DIMENSIONS OF A SOFT PATCH, From David Kelly, Chief Market Strategist, JPMorgan Funds
Like a road crew repairing potholes, analysts this week will be trying to measure the length and depth of the economic “soft patch” currently afflicting the U.S. economy.
Economic data should show signs of deflation in three key inflation reports, although this will mostly reflect lower gasoline prices in the month of June. Retail Sales, due out on Wednesday, could show a further decline, reflecting weak light vehicle sales and lower gasoline prices and only a modest gain in chain-store sales.
Jobless Claims may have fallen quite sharply in the latest week as the seasonal factors expect shutdowns in GM automotive operations, which generally didn’t occur this year. Meanwhile, Industrial Production should look soft, apart from a further gain in utility output due to unusually hot June weather. Consumer Sentiment, due out on Friday, may show a slight relapse from its June reading although psychologically, the “soft patch” is more recognised in Wall Street than on Main Street where the public didn’t really notice a recovery in the first place.
This will also be the kick-off week of the second quarter earnings season. Twenty-three S&P500 firms are expected to report their numbers, including Alcoa, CSX, Google, Intel, Bank of America, JPMorgan Chase, General Electric, and Yum Brands. Combined these firms should provide a good overview of the state of the industrial, technology, financial and consumer sectors.
At the start of the earnings season, according to Standard and Poors, analysts expect operating earnings of $19.68 for the second quarter, up from $19.38 for Q1. Based on recent quarters, it is reasonable to expect companies to beat this $19.68 target. It is also predictable that commentators will ignore this good news and focus on company “guidance” for the rest of the year and 2011.
Fundamentally, this is a silly exercise. While some companies could reveal some near-term company-specific information in their guidance, their general view (beyond a quarter or two) should be no more revealing than that of economists in general, bring us back to an assessment of the “soft patch”.
As of right now, economic data suggest that the “soft patch” could be relatively shallow and temporary, allowing corporate fortunes to improve along with those of the economy overall. If this is the case, then S&P500 operating earnings, which are once again moving above $20 per quarter, should justify a significantly higher level for the index than the 1078 reached last Friday, at the end of what was a very good week.
KEEP LOOKING UP, from Jeffrey Saut, chief investment strategist, Raymond James
Depressions, and recessions, are even more difficult to predict than the stock market. Yet, most economists agree the recession ended around this time last year. Currently, the question du jour is whether the economy is going to slip back into recession; aka . . . the dreaded double-dip. At present, while the economy has hit a “soft spot,” the odds of a sliding into recession are indeed low.
In a past life I wrote fundamental research on container board companies. Currently, those companies are raising prices, which only happens when demand warrants. Then too, rail traffic is increasing and diesel fuel consumption is rising, another metric that is inconsistent with a double-dip recession. Moreover, the number of Manhattan apartment rentals doubled in 2Q10 on a YoY basis, while office vacancies in U.S. metro areas fell in 2Q10 vs. 1Q10 for its first drop since 2007. Ladies and gentlemen, these are NOT the metrics of a double-dip recession! Meanwhile, since 2008 there has been almost NO difference between the forward PE of the S&P 500 Growth and Value composite indices. Obviously, this favors growth versus value, which is why I have been emphasizing Technology in these missives. This morning, however, the pre-opening futures are lower on rumors that Deutsche Postbank had failed the stress test. Nevertheless, I think the selling will be contained and in the short term be resolved with higher prices. The real upside challenge should come at the S&P 500’s (SPX/1077.96) 50-day moving average (DMA), which currently stands at 1100.30, and the 200-DMA at 1111.60. Longer term, I remain cautious.
GET READY TO DIP, from Charles Biderman, CEO, TrimTabs
Our most sensitive indicators show the U.S. economy continues to deteriorate. Adjusting for tax changes, income tax withholdings were flat in June, versus the growth of 3.5% y-o-y in April and 5.4% y-o-y in May. Also, various high frequency indicators show labor market demand remains weak. Based on recent data, we project employment in July will be flat at best, as weak private sector hiring fails to offset layoffs of an estimated 75,000 census workers.
While most of Wall Street believes there is still little risk of a double-dip recession, we think the risk of a double-dip recession is high. The main reason the economy stopped sinking is that the U.S. government is borrowing and spending about $1.5 trillion per year—an amount equal to roughly one-quarter of the $6.1 trillion after-tax income of all individuals—to bail out the largest financial institutions, support state and local governments, and shore up consumer demand.
The deterioration in the economy suggests companies will spend less money shrinking the float, and our supply indicators have already turned from bullish to neutral. The TrimTabs Supply Index, which measures corporate actions in the U.S. stock market, fell to 50.5 on Thursday, July 8 (readings above 50 are bullish). In the past month, companies shrank the float only $6.7 billion. Also, buying by corporate insiders was below $1 billion for the fifteenth consecutive month in June despite the correction.
We are not turning any more bearish because our demand indicators remain bullish. The TrimTabs Demand Index (TTDI), which uses the historical relationship between market returns and 21 flow and sentiment variables for market timing, stood at 79.6 on Tuesday, July 8 (readings above 50 are bullish). Outflows from long equity ETFs (a bullish contrary indicator) and low levels of equity mutual fund cash and retail money market fund assets (bullish leading indicators) are keeping the index bullish.
A SLOW QUARTER, From David Rosenberg, chief economist and strategist, Gluskin Sheff
Let’s face it, whether the economy is facing a double-dip or just a speed bump, each and every passing data point is coming in below consensus view, including the 0.3% drop in wholesale trade in May (was released last Friday to little fanfare), which was the first decline since March 2009 when the economy was plumbing the depths — and prompting even more downgrades to Q2 GDP growth estimates.
