Daily Insight

U.S. stocks wavered between gain and loss for the entire session on Wednesday as investors were torn between better-than-expected earnings reports (with the exception of the day’s financial-sector results) and the concern that a new wave of commercial real estate defaults would roil the markets – in the end the broad market closed fractionally lower.

Bernanke, for a second-straight day, addressed the commercial real estate topic stating that the Fed is carefully monitoring the situation. This, along with rising credit-card defaults (which hit a new high of 10.76% in June) are topics we’ve addressed as significant challenges for the financials system. For now, a very positively sloping yield curve (nearly the steepest on record) is helping banks offsets these drags, but I question it will be enough.

Energy was the worst performing sector as the weekly energy report showed a smaller-than-forecast decline in crude inventories. Consumer discretionary and tech shares were the top performers on the session. The NASDAQ Composite, led by those tech shares, rose for an 11th straight day.

Market Activity for July 22, 2009
Federal Housing Finance Agency’s Home-Price Index

The FHFA released its home-price data for May, showing prices rose 0.9% -- down 6.5% over the past year. This gauge shows the degree of decline as much milder than the other home-price figures are showing.

Case/Shiller, for instance, has prices down 18% (although this index is weighed down by areas that had the highest level of speculation during the boom and hence the most foreclosure activity in the bust; the index is also value-weighted so high-end homes have a larger effect – the FHFA index is equally weighted). Existing home sales out of the National Association of Realtors has prices down 16% over the past 12 months. The FHFA figure is a very broad look at the housing market, however it does miss the high-end home market as it does not capture jumbo mortgage properties. Basically, we like to average these three for a clearer picture – doing so results in a 13% decline in home prices, on a 12-month basis.

In terms of region, prices rebounded by the most on the West coast, up 2.7% in May, and New England showed the weakest results, down 2.0%. Home prices rose 1.4% in the Southeast and were up about 0.8% in the Midwest.

Mortgage Applications

The Mortgage Bankers Association reported that their mortgage apps index rose for a third-straight week in the period ended July 17, up 2.8% after a 4.3% advance in the previous week.

Purchases rose 1.3% after a 9.4% decline in the week prior, while refinancing activity rose 4.0% – the third-straight increase – even as the rate on the 30-year fixe mortgage rose to 5.31%. Back in April and May when the 30-year fixed rate moved below 5%, refinancing activity jumped; activity would suddenly cease when the rate moved back in the 5% handle. Now, borrowers are more willing to get refis done and the trigger point seems to be something closer to 5.30% now as many probably fear they won’t get a shot at sub-5.00% again.

The average loan size fell to $218,700 from $226,500 in the week prior and is down from $250,000 at the end of last year. Refinancing activity accounted for 55.5% of the index in this latest week.

In other mortgage-related news, the Washington Post reported that Freddie Mac will pick up the closing costs (up to 3.5% of the sale price) on the purchase of foreclosed properties. In addition, as part of their “Smart Buy” program Freddie is offering a two-year warranty on the home’s plumbing, a/c and heating systems, and appliances (water heaters, stoves, washers/dryers and dishwashers). This applies only to primary residencies, and to homes selling out of Freddie’s own foreclosure inventory. Oh, the plan also includes discounts on replacement appliances of up to 30%, and 15% on installation costs.

As we talked about when the agencies upped their refinancing LTV requirement to 125%, stating that this is a sign the government will take it to another level in using Fannie and Freddie to spark home buying and put the taxpayer on the hook for many more costs (as if they need more), it appears the great minds in government are just getting started in sticking it to people who have conducted their lives in a relatively responsible manner. And speaking of great ideas…

Government-Run Health Care

House Majority Leader Steny Hoyer left open the possibility that Congress may wait until after the August recess to vote on health-care legislation, as we briefly touched on yesterday. If they do, it would potentially be a serious positive for longer-term growth. There is opposition building as people learn more about the specifics and waiting certainly decreases the likelihood of passage.

Maybe some do not see the connection between this legislation and the economy.

First off, this additional financial burden (on top of the Social Security and Medicare time bombs) is hardly a necessity even if it were a smart thing to do – the actual number of uninsured Americans is much lower than the scaremongers incessantly state. Of the supposed 45 million uninsured, 10 million are eligible for either Medicaid or SCHIP but do not sign up – doesn’t matter anyway because these programs are available at the point of service so they are covered. Another 17 million live in $50,000-$75,000 households – these are people who can afford catastrophic insurance at a minimum (probably a lot of young people who simply prefer to go without) and half of those within this segment are transitory uninsured, meaning they lose their jobs and their health plan too, until they get a new job. Then you have another 5-8 million who are not even Americans, but the quacks that cause the uproar over the uninsured have to add in illegals to make the number sound scarier. This leaves us with about 12 million truly uninsured, and even these people cannot be refused care. While 12 million is a big number, one has a hard time finding a reason to venture down this government health-care road at the harm of everyone else. (These numbers are according to the 2007 Census Bureau report: “Income, Poverty, and Health Insurance Coverage in the United States.” the Heritage Foundation, and the Kaiser Family Foundation)

Now that that is out of the way, back to the economic harm of it all. To put it simply, our budget is already burdened in a structural way with enormous costs that will be harmful to both economic growth and the value of the dollar. The increase in tax rates alone in order to pay for this monstrosity would be the concrete boots that drown this economy over several years. Not to mention the damage this does to the American principle of self-reliance (however much of it is left anyway) – a principle that in the past has kept government spending at bay in terms of its percentage of GDP. If we add on another several hundred billion to a trillion dollars in government spending, especially via borrowing, you can forget about purchasing power of the dollar moving in the right direction. Let’s hope this thing that even the President admitted on Tuesday he had not read (there are a couple of competing bills), goes the way of the ash heap.


Have a great day!


Brent Vondera

Quick Hits

• Goldman Sachs Pays $1.1 Billion to Treasury, Handing Taxpayers 23% Return
• Goldman Sachs Internal Memo
• Bernanke Takes Message, Shows Exit to the People
• On the mend: The Fed’s chairman talks up the economy
• Bears: Correction Coming This Fall
• What went wrong with economics
• Taxpayers Inferior to Shareholders

Pfizer's cost cutting ability leads to upside guidance

Pfizer (PFE) reported second quarter profit that beat expectations and boosted its 2009 profit view based on slightly higher revenue expectations and lower cost projections. Pfizer has historically shown great ability to lower costs, which makes me confident they can meet their new earnings goal.

Revenue during the quarter fell 9.4% to $10.98 billion, essentially all due to currency changes. On the operating side, Pfizer was able to reduce COGS, marketing and administrative costs, and R&D as a percentage of total sales. Gross margin improved 290 basis points to 84%.

Pfizer’s $65.64 billion acquisition of rival Wyeth (WYE) remains on track to close this year, but still requires U.S. antitrust approval. Pfizer, like much of the rest of the pharmaceutical industry, is trying to cope with decreasing revenue from patented drugs and difficulties developing new drugs.

Pfizer is acquiring Wyeth to gain access to fast-growing biotechnology drugs and vaccines as the world’s best-selling drug, Lipitor, faces patent expiration in 2011.
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Peter J. Lazaroff

St. Jude's largest segment has abnormal rhythm

St. Jude Medical (STJ) reported profit grew 14% and revenues were up 4%, both in line with the Street’s expectations. The medical-device company tightened the high-end its full-year sales forecast, but held its full-year earnings projection in place.

What really concerned investors today – the stock is down more than 9%– was that St. Jude lowered the top-end of revenue guidance for heart-rhythm devices such as pacemakers and defibrillators. This business segment, which makes up nearly 62% of total revenue, also reported considerably lower revenue growth compared to the last two years.

On the bright side, St. Jude reiterated its profit guidance for the full year, and gave a third-quarter forecast that was in line with estimates. The company also said it authorized a buyback of up to $500 million in stock.
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Peter J. Lazaroff

Some Specifics on CIT’s Emergency Funding from PIMCO and Friends

The interest rate for the 2.5 year loan is set at 1000 bps over Libor, with Libor floored at 3%. That means the rate will be 13% annually, payable monthly, and will increase only after Libor rises above 3%. Libor is currently at .5%.

CIT will pay a 5% commitment fee when they draw on the funds. This amounts to the lenders buying a 13% floating rate bond at a 95 dollar price. Which comes out to a 15.4% yield at the current coupon.

The loan to CIT is collateralized with assets with a book value of at least 5 times that of the funds drawn from the facility and the collateral must maintain a fair value of 3 times that of the loan. This part of the agreement makes the emergency loan essentially risk free for the lenders. If CIT defaults, the lenders will receive the collateral, which I would assume the lending group would be alright with considering those terms.

Talk about being desperate. This deal sounds better than the Treasury’s Super Senior Preferreds.

Cliff J. Reynolds Jr., Investment Analyst

Boeing reports decent results

Boeing (BA) second-quarter results beat expectations with profits jumping 17%, reflecting a year-earlier charge and strength at its defense business.

