June 2009 Recap

(Click image to enlarge)

Following several months in which the market moved steadily higher in anticipation of an economic recovery, the stock market largely traded sideways as investors searched for actual signs of growth rather than second derivative improvement. Still, the S&P 500 managed to push its winning streak to four months and finished June with a quarterly gain of 15.93 percent.

Despite the lack of obvious indicators that the economy is recovering, the VIX index dropped to the lowest level since the Lehman Brothers collapse, which suggests that investor fear has subsided. The VIX index is often used to gauge fear and volatility in the market via the prices investors are willing to pay for protective options. The VIX averaged 20.18 in its history stretching back to the start of 1990, but topped 80 during the height of the financial crisis. Today the VIX is about 25.

All domestic asset classes posted gains led by the utilities, technology, and healthcare sectors. Utilities advanced as the U.S. House of Representatives passed a comprehensive energy policy and helped clear uncertainties surrounding the sector – although it will likely change in the Senate. Technology continued to rise on the expectation that businesses will loosen their purse strings first for technology spending, which enhances efficiency and productivity. Sentiment towards the healthcare sector improved as details about healthcare reform have not implied the draconian consequences as originally thought.

Developed and emerging international markets pulled back after outperforming in recent months – especially in the case of emerging markets. Alternative asset classes also recorded declines in June. The Greenhaven Continuous Commodity Index, which represents a broad range of commodities, fell more than the energy-heavy S&P GSCI Commodity Index. Meanwhile, global REITs managed to squeak out a minor gain and domestic finished the month in the red.

Treasury yields whipsawed during the month of June. Then ten-year reach an intraday high of 4 percent on June 11 as inflation fears really began to envelop the market, but finished the month yielding 3.53 percent. Inflation concerns have subsided, but such volatility can be expected to continue with so many non-traditional factors (Fed buying Treasurys/MBS, Fed Funds at zero) at work in the market.

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Peter J. Lazaroff, Investment Analyst

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks lost some ground Tuesday, trimming the S&P 500’s quarterly advance, as the latest manufacturing report illustrated activity remains in pretty deep contraction mode and the latest consumer confidence reading moved back below a key level. The Case/Shiller home price index showed some really nice improvement, still ugly but by far the best progress recorded thus far; however, it was not enough to offset the aforementioned drags.

Telecom, basic material, financial and industrial shares led the market’s decline. Consumer discretionary and tech were the relative winners. These are two of the three best performing industries for the quarter so maybe a little window dressing helped buoy those shares.

For the quarter, the S&P 500 jumped 15.22%; the Dow average gained 11.01%; and the NASDAQ Composite surged 20.05% after two quarters of treacherous descent (down 11.67% in the first quarter and 22.56% in the fourth for the S&P 500) and six-straight quarters that had sent the broad market lower by 50%.

Mid cap stocks, as measured by the S&P 400, jumped 18.23% and small caps, as measured by the Russell 2000, rallied 22.19%. Developed-nation international stocks leapt 26.82% and the emerging market index soared 33.57% (this marked the second quarter of increase for the emerging market group after back-to-back 27% declines; the index plunged 68% in 2008)

Market Activity for June 30, 2009
Prime Mortgages Continue to Show Cracks

The Office of Thrift Supervision reported that delinquency rates on prime mortgages more than doubled in the first quarter from the year-ago period. This is not exactly new information as rising prime default rates have been evident for some time, but thought it was worth a mention as this specific report is a new release.

Prime mortgages 60 days or more past due rose to 2.9% of such loans from 1.1% a year ago, according to this report. First-time foreclosure filings for these loans jumped 22% from the previous quarter. One can expect this number to jump again for the quarter that just ended. The Mortgage Bankers Association, which doesn’t provide a 60-day delinquency but does report a seriously delinquent (90-days+) rate had this number at 4.70% at the end of the first quarter. Their straight delinquency rate (just 30-days past due) is up to 6.06%.

And the modifications aren’t working out well either. Mortgages that have been modified to help struggling borrowers stay in their homes fail within the first nine months more than half of the time and increases to 63% after a year, according to the report.

It’s all about the job market. Those, and they are many, who have constantly exhorted that the housing market must come back before the overall economy can stage a rebound have it exactly backward. What is needed is a level of broad economic growth that brings back capital spending and pulls jobs along with it. This is why we harped on the need for aggressive broad-based tax rate reductions and higher current-year write-off allowances and bonus depreciation schedules last fall. This is the quickest route to labor market improvement, which is essential to a marked improvement in the mortgage market and home sales.

Case/Shiller

The S&P Case/Shiller home-price index registered another decline for April (yes, there’s a huge lag to this data), the 32nd straight monthly decline and the seventh-consecutive year-over-year drop of at least 18%. However, the figure recorded the most significant level of improvement since the respite from large monthly losses that occurred last summer.

(As always, I’ll repeat that there is a high likelihood that this home-price index overstates the downside. Roughly 40% of the cities captured in this survey witnessed the greatest level of speculation during the boom years. As a result, these are also the areas currently burdened with the highest foreclosure rates and thus the steepest price declines)

While the index recorded an 18.12% decline from the year-ago level, the measure fell just 0.56% for April and the three-month annualized rate of change fell to 18.18% after five-consecutive months of mid-20% declines.

This data is far from showing a rebound in housing is upon us, let’s face it housing isn’t coming back until the labor market shows significant improvement, but we may have finally gotten past these really large declines.

Eight of the 30 cities measured posted an increase on a monthly basis, last month it was only two. Dallas, Denver and Cleveland posted strong gains in April. Cities such as San Francisco, Boston, Atlanta and Seattle showed gains as well; while they were mild, it’s quite a shift from deep declines of the previous months. Even San Diego, Charlotte, Portland, Minneapolis and Tampa (areas that have shown some of the deepest contraction) posted more moderate declines.

Detroit, New York, Miami, Phoenix and Las Vegas remain pretty mired. These cities registered 1.5%-3.5% monthly declines and, save New York, posted prices declines of at least 25% from the year-ago period.


