Visit us at our new home!

For new daily content, visit us at our new blog: http://www.acrinv.com/blog/

Friday, February 27, 2009

Afternoon Review

Hansen Natural Corp. (HANS) +7.32%
Hansen reported impressive earnings that came in ahead of expectations and, even more importantly, the Monster energy drink brand continued to take market share from competitors.

Despite weaker consumer spending trends, the company increased revenues more than 3 percent year over year, primarily as a result of higher prices. Gross margin expanded more than 3 percentage points, as greater volume of the firm’s new energy shooter drinks provided a more favorable product mix.

Hansen has performed very well in this economic climate because energy drink consumers don’t have good substitutes – most people drink these products because they don’t like coffee. Sales have also been helped by the fact consumers can not make comparable energy drinks at home the way that a coffee drinker could easily make their own cup. Also helping Hansen is their younger consumer base, which is less adverse to the economic climate and likely to spend more discretionary income.


Dell (DELL) +3.90%
Dell had a positive earnings report in which cost discipline saved an otherwise difficult quarter.

PC revenues declined 22 percent on a 12 percent decline in units. Gross margin performance was likely the most important factor for investors this quarter. Cost and pricing discipline allowed Dell to post gross margins of 18.1%, which should be viewed positively in this environment.

Dell’s unit declines coupled with Hewlett-Packard’s poor numbers last week, supports the fear that demand conditions continue to deteriorate in the PC and enterprise segments. The next several quarters should be remarkably challenging for Dell, but there is growing sentiment that the shares can’t fall much lower without a significant deterioration of market share.


General Electric (GE) -6.48%
GE is finally cutting its annual dividend in a move to preserve cash and protect the company’s top credit rating. GE’s stock price has reflected the assumption that the company would have to cut its dividend for quite some time. Now yielding 4.5 percent, GE shares may offer even more upside potential than before since the company will have an extra $9 billion annually to invest in future growth of their business.


Quick Hits

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks began the trading day higher on Thursday, even after the release of a horrible durable goods report and another very weak jobless claims reading (both prior to the bell), but began to sink as the morning session came to a close and then fell to negative territory in the final hour.


The market appeared to give the Obama budget – some of which we touched on yesterday – a thumbs down but I’m not sure it’s fair to blame yesterday’s activity on the fact that the relationship between the federal government and the private sector is in the process of being altered. This has been a major reason the market is down 25% since Election Day– per yesterday’s session, we’ve known the agenda for a while so it’s not like what was announced was much of a surprise. We’re going to see government spending as a percentage of GDP move from the 18%-20% range of the past quarter century to something closer to 30%, and this will have an effect on longer-term growth rates simply because the private sector allocates resources in a much more efficient manner than government, period.

Financials and telecoms were the only winners yesterday – telecoms have been on a nice little run of late. In terms of financials, it’s a rarity these days to see the overall market decline on a day the banks gain ground, but the broad market was weighed down by the drubbing health-care stocks took – the budget was not kind to this sector as a push to universal health care, a proposal to lower Medicare Advantage payments to managed-care firms and requiring drug-makers raise rebates (you want to crush drug discovery, this is the way to do it) pushed the group lower.


Market Activity for February 26, 2009

Well, let’s get to the economic data.

Initial Jobless Claims

The Labor Department reported initial jobless claims for the week ended February 21 rose 36,000 to 667,000 -- the expectation was for a decline. Claims just keep rising and we’re approaching the all-time high hit in 1982. However, while one shouldn’t downplay this event, when adjusting for payroll position growth claims would have to hit one million to match that 1982 level. There are 135 million payroll positions today compared to 88 million in 1982.

The four-week average of claims – a less volatile figure -- jumped 19,000 to 639,000.


Continuing claims rose 114,000 to 5.112 million in the week ended February 14. The insured unemployment rate – which tracks the overall jobless rate – rose 0.1 to 3.8%.

I think it’s pretty clear payrolls will show another huge 600,000 loss for February when the data is released next Friday. The unemployment rate may hit 8.0%, currently it is 7.6%. I’ve got to believe the degree of monthly job losses will ease a couple of months out as firms may have gone too far in job cutting, scared by the combination of the credit freeze last quarter followed by policy that has not exactly offered a boost to confidence.


Durable Goods Orders

The Commerce Department announced durable goods orders dropped 5.2%, following an almost equally large 4.6% decline in December. A decline in transportation orders of 13.5% led the decline as defense aircraft and auto bookings dropped.

Excluding transportation, durables orders fell 2.5%, following a big 5.5% decline for December that was revised down to show double the damage of the initial estimate. There were no silver linings in the data. Primary metals orders fell 4.6%, industrial machinery was down 2.0%, computer orders fell 5.0%, electrical equipment was down 6.1%, autos were down 6.4%.

The component of the report we watch most closely (as longer-term readers are aware) is nondefense capital goods ex-aircraft, this the proxy for business equipment spending. This figure dropped 5.4% last month and 5.8% in December – down 34.3% at an annual rate the last three months. This as well as anything explains the level of caution with which businesses are operating. This gets the business equipment side of GDP off to a horrible start for the first quarter.

New Home Sales

Wow! The Commerce Department reported new home sales declined 10.2% in January to 309,000 units at an annual rate from an upwardly revised reading of 344,000 for December – first reported at 331,000.


The supply of new homes fell 3.1% in January – the 21st straight month of decline – to 342,000 to the lowest level since April 2003. The population was 19 million lower back in 2003; I think this shows how the supply glut has been completely erased, new home prices are down 26% from the peak.


It will take some economic confidence, however, for this to flow through in sales. The supply of homes relative to sales rose to 13.3 months’ worth.


By region, sales in the Northeast rose 12.5%, but the Midwest and South fell roughly 6% and the West saw new home sales plunge 28%, for the month! This depressed activity in the West is quite different from existing home sales data as we’ve seen activity rebound to a decent degree for existing.

New home sales are down 65.8% at an annual rate over the past three months and have yet to show any sign of bottom, but we’ve got to be close.

Have a great weekend!


Brent Vondera, Senior Analyst

Thursday, February 26, 2009

Daily Insight

U.S. stocks fell for the seventh session in eight after the President’s address to Congress showed contempt for business (sorry, don’t know another way to put it) and clearly believes the government should play a greater economic, permanent, role.

Dividend cuts from a number of insurance names, as they get hammered by mark-to-market and a falling stock market and thus have to put additional money aside to support annuity guarantees, kept financials down even as Fed Chairman Bernanke reiterated bank nationalization is not in the cards.

It appeared those comments from Bernanke, along with some clarity with regard to the Treasury’s “bank stress test” and future capital injections plan, is what helped stocks rally in the afternoon session. The S&P 500, for instance, jumped 3.5% after lunch until it all fell apart again in the final 30 minutes of trading.

Industrial shares led the market lower, the index that tracks these shares fell 2.86%, with health-care and basic material stocks not far behind. Worries the economy will take quite a while to bounce back put pressure on material and diversified manufacturing shares. The sole winner was telcom, which added 1.01%.


