Time for a correction?

We certainly have not participated in this great rally, and we must admit, we regret such misstep. However, we remain skeptical as although the economy has avoided the black hole, recovery is no where in sight. Unfortunately, in our opinion, the market has not yet realized such ... reality.

Unemployment

July unemployment numbers came in better than expected. Those figures included decline of 247k in non-farm payrolls (compared to the market's expectation of -325k), 33.1 average working hours, 0.2% higher average wages, and a 9.4% unemployment rate. In our opinion, these not so bad numbers were temporary and are misleading. Decline in non-farm payrolls was impacted by more government jobs (which we hope are only temporary as the last thing we need is further expansion of the government), higher payrolls in healthcare, and the seasonally expected higher payrolls in hospitality/leisure.

However, heavy declines in other industries such as manufacturing were alarming. Manufacturing employment declined by 52k. We note that this number was helped by a 28k increase in auto workers, which we believe is temporary and driven by the famous "cash for clunkers" program. Also, as stated by the BLS, these numbers were not that bad because there may not be any more jobs (and other costs) to cut in manufacturing. Professional and business services industries lost another 38k. And financial services shed another 13k jobs in July.

What caught our attention were the temporary help and part-time employment figures. Historically, those have been leading indicators of recovery. However, we did not see any improvement in those figures. We currently have nearly 9MM part-time workers. Temporary help, which is considered a segment of professional and business services, continues to fall.

Increase in weekly average hours of work was somewhat of good news. But then again, given the lack of stability in most positions within the workforce combined with continuing decline in employment, many are working harder just to keep their jobs. In addition, although total average weekly earnings increased slightly, we believe such movement was driven not only by more hours worked, but also partially by the increase in minimum wages which went into effect in late July. Of course higher minimum wages could impact weekly earnings more positively, but we believe it will also drive many companies to layoff more workers.

The July 9.4% unemployment rate was very welcomed by the market. Unfortunately, many overlooked the fact that such figure was due to many unemployed no longer looking for jobs. The BLS stated that the labor force participation rate declined by 20bps in July. The BLS excludes those when calculating the 'official' unemployment rate. Luckily, it also provides a rate which includes the discouraged workers. Unfortunately that rate increased to 10.2% in July from 10.1% in June.

Overall, the employment situation in the U.S. has not improved. Of course, the figures that we discussed are lagging indicators. However, the employment figures that we consider as leading indicators, such as jobless claims, remain very weak. Last week's initial jobless claims came in at 558k, approx. 14k higher than market’s expectation. Initial jobless claims have remained above 500k for approx. nine months.

Lastly regarding employment, some are comparing the current situation to previous recessions. As displayed by the graph below (provided by FAO-Economics), some believe that the similarities seen in the chart indicate that we are well on our way to a recovery. We must note several differences between this recession and the ones included in the graph. First, we believe this recovery will be another jobless recovery, similar to the last two recessions. As displayed in the chart, employment did not recover to pre-recession levels. However, we note that consumer debt levels were also lower in those recessions, which leads us to believe that employment may not be a lagging indicator during this downturn. In order for consumption to recover, consumers can no longer borrow more (although the government can!). For this reason consumption, which represents 70%+ of the economy, will not aid in recovery until there is some improvement in the employment picture.


Figure 1 (provided by FAO-Economics)

Consumption

Consumption remains weak as shown by last week's retail report which indicated a 0.1% decline, worse than the market's expectation of a 0.8% increase. That figure was more disappointing when we exclude auto sales, which of course have been pumped up by the "cash for clunkers" government program.

In order for consumption to rebound, we need some stabilization in the declining consumer revolving credit, combined with increase in consumer confidence. However, both continue to decline (Figure 2). We note that week's preliminary University of Michigan consumer confidence of 63.2 was significantly below the 69.0 consensus estimate.


Figure 2

What we are looking for is a combination of deleveraging, higher savings rates followed by stabilization in unemployment, all of which represent a slow recovery. Unfortunately, this is not yet taking place.

Although we are seeing some deleveraging in consumer balance sheets, as the revolving credit continues to decline, we have not yet seen a correction in revolving credit as a percentage of disposable income (Figure 3). We believe this is mainly due to continuing rise in unemployment (Figure 4), which may not be a lagging indicator in this recession.

Figure 3


Figure 4

We note that we may see some sequential improvement in consumption in August, which would be due to seasonality (back-to-school spending) and not necessarily consumers wanting to spend more.

Lastly regarding consumption, the bulls are now widely using the phrase "pent-up demand" (we no longer hear or read the "green shoots" phrase too often) and believe it will drive the economy to full recovery in 2H09. In order for consumers to meet their pent-up demand, they must have income, credit and/or other assets. Unfortunately, currently that is not the case. Many also state that consumers have profited from the latest rally in equities. Unless consumers are the institutional funds, we must disagree. Unfortunately, it is more likely that the average investor jumps in at the peak of this rally, which of course is bad news. We note that approx. 25% of the population is in the 45 - 64 year age bracket; and this figure continues to increase every year. We believe that with so many risks and uncertainties associated with the economy, the job market and the equity market, which all significantly impact retirement savings, it is unlikely that most individuals in this age group jumped in (after getting out in late '08 and early '09) and benefited from this rally.

Housing Market

We have seen some improvement in the housing market as June sales of existing and new homes increased 3.6% and 11.0% sequentially. However, we believe this has been driven by the great 'gift' that the government provides for first-time buyers. We wonder how the housing market will behave after such 'gift' expires by the end of November.