The recent increase in mortgage rates will add another challenge to the housing market for the next couple of months. The current 30-year fixed rate of 5.35% is certainly an extreme low from a historical perspective, but the market became attracted to that sub-5.00% level in late-April and May and we may find it difficult to extend on this improvement as a result of the rise in rates. Nevertheless, this latest reading is the best we’ve seen in quite a while.

Chicago PMI

The Chicago Purchasing Managers Index rose to 39.9 in June (a bit better than the 39.0 expected) from the May reading that saw the figure hammered back down to 34.9. All sub-indices managed to improve from the previous month’s level, but only the production component managed a move above 40, coming in at 41.6 from 37.3 in May. Employment was the laggard, rising but only to 28.9 – although this isn’t a surprise as this will be the last component to show meaningful improvement.
A rebound from last month’s reading, which was beaten back below the average reading of the deep level of contraction that took place in the previous two quarters, means nothing to me as the figure failed to make it above 40. As we discussed yesterday, no one should be under the illusion that Chicago is about to hit 50 (the break-even point, dividing expansion from contraction) due to the auto-sector woes, but still if a meaningful rebound in factory activity is upon us the measure should have been able to make it to 42-43.

We’ll get ISM (the nationwide factory gauge) this morning. The market expects the measure to rise above 43 for the first time since the economic world changed in September. It needs to hit 45 to show the next leg of improvement has really occurred. If so, it will illustrate that Chicago’s inability to move above 40 is solely due to the auto sector’s problems instead of an overall weakened state within the manufacturing arena.

Consumer Confidence

The Conference Board’s consumer confidence reading fell in June to 49.3 from the 54.9 hit in the previous month. (The overall is an average of respondents appraisals of current business conditions, business conditions six months out, current employment conditions and employment conditions six months out)
The present situation index moved back to 24.8, from an already low 29.7, on a less favorable assessment of business conditions and employment
The expectations index (for the next six month) fell to 65.5 from 71.5.
The jobs “plentiful” minus “hard to get” differential retreated to -40.3 from -38.1. This is probably the most important aspect of the report to watch as consumers will not feel right about things until they get a sense that the labor market has turned. (The differential is in the lower part of the chart below)

Have a great day!


Brent Vondera

Bond Recap

Treasuries began the day down slightly but really dipped after April’s Case-Shiller Home Price Index came in better than anticipated. The market was anticipating a 18.63% drop in the index that contains the 20 biggest housing markets in the U.S., yesterday’s reading for the month of April showed a drop of only -18.12% from the same period a year ago. It’s kind of interesting to see how little it takes people to get excited these days. The ten-year yield got as high as 3.57% before Consumer Confidence disappointed and Treasuries rallied.

The long end was the underperformer on the day, a change in recent trend, as the curve steepened by 4 bps, the biggest one day steepening since June 18. The Fed will purchase Treasury notes again today, this time in the 10-17 year area. Look for a short term rally in bonds if the auction shows stronger results compared to yesterday.

Cliff J. Reynolds Jr., Junior Analyst

Are you chasing performance?

Many investors unknowingly chase performance when making investment decisions. This type of investing is often seen as irrational as decisions are based on emotion instead of careful analysis of the value of the investment.

One of the most common examples of performance chasing is when investors use performance over the last one, three, or five years as the sole criteria for selecting investments in their retirement accounts. Historically, a period of above-market performance for a given fund will be followed by a period of below-market performance.

This is because it is virtually impossible to consistently predict the next direction of the market as a whole. Timing the purchase or sale of investments in an attempt to “beat the market” is highly unlikely to increase long-term investment performance.

Notice the first graphic below (you may want to click to enlarge). If an investor looked at this table in the year 2000, he/she might have concluded that Information Technology was a sure-fire way to make money. Unfortunately for those performance chasers following this logic, the Information Technology sector was one of the worst performing sectors for the next three years.


Of course, the same holds true for asset classes as you can see in the graphic below (click to enlarge).

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Peter J. Lazaroff

Quick Hits

• Financial Turmoil Timeline (June 2007 – June 2009)
• Bernanke’s ‘Green Shoots’ Take Over Lexicon, If Not U.S.
• How a Loophole Benefits GE in Bank Rescue

Fed Buys Treasuries

Today’s purchases in the 7-10 year sector were less than impressive. The Fed bought $7 billion in bonds on $23.5 billion in bonds submitted for sale. This larger than average difference between the amount that primary dealers would like to sell and the amount the Fed is willing to buy is a negative for the market. The whole point of the Fed buying program was to create the additional demand for Treasuries that is needed to keep longer term rates low. As today’s operation shows, the program is overwhelmed and without a significant increase in the amount the Fed is willing to buy it won’t have much impact.



Cliff J. Reynolds Jr., Junior Analyst

Fixed Income Recap

Last week’s rally in Treasuries continued on Monday, driving yields lower as the ten-year finished below 3.5% for the first time since May 29. The long end of the curve continues to outperform and the flattening trend that has persisted since the beginning of June is showing no sign of stopping. The benchmark curve, the difference between the yield on the 2-year and 10-year Treasuries, finished yesterday at 238 bps, down from 275 bps on June 4.

Inflation expectations have pulled back recently. The Ten year TIPS Breakeven Rate, a number derived from the difference in yield between the ten-year inflation protected Treasury and the nominal Treasury that is used as a proxy for inflation expectations over the next ten years, has fallen to 1.7% from 2.08% just three weeks ago. As traders feel inflation expectations are overblown, they move into long term Treasuries, forcing prices up and yields down.

There is no Treasury supply coming this week but the Treasury will hold auctions every day but Friday next week. Expectations are for $65 billion in nominal coupon supply, pretty light by today’s standards, plus a TIPS auction on Monday. Official auction sizes are not yet available on Bloomberg.

Cliff J. Reynolds Jr., Junior Analyst

Daily Insight

U.S. stocks rose on Monday, extending the best quarterly performance for the S&P 500 since the final three months of 1998. The index has jumped 16.2% over the past three months, following five-straight quarters of decline and at its worst was down 57% from the October 2007 peak.

