sure the optimism was full justified, however. The stress tests are a political joke in my view and the employment report was far from good, which we’ll get to below.

On the banks, while they remain more than “well capitalized” for now, they have quite a road ahead of them as consumer default rates continue to rise and it’s early days for commercial real estate delinquency and default rates.

The banks have gotten a bad rap with regard to capital as the government has tried to change the way that capital is counted, but they were also able to convince the Fed to scale back capital deficiencies. In short, it seems kind of reckless to recommend an investment in bank stocks merely because of these stress test results; there’s simply too much game playing. All you have to know is that the industry is going to have to deal with a high level of non-performing loans for an extended period. While the very positive yield curve helps them to offset these losses (they will be very profitable on the interest-income side as they borrow near zero and lend at 5-6%) but that will not remain in place for much longer than a year, if I had to guess; at which point, they will be dealing with a yield curve that may not be so accommodating.

That said, financials were the best performing sector on Friday. The other market-beating sectors were energy, industrials and basic materials – the reflation trade.

Tech-related sectors, information tech and telecom, were the only two of the major 10 S&P 500 industry groups that failed to close to the plus side.


As we’ve talked about on several occasions, the top end of this trading range is 935 on the S&P 500. It will be important to watch whether or not we hit a wall at 930-935, or we go on to make a higher range.

The broad market has just completed another week of big gains, up 5.9% -- the S&P 500 has increased in eight of the past nine weeks and is 39.5% above the March 9 low.

Market Activity for May 8, 2009


April Employment Report

The Labor Department reported that payrolls declined 539,000 in April, which was well below the 600,000 expected. This lower-than-expected reading was accompanied by a downward revision for the prior two months – 66,000 worse than previously printed.

The economy has now shed 5.7 million payroll positions since January 2008, nearly half of which has occurred in the last four months.

The bulk of the losses occurred in the manufacturing and trade&transportation components of the survey.

The thought that the worst has been seen is probably correct, but it’s really tough to have conviction on this point as the decline in payrolls was cushioned by a large 72,000 gain in government jobs (most of which were due to hiring for the 2010 census – obviously very temporary positions).

Goods-producing sectors shed 270,000 positions. The construction component cut 110,000, a bit below the three-month average of -119,000. The manufacturing component slashed 149,000, also a bit better than the three-month average of –163,000.

Service-producing industries cut 269,000 positions. Trade and transportation jobs were reduced by 126,000; business services cut 122,000 positions and retail shed 47,000 positions – all of these were also a bit better than the three-month average of losses

Education and health continues to be the only component that has yet to show a monthly decline during this 16-month labor-market contraction. The segment added 15,000 positions in April.

Again, the government added 72,000 jobs and 66,000 of those was for the 2010 census. Take that number out and total payroll losses for April would have outpaced the estimate of 600k by 5k.

The unemployment rate rose four ticks to hit 8.9%, the highest since September 1983 – although back then the number was falling from the high of 10.8%.

U6 -- another measure of unemployment that includes those counted in the headline unemployment rate, plus marginally attached workers (those who want a job and have looked for one in the past 12 months but have not searched during the four weeks prior to this data report, and thus not counted in the headline figure), plus those working part-time for economic reasons (they can’t find full-time work so settle for part-time) -- fell to15.4% from 16.2%. While very high, it’s a good sign to see this figure halt its march higher. This is about the only good news of the report.

The average duration of unemployment continued to rise in April, up to 21.4 weeks from 20.1 in March.

The number of long-term unemployed (those jobless for 27 weeks or more) jumped 498,000 to 3.7 million – 27% of those officially termed unemployed.

Since we’ve hit 8.9% it seems the peak forecast for joblessness is 10% -- which is the number we’ve seen the Fed throw around. The jobless rate has been known to rise an additional percentage point, even as the jobless claims figures comes crashing lower.

Now, we haven’t yet seen claims plunge, they have eased from the peak hit four weeks ago, but the precipitous decline in claims that occurs as the economy rebounds certainly has not yet begun. It also seems to me that when the economy does begin to add jobs again it will be so in a very tepid way – there will be a lot of headwinds still to deal with even when GDP returns to the plus side. But still, it seems a number very close to10% unemployment will be where we peak out, based on what is currently known

And this all brings us to the productivity number we touched on in Thursday’s letter. If employers remain very cautious with regard to adding jobs when growth returns, this means shorter-term productivity will improve substantially – output will meaningfully outpace hours worked.

