Commentary from Bob Doll, BlackRock's Vice Chairman and Chief Equity Strategist, For the Week of July 19
Stocks continued to rally in the early part of last week before embarking on a sharp sell-off that resulted in moderate losses. Overall, the Dow Jones Industrial Average lost 1.0% to close the week at 10,098, the S&P 500 Index fell 1.2% to 1,065 and the Nasdaq Composite declined 0.8% to 2,179.
The second-quarter earnings season has started and will help determine whether the economy remains on a recovery track. It is still early, but the preliminary numbers look good — 70% of companies that have reported have exceeded their revenue expectations and 80% have beat earnings expectations. The recent trend of weaker economic data does remain a source of concern, but we are hopeful that stronger corporate data will offset this weakness. We are seeing a “V-shaped” recovery in manufacturing, while the consumer sector is looking more like a “U shape.” The credit and housing markets, however, are still stuck in an “L shape.” Recent data suggests that second-quarter gross domestic product growth will come in at around the 2.5% mark, and we are expecting the second half of the year to remain choppy. Nevertheless, we believe income levels and consumption will continue to expand and we are still calling for an increase in private payrolls. Current trends support our belief that the recovery will proceed, albeit at a slow pace.
Stock prices have remained in a broad trading range for the past several weeks. Equity markets appear to be caught between a number of positive and negative forces. The list on the bullish side includes continued strong corporate earnings, reasonably cheap valuations, lower bond yields that have been helpful to both consumers and businesses, increasing share buybacks and dividend payments, and a still-accommodative Federal Reserve. On the negative side, stocks are being hurt by an environment of slowing (but still positive) economic and profits growth, weak money and credit growth, and ongoing uncertainty surrounding issues such as the sovereign debt crisis, the Gulf oil spill and the legislative agenda in Washington, DC. Over time, we expect the positive forces to win out and stocks to grind higher, but we would not be surprised to see equity markets remain in their current trading range until there is more clarity around the severity of the current slowdown.
A Whiter Shade of Pale - David Kelly, JPMorgan Funds
To paraphrase Procol Harum, for many observers, the economic recovery, which had looked a bit ghostly, just turned a whiter shade of pale.
Last week’s numbers on retail sales, while in line with expectations for June, contained downward revisions for April and May, suggesting that consumer spending may only have grown by 2% annualized in the second quarter. In addition, a combination of lower-than-expected inventory accumulation and higher-than-expected imports in May will have further eroded estimates of second quarter GDP growth, which may now come in below 2% annualized in the numbers due out on July 30th.
Economic numbers this week will do little to restore color to the face of the recovery. Housing Starts, due out on Tuesday and Existing Home Sales, due out on Thursday, likely both fell again in June in a continued hang-over from the expiration of the home-buyer tax credit. Unemployment Claims may have ticked up in the latest week, although these numbers are still distorted by unusual seasonal patterns in automotive plant closings. Meanwhile, the Index of Leading Economic Indicators, also due out on Thursday, should show a mild decline, as growth in the money supply and a steep yield curve only offset some of the weakness eminating from the housing and manufacturing sectors.
Ben Bernanke will testify on Wednesday and Thursday to Senate and House committees, as the Federal Reserve releases its mid-year Monetary Report to the Congress. His comments, and the report, will likely reflect the Fed’s recent downgrade of its forecast for economic growth, while still stressing the likelihood of continued moderate expansion over the next few years. While wanting to be realistic, the Fed will not want to further undermine already fragile confidence.
On a brighter note, according to Zacks Equity Research, 129 S&P500 firms are slated to report second quarter earnings. The earnings season so far has been a positive one with 80% of firms beating analysts’ expectations. This trend is likely to continue for the rest of this earnings season, and the current Federal Reserve forecast of roughly 3.25% growth in real GDP in 2010 and 3.85% in 2011, should be sufficient for a continued solid rebound in earnings, as well as an eventual increase in both long-term and short-term interest rates.
The investing public, which is continuing to pull money out of stock funds and reallocate to bonds, does not appear to be buying even the idea of continued recovery. But with foreward P/E ratios and Treasury interest rates both at extraordinarily low levels, the odds still favor better returns to stocks than bonds in the years ahead.
