Daily Insight

U.S. stocks bounced between gain and loss several times Wednesday, but the broad market rallied in the final hour of trading to close higher. The Dow Average failed to follow suit as telecom names AT&T and Verizon, along with shares of 3M held the index back.

Financial, energy and technology shares were the leaders, with telecoms, industrials and utilities the laggards.

The weakness mid-day came on reports that homebuilders are worried that Congress has yet to signal an extension of the homebuyers tax credit. We all know that the housing market needs this credit (along with FHA-backed originations this is just another crutch), although I’m skeptical the beneficial impact its had on home sales will continue as the duration of joblessness continues to climb – having a job is sort of a big factor in buying a home. But you can’t keep a good market down, the performance chasers have come to town.

Volume was fragile again, with just 978 million shares traded on the NYSE Composite, roughly 25% below the three-month average. Got conviction?

Yesterday’s $20 billion auction of reopened 10-year Treasury notes went off without a hitch again. In fact, this is an understatement. The bid-to-cover ratio (gauge of demand) was through the roof at 3.01 (2.56 is the average over the past eight auctions). At this heightened level of over-subscription one would think the government was paying 6, 7 or 8% for 10-year money, instead of the 3.18% locking in for 10 years currently offers.

The Fed was in there again, buying $1.3 billion in Treasury securities, but even so these yields illustrate a view within the bond market that is quite removed from the euphoric optimism currently exhibited within the equity markets. In time we’ll find out which market is correct. It may be that neither are viewing things accurately, but no time to get into this take right now.

Market Activity for October 7, 2009
Mortgage Applications

The Mortgage Bankers Association’s index of applications jumped 16.4% in the week ended October 2 after declining 2.8% in the prior week.

Purchase leapt 13.2% as the rush is on to get in before the first-time homebuyers tax credit expires on November 30 (the contract has to close by that date). This buying is also being helped by FHA-backed loans, which now make up 23% of all originations, up from just 3% in 2006. A borrower need to only put down 3.5% of an FHA-backed purchase.

I guess I don’t have to say what this means for foreclosures if home prices dip again – at the end of June, 8% of FHA-backed loans were 90 days late; 15% are 30 days past due. The writing is on the wall.

Refinancing activity also surged, up 18.2% for the week – this segment made up 66.3% of the mortgage apps index, up from 65.3% the week prior. A 30-year fixed-mortgage rate of 4.89% for the week (lowest level since late May) certainly provided some jet fuel to contract signings and refis.

Weekly Energy Report

The price of oil pulled back a bit yesterday after the Energy Department reported that gasoline and distillate stockpiles jumped last week. Gasoline supplies rose 2.94 million barrels, a build of one million barrels was expected. Distillate inventories (diesel and heating oil) climbed 679,000 barrels, 70% more than the 400,000 expected. The 171.8 million barrels of distillates in inventory is the highest since January 1983 – although if the current temperature track holds it will soon boost demand for heating oil.

Crude stockpiles fell one million barrels, but the current level of inventories is 5% above the five-year average.

The fact that crude prices barely budged on the gasoline and distillate news shows the oil trade is not about supply/demand fundamentals and all about a hedge against a falling dollar and an overall move into commodities fostered by aggressive global monetary easing.

Consumer Credit

The Federal Reserve reported that consumer credit fell in August for a seventh-straight month (down 10 out of the past 11), matching the record streak of decline. The last time consumer credit (which includes both revolving – such as credit cards – and non-revolving – like auto loans) fell for seven-straight months was 1991, although the degree of decline this go around is three times greater. The data goes back to 1943, but it wasn’t really of much significance until the 1970s.

Consumer credit fell $12 billion, or 5.8% at a seasonally-adjusted annual rate, in August after the largest decline on record of $19 billion in July, according to the Fed. A median forecast of 36 economists estimated the figure to drop by $10 billion; projections ranged from an increase of $6.2 billion to a decline of $15 billion. The plunge in July was actually an upward revision from the initial estimate of -$21.6 billion when it was released last month.

The driver of the decline was a $9.9 billion, or 13.1%, drop in revolving credit as credit card lines have been slashed due to rising default rates and consumers pulling back and paying down balances. This is a necessary condition to a meaningful rebound in consumer activity 18-24 months out and is just something we’ll have to work through so long as the labor market remains mired.

Non-revolving credit eased just $2.1 billion, or 1.6% -- it had crashed during the previous two months, falling 12.6% in July and 8.0% in June. The cash-for-clunkers program clearly provided a respite to this continued decline, but like any scheme to boost activity when the consumer needs to repair the aggregate balance sheet, this only delays what is inevitably going to occur.

I suspect large declines in borrowing will continue over the ensuing months, and its natural effect on retail sales figures, now that Uncle Sugar is no longer distributing clunker cash. Domestic auto sales fell back to their pre-clunker cash levels in September, as the chart below illustrates, so next month’s reading on consumer credit won’t get help from the non-revolving side of things – it was a one and done event.

The clunker-cash program is a microcosm of what will occur when the various other types of government stimulus are removed – when the crutches are taken away. And if they are not taken away in an appropriate manner…well, reflation experiments always carry huge costs that must be borne down the road. We seem to live in a world in which more and more people are unaware of this reality and this does have an effect on one’s near-term (call it 18-24 month) expectations. Just as one has to come down from gorging on energy drinks, NoDoz (dang, two 1980s references in two days), or a sugar high (as is PIMCO’s El-Erian’s famous phrase), it must also come down from easy money policy – how quickly we forget.

Futures

Stock-index futures are off to the races this morning, juiced by Alcoa’s earnings results last night. Sales plunged 34% from the year-ago period, but were up 8% sequentially – that is, from the previous quarter. The market generally does not view revenue trends on a quarter-over-quarter basis because they are not good comparisons from a seasonal perspective, but that is all the market has to go on right now as the same-quarter year-ago comparisons remain abysmal.

Earnings came in much better-than-expected, posting a 4-cent profit vs. estimates for an 8-cent loss. The quarter was helped by a 24% jump in the average price of aluminum relative to the pervious quarter. China’s desire for metals has yet to be sated. And the Chinese will remain voracious with regard to their commodity purchases as they seek to offset the damage they are seeing in purchasing power via their U.S. dollar assets.

The firm engaged in another round of massive cost-cutting, slashed its smelting capacity as the firm said prices aren’t yet high enough to warrant restarting these plants. The company stated that global demand remained weak, with the exception of China.

Whether or not the rally we’re seeing in pre-market activity flows into the trading session may very well depend on how the weekly jobless claims data plays out. If claims can break the 540K level, the rally will rumble; if not, it will stumble. We get the number at 7:30 CT.


Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

It’s a Rick Ocasek market, “let the good times roll,” as stocks engaged in another significant rally yesterday. This brings to mind another song from the Cars: “Don’t Cha Stop.” The great reflation of asset prices continues as the Fed keeps easy-money policy floored.

The broad market has nearly erased the decline of the previous two weeks as investors appear pretty upbeat regarding the third-quarter earnings season, which will officially get underway today, but not in earnest until next week. The market is sanguine that we’ll see revenue growth for the quarter. I think it is more likely that the bottom line will be assisted via aggressive cost-cutting, mostly through the slashing of payrolls – just as was the case with second-quarter earnings (still profits will be down at least 15-20%).

If we do fail to get top-line improvement, which depends upon final demand, I think the music’s going to run out on this leg of the rally – but I’ve been saying that for 150 S&P 500 points now; as the Fed keeping the pedal to the metal, one never knows another asset bubble may just ensue. One thing is pretty clear, a prolonged period of cost-cutting via payrolls today means a lack of aggregate demand tomorrow.

Another weak session in terms of volume as less than 1.2 billion shares traded in the NYSE Composite. One would like to see these rallies exhibit more conviction, say 1.5 -1.8 billion shares, but no one seems to be too concerned about it.

Energy and basic material stocks led the rally as the surprise hike in rates by the Reserve Bank of Australia (their central bank) delivered yet another body blow to the greenback, which we’ll discuss below. Tech, consumer discretionary and financials performed very well too.

More positive comments from analysts/economists helped yesterday’s extension. A top executive at Fidelity International stated sustainable economic growth and low interest rates worldwide will spur a “multi-year” bull market in equities. Also, Deutsche Bank’s chief U.S. economist appeared to reverse course after being pretty pessimistic over the past few months by stating, “[t]he momentum in the economy is moving forward” and “housing is poised for a rebound.”

Market Activity for October 6, 2009
Interest-Rate Differentials – a Driving Force Again

The Australian central bank unexpectedly increased their cash-rate yesterday, becoming the first G-20 nation to begin tightening. This will keep the Aussie dollar in rally mode, and have the opposite effect on the greenback. The USD got hammered again yesterday, resulting in another rally for metals and oil – gold hit $1,040 per oz.

