Evening Update

Pessimism in the Rear View Mirror

Stocks ended higher after a brief retreat following the Fed release of the bank stress test methodology. Federal bank regulators concluded that it is prudent to raise additional capital to buffer against further losses, but that banks are currently well capitalized. Earnings results have generally come in better-than-feared this week, capped off by today’s release of an improved cash burn rate from Ford and an earnings beat by American Express. In other earnings news, Amazon.com and Xerox beat, Microsoft, Honeywell and Juniper matched estimates, while 3M and Amgen missed expectations. Elsewhere, Immucor reported it received a subpoena from the Department of Justice regarding an antitrust investigation. In economic releases, durable goods orders fell less than expected and new home sales were better than forecasted. Treasuries were lower.

The Dow Jones Industrial Average rose 119 points (1.5%) to close at 8,076, the S&P 500 Index gained 14 points (1.7%) to 866, and the Nasdaq Composite advanced 42 points (2.5%) to 1,694. In moderate volume, 1.7 billion shares were traded on the NYSE, and 2.5 billion shares were traded on the Nasdaq. Crude oil gained $1.93 to $51.55 per barrel, wholesale gasoline rose $0.05 to $1.44 per gallon, and gold increased $8.15 to $912.45 per ounce. For the week, the DJIA fell 0.7%, the S&P 500 Index lost 0.4%, while the Nasdaq Composite advanced 1.3%.

Ford (F $5) shares were 11% higher after the US automaker reported a 1Q net loss ex-items of $0.75, which was much narrower than the $1.23 loss the Reuters estimate called for, and revenues excluding special items was $24.8 billion. Ford ended March with $21.3 billion in gross cash, its 1Q cash burn rate of $3.7 billion improved, and its CFO said he expected this to be the worst burn rate for the year. The company said it was on track to at least break even in 2011 and did not expect to seek government loans.

Dow member American Express (AXP $25 ¹) rose 20% after posting 1Q EPS ex-items of $0.20, above the Reuters forecast of $0.14, as revenues fell 18% to $5.9 billion. The company said revenues declined on lower card member spending, but expenses were reduced. The company's tier-1 capital ratio—a key financial strength metric—grew to 14.8% from 9.7% last quarter, according to Reuters. Also, its US card service business' charge-offs—the annualized rate of writing off bad loans—rose to 8.5%, from last quarter's 7%, the company said, and the rate is likely to rise by anywhere from 2-2.5 percentage points in 2Q, followed by another half a point in 3Q. AXP's CFO said it is in the best interest of the company and good public policy to return the Troubled Asset Relief Plan (TARP) funds back to the government.

Fellow Dow component 3M (MMM $57) reported 1Q EPS ex-items fell 41% to $0.81, five cents below analysts' forecasts, as revenues dropped 21.3% to $5.1 billion. The company said the global economic slowdown dramatically affected its businesses in 1Q. The company said the economy will bottom sometime between the end of the second and the end of the third quarter. Shares moved into positive territory after overcoming early weakness.

Dow member Microsoft (MSFT $21) reported fiscal 3Q EPS ex-items of $0.39, matching the consensus estimate, as revenues fell 6% to $13.7 billion. The company said revenue in client, Microsoft business division, and server & tools units was negatively impacted by weakness in the global PC and server markets, while revenue from enterprise customers remained stable during the quarter. MSFT said while market conditions remained weak during the quarter, it was pleased with its ability to offset revenue pressures with swift implementation of cost-savings initiatives. The company added that it expects weakness to continue through at least next quarter. Shares rose 10%.

Amazon.com (AMZN $84) reported 1Q EPS of $0.41, ten cents ahead of analysts' forecasts, as net sales increased 18% to $4.9 billion. The online retailer said it was grateful and excited that sales of its Kindle—its handheld media device—have exceeded its most optimistic expectations. AMZN reported 2Q guidance in line with expectations. Shares were higher.

Honeywell International (HON $31) reported 1Q EPS of $0.54, in line with forecasts, and revenues fell 15% to $7.6 billion. The company said the slow global economic conditions continue and it is adjusting its outlook accordingly. HON lowered its full year earnings outlook and issued revenue guidance below analysts' estimations. Shares fell.

Xerox (XRX $6) reported 1Q EPS of $0.05, one penny ahead of the Street's forecast, and revenues fell 18% to $3.6 billion. The drop in sales was largely due to the economy with constraints in the overall business environment delaying purchasing decisions and the company's distributors holding lower inventory levels. The company said it is focused on cost and expense management, and it plans to reduce overall debt by more than $1 billion this year. XRX issued 2Q and full-year profit guidance below analysts' expectations. Shares were higher.

