Morning Review - 082410

Nicholas Colas (Chief Market Strategist): 212 448 6095 or ncolas@convergex.
com
Christine Clark: 212 448 6085 or cclark@convergex.com
Beth Reed: 212 448 6096 or breed@convergex.com
Stocks declined Monday (S&P 500 -0.4%, Dow -0.4%, Nasdaq -0.9%), led by industrials, materials and
Morning Markets Briefing
techs, as investors once again shrugged off a wave of M&A activity. Volume was the lightest it’s been
all year. Oil prices slid on a stronger dollar, ending below $73 a barrel, while gold remained mostly Market Commentary: August 24th, 2010
flat. In economic news, the Chicago Fed’s National Activity Index rebounded in July, led by
A snapshot of the markets through the
improvements in production-related indicators. The index climbed to its historical average of zero
from June’s reading of -0.70. Existing home sales and the Treasury’s 2-year note auction are on tap for lens of ConvergEx.
Tuesday.
You’re Gonna Make Me Lonesome When You Go
Summary: Markets are braced for more bad news from the U.S. residential housing market over the next two days and fears of another leg down in real estate are
certainly weighing on hopes for broad based economic recovery. The other shoe to drop, however, is how the housing market will inform the ongoing debate on
inflation/deflation. In today’s note we look at house prices and their contribution to the Consumer Price Index through two lenses: Owners’ Equivalent Rent (OER) and the
S&P/Case-Shiller Home Price Index. OER is the “official”- and sluggish - arbiter of inflation in the housing market; Case-Shiller is designed to track house prices in close to
real time, making it more volatile than OER. What’s clear to us is that OER is simply too slow, too sticky and too complex to be a useful measurement of housing inflation.
Had the Fed used Case-Shiller data rather than OER in the CPI over the last decade, they would have tightened much more quickly, for example. Now, it looks like Case-
Shiller is on the knife’s edge again. Another leg down in the housing market doesn’t just mean sluggish economic growth; it means deflation becomes a much more
pressing threat.
“When something’s not right, it’s wrong” is my all-time favorite Bob Dylan lyric. It’s from You’re Gonna Make Me Lonesome When You Go on the record Blood on
the Tracks. Yes, there are other great tracks on the album – Tangled Up in Blue, Simple Twist of Fate and Idiot Wind are all masterpieces, of course. But the simplicity of
Dylan’s definition of right is something I think about frequently. You can save a lot of time in everything from investing to picking what food to eat with this maxim in
hand. So much in life is presented as a shade of grey that it is refreshing to remember what’s black and white. Or right and wrong.
Take, for example, the simple task of figuring out how much something costs. For most of us that involves checking the price tag at a store or online. If it is a big
ticket item, such as a car, you might go on the Internet and see what shopping sites are reporting in the way of recent purchases prices. Or how much the dealer paid for
the car. In the case of houses – the biggest purchase most people make, so price is important – you check comparable sales in the same neighborhood.
Market Commentary – Pages 1-4, Equities/Conferences & Earnings – Page 5, Fixed Income – Page 6, Options – Page 7, Exchange-Traded Funds/Indexes – Page 8, Social
Media & Internet Blogs Top Stories – Page 9
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Nicholas Colas (Chief Market Strategist): 212 448 6095 or ncolas@convergex.com
So, that’s the right way.
But let’s say you wanted to do this the wrong way. I don’t know why you would, but stay with me here – we’re going someplace important. If you wanted to track
the cost of a house over time and did not want to simply work with transaction data and comparable sales, what might you do? Well, you could call thousands of
homeowners every month in the area where you intend to buy and ask how much they thought their house would rent for. Now, you could tell yourself that this was a
good measurement. After all, the cost of a house is really part investment, part shelter. You want to tease out the shelter piece of the equation and eliminate the
investment return. Rents are the cost of shelter.
This is how the Bureau of Labor Statistics estimates the cost of housing for the Consumer Price Index. It is a statistic called ‘Owners’ Equivalent Rent’ (OER), and as I
will outline here, it’s not right. Which makes it wrong.
• First of all, most Americans own their primary residence, so they have little firsthand experience to know for what price their house would rent. Renters
know, but they are only about a third of all the households in the U.S. A rising proportion in the last few years, yes… But still only a third. Asking a homeowner
