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In last week’s review I opined that the market felt as if it was making some sort of bottom. Um, not exactly. One thing I’ve learned after many years of observing markets is that predicting the future movements - especially short term movements - is impossible. Last week proved that I’m no better at it than anyone else. So, yeah, I’m human. Having said that, I still think the overwhelmingly negative sentiment and the relative value of stocks versus bonds favors the former - by a pretty wide margin - at this point. Unless we are truly headed for a third depression as Paul Krugman believes, stocks are as cheap as they’ve been for most of my investing lifetime. Fortunately, Mr. Krugman’s track record suggests a reprieve from his fears of economic stagnation.
First, as always, let’s dig into last week’s data which did nothing to change the overall view that the economy is still expanding but the pace of expansion is slowing. Most of the attention was focused on the lousy employment report, but there were other important indicators that weren’t as negative. The personal income and spending report was fairly positive with income rising 0.5% and spending up 0.2%. More importantly, the rise in income was primarily due to wages and salaries rather than an increase in transfer payments as some previous months have shown. Spending seemed sluggish on the surface but at least some of that can be blamed on lower gasoline prices. Durables spending was actually up 0.8%, a quite robust figure that was boosted by higher auto sales. Finally, the savings rate improved slightly to 4% which despite the fears of the Keynesians is a positive sign for future growth.
The weekly retail sales checkups from Redbook and Goldman continued the recent trend of continued, if slower, growth. Sales are growing at 2.5 to 3% year over year and while that isn’t a boom it isn’t a bust either. Given continued high unemployment it actually seems pretty damn good. Mortgage applications for purchases regressed last week by 3.3% but that isn’t much of a surprise since the home buyer’s tax credit has now expired. Home sales the next few months don’t mean anything since we already know the credit did nothing but pull sales forward. Of more interest will be how quickly the market recovers to a higher sales pace. It should also be noted that with interest rates at record lows, there is what appears to be a bit of refinancing boom underway. Refinance applications were up 12.6% last week.
On the goods producing side of the economy last week’s reports continued to show a pretty robust recovery. The Chicago PMI came in slightly less than expected but at 59.1 is still at a very positive level. The production component was 64.2 and employment 54.2 up 5 points and indicating month to month hiring. New orders matched the headline at 59.1 and businesses drew down inventories. The inventory draw down is a slight negative as it shows an unwillingness to build stocks which are still running at very low levels in relation to sales. In other words, businesses still lack confidence in the recovery. The national ISM report on Thursday confirmed much of the regional Chicago report. The overall index was at 56.2 which was down from last month and less than expected. It needs to be stressed though that a reading that high is still very robust and if annualized corresponds to a GDP growth rate of 4.8%.
In what has to rank as the least surprising report of the week, construction spending fell again. On the bright side, spending was down just 0.2% and 8% year over year. That might not sound that good but the rate of decline is slowing from last month’s 9.5% rate. Also on the real estate front, pending home sales plunged in May by 30%. The direction wasn’t unexpected but frankly I don’t think anyone expected the drop to be that dramatic. The weakness was widespread with all regions reporting big drops in contract signed. Factory orders also showed some weakness but like the personal consumption numbers earlier in the week, part of the decline was due to lower energy prices. There was some underlying strength to the report. Unfilled orders and durables inventories both rose which bodes well for future hiring.
And that brings us to the big report of the week, employment. The headlines showed a drop of 125,000 jobs and an unemployment rate of 9.5% and on the surface those didn’t seem bad. Unfortunately, if you read the whole report there isn’t a lot of positive information. The drop in jobs for the month was due to laying off census workers by the government. Private employment rose by 83,000 which was better than last month’s 33,000 but still weak by historical standards and expectations of 105,000. Service jobs rose by 91,000 while goods producing jobs fell by 8,000. The drop in goods producing jobs was - again - centered in construciton; manufacturing employment rose for the 3rd month in a row. Someday we’ll get to a point where the construction industry stops laying people off but for now it continues to be drag.