The broad market ended its first consecutive weekly decline since the market doldrums of February and those who want in found that mild move lower as an opportunity. We also have the second quarter coming to a close tomorrow so one certainly can’t rule out some window dressing among mutual fund managers – one wouldn’t want to appear underweight stocks during such a strong quarter, now would they.

Financials, energy and utility shares led yesterday’s market higher. All 10 major industry groups gained ground; health-care and consumer staples, while up, were the laggards.

Even as the major indices posted nice gains, lackluster volume remains the trend as just 1.02 billion shares traded on the Big Board; there is certainly a lack of conviction out there as volume has been particularly weak for three weeks and trading has been sideways since May 8. A period of low volume should remain the rule as is usually the case for the summer months.

The dream shoots, I’m sorry the green shoots, better begin to show themselves in a pronounced manner or this market is going to have another rough period some time in the near future even with the liquidity trade that remains in play. We’ve yet to see anything that resembles a normal business cycle turnaround. One would certainly think we’re to have a robust economic rebound on our hands very soon with the massive stimulus that is in the global system, but I remain concerned that government action may cause businesses to further delay capital outlays. We need the business side of the economy to step up because its going to take the consumer a while to gets things right again.

Market Activity for June 29, 2009
Activity in Crude

Oil futures for August delivery are back on the march, rising 3.3% yesterday to close the session at $71.50 per barrel. What drove yesterday’s rise? It’s tough to say for sure what causes a daily move, but I doubt it was increased optimism over global growth. Heck, it was just Friday when concerns over near-term economic prospects increased again.

One thing is pretty certain; the energy market has begun to pay attention to Nigerian militant attacks – additional attacks over the weekend forced Shell to close production wells.

There were also talks between OPEC and the European Union in which they both seemed to agree that the weakened state of the global economy can support $70-80 per barrel – why the EU offers the cartel such fodder is beyond me. It may simply have been a blanket statement from the Europeans, but you can probably bet OPEC will use it as a source to justify production cuts the moment economic activity looks set to rebound. The market realizes this and crude caught a bid as a result.

The Week’s Data

On the economic front, we received a couple of lesser watched regional manufacturing readings. Both showed factory activity improved from deep depths but remain at recessionary levels.

The market waits for more substantial data, and we’ll get it in this holiday-shortened week.

This morning the April reading on the S&P Case/Shiller Home Price Index is expected to show the seventh month of year-over-year decline of at least 18% – it’s been more than two years now since the figure has posted an increase on a 12-month basis and 2 ½ years since posting a monthly increase.

As we always point out though, this is a fairly narrow index – it includes the 20 largest metro areas, but many are those in which the greatest level of speculation took place in the boom years. As a result, these are also the areas currently burdened with the highest foreclosure rates and thus the steepest price declines.
Also today we get the Chicago Purchasing Managers Index (PMI), which is the most watched factory gauge outside of the nationwide ISM figure. This reading has been more subdued than many of the other factory indices as it is most exposed to the auto sector. Due to those auto-industry woes we shouldn’t expect Chicago PMI to make it close to 50 (the line of demarcation between expansion and contraction) but if it moves to 42-43, this will be a big plus. Conversely, if the reading remains in the 30s the market will be disappointed and may sell off even if this is the final day of a big quarter.
On Wednesday we’ll receive the preliminary employment reports in the Challenger Job Cuts Announcement index and the ADP Employment Change reading. ADP is expected to show the economy shed 390,000 payroll positions in June, which is more than is expected for the official data.
We’ll also get that ISM number, giving us the June reading on overall manufacturing activity for the nation.
On Thursday, we’ll get an overdose of employment data as the usual jobless claims reading is released, but in a rare Thursday appearance (due to the market close on Friday) we’ll receive the official monthly payroll data (June) as well. The market expects a decline of 350,000 positions, and if accurate it will mark the second-straight month of improvement from the outsized losses of 550K-740K that was the trend over the previous six months. A level of 350,000 brings us back to the peak level of losses that are seen during the more typical recession, which is the situation we currently find ourselves.
This job number is the big one and will set the stage for how the market reacts as we come back from the July 4 holiday.


Have a great day!


Brent Vondera

Quick Hits

• GE and industrial loan companies
• Fed and Inflation

Lower rail volumes create buying opportunity in NSC

Norfolk Southern (NSC) fell along side the rest of the railroad industry as the U.S. Rail Carload Traffic Report for the week ended June 20 showed that freight traffic remained weak, down 17.7% from a year ago.

The last few weeks had showed some modest improvement, but today’s report indicates the gains were short-lived and are likely to remain at this level until there is more visible evidence of an economic recovery.

Intermodal volume, which is not included in carload data, was down 17.8% from a year ago, with container volume falling 12% and trailer volume declining 39%.

18 of 19 commodity groups tracked by the Association of American Railroads (AAR) were lower except for the “all other carloads” category, which was up 11.9% year-over-year. Lumber and wood products were down by 37.6% and motor vehicles and equipment were down by 51.6%.

Volumes and pricing in the railroad industry are not barometers of the general economy like other transportation companies like FedEx (FDX) or United Parcel Service (UPS) since railroads returns cost of capital and companies pay for their own infrastructure improvements.

Like all railroads, volumes have been in decline in recent quarters due to depressed economic activity. This has created an attractive buying opportunity in Norfolk Southern, whose strong pricing power helps the company generate about $1 billion in free cash flow per year – over 10% of revenue. As the economy recovers, strong pricing power and increasing volumes should enhance Norfolk’s earnings power and produce attractive shareholder returns.

For more on NSC, see my March 17 post.

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Peter J. Lazaroff

Earnings season is coming

Following an extended period of pessimism on Wall Street, April’s corporate earnings season beget rabid green shoot sightings. The market responded by moving higher as investors armed themselves with previously shunned equities, waiting to move in for the kill once these green shoots turned into growing profits.

First-quarter profits beat expectations, but were still down from a year earlier. Nobody expects earnings recovered during the second quarter, thus all eyes will be focused on guidance into the second half of 2009. With a second-half recovery largely priced into the market, the Street must be reassured profits are on the horizon.

