Friday, July 30, 2010

Morning Note...

Happy Friday…macro dominates this morning…  Futures are ~1% lower as U.S. Q2 GDP comes in weaker than expected at +2.4% vs. the +2.6% expectation and the +3.7% Q1 revision.  Thus markets now have concrete evidence that the rate of U.S. economic growth certainly slowed in Q2.  The GDP reading is also troubling for its make up:  personal consumption (70% of our economy remember) growth decreased while inventories built.  Obviously demand has not kept up with inventory… Also government spending increased from -1.6% to +4.4%... Overseas, European markets are weaker as Moody’s cautioned over Spain’s credit rating (and also made cautious U.S. comments):

Spain May Lose Rating, U.S. Needs Plan, Moody’s Says 2010-07-30 09:57:41.778 GMT
           
July 30 (Bloomberg) -- Spain will probably lose its Aaa credit rating after the country was put under review for possible downgrade in June, and the U.S. needs a “clear plan”
to tackle its deficit, Moody’s Investors Service said.  “Spain is very highly rated and I can’t say where that rating will end up, but it’s likely to go down a bit,” Steven A. Hess, senior credit officer at Moody’s, said in an interview in Sydney yesterday. In the U.S., slower growth may hinder government efforts to address the budget shortfall, he said. “We’re watching the government’s measures that they are implementing and we’ll probably try to put that rating at the level we think it should belong for some time to come,” Hess said. “We don’t see it moving down as many notches as Greece did.”
    
The U.S. faces a difficult task in trying to stimulate growth as its current debt trajectory would threaten the nation’s top rating in the years ahead, said Hess. “The U.S. certainly shouldn’t be trying to put more debt on its books, but we do have questions about the strength of the economic growth,” Hess said. “If economic growth is not there, then the government’s ability to fix its budget problem is less because the revenue will be less. So it can be counter- productive not to stimulate.”  Hess said the U.S. needs a strategy for curbing its budget deficit, which was 9.9 percent of GDP at the end of last fiscal year on Sept. 30. The fiscal shortfall is projected to reach a record $1.47 trillion this year.  “Having a clear plan certainly increases confidence and the U.S. doesn’t have that yet,” said Hess.
    
Note that next week is a very busy earnings week in Europe and – given recent moves – some desks feel that a “sell the news” type week may be in order there.  A bit further afield in Japan, unemployment data there was slightly worse than expected as was industrial production.  This took Asian markets down overnight, led by the Nikkei’s -1.6%.  Chicago PMI due at 9:45am and Consumer Confidence is due at 9:55am.  Note that today is the last trading day of the month and there is always “window dressing” chatter relative to some funds marking up positions on the bell in order to report better month-end numbers.  Of course, for some funds this would have been a few days ago considering trades settle on Trade Date + 3 business days.  But for others, today matters.  (I have never been able to figure out who does what and when…but if the market turns higher at about 3:40pm today, people will be saying “window dressing.”)  Relative to yesterday’s mid-day rally off the Bullard Fed comments, see the quote section below for an excellent summary from Mike O’Rourke.

For more cheerful news relative to equity markets, FBR is out this morning with a Washington Policy piece on taxes:

What Will Your Taxes Be Next Year?
 
At the end of the year, the Bush tax cuts will expire and taxes will increase. Congress’s response will have far-ranging impacts on the economy from consumer consumption and investment activities to general economic growth. Even with an end-of-the-year deadline looming, Congress has an even more pressing deadline—the November elections—and as of right now neither party has much political incentive to compromise. As a result, there is a growing risk that the tax rate on dividends, capital gains, estates, and high-income individuals will be allowed to increase. This is a highly fluid situation that could easily extend into next year.
 
            Key Points

·                     This highly fluid situation could have wide ranging sentiment impacts from wealth effects on consumer spending to allocation strategies between growth (capital gains taxes) and income (dividends). The automatically rising tax on dividends, for example, could inspire 4Q10 special dividend payments or it could raise the cost of capital in 2010.

·                     The most likely tax cuts to be extended are personal income taxes for individuals with less than $200,000 and families with less than $250,000 in taxable income. What is far less certain is the tax treatment for individuals and families above that level, the tax rate on dividends, capital gains, and the taxation on estates. The two biggest factors influencing the debate are the elections this fall and the difficulty finding other revenues necessary to offset the extension of many of these provisions. Below is a discussion of the current proposals before Congress and their likelihood for passage, detailed information on the tax rates in each category, and the potential impact to various sectors should Congress fail to act on certain provision.

·                     Our conversations with our Washington contacts suggest that a full extension of the 2001 and 2003 Bush tax cuts remains unlikely due to the expense in this tight budgetary environment. We believe that Democratic strategists consider opposition to tax cuts for the rich to be a winning campaign strategy. This likely means that a final decision will be postponed until after the November elections with some increase appearing to be the most likely outcome.

·                     Dividend taxes are 15% and are scheduled to revert to normal income in 2011 and President Obama has proposed reducing the increase to 20%. However, cost remains a hurdle. Preliminary estimates have the cost of maintaining the current rates at $99 billion over the next 10 years. We note the significant chance that the Democrats allow dividend rates to revert at the end of the year and attempt to return and extend lower rates retroactively in 2011.

·                     We do not expect to see any significant changes to the 20% capital gain taxes.

·                     Federal estate taxes are nonexistent this year, but are scheduled to reset to 55% on estates over $1 million next year, but we believe Congress will intervene. We view a tax rate in the 35% to 45% range with an exclusion of $3.5 million to $5 million as the most likely outcome.

·                     We believe the most likely scenario is a two-year increase in the exemptions level allowed to avoid the AMT to keep the number of individuals affected at the same level as 2008.

·                     We believe that a value added tax (VAT) is a political non-starter.

BERN ups UBS, cuts BIIB.  ALU higher on earnings.  CRL and WX terminate merger agreement and CRL announces buyback.  CSTR -8% on earnings.  GNW -2% on earnings.  MET +2% on earnings.  NTRI -3% on earnings.  SWIR beats by 6c and trades higher.  UFS beats on earnings and revs.  WFR misses by 3c.  WYNN beats by 10c. 

