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.

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 Street.com

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.

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:



Light Sweet Crude Oil



However, also consider that gas prices decreased in June:

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.



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



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.

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.....

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?

Weekend Weimar

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

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:



Corn



Gas



Oil



Soy Beans



Wheat



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.

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.

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.



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.



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.



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.



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.




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.

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:



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.



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.



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

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.

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.



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.

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:



Here's the Moody's seasoned AAA chart:



Here's the Moody's seasoned Baa chart:



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.

Where Are All the New Products?

Railroads

These charts are from Transmatch:

13-week rolling average



4-week rolling average



Trucking

From Truckline

QQQQ Break-Out?

The QQQQs have been in a slightly upward trending channel for the last three years. Are we going to see this break-out continue? Will we see a shift from a basic materials driven market to a technology driven market?

More On Consumer Spending

This is a chart from Martin Capital. Notice the following.

1.) The YOY change in retail sales has dropped since the beginning of 2006. However, it has picked-up since the beginning of 2007, possibly representing a reversal of the downward trend.

2.) New and existing home sales have been dropping since mid-2005.

3.) Car sales have consistently fluctuated between roughly 16 million/year and 17.75 million a year since 2001. However, the annual sales pace has consistently declined since the beginning of the year.

Weekend Weimar

The Markets Are Closed. Relax. Do something else.

A classic Weimar look.

How Confident Are Consumers?

From CBS Marketwatch:

Consider this news from Tuesday:

* Sales at retail chain stores continued to weaken in the last week of June. The International Council of Shopping Centers index barely grew week-over-week, while the Redbook index fell to a cyclical low, with same-store sales up just 1.2% compared with a year earlier.

* Vehicle sales declined for the sixth straight month in June. In the past six years, sales have been weaker on only two occasions. At the same time, the automakers have stepped up their production, setting up the industry for another round of layoffs and production cutbacks.

* Home sales fell again in May. The National Association of Realtors said the number of contracts signed on previously owned homes fell 3.5% to the lowest level since the recession.

* More consumers fell behind on their debt payments in the first quarter. The percentage of loans that were 30-days past due rose to the highest level since the recession of 2001.

The news in prior weeks hadn't been much better:

* Home prices fell 2.7% in the past year, the biggest decline in 16 years. A 2.7% drop may not seem like much, but considering how hard it is to get homeowners to accept less than they paid for their house, it's startling.

* Homebuilders got even more depressed about their industry. The housing market index fell to a 16-year low.

* Delinquencies on home mortgages are rising, especially for subprime loans. Unfortunately, delinquencies and foreclosures are also rising for borrowers with good credit who took out adjustable-rate loans. That's unheard of when the unemployment rate is under 5%.

* The stock market, after a nice run up from March to May, has been flat over the past seven weeks.

* Consumer prices rose 0.5% in May, the fastest monthly increase in 17 months.

* Real take-home income (that is, adjusted for inflation) has fallen two months in a row, after a big boost in the first quarter that mostly went to the ultra-rich who received mammoth bonuses and stock options. For the rest of us, the picture is a well-known story around kitchen tables: The median hourly wage, adjusted for inflation, has fallen four months in a row through May and was up just 1.1% in the past year.

* The personal savings rate was negative for the 26th consecutive month in May.

Over the last few years, I've written a fair amount about the heavy indebtedness of the US consumer. The short version is household debt has increased from a little over 70% of total US GDP in 2001 to over 90% in the fourth quarter of 2007. In addition, over the same period of time household debt has increased from over 90% of disposable income to over 130%. Mortgage debt is the primary reason for this increase, as households went on a huge home buying and mortgage equity withdrawal binge over the last few years.

However, I also predicted that the high debt load would lead to a recession or economic slowdown. While the economy did slow in the first quarter of 2007, predictions are for an increase in the second quarter. In other words, my analysis was right by my conclusion was wrong. At least it was wrong.

Is something different now? Has consumer spending reached a point where it will no longer increase, driving economic growth? I don't have an answer for that. However, the initial signs are the consumer is slowing his purchases -- at least for now.

However, history has demonstrated the US consumer loves to shop, and will do almost anything to continue shopping. The US economy has had more than ten straight years of quarterly increases in consumer spending.

For now, I will punt this question but will be thinking about it for quite some time.

Payrolls Increase 132,000

From the BLS:

Nonfarm payroll employment increased by 132,000 in June, and the unemployment rate was unchanged at 4.5 percent, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Employment rose in several service-providing industries, while manufacturing employment continued to decline. Average hourly earnings rose by 6 cents, or 0.3 percent, over the month.

However, the BLS revised the two previous reports higher by 75,000.

There are some big areas of concern in this report.