At some point, however, the market will need more than a chorus “less bad” or “slowing rate of decline” to justify any move higher from here. This article in today's Wall Street Journal suggests stocks have entered “a Twilight Zone of uncertainty that leaves them vulnerable to earnings disappointments as they wait for earnings to recover.”

Once corporate earnings do recover, they will look impressive when compared to the prior year’s ruinous results. Of course, the best of the hunting season will be long over by the time this occurs because the market is forward-looking.
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Peter J. Lazaroff

Daily Insight

U.S. stocks ended pretty much flat on Friday as the financial press blamed the lack of investor commitment on a jump in the savings rates. We think it had more to do with the monthly income data that showed the vast majority of the increase came from government transfer payments, but we’ll get to that below. The NASDAQ Composite managed to post a decent gain.

Renewed concerns that consumer spending will slow hit economic forecasts and that meant pressure for energy, consumer discretionary and industrials shares, which were among the biggest losers.

I find the number of people believing the consumer is poised to bounce back pretty amazing. The job market is going to take another year, at least, before it shows net job creation (and it’s likely to take longer than that) and consumers have a debt problem to manage around right now. The level of debt incurred was manageable at 5% unemployment and rising private-sector incomes – a vastly higher stocks market also helped consumers feel less pressure from the levels of debt that very low interest rates encouraged. But now with the unemployment rate on its way to 10%, private-sector incomes flat and the stock market still 41% off of its 2007 peak…well, it’s no surprise that the cash savings rate has hit a 15-year high; it will continue to go higher too if higher gas prices don’t eat into this savings, which is another issue for the rough consumer environment.

The major indices ended mixed for the week as the broad market closed down 0.25% and the Dow Industrials lost 1.19%; the NASDAQ Composite bucked the trend, closing up 0.59%. Mid cap stocks closed down 0.22% and small caps ended mixed with the Russell 2000 up 0.10% and the S&P 600 down 0.08%.

Market Activity for June 26, 2009
Personal Income and Spending

The Commerce Department reported personal income jumped 1.4% in May, more than four times the amount expected as employers boosted wages and salaries even as they struggle to deal with very weak business conditions. Just kidding, but one would think this to be the case by the way people positively reacted to the headline increase. A look within the data shows wages and salaries fell again in May. The increase in the monthly income numbers was almost totally due to another large increase in government social benefit payments.

Government transfer payments recorded their largest monthly jump yet, up 7.8% in May after the 2.9% increase in April and a1.6% rise in March – this very European-like segment of the data is up 12.2% year-over-year and will have to be paid for at some point – higher tax rates are coming. Rental income was the only real bright spot on the private sector side, up a very strong 5.7% in May and with the housing market in the tank has rocketed up by 66.7% on a year-over-year basis.

That said, this is a very minor aspect of income, making up just $5.2 billion of last month’s $167.1 billion increase in income. Government transfer payments, on the other hand, made up a huge 97% of the income gain for May. Maybe this illustrates why we’re not exactly excited over the large increase in total income last month – the way incomes have increased is hardly sustainable.

The largest private sector aspect of the data, wages and salaries, fell 0.1% in May marking the seventh monthly decline in the past eight months. On a year-over-year basis, wages and salaries are off by 1.1%. Dividend income fell 0.7% and interest income rose 0.7%, pretty much offsetting one another as the dollar change in dividends fell $5 billion, while the increase in interest income was $7 billion.

On the other side of the data, personal spending rose 0.3% last month and followed no change for April, which was revised up from the -0.1% initially estimated. Nominal spending is down 1.8% from the year-ago period.

As incomes easily outpaced spending in May, the savings rate (the cash savings rate as I call it) jumped to 6.7%. The policy makers that believe massive government spending will boost consumer activity are surely dismayed by this reality as they need these transfer payment to be spent.

However, with the shape the labor market is in, along with the decline in consumers’ two largest savings vehicles (stocks and houses) the build in cash savings will continue over the next year or two. On a year-over-year basis, the savings rate is up 4.8%, a huge shift from levels that hovered near zero. We’re looking for this year-over-year figure to move closer to 8% before consumers feel better about their situation. Ultimately, it will take meaningful improvement in the labor market to allow a sustainable move in consumer activity.

Even with the rise in spending last month, the jump in the savings rate is evidence that consumers have cut discretionary spending to the core. I am concerned that if gasoline prices rise much further this will be too much to bear – that release valve (as Daniel Ahn at Macroeconomic Research likes to put it) of cutting discretionary spending as a way to ease the outlays at the pump is no longer there.

I continue to believe that GDP will post a slight positive reading in the third quarter and a more substantial increase in the fourth. However, if policymakers continue along the current path (massive government spending that results in a growing concern over the chances of austere future tax rates and thus less private-sector activity) we may not get the boost from the business side that we’ll need to offset some of the consumer weakness.

That savings rate figure shows that bank deposits are increasing at a robust rate. Problem is, business caution means that the demand for loans is very weak – deposits grew 7.4% faster than loans last year, the widest gap in 30 years, and that number has surely increased so far this year; commercial and industrial loans have declined 8.2% since October. This could signal two things:
One, it may take a bit longer for a positive GDP print to result.
Two, when businesses do begin to increase borrowing again the massive levels of liquidity that is currently sitting fallow will then explode through the system. Since production has been extremely subdued for three quarters now that means a whole lot of money chasing too few goods – and that ladies and gentlemen is how harmful levels of inflation comes screaming out of no where. This is a real concern with regard to the duration of the rebound when it does occur.

Cap and Trade

The Cap and Trade bill passed the House by a narrow margin on Friday night. The quixotic nature of this legislation is troubling enough – demanding that power plants produce 15% of output from “renewable sources” in a decade will not only reduce our competitiveness, it’s absent common sense. We use roughly 50 million of oil-equivalent barrels of energy per day and of this amount wind, solar and geothermal combine to make up less than one million barrels. It’s an understatement to say that this target fails to conform to reality. If people were serious we would double our amount of nuclear power plants over the next decade and remove the recycling ban so that we no longer have a waste storage issue – we seem to recycle everything else under the sun but refuse to do so with the one thing that can make the biggest difference.

