Evening Update

Concerns Resurface to Take Stocks Below the Surface

Stocks finished moderately lower as economic uneasiness that followed China's sharp sell-off and a larger-than-expected drop in durable goods orders proved to be too much to overcome. Crude oil fell sharply to lead commodity-related issues as the worst performers, exacerbated by a bearish oil inventory report and the aforementioned economic concern. However, equity markets finished well off of the worst levels of the day—keeping up their recent trend of late-day resiliency—supported somewhat by some more positive earnings reports and after durable goods actually posted a gain, when excluding transportation. Time Warner, WellPoint, ConocoPhillips, and General Dynamics all either matched or beat Street forecasts, although Sprint Nextel missed. Outside the earnings front, Yahoo and Microsoft revealed a long awaited internet search partnership, and American Express took the final step to fully exit the government's bailout program. Treasuries were mixed after the durable goods report and following another disappointing note auction.

The Dow Jones Industrial Average dipped 26 points (0.3%) to close at 9,071, the S&P 500 Index declined 4 points (0.5%) to finish at 975, and the Nasdaq Composite lost 8 points (0.4%) to 1,968. In moderate volume, 1.3 billion shares were traded on the NYSE and 2.1 billion shares were traded on the Nasdaq. Crude oil fell $4.26 to $62.97 per barrel, wholesale gasoline decreased $0.07 to $1.81 per gallon, and gold fell $8.15 to $929.35 per ounce.

Yahoo (YHOO $15) and Microsoft (MSFT $24) revealed that they have signed a deal to form an internet search partnership. The agreement will last 10 years, under which Yahoo will make Microsoft’s newly designed Bing search engine the search provider on its web sites. Microsoft will have access to Yahoo’s search technology to integrate if it chooses and will gain access to Yahoo’s sales force, which will handle all search ad sales for both companies. Google (GOOG $436) had tried to form a partnership of its own with Yahoo last year, but was forced to abandon the plan after U.S. antitrust officials threatened to sue. In terms of market share, Google still dominates with a commanding 65% of all internet searches using its engine, followed by Yahoo with 20%, and Microsoft with 8%. This tie-up comes after Yahoo last year rejected Microsoft’s takeover bid of $47.5 billion. YHOO was down over 10% after the announcement, while MSFT finished positive and GOOG was lower.

The search deal follows yesterday's announcement from IBM (IBM $117) that it will acquire two business analytics software firms, and the M&A activity can be a good sign of health in the industry, potentially supporting Schwab's Director of Sector and Market Analysis, Brad Sorensen's, CFA, outperform rating on the information technology sector in his Schwab Sector Views: Sticking With Cyclicals, located at www.schwab.com/marketinsight.

Brad has had an outperform rating on the group since December, as he has noted that if businesses are going to loosen their still extremely tight purse strings for anything, it's likely to be for technological improvements. These investments are typically attractive because they tend to increase companies' efficiency and productivity at all levels. As a result, companies can produce more with fewer workers, which allows companies to cut back on costs and potentially expand margins. Additionally, technology companies continue to have good cash balances and solid balance sheets which are especially attractive characteristics in this tight credit environment. However, Brad is carefully watching for signs that the rally may be growing weary as more analysts and investors are jumping on the tech bandwagon—a situation which makes us a bit uncomfortable. His views are appropriate for investors looking for tactical ideas and market conditions change quickly so he updates his views every two weeks.

Time Warner (TWX $27) posted 2Q EPS ex-items of $0.45, above the $0.37 estimate of Reuters. Sales dipped 9% to $6.81 billion, below the $6.97 billion forecast as the media conglomerate continues to suffer from the recession. Time Warner’s networks division held up the best during the quarter, with 5% sales growth, while the filmed entertainment division fell 9% due to slow DVD sales, and the publishing unit plummeted 26% due to the industry wide advertising slump. Meanwhile, AOL, which Time Warner plans to split into a separate company, suffered a sales decline of 24% to $804 million. Following the report, management reaffirmed its full-year target of $1.98 in EPS, roughly in line with the 2008 earnings level. Shares were lower.

Sprint Nextel Corp (S $4), the US’s third-largest wireless provider, reported a 2Q loss ex-items of $0.04 per share, wider than the loss of $0.01 that analysts had forecast. Revenues dropped 10% to $8.14 billion as Sprint lost a net 257,000 subscribers during the quarter, with a loss of 991,000 postpaid customers being partially offset by a gain of 938,000 prepaid customers, with further lost customers coming from wholesale and affiliate subscribers. “We are not satisfied that we lost a quarter of a million customers in the quarter,” CEO Dan Hesse told investors. Yesterday Sprint Nextel announced a deal to acquire Virgin Mobile USA (VM $5) for $483 million, which is expected to improve Sprint’s prepaid business, as competition for the more lucrative postpaid customers has become more intense. Sprint shares came under heavy pressure.

