U.S. stocks enjoyed an upbeat pre-market session that funneled into the official trading day after a business sentiment survey in Japan came in above expectations and the Reserve Bank of Australia offered the market positive comments – yes, the same Aussie central bank that suddenly had to halt their monetary tightening campaign after learning things weren’t quite as rosy as they previously expected a couple of months back.

But as has been the case most days since the May 6 flash crash rocked investor complacency, stocks turned lower as the session wore on, dipping to negative territory with 30 minutes to go.  A final push higher delivered the three major indices to the plus side, but much of the earlier gains were erased – the latest data from the service sector didn’t help as it missed expectations.  The Dow, for instance, was up 170 points in the morning, but ended higher by just 57 as traders remain unwilling to commit, and who can blame them with increasing calls for another round of QE-based Fed stimulus – which doesn’t exactly give one a sense that things are on track, but we knew this. 

Nine of the 10 major industry groups closed up with utilities and energy leading the way.  Consumer discretionary was the only group to close down, and they’ll continue to turn down (unless Washington decides to send check directly to households) as it was blind performance chasing that fostered the final leg of the rally from the depths of the March 9 lows – a 25% surge Feb.-April that ignored harsh realities in consumer-land.

Market Activity for July 6, 2010

ISM Service

The Institute for Supply Management reported that their service-sector gauge decelerated to 53.8 in June from 55.4 in the previous month – coming in shy of the 55.0 estimate.  Despite the decline in activity the measure has been in expansion mode (a reading above 50) for seven-straight months.

Overall, the report didn’t look bad.  A reading in the 53 handle is a good one, but after holding at 55 during the three previous months one does become concerned that the weakening suggests trouble ahead, as another of other indicators also suggest.

The new orders, backlog of orders and supplier deliveries remained a pretty good levels even though two of the three decelerated. 

The concern was on the employment, inventory sentiment and export activity readings.

The employment index slipped back to contraction mode, down to 49.7 after one month over 50 (May) – the only 50-plus reading since December 2007.  A high 40s figure, while suggesting contraction, is generally accompanied by some service-sector job growth, as we’ve seen over the past few months.  But we need more aggressive labor-market activity than what we’ve seen, so just hovering around the 50 mark isn’t going to help as we’ve got a large amount of the actual workforce that will eventually re-enter the labor market.

The inventory sentiment gauge remained elevated for a second month, 59.0 in June after 60.5 in May – a higher reading on this measure shows that respondents believe their inventories are too high and thus raises concern that the bulk of the inventory cycle has run its course. 

The export orders measure fell back to contraction territory, sliding to 48.0 from 53.5.  Exports along with inventory rebuilding have really fueled economic activity over the past three quarters and signs that these two segments are running aground is obviously not good.  While new orders remain in expansion mode, weakness in these three areas will probably funnel into orders a couple of months down the road – right around that September period we’ve been expecting overall economic weakness to show up again.

Futures

U.S. stock futures are down this morning and the yield on the 10-year Treasury is below 2.92% as traders believe earnings results will disappoint – the second-quarter earnings season gets rolling in about a week-and-a-half.  The rally in Treasury securities, pushing yields even lower is certainly signaling trouble ahead.  Surely it’s not all about the possibility of another contraction a couple of quarters down the road, speculation that the Fed is going to step in and aggressively buy government bonds sometime before year end also has traders stepping in for some quick profits. 

On earnings though, I’m not sure they’ll disappoint just yet; we have seen very little payroll growth, so even mild revenue gains will flow directly to the bottom line as firms keep costs to an absolute minimum.  It’s the third quarter and into the fourth in which we’ll see the profit story fizzle out, led lower by financials. 

Even a Fed at zero, the central bank subsidizing bank earnings at the expense of the depositor, won’t overcome the next round of mortgage losses as home prices decline over the next few months and strategic defaults rise again – more underwater mortgages will drive the strategic default.   This problem could have been managed if banks would have been setting aside more provisions for future losses.  But they chose to pretend that the housing market was in a durable, albeit soft, upswing.  This decision boosted profits in the very short term, but will result in profit deterioration in near future.

Have a great day!

Brent Vondera, Senior Analyst