U.S. stocks began Monday’s session lower but looked to reverse course as the indices quickly popped to positive territory in the first 30 minutes of trading; that was until a dire IMF (International Monetary Fund) statement was released about 9:30CT. That release stated there was no end in sight to the housing woes and warned deteriorating credit conditions for consumers and banks may prolong a period of slow growth. (Interesting how they are now reframing their negative predictions as “slow growth” rather than “recession.”)
On this point for a moment, there is no doubt the credit markets are going through a period of trouble, but let’s not act as though things are worse than they actually are. I’ll point out that commercial and industrials loans have risen 18% over the past year and at a 9% annual rate over the past six months. The pace has slowed, but comments that credit has slowed to a halt are removed from reality. Below is a chart of C&I loans.
Losses among the benchmark indices increased in the afternoon after Treasury Secretary Paulson held a press conference that failed to address the market’s chief concerns – we’ll touch on this below.
Market Activity for July 28, 2008
To no surprise, financials and consumer discretionary shares led the market lower – these are the pressure points on days of weakness as concerns over housing, tax rates, price stability and the job market effect these sectors more than any other.
The good news that people should have been focused on yesterday was exactly that IMF report, as this organization’s predictions are rarely accurate. While we expect housing to remain weak for some time still, likely another year due the elevated nature of home supply and higher foreclosure rates, the fact that the IMF has predicted no end in sight may be the best indication the worst is over.
While financials and consumer disc. shares led the indices lower, nothing really helped as all 10 major industry groups were down yesterday. Industrial and information technology shares got wacked with the rest of the market. Utility, energy and basic material shares were the relative winners down 0.19%, 0.46% and 0.58%, respectively.
On the earnings front, outside of the financial sector, things continue to look quite good. Ex-financial profits are up 12% with 55% of S&P 500 members reporting thus far. Seventy-percent of those reporting have beat expectations. Still no one cares right now.
Take Verizon’s results as an example. The phone giant reported Q2 operating profit rose 15.5% as their wireless business was strong. Yet, all people could focus on was their weaker-than-expected landline business. Now, which segment is the growth story? Bad news would have been weak wireless activity, not the case though. So you have a stock that offers a 5.12% dividend yield and is delivering high single-digit profit growth trading at 12.8 times 2008 earnings. And this isn’t even one of the more compelling buys out there. The problem is investors may have to wait a while for attractive returns to materialize, but when they do, it will be big.
For now there are plenty of uncertainties in front of us. The shame of it is policy makers have created most of these uncertainties. A Fed that left rates too low for too long into 2004 and 2005 encouraged the mortgage mess we find ourselves in. The economy was rolling along at a very nice pace, yet they waited until June 2005 to get fed funds above 3.00%. Heck, they were still easing in the back-half of 2003, cutting fed funds to 1.00% in June of that year even as the stock market was signaling a boom and their own June 11 Beige Book report showed things were turning. Now, the same reckless easing policy is on again. Yes they must ensure liquidity and they are doing that via their lending facilities, but to jack their benchmark rate down 325 basis points in nine months (225 of that in six months) is reckless.
And then there is the Treasury Secretary.
Paulson Tries Again
Treasury Secretary Hank Paulson held a press conference yesterday afternoon -- in an attempt to reassure the markets I presume – explaining the virtue of “covered bonds” and the beneficial affect such debt instruments would have on the credit markets. However, while this may be the direction the industry goes over the next several years, it doesn’t do much for now because banks are still set up under the securitization framework – hence, many times they do not hold the assets that back these debt instruments on the balance sheet.
(The way I understand it: Covered bonds are securities issued by a bank and backed by a dedicated group of loans – a “covered pool.” If the issuing bank becomes insolvent, the assets in the covered pool are separated from the issuer’s other assets solely for the benefit of the covered bondholder. This is the major difference between covered bonds and asset-backed securities. Loans backing a covered bond remain on the balance sheet and should the originating bank fail to make payments, interest payments from the underlying mortgages would go to investors.)
Anyway, Paulson’s attempt whiffed, reminiscent of a Dave Kingman strikeout – for you 1970s and 1980s baseball fans, because this is not that which market participants are currently concerned – at least regarding the here and now.
At risk of sounding repetitious, it is the uncertainty over the housing market and its effect on consumer behavior, questions over tax rates, and the possibility/likelihood that the Fed is ignoring price stability.