What does this mean? It means that corporate profits will surge. The question is: If the economy does rebound in a healthy way, as Fed monetary policy remains extremely easy (and combines with nearly a trillion in additional government spending) will it send commodity prices significantly higher and crimp that profitability as a result?

This is one more reason current policy makes the environment of investing, in my opinion, feel like crossing a road in which you’re not quite sure the traffic signals are in sync. Does that “walk” signal truly mean that that monetary and fiscal policy 18 wheeler, carrying all of its potentially adverse ramifications in the trailer, will stop? In which case, you are free to venture down the road of multi-year returns. Or will it blow right through and flatten you if the appropriate level of caution is disregarded?



Have a great day!


Brent Vondera, Senior Analyst

REIT and Bank rally continue

S&P 500: +21.84 (+2.41%)

REITs
REITs have rallied hard as investors perceive that fresh capital will lead to stabilization of balance sheets, guaranteeing that the companies raising money won’t go bankrupt (see: General Growth Properties). In 2009, REITs have raised $10.6 billion from share sales.

Many believe that REITs are building war chests that will allow them to make opportunistic acquisitions of properties from struggling rivals. Still, building a war chest comes at a price, and in the case of these public stock offerings, that price is the dilution of current holders’ interests. The concern seems negligible when market values have swelled by two-thirds in the span of four weeks, but perhaps will become more of an issue if the rally runs out of steam.


Banks still rallying
Lenders are scrambling to raise cash, with several banks already raising capital through equity sales. Adequate capital or not, these shares have been in high demand this week.

Bank shares may be receiving a boost from long-only mutual funds that have very little exposure to the sector, and thus are rushing to add them before they disclose their holdings at the end of the month.

Also helping bank shares is the government’s commitment to not let any of the banks fail. This was the big concern when banks hit their lows in March. Now, it seems that investors are only focused on dilution risk since many firms will raise capital by offering new common equity or converting existing preferred shares into common shares. But, the real concern should be exposure to commercial real estate and credit card debt.


Peter Lazaroff, Junior Analyst

Fixed Income Recap

Treasurys corrected a little today after the shellacking they took this week. The two-year finished up 1/32 on the day, and the ten-year was higher by 13/32. The benchmark curve flattened 4 basis points, and currently sits at +230 bps. A basis point represents .01%.

We finally get a break from supply until the end of the month. CPI comes at us on Friday, and is expected to be flat on the headline number and +.1% ex food & energy. Any surprise higher could cause another selloff in the long end.

Credit
Financial Institutions must show the ability to issue debt not guaranteed by the FDIC under the Temporary Liquidity Guarantee Facility in order to be allowed to repay TARP. (This is just one of the few requirements released so far.)

Morgan Stanley and Bank of America did just that this week, giving the banks a little taste of how valuable that guarantee has been to them over the past 6 months. BAC and MS will pay 7.52% and 6.08% respectively for 5-year debt, (537.5 bps and 3.90 bps over Treasurys), a considerable premium over where they were issuing TLGP debt. This is a good sign, showing investors are willing to again take risk, but financial industry credit spreads remain very wide compared to the rest of the market.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Daily Insight

U.S. stocks pulled back from a four-month high as declines in bank, telecom and basic material shares put pressure on the broad market. It appeared we’d be off to the races again yesterday morning, after the latest data on initial jobless seemed to confirm what yesterday’s jobs data suggested -- that we’ve seen the worst of the labor market weakness – but things fell apart about 90 minutes into trading. Stocks had to take a breather eventually after the run we’ve seen and that is probably what the sell-off was all about.

The traditional areas of safety were the outperformers yesterday as health-care, utility and consumer staples were the only S&P 500 sectors that managed to close on the plus side.


Market Activity for May 7, 2009


Chain Store Sales

The International Council of Shopping Centers released their latest look at year-over-year retail sales, showing sales at stores open at least a year rose 0.7% during April. This marks the first monthly increase since September.

However, despite posting the first positive print since the economic world changed seven months ago, the results pretty much smoked the idea that consumer activity is back. The figure was boosted by increases in discount and drug store sales, but apparel store sales fell 2.7% (a really bad number for April), department store sales declined another 10.5% and luxury sales plunged 19.6% -- this segment has posted double-digit declines each month out of the past seven and at least a 17.5% drop in all but one of those months. Maybe we’re getting closer to that income equality some have been desiring.

