Cochise County Business Alliance

Wall Street is hoping for a strong economic recovery, but again and again investors are disappointed by signs that American consumers remain cautious and careful about opening their wallets. The latest evidence arrived Nov. 17, when Home Depot (HD) reported earnings.

Home Depot's profits actually beat expectations, but what worried Wall Street was the picture executives painted of their customers' moods. "There is still a great deal of pressure in the housing and home improvement markets, though there are some positive signs of stabilization," Frank Blake, Home Depot's chairman and chief executive said in a statement.

There are at least a few reasons for Home Depot to be upbeat. Many sales measures did improve from the second quarter to the third.

According to comments to analysts by Blake and other executives, Home Depot customers are happy to spend on simple home remodeling projects. Basic maintenance -- plumbing repairs, for example -- is still being done. Customers are also launching do-it-yourself projects, including boosting the energy efficiency of their homes. Finally, customers are updating the decor with new coats of paint or new carpet, or sprucing up their yards with better gardens.

What Americans aren't doing, however, is launching major remodeling or expansion projects. Executives said lumber, hardware, electrical and mill work sales all underformed. The average customer's sales ticket was down, a sign contractors are still spending a lot less at Home Depot, the world's largest home improvement chain.

The caution from Home Depot on the consumer environment echoed comments from rival Lowe's (LOW) when it reported earnings on Nov. 16. Lowe's chairman and chief executive Robert Niblock said in a statement:

The broad-based pressures of the macro environment are clearly evident in our sales as consumers continue to delay large purchases until they feel better about the economic outlook.

Home Depot's gloomy outlook sent share tumbling more than 3% lower by midday on Nov. 17. Lowe's shares also slipped.

But focusing on one day's stock performance might overstate the significance of current pessimism about the U.S. consumer. Home Depot shares are still up 7% in November, while Lowe's shares have risen almost 10%. Third quarter results may discourage unrealistic investor expectations, but they don't mean the U.S. consumer is hopeless in 2010 and beyond.

And, analysts praised Home Depot's ability to cut costs. Morgan Stanley (MS) analyst Matthew McGinley wrote:

To the extent that it is sustainable, this [cost-cutting] reflects the potential to expand margins dramatically in a sales upturn. ... [Home Depot] management deserves an award for cost control in 2009, but the stock may pause unless we see confirming evidence that 2010 [sales trends] will be positive.

"While the stock should give back some of its recent gains," JPMorgan (JPM) analyst Christopher Horvers noted, sales and profit margins should improve. "We believe a longer view is appropriate."

Robert W. Baird analyst Peter S. Benedict also saw the glass as half full. "Bottom line," he wrote: "More signs of stabilization here, and we see improved trends going forward."

The big question for Lowe's and Home Depot is how long the U.S. consumer continues to put off major home improvement projects. Many Americans may be contemplating major addition to their houses or the construction of a new deck or garage. But they can't be expected to make such major expenditures until their confidence -- in their jobs and in their investments -- truly returns.

Although municipal bond insurers have been on life support for almost two years, Ambac Financial Group’s (ABK) revelation in a Nov. 9 filing to the U.S. Securities and Exchange Commission that it might have to file for bankruptcy protection in mid 2011 should serve to remind muni investors of the need to be especially careful with what they buy.

Until early 2008, cities, towns and states across the U.S. were able to offer muni bonds at a nice premium if they were insured by Ambac, MBIA (MBI) or a handful of other companies. Now that it’s understood how insurance, once limited to munis, has been spread thinly across many riskier assets, the market has no illusions about insurers’ ability to cover losses in the event of another perfect financial storm, says Bill Larkin, a portfolio manager for fixed income at Cabot Money Management in Salem, Mass.

Despite the strong possibility that after June 2011, Ambac may not be able to fulfill its obligations, muni investors don’t have much reason for worry: bond prices have already factored in the increased risk of default, since investors no longer depend on insurance, say some bond fund managers. While it’s bound to be painful, municipal governments have no choice but to bring their spending in line with lower revenues, says Larkin. "States can raise fees, levy fees, auction off properties, lay [city workers] off. They can do some uncomfortable things, but the bond holders get paid."

