Issue 37 • August 12, 2009

The Growing Risk of Rising Expectations

Last week saw the mother-of-all-green-shoots data as the July jobs report posted its best performance of the year, giving fresh momentum to the “recession-is-over” viewpoint.

After June’s disappointing payroll report showing more job cuts than expected, economists cheered to see fewer layoffs than feared in July. Keep in mind: This data is notoriously volatile and often subject to large revisions.

The “headline” payroll numbers showed “only” -247,000 lost jobs in July — better than the consensus forecast of -325,000 ... but the numbers may have been somewhat skewed by changes to government jobs and Detroit calling back workers from their extended summer break.¹ Both are one-time factors unlikely to be repeated next month.

Employment Leading Indicator Turns Up ... Slightly

Still the unemployment rate notched down to 9.4% ... from 9.5% — significant in that it was the first decline in the “headline” jobless rate since early 2008.²

However, in this statistic too there was less than meets the eye. The decline was not due to job creation, but because the overall size of the labor force contracted.

In other words, some job seekers simply gave up looking for work.

Nevertheless, there was some genuine good news in this report.

The length of the work week moved higher, along with an uptick in average hourly earnings.³ This is considered a good leading indicator of stabilization in the labor market, since employers are more likely to increase hours for part-time workers first, before they actually begin creating new jobs.

We’ll be keeping a close eye on this data to see if this is indeed the beginning of a positive and sustainable trend.

The favorable July jobs report is the latest in what has become a verdant field of green-shoots for the economy. But, now that the consensus view is that the recession has ended, you can’t blame investors for asking, “Now what?”

What can the markets possibly do for an encore ... following a rally of nearly +50% in the S&P 500?

Beware the Junk Rally in Stocks

The big rebound rally this year in the S&P 500 has proceeded in two phases.

The first phase off the March low was quite powerful, with technology leading the way along with other “cyclical” sectors, and the rally was fairly broad based.

Stocks paused again in June, only to start a second rally phase in July. However, this latest leg of the market rally has been led mainly by lower quality companies.

Since early July, stocks with a credit rating of CCC (below investment grade) have surged 26.4%, while AAA-rated blue chips (the highest credit tier) have lagged, rising only +9.5%!⁴

In other words, the second phase of this rally has been a “junk” rally.

The much-maligned financials helped propel this low quality rally, perhaps fueled in part by short covering in the sector. But we’re not talking about Goldman Sachs here; much of the action has come from the more speculative financial stocks.

For instance, when you see companies that are basically insolvent, such as AIG and Fannie Mae (FNM) leading the charge ... assisted by the likes of Citigroup (C) , which survives only on taxpayer funded life-support ... you have to wonder about the durability of this rally after a +50% gain from the lows.

Going back to 1950, on average, it takes about 18 months for the stock market to rebound +50% from a recession-induced low ... not five months as has been the case since March!⁵

For me, the phrase “too far too fast” comes to mind.

Banks Still a Big Question Mark

While even housing has shown signs of stabilizing recently, there are still a few big question marks.

The first question is the fundamental health of the financial sector.

Although the aforementioned financial stock rally has been stunning, is this troubled group of companies really a “leadership” sector the market can count on for more big gains going forward?

Just this week, Congress released its latest oversight report on the Troubled Asset Relief Program (TARP). You may recall that when TARP was hatched late last year, the central idea was to relieve banks of troubled assets rotting on their balance sheets.

But the Treasury Department never actually bought troubled assets, preferring to “invest” $700 billion of taxpayer’s money directly into the big banks instead.⁶

The good news from the latest TARP oversight report is that 18 of the 19 biggest banks appear to have enough capital to survive, even if the economy takes another turn for the worse. The bad news is that thousands of small and mid-size banks across the country, most of which didn’t get government bailout money, could soon find themselves in trouble.⁷

The main source of troubled assets here comes from commercial real estate and other loans these smaller banks hold on their books — rather than the home mortgage loans (and mortgage-backed paper) that plague the bigger banks.

In fact, commercial mortgage-backed securities (think hotel and shopping center development loans) are now defaulting at record rates of nearly $2 billion per month. At this pace, the delinquency rate on commercial loans could double by the first quarter of next year.⁸

Both Goldman Sachs and the International Monetary Fund have forecast that total U.S. financial sector losses may reach the $1 trillion mark before this crisis is over. In May, the Federal Reserve estimated that U.S. banks still have nearly $600 billion worth of asset write offs to come.⁹

So far, we’ve only seen the first big wave of write offs at the biggest banks. Now, we are bracing for the next wave of losses from many more community banks, which could continue to be a drag on the economy into next year, and perhaps beyond.

Investors holding big gains in low-quality financial stocks should be forewarned.

Recovery Still Searching for the Consumer

Then there is the question of the consumer.

At least one major leading indicator of economic recovery still hasn’t fallen into place: consumer spending. The U.S. consumer accounts for more than two-thirds of our economy, as most folks are aware. I have also seen research suggesting that as much as 20% of the world’s total GDP is due to American consumption ... think of all the “stuff” that China USED to ship to our Wal-Mart’s!

Consumer incomes were down for eight months straight through June ... declining at a steep -7.4% annual rate over the period.¹⁰

Not surprising, chain store sales fell another -5% year-over-year in July, with nearly 60% of retailers missing sales forecasts.¹¹

In the first year of a typical economic recovery, consumer spending accounts for over three percentage points — or nearly HALF — of total GDP growth, on average (See graph). The second and third most important factors are, respectively: firms rebuilding depleted inventories and housing.¹²

While housing may be showing signs of stability, it could be mid-2010 or even 2011 before housing kicks in significantly to create positive GDP growth again. We also know that commercial construction has hit the skids, which leaves only business spending on equipment and software, and of course, government transfer payments, to support the economy in the absence of a stronger consumer.

Risk of Rising Expectations

As I pointed out in last week’s Weiss Advice, inventory rebuilding can carry the economy only so far. Last quarter’s positive earnings surprises were driven mostly by cost cutting, which cannot go on indefinitely either.

At some point, we need to see concrete signs of a lasting recovery in real final sales — rather than government-sponsored monetary and fiscal stimulus — in order to realize sustainable growth in the economy.

Current consensus forecasts call for +2.5% to +3% GDP growth in the current quarter. They also see a rebound in corporate profits by the end of this year.¹³

In my view, one of the biggest (and growing) risks to this rally is that it will get very difficult — if not impossible — for incoming data to meet growing expectations going forward ... much less to continue surprising on the upside and fuel an enduring rally.

Good investing,

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

¹ IHS Global Insight, U.S. Employment Report Shows Slower Job Losses, Lower Unemployment, 8/7/09
² Ibid.
³ Ibid.
⁴ Gluskin Sheff Economics Commentary, 8/7/09
⁵ Ibid.
⁶ New York Times: Troubled Assets May Still Pose Risk, 8/11/09
⁷ Ibid.
⁸ Gluskin Sheff Economics Commentary, 8/11/09
⁹ New York Times: Troubled Assets May Still Pose Risk, 8/11/09
¹⁰ Gluskin Sheff Economics Commentary, 8/5/09
¹¹ Gluskin Sheff Economics Commentary, 8/7/09
¹² Ibid.
¹³ Gluskin Sheff Economics Commentary, 8/4/09