But the really troubling aspect of this bill is the protectionism that was pushed into the 1200 page document. It’s a rather circuitous route to protectionism, but protectionism nonetheless.

The authors of this bill apparently understand that raising the price of emission will erode our competitive advantages so they propose to protect steel, cement and chemical manufacturers via tariffs (raising the prices of imported goods so domestic industries that will be saddled with higher costs can compete). While this trade protectionism would not kick in for a number of years, it sends the wrong message to our trading partners who will be likely to impose their own trade restrictions in advance. This is called retaliation, a trade war, and is exactly what we do not need right now.

We can get away with making mistakes from an economic policy standpoint. But when you throw a number of things together, the eventual unwind of an aggressive monetary easing, higher tax rates, the attempt to impose sanctions on imports, a substantial increase in regulations and massive deficit spending I don’t think it is time for investors to take down their guard. This may be a very tempting thing to do over the next several months as the economy will (even if it is relatively mild and short-lived) rebound from these deep depths of contraction. Concern and caution will remain a prudent mindset until we see a shift in the direction of policy.


Have a great day!


Brent Vondera

Daily Insight

U.S. stocks rallied as better-than-expected results out of Bed Bath and Beyond fueled consumer discretionary shares, higher oil prices boosted the energy sector and the entire market was helped by a very successful $27 billion seven-year Treasury auction. All of these factors were able to offset a disappointing jobless claims report that showed the labor market remains very fragile.

News out of Bed Bath and Beyond helped ease concerns over the consumer, but we’ve seen this story before. Expectations shouldn’t get carried away here, heck even with the demise of competitor Linens ‘n Things the home-furnishing retailer couldn’t manage an increase in same-store sales – same-store results fell 1.6% -- but this is the market we’re in, sentiment sways on a daily basis.

Oil prices pushed above $70 per barrel on Nigerian pipeline attacks. For those who watch these things, this is a monthly, sometimes weekly, event. In a really strange way this could be looked at as another sign we’ve moved to a more typical recession – when the economic world was in free-fall the market had larger issues to deal with and ignored these attacks.

The seven-year Treasury auction went very well with strong foreign bidding and a super-strong bid-to-cover of 2.82. With the massive amount of debt issuance coming down the pike, these auctions, normally a non-event, cast some anxiety over the market these days. The last few have been market positive.

Stocks also benefited from what many viewed as a successful defense by Fed Chairman Bernanke of his emergency measures related to the Bank of America and Merrill Lynch deal – the conventional wisdom views that this increases his chances of keeping the position and the market probably doesn’t want to see a changing of the guard anytime soon (Bernanke’s term is up in January). I, on the other hand, am betting Bernanke will be gone as Larry Summers (Obama’s chief economic advisor) has the job in his sights and the Treasury may need an administration insider so they can monetize these massive debts. I’m not saying that’s a good thing, as we’ve spent much time talking about over the past couple of months this is a very concerning risk, but this is what is likely to occur.

Market Activity for June 25, 2009
Final Revision to Q1 GDP

The Commerce Department reported that first-quarter GDP was revised upward slightly to show the economy contracted at a 5.5% real annual rate during, up from the -5.7% previously estimated. The main reason for the higher revision was less drag from inventory liquidation. Now that all the data for the quarter has been collected, the Bureau of Economic Analysis showed that firms didn’t quite slash stockpiles as much as previously thought – although it was still the highest degree of inventory liquidation since records began in 1947.

In my view, the most interesting aspect of the final revision was how the personal consumption (consumer activity) figure has been revised down. When the initial estimate for the first-quarter GDP reading was released at the end of April, it had personal consumption up 2.2% at an annual rate, which was a good number particularly considering the state of consumer affairs in this environment. That figure followed two massive declines in consumer activity during the third and fourth quarters of 2008 (the largest consumer contraction since the 1980 recession).

Many believed the consumer was poised to bounce back in a sustained manner after that initial consumption number. Now that is has been revised down to 1.4% (in real terms at an annual rate) its shows the figure hardly bounced from the significant two-quarter contraction. Coming out of the 1980 contraction in personal consumption the figure roared back, printing readings of 4.4% and 5.4% in the following two quarters. This will not be the case this time. It will take a considerable period, to use a Fed phrase, before the consumer is in a position to push activity higher in a sustained manner.

Initial Jobless Claims

The Labor Department reported that initial jobless claims rose more than expected in the week ended June 20, rising 15,000 to 627,000 – economists had expected the reading to fall to 600,000. The four-week average of initial claims, a figure that takes out some of the volatility, rose ever so slightly to 617,250 from 616,750 in the prior week.
Continuing claims, those on jobless benefits for more than a week, rose 29,000 to 6.738 million -- still down from the peak of 6.835 million hit a couple of weeks back, but very elevated. This shows that firms are not adding jobs, which should not be surprising as businesses want to see sustained gains in demand before doing so. This process may even take longer than normal as firms are very eager for their cost-cutting measures to flow through to the bottom line. First we must see some economic growth occur, which has yet to manifest itself.
Remember, last week was the first time continuing claims halted its record-setting run in 19 weeks. Some viewed this as a sign the labor market was on the cusp of bouncing back, but like commentary on a number of economic data releases of late, people get prematurely excited. We must see a trend emerge before making such calls, a multi-week move. In addition, we mentioned that last week’s decline in continuing claims may have been more a function of jobless benefits running out than one of laid-off workers finding employment – the exhaustion rate pretty much confirms this view.
Digressing for a moment, this development in the exhaustion rate does not bode well for credit-card delinquency rates, which will continue to be a challenge for the banking sector and consumer activity in general. Don’t be surprised to see the federal government extend, again, the duration of jobless benefits. Egad! This does nothing for economic growth. Sure, it calms the downside at the margin. But please, we need big bang pro-growth policies. An agenda that drive the tax rates on income, capital and corporate profits lower. A policy that increases current-year write-off allowance and the depreciation firms can record in the year of an equipment purchase – this jolts small business activity. These are the things that can get an economy flowing again. For now, however, we’re going to use government spending as the tool to revive growth – we’ll see how that turns out.

