Bloomberg:

A measure of U.S. business activity unexpectedly shrank in September, indicating companies are likely to limit spending and production.

The Institute for Supply Management-Chicago Inc. said today its business barometer decreased to 46.1, worse than the lowest estimate of economists surveyed by Bloomberg News, from 50 in August. Readings below 50 signal contraction.

Near-record excess capacity and gains in spending induced almost solely by government stimulus programs are likely to prevent companies from ramping up assembly lines. The manufacturing recovery may be uneven as federal assistance begins to wind down.

“Conditions are still very sobering,” said Ellen Zentner, a senior macro economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “There’s always a payback period on the other side for government stimulus.”

My comment: Taking money from Peter to pay Paul can only give the illusion of a rebounding economy. How anyone thinks 25 plus years of excess will be cured in one or two years is beyond me. Things will continue to worsen as we are nowhere near the bottom. if you are speculating in the stockmarket you should be very wary of the economic underpinnings so many are betting on.

John Polomny
The Real Deal

But when it comes to figuring out the bigger-picture, longer-term moves for whole investment classes, there’s nothing better than watching a few key economic indicators.

And since this week is going to be a very busy one for data releases, I wanted to spend a little time today talking about the most important indicators you should pay attention to, along with an update on where those items currently stand right now.

Let’s start with one that will be coming out this Friday and is sure to make a big splash …

U.S. Employment Numbers from
The Bureau of Labor Statistics

While weekly unemployment claims are somewhat important to the markets, the major employment dipstick is what we get from the BLS every month.

In the “Current Employment Statistics” report we hear what 150,000 businesses and government agencies are doing with worker levels, hours, and earnings.

And in the separate monthly household survey, which is officially called “The National Employment Situation,” we get the actual unemployment rate. It’s expressed as a percentage of the overall labor force … and it’s the number most of us are familiar with hearing.

According to the August measures, the national unemployment rate rose to 9.7 percent, the highest level since June of 1983, while employers cut 216,000 jobs.

Unemployment should stay elevated for some time, even if the economy is already recovering.

This Friday, both items will be released for the month of September.
While fewer jobs were probably lost, I don’t expect to see an improvement in the unemployment rate yet. In fact, most economists are still expecting a surge above 10 percent before the end of the year.

But pay close attention to these releases going forward. By knowing whether there were more or less jobs in the economy in the previous month, you can then adjust your expectations for other data accordingly.

For example, if jobs were created, we would expect more factories to be utilized.

And it follows that more people working will also be a strong gauge of our economy’s overall economic output … which is another MAJOR thing to watch …

Gross Domestic Product:
The Economic Fruits of Our Labor

This quarterly number measures our country’s economic output from all manufacturing and services. It is reported as an annual number in “real” terms, meaning that it is adjusted for inflation.

Much ado is made about the GDP releases, because they are used as the basis for the textbook definition of a recession (two subsequent quarterly contractions).

However, one of the things that many investors fail to realize is that each GDP release is eventually subjected to two subsequent revisions. That means the original number reported is not the only one to watch.

Case in point: Tomorrow we will get the final reading on second-quarter GDP. It is likely to show a 1.2 percent annualized contraction rather than the previously-reported 1 percent rate!

GDP is still what most people mean when they refer to economic growth and its effect on investor sentiment is huge.

Of course, perhaps no release has more of an immediate and far-reaching impact on all the markets than …

What the Federal Reserve Does (and Says)
At Its Open Market Committee Meetings

This group of government bankers gets together about eight times a year to talk about the current state of the economy as well as its future prospects. Meetings are on Tuesdays, and sometimes into Wednesdays.

Sometimes the Fed actually says what it means …

The Fed issues a statement at the conclusion of every meeting, and the market dissects every single word of it. This is also when interest rate actions are most likely announced. Obviously, those have a huge market impact.

Much of what’s happening in each individual Federal Reserve district is contained in the Fed’s so-called “Beige Book,” which is released on a lag.

Likewise, each meeting’s minutes are disseminated to the public later. If you want to know how localized economies are holding up, the Beige Book is very helpful. And the FOMC minutes are a great way to sense what the Fed’s next move might be.

As it stands right now, the Fed is unlikely to make a major interest rate move anytime soon. In fact, at their meeting last week, they had the following to say:

“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

Of course, you cannot always take what the Fed says at face value. And as I have made known plenty of times before, I remain concerned that they will mismanage their rate actions going forward, setting up the possibility of a significant bout of inflation.

Rather than pay attention to their reassurances that “inflation will remain subdued for some time” I suggest you …

Watch the Inflation Rate Via the CPI and PPI!

The Consumer Price Index (CPI), which is released every month, is still important to the markets, because it’s a reliable benchmark for inflation, no matter how much it’s understating things.

And the PPI is also significant because it measures what businesses are paying for things. As such, it is a good front-runner to the CPI. Like the CPI, it’s based on a basket of goods, and is reported in a “headline” version as well as a “core” version. The latter excludes food and energy prices.

Both PPI and CPI are expressed as percentage increases or decreases, both against the previous month as well as against the same month a year earlier.

It’s worth noting that — after showing some outright price declines in many categories during the height of the credit crunch — these two inflation gauges have been showing renewed increases.

For example, in the latest batch of data released on September 15, PPI advanced 1.7 percent and CPI gained 0.4 percent.

A Couple of Important Points about These Four Items …

First, they’re released by the government and not necessarily perfect measures. In past Money and Markets columns, I have discussed some of the problems with these measures.

Likewise, you cannot just accept the government’s measures of other items, either. Many reports suffer from flawed assumptions.

However, with a grain of salt, these numbers can at least help you form a baseline opinion of what’s happening out there.

Second, some of these items are lagging indicators. GDP and unemployment tell us what has BEEN happening … not what is about to happen.

But when we’re trying to contextualize our long-term investment decisions, they’re still extremely useful. And when you use them to frame other short-term indicators and data items, you’ll be better able to draw reasonable conclusions.

Third, the four items I described today are just the tip of iceberg.

Heck, if you want to get a sense of how much data is out there just watch the headlines this week! We’re going to hear about consumer sentiment … other jobs numbers … a couple of manufacturing indexes … and plenty more.

Plus, in a few short weeks it will be “put up or shut up” time for Corporate America again as earnings season gets underway.

My larger point is that you’ve got to separate the wheat from the chaff and put together a series of indicators that help you quickly understand what’s happening. Once you couple that information with what you’re experiencing in your own life and hearing from friends and family, you’ll be in a better position to make solid investment decisions.

Best wishes,

Nilus Mattive
Money and Markets

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

In spite of the excessive, in-your-face, rhetoric in the hundreds, if not thousands, of newspaper and on-line articles this past week on gold bullion it does not warrant the hype – at least not yet. All one has to do is examine the performance of gold relative to the broad stock market indices and the various commodity-related indices to see that its rise above $1000/oz. is not really that impressive. Don’t get me wrong, I think gold has a very bright future but what has happened over the past week, other than the fact that it is closing in on its all-time high, pales in comparison to all other associated precious metals investment vehicles. Frankly, gold is a laggard, any way one looks at it, as the table below so clearly illustrates:

(1) All calculations are based on U.S. dollar equivalents

(2) Week ending September 11th, 2009

(3)HUI is the symbol of the AMEX Gold BUGS (Basket of Un-hedged Gold Stocks) Index. It is a modified equal dollar-weighted index of 15 large/mid cap gold mining companies that do not hedge their gold beyond 1.5 years.

(4)GDM is the symbol for the NYSE Arca Gold Miners Index. It is a modified market capitalization weighted index of 31 large/mid/small cap gold and silver mining companies.

(5)CDNX is the symbol for the S&P/TSX Venture Composite Index. It consists of 558 micro and nano cap companies of which 44% are engaged in the mining, exploration and/or development of gold and/or silver and other mineral resources and 18% in oil or natural gas pursuits.

