Daily Insight

Major market indexes broke a two day losing streak with a powerful rally based on … well, it’s hard to say. All of the post-mortem articles about yesterday’s rally attribute the rally to statements from the Federal Reserve, but the Bernanke & Co. didn’t come out with their announcement until 2:15 and the market had been surging since 10 am.

When the rally first got started, the gains were attributed to better than expected earnings from Macy’s. It’s hard to see how this could really push the market, though, since this is a distressed mid-cap stock, the source of improvements were related to cost cutting in spite of weak sales, and it still lost money for the quarter.

In my opinion, a strong rally from a weak data point indicates that markets are not trading on fundamental values at the moment. Just as markets were unjustified in their 25 percent drop earlier this year, the 50 percent rally from the low in March seems to have allowed optimistic euphoria to carry a day like yesterday even when it doesn’t seem well founded.

Market Activity for August 12, 2009

Even though the Fed announcement didn’t end up carrying much weight in the stock or bond market yesterday, the news was good. (There was a rally after the announcement, but it faded back to pre-announcement levels before the end of the day.)

First, it was reassuring to hear the Fed say that “economic activity is leveling out,” which fits with the conventional wisdom that the recession is ending. The bigger news, though, is that the Fed is removing one of the lifelines by announcing that it would not purchase more Treasury bonds after October.

To keep interest rates low across the board, the Fed engaged in a massive buying spree in the mortgage, treasury and agency bond markets. This is known as quantitative easing because it injects liquidity into the economy. They couldn’t push interest rates below zero and this was a strategy that the U.S. had not engaged in before but had it been done in other parts of the world, most notably Japan.

By announcing the end of the Treasury program, the Fed is signaling that they are beginning to withdraw the support that they had put in place during the crisis. This isn’t to say that everything is fine and dandy, though, because many of the lifelines are still in place and the Fed will still own all of the Treasury bonds that they bought, they just won’t be buying any more.

In addition to saying that the economy seems to be stabilizing and that the Treasury purchase program will end in October, the Fed was clear that they do not view inflation as an immediate threat. Their exact language remained unchanged - that inflation will be ‘subdued for some time.’

Markets are set to open higher this morning, though some early enthusiasm has been reduced with the retail sales data from the Commerce Department. Earlier, markets showed a triple-digit rise for the Dow based on earnings news from Wal-Mart.

Retail sales fell 0.1 percent in July, despite the ‘cash for clunkers’ program that was so successful it ran out of money in the first week. Retail sales ex-autos fell by -0.6 percent, well below expectations. Retail sales are an important measure of broad consumer spending patterns, so this may put more of dent on the markets as the bell rings.

Have a great day!


David Ott, Partner

Fixed Income Recap

FOMC
The FOMC pleased the market yesterday with its comments following two days of meetings that concluded Tuesday. The most important topic this time around, which I have touched on pretty heavily this week, is the Fed decision on Treasury Purchases and other forms of quantitative easing. Before yesterday’s comments, the Fed’s Treasury purchases were scheduled to conclude before the end of September. The Fed has decided to extend the purchases to the end of October, while leaving the original $300 billion target unchanged. The other two programs – $1.25 trillion in MBS and $200 billion in agency bonds - will end in December as originally scheduled.

This is a good sign from the Fed. They are reluctant to talk exit strategies at this point, which I think is appropriate, but by coming out and telegraphing how the security programs will end the Fed is taking a step in that direction. In the Fed’s eyes, the US economy is stabilizing enough to not warrant such an aggressive program, so slowing the pace down can be viewed as a type of easing. I know that may be a little bit of a stretch but it’s still a positive sign.

The Fed sees that, “economic activity is leveling out”, a positive change from, “the pace of economic contraction is slowing”, in the June meeting statement. We also got the standard, “The Committee… continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

The Fed pretty much gave the market what they wanted. They outlined the end of the Treasury purchase program, noted that they see the contraction coming to an end and more or less left it at that.


Cliff J. Reynolds Jr., Investment Analyst

Fixed Income Recap

Despite the strong 3-year auction and weakness in stocks the short end was unable to break out of its pre-FOMC deadlock. The 3-year was already a little higher by the time the $42 billion auction drew to a close and was mostly unchanged by the results, but finished the day a few bps tighter than the auction level.

Eyes will be on the Fed today as the market waits for the committee’s comments regarding bond purchases. They will for sure comment on the progress, but the Fed might not be perfectly clear about whether they plan to shutter the Treasury program after the last of the $300 billion is spent in September or extend it to the end of the year. At this point I think the Fed needs to come out and be pretty clear here. People are certainly expecting to hear something meaningful one way or another, so I fear that saying nothing could just throw a wrench into this market, which would not be good.


Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

Following a steep run-up in recent weeks on the strength of better-than-expected earnings, stocks fell for the second consecutive day as investors take pause amid a lull in new economic data and focus attention on today’s Fed policy decision. It is widely expected the Fed will hold interest rates steady at near zero, but the group’s economic assessment will be closely studied to determine the state of the economy.

All ten sectors finished lower with financials dropping the most on concerns that the sector’s earnings may pull back and the possibility of higher interest rates. Volume was relatively low with only 1.2 billion shares trade on the Big Board.


Market Activity for August 11, 2009
Productivity and Wholesale inventories

Productivity surged between April and June, increasing at an annual rate of 6.4%, marking the largest gain in almost six years and easily beating the Bloomberg forecast of 5.5%. The growth was not a result of improving production, but rather a result of employers cutting the number of hours worked faster than the decline in output. These efficiency gains, however, provides the basis for a recovery in corporate profits and investment in the second half of 2009 – aggressive cost-cutting helped many companies exceed earnings expectations last quarter despite weak sales. Solid productivity growth also keeps the lid on prices and inflation, which gives the Fed justification for keeping rates lower for longer.

Meanwhile, unit labor costs fell 5.8%, the biggest decline since 2000 and far more than the expected drop of 2.5%, which may be read as a positive signal for the employment since companies may not need to layoff as many workers as sales stabilize.

Wholesale inventories showed a 1.7% decline in June, larger than the expected 0.9% drop. Durable goods, particularly in the professional equipment sector, led the decline. Total sales rose 0.4% thanks to a 4.5% boost in the automotive sector. The inventory-to-sales ratio – the amount of time it would take to deplete inventories at the current sales pace – improved from 1.28 months in May to 1.26 months in June. No surprise that after ten straight months of decline, inventories sit at the lowest level in more than two year. Companies’ hesitancy to restock in the face of weak demand has added to the severity of the downturn, but retail volumes are showing signs of stabilizing and there is a strong possibility that production will ramp up with even the slightest increase in demand.

Rising productivity and falling inventories fits well with the general consensus that a big inventory rebuild is going to boost both GDP and corporate profits. The inventory destocking in the second quarter took away from GDP, so even if inventories are flat in the third quarter, the drag to GDP would disappear. This idea that the inventory dynamic may mathematically provide a temporary boost to GDP is valid, but the sustainability of such an upturn is seriously questionable because inventory can again be a drag on future GDP if it is slowly depleted. In other words, people won’t necessarily buy stuff just because its there.

In our minds it all still hinges on consumer demand, which will be slow to recover in light of a weak job market, stagnant wages, and falling home values. Without strong consumer demand, any inventory dynamic that boosts third-quarter GDP won’t be lasting, and the odds of a letdown in the fourth quarter or 2010 become greater.


FOMC
The markets will be carefully attuned today to the Fed’s meeting statement, searching for clues regarding how soon and how aggressively the Fed can withdraw its support of the economy. The statement released following the June 23-24 FOMC meeting showed a modest upgrade of their assessment of the economic, which in turn lowered the probability of deflation even though the statement indicated, “Inflation will remain subdued for some time.” Today’s remarks will likely continue to reflect cautious optimistic view so as not to spark inflation concerns.

The first Fed rate increase is not likely to occur until late 2010 or even 2011. Historically, the Fed has never lifted rates when unemployment was rising, it has always occurred when unemployment started to move substantially lower. Despite last week’s July employment report showing improvement, sub-par growth will keep the unemployment rate higher than in a typical recovery. As a result, policy makers are expected to be extremely measured in their removal of policy accommodation.