Market Activity for February 25, 2009

Crude

Crude oil rose to a three-week high, jumping 6.36% yesterday, after the weekly Energy Department report showed gasoline inventories fell 3.32 million barrels to 215.3 million last week. Motor fuel consumption averaged nine million barrels per day over the past four weeks, up 1.7% from the same period last year. The price of crude is up 25% since February. While half of this move is due to the March contract expiring on the 20th (the April contract traded higher than that expiring March contract) the rest is due to gasoline fundamentals.

Refineries have also reduced production, which is normal for this time of year as they retool to shift from heating oil to more gasoline production.

Oil supplies went in the other direction (although as you can see the supply of gasoline can drive the price of crude) as supplies at Cushing, Oklahoma (where traded West-Texas Intermediate crude is delivered) rose 34.5 million barrels to the highest level since April 2004.

Oil trades in contango right now, meaning you can buy the front month contract and sell later month contracts at a higher price. This means oil is being delivered to Cushing for storage. The opposite of contango is backwardation, the situation in which the front month trades higher than months forward.


Mortgage Applications

The Mortgage Banker’s Association reported that mortgage applications fell in the week ended February 20 as the 30-year fixed mortgage rate moved above 5.00%. We’ve talked about how activity bounces when that rate moves into the 4% handle and vice versa when it moves back above 5%, and this seems to be the case.

The outlier to this view is the rebound that occurred in the week ended January 30 even as the 30-year mortgage rate hit 5.29%, but this may have been because the prior week’s decline was so large. Therefore, the bounce was a function of coming off of that low level. A rate below 5.00% is still the target and if we can get below that level for an extended period we may begin to see some sales and refi activity that helps to absorb supply and lower servicing costs.

Purchases fell 2.6% last week and refinancings dropped 19.1% after a big 64.3% jump in the prior week.


Existing Home Sales

The National Association of Realtors (NAR) reported that existing home sales fell 5.3% in January (that was weaker-than-expected and the increase in December was revised lower) to 4.49 million units at an annual rate. Multi-family activity led the decline as sales for this segment slid 10.2%. Single-family existing home sales fell 4.7% last month.


In terms of region, sales in the Northeast fell 14.7%, the Midwest and South both declined 5.7% and the West was flat (the West region has endured the largest foreclosure activity and thus the largest price decline – sales seem to have found a bottom for now as a result).

On supply, the number of existing homes on the market continues to come lower – which is a good thing for when sales do bounce back, supply (relative to the sales pace -- the month’s worth of supply figure) will come lower quickly. The issue right now is the job market and general lack of confidence. We get those two things turned around and this housing correction will have run its course rather quickly.



On that last point, this is why we’ve argued the way to go is to focus on economic growth and let the housing market correct as it will. Policy makers keep talking in terms of doing the opposite (focusing on housing and allowing hope for a rebound to spur economic activity), which will only prolong the housing correction as the consequences of their actions have adverse effects. We cannot turn jobs around on a dime, but by focusing on incentives (lowering tax rates on capital, labor income and profits -- and thus raising after-tax returns on these activities) we can stop the bleeding and allow the growth in economic activity take care of the rest. That’s when confidence turns and that’s when we’re back in business.

Unfortunately, the administration is out with next year’s budget and they are wasting no time raising taxes. It’s not that this is a surprise, but the fact that they are moving, even if incrementally, so quickly on this front is very concerning to me. In this budget proposal, there will be limits on deductions for those in the top two income tax brackets and higher tax rates on hedge funds.

We’ll then see the current income tax rates rise across the board as they revert back to the pre-2003 levels; the capital gains and dividends rate will revert as well (end of 2010). And you watch, the middle class will be hit hard as well – not just from the perspective of lower economic growth and stock market activity as higher tax rates are destructive to after-tax returns, but more directly via their paychecks. Anyone who believes that payroll taxes (FICA) will not be increased is not in tune with the agenda, in my humble opinion.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries
Treasuries were down across the board today as the long end of the curve underperformed shorter Treasuries. The two-year traded down one-eighth of a point while the ten-year was lower by about 1.25 points in price as the benchmark curve steepened by 5 basis points. A basis point represents .01%.

MBS
Mortgages outperformed comparable Treasuries on Wednesday, tightening 7 basis points to remain at the bottom of the range we have established. I would expect FNCL 5’s, 30-year Fannie Mae 5% MBS, to maintain a spread over Treasuries of about 145 to 160 basis points for the next couple weeks.

Municipals
Highly rated municipal bonds have tightened in considerably and many cities, counties and states in all parts of the country are taking advantage of the opportunities at these lower rates. I would expect AA- rated or better munis to tighten more from here.

From an investor’s perspective shorter munis still look attractive on a relative basis, assuming the investor is in the top tax bracket for tax exempt issues. For investors who can take additional liquidity risk in smaller blocks, odd-lot munis look especially attractive.


Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Wednesday, February 25, 2009

Afternoon Review

Stress Test Details Unveiled
The market obviously welcomes any details they can get their hands on regarding the government’s plans for the financial system. It is not a surprise that the market took off this afternoon when these details were released. The good people in Washington also provided us with some FAQs. Gosh golly, how did they know we would have questions?

Bernanke’s comments today also seemed to lift sentiment for financials.


AT&T (T) +1.98%
AT&T rallied on a U.S. Supreme Court ruling in the company’s favor, which makes it tougher to sue companies for antitrust violations. Bloomberg reported the justices unanimously rejected a claim that an AT&T subsidiary engaged in a “price squeeze” aimed at driving out competition in the market for digital subscriber line (DSL) service.

Also boosting shares was an analyst upgrade at JPMorgan, citing the growing number of iPhone customers spurring sales growth. The report estimates that iPhone customers will boost AT&T’s the average monthly bill 1.2 percent this year by paying extra for plans that support the phone’s web-surfing features.

Last quarter, AT&T posted subscriber gains that exceeded estimates as consumers scooped up web-capable phones and projected that their decision to subsidize the iPhone (which cut into profit margins) would begin to pay off in the upcoming quarters. This analyst report supports AT&T’s projections.


Positive prospects for PC sales
Reports that Microsoft’s Windows 7 may ship as early as September, sent PC makers Dell and Hewlett-Packard higher on hopes the release may spur sales of PCs amid the global recession.

Intel (INTC) also moved higher, despite reports that global chip sales will decline in 2009, as the company could benefit from higher PC and netbook sales. Unlike Vista, Windows 7 is also designed to run on the increasingly popular netbooks that run on Intel’s lower-priced Atom chips.

There has been a large concern that these cheaper chips would erode profits, but Intel said today at Goldman Sachs Technology and Internet Conference their margins in netbooks are better than cheap notebooks.


