Daily Insight

It looked like markets were going to set aside the Wal-Mart (WMT) earnings surprise yesterday and focus on the retail sales and jobless claims. Futures markets had indicated a positive triple-digit open, but had a tepid open on the economic news only to fall 60 points in the first half hour of trading.

Throughout the day, the Dow and crossed between positive and negative territory almost a dozen times, but ended on a positive note. Just as with yesterday, there was no single defining event to point to, but appears to be nothing more than increased optimism about the economy.

Market Activity for August 13, 2009

On the plus side, there were three pieces of good news to look at. First, the market was happy to see the WMT news. Analysts had expected the retail giant to report earnings of $0.85 per share and instead WMT surprised the market to the upside and announced actual earnings of $0.88 per share. The stock gained $1.37 per share, or 2.71 percent.

I am often asked why the market gets so excited over just a few pennies. The answer is that it is a few pennies per share. WMT has almost 3.9 billion shares outstanding, so this earnings announcement means that WMT’s profit for the quarter was $117 million more profit than analysts had expected. That’s why those pennies are worth so much!

The second piece of good news was that John Paulson of the bought $168 million shares of Bank of America (BAC). Who is John Paulson, you ask? He is a renowned hedge fund manager who not only foresaw the subprime crisis, but turned $2 billion of his client’s money into $15 billion in 2007 by betting against housing. His results were more modest in 2008, earning only 37.6 percent while the market fell 37 percent.

In short, it’s a big deal when he makes a move. Unlike a lot of the bets on the subprime market which were done with securities without much transparency, he had to file his new ownership stake in BAC. He is now the fourth largest shareholder and he has already made a good deal of money on the buy.

Just because he has bought shares, doesn’t mean they are a buy today, though. His purchases were between $6.82 and $14.17 (the high and low during the second quarter) and the stock now trades at $17. That means he has earned between 20 and 150 percent on his trade, which isn’t bad for a $1 billion plus investment.

The third factor in yesterday’s jump was the continued evidence that credit markets are getting back to normal. One of the more technical measures of credit markets is the LIBOR-OIS spread. While it’s probably not critical to explain what these two rates are, suffice it to say that spreads have tightened to what most consider normal levels.

The negative factors weighing on the market were the retail sales and jobless claims data. As we mentioned yesterday, retail sales were expected to be positive, but fell by 0.1 percent instead. Even worse, retail sales ex autos, fell by 0.6 percent. This is considered a broad measure of consumer spending, which, in turn makes up roughly 70 percent of economic activity. Obviously, consumers are still concerned about job losses and stagnant incomes and are continuing to tighten their belt.

The jobless claims showed that 558,000 Americans filed initial claims for jobless benefits last week. While you can’t get more timely than last week, initial jobless claims are discounted to some degree because they can be so volatile. Plus, economists were expecting 545,000 claims, so the number wasn’t too far from expectations. The four-week moving average was 565,000.

Futures are unchanged following the release of the Consumer Price Index (CPI) data, which showed that the cost of living in the U.S. was unchanged month-over-month. Year-over-year the index that tracks inflation fell 2.1 percent, a bigger decline than expected. Peter will pick apart the releases for you on Monday. Until then…

Have a great weekend!


David Ott, Partner

Fixed Income Recap

Treasuries opened mostly flat yesterday, before weak July retail sales data sent bonds higher. The headline number posted -.1% for July, compared to +.8% expected. Stripping out autos the number was still a disappointment, -.6% compared to +.1% expected. The biggest contributor to the upside was from the automotive sector, which was not surprising considering the popularity of the cash for clunkers program, but was more than offset by weakness in gas station and building materials sales.

Bonds leveled off mid-morning before the strong auction results boosted prices going into the afternoon. $15 billion of 30-year bonds were sold at a high yield of 4.541%, with a bid/cover of 2.54. The bid/cover is the ratio of bids to the amount actually sold to bidders, and is used as a gauge of demand. Yesterday’s auction was considered strong compared to an average of 2.43 over the past four 30-year auctions.

As I write July CPI has just posted no change MoM and +.1% Ex Food & Energy, in line with expectations. Bonds have rallied on the news. More on this number on Monday.


Cliff J. Reynolds Jr., Investment Analyst

Wal-Mart beats earnings expectations

Wal-Mart’s earnings beat the consensus earnings view on strong international growth and efficient inventory management.

Excluding currency effects, revenue grew 2.7%, led by the international segment’s 12% increase. This is a trend we can expect to continue as the company penetrates developed and emerging international markets. The company hinted during the conference call that they may continue to be on the prowl for acquisitions that could boost international growth.

U.S. revenue was weaker, with same-store sales falling 1.5%, which was partially a result of stimulus checks the year-ago period benefited from. The third quarter should have an easier comparison and, thus, show some improvement.

Operating margins improved 0.3 percentage points sequentially to 7.6%.

Management said that the Wal-Mart customer is still being pinched by the recession, evidenced by less spending at the end of the month, using more cash than credit, and buying basics and putting off discretionary purchases.