Have a great day!


Peter J. Lazaroff, Investment Analyst

Amgen (AMGN) trades higher in advance of FDA panel

Amgen (AMGN) shares received a boost just two days before the FDA votes whether to support denosumab as an osteoporosis treatment in post-menopausal women and to help prevent bone loss in treat cancer and prostate cancer patients on hormone therapy.

The shares rallied after a study released showed that denosumab prevented fractures and strengthened bones in men taking hormone therapy for prostate cancer. Almost exactly a month ago, AMGN released encouraging Phase 3 trial results for denosumab in breast cancer patients.

A potential blockbuster like denosumab could eventually generate $2 billion to $3 billion of annual revenues, which could help take the pressure off Amgen’s other drugs, which are facing higher scrutiny from the FDA as well as increased competition from both branded and biosimilar (generic biologic) drugs.

AMGN shares finished the day +2.56%
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Peter J. Lazaroff, Investment Analyst

Analysts get bad signal from Harris (HRS) radio business

Harris Corporation (HRS) is down more than 6% today as analysts anticipate poor earnings results, which are due to be released after the close of trading on Wednesday, and lowered earnings guidance.

The concerns in several analyst reports are centered on the company’s tactical radio business, known as RF Communications. RF Communications’ radios are like the iPhone of walkie-talkies. Mainly used by the military, the radios are encrypted to prevent eavesdropping and have the ability to send data and videos. Aside from working with the military, RF Communications has a public safety and professional communications business.

This high-margin business segment was a major driver of Harris’ earnings for the past several years, but is now faced with order delays that are largely a result of the change in administration and the shift in military focus to Afghanistan from Iraq.

HRS shares finished the day -7.84%

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Peter J. Lazaroff, Investment Analyst

Daily Insight

Stocks got off to a slow start this week as investors questioned the S&P 500’s highest valuation, relative to earnings, since December 2004. Commodity producers and retailers were the main culprits dragging down the S&P 500. Meanwhile, the increasing VIX index showed that options trades are betting that the S&P 500’s rally won’t last through September.

I received a lot of feedback yesterday regarding my discussion on REITs and the accompanying write-up on our blog, some of which were requests to add U.S. REITs to the performance table. Ask and you shall receive…

Market Activity for August 10, 2009



FOMC

The Federal Reserve’s policy makers meet over the next two days and will likely discuss their quantitative easing measures, which helped unfreeze credit markets by holding down yields on Treasuries. When the Fed unveiled its strategy, deflation was the market’s primary concern. Now that credit costs are returning to pre-crisis levels and recovery expectations are growing, the inflationary risk posed by the Fed buying Treasuries is a bigger risk to bond prices than its exit from the market.

The market is concerned that the money printed to fund the program will fuel inflation, and we would likely see a positive reaction to the Fed’s nonrenewal of their quantitative easing program. Exiting this program would provide a clear signal to the world that the Fed is determined to control inflation before it starts. Low inflation makes Treasuries’ coupon payments more desirable, keeping yields in check longer. This is especially important during a period in which foreign buyers, particularly China, are apprehensive about the value of their investments in U.S. debt. We need these foreign buyers to help soak up the record issuance of U.S. government debt to cover the cost of putting a floor under the economy.

While ending the quantitative easing program should calm some of the inflation fears, these purchases could still lead to inflation pressures on a longer horizon and, appropriately, inflation expectations might come earlier.

The other always important topic being discussed will be the Fed’s target for the federal funds rate, which broadly influences borrowing costs. For some of the newer Daily Insight readers, the federal funds rate is an overnight rate banks use to lend to each other. The federal funds rate serves as a benchmark for all other short-term interest rates including the prime rate, the benchmark for most consumer and commercial lending, and short-term Treasuries.


Fed funds rate and stock prices
Over most of the past 50 years, changes in the fed funds rates have been a very good predictor of future stock prices. Using research from Jeremy Siegel’s Stocks for the Long Run, the table below shows the returns on the S&P 500 Index following a change in the fed funds rate over 3,6, 9, and 12 month periods. The benchmark represents an average of all the time periods in each particular sample – for example, the average of every 3-month time period between 1955-2006.


As you can see, the Fed’s actions have a dramatic effect on stock prices. Stock returns following an increase in the federal funds rate are significantly less than average, while stock returns are significantly higher than average when the federal funds rate decreases. Now, I know some people will glance at this table and think they can beat the buy-and-hold strategy by buying stocks when the Fed is lowering rates and selling stocks when the Fed is increase rates. But if you look at the entire table, this trend (like all trends) is hardly foolproof. Since 2000, the impact of the Fed’s interest rate changes on the stock market has been the complete opposite of the historical record.

Why has this occurred? It is possible that investors have become so accustomed to watching and anticipating Fed policy that the effect of its tightening and easing is already priced into the market so that the impact of Fed actions extend over a period of a few days rather than over several months. After all, if investors expect the Fed to do the right thing to stabilize the economy, these expectations will be built into stock prices far before the Fed even begins to take stabilizing actions.

Of course, there is no perfect explanation for the runs of good or bad returns in the stock market. If you spend enough time data mining, then you will find all sorts of apparent trends in historical data. As Burton Malkiel, author of A Random Walk Down Wall Street, so eloquently stated: “Technical results have been tested exhaustively…The results reveal conclusively that past movements in stock prices cannot be used to foretell future movements. The stock market has no memory. The central proposition of charting is absolutely false, and investors who follow its precepts will accomplish nothing but increasing substantially the brokerage charges they pay.”

For more commentary on the Fed funds rate, check out Cliff Reynold's Fixed Income Recap.


Have a great day!


Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

Yesterday was without an economic release resulting in a slow, low volume day in bond land. The snail like pace will continue today as most of the market is waiting to hear if the FOMC will say anything big following the conclusion of their policy meeting on Wednesday.

It’s a foregone conclusion at this point that the Fed Funds rate will remain where it is for this meeting, a target rate of 0-.25%, but futures have shown an uptick in amount of people expecting an increase soon. Current data show that the market is leaning toward an increase in the Fed Funds rate to .50% by the January 27 meeting. If that were correct it would mark the first increase in the rate since June 2006 when it topped out at 5.25%, and would also be the first adjustment to the rate since December 2008 when it was floored.

Shorter-term yields have been on a steady rise since early July when the 2-year reached .904% on July 13. The same bond was yielding 1.222% after yesterday’s rally from 1.302% at the close of last week. While long term yields react more to inflation expectations, short term yields are more sensitive to Federal Reserve policy, and the recent rate movement is showing this increased chance of a Fed policy reversal. It is important to note that the recent selloff in the short end can be partially attributed to poor auctions in late July, but expectations for a reversal in Fed policy coming sooner rather than later made that section of the curve unfavorable at lower yields. The FOMC comments tomorrow, retail sales data on Thursday and CPI on Friday could make for a bumpy ride later this week.

CIT
Just to touch on a brief piece of news from last Friday that I missed in yesterday’s recap, CIT announced that it will be suspending dividends on its preferred stock effective immediately. CIT hasn’t had to pay preferred dividends since June 15, but since one of its issues was due to go ex on Friday they announced the suspension of dividends for all preferred stock. This is no surprise to the market - the market prices for the issues were unaffected by the news – but the move is expected to save CIT $50 million dollars each quarter, a drop in the bucket compared to the $10 billion in debt that is scheduled to come due in the next 18 months. The company currently has no prospects for refinancing their maturing debt, and has also drawn on the final $1 billion of the $3 billion in emergency financing they secured on July 20.


Cliff J. Reynolds Jr.

Quick Hits

• Corporate Earnings Are No Sign of Recovery
• Investing: Hold or Fold, but Don’t Waver
• Fed does not need more powers
• Big Macs and Moving Debt to Asia
• July Jobs Numbers Not All Their Cracked Up to Be

Daily Insight

Stocks finished the week strong as better-than-expected employment data gave investors reason to believe the recession is over. Nine of ten sectors gained, with the only loser in the broad-based rally being the energy sector. As you can see below, all domestic equity asset classes made solid gains but I want to make special note of REITs’ performance since they are not listed in the table.