Inventory remains high as the months-to-sales figures for both existing and new homes remain significantly above historical average and prior recessions. June's month-to-sales ratio came in at 8.8, which was a significant improvement from May's 10.7. However, we believe such improvement is temporary and, again, based on government's gift to first-time-buyers. Increase in new home construction, which many believe is positive, will add to the market's inventory dilemma.

There are many questions regarding the housing market, such as - what will happen once the government no longer induces many to buy? Have employment, credit and savings improved enough to maintain the slight upward movement that we have seen during the last two months? Has the average investor profited from this latest rally in equities in order to put his/her gains towards a new home, a transaction which now will likely be based on higher mortgage rates? We believe answers to these questions clearly point to continuing weakness in the housing market. Although, again, we note that the government's assistance could artificially create additional upside during the next couple of months.

Of course, this government could continue to run the economy (and not the country), and may not only extend its housing 'gift' policy, but also provide more so-called incentives for people to spend while they are in debt and/or unemployed. Mortgage rates are higher but home sales are also increasing, while income is declining and job losses continue. What does this mean? It means again that the only factor behind the recent higher home sales is the 'gift' policy, which again could be 'wrapped up' by the end of November. Adverse impact of such policy, besides not allowing the housing market to correct itself, is that it could lure many sellers to take their homes off the market. Some sellers could begin thinking that 'hey, maybe I should wait. Prices are slowly going up, so I'll wait to get a higher bid.' If this occurs, we can expect additional increase in inventory.

July housing starts and existing home sales figures will be released this week, which we believe will likely be in-line or better than expected. But again, we believe this is temporary.

Q2 earnings season has ended

Pessimism which lowered expectations and drove many analysts to post very low Q2 estimates, was certainly helpful for many public companies during the Q2 earnings season.

However, we note that as of last week S&P 500 Q2 operating earnings actually came in lower than expected. According to the latest S&P numbers, Q2 earnings were $13.94/share, lower than the $14.31/share estimate that we saw in late June. We note that the latest S&P figure is based on approx. 91% of S&P 500 companies’ earnings.

Although the market has spiked up approx. 50% since the Match lows, we expect continuing pessimism as estimates across the board have been adjusted lower. Q3 and Q4 estimates are now 4% lower than they were in late June. For 2010, Q1 and Q2 projections have been adjusted lower by 2%, Q3 by 3% and Q4 by approx. 0.5%. In our opinion, these numbers indicate that the market just may be ahead of itself.

Summary

We believe that the state of the economy has not improved as much as the equity market currently indicates. Given where the S&P 500 closed at last Friday, it appears that the market expects a rapid or 'V' shaped recovery, although the S&P 500 operating earnings estimates indicate otherwise. Given continuing weakness in employment, consumption and the housing market, we believe the economy has a long way to go before recovering. For this reason, the market is overvalued and we expect a correction within the next couple of months, more specifically, before the start of the Q3 earnings season.

Is Alcoa a bellwether for the US economy?

It is becoming pretty tough to answer yes to this question, especially after Alcoa's Q2 earnings release.

We won't go through the earnings results as everyone is aware that they came in better-than-expected, driven by cost reduction and strong demand in China. Another pleasant surprise was the Company's revenue figure, which was nearly $300MM higher than what the analysts were looking for.

With that said, from a macro standpoint, nearly everything else mentioned on the call was negative. It appears that the Company's well-being is in China's hands. We do not view the better results as a signal for an economic turnaround in the U.S. anytime soon.

According to CEO Klaus Kleinfeld, global aluminum demand projection for 2009 has not changed. It remains at -7.0%. However, without China, that figure slides down to -10.0%. The Company's projection for various end markets is provided below:

Source: Alcoa analysis

Obviously, when it comes to North America, we're not seeing any good news in the table above. And who knows how significantly this could change in 2010, given the lack of consumption, unemployment, and higher savings; all of which are indications of no demand, resulting in less manufacturing and construction.

China is the only region in which Alcoa expects to see some growth. According to Kleinfeld, the fact that China's stimulus plan has strong infrastructure components, or is "shovel ready", is helping Alcoa. In addition, given China's average domestic savings rate of 40%, the government is pushing the Chinese to lower that rate, open credit card accounts and consume. Unfortunately, that is not the case with us, nor can we afford to do that.

Kleinfeld did mention that the automotive industry in the U.S. may be stabilizing in 2H09, but then again, we do know that such stabilization is nothing but inventory replenishment, demand for which is not yet clear. And we must say this may also be partially driven by the 'cash for clunkers' government policy, which will not positively impact auto demand in the long-run. As a reminder, June auto sales (announced last week) came in below expectations, below 10.0MM and below sales in May.

Overall, even though Alcoa's Q2 results beat expectations, we do not view it as an indication of a turnaround in or stabilization of the U.S. economy. Cost reduction and strong demand from China were behind those results. We do not yet see significant increase in consumption, stabilization of the unemployment rate, decline in savings rate nor an end to the deleveraging that nearly every household continues to execute.

The fantasy-to-reality consumer transition will take time

It appears that it will take some time for consumption to rebound in the U.S., which could lengthen the recovery of this latest recession.

In order for consumption to rebound, we need some stabilization in the declining consumer revolving credit, combined with increase in consumer confidence. However, both continue to decline. We note that the increase in consumer confidence since April '09 is likely due to what we believe to be a non-warranted 33% increase in the equity market since the March lows.
What we are looking for is a combination of deleveraging, higher savings rates followed by stabilization in unemployment, all of which represent a slow recovery.