Wal-Mart has gained market share thanks to their low-cost reputation, but it is difficult to know whether or not their new customers will trade up once the economy improves. In attempt to keep customers coming back, Wal-Mart has focused on its shopping environment by remodeling stores with less clutter and better merchandising.
WMT shares finished the day +2.71%
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Peter J. Lazaroff, Investment Analyst

Harris proves analysts wrong

On Tuesday I wrote that several analysts had downgraded Harris because they believed weakness in the company’s tactical radio business would cause the firm to miss earnings estimates and lower guidance.

Turns out these guys were way off and Harris easily beat earnings estimates and also boosted the low end of their full-year earnings forecast. The raised outlook was a very significant upside surprise relative to expectations.

Revenues for the quarter rose 4% to $1.29 billion, compared with the average estimate of $1.21 billion. Orders rebounded significantly in all three businesses and, more importantly, the steep fall-of in orders expected in the high-margin tactical radio unit (RF Communications) did not materialize.

Management said increasing U.S. troop levels in Afghanistan provided RF Communications with the most significant boost in orders across all of Harris’ business segments. This is somewhat ironic because increasing troop levels in Afghanistan was the main reason multiple analysts lowered future revenue forecasts for Harris’ tactical radios.
HRS shares finished the day +12.14%

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Peter J. Lazaroff, Investment Analyst

Daily Insight

Major market indexes broke a two day losing streak with a powerful rally based on … well, it’s hard to say. All of the post-mortem articles about yesterday’s rally attribute the rally to statements from the Federal Reserve, but the Bernanke & Co. didn’t come out with their announcement until 2:15 and the market had been surging since 10 am.

When the rally first got started, the gains were attributed to better than expected earnings from Macy’s. It’s hard to see how this could really push the market, though, since this is a distressed mid-cap stock, the source of improvements were related to cost cutting in spite of weak sales, and it still lost money for the quarter.

In my opinion, a strong rally from a weak data point indicates that markets are not trading on fundamental values at the moment. Just as markets were unjustified in their 25 percent drop earlier this year, the 50 percent rally from the low in March seems to have allowed optimistic euphoria to carry a day like yesterday even when it doesn’t seem well founded.

Market Activity for August 12, 2009

Even though the Fed announcement didn’t end up carrying much weight in the stock or bond market yesterday, the news was good. (There was a rally after the announcement, but it faded back to pre-announcement levels before the end of the day.)

First, it was reassuring to hear the Fed say that “economic activity is leveling out,” which fits with the conventional wisdom that the recession is ending. The bigger news, though, is that the Fed is removing one of the lifelines by announcing that it would not purchase more Treasury bonds after October.

To keep interest rates low across the board, the Fed engaged in a massive buying spree in the mortgage, treasury and agency bond markets. This is known as quantitative easing because it injects liquidity into the economy. They couldn’t push interest rates below zero and this was a strategy that the U.S. had not engaged in before but had it been done in other parts of the world, most notably Japan.

By announcing the end of the Treasury program, the Fed is signaling that they are beginning to withdraw the support that they had put in place during the crisis. This isn’t to say that everything is fine and dandy, though, because many of the lifelines are still in place and the Fed will still own all of the Treasury bonds that they bought, they just won’t be buying any more.

In addition to saying that the economy seems to be stabilizing and that the Treasury purchase program will end in October, the Fed was clear that they do not view inflation as an immediate threat. Their exact language remained unchanged - that inflation will be ‘subdued for some time.’

Markets are set to open higher this morning, though some early enthusiasm has been reduced with the retail sales data from the Commerce Department. Earlier, markets showed a triple-digit rise for the Dow based on earnings news from Wal-Mart.

Retail sales fell 0.1 percent in July, despite the ‘cash for clunkers’ program that was so successful it ran out of money in the first week. Retail sales ex-autos fell by -0.6 percent, well below expectations. Retail sales are an important measure of broad consumer spending patterns, so this may put more of dent on the markets as the bell rings.

Have a great day!


David Ott, Partner

Fixed Income Recap

FOMC
The FOMC pleased the market yesterday with its comments following two days of meetings that concluded Tuesday. The most important topic this time around, which I have touched on pretty heavily this week, is the Fed decision on Treasury Purchases and other forms of quantitative easing. Before yesterday’s comments, the Fed’s Treasury purchases were scheduled to conclude before the end of September. The Fed has decided to extend the purchases to the end of October, while leaving the original $300 billion target unchanged. The other two programs – $1.25 trillion in MBS and $200 billion in agency bonds - will end in December as originally scheduled.

This is a good sign from the Fed. They are reluctant to talk exit strategies at this point, which I think is appropriate, but by coming out and telegraphing how the security programs will end the Fed is taking a step in that direction. In the Fed’s eyes, the US economy is stabilizing enough to not warrant such an aggressive program, so slowing the pace down can be viewed as a type of easing. I know that may be a little bit of a stretch but it’s still a positive sign.

The Fed sees that, “economic activity is leveling out”, a positive change from, “the pace of economic contraction is slowing”, in the June meeting statement. We also got the standard, “The Committee… continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

The Fed pretty much gave the market what they wanted. They outlined the end of the Treasury purchase program, noted that they see the contraction coming to an end and more or less left it at that.


