Daily Insight

U.S. stocks slid yesterday as jobless claims jumped, China continues to make gestures toward reining in stimulus, and the White House proposed new bank regulations.

President Obama’s announcement yesterday morning, proposing new rules designed to restrict the size and activities of the largest banks, led to concerns over the sector’s profit potential.

The White House proposal, on its surface and if passed by Congress, would force financial institutions to spin off operations and change their regulatory status. Dang, and it was just over the past two years in which the government “encouraged” banks like JP Morgan and Bank of America to buy the troubled investment banks Bear Stearns and Merrill Lynch – both of which engage in the politically disparaged proprietary trading.

Let’s hope this is more a diversionary tactic on the heels of the health-care rebuke via the MA election than anything else because this proposal is ill-conceived and terribly timed.

First, you never, ever offer such a proposal without international cohesion – unless your goal is to deliberately put your own financial industry at a global disadvantage.

Second, this is about as poorly timed as it gets. Proprietary trading is one area that is helping to ease the losses on the traditional banking side of things – sky-high loan delinquency rates. You want to watch credit contract for a long time, implement this proposal now. (Also, this is a reminder of why I keep harping on the consequences of intense government intervention and waves of populism. Do not underestimate Washington’s ability to royally screw things up.)

Finally, firms will always employ an army of lawyers to find regulatory loopholes and this does nothing to tackle the “too big to fail” issue. If Goldman Sachs simply de-banks (recall they, like so many others, scrambled to become bank holding companies little more than a year ago so they could get in under the TARP and it’s bailout funds), their counterparties along with the rest of the universe will still see them as TBTF.

None of this may even matter. The banks have already easily identified the rather conspicuous loophole. The key phrase in the President’s proposal is “operations unrelated to serving clients.” Well, proprietary trading can be done through hedge funds in which clients may now be permitted to invest. One supposes even a bank’s own employees can be termed “customers.” It seems as if the weak regulations are by design, which gives credence to the charge that this is purely a political move.

If you’re going to get serious about this thing, you state that only traditional banks – engaging in only the most conservative of activities – are the sole institutions that have government backing and the safety net. The rest can do whatever they please, but it must be clearly stated that they do not have a government safety net. If they fail, they go down. When you explicitly state that investments are walking the tightrope without a net, the market will do the regulating. When the government gets involved with its backstops and safety nets risk will not be assessed properly.

Anyway, the announcement had wide-ranging effects on the market. It wasn’t only financial shares that got hit, basic material shares were by far the worst-performing sector for the session – got clocked by 4.3%. The group was already getting hammered over news that the Chinese are planning to remove some stimulus measures; they endured another leg down after the President’s press conference. Sudden regulatory changes may be seen as damaging the fragile, nascent and thus far slight global expansion and that’s why commodity-related stocks took the brunt of the hit.

The broad market’s decline was the largest since the 2.81% loss on October 30. Still, for all of the commenting from the press that yesterday’s activity was a bloodbath, it was not. The S&P 500 is up 68% from the March low. We’re considerably past the point of a correction in my view, the 2.95% lost over the last two sessions is child’s play – has everyone already forgotten what a bloodbath truly looks like? Of course they have, that’s what a zero interest-rate policy does. If Washington is going to play a game of chicken with the market by traveling down the path of populism, we will be reminded of what a real sell-off feels like.

Market Activity for January 21, 2010

Jobless Claims

The Labor Department reported that initial jobless claims rose 36,000 (expectations were for a 4K decline) to 482,000 in the week ended January 16. This moves the figure back above the 480K level for the first time in five weeks, just when it looked like claims would remain below 450K and on their way to 400K. The four-week average of initial claims rose 7,000 to 448,250 – the first increase in nearly five months.

Continuing claims fell 18,000 to 4.599. That’s for the standard sort, the benefits that are good for the first 26 weeks. When those are exhausted Emergency Unemployment Compensation (EUC) kicks in to provide up to another 73 weeks of benefits. That’s right, another 73 weeks. These claims surged 613,000 for the week ended January 2 – there’s a two-week lag to the EUC claims. Standard claims have declined 2.3 million since peaking out last June. However, EUC claims have more than offset this move as they have jumped 3.2 million.

The data continues to paint the same picture that it has for a couple of months. While the pace of job firings has eased greatly, hiring has not begun to occur and a very disturbing level of long-term unemployment continues to grip the workforce.

Last week we mentioned that EUC claims halted their march higher for the first time since May. This offered some evidence that jobs have begun to pick up, but we expressed the caveat that the data in the following weeks must confirm this. Well, obviously the move in EUC failed to confirm that dip. Instead, those claims rose by the most since the program’s implementation in July 2008.

Philly Fed

The Philadelphia Federal Reserve Bank’s gauge of factory activity in the third Fed district posted its fifth-straight month of expansion in January, although the reading did decelerate to 15.2 from 22.5 in December.

In terms of the sub-indices, the new orders index slipped to 3.2 from 8.3 in December (a reading above zero marks expansion). Unfilled orders and delivery times both accelerated – unfilled orders rose to 3.6 from 1.7 and delivery times rose to 6.6 from 4.1. (These are two areas we’ve been keeping a close eye on because if they spend several months in expansion mode it illustrates that factories are getting stretched and may be forced to add workers. Among the several regional manufacturing readings, these two components have moved to expansion mode for two months now.)
The average workweek reading slipped but remained in expansion mode, coming in at 4.2 for January after 6.3 in December. (This another area to watch as a signal for future factory employment growth as current workers hours must rise and become stretched before firms will increase payrolls.)

The inventory index remained in contraction mode, but just barely as the -1.6 reading for January is the best number since November 2007.

The worst aspect of the report was the differential between prices paid and prices recieved. Prices paid continues to hugely outweigh that of price received, the former came in at 33.2 and the latter rose to just 2.7. This is not good for manufacturing profit margins. While they will be able to absorb these costs due to the massive reduction in payrolls (higher worker productivity via the slashing of employees), this could become a problem when hiring begins. It may even cause manufacturers to further delay new hires.

The Call – Part II

Earlier in the week we talked about the official date for which the NBER (National Bureau of Economic Research, the official arbiter of business cycle dating) will call the recession ended. While this announcement is not expected for sometime (the NBER generally take a considerable period of time before they call the official date), I have guessed they will state the recession ended in June; the St. Louis Fed staff believe it will be July. Overall, it’s meaningless, but it is interesting to talk about.

I bring this topic up again because Invictus (a blogger than keeps a close eye on the business-cycle dating committee) states that the NBER has posted some comments on their website that seem to raise some uncertainties as to whether they’re even planning to call the recession ended in 2009. I found his comments intriguing so I went to the site to see read the post. There one finds that the NBER doesn’t seem so sure the recession has actually ended via the statement: “In both recessions and expansions, brief reversals in economic activity may occur – a recession may include a short period of expansion followed by further decline; and expansion may include a short period of contraction followed by further growth (my emphasis).”

I continue to believe they will call the recession ended in 2009, but these posted comments do cause some doubt – they certainly had some kind of message they meant to relay by the posting. It is unclear as to whether the NBER views the unprecedented fiscal and monetary stimulus that has been by far the main reasons most economic indicators have begun to move higher, or at least halt their significant decline, as an invalid reason to state that the business cycle has truly troughed. Maybe they will wait an extended period this go around to make the call in order to see how the economy reacts to the fade out of fiscal stimulus. They are making things very interesting.

Below are the key indicators the NBER watches to make their call. While employment has halted steep declines and real retail sales have at least stabilized, industrial production is the only indicator that has shown a clear upward trend.

Have a great weekend!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks were headed for their worst session since mid-November until a little afternoon rally eased early-session weakness. Speculation coming out of China that they’ll rein in bank lending, along with an IBM earnings report that failed to confirm private-sector orders are rebounding, started things off on a bad note yesterday.

