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U.S. Week Ahead: ISM and Employment Steal the Show

March 30th, 2008 Michael McDonough Comments off
Looking back to last week, as we expected the market was unable to maintain the upward momentum it experienced the week prior. This was due to weaker than expected data from the consumer sector and financial related news. The Dow and S&P500 ended the week down 1.17% and 1.08%, respectively, and we could have more bad news this week.

There is a significant chance we could see the probability of a 50bp cut rise this week after the ISM and employment data are released

Source: Cleveland Fed

This week has its fair share of important data releases; underscored by Tuesday’s ISM release and Friday’s pivotal employment report. We believe both of these indicators have considerable downside risks as the economy moves further into a recession. Here’s why, the charts below show the performance of the ISM and the change in nonfarm payrolls over the last 50 years (recessions highlighted in gray). As you can see from the charts, we haven’t begun to touch the lows for these indicators during a recession. In fact, over the past 50 years the ISM has averaged 42.6, while the change in payrolls has averaged -154K during recessions. To make matters worse, in nearly every case the ISM moved sub-40, while in every case the net change in payrolls broke -300K. As these indicators continue to deteriorate, it will become more apparent, that this crisis isn’t solely contained in the financial economy. However, we believe the Fed’s response up to this point has been the correct one for a slowdown in the real economy. This should help curtail long-term sustained losses in these indicators when compared to past recessions. Nevertheless, things will get worse before they get better.


ISM performance over the past 50 years (recessions highlighted in gray)

Source: BBerg

Change in nonfarm payrolls over the past 50 years (recessions highlighted in gray)

Source: BBerg

Let’s take a look at the some of the important indicators coming out this week in the US :

Monday March 31st:
9:45AM: NAPM-Chicago (Risk: Downside)- According to the consensus survey the market is expecting a reading of 46.0, compared to 44.5 the previous month. We believe the NAPM will continue to deteriorate as the economy moves into a recession.

TBD: Annual Crop Planting Report- The Department of Agriculture’s annual crop planting report is something I have never really looked at in much detail. However, this year investors are using it as an indicator towards the commodity. The report is considered a bellwether for farming in the year ahead. In any case, this report will likely have an impact in the commodities market, so keep an eye out. This report outline’s farmers intentions to plan crops; the USDA will release actual numbers in June.

Tuesday April 1st:
10:00AM: ISM Manufacturing Index (Risk: Downside)- The BBerg consensus survey is anticipating a release of 48.0 versus 48.3 the previous month. As we outlined in the text above we believe there are considerable downside risks to this indicator, given it has averaged 42.6 during recessions over the last 50 years.

10:00AM: Construction Spending (Risk: Neutral)- The consensus survey is anticipating a change of -1.1% m/m vs. -1.7% m/m last month. What will be important to look at in this release is the change in non-residential construction. Non-residential construction has remained resilient during the current crisis, but it has begun to falter. Last month private non-residential construction spending moved negative for the first time during this crisis, and we believe this may be the start of a trend.

Wednesday April 2nd:
8:15AM: ADP Employment Report (Risk: Downside/Neutral)- This release will be used to help gauge the change in Friday’s employment report.

10:00AM: Factory Orders (Risk: Neutral)- The consensus survey is anticipating a release of -0.6% m/m compared to -2.5% the month prior. Factory orders should continue to slow-down as the economy cools down.

Thursday April 3rd:
8:30AM: Jobless Claims (Risk: Neutral)- According to the consensus survey the market is expecting weekly jobless claims of 366K. This number should remain within recession territory (+350K), which does not bode well for the overall employment situation.

10:00AM: ISM Non-Manufacturing Index (Risk: Neutral)- The consensus survey is anticipating a reading of 49.0 compared to 50.8 the month prior.

Friday April 4th: Employment Day!
8:30AM: Employment Report (Risk: Downside)-
The BBerg consensus survey is expecting a 50K decline in non-farm payrolls and an unemployment rate of 5.0%. We believe there is significant downside risk for both of these indicators, and believe it is possible we could see a large spike in both (as we outlined in the text above).

