Daily Insight

U.S. stocks gave back early-session gains as energy and financial shares put pressure on the broad market. The day’s major economic release, the weekly jobless claims data, actually offered the best result on the direction of claims we’ve seen in a while; however, a negative energy report reminded the market of the economic weakness and lack of demand that remains – more on that below.

Traders sort of put the screws to energy stocks after that report, and financials took a little heat too as RealtyTrac stated U.S. foreclosures surpassed 300,000 for the eighth month in a row. The bigger issue is the inventory that has yet to hit the market as banks are delaying the foreclosure process.

All 10 major S&P 500 sectors declined on the session, although the broad market jumped 6% over the past couple of weeks so a day of weakness is hardly consequential. The S&P 500 has bumped against the 1100 mark twice now, yesterday and on October 19, only to retreat. This is probably going to be an important level for technicians over the very short term.

Eight stocks fell for every one that rose on the NYSE. Some one billion shares traded on the exchange – that’s three days in a row now; the six-month average is 1.25 billion.

The $16 billion 30-year Treasury auction didn’t go quite as well as the 3 and 10-yrs earlier in the week, but those were very successful auctions – this one was still pretty good considering the duration. The yield was a bit higher than the pre-auction expectation (4.469% vs. 4.424%) and the bid to cover was 2.26, down from the 2009 average of 2.43. Indirect bidders (foreigners) totaled 44%, which is in line with the 2009 average.

These long bond sales are definitely trickier events as 4.46% for 30 years only looks good in this low inflation, weak economic environment we find ourselves. But with Fed at zero, the dollar’s trend lower and the largest budget deficits since WWII (all factors that have great potential to crush the long bond), the government is surely very happy people are out there buying this stuff at these levels.

Market Activity for November 12, 2009
Crude Oil

The weekly Energy Department report showed crude supplies rose 1.76 million barrels last week to 337.7 million (5% above the 5-yr avg. for those keeping track) – a one million barrel build was expected.

Gasoline stockpiles rose 2.56 million even a refinery runs are at the lowest level since Hurricanes Gustav and Ike hit the Gulf coast n September 2008. Refineries operated at 79.9% of capacity (the average rate is closer to 88%). Demand is ugly, fuel consumption tumbled 4.3% to 18.3 million/day last week (12% below average).

This report is not a good sign for those expecting average economic growth to emerge.

Mortgage Applications

The Mortgage Bankers Association’s index of applications rose 3.2%, fueled by an 11.3% jump in refinancing activity for the week ended November 6 – this follows a 14.5% surge in the prior week as the 30-year fixed mortgage rate held below 5.00% for these two weeks. We’ll note, the refinancing index running at only a third of 40% of where it was back in April and is just 30% of the spike during the refi wave of 2003 – the vast majority of those who can refinance their mortgage likely already have.

The purchases index fell 11.7%, marking the fifth-straight week of decline – the purchases index fell to the lowest level since December 2000 (and that is only because of an anomalous one month slide in 2000, one really has to go back to 1998 to match this level of purchases. Apparently, a sub-5.00% 30-year mortgage rate isn’t enough to unfreeze buyers as they saw the tax credit expiring. That credit has been extended now and we will see if it has the same effect on sales as it had over the previous few months. It all depends on the degree to which the original timeline of the credit front-loaded home buying. Of course, home sales also have to contend with troubled labor market conditions. Those thinking housing is out of the woods need to think again.


Jobless Claims

The Labor Department reported that initial jobless claims made additional progress last week, falling 12,000 to 502,000 – this is the lowest level since hitting 488K in early January.

While 500K is an elevated level, the trend of the past two weeks is a very good sign as we’ve been looking for sub-500K as real evidence that labor market losses have bottomed. That does not mean the jobless rate will fall. To the contrary, it will rise for sometime and the upward move may still have some spike to it (remember the latest monthly jobs report saw the unemployment rate rise significantly even though the labor force participation rate fell. We still need to see that participation rate rise, as more workers come back in to look for work and that means meaningful increases in the unemployment rate ahead. But for the monthly job losses reading, as we talked about last week, those numbers will move to statistically insignificant levels of < 100K per month over the next couple of months and then to mild gains.

The four-week average of initial claims fell 4,500 to 519,750.

Continuing claims fell for an eighth-straight week, down 139,000 to 5.631 million, although more because of traditional benefits running out than job creation, as the exhaustion rate chart illustrates below.

Extended benefits also show there is some expiry going on as the EUC (Emergency Unemployment Compensation) program showed claims rise (more recent laid off workers moving from traditional to EUC), while extended benefits fell (the longer-term unemployed exhausting the extensions).

For a run down of how this works: Workers can apply for EUC when the standard 26 weeks of claims run out. EUC has four tiers (the second to fourth tiers are known as extended benefits: Tier 1 pays an additional 20 weeks, Tier 2 pays another 13 weeks, Tier 3 offers another 13 weeks and Tier 4 adds yet another six weeks – all automatically enroll those who are eligible when they run out of the previous tier. You can kind of see now how many unemployed workers are unlikely to have quite the sense of urgency to look for work, which is a reason there’s such a gap, a record gap, between U3 and U6 unemployment rates (U3 being the official jobless rate of 10.2% and U6 being U3. plus those that didn’t look for work during the month, plus those working part time for economic reasons).

A Tier 5 was added when Congress passed another extension measure last week, but since the emergency and extended claims data is only available through October 24, it shows a decline in extended claims. This figure will pick back up thanks to another extension when we get the next couple of weeks of data.

All in all, the claims data suggest that the pace of firings continues to decline, yet a pick up in hiring has yet to become evident.

But it’s Friday, so have a great weekend!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks gained ground as the S&P 500 moved to a new 13-month high. The broad market pared early-session gains on a quiet Veterans Day of trading (the bond market was closed, they’ve get more days off than a government job) but held to enough of that rally to now have completely erases the late-October pullback.

Financial led the way yet again, but basic material stocks weren’t far behind as the Bank of England signaled they will keep rates at emergency levels and left the door open to more government bond purchases. As this follows the Fed’s pledge to keep standing on the accelerator, the trade into commodity-related material stocks rolls on. Energy shares weren’t able to participate in the rally, ending the session essentially flat as the latest data out of Mastercard showed gasoline demand fell 2.3% in the latest week and is up just 2% from the very weak levels of a year ago.

Advancers beat decliners by a two-to-one margin on the NYSE Composite. Volume was weak as barely one million shares traded on the exchange, although I was expecting even less considering the holiday.

Futures are pointing lower this morning even with the news that Hewlett-Packard will purchase networking gear maker 3Com. Such deals usually get investor optimism going, maybe the market sees it as a bad deal. HP clearly wants to take on Cisco, they may be stretching themselves on this one.

Also, Wal-Mart just released quite good quarterly results, maybe too good as it shows discounters will reign supreme this holiday season, reminding this fairly euphoric market that the consumer is in rough shape – as if anyone needs reminding.

Market Activity for November 11, 2009
Holiday Sales, and More Importantly Spending Trends Beyond

And speaking of holiday shopping, we received some welcome news out of FedEx yesterday as the second-largest U.S. package-delivery company projects handling about 8% more shipments on their busiest day of the Christmas season. The company expects to handle 13 million packages on December 14, up from 12 million on December 15, 2008. The forecast is based on “positive signs” via the latest GDP and industrial production reports. For sure, what were likely good spending numbers during October probably also stoked their forecast. We’ll get the October spending numbers on November 25.

This is all fine and dandy, certainly expectations we would celebrate under normal circumstance, but the reality remains that households are dealing with a nasty combination – the highest level of joblessness in 26 years (and rising) and very high levels of indebtedness. We can get excited about higher holiday sales (and let’s hope this is true considering the year-ago period occurred smack-dab in the middle of credit-market chaos and a relative shutdown in spending), but basing expectations on the latest economic numbers that have been boosted by short-term stimulus programs may not prove to be the wisest thing to do. This is a theme we’ve talked about for some time now as the indicators that economists/analysts/businesses have historically looked to for evidence of what will occur in the near future may not work well this go around.