(6)SWI is in reference to the commodity-related Stocks with Warrants Index. It consists of all such warrants with at least 24 months duration outstanding trading on the Canadian and U.S. stock exchanges. Of the current 35 companies in the index 4 are large-cap, 4 mid-cap, 4 small-cap and 23 are micro- or nano-cap in size. The index represents 20 gold/silver/copper mining and/or royalty companies, 9 miscellaneous mining companies, 2 oil and gas operators, 3 merchant banks and 1 mutual fund.

(7)CWI is in reference to the Commodity-related Warrants Index. It consists of 48 warrants, of at least 24 months duration, associated with the 35 SWI companies.

Sources: stockcharts.com (prices); oanda.com (exchange rates); preciousmetalswarrants.com (warrant data)

Whether we have continued deflation or limited inflation in the years to come it probably would be prudent to follow the advice of many of the non-mainstream financial advisors who suggest that one should have at least 5%, if not as much as 15%, of one’s portfolio in gold (and silver) as financial “insurance” to withstand whatever transpires in the years to come. That being said, given the data in the table on the previous page, if one truly believes that gold and silver are going to double or triple in price in the next few years then it would seem logical to put a portion of that gold/silver allotment in either the stocks of the companies that mine it, the royalty companies that buy it from the miners at predetermined fixed prices or in certain of the long-term warrants offered by some of the mining and royalty companies to enhance one’s returns.

Many investors are wary of investing in such a supposedly volatile asset class as gold stocks but old and new research shows that the judicious addition of gold stocks can enhance investor returns without adding portfolio risk. Research by Jeffrey Jaffe which covered the period between 1971 and 1987 identified that, while adding gold and gold stocks to a large portfolio did, in fact, increase both risk and return, the additional return from these non-correlative assets more than compensated for the additional risk. On the risk side gold and gold stocks had greater volatility, as measured by standard deviation, than the S&P 500 but Jaffe found that, due to their non-correlative qualities, adding gold-related assets to a diversified portfolio would likely reduce overall risk. Below is an updated chart of a portfolio holding 85% S&P 500 and 15% gold equities for the period from 1971 to this past May, 2009. It shows that such a portfolio had essentially the same volatility as the S&P 500 (horizontal axis) but delivered a 22% higher return (vertical axis) over that period of time (rebalanced annually) than a 100% S&P 500 portfolio. (Source: “Gold Stocks Can Add Returns With No Extra Volatility” by Frank Holmes)

The Merits of Owning Gold and Silver

Let me count the ways. Declining U.S. dollar value versus other foreign currencies; increasing likelihood of accelerating U.S. inflation; dwindling in-ground reserves; reduced annual production; shortage of new discoveries; increasing investment demand; declining supply due to company de-hedging and reduced central bank/IMF sales; susceptibility to future mania due to small market size and a number of other factors (subject of a future article) all strongly suggest that gold (and silver) has nowhere to go but up significantly in price in the near future.

The Merits of Owning Gold and Silver Mining Stocks

If gold were to escalate considerably in price (i.e. to $2,000, $3,000, or even more) in the next few years it would have a significantly positive impact on the profitability of the companies who mine it and the royalty companies that buy it from marginal producers. For example, with gold priced at $1,000/oz., and the cost of production at perhaps $400/oz. the gross profit margin is 60.0%. If 2 years from now, however, gold has risen to $2,000 and the cost of production has increased by only 20% to $480/oz. then the mining companies’ gross profit margins will have gone up from $600/oz. to $1520/oz. or 153%!.

With such a dramatic increase in their operational profits one could reasonably expect that the share prices of such companies’ stocks would go up dramatically too. That, coupled with the fact that most gold and silver based stocks are still significantly below what they were at their highs back in 2007 would lead one to expect truly major increases in their stock prices. That is the rationale for finding and investing in those gold and silver mining and/or royalty companies with the right mix of capable management, strong financing, major resources and geographically and politically well-located properties to reap the benefits of such a surge in the price of gold and silver. Were the trend in appreciation of the large- and mid-cap producers versus gold remain constant at approximately 3 to 1 (as depicted above) such profits would be exceptional.

The Merits of Owning Royalty Gold and Silver Company Stocks

The companies involved in just buying producing miners’ marginal gold or silver production at predetermined fixed prices (i.e. royalty companies) have a license to print money. They have no production risks, no staffing risks, no financing risks, no – you get my gist – so if the price of gold and silver goes up dramatically their gross and net profit margins will go up even more so than those of the producers themselves provided they have strong management.

The Merits of Owning Certain Warrants of Certain Gold and Silver Mining and Royalty Companies

However, for those who are prudent enough to do their homework and buy the right long-term warrants associated with the right gold and silver mining companies at today’s undervalued prices, their returns could quite possibly be 2 to 3 times greater than had they invested in the stocks themselves. So if gold and silver were to go up 100% in the next year or two or three then the stock of many of the companies that mine these products could well go up 200% – 300% and even more if the circumstances were just right. Taking this one step further, if a stock with warrants were to go up 300%, for example, one might well earn an enhanced return of 2 to 3 times (the current average leverage factor) that of owning the warrant instead of the stock itself depending on the duration of the warrant chosen (some are as long as 4 years, a few in excess of 5 years) and the stock price appreciation realized. Warrants are the only true buy-and-hold investment enabling an astute investor to seize the opportunity to buy in at depressed price and ride out the fluctuations the day-to-day price of a stock until the warrant has risen enough (before its expiry date) to surpass the price originally established, i.e. the exercise price, to convert the warrant into a share. If you are a ‘gold bug’ then warrants are the ideal investment vehicle to reap the maximum benefits of any ensuing major increase in the price of gold (and silver).

While the process is straightforward enough most people don’t have a clue what a warrant is, which companies have them, which ones have the best leverage/time values and exactly how to go about buying them. If you are interested in warrants please visit our site and check out our free database of such companies and our learning center to learn all there is to know on the subject. If you catch the gold fever that is going around and just have to own some warrants then a modestly priced subscription would assist you immeasurably in selecting the right warrants of the companies you have determined to have the greatest future prospects.

In conclusion it is important not to get all caught up in the hype surrounding gold’s ascent beyond $1000. If you are a true ‘gold bug’ then better profits are to be had by broadening one’s investment horizon to include some large- or mid-cap gold and silver producers, a royalty company or two and a handful of the right warrants of the right gold and silver small-, micro- and nano-cap companies be they small producers in the development stage and ripe for a buy-out or determined explorers with encouraging prospects. Remember the old refrain “Got Gold?” Perhaps it is time to change it to “Got Gold Stocks and Warrants?”

To my readers:

I receive many emails with questions and comments regarding my articles and I make a point of replying to each and every one. Don’t be shy – drop me a line or two at Lorimer@preciousmetalswarrants.com. To all you closet authors/commentators out there; if you are interested in becoming a periodic Guest Contributors send me a draft of your proposed article for consideration. That’s how I got started and now I write 3-4 articles per month on a variety of economic/financial topics and get widespread distribution and extensive readership. It is a very enjoyable and stimulating activity. I am a guest speaker at the inaugural World MoneyShow in Toronto this coming October 22/23. If you attend please introduce yourself. We have two web sites that we believe will help you make money in these very volatile times. www.PreciousMetalsWarrants.com provides a  free one-of-a-kind database (updated weekly) on all commodity-related warrants trading on exchanges in the United States and Canada and offers a subscription service ($19.95 or $49.95) which ranks all warrants according to their own current unique leverage/time values based on four projected stock price appreciation levels. You can also sign up for a free weekly email highlighting events in the marketplace and in the wonderful world of warrants in particular.  www.InsidersInsights.com alerts subscribers ($24.95) as to when corporate insiders of a limited number of junior mining and natural resource companies are buying and selling.

Thanks for the read. – Lorimer.

