Evening Update

Markets See Gains Slip Away

In a light day of trading that saw bond markets close early, markets battled continued concerns over the US government’s debt load and gave back their gains just before markets closed. With relatively little newsflow and no new economic data, government debt ratings continued to hold the market’s attention. A day after the UK’s credit outlook was downgraded, Moody’s tried to quell speculation by reaffirming its AAA rating on the US and the White House maintained that a downgrade is unlikely even though debt levels will continue to rise as officials try to stimulate the economy back to growth. The main loser as a result of this speculation has been the US dollar and US Treasuries as investors dumped both today in preparation for further US indebtedness. In equity news, consumer stocks were one of the strongest segments of the market after Sears Holding Corp. reported positive 1Q earnings when analysts were expecting a loss. Gap, Aeropostale, and Campbell Soup also all posted better-than-expected earnings. The financial sector was the weakest segment after federal regulators seized BankUnited – the largest bank failure so far this year – and the Treasury confirmed that it will inject $7.5 billion in additional taxpayer funds into GMAC.

The Dow Jones Industrial Average lost 15 points (0.2%) to close at 8,277, the S&P 500 Index fell 1 point (0.2%) to 887, and the Nasdaq Composite declined 3 points (0.2%) to 1,692. In light volume, 1.1 billion shares were traded on the NYSE, and 1.6 billion shares were traded on the Nasdaq. Crude oil gained $0.62 to $61.67 per barrel, wholesale gasoline rose $0.04 to $1.84 per gallon, and gold gained $3.65 to $957.45 per ounce. For the week, the DJIA gained 0.1%, the S&P 500 Index rose 0.5%, and the Nasdaq Composite advanced 0.7%.

Federal regulators seized Florida-based BankUnited FSB, whose parent company was Bank United Financial Corp. (BKUNA $0.49), in the largest bank failure this year. The failure is estimated to cost the Federal Deposit Insurance Corp. (FDIC) about $4.9 billion and the FDIC has sold the bank to a group of private equity firms who will put up about $900 million of capital to the help rescue the firm. BankUnited opened for normal business today with the same name.

The US Treasury confirmed that GMAC LLC will receive $7.5 billion in additional government funding. The struggling auto lender has already received $5 billion in loans from taxpayer funds. The US government already holds 5 million GMAC shares and has used that control to tell the firm that it must extend about $4 billion of the capital injection to help financing services to customers of now-bankrupt Chrysler. The remaining $3.5 billion will go toward strengthening GMAC's capital position after the government's bank stress test earlier this month mandated the company raise $11.5 billion within the next six months.

Sears Holdings Corp. (SHLD $55) was up over 10% after it unexpectedly posted 1Q EPS ex-items of $0.38, versus the Reuters estimate which called for the company to record a $0.88 per share loss. Revenues declined by $1 billion to $10.1 billion, due to lower same-store sales. Housing market conditions and lower apparel sales were the primary drivers of the sales decline, the company said. SHLD said its gross margin increased by 130 basis points as it controlled inventories and reduced domestic selling and administrative expenses by 6.7%.

Retailer Gap Inc. (GPS $16) reported 1Q EPS of $0.31, one penny ahead of the Reuters estimate, as revenues fell about 7% to $3.1 billion and same-store sales for the quarter fell by 8%. The company said it is pleased with the results in this "challenging economic environment" and it is particularly encouraged by Old Navy's recent performance. Shares were higher.

Aeropostale Inc. (ARO $34) 1Q EPS of $0.49 was slightly ahead of the consensus estimate of $0.48. Sales rose 21% to $408 million as same-store sales growth was 11% during the quarter. ARO also gave 2Q guidance that was above analyst expectations, pointing to EPS of $0.46-0.48 next quarter, well above the $0.37 that the Street had forecast. The stock was up today.

Campbell Soup (CPB $27) posted adjusted fiscal 3Q EPS of $0.48, six cents above the Street's forecast, but revenues declined 10% to $1.7 billion. The soup firm said its earnings results were boosted by previous pricing actions and ongoing productivity improvements, and its gross margin improved versus last year. CPB said despite softer sales in the quarter, year-to-date it delivered one of the strongest US soup sales performances in years, with sales up 6%. The company raised its full-year EPS outlook. Shares were higher.

Salesforce.com (CRM $36) released 1Q EPS of $0.15, nearly double the $0.08 it had earned in 1Q 2008. This was ahead of the $0.11 that analysts had been expecting. Revenues increased 23% to $305 million. Based on this positive start to the year, management raised its full-year earnings guidance, but warned that sales this year will be weaker than it originally thought. CRM is now expecting EPS in a range of $0.59-0.60 for the full year, although revenues will only be $1.25-1.27 billion, down slightly from the $1.30-1.33 billion that was previously expected. Analysts had been forecasting earnings of $0.55 per share on sales of $1.31 billion for the year. Management credited its “strong cost controls” with helping it maintain earnings in spite of a weak sales environment. The stock fell almost 10% following this announcement.

Treasuries fall as credit ratings remain a hot topic in the absence of economic reports

Treasuries turned lower in relatively light action as there were no major economic releases scheduled for today and the bond market closed early. The yield on the 2-year note rose 2 bps to 0.88%, while the yield on the 10-year note added 9 bps to 3.45%, and the yield on the 30-year bond increased 7 bps to 4.38%. Please note that all US markets will be closed on Monday in observance of the Memorial Day holiday.

