July 2009 Portfolio Insights

Click here to read the latest issue of Portfolio Insights.


Inside you will find:

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

Daily Insight

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

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

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

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

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

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

Market Activity for July 9, 2009
Jobless Claims

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

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

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

Wholesale Inventories

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

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

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

Chain Store Sales

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

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

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


Have a great weekend!


Brent Vondera

Fixed Income Recap

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

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

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

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

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

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

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

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

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

Market Activity for July 8, 2009
Mortgage Applications

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

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

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

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

Increasing Regulations on Commodity Trading

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

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

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

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

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


Have a great day!


Brent Vondera

Fixed Income Recap

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

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

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

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


Cliff J. Reynolds Jr., Investment Analyst

WAG raises dividend 22%

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

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

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

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



Minjung Son

Amgen (AMGN) set for a big day

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

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

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

Peter J. Lazaroff

Daily Insight

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

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

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

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

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

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

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

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

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

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

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

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

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

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


Have a great day!


Brent Vondera

Fixed Income Recap

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

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

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

Cliff J. Reynolds Jr.

Finance arm still weighing on General Electric (GE)

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

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

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

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

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

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

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

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

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

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

Peter J. Lazaroff

Fixed Income Recap

The curve steepened again yesterday to +256 as short term yields fell for the fourth trading day in a row. That’s fourteen out of the last sixteen for those keeping track. Bonds shrugged off a better than expected ISM number and a stronger stock market and rallied anyway. Even more impressive is they are rallying ahead of a week of relatively heavy supply. Like I said in yesterday’s recap, the $73 billion in supply this week is far from the $100+ billion weeks we have gotten used to lately, but with bonds being auctioned on 4 days this week for the first time since the Treasury began regularly issuing bonds, it’s a hurdle nonetheless. Treasuries look a little overbought, especially on the short end in my opinion.

Yesterday’s TIPS auction kicked off this week’s supply schedule and went off without a hitch. The bid/cover ratio, a measure of demand for Treasuries, was a healthy 2.51, higher than the 2.37 average for the previous four auctions. Today we will get $35 billion in new three-year notes, an area of the curve that has had a very strong past couple weeks. I wouldn’t be surprised to see a pullback in prices, (higher yields), come with the supply today.


Cliff J. Reynolds Jr.

Daily Insight

U.S. stocks ended mixed on Monday (I think I have my days right now) as the Dow and S&P 500 gained ground, while the NASDAQ Composite was held back by a decline in technology shares. A better-than-expected reading on service-sector activity for June helped buoy the market.

After spending nearly the entire session in the red, the broad market (as measured by the S&P 500) rallied in the final minutes of trading to close above the day’s opening price. Market weakness just prior to the release of the day’s sole economic reading suggested things were going to get ugly if that number was to miss the expectation; when it beat, most stock prices began to slowly improve and picked up steam in the final half hour.

The traditional areas of safety, consumer staples, utilities and health-care shares were among yesterday’s top performers. Energy, basic materials and tech were the biggest losers. We talked about the likelihood of sector rotation taking place a couple of weeks back, out of the reflation trade of oil and basic material shares and into consumer staples, health-care and utilities. We’ll see if this move has some legs this time.

Volume remained weak on Monday as just 1.1 billion shares traded on the NYSE Composite, 21% below the three-month average. Ten shares fell for every seven that rose on the Big Board.


Market Activity for July 6, 2009
Crude-Oil

Crude for August delivery continues to pull back after its steep 70% run up from $34 to $73 that occurred in just four months. Oil continues to trade on prospects for GDP, and with concerns that the economic rebound may be delayed (at least in terms of the recent consensus estimate) its moving lower again, down 4% on Monday to $64 per barrel. Of course, some of this is just natural profit taking after such a powerful move higher.

I’m not even going to try to guess where crude goes from here. Supply/demand fundamentals probably don’t justify a price higher than $50-55 per barrel, but we’ve got massive deficits and very easy monetary policy to think about. These policies should affect the dollar’s value over time, pushing it lower, and this will have the opposite result on commodity prices. If the dollar does trend lower over the next couple of years, one wonders if what has become the anti-dollar trade (the euro) will continue as the Eurozone is going be burdened with lackluster growth prospects for some time. This means the commodity play may work as the anti-dollar trade for the next 18-24 months and that means higher oil prices, but probably not before an additional pullback as is typically the case after surges, such as the one we’ve seen over the past three months.