So is it time to sell?

After all, no one knows a company better than insiders. They see the day-to-day operations, the sales figures, expenses, and everything else. They know their business better than anyone else. Their business is what they do every day.

So it makes sense to track when insiders are buying and selling their own shares. Buying is bullish and selling is bearish, right?

Well, it may be. But if we take a look at history, it’s not as clear cut as many analysts make it out to be. More importantly, the insiders are teaching us one very important lesson that will go a long way to making you a more successful investor.

Insiders Rush for Exit

The recent rally has presented many investors the opportunity to take some money out of the markets. Insiders have jumped at the opportunity.

TrimTabs research has found that insiders unloaded $6.1 billion worth of stock in August. That’s the highest rate of insider selling in 16 months.

More importantly, insiders haven’t been buying much either. Trimbabs also found the ratio of insider selling relative to insider buying has surged to 30-to-1. That’s the highest the ratio has hit in five years.

Charles Biderman, the CEO of Trimtabs, pointed out in the New York Times that, “You have a classic case of greed stampeding investors into believing that nirvana is at hand. We just don’t see how the market’s going to last.”

But what does massive insider selling really tell us?

The Truth About Insider Buying and Selling

We know there are plenty of stock market myths which are perpetuated over time to match whatever the market sentiment is. Insider selling might be the myth du jour.

Thankfully, insider selling has had a long track record to which we can see whether it’s something to be concerned about now.

For instance, I recently came across this Associated Press report:

Rampant Insider Selling Raises Red Flags

Major Corporate Execs, Including Some from the Homebuilding Industry Are Dumping Stocks – Serious Predictor of a Coming Crash

You’d think it was a recent headline. There’s been a recent wave of insider selling, homebuilders have been big winners, and fears of another crash are still high.

It is, however, from December 2004. That was over a year before the peak in housing. And it came at a time when the S&P 500 was at 1200 and almost three years before its recent peak at well over 1500.

In more current times, insiders haven’t been very trigger shy about pushing the selling button either. Back in June Bloomberg reported: Insiders exit at the fastest pace in two years.

Here we are two months later and the market has held up exceptionally well.

On the other side, insider buying isn’t always bullish either. For instance, corporate insiders in the retail sector recently saw a big “opportunity” to load up on company shares.

Bloomberg reported: Insider Buying of Retailers, Led by Dillard’s, Climbs:

Consumer confidence is falling, the odds of a recession have risen, analysts predict the worst holiday shopping since 2002 — and retail-industry executives are buying their companies’ shares like never before.

Limited Brands Inc. Chief Executive Officer Leslie Wexner and eight other executives bought a record amount of stock last month after prices fell to a four-year low. Dillard’s Inc. director Warren Stephens made the biggest insider purchase ever as shares of the Little Rock, Arkansas-based department store chain headed for the steepest decline since at least 1980.

A lot of retail executives saw opportunity, but this article is from December 2007. That was two months into the official recession. And the moves haven’t proven to be very wise since. Dillard’s (NYSE:DDS) went on to fall 75% and is still down 40 from then. The retail sector as a whole has been lagging well behind too.

Of course, these examples are just that – examples. They’re hardly enough to define a true trend.

The chart below from Sentimentrader.com shows a much better picture of the trend and the relative importance (using that terminology very loosely here) of insider buying and selling as an indicator for the overall market direction:

 Investing 101: Let History Be the Judge

As you can see, insider buying and selling trends have been very volatile over the past decade. There have been plenty of times when insider buying and selling is at the right time and at the worst possible time.

This time should be no different. The wave of insider selling and lack of insider buying may be a warning sign. It may simply be what it always has been: something to be aware of. Or it may be even more proof that the majority of company insiders are just like the majority of investors, really bad.

There is one thing we can learn from company insiders though…

Did Enron Teach Us Nothing

That’s to stay diversified.

When company insiders buy their own stock, have the majority of their 401K’s tied up in company stock, and have their jobs, insurance, and salaries tied to one company, they are not well-diversified.

This is what those tens of thousands of Enron employees went through. Most of them had bet big on their own company. No one was complaining when Enron’s shares nearly tripled in two years, the company was printing stock options and shares for employee 401Ks, and salaries were rising.

Most everyone in the company was highly leveraged…and loving it. Eventually, as all investors do eventually learn, the ups and downs are only more severe when you’re not diversified. Most folks with families and bills just aren’t prepared for the risks.

So I think the same way when I hear about how corporate insiders are selling out in droves. It’s more likely most just relearned the value of diversification the hard way. Now they are trying to salvage what they can.

You know my take on the markets since April: don’t bet against it until it starts going down. So right now is not likely a good time to sell out, but if you’re sitting on a few big winners, it could a good time to get more diversified.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

So … what does this clear improvement tell us? How important is it? Does it give us an all clear signal that a strong recovery is on its way?

The LEI Is a Very Successful
Recession Predictor …

The LEI is the most successful recession predictor I know of. It has forecast every recession since 1960, an accomplishment the vast majority of well-known economists and the Fed can only dream of.

Whenever the year-over-year percentage change fell below the zero line for three consecutive months, a recession followed suit. There was, however, one minor exception: In 1966 the LEI predicted a recession, but the economy technically barely averted one …

In 1966, the LEI stumbled. It had predicted a recession, but the economy technically barely averted one …

Growth slowed dramatically, earnings stumbled, and the stock market was hit hard. But according to the official arbiter of recessions, it wasn’t a recession. Even though for all practical intents and purposes it definitely felt like one — and in Europe it actually was a severe recession.

In 2007 a New
Pattern Emerged …

At the beginning of 2007 the LEI started to send warning signs. But its behavior was a little strange. The year-over-year change fell below zero. Then it rose back to positive readings, creating a pattern it had never done before …

In previous cycles it had always accelerated to the downside after getting negative for more than two months. This time, though, after a few months of soft landings, it fell below the zero line again, but now it was for real.

And for the rest of 2007 and all of 2008, the percent change of the LEI continually got much worse!

•  In November and December 2008 the LEI had fallen to -4.0 percent.

•  In January it recovered a little to -3.8 percent.

•  In February it went down to -3.9 percent and again to -4.0 percent in March.

Then it got better …

•  To -3.0 percent in April, -1.8 percent in May,

•  And -1.1 percent in June to the already mentioned +0.2 percent in July.

These numbers show that the turning point during the current cycle was between March and April 2009.

So in 2007 the LEI had done it again: For the eighth time since 1960 it had correctly forecast a recession.

The LEI Signals the End of the Recession —
But Nothing More …

After getting better three months in a row and rising above the zero line during the fourth month, the LEI is telling us that this severe recession will be over soon. That’s a positive message.

Although it does not tell us that a strong or long-lasting recovery is now in front of us. Yet that’s what most economists are saying! Many of these experts are the same ones who didn’t see the recession coming in the first place.

How do they know?

This isn’t a garden variety post-WWII recession … the kind that almost always shows a strong rebound after a recession.

Well, they don’t, of course. They’re still hoping that this recession will finally turn out to be a garden variety post-WWII recession — which it isn’t by a mile. They hope for a repeat of the typical post-WWII business cycle pattern … the kind that almost always shows a strong rebound after a recession.

Only the events after the 1980 recession diverged from this script. Back then the LEI shot up to nearly 5 percent, but soon thereafter it relapsed into negative territory. Sure enough, the blossoming recovery was aborted, and another recession began by the end of 1981. And it was more severe than its predecessor and lasted much longer.

What does the history of the LEI tell us then?

It signals the end of the recession … and nothing more. It tells us nothing about the quality of the recovery — its length or its strength.

This Is Not a Garden Variety Recession —
Be Careful

This is obviously not a garden variety recession. It’s the result of a huge burst real estate bubble. Hence I deem it very dangerous to treat it like a normal post-WWII business cycle.

