Saturday, July 21, 2007

Financials Are Still Under Pressure

Remember that financial stocks are the largest percentage sector in the S&P 500, coming in at a little over 20%. Last week there was a ton of bad news in the sector.

Bear's two funds are worthless.

S&P downgraded over 400 bonds.

Several financial institutions increased their loan loss reserves.

As a result, investors are nervous about what will happen to various financial companies.

That means they are selling financial shares. Also note the increased volume in this sector over the last three days. The selling is accelerating.

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Friday, July 20, 2007

Weekend Weimar

The markets are closed.

Get off your computer.

See you tomorrow.

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Great Paper on the Housing Market's Problems

Mike Larson -- who writes on the blog Interest Rate Roundup -- has written a paper titled How Federal Regulators, Lenders, and Wall Street Created America’s Housing Crisis Nine Proposals for a Long-Term Recovery. While the title is less than exciting (when will economists learn to get great titles to their papers?), the paper is very good and I highly recommend it.

So Far, Earnings Look Good

From Zack's

Through the close of Tuesday, Jul 17, a total of 55, or 11.0% of the S&P 500 firms have reported their second-quarter results. So far the results look very encouraging with positive surprises outpacing disappointments by a ratio of nearly 4:1. The median year-over-year growth rate is a very healthy 11.7% and the median surprise is 3.7%. Seven sectors have had at least one firm report, and of those, five are seeing double-digit median growth rates. There are only three sectors which have yet to have any firms report.

While it's too early to draw firm conclusions, the trend is promising.

Borrowers Are Sweetening Deals

From the WSJ:

Banks raising nearly $40 billion in buyout-related debt for Chrysler Group and the United Kingdom's Alliance Boots PLC are being forced to sweeten terms for investors and face delays in their sales, in another sign of turbulence in global debt markets.

Chrysler is being taken over by Cerberus Capital Management, a New York hedge fund, and is raising $20 billion in loans as it separates from DaimlerChrysler AG. Alliance Boots, a chain of U.K. drug stores and a wholesale pharmaceutical-distribution firm, is being taken over by Kohlberg Kravis Roberts & Co. and is raising the U.S. dollar equivalent of $18.4 billion.

In both cases, bankers are shopping interest payments to investors that are around a half percentage point more than originally planned. And in both cases, they're putting off plans to close the deals in the next few days. The Alliance fund raising might be delayed by months, people familiar with the situation said. The Chrysler debt sale is expected to close next week.

This is far from the end of the world for the M&A market. Credit terms have been incredibly lax for the last few years. A better description of events would be a "return to prudent lending standards".

As an example, here is a chart of the daily baa yield for the last 10 years. While rates have increased, they are still below the levels at the end of the 1990s.

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Thursday, July 19, 2007

Fed Still Focused on Inflation

From the Federal Reserve

At its May meeting, the Federal Open Market Committee (FOMC) maintained its target for the federal funds rate at 5-1/4 percent. The Committee’s accompanying statement noted that economic growth slowed in the first part of the year and that the adjustment in the housing sector was ongoing. Nevertheless, the economy seemed likely to expand at a moderate pace over coming quarters. Core inflation remained somewhat elevated. Although inflation pressures seemed likely to moderate over time, the high level of resource utilization had the potential to sustain those pressures. The Committee's predominant policy concern remained the risk that inflation would fail to moderate as expected. Future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

The Fed has been saying the same thing for about 6 months now. No one should be surprised by this statement.

Subprime Problems Not Over

From Bloomberg:

Subprime mortgage defaults will increase this year and holders of securities linked to those home loans may experiences losses well into 2008, JPMorgan Chase & Co. analysts said.

``The worst is not over in the subprime mortgage market,'' analysts led by Chris Flanagan, the head of structured finance strategy, said in a report today. ``We expect continued deterioration in subprime loan performance through the balance of this year, and it is likely to be well into 2008 before the problems in securitized portfolios begin to abate.''

Home price declines will lead to ``substantial increases in subprime mortgage defaults and losses,'' Flanagan, who is based in New York, said in a report titled ``Subprime Meltdown, the Repricing of Credit and the Impact Across Asset Classes.'' Borrowers of as much as 50 percent of the $500 billion of mortgages that will reset in the next 18 months may not be able to refinance, Flanagan estimates.

Mortgages defaults at 10-year highs have reduced prices of some bonds backed by home loans to people with poor or limited credit by more than 50 cents on the dollar. The increased risk of default prompted Moody's Investors Service, Standard & Poor's and Fitch Ratings to begin cutting credit ratings on hundreds of bonds last week.