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Short Interest Ratio NYSE Top 100

March 28th, 2008 Michael McDonough 2 comments
I was looking at an interesting article on Seeking Alpha regarding short interest. I decided to extend the analysis slightly and calculate the Short Interest Ratios for the top 100 NYSE stocks. Unfortunately, the NYSE charges for the entire time series so I was only able to use the data from the most recent release. Here are the results with the % change from the previous period:

Stock Name SIR Change
TOC THOMSON CORPORATION 89.6 20.7%
NYT NEW YORK TIMES CO 20.9 -8.3%
KMX CARMAX, INC. 16.7 12.0%
CBB CINCINNATI BELL INC. 16.3 7.4%
ACF AMERICREDIT CORP 14.7 -4.1%
BZH BEAZER HOMES USA INC 14.0 3.6%
IMB Indymac Bancorp, Inc. 13.9 -3.6%
CDL CITADEL BROADCASTING 12.2 10.3%
SPF STANDARD PACIFIC 11.8 -0.5%
BE BEARINGPOINT, INC. 11.8 9.5%
MAS MASCO CORP 10.3 4.7%
EK EASTMAN KODAK CO 9.7 1.5%
CNB COLONIAL BANCGROUP 9.7 10.2%
MIR Mirant Corporation 9.2 -3.3%
IPG INTERPUBLIC GROUP 8.7 1.2%
MCO MOODY’S CORPORATION 8.2 2.4%
BBI BLOCKBUSTER INC 7.8 16.0%
NYB NEW YORK COMMUNITY 7.6 4.1%
CC CIRCUIT CITY GROUP 7.1 11.2%
CSE CAPITALSOURCE INC. 6.8 5.0%
Q QWEST COMM INT’L INC 6.8 1.9%
GGP GENL GROWTH PROPS 6.8 19.2%
THC TENET HEALTHCARE 6.5 9.9%
RAD RITE AID CORP 6.3 -17.3%
CBS CBS Corporation CL-B 5.8 -8.4%
MBI MBIA, INC. 5.7 8.8%
BX The Blackstone Group L.P. 5.7 18.4%
BSX BOSTON SCIENTIFIC 5.5 13.1%
USU USEC INC 5.5 -1.2%
HST Host Hotels & Resorts, Inc. 5.4 15.2%
SNV SYNOVUS FINANCIAL 5.3 23.1%
RF Regions Financial Corp. 4.9 18.5%
LEN LENNAR CORP 4.8 2.3%
DIS WALT DISNEY-HLDG CO. 4.7 8.9%
BBT BB&T CORPORATION 4.6 2.2%
MYL MYLAN INC 4.6 5.8%
MU MICRON TECHNOLOGY 4.5 -4.7%
LSI LSI LOGIC CORP 4.5 5.4%
HAL HALLIBURTON CO-HLDG 4.5 2.6%
BBY BEST BUY CO., INC. 4.2 -2.7%
PHM PULTE HOMES, INC 4.2 14.1%
