U.S. stocks remained under pressure as the 5% slide in Shanghai overnight (Sunday night) and continued concerns that the European crisis will derail the global economic recovery weighed on investor sentiment.  However, the market shook off its morning-session weakness, rallying in the afternoon to erase a 1.8% decline, closing just above the cut line. 

Six of the 10 major industry groups gained ground during the session.  Telecom and consumer staple stocks led the led the way – so there remains a safe-haven play here (telecoms are not traditional safe-havens, but since the sector is dominated by Verizon and AT&T it is the dividend yields that has investors seeking succor in this area).   Energy shares led the four declining groups.  Industrials, basic material and financials rounded out the losing sectors. 

We’ve talked about this European debt crisis since first bringing it up in the December 9, 2009 letter and really got into it with the February 10 issue when we stated: It was always a fantasy that the EU would escape bailing out Greece, and unless things go very well they’ll be bailing other countries too as the Greek situation is the canary in the coal mine.  But we’ve also said that EU trouble has implications beyond that continent as the eurozone is the world’s second-largest importer (a plunging euro will make life more difficult on the globe’s main exporting economies – specifically Asia) and the entire situation puts the hurt on European banks.  It appears the market is beginning to think about these implications and unfortunately is likely to keep pressure on riskier assets. 

Market Activity for May 17, 2010

Empire Manufacturing

The New York Federal Reserve Bank’s gauge of manufacturing activity within the second Fed district came in at 19.11 for May (well below expectations) after a very hot 31.86 reading in April.  This marks the 10^th month of expansion for the Empire Manufacturing Index (a reading above zero marks expansion), but quite a bit slower than the robust activity of late and the internals showed things may weaken further in the months ahead. 

The new orders index continued to post a good number, cut in half from April’s reading but the 14.30 for the month shows good order growth.  However, the delivery time and backlog of orders figures (two areas we’ve been keeping very close eye on) failed to keep their growth streak going.  Delivery times retuned to contraction after two months of expansion and backlog of orders contracted for a second-straight month.  Inventories fell 10 points to 1.32 (and future inventories, expectations six months out, fell to contraction for the first time in six months).  The number of employees accelerated to 22.37, about as strong as this segment gets (nearly a third of respondents reported an increase in hiring), but the average workweek measure slid 13.92 points to zero – this suggests the hires were part-timers. 

And then we have the prices paid figure, which is showing factories are going to struggle with margins as prices received have actually turned down again.  The difference between prices paid and received is one of the largest in the survey’s history (although a short history as Empire began in 2001) – not good for profit margins. 

NAHB HMI and Foreclosures

The National Association of Home Builders’ Home Market Index (HMI) increased for a second-straight month, hitting the highest level in over two years.  The HMI rose to 22 for May from April’s reading of 19.  The bounce over the past two readings clearly reflects builders reacting to the sales boost as home-buyers came in before the tax-credit deadline.  (A reading below 50 indicates that more builders view sales conditions as “poor” than those stating conditions are “good.”  So a reading of 22 isn’t much to get excited about, but everything’s relative.)

And while we’re on the topic of the housing market, I didn’t get a chance to touch on the April foreclosure numbers that were out last Thursday, so here you go:

The April figures on foreclosure extended the 300K-plus/month foreclosure filing streak to 14 months, according to RealtyTrac.  The good news is that foreclosure filings declined 9% to 333,837 from March’s record high reading 367,056. 

What kept foreclosure filings above 300K again in April was a rise in REO (real estate-owned by the bank, the final stage of the foreclosure process) to a record high.  However, NODs (notice of default, the first stage of the foreclosure process) fell. 

We hope the NOD figures suggests the beginning of a trend lower, but REOs are likely to remain elevated as the government had placed moratoriums on foreclosures and many of these defaults have been desperately pushed through the modification process (never intended to make it to permanent modification, just to delay the foreclosure process through the election.)  As a result, there is a large backlog of previously filed NODs that will keep distressed sales elevated over the next many months. 

If housing endures another round of price declines, which I believe will occur based on more distressed sales hitting the market, then NODs will rise again and stretch the period of time with which distressed sales will dominate the market.  If not, and the market has found a market-clearing price, then we still have another year of foreclosures adding to supply. 

Even assuming the best outcome, a high level of distressed sales will continue to make life unpleasant for home builders and all but guarantees that the NAHB HMI will remain depressed, and likely endure another move lower even from current low levels.

Finally, just to back up the above parenthetical statement, have you seen the latest median debt-to-income numbers for home-borrowers being filtered through HAMP (the government mortgage modification program)?  The median front-end debt/income is 44% -- that means that the mortgage payment, insurance and real estate taxes make up 44% of pre-tax income.  The back-end debt/income is 64% -- that is the mortgage payment, insurance and taxes in addition to the car payment, credit-card payment and student loan payment. And this is after the trial modification has begun – before the modification the median back-end debt/income ratio was 80.2%!  These people couldn’t get modified unless the mortgage balance was forgiven – I shouldn’t give Washington any ideas. 

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900

www.acrinv.com