Principal Financial Group (PFG) -6.68%
Labor federation Change to Win has made a direct request to Geithner that Principal’s $2 billion TARP application be denied due to its lobbying activities, specifically regarding it’s opposition to Employee Free Choice Act.

Principal later in the day released this statement, denying any stance on the Employee Free Choice Act.



Quick Hits

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks recovered all of Monday’s losses (and then some for the broad market, mid and small cap indices, not so for the Dow) after FDIC Chair Bair stated large U.S. banks have enough capital and Fed Chairman Bernanke provided some clarity and thus assuaged concerns over bank nationalization.

The Chairman came through yesterday in his best performance I’ve seen. In his testimony to Congress, Bernanke smoothed things over (after the administration along with Senator Dodd scared the heck out of the market again via its lack of clarity) by explaining that additional capital injections and more government control over banks would only occur if absolutely necessary. That helped things out enormously in yesterday’s trading; thank you Mr. Ben.

Regarding the administration, it’s like they’re afraid to say anything terribly concrete for fear a policy will fail and they’ll have to take responsibility – this is a major issue for stocks right now; we cannot afford additional uncertainty.

Financials led the rally; the index that tracks these shares jumped nearly 12%. Consumer discretionary and energy shares also outperformed.


It’s tough to get excited though as the political environment is costly right now. We have higher tax rates on the horizon (and I can’t even believe the President’s comment last night that he’ll raise corporate tax rates), way too much government involvement and much more regulation coming down the road.

There are reasons stocks now trade at these low levels. Yes, one is earnings are weak. Yet another factor is massive selling pressure due to de-leveraging. But there should be little doubt that valuations also reflect the fact that after-tax return expectations have been diminished and a coming regulatory burden that always crimps growth. We do not need more regulation we need enforcement, along with sound monetary policy that does not encourage excess credit expansion. Higher tax rates are the worst thing we can do right now, they must be driven lower.

In the end, nearly the entire universe of stocks offer great return potential over the next decade – even if the next couple of years will be tough; the more the government does, the longer the rebound will take. Beyond that, assuming we snap back and do not go the way of Western Europe, which is one of the questions the market is dealing with, the potential in stocks is huge.

The really sad thing about all of this is that U.S. firms are streamlined, energy prices are very low, stock multiples are compressed (S&P 500 trades at the lowest P/E since 1986 on a 10-year average earnings basis) and there are mounds of cash on the sidelines. If we could just get policy that drives incentives and offers some economic confidence we could really be on to something. Of course, there is no magic bullet, only time can correct for the credit excesses fostered by mistaken monetary policy and government involvement in the housing market (Congressional demands to offer easy credit to poor credit-score borrowers). But bold action with regard to after-tax returns on capital, incomes and profits would be a huge jolt to the American spirit – this is what’s missing. We’ll find that groove again. For now though, ebullience is absent.

Market Activity for February 24, 2009

Home Prices

The S&P Case/Shiller home price index continues to show rapid deterioration, the year-over-year decline sped up to 18.5% for December from 18.2% in November – setting a new record.

The table below speaks for itself, so not much reason to expound on its figures. All in all, I don’t like this indicator as it only follows the 20 largest metro areas, about half of the index involves the cities in which speculation was most rampant. Housing market traders would set up consortiums, and spec houses using no money down (because they didn’t have to) and simply walked away when prices began to fall. Hence, foreclosure rates are hitting this index harder than any other.


Another look is the Federal Housing and Finance Agency’s (FHFA) home price index, which offers a very broad look at the housing market. Its results for December were out yesterday too, showing prices actually rose 0.1%. This marks the first monthly increase since February 2008 and only the second since April 2007.

Unfortunately, it’s too early to get jazzed just yet as price increases in the West region is what drove the number into positive territory. Prices have been so wrecked in the West that some sort of increase was bound to occur. The Northeast, Mid Atlantic and Southeast continue to show robust declines. This index has home prices down 9.5% over the past 12 months.

Consumer Confidence

The Conference Board’s consumer confidence survey dropped to a stunning reading (even in this environment) of 25.0 in February from 37.4 last month – this is a record low. The expectations index got slammed, coming in at 27.5 after posting 42.5 in January. The survey was taken after the announcement of the stimulus plan.


Consumers’ assessment of the labor market conditions is dirt – no surprise there. The percentage of those judging jobs as “plentiful” fell to 4.4% in February from 7.1% in January, while those viewing jobs as “hard to get” rose to 47.8% from 41.1%. Thus the net “plentiful” less “hard to get” index fell to -43.4% last month from -34.0% in January. (That January reading improved a bit, giving some people hope, but this latest look will crush that feeling, if last Thursday’s jobless claims data hadn’t already.)

The market will have its eye on mortgage applications and existing home sales data for January today. Existing home sales rose 6.5% last month, so we’ll be looking to build on that and get some kind of trend going. Fixed mortgage rates are very low, but a positive trend is probably a ways out still simply because the weak labor market will delay a rebound in sales. We shall see.

Have a great day!


Brent Vondera, Senior Analyst

Tuesday, February 24, 2009

Afternoon Review

United Natural Foods (UNFI) +20.16%
United Natural Foods soared as earnings exceeded expectations on lower fuel costs, expense control and the continuing integration of Millbrook Specialty business.

For the quarter that ended Jan. 31, United Natural managed to increase sales by 2 percent. This is very impressive given the trade-down trend the more expensive organic/natural foods are facing.

Lower costs stemming from new distribution centers as well as the Millbrook Specialty business helped boost gross margins by 50 basis points. The Specialty business has unique products that serve niche markets and affluent customers, which might explain why it has held up in this weak consumer environment. The Millbrook’s integration appears to be going smoothly and margins in this segment should continue to improve. United Natural’s improved network of distribution centers will also contribute to margin expansion in the future.

The company lowered revenue guidance and widened earnings guidance to reflect lower sales growth and greater uncertainty surrounding the impact of the recent peanut recall. The company also lowered its capital expenditure guidance for fiscal 2009.


H.J. Heinz Company (HNZ) +5.63%
Heinz reported quarterly earnings rose 12 percent on increased pricing, currency hedges and a lower effective tax rate.

Revenues declined 7.5 percent because of the stronger dollar, but sales increased 3.9 percent excluding currency fluctuations as price increases more than offset weaker volume.

The company indicated that the trade-down trend hurt sales results, but the company has been offering different size packages with different price points to better compete against generic products. Also slowing sales were lower orders from retailers that are trying to work down inventory.

Heinz last year enacted price increases as commodity costs rose and they do not plan to roll those increases back, noting the increases weren’t enough to cover the sharp spike in most commodities.

The takeaway from the report today is that Heinz’s business remains fundamentally sound, which is evident in its strong cash flow and balanced portfolio of leading brands.


Quick Hits


Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks took another good old-fashioned street beating as policymakers scare the heck out of capital – it’s running for the hills, maybe Galt’s Gulch if not careful, and they seem oblivious to the fact that it’s their fault. JP Morgan’s Jamie Dimon put it straight when on the decision to slash the dividend payout stated he is preparing for a worsening economic situation due to a more costly political environment. That pretty much sums it up.