1.) Manufacturing lost 18,000. Most of the manufacturing indicators (such as the ISM and the various regional Federal Reserve reports) have given a positive signal for manufacturing. Yet the sector continues to shed jobs. Part of this is the increased productivity of the sector. However, I have to wonder if there is something else going on as well.

2.) Construction jobs increased 12,000. It appears commercial construction projects are absorbing the loss of jobs in the residential construction area.

3.) Retail lost 24,000 jobs. This is further confirmation of a slowdown in consumer spending. Here is a chart of chained 2000 dollar month over month increases in personal consumption expenditures for the last 7 months. Notice that sales have slowed the last three months.



4.) Education/health services added 59,000 and leisure/hospitality added 39,000. Neither of these areas are considered high-pay areas. Regarding health services, note where the jobs were created:

Health care employment grew by 30,000 in June, with gains in hospitals (+14,000) and in nursing and residential care facilities (+8,000).

5.) Professional and business services lost 9,000 jobs. The report notes the slowdown in this area:

Professional and business services employment was little changed in June. During the first 6 months of 2007, job growth in the industry averaged 13,000 per month compared with an average of 42,000 per month in the last half of 2006.

Employment growth is one of the bullish arguments for the economy going forward. If the headlines focus only on top-line growth, this report should help although it is not a blockbuster. However, looking at the details a different picture emerges: Slowing retail and professional services growth, the continued decline in manufacturing and a big addition of lower-paying jobs.

Is It Time To Go Long?

Several technical indicators have given preliminary buy signals on the SPY. The MACD has turned bullish and the CMF is hovering around 0 where a few strong days could send the indicator into buy territory.

However, there are two concerns going forward.

1.) Here is a 5-year, weekly chart. Notice the index has moved up strongly and sharply over the last few months. In addition, notice the big pick-up in volume during this rally. This could be a buying climax, which is a sign of a market top.



2.) In addition, we are still in a downward trend with lower lows and lower highs. The market would have to break through the top downward sloping line and/or move above a previous high on decent volume to give a buy signal.

Junk Bond Market About to Take A Hit?

Right now, the spread between junk bonds and treasury debt is very tight. This indicates that junk bonds have reallied over the last few years. It also indicates there may be a pricing mis-match in the market. Junk debt has more risk, yet is not trading like it has more risk.

However:

Junk bonds lost 1.61 percent last month, the most since March 2005 when GM forecast its biggest quarterly loss since 1992. Junk bonds globally returned 2.88 percent in the first half, the lowest in two years, according to data from New York- based Merrill Lynch.

Investors withdrew $502 million from high-yield mutual funds in the week ended June 20, the most since September 2005, according to AMG Data Services in Arcata, California.

.....

``Demand has spiraled out of control,'' said Sethi, who helps oversee $2 billion at Fidelity International, an affiliate of Boston-based Fidelity Investments. ``We think the market is overpriced. There's a little bit more scope for spreads to tighten, but a lot more scope for widening.''

If this trend continues, it will be another sign that the LBO market will at minimum go through a minor shake-out.

Big Investment Companies Start to Boycott LBO Debt

From Bloomberg:

The world's biggest bondholders have had their fill of leveraged buyouts, convinced that increasing mortgage delinquencies will drag down the U.S. economy and drive debt-laden companies into default.

TIAA-CREF, which oversees $414 billion in retirement funds for teachers and college professors, is boycotting some debt offerings used to finance LBOs. Fidelity International, a unit of the world's largest mutual fund company, and Lehman Brothers Asset Management LLC, the money-management arm of the third- biggest bond underwriter, say they're avoiding debt from buyouts.

Investors are getting skittish just as private-equity firms led by Kohlberg Kravis Roberts & Co. and Blackstone Group Inc. prepare to sell $300 billion of bonds and loans to finance LBOs, according to Bear Stearns Cos. In the past two weeks alone, more than a dozen companies were forced to postpone or restructure debt sales.

``There are some very scary analogies between high yield and the mortgage market,'' said Kevin Lorenz, a managing director who oversees $2.5 billion of high-yield assets at TIAA- CREF in New York. ``You cannot do fundamental analysis and believe that those are creditworthy companies.''

These are two big firms and one large money manager publicly stating they are concerned about the debt issued in some of the recent IPO deals. This is big news because it indicates the buyers market for the debt from these deals is shrinking.

LBOs have been a primary driver of the stock market in the most recent advance. Yet there has been a ton of news related to the mortgage bond and LBO business as of late -- none of which has been good.

If these deals go away or decrease, will the market still be able to advance? Is there another driver out there for increased stock prices?

Home Inventories Continue to Grow

From the WSJ:

Total listings of homes in these metro areas at the end of June was up 2.5% from May, according to figures compiled by ZipRealty Inc., a national real-estate brokerage firm based in Emeryville, Calif. The data cover all listings of single-family homes, condominiums and town houses on local multiple-listing services in those areas.