The insured unemployment rate, the jobless rate for those eligible for benefits, held at 5.0% for a second straight week. This is good news as the historic data shows the overall unemployment rate tops out within a year of the insured peak being reached.


Have a great day!


Brent Vondera

Daily Insight

U.S. stocks ended mixed again yesterday as the S&P 500 and NASDAQ Composite closed to the plus side, while the Dow was held back by Boeing shares for a second-straight session.

The broad market began the day nicely higher after the OECD (Organization for Economic Cooperation and Development) raised its forecast for global growth – the battle among the organizational basket cases is on, recall how it was just two days ago in which the World Bank lowered its forecast. Stocks also got a boost from a much better-than-expected durable goods orders report; however, the broad market pared those gains as traders had time to consider the internals of that report and lost additional momentum after the Federal Open Market Committee’s (FOMC) statement was released. (The FOMC is the monetary policy setting committee of the Federal Reserve System)

Tech, financial and basic material shares led the market higher and in fact all 10 major industry groups closed higher on the day.

Some 1.04 billion shares traded on the NYSE Composite, 25% below the three-month average. Activity has been subdued for about a month now, which illustrates a lack of conviction. Two stocks rose for every one that fell on the Big Board.

Market Activity for June 24, 2009
Durable Goods Orders

The Commerce Department reported that durable orders rose 1.8% in May (easily surpassing the estimate that had orders declining by 0.9%), which matched the 1.8% increase for April – that reading was revised slightly lower, initially reported as a 1.9% increase when the data was released last month. This marks the first back-to-back gain for durable goods in nearly a year.

The ex-transportation number rose 1.1%, following a 0.4% rise in April – this ex-transportation reading is important because very volatile commercial aircraft orders have a propensity to skew the overall reading. Commercial aircraft orders jumped 68% last month, which followed a 1.4% decline in April.

Driving the ex-trans figure was a 7.7% increase in machinery orders and a 2.2% rise in computer/electronics orders. This is very goods news but we need more than a one month move in these key components, a trend must present itself before we get too excited. Machinery orders have gotten thumped over the past year, down 28%; computer/electronic orders are down 12% since May 2008.

Conversely, the drags came from vehicles and parts, down 8.1% (but no surprise there), a 1.1% drop in electrical equipment and a 2.5% decline in fabricated metals.

Shipments of durable goods fell 2.1% in May, and since this is the component of the report that flows into GDP, we won’t see much help from this data for the second-quarter growth reading unless the June figure is up big. However, these back-to-back increases in orders means shipments will rise in the ensuing months, which will help deliver the first positive GDP reading in a year by the time the third-quarter growth number is reported. That has been our estimate, a mild GDP increase in the third, followed by a more substantial level of economic growth by Q4.

The most important component of this data is non-defense capital goods ex-aircraft orders (the proxy for business spending), which jumped 4.8% after a 2.9% decline in April – this figure is down 23.1% from the year-ago period but the three-month annualized decline has improved nicely, down 13.5% vs. -30.5% in last month’s report.


This really remains the big issue, will business spending begin to trend upward. I have my doubts simply based of the way fiscal policy is going. The government is in the process of massive deficit spending (the 2009 fiscal budget will record a shortfall of 12-15% as a percentage of GDP, that’s more than double the previous post-WWII record and four-five times the long-term average of 3%). Firms know what normally follows big deficit spending, and that is higher tax rates. They understand this with ultimate clarity today as the current majority constantly talks about increasing taxes on income, capital and business profits. As a result, firms worry about future growth and may decide to hold off on purchases; the recent earnings report out of Oracle is the latest example of this phenomenon.

Firms need confidence right now and to deliver it, policy makers should be implementing an aggressive tax-rate strategy that drives current-year write-off allowances and bonus depreciation higher. This is one of the fastest ways to deliver a shot to business purchases and economic growth -- jobs will follow. Alas, this is not the direction the current majority will take. Instead, they believe massive government spending will drive aggregate demand --good luck with that -- and in so doing may actually cause the opposite to occur as firms delay purchases for fear higher tax rates will shut down a nascent recovery a couple of quarters out. It will be very important to watch if business spending can muster a sustained rebound, or we’re only to see occasionally monthly bounces off of depressed levels. This is a key watch area, I can’t emphasize that enough.

New Home Sales

The Commerce Department reported that new home sales fell 0.6% in May to 342,000 at an annual rate from 344,000 in April. This figure combines with yesterday’ previously-owned home sales data to show the housing sector remain very weak despite efforts that have driven mortgage rates lower and provided substantial tax credits to first-time buyers.
(There is simply nothing that can be done to revive housing until the labor market – absolutely the largest factor in such a large decision like financing the purchase of a home – regains its health. This is where the consensus has been wrong all along. How many times have you heard a pundit state that the economy is dependent upon a housing rebound. Wrong! We must first put in place the policies that drive private sector growth. The job creation that follows will revive the housing market.)

By region, the Northeast and Midwest saw new home purchases jump 28.6% and 18.6%, respectively. However, sales in the South (the region in which the most new-home sale activity takes place) fell 8.5%. On a non-seasonally adjusted basis, there were only 33,000 new homes sold in the U.S. last month – 3K in the Northeast, 5K in the Midwest, 17k in the South and 8K in the West.

The supply of new homes, relative to sales, barely budged and remains at a very elevated level of 10.2 months worth.

However, the number of homes for sales (not adjusted to the depressed sales rate) has nearly been cut in half over the past 2 ½ years. When sales do bounce the inventory-to-sales ratio (months worth of supply) will fall in quick order, but this rebound in sales will have to wait for the labor market to come around.

FOMC

Well, Monday we touched on how the question regarding the FOMC meeting was whether the members would decide to ratchet up their quantitative easing strategy (by increasing the purchases of Treasury and mortgage-backed securities) as way to keep rates from rising, or go the tamer route of merely attempting to talk down nascent inflation concerns. That question was answered yesterday afternoon as the FOMC chose talk over action. At least for now, I think if rates begin to jump again in the near term they may choose action again.

