Daily Insight

U.S. stocks began yesterday’s session lower after Wal-Mart stated fourth-quarter profit will miss its forecast and predicted January sales may not grow at all. If any retailers seemed safe in this environment it was the discounters, so this news out of Wally world is a surprise. Most indices, however, rallied in the back-half of the day, led by energy and technology shares.

The Dow Industrial Average failed to participate in the rally, held back by shares of Wal-Mart – the most hated retailer on the planet subtracted 33 points from the index.

Bloomberg reported that stocks were also helped by news that Citigroup agreed to back legislation allowing bankruptcy courts to modify mortgage contracts.

We’re not so sure. This may be one of the early signs that government has greater power to force the private-sector’s hand -- after all, Citigroup was opposed to this legislation when it was initially proposed just a few months ago; it didn’t have the numbers to pass Congress back then. If you accept money from the government (such as TARP funds and the rescue package Treasury came up with in early December) then you’ll find the government has more sway in determining business decisions.

I’ll note, these institutions didn’t have much choice in the matter, without the government assistance firms like Citigroup would have gone down as mark-to-market accounting rules greatly exacerbate their over-leveraged troubles. Oh, and that increased degree of leverage was encouraged by a Federal Reserve that kept real short-term interest rates negative 2003-2005, which essentially subsidizes debt

But back to the topic, I don’t necessarily view what’s known as cram down as a good thing, particularly with regard to borrowers that put little if any money down.

For instance, the FDIC’s plan to modify loans is showing that 50% of those with no skin in the game simply live rent-free for another three months only to walk away later. Why would Citigroup’s borrowers be any different? Sure, bankruptcy courts will be able to reduce the principal amounts of mortgage loans along with the rate of interest, which will be helpful to those that put little money down. Nevertheless, I don’t think we should have much confidence in these derelicts (people who simple walk away from their largest financial obligation) to do what it takes to stay in their homes no matter how the loan is modified. Well see.

Market Activity for January 8, 2009

Economic Front

The Labor Department reported initial jobless claims unexpected fell last week, declining 24,000 to 467,000 – three-month low. This was quite a surprise and marks the second week in which first-time claims remained below the 500k level, two weeks ago the number looked as if it would soon blow through the 600k level.

Many seemed to believe the previous week’s decline was due to seasonal adjustments and winter weather that closed unemployment offices. For this latest week, there are reports from several states that electronic filing systems crashed due to volume, so we’ll really need to wait another week to see what is truly going on.

Considering the data we’ve received from a number of economic surveys – ISM , ADP, Challenger and the Conference Board’s net “plentiful less “hard to get” (pertaining to jobs) index – it is very difficult to believe the past two initial claims readings are pointing to an improving employment market. It’s just too early for improvement to occur – in my view we’re still several months away from meaningful reductions in the level of job losses.

The four-week average of initial claims fell for a second week as well.



The continuing claims data, those that remain on jobless benefit rolls for longer than a week, does jibe with other job-market indications. Continuing claims rose 101,000 to 4.611 million in the week ended December 27. This figure is just barely below the 1982 high and more closely resembles the nature of the job market.


This morning we get the official jobs report for December and expect payroll positions to decline 600,000 – the unemployment rate will likely hit 7.0%. If we get a decline of 600k, the economy will have lost 2.5 million jobs in 2008 (75% of which occurred in the final four months of the year). The job losses last year erased 30% of the 8.2 million jobs created 2003-2007.

In a separate report, the International Council of Shopping Centers (ICSC) announced same-store sales fell 2.7% in November from a year earlier. This marks the third-straight month of decline – since the ICSC began reporting on same-store retail sales there has never been back-to-back declines much less three in a row.

Drug and discount store sales have been the least affected, naturally, by the three-month pullback in consumer activity as was the also the case in November falling 0.6% and 1.0%, respectively. Department, luxury and apparel stores were the hardest hit as sales fell 10%-13%.

This is all part of consumers adding to cash savings as the major savings vehicles, homes and stocks, have been hit hard. It has been the damage in the stock market in particularly that has really caused consumers to retrench. No doubt the decline in the labor market has had an affect as well, but in the aggregate most of the damage to confidence has resulted from the plunge in equity prices October-November.

This is why a tax-rate response is the most efficient, and least burdensome to the budget, prescription to the current weakness. Legislation that drives disposable incomes immediately higher via substantial bracket cuts and boosts after-tax return expectations by halving the capital and dividend tax rates would do more than the panoply of programs and facilities delivered by the Treasury and the Fed – and without the unintended consequences. (Although, some of what the Fed has done, such as the commercial paper funding facility, has worked very well and reduced damage immensely. However, in the aggregate their decisions will leave us with an inflation issue to deal with, and I’m not talking 5% on the CPI if they’re not acutely responsive.)

We can engage in $800 billion, $1 trillion, or more in public works programs but this type of stimulus does not only lack staying power it takes 12-18 months to get off the ground. I don’t care how many times politicians state that shovels are already in the ground, they still have to go through federal and state appropriations. While this is good government, it causes a huge lag affect. It may very well prove to be the case that just when the bulk of the public spending is flowing through to the economy the business cycle will have already turned. We shall see.

Correction:

Yesterday, in an attempt to put the labor-market weakness in perspective, I stated the 500k in job losses that occurred in February 1958 accounted for 9% of payroll positions and the 600k in jobs losses that occurred in December 1974 accounted for 7.5% of total payroll positions. Today 600k in losses accounts for just 4.3%.

Those figures are actually 0.9%, 0.75% and 0.43%. Dan Esser informed me of this mistake. I apologize for the carelessness.

Have a great weekend!


Brent Vondera, Senior Analyst

Afternoon Review

Wal-Mart (WMT) -7.49%
Wal-Mart shares weighed on sentiment after the retailing giant cut profit guidance and reported lower than expected December same-store sales. The company said the difficult economy and severe winter weather in some regions hampered the holiday seasons at Wal-mart Stores, with softness in apparel and jewelry. Looking ahead, Wal-Mart said customers are focused on “value and necessities” and it expects same-store sales to be flat to up two percent.


Peabody Energy (BTU) +4.71%
Peabody announced it is cutting its expected 2009 production targets in response to the current weak U.S. thermal and global steel markets. To address excessive inventories in the Power River Basin (PRB), Peabody plans to reduce targeted 2009 PRB output by 10 million tons (approximately five percent of their total U.S. output). Following the cuts, Peabody’s U.S. production is essentially fully priced.

To address weak global steel demand, Peabody plans to reduce targeted Australian metallurgical coal (coal used in the steelmaking process) production by two million tons (approximately 20 percent of Peabody’s Australian metallurgical coal production).


EMC Corp (EMC) +6.35%
Data storage company EMC reaffirmed its fourth quarter earnings and revenue guidance and announced a program to cut costs. As part of its restructuring program, EMC plans to cut 2,400 jobs, or about seven percent of its workforce. EMC expects the program to reduce costs from its 2008 annualized rate by approximately $350 million in 2009, increasing to approximately $500 million in 2010.


Quick Hits

• Credit Downgrade Hits Bank of America’s Debt, Equity
• Citigroup Supports Letting Bankruptcy Courts Reset Mortgages
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks began the day lower, a typical breather after rallying six of the past eight sessions, and the downward pressure accelerated after Kansas City Fed Bank President Thomas Hoenig delivered a rather gloomy picture of the economy and preliminary employment reports indicated the December losses will likely eclipse what we saw in November. News out of Intel explaining how business equipment production collapsed in the back-half of the fourth quarter didn’t help matters.

Technology shares took a lot of the damage, but energy stocks endured the biggest hit as oil prices slid – so much for those worries over Russia and the Middle East. Traditional safe-havens, health-care, utilities and consumer staples were the relative winners yesterday, but even these shares traded lower.