One-month Aussie bills now yield more than our 10-year Treasury note. The fact that U.S. long-term interest rates are so low is not only because the Fed has pushed short-term rates to zero and have engaged in actually purchasing bonds (quantitative easing). It is also because we continue to enjoy huge global demand for U.S. government debt. How long will this continue at the current level of U.S. rates? That’s a big question.

I think we’re going to see interest-rate differentials become a driving force again for currency values as foreign central banks begin to de-link their policy from the super-aggressive easing campaign that the Federal Reserve is currently engaged – something we talked about last week. If other central banks begin to tighten (raise rates), even mild increases, this is going to put intense pressure on the U.S. dollar and may force Bernanke’s hand more quickly than the market currently expects.

Trying to gauge these things is impossible, but it appears things may be moving in this direction. The U.S. has the luxury of enormous levels of liquidity that allow us to get by with lower rates on government bonds than other regions of the globe, but with gold tracking to $1,050, copper back on its horse toward $300/lb and oil back above $71/barrel (even though energy demand remains weak) one wonders when the trade will change full-blown to commodities and away from the USD.

While the Federal Reserve decides nary a mention of the dollar in any of their statements (which is strange considering they have a monopoly on dollar creation), they will not be able to sit by and idly watch a greenback in freefall – if that happens to occur. This would have huge ramifications for stocks, as the current rally is more a function of easy money (extremely low rates that keep money flowing into stocks as there are very little alternatives -- at least from an attractive interest-rate perspective -- in the bond market. That will all change if the Fed is forced to change course in order to throw a lifeline to a drowning dollar and begins to increase U.S. rates.

What will the Recovery Look Like?

This is a big question and something I think about on a daily basis. I had been assuming, even if I’ve carried a pessimistic tone since May, that we’ll get a decent upturn in GDP – even if it is a short-lived expansion as the Fed reversal alone will crush it – as the inventory dynamic and infrastructure spending combine to catalyze activity. However, I am really beginning to question even half the bounce we usually get from such deep levels of contraction. Sure, we are likely to see a two-quarter bounce in economic activity from these low levels but I’m not sure government spending will be able to fully offset consumer weakness. And there is also a payback effect to this government intervention as the private sector holds back – we’ve got to pay for this spending and businesses have seen this game before, they know what follows – one gets this sense that the business community will remain cautious for a prolonged period.

The drag from the consumer side of things (currently 70% of GDP and on its way to the historic average of 65%) will be quite large. How is consumer activity supposed to get going? The jobless rate is sky-high, the duration of unemployment is at record lengths and we don’t have credit to fall back on this time as consumer credit is in decline – a high level on unemployment is unlikely to change this reality as default rates will remain high and this will keep both the supply of and demand for loans moving lower.

And then we have consumer confidence (CC), which many people have pointed to as a bright spot. Bright spot? The reading only looks good next to near-record lows. There has never been a meaningful economic expansion when CC is below 60 without an ability to extend on the credit side (at least going back to 1967). The long-term average on the main confidence reading is 95.6 – it currently sits at 53.1.

What is typical coming out of a deep recession is for GDP to bounce back at 6%-8% real annual rates, and this seems to be what most expect. I’m sorry, but don’t see how this is possible.

What the economy needs is broad-based tax rate reductions to really cement an expansion that extends past a couple of quarters. A cut in marginal income tax rates will drive aggregate disposable income, very needed at this time of stagnant incomes and high joblessness; slashing the corporate tax would drive profits; stating that capital gains and dividend tax rates would remain at current levels would be a big help to stock prices (although at this rate it doesn’t appear stocks need much help); and higher current-year write-down allowances would spark a business spending expansion – it would also have a positive effect on job creation as the orders for plant and equipment would drive hours worked, a necessary condition for an increase in hiring that follows. In total, what broad-based tax cuts would do is help the economy to withstand the coming (even if the timing is delayed) reversal of monetary policy.

But policymakers have painted themselves into a corner. After spending their time vilifying lower tax rates, the administration can hardly turn and engage in such policy. Higher scheduled tax rates and tighter monetary policy will prove to be a deathblow to economic recovery. All they have for now, regarding the tax-rate lever, is an extension of the first-time home-buyers tax credit, which we wouldn’t be surprised to see extended to all homebuyers. But this is hardly enough, I even question if it can keep home sales going as the credit has already front-loaded sales and labor-market conditions will make it tough to keep housing activity in rebound mode.

We’re moving from what has been termed the “great moderation” of the past quarter century to a period that exhibits significantly more erratic business cycles. Going back to 1982 expansions became longer and contractions shorter – smart economic and correct (for most of this period) monetary policy were the driving forces. Returning to higher tax rates, more regulations and misguided monetary policy will bring a scenario in which recessions become more frequent.

Policy can always shift, and sometime in a fairly rapid manner; although, history shows it generally takes a significant electoral transfer to foment such a change in direction. I’ll certainly turn much more upbeat if pro-growth policies even begin to get a look from the President, but wishful thinking seems to be a wasteful and dangerous activity in this environment. For now, I would remain cautious.

Correction

Yesterday I was referring to the Cap and Trade bill as C&I – what can I say, I’m an idiot; must have had the decline in Commercial and Industrial loans on the mind. Anyway, obviously I meant to type C&T.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review: EMR, STJ, BA

S&P 500: +14.26 (+1.37%)

The news of the day was that Australia became the first G20 nation to raise interest rates since the start of the financial crisis. The surprise move by the Reserve Bank of Australia signals that the global economic recovery is gaining momentum and may lead to rate hikes in other countries, particularly in the Asia-Pacific region.

U.S. dollar declined in part due to Australia’s rate hike, which sent commodity prices higher.


Emerson Electric (EMR) gained 1.40% on news that they acquired Avocent Corp for $1.2 billion in cash. Avocent designs, manufactures, licenses, and sells hardware and software provides connectivity and centralized management of IT infrastructure. Half of Avocent’s 2008 revenue, which totaled $647 million, was generated outside the U.S.

Emerson intends to apply the company’s infrastructure management to its network of power systems, energy management, and precision cooling services. In addition, Emerson can now better address energy efficiency, which they cite as their data center customers’ most pressing challenge.


St. Jude Medical (STJ) fell 12.66% as the company said it would have lower than expected third-quarter sales. CEO Dan Starks said hospitals had cut device purchases in the quarter and said St. Jude also lost revenue due to changing foreign exchange rates.

Also weighing on St. Jude, as well as other medical device companies, is the expectation that medical device companies will be forced to pay fees based on market share in any healthcare reform.

Boeing (BA) finished flat after announcing delays to its 747-8 Freighter aircraft program. The announcement comes just two montsh after the aircraft maker said it would take a $2.5 billion charge to earnings because of production delays and additional costs associated with its development of the 787 Dreamliner.



Quick Hits

• Goldman: Markets Miss ‘Dramatic Improvement’ at Big Banks
• Earnings preview
  

Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks rebounded on Monday after a four-day decline, supported by positive comments from Goldman Sachs and Credit Suisse. The press seemed to focus on the latest ISM service-sector reading as the catalyst, this gauge hit expansion mode of the first time in 13 months, but it wasn’t.

The broad market rallied at the open but pulled back after the service-sector reading. While pretty decent, the reading seemed to be boosted more by promotional activity than outright demand and the employment figure remained sluggish. The market moved to its highs on the session after Goldman Sachs recommended buying large banks (egad! – they are trading at 2006 multiples, yet earnings are less than half what they were back then) and Credit Suisse strategists’ put out a report titled, “No Time to Sell.”

Financials led the rally. Commodity-related energy and basic material shares were the next best performers as another session of dollar weakness causes money to funnel directly to these sectors – metals and oil.

Advancers trounced decliners by an 8-to-1 margin on the Big Board. However, volume was weak again with just 1.07 billion shares traded on the NYSE Composite – roughly 20% below the six-month average.

Market Activity for October 5, 2009
ISM Service

The Institute for Supply Management’s gauge of service-sector activity (the respondents to this report are purchasing and supply executives) rose above 50 (the dividing line between expansion and contraction) for the first time since August 2008. While the measure moved just barely into expansion mode for September, a number of the sub-indices within the report showed really nice improvement -- although, the gains looked to be largely price driven as the prices paid component plunged to 48.8 from 63.1 in August.

The headline index rose to 50.9 for September from 48.4 in the previous reading and 13-straight months of contraction.

For the sub-indices that make up the headline number:

The new orders index rose very nicely to 54.2 from 49.9 in August and follows 11 months of contraction. I’ll note, comments from respondents pointed to “promotional activities” as the driver for new orders – this helps to back up the price-driven comment above.

