Ready For Good Times?
Our great nation is on the verge of another great wave of growth. It may not come rapidly or at the exact time we may expect it, but it is coming. Why? Because we have all the ingredients we need to get lots of economic growth. Interest rates are low. There is lots of money flowing around. We have lots of unused capacity in labor and capital markets. Many cyclical industries are operating at minimal operating levels (so any increase in demand translates into marked growth). We have a consumer who has dramatically reduced consumption. Inflation is virtually non-existent, outside periodic bouts of commodity-driven price increases. And, the government has a program to pump money into the economy and create make-work jobs. There should be no question we are going to have a recovery. The only question is how powerful it is likely to be.
In an economy dominated by services, it is unlikely we will have the same kind of rapid expansion as back in the ‘good old days’ when the economy was dominated by manufacturing. Wal-Mart ramping up for more growth in the 00s is not the same as General Motors cranking up growth back in the 60’s. The cyclical segment of the economy is just not as big as it once was. The consumer, the current leading sector, will likely wait until things start going better before they join in on expanding their activity. Consumer confidence is near lows seldom seen before. That will have to improve before the consumer will stop being a drag on the economy. Though money is widely available, few banks really want to increase lending. Saddled with lots of bad loans, banks are broadly gun-shy about making more potentially bad loans. And, our trading partners are generally not growing, so the export sector is not going to be a driver. Quite the contrary, all our trading partners are looking to our economy to drag them out of recession, much of our potential growth from increasing consumption will likely leak overseas.
There are many obstacles to a powerful economic rebound, but more reasons to believe that we are on the road to recovery and it will likely be stronger than now widely assumed. That strength may take a few quarters to show itself, but don’t be surprised when you see the headline about surprising growth in the middle of 2010.
Then there is more good news on the investment front. After several quarters of incredibly bad earnings with many dividend cuts (or eliminations) and write-offs of failed business combinations or new product lines or R&D expenses, corporate earnings are ready to explode. The next four quarters are easy comparisons to beat. Starting with the third quarter this year, we start comparing to the surprises of 2008. Remember it was in the third quarter last year that Fannie Mae and Freddie Mac were absorbed by the Treasury, that Lehman Brothers failed, that Merrill Lynch, Wachovia and Washington Mutual were all sold. Each of these came with massive write-downs of securities held on their balance sheets. The fourth quarter was worse and the first quarter this year was worse yet.
Each of these massive write-downs is a one-time event that will not be repeated. The cumulative impact is that the earnings for the next year will be markedly higher than the prior year. That will help the apparent valuation of the market as earnings grow dramatically over the four quarters. If you take the current P/E of roughly 16 on the S&P 500, next year it would be about 8-10 unless the price goes up to adjust for the higher earnings. Don’t be surprised if the P/E is lower than 16 next year because the stock prices probably can’t keep pace with the earnings increases.
Good Economic News
The Institute of Supply Management (ISM) released their monthly report on manufacturing activity on Monday and it was good. The prior month, the index read 44.8% and now it is up to 48.9%, almost to the magic 50% that would indicate expansion. But even the 48.9% is pretty good. For most of the long expansion in the 90s manufacturing seldom got above 50% for long and yet we enjoyed a long period of apparent prosperity. But, given where manufacturing has gotten to, a period above 50%, well above 50%, is probably in the cards early in this expansion. And yes, we are in expansion before any stimulus begins to kick in or before we fix healthcare of solve global warming.
Construction spending rose by 0.3%, much to the surprise of the economics fraternity. This is a volatile series as it includes not just residential construction but also commercial and public construction. Note, we are growing this despite almost no spending from the stimulus package aiding public spending. All those ‘shovel ready’ projects are still just waiting until some money gets spent.
The employment report was delivered right on time on the first Friday of the month. Most economists were expecting a better report this month than last or the one before that. While earlier this year the job-loss number had been trending from -550,000 toward -750,000, the last two months had shown drops and were below -443,000 last month. The best guesses for Friday’s number were around -275,000 until the ADP Employment Report moved the needle toward -375,000. To be honest, your pundit was starting to fear that we were getting far too optimistic about the outlook for this number. But, when the announcement came Friday morning, we were at -247,000. What a relief!
The jobs picture isn’t really good yet. Even a smaller decline than July is still a decline. For the economy to grow, we don’t really need higher employment because increases in productivity can give us a small gain even if employment is slightly negative. But, that can’t pertain for very long and be stable. The labor force grows at about 1.5% a year, so we need 1.5% more jobs just to keep unemployment stagnate. We need even more jobs before unemployment starts moving down. The labor force, according to the Bureau of Labor Statistics, is 154 million and some change. So we need to create about 2.3 million new jobs a year just to keep up with growth in the labor force (that is roughly 192,000 a month). Until the monthly statistics start showing gains in employment in the 200,000 range, we are not going to see the unemployment rate drop consistently. That day may still be a ways off even if the economy stops dropping and starts growing slowly. We may hit it every so often, but we will need to add a lot more jobs than that to get unemployment back where we feel better about it.