Additional data on housing starts was also portrayed as putting pressure on stocks, but I’m not so sure about that one. While housing starts fell more than expected, the permits data showed a bounce back will take place in the subsequent months. Besides, does the market really believe that residential construction is making a comeback anytime soon? Doubtful, it’s hardly a secret that we continue to see 300k-plus in foreclosure filings per month, that’s a lot of supply on the horizon. The point is the market shouldn’t be caught off guard by weak home construction data. Besides, it means ZIRP’s longevity is extended and I haven’t seen a shift back to market fundamentals; the liquidity trade remains in play, so I doubt the housing number played a role.

If we’re going to base what drove the market lower on any single day you have to look at the internals. Since the commodity-related areas (such as basic material and energy sectors) along with tech led the decline, you’ve got to surmise that the weakness was about China and IBM’s results. (And the China story is getting interesting. Concerns that they really will begin to rein things in have increased this morning after a fourth-quarter GDP print of 10.7% -- the growth appears to be largely driven by the construction sector, fueled by significant credit expansion. How many times are we going to watch this trainwreck? First in Japan, then the U.S. – now China?

While the financials were the best-performing sector (health-care was the next best, although both were down), earnings reports out of Bank of America and Wells Fargo showed loan losses remain elevated and “will continue so for the next several quarters,” according to BofA’s Moynihan. Mortgage and credit-card delinquencies continue to present a problem – a problem that only a stronger job market can fully fix. BofA’s charge offs fell 12% from the previous quarter (that’s good), but Wells’ charge offs increased 6%. Both banks reported an increase in non-performing loans (payments late by 90 days), up 5% for BofA and 18% for Wells.

Market Activity for January 20, 2010
Mortgage Applications

The Mortgage Bankers Association reported that applications rose 9.1% in the week ended January 15, after a 14.3% increase in the week prior. But while the prior week’s rise was all due to refinancing activity, this latest week did have some purchases in it. Purchases were up 4.4% after a paltry 0.8% rise for the week ended January 8 – the chart below shows purchases continue to muddle around the cycle low. Refi activity rose 10.7% after up 21.8% in the previous week. The rate on the 30-year fixed mortgage fell to 5.00%.

Housing Starts

The latest housing starts figure dovetails that very low homebuilder confidence reading we mentioned yesterday. Builders broke ground on just 557,000 units at a seasonally-adjusted annual rate (SAAR) in December, which amounts to a 4% decline from November’s activity – the expectation was for starts to come in pretty much flat relative to November.

This latest data moves the figure back to the level that is just a tier above the all-time low of 479,000 units hit in April – the data goes back to 1959. Surely, the weather played a role in the decline. The permits data seems to confirm this, which we’ll get to below However, most of the new-home construction occurs in the West and South regions. While temperatures were below normal in the South (the largest new home market by region) and they did get some snow, it may not have been a large effect on overall starts.

The permits data, an indicator of future building, jumped 10.9% month-over-month to 653,000 units SAAR. That’s the highest reading we’ve seen since October 2008 and suggests that we’ll get some bounce in homebuilding activity in the current month and into February.

Regardless of whether the December building numbers were adversely affected by the weather or we get a two-month bounce back, builders will be forced to keep activity to a minimum for an extended period of time. The supply of foreclosures may just double the current amount of existing homes available for sale – and that’s using the low end of estimates.

So try as you will boys and girls of the Beltway, but even rock-bottom interest rates, tax-credit extensions and the Fed’s foray into the mortgage market will only delay the inevitable. You’re barking up the wrong tree, for until the job market comes rocketing back housing is going to remain on the mat – that’s what policy should be targeting, the job market.
(And I’m not talking about some short-term public works program or this monetary fantasy currently wandering through the blogosphere that recommends a quantitative-easing orgy, calling for the Fed to buy an additional $2 trillion in Treasury securities. As explained yesterday, I’m referring to elimination of the corporate income tax. And, as mentioned on several occasions, a winning energy strategy that creates high-paying manufacturing jobs in order to fill the gap from the 840,000 permanently lost auto-assembly jobs and most of the 1.3 million construction jobs that have been eliminated for a very long time.)

Producer Price Index

The Labor Department’s gauge of producer prices rose 0.2% in December (the expectation was for no change) basically all on the food component. Energy fell after a large increase in November. Prescription drug prices rose 0.8% for the month after a series of very tame monthly readings.

The year-over-year figure jumped to 4.4%, a big turnaround just two months following what was an eleven-month streak of decline. But these latest figures are against very easy year-ago comparables. The PPI figures should ease about six months out, before they eventually shoot higher, as the comps are not so easy by June. This is similar to the declines we saw for the eleven months that ran December 2008 through October 2009. Many people were calling this deflation; it was not in the specific sense of the term. It was just that the figures were being compared to very high year-ago levels that resulted from the commodity-price spike of summer 2008.

Overall, even though the Fed likes to minimize the food and energy components, these will be the ones to watch for signs that inflation will become a problem down the road. The Fed is so wrong. Their recalcitrance is going to get them, and the rest of us, into trouble again. They continue to believe that so long as the unemployment rate remains well above average, there is little to no chance that inflation can occur, particularly their core rate look – which excludes food and energy. But the inflation that will take hold over time will be of the commodity-push variety, not the wage-push that the Fed myopically watches for. Therefore, the core rates are not the measures to focus on. Again, it is food and energy prices. The core rates become much less meaningful in an environment such as the one we find ourselves.

I must make it clear that it may take some time for the official inflation gauges to move meaningfully higher in a consistent manner, remember credit is still contracting and that means trillions of dollars the Fed has pumped into the system remains fallow. When credit begins to expand, which I suspect is still a ways away, that money will move into the system and if the production of goods isn’t there in a commensurate way to absorb this money (which I think is unlikely) that’s when inflation begins to become a major problem. We’ll continue to very closely watch credit activity.

Some Common Sense

The Federal Housing Authority (FHA) is struggling with a 14% delinquency rate and is in the process of making some changes to deal with this. They’ve been leaned upon, along with Fannie and Freddie (the three accounted for 90% of home loans during most of 2009), to resuscitate the housing market as the FHA has guaranteed more than 30% of new home loans.

As a result of these default rates, the FHA is raising the premium charged to insure mortgages to 2.25% from 1.75%. They will also raise the down payment requirement to 10% for those with credit scores below 580. Borrowers with FICO scores above 580 will still only have to put down 3.5%. Subprime is defined as a credit score below 650, so this new rile isn’t exactly stringent

Frankly, I would argue that sub-580 FICO shouldn’t even qualify for an FHA backed mortgage and they should boost their down-payment requirement to 10% for all – I know, cruel thought. But look, down payments are necessary and if you don’t have at least 10% then sorry you’ll just have to take some time to save it – like most people used to do before all common sense was thrown out the window. A return to common sense would put the market on a more solid foundation as borrowers are able to withstand home-price declines and still have some equity in their home.

The FHA change is a minor one, but should help their solvency. It will have some level of negative effect on the housing market in the short term, but sometime you just have to deal with reality. When we mask problems, history continues to show that more result – and the economic damage that everyone must endure becomes increasingly acute.


Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks gained some good ground Tuesday, erasing Friday’s decline, on what many were calling the Scott Brown rally. A vote for 41 more than it seemed to be for Scott Brown means the most economically damaging aspects of Washington’s agenda will be blocked – either in absolute terms via the elimination of 60 in the Senate or via the message it sends to those up for re-election later this year.

We didn’t have much by way of data yesterday, but what we did get wasn’t pretty; nevertheless, the market was able to shake off a U.S. homebuilders confidence reading, which is all but floored and another on European investor sentiment by way of the ZEW index on economic growth expectations – that reading dipped more than expected..

Health-care shares led the advance on bets that the outcome of the special election Senate seat in Massachusetts will go to Scott Brown and foil additional government involvement in the sector, among other things. While a Brown victory will result in some gridlock – and may even offer some focus on pro-growth measures -- rather than adding trillions to an already bloated budget, it is still unclear how the health-care legislation will ultimately turn out. It remains unclear how tax rates will change. Nevertheless, the GOP win in a state like MA will surely shift some yea votes to nays as politicians really begin to worry about November 2010. Enough to erase even the 51 Senate votes needed via the reconciliation process? We’ll see.

