CPI and PPI biases

As I mentioned in the most recent Portfolio Insights article titled “Inflation FAQs,” there are a few problems with the Consumer Price Index (CPI) and Producer Price Index (PPI) as inflation gauges.

CPI has an upward bias that is estimated to overstate inflation by about 1 percentage point per year. This can be particularly problematic for employment contracts with cost-of-living adjustments based on CPI as well as for a substantial portion of government spending, such as entitlement payments, which automatically increase with CPI.

The most commonly cited biases that tend to overstate the CPI include:

• New goods. New products that replace existing products are often more expensive at first. This biases the index because some of the newly-available goods perform the same function as different lower-priced goods in the base-year market basket.
• Quality changes. If the price of a product increases because the product has improved, the price increase is not due to inflation, but still causes an increase in the price index.
• Substitution effect. Inflation or not, prices of goods relative to each other are always changing. When two goods are substitutes for each other, consumers increase their purchase of the relatively cheaper good and buy less of the relatively more expensive good. Over time, such changes can make the CPI’s fixed basket of goods a less accurate measure of typical household spending. The chained CPI, however, does adjust to the substitution effect in a timely manner as the basket of goods is “chained.”
• Outlet substitution. When consumers shift their purchases toward discount outlets like Wal-Mart and away from convenience outlets like the neighborhood grocer, they reduce their cost of living in a way the CPI does not capture.
  

The biases to Producer Price Indexes (PPI) are not quite as extreme and not as important because firms can absorb costs and they don’t get passed on to the consumer. But for educational purposes, here are some of the minor shortfalls of PPI:

• Industry weightings. PPI uses relative weightings for different industries, but these weightings might not accurately represent their actual proportion to real gross domestic product (GDP). As a result, the weightings are adjusted every several years, but small differences still occur.
• Hedonic adjustments. PPI calculations involve an explicit “quality adjustment method,” called hedonic adjustments, to account for changes that occur in the quality and usefulness of products over time. These adjustments may not effectively separate out quality adjustments from price level changes as intended.
• Volatile elements. Energy and food often skew the data because they are so volatile. As a result, the removal of food and energy prices is almost implicit in most media releases. However, the long-term growth rates should not be ignored if these costs grow faster than the core PPI (or CPI) over time because consumers and eventually GDP will feel the pinch.

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Peter J. Lazaroff

Norfolk Southern (NSC) up on competitor's earnings

Norfolk Southern (NSC) jumped 3.5% today as CSX, the third-largest U.S. railroad, beat analysts’ profit estimates due primarily to cost cutting.

As expected among all of the railroads, CSX said the slump in coal shipments widened significantly, falling by 21% in the second quarter from 7% in the first quarter.

Coal is the biggest product category by volume at the four biggest U.S. railroads, which probably were hurt in the second quarter when tumbling natural-gas prices spurred electric utilities to switch fuels. Also impacting coal volumes is reduced coal exports due to lower steel production Europe. Coal volumes have a significant impact since haling coal is a very profitable business for the rails.

CSX expects the coal volume to moderate a bit in the third quarter, but would not predict the trend will improve. Also interesting was that CSX said it has seen “some compression” in prices on new business where the railroad competes with truck and barge transport.

Norfolk Southern is expected to see a 47% drop in earnings from a year ago, according to a Bloomberg analyst survey. I would expect Norfolk to cite similar coal volume declines and it will be interesting to see if they needed to make any price concessions on new business.
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Peter J. Lazaroff

Dell (DELL) warns of lower profit margins

Dell (DELL) shares are off more than 7% after announcing yesterday that “higher component costs, a competitive pricing environment, and an unfavorable mix of product and business-segment demand” will eat away at its profit margins for its current quarter ending July 31.

On the bright side, Dell did suggest that computer sales may be stabilizing after declining for more than 20 months and they expect a “slight” sequential increase in the current quarter. Still, the comments spooked investors, whose high expectations for technology companies have helped the sector outpace the broad market since the March 9 bottom.

The technology sector benefits from the idea that businesses spend first on technology improvements, which tend to increase efficiency and productivity. Thus, technology improvements allow companies to produce more with fewer workers, which lead to lower costs and expanded margins. Even more, technology companies sport pristine balance sheets, which is especially attractive in this tight credit environment.

It’s true that PC sales have dropped during the recession as consumers have shifted to cheaper netbooks in favor of the more traditional (and more expensive) notebooks and desktops. Not only do netbooks sell for less, but they have smaller profit margins. However, gauging the sector’s health by these statements from Dell’s may be a bit premature, especially when bellwethers like Intel and IBM report earnings later this week.

As for Dell, the company issued longer-term guidance of 5% to 7% annual sales growth and operating margins above 7%. However, these targets have no time-frame and are dependent on a market recovery including higher worldwide IT spending and a sustained double-digit growth rate in demand for computer systems.
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Peter J. Lazaroff

Johnson & Johnson (JNJ) reports earnings

Johnson & Johnson (JNJ) reported sales and profits that topped expectations and reaffirmed its full-year 2009 guidance. The maker of thousands of healthcare products announced sales decreased 7.4% compared to a year ago, hurt by the stronger U.S. dollar (the negative impact of currency was 6%) and patent expirations.

Drug-patent expirations of migraine treatment Topamax, mood-stabilizer Risperdal, and (to a lesser extent) mild Alzheimer’s treatment Razadyne were the main cause for the 8.5% operational sales decline in the Pharmaceutical segment. Excluding the impact of generic competition on these products, the pharmaceutical segment’s operational sales growth was approximately 9%. Despite patent-expirations and less investment in R&D, J&J’s massive pipeline is near the top of the industry in terms of quality and depth, which should give investors reason to be optimistic for the Pharmaceutical segment.

Meanwhile, Consumer segment operational sales grew 3.1% primarily due to strong results from skincare, driven by new product launches, and oral care, driven by strong growth in sales of Listerine mouthwash. Over-the-counter pharmaceuticals and nutritional products struggled as competitive pressures from private labels impacted growth in this category.

