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Thursday, 12 November 2009 01:14 Written by James Van de Voorde

The stock market rally finally paused in October with the Dow Jones Industrial Average flat for the month, while the S&P 500 Composite and NASDAQ Composite  declined by 1.98% and 3.64% respectively.  For the year-to-date through October, the Dow Jones Industrial Average, S&P 500 Composite and NASDAQ Composite are now up 10.67%, 14.72% and 29.68% respectively.      

The market’s pause may be a case of “buy on the rumor, sell on the news” as the U.S. economy registered its first quarterly advance in five quarters.  GDP for the third quarter rose 3.5%, offering concrete evidence that the economy is on the mend and the recession finally over.  As pleased as we are that GDP is back in the black, we are weary of the impact played by temporary government programs on the quarterly rise.  Auto sales accounted for one percentage point and residential construction accounted for half of one percentage point of the total 3.5% quarterly advance.  Clearly, without “cash for clunkers” and the $8,000 first-time home buyer tax credit, GDP would have been positive, but far less impressive.  On the positive side, inventory rebuild accounted for just nine-tenths of one percentage point of the total, leaving room for more sustained upside from the cyclical benefits of inventory replenishment typical of all economic recoveries.   

Notwithstanding the temporary boost from government programs, other economic data continues to point towards sustained growth.  U.S. factory orders rose by .9% in September, the fifth increase in the last six months and ahead of the .8% increase expected by economists.  The ISM manufacturing index rose to 55.7 in October, up from 52.6 in September, ahead of the 53 reading expected by economists and the highest level of the index since April of 2006.  While slipping from 51.5 in September, the ISM service index remained in growth mode (above 50) at 50.9 for the second consecutive month.  Retail sales rose 1.8% in October, barely missing the consensus expectation for a 2% increase.  And the National Association of Realtor’s Pending Home Sales Index rose 6.1% in September to its highest level since December 2006.  Pending home sales have now risen for eight consecutive months, the longest such streak since 2001.  Meanwhile, key manufacturing data in Europe and Asia signal a synchronized global recovery.  The Purchasing Managers Index (PMI) for the U.K. rose to 53.7 in October from 49.9 in September, its strongest reading in two years.  The same PMI for the euro-zone (Germany, France, Italy, Spain, Ireland, Austria, Greece and the Netherlands) rose to 50.7 in October from 49.3 in September.  Finally, PMI in China rose to 55.2 in October from 54.3 in September, the eighth consecutive monthly increase and the fastest pace in 18 months.        

While the above economic trends are encouraging, much hand-wringing remains about that state of the U.S. labor market.  With unemployment at the highest level in 26 years at 10.2%, investors and economists alike are rightfully concerned that the recovery now underway is unsustainable without a pick-up in hiring.  While still early to call a turn in unemployment, this “lagging” indicator continues to show incremental signs of improvement.  The ADP private payroll employment survey fell by 203,000 jobs in October, the smallest decline since July of 2008.  Also, the Labor Department reported that first-time claims for unemployment benefits fell by 20,000 in October to 512,000, the lowest level in 10 months.  The four-week moving average for initial jobless claims is now at 523,750, an improvement of 135,000 from the depths of the recession.  Again, while these signs are encouraging, economists estimate that a level of initial jobless claims at 400,000 is necessary before new jobs are created.  Finally, nonfarm payrolls fell by 190,000 in October, 15,000 jobs worse than the 175,000 consensus but the best reading on job losses in over one year.  While the trend is clearly improving, unemployment will remain stubbornly high for an extended period and may not improve much for at least another six months.   

Perhaps the greatest story never told during this recovery is the amazing gain witnessed in productivity.  Productivity, the amount of output gained per hour worked, catapulted 9.5% during the third quarter, the largest such increase in six years and well ahead of the consensus estimate for a 6.4% gain.  Strong productivity gains enable corporate America to increase profitability despite the very difficult economic environment.  With 82% of the S&P 500 companies having reported third quarter earnings, 80% of these companies have managed to top expectations.  In the last two weeks, the consensus forecasted earnings estimate for the S&P 500 has risen to $76.57 for 2010 and $93.40 for 2011 – implying still very reasonable PE valuations for the market at 14 times 2010 and 11 times 2011 forward earnings.   