Asia lower overnight.  Europe ~1% lower.  Oil -160bps.  Gold +22bps.  EUR/USD 1.3021. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 
MEMC ELEC MATER        9.92      -11.9 % 330269
GENWORTH FINANCI      14.70    -6.9 %  12714
ITT CORP                      46.96    -5.93%  4300
TELLABS INC                  7.04      -4.74%  32501
EASTMAN CHEMICAL      62.15    +4.0 %  3400
FORTUNE BRANDS          44.79    +3.25% 1925
DR HORTON INC             10.54    -3.13%  450
PACTIV CORP                30.60    -2.98%  64600
ABERCROMBIE & FI        35.35    -2.94%  2000
TERADYNE INC               10.75    -2.89%  5000
NOVELLUS SYS              27.70    +2.78% 600
HALLIBURTON CO           29.30    -2.69%  28488
TEREX CORP                  18.93    -2.62%  700
WHIRLPOOL CORP          82.01    -2.5 %  100

Today’s Trivia:  Name the first U.S. state that allowed women to vote. 
                                                                                                                                                                       
Yesterday's Answer:  1 in 20 people have an extra rib.   

Best Quotes:  “When the Federal Reserve Bank President authors a paper with a title that sounds like a Stephen King novel, it is certainly going to garner some attention and rightfully so.  “Seven Faces of ‘The Peril’” is the title of St. Louis Fed President James Bullard’s latest research.  Bullard did not pull any punches in the abstract, he states “I emphasize two main conclusions: (1) The FOMC’s extended period language may be increasing the probability of a Japanese-style outcome for the U.S., and (2) on balance, the U.S. quantitative easing program offers the best tool to avoid such an outcome.”  The importance of these statements is remarkable.  This is a relatively new (2 years into the post) Regional Bank President producing research concluding that the current trajectory of FOMC policy may increase the likelihood of an outcome that we all know we don’t want.  If you read between the lines, it sounds like he is really saying, “Ben, I think you are wrong, and now that I have called you out on it, if you don’t adjust policy you will be subject to very serious hindsight risk.”  We are accustomed to hearing Richmond Fed President Jeff Lacker and Kansas City Fed President Thomas Hoenig dissent on FOMC policy all of the time, almost always simply in favor of being more hawkish, and usually provide some balance to the debate.  Bullard appears to be staking out the ultra-dove ground with his conclusions.  If we wind up in a Japan scenario, regardless of the cause, this research will be used to blame the Fed.

The policy Bullard is advocating and the stance he is taking is not new. As early as last November he advocated using Quantitative Easing (asset purchases and sales) to administer monetary policy much in the same way the Fed has traditionally used the Fed Funds rate.  He was opposed to allowing the Fed’s asset purchase program sunset in March.   Bullard wanted to leave the program open in order to buy and sell assets as deemed necessary by the state of the economy.  He was unsuccessful in his attempt, now it appears he has gone back done additional homework and is re-opening the debate backed by research. 

This is an attempt to overcome the debate surrounding the zero bound of interest rate policy.  The essence of Bullard’s work is that the zero interest rate policy “would also be consistent with the low nominal interest rate steady state in which inflation does not return to target but instead both actual and expected inflation turn negative and remain there.”  In that scenario the policymaker risks being perceived as running out of ammunition because they are locked into the perception that interest rates are the primary tool of monetary policy.  Here in 2010 we have witnessed a good example of the dilemma Bullard highlights.   When the market was rallying early in the year, everyone was discussing when would the Fed begin the exit strategy. As the economy hit a soft patch and the market sold off over the past few months up prior to last week there was little conversation about what the Fed would/could do.  When the topic emerged the debate centered around the Fed being out of bullets.  Case in point for Bullard.  His proposed solution is as follows. “To avoid this outcome for the U.S., policymakers can react differently to negative shocks going forward. Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”

You have to give Bullard credit for creativity while remaining within the realm of reality.  Simultaneously, we can imagine the German’s at  the Bundesbank thinking this is heresy in the almost cavalier way Bullard talks about adding liquidity to the system. “We can double the monetary base one day, and return to the previous level the next day, and we should not expect such movements to have important implications for the price level in the economy. Base money

can be removed from the banking system as easily as it can be added, so private sector expectations may remain unmoved by even large additions of base money to the banking system.”  A statement like that alone should fuel an uptick in inflation expectations.  Nearly everyone fears the slippery slope of creating money seemingly at a whim.  On some level it is a fear of the unknown , but sometimes that is a good thing.  In this age of transparency we believe one of the largest threats out there is predictability of policy. Bullard’s approach prevents the FOMC policy from becoming what he calls “passive,” a euphemism for inconsequential.  It allows carry traders to lever and permits investors to put on marginal positions where the risk does not match the reward.   A little uncertainty keeps the market honest, and if you have a position it is because you like it and not simply because the Fed is not tightening until 2012 or vice versa because rates can’t go any lower.  We can’t wait to see where Bernanke weighs in.” 

BTIG’s Mike O’Rourke

Thursday, July 29, 2010

Morning Note...


Futures are ~70bps higher this morning largely on in-line jobless claims and better-than-expected German unemployment and Eurozone confidence data.  Initial Jobless Claims for the week ending July 24th were 457k vs. the 460k expectation.  This is also lower than last week’s 468k reading.  Continuing Claims for the week ending July 17th came in at 4.565M vs. the 4.5M expectation.  Overseas, Germany’s unemployment picture improved slightly and fell by a seasonally adjusted 20,000 jobs.  Further, Euro-Area July Economic confidence rose to 101.3 vs. the 99.0 expectation, which is actually the highest reading in two years.  (Really?  A two-year high?  Does that pass the sniff test to everyone?  It was not alcohol- and World Cup-fueled or anything?  Seems a bit odd…)  Note that UBSS cut U.S. stocks to Neutral this morning.  In earnings news, Visa (V; flat) beat and reaffirmed forward guidance.  Oil giant Exxon Mobil (XOM; +70bps) beats on the highest profits since 2003.  Kellogg (K; -4%) misses and guides lower.  Agriculture giant Bunge (BG; -8%) missed on all fronts.  Tyco (TYC) reported better-than-expected.  Walter Industries (WLT; -2%) also beat.  Tech company Akamai (AKAM; -6%) reports in-line.  Ameriprise Financial (AMP; +4%) beat on earnings and revenues.  Biotech firm Celgene (CELG; +3%) beat by 3c and raised guidance.  Consumer staples giant Colgate-Palmolive (CL; -5.5%) beat by a penny but misses on revenues.  Citrix Systems (CTXS; +10%) beats by 3c and guides revenues higher.  Lincoln National (LNC; +2%) beats by 6c and reports revenues that are in-line with estimates.  Rating’s firm Moody’s (MCO; +2.4%) beats and reaffirms forward guidance.  LSI Logic (LSI; -5%) reports in-line but guides lower.  Graphics maker NVIDIA (NVDA; -8%) guides lower.  Symantec (SYMC; -9%) reports in-line and guides lower.  Avon Products (AVP; +3%) beat by 3c.  Mead Johnson Nutrition (MJN; -1%) beat and raised guidance.  Q2 GDP data is due tomorrow. 