Although we are seeing some deleveraging in consumer balance sheets, as the revolving credit continues to decline (Figure 1), we have not yet seen a correction in revolving credit as a percentage of disposable income (Figure 2). We believe this is mainly due to continuing rise in unemployment (Figure 3), which we do not view as a lagging indicator in this recession. We also believe that more and more of the currently employed consumers are becoming cautious as they may be next. This also explains the continuing increase in savings rate.

Figure 1





Figure 2

Figure 3

Higher credit card default rates, decline in home equity loans (as the housing market has yet to hit a bottom) also provide support for our view that consumption recovery will not begin in Q3, nor in Q4.

We would like to see savings rate climb to 8% (from 6.9% in May), the level at which it stabilized in the late 80's. In addition, although it may sound extreme, we would also like to see revolving credit as a percentage of disposable income to decline to 4% - 6% (from 8.5%), where it was in the late 80's. During the mid-to-late 80's, we believe consumers were 'wowed' more by credit cards. Unfortunately, over time, the increased awareness of credit cards, changed American consumer behavior and started the enormous leveraging for which we are now paying. Of course, although we are hoping for consumers to once again become realists, the federal government's policies and unfounded optimism may lengthen the fantasy-to-reality transition.

Lastly, the Fed will provide an update on change in consumer credit on Wednesday at 3pm (ET). The current consensus stands at -$7.5 billion, which we hope will be met. We note that although this data is somewhat lagging, again, the trends we see will provide us a clearer picture of a maybe-recovery.

Savings rate highest in 15 years

We believe the American consumer is taking the right steps to survive the current crisis - deleverage and increase savings. Of course, these steps do not help stimulate the consumer spending dependent economy in the short-term; and that's fine with us. As mentioned in our June 17 article, "The Savings Rate Must Increase", savings rate must increase in order to reduce consumer debt, restore long-term consumer confidence, and provide capital for overall economic growth.

May's Personal Income and Outlays report, which was published earlier this morning, indicated consumers may be thinking along the same lines. While personal income increased 1.4%, much higher than expected mainly due to government payouts, personal consumption expenditures (PCE) were only in-line with expectations, at 0.3%, which resulted in a 6.9% savings rate, the highest in 15 years. We must note that such a high rate is driven by the higher 'government sponsored' income, which we believe (and hope) will not continue. In fact, wages and salaries (excl. govt. payouts) decreased 10bps for the month. That decline could have been higher if it were not for a 20bps increase in wages and salaries of government jobs. Without government assistance, we may have seen a decline in consumption.

While we view this morning's report as positive, we believe in order for the economy to benefit from higher savings rate, consumers will have to maintain savings rates above 6% for another 3 - 9 months.

On a positive note, higher savings may also drive a potential recovery of the housing market as they can keep inflation and interest rates, therefore mortgage rates, low. However, we believe this will be more than offset by unemployment in the short to medium term.

We continue to expect more savings, minimal growth in consumer spending, therefore a slower turnaround in the GDP, from which the economy and the country will benefit in the long-run.

Michigan Consumer Sentiment - good & bad

There were no surprises in the Michigan Consumer Survey published this morning. The overall index increased to 70.8 in June, from May's 68.2. This figure was the highest since September of last year.

However, the increase was mainly driven by the Present Conditions index, which includes the rally that we have seen in the equity market. In fact, the Expectations index actually declined slightly to 69.2, from 69.4, indicating that consumers remain doubtful. The decline in June reversed a three month increase which had begun in March.

The lower expectations index, combined with higher savings rate that we saw in the personal income report, indicate a slower recovery in consumption.

Initial claims disappoint, as we expected; last week's revised upward

Claims for the week of June 20 jumped to 627k from upwardly revised 612k. The 4-week average of initial claims also went up. It increased to 617,250 from 616,750.

In addition, as we expected, continuing claims increased, reversing what many "green shooters" were referring to as the start of a downward trend. The only slightly positive news was that the 4-week average of continuing claims declined by 3,250. However, again we have cited many reasons as to why this may be occurring, none of which is a bottoming-out signal of U.S. unemployment. We look for another all-time record of the exhaustion rate in Dept. of Labor's next monthly report.

Lastly, federal program extended benefits, continued to increase week-to-week. It shot up 29,150 from the prior week. We expect this figure to continue to increase. We note that this number lags continuing benefits by one week and initial claims by two.

Economic indicators for June 25, 2009

Q1 GDP will likely be revised and many think the new figure will be slightly better than the 5.7% contraction that was previously released. What we will be looking at is the price index. Given Fed's statements yesterday, the market could react negatively if the price index was revised upwards.

Consensus - GDP: -5.7%

Initial jobless claims will likely come in slightly higher than the 600k consensus. Of course, there is a chance of an upward revision of last week's numbers. We expect an increase in continuing claims after last week's surprising decline, which we believe was possibly driven by no filings 1-2 weeks before/after the Memorial Day weekend, higher exhaustion rate, and not all auto industry 'victims' yet being accounted for. As a reminder, continuing claims lag initial claims by one week.