Jobless Claims

The Labor Department reported initial jobless claims fell 34,000 to 601,000 for the week ended May 2 – the expectation was for a 4,000 increase to 635,000. This is the closest we’ve come to the 500K handle and thus suggests we’ve seen the worst the labor market has to offer. Make no mistake, the job scene is not only tenuous but remains very weak; however, we have to move in steps and this is an important first step.

The four-week average of initial claims fell for the fourth week in a row – the last two readings being the meaningful declines. The figure fell 14,750 to 623,500, the lowest level in nearly three months.

Continuing claims, on the other hand, have yet to halt their march to new record levels rising another 56,000 to 6.351 million. One of the next steps in this process is for this figure to halt making news highs. No one should expect it to improve markedly, but the new high scenario will have to end.

The insured unemployment rate (the jobless rate for those eligible for benefits, and a figure that closely tracks the direction of the overall unemployment rate) ticked up another 0.1% to 4.8%.

So now we wait for the official jobs report for April; we get it this morning at 7:30CT. Everything surely suggests its going to show a much better-than-expected reading. The market expects a decline of 600,000 payroll positions, it may post something in the -450,000 to -500,000 range.

Productivity

The Labor Department also reported that worker productivity (the measure of output per hour worked) advanced 0.8% at an annual rate last quarter, beating the 0.6% expected. Compared to the first-quarter of 2008 (the 0.8% figure just mentioned is measured on a quarter-over-quarter basis at an annual rate) productivity grew 1.8%. This is substantially below the 2.5% annual rate since 1995 and the nearly 3% during the 2001-2007 period.

Overall, productivity readings are not all that meaningful during downturns – that is, the reading does not give one a good sense of where productivity is going over the next, say, year simply because the figure generally gets a boost from cost cutting.

In fact, a reading of 0.8% is pretty weak for this stage in the business cycle, it usually hits 3%-4% simply because firms cuts jobs to a greater degree than production is reduced – productivity is measured by dividing output by hours worked; when firms cuts jobs obviously the denominator is going to fall, thereby boosting the whole number. This low level of productivity shows just how massively production was cut, especially since we know firms slashed jobs at an alarming rate. Firms cut hours worked at a 9% pace during the first three months of the year (biggest drop since 1975), exceeding even the large 8.2% decline in production.

What’s most important is where this figure is headed over the next few years and I’ve got to say it may have a tough time meeting the level we’ve enjoyed over the past 20 years.

Productivity improvements are essential because it allows firms to absorb costs, therefore they do not have to pass all of their input costs on through prices. This helps to keep inflation at bay and drives living standards higher via higher real (inflation-adjusted) incomes – real wages are dependent on the marginal productivity of labor. Productivity is driven by innovations and innovation needs seed money to bring these technological advances to market. If policy drives tax rates to a range that lowers after-tax return expectations, capital may just steer clear of the more risky areas of the capital markets – areas that provide the seed money for innovations.

Now, technology has been put on such a tremendous roll over the past two decades, it will take quite a tax-regime wall to stop it. The point is we must be very careful in this regard because we can, at the margin, do meaningful harm to productivity – and thus real wages and living standards over time.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

The two-year finished down 2/32 for the day, and the ten-year was lower by 1&10/32. The benchmark curve steepened 15 basis points, and currently sits at +234 bps. A basis point represents .01%.

Today’s 30-year Treasury auction confirmed the fears of many traders who kept bonds from rallying earlier this week on speculation that demand for the long bond would not be met. $14 billion in new 30-year Treasuries were issued today to wrap up the government’s refunding activity for the month. The bid/cover ratio on the auction was 2.14, well under the 2.4 from last month’s 30-year auction, and came in at a yield of 4.288% compared to a 4.205 market rate before the auction. The 30-year bottomed out at a yield of 4.309% shortly after results were released, but rallied to end the day at 4.303%.

Stress Test

Below are the official results of the Treasury’s Supervisory Capital Assessment Program (SCAP). They are more or less in line with what has been leaked the past few days, except for PNC and Morgan Stanley who were previously expected not to need any.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Who will replace GM in the Dow Jones Industrial Average?

S&P 500: -12.14 (-1.32%)


Who will replace GM in the Dow Jones Industrial Average?
GM’s place in the Dow is, by no surprise, in jeopardy. It represents only 0.2 percent of the price-weighted measure used by the Dow, which makes GM as important to the Dow as Ryder System Inc is to the S&P 500. (Click here for the list of Dow companies)

John Prestbo, executive director of Dow Jones indexes, said yesterday: “There are two choices for GM: bankruptcy or increased government ownership. Both of those events are negative for continued membership. Definitely the trend is in the direction that would force us to remove it.”