The stimulus is temporary, this form of stimulus must be as the levels of government spending, aggressive monetary accommodation and incentives to keep consumer debt levels high cannot last. Therefore, we’ll see more choppy activity instead of the typical development of things flowing and trending higher during the normal expansion. Indeed, consumers will have to work down debt levels and this will adversely affect spending, a situation that will prove more difficult and elongated if the jobless rate remains elevated for an extended period. This must occur in order to get back to normal and it’s why I remain quite skeptical about growth prospects – a skepticism that long time readers understand has not been my nature.

So let’s hope the holiday shopping season is stronger than that of the year-ago period. But don’t hope for too much because fundamentals do not support such behavior.

The China Trip

President Obama and his Treasury Secretary Tim Geithner are making a trip to Asia, actually Geithner has been there for a couple of days explaining to Japanese and Singaporean officials about how the administration will deal with massive budget deficits in the intermediate term – you know how to read these statements: higher across the board tax rates.

I believe President Obama arrives in Asia today and the main focus of the trip is to talk to Chinese President Hu Jintao about the “need” to strengthen the yuan (Chinese currency). I’m sure that’s going to go over really well as our own currency is devalued on weekly basis.

It was just Monday night in which the Chinese got in front of this trip by making the explicit statement that they’ll keep the yuan pegged to the U.S. dollar – meaning they are not going to allow it to rise. Then, suddenly, by Tuesday night they revised their statements to say they may gradually re-peg the yuan to a higher level against a basket of currencies. (This has its own implications. When the yuan is pegged to the U.S.dollar it means the Chinese must buy dollars to keep the pegged rate intact, which means they must buy Treasury securities. If they go to a basket that means their need to buy our government debt is reduced.) This revision to the statement comes after intense pressure from other countries in the region. The dollar has gained some support over the past two days as governments in Thailand, South Korea and Russia buy dollars (devaluing their own currencies) because the yuan is sliding in value against those currencies due to its peg to the dollar – as the dollar slides so does the yuan. It appears there is a race to the bottom as a destructive zero interest-rate policy by the Fed affects behavior across the globe. Widespread devaluation of currencies is not a good sign for future global growth.

But the administration goes to China with the overall belief that large amounts of Chinese exports funnel into the U.S. (well, at least before consumer activity took a turn for the worse), thus allowing higher levels of prosperity in China, only because their currency is fixed at what the administration judges as a low currency value. This is a flawed premise. The Chinese were not “dumping” goods into the U.S., as if to take advantage of the American consumer. The administration seems to be ignoring a vital piece of this puzzle – monetary policy.

Look, I’m not trying to play the Chinese apologist here, I frankly despise communist regime, and while they appear to have shifted to a softer communism that government can hardly be trusted. But darn, one cannot look at this as if we were preyed upon. Let’s concentrate on getting our own policies right and the rest will fall into place.

But the flood of imports from China in the previous few years was not nearly so much the result of the Chinese holding the yuan from rising as it was a function of our Federal Reserve’s stance back in 2002-2005, a topic we’ve spent much time on over the past several years. Chinese goods don’t arrive on our shores unless there is demand to support those shipments. (Besides, we should remember that the Chinese yuan has been pegged to the U.S. dollar since the mid-1990s – with the exception of an adjustment a couple of years back; this peg helped them escape the direct effects of the Asian Contagion in 1997-1998. I don’t remember anyone expressing a problem with this pegged rate until the Fed’s actions began to create market distortions. The people who should be, and probably are, complaining are the Europeans as the yuan has declined in value along with the U.S. dollar against the euro.) The goods really began to flood in when the Fed kept rates too low for too long earlier in the decade. This monetary policy fueled a consumer credit expansion that drove demand for these imports. So long as the Fed doesn’t royally screw up, the degree of trade deficit with China would not be nearly as wide. For that matter, the housing bubble would have never occurred. While literally everyone takes the blame for this mess, it’s starkly ironic to see the Fed largely escapes criticism.

When our government officials fail to understand, or simply ignore, the preponderant reason driving the topic with which their argument is based, it sort of makes their goal tough to achieve. We’ll find out who holds the whip hand during this visit to China. I don’t like the probable intermediate term answer to this question, based on the obscene level of deficit spending we’re engaged in.

Going Off

Emerson Electric’s CEO David Farr didn’t hold back in expressing his opinion of U.S. policy yesterday at an industrial conference in Chicago, saying: “Washington is doing everything in their manpower, capability, to destroy U.S. manufacturing – cap and trade, medical reform, labor rules.” He stated tax rates and regulations are pushing his company to create jobs in emerging market regions, “places where people want the products and where the governments welcome you to actually do something.” He didn’t stop there, going on to project his own question and answer: “What do you think I am going to do? I’m not going to hire anybody in the United States. I’m moving. They are doing everything possible to destroy jobs.” Wow!

This guy is going to take a lot of heat for these statements. I can see the coming accusations of anti-patriotism. But his attitude just shows he cares and wants to wake people up. He could be like the vast majority of multi-national corporate CEOs, who say nothing for fear of a backlash, but go ahead and move jobs overseas anyway due to higher domestic costs – and we should not only concentrate on the labor cost differential (which is simply the difference between rich and relatively poor societies), if we were to slash the corporate tax rate and implement a regime of streamlined and common sense regulations instead of insane mandates that do nothing but drive costs higher and destroy jobs we wouldn’t see so much outsourcing occur. (For the record, not all outsourcing is bad, some result in increased profitability and thus more higher-paying jobs here at home, but certainly more of it than would otherwise be beneficial occurs due to policy that drives capital away.)

So, Mr. Farr will certainly be labeled as anti-patriotic, but it is the business leaders that remain quiet, for fear of a backlash, who assist in damaging American exceptionalism.

Economic Data

We get back to economic data releases after essentially nothing over the past three days. This morning we await the weekly jobless claims data.


Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

S&P 500: -0.07 (-0.01%)

Today’s slight loss snapped an impressive streak of gains for the S&P 500 – the index had finished higher on every single trading day this month.

The U.S. dollar traded all over the place despite early gains that came on news that Fitch credit analysts said Britain is the most likely of the major economies to lose its AAA credit rating.

Several Fed officials delivered speeches today, which reiterated their view that the economy will recovery slowly and the unemployment rate will continue to rise in the near-term. There was also mention that financial reforms are needed to avoid a repeat of last year’s credit crisis.

In other news, the Fed’s latest survey of loan officers showed that credit conditions had tightened again, although less than in its previous survey. The results also revealed that banks are ramping up purchase of securities, notably Treasuries, instead of making loans. This is no surprise and has been happening for quite a while now. Banks borrow at practically nothing and earn a risk-free return on Treasuries. This trade is a lay-up for the banks and far easier than dealing with credit cards or business loans.

The Fed can create as much money supply as they want, but that doesn’t guarantee it will create credit. Without willing lenders and able borrowing, the cheap money will continue to flow into assets from equities to commodities to corporate debt.

Most market participants acknowledge recent gains have been fueled by cheap money, but there still is quite a bit of disagreement regarding the sustainability of the rally in coming months if the real economy remains sluggish.


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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks rolled on wave of investor euphoria Monday, now almost completely recouping the losses of late October, as the nitrous oxide boost from global governments and central banks continues to stoke equity-market traders.

Stock-index futures showed strong investor sentiment in pre-market trading and that rushed into the official trading session. This weekend’s G-20 meeting dovetailed last week’s Fed meeting (you know, where Bernanke & Co. explicitly stated their zero interest rate policy (ZIRP) lives on) as all nations involved agreed to maintain measures of support to the global economy.

The market could have also been driven by the results of Saturday night’s health-care bill in which the House barely passed the measure 220-215. This was clearly a pyrrhic victory and it’s very likely the bill is DOA in the Senate, at least in its current form. I’m certainly not saying some wonderful common sense-based legislation is going to suddenly appear. But the most horribly harmful and foolish proposal is going down – unless they use the reconciliation process.