WHERE IS THE GROWTH? From David Rosenberg, chief economist and strategist, Gluskin Sheff
This has certainly become a more discerning market — just having headlines that three in four S&P 500 companies have beaten their estimates are not good enough. (A year ago, bank earnings improvement on the back of lower loan loss provisioning was being treated with glee, but now investors are demanding that they see signs of top-line growth.) All the more so when a proxy for nominal GDP — G.E.’s revenues — was off target and down 4.3% from year-ago levels. Gannett, the country’s numero uno newspaper, also posted a 6% slide in print ad revenue. Citi's top-line was crushed 33% and also missed analyst views (BoA's revenues also fell 11% YoY), and the Basel Committee on Friday also issued a report stating that global banks need a further capital raise ... hardly music to the ears of anyone still long the sector. In a classic reminder that we are in a deflationary environment, Sanford Bernstein cut Wal-Mart’s sales and profit outlook. Mattel, the world's largest toymaker, missed on its bottom line and issued cautious guidance over the sales outlook.
A Weakening Recovery, From Stephen J. Huxley. Ph.D., chief investment strategist, Asset Dedication
Recent figures released by the American Institute of Economic Research (AIER) suggest that while the economy’s expansion appears to be continuing for now, its pace may be weakening. Most of the leading indicators were up, but a few declines have begun to show up, and still others are mixed.
Consumer spending continues to cause the most problems for the leading indicators. The worst declines were in housing. New housing permits dropped 16 percent since March, and sales of new homes fell 33 percent. The lapse in the federal home buyer tax credit, which expired in April, is the likely explanation. Spending on consumer goods also declined 0.5 percent in April. The change in consumer debt remains negative, meaning consumers are still paying off debt rather than loading up more, suggesting they are still worried about the economy. Expectations play a major role in any economic recovery and worry about the future is clearly prevalent among the general public. One good piece of news this week was the successful plugging of the Gulf oil leak, but much more good news is needed to swing the national mood from pessimism to optimism.
Coincident indicators, those that coincide with economic activity, show a better picture than the “leaders,” meaning we are in an expansion right now. All the coincident indicators were up, with the lone exception of the ratio of civilian employment to population. It dropped to 59 percent, its lowest level since the early 1980’s. Before the recession began, more than 63 percent of the working age population was employed.
Lagging indicators, those that lag economic activity, are sending mixed messages, similar to the leaders. Theoretically, positive values among the lagging indicators provide confirmation of the strength of the recovery. Based on the AIER report, most continue to show negative values. The worst of the “laggers” is average duration of unemployment, which reached 34 weeks, a record high. This may mean that employers prefer to give more hours to current workers, who are still working a shorter average workweek than before the recession, than hire new ones. If so, it could be awhile before hiring starts.
So what is to be concluded? Are the indicators signaling a faltering recovery or simply a slow one? That is the question everyone would like to have answered. Unfortunately, only spin doctors with other agendas are willing to answer it.
WHERE ARE THE BUYS, From Ron Muhlenkamp, founder and president, Muhlenkamp & Co.
In 2008, stock and bond prices got cheap, and then got cheaper. We believe forced selling by hedge funds and other investors played a major role in the selloff. As a consequence, in monitoring the markets, we now ask "Who might have to sell, and how much?"
There may be some forced selling of securities by European banks, although it's hard to get good numbers on the amounts. We do know that they're in a squeeze and we're monitoring a number of the "street signs," including LIBOR (London Interbank Offered Rate) and bond yields. So far, the rates are still increasing; we are monitoring for signs of abatement.
We do see signs that the European political leadership is attempting to deal with their problems (many years of spending more than they're earning - sound familiar?), but we don't yet know whether their proposals will be accepted by the public. In the U.S., our politicians seem to think that past European actions should be emulated, and we continue to spend far more than we take in. And we're seeing more signs that our government is looking to tax or otherwise penalize any company that it thinks is making too much money.
If we were coming out of a normal cyclical recession, we'd be fully invested in good companies at their current stock prices. But the larger uncertainties make us more cautious. The net of all this is that we've raised cash to 25%-30%, and we're watching the road signs for the opportunity to put it to work.
