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Goodbye Second Quarter


Company announcements quieted down during this shortened trading week. Most of the news this week showed that the economy was at least treading water if not signaling a pickup in activity. The ISM manufacturing headline number looked dismal coming in at 49.8 for June. Not only did it remain under 50 for the fourth consecutive month, but fell short of the 51.0 reading economists expected. However, digging past the headline number revealed that the manufacturing sector might not be in as bad of shape as the headline number suggested. The more important components, new orders and production, not only increased in June, but remained over 50. Almost all the weakness was confined to inventories, which dropped almost 5 points to 41.3. Employment perked up, but remained under 50, as it has since Henry Ford introduced the assembly line.

Speaking of Ford, automakers reported June sales this week that came in at a 16.4 million annual rate, a bit better than expected. Here are the scores.

Automaker June Sales Comments
GM +1.2% Solid June driven by trucks, SUVs
Ford -1.2%  
DaimlerChrysler +6.3% Economic environment trending up
Honda +8.7%  
Acura +3.4%  
Toyota +10.9% Best ever half year in 46 years
Lexus +11.7% Led by SUVs
Nissan +21.5% Infinity a big boost
Infiniti +43.0%  
Mazda -3.0% Summer season kicked off slowly
Mitsubishi +9.6% Strong SUV growth of 55%
Subaru +11.5%  
Isuzu -55.5%  
Suzuki +9.3% Strong SUV sales
Volkswagen -14.4%  
Mercedes +15.6% Strong E Class sales
BMW +19.4% Best half year ever
Volvo +31.9% Wagon V70 sales noteworthy
Audi +18.9%  
Jaguar +4.0%  
Saab +6.7%  
Porsche +37.6% Second best June ever
Land Rover -8.9%  
Hyundai +1.9% Customers looking for value
Kia -2.2%  
Industry Total +4.1%  

After the June vehicle numbers were tallied and analyzed, it was clear who the winners and losers were. Nissan realized exceptional growth of over 20% year over year, boosted by its increasingly popular Infiniti division. Toyota and Honda also had a strong month, with at or close to double digit sales increases over June 2002. High-end car makers had an excellent month as Porsche saw percentage gains of 38% over last June, Volvo 32%, and Audi 19%. Clearly low interest rates are allowing customers to "trade up" to more expensive vehicles.

DaimlerChrysler led the Big 3 with sales growth of 6.3%, and the company said it sees the economic environment trending upward. The news was not so good for the other members of the big 3 as GM reported growth of 1.2% and Ford saw sales decline 1.2% over June 2002. Nonetheless, Ford also expects industry sales to improve in the second half as "disposable income levels receive a boost from a rising US stock market, tax cuts and record low interest rates." I'm skeptical. Granted the economy looks to be stabilizing and could very well have a strong third quarter, but Ford increased incentives by 2.4% from just last month. These ever increasing incentives are having a diminishing return. Most of the growth in the industry is due to the strength in imports, which are not in the incentive battle with the Big 3. The Big 3 are already offering zero-percent for five years. What's next to drive sales? Will Freddie and Fannie start offering 30-year loans?

The big data this week is the employment situation report for June, which is released Thursday morning. Poor employment data has stopped making headlines since everyone acknowledges the labor markets are weak. Because of this, it is likely the market will shrug off any downside surprise and rally if report is better than expected. Jobless claims trended down during June, but continuing claims have held above 3.7 million for a couple of months. One glimmer of hope came from the May job cuts report from Challenger, Gray & Christmas. The recent report showed the lowest number of announced layoffs since the spike in December 2000.

After pointing out the hiring growth of mortgage bankers last week, I chuckled when I read Wednesday's Reality Check column from Market News International. "For now, his [Charles Sigrist, president of Stivers Temporary Personnel] only major source of hiring is in the mortgage business. 'In perhaps all of our 35 offices, mortgage banks represent about 20% of our clients,' he said." - naw, there is no bubble.

The obvious story of the second quarter was the rally in the stock market. The 15.1% gain in the S&P 500 was the largest quarterly gain since the fourth quarter in 1998. It was also the sixth best quarter since the beginning of the recently slain bull market that started in 1982. As we have previously discussed the rally was led by the most speculative issues. The table below details the gains of several different indexes during the second quarter:

S&P 500 14.9%
S&P 100 (Large Cap) 14.3%
S&P 400 (Mid Cap) 17.3%
S&P 600 (Small Cap) 19.6%
NASDAQ 21.1%
S&P Growth Index 11.8%
S&P Value Index 18.2%
Street.Com Internet 34.8%
AMEX Broker/Dealer 34.7%
AMEX Biotech 29.5%
Morgan Stanley High Tech 27.6%
NASDAQ Telecom 23.7%
Philadelphia Semiconductor 21.4%
Philadelphia Bank Index 21.2%
Morgan Stanley Cyclical 21.0%
AMEX Gold Bug 20.8%
S&P Retail 20.1%
AMEX Financial 17.8%
Morgan Stanley Consumer 11.1%
AMEX Pharmaceutical 10.4%

It is clear that more speculative stocks outperformed the rest of the market with Internet and biotech stocks up twice as much as the S&P 500. Prudential Securities did some analysis on the Russell 2000, which is another small stock index. The Russell 2000 was up 23.0% in the second quarter, which was the best quarter since the first quarter in 1991. The more speculative stocks within the index were up even more. The stocks in the index without earnings jumped a whopping 38.5%. Additionally, the smallest quintile, less than $180 million market cap, outperformed as well. These "smallest of the small" stocks soared 47.2%. That is close to a lifetime of CD returns. These two categories even trounced my index of highly shorted stocks, which was up 29.7% in the second quarter.

Since the market has started to consolidate after the recent rally, traders have started to discuss the decline in implied correlation. During the market sell-off in the first quarter, the correlation between stocks rose to the highest level since the fourth quarter of 1998. This simply means that stock prices were largely influenced by the movement of the overall market. Part of this is explained by investors positioning their portfolios in light of the heightened geopolitical risks. Investors were "indexing" their portfolios and not buying individual securities in order to minimize risk. By looking at the implied volatilities on options, it is possible to conclude what the forward implied correlation is. If investors are buying puts and calls in individual securities, the implied volatility will increase as the price is bid up. Since the geopolitical risks have subsided and earnings season is around the corner, investors have begun purchasing options on individual securities. This has pushed up the implied volatilities on the options for individual stocks vs. the implied volatilities on index options. This relative increase in implied volatility pushes down the implied correlation. In short, investors are starting to become stock pickers again. It should be noted that the implied correlation is still high historically, but is coming off a period in which was one of the highest on record. According to a note from CitiGroup's Equity Derivative Research, the implied correlation of the S&P 100 is around .4 to .5, which is "around the 60% to 70% percentile of historic implieds."

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