Basic material and tech shares also outperformed the market. Interesting to see commodity-related material stocks gain ground on a session in which the U.S. dollar advanced -- that’s become an unusual event over the past couple of years. The dollar was the benefactor of increased concerns over the euro’s value. That ZEW index didn’t help and there are still many questions about the state of things in Greece. The EU continues to state that they won’t backstop any major trouble Greece may run into if they more or less default, they’re likely to get tested on that statement. If things get nasty, they’ll have to offer something – Greece can’t go to the IMF for help without EU nations offering support. For now Greece says it is going to get things done in the capital markets. That would be the best route, even as it costs them in higher interest payments.

Market Activity for January 19, 2010
Foreign U.S. Security Purchases

The Treasury Department reported that international demand for longer-term financial assets jumped in November, ending a four-month period of weakness. Net buying of stocks and corporate, agency and government bonds rose $127 billion – largest increase since October 2007. (I guess government and agency bonds are effectively the same now with Treasury’s December 24 decision to provide an unlimited backstop to future Fannie and Freddie losses over the next three years, but the data separates the two so we will too.)

Net buying of Treasury notes and bonds by foreigners totaled $118.3 billion in November (all-time record for one month) after a $38.9 billion increase in October – the UK was the largest buyer of Treasury securities for the month, followed by Japan; the Chinese were net sellers. Net buying of agency bonds totaled $5.9 billion after declining $5.4 billion in October. Foreigners sold a net $4.6 billion in corporate bonds -- the second-straight month of decline; foreigners have been net sellers for seven of the past eight months. Net purchases of U.S. stocks totaled $9.7 billion after increasing by $10.3 billion in October – foreigners have been net buyers of U.S. stocks since March.

Based on the rise in yields during December, we should expect to see a large pull-back in Treasury purchases in the next report. Concerns within the bond market over the durability of this expansion will keep money flowing into the Treasury market for a while still, but if policymakers don’t get things right – speaking both of fiscal and monetary policy – the question over the next couple years is at what price investors be willing to buy U.S. government debt. If the economy shows considerable weakness in 2H 2010 then other problems will take over, which means demand for Treasuries won’t be a problem. But this isn’t a winning strategy. At some point we’ll have a durable expansion that takes hold (the timeline will depend on policy). Even when this good news occurs, we’ll have funding issues when investors demand higher yields.

NAHB Housing Market Index

The National Association of Home Builders index of builder confidence fell to 15 this month, following December’s slip to 16 from 17 in November. Readings below 50 mean that most respondents view conditions as poor.

I’m not sure if the index is going to test the all-time low hit in January 2009 but this thing remains just about floored from a historical perspective – NAHB began looking at builder confidence in 1985. Builders are still competing with foreclosures coming back onto the market and that’s not going to change anytime soon.


The report’s look at buyer traffic slowed to a 10-month low, falling to 12 from 13 – the record low of 7 occurred in December 2008. Factors such as consumers’ concerns about job security and the future trajectory of economic growth appear to be overwhelming the extension of the home-borrowers tax credit.

As unpleasant as it is this is a necessary condition for a rebound in housing to take hold. We have too much supply out there, particularly when factoring in all of the foreclosures that will be hitting the market, and building more houses right now isn’t going to help the matter.

The government is attempting to thwart the foreclosure process via their programs to modify home loans in order to keep people in their houses. This only delays the process, besides according to the Fed’s latest data on the issue, 57% of modified mortgages are now in default a year later.
The market will find equilibrium, but it must be allowed to find that point. We keep targeting housing, but artificially propping it up will do zero good – heck, we can’t even keep a rebound going with rock-bottom interest rates. Pro-growth policies must be implemented in order to get job growth rolling again. It doesn’t take a stroke of genius. Reduce tax rates on income and capital, even hold them steady; just don’t increase the view that they are going higher. Eliminate the corporate incomes tax, it’s ultimately borne by the consumer anyway and we hardly need more layers of taxation. Eliminate it and watch both domestic and foreign firms open more plants and offices in the U.S. The increase in tax revenue via job creation will more than make up for the corporate tax receipt loss. When the labor market begins to recover in earnest, that’s when a lasting housing rebound will begin. Follow this up with sound monetary policy and a strategy to keep the spending side of the budget moored to growth rates and the rest will take care if itself.

The Call

Yesterday while talking about the Industrial Production number I failed to mention something of interest noticed on Friday. Blogger Invictus mentioned that the St. Louis Federal Reserve Bank’s economic research site was no longer indicating recession on their latest Industrial Production chart – you know, the shaded vertical bars that indicate recessionary periods. Their chart has the shaded area coming to a halt a few months back. While we’re pretty confident the recession ended in 2009, data charts generally don’t show a recession has ended until the NBER officially announces the start of a new business cycle expansion. (NBER is the National Bureau of Economic Research, the official arbiter of dating business cycles.)

Anyway, according to Invictus, the St. Louis Fed staff believes July is the date NBER will call the recession officially ended, which prompted them to cease the shading.

Maybe some remember that we called June to be the date at which NBER will state the “Great Recession” ended – I noted this in one of the letters last summer. NBER watches significant changes in five areas (real GDP, real income, employment, industrial production and retail sales) before calling a recession or expansion has begun. Meaningful changes in employment, IP and real GDP match up very nicely for the NBER to call the recession’s end in June. It’s important to note that IP remains below 2004 levels and the labor market is very fragile, but the changes are meaningful and that is all that matters. While income and retail sales are unlikely to show consistent improvement for some time (incomes rarely trend higher until we’re well into an expansion and retail sales are going to be pressured by debt pay downs), I think NBER will focus more on the other three data sets.

The NBER is notorious for waiting a rather long period of time before officially calling a change in the business cycle. According to the group, the recession started in December 2007 but didn’t officially state this until November 2008.

I continue to believe that this will be the shortest expansion since the two-quarter long 1980 expansion (a brief increase in economic activity that was made possible by a respite in the Volcker Fed’s strict tightening campaign; Volcker & Co. quickly resumed the policy by eventually sending fed funds to as high as 20% by January 1981). The average length of expansion via the three business-cycle upswings we’ve enjoyed since 1983 is eight years – by far the longest average duration of successive expanding business cycles in the postwar era. I give this expansion four-five quarters.

Futures

Stock-index futures are down this morning – maybe some buy on the rumor (ahead of the MA election) and sell on the news action here. More likely, continued comments out of China that they’ll begin to restrict lending is causing some boosting concerns that global recovery will have one less crutch of support. The market is so mercurial in this regard I feel like an idiot even stating such things. One minute it’s all hopped up that the expansion is for real and the next that it isn’t.

Anyway, other things may also be playing a role in the pre-market weakness. IBM’s numbers out last night were not that great. While earnings expanded 9% from the year-ago period, revenues was flat. Also, CEO Loughridge stated that while they see encouraging signs they want to see this confirmed by first-quarter results. Since their fiscal year 2009 improvements were boosted by public-sector expansion – private sector businesses all showed a decline for the year -- some degree of validation is prudent.

Have a great day!

Brent Vondera, Senior Analyst

Healthcare sector trending up

Sentiment towards healthcare stocks has dramatically improved as it became clear that any reform was unlikely to impinge industry profitability as much as originally thought. Today, however, the sector surged as investors speculated the bill might be scrapped altogether (see more here).

Overhaul or not, healthcare firms are in solid position for 2010. Removing the uncertainty that has been a major overhang on valuations in the sector is an obvious positive going forward. The uncertainty has led to the industry’s cheapest valuations in decades; for example, Johnson & Johnson (JNJ) trades at 14 times earnings, while its 10-year average exceeds 20.

