Morning Review - 091610

Nicholas Colas (Chief Market Strategist): 212 448 6095 or ncolas@convergex.
com
Christine Clark: 212 448 6085 or [email protected]
Beth Reed: 212 448 6096 or [email protected]
Stocks ended higher Wednesday, after the S&P 500 and Dow snapped a 4-day winning streak on Morning Markets Briefing
Tuesday (S&P 500 +0.4%, Dow +0.4%, Nasdaq +0.5%). Shares of homebuilders faltered however, as
mortgage applications fell almost 9% last week and a survey showed home sellers slashed asking
Market Commentary: September 16th, 2010
prices for a 3rd consecutive month in August. In other economic news, industrial production rose 0.2%
last month following a 0.6% gain in July. Excluding auto-related components, industrial production A snapshot of the markets through the
was up 0.4% in August following July’s 0.3% increase. The Empire State manufacturing survey for lens of ConvergEx.
September unexpectedly dropped to 4.14 from 7.10 in August, while import prices added 0.6% in
August from on top of a 0.1% rise in July.
Old School Business Math Gives Insight on Lackluster Market Valuations
Summary: One of the lingering questions about U.S. equities remains the conundrum of “cheap” price earnings valuations on so many high quality stocks. Perhaps
estimates are too high, but after several quarters of generally in-line-or-better earnings reports, that doesn’t seem to be the worry (at least for now). We think the
DuPont model, an old (ancient, really) financial analysis model highlights why multiples are as low as they are. Problem #1 – cost cutting only takes you part of the way
to maximizing shareholder returns in a cyclical downturn. Problem #2 – investors need to see a resumption of corporate investment growth to allow valuations to return
to more normal, long term levels.
We’re going to take it old-school today – back to when companies were managed without the benefit of computers. That’s not really that long ago, although you
need to go back to the 1930s and 1940s to really remove 100% of the impact of silicon chips on corporate decision making. Before then, everything was done with ledger
books and hand-written pages that resemble the spreadsheets of today. Or, the other way around, to be historically accurate.
And we’ll use as our paradigm of pre-computing business practices one Alfred Sloan, the Chairman of General Motors from 1937 – 1956. Sloan’s business practices
were a new combination of ruthlessness and precision. If you want evidence of the former, consider the Los Angeles trolley car system. There isn’t one now. That’s
because Sloan recognized early after World War II that LA could be a major growth market for automobiles. Commuting distances were on the upswing to accommodate
fast-growing suburbs. So GM secretly bought several of the more popular trolley companies and slowly reduced service. That encouraged Los Angelinos to migrate to
cars, which were more convenient than waiting for a trolley. What started the decade as one of America’s most expansive mass-transit systems ended up being paved
over for the highways that crisscross greater Los Angeles to this day.
Market Commentary – Pages 1-3, Equities/Conferences & Earnings – Page 4, Fixed Income – Page 5, Options – Page 6, Exchange-Traded Funds/Indexes – Page 7, Social
Media & Internet Blogs Top Stories – Page 8
1 1
Nicholas Colas (Chief Market Strategist): 212 448 6095 or [email protected]
Makes modern “tough guy (and gal)” managers all look like pikers, if you ask me.
As for Sloan’s precision in running General Motors, consider the DuPont model of financial analysis. Invented by the du Pont family for the purpose of managing the
chemical/munitions company of the same name, it is a method of financial tracking that breaks down Return on Invested Capital into its component pieces. We’ll review
those in a minute, but the output of the DuPont model is two-fold:
• It tells you what’s right and wrong about a business from the perspective of adding value to shareholders. Sloan centered all investment decisions at GM
on the Return on Invested Capital each business made. The higher the better. If a given business began to slip, the DuPont model showed whether or not the
problem was margin based (cost cutting is the answer there) or asset intensity (such as a bloat of working capital or too-expensive machinery required for a
product). With those observations, the business/product would be fixed or closed.
• It guides future investment in the businesses. The beauty of using Return on Invested Capital and the DuPont model is that it allows a manager to score every
product or service in the company from best to worst. The best ones get more capital for growth. That process allocates growth capital to its best possible use
within a company, just as capital markets are supposed to do for an economy.
Sloan used the model religiously to manage all aspects of General Motors. There was a whole room dedicated to charts and graphs pinned to the walls, each
showing the trends in Return on Invested Capital for Chevrolet, Oldsmobile, Cadillac, Opel, Vauxhall, Holden, and all the other businesses in the GM global footprint. This
