Evening Update

Bank Credit Losses Give Market a Case of the Mondays

Stocks were sharply lower today, led by financials after Bank of America’s results, while better-than-expected, highlighted rising credit losses, and Ken Lewis commented that credit is going to get worse before it gets better. Even a series of acquisition activity failed to prop up markets, after Sun Microsystems agreed to be acquired by Oracle and PepsiCo offered to acquire the remaining stake in its key bottlers. In earnings news, Eli Lilly significantly beat earnings forecasts. The Leading Index of economic indicators fell more than expected, and the dollar rose in a flight to safety, putting heavy pressure on dollar-denominated commodities such as crude oil, and Treasuries were higher.

The Dow Jones Industrial Average fell 290 points (3.6%) to close at 7,842, the S&P 500 Index lost 37 points (4.3%) to 832, and the Nasdaq Composite declined 65 points (3.9%) to 1,608. In moderately heavy volume, 1.8 billion shares were traded on the NYSE, and 3.1 billion shares were traded on the Nasdaq. Crude oil fell $4.45 to $45.88 per barrel, wholesale gasoline lost $0.08 to $1.41 per gallon, and gold rose $16.15 to $884.95 per ounce.

Dow member Bank of America (BAC $8) reported 1Q EPS of $0.44, well above the Reuters estimate of $0.04, on record revenue of $36 billion. The company said its recent acquisition of Merrill Lynch contributed more than $3 billion to net income and its earnings for the quarter exceeded all of its 2008 profit results. BAC added $6.4 billion to its loan loss reserves but said its key financial strength ratio of tangible common equity improved to 3.13%. The company’s CEO Ken Lewis said its ability to post strong, positive net income for the quarter is extremely welcome news in this environment, and the company is especially gratified that its new teammates in Countrywide and Merrill Lynch had outstanding performance that contributed significantly to its success. BAC said they funded $85 billion in mortgage loans during the quarter, and extended $183 billion in credit.

However, shares finished down sharply amid credit loss concerns, exacerbated by its conference call with analysts, where Ken Lewis said, "Credit is bad and we believe credit is going to get worse before it will eventually stabilize and improve." He added that its loan loss reserve increases will continue for the next couple quarters. Lewis, however, did note that, "We absolutely don't think we need additional capital," and commenting on the government "stress tests" and the potential to convert preferred to common equity, he said “we think we’re fine,” but it is “in the hands of the regulators at the moment.” BAC added that it continues to face extremely difficult challenges, driven by weakness in the economy and growing unemployment, but it continues to help revitalize the US economy through its efforts to reform mortgage lending, restructure home loans and mitigate foreclosures wherever possible.

Shares of Sun Microsystems (JAVA $9) were up sharply after Oracle (ORCL $19) announced that it has reached a definitive agreement to acquire JAVA for $9.50 per share in cash. Including JAVA's cash and debt, the deal is valued at about $7.4 billion. ORCL said the deal is expected to be accretive to its earnings ex-items by at least $0.15 per share in the first full year after closing. ORCL CEO Larry Ellison said, "The acquisition of Sun transforms the IT industry, combining best-in-class enterprise software and mission-critical computing systems." ORCL shares were lower.

PepsiCo (PEP $50) announced that it is offering to acquire all of the outstanding shares of common stock it does not already own in its two largest bottlers, representing 80% of its total North American beverage volume, the Pepsi Bottling Group (PBG $31) and PepsiAmericas (PAS $25), at a value of $29.50 per share for PBG and $23.27 per share for PAS, totaling about $6 billion. PEP said the acquisition could help it unlock more than $200 million in cost synergies, improve the speed of decision making, and create a fully-integrated supply chain and go-to-market business model to accelerate revenue growth, and marks a reversal from the 1999 spin-off of the bottling operations. The transaction is expected to be accretive to PEP earnings by at least $0.15 per share when synergies are fully realized. Separately, the company reported adjusted 1Q EPS of $0.71, four cents ahead of analysts' estimates, as revenues came in at $8.3 billion. Shares of PEP fell, while PBG and PAS were sharply higher.

Eli Lilly (LLY $33) reported 1Q EPS ex-items of $1.20, easily beating the Street's estimate of $0.99, as adjusted revenues increased 3% to $5 billion. The drug maker said despite the economic downturn, it delivered strong financial results in 1Q, including solid volume-based gains, while its gross margin benefitted from a stronger US dollar, which combined with prudent expense management, helped it achieve operating leverage and "robust earnings per share growth." LLY reiterated its full-year outlook, saying it expects EPS to be in the range of $4.00-4.25, versus the Street's expectation of $4.14. Shares were lower.

Eaton Corp (ETN $40) fell after the maker of circuit breakers and fuel pumps posted a 1Q loss of $0.30 per share, worse than the estimate of a $0.27 loss. Eaton’s CEO said “we think that the economy has declined further, and we think it is going to last longer in recession than we had originally anticipated.” He added that there are “signs of hope,” saying they are seeing projects specifically funded from the Chinese stimulus, possibly as a reflection that there are fewer layers in awarding contracts in China than there are in more mature economies.

Leading Index declines, but data for the week will be light

The Leading Index (chart) declined 0.3% in March, more than the 0.2% decrease that economists surveyed by Bloomberg expected, and February's decline was revised from -0.4% to -0.2%. The largest negative contributors were building permits, stock prices, and supplier deliveries. These negative contributions in the index offset benefits from a favorable interest rate spread and the growing money supply—as the Fed has been aggressive to pump up the money supply to return some normalcy to the credit markets.

After exhausting the option to cut its benchmark interest rate, the Fed has launched unconventional campaigns to resuscitate the financial system, such as purchasing mortgage-backed securities and longer-term Treasuries. Treasuries were higher in concert with the fall in equity markets. The yield on the 2-year note lost 6 bps to 0.91%, the yield on the 10-year note fell 11 bps to 2.84%, and the yield on the 30-year bond declined 11 bps to 3.69%.

The economic calendar will be back-end loaded and relatively light this week, with a bias toward housing and manufacturing. With the economic front expected to be quiet, the earnings calendar will likely provide plenty of sustenance to shape sentiment for the week as 1Q earnings season continues to heat up and technology reports will likely grab the lion's share of attention. As the market has gotten a bit of a reprieve from the seemingly endless stream of government policy initiatives and new Fed action just in time to turn its focus to earnings season. The market has rallied into the start of earnings season as some economic data have started to show signs of improvement, or at least is deteriorating at a less rapid rate.

However, whether this move can continue through the reporting season is in question, while the debate as to whether the market is currently “cheap” still rages.

Standard and Poor’s is forecasting S&P 500 as reported diluted earnings of $7.32 for the first quarter, down 53% from the $15.54 reported a year ago. Of course, at this point in time, all earnings estimates should be taken with a grain of salt, as companies have become much more reluctant to give meaningful guidance in this environment. Regardless, earnings season will be brutal, but that doesn’t mean the market can’t move higher. With expectations so low, it may not take much in the way of positive news or guidance to propel the bulls—something we’ll be watching as the season progresses.

There are no major US economic releases scheduled for tomorrow.