Rising productivity implies that companies are squeezing more from their existing work force and does not bode well for an imminent change in the employment landscape.  However, recent productivity trends are rising at an unsustainable pace and, at some point, companies will have to ramp up hiring to meet end demand.  Companies seem poised to invest in their businesses as evidenced by corporate America’s mounting hoard of cash.  The Wall Street Journal recently reported that the 500 largest nonfinancial U.S. firms held just under $1 trillion of cash and short-term investments at the end of the second quarter, the greatest percentage of corporate cash assets for the last 40 years.  Corporate America has the wherewithal to hire but is clearly cautious, waiting for further evidence that end demand is real, the recovery self-sustaining and the economy finally at “escape velocity”.   

The lack of escape velocity has not been lost on the Federal Reserve who again left interest rates unchanged at their November meeting of the FOMC.  In fact, the Fed added three qualifiers to their statement that justify low rates: “low rates of resource utilization, subdued inflation trends and stable inflation expectations”.  Presumably, changes in these qualifiers (improvements in capacity utilization and lower unemployment, higher inflation or rising inflation expectations) would warrant a change in Fed policy.  Since the Fed did not alter its intention to keep rates “exceptionally low” for an “extended period” and since it seems that dramatic improvements in the Fed’s qualifiers are at least months away, expectations are growing that the Fed will remain sidelined for at least the next six months.  This is creating a “dollar carry trade” whereby traders borrow cheap dollars and buy riskier asset classes.  While this may portend looming asset bubbles, we presently do not see equities as the bubble du jour (last month’s cover story offered evidence of emerging trouble in the bond market).  We would grow even more convinced of this theory as additional evidence of sustainable economic growth emerges.  Sentiment remains skeptical towards equities and equity valuations remain reasonable, assuming the recovery gains traction.  We’ll remain on “bubble watch” as the Fed maintains its easy money policy and beckons investors to climb the ladder of risk.  Given the spectacular rise and fall in the price of oil and other commodities last year,  gold’s recent spike above $1,100 per ounce would seem to be worth watching.  Lest we become too skeptical of the yellow metal’s ascent, India’s purchase of 200 tons of gold from the IMF at prices very near current highs seems to validate our hedge and confirm our theory that central banks will increasingly diversify their substantial currency reserves.   

So, investors remain cautious.  Economists are cautious.  Corporations are cautious.  The Federal Reserve is cautious.  The only (important) player seemingly throwing caution to the wind is the U.S. government under the Obama Administration and Pelosi/Reid Congress.  The Congressional Budget Office reports that the House Pelosi healthcare bill will add $1 trillion to our deficit, while the Baucus Senate bill will add $800 billion.  Both bills reduce existing Medicare benefits, do little to reign in medical costs, add hundreds of billions to our deficit and raise taxes at a time when Americans can least afford it.  The cloud of healthcare reform, potential “cap and trade” legislation and the looming expiration of the Bush tax cuts in 2011 are real cause for concern and are likely to give the markets further pause in the coming months.  Yet the Obama agenda has been in the markets for months now, so any centrist surprise would certainly be welcomed by investors.   

Such a surprise emerged with the recent election of Republican governors in New Jersey and Virginia.  It is stunning that the difference in margin by which Obama won these two states just one year ago compared to the Republican margin today amounted to a 25 percentage point swing in Virginia and a 20 percentage point swing in New Jersey.  Independent voters made up 30% of the vote in Virginia and voted Republican by a 2 to 1 margin.  Similarly, independents were the margin of victory in New Jersey.   To be fair, a moderate Democrat beat a Conservative Party candidate for a House seat in upper New York, a seat that had belonged to a Republican since 1872.  With this particular New York election gaining much notoriety as the likes of Rush Limbaugh and Sarah Palin campaigned hard for the conservative candidate, it seems again that the independent voter has spoken.  While there are certainly differences along social beliefs, independents and the vast majority of Americans believe in fiscal conservatism.  The recent contests in New Jersey, New York and Virginia seem to be sending a strong message from the independent voter: government must move away from the polar opposites of Obama and Limbaugh and come back to the middle.     

Should this centrist message resonate with otherwise centrist Democrats that might like to be reelected in 2010, the odds may grow for a defeat of Obama’s most liberal policies, including a health care “public option” and “cap and trade”.  As the campaigns for reelection intensify in the coming year, one can almost hear the winds of compromise for the soon-to-expire Bush tax cuts.  Now that would be change that we and the markets can believe in.

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