methodical attention to basic but repeated financial analysis was one key reasons GM became the largest company in the world in the 1950s, and held that title into the
1980s. The company’s ultimate demise was not due to its inability to analyze the problems in the organization; it was management’s lack of will to do enough to fix the
problems that the financial analysis so clearly highlighted.
At this point you should note that we are a long way – both in terms of time and attention – from where much of corporate America and equity investors spend
their time today. When was the last time you heard an analyst ask “What business has the highest return on capital in your company?” at an investor day? Or “I notice
that your corporate Return on Invested Capital has been trending down versus your competition. Is that a margin problem or have you overinvested in lower return
projects?” No, the focus now is almost exclusively on quarterly results and near term data points.
The beauty of the DuPont model, however, is that it continues to provide valuable insight even when it is no longer center stage. That’s because the key indicator
that markets do pay attention to – earnings growth – is a direct outcome of the decisions made by managers that pull the levers of the model. Accelerating returns
translate into faster earnings growth, for example.
In fact, it has a lot to say about why Price/Earnings multiples still appear to be so low for many U.S. companies. The DuPont model actually highlights the
problems - and some potential solutions - that could earn U.S. companies better valuations over time.
Consider the following:
2
Return on Invested Capital is a function of two basic inputs: Profit Margins and Asset Turnover. Companies in both the US and around the world have done an
impressive job at preserving profit margins in the current downturn through layoffs and other downsizing. That is only half the equation, however. Asset Turnover is a
measure of how much capital a business needs to run its operations. If you are looking at a retailer, it is the stores, warehouses and inventory needed to run the business.
If you are software company, it is the cost of keeping all your key people at the company while you build new iterations of your products. That includes stock grants,
comp guarantees and the like. Intellectual capital is every bit as important as physical capital, after all.
The essential point, however, is the maximizing Profit Margins only takes you part of the way to increasing Return on Invested Capital. The other part of the
equation – Asset Turnover – tends to be stickier and harder to improve. Take that retail example we noted above. You can fire 10% of the employees out of every store,
of course. But how do you keep your sales up when you close 10% of your stores? It is harder – much harder – to do.
We suspect that one reason why valuation multiples are on the low side is because markets understand that it is hard to really improve Return on Invested
Capital in a sustainable way for many companies. Cost cutting is great for margins – we have seen that in spades over the past year – but it also begs the question of
what is happening on the Asset Turnover side of the DuPont model. As mentioned, that part is harder to manage and can act as an anchor that offsets much of the good
work done on the cost structure.
The other point that merits attentions with respect to the DuPont model is that it is very much a tool meant to point the way for future expansion and growth.
The key challenge Alfred Sloan mastered with its use was not cost cutting or manufacturing rationalization. It was expansion. The best businesses with the strongest
returns got cash to grow. That growth would, of course, be monitored so that returns did not drop with the new investments. And if it did, the DuPont model would
show whether the problem was Margins or Asset Turnover.
I cannot help but think that much of the current lackluster stock valuations so evident in equity markets are a result of corporate America’s reluctance to invest
in new projects. Now, if you are a market/economic bear that will sound like a sound strategy. After all, why invest in incremental capacity or new products if you are
convinced end demand will not merit the effort? But if you want to profess a positive view on equities, you need to address the same concern and also outline what
catalysts will change the current turtle-like behavior among managers. And if you are a manager, your shareholders will rightly ask why you should hold on to extra cash
if you are not investing it.
3
U.S. EQUITIES
In tech land, shares of AAPL were up 0.8% after BMO raised its target price to $320 from $315, while YHOO added 4.7% on news it does not intend to sell
its 39% stake in Chinese internet firm Alibaba Group. Chip stocks struggled after Goldman Sachs downgraded MU (-4.5%) to “Neutral” from “Buy,” citing
PC market weakness due to an increase in tablet sales. Homebuilders BZH (-7.3%), HOV (-2.0%) and PHM (-2.1%) tumbled as mortgage applications fell
8.9% last week and sellers cut home price for a 3rd straight month. Shares of MA soared 5.2% after the company predicted its EPS will grow at a
compound annual rate of +20% for 2011 through 2013.
Important Earnings Today (with Estimates) From…