Regarding GDP, great note from the guys at Hedgeye this morning (longer than I usually post, but worth a glance…bold emphasis on tomorrow’s GDP and next week’s unemployment mention is mine):

I think I have become way too cynical, but it's getting harder for me to believe what I hear and read about the outlook for 2H10.  I normally give people the benefit of the doubt, but signs of the early stages of a renewed economic downturn are everywhere.  Yet, given what we read during the current earnings season, corporate America is not tuned in to the same channel or at least they don't want to fess up to it.

This is what I'm seeing - a weakening labor market, softening consumer confidence, softening housing activity and retail sales, and an intensifying trade deficit - the early stages of a renewed economic decline.

I'm not alone because in my back pocket I have the FX market, the bond market and the US consumer all seeing what I see.  For the time being, equity investors willingly believe what they want to. 

Currencies are a leading indicator for a country's health and the US dollar is getting crushed.  The DXY is down 4.8% over the past month and looks to be down 4 of the last five days (trading down 72 bps today at the time of writing). 

While the dollar is getting crushed the EURO has rallied 7.0% (trading up 67 bps at the time of writing).  Knowing that a country's currency is a leading indicator for a country's health, what are the MACRO headlines in Europe today - European confidence in the economic  outlook rose to the highest in more than two years in July and German unemployment declined for a 13th straight month as an export-led recovery gathers strength.

Tomorrow, what will the headlines look like for the USA?

We'll get the BEA's overstated estimate of Q2 US GDP.  Bloomberg is showing a consensus estimate of 2.5% for the second-quarter, down from the 2.7% as reported for the first-quarter (and downward revisions are likely).  In 2Q10, a slower growth rate would be consistent with recent underlying MACRO data points.   I believe that risks are fairly high that the reported growth will surprise the consensus on the downside.

The following week we will get the July labor numbers and there is a good chance that they will be softer than an already soft consensus.  Bloomberg is posting expectations of a 100,000 decline in monthly payrolls.  I believe that number includes layoffs of temporary and census workers in July, which will be roughly 144,000 (per Census reporting).  This implies little or no growth in nonfarm payrolls, ex-census workers.  In June, payrolls declined by 125,000, gaining 100,000 ex-census.  Bloomberg also has the unemployment rate estimate at 9.6%, up from June's 9.5%.

Yesterday, the FED provided a very consistent message about the current consumer trends:

New York - Contacts generally indicate that sales of fashion items and apparel were particularly strong, whereas sales of big-ticket appliances were relatively sluggish.

Philadelphia - Most retailers said warm weather boosted sales of summer apparel, but sales of big-ticket appliances, remained weak.  "The consumer is still cautious and looking for value."

Cleveland - Purchases of apparel and food products are doing well, while spending on discretionary items has weakened.

Richmond - A contact at a large home and garden chain reported that impulse buying fell, and that home remodeling purchases had scaled back dramatically as consumers "splurged small." Overall, according to our District survey, big-ticket purchases and shopper traffic plummeted.

Atlanta - Although most merchants have reported improved conditions since the beginning of the year, the outlook among retailers was more subdued than in previous months.

Chicago - While spending on food and other necessities rose, spending on home-related and luxury items decreased.

St. Louis - Contacts in education services, air transportation support services, and the casino industry announced plans to decrease operations and lay off workers.

Minneapolis - In South Dakota, a mall manager noted that recent sales were mixed; consumers remained cautious as traffic continued to be driven by promotions.

Kansas City - Retailers expected sales to rise over the next three months and a continued downward trend in prices... Restaurant sales were flat compared to the previous survey, but the average check amount fell.

Dallas - Department store sales were slightly stronger than anticipated, but the pace is expected to moderate in the second half. Consumers continue to deleverage and correspondingly remain price sensitive.

San Francisco - While consumers remained focused on necessities and lower-priced options, reports indicated expanding consumer appetite for discretionary spending.

The most bullish commentary came from the San Francisco region.  I'm not sure what to do with that, knowing that California is in a financial mess, though comparisons are likely easier in that region.

In the last month, the corporate earnings season (and corporate storytelling) has driven the S&P 500 and the Consumer Discretionary index higher, up 2.9% and 2.6%, respectively.   This market rally has occurred against the backdrop of sluggish  macro headlines, but over the last three months, Consumer Discretionary was the second worst performing sector (-9.8%) next to Energy (-11.1%).  As Keith always says, markets don't lie, people do.

Function in disaster; finish in style
Howard Penney

BCAP ups SLF, WSM.  BARD ups DST.  SocGen ups BA.  CTXS raised at CITI/DBAB.  FBC raised at FBRC.  SYMC cut at FBRC.  AMZN introduces the $139 Kindle.  AMAG misses by 5c.  ARRS misses by 1c.  ASIA beats by 3c.  CML beats by 3c.  CML beats but guides lower.  CVD reports in-line but guides lower.  DRYS beats by 8c.  ESRX beats by 1c and guides in-line.  GMR misses by 10c.  HRC beats by 14c.  HS beats by 40c.  IDCC beats by 12c.  ITRI beats by 25c.  IPG beats by 5c.  MPWR beats by 2c.  NETL beats by 6c.  NEWP beats by 8c.  NLY misses by 3c.  OII beats by 17c and guides higher.  SKX beats by 38c.  TER beats by 22c.  TGI beats by 26c.  UAM reports in-line.  VPRT beats by 1c but guides lower.  WIRE beats by 23c. 

Asia mixed overnight.  Europe ~75bps higher.  Oil flat.  Gold +10bps.  USD -70bps.  EUR/USD $1.3081. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 
CITRIX SYSTEMS           51.85    +9.55% 120475
SYMANTEC CORP           13.33    -9.13%  794787
INTERPUBLIC GRP           9.00      +9.09% 8300
TERADYNE INC               11.06    +8.33% 40922
NVIDIA CORP                 9.29      -8.29%  2587493
AKAMAI TECHNOLOG      41.06    -6.75%  299115
COLGATE-PALMOLIV       78.99    -5.81%  138865
LSI CORP                       4.47      -5.7 %  14900
KELLOGG CO                  48.75    -5.38%  33287
GENZYME CORP              71.43    +5.05% 134021
AUTOMATIC DATA         40.27    -4.35%  800
CELGENE CORP              54.92    +3.92% 26470
CONSOL ENERGY            37.20    -3.65%  3581
SOUTHWEST AIR           12.40    +3.25% 7820
GOODYEAR TIRE            12.31    +3.01% 3300
NOVELLUS SYS              28.01    +2.83% 300
HERSHEY CO/THE           47.68    +2.74% 100
AVON PRODUCTS           30.30    +2.61% 200
CIENA CORP                  13.53    +2.58% 300
VARIAN MEDICAL S        56.00    +2.51% 500
HARTFORD FINL SV        23.38    +2.5 %  489

Today’s Trivia:  5% of all people have an extra what
                                                                                                                                                                       
Yesterday's Answer:  Oak trees are most commonly struck by lightning.   

