Melting Up

The stealth rally as it has been called has continued, with every attempt of selling pressure being easily swatted away. Last week had some huge news, as V.P. Biden made us aware of, but little effect in the equity markets. We think this deserves a second look. Based on the laws, there will be an impact felt on corporate earnings and therefore valuations. Caterpillar and John Deere already announced non-cash charges of $100 and $150 million, respectively, for this year based upon the impact of this bill on forward retiree health care costs.
The law says you must account for such changes when you become aware of them, and that would be now. AT&T took a hit to their balance sheet announcing a $1 billion non-cash charge. Ouch!

On March 23, 2010, the President signed into law comprehensive health care reform legislation under the Patient Protection and Affordable Care Act (HR 3590). Included among the major provisions of the law is a change in the tax treatment of the Medicare Part D subsidy. AT&T’s is taking non-cash charge in the first quarter of 2010 to reflect the impact of this change.

What is the bottom line?

AT&T had revenue of $123 billion and a reported profit margin of 10.19%, for a net profit of $12.54 billion - around 8% - for this quarter.

Caterpillar (NYSE: CAT) reported $32.4 billion in revenue and a 2.76% profit margin, with a net income attributed to common of $895 million. Their $100 million charge amounts to 11% of that income.

John Deere (NYSE: DE) reported $22.8 billion in revenue, a 4% profit margin and $912.80 million in net profit; their $150 million charge amounts to 16% of net income.

Based on the notion that most people value stocks based on Earnings Per Share, these charges would imply that stocks instantly became overvalued by somewhere between 10-15% when President Obama's signed this into law. Historically the market starts looking forward and discounting futures known facts.

On to the Treasury Bonds:

David Rosenberg, one of North America's leading economists at Gluskin Sheff + Associates Inc., a Toronto-based wealth management firm notes"¢ Last week's bond auctions did not go well. It seems that Japan and China did not show much interest. The lack of bids was no better underscored than in the 7-year Treasury note auction where the median yield was 3.29% versus 3.05% a month earlier. April is a cruel month for the U.S. Treasury market, with 10-year yields rising in each of the past 4 Aprils and in 6 of the past 7, and by an average of 25 basis points.

"That, in turn, could spook the equity market since another 25bps of upside pressure could then generate a fund-flow spiral as was the case in the summer of 2007 "” 3.85% (where we are now) ostensibly is a trigger point for selling of mortgage bonds. As rates rise, homeowners are less likely to pay their mortgages early, which extends the life of the mortgage and that in turn encourages mortgage investors to neutralize the duration of their portfolios by selling T-bonds and notes. We have seen this happen before and while it will likely provide a nice buying opportunity given the deflationary headwinds the economy now faces, the prospect of a spasm in the Treasury market is worth considering. Every equity market correction in the past "” 1987, 1994, 1998, 2000, and 2007 "” was preceded by what turned out to be a brief but significant run up in yields. See Stock Rally at Mercy of Rising Rates on page C1 of today's WSJ). And, the more overvalued the equity market is, the more the downside risks if bonds begin to provide greater yield competition in the near-term. Jeffery Hirsch over at the Stock Trader's Almanac is in today's NYT predicting a 20-30% correction ahead (see Stocks Soar, But Many Ask Why on page B1) "” he notes the modest number of stocks hitting new 52-week highs with every new interim peak being reached by the overall market.

At any rate, the march towards 1200 continues for the S&P, but it does appear that the bull has taken a breather and gotten a little tired.