This is almost becoming comical -- if it wasn't so serious. The inventory of existing homes on the market is at a historical absolute high in terms of total units on the market. Yet the number of homes for sale continues to grow. At some point, prices will have to give and it won't be pretty.

Happy Fourth of July

The markets are closed. Posting will be light today -- if at all.

More On PCEs

Here is a chart of the month over month percent change in personal consumption expenditures in chained 2000 dollars. Notice the drop-off.



Also see The Big Picture and Calculated Risk

Is Consumer Spending Slowing?

From Dow Jones:

National chain store sales fell 1.1% in the first four weeks of June versus the previous month, according to Redbook Research's latest indicator of national retail sales released Tuesday.

The drop in the index compared with a targeted 0.8% drop.

The Johnson Redbook Index also showed seasonally adjusted sales in the four week period rose 1.6% compared with June 2006 and relative to a 1.9% targeted gain.

Redbook said on an unadjusted basis, sales in the week ended June 30 were up 1.2% from the same week in 2006, after a 1.4% increase the previous week. June is a five-week month on the fiscal calendar, ending Saturday, July 7.

Later in the report there is a comment that warm weather pulled people out to summer activities. Earlier this year, cold weather was the reason given for low retail sales figures.

However, according to the BEA, chained personal consumption expenditure increases for March, April and May were -.1, .2 and .1, respectively.

A slower pace of consumer spending also jibes with today's auto sales figures:

Overall, the total industry sales rate looked to come in at about 16.1 million vehicles, lagging Thomson First Call estimates of about 16.5 million. There was one extra selling day in June 2007 than a year earlier.

"As we look at the results coming in, the performance is capping off a second quarter for the industry that I think can best be described as a bit underperforming," Paul Ballew, GM's top sales analyst, said in a conference call. "We're dealing with the twofold impact of gas prices and the housing correction that is occurring in a couple of key states."

A slowdown in consumer spending also jibes with the chained disposable income figures from the BEA. For March, April and May, disposable income figures increased .3 -.6 and -.1 respectively. These figures bring the low unemployment rate into question as well.

Energy Costs Highest Since 1987

From the Christian Science Monitor (hat tip Kirk report):

Kilowatts, gallons — they all add up. Energy is now sucking money out of Americans' bank accounts at a record level — hitting $612 billion at an annual rate in the month of April, the last month of data. Over the past two years, energy bills as a share of income have risen and are now at their highest point since 1987, but still below the levels of the 1970s and early 1980s. For low-income households, some economists estimate energy consumption as a percentage of income is closing in on 10 percent.

I've written a fair amount about gas prices for several reasons.

1.) Consumers see gas prices at least once a week if not more. As a result, these prices have a tremendous impact on consumer sentiment and spending habits.

2.) Despite the Federal Reserve's love of core inflation, total inflation is what consumers see on a regular basis. Energy and food prices are prices that have the most impact on consumer's inflation expectations.

3.) As fuel prices increase, discretionary income for other items decreases. This will have an impact on retail sales and other consumer purchases.

4.) I would argue there is a gradual inflection point with energy prices. At some point, energy prices will hit a level where consumer sentiment and spending take a disproportionate hit. I don't know what that level is, but I would guess it would start at about the $3.25/gallon area.

Hedge Fund Closes Redemptions

From Bloomberg:

John Devaney, who invests in subprime- mortgage bonds, restricted redemptions to protect some of his Horizon Strategy hedge funds from being forced to sell assets.

It's ``a defensive move because we had an unusually high number of redemption requests,'' Michael Gregory, a spokesman for Devaney's United Capital Markets Holdings Inc., said in an interview yesterday. One of the investors who wanted to withdraw accounted for about 25 percent of the funds' money. United Capital, based in Key Biscayne, Florida, had about $619 million as of March, including the money-losing Horizon ABS Fund LP

....

In addition to the Bear Stearns funds, this year's declines have claimed UBS AG's New York-based Dillon Read Capital Management LLC hedge fund and Caliber Global Investment Ltd., a $908 million fund managed in London by Cambridge Place Investment Management LLP. Both have been shut down.

In this article at the Huffington Post I argued the market would eventually be alright, but we would see a few poorly managed funds take a big hit. This is what appears to be happening.

The main issue right now is investor confidence in these funds and this market. If we see a rash of redemptions we could see a big problem emerge very quickly.

A Technical Look At the SPYs

Yesterday's rally was technically important for a few reasons.

1.) The SPYs closed above the 10, 20, and 50 day SMA. If prices continue to trade above the SMAs they will pull them up. This will increase the SMAs and will eventually give them an upward angle, which is a bullish indicator.

However, the 10 day SMA is below the 20 SMA and crossed below the 50 day SMA on Friday. The 20 day SMA is close to crossing below the 50 day SMA and will probably do so in the next few days. Both of these are considered negative indicators.