Additionally, the sector has never had more cash relative to their market capitalization then they have today. Healthy balance sheets provide financial flexibility for stock buybacks, dividend payments, and acquisitions.

Pharmaceuticals expect game-changing clinical trial data throughout 2010 and positive results could go a long way in shifting negative sentiments surrounding the industry’s drug pipeline. Even more, the number of drug approvals by the FDA are moving higher, which has historically led to increased pharmaceutical sales.

Healthcare companies are also doing a good job of meeting earnings estimates thanks to cost-cutting and revenue growth, partly due to the weak U.S. dollar and significant overseas sales. Meeting (or exceeding) earnings estimates should help lure investors back to a sector known for steady reliable profits.

Though the stocks rallied significantly in the second half of 2009, they remain attractive. The worst case scenarios for the majority of the sector are off the table. Now investors can focus on long-term fundamentals and trends such as an aging population, significant international exposure, and financial flexibility to grow and return value to shareholders.
--

Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks fell on Friday, and were heading for their worst daily performance since November but a relative rally in the final hour of trading pared the losses. The most well-rounded manufacturing report we’ve received yet, in my view, couldn’t offset an earnings report from JP Morgan that reminded traders consumer credit quality is probably quite a ways from improving.

Industrial production (IP) was of little help, even though the report showed activity advanced for a sixth-straight month. All of the gains came from utility production. Without abnormally cold weather IP would have likely halted its streak.

As we’ve been talking about for a while, what’s-bad- is-good has been the traders’ mentality as it indicates ZIRP live on, so maybe it was the well-balanced factory number that shook traders a bit. I’ve got a feeling though the retail banking side of the JP Morgan report is what did it. This situation isn’t good for anyone because it shows deep problems that exist and relays the message that it will take much longer than is normal for a durable recovery to materialize. Debt levels are way too high and impossible to manage around for too many people at the current rate of joblessness.

Just looking at the headline profit number out of JP Morgan it appeared they knocked the cover off the ball, but it was all on higher investment-banking fees – thank you ZIRP, say the banks. If not for the Fed at zero, corporate refinancing and securities trading activity would not be robust enough in the current environment to offset serious retail banking weakness.

And JP did warn on the retail banking side as consumer-credit problems persist. Their card-services division’s fourth-quarter losses were artificially low due to a payment holiday the bank implemented. This only means you’ve delayed things. Chairman and CEO Jamie Dimon told investors that the unit’s losses will continue through 1H 2010, even before setting aside more money to cover losses. He mentioned that proposed credit-card legislation will add to these losses and if the unemployment rate doesn’t reverse course fast, they’ll have to add meaningfully to loan-loss reserves. (Adding provisions to loan losses subtracts from profit.) Dimon also expressed concern about a double-dip – the economy falling back into recession a few quarters out.

Market Activity for January 15, 2010
Consumer Price Index

The Labor Department reported that CPI for December rose 0.1% (+0.2% was expected). Core CPI, ex food and energy, was up the same and in line with expectations. From a year-over-year perspective, consumer prices as measured by this gauge are up 2.7% -- the second month of increase after eight months of decline as those readings were being compared to very elevated levels due to the commodity-price spike of summer 2008. The core rate was up 1.8% after a 1.7% in November – both of these y/o/y readings were in line with expectations.

The owner equivalent rent component, the largest component of CPI as it makes up 24% of the index, came in unchanged (up just 0.7% over the past year). Recreation, which makes up 6% of CPI, was down 0.4% (also down 0.4% year-over-year). The transportation component, which accounts for 15% of CPI, rose 0.4% (up 14.4% y/o/y) -- pushed higher for the month by a 0.3% increase in vehicle prices and a 0.2% rise in gasoline. Food and beverages also makes up 15% of the gauge, and that component rose 0.2% (down 0.4% y/o/y).

Overall, CPI continues to print pretty harmless results and an environment in which credit continues to contract will keep the traditional inflation readings from getting out of control for a while.

Those are the official figures, the what is seen. Let’s focus for a moment on what is not seen, as the 19th century French economist Frédéric Bastiat would put it

While the vast majority of economists focus on the CPI (or even narrower versions such as core inflation readings, which exclude food and energy prices – the Fed’s preferred gauge), it’s not all about official inflation data. One must also be cognizant of cost volatility that arises from the Fed’s willingness to implement exceptionally easy monetary policy for extended periods of time. While the official inflation gauges will eventually reflect mistaken Fed policy, global trade and high rates of productivity via massive payroll reductions may just keep a lid on these conventional inflation measures for some length of time. Certainly too, as mentioned above, credit contraction has put a ceiling on the inflation gauges.

But the costs of goods such as energy, building materials, essential metals and certain foods presents a sort of shadow inflation. Another key point is that wild swings in commodity prices, such as the volatility we’ve witnessed over the last several years, make it very difficult for businesses to manage and hedge around. These are large costs that are not fully captured by the official inflation readings. When commodity prices are left to rise as high as traders care to push them (as the markets respond to careless Fed policy), the deeper the economic damage we face on the back side of it.

The Fed can do something about this risk by gently tightening monetary policy. Even a mild exhibition that shows they are serious about future inflation, specifically the rising prices that may result from a downed currency, would send a message and remove the green light from accumulating commodities and selling the dollar. Of course, the housing market likely cannot withstand mortgage rates that are even 0.75-1.00 percentage points higher. Thus the Fed is choosing to err on the side of future inflation; I think this is a mistake because the downside that still needs to occur in housing is going to eventually occur anyway.

Empire Manufacturing

The New York Federal Reserve Bank’s measure of factory activity within the second Fed district posted a great number for January. Empire manufacturing printed 15.92 for the month after a disappointing 4.50 in December. While the reading has printed higher number over the recent past – hitting 33.4 in October and 22.3 in November – the internals of this latest report were the best we’ve seen yet.

New orders jumped to 20.48 from 2.77 in December; delivery times rose to 6.67 from -2.63; unfilled orders surged to 2.67 from -21.05; the average workweek (hours worked) jumped back to positive territory hitting 5.33 from -5.26 in December.

The only disappointment came by way of the inventory reading that still shows substantial contraction. Thursday’s business inventories reading was a good one, but the rebuilding surely isn’t universal.

The figures we’ve been watching most closely are delivery times, unfilled orders (for evidence that current employees are becoming stretched, which it what it will take to force new hires) and inventories (for a pick up in business confidence). We’ll take two out of three for now.

The report also offers an attachment called the Capital Spending Survey. When manufacturers were asked about their capital spending plans 6-12 months out, 44% indicated they expected to increase spending relative to levels of the past 6-12 months, 44% indicated it would stay the same and 12% indicated a decline. Since the previous 12-month period saw the largest capital spending declines in the postwar era, I’m not sure this is saying much. Seventy-nine percent noted the expected increase reflected investment that had been postponed during the recession. The most commonly cited factor behind increased investment spending was a need to replace IT and other capital equipment – 82% of respondents.

This is in line with our expectation that firms will manage capital spending to maintenance levels and not much more over the next year.

Industrial Production

The Federal Reserve released their industrial production number for December, showing a 0.6% increase – the sixth-straight positive reading. However, the pick up was completely due to colder weather as the utility component accounted for 97% of the rise in the total index.

Manufacturing production slipped 0.1%. This component makes up 79% of the IP index. This is not what the other manufacturing surveys have shown as most pointed higher in December – although most of the regional factory gauges are solely based upon what respondents are saying rather than pure degrees of improvement. Industrial production is about absolute improvement.

The utility component, which accounts for a little more than 10% of the index, surged 5.9% in December. (This was the second-highest utility production increase since records began in 1939 – second only to the 7.0% jump in November 1989 and wildly above the monthly average of 0.4%; it has weather-related increase written all over it.) Mining, the third component of the index, rose 0.2%.

To offer a little clarity here, the manufacturing component was held back by a substantial 2% decline in construction-supply production. Other areas of the business side and the consumer-related markets looked pretty good. The construction area is going to weigh on things for a while.

