Daily Insight

U.S. stocks ended mixed as the S&P 500 and NASDAQ Composite fell for a third-straight session, while the Dow Industrials managed to close higher helped by shares of Home Depot, United Technologies, Proctor & Gamble and Chevron.

Information technology shares put pressure on the tech-laden NASDAQ and basic material, energy and those tech shares kept the S&P 500 down.

We’ve been trapped in a trading range between 1215 and 1450 on the S&P 500 since the beginning of the year and over the past month stuck between 1250 and 1300. The market doesn’t know what to do. Multiples are not high enough to send us much lower – based on what is currently known – and there are simply too many uncertainties lurking to propel the index out of this range.

The nearest term event will likely be the election. At least then we’ll have a good sense of where tax rates are going as after-tax return expectations on capital, dividends and labor income (small business consists two-thirds of the top federal income tax bracket) are necessary to assess the correct market multiple. Disposable, or after-tax, income growth is also hugely important right now, and the tax-rate uncertainty raises an issue here as well. Until then, we’ll just have to lean on patience.

Market Activity for September 3, 2008

That said, there are many individual stocks that trade at attractive P/E levels, but uncertainty is a terrible thing for stocks and these opportunities often get ignored in such an atmosphere. There are also entire sectors that look cheap in my view, as the S&P 500 index that tracks tech shares trades at 19 times earnings and industrials trade at 15 times. Energy stocks are back down to 10 times trailing earnings and 9 times this year’s profit expectations as many focus on oil’s recent decline and forget that these firms will make a lot of money at $110/barrel oil. The good news is the major indices seem to have found a bottom – knock on wood.

Yesterday we mentioned how all will be focused on the direction oil trades as the weekly energy report will surely show a big drop in inventories due to Gulf-rig shutdowns and closure of the LOOP. In addition, 13 refineries in the area were shut down completely and 10 others ran at reduced rates due to Gustav. The problem is I forgot that due to the holiday the weekly energy report, which is usually released on Wednesday, will be pushed back by a day. So, we’ll have to wait a couple of hours still for that report.

In any event, it does seem that production will resume quickly as the hurricane did very little damage to production infrastructure -- we should see stockpiles rebuilt in short order.

On the economic front, the Commerce Department reported factory orders rose 1.3% in July, beating the 1.0% estimate. This followed a large 2.1% increase in June that was revised up from the initial estimate of 1.7%. That’s a meaningful revision and may push the second-quarter GDP reading a bit higher when we get the final revision at the end of this month.

For this quarter, the July reading puts the period off to a good start and reinforces our view that business spending (capital expenditures) will provide an offset to what will likely be weak consumer activity (in real terms) during the third quarter. For instance, the non-defense capital goods, ex-aircraft, component of this report – which is the business capital spending number – jumped 2.5% in July.

It will be very interesting to watch the trend in capital spending as this is on top of three months of pretty strong growth for this component. I’ll note: the rebound in capital spending corresponds directly to the increase in current-year business write-off allowance and bonus depreciation the president signed into law back in May. Unfortunately, the way I understand the legislation, this will expire in 2009 as he had to drag Congress kicking and screaming to add it to the tax-rebate bill and could only manage a very short-term incentive boost as a result.

In terms of overall factory orders, they have risen for five-straight months now and in dollar terms stand at the highest level since the series began on an NAICS (simply put, a new classification system) basis in 1992.

Importantly, the unfilled orders figures is up 29 of the past 30 months and also stands at the highest level since the series began reporting on an NAICS basis. One would expect, outside of normal fluctuations, orders will remain on an upward trajectory for at least the next few months based on this heightened unfilled orders figure.

The weakness within the report came from high-tech equipment, specifically computer orders -- down 11% in July and 4.8% from July 2007.

In a separate release we received Challenger’s Job Cut Announcement survey (this is comprised by the executive outplacement firm Challenger, Gray and Christmas), which stated that the rate of layoffs slowed in August as they reported 88,730 job cuts were announced -- 103,312 were announced in July. However, while that number was lower than their July figure, job cut announcements were nearly 12% higher relative to August 2007. This is not seasonally adjusted data.

According to this report, one-third of the 88,736 in August came from the automotive and government sectors.

In other news the Fed released its regional economic survey known as the Beige Book. This report is released every six weeks and to be honest is a bit outdated, but is worth a read nonetheless. It found:

• Consumer spending was slow in most districts and many districts showed a pattern toward discount stores and lower-priced brands. (I think we should expect consumer activity to exhibit a two quarter respite after pretty good numbers over the past few months and inflation has cut into real income growth)
  
• Manufacturing was weak and declining in most districts, but improved in KC and Minneapolis (this doesn’t totally match with the ISM reports, which show things are a bit more optimistic within the sector)
  
• Residential real estate remained soft in most districts, save KC (no surprise there)
  
• All districts reported continued upward price pressures, with Boston, New York, Philadelphia, Atlanta and Dallas indicating businesses have stepped up the pass-through of higher costs. (This matches with what both small and large business price surveys along with the ISM and NAPM (factory surveys) reports have shown. Further, the Cleveland Fed’s Trimmed-Mean CPI, which takes out the most volatile components, and non-energy CPI are both at 17-year highs)
  

One obviously hopes the large and rapid decline in energy prices will ease price pressures, but the more data one studies the more it paints the picture that the 48.5% rise in crude, the 41.5% in gasoline and the 45% in diesel prices over the past year have become at least partially embedded.

This morning we get a number of data releases, with the final revision to Q2 productivity, weekly jobless claims and the ISM service index for August receiving the most attention.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks reversed course as a substantial early-session rally fizzled, succumbing to losses within the energy and basic material sectors; driving the broad-market into negative territory by mid-day was deterioration within the tech-sector. With all three of those sectors losing between 1.4% and 4.6%, and no real help from anywhere else save financials and consumer discretionary shares, the market could only go lower.

Energy stocks got drilled, pun intended, as oil prices shed $5.75, or 4.98%, to close the session at 109.71. Crude had been down as much as 8.8% yesterday, but a roughly 5% decline ended up being plenty to clock the sector. Oil is down to $108.32 this morning, the lowest level since early April.

Energy, basic material and information technology shares combine to make up 33.2% of the S&P 500.

Market Activity for September 2, 2008
As the chart below depicts, stocks started the day much higher after Hurricane Gustav’s impact proved to be much less than initially feared, sparing drilling platforms in the Gulf of Mexico and the New Orleans’ levees mostly held. However, things nonetheless fell apart as information technology, industrial and health-care shares erased early gains providing zero offset to the basic material and energy stock woes.

The S&P 500 began the session up 1.6% at the get go, but ended up losing 2.0% from that intraday high. The broad market declined 0.41% relative to the opening price. (The yellow line represents that opening mark.)


This morning, as the day progresses, it will be interesting to see how the oil market prices things in as we get the weekly energy report. Supplies will surely drop as the LOOP (Louisiana Offshore Oil Port) remains closed and Gulf production was shut down. Too, we have Hurricane Ike that looks to be making its way to the area.

On the economic front, the Institute for Supply Management (ISM) reported that manufacturing activity (on a national level) remains right at that dividing line between expansion and contraction. The reading came in at 49.9 for August and has hovered there for six months as the average for this period is 49.5.

The fact that the survey failed to show a pick up is decent proof the large acceleration in the Chicago-manufacturing reading (which we touched on yesterday) was mostly due to an increase in auto production – U.S. auto production is a large component within that regional survey. Normally, this would be fine, but since vehicle sales remain subdued, one shouldn’t expect auto production to have much staying power. That said, it is remarkable the manufacturing sector – from a national perspective -- remains solidly at the 50 level even as housing weighs heavily on the sector. (Again, above 50 marks expansion and below that mark, contraction – a reading very close to 50 on either side is a push.)

In terms of the sub-indices, which are hugely important to watch as they give evidence of future ISM readings, most remain subdued but a couple did improve from the July readings. For instance, the new orders index rose to 48.3 in August from 45.0 in July. Backlogs of orders increased slightly to 43.5 from 43.0.