ISM Service Sector

The Institute for Supply Management’s (ISM) service-sector gauge continued to show improvement as the reading for June came in at a better-than-expected 47.0 – three percentage points higher than the May reading of 44.0 and a pretty darned good number considering the state of things.

While a reading below 50 suggests the service sector remains in contraction mode (for the ninth-straight month now), continued improvement is obviously a good sign but like so many data releases these days there’s always something that diminishes an attempt at relative optimism. Six of the 18 industries the index covers reported business grew in June, which is unchanged from May and down from seven in April. One would certainly want to see a steady trend of improvement here.
This headline reading of 47.0 is a composite of several sub indices: business activity, new orders, prices and employment. These individual indices are important to also view separately as a gauge of where things are going from here.

The business activity reading came closer to hitting 50 than anytime since the economic world changed in September, posting a reading of 49.8 after the 42.4 in May.

New orders, one of the best indicators of future activity, hit 48.6 after posting 44.4 (and a drop from the April reading) in May.

The employment index rose to 43.4 in June from 39.0 in May. Five industries reported an increase in employment (Real Estate, Rental & Leasing, Entertainment & Leisure, Agriculture and Forestry), eight reported a decrease and four reported no change.

The prices paid index moved above 50 for the first time since October, hitting 53.7 – this may be something to watch. We’re far from the level of 80 hit when last summer’s commodity spike pushed the CPI to 5.6% on a year-over-year basis, but I don’t think it will take much to juice prices again, and the ISM prices paid figures will be a key number to watch.

The inventory sentiment reading jumped to 67.0 from 62.5, which means more industries view their level of stockpiles are too high at this time – this reading likely completely offsets the improved reading in the new orders index; with respect to the outlook for the next couple of headline ISM readings. If firms continue to believe inventories are too high, it’s tough to make the argument that new orders will trend higher.

The export index hit 54.5 and was the brightest aspect of the report (remember that very targeted Asian stimulus, led by the Chinese, we’ve been talking about) as the Chinese spending may be starting to show up in this figure.

Corrections:

Beyond referring to all of Thursday’s activity as Friday’s in yesterday’s letter – sorry about that, it’s habit I guess, I also reported the wrong number on the duration of unemployment (in weeks). The numbers I posted were from the previous month when stating: “The mean duration of unemployment (in weeks) made another new high since this series began in 1947, moving up to 22.5 weeks from 21.4.”

The correct number is 24.5 weeks, jumping by the largest amount since the recession began, up from 22.5 weeks in May.


Have a great day!


Brent Vondera

Daily Insight

U.S. stocks slid on Friday after the two main jobs reports showed the labor market remains very fragile and in fact still in a weaker state than is the case during the typical recession.

There had been this thought, particularly after the better-than-expected May employment report, that labor conditions had improved to the peak levels of monthly job losses seen during the normal recession – a level around 300K-350K in jobs losses per month. That thought was crushed on Friday as 467,000 payroll positions were lost and the duration figures (the data that shows the percentage of unemployed persons who go at least 27 weeks before finding a jobs and the overall average duration of unemployment) continue to move higher.

These results increase doubts that consumer activity will be able to muster a sustained rebound in the near future, and thus this extends the concern that the economic rebound will be delayed. One thing is pretty sure. Whether it’s the private-sector income data, jobless claims, or the monthly payroll data, a sustainable consumer rebound is a ways off, certainly more than a year out. If it took this latest employment data to make people realize that, then it’s all for the better. We don’t need the equity market getting out of hand and then selling off in a major way simply because wishful thinking allowed stock values to get ahead of economic improvement.

Friday’s decline capped the worst weekly performance in seven weeks and the first three-consecutive weeks of decline since hitting the 12 ½ year low on March 9. Volume was very weak again on Friday as just 704 million shares traded on the Big Board. This is pretty normal for the session just ahead of the July 4 holiday, but with the combination of jobless claims and the monthly payroll data out on the same day (a very unusual event) I would have thought more people to be around. The NYSE also endured another technical glitch, we had one of these a few sessions back, as they move to a new system, so that likely had an effect on trading volume as well. Still, volume has been lackluster for about a month now, evidence that there isn’t much conviction at these levels. For perspective, Friday’s volume was little more than half the three-month average.