Economic Insights: Double Dip? Seven Reasons Why Not, From Milton Ezrati, senior economist and market strategist, Lord Abbett
It seems these days that half the headlines in the financial media fear a double-dip recession, as do half the conversations on Wall Street. There certainly are risks, not least in Europe’s financial difficulties. But still, there are reasons to question such widespread concerns. Following are seven reasons to doubt the double-dip outlook.
1. The Consumer Seems Firm Enough
At some 70% of the economy, the American consumer almost always calls the general tune, and here, the picture is one of relative strength. To be sure, the market took it to heart when reports some weeks ago showed that retail sales in May dipped by 1.4%. But that sales decline followed a powerful 10% advance in retail sales during the prior 12 months. Had the consumer not paused, it would have been worrying. Meanwhile, broader-based measures of personal outlays have expanded moderately throughout. The 2.4% annual rate of expansion registered for overall outlays in May was slightly slower than the 4.2% annual rate of expansion recorded for the prior six months, but still, that was a slowdown not a decline.
More telling fundamentally, household income has risen sufficiently to support future spending. Overall personal income rose at an annual rate of 5.4% last May (the most recent month for which data are available), actually accelerating from the 4.4% annualized rate of advance during the prior six months. Meanwhile, the personal savings rate, at 4.0% of after-tax income, generates a $454 billion annual flow of new money from which households can pay down debt even as they maintain existing levels of spending. If income continues to expand, as is likely, households will have the wherewithal to continue that “de-leveraging,” even as they increase spending. All they need do is keep outlays from growing faster than income—a circumstance that should easily support at least moderate spending growth.
2. Housing Data Are Misleading
The $8,000 first-time homebuyer’s tax credit has played hob with monthly housing statistics and investor perceptions of the sector’s fundamental strength. Of course, it was always ridiculous to suggest, as Washington did, that the credit would prompt someone to purchase a house. Even those with the most backward approach to financial matters would resist taking on a $200,000 debt to save $8,000 on taxes. But for those who otherwise would have bought a house, the homebuyer credit could and did affect the timing of purchases.
Thus, as the first expiration of the credit approached last November 2009, many who were otherwise looking for a new home crowded their purchases into the eligible period. Not surprisingly, home buying surged in October and November. But since many of these hurried sales would have otherwise occurred in December, January, and February, new purchases in those months dropped by more than 12%. Something even more extreme occurred as this latest expiration date approached in April 2010. People who were looking crowded their purchases into March and April in order to qualify for the credit, driving up home sales by almost 30%. Then, because so many of those sales would have occurred after April, recorded sales fell suddenly by about 30% in May. Housing starts and residential construction put in place followed this same up-and-down pattern.
But none of this says anything fundamental about the housing market. There, the more significant consideration is the drop in the inventory of unsold homes by 27%; in fact, during the last 12 months, from the equivalent of 13 months’ supply during the 2008–2009 crisis to about eight months’ supply more recently. This development fundamentally has lifted previous downward pressure on new construction, sales, and pricing. According to the National Association of Realtors, for instance, the median sales price of homes sold in the United States has risen 5.3% so far this year, and prices continued to rise in May. It will be a long while before residential real estate becomes a good investment, but the price pattern nonetheless suggests that the market has easily compensated for the gyrations surrounding the tax credit.
3. Business Spending and Exports Are Awfully Strong for a Dip
If business is anticipating a second dip in the economy, it has chosen a strange way to show it. To be sure, firms have held back on new construction, hardly surprising given the low level of capacity utilization. So far this year, nonresidential construction spending has dropped by 2.1%, or at an annual rate of 5.0%. But business managers cannot be too frightened, for they are spending heavily on new equipment. Shipments of capital goods (excluding defense materials) rose at a 3.0% annual rate during April and May—the same pace they have maintained during the past 12 months. More telling of expectations than actual shipments, new orders for such capital goods exploded at a remarkable 48.3% annual rate during this supposedly weak April–May period—a tremendous acceleration from the already rapid 25% rate of expansion during the prior 12 months.
Meanwhile, business also has begun to rebuild inventories, presumably in anticipation of future sales growth. Stocks of finished goods on hand rose at a 6.0% annual rate between March and May (the latest month for which data are available), and work in progress increased at a 4.3% annual rate.