The housing market will simply take time to correct; after several years of outsized gains, there is nothing Congress or anything other than time can do to fix it. The Fed will do what they are going to do; this is not Paulson’s turf, so nothing he can really do there either. But this is the Treasury Secretary we are talking about, the appropriate person (after the President) to offer tax rate proposals.
What he should be doing is demanding that Congress make the tax rates on capital, dividends and income permanent – as permanent as Washington gets anyway. Follow that up with a proposal to cut the corporate income tax -- which has become one of the highest rates in the world as virtually every other serious country has cut this rate -- and vastly reduce the tax on repatriated income. (This income earned overseas will stay there so long as it is taxed at a 35% rate) You want to bring it home, cut this rate down to single digits; it will come home in droves.
This would combine beautifully with the increased current-year business equipment write-off allowance and bonus depreciation that was delivered in May, and by the way has kicked started business spending as we discussed yesterday. This combination would be a big job and productivity producer, but Paulson doesn’t get it, and thus the market will continue to send the message that he is not delivering what it wants.
Look, these are times the equity investor must deal with on occasion. But this economy is fundamentally sound; allow the housing correction to run its course, get monetary policy back in order and simply do not damage after-tax return expectations by driving tax rates higher and the market will get back on its horse We only need a little tweaking, U.S. businesses are more streamlined than anytime in history, able to compete and dominate on a global scale, but bad policy should not get in the way. Raise tax rates in this environment of intense global competition and you get your hat handed to you.
As of the latest count, there was $3.5 trillion sitting in money-market funds – plenty of capital out there. Give it a reason to come out of hiding and you’re looking at a powerful market run – long-lasting. That said, the equity investor will need patience here, but when things turn, it will make it all worth it.
Have a great day!
Brent Vondera, Senior Analyst
On this point for a moment, there is no doubt the credit markets are going through a period of trouble, but let’s not act as though things are worse than they actually are. I’ll point out that commercial and industrials loans have risen 18% over the past year and at a 9% annual rate over the past six months. The pace has slowed, but comments that credit has slowed to a halt are removed from reality. Below is a chart of C&I loans.
Losses among the benchmark indices increased in the afternoon after Treasury Secretary Paulson held a press conference that failed to address the market’s chief concerns – we’ll touch on this below.
Market Activity for July 28, 2008
To no surprise, financials and consumer discretionary shares led the market lower – these are the pressure points on days of weakness as concerns over housing, tax rates, price stability and the job market effect these sectors more than any other.The good news that people should have been focused on yesterday was exactly that IMF report, as this organization’s predictions are rarely accurate. While we expect housing to remain weak for some time still, likely another year due the elevated nature of home supply and higher foreclosure rates, the fact that the IMF has predicted no end in sight may be the best indication the worst is over.
While financials and consumer disc. shares led the indices lower, nothing really helped as all 10 major industry groups were down yesterday. Industrial and information technology shares got wacked with the rest of the market. Utility, energy and basic material shares were the relative winners down 0.19%, 0.46% and 0.58%, respectively.
On the earnings front, outside of the financial sector, things continue to look quite good. Ex-financial profits are up 12% with 55% of S&P 500 members reporting thus far. Seventy-percent of those reporting have beat expectations. Still no one cares right now.
Take Verizon’s results as an example. The phone giant reported Q2 operating profit rose 15.5% as their wireless business was strong. Yet, all people could focus on was their weaker-than-expected landline business. Now, which segment is the growth story? Bad news would have been weak wireless activity, not the case though. So you have a stock that offers a 5.12% dividend yield and is delivering high single-digit profit growth trading at 12.8 times 2008 earnings. And this isn’t even one of the more compelling buys out there. The problem is investors may have to wait a while for attractive returns to materialize, but when they do, it will be big.
For now there are plenty of uncertainties in front of us. The shame of it is policy makers have created most of these uncertainties. A Fed that left rates too low for too long into 2004 and 2005 encouraged the mortgage mess we find ourselves in. The economy was rolling along at a very nice pace, yet they waited until June 2005 to get fed funds above 3.00%. Heck, they were still easing in the back-half of 2003, cutting fed funds to 1.00% in June of that year even as the stock market was signaling a boom and their own June 11 Beige Book report showed things were turning. Now, the same reckless easing policy is on again. Yes they must ensure liquidity and they are doing that via their lending facilities, but to jack their benchmark rate down 325 basis points in nine months (225 of that in six months) is reckless.