Amgen (AMGN $50) posted 1Q EPS ex-items of $1.08, six cents shy of the Reuters estimate, as revenue declined 8% to $3.3 billion. Total product sales also fell 8%, led by a drop of 10% in the US, as revenues were negatively impacted by changes in foreign exchange and broad weakness in its key drug sales. The company's head of commercial operations said, "I can't imagine a worse situation in terms of patients being able to afford their medicines." However, AMGN maintained its full-year adjusted EPS guidance, but lowered its revenue forecast. Nonetheless, shares rose.

Juniper Networks (JNPR $22) shares advanced 16% after the company reported 1Q results in-line with its pre-release forecast. JNPR’s CEO said that during 1Q many of the company’s customers reset budgets and determined how the recession was impacting their businesses, and now “things are beginning to become more stable.” However, he added that visibility on revenue remains low. The company projected 2Q revenues of $740 – 780 million and adjusted EPS of $0.16 – 0.18, roughly in-line with analyst estimates of $773.6 million in revenues and EPS of $0.17.

Shares of Immucor (BLUD $15) fell 27% after the blood testing product firm reported that it received a subpoena from the Department of Justice pertaining to a request for documents regarding an investigation of possible violations of the federal criminal antitrust laws. BLUD said it intends to fully cooperate with the investigation.

Durable goods and new home sales better-than-expected

New home sales (chart) for March fell 0.6% month-over-month (m/m) to 356,000 units on an annualized rate, better than the 337,000 units expected, and February was revised up to 358,000 units, up 8.2% m/m. Year-over-year, new home sales fell 30.6%. Inventory of new homes for sale fell to 311,000, comprising 10.7 months worth of sales, a significant improvement from February’s initially reported 12.2 months supply, but still higher than the 5 to 6 months that is considered a stable market. The median price of a new home fell 12.2% year-over-year, to $201,400. By comparison, yesterday’s existing home sales report showed a 3.0% fall m/m, with 9.8 months of homes available for sale, and a median price of $175,200.

New home sales now account for 7% of the market, down from 16% at the peak, as they have been seen as less attractive than existing homes, which have had significant declines in prices due to the flood of foreclosures. In response, homebuilders have significantly cut back on new housing starts, and the improvement in new home sales is encouraging.

Durable good orders (chart) fell 0.8% m/m in March, versus the expected drop of 1.5% but February's gain was revised lower to 2.1% from the originally reported 3.5%. Ex-transportation, orders declined 0.6%, versus the forecast of a 1.2% decline, while February was also revised lower. Orders for non-defense capital goods ex-aircraft, which is considered a good indicator of capital spending, gained 1.5% in March, after rising a revised 4.3% in February. Inventories fell 1.1% in March, after falling 1.3% in February, and have now declined for three consecutive months.

The index measures the demand for goods designed to last at least three years, such as appliances, cars and airplanes. Consumers and businesses have been cutting back on large purchases, as they are highly discretionary and may require access to capital to finance. The steep drop in spending and manufacturing in the fall was so dramatic that it simply could not be sustained and some pent-up demand built up. Additionally, although we have seen improvement in some credit markets, spreads remain high, indicating extreme caution. The economy is still contracting, and while the pace of decline is slowing in some indicators (an improving “second derivative” or rate of change), others continue to deteriorate. It is probable that the path to recovery will have some bumps along the way. However, a majority of the Conference Board’s Leading Economic Indicators are moving in the right direction. Astute investors know that the stock market is one of these indicators, typically bottoming before the economy. Treasuries remained lower after the manufacturing and housing reports. The yield on the 2-year note gained 3 bps to 0.96%, the yield on the 10-year note rose 7 bps to 2.99%, and the yield on the 30-year bond increased 8 bps to 3.87%.

Banks currently well capitalized, but regulators urge more capital

Banks privately received preliminary results of the U.S. government stress test today and the Fed released a white paper outlining the design and implementation of the exams. The tests on banks with year-end 2008 assets greater than $100 billion (the largest 19 banks) have been conducted over the past 6 weeks by a group of 150 federal regulators. The Fed said that most banks currently have capital levels well in excess of the amount required to be well capitalized. However, public confidence has eroded due to the uncertain economy, and regulators believe “it is prudent for large bank holding companies to hold additional capital to provide a buffer against higher losses than generally expected, and still remain sufficiently capitalized” over the next two years and be able to lend if such losses materialize. As a part of the exams, banks were asked to estimate potential losses on loans, securities and trading positions. The purpose of the exams was to determine if banks need to raise capital or improve the quality of capital, and the amount of capital needed. Bank supervisors indicated that common equity should be the dominant component of Tier 1 capital. They state that the tests are not a measure of the current solvency or viability of individual banks. The U.S. Treasury has committed to make capital available under the Capital Assistance Program (CAP) and banks can also apply to exchange their government preferred stock to meet their buffer requirement.