While the press focused on the Intel, Thomas Hoenig and employment report news as the reasons for the sell-off, those realities are not unexpected as a stock market that is down 42% from the peak suggests. Market participants know full-well that the fourth quarter was a disaster; the worst quarter in at least 26 years.

In terms of the Hoenig speech, the Fed member stated a recovery may not emerge until the third quarter. Now I know the NBER (the arbiter of business cycle peaks and troughs) officially announced the recession began in December 2007, but come on most know it truly began in September 2008. What? Is the press acting as if this is some revelation? There’s little doubt economic growth will remain depressed in the first half of 2009; the KC Fed Bank president’s comments on this topic are in line with overall expectations

Stocks were destined to give back some of the rally that had brought us 24% above the November 20 low, such rallies rarely occur without some sort of pullback; the Intel and Hoenig news just offered a more concrete reason to explain the declines.

Market Activity for January 7, 2009

That said, Hoenig did warn against trying to mitigate what naturally needs to occur in the economy by making too many attempts at mollifying recessionary effects. By trying too much (pumping massive amounts of liquidity into the system that will cause inflation to rage if not taken back properly) or implementing plans that have a history of doing more harm than good in the long run (such as public works programs, and the way it crowds out private sector activity) we put future stability and growth at risk.

Indeed, he has a concerning point there. As we discussed in yesterday’s letter, there is not free lunch, every action has its cost. In terms of the market, however, it is not necessarily focused on these risks right now as getting things up and running is the primary agenda.

We too were concerned about the deterioration that resulted back in October/November, but some of the most troubling issues – the growing risk of runs on banks and a total shutdown of credit -- are no longer a major concern. But make no mistake, from where I sit, these were very real concerns and we were staring down the abyss at the beginning of the fourth quarter. Now that those risks have eased, however, the government needs to lay off a bit and allow things to run their course.

Crude-Oil

Oil futures prices plunged 12% yesterday after the weekly Energy Department report showed supplies of crude and gasoline rose more than expected.


Inventories of crude rose 6.68 million to 325.4 million barrels in the week ended January 2 – supplies were forecast to increase just 800,000 barrels. While the jump was large, supplies are in line with the five-year average.

Gasoline inventories jumped by triple the amount expected, yet stockpiles are only hitting the May levels.

On the demand side, activity actually increased last week and is just 1.4% below the May level, according to the American Petroleum Institute. It appears to me that the price of oil and its derivatives are artificially low, just as they were artificially high back in July.

Gasoline demand is a mere 1% below the 200-day moving average; for all we’ve heard about demand destruction (one of the favorite new phrases of our beloved press corps) activity isn’t terribly depressed.


The Housing Market

The Mortgage Bankers Association announced its mortgage applications index fell 8.2% for the week ended January 2 after no change in the previous week and a huge 48% bounce the week ended December 19.

On the table below the Market Index represents total mortgage applications.


While the overall index declined due to a 12.3% drop in refinancing activity, the purchase side of the index rose 7.3%, marking the third week of increase -- much lower mortgage rates has begun to fuel sales, let’s hope the trend holds.


Employment Reports

The Challenger Job Cuts report showed layoff announcements nearly quadrupled in December from a year earlier. The declines were driven by job cut announcements in the East, which means the financial sector led the overall figure higher.

Firing plans jumped 275% to 166,348 last month, according to the nation’s premier outplacement firm Challenger, Gray & Christmas. The firm expects the job-cutting to continue through the first-half of 2009.

In yet another jobs report, the ADP Employment Change survey estimated that December job losses will approach 700,000 – the official Labor Department report is released on Friday and a loss of 500,000 jobs is expected.

We’ll note ADP isn’t the most reliable indication of what actually occurs, which is strange considering they’re a major payroll-service firm. ADP has made methodological revisions to their survey in an attempt to more closely fit the employment data, so we’ll see if it is more accurate this go around. In any event, it does offer a good indication that the official job losses for December will be a large number, which is corroborated by the initial jobless claims figures and the ISM surveys that have printed very weak employment readings.


Friday’s jobs report is going to be ugly, and we’re thinking the number will be worse than expected, possibly approaching 600,000.

Monthly job losses of 500,000 or more are rare and one has to go back to the deep recessions of 1957-58 and 1973-74 to see such declines. That said we need to provide some context, especially since no one else seems to be doing so. The job market is obviously much larger than it was in 1974, and nearly triple the size of the 1958 economy.

Back in 1958, a decline off 500,000, which occurred in February of that year, accounted for 9% of all payroll positions. Back in December 1974, when payrolls declined 602,000 it accounted for 7.5% of total payroll positions.

Today, there are 137 million payroll positions, so a decline of 600,000 accounts for just 4.3% of the job market. To hit the degree of job losses in those past periods, adjusting for job growth, we’d have to see a monthly job loss of more than one million. While the current levels of job losses are harsh – I’m not trying to downplay it – we need to keep things in perspective.

Just out, the Bank of England has cut their key interest rate (the bank rate, which is their version of our fed funds rate) by 50 basis points. The bank rate now sits at the lowest level on record at 1.50%.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

Monsanto (MON) +17.29% *updated tearsheet available*
Monsanto reported strong earnings and revenues for its first fiscal quarter and raised its full-year outlook. The company continues to benefit from market share gains due to the quality of its portfolio.

With the most significant part of its business cycle still to come, the first quarter results signaled a good start to the year, though it primarily reflects the impact of its Latin American businesses. The company said its second and third quarters are expected to be the primary drivers for full-year results since they reflect the relative size of its U.S. businesses and the importance of its seeds-and-traits business.

Monsanto is exceptionally well positioned, the balance sheet is strong and competitors are struggling to keep up, much less narrow the gap. While profitability in the agriculture sector is clearly important for Monsanto, the value proposition in the products and the near-global political focus on agricultural output positions the company for strong growth.

Monsanto has a strong record of buybacks, but pays a relatively tiny dividend considering the strength and likely longevity of profitability. As markets become more restive, a higher dividend might be more beneficial for the stock’s valuation than continued buybacks.


Intel (INTC) -6.05%
Intel said it expects fourth quarter revenue of about $8.2 billion, down 20 percent sequentially and 23 percent year over year, and below its previous guidance of $8.74 billion. Intel’s fourth-quarter gross margin, the percentage of sales left after production costs, was at the lower end of the range it had predicted. Intel also wrote down the value of its investment in Clearwire Corp by $950 million.

Intel cited the weakness in end demand and inventory reductions by its customers in the global PC supply chain as causes for the shortfall. Global PC production fell 15 percent from the previous quarter with PC companies making 3 percent fewer notebooks and 27 percent fewer desktop machines.

The earnings warning from Intel was not entirely surprising given the other semiconductor warnings that have stacked up in recent weeks. Intel’s smaller rival, Advanced Micro Devices (AMD), cuts its sales forecast on December 4, saying it expected revenue to decline about 25 percent.

Much of the upside for Intel is dependent upon a new chip called Atom, designed specifically for simple, inexpensive mobile machines such as netbooks. The problem is that Intel has traditionally commanded a premium for its processors, but it’s not clear the company can continue to command that premium given that vendors such as Hewlett-Packard seem willing to choose chips from rival Advanced Micro Devices (AMD) for these simple machines.


Quick Hits

• Commodity Rebalancing Rally Tails Off
• PG Fights for Cash Amid $2 Trillion U.S. Borrowings
• Pawn Shop Borrowing: The Upside

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks ended a bouncy session higher as President-elect Obama explicitly stated his stimulus plan will reach $775 billion. (These budget and cost assumptions are never accurate, so give zero credence to this number; what it shows is the plan will be massive). On Monday corporate profit concerns seemed to outweigh any excitement over government stimulus, yesterday it was the reverse.