F FORD MOTOR COMPANY 4.2 8.9%
WMB WILLIAMS COMPANIES 4.2 3.9%
NWSA News Corporation CL-A 4.1 19.0%
NCC NATIONAL CITY CORP 4.1 15.1%
AMD ADVANCED MICRO DEV 4.0 6.4%
COF CAPITAL ONE FINANCL 3.9 15.5%
GM GENERAL MOTORS CORP 3.9 29.1%
CHK CHESAPEAKE ENER (OK) 3.8 0.4%
TGT TARGET CORPORATION 3.7 -4.7%
LUV SOUTHWEST AIRLINES 3.7 -2.7%
ALU Alcatel-Lucent 3.7 4.8%
HD HOME DEPOT INC 3.6 -0.3%
DHI D.R. HORTON INC 3.6 3.3%
CFC COUNTRYWIDE FINANCIA 3.4 9.0%
DYN Dynegy Inc. 3.3 18.0%
DUK Duke Energy Corporation (Holdi 3.2 12.1%
CVS CVS CAREMARK CORP 3.0 10.7%
WFC WELLS FARGO& CO 2.9 8.0%
USB U.S. BANCORP 2.9 24.6%
KFT KRAFT FOODS INC. 2.9 11.1%
SLM SLM CORPORATION 2.8 11.6%
FCX FREEPORT-MCMOR C&G-B 2.5 13.8%
AMR AMR CORP 2.5 12.1%
CVX CHEVRON CORPORATION 2.5 9.3%
LOW LOWE’S COMPANIES 2.4 -0.1%
PG PROCTER AND GAMBLE 2.3 15.7%
WM WASHINGTON MUTUAL INC 2.3 10.4%
WB WACHOVIA CORPORATION 2.3 2.1%
T AT&T Inc. 2.3 3.7%
CDE COEUR D’ALENE MINES 2.3 8.5%
TXN TEXAS INSTRUMENTS 2.3 2.9%
FRE FREDDIEMAC VOTING 2.2 10.9%
VZ VERIZON COMMUNICATNS 2.2 3.0%
EMC EMC CORP 2.1 8.4%
FNM FANNIE MAE 2.1 17.2%
HPQ HEWLETT-PACKARD (DE) 2.1 -6.1%
MO ALTRIA GROUP, INC. 2.0 12.1%
RIO COMPANHIA VALE DO RI 2.0 6.6%
CCU CLEAR CHANNEL COMMUN 1.9 12.4%
WMT WAL-MART STORES INC 1.8 -6.2%
AIG AMERICAN INTL GROUP 1.7 19.2%
TWX Time Warner Inc. 1.6 -5.4%
ABK AMBAC FINL GROUP INC 1.6 -2.1%
MOT MOTOROLA INC 1.6 14.0%
BAC BANK OF AMER CORP 1.5 23.2%
PFE PFIZER INC 1.5 4.9%
LEH LEHMAN BROTHERS HLDG 1.4 7.7%
XOM EXXON MOBIL CORP 1.3 1.3%
S Sprint Nextel Corporation 1.3 66.8%
MER MERRILL LYNCH & CO 1.1 17.6%
NLY ANNALY MORTGAGE MGMT 1.0 104.3%
JPM J.P. MORGN CHSE & CO 1.0 13.2%
C CITIGROUP INC 1.0 5.9%
GE GENERAL ELECTRIC CO 0.8 6.1%
IWM iShares Russell 2000 Index Fun
EEM iShares, Inc. Emerging Mkts In
IYR iShares Trust US Real Estate
EWJ iShares, Inc. MSCI Japan
EWT iShares Inc. MSCI Taiwan