REITs (real estate investment trusts) had a particularly impressive performance last week (up 16.80%) as investors anticipate some of the financially stronger REITs to shift from defense to offense. Faced with a deteriorating commercial real estate market and hundreds of billions in debt coming due in the next few years, REITs have generally been shunned by investors in 2009. However, REITs have been raising capital by slashing dividends, issuing new equity, and buying back their public bonds at steep discounts. Financially strong REITs have offered attractive yields for several months, but now REITs are getting a boost from investors as they prepare to unleash billion dollar-war chests to fund acquisitions of troubled properties on the cheap. To read more about this, check out my post on our blog from last week by clicking here.

Market Activity for August 7, 2009
Dissecting Friday’s Data

Much to everyone’s surprise, the unemployment rate actually fell in July, hitting 9.4% from 9.5%. Although this report continues to support the view that the recession ended in the summer of 2009, the decline in the unemployment rate was not a product of job creation, but rather due to people dropping out of the work force. If people drop out of the labor force, the unemployment rate can decline because fewer people would be considered jobless.

The July household survey showed the civilian labor force shrinking by 422,000 and employment falling 155,000. That translated into 267,000 fewer people listed as unemployed. The labor-force participation rate fell 0.2 percentage point in July to 65.5%. Once the economy improves, these people will likely return to the workforce, which will result in the unemployment rate climbing higher – for example, people who decided to return to school during the downturn will eventually return to the job search and help push unemployment higher.

Another factor that could keep the unemployment rate elevated is the considerable degree of structural unemployment, evidenced by the 53.5% of those unemployed because they have lost their jobs permanently – the highest figure since this data has been tracked. Structural unemployment, as opposed to cyclical unemployment, is caused by changes in the economy rather than the business cycle. The high number of people permanently laid off reflects the excess capacity that had developed in the economy over recent years in areas such as construction, financial services, retail trade, and auto production/sales. Even as the economy recovers, these displaced workers will likely be unemployed for a prolonged period.

The point to take away here is that we shouldn’t get ahead of ourselves. The improving trend of the labor market cannot be denied, but businesses are not about to start hiring people. Businesses will want to make sure that a sustained economic recovery is here before doing any substantial hiring. For this to happen, demand will need to improve – a process we believe will continue to be a slow one as households contend with weak income growth and balance sheet issues for some time.

Speaking of consumers’ balance sheet issues, the Friday’s consumer credit report showed borrowing by U.S. consumers dropped in June for the fifth straight month, the longest series of declines since 1991. Consumer spending, which accounts for about 70% of the economy, will take time to recover as households put off major purchases in light of a weak job market, stagnant wages, and falling home values.


Where do we go from here?

It seems like a long time ago when stocks were priced for the possibility that the global banking crisis would shut down the world’s financial infrastructure. Being a forward-looking indicator of the economy, stocks rallied since March in anticipation of the end to the recession. But it’s a bit of a head scratcher that stocks are now rallying because the recovery that stocks themselves predicted comes true.

The point I’m trying to make here is that it’s easy to be greedy here and pretend that the crisis never happened. But, it did happen. As a result, the financial system was left crippled and the government has taken on trillions in debt which will threaten the world economy with inflation and higher tax rates. I’m not necessarily saying that stocks can’t continue their progress – although they seem overdue for a small correction following the 50% jump from the March lows – but it would be foolish to think everything is back to normal and stocks will quickly return their 2007 highs.

Patience and discipline is crucial for all investors in this environment.


Have a great day!


Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

Stocks were juiced to new highs for the year on better than expected employment numbers. Nonfarm payroll employment declined by 247,000 in July on a seasonally adjusted basis, much better than the -325k expected. June’s data was revised upward from -467k to -443k.

The main reasons for the better than expected numbers include a 28.2k addition to automotive manufacturing payrolls during a month that historically cuts some due to planned summer shutdowns, this surprise increase is exacerbated by the seasonal adjustment. Federal Government payrolls increased 12k and several service sectors were better than expected but unfortunately too much of the positive surprise compared to what was expected seems to be one time in nature. The auto industry has “cash for clunkers” to thank for the pop last month but that shaping up to be short lived.

Last week was the worst for Treasuries since the March of 2003. Yields were up across the curve every day but one last week to their highest levels since mid-June as investors continue to shed Treasuries in exchange for riskier investments like stocks and corporate bonds. The 5-year credit default swap index, which measures the cost that investors are paying for protection against default for 125 different companies, is at its lowest levels since May 30 2008.

The FOMC will meet this week, and while it is expected to leave the Fed Funds Target Rate unchanged at 0-.25%, a large question mark remains over the future of the Fed’s open market operations. Recent fedspeak has shown some member’s hesitation to increase the amounts dedicated to buying Agency MBS and debentures along with Treasury bonds, fearing the price instability that could ensue if the Fed does too much to keep rates low. Nonetheless it stands to be a heated topic and if the Fed comes out and states that all programs will end as scheduled it will mark the first real tightening of monetary policy during this latest cycle. But that is probably wishful thinking on my part. Something to the effect of, “We will continue to monitor market conditions before making a final decision” is more realistic. Especially considering the next meeting on September 23 will likely be the Fed’s final chance to extend the Treasury program before it completes.

Treasury supply for this week looks like this:
· Tuesday - $37 billion 3-year notes
· Wednesday - $23 billion 10-year notes
· Thursday - $15 billion 30-year bonds


Cliff J. Reynolds Jr., Investment Analyst

Higher sales of Monster Energy drink lift Hansen Natural (HANS)

Shares of Hansen Natural (HANS) are trading nearly 20% higher following the company’s earnings release after yesterday’s close. Hansen said profits grew 14% on higher sales of its Monster Energy drink and improved margins.

Although slightly below consensus estimates, revenue climbed 6% to $300.3 million. Demand is strong for Monster Energy drinks despite tough economic conditions that have led some consumers to replace their consumption of soda and energy drinks with tap water.

Hansen noted their distribution deals with certain Coca-Cola bottlers and Ansheuser-Busch last year has paid dividends for the company and market share has grown in its main distribution channels nationally, namely in convenience and grocery stores. The distribution deals have also helped Hansen grow sales outside the U.S. to $39.4 million, compared with $27 million a year ago.

Gross margins jumped to 53.9% from 51.8%. Distribution costs as a percentage of net sales were 4.2% for the second quarter, compared with 5.5% from the year-ago period. Selling expenses as a percentage of net sales were 11.2%, compared with 12.1% a year ago. The distribution deals mentioned have played a part in lower distribution and selling costs.

Monster is the leading brand in terms of volume share and growth. Distribution agreements and lower expenses have positioned Monster for even higher sales once the economy improves.

Not included in the earnings report, but also of interest – Hansen announced that Monster Energy drinks are hitting fast-food chains, with Hardees company-owned units offering Monster Energy in mid-August and franchised units joining later. Carl’s Jr. will immediately begin offering Monster Energy drinks in all units.
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Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

Initial Jobless Claims for the week ending July 31 fell to 550k from 588k the previous week, surprising the market that was expecting 580k. The better than expected news hurt Treasuries as the yield on the 10-year rose 5 basis points to 3.78%, near its high for the day.

The Fed purchased $7 billion in the 7-10 year area yesterday, just under the average for that maturity range, but received just over $48 billion in submitted offers from dealers, almost double the average for that area of the curve and more than any other time since Treasury open market operations began in March. Surprisingly it didn’t move the market all that much. Bonds had already rallied off their lows by that point and stayed pretty steady until late afternoon trading.

There was an article in yesterday’s Washington Post on the potential avenues the government is considering for the unwinding of Fannie and Freddie. When the two Government Sponsored Enterprises were taken over by their regulator last year and an unwind was scheduled to begin at the end of 2009. With that deadline rapidly approaching, and a worse than expected housing market still plaguing the GSE’s portfolio, an early 2010 beginning to a FNMA FHLMC unwind seems unlikely.