Market Activity for July 2, 2009
Jobless Claims

The Labor Department reported initial jobless claims fell 16,000 to 614,000 in the week ended June 27. The four-week average fell 2,750 to 615,250.
Continuing claims fell 53,000 to 6.702 million. So, it appears we’ve seen the peak, but the decline in continuing claims is a function of benefits expiring rather than from an increase in job opportunities. It will be interesting to watch how this figure reacts over the next couple of months. The fiscal stimulus package funds $7 billion to states so that they can increase the duration of unemployment benefits, increasing it to 59 weeks from the current 26. I’m not completely sure if this extended time period has already been put in place within a number of states or not, but I am sure that this extension will make interpreting the data that much more difficult.
Bottom line is that jobless claims remain stubbornly high, not able to move below the very elevated 600K mark. Until we begin to see this figure move back to the 550K range (still a very elevated level but meaningful improvement from here) one cannot expect much good news from the overall employment situation. And speaking of which…

June Jobs Report

The Labor Department also reported that payrolls declined 467,000 in June, much worse than the expected decline of 365,000 – it appears that ADP figure was right on the mark, as it had the decline at 473,000.
The prior month’s reading was actually revised to show better-than-initially recorded improvement as just 322,000 positions were lost, down from the 345,000 initially estimated.

That initial 345,000 figure had many hoping the monthly job losses were set to trend to a level that more closely corresponds to the peaks of monthly job losses for the past three recessions (which is why I labeled them on the chart above). Those hopes were dashed with Friday’s release as we’ve moved back to the 1980 peak (lower horizontal line on the chart above). Problem is, this amount of monthly jobs losses was the peak hit in the 1980 recession; this time this level is actually an improvement from recent peaks we’ve seen this go around. It’s going to be a couple of months still before we move back to calmer monthly declines.

In terms of specific, the goods-producing sectors shed 223,000 positions last month, down from the 215,000 loss in May – still a bit better than the three-month average of -235K though. The manufacturing sector led this component lower, cutting 136,000 jobs – a bit better than the three-month average of -147K; the construction sector reduced payrolls by 79,000 – right in line with the three-month average.

Service-producing industries led the declines, slashing 244,000 positions. Business services cut 118,000 jobs, worse than the three-month average of -98K. Trade and transportation shed 51,000, a nice improvement however from the three-month average of -72K.

Yet again, the only component of the data that showed job creation was education and health services as education added 15K and health-care services added 19K.

The unemployment rate rose to 9.5% (highest level since August 1983) from 9.4% in May – this was a bit better than the 9.6% expected, but it’s only because workers removed themselves from the official jobless rate by not looking for work in the four weeks that encompassed this survey period, the “discouraged worker.”
The U4 unemployment rate jumped again (this reading adds in those discouraged workers – again, these are people who have looked for work sometime over the past 12 months but not in the four weeks covered by this report) to 10.0% from 9.8% in May.

The U6 unemployment rate (this is U4 and adds those working part-time for economic reasons – could not find full-time work so settled for part-time) ticked up to 16.5% from 16.4%.

The mean duration of unemployment (in weeks) made another new high since this series began in 1947, moving up to 22.5 weeks from 21.4.

The percentage of those out of work for at least 27 weeks (the longest duration measured by the BLS) jumped to 29% of those unemployed from 27% in May.
Hourly earnings came in flat ($18.53 per hour) and hours worked fell again (down to 33.0 avg. hours per week, which is a record low since the series began in 1964). These figures, needless to say, do not bode well for the monthly income data over the next few months. Recall, 97% of the increase in personal income for May was due to government transfer payments, all private-sector components (save rental income, which makes up only 5% of the total) have been in decline for months now, and it won’t be long before this Western European-style income boost runs its course. Those clinging to the belief that consumer activity will make a sustained rebound anytime soon are kidding themselves.

This morning we get the ISM service –sector reading fro June, and a number above 45 is going to be needed to calm concerns. While this level would still suggest the service economy is in contraction mode, we need to see additional improvement – the reading came in at 44.0 for May. Outside of this figure, we don’t have a heck of a lot of data out this week – the only other big release is initial jobless claims 0n Thursday. We’ll get into second-quarter earnings season next week and the trading may just be especially lackluster until those results begin to come in.


Have a great day!


