Evening Update

Stocks Pause, Await Results of Bank Stress Test

Stocks were lower today, as traders booked some gains from yesterday’s surge and continued to digest what has become the “rumor de jour” - speculation regarding the additional capital needs of banks undergoing the stress test coordinated by the Federal Reserve. In an interesting twist, Bloomberg reported that AIG’s first-quarter report due out later this week will reportedly not ask for a new capital injection. The Fed’s program to restart the securitization market, the Term-Asset Backed Securities Loan Facility (TALF), had increased demand relative to prior rounds. In earnings news, Kraft Foods, CVS Caremark and Molson Coors Brewing beat earnings estimates, while Archer Daniels Midland, D.R. Horton and Chesapeake Energy disappointed. Treasuries were lower following a better-than-expected reading on the ISM Non-Manufacturing Index, and Fed Chair Ben Bernanke’s Congressional testimony where he reinforced the sentiment that there are signs of stabilization in the economy, and said the Fed is not targeting a particular interest rate in its program to purchase up to $300 billion in Treasuries.

The Dow Jones Industrial Average fell 16 points (0.2%) to close at 8,411, the S&P 500 Index lost 3 points (0.4%) to 904, and the Nasdaq Composite declined 9 points (0.5%) to 1,754. In moderate volume, 1.5 billion shares were traded on the NYSE, and 2.6 billion shares were traded on the Nasdaq. Crude oil fell $0.63 to $53.84 per barrel, wholesale gasoline declined $0.01 to $1.57 per gallon, and gold lost $3.95 to $898.15 per ounce.

According to the Wall Street Journal, US regulators have determined that “about ten” of the largest US banks will need to raise more capital, citing a source familiar with official talks. The Financial Times had reported yesterday that 4 banks, including Bank of America (BAC $11 ¹), Citigroup (C $3) Wells Fargo (WFC $23) and PNC Financial (PNC $42) would be required by the government to improve their balance sheets. The report was described by Bank of America as “completely inaccurate” and other firms have not commented on the matter. The Fed has also declined comment. The identities of the other banks needing to raise capital are not yet clear. Shares of BAC and Citi were higher, while WFC and PNC were lower.

The final results of the U.S. government stress test of the 19 U.S. banks with assets greater than $100 billion will be released on Thursday. Preliminary results were given to the banks privately on April 24, and the Fed released a white paper saying that most banks currently have capital levels well in excess of the amount required to be well capitalized. However, regulators said they 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. Regulators are expected to brief the banks on the final results and how they will be revealed today.

American International Group (AIG $2) was up 19% today based on a report that the insurer will not need additional capital. The source declined to be named because the company’s 1Q results, scheduled to be released on Thursday, are not yet public. The company did not comment on the report. The American insurance company is now approximately 80% owned by US taxpayers after receiving multiple federal bailouts totaling $183 billion. Last quarter AIG posted the largest quarterly loss in US corporate history.

Dow member Kraft Foods (KFT $25) reported 1Q EPS of $0.45, a growth of 10%, beating the Reuters consensus of $0.40. Company revenues fell 6.5% to $9.4 billion, although organic revenue growth was 2.3% and management attributed much of the fall in sales to unfavorable currency moves. The food producer, famous for brands such as Velveeta, Oreo cookies, and Maxwell House coffee, was able to expand its operating margin by 2.9% by restructuring its operations and raising prices on some of its products. Shares rose.

Archer Daniels Midland (ADM $24) announced 3Q EPS of $0.37, down from $0.80 a year ago, and below analyst expectations of $0.49. ADM sales dropped 21% to $14.8 billion. The agribusiness company cited weak demand in North America, falling global commodity prices, and continued challenges in the ethanol industry as reasons for the decline. Shares were lower.

Chesapeake Energy (CHK $20) announced 1Q EPS-ex items of $0.46, down from the $1.09 that CHK earned in the year-ago quarter, and below the profit of $0.49 the Street had been expecting. Revenues increased 25% to $2 billion in the quarter. Management reported that the company is curtailing natural gas production and will continue to do so until commodity prices are higher. The management team has come under pressure from investors due to the $113 million payout its CEO received, the largest of any CEO in the S&P 500 according to the Associated Press, and the company defended his pay package, pointing out that Mr. McClendon is required to invest alongside Chesapeake in drilling programs so as to share in the firm’s risks. CHK shares were down 10%.

CVS Caremark (CVS $32) published adjusted 1Q EPS of $0.55, slightly better than the $0.54 consensus expectation. Revenue was reported at $23.4 billion. Adjusting revenues for the impact of one less trading day, growth would have been 11%. Sales from stores open more than a year increased 3.3%. Management also raised its full year forecast by 2 cents, now guiding to 2009 EPS in a range of $2.55-2.63. CVS shares were modestly lower.