Boeing said it has identified a “technical solution” to the problem that caused the Dreamliner’s fifth delay and said an updated schedule will be released sometime in the third quarter. The Seattle Times reported today that the maiden flight is four to six months away, according to unidentified engineers with knowledge of the problem. The newspaper said Boeing must redesign the area where the 787’s wing joins the fuselage, and parts are difficult to install on the test planes that already have been built.

Revenue and total commercial airplane deliveries were roughly flat in the quarter, but the second half numbers should look strong due to very easy comparables (due to last year’s machinists’ strike). The defense business saw revenues rise 9% and operating earnings grow 38%, with growth in all underlying segments.

Operating cash flow totaled $1 billion during the period, marking a reversal of an operating cash outflow in the same quarter last year. Total company backlog fell 3% sequentially as Boeing continues to eat away at this large buffer – the commercial airplane segment’s backlog of $257 billion is still more than seven times annual segment revenue, however.

Given the well-known challenges with its commercial and defense markets, Boeing’s results should be viewed positively.
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Peter J. Lazaroff

Daily Insight

U.S. stocks bounced between gain and loss several times yesterday but closed on the plus side even after pretty negative comments on the economy from Fed Chairman Bernanke. Earnings results, although very weak and revenues hammered, are beating estimates and this may have been what lifted stocks in the end. The gain pushed the broad market to a post-Election Day high.

The big earnings news of the day seemed to be Caterpillar’s results. The heavy-equipment maker whipped analysts’ estimates, even as earnings per share fell 58% from the year-ago period and sales plunged 41%. The firm raised its full-year earnings forecast (I’m not sure you can actually call their very wide range of $1.15 - $2.25 per share much guidance) as even the low end of this range is above the previous forecast of $1.12. Cat stated global stimulus plans (namely out of China) will help results. The news boosted basic material shares, and this is why you want to own the sector, or names related to it.

Health-care shares led the advance with utilities, energy and the aforementioned materials recording a nice session too. There is a possibility that Congress will wait until after the August recess to vote on health-care legislation. If they do, it decreases the chances of passing as the longer this thing sits out the worse it looks. It’s probably not a coincidence that health-care shares led the broad market higher.

Advancer just about matched the number of shares that declined on the Big Board. Some 1.1 billion shares traded on the NYSE Composite – the three-month average is 1.3 billion per day.

Market Activity for July 21, 2009
Bernanke Testimony

The Fed Chief was on Capitol Hill yesterday testifying before Congress on the state of the economy and shedding some light on the FOMC’s exit strategy -- the process of unwinding the unprecedented monetary easing they’ve been in engaged in for 18 months now.

Rather than getting into the specifics of the tools by which they’ll be able to tighten, and they are many, let’s just say it may prove politically difficult for the central bank to remove much of this liquidity as the unemployment rate is likely to remain elevated for a prolonged period – and that political battle will be fought both within and outside of the Fed system. He’ll have to battle those on the policymaking committee who depend on the unemployment rate to drive their decision-making process and those in Congress who will also put pressure on the Fed to keep monetary policy loose if the jobless rate remains heightened ahead of elections in both 2010 and 2012 – that is if Bernanke is even around by that time, he’s up for re-appointment in January 2010.

At least the Chairman does acknowledge inflation expectations to be a risk in the not-too-distant future, which is more than one can say for a number of FOMC members who believe price levels cannot rise when economic slack is this large. By slack we mean high unemployment and low plant use. The Chairman did downplay inflation concerns in the near term.

On current policy, Bernanke said that the economy remains too weak to start tightening policy and that despite improvements the fed funds rate will remain near zero for an extended period. He seemed to concentrate on the potential for commercial real estate default rates to cause another blow to the system, which is a topic we’ve mentioned several times over the past few months. The Fed Head also mentioned that household spending remains a key risk because of continued job losses and falling home values. And speaking of the consumer...

Consumer Activity – Don’t Count it to Lead the Economy

Monday night I listened to an economist (one of reasonable prominence) who was saying consumer activity was coming back just like nearly every other business-cycle turn from contraction to expansion. The person interviewing him stated that private sector incomes are stagnant to falling, isn’t that going to keep activity depressed? The economist stated that this is always the case at the end of recession, and this doesn’t stop the consumer from releasing pent up tendencies to purchase, they’ll do the same this time.

Yes, it is true that incomes go stagnant – even short-term negative – at the end of recession and into the next expansion. Incomes do not rebound quickly, just as job creation lags. Nevertheless, I just don’t see how one can count on consumer activity rebounding in a sustained manner.

Why is it different this time? The reasons are copious. Consumers generally have access to fairly easy credit (very easy credit coming out of the previous downturn), but this is hardly the case this time. Further, it is extremely unusual for stocks to fall to this magnitiude (currently the S&P 500 is 40% off the peak and down 57% at the March 9 nadir) and also for falling home prices to beat the consumer into submission.

Before continuing on, let me explain to relatively newer readers that I was the guy ripping on the inaccurate “consumer is tapped out” phrase back in 2004, and then again in 2005 and 2007 when the term made a comeback. Nothing could have been farther from the truth. Expectations that tax rates would remain low were high, credit was easy, the unemployment rate stood at 5% and real income growth was solid. Also, home prices were flying and stocks were back to record highs (the wealth effect was rolling!).

But today we have not one of these factors helping out. I’m not going to say the consumer is “tapped out” but it will take some time to get things right again, dealing with the debt levels that a low interest rate environment encourages is difficult to manage around with incomes, stock/home prices and unemployment all tugging in the wrong direction. Oh, and I wouldn’t rule out a large increase in the social security cap, which would result in easily the largest tax hike in history. And this is a job killer too, don’t forget that a higher cap on FICA taxes raises the cost of employment. This makes resurgence in consumer activity all the more unlikely.

As a result, we are going to see personal consumption as a percentage of GDP move back to 65% (the historic average) from the current 71% -- this will be a huge drag on economic growth. This will not be a consumer led recovery; it will be a statistical recovery by which some inventory rebuilding takes place after record-setting liquidations and exports add to growth as they easily outpace import activity. But the inventory dynamic is more of a short-term pop than something that lasts for years and export-driven GDP advances results in fairly low levels of growth.

By 2010, we will then have the government side of GDP helping out (that’s when the bulk of the stimulus program is released), but this nearly trillion in spending has the chance of crowding out the private sector as funds are sapped from businesses, workers and investors via higher tax rates. Therefore, it may very well work against itself.

The Dollar

One final comment, speaking of export activity helping to drive GDP, White House Chief Economic Advisor Larry Summers made comments over the weekend on how the U.S. needs to drive policy in a direction so to fire up exports. The market reads this as a weak dollar policy – and this is a terrible message to send to trading partners as you can bet that export-driven Asian economies will now have a reason to drive their currencies lower, this is how trade wars get started.

For sure the market is getting the message, as traders drive the greenback down again; the Dollar Index is back below 80. The Bush administration did a terrible job managing the dollar’s value, and certainly easy Fed policy did the most damage. One would hope for a turn in direction here but its going to be a while until sensible dollar policy returns, it seems.


Have a great day!


Brent Vondera

Fixed Income Recap

Bernanke’s comments, beginning with his op-ed that was published in yesterday’s Wall Street Journal and continuing into the early afternoon with his testimony on Capitol Hill, sent Treasuries higher and rates lower.

The Fed Chairman stressed the wide range of tools available to the Federal Open Market Committee including beginning to liquidate their portfolio of Treasuries and MBS, cutting back their lending facilities such as TALF, and entering into reverse repo agreements that pull money out of the system. Bernanke also discussed a new tool the Fed has at their disposal. In the fall Congress gave the Fed the authority to pay interest on reserves that banks are required to hold at the Federal Reserve. That rate is currently in line with Fed Funds (.25%), but can be adjusted to persuade some banks to either hold more than the required amount at the Federal Reserve or charge more on loans they make. Either of these outcomes would result in a contraction of money. Bernanke again said, “The FOMC anticipates that economic conditions are likely to warrant maintaining the federal funds rate at exceptionally low levels for an extended period”, maintaining the stance that although there are many things the Fed can do to pull back liquidity, they don’t plan to do anything for some time.

Bernanke of course did a little self glorification, citing the alphabet soup of programs like TALF, MMIFF, TSLF and CPFF. I agree that the financial landscape as a whole looks much better than it did last fall, but at times the programs appeared less like a series of calculated steps and more like the Fed was blindly throwing handful of darts at the board, and then cheering when one stuck. Many will argue that all of the programs were necessary. Others will say that programs like TALF will never reach their lofty goals, ($1 trillion anticipated vs. less than $30 billion done so far).

Bernanke’s speech quelled inflation concerns a bit as TIPS breakevens eased and the curve flattened. The risk still lies in the Fed’s ability to ratchet back the liquidity at the right time, both in term of using their tools effectively and being left to act independently.

