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Wednesday, 13 May 2009 15:13 Written by James Van de Voorde

The stock market continued to rally off the March lows with the S&P 500 Composite, Dow Jones Industrial Average and NASDAQ Composite gaining 9.39%, 7.35% and 12.35% respectively in April.  The strong market advance from the March market bottom leaves the S&P 500 and Dow Jones down “only” 3.37% and 6.93% respectively for the year through April.  Meanwhile, the NASDAQ is now up 8.89% year-to-date through April.

With the overall market now up approximately 34% since early March, investors have become rightfully focused on whether the current move is a “bear market rally” or the beginning of a new “bull market”.  With almost each passing day, additional evidence emerges that the “worst has passed” for the economy.  To believe that we are merely in the midst of a rally within a bear market seems to ignore this mounting evidence.  Thus far, the data clearly points to an economy in the bottoming phase and to realities that are far “less worse” than previously expected.  However, the data thus far does not point to any potential V-shaped or sharp recovery.

The recent V-shape of the stock market advance seems justified, despite the absence of a V-shaped economic recovery, because valuations had become unjustifiably low and expectations had become so excessively pessimistic.  The sharp move off the March market low seems sustainable as investors recalibrate expectations from the second coming of the Great Depression to the awful recession that we actually have.  While we first reported on various “Markets on the Mend” back in February, the data points witnessed since then only bolster our argument that the worst has indeed passed.  Further, we are now increasingly optimistic that there is little reason for the stock market to retest the March lows.  And we are becoming more comfortable with the outlook we offered in January for a trading range of 850 to 1050 on the S&P 500 and a potential year-end target of 1065 to 1150.  With trillions of dollars still on the sidelines, “buying on the dip” should replace “selling into strength” as the new market mantra.  And this new mantra is what differentiates a bull market from a bear market.   

Economy

GDP for the first quarter of 2009 turned out to be slightly less negative than the fourth quarter of 2008, with a contraction of 6.1% compared to negative 6.3% in the fourth quarter of ’08.  This back-to-back steep decline in GDP supports our consistent prognostication that the economic trough would prove to have occurred during this two-quarter period.  Furthermore, aggressive draw down of inventories was responsible for almost half of the GDP decline, so real demand in the economy actually fell at a 3.4% annual rate compared to a 6.2% annual rate during last year’s fourth quarter.  This is the most rapid pace of inventory reduction since the “dot-com bubble” and paves the way for manufacturers to ramp up production in coming quarters.

Perhaps the greatest surprise to the GDP report was the 2.2% annual rate of increase in personal consumption, compared to the 4.3% decline in the fourth quarter of 2008.  Most of this increase was seen in January (+.9% versus +.1% in February and -.2% in March) and may be attributed to post holiday bargain shopping.  But it is testament to the resilience of the American consumer that consumption increased to such levels even as the national savings rate rose from 4% in February to 4.2% in March.  With the national savings rate now already at long-term historical averages, it seems clear that consumers do not have to undergo a material retrenchment in spending to adjust to the new normal.   

Other data points include the increase in the ISM services index to 43.7 in April from 40.8 in March; the rise in the ISM manufacturing index to 40.1 in April from 36.3 in March; better-than-expected durable goods orders for March; surprisingly strong April retail sales; and consumer confidence readings that soared higher in April.            

And finally, it appears that the job market is stabilizing as nonfarm payrolls fell 539,000 in April versus an expectation for a decline of 610,000 jobs.  Unemployment is now at 8.9% and at it’s highest level since 1983.  While the current level of job losses is indicative of how bad this recession is, the fact that the losses are leveling off is a positive for this always-lagging indicator.  Initial jobless claims fell during the last week of April and the four-week average of initial claims peaked in early April and has dropped for three straight weeks.                    

Housing

The National Association of Realtors reported that its Pending Home Sales Index rose 3.2% in March, led by first-time homebuyers who accounted for 53% of transactions.  The participation by first-time buyers is especially bullish since the contracts were signed even before the $8,000 housing credit was enacted by the stimulus bill, suggesting the potential for additional demand.  Furthermore, first-time buyers do not need to sell another home, so a continued decrease in inventories is highly likely.   

Other housing data points include the first time in 16 months that the Case-Shiller home price index did not post a new year-over-year record decline; construction spending rose in March for the first time in six months; the median price of homes in California rose for the first time 18 months; and new home sales dropped much less than expected in March.                

Banking

The much-feared government “stress test” revealed that 10 of the nation’s largest banks must raise an additional $74.6 billion in capital.  Since it was only a few weeks ago that the insolvency and potential nationalization of banks was on the table, this relatively minor need for additional capital indicates that the U.S. banking system is generally sound.  TED spreads, swap spreads and LIBOR all continue to decline.

Interest Rates   

Interest rates are moving higher amidst a further steepening of the yield curve.  The yield on 30-year Treasury bonds has jumped to 4.28% from the 3.7% level reported in February’s “Markets on the Mend” and 2.5% at the peak of the crisis.  The yield on 10-year Treasury notes has risen to 3.29% from the 2.9% level reported in February and 2% at the peak of the crisis.  The yield on 5-year Treasury notes has risen to 2.14% from the 1.9% level reported in February and 1.1% at the peak of the crisis.  The flight to safety trade that marked the peak of the credit crisis is clearly being unwound as investors sell government bonds and assume additional risk.  In addition to the recent rally in stocks, yield on high-risk corporate bonds or “junk bonds” has fallen steadily over the last two months.   

Volatility

The Chicago Board of Trade Options Exchange Volatility Index (VIX) has fallen from just over 80 at the peak of the crisis to just under 32.  The extraordinary levels of the VIX last Fall indicate how excessive and rampant the “fear bubble” had grown.  These more normalized levels of volatility should encourage sidelined investors to consider taking additional risk.   

Perhaps the greatest surprise has been witnessed by stronger-than-expected first quarter corporate earnings.  Approximately 70% of companies have reported earnings that surpassed consensus estimates.  According to Ed Yardeni, the average earnings surprise has been 9.5% and is the highest since the average 8% earnings surprise during the first quarter of 1988.  Corporate America has been able to deliver earnings surprises largely by taking extraordinary measures to cut costs.  When the economy finally shows signs of moving beyond stabilization to a new growth phase, the uptick in demand will flow right through to the bottom line and lead to a new cycle of pleasant earnings surprises.

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