The real problems of the economy have not been solved by the Fed’s easy money policy, by the big bank rescues or by the stimulus programs …

The real problems — too much bad debt, overleverage, a sick banking sector, and an over-stretched consumer — are still with us. If history is any guide, a huge deleveraging process will weigh as a major negative on the economy for many years to come. That’s why the prediction of a normal and strong economic recovery seems to be based much more on hope than on reality.

For now, the worst of the post real estate bubble crisis seems to be over. That’s the message that the LEI currently confirms. But I suggest that you keep watching this recession predictor during the coming months … a new message could be given any time. And the long– awaited, stimulus-based recovery may turn out to be short lived.

Best wishes,

Claus Vogt
Money and Markets

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

Here in the United States, at a cost of a mere $3 billion, the “Cash-for-Clunkers” program appears to have given new hope to the U.S. auto industry.

But that new hope is destined to be short-lived.

It’s true that – in terms of value delivered for the money invested – “Cash for Clunkers” has eclipsed every other stimulus program that has been tried. But the program has a projected lifespan of only three months, meaning it can’t reverse the powerful global forces that are destined to turn the U.S. auto market from leader to laggard on the global stage.

Financial Crisis Fallout Reshapes Sector

Thanks to the financial crisis whose impact continues to be felt, worldwide automobile demand had dropped on an overall basis since 2008.

But regional differences are already emerging.

In the United States, for instance, the benchmark seasonally adjusted annual sales rate (SAAR) finally jumped up past the 11-million mark in July after failing to eclipse the “breakeven point” of 10 million vehicles in any prior month this year. But the actual year-to-date sales of 5.81 million vehicles through July was still 33% below the 8.55 million that had been sold by that point in 2008, and is 67% below the all-time annual record of 17.4 million achieved in 2000 and 65% below the decade average of 16.4 million.

(Prior to the global financial crisis and accompanying recession – which prompted the U.S. auto industry to restructure and shift its breakeven point down to 10 million vehicles – the breakeven point was actually 16 million vehicle sales in a year. Below that point, several or all of the U.S. “Big Three” would be spinning their wheels in red ink.)

It’s a much different story abroad, however, where several markets are in a long-term growth mode. In India, for example, sales were up 31% on a year-over-year basis, while auto sales in China were an astonishing 70% above those of a year ago. Even if U.S. auto sales continue to improve, China’s automobile market may outsell its U.S. counterpart for a full year for the first time ever.

Granted, India’s auto market – around 2.5 million cars and light trucks a year – is still much smaller than either China or the United States. However, its growth makes it comparable to the Japanese or German markets, the next largest automobile markets after its U.S. and China counterparts.

Thus, global automobile sales are undergoing a major reorientation towards Asia and away from the United States and Europe. This will inevitably have a huge effect on the structure of the sector.

That’s why Asia will become the new Detroit – the future center of the automaking world.

Gone For Good?

In the United States, General Motors Corp. and Chrysler Group LLC have lost market share because of the government takeover. They are unlikely to get it back in spite of the debt costs they have relinquished through bankruptcy.

For Chrysler, the partnership with Fiat SpA (OTC ADR: FIATY) is unlikely to help much. Fiat is among the weakest of the European companies, and has not been competitive in the United States since the 1980s. The U.S. market is undoubtedly moving toward smaller automobiles. That trend is being “fueled” by the new Corporate Average Fuel Economy (CAFE) standards for 2015 and probably by higher fuel taxes for environmental and budget reasons. Nevertheless, it seems unlikely that the Chrysler/Fiat partnership will have the models to compete.

General Motors has the model range to compete in the United States. However, GM is doing much better in China, thanks largely to its joint venture with Shanghai Automotive Industry Corp., which expects to sell 1.4 million vehicles in 2009. Since GM is also selling Opel, its European operation, GM will find itself driven primarily by the demands of the Chinese market. Given the growth of that market, it will probably make the most economic sense for GM to become Chinese-owned. Politics may delay this, but probably only for a few years.

The United States’ One “Better Idea”

Ford Motor Co. (NYSE: F) has picked up market share in the United States from GM and Chrysler’s problems. It should benefit both from "Cash for Clunkers," and from the early stages of the U.S. market recovery. If GM and Chrysler continue to have difficulties, Ford may be in a good position here in the large U.S. market – as the most-effective manufacturer of the large automobiles that Americans continue to prefer – no matter what the government tells Ford to do.

Nor is that Ford’s only competitive advantage going forward. Ford Europe is big and viable enough to allow Ford to remain credible as a producer of smaller cars, primarily in the higher price brackets.

Outside the United States, European manufacturers will find themselves increasingly confined to the luxury end of the market. However, as global incomes rise and the newly wealthy become brand-conscious – particularly in the emerging economies of Asia – that upscale portion of the auto market should continue to be strong.

Japanese and Korean manufacturers will continue to dominate their domestic markets. And such companies as Honda Motor Co. Ltd. (NYSE ADR: HMC), Toyota Motor Corp. (NYSE ADR: TM) and Kia Motors Corp., will also do well in the United States and Europe, and in countries where they have been able to establish viable local manufacturing operations, and lower labor costs.

But it will be the players from China and India who are destined to be the big market-share gainers on a global basis.

The New Leaders

For U.S. investors, India’s Tata Motors Ltd. (NYSE ADR: TTM) is the best known of the newly emerging global auto elite. Tata’s $2,500 for-the-masses “Nano" car has been well received. Over the long term, the Nano may expand the entry-level portion of the worldwide auto market, forcing other manufacturers to produce equivalent low-price models.

Indeed, the introduction of $2,500 cars may greatly expand the market’s size in India and other emerging markets, much as Ford’s Model T did after its introduction in 1908, or the Volkswagen AG (OTC ADR: VLKAY) VW Beetle did in the 1950s and 1960s.

Tata looked to be in financial difficulty after it bought the loss-making Jaguar and Land Rover brands in 2008 at the top of the market. However, the $300 million loan for its Jaguar Land Rover Unit announced on Aug. 10 gives Tata the room it needed to maneuver. Market growth in India, combined with the strength of its Tata Group parent now suggest that Tata Motors has the strength to survive without dismemberment.

The bottom line: Tata and its India-based competitors – Maruti Suzuki India Ltd. (Mumbai: MSIL) and Mahindra and Mahindra Ltd. (London: MHID) – as well as such top China carmakers as Chery Automobile Co. Ltd. (still publicly owned), Geely Automobile Holdings Ltd. (OTC: GELYF) and Great Wall Motor Co. (OTC: GWLLF), are thus the companies that will see most growth in the automotive market of the decade to come.

By 2020, the global auto sector will look nothing like it does today. Given that most of the muscle will be in Asia, investors shouldn’t be surprised.

By Martin Hutchinson
Money Morning

P.S. “No one can predict the market.” Right? Wrong!

But Obama’s high-speed rail initiative has gotten off to a sluggish start, while a much bigger, $300 billion plan to create the world’s largest and most sophisticated high-speed rail network is already rapidly unfolding in China.

“Railroads were always the pride of America, and stitched us together. Now Japan, China, all of Europe have high-speed rail systems that put ours to shame,” Obama said in April.

In a proposal called “A  Vision  for  High-Speed  Rail  in  America” Obama and the Federal Railroad Administration outlined a plan to develop 10 “potential” 100-600 mile corridors in the United States, “similar to how interstate highways and the U.S. aviation system were developed in the 20th century.”

Developing all 10 high-speed corridors could eliminate 6 billion pounds, or about 3 million tons, of greenhouse gas emissions each year, the FRA said.

But the plan was pitched as more than a way to make travel cleaner and more efficient. It was touted as a way of creating jobs. In April, when Obama gave his speech, the unemployment rate stood at 8.9%. It’s since risen to 9.4% in July and will likely test 10% by the end of the year. 