Financials were the top-performing sector, even as the Fed confirmed what many have been guessing -- banks are taking their basically zero-cost to borrow and using as much of these funds to buy Treasury securities as is going to loans. This should have put the screws to the banks stocks. (This is not to suggest that banks should be boosting loan originations. If they are concerned about problem loans on their books, then they shouldn’t be growing by making new loans. Too, the demand for loans is weak as well, particularly from the consumer side as households work down already heavy debt burdens. It’s kind of a dual issue for small businesses. Some need financing, but remain locked out of the credit markets. Others have no desire for additional credit, as the NFIB survey continues to show, as many see no reason to expand.) This is not the stuff that economic growth is made of. Borrowing at close to zero and investing in 1%-4% yielding Treasury securities may boost banks’ interest income in the short term, but the music stops when the Fed must eventually unwind policy, and that means Treasury yields shoot much higher as this source of government debt dries up. In addition, the lack of demand for credit also shows there is little confidence among business regarding future sales prospects.

Commodity-related basic material shares were the second-best performing group on the session as that G-20 meeting goosed the trade.

Advancers smoked decliners by an eight-to-one margin on the NYSE. Nearly 1.2 billion shares traded on the exchange, in line with the six-month daily average.

Market Activity for November 9, 2009
The Dollar

The U.S. dollar looks to make another dive for the 74 handle on the Dollar Index (and it did move to the 74 handle briefly before bouncing off the intraday low), a level that should begin to get policymaker’s attention. If the greenback cements that move it may be “Katy bar the door” time as the buck may slide back to the all-time low of 71.35 in quick order, this will surely get the Fed’s attention.

The greenback rallied in the final two weeks of October as there was some uncertain as to whether the Fed would change its statement regarding the latest meeting. Would they removed the word “exceptionally” (referring to the low levels of fed funds) and thus signal a removal of ZIRP – the emergency level of fed funds – in the near future. But when the Fed’s meeting concluded and the “exceptionally low level of the federal funds rate for an extended period” phrase remained intact, it was a clear sign the pedal to the metal stance will be with us for a while. This is damaging to the dollar and the gold trade shows it – breaking through $1110/oz. yesterday morning.

There doesn’t seem to be any policymakers (at least domestically) who currently see a falling dollar value as a problem. For sure, the conventional wisdom views this as a good thing in that it will boost U.S. export activity. If the dollar continues to decline, we’ll see yet again how flawed conventional wisdom can be.

It’s all up to the Fed from here, don’t wait for the Treasury Department to offer assistance because they are the conventional wisdom – so is the Fed for that matter, but I’m trying to give them the benefit of the doubt; although I’m not sure why. Just as the previous administration wrongly judged, this one also believes a lower dollar will benefit U.S. growth and jobs. They forget one very important reality. As capital leaves the U.S. (a falling, and unstable, currency value coupled with the very high probability that tax rates on investment are going higher does not promote capital inflows) it will create jobs in the places that that capital finds it will be best treated. My concern is the Fed will not focus on the dollar until it is already obvious we have a problem. If this occurs, the reversal of monetary policy will be quick, abrupt and very damaging.

This Week’s Data

We have a very quiet week on the data front, so the letters will be short as a result. There is not a major economic release until Thursday, which brings the usual jobless claims data.

What we’ll be watching for is a move below 500K on initial jobless claims, a level that has proven elusive since January. We saw claims fall to 488K in the first week of the year, only to deteriorate big time, jumping to 675K by February. For evidence that some net job creation is occurring, we’ll need for initial claims to at least make it back to the high 400K level.

On Friday we’ll get the trade balance (September), import prices (October) and the University of Michigan’s consumer confidence reading (November).

On trade, the market will be looking for evidence that the weak dollar condition is helping export activity.

On import prices, the data results will remain unconcerning, but this will change come the November data. This is when the year-ago comparisons become very easy and all of the inflation numbers begin to move higher.

On the confidence reading, despite the market’s focus on the easy-money trade, I think traders will still need to see a rebound from October’s drop. (It’s important to remember that the UofM confidence reading does not include a labor market component, as the more watched Conference Board’s confidence reading does. Thus, the UofM’s measure remains at a higher level, but still well below the long-term average.


Have a great day!


Brent Vondera, Senior Analyst

8 months since S&P 500 bottomed

The S&P 500 bottomed exactly eight months ago and has since rallied 64%. The U.S. economy was still contracting when the rally began, which is no surprise since financial markets tend to predict the direction of the economy anywhere from three to six months into the future.

As it turns out, third quarter GDP grew at a 3.5% annualized rate, vindicating the stock market’s rally. Whether the market has rallied too much is an entirely different discussion for another day. Today, I examined sector performance since the March 9 low. Take a look at the table below.

Clearly, economically-sensitive stocks have been outperforming strongly, something that one expects in bull, not bear, markets. “Cyclical” sectors outperformed in the eight months since the S&P 500’s bottom, with the financials sector jumping 140.6%, the consumer discretionary sector adding 81.5%, the materials sector growing 78.6% and the information technology sector gaining 77.7%. In contrast, “defensive” sectors like healthcare, utilities, and telecom underperformed.

The results in the table above should come as no surprise because these are often the sectors that benefit the most during this stage of an economic cycle. The diagram below from S&P Equity Research illustrates this very well.


Tomorrow I will explain why these sectors often perform the way they do in the different stages of the economic cycle.

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks rose Friday, not by much, but the numbers were green as the ZIRP trade rolls on.

Stocks had no reason to rise on Friday, let’s be serious. Take everything into consideration – record low hours worked data, which means meaningful employment gains will be hard to come by; a jump to 10.2% unemployment; a decline in labor force participation, which means the jobless rate will continue to spike in the months ahead; and Washington in complete freak out mode as they worry about the state of the labor market. This is the most worrisome event of them all as Congress is dead set on putting additional policies in place in their attempt to “fix” things in the short term, an agenda that will surely carry pernicious longer-term effects.

But that’s from the lens of labor-market fundamentals. As we’ve talked about for some time now, and a Sunday night WSJ piece appropriately touched on, what’s bad is good for stocks. Just maybe the jump in the jobless rate received a cheer from the market. ZIRP lives so long as the labor market is in shambles and stocks like that. However, it also means the last leg of this stock-market rally has zero to do with what’s going on in the economy, it is nothing more than the chasing game – lurching to capture any additional return that may remain. At some point though, the market must show it can grow on its own and the Fed must reverse course. The market will anticipate these events and that is when market psychology shifts on a dime, again. The longer ZIRP lives the more damaging its removal will be.

Industrials, consumer discretionary and health-care shares led Friday’s gains. Financials, utilities and energy were the losers on the session.

Volume was especially lackluster with just 1.034 billion shares traded on the NYSE Composite – about 20% below the six-month average.

The broad market recaptured 3.20% last week. This bounce nearly erases the losses of the previous two weeks – the S&P 500 is flat over the past seven weeks.

Market Activity for November 6, 2009
October Jobs Report

The Labor Department reported that payrolls declined 190,000 in October, a bit more than the -175,000 expected. The previous month’s data was revised substantially more positive though, showing a decline of just 219K vs. the -263K estimated last month. Revisions for both September and August showed 91,000 fewer jobs were lost than previously estimated.

Over the past six months jobs losses have averaged 272,000 per month, this is a huge improvement from the previous six months in which losses averaged a super-high 645K per month. The current level of job losses has finally moved to a range that is no longer at the deep levels of the prior three recessions and that is an important development – for the short term, and I’ll explain what I mean by this below.

In terms of specifics, the goods-producing industries shed 129,000 jobs last month, a deterioration from the 114,000 decline in September – just barely worse than the three-month average of -124K. The construction segment cut 62,000 positions, an improvement from the 68,000 reduction in September – a little better than the three-month average of –65K. Manufacturers shed 61,000 positions, significantly worse than the 45,000 loss in September – and worse than the three-month average of -54K.

The service-providing industries shed 61,000 positions, a huge improvement from September’s 105,000 decline – in line with the three-month average of -63K. The trade and transportation segment lost 66,000 jobs, exactly the same as September – the three-month average is -53K. Retail slashed 40,000, which was a bit better than the 44,000 cuts in September – three-month average is -35K. Business services posted its second straight month of increase, adding 18,000 payroll positions after September’s gain of 3,000 – three-month average is positive too at +5K per month.

The best sign in the report was the rise in temporary work, which is the best indicator that job losses will ease substantially in the coming months and we’ll print some mild job gains in the not-to-distant future. Temp services added 34,000 positions, after a 7,000 gain in September – that number was revised up as it showed a 2K decline via last month’s employment survey.