Capacity utilization (proportion of plants in use) rose, but will remain below average for an extended period unless business and consumer activity surges in the coming months and put idled resources to work. The overall figure rose to 72.0% from 71.5% in November.

Again, it was all from the utility component where the utilization rate jumped to 82.9% from 78.4% -- 87.7% is the long-term average. Manufacturing capacity utilization ticked up just slightly to 68.6% from 68.5% -- the long-term average is 80.8% and the current 68.6% remains the second-lowest level on record outside of the recent lows it is now bouncing off of. Mining rose to 85.7% from 85.5% -- close to the long-term average is 87.3% as commodity prices have been hot, save the last two weeks.

Futures

U.S. stock-index futures are down this morning as disappointing earnings results out of China, Europe’s ZEW – a gauge of investor expectations -- fell, and an inflation report out of Britain showed the largest monthly jump on record has traders pulling back just a bit.

Not much by way of data today, all eyes will be on that Senate race in Massachusetts.


Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks side-stepped the latest foreclosures report that showed 349,000 filings for December – a 14% jump from November’s 305,000 filings – to advance for a second-straight session. A good report on business inventories and high hopes for Intel’s earnings release – which came after the bell and did easily surpass expectations – offered the market some juice.

The market’s what’s bad is good mentality doesn’t jibe with stocks moving higher on the positive inventory report. In fact, the market traded lower shortly after the release of that report, but comments from New York Federal Reserve Bank President Dudley, stating that short-term interest rates may remain low for at least six months and possibly up to two years, came to the rescue to help traders’ sentiment regarding the expected shelf-life of ZIRP. Not sure I can say the same for the Fed’s sentiment; comments like this don’t portray ebullience about economic prospects.

The 10 major industry groups were split with half up and half down. Health-care, tech and financials led the way again. Telecom, basic material and utility shares led the losers.

Intel reported that fourth-quarter profit surged three-fold and offered great guidance for both the top and bottom lines. The fabulous results were driven by a three-fold story: massive cost cutting, largely via payrolls; improved business demand as firms move to managing business spending to maintenance levels from the largest collapse in equipment purchases in the postwar era; easy comps as profit was down 90% in the year-ago period. Still, Intel would have posted a nice number even without easy comps as this was a record profit quarter for the tech giant. (They better be careful or some in Congress may view these results as “windfall” profits.)

Thing are likely to get much tougher for the firm over the next four quarters as their gross margin, which super-spiked to 65%, has only one direction to go from here. Further, when you post such a large increase so quickly (again hugely helped by the payroll reductions) it makes it tough to keep the ball rolling. I like Intel, particularly the dividend they now pay -- and they were given room to boost that payout thanks to this number, but like the rest of the universe I’m not sure the profit story has much staying power past two-three quarters.

Market Activity for January 14, 2010
Jobless Claims

The Labor Department reported that initial jobless claims rose 11,000 to 444,000 (7K above expectations) in the week ended January 9 – initial claims up but it remains under 450K so no real harm done. The four-week moving average fell 9,000 to 440,750, the lowest level since early September 2008 – just prior to the Lehman collapse.

Continuing claims offered the first positive news that possibly long-term unemployment is beginning to decline a bit. As you may recall, we’ve spent a lot of time talking about this story. As of the latest monthly jobs report, those out of work for at least 27 weeks (the longest duration of joblessness that labor measures) continues to make new highs. But both standard and EUC claims fell for the first time in a while. The standard continuing claims figure fell 211,000 in the latest week. This has been the trend. The problem has been claims for Emergency Unemployment Compensation (EUC) continued to rise – this is what long-term unemployed persons rotate to when their traditional 26 week of benefits run out. This latest data, however, showed EUC claims fell meaningfully for the first time since the beginning of the year.

As we touched on last week, we’ve watching for the EUC to halt its march higher as evidence that employers just may be starting to hire a bit. This helps to back up our belief that mild payroll increases will begin by February/March. The caveat here is that the standard continuing claims data has a one-week lag to the initial claims number and a two-week lag for EUC. That means we’re talking about the week’s ended January 2 and December 26, so there may be some holiday distortion in the declines. We’ll ultimately have to wait two weeks (get fully past the holiday distortions) for EUC data to confirm this easing.

Retail Sales

The Commerce Department showed that retail sales for December came in well-below expectations, falling 0.3% (+0.5% was expected). The November reading was revised substantially higher to +1.8% from the initially reported +1.3%. Based on the unrevised November figure, December sales would have been up 0.2%, so the estimate wasn’t off by quite so much based on what the consensus was working off of.

Put the past three months together and consumer activity was up a super-strong 11.3% at an annual rate, fostered by a price-driven 35% annualized increase in gasoline. The reading that gets plugged into the personal consumption component of GDP, which excludes gasoline BTW, is up a solid 3.1% for the quarter. This is being distorted by government transfer payments that currently make up a record percentage of total income. Those out of work would have had to reduce expenditures to a greater extent if not for these cash transfers – a trajectory of government spending that is not sustainable and among other things will result in an economic payback.

Excluding autos, retail sales fell 0.2% (+0.2% was expected). Excluding gasoline, sales fell 0.4%. The gasoline station component was one of the few positive readings for the month, up 1% -- the price of gasoline rose about 6%, which more than offset lower volumes. Health-care (up 0.8%), sporting goods (up 1.6%), furniture (up 0.3%) and non-store retailers (up 1.4%) were the other components that showed an increase.

Among the components that declined: electronics sales fell 2.4% -- completely erasing the November gain; building materials declined 0.4%; food and beverage fell 0.8%; clothing sales were down 0.6% -- and erased the mild gains of the previous five months; auto sale fell 0.8% -- but this is after two big months of increase.

This data has bad weather written all over it. Even the eating, drinking component fell – a figure that is dominated by 20-somethings who are resistant to economic weakness. The rise in non-store retailers (online sales) pretty much confirms the weakness was driven by the snowstorms that hit most of the country.

I noticed that there were a few commentators stating the unexpected December decline in retail sales is a sign the economic recovery will be slower than many believe. Not exactly. This data doesn’t illustrate the likelihood of a much less durable expansion, but many other things do as I’ve laid out over the past few months. This data simply shows an easing off of the pretty strong readings of the previous three months, along with some weather-related obstacles.

Again, though one should not expect the consumer to play quite the role they have over the past few years – personal consumption made up 71% of GDP for several years, and still does. That number is going to decline back to the historic average of 65-66%; there’s no way around it as household debt burdens are way too high (a reality that was manageable at 5% unemployment but not at 10%, or even 8%). The government can pump these numbers up for a time, but eventually the economy must stand on its own two feet. Unfortunately, the way we’ve chosen to attack this situation is very likely to hinder private-sector activity for an extended period. Those are the things the financial press should be focused upon, not one month’s spending data.

Import Prices

The import price index came in flat for December, right in line with expectations. This follows a trend that has shown substantially higher prices over the previous eight months. Take out petroleum prices though, which fell 2.0% in December after jumping over the previous few months (up 78.4% year-on-year), and import price rose 0.5% in December.

The ex-fuels price reading was boosted by food and industrial-supply prices. Agricultural imports rose 2.0% in December (up 9.6% y/o/y) and industrial supplies rose 1.8% for the month (up 7.4% y/o/y).

In total, import prices are up 8.6% over the past year – a combination of easy year-ago comparisons and a dollar that lost about 5% of its value as measured against a basket of other currencies.

Business Inventories

Here come the inventories! The Commerce Department reported that business inventories rose 0.4% in November (+0.3% was expected), following the same increase for October – the first back-to-back increases in over a year as they follow 13-straight months of decline. Importantly, the sales data jumped 2.0% for the month following a 1.4% increase in October.

The inventory data is made up of three components: manufacturing, wholesale and retail stockpiles. Manufacturing inventories rose 0.2% and wholesaler increased 1.5%. Retail inventories was the only segment down, off by 0.2% -- would have been even lower if not for auto rebuilding. Ex-auto, retail inventories fell 0.4%. This jibes with what Beige Book showed on Wednesday.