So if GM is out, who is in? According to the Dow Jones website, the Dow is intended to “provide a clear, straightforward view of the stock market and, by extension, the U.S. economy.” This would make Ford Motors a logical choice so that the index maintains its exposure to the auto industry, but this seems unlikely given Ford’s still-low share price ($6.26).

After glancing at some companies with big market caps and ruling out all financials – there are already four in the Dow and the timing would be rather inappropriate – it seems that Apple, Cisco Systems, or Google would be the logical choices. Broadly speaking, Apple gives the index more consumer exposure, Cisco Systems gives the index exposure to the internet, and Google gives exposure to advertising.

FedEx or UPS could get the call since both stocks are considered to reflect the overall health of the economy. Another possibility would be Lockheed Martin, which would give the index more exposure to the defense sector and government spending – maybe they should just add the U.S. Treasury to the Dow.

Of course, Citigroup could become a candidate for removal if the government ends up with a controlling stake in the bank making the options more interesting – Wells Fargo or Goldman Sachs could suddenly become candidates.

What do you think?


Quick Hits

• GE to Spend $6 Billion on Health Care by 2015, Double Research
• The Preferred Answer to Stress Tests
• Still Waiting for Stock Picking
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks resumed their roll after preliminary reports on the job market suggested the decline in April payrolls will be meaningfully lower than what’s been expected. Orchestrated leaks regarding the bank stress test results (although the official numbers are not scheduled for released until today) also seemed to help the broad market as bank stocks rallied – even banks that were reported to have the need to raise substantial amounts of capital participated in the upswing.

Stock-index futures were down meaningfully yesterday morning, but reversed course when those preliminary reports on the employment situation were released. That data was the main driver, even for the banks, as less severe job losses will certainly show up in lower levels of consumer credit default rates.

But the stress test leaks also helped. Initially, I found the way the bank stocks rallied on the stress test news stunning. The firms that were stated as not needing new capital were not expected to need it, so no upside surprise there; the banks that were reported to have need to raise additional funds will have to do so in a way that dilutes the shareholder (converting preferred shares to common). If that’s not enough, the White House spokesman stated the administration may choose to remove the management from certain institutions – this degree of government control wouldn’t seem to be market friendly but hey, maybe the market is beginning to embrace the socialist tendencies. I’m obviously being facetious here.

But then we learned of the type of preferred shares the Treasury Department has magically created: mandatory convertible preferred shares – talk about financial engineering. Remember, yesterday we mentioned the government would seek to minimize the concern that they’ll have more control over the banks (as a result of the conversion to common, which has voting rights, from their current preferred-share stakes. Well, this is how they are doing it. These mandatory convertible preferred shares will convert to common shares only as capital is needed – very fancy legerdemain. This may be what sparked the rally in banks, the fear of government control has eased a bit. Personally, I remain skeptical; Washington will continue to direct the way in which banks compensate top employees and provide loans, I don’t think they’ll be able to resist.

Financials and energy were the best performers – a reversal from yesterday when they were the biggest drags on the broad market. Energy stocks got back on their horse as the price of oil shot up 4.45% to blow past the $55 per barrel handle.

The traditional sectors of safety, healthcare and utilities, were the laggards.


Market Activity for May 6, 2009


More on the Stress Tests

The government says the banks that they deem deficient of capital must develop a plan to raise additional funds by June and implement that plan by November. From there they must keep their Tier 1 capital ratio at a minimum of 6% (Tier 1 being the traditional measure of capital adequacy until the government changed the rules of the game to also include Tangible Common Equity, which does not count preferred shares as capital) and TCE at 4% through 2010. Just for color, Bank of America has a Tier 1 ratio of 9.15% right now.

I’m not sure the banks will actually devise a real plan now that we’ve got the spiffy new mandatory convertible preferred shares – it’s really so sweet if you think about it; a government official, say Mr. Geithner, can just make up a new security. But from an investors standpoint it kind of feels like you’re walking across a busy street blindfolded.

This whole game is going to be very interesting to watch. The government says certain banks are deficient capital, yet at the same time they state they must lend – in fact Barney Frank and Co. call bank executives up to Capitol Hill for the explicit purpose of vilifying them in front of the cameras for taking government money while not lending to a degree at which Mr. Frank thinks is appropriate.