The tests were run under two different economic scenarios, a “baseline” view and a more “adverse” view. Fed officials say the adverse economic situation in the test is “severe but plausible.“ The parameters of the adverse scenario include an unemployment rate of 10.3% in 2010, home prices as measured by Case-Shiller decline by 22% in 2009 and 7% in 2010, and gross domestic product contracts 3.3% in 2009 and 0.5% in 2010.

The results were somewhat disappointing in the lack of an identified level of capital buffer required or specific amount of capital needed to be able to absorb the estimated losses. Final results will be released to the public on May 4.

Earnings season looks less bleak, but stocks end streak

Although stocks failed to post meaningful gains for a seventh-straight week, one takeaway the bulls can feel relatively enthusiastic about is the fact that earnings season has not shown the destruction of profits that expectations suggested heading into the season. Several key reports came from the tech sector and results were generally better than expected, to help the sector finish in the green, highlighted by Apple Inc's (AAPL $124) much better-than-expected report on strength of its iPhone sales. But in typical fashion, the company issued conservative guidance that missed the Street's forecast.

However, unlike last week, reports from the financial sector promoted some pessimism toward the group after Morgan Stanley (MS $22) posted a larger-than-expected loss and Dow member Bank of America (BAC $9 ¹) stoked some credit concerns after it added $6.4 billion to its loan loss reserves and its CEO Ken Lewis commented that credit is going to get worse before it gets better. BAC shares were pressured heavily, overshadowing its profit report that easily exceeded analysts' expectations. Financials finished among the worst performers for the week as the resurfaced credit concerns overshadowed optimism that stemmed from US Treasury Secretary Timothy Geithner saying “currently, the vast majority of banks have more capital than they need to be considered well capitalized by their regulators.” All in all, the week of earnings reports showed some signs of optimism, but also showed that the recession had taken its toll on corporate bottom lines, as the majority of the reports showed solid declines in profits and revenues. Going into the profit season analysts had ratcheted down their expectations—which may have led to the relative relief we have seen so far—but the Street was still somewhat caught by surprise after United Parcel Service (UPS $53 ¹) missed expectations and provided guidance that fell short of estimates. There was one notable story outside the earnings arena when Oracle (ORCL $20) surprisingly reached an agreement to acquire Sun Microsystems (JAVA $9) for about $7.4 billion.

The economic front offered little sentiment shifting reports as earnings results took the lion's share of attention. A larger-than-expected drop in existing home sales and continued elevated levels of jobless claims are worth noting, as they contradicted recently growing sentiment that the economic slide may be leveling off. Even though earnings season will continue to roll on, next week's economic calendar is likely to at least share the reins of market sentiment.

Economic data next week will be dominated by 1Q GDP and the Fed meeting

The S&P/Case-Shiller Home Price Index for February will be released on Tuesday and is expected to fall 19.0% year-over-year (y/y). The index is a three-month rolling average representing 20 major cities, and through January had fallen 29.1% from its peak in 2006. Steeply falling prices brought on by foreclosures have motivated buyers to begin to bargain shop and sales of new and existing homes have begun to stabilize.

Advance Gross Domestic Product, the broadest measure of economic output, for 1Q will be released on Wednesday, and is expected to have fallen an annualized 5.0%, after dropping 6.3% in 4Q. Personal consumption is expected to rise 0.8% after falling 4.3% in 4Q and the GDP Price Index is expected to rise 1.8%, with the core PCE Index, which excludes food and energy, increasing 1.2%.

The ISM Manufacturing Index will be released Friday, and is expected to improve to 38.0 in April from 36.3 in March, according to a survey of economists by Bloomberg. The separation point between contraction and expansion is 50, and the improvement expected in the index would indicate the economy contracting at a slower pace.

The economy is still contracting, and some incoming economic data has shown signs that activity is declining at a less rapid rate – the first step in a potential recovery. We’re encouraged by the progress being made, but improvements remain tenuous.

The Federal Open Market Committee (FOMC) is holding a two day meeting, concluding on Wednesday. With the fed funds rate already targeted to a rate near zero, no action is expected on the targeted interest rate. However, the Fed will likely update the market with regard to the unconventional measures it is taking to stabilize the economy and credit markets. Of particular interest will be any details regarding the status of the Term Asset-backed Securities Loan Facility (TALF), which has gotten off to a slow start. Additionally, investors will be monitoring progress on the Fed’s purchases of mortgage-backed securities and Treasuries.