And then there is the Treasury Secretary.
Paulson Tries Again
Treasury Secretary Hank Paulson held a press conference yesterday afternoon -- in an attempt to reassure the markets I presume – explaining the virtue of “covered bonds” and the beneficial affect such debt instruments would have on the credit markets. However, while this may be the direction the industry goes over the next several years, it doesn’t do much for now because banks are still set up under the securitization framework – hence, many times they do not hold the assets that back these debt instruments on the balance sheet.
(The way I understand it: Covered bonds are securities issued by a bank and backed by a dedicated group of loans – a “covered pool.” If the issuing bank becomes insolvent, the assets in the covered pool are separated from the issuer’s other assets solely for the benefit of the covered bondholder. This is the major difference between covered bonds and asset-backed securities. Loans backing a covered bond remain on the balance sheet and should the originating bank fail to make payments, interest payments from the underlying mortgages would go to investors.)
Anyway, Paulson’s attempt whiffed, reminiscent of a Dave Kingman strikeout – for you 1970s and 1980s baseball fans, because this is not that which market participants are currently concerned – at least regarding the here and now.
At risk of sounding repetitious, it is the uncertainty over the housing market and its effect on consumer behavior, questions over tax rates, and the possibility/likelihood that the Fed is ignoring price stability.
The housing market will simply take time to correct; after several years of outsized gains, there is nothing Congress or anything other than time can do to fix it. The Fed will do what they are going to do; this is not Paulson’s turf, so nothing he can really do there either. But this is the Treasury Secretary we are talking about, the appropriate person (after the President) to offer tax rate proposals.
What he should be doing is demanding that Congress make the tax rates on capital, dividends and income permanent – as permanent as Washington gets anyway. Follow that up with a proposal to cut the corporate income tax -- which has become one of the highest rates in the world as virtually every other serious country has cut this rate -- and vastly reduce the tax on repatriated income. (This income earned overseas will stay there so long as it is taxed at a 35% rate) You want to bring it home, cut this rate down to single digits; it will come home in droves.
This would combine beautifully with the increased current-year business equipment write-off allowance and bonus depreciation that was delivered in May, and by the way has kicked started business spending as we discussed yesterday. This combination would be a big job and productivity producer, but Paulson doesn’t get it, and thus the market will continue to send the message that he is not delivering what it wants.
Look, these are times the equity investor must deal with on occasion. But this economy is fundamentally sound; allow the housing correction to run its course, get monetary policy back in order and simply do not damage after-tax return expectations by driving tax rates higher and the market will get back on its horse We only need a little tweaking, U.S. businesses are more streamlined than anytime in history, able to compete and dominate on a global scale, but bad policy should not get in the way. Raise tax rates in this environment of intense global competition and you get your hat handed to you.
As of the latest count, there was $3.5 trillion sitting in money-market funds – plenty of capital out there. Give it a reason to come out of hiding and you’re looking at a powerful market run – long-lasting. That said, the equity investor will need patience here, but when things turn, it will make it all worth it.
Have a great day!
Brent Vondera, Senior Analyst
Financials led the market lower, as the S&P 500 index that tracks these shares plunged 6.75% -- the group had caught fire over the previous six trading sessions, jumping off a 10-year low, up 30%. Consumer discretionary, the other catalyst behind the market’s recent multi-day rally, lost 2.81%; industrials also took it on the chin, losing 2.51%.
Certainly not helping sales is a wider-than-normal 30-year fixed mortgage spread. As the chart below illustrates – depicted by the yellow line – even though the 10-year Treasury sits at the very low level of 3.99%, the 30-year mortgage rate is higher than it otherwise would be due to increased risks. The current spread has widened to 260 basis points, from its normal range of 150-180 basis points. (We’re referring to the spread between the 30-year mortgage and the 10-year Treasury it runs off of.) 
On supply, the number of existing homes on the market rose 0.2% in June, resulting in the months’ worth of supply figure increasing to 11.1 – likely double where we need to be. Exacerbating this situation is rising foreclosures, which have doubled over the past year. As of the latest data, foreclosures have risen to 2.5% of the total mortgage market. Roughly 11% of sub-prime loans have entered the foreclosure process and 1.25% of prime loans are in foreclosure.