The economic environment is still quite fragile, delinquency and default rates continue to climb. Therefore, if banks are going to guard capital then lending activity needs to slow. Bank managers understand this; investors who provide much of the funds essential to keep the lending channels flowing understand this. Government officials do not care to understand this, it’s all of sophistry and pretense to them. This is why when the government decides to push the market aside and allocate resource as they see fit, bad things occur. This indeed will be very interesting to watch unfold. I shouldn’t be this negative as the stock market moves higher, but it just feels like something isn’t quite right.

Mortgage Applications

The Mortgage Bankers Association reported their mortgage apps index for the week ended May 1 rose 2% after the 18.1% decline in the prior week. Purchases jumped 5.0%, marking the first increase in a month, and refinancings increased 1.2%.

Refis continue to dominate the index, but make up just 75% of the total (down from 80% that had been the average for a while) thanks to the nice gain in purchases. Fixed mortgage rates below 5% will certainly help activity over the next few months, but the job market will have to improve markedly before a substantial rebound occurs.

Challenger Survey

The Challenger Job Cuts Announcement survey stated U.S. layoffs increased 47% from the year earlier, down from the 180% increase posted in March.

Firing announcements rose 132,590 compared to 90,015 in April 2008, according to Challenger. Automotive, retail and financial sectors led the cuts. While this rise in job cut announcements is a big number, this is a massive improvement from the huge increase we’d seen over the previous few months.


ADP Report

In another preliminary employment survey, the payroll services firm ADP stated the economy shed 491,000 payroll positions last month (it was forecast to show a decline of 645,000) – again, while this is a huge level of job losses it is also a serious improvement from the 650,000-740,000 decline in payrolls over the last five months, if this survey is measuring things accurately – it’s been a darned good indicator of late so there’s little reason to believe it’s off by a wide margin.

If these two numbers are in the ballpark, we could be setting up for a much better-than-expected April jobs report from the Labor Department on Friday. The consensus estimate is for another 600K decline in payroll positions. If we get a decline of just 500K, as ADP is suggesting, that would be a very nice sign that the labor market has seen its worst and is stabilizing – albeit at very depressed levels – and should provide the impetus for stocks to go meaningfully higher as the market has been expecting worse. Conversely, this also sets the market up for a major disappointment. If what we saw in the preliminary readings fail to show up in Friday’s official numbers…look out.

Following the last two monthly employment reports we’ve talked about how the rate of job losses will ease. U.S. firms have shed jobs for 16-striaght months and the losses have been huge over the past five months – 75% of the 5 million jobs lost over the past 12 months has occurred since October. This pace cannot last, although my view was that it would take another few months before the improvement began to show up. It may be occurring sooner than that.

Initial jobless claims will remain a very important figure to watch, we get the latest reading this morning. Jobless claims continue to show that the labor market is very fragile and we’ll have to see this number move solidly into the 500K handle (last post was -631,000) to provide complete evidence the labor market has stabilized and improve in such a way that we reduce the losses to 300,000-350,000 per month..

Have a great day!


Brent Vondera, Senior Analyst

The two-year finished flat on the day, and the ten-year was lower by 1/64. The benchmark curve was unchanged on the day, and currently sits at +219 basis points. A basis point represents .01%.

The Fed submitted bids to buy 22 different Treasury notes as was only successful in buying $6.9 billion of one issue. On a normal day, news like this would roil the market for Treasuries. But help from a well bid Treasury ten-year auction and stress test results, it was largely ignored.

The Treasury auctioned $22 billion in new ten-year notes with a bid/cover of 2.47 and yield of 3.19%. Primary dealers in the US dominated the auction for the second time in a row as the indirect bid, foreign investors and central banks, fell to 18.7% from 31.9% in the previous ten-year auction.

Stress Test Results

Although the stress tests aren’t due to be officially released until tomorrow, results are being leaked left and right. Here is what we know as of Wednesday afternoon.

Bank of America, who needs $34 billion, leads the pack. According to most analyst SunTrust needs some but no numbers have been disclosed, the Treasury told Regions they will definitely need some but wouldn’t give them an amount, and Citigroup needed $10 billion this morning but now only needs $5 billion and thinks KeyCorp will need some. Confused yet?