The Dow Industrial Average closed at its lowest level since May 1997 and the broad S&P 500 at its lowest point since April of that year.

Stocks engaged in a brief rally during the initial hour of trading, apparently on news the government would inject more capital into banks. However, possibly after traders had a chance to think about it sentiment did a 180 – oh, talk of raising tax rates didn’t help either; good job!

The administration delivers a new plan each week, and absent of detail to boot. Then we have Senator Dodd popping off, making statements that increase market confusion. It’s hard to see how they could screw up anymore. More on the capital injection and policy response thing below.

Basic material, information technology, industrial and energy stocks led the broad market’s decline as expectations of an economic rebound occurring anytime over the next six months deteriorated, at least for now. A gloomy forecast for the PC market from Morgan Stanley certainly didn’t help things, especially for tech names.


Market Activity for February 23, 2009


Please Stop

Well, here we go again. Policymakers chose to engage in essentially more of the same by proposing a plan to pump additional capital into banks, and the current preferred shares they own via former injections would convert to common shares – this conversion will help capital adequacy as what is known as tangible common equity (TCE) will improve financial health since that health is based in part on common share-based capital. Problem is this is just another step toward nationalization – and if some form of nationalization is not swift (take the troubled institutions over, clean them up, and summarily send them back out to the private sector) such action only exacerbates the capital strike.

But assuming, on the surface, that more capital injections from the government is a good thing, what happens when current “toxic” assets continue to fall in price, or assets acquired by writing new loans are dragged down by distressed pricing as mark-to-market accounting demands? You’ll get more capital injections and thus greater government control over banks -- that can’t be good, only need to look at Fannie and Freddie for that one. (Regulators say major banks have capital ratios that exceed requirements, but as we’ve seen all we need is a couple of quarters of distressed-pricing write-downs and suddenly more capital is needed. The more capital that comes from the government, the longer private capital will sit on the sidelines.)

Public-sector injections can make things even worse in two ways (the freeze it puts on private capital is the result):

One, does anyone really believe Washington can manage the banking system? This of course is a rhetorical question – to ask is to answer --, as we all know politicians are not at all capable of this task. You think things are highly politicized now, just wait.

Two, what happens to the thousands of banks that have not needed government assistance? What is the fall-out from the appearance that government funded institutions are stronger. Does money run from those that did not engage in poor decisions to those that did as the perception is your money is safer at the government-backed bank?

These are the types of consequences that result from government action and we’re seeing Washington involved on such a grand scale right now that no one can contemplate the magnitude of consequences that will bring about their own problems.

We have argued for mark-to-market accounting to be abolished. For one thing, pro-cyclical accounting rules are extremely damaging. In good times, banks can hold less capital and in bad times they are forced to build more – either way you look at it such behavior is destructive.

The second reason to abolish this 15-month accounting regime (and more appropriate to today’s discussion) is because the longer we wait it means that government engages in a plethora of programs that have huge economic costs – not just from a perspective of money but simply because the market is at the whim of Washington; in which case, capital freezes (as the rules are changed weekly), essentially going on strike.

Eliminating mark-to-market is not an elixir that heals all, but it stops the self-affliction, with the former accounting standard in place I am convinced we would not have been this damaged – the credit chaos would not have occurred (not to the extent with which it did last quarter) and thus economic deterioration and job losses would not have been so substantial.

I believe when the history is written readers two decades hence will be bewildered why we chose to engage in various highfalutin ideas when abolishing mark-to-market was staring us right in the face.

The other thing readers of history will be astonished by is how we let the Federal Reserve off the hook for so long – without their mistakes earlier in the decade, none of the damage from credit expansion, with little standard, would have occurred. I do believe though that it won’t be too long – five years or so – in which setting major constraints on the Fed’s monetary policy decisions will be a consensus view. The Fed has been responsible for the largest economic distortions since its inception in 1913. Certainly Congress plays its role in causing havoc, but substantial policy mistakes from the FOMC are the origin of the major crises over the past 96 years.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries were mixed today as the long end of the curve outperformed shorter Treasuries. The two-year was unchanged while the ten-year traded higher by 1/8 of a point as the benchmark curve flattened by 2 basis points. A basis point represents .01%.

The Federal Reserve Bank of New York is now $134.8 billion into their $500 billion dollar MBS buying plan to keep mortgage rates low. The Fed announced last week that it purchased $19.9 billion in agency MBS during the seven day period ending last Wednesday, bringing the weekly average to $19.25 billion.

Mortgage spreads over Treasuries have normalized in the past week into the 145-160 basis points range. With all the demand from the Fed it’s hard to imagine MBS widening anytime soon. If demand for U.S. Treasury debt doesn’t keep up with issuance as it continues to grow in order to fund the ever growing deficit, I would expect MBS to tighten, keeping yields on MBS fairly constant. The government remains dead-set on keeping mortgage rates low and its ability to create artificial demand in order to do so is being felt in the market now.

Links

Hillary Clinton, Treasury Sales Rep

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Monday, February 23, 2009

Afternoon Review

Capital adequacy ratios
Until now, the most popular ratio in determining a bank’s capital adequacy was the amount of Tier 1 capital it had as a percentage of total assets. Tier 1 capital is used to measure a bank’s ability absorb losses without a bank being required to cease trading.

Today, attention has been refocused on banks’ tangible common equity, or TCE. TCE is a bank’s assets minus all its liabilities and, most importantly, all of its preferred shares and intangible assets like goodwill, brand names and patents. In short, tangible common equity shows what common shareholders would get if the company was liquidated.

Banks’ TCE ratios had historically been between 3 percent and 5 percent before the credit crisis. Today, Citigroup’s TCE ratio is 1.5 percent, Bank of America’s ratio is 2.83 percent and J.P. Morgan’s ratio is 3.8 percent.

Companies have some discretion as to what their TCE ratios are, but those with a TCE below 3 percent of assets should consider raising more capital. Because these companies would have difficulty raising capital in a stock sale, some (like Citigroup and AIG) are asking the government for assistance.

The government’s injections so far have been through buying preferred shares, which increase a bank’s Tier 1 capital but does not increase its TCE ratio. To help bolster banks’ TCE, it sounds like the government plans to convert some of its preferred shares into common shares.

What is troubling about this “reclassification” of balance sheet items is that the government is, in effect, changing the accounting rules. This leads me to wonder, why not just adjust the fair-value, or mark-to-market, accounting rule? While I understand the merits of fair-value accounting, it seems to me that there must be a better valuation methodology that is less volatile.


Garmin (GRMN) +7.32%
Garmin, maker of GPS devices, reported earnings that missed analyst expectations and opted not to give 2009 guidance until the “outlook for the year becomes clearer.”

Revenues fell 13.9 percent year-over-year and operating margins slipped 200 basis points compared to the third quarter and 310 basis points from the prior year.