Exports also showed strength. So far this year, through April (the latest month for which data are available), total U.S. exports to the rest of the world have expanded at an impressive annual rate of almost 17%. In April, they jumped at a 12.7% annual rate. That kind of growth will not only help spur the overall U.S. economy but it also argues that the world economy is far more robust than double-dip arguments suggest. As a take on domestic U.S. demand, it is noteworthy that imports have expanded at a 23.5% annual rate so far this year, a pace they held in April. Clearly, someone in this economy is buying.
4. Overall Production Levels Look Fairly Good, Too
More general measures of economic activity also cast doubt on the double-dip outlook. Industrial production, for instance, continues to rise at impressive rates. The year-to-date rate through May (the most recent month for which data are available) has seen this measure of output in factories, mines, and utilities rise at an annual rate of more than 8%, and in May, the pace actually accelerated to an annual rate of more than 15%—clearly unsustainable, but quite the opposite of weakness, much less a double-dip. Similarly, the Purchasing Managers Index of the Institute of Supply Management shows continued growth. To be sure, the index fell in May and June (the most recent months for which data are available), to a level of 56.2 from an April level of 60.4. But since any reading above 50.0 speaks to economic expansion, even the lower figure records continued growth and not another dip. The fact is that the April figure was unsustainably high.
5. Employment Does Not Look Threatening, Either
Indicators on hours, temporary employment, and even full-time employment have begun to edge up. And even though the unemployment rate has failed to fall in a concerted way, such a move would be premature at this stage in the recovery, at least given the lags averaged in past cycles. Actually, the jobs market is slightly ahead of schedule, according to these historical benchmarks.
6. Financial Markets Are Healthier Than the Headlines Imply
Though Europe’s sovereign debt problems present a huge financial and, consequently, economic risk, financial markets have nonetheless demonstrated an impressive resilience. Indeed, their behavior under this strain speaks to a significant, fundamental healing. Contrary to the tone of the headlines, markets have avoided the much-looked for relapse into the mess of 2008–2009. For example, the TED spread (the gap between Treasury bill and interbank lending rates, and a good indicator of liquidity) has only widened in this crisis, from 20 basis points (bps) to about 40 bps. Some widening was to be expected in the face of European uncertainties, but matters are still a long, long way from the 460 basis-point spread recorded during the 2008–2009 crisis.
Similarly, junk bond spreads have widened, from some 600 bps over Treasuries earlier this year, to 700–750 bps, as the European problems have become evident. Though an unsurprising reaction to the European credit scare, these spreads are a far cry from the 2,100 bps they reached in 2008–2009. Meanwhile, issues continue to get sold on bond and money markets, and even bank lending has shown some tentative signs of flowing again.
7. China Continues to Grow
A slowdown in China is not only consensus but it also is a reasonable expectation. A housing bubble of sorts is deflating in China’s major cities. The government in Beijing has taken monetary and fiscal steps to slow the pace of growth. Beijing’s recent decision to allow the yuan to appreciate against the dollar on foreign exchange markets has raised questions about the future growth of Chinese exports, both to the United States and to Europe.
But though all these factors are real and will slow China’s general economic growth rate, it would be a mistake to exaggerate them. China’s decline in residential real estate prices hardly risks the financial collapse that occurred in the United States about a year and a half to two years ago. For one, debt levels in China are much lower than they were or are here. While Chinese households on average are carrying debt equal to about 40% of income, American debt levels approach 120–130% of income. For another, Chinese typically put 50% down for a home purchase and almost never less than 20%. Neither will the yuan’s increase impact exports very much. The currency appreciation is so slight and so carefully managed that it is more cosmetic than real. It is certainly insufficient to threaten Chinese exports. Broad economic indicators also show a slowdown, not a decline. The PMI, for instance, dropped from 53.9% in April to 52.1% in May, but still anything above 50% is expansion. If, as expected, China’s overall growth slows for an 11.9% annual rate in the first quarter, to 9.5%, it will still remain faster than the rest of the world—and hardly the stuff of which double dips are made.
REPORTS CALENDAR
Monday, July 19:
July Housing Market Index
Tuesday, July 20:
Retail sales (weekly), June Housing Starts
Wednesday, July 21:
Mortgage applications (weekly)
Thursday, July 22:
Jobless claims (weekly), June Existing Home Sales, June Leading Economic Indicators