Consensus - Initial jobless claims: 600k

Technical observation of S&P 500

It appears that after today's minimum gain, the S&P 500 is on the brink of hitting the Golden Cross (bullish; when the 50-day and 200-day MA's cross while both are going up). However, this has not yet occurred as although the slope of the 200-day MA has flattened and is nearing zero, it has not yet turned positive. But the 50-day MA (900.5) did cross the 200-day MA (897.2).

If S&P 500 stays positive for the next few days, the 50-day MA would remain above a positively sloped 200-day MA, which could be viewed as a bullish signal. However, even a small decline in the index can turn slope of the 200-day MA negative again.

The 50-day moving average is almost at a turning point too. The slight increases that we saw these last two days in the S&P 500 prevented it from going down.

With all of that in mind, we could see a bullish signal for the S&P 500 the next few days, if the market continues to go up. However, if not, and if the 50-day MA becomes negatively sloped, we could see S&P 500 at 850 again.

For this reason we think a simple straddle strategy might be appropriate for SPY. Buy SPY Jul 91 calls and SPY Jul 91 puts. Although we're entering the Summer season, which has not been volatile historically, we're thinking that important economic news (initial claims, personal spending, consumer confidence, and unemployment rate) which will be released the next 2 to 10 days, combined with the current state of the economy, will help increase volatility. We also looked at the Bollinger Bands and it appears that we're at a very narrow range right now, which could mean that a breakout is due.

Lastly, the ADX (avg. directional index) is sloping upwards but only at 18.7 right now. A slight push above 20 could indicate a positive trend in the making, which will likely bring many others on board to long SPY for the short-term. Of course, if such trend is reversed and ADX remains below 20, many may jump the ship and push SPY back down to $85 (or S&P 500 to 850).

No surprises in Fed's statements; does not expect inflation for "some time"

The Fed did not change its rates. It said the economy is still contracting but at a slower pace. Unfortunately, the Fed sounds like it does not expect inflation, with which we disagree. Another way to look at this is that the Fed does not expect economic recovery anytime soon (likely not even by Q4 as all "green shooters" expect), therefore it does not see a threat of inflation. We believe that without any "exit" strategies, the Fed will have a tough time addressing inflation which can pop up without any warnings. We think that just re-stocking inventories, which many companies may do in anticipation of a recovery, could ignite inflation, or would put a pressure on earnings as producers will not be able to pass the higher costs to consumers and would absorb those costs. The Fed disappointed, in our opinion.

• Fed funds rate target range remained at 0.00% - 0.25% because it "continues to anticipate that economic conditions are likely to warrant" those levels for "an extended period."
• It was positive regarding the financial markets.
• However, it remained negative on consumption, citing unemployment, declining wealth and tight credit as reasons why.
• The Fed "expects that inflation will remain subdued for some time."
• The Fed also did not change its plans to buy $1.25 trillion of mortgage backed securities. It appears that the Fed anticipates further devaluation of those so-called assets later this year, making them more attractive to purchase.

5-year Note Auction Was Successful

Surprisingly, it appears bidders were not worried too much about potential inflation, therefore did not demand higher yields. The yield on today's offering was 2.7%, slightly lower than a 2.72% which many had expected. Bid/cover ratio of 2.58 was very strong. This is good news as many view it widening the spread of the notes yield and the equity market yield, which makes the stocks more attractive.

Again, this is very surprising. We remain cautious because suddenly it appears that everyone (at least market players) is ignoring the realistic threat of inflation. All markets are displaying too much confidence in the Fed and the entire government, which is literally scary. We'll see what the Fed says later this afternoon. Given all of the political BS surrounding the entire market, we think the Fed will not say anything negative. But we hope that the Fed will be more realistic.

New Home Sales Disappoint

New home sales for May came in at 342k, significantly below the 360k consensus. In addition, the April figures were revised down. Annual sales rate in April was lowered from 352k to 344k. May's sales were still below April's downwardly revised figures. Today's results, combined with yesterday's existing home sales, indicate that the housing market may not have hit the bottom yet.

Besides the overall miss, another figure that caught our attention was month's for sale. This number increased to 11.5, from 10.8 in the prior month. We view this as another indication of weak demand in the housing market.

The only positive number that we saw was a slight decrease in the month's supply, going to 10.2, from 10.4 in April (then again, April's month's supply was revised up to 10.4 from 10.1).

However, as mentioned before, this figure remains significantly above what we have seen on average during other recessions. Month's supply was around 8.1 in prior recessions. The overall historical average figure is 6.1.

The housing market remains weak. With inflation possibly around the corner, this market could take another hit. We will see what the Fed will have to say about inflation later today.

Technically, S&P 500's downward trend could be reversed today

The better than expected durable goods and MBA Applications survey have pushed S&P 500 futures up more than 1%. If S&P 500 closes above 900 today, it will not only be crossing the 200-day MA, but will also prevent the slope of the 50-day MA from turning negative; all of which are very positive.

We note that new-home sales, comments from the FOMC meeting and the 5-year note auction could impact what we are seeing now. We had a negative sentiment for all of these, but then again, we're dealing with politics and today's durable goods numbers will probably give the Fed something to brag about, which would be positive for the market.

Durable goods better than expected

Surprisingly, May durable goods were not only positive, but they matched April's increase. It appears that inventories of manufactured goods remain at low levels.

• Durable goods orders increased 1.8% in May from the prior month. We expected a decline of at least -0.7%.
• We note that shipments were down 2.1%; however, shipments of cores capital goods were up 0.3%. This was the first increase since Dec.

Again, we may have been too pessimistic about this economy. However, we remain cautious.