The production index did slip from the July reading but remained in expansion mode, coming in at 52.1 in August after 52.9 in July. Inventories remained below 50 for the second-straight month, but did rise, coming in at 49.3 after July’s 45.0 – one watches this reading to gauge the effect inventories have on GDP. However, the customer inventory reading hit 54.5 – a 7.5-point jump from July. A reading over 50 for this index shows that respondents believe their customers’ inventory levels are too high. (This illustrates the cautious nature of business more than anything else as we know that inventory levels in a broad-based sense are at historic lows)

New export orders jumped to 57.0 from 54.0 in July.


The prices paid index has decelerated nicely, yet remains elevated.


Bottom line: the report was a decent one as the headline ISM reading remained very near the 50 level, yet it doesn’t give us a sense the manufacturing sector is ready to engage in rip-roaring activity anytime soon. That big increase in new export orders is a great sign though as many have worried economic weakness in Europe will cause export activity to ease. This reading shows other regions of the globe are filling the void.

It is good to see the prices paid reading come lower, but we’ll need to see continued deceleration to ease broad-based inflation concerns.

In a separate report, the Commerce Department reported that construction spending fell 0.6% in July after two months of gains. A 2.3% decline in private residential construction in the month led the overall figure lower. Non-residential private-sector construction (commercial) was also lower, falling 0.7%, marking the first decline for this figure in more than a year. (Private-sector residential construction is down 27.5% year-over-year. Commercial construction is up 16.0% since July 2007, just to mention the contrast)

July marked the first month since January 2007 in which private-sector commercial construction has not helped to offset residential weakness.



The public-sector did help to prop up the overall reading as public-sector residential construction rose 3.4% in July and non-residential (boosted by transportation and schools) rose 1.4%.

I’ll note, however, even though residential construction remains mired as inventory levels are hugely elevated, we have seen some encouraging signs as the degree of decline has waned over the past three months. For instance, single-family new homes sales fell at an 18.5% annual pace over the past three months – about half the 35.3% decline of the past 12 months. Pending home sales – those existing home sale contracts that have been signed, but not yet closed -- have jumped 32.2% at an annual rate since April, compared to the 12.1% decline over the past 12 months.

The pig in the python is foreclosures, as it will take some time still for this figure to peak. U.S. loans past due have increased to 6.35% of the total mortgage market vs. 4.84% a year ago. (These will not all turn into to foreclosures as this reading accounts for all mortgage loans just 30 days past due, but the number is nonetheless higher) Prime loans past due hit 3.71% as of the latest data. Subprime loans past due hit 18.79% for that universe. That is up from 2.58% and 13.77%, respectively.

This morning we get the latest factory orders report, which should show business spending continued to trend higher. This is the big bright spot from a domestic GDP standpoint (outside of trade) as we’ve seen signs that the business side will offset any consumer weakness in the current quarter.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

• U.S. stocks ended a three-day winning streak on Friday as the Commerce Department showed personal spending was weak during July and incomes declined for the first time in three years. More than anything though, Friday’s down market was more a function of traders’ unwillingness to take on additional long positions considering the increased uncertainty that Hurricane Gustav wrought.
  
  That personal income figure was really more a function of the government’s rebate check program coming to an end as this caused government transfer payments to fall substantially. The fundamental components of the data continue to look pretty good, as we’ll touch on below. (Real income growth remains a chief concern, but the income data looked much better in July than the headline number would lead one to believe.) Further, it’s tough to blame economic data for Friday’s stock-market decline considering the most important regional manufacturing survey showed activity was just shy of robust last month.
  
  Market Activity for August 29, 2008
  

All 10 major industry groups ended the week on a down note, with information technology, utility and industrial shares leading the declines. Financials were the best-performing sector on a relative basis, falling just 0.59%.

Crude-oil prices have plunged this morning, falling 6.30%, or $7.27 per barrel, as Hurricane Gustav failed to strengthen to the level many had feared and thus oil and gasoline production should resume in pretty quick order. We won’t know the extent of the damage until tomorrow – firms will get out and assess rigs today – but there’s a strong possibility we escaped major damage. That said, the Louisiana Offshore Oil Port (LOOP) has been closed for a few days and likely won’t be able to begin taking shipments again until Thursday, so this will have a meaningful effect on stockpiles in the very short term.

As the chart below illustrates, we’ve enjoyed a welcome 25% decline in oil prices over the past six weeks, yet remain 43% higher from the this time last year and 24% higher from date the Fed began to aggressively ease with their January 22 inter-meeting cut. (The annualized figures are meaningless for the purposes of this graph, so pay not attention to those readings, if you can even read them.)

It’s been amazing to watch how emotion-driven trading has turned. Just six weeks ago the slightest disturbance would lead to large moves higher as crude hit $145 per barrel in mid July. Now, even when a large production disturbance occurs, so long as it doesn’t reach the worst-case assumption, traders push crude down 4-7%. This is a huge development for the consumer and profit margins.

Helping this trend out is some encouraging signs from Congress regarding the removal of energy production restrictions; let’s hope the recent decline in prices doesn’t cause a reversal. Further, the pro-drill candidate continues to make progress in the polls, which likely has an effect on traders’ mentality as well.

I’ll caution though, OPEC meets next week and you know what that means with crude 25% off its high. Yep, they’re likely to push through a production cut, especially since Russia will put pressure on them to do so. (Russia is not a member of OPEC, but they do have strong, and concerning, ties to Iran and Venezuela – regimes that very much depend on the high price of oil to remain relevant.)

On the economic front, the Commerce Department reported personal income fell 0.7% in July. This decline was due to the rebate-check effect. Recall back in June how we explained the big jump in May income growth was due – largely – to government payments and that there would be some blowback effect as the numbers were adjusted to this one-time situation. Well, here it is.

The large 17.6% decline in the “other” component of government transfer payments moved the overall figure lower. However, the components that really matter – compensation, wage and salary, proprietor’s income, rental income and dividend income all posted decent-to-strong results.

Compensation was up 0.3% in July and 4.0% year-over-year (YOY)

• Compensation was up 0.3% in July and 4.0% year-over-year (YOY)
• Wage and salaries gained 0.3%, up 4.1% over the past 12 months
• Proprietor’s income rose 0.4% -- nonfarm proprietor’s income up 3.2% YOY, accelerating to 8.9% at an annual rate last three months
• Rental income jumped 7.2% in July and has soared 50.6% YOY
• Dividend income was up 0.6% in July and up 8.2% YOY
• Disposable (after-tax) income is up a very healthy 5.8% YOY

So the income components that matter show pretty nice trends, although for the labor-income related segments the growth has not been enough to keep up with elevated inflation rates. Broadly speaking, disposable income does continue to outpace inflation, which is good.

On the spending side, personal consumption rose 0.2% last month and is up 5.1% YOY and just a bit more six-month annualized. One should expect the pace of spending to ease as inflation eats into the growth of income. Lower commodity prices of late will help, but as we’ve touched on in past letters there is a risk that inflation has become embedded. We’ll just have to see how the data turn out over the next two months.

And speaking of inflation, the gauge tied to this personal spending data showed the PCE deflator (one of the big-three inflation gauges) has increased 4.5% over the past 12 months – a large acceleration from the June year-over-year figure of 4.0%.

The core rate also edged up, coming in at 2.4% YOY – well-above Bernanke’s stated comfort zone of 1%-2%. We’ll admit, as this letter has stated before, a comfort zone of below 1.50% is rather ridiculous as some pricing power is important, but I believe it is worth mentioning that the actual readings continue to blow past his comfort level even if the lower end of the range is silly.


Lastly, the Chicago Purchasing Manager’s survey (tracks Chicago-area manufacturing) came in much stronger than expected, jumping to 57.9 in August from 50.8 in July – a reading above 50 marks expansion and a reading approaching 60 borders on robust.


The sub-indices within the survey were extremely encouraging. The production index jumped to 63.4 from 49.2 in July. New orders rose to 60.2 from 53.5 last month. The order backlog reading rocketed to 63.0 from 45.7.

While these are all very good readings, we’ll need the national reading to confirm this strong rebound before getting too excited – and we’ll get that with the ISM report this morning. Stronger auto production of late likely helped to push this figure higher and since auto sales are relatively weak…well, that’s where the caution comes in. Overall, though the manufacturing sector has remained largely upbeat despite housing’s woes -- and the heretofore drag from the auto sector -- and this reading does offer optimism that the sector will remain in expansion mode. That order backlog reading is also very encouraging.