This is such a mess. In addition to the results being leaked left and right and private analysts being confused with anonymous Treasury sources, there is nothing new about these capital needs. Every one of these companies, with the exception of Met Life, has received a preferred stock investment from the government through TARP. The government has simply switched their preference from preferred equity to common equity, and will officially disclose common equity needs tomorrow ignoring what the company may have already received through TARP.

Bank of America for example received $45 billion in preferred equity from the government. The $34 billion listed in the table ignores that number, and only means that the government would require B of A to convert $34 billion of government’s preferred stake to common equity to satisfy the regulators “ratio du jour” - Tangible Common Equity. Tangible Common Equity is more stringent than traditional capital measures and places a premium on common equity over preferred. “We think we are fine, but it’s now out of our hands,” Bank of America CEO Ken Lewis said at the company’s annual meeting last week. I think that pretty much sums it up.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Stress test results are leaked

S&P 500: +15.73 (+1.74%)

Stress test results
Although the results are to be officially announced tomorrow, the stress test results were slowly leaked throughout the day. The leaks were greeted with cheers as the additional capital needed by the nation’s lenders was not as extensive as some had feared. Investors may also be taking comfort in the fact that some of the uncertainty that has plagued the banking sector is dissipating.

The Fed is expected to direct about 10 of the 19 banks undergoing government stress tests to boost capital so they can withstand losses in a worse economic environment. Those that are deemed to need additional capital will get six months to raise that money, which will likely come from private equity placements, a public stock offering, or a conversion of government-owned preferred shares into common equity.

Those that do not need additional funds include:

• Goldman Sachs Group
• Morgan Stanley
• MetLife
• JPMorgan Chase
• Bank of New York Mellon
• American Express
  

The banks that do need are additional funds include:

• Bank of America - $34 billion
• Citigroup - $5 billion or $10 billion (depending on the source)
• Wells Fargo - $15 billion
• GMAC - $11.5 billion.
• Regions Financial - unknown
  

Garmin (GRMN) -14.93%
Garmin’s first-quarter sales and profit trailed analysts’ estimates, hurt by declining orders for car-focused gadgets. Revenue from the automotive unit, which accounted for more than half the total, declined 43 percent. U.S. car sales dropped 34 percent in April, the 18th consecutive monthly decline.

Portable internet devices and smartphones, which have access to GPS, remain a long-term threat to Garmin since they are a convenient and more economical substitute to Garmin’s automobile and outdoor products. Garmin continues to develop a smartphone, although this is a notoriously difficult market to crack and the launch date has been pushed back several times.

At this point, however, the portable internet evolution is too callow to cast off the navigation device maker and Garmin’s shares should benefit from an increase in auto sales.


Harris Corporation (HRS) -8.02%
Harris fell after reporting a 27 percent decline in orders due to reduced government purchases, which led Harris to reduce its revenue expectations for 2010.

CEO Howard Lance described the reduced government purchases as a delay and expects several hundred million dollars in radio orders eventually will be received. Lance continued that beyond fiscal 2010, the company is well-positioned to return to growth.


Transocean (RIG) +2.22%
Transocean easily beat first-quarter earnings estimates as a 17 percent drop in operating costs offset weaker oil and gas prices. The results reflect the steadying influence of the firm’s largely contracted rig fleet.

Sticking to its commitment to reduce debt from the GlobalSantaFe acquisition, the company paid down nearly $600 million in debt during the quarter. Management indicated that the free cash flow from its backlog is more than adequate to repay its debt maturities as they come due over the next few years.

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks held in there pretty well yesterday, giving back very little of the prior day’s strong session. Traders were probably unwilling to take additional positions directly ahead of the official bank stress test results due over the next couple of days and the employment figures for April. A better-than-expected reading from the latest service-sector survey kept stocks from falling further.

Ten stocks fell for every seven that rose on the NYSE. Some 1.4 billion shares traded on the Big Board, roughly in line with the three-month daily average.

Energy and financial shares led the declines – financials ahead of the stress test announcement and energy stocks were held back by a decline in the price of oil after a five-session jaunt that pushed crude for June delivery up 12%.

Health-care and industrial shares outperformed, as measured by the S&P 500 indices that track these components. There seemed to be some sector rotation going on, out of financials and energy and into pharmaceutical stocks.


Market Activity for May 5, 2009

Bernanke Testimony

Federal Reserve Chairman Bernanke, in comments to the Joint Economic Committee of Congress, stated the recession appears to be losing steam, with growth likely to resume later this year on the back of higher household spending, a bottoming in the housing market and an end to inventory liquidation. He warned though that the recovery may be slower than usual and the unemployment rate may remain high for an extended period as businesses remain cautious about hiring and business investment remains weak.