Cliff J. Reynolds Jr., Investment Analyst

Quick Hits

• The Fed’s Exit Strategy
• America is for now still blowing bubbles
• Ten Questions on the Health-Care Overhaul
• Harvard’s Feldstein Sees Risk of ‘Double-Dip’ Recession in U.S.
• The Bank Profits That Weren’t
• The $23.7 Trillion Question: Treasury Calls Figure ‘Inflated’

FCFS cashes in on Mexico

Pawn shop operator and payday lender First Cash Financial Services (FCFS) posted a 42% increase profits, helped by higher revenue from its Mexico pawn operations, and reaffirmed its 2009 profit outlook.

U.S. payday loan revenue fell 10% for the quarter and the company is investing more in their pawn operations as stricter regulations and rising unemployment make payday loans less attractive.

Pawn revenue from its Mexico operations rose 31% to $40.2 million and U.S. pawn revenue rose 4% to $30.1 million. Because access to consumer finance is limited in Mexico, the country has a huge market for pawn lending. In addition, Mexico’s culture is more accepting of these types of lending arrangements than the U.S. The company said it is on pace to meet its target of 55 to 60 new store openings in Mexico during 2009.

First Cash’s older and more mature network of operations in Mexico allows them to capture more growth than their competitors. Management expects the new and existing store base in Mexico to be a strong source of revenue and profit growth for years to come.
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Peter J. Lazaroff

Quest Diagnostics (DGX)

Quest Diagnostics (DGX) reported that profit grew 17% in the second quarter as the diagnostic testing company improved margins and revenues. Cost cutting efforts, positive revenue mix, and the increased Medicare fee for lab testing contributed to higher prices and improved margins.

A 4.6% increase in pricing per test drove the 4% revenue growth in clinical testing, which accounts for about 91% of total revenues. Testing volume declined 0.6% year-over-year as drug-abuse testing tumbled 24%. This drop-off was expected since drug-abuse testing is highly sensitive to hiring and companies are ordering fewer drug tests for new employees. Excluding drug-abuse testing, testing volume grew 1.1%.

Quest raised its 2009 earnings projections citing increased demand for testing for cancer, sexually transmitted diseases, and allergies. We can’t expect pre-employment drug screening to rebound in the near-term, but at least we know that Quest can grow revenues and profits in a difficult environment.

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Peter J. Lazaroff

UnitedHeath Group (UNH) tops Street's view

Higher premiums and growing Medicare enrollment helped UnitedHealth Group (UNH) beat analysts’ estimates and the health insurer raised the lower end of its 2009 forecast. Profit of 73 cents a share was more than double the prior-year number; however, earnings only improved 8% when excluding the prior-year charges including a legal settlement. (Still a solid improvement, but it’s necessary to clarify.)

Revenues rose 7% to $21.66 billion, despite a 5.5% yearly decline in commercial membership. Revenue growth was driven by pricing increases as well as membership gains in the government business (Medicare and Medicaid).

The medical-loss ratio – the percentage of premium revenue used to pay patient bills – rose to 83.6% from 83.2% a year earlier. Medical expenses are watched as an indicator of future industry profits. The uptick in the medical-loss ratio was a result of increases in costlier Medicare and Medicaid patients, as well as increased illness due to the H1N1 swine flu virus.

While UnitedHealth had a good quarter, but the reliance on government business raises caution and might deter excitement about this outperformance. The government business could be less profitable for the company in the long run as payments from their government plans are expected to fall.

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Peter J. Lazaroff

Lockheed Martin (LMT) disappoints

Lockheed Martin’s (LMT) profit fell 17% on pension-related charges and delays (due to protests) to three of its largest new information contracts. The quarterly profit decline is Lockheed’s largest since a 25% drop in the third quarter of 2003. Despite challenges, Lockheed remains on track to meet sales and earnings targets for 2009.

Revenues posted a slight gain of 1.8% to $11.24, but higher costs caused gross margins to decrease by 180 basis points. Sales increased at two of Lockheed’s four businesses, information systems and aircraft, and declined at the other two, electronics and space.

Lockheed is the first of the five largest U.S. defense companies to report earnings this quarter. The defense industry is coping with changes in the U.S. defense budget, with some programs still up in the air. Lockheed has already gotten backing for its biggest program, the F-35 Joint Strike Fighter, which will account for 10% of sales this year and could make up 15% to 20% of revenue in the next five to seven years.

These results were not what the market was looking for, but at least Lockheed was able to maintain its financial guidance, primarily because of the size and breadth of their portfolio.
Another positive is that Lockheed continues to generate strong cash flows, $2.4 billion in the second quarter, which the company expects to continue using for repurchasing shares, paying dividends, and making acquisitions.

Lockheed has a bit more expensive valuation relative to its peers, but this pull back may present a nice opportunity to invest in the largest defense company in the U.S. Check out my March 5 post, which has many of the reasons I like Lockheed as a long-term investment.

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Peter J. Lazaroff

Cost-cutting, not revenue growth boosts earnings

As I sat on my couch eating Honey-Nut Cheerios and watched earnings releases from Caterpillar (CAT) and United Technologies (UTX), among others, it occurred to me that many companies thus far were beating earnings expectations on cost cutting rather than sales growth. Apparently Brent noticed the same thing as he was writing today’s Daily Insight.

To echo Brent’s comments, expectations are extremely low and it would be nice to see more revenue growth in these reports. Of course, we don't view these cost cuts as a bad thing. After all, this is what a business cycle is all about. Companies trim fat during a downturn so that they are more efficient and productive when the expansion phase of the cycle returns. It’s pretty obvious that the second-half will have easier comparisons and those companies that have trimmed excesses will post nice profits.

What should raise red flags are companies that are not aggressively trying to reduce costs. It is crucial for companies to be as lean as possible going forward – especially with the growing fear of a “double-dip” recession, or W-shaped recovery.

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Peter J. Lazaroff

Caterpillar surges for second straight day

Profits at Caterpillar (CAT), the world’s largest maker of bulldozers and excavators, fell 66%, but still crushed expectations as cost cutting offset a disappointing 41% slide in revenues.

Yesterday, shares advanced 7.83% on an analyst upgrade that called a bottom for the construction market. The analyst predicted Caterpillar’s second-quarter results would mark the bottom for the company’s machinery unit and the engine segment will stabilize in the second half of 2009.

Today, shares are marching higher on optimism from management and upside guidance. CEO Jim Owens sees “signs of stabilization” as stimulus programs and improved credit markets helped stabilize demand.

The company raised its full-year forecast to $1.15 to $2.25 a share, above analysts’ average estimate of $1.12. Sales will be from $32 billion to $36 billion for the year, in line with the average estimate of $34.8 billion.

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Peter J. Lazaroff

United Technologies beat estimates by a penny

United Technologies’ (UTX) cost-cutting efforts helped second-quarter profit dropped 23% to $1.05 a share, beating estimates by a penny. As the recession impacts the markets for aerospace and building-construction products, UTX cut its full-year revenue and lowered the top end of profit guidance, but both cuts are in line with analysts’ estimates.

Revenues decreased 17% to $13.2 billion, short of estimates, with revenue at the company’s heating and ventilation-systems business (Carrier) falling 29% on a slide in commercial new-equipment orders. Carrier accounts for about one-fourth of UTX’s annual revenue. The only one of UTX’s business divisions to post sales and profit growth was the Sikorsky helicopter unit.

The company said restructuring costs hurt profits by about 22 cents a share during the quarter. Excluding restructuring costs and a non-cash gain from an Otis joint venture, all of UTX’s segments had operating margins of more than 10%. Currency effects – overseas sales account for about 60% of revenue – reduced profit by 11 cents a share.

CEO Louis Chenevert said orders remain lower than UTX anticipated, but “the rate of decline in orders across the businesses appears to have stabilized.” He added that he saw acquisition opportunities this year, especially in aerospace and the highly fragmented fire-security industry.
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Peter J. Lazaroff

Daily Insight

U.S. stocks kept the rally alive, as the broad market added to last week’s gain, up 8% now over the past six sessions. The major indices began the session higher on the news that CIT was able to find a private-sector rescue, and building on this momentum after the June index of leading economic indicators increased for a third-straight month.

Real quick on CIT, basically they are going to need the FDIC and Federal Reserve to offer them an exemption so that they can transfer funds from the holding company to the bank. This $3 billion in financing the company has just received isn’t going to do much good with $8 billion in debt coming due in 2010. With the exemption, CIT will be able to use deposits to fund assets, largely with regard to their factoring business – factoring refers to the receivables that they own; basically, they buy receivable accounts from manufacturers, pay the manufacturer cash and collect the payments when the customers pay, plus the fee from the manufacturer for the immediate cash payment. Funding is needed for this and since their commercial paper funding has dried up, having the ability to use deposits to fund these operations is about the only thing that will keep CIT from bankruptcy. This is where the big bondholders come in. Many of these investors are politically connected, and now that they have even more money at risk with this additional $3 billion in financing they’ve provided. I’m going to bet they’ll convince the Fed and FDIC to offer the exemption – call me a cynic but I doubt this additional money would have been put at risk without the belief that they (the big bond players) would be able to persuade the authorities, if you will.