Nobody should be surprised by this. The Fed's most recent Monetary Report to Congress stated:

Delinquency rates on subprime mortgages with variable interest rates -- which account for about 9% of all first lien mortgages outstanding, continued to climb in the first five months of 2007 and reached a level more than double the recent low for this series, which was recorded in mid-2005.

Here's a chart of the result -- an increase in foreclosures from the blog Interest Rate Roundup

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And don't expect this stop in the near future. One of the reasons for the financials poor performance (see post just below) is concern over foreclosures and an increase in loan loss reserves at financial institutions.

Financials Still Hurting S&P

Remember that financials are the largest sector of the S&P 500, comprising about 20% of the average. Yesterday the sector dropped because of issues in the subprime market:

Bear Stearns fell 0.4% after reports that investors in two of the investment bank's hedge funds that made big bets on subprime mortgages have been practically wiped out, in more evidence of the turmoil in that corner of the bond market. Dick Bove, an analyst at Punk Ziegel, said the Bear Stearns woes are likely an industrywide problem and cut his ratings on eight top banks and brokerages.

The news and the downgrade were felt throughout the sector and the broader market. Goldman Sachs Group fell 2%, and Merrill Lynch was off 3.3%. Dow component Citigroup declined 1.6%, and Bank of America fell 0.8%. Even J.P. Morgan Chase, which reported a better-than-forecast 20% profit rise, was down 2.4%. Shares of Lehman Brothers, meanwhile, fell 1.9% amid those market rumors of losses from its subprime business.

Here's a chart of the sector. Notice that all short-term moving averages are headed lower. Also note the shorter-term SMAs are below the longer term SMAs. This pulls the longer term SMAs lower, adding to bearish pressure in the sector. Finally, the index is below the 200 day SMA, another bearish signal.

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Wednesday, July 18, 2007

JP Morgan Triples Loan Loss Reserves

From Reuters:

JPMorgan Chase & Co. (JPM.N: Quote, Profile, Research) said on Wednesday it tripled the amount set aside for loan losses as even borrowers with good credit defaulted on home equity loans, hurting the bank's quarterly profit.


But the bank set aside $1.53 billion for loan losses, up from $493 million a year earlier. About a one-third of the increase resulted from higher loss estimates on home equity loans in which borrowers had little equity in houses with falling values.

This is something to keep an eye on going forward.

Bernanke's Testimony

Here is the complete opening statement

Here are the highlights.

Despite the downshift in growth, the demand for labor has remained solid, with more than 850,000 jobs having been added to payrolls thus far in 2007 and the unemployment rate having remained at 4-1/2 percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the past decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors, but the underlying pace of productivity gains may also have slowed somewhat.

There is controversy about the labor picture. Some economists have argued the BLS' birth/death model has skewed recent numbers higher. Here is a full explanation of the problem. While statistic issues are not my strong suit, the previous link provides a convincing argument that current employment numbers are too rosy.

To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales and construction have slowed substantially and house prices have decelerated. Although a leveling-off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders’ inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent below the pace in the second half of last year.

Notice that Bernanke is finally admitting the housing market is a bigger problem than currently thought and is largely responsible for the current economic downturn. However, it's also important to remember the Fed Chair is in a difficult position. He can't simply come out and say housing is dropping like a stone; part of his job is to offer assuring statements and a calm outlook. But considering the length of the housing downturn and the severity of the inventory overhang, I personally think Bernanke has understated the problem to a larger degree than prudent.

Real consumption expenditures appear to have slowed last quarter, following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace, aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year, and barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases.

This statement slightly contradicts Bernanke's "the employment outlook is good" statement. If job growth were as robust as the numbers illustrate -- and if wage growth were as strong as indicated by the low unemployment rate-- then consumer spending would probably be stronger.

In the business sector, investment in equipment and software showed a modest gain in the first quarter. A similar outcome is likely for the second quarter, as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories. Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year, motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth.

Business investment will help, but not in as large a degree as we would like. In other words, the bullish argument's belief in a strong business sector may be overshooting the mark.

The global economy continues to be strong. Supported by solid economic growth abroad, U.S. exports should expand further in coming quarters. Nonetheless, our trade deficit--which was about 5-1/4 percent of nominal gross domestic product (GDP) in the first quarter--is likely to remain high.

Exports should grow, but not enough to tame the trade deficit.

So here's his conclusion:

Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.

Housing Starts Up 2.3%

From the Census

Housing inventory is at inter-generational highs, home builders are reporting terrible earnings and credit is tightening.