Meanwhile, the FRA has until 2012 to disperse the first $8 billion of the total $13 billion allocated to high-speed rail. And when that money is finally paid out, it’s more likely to go towards upgrading existing infrastructure than laying new high-speed rail.

"No one expects we are going to begin, let alone complete, the high-speed rail system with $8 billion," FRA spokesman Warren Flatau told CNNMoney. But the stimulus funds represent the "groundwork for a more sustainable program of funding in the future."

The remaining $5 billion has been included in the president’s budget over the next five years.

Already, it that amount seems to be woefully inadequate. Last month, more than 40 states submitted 278 pre-applications for stimulus-funded high-speed rail projects. The total amount of funds requested amounted to $102.5 billion in requests, according to CNN.

China Fast-Tracks High Speed Investment

High-speed rail may be on its way to the United States but it’s already arrived in China.

China introduced a 270mph maglev train service in March 2004 and regular high-speed train services in April 2007. But it’s not stopping there.

Beijing will spend $50 billion on high-speed rail this year alone, and the central government plans to spend another $250 billion over the next decade. By 2020, China will have laid nearly 16,000 miles of high-speed track capable of carrying the fastest trains on the planet. By comparison, America has just 457 miles of high-speed track.

And unlike in the United States, China’s high-speed railroad initiative is already producing jobs. So far, the construction of the Beijing-Shanghai high-speed route alone has created about 110,000 jobs and is playing an enormous part in China’s economic recovery.  

Spending on railways jumped 126.5% year-over-year in the first half of 2009, leading to a huge increase in the nation’s steel production at a time when global demand was decidedly weak. China’s crude steel output in July reached a record 50.68 million metric tons, up 12.6% compared with last year, according to figures from the National Bureau of Statistics.

There is no doubt that “the acceleration of [the massive railroad build-out is playing a key role in China’s recovery,” David Li, an economist at Beijing’s Tsinghua University told Fortune.

Liang Yi, the vice CEO of the China Railway Construction Co. (CRCC) subsidiary working on the Beijing-Shanghai route told Fortune that his company may hire up to 20,000 new university grads to meet the growing workload. Liang said his unit alone is absorbing 8,000 more workers this year than it did last.

Of course, that doesn’t mean Chinese companies are the only ones profiting from China’s railroad expansion.

International Business Machines Corp. (NYSE: IBM) won a contract to provide software for high-speed trains the Guangdong province. Also, IBM last month announced that it was opening a “Global Rail Innovation Center” in Beijing.

“In the next five years, China is investing more in high speed rail than the rest of the world combined,” Keith Dierkx, the director of this new center, told TheInfrastructurist.com. “This enormous build out of the HSR frees up their traditional rail network for freight. So, they’ll have more high-speed rail than the rest of the world combined–but they’ll also be getting better freight capacity.”

Canada’s Bombardier Inc., the world’s largest rail equipment manufacturer, also got in on China’s massive HSR initiative when it won a contract for work on 40 high-speed trains, as well as a signaling system.

Fortune estimates that foreign companies have won about $10 billion worth of contracts for work on China’s high-speed rail system.

Still, Money Morning Investment Director Keith Fitz-Gerald believes that the best way to capitalize on China’s massive rail build-out is by investing in Chinese companies that will have a long-term presence.

“There’s certainly hay to be made on high-speed rail development in the United States, but if you really want to capitalize on this trend you should look at China, which accounts for 25% of the world’s railroad traffic but has only 6% of the world’s rails,” Fitz-Gerald said. “To the extent that China builds high-speed rail, then effectively railroad companies across the country will benefit from increased traffic.”

In a recent Money Morning Webinar, Fitz-Gerald named Guangshen Railway Co. (NYSE ADR: GSH) as company that has good long-term prospects in China’s transportation sector.

“Guangshen is involved in high speed, it’s involved in capacity and it’s got relatively low debt,” said Fitz-Gerald. “It’s just another example of a Chinese company capitalizing on a huge infrastructure expansion that’s backed by billions of dollars in government investment.”

Guangshen’s 2008 operating revenue jumped 11.23% in 2008, in part because of HSR development.

By Jason Simpkins
Money Morning

In February, I analyzed the top 12 U.S. banks to determine whether they really needed $1.5 trillion in taxpayer-provided bailout capital. I concluded that only a few of those banks seemed to be in any danger of collapse, and actually recommended several.

Policymakers and the market later came to agree with me: The Standard & Poor’s 500 Financial Index has more than doubled from its March low and several bank stocks have posted triple-digit returns.

An April review of the first-quarter financial results of the top 13 U.S. banks (I added Fifth Third Bancorp (NYSE: FITB), at a reader’s request, to make it a Baker’s Dozen) only reinforced my conclusions.

But now the second-quarter results are out and an examination of those financial statements makes it appear this optimism may have gone too far. And that could mean that bank stocks will pose more risk in the year’s second half than they did in the first six months of 2009.

Let’s take a closer look.

Stressed Out Over Stress Tests

The highly controversial government bank “stress tests” may be the best place to start. Since the results of the government stress tests (Money Morning conducted bank stress tests of its own) were published, a number of banks raised extra capital.

However, it’s now clear that the government’s stress tests may not have been stressful enough.

The government’s “more adverse” scenario postulated unemployment averaging 8.8% in 2009 and 10.3% in 2010. With unemployment already at 9.5% in June we have blown through the 2009 estimates. And with some economists actually projecting that unemployment could actually reach the 12% level next year, the government estimates for 2010 were clearly also too low.

Furthermore, neither scenario considered what might happen as a result of the enormous budget deficits, currently forecast at $1.8 trillion in 2009 and $1.3 trillion in 2010. If interest rates zoom up, bank profits will take an additional hit. On the other hand, the “more adverse” scenario assumed a 22% decline in house prices in 2009, followed by a gain of 7% next year. Recent good news in housing suggests those figures may indeed be a bit pessimistic. Overall, therefore, the fact that a bank passed the stress test is not a guarantee of future success.

Goldman Sachs Group Inc. (NYSE: GS) and Morgan Stanley Inc. (NYSE: MS) – onetime investment banks now operating as bank holding companies – fall into a separate category. Both institutions depend almost entirely on their trading prowess, which in the case of Goldman Sachs produced impressive results in the second quarter. However, I am old-fashioned enough to regard what they do as not really banking, and hence propose to ignore them in this piece.

The Indicators That Separate Winners From Losers

There is lots of information – about potential bailout needs and about possible investment bargains – that can be gleaned from the banks’ second-quarter figures and from the earlier government “stress test” results. In particular:

A number of banks did fine on the stress tests, but then went on to report thumping losses in the second quarter, suggesting the stress tests were wrong (my own ratings seem to have been more accurate!).

• Banks that have lost money at an operating level in each of the last three quarters are probably in terminal trouble, regardless of whether the “stress test” said they were okay.

• Banks that relied more on the Goldman-Sachs-type trading business had better quarters than the banks that relied upon more-traditional lending. I regard this as a danger sign, since that business is likely to be much less profitable going forward and some products (credit default swaps, for example) may land an institution in serious trouble. What’s more, it now appears that commodities trading is poised to come under political fire, particularly since it appears that regulators are looking to restrict risk.

• In most cases, such key financial-analysis ratios as stock price to book value (Price/Book ratio, or P/B ratio) have risen sharply in the last few weeks. If the bank is trading above book value, but is still making losses or tiny profits, it’s overvalued.

• Several banks did share issues at huge discounts to book value, badly diluting existing shareholders. As far as I’m concerned, any bank that has a management team that’s hostile to shareholders is a bank to avoid.

• None of the banks seem likely to pay reasonable dividends going forward, though BB&T Corp. (NYSE: BBT) is at least making an effort, with a dividend yield of around 2.7%. Over the long term, dividends are a key component of investment returns, so they should always be a consideration.