Also helping to boost prices was Goldman Sachs’ call for 1060 on the S&P 500 by year end – increasing their target from 940. I see that Credit Suisse has also upped their target this morning to 1050. These are very typical target-price increases, the big investment banks have a track record of increasing forecasts when things are running. I recall Goldman’s target price for oil of $200 per barrel last July when crude hit $140. Point is, while 1050-1060 is not out of the question – although I find it hard to believe and also pretty unjustified for the broad market to trade at 19-20 times earnings in this environment – don’t expect it just because the big guys are saying it.

The S&P 500 marched past the 946 hurdle yesterday (which had been a seven-month high) closing within two points of the post-Election Day high of 953. This time around the trailing P/E on the index is a bit richer at 15.3 times vs.13 back in November – although we’re naturally closer to a rebound in profits at this stage. We expect a statistical recovery to begin this quarter, likely the first positive GDP print in a full year by the time it is reported in October, and higher profits should result three-six months later. (My concern is that those results will prove short-lived as the direction of policy will do its best to choke off a nascent rebound). For now though, stock have momentum working, even the Dow Industrials have gone positive for the year.

Consumer discretionary shares led the rally, with basic material and industrial shares close behind. All 10 major industry groups closed to the plus side; the relative losers being traditional areas of safety, namely health care and consumer staple shares – it was only two weeks ago in which these safety trade sectors were in vogue. How quickly things change these days.

Market Activity for July 20, 2009
Early Excitement

This latest rally in stocks is largely on early profit reporting (just 20% of S&P 500 members have reported thus far) as 75% of firms have beat expectations – the longer-term average is closer 65%. But these are very low-quality earnings, the expectations bar is set very low. A couple of examples are yesterday morning’s release out of Johnson Controls (JCI) and last week’s results from Intel.

JCI stated operating earnings per share easily beat the expectation for 19 cents a share as actual results came in at 27 cents. However, this result means profit is down 64% from the year-ago period; revenue was down 30% and missed expectations. In terms of Intel, the chip giant reported earnings per share of 20 cents, which blew by the eight-cent estimate. Still, earnings were off by 31% from the year-ago period. Heck, DuPont’s results are just out this morning and their numbers easily surpassed the estimate by 15%. However, this number is 48% lower from the year-ago and next quarter’s figure is expected to be off by 44%. Revenues were down 22%.

Another thing to consider is a number of important industries that will post the largest profit declines have hardly reported. Energy profits were crushed in Q2, and just one of the 40 S&P 500 members within the industry has reported. Industrials were hit especially hard as well, probably showing 35%-40% decline in bottom line results; just seven of the 58 members in this industry have reported. Then we have basic material shares, hammered by the plunge in commodity prices and very soft mining activity. These firms ramped up production due to the commodity-price spike of last year, but couldn’t possibly adjust to the speed at which activity shut down – that destroys profit growth. Only 15% of these companies have reported. These three industries make up 25% of the S&P 500. Throw in financials (now your up to roughly 40% of the broad market) where only 16% have reported, and with earnings are on pace to decline 45% we’re looking at some real weakness.

As we’ve talked about many times now, earnings are beating expectations as the cost-cutting that has taken place was more massive than analysts calculated. Cost-cutting is a good thing and an essential aspect of economic downturns. Streamlining makes a business more sound and leads to higher profit results over the longer term, but we need to see final demand make a comeback and that means top-line growth, which we are not even close to seeing.

I just don’t think stocks have much more upside potential here (which absolutely does not mean prices won’t go higher, but in my view it will be unjustified) until we see improvement in revenue results and better-year-over-year bottom line growth, which is likely a ways out still. You’ve got to be careful not to chase these rallies, be patient and wait for your spots. High-powered profits may very well present occur a couple of quarters out (and that may be too optimistic) as the degree to which payrolls have been cut almost guarantees it, especially as year-ago comparisons will be much easier to beat. But this market is mercurial to the extreme and if the current earnings season fails to surpass expectations by the time all reports are in… well that’s why its important to pick your spots in these trading-range environments.

Leading Economic Indicators (LEI)

The Conference Board’s LEI index (a gauge that is supposed to predict economic activity six months out) increased for a third straight month in June, up 0.7% after strong readings in the prior two months of 1.3% and 1.0%, respectively. The components that contributed most to the last month’s reading were building permits, interest-rate spreads (the yield curve) and stock prices.

While seven of the 10 components rose in June, just like on earnings, I’d caution from making too much of this trend.

Building permits were the biggest contributor to LEI, accounting for a third of the index’s gain. When one factors in the high level of home supply and the likelihood that home sales (due to tough labor market conditions) are not likely to be sufficient to absorb this supply anytime soon, I don’t think we can count on residential building construction to propel this figure higher in a sustainable manner.

The interest-rate spread (much lower short-term rates than long term) component accounted for half of the gain in June LEI and a third of the May and April gains. The spread we often talk about is that between the 10-yr and 2-yr Treasury notes, which remains near a two-decade high (it may be an all-time high) of 275 basis points hit in late May. The actual spread measured by LEI is that between the 10-year and fed funds, which is ultra wide since the FOMC has pushed fed funds to essentially zero. While this spread is undoubtedly very helpful for growth, it is also a function of the Fed holding the short end very low. This spread is always a function of Fed policy, so no difference in that respect, but I don’t like to see the LEI index as dependent on this one component as it is today. Surely the ability for banks to borrow low and lend much higher is a huge incentive to make loans. But let’s not forget that it’s not only about the supply of loans, but the demand for credit is soft. Firms continue to cancel projects, there are fewer business upstarts and credit standards are much tighter – and appropriately so. Even a massively upwardly sloping yield curve can’t fix this, only time can mend this situation.

Then we have stock prices, which accounted for 15% of the pick up in LEI (so these three components were responsible for 98% of the June increase), and with the activity we’ve seen over the past several months – rallies met by subsequent weakness that has kept us range bound – it’s tough to view stocks as an indicator that economic conditions have changed to an environment in which we’ll see the typical business cycle expansion.

What’s more, what I consider one of the most important components of the index (orders for business equipment) declined in June. As business managers have expressed via earnings reports, firms continue to delay equipment purchases and one should be concerned this trend will continue as economic policy (specifically higher tax rates on small business) is not inspiring the outlook for growth over the next two years. This component has to rise in order to confirm what LEI is suggesting.

All of this said, a rising LEI is certainly better than it declining, as it did in 16 of the previous 18 months prior to this three-month trend higher. However, as we’ve expressed a number of times, one needs to be carful here as the normal indicators may not be as reliable as is usually the case. In a letter back June I stated that June will be the month by which the NBER (official arbiter of the business cycle) marks the end to this recession. We may have to push this up to July or August, but when they do call it one of these months will mark their end date. However, things may remain quite soft even as we do rebound because we see the eventual expansion as a statistical bounce off of very low levels of activity. The economy will have to deal with a few serious drags on growth, specifically consumer activity that will take an extended period of time to come back.

Caterpillar is just out with earnings results as I type. The heavy-equipment maker destroyed the estimate, reporting 72 cents per share vs. the 22-cent estimate. This has turned stock futures to positive territory. Cat’s year-over-year results are down 58% and revenue was crushed, off by 41%.



Have a great day!


Brent Vondera

Fixed Income Recap

Treasuries started the morning lower but finished yesterday higher on a market oddity that follows large corporate debt issuance. Companies will either short Treasuries or enter into interest rate swaps in order to hedge against the risk of rates rising from the time the company decides to issue bonds to when the bonds actually price in the market. When a large amount of hedges are unwound all at once, it can have a material impact on the market. Short-staffed trading desks due to the vacation season exacerbated the move upward.

Atlanta Fed President Dennis Lockhart spoke yesterday on the Fed’s exit strategy, saying, "One should not assume at this point that extraordinary measures to shrink the balance sheet are required to contain inflationary pressures." Bernanke is scheduled to start two days of testimony today, where he is likely to continue the same sort of message. Although the minutes from the previous FOMC meetings show some member’s hesitation to increase lending and securities purchase programs, according to public statements by Lockhart and other Fed presidents a tighter overall policy is still a ways off. We will be listening to Bernanke’s comments closely to see if any more insight is given by the Fed Chairman.

Cliff J. Reynolds Jr.