Garmin’s Outdoor/Fitness segment had revenue increase 5 percent in the quarter, but Automotive/Mobile revenue plunged 17 percent, Aviation revenue was down 5 percent and the Marine segment turned in flat revenue for the quarter.

Still, the stock managed to rally today on reduced inventory. Garmin said it reduced its inventory by $274 million in the quarter, up from expectations of a drop of about $150 million in inventory levels by the end of the year.


UnitedHealth Group (UNH) -14.87%
Health insurers took a beating after Humana Inc. said the 2010 preliminary rates for the U.S Medicare Advantage program would have a “significant adverse impact” on premiums and benefits for plan members.

Bloomberg reports, that Humana, UnitedHealth Group and other insurers with U.S. Medicare-backed health plans for the elderly and disabled would get a rate increase of 0.5 percent in 2010, far less than premium growth projected by analysts that ranged as high as 2 to 4 percent growth.


Quick Hits

Peter Lazaroff, Junior Analyst

Daily Insight

Fears about the health of our nation’s largest financial firms sent U.S. on a wild ride lower on Friday. Talk of nationalizing troubled banks pushed the S&P 500 near its November 2008 lows, but markets jumped after the White House insisted nationalization was not in the cards. Of course, it’s hard to believe statements like these since the government has made similar comments in the past, only to change their stance later.


Market Activity for February 20, 2009

Economic data
The Consumer Price Index (CPI) rose 0.3%, showing the cost of living in the U.S. rose in January for the first time in six months. The CPI year-over-year rate remained unchanged for the first time since 1955, according to Bloomberg.

The core rate, which excludes food and energy items, advanced 0.2% last month and was up 1.7% on a year-over-year basis. Both measures came in slightly above expectations. These increases were largely due to higher prices for autos, clothing and medical care.


Bank nationalization
After Citigroup’s shares fell below $2 to an 18-year low, reports surfaced over the weekend that Citigroup is in talks to have the government take a larger stake in the company by converting a substantial portion of its preferred shares into common stock. The government holds $52 billion of preferred shares in Citigroup, five times the bank’s market value as of Friday.

Multiple reports say that the government could wind up holding as much as 40% of Citigroup’s common stock, which would dilute the stakes current Citigroup shareholders. The positive for U.S. taxpayers is that such a move would not cost them any additional money. Citigroup is also encouraging Government of Singapore Investment Corp, Abu Dhabi Investment Authority and Kuwait Investment Authority to convert their preferred stakes into common stock, which will only further dilute current shareholders’ stake more.

The idea behind Citigroup’s strategy is that converting preferred shares to common stock will bolster the company’s tangible common equity (or TCE) ratios – one of several gauges of a bank’s financial strength. Until this point, banks and regulators have referred to the Tier 1 capital ratio to determine a bank’s ability to absorb future losses. I will talk about these ratios in more detail in today’s Afternoon Review, which you can access by visiting our blog at http://www.acropoblog.com/ (the Afternoon Review is usually posted around 4PM CST).


Looking ahead

Futures are up this morning, which may be a sign that investors would embrace a temporary nationalization. The news of government’s potentially increased stake in Citigroup overshadowed the Obama administration’s announcement that they will seek to cut the deficit in half by 2013, through tax increases and spending restraint. The idea of raising taxes during a period of economic weakness makes a lot of people cringe, but it is likely the market has already priced in the expiration of the Bush tax cuts in 2010.

This is a big week for economic data, and Brent will be back tomorrow to guide you through it all.


Have a great day!

Peter Lazaroff, Junior Analyst

Friday, February 20, 2009

Afternoon Review

S&P 500 still above November lows
The S&P 500 continued its slow trek towards its November intra-day low of 741.02, but has still yet to reach it. While there is far less panic and fear in today’s market than there was last November, the level of uncertainty still remains very high.

The fate of the financial system’s largest institutions is the biggest question mark at this point in time. Comments from Senate Banking Committee Chairman Christopher Dodd about the possibility of nationalizing banks “for a short time” sent Citigroup and Bank of America tumbling. Both companies’ stocks, at their current levels, are trading more like options that bet on the government’s forthcoming actions. (If anyone has a crystal ball, please contact me.)

The rally that started last November came to an abrupt stop when Treasury Secretary Tim Geithner could not provide specific details on how the government will rescue the financial system. Today, as the S&P 500 flirted with its November lows, the White House announced they will give the details of the financial bailout sometime next week and added that they are against nationalizing banks.

At this point, we can only hope that the details aren’t as opaque as last time.


Quick Hits

Peter Lazaroff, Junior Analyst

Veteran investors get jittery

Acropolis is in the news again with Chris Lissner appearing in today's St. Louis Post-Dispatch.


To view the article click here or on the logo below.


Daily Insight

U.S. stocks continued their losing streak and the Dow hit new lows Thursday, but the S&P 500 still remains above its November 2008 low.

Investors went into defensive sectors yesterday as concerns about rising credit-card defaults dragged financial shares to their lowest level since 1995 and poor earnings from Hewlett-Packard pushed the technology sector down. Energy benefited from surging oil prices, which rose over 12% on the New York Mercantile Exchange after a U.S. government report showed an unexpected drop in inventories.



Market Activity for February 19, 2009


Economic Data

The Labor Department reported the producer price index (PPI) for January jumped 0.8% for the month, but was down 1.0% on a year-over-year basis – both numbers were higher than anticipated. Core PPI, which excludes food and energy, rose 4.2% year-over-year. Although producer prices climbed more than forecast, it’s unlikely these prices increases will hold given the weakening economy and rising unemployment.

Continuing claims surged by 170,000 in the week ended February 7, and initial jobless claims were unchanged at 627,000 last week (the prior week’s number was revised up to 627,000).

Meanwhile, the Philadelphia Fed Business Outlook Survey showed manufacturing in its region shrank the most since 1990.


Fed Releases Longer-Term Economic Projections

The Fed is doing their best to keep public inflation expectations at reasonable levels and has begun to release longer-term projections for inflation, economic growth and unemployment. The goal is to provide the policy, according to Bernanke, is to “provide the public a clearer picture of FOMC participants’ policy strategy for promoting maximum employment and price stability over time.” This, in turn, would stabilize the public’s inflation expectations and keep actual inflation from rising or falling too dramatically.

The Feds minutes, released on Wednesday, indicated that officials are aiming to move public expectations at a 2% rate. Policy makers estimated long-term economic growth at 2.5% to 2.7% and an unemployment rate at 4.8% to 5%. Only time will tell if this self-fulfilling prophecy strategy can work.


Mortgage Relief Program

Sentiment remains that home prices are still way to high by historical standards for the U.S. housing market to stabilize, and Obama’s mortgage-relief plan is only slowing the bottoming process.