Cliff J. Reynolds Jr., Investment Analyst

Fixed Income Recap

Despite the strong 3-year auction and weakness in stocks the short end was unable to break out of its pre-FOMC deadlock. The 3-year was already a little higher by the time the $42 billion auction drew to a close and was mostly unchanged by the results, but finished the day a few bps tighter than the auction level.

Eyes will be on the Fed today as the market waits for the committee’s comments regarding bond purchases. They will for sure comment on the progress, but the Fed might not be perfectly clear about whether they plan to shutter the Treasury program after the last of the $300 billion is spent in September or extend it to the end of the year. At this point I think the Fed needs to come out and be pretty clear here. People are certainly expecting to hear something meaningful one way or another, so I fear that saying nothing could just throw a wrench into this market, which would not be good.


Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

Following a steep run-up in recent weeks on the strength of better-than-expected earnings, stocks fell for the second consecutive day as investors take pause amid a lull in new economic data and focus attention on today’s Fed policy decision. It is widely expected the Fed will hold interest rates steady at near zero, but the group’s economic assessment will be closely studied to determine the state of the economy.

All ten sectors finished lower with financials dropping the most on concerns that the sector’s earnings may pull back and the possibility of higher interest rates. Volume was relatively low with only 1.2 billion shares trade on the Big Board.


Market Activity for August 11, 2009
Productivity and Wholesale inventories

Productivity surged between April and June, increasing at an annual rate of 6.4%, marking the largest gain in almost six years and easily beating the Bloomberg forecast of 5.5%. The growth was not a result of improving production, but rather a result of employers cutting the number of hours worked faster than the decline in output. These efficiency gains, however, provides the basis for a recovery in corporate profits and investment in the second half of 2009 – aggressive cost-cutting helped many companies exceed earnings expectations last quarter despite weak sales. Solid productivity growth also keeps the lid on prices and inflation, which gives the Fed justification for keeping rates lower for longer.

Meanwhile, unit labor costs fell 5.8%, the biggest decline since 2000 and far more than the expected drop of 2.5%, which may be read as a positive signal for the employment since companies may not need to layoff as many workers as sales stabilize.

Wholesale inventories showed a 1.7% decline in June, larger than the expected 0.9% drop. Durable goods, particularly in the professional equipment sector, led the decline. Total sales rose 0.4% thanks to a 4.5% boost in the automotive sector. The inventory-to-sales ratio – the amount of time it would take to deplete inventories at the current sales pace – improved from 1.28 months in May to 1.26 months in June. No surprise that after ten straight months of decline, inventories sit at the lowest level in more than two year. Companies’ hesitancy to restock in the face of weak demand has added to the severity of the downturn, but retail volumes are showing signs of stabilizing and there is a strong possibility that production will ramp up with even the slightest increase in demand.

Rising productivity and falling inventories fits well with the general consensus that a big inventory rebuild is going to boost both GDP and corporate profits. The inventory destocking in the second quarter took away from GDP, so even if inventories are flat in the third quarter, the drag to GDP would disappear. This idea that the inventory dynamic may mathematically provide a temporary boost to GDP is valid, but the sustainability of such an upturn is seriously questionable because inventory can again be a drag on future GDP if it is slowly depleted. In other words, people won’t necessarily buy stuff just because its there.

In our minds it all still hinges on consumer demand, which will be slow to recover in light of a weak job market, stagnant wages, and falling home values. Without strong consumer demand, any inventory dynamic that boosts third-quarter GDP won’t be lasting, and the odds of a letdown in the fourth quarter or 2010 become greater.


FOMC
The markets will be carefully attuned today to the Fed’s meeting statement, searching for clues regarding how soon and how aggressively the Fed can withdraw its support of the economy. The statement released following the June 23-24 FOMC meeting showed a modest upgrade of their assessment of the economic, which in turn lowered the probability of deflation even though the statement indicated, “Inflation will remain subdued for some time.” Today’s remarks will likely continue to reflect cautious optimistic view so as not to spark inflation concerns.

The first Fed rate increase is not likely to occur until late 2010 or even 2011. Historically, the Fed has never lifted rates when unemployment was rising, it has always occurred when unemployment started to move substantially lower. Despite last week’s July employment report showing improvement, sub-par growth will keep the unemployment rate higher than in a typical recovery. As a result, policy makers are expected to be extremely measured in their removal of policy accommodation.


Have a great day!


Peter J. Lazaroff, Investment Analyst

Amgen (AMGN) trades higher in advance of FDA panel

Amgen (AMGN) shares received a boost just two days before the FDA votes whether to support denosumab as an osteoporosis treatment in post-menopausal women and to help prevent bone loss in treat cancer and prostate cancer patients on hormone therapy.

The shares rallied after a study released showed that denosumab prevented fractures and strengthened bones in men taking hormone therapy for prostate cancer. Almost exactly a month ago, AMGN released encouraging Phase 3 trial results for denosumab in breast cancer patients.

A potential blockbuster like denosumab could eventually generate $2 billion to $3 billion of annual revenues, which 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.

