U.S. stocks held onto early-session gains for most of the session but eventually succumbed to a bit of weakness as Europe’s sovereign debt issues remained in focus and China appears willing to continue their pull-back of stimulus measures. 

Stocks got off to a good start after Caterpillar’s results were released during pre-market trading but the results didn’t justify the reaction, unless you’re talking about the go-for-the-gusto behavior of this stock market that has people ignoring the signs of weakness.  (If you want more specifics on these results, I’ll post some comments at the end of the letter.)  But the recent weakness in Chinese stocks, off 8% in 10 sessions as traders fear removal of the stimulus measures, and a spreading contagion in Europe was just enough to sap momentum late in the session. 

Consumer discretionary, industrial and basic materials were the only three of the major industry groups to close higher yesterday.  Consumer discretionary shares remain on fire, up 125% from the March 2009 low and up 25% since February as the momentum trade comes in.  Are you kidding me?  These shares are now just 10% below their all-time high hit in 2007, but this time the unemployment rate is 10% vs. 5%, incomes ex-transfer payments are down instead of rising and the cash-out refi is dead.  Performance chasers don’t care about these realities; their actions are blind to anything but quick money.  Some things never change, and never will.

Financials led the decliners, with health care and utility shares the next worst performers.

Market Activity for April 26, 2010

Achtung Baby

I’ve sounded a cautious tone over the past nine months, and my increasing pessimism has probably grown a little old.  Sorry about that, but I’m not here to cheerlead when policy and organic growth doesn’t justify it in my mind.  I celebrated the 40% move in stocks that occurred within three months of hitting the March 2009 low, but the roughly 30% run that followed this initial boost has not been a fundamentally sound move in my view.  That said, there are some good things happening with regard to profits and the overall economic data.  S&P 500 profits are coming in strong this quarter, and it’s not all boosted by financial-industry profits as was the case in the previous quarter; financials are an industry that is being propped up by the Fed at zero and a wonderland thinking that the housing market will rebound in a consistent manner (so they decrease provisions, which boosts earnings).  No, during this second-straight quarter of profit growth, which follows a post-depression record nine quarters of decline, the results are more balanced with overall profits are up 46.1% and ex-financials up 25.9%, which is the figure to watch. 

One could see this profit story coming, as we talked about as early as last summer (in the July 8, 2009 letter to be exact).  And as long-time readers may recall, we watch the after-tax profits figure within the GDP reports, a measure that signaled something was occurring -- up for four-straight quarters (+16.6%, +5.6%, +13.8% and +8.2% in each of the past four quarters).  The other thing that was evident was the boost to the corporate bottom line from the massive payroll cuts – you eliminate costs by such a degree and it makes profits pretty easy to come by, especially as the numbers are compared to the fear-of-armageddon period of a year ago.

That said, the concern lies in what occurs a few quarters down the road.  Usually, once a recovery presents itself one can count on a multi-year expansion resulting.  But this recession was different than most.  It was not the typical inventory-led recession, but the more unusual credit/balance sheet-caused recession.  These are particularly acute downturns, as we all know by now.  The origin of this event, while there were several reasons, was the Fed continually combating financial crises and recessions by jacking rates lower over the past 15 years.  The Fed’s most harmful reaction was to keep fed funds below the rate of inflation for three full years 2002-2005, something that has not occurred since the 1970s, and we know how those Fed mistakes turned out. 

In addition, there has been an unprecedented response from governments worldwide as fiscal policies have pumped colossal sums of money into economies.  Here in the U.S. we have the $787 billion in “stimulus” -- and roughly $400 billion more in transfer payments -- and the Chinese added a similar amount within their “official” stimulus program– and who knows how much more as they had aggressively eased lending standards within their state-run banking system.  All of this pump-priming, as the Keynesians like to call it, has propped up the economy. 

But as this helps the economy in the near term, it comes back to haunt a few quarters down the road.  We can see it in sovereign-debt risks and this is why credit-led recessions take several years to completely play out.  The story goes: The downturn is very severe, therefore politicians do whatever they can to ease the damage in the short term, which means financial damage down the road as their short-sighted decisions lead to consequences in the future.  Households have not meaningfully begun to reduce debt levels*, the government and banks have delayed the foreclosure process, and we must still deal with the unwind of the most aggressive monetary and fiscal responses the modern world has ever seen. 

So while things look much better in the short term, time will show the process of this credit event has not fully run its course.  In addition, higher tax rates, regulations and the ramifications on both job growth and economic activity via the largest new government program since the Great Society days of the mid-1960s will only make achieving a rate of growth that allows for an escape velocity all the more difficult. 

Because of the Fed’s aggressive actions (pushing investors into riskier assets as they have made the yields on safer assets unappealing) and what is now an improving economy, the stock market has been on a tear from the March 9, 2009 13-year low.  A rebound from a heavy slide in stock and corporate bond prices is very normal, but the way investors have lined up to put their hands back into the fire again, so quickly following the worst financial event since the 1930s, is not normal – in fact, such a willingness to step up and test the stove top is only matched by the activity in the 1930s, and let’s pray we don’t find other similarities to that period. 

The point: Policymakers can combat downturns by jacking up spending and jacking down interest rates, but only in the short term.  Their decisions will result in large-scale economic damage down the road; this story has yet to play out.  And this is why I continue to beat the drum of caution.

Today’s Data

We didn’t have a major economic release yesterday, but data begins to flow again today with CaseShiller HPI, the Richmond Fed index and Consumer Confidence. 

On CaseShiller, the non-seasonally adjusted (NSA) reading has differed from the seasonally-adjusted (SA) figure.  Seasonal adjustments are not as accurate during times in which markets have been roiled.  This is because it changes the way the data normally behaves.  Further, all kinds of government-driven initiatives to foster a rebound play havoc with the way the SA is calculated.  The NSA reading has shown a decline in home prices for four-straight months; the SA reading continues to show price increases as of January.  We’ll see if the SA data turns over during the next couple of reports.

The Richmond Fed survey should post nice numbers as the manufacturing sector is hot, although this region has not been one of the more robust as it showed factory activity contracted for two months straight in December and January.  Still, the market expects a good number.

The latest consumer confidence reading, there are a few but this one from the Conference Board is really the best indicator on the subject.  The measure has improved from the all-time low (by far a record low) hit in February 2009, but has been unable to rise from its still lowly range it’s been trapped in for 18 months.  We’re still waiting for this reading to make it into the 60 handle, which would mark a breakout from past recession lows.  It will ultimately take substantial job growth to break the number from its current range and consistent labor-market improvement to get this reading above 80, which is the level achieved at the beginning of all previous expansion – expect for this one. 

On CAT earnings:

While CAT’s profits were better-than-expected, a 28% increase in operating profit off of results from a year ago that were down 73% from the year before that is not terribly impressive.  Of course I realize that stocks trade on expectations, but this one has jumped three fold and now sits just 10% from its 2008 high even though sales were double what they are currently and profit was four times greater back in 2008.  And what would CAT profits look like if not for the gargantuan stimulus from China, which is fueling most of the industrial/infrastructure growth.   What happens when this short-term stimulus is removed?  Sales were down again, falling 11% from depressed levels of a year ago.  

*Only via involuntary sources thus far, such as banks reducing credit-card lines and foreclosures (this is an expansion upon the household debt level comment above).

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900