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Five Things You Need to Know: Manufacturing Growth Slows; There's a Profit Recession On; More Ratings Downgrades on the Horizon; Even Credit-Worthy Borrowers Facing Problems; But Stocks Look Good


What you need to know (and what it means)!


Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. Manufacturing Growth Slows

The Institute for Supply Management's manufacturing index dropped for the fifth straight month to 50.8.

  • The Institute for Supply Management index of national factory activity fell to 50.8 in November from 50.9 in October, though that was above economists' median expectations for a drop to 50.5.
  • The line in the sand between growth and contraction is 50, according to the ISM.
  • So we're slowing, but not all details in the report were weak.
  • Export Orders rose to to 58.5 from 57.0, the highest since May, while Imports remained sluggish at 47.5 for the second straight month, down from 53 in September.
  • This is partially a U.S. dollar story.
  • The benefits of a weak dollar are strong exports. That's the good news.
  • The bad news is that the domestic figures in the ISM are weakening rapidly.
  • Prices Paid remains elevated at 67.5, Backlog of Orders fell to 41.5, Employment is the weakest in more than four years at 47.8.

2. There's a Profit Recession On

Manufacturing growth is slowing. Eh, so what? We're a finance-based economy, not a manufacturing economy. And it's about the velocity of money, not the production of widgets. Right?

  • Corporate profits, as measured by the Commerce Department, fell at an annual rate of $19.3 billion in the third quarter as domestic earnings dropped by $41.2 billion, according to a gloomy article on Bloomberg.
  • "U.S. corporate profits are in a recession, and the entire economy may not be far behind," warned Bloomberg.
  • Profits for S&P 500 companies fell almost 25% on a per-share basis in the third quarter, the biggest year-over-year decline in almost five years, the article noted.
  • The problem with being a finance-based economy and no longer a manufacturing economy, however, is that we really need those finance-engines to run smoothly in order to generate solid economic growth.
  • Since a good portion of the damage occurred in financials, where operating earnings fell 25%, perhaps Bloomberg is right in looking at the glass as half empty.

3. More Ratings Downgrades on the Horizon

Moody's late Friday said ratings may be cut in $105 billion of debt sold by structured investment vehicles (SIV's) after the net asset values of 20 SIVs sponsored by firms such as Citigroup (C) declined to 55% from 71% a month ago, Moody's , according to Boomberg.

  • "In recent weeks, Moody's has observed material declines in market value across most asset classes in SIV portfolios,'' the ratings company said in the statement.
  • As a result the ratings agency has placed this debt on review for a potential downgrade.
  • SIVs had about $320 billion of assets as recently as October, according to the ratings companies.
  • Why does this matter?
  • Downgrades would make it more difficult for SIVs to obtain financing.
  • And this would continue the ongoing freeze in credit markets, particularly in short-term debt financing.
  • Normally, if you or I were short on cash and unable to refinance our short-term borrowings to continue operations, we would be forced to liquidate something we own to raise capital.
  • Not these SIV's. Why? Nobody wants to liquidate their holdings because they aren't happy with the prices being offered (if prices are being offered at all).
  • This is why the Florida State Board of Administration withdrawal freeze we mentioned last week is important.
  • The concern is that funds forced to sell holdings at fire-sale prices if they eventually must liquidate will create more losses among the hopeful still holding these assets on their books at higher prices, creating still more losses, and generating observable inputs in the valuation of the assets.
  • No one wants to take a loss.
  • As MaryEllen Elia, superintendent of Hillsborough County Public Schools, which has $573 million tied up in the pool, said, "The very fact that you're out here talking to us about taking less than 100 percent is in my mind unacceptable,'' Bloomberg reported after the agency that runs the fund proposed returning 90 cents on the dollar to investors.
  • So the waiting game continues.

4. Even Credit-Worthy Borrowers Facing Problems

It's amazing what can change in 90 days. Three months ago any credit market issues were limited (contained) to "those subprime people," a general euphemism for "undeserving borrowers." Of course, all borrowers were deserving when asset prices were rising. Interestingly, it turns out now that a sizable chunk of those undeserving subprime borrowers weren't really subprime at all.

  • According to an analysis for The Wall Street Journal of more than $2.5 trillion in subprime loans made since 2000, as the number of subprime loans ballooned an increasing proportion of them went to people with credit scores high enough to qualify for conventional loans with far better terms.
  • In 2005, the peak year of the subprime boom, borrowers with good credit scores were recipients of 55% of subprime loans.
  • The study by First American LoanPerformance says the proportion rose even higher by the end of 2006, to 61%.
  • Wait, wait, don't give up yet... there's a silver lining, according to the Journal.
  • "Credit-worthy borrowers holding subprime loans may turn out to serve as a sort of shock absorber for the current mortgage crisis. They may be more likely than traditional subprime borrowers to withstand the double whammy of declining home prices and adjustable-rate mortgages soon due to reset at higher interest rates."
  • It's a weird silver lining, but it's a silver lining nonetheless... we guess... although, the fact that selling people expensive mortgages they don't need can be considered a silver lining probably is indicative of still deeper problems.

5. But Stocks Look Good

Ok, that's a hefty chunk of negative economic news in numbers one through four today, but stocks look good here. Why? How? Is this the "wall of worry" people talk about? Is it denial? It's actually far simpler. The stock market is not the same thing as The Economy. Here's what we're seeing:

  • As we mentioned last week, the S&P 500 and Nasdaq-100 Bullish Percent Indexes are positive, meaning demand is in control for those areas of the market.
  • With Friday's action another important equity indicator reversed up, the NYSE High-Low Index.
  • According to data from Investors Intelligence the NYSE High-Low Index reversed up from 12, a very washed out level, and near where the August reversal occurred.
  • Why is this important?
  • This indicator does not reach such low levels very often.
  • The move to 8% in August was the lowest level this indicator had reached since July, 2002.
  • Prior to 2002, the lowest level for the NYSE High-Low was September 1998, when it reached 6%.
  • The bottom line is demand is creeping back into control of stocks even as sentiment in the headlines remains negative.
  • At the end of the day we really have no idea what will happen next week or next year, so we rely on these unbiased indicators to tell us when risk in stocks is higher or lower.
  • Right now they are saying that no matter what is happening in the economy demand is in control of stocks.

    NYSE High-Low Index, courtesy Investors Intelligence

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