Tuesday, May 4, 2010

Morning Note...

**There will be no Morning Note tomorrow, Wednesday May 5th**

Futures ~100bps this morning as the U.K. and China markets re-open post-holiday and weigh on global equities.  The USD is higher on a flight-to-quality and Gold set a new record high when measured in euro terms.  Europe is down nearly 2%, led by the financial sector there.  Further, bond yields have risen and credit default spreads have widened.  Strikes and social unrest continue in Greece, where austerity measures needed to pay debt tabs are met with less-than-cheerful throngs of supporters.  (May 4 (Bloomberg) -- Greek government workers shut down schools and hospitals and disrupted flights as demonstrators occupied the Acropolis in an escalation of protests against 30 billion euros ($40 billion) of additional wage cuts and tax increases unveiled this week.)  Looking broader, there is continued concern for the euro and the EU itself, and the ECB may have to completely re-write its rule book given the change in collateral requirements for Greece.  Further, the NY Times this morning has an article on the potential default risks ahead for Spain.  And, ahead of U.K. elections, is there something to the concern that U.K. deficit levels are nearly equal to those of Greece?  In China, the recent PMI reading was 55.4, the lowest in six months, and indicates that 1) recent monetary tightening has had the desired effect and 2) perhaps the most recent capital reserve requirement raise – this past weekend – has overshot the mark.  Additionally, Australia raised rates for the sixth time to 4.5% overnight.  Recall this comes on the heels of a new tax on miners announced over the weekend.  For our part, CVS, Mastercard (MA), Pfizer (PFE) and Merck (MRK) reported better-than-expected earnings, but the recent trend now seems to favor European unrest (in social and financial terms) and looming financial reform over earnings (according to the Washington Post, by the way, “opposition is mounting to the Lincoln plan to force banks to spin off their derivative businesses”).  Note that an arrest has been made in the NYC Times Square bombing…supposedly the suspect was caught attempting to board a flight to Dubai last night.  Apparently the car bomb – because it did not detonate – has yielded a wealth of evidence. 

Looking ahead, recall that Friday’s GS annual shareholder meeting and the Unemployment data will be closely watched.  Today, Factory Orders and Pending Home Sales are due at 10am.  There could be some television drama on the Hill over the next couple of days, as Hank Paulson (rumored to be heading back to GS to replace Blankfein??), Tim Geithner, and Jimmy Cayne – among others – testify as to what drove the 2008 financial crisis.  Regarding BP and energy policy, note that California Governor Ah-nold has come out against off-shore drilling while Alaska Governor Sarah Palin reiterates “drill, baby, drill.”  Bloomberg has a good summary of the potential for looming reform in energy policy stemming from the Gulf spill:

BP Gulf Oil Spill Reshaping Energy Debate in U.S. Congress 2010-05-04 04:00:05.0 GMT By Patrick O’Connor and Lisa Lerer

May 4 (Bloomberg) -- The oil leak spreading 5,000 barrels of crude a day in the Gulf of Mexico is reshaping the politics of the energy debate as Congress considers U.S. climate policy and lawmakers brace for the November elections…

At least three committees -- House Energy and Commerce, House Natural Resources, and Senate Energy and Natural Resources -- plan hearings to investigate the spill during the next month. Obama on March 31 agreed to open new sections of the Atlantic coastline and the eastern Gulf of Mexico to new underwater drilling. Administration officials hoped the move would help win Republican support for a climate bill that has languished in the Senate since passing the House of Representatives last June. “From the standpoint of energy independence, in the transitional period, domestic drilling is one of the things that we ought to look at,” said senior Obama adviser David Axelrod. “That hasn’t changed.” The spill now threatens any deal.

“It could have as big an impact as Santa Barbara,” said Philip Verleger, an oil industry expert, referring to the 1969 oil spill off the California coast that reshaped the country’s environmental policy and was the catalyst for the first Earth Day in 1970. “This is a big setback,” he said. The Gulf of Mexico leak solidifies a division in the Senate between Republicans and Democrats on one side who favor more domestic oil and gas exploration, and Democrats who don’t. “To get my vote, any energy or climate bill must prohibit drilling in places where a spill could reach New Jersey’s waters,” said Senator Frank Lautenberg, a New Jersey Democrat. In one respect, “it really hastens the debate” over an energy bill,” said Dick Durbin of Illinois, the second-ranking Senate Democrat. On the other hand, the safety of offshore drilling now becomes paramount, he said. “It’s a hard case to make until you get down to the safety issues,” Durbin said.