Best Quotes:  Shout out to all the guys who remember Trader Monthly and who pointed out that its publication signified the greed and excess that typically marks the “top of the market”…

Trader Monthly’s Lane Gets Stuck in His Own ‘Jealousy Machine’
2010-07-28 23:00:01.7 GMT


Review by James Pressley
     July 29 (Bloomberg) -- Magazine maker Randall Lane built a career out of what he came to call “the jealousy machine.”
     Then the machinery chewed him up and spat him out, as he shows in “The Zeroes,” a farcical memoir of how Lane’s Trader Monthly and other glossy tributes to financial stars made him a Wall Street insider and lost him $530,000.
     Lane, a former Washington bureau chief for Forbes, didn’t set out to become a cheerleader for hubris. He began his trip into the land of high rollers with an offhand idea from a Canadian-born trader, Magnus Greaves: Why not create a publication devoted to the buy-and-sell set?
     Advertisers would love the homogenous audience of alpha males earning six figures or more, Lane figured. Traders, for their part, would warm to a publication that glamorized their work, winnings and silver Ferraris.
     Over some Bass ales at Tao in midtown Manhattan, Lane got Greaves, his business partner, to sum up what motivates the desk jockeys with the Franck Muller watches. Then Lane distilled the trading ethos into six words scribbled on a cocktail napkin: “See It, Make It, Spend It.”
     It was 2004, and the slogan soon spawned content ranging from trading strategies to the joys of gluttony, including a column called “The 5,000 Calorie Meal.” A driving force would be the desire of big earners to know how they were doing relative to their peers, a preoccupation Lane first encountered while reporting for the Forbes 400 list.
     “Most of all, we would feed the anxiety, by publishing and celebrating, what the top dogs made -- the Trader Monthly 100.”

                       Maybachs and Moet

     Before long, their upstart Doubledown Media LLC was throwing parties featuring Maybachs, Moet & Chandon bubbles, lithe dancers on a trapeze, and a faux James Brown in gold lame.
     By 2007, Doubledown would add a boxing match for charity at New York’s Hammerstein Ballroom, where traders from Goldman Sachs Group Inc. and Bear Stearns Cos. slugged it out before guests dressed in Armani tuxedos and Brioni suits. As Lane gazed at the pugilists, ring-card girls and roaring crowd, he settled on an apt name for the decade, “the Zeroes.”
     “Wall Street’s breathless pursuit of zeroes, that easy money mentality, had permeated every aspect of our culture,”
Lane writes. “In my role as Wall Street’s scorekeeper, I too had fallen prey to the mind warp.”
     As that last comment suggests, Lane presents himself as the dazed victim of “the kind of greedfest that comes along only once every thousand years.” Yet he also fed the bonfire, as Doubledown added more magazines extolling indulgence and finance, including Dealmaker, Private Air and the Cigar Report.

                         Travolta Flap

     Lane faults and excuses himself by turns. On one occasion, he allows John Travolta to nix more than 100 photos taken for a cover shot of Private Air. On another, he asks his lifestyle editor to avoid criticizing advertisers’ products.
     “I knew this was a long way away from my days at Forbes, but I also knew that the other option was bankruptcy.”
     His ultimate self-pardon: He grew up in a suburban house abutting the Rockefeller estate in New York’s Westchester County. “My middle-class nose had been pressed up firmly to the glass of American wealth and power from birth.”
     Keeping up with the moneyed class proves a dicey business for Lane, whose quest to keep Doubledown afloat draws him into a circle of characters that could have come straight out of a potboiler. Trader Monthly’s first big advertiser was Refco Inc.
Chief Executive Phillip Bennett, who was later sentenced to 16 years in prison for cheating investors out of $2.4 billion.

                           Peter Max

     Pop artist Peter Max turns up to paint portraits of hedge- fund heavies including John Paulson. Baseball star-turned- stock-picker Lenny Dykstra arrives with a business plan and multiple laptops. A source called the Candyman -- Lane’s Deep Throat on what hedgies are earning -- expects to be treated to a “proper” night out, at a strip club where the bill runs to almost $10,000.
     The gossipy narrative proceeds apace with the lacquered language favored by magazine writers. Characters don’t just eat and drink, they “tuck into” Dover sole and “throw back”
Chopin vodka. Yet Lane can be vivid, as when he describes short seller James Chanos, “his lips pursed as if he were passing an oddly shaped kidney stone.”
     It’s hard to feel sorry for Lane, even when the meltdown forces Doubledown to file for Chapter 7 liquidation in February 2009. Yet he’s right to note that Wall Street hasn’t changed its ways just because his magazines are no longer around to glorify the excesses. For those who still wonder what got into Americans during the decade of housing helium, this beach read of a book is a fine place to start.

     “The Zeroes: My Misadventures in the Decade Wall Street Went Insane” is from Portfolio (359 pages, $27.95).

Wednesday, July 28, 2010

Morning Note...


Futures are ~20bps lower this morning as the stream of earnings releases continues and June Durable Goods Orders came in weaker than expected, at -1.0% vs. the +1.0% expectation.  As for earnings, this morning’s tepid action seems to indicate another underwhelming response to the recent beats:  Sprint (S; +5% pre-market) surprised to the upside; Boeing (BA, -1.5%), Norfolk Southern (NSC, -2.3%), Aflac (AFL, -1.4%), Aetna (AET, -1.6%), Broadcom (BRCM), WellPoint (WLP, +2.3%), and Comcast (CMCSA, +2.2%) all beat expectations; and Massey Energy (MEE, -2.5%) and Newmont Mining (NEM, -1.4%) missed analysts’ estimates.  Steel giant ArcelorMittal (MT) also beat estimates but offered cautious forward guidance.  CVS (-3.5% pre-market) misses slightly and lowers guidance but wins a long-term AET PBM contract.  Restaurateur PFCB missed by 2c but comp sales were slightly better-than-expected, whereas PNRA sales slowed.  BWLD also showed major improvement in comp store sales.  LVMH is higher overseas as their fashion/leather goods segment was notably strong.  Also, Moody’s affirmed a negative outlook on financials Bank of America (BAC), Citigroup (C, -75bps), and Wells Fargo (WFC, -1%).  Finally, AT&T (T, -60bps) was also placed on the S&P ratings watch list.  In M&A news, HES agreed to buy AEZ in an all-stock deal.  Across the pond, Portugal and Italy had successful debt auctions, and Bank of England monetary policy member David Miles borrowed from Bernanke and called the economic outlook “unusually uncertain.” 

