Profits Good - Economy Not So Much

It is often difficult to determine why the markets rise or fall based on either good or bad economic news. Sometimes markets fall on good economic news and sometimes markets rise when poor economic data is reported. Recently, the market has seemingly defied logic over the past few weeks by rising in the face of poor economic data. The recent rise can probably be attributed to the fact that earnings (for the most part) are meeting or beating expectations. While main street is still hampered by job losses, it is a boon for corporate profits.

As of yesterday, roughly 80% of reporting companies have beat earnings estimates, but only approximately 65% have been beating top-line revenue growth estimates. In other words, companies are making their numbers by continuing to cut costs. This outcome is not how to build a foundation for solid long term growth and is likely not good news for longer term earnings growth (beyond next quarter).

Jacob Hacker of Yale recently presented a study sponsored by Yale University in conjunction with the Rockefeller Foundation on economic security and income. The study argues that in the past year, one in five households suffered income losses greater than 25%. It typically takes several years for households to recoup the lost income. In addition, household budgets are stretched and have little in savings.

So while the markets rise in the face of good earnings (remember, markets will follow earnings, not the economy), these results are unfortunately coming at the cost of future consumption which still constitutes roughly 70% of GDP.

Watch the Transportation Index

The Dow Jones Transportation Average (DJTA) hit a high in May of this year and seems to be steadily declining; registering lower highs and lower lows. (see chart below)




Over the past few months, the DJTA has declined along with the broad market averages. Usually, the transportation index can give us a good indication of growth in the economy. Transportation companies charge freight rates based on demand. If demand is strong, higher rates can be charged, improving transportation companies' earnings. When demand is soft, the opposite occurs. While so far the DJTA has declined along with the broader market, the index and company earnings (such as Fedex, UPS, & CSX Corp) should be watched carefully. A continued decline in the index could be a precursor of slower growth, while a rebound in the index and transportation stocks should point to at least stable demand in the intermediate term.

S&P 500 Earnings Update

Our current assessment is that the US stock market averages (based on S&P 500 index) are priced at fair valuation, taking into account the recent decline in the index and our expectation that earnings estimates will be adjusted in the coming months. Surprisingly, earnings estimates have continued to move higher over the past several weeks, despite expectations for a possible global slowdown in growth. As of April 1, 2010, earnings estimates were $78.15 for 2010, a 37% increase over final 2009 numbers ($56.86). As of June 30, 2010, earnings estimates increased to $81.73 for 2010 and $94.84 for the 2011 calendar year, increases of 44% and 16% year over year respectively – still too optimistic in our opinion.

If we make a reasonable yet optimistic assumption of 20% earnings growth this year and 16% earnings growth next year – earnings estimates would be roughly $68.23 for 2010 and $79.15 for 2011, below current expectations. Using a price-earnings multiple of 15 (long-term average valuation), we calculate valuations of roughly 1,023 for the S&P 500 Index for 2010 (near end of June levels) and approximately 1,187 for 2011. We believe markets are adjusting to this new fundamental reality and this is likely why the markets have declined in recent weeks. Currently, second quarter earnings releases are in full swing and company comments will give us a good indication of earnings prospects for the second half of the year.

Consumer Credit Declines Again

A report yesterday by the Federal Reserve showed that U.S. consumers shed some of their debt for the fourth month in a row in May. Total seasonally adjusted consumer debt fell $9.15 billion, or at a 4.5% annualized rate, in May to $2.42 trillion. Economists expected a decline but of only $3 billion. Of course, this data series tends to be very volatile from month to month. For example, the April consumer credit was revised sharply lower to a decline of $14.86 billion compared with the initial estimate of a gain of $1 billion. The decline in May was led by revolving credit-card debt, which fell $7.32 billion or 10.5%. This is the 20th straight monthly decline in credit card balances. Non-revolving debt such as auto loans, personal loans and student loans, fell $1.82 billion or 1.4%. Since the collapse of Lehman Brothers in September 2008, consumer credit has declined in 18 out of the past 20 months.

While consumers reducing debt is a long-term positive for the economy, it reduces short-term consumer spending and impacts economic growth.

Special Update

The recent report from the Institute for Supply Management, which measures productions of goods in the manufacturing sector, showed slower growth in the month of June. Almost of all the components of the report showed declines from May. Of particular concern was the deceleration of new orders (dropping by 7.2%) and prices paid (dropping 20%).

Going forward, we expect further deceleration in manufacturing. The combination of a stronger dollar and slower demand coming from Europe should hit export orders moving forward. The overall level of ISM readings are consistent with GDP growth of 3%-plus. However, further declines in the data in the coming months could bring down growth in the second half of this year.

In order to the economy to have enough momentum going into 2011, economic growth needs to be humming along by the end of the year, including job gains of roughly 200,000 per month by the end of the third quarter. With today's payroll number showing a loss of jobs for last month, it is becoming more unlikely we will see significant job growth in the next few months.

At this point, the prospects for the economy are moving between a worst-case scenario of a relapse into recession (which is a low probability) to a best-case of sluggish, sporadic growth in 2011. Thus, the current decline in the markets is expected given this fundamental change. We have stated earlier this year that earnings expectations were probably too high and adjustments would be made in the second half of this year; which would could see in the coming months. It is likely the markets will remain in a trading range until signs are clearer as to where to economy and earnings growth is headed. Until there is further confirmation of the data, we should expect volatility to continue, with a good news/bad news driven market.

In the meantime, it is best to continue our defensive-minded approach as we have since the beginning of the year - holding more fixed income, income producing investments (utilities), and cash as we wait for the dust to settle and less cloudy days to appear.

Enjoy the long weekend!