FDX: $1.21 ORCL: $0.35 S&P Futures
MLHR: $0.26 PIR: $0.12 One Day (High –1121.50; Low – 1109.00):
Source: Bloomberg
Important Conferences/Corporate Meetings Today:

Bank of America Merrill Lynch Media, Comm & Entertainment Conf. – Newport Beach, CA
Bank of America Merrill Lynch Global Healthcare Conference – London, GB
Barclays Financial Services Conference – New York, NY
Credit Suisse Credit Products Conference – Miami, FL
Credit Suisse Chemicals Conference – New York, NY
Deutsche Bank Technology Conference – San Francisco, CA
G7: Think Equity Growth Conference – New York, NY
Longbow Research Industrial Manufacturing & Tech Investor Conference – New York, NY
Stifel Nicolaus Healthcare Conference – Boston, MA
Prior Day SPX (High – 1126.46; Low – 1114.63; Close – 1125.07): Three Day (High – 1127.00; Low – 1109.00):
Source: Thomson ONE

4
FIXED INCOME
Ten-year Treasury notes fell for the first time in 3 days on Wednesday, as investors speculated Japan will purchase shorter-term U.S. sovereign debt after
selling the yen for the first time in 6 years. The yen slid 3% against the dollar to 85.58 after reaching a 15-year high of 82.88 earlier in the week. Two-
year Treasury yields dropped 2bps, while 5-year securities were flat on the day.
Source: Bloomberg Source: Bloomberg
Today’s Important Economic Indicators/Events (with Consensus):

Producer Price Index (8:30am EST): 0.3%
o Excluding food & energy: 0.1%
Jobless Claims (8:30am EST): 455 K
Current Account (8:30am EST)
Treasury International Capital (9:00am EST)
Philly Fed Survey (10:00am EST): 3.8
Elizabeth Duke speaks at 9:30am EST
Tim Geithner speaks at 10:00am EST
5
U.S. EQUITY OPTIONS
SPX – The index trades back and forth in a fairly tight range of -0.6% to +0.5% ending on a positive note, +.4%. The activity in the options was mixed with much of the volume
related to the Settlement of the VIX on the opening, which was small to buy. There were several other trades followed patterns often seen just prior to expiration. In a typical
calendar roll, the September 1100 calls were bought vs. selling the November 1075 calls about 7,000 times. Also the September 1065 calls were bought vs. selling the October
1120 calls. Two protection trades were worth noting: the October 1000 puts were bought 5,000 times vs. selling the October 1200 calls 10,000 times for a net debit of $0.85 tied
to 1118; and the November 950 put was bought at $7.00 vs. the sale of the December 1225 calls at $7.20, over 10,000 times each, tied to 1117.
ETF – The market opened in negative territory and trended higher to close up on the day. In EWJ (Japan) we highlight a volatility buyer in through 14,000 Dec 9 / 10 strangle
delta neutral. In other flow, paper bought 10,000 IWM Oct 61/64 put spreads vs. selling the Oct 51/59 put stupid. Gold ETF, GLD, saw mixed flow with one investor rolling short
10,350 Sep 124 calls into the Oct 124 calls , while in another trade paper bought volatility through 10,000 Oct 124 Calls delta neutral. Lastly in quarterly SPYs one investor
protecting against a short-term slide in shares bought 10,000 Sep (Qrtly) 112 puts, sold 10,000 Sep (Qrtly) 107 Puts, and sold 13,000 Sep (Qrtly) 105 puts.
CURRENT IMPLIED VOLATILITY / CURRENT HISTORICAL VOLATILITY