Business activity rose to 55.1 from 51.3.

The employment index picked up a bit, rising to 44.3 from 43.5; still sluggish but no surprise there. Three industries reported increased employment, 12 reported decreased employment, leaving three reporting unchanged employment compared to August.

As touched on, the prices paid index fell to 48.8 from 61.3. Six industries reported an increase in prices, eight reported prices as decreasing and four unchanged.

Interestingly, even though the overall reading rose, the number of industries that reported growth fell to five out of the eighteen tracked, down from six for August. Respondents’ comments varied and remained quite mixed about business conditions and the overall economy.

The five industries that reported growth in September were: Utilities, Health-Care & Social Assistance, Retail Trade, Construction, and Wholesales Trade.

What respondents said:

• “Sale are very steady and have risen some each month in the past six months. The bottom is now here.” (Construction)
• “Economic recovery turnaround has begun in the financial services sector; however, cautious expense management is still practiced.” (Finance & Insurance)
• “Lack of available capital for new project development.” (Accommodation & Food Service)
• “Continue to see signs of slow recovery, but customers are still putting orders off until the beginning of 2010.” (Professional, Scientific & Technical Services)
  

Government Induced Rise in Energy Prices

The Cap and Trade (C&I) agenda seems dead right now, but never underestimate Congress’ ability to do something really stupid even when the public outcry hit its crescendo. The WSJ reported yesterday on last weeks’ coordinated release of the EPA’s new rules that make carbon dioxide a “dangerous pollutant” (I guess that means we should all stop breathing) and the John Kerry-sponsored energy-tax bill.

As the EPA has now promulgated its decision to label CO2 a pollutant, even if the C&I bill is voted down, the EPA is coming to punish the utility companies (which means the consumer will bear the cost of these regulations). The strategery, to bring back a Bushism, is to get utility companies to back the C&I bill, in which they’ll be better off than the EPA running roughshod over them, as C&I would grant emissions allowances (permits) that they can sell to offset the cost of the EPA’s stricter regulations.

Surely everyone understands that once the EPA designates a chemical compound as a pollutant it has the legal authority to regulate it under the Clean Air Act. If the agenda can’t pass Congress, you’ve always got this to fall back on – isn’t that sweet.

It doesn’t matter that carbon is a result of warming and not a cause – and this is the route proponents take, if we don’t reduce carbon emissions then the earth’s ecosystem will collapse and we’ll all be dead – or so they say. (This too is yet another reason I’m not terribly optimistic about the direction we’re going. The priories are all screwed up as we put an “environmental” agenda ahead of economic growth imperatives.)

Climate change is a function of solar activity, plain and simple; we’re seeing solar activity wane now after a decade-long period of increased activity, and thus the reason for the cooler temperatures. In a period of rising atmospheric temperatures ocean temperatures rise as well, which means carbon is less soluble. Thus more carbon is emitted instead of being absorbed into ocean water – it is a result, not a cause.

(If it were true that humans were the primary cause of higher temperatures, then how exactly were temperatures higher during the medieval warming period that ran roughly 900-1300, an era in which Vikings colonized Greenland -- which means they cultivated crops -- in what is currently a frozen tundra?)

Increasing costs on the economy by regulating, and therefore taxing, carbon in an attempt to reduce this emission is not only futile, it will destroy economic growth in the process. But when Congress is dead set on their command-and-control agenda, it sure as heck won’t let facts get in the way.

I don’t think the market is pricing in the fact that we may not be dealing with a President Clinton here. When Clinton swerved way left following the 1992 election, his political finger always remained in the air. When the public outcry began, he shifted to the center, and even right of center once the Gingrich Congress rolled in in 1995. The Obama administration, conversely, does not appear to be of the same mold to me, they are determined to lay the ground work of their agenda no matter what the public thinks; the coordinated release of the EPA’s carbon decision and the C&I bill last Wednesday illustrates a willingness to get around the normal legislative process.

We cannot burden the economy in these ways. It wouldn’t work well in any situation, but at a time in which the economy remains vulnerable the damage done will be particularly acute.

This Week’s Data

It is a light data week as we have no releases today. We’ll receive mortgage applications tomorrow, which is always something to watch but not a major data set. The big release will be consumer credit for August. This figure collapsed in July and is expected to fall again by a huge amount. Credit in general is declining as credit-card lines are being cut, banks are unwilling to lend to all but the highest credits, and consumer are repairing household balance sheets – thus the demand for credit is down as well.

Then on Thursday, we’ll get the jobless claims figure. We need this reading to fall below the 550K level and make progress toward 500K thereafter. The market is ignoring labor-market conditions right now but won’t be able to do so forever. Jobless claims is one of the few forward-looking indicators within the labor-market data. Average weekly hours worked is the other, and this reading returned to an all-time low in September. Without a substantial rise in average hours worked and a meaningful decline in jobless claims, no one should expect job creation to come back.

On Friday we’ll get same-store sales for September, expected to show its 13th straight month of decline – the declines have eased though from big negatives of 4-5% year-over-year results to -2% in August. September should show additional progress, but consumer activity is likely to remain subdued for some time due to a sky-high jobless rate and much less availability of credit to help us out of this hole.



Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review: BTU, CAT, GD

S&P 500: +15.25 (+1.49%)

Bargain hunters scooped up stocks following two weekly losses and an encouraging reading in the ISM Non-Manufacturing Index signaled a return to growth. Also boosting sentiment was an upgrade of bank stocks by Goldman Sachs. The day was otherwise light in news as the investment community gears up for 3Q earnings season.


Peabody Energy (BTU) climbed 4.09% in response to a story in this week’s edition of Barron’s, which suggests the stock could double as coal demand increases. The story makes particular note of the company’s Australian coal, which has 30% profit margins, and argues the market has not correctly valued Peabody’s Asian and American coal. Peabody also stands to benefit from rising Indian and Chinese coal demand.

Caterpillar (CAT) shares jumped 3.93% as the company announced plans to increase machinery prices as much as 2%, the smallest increase since at least 2006, citing “current industry factors and current and expected general economic conditions.” Caterpillar shares also benefited from Morgan Stanley analyst Robert Wertheimer raising his target price on the world’s largest maker of construction equipment citing a “slightly stronger economy.”

General Dynamics (GD) rose 2.68% as Morgan Stanley analyst Heidi Wood raised her rating on the company citing a recovery for Gulfstream business jets. Several weeks ago, the Chinese government announced changes that open up its airspace for business jets. Wood notes the changes effectively unlock the Chinese business jet market and could drive “substantial incremental demand.”


Quick Hits

• Fed Needs Goldilocks for Roach Motel Check-Out
• The end is nigh (again)
• Corporate finance: Thawing out
  
  
  

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks held in very well on Friday considering the weakness of the September jobs report, and specifically the increase in long-term unemployment. Those jobless for at least 27 weeks (as a percentage of the total number of unemployed) jumped to another new record of 35.6% last month. The average duration of unemployment rose to 26.2 weeks – a record since this data began in 1948. The jobs report shouts the damage done to small businesses and their lack of credit availability – firms with less than 50 employees are the major job creator for our economy.

One would think stocks to sell off by at least 2% on this data, but after a 1% move to the downside right from the get go the broad market pared those losses, down just ½ percent by the close.

Still, the market has declined for four-straight sessions, and down for back-to-back weeks. The last time we fell for two weeks in a row was the beginning of July, which preceded another 20% jump to the highest levels in a year. Will this move exhibit the same move, or are we headed lower. It appears traders are unwilling to send stocks much lower right now, but we get some key data on the consumer this week and it all depends on how that goes; the market is probably the closest to cracking a bit since this surge from the March lows began.

The dollar came under additional pressure on Friday – strange since the only thing going for it right now is the safety trade, so one would think the greenback to have found a little support on the jobs data. I don’t know what to think about the dollar frankly, other than it’s going to be in a very tough spot. The only thing to keep it from plunging to new lows is the fact that foreign governments have to keep buying it otherwise their domestic currencies will strengthen to a point that hurts their export markets. The price of gold rose back above $1,000 per oz. as a result of the dollar weakness.


Market Activity for October 2, 2009
September Jobs Report

The Labor Department reported that payrolls declined 263,000 in September, which was a good deal worse than the 175,000 drop that was expected. The prior two months of data were revised down to show 13,000 more jobs lost that previously reported.

So over the past six months monthly job losses have averaged 307,000 per month, this is a big improvement from the previous six months in which losses averaged a super-high of 645,000 per month. Problem is, the latest month failed to show continued improvement, and in fact deteriorated, and this level of jobs losses remains above peak six-month average declines of every post-WWII recession except the 1974 contraction in which the six-month decline averaged 327K per month.