*I am not sure if the Thomspon Financial data is accurate, but it is what the NYSE is reporting.

According to my calculations excluding the securities with no average daily volume data the NYSE top 100 has a SIR of 2.8 days, up 8.1% from the previous month .

Why is this important? Well besides giving investors an idea of market sentiment on specific securities or sectors; it also creates the opportunity for a potential short squeeze. A short squeeze is when investors cover their short positions in order to stop losses by purchasing the equities on the open market, in theory bringing up the securities price. So, the higher the SIR the higher the potential magnitude of a short squeeze.

In any case here is the data. I hope you find it useful.

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A simple quick explanation as to why US gasoline prices will continue rising rapidly

March 24th, 2008 Michael McDonough Comments off

Consumers around the world are being indirectly taxed through record high gas prices. This of course hurts consumers’ pockets and can raise inflation fears. We wanted to take a look at the crack spread between WTI crude prices and US petroleum prices as measured by the Energy Information Agency. We outline the results below.

The February reading of the U.S. all grades all formulations retail gasoline prices per gallon was $3.078 verses a WTI price of $95.35/barrel for the month. Why is this important? First off, gasoline is produced by applying a refining process to crude oil, so factoring out crude previously purchased at a lower price and hedging activities, gasoline has to be more expensive than crude. For comparative reasons we broke the WTI/barrel price into a WTI/gallon price, so we could compared it to gas prices. The results were not surprising, that is until recently. The average spread over the last 15 years of WTI to gasoline prices per gallon has been $0.53; never going below $0.25, that is until October of 2007. As you can see from the chart below the Gas/WTI spread has remained fairly constant over the years until the recent convergence. We currently estimate the spread for March 2008 stands around -$0.15 after a reading of 0 in February. What does this mean? Well it means eventually, and likely sooner rather than later, the US will experience a sharp rise in gasoline prices, at least without an offsetting drop in WTI prices. If you were to apply the historical spread to current WTI/gallon prices US gasoline prices would total $3.96/gallon. This number seems quite realistic to me.

This chart shows the spread between WTI and gas prices has collapsed, meaning WTI prices will need to experience a sharp decline or gas prices need to catch up…

Source: Energy Information Agency & my calculations

Investment Relevance: Crack spreads are used as a measurement of the profit margins for oil companies, such as XOM. In fact, recently, we have seen a drop in both the spread and XOM’s share price. If this spread reverts to its historical level, then we would expect to see higher margins, which should be reflected in share prices. However, the current zero to negative spread does not bode well for the industry, but as we mentioned above we do not imagine that will last for long. One concern however, is that there tends to be a lagging relationship between the two variables. As you can see from the chart below there does in fact appear to be a correlation between the 4 month lagged XOM price and the Gas/WTI spread. This implies that the recent drop-off in the Gas/WTI spread could place some downward pressure on XOM. However, this is a very simplistic model, and I would strongly discourage anyone from trading on it without significant refinements. There is a lot more than one variable that will affect price; this is simply meant to be a demonstration.

4-Month lagged XOM price vs, Gas/WTI spread shows that XOM stock price could face some downward pressure in the coming months

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Week Ahead: The Potential to be a Downer

March 23rd, 2008 Michael McDonough 1 comment
As I expected the Fed cut rates by 75bp. However, we did see Governor Plosser and Fisher dissent on the decision, both wanting smaller cuts. This is interesting news because I now believe we may be closer to the end of the current rate cut cycle than I originally thought. This may be good news for the Fed. Recently, there has been a lot of chatter in the markets over the US encountering a possible liquidity trap, like that in Japan. However, with the two dissentions on Tuesday’s vote markets are now pricing in a lower probability of more significant rate cuts at April’s meeting, meaning the Fed may have found a way to reduce or end the current rate cut cycle, before rates became low enough to invoke a liquidity trap, and importantly, without disappointing market expectations. You can see from the chart below that after Tuesday’s announcement market expectations shifted to a 2.00% fed funds rate vs. 1.50% prior to the announcement.


The Cleveland Fed’s Implied Probabilities for the April meeting outcomes as shown that the magnitude of the expected rate change has declined significantly

Source: Cleveland Fed

This week has the potential to bring some negative consumer focused news to the market place. It is likely GDP will be revised downwards, housing numbers will continue to disappoint, and PCE will help convince a few more people a recession has arrived. We are not sure if the market will have enough upside momentum to keep up last week’s gains through-out this week. For those of you looking at global markets, make sure you keep an eye on Taiwanese markets which are set to rally after the big victory of the ‘China friendly’ party in the country’s Presidential elections.

Let’s take a look at the some of the important indicators coming out this week in the US :

Monday March 24th:
10:00AM: Existing Home Sales (Risk: Downside) The Bloomberg consensus survey indicates the market is currently anticipating a reading of 4.85mn units, this would be slightly lower than last month’s 4.89mn reading. There hasn’t been much good news in any of the housing market indicators, and considering the difficulty in acquiring home loans I do not see much upside. We should continue to see inventories increase, and prices falling.