Rank 9/9/2010 9/10/2010 9/13/2010 9/14/2010 9/15/2010 30-Day Implied Vol
1 ARG ARG ARG ARG FDO 33.78
2 FDO FDO FDO NOVL FSLR 39.39
BIGGEST MOVERS
3 NOVL NOVL NOVL FDO PG 13.89 Top 10 30-Day Implied Vol Bottom 10 30-Day Implied Vol
4 Q FSLR MKC PG AGN 29.10 PBI 136.53% 21.77 ARG -69.91% 14.59
5 DTV Q Q AGN AZO 25.22
6 MKC DTV CEPH FSLR DTV 23.33 PCLN 80.72% 41.74 NOVL -36.73% 45.60
7 GENZ GIS FSLR AZO CEPH 32.51 WFMI 49.62% 30.42 PTV -26.20% 6.22
8 FTR STZ AGN Q RHT 47.86
9 SLM GENZ STZ CEPH GIS 24.88 PNW 49.34% 24.37 FTR -26.02% 18.10
10 YHOO DTE DTV DTV STZ 29.11 TIE 25.56% 47.67 PLL -20.60% 35.63
11 STZ CEPH GENZ HSP HSP 33.75
12 CLX SLM SLM STZ KMB 14.03
RL 22.56% 32.47 MCK -19.62% 24.02
13 NKE YHOO HSP PEP PEP 16.38 ERTS 20.75% 34.65 DVA -16.12% 21.64
14 HSP HSP PEP YHOO Q 18.19 FDO 17.86% 33.78 BCR -15.18% 19.15
15 PNW CLX YHOO SLM STR 25.31
16 PEP NKE CLX CLX SLM 48.35 AEE 17.57% 23.10 MA -14.48% 31.93
17 GIS WFR KMB KMB QLGC 41.64 DO 16.71% 35.43 CAH -13.28% 25.81
18 STR AZO AZO GENZ MAT 30.60
19 CEPH MSFT WAG MKC CLX 15.50
20 MSFT PX WFR GIS WAG 25.99
21 WAG PEP JEC NKE NKE 25.85 We ranked the S&P 500 companies from the highest to lowest 30 day implied to
22 MAT CTXS PX QLGC AIV 38.70 historical volatility ratio. Above we identify the 10 most positive and negative
23 WPI RSH NKE WAG NOVL 45.60
movers.
24 PX WAG GIS RHT JEC 31.99
25 KR MAT BBY DVA PX 22.24
The table to the left represents the 25 highest 30 day implied to historical
JEC KR MAT BBY DVA
C WPI RSH PX MKC
volatility ratios within the S&P 500 companies. The green represents names
MCK PNW CTXS JEC YHOO new to the list while the red represents names that have fallen out.
AZO FTR DTE WFR ARG
PBCT MKC MSFT GRNZ
DPS STR
6
Exchange-Traded Funds/Indexes
Prior Day Peformance of Largest ETFs by Assets S&P 500 Sector ETFs
Name (Net Assets*) Ticker Category Daily Return Sector Ticker 1-Day Perf YTD Perf Sector Ticker 1-Day Perf YTD Perf
SPDRs SPY Large Blend 0.38% Energy XLE -0.20% -4.12% Telecomm IYZ 0.76% 6.29%
SPDR Gold Shares GLD N/A -0.07% Health XLV 0.94% -2.74% Technology XLK 0.63% -2.49%
iShares MSCI Emerging Markets Index EEM Diversified Emerging Mkts 0.14% Industrials XLI 0.00% 10.15% Consumer Discretionary XLY 0.18% 10.08%
iShares MSCI EAFE Index EFA Foreign Large Blend 0.04% Utilities XLU -0.57% 1.00% Financials XLF 0.34% 2.50%
iShares S&P 500 Index IVV Large Blend 0.37% Consumer Staples XLP 0.69% 4.99% Materials XLB -0.18% 0.73%
Prior Day Top Volume ETFs Currency ETFs
Name Ticker Category Shares Traded Currency Ticker 1-Day Perf YTD Perf Currency Ticker 1-Day Perf YTD Perf
SPDRs SPY Large Blend 137,365,807 Australian Dollar FXA -0.36% 4.36% Mexican Peso FXM 0.37% 2.10%
Financial Select SPDR XLF Specialty - Financial 64,010,818 British Pound Sterling FXB 0.39% -3.53% Swedish Krona FXS -0.37% 0.91%
iShares Russell 2000 Index IWM Small Blend 53,854,329 Canadian Dollar FXC 0.10% 2.12% Swiss Franc FXF -0.83% 2.91%
PowerShares QQQ QQQQ Large Growth 46,488,356 Euro FXE 0.02% -9.30% USD Index Bearish UDN -0.38% -4.83%
Direxion Daily Financial Bear 3X Shares FAZ Bear Market 35,269,220 Japanese Yen FXY -2.94% 8.44% USD Index Bullish UUP 0.43% 2.30%
Prior Day Top Performers VIX ETNs Fixed Income ETFs
Name Ticker Category Daily Return Name Ticker 1-Day Perf YTD Perf Bonds Ticker 1-Day Perf YTD Perf
GlobalShares FTSE All-World GSW N/A 20.71% iPath S&P 500 VIX VXX -1.48% -49.19% Aggregate AGG -0.18% 4.59%
ProShares Ultra MSCI Pacific ex-Japan AXIT Technology 8.45% Short-Term Futures ETN Investment Grade LQD -0.16% 6.87%
ProShares UltraShort Yen YCS Bear Market 5.73% High Yield HYG -0.09% 0.97%
UBS E-TRACS CMCI Livestock TR ETN UBC N/A 4.84% iPath S&P 500 VIX VXZ -0.58% 9.76% 1-3 Year Treasuries SHY 0.02% 1.53%
Direxion Daily 30 Yr Trsy Bear 3X Shares TMV Bear Market 4.54% Mid-Term Futures ETN 7-10 Year Treasuries IEF -0.34% 9.93%
20+ Year Treasuries TLT -1.48% 13.77%
Others
ETF Ticker 1-Day Perf YTD Perf ETF Ticker 1-Day Perf YTD Perf
Gold GLD -0.07% 15.50% Crude Oil USO -1.18% -14.74%
Silver SLV 0.60% 21.95% EAFE Index EFA 0.04% -2.04%
Natural Gas UNG 1.21% -33.73% Emerging Markets EEM 0.14% 4.36%
SPDRs SPY 0.38% 1.47%
Major Index Changes:

None
ETFs in the Headlines and Blogs:

PHB: Different Kind Of Junk Bond ETF - http://etfdb.com/2010/phb-different-kind-of-junk-bond-etf/
New ETFs: Natural Resources, Emerging Market Consumers - http://www.etftrends.com/2010/09/new-etfs-natural-resources-emerging-market-consumers/
7
Top Online Social Networking Stories
Latest Popular Digg.com Business Stories

Finding Higher Yields in Unlikely Places - http://www.mint.com/blog/saving/savings-yield-09142010/
Report: More women than men in U.S. earned doctorates last year for first time - http://www.washingtonpost.com/wp-
dyn/content/article/2010/09/14/AR2010091400004.html
Calculated Risk
Industrial Production, Capacity Utilization increase in August - http://www.calculatedriskblog.com/2010/09/industrial-production-capacity.html
NY Fed: Manufacturing Index declines slightly in September - http://www.calculatedriskblog.com/2010/09/ny-fed-manufacturing-index-declines.html
MBA: Mortgage Purchase Activity decreases slightly - http://www.calculatedriskblog.com/2010/09/mba-mortgage-purchase-activity_15.html
LA Port Traffic in August: Imports Surge, Exports down year-over-year - http://www.calculatedriskblog.com/2010/09/la-port-traffic-in-august-imports-
surge.html
The Big Picture