AMGN shares finished the day +2.56%
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Peter J. Lazaroff, Investment Analyst

Analysts get bad signal from Harris (HRS) radio business

Harris Corporation (HRS) is down more than 6% today as analysts anticipate poor earnings results, which are due to be released after the close of trading on Wednesday, and lowered earnings guidance.

The concerns in several analyst reports are centered on the company’s tactical radio business, known as RF Communications. RF Communications’ radios are like the iPhone of walkie-talkies. Mainly used by the military, the radios are encrypted to prevent eavesdropping and have the ability to send data and videos. Aside from working with the military, RF Communications has a public safety and professional communications business.

This high-margin business segment was a major driver of Harris’ earnings for the past several years, but is now faced with order delays that are largely a result of the change in administration and the shift in military focus to Afghanistan from Iraq.

HRS shares finished the day -7.84%

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Peter J. Lazaroff, Investment Analyst

Daily Insight

Stocks got off to a slow start this week as investors questioned the S&P 500’s highest valuation, relative to earnings, since December 2004. Commodity producers and retailers were the main culprits dragging down the S&P 500. Meanwhile, the increasing VIX index showed that options trades are betting that the S&P 500’s rally won’t last through September.

I received a lot of feedback yesterday regarding my discussion on REITs and the accompanying write-up on our blog, some of which were requests to add U.S. REITs to the performance table. Ask and you shall receive…

Market Activity for August 10, 2009



FOMC

The Federal Reserve’s policy makers meet over the next two days and will likely discuss their quantitative easing measures, which helped unfreeze credit markets by holding down yields on Treasuries. When the Fed unveiled its strategy, deflation was the market’s primary concern. Now that credit costs are returning to pre-crisis levels and recovery expectations are growing, the inflationary risk posed by the Fed buying Treasuries is a bigger risk to bond prices than its exit from the market.

The market is concerned that the money printed to fund the program will fuel inflation, and we would likely see a positive reaction to the Fed’s nonrenewal of their quantitative easing program. Exiting this program would provide a clear signal to the world that the Fed is determined to control inflation before it starts. Low inflation makes Treasuries’ coupon payments more desirable, keeping yields in check longer. This is especially important during a period in which foreign buyers, particularly China, are apprehensive about the value of their investments in U.S. debt. We need these foreign buyers to help soak up the record issuance of U.S. government debt to cover the cost of putting a floor under the economy.

While ending the quantitative easing program should calm some of the inflation fears, these purchases could still lead to inflation pressures on a longer horizon and, appropriately, inflation expectations might come earlier.

The other always important topic being discussed will be the Fed’s target for the federal funds rate, which broadly influences borrowing costs. For some of the newer Daily Insight readers, the federal funds rate is an overnight rate banks use to lend to each other. The federal funds rate serves as a benchmark for all other short-term interest rates including the prime rate, the benchmark for most consumer and commercial lending, and short-term Treasuries.


Fed funds rate and stock prices
Over most of the past 50 years, changes in the fed funds rates have been a very good predictor of future stock prices. Using research from Jeremy Siegel’s Stocks for the Long Run, the table below shows the returns on the S&P 500 Index following a change in the fed funds rate over 3,6, 9, and 12 month periods. The benchmark represents an average of all the time periods in each particular sample – for example, the average of every 3-month time period between 1955-2006.


As you can see, the Fed’s actions have a dramatic effect on stock prices. Stock returns following an increase in the federal funds rate are significantly less than average, while stock returns are significantly higher than average when the federal funds rate decreases. Now, I know some people will glance at this table and think they can beat the buy-and-hold strategy by buying stocks when the Fed is lowering rates and selling stocks when the Fed is increase rates. But if you look at the entire table, this trend (like all trends) is hardly foolproof. Since 2000, the impact of the Fed’s interest rate changes on the stock market has been the complete opposite of the historical record.

Why has this occurred? It is possible that investors have become so accustomed to watching and anticipating Fed policy that the effect of its tightening and easing is already priced into the market so that the impact of Fed actions extend over a period of a few days rather than over several months. After all, if investors expect the Fed to do the right thing to stabilize the economy, these expectations will be built into stock prices far before the Fed even begins to take stabilizing actions.

Of course, there is no perfect explanation for the runs of good or bad returns in the stock market. If you spend enough time data mining, then you will find all sorts of apparent trends in historical data. As Burton Malkiel, author of A Random Walk Down Wall Street, so eloquently stated: “Technical results have been tested exhaustively…The results reveal conclusively that past movements in stock prices cannot be used to foretell future movements. The stock market has no memory. The central proposition of charting is absolutely false, and investors who follow its precepts will accomplish nothing but increasing substantially the brokerage charges they pay.”

For more commentary on the Fed funds rate, check out Cliff Reynold's Fixed Income Recap.


Have a great day!


Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

Yesterday was without an economic release resulting in a slow, low volume day in bond land. The snail like pace will continue today as most of the market is waiting to hear if the FOMC will say anything big following the conclusion of their policy meeting on Wednesday.