The Fed’s Beige Book report is due at 2pm.  For a refresher, the Beige Book is formally known as the “Summary of Commentary on Current Economic Conditions by Federal Reserve District.”  (Thus the need for a shorter title.)  This report is published eight times per year.  Further, Each Federal Reserve Bank gathers anecdotal information on current economic conditions in its District through reports from Bank and Branch directors and interviews with key business contacts, economists, market experts, and other sources. The Beige Book summarizes this information by District and sector. An overall summary of the twelve district reports is prepared by a designated Federal Reserve Bank on a rotating basis.  (www.federalreserve.gov)

Regarding recent market action, I think Mike O’Rourke summarized things nicely last night:

When thinking about today’s trading action, the term “summer doldrums” is a fitting description.  The S&P 500 spent 75% of the trading day in what was approximately a 50 basis point range.  Trading volume remains unimpressive.  We suspect the tight trading action is representative of a distribution day in the equity market.  As the S&P 500 runs into upside resistance, some investors took the opportunity to sell into the early strength to do some profit taking.  The 1120 level which the S&P 500 tested on the open today is  important resistance.  It was the level where the market ran out of steam during the June rally.  It is also just below the level where the flash crash rally stalled.  The level was only exceeded by the EU’s announcement of the “Shock and Awe” package a few of days later, which, as we all know, was a selling opportunity.  The market running out of gas as it hits resistance should not be viewed as a negative.  Taking a breather at the appropriate levels should be expected and is constructive.  Currently, the S&P 500 is up 8% month to date, and a little consolidation would be the healthier course.  On the positive side, it was impressive that today’s reversal halted after pulling back 1%, and did not become an all out rout in this Jekyll and Hyde market that shifts from no offer to no bid  on a dime.

In today’s trading, Treasuries finally down-ticked enough to drive the 10 year yield above 3%.  That being said, the yield’s close proximity to 3% is a sign that despite the equity rally, there is still a cautious tone in the financial markets.  We believe we may be witnessing early signs that investors are willing to increase their exposure to risk, notably equities, but in a defensive manner.  Most sectors are posting a strong performance in July as one might expect with the S&P 500’s big rally.  What has caught our attention are the Utility, Telecom and Consumer Staples sectors.  The Utility sector is up 10.4% this month and on track for its best monthly performance since March 2002.  The Telecom sector is up a less impressive 8.7% on track for its best monthly performance since May 2007.  Consumer Staples are up 7.4%.  Although they are mildly underperforming the S&P 500 this month, they outperformed the S&P 500 by 259 and 346 basis points, respectively, the previous 2 months.  The kicker is that Consumer Staples are on track for their best monthly performance since October of 2000. 

If you are a BP-watcher, I thought this quick BBERG story was interesting:

BP Oil From Spill Is Biodegrading, Easing Threat to East Coast 2010-07-28 07:03:13.744 GMT

July 28 (Bloomberg) -- Oil from BP’s GoM spill is biodegrading quickly, probably eliminating risk it will hit the East Coast, National Oceanic and Atmospheric Administration says.
                        * Oil has been evaporating since BP stopped well flow on July 15 and crude that’s dispersed into the sea is being gobbled up by bacteria
                        * Seasonal shifting of Loop Current also eases threat
                        * Risk of oil reaching more shoreline in northern Gulf is also decreasing
NOTE: By yesterday, ~640 miles (1,030km) shoreline in northern Gulf, northwest Florida had been tarred by oil, govt. said

WSJ “Heard on the Street” cautious on DB.  CITI ups ENTG.  BARD ups PCAR, TOMO.  SocGen ups BEAV.  WEFA ups AHGP, ARLP.  BARD cuts HSII, OMI. 

Asia higher across the board overnight.  Europe has weakened slightly throughout their session.  EUR/USD $1.2981.  Oil -115bps.  Gold flat.   

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 
EASTMAN KODAK           4.57      -7.3 %  44805
SLM CORP                     11.83    +5.44% 22580
CH ROBINSON                64.52    +5.42% 46500
SPRINT NEXTEL CO        5.07      +4.97% 24233008
INTL GAME TECH            16.02    -4.07%  7500
FAMILY DOLLAR ST        41.01    +3.9 %  119023
CVS CAREMARK COR      29.50    -3.59%  845823
IAC/INTERACTIVEC        24.49    +3.2 %  500
WYNDHAM WORLDWID   24.00    +3.14% 100
FISERV INC                    46.19    -3.02%  1688
TENET HEALTHCARE       4.34      -2.91%  5501
MASSEY ENERGY CO       28.91    -2.5 %  62775

Today’s Trivia:  What type of tree is most commonly struck by lightning? 
                                                                                                                                                                       
Yesterday's Answer:  The Devil’s Tower in Wyoming was designated by Teddy Roosevelt in 1906 as the first national monument.   

Best Quotes:  “Good Morning - Earnings vs. Economy continues.  Durable goods at 8:30 Est. and Beige Books at 2 est. could be a drag on the current momentum built by the earnings trend.  How about this for a month we are up 8% in the S&P 500.  Doesn't feel that good, but a move that can't be ignored.  It feels like the cover trade has taken place, so what little risk that was out there may have been covered, and with the earnings trend shorts may be hesitant to be put back on.   I am a buyer of all dips through earnings season, maybe through September.   Equities at some point have to come back into vogue.  Maybe Dividend increases are the catalyst.  Growth expectations are tepid at best, but if companies with these large cash balances can give dividend incentives maybe the yield s and valuations gets folks out of Treasuries.   1118.75 is yesterdays high, 1122.30 is the 100 day moving average.  Have a good day.”  --trader talk

Tuesday, July 27, 2010

More Miami driving and a theory on the dumbing down of America...