James Lockhart, head of the FHFA, Fannie and Freddie’s regulator, proposed a good bank bad bank model where existing securities issued by Fannie and Freddie will remain as they are, but a new entity will be spun off in order to attract new private investment.

The two mortgage lenders existed for many years as quasi government supported entities. They were able to borrow at lower rates than the rest of the private sector, thanks to an implied government backing, but were privately owned, and therefore had a responsibility to return profits to their shareholders. In my opinion, the new “good bank” cannot survive in a hybrid form like it did previously. That model is flawed. The new company must be either completely spun off, and stand entirely separate from both the support and influence of the government, or simply be combined with Ginnie Mae, who’s securities carry the full faith and credit of the US Treasury. Regardless of what happens the mortgage lending landscape will look very different in a few years.


Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

After starting the day in positive territory, stocks swung to a loss yesterday on mixed earnings reports and weak retail sales numbers. Meanwhile, others waited on the sidelines for today’s jobs data.

Eight of ten major industry groups declined, with industrials (led by the defense and industrial conglomerate sectors) and utilities posting the only gains. Telecom and healthcare were the worst performers for the second consecutive day. Healthcare shares slid on an analyst downgrade of the industry. Meanwhile, telecom as well as technology shares slid after several companies announced disappointing earnings or forecasts.

Market Activity for August 6, 2009

Retail Sales

Retail same-store sales for July fell 5.1%, worse than the 5% decline expected. Department stores and luxury retailers continue to see declining sales, while discounters posted unexpected misses. Categories that were most cited as seeing soft demand included apparel, home and garden, and electronics. The lackluster results can partially be attributed to Americans spending on new cars via the Cash for Clunkers program in July or splurging on new homes to take advantage of tax credits, rather than visiting stores. In addition, several retailers said a later back-to-school season this year pushed out the typical boost in sales from several state-tax holidays to August from July.

Also hurting sales could be the fact that retailers have slashed inventories to the bone, causing shoppers to leave empty handed when the product they are seeking is out of stock. Two years ago, someone looking to buy a coffee maker could go to Wal-Mart Stores or Target and choose from several different models in stock. Today, shoppers are finding that they only have one or two options (or none!) to choose from. Reducing inventories is a natural occurrence in a recession, but retailers can’t win if they don’t play. Stores will need to be sure they have adequate inventories to take advantage as the school shopping season approaches. I am confident this won’t be a problem next month.


Initial Jobless Claims

The number of U.S. workers filing new claims for state jobless benefits fell last week, providing another glimmer of hope that the economy may be on the road to recovery. The improving trend in initial claims is a positive, although the trend is slightly distorted by fewer layoffs in the auto sector than typically seen during summer production shutdowns. Still, the four-week average of claims has fallen 104,000 from the peak to its lowest level since January 24.

Historically, the U.S. economy has come out of recession when the four-week average of claims has declined by more than 100,000 jobs. This should not be confused with the unemployment rate, however, which typically lags by six months on average and doesn’t peak until after the recession ends.

While the drop in initial claims is welcome, most evidence still suggests a difficult job market longer-term. If there is a “new normal” and some of the debt-fueled growth of this decade is gone forever, then there will be less demand for workers. Even more, employers are likely replacing workers with technology or outsourcing jobs internationally.

Initial claims, though, do lead to continuing claims and we’ll see how long the transition is between a slowdown in firing to a pickup in hiring. There is certainly potential for an upward surprise on payrolls over the next few months if employers find they need to quickly undo some layoffs when growth returns.


Today’s Data

Nonfarm payrolls will be in focus this morning. According to Bloomberg, economists predict payrolls fell 325,000 in July, which would be quite an improvement from the disappointing June decline of 467,000. Meanwhile, the unemployment rate is expected to tick up to 9.6% in July, following a 9.5% reading in June.

Consumer credit is the other release today, and credit is expected to have declined by $5.0 billion in June.

As unemployment approaches 10%, frugal consumers and banks threaten to stymie economic growth and perhaps even drive a double-dip recession. I’m not necessarily agreeing or disagreeing with that view, but I think it is foolish to think that the recovery will be quick. Instead, I side with the view that an economic recovery will more likely be slow moving.


Have a great weekend!


Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks traded down, halting a four-day winning streak, after a closely-watched employment report suggested the July jobs figure will be weaker-than-expected. That was followed by the latest service-sector reading that declined at a faster rate than the previous month. We’ll get the weekly jobless claims figure today and the official July payrolls report on Friday, so traders may just have decided to hold off until they get the release of those figures.

Eight of the 10 major industry groups declined, with financials and basic material shares as the only winners on the session. Worst hit were telecoms, health-care and energy – strange that this group slipped after the latest inventory report showed distillate inventories declined and gasoline and crude stockpiles rose less than expected; oil prices rose on the day.

Market Activity for August 5, 2009
Mortgage Applications

The Mortgage Bankers Association reported that its index of mortgage apps rose 4.4% for the week ended July 31 after a 6.3% decline in the prior week. Refinancing activity led the index higher, up 7.2%, as the 30-year fixed-rate mortgage fell back to 5.17%. Purchases rose 0.9% after no change for the week prior.

Mortgage rates remain in a sweet spot, above the sub-5.00% lows hit back in March/April/May but still very attractive for both refis and purchases. One thing I find interesting though is how buying activity has declined over the past five weeks. If this data is accurate, it shows the sales boost the pending home sales data suggesting is in the works will be short-lived.

Preliminary Jobs Data

As we gear up for tomorrow’s July employment report, yesterday we received preliminaries in the Challenger Layoffs report and the ADP Employment Survey.

The Challenger Job Cuts report – which comes out of nation’s premier outplacement firm Challenger, Gray & Christmas – showed employers announced fewer layoffs for a second straight month, marking the first consecutive decline since early 2007.

Planned firings in July fell 5.7% to 97,373 from the year earlier, this followed a 9% decline in layoff announcements in June. The transportation industry led the cuts, announcing 22,367 layoffs last month, followed by the telecom industry with its 16,799 in cuts – largely led by Verizon’s layoffs.

This data is certainly moving in the right direction, but the layoff cycle continues to run its course.

The ADP Employment Survey estimated the economy shed 371,000 payroll positions in July, which was a bit more than economists expected of -350K. This is also more than what is expected out of the official jobs report, which is for a 328K decline in payrolls. ADP has been very accurate over the last several months in predicting the actual number.

What we’re seeing here is that job losses are moving to levels that mirror the peaks seen during the normal recession. While the labor market will continue to shed jobs for at least several months, the rate of decline has improved markedly.

ADP estimated that the service sector shed 202,000 and the goods-producing sector cut 169,000 positions – an improvement for both areas relative to the June figures. In the previous employment report the service sector lost 244K positions and goods-producing sector slashed 223K.

Large businesses, defined as those with more than 500 employees, saw employment decline 74,000 (-91K in the June report); medium-sized firms shed 159,000 (-205K in June); and small firms, less than 50 employees, cut 138,000 (-177K in June).

ISM Service Sector

The Institute for Supply Management’s service sector index fell to 46.4 for July after a reading of 47.0 in June, the reading was expected to come in at 48.0 – a reading below 50 illustrates contraction.

This is the first time the non-manufacturing index (the service sector makes up roughly 85% of the U.S. economy, and thus factory activity about 15%) slipped below the level of the manufacturing reading since November and one of the very few times this has occurred since this survey began in 1997. This probably doesn’t bode well for the economic prospects regarding the current quarter and we’ll be even more dependent upon that inventory dynamic as a result.

Within the report, the business activity sub-index fell to 46.1 from 49.8; the new orders index slipped to 48.1 from 48.6; the employment index declined to 41.5 from 43.4; supplier deliveries bucked the trend, rising to 50.0 from 46.0 – the overall index reading is based upon these four sub-indices. The order backlogs index, which is not included in the overall index’s readings but key in predicting the direction of ISM over the next few months in my view, fell slightly to 42.0 from 46.0.