MBA Mortgage Application Survey better than expected

For the week ending June 19, both the purchase and refi indexes showed week to week growth as mortgage rates began to fall slightly.

• Total index came in at 548.2, up 6.6% from the prior week
• Purchase index was at 280.3, up 7.3% from last week
• REFI index was at 2116.3, up 5.9% from the prior week

We certainly did not anticipate such positive news. However, we must note that this data also displays the sensitivity level of purchases and ref's to mortgage rates, which is very high. If inflation shows its ugle head (which many fear it will), purchases and refi's could plummet very quickly.

Economic indicators for June 24, 2009

We think durable goods will likely disappoint mainly because of the surprisingly positive numbers we saw last month. Given the economic environment, we think manufacturers continue to test the waters and remain conservative in order to keep inventories at low levels. They have not yet seen strong indications of recovery in consumption. We note the consensus varies as Econoday lists it at -0.5%, while Thomson's is at -0.7%. We think it will likely come in around -0.7% or lower.

Consensus estimates -
Durable goods: -0.7%

MBA Mortgage Application Survey is also likely to disappoint. This was supported by MBA's forecast revision released on Monday.

On the other hand, new-home sales could come in higher than the 360k consensus. MBA raised its new-home sales forecast earlier this week. We must note that the revision was based on lower prices and increase in new home construction, not necessarily a turnaround in the housing market. As we've mentioned before, this data is for the month of May. Given higher mortgage rates, we expect this annualized figure to decline in June.

Consensus estimates -
New-home sales: 360k


We don't expect any surprises from the FOMC meeting regarding the fed funds rate. However, we hope the Fed's comments on the economy will be more 'realistic', and if so, the mkt's reaction will be negative. Let's see if they mention anything about buying those great mortgage backed securities. Then again, nothing that these guys have done or said during the last 18 months has been 'realistic'.

Although the 2-year note auction was successful on Monday, the 5-year note auction may not do as well on Tuesday. Bidders may demand lower prices and higher than expected rates due to fear of inflation in the long-term.

We think durable goods, new-home sales and results of the 5-yr notes auction will impact the market more than anything else on Tuesday; and overall, we believe such impact will be negative. If we are correct, then the S&P 500 hitting 850 could be right around the corner.

Consumption not looking good in June

• ISC-Goldman Store Sales for the week of 6/20 came in flat compared to the prior week, and down 1% Y/Y. That report expects a 5% monthly decline, which is certainly negative. Although the ISC-Goldman Store Sales report cites bad weather conditions as one of the main factors contributing to the disappointing numbers, we remain realistic, which means that personal income, unemployment and continuing deleveraging in many households are the main drivers behind such decline.
• The Redbook Retail index was also disappointing as it showed a 4.4% month-to-month decline.

We note that WMT sales figures are no longer included in these and other retail reports.

ABC News Consumer Confidence Index near 2009 and all-time lows

ABC News Consumer Confidence Index (CCI) for the week ending on 6/21, came in at -53, only one point above the -54 all-time low, which we saw in late Jan. This indicator is not widely followed, but we think it provides more evidence that a bottom and a recovery are not necessarily around the corner.

The CCI has three components - National economy, buying climate, and personal finances.

• All three declined from the prior week.
• Buying climate and personal finance indexes dipped below this year's average, while the national economy index matched the measly 2009 average of 7 (only 7% have a positive view on the economy).

Is unemployment really stabilizing?

We don't think so. We have provided evidence and arguments that we think strongly support our view. Here is another one - the Bureau of Labor Statistics (BOL) released a record mass layoffs figure for the month of May. Second increasing monthly mass layoffs since a temporary decline seen in Feb. and Mar.

The U.S. economy saw 2,933 mass layoffs in May, up from 2,712 in April. Mass layoffs is defined as layoffs of at least 50 workers from a single company.

We may not see record mass layoffs going forward, but the question is - are there enough jobs out there to employ the recently laid-off workers? Not yet, in our opinion. Unemployment could stabilize in Q4, but that's certainly not early enough. We think it will stay at least above 8% through 2010. The new normal rate, which likely would not be seen until 2H10, will be around 8%.

Existing home sales disappoint; no bottom yet

May existing home sales of 4.77MM was 2.4% higher than April, but it was lower than the 4.82MM expectation. The numbers were disappointing because May is the seasonally strongest month.

Existing home sales grew sequentially in three of the four regions. It continued its decline in the West region. A big chunk of the sales figure was from foreclosures, which explains the lower prices. They dropped another 14.7% Y/Y.

Sales of condos and co-ops were much stronger than single-family homes.

Inventory slightly declined, but the months supply figure remained above 9.5, which remains above where it was during other recession periods. Months supply, although lower than April, is not showing any declining trend. The latest figure is equivalent to what we saw in March. Months supply was at 9.7 in Jan. and Feb. Again, we are not seeing any so-called trend of declining inventories.

As a reminder, this was data for not only a seasonally strong month but also a month that saw nearly record low rates. We expect a sequential decline (and of course a Y/Y decline) for June. In addition, the continuing increase in unemployment (which President Obama will likely touch on in a few minutes) will continue to drive home sales lower.

Market decline was expected, but will it continue?

Since we mentioned that the market was up too high (weekend of 6/14), NASDAQ (IXIC) has declined 5%, while the Dow (DJI) and S&P 500 (GSPC) have declined approx. 6%. Such decline was driven by profit-taking (as the market shot up too high and too fast after the March lows) and finally a sense of reality regarding the housing market, unemployment and consumption.