Miami Driving.  It hit me this morning.  The critical distinction between the commuter experience in Miami versus New York City (or any other major metropolitan city, probably) lies in the striking difference in approach - or attitude - toward the commute itself.  You see, New Yorkers are problem solvers.  (These are people who spend their free time on the subway doing crossword puzzles or sudoku...by contrast, in 2.5 years I have never seen anyone in Miami ever do a crossword puzzle. or sudoku.)   New Yorkers see the commute as sport:  they choose to approach it as a challenge...as a gauntlet to be run.  Each and every day creates an opportunity for increased efficiency or for a better overall time.  Hell, guys used to come into work bragging about a "great move" that shaved minutes, or out-elbowing someone through the turnstile to catch the train door, or discovering a new stairway that allowed for a quicker exit from Penn Station.  You get the idea:  New Yorkers worship at the altar of efficiency and problem-solving.  In part, it helps make The City what it is.  Here?  There is no such approach.  I see the northeastern commuter as a warrior, suiting up for battle each and every day, whereas the Miami commuter brings kitten posters to mind:  Hang in there... or It'll get better.  These are Garfield people, who accept their lot in life and could care less if they get to work sooner or later or even at all.  The message is, the commute is a drag...I don't care.  Where is the heart, people?  Where is the attitude, the effort?  How about rising to the challenge and actually - gasp! - making it better?  Or, how about paying attention at all?  (That would be a start.)  From my perspective, this is incredibly frustrating.  I seem to be the only person, day after day, who understands that you have to make it past that one light in order to catch all the others.  I seem to be the only person who understands that cutting through the parking garage when it looks like I will miss the next light can save valuable minutes.  I seem to be the only person who is actually not texting or talking on the phone during the morning commute.  And I am certainly the only person who is actually ready to accelerate when the light turns green.  Imagine that.  (But hey, I also work in a building where I watch people walk the entire length of the parking garage ramp in order to take an elevator one floor down instead of simply taking the stairs...which are right next to where there parked.  btw, stairs get no love in this day and age.  I might have to do an entire future rant about people who actually take the elevator in between floors of the gym while they are there working out!  I mean, huhn?).  Anyway, go figure:  in Miami, it is what it is...but some days, what "it is" is also waaay too much to handle for any sane person...  (And do you know the punchline of this entire rant?  How long is my commute that it could cause such vitriol?  And also cause the certain knowledge that a texter will crash into me through absolutely no fault of my own and that there is no way I can even prepare for that or avoid it?  Ahem...3.1 miles...which can actually take up to 30 minutes!  Imagine what this blog would look like if I had a ten-mile commute.)

More.  Since I am on a roll here, let's keep going.  Here are a few other observations about Miami, its drivers, and its roadways.  First (and I have never seen this in anywhere else - I just assumed all cities had a uniform infrastructure and copied one another), traffic lights in Miami are not hung over an intersection to give everyone the proper perspective and view of the lights.  Instead, they are generally hung closest to each street approaching the intersection.  That probably sounds vague, so let me say it this way:  when you pull up to the white line at a Miami intersection, you can not see the traffic light unless you are in a convertible because it's directly overhead!  The best view of the "light-change" is thus typically a car length back from the intersection, and most cars at the front either don't see the light change at all, or are too lazy to crane their necks upward to see what is above them.  So in that sense, the infrastructure - the set-up of the roads - is not exactly helping the driving experience.  Second, I may have a theory as to why people don't actually go at a green light.  This has been puzzling to me.  Half the time I can see what the person ahead of me is doing, and it's usually talking on the phone or reading the paper or taking a gulp of coffee instead of watching for the light.  But the other half of the time, I see the brake lights release as they take their foot off the brake...and then...and then...and then...there is this 2-3 second pause before they hit the gas to accelerate.  What does this mean?  Is it that hard to shift your right foot off the brake and onto the gas?  Does everyone in Miami have Parkinson's or something?  Or can people possibly be that lazy?  Hmmm, well...maybe not, actually.  In trying to give Miamians the benefit of the doubt, I came up with this theory, which again stems from a structural issue:  Up north, when one light turns red, there is a one mississippi, two mississippi, three mississippi pause before the perpendicular light turns green.  (Which is presumably for smart safety reasons and adds a buffer in case someone blasts through the yellow-to-red coming the other way.)  Every kid who tries to jump all the cars waiting at a light by pulling up alongside in the "right hand turn" lane knows this by the time they are 16-years-and-1-day old.  But in Miami, there is no delay of any kind.  When the other light goes red, yours goes green immediately.  My theory is that people probably run - or at least "close shave" - red lights all the time in Miami...and as a result, the drivers here have built in their own slight safety delay when the light turns green in case some Porsche-driving d-bag late for his tee-time flies through the yellow-to-red light the other way and risks taking you out in the intersection.  So ironically, not going at green may simply be a survival response to another terrible planning/design issue here since there is no "safety" delay at our intersections. 

More.  Here's another good one.  I also have a theory that non-native speakers here may very often confuse right and left when following directions.  I have never, ever seen more cars brake to turn, realize it's not their turn, and then swerve across traffic to attempt to make the opposite turn at the same intersection.  Yes, you read all that correctly.  That happens here...a lot.  Look, I have seen plenty of people pause to turn (let's call it a "left" for the sake of illustration), realize it's the wrong turn, and then straighten out and drive forward and make the next left turn.  We've all done that.  And I assume - in part - it's because most of us know we have to turn left, but just turned left too early...maybe at 14th street instead of 15th street or whatever.  But very rarely have I ever gone to turn left and realized "oh wait, that was supposed to be a right."  And IF that ever happened, my logical response would probably be to make that left regardless (but as a u-turn), then make another left to get back on my "main road" for a shot at turning right this time as I re-approached the intersection.  But under NO CIRCUMSTANCE would I say "oh crap, I should be going right here and not left," then break out of my left hand turn and swerve across traffic to force the right hand turn.  I mean, WTF?  Again, I see this once a week in Miami.  And I have no idea why. 

Last driving observation.  Dear Random Miami Driver:  Why are turn signals so difficult for you?  Is it that much of an effort?  Does it require Herculean strength to flick that lever up or down in your car?  Is it stuck?  Or are you purposely trying to trick me... perhaps to get me to careen into the back of your car as you randomly smash on the brakes and violently turn either left or right at a whim?  Or do you feel that driving is a private experience and thus your thoughts and movements are protected under the Constitution and thus not subject to public - and public safety - display?  Is that it - are you just a Libertarian at heart?  Please explain.  Thanks, Ben.  Seriously...I understand that turn-signaling is lax in many places.  But I also know that in places like Rome I am only going 15mph down the little cobblestone street anyway and really it's not that big a deal.  But in Big American cities, on Big American roads, and with Big American cars PLEASE use the damn turn signal!  Do you really want someone to plow into the back of you?  Don't you think the nanosecond flick of a wrist effort is worth staving off a potential pile-up?  Again, I see a near-accident from lack of turn signals at least once a week here.  And once again, I just don't get it. 