what their house would rent for is a little like watching a really clueless contestant on “The Price is Right.” They think they know how much milk at the store sells
for. But then they guess “99 cents” for a gallon container.
• Secondly, the raw data is subject to a lot of interpretation. If you are curious to delve into the process further, here is the link to the BLS description of the
process: http://www.bls.gov/cpi/cpifact6.htm
To highlight what’s wrong with OER, just compare the results from this measurement to the S&P/Case-Shiller Home Price Indices. This dataset is based on house
values, rather than OER. The first three charts that accompany this note show just how different the data sets really are.
• There is significantly more volatility in the nationwide Case-Shiller House Price Index than in the OER data. Most Americans would recognize the Case-
Shiller data as representative of the housing market they know. In the middle part of the last decade, for example, house prices were up 20% according to Case-
Shiller. OER was up less than 5%. In the downdraft during and after the financial crisis, house prices were down almost 20% in the Case-Shiller data. OER was up
about 2% year on year.
• These disparities really only came to the fore in the last decade. The next two charts attached to this note show an indexed OER and Case-Shiller from 1988 –
present and 2000-present. Case-Shiller and OER spent over a decade tracking each other quite nicely, through the entire 1990s. But in the 2000s, the tracks
diverged. Case-Shiller more than doubled from January 2000 to January 2006. The OER for residential houses was barely up 20% in the same period.
You’d be forgiven for thinking this is inside baseball stuff for econogeeks, but this simple difference meant disaster when it came to monetary policy over the
last decade. Look at the fourth chart in our series. Here we took the headline Consumer Price Index, stripped out the effect of OER and replaced it with an equivalent
weighting of Case-Shiller data. Think of this as genetic splicing for econometric data. We’ve stripped out the bad genes and replaced them with good ones.
Through the entire decade of the 2000s, all we heard from the Federal Reserve was that inflation was under control. The CPI never really got hotter than about 4%,
after all. But that was because the OER was so artificially low. And the OER has a 20-24% weighting in the CPI calculation, one of the largest weightings in the index.
2
Replace OER with Case-Shiller, and the truth about inflation comes through loud and clear. Inflation was actually over 6% for much of 2004 – 2006. It also grew
much more quickly earlier in the decade, doubling from 2% to +5% in 2002-early 2004. It is pretty clear that the Fed should have been raising rates much more
aggressively in the decade. Had it done so, house prices would not perhaps have gotten to the stage where their trajectory resembled a boulder rolling down a cliff.
If something’s not right, it’s wrong.
But enough of the finger waving… What does this mean for the ongoing inflation/disinflation/deflation debate?
If you accept that house price inflation is better measured by Case-Shiller than OER – and we hope we have proven this point – then a quick examination of
where Case-Shiller is right now is in order. That’s the last chart in our stack.
The index has flatted out from its free fall, at least partly due to the first time home buyer tax credit from the Federal government. That program ran from
January 2009 to April 2010. Case-Shiller bottomed in May 2009. The data we will get on the residential housing market this week should help determine if the index will
begin to decline once again, or continue to stabilize.
My thought is that the odds are tilted to deflation. Unemployment is still high, confidence is still low, and savings rates are still moving up. That’s not a recipe for
housing market strength.
And while we may poke fun at the Fed, in reality they must know all this. Their recent announcement about holding the size of their balance sheet constant is a
warning flare on a host of issues, but the housing market has to be at the head of the list. It is the fulcrum issue for the economy, and not just because there are so many
houses still for sale. It is, in fact, ground zero for deflationary pressures and the Fed must keep moving its policy in an ever more aggressive manner to try to catch that
boulder before it rolls further down the hill.
3
Owners' Equivalent Rent vs Case-Shiller HPI (Index = 100 in 1987) Owners' Equivalent Rent vs Case-Shiller HPI (Index = 100 in 2000)
400.0
240.0
350.0 220.0
300.0 200.0
250.0 180.0
160.0
200.0
140.0
150.0 120.0
100.0 100.0
OER Case-Shiller OER Case-Shiller
Year-Over-Year % Changes in Select Measures of Inflation Case-Shiller HPI

