Opinions Investor's Corner From less bad to less good
Order Reprints
Follow @MiBiz
Investor’s Corner
ByGudritz CFA
Principal
Front Street Investment Management LLC
This e-mail address is being protected from spambots. You need JavaScript enabled to view it
The stock market sold off strongly in May but was able to hold on to the February lows of 1040 on the S&P 500 Index. That amounted to a correction in the market of a little over 12 percent. Those investors and market strategists who use technical analysis to forecast the market’s future have taken solace by the fact that the stock market had put in a “double bottom,” which is a bullish price pattern. This means, according to them, that the bull market has resumed. I am skeptical about that bullish confidence because I have seen many signs that the economy has gone from being “less bad” to “less good.”
As I have mentioned in previous columns, I believe that the 82 percent rise in the S&P 500 Index from the lows in March 2009 has been way overdone when considering what has actually been going on in the economy. The rally in the market began when the economic news became less bad. Even when the stock market peaked in April, few if any of the economic indicators were considered to be good or, better yet, strong. They were obviously much better than they were in the depths of the recession but not as good as they should be if this recovery was healthy and strong.
Now in the last month or two I have seen economic indicators that are less good. Some of it has to do with the government stimulus programs coming to an end. Others are related to the high unemployment rate and the fact that personal income continues to increase at less than the inflation rate while credit lines are still being cut.
What I find most disconcerting about the outlook for economic growth over the next six-12 months are the declines in two major leading economic indicators. The Economic Cycle Research Institute’s Weekly Leading Index has declined to where it was last July, a 43-week low. The managing director of ECRI, Lakshman Achuthan, stated that “U.S. economic growth is set to start easing in fairly short order.” David Rosenberg, the chief economist with Gluskin Sheff & Associates, who closely follows the ECRI Weekly Leading Index, says that this Index is now forecasting a dramatic slowdown in real U.S. GDP growth to only 1.5 percent in the second half of this year.
The Conference Board Leading Economic Index (LEI) declined 0.1 percent in April, the first decline in more than a year. Its six-month growth rate has moderated since December. I believe that we will soon see indicators of current production such as the Purchasing Managers Index also show a softening in economic growth.
While the government’s $8,000 and $6,500 tax credits for first-time and some repeat home buyers helped boost existing and new home sales in March and April as the program came to an end, I believe we will see significant declines in sales in May and beyond. The tax credit incentives only pushed future sales forward. The 36 percent reduction in mortgage applications for new purchases over the past few weeks is an indication of it happening. I also believe that we will continue to see housing prices decline as the banks bring the “shadow inventory” of foreclosed houses to the market.
Retail sales were stronger than I expected in the first quarter of this year, but there are signs that consumer spending may be less in the second quarter. The management of many retail establishments have commented in their first quarter results that their customers are still being very conservative in their spending, especially for the lower-end mass merchandisers.
Despite the fact that exports are a relatively small part of our economy, we will feel the economic effects of a severe slowdown in the European economy. Most countries in Europe are taking steps to cut their deficits by decreasing spending and raising taxes.
The U.S. will be experiencing its own fiscal tightening over the next few years in an effort to rein in the exploding budget deficit. Higher taxes and spending cuts will reduce growth next year and beyond. As a result of this global fiscal tightening, most companies will be more conservative with their future hiring and investments into new plants and equipment.
Obviously if these leading indicators are correct and the economy slows to a real growth rate of 1.5 percent by the fourth quarter of this year or the first quarter of next year, then corporate earnings will be less than is currently expected. The consensus view is that the economy will grow at a 3.5 percent rate and that earnings for the S&P 500 companies will be up 30 percent in 2010 and another 10-15 percent in 2011. Again, that won’t happen if the economy is growing at less than 2 percent. Earnings growth will be half those rates at best and that will leave the stock market vulnerable to another significant decline.