Tuesday March 25th: Fed Day!
10:00AM: Consumer Confidence (Risk: Neutral)- According to Bloomberg.com the market is currently expecting a reading of 73.0 vs. 75.0 last month. We have already seen a substantial drop in the confidence numbers and imagine it will stay around these levels for some time. Minor changes in the Consumer Confidence numbers are not overly important. However, what is important is large swings, such as the major drop we have experienced at the beginning of this year.

Wednesday March 26th:
8:30AM: Durable Goods Orders (Risk: Downside)- According to Bloomberg.com the market is currently expecting a reading of 0.7% m/m vs. -5.3% m/m previously. We have seen continued weakness in the manufacturing sector and imagine this weakness will be reflected in the durable goods number.

10:00AM: New Home Sales (Risk: Downside)- According to Bloomberg.com the market is currently expecting a reading of 575K vs. 588K previously. For the same reasons as Existing Home Sales outlined above.

Thursday March 27th:
8:30AM: GDP Final (Risk: Downside)- According to the consensus survey the market is expecting a reading of 0.6%q/q SAAR, or no change from the preliminary reading. However, I believe there could be more downside in this number than upside and thus believe there is a chance the number could somewhat disappoint.

8:30AM: Jobless Claims (Risk: Neutral)- According to the consensus survey the market is expecting a new jobless claims of 370K,vs. 378k last week. I still continue to monitor this release as one of the most important for the employment situation.

Friday March 28th:
8:30AM: Personal Income and Outlays (Risk: Downside)-
According to the consensus survey the market is expecting 0.3%m/m and 0.1%m/m for personal income and personal outlays, respectively. Rising energy and food prices in February will likely eat into the consumer spending figures out pacing the rise in personal income. Remember, about 70% of US GDP is based on consumer spending.

10:00AM: Consumer Sentiment (Risk: Neutral)- According to the consensus survey the market is expecting a reading of 70.0 for consumer sentiment vs. 70.8 last month. After experiencing a large downward swing at the beginning of this year I expect sentiment to stay around this level for the time being.

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Opposition Party Wins Taiwanese Presidential Election

March 22nd, 2008 Michael McDonough Comments off

As we expected the opposition candidate Ma Ying-jeou has won the Taiwanese Presidential elections. As we outlined in the entry below this should bode well for Taiwan’s economic outlook.

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Taiwanese Presidential Elections Being Held Today

March 21st, 2008 Michael McDonough 3 comments
As I mentioned in my January 30th post, I believe that the ‘ China friendly’ Kuomintang party, after their sweeping victory in the legislative elections, will win the Presidential elections. Once this occurs it is likely that we will see the new leadership attempt to open direct ties with China allowing tourists, and more importantly investments, to flow freely between the countries. Lets be clear though, the Kuomintang party is not calling for reunification, just for an improvement in ties. With this in mind it will be important to monitor the new officials progress in negotiating with the Chinese government. However, after spending some time on the ground in Taiwan and gaining a rough gauge on local sentiment, I believe people are ready for change, especially change that brings stronger economic growth and more jobs. Thus, we think it is more likely than not the Kuomintang will be successful at reopening ties with China. We anticipate that this will have a substantial positive impact on the Taiwanese economy. I still believe the best way to leverage this potential is through the ETF ‘EWT’. In fact we have realized we are not alone in this assumption. Since we first recommended looking at EWZ on Jan 30th it has experienced near 20% gains outperforming the overall MSCI EM ETF ‘EEM’ by around 23%. This performance is surely on the back of the expected improvement in ties with China and the potential catch-up effect we could see in the Taiwanese economy.
Take a look at the charts below for more details:

Taiwan ETF (EWT) and Overall EM ETF (EEM) rebased to 100: EWT has been significantly underperforming the EM benchmark

Source: BBerg

But that has changed… EWT has begun to outperform EEM and we expect this trend to continue as long as ties with China are improved
Source: BBerg
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Chinese Monetary Policy vs. Inflation FIGHT!