Government employment came in unchanged as a 19,000 increase in federal government jobs offset declines in state and local employment – state and local budget are in a world of hurt and will remain that way for a long time. In fact they are likely to even erode from here as federal government stimulus injections are making those budgets look better than they actually are.

The unemployment rate, which was the newspaper headline, jumped to 10.2% from 9.8% as we are in the process of testing that post-WWII era record of 10.8% hit in December 1982.

The labor force participation rate fell, which actually held back the rise in the jobless rate (you would normally see a large increase in participation for the unemployment to jump like this). This means when these workers feel good enough about things to look for work again the jobless rate will jump. One expects that the now 93 weeks of available jobless benefits (99 weeks for those in the 27 states with unemployment rates above 8.5%) is marginally decreasing the sense of urgency to look for work. Bienvenue a le au pair etat.

The U6 jobless rate – this figures includes the official jobless rate, plus those marginally detached (those too discouraged to look for work during this survey period), and those working part time because they can’t find full-time work, which probably reflects labor-market torpor more than anything else -- jumped to 17.5% in October from 17.0% the previous month. This measure was re-calculated in 1994, so we can only view it to that point.

In terms of its previous methodology the U6 jobless rate hit 14.0%, which is still below the postwar record of 14.3% hit in 1982.

The average duration of unemployment hit 26.9 weeks from 26.2 in September.

The duration of long-term unemployment (the percentage of the unemployed that have been out of work for over 27 weeks) held at the record high of 35.6%.

The average weekly hours worked data fell back to the record low (data goes back to 1964) of 33.0 from 33.1 in September – it’s dropped back to this record low three times now. Unfortunately, we’ll need to see this figure head to 34.0 before employers even think about adding jobs. The average over the past decade is 33.8 hours per week.

Ok, so we’ve endured 22 months of jobs losses now and they have been massive, unprecedented in the postwar era in many ways. Nearly 7.5 million payroll positions have been lost during this stretch and with the exception of the 602K decline in December 1974, even when adjusting for the expansion in the labor force, the monthly losses are without precedent – again, in the post-WWII era. The duration of this level of decline has no comparison, not even close.

As a result of this period of deep job losses, we will soon see the number of payroll decline move to a statistically insignificant level, < 100K per month, and mild payroll increases should arrive by mid-2010. (Notice, this is changed from the estimate that they’ll arrive by early-2010 that I mentioned in Friday’s letter based on the hours worked figure that can’t get off the mat, and even then the job additions look to be slight unless that hours worked number spikes). However, the unemployment rate, which usually takes only about 10-12 months to come down by 2-3 percentage points once it peaks, may remain very elevated for a long stretch this go around. As we touched on Friday, the Fed is at zero – as if I need to remind anyone. This means that the tightening campaign, which almost always induces recession and causes labor market weakness, will be substantially more aggressive than what is typical. We should not expect the normal Greenspan-era ¼ point increases, they will be more substantial. Further, this tightening campaign will accompany higher tax rates this time – a nasty economic brew. These are the unfortunate thoughts the investor must be aware of. Just as the stock-market cheers the fact that ZIRP lives, it will jeer when it’s euthanized (whether it’s on the Fed’s longer timeline, or is more abrupt as much higher interest rates will be necessary to rescue a drowning dollar). The average time period in which the Fed has begun hiking rates following a peak in the jobless rate is six months. One month is the shortest period of time and 22 months is the longest. We have not yet seen the unemployment rate peak, but even if this were it, one can be sure the Fed is going to wait longer than the average – unless forced to move by some other event. The longer they wait, the more abrupt the tightening campaign will be.

Consumer Credit

The Federal Reserve reported that consumer credit fell $14.8 billion, or 7.2% at an annual rate, in September. This marks the eighth month of decline and the longest streak since records began in 1943. Borrowing for both revolving (such as credit cards) and non-revolving (such as auto loans) continue to tumble due labor market conditions and high delinquency rates – that is, both the supply of and demand for loans is on the slide.

Not that we needed further evidence, but credit expansion will not be here during this expansion, an element of the economy that had been especially present over the past two economic recoveries –credit expansion aided in smoothing out personal consumption until job and income growth returned. One of the major problems right now is that the Fed’s extended easing campaign in the period 2002-2005 that kept rates too low for too long encouraged a debt burden that we now must work through – it will take a while to accomplish.

Revolving credit fell $9.93 billion in September, or 13.3% at an annual rate. Non-revolving credit declined $4.87 billion, or 3.7% at an annual rate.


An Auspicious and Horrible Century

Today’s date marks the 20th anniversary of the fall of the Berlin Wall -- the reunification of Germany. November 9 also marks the terrible, evil event of Kristallnacht – 71 years ago. We should never forget either occurrence, particularly the actions that brought them about.


Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review

Stocks got off to a slow start after disappointing jobs data, but ultimately finished higher on the strength of the industrial sector. Today marked the fifth straight advance for the S&P 500, which posted a weekly gain of 2.53%.

Today’s labor report showed that payrolls fell by 190,000 in October versus an expected loss of 175,000. The bigger headline in the media, though, was the unemployment rate hitting 10.2%, the highest level since 1983.

General Electric (GE) led industrials after two separate analysts raised their ratings and share-price estimates. Also contributing to gains were transportation stocks, especially the railroads, which are still rising after Warren Buffett’s lofty valuation of Burlington Northern Santa Fe. (More on this topic can be found here.)

Despite all of press industrials received, the materials sector was the best weekly performer, finishing with a 5% gain. Gold stocks led in the sector, advancing nearly 13% this week. Although the Materials sector was strong this week, the CRB Commodity Index recorded a 1.8% loss on the week. This may not surprise you if you read the September 17 post comparing commodity exposure strategies.

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Peter J. Lazaroff, Investment Analyst

Fixed Income Weekly

FOMC – Baby Steps

This week’s decision by the Federal Open Market Committee (the committee that determines the Fed’s monetary policy) did some decent market moving this week despite only being one of many baby steps to come.

So what changed from last release? Not much. The committee sees household spending expanding, compared to only stabilizing in September. The previously scheduled $200 billion in agency debt purchases will now be reduced to “about $175 billion”, due mostly to the lack of paper available. Other than that, it was a carbon copy of the statement from the September 23 release. A Barron’s article from a couple weeks ago speculated that some Fed officials were considering removing all or part of the “exceptionally low levels of the federal funds rate for an extended period” phrase from the comments. We didn’t get that much of a switch from last meeting but we are definitely a little closer now.

Fannie Mae – The Landlord

Announced yesterday, Fannie Mae will begin renting homes back to troubled homeowners who prove they cannot afford to pay their mortgage. The new “Deed for Lease” program will offer an alternative to eviction to homeowners who have their mortgage either owned or guaranteed by Fannie Mae. In order to qualify homeowners must be between 1 and 11 months late on their mortgage and cannot qualify for a loan modification. Yes. There are homeowners who are more than 11 months late on their mortgage but still living in their home. Could that be masking some problems from the housing data the market has been juiced about lately? Just a thought…

The leases will be for 12 months, after which they will try to sell the home at a higher price than they could right now. Fannie claims that it is unlikely that homeowners will be able to buy their home back after the lease expires, sighting that the home will only be offered to qualified homebuyers. In reality, the term “qualified” has held several different meanings within the credit universe during the last few years, so who’s to say that someone with a major blemish on their credit history in the last year and no down payment won’t again be considered qualified. It’s a loose term at best. My expectation is for this program to crash and burn just like the mortgage modification program.


Cliff J. Reynolds Jr., Investment Analyst

Daily Insight

Dow 10,000! Again.

Stocks rallied hard as a number of better-than-expected results removed the wait-and-see attitude that has been the trend the day before a monthly employment report. The market sure seems willing to erase the losses recorded over the previous couple of weeks, undoubtedly helped by the Fed’s latest signal that the Bernanke bullet train will remain a blur – after Wed’s very soft FOMC statement it’s obvious ZIRP is with us for quite a while still as they kept the “exceptionally” low level of rates for “an extended period” wording in place.

Futures started things off higher after much better-than-expected profit and revenue results from Cisco Systems Wednesday night. Then, yesterday morning’s larger-than-expected decline in initial jobless claims and a chain-store sales report that easily surpassed expectations boosted investor sentiment into the official trading session.