We have improved and yet we remain at or near the worst average levels of the past seven recessions/downturns. This cannot be ignored; those expecting consumer activity to begin a sustained rebound are living on another planet.

This is important to understand and I’m not sure the market has come to grips with it. We have lost 7.2 million jobs since December 2007 and that means we’ll need 1.5 million in job creation per year (beginning right now) to get these jobs back by 2015. Roughly 1.5 million in annual job creation is what we averaged over the past 25 years – a quarter century of amazing prosperity. If we don’t get a shift to pro-growth policies a couple of years from now (completely out of the question before then), total employment repair will take even longer.

(Heads up on the chart above came from Annaly Capital)

In terms of specifics, the goods-producing industries shed 116,000, an improvement from the 132,000 lost in August and a bit better than the three-month average of -121K. The construction segment cut 64,000, a bit more than the 60,000 in August and smack dab on top of the three-month average decline. Manufacturers cut 51,000 positions, up from the 66,000 subtraction in August and a mild improvement relative to the three-month average of -53K.

The service-providing industries shed 147,000 positions, vastly worse than the 69,000 cut in the previous month and lower than the three-month average of -135K. The trade and transportation segment cut 60,000 positions, worse than the 22,000 decline in August that seemed to show big improvement was upon us – three-month average is -55K. Retail slashed 39,000, much worse than the 9,000 cut in August – three-month average is -31K. The business services component did show nice improvement, down 8,000 vs. the -19,000 in August – three-month average is -19K per month.

Again, health-care and education remains the only segment that has yet to show a decline, supported by a 19,000 increase in health-care jobs as state and local governments cut teacher positions in September – which resulted in a 53,000 reduction in total government employment.

State and local governments are in terrible shape and the problems are being masked by the first leg of the stimulus spending injections. When the next leg of the stimulus spending goes from Medicaid and unemployment benefit supplements to infrastructure spending, state and local budgets will worsen. (We’ll see if the federal government extends jobless benefits, again, which we are hearing is gaining support in Congress. Right now unemployment benefits extend to 59 weeks, if we increase this number I might begin to wonder whether I’m living in the USA or Western Europe – and it’s even worse since we don’t have an autobahn.)

The unemployment rate rose from 9.7% to 9.8% as we’re headed for 10% plus and we’ll test that post-WWII record of 10.8% – the current jobless rate is the highest since June 1983.

The number that really shows the degree of labor market trouble is the U6 unemployment rate, the duration of long-term unemployment and hours worked

The U6 jobless rate continued it record-setting march, rising to 17.0% from 16.8% in August. This reading goes back to 1994 in its current form. In terms of the former way U6 was calculated this reading would sit at 13.5%, which remains below the peak hit in 1982 of 14.3%.

As many readers may remember, this U6 unemployment figure is defined as the regular unemployment rate, plus “discouraged workers” (those that didn’t look for a job during the survey period -- which the regular unemployment rate excludes), plus those working part-time because they can’t find full-time work.

The duration of long-term unemployment (the percentage of the unemployed that have been out of work for over 27 weeks) jumped to a new high of 35.6% after showing mild improvement in August (falling to 33.3% from 33.8% in July). This spells additional trouble for credit quality – consumer delinquency rates.

The average weekly hours worked data fell back to the record low (postwar) of 33.0 -- first hit in June -- from 33.1 in August. This is unfortunate as we need to see this reading move back to the high 33s on its way to 34 hours a week before we even think about expecting jobs to rise again. Firms will increase the hours worked of current employees for several months at least before adding to payrolls.

So that’s it, anywhere you look in this report it was ugly.

You know what this jobs report and the pretty much guaranteed march to the post-WWII record high jobless rate of 10.8% has me thinking? More government intrusion. Oh, sorry; I mean “stimulus.”

If the economy fails to create just some jobs over the next several months, which is highly unlikely since the largest jobs creator (small business) remains in a world of hurt, we will see Congress/Obama begin to freak out about the 2010 elections coming up and offer some new “fixes.” I have no idea what they’ll come up with but whatever it happens to be will be damaging. If they choose to extend unemployment benefits, this will only keep the jobless rate elevated and continue to mask the state and local government fiscal troubles. If they do something like increasing spending on infrastructure, it may very well help GDP in the near term, but there will be a price to pay in weaker growth a few quarters thereafter. And all of this spells higher tax rates, which already has the business community uneasy and they’ll continue to hold back on investment (both equipment and labor) as a result.

The Administration’s economists believe in an economic “escape velocity” – current government stimulus resulting in a sufficiently high and sustained level of growth so to enable it to withstand the coming tax hikes, higher interest rates and increased regulations. What I’m worried about is failing to escape the evils of Pandora’s Box. Intense government intervention is prying it open.



Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks slid on the first trading session of the fourth quarter after the latest manufacturing report missed estimates, initial jobless claims rose and everyone awaits this morning’s jobs report. The pressure mounted as we headed for the close; the Dow, for instance, fell another 70 points in the final 15 minutes of the session. Not a good sign, but one can’t make too much of one day’s activity, especially after the run we’ve seen.

All major S&P 500 sectors declined, led by financials as the main index that tracks these shares slipped 4.38%. Basic material, tech, energy and industrials also took it on the chin. The relative winner was consumer staples, down just 0.94%.

The manufacturing report seemed to have the most effect on activity, the major indices fell from the opening bell, but the slide didn’t begin in earnest until after that ISM report was released – the market was expecting at least some cash for clunker-related improvement, but instead the rate of growth declined relative to August’s reading.

And then we have that all-important jobs report this morning, which was already in the back of traders’ minds. The increase in jobless claims, and the continued run up in emergency unemployment benefits (showing clear as day that traditional benefits continue to run out as employers remain unwilling to hire – which isn’t much of a surprise at this point of the cycle but expectations were prematurely optimistic) just added another reason for traders to take some off the table. Whether a significant correction has arrived or not will all depend upon this morning’s jobs report. If it comes out better-than-expected, the market will likely catch a bid, if not it could get a little ugly – this is pivotal data.

Decliners smoked advancers by a 17-to-1 margin on the NYSE Composite. Some 1.55 billion shares traded, roughly 20% above the six-month average.

Market Activity for October 1, 2009
Initial Jobless Claims

The Labor Department reported that initial jobless claims remain unhelpfully sticky. Initial claims rose 17,000 to 551,000 in the week ended September 26. So we’re back to the 550K handle after falling to 534,000 in the week prior.

The four week average of initial claims fell to 548,000 from 554,000. This is the first move below 550K for the four-week average since the first week of 2009, but it’s only because of the prior week’s move to 534K, which seems to be a result of some distortion since the rest of the month hovered around 550. What we need is for this reading to plunge through 500K, which is still and elevated historical reading but at least it would provide some evidence of additional improvement.

Continuing Claims fell 70,000 to 6.09 million. This followed a very nice decline of 105,000 in the prior week. Still, it is difficult to get excited about this move because we have all of these benefit extensions in play. Fact seems to be, the decline in continuing claims is merely a function of benefits running out rather than some form of job creation. All that has occurred is that unemployed are being moved from the traditional continuing claims reading to the extended benefits and emergency unemployment benefits (EUC) rolls. (Most of those who extinguish their traditional 26 weeks of unemployment benefits can then move to the extended benefits rolls – another 13 weeks of benefits – and then onto the EUC – which provides another 20 weeks after that for 59 weeks total. Whoa!)

Extended benefits rose 4,650 to another new high of 443,000 and EUC jumped 99,832 (notice this is more than the decline in traditional cont.claims and thus more than offsets that decline) to another new high of 3.275 million. So, continuing claims haven’t really fallen as much as it appears from the Mt Everest peak of 6.90 million as they remain at 6.42 million when you add in the extensions.


Personal Income and Spending

The Commerce Department reported that personal incomes rose 0.2% in August (up $19.3 billion), following an upwardly revised 0.2% increase for July. The increase was driven by a 0.2% rise in both the wage & salary (w&s) and compensation components – both remain down sharply over the past year, w&s is down 4.3% and compensation is off by 5.2%.

A 2.1% rise in the rental component also helped, although this isn’t one of the larger components. Transfer payments are back again, up 0.6% in both of the past two months after a significant 5.4% decline back in June; the rise in government social benefits equaled the gain in the largest private sector gauges (w&s and compensation).

The $12 billion increase in social benefits nearly offset the $15 billion decline in personal income from assets – interest income fell 0.5%, or $6.4 billion and dividend income slid 1.8%, or $9.3 billion.