Dumbing down of America.  It's easy to rant against television - among other things - as causal to the gradual "dumbing down of America."  It's easy to point the finger at an electronic box that fills in all the blanks for your mind (unlike books - which require you to translate the written word into mental images yourself) and promotes a type of mental atrophy that was outlined in a recent Newsweek cover story on the death of creativity.  But I think it goes further than that.  There is one particular aspect of television - especially cable television - that stands out to me that no one seems to question.  Since roughly 1985 when MTV came on the scene, HBO came into its own, and cable TV exploded, the concept of playing the same movie over and over again became the norm in cable television programming.  And - this is my theory here - the mindless repetitive viewing of those movies probably causes exponential "creativity atrophy" in all our brains.  (While at the same time perhaps surprising the hell out of the cable companies.  Can you imagine that first HBO board meeting when the Neilsen results or whatever measuring-stick they had came back and someone said "holy crap - we never thought we'd get away with this, but people actually watched the same movie three nights in a row!")  Someone please tell me - how come this goes completely unnoticed in today's world?  Remember, before cable TV (and VCRs, I suppose) we all watched favorite movies annually (!!)...The Wizard of Oz was on every year around Halloween...The Ten Commandments was on at Easter time...Singing in the Rain was on sometime in the spring...and I am sure there are other examples.  And all of a sudden cable execs must have been shocked to discover that people will watch the same movie over and over and over again.  But at what cost to our brains?  Why do we watch things when we know exactly what is going to happen?  For my part, as I wrote over New Year's 2010, I have tried to implement a five-year rule for myself when it comes to watching movies.  In other words, if I have seen the movie within the past five years, I cannot watch it again.  (And I am as guilty of this as anyone...I can't seem to pass by Hoosiers, Bull Durham, Trading Places, or any Rocky movie without stopping for at least twenty minutes.  And - as much as I hate to say it - the same thing probably applies for Notting Hill, Serendipity, and Love Actually.)  But no more mindless repetition!   I feel like it literally makes me dumber by the minute - it kills my brain cells...and my time is better spent on a new movie, a new book, or any other new experience.  (And I think about it with my daughter now too...we will have at least a five-year rule in the house when she gets older.)  So my broader question remains, How is the socially-accepted norm of watching the same movie over and over and over not making us all intellectually lazier (and dumber) than previous generations?

That's it for now.
All the Best,  Ben

Morning Note...


Futures are ~70bps higher as market momentum is driven up through the 200-day moving average (S&P500) by positive earnings overnight from European banks UBS (+8% pre-market) and Deutsche Bank (+6%).  Further, there is speculation overseas that softer rules on banking and liquidity from the Basel Committee on Banking Supervision will help bank earnings going forward.  Yesterday the Basel panel agreed to allow certain assets – including minority stakes in other firms – to count as capital.  They also set a leverage ratio to apply to banks globally for the first time, but it will not become binding – and could surely see adjustments – by 2018.  As a result, global financials are leading worldwide markets higher this morning.  Germany’s consumer confidence poll was also better-than-expected.  Additionally, this morning’s CaseShiller Home Price Index for May (year-over-year) was higher than expected, at +4.6% vs. the +3.85% expectation.  In other earnings news, solid results across the board today:  Corn Products (CPO; +14%) is higher on earnings, DuPont (DD; +5%) beat estimates and raised guidance, defense contractor Lockheed Martin (LMT; indicated higher) beat and announced a buyback, retailer Office Depot (ODP; +5.5%) beat analyst’s expectations, engineering giant Fluor (FLR; +2.5%) beat numbers, and steel stock AK Steel (AKS; +4.5%) also beat.  In other news, US-born Robert Dudley will replace BP CEO Tony Hayward on October 1st.  Apple is expected to make a surprise announcement at some point today.  Fed’s Beige Book due tomorrow afternoon.  Loved this technical commentary from BofAMLCO this morning:  “1110.70 is unchanged on the year.  1122.50 is the 100 day moving average.  Buy the dips till earnings end.   After that we'll be stuck with election doom and gloom. So enjoy this moment in time.”  Also note that the DJIA has enjoyed three-straight days of triple-digit gains for the first time since 2008.  Hmmmm.

Regarding yesterday’s market-sparking guidance from FedEx, Mike O’Rourke offered some valuable perspective on it all last night:

We have discussed the influences of sentiment and expectations all month, and today provided two excellent examples of expectations imbalances within the markets.  The first is FedEx.  On June 15th, FedEx shares closed at $83.01.  On the morning of June 16th, the company announced earnings and provided initial guidance for 2011 of $4.70 per share below street expectations of $5.07.  The stock dropped nearly 6% that day despite a very upbeat conference call by management.  A sloppy broad market fueled an additional sell of FedEx shares over the next couple of weeks.  As the market bounced so did FedEx and last week the rally continued on good earnings news from competitor UPS.  Today, a mere 6 weeks after that initial guidance, FedEx raised 2011 expectations to $4.90 per share based upon Q1 looking 15% better than expectations.  FedEx Shares closed today at $83.39, higher than the June 15th close.  It is remarkable that the company has managed to bring expectations down by $0.17 and subsequently wind up with a higher share price.  For the time being since the revision has been upward, as have those of the competition, the market will likely expect future announcements to go in the same direction.  One might be tempted to call this chicanery, but we have seen them do the same exercise in reverse in the past.  Regardless, the actions and results merit being mindful of them.

This is from yesterday’s Hedgeye commentary, but is worth reading nonetheless (bold is mine, interesting timing of Q3 GDP):

"My job is to make sure we can borrow to finance."
-Timothy Geithner, July 25, 2010

That's what US Treasury Secretary Timmy Geithner told Meet The Press host David Gregory yesterday. Timmy has already told us that he "isn't an economist." He's not a mathematician or risk manager either. He's simply a professional politician who is doing his job.

In another article by Bloomberg's Daniel Kruger this morning titled "Deficits Don't Matter as Geithner Growth Gets Lowest Yield", Timmy expanded upon his aforementioned job description explaining that "if you look at financial markets, say, look at how much the Treasury is paying to borrow today, there is a lot of confidence, not just of Americans but investors around the world, that we're going to find the political way to do it... there's no alternative for us."

There may not be an alternative to marking-US-interest-rates-to-model, yet... but the days of seeing American politicians borrow from their citizenry's long term future in order to finance their short term political agendas are numbered. Borrowing short to lever yourself up long of debt doesn't work.

Geithner must not realize that his financial outlook and fiscal policies contradict one another. If US economic growth were to, as he said yesterday, "gradually strengthen for the next year or so", what in God's good name are US bond yields doing at all time lows?

This is already getting priced into political polling expectations, but Timmy and the Administration of Groupthink Inc. will meet their maker come the fall (unless they change the reporting date, Q3 US GDP is going to be reported 4 days before the mid-term elections and we think that US GDP growth will slow sequentially). I think global risk managers already get that, but do they get how this game of US currency and interest rate manipulation ends?

Without reviewing his entire book this morning, one way to start answering the question of how this gigantic game of over-leveraged countries playing a Fiat Fool version of Monopoly ends is reading Richard Duncan's, "The Dollar Crisis."

Originally published out of Asia in 2003, Duncan's International Bestseller has recently been revised and updated, but it gets a real-time update that is marked-to-market by the US Dollar, deficit, and debt balances every day. The upshot of Duncan's answer is that this game will not end well.