On the inventory front, I focused on the real estate industry where inventories rose in July, while inventory sentiment showed respondents within the industry believe levels are too high. This is probably not a good sign for prices over the next few months.

Six of the 18 industries that respond to ISM reported an increase in business activity, eight reported a decrease and four reported no change. Comments from respondents included:
“Reductions in revenue and staff”
“Lower customer demand”
“Continue to make efforts to reduce inventories”
“Orders are being placed on hold pending economic recovery”


I’ll be out of the office until August 18. Either David or Peter will be taking over until I return.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Bonds opened in the red as the market prepared for yesterday morning’s supply announcement for next week. The Treasury announced $75 billion in 3-, 10- and 30-year supply, a record for one week’s issuance of those bonds and in line with expectations.

Treasuries recovered after the ISM (Non-Manufacturing Index) registered 46.4 in July, well below the 48 expected. Expectations were elevated after July’s manufacturing index surprised to the upside and the disappointment brought Treasuries into positive territory.

But the rally didn’t last as comments from former Fed official Laurence Meyer hinted at an as scheduled stop to the Fed’s Treasury Purchase program in September. Few in the market were looking for any meaningful expansion of the program, although some think that it would make sense to stretch it to the end of the year, and make it consistent with the MBS purchase program. I personally am indifferent. It most likely wouldn’t make an impact either way. I think today’s reaction was a little exaggerated on account of the morning’s volatility. I also will only believe for sure that they are done when they actually stop buying.

The Treasury announced that it will increase TIPS issuance next year and is also open to replacing the 20-year with a 30-year, which was last issued in 2001. This makes sense considering the Treasury is issuing gobs of the nominal 30-year so there is plenty of interest among buyers. Plus it will give the market a new data point on the breakeven curve. The proxy for inflation expectations currently ends at 20 years. TIPS outperformed nominal Treasuries on the news as 10-year breakeven’s widened to 193 bps.

Cliff J. Reynolds Jr., Investment Analyst

REITs rally on cheap valuations and improved balance sheets

In a down market like today, it’s easy for me to take notice of the one green area of my Bloomberg screen – REITs.

REITs have been reporting second-quarter results, many of which have been weighed down by rising expenses that are a result of landlords putting more money into their properties to maintain occupancy – a natural occurrence when demand is weaker than supply. But, it is the encouraging progress on raising capital and deleveraging balance sheets that is sending REITs higher.

REITs were beaten down worse than other asset classes as the credit crunch made it difficult to refinance coming debt maturities. At their peak, REITs average leverage ratio was over 60%, significantly higher than in the early 1990s when debt accounted for just one-third of REITs’ balance sheets. Such high debt levels were a result of REIT managers assuming that the capital markets would always be welcoming. As a result, REITs piled on what seemed to be cheap debt rather than sell shares to pay for acquisitions.

After their market values got pummeled, many REITs began slashing dividend payments to bolster their capital levels at the beginning of 2009. Investors cheered.

It wasn’t long before REITs tapped equity markets to take advantage of surging prices to raise capital. According to the National Association of Real Estate Investment Trusts, REITs raised roughly $15 billion through common stock offerings during the first half of 2009. Investors cheered.

Even more, REITs have been buying back their public bonds at steep discounts – in essence using $1 to retire $2 of debt. In some cases, cheap buybacks create an arbitrage opportunity if a REIT sells properties at a smaller discount than that in which it is buying back bonds. Investors cheered.

In raising all of this capital, some REITs are preparing themselves for the hundreds of billion in debt coming due in the next few years. Others, however, are preparing to unleash their billion-dollar war chests to fund acquisitions of troubled properties on the cheap. With an estimated $90 billion in commercial real estate in the U.S. alone that is “distressed,” there is no shortage of opportunities.

One particularly big opportunity many REITs are watching closely is the portfolio of General Growth Properties, the real estate giant that filed for Chapter 11 in April, taking more than 160 properties with it, including such trophies as Faneuil Hall Marketplace in Boston and South Street Seaport in New York City.

The point I’m trying to make is that financially strong REITs have offered attractive yields for several months, but now some REITs with stronger balance sheets are looking to move from defense to offense. The risk-adjusted returns these offensive REITs can achieve in this environment has fueled the recent rally.

REITs are lagging most other asset classes year-to-date, and investors still seem to be shying away because of the slowly deteriorating commercial real estate market. However, the massive oversupply that existed during the late 1980s and 1990s in the commercial real estate market does not exist today, suggesting prices could have a decent recovery once demand improves. Of course, this could also be a sign that the worst is yet to come.

Either way, the aftermath of an intense sell-off and massive capital raising has left REITs reasonably priced – which explains the buying fury of the past few weeks – and investors should stop fearing the sector.
--

Peter J. Lazaroff, Investment Analyst

July 2009 Recap

The S&P 500 pushed its winning streak to five months on better-than-anticipated earnings reports and the expectation that the U.S. economy will expand in the current quarter for the first time in a year.

Historically defensive sectors like utilities, healthcare, and telecom were laggards during the month. Offensive groups like technology, industrials, materials, and consumer discretionary, continued to shine in July. These offensive groups have led all other sectors since March 9, excluding financials. The year-to-date performance for financials disguises the sector’s enormous volatility – declining roughly 50 percent from January 1 to March 9 and recovering 100 percent since then.

As of July 31, three out of four companies in the S&P 500 have reported earnings results that exceeded analysts’ estimates. They’ve beaten forecasts by an average of 9 percent, even as earnings tumbled 32 percent and sales slid nearly 17 percent. Cost cutting, rather than revenue growth, has been boosting companies’ bottom lines. However, easier comparisons in the second half of 2009 and extremely low inventory levels should help bolster revenue growth in the near term.

Highly accommodative monetary policy is helping buoy markets in developed international countries. Meanwhile, emerging markets economies are healing – especially China which has resumed strong growth – thanks to massive global stimulus.

In the fixed income markets, corporate bonds have seen huge gains and spreads on investment-grade debt have narrowed to levels prior to the Lehman Brothers bankruptcy. The Treasury market has occasionally shown that investors are concerned with the increasing level of government borrowing and spending. If that concern persists, then interest rates could move substantially higher and stymie the recovery.

The S&P 500 may not be as cheap as it was several months ago, but at 13 times 2010 earnings, the index is reasonably valued by historical standards, especially considering the low yields on longer-term Treasuries and near-zero yields on money-market funds. The biggest risks we see going forward include a possible economic “double-dip,” the threat of higher taxes, and higher inflation.
--

Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks wavered between gain and loss several times yesterday before rallying in the final minutes to close higher. The tug-and-war session began after the pre-market release for July personal income registered the largest decline in four years as a special addition to government transfer payments (part of the stimulus package) ran its course – this has been the only boost to incomes for several months as private-sector components have been falling. Stocks rallied, however, after the latest pending home sales report easily surpassed expectations, suggesting home-buying activity will rise for the next couple-to-three months.

Financial, industrial and consumer shares were the leaders yesterday. Certainly the housing number helped these groups, but it was rather surprising how consumer shares looked past the income figures. In the very short-term the “cash for clunkers” program will offer a boost to consumer activity but it is front-loading spending; personal consumption will fall off again when the program expires.

Utility shares led the declining sectors after East coast electric power company PPL Corp. reduced its 2010 forecast as they see power demand will continue to erode.

Market Activity for August 4, 2009
Personal Income and Spending

The Commerce Department reported that personal income fell 1.3% in June, the largest percentage decline in four years, pretty much erasing the May increase of 1.3% -- that number was revised lower, originally estimated as a 1.4% increase.

The June figure was pushed lower as government transfer payments fell 5.9% for the month. As we mentioned last month, government transfer payments made up 97% of the May income gain and one cannot view such realities as sustainable – it was illogical for the market to get excited about that increase. The area that really matters, private-sector incomes, fell again – rental incomes were the only segment to rise, up 1.0%.