This is a great time to add to inventory.

CPI Up .2%

From the BLS:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.2 percent in June, before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The June level of 208.352 (1982-84=100) was 2.7 percent higher than in June 2006.

There are a couple of interesting points in this report.

1.) For those of you who consume food and energy, those prices are up Y/Y on an unadjusted basis of 4.1% and 4.6%, respectively.

As CBS Marketwatch noted:

Energy prices fell 0.5% in June after surging the previous three months at an annual rate of more than 70%. In June, gasoline prices fell 1.1% and natural gas prices fell 0.1%.

Gasoline prices have inched higher in recent weeks, however.

Food prices continued to climb, rising 0.5% in the month. Dairy prices rose 3.2%, and poultry prices rose 2.1%, on higher prices for corn as a feed for poultry and livestock. Fresh fruit and vegetable prices fell.

Food prices are up at an annual rate of 5.1% in the past three months, driven higher by adverse weather, strong global demand and the diversion of much of the corn crop and the nation's arable land into the production of ethanol for fuel.

2.) From the BLS report:

Consumer prices increased at a seasonally adjusted annual rate (SAAR) of 5.2 percent in the second quarter after advancing at a 4.7 percent rate in the first three months of 2007. This brings the year-to-date annual rate to 5.0 percent and compares with an increase of 2.5 percent in all of 2006.

Those are not happy numbers for the Fed.

3.) The unadjusted 12-month core rate of change is 2.2% which is still above the Fed's comfort zone of 1% to 2%.

Pulte Homes Reports Big Loss

From the

Pulte Homes (PHM - Cramer's Take - Stockpickr - Rating) projected a hefty loss for the second quarter and posted a 20% drop in orders for the period, joining other homebuilders in reporting still-dismal conditions for the housing market.

The Bloomfield Hills, Mich.-based builder said Tuesday that it expects to report a second-quarter loss of $2 to $2.10 a share due to numerous charges. The company expects land impairment charges of $1.85 to $1.92 a share, as well as 10 cents a share in charges for a previously announced restructuring.

Previously, Pulte predicted results ranging from break-even to a loss of 10 cents a share, before any charges. Analysts, on average, forecast a loss of 17 cents a share, according to Thomson Financial.

This is simply another announcement from the housing sector that shows housing is nowhere near a bottom in any way shape or form. Expect more of the same as other builders make their respective announcements.

Pay particular attention to the announcement that came with the announcement:

"The difficult conditions that plagued the homebuilding industry in the first quarter of 2007 worsened in the second quarter, with increased competitive pricing pressures, elevated levels of new and resale home inventory, and weak consumer sentiment for housing affecting the entire industry," said Richard Dugas Jr., president and CEO of Pulte Homes, in a press release.

Note the statement "worsened in the second quarter." This is not a cheery report and indicates management is extremely concerned about the market right now.

Tuesday, July 17, 2007

This Is Not Good

From the WSJ

Weeks after the meltdown of two prominent Bear Stearns Cos. hedge funds that bet heavily on the market for risky home loans, the brokerage has told the funds' investors that the portfolios' assets are almost worthless, according to people familiar with the matter.

The assets in Bear's more-levered fund, the High-Grade Structured Credit Strategies Enhanced Leverage Fund, are worth virtually nothing, according to people familiar with the matter. The assets in the larger, less-levered fund are worth roughly 9% of the value since the end of April, these people said. The April valuations were not immediately available, but in March, before their sharp losses, the enhanced leverage fund had $638 million in investor money, while the other fund had $925 million.

The two funds have been in the spotlight for weeks after suffering heavy losses in the subprime market. Late last month, Bear helped stabilize the less-levered fund with a $1.6 billion secured loan; the enhanced fund began trying to unwind its remaining $1.1 billion in debt.

Bear disclosed this information to investors earlier today and is expected to make a statement this evening, these people said. A spokeswoman for Bear did not return calls for comment.

These losses, which took more than two weeks to calculate because of the fluctuating values in the market for risky, or subprime, mortgage securities, came amid another tumultuous day for the broader mortgage market. One particularly wobbly slice of the market tracked by a closely watched index called the ABX fell to an all-time low of 44.

Homebuilder Confidence Drops

From Bloomberg:

Confidence among U.S. homebuilders fell this month to the lowest level in 16 years, signaling the housing market continues to tumble.

The National Association of Home Builders/Wells Fargo sentiment index declined to 24 this month, the lowest since January 1991, from 28 in June, the Washington-based association said today. Readings less than 50 mean most respondents view conditions as poor.