Interesting story on Bloomberg this morning about a disconnect between equities and options volatility:

Stock Market Disconnect in Options Revealing Unsustainable Risk 2010-05-04 04:00:01.1 GMT By Jeff Kearns
May 4 (Bloomberg) -- U.S. stocks are rallying the most in seven decades, housing prices are stabilizing and the economy is expanding again after the worst recession since the Great Depression. Yet Dean Curnutt, founder of options advisory and brokerage firm Macro Risk Advisors LLC in New York, is wary. Curnutt studies the equity options market to gauge traders’ expectations of swings in stock prices, or volatility. He’s concerned because he’s picked up mixed signals in recent months. On the one hand, the benchmark measure of volatility on short-dated options -- the Chicago Board Options Exchange Volatility Index, or VIX -- fell in mid-April to where it was before the global credit crisis, indicating that investors weren’t expecting any shocks for equities. At the same time, mounting U.S. debt and questions as to what the removal of government stimulus measures might mean for the recovery indicate that risks to the financial system remain. That disconnect, Curnutt says, is similar to the one he saw four years ago before stocks peaked, when volatility measures were subdued even as overheated housing prices were creating stresses in the credit markets. Like then, when the euphoria in housing was both propping up stocks and creating longer-term risks, Curnutt is concerned that the forces fueling the current rally -- low interest rates and government borrowing to finance stimulus funding -- may derail it. “These structural deficits can’t continue,” says Curnutt, 40, who started Macro Risk Advisors two years ago after working for more than a decade on equity derivatives desks at Lehman Brothers Holdings Inc. and Bank of America Corp. “The alternative is very harsh medicine, spending less and battening down the hatches, which is not good for equity prices.”

Options Shield…Investors can shield themselves from potential tumult in stocks using options, says Curnutt, who set up Macro Risk to advise institutions about equity derivative strategies and to handle trades for clients. Options give the right but not the obligation to buy or sell shares at a set price on or before expiration. Traders use options to guard against price fluctuations, speculate on share-price moves or bet that volatility will increase or decrease. Thirty-seven years after options appeared on the CBOE, trading has expanded to eight U.S. exchanges and volume has climbed steadily, rising in 2009 to a record 3.61 billion contracts.

Risks in System…Curnutt, leading a staff of eight from Macro Risk’s offices near Manhattan’s Times Square, tracks implied volatility: what options prices are saying about investors’ expectations for market swings. He then combines this information with macroeconomic and financial analysis in a daily report to the firm’s 75 clients, which include hedge funds and pension funds. “We’re trying to understand where the risks in the system are,” says Curnutt, who monitors relationships between market gauges, including the Standard & Poor’s 500 Index, credit- default swaps, Treasury yields, sovereign debt and oil. “It’s really just trying to figure out where risk may be overpriced or underpriced.” One place where Curnutt says risk is underpriced is the VIX. Known as the stock market’s fear gauge, the index reflects the cost of using S&P 500 options to protect against equity- market turbulence. After surging to a record of 80.86 in November 2008 following Lehman’s collapse, the VIX fell more than 80 percent to an almost-three-year low of 15.58 on April 12. The VIX reversed course last week, surging to 22.81 amid debt downgrades of Greece and Portugal. The gauge fell back to close at 20.19 on May 3, just below its 20-year average.

Short-Sighted VIX…For Curnutt, the level of the VIX is misleading -- even after last week’s surge -- because it doesn’t adequately reflect the risks posed by historically low interest rates, growing public debt and the consequences of unwinding government stimulus measures, not to mention the possibility of contagion in financial markets from the debt crisis in Europe. The VIX only reflects expectations for stock swings during the next 30 days and this year has been further depressed by decreasing volatility, which reduces options prices, he says. “The VIX isn’t forward-looking,” Curnutt says. He compares April’s levels to those of late 2006, when the index fell below 10 even as “the housing market was crashing and subprime was exploding.” “Recent history shows us that extremely low volatility can coexist with a market in which systemic risks are very high,” Curnutt says.

Anecdotally, if you’ve tried to buy high quality names like BP, GS, or MEE on their headline news weakness, you’ve probably been run over.  Is there something to this?  In the past, pre-2008, you probably would have done very well buying blue chips on negative events like the Exxon Valdez or cigarette legislation… But in the current environment it truly feels like there is always another shoe dropping somewhere.  It’s impossible to gauge market sentiment from three stocks – moreover it’s actually foolish – but a brain wired to identify patterns can’t help but wonder if this is just the “new normal” investing environment.  I can tell you this – the “oversold” conditions of these names and the resulting “catch a falling knife” carnage are certainly not helping John Q. Retail-Investor dip his toe again…

MSCO ups ANF; positive COST/NKE.  AKRX higher on earnings.  ALVR misses by 4c.  BZH beats by 72c and beats on revs but announces 12.5M share offering.  FRO upgrade at DBAB.  GHL files for mixed shelf offering.  HOLX reports in-line.  IVAC beats by 9c.  KFN announces $200M credit facility.  LF misses by 9c.  MCK misses by 3c.  NTRI beats by 3c.  PBI beats by 1c.  RDN beats on revs but misses earnings estimates.  PWAV misses by 5c.  SIRI beats by 1c.  UBS -3% on earnings.  VVUS beats by 3c. 