The Medical Device and Diagnostics segment posted operational sales growth of 3% as strong sales in the orthopedics and surgery units offset weakness in the drug-eluting stents unit. Also weighing on the segment were the vision and diabetes units, which typically require out-of-pocket expenditure for items like contact lenses and diabetes strips.

COGS was 30 basis points higher due to unfavorable mix in the pharmaceutical business, but SG&A expenses were down 200 basis points driven by leverage across the businesses. Pretax operating margins improved, which was expected for 2009 when J&J provided annual guidance in January.

All and all, the company remains in solid condition. J&J’s ongoing acquisition program, expansion opportunities in emerging markets, and its promising late-stage pharmaceutical pipeline are the three main catalysts for the company’s longer-term earnings growth prospects.

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Peter J. Lazaroff

Fixed Income Recap

Treasuries sold off yesterday on light volume as many market participants remained sidelined, waiting for earnings season to get going. Treasuries hovered around unchanged for most of the day, even as stocks were up 1%, but the bottom fell out of bonds as stocks accelerated higher to close up 2.5%.

CIT Group, one of the nation’s largest commercial lenders and a receiver of TARP funds, obtained the services of a bankruptcy lawyer over the weekend raising some concerns over the company’s ability to refinance their $2.5 billion in debt coming due this year. They have applied to issue debt under the Temporary Liquidity Guarantee Program (TLGP), which could be their only shot at survival, but have yet to hear from the government on whether they qualify. The WSJ is reporting this morning that CIT Group, which gained bank holding company status in 2008, is currently discussing their options with regulators.

Many are saying that it is unclear how broad of a threat CIT poses to the broad financial market. The rhetoric sounds far too much like Lehman Brothers in early September, and we all know how that turned out. The market cannot stomach a bankruptcy of this magnitude in my opinion. For a company like CIT to be denied TLGP, a program that was designed solely to help banks refinance their debt, confuses me, considering that is their exact problem. Whether the solution is a FDIC brokered sale of CIT to a larger institution that can take on the balance sheet or just allowing CIT to issue FDIC insured debt through the TLGP, the sooner it is resolved the better. The credit markets are functioning, but are still very fragile. Letting CIT enter bankruptcy would be like taking the stitches out before the wound is fully healed.

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks rallied, getting the workweek started on a very nice note after four weeks of losses, as bank, basic material and industrial shares fueled the bounce. Positive analyst recommendations on Goldman Sachs and Best Buy helped kick start investor enthusiasm.

That call on Goldman came from Meredith Whitney, probably the biggest name among bank analysts behind only Dick Bove – nothing like an upgrade after a 90% upshot in the stock in a matter of four months. For Best Buy, I wouldn’t count on anything special. We saw the retailers results for the first quarter: total sales down 15% and same-store comps down 6.2% -- and that was with bankrupt Circuit City out of the game; I don’t see results reversing course anytime soon.

I’m not trying to be overly pessimistic here, just rational. For goodness sakes, sure banks will have a couple of big quarters with the Treasury yield curve positively sloped to a massive degree (the curve has narrowed from the record spread between 2s and 10s hit in June but remains very wide), but I think of Sisyphus when contemplating the banking sector – that rock will come rolling back down as commercial real estate and consumer loans and credit cards bedevil the industry for some time to come. On Goldman, everyone knows they’ll knock the cover off of the ball for another couple of quarters, my six year-old knows that. Heck, their profits tied to massive government issuance (specifically Buy America Bonds) and corporate debt issuance related to maturity rolls will fuel results. But this is kind of what the run from $70 to $150 is about.

Volume was weak as just 1.1 billion shares traded on the NYSE Composite, 26% below the three-month average.

Market Activity for July 13, 2009

The Dollar

We like to talk about the old greenback on occasion as one keeps a watchful eye on its value against other currencies. In a time of exploding debt issuance and lower after-tax return expectations you’ve got to think U.S. dollar will have to fight to remain above the recent lows we saw back in June.

For now, the safety trade has made a return – even yesterday on a strong positive session for stocks the long-end of the Treasury market rallied – and the greenback has found some support right around $80 on the Dollar Index. Let’s hope we engage in some policy changes to keep the currency from falling too much, but it is pretty unlikely as $3 trillion in government debt will occur this year and another $2 trillion at least next year. That’s a lot for the debt market to absorb and even though foreign government will not be able to sell the dollar en masse, it’s going to be a tough road for old green. An aggressive reduction in capital gains tax rates (boosting after-tax return expectations and thus dollar demand) could go a long way in mitigating pressure in my view, but that sort of thing is anathema to the current leadership.

Stimulus, the Economy and Patience

There has been a lot of talk recently about the stimulus plan not working. While I in no way agree with the track the administration and Congress have taken in their attempt to boost economic activity let’s be clear that less than 10% of the planned spending has occurred to this point. For all that was said about “shovel-ready” projects, that was just political speak. The appropriations process (as we talked about early this year) makes quick results impossible. Further, most of the money is not spent until 2010 and even the planned spending for 2011 is more than what will be injected during 2009 – that is by design too, we’ve got mid-term elections next year and of course the next presidential race in 2012.

There is little doubt the $787 billion (look let’s call it a trillion for now because that’s what it will end up being) will have an ameliorative effect on GDP. When you throw a trillion dollars into a $14 trillion economy you will have a positive short-term effect – even if muted. However, while this spending will calm such aspects of the economy such as job losses (you’ll have construction and manufacturing firms refrain from laying off workers as they land construction contracts) it only delays the inevitable. We may not see the unemployment rate peak until 2011. I know this sounds shocking but it’s a real possibility.

My expectation has been for the jobless rate to peak somewhere near 10.5% in early 2010, but I’m beginning to think this view needs to be reassessed as we may see the rate begin to flat line at the end of 2009 only to climb again by 2011. Government can’t keep this spending going for long and the massive deficits, higher tax rates (and have you seen the surcharge to income-tax rates many in Congress are pushing?) and the potential for higher interest rates in the not-too-distant future combine to whack economic activity. Anyone who believes that government can boost aggregate demand or that this level of spending (and the more austere tax-rate environment that ensues) doesn’t cause businesses to hold back due to caution is kidding themselves I’m afraid.