Another big concern is that modifying loans will not have a very large impact. According to the December report by the Comptroller of the Currency and the Office of Thrift Supervision, “The number of loans modified in the first quarter that were 30 or more days delinquent was 37 percent after three months and 55 percent after six months. The number of loans modified in the first quarter that were 60 or more days delinquent was 19 percent at three months and nearly 37 percent after six months.”


Have a great day!

Peter Lazaroff, Junior Analyst

Thursday, February 19, 2009

Afternoon Review

Hewlett-Packard (HPQ) -7.89%
While earnings and sales were mostly in line with expectations, Hewlett-Packard’s guidance showed that the world’s largest PC maker can not dodge the recession. To combat the difficult economy the company is cutting pay for most of its employees.

Revenues were down 19 percent in the personal systems group as well as in the imaging and printing segment. Enterprise storage and servers had revenues decline 18 percent, and software revenues were off 7 percent. Services rose 116 percent due to the EDS acquisition.

The company’s downside forecast for the quarter and full-year were well below consensus estimates. Hewlett-Packard’s outlook sent a slew of tech names lower today including IBM, Dell, Intel, EMC, and Cisco.

Going into today, the technology sector was the second-best performing industry in the S&P 500 this year, which is largely due to the safe haven they offer in strong balance sheets.


United Natural Foods (UNFI) +8.29%
United Natural Foods rallied in response to higher-than-expected earnings and guidance from Whole Foods Market (WFMI).

United Natural Foods derives about 31 percent of net sales from its relationship with Whole Foods as their primary U.S. distributor. With United Natural set to report earnings next week, it appears some investors are expecting the company to replicate Whole Foods’ earnings surprise. Is this enthusiasm overdone?

A closer look at Whole Foods results showed that the earnings surprise was from vast improvements in cost controls and store/property management. The important number relating to United Natural is sales, which declined 4.9 percent as shoppers are trading down from costly organic and natural products to less-expensive nonorganic goods.

While we expect to see United Natural report lower sales next week, it will be more important to evaluate the company’s progress integrating Millbrook (purchased in November 2007). The company has also invested in several new distribution facilities that will help widen margins and add capacity so the company can take on more business in the long-run.


Boeing (BA) -1.08%
Boeing continues to lose orders for its new 787 Dreamliner, which is now almost two years behind schedule. Boeing’s backlog still stretches out well over six years, but investors should brace themselves for more cancellations as airlines’ demand for the new fuel-efficient plane wane in light of lower fuel prices and less passenger traffic.


Oil surges
Crude oil rose over 12 percent on the New York Mercantile Exchange after a U.S. government report showed an unexpected drop in inventories as imports declined.


Quick Hits

Peter Lazaroff, Junior Analyst

Daily Insight

Most U.S. stocks fell as reports on housing and industrial production showed very weak activity remains the case. The President unveiled his mortgage-relief plan, but the market seemed unenthused.

The Dow rose just a bit as gains in shares of Wal-Mart, Proctor & Gamble and McDonalds offset declines in the industrial components of the index. The broad market and NASDAQ Composite lost a bit of ground. Mid and small-cap stocks were the hardest hit, down a bit more than 1.00%.

Two stocks fell for every one rose on the NYSE. Some 1.3 billion shares traded on the big board, 16% below the three-month daily average.


Market Activity for February 18, 2009

Treasury’s Mortgage Plan

The President announced a plan to help nine million (I don’t know how they come up with these numbers) restructure or refinance their mortgages. The program will use $75 billion to bring down mortgage rates and encourage loan modifications – sharing in the cost of reducing monthly mortgage payments (subsidizing a lower interest rate) by having the government match lender reductions to bring that payment down to 31% of borrowers’ monthly income. The Treasury will also double the amount of stock purchases of Fannie Mae and Freddie Mac to as much as $200 billion for each.

In 2008, 75% of home loans were financed by Fannie and Freddie – they’re just about the only game in town -- and the $400 million in capital injections will help to maintain a positive net worth as the government leans on them to provide liquidity for the mortgage market.

On the Economic Front

The Mortgage Banker’s Association reported their index of mortgage applications jumped 45.7% in the week ended February 13 as the 30-year fixed rate fell just below the 5.00% mark. As we’ve been talking about, this is what homeowners are looking for and if this rate can hold below 5% we’ll see several weeks’ worth of gains.

Again, refinancing activity is driving the mortgage apps index as the segment rose 64.3% last week -- although purchases did rise as well, up 9.1%.


In a separate report, the Commerce Department announced housing starts plunged 17% last month to an annual rate of 466,000 units.

U.S. builders broke ground on the fewest houses on record in January (data goes back to 1959) as tighter credit and labor-market deterioration continued to crush sales. Severe weather in January had an effect as well. Multi-family starts fell 27.9%, while single-family starts dropped 12.2%. Single-family starts are 81% off the January 2006 peak.


Commerce also stated building permits fell 5.1%, marking the seventh-straight monthly decline. This is a sign housing construction will remain depressed, as if we need another.


In yet another release, the Labor Department reported import prices fell 1.1% in January, which brings the year-over-year reading to -12.5%. My how thing have changed. It was just six months back when the YOY reading had hit +21.6% -- this is what occurs when monetary policy goes berserk. Granted, Bernanke and Co. don’t have much choice right now; however, all of the current problems can be traced back to flawed monetary policy earlier in the decade.

The plunge in petroleum prices has had the most effect on import prices, that component is down 55% year-over-year. Excluding fuel, import prices are essentially flat – down just 0.3%.


Finally, the Commerce Department stated industrial production fell 1.8% in January, marking the third-straight month of decline – all were substantial declines (down 1.2% in November, down 2.4% in December and, as stated, down 1.8% last month).

Consumer goods, business equipment, construction supply and machinery were all hit hard last month. The manufacturing component delivered the heaviest blow – this segment makes up 77% of the index and it was down 2.5% last month -- pushed lower by a huge 23.4% plunge in auto-related production. Utility activity was the sole bright spot, up 2.7% for the month.

Activity is very depressed, especially within the manufacturing sector. But when we do get a bounce in activity, or at least a flattening process, inventory dynamics should provide a boost to GDP. The inventory-to-sales ratio has jumped since this debacle truly began in September, but is still meaningfully below recessionary levels. Inventory dynamics remain in place and this will provide a catalyst to growth – if only I knew when. Beyond that there is still a sustainability issue as the government is so involved that it puts the private sector increasingly on edge each day.

I’ll be out of the office for the next three days; either David of Peter will take over during this time.

Have a great day!

Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries sold off today as investors took profits after yesterday’s rally. The two-year was down 5/32 of a point in price while the ten-year traded lower by 3/4 of a point as the benchmark curve was virtually unchanged on the day. A basis point represents .01%.

New issue MBS outperformed comparable Treasuries today after lagging yesterday. MBS tightened seven basis points to +150, reversing about half of the widening that occurred yesterday.

Homeowner Affordability and Stability Plan
Here are a couple bullet points from the housing plan announced today by the Obama administration.