This possible lack of activity with regard to the business side is the correct concern. Specifically, business spending on capital equipment must reverse course; we’ve seen this figure rebound over the past two months off of very depressed levels, but that bounce has been slight. Before touching on the business side though, I’m not sure his relative optimism on the consumer is justified. We’ll see intermittent pops in consumer activity but one should not expect a sustained improvement – the consumer still has to deal with large amounts of debt that are tough to manage now with the labor market in the shape it’s in and incomes flat – not to mention the declines in stocks and houses that have the consumer appropriately shy of engaging in much consumption. These debt levels were quite manageable when the unemployment rate hovered around 5% and incomes were growing at a nice clip (and rising investments boosted confidence) but that has all changed.

As a result of this scenario, we will rely on business spending to augment growth. However, as government has inserted itself as the economic driver this may actually have an adverse effect on business activity over time. We will most likely see a two-three quarter jolt in GDP as firms increase production in order to rebuild stockpiles after massive liquidation (the inventory dynamic we often refer to) and the government’s additional billions in spending kicks in. But the government cannot create aggregate demand, no matter how many Keynesian economists say it is so – if this were true, central-planning economies would be the beacons of economic virtue instead of the slow-to-no growth baskets cases they are in reality. Therefore, it will be difficult for sustained growth in GDP if the government effectively crowds out the private sector.

Substantially higher levels of spending and debt mean that taxes will rise and the debt issuance to provide immediate funds for that spending must be purchased – both remove funds from the private sector spending pool. In addition, this activity also has the potential to cause firms to hold back as higher tax rates reduce confidence in future economic activity, and thus firm’s sales growth forecasts. If the policy were focused on reducing tax rates (on capital, labor income and corporate profits) we’d have a much better shot of businesses boosting plant, equipment and inventory spending in an aggressive manner – they have the means. But this is not the case.

Bernanke is right to have focused his caveat on the business side – we will depend on this segment of the economy greatly over the next couple of years. Let’s hope the government’s actions do not scare business into prolonged caution.

Earnings

First-quarter earnings season, while posting big declines, has come in better-than-expected. Even as S&P 500 profits are down 32% (that’s from the year-ago period with 80% of firms reporting thus far), 68% of companies have beat expectations with 26% missing and 6% reporting results that are in line. The longer-term average for the positive/negative reading (positive being those that beat, negative for those that miss) is 59%/24%, with 17% meeting estimates.

The fact that some economic readings suggest the worst in certain areas of the economy have been seen, along with historic levels of cash in this zero interest rate environment, have been main contributors to the rally of the past couple of months; certainly the scenario that roughly 70% of S&P 500 companies have surpassed even very weak estimates has played a major role as well. We shouldn’t get too carried away, estimates were pathetically soft and this is true for second and third-quarters profits, expected to decline -38% and -30%, respectively. Nevertheless, the market has found reason to celebrate the worst-case scenario that was being priced in back in February and early March has not come to fruition.

We have many issues to deal with still, those touched on above along with rising consumer default rates, the commercial side of the mortgage market is only in its early stages of deterioration and (as discussed yesterday) every action that the government engages in has to be viewed as having a consequence that the market will have to deal with in the not-too-distant future. One of the main consequences may be levels of inflation. A harmful inflationary event will have to be met, at some point, by tighter monetary policy. This means we’ll have higher interest rates and higher tax rates combining at the same time – not exactly a mix that augments economic growth, just the opposite in fact.

But for now we should celebrate the market rally and the fact that first-quarter earnings have come in at better-than-expected rates on the whole.

ISM Service-Sector

The Institute for Supply Management reported its service-sector survey rose to 43.7 in April (42.2 was expected) after posting 40.8 for March – this indicates the non-manufacturing sector contracted at a slower pace than the month prior. I was thinking this reading had a shot of hitting 45.0, which would have been very positive for stocks, but we’ll take these smaller steps toward the 50 level. (50 is the dividing line between expansion and contraction)

I don’t think we should expect an uninterrupted march to expansion mode, the trend to that reading may prove choppy (much like the pullbacks in Feb. and Mar. after the Dec.and Jan. readings looked to suggest we were going to move up consecutively from the November low). Still, we should be able to move closer to the 50 mark over the next four months – assuming nothing changes for the worse during this time. A move above 45 when the May figure is released will be convincing.