What’s more, we have another hike in the minimum wage coming later this month. This will have a disemployment effect on low-skilled labor, which will also shows up in joblessness over time – as the WSJ editorial board states, “those who never get a job in the first place get a minimum wage of zero.” Businesses that have a low-skilled component within their labor force will likely choose to get more work out of existing employees to counter this mandatory increase in wages.

I bring this all up to extend upon a theme of the past month – the investor needs to be careful, don’t let emotions drive you to improperly assess risk merely for the objective of attempting to make up for prior losses, or hunt for yield as the government holds interest rates lower than they otherwise may be.

Policymakers are in the process of prolonging the economic stagnation, but the spending will offer some short-term bounce first. It is then that expectations could begin to run ahead of the realities. Again, investors must pick their spots in this environment. Don’t get sucked into thinking you’re missing out when stock prices move to the high-end of this trading range, you’ve got to have discipline and patience and buy on the meaningful pullbacks – do not chase rallies! We could witness several moves to and from the high-end of this range for a couple of years – have that expectation and you’ll mitigate the damage emotions and performance chasing can do.

Monthly Budget Statement

The Treasury Department reported the fiscal deficit topped the $1 trillion mark for the first, as we’ve blown past the previous nominal-dollar record hit in the 2004 fiscal year. I recall that year vividly as the deficit was all the rage within the financial press – that shortfall was $459 billion. The shortfall for June broke a record for that month as well, coming in at -$94.3 billion (and that’s with $70 billion in TARP pay backs in June) – a month that almost always shows a surplus. We’re up to $1.1 trillion and counting so far this fiscal year, on course for a deficit-to-GDP ratio of 12% -- twice the post-WWII era record of 5.6% hit in 1983.
Corporate and individual tax receipts are off big time, down 57% and 22% fiscal-year-to-date (FYTD), respectively. One wonders how deep the deficit-to-GDP ratio will go in 2010 when the bulk of stimulus spending begins to roll.

Social security outlays led the way on the spending side, up 11% FYTD to $511 billion. Defense spending, one of the few aspects of the budget that was originally enumerated, rose 7.4% to $491 billion. Income security (yes, this is in addition to social security) jumped 17.5% to $403 billion. Medicare outlays increased 10.3% to $315 billion, just to name the big ones. Again, this is hardly sustainable and a certain degree of circumspection should be employed as the road to deal with the ramifications of this spending trajectory will likely be a rough one.


Have a great day!


Brent Vondera

GE trading higher

General Electric (GE) is trading about 6% higher with a few news items lifting sentiment.

GE Transportation announced today that GE’s Evolution Series locomotive has been commissioned and officially released to Egyptian National Railways (ENR) at the end of June. GE’s Evolution Series is the most technologically advanced diesel electric, heavy-haul locomotive in the world. Best-in-class fuel efficiency, higher pulling capability with less wheel slippage, and measurably higher reliability and lower maintenance costs are just a few of the reasons GE’s Evolution Series locomotives are in demand.

The Evolution Series is a global locomotive platform that has had nice success since GE delivered the first 300 locomotives to the Ministry of Railways in China. Other significant orders include forty heavy-haul Evolution Series locomotives to Rio Tinto Iron Ore and Zazakhstan’s 310 locomotive orders.

GE Energy, meanwhile, said in this Bloomberg article that their microgrid power system could pay for itself in four-years.

This is just a small example of what I have harped on in the past (See March 3, March 19, July 7) -- GE’s industrial businesses have tremendous upside because of the demand from developed and emerging nations for their technologically-advanced products. And it's the industrial businesses that will make pay off for the patient, long-term investor.

Also lifting sentiment was reports that Universal Pictures’ Bruno opened a the top film at theaters in the U.S. and Canada over the weekend with the $30.4 million in ticket sales for distributer NBC Universal. Sales should provide a boost to Universal Pictures, which ranked last among the six major studios in 2009 ticket sales with $604.3 million as of July 9.

Adding fuel to GE’s surge was analyst Meredith Whitney’s upgrade of Goldman Sachs, which helped lift sentiment for financials, including GE Capital. This is slightly odd that other financials would benefit because Whitney thesis isn't an improving economy, but rather the weaker economy will boost Goldman who will play a key role in the “tsunami of debt issuance from federal, state and local governments ramping up debt issuance to fund woefully underfunded budget gaps."

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Peter J. Lazaroff

Expeditors International of Washington (EXPD)

Expeditors International of Washington (EXPD) is trading nearly 6% lower after the third-party logistics firm said second quarter earnings would be 24 cents to 26 cents a share, less than the average estimate of 30 cents a share.

Like most companies related to freight transportation, Expeditors’ performance has been hurt by a steep drop in production across a range of sectors. Encouragingly, the firm noted that volumes improved in late June, but it will be important to see if the company maintained its industry leading profitability. During the first quarter of 2009, Expeditors managed to produce $164 million of free cash flow – a whopping 18% of revenues – despite challenging conditions.

Expeditors’ low-cost business model is behind the firm’s ability to generate strong returns on invested capital (ROIC) of over 30% during the last five years. Expeditors also benefits from a network effect, in which each node in the network becomes more valuable when the firm adds more nodes. As the system grows, shippers gain the ability to ship efficiently to even greater locations.

This network effect along with other competitive advantages like economies of scale and pricing power have historically awarded Expeditor’s a premium. During the past decade, Expeditors traded at rich P/E multiples ranging from 32 to 40. Today, Expeditors’ forward P/E is about 23.

This may not be an absolute bottom, but the low multiples suggest this could represent an opportunity for patient investors.