It’s a foregone conclusion at this point that the Fed Funds rate will remain where it is for this meeting, a target rate of 0-.25%, but futures have shown an uptick in amount of people expecting an increase soon. Current data show that the market is leaning toward an increase in the Fed Funds rate to .50% by the January 27 meeting. If that were correct it would mark the first increase in the rate since June 2006 when it topped out at 5.25%, and would also be the first adjustment to the rate since December 2008 when it was floored.

Shorter-term yields have been on a steady rise since early July when the 2-year reached .904% on July 13. The same bond was yielding 1.222% after yesterday’s rally from 1.302% at the close of last week. While long term yields react more to inflation expectations, short term yields are more sensitive to Federal Reserve policy, and the recent rate movement is showing this increased chance of a Fed policy reversal. It is important to note that the recent selloff in the short end can be partially attributed to poor auctions in late July, but expectations for a reversal in Fed policy coming sooner rather than later made that section of the curve unfavorable at lower yields. The FOMC comments tomorrow, retail sales data on Thursday and CPI on Friday could make for a bumpy ride later this week.

CIT
Just to touch on a brief piece of news from last Friday that I missed in yesterday’s recap, CIT announced that it will be suspending dividends on its preferred stock effective immediately. CIT hasn’t had to pay preferred dividends since June 15, but since one of its issues was due to go ex on Friday they announced the suspension of dividends for all preferred stock. This is no surprise to the market - the market prices for the issues were unaffected by the news – but the move is expected to save CIT $50 million dollars each quarter, a drop in the bucket compared to the $10 billion in debt that is scheduled to come due in the next 18 months. The company currently has no prospects for refinancing their maturing debt, and has also drawn on the final $1 billion of the $3 billion in emergency financing they secured on July 20.


Cliff J. Reynolds Jr.

Quick Hits

• Corporate Earnings Are No Sign of Recovery
• Investing: Hold or Fold, but Don’t Waver
• Fed does not need more powers
• Big Macs and Moving Debt to Asia
• July Jobs Numbers Not All Their Cracked Up to Be

Daily Insight

Stocks finished the week strong as better-than-expected employment data gave investors reason to believe the recession is over. Nine of ten sectors gained, with the only loser in the broad-based rally being the energy sector. As you can see below, all domestic equity asset classes made solid gains but I want to make special note of REITs’ performance since they are not listed in the table.

REITs (real estate investment trusts) had a particularly impressive performance last week (up 16.80%) as investors anticipate some of the financially stronger REITs to shift from defense to offense. Faced with a deteriorating commercial real estate market and hundreds of billions in debt coming due in the next few years, REITs have generally been shunned by investors in 2009. However, REITs have been raising capital by slashing dividends, issuing new equity, and buying back their public bonds at steep discounts. Financially strong REITs have offered attractive yields for several months, but now REITs are getting a boost from investors as they prepare to unleash billion dollar-war chests to fund acquisitions of troubled properties on the cheap. To read more about this, check out my post on our blog from last week by clicking here.

Market Activity for August 7, 2009
Dissecting Friday’s Data

Much to everyone’s surprise, the unemployment rate actually fell in July, hitting 9.4% from 9.5%. Although this report continues to support the view that the recession ended in the summer of 2009, the decline in the unemployment rate was not a product of job creation, but rather due to people dropping out of the work force. If people drop out of the labor force, the unemployment rate can decline because fewer people would be considered jobless.

The July household survey showed the civilian labor force shrinking by 422,000 and employment falling 155,000. That translated into 267,000 fewer people listed as unemployed. The labor-force participation rate fell 0.2 percentage point in July to 65.5%. Once the economy improves, these people will likely return to the workforce, which will result in the unemployment rate climbing higher – for example, people who decided to return to school during the downturn will eventually return to the job search and help push unemployment higher.

Another factor that could keep the unemployment rate elevated is the considerable degree of structural unemployment, evidenced by the 53.5% of those unemployed because they have lost their jobs permanently – the highest figure since this data has been tracked. Structural unemployment, as opposed to cyclical unemployment, is caused by changes in the economy rather than the business cycle. The high number of people permanently laid off reflects the excess capacity that had developed in the economy over recent years in areas such as construction, financial services, retail trade, and auto production/sales. Even as the economy recovers, these displaced workers will likely be unemployed for a prolonged period.

The point to take away here is that we shouldn’t get ahead of ourselves. The improving trend of the labor market cannot be denied, but businesses are not about to start hiring people. Businesses will want to make sure that a sustained economic recovery is here before doing any substantial hiring. For this to happen, demand will need to improve – a process we believe will continue to be a slow one as households contend with weak income growth and balance sheet issues for some time.

Speaking of consumers’ balance sheet issues, the Friday’s consumer credit report showed borrowing by U.S. consumers dropped in June for the fifth straight month, the longest series of declines since 1991. Consumer spending, which accounts for about 70% of the economy, will take time to recover as households put off major purchases in light of a weak job market, stagnant wages, and falling home values.


Where do we go from here?

