MarketView for July 20

 

 

Summary 

 

Stock prices rose sharply again on Monday, sending the S&P 500 to an eight-month closing high, after CIT Group was thrown a lifeline to avoid bankruptcy, along with the premise that we would see another strong set of corporate earnings numbers this week.

 

Broker upgrades of technology bellwethers, which included Cisco, sent the Nasdaq to its ninth straight daily advance, thereby matching run last seen in July 1998. The end result was that the Nasdaq closed at a high for the year.

 

CIT, a lender to nearly 1 million small- and mid-sized companies, reached a deal with bondholders for $3 billion in emergency financing. Furthermore, the rescue was a private-sector deal instead of a government bailout, a factor the Wall Street found exceedingly desirable.

 

Monday's rally not only extended the market's recovery but analysts who focus on technical indicators expect more upward momentum after the S&P 500 punched through near-term resistance at the 950 level.

 

The earnings season picks up steam this week with raised expectations given that 71 percent of 55 S&P 500 companies that have reported so far have beat expectations. As a result, several analysts upgraded bellwether stocks, including three Dow components. Bank of America-Merrill Lynch raised Caterpillar to a “buy," writing that the second quarter could mark a bottom for the construction sector. Caterpillar advanced 7.8 percent to $36.65 followed by United Technologies up 2.2 percent at $54.97.

 

Credit Suisse upgraded Cisco to "outperform," writing that field checks indicated that business trends were improving throughout the quarter. Cisco's routers and other networking gear form the backbone of corporate technology infrastructure. Cisco's stock gained 3.1 percent to $21.15.

 

Morgan Stanley raised its rating on Disney to "overweight" from "equal-weight" as part of a larger call on the media sector, which was raised to "attractive." Disney gained 3.5 percent to $25.37.

 

Halliburton, Johnson Controls, Eaton and Hasbro all advanced after quarterly results impressed the Street.

 

At Monday's close, the S&P 500 was up 40.6 percent from the 12-year closing low of March 9.

 

On the economic data front, an index gauging U.S. economic prospects increased for a third straight month in June, suggesting the recession was drawing to a close, the Conference Board said.

 

Index of Leading Indicators up Again

 

The Conference Board reported on Monday that its index of leading economic indicators rose for the third straight month in June, suggesting the recession was drawing to a close. The index, which is supposed to forecast economic trends six to nine months ahead, rose 0.7 percent in June, following a revised 1.3 percent gain in May, the Board said.

 

For the first half of the year, the index is up 4.1 percent on an annualized basis, the research group said. In the prior six months, it had dropped at a 6.2 percent pace.

 

"The recession has been losing steam since the spring, although very large job losses continue," Ken Goldstein, a Conference Board economist, said in a statement. "Nevertheless, confidence is slowly rebuilding." "If these trends continue, expect a slow recovery this autumn," Goldstein said.

 

Recent economic data has suggested that the current recession, the longest since the Great Depression, is loosening its grip and it is generally expected that demand and GDP growth will resume in the second half of the year.

 

Seven of the 10 indicators that comprise the index increased last month, the Conference Board said. It said a separate index gauging current conditions fell, primarily because of a rise in unemployment and decreased industrial production. Since December 2008, the so-called coincident indicators index has dropped at a 5.9 percent annual rate.

 

CIT Out of Frying Pan But Not In Fire

 

Word is that CIT Group has successfully arranged for $3 billion of emergency financing from bondholders, thereby removing the threat of bankruptcy, at least for the time being. The rescue from several big bondholders has been approved by CIT's board. The financing will provide  time for the 101-year-old lender to small and mid-sized businesses to restructure its debt, and preserve the ability of thousands of businesses to obtain cash needed for day-to-day operations.

 

According to published reports, CIT would pay interest on the financing of 10 percentage points more than the three-month London Interbank Offered Rate. This equates to an annual rate of about 10.5 percent.

 

The bondholder group includes Pimco, a unit of German insurer Allianz SE, and other large investors, and is expected to provide financing with a 2-1/2-year term. This financing is likely backed by un-securitized CIT assets, which probably exceed $10 billion.

 

A rescue would help CIT address a looming $1 billion bond payment due next month. Yet it would not necessarily restore longer-term confidence in the company, following a liquidity squeeze exacerbated by customers who drew down credit lines.

 

The bondholder rescue could, however, preserve the government's $2.33 billion investment in CIT from the Troubled Asset Relief Program. CIT became eligible for such financing when it became a bank holding company in December.

 

Problems at CIT mushroomed two years ago in the wake of Chief Executive Jeffrey Peek's decision earlier in the decade to expand into subprime mortgages and student loans. A bankruptcy would make CIT, with $75.7 billion of reported assets, the largest U.S. financial company to go bankrupt since Lehman Brothers Holdings Inc last September.

 

On Monday, it cost $4.3 million upfront plus $500,000 annually to insure $10 million of CIT debt against default for five years, down from $4.45 million upfront on Friday, according to Phoenix Partners Group.