By the way, the unemployment rate fell in July from 9.5% to 9.4% mostly because a lot of unemployed people became discouraged workers and fell out of the labor force. We probably had higher than expected enrollment in education than typical in the summer due to the shortage of summer jobs for college students. All the employment statistics are adjusted for normal season inflows and outflows of workers, but in odd times these seasonal adjustments can just make the number less reliable.
Speaking of unemployment, during the 1981-1982 recession unemployment peaked at almost 11%, more than 10.6 million people out of work in a population of about 175 million. We now have about 14.5 million unemployed out of a population of roundly 300 million. First, this recession is not unprecedented. Second, it is not the worst since the Great Depression. Third, it is essentially over and we will start seeing recovery very soon. Stop with the hyperbole already!
Other Economic Numbers
Personal income and consumption was reported on Tuesday and it was a mixed bag. On the income side, we actually aren’t getting ahead at all. Personal income declined by 1.3%, marking a shift from the modest gain in May. The difference was the one part of the stimulus that has actually been made, a one-time payment to Social Security recipients as part of the stimulus package. The payments, made in May, were not there to buoy incomes in June, so incomes fell.
Consumer spending was up regardless. The 0.4% gain in consumer spending is ascribed to higher gasoline prices and a recoil in the savings rate from May’s level. Evidently, much of that one-time Social Security payment was saved and not spent.
ISM non-manufacturing slipped in June, surprisingly. The service sector didn’t show the modest growth that most economists were looking for. The dip wasn’t all that big, but it was a dip. The June number of 46.4% was below the 47.0% of May and the 48.0% guess. When you consider the small gain in manufacturing, the non-manufacturing number is all the more unusual. Oh well.
The big winner in a pretty good week was the real estate sector. How can that be? Well, the stocks got pretty cheap compared to their earning power, compared to the underlying value of the real estate they owned and compared to other stocks. So, it was little surprise that the shares of REITs and other real estate related companies showed a little life. Typical gains were in the 15% or better range for the week. That feels a little like the good old days in commercial real estate when every new deal was greeted with a wave of buying. So, what was the spark that lit-up the REITs? Who cares? Just be happy you owned some and be happy that a modicum of diversification and discernment has returned to the market.
What is odd about the REITs doing well finally is that the financials in general weren’t all that outstanding last week. They did well, but real estate outran the financials by better than two to one. So, rather than following financials last week, real estate led financials last week.
There is some fundamental justification for a rally in real estate now. First and foremost, if the economy turns any time soon, commercial real estate’s fundamentals will turn with it (or somewhat behind it as it does take some time to translate economic growth into demand for more shopping malls, office buildings and storage places). But, as we have seen, most tenants managed to survive the recession so revenues aren’t down as badly as feared. Rent increases took a holiday as landlords are compelled to be a lot more flexible than maybe they were during headier times. Long-term leases with nice escalators do their job even if some of those had to be renegotiated. What is more important, many of the plethora of new projects slated to begin construction about now have been postponed, scaled-back or cancelled. That means that when the economy comes back, commercial real estate will tighten up relatively quickly as new demand will outstrip new supply for many years to come. Lastly, the REITs have been able to sell equity or sell properties with an eye to meeting their debt payments over the next several years. Many have renegotiated their debt as anxious creditors were willing to take less rather than be forced to take nothing.
The loser last week was the bond market, or at least the Treasury market. Treasury bonds fell across most maturities and took several of their surrogates with them. This explains the droop in GNMAs and high grade corporates as well as foreign government bonds. It seems that the bond market believes the recovery is on.
High yield and convertible bonds followed the stock market higher and municipals were better as any gain in the economy will provide that market some relief from ongoing issues with state and local government revenues.
The dollar was higher and generally foreign markets were up less than the US. Emerging market stocks were a mixed bag with Asian markets weak and Latin America strong. The developed markets were generally up, but just not as much as US markets.
US stocks showed strength as the earnings cycle slowed to a crawl. The remainder of this quarter’s earnings ought to have few surprises. Earnings have so far averaged 13% better than estimates. Surprise, stocks have done well.
Lastly, commodity prices trended higher last week with energy, industrial metals and many agricultural prices gaining. Precious metals tended to be weaker. Actually, if you look one by one, most commodities were lower, but the heavily weighted ones did better than the others. When ever the regulators close a door, Wall Street finds an open window.
Have a really great week!
Karl Schroeder, RFC
Investment Advisor Representative
Schroeder Financial Services, Inc.