The median home price dropped 6.1% last month compared to June 2007 – although that figure is up 10% since hitting a multi-year low in February. As of June, the median price of an existing home came in at $215,000.
In a separate report, the Labor Department reported initial jobless claims jumped to 406,000 in the week ended July 19 from a revised 372,000 the previous week.
This morning crude-oil prices are extending upon yesterday’s gain. Oil hit the $124 handle on Wednesday, but has moved up a bit to $126.33 as I type.
The laggards were energy, basic materials and utility shares. The CRB Index, which measures a basket of commodity prices has dropped 12.5% over the past eight trading sessions and oil alone has fallen $20 from the all-time high of $145.29. The S&P 500 Energy index has plunged nearly 17% from its high hit in mid-May and 15% this month. The group has likely been oversold as they’ll continue to make great money at these levels and continue to boost dividend payouts.
Oil and the dollar trade are based on a variety of factors, but a major variable is the Fed’s direction. The sways in the table above helps to explain the ups and downs in the dollar and oil prices off late. As the market increases its expectation the Fed will hike, oil will continue to move in the right direction – of course hurricane activity and geopolitical events will have their own effect on price. If they send market expectations on another wild goose chase by becoming more dovish on the inflation front again, oil and the dollar may just return to an undesirable direction.
Of course, the very welcome decline in oil prices has also helped the market over the past five sessions – actually four of the past five sessions as we were fractionally lower on Monday. Yesterday oil prices closed in on the $125 per barrel handle, pushing stocks higher in the afternoon session.
Oil prices have plunged $20 over the last seven sessions as we have hit the $125 handle this morning – falling another 1.59% to $125.92. We began to come off the all-time high closing price of $145.18 hit last Tuesday and estimations, and now the reality, that Hurricane Dolly will remain West of the major energy infrastructure in the Gulf has certainly helped things. Program trading has likely kicked into gear due to the degree of the decline, pushing the price of oil even lower.
And speaking of inflation, it’s been interesting to watch bond yields remain so low. Yes, yield have risen of late but we sit at 4.15% on the 10-year Treasury as we speak, which is still one of the lowest levels of the past 40 years.
Maybe inflation will come crashing lower and this spread, which is probably the most accurate high-frequency market indicator we have, is gauging things correctly. Of course, some of the low-interest rate environment is due to risk concerns, thus investors have fled to the Treasury market for safety – so there’s a possibility this market has not fully accounted for future inflation expectations. We shall see, but I would expect yields to rise some from here.
All and all, the losses among the benchmark indices were mild. Mid and small cap stocks posted nice gains.
We received some earnings disappointments after the bell last night, the largest being poor results from American Express as credit-card defaults rose to 5.3% from 2.9% a year earlier. This is the big one that is sending stock-index futures lower this morning. We’ve had a number of financial names post better-than-expected results, but all it takes is one bad one in this environment and the bears got it in AMEX’s results. 
My chief concern regarding real income growth is this escalation in commodity prices, namely the energy area. Congress and the White House must follow through on last week’s very good comments on drilling with action. Too, the Fed must focus more on price stability. If crude prices do not stabilize this economy will be in trouble as income growth will not be able to keep up and business profit margins will be squeezed further. There are some things that are out of our control in this regard, but within those areas that we do control this must be dealt with now.
We have to get several uncertainties out of the way still, inflation concerns are now another issue equity investors must deal with, making the task of assigning the correct market multiple very difficult, so one should be prepared for stocks to continue within this trading range. But we’ll eventually break out to the upside. Several positives that no one seems to be talking about is the awesomely streamlined nature of most industries – it is absolutely amazing how many sectors continue to record decent-to-healthy profit growth even as most input costs have risen in such a quick fashion.
The spread between the 10-year Treasury and the 30-year mortgage rate remains much higher than normal, as you can see – currently running at 210 basis points, the normal range is 150-175. The Fed can keep rates very low – thus keeping the 10-year probably lower than it otherwise would be – but the market is saying, I don’t think so; we’re not originating mortgages at normal spreads due to increased risks.