We think there are some fundamentals that might push the market down further. For example, take a look at the GSPC P/E ratio for 2010. As of Monday's close, it stands at 23.6 (based on GSPC's GAAP earnings estimates). This figure represents a 0.8 PEG, which surprisingly, indicates GSPC being fairly valued at 893.

But the question is - is the GSPC 2010 consensus earnings growth estimate of 32%+ realistic? We don't think so, especially given the 2.0% consensus 2010 GDP growth. Average annual GDP growth after the last recession until 2007 was only 2.6% (1.6% for the first year after the recession), and that growth was debt driven, for which we have been paying the last 18 months (and likely longer). During the same period, average GSPC earnings growth was 21.0%. We are using the latest recession figures mainly because they more closely resemble the more purely consumption-driven economy. We note those figures are less favorable for the expansion years between the 1991 and 2001 recessions.

Given continuing deleveraging by households, significant decline in wealth and the not-yet-stabilized unemployment rate, all of which will keep consumption at low levels, we think a 32% earnings growth for 2010 is too optimistic. Assuming a more conservative, or realistic, 25% earnings growth in 2010, an 850 GSPC valuation (5% below Monday's close) could be more realistic. This also represents a PEG of 1.0.

From a technical standpoint, with GSPC closing below its 50-day and 200-day MA, it could go down to the 880 level, after which 850 could be next. The next few days could provide a clearer picture of whether or not GSPC will hit 850. The slope of the 50-day moving average is on the brink of turning negative, which will be bad news. We don't believe the market will get back to the March lows, but the correction, we believe, is not yet complete.

Although many think the market could turn around tomorrow, after Monday's big dip, we note that there is one driver tomorrow that may push the market further down - President Obama's press conference on the economy. Even though the market has shot up nicely during half of his YTD tenure, it hasn't responded positively too often when he's discussed the economy and his regulations. Disappointment in this week's treasury auctions could also negatively impact the market.

Mortgage Bankers Association (MBA) finally released a more realistic forecast … maybe

As we have been saying, the housing market has not yet 'stabilized' and going forward it may not become rosy as soon as some assume. It appears that MBA is now viewing the real estate market from a more 'realistic' standpoint. MBA released a revised 2009 forecast which included mortgage originations of $2.03 trillion, down from its earlier projection of $2.78 trillion.

The lower guidance is due to not only lower purchases but also significantly lower refi's, which is self-explanatory given the higher rates. What was interesting was the fact that the government's HARP (Home Affordability Refinance) program has been applied to only 13k loans YTD, which is significantly below the government's 1.5MM - 2.0MM expectation. Of course 2009 is not yet over, but we can safely assume that HARP will not meet the "green shoots"-loving government's estimate.

Another number that stood out in MBA's projections was number of new homes sold in 2009. It expects 352k homes, up from it previous projection of 293k. This might sound positive, but obviously more homes sold are offset by much lower prices. Again, it lowered its total purchase origination estimate. We wonder why MBA upped its new homes sold projection. We think it may be due to the better-than-expected construction numbers released last week, which we actually viewed as a negative. We continue to believe that construction is out-pacing purchases by too much, resulting in higher inventories which could drive down prices further.

MBA maintained its existing homes sales forecast of 4.8MM, with which we again disagree. We must say that tomorrow's existing home sales numbers may come in better than expected, but that's mainly because the data (annualized) is for the month of May. We think a potential decline in June has more than offset May's good numbers. This is similar to our opinion regarding new homes sales data, which is to be released on Wednesday, 6/24.

Overall, it appears that the housing market has not yet hit a bottom. As MBA also mentioned, this market moves along with interest rates, which will either remain at current levels, or may shoot up to too-high levels due to potential inflation, which will not be driven by economic growth but rather by all the money printing. The Fed is in a tough spot.

China's economy, therefore its market, still remains attractive

Just as an update, below is what we were saying mid-May about China. We're sticking to it even if the emerging mkts are not viewed as attractive as before (according to the World Bank).

• Lack of growth within emerging markets will not impact China as much as other economies mainly due to the fact that China's domestic mkt is very large and it yet hasn't been tapped into significantly.
• With a huge surplus, China can further stimulate consumer spending and over time prices can adjust slightly lower to meet average consumer income/wealth. China also has huge capacity to produce many goods. The "buy Chinese" thinking will work in China, unlike Obama's "buy American" in the US.
• Lastly, regarding commodities, China's relationship with Iran and other countries with which the US does not conduct business (supposedly), in addition to its own huge supply will help. We don't think Iran's instability will impact it much. Whichever government gets in there (unless something plugged in by the US or its favorite ally in the Middle East) Iran will do its best to maintain its relationship with China.

Review of today's main economic indicators

Initial jobless claims came in at 608k, above the Street's 600k, but below our 615k estimate. Continuing claims reversed its 19-week downward trend. However, we must note that last week's number was revised up, and the number of claimants with extended benefits increased by more than 44.5k from the previous week, which in itself is not that great.

Although the numbers were better than expected and we admit that the job market may not be as bad as it was in the beginning of the year, we must note that a few factors may have contributed to today's data.

Before explaining this we must define exactly what continuing claims represents. This figure is the number of claimants filing for unemployment benefits every week. Historically, some claimants have skipped one or two (or more) weeks of filing then re-filed, which may have impacted this stat. In addition, we must note that continuing claims lags initial claims by one week. With those things in mind ...