  • $75 billion to help homeowners refinance and reduce their monthly payment through non-traditional means
  • Loans with 80-105% LTV will qualify for the program
  • Efforts will be made to reach homeowners early. Homeowners who are struggling, but are still current on their mortgage will qualify.
  • Sacrifices made by the private mortgage servicers will be matched dollar-for-dollar by the government.
  • The interest rate will be modified to bring the monthly payment to a target of 31% of household gross income. After 5 years the interest rate may be gradually stepped up to the prevailing interest rate at the time of the loan modification. For example a 6% mortgage may be modified to 4%, and after five-years will gradually step up to today’s market rate of 5.15%.
  • Private servicers will receive upfront payments of $1,000 for each loan they modify, and $1,000 per year for 3 years on successfully modified loans that stay current.
  • Homeowners who have their loan modified under this program will be eligible for a $1,000 reduction in principal outstanding each year for five years as long as they stay current.
  • For securitized mortgages these modifications will appear to investors as prepayments.The new mortgage will either be held by the servicer or sold in the secondary market.
  • Responsible homeowners and renters who have chosen to live within their means will be penalized through future taxation in order for the government to reward those who did otherwise. (not explicitly noted in the text of the plan)


Preferred Stock Purchase Agreement

Today the Treasury announced an amendment to its Preferred Stock Purchase Agreement with mortgage agencies Fannie Mae and Freddie Mac. The agreement was originally formed to allow for the Treasury to inject up to $100 billion in capital in each agency, $200 billion total, through investments in preferred stock. The limits were doubled today to $200 billion each, or $400 billion total. The limits on the size of their retained mortgage portfolios were also increased $50 billion, to $900 billion each, leaving room for over $200 billion dollars in mortgage demand from the Government Sponsored Enterprises. That’s on top of the $385 billion of securitized mortgages that the Fed has left to purchase in the open market before June.

The Treasury wasn’t nearing the original limits on capital injections, total government funding may soon reach $50 billion and $16 billion for Freddie and Fannie respectively, but this was a good move to avoid questions from the market. In an environment where the government is being very unclear on many fronts, they aren’t leaving much to the imagination here. The government is dead set on keeping Fannie and Freddie strong in order to use them to strengthen the mortgage market. The solvency of the agencies is pivotal to the Treasuries operations.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst

Wednesday, February 18, 2009

Afternoon Review

Curtiss-Wright (CW) +3.29%
Curtiss-Wright’s fourth-quarter earnings declined 9 percent year-over-year, below consensus estimates, mainly due to a higher effective tax rate.

Fourth-quarter sales increased 2 percent as higher sales to the power generation market were mostly offset by declines in oil and gas, commercial aerospace, and the general industrial markets primarily related to the automotive industry. Operating income for the fourth quarter remained flat.

Full-year 2008 net sales and operating income increased 15 percent and 11 percent, respectively, driven by solid organic growth of 6 percent and incremental sales from 2007 and 2008 acquisitions. Organic growth in the commercial markets was driven by a 48 percent increase in the power generation market, while the defense markets were led by strong growth in both the ground and aerospace defense markets, which grew 17 percent and 9 percent, respectively.

CW’s full-year sales and profit gains were particularly impressive considering several external factors, including the Boeing strike, delays on the Eclipse 500 and Boeing 787. New orders received in 2008 increased 19 percent from the year before, and CW’s backlog at year-end was $1.7 billion, up 29 percent. This further demonstrates the strength of the company’s wide portfolio of products that it sells to a diversified set of markets.

Looking ahead, CW anticipates another year of growth in 2009 based upon their solid backlog, key positions on long-term defense programs and the continuing demand for advanced power generation technologies. Management has also focused on improving operational efficiency and cutting costs, which should allow the company to maintain its margins.

CEO Martin Benante noted, “the beginning of the year will be particularly challenging as our customers are resetting inventory levels which will shift new orders and existing backlog to later in the year.” Benante also added that CW’s commercial power generation market remains strong and is still “in the early stages of a renaissance.”


Principal Financial Group (PFG) -2.50%
After declining over 38 percent in the past six sessions following a discouraging earnings report, Principal Financial may turn to ‘strategic’ investors in hunt for capital.

Last week, the company reported unrealized investment portfolio losses that were substantially worse than expected, raising concerns the company may need more capital. Moody’s lowered its outlook on Principal to “negative” following the earnings release.


Quick Hits

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks tumbled again, bringing the Dow Industrials to close smack dab on top of the November 20 multi-year low and the S&P 500 closed below 800 for the first time since that date.

Concerns that the global economy will continue to deteriorate, fatigue and complete uncertainty regarding incessant government action, talk of bank nationalization and another investment scam (returns are so much easier to come by if you just make them up) have put capital on strike.

Financials led the beat-down, tumbling 9.80%. Energy and utilities weren’t far behind, down 6.31% and 4.90%, respectively. You think utility stocks are safe? (After all, the group is a traditional area of safety.) You better make sure the one’s you own are good credits and haven’t over-extended the dividend – dividend cuts have smacked the group over the past week.

The lack of clarity makes it impossible to value anything for the near term – as we’ve touched on for some time, you can forget about fundamentals for now, it’s all about the government; the investor is held hostage by the whims of Washington. For the longer-term, looking out at least five years, we’re looking at a buying opportunity that comes along once every 35 years. Problem is you’ll need lots of patience and risk aversion is probably as high as it gets, and understandably so, likely delaying a sustained rebound.


Market Activity for February 17, 2009


Back to the Till

General Motors and Chrysler have come back for another $22 billion (little more than $16 billion for GM and nearly $5 billion for Chrysler). The goods news is GM is shedding programs and bloat that have sapped any inkling of efficiency. The bad news is now that they are on the government dole the high and mighty in Congress will direct what they automakers will produce – forget what the market demands, these central planners clearly know better.

Crude-Oil

Oil moved below $35 per barrel as the commodity is trading on GDP right now – that is, people are focused on very weak economic activity rather than supply/demand fundamentals. It’s not that supply is tight, U.S. crude supplies sit 15% above the five-year average, but I’m not sure this justifies $35 per barrel. (That said, these supply figures are probably not terribly accurate either. There is a lot of crude just floating around in tankers as the contango situation – prices for delivery in future months are higher than for earlier contracts, thus allowing buyers to profit from hoarding oil – is in place.) Still, the point is crude will probably not turn until we see some bottoming in GDP. While the lower GDP figures weigh on demand expectations, to this point world oil demand is just 3% off the peak hit in November 2007. During the 2001 downturn, for instance, demand fell 6% from the peak.


Looking out several months, we shouldn’t forget about a $600 billion stimulus package coming out of China (and our own $800 billion spending spree – even if much is entitlement programs and staggered three years out), which will boost energy demand. Government spending on parade along with the massive liquidity injections via the Fed that have not yet run through the economy should drive inflation rates to unwelcome levels.