For Recovery, Housing Market Must Clear Out Excess Inventory - http://www.ritholtz.com/blog/2010/09/for-recovery-housing-market-must-clear-out-
excess-inventory/
1990 Newsweek Cover: The Real Estate BUST - http://www.ritholtz.com/blog/2010/09/1990-newsweek-cover-the-real-estate-bust/
Tale of Home Prices Told Through Covers of TIME - http://www.ritholtz.com/blog/2010/09/a-tale-of-home-prices-told-through-the-cover-pages-of-time-
magazine/
Zero Hedge
“Shut Up and Eat Your Paint Chips, Kid” – Miseducating America - http://www.zerohedge.com/article/guest-post-%E2%80%9Cshut-and-eat-your-paint-
chips-kid%E2%80%9D-%E2%80%93-miseducating-america
Bespoke Investment Group

The Miracle of Time: Lehman Two Years Later - http://www.bespokeinvest.com/thinkbig/2010/9/14/the-miracle-of-time-lehman-two-years-later.html
Volumes Down at the Real Casino’s Too - http://www.bespokeinvest.com/thinkbig/2010/9/14/volumes-down-at-the-real-casinos-too.html
Just When You Thought It Was Safe to Start Shorting Again - http://www.bespokeinvest.com/thinkbig/2010/9/14/just-when-you-thought-it-was-safe-to-
start-shorting-again.html
Robert Reich’s Blog

The Republican Threat to Shut Down the Federal Government - http://robertreich.org/post/1121362907/the-republican-threat-to-shut-down-the-federal
The Baseline Scenario

Brady Bonds for the Eurozone, Starting with Ireland - http://baselinescenario.com/2010/09/15/brady-bonds-for-the-eurozone-starting-with-ireland/
8
GENERAL DISCLOSURES
This presentation discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions. It is provided for general
informational purposes only and should not be relied on for any other purpose. It is not, and is not intended to be, research, a recommendation or investment advice,
as it does not constitute substantive research or analysis, nor an offer to sell or the solicitation of offers to buy any BNY ConvergEx Execution Solutions LLC
(“ConvergEx”) product or service in any jurisdiction. It does not take into account the particular investment objectives, restrictions, tax and financial situations or other
needs of any specific client or potential client. In addition, the information is not intended to provide sufficient basis on which to make an investment decision. Please
consult with your financial and other advisors before buying or selling any securities or other assets. This presentation is for qualified investors and NOT for retail
investors.
Please be advised that options carry a high level of risk and are not suitable for all investors. To receive a copy of the Options Disclosure Document please contact the
ConvergEx Compliance Department at (800) 367-8998.
The opinions and information herein are current only as of the date appearing on the cover. ConvergEx has no obligation to provide any updates or changes to such
opinions or information. The economic and market assumptions and forecasts are subject to high levels of uncertainty that may affect actual performance. Such
assumptions and forecasts may prove untrue or inaccurate and should be viewed as merely representative of a broad range of possibilities. They are subject to
significant revision and may change materially as market, economic, political and other conditions change.
Past performance is not indicative of future results, which may vary significantly. The value of investments and the income derived from investments can go down as
well as up. Future returns are not guaranteed, and a loss of principal may occur. The information and statements provided herein do not provide any assurance or
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Nicholas Colas (Chief Market Strategist): 212 448 6095 or ncolas@convergex.

Old School Business Math Gives Insight on Lackluster Market Valuations

Important Earnings Today (with Estimates) From…

Important Conferences/Corporate Meetings Today:

Source: Thomson ONE

Source: Bloomberg Source: Bloomberg

Today’s Important Economic Indicators/Events (with Consensus):

U.S. EQUITY OPTIONS

CURRENT IMPLIED VOLATILITY / CURRENT HISTORICAL VOLATILITY

Major Index Changes:

ETFs in the Headlines and Blogs:

Top Online Social Networking Stories

Latest Popular Digg.com Business Stories

The Big Picture

Bespoke Investment Group

Robert Reich’s Blog

The Baseline Scenario

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