Overall the report showed a job market that is still very weak. The average work week fell back again to 34.1 hours and that number can obviously rise before new hires are needed. The unemployment rate fell simply because a large number of people dropped out of the workforce. The civilian participation rate has fallen to 64.7% and is now the lowest it has been since the mid 1980s.
The employment to population ratio is also falling:
There is an interesting debate to be had about these numbers and whether they are good or bad. As you can see we have had much lower participation rates and employment/population ratios in the past when the economy was quite good so high numbers do not equate simply with a good economy. The rise in these levels over the last few decades represents primarily the rise of women in the workplace and that is obviously a good thing. The participation rate of men has fallen slightly over that same time frame. But what does it say about our economy and society that we have chosen a way of life that requires so many people to work full time to pay for it? Notice how participation rates rose steadily starting in the early 1970s; is part of the rise in civilian participation a result of inflation? Are two incomes per family required just to pay the bills? Surely part of this has to do with our keep up with the Jones’s consumption attitude. In fact it appears that even adding another income to the household wasn’t enough to keep up with our consumption desires since we also find ourselves deeply in debt. Maybe the drop in the participation rate is not as bad as everyone seems to think if it also forces us to re-evaluate our way of life and what it takes to lead a fulfilling one.
I’m not trying to minimize the situation in which we find ourselves but I do wonder if we aren’t over reacting at least a little bit. Every economic recovery I’ve ever been through has had more than few hiccups along the way and this one is no different. I do think there needs to be a change in policy if we want anything more than a muddle through, slow growth economy but that takes time and isn’t likely in an election year. For now, let’s not overstate the facts. The economy is still expanding but the pace of recovery is slowing. That is not what I’d like to report but it isn’t disaster either.
Markets reacted negatively to the data last week and the bears definitely have the upper hand at this point. The fear of a double dip recession seems to have overwhelmed common sense for the time being. As I said above, assuming we aren’t headed for a depression as Krugman thinks, stocks are cheap. I suppose it is possible that earnings are about to fall off a cliff again as they did in 2008 but two such events so close together is quite unlikely and hopefully the Federal Reserve is a little more attentive to things now than they were in the crisis environment of late 2008. There appears to be an ongoing debate at the Fed about the need or desirability of a new round of quantitative easing. I fully expect the printing press faction to win the debate in the end and if we get QE II the downside in nominal stock prices is probably fairly limited. And the upside in gold is probably considerable as well.
From a technical perspective the S&P 500 is just above some pretty significant support at 1000 and again at around 950. I have no idea whether those will hold but I do know that I find a lot of cheap stocks when I run fundamental screens. Technology stocks in particular look very cheap with bellweathers such as Cisco, IBM and Hewlett Packard trading at just 8 to 12 times 2011 estimates. Current estimates for 2010 mean the S&P is trading at an earnings yield of 7.8% which compares very favorably to the current yield on the 10 year Treasury note that is south of 3%. If estimates for next year are in the ballpark the market is offering an earnings yield of over 8%. If you are selling this market here, you have to be predicting not just a slowing economy but another very severe recession that reduces earnings dramatically. For instance, even if earnings were to fall 25% next year (to roughly $60) the market is still offering an earnings yield (5.9%) that is considerably higher than that offered by the ten year Treasury (2.98%). That seems a pretty wide margin for error to me.
I am also encouraged by the prevailing sentiment which is overwhelmingly bearish. The American Association of Individual Investors poll has finally reached capitulation levels with just less than 25% of respondents willing to wear the bull label. All the other sentiment indicators show similar levels of skepticism about the market. The VIX is trading back over 30 which indicates robust demand for portfolio protection. Negative sentiment and cheap valuations should have long term investors licking their chops but the appetite for risk continues to be suppressed by the uncertainty of future economic policy. That doesn’t look to lift anytime soon but earnings season may provide some short term relief as I expect earnings to once again beat estimates.
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