1. Given the lag factor, we think Memorial Day may have continued to play a role in the June 6 continuing claims numbers. During Holidays some claimants either forget or postpone their weekly filings by 1-2 weeks.

2. The exhaustion rate of claimants (the ones with expired benefits) eached its highest level on record, 49.2, in May. So the decline in continuing benefits could be driven by such a high exhaustion rate, as those ex-claimants are no longer included in continuing claims. Such high exhaustion rate will negatively impact consumer expenditure the rest of the year. Remember, most of those people are no longer being paid by the govt and it is likely that they have not yet found a new job nor will they until another 3-9 months down the road ... hopefully.

3. Not all of the auto industry 'victims' have yet been accounted for. Both GM and Chrysler released their plans to reduce headcounts and close dealerships, etc going into July. We think we have only seen some of those come through to-date.

So, we're not saying that everything is as bad as it was in the beginning of the year, but this economy still stinks and that stench can last a while. Regarding, the leading indicators, it was no surprise as performance of the stock market is used in calculating that figure.

And on Philadelphia's Fed survey, that was a very big surprise, especially the strong new orders index. We are still cautious because again given the current state of the economy, manufacturers will likely just be testing the waters for a while. For this reason, we don't expect such optimism displayed by Philly's Fed survey to continue. It'll still be a bumpy road.

MBA Mortgage survey Purchase Index reversed 3-week trend

MBA Mortgage Application survey index results provide support for our thoughts that we may be seeing at least a short-term inventory build up in housing again, which could help dry up some of the many economic "green shoots" that everyone is seeing everywhere these days.

• The index came in at 514.4, down from 611.0 in the prior week.
• The refi index was at 1998.1, down 23% from the prior week. It is now at levels not seen since late last year.
• The purchase index was at 261.2, down 3.5% from the prior week, reversing its 3-week increasing trend.

Prices still appear not to be low enough for consumers

Core CPI monthly change of 0.1% was in-line with the consensus, however, surprisingly, higher energy prices did not impact overall CPI, as that also came in at 0.1%. We think this is simple:

• Consumer demand remains low enough for producers not pass on any increase in their costs
• What appears to be a never-ending attempt to clear inventories by producers and retailers, appears to be ... never ending, which further holds prices down.
• Although we still expect inflation to hit the economy within the next 1-3 years, it appears that prices have not yet adjusted to the plummeting demand. Looks like from a pricing standpoint, we might experience both deflation and too-high inflation in a record 6-12 month period.

ECONOMIC INDICATORS FOR JUNE 17, 2009

MBA Mortgage Application Survey will likely be lower than the data reported last week, as mortgage rates have increased significantly during the past 1.5 weeks. Dip in refi apps will be more significant. The purchase and the refi indices were at 270.7 and 2605.7, respectively. If change from the prior week is significant (double digits), it provides short-term support for our theory that yesterday's 'positive' housing permit and construction data were just a head-fake (although this survey does cover both new and re-sale homes), as inventories could once again build up.CPI, will likely be in-line. The PPI released yesterday did not indicate any potential significant movement in this.

Consensus estimates -
Core CPI: 0.1%
CPI: 0.3%

Savings rate must increase

This economy will continue to be driven by consumption (until the dollar gets cheap enough for China, India and possibly Russia to decide to tap into the under-utilized resources in the US for manufacturing). However, in order for a recovery in consumption to begin, we must first see a sizable increase in personal savings. Savings must also be viewed as a source of capital to drive economic growth. In our opinion, it is simple.

We believe savings rate must hit 6%+ before consumption can get kickstarted. This is for two reasons - 1) consumers must gain confidence in their ability to spend without becoming highly levered again, and the rising unemployment will hinder such change in attitude; and 2) savings must increase to the point where they are used as capital to fund overall economic growth. The current more stringent credit standards (with which we agree) provide support for this. Once savings increase to the appropriate level, consumers will feel comfortable and may begin using a portion of their savings for additional consumption, potentially creating some growth. At the same time, those savings will have created capital for banks to disburse and fund the consumer driven growth.

Lastly, after looking at the savings rate data, we noticed that it has averaged at approx. 6.8% historically (1959 - present). Although during the past 10 years this rate has dwindled down to only 1.7%. Given the expected continuing increase in unemployment, consumers are more likely to continue to increase savings. And don't forget the fact that the US lost nearly $1.3 trillion in wealth in 1Q09. This figure represents 10% of personal income during the reported period. The level at which consumers will feel more at ease in increasing consumption, we believe is a savings rate of 6% - 7%, which may take another 2-3 quarters to establish.

Summary of our view on today's economic indicators

Housing data, which included an update on permits, housing starts and housing completions, were too good to be true. This data may be positive for residential construction companies, but it is bad news for the housing mkt as it will increase inventory, as we mentioned in our initial analysis.

Consensus Actuals
Housing starts: 485K 532K
Housing permits: 500K 518K

PPI was significantly below the consensus. It appears that even the significant increase in energy costs that we have seen during the past two months, was not enough to offset low demand and indicate any type of inflation. We continue to believe that we will face severe inflation during the next 1 - 3 years as the govt continues to print cash to combat the economic downturn.