Brent Vondera

Bond Recap

A disappointing Nonfarm Payrolls number forced short-term yields lower on Friday as the two-year finished below 1% for the first time since 6/4. Unlike long term interest rates, which are primarily influenced by inflation, short term rates move more with expectations of Fed policy, namely the Fed’s manipulation on the Fed Funds Target Rate. As expectations grow for an improving labor market, so will expectations for a turnaround in Fed policy. The two year sold off throughout June as some in the market believed the Fed was moving closer to raising Fed Funds from their current target of 0-.25%, but the optimism proved to be too much too fast as we have moved back to where we began the month. The graph below recaps the last 60 days on the 2-year.

Supply yet again comes to the forefront this week with $73 billion being auctioned, including $8 billion in ten-year TIPS. Although the dollar amount is far from the $100+ billion weeks we have seen so far this year, the market will have to deal with 4 days of auctions in one week for the first time.

Cliff Reynolds

Buy your ticket now before Boeing takes off

The Wall Street Journal reports that Boeing (BA) may purchase the 787 Dreamliner operations of Vought Industries. The purchase would bring more of the manufacturing process back in-house, but also marks a first step towards establishing a second assembly line for the Dreamliner.

One of Credit Suisse’s analyst is viewing the transaction as a negative, but I see just the opposite. Sure, the purchase signals to the investment community that Boeing is struggling with their complete change in their manufacturing stragey, but the price of Boeing shares already reflects these difficulties. This negative analyst outlook may, in fact, represent an excellent buying opportunity for the long-term investor.

What I see are growing pains that have to be expected with a drastic shift in strategy. For Boeing, the 787 Dreamliner represents the beginning of a new era that includes the first ever streamlined manufacturing process that reminds many of the assembly line process that revolutionized automobile manufacturing forever.

The most significant change – an in my opinion the biggest reason for the many delays – might be Boeing’s increased use of outside suppliers from Japan, Italy, and the U.S. for the development and manufacturing of the aircraft. This change made Boeing more of a systems integrator instead of a manufacturer. Consequently, this transformation has been met with many unexpected challenges in the design and engineering processes as well as the way it manages its global supply chain.

What makes me bullish on the Boeing (BA) over the next several years?

First, the purchase of Vought’s 787 unit helps Boeing regain more control over its supply chain and manufacturing process. Second, and more importantly, the purchase sets the stage for Boeing to create a second assembly. A second assembly line will help Boeing ramp up production and fill orders that would have otherwise been delayed – and delayed orders lead to a financial penalty against Boeing. A second assembly line that would be outside of Seattle would also send a strong message to the aerospace unions in Seattle.

What makes me more bullish is that Boeing’s order backlog suggests the aircraft has been highly successful. Despite deferrals and cancelations related to the global recession, Boeing’s order backlog equals about seven years of production – that provides a lot of revenue and earnings visibility once production ramps up.

Of course, the problem in the near-term is determining when Boeing will reach full production. On the bright side, patient investors can collect Boeing’s hefty 4% dividend until production gets going at full tilt. With shares trading at just under 9 times future earnings, the pessimism surrounding Boeing may be overdone and we are beginning to reach levels that represent an excellent entry point for long-term investors.

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Peter J. Lazaroff

Daily Insight

U.S. stocks caught a bid yesterday as the key domestic manufacturing report hit it highest level since August offset a weaker-than-expected preliminary report on the job market for June. Stocks did give back much of their early-session gains as traders likely questioned getting to aggressive in front of this morning’s official monthly jobs figure.

The late-session release of U.S. car sales also caused some hesitation as wishful expectations for consumer activity hit the wall of reality, again. Many expected sales volumes to hit what the auto industry calls the break-even point of 10 million units (at an annual rate). Actual sales volume for June failed to hit that number, in fact coming in even weaker than the May results.
Eight of the 10 major industry groups closed the session higher, financial and health-care shares being the only losers, as utility and consumer staples led the broad market higher. One wouldn’t think the traditional areas of safety to lead the way on a day that the factory data hit its highest reading since the economy went into a tailspin in September – that’s a significant development. But that jobs data is weighing on people and causing a lack of conviction. So long as monthly jobs losses of at least 400K is seen as a distinct possibility (this is a level that, if even touched during a recession, is a one month deal, not the eight-month reality we’ve been hit with) investor certitude is going to be slight.