Cash and equivalent, an item that is always near and dear to my heart, for the S&P old Industrials, which is the S&P 500 less Financials, Utilities, and Transportation issues, is running 9.8% ahead of the record setting second quarter value of $773 billion. Information Technology, lead by Oracle which increased $7.9 billion in the quarter, Microsoft which added another $3.6 billion, and Google which has $2.6 billion more, as a sector now has over 13% of it’s market value sitting in cash, which can’t be making much money, and the sector account for 35% of all the cash in the Industrials. Health Care, lead by Merck’s additional $5.2 billion, UnitedHealth’s $2.3 billion gain and Amgen’s $2 billion increase, now has over 17% of it’s market value in cash, and accounts for 28% of the cash. Nine of the ten sectors are up, with Energy being flat, which since Exxon has $3.1 billion less in cash this quarter, but trust me I wouldn’t be passing the plate around for them at this point, means that the rest of the Energy sector was up. Overall, 67% of the issues increased their cash position in the third quarter, mostly due to cost cutting, lower dividends and much lower buybacks, although both dividends and buybacks do appear to have hit the bottom, with dividends actually turning the corner. The cash build up has been occurring over the last year, as companies pulled back after the Lehman credit crunch to insure their own ability to finance their business, and ride their way through the recession.

But it appears that Q3 may be the height of that cash mountain, as companies start to spend some of that money. The expenditures won’t be on CapX, unless we get an accelerated depreciation bill from congress, or jobs, especially since we believe we will be testing the Dec,’82 10.8% unemployment high, nor is it on plant expansion. Shock and dismay, its M&A, and its back and alive in the market place, as well as the pockets of investment bankers. Both Pfizer and Merck have closed fourth quarter deals, with their cash component being over $61 billion. That alone should insure that cash levels decline. Hewlett-Packard announced it will buy 3Com for $3 billion, and United Technology is buying a unit from GE for $1.8 billion. As we progress in the recovery we believe M&A will increase, as companies try to buy market share, bottom fish those companies that remain in poor condition, and recapture a returning consumer, who is now significantly more attuned to the cost factor. Let me put it this way, companies now have more cash then they ever made in any one year period. And if you add that cash to the value of treasury shares, it’s 23% of market value, that’s a lot of assets sitting on the side, especially when the risk-reward trade off now appears to be bending more towards risk. So the question is can Monday Morning Merger Mania be fare behind?

Sure, Lady Gaga, Chris Brown and Jay Z make headlines, but are Viacom (VIA) investors too focused on MTV?

The folks at Ariel Investments think so. MTV accounts for just 13% of Ariel's estimate of Viacom's value, according to Ariel's analysis of Viacom , released on Nov. 13. (Viacom is a holding in the Ariel Appreciation Fund.)

And Viacom's filmed entertainment business "also receives a disproportionate amount of attention," Ariel says. That unit, which includes DVDs, generates 40% of the company’s revenues, but it accounts for only 4% of profits because of its low margins. "Investors focus on the near-term headwinds of declining DVD sales and a crowded film production industry, because the output of this segment—glamorous movies—is very visible, even though not highly profitable," Ariel says.

Ariel says it started buying Viacom in mid-July at $20.83.

Despite the stock’s increase, we believe the stock still has substantial upside opportunity. As of September 30, 2009, shares traded at $28.04, a 22% discount to our private market value of $35.76

Now Viacom is trading around $32. Do you think it still has room to rock and roll?

Stock strategist these days seem obsessed with the concept of quality.

As I wrote as early as June, the March-to-October rally was driven largely by "junk stocks." Leading the way were smaller firms with more debt, less cash, low stock prices and falling sales. These stocks were rebounding from terrible 2008's and their rise reflected investors' relief that worst-case scenarios had not occurred.

But, now, market prognosticators are watching closely to see if the low-quality rally might be over. Or at least waning.

Three different views on this topic:

1. The rally may have further to run, Robert W. Baird strategist William Delwiche noted Nov. 5. But, he says, trends will moderate and not all stocks will participate. He writes of recent activity:

Small-caps have moved into a lagging position relative to large-caps, failing to match gains on the upside and leading the way lower on pullbacks.

Financial stocks look weaker to Delwiche, while energy, consumer staples and utilities are looking stronger.

2. Commentators at Bank of America Merrill Lynch, led by chief U.S. equity strategist David Bianco, focused on the concept of beta, a measure of volatility, in a Nov. 9 note:

We expect higher beta stocks in general to outperform lower beta stocks as the market grinds higher. We expect higher quality stocks to outperform lower quality stocks of equivalent beta.

But beta and quality aren't the same things, and disentangling the two concepts can be difficult, they warn.