Quick Hits

• 7 Reasons Why Housing Isn’t Bottoming Yet
• Quiz: Some Surprising Trends in Global Aging
• U.S. Bailout Costs May Reach $23.7 Trillion, TARP Inspector Says
• Why Toxic Assets Are So Hard to Clean Up
• America is for now still blowing bubbles
• Bernanke May Hold Rates Down by Showing He Can Reverse Course
• U.S. Economy: Leading Index Shows Recession May Be Nearing End

The Always Improving Market of Credit Default Swaps

The cost of protecting bonds against default has improved greatly, and is essentially back to pre-Lehman collapse levels. Of the 125 companies represented in the index below, CIT is the most expensive, it will cost you $400k per year to insure $1mm in CIT bonds against default for five years. Other names that remain elevated include AIG ($160k/year/$1mm notional), GE Capital ($38k/year) and MetLife ($51k/year). Just for a comparison, the cheapest bonds to insure are those issued by AT&T ($2k/year/$1mm notional).

This weekend, CIT used a lifeline and phoned their friends, or a mobile shout out for those of you who prefer Cash Cab over Millionaire, but the CDS market didn’t even flinch at the possibility of CIT’s default. A good sign? Depends on how you look at it. From one perspective, perhaps CIT’s bankruptcy would be inconsequential to the market as a whole and the system could keep on its current path. Or maybe our memories are just too short for us to be worried about what could still become the fifth-largest bankruptcy in US history.

Cliff J. Reynolds Jr.

Cost cutting helps JCI get back in the black

Auto-parts and heating-systems maker Johnson Controls (JCI) reported fiscal third quarter earnings that topped expectations, as cost cutting initiatives partially offset lower-than-expected revenue.

Sales in the auto-parts division fell 38% to $3 billion, while the battery division revenues fell 39% to $856 million because of fewer orders from automakers. Johnson Controls gets 55% of its revenue from auto-parts and batteries units.

The rest of the company’s revenue come from the buildings-services division, which saw revenues drop 14% from a year ago as construction spending contracts and companies defer discretionary maintenance and retrofit projects.

Johnson Controls is bidding on about 2,700 projects worth about $800 million related to the U.S. government’s stimulus package. The company expects the stimulus programs to have a “meaningful positive impact on financial performance in the second half of fiscal 2010.”

Management said uncertainties remain in their businesses, but global automotive production “appears to be stabilizing.” In addition, management estimated that commercial buildings and residential HVAC markets would bottom in the next six to nine months.
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Peter J. Lazaroff

Daily Insight

U.S. stocks ended mixed on Friday -- as the Dow and NASDAQ managed to close on the plus side, while the S&P 500 closed fractionally lower – but it was a very good week as the broad market gained nearly 7%. This followed four weeks of decline and unfortunately that’s what it takes for rallied these days. We’re closing in on the post-Election Day level again of 952 on the S&P 500 and about a half of a percentage point from 946, which has proven to be a mark we haven’t been able to eclipse for several months.

A good (all things considered) housing-market report helped to buoy stocks on Friday. Even though earnings reports are beating expectations, it looked like the market was going to fall apart in early trading as profit reports out of GE and Bank of America mirrored what JP Morgan’s earnings report clearly stated: the consumer is in trouble and delinquency rates continue to climb and commercial real estate issues are still in early innings. While more residential home building will not be helpful for supply, the market did like seeing a much better-than-expected housing starts figure and that helped to combat early-session weakness.

Tech, telecom, basic material and energy shares were the best performers. Financials and industrials were the laggards. Financials were hurt by rising consumer-segment default rates. Industrials probably had a little profit taking weighing on these shares after six-straight sessions in which the group jumped 10.2%.

Market Activity for July 17, 2009

Housing Starts

The Commerce Department reported that housing starts rose 3.6% in June after the large 17.3% jump in May as the figure came off of a the all-time low hit in April. But unlike last month’s increase, in which the very volatile multi-family segment drove the reading higher, single-family construction drove the June reading. (Multi-family starts fell 25.8% in June after a massive 65.9% jump in May; single-family units were up just 5.9%. In this latest reading singles were up a strong 14.4%). For a bit of perspective, housing starts are down 46% from June 2008.


While this reading will be good for GDP – residential construction accounts for about 3% of GDP – we don’t really need more supply. Sales need to rise in order to absorb this supply and that is going to be tough with the labor market in the shape it is in. The sales data will be helped as mortgage rates have come lower again, hovering just above 5% on the 30-year fixed rate. Foreclosures continue to rise though (up 33% in June from a year-ago) and that also adds supply.

What we have here are probably offsetting developments. The low rates will help but I’m not sure how long they’ll stay down, that short-term scare we got via higher rates about a month ago underscore this issue. Too, I’m just not sure the rate environment is enough, outside of one-two month pops, to offset the labor market and foreclosure conditions.

Public Health Care

The national health-care bill made it through committee on Thursday night and the way they plan on paying for it is by burdening the successful. You burden the only people with the means to pull this economy out of its doldrums and the results aren’t going to be pretty. Whether it’s adding surtaxes to top income tax rates that will already rise alone (and how weak is that, if you’re a politician that believes in higher tax rates then say it instead of some mealy-mouthed “surtax” locution) or boosting the tax burden on small businesses that have payrolls over $400,000 the middle class is hurt far more than the wealthy people that politicians have bulls-eyed. The top tax bracket will see their federal rate move to 39.6% at the end of 2010, then they’ll have this 5.4% “surcharge” added on if the legislation passes (and even in this Congress it’s hard to believe it will). On small business, those firms that have payrolls of $400K and do not offer health-care plans will be hit with an additional eight percentage point payroll tax – that brings the rate to roughly 23% from 15%; this is on top of income taxes. Individuals who do not buy health insurance will be smacked with an additional 2-5% tax.

These people aren’t this stupid are they? What do you think small businesses will do? They’ll make damn sure their payrolls remain below $400,000 and that doesn’t exactly bode well for job creation.

Outside of the burden related to paying for this insanity, there are even larger implications to national health care. You like freedom? Then you don’t like government-run medical insurance. I think people will be amazed how quickly national health care will meld into the government’s right to tell you how to live your life in order to access this health care.

A well-known remark from Thoreau: “If I knew for certain that a man was coming to my house with the conscious design of doing me good, I should run for my life.” What one views as “good” for you, may be quite different from what you yourself consider as good. Too many people these days are more than willing to allow government the power to state what is good for them. If this trend continues to roll, individual freedom will evaporate at blinding speed.

When President Clinton engaged in his shot at national health-care it ran into a brick wall as his party didn’t have a huge majority, his poll-driven tendencies caused him to pullback and the nation still had more of it individual ruggedness/self-reliant principles intact. Currently, I’m not sure those principles are fully intact, President Obama is rushing to get this thing done as he races to outrun his declining poll numbers and the proponents of this catastrophic bill have a huge majority.

If this thing fails to pass, I think it’s a sign to marginally become longer-term bullish. On the other hand, if it passes, I’m sorry, but I don’t see how one can expect past growth rates to continue.

Futures

Stock-index futures are higher this morning on news that CIT found some private-sector financing to stave off bankruptcy for now. While the situation at CIT illustrates the fragile nature of things (their inability to get normal financing in order to fund operations), the fact that we’ve got private-sector vultures willing to step up to offer the firm a lifeline I think is pretty optimistic – even if the terms of the financing is austere – 10.5% for 2.5 years).

CIT remains in a precarious situation as 2.5-year funding is not exactly the same thing as capital, and the uncertainty within the entire system is heightened in fact as banks still rely on FDIC backstopping to issue debt – at least at terms that are not strict. CIT was not awarded FDIC backstopping (the TGLP program), hence their problems.


Have a great day!


Brent Vondera

Fixed Income Recap

Treasuries turned lower and rates higher as the short end outperformed to move the curve steeper by 6.5 bps to +265.5, the steepest it has been since June 4.

CIT Grouped staved off bankruptcy this weekend by securing $3 billion in financing from existing bondholders including PIMCO. Many of the details are not yet public because some specifics have yet to be hammered out, but the cost of the financing is rumored to be 1000 bps over three-month Libor, (50.5 bps as of this morning), and may require CIT to post specific collateral in exchange for the loan, according to The Wall Street Journal. The deal, expected to be officially announced later today is more of a temporary band aid than a cure all. It does solve CIT’s short term liquidity problems, but still leans on some sort of debt restructuring in the future.

A group of outside lenders, including JP Morgan, were in talks with CIT Friday to provide debtor in possession financing, a form of financing for companies wishing to maintain operations during bankruptcy protection. To see CIT’s situation deteriorate so far as to take steps to negotiate that kind of financing, but instead emerge with a plan that gives Cit the chance to restructure outside of Chapter 11 is a decent sign. CIT’s chances of restructuring existing debt also improves as current bondholders put more on the line to protect their existing stake. However, over 10% for short term financing is very expensive and details the risk that existing lenders see with the deal. The longer CIT takes to restructure its debt load the more penalizing that rate will be.

Cliff J. Reynolds Jr., Investment Analyst

GE's ugly earnings

General Electric (GE) managed to surpass muted quarterly expectations, but industrial businesses showed signs of weakness and the company issued downside guidance.