A great indication of this lack of conviction is trading volume, which has been weak for about three weeks now. Yesterday was one of the lightest days we’ve seen as just 905 million shares traded on the NYSE Composite, that’s 35% below the three-month average. This is summer, but levels this low are generally not seen until August when most traders are off to the beach; we should be hovering around the three-month average of 1.4 billion shares per day at this stage.

Market Activity for July 1, 2009
Mortgage Applications

The Mortgage Bankers Association reported its index of mortgage activity fell 18.9% in the week ended June 26 as refinancings declined 30% and home purchases dropped 4.5%. Refinancing activity, as a percentage of total applications, has plunged to 45% from 75% back in April. This shows the degree to which refi activity has cooled and is a direct result of the rise in mortgage rates.

Purchases haven’t looked too bad on a relative basis even as they fell last week; they are coming off of a nice 7.3% rise in the prior reading. It’s tough though to see this segment go on a multi-week run if the 30-year fixed rate remains above 5.00% -- it settled in at 5.34% last week – as the labor market weighs heavily on the housing market and it may very well take (we’re getting technical here) super-duper low rates to partially offset this factor.


125%? How Special!

And while we’re on the subject of the mortgage market, we see Fannie and Freddie will begin refinancing mortgages with loan-to-value (LTV) ratios of as much as 125% as the visible hand of the Obama administration (all of you Adam Smith fans should appreciate that snide remark) seeks to slow the foreclosure rate via their Refinancing Program. This LTV requirement (gosh it feels bizarre to even term this as a “requirement”) is up from the previously adjusted 105% and the historic level (the sane level) of 80%.

You see, the prior program was not getting much participation, even in this interest-rate environment. Why not? Because too many borrowers had a LTV of greater than 105%, apparently. Well, let’s see if 125% does the trick. But wait, even if it does allow more to refi, does it mean that all is well? Will the horribly underwater borrowers have the fortitude to tough it out and make that payment no matter the sacrifice?

Oh dear taxpayer, I fear this is not going to end well. And this will only delay the foreclosure reality that is currently making its way through the system, which means it may very well delay the recovery.

The Preliminary Jobs Reports

The Challenger Job Cuts survey (a measure of layoff announcements via the outplacement firm Challenger, Gray & Christmas) showed another month of substantial improvement in June. The survey measured that layoff announcements actually fell for the first time since February 2008 – down 9.0% from the year-ago period.
Planned firings fell to 74,393 from 81,755 in June 2008. It appears that employers have accomplished the payroll levels they feel is needed to get through this period, which is something we’ve talked about for a couple of months now.

Nevertheless, it will take additional time for this decline in layoff announcements to flow into the monthly payroll declines. Firms have slashed and burned expenses, and payrolls are the largest expense, ever since the shock of the Lehman collapse/credit market chaos that ensued. The monthly job readings will continue to record big losses, as the ADP report illustrates (touched on below), but one would think we’ll move back to a more normal labor-market recession of 150,000-200,000 in monthly job losses as we enter the fourth quarter. While this level of decline will illustrate that the labor market remains fragile, it’s a massive improvement from the currently outsized payroll losses.

In a separate report, the ADP Employment report, a survey that is more appropriate to gauging the official monthly jobs data, measured that 473,000 payroll positions were cut in June. This gauge has done a really good job of tracking the official jobs data, as compiled by the Bureau of Labor Statistics (and a reading we’ll get this morning) – although ADP’s May reading did overstate the degree of decline (ADP said -485K and Labor Department recorded -365K) unless today’s release shows a downward revision to that May data.
This level of decline out of ADP pretty much matches what the jobless claims data is suggesting – monthly payrolls declines of at least 400K will remain the rule for June and possibly July.

From a stock market perspective, it’s a bit concerning that the consensus estimate has payrolls falling just 365,000 – if the ADP number is gauging things accurately for June, the market is going to be quite disappointed. This is very short-term activity we’re talking about here, but I feel it’s worth mentioning.

According to ADP, service-producing industries shed 223,000 positions in June and goods-producing cut 250,000 jobs – both of which are right at the average level of decline we’ve seen in the official data over the previous three months. Large firms cut 91,000 positions in June; medium-sized firms (50-499 employees) cut 205,000 positions: and small firms reduced payrolls by 177,000.