SOA beats by 5c.  UA beats by 4c.  TEVA beats by 4c.  VECO beats by 18c.  STFL cuts WMT to Hold.  ZRAN cut to Hold at NEED.  CITI cuts AFL.  CNL, PCG upped at GSCO.  ETR, NTR cut at GSCO.  ARMH lower on earnings.  BMI beats by 34c.  ENR higher on earnings.  IDTI beats by 3c.  LM misses by 1c.  BCAP sells stake in IHG LN overnight.  MAS misses on revenues.  BMOC cuts PCL.  PLT beats by 10c.  SAP beats by 3c.  VLO reports 23c better.  VLTR beats by 3c.  DBAB cuts WERN.  X lower on earnings. 

Asia mixed overnight.  Europe higher.  Oil +70bps.  Gold -30bps.  EUR/USD +1.3003. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 
UNISYS CORP                26.14    +9.14% 23500
LEXMARK INTL-A            37.74    +8.42% 53796
TELLABS INC                  8.29      +6.42% 362940
CUMMINS INC                82.16    +5.54% 68940
REGIONS FINANCIA        7.48      +5.5 %  1292247
OFFICE DEPOT INC         4.99      +5.5 %  48490
COVIDIEN PLC                41.59    +5.18% 100
DU PONT (EI)                 40.80    +4.64% 147829
AK STEEL HLDG              15.81    +4.01% 675456
VALERO ENERGY            18.24    +3.87% 377013
US STEEL CORP             47.04    -3.78%  457705
LEGG MASON INC           28.99    -3.62%  31883
MASCO CORP                11.50    -3.6 %  30726
INTL GAME TECH            17.34    +3.58% 200
BIOGEN IDEC INC            56.13    -3.04%  100
UNUM GROUP                 22.98    +2.96% 100
PLUM CREEK TIMBR        37.52    -2.8 %  1960

Today’s Trivia:  What was designated as the very first “national monument” in the United States? 
                                                                                                                                                                       
Yesterday's Answer:  Detroit gave Saddam Hussein a Key to the City in 1980.   

Best Quotes:  For those who like to play around in their P.A., here’s some advice from a Bloomberg editorialist…

Four Rules to Remember in the Age of Austerity: Matthew Lynn 2010-07-26 23:00:00.0 GMT

     July 27 (Bloomberg) -- One thing has become clear during the sovereign-debt crisis: Governments everywhere are going to be cutting their spending savagely over the next five years.
     They may do it under the direction of the International Monetary Fund, like Greece. Or voluntarily, like the U.K. and Germany. Or slowly and reluctantly, like the U.S. One way or another, it has to happen. You can’t run deficits of 10 percent of gross domestic product or more forever.
     But what does that mean for investors?
     The U.K. stock market has already priced in earnings shocks from companies that have run into trouble because of reduced government spending. And, in most developed countries, the cuts are only just starting. We’ll see a lot of corporate-profit declines across Europe and the U.S. in the next couple of years.
     To survive that you need to short companies that depend on government spending; think about the regions that will avoid the worst of the pain; and focus on businesses that can save the government some money. Follow those simple rules, and your portfolio should make it through the years of belt-tightening.
     There is already plenty of evidence from the U.K. about the impact that the austerity drive can have on share prices. Cable & Wireless Worldwide Plc, the telecommunications provider, said last week that spending cuts by David Cameron’s new coalition government would lower earnings. Its shares dropped 17 percent on the day. Last month, Connaught Plc, which maintains social housing, told shareholders the same message. Its shares dropped as much as 41 percent on the day.

                           50 Percent

     It’s no great surprise that austerity drives will hit a lot of companies hard. State spending accounts for 30 percent to 50 percent of the economy, depending on which country you look at.
Start hacking away at half of your GDP, and a lot of people will find life much tougher.
     So how should you steer your portfolio through the age of austerity? Here are four principles to keep in mind:

     One: Keep away from government contractors. In the last decade, the state has outsourced a lot of its work. There have been big contracts awarded -- and, as we know, governments are very bad at getting value for money, so most of those contracts came with fat profit margins. Likewise, defense companies will do it tough -- wars are a real luxury when you need to cut public spending by a quarter. You don’t want to be holding shares in companies such as defense manufacturer BAE Systems Plc in that kind of environment. All of them are going to suffer.
Clear them out of your portfolio -- then short them.

                         Regional Focus

     Two: Focus on regions. Government spending is always concentrated in particular areas, either because they are poor, or because it is where the governing party’s voters happen to live. In the U.K., that is Scotland, Wales and the north of England, the heartland of the Labour Party, which held power for the last 13 years. But every country has a region of high public spending. Avoid them, because they will be hit hardest. But other places such as prosperous London and the south-east of the country will do fine. Invest in businesses that focus on those places and you won’t regret it.
     In the U.K., take a look at Ocado Group Plc. The online grocery retailer got a rough ride in its initial public offering last week. Yet the wealthy shoppers of the south-east of England who make up its core market are going to get through the austerity drive better than most people.

                         Cheap New Ways
                               
     Three: Look for better mousetraps. Governments won’t just be able to cut their way out of trouble. The deficits are just too big for that. They will have to innovate as well, finding new ways of doing the same things more cheaply. The private sector is much better at that than the public sector. So look for companies in health care, education or outsourcing that can come up with new, more-efficient ways of doing things. They will have plenty of demand for their services.
     One example. Capita Group Plc, which provides a criminal- records service for the U.K. Home Office, is pitching money- saving ideas to the British government. If they are good, they can expect an enthusiastic reception.

     Four: Don’t forget about growth. The historical record shows that times of austerity are also ones of great entrepreneurial energy. During the 1930s, new industries such as consumer electronics and plastics were created. In the turbulent mid-1970s, the personal-computer industry was born, as companies such as Microsoft Corp. and Apple Inc. were founded. When times are hard, a lot of smart people don’t have any choice but to set up their own business. And they will have to do it on the cheap as well, which is usually the best way.

                        New Opportunities

     So don’t be too defensive. Even amid austerity, there will be some terrific new companies getting started. It is a good time to be looking for businesses to back.
     Where should you be looking? How about Nathaniel Rothschild’s new mining company, Vallar Plc, which has just listed its shares in London? The best brand name in global finances should be able to open a few doors, and resources are a growth industry.
     Some of those investments may do well, others badly. But stick to those four principles and your portfolio should survive just fine. Ignore them, and you can expect to get burned.

     (Matthew Lynn is a Bloomberg News columnist and the author of “Bust,” a forthcoming book on the Greek debt crisis. The opinions expressed are his own.)