The prices paid index pulled back, falling to 80.6 from 90.7 in July, but remains very elevated.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks rallied, pushing the broad market higher for the third-straight day, after the Commerce Department reported second-quarter GDP was revised significantly higher. This followed a durable goods orders report, the first look at this segment of the economy for the current quarter, that offered a reasonable indication the business side of the economy will offset potential consumer weakness as inflation has put a halt to real income growth.

The caveat is that after three days of stock-market gains, we have a pretty good idea of what’s to follow in this market. We’re in a trading range, as we’ve explained for some time now; there is no reason to ignore it. A multitude of uncertainties reign down and will affect the market for a while still. These range from questions over the duration of the housing market; to inflation, and thus what Fed policy will look like if this trend does not abate; to across-the-board tax rate uncertainty, weighing heavily on investor sentiment; and geopolitical risks, which will be with us for a long time.

But these situations present opportunities. There are a number of sectors that currently trade at attractive valuations – in addition both large and mid-cap indices will trade at very low levels once the financial sector flattens out --, and thus present strong multi-year return potential. However, we should all be prepared for continued sideways trading and possibly further declines. Patience will eventually pay off though.

Market Activity for August 28, 2008
Back to yesterday’s activity, nine of the 10 major industry groups gained ground; energy shares were the only loser. Financials, industrials, consumer discretionary and basic materials lead the way – health-care and information technology shares also posted nice increases.

Crude-oil prices fell $2.42, or 2.05%, to close at $115.73 yesterday even as TS Gustav (soon to be a hurricane, but now only expected to make it to category 2) appears on track to hit Gulf of Mexico energy infrastructure. One reason for the decline was a statement out of the IEA (International Energy Agency) that they would supply strategic stockpiles if needed. This would include the release of stockpiles from European gasoline supplies. The downgrade to cat. 2 also helped a great deal.

On the economic front, GDP was revised much higher, showing the economy grew at a 3.3% real annualized rate – the initial estimate had the figure at 1.9%. We’ll get another revision to the number next month, but it shouldn’t change much from here as all data for the quarter is in by this point.

The components that led to the higher revision were personal consumption, net exports and the change in inventories.

• Personal consumption was revised to show a 1.24 percentage-point contribution to real growth from 1.08 initially.
  
• The change in inventories subtracted less-than-initially estimated taking 1.44 percentage-points from growth vs. the 1.92 percentage-point drag initially.
  
• Net exports exploded, offsetting the drag from inventories, adding 3.10 percentage-points vs. the 2.42 contribution estimated last month
  

Residential fixed investment (housing) was unchanged. This component subtracted 0.62 percentage-point and the main point here is that this is half the average drag of the past nine quarters when the segment was subtracting more than a full percentage point.

Many continue to say current quarter growth will be a payback period for this much stronger-than-expected reading – meaning third-quarter GDP will be very weak if not negative. They cite the fact that the end of rebate checks will cause the personal consumption component to ease. While this may be true, not so much because the ridiculous rebate check scheme comes to a close but simply because income growth has not outpaced the jump in inflation of late (real income growth is flat as both year-over-year income and inflation have risen at roughly the same rate). Thankfully, strong productivity improvements have held back consumer-level inflation more than otherwise would be the case as import, producer and intermediate goods prices soar.

What those predicting a weak Q3 GDP reading may be missing is strong business spending trends and the likelihood this will offset the weakness on the consumer side. Further, even though the drag from inventories was less than first expected in the second quarter, it still posted a large weight on GDP. As business sales continue to rise and inventory-to-sales ratios sit at record low levels, an inventory boost should also help to keep third-quarter GDP somewhat upbeat.

Real year-over-year GDP has increased 2.2% even as residential construction has declined 22.2% -- this illustrates the breadth and dynamism of the U.S. economy.

I’ll note that real final sales (GDP minus inventories) jumped 4.8% last quarter, which followed a 3.9% reading in the first quarter. This final sales figure will ease over the next couple of quarters as inventories rise, and this production will push the headline GDP figure higher.

In a separate report the Labor Department reported that initial jobless claims fell 10,000 to 425,000 in the week ended August 23. This number remains elevated and it’s not good that it remains above the 400k level, but we are seeing some signs that the effect of the government’s program to extend unemployment benefits is waning.

The four-week average for jobless claims did tick down ever so slightly and I think there’s a good chance we’ll see a mild trend lower over the next few weeks. Thirteen states and territories reported an increase in jobless claims, while 40 showed a decrease.

Unfortunately, continuing claims (those on the dole for longer than one week) will remain elevated for a while as the government’s assistance program extended the time (normally 26 weeks) one can collect the hand out.

I’ll leave you today with graphs of real (inflation-adjusted) GDP and after-tax income per capita of the past quarter century.

The charts below are quite enlarged but it was necessary in order to read the percentage increase figures.

Disposable (after-tax) income on an inflation-adjusted basis up 3.0% per year since 1981 – that is huge and explains the level of prosperity we enjoy today.

Have a great weekend and holiday!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks rose yesterday after durable goods orders unexpectedly rose in July and concerns over Fannie Mae and Freddie Mac waned for a second day – for now at least, who knows when the next article comes out that causes investors to concentrate more on hypotheticals than current realities and thus swing perceptions back in the other direction.

The durable goods news, which we’ll touch on below, was great to see and may be illustrating – as we’ve mentioned for a couple of months now – that the business side of things will help to offset future weakness that may arise on the consumer side as real (inflation adjusted) income growth has flattened of late and housing prices continue to decline.

All but one of the 10 major industry groups gained ground yesterday – health-care was the laggard. Financial, energy, basic material and information technology shares led the way.

Market Activity for August 27, 2008
The U.S. Federal Deposit Insurance Corporation (FDIC) stated a couple of days back that its “problem list” of banks increased 30% in the second quarter – the figure rose from 90 to 117, marking the highest level since mid-2003. “Problem” institutions are those under closer regulatory scrutiny, meaning their capital cushions are weak.

The media has jumped all over this, but it is hardly an issue at this point – it’s not like we’re talking about the highest level in 20 year, far from it. And think about it, do you even recall hearing about the FDIC “problem list” in 2003? I don’t, which shows this is a relatively low level. In terms of actual failures this year, the figure sits at nine. There will be more to come, but we shouldn’t get carried away.

What this does illustrates is that strong bank earnings may not return anytime soon – it had been expected banking-sector profits would rebound in the fourth quarter; the return of much better results won’t be seen until next year.

But back to actual failures, for now these are being reported over weekends. When bank failures begin to get reported on Tuesdays and Wednesdays, that’s when you’ll know the FDIC pipeline is filling up. It’s been reported that to this point 99% of banks and thrifts remain “well-capitalized.”

On the economic front, the Commerce Department reported durable goods orders unexpectedly rose in July as overall orders increased 1.3%. The ex-transportation figure rose 0.7%. The expectation was for overall orders to come in unchanged from June and ex-trans to decline 0.7%.

These are very healthy increases especially considering orders have trended higher for three months now – total orders are up 11.3% at an annual rate since April and ex-trans up 11% annualized for the same period.

The component that we watch most closely is non-defense capital goods, ex-aircraft (a proxy for business capital spending). The figure jumped 2.6% in July and is up 14.4% at an annualized rate over the last three months – so the nice bounce we’ve seen in business spending continues. This reading is being helped by the increased current-year write-off allowance and bonus depreciation schedule that President Bush demanded to be added to the government’s “stimulus” package back in May – these policy decisions provide meaningful incentives.

Capital spending will help to keep GDP positive this quarter as other components may weigh on growth. The trend in capital goods orders is encouraging -- the segment continues to be driven by industrial machinery orders.

Shipments have outpaced inventories for two months now, pushing the I-S (inventory-to-shipments) ratio lower, which is a good sign for future orders growth. That said we should expect to see durable orders decline when the August number is released simply because of the strength over the past three months – a respite over the next month or two would be quite natural as orders for these big ticket items can fluctuate wildly. The media would use it to spread their proclivity toward hyperbole and typical gloom and doom prose, but we should all be conditioned for this by now.