Stocks have gained ground in four of the past five sessions. More likely than some shifting in sentiment between the stimulus plans and what will be a very weak earnings season is that money managers are stepping into the market after stocks have rallied nicely off of the November 20 low.

We are now 24% above that multi-year low on the S&P 500 and 28% for the NYSE Composite and should expect the market to take a breather after a run of this magnitude.

Real estate and financial shares (the sectors that have endured the deepest losses) benefited on the news firms will be able to take losses incurred in 2008 and 2009 to offset tax bills dating back five years. I suppose this means they’ll be refunded, if indeed the plan is implemented as we discussed yesterday.

The tech-sector jumped 3.3% as the group will be a primary beneficiary of higher business-equipment write-off allowances, the most constructive aspect of the Obama overall stimulus proposal.

Market Activity for January 6, 2009

Economic Data

The Institute for Supply Management announced their survey on the service-sector contracted in December for the third-straight month as consumers continue to build up cash savings in the face of a continued decline in home prices and the October/November plunge in stock prices. While the broad market has bounced nicely off of the November 20 low the psychological blow remains in place.

The ISM non-manufacturing index posted a reading of 40.6, a mild improvement from the 37.3 low hit in November. That November reading was the lowest in the survey’s history; although, it only goes back to 1997, so not much history here. The December reading was better-than-expected as further deterioration was anticipated. Still, 50 is the threshold between expansion and contraction, so a reading of 40 illustrates activity remained very weak.


The more forward-looking sub-indices within the report showed a little improvement as well. The new orders index rose to 39.9 from 35.4 in November. The orders backlog index hit 42.5 after 39.5 in the previous month.

We expect the overall reading to improve over the next couple of months. The bounce in stocks, if it holds, should help to relieve some anxiety. Plus, the 65% plunge in gasoline prices has left billions in the pockets of consumers and this extra money should find its way to retail stores. Taking a longer view though, it will be a while (only wish I knew what a while means in months) before we can get to a situation in which the service sector shows sustainable growth as a deteriorating labor market weighs on consumer activity. Mining and utility activity is also part of the index and these sectors should remain depressed for some time still.

On the bright side, the government’s stimulus plan (while I’ve got major issues with its short-term nature and inefficient use of capital) will boost public-sector construction activity, which is also part of the ISM non-manufacturing index. As we head into the third quarter, this segment of the report should offer some life to the index’s readings.

In a separate report, the Commerce Department reported that November factory orders declined 4.6% after plunging 6.0% in October. The back-to-back declines were the largest since records began in 1992.

The business-equipment spending component of the report bounced, rising 3.9% in November after declining for three months – mirroring what the durable goods orders report showed just before the Christmas holiday.

The downside is a 7.4% decline in nondurable goods fully offset the rebound in business spending. This was related to a substantial drop in the price of petroleum products as petro and coal products fell 21% in November.

Finally, in a separate report Commerce reported that pending home sales fell a larger-than-expected 4.0% for November and the October reading was revised much lower to show a 4.2% drop instead of the mild 0.7% decline estimated last month. This large downward revision explains the 8.0% decline in existing home sales for November, a reading we received several days ago.

This data continues to show there is little evidence housing activity has hit a bottom. However, we do believe reversion to the mean (erasing the outsized growth in home prices that occurred 2002-2006), has occurred and may have moved beyond the longer-term average for home prices. Since 2000, the median price of an existing home is up 3% at an annual rate – the long-run average is closer to 5%.

No one should expect the housing market to bounce back quickly as we have foreclosures and a weak labor market to deal with still, but the market has done much work in removing past excesses. Another thing is the meaningful decline in mortgage rates. This should boost sales over the next few months.

The Fed is currently working to lower mortgage spreads (the spread between the 10-year Treasury and the 30-year fixed mortgage rate is traditionally 180 basis points, today that spread is very wide at 250 basis points). The Federal Reserve began to attack this head-on yesterday by buying mortgage-backed securities.

The plan is part of a $600 billion plan that also includes buying GSE (Fannie and Freddie) debt. Mortgage rates would be in the low-to-mid 4% range if spreads were normal and this is the level the Fed will try to bring the fixed rate down to. The downside is they are printing money to fund the plan, which will kick inflation higher 8-12 months down the road – everything has its cost.

Fed Minutes

The Fed released its minutes (notes) yesterday from the previous FOMC meeting. In short, they stated the credit markets have improved but remain under severe stress, the downside risks to economic activity were a serious concern and they will remain very aggressive with regard to their policy.

Their key interest rate is virtually zero, so there’s no firepower left regarding traditional monetary easing. What they’ll do is continue to engage in aggressive quantitative easing, which means they will continue to engage in lending facilities to pump liquidity into the system. Problem with this is they can’t force banks to lend or consumers to borrow. However, when this does begin to occur in a more normal way that liquidity is going to rage throughout the economy.

The FOMC will also continue to print money in order to fund programs like buying mortgage-backed securities we touched on above.

This brings us to the most interesting aspect of the minutes. The Fed seems to think that their decision to pay interest on bank deposits at the Fed will allow them to take back this liquidity quickly so to avoid a troubling inflationary event. They’ll simply increase the interest rate on Fed deposits, which will cause banks to keep a higher level of deposits at the Fed, thus removing money supply from the system.

Problem is it will be difficult to pull this trigger as these higher rates will mean the longer-end of the Treasury curve will sell off, sending those rates higher as well. At which point, what may be a nascent housing market rebound will run into the road block of higher rates, making it very difficult for the Fed to do what it takes to keep inflation in check. But the Fed seems confident they can pull it off.

Good luck with that one.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

There was no major news that specifically moved any of our Approved List companies today. The markets continue to move higher on speculation that the U.S. economic stimulus plan can help the country out of recession. Barack Obama told House Speaker Nancy Pelosi he favors a price tag of about $775 billion for the stimulus, and pledges “unprecedented transparency” including publishing online “very detailed information about all the projects that are taking place.”

At this point, Obama is trying to provide the markets (both domestic and global) with what they need most: confidence. The stimulus itself is unlikely to make the economy turn around any faster, but the speed and efficiency with which the government implements the funds will have a large effect on confidence.

Rewind to 9/29/2008 when Congress could not agree on the Economic Stabilization Bill. The government’s perceived uncertainty transferred directly to the stock markets, which fell nearly 9 percent that day.

I personally think economists are kidding themselves if they believe this stimulus package will create long-term jobs; however, the country’s rising unemployment could benefit if short-term employment opportunities prop up the work force until the economy reverses course.

I also think that the personal tax cuts will provide little aid to the economy. Look no further than the Bush tax refund in 2008 to see that most people pocketed the money and the temporary increase in spending simply delayed the inevitable. The business tax cuts, on the other hand, are more likely to have a positive effect on the economy. Either way, the tax cuts are crucial to the acceptance of a plan that is based on building confidence.

Spending nearly $800 billion on a short-term fix does seem a bit irrational, but if the money is spent in areas that will improve U.S. productivity and competitiveness then we can truly view this package as an investment rather than spending. This isn’t like the taxpayer’s investment in the financial system – which someday in the future will be viewed as genius or asinine – in that the dividends and returns will be far more difficult, if not impossible, to measure.

But, few can argue with long-term vision for the stimulus plan. Our internet infrastructure is embarrassing, our healthcare sector wastes billions of dollars a year due to record keeping mistakes and our transportation system leaves much to be desired, just to name a few.

How can the government can possibly allocate resources better than the free market? They probably can't. I am sure that there will be projects receiving funds that don’t deserve it, and contracts will not always be awarded as they might be on the free market, but that is not what a stimulus is about. This stimulus should serve as a kick in the butt to our country to tackle projects that wouldn’t be touched for years, while instilling much needed confidence in our country.

--


Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks fell for the first session in four as concerns over corporate-profit growth (fourth-quarter earnings season kicks into gear next week) outweighed encouraging statements from the Treasury Department regarding bank rescues and talk of some tax cutting within the Obama stimulus plan.