Click here to read more about Expeditors’ core business and strengths from my March 18 post.
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Peter J. Lazaroff

Daily Insight

Most U.S. stocks closed lower on Friday but a good relative performance among technology shares resulted in a mixed session for the major indices. We’ve seen a number of mixed results lately; on Friday it was the Dow and S&P 500 losing some ground, while the NASDAQ Composite added a few points.

A lower consumer sentiment reading and weak import data both put the screws to those holding out for a bounce in consumer activity. Another decline in oil prices pressured energy shares, which held the Dow average back as Chevron and Exxon subtracted 20 points from that index.

The broad market has declined for four weeks now, the longest stretch since we’ve rebounded from the lows of early March. We’ve now backed off of the recent highs by 7%, something that should not have been unexpected after the substantial run from those March lows – the investor should be prepared for an additional pullback.

It is quite usual to see at least a 15% retracement in these trading-range environments and one needs to be cautious and pick their spots. No one knows how people will react to a 15% pullback (if we get it) after the shock they endured on the way to the notorious low of 666. If they fear another move to those levels they may just throw in the towel and make the move lower a severe retracement rather than a more moderate correction. (I’m not saying such a move would be justified, just explaining that this is a concern of mine)

Market Activity for July 10, 2009
The Economic Data Front

Overall Friday’s economic releases were not particularly good. The trade data was reported with a lean to the positive side because some of the export numbers were encouraging, but the import side remained very weak and was just another reminder of the depressed nature of consumer activity. The latest confidence reading, if one is to give these surveys a meaningful degree of credence, suggested we’re not ready to see the consumer bounce back just yet.

Import Prices

The Labor Department reported that import prices jumped 3.2% for June and marked the fourth month of increase. While the year-over-year reading continues to post deep negative readings, that will all change by the fall when the comparisons are no longer against the commodity-price spike of last summer.

A 20% increase in petroleum-product prices led the import data to its large gain last month. This got all the news as the financial press suggested that without this run up in petro prices the data would not be on this trajectory. However, a closer look at the data shows that industrial supply prices are on a run, bouncing a huge 10.3% in June and up 64% at an annual rate over the past four readings. Now, this increase has occurred off of large multi-month declines that ran September 2008- January 2009 but the trend is disturbing nonetheless.

On an overall basis import prices are up 18% at an annual rate since March and this is something to watch especially if the dollar weakens – such a scenario will have an even larger effect on import prices as a weaker domestic currency obviously makes imports more expensive.

This trend within some of the inflation gauges, and the pretty high potential for another spike in commodity prices, could spell trouble for corporate profits a few quarters down the road. I think we’ve got a shot at a 2-3 quarter run of high-powered profit results (a couple of quarters out from this point) but higher commodity prices (which is one aspect having an effect on industrial supply costs) could result in a significant margin squeeze quickly thereafter. This will either show up in softer bottom line growth or firms will simply hold off on adding to payrolls for an extended period. Neither issue is a good one.

Trade Deficit

The Commerce Department reported the trade deficit narrowed 9.8% in May to the lowest level in nearly a decade. Exports rose 1.6% (and would have been stronger if not for a 7.6% decline in auto exports) and imports fell 0.6%.

Exports were driven by better results out of Asia , something we’ve talked about a few times now and touched on again in Friday’s letter, as Chinese stimulus spending boosts activity in the entire region. Exports to the Pacific Rim rose 7.3% -- up 10.3% to Japan, up 8.9% to the NICs (newly industrialized countries), and a big 19.4% to Australia. (This is where China gets most of it imports and areas such as Japan the NICs and the Aussies get many of their machinery and industrial goods from the U.S.)

The import numbers illustrate U.S. consumer (and business) activity remains in the dirt, down 31.3% on a year-over-year basis. The monthly number of -0.6% was even worse when you adjust for the price increases – real $ imports fell 2.1% in May, which follows a large 3.0% decline for April.

University of Michigan Consumer Sentiment

As many readers know, there are two major confidence measures. The most watched reading remains the Consumer Confidence survey out of the Conference Board (an independent research organization), but this U. of M. number gets decent attention as well and it showed a decline in June that moved the level back below where it stood in April – the month when we really began to see improvement from the two-decade lows.

The U. of M. survey came in at 64.6 in June after hitting 70.8 in May. Too many people had assumed that consumer activity would make a sustained comeback simply because of better readings of the previous couple of months. This was a misguided view as the fragility of the labor market will keep a lid on consumer sentiment – this move back down should not be a surprise. It will take a full year, at least, for the consumer to get his/her bearings as a weak labor market combines with the reverse wealth effect via the plunge in stock and home prices.



Have a great day!


Brent Vondera

Fixed Income Recap

Treasuries ended a strong week with another rally that flattened the curve seven basis points for the day. Looking back, the market as a whole handled the supply relatively well considering the record four days of issuance.

We have a much more active economic calendar this week compared to last, dominated by June CPI and the Empire Manufacturing Survey for the month of July on Wednesday, and Housing Starts for the month on June on Friday. Although from a technical perspective Treasuries look rich, any weakness in the economic data this week could force yields even lower, especially with no supply scheduled for the next two weeks.

Cliff J. Reynolds Jr.

July 2009 Portfolio Insights

Click here to read the latest issue of Portfolio Insights.


Inside you will find:

• Market of stocks is presenting some great opportunities
• Inflation and how it has affected us
• Inside the Economy
• Inflation FAQs
• Equity Markets Activity
• Fixed Income Strategy
• New at Acropolis
• Ask Acropolis
• The Big Picture

Daily Insight

U.S. stock indices ended higher on Thursday as the S&P 500 and NASDAQ Composite gained decent ground. The Dow average squeaked out a gain but was largely held back by shares of drug-makers JNJ, Merck and Pfizer.

Stocks began the session higher on news that Chinese auto sales surged 48% in June, another sign the country’s stimulus program has kicked overall economic activity higher (Chinese manufacturing has been in expansion mode for four months now). This has helped calm some concerns regarding global growth as the activity should help the entire Pacific Rim and may very well boost U.S. export activity, at least in the short term. By the end of the session, however, some of that momentum eased as the S&P 500 ended at about half of its intraday highpoint.

