Evening Market Update

Further Fed Action and Economic Worries Weigh

Stocks fell today as traders continue to consider the implications of yesterday’s Federal Reserve meeting, wherein the central bank indicated that the economy is falling short of its targets. As such, the Fed said it was prepared to provide additional stimulus if needed, while some traders wonder if the change in the Fed’s language on inflation indicate that more stimulus is just a matter of timing. Financials led to the downside on the Fed’s move, along with an earnings miss by investment bank Jefferies Group. Additionally, Treasuries were mixed, despite a decline in mortgage applications, and the US dollar fell. In the technology sector, Adobe Systems Inc issued a disappointing outlook, prompting shares to fall nearly 20%, PMC-Sierra lowered revenue guidance, and Dow member Microsoft increased its dividend. Elsewhere, General Mills Inc and CarMax beat the Street’s earnings estimates, eBay reiterated its full-year outlook and announced a departure of a top executive, and Darden Restaurants provided mixed results.

The Dow Jones Industrial Average lost 22 points (0.2%) to close at 10,739, the S&P 500 Index declined 6 points (0.5%) to 1,134, while the Nasdaq Composite dropped 15 points (0.6%) to 2,334. In moderate volume, 1.0 billion shares were traded on the NYSE and 2.2 billion shares were traded on the Nasdaq. Crude oil declined $0.26 to $74.71 per barrel, wholesale gasoline was $0.02 lower at $1.90 per gallon, and the Bloomberg gold spot price advanced $4.84 to $1,291.98 per ounce. Elsewhere, the Dollar Index—a comparison of the US dollar to six major world currencies—fell 0.7% to 79.81.

Dow member Microsoft Corp. (MSFT $25) announced that it will increase its quarterly dividend by 23% to $0.16 per share, payable on December 9, 2010, to shareholders of record on November 18, 2010. MSFT also announced that that it has authorized up to $6 billion in incremental commercial paper and longer-term debt. Shares fell.

Adobe Systems Inc. (ADBE $27) reported 3Q EPS ex-items of $0.54, above the $0.49 Reuters estimate, with revenues growing 42% year-over-year (y/y) to $990.3 million, above the $984.9 million that the Street was looking for. The software firm said it had “strong performance” in each of its major businesses and it remains bullish about its long-term role in enabling the transformation of content and applications across industries. ADBE said it is taking a cautious approach in issuing its 4Q guidance with the mid-points of both its EPS and revenues ranges coming in short of the Street’s forecasts and shares were down sharply. Analysts expressed some disappointment that revenues were not projected stronger as 4Q is a typically strong season for ADBE. On a conference call, the company said it has seen weakening sales of its Creative Solutions in the US education market—its largest market—and in all products in Japan, which it expects to continue in the current quarter, per Dow Jones Newswires.

General Mills Inc. (GIS $37) posted fiscal 1Q EPS of $0.64, one penny above the Street’s forecast, with revenues increasing 1% y/y to $3.5 billion, which was below the $3.6 billion estimate. The cereal company said consumer demand for its established brands “remains strong” and it is pleased to see continued growth in volume and net sales across its worldwide businesses. The company’s US retail segment benefited from favorable volumes, pricing and product mix, but increased input and advertising costs caused operating profits to come in below last year’s level. Meanwhile, the company’s international segment enjoyed higher volumes but foreign exchange reduced net sales. GIS reaffirmed its full-year EPS outlook and shares traded solidly to the upside.

Darden Restaurant Inc (DRI $43) reported 1Q EPS of $0.80, beating the Street estimate by $0.03, but revenues of $1.81 billion fell short of the $1.82 billion forecast, prompting shares of the company to decline. Same-restaurant sales rose 1.1%, as Olive Garden and LongHorn Steakhouse posted gains, while Red Lobster continued to struggle, with same-restaurant sales falling 1.7% year-on-year, despite a sharp decline last year. The company said that the rebound in its comparable restaurant sales would fall behind the industry, as DRI did not provide discounts as big as its peers, who would benefit as those discounts ended. DRI said industry promotions were still prevalent in the casual dining segment, but that the company remains “wary of utilizing deep discounts.” DRI reaffirmed its previous guidance of EPS growth from continuing operations of 14-17% in fiscal 2011.

eBay Inc. (EBAY $24) announced that its President of eBay Marketplaces, Lorrie Norrington, will be leaving the company for personal family reasons. Additionally, the online auction company said it expects its 3Q results to be “near the high end” of the guidance provided on July 21, where it forecasted revenues between $2.13-2.18 billion and EPS ex-items of in a range of $0.35-0.37. Analysts were expecting the company to report 3Q revenues of $2.18 billion and EPS of $0.37. Shares were solidly lower.

CarMax Inc. (KMX $26) shares rose nicely after the auto retailer reported 2Q EPS of $0.48, eight pennies above the consensus estimate of analysts, as revenues rose 13% y/y to $2.3 billion, roughly inline with forecasts. Same-store sales—sales at stores open at least a year—gained 4% y/y, driven by an improvement in sales conversion, and traffic was similar to last year’s 2Q, notwithstanding the absence of the spike in traffic provided by last year’s “cash for clunkers” program.

Jefferies Group Inc (JEF $23) shares were lower after the company’s 3Q earnings results of $0.23 per share fell well short of the Street estimate of $0.31, despite the company posting revenues of $609.3 million, besting the $572 million forecast. Sentiment for other brokers took a hit as the CEO said that trading activity was “painfully slow” during the quarter, and that the seasonally slow summer period was “exacerbated” by continued concerns over the state of the global economy.

