U.S. stocks began the session higher on Tuesday, but prices deteriorated as we headed into the afternoon session.  Chances of recovery within the eurozone are falling, which caused traders to run for a little more cover.   German Chancellor Merkel sated that she would support a tax on the financial sector to help fund the costs of the sovereign-debt rescue plan.

Combining with this ongoing worry was a surprise ban on naked short-selling and credit-default swaps by German regulators.  I’m certainly not going to defend naked positions, but this sudden unilateral decision had on affect on U.S. trading as people believed it would shake up European markets when they opened last night – and indeed they were shaken, down 2.5%-3.0% across the board.  Politicians can maintain their attempt to control the markets from responding to terrible policy decisions, but if they take away just one in a number of ways to short policy then traders will just shift their assault to the currency – and the euro surely doesn’t need additional attack. 

Further complicating things was an amendment out of the U.S. Senate that would allow states to enforce their own credit-card rate limits regardless of where the issuer is located.  Banks currently get around various state usury laws by domiciling in states with the least regulations – imagine that.  Differing state laws is about as messy as legislation can get, leading to confusion within the industry.  This is on top of the debit-card “swipe” fees – the fees charged to merchants on each transaction, which continues to whack shares of Visa and MasterCard.  Financial regulation is really starting roll.  

To no surprise, financial shares led the market lower.  Consumer discretionary shares also got hit hard, along with tech.  Consumer staples and telecoms were the relative winners for a third session.  All 10 major groups did decline during the session.

In other regulatory news, U.S. stock exchanges and regulators proposed a six-month pilot program to help guard against events like the “flash crash” that occurred on May 6.  Circuit breakers will be put in place on individual stocks (trading paused if a stock price moves 10% or more in a five-minute period).  Broader circuit breakers will be rolled out at a later date that will force a pause in market-wide trading.  These new circuit breakers are aimed at electronic exchanges.  The New York Stock Exchange has had circuit breakers in place for many years, as laid out below the jump.

Market Activity for May 18, 2010

NYSE circuit breakers are in Eastern Time.

In the event of a 1050-POINT decline in the DJIA (10 percent):

In the event of a 2150-POINT decline in the DJIA (20 percent):

In the event of a 3200-POINT decline in the DJIA (30 percent), regardless of the time, MARKET CLOSES for the day.

Producer Prices

The Labor Department reported that producer prices fell 0.1% for April (expected to rise 0.1%) after a 0.7% pick up in March.  The decline was due to a 1.3% fall in residential gas and a 2.7% slide in wholesale gasoline.

Prices in the pipeline were not so benign, in fact not benign at all, as intermediate goods prices rose 0.8%, up 8.6% y/o/y.  At the initial stage of production, crude materials, prices fell 1.2% as the energy component slid 5.9%.  However, this component (crude materials) is up 28.8% from the year-ago level – a depressed level of a year ago, but that’s a move you can’t totally ignore. 

I wouldn’t fear inflation just yet, the weakness of the global recovery and the continued contraction in lending will hold inflation back, certainly longer than I anticipated a year ago.  But one has to eventually acknowledge that the Fed is not only attempting to reflate things, but will attempt to incite 5%-6% inflation, and once that devil is out it’s tough to stuff him back into the crypt.  Bernanke is still worried about depression, and thus he sees inflation as the lesser of two evils; he’s going to err on the side of inflation rather than deal with another major contraction.  

In the end, we’ll get another major contraction, and frankly I believe a milder one two-three quarters out, because the policy tighten that is necessary to stamp out high inflationary levels has to be severe.  (Just to explain the mild contraction comment.  I believe the recovery we’re seeing now is largely artificial, propped up by the Fed at zero and government fiscal stimulus.  When that fiscal stimulus begins to wane, which will occur in the back-half of the year, the economy will not be strong enough to stand on its own.)

Housing Starts

The Commerce Department reported that builders broke ground on more new homes than expected in April as starts rose 5.8% from the prior month – 672,000 units at an a seasonally-adjusted annual rate (SAAR), beating expectations by 22,000 units. 

So, housing starts remain at very depressed levels, particularly from historical and population perspectives, but have jumped 11% over the past two reporting months.  Considering the challenges the housing market continues to face – high foreclosure rates and the distressed sales that follow, a fat pipeline of NODs (notice of default) that must still be worked through the system, the likelihood that the jobless rate will remain stubbornly high for an extended period and persistently high debt-to-income levels – this increase in home building is not going to prove helpful. 

In time home builders will be able to ramp up new home construction in a consistent manner and those units will be absorbed by household formation.  However, for now builders will have to contend with distressed properties (chart below), which currently make up 40% of previously-owned home sales, and the likelihood that household formation will remain weak due to the economic environment.

In fact, the permit data (a clear indication of future building) appeared to indicate the recent home building will prove to be very short-lived.  Building permits slid 11.5% in April – largest decline since December 2008, which reflects the extent to which activity is likely to retrench as the home-buyers’ tax credit has officially expired.  Of course, we’ll really need a couple more months of data to confirm this, one can’t conclude too much from one month’s figure.  But the fundamentals within the housing market hardly suggest that this decline in April was a one-off event. 

Risk?  What Risk? Give Me Yield Baby!

Moody’s Investor Service released a report stating that junk-bond investors are accepting the weakest creditor protections since 2007, such as fewer restrictions on using assets as collateral for future borrowing and thus reducing the funds available to meet creditors’ claims in bankruptcy.  Corporate borrowers are offering debt on terms historically available only to higher-rated companies.

This is something we’ve spent much time on over the past year or so, but we’ve concentrated on returns relative to risk rather than on debt covenants as the Moody’s report focused on.  Current returns do not appear to compensate for the risks one must accept in this economic environment.  Investors have clearly pushed aside consideration of the risk they are taking on, focusing solely on yield.  Such is one of the perils of the Fed’s unprecedented monetary-easing campaign -- push interest rates on relatively safe assets to zilch, or close to it, and you’ll get people to flood into riskier assets.  Alas, such scenarios do not end well.  How quickly we forget. 

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900

www.acrinv.com