Consumer discretionary, financials and industrials (the same groups that led the market lower on Wednesday) led the broad market’s advance.

Trading in the U.S. dollar was very volatile yesterday, but it did manage to gain some ground. ECB and Bank of England presidents Trichet and King signaled they will begin to remove their emergency level of monetary easing. This will not make the dollar’s road any easier to travel as our Fed keeps policy floored. As (if they actually end up doing so) the European central banks begin to gently raise rates and reduce their government bond purchases it should strengthen their currencies relative to the greenback and further boost interest-rate differentials in their favor.

The Fed isn’t even mildly changing course for some time…unless forced to by a catastrophic dollar rout – that seems to be the only thing that could get their attention and end the ZIRP.

Market Activity for November 5, 2009
Productivity

The Labor Department reported that productivity (output per hour worked) surged 9.5% at an annual rate in the third quarter. To offer some perspective, anything over 3.0% at an annual rate is powerful. It means that firms are able to absorb higher costs and that means they do not have to pass those costs, in full, onto the consumer via prices. But we need to explain a distinction between good productivity, which is longer-lasting, and productivity that is, well, less good as it comes solely from the slashing of payrolls.

The good productivity occurs when firms have the incentive to produce and innovate. This results as investors, the providers of seed money, take calculated risk and finance future innovations – generally driven by higher after-tax return expectations. When this innovation comes to market in the form of equipment enhancements, it means higher living standards -- jobs and real wages are driven higher. This type of productivity was in play over the past quarter century as tax rates on capital and income were reduced from the harmful levels of 70% on income (at the top rate) and 40% on the capital gains tax. Productivity continued to expand through the 1980s, 1990s and 2000s even as 48 million jobs were created in the U.S. over this stretch.

Conversely, the less than good sort of productivity is no friend of those looking for work right now because it arrives only when firms slash payrolls (specifically hours worked). And this is what we’re seeing in these latest productivity readings. (This is along the lines of what we’ve discussed for some time now. Firms will very likely squeeze evermore work out of existing employees, for an extended period, before adding to payrolls – this means a lack of final demand and economic weakness; it’s kind of tough for consumers to boost spending when the jobless rate remains at such heights. It becomes even more difficult when consumers are already burdened by historically high debt levels.

The policy direction of massive deficit spending, and the higher tax rates that follow, will only increase the chances that firms remain cautious and this has additional implications for the labor market. Higher tax rates, and while they are not here yet those paying attention understand much higher tax rates via various forms are a very real threat, will make it difficult for the new innovations needed to keep good productivity rolling without high levels of unemployment.

What drove this latest productivity reading was a 4% annualized increase in output, while hours worked slid 5.0% at an annual rate. On output, this gain was the first after falling for four-straight quarters (two of which saw output decline at record postwar levels). The other part of the equation, the tumble in hours worked marked the eighth-straight quarter of decline.

So these very heightened levels of productivity will prove helpful in the short term (particularly with regard to profits), but the benefit is likely to be fleeting if the correct economic policies are not advanced. The good type of productivity (via capital equipment enhancements, which is dependent upon lower tax rates on both capital and incomes), the type with a longer staying power, may have a rough time getting going in the new policy world it appears we find ourselves. It’s important to make these distinctions.

Jobless Claims

The Labor Department reported that initial jobless claims fell 20,000 to 512,000 in the week ended October 31. This beat the expectation by 10,000 as economists has expected claims to fall to 522K. This is the best move to the 500K level since they fell from 554k in late December to 488K in the first week of January. We have yet to get below what I’m calling the critical 500K level again (a point that is just above the 1991 recession and 2001 downturn peaks), but things appear to be on the right track.

The four-week average of claims fell 3,000 to 523,750 – the lowest level since January before they skyrocketed to 658K. No one expects that to occur again as we’ve gotten past the worst of the payroll declines.

Continuing claims fell for a seventh-straight week, down 68,000 to 5.749 million. As we’ve touched on for weeks now, this reading is being distorted by the exhaustion of benefits, which as of the latest payroll data continues to climb to record levels – as of September the exhaustion rate of the unemployed who had been collecting jobless benefits rose to 52.4%. Tomorrow’s data will shed new light on this reading.

Further, the 68,000 decline in traditional claims was more than offset by the 114,800 increase in emergency and extended jobless benefits.

By the way, Congress, or is it Parliament, has passed another 20-week extension to jobless benefits. I believe this brings the total to 79 weeks for those that are eligible. The extension provides another 14 weeks of benefits in all states, plus another six weeks for those in states with jobless rates over 8.5%. There are 26 states that meet that threshold.

(Also part of that bill is an extension of the homebuyers’ tax credit of $8,000 to April 30. Buyers who have owned their residence for at least five years would qualify to receive a $6,500 credit if they buy another – they would not have to sell the current home but the new one would have to qualify as their primary residence. Singles making up to $125,000 and couples making up to $225,000 would qualify. The market distorting games continue.)

Chain Store Sales

Chain-store retail sales (which is just year-over-year results for stores open at least one year) rose 2.1% in October, which blew by the expectation for a rise of just 0.1%. This move marks the second month of increase, same-store sales rose 0.1% in September, after 10-straight months of decline. All segments of the data have posted at least 14 months of declines with the exception being discount and drug chains. Thus, the year-ago comparisons have become very easy. Recall that these past two months of increase are compared to the beginning of economic hell when the consumer went into hiding in late September-October of 2008.

Apparel chains saw y/o/y sales rise 1.0%, after a 0.7% increase in September. Luxury chains posted a 1.8% increase in sales, the first in 16 months and those declines were huge averaging -13% y/o/y during this stretch. Discounters posted a 2.5% y/o/y sales jump in October. Drug chains saw sales boosted by 3.4%.

The only segment that continued to post declines was department stores, which extends the y/o/y declines to 16 months.

Overall, this is a good report, but it is off of easy comps and considering the fragility of the labor market results will likely be choppy over the next several months.

Employment Report

All eyes will be on the October jobs report this morning, which is expected to show 175,000 in payroll losses. This will mark the 22nd straight month of payroll declines and the losses have been massive – 7.2 million jobs have been erased over this stretch. We are going to see these declines move to statistically insignificant levels of < 100K per month in short order and one should expect to see mild job increases (yes, increases) by early 2010.

However, it will very likely take at least four quarters of above average (avg. being 3.4%) real GDP readings in order to bring the unemployment rate below 9.5%. (First, the jobless rate must move well above 10% as it always continues to rise even when job creation begins.) I am extremely skeptical above trend GDP results will occur for four quarter in this environment and give zero credence to forecasts that this expansion even comes close to those we’ve seen over the past 25 years.

The Fed is at zero, which means when the tightening campaign begins, it will not look like the normal ¼ point increases. The tightening will be aggressive, and when it occurs at the same time that tax rates are moving higher, the challenge to the economy will be enormous. It will take quick and substantial changes to the policy direction in order to expect otherwise, and even if that occurs, we still have to deal with the reversal of monetary policy.



Have a great weekend!


Brent Vondera, Senior Analyst

Performance 1-Year After Presidential Election

Yesterday marked the one-year anniversary of the 2008 election. Since the close on November 4, 2008, the Dow Jones is up 1.52%. If you didn’t know any better, you might think the last 12 months were rather uneventful.

I was only planning on using the S&P 500 since it is a broader gauge of market performance, but then realized that data from 1900-1925 (which was unavailable for the necessary 12-month periods) would yield significantly different average returns. As a result, I included the less broad market measure the Dow Jones Industrial Average.

No real or meaningful conclusions can be drawn from this data – obviously there are many factors that contributed to the market’s movements in these 12-month periods.

The table is a bit small, so make sure to zoom in on your browser (press Ctrl and + simultaneously).

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks sold off in the final hour of trading after spending the entire session higher by about 1.5%. By the time the bell rang the Dow closed up just 0.30% and the broad S&P 500 just 0.10%. I guess it was the old story “buy on the rumor sell on the news” as Fed policy makers kept their aggressive easing campaign in place.

Financial, industrial and energy were the worst performing groups on the session. The fact that energy was down seemed a bit strange on a day in which the price of crude rose back above $80. But think about it. The Fed keeps the pedal to the metal, that doesn’t exactly give the impression that the economy is at all able to stand on its own – as a result, these sectors will lead to the downside. The credit-card regulations coming out of Washington certainly also put pressure on the financials.