Within a couple to three months we should see monthly job losses ease to a level that resembles the normal recession, as expressed above I’m thinking we’ll move to a range of 150,000-200,000. However, we’re not there yet and the data for the next couple of readings may show we’re stuck in this 400K-450K range.

ISM Manufacturing

The Institute for Supply Management (ISM) reported that its nationwide factory gauge showed another month of improvement. The index rose to 44.8 for June from 42.8 registered in May. While the measure remained in contraction mode for the 17th straight month (a figure below 50 means activity continues to decline), it is doing so at a reduced rate. This is the highest level since the economy spun out of control in September.

Further, the fact that the gauge darned-near made it to 45 very likely shows the weak readings we’re getting out of Chicago PMI (the most important regional factory survey) is vastly due to auto-sector troubles and not necessarily from heavy weakness in other areas.
ISM economists like to say that a reading of 42 over a period of time on their survey is commensurate with mild real GDP growth. The figure averaged 42.5 for the entire second quarter, but if we continue to see mild improvements, this reading will help support our view that the first positive GDP print in five quarters will occur in the third quarter.

Seven of the 18 industries tracked by the index reported business growth in June, that’s up from five in May and one in April – now this is meaningful progress, let’s hope policy decisions don’t ruin it..

Results remained mixed with regard to the sub-indices within the report.

The most encouraging was the production measure, which moved to 52.5 from 46.0 (and has jumped 12 points in two months). The supplier deliveries index also moved to expansion mode, hitting 50.6 from 49.8 in May. But these were the only sub-indices to make it above 50, which does raise some doubts about continued progress over the next two months.

The new orders index, the best leading gauge within the report, fell to 49.2 from 51.1; the backlog of orders index fell slightly to 47.5; the inventories index fell to 30.8 from 32.9 (lowest level since 1982) – this raises doubts firms are on the cusp of boosting inventories after two quarters of slashing stockpiles at a record pace.

The employment index did jump to 40.7 from 34.3, nice move but it will be a while before factories begin to boost workers. We generally have to see two meaningful quarters of GDP growth before the factory sector begins to add jobs again.

This morning we get jobs data overload as both jobless claims for the week ended June 27 and the employment report for June are out. This data will set the stage for trading as we come back from a holiday weekend. I guess what has become North Korea’s own fireworks display could have an affect on trading as well. We shall see.


Have a great weekend and a great July 4!


Brent Vondera

Bond Recap

Fed comments yesterday sent the short end screaming lower as recent expectations for higher short term rates are proving to be too much too soon. The Fed has hinted at nothing but doing everything they can to stimulate growth in the economy, so one must question where the rate hiking expectations originated from. Regardless, the recent spike in short term Treasuries in anticipation of a Fed reversal was unjustified in our view and yesterday’s movement has brought all but brought us back to early June levels, (2-year was .95% on June 4).

Cliff Reynolds

Obama Expands LTV Limits to 125%

WASHINGTON, July 1 (Reuters) - Mortgage finance companies Fannie Mae and Freddie Mac will expand their efforts to prevent foreclosures, and refinance borrowers whose loan-to-value ratio is as high as 125 percent, an administration official said on Wednesday.

Under current rules, the mortgage finance companies may only refinance borrowers whose mortgage loan-to-value ratio is no greater than 105 percent. The new policy is intended to aid more struggling borrowers who have seen their property lose value in the recent years of a housing crisis.

The new program expands a housing rescue plan first outlined by the Treasury Department in February and was meant to lower the costs of home ownership for borrowers who are making timely payments.

Refinancing up to 125% is only available to loans that are already owned or guaranteed by Fannie and Freddie, so the move doesn’t expose the government run companies to any additional risk initially. However, this doesn’t really solve any of the pressing issues in today’s housing market. Mortgage rates have risen roughly .75% in the past month, making a refi a much less meaningful in terms of saving money on monthly payments. In order to qualify for the program the borrower must be current on their mortgage. So it really misses the trouble areas completely. The impact of the program expansion is expected to have little effect considering this only includes 10% of the mortgage market.

Cliff J. Reynolds Jr., Junior Analyst

June 2009 Recap

(Click image to enlarge)

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

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

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

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

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

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Peter J. Lazaroff, Investment Analyst

Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

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

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

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

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

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

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

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

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

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

Case/Shiller

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

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

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

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

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

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


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

Chicago PMI

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

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

Consumer Confidence

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

Have a great day!


Brent Vondera