Health insurer WellPoint (WLP $51) announced 2Q adjusted EPS of $1.50, above the $1.43 that analysts had forecast. Revenues fell 2% to $15.41 billion as WLP’s total membership slipped 3% to 34.2 million, and premiums fell 1.5%. Management also reported that they withdrew from some Medicaid programs "for which actuarially sound reimbursement could not be obtained." WellPoint reaffirmed its full-year guidance for earnings of $5.06-5.12 per share, including net investment losses of $0.54 per share. WLP traded lower.

ConocoPhillips (COP $43) released 2Q earnings of $0.87 per share, slightly above the $0.85 Street forecast. Revenues fell by more than half to $35.4 billion. The company was hurt by much lower prices for crude and natural gas, although that was offset somewhat by cost reductions and management pointed out that the company still generated $2.6 billion in cash flow from operations during the quarter. The stock finished lower following the report.

Defense contractor General Dynamics (GD $55) said it earned $1.60 per share in 2Q, above the average analyst estimate of $1.57, while sales grew almost 11% to $8.10 billion. The company’s backlog of orders now stands 22% higher than a year ago and management raised its full-year outlook. By division, GD saw 19% sales growth in its military vehicles and armaments segment, while the marine unit grew almost 17%, and the business jet division rose 7% during the quarter. Shares were higher.

Dow member American Express (AXP $28 ¹) fully exited the government's Troubled Asset Relief Program (TARP) after reporting it has paid the US Treasury Department $340 million to repurchase warrants, which would have allowed the government to purchase over 20 million shares of the credit card firm. This was the final step for AXP to exit the government's bailout program as it had paid back $3.4 billion to repurchase preferred shares it has issued the government last month. Shares were modestly higher.

Durable goods orders drop, Beige Book suggests pace of economic slide moderated

Durable goods orders (chart) fell 2.5% in June, worse than the 0.6% drop that had been forecast and below the revised 1.3% growth seen in May. Although the headline number was alarming, ex-transportation, orders actually rose 1.1%, compared to the forecast of flat growth and the revised 0.8% increase in May. The monthly orders data can be very volatile as large orders for items such as airplanes and military equipment have a tendency to distort the data. Excluding aircraft and defense equipment, orders rose 1.4% in June, although that was below the 4.3% growth in the prior month. Meanwhile, shipments of these items – the figure used in computing GDP – rose 0.1%, the first gain since December, today’s report showed. Treasuries were mixed as the longer maturities rose following the economic data, while prices at the short end of the curve moved lower after a disappointing auction of $39 billion in five-year notes, which drew a larger-than-expected yield, suggesting weaker-than-expected demand. The yield on the 2-year note added 5 bps to 1.17%, the yield on the 10-year note decreased 3 bps to 3.66%, and the yield on the 30-year bond dropped 4 bps to 4.51%.

The Federal Reserve Beige Book showed that just one of the twelve District Banks – Minneapolis – reported that the recession worsened during 2Q. This improvement is inline with comments from several Fed officials recently that the recession has eased considerably. The Beige Book will be used by the Fed in its next policy meeting in two weeks, and today’s report indicates that the Fed’s easy monetary policies are likely to be continued. Inflationary pressures were reported to be only modest, and several key components of the economy were still described as weak.

The report noted bank lending is flat, or weakening, while retail sales remain sluggish and the commercial real estate market deteriorated further during 2Q. All districts reported that the job market remains slack, with many contacts reporting that various methods besides layoffs are being employed to reduce compensation, such as wage reductions and temporary shutdowns. In terms of positive aspects, reports on the manufacturing sector, although still “subdued,” did show notable improvement relative to last quarter and many contacts reported that they saw a turnaround on the horizon as a result of an inventory replenishment cycle.

As Schwab's Chief Investment Strategist Liz Ann Sonders, and Director of Market and Sector Analysis, Brad Sorensen, CFA, note in the bi-weekly Schwab Market Perspective, we view the growing number of calls for the Fed to lay out its exit strategy as premature. The economy is still fragile and much of the recent stabilization has been a direct result of government stimulus of the economy. As such, any anti-growth policies at this point could lead to a double-dip recession. Read more at www.schwab.com/marketinsight.

Elsewhere, crude oil prices fell sharply as the early pressure on the commodity—amid the resurfaced economic uneasiness on China's slide and disappointing economic data—was exacerbated by a bearish weekly oil inventory report. The Energy Information Administration (EIA) reported crude oil inventories unexpectedly jumped by 5.1 million barrels, versus the Reuters consensus that called for stockpiles to drop by 1.3 million barrels.

Tomorrow on the economic calendar, weekly initial jobless claims will be released and are forecast to increase by 21,000 to 575,000, and continuing claims are expected rise by 75,000 to 6,300,000.