U.S. stocks spent most of the session in positive territory, and looked set to complete the first five-day winning streak since April (when the broad market hit its 19-month high), but it was not to be as the rally fizzled out in the final minutes.

Stocks were fueled for most of the session by better-than-expected retail sales and inventory figures, along with news that Cisco Systems will initiate a dividend – the company is said to be targeting a 1-2% yield.  But Chairman/CEO John Chambers’ comments, later in the conference call, that the economy has become “bumpy” relative to three months ago threw a little cold water on the rally.

The economic news from retail sales and inventories allowed the market to brush off yet another ugly reading from the NFIB’s gauge of small business confidence, which remained in recessionary territory for August.  But even with regard to the reports that were positive, retail sales offered no evidence that activity will improve in a consistent manner (meaning the gains weren’t broad based) and the inventory report may be signaling the rebuilding cycle has largely run its course (inventories have outpaced sales activity for three-straight months).

On the dividend announcements, these are good signs for future return expectations, if and only if firms show a commitment to add to payout ratios over the longer term.  What gives me pause here is that a trend has emerged in which companies are borrowing to fund these dividend payouts – a strategy that is understandable due to the extremely low cost of money, but it doesn’t exactly give one confidence that future commitment will be there.  What’s more, I would think that due to the high likelihood dividend tax rates for the top two federal tax brackets are going to dramatically increase, and end up a lot higher than the capital gains tax, that firms would choose to borrow in order to buy back shares rather focus on dividends.  The affluent investor will return to demanding that firms focus on their stock price rather than dividends as that’s where the after-tax return may be enhanced due to the decision to eliminate the equilibrium between the two tax rates.  (The tax rate on capital gains is set to increase to 20% and for dividend income to 36% and 39.6% for the top two federal tax brackets – currently, they both reside at 15%.)

Tech and health-care shares were the outperformers; telecoms and consumer staples were in the middle of the pack; financials and industrials the worst performers.  Of the 10 major industry groups, gains and losses were split, with five up and five down. 

For the quarter, which comes to an end in two weeks, basic material and telecoms are the best performing groups.  Since hitting the April 20 intermediate-term high, telecom and utility shares are the best. 

Market Activity for September 14, 2010

NFIB

The National Federation of Independent Business reported that their small business confidence index rose slightly in August to 88.8 (89.0 was expected) from 88.1.  So, the measure remains below the vital 90 level (sub-90 shows small business remains in recession). 

Four of the measure’s 11 major components improved (higher selling prices, expect a better economy, expect higher sales and positions not able to fill) but they remain at depressed levels. 

For the other seven, they deteriorated further as the plan to increase capital spending and plan to increase inventories components have turned back down – floored on the business spending indicator and sliding back toward ugly levels for inventories. 

Since these have been two areas that have helped the GDP figures, well it doesn’t show much momentum is present for 2010’s second half.

The troubles within the small-business community – higher costs from health-care legislation, uncertainty over tax rates and flat-to-very low sales activity – continue and that spells trouble for the labor market. 

Retail Sales

Back-to-school, and no I’m not talking about the 1980s classic – ok, calling it a classic may be a bit of a stretch, was the theme for August retail sales.  The figure rose at a better-than-expected 0.4% in August (+0.3% was expected) but from a downwardly revised 0.3% (previously 0.4%) in July. 

And for the exclusions: Excluding autos, retail sales rose 0.6% (vehicles and parts fell 0.7%).  Excluding gasoline, retail sales rose 0.3% (gasoline station receipts jumped a big 1.9%, which followed a large 2.2% increase in July -- summer driving I suppose).  Excluding gas, autos and building materials (what’s known as core sales, the figure that is directly plugged into the consumer spending figure of GDP) sales rose 0.6% - that’s a number that was needed for Q3 GDP as the July figure declined 0.1%.

So what drove headline the number?  It was spending on gasoline (up 1.9%), clothing (up 1.2%), sporting goods (up 0.9%), internet retailing (up 0.6%) and groceries (up 1.3%). Put together the traditional clothing retail, online sales and sporting goods and it has a back-to-school tone to it. 

The weakest components were electronics sales (down 1.1%) -- which have turned back down over the past couple of months, the aforementioned car sales (off by 0.7%) and furniture (down 0.5%).

So the overall reading improved a bit more than estimated and the core figure showed a nice rise after getting the quarter started off poorly in July.  This is a pretty good report, save the turn down in electronics and the furniture sales data (which shows troubles in the housing sector). 

Overall though, one can’t get excited until we’re able to move to an environment in which the consumer is able to propel sales higher in a consistent manner.  Retail sales remain 4.3% below the 2007 peak, which is the longest amount of time in which retail activity hasn’t returned to expansion mode – most recessions merely see retail sales flatten out and are making new highs within 18-24 months.   This time, however, we saw sales fall more than any time in the postwar era and nearly three years later are still not close to a new peak. 

Business Inventories

The Commerce Department reported that business inventories rose 1.0% in July (easily surpassing the 0.7% estimate) and the June reading was revised up to 0.5% (0.3% initially reported).  The higher revision for June will result in a mild boost to the final Q2 GDP revision, assuming no substantial downward revisions somewhere else.

The sales data within the report rose 0.7% in July, bouncing back from two negative readings in a row for May and June.  While sales were able to rebound, the rate of increase failed to meet the rate of growth in stockpiles, and this marks the third-straight month in which the mismatch occurred in the wrong manner – you’d much rather see sales activity outpacing inventory rebuilding as this will keep stockpiles low and provide the incentive to continue producing. 

That said, inventory levels do remain very low for now, near historic lows in fact, so unless the economy completely derails there’s very little chance of a major production declines.  But that doesn’t matter, the fact that the inventory cycle appears to have run its course is trouble enough for an economy that’s relied heavily on inventory rebuilding to boost GDP.  And the area I’m most concerned about, as expressed for a couple of months now, is auto inventories.  These inventories have jumped 7.4% since May, while auto dealer sales are down 1.6%. 

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900