3. If you think the market rally has run out of steam, it may be time to move into so-called defensive stocks, firms that will hold value even if the market sinks or moves sideways.

Barclays Capital portfolio strategist Barry Knapp believes it may be too early to make any drastic moves. But, he wrote Nov. 6, "we have reached a turning point in the Fed liquidity-driven, highly-correlated rally across all asset classes." He adds:

While it's probably too early in the cycle to be playing defense, the valuation opportunities present in the space compel us to take a small step in that direction.

He proposes buying more defensive stocks but still favoring more economically sensitive stocks overall. For example, he believes tech, industrials and energy "should continue to outperform."

No matter what happens, many high-quality stocks seem to be trading at prices that could be attractive to long-term investors.

In the meantime, much will depend on corporate profits in the last three months of 2009. After a long recession and financial crisis, two of the weakest sectors are consumer discretionary and financials. Both are predicted to report huge boosts in earnings early next year.

If they do so -- if retailers have a better-than-expected holiday season and banks repair their balance sheets significantly -- the low-quality rally just might continue.

This was my ninth New York Yankees World Series parade and my sons first. There are no more $5 hats ($35 for the ‘official’ ones and $10 for the ‘others’), most of the windows don’t open, Broadway was closed-off by 11AM (start time), and there is no more tape, just purchased shredded paper. But I’ve waited nine years to pass on the tradition that my mother first taught to me in 1961 (my father had taken me to the last game of the regular season that year, in which Maris hit 61, breaking Ruth’s record). My mother was a Yankee fan, she lived a few blocks from the stadium, and dated her games back to the early 30s. Her parents were both immigrants and there was no better way back then to show your new pride than being a baseball fan, especially if you lived in the Bronx. Her big item was being at the stadium on July 4, 1939, when Lou Gehrig made his final speech; her father brought her a souvenir ball that day with Gehrig’s name on it. Many years ago I stole that ball from my mother, and joked that it would pay for my kids’ first years’ tuition. Two years ago, my son, who attended his first NYY parade today, as well as the first game at the new Yankee Stadium, stole that ball from me. It sits in a case, in his room, on a mantel. However, unknown to him, behind the case there are two notes. The first is from my mother, saying that the ball is now his. The second, I wrote, and is dated July 4, 2039, and addressed to “David’s child”. It says that I stole the ball from my mother, that their father stole it from me, and that today, July 4, 2039, on the 100 year anniversary of Gehrig’s speech, they need to steal it from their farther, my son. I don’t know, or care, if my grandchildren will be Yankee fans, but I sure hope they will understand tradition; it took me a lot of years to get there, thanks mom.

Shares of Whole Foods Market (WFMI) took a nosedive on Nov. 5, dropping 15.5% to 27.10.

What scared Whole Foods shareholders should concern all investors, especially those in consumer-focused stocks: The outlook for next year.

Like many other retailers, Whole Foods gets praised for navigating through the recession relatively well. Investors worried about Whole Foods' sales trends and debt load dumped shares in 2008, and shares fell to as low as $7. Since the beginning of 2009, however, Whole Foods' stock is up 187%.

Announced the evening of Nov. 4, last quarter's results didn't contradict the thesis that the food retailer's business has stabilized. In fact, fourth-quarter earnings of 23 cents per share beat Wall Street expectations by 2 cents.

Sales trends weren't bad. Chairman and chief executive John Mackey told analysts: "We believe our sales have stabilized and officially turned the corner."

After five quarters of declines, comparable store sales figures rose 1.6%. Total sales for the quarter rose 2.3% to $1.8 billion.

With results that good, why are investors bailing on the stock? One problem, which I noted back in August, is the high expectations built into Whole Foods' stock price. Because it is a growing firm, investors are willing to pay far more for Whole Foods than other grocery chains. Before earnings were released, on Oct. 30, J.P. Morgan (JPM) analyst Charles Grom noted that Whole Foods traded at 27.6 times his 2010 earnings prediction. Rival supermarket chain Kroger (KR), meanwhile, trades at a price-to-earnings ratio of 11.2. That "seems a bit excessive," he wrote.

But even if you believe Whole Foods deserves a premium stock valuation, you should be worried that 2010 sales and profits will disappoint. And that's the warning investors received from Mackey.

Mackey said he sees "no anticipated positive change in the economy over the short-term." Whole Foods, like many other retailers, has already slashed its expenses, and further cuts will be harder to find. "We will have difficult expense comparisons due to the cost savings realized in 2009," Mackey said.