Financials and telecoms led the market lower on analyst downgrades of telecommunication firms and the likelihood of higher default rates put pressure on bank stocks.

Energy and utility shares were the only bright spots, adding 1.36% and 0.72%, respectively. Energy is a great way to at least partially hedge against geopolitical risk, which isn’t going away anytime soon unfortunately.

Besides the Israel/Hamas conflict, Russia has now shut off shipments to Ukraine and that affects much of Western Europe as well. While $50 per barrel oil is not a major issue – after coming from $145 just six months ago – crude is up 40% over the past seven trading sessions. These big swings makes it difficult for businesses to manage, and nearly impossible to hedge, around the issue and that’s the problem.

Market Activity for January 5, 2009

Economic Data

The Commerce Department reported that overall construction spending fell 0.6% in November, following a 0.4% decline for October -- a number that was revised substantially higher from the estimated 1.2% decline reported last month. Over the past year overall construction spending has fallen 3.3%.

Gains in commercial and government building helped to offset weakness from the private residential component of the report, which continues to fall at a substantial rate.

Private residential construction fell 4.2% in November and is down 23.4% from the year-ago period. For additional context, the three-month annualized decline in private residential construction has worsened, down 8.1% for November, compared to -5.5% for October. Public-sector residential construction spending rose 1.4% and is up 7.9% over the past 12 months.

On the commercial side, private nonresidential construction rose 0.7% in November and is up 10.3% since November 2007. This segment is holding up pretty well, but we expect the year-over-year rate to continue to decline, which has been occurring. (Private commercial construction was up 13% year-over-year back in August.)

Public sector nonresidential spending rose 1.4% -- boosted by school and highway construction – and is up 7.8% over the past 12 months.

At some point private residential spending will begin to rise again as it has been declining every month since March 2006, save August 2008. (In August the figure jumped 5.5%, causing many to believe the housing contraction had run its course, but then September followed with its collapse of Lehman Brothers and the credit-market freeze up.)

But housing will rise again. Looking at the annual increases in home prices going back to 2000, it appears we’ve fully reverted to the mean, and in fact may have gone too far. Lower mortgage rates should boost home sales, even as the weak labor market curtails this boost.

As the inventory/sales ratio moves lower home building will resume, but this does not work on a dime and will take a year or more to occur based on what we currently know – and this is more a guess than anything else, there are too many variables to call it with any confidence. Over the next several months we won’t need residential investment to add to GDP, if it only flattens out and is no longer a drag on growth it will be a big plus.

In the meantime the public sector will take over as the next administration is focused on traditional Keynesian-style public works programs.

Tax Cut in the Works

There is talk that the Obama Administration is crafting a plan to offer as much as $310 billion in tax cuts. (These costs that CBO and other assign to tax cuts are generally well off base as it does not take into account that when correctly targeted the Treasury enjoys large windfall over the ensuing years – they employ static analysis instead of the appropriate dynamic type. So we wouldn’t put much credence in the size, hopefully it’s targeted in the right way, which is what matters.)

Anyway, among the business tax cuts being discussed, one is to allow firms to write-off large losses incurred in 2008 and 2009 to retroactively reduce tax bills dating back five years. What this means is that the government will be replacing losses with current-year government spending.

That’s all fine but it does not boost government revenues (which is kind of important right now) or provide longer-lasting incentives, incentives that eventually drive jobs and productivity higher via increased business-equipment spending and higher profits. Tax policy that is longer-lasting in nature provides higher revenues two, three and four years out and thus offsets the higher deficit spending in the first year of implementation.

However, there is talk that something else is being crafted that would offer a longer incentive cycle. Word is they’ll extend the 2008 legislation that increased current-year business spending write-off allowances into 2009 and 2010.

This plan, according to press reports, offers powerful incentives to boost business equipment outlays, which boosts jobs (more workers are required to produce this equipment) and has long-lasting productivity benefits. This plan would also extend the bonus depreciation provision, which allows an additional 50% of the cost of an asset acquired and placed into service this year and next to be depreciated immediately.

This would be big and we should applaud such a move if they do it. However, as they plan to permanently boost the size of government, they should at least make these private-sector incentives permanent as well. Permanence brings the most bang for the buck as certainty makes life much easier for business decision makers and you don’t get this front-loading phenomenon only to see business-equipment spending fall off when the legislation expires.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Long-Dated Treasuries Drop
The curve steepened 15 basis points today to 170 basis points as the 2-year rallied 3/32 of a percentage point in price to yield .77% and the 10-year sold off about one percent to yield 2.48%.

There are multiple factors negatively effecting Treasuries on a broad scale, I will try to touch on a few of them here.

Obama’s stimulus plan will leave the government hungry for cash, thus increasing the supply of Treasuries coming to market. Even with the Federal Reserve increasing its purchases through open market policy, the demand for the paper just doesn’t seem to exist at these yields. The yield on Treasuries, and the cost for financing the stimulus will go up as a result.

Treasuries are beginning to look rich to other markets around the world as foreign investors continue to become a lower percentage of the bidders at Treasury auctions. Over the past month the dollar has weakened 5.15% to a basket of global currencies according to the DXY Index and the CRB Commodity Index is down 45% from June 30th of last year, while gold is down less than 9% over the same period. If these factors draw more foreign investors away from US Treasuries, via a weakening dollar, demand for U.S. Government debt will continue to struggle to find a buyer.

If, or when, depending on who you ask, rapid inflation from excessive easing comes about, it will drive people even further from long bonds. Increasing concerns about inflation can cause large swings in the price of loner dated Treasury bonds. Although they are considered riskless from a credit standpoint, long duration bonds can be very volatile securities, as can be seen by the 3.7% drop in the thirty-year Treasury today.


Cliff J. Reynolds Jr.
Junior Analyst

Afternoon Review

Pfizer (PFE) -0.06%
CEO Jeff Kindler said in this interview with The Financial Times that the company is open to acquisitions, big or small.

Pfizer’s cholesterol drug Lipitor, with sales of $12 billion a year, is expected to encounter stiff competition in 2011 when generic versions hit the market. Kindler said any new acquisitions will be designed to “generate new and diverse sources of revenue growth and cost structures to position us to be strong after Lipitor.”

The article also raises the possibility of Pfizer acquiring Amgen (AGMN) to strengthen its biological medicines by purchasing Amgen, which has developed a range of promising medicines.


Walgreen (WAG) +5.05%
Walgreen said that sales increased 10.8 percent in December and same-store sales rose 4.9 percent in December in the face of challenging retail headwinds. Comparable pharmacy sales increased 8.5 percent in December. The company said that comparable pharmacy sales were negatively impacted by 2.5 percentage points due to generic drug introductions. Meanwhile, competitor Rite Aid said same-store sales fell 0.2 percent.

U.S. drugstores are feeling the effects of the recession as more customers seek cheaper alternatives to prescriptions and other medical items. In addition, prescription drug sales are slowing as consumers skip doses of medicine to reduce their medical costs.

Walgreen is a leader in what is generally viewed as a lucrative industry. The company’s strong cash flow generation should help them remain active on the acquisition front, adding smaller, less traditional businesses to the mix until a better opportunity arises. Walgreen’s strong sales numbers are encouraging and the company appears to be well-positioned for growth once the economy recovers.


General Electric (GE) -2.58%
GE Capital, the lending arm of General Electric, plans to raise $10 billion in the biggest offering of debt backed by the FDIC since the program began. The sale will be split between $2 billion of two-year notes, $5.5 billion of 3.5-year debt and $2.5 billion of 18-month securities.

Today’s offering would put GE Capital halfway toward its goal to “pre-fund” $45 billion in debt that the company plans to refinance this year. GE Capital sold about $12.5 billion of FDIC-backed notes last year.