The Fed stated, “[t]he prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”

Not surprisingly, they stuck to this Keynesian model in the downplaying of the inflation threat. And for sure, it doesn’t take much to downplay inflation right now as the price gauges are extremely benign. The issues that some have is with commodity prices on the march, higher prices among other early-stage inputs and a declining dollar (which makes imports more expensive and will drive commodity prices higher if the trend continues) all point to trouble down the road.

In addition, if the Fed is not on top of these things, and relies on their typical signals, such as the unemployment rate, they will be slow to meet the inflation issue head on. Unemployment is a massively lagging indicator and if they continue to watch this figure as their main beacon they may find trouble as they have injected unprecedented levels of money into the system – once credit begins to flow, the money multiplier will take off and there will be no stopping a harmful rise in prices. If this occurs, an austere level of monetary tightening will be necessary, thus shutting down the economy – and that is my concern over the next 18-24 months.

All of this said, of course the Fed was not going to raise rates or enter into the so-called exit strategy just yet, but some stronger words would have been a nice balance. The only bone they threw to those concerned about future inflation was to drop the deflation risk comments in the prior meeting’s statement.

The rest of the text was pretty much unchanged:

• The bond purchases program remain the same, and will occur along the same timeline.
• The pace of economic contraction is slowing.
• Household spending shows further signs of stabilization
• Exceptionally low levels of the federal funds rate is warranted for an extended period
  

Have a great day!


Brent Vondera

Post FOMC

Bernanke and Company did a quick copy/paste job with the comments from April’s meeting this time around as it appears that both the environment and the way that the Fed plans to improve it will remain unchanged “for an extended period”.

There were no real surprises in the statements. The recent glimmers of hope in the housing market were dismissed by the committee sighting “ongoing job losses, lower housing wealth, and tight credit.” Although the Fed catches some flak from time to time for concentrating too much on unemployment, a lagging indicator, their concerns here are pretty accurate.

On the inflation front – “The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.” This also follows what we have been writing here on the Acropoblog.

Also as expected, the Fed’s securities purchases will be left unchanged.

Cliff J. Reynolds Jr., Junior Analyst

Quick Hits

• Fed Statements: Side-by-Side
• Has Apple won the smart-phone wars?
• Home-Price Recovery in U.S. May Be Undermined by Appraisals

Monsanto misses revenue estimates on weaker Roundup sales

Monsanto (MON) reported earnings that topped estimates, but revenues fell short of expectations and the company recorded negative free cash flow.

Total revenues fell 11 percent on weak sales of the company’s branded glyphosate herbicide, Roundup, which were partially offset by strong sales in the core seed and trait franchise. Roundup sales and gross profit (revenues less cost of goods sold) plunged 47% and 54%, respectively, as massive amounts of generic brands flooded the market.

According to Monsanto’s estimates, generic inventories will finish the year at a level equal to 40% of next year’s consumption, which has put extreme pricing pressure on both generic and branded products. Adding fuel to the fire, distributors are slashing prices in order to move this heap of inventory and generate cash.

Despite branded competitors’ price concessions, Monsanto has stubbornly kept Roundup prices unchanged. As a result, Monsanto estimates the price spread between Roundup and its primary competitors on a gallon basis has widened from roughly $2 in September 2008 to about $10. This premium can’t possibly be sustainable on a long-term basis and I expect Monsanto will ultimately lower Roundup prices.

On a brighter note, the seed and genomics franchise continues to deliver and recorded nice gains in market share and trait penetration. Seed and genomics gross profit has grown 22% year-to-date versus 2008, with corn seeds still the biggest driver expanding gross profit by 21% year-to-date. Monsanto expects high-single digit percentage price increases for its existing seeds, and additional pricing gains through further trait penetration.

Despite near-term concerns about Roundup, there is little reason to believe that the seed business won’t continue its break-neck growth and ultimately increase the bottom line. Agricultural productivity is a political priority in most major economies, which is driving policy that encourages better and more intensive agricultural practices.

Genetically modified seed is already the standard in corn and soy in the U.S., while Brazil and Argentina are driving a new wave of growth. Don’t be surprised if China, Russia, and Eastern Europe provide the next wave.
Monsanto is currently down 4%.

--

Peter J. Lazaroff

Today - Pre FOMC

The market is a bit confused this morning as it continues to digest some conflicting information. The Organization for Economic Cooperation and Development (OECD) revised upwards its previous forecast for the combined GDP of its member states. The previous forecast made in March was for contractions of 4.3% in 2009 and .1% in 2010, both revised up today to -4.1% and +.7% respectively. This comes just one day after The World Bank revised their forecast for global GDP downward to -2.9% in 2009, from -1.7% in March. The scale of these predictions is obviously way too large to be accurate, but I just use it as an example of the contradicting information the market is dealing with in this environment.

Which brings us to what lies ahead for today. A strong Durable Goods number lead by better than expected increases in new orders for machinery and capital goods (up 7.7% and 9.5% MoM respectively) is helping futures higher pre-market, but most of the market is carefully awaiting the statement from the Federal Open Market Committee (FOMC) that is expected to maintain a 0-.25% target for Fed-Funds (the rate used for overnight lending between banks).

The real question lies in what kind of guidance they choose to give on their open market operations, namely their large scale quantitative easing campaign that they injected with steroids in March. The numbers are already huge, ($1.25 trillion in agency MBS, $300 billion in Treasuries and $200 billion in agency debentures) but some think that increasing them is not completely out of the question. Consider the effects that would have on the market. The market is forward looking, not always 20/20 but undoubtedly concerned about the future. Let say the Fed triples their Treasury purchases to $1 trillion in an attempt to lower long term rates to help worthy corporate borrowers who would benefit from lower long term rate to finance expansion. There are two quick problems with that scenario. First, the market has chilled out considerably on the inflation front in the past 3 weeks or so, but boosting quantitative easing will only renew those fears in my opinion, and along with increased inflation concerns comes higher long term rates. Result… the Fed fails to manage the long end of the curve and has only succeded in funding our Nation’s irresponsible deficit. Second, rates are already very low, sure they have run up since the beginning of this year, but mortgages are at 5.5% and a company who is rated one notch above junk can borrow for 10 years at roughly 7.5%. (HT Brent Vondera) That is far from a contractionary interest rate environment. The Fed has eased enough here in my view.