Builders are pulling back on construction of new homes as inventories remain high as sales haven't recovered. Housing probably will be a drag on economic growth the rest of this year, economists said.

``Higher inventory levels would suggest that builders are going to have slow down their activity,'' said Jeffrey Roach, chief economist at Horizon Investments in Charlotte, North Carolina, before the report. ``We still expect to see, for the next couple of months, building being a drag on economic growth.''

This should surprise no one. Consider the following recent housing news.

M/I Home warns on earnings

M/I Homes Inc. warned investors Thursday to expect as much as $75 million in charges to snag its second quarter results.

M/I Homes said it expects to record up to $70 million in pretax asset impairment charges and write-offs related to its homebuilding assets and investments. Another $5 million charge will come from writing off intangible assets related to the 2005 acquisition of Orlando, Fla.-based Shamrock Homes.

Realtors forecast weak housing market into 2008:

he slump in home sales and prices will be deeper and last longer than previously expected, according to the latest forecast Wednesday by the National Association of Realtors.

The trade group is now looking for flat prices for existing homes in the first quarter of 2008 compared to the first quarter of 2007, and a more year-over-year declines for new home.

DR Horton sales down:

The traditional spring home-selling season was a bust for D.R. Horton Inc., one of the biggest nationwide homebuilders. Horton said Tuesday it will post a loss from operations for its latest quarter after net orders fell 40 percent and it wrote down the value of unsold houses.

Ryland expects loss:

Luxury homebuilder Ryland Group Inc. said Tuesday its expects to post a second-quarter loss as a result of the continued slump in the housing market.

According to preliminary figures, Ryland expects to report a loss of $1.25 to $1.35 per share for the quarter.

The news has been uniformly bad. Considering that inventories are at inter-generational highs, credit is tightening and the subprime financing market is experiencing problems, there is no reason to expect this trend to reverse anytime soon.

Industrial Production Up

From the Federal Reserve:

Industrial production rose 0.5 percent in June after a decrease of 0.1 percent in May. At 113.4 percent of its 2002 average in June, total industrial production was 1.4 percent above its year-earlier level. Manufacturing output moved up 0.6 percent in June; excluding motor vehicles and parts, factory output increased 0.4 percent after having been unchanged in May. In June, the output indexes for mining and utilities registered gains of 0.5 percent and 0.3 percent respectively. For the second quarter as a whole, total industrial production advanced at an annual rate of 2.9 percent after an increase of 1.1 percent in the first quarter. Capacity utilization for total industry moved up to 81.7 percent in June; the rate was 0.6 percentage point below its level in June 2006 but 0.7 percentage point above its 1972-2006 average.

This jibes with yesterday's Empire State manufacturing report, which showed gains as well.

There were increases across the board: consumer goods, business equipment and construction all saw gains. Business equipment is up 3.4% Y/Y. However:

The index for business equipment was unchanged in June for a second consecutive month, but it advanced at an annual rate of 3.6 percent in the second quarter

Automotive production is ramping up:

After little change in the first quarter, the production of automotive products surged at an annual rate of 20.7 percent in the second quarter.

The housing slowdown is clearly having an effect:

The output of home electronics recovered 2.6 percent in June after a decline of the same amount in May. The index for appliances, furniture, and carpeting fell 0.5 percent in June; production increased at an annual rate of 0.8 percent in the second quarter after declines in each of the preceding six quarters.

One of the central themes of the bull's argument going forward is an increase in manufacturing capacity and activity. So far this month, we are getting a decent confirmation of that trend.

PPI Down -.2%

From Bloomberg:

Prices paid to U.S. producers unexpectedly dropped for the first time in five months, restrained by declines in fuel and food costs.

The 0.2 percent fall followed a 0.9 percent increase in May, the Labor Department said today in Washington. Core prices, which exclude food and energy, rose 0.3 percent, reflecting a jump in automobile prices. Excluding passenger cars, core prices were up 0.1 percent.

The figures, coming a day before Federal Reserve Chairman Ben S. Bernanke testifies to Congress on the economy, would be welcome news for policy makers. Central bankers last month said a pickup in inflation remained the biggest risk and more evidence of a slowdown in prices would be needed before concern eased.

From the BLS:

The Producer Price Index for Finished Goods decreased 0.2 percent in June, seasonally adjusted, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. This decline followed advances of 0.9 percent in May and 0.7 percent in April. At the earlier stages of processing, prices received by producers of intermediate goods rose 0.5 percent in June after increasing 1.1 percent in the prior month, and the crude goods index moved up 0.3 percent following a 2.0-percent advance in May.