8% 250
230
6%
210
4% 190
170
2%
150
0% 130
110
-2% 90
-4% 70
50
-6%
Headline CPI CPI Excluding OER Case-Shiller Replacing OER in CPI
4
U.S. EQUITIES
PAR surged 44.6% after HPQ (-2.0%) said it offered to purchase data storage firm 3PAR for $24 a share in cash, or $1.6 billion, representing a 33%
premium to the price offered by DELL (-1.1%). In other M&A news, POT (+0.4%) announced that its board voted unanimously to reject BHP Billiton’s (BHP:
-0.5%) takeover offer and has commenced talks with other companies on alternatives. Shares of MMM rose 0.5% following news the company intends
to spend about $2 billion on acquisitions in 2010, double its previous estimate. Finally, GILD shares added 0.6% as team researchers said they found a
possible cure for cocaine addiction.
Important Earnings Today (with Estimates) From…

BKS: $-0.80 S&P Futures
BIG: $0.47 One Day (High –1080.25; Low – 1065.50):
BKC: $0.34
MDT: $0.82
PAY: $0.26
Source: Bloomberg
Important Conferences/Corporate Meetings Today:

EnerCom Incorporated Oil & Gas Conference – Denver, CO
Prior Day SPX (High – 1081.58; Low – 1067.08; Close – 1067.36): Three Day (High – 1080.25; Low – 1061.75):
Source: Thomson ONE

5
FIXED INCOME
Treasuries advanced Monday, with 2-year note yields falling to within 4 basis points of a record low on concern the recovery is stalling. Tuesday the
government will auction $37 billion of the debt. Monday’s $8 billion sales of 30-year TIPS drew a yield of 1.768 percent, which was the lowest ever for
sales of the debt dating back to 1998. The bid-to-cover ratio was a record high 2.78. Indirect bidders bought 39 percent of the securities versus 42
percent at the last offering in February.
Source: Bloomberg Source: Bloomberg
Today’s Important Economic Indicators/Events (with Consensus):