The dollar got Bernanke’d, giving up the little progress it had made over the previous six sessions.

Market Activity for November 4, 2009
Mortgage Applications

The Mortgage Bankers Association reported that applications rose 8.2% in the week ended October 30, the first increase in four weeks. Purchases continued to fall though as the homebuyers’ tax credit has effectively expired and potential buyers were uncertain as to the extension.

Refinancing activity rose 14.5% after three weeks of decline (outsized declines over the previous two weeks) as the 30-year fixed mortgage rate moved below 5.00% again.


Challenger Layoffs Announcements

The job-cuts survey from executive outplacement firm Challenger, Gray & Christmas estimated that layoff announcements declined 50.7% to 112,884 last month from October 2008. On a month-over-month basis, layoffs fell 10,725, or 16%, to 55,679.

In terms of region, the South endured the heaviest level of coming layoffs last month as employees announced 22,818 cuts. There were 17,187 announced layoffs in the West, 10,453 in the Midwest, and 5,221 in the East.

The October reading is the lowest level of monthly announced layoffs in 17 months, so things are moving in the right direction. This is a vital first step. The next step is obviously payroll additions but firms are very likely to squeeze more work out of existing employees before adding jobs. There is a lot of slack out there. Just as we talked about yesterday by way of the factory orders reports, unfilled orders continued to decline and that means the existing workforce is having no problem keeping up with orders. Until existing workers become quite stretched, firms are not going to rush to hire more workers in this environment.

Additionally, small and medium-sized businesses will lead job creation, as is always the case. But these firms are having trouble getting financing as the banking industry remains saddled with poor credit quality and loan defaults. Thus they are preserving their capital positions and holding back from providing the financing to small business. There is nothing terribly unusual about this in general, it is the reality when loan delinquencies rise. But the current environment has seen an abnormally high level of delinquency rates, and that means financing is that much harder to come by for the smalls and mediums.

ADP Employment

U.S. companies eliminated 203,000 in October, according to business outsourcing solutions firm ADP, down from the 227,000 estimated by the firm during September (the official government jobs report showed a loss of 263,000 jobs for that month – we get the official October reading tomorrow). This marks the 21st straight month of job losses.

This level of job losses remains in line with pretty heightened level of monthly job losses during the typical recession. We’ve seen the level of losses fall from extreme levels, but they will have to move to the minus 100k-150K level per month before we begin to get excited that firms have moved past this very damaging job slashing phase.

Small and medium firms led the job cuts last month, again not official but according to this survey, as both reduced payrolls by 75,000 a piece. Small firms are defined as those with less than 50 employees and medium firms as those with between 50-499 employees. Large firms shed 53,000 positions.

ISM Non-manufacturing

The Institute for Supply Management reported that the service sector expanded for a second-straight month in October. Although, the pace of expansion eased a bit as ISM non-manufacturing slipped to 50.6 from 50.9 in September. A reading above 50 marks expansion, so you can see service-sector growth is pretty tenuous.

Most of the sub-indices moved in the right direction. Overall business activity picked up to 55.2 from 55.1; new orders rose more than one point to 55.6 from 54.2; backlog of orders rose to 53.5 from 51.5.

However, the measures that are most in sight right now slipped. The inventory measure fell 4.5 points to 43.0 (been in contraction mode for 14 months). The inventory sentiment figure rose to 63.5 from 62.0 (a reading over 50 on this one means that firms view stockpiles are still too high). And the employment gauge fell to 41.1 from 44.3 on September.

Nine of the 18 industries tracked reported expansion, and that is up from five in September.

What respondents were saying:
“Cost-cutting efforts continue.” (Transportation & Warehousing)
“Overall business activity increasing – forecast even better market conditions in the coming months.” (Construction)
“Business climate remains encouraging, but recovery will remain slow in rebounding.” (Professional, Scientific & Technical Services)
“The weakening U.S. dollar contributing to upward pressure on commodity prices.” (Wholesale Trade)

FOMC – ZIRP Lives

The FOMC (rate-setting and policy decision-making committee of the Federal Reserve) kept their statement essentially unchanged from that of the September meeting as the “exceptionally” low level of fed funds for an “extended period” phrases remained. As touched on yesterday, this is a clear signal to all that the banking system remains in a tough spot – credit quality is deteriorating and lending continues to contract. Therefore, the Fed feels the need to continue recapitalizing the banks, the main goal of the zero interest-rate policy (ZIRP), and whatever it can do to juice the housing market.

In terms of these key comments the statement was a carbon copy of the previous meeting’s wording. But there were some changes in other regards:

• The Fed will purchase just $175 billion of agency debt now, versus the $200 billion in the previous plan. (For clarity, they will complete their $1.25 trillion of agency mortgage-backed securities by the end of the first quarter 2010. They’ve completed the $300 billion purchase of Treasury securities.)
  
• Household spending appears to be expanding. The previous statement said that household spending seems to be stabilizing.


• The Fed stated three conditions that will determine how long they keep policy accommodative: elevated resource slack (a high unemployment rate), subdued inflation trends and stable inflation expectations.

Mainstream economists, in their reaction to the FOMC statement, sang in unison about the Fed’s three stated criteria. As if from a choir, they acted as if this is some new revelation. It is not. Anyone who has paid attention and studied the Fed’s mindset for decades now knows that the unemployment in particular is what the Fed focuses on. Long-time readers know that this has been my main critique of the Fed for several years now. It’s nothing more than the same old Phillips Curve nonsense that has gotten the Fed, and the rest of us, in trouble so many times -- and none greater than their previous policy mistakes (2002-2005 when they kept real rates negative) that led to the housing bubble and the over-leveraged nature of households and institutions.

Many may have suspected it, these latest statements remove any doubt. Bernanke is not going to remove the spike punchbowl for some time. The unemployment rate is a lagging indicator, and so are the traditional measures of inflation. Therefore, they will extend the aggressive accommodation for much longer than is warranted – nothing new there. This means the unwinding of this policy, the tightening, is likely to be severe and harsh. Better to mildly remove the emergency level of fed funds, bringing it 0.75%-1.00%, than to keep things floored like this. If the economy cannot deal with a 1.00% FF, then stocks have gotten ahead of the economic state of things by a larger degree than I have thought.

What Bernanke & Co. needs to focus on is credit expansion. When this begins to kick up, that’s when the money-pumping agenda explodes into inflation. Instead, they just cannot bring themselves to shed the flawed Keynesian models that cause them to make harmful mistakes. This latest FOMC statement does nothing to increase my level of confidence in this Fed.

Have a great day!


Brent Vondera, Senior Analyst

P/B ratio

In honor of Warren Buffett’s latest acquisition, I wanted to explain one of his favorite valuation methods: evaluating a company’s price-to-book (P/B) ratio. Broadly speaking, the P/B ratio compares a stock’s market value to its book value to determine whether or not the company is undervalued.

Book value is a company’s assets (cash, inventory, equipment, real estate, etc) minus intangible assets (copyrights, logos, etc) and liabilities (debt, unearned revenue, etc.).

Consider a simple example in which a company has $100 million in assets on the balance sheet and $75 million in liabilities. If there are 10 million shares outstanding, each share would represent $2.50 of book value. If each share sells on the market at $5, then P/B ratio would be 2.

A company may be trading at less than its book value (or have a P/B ratio of 1) for two very different reasons. One reason could be that the market believes the asset value is overvalued or that there is something fundamentally wrong with the company. If this is true, then investors should stay away since a downward correction of that asset value by the market would result in negative returns.

The other possibility is that the company is earning a dismal (maybe even negative) return on its assets. In this case, changes in management or business conditions may prompt a turnaround in prospects and provide strong positive returns. If this turnaround never materializes, then the company could at least be broken up for its asset value and, in turn, provide shareholders with a profit.

Although the P/B ratio is traditionally used by value investors, it’s also useful for investors seeking growth at a reasonable price. Growth companies tend to have higher P/B ratios, which is fine as long as the company has a high return on equity (ROE). Large discrepancies between P/B and ROE should raise a red flag.

