MarketView for September 21

 

 

Summary  

 

About the only good thing you could say about Wednesday’s trading day on Wall Street was that trading was active with about 9.12 billion shares changing hands among the three major equity exchanges. The daily average is about 7.91 billion shares. However, share prices in general suffered their worst decline in a month after the Federal Reserve said there were "significant downside risks" to the economy even as it announced a new policy to keep interest rates low and hopefully stir up some economic activity.

 

Traders attributed the late-day drop to investors pulling back from bets made during last week's rally, and new short positions after the market failed to rise on the Fed news.

 

The Fed, as expected, said it would buy more long-term Treasury securities in an effort to lower borrowing rates. But investors worry that the Fed's latest plan will have little effect on lending in an economy that appears to be stagnating, which the Fed also noted.

 

What the Fed said was that it will tilt its $2.85 trillion balance sheet more heavily to longer-term securities by selling shorter-term notes and using those funds to buy longer-dated Treasuries. The hope was that the Fed might surprise with more aggressive efforts than expected. With the plan details now known -- and it appearing to be an extension of previous efforts -- pessimistic types felt more secure in betting on more declines.

 

The Fed said economic growth remains slow, and recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. The Fed's $400 billion plan, dubbed "Operation Twist" by market participants, is the latest in a series of steps aimed at reviving an economy that has struggled to rebound from the 2008 financial crisis. Investors are less optimistic after previous efforts, particularly in light of the Fed's own statement pointing to economic risks.

 

Selling accelerated as volume spiked in the last hour of trading, with banks and insurers leading the decline. Bank of America ended the day down 7.5 percent to close at $6.38 and Prudential Financial closed down 6.6 percent at $45.73.

 

Insurers were some of the hardest-hit names as Operation Twist could threaten their earnings because their investment portfolios are going to have a hard time keeping up with their obligations if the Fed successfully keeps rates at very low levels.

 

Moody's cut the debt ratings of Bank of America, Wells Fargo and Citigroup, stating that the Federal government is becoming less comfortable with bailing out large troubled lenders.

 

There were a few bright spots in the tech sector. Oracle gained 4.2 percent to close at $29.54 a day after forecasting higher-than-expected earnings for the current quarter as well as robust sales.

 

Hewlett-Packard saw its share price rise 6.6 percent to $23.96 after it became known that the company's board is considering ousting Chief Executive Officer Leo Apotheker, despite his being on the job less than a year, and replacing him temporarily with former eBay CEO Meg Whitman.

 

Fed to Shift $400 billion in Holdings

 

The Federal Reserve announced that it would launch a new $400 billion program that will tilt its $2.85 trillion balance in the direction of longer-term securities by selling shorter-term notes and using those funds to purchase longer-dated Treasuries. The action is the Fed’s latest effort to boost a weak economy. By rebalancing its $2.87 trillion portfolio the Fed will likely lower Treasury yields further. Ultimately, it might reduce rates on mortgages and other consumer and business loans.

 

The Fed also said it also plans to reinvest proceeds from maturing mortgage and agency bonds back into the mortgage market, an acknowledgement of just how weak conditions in the sector have remained.

 

"Recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated," Fed said in its statement.

 

Faced with a lofty 9.1 percent jobless rate, consumer and business confidence sapped by a troubling U.S. credit downgrade, and an escalating sovereign debt crisis in Europe, Fed officials have signaled they would seek to prevent already sluggish economy from weakening further.

 

At the same time, Fed activism has become a punching bag for politicians as an election year nears. Top Republican congressional leaders wrote to Fed Chairman Ben Bernanke this week urging the central bank to desist from further economic interventions, echoing criticism voiced by Republican presidential candidates in recent weeks.

 

Fed officials, however, believe that by shifting their bond holdings they could encourage mortgage refinancing and push investors into riskier assets, such as corporate bonds and stocks, without stoking a run-up in consumer prices.

 

The Fed is not alone in its concerns. The Bank of England on Wednesday signaled it was ready to pump more money into the weakening British economy, potentially as soon as October.

 

Similarly, the Norwegian central bank held its main interest rate unchanged and signaled it might refrain from rate increases for longer than previously expected due to a weaker global economy and the euro zone debt crisis.