AT&T (T) -3.37%
Bernstein Research analysts downgraded AT&T to neutral today. The analyst report acknowledges that the company is more recession-resistant than most, but the U.S. recession and saturation of the wireless market will make it tougher to find new mobile customers and will accelerate losses of home phone customers.

AT&T is solidly profitable and recent cost cutting should boost profits over the next couple of years. The company’s debt load remains very manageable relative to the firm’s cash flow and their nice dividend (yielding 5.77%) is in no danger.


Quick Hits

• Obama Said to Push for Tax Cuts in U.S. Stimulus Plan
• Investing Experts Urge ‘Do as I Say, Not as I Do’
  

Peter Lazaroff, Junior Analyst

4Q 2008 Participant Insights

Bear Market Spooking You? That is the question Debra Moran tackles in the most recent issue of Participant Insights. If you haven't seen it yet, it's just a click away!

Click here to view the 4Q 2008 Participant Insights

Daily Insight

U.S. stocks continue to advance, adding to a rally that has brought us 24% above the November 20 low. The broad market added roughly 3% on Friday, brushing aside a very weak manufacturing report to focus on New Year optimism.

The gains came on very light volume and we’ll see how traders react to geopolitical events that have intensified over the past week. Some are suggesting we can jump to the pre-Lehman collapse levels, which would be nice (1260 on the S&P 500) but is highly unlikely with events we face – both inside and outside of the economy. We think 1050 on the S&P 500 is quite possible, but probably not without another move lower. From there is all depends on how geopolitical events unfold, and we remain in a secular bear market so we shouldn’t expect stocks to magically move higher without bouts of weakness.

Also helping the benchmarks advance was a statement out of the Treasury Department that a Citigroup-style rescue package would be used to help other financial institutions if needed – this is a confidence booster for investors.

Many, including us, had assumed this to be the case but the government has been so capricious regarding its decision-making process it has caused additional uncertainty over the financial markets.

Bank preferred shares rallied on the statement as it signals the government will not render these shares worthless in place of new super-senior government securities if some assistance is required.
(The Citigroup plan involved pumping liquidity into the bank and backing potential losses. This too can bring problems down the road, obviously the government can’t back everything, but at least investors can have a little more certainty their positions will not be driven worthless if some assistance is deemed necessary.)

Again, today will be an important one as traders come back from vacation and we see how they react to Israel’s incursion into Gaza, Iran’s call to cut oil exports to the West and Russia feeling things out to possibly do the same regarding Europe.

Market Activity for January 2, 2009

And speaking of oil, prices extended upon Wednesday’s 14% advance, adding 3.7% on Friday. Wednesday’s gain was on the heals of the weekly Energy Department report that showed stockpiles rose less than expected.

On Friday, the price began the session lower after the release of that very weak manufacturing report, which we’ll get to below, but reversed course as stocks gained ground on supply concerns related to the Russia-Ukraine dispute. Crude is up another 1.2% this morning, and looks headed for $50 per barrel. Not a big deal whatsoever, but the issues driving the price higher are.


Economic Data

The Institute for Supply Management (ISM) reported their manufacturing index continued to slide in December, blowing past the 1982 nadir to hit the lowest reading since June 1980. The December reading came in at 32.4, down from an already very weak 36.2 in November.

None of the 18 manufacturing industries surveyed reported growth in December, which is down from 11% for November and October and 33% in September. The ISM stated that based on the historical relationship between the manufacturing data and the overall economy the average readings for 2008 – 45.6 – suggests a 1.4% real annual increase in GDP. If activity for December were annualized it would correspond to a 2.7% decline in real GDP annually.

I don’t like annualizing extreme lows as it is unlikely activity will remain this soft for long; nevertheless, found it worthwhile to mention the comment from the ISM Chairman


All of the sub-indices within the report deteriorated, which isn’t a surprise based on the weakness of the overall survey. However, the degree to which some indices fell, from already low levels, took me by surprise.

The new orders index dropped to 22.7 from 27.9 – remember a reading below 50 marks contraction; the production index hit 25.5 after posting 31.5 in November; the export index came in at 35.5 from 41.0; the employment index hit 29.9 from 34.2 in November.

And it is this employment index that most are focused on considering the state of the labor market. People are looking for clues of a bounce, but they may need some patience as this is unlikely to occur for a few months.


The report in total shows that the recession continued to deepen in December and the forward-looking sub-indices suggest more of the same for January.

This report is going to augment what’s going to be a massive stimulus program, and it will approach $1 trillion. My wish is for a tax-rate response that provides incentive effects to producers and kicks disposable income higher for consumers, but this is not in the cards as politicians are myopically focused on a government spending related response. That’s what we’ve got to go on for now. The goods news is the next administration is considering higher current-year write-off allowances on business equipment purchases. This would be a very smart decision, let’s see if they do it.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries Trade Lower
After three straight days of strong rallying in stocks, the flight to quality trade had a bit of a reversal on the first trading day of 2009. In late trading the two-year was down 6 ticks to yield .86% and the ten-year traded almost two points lower to yield 2.4%. A tick represents 1/32 of one percentage point of a bond’s price.

Attention turns to supply next week when the Treasury plans to auction another $30 billion of three-year and $16 billion of ten-year notes. Most trading desks will be back to full strength next week, as a result we look for liquidity to improve. If investors fail to absorb the new auction supply don’t be surprised to see a real jump in yields come Wednesday and Thursday. On the other hand, the employment numbers that are planned to be released on Friday could disappoint, and bring back the flight to safety trade.


Cliff J. Reynolds Jr.
Junior Analyst

Afternoon Review

December Recap:

Markets rallied in December as governments around the world responded aggressively to the global fallout and investor appetite for risk edged higher. The widely publicized VIX index, a measure of fear in the market, has declined over 50 percent from its November 20 high, which suggests that the fear surrounding stocks has dissipated somewhat and demand for risk-taking increased. Another indication of an increased demand for risk-taking is evident in the S&P 500’s lagging performance compared to riskier asset classes.

While the S&P 500 posted a modest return of 1.06 percent, the S&P 400 Mid Cap Index and S&P 600 Small Cap Index climbed 4.85 percent and 6.10 percent, respectively. Meanwhile, international equities surged with the iShares MSCI EAFE (EFA) climbing 8.88 percent and the iShares MSCI Emerging Markets (EEM) up 10.35 percent. Even more impressive were the returns on REITs, which had been smashed in the prior two months by investors’ preference for businesses that don’t require debt. The Vanguard REIT ETF (VNQ) gained 16.68 percent in December and global REITs increased 10.14 percent.

Most sectors posted gains with the exception being energy stocks. The main culprit for the sector’s poor performance is commodity prices that have plummeted in response to a global recession that has created expectations for decreased global demand. S&P GSCI Commodity Index Fund (GSG), which is about 75 percent devoted to energy with the bulk of that focused directly on crude oil, fell 11.18 percent this month. Greenhaven Continuous Commodity Index Fund (GCC), which tracks an equal weighted basket of 17 commodities, increased 0.64 percent.

The record low yields seen in November were surpassed in December with the two-year falling 21.5 basis points on the month to yield 0.76 percent, and the ten-year fell 70.5 basis points to yield 2.12 percent at the end of 2008. Yields on MBS ended the month flat to Treasuries on a spread basis, after widening out in early December only to snap back in the final week of the year.

The iShares Barclays Aggregate Fund (AGG) was up 6.65 percent due to considerable tightening of credit spreads, the continuing rally in Treasuries and the fund itself moving from a discount to a premium. iShares TIPS fund (TIP) also enjoyed some nice price appreciation as the deflationary scare that hurt TIPS the past two months proved to be short lived.