More economists are coming around to the notion that the credit-market troubles are not having an adverse effect on capital expenditures – this is why we’ve spent several letters over the past few months explaining that corporate cash levels are at or near an all-time high; firms have the resources to engage in projects and large equipment purchases without necessarily borrowing to do it. This is the power of the double-digit profit growth that took Q3 2002 through Q2 2007 – that period of 10%-plus earnings increases marked a post-WWII record and we continue to see feel the benefits today.

This morning we get the first revision to second-quarter GDP, which will be revised higher. Back in July we estimated that GDP would post 2.5%-3.0% real growth at an annual rate, which looked pretty much off the mark when the number came out at 1.9%. This revision should show that estimate was pretty close after all as the figure is expected to be revised up to show 2.7% real growth. A narrower trade gap, stronger-than-initially estimated business spending and better-than-expected inventory data will be the reasons for the upward revision.

The latest durable goods orders figure has also led to higher third-quarter GDP estimates.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ended mixed on Tuesday as the Dow and S&P 500 closed a bit higher, while the NASDAQ failed to gain ground as information technology shares struggled.

Analysts’ comments on Fannie Mae and Freddie Mac – explaining that the two GSEs have enough capital to withstand losses through the end of the year and still keep a capital cushion above their requirement – helped financials shares gain ground. Energy shares also helped the broad market close higher as oil prices rose for a third-straight session as what is now Tropical Storm Gustav is on a projected path to threaten the Gulf.

Market Activity for August 26, 2008
All in all, seven of the 10 major industry groups closed yesterday’s session higher. Consumer staples, information technology and telecom shares were the losers.

The dollar has staged a very welcome rally of late as it has become evident the super-strong euro made zero sense considering the Eurozone economy has weakened considerably. This may force the European Central Bank to lower interest rates – they had been increasing rates even in the face of weakness as unions (which are much more powerful in Europe than here in the U.S.) force wages higher. The liklihood that the interest rate differential between the EU and U.S. will move in our favor has been one reason for dollar strength.


Oil prices have also moved substantially lower, as everyone knows – falling 20% from the all-time high hit on July 3. This trend is in jeopardy though as Gustav tracks toward Gulf of Mexico energy infrastructure. Evacuations of oil and natural gas production facilities are scheduled to begin as early as today.

In addition, Russia continues their disruptive behavior (which appears to be the correct term for now, their actions could escalate into something worse if not confronted) as they see how far they can push things. Their immediate objective: Gain control of the Tbilisi pipeline – the only Caspian-region oil flow to Western Europe that they do not have control over – and determining the future political environment of Eastern Europe. NATO needs to step up; this is their backyard; this is their reason for existence. Problem is European militaries have been so degraded that the Euros seem to have neither the will nor the ability to commit troops.

So we’ll see we’re these issues take the price of oil. For now, let’s hope Gustav misses major oil infrastructure – good news is the industry caps rigs very effectively these days and can get up and running again very quickly.

On the economic front yesterday housing data dominated.

First, we had the release of the S&P Case/Shiller Home Price Index and its tracking of 20 major cities showed prices declined 15.92% from the year-ago period. That’s quite a large drop and much worse than the National Association of Realtors, Commerce Department and OFHEO surveys have shown.

We’ll note that this survey’s reading (Case/Shiller) has been dragged lower by six cities – L.A., San Diego, Las Vegas, Miami, San Francisco and Phoenix – all down at least 25% year-over-year. These were the areas that exhibited the largest price spikes over the previous three years. As a result of its narrow reach, this survey does not show the true picture for home values across the nation as the aforementioned areas were where the most speculation took place.

On the bright side, the survey does show that price declines are waning from a three-month annualized perspective, decelerating to a decline of 10.05% vs. price declines of 15.87% in May, which followed a 21.73% hit in April and 24.98% in March.

Shortly after the release of Case/Shiller, we received the OFHEO Home Price Index. (OFHEO stands for Office of Federal Housing Enterprise Oversight and is a much broader-based survey. This survey’s main fault is that higher-end homes are not included, yet it does offer a better look at the housing situation from a national perspective.)

The OFHEO survey showed prices fell 5% from the year-ago period, coming in flat for June (meaning zero change) relative to the May figure.

Lastly, the Commerce Department reported that their new home sales report showed prices declined 6.3% from the year-ago period.

So we put the existing home sales data (which we touched on yesterday), the new home data and the OFHEO survey together and it shows home prices are down 6.1% on average over the past 12 months. This is quite different from the degree to which Case/Shiller is showing values declined and I think closer to the truth from a national perspective.


In terms of new home sales, they rose 2.4% in July, halting a two-month decline, to 515,000 at an annual rate -- new home sales have declined during 12 of the past 15 months. Lower prices may be starting to work, but I’m not convinced we’ve stabilized just yet – more data will be needed to confirm this.


The best news within the report was that the supply of new homes on the market fell a meaningful 5.2% to 10.1 months’ worth of supply at the current sales pace (as the chart below illustrates). While this level of stockpiles remains very elevated the trend is moving in the correct direction at least -- off from 11.2 months’ worth in March.


Important: The number of unsold new homes on the market has declined for 15-straight months. The problem is when the figure is matched against the sales rate (which is that 10.1 months’ worth of supply number mentioned above) supply remains very elevated. However, when sales do bounce that months’ worth of inventory figure should drop very quickly.

We need to see the above chart get to nine months worth before we get too excited and then work its way down to six months’ worth before home construction will begin to add to GDP again – this whole process will likely take another year to play out and we can’t rule out two-full years before this occurs. In any event, it will be a very nice plus when housing merely flattens out; at which point it will no longer subtract from GDP and this will be a substantial positive.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks continued along the path of vacillation, erasing the last three sessions of gains and returning the broad market to last Tuesday’s level.

The press advanced the notion that yesterday’s existing home data, which showed prices down 7% from the year-ago period, was the culprit for the move lower. But this is what needs to occur in order to reduce home-inventory levels that remain extremely elevated – not to mention that this degree of price decline was expected anyway.

Certainly financial shares put pressure on the market as third-quarter losses are now estimated to be larger than previous expectations. However, the losses were widespread, as every major industry group came under pressure – the best performing sector was utilities and even they were down 1.10%; most sectors lost between 1.50%-2.00%.

So it was not all about financials, it was something more. Iran claiming to do away with Israel, again, and Senator Obama’s economic proposal likely didn’t help things either.

Market Activity for August 25, 2008
On the Obama proposal, it seems now that he will not attempt to raise only the top two income tax rates, but the top three as the WSJ reported married couples with taxable incomes of more than $165,000 will see their marginal bracket raised to 36%. This doesn’t just raise the 33% tax bracket (currently the second-highest rate) but also much of those within the 28% bracket. (The range for the 28% bracket consists of married couples making between $131,451 and $200,300). Of course, the top rate would be raised to 39.6% from the current 35%.

This likely caused the market to believe his plans to raise tax rates will be worse than expected. For instance, if the proposal will now raise rates for more than just the two top brackets – which is bad enough as those within these brackets are the main source of capital supplied to the private sector – what’s to say this potential administration will refrain from raising the rates on dividends and capital gains more than currently proposed?

Of course, the more the Obama camp talks this way the less likely they are to actually win, so maybe we should hope they keep talking. Hopefully, no one clues them in on how politicians are not supposed to talk about raising taxes until after they are actually elected. Talking this way is a mistake on their part, and while harmful to stocks in the short-term, it could turn out to be a plus as this strategy is not one that wins elections. Add in that most other countries around the globe are doing the opposite and lowering tax rates such proposals are not only unacceptable, but illustrate a complete lack of understanding over the importance of global competitiveness in the current epoch. And that is what this commentary is all about. It is not about Senator Obama per se, but the harmful effects to our entire economy that such actions would cause.

Then we had the Iranian comments, which are nothing new but do keep geopolitical risks front and center.

I think one could look at all that is weighing on the market – tax talk, housing correction, inflation rising, Iran/Russia – and be fairly surprised the broad market has held up as well as it has. Surely, we could move another leg lower, but the fact that equity valuations within a number of industry groups appear long-term very attractive may just work as a buoy for stocks.