Basic material and energy stocks recouped some of the losses recorded over the prior four sessions, surely a result of that news out of China, and the financial sector was the best performer on the day after an analyst upgrade of Goldman Sachs pushed those shares higher.

Our own economic data releases offered little help as the latest look at same-store retail sales posted another big decline and continuing claims for unemployment benefits made a new high.

And speaking of jobless claims, I wouldn’t be surprised to see a boost in the duration of jobless benefits, again. Heck, many states have already extended benefits out to 46 weeks. Why not make it a full year? This is nuts and does nothing for future growth. Look, I know the whole countercyclical argument but enough is enough, this spending is going to end up weighing on the economy whenever it is a bounce does occur as Congress will jack up tax rates to pay for all of this.

Volume was weak with just 962 million shares traded on the NYSE Composite. Advancers just barely edged out decliners by a margin of nine-to-eight.

Market Activity for July 9, 2009
Jobless Claims

The Labor Department reported that initial jobless claims fell a large 52,000 in the week ended July 4 (keep that holiday in mind) to 565,000 from 617,000 in the week prior. This is the first move below the 600K level since January – a move we’ve been waiting for as evidence the labor market will markedly improve in the near future.

One only wishes it would have occurred during a full week – last week unemployment offices were open just four days due to the holiday as government offices were closed on Friday July 3. The seasonal adjustment on claims was also distorted due to the auto plant closings that occurred last month as a result of the bankruptcy filings of GM and Chrysler. Auto plants generally shut down in early July in order to retool for new models, but the claims that typically result were shifted to June due to auto-industry woes; this had an effect on the number, according to the Labor Department.

The four-week average of initial claims fell 10,000 to 606,000.
As evidence that the move in initial claims was due more to the holiday-shortened week and other distortions than an improvement within the labor market, continuing claims jumped 159,000 to set another new record at 6.883 million – this is unfortunate as claims had halted what was a 19-week march higher before easing in the prior three weeks.
The insured unemployment rate, the jobless rate for those eligible for benefits and a number that has historically tracked the direction of the overall unemployment rate, returned to 5.1% -- the figure has been wavering between 5.0% and 5.1% for several weeks now.
We’ll watch for next week’s data to get a better glimpse on initial claims, but it appears we’ll move back above that 600K level and the move may be abrupt as claims are likely pent up due to the office closings on July 3.

Wholesale Inventories

The Commerce Department reported that wholesale inventories fell less-than-expected in May, down 0.8% after an upwardly revised 1.3% decline for April. This gives us a sense of what next week’s business inventories number is going to post and since this latest look was pretty much in line with expectations the final Q1 GDP print will probably not be revised.

The sales data within the report posted a monthly increase of 0.2%; we’ve seen just two increases in merchant sales over the past 11 months. While it’s good to see a rise, and a trend higher is what we’re watching for, the May increase was completely due to higher energy prices as the ex-petro sales figure was down 0.3%.

We should see inventory rebuilding catalyze, even if it’s a mild boost, economic activity by the third quarter and when the ex-petro sales figure begins to rise…well, then we may be onto something.

Chain Store Sales

The International Council of Shopping Centers (ICSC) released it same-store sales survey yesterday and reported that year-over-year results fell 4.6% in May. This marks the eight month of decline. While the overall reading is tough to gauge now since Wal-Mart halted monthly guidance, and as a result was removed from the overall ICSC index (it accounted for a huge percentage of the survey), the report is still helpful in offering a view within the various segments of the report.

All segments of the report, save drug stores, saw same-store sales decline. This is actually a bit worse than the April figures as drug and discount stores posted an increase in sales as compared to the year-ago period. Discount stores saw sales drop 3.5%; apparel-store sales fell 5.0%; department-store sales plunged 9.4%; luxury-store sales got clocked again, falling 18.1% -- this segment has been in a world of hurt, posting at least a 17% year-over-year decline in sales each month going back to October.

Comparisons are going to get incredibly easy for retail chains as we head into the fall, and this might be what it takes to halt this string of monthly declines – we’ll need easy comps as it will be a while before consumer activity begins a sustainable upswing as the labor market remains fragile and we have a negative wealth effect sapping consumer vitality, which is very evident within the luxury segment.


Have a great weekend!


Brent Vondera

Fixed Income Recap

Treasury yields climbed across the entire curve in Thursday’s trading. The thirty-year auction results were less than desirable, but Treasuries were struggling before stocks even opened so we can’t blame it all on supply. Profit taking after the recent rally is likely to blame for the selloff, considering stocks were mixed and the morning’s economic data, which included a new record on Continuing Jobless Claims, probably kept yields from rising even further if anything.

The $11 billion thirty-year reopening auction came in at 4.30%, two basis points higher than the market, and a bid/cover of 2.36 right at the four auction average. The bonds were issued at the high yields of the day as the 30-year rallied to 4.26% by the close of stocks, only to sell off again in the late afternoon.

As expected, England’s central bank left their version of the Fed Funds Target Rate unchanged but surprised the market when they left their commitments to purchase government debt, or queasing, unchanged at £125 billion, or $200 billion for those comparing it to our $1.25 trillion program. The market consensus was for the Bank of England to increase their purchases by £25 billion to £150 billion but the committee decided to stand pat and remarked that they will need only another month to complete the £15 billion or so they have left. In true major central bank fashion they were not explicit about any future increases, but similar actions coming from the U.S. Federal Reserve combined with the BOE’s actions yesterday may begin to reverse the market’s expectation for more quantitative easing globally.

The Fed lagged behind its usual pace for MBS purchases this week with only $17.05 in net purchases compared to their weekly average of $23.8 billion. The July 4th holiday translated into one less trading day during the period so that explains the lower number.

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

U.S. stocks ended mixed on Wednesday as the Dow and NASDAQ Composite closed slightly higher, while the broad S&P 500 was unable to make it back to the flat line. The major indices spent most of the day lower on concern second-quarter earnings season will disappoint investors, but erased those losses (nearly all of what was a 1.4% decline at its lowest point regarding the S&P 500) in the final hour of trading.