On the spending side, expenditures jumped 1.3% for August (a 1.1% increase was expected), driven by the clunker-cash program. This marks the largest monthly spending increase since a 2.8% surge in October 2001 as auto dealers offered zero percent interest and the figure rebounded from a large decline in spending due to the 9/11 attacks.

Spending was strong across the board, though, as back-to-school purchases, helped by a sales tax holiday in most states, also brought consumers into stores. We’ll see what happens from here as CFC and sales tax holidays are no longer with us and consumers still need to deal with a 26-year high jobless rates along with high debt burdens that must be managed. (Last night we got the vehicle sales numbers for September showing activity plunged back to pre-CFC levels)

The inflation gauge that accompanies this report rose 0.3% for the month, so on a price-adjusted basis spending was up 1.0% in August and income fell 0.1%

In terms of future consumer activity, the figures will very likely be weighed down by a cash savings rate that must level out at at least 5-6%, and may bounce to something closer to 8% with other savings vehicles lower -- stocks still 32% off of their peaks and home prices down 20% from their apex. The fact that spending outpaced income by seven-fold in August means the cash savings repair has exhibited a setback falling to 3.0% from 4.0% in July. And, this means a sustained expansion in personal consumption, the largest component of GDP, will be delayed.

The cash savings rate made great progress last spring, jumping to 5.9% in May from less than 2% in late 2008. This came at the expense of much lower spending figures that weighed heavily on GDP, but this was simply a fact of life with the plunge in payrolls and stock and home prices.

Even with the strong rebound in stocks, the fact that cash savings must go up and debt burdens must go down is a reality the economy still needs to deal with. As a result of high debt levels and tighter credit standards, we cannot rely on increasing consumer borrowing levels to elevate us out of this contraction. When the bulk of the government stimulus plays out and the inventory dynamics runs its course (say six months out) we will still be stuck repairing household balance sheets and this will keep consumer activity bogged down.

ISM Manufacturing

The Institute for Supply Management reported that its manufacturing index showed the rate of growth slowed in September, but remained in expansion mode. The ISM manufacturing reading came in at 52.6 after printing 52.9 in August – a reading above 50 marks expansion. The consensus estimate was 54.0.

Many sub-indices declined relative to the previous month’s reading, but remained in expansion territory. The production index fell to 55.7 from 61.9; the new orders index fell to 60.8 from 64.9 (still a nice reading); export orders fell to 55.0 from 55.5.

The backlog of orders rose to 53.5 from 52.5 and supplier deliveries rose to 58.0 from 57.1 – this is a key indicator as a higher reading means that deliveries have slowed, meaning suppliers are having trouble keeping up with stronger orders. The inventory reading jumped 8.1 points to 42.5. This is a really nice move, still contracting, but the change is helpful. (This gain in inventories helped to offset the easing among other indices).

The employment index remained pretty much unchanged, down just slightly to 46.2 from 46.4.

This is a pretty good report, especially after the Chicago factory survey gave some people a scare when it moved back to contraction mode, but most analysts/economists were expecting more of a boost from the CFC program and the August back-to-school and sales tax holiday.

Construction Spending

Construction spending rose 0.8% in August after three months of large declines – the figure fell at a 14.35% annual rate over that period. The August increase was fueled by a 4.2% bounce back in residential construction. Commercial construction fell for a fourth-straight month, down 0.4% for August.

Pending Home Sales

The National Association of Realtors (NAR) reported that pending home sales (contract signings) jumped 6.4% in August after a 3.2% rise in July. This is a huge move and likely reflects the rush to close on contracts by the tax credit deadline of November 30. The pending home data from here should move lower as purchases have been pushed forward to get the $8,000 offset to taxes owed for 2009 – and since this is a “refundable” tax credit, if a first-time homebuyer doesn’t have $8,000 in federal income tax liabilities then they will receive a spiffy check from the IRS.

Pending home sales were driven by a 16.0% jump in the West region, California offers an additional tax credit for those buying a new home (as opposed to an existing structure) and this is also where most of the foreclosure-driven price declines have occurred, two main catalysts for sales in the region. Pending sales rose 8.2% in the Northeast, 3.1% in the Midwest and 0.8% in the South.

A cautionary note on this data: NAR’s chief economist stated that contracts are not closing because of complex new appraisal rules and that there has also been some double-counting -- buyers whose contracts were cancelled then sign a new contract after finding a different home. So, this pending home data may be overstating the boost that would result in existing home sales (existing home sales are counted when a contract closes).


Have a great day!


Brent Vondera, Senior Analyst

September 2009 Recap

Many investors fretted about September based on its historical record, but the S&P 500 managed its seventh con­secutive monthly gain. Growth continues to outperform Value due to the technology sector, which has been viewed positively through­out the recession thanks pristine balance sheets and historically low inventory levels. Following a sluggish August, Emerging Markets topped all asset classes this month with a gain of 10.2%. Close behind was the Pacific ex-Japan region, which returned 9.69% on the month. Treasury yields held within a tight range and ended the month slightly lower, while credit spreads improved to make corporate bonds the best performing sector in fixed income.

Good news continues to be magnified while bad news is ignored – a drastic change from the beginning of the year. Meanwhile, sell-side analysts are busy raising index targets to catch up to the market level and explaining why they aren’t selling as their existing targets have been reached. With incredible amounts of liquidity sloshing about global markets, the Fed announced plans to slowly pull back on a number of its liquidity programs. The Fed’s purchases of Treasurys are set to end in October and the buying of mortgage and agency debt will cease at the end of the first quarter of 2010. The pull back by the Fed is calming to inflation hawks, but caution still reigns as the economy is weaned off of government support.

There is no denying that this has been a rally of market sentiment rather than pure fundamentals. The one posi­tive factor is the investing community’s reluctance to embrace the rally energetically – inflows into bond funds have been staggering, but those into equity funds have been tepid. When the masses are positioned for a sell-off, it means there’s a lot of ammunition for a rally if the market doesn’t cooperate. The fact of the matter is that investors are more worried today about missing money-making opportunities than about risking any invested capital. It is difficult, however, to ignore the increasingly convincing bear case and we seem well overdue for a pullback. Of course, the market has a history of remaining overvalued for extended periods of time and it is impossible to determine when this turning point might be.

--

Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks failed to close higher on the final session of the second-best quarter in a decade as an unexpected drop in Chicago PMI (factory activity for the region) killed early-session excitement. The reading came in well-below expectations and would have resulted in a significant sell-off in most situations, but not in this market environment.

The broad market vacillated wildly (at least relative to how chilled out volatility has become). Stocks rallied at the open, then retreated 1.6% following that Chicago PMI reading, bounced back to the flat line with just an hour left, slid again and looked headed for session lows, only to rally again in the final minutes – wasn’t enough to get back to the opening price though . This activity was like watching a buy-on-the-dips strategy all packed into one session – the scamper from mutual fund managers to window dress for quarter-end reports went right to the last minute.

The market was also buoyed by Federal Reserve Vice Chairman Kohn’s comments that dispelled opinions from a number of FOMC/Fed members over the past week suggesting the central bank will have to reverse policy in an aggressive manner and possibly sooner than many expect. Kohn explained that the Fed will hold its Keynesian models close to its chest, meaning they are very unlikely to raise rates while the unemployment rate remains elevated. (If the Fed couldn’t raise rates in early 2004 when the unemployment rate moved below 6%, it seems quite difficult to belief they’ll reverse policy when the jobless rate sits in the 8-10% range.) Kohn reminded everyone that the facts on the ground is the FOMC statement, and that statement explains that the Fed will keep fed funds at exceptionally low levels for an extended period. This was the beat down statement to the various Fed officials who have recently stated otherwise. This may be the most confused and conflicted FOMC/Fed in at least 30 years. I’m not an expert on this history, but I know a few things and don’t think this view is a stretch.

The market loves very low interest rates. Despite the fact that the Fed appears to be in disarray, traders only care about the here and now, and for now Fed policy will continue to support the market until a major economic data release, lack of final demand keeps corporate revenues in the tank, or geopolitical development scares the market into correction mode.

For the quarter, the S&P 500 and Dow Average both jumped 14.9%. The NASDAQ Composite gained 15.6%. Mid cap stocks, as measured by the S&P 400 climbed 19.5% and small caps, as measured by the Russell 2000, were up 18.8%.

By sector, financial, commodity-related basic material and industrial shares were the top performers during the third quarter. Financials led the way, for a second straight quarter now, as the index that tracks these shares surged 25%. This group was by far the most beaten down during the height of the credit crisis and still has another 158% to climb back to 2007 highs. Both basic material and industrial shares jumped 21% for the quarter. Industrials still have 61% to go to get back to the high. Basic materials need to jump 50% to climb back to the all-time high.