You say buoy? Values are falling! Yes, but we are just 19% from the all-time high the S&P 500 reached on October 9 – with the short-term headwinds the market faces (much of this uncertainty may never come to fruition but it does weigh down), it could be worse if not for reasonable valuations almost across the board.

On the economic front, the National Association of Realtors (NAR) reported existing home sales rose 3.1% in July to an annual rate of 5.00 million, surpassing the consensus estimate of 4.91 million units. The median home price dropped 7% from July 2007, according to the report. (Single-family home sales are down 12.4% over the past 12 months, but up at an annual rate of 4.7% over the past three months, which is somewhat encouraging.)

The combination of tighter lending standards, an increase in foreclosures and potential buyers waiting for signals of a bottom has pushed prices lower.

This is not something the homeowner likes to hear, but it is a necessary condition to reduce the supply of homes on the market, which sit at a record high. This is evident by what has occurred in the West where the pick up in sales has been most striking – prices are down 22% in that region from year-ago levels. Of course, this is an area where much speculation took place as well.
(Note: This inventory measure that has hit a new high includes both single-family homes and condo sales – an increase in the supply of condos was due to projects started 12-18 months back. In terms of just those defined as single-family homes, the inventory figure did tick down to 10.6 months’ worth – a 3.6% decline from the prior month.)

We’ll point out even as existing home prices have declined 7% over the past year – and will fall at least a bit further as foreclosure rates keep supply elevated – the median price remains 15.5% higher over the past five years and up 5% since July 2004. Point is, with the exception of those that had purchased a home in just the past three years, most are still higher from the point of purchase. Since 1999, the median price for an existing home is up 50.6%.

All that said, this rise in existing home sales is encouraging especially since pending sales have risen 32.2% at an annual rate over the last three months, which may suggest things are beginning to stabilize. We’ll need another couple of months of data still to confirm this, however.



Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

(from August 25, 2008)

U.S. stocks rallied big on Friday, led by financial and consumer discretionary shares, as oil plunged $6.59 per barrel, or 5.44%. That decline erased the prior day’s increase, sending crude back to $115 per barrel.

For the week, the S&P 500 and Dow average slipped 0.46% and 0.27%, respectively. A rally in the back-half of the week nearly erased an ugly start – the broad market lost 2.45% during the first two trading sessions. The NASDAQ Composite was a different story as tech stocks failed to participate in the Wednesday/Thursday upswing – the index fell 1.54% for the week.

Market Activity for August 22, 2008
On Friday, while financial and consumer discretionary shares led the market higher – a trend that broke down the previous three days – there were other bright spots as industrial, information technology and consumer staple shares all rose more than 1.10%.

For the year, the broad market, as measured by the S&P 500, is down 12.00% and we have moved to a lower trading range as uncertainties over future tax rates (and the direct effect this has on after-tax return expectations), inflation, oil/dollar (although this worry has eased), the housing and credit markets and geopolitical risks all put pressure on stocks. We have rebounded more than 6% from the new low set on July 15, but credit spreads remain wide in most cases and until these narrow it will be tough for the market to sustain a rally in the near term. (Thankfully mid cap stocks are down just 5% and smalls are off by just 3.7% -- as measured by the Russell 2000 -- year-to-date)

The November election will also likely keep us in a trading range.

However, the election is just 70 days away, and if the outcome shows tax rates will not change for the worse this market will very likely rally in a significant way. From there it will take an end of the housing correction to get us back to all-time highs. For this all to play out it will take some time, but for now the market is expecting the worse and if that scenario doesn’t play out then things will be looking upbeat for stocks.

From a longer-term perspective, these tough markets create opportunities. Too, if some bad policy initiatives get implemented, it sets the stage for a pro-growth agenda – don’t forget House elections take place every two years. Patience is really the best prescription right now – without it, I think it is easy for people to make some poor decisions regarding longer-term portfolio performance.

We were without an economic release on Friday, so Bernanke’s speech was the big economic-related news of the day (you may remember we mentioned on Friday that the Fed Chairman would be speaking). Below are some key remarks from the speech and my analysis on each.

“In view of the weakening outlook and the downside risks to growth, the Federal Open Market Committee (FOMC) has maintained a relatively low target for the federal funds rate despite an increase in inflationary pressures.”

Comment:
This is a negative with regard to Fed credibility in the future – keeping fed funds this low even though inflationary pressures have increased?

“This strategy has been conditioned on our expectation that the prices of oil and other commodities would ultimately stabilize, in part as the result of slowing global growth, and that this outcome, together with well-anchored inflation expectations and increased slack in resource utilization, would foster a return to price stability in the medium run.”

Comment:
This is a full-fledged Keynesian view and one that history has proven is hardly a foregone conclusion. Further, inflation expectations are not well-anchored as a 20% year-over-year rise in import prices, a 10% year-over-year rise in producer prices, both large and small business surveys show price increases and plans to raise prices are at historic highs, core (ex-food and energy) intermediate goods have jumped 10.2% year-over-year and consumers believe prices will rise at 5-6% over the next year. (I don’t put a lot of faith in this consumer reading, but use it for purposes of illustration nonetheless.)

In addition, while the bond market has not priced in harmful levels of inflation – which is probably what the Fed is referring too when they state “inflation expectation are well-anchored” – we shouldn’t discount the fact that geopolitical and financial-sector risks have the market flooding to this safe-have, which has pushed yields lower. What’s more, there have been periods in the past when the bond market took some time to price in bouts with inflation, such as the mid 1970s even though CPI was hitting double-digit rates. If they are wrong, these yields will reflect the inflation problem soon enough.

That said, I do hope Bernanke and Co. are correct, it’s just that it doesn’t jibe with my study of the historic data. We shall see.

“In this regard, the recent decline in commodity prices, as well as the increased stability of the dollar, has been encouraging. If not reversed, these developments, together with a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year. Nevertheless, the inflation outlook remains highly uncertain, not least because of the difficulty of predicting the future course of commodity prices, and we will continue to monitor inflation and inflation expectations closely. The FOMC is committed to achieving medium-term price stability and will act as necessary to attain that objective.”

Comment:
Recall the chart we posted in Friday’s letter illustrating MZM money supply growth. Commodity prices could come down from these levels, but it is not clear to me that overall prices will fall to a level that comes even close to the Fed’s stated comfort zone. Money supply has grown at a rate that has surpassed nominal GDP growth by a long shot over the past 12 months. As Brian Wesbury laid out in a WSJ Op/Ed last week, this excess money creation has been absorbed to some degree by higher energy prices. If those prices fall, that money is still out there – without the necessary production of goods to mop it up. Therefore, demand for other goods may increase and push those prices higher.

Unfortunately, there is nothing in the Fed’s remarks that recognizes their easy money stance has contributed to the rise in commodity prices, nor is there a mention that this type of policy got us into the housing mess in the first place. (I’m not even going to expound on how this policy and the higher commodity prices that have resulted have contributed to Russia’s and Iran’s (oil-exporters) newfound chutzpah)

In the end, the Fed and government policy will choose the correct course – although possibly not before further mistakes are made. But for now things are quite uncertain; I’ll repeat, however, these types of environments do make for great opportunities. On interest rates, if longer-term rates shoot up (to reflect higher inflation expectations) it presents and opportunity to lock in at those higher rates (ala, those that still own 30-year T-bonds from say 1982 that yield 14% -- not saying things will get to that level, but you see the point). Further, stocks behave undesirably during these situations, as we have all seen. But valuations, even if uncertainty over inflation makes valuing equities more difficult, are set up for strong long-term performance and we believe this will pay off in a very nice way for those with patience over the next several years.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ended mixed on Thursday as the Dow and S&P 500 gained some ground, while the NASDAQ Composite declined. The broad market managed to move higher as a gain in energy and basic material shares offset a decline among financial stocks. That trend has broken down for two days now (the financial/consumer discretionary/overall market direction correlation).

Information technology shares held back the tech-laden NASDAQ Composite as the S&P 500 index that tracks these shares slipped 0.24%.