Credit Suisse (CS) analyst Edward J. Kelly noted:

The company is making progress in addressing some of its issues (slowing growth, downsizing its stores, exiting bad leases in development, and cutting its bloated expense structure), [but] this catalyst seems to be more than price in [its stock.]

The recession forced Whole Foods -- and many other companies -- to become more efficient and make tough choices. However, investors already have reaped most of the benefit of these changes.

In 2010, investors will need robust consumer spending to drive results. And, with the job market weak, that might be too much to hope for.

When the S&P 500 opened at 1047.30 on Nov. 5 and quickly rallied 1.65% to 1063, investors could be pardoned for feeling a sense of déjà. Just yesterday, the S&P 500 opened at 1047.14 and barreled its way up to 1061. But stocks gave back most of their gains after the FOMC meeting, and closed at 1046.50. Will today's trading end on a happier note?

Technical analysts see some indications that it could. For starters, the market is pushing strongly against its near-term resistance, which is around the 1060 to 1066 level. Yesterday, it hit those levels and fell back. But short term sentiment, as measured by the percentage of stocks trading at 10-day lows, is bearish, says technical analysts at institutional brokerage Concept Capital. That indicates an oversold condition and could point the way higher for stocks.

Still, there are signs that the market is poised to roll over. On Nov. 4, more stocks moved down than up, a bad sign after the S&P 500 spent so much of the day in the green. And despite the oversold conditions, the market hasn't been able to put together any positive momentum, Concept Capital says.

More worrisome is the 60-day average correlation of individual stocks to the S&P 500. Right now, that number is 62% -- it would have to trade above 70% to be problematic. But if it keeps rising, it could be a sign of long-term weakness to come. Says Concept Capital: "A prolonged rise in correlation could indicate that a more significant period of market weakness is starting to develop."

Equities are expensive, says High Frequency Economics chief economist Carl B. Weinberg. But before you start dumping all the stocks in your portfolio, pay heed – it’s Europe, Japan and England – not the U.S. – you need to worry about.

During the past two quarters, U.S. investors have become accustomed to companies beating earnings estimates. Sure, much of that has been done with cost cutting, but a beat is a beat. In Europe and Japan, however, third quarter corporate earnings have been coming in below expectations. That's impacted valuations across the board. The Japanese Nikkei 225 has a trailing p-e of 37.58, the Xetra DAX 100 has a p-e of 43.95 and England's FTSE 100 has a p-e of 21.15. The S&P 500, in contrast, has a p-e of just 21.15.

The difference, Weinberg says, stems from labor market differences. In the U.S., job cuts have been deep and painful, but they've also been quick. Costs have quickly been realigned and that's helped keep price-to-earnings ratios near "historical norms," Weinberg says. European and Japanese lack the flexibility to cut wages or lay workers off to match falling demand. That’s good for workers but bad for valuations. Says Weinberg: “This will be a bad season for [Japanese, Euroland and London] stocks.”

The first Charles Schwab-branded exchange-traded funds launch tomorrow, Nov. 3, and Schwab is offering free, uncapped trading to its customers who buy in online—essentially creating a platform that enables retail investors to dollar cost average with ETFs.

At a press conference in New York today, Schwab chief executive officer Walter W. Bettinger II described the move as “game-changing.” Previously, investing a fixed dollar amount at regular intervals into ETFs would have incurred steep trading costs: Investors who execute fewer than 120 trades per year pay a hefty $12.95 per trade.

The four ETFs that debut tomorrow are designed to track the following broad indexes: Dow Jones U.S. Broad Stock Market Index, Dow Jones U.S. Large-Cap Total Stock Market Index, Dow Jones U.S. Small-Cap Total Stock Market Index, and FTSE Developed ex-U.S. Index. Schwab also said it will launch four additional ETFs—tracking U.S. large-cap growth and value stocks, international small-cap stocks, and emerging markets stocks—later this year. The stated expense ratios for all but the emerging markets ETF are below those for comparable funds from the three biggest players in the ETF market: Vanguard, Barclays Global Investors, and SSGA.

Vanguard spokesperson John Woerth told BusinessWeek that Vanguard will continue to introduce new ETFs, including seven new bond funds over the coming new weeks, but “has no plans to offer commission-free ETFs.” Woerth did note that investors should evaluate the “all-in” costs of any product, which would include a fund's expense ratio, trading fees, and other expenses.

For more information about the new Scwab ETFs, click here.