We should see significant sector rotation for Q1 to Q2. While Financials led the way in Q1 (up over 370% partly due to very weak comps), Materials and Energy are expected to be the outperformers in Q2 at 91% and 72%, respectively (Q2 Financials results are expected to be much more modest, at 18%).
Analysts see a dichotomy in consumer-related earnings as well — Discretionary earnings are forecast to be close to 50%, while Staples are expected to come in at 5%. In fact, analysts have become progressively more bullish on Consumer Discretionary earnings over time — last October estimates were half of what they are today, at around 28%. The opposite is true for Staples — here analysts have continuously marked down forecasts from close to 10% last year to currently just over 5% now.
The laggards in Q2 are expected to be Utilities (-5%), Telecom (-2%) and Health Care (+5%).
WHY NOT TO BUY TREASURIES, from Edwin Chancellor, asset allocation team member, GMO
As a result of the financial crisis, the world’s leading sovereign credit markets have left the world of risk, where probabilities of gains and losses can be measured, and entered the darker province of uncertainty. The future performance of sovereign credits depends on future events and decisions that are unknowable.
Will the global economic recovery be sustained? Or will economic growth and tax revenues remain weak for a prolonged period? Will policymakers in leading countries find the political strength to restore their government finances to order? Or will, as some fear, the attempt to cut deficits actually increase them (by hurting the economy and reducing tax revenues)? Will central banks engage in further bouts of quantitative easing until they reach the point of no return? Or will they err on the side of caution and tighten too early? Will the current deflationary policies within the Eurozone persist? Or will the ECB turn toward the monetization of excessive debt levels? Will interest rates on long-term government debt remain low? Or will bond vigilantes take fright and demand higher rates as compensation for all this uncertainty and risk?
These are interesting but intractable questions. Nobody knows their answers. Current yields on government bonds in most advanced economies (PIGS excepted) are at very low levels. Under only one condition – that the world follows Japan’s experience of prolonged deflation – do they offer any chance of a reasonable return. But this is not the only possible future. For other outcomes, long-dated government bonds offer a limited upside with a potentially uncapped downside. As investors, such asymmetric pay-off profiles don’t appeal to us. Caveat (sovereign) creditor!
THE PROBABLE FUTURES GRID, from Dorsey Farr, co-founder, French Wolf & Farr
The figure nearby presents a simple two-factor model we use to analyze the capital market environment. Points inside the box describe various combinations of economic growth and inflation, with the vertical axis measuring real economic activity and the horizontal axis measuring price level activity. For analytical purposes, it is often easiest to consider the extremes - the corners of the box. Here are some of the potential scenarios we see today, along with our assessment of the likelihood of each outcome and the assets we believe will benefit.
X Reflationary growth (Probability = 45%). In our view, ongoing global growth accompanied by higher rates of inflation is the most likely outcome over the next several years. In order to capitalize on this outcome, investors should go where the value is. This means emphasizing emerging markets (perhaps avoiding the BRICs) and non-U.S. developed market equities (especially major Western European countries). In the credit markets, floating-rate loans will benefit. Loans still trade at a reasonable discount to par and offer the opportunity to capture attractive credit spreads without duration risk.
X Deflationary Growth (Probability = 25%). Growth with moderating inflation (or perhaps even a bit of deflation) appears to be the current trajectory. In the United States, annualized GDP growth has averaged 3.6% over the last three quarters while core inflation has declined to less than 1%. The fact that inflation remains tame despite massively accommodative monetary policy highlights the deflationary forces still weighing on the economy. This environment would likely benefit long duration credit instruments, preferred stocks, and yield-oriented equities.
X Stagflation (Probability = 10%). Yikes. The Obama-Bernanke policy combination of increased regulation, higher taxes and easy money makes this scenario impossible to dismiss. Many economists a double-dip combined with further declines in stock prices and real estate. Still, the likelihood of stagflation is low, since renewed economic weakness would exert renewed disinflationary pressures. However, to guard against a stagflation environment, investors should generally avoid risk assets and favor cash, inflation-linked bonds, and precious metals.
X Roubini’s World (Probability = 20%). Double yikes. A renewed downturn accompanied by deflationary pressures is more frightening than stagflation. It is also more likely, because deflationary forces would be magnified by a weaker economy. A deflationary recession would put Columbia economist Nouriel Roubini (aka Dr. Doom) back on the front page and risk assets in the tank. Cash would be an appropriate safe haven and Treasury bonds would benefit as long-term yields drop to levels observed at the end of 2008.
THE WEEK’S REPORTS
Monday, July 12: Corporate Earnings: Alcoa, CSX, Pfizer, Provident Bancorp, Shaw Group, Wyeth
Tuesday, July 13: Same story sales (weekly), May International Trade, June U.S. Treasury report
Corporate Earnings: Intel, Yum! Brands
Wednesday, July 14: Mortgage applications (weekly), June retail sales, June import/export price indexes, May business inventories
Corporate Earnings: Cintas, Marriott International, Six Flags
Thursday, July 15: Initial jobless claims (weekly), June producer price index, June industrial production
Corporate Earnings: Advanced Micro Devices, Charles Schwab, Google
Friday, July 16: June Consumer price index, May Treasury international capital, July Consumer Sentiment
Corporate Earnings: Bank of America, Citigroup, Gannett, GE, Mattel