So how does Buffett’s recent acquisition of Burlington Northern Santa Fe (BNI) railroad look?

The purchase price of $100 a share gives BNI a P/B of 2.80 and a P/E of 20 times future earnings – not exactly what most would consider a “value.” What this means is that Buffett believes the company’s growth prospects are very attractive once the economy recovers.

Railroads do, in fact, have good operating leverage to an economic recovery since more than half of operating expenses are fixed – increases in rail volume would significantly enhance profit margins. Buffett also has a history of seeking companies with strong competitive advantages such as barriers to entry. The established network of nearly impossible to replace assets provides railroads with staggering barriers to entry.

Acropolis, too, has been buyers of railroads since March; however, we favor Norfolk Southern (NSC) due to its cheaper valuation, impressive profitability, diverse customer base, and commitment to returning value to shareholders. And since we are talking P/B ratios, NSC’s is only 1.82 compared to BNI’s 2.70.

The P/B ratio shouldn’t be the sole reason for making an investment decision. Like all valuation methods, it varies across industries and can be distorted by a company’s accounting methods in their financial statements. Still, the P/B ratio is a nice starting point for finding undervalued companies.

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks spent most of the session below the flat line on a downgrade of chipmakers and investors seemed content to wait for the end of the Fed’s two-day meeting, but the broad market rallied late in the session to close in positive territory. A couple of merger and acquisition deals helped to offset substantial weakness in pre-market trading that flowed into the official trading session. Stanley Works will purchase Black & Decker and then there is the big one, announced early yesterday morning, which was Berkshire Hathaway’s purchase of the 77% of Burlington Northern it didn’t already own.

Industrial shares led the broad market’s advance, propelled by the two deals. The basic material (certainly helped by a big time rally in the price of gold) and energy sectors were close behind. The losers on the session were health-care, utilities, tech, telecoms and consumer staples – all closed lower on the session.

Berkshire’s all-out purchase of railroad giant Burlington Northern is clearly a bet (since Buffett is an economic advisor to the Obama Administration it was probably much safer than a “bet”) on increased infrastructure spending and future taxes on carbon emissions that make truckers less competitive relative to the rails.

Advancers whipped decliners by a two-to-one margin even though the overall market didn’t really have much juice to it. The advancers surely didn’t advance by much, with the exception of the transports on the Burlington deal. The Dow Jones Transportation Average massively outperformed the market (up 5.28% on the trannies vs. the 0.24% pick up for the broad index).

Market Activity for November 3, 2009
Gold

The front-month gold contract rose to a record, spiking $31 to $1085.80 (still well below the 1980 inflation-adjusted price of roughly $2350/oz.) as India’s central bank went on a little buying spree – they purchased 200 tons, or $6.7 billion worth, of gold from the IMF.

Bianco Research

Is this a move to diversify away from currencies (namely the U.S. dollar) as the world loses confidence in governments’ ability to stabilize currency values? It seems that way. The purchase boosted India’s gold holdings by 55%. Hey big Ben, it’s kind of difficult to ignore this transaction!

Earnings Season

We haven’t heard a lot about earnings season after the first couple of weeks of results. It’s interesting how the press makes such a big deal in the early stages of the season when just a few companies have reported, and attention tapers off when it really counts -- and it counts now as 80% of S&P 500 members have released results.

Analysts and financial commentators had talked much of the fact that 82% of S&P 500 members have beat expectations, but those were pretty low-ball estimates – firms have low-balled estimates for several years now, but the percentage of positive surprises shows they were really marking things low this go around; the long-term average of S&P 500 members that beat expectations is 59%.

Profit results overall though are quietly eroding, quietly because no one seems to be talking about it. A couple of weeks into the season results were down roughly 8% from the year-ago period. Last week when we touched on profit results, S&P 500 earnings were down 15%. Currently, with most firms now having reported, overall profits are down 22.3% (down 26.6% ex-financials). That’s not much better than the previous quarter’s results in which overall profits fell 28.9% and ex-financial was down 27.9%. And the current results are being compared against easier year-ago period comps than the comparisons for the previous quarter.

FOMC

We’ve got a lot of important data/announcements for the remainder of this week. We have the preliminary jobs reports via the Challenger Layoffs and ADP Employment surveys as we wait for the official October jobs results on Friday. We also have same-store retail sales results for October coming on Thursday. But we also have the latest FOMC (Fed’s rate-setting and monetary policy committee) two-day meeting and the comments that follow the meetings end, which occurs this afternoon.

So we turn to the Fed and the market awaits the comments. It is clear that one expects they’ll increase the benchmark fed funds rate. So, the market will be intensely focused to the wording and clues as to when Bernanke & Co. will shift from their ZIRP “for an extended period” to simply a policy that is just accommodative. That is, shifting from the current emergency level of fed funds to something closer to 1%-2% over the next several months to a year. It’s easy to forget, I guess, as the Fed has kept the pedal to the metal, but 1%-2% FF is still amazing accommodative.

This ZIRP policy that has been in place for almost a full year now, and will have extended beyond a year by the time it is removed, is arguably justified based on the troubled state of the economy but it is also destructive as well. The Fed needs to be very careful not to extend this for too long – besides we need to know if the economy can stand without it. If it can’t manage to grow at 1%-2% FF, then the market has some valuation adjustments to get on with – for sure, the distorting effects of the Fed’s policy needs to end for it will only cause a more severe blowback the longer they wait.

For instance, the ZIRP has devolved the U.S. dollar into a carry trade currency – traders borrow at the exceptionally low U.S. interest rates and invest in higher return vehicles; the occurrence of this is obvious as virtually all asset classes (and even those that are not official asset classes) are moving in the same direction. Stocks, bonds, gold, oil, industrial metals, they are all moving in tandem – a very unusual occurrence. When the Fed does turn course and eventually moves to increase rates (and removes the carry trade) the mad dash for the riskier-asset exit door will ensue and that more than likely means a simultaneous decline among many different asset classes. The longer the Fed waits, the more damaging this run for cover will be on asset prices.

The Fed has backed itself into a corner, and it began with their mistakes all the way back in the 2002-2005 period, which was a primary cause of this entire mess. The longer they remain in the corner, the more head shots the economy will take when they step out. As a result, the Fed meetings, and comments that follow, will become intensely important events.

I’ll tell you this, the Fed is keeping a close eye on the banking industry now and may see the challenges to the financial system as still so great that they feel compelled to keep ZIRP in place. If the members of the FOMC cannot decide to even mildly remove some of this aggressive accommodation, then that should be a crystal clear signal to all that they see loan portfolios are continuing to erode at an alarming rate. What else would justify this emergency level of rates and the consequences that follow?

Factory Orders

The Commerce Department reported that factory orders rose a healthy 0.9% in September, slightly more than expected, after a 0.8% decline in August. Bookings for durable goods orders (which currently make up half of factory orders) jumped 1.4% after a 2.7% decline in August. Machinery orders fueled the gain in durables as mining, construction and power transmission companies ordered new equipment. Bookings for non-durable goods (such as food, petroleum, clothing, paper products, etc.) rose 0.5% in September. Food, petro and paints and coating (autos) led non-durable shipments higher. Beverage & tobacco, apparel and paper products dragged on non-durables.

The proxy for business-equipment spending rose 1.8%, after a 1.0% decline in August; the figure has been absolutely crushed over the past year, down 16% -- although an improvement from the year-over-year 21% decline as of August.

Unfilled orders fell for a 12th straight month (longest stretch of decline since records began in 1992), down 0.3% in September, which shows factories (even with much lower payroll levels) are having no problem meeting orders.

Inventories fell for a 13th straight month, down 1.0% for the month. The inventory-to-shipments ratio fell for a fourth straight month to 1.36 (from 1.38) but remains well-above the record low of 1.13 hit in December 2005.

The gain in factory orders marks the fifth increase in six months. From here we will see if it is sustainable, it will all depend on the timeline with which final demand arrives. If it is lacking, due to a persistently high jobless rate, we won’t get that full-blown inventory dynamic we’ve been waiting for and that will show up in the production numbers.

October Auto Sales

Late in the day yesterday we got the October auto sales figures, which bounced a bit from September’s very weak 9.20 million units. Vehicle sales rose to 10.45 million at an seasonally-adjusted annual rate (SAAR).