 

The company has been scheduled to report second-quarter results on July 23. It was unclear how the bailout talks might affect the timing of that report. 

 

Freddie Repurchases Subordinated Debt

 

Freddie Mac bought back much of its subordinated securities, the canary-in-the-coal-mine debt that was meant to signal broader problems before the company and its counterpart Fannie Mae were taken over by the government last September.

 

The greatest interest was in selling back the longer maturities back as a result of some uncertainty as to the fate of Freddie and Fannie once Congress again turns its attention to the two largest U.S. home funding companies. Freddie Mac said it repurchased about $3.9 billion of its outstanding subordinated securities on Monday, aiming to lower its borrowing costs.

 

Investors were paid as much as 1.25 percentage points more than Treasuries to sell the securities to Freddie Mac. The company now has about $909 million outstanding subordinated debt from the $5.85 billion originally issued.

 

"From an economic point of view, it was fairly clear," Doc Ghose, vice president of debt portfolio management at Freddie Mac, said. "These have relatively higher coupons and we can issue our reference notes and other debt at lower coupons," he said, adding that the tender thus reduces debt costs.

 

Based on an agreement with their regulator last September, after being seized by the government, Freddie Mac is committed to continuing to make interest and principal payments on its subordinated debt.

 

Freddie Mac bought back nearly 90 percent of the $4.39 billion of securities it offered to repurchase from investors for cash in a week-long operation. There were three issues in this tender: 5-7/8 percent notes due March 21, 2011, 5-3/4 percent notes of June 27, 2016 and 5 percent notes due Dec. 14, 2018. The tender offer yields were 1.999 percent, 4.482 percent and 4.921 percent, respectively.

 

Yield spreads versus Treasuries were 100 basis points for the 2011 issue and 125 basis points for the longer two maturities.

 

The company sells reference notes and other debt to finance its mortgage asset purchases. Freddie Mac's debt outstanding has fallen, however, from a peak this year of $932 billion in March to $893 billion in May. The company has conducted large buybacks of both dollar and euro-denominated debt in recent weeks in asset-liability management moves.

 

Subordinated debt has become extremely illiquid, though offering attractive premiums for securities with close government ties. The buyback offered up a chance to get out at a profit or recover some of the deep losses from distress that began in the second quarter of 2008, Vogel said.

 

Human Genome Rolls Over Those Shorting its Shares

 

Human Genome Sciences reported on Monday that its experimental lupus drug had succeeded in a late-stage clinical trial, shocking those who had written the product off, with the result that its shares rose 195 percent.

 

The announcement just after midnight, showed patients who took the drug, Benlysta, demonstrated a statistically significant improvement in the symptoms of their disease compared with those taking a placebo.

 

Results of the 52-week trial, the first of two requested by U.S. regulators, showed 57.6 percent of patients taking a high dose of Benlysta experienced an improvement in their symptoms, compared with 43.6 percent who took a placebo. The result was statistically significant and met the main goal of the clinical trial.

 

Of patients who took a low dose of the drug, which is administered once a month by IV infusion, 51.7 percent showed improvement in their symptoms, a figure that was also statistically significant.

 

The main goal of the trial was to show a four-point or greater improvement in disease symptoms as measured by a scale known as Selena Sledai. A four-point reduction on a scale of 10 constitutes a good, or meaningful, response. The lower the score, the less disease activity a patient has. All patients entering the trial had a score of six or higher.

 

The trial also required that patients did not experience a worsening of their disease in any organ beyond the originally affected one. The trial met all of these goals at both doses.

 

Lupus is a complex disease that causes the immune system to attack the body's own tissue and organs, including the joints, kidneys, heart, lungs, brain, blood or skin. Symptoms include achy joints, fever, arthritis, kidney damage, chest pain and skin rash.

 

Data from the 867-person trial, known as BLISS-52, take the company one step closer to being the first to have a new lupus drug approved in 50 years. Multiple drugs are approved for other indications and used to treat lupus, but none has been approved specifically for the disease in decades. The disease affects an estimated 1.5 million people in the United States and 5 million worldwide, according to the Lupus Foundation of America.

 

Human Genome's drug is not expected to treat all patients, but is aimed at a subgroup who have mild to moderate disease. That is because an earlier trial failed to meet its main goal, but investigators noticed that a subset of patients did very well.

 

The late-stage, or Phase III, trials were designed in conjunction with the U.S. Food and Drug Administration to test those patients most likely to benefit from the drug.

 

According to CEO Thomas Watkins, the initial market for Benlysta consists of some 300,000 patients, said. Roughly 150,000 patients in the United States stand to benefit from the drug, if it is approved.

 

While that may represent a small portion of the total number affected by lupus, it is nonetheless an important advance, and Watkins said that from a corporate perspective, it represents a substantial revenue opportunity.