The new orders (both domestic and exports) sub-indices of the survey offered encouraging signs regarding the next couple of months.

The new orders index hit its highest level since September.

The new export orders gauge jumped too; still in contraction mode, but barely.

Unfortunately, the employment gauge remains deep in contraction mode, but this will be the last of the sub indices to improve.

This morning we get preliminary reports on the April jobs situation. Two surveys, one from outplacement (finding people new jobs) services firms Challenger, Gray and Christmas and the other from payroll services firm ADP, will offer a decent glance of how Friday’s official jobs report will turn out. So the market will be focused on those readings.

Too, we’re getting reports that Bank of America will need $34 billion in new capital, as determined by the government’s stress tests and this may very well put pressure on market as the, in my view, stupid and unnecessarily damaging decision to switch the measure by which capital adequacy is determined may wreak havoc. That is, regulators are now using what’s known as tangible common equity as the way to count capital, moving away from the historically used measure of Tier 1 capital – the former excludes preferred shares, the latter includes it. This will have investors worried about conversion from preferred shares to common shares and the dilution and increased government power within the banking industry that will result.

That Challenger Job Cuts survey is just out and it showed that year-over-year job cuts rose 47%. This may sound bad, and it is, but it is a huge improvement from the 180% increase the figure posted in last month’s reading.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries were down today despite the selloff in equities. The two-year finished the day down 3/64, and the ten-year was lower by 2/32. The benchmark curve was flatter by 2.5 basis points on the day, and currently sits at +219 basis points. A basis point represents .01%.

Today’s auction was well received but the market didn’t react to the results as expected. The three-year Treasury came in at a yield of 1.473%, lower than the market rate of 1.476% just before the auction. The bid to cover was 2.66 and the auction was dominated by bids from primary dealers in the US, all considered to be good signs. However, supply fears took over as the day wore on. Traders all but ignored today’s activity and turned their attention to the ten- and thirty-year auctions later this week.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

HOLX, PFG, EMR, WAG

S&P 500: -3.44 (-0.38%)


Hologic (HOLX) -20.19%
Hologic missed earnings estimates as a result of significant write-downs to goodwill, but much of the disappointment was in response to delay in the U.S. launch of its Tomosynthesis mammography system.

The company said it would postpone its filing for next-generation imaging device with U.S. health regulators, which was proposed for June 2009. The approval of the tomosynthesis product is expected to be a key growth driver in the Breast Health division, which accounts for more than half of Hologic’s revenues.


Principal Financial Group (PFG) +10.75%
Principal blamed the decline in profit on lower asset valuations, including the impact of “significant equity market declines.” Specifically, Principal said its assets under management tumbled 22 percent from a year ago to $236.6 billion.

Looking to address balance sheet concerns, Principle said it increased its position in highly liquid assets by 76 percent to $5.8 billion and boosted its cash and equivalent holdings by 141 percent to $2.7 billion. Principal noted the earnings power of their three key retirement and investment products, which generated $6 billion of sales on a combined basis in the first quarter.

Because Principal is highly sensitive to the equity markets and the economy, they will continue to face tighter liquidity and depressed earnings in coming quarters. Still, the company has one of the most valuable franchises in the life insurance industry, while its core fundamentals of its pension and asset management businesses are still largely intact.


Emerson Electric (EMR) -1.50%
Emerson’s fiscal second-quarter profit fell 32 percent on slumping sales and a stronger dollar, though the earnings quality was strong – as is usually the case with Emerson.

CEO David Farr doesn’t expect a full recovery in their business to occur until 2011, as end-market demand recovers slowly in Europe and North America. Nevertheless, Emerson reaffirmed its 2009 earnings outlook. The company also said it will not deviate from its plans to acquire complementary businesses and expects to spend about $1 billion on takeovers this year.


Walgreen (WAG) -0.32%
Walgreen posted a 5.7 percent jump in April same-store sales, versus consensus estimates of 4.5 percent, aided in large part by the Easter holiday.

Pharmacy script growth of 4.2 percent was the strongest result reported since July 2007, as the industry continues to benefit from cycling Zyrtec’s shift to over-the-counter and an unusually high number of safety concern issues.

The impact of swine flu in the front-end (hand sanitizer, masks, etc) and pharmacy (Tamiflu, Relenza) was only 20 basis points.


Quick Hits

• Company Balance Sheets: The Sensible Giants
  
  

Peter Lazaroff, Junior Analyst