Dow 10K stopped by, hello and goodbye.

U.S. stocks gained ground yesterday morning on that Chinese export growth figure for May that we talked about yesterday, and comments from Fed Chairman Bernanke that provided an additional boost -- reiterating that the Fed will act as needed to aid the economic recovery. 

(Never in the postwar era has a recovery needed so much support. Does that make it a recovery?  Maybe, but certainly not an organic expansion.  The 1981-82 recession took seven quarters before real GDP surpassed the previous cycle high, and that was with fed funds hovering around 10%.  Currently, we’re seven quarters from the previous cycle peak and still haven’t returned to that level, with the Fed at virtual zero.)

But there are two sessions to each trading day, and they are becoming increasing bifurcated these days.  Momentum faded in the afternoon as investors were once again forced to think about European economic woes.  While the broad market showed just a 0.60% decline for the day, the afternoon session saw a 2.1% deterioration from the intraday high.

The Dow Jones Industrial Average jumped above the 10K mark after spending three sessions below, but the visit lasted only 60 minutes.

Comments from German Chancellor Merkel took everyone’s attention off of Backstop Bernanke when she stated that bailout packages only buys time for the euro-zone.  She went on to state that the time to withdraw stimulus has come in defending her government’s fiscal austerity plan.  Since Germany is Europe’s ultimate backstop, such anti-bailout commentary is not treated well by this market, it doesn’t like being forced to rely on more intrinsic fundamentals.

Market Activity for June 9, 2010

Mortgage Applications

The Mortgage Bankers Association (MBA) reported that its applications index plunged 12.2% for the week ended June 4 as both refinancing activity and purchases dragged the measure lower. 

Refinancings fell 14.3% even as the average contract interest rate for the 30-year fixed mortgage remained very low, slipping to 4.81% from 4.83% in the previous week.  A decline in refi activity at such a low cost of borrowing shows that those who can refinance (have the equity to do so) already have.  Directly from MBA’s VP of Research and Economics: “Despite the historically low rates, many homeowners have already refinanced recently, remain underwater on their mortgages, have uncertain job situations, or have damaged credit following this downturn, and therefore may not qualify to refinance.”

The index that tracks applications to purchase a home fell for a fifth-straight week, down 5.7% -- that index has slid 42% since April 30 and is 28% below the level of sales before the tax credit was initially put in place back in February 2009. 

It’s been five weeks since the tax credit expired on April 30 (had to sign a contract by that date), so like clockwork sales have retreated.  Just as initial implementation of the home-buyers subsidy pulled sales forward, it happened again with this second go around – it should come as no surprise.  The existing home sales figures beyond July (sales that reflect contract signing post expiration, remember July sales numbers are May and June contract signings) are going to be ugly.   Look out below!

As the foreclosure process, which has been delayed due to attempts to modify loans (many of which are mortgage that cannot be cured as witnessed by recidivism rates), is beginning to pick up more distressed properties will be hitting the market.  Without the sales to absorb this supply there is only one direction for prices to go. 

My concern is what this does to loan quality as banks appear to be pretending home prices will trend higher.  I believe banks have not been setting aside the proper level of provisions to protect capital against non-performing loans due to this fantasy home prices have stabilized.  What this means, if correct, is they’ll be setting aside more cash over the ensuing quarters, which will hurt profits; and the increase in non-performing loans alone makes credit expansion unlikely – a crusher for small business and the labor market.

Weekly Energy Report

The Energy Department reported that crude oil supplies fell 1.82 million barrels last week, nearly double what was expected.  Undoubtedly, we’ve got problems in the Gulf of Mexico as the primary reason for the decline – drilling activity has been shut down due to the BP gusher.  However, crude stockpiles stand at 361.4 million barrels, roughly 10% above the five-year average.

Oil prices were up ahead of this report as traders expected a larger-than-anticipated decline in oil supplies, but those gains were pared as the report also showed gasoline supplies fell much less than expected – down just 8,000 barrels vs. the 500,000 decline that was anticipated.  Gasoline demand over the past four weeks was down 1.0% from year-ago levels.

The price of oil/barrel for July settlement rose 3.3% to $74.38.  The wholesale price of gasoline gained 2.5% to $2.04 (which results in a pump price of about $2.60). 

Beige Book

The Federal Reserve’s Beige Book, a summary of economic conditions within each of its 12 districts and released roughly every six weeks, reported that activity improved modestly. 

* Consumer spending and tourism generally increased.  Consumer spending was focused on necessities rather than big-ticket items during April and May.  Tourism improved with occupancy rates up in New York, Atlanta, Chicago, KC and San Fran.  The Gulf gusher did cause some cancellations. (I suspect there will be more of this in the next Beige Book, specifically within the Atlanta district, which covers Alabama and Florida.)

* Business spending rose on net.  Employment and capital spending edged higher but inventory investment slowed.  (This leveling off in inventory rebuilding will prove evident by the fourth-quarter GDP, by my estimation.)

* Residential real estate was buoyed by the deadline of the tax credit (The next report six weeks from now will show significant deterioration.)  Commercial RE remained weak. 

* Labor market conditions improved slightly, with a little uptick in temporary-to-permanent transitions (That’s a good sign, but we’ll need much more.)  Wage pressures were limited (no surprise there with virtually 10% unemployment)  Prices were basically unchanged (probably the true reality on the ground -- for the most part -- as firms have little pricing power.) 

Bottom line: “Modest” growth isn’t going to do it; it’s not enough to propel the job growth we need that’s sufficient to absorb population growth and labor force re-entries.  The Fed can hold ZIRP in place for another five years and engage in another round of trillion dollar-plus quantitative easing.  The government can spend at levels that make drunken sailors look frugal, as they continue to believe their Keynesian multiplier is 1.4 (problem is it’s closer to 0.7).  But none of this will produce an organic and durable expansion. 

What we need is spending constraint, by eliminating a litany of unnecessary and redundant federal programs and getting entitlement programs in line with the shift in demographics; what we need is a tax policy that drives incentives; what we need is a government that is capable and willing to offer the marketplace relative certainty, a necessary condition for meaningful job growth to materialize.   Alas, the exactly the opposite is in play.  We’ll eventually get things right again, a leadership that understands the importance of the aforementioned points.  Unfortunately, we’re not there yet.

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900