The Four Categories of U.S. Banks

Using these indicators, we can assess the viability of the leading U.S. banks. They can be divided, as before into four categories:

• Zombies: Institutions making persistent losses at an operating level. These subtract value from the economy and should be put out of their misery through controlled liquidation, with the healthy parts being salvaged. They are surviving only because of ill-advised government (taxpayer) largesse.
• Walking wounded: These may well need another bailout if troubles develop. Right now, however, despite the fact that profits are too low, these banks are currently operating adequately on their own. An intensification of economic downturn would push some of them into “zombie” status or bankruptcy.
• Risky but Proud: These banks have relatively high risks, because of acquisitions or their business mix, but appear to be overcoming the challenges they face. However, their profitability is poor and may remain so.
• Hidden gems: These banks have conquered 2008’s difficulties, taken care of their bad-debt problem, and still managed to make a substantial profit. Short of a repeat of 1929-33, they should continue to do so. However, many have seen their stocks soar, meaning their shares are often now overpriced – especially given the likelihood of a prolonged recession still to come.

A Baker’s Dozen for Bank Investors

That brings to a review of the 13-largest U.S. banks by assets as of Dec. 31 (ignoring Goldman Sachs, Morgan Stanley, and foreign-owned banks). They are listed here in reverse order of size (as measured by assets):

13. Fifth Third Bancorp (Nasdaq: FITB) – Zombie: With $120 billion in assets, this Cincinnati-based regional bank accepted a $3.4 billion Troubled Assets Relief Program (TARP) investment from the federal government. Fifth Third grew by buying other banks in the Midwest and Florida. At Monday’s closing price of $8.67 a share, the bank is trading at 67% of book value and twice its level of three months ago. It lost $1.2 billion in 2008 even after goodwill write-offs, and has lost another $26 million in the first quarter of 2009 – a bad result, since the 2008 disaster and the TARP investment should have allowed it to mark down its bad assets, taking “everything but the kitchen sink” into the 2008 loss. It posted an additional operating loss of $200 million in the second quarter, but showed a profit because of a $1.1 billion sale of its processing unit. Stress test said it needed another $1.1 billion of capital, which it raised through the dilutive sale of  $1 billion in stock, as well as the asset sale. Fifth Third’s survival as an independent entity – without further state assistance – remains doubtful; an orderly liquidation would seem the best alternative. However, both the Ohio economy, and the U.S. housing market – both major problems for FITB – are looking better. Second-half rating: AVOID.

12. Regions Financial Corp. (NYSE: RF) – Zombie: With $146 billion in assets, and a $3.5 billion TARP investment, this Birmingham-based regional bank operates primarily in the Southeast. At Monday’s closing price of $3.69, Regions’ shares are trading at 28% of book value. The bank lost $5.6 billion in 2008, and its tangible net worth is only $10.5 billion, but that loss was based entirely on goodwill impairment; on an operating basis it made a profit of about $300 million. Regions earned $77 million in the first quarter, but lost $244 million in second quarter.  According to the federal stress test, Regions needed $2.5 billion; it raised $2.1 billion through equity issues, thus diluting the hell out of existing shareholders. I have downgraded it from Walking Wounded to Zombie, although there may still be a pulse there. Second-half rating: AVOID.

11. BB&T Corp. (NYSE: BBT) – Hidden Gem: With$152 billion in assets, this Winston-Salem, NC-based regional bank operates mostly in the Mid-Atlantic region. At Monday’s closing price $21.62, BB&T was trading at about 90% of book value. This bank was profitable in each quarter of 2008, as well as in both quarters so far this year, making $1.5 billion for all of last year, $271 million in this year’s first quarter and $208 million in the second quarter. BB&T “aced” the government stress test, sold $1.7 billion in common stock and repaid its TARP funding. It cut quarterly dividend to 15 cents a share for second quarter of 2009 and it will be interesting to see what it does going forward. The shares are up more than 50% since I highlighted BB&T as one of the three U.S. banks that posed plenty of promise with very little downside risk. However, the stock-price increase since spring doesn’t reflect BB&T’s truly superior performance, which should improve now that it’s rid of TARP. Second-half rating: BUY.

10. Capital One Financial Corp. (NYSE: COF) – Zombie: Based in McLean, Va., Capital One is primarily a credit-card operation, though it has also acquired banking operations. Total assets equal $161 billion. It has repaid its $3.5 billion TARP investment. Because of its large market share with aggressive lending practices, Capital One looks to me like the credit card equivalent of the formerly independent mortgage lender Countrywide Financial Corp., which is now part of Bank of America Corp. (NYSE: BAC). At Monday’s closing price of $29.79, Capital One was trading at 53% of book value. It lost $1.4 billion in fourth quarter of 2008, $112 million in first quarter of 2009, and $275 million in second quarter. The second-quarter loss included the alleged $453 million cost of repaying TARP, but also a negative write-down on its credit-card portfolio.  Stress test said it was fine; an extraordinary view, so it issued $1.5 billion of very-dilutive shares and repaid TARP. I don’t like the business and I don’t trust the accounting. Second-half rating: AVOID.

9. State Street Corp. (NYSE: STT) – Risky but Proud: A Boston-based bank, with a uniquely institutional orientation, State Street has $174 billion in assets, and repaid its $2 billion TARP investment. At Monday’s close, its share price was $48 – an extremely rich 199% of book value. State Street has $2 billion in (non-dilutive) stock to repay TARP. Last year’s reported per-share earnings of $3.89 represented a 13% increase from 2007. Its first-quarter net income fell 16%, but was still $445 million. However, State Street posted a second-quarter loss of $3.3 billion after a $6.3 billion charge that was related to its asset-backed commercial paper (ABCP) program. Although the government stress test said State Street was fine, those conclusions were made before the ABCP loss. Rating cut a notch; one worries how many other banks have this kind of disaster lurking somewhere. Way overpriced. Second-half rating: AVOID.

8. SunTrust Banks Inc. (NYSE: STI) – Walking Wounded, but on a path to Zombification:  Based in Atlanta, this regional bank has $189 billion in assets and operations throughout the Mid-Atlantic region, as well as throughout the Southeast – particularly in Florida. SunTrust accepted a $4.9 billion TARP investment. At Monday’s closing price of $18, SunTrust was trading at 47% of book value. It posted a fourth-quarter loss of $379 million, but an overall 2008 profit of $747 million. However, SunTrust’s first-quarter loss of $815 million included $715 million of mortgage and real-estate-loan losses and it posted a second-quarter loss of $184 million. The stress test concluded it needed $2.2 billion in additional capital, which it raised by a share issue, heavily diluting existing shareholders. SunTrust has not been permitted to repay TARP. Second-half rating: AVOID.

7. The Bank of New York Mellon Corp. (NYSE: BK) – Hidden Gem: A New York-based bank with operations primarily in New York and Pennsylvania, and an institutional/corporate business orientation, Mellon has $237 billion in assets and repaid its TARP investment. Monday’s closing price of $27 meant the bank was trading at 119% of book value. It passed the stress test. Net income for 2008 was $1.39 billion and it reported a first-quarter profit of $322 million, after which bank reduced its quarterly dividend from 24 cents to 9 cents. It posted a second-quarter profit of $176 million after a $196.5 million charge for TARP repayment costs. Bank of New York Mellon raised $1.5 billion of subordinated debt and $1.4 billion of non-dilutive equity to repay TARP. This looks solid to me, with profits steady if you add back the TARP repayment cost. Second-half rating: BUY.

6. U.S. Bancorp (NYSE: USB) – Hidden Gem: With $266 billion in assets, this Minneapolis-based regional bank operates mostly in the Northwest and Upper Midwest. It has repaid its TARP investment. Monday’s closing price of $20 a share meant the bank was trading at 169% of book value. It reported a profit of $2.94 billion for all of 2008. It posted a first-quarter profit $419 million, and a second-quarter profit of $221 million after a $154 million TARP repayment charge. It passed the stress test. It issued $1 billion of debt and $2.7 billion of non-dilutive equity. It cut its quarterly dividend from 42.5 cents per common share to 5 cents to repay TARP. Second-half rating: HOLD.