It appeared to be a better-than-expected consumer credit report for May, which was released around 2:00 CDT, that helped boost stocks late in the session. This is not normally a heavily-watched report but with consumer activity in the shape it is in, these readings garner increased attention. The report out of the Federal Reserve showed consumer credit shrank $3.2 billion at an annual rate; it was expected to drop by $8.8 billion. Revolving credit (such as credit cards), fell $2.9 billion, while non-revolving (such as car loans) came in essentially flat. The average maturity on car loans rose to 62.9 months and the loan-to-value increased to 93% in May. Yow!

Health-care and consumer-related shares helped to buoy stocks with their late-session surge. Financial shares weighed on the broad S&P 500 index – the sector, which makes up 13.2% of the index, lost 1.7% for the session.

More than two stocks fell for every one that rose on the NYSE Composite. Roughly 1.3 billion shares traded on the Big Board, about 7% below the three-month average – while relatively weak again, yesterday’s volume was the most in seven sessions.

Market Activity for July 8, 2009
Mortgage Applications

The Mortgage Bankers Association reported its mortgage apps index rose 10.9% for the week ended July 3 as refinancing activity jumped 15.2% and purchases rose 6.7% despite a 30-year fixed mortgage rate that held at 5.34% for a second week. (Just to explain to new readers, we do not view a 5.00% fixed rate as onerous per se, from a historical perspective this is super low as anything below 7.5% is viewed as very attractive from a long-term perspective. However these days people have become accustomed to view anything above 6.00% as high and with the job market in the shape it is in, we’ve seen it is rather unusual to see such a large increase in refis and purchases at a rate higher than 5.00%)

I can’t explain the jump in refis, maybe enough people who had been holding out for the long mortgage rates to come back below 5.00% threw in the towel and went for it. On the purchases side, it’s not quite as surprising as foreclosure-driven price declines have enticed buyers – average existing home prices are 25% off the peak hit in the summer of 2006.
Crude-Oil

Oil for August delivery fell for a sixth session, lower by 4.4% to $60.17 per barrel, as the latest Energy Department report showed fuel inventories rose more than expected. Crude is now down 17% from the recent intraday high of $73 touched on June 29.
While crude stockpiles fell 2.9 million barrels, gasoline inventories climbed 1.9 million barrels – more than twice the level expected -- and distillates (heating oil and diesel) rose 3.74 million – a gain of just 1.83 million barrels was expected. In addition, total U.S. daily fuel demand averaged 18.4 million barrels in the past month, down 5.9% form the year-ago period. Distillate consumption fell 12% to the lowest level since July 1999.

Just as the stimulus plans, with regard to both the U.S. and China, had helped foster the rise in energy prices, now that the economy is failing to show the improvement expected people are beginning to question the effectiveness of these plans. This is now moving crude in the opposite direction. And speaking of oil trading…

Increasing Regulations on Commodity Trading

The government will consider greater regulation over energy markets at hearings this month. Specifically, they want to weed out the “speculators” that drive prices higher. They leave out that this essential aspect of the market also drives prices lower at other points in time and is pretty important to the price discovery process.

The government seeks to reduce the use of commodity swaps, which are derivatives used to hedge positions. While regulators will surely allow large consumers (such and airlines and other transportation companies) and producers of energy to have nearly unlimited positions, they will go after the scapegoat of hedge funds and investment banks. When prices are rising, these are the easy targets and in this current environment of populism, the regulators will likely get their way in putting onerous restrictions on commodity trading for these players.

I would also point out that performance chasers are also a reason for spikes in commodity prices (such as all of those pension funds that jumped into the energy market last summer), but that doesn’t exactly make them rogue traders. Further, a burdensome regulatory regime will drive participants out of the market and less liquidity doesn’t exactly make for a better pricing mechanism – the swings could be more dramatic than would otherwise be the case. Ah, the world of unintended consequences.

It’s always easy for politicians to point the finger at others, even when it is the ignorance and short-sighted nature of Washington that causes most of society’s problems. I wish more people would consider that it just may be reckless and insensible policy that causes traders to make the bets they do. When supplies are tight, demand is strong and energy policy is ignorant of geopolitical realities, just maybe the market is simply adjusting to the situations in place at any given moment in time. Just as politicians fail to realize how utterly stupid it sounds to call for less foreign dependence on energy, while simultaneously restricting the production of domestic energy, they also fail to look inward. All the regulations in the world can’t stop poor policy decisions from causing adverse consequences for the consumer and the country in general.

So go ahead with your regulatory regime, you geniuses of how the world works. You still won’t be able to stop energy prices from adjusting to mistaken policy decisions; you won’t be able stop traders from expecting commodity prices to rise and then jumping onto that train when you signal hundreds of billions of dollars in infrastructure spending is coming; you won’t be able to stop foreign governments from buying up commodities (thus pushing the prices higher) as a way to hedge against the falling value of their dollar positions – unless, of course, we bring back price controls, but then shortages ensue. Say hello to That ‘70s Show! Eventually though, quixotic notions run into the brick wall of reality. We’ve learned these lessons; apparently we need to be taught again. Oh, joy.


Have a great day!


Brent Vondera

Fixed Income Recap

If you never had a reason to check the blog out before you surely do now. Minjung made her first post yesterday. Check it out!! WAG raises dividend 22%

The Treasury rally ran right through yesterday’s ten year auction as rumors that foreign central banks may step back from the longer auctions never materialized. I know the table has all the details but some parts deserve highlighting. The impressive outperformance of the long end despite the ten-year supply led to a 9 basis point curve flattening that was the biggest move flatter since June 5. One must begin to think about mortgage rates dipping again. The last time the ten-year was at 3.30% the 30-year fixed was 4.81%, (currently 5.34%). The market can definitely take the origination, thanks to the Fed averaging over $4BB in MBS purchases each day, so it seems like many of the pieces are in place for rates to move closer to their lows from this spring. The ten-year however, is probably going to need to hold a sub-3.50% level for more than just a few days in order to lower mortgage rates and with this volatility calling that would be impossible.

