U.S. stocks rallied following an equaling big session overseas the night before.  Some of the excitement was due to better-than-expected European-bank profit results, although we’re seeing this “extend and pretend” scenario play out as the profit boost is helped by a reduction in loan-loss provisions – if credit quality fails to improve then these profits are “all ink,” as Jamie Dimon put it . 

Overall profits in the U.S. continue to come in strong so there is a justified reason for stocks to go higher, unless you see the event as a Catch-22.  That is, if firms begin to hire without substantial final demand materializing then earnings growth will take a quick turn for the worse a couple of quarters out.  If they don’t hire, then final demand doesn’t have a chance of firing up to begin with. 

Yesterday’s relative euphoria seemed more than anything to come on the heels of less-than-favorable results as it appears the what’s-bad-is-good theme is back in vogue, at least for now.  The market’s were clearly juiced by the latest Chinese manufacturing reading released on Sunday night – this news was all the rage pre-market -- and what those results mean for policy in the Pacific region as we look ahead to year end.  That reading showed the weakest factory activity in 17 months occurred in July – China’s PMI fell to 51.2 from 52.1 in June and thus dangerously close to contraction mode (less than 50).  As a result, this got traders thinking the Chinese won’t go full bore with tightening up on their monetary and credit activity and may even end up implementing more stimulus by year end.

As we mentioned last week, the bond market remains a non-believer in this recovery as the yield on the 10-year Treasury remains below 3%, currently resides at 2.91%.  Of course, some of the support to the Treasury market (prices go up, yields go down) is due to expected Fed action, the increased prospects of QE2 and thus more Fed purchases of government bonds.  But not all can be a result of this speculation.  The bond market certainly appears to be calling a double dip. 

Energy and basic material shares led the S&P 500 higher yesterday, up 3.56% and 2.65% respectively.  Consumer staples and health-care shares were the laggards, up just 1.17% and 1.95%, respectively.

Market Activity for August 2, 2010

Crude Oil

The price for a barrel of oil stormed past the $80 mark to $81.56 yesterday even though supplies have jumped for three-straight weeks (up a huge 7.1 million barrels according to last week’s report), placing the total stockpile at 360.8 million barrels – 11% above the five-year average.  That’s a trade driven by a belief that there is more central bank stimulus coming (also why the U.S. dollar got whacked); it can’t be on expectation that demand is about to go through the roof – not when Bernanke is out warning about the danger of increasing interest rates too early, even from these ultra-low emergency levels. 

ISM Manufacturing

The Institute for Supply Management reported that their measure of nationwide manufacturing activity came in at a healthy 55.5 in July, down from 56.2 in June.  The market expected a reading of 54.0 and that was really the cut line with regard to stocks holding their opening gains or not.  A level below 54 is what many are watching as the sign that factory activity is beginning to falter. This latest figure marks the 12^th-straight month of expansion for the manufacturing sector, but is the weakest reading of the year.

In terms of the internals, new orders continue their trend lower as that sub-index fell five points to 53.5 in July – this is the best indicator for future production.  Backlog of orders also continues to trend down, falling to 54.5 in July – down from 57.0 in June and 59.5 in May – but the level remains a pretty good one.  Employment remains in the high 50s, up nearly a point to 58.6 from 57.8 in June – this probably signals we’ll continue to see some factory job growth via the July jobs report on Friday, but it needs to be big to offset the declines in construction.  Export orders continue to propel U.S. factory work, up a ½ point to 56.5 in July.  Customer inventories rose to 39.0 from 38.0 in June – higher is worse for this component as a reading above 50 suggests that respondents believe their customers’ inventories are too low at this time.  The measure has been trending higher over the past two months.

Bottom line, this is a good report on the surface, but it appears we remain on pace for that factory sector weakness that I expect to arise by September -- the number of industries that reported growth in July fell to 10 out of 18, which is down from 13 in June and 17 in May.  It’s at that time (September) in which the combination of weaker export orders and inventory rebuilding running its course will likely send what has been the strongest segment of the economy back into contraction mode.  For now though, the area is holding up.

Construction Spending

The Commerce Department reported that construction spending rose 0.1% (expected to fall 0.5%) in June following a large downward revision for May, which took the decline for the month down to 1.0% after initially reported at -0.2%. 

Activity in June was held up by a massive 10.0% month-over-month jump in public-sector residential construction and a 1.2% increase in non-residential work.  On the private-sector side, residential construction fell 0.8% in June and work on non-residential structures fell 0.5%. 

Over the past three months, public-sector residential construction spending has spiked 55.6% at an annual rate and is up 14.7% on non-residential work.  Private-sector residential is up 10.1% (on the same three-month annualized basis) and down 8.6% on the non-residential side.  The government boost will wane significantly as we progress through the back-half of the year.

Have a great day!