Existing Home Sales (10:00am EST): 4.650M SAAR
6
U.S. EQUITY
OPTIONS
SPX- The market spiked trading up ~ .7% to open but gradually sold off throughout the day to finish down roughly -.5%. Accordingly, we saw precisely
the opposite in the VIX, which traded between roughly -.5% early before rallying up to .67% at the close. In a relatively light day, we note some bearish
trading in the near term with the sale of ~ 10,000 SPX Sep 1085 calls and a buy of ~ 5,000 Sep 1025 puts.
ETF – With a light economic calendar and very few earnings having any market significance trading was mixed. In VXX (Short Term VIX future) we saw
some bullish flow, where one participant bought 5,000 Sep 25 calls delta neutral, and another sold 44,000 Sep 20 puts. In EEM we noted bearish activity
through 2 spreads. In the first an investor bought 10,000 Sep 37/40 put spreads while another investor bought 13,000 Oct 39/36 put spreads. In FXY we
saw a bearish call spread, where an investor sold roughly 9,000 Jan 110/125 spreads. Finally, one player looking for some movement in XME prior to
September expiration bought the Sep 52/49 strangle 5,000 times.
CURRENT IMPLIED VOLATILITY / CURRENT HISTORICAL VOLATILITY
Rank 8/17/2010 8/18/2010 8/19/2010 8/20/2010 8/23/2010 30-Day Implied Vol
1 Q Q Q Q Q 33.40
2 NOVL NOVL ARG ARG SCG 52.87
3 KR ARG NOVL NOVL ARG 18.36 BIGGEST MOVERS
4 ARG CRM CRM HSY MKC 31.86 Top 10 30-Day Implied Vol Bottom 10 30-Day Implied Vol
5 AMAT AMAT SJM NRG NOVL 45.75
6 CRM KR WIN FDO FDO 28.09
MFE 1697.25% 36.86 MHP -95.85% 5.48
7 CTL FRX INTU KR AMAT 31.67 WY 649.59% 26.88 WYN -86.84% 36.78
8 NSM SJM MO WIN SBUX 28.87 QCOM 293.21% 33.40 PWR -60.18% 11.04
9 FDO INTU AMAT HRB AAPL 29.37
10 NRG MO FRX MO WIN 21.62 PTV 203.16% 27.91 Q -57.63% 37.40
11 INTU CTL KR AMAT FRX 30.28 SE 169.12% 52.87 PCAR -54.40% 25.26
12 HSY NRG MRK FTR PLL 35.00
13 CPB HSY FDO CPB KR 26.21
PBI 116.47% 22.89 R -43.75% 35.12
14 SJM RDC CPB SAI MO 15.45 MMC 94.03% 31.86 PCP -43.46% 39.16
15 ADI CPB HRB FRX LM 36.48 NTAP 61.70% 33.31 NOVL -42.24% 34.87
16 SHLD FDO RDC NTRS WHR 44.56
17 GME KO DELL LM NRG 31.55 TMO 60.52% 29.39 NTRS -40.20% 34.96
18 LMT HRB L RDC HRB 36.76 PCLN 59.29% 25.83 WHR -38.84% 44.39
19 RDC NSM KO MRK L 25.82
20 DE LUV HSY WMB AMZN 33.97
21 AAPL STZ LQ APOL NTRS 34.26
22 FRX NTRS CTL CTL PX 21.91
23 JDSU APOL PX SBUX MOLX 37.02 We ranked the S&P 500 companies from the highest to lowest 30 day implied to
24 DVN NU NSM STZ LMT 20.23 historical volatility ratio. Above we identify the 10 most positive and negative
25 APOL LO SBUX LO CPB 17.03 movers.
MO, MOLX, TGT, AAPL LO NSM LO
MCK, L, MRK, JDSU NU PX STZ
The table to the left represents the 25 highest 30 day implied to historical
SAI, STZ, LO, DVN APOL LQ CTL
GPC, SAI DE NTRS KO APOL
volatility ratios within the S&P 500 companies. The green represents names
LMT STZ L WMB new to the list while the red represents names that have fallen out.
GME LUV DELL MRK
SHLD NRG INTU RDC
ADI SJM SAI
CRM FTR
HSY
7
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 0.04% -8.42% Telecomm IYZ -0.75% -0.55%
SPDR Gold Shares GLD N/A -0.16% Health XLV 0.45% -7.31% Technology XLK -0.89% -7.72%
iShares MSCI Emerging Markets Index EEM Diversified Emerging Mkts -0.93% Industrials XLI -1.10% 3.81% Consumer Discretionary XLY -0.91% 2.86%
iShares MSCI EAFE Index EFA Foreign Large Blend -0.20% Utilities XLU 0.66% -1.13% Financials XLF -0.65% -4.58%
iShares S&P 500 Index IVV Large Blend -0.37% Consumer Staples XLP 0.22% 1.21% Materials XLB -1.11% -5.61%
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 149,350,087 Australian Dollar FXA -0.07% -0.77% Mexican Peso FXM -2.31% 0.98%
PowerShares QQQ QQQQ Large Growth 52,004,719 British Pound Sterling FXB -0.12% -4.15% Swedish Krona FXS 0.16% -3.65%
iShares Russell 2000 Index IWM Small Blend 51,116,179 Canadian Dollar FXC -0.31% -0.35% Swiss Franc FXF -0.56% -0.78%
Financial Select SPDR XLF Specialty - Financial 46,548,064 Euro FXE -0.36% -11.69% USD Index Bearish UDN -0.19% -6.90%
iShares MSCI Emerging Markets Index EEM Diversified Emerging Mkts 42,873,489 Japanese Yen FXY 0.48% 8.97% USD Index Bullish UUP 0.21% 4.77%
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
Direxion Daily Latin America Bear 3X Shares LHB Bear Market 4.08% iPath S&P 500 VIX VXX -1.23% -33.78% Aggregate AGG 0.10% 5.06%
Direxion Daily Small Cap Bear 3X Shares TZA Bear Market 3.97% Short-Term Futures ETN Investment Grade LQD 0.21% 7.86%
Direxion Daily China Bear 3X Shares CZI Bear Market 3.87% High Yield HYG 0.00% -0.13%
ProShares UltraPro Short Russell2000 SRTY N/A 3.65% iPath S&P 500 VIX VXZ 0.52% 19.28% 1-3 Year Treasuries SHY -0.01% 1.60%
B2B Internet HOLDRs BHH Specialty - Technology 3.57% Mid-Term Futures ETN 7-10 Year Treasuries IEF 0.15% 11.09%
20+ Year Treasuries TLT 0.02% 17.99%
Others
ETF Ticker 1-Day Perf YTD Perf ETF Ticker 1-Day Perf YTD Perf
Gold GLD -0.16% 11.62% Crude Oil USO -1.58% -17.44%
Silver SLV 0.11% 6.48% EAFE Index EFA -0.20% -9.17%
Natural Gas UNG -1.29% -31.94% Emerging Markets EEM -0.93% -2.07%
SPDRs SPY -0.38% -3.87%
Major Index Changes:

None
ETFs in the Headlines and Blogs:

Desire for income drives high-yield bond ETFs’ popularity - http://www.marketwatch.com/story/junk-bond-etfs-boom-as-investors-crave-income-2010-08-
22?reflink=MW_news_stmp
The Ivy League View on ETFs - http://www.benzinga.com/general/10/08/438691/the-ivy-league-view-on-etfs
8
Top Online Social Networking Stories
Latest Popular Digg.com Business Stories:

Deflation Education: Secrets of the Death Spiral - http://www.trademonster.com/zine/deflation-education-secrets-of-the-death-spiral-infographic/
JetBlue CEO sees silver lining in big airline mergers - http://articles.chicagotribune.com/2010-07-24/business/ct-biz-0725-jet-blue-barger-
20100724_1_jetblue-airways-airline-mergers-airline-consolidation
Majority of U.S. Workers Now Happy With Their Salary - http://www.examiner.com/gallup-polls-in-national/majority-of-u-s-workers-now-happy-with-their-
salary
American Apparel faces bankruptcy as store chain unravels - http://www.examiner.com/gallup-polls-in-national/majority-of-u-s-workers-now-happy-with-
their-salary
Calculated Risk
DOT: Vehicle Miles driven increase in June - http://www.calculatedriskblog.com/2010/08/dot-vehicle-miles-driven-increase-in.html
Chicago Fed: Economic activity rebounded in July - http://www.calculatedriskblog.com/2010/08/chicago-fed-economic-activity-rebounded.html
Report: Home buyers remain optimistic about appreciation - http://www.calculatedriskblog.com/2010/08/report-home-buyers-remain-optimistic.html
Greece Unemployment Rate continues to rise - http://www.calculatedriskblog.com/2010/08/greece-unemployment-rate-continues-to.html
The Big Picture

Housing: No Longer a Sure-Fire Wealth Builder - http://www.ritholtz.com/blog/2010/08/housing-no-longer-a-sure-fire-wealth-builder/
Is Gold a Shadow Currency? - http://www.ritholtz.com/blog/2010/08/is-gold-a-shadow-currency/
“Pseudo-variety”: Soft Drink Industry Structure - http://www.ritholtz.com/blog/2010/08/pseudovariety-soft-drink-industry-structure/
Robert Reich’s Blog

Corporate Rotten Eggs - http://robertreich.org/post/985703357/corporate-rotten-eggs
The Becker-Posner Blog

Will the Next Generation be Better off Than Their Parents’ Generation? (Becker) - http://www.becker-posner-blog.com/2010/08/will-the-next-generation-
be-better-off-than-their-parents-generation-becker.html
The Decline in American Optimism (Posner) - http://www.becker-posner-blog.com/2010/08/the-decline-in-american-optimismposner.html
The NY Times
Inside the Knockoff-Tennis-Shoe Factory - http://www.nytimes.com/2010/08/22/magazine/22fake-t.html?_r=1
In Striking Shift, Small Investors Flee Stock Market - http://www.nytimes.com/2010/08/22/business/22invest.html?_r=1&hp
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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, 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. 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 guarantee as to returns that may be realized from investments in any securities or other assets.
The opinions expressed in this presentation are those of various authors, and do not necessarily represent the opinions of ConvergEx or its affiliates.
This material has been prepared by ConvergEx and is not a product, nor does it express the views, of other departments or divisions of BNY ConvergEx
Group, LLC and its affiliates.
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Nicholas Colas (Chief Market Strategist): 212 448 6095 or ncolas@convergex.

You’re Gonna Make Me Lonesome When You Go

So, that’s the right way.

If something’s not right, it’s wrong.

OER Case-Shiller OER Case-Shiller

Year-Over-Year % Changes in Select Measures of Inflation Case-Shiller HPI

Headline CPI CPI Excluding OER Case-Shiller Replacing OER in CPI

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):

Major Index Changes:

ETFs in the Headlines and Blogs:

Top Online Social Networking Stories

Latest Popular Digg.com Business Stories:

The Big Picture

Robert Reich’s Blog

The Becker-Posner Blog

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