March 19th, 2008 Michael McDonough Comments off
*FX data updated on March 27th 2008

Policy makers in China have not only continued their anti-inflationary rhetoric, but have started acting on it. We have seen the RMB reach several new highs verse the USD in recent days (7.01). Additionally, Chinese authorities have increased reserve requirements for the second time this year by 50bp to 15.50%. It does not appear this news has settled too well with Chinese equities markets, which have experienced a significant sell-off from the combined fears of tighter monetary policy, a stronger RMB, and possible global slowdown. As a result, local investors seeking more attractive yields have started moving away from EQ and into the domestic fixed income market; yields have rallied accordingly. We expect this trend to continue.

Fears of a global economic slowdown and tighter monetary conditions have begun to show up in the SSE Composite…

Source: Bloomberg

This was not unexpected, as we outlined in an early posting, this how we expect Chinese policy makers to combat high inflation levels:

1) The Central Bank will increase interest rates, which it hasn’t done since December 07;

2) They will allow the RMB to appreciate at a faster rate;

3) They will implement new or stronger policies to reduce monetary growth. (i.e. Higher reserve requirements).

Additionally, we believe the government will continue to enforce its recent price control measures. With that said it is highly likely the Chinese government will continue increasing reserve requirements and continue appreciating the RMB at a faster rate. Given the recent weakness of the USD, the RMB has weakened substantially against the Euro, which probably implies European officials will begin placing pressure on the Chinese officials for quicker appreciation. We also expect to see increases in the Chinese reference rate, the last increase occurred at the end of December.

The Chinese Reserve Requirement Ratio has been increased steadily with inflation, and will continue to rise…


Chinese officials will continue to speed up appreciation of the RMB to combat inflation…

Investment Idea: We see potential upside in the domestic Chinese Steel industry. We have seen an increase in domestic demand as the country continue to develop and we believe the industry is ripe for consolidation. We may actually see the amount of Chinese steel exports decrease this year due to increased local demand, higher export tariffs, and an appreciating RMB. A reduction in Chinese steel exports could put upward pricing pressures on the global market. We also expect domestic steel makers to increase domestic prices as international prices rise. In fact, Baosteel has already announced price increases and may adjust prices on a monthly basis vs. quarterly previously. This of course will put further pressure on Chinese inflation. Which means it will be important to monitor to what degree government officials allow steel producers to pass costs to consumers. However, for steel, we see plenty of demand and a sticky supply. The bottom line is in 2008 look for higher steel prices, industry consolidation, and fewer exports from China (reducing the global supply). We believe this should directly benefit Brazil (ETF:EWZ), especially domestic iron ore producers. Brazil’s largest exports to China are soybeans and iron ore. However, there is a risk that a global economic slowdown could adversely affect steel demand.

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Fed Cuts 75bp

March 18th, 2008 Michael McDonough Comments off
As we expected the Fed cut the fed funds rate by 75bps, and made an equivalent move in the discount rate. What is interesting is that the Fed had two dissenters to the vote, Governor Plosser from Philly and Governor Fisher from Dallas, both wanted a smaller cut. Plosser is a well known hawk on the FOMC, so this was not surprising. However, this combined with a stronger inflation message, could imply the end of strong rates cuts. Keep in mind, the market responded very favorably to the move, despite at one point having priced in a 100% chance of a 100bp cut (the GS and LEH news did help). This also supports the possibility that we could be near the end end of the rate cuts or at least at a point where we see a significant reduction in its magnitude (ie 25bps). Of course the Fed’s future reaction will be very reactionary to market news and data.

Investment Idea: We continue to believe home builders may soon become a good play and should be payed close attention to. We will be looking at the ETF ‘ITB’

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The Week Ahead: Fed Cuts and Bank Failures

March 16th, 2008 Michael McDonough Comments off

Despite the news from Bear Stearns and a weak retail sales report, the Dow actually ended the week up 0.48%. Nonetheless, there isn’t much else to boast about; the NASDAQ ended unchanged while the S&P500 lost 0.40%. However, the CPI release surprised the market by coming in well below expectations and showing no increase for either the core or headline indices. This development was mostly sidelined by the problems at Bear.