Have a great day!


Brent Vondera, Senior Analyst

Afternoon Review: Buffett, Transports, Semiconductors

S&P 500: +2.53 (+0.24%)

Markets swung between gains and losses before ending higher. Helping push stocks higher was the fact that the dollar pared early gains. The dollar’s losses also resulted in crude oil bumping up to just under the $80 level.

Traders’ may be hesitating to push stocks into positive territory as they await several economic releases later in the week including the monetary policy announcement from the Fed tomorrow, and the labor report on Friday – both items could potentially give investors a better view of the pace of ht economic recovery.

Berkshire Hathaway’s acquisition of Burlington Northern Santa Fe was the top story of the day, pushing railroad companies and other transportation stocks higher. Berkshire’s Chairman and CEO Warren Buffett paid a 30% premium for the railroad.

Believers in the Dow Theory may make a bullish argument following today’s upward action in the Dow Jones Transportation Index. The Dow Theory says that transportation companies move what industrials are making and, thus, serve as a good leading indicator. Others, however, argue that semiconductors are better indicators of future market direction.

Within the technology universe, economically sensitive semiconductors tend to lead the pack. Just as some technicians watch the Dow Jones Transportation Index for indications of future market movements, others refer to the Philadelphia Semiconductor Index (SOX). The SOX has slipped this week on unfavorable research notes from Morgan Stanley and Goldman Sachs, both of which citing higher expectations following strong third-quarter earnings and, thus, greater downside risk.

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Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks were sent on a wild ride Monday as the day’s economic data spurred a strong morning-session rally, only to see it fizzle after some reality-based comments from a Federal Reserve official scared the market out of it easy-money stupor. The market later rallied to recoup nearly half of the early-session gains.

The sell-off, which completely erased a 1.5% rally from the get go, seemed to follow a statement from the associate director of the Fed’s bank supervision division that banking system conditions remain “far from robust” and examiners have noticed “sharp deterioration” in loan portfolios. He explicitly stated problems the Fed is seeing in commercial real estate loans but also seemed to show concern regarding corporate loan portfolios as well. We’ll touch on some statements on bank regulation and commercial real estate below.

In the end consumer staples, basic material, and industrial shares led the gains. Utilities and telecoms were the losers as the only two of the 10 major industry groups that failed to end on the plus side. Financials were whipsawed, down as much as 4.2% from their day’s peak but ended up closing just 1.6% below the session’s apex – the group closed the session higher by roughly 0.8%.

Ten stocks rose for very seven that declined on the NYSE. Some 1.5 billion shares traded on the NYSE Composite, 16% higher than the six-month average.

Market Activity for November 2, 2009
Banking Industry Issues – and That Means Economic Issues

The WSJ reported on Saturday that regulators have issued guidelines that allow banks to term commercial real estate loans as “performing” even when the underlying property values have fallen below the loan amount. This is not a reversal of existing rules, but does provide more clarity as banks struggle to deal with the erosion in commercial RE assets.

This increased clarity is not that all that much different from the change to mark-to-market (specifically FASB 157) accounting that offered greater lucidity (at the time with regard to troubled residential loans) and stopped the regulation from artificially destroying capital positions within the banking system. If banks are going to hold assets (a loan) to maturity, so long as the interest and principal payments are current, why write them down to distressed prices and destroy capital? It would only cause additional economic harm – and indeed it did.

But also recall, before that I was conspicuously in favor of the original TARP. That program would have used an RTC-style structure to remove bad assets from banks’ books and placed them in an account that the government would run -- hold assets for 5-10 years, however long it takes, until the RE market normalizes and sell them off. Regulators can provide increased levels of clarity, and that is helpful, but it doesn’t change the fact that banks still carry a lot of troubled loans on their books.

This was Bill Seidman’s Resolution Trust Corp. back in the very early 1990s that proved so successful, it made a profit for the government, and that is the point – doing what history has shown to work. Unfortunately, TARP was changed to this idiot idea of injecting government money into the banking system – we expressed a steadfast objection to this move back in the winter of 2008. It was changed because the original TARP plan was seen as too plodding, but it may very well have been up and running by now – if so, we may just be on the road to a somewhat more normal environment.

The overall reality though is that commercial RE defaults are a ticking bomb for a large portion of the banking system that the market seems to be ignoring – a lot of risks have been ignored of late but this is what an easy-money/ZIRP does, it distorts markets. The larger issue now is that without an RTC-style program banks will be saddled with bad assets for some time to come and that means little to no credit expansion. In the world of intense government intervention we currently find ourselves, an RTC-style solution would have been much less damaging than many of the things we have tried (and continue to try).

We are in a nasty situation here and the investor needs to come to grips with the reality on the ground, you just can’t casually move out along the risk curve as if this were a normal business-cycle expansion, or a typical political environment.

ISM Manufacturing

The Institute for Supply Management’s manufacturing index rose to 55.7 in October (highest since April 2006), up nicely from 52.6 printed in September – the reading blew by the expectation of 53.0.

This move in ISM marks the third month of expansion and the October reading is fairly robust (for this environment); it mirrors the 55 print out of China the night before.

Most of the sub-indices looked good as new orders, backlog of orders, supplier deliveries and export orders remained in expansion mode. However, all of these but export orders showed a slower pace of expansion relative to the September readings.

The best news of the report was the rise in the employment figure – up to 53.1 from 46.2, the first month of expansion since July 2008 (probably some callbacks thanks to increased auto assemblies). This area was a big concern on Friday when the Chicago manufacturing’s employment figure remained pretty deep in contraction territory. Eight of the 18 industries tracked by ISM reported employment growth, up from three in September.

The inventory figures have been another area of concern as the data has yet to show an actual rebuilding of stockpiles is taking place. ISM’s inventory figure bounced in October, but it does remain in contraction mode, up to 46.9 from 42.5 – the trend is really nice though. The customer inventories reading (what respondents to the ISM survey think of their customers’ inventories levels) fell 0.5 to 38.5. This means they think their customers’ stockpile levels are too low, so after seven months now of this reading being below 50 maybe this is a sign some inventory rebuilding may ensue over the next couple of months. Conversely, it also shows that businesses have little confidence regarding future sales.

Overall, it was a good report and certainly the best we’ve seen (from an all-around perspective) since the summer of 2007. Thirteen of the 18 industries tracked reported growth, unchanged from September.

Pending Home Sales

The National Association of Realtors reported that September pending home sales jumped 6.1% from the previous month – the reading was expected to come in unchanged. This large increase in contract signings was undoubtedly due to the rush to get in before the first-time homebuyers’ tax credit expires (have to close before November 30, and it’s taking 6-8 weeks to close). The October data will likely mark an end to this strong six-month run that was driven by a powerful trifecta – the tax credit, the home buying season and Fed-induced rock bottom interest rates. Of course, September home buyers didn’t know the credit was going to be extended, which is highly likely now.

In terms of region, the West led the way as pending home sales jumped 10.2% -- a sign foreclosure-driven price declines also fueled the September increase. The Midwest posted the second-best increase, up 8.1%, with the South printing a 4.9% rise. Contract signings fell 2.0% in the Northeast.

In terms of the tax credit’s extension, the number we keep hearing is April 30 (or contract closed 60 days after that date). At some point though the credits must come to an end and that is when we’ll learn the true status of the housing market. As mentioned above, this is just another government scheme that distorts the true market fundamentals.

Construction Spending

Construction spending rose 0.8% in September, fueled by a 3.9% jump in residential construction. I can see this becoming quite the problem when home sales wane as the supply figure will jump again.

The commercial side declined for a fifth-straight month, down 13.7% at an annual rate over the past three months. The public side has helped to offset the plunge in private-sector commercial construction (private sector down 26.8% annualized over the past three months and getting worse, public sector commercial construction up 5.3% on the same basis).

Futures

Stock-index futures are down big this morning as the safety trade makes a bit of a comeback. However, pre-market trading has pared some of those losses on news that Berkshire Hathaway, the investment vehicle for Warren Buffett, will purchase the 77% of Burlington Northern (railroad) that is doesn’t already own in a cash and stock deal. The deal is $100/share, or a 30% premium to yesterday’s closing price.


Have a great day!


Brent Vondera, Senior Analyst