Earnings are looking good, outside of the financial sector – and this morning’s releases have turned stock-index futures around. Dow futures were down 100 points a few minutes ago, but have reversed course, down just eight points as I type thanks to additional better-than-expected results. Citigroup has just reported results that beat expectations and Honeywell has knocked the cover off of the ball – 24% operating profit growth, beating their number by 16% and raising full-year guidance. This follows a very nice report from United Technologies yesterday.
On the economic front, the Commerce Department reported housing starts jumped 9.1% in June, but that was only because of a change in New York’s building code. That change resulted in a large jump in multi-family units in the Northeast, but excluding this jump starts would have declined 4%.
Residential fixed investment has been a drag on GDP for 10 quarters now. Single-family homes fell 5.3% in June, down 43% year-over-year, but the monthly declines have eased of late. We are probably close to seeing the worst, but foreclosures are the pig still moving through the python, so I’m not sure the bottom in housing can be called just yet. Again, these things just take some time – hopefully we don’t get anymore harmful legislation out of Congress, the more they attempt to be the savior of all of those who made poor decisions the more unintended consequences will result and extend this housing correction.
In addition to better-than-expected profit results, we’ve received official announcement this morning that Teva Pharmaceuticals, an Israeli company and the world’s largest generic-drug maker, will buy Barr Pharmaceuticals for $7.46 billion in cash – a 41% premium over Barr’s closing price on Wednesday. The deal is helping to boost stock-index futures, so hopefully another nice day is in store.
On the economic front, the Labor Department reported that the consumer price index (CPI) jumped 1.1% in June – that’s on a month-over-month basis – and 5.0% over the past 12 months. We’ve been warning that the consumer-level inflation gauges will rise to 5% before the Fed knows it and here we are. Consumer prices jumped at a seasonally adjusted annual rate of 7.9% in the second quarter and all Benflation Bernanke could say yesterday was that inflation is too high – as if he has zero control over this situation.
Personally, I prefer the chained CPI figure, which we do mention each month, even as the financial press totaling ignored the figure. The chained reading had inflation up 0.8% in June and 4.2% on a year-over-year basis. Certainly higher than we’d like but better at least than the regular CPI reading. Still, if the Fed continues to ignore price stability we will see all of the inflation gauges hitting 5%.
In addition to the Capitol Hill appearance by the dynamic duo, SEC Chairman Chris Cox was also testifying. Of his statements, his comment that naked short-selling would be outlawed regarding financial-sector shares probably garnered the most attention. Naked short-selling is supposedly when someone borrowers the same stock from the same brokerage firm multiple times. What this means is that the person selling short has no intention, or ability, to deliver the shares. I’ve got to be honest, not even sure how this works in reality, but I was under the assumption it was already illegal; it certainly sounds illegal. Maybe what Chairman Cox was saying is now it is really really illegal. Or maybe he found it appropriate to voice the term “naked shorts” in front of members of Congress based on their indecorous behavior.
Finally, we had the Labor Department’s report on wholesale inflation via the producer price index for June. I’ll let the chart speak for itself.
Despite the troublesome pick up in producer and import prices – import prices are up 20.5% over the past year due to the weak dollar – Bernanke offered nothing that would lead one to believe he is focused on price stability. But reality will continue to ask ol’ Ben how many lumps he wants as it continues to beat him over his Keynesian skull..v2.JPG)
Fact is the big banks are very likely well capitalized, in fact they are “well-capitalized” as defined by regulations, but they are also prepared for further deterioration in housing and on the consumer front, such as credit-card defaults – they’ve raised large sums of capital to guard against this likely scenario. However, there will be smaller banks that do go under; although, this is not something to panic over. (Of course, one can’t rule out one of the larger ones taking a header as well if depositors overreact.)
In other news, the board of Anheuser-Busch agreed to the $50 billion ($70 per share) takeover from InBev last night, so the situation will go to shareholders for approval, which will undoubtedly get the green light.
Unfortunately, this received zero attention as everyone focused on the Fan/Fred story, but one has to worry that this level of price increases will funnel to the consumer level – as energy is already a major issue for consumers. The Fed continues to clinch, precariously, to their Phillips Curve models. These are Keynesian-economic teachings that state; so long as wage pressures do not present themselves, one doesn’t have to worry about inflation. Problem is, as is the case with most other Keynesian type beliefs, they are often removed from reality.