Combined earnings at GE’s non-finance businesses fell 8% to $4.16 billion and CEO Jeffery Immelt said the combined earnings of these businesses will come in at the low end of the guidance range (flat to 5% growth) given in December – thanks Jeff, we couldn’t have figured that one out ourselves. The company also adjusted their full-year free cash flow forecast from $16 billion to a range of $14 billion to $16 billion after only generating $7.1 billion in free cash flow from operating activities through the first two quarters of 2009.

GE’s overall order backlog dropped 1.7% from a year ago to $169 billion, but the backlog for higher-margin maintenance and services contracts increased. The company added they are targeting more than 400 stimulus projects valued at $200 billion worldwide. Few of these projects have been realized so far this year, but management expect an increase in the second half of 2009.

Operating margins improved by 140 basis points within the non-finance businesses, primarily due to an increase in services revenue. And with about $2 billion of additional cost reductions under consideration for this year, GE has plenty of levers to pull if revenues continue to plunge.

GE Capital reported profit of $590 million, down from $2.9 billion a year earlier, as consumer credit deterioration weighed on performance. The finance unit’s pretax profits fell 40% from a year ago, but increased 15% sequentially. Pretax profits are important to some investors because of tax credits that often bolster profit. Management reiterated that the finance arm remains on track to be profitable for 2009.

The company has reached its 2009 long-term funding goals for GE Capital and noted that the company has pre-funded about a third of its 2010 target, which means GE Capital could wait almost a year before having to access the capital markets again. This gives them a substantial cash balance right now, which is a positive when you consider the crunch that other wholesale-funded banks like CIT Group have faced.

There is no sugar-coating it: GE had an ugly quarter. Trading just under 12 times earnings, it is hard to imagine that an improvement will justify a higher multiple anytime soon. In the meantime, GE investors need to be patient and hope they continue to receive the 3.5% dividend payout until the economy climbs out of this rut.

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Peter J. Lazaroff

IBM's earnings smash expectations

IBM’s earnings smashed expectations as margin upside offset weaker revenues, and the firm significantly raised guidance for 2009.

Revenues fell 13.3% to $23.25 billion from a year ago, but only declined 7% when excluding currency effects. With the exception of software, every business segment saw revenues decline versus last year. Hardware sales, which declined 26% from a year ago, and short-term consulting also showed considerable weakness. All geographic areas saw revenue decline, with the Americas down 9%, Europe/Middle East/Africa down 20%, and Asia-Pacific down 7%.

These sales results along with management’s commentary suggest that businesses are not prepared to resume spending.

Although revenues disappointed, the Street totally underestimated IBM’s cost efficiencies. Gross profit margin was 45.5% in the quarter compared to 43.2% last year, and pretax profit margin rose 4.1 percentage points to 18.3% – a level normally reserved for the seasonally strongest fourth quarter. Margin improvement was driven by a more profitable business mix – particularly with software and consulting contracts – and dramatically lower costs from aggressive restructuring and improved labor productivity.

Really juicing investors was the upside guidance from IBM, saying they expect earnings of “at least $9.70” per share. IBM previously expected $9.20 per share while the consensus estimate currently stands at $9.15.

IBM’s business recovery may be more muted than other, more cyclical companies. Still, IBM’s improved signings in the service business, their largest segment, and a near-record backlog bode well for the company’s prospects.

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Peter J. Lazaroff

Daily Insight

U.S. stocks reversed morning-session losses after Nouriel Roubini, an economist who predicted the financial crisis, stated the recession will end this year. He also stated a second economic stimulus plan may be needed to guarantee a recovery. God help us! I assume he doesn’t mean broad-based reductions in tax rates and higher current-year business-equipment write offs, but rather another $500 billion-$1 trillion in government spending.

The broad-market rally extended to a fourth session as the S&P 500 honed in on its trading-range high of 946-950 (for those keeping count), roughly the post election-day high . Industrial, technology and basic material shares led the indices higher. Financials and telecoms were the laggards – bank stocks were hurt by the news that CIT will very likely go bust today (CIT being the holding company that offers lending to small and mid-sized businesses and to more than half of the “Fortune” 1000 names. The overall market had no problem shrugging it off, instead finding reason to rally on the Roubini comments.

Yesterday’s economic data was really no help. Initial jobless claims posted a substantial decline, but it was met with skepticism as seasonal adjustment factors likely played a major role in the decline rather than some meaningful improvement in the labor market. The latest manufacturing gauge deteriorated.

Volume was pretty soft again, even for this time of year, as just 1.1 billion shares traded on the NYSE Composite – 21% below the three-month average. Advancers beat decliners by a 3-to-1 margin on the Big Board.

Commercial Paper

The commercial paper (CP) market is shrinking at a record pace, as investors demand for all but the top-rated paper dwindles. A proposal from the SEC may worsen the situation by restricting money-market funds (these funds hold roughly 40% of the CP market, according to Bloomberg) to only top-rated debt – anything below A-1, which in short-term credit ratings is equivalent to anything below AAA and AA+ on long-term ratings.

Commercial paper is used by corporations to provide very short –term funding, allowing firms to borrow at cheaper rates. When your CP dries up a firm’s cost of capital rises as the business needs to borrow for longer terms, and that increase is substantial – depending on the credit rating of the firm it may be 4-8 percentage points higher! When borrowing costs rise, it results in less expansion and less jobs than would otherwise be the case. The short-term funding game is over for a lot of U.S. companies.

Maybe this is a good thing over the longer term, certainly CP issuance jumped to levels that were harmful by 2007 – harmful from the respect of when investors flee for safety your funding evaporates; long-term maturities reduce this effect, but the point is this situation is another thing that will affect economic activity over the next couple of years.

Jobless Claims

The Labor Department reported that initial jobless claims plunged 47,000 in the week ended July 11 to 522,000 (a decline of 12,000 was expected). This marks the second week in which we’ve seen a huge decline. Initial claims fell 48,000 in the week ended July 4, which I accounted to the holiday-shortened week and seasonal adjustments due to auto-plant closing.

However, with a second-straight week of huge declines maybe something else is occurring. It’s one of two things: Either the job market is beginning to improve substantially, or we still have this seasonal adjustment thing occurring. (That is, auto plants normally shutdown in July as they retool for new models, the seasonal adjustment factors this in. However, this year, with the GM and Chrysler bankruptcies, they shuttered plants a month earlier than usual so the normal rise in claims is not showing up when it typically does.

I find it very difficult to believe -- with the duration of unemployment making a new record high to 24.5 weeks, another 467,000 jobs slashed in June and the U6 unemployment rate hitting 16.4% -- that the labor market has improved to such a huge degree as this claims data is suggesting. It’s got to be the seasonal distortion. I want to be careful here not to send the wrong message. I’m not stretching to offer a negative view, I don’t want anyone to read it that way – I as much as anyone want the economic scene to improve and improve markedly. But we look at every number that comes across on a daily basis very closely and this large reduction in claims just doesn’t make sense. If the number remained below 600K but rose a bit, or even held steady, I wouldn’t have this level of skepticism, but this degree of decline is not commensurate with the other data.

Now, the rate of job cuts will ease (as we first talked about two months back when estimating that monthly job losses will fall back to the normal recessionary levels of 250K-300K by August) and this is going to have an affect on the claims data, but again this level of decline just seems to not quite jibe with reality. We’ve lost 6.46 million jobs since January 2008 as businesses had been shocked by the degree and quickness of the economic weakness, so we must see some sort of easing simply on a statistical basis. (And just to make something clear, I’ve seen a lot of people state that we’ve lost all of the payroll positions created from the previous expansion. That is not true, we still have a net gain of 1.86 million as 8.32 million were added September 2003-December 2007 and 6.46 have been lost since.

The four-week average on initial claims fell 22,500 to 584,500 – first move below 600K since January.

Continuing Claims fell a massive record-setting 642,000 to settle at 6.273 million in the week ended July 4 (there is a one week lag between initial and continuing claims data).

On a non-seasonally adjusted basis continuing claims rose 64,000 to hold above the six million mark.

Philly Fed

The Federal Reserve Bank of Philadelphia released their manufacturing survey for July, showing activity fell at an increased rate from the month prior. The Philly Fed index declined to -7.5 from -2.2 in June, which was the best reading since September when Philly posted its last positive reading. Expectations were for the reading to come in at -4.5.

A number of sub-indices actually improved, but a large decline in shipments made the headline number appear possibly worse than things actually were.

New orders improved to -2.2 from -4.8.

Unfilled orders looked better, hitting -14.6 from -19.6.

Delivery times picked up to -10.3 from -18.9.

The workweek improved substantially to -15.5 from -26.6 in June.

While all of these readings remain in negative territory, these are nice improvements.

The sub-index that caused the headline figure to worsen was the decline in shipments, which fell to -9.5 in July from +2.1 in June. This reading was surprising since the new orders index improved greatly in June to -4.8 from -25.9 in May – new orders generally portend the direction of shipments. Either the Philly region saw a big cancelation in orders or we’ll just have to wait another month for it to flow to shipments.