5. PNC Financial Services Group Inc. (NYSE: PNC) – Hidden Gem: With $291 billion in assets, this Pittsburgh-based bank bought the slightly larger Cleveland-based National City Corp. in October, and now operates in the Mid-Atlantic and Midwest regions. It accepted a $7.6 billion TARP investment. At Monday’s closing price of $35, PNC is trading at 84% of book value. It reported net income of $882 million for 2008, $460 million for first quarter of 2009 and $207 million for second quarter of 2009. PNC’s quarterly dividend is now 10 cents per common share. The bank raised $600 million as required under TARP, with only small dilution. PNC appears to be integrating its National City acquisition well, but remains concerned about possible deteriorations in its credit quality. It plans to redeem TARP in a “shareholder-friendly manner.” I’ve upgraded this to a Hidden Gem on the basis of continued earnings and a reasonable stock price. Second-half rating: BUY.

4. Wells Fargo & Co. (NYSE: WFC) – Risky but Proud: A San Francisco-based bank that’s evolved into a nationwide player following its buyout of Wachovia Corp., Wells Fargo has $1.31 trillion in assets, and accepted a $25 billion TARP investment.Monday’s closing price of $24 means the stock is trading at 135% of book value. Wells reported a fourth-quarter net loss of $2.55 billion, not including an $11 billion net loss at Wachovia; full-year 2008 earnings totaled $2.84 billion. So far this year, Wells has reported a first-quarter profit of $2.38 billion, and a second-quarter profit related to common stock of $2.58 billion. The bank cut its dividend to 5 cents per share. The government stress test concluded that Wells Fargo required an additional $13.7 billion, which it raised via $8.6 billion in outside equity and $5 billion from internal sources. Wells now looks riskier than PNC; its loan write-offs in the second quarter exceeded loan-loss provisions. Second-half rating: HOLD.

3. Citigroup Inc. (NYSE: C) – Zombie: For regulators, Citi is the Big Kuhuna, and in my opinion, it should have been liquidated. A global financial conglomerate based in New York, Citigroup has been a serial flirter with bankruptcy over the last 30 years. Citi right now has $1.945 trillion in assets, and accepted both a $45 billion TARP investment, and government guarantees on $301 billion of assets. At Monday’s close of $2.86 per share, Citi is trading at 19% of book value. It lost $18.7 billion in 2008. It theoretically made money in the first quarter of 2009, but then fell back to a loss because it had to re-set the terms of some preference shares issued the previous year, diluting common shareholders further. Its $11.1 billion gain from the sale of its Smith Barney brokerage gave it a $4.3 billion second quarter profit, but Citi still lost oodles on an operating basis. The banking giant swapped $58 billion of preference shares for common, which will dilute shareholders still further. And it reduced its dividend to a nominal 1 cent per share.  This is the Zombie of Zombies, and seems to be getting no better. Second-half rating: AVOID - though, as ataxpayer, you own 34% of it, anyway.

2. JPMorgan Chase & Co.  Inc. (NYSE: JPM) – Risky but Proud: With $2.175 trillion in assets, JPMorgan is a major international player with a New York headquarters and its banking and investment-banking operations are both major global players. It bought The Bear Stearns Cos. Inc. investment bank in March 2008 and the Washington Mutual Inc. (OTC: WAMUQ) thrift in September, both with federal government help. It has paid back its TARP investment. Monday’s closing price of $38 meant that JPMorgan was trading at about 102% of net asset value. It reported net income of $5.6 billion for 2008. So far this year it reported $2.1 billion in first quarter and $2.8 billion in second quarter – after TARP repayment costs of more than $2 billion.  JPMorgan reduced its quarterly dividend from 38 cents per share to 5 cents a share. However, the second-quarter profit was largely from investment banking, which I view as very low quality earnings, though JPM gains from lack of competitors currently. Second-half rating: HOLD.

1. Bank of America Corp. (NYSE: BAC) – Zombie: With roughly$2.8 trillion in assets – including Merrill Lynch, which was acquired after the 2008 year-end – this nationwide retail-banking giant is based in Charlotte, and has used the financial crisis to grow through acquisitions. In addition to its purchase of Merrill, the No. 3 investment bank, BofA also purchased No. 1 mortgage giant Countrywide Financial Corp. last year.  Bank of American accepted a total TARP investment of $45 billion, as well as $118 billion in asset guarantees against Merrill Lynch assets. Monday’s closing price of $13 meant that BofA was trading at 50% of book value. The banking giant reported a fourth-quarter net loss of $1.55 billion, and had to shoulder the additional Merrill Lynch net loss of $15.3 billion. Bank of America reported a first-quarter profit of $2.8 billion after preferred-share dividends, but that included $2.2 “mark-to-market” write-up of Merrill Lynch debt (the opposite of all those “mark to market” write-downs banks are whining about). It reduced its quarterly dividend to a nominal 1 cent per share. Second-quarter net income of $3.2 billion was after $9.1 billion of pre-tax gains from asset sales, so on an operating basis it still loses money. It’s still a Zombie, and I question the quality of its management. Still a Zombie, and management quality is doubtful. Second-half rating: AVOID.

A Final Look Forward

From this extensive analysis, it’s very clear that the leading U.S. banks are still very troubled, and that several lf them will probably have to be liquidated over time or taken into public ownership. In fact, in many ways the continued virulence of the problems in this sector make me even less optimistic than in February. In particular, the government’s decision to allow Citigroup and perhaps even Bank of America to continue operating causes a huge moral hazard: As a Money Morning investigation demonstrated, banks will take endless risks and merge like madmen in order to be thought “too big to fail.”

There’s another problem – this one of particular concern to current stockholders, or prospective investors: The downside risks for all these banks now exceeds the upside.

Many of these banks have experienced huge share-price run-ups. Take Bank of America. At the closing price of $13.34 yesterday, BofA’s shares have soared more than 320% from their early-March lows. Looking ahead, the liquidity growth in the U.S. monetary system has been so excessive, and the projected U.S. federal budget deficit is so great, that there must be a substantial chance of a bond market crash in the months ahead. That would undoubtedly hit some of these banks hard, possibly pushing them over the edge – but there’s no way of figuring out which. So, in general, I would give the sector a miss.

By Martin Hutchinson
Money Morning

Despite a growing belief that the recession is at or near its nadir – and a string of upbeat corporate profit reports that have sent stocks up to their highest levels this year – consumer confidence dropped to its lowest level since April. According to the Reuters/University of Michigan Survey of Consumers, the final sentiment level for this month dropped to 66.0, down from 70.8.

"People are a little more worried about the economy, especially over the labor market and what’s happening in Washington,” David Wyss, chief economist with Standard & Poor’s Ratings Services, said in a Reuters interview. “It’s still consistent with the picture that the economy is bottoming out, but you are not going to get a big bounce in consumer spending,"

Without that surge in consumer spending – which accounts for two-thirds of U.S. economic activity – the rebound may run out of fuel.

“The consumer isn’t going to be a leader in this recovery,” Nigel Gault, chief U.S. economist at IHS Global Insight Inc. (NYSE: IHS), told Bloomberg News. “Consumers are aware that the labor market is still pretty bleak. Any recovery in consumer spending will be very, very modest.”