The laggards for the quarter were utilities (up 5.2%) and telecoms (up 4.2%).

Volume was strong, a rarity for the past three months, as 1.7 billion shares traded on the Big Board – that’s 30% above the six-month average.

Market Activity for September 30, 2009
Energy Report

The Energy Department’s weekly report showed gasoline stockpiles unexpectedly fell 1.66 million barrels last week, a rise of 1 million barrels was expected. While crude inventories didn’t only rise, but rose more than expected – up 2.8 million barrels, a rise of 2 million was expected -- oil prices still rallied 5% to close at $70.25/barrel (retreated to $66 over the previous few sessions) as the decline in gasoline inventories supported the view that oil demand will rise to replenish refined product.

Mortgage Applications

The Mortgage Bankers Association’ s index of application activity fell 2.8% in the week ended September 25, following a strong 12.8% rise in the prior week. Applications to purchase a home fell 6.2% after a 5.6% increase in the week ended September 18 and refinancing activity was essentially flat – down 0.8% -- after a 17.4% surge in the prior week.

The fixed-rate 30-year mortgage remained in the sub-5.00% sweet spot, yet applications to purchase a home couldn’t string back-to-back gains. Is this a sign that sales were pushed forward due to the tax credit – those who applied for a mortgage in the week of September 25 are cutting it close to the meet the closing date deadline of November 30 to capture that credit. Even if the tax credit is extended, and I certainly wouldn’t bet against it, it won’t be a continuous extension and sales will show some weakness again as a result.

ADP Employment Report

The preliminary employment report out of business outsourcing solutions firm ADP had payrolls decreasing 254,000 for September – the expectation was for this reading to come in at -200K, which is roughly the same estimate for the official jobs report that will be released on Friday.

If this number is accurate in predicting the official reading, which was not the case for August but ADP had been accurate in the previous few months, it means we continue to show improvement from the outsized monthly job losses of a few months back. Still, a number above 200K in payroll declines is elevated from a historical perspective. The job losses remain above the average of the 1981-82 recession (avg. -185K in monthly losses), above the 1990-91 recession (avg. -147K) and above the 2001 downturn (avg. -173K). So improvement, yes, but still very weak.

ADP estimates that service-providing industries shed 103,000, which would be worse than the 80,000 actually cut in August. They estimated that goods-producing industries cut 151,000 positions – 136,000 were actually cut in August, according to the Labor Department’s official data.

Large firms (500-plus employees) cut 61,000 positions in September, as estimated by ADP. This is right in line with August’s 57,000 reduction in payrolls. Medium-sized firms cut 93,000 positions, a 13,000 improvement from August. Small firms (1-49 employees, and the main job creation engine of our economy) reduced payrolls by 100,000, which was better than the 114,000 decline in August, as estimated by ADP.

Final Revision to Q2 GDP

The Commerce Department reported second-quarter gross domestic product fell less than initially estimated, down 0.7% at a real annual rate vs. the 1.0% decline printed from the first revision. The main reason for the improvement was a slight upward revision to personal consumption and business equipment and software. Personal consumption, the largest component of GDP, fell 0.9%, not the 1.0% reported via the first revision. Business equipment and software spending dragged GDP lower by just 0.32% vs. the 0.56% previously reported.

So, the four-quarter contraction, the longest stretch of GDP decline in the post-WWII era ended on a sweeter note than previously thought. The current quarter will post a gain, likely to come in at at least +2.5% and maybe as high as 3.5%, but I’m skeptical of that higher number occurring even with the cash of clunkers-driven boost to auto sales and inventories.

We’ll then probably see a larger jump in economic activity in the fourth quarter as the inventory dynamic will take full effect, but final demand is likely to remain weak as result of continued job losses and a heavy debt burden; the government stimulus spending will not be able to fully offset this drag.

As a result of this reality, which will take time to work through, along with pressure from the reversal of monetary easing, higher tax rates, increased regulations, et al. in the near future this expansion will look nothing like the normal 6-10 year run we have become accustomed to over the past quarter century. No, this one will be different both in degree and duration. In degree, typically coming out of a huge economic contraction we see GDP bounce back as a 6%-8% rate – I think we’ll be lucky to see 4% this time. In duration, I don’t believe more than a four-quarter recovery is possible considering the headwinds we face.

Chicago Purchasing Managers Index

The Chicago PMI (a gauge of factory activity for the largest manufacturing region in the country) unexpectedly fell back to contraction mode in September. The reading declined to 46.1 from hitting the line of demarcation between expansion and contraction (which is 50.0) in August. Expectations were for additional progress – a reading of 52.0.

This is a major setback for the camp that believes we’re on the cusp of a serious expansion and shows that firms remain unwilling to rebuild stockpiles and buy capital equipment as concerns regarding a lack of final demand weigh heavily on the minds of decision makers.

All sub-indices of the index slid back to contraction mode, with the exception being the prices paid component – it accelerated. The forward-looking new orders and supplier deliveries readings fell to 47.2 and 49.3, respectively after hitting expansion territory in August. Order backlogs got clocked, falling to 36.7 from 45.8. Inventories picked up, rising to 38.9 from 27.5 (which was just slightly above the all-time low of 25.4 hit in June).

Everyone, including myself expected the clunker-driven auto assemblies to have a two-three month positive effect on Chicago PMI, only then to fall back again by the end of 2009/early 2010. . If the hangover has begun already, the CFC binge-drinking event was even more worthless than suspected.

Tomorrow we get the national look at factory activity via the ISM reading. This measure will combine the results from all regional manufacturing surveys and the market expects it to accelerate further into expansion mode for September. If it does, it will be the first time in the data’s history, which goes back to 1968, in which ISM posted two months above 50 without Chicago doing the same. If ISM does remain above 50, it will be because of the export component, which Chicago PMI does not include.


Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks slipped on Tuesday as the latest consumer confidence reading unexpectedly declined and tech shares pulled back from a one-year high. The dollar rose for a second day, which put a little pressure on oil prices, sending energy name lower too. All in all though, the broad market’s decline was inconsequential, holding on to almost all of Monday’s strong showing.

Strangely, consumer discretionary shares were the best performing industry, offering the market support. The confidence reading, as we’ll get to below, did not offer a good vibe regarding the direction of consumer activity over the near-term, and frankly the next year, as the jobless rates will remain elevated.

The dollar got decent press yesterday as the Dollar Index posted its first back-to-back rise since early August. It appears some believe recent trends have changed; maybe the dollar has more going for it than just the safety trade. Just maybe stocks and the dollar can rise in tandem, as is usually the case.

Don’t bet on it though. The greenback was supported by lip service, talk coming from the heads of the European Central Bank and World Bank. Just words, and not even from members of our own Fed. No, nothing has changed; the dollar’s rise was only on the hope of supportive policy. Sorry, I wish the dollar would find a little strength, and most importantly stability, but I’m not interested in wishful thinking – it will only bring one trouble in this environment.

Decliners just barely outnumbered those that advanced on the NYSE. Volume was weak again, with just 1.1 billion shares traded on the Big Board, 15% below the six-month average.

Market Activity for September 29, 2009
S&P Case/Shiller Home Price Index

The Case/Shiller Home Price Index, not the most geographically diverse but certainly the most watched housing market survey, showed home prices in the 20 U.S. metro area tracked rose 1.61% in July. This marks the third-straight month of gains, following 33 months of decline. The index remains down 13.3% from the year-ago period – it was expected to decline 14.2%.

L.A., San Diego and San Francisco accounted for 40% of the July price increase – these three cities make up 27.4% of the index. California offers a tax credit for new home purchases that is in addition to the federal tax credit, which has definitely helped sales in the state.

Eighteen of the 20 cities tracked registered an increase in prices, the same as June. Las Vegas and Phoenix were the only cities to show a monthly decline for July, in June it was Vegas and Detroit.

On an annualized basis, home prices have jumped 15.21% over the past three months – this data is not seasonally adjusted so this traditional peak period for home buying has influenced the sales data, and thus prices within Case/Shiller. For perspective, it would take a 43% surge in home prices to return to the peak hit in Case/Shiller, which occurred in July 2006

Foreclosure-driven price declines, a new homebuyer’s tax credit of $8,000 and fed-induced rock-bottom interest rates have helped sales, which have allowed overall housing-market prices to rise from the cycle-low hit in January (the Case/Shiller cycle low was hit in April). Problem is it has front-loaded buying, so the market will have to deal with a decline in sales and a little more pricing pressure in the months ahead. Foreclosure rates are likely to pick up gain, as all state moratoriums on the foreclosure process have expired, and this will put pressure on prices again also.