Consensus Actuals
PPI: 0.6% 0.2%
Core PPI: 0.1% -0.1%

Industrial production was slightly below expectations with capacity utilization in line. The 1.1% monthly decline, which was slightly more than expected, mainly due to the fall of the auto industry. Decline in industrial production may have stabilized, but we believe it all depends on a recovery in consumption, which we do not expect until late Q4. For this reason, similar to the housing data, we might be questioning inventory mgmt conducted by non-auto producers of finished goods.

Consensus Actuals
Production: -1.0% -1.1%
Capacity utilization: 68.1% 68.3%

Higher than expected housing construction data is not necessarily good news

Residential building permits, starts and completions data came in higher than expected. Although this may be good news for residential construction companies and suppliers, we believe it is a negative for the overall residential market.

Data released today indicates potential inventory build up, in our opinion. One of the data points that we look at is the ratio of houses for sale to houses sold. In April, this figure stood at 10.1, significantly below January's 12.4 and a 4-month consecutive decline.

However, April's figure remains significantly above the historical average of 6.1 (from January 1963 though April 2009). In fact, this ratio averaged around 8.1 during prior recessions (the supply-demand relationship is presented in the chart below).

In addition, we believe such ratio for May will reverse the declining trend, which is not good news. For these reasons, we do not yet believe the housing mkt has hit a bottom and view today's economic data as potentially negative, as it may signal increase in inventory.

We will provide additional thoughts on the housing mkt in the near future.

PPI was too low

Today's released PPI was significantly below the consensus. It appears that even the significant increase in energy costs that we have seen during the past two months, was not enough to offset low demand and indicate any type of inflation.

We continue to believe that we will face severe inflation during the next 1 - 3 years as the govt continues to print cash to combat the economic downturn. Prices increase as demand grows. However, with so much more money printed and basically thrown out into the market (which partially explains why the equity mkt has gone up the last 2-3 months), only a small increase in demand could drive inflation to very high levels, which may require rate increases, which may stall this entire so-called stimulus push that the govt has attempted to implement.

Its basically a no win situation unless no further stimulus plans are implemented, no other companies are 'rescued' and banks are no longer forced to bat on both sides of the plate (implement stringent credit standards while also trying to help everyone with their foreclosures, not force credit card holders to pay back, etc).

Economic Indicators for June 16, 2009

Building permits and Housing starts (for May09) - figures too high could create short-to-medium term doubts about the housing and equity markets, as they may represent additional push on inventories in the future.
Consensus estimates-Housing starts: 485KHousing permits: 500K

Fear of inventory build-up could worsen if permits data is significantly higher than the consensus and housing starts match or exceed the consensus (we note that the avg 30-yr mortgage loan rate has climbed nearly 100 bps since end of April). Mkt may react negatively based on such fear.

PPI (for May09) - watched even more closely now, especially given the govt's continuous printing of money, and the latest rise in commodity prices. Of course the core measure can take care of that. Over time, we believe inflation could raise its head. Again, given the fact that the Fed has pumped so much additional cash into the market. Higher inflation and lower dollar (too low to act as a buffer against the risk of the equity mkt) remain a possiblity.
Consensus estimates-PPI: 0.6%Core PPI: 0.1%

In our opinion, if not now, then later, the dollar will no longer be considered as the safe haven, with the government levered up to its eye balls, and its continuous need to print money which means more debt. There is always the risk of the US' largest debt holder, China, sticking with only short-term bills. In fact, such trend or worse may be taking place. China sold $4.4 billion, or approx 0.6%, of its treasuries in April, in addition to Russia's sale of approx. $1.4 billion (1% of its holdings) and Japan's sale of $800 million (0.1% of its holdings).

Industrial production (for May09) - we believe the figure may come in below the consensus (provided below).

In fact, we believe it will also be negative for the mkt to see a higher than expected figure. This is mainly due to the fear that inventory build-up may raise its ugly head again as we remain skeptical in seeing a recovery in consumer expenditure in 2H09, in addition to continuing decline in exports. We are also doubtful in seeing the majority of businesses expand and increase capex significantly. An increase in industrial production certainly does not mix well with continuing decline in consumption, which will likely not recover until more than a year from now. For the same reasons, which will make the probablity of increased prodction and capex minimal in the near future, we expect a slightly disappointing capacity utilization figure.
Consensus estimates-Production: -1.0%
Capacity utilization: 68.1%

Green shoots or just some government installed artificial turf?

Our view regarding the market and the economy has not changed. It is simple - there remains a possibility that the light at the end of the tunnel could be an oncoming train and that the "green shoots" may not necessarily sprout, especially if they are merely some artificial turf "planted" by Obama and the government. Believe it or not, such greenery may require much more maintenance than naturally sprouting greens. Below are reasons why we remain skeptical:

• Recovery in consumption will take more time.
  o Savings rate must and will likely go higher to match historical average
  o US lost $1.3 trillion in wealth during Q1 (according to the Fed)
  o Stringent credit standards, with which we agree, will limit consumption
  o Rising unemployment
• Unemployment rate continues to rise. The so-called stabilized weekly jobless claim filings could be a head fake.
• No recovery yet seen in the housing market
  

The bullet points above resemble our reasoning used when S&P 500 was at around 800. We certainly did not jump in after it broke through that level. Of course, we missed a great opportunity. But we expect a similar opportunity before Q4, as we believe the latest run-up has raised expectations, which we believe the US economy will have difficulty meeting. We believe the equity market remains a trader’s market and do not recommend long-term investing for regular retail investors. We must note there are some names that are attractive in this environment, and we will try to point those out in the future.

We will provide detail and additional support for the bullet points above during the next few days.