Shares of chipmaker PMC-Sierra Inc. (PMCS $7) were under solid pressure after the company lowered its 3Q revenue forecast from a previous range of $169-177 million to $161-163 million, and analysts expected it to report revenues of $173 million. Also, the company said it expects its gross margins for 3Q to be at the lower end of its previous guidance.

Mortgage applications decline despite a near record low in 30-year rates

The lone report on today’s US economic calendar is the MBA Mortgage Application Index, which declined 1.4% last week, after the index that can be quite volatile on a week-to-week basis, fell 8.9% in the previous week. The decrease came as the Refinance Index dipped 0.9%, while the 3.3% drop in the Purchase Index accounted for the bulk of the decline. The decrease in the overall index came despite a 3 basis-point decrease in the average 30-year mortgage rate to 4.44%, just above the record low of 4.43% reached on August 27.

Treasuries were mixed with the yield on the two-year note 1 bp higher at 0.42%, while the yield on the 10-year note fell 2 bps to 2.55%, and the 30-year bond yield lost 5 bps to 3.74%.

Treasury rates may come under renewed pressure as many on the Street believe the Fed is considering another round of quantitative easing (QE), or purchases of assets such as Treasury bonds, after the Fed yesterday slightly tweaked their view on inflation, saying “measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.” In the Fed’s statement yesterday, they said, “The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.”

The Federal Reserve is charged with promoting maximum employment and price stability, and the economy is falling short on both accounts. Those arguing against more QE note the ineffectiveness of the first program, as lending remains subdued despite the Fed’s injection of money, and the high level of reserves in the system could quickly multiply in the economy when confidence, economic growth and lending return, generating inflation. Additionally, the weak jobs picture may not be that responsive to monetary stimulus - the Minneapolis Fed President believes a mismatch between jobseekers' skills and business needs is responsible for 2.5% of the current unemployment rate. The overhang of debt built up in the period before the recession is complicating monetary policy, depressing growth and keeping consumer spending subdued. The case for more QE centers on deflation, and although it's not in the Fed's forecast, it's possible that the specter of deflation is viewed as a more negative outcome. Another potential outcome of more QE is that it could weaken the US dollar, boosting the competitiveness of US exports. While we acknowledge the downside risks to the economy, we continue to believe the US economy will avoid a double-dip recession, and with interest rates already at historically low levels, we don't believe lowering the rate to borrow money, the cost of capital, is likely to spur economic growth and employment. Further, rhetoric out of Washington has done little to lower the cost of labor or engender confidence among business leaders, and we prefer actions that give businesses increased certainty about how to plan for future operating costs in relation to demand growth.

Europe leads international economic news

Central bank policy was in view across the pond as well, as the minutes from the last Bank of England’s policy meeting were released, showing members voted 8-1 in favor of keeping its benchmark interest rate unchanged at a record low of 0.5%, while making no change to its asset purchase target. However, the report showed that some BoE members discussed adding more stimulus efforts, as it said some members increased the probability that further action would become necessary to stimulate the economy and keep inflation on track to hit its medium-term target.

Elsewhere in Europe, Portugal conducted a debt auction that was met with strong demand, easing some sovereign debt fears, however the debt was sold at nearly 100 bps higher rates than one month ago, because Poland’s deficit has increased this year, while the other troubled euro-zone countries have made progress reducing deficits.

In other economic news, euro-zone industrial new orders dropped more than expected month-over-month (m/m) in July, falling 2.4% compared to the 1.4% decline that economists had expected, after rising a slightly downwardly revised 2.4% in June. The y/y rate of industrial new orders was 11.2% higher, below the 16.2% that was forecasted. Moreover, euro-zone consumer confidence came in worse than economists had expected for September, adding to the pressure on European sentiment.

Elsewhere in the Americas, Canadian retail sales unexpectedly fell m/m for July, declining 0.1%, compared to the 0.6% increase that economists had expected, overshadowing a better-than-expected reading of Canada’s leading indicators.

In Asia/Pacific, a leading index of the Australian economy rose 0.4% in July, prompting the Aussie dollar to advance to a two-year high versus the US dollar, as traders believe the Reserve Bank of Australia may need to resume rate hikes after keeping rates unchanged for four straight months, while the Federal Reserve hinted at further stimulus for the US economy in the FOMC meeting yesterday. The minutes from the last RBA meeting released yesterday indicated that high levels of resource utilization were likely to put pressure on inflation and the Australian economy was likely to grow at trend pace, prompting the need for higher interest rates.

Housing market status on tap

Tomorrow brings the report on existing home sales, which reflect closings from contracts entered one to two months earlier, forecasted to rebound 7.1% m/m in August to an annual rate of 4.1 million units after plunging 27.2% m/m in July to an annual rate of 3.83 million units. Friday follows up with the release of new home sales, expected to increase 6.9% m/m in August to an annual rate of 295,000 after dropping 12.4% in July. Sales of new homes are considered a more timely indicator of the housing market, as sales are recorded as contracts are signed, while the majority of transactions are on existing homes. Home sales figures dropped off after the benefit from the tax credit ended, although July’s pending home sales figure, which leads closings by one to two months, posted the first increase in the period after government stimulus ended.

The other report on tomorrow’s US economic calendar is the Conference Board’s Index of Leading Indicators, expected to rise 0.1% in August.

International releases tomorrow include euro-zone PMI reports on manufacturing and services, and Italian unemployment.