Government debt ratings continue to be a hot topic on Wall Street. Stock and bond markets sold off yesterday in part because the UK’s credit outlook was downgraded from “stable” to “negative” by Standard & Poor’s – prompting markets to question the impact of growing debt burdens of many of the world’s largest governments. In response to this, Moody's Investors Service released a statement that it is still comfortable with its AAA sovereign rating for the US, but that “there are longer-term pressures on the rating, that's very clear." A Moody's spokesman stated that “we put out a credit opinion on May 6 and it remains triple-A and stable." Whether the US’s rating is eventually threatened will depend on whether debt continues to climb after the recession, Moody’s said.

Gains resume but not without apprehension

Heading into the week, it seemed like the bulls would have an uphill battle if they were going to gain back some of the lost momentum from the previous week's decline as there appeared to be little in the way of sustenance from the economic and equity fronts. However, as the week commenced, a 17% rally in India on a favorable nationwide election got the ball rolling on Wall Street. The ball was picked up by improved sentiment toward the health of the financial sector as several banks jockeyed to position themselves to fill the capital gaps that resulted from the recent government stress tests or to gain approval to pay back the government the loans from its Troubled Asset Relief Program (TARP). Even though earnings season has all but passed, corporate earnings reports from Dow member Home Depot (HD $23) and Lowe's (LOW $20)—the world's number one and two largest home improvement retailers, respectively—both topped analysts' estimates, adding some relative optimism about the health of the housing sector.

The week was not all positive for the bulls as the economic calendar yielded some disappointing reports that curbed some of the enthusiasm and limited gains. Housing starts and building permits unexpectedly fell to record lows in April and although the data is encouraging as they suggest possible relief to severely elevated inventory levels, sentiment soured as expectations were for starts and permits to rise, showing conditions in the housing sector improving. Elsewhere, a drop in jobless claims was offset by a new record level of continuing claims—dampening some hopes that had built up in the relatively recent moderation in the most current gauge of employment conditions. But the biggest source of economic pessimism came from the release of the Federal Reserve's minutes from its last monetary policy meeting. While the Committee said there was tentative evidence that the pace of contraction was starting to decline, the quarterly update to their economic forecast was revised lower and a majority of the participants believed risks were skewed to the downside and subject to greater-than-average uncertainty. Even though the markets finished higher for the week, sentiment has appeared to have shifted from optimism from signs that the rate of economic decline is "less bad" to wanting to see actual signs of economic growth.

Housing market will be under the microscope, durable goods and GDP also on the docket

The S&P/Case-Shiller Home Price Index for March will be released Tuesday, and is expected to have fallen 18.4% year-over-year (y/y), after falling 18.6% in February. The index is a three-month rolling average representing 20 major cities, and has been falling at a slower rate in recent months. Through February, the index had fallen 30.7% from its peak in 2006. On a month-over-month basis, prices have improved slightly, but the housing market seasonally starts to perk up in spring, and therefore month-to-month fluctuations are less meaningful than y/y comparisons.

Existing home sales for April will be reported on Wednesday, and the forecast is for sales to rise 2.0% month-over-month (m/m) to an annual rate of 4.66 million units, after falling 3.0% in March and rising 4.9% in February. Pending home sales have risen two months in a row, and are a leading indicator for this data series.

The last of the housing data for the week will be released on Thursday, where new home sales are expected to have risen 1.1% for April m/m to an annual rate of 360,000 units, after falling 0.6% in March and rising 8.2% in February. New home sales now account for 7% of the market, down from 16% at the peak, as they have struggled to compete with the steep discounts afforded by foreclosures. In response, homebuilders have significantly cut back on new housing starts, allowing inventory levels to fall.

Durable goods orders will be released Thursday, and are expected to show a rise of 0.5% m/m in April, after falling 0.8% in March, and rising 2.1% in February. Ex-transportation, orders are forecasted to decline 0.3%, following a fall of 0.6% in March.

Lastly, the second reading on 1Q Gross Domestic Product will be released on Friday, and is expected to show a decline of 5.5%, revised up from the initial report of -6.1%. The initial read was worse than projected, but investors were encouraged by the surprisingly rebound in consumer spending. While the 1Q GDP estimate has been positively revised, the personal consumption component has been revised down, and enthusiasm for the strength and sustainability of spending by the U.S. consumer has been tempered in recent weeks.

We may now be starting the natural and necessary reversal of the plunge post the Lehman collapse, where cyclical, shorter-term forces trump secular, longer-term forces, at least for a period. History shows that, typically, the steeper the recession, the steeper the recovery, and the record-lean inventories suggest an eventual ramping-up of production. Recent improvements in lending standards could presage a turn in consumer and capital spending. However, consumers are paying down debt and saving more, which will likely keep a lid on economic growth longer-term, and there is risk of a W-shaped cycle. The market has rebounded on the potential for the first leg up of the economy. We are beginning to see signs that investors are looking for more than just “less-bad” news to propel the market higher.

Other releases on the economic calendar include the Richmond Fed Manufacturing Index, MBA Mortgage Applications, initial jobless claims, Chicago Purchasing Manager survey, and University of Michigan consumer sentiment.