Molson Coors Brewing (TAP $42) declared 1Q adjusted earnings of $0.53 per share, up from the $0.19 the company earned a year ago, and above the average estimate of $0.32 from analysts surveyed by Bloomberg. As the brewer moves into its peak summer selling season, management noted that they “remain cautious about the rest of the year”, citing beer market volume trends and continuing commodity price inflation. Worldwide beer volume declined 3% on a pro forma basis during the quarter while increased beer prices and an additional $18 million in cost cutting allowed TAP to offset this headwind. Over the next 3 years TAP management intends to cut $250 million in company costs in an attempt to improve group profitability. The stock rose nearly 10% today.

D.R. Horton (DHI $12) revealed its 2Q results, showing a loss of $0.34 per share. Analysts had been expecting a loss of just $0.30 per share. The results show an improvement from the net loss for the same period last year of $4.14. Revenue in the quarter fell by approximately half to $775.3 million from $1.6 billion in 2Q 2008 and the sales order backlog was reported as 4,581 homes, down from 8,947 homes at this time last year. As the traditional spring home buying season gets under way, DHI’s management remained negative on the market conditions in the homebuilding industry, citing rising foreclosures, high inventory levels of both new and existing homes, increasing unemployment, tight credit for homebuyers and eroding consumer confidence. Shares were lower.

Treasuries lower after economic data surprises, Bernanke testifies and strong TALF auction

The ISM Non-Manufacturing Index (chart) for April rose to 43.7 from 40.8 in March, better than the estimate of 42.2. The separation point between contraction and expansion is a reading of 50. The index for new orders jumped to 47.0 from 38.8 and employment improved to 37.0 from 32.3. Prices paid moved to 40.0 from 39.1, indicating a slower rate of decline in prices during the month. While volatile, the improvement in new export orders, to 48.5 from 39.0, is particularly encouraging. The report is another in a string of economic reports showing a slowing rate of decline, and showed the service economy is contracting at the slowest pace in six months. Treasuries were lower. The yield on the 2-year note gained 3 bps to 0.97%, the yield on the 10-year note rose 1 bp to 3.17%, and the yield on the 30-year bond increased 1 bp to 4.06%.

There is of course, a caveat: the aftermath of the great debt experiment of the past quarter-century and the resultant necessity of private sector deleveraging will be with us for some time, not to mention the troubles in commercial real estate. This could keep a lid on economic growth even in recovery. The fact that the market rally has been accompanied by economic leading indicators suggests that it may have legs and this year could be an exception to the “sell in May and go away” axiom.

Federal Reserve Chairman Ben Bernanke gave his testimony before the Joint Economic Committee. Echoing the sentiment from the FOMC meeting last week, Bernanke indicated that the pace of contraction in the economy may be slowing and he is seeing “some tentative signs” that demand may be stabilizing, but that the economy is likely to remain below its longer-run potential “for a while”. Bernanke noted that the housing market has shown some signs of bottoming. Bernanke also called attention to the importance of the banking system for any prospects of a recovery and mentioned again the stress tests that have been applied to major US banks. In response to a question regarding the International Monetary Fund (IMF) estimates that banks need another $275 to $500 billion of additional capital, Bernanke said that “There are a number of offsets that will help make up for those losses,” such as reserves and write-downs taken, as well as earnings potential. He said that he believed that “there will be significant opportunities for capital-raising outside the government’s programs,” although it will depend on the market’s perception of the strength of the banking sector. With regard to the Fed’s program to buy up to $300 billion in Treasuries, Bernanke said "We're not trying to target a particular interest rate," adding "Our objective is to provide more liquidity into the system and to help private credit markets, and I think it has had some benefit."

The Fed’s Term Asset-Backed Securities Loan Facility (TALF) is undergoing its third round of funding today, and companies have filed to sell up to $11 billion in debt to the Fed. The program intends to unfreeze the market for securities backed by consumer, business, equipment and commercial real estate loans by allowing investors to buy asset-backed securities using loans from the Fed. The TALF had gotten off to a slow start, likely due to investor reluctance as well as technical issues relating to relationships between investors and dealers, with $4.7 billion of interest in March, and a paltry $1.7 billion in April. The pick-up in demand for this program could indicate more willingness by investors to invest alongside the government, and could prelude interest in the Public-Private Investment Program (PPIP) to remove toxic assets from bank balance sheets.

Economic releases on tomorrow’s calendar include MBA Mortgage Applications and the ADP Employment Change, which is expected to show that the private sector cut payrolls by 645,000 in April, after cutting a stunning 742,000 in March.