Business sales have rallied 6.2% from the nearly five-year low hit in May and have nearly climbed back to November 2008 levels. That means sales are still down 14% from the cycle peak, but moving in the right direction.

The inventory-to-sales ratio has returned to low levels and this speaks well for additional inventory rebuilding in the coming months. The sales data will have to keep rolling along for this to come to fruition.

The fourth-quarter has gotten off to a great start in this regard. Even if the inventory day shows a pullback when the December figure is released, this component is going to add nicely to GDP – another topic we’ve spent much time on; it is the inventory dynamic. We should get a 4.0%-4.5% GDP reading for the fourth quarter.

Looking out beyond 1H 2010, we’ll need final demand to keep the ball rolling as inventory rebuilding is a very short-term catalyst without healthy business and consumer consumption.

Have a great weekend!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks shook off early-session weakness to close smartly higher on Wednesday. Analyst upgrades and earnings optimism overcame the latest energy report that showed fuel demand remains weak. The Fed’s Beige Book report (economic conditions within the Federal Reserve’s 12 bank districts) probably had little overall effect on market activity. The report showed some economic broadening as more districts reported improvement relative to the previous release, but it wasn’t terribly confirming.

Nine of the 10 major industry groups closed higher on the day, telecoms being the only loser. Health-care, financials and tech were the top performers.

The broad market currently resides at its highest level since October 1, 2008, surging 72% from the March 2009 abyss – capturing just more than half of the losses from the October 9, 2007 peak. We’ll now watch to see if the S&P 500 can make it back to its pre-Lehman collapse level of roughly 1240, just 8.3% higher and we’ll hit it.

The bulls remain in charge as the direction of stocks is more a function of earnings and interest rates than employment and GDP. Net bullishness (the difference between bullish and bearish sentiment) as measured by the American Association of Individual Investors has hit its highest level since February 2007.

Interest rates are certainly extremely low; the profit story has yet to play out -- expectations are very optimistic. The market cares little about the unemployment rate or GDP right now simply because the longer these figures remain weak (actually depressed in terms of employment and lackluster in terms of GDP thus far) the longer traders expect interest rates to remain very low. But the market should be giving a little more consideration to the jobs picture. Employers will likely wait quite a long time before they aggressively begin to hire again – they’ll want to book several quarters of good profit growth first. Besides, resource utilization rates are very low and that means they can squeeze more work out of existing employees; therefore, they will delay boosting payrolls in a meaningful manner – not to mention the delaying effects due to uncertainty about tax rates and health-care costs per worker; policymakers can remove this uncertainty in one fell swoop if they cared to do so.

While the slashing of payrolls is good for profits in the short-term, it doesn’t help final demand rebound – tough for this to occur at peak post war unemployment rates – and leads me to question the durability of earnings growth.

In addition, high joblessness doesn’t help mortgage-default rates or overall credit quality to improve. As default rates remain high, this puts additional pressure on bank capital ratios – banks will be hesitant to lend as they fear an erosion in capital adequacy ratios. This spells trouble for credit expansion.

Market Activity for January 13, 2010

Dollar, Fed Speak and a Little Oil

The U.S. dollar got a lift in early trading on hawkish comments from Fed officials. Federal Reserve Bank Presidents Plosser and Fisher (Plosser from the Philly Fed Bank and Fisher from Dallas) commented on how the FOMC should not be deterred from tightening policy by a sluggish job market or other unfortunate realities.

Plosser focused on the need to hike rates in a timely manner. He stated that: “economic slack is neither a necessary or sufficient condition to ensure low inflation.” (That kind of anti-Keynesian talk won’t get him invited to any Federal Reserve dinner parties.)

Fisher focused more on allowing the economy to adjust on its own at this point. He commented on the perils of holding interest rates artificially low, which has certainly been the case as the Fed’s $1.25 trillion in MBS has pushed mortgage rates lower -- and Treasury yields too as investors sell MBS to the Fed and buy Treasuries with the proceeds. He also engaged in a bit of digression, moving onto fiscal policy (which is obviously out of his jurisdiction), as he brilliantly stated: “While it appears urgent, if not agreeable, to use massive public spending to stimulate an economy under duress, an economy cannot sustain long-term growth under the weight of significant fiscal burdens. At some point, what is considered a temporary economic prosthesis becomes a hindrance to the workings of the private sector.”

Neither of these two are current FOMC members, so they don’t have a vote on policy.

The market apparently didn’t view these comments as siren songs as the dollar rebound was extremely short-lived and headed back down to close the session lower.
Even though we have Fed officials out there talking up the exit story on occasion, the voting members continue to infer that monetary policy will remain floored for some time still. You listen to the latter for policy guidance. Personally, I find myself in the Plosser/Fisher camp.

Moving on, the dollar weakness didn’t stop crude from falling as the February contract fell back below $80 (closed at $79.67/barrel) after the weekly Energy Department report showed stockpiles rose twice as much as expected. Total fuel demand was down 1% from the same week last year. There is really no improvement in transportation demand and that is a key indicator to watch for economic progress.

And speaking of transportation, ASI/Transmatch’s latest data on weekly freight carloads showed extreme weakness continues. The chart below is on a four-week rolling average basis.





Mortgage Applications

The Mortgage Bankers Association reported that its mortgage applications index jumped 14.3% for the week ended January 8. This followed a 0.5% rise in the prior week.

The increase was all on the refinancing side as the segment bounced 21.8% and accounted for 71.5% of all applications during the week. This bounce follows three weeks in which refinancing activity fell 38.4%. Purchases were up just 0.8%; the separate purchases index remains floored. After a rebound in home purchases during the first 10 months of 2009, the index has slid back to levels that were first hit in 1997.

The rate on the fixed 30-year mortgage averaged 5.13% for the week, down from 5.18% in the previous week.

Beige Book

The Federal Reserve’s latest analysis of economic conditions showed that activity improved in 10 of their 12 districts (up from eight in the previous report), but remained at a low level. The assessment was for the period November 21-Janaury 4. Labor markets did remain weak across the board and real estate markets are causing a serious drag on things – but of course these are widely known. Richmond and Philadelphia were the two districts that reported activity was not much changed from the last Beige Book.

Most districts reported that consumer spending was slightly greater during the holiday season relative to year ago, but well off 2007 levels – districts noted that since sales were so weak in 2008 compared to 2007 that the 2009 gains did not represent a meaningful shift in trend. Retail inventory levels remain very lean in nearly all districts. Auto sales held steady or increased slightly from the previous report. Reports on tourism were mostly flat or weak. Overall, consumers were described as cautious, prices sensitive and necessity-driven.

Manufacturing activity increased or held steady. Among districts reporting near-term expectations, the factory outlook was optimistic, but spending plans remain cautious. Most activity was reportedly driven by auto assemblies and exports to Asia.

Home sales increased in most districts, but mainly for lower-priced homes. Home prices appeared to have changed little since the last Beige Book, according to the Fed. Residential construction remained at low levels in most districts. The report mentioned that the tax credit boosted sales in November and led to an unusual slowdown in December. Commercial real estate was still weak in all districts with rising vacancy rates and falling rents.

Since the last report loan demand continued to decline or remained weak in most districts – and would have been worse if not for refinancing activity and auto loans. Credit quality continued to deteriorate.
Price pressures remained subdued, though metals prices increased and some districts reported higher agricultural prices.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks, at least in terms of the broad market, rallied in final hour of trading after losing all of its opening session gains and spending most of the day in negative territory. The Dow Industrial Average only spent a brief time under the cut line as it was propelled by shares of Caterpillar and United Technologies – the two stocks accounted for nearly 90% of the index’s gain.

Tech stocks were the worst-performing sector, weighing on the NASDAQ Composite as the index shed all of its morning-session gains just 30 minutes into trading and was unable to make it back to the plus side. Mid and small-cap stocks also closed to the downside, but just fractionally.