 

Drugs are typically referred to as blockbusters when they generate $1 billion or more in revenue. Profit would be split between Human Genome and its partner, GlaxoSmithKline Plc.

 

The second of the two late-stage trials is due to be reported in November. There are no substantive differences between the two trials, the company said. The first was conducted in Asia, Latin America and Eastern Europe, and the second in Europe and North America.

 

If the second, confirmatory trial, replicates the findings in this trial, Human Genome and GlaxoSmithKline would aim to file for approval of the drug by early 2010, according to David Stump, the company's head of research and development.

 

If the agency gives it a priority review, the drug could be on the market by the end of next year. Priority review is given to drugs that meet unmet medical needs. Without priority review, it could be on the market by early 2011.

 

Benlysta is designed to inhibit BLyS, a naturally occurring protein in the body that exists to keep B-cells functioning normally. B-cells make antibodies that prevent infection. In patients with lupus, B-cells are over stimulated, producing antibodies known as auto-antibodies that attack the body.

 

Time Is Not Now Says Fed

 

The Fed will unwind its dramatic monetary expansion when the time is right, but that exit is not imminent even though slow growth should resume in the second half of this year, Dennis Lockhart, president of the Atlanta Federal Reserve Bank said on Monday.

 

"The Fed has a number of tools being readied to unwind the policies used to fight the recession, and it will be some time before their use is appropriate," Lockhart said.

 

Lockhart, in a speech to the Rotary Club of Nashville, Tennessee, said the economy appears to be stabilizing. He also downplayed the threat of inflation as a result of the Fed's low interest-rate policy and other measures designed to stimulate the economy.

 

"Current economic conditions are mixed at best, but the economy appears to be in stabilization mode," he said. "Stabilization necessarily precedes recovery. A recovery has not yet taken hold, but should begin before too long."

 

In this environment, Lockhart said the risks of inflation and deflation were roughly balanced, adding he would challenge critics who argue the dramatic expansion of the Fed's balance sheet mean that money-supply-fueled inflation is imminent.

 

"Slack in the economy will suppress inflation. And inflation is unlikely to result -- by direct causation -- from the recent growth of the Fed's balance sheet," Lockhart said.

 

Lockhart said the ability of the Fed to pay interest on excess reserves held with the U.S. central bank, granted by Congress during the crisis, would inhibit the transmission of this additional liquidity into higher prices.

 

"One should not assume at this point that extraordinary measures to shrink the balance sheet are required to contain inflationary pressures," Lockhart said. "Some inflation pessimists are not giving weight to the changed mechanics of monetary policy transmission to the broad economy."

 

As interest rates neared zero, the Fed switched to unconventional measures to stimulate economic activity by purchasing up to $1.45 trillion of mortgage-related debt and $300 billion of longer dated U.S. government bonds.

 

The Fed opted to not alter the scale of the program at its policy meeting last month. Lockhart said that he felt the buying had helped economic conditions, and he did not rule out making adjustments in the future, if warranted.

 

"I am going to keep an open mind on that subject. It will depend on the overall conditions at the time, whether we think that ... more Treasury purchases would be helpful," he told reporters after the speech. "That may mean extending the program in terms of quantity of purchases as well as timeframe."

 

Lockhart said that the decision to buy Treasuries had not been about driving long-term yields to a specific point, but rather was aimed at improving overall credit conditions.

 

"I think the purchases influenced interest rates and therefore the program, as it has rolled out, in probability had some positive effect on interest rates during the period," he said.

 

Profits at Texas Instruments Down 56 Percent

 

Texas Instruments reported after the close of regular trading on Monday that its second-quarter earnings fell 56 percent as due, the company said, to a weak economy that the company expects will "take some time" to strengthen. Nonetheless, TI was pleased with its improvement from the first quarter, as customers started ramping up their inventory to more closely reflect demand.

 

TI earned $260 million, or 20 cents per share, compared with $588 million, or 44 cents, in the same period a year ago. Revenue fell 27 percent to $2.46 billion from $3.35 billion. Looking ahead, TI said it expects third-quarter earnings to come in at 29 to 39 cents per share, and revenue to range from $2.5 billion to $2.8 billion.

 

TI's largest division makes analog chips used in digital music players and other gadgets, while its embedded unit makes chips that go into machinery and cars. The wireless division makes chips for mobile phones, although TI's dominance in this market has eroded.

 

In the second quarter, analog revenue fell 24 percent from a year ago to $983 million, but it was up sequentially by 21 percent. The embedded unit saw sales fall by 20 percent to $350 million year-over-year, but they were up 11 percent from the prior quarter. Wireless saw the same trend, down 33 percent to $601 million from 2008 but up 9 percent from the first quarter.

 

Orders in the second quarter were down 19 percent from last year but improved by 27 percent from the prior quarter. Shares of TI fell 31 cents, or 1.3 percent, to $23.30 in after-hours trading Monday. The stock rose 60 cents, or 2.6 percent, to $23.61 during the regular session.