Compensation, normally the largest part of personal income, fell another 0.3% in June, down 3.8% year-over-year. Wages and salaries fell 0.4%, down 4.7% from the year-ago period – the largest annual decline since these records began in 1960. Proprietor’s income slipped 0.1% in June, off by 8.3% year-over-year. Income from assets (a combination of interest and dividend income) fell 0.4% and is down 10.8% from June 2008. Farm income got hammered, down 3.2% in June and crushed over the last year, lower by 44.5%.

This didn’t stop spending from rising for the month though as personal outlays rose 0.4%, which was more than the 0.3% expected. This may marginally improve the Q2 GDP report when it is revised later this month. Spending on non-durable goods led the increase, up 1.65% for goods meant to last less than three years. Spending on durable goods fell 0.2%. On an inflation-adjusted basis personal spending was down 0.13% in June and is down 2.15% year-over-year.

As a result of the decline in incomes, while spending increased at the same time, the personal savings rate (what I refer to as cash savings) slipped to 4.6% from 6.2% in May. This reading will pull back a bit more over the next couple of months as the CARS program will boost spending for July and probably August. (The market may become very excited over these consumer readings, but will have the rug pulled out from under its euphoria as personal outlays will decline when Uncle Sugar…sorry, Sam, ends his cash handouts.

A few months out, we will then see this measure of savings resume its march to 8-10% as the job market remains fragile for sometime to come and stock and home values (the two largest savings vehicles) remain off of their peaks by 36% and 21%, respectively. Later, when interest rates being to move higher, this savings figure will pick up speed as there will be an additional incentive to hold cash.

Pending Home Sales

The National Association of Realtors reported that pending home sales jumped in June, marking the fifth-straight month of increase. Pending sales, which indicate actual sales will follow two months later, rose 3.6% for June after a 0.8% rise in May, a number that was revised up from 0.1%. So long as there aren’t too many loans that fall apart by the time of closing, we’re going to see a few months of sales advances – a very good sign for the supply figure, which has improved but remains elevated.

All four regions of the country reported an increase in contract signings. The South led the way with a 7.1% gain; the West saw pending sales rise 2.9%; pending sales in the Midwest rose 0.8%; the Northeast was the laggard, with pending home sales up just 0.4%.

As we’ve been talking about, a sustained recovery in home sales is unlikely as the tax-credit for first-time buyers expires by December and one cannot expect interest rates to remain this low for long. Still, this is great news for the housing market as it is beginning to find its legs, even if the rebound is due to the aforementioned stimulus. Let’s hope we’re not front-loading things (as we seem to be within other areas of the economy), as first-timers are rushing to get in by the November 30 cut off for that tax credit, only to see sales move meaningfully lower in 2010. (I don’t enjoy striking this pessimistic tone, but I also don’t want to look naïve when the inevitable occurs).


Have a great day!


Brent Vondera, Senior Analyst

PFG 2Q09 Earnings release

Principal Financial Groups (PFG) reported 2Q09 earnings result of $150.3 million net income available to common stockholders or $0.52 per diluted share, compare to 2Q08 number of $168.3 million or $0.64 per share. It missed analysts’ estimate by 20%. Reduced fees earned from asset valuations, a stock offering on May of 2009 that increased number of shares outstanding, and high pension costs due to negative market performance all contributed to the decline in the per share result.

Generally, their numbers were all lower compared to 2Q08 when the S&P 500 still was trading at upper 1200 level. However, over the three consecutive quarters, PFG has shown some improvements and their business has returned to more normal state. Total assets under management decreased to $257.7 billion from $308.0 billion year ago period, but increased 9% since the last quarter.

Net income available to common stockholders includes some realization of capital losses on their other than temporary impairment of fixed maturity securities, losses related to hedging activities, commercial mortgage loan losses, and etc.

Significant market losses coupled with rising unemployment level and reduced investment income is negatively affecting company’s earnings result for the quarter, but the company is also likely to benefit more upon improvement in unemployment level and interest rate increase. The market is already recovering, up 48% from the March low, which will make PFG’s comparable earnings look fabulous in the near future.

Patience has been proven to be a virtue with this company, marking remarkable 289% come back from March low. However, the stock is still 65% below its end-of-2007 price level and it will only be taking longer from here to recover, since the job market will not be able to turn around as quickly as the market did.

PFG is trading at 8.5 P/E, near half of their historical 14 average P/E level.

Whole Foods Market Inc. 3Q09 Earnings release

Whole Foods Market Inc. reported 3Q09 earnings of $0.25, beating 3Q08 earnings of $0.24 by 4% and surprising analysts’ estimate of $0.20 by 25%. Revenue increased 2% to $1.88 billion even as store sales decreased overall. It is especially remarkable, considering current economic situation, and compared to last quarter’s negative sales growth. Their Ccst conscious approach to expenses paid off, increasing their overall gross profit 33 basis points (excluding LIFO adjustment). WFMI increased fiscal year 2009 diluted EPS to $0.80-$0.82 from previous guidance of $0.65-$0.70.

WFMI closed at $24.82 pre-earnings, and earnings release after market boosted the company 13.5% in after market trading.

Haemonetics 1Q09 Earnings

Haemonetics (HAE) reported earnings for the first quarter of fiscal 2010 of $0.69 diluted earnings per share, a 17% increase from $0.59 1Q09 diluted earnings per share, and beating Bloomberg analysts’ estimate by 6%. HAE also pulled strong margin improvement, adding 370 basis points to operation income margin of 17.1%.

The largest component of Haemonetics business, plasma disposables, showed some nice growth for the quarter, marking a 26% increase in $154 million revenue, benefiting from long term contract implementations, global growth in plasma collections, and price increases. Platelet disposables revenue was $34 million for the quarter, down 4% and Red Cell Disposables revenue was $12 million, leveling with previous year over year.

The company reiterated its full year earnings per share guidance at $2.75 to $2.85.

With all this positive news on Haemonetics earnings, stock still closed 5.1% lower for the day.

Hologic, Inc. 3Q09 Earnings Release

Hologic, Inc. (HOLX) reported 3Q09 revenue of $403.1 million, a 6.1% decrease from $429.5 million in 3Q08. Diluted earnings per share excluding one time items came in at $0.29, a 12% decrease from 3Q08, beating Bloomberg analysts’ expectation by 12%.

The company blamed the current economic environment, the resulting delays and reductions in hospital spending and longer sales cycles for this decline. As evidenced by a reduction in Selenia System sales, and a decrease in company’s osteoporosis assessment, mini C-arm, MRI Product lines, and flat ThinPrep products, HOLX is having a difficult time selling their product to hospitals and upgrading current systems in the hospitals.

HOLX’s write-off of certain intangible assets continued for 3Q09, albeit at a much smaller pace of $4.1 million dollars, and the company also recognized net charges of $40.1 million on amortization of intangibles related to Cytyc merger and the Third Wave acquisition, and a full quarter of costs and expenses from Third Wave.

Considering the current market situation, where hospitals are just waiting on health reform to finalize before making any big purchases and trying to make their books strong to secure any financing needs, plus all their internal write down issues inherited from untimely acquisitions, are double whammy for the company. That is why the company with a 39 average P/E ratio for the past 5 years is currently trading at 12 P/E, and it seems all this bad news is already priced in. Frankly in my view, they rather seem to be weathering this storm quiet well.

A few positive notes include FDA Approval of Adiana Permanent Contraception System, which will start contributing in 4Q09, and expected continuing double digit growth on Diagnostics and GYN Surgical revenues. Diagnostics newly includes Third Wave product revenue of $10.3 million in 3Q09.

HOLX’s backlog stands at $333.6 million, which is within its historical range.

For the fiscal year 2009, the company now expects sales to come in between $1.625 billion and $1.65 billion, lowering the top estimate by $15 million.

Daily Insight

U.S. stocks rallied, sending the S&P 500 past 1,000 for the first time since November, as China’s factory sector recorded its fifth-straight month in expansion mode and U.S. manufacturing made nice progress toward expansion mode for July.

Commodities rallied on that news out of China, helped even more by a dollar that continues to get crushed, as basic material shares led the broad market higher. Energy shares also helped lead the rally as crude marched back to $71 per barrel.

