U.S. stocks extended the latest winning streak to three days and the Dow, after facing afternoon rejection during a number of sessions over the past 10 trading days, finally closed above the 11000 mark for the first time in 18 months.  This is now the third, I’m going to say secular, run through 11K after initially breaking through in May 1999.

A plan, this time with specifics (although it would take unanimous consent to implement), to bail out Greece from its debt financing problems helped stocks in pre-market trading.  The hope that the first-quarter earnings season would post good results helped momentum just enough to hold onto half of the early-session gains – and the current earnings season will be a good one, it’s a couple of quarters out when things may get sketchy, as we’ll get to below.

First-quarter earnings season kicked off last night after the closing bell, but won’t begin in earnest for another week.  Within three weeks time we’ll have about 30% of S&P 500 members in and a pretty good idea of how the season will turn out. 

The fourth quarter of 2009 ended a nine-quarter string of declining earnings as ex-financial S&P 500 earnings per share rose 13.8%.  This quarter the market expects 25%, and we should get that as industrials will finally begin to help out and consumer discretionary will have the easiest comparisons (remember what was occurring a year ago) in a very long time, if not ever.  (Earnings results are matched against the year-ago period.)

Six of the major 10 industry groups led the broad market higher.  Financials performed the best, with utility and technology shares not far behind.  Basic material and health-care led the losers for the third-straight session.  Telecom and consumer discretionary shares rounded out the sectors that ended in the red. 

Market Activity for April 12, 2010

Provisions, and Living on a Prayer…and no I’m not a Bon Jovi fan, just for the record

Bloomberg News reported that the largest banks may have to set aside an additional $30 billion to cover potential losses on home-equity loans alone – the largest four banks hold more than 40% of the $1.1 trillion in second-lien mortgages, according Amherst Securities (a leading market maker for mortgage-backed securities).  And the level of provisions (cash set aside to protect capital ratios from potential losses) that will need to be increased among all insured banks is much greater when we think about first mortgages, unless the housing market is about to engage in a sustained rebound.

I like how the mainstream press corps is finally getting up to speed and reporting on this story.  As we’ve talked about several times, the FDIC’s own coverage ratio, which tracks the relationship between noncurrent loans and the provisions set aside to protect capital against these potential losses continued to decline.  In the fourth-quarter, the most recent data, the coverage ratio fell to 59% from 61% in the third quarter – and that’s down from 74% a year ago and less than half the historic average. 

At some point, insured banks will not have the luxury of living on the prayer that the housing market is about to begin even a mild recovery anytime soon.  Foreclosure filings continue to run at 300,000-plus per month and last week Bank of America forecasted that monthly foreclosures will jump dramatically by year end.  As these foreclosures hit the market it is going to put pressure on prices, which is going to increase the number of underwater mortgages.  (And if House Banking Committee Chairman Frank gets his way in forcing banks to reduce principal payments on all 11 million underwater mortgages then we’ll have another massive write down cycle on our hands.  Banks must have the leeway to use principal reductions as a strategic tool; force them to broadly forgive principal -- a Congressional tool to halt foreclosures -- and you can count on higher mortgage rates, continued credit contraction and market turmoil that we don’t need to endure.)

When banks come back to reality and get provisions to a pace that keeps up with the rise in noncurrent loans it will hit their earnings and damage total S&P 500 profits.  Financial-industry profits are by far the catalyst behind the return to positive S&P 500 earnings last quarter – total S&P 500 earnings per share (EPS) surged 176% from the year-ago period, exclude financials EPS rose 13.8%. 

Commodity Inflation

The inflation gauges are printing tame readings and that should remain the case for a while – of course, the fact that the housing component of the CPI makes up 42% of the index is also holding the gauge down.  But if the Fed isn’t careful we will have a problem on our hands.  As they myopically watch the labor market and wages, the conventional wisdom within the Fed is that if job growth is absent then wages won’t rise and thus inflation cannot take off, they’ll miss the boost in costs that result from higher energy and metals prices. 

After surging 22% in two months time, the price of oil has settled in at the mid-$80/barrel level over the past week as the jobless claims data and a larger-than-expected build in crude stockpiles last week hit demand expectations – we may have otherwise moved right through $90.  But the latest dovish comments from the two most listened to Fed officials, Bernanke and Kohn (and dovish just means they are not worried about inflation so find no problem with keeping ZIRP in place), will only lead traders to push the price of commodities higher.  You see, we won’t need higher demand; the fact that the Fed is signaling no end in sight to record-low fed funds gets people looking for quick profits via this trade.  This means higher pump and materials prices.  As each month turns, we’ll find Fed policy will turn from tailwind to headwind if Bernanke & Co. are not very careful. 

March Budget Statement

The U.S. posted a budget deficit in March for a record 18^th consecutive month in March.  (While deficits, of varying degree, are the norm, it is unusual to go this long as the months of April, June, September and January often record surpluses - - but this wasn’t the typical recession either.)

No reason to spend much time on the topic, we all know we’re running extraordinarily deep deficits and that’s going to be the case for...well, some time.   If we can achieve several years of profit growth, which is what occurs during the normal expansion (although I’m a bit skeptical as laid out above) and healthy/consistent job growth, most of these deficits will be cut to levels that are manageable – at least until the demographic shift goes into full throttle with baby boomers hitting Social Security and Medicare retirement age. 

To solve much of this problem is really quite simple, although politically difficult:  Slash non-essential spending (and there’s a lot of it to cut); reform Social Security and Medicare by raising the retirement ages for those 50 and under (these programs were never meant for 20 years of recipient payouts); and put in place a tax policy that greatly simplifies the tax code, drives incentives and offers businesses confidence to boost payrolls.  Implement these very common sense  policies and we’re golden.  Now all we need to do is reverse course and do it.

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900

www.acrinv.com