Market Activity for August 21, 2008
Seven of the 10 major industry groups rose yesterday with energy, utility and basic material stocks leading the way. Energy shares within the S&P 500 have recorded their biggest three-day advance since 2002 – jumping 8.5% after getting clocked since July 3, down 20% since that date prior to this latest move higher.

Crude-oil jumped $6.20 per barrel, or 5.39%, as Russia’s behavior in Eastern Europe is very likely the reason for this latest move.

On the economic front, first-time claims for unemployment benefits fell 13,000 to 432,000 in the week ended August 16. The four-week average, however, (as illustrated by the chart below) moved to the highest level in seven years.


While this is disturbing, the boost may prove temporary as more unemployed workers apply for benefits due to the Emergency Unemployment Compensation Program. Further, they are allowed to remain on the dole for a longer period than would otherwise be the case – this has moved the continuing claims figure higher.

For now it will be difficult to surmise from this figure the degree of monthly job losses. Claims in this range would normally indicate job losses of over 100,000 per month -- higher than the 66,000 average in monthly payroll declines over the past seven months.

Hopefully, any pick up in job losses will prove temporary but it will take a couple of weeks to get a cleaner look due to the government’s widened safety net – hammock, rather.

Thirty-three states and territories reported an increase in claims, while 20 reported a decrease.

In a separate report, the Philadelphia Federal Reserve Bank’s index of manufacturing activity – known as the Philly Fed survey -- posted its ninth-straight negative reading, but the pace of decline did moderate in August.

I’ll point out, the Chicago PMI (which tracks factory activity within that region – the most active region for manufacturing work) and the nationwide look that comes out of the Institute for Supply Management (ISM) have shown that the manufacturing sector as a whole remains right at the level that separates expansion from contraction – meaning activity is pretty much flat. Point is manufacturing activity is holding up remarkably well considering substantial drags from the housing and auto sectors.

Back to the Philly number, the price indices within the report remain elevated -- two-thirds of respondents reported higher input prices this month. That is down from 77% as energy prices capped their meteoric ascent last month. Regarding prices for their own manufactured goods (prices received as opposed to prices paid), the percentage of firms reporting higher prices in August exceeded the percentage reporting lower prices by a four-to-one margin.

And speaking of which…

MZM (money zero maturity) money supply [this includes checking accounts, savings accounts and money-market funds minus time deposits (CDs)] has soared over the past year rising 14.4%. The rate of growth has cooled over the past few months, but the 12-month rise has enormously outpaced nominal GDP growth of just 3.8% over the same period. The cause of inflation is too much money chasing too few goods and since MZM is money and GDP is goods produced…well, the rise in inflation should come as no great surprise.


We’re without an economic release this morning, but Fed Chairman Bernanke is scheduled to speak on “Financial Stability” at the annual symposium in Jackson Hole. It may behoove him, the market and the rest of society to make some comments on price stability too. I also wouldn’t be surprised to hear from Treasury Secretary Hank Paulson either today or Monday regarding the GSEs -- Fannie Mae and Freddie Mac.

Have a great weekend!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks gained ground yesterday, ending a two-day decline that had erased the previous six-session gain. Energy shares led the way as crude-oil rose for a third-straight day. Financials also enjoyed good results. The S&P 500 indices that track energy and financial stocks rose 2.77% and 1.67%, respectively.

It was interesting to see a trend broken yesterday as the market managed to gain ground even as consumer discretionary shares fell 0.55%. As we’ve been discussing, the direction of financial and consumer disc. shares has determined the path of the overall market on a daily basis for quite a while now.

Now if we can get the indices to gain ground even on days that financial shares fall, we may be moving past fears over the credit markets – maybe, just a thought. That said, credit spreads remain pretty wide and until those narrow, it will be tough for this trend to break. It is becoming easier though as financial shares make up just 14.4% of the S&P 500 Index today, down from 20.7% one year ago.

Market Activity for August 20, 2008


On oil, crude for October delivery remains well below the peak closing price of $145.29 hit on July 3, but has gained 4% over the past three sessions. Certainly Russia’s Cold War-like activity is not helping in this regard. I see they are calling themselves “peace-keepers” even as they pillage residential areas, destroy infrastructure, block ports and make L.A looters look like amateurs. They have moved well past South Ossetia and Abkhazia and into other cities, such as Gori – it is far from certain they’ll refrain from entering the capital, Tbilisi. I also see they have taken over the hydroelectric plant that provides much of Georgia’s power.


For those that remember the Cold War era, this looks quite familiar to what occurred in the Czech Republic and Poland in the 1960s and 1970s – it is the same playbook and their aim is clear: take over the Baku-Tbilisi-Ceyan pipeline – which is the only regional pipeline supplying Western Europe that the Russian’s do not yet have control over – and determine the future of Eastern Europe. NATO needs to step up or they risk becoming as feckless as the UN. The good news is this may rally support for Eastern European entry to NATO and hopefully sound the alarm to Western Europe to accept this needed result, which they have been blocking.

Moving on…

We were without an economic release yesterday, so I thought we’d touch on a topic that has been plaguing the market of late. There are a number of uncertainties that have hurt investor sentiment – the housing market – and the duration of that correction, inflationary pressures -- and future Fed action to control this situation, and geopolitical risks. The other major concern is the uncertainty over tax rates.

Lower tax rates on capital gains and dividends have been instrumental to the 64% rise of the S&P 500 (9.81% annualized) since March 2003 as it offered a boost to after-tax return expectations and provided the incentive to take on measured risk. The capital gains tax rate reduction -- from 20% to 15% at the federal level -- led to a 6.25% increase in the after-tax return of retained income for an additional dollar put at risk – as Larry Kudlow importantly pointed out a couple of days back.

The dividend tax cut raised after-tax income from this source dramatically as the rate was reduced to 15% from 39.6%, for those in the top tax bracket. Not counting state taxes, this meant an investor kept 85 cents on the dollar, as opposed to just 60.4 cents – a 40.7% incentive boost on an additional dollar put at risk. Needless to say that was enormous and explains why investors have demanded higher dividend payouts and the dividend component of the personal income data has soared. Make no mistake, this extra income does flow through to the rest of the economy by way of higher capital formation and thus higher innovation, productivity gains and jobs growth.

In terms of federal income tax rates on labor, one should know that small business makes up roughly 65% of those within the top tax bracket – this group is the largest job creator in the country. Raise their after-tax income growth (by reducing tax rates) and you get more jobs and higher levels of business investment over the long term.

This is why when a presidential candidate, or members of Congress, talks about raising these tax rates it has a significant effect on investor sentiment and the proclivity of investors to take risk. Raising the capital gains tax rate from 15% to 20% results in a 6% reduction in after-tax retained income for an additional dollar put at risk – from 85 cents on the dollar to 80 cents. Same is true for the dividend tax. Of course, if these rates are pushed even higher, as some have suggested to 28%, that after-tax income number becomes smaller.

In an attempt to justify these tax rate increases, proponents have stated that these rates are the same or less than where they were in the 1990s – most of which were big growth years as everyone knows.

But this not the 1995 global economy, the world is much more competitive today as there are more legitimate players and many countries have slashed their tax rates on income and investment. You try to raise tax rates – and thus lower the after-tax rate on investment and income – in this environment and it means you lose by way of competitiveness. These are the reasons this stuff is so important.

This morning we get initial jobless claims for the week ended August 16. It will be important to see this figure decline; it is not yet known the extent at which the government’s Emergency Unemployment Compensation Program has affected this reading, which has jumped. The BLS (Bureau of Labor Statistics) believes the impact may have peaked. Hopefully over the next couple of weeks we get a cleaner look and can surmise whether the monthly job losses will remain relatively tame or not.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks declined for second day after wholesale prices accelerated from an already hot pace in July – and well-faster than analysts had expected – and housing starts fell to the lowest level in 17 years.

Again, like clockwork, financials and consumer discretionary shares led the market lower falling 3.05% and 2.24%, respectively. As we’ve discussed, one only needs to look at these two sectors to learn the direction of the overall market. When this trend begins to break, it may signal the moment financials and consumer discretionary shares begin their sustained moved higher.

It’s tough when you’ve got these two indicators (inflation and housing) posting bad numbers as higher levels of inflation keep real incomes from rising (amazingly though this figure remains flat, not declining, as the broadest measure of incomes continue to grow at a nice nominal clip) and poor housing market results keep financial-sector concerns alive.