Below is the individual city break down:


Consumer Confidence

The Conference Board’s consumer confidence reading unexpectedly declined in September, coming in at 53.1 after an upwardly revised 54.5 for August. This missed the expectation for a rise to 57.0.

The fact that we can’t get above even the lowly level of 60 (a level where the index had settled during previous recessions) is quite telling. The drag the largest component of GDP will put on economic growth does not seem to be factored into the market right now.

The present situation index fell to 22.7 from 25.4 – the cycle low is 21.9 touched in March and the all-time low is 15.8, touched in December 1982.

The expectations reading (view of economic prospects six month out) came in at 73.3, down slightly from August’s 73.8 – the cycle low is also the all-time low, 27.3 hit in February.

The most important aspect of this report, in my opinion, is the jobs “plentiful” less jobs “hard to get” figure; this is likely the best indication of future consumer activity trends. This reading fell to -43.6 from -40.0 in August.
The share of consumers stating jobs are plentiful fell to 3.4% from 4.3% and those stating jobs are hard to get increased to 47% from 44.3%

The cycle low is -44.1, which was hit in March. The all-time low for this reading is -58.7, recorded in November 1982 when the unemployment rate hit 10.8% -- the post-WWII peak. We are going to test that number sometime over the next six months.

The reasonable probability that aggregate demand will remain weak (as mentioned yesterday, today’s very aggressive corporate cost-cutting, mostly via payroll slashing, is tomorrow’s lack of final demand) does not seem to be factored into the equity-market valuation equation right now. Rather, particularly regarding the latest leg of this rally, the attraction to stocks seems to more a function of a run for money while the gettin’ is good type of behavior.

If policymakers’ belief in an economic “escape velocity” doesn’t occur – that is, a sufficiently high and sustained level of growth that enables the economy to shed its supportive crutches and keep on running (think of a young Forrest Gump) even as tax and interest rates rise and the government regulates… well, let me say: I wish the market and policymakers luck with that fantasy http://www.youtube.com/watch?v=7_nwbTeIN4Y.

If history is any guide, for policymakers who find it fancy to borrow phrases from Newton, it seems his laws of motion (specifically the third law, “to every action there is always an equal and opposite reaction”) would be more apropos.


Have a great day!


Brent Vondera, Senior Analyst

Walgreen (WAG) shares up 9.24% on earnings

Walgreen (WAG) shares soared as the drugstore chain reported a 7.6% increase in revenues with same-store sales improving 2.4%. Total prescription sales rose 9% and accounted for 66.5% of the firm’s total sales in the quarter. Walgreen’s prescription sales growth follows competitor CVS Caremark’s (CVS) statement in August that it saw no recession in its prescription-drug business. Pharmacies are also expected to benefit from a cold-weather return of the H1N1 virus in the U.S.

In addition to increased pharmacy sales, Walgreen said savings associated with the “Rewiring for Growth” initiative boosted earnings by 17.5%. As part of Walgreen’s “Customer Centric Retailing” initiative, the drugstore chain will start selling beer and wine in a majority of its 7,000 stores. (You can read more about Walgreen’s initiatives in this June post).

The most impactful news is that Walgreen will start offering 90-day prescriptions of maintenance medications to all payers, not just its own pharmacy benefit manger (PBM) customers. This is a direct hit to CVS Caremark’s integrated value proposition and should make it more difficult for CVS to win PBM customers. It’s also bad news for independent PBMs (like Express Scripts) if the market share gains of mail-order pharmacies begin to reverse, and thus eliminate a key component of PBMs’ value proposition to customers. Even more, 90-day retail scripts could serve to accelerate the decline of independent pharmacies to the benefit of large chains, given the increased importance of scale under this model.

--

Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks rallied Monday, breaking a three-session losing streak as investors sidestepped heightened geopolitical risks, focusing on the day’s acquisitions as a reason to bid prices higher. The broad market is in route to its best quarterly performance in 10 years, bouncing 15%-plus for the past two three-month periods. The S&P 500 declined for six straight quarters prior to this surge, falling 48% during that stretch and 57% peak to trough.

The market likes to see firms put money into the market, so gets juiced on the merger and acquisition (M&A) activity from the tech and pharmaceutical industries (the Xerox and Abbott Labs deals). If only this were true for business-equipment spending; there are few things more powerful for job creation than a plant and equipment spending binge. Of course, such activity takes confidence and it appears the business community is just fine with lying low right now.

Many people believe a surge in M&A activity will present itself as firms go hunting for profits as final demand remains weak, cost cutting gets you only so far and firms have slashed to the bone. But today’s degree of cost cutting means tomorrows lack of demand -- if the jobless rate remains at 26-year highs it’s kind of tough to see demand dynamics improving much. I’m not sure firms will go on buying sprees with demand where it is.

Friday’s biggest losers, financial and basic material shares, led Monday’s advance. The traditional safe-havens – health-care, utilities and consumer staples – were the laggards on the session, although they did move higher as well.

Volume was dirt, the lowest level since the holiday weekend of September 4, nearly 30% below six-month daily average.

Market Activity for September 28, 2009
Fed Bank Economic Conditions Gauges

We received two rarely watched business surveys yesterday, readings we generally do not report on but since these were the only two releases yesterday…well, it’s time to talk about them.

The first was the Federal Reserve Banks of Chicago’s national index, which draws on such indicators as industrial production, capacity utilization, the jobless rate, consumer spending and housing starts, to name a few – 85 economic indicators in all. The survey came in at -0.90 for August, only mildly in contraction mode, but the reading was worse than July’s -0.56.

The Chicago Fed stated that they believe a three-month average of greater than 0.20 needs to be achieved following a period of economic contraction to provide a significant likelihood that the recessions has ended. We have yet to see this occur as the three-month average is -1.09. Still, I think it is safe to say that the recession has ended.

The second was a reading out of the Dallas Federal Reserve Bank, which also stated activity continued in contraction mode, but this reading was for September. The trend is looking good though as the chart below illustrates. (This reading is specific to the manufacturing sector)

All sub-indices within the report remained in contraction with the exception of new orders and volume shipments. New orders rose to 8.0 from -1.7 in August. Volume shipments posted 0.3 after a -11.2 in August.

The finished goods reading remained deeply weak though, coming in at -21.3 from -23.2. This indicates the region fails to show improvement in final demand, a topic of concern we’ve had for some time. If final demand doesn’t rebound here these improvements seen in the factory surveys over the past four months are unlikely to continue.

Further, as the other factory gauges have shown, this survey’s prices paid index posted another month in expansion mode – came in at 9.8 after hitting 9.9 in the prior month – while the prices received index recorded another negative reading, -17.9 vs. -21.4 in August. This does not bode well for profit margins.

Failing to Learn from History’s Guide is Unwise

Last week we focused on a new protectionist precedent taking hold in Washington with the Obama Administration’s decision to levy a 35% tariff on Chinese manufactured tires. This action went beyond WTO anti-dumping rules, citing simply that these imports were harming the U.S. tire industry. (I’ll remind everyone that the recent inflow of imported tires was fostered by the CFC program. The auto industry saw annual car sales fall to nine million from 16 million in a matter of one year. As a result, tire plants were idled and when the CFC-driven sales meant vehicle assemblies had to speed up…well, you had to get the tires from somewhere.)

Now, the paper and steel industries have gotten into the mix, yeah they’re being “harmed” by competition too, by lobbying the administration to place tariffs on these imports. You can bet there will be more industries that will do the same.

Further, in a recession, and a labor market that is likely to remain weak for an extended period, it is very easy for the populace to see the “harm” that certain industries endure via intense globalization and trade, while ignoring the benefits society in general enjoys from free trade. This makes a trend of protectionism even more likely; there may be no stopping it until time enough passes to make clear the perils of trade barriers.

The sparks of protectionism can quickly turn into a raging forest fire, this is what history teaches. When one side sets up trade barriers the other side is very quick to counter, this leads global economic activity to deteriorate and obviously does damage to living standards.

Thankfully, there is a higher degree of interdependence within the global economy today (due to freer trade over the past 25 years) and this may keep trade wars at bay longer than has occurred in the past. But that fire will eventually rage if smarter heads do not prevail.

The Market and the Fed

On this day last year the Dow plunged 778 points, or 7%, as Congress failed to pass the TARP. Still, the Dow closed 576 points higher than its current quote. The S&P 500 got nailed by 107 points, or 8.8% -- 43 points higher than yesterday’s close.

I bring this up not because of why the market plunged, but only as a reminder of how volatile things can get. We shouldn’t forget these wild swings because there’s a high likelihood we’ll see more of it over the next several months, likely driven by central bank actions.