It seems like a long time ago when stocks were priced for the possibility that the global banking crisis would shut down the world’s financial infrastructure. Being a forward-looking indicator of the economy, stocks rallied since March in anticipation of the end to the recession. But it’s a bit of a head scratcher that stocks are now rallying because the recovery that stocks themselves predicted comes true.

The point I’m trying to make here is that it’s easy to be greedy here and pretend that the crisis never happened. But, it did happen. As a result, the financial system was left crippled and the government has taken on trillions in debt which will threaten the world economy with inflation and higher tax rates. I’m not necessarily saying that stocks can’t continue their progress – although they seem overdue for a small correction following the 50% jump from the March lows – but it would be foolish to think everything is back to normal and stocks will quickly return their 2007 highs.

Patience and discipline is crucial for all investors in this environment.


Have a great day!


Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

Stocks were juiced to new highs for the year on better than expected employment numbers. Nonfarm payroll employment declined by 247,000 in July on a seasonally adjusted basis, much better than the -325k expected. June’s data was revised upward from -467k to -443k.

The main reasons for the better than expected numbers include a 28.2k addition to automotive manufacturing payrolls during a month that historically cuts some due to planned summer shutdowns, this surprise increase is exacerbated by the seasonal adjustment. Federal Government payrolls increased 12k and several service sectors were better than expected but unfortunately too much of the positive surprise compared to what was expected seems to be one time in nature. The auto industry has “cash for clunkers” to thank for the pop last month but that shaping up to be short lived.

Last week was the worst for Treasuries since the March of 2003. Yields were up across the curve every day but one last week to their highest levels since mid-June as investors continue to shed Treasuries in exchange for riskier investments like stocks and corporate bonds. The 5-year credit default swap index, which measures the cost that investors are paying for protection against default for 125 different companies, is at its lowest levels since May 30 2008.

The FOMC will meet this week, and while it is expected to leave the Fed Funds Target Rate unchanged at 0-.25%, a large question mark remains over the future of the Fed’s open market operations. Recent fedspeak has shown some member’s hesitation to increase the amounts dedicated to buying Agency MBS and debentures along with Treasury bonds, fearing the price instability that could ensue if the Fed does too much to keep rates low. Nonetheless it stands to be a heated topic and if the Fed comes out and states that all programs will end as scheduled it will mark the first real tightening of monetary policy during this latest cycle. But that is probably wishful thinking on my part. Something to the effect of, “We will continue to monitor market conditions before making a final decision” is more realistic. Especially considering the next meeting on September 23 will likely be the Fed’s final chance to extend the Treasury program before it completes.

Treasury supply for this week looks like this:
· Tuesday - $37 billion 3-year notes
· Wednesday - $23 billion 10-year notes
· Thursday - $15 billion 30-year bonds


Cliff J. Reynolds Jr., Investment Analyst

Higher sales of Monster Energy drink lift Hansen Natural (HANS)

Shares of Hansen Natural (HANS) are trading nearly 20% higher following the company’s earnings release after yesterday’s close. Hansen said profits grew 14% on higher sales of its Monster Energy drink and improved margins.

Although slightly below consensus estimates, revenue climbed 6% to $300.3 million. Demand is strong for Monster Energy drinks despite tough economic conditions that have led some consumers to replace their consumption of soda and energy drinks with tap water.

Hansen noted their distribution deals with certain Coca-Cola bottlers and Ansheuser-Busch last year has paid dividends for the company and market share has grown in its main distribution channels nationally, namely in convenience and grocery stores. The distribution deals have also helped Hansen grow sales outside the U.S. to $39.4 million, compared with $27 million a year ago.

Gross margins jumped to 53.9% from 51.8%. Distribution costs as a percentage of net sales were 4.2% for the second quarter, compared with 5.5% from the year-ago period. Selling expenses as a percentage of net sales were 11.2%, compared with 12.1% a year ago. The distribution deals mentioned have played a part in lower distribution and selling costs.

Monster is the leading brand in terms of volume share and growth. Distribution agreements and lower expenses have positioned Monster for even higher sales once the economy improves.

Not included in the earnings report, but also of interest – Hansen announced that Monster Energy drinks are hitting fast-food chains, with Hardees company-owned units offering Monster Energy in mid-August and franchised units joining later. Carl’s Jr. will immediately begin offering Monster Energy drinks in all units.
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Peter J. Lazaroff, Investment Analyst

Fixed Income Recap

Initial Jobless Claims for the week ending July 31 fell to 550k from 588k the previous week, surprising the market that was expecting 580k. The better than expected news hurt Treasuries as the yield on the 10-year rose 5 basis points to 3.78%, near its high for the day.

The Fed purchased $7 billion in the 7-10 year area yesterday, just under the average for that maturity range, but received just over $48 billion in submitted offers from dealers, almost double the average for that area of the curve and more than any other time since Treasury open market operations began in March. Surprisingly it didn’t move the market all that much. Bonds had already rallied off their lows by that point and stayed pretty steady until late afternoon trading.

There was an article in yesterday’s Washington Post on the potential avenues the government is considering for the unwinding of Fannie and Freddie. When the two Government Sponsored Enterprises were taken over by their regulator last year and an unwind was scheduled to begin at the end of 2009. With that deadline rapidly approaching, and a worse than expected housing market still plaguing the GSE’s portfolio, an early 2010 beginning to a FNMA FHLMC unwind seems unlikely.