I will point out though that housing construction declines did ease in the second quarter as the drag on the GDP figure was half what it has been of late. It will just take some time to work off the excesses of the previous years; it’s as simple as that. On inflation, the numbers look ugly, and we have our concerns on this front, but the decline in oil prices of late should help inflation pressures ease – that is not a forgone conclusion though as I’ll discuss below.

Market Activity for August 19, 2008

In earnings news, Hewlett-Packard posted another great quarter – releasing results after the bell yesterday – as operating profit jumped 21%, revenue grew 10% and the firm issued strong guidance. Information technology posted the second-best profit performance of the 10 major industry groups for Q2 as operating profit rose 14.8%. This trailed only the energy sector, which posted operating profit growth of 17.9%.

Three of the 10 major industry groups enjoyed double-digit profit growth last quarter – consumer staples being the third. Another three industries posted profit growth in the range of 6%-9.5% -- health-care, industrials and utilities. Three industries reported profits declined in the March-June period – financials (down 94%), consumer discretionary (down 55.8%, much of this due to Ford, GM and housing-related retailers) and telecoms (down 1.9%)

On the economic front, U.S. producer prices (PPI) accelerated in July coming in at twice the rate expected on a month-over-month basis and jumping 9.8% from the year-ago period – fastest rate in 27 years. PPI rose 1.2% in July, an increase of 0.6% was expected, and the year-over-year reading surpassed the expected 9.3% increase. Even excluding energy, producer prices were up 0.6% over the past 30 days and 5% year-over-year.

Most concerning to me is the pace of core intermediate goods, which accelerated to 2.0% on a month-over-month basis and 10.2% year-over-year. (That’s up from the 8.4% pace hit in June.) For clarity, core intermediate goods are those factories use to produce finished product and it excludes energy. There is a real possibility that this segment funnels down to the consumer. If won’t occur in full, as productivity improvements and firms’ desires to keep market share hold consumer prices back, but it may be enough to drive the figure even as commodity prices have declined in a substantial way.

Many were probably looking past this reading as dollar strength and oil’s decline lead most to believe inflation will moderate – the drop in commodity prices, which began to take place in mid-July, did not occur in time to help ease the July PPI reading, but should help the August reading. With energy prices off 22% from the high, it will undoubtedly help. Still, this core intermediate goods segment will be something to watch over the next few months.


In separate report, July housing starts fell to a 17-year low. Building permits, a sign of future construction, also fell.

Starts fell 11% to an annual rate of 965,000, the lowest level since March 1991, followed a 1.084 million pace in the prior months. The report will reinforce the concern that stricter lending rules, rising borrowing costs and foreclosures will keep home sales depressed and cause builders to hold off on new construction. But this is what needs to occur when inventory levels are so elevated – this figure really needs be cut in half from the high hit in March. It will simply take time, but demographics and household formation will eventually take care of this issue.

Construction of single-family homes fell 2.9% in July (down 39.2% from July 2007) to 641,000 at an annual rate – also the fewest since 1991. Work on multi-family homes plunged 24% from the prior month after getting a boost in June from that change in New York City building codes that we discussed yesterday.



Have a great day!


Brent Vondera, Senior Analyst

From Revolution to Evolution

By: David Ott

In his 1992 book, Capital Ideas, Peter Bernstein guides us through the four decades when Modern Portfolio Theory (MPT) revolutionized Wall Street. Now, fifteen years later, Bernstein’s new book Capital Ideas Evolving (referred to as Evolving hereafter) critically examines MPT from three perspectives.

In the first section, he presents the two most substantial academic critiques of MPT that attack some of the underlying assumptions within the theory. For example, MPT assumes that investors are rational. These fictional investors are emotionless automatons that are absolutely capable of making optimal decisions about their portfolio.

This is obviously false. It may make sense with respect to the creation of a theory, but any practitioner will tell you that neither markets nor investors are rational. A whole new field within economics, referred to as behavioral finance, seeks to examine investor behavior in attempt to mitigate some of the frequent problems that arise.

For example, one study looked at how 401(k) participants make decisions about their retirement savings based on the choices that their plan sponsor provides them. The study breaks the participants into three groups and gives each group a choice between two mutual funds.

The first group was given a choice between a stock fund and a bond fund. This group split the money basically down the middle and basically had a 50/50 stock/bond allocation.

The second group was given a choice between a stock fund and a balanced fund that split the money 50/50 between stocks and bonds. Instead of putting all of the money into the balanced fund, the participants split the money between the two funds, which meant that their stock/bond split was 75/25.

The third group was offered a bond fund and the same balanced fund that split the money 50/50 between stocks and bonds. Investors split their money half and half between the two funds instead of the balanced fund and ended up with a portfolio heavily weighted towards bonds.

The researches subsequently interviewed the participants and found that they had wanted to diversify, and since they didn’t understand their options, they just split the money half and half into each option thinking that being diversified into two funds was better than one, even though the results of that simple decision had radically different asset allocation implications for the 401(k) assets.

Whether it is a problem of being uneducated about investments or acting irrationally, this experiment shows that investors are generally not well equipped to make appropriate decisions about their investments. Even Harry Markowitz, the great-granddaddy of MPT says that many of the theories “make unrealistic – absurd – assumptions about the actors.”

In the second section of the book, Bernstein revisits many of the academics that led the revolution to ask if their theories are still relevant. In short, they all seem to agree that the theories aren’t perfect, but are clearly relevant and useful in today’s environment. As Nobel Laureate Robert Merton says, “there is much left to do because so little has been done.”

In the third section, Bernstein describes a variety of practitioners who have put the MPT to work with a great degree of success. The first case is an extension of one of the real world examples in Capital Ideas. In the first book, he describes how Wells Fargo created the first index fund. It seemed odd that they had no visible name regarding indexing in today’s investment landscape.

The answer to that riddle is that Wells Fargo wasn’t making any money indexing, so they sold it to Barclays who – years later – turned their experience in indexing into the dominant player in the exchange traded fund and exchange traded note industry under the successful brands iShares and iPath.

He also describes the Yale Endowments diversification efforts through the extensive use of private equity, long-short and absolute return funds as well as other esoteric strategies like ‘portable alpha.’ The basic idea is use leverage to invest in an equity index like the S&P 500 using futures and invest what you don’t need for collateral into something that will earn interest in excess of your borrowing rate.

The idea was first developed by bond king Bill Gross at PIMCO in a product called StocksPLUS. The result is an investment with the same volatility as the S&P 500, but slightly more return, creating what is known as alpha. The portability refers to the use of capital not used to fund the futures contract in any investment that is likely to earn returns in excess of the cost of capital.

Interestingly, Bernstein mentions that StocksPLUS as an institutional product had earned positive alpha over the S&P 500 in 194 of 195 rolling three year periods from July 1989 through September 2005. For the ten years ending in September 2005, the fund added 50 basis points of performance annually to the S&P 500 with basically identical volatility and nearly perfect correlation.

Since that time, however, it would appear that it has been harder for Gross to find portable alpha since 2005. A review of the data from Morningstar regarding their retail offering of the same name shows that for the three years ending July 31, 2008, the fund has trailed the S&P 500 by 148 basis points per annum and produced negative alpha. This may be a reflection of increased market efficiency.

Additionally, upon review of the mutual fund, the strategy may sound very appealing, but it has some clearly negative implications for taxable investors. According to Morningstar, the fund has had pretax return of 1.41 percent for the three years ending July 31, but the tax-adjusted return is -2.05 percent over the same time frame. One would have done much better to forgo the excess returns and pay less in taxes.

This highlights one my own critiques of the some of the high-minded strategies seem so appealing. While it is amazing what Gross and Swenson have done, it isn’t repeatable for most investors. Of course, we could use StocksPLUS in an IRA or some other deferred account, but how could we replicate Swenson’s ownership of timberlands? Despite the new stream of products, it seems highly unlikely that an individual investor could replicate many of these strategies.