But looking forward; this week it’s all about the Fed. Despite the encouraging CPI report the Fed will not view one month’s data as the beginning of a trend; they will remain very vigilant over inflation. However, the news from Bear Stearns and growing trouble in the financial sector will cause the Fed to cut rates by 75bps. We do not believe the Fed will move a total of 100bps given their current concerns over inflation. If the Fed was to move a total of 50bps verses 75bps and the market reacted adversely it would potentially open the window for an additional inter-meeting rate cut, which the Fed would like to avoid. As we have said before we feel one of the best indicators for the Fed’s move is what the market is currently pricing in. The Fed typically does not disappoint the market. (For a more detailed analysis on Fed cuts and inflation please look at our posts from March 11th titled “Inflation, Inflation, Inflation” & February 27th titled “Fed Cuts & Inflation”)

Effective Fed Funds rate pre-March 2008, implied Fed Funds rate post, as of March 14th.

Monday March 17th:
8:30AM: Empire State Manufacturing Survey (Risk: Neutral) The Bloomberg consensus survey indicates the market is currently expecting a reading of -6.3, this would be an improvement from last’s month unexpected drop to -11.7, but still in negative territory. This survey is one of the first indicators monthly indicators released covering the manufacturing sector and thus it is used as a tool to help forecast the overall ISM number. A negative reading of this survey combined with negative readings from the Philly Fed and the Chicago-NAPM can indicate a slowdown in the ISM.

9:15AM: Industrial Production (Risk: Downside) The Bloomberg consensus survey indicates the market is currently expecting a reading of -0.1% on production and a 81.3% capacity utilization rate, compared to 0.1% and 81.5% on production and capacity utilization, respectively. The recent slowdown observed in manufacturing could adversely impact production.

Tuesday March 18th: Fed Day!
8:30AM: Housing Starts (Risk: Downside)- According to Bloomberg.com the market is currently expecting housing starts to total 0.99mn. Permits continue to decline, inventories continue rising, we just don’t see much upside potential for this indicator. (For more information please read our post on the Housing Crisis from March 5th titled ‘How will it end?’)

8:30AM: Producer Price Index (Risk: Neutral/Slight Upside)- According to Bloomberg.com the market is currently expecting PPI and Core PPI to increase 0.4% and 0.2%, respectively.

2:15PM: Fed Announcement (Risk: Neutral/Slight Upside)- We expect the Fed will cut rates by 75bps and continue to hold a negative bias. We expect the Fed will indicate that they will continue monitoring inflation, and that downside risks to growth still exist and will continue to affect employment. They may also mention in more detail their concerns about the financial sector after the Bear Stearns bailout and surprise rate cut on Sunday.

Wednesday March 19th:
None

Thursday March 20th:
8:30AM: Jobless Claims (Risk: Neutral)- According to the consensus survey Jobless Claims are expected to come in at 360K, still above our 350K threshold.

10:00AM: Leading Indicators (Risk: Neutral)- Bloomberg.com currently states a market consensus of +0.3% M/M change for the leading indicators.

10:00AM: Philly Fed Survey (Risk: Neutral)- Bloomberg.com indicates the market is expecting a reading -20.0 verse -24.0 last month. As with the Empire Survey being released earlier in the week, the Philly Fed will be the second release to address the health of the US manufacturing sector.

Friday March 21st:
Market Closed (Good Friday)

Investment Idea:

Please look at the posting from March 9th. Also, we have begun looking at long dated Citigroup calls as a possible investment idea. At the same time, we are very concerned about Lehman Brothers and expect to see its shares catch a strong bid.

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Food or Fuel for Thought?