James Lockhart, head of the FHFA, Fannie and Freddie’s regulator, proposed a good bank bad bank model where existing securities issued by Fannie and Freddie will remain as they are, but a new entity will be spun off in order to attract new private investment.

The two mortgage lenders existed for many years as quasi government supported entities. They were able to borrow at lower rates than the rest of the private sector, thanks to an implied government backing, but were privately owned, and therefore had a responsibility to return profits to their shareholders. In my opinion, the new “good bank” cannot survive in a hybrid form like it did previously. That model is flawed. The new company must be either completely spun off, and stand entirely separate from both the support and influence of the government, or simply be combined with Ginnie Mae, who’s securities carry the full faith and credit of the US Treasury. Regardless of what happens the mortgage lending landscape will look very different in a few years.


Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

After starting the day in positive territory, stocks swung to a loss yesterday on mixed earnings reports and weak retail sales numbers. Meanwhile, others waited on the sidelines for today’s jobs data.

Eight of ten major industry groups declined, with industrials (led by the defense and industrial conglomerate sectors) and utilities posting the only gains. Telecom and healthcare were the worst performers for the second consecutive day. Healthcare shares slid on an analyst downgrade of the industry. Meanwhile, telecom as well as technology shares slid after several companies announced disappointing earnings or forecasts.

Market Activity for August 6, 2009

Retail Sales

Retail same-store sales for July fell 5.1%, worse than the 5% decline expected. Department stores and luxury retailers continue to see declining sales, while discounters posted unexpected misses. Categories that were most cited as seeing soft demand included apparel, home and garden, and electronics. The lackluster results can partially be attributed to Americans spending on new cars via the Cash for Clunkers program in July or splurging on new homes to take advantage of tax credits, rather than visiting stores. In addition, several retailers said a later back-to-school season this year pushed out the typical boost in sales from several state-tax holidays to August from July.

Also hurting sales could be the fact that retailers have slashed inventories to the bone, causing shoppers to leave empty handed when the product they are seeking is out of stock. Two years ago, someone looking to buy a coffee maker could go to Wal-Mart Stores or Target and choose from several different models in stock. Today, shoppers are finding that they only have one or two options (or none!) to choose from. Reducing inventories is a natural occurrence in a recession, but retailers can’t win if they don’t play. Stores will need to be sure they have adequate inventories to take advantage as the school shopping season approaches. I am confident this won’t be a problem next month.


Initial Jobless Claims

The number of U.S. workers filing new claims for state jobless benefits fell last week, providing another glimmer of hope that the economy may be on the road to recovery. The improving trend in initial claims is a positive, although the trend is slightly distorted by fewer layoffs in the auto sector than typically seen during summer production shutdowns. Still, the four-week average of claims has fallen 104,000 from the peak to its lowest level since January 24.

Historically, the U.S. economy has come out of recession when the four-week average of claims has declined by more than 100,000 jobs. This should not be confused with the unemployment rate, however, which typically lags by six months on average and doesn’t peak until after the recession ends.

While the drop in initial claims is welcome, most evidence still suggests a difficult job market longer-term. If there is a “new normal” and some of the debt-fueled growth of this decade is gone forever, then there will be less demand for workers. Even more, employers are likely replacing workers with technology or outsourcing jobs internationally.

Initial claims, though, do lead to continuing claims and we’ll see how long the transition is between a slowdown in firing to a pickup in hiring. There is certainly potential for an upward surprise on payrolls over the next few months if employers find they need to quickly undo some layoffs when growth returns.


Today’s Data

Nonfarm payrolls will be in focus this morning. According to Bloomberg, economists predict payrolls fell 325,000 in July, which would be quite an improvement from the disappointing June decline of 467,000. Meanwhile, the unemployment rate is expected to tick up to 9.6% in July, following a 9.5% reading in June.

Consumer credit is the other release today, and credit is expected to have declined by $5.0 billion in June.

As unemployment approaches 10%, frugal consumers and banks threaten to stymie economic growth and perhaps even drive a double-dip recession. I’m not necessarily agreeing or disagreeing with that view, but I think it is foolish to think that the recovery will be quick. Instead, I side with the view that an economic recovery will more likely be slow moving.


Have a great weekend!


Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks traded down, halting a four-day winning streak, after a closely-watched employment report suggested the July jobs figure will be weaker-than-expected. That was followed by the latest service-sector reading that declined at a faster rate than the previous month. We’ll get the weekly jobless claims figure today and the official July payrolls report on Friday, so traders may just have decided to hold off until they get the release of those figures.

Eight of the 10 major industry groups declined, with financials and basic material shares as the only winners on the session. Worst hit were telecoms, health-care and energy – strange that this group slipped after the latest inventory report showed distillate inventories declined and gasoline and crude stockpiles rose less than expected; oil prices rose on the day.