One big disappointment is that we continue to allow enraged environmentalists (people who are completely unwilling to compare air quality today to say the 1940s) to block energy production via lawsuits and permit schemes. Oh, and by the way, CO2 levels follow warming trends, not the other way around; warming results from solar activity. Increased CO2 levels result from warming oceans; the solubility of CO2 falls when oceans warm and thus emit more of it.

If we can get our senses, we can take down two birds with one stone by putting in place a policy to drive energy production – this would help to create the supply that will be needed to absorb the money that will explode through the system 6-12 months out – tamping inflation -- and create high-paying technical jobs at the same time. While we watch oil tank for now, I’ve got a feeling we’ll wish we had begun to put such a plan in place when we look back a year from now.

On the Economic Front

The New York Federal Reserve Bank’s survey of the area’s factory activity (known as the Empire Manufacturing Index) fell to -34.7 in February (lowest level since records began in 2001) from -22.2 for January. In ISM terms (as longer-term readers know ISM is the nationwide factory activity index), Empire improved a bit to 40.2 from 40.0 – still quite depressed but not the substantial deterioration headline Empire printed. The headline reading on Empire is based on sentiment, not the weighted average of new orders, shipments, delivery times, inventories and employment like ISM.


While the new orders and employment sub-indices of the report declined, inventories, shipments and delivery times improved.

The decisive point is that New York-area manufacturing activity remains very weak, surely due to weak housing-related production as the area is hit hard by the financial sector woes, to put it mildly. But when we properly weight the major components activity was not as bad as the headline figure showed.

The question, since the weighted reading was boosted by a meaningful improvement in the inventory index is whether or not this is a fake out or manufacturers are actually feeling much better about inventory levels. If so, we could begin to see sustained factory activity improvements a couple of months out. We’ll get the Philly Fed index later in the week, and since this a better indication of what is occurring on the national level it will help to provide evidence as to whether we’ve seen bottom in factory activity or not.

In a separate report, the Treasury Department showed international demand for longer-term U.S. financial assets rose in December (quite a lag to this data) by more than expected. Total net purchases of stocks and bonds rose $34.8 billion in the final month of the year after posting one of the rare declines in November – net selling of U.S. assets was $25.6 billion that month.

Demand for corporate debt drove the increase as spreads widened, making these securities more attractive after five-straight months of decline. Demand for U.S. stocks was upbeat, rising $3.9 billion.

Net purchases of U.S. longer-term assets have risen $520 billion over the past 12 months. Some say the difference between the trade deficit and this measure of foreign investment inflows is what determines the value of the dollar. That is, if the trade deficit is larger than the investment inflow, the dollar will fall in value, and vice-versa.

But this hasn’t proven to be the case, as we’ve talked about within this letter for a few years now. While the dollar was declining 2003-2007, the inflow of investment to U.S. assets was outpacing the level of trade deficit, yet now that the trade deficit has outpaced the investment inflows, the dollar has strengthened. This is the opposite of what the so-called pundits state should occur.

The fact is there are a number of variables that go into currency fluctuations – for now the dollar is benefiting from the safety trade as global investors rush into the Treasury market. Overall though, there are two simple things to remember for those that desire a strong currency, which should be a goal: One is sound monetary policy; the other is low tax rates, especially on capital. An economy that remembers these two things will have both a strong currency and rising levels of prosperity.

Signed

The stimulus bill was signed yesterday. Too bad -- and I say this in jest because personally I would rather they had scrapped it for something that incentivizes the private-sector -- the spending doesn’t occur as quickly as the boondoggle was passed. More than $200 billion will be spent after 2010 (so much for what Keynes called “priming the pump”), $584 this year and next.

And speaking of the impact on growth, one thing we did not touch on yesterday was what is termed as the “crowding out” effect. Normally, I don’t give much credence to this argument, but at the level of budget deficits we’re now sowing there may be something to say about this thought. One would think bond yields to eventually rise as the Treasury market is flooded with supply, and as this occurs it will have an effect on mortgage rates, corporate borrowing costs and of course dampen any nascent housing rebound just as it may begin to materialize.

I have to say, instead of stimulating, this legislation just may actually depress economic activity. I use the word “may” out of kindness. I do not believe it is a likelihood, but rather a certainty that any actual stimulant that is in the plan will be completely offset by this effect, at which point we are left with only the debt. It may not be long before the Hope Express runs out of track.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries rallied today as stocks sold off considerably. The two-year was up 6/32 of a point in price while the ten-year traded higher by more than two points as the benchmark curve was flatter on the day by 14 basis points. A basis point represents .01%.

TIC (Treasury International Capital System) flows for the month of December were released today showing that foreign investors may have the appetite to support Treasuries at these levels. The report showed net foreign purchases of U.S. Treasury bonds increased by $41 billion in the month of December. The looming increase in Treasury debt issuance is really controlling the market, so the large jump in prices today can be expected from news like this, even considering its lagging nature.

New issue MBS widened to comparable Treasuries today as mortgages underperformed the fast rallying ten-year Treasury. MBS widened thirteen basis points to +157 and 25 basis points wider from the twelve month low of +132 reached last week.

The Four Primary Risks of Bonds

Credit
Duration
Liquidity
Structure

The timing and order of cash flows generated from a bond is referred to as the bond’s structure. Investors have their pick from many different kinds of structure to fit their risk tolerance and overall investment strategy.

The most common bond structure is a simple bullet structure where the bond holder receives an interest payment every six months until maturity when the entire principal value is received at par. The interest income allows the investor to have cash for expenses or for reinvestment during the life of the bond. Most Treasury, corporate, agency and municipal debt is structured in this way.

Another common structure is the callable structure. One form of callable bond is very similar to the bullet structure except for a provision that gives the issuer the ability to pay back the principal before the bond matures. A callable bond will have a higher yield to maturity than a comparable bullet because of the added risk of the call structure. Issuers will often call bonds if rates have fallen and they are able to reissue the debt again at lower interest cost. Consequently, investors receive their principal back at a time when rates are low and reinvestment looks unattractive compared to before. Mortgage backed securities are partially called every month when the bonds pay principal from regularly scheduled mortgage payments and prepays resulting from the home being sold or refinancing. This leaves the investor with both interest income and principal to reinvest or spend.

Zero coupon bonds are issued at a discount, but mature at par, generating return for the investor without any interest payments. Although reinvestment risk isn’t as much of a concern with zero coupon bonds, delaying all of the return until maturity is also a risk. Zeros may be appealing for investors with no need for cash flow before maturity.

Another form of structure is credit structure. Some bonds are split up into sections called “tranches”, with each tranche having different exposure to credit risk. This form of structure is common among non-agency mortgage backed securities where defaults within the mortgage pool can be allocated to lower quality tranches first, in order to protect the higher quality tranches. Each tranche trades separately from the others, but their returns are often linked.

There is no best structure. The market prices the risks associated with each form of structure so investors must consider value along with their own needs for cash flow when choosing a structure. Diversification of structure, like other forms of risk, is important to any fixed income portfolio.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst