Saturday, July 14, 2007

The Employment Numbers and the Birth/Death Model

There has been a lot of commentary among economists about the effect of the BLS' birth/death model on employment numbers. However, most of these discussions have been annoyingly wonky in my opinion and difficult to understand.

John Mauldin has provided an excellent analysis of exactly what the controversy is and more importantly provides a very readable explanation.

To start with, let's dissect the employment numbers. The official headline number for June was 132,000 new jobs. Since we need about 150,000 new jobs just to stay even with population growth, that is hardly a robust number, but not too far off from what would be a good number. Except that there are some problems with the headline number.

The employment numbers come from a survey of established businesses. But obviously the Bureau of Labor Statistics (BLS) cannot call every business in the US, so they simply survey the larger businesses. But that means they miss the growth in the small-business sector of the economy, which is where the largest amount of new jobs are created.

The BLS surveys about 160,000 businesses in its sample model. There is an unavoidable lag between an establishment opening for business and its appearing on the sample frame and being available for sampling. Because new firm "births" generate a significant portion of employment growth each month, non-sampling methods must be used to estimate this growth. To make up for this, they add or subtract a certain number of jobs, called the birth/death (of new businesses) ratio.

They use the actual births and deaths of real businesses for the last five years to make their estimates of new jobs created from new business. This is quite a legitimate methodology, but it does have one problem. It is backward-looking data. BLS knows that and states the following on its web site:

"The most significant potential drawback to this or any model-based approach is that time series modeling assumes a predictable continuation of historical patterns and relationships and therefore is likely to have some difficulty producing reliable estimates at economic turning points or during periods when there are sudden changes in trend. BLS will continue researching alternative model-based techniques for the net birth/death component; it is likely to remain as the most problematic part of the estimation process."

Remember the jobless recovery of the first Bush term and the constant criticism about the poor economy? Why was the economy doing so well and yet job creation was so poor? It turns out that a great deal of the explanation is that the BLS underestimated the number of new jobs being created by small business. In the early years of the recovery, rather badly.

Likewise, the BLS data will overestimate jobs when the economy is slowing down. Is there some evidence that may be the case today? I think there is.

To the credit of the BLS, they are very transparent about their data. There are massive amounts of data available at www.bls.gov and the data on the birth/death ratio is at http://www.bls.gov/web/cesbd.htm. Now, let's examine the contribution of the birth/death ratio to the employment numbers.

Last month, the BLS estimated that there were 156,000 new jobs in the birth/death ratio category, which was 24,000 more jobs than they estimated were created for the month. OK, maybe no problem. Looking back over five years, the economy has created about that many new jobs during the month.

Except that they estimated 26,000 new small-business construction jobs. With home construction dropping, do we really think that the same number of new jobs was created in construction as in June of 2006 and 2005? Or that 153,000 new jobs in small-business construction have been created this year? Really?

In fact, since January, the BLS estimates for the birth/death ratio have added 747,000 new jobs of a total projected growth of 871,000 jobs, or 86% of the total of the jobs estimated supposedly created for the first half of the year.

Is there any other reason to believe that the birth/death ratio may be overstating employment as the economy slows? The always astute Paul Kasriel of Northern Trust thinks there is. He notes that in 2005 the contribution of the birth/death ratio (12-month average) to the overall employment numbers was well under 35%. Today it is over 56%. Given the recent numbers, that ratio is likely to rise.

"What has been happening to the relative contribution of birth/death estimates as the economy has slowed in the past year? The chart below shows that it has been rising. In the 12 months ended March 2006, the birth/death adjustment was contributing only 30.9% of the jobs to the change in nonfarm payrolls. The birth/death relative contribution has been trending higher since then. Notice that as the birth/death contribution to nonfarm payrolls has been trending higher, the percentage of small businesses saying that now is a good time to expand their operations has been trending lower. If existing small business managers do not think now is a good time to expand their operations, does it make sense that there are a lot of new small businesses starting up and hiring?


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Friday, July 13, 2007

Weekend Weimar

The markets are closed. Stop thinking about economics. Go do something else.

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How Stupid is the Fed's "Core Inflation" Obsession?

Core inflation doesn't include food and energy prices. So -- here are charts of some raw food and energy prices from the future's markets.

Cattle prices:

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Corn

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Gas

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Oil

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Soy Beans

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Wheat

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Notice how little these prices have moved over the last few years....

Import Prices Increase

From the BLS:

Import prices rose 1.0 percent in June, the fifth consecutive increase for the index. Petroleum prices were also up for the fifth month in a row, increasing 4.7 percent in June after a 3.7 percent advance the previous month. After declining at the end of 2006, the price index for import petroleum rose 28.1 percent from January through June. However, the index was only up 2.1 percent over the past year compared to a 33.7 percent increase over the previous 12 months. Nonpetroleum prices also advanced in June, rising 0.2 percent after advancing 0.5 percent in May. Prices for nonpetroleum imports increased 2.6 percent for the year ended in June, while overall import prices rose 2.3 percent for the same period.


Once again, a report brings into focus the ridicules obsession with core inflation at the expense of the whole picture. Import oil prices are up 28.1% this year. But according to the Fed, this increase is not important.

Retail Sales Drop

From the Census Bureau:

The U.S. Census Bureau announced today that advance estimates of U.S. retail and food services sales for June, adjusted for seasonal variation and holiday and trading-day differences, but not for price changes, were $373.9 billion, a decrease of 0.9 percent (±0.7%) from the previous month, but 3.8 percent (±0.7%) above June 2006. Total sales for the April through June 2007 period were up 3.9 percent (±0.5%) from the same period a year ago. The April to May 2007 percent change was revised from +1.4 percent (± 0.7%) to +1.5 percent (± 0.3%).


All areas of retail sales declined -- motor vehicles and parts, general merchandise, gas stations, apparel, electronics and appliances and health stores.

However:

Retail sales decreased 0.9% last month, the Commerce Department said Friday. The drop followed a big, 1.5% increase in May, revised up from an originally estimated 1.4% jump. Demand dropped 0.3% in April, the first month of the second quarter.

Economists have been predicting consumer spending would soften after its first-quarter surge, and they expected a drop in June sales. But the 0.9% fall was much bigger than forecast; the median estimate of 27 economists surveyed by Dow Jones Newswires was a 0.1% decline.

In fact, the 0.9% decrease was the largest since a fall of 1.5% in August 2005. Still, the decline wasn't broad, with demand among some retailers, including general merchandise stores, rising. The decrease among all retailers except the auto and gasoline sectors was a much smaller 0.3%.


In other words, the auto sector was a pretty big reason for the large drop.

Yesterday's Rally In Perspective

Here is a chart of the SPYs. Before we get too excited about yesterday's rally, let's put it in perspective.

In index broke through the upward band of a downward channel which is bullish. But the index is barely above resistance a bit above $154. If the index holds at this level a further upward move is more probable. But the index has had trouble maintaining gains recently, so don't be surprised if it pulls back.

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Trade Deficit Widens

From the BEA:

The U.S. Census Bureau and the U.S. Bureau of Economic Analysis, through the Department of Commerce, announced today that total May exports of $132.0 billion and imports of $192.1 billion resulted in a goods and services deficit of $60.0 billion, compared with $58.7 billion in April, revised. May exports were $2.9 billion more than April exports of $129.2 billion. May imports were $4.2 billion more than April imports of $187.8 billion.


An increase in the price of oil was the primary reason for the increase.

This is one of the underlying reasons for the decrease in the dollar's value.

Thursday, July 12, 2007

Economists Predicting Stronger 2Q Growth

From Bloomberg:

The economy probably expanded at an annual rate of 3.6 percent last quarter, rather than the 3.2 percent rate Global Insight had forecast prior to the trade report, Gault said.

Economists at HSBC Securities USA Inc. and Morgan Stanley in New York were also among those raising their second-quarter estimate.

In a Bloomberg News survey of economists taken July 2 to July 9, economists expected the economy to expand at a 3 percent rate in the second quarter, based on the median of 69 estimates. That compares with a 0.7 percent rate in the first quarter.


There are a few points I would like to address from the above referenced predictions.

1.) Currently, most economists are looking at the first quarter as a brief slowdown in a otherwise long expansion. In other words, there is a consensus that things are getting better.

2.) Let's say the number comes in below expectations. That could create a big problem for people because it would shock the regularly held consensus view.

3.) I would personally be far more comfortable if the median was say 2.3% - 2.5%. Going from .7 to 3% is a big jump whereas moving from .7% to the mid 2% range seems far more possible.

Bank of Tokyo Mitsubishi's Retail Sales Stronger Than Expected

Here's the link to the report (PDF)

Specialty and Apparel Store Sales Increased 3.4%.
General Merchandise increased 2.4%
Home Supply Decreased (this does not include Home Depot or Lowe's) -15.5%
Drug Store Sales Increased 4.8%.

The annual total for 2007 so far is 2.8%. This is the lowest total since 2001. However, we still have 7 months to go until the end of the year.

Wal-Mart was up 1.3%. Because Wal-Mart is by far the largest retailer in the US, their sales figures are closely watched.

Target was up 5.8%.

Overall, this report is fairly solid. While the low annual rate should raise a yellow flag, the strength of this number should console the bulls.

Foreclosures Increasing

From Bloomberg:

he number of U.S. properties in foreclosure climbed 87 percent last month from a year earlier as home prices fell and lending standards tightened, making it harder for borrowers to sell homes and refinance mortgages.

There were 164,644 loan default notices, scheduled auctions and bank repossessions in June, led by filings in California, Florida, Ohio and Michigan that together accounted for half the total, according to RealtyTrac, a seller of foreclosure data.

The June foreclosure figure was 7 percent lower than in May, when filings reached a 30-month high, Irvine, California-based RealtyTrac said today. ``Still, rates in most states remained substantially above last year's levels,'' James Saccacio, the company's chief executive officer, said in the statement.


Recent housing news has been incredibly bearish. Two ratings agencies have announced a downgrade of CDO/CLO deals. Homebuilders have announced lower earnings, higher cancellation rates and stated the current environment is difficult. Now we learn that while forclosures decreased from last month, they are still far higher than last year. It's also important to remember foreclosures are coming off of record lows, so they really only have one way to -- namely, up.

A Look At the 5 Largest S&P Sectors

According to S&P, the 5 largest sectors of the S&P 500 are financials (20.77%), information technology (15.45%), health Care (11.67%), industrials (11.43%) and energy (10.79%). Here are the industry charts for those sectors from the largest to the smallest.

The financials are getting hit by the subprime issue in a big way. Notice the 10, 20 and 50 day SMA are all heading lower. The 10 day SMA is below the 20 day SMA, which is below the 50 day SMA. As a result, the smaller duration moving averages are pulling the longer duration averages lower. Finally, the index is trading below the 200 day SMA.

In short, 20% of the S%P 500 is in a terrible technical position.

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Technology is heading higher, although it's not the strongest rally; the upward trajectory is weak. However, a weak upward rally is better than nothing. Also notice that all the moving averages are heading higher. If this index continues on its current trajectory it will help to stabilize the downward pull of the financials.

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Health care sold off in early June and has trended down since then. However, it appears to be stabilizing. The 10 day SMA is heading higher. However, the shorter term SMAs (the 10 and 20) are still below the 50 which will pull the longer term SMAs lower. Short version: health care is struggling.

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The industrials mirror the technology area. While this index is heading higher, it's not the strongest rally we've seen. However, the larger industrials have good international sales exposure and a very cheap dollar. This should help earnings reports giving this sector a lift.

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Energy is in good shape. It has rallied since the end of June. All the SMAs are heading higher. Also, oil is trading above $70/bbl. Assuming oil continues at current prices we should see this sector do well.

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1.) Two sectors -- financials and health care -- are languishing. Health care is trying to make a comeback, but the jury is still out. These sectors comprise 32.44% of the S&P.

2.) Two sectors -- technology and industrials -- are rallying, but the rally's trajectory is weak. These sectors comprise 26.88% of the S&P.

3.) One sector -- energy -- is doing well. It comprises 10.79% of the index.

Wednesday, July 11, 2007

Gas Prices Now Near Last Year's Levels

From This Week In Petroleum:

For the first time since May 21, the U.S. average retail price for regular gasoline rose, increasing 2.2 cents to 298.1 cents per gallon as of July 9, 2007. Prices are 0.8 cent per gallon higher than this time last year. Regional prices were mixed with East Coast prices dropping 0.1 cent to 292.4 cents per gallon. The largest rise was in the Midwest, where prices jumped 9.1 cents to 304.5 cents per gallon. Prices for the Gulf Coast increased 0.7 cent to 285.8 cents per gallon. In the Rocky Mountain region, prices fell 3.1 cents to 306.6 cents per gallon, although they remain 17.9 cents per gallon above last year. West Coast prices were down 2.6 cents to 308.0 cents per gallon. The average price for regular grade in California was lower by 2.1 cents to 313.6 cents per gallon.


Here is a chart of gas prices from the same report:

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Note that prices increased at the same time this year as last year. But, this year's prices were consistently higher than last years prices. This year's prices continued to rise into May, decreasing to current levels starting in about June.

In other words, the economy has now had about 6 months of gas prices that were higher than last year's prices, although year to year comparisons are currently near parody.

How has this impacted wages? According to the Bureau of Labor Statistics, the average hourly earnings of production workers increased from $17.16 to $17.29 from January to June, or an increase of .75%. Over the same period, the overall inflation level increased from 202.416 to 207.949 or an increase of 2.73%, for an overall drop of 1.98%.

Here's a chart of energy prices from the St. Louis Federal Reserve.

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It looks like energy prices hit earnings pretty hard.

Bear Stearns Selling Bonds

From The Street.com

Bear Stearns (BSC - Cramer's Take - Stockpickr - Rating) is set to offload about $450 million of securities tied to one of its failing hedge funds.

The offering consists of securities from a cash collateralized debt obligation tied to a credit from debt backed by subprime mortgages. The CDO debt list is peppered with fixed- and floating-rate junk debt but includes primarily securities that carry higher-credit quality as rated by Standard & Poor's and Moody's Investors Service.

...

It's hard to say how the debt might trade in the market in light of all the distress in subprime, one CDO manager says, noting that previous offerings from Bear have fared "OK." He was unable to provide pricing on past Bear deals.


This could create a big problem. Depending on which bonds Bear is selling, it may be selling very illiquid securities. If this is the case, then bids for the bonds might come in lower than Bear would like. This could lead to a wave of similar debt being written down, which could impact a lot more funds.

Dollar Still Falling

The S&P downgrade story really hit the dollar yesterday. Notice the drop below key support levels.

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The weekly chart looks terrible. Notice the downtrend is still firmly intact and all of the moving averages are still headed lower.

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Was Yesterday A Turning Point?

I have been moderately bullish for the upcoming quarter. I have thought that earnings would come in above the 4% level. I have also argued that the structure of the CDO/CLO deals would mitigate the impact of decreasing

Consider the following news items which came out yesterday:


Sears (NasdaqGS:SHLD - News), which operates both Sears and Kmart stores, blamed slow home appliance sales for its big warning. Shares fell 10%.

Home Depot, the No. 1 home improvement retailer, trimmed its 2007 forecasts. Shares edged higher on its buyback plans.

Major home builder D.R. Horton (NYSE:DHI - News) warned of a loss, too. Orders fell 40% in its fiscal third quarter and cancellations rose thanks to the glut of homes on the market.

Meanwhile, Standard & Poor's said it may cut ratings on some $12billion worth of bonds backed by subprime assets. It announced tougher standards for evaluating mortgage-backed securities.


In addition:

Hours after S&P's move, Moody's Investors Service said it was downgrading 399 mortgage-backed securities issued in 2006 and reviewing an additional 32 for downgrade, affecting $5.2 billion of bonds. It also downgraded 52 bonds issued in 2005.

"The level of losses continues to exceed historical precedents and our expectations," said Susan Barnes, an S&P managing director, in a conference call with investors to discuss the looming downgrades.


Also add:

LOS ANGELES, July 10 (Reuters) - The Ryland Group Inc. (RYL.N: Quote, Profile, Research) warned on Tuesday that it expects to post a second- quarter net loss of $1.25 to $1.35 per share due to continued deterioration in the housing market.

...

Analysts, on average, had been looking for the company to post a second quarter profit, excluding items, of 46 cents per share, according to Reuters Estimates.


And finally:

The Home Depot Inc., the world's largest home improvement store chain, on Tuesday cited continued weakness in the housing market and the sale of its wholesale distribution business as it issued a bleaker-than-expected financial outlook for the year.

...

Home Depot said it now expects its earnings per share to decline by 15 percent to 18 percent for fiscal 2007. In May, the company had projected an earnings per share decline of 9 percent for the year.


So --

1.) The primary method of financing the housing market expansion -- mortgage backed securities -- takes a major hit with a huge wave of ratings downgrades. This will dry-up funding for the more speculative elements of this market, as well as increase funding problems across the board for all mortgages.

2.) 2 major retailers are reporting the consumer is not spending as much as we would like. Remember that consumer spending is responsible for 70% of economic growth.

3.) The homebuilding sector is still experiencing some really big problems. Sales are down, cancellations are up and the business environment is "challenging."

This is a deluge of bad news in one day that has hit literally every possible spectrum of the housing market. Wall Street reacted with a big wave of selling.

Days like yesterday can have a profound impact on market psychology. The breadth of the negative news was profound.

Tuesday, July 10, 2007

Homebuilder's Report Lousy Quarter

From The Street.com

Homebuilder Ryland (RYL - Cramer's Take - Stockpickr - Rating) projected a loss for the second quarter and reported a 17% drop in new-home orders for the period.

The company said late Tuesday that it expects to report a loss of $1.25 to $1.35 a share for the quarter ending June 30. Analysts had been expecting a profit of 32 cents a share, according to Thomson Financial.

The expected loss stems from $145 million to $155 million of charges related to inventory impairments and write-offs, Ryland said.

As prices fall for new houses, builders are finding previous land investments are no longer profitable, forcing them to record impairment charges. Ryland said its impairments were associated with projects in Arizona, California, Florida and Nevada.


From CBS.Marketwatch:

Home-building bellwether D.R. Horton Inc. early Tuesday said quarterly orders for new homes fell 40% from a year earlier and that it expects to post a loss after impairment charges.

The Ft. Worth, Texas-based company said net sales orders for its fiscal third quarter ended June 30 dropped to 8,559 homes valued at $2 billion, compared with 14,316 homes or $3.8 billion in the year-ago period.

"Market conditions for new home sales declined in our June quarter as inventory levels of both new and existing homes remained high, and we expect the housing environment to remain challenging," said D.R. Horton Chairman Donald Horton in a statement.

He said the builder lowered its prices in response to sagging sales. The company expects to see a loss for both the third quarter and the nine months ended June 30, after charges. Analysts polled by Thomson Financial had been looking for net income of 7 cents a share in the latest quarter, on average.


I would expect more news like this from the homebuilders for the foreseeable future.

Big Bond Downgrade

From CBS MarketWatch:

Influential rating agency Standard & Poor's said on Tuesday that it may downgrade $12 billion of subprime mortgage-backed securities because losses in this low-end part of the home-loan market have increased and will probably get worse.

Credit ratings on 612 classes of residential mortgage-backed securities (RMBS) backed by U.S. subprime collateral have been put on CreditWatch with negative implications, S&P said. Beginning in the next few days, the agency said most of these classes will be downgraded.

That covers about $12.078 billion in rated securities, or 2.13% of the $565.3 billion in U.S. RMBS rated by S&P between the fourth quarter of 2005 and the fourth quarter of 2006, the agency noted.

The agency said it's also reviewing ratings of Collateralized Debt Obligations (CDOs) that invested in the RMBS that could be downgraded. (CDOs are a bit like mutual funds that hold asset-backed securities. Many CDOs bought subprime RMBS, helping to fuel the housing boom earlier this decade.)


This is a really big story. I would add the following points:

1.) S&P is downgrading the underlying mortgage pools of certain CDOs. We have yet to see how this will effect the actual CDOs. While I don't think the implications are good, we'll have to see how this plays out.

2.) I would like to see a diffusion index of where these bonds are. If owership is spread out or concentrated.

Consumer Credit and Consumer Spending Update

From IBD:

Consumer credit rose at a 6.4% annual rate, or $12.9 bil, to $2.441 tril, after a $2.3 bil gain in April. Credit-card and other revolving debt jumped by $7.2 bil, evidence that Americans are still willing to borrow to spend. The 9.8% rate was the best in 6 months. Auto and other nonrevolving loans grew by $5.7 bil.


Retail spending is a huge wild card right now. I posted this chart from Martin Capital a few days ago, but it deserves a second look. Notice that

1.) Housing sales have been dropping since 2005,

2.) Car sales have been dropping since the beginning of the year and

3.) Year over year retail sales have been declining since the beginning of 2006.

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Let's call housing a lost cause for the foreseeable future, largely because of the massive inventory overhang. That means a pick-up in the YOY numbers will have to come from cars and retail sales. Note the YOY retail sales numbers have been increasing since the beginning of the year and the car sales are at the low end of a range that has lasted since the beginning of 2001. According to Barron's Pulse of the Economy Section the YOY change in auto sales is 4.31% for domestic cars, 7.16% for imports, 2.27% for domestic trucks and 7.32% for import trucks. In other words, sales are fair for domestic companies but good for foreign autos.

That means we need to keep a close eye on retailers this earnings season to see how their earnings are shaking out.

Companies Issuing Conservative Earnings Guidance

From IBD:

Firms have given bearish outlooks. The negative-to-positive ratio of preannouncements for all stocks is 2.3 to 1 for the second quarter, a bit above average. The S&P 500 ratio is 3.2 to 1, so investors may have priced in bad news.


This is something the financial press should write about a whole lot more. Companies are very media savvy -- they know how to try and manage expectations through media relations. Because of the slow growth in the first quarter it makes perfect sense for companies to issue conservative earnings guidance. As a result, an earnings announcement that beats lowered guidance will have a larger possibility of having a positive impact on the stock price.

Home Depot Issues Earnings Warning

From Bloomberg:

Home Depot Inc., the world's largest home-improvement retailer, cut its forecast for annual profit because of the sale of the HD Supply unit and the slump in the U.S. housing market.

Earnings per share will drop between 15 percent and 18 percent in the current fiscal year, the Atlanta-based company said today in a statement. Home Depot forecast a 9 percent per- share profit decline before announcing the sale last month of HD Supply, which contributed more than 10 percent of sales.


This should surprise no one.

Monday, July 9, 2007

Massive Buybacks Announced

From Bloomberg:

Johnson & Johnson and ConocoPhillips today announced plans to repurchase a combined $25 billion of stock, adding to this year's record pace of U.S. share buybacks.

J&J, the world's largest maker of health-care products, will use a combination of cash and debt to fund a $10 billion repurchase program, the company's largest. ConocoPhillips, the third-biggest U.S. oil producer, plans to buy back as much as $15 billion of its shares through 2008.

Today's buyback announcements follow record repurchase programs initiated this year by Home Depot Inc., the largest home-improvement retailer, and International Business Machines Corp., the biggest computer-services provider. U.S. companies announced $415 billion of share buybacks in 2007, 24 percent ahead of last year's record pace, according to data as of June 29 compiled by Birinyi Associates Inc.

``Corporations are flush with cash to the extent they feel they can grow their businesses and still have money left over to return to shareholders,'' said James Awad, who oversees about $1.3 billion as chairman of Awad Asset Management in New York. ``One of the legs of this bull market has been that the supply of common stocks has been shrinking.''


Earlier today, I commented on the large amount of cash that companies have on hand. This is where all of the money for these buybacks is coming from. These buybacks have provided a certain amount of support for stocks, as well as providing fuel for the large amount of M&A that has happened for this expansion. So long as companies have large amounts of cash on hand, expect to hear more announcements like this.

Are Yields Too Restrictive?

From Bloomberg:

The U.S. economy's take-off from a near standstill in the first quarter may prove bumpier than the Federal Reserve and many on Wall Street expect as tighter credit acts as a headwind to growth.

What started as a financing squeeze in the subprime- mortgage market now threatens other parts of the economy. Borrowing costs for companies are climbing as banks and investors demand more for their money. Consumers feel the pinch from rising interest rates and sagging house prices.

As a result, the economy may struggle to achieve the 2-1/2 to 3 percent growth rate that most forecasters inside and outside the Fed have penciled in for the second half of the year. Instead, economists at International Strategy & Investment Group, UBS AG and Commerzbank AG see growth below 2 percent as consumer spending slows and business investment fails to pick up under the weight of tougher financing conditions.


As I've written before, I am having a hard time buying the "interest rates are at a restrictive level" argument.

Here's the 10-year CMT Treasury chart:

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Here's the Moody's seasoned AAA chart:

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Here's the Moody's seasoned Baa chart:

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None of these interest rate levels look restrictive, especially compared with levels at the end of the 1990s.

Investors now demand almost 3 percentage points in extra interest to own U.S. high-yield bonds rather than government debt, compared with a record low of 2.41 percentage points on June 5, Merrill Lynch & Co. data show. That's the fastest increase in spreads since April 2005.

``The credit cycle is peaking,'' says John Lonski, chief economist at ratings company Moody's Investors Service in New York. He sees the high-yield spread rising to 4 percentage points by the end of 2007.

The tougher corporate-credit conditions are starting to bite. In the past two weeks, more than a dozen companies postponed or restructured debt sales.

Among those postponed: a $350 million note sale by Magnum Coal Co., a West Virginia-based coal producer, and a $500 million bond sale by Kia Motors Corp., South Korea's second largest automaker. Kia planned to use some of the money to help finance construction of a U.S. factory employing 2,500 in Georgia.


3% above Treasuries is about 8%. That's still not that high. One of the main issues in the LBO market is borrowers have gotten away with incredibly lax lending standards. For example, some recent LBOs have had a covenant that if a borrower couldn't make a payment, he could instead issue more bonds (I forget the technical term for this practice). Why any lender would accept this term is simply beyond me. A borrower who can't pay now probably won't be able to pay in the future. Yet lenders accepted these terms as they chased yields.

It's also important to note that companies have a ton of cash on their books right now. According to the Federal Reserve's Flow of Funds Statement (PDF) nonfarm nonfinancial corporate business has $2.683 trillion of collected financial assets (see pages 103 and 104 of the FOF report). In short, the money is out there to get deals done.

My guess is the market will now return to more prudent lending and borrowing standards. That does mean some of the more aggressive terms will no longer be included in these deals. However, good deals will still get done.

Looking Ahead To Earnings

From the WSJ:

Wall Street consensus is that S&P 500 earnings will grow just 4% year-over-year in the quarter, a far cry from the long stretch of double-digit earnings growth just completed. But many analysts are growing more optimistic that this profit season will be surprisingly strong.

"We've seen very few pre-announcements of companies missing their numbers," notes Georges Yared, of Yared Investment Research. "I think we'll see a fair bit of optimism next week. Portfolio managers will want to [buy] companies they think will have solid second quarters."

But if banks and financials report earnings below expectations, substantiating fears of broader fallout from the subprime-lending bust, bond yields could eventually start to tick higher again, notes Doug Roberts, chief investment strategist at Channel Capital Research. That could hurt equities.


This is good synopsis of the current situation. I would add the following:

1.) 4% earnings growth is a pretty low hurdle to hit, especially with a fair number of companies having decent international market exposure. Also remember that analysts typically turn very conservative when the economy gets weak.

2.) When financial companies report, pay very close attention to the details of the announcement. If a company misses earnings, find out why. If we see a slow build of bad reports from the financial sector because of mortgage/loan issues, we could see some some spillover into the larger market.

3.) Awhile ago I commented that Fed Ex's announcement would be the announcement for other companies. "The quarter was weak but so was overall growth. Signs are business is picking up." I would expect a fair number of companies to make similar reports.

4.) Last quarter there were a lot of companies that surprised on the upside thanks to international sales. I would expect to see the same thing this quarter.

Sunday, July 8, 2007