The S&P 500 has now jumped 48% from the wicked March 9 low of 666. This is great news, it is certainly very nice for the American psyche, but I also find it difficult to get excited about the latest leg of this move – I’m talking about the 12% move in the last three weeks. (And just for the record, for those who may not remember, in the March 10 letter we stated it does feel like something powerful is about to occur as we were 515 days into the bear market and the S&P 500 was down 57% -- following the 1929 crash the broad market was down 42% 515 days in and this is no Great Depression. Others know that my view of fair value is 900 on the S&P 500, so I don’t want anyone to believe that my comments of concern means that the vast part of this rally is not justified; the vast majority of this rally is justified – particularly since health-care legislation and Cap&Trade have run into trouble).

But one understands, or should, that when things go up this fast, even if it is off of an unjustified low, the pullback is not far off. The degree of the pullback will depend upon the extent to which values run up beyond what is rational. The concern here is that when the inevitable move down of 15-20% does occur, investors will fear a replay of last March and exacerbate the retrenchment. I don’t think it is beyond reason to guard against this possibility. Don’t’ increase your equity exposure and chase this thing higher.

ISM Manufacturing (July)

The Institute for Supply Management’s manufacturing index rose to 48.9 for July, easily surpassing the 46.5 that was expected, up from 44.8 for June. While this latest reading shows factory activity contracted for an 18th straight month, a reading over 42 suggests the overall economy is growing (although as the ISM report states, “it would be difficult to convince many manufactures that we are on the brink of recovery”).

Most of the sub-indices of the report looked really good, with production hitting a pretty robust level of 57.9 (second month of expansion), new orders hitting 55.3 (second month in three above 50) and the backlog of orders posting 50.0 (first 50 print since the September debacle).

Export orders also moved into expansion mode, posting 50.5 and this is going to be a number that drives ISM, and helps the economy in general over the next few quarters.

Still, the inventory gauge remains deep in contraction mode, moving up to 33.5 from 30.8 but nevertheless really depressed as the chart below illustrates. I happen to look at this as not such a bad sign as it means the production needed to rebuild stockpiles is soon to come, but most economists view this low level as a possible sign that businesses are still very cautious and may not rebuild stockpiles to a meaningful degree.

This is a concern, and one I share but over a longer-term perspective. Whether it occurs in the third or fourth quarter (the boost to GDP from inventory rebuilding), it doesn’t really matter, it’s going to happen. But businesses know that tax rates are going higher and this adversely affects their expectations for growth. As a result, they’ll hold back over the next year more than would otherwise be the case. This is why I believe the government’s spending, while helping GDP in the short term, will come back to haunt thereafter as the capital sapped from the private sector will do damage.

Six of the 18 industries within the survey reported growth in July, matching the June report. Here is what ISM reported respondents as saying:

“There is concern about overall health of strategic suppliers – continue to see new suppliers filing Chapter 7 or 11, posting significant risks to supply chain.” (Machinery industry)

“We believe our inventories are now at the bottom of this cycle, driving stronger demand for raw materials.” (Paper Products)
My comment: This speaks well for the commodity trade.

“While our aftermarket business has improved slightly, we are still awaiting an increase in OEM demand.” (Transportation Equipment)
My comment: This will turn as auto plants kick start production, which should be soon as “cash for clunkers” will drive auto sales for a couple of months. Problem is it will be short-lived.

“Looking at another round of shutdowns to align supply with projected demand.” (Nonmetallic Mineral Products)

“No stimulus for manufacturing.” (Fabricated Metal Products)
My comment: this is one of the problems. These last two responses illustrate that economic activity remains very soft and outside of the areas that either the Fed or fiscal government stimulus specifically goose, things don’t look much like a recovery.

Construction Spending (June)

The Commerce Department reported that June construction spending rose for only the third month of the past 12 as residential building activity offset weakness on the private-sector commercial side of things.

Spending rose 0.3% in June to $965.7 billion at an annual rate, after a 0.8% decline in May, as both private and public sector residential activity increased. The big boost came from government outlays for both residential and commercial projects (up a large 4.6% for residential and 0.9% for commercial). Private-sector residential construction rose 0.5% and was down 0.5% on the commercial side.

As we’ve talked about for six months, the government construction spending will drive this overall reading higher and will be able to offset weakness within the private-sector commercial component, which I suspect will get pretty ugly over the next year (20% of hotel loans are expected to default through 2010 and warehouses, distribution centers and industrial buildings are having a rough go due to very weak activity).

While private-sector residential construction spending rose at a nice pace for June, I don’t think it will stage a sustained uptrend as sales will have too many issues weighing on home purchases. The tax credits for new home buyers will run out after this year and unless interest rates remain very low, the fragile job market will keep sales from rebounding outside of one-two month pops.

U.S. Vehicle Sales

The CARS (Car Allowance Rebate System) program – also known as “cash for clunkers” – helped to spark vehicle sales in July, pushing the figure above what the industry believes to be the breakeven point of 10 million units for the first time since December.

Total U.S. sales (both domestic and foreign) rose to 11.3 million units SAAR (seasonally-adjusted at an annual rate), up from 9.7 million in June. I don’t think there is any doubt the CARS program will be extended as the plan’s originally allotted $1 billion in funding has run out. The House passed legislation to add another $2 billion and we may find another couple of billion dollars added on top of that before it is all said and done.

This is one of the most economically stupid plans the government has ever come up with, and that’s saying something. Yes, there will be those that state it’s a huge success, and no doubt when people are going to be given money they’ll take advantage of it. But even if this plan were smart economics, all we’re doing is borrowing sales from the future and encouraging consumers to take on more debt as the unemployment rate has double-digits in its sights and incomes are stagnant-to-lower for most workers.

What’s more, as stated above, these sales should boost manufacturing activity as auto plants will ramp up production again, but this too will just front load things. What happens when the unemployment rate remains high, incomes flat and the consumer is saddled with a higher debt burden? It doesn’t take a genius to answer that one.

From an economic point of view, it makes zero sense to destroy vehicles that have a useful life. The familiar “cash for clunkers” nomenclature gives the impression that the trade-ins are all 1980 Chevy C-10s, but many of these vehicles are very likely 12-year old SUVs that have plenty of life in them – the dealership is required to destroy the motor before collecting their $3500-$4500.
Beyond that, one wonders if those at the lower rungs of the economic ladder are not hurt the most by this program. You can bet there will be less 10-15 year old cars on the market and that means higher prices for those who cannot get a loan to buy a newer car and have only enough cash to buy vehicles such as those now being destroyed. Like so many things that come from those who prop themselves up as the champion of the “little guy,” their incredibly stupid ideas hit those at the bottom the hardest.

Have a great day!

Brent Vondera

Fixed Income Recap

Positive news overnight from China’s manufacturing sector sent commodities skyrocketing and the dollar suffered as a result. Dollar weakness and a 1.5% rally in stocks lead to a broad selloff in Treasuries. The intermediate section of the curve suffered the worst, not surprising considering the news.

Inflation was the catalyst for yesterday’s move, shown by the outperformance in TIPS (10yr breakevens were wider by 10 bps). The curve steepened by 8 bps on Monday to +244 bps after flattening 32 bps last week.

CIT
CIT took another step toward avoiding bankruptcy yesterday by boosting the price they will pay in a tender offer for notes due August 17. The terms of the offer have changed a few times in the past few weeks, but in its most recent form CIT agreed to pay 77.5 cents on the dollar for the bonds. The offer was bumped to 87.5 yesterday, and the participation needed for the tender to be successful was lowered from 90% of bondholders to just 58%. CIT claims that 65% of bond holders have already agreed to tender their notes.

This is an important hurdle for CIT, but the fight is far from over. The notes being tendered are trading on the open market around 93, a large rally from the low 80’s just a day ago, but still a 28% annualized yield. CIT continues to face a steep uphill battle.

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks ended mixed on Friday as the latest GDP report came in better-than-expected, yet the latest regional manufacturing report failed to impress investors. A number of times it looked like stocks would stage a rally as many saw that GDP report as a sign the economy has turned, but the figure was helped too much by the government side of things (this may have increased doubts about the sustainability of a recovery) and that manufacturing report (for the Chicago region) failed to make it to 45, which appeared to be the whisper number.