There are a number of potentially contradictory forces at play that could either boost – or blunt – consumer confidence:

• The Consumer Price Index (CPI): The CPI continues to fall on a year-over-year basis, despite the U.S. government increasing the money supply.
• The U.S. Federal Reserve’s “exit strategy:” When the recession does end, will the huge, afore-mentioned increase in the money supply start a rash of inflation, or will the central bank’s exit strategy keep prices in check?
• The lack of income gains: In the Reuters/UM survey, the fewest consumers in its more than 60-year history reported income gains. While it didn’t go into specifics, the U.S. Bureau of Economic Analysis (BEA) said incomes grew 1.4% thanks in large part to stimulus checks. Without those checks, growth was just 0.2%.
• The health of the housing market:  In many places, the housing market appears to have finally hit bottom, with nationwide sales of existing homes rising 3.6% in June, the third straight monthly increase. Prices are still low in many U.S. regions, and the $8,000-tax-credit incentive for first-time homebuyers continues through November. Twenty-nine percent of home sales came from first-timers, according to the National Association of Realtors.
• Rising unemployment: U.S. unemployment is still rising, and will continue to do so in the second half of 2009, topping off between 9.8% and 10.1%, according to Fed estimates.
• Unemployment insurance claims: While overall joblessness is rising, the moving average of initial unemployment insurance claims is shrinking: For the week ended July 18, the average was 566,000, down 19,000 from the week before.
• The personal savings rate: Suddenly, spendthrift Americans have become good little savers, causing the personal savings rate to zoom to its highest level in more than 15 years; in May, the rate was 6.9%, up from the near-zero levels of early 2008.
• Tightening credit: The once-free-flowing credit for those great financing deals aren’t nearly as abundant as they once were, and it’s showing. Buying plans for homes, vehicles and major household durables all declined this month, according to the Reuters/UM survey.

While Wall Street and the public companies who rely on its backing  rallied last week thanks to a wave of mostly positive earning and an equal amount of positive forecasts for the second half, the fact is most consumers are either out of touch with such news – or just don’t care.

Instead, these key economic and financial factors will be the catalysts that make or break the consumer spending – and perhaps the economic rebound – this fall and through to the end of the year.

Bob Blandeburgo
Money Morning

The stock market will give important clues. But the economy, especially unemployment, defines depressions.

That should be obvious. However, after the stock market rallied off its March 2009 low, the media and many pundits seem to be fixated on the financial markets to determine the severity of the crisis and to call its end.

To see if the bulls’ hopeful thinking holds water, let’s go back to 1929 and have a look at the stock market’s behavior during those horrific times …

The Bear Market Rally of 1929/30

Yes, there was a spectacular stock market crash in 1929. But a stock market crash does not a depression make. Remember 1987? There was a very similar crash … but no depression. Not even a mild recession.

The crash of 1929 proved to be only the prelude to further heavy losses in 1930-1932. After the initial crash from 381 to 199, a huge rally emerged. Prices rose all the way back to 294 for a 48 percent bear market rally. Hence initial losses were roughly cut in half!

The stock market crash on Black Thursday, October 24, 1929, was just the beginning of the carnage to hit Wall Street.

Unfortunately, investors didn’t recognize this rally as a selling opportunity. Instead, they listened to the bullish advice of Wall Street pundits and the government’s declarations that the worst was over and prosperity was right around the corner.

As we all know, this optimism proved to be, well, premature. The huge rally turned out to be just a bear market rally … soon the market started to tank again.

First, stocks tumbled back to the crash-lows, where a second and shallower rally emerged. Then after this bout of hope had evaporated, the market cascaded lower for another two years. From the high during the summer of 1929, the losses mounted to a staggering 89 percent.

Now, let’s fast forward to …

The Bear Market Rally of 2009

After having lost more than 50 percent off its October 2007 high, a huge stock market rally started in March 2009. This rally amounted to 43 percent and had all the typical characteristics of a counter trend move. Especially noteworthy was the low and diminishing volume, which is typical bear market rally behavior.

Just as in 1929, this rally led Wall Street and official sources to conjure economic optimism. This is not a coincidence … the stock market and sentiment measures are highly correlated. But rising sentiment does not forecast a betterment of the economy. Instead a rising stock market foregoes rising optimism.

Now it looks like this bear market rally is over …

There is technical support around 880 in the S&P 500. A break below this mark would ignite another sell signal and confirm the end of the rally. The next support level is around 800. If this line doesn’t hold, it’s back to the March lows. And if these lows do not stop the slide, a very important message concerning the economy will have been given: “Depression ahead.”

I think that the next few weeks and months will not only be very interesting, but also very important. Yet hardly anybody on Wall Street seems to think about the possibility of a new, stock market low.

They should. And so should you. Remember …

Employment Is Much More Predictive
Of Recessions and Depressions Than the Stock Market …

Since the start of this crisis, world industrial production and world trade have been following the pattern of the 1930s very closely. But unemployment is the most important indicator to distinguish a recession from a depression.

by Claus Vogt
Money and Markets

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Since then, it has been known as “The Friedman Effect.”

It’s important to understand the Friedman Effect because it can have dramatic impact on your investment decisions and your portfolio…

Milton Friedman & The Friedman Effect

Basically, Milton Friedman found that if the Fed switched from tight money to easy money, or vice versa, it would take about six months before you would see any change in the direction of the economy or Wall Street.

The Friedman Effect worked like clockwork during the financial crisis of 2008. In late 2007 and early 2008, the Fed decided to squeeze the money supply and impose a credit crunch on the financial markets to slow down the real estate boom. The Fed got more than it bargained for. Its tight-money policy had a dramatic impact – the real estate market crashed and took the financial markets with it.

The Fed panicked and in September, 2008, Ben Bernanke & Co. reversed course and injected billions of dollars into the marketplace. The Fed’s balance sheet (see chart below) doubled in a few months as the Fed acted aggressively. Among other bold efforts, the Fed bought Treasuries and mortgage-backed securities directly in an effort to stem the tide of a deflationary collapse.

As you can see from the above chart, the Fed’s bank account (Adjusted Monetary Base) doubled in short order in 2008-09.

The Friedman Effect – Pinpointing The First Signs of Recovery

According to the Friedman Effect, that means the first signs of a recovery and stock market rally would occur six months later. Sure enough, in March, 2009, Wall Street bottomed out and roared ahead in one of the strongest rallies in Wall Street history. The S&P 500 Index has climbed an incredible 34% from its lows of March 8.

Moreover, we’ve seen sure signs of stabilization in the financial markets and the economy. The Libor rate – the interest rate banks charge each other to borrow short term – has fallen sharply, an indicator that the financial crisis is ending.

Many economic indicators have also turned positive. On Thursday, the Labor Department announced that the total number of people filing for unemployment insurance fell by 148,000 to nearly 6.7 million in the week ending June 6. That was the largest drop in more than seven years, and snapped a streak of 19 straight record-highs.

The best overall indicator of a possible recovery is the U.S. Index of Leading Indicators published monthly by the Conference Board, a private research group based in New York. The Ten Leading Indicators are designed to forecast the economy in the next three to six months. Most of the indicators are business related, such as new orders for capital goods, building permits and unemployment claims – and, I might add, the stock market and real money supply growth. The Conference Board also surveys the leading economic indicators for 10 other countries around the world.

The Board reported that the U.S. Leading Indicators fell sharply over the past year, and finally bottomed out – in March of this year! The leading indicators have now risen two months in a row. And on Thursday, the index rose 1.2%, the biggest gain since March 2004.

• In short, the good news is that the U.S. economy is slowly but surely on the road to recovery.
• The bad news is that the Fed has apparently decided to step on the brakes again, reversing course in its monetary policy. The days of quantitative easing are apparently over. As the graph above indicates, the Fed has stopped adding to its balance sheet – the adjusted monetary base has stopped growing.

The broader-based money supply (M2) was growing at double-digit rates until a few months ago. Now’s it’s growing at only 2% or less.

This tight money policy could spell trouble down the road if it continues. The stock market will probably continue to push higher for now, due to the lag time in the Friedman Effect. The Dow might even reach 10,000 by the end of this year. But if the Fed maintains this new tight money policy, we could be in for another rough period and a return of the bear market.

Good investing,

Dr. Mark Skousen
Investment U