The latest trade data out of China showed exports were up strong and imports surged 56% from December 2008 – that’s got massive Chinese stimulus written all over it even if the figures are relative to extremely depressed levels of a year ago – and was responsible for most of the day’s gains. Industrials jumped 1.17% and that’s a China story.

Utility shares also performed well, up 1.10% for the session. Although, the group accounts for a much smaller percentage of the S&P 500 than industrials do so it didn’t have much impact on the index. Comments from St. Louis Fed Bank President Bullard stated the Fed is likely to keep policy floored for longer than most expect and that’s a green light for higher-dividend paying shares.

Bullard also mentioned that the Fed’s quantitative easing (QE)campaign may be extended and increased, referring to the central bank’s mortgage-backed security purchases and possibly Treasury securities too. It seems the Fed is floating messages out there to see how the market reacts. The chances of Bernanke & Co. increasing QE is heightened in my view. That’s unfortunate. At some point they are going to have to make the economy to stand on its own, or at the least force it to use just one crutch. If they choose otherwise, it will create additional problems down the road – and they’re choosing otherwise.

Market Activity for January 11, 2010 Crude, Delinquencies, Printing and the Consumer

The price of oil for February delivery hit a new 15-month high yesterday as Chinese exports recorded the first year-over-year increase in 14 months, colder than usual temperatures continue to grip the U.S. and many other parts of the world, pipeline attacks returned to the Nigerian Delta (it was a brief respite), and a declining U.S. dollar that has now erased a three-week bounce. (Crude has pulled back a bit this morning after Alcoa’s disappointing earnings report but remains solidly above $80/barrel.)

The weather will turn warmer and an extraordinary level of Chinese government stimulus will dissipate, but what will remain in the near future is a Fed that holds monetary policy at emergency levels – the only thing that will outlast this is oil infrastructure attacks within troubled parts of the world. As a result, the dollar will remain under pressure -- barring some nasty event that causes a full-fledged run for safety – and this will add more fuel to possibly propel the price of oil higher.

It is obviously impossible to predict where oil is going. I could actually see all commodity prices pulling back for a spell as supplies have probably become a bit bloated as higher prices have encouraged production and an intensification of banking-sector troubles cause traders to worry about already weak demand to get hit again.

It is only prudent to expect mortgage-delinquency rates to increase in the coming months simply because of persistently high unemployment, a shadow supply of homes that can’t be held from the market forever, and high loan-to-value ratios (additional price declines will increase the percentage of underwater mortgages). Now we have Washington looking at adding fees to the banks as a way of raising government revenue. Bad timing boys and girls, but when is Washington’s timing ever on target. Populism is running wild and I’m not sure investors are properly assessing the risks involved with such behavior. That’s the problem with pedal-to-the-metal monetary policy though; it causes a gratuitous level of complacency.

The overall point is that the likelihood of higher delinquency rates along with other financial-sector issues may just cause another run for safety and that means transitory dollar support and probably a correction in commodity prices – unless, and this is a big caveat, the Fed immediately meets this trouble by announcing they will increase their mortgage-backed security purchases. In that event, such money-printing behavior may just keep the commodity train rolling and escape what would otherwise be a normal pull-back before trending higher again.

For now, crude is showing substantial momentum and if the Fed expands QE that momentum will increase, creating some issues for an already burdened consumer. The only thing that is likely to ultimately hammer the price of oil, not a transitory pullback but a prolonged hit, is when the Fed signals they’ll begin to unwind current policy and raise interest rates. When that occurs, Katy bar the door on the oil trade; but then again, it may just mean a run for the exits with regard to all kinds of assets. This seems to be quite a way off though as Bernanke & Co. understands very well the challenges we face. While I believe they should mildly remove some accommodation and rid the economy and the market of this state of dependency, the Fed sees things quite differently.

As I’ve stated many times now, the Fed is in a box. If they begin to move now, the housing market will show its underlying foundational cracks and that will obviously have an effect on consumer activity. Yet, if they continue to keep policy floored, commodity prices (namely energy for this discussion) are very likely to trend higher, also hitting the consumers’ pocketbook – draining real incomes.

(On the consumer, what I would watch for is those first-time home-buyers tax credits to begin to take hold in the spring. These checks, which will total up to $8,000 for new home-borrowers, will boost spending or at least help consumers manage around higher crude prices or another round of economic trouble. But the ameliorative effects of this housing subsidy will prove short-lived as it provides one-and done spending. What we’ll be left with is labor market trouble that is unlikely to meaningfully ease anytime real soon. We’re in store for more extend and pretend.)

This Time They Mean It

Fourth-quarter earnings season kicked off yesterday evening with Alcoa’s earnings release. Alcoa marks the traditional beginning of quarterly earnings results, but things don’t get going in earnest until a couple of weeks later when the bulk of releases begin to stream in The market will be watching for some degree of top-line improvement – sales growth. While S&P 500 profits (bottom-line results) have sucked wind over the past nine quarters (remaining very depressed even as of the third quarter as total profits fell 15.6% and ex-financial results declined 24.1%), they have been better-than-expected as massive cost-cutting via payroll slashing has assisted the bottom line.

Prior to third-quarter earnings season, analysts were stating they would have to see some sales growth in order for the market to rise. Well, we didn’t get it as sales fell 9.6% from year-ago results. Stocks, nevertheless, continued to climb, up another 10% since the previous earnings season effectively came to an end. This time they say they mean it. We shall see.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks shook off a worse-than-expected jobs report and the largest decline in consumer credit on record to push higher as both releases boosted the longevity of ZIRP – the Fed’s zero interest-rate policy.

Industrial, commodity-related basic material and energy, along with technology shares led the way. Financials, consumer, telecom and utility shares were down on the session.

While the jobs data was not bad in terms of the degree to which payrolls declined -- a drop of 85,000 is a statistically insignificant number, the long-term unemployment numbers are more than disturbing. But when the market is going on what I believe is a very short-term mindset, easy-money delight, what is bad remains good. Because of this I wouldn’t have been surprised to see quite a substantial sell off if the data had shown a 100k increase in payrolls.

I saw a Bloomberg News reporter state that the market is excited about what this jobs data means for profit growth. For sure, the lack of hiring will help earnings advance – recall that we have talked about how there could be a couple of big-bang quarterly earnings results over the next year. Heck, slash 7.5 million payrolls and firms are going to show some level of profit growth even if sales remain weak. While there’s a good shot growth may be pretty strong for a couple of quarters, if the profits are mostly due to massive cost-cutting via payrolls this will obviously keep final demand lackluster, which means the growth is short-lived. Add in the consumer credit situation and the chance that final demand sticks is low.

So, I look each and everyday for positives to give me more confidence that a durable recovery will emerge, but the more I look the more problems I find. The bulls seem to be awfully short-sighted these days, and what we’re seeing is not a move higher based on fundamentals but a continued move to riskier assets based upon the Fed holding interest rates artificially low, in my opinion.

Volume was weak again, I really thought trading activity would rebound back to normal levels with the holidays behind us, as just 950 million shares traded on the NYSE Composite – 18% lower than even the pathetic average of the last six months. We should be seeing at least 1.4 billion trade per day.

For the week, the broad market gained 2.6%. This marks the seventh weekly gain out of the last 10 and puts the S&P 500 up 72% from the March 9 intra-day low. I should be really excited about this, but the move above 900-950 on the index just doesn’t feel right to me based on the headwinds – a number of challenges I laid out in the year’s first letter a week ago.

I think one has to build a market valuation analysis around $65 in S&P 500 earnings (earnings peaked at roughly $85 in 2007 and the cycle trough just recently came in at $45) and that means a value of 950 puts the S&P 500 at 15 times – a multiple that is right in line with the long-term average. It is tough to justify a multiple that’s above the average in light of the challenges we face.