Market Activity for August 5, 2009
Mortgage Applications

The Mortgage Bankers Association reported that its index of mortgage apps rose 4.4% for the week ended July 31 after a 6.3% decline in the prior week. Refinancing activity led the index higher, up 7.2%, as the 30-year fixed-rate mortgage fell back to 5.17%. Purchases rose 0.9% after no change for the week prior.

Mortgage rates remain in a sweet spot, above the sub-5.00% lows hit back in March/April/May but still very attractive for both refis and purchases. One thing I find interesting though is how buying activity has declined over the past five weeks. If this data is accurate, it shows the sales boost the pending home sales data suggesting is in the works will be short-lived.

Preliminary Jobs Data

As we gear up for tomorrow’s July employment report, yesterday we received preliminaries in the Challenger Layoffs report and the ADP Employment Survey.

The Challenger Job Cuts report – which comes out of nation’s premier outplacement firm Challenger, Gray & Christmas – showed employers announced fewer layoffs for a second straight month, marking the first consecutive decline since early 2007.

Planned firings in July fell 5.7% to 97,373 from the year earlier, this followed a 9% decline in layoff announcements in June. The transportation industry led the cuts, announcing 22,367 layoffs last month, followed by the telecom industry with its 16,799 in cuts – largely led by Verizon’s layoffs.

This data is certainly moving in the right direction, but the layoff cycle continues to run its course.

The ADP Employment Survey estimated the economy shed 371,000 payroll positions in July, which was a bit more than economists expected of -350K. This is also more than what is expected out of the official jobs report, which is for a 328K decline in payrolls. ADP has been very accurate over the last several months in predicting the actual number.

What we’re seeing here is that job losses are moving to levels that mirror the peaks seen during the normal recession. While the labor market will continue to shed jobs for at least several months, the rate of decline has improved markedly.

ADP estimated that the service sector shed 202,000 and the goods-producing sector cut 169,000 positions – an improvement for both areas relative to the June figures. In the previous employment report the service sector lost 244K positions and goods-producing sector slashed 223K.

Large businesses, defined as those with more than 500 employees, saw employment decline 74,000 (-91K in the June report); medium-sized firms shed 159,000 (-205K in June); and small firms, less than 50 employees, cut 138,000 (-177K in June).

ISM Service Sector

The Institute for Supply Management’s service sector index fell to 46.4 for July after a reading of 47.0 in June, the reading was expected to come in at 48.0 – a reading below 50 illustrates contraction.

This is the first time the non-manufacturing index (the service sector makes up roughly 85% of the U.S. economy, and thus factory activity about 15%) slipped below the level of the manufacturing reading since November and one of the very few times this has occurred since this survey began in 1997. This probably doesn’t bode well for the economic prospects regarding the current quarter and we’ll be even more dependent upon that inventory dynamic as a result.

Within the report, the business activity sub-index fell to 46.1 from 49.8; the new orders index slipped to 48.1 from 48.6; the employment index declined to 41.5 from 43.4; supplier deliveries bucked the trend, rising to 50.0 from 46.0 – the overall index reading is based upon these four sub-indices. The order backlogs index, which is not included in the overall index’s readings but key in predicting the direction of ISM over the next few months in my view, fell slightly to 42.0 from 46.0.

On the inventory front, I focused on the real estate industry where inventories rose in July, while inventory sentiment showed respondents within the industry believe levels are too high. This is probably not a good sign for prices over the next few months.

Six of the 18 industries that respond to ISM reported an increase in business activity, eight reported a decrease and four reported no change. Comments from respondents included:
“Reductions in revenue and staff”
“Lower customer demand”
“Continue to make efforts to reduce inventories”
“Orders are being placed on hold pending economic recovery”


I’ll be out of the office until August 18. Either David or Peter will be taking over until I return.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Bonds opened in the red as the market prepared for yesterday morning’s supply announcement for next week. The Treasury announced $75 billion in 3-, 10- and 30-year supply, a record for one week’s issuance of those bonds and in line with expectations.

Treasuries recovered after the ISM (Non-Manufacturing Index) registered 46.4 in July, well below the 48 expected. Expectations were elevated after July’s manufacturing index surprised to the upside and the disappointment brought Treasuries into positive territory.

But the rally didn’t last as comments from former Fed official Laurence Meyer hinted at an as scheduled stop to the Fed’s Treasury Purchase program in September. Few in the market were looking for any meaningful expansion of the program, although some think that it would make sense to stretch it to the end of the year, and make it consistent with the MBS purchase program. I personally am indifferent. It most likely wouldn’t make an impact either way. I think today’s reaction was a little exaggerated on account of the morning’s volatility. I also will only believe for sure that they are done when they actually stop buying.

The Treasury announced that it will increase TIPS issuance next year and is also open to replacing the 20-year with a 30-year, which was last issued in 2001. This makes sense considering the Treasury is issuing gobs of the nominal 30-year so there is plenty of interest among buyers. Plus it will give the market a new data point on the breakeven curve. The proxy for inflation expectations currently ends at 20 years. TIPS outperformed nominal Treasuries on the news as 10-year breakeven’s widened to 193 bps.

Cliff J. Reynolds Jr., Investment Analyst