Comstock Partners, Inc.August 09, 2012
Investors Should Be Careful What They Wish For
Investors who cheer for bad news on the grounds that it leads to more central bank ease should be careful what they wish for. The majority of key economic indicators seem to be signaling a recession ahead, and recessions have almost always been accompanied by bear markets. This is particularly so in the present circumstances when the Fed's ability to maneuver is severely restricted since it has already reduced interest rates to near zero and tripled its balance sheet in generating an extremely weak economic recovery. No measures anywhere close to that magnitude are available now. At the same time we face the notorious "fiscal cliff", declining corporate earnings guidance, recession in Europe and sharp slowdowns in China and India.
The weight of the evidence for recent key economic releases indicates slowing across a broad segment of the U.S. economy. Retail sales (both total and non-auto) have dropped for three consecutive months. This has happened only five times since 1967----four times in 2008, and one now. The University of Michigan Consumer Sentiment Survey has been down for two straight months. Real consumer spending in June was down 0.1% despite a paltry 4.4% savings rate.
July payroll employment popped back up to 163,000, although the true rate of growth is probably closer to the 105,000 average over the last five months. This is far below the level needed to induce more consumer spending or to reduce the unemployment rate.
The ISM Manufacturing Index for July was under 50 for the second consecutive month, the first time this has happened since June and July 2009. The weakness in manufacturing was also reflected in the decline of core factory orders for June, the fourth drop in the last six months.
The small business confidence index declined in June to to its lowest level since October, and has now dropped in three of four months. Sub-sectors of the report showed that plans for capital spending and new hiring have dropped sharply.
Although there has been a lot of discussion about a housing bottom, June existing home sales fell 5.4% to its lowest level since the fall year. Pending home sales dropped in June, while the mortgage purchase index has declined for four consecutive weeks and six of the last eight.
The conference board index of leading indicators has declined for two of the last three months, and is up only 1.4% over a year earlier, the lowest since November 2009, when the economy was emerging from recession. In the past, whenever the year-to-year rate of growth dropped to 1.4%, a recession almost always followed. Similarly, the ECRI weekly leading index is also pointing to a recession ahead.
Indicating that the mediocre growth reflected in the economic releases is no fluke, the GDP for the 2nd quarter came in at only 1.5%, a number that is not enough to maintain sustainable economic growth. A level this low is most often a precursor to a coming recession.
In addition to a softer economy, the corporate earnings picture is weakening as well. Of S&P 500 companies reporting to date, only 51% have exceeded expectations, the lowest since the first quarter of 2009, when the economy was collapsing. Furthermore, 50% lowered third quarter estimates as opposed to only 21% raising them. Year-over-year earnings estimates for the third quarter are now flat, although analysts are still looking for plus 11% in the fourth quarter, an estimate that seems unrealistic.
We also note that the U.S. will get no help from the global economy. If anything the outlook for foreign economies is more likely to be a drag than a help for the U.S. A number of European nations are already mired in recession, while others are on the cusp. Both Chinese and Indian GDP and production are slowing significantly and Japan is still in its funk that is now in an unbelievable third decade.In the current circumstances neither central bank action nor corporate earnings are in a position to underpin the stock market, while the continued dysfunction in Washington can only make things worse. We continue to believe that a major downturn in the market is ahead.