 

Existing Home Sales on the Rise

 

Existing home sales were up more than expected in August to the fastest annual pace since March as falling prices and low interest rates drew more buyers into the market, the National Association of Realtors said.

 

Sales rose 7.7 percent month over month to an annual rate of 5.03 million units, the NAR said on Wednesday. The median price was 5.1 percent lower than a year earlier. Rising rents are also helping Americans decide to buy homes, the NAR said.

 

"Favorable affordability conditions and rising rents are underlying motivations," Lawrence Yun, chief NAR economist, said in a statement.

 

Yun said the increase in sales came despite some disruptions from Hurricane Irene, which battered much of the East Coast at the end of the month.

 

Bernanke Wants to Improve Communication

 

Ben Bernanke, Fed Chairman, has charged two of his top lieutenants with the task of examining how the Fed can improve the way it communicates its policy goals. Bernanke appointed Philadelphia Federal Reserve Bank President Charles Plosser and Chicago Fed President Charles Evans to work in conjunction with Vice Chair Janet Yellen in looking at how the central bank could better explain its goals to the public. Of note is that Plosser and Evans have strongly divergent views on current monetary policy.

 

One issue that will be under discussion is what changes to unemployment and inflation it would take to make the Fed lift its commitment to ultra-low rates and extra-accommodative monetary policy, the official confirmed. The existence of the working group was first reported by the Wall Street Journal.

 

At a meeting on August 9, policymakers debated whether they should tie the path of interest rates to either unemployment or inflation. In the end, officials decided to tell markets they expected to keep the overnight federal funds rate low at least until the middle of 2013, but some Fed officials chafed at offering a time-related commitment and three dissented.

 

Plosser, who as recently as late-July had been saying a tightening in monetary policy might be needed by year end, is an inflation "hawk" and long-time advocate of the Fed setting a specific numerical inflation target. He was one of the dissenters at the August 9 meeting.

 

Evans, in contrast, has said the Fed should consider an aggressive easing of monetary policy. He has also recommended a commitment to keep rates low until unemployment falls to 7.5 percent or lower, as long as inflation stays below 3 percent.

 

An approach that sets explicit targets for economic conditions would serve the twin goals of increasing transparency about the aims of policy and requiring only a verbal commitment rather than outright asset purchases, which have proven controversial.

 

General Mills Reports Better Than Expected Numbers

 

General Mills (GIS) reported better-than-expected quarterly earnings on Wednesday, as price increases helped it contend with rising ingredient and fuel costs. The maker of Cheerios cereal and Progresso soups said its first quarter net sales rose 8.9 percent to $3.85 billion, helped by its recently acquired Yoplait yogurt business and consumers' willingness to accept higher prices. General Mills other brands include Pillsbury, Green Giant and Old El Paso

 

In a statement, Chief Executive Ken Powell said the sales gains reflected "resilient consumer demand."

 

Some of the U.S. segments that enjoyed the largest sales gains were its snacks, which include Nature Valley bars and rose 17 percent. In contrast, sales in its meals unit, which includes canned soups and dinner mixes, fell 4 percent. Its U.S. business accounts for nearly two-thirds of sales. The international Yoplait unit accounted for about one-third of General Mills' sales growth

Sales overseas rose 30 percent, thanks largely to Yoplait, while sales in its bakeries and foodservice unit rose 13 percent.

 

General Mills reported net income of $405.6 million, or 61 cents per share, in the fiscal first quarter, which ended on August 28, compared with $472.1 million, or 70 cents per share, a year earlier. Adjusted earnings for the quarter came to 64 cents a share, beating the 62 cents a share expected by analysts.

 

The company affirmed its full-year outlook, saying it expects fiscal 2012 earnings of $2.59 to $2.61 per share, excluding the costs of integrating Yoplait.

 

Looking at the intrinsic value of the shares, a discounted earnings approach using earnings of $1.8 billion with a growth rate of 8.00 percent and a discount rate of 15 percent has General Mills fairly priced. However, by lowering the discount rate to 12 percent, not unreasonable given today’s investment environment with its low interest rates, and the per share intrinsic value grows to $48. The discounted free cash flow to the firm model yields an intrinsic value of $64. Keep in mind that General Mills ended the day at $38.44.