Material, financial, energy and industrial shares led the broad market to a fractional gain. (Commodity prices are on fire this morning on a another good factory number out of China, which we’ll touch on below, with Dr. Copper up 4.5% and crude back above $70 per barrel; this should keep the rally in basic materials and energy going).

The Dow Average added 17 points thanks to a big day from Chevron. The NASDAQ Composite slipped as the index was pressured by tech shares. Mid cap stocks registered a fractional gain, while small caps declined.

Second-quarter GDP (initial estimate)

The Commerce Department reported their initial estimate to Q2 GDP came in at a much-better-than-expected -1.0% at a real annual rate, yet the previous two reading (Q1 and Q4 2008) were revised lower. That doesn’t matter right now as the market looks forward but it’s a reminder, as if we needed one, of the severity of this downturn.

We’ve now contracted for four-straight quarters. Prior to this recession we have never seen more than two-consecutive quarters of decline in the post-WWII era and the previous two readings of -6.4% and -5.4% are far and away the most harsh two-quarter decline since the 1957-58 recession (-4.1% in Q4 1957 followed by -10.4% Q1 1958).

Economic activity was buoyed by a 5.6% jump in government consumption that added 1.12 percentage points to the figure – much more of this to come – and net exports, which added 1.38 percentage points to GDP. Exports actually fell 7.0%, but imports fell more, down 15.1%. (The decline in real exports of 7% was a vast improvement from the 29.9% plunge in the first quarter. Real imports fell 15.5% at an annual rate, big move down that speaks to the troubled in consumer land but much better than the slump of 36.4% in Q1)

And speaking of the consumer, the largest segment of GDP – personal consumption – fell for a third quarter in four (that’s never before occurred since records began in 1947), down 1.2% at an annual rate. This followed a 0.6% rise in Q1, a 3.1% slide in Q4 and a 3.5% slump in Q3. (That Q1 rise of 0.6% was revised down from 1.4%, which was revised down from the initial 2.2% estimate that had the press giddy that the consumer was back. Oh, I wish it were true.) Personal consumption subtracted 0.88 percentage-point from real GDP. Durable goods shipments got slammed by 8.1% last quarter, which is what led the segment lower. Non-durables fell 2.5%.

Business investment (structures, equipment and software) fell 8.9%, normally a large move but not compared to the record 39.2% collapse of the prior quarter. Non-residential structures decline 8.9%. Equipment and software fell 9.0% --this reading was down 36.4% in the first quarter.

One should expect a statistical bounce from business investment for the current quarter, as we discussed after that last durable goods report. Business investment subtracted 1.82 percentage-points from the GDP reading.

Inventories, which many expected to rebound, fell for the sixth quarter in seven, down $141 billion at an annual rate, which put the two-quarter reduction at $250 billion – by far a record decline. Again, we will se a statistical bounce in GDP as the inventory dynamic catalyzes growth – simply put, there must be some ramp up in production after a slashing of inventories such as this.

And this is where the meat is for the next two quarters. Massive inventory liquidation and the small reduction in real final sales of just 0.2% in Q2 – final sales is GDP less inventory change – sets up for that inventory dynamic to rush through the pipeline. (Although the timing of this statistical bounce is fairly uncertain by way of the Chicago manufacturing number discussed below, it may not occur in the third quarter as we currently expect; we’ll just have to see how things progress over the next two months)

A statistical rebound does not make for a sustained recovery, we must see final demand come back and businesses must begin to spend again. In addition, all of the government spending in the world cannot fully offset weak consumer and business consumption. It can foster a three-four quarter increase but not much beyond that.

Residential fixed investment (housing) subtracted from GDP for the 14th straight period, down 29.3% at an annual rate last quarter. The segment reduced GDP by 0.88 percentage point.

So, this latest report, and with the revisions to the prior quarters, shows the economy contracted at a 3.9% in real terms over the past year. This marks a new record since data began in 1947.

This downturn has been severe and the damage done to the consumer will take some time to work out, putting a drag on GDP in the coming quarters. Over the next two quarters, its appears the inventory dynamic and net exports will offer a boost to growth, followed by a reading that more closely resembles something more typical of expansion in the fourth (its four–six weeks to early to throw out an actually number.) Government spending will keep the “dream” alive for the first two quarters of 2010 (most of the stimulus spending will kick in next year) but after that the expansion will peter out as the pay back for the way we’ve attacked this contraction will come due.

The economic rebound needs to be put into perspective, even if we get one, maybe two, 4% readings (although unlikely with unemployment this high and tighter credit standards) these would still be weak numbers coming out a contraction such as this – normally you see a 6.5%-8.0% bounce after rough recessions.

The way I see it the recovery will be similar to the 1980 recovery in terms of its short duration. Notice how the bounce back in GDP is strong after a deep contraction (such as the 1961 recovery following the rough late 1950s contraction, the 1975 recovery following the harsh 1974 recession and the 1982 recovery). I have my doubts that this one will be followed by a strong 6.5%-8.0% quarter even with the huge stimulus money set to roll in 2010

Chicago Purchasing Managers Index

In the day’s other release the Chicago PMI showed manufacturing in the nation’s most significant region improved for a second-straight month. The index rose to 43.4 for July after a 39.9 print in June. While the gauge remains in contraction mode – a move above 50 marks expansion – it is being weighed down by the auto sector. As production come back in autos this reading should move above 50, call it September when it moves back to expansion is what I’m guessing.

Most sub-indices of the report suggest things continue to improve, however, the inventory reading is disturbing as it got slammed back to 25.4 – a record low.

The Rally Rolls

Stock-index futures are up big this morning on last night’s news that China’s manufacturing sector remained in expansion mode for the fifth-straight month. China’s PMI (equivalent to our ISM manufacturing report, which we’ll get this morning) came in at 53.3 for July (a number above 50 marks expansion). While the figure is not raging to robust levels, pretty much holding at this 53 level, the Chinese government is pushing banks to lend aggressively. I haven’t seen the latest number, but the previous reading on credit expansion showed lending tripled from the year-ago level. So long as this is the case, China’s PMI will continue to grow, even if it means big banking trouble down the road.

If U.S. manufacturing shows additional progress toward that 50 mark, we hit 44.8 in June after 42.8 for May, and hit or surpass the estimate of 46.5 when this morning’s figure is released, we should make a run today for 1000 on the S&P 500.
Have a great day!

Brent Vondera

Fixed Income Recap

Today the Treasury will announce the sizes for next week’s 3-, 10- and 30-year auctions and the market is expecting some big numbers. Last week was a rough week for supply, with bid/covers down pretty much across the board, but after everything was said and done, the long end of the curve was higher for the week and the short end was down only marginally.

Some are saying short term yields were up in anticipation of the Fed raising rates soon, but I just don’t how the market can be thinking that now. Bernanke’s favorite phrase continues to be “Economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” And in his last speech, William Dudley, President of the New York Fed, argued, “That it is still premature to talk about ‘when’ we are going to exit from this period of unusual policy accommodation.” How do those words coming from the two most influential monetary policy makers translate into higher short term rates in the near future? I’m confused.

CIT
Little has changed with CIT since they adjusted the terms of their tender offer for $1 billion in notes maturing on the 17th. Analysts are estimating that CIT will need 90% participation from bondholders to avoid bankruptcy, but even if that is successful they will need a few more pieces to fall into place in order to stave off Chapter 11. Debt for equity swaps will likely follow for large issues maturing after this month, and as always, are far from a sure thing. CIT’s “hail mary pass” in all of this continues to be their request to move assets from some of their lending units to their bank. The primary benefit to doing that is the FDIC guarantee on CIT Bank deposits, something that CIT corporate bonds were denied when they did not qualify for the TLGP program. Whether they will be able to move assets to CIT Bank in order to better fund them is in the hands of the regulators, and does not look very promising.


Cliff J. Reynolds Jr., Investment Analyst