The $19 billion ten-year auction was “out of this world strong” with a bid/cover of 3.28 much higher than the 2.72 four auction average. After announcing that they would sell $19BB in ten-year notes the Treasury received $62.4BB in bids!! Who’s thinking the dollar is junk now? That is some strong demand, and the fact that it came 3.5 basis points tighter than the market right before the auction also bodes very well for supply concerns into the future.

Some are calling the recent demand for Treasuries simply part of the negative repo dynamic in the market currently. I won’t get into the technicals of the problem but it is resulting from a new rule implemented by SIFMA that forces participants who are failing to deliver a Treasury security to their counterparty in a trade to pay penalties. It is creating more demand for the securities than their previously was because before May of this year there was no explicit cost of failing. This is an interesting dynamic, but to say it is a major contributor to the recent Treasury rally is going a little far in my view.


Cliff J. Reynolds Jr., Investment Analyst

WAG raises dividend 22%

Walgreen Company’s (WAG) board of directors today announced a 22% increase in the quarterly dividend to 13.75 cents a share from 11.25 cents a share. This marks 34 consecutive years of dividend increases in Walgreen's 76 years of dividend payment history.

This will put WAG’s payout ratio at about 26%, which is a slight increased from 21% previous quarter, while holding the income before extra ordinary items constant.In an environment where we mostly hear about dividend cuts, this news was welcomed by investors, and WAG finished up 3.12% for the day (and is trading as much as 0.8% up in after market trading).

WAG is weathering the storm relatively well, even though we've seen recent earnings number slightly miss the expectation. (See Peter's post for recent earnings release: http://acrinv.blogspot.com/2009/06/walgreen-wag-trades-lower-after.html)

By slowing down new store openings, rejuvenating existing stores, and focusing on inventory control, WAG’s is making an effort to reduce costs during a period of depressed consumer spending and setting itself up for stronger turnaround. WAG's main line of businesses, prescription drugs and consumer staple items, are also a better positioned area to hold up well during downturn.



Minjung Son

Amgen (AMGN) set for a big day

Shares of Amgen (AMGN) are flying higher in response to a Phase 3 trial of experimental drug denosumab, a bone strengthening medicine, worked better than a potential rival (Novartis’ Zometa) in reducing or delaying bone problems in breast cancer patients. This study only increases the likelihood that denosumab will reach blockbuster status – a “blockbuster drug” is one that generates at least $1 billion in annual sales.

Amgen expects a decision from the U.S. Food and Drug Administration on whether it can sell denosumab for osteoporosis by October 19. Amgen is also studying denosumab to see if it can prevent serious fractures and other damage that frequently occurs in patients with cancer that has spread to the bones.

Amgen currently has five blockbuster drugs, which helped push global sales to $15 billion in 2008. Still, a potential blockbuster like denosumab that could eventually generate $2 billion to $3 billion of annual revenues, could help take the pressure off Amgen’s other drugs, which are facing higher scrutiny from the FDA as well as increased competition from both branded and biosimilar (generic biologic) drugs.
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Peter J. Lazaroff

Daily Insight

U.S. stocks fell for a second session in three as the S&P 500 flirted with 880 but was able to hold above what many technicians (for what it is worth) see as the current key level. The broad market first crashed below 880, regarding the post credit-crisis period, on October 24.

The onus has shifted to the bulls to make the case that higher levels are justified as the market has clearly cast aside the “green shoots” and “second derivative” arguments and wants results. While a number of data sets have shown we’ve progressed from deep recession to something that reflects a more normal downturn, the labor market figures are ugly and suggest consumer activity isn’t going to be much help, and is more likely to work as a drag on the economy, for some time to come.

The most economically sensitive sectors led the market lower. Industrials held the position of the worst-performing sector and consumer discretionary, tech, basic material and energy shares also took a beating.

Volume was 25% below the three-month daily average on the NYSE Composite – outside of two sessions when volume popped above two billion shares, volume has been at least 20% below the YTD average for over a month now.

Market Activity for July 7, 2009
Earnings Season and the Economy (and what we may expect a few quarters out)

Investors will partially shift their focus from the economic releases to the earnings front as Alcoa assumes the traditional role of kicking off the season after the bell today -- although, not really getting started in earnest until later next week. The consensus estimate is for S&P 500 earnings to decline 34% from the year-ago period, which follows a 60% decline in the previous quarter. Earnings results are expected to decline 20% in Q3 and post the first positive results in two years by Q4.

The results will receive a pass during the current season with regard to the degree that cost-cutting plays a role. That is, if overall profits beat expectations largely due to the slash and burn that has occurred within the labor market, investors will accept that but not beyond this period. When third-quarter season rolls around investors will want to see some improvement in sales, some sign that demand has bounced. (The same is true for GDP. We expect a rebound that pushes GDP to post positive results by the third and fourth quarters simply because of the inventory dynamic, but if final sales fail to rebound as well, the market is going to become very concerned)

As is the consensus estimate, we also believe profit results will post positive results by Q4 as the year-ago comparables will be relatively easy to beat and the massive reduction in expenses allows for the potential for big profit growth a couple of quarters thereafter.

The concern that I believe is the issue is that this bounce, whenever it occurs, will be transitory in nature, not the typical rebound that lasts for several years. This is not the normal downturn, it is not a situation in which the Fed cut growth off by raising interest rates as they feared inflation would run to harmful levels – hence all you have to worry about is the scale down in stockpiles. Instead, it was a very large credit event that put us in this situation and this takes additional time to work through; one cannot expect consumer activity to lead GDP higher as debt levels are too burdensome and businesses are unlikely to grow payrolls along the typical expansionary timeline.