Market Activity for January 8, 2010
December Jobs Report

The Labor Department reported a jobs report that was worse-than-expected as payrolls declined 85,000 in December (the consensus expectation was for no change, with +85K at the high-end of the range and -100K at the low end). The November payroll figure was revised higher to show a 4K increase, previously reported as an 11K decline – marks the first positive reading since December 2007. Still, all of these numbers are statistically insignificant as anything within +/- 100K is.

One thing that people were focused on was the revisions for the previous couple of months, expecting more positive changes – this is important because the revisions generally portend the future trend. While the November reading saw a positive revision, the October data was revised a bit lower, so no effective change.

In terms of industry, goods-producing industries shed 81,000 jobs -- a decent deterioration from November’s -58K; in line with the three-month average of -83K. The construction segment cut 53,000 – double the decline of November and worse also compared to the three-month average of -45K. (Keep in mind though that we had some nasty weather in December and this surely damaged the monthly figures for the segment.) The manufacturing segment shed 27,000 – better than the -35K in November and an improvement relative to the three-month average of -37K. (It seems the better employment figures within the regional factory reports were correct in signaling some improvement.)

The service-producing industries cut payrolls by 4,000. This is nothing, completely insignificant, but is a large deterioration from the 62,000 increase registered in November. The three-month average is +13K. The trade and transportation segment cut 37,000 – more than the -32K in November but better than the three-month average of -43K. Retail payrolls declined 10,000 – an improvement from the
-14K in November and also the three-month average of -21K. Business services payrolls increased 50,000, boosted by another nice pick up in temporary hiring. Temp. help increased 47,000, following +89K in November – the three-month average is +49K. Temporary hiring is a key component to watch as historically it has proved to be a nice signal that at least mild overall job growth will soon follow.

Ex-post office, the federal government added jobs but state and local gov’ts cut jobs -- states are in a world of hurt and are going to present a problem for quite some time; the Medicaid expansion will put the states on a path of financial ruin if it is ultimately passed In total, government jobs declined 21,000, but this figure is going to pick up in the months ahead. Hiring for the 2010 census will begin in earnest over the next couple of months. This is going to distort the jobs figures as (if memory serves) 800,000 workers will be needed, and those additions will be spread out over a multi-month timeline. However, it won’t be long again before the census workers are hunting for employment as this is a six-eight week gig.

The unemployment rate held at 10%, but this number is going meaningfully higher. Why? Because the civilian labor force plunged 661,000 during December. These are people who removed themselves from the labor market because they didn’t look for work during the previous four weeks – termed the “discouraged worker.” When the labor force increases, workers returning to look for work as they feel better about the chances of finding a job, the jobless rate will rise. This why the unemployment rate is a lagging indicator, continues to increase even as the economy has moved to expansion mode. That said, I think the degree to which the rate still has to rise is more pronounced this time. Look for 11% by summer.

Taking a minute to clarify the two surveys that make up the jobs data: The Establishment Survey is used by the Labor Department to measure the change in payrolls – the +/-monthly jobs number you read in the headline; it is a survey of 150,000 businesses. The Household Survey is how the government measures the unemployment rate, this number includes the self-employed; it is a survey of 60,000 households.

The U6 unemployment rate (also referred to as under-employment), which includes discouraged workers and those working part-time because they can’t find full-time work, ticked back up, rising to 17.3% from 17.2% in November – although still below the high of 17.4% hit in October.

The number of unemployed that have been out of work for at least 27 weeks (the longest duration the labor statistics track) is now 4 out of every 10 – actual percentage is 39.8%. The average duration of unemployment rose to another new high, increasing to 29.1 weeks from 28.6 in November – the third straight month in which it has exceeded the 27 weeks figure. This completely jibes with what the jobless claims data has been suggesting as continuing claims keep rising.

The average weekly hours worked reading also failed to improved, holding at the low level of 33.2 hours. The figure rose in November from its record low of 33.0 in October, but we need to see something closer to 33.8-34.0 before firms begin to substantially add workers. Hours worked were adversely affected by weather, particularly construction jobs, so one hopes some improvement would have resulted otherwise but we’ll need confirmation from the data in the coming months.

Last month I mentioned that the excitement over the November jobs report appeared a little amateur. There were a lot of people that expected the data to magically begin to post increase beginning in December and statistically significant improvements beginning in January. But it doesn’t happen this way, especially since there remains too much room with which to stretch current employee workloads, as that weekly hours worked figure suggests. However, we should begin to see a trend of positive monthly results by February/March and with some luck statistically significant increases by early summer. The problem is that firms are not seeing much by way of sales growth and that means they’ll wait eve

While that’s the brighter side of the situation, the labor market participation rate continues to make new 25-year lows and that means there will be an enormous number of people re-entering the workforce when they feel better about the labor outlook. This means we will have to see more than the usual 100K/month job growth for an extended period in order to bring the jobless rate lower. Based on what the data is suggesting, we may need 200K/month for more than 12-18 months to even bring the unemployment rate back to 8.0-8.5% by mid-2011. And even this rate is elevated from a historical perspective, the peak level of joblessness during the normal recession. To get back to our long-term average of roughly 6%, we could be waiting until 2014-2015.

I think the response we have taken to combat this serious downturn is actually doing more harm than good My concern is that as the jobless rate rises just ahead of the 2010 election, Congress will scurry to endeavor upon polices they believe will increase jobs in the short term, but does significant damage to the longer-term situation.

Consumer Credit

A point we’ve touched on a number of times, the slashing of credit-card lines, is going to work as a drag on consumer activity. There are approximately $4.5 trillion in credit-card lines outstanding (a significant percentage of which is for businesses, which is not relevant to this topic) and $874 billion is drawn upon via the consumer. These lines of credit run off of models based upon the national delinquency rate, and since delinquencies are at a record level, according to Fitch Ratings (I assume they mean post-WWII record), that means these lines will continue to be cut.

The latest Federal Reserve data on consumer credit was out Friday, showing it got whacked by $17.5 billion in November (a decline of $5 billion was expected) and is down for 10-straight months – both are the most on record. Records go back to 1943.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Weekly

This week the market’s attention was focused primarily on comments from various Fed officials and the minutes from December’s FOMC meeting.

The Fed minutes were pretty uneventful. Some voting members are content with winding down the Fed’s purchasing program on schedule (March) while others are pushing a possible expansion of the program in order to protect the still fragile housing market from the exit of the mortgage market’s biggest investor.

So far the Fed’s exit strategy has been limited to emergency lending programs that have been slowly unwinding due to decreased demand, but if the March does end up being the final month of MBS purchases it will be the first active step by the Fed to begin tightening. It’s not surprising to see some disagreement within the FOMC.

Bernanke
Several Fed officials spoke this week, but Bernanke’s speech on Sunday at the Annual Meeting of the American Economic Association in Atlanta caught my eye. The argument he presented was based on his belief that a lack of regulation, not unnecessarily low interest rates, led to the housing bubble.

From Big Ben’s speech…
The most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards… The lesson I take from this experience is not that financial regulation and supervision are ineffective for controlling emerging risks, but that their execution must be better and smarter.

This argument isn’t anything new from the Fed. The street is used to investors like Bill Gross talking up their positions on CNBC, and that’s all the Chairman is doing here. We are entering the second year of a 0-.25% target for Fed Funds and there are still 3-months to go until the Fed is finished buying MBS, so unless he wants the bond vigilantes to run his current monetary policy out of town he better keep up this sort of talk.

Exotic mortgage products did help bring monthly payments down, which in turn brought a much stronger bid to the property market. But Option Arms and the like came about only because there was enough demand from investors (Banks, Hedge Funds, Pensions, etc.) for those products. Extremely low interest rates, if left too low for too long, incentivizes investors to ignore risk in their search for additional yield which leads to more bubbles and more instability in the future. Talk up your position if you want Chairman Bernanke, but relying heavily on regulation instead of worrying about the effect monetary policy can have on asset prices is foolish and irresponsible.

Have a good weekend.

Cliff J. Reynolds Jr., Investment Analyst