On Earnings

IBM blew by their number, reporting really good bottom line results – and the numbers weren’t like many other results of late by which a firm easily hurdles a low estimate but the year-over-year results are down big. IBM’s year-over-year profit rose 17% (operating earnings basis) on massive cost-cutting. They have also moved into markets, specifically consulting within the electric grid market, that will benefit from government spending. However, the company repeated what Intel, among other techies, have stated: businesses continue to delay spending. This has been a concern of ours, as we’ve expressed for a while now, and I don’t see how the direction of policy eases this situation beyond the very necessary equipment purchases.

On the top-line, things were not so rosy as revenue fell 13%. The market is ok for now with cost-cutting as the catalyst for better-than-expected results, but by next quarter investors and traders are going to want to see meaningful improvement in final demand and that means higher revenue numbers.

Google was also out last night, reporting that earnings rose 18% from the year-ago period, but this was below expectations. They predicted that online advertising would decline another 10% this year and that a recovery in technology will take longer than expected.

Bank of America is probably the big earnings news of the morning – at least before the delivery of this letter. The bank reported per share profit that beat expectations by 36% but those results were 66% below year-ago results. CEO Ken Lewis predicted the weak economy will persist into 2010 – he knows what’s coming in terms of commercial real estate defaults.

The bright spots were mortgage lending (big revenues on refi activity) and global markets (trading of stocks, bonds and currencies). The consumer area, just as JP Morgan showed earlier in the week, continues to worsen.

Brent Vondera

Fixed Income Recap

Rates settled lower after rising for three days straight on poor economic data. The worsening situation with CIT brought an even stronger bid to the market but we didn’t get the flattening effect along with the rally like we have grown so accustomed to during this past cycle. The middle part of the curve (five-year) outperformed, while the 2-10 spread was unchanged on the day.

The Federal Reserve purchased $1.499 billion in TIPS on $9.188 billion in bonds submitted, a weaker ratio than average. The entire Treasury buying program is very small when considering the size of the Treasury market, and hasn’t made a material impact on anything outside of the initial fury when the program was first announced. The FOMC minutes that were released Wednesday show the committee’s reluctance to increase the number going forward. In my opinion this is a smart move by the Fed.

Cliff J. Reynolds Jr.

Daily Insight

Stocks rallied again yesterday as the latest reading on industrial production recorded it lowest rate of decline in eight months and New York-area manufacturing activity nearly made it to expansion mode – the new orders index within the Empire Manufacturing survey posted its first month of expansion since September. That Intel news from Tuesday that we touched on yesterday also played a role in the upshot.

The broad market has returned to the high-end of the trading range for the fifth time this year, up 7% since hitting a 10-week low of 870 on July 10. If this morning’s jobless claims data indicates the prior week’s move below 600K was the beginning of a trend rather than a function of the holiday-shortened week of July 4 and seasonal adjustments due to auto plant shutdowns we may have a shot at putting in a higher end to this ambit.

Technology, basic material, energy and industrials led the rally. All 10 major industry groups in fact participated in the move; health-care was the laggard managing a mere 0.8% increase.

Yesterday’s move higher was on the best volume in six sessions, yet still 9% below the year-to-date average on the NYSE Composite. Advancers torched decliners by a 17-to-1 margin.

Market Activity for July 15, 2009
Mortgage Applications

The Mortgage Bankers Association reported that their mortgage apps index rose for a second-straight week, as refinancings remained strong – up 17.7% for the week ended July 10 after a 15.2% increase in the prior week.

Borrowers were attracted to a 30-year mortgage rate that fell back to hover around the 5.00% level. Further, the Obama administration’s decision to allow Fannie and Freddie to refinance mortgages with up to a 125% loan-to-value ratio certainly didn’t hurt this activity. Looking beyond the next six hours, no one can tell me that this is healthy. If home values do not begin to rise I’m going to guess that many of these loans will eventually turn into foreclosures and hence you are just delaying the inevitable, and thus delaying the recovery. But hey, who knows. We’ve got hope, right?

Purchases fell in the week ended July 10, down 9.4% after increasing 6.7% in the previous week. The rate on the 30-year fixed rate mortgage fell to 5.05%, down meaningfully from 5.50% in mid June.
Consumer Price Index (CPI)

The Labor Department reported the CPI rose a bit more than expected in June, up 0.7% vs. the 0.6% estimate. The gain was driven by higher energy prices (a recurring story as this was the case with Tuesday’s PPI reading), which accounted for 70% of the monthly gain. This will not be the case next month as energy prices have declined substantially. The core rate, which takes out the volatile food and energy components, rose 0.2% last month (also more than expected) but up only 1.7% year-over year.

The headline number remains negative on a 12-month basis and this may remain the case until the comparisons become easier by November; these year-over-year numbers are still being compared to last summer’s commodity price spike that pushed CPI up to 5.6%.

Outside of energy (and transportation, which is impossible to hold back when gasoline is up 17% for the month) all other component’s prices remain very tame. Food was flat; housing flat (no surprise there); apparel was up 0.7% for the month, but this followed three months of decline; medical care up just 0.2%.

I do see some concern though within the commodities component of CPI. This segment was up 1.8% in June, again largely due to energy prices. However, when you take out food and energy commodities were up 0.3% last month and 4.1% at an annual rate over the past three months. This is the base we’ve been talking about. While inflation outside energy remains very low, this core commodity reading is starting from a pretty high base considering the weakness of economic activity. Once activity bounces, I believe there is real potential for the inflation gauges to spike. This remains a very early call, but if correct it will be a really tough thing for the economy to deal with as it will be another catalyst for higher interest rates.

Industrial Production

Industrial production fell 0.4% in June, marking the 17th decline in 18 months. This contraction in production is the deepest both in term if degree and duration since the wind down from WWII. Yet the fact that this latest reading marked the slowest rate of decline in eight months (actually, since the figure posted its only positive number over the past 18 months back in October) it led many to believe the worst of the recession is over.


I don’t think this idea that the worst is over is a novel thought as we will soon see a statistical recovery (a boost in GDP simply based on the low levels we’re coming from and the inventory rebuilding that will ensure after the largest inventory liquidation since records began in 1947). I’ve got to say though that the manufacturing component within this data is not showing we’re quite there yet – particularly the machinery data, which posted another large decline of 1.9% in June – down 25.5% year-over-year. If machinery can’t yet muster a rebound as China engages in robust infrastructure-building projects and the U.S. spending begins to get underway, I think that says something.

And in terms of the industry components, manufacturing activity declined 0.6% in May (the eighth month of decline) and is down 15.5% year-over-year. And the woeful situation within the auto sector can’t be blamed for all of this as ex-motor vehicles/parts manufacturing production is down 14% year-over-year. Utility output rose in May for the first time since January, up 0.8% -- it is down 4% yoy. Mining activity dropped 0.5% last month (the seventh month of decline), down 10.4% yoy.

Capacity utilization fell to make another record low (since records began in 1967), down to 68.0% from the 68.2% hit in May. This record low capacity util. reading will cause the economic world to believe inflation cannot rise to troublesome levels – too much slack in employment and thus no wage-related inflation as they say. But our Keynesian world needs to be very careful here for Phillips Curve/NAIRUist models have gotten us in trouble in the past – inflation is more a function of too much money chasing too few goods than a function of wages. And whenever it is that credit begins to flow a bit, and all of that money the Fed has pumped in is no longer fallow, the productive capability will not be there to create the goods in order to absorb all of this money – that’s when inflation hits and teaches us, again, that Keynesian models are quite flawed.

FOMC Minutes

The Federal Open Market Committee (the policy-setting group of the Federal Reserve System) released its minutes (notes) from their June 23-24 meeting. We don’t always report on this news as it pertains to what the Fed saw in the six weeks leading up to that meeting and data we’ve already discussed on a daily basis. However, people were watching this release in particular looking to see what the members said about their quantitative easing (QE) campaign (bond purchases) for clues related to the direction of those actions.

First though, most members “saw the economy as quite weak and vulnerable to further adverse shocks.” Although market conditions had improved, “credit remained tight in many sectors.” They also correctly worried that consumer spending will resume its decline once temporary benefits to household income subsides as the fiscal stimulus subsides. (This is the point we’ve made when explaining that the past two months in which personal income rose was completely a function of government transfer payments – payments that accounted for 97% of the income gain in May.)

The members found conflict with respect to inflation as a few expressed concern the rate could “temporarily rise above levels consistent with their mandate” to keep prices stable. They also raised their 2010 forecasts for both GDP and the unemployment rate.

Uh, someone will have to explain that one to me. It is certainly true that the unemployment rate always continues to rise even as the economy bounces back. However, in a consumer-led and credit contraction, coupled with a plunge in stock and real estate prices, the jobs data should be seen as a more coincident indicator – consumers will not see their optimism increase until they see the job market turn simply because they have less access to credit and stock and house prices have been smashed. I don’t see how you increase your GDP forecast when you believe the jobless rate will get worse than previously expected.