--

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks ended the market’s worst year since the 1930s on a positive note, rising roughly 4% over the final two trading sessions of 2008. Wednesday’s gains may have been helped by a much-better-than expected reading on initial jobless claims, although continuing claims jumped, honing in on the high point reached during the 1981-82 recession.

More likely investors and traders were positioning for the so-called January effect, the tendency of the stock market to rise in the first week or month of January – the definition is not concrete. I don’t buy into this idea, since it seems to occur largely in up markets. In any event, positioning for the New Year is likely what drove stocks higher.


The benchmark S&P 500 declined 38.49% in 2008, resulting in the first 30% slide since the 38.59% plunge in 1937. There have been just two years that exceeded 2008’s decline -- 1931, when the S&P 500 lost 47.07% and 1937 when the index slid 38.59%. The 1931 debacle followed an 11.91% decline in 1929, a 28.48% drop in 1930 and preceded a 14.78% drop in 1932. So I wouldn’t go comparing what occurred in 2008 to the early years of the Great Depression years just yet.

Most other large annual declines in stock prices were followed by strong upside activity. The slide in 1937 was followed by a 24.55% rise in 1938. In 1974 – which we think is a more appropriate comparison -- the broad market fell 29.72% and was followed by a 31.55% surge in 1975. In 2002, the broad market lost 23.37% and was followed by a 26.38% jump in 2003, a year that kicked off the five-year bull market that saw the S&P 500 rise 77% by the time it peaked in October 2007.

That said, investors will be faced with plenty of headwinds this year. If the economy, not just domestically speaking but globally as well, does snap back and lending activity turns a bit more normal we’ll have an inflationary event on our hands as the Fed is printing dollars like mad. The Fed will then have a choice. Stamp out the inflation by raising interest rates, or ignore it for fear that higher rates will push the cost of money to levels that impede corporate profit growth. And even if the Fed doesn’t raise short term rates, one would think the long end to rise, which will affect corporate borrowing costs, and mortgage rates as well.

If inflation does not rise, it will probably mean that the banking system remains in disarray and lending has not returned to normal, which will also be a drag on equity prices.

The likely scenario, based on what is currently known, is that we will rally from these levels, but then run into some trouble a few months later as the previous concerns arise.

There are positives, however – as long-term readers know I do not enjoy this tone of pessimism.

Fed stimulus, fiscal stimulus, trillions in cash on the sidelines, very low gasoline prices and very low mortgage rates should help out. In addition, U.S. businesses are very streamlined these days; inventory levels are much lower than normal heading into recession and that will help to ease the duration of the downturn (less goods to sell off before production ramps up again) – so long as government policy mistakes don’t work against this private-sector efficiency.

But back to last year, if you thought it was a rough year for the U.S. market, it was worse for most overseas bourses. Overall, international stocks within developed markets fell 45.09%, led by a 42% decline in the Nikkei 225 (Japan). Emerging markets got hammered, losing 54.48%, led by a 72% in Russia’s main index.

Jobless Claims

The Labor Department reported initial jobless claims fell 94,000 to 492,000 in the week ended December 27. That’s a very big decline and the first time since October initial claims have moved below the 500k mark. While this decline is very welcome, most of it was likely due to the seasonal adjustment as the week covered the Christmas holiday. The unadjusted level of first-time claims fell only 2,000. Additionally, some suggested winter storms prevented people from filing. We’re not sure of the extent this may have played, possibly government offices closed down as a result.

The four-week average of claims fell 5,750 to 552,250.


Continuing claims jumped 140,000 to 4.506 million in the week ended December 20 – there is a one-week lag between initial and continuing claims data. Continuing claims are closing in on the 1982 peak, but as we’ve touched on many times now, this level of continuing claims is not nearly as bad as it was back then when payroll employment stood at 88 million; today that figure is 136 million, so that context is important. Nevertheless, this high level of claims illustrates labor market conditions are very weak.


In terms of the December payroll survey (job losses for the month), we look for another big decline, maybe another 500,000, as the previous jobless claims reading hit a 26-year high. That previous reading was for the week that corresponds with the December payroll reading – the Bureau of Labor Statistics defines as unemployed those persons who didn’t work in the week of the monthly employment report.

It’s too early to tell, but if I had to throw a guess out there, we should expect the monthly job losses to ease over the next three months. The job market lags the overall economy, so the labor market will remain weak for even after the economy rebounds (although the type of stimulus the Obama Administration will implement will give jobs a short-term boost) but we should see the degree of decline level off by late spring.

Russian Revanchism and Energy Supply Threats

The Russian economy has been hit exceptionally hard as global growth wanes, oil prices have plummeted (they’re economy is heavily dependent on oil revenue) and the ruble continues to get crushed and will very likely slide further. GDP trends will reverse, from growing 6-7% over the past few years to contraction.

As a result, the Russian populace will become increasingly perturbed and the number of demonstrations will rise. The regime has already countered by expanding the definition of treason (endangering order as they define it) and punishable by up to 20 years in prison. The riot police will be cracking down in force.

In order to take the citizens’ minds off of their eroding circumstance one should assume they’ll seek to reclaim former Soviet satellites, much like the conflict with Georgia last summer. Propaganda will increase to foment anti-American/anti-Western ideology. Further, as the WSJ pointed out last week Russian authorities have rewritten the constitution to grant the president 12-year consecutive years in office. They point out that current President Medvedev will take the fall for the ailing economic state to usher in Putin’s return.

This will likely become quite problematic and the Obama Administration will need to remain on top of things. Over the past couple of days, Russia has cut off gas supplies to Ukraine and threatens to extend this action. This does not only affect Eastern Europe but Western Europe as well. For now, natural gas supplies are well built, so this action by the Russians does not harm energy requirements in the near term, but it is a concerning indication of how Putin and Co. will roll over the next few years.

The West needs to get off of its environmental concerns and think much more logically by increasing energy production. This is serious stuff. We also need to dramatically expand nuclear energy capabilities, which is extremely clean energy production and should be embraced whether you believe in anthropogenic climate change or are more concerned from a national security perspective.

Have a great weekend!


Brent Vondera, Senior Analyst

Afternoon Review

Spotlight: Transocean (RIG) *updated tearsheet attached*
Two weeks ago, I mentioned that Transocean may have some near-term selling pressure following their approval to change the place of their incorporation to Switzerland and their subsequent removal from S&P 500 and the Russell 2000 indices. Transocean tumbled more than 26 percent in the seven trading days following the decision, and today trades at just more than three times earnings (the company’s has typically traded between 12 and 15 times earnings).

Also fueling the share price meltdown was CEO Bob Long’s comment last month that deepwater projects need $60-a-barrel oil to be economic. With oil hovering around $40-a-barrel, fears have grown that projects may be canceled. However, this is not a valid concern for Transocean since only 1 to 2 percent of their contracts can be canceled by client termination, and those particular contracts contain day rates far below market rates.

The deep-water market is positioned to expand substantially in coming years because of large deep-water discoveries, and Transocean has positioned itself as the prime beneficiary. The company’s $41 billion backlog (nearly three times its current market capitalization) and orders extending out to 2020, provide stability for the business and nice visibility into the future.

Noble (NE) is will likely be the next driller to change the place of their incorporation to Switzerland, and thus will be removed from the S&P 500 and Russell 2000 indices as well. Though much smaller than Transocean and less leveraged to the deepwater market, Noble’s $12 billion backlog (double the company’s current market capitalization) gives revenue visibility out to 2016. About 88 percent of Noble’s business is with national oil companies, giant public firms and large independents, thus the risks of customer financing issues are low.

Noble also provides engineering and consulting in addition to contract drilling services, giving the company a diversified revenue stream. Noble is contracted to build the largest ultra deepwater drill ship to be put into service in 2011, for $585 million. Out to 2011-2013, the deepwater market will become a larger proportion of Noble’s revenues, which should allow them to maintain wide margins.