Instead of increasing the size of the total purchases, I believe the Fed if anything is more likely to slice up the pieces a little differently. Take some money away from MBS and put it towards Treasuries, and concentrate on moving the risk free curve instead of individual markets. That’s my prediction, now we just sit and wait for 2:15 ET.

Cliff J. Reynolds Jr., Junior Analyst

Daily Insight

U.S. stocks ended mixed on Tuesday as the S&P 500 managed a decent gain, able to fight off several moves into negative territory; however, the Dow and NASDAQ Composite failed to close in positive territory as tech shares led the latter lower and a 6.5% decline in Boeing shares weighed on the Dow average. Shares of Boeing subtracted 22 Dow points from that index, it would have been nicely positive otherwise.

The broad market came under pressure during the morning session after the latest housing market report showed activity remains very weak despite a number of policy decisions that were meant to offset a troubled environment for the consumer. But financial, basic material and telecom shares helped propel the S&P 500 to the plus side by the close.

Consumer discretionary shares were among the worst performing sectors after memory-chip designer Rambus Inc. reduced its second-quarter revenue forecast, citing weak demand for consumer electronics. This news certainly didn’t help tech shares either.


Market Activity for June 23, 2009
Credit Spreads

There has been a lot of talk about the narrowing of credit spreads – the difference between Treasury yields (known as the risk-free rate) and the yields on variously rated corporate bonds. This is normally a key signal regarding financial market improvement and that economic growth prospects have increased. Like so many things in this environment, however, we need to be careful as the normal green lights may be malfunctioning as the Fed’s very aggressive easing campaign, which has sent interest rates very low, has a way of causing investors to misprice risk.

Corporate spreads have certainly narrowed, no arguing that, but it’s tough to tell whether this has occurred because the market believes earnings will rebound in strong fashion (hence default risk has eased substantially) or because investors have pushed corporate bond prices higher as they hunt for yield in this very low interest rate environment. Too be sure, one should also acknowledge that spreads remain at levels seen during the typical recessionary environment. Like so many economic indicators today, what we’re seeing may not be an all-clear signal but simply a move from economic armageddon to something that more closely resembles a normal downturn scenario.

BBB Rated Spread over the 10-Year Treasury

A repeating theme of this letter over the past couple of months has been that of caution. I just want people to be aware of how things look, not only relative to the deep contraction scenario of the previous several months, but to past economic downturns. When we compare the data to past contractions it tells us that we have moved to an environment of normal recession (from the worst since at least the 1957-58 contraction) rather than to a situation in which the business cycle is poised to expand with vigor.

Existing Home Sales

Well, I tried to offer some optimism over the past few days, estimating that previously owned home sales would blow by very low expectations, but it was not the case. A 6.7% rise in the latest pending home sales data sure seemed to suggest a bounce would take place, but the credit markets remain relatively fragile and some of these mortgage contracts may not be making it to the close. In addition, fixed mortgage rates spent the month of May below the 5.00% level, and May is one of the top three sales months of the year; combine that with the tax credit of $8,000 for first-time home borrowers and if these factors couldn’t produce a larger bounce you’re not going to get it until the largest factor of them all – the job market – improves markedly.

But getting to the data, the National Association of Realtors reported that existing home sales rose 2.4% in May to 4.77 million units at an annual rate – and that was from a downwardly revised level for April. The market expected sales to rise 3% from the higher initial April reading. Even the lower-than-expected reading was boosted by a 6.1% rise in multi-family units (co-ops and condos), single-family units rose just 1.9%.

As you may remember, we’ve been gauging single-family units against the December reading (the 12-year low put in place in January was largely due to worse-than-normal weather, which skewed the bounce back in February, so that December reading is the level with which I think makes most sense to gauge things instead of simply using the previous month). Single-family units came in smack dab at that 4.25 million annual rate hit in December. So, we have yet to get past that reading to this point and while it sure appears that the housing market has bottomed we have yet to bounce off of the weather-adjusted depressed levels.

The supply of previously-owned homes (relative to the rate of sales) remains elevated at 9.0 months worth. This is down nicely from the peak of 11.0 months worth hit a year ago but needs to come down to 6-7 months worth before the residential market will begin adding to GDP again.

The median price on existing homes rose 4% last month to $172,900 after hitting $166,000 in April -- the multi-year low of $164,200 was put in in January. From a year-ago perspective, the median price for existing homes is down 17%.


Richmond Fed

The latest reading out of the Richmond Federal Reserve Bank’s manufacturing gauge continued to show nice improvement in June. The Richmond Fed index rose to 6 in June from a reading of 4 for May – a reading above zero marks expansion, unlike the nationwide ISM index and the Chicago manufacturing report in which 50 is the dividing line between expansion and contraction.

The sub-indices of the report also registered very positive results, as the new orders index jumped to 16 from 10; order backlog rose to 8 from -3; and the average workweek rose to 8 from 5.

However, respondent expectations for these readings over the next six months weakened a bit, which offset some of the aforementioned positives.

All in all, this is not a closely watched reading as the Richmond Fed index is one of the smaller regional factory reports. Still, I thought it was worthwhile to touch on the results as we’ll take every positive reading we can get.

The big ones are Chicago (the largest and most watched regional factory report) and ISM (the nationwide factory index), both of which will be released at the end of the month. The other regional surveys we received thus far for June had pretty much offset one another -- New York factory activity fell, while Philly-area manufacturing rose -- and that is why Chicago and ISM are immensely important right now. (Note: it will not take a move to expansion on Chicago to be considered a good number as everyone understands auto-industry woes will weigh on the figure. If it can manage a rise to the low 40s (the May reading fell back to 34.9) and we can get ISM back to 45 it will be very helpful for stocks.

Have a great day!


Brent Vondera

Quick Hits

• Bernanke Prepares to Defend Record as Debate Over His Reappointment Begins