In some respects, the inability to mimic these strategies may be a good thing. All of Bernstein’s examples cover those who were immensely successful at the time he went to print, and a few things have changed since then. The description of Goldman Sachs flagship hedge fund, known as Global Alpha, sounds like investment nirvana. As their chief of quantitative strategies, Bob Litterman says, “We run an alpha factory here.” That was before the fund lost ten percent in 2006 and additional 40 percent in 2007.

Of course, these changes are what keep investing interesting, and Bernstein has enjoyed a front row seat through his career initially as a successful investment manager, then as the first editor of the Journal of Portfolio Management, and finally as a top-tier consultant and critically acclaimed author. As with his other books, this is impeccably written and his direct access to all of the subjects in his book brings you much closer to the story.

Although Evolving isn’t a quite a classic like Capital Ideas, it would be unfair to expect as much since it chronicles a slow-burning evolution rather than an explosive revolution.
_______________________________________________________

Recommendation: Buy

Capital Ideas Evolving
By: Peter L. Bernstein

John & Wiley & Sons, Inc., Hoboken, New Jersey 2007
First Published: 1993

ISBN: 978-0-471-73173-3

Daily Insight

U.S. stocks erased the gains of the previous two sessions as even additional declines in the price of oil failed to offset housing/financial market concerns. Yesterday it was a Barron’s article that raised concerns over the two GSEs Fannie Mae (FNM) and Freddie Mac (FRE), although much of the piece offered nothing new.

I’ve got my issues with Barron’s, and to be honest besides this piece I haven’t read the source in a couple of years simply because I found it a waste of time – personal opinion. But what I fail to understand, regarding the entire GSE capital raising discussion, is why the government would cause harm to the preferred shareholder – which is a hypothetical Barron’s raised in the article.

For one, they would not want to eliminate access to the capital markets, which is what putting these dividends in jeopardy would do. Two, it would worsen the capitalization issues within the banking system as whole – not exactly a desired outcome. Three, why would they change the accounting rules (for those that haven’t kept up on this, it is the hypothetical scenario that the GSEs would have to abide by new accounting rule FAS 140 that would force a capital raise right now) on FNM and FRE at a time when they are currently attempting to bail out the housing market. This would be like performing knee replacement surgery only to then introduce the patient to Shane Stant.. It doesn’t make much sense.

Bottom line, as we’ve talked about for a long time now, any day with which there’s bad press regarding the financials the market’s going down; to no one’s surprise that trend holds true.

Market Activity for August 18, 2008

Financial and consumer discretionary shares led the indices lower – down 3.58% and 1.75%, respectively. In fact, nine of the 10 major industry groups lost ground yesterday – utility shares being the only group that flashed green, up 0.10%.

We were quiet on the economic front yesterday, but did get the National Association of Home Builders/Wells Fargo index for August, which was unchanged from the July reading.

The index remained at a record low; but hey, it didn’t make a new one. Seriously though, the figure is tremendously low, as the graph below illustrates. A reading under 50 marks most respondents view conditions as poor. As the reading came in at 16 again, there aren’t many that view it otherwise.

The survey, first published in 1985, asks members to characterize current sales as “good.” “fair” or “poor” and to measure buyers traffic as well as to assess the outlook six months from now.


Builders are delaying projects as sales drop and home inventory remains hugely elevated. In the meantime, mortgage spreads continue to widen. For clarity, during normal circumstances the 30-year fixed mortgage yields 150-180 above the 10-year Treasury rate. Today that spread sits at 260 basis points, or 2.60 percentage points higher. The chart below shows what has occurred with this spread – the yellow line represents the spread and thus the higher 30-year fixed mortgage rate than would be the case under normal circumstances.


This morning we get producer prices and housing starts for July.

The producer price index (PPI) will post another ugly reading, expected to show an increase of 0.6% for the month and 9.3% on the year-over-year reading. If that expectation holds true it would mark another acceleration -- the year-over-year reading came in at 6.5% in April, 7.2% in May and 9.2% in June.

While much of this increase is due to risings oil prices for the period measured, I’ve noticed that core intermediate goods (those used in early stages of production and excluding food and energy) have jumped 8.4% over the past 12 months. The market will likely discount this July look at PPI considering the dollar strength and decline in oil of late. However, I’m not sure we’ll get a meaningful trend lower based on what has occurred in this core intermediate good number. We could very well see this rise passed along to the consumer level. Thankfully, we’ve got strong productivity improvements that remain and may quell this effect. The next three months of inflation data will be very important.

On housing starts, we should see a meaningful decline as the June figure was boosted by a change in New York City building codes, which spurred a jump in multi-family construction and overshadowed a slide in single-family units. As home inventory levels remain extremely elevated, it may take several months, if not a full year still, before this reading begins to bounce back and trend higher.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks added to Thursday’s gain, rounding the week out on a positive note as the dollar completed a two-week rally and crude moved lower in six of the eight sessions of that fortnight. Again, consumer staples and financials led the way. These are the industries that present the largest concern, and thus they move the most based on wavering investor sentiment. A stronger dollar and lower oil price reduces concerns over the consumer as they are already hit by a housing market correction.

Consumer staples and industrial shares also provided the benchmarks with a boost on Friday. Industrials are enjoying a very nice machinery-orders trend and overall increase in business spending of the past three months – the S&P 500 index that tracks these shares has bounced 10% from the mid-July multi-year low.

Market Activity for August 15, 2008

We’ve talked about how the market is stuck in a trading range as uncertainties over tax rates, housing, inflation and geopolitical risks (now Russia throws another risk in as they attempt to gain control over the Tbilisi pipeline and Eastern Europe as a whole, if allowed). The broad market moved to a new, lower trading range in July but we have bounced nicely from those lows as the dollar/oil trend has offered a concrete boost.

The chart below shows the 22.38% decline from the October 9 all-time high and the 6.85% bounce from that July 15 multi-year low. The shaded area (it’s tough to make out, but it’s lightly shaded in green) illustrates the trading range that formed prior to moving below 1275 on the S&P 500 in July.


From a longer-term perspective, there are many attractive buys out there as an abundance of stocks trade below the market multiple, yet offer market-beating earnings growth. As we have to deal with a bevy of uncertainties at the present it makes for a frustrating time to be invested in stocks. However, whether it takes six months or two years, at some point stocks are going to rebound in strong fashion, in my opinion. While the S&P 500 is up 72.2% since March 2003 (10.5% annualized), the index is essentially flat going all the way back to August 2000. While the market struggles with the uncertainties mentioned above, these risks will eventually wane. (We’ll note that mid and small cap stocks are up roughly 6% and 5% at annualized rates, respectively over the past eight years.)

Outside of geopolitical events, my chief concern is what will happen to tax rates across-the-board. But any mistakes in this regard will lead to a reversal as the House comes up for election every two years. Further, the fact that most developed countries are pushing tax rates lower, it will become quickly obvious (if not painfully so) the decision to raise rates here at home is the wrong prescription.

On the economic front, New York manufacturing conditions improved mildly as the Empire Manufacturing survey advanced to +2.8 – the first positive number for the index in three months. A reading above zero marks expansion, as opposed to the ISM and Chicago manufacturing surveys where it takes a reading above 50 to mark expansion, just for clarification..

However, some of the sub-indices within the report deteriorated as the new orders index fell to -2.2 from 8.3 in July and the shipments index fell to -0.9 from a strong 13.5 reading last month.

Inflation pressures remained elevated and the future prices received index jumped to a record.

On the bright side, the employment index improved, even if it remained below zero. Expectations of business conditions six month out jumped 19 points to 34.6.

In a separate report the Commerce Department reported industrial production rose for the second-straight month in July, increasing 0.2%.


Production of machinery (up 0.7%) and business equipment (up 0.8%) led the figure higher. Even when we exclude motor vehicles and auto parts, as vehicles and auto parts were up a large 3.6% in July simply because the American Axle strike came to an end a couple of months back, the reading remained positive. (Since unit vehicle sales remain weak, one should not expect this segment to help out over the next few months, so the ex-vehicle/parts reading becomes important to watch.)

Many were expecting electrical utility output to lead the production reading higher, but this segment actually declined 2.3% -- which is unusual for July. It is quite telling that the overall, and that ex-auto reading, advanced even with this segment –which accounts for 10% of the total – declining significantly.

Have a great day!

Brent Vondera, Senior Analyst