Quick Hits

• Tallying the Trillions in Bailouts to Bankruptcies
• The Deals and No-Deals of 2008
• VIX Declines Below 40 as ‘Sheer Panic’ on Wall Street Recedes
  
  

Peter Lazaroff, Junior Analyst

Fixed Income Recap

Treasuries Rally
U.S. Treasuries were higher across the board today on thin trading, despite the gains in the stock market. The two-year ended the day at .73% while the ten-year closed at a yield of 2.06%.

The yield curve has steepened 9 basis points this week to 179 basis points, after flattening considerably over the last month. Like stocks, Treasuries continue to be range bound in an environment where volume is very light and most desks are waiting out the end of the year.


Fed MBS Purchasing Program
Goldman Sachs, Blackrock, PIMCO and Wellington Management were announced as managers for the Federal Reserve’s $500 billion MBS buying program. Actual purchases are expected to start in early 2009 and be completed by June. Only, Fannie Mae, Freddie Mac and Ginnie Mae fixed-rate mortgage-backed securities are eligible for the program.

The market has already begun to price these purchases in, which has significantly lowered fixed rate mortgage yields over the past few weeks. The market is hopeful that the demand from the Fed will spill over to new mortgage originations and continue to re-establish confidence in the overall mortgage backed securities market.

Cliff J. Reynolds Jr.
Junior Analyst

Daily Insight

U.S. stocks managed some nice gains on very light volume yesterday, brushing aside manufacturing data that showed activity within the sector remained very weak and housing data showed price declines accelerated in October.

The news that the lending arm of GM will receive $5 billion in TARP funds (at a cost 8%) likely helped the indices advance. While bankruptcy is the best path to viability for the Detroit Three, the market probably doesn’t want to contemplate the ramifications to an already weak labor market that would result.

We’ll note the dire predictions that an additional three million workers will be thrust into the unemployment rolls are a bit hyperbolic; nevertheless, such an event would cause the unemployment rate to jump. Re-organization is a necessary condition to get GM, Chrysler and Ford streamlined for the future, but the marketplace doesn’t want to deal with this reality right now, so stocks get a short-term boost on news of government-assistance.

Unfortunately, the rally in stocks was not accompanied by a decline in Treasuries. We’ll really need to see some money come out the Treasury market as this will signal an easing in risk aversion. So long as money continues to hide under the Treasury market rock, it’s tough to get too excited.

The goods news is intraday swings have become much milder, so we may have entered into this feeling out process, as we’ve termed it – a period in which the market determines which way it wants to go after a serious plunge, such as the 40% slide in the two months that ended November 20. During the 1974 bear market a similar period of relative calm ushered in a powerful rally.

Many seem to believe a robust rally will come in January. We’re not so sure as the de-leveraging event may have not yet fully run its course. The Middle East is also heating up, which won’t help things. Based on what is presently known, we do believe a powerful bear-market rally is on the horizon, but may have to wait a few weeks still. It’s impossible to time.

Market Activity for December 30, 2008

U.S. stocks are headed for their worst year since 1931 as things fell apart when Lehman went down on September 15; the event roiled the money markets and caused the overall credit market to freeze up. The following chart of the S&P 500 Index shows what has occurred from the peak hit in October 2007. It took us basically a year to fall 20% from that peak, but prices began to plunge in the third week of September.


Economic Data

The S&P Case/Shiller Home Price Index, a gauge of the largest 20 metro areas in the U.S., posted its largest decline yet in October.

Case/Shiller recorded home prices fell 18.04% on a year-over-year basis. As you can see via the table below, the most significant damage continues to occur in the West, although Miami, Detroit, Tampa and Minneapolis also continue to see exceptionally large declines. This home price index has values down 23.4% from the peak.


We’ll note, as long-term readers know, that this gauge is not a broad representation of what is occurring nationwide. The FHFA (Federal Housing and Finance Agency) offers the broadest measure of home prices. This measure has home prices down 10% from the peak hit in early 2007 (the exact time of the peak depends on the gauge). This measure also has its flaws though. Where Case/Shiller is not a broad index, and subject to a number of cities that saw the greatest speculative fervor at the height of the housing euphoria, the FHFA index fails to cover high-end homes.

In our view averaging the four main home price measures, the two just mentioned along with price data from the new and existing home sales figures, offers the best look at what prices in general have done. This shows average home prices are down roughly 16% from the peak.

For a longer term perspective, home prices in generally are up about 35% since 2000. That means home prices have grown about 3.4% annualized, which is slightly below what I believe to be the long-term average of 5%.

The decline in home prices has been a harsh reality; however, it is a necessary condition to bring sales back. It appears the process of reversion to the mean has run its course, in fact may have moved beyond what is justified. This does not mean prices will bounce back over the next couple of months, we do have a weak job market to contend with, which is the more traditional drag on housing. Nevertheless, we may be very close to the bottom.

In a separate report the Chicago Purchasing Managers Index (PMI), which measures factory activity in the region, edged slightly higher from the prior month’s depressed reading.

The overall activity index came in at 34.1 after posting 33.8 in November – the weakest readings since the spring of 1982. A reading of 50 is the line of demarcation between expansion and contraction.

(For context, Chicago-area manufacturing showed activity expanded 54 of the 55 months that ended in February 2008, which marked the longest run in the survey’s history. In February the index contracted mildly, but bounced back July-September as business spending accelerated. Things collapsed though beginning in October as the credit event caused businesses to cancel spending projects when the credit markets froze up.)


The new orders index moved up to 29.4 from 27.2 last month, while production fell to 31.7 from 34.3. The employment index rose nicely to 39.6 from 33.4; however this level still represents a significant decline in manufacturing jobs. For new readers, these are the sub-indices of the overall report.

Nothing in this report offers an indication the nation’s largest manufacturing region in on the verge of a rebound. The next reading on factory activity comes on Friday via the ISM survey (manufacturing activity for the entire nation).

The US Dollar

The greenback has given up much of the gains recorded in summer and fall and will very likely take a beating in 2009 as the combination of the Federal Reserve’s massive liquidity injections pumps more dollars into the system and the government’s spending spree will cause budget deficits to soar. And we’re not talking about deficits the media has harped on over the past several years, those were child’s play, extremely manageable levels that ran 1.2%-4.0% of GDP. No, the deficits that the government will record for 2009 and 2010 will hit $1 trillion plus, or more than 7% of GDP.

Last spring, the Dollar Index (DXY) hit the very low level of 71 but rallied beginning in July as it benefited from a flight to ultra-safe investments such as Treasury securities. Now though with yields at record lows, that money may move to other currencies, or more likely gold as the safety trade moves to this hard asset. We’d look for, as much as it pains us to say it, the DXY to return to the lows we saw in mid 2008.


This morning we get initial jobless claims for the week ended December 27, a day earlier than usual due to the New Year’s holiday.

Have a great day and happy New Year!


Brent Vondera, Senior Analyst

Afternoon Review

Spotlight: General Electric (GE) *contact for updated tearsheet*
On December 18, S&P cut the outlook for GE to negative and gave the company a 1-in-3 chance of losing its top grade within two years. This announcement came one day after GE’s investor presentation, which suggested that the company’s AAA credit rating could be sacrificed in the name of the dividend.

This does not mean that GE has completely given up on maintaining its top rating. GE plans to shrink GE Capital from 50 percent to 40 percent of total profit. Even more, the company plans to issue $45 billion in long-term debt in 2009, less than the $66 billion it has maturing, and to reduce commercial paper to $50 billion, less than the $75 billion they had planned before.

Bloomberg ran this article today, which showed that the gap between bonds rated AAA and those three steps lower, at AA-, averaged a record 1.12 percent in December as the credit crunch deepened. Before credit markets began unraveling 16 months ago, the difference averaged about 0.06 percent. Insert GE as an example, and an extra percentage point in interest would have cost the company $233 million more in annual payments on the $23.3 billion they raised in the bond market in the first half of 2008.