Asia lower overnight.  Europe lower.  USD +80bps.  Gold +50bps. Oil -2%. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 
PITNEY BOWES INC        24.50    -5.33%  300
EMERSON ELEC CO         51.01    -4.87%  34966
BAXTER INTL INC           45.49    -4.23%  515005
MGIC INVT CORP            10.72    -4.11%  2450
MBIA INC                       9.77      -3.93%  67953
COGNIZANT TECH-A       53.80    +3.42% 72908
MCKESSON CORP           67.02    +3.31% 1500
TENET HEALTHCARE       6.15      -3.0 %  7930
MASTERCARD INC-A       258.00  +2.9 %  58878
XEROX CORP                 10.76    -2.62%  6900
FREEPORT-MCMORAN    71.90    -2.5 %  43986
EDISON INTL                  33.84    -2.45%  3420
PEABODY ENERGY           44.765  -2.43%  712
BED BATH &BEYOND       45.8000 -2.37%  500
EOG RESOURCES           110.89  -2.35%  200
PNC FINANCIAL SE         66.98    -2.32%  300
TESORO CORP               13.35    -2.27%  1300
MASSEY ENERGY CO       36.65    -2.24%  1964
US STEEL CORP             53.77    -2.18%  41961
CARNIVAL CORP             41.52    -2.12%  7100
TEREX CORP                  27.60    -2.09%  1400
AFLAC INC                     50.37    -2.06%  3000
WEATHERFORD INTL      17.56    -2.01%  9160

Today’s Trivia:  What does the term “dinosaur” mean?
Yesterday's Answer:  Varney Speed Lines ultimately became Continental Airlines. 

Best Quotes: 

Downshifting to Neutral.
In last night’s note, we highlighted the importance to the equity market of the ISM Manufacturing Report crossing above 60.  Today our expectations that the markets were approaching an important juncture were confirmed as the April ISM Manufacturing Report posted a reading of 60.4.  This reading is important.  It definitively shifts our view out of the bullish camp where we have resided since October 7, 2008 into the neutral camp.

We can cite numerous reasons for remaining bullish, most of which we believe in enthusiastically, including earnings and economic recovery combined with inexpensive valuations.  This is an environment in which most investors are underexposed to U.S. equities although they offer the best combination of growth and safety for a global investor.  Investor skepticism remains high as investors have an insatiable appetite for bonds and little appetite for equities.  Finally, the Fed appears to be afraid of its own shadow, indicating that monetary policy will remain accommodative for some time.  All of that being said, we believe today’s ISM Report provides the signal that the recovery rally from the March 2009 low is essentially over.  Although there might be additional single digit gains left over the intermediate term, it is unlikely they will be compelling enough for opportunity to outweigh the risk.  The ISM simply serves as confirmation for the economic gains the equity market has already discounted.  As we noted last night, we do not foresee a major down leg, but we do envision a market that marks the time where rallies should be sold and dips could be bought.  We would use rallies following strong economic data as an opportunity to rebalance portfolios and de-risk, as well as initiate hedges.  As we noted a couple of weeks ago, the environment should be one that offers opportunities on both the long and short side for individual stock pickers.

Below is a table highlighting the performance of the S&P 500 leading up to and following the ISM Manufacturing’s cross above 60.  The average performance during the 12 months following the first cross above is 4.28% and over the two years following it is 11.92%.  In most episodes over most time frames, the S&P 500 wound up higher, but gains were unimpressive considering the increasing level of economic activity.  Since the earnings and economic recovery have been a cornerstone of our bullishness over the past 6 months, it is hard to justify remaining as enthused if the increased economic activity from these levels only translates into modest market gains. 

As far as how the data presents, the 1987 crash is included within the table.  Even if one were to view that as an outlier (although many would not), dropping the performance would only boost the 1 year forward average return to 6.1% and the 2 year to 12.23%.  If you segregate the data into periods post-1970 and pre-1970, which places 6 episodes in each time frame, the post-1970 returns are notably weaker than the pre-1970 returns.  We have viewed this recovery and modeled our strategy based upon the activity of the previous two worst post-war recessions, during 1973-1974 and 1981-1982.  As the table below shows, those recoveries were also the ones with the highest Unemployment Rate at the time the ISM Manufacturing crossed 60 (1976 and 1983).  They both also had similarly strong rallies in the year preceding the crossover.  Over the past 52 weeks, the S&P 500 is up 37%.  In 1976, the rally over the preceding year was 31%.  In 1983, it was 52%.  Those continue to be our benchmark environments and as such, the average forward returns were among the weakest.  As much as we believe in the bullish catalysts we mentioned early on, we believe risk and opportunity are finally in balance.  We need better valuations (lower prices or higher earnings) to compel us back into the bull camp. 

Mike O’Rourke, CMT
Chief Market Strategist

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