What’s more, firms may be faced with significantly higher commodity prices a few quarters out and deal with a margin squeeze as a result. (We see a lot of people talking about how consumer staple stocks are the place to be over the next few years as their higher dividend yields and steady, albeit low, earnings growth makes this area a safe play. Problem is, these are the names hit the hardest by rising input costs). This is one of the downsides to the massive global stimulus plans as large infrastructure projects means big demand for commodities, and that is essentially what will drive those prices higher. In addition, the very large (and unprecedented post-WWII era) deficits and aggressive monetary easing may encourage foreign governments to buy up commodities as a dollar hedge, driving those prices even higher. I do not see how the dollar holds up, even at these levels, based on the policy that is in place.

These are all things to think about as we look out over the next couple of years -- specifically the 18-24 month timeframe. I can see euphoria rising a couple of quarters out as an economic snapback ensues, likely helped in some manner by government stimulus plans and certainly by that inventory dynamic. Even if this rebound is not substantial, people will get excited simply because these will be the first readings of increase in a year.

But the way the U.S., and many parts of the globe, are combating this economic weakness is very short term in nature (short-sighted thinking), and along with separate policy agendas have ramifications for the economy a few quarters out – ie. dollar weakness and higher commodity prices, higher tax rates at exactly the wrong time (if there is ever a right time), energy policy that fails to acknowledge geopolitical realities, and an overall massive increase in government involvement that is never conducive to growth and .
Now we’re hearing increased calls among policymakers for another stimulus package even before this nearly trillion-dollar behemoth is off the ground. What we need is for government to get out of the way; alas that is not going to happen, lets’ face it.

In summary, the euphoria that is likely to ensue when GDP posts its first positive readings after the longest stretch of economic decline in the post-WWII era, and profits in the black for the first time in two years, should be held in check even if it will be difficult (and remember I’m looking ahead here a bit, for now we’re dealing with a market correction off of the 42% march that brought us to 946 on S&P 500 from the nefarious 666 low). We will remain in a rather precarious situation for some time and corralling emotions when stocks move to the next upswing in what may prove to be a long-dated trading range will take discipline. Don’t chase the high end for fear you’re missing out. Be patient and buy on the weakness.

We were without an economic release yesterday and today is another quiet one on this front. Tomorrow we’ll get back to it with jobless claims and wholesale inventories.


Have a great day!


Brent Vondera

Fixed Income Recap

Treasuries were mixed as the curve flattened due to a two-year selloff even though one-year bills and three year notes rallied on the day. Economic data has been light this week so many in the market are concentrating on earnings season that is right around the corner.

My comments yesterday about Treasuries looking rich with the ten-year at 3.55%, (which rallied to 3.48% yesterday… whoops!), will be truly tested today with the Treasury auctioning $19 billion in a ten-year note reopening. There is some chatter about foreign central banks, who are by nature heavy buyers on the short end of the curve, creating some problems for the Treasury by stepping even farther away from the longer duration auctions in favor of the shorter end of the curve. We will see if there is much truth to the rumors when we receive today’s results.

The $35 billion dollar three-year auction was stronger than expected and helped fuel most Treasuries higher for the day. The notes were sold at yield of 1.519% with a bid/cover ratio of 2.62, right at the four week average. Just over half of notes sold went to indirect bidders, a group of buyers that includes foreign central banks.

Cliff J. Reynolds Jr.

Finance arm still weighing on General Electric (GE)

After reading about GE Capital’s Political Minefield in today’s Wall Street Journal, I went back and looked at some of my commentary on General Electric (GE) from earlier in the year.

In this post on March 3, I suggested that the GE was oversold. Most of my reasoning was based on the fact that everyone was forgetting about the company’s industrial business and only focusing on GE Capital. Only a few weeks later I posted in my March 19 note:

“Investors have become somewhat single-minded in their focus on GE Capital as they fear the unit’s $637 billion balance sheet (as of 12/31/08) is full of souring assets like commercial real estate loans and securities that make the unit and its parent vulnerable to future losses.”

While I was correct that GE didn’t face the threat of nationalization like other U.S. bank holding companies, it never occurred to me that the government may alter the way GE Capital is classified and, thus, change the rules of the game – although considering how often the government changed the rules throughout the financial crisis, I am not really surprised.

After steadily climbing from its lows, GE’s stock price did a U-turn after Obama administration issued their proposal for reforming the U.S. financial system. The declines were a result of investors’ refocusing attention towards GE Capital – and for good reason.

GE Capital is one of the world’s largest and most diverse financial operations. If GE Capital were classified as a bank holding company, then it would be the nation’s seventh largest by assets. While GE has benefited from more relaxed regulation than bank holding companies, the reform proposal could lead to GE Capital being classified as a “Tier 1,” or systemically important bank. In this case, GE Capital would be subjected to tighter regulation, higher capital ratios, and bigger loan-loss reserves. And any increased restrictions on the industrial activities could very well lead to a spin-off of GE Capital from its parent company.

A break-up, however, causes a few problems and makes the finance business worth less to GE shareholders than the value it provides as part of GE as a whole. First, GE Capital would almost certainly have its credit rating downgraded without the financial safety net of its former parent company. Consequently, large collateral calls would be triggered in response to a GE Capital credit downgrade.

Second, the company would almost certainly need to raise capital to enhance its Tier 1 ratio and bolster its loan-loss reserves, both of which are well below the largest four U.S. banks. Even more, GE Capital could be forced to reduce assets like their $36 billion in real-estate equity investments, which banks are typically not allowed to hold, at “below-value” prices and resulting in large losses.

It’s easy to see why shareholders consider GE Capital a more valuable business when combined with the parent company than on its own. GE shareholders who would likely receive shares of a spun-off GE Capital would likely see negative earnings as the company adjusted to new regulatory requirements and may also see their shares diluted if GE Capital taps the equity market for fresh capital.

Despite all of these concerns, I wouldn’t be hurrying to shed your GE shares. Although there is less upside for the shares than there was in early March, GE is trading at a fairly reasonable valuation and still offers a great value for the long-term investor.
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Peter J. Lazaroff