The MACD has decreased for the last two months and appears close to giving a buy signal over the next few trading days.



The CMF went positive yesterday, another bullish signal.



The SPYs came close to hitting the 38% fibonacci retracement in their latest sell-off. I'm not a strict fibnocacci guy; if the chart come close to a fib number it's usually good enough.

ISM Increases

From the Institute for Supply Management:

In June, manufacturing expanded at its fastest pace since April 2006 when the PMI Index registered 56.9. This performance appears sustainable in the third quarter due to the current strength in New Orders and Production."

WHAT RESPONDENTS ARE SAYING ...

* "Business remains brisk with isolated areas of softness." (Nonmetallic Mineral Products)
* "Things are picking up." (Primary Metals)
* "Busy now but still down approximately 13 percent from this time last year." (Fabricated Metal Products)
* "Exchange rate and some raw material increases have had a negative impact on our purchased components." (Transportation Equipment)
* "Petroleum-based material prices have begun to escalate at a faster pace." (Paper Products)

A few notes.

1.) This is a good report. There are a group of economists currently arguing that business spending and growth will keep the economy from falling into a recession. This helps to bolster that argument.

2.) "Busy now but still down approximately 13 percent from this time last year." This comment jibes with the following information from Barron's pulse of the economy section. This indicates things are improving, but are still in general below year ago levels.

3.) Commodities and Industrials have been strong performers for the last half year. Some of these industries have sold off over the recent pullback. However, this news might make those areas more attractive again.

The Pros and Cons Going into the Third Quarter

Let's look at the pros and cons of the market as the third quarter begins.

Earnings Concerns

Second-quarter earnings growth is so far expected to fall further to 4.3%, even though rising energy prices seem poised to given another lift to earnings.

The expectations for first quarter earnings were low as well. Analysts and companies issued very conservative guidance because of the slowing economy. As a a result, many companies surprised to the upside, adding fuel to the bulls argument.

International Sales

But the market thus far remains confident that strong global growth, led by China and Asia, will continue to boost U.S. profits, even as the economy slows.

This was one of the main reasons for the surprising strength of some earnings reports. Companies with strong international exposure were the obvious beneficiaries of this trend. The rest of the world still looks like they will do well in the second half of the year, so this trend will probably continue.

Mergers and Acquisitions

This year's record pace of takeovers slowed by 49 percent in June, data compiled by Bloomberg show. Delaware Investments, the Hartford and City National Bank, which manage more than $500 billion, say the decline plus the decision by leveraged buyout firm Blackstone Group LP to sell shares to the public are signaling that the five-year bull market is nearing an end.

The drop-off may simply be seasonal; M&A firms obviously had a ton of deals in the pipe which they continually announced over the last few quarters. However, there may also be a problem developing with the financing of these deals. The Bear hedge fund problems may tighten the lending markets, preventing some of these deals from going through. There has been a fair amount of press over the last week about lenders tightening standards in a variety of ways.

Housing

Adding to existing concerns, the woes of the housing market and the resulting meltdown in the subprime-mortgage market have claimed new victims. Two hedge funds owned by Bears Stearns & Co. were brought close to collapse two weeks ago.

I debated this issued with Barry Ritholtz. There are plenty of reasons to be concerned, but I think what we'll see is a few funds having big problems, but a limited broader impact. I should add, this is a developing situation and as more facts come out that conclusion will either be supported or shot down.

There is also the possible impact on the economy as a whole. The housing market will go through another 12-18 months of mortgage rate resets. These will continually add downward pressure on the economy as a whole.

Oil Crosses $70/bbl

From Bloomberg:

Oil prices jumped 2.2 percent last week, the third straight weekly gain, after the U.S. government said gasoline stockpiles unexpectedly fell the week before. This week, a record 41.1 million vacationers in the U.S. will travel for the July 4 Independence Day holiday, according to AAA motorist club. More than a third of those surveyed planned to start driving last week.

Crude price are rising ``because of tightness on the refinery side, some maintenance or some accidents, and the utilization rate isn't so high,'' Kenichiro Yamaguchi, the chief operating officer for Petro Diamond Risk Management Ltd. in London, a unit of Mitsubishi Corp., Japan's largest trading company. ``The market is strong on the product side,'' with high demand for distillates, including heating oil, and gasoline.

It's been awhile since we've looked at oil prices, so let's see what the daily and weekly charts say.

The $67/bbl area provided a ton of resistance to oil's price for about two months. But oil broke through in mid-June. In addition, oil retreaded back to the $67 area later in the month and instead used the $67 price level for support.

We also have an ascending triangle formation, which is usually another bullish sign.



The weekly chart says oil has consolidated in the head and shoulders formation and is now advancing, using the neckline as preliminary support.