On QE, the Fed appeared to lean toward leaving their program to buy $1.25 trillion in mortgage-backed and $300 billion in Treasury securities unchanged. They stated, “[al]though an expansion of such purchases might provide additional support to the economy, the effects of further assets purchases, especially purchases of Treasury securities, on the economy and on inflation expectations were uncertain.” They are questioning how much this program can boost the economy, while acknowledging the downside of the bond purchases – the actions may have the opposite of the desired effect. Instead of pushing rates lower, the bond market may sell off if it fears this money printing will spark a harmful inflationary event, which means rates will rise.

Futures

Stock-index futures were down big earlier this morning on news the talks to rescue CIT Group have collapsed, but have now reversed course after JP Morgan reported earnings that destroyed estimates.

The bank reported operating profit of 28 cents per diluted share for the quarter, the estimate was for a lowly 4 cents. While the market would certainly not cheer a 28-cent quarterly profit for a firm that made 50 cents in the same quarter during the previous recession, they easily jumped the estimate – a hurdle that was about the height of a speed bump -- as investment banking fees were boosted by big debt issuance and a massive amount of financial-industry stock issuance as the group needed to raise capital. The consumer side of their business continued to deteriorate. Home-equity charge-offs continued to rise and credit card charge-offs rose to 10.03% from 7.72% in the previous quarter and 4.98% a year ago.


Have a great day!


Brent Vondera

Fixed Income Recap

Rate volatility continued yesterday as yields rose to their highest point in three weeks. The two-year closed above 1% for the first time since July 1, but still far from the recent high of 1.4% on June 8. The curve continues to steepen on higher than anticipated inflation numbers. The 2/10 spread closed yesterday at 259 bps, the steepest it has been since the second week of June.

CPI for June came in at +.7% MoM, a little higher than the +.6% expected, and was dominated by energy (+7.6%) which explains the meager +.1% MoM ex food & energy number. TIPS have enjoyed the past few days. Nominal coupon Treasuries are down 2 points compared to just ¼ of a point for TIPS, translating into higher breakeven yields.

New developments in the CIT saga are pointing toward a bankruptcy filing for the lender soon. According to CIT’s website “it has been advised that there is no appreciable likelihood of additional government support being provided over the near term.”

The market seems alright with letting CIT fail, stock futures are up premarket, but I’m afraid it may be for the wrong reasons. “Let them fail, their business model is broken”, many are saying. Was AIG’s business model not broken? What about Bear Stearns’? CIT has failed to convince regulators that their failure would pose systemic risk to the financial system. Maybe they hired some former Lehman employees to debate on their behalf because they failed to do the same and look where that got us. I agree that Lehman’s bankruptcy was worlds larger than CIT’s would be, but the market is pricing its impact as if the credit market is some well oiled machine. Maybe I’m hanging on to what happened last fall too tight but what happens if CIT’s large CDS counterparties begin to disclose their exposure and we get a another run on the banks? Just because CIT is smaller than Lehman does not mean that it can’t snowball into something much larger.


Cliff J. Reynolds Jr., Investment Analyst

Quick Hits

• The Bernanke Market
• Fed Saw Economy as ‘Vulnerable’ at June FOMC Meeting
• Intel Earnings: Analyst Takeaways Hint at Frugal Consumers
• UnitedHealth, Cisco Will Spend ‘Millions’ On Virtual Clinics
• Green Shootists are Smiling. Should They Be?
• Blinder Says Fed May Raise Rates in First Half of Next Year

Asset Allocation Worked in 2008

I’m annoyed.

Last year was a terrible year for investors. Now, the peanut gallery is making the claim that asset allocation failed and diversification didn’t work. That’s bull.

Although there have been several articles from a variety of places, it is this front-page article from the Wall Street Journal that has my blood boiling.

The incendiary title started me off on the wrong foot: Fail-Safe Strategy Sends Investors Scrambling.

Any responsible investor with any appreciation for markets knows that no strategy is fail-safe. The only thing that worked all the time was Bernie Madoff (that is, until it didn’t).

The thrust of the article is that everything went down. It is true that pretty much all stock indexes went down, and diversifying amongst equity asset classes didn’t offer any benefit. However, it is outright false to say that asset allocation didn’t work.

For me, the Ibbotson SBBI Classic Yearbook is like the Rosetta Stone because SBBI was instrumental in developing my thinking about asset allocation and diversification. So, I start there with the six asset classes that Ibbotson lays out in the Basic Series:

Large Cap Stocks - 37.00%
Small Cap Stocks (really Microcap) - 36.72%
Long-Term Corporate Bonds + 8.78%
Long-Term Government Bonds +25.87%
Intermediate Term Government Bonds +13.11%
U.S. Treasury Bills (Cash) +1.60%

At the most basic level, asset allocation worked perfectly well. Stocks went down, but bonds and cash went up.

It is true that pretty much all stocks went down. It didn’t matter if you were large or small, international or domestic, growth or value. All of the subsets and derivations lost big.

As for bonds, I am not sure exactly where Ibbotson gets their Long-Term Corporate Bond data; it isn’t quite what I saw last year. For example, the Barclays US Long Credit A/Better Index lost 0.24 percent. Ibbotson says that their index is based on 20 year maturities, but the current maturity for the Long Credit Index is 24.80 years (11.7 year duration).

Other credit bond indexes were as follows:


iBoxx $ Liquid Investment Grade Index: +0.96%
Barclays U.S 1-3 Year Credit Index +0.30%
Barclays U.S. Intermediate Term Credit Index: -2.76%
Barclays U.S. Credit Index -3.08%

These aren’t exactly eye-popping returns, but they were lowly correlated with U.S. stocks. And, this was the year that credit markets were broken. Take a look at Treasury bond performance:

Barclays U.S. 20+ Year Treasury +33.72%
Barclays U.S. 10-20 Year Treasury +19.69%
Barclays U.S. 7-10 Year Treasury +17.97%
Barclays U.S. 3-7 Year Treasury +13.26%

And, you didn’t have to be solely in Treasuries either. The Barclays U.S. MBS Index gained 8.34 percent, and the Barclays U.S. Agency Index gained 9.26 percent.

Even muni indexes posted positive returns, despite the increasing trouble in many states and municipalities. The Barclays National 0-5 Year Municipal Bond index gained 5.05 percent.

This isn’t to say that all bonds went up – some went down. Preferred stocks, non-Agency mortgage backed securities, high yield (junk) bonds all lost substantially. These are derivations of the credit markets, which had a lot of trouble. They also shouldn’t be in the vast majority of portfolios. Professional investors know, for example, that junk bonds trade like stocks, not bonds.

If you didn’t want to bother with all of the various bond market sectors, just take a look at the Barclays U.S. Aggregate Index. It gained 5.25 percent last year, which is pretty consistent with what you would expect from a long-term bond allocation. In fact, the long-term rate of return for Intermediate Term Government Bonds according to Ibbotson from 1926 through 2008 is 5.24 percent.

Despite one money market mutual fund breaking the buck, all the others held up. It’s true that the government had to come in and lend a helping hand, but cash is pretty much cash. Those who had made sure that their cash didn’t contain undue credit exposure for a little extra yield didn’t have any problems.

If it wasn’t obvious, this article was meant to say that the basic building blocks of asset allocation worked exactly as one would expect. My next article on the subject will look at whether one year is the right time frame to make the statement that asset allocation doesn’t work. I’ll bet you can guess where I come down on that when I say that investing is for the long term…
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David Ott

Intel's earnings impress

Intel (INTC) generated a monster reaction to their great second-quarter results, which they reported yesterday after the closing bell. The chipmaker’s reported profits that were nearly double the average estimate.

Second-quarter sales jumped 12% from the previous quarter as PC makers boosted orders for chips in anticipation of increasing demand in the second-half. CEO Paul Otellini explained that businesses probably won’t start buying PCs until next year, but Asia (and especially China) is leading the recovery.

Intel’s Asia-Pacific sales were up 21% from the previous quarter, but still 8.2% below last year’s figures. Sales in the Americas rose 12% sequentially, while Europe dropped 9.4%.

Intel’s guidance for the third-quarter also impressed, with the firm projecting $8.1 billion to $8.9 billion in sales, compared with average estimates of $7.86 billion. Even more, Intel expects gross margin to be about 53%, which is also higher than estimates.

The thing that really caught everyone off guard was how fast Intel was able to shutter capacity and cut workers to drain chips out of the global supply chain, leaving PC makers to scramble for parts.

But what are we really seeing here? Intel is benefiting from a rebound in chip demand because of inventory restocking along the electronics supply chain. The third-quarter guidance suggests that Intel sees this trend continuing for a few quarters. But one must exercise caution.

The company is still not expecting a recovery in business PC demand until 2010, if then. Another sign of uncertainty is that Intel is still not forecasting full-year gross profit. As we have mentioned before, we must see significant increases in the level of global technology spending over the next several quarters for a sustainable recovery.

This message of caution also applies to the entire economy.


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Peter J. Lazaroff