As Mohamed El-Erian recently wrote, central bank synchronization is coming to an end. We’ll begin to see some parts of the globe begin to tighten just a bit and this may very well result in another wave of high volatility as global markets begin to reassess things; the equity markets are currently very cozy with the massive easing and liquidity pumping measures of central banks, specifically policy from our own Federal Reserve. (There’s little doubt a main element of the Bernanke strategy is to repair household balance sheets by pumping up the stock market – all of this liquidity must go somewhere as the Fed holds to its zero interest-rate policy, thereby removing the bond and money markets as an alternative to stocks.)

Indeed, we see this occurring already, if only via words for now – in time not to distant this will become action if the current path of fiscal and economic policy doesn’t cause an additional period of significant weakness.

European Central Bank President Trichet was out yesterday harping on the importance of a “strong” dollar. Trichet is worried that the strength of the euro vs the dollar will hurt EU export markets, so that is one reason for his statements on dollar weakness. But when the head of a foreign central bank becomes outspoken about the dollar’s value -- at a time in which our own Fed, the only party that has a monopoly on dollar creation, refuses to even mention the greenback in their meeting statements – you know monetary policy synchronization will soon come to an end.

Trichet, and other central banks, may remain moored to Bernanke’s easy money ways for a while as they fear hiking interest rates will only further strengthen their domestic currencies against the dollar. But it won’t be long before they realize that capital inflows, promoted by sound money policy, will offset the hit to export markets and at that point, if the Fed remains easy for a prolonged period, they’ll separate from the Fed’s hitch. That will send a strong signal that the stock-market pumping activity from the Fed will begin to unwind. The easy-money trade will end in anticipation of this shift; it won’t wait for implementation of the unwind.

(This whole process will result in a major conundrum – to use a Greenspan term – for the Fed. If other central banks begin to raise rates, while our Fed remains near zero, you’re looking at significant dollar weakness even from these levels. But, if the Fed begins to raise rates, then the $500 billion in IO resets coming in 2010-2011, the commercial real estate default rates and overall bank-industry woes become an even larger problem for the economy to handle. This will be very interesting/troubling to watch play out. The Fed has backed itself into a corner and there is no easy way of returning to the center of the ring.)

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

S&P 500: +18.60 (+1.78%)

“Merger Monday” sparked a big rally, with Xerox Corp’s acquisition of Affiliated Computer Services, Abbott Laboratories (ABT) buying Solvay to gain a stronger emerging markets presence, and Johnson & Johnson (JNJ) buying an 18% stake in biotech firm Crucell to develop a universal flu vaccine.

Despite the today’s gains, volume on the NYSE fell to its lowest level in one month, coming in below one billion shares.

The Wall Street Journal ran an article (see abbreviated version here) that said earnings could surprise to the upside, this time as a result of stronger sales rather than cost cutting. Still, the vast majority of columnist and opinion articles floating around carry a negative tone regarding the market rally’s sustainability.

Our concern about the market outpacing fundamentals has been well-documented at this point. The one positive factor, in my mind, is the investing community’s reluctance to embrace the rally energetically. As I said repeatedly, the market has a history of remaining overvalued for extended periods of time and it’s impossible to predict when the market will correct.

While it’s anybody’s guess as to the timing of a pullback – it could be two weeks or two years – there is no denying the bear case is stronger the bull case at this juncture.


Quick Hits

• The rally in financial markets: Liquid fuel
• Can Irrationality Be Rational?

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks fell for a third-straight session, sending the broad market to its worst weekly decline since early July. Since mid-July the S&P 500 has recorded weekly gains of 2.2% or more in six of those 11 weeks. One has to go back to right around the July 4 holiday to see even a meager pullback of 7%; it’s unusual to see a move to the upside we’ve witnessed since early March without a pronounced correction. We will get that correction, there is no way around it and the higher we go without one occurring, the deeper it will be.

The market ran into another slight roadblock as Friday’s weak durable goods orders report and new home sales failed to meet expectations (and the prior month’s reading was revised lower). This data offset an improvement in a consumer confidence survey.

Friday morning’s news out of Iran, confirming that they have a second uranium-enrichment facility, didn’t help investor sentiment either. However, I’ve got to say, the market’s resilience is remarkable. This is big news and yet investors hardly flinched.

One has to assume any chance at sanctions on Iran is off of the table now – even if our Congress is unwilling to admit it. The mullahcracy has cemented a deal with Venezuela to supply the regime with gasoline and it is highly likely that Russia will truck refined product into Tehran simply to put a thorn in our side. Since Iran has very little refining capabilities, this was what many saw as their main non-military weakness, but that has now changed. The options are becoming a heck of a lot more concerning. It seems a lot of people continue to hold out for concrete measures from the UN and G-20 on getting Iran to change course, but only a sucker would expect anything of substance out of these two organizations as China and Russia can block anything that has bite to it.

Basic material, financial and industrial shares led Friday’s decline. Energy and health-care shares were the relative winners, even though they too closed lower.

Market Activity for September 25, 2009
Durable Goods Orders

The Commerce Department reported that durable goods orders fell 2.4% in August (much less than the 0.4% rise that was expected) after the CFC–driven jump of 4.8% in July. Ex-transportation orders, durables printed a big goose egg after rising 0.8% in July.

The headline reading was led lower by transportation orders, which fell 9.3%. Vehicle and parts orders did rise a bit, up 0.4% (although this number was probably expected to be much stronger as most thought vehicle assemblies to be robust after CFC-driven sales). The incredibly volatile commercial aircraft component led the transportation reading lower as this segment plunged 42.2% after surging 98.2% in July.

So this brings us to the ex-trans number, which came in flat -- unchanged. Orders for both primary (cars) and fabricated metals rose 1.9% and 0.8%, respectively. Machinery orders gained 0.7% after a 7.9% drop in July. Computer and electronics and electrical-equipment orders put pressure on ex-trans as these components fell 0.7% and 0.5%, respectively.

The very important business spending reading (technically, non-defense capital goods ex-aircraft) fell 0.4% after a 1.3% decline in July. Businesses remain cautious and will continue this stance so long as an over-bearing government keeps the private sector uneasy.

Shipments of durable goods orders fell 1.4%. This number flows directly to GDP, so it won’t be helpful for the third-quarter reading. And speaking of GDP, it appears that the biggest boost from the inventory dynamic will occur in the fourth quarter, not the current quarter as many had expected.

U of M Confidence

The final reading for September consumer sentiment out of the University of Michigan’s survey showed a three point increase to 73.5 from the initial reading of 70.2 and up from 65.7 for August.

Both the Current Conditions and Economic Outlook (six months out) surveys were revised higher from the preliminary readings. Inflation expectations for the next year fell to 2.2% from 2.8%.

New Home Sales

The Commerce Department reported that new home sales rose 0.7% to 429,000 at an annual rate (a bit below the expectation for a 1.6% rise). By region, sales fell in the Northeast (smallest market for new homes) and Midwest and rose in the South (largest market for new homes) and the West.

The inventory/sales ratio made additional progress, falling to 7.3 months worth (lowest since January 2007) from 7.6 months in July.

The median price of a new home got slammed last month, down 9.5%.

The August number may be beginning to show the signs of the front-loading effect due to the tax credit. I suspect the September reading will begin a trend of falling sales as those who sign a contract struggle to close by November 30 – even if that credit is extended we should see sales decline again as the extension will hardly be perfectly continuous.

Fed’s Eventual Direction

Other big news on Friday was Fed Governor Warsh’s comments via an Op/Ed on how the FOMC will have to aggressively raise rates (much more than is customary) when the time comes, whenever that may be.

We’ve discussed this topic for some time now. It’s pretty simple, based on their extraordinary/ unprecedented level of easing the other side of this will be harsh. This is the main reason no one should expect this expansion to be long-lasting. The crutches that currently support the economy will turn and whip it when they are reversed – combine this with higher tax rates and protectionist policies (pray this doesn’t occur) at the same time and you’re looking at massive economic headwinds.

Futures

Stock-index futures have reversed coarse, after being meaningfully lower early this morning they are now pointing to a higher open. International bourses were supported by electoral victories for Germany’s pro-business government, allowing most overseas indices to pare earlier losses and offering support to the U.S. trading session. M&A activity is also offering support as Xerox stated it will pay $6.4 billion for Affiliated Computer Services and Abbott Labs will buy Solvay’s pharmaceutical unit.

Still, with all of the uncertainties, which have now just increased as we can’t make light of the fact that Israel’s trigger finger just got itchier, one has to be cautious with the market at this level. It seems unwise to increase equity exposure, but that is the tendency when stocks are in rally mode and the impulse to win back losses overtakes common sense.


Have a great day!


Brent Vondera, Senior Analyst