March 14th, 2008 Michael McDonough 3 comments
Energy prices are showing absolutely no signs of abating; those peak oil theorists may be on to something (at least in the short-run). We just don’t see oil prices coming down significantly without a considerable reduction in demand; through improved fuel efficiency or a considerable economic slowdown. Now that we have settled that, we want to tackle a potentially larger problem verse high energy prices alone. That problem is higher energy prices combined with higher food prices. As people search for alternative energy sources, they have begun to tap heavily into the worlds’ food supply (i.e. corn). Ethanol, though 9,000 years old, has had a proliferation recently thanks to lofty oil prices. According to the Renewable Fuels Association just the US is producing around 375,000 barrels per day. This equates to almost 2 billion bushels of corn a year (around 25% of the domestic use), and it’s growing. Essentially, that means 2 billion fewer bushels of corn are going into the food supply for both humans and animals. Of course productivity improvements and new farm land could reduce the overall effect, but not nearly enough to compensate for the sectors rapid expansion.

US Ethanol Production has been increasing drastically

So what does this mean for food?

We are all aware that global food prices are rising sharply for a variety of reasons including weather and demand and supply shocks, but have energy prices had any affect?. Below we outline our view that the increasing in oil prices, have led to a substantial rise in ethanol production, and will have significant effect on food prices and eventually overall CPI. In order to have a consistent time series of agricultural prices we used the USDA prices received by farmers’ data. First off, let’s look at the relationship between WTI prices and ethanol production (chart below). As you can see below the two variables are highly correlated, this makes sense since the price of producing ethanol relative gas drops as oil prices move higher. However, the important question is what effect (if any) does the increased production of ethanol have on the food supply and prices?

High energy prices have been the driver behind the increased production

To answer this question we first analyzed corn price verse ethanol production (chart below). Again we see a strong correlation between the two, with the only anomaly being in 2005. This was caused by a good harvest and the effects of Hurricane Katrina. As we stated early the price of corn is influenced by a number of variables. Given the minimal use of ethanol prior to the beginning of this decade we do not believe ethanol production has had much, if any, affect on corn prices before now. In 1999 only 1.5bn gallons of ethanol were produced a year verse over 5bn today. That’s a lot more corn! Now that we now the production of ethanol can influence corn prices, what is the relationship of corn prices to the food and beverage CPI component and overall CPI?

Corn Prices have been influenced by ethanol production

Before we start this analysis lets mention some important direct uses of corn; food, corn syrup, animal feed, ethanol, etc… Meaning corn prices can influence everything from candy to milk. Now with this in mind, we would expect a significant rise in corn prices to eventually pass-through the food chain into every product that utilizes corn. In the chart below we compared corn prices to the food and beverage component of the US CPI on a y/y basis. Again the result was not surprising; the food and beverage component of the CPI has been increasing with corn prices. Given the wide spectrum of uses for corn it is hard to judge the total effective corn would have in the index (at least for this brief analysis), but we imagine it is significant.

Corn prices have helped to drive up the overall food and beverage CPI component

Conclusion:

The massive increase in ethanol production brought on by elevated energy prices has had a significant effect on corn prices. This means that as long as energy prices remain elevated, and corn is used as the primary crop to produce ethanol, we can expect to see the prices continue on this path. Given corns multiple uses within the food industry, we can also expect to see the food and beverage component of the CPI increase as a result. Also as lower value crops are switched over to corn we may also see a rise in the price of other crops as supply comes down. One alternative on the horizon is using switchgrass instead of corn to produce ethanol. It is believed that switchgrass will be a more efficient producer of ethanol and also will not directly impact the food supple, since you can’t eat it. However, this is still in an experimental stage and will take time. The bottom line is, so long as energy prices continue to rise and ethanol production along with it, we can expect to continue seeing the food and beverage component of the CPI trending up.

Investment Idea:

If you believe that the price and value of agricultural goods will continue to rise from cross-over to energy products and higher world demand, we recommend purchasing agriculture based ETFs such as ‘MOO’ or ‘DBA’ as a good play on the sector. However, it is important to keep in mind that speculators may have artificially driven up prices in agro indexes, so it is possible that we could see the indices catch a bid in the short-term.

Price of DBA vs wheat, corn, & soybean (rebased to 100)

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