According to the BLS, energy prices decreased 1.1% in June and Food prices decreased .8% in June.

However -- consider the following charts:

The Goldman Sachs Agricultural futures index:

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Light Sweet Crude Oil

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However, also consider that gas prices decreased in June:

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Monday, July 16, 2007

Rail Volumes Down in June

From the American Association of Railroads:

U.S. freight railroad carload traffic fell 2.7 percent in June 2007 compared with June 2006, while intermodal traffic fell 1.8 percent compared with the same month last year, the Association of American Railroads (AAR) reported today.

Overall, U.S. railroads originated 1,344,296 carloads of freight in June 2007, down 37,679 carloads (2.7 percent) from June 2006. U.S. railroads also originated 961,545 intermodal units in June 2007, a decrease of 17,956 trailers and containers (1.8 percent) from June 2006.

“Rail volumes remained relatively soft in June, though they are up against some very strong comparisons from last year,” noted AAR Vice President Craig F. Rockey. “Most economists are fairly upbeat about economic growth in the second half of this year, and when the economy does pick up, we can expect rail volumes to rise commensurately,” Rockey added.

Once again, Bonddad returns to the old Dow theory -- transports an transportation have to perform well for the economy to be doing well. The reason is simple -- goods have to be shipped somewhere. Declining rail traffic indicates the manufacturing expansion isn't happening as strongly as we would like.

Empire State Index Shows Strength

From the NY Fed:

The Empire State Manufacturing Survey indicates that conditions for New York manufacturers continued to improve in July. The general business conditions index held near its June level, at 26.5.

The new orders index climbed for a fourth consecutive month to its highest level in more than a year, while the shipments index remained near its June level. The inventories index tumbled sharply into negative territory. The prices paid index, although elevated, eased modestly, as the prices received index held steady. Employment indexes were modestly positive. Future indexes conveyed significant optimism, with notable improvements in the outlook for employment and capital spending.

I'm a big fan of these regional Federal Reserve reports. They give us a nice regional picture of good, general business information.

This release gives us further confirmation of a strengthening manufacturing sector. However, the inventory questions could indicate a period of slowing activity in the next few months. That situation -- as with most in the economics realm -- will have to play out.

I should add that I am not a big fan of the future outlook question because it's really easy for those being polled to be really optimistic.

Higher Energy Prices Are Here to Stay?

From the WSJ:

World oil and gas supplies from conventional sources are unlikely to keep up with rising global demand over the next 25 years, the U.S. petroleum industry says in a draft report of a study commissioned by the government.

In the draft report, oil-industry leaders acknowledge the world will need to develop all the supplemental sources of energy it can -- ranging from biofuels to nuclear power to oil extracted by unconventional means from the oil sands of Canada -- to meet soaring demand. The surge in demand is expected to arise from rapid economic growth in such fast-developing countries as China and India, as well as mounting consumption in the U.S., the world's biggest energy market.

This is a good time to look at the daily and weekly oil charts to see how they are performing.

Here's the daily chart. Notice that prices consolidated for about two months between $61 and $67. As a rule of thumb, when prices move within a roughly 10% range, it's usually a consolidation pattern where traders are either selling old positions and taking profits or buying new positions and betting on higher prices. Because oil prices typically increase during the summer, traders were buying contracts in April and May betting on a summer rally.

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From the weekly perspective, we have prices bottoming in a classic head and shoulders formation and rallying from that base.

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From both a daily and weekly perspective we have a strong reason to expect the rally to continue and for prices to remain high. From the daily perspective we have a solid two month base. From the weekly chart we have a classic reversal.

From the fundamental perspective we have India and China growing at high rates creating an additional 2 billion people demanding energy. Increased demand = higher prices.

In addition, there is the peak oil argument which states oil supplies are already at or near their highest levels and will only decrease from here. I can't speak to the veracity of that claim, but if it's true then we have a big problem on our hands.

Sunday, July 15, 2007

The Upcoming Week

It's going to be a busy week in the markets.

1.) It's earnings season. 'nuff said.

2.) There are three manufacturing reports. The Empire State survey on Monday, Industrial Production on Tuesday and the Philly on Thursday. Remember that manufacturing/exports are supposed to be a big reason for the US not entering a recession soon, so these numbers are crucial.

3.) PPI is Tuesday and CPI is Wednesday. But remember -- food and energy don't count at all in these numbers.

4.) Housing starts are on Wednesday. Just when the market doesn't need more bad housing news.....