Despite the increased borrowing costs, shareholders should be pleased with GE giving priority to the dividend and future earnings growth instead of their credit rating. If GE decided to do the opposite, they would be forced to focus on raising capital by selling business units or forgoing opportunities that would benefit the company in the long term.

The financial crisis has called into question the balance sheets of even the most creditworthy institutions. Consequently, GE’s valuations are at multi-decade lows.
With a recent capital infusion as well as government loan and guarantee programs, GE Capital’s funding position appears stable. In addition, strong cash flows are expected from GE’s industrial businesses, enabling the company to maintain its current dividend through the end of 2009.



Quick Hits

• The Financial Crisis Timeline
• GMAC Adds Loans as U.S. Injects $6 Billion to Aid GM
• Billionaire Blowups of 2008
  
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks fell on concern merger and acquisition (M&A) activity will continue to slow after Dow Chemical’s deal to sell half of its plastics unit to Kuwait was canceled. The funds were slated to help fund Dow’s $16 billion purchase of specialty chemical firm Rohm & Haas. The deal would have provided Dow with $9 billion.

The fact that M&A activity will continue to slow in the current environment is obviously not of great surprise, but the market still comes under pressure each time investors are reminded of this fact.

Kuwait’s decision to pull out means the Dow acquisition is much less likely and this has larger ramification for the market in general as it illustrates the problems related with funding deals right now. Kuwait’s issue was not from a financing perspective so to speak but rather the 75% plunge in the price of oil has them reigning things in. Nevertheless, it keeps the issue in the back of investors’ minds, adding just another concern tugging at sentiment.

Dow shares slid 21% as the failure to sell part of the plastics unit may put the dividend in jeopardy. Most people own the stocks for the dividend. The company will now try to re-negotiate the R&H purchase, probably attempting to shave 10%-15% off the original purchase price. R&H shareholders will likely do the deal at the lower price as they will have a rough time finding other bidders for a while and a price of $70 (original deal was set at $78 per share) is suddenly looking pretty darned good.

For the market in general, the goods news is major indices pared earlier losses. The S&P 500, for instance, was lower by nearly 2% when the afternoon session began, but a late-session rally erased most of those losses. Still nine of the 10 major industry groups lost ground. Energy shares gained ground as the Middle East heats up, pushing oil prices higher.

Market Activity for December 29, 2008

Interestingly, the rally in crude prices early yesterday morning fizzled just after stocks opened yesterday – the spot price jumped nearly 7.7% in pre-market trading but gave most of those gains back by lunch.
However, crude rallied again in the afternoon session to close the day up 6.13%.


They’re a Bank!

Last night it was reported that GMAC will get $5 billion in TARP funds in exchange for super-senior preferred shares yielding 8% to the Treasury Department. GM will get another $1 billion that is supposed to help them finance the lender’s (GMAC) reorganization as a bank holding company – so I guess they got the TARP money before they were officially in a position to be called a bank holding company. That’s what you call making up the rules as you go along.

So GMAC gets $5 billion, GM get $1 billion, which is on top of the roughly $7 billion they received earlier in the month. Maybe this will get GM through the spring. Isn’t that grand?

Some were saying without the TARP funds GM would be forced to eliminate 40% of its 6,500 U.S. dealerships. Yeah, that’s what’s going to occur anyway in time as the GM model pretends as if they still enjoy 50% market share when in reality it’s below 20%.

GM has too many dealerships, too many assembly-line employees and a compensation and layoff structure that makes zero sense in today’s highly competitive world. The checks will fly as the 111th Congress rolls in, but it won’t do a darn bit of good in terms of viability until the firm is forced to streamline

Cash Galore

A story ran yesterday explaining that $8.85 trillion currently sits in bank deposits and money-market funds, which is equal to 70% of the market value of U.S. stocks as measured by the NYSE Composite.

This is a theme we’ve touched on for a couple of months now, yet we focus specifically on money-market funds as this is a more natural area for cash to flow into equities.

Logically, bank deposit accounts are higher as households increase cash savings after the stock market has gotten crushed by 45% (from the October 2007 peak) and home prices are down roughly 15% on average – these are the two largest savings vehicles for U.S. residents. As those savings vehicles have declined people have chosen to boost cash savings and I’m not sure this money should be included among the funds that will potentially move to stocks any time soon.

Still, specifically regarding money market funds there is $3.8 trillion in cash, which could theoretically by 48% of the S&P 500.


Of course, this money needs a compelling reason to enter the market, and with concerns heightened right now it may take a little while to flow into stocks. Once we get a couple of months out and the Obama stimulus plan begins to get off the ground, we should see these funds seek some risk -- the market is cheap from both an earnings-multiple standpoint and a dividend-yield perspective, especially compared to rates along the Treasury curve.

This is one of those rare occasions in which the investor can pick up shares at prices that offer superior long-term returns – December 1974 is probably the last time such an opportunity presented itself. However, over the short term things will remain highly precarious.

We’re not at all convinced a rally from these levels, whenever it happens, will have sustainability however (talking months not years) – the market will need to see concerns ease over future trade pacts, tax rates, how the Fed is going to deal with eventually removing some of the liquidity it’s pumped in and the degree to which regulations will increase, among other things. But the cash is available to spark a rally and as this occurs it should remove some of the caution currently in the marketplace and bring with it a bit of optimism.

It’s a crisis in confidence that needs to be addressed, which is why a tax-rate response could go very far in building optimism as it would spark a stock market rally as quick as anything can. However, this does not seem to be in the cards (ok, it’s not at all probable) considering the make up of Washington after January 20. The policy that will be put in place over the next few months is all we have to go on right now.

Economic Data

We’ve had a couple of quiet days in terms of economic reports, but get back to it today with the S&P Case/Shiller Home Price Index (October) and Chicago-area manufacturing activity. Tomorrow we get initial jobless claims for the week ended December 27 – a day ahead of the normal schedule as Thursday is a holiday.

Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

Spotlight: 3M Company (MMM) *contact for updated tearsheet*
3M’s highly diverse business portfolio, healthy international mix, continuing commitment to R&D and an intensive focus on productivity has contributed to the company’s high profitability and strong cash flows.

Considered a highly reliable barometer of the general health of the economy, 3M stock has fallen in tandem with the market. However, 3M has historically turned crisis or recession into opportunity by utilizing its very solid finances (currently almost $3 billion in cash) to buy quality companies at low valuations.

3M generates significant free cash flow and has plenty of financial flexibility to continue to invest for organic growth, concurrently still pursue business portfolio realignment activities and also reward shareholders materially.


Dow Chemical (DOW) -20.79%, Rohm & Haas (ROH) -16.08%
Dow’s acquisition of Rohm & Haas hit a major snag as a Kuwait backed out of a deal in which a state-owned petroleum company was to pay Dow $7.5 billion for a 50 percent stake in several chemical plants. The deal was to become effective in less than a week, and Dow had intended to use the money to help finance its $15.3 billion purchase of Rohm & Haas.

Kuwait’s decision is a result of significantly lower energy prices compared to when the deal was struck about one year ago, making the deal less attractive. The deal would have given Dow much needed access to low-cost natural gas, which they consume in huge quantities to make its chemicals.

In July, Dow offered $78 per share for Rohm & Haas in an $18 billion deal, but Dow is coming under pressure from lenders and shareholders to renegotiate its offer price in light of the current situation. For years, Dow has been trying to reposition itself, moving away from producing low-margin commodity chemicals and into the higher-margin specialty chemicals business. These events present a major setback for Dow’s plans.



Quick Hits

• Democrats May End Minimum Tax on Municipal Bonds to Spur Market
• Cash at 18-Year High Makes Stocks a Buy at Leuthold
  
  
  

Peter Lazaroff, Junior Analyst