U.S. stocks broke to the upside in the final 20 minutes of trading on Friday to book a second day of gains.  The broad market spent most of the session in negative territory after May retail sales missed expectations by possibly the largest margin ever, but basic material and technology shares led a rally late in the afternoon to overcome the weakness.

Eight of the 10 major industry groups gained ground for the session, again with materials and tech leading the way.  Utility and consumer staple shares were the only two groups to close the session lower.

For the week, the broad market (as measured by the S&P 500) gained 2.5%, which erases the prior week’s decline; the index is 10.2% below its 19-month high hit on April 23.  The Dow Industrial Average picked up 2.8% for the week, and remains 8.8% below its recent high.  The NASDAQ Composite rose 1.1%, and is currently 11.3% off its most recent high mark.

Market Activity for June 11, 2010

Retail Sales (May)

The Commerce Department released an ugly retail sales report for May as the headline figure slid 1.2% and ex autos were down 1.1%.  This follows two big months as headline retail sales for March jumped 2.1% with a 0.6% increase in April.  Excluding autos, March sales gained 1.2% and were up 0.6% in April – with that robust back-to-back activity you could kind of see weakness setting up for May. 

As unemployment insurance winds down, those extensions that deliver government cash to the unemployed for up to 99 weeks, and the tax credit funds are now spent we’re back to organic fundamentals and that means more tepid spending.  Further, we’ve likely already seen the bounce that results from pent up demand, specifically luxury purchases that will wane in terms of year-on-year growth -- and any additional downside to stocks will not be kind to this segment.

Most of the May retail sales damage came from precisely the items that were goosed by the government.  Building material sales were crushed in May, down 9.3% -- which follows huge 8% increases in March and April.  The government subsidy to home buyers brought activity forward and that means we now feel the hangover.  Autos were down 1.7% after up 0.6% in April and a massive 6.6% in March.  It was interesting that autos fell so much as incentives were active in May, pretty big rebates and the return of zero down/zero financing for the best credits. 

The other components showing weakness: Gasoline station sales were down a large 3.3%; clothing sales were down 1.3%; general merchandise sales off by 1.1%; department stores were down 1.8%. 

On the bright side, Non-store retailer sales (internet) were up 2.0% -- an offset to that 1.8% decline in the department store segment; furniture was up 1.0% -- so there was still some tax credit spending in May; electronics sales gained 0.6% after two months of decline; food & beverage was up 0.3%; and sporting goods gained 0.4%.

So most of the pressure came from building materials, which will show a new round of weakness for several months, and autos.  But even removing building materials, autos and gasoline from retail sales (known as core sales and the figure that funnels directly into the GDP report) sales were up just 0.1% after April’s 0.2% decline.

Unless we get a big core reading for June, we’ll see significant weakness from the largest segment of GDP (personal consumption) and that means a weaker-than-expected second-quarter growth reading. 

Business Inventories

The Commerce Department reported that business inventories rose 0.4% in April, which follows the 0.7% increase for March and makes for the fourth consecutive monthly gain.  Inventory rebuilding occurred in every major segment except autos, which declined 0.4%.

The all important sales data showed a 0.6% increase, following the huge 2.5% jump in March.  Business sales have increased for 13-straight months.  The inventory-to-sales (IS) ratio held at the record low of 1.23 months worth. 

(The chart below shows that when the market is left to correct/adjust to changes in the economic environment the adjustments process is shortened.  It is harsher in the short term, but the shift back to the production cycle is swift – what I’m referring to is that spike in the IS figure, which means production all but shut down to reduce inventories, but as sales came back stockpiles slid again and production could restart.  Within the housing market, just the opposite has occurred, and it is because Washington has jump in with all of its quick “fixes.”  In fact, these actions don’t deliver a quick adjustment period at all, but merely delays the arrival of the production cycle.)

So, the inventory rebuilding process continues to play out and so long as sales continue to rise we’ll see at least mild production levels that are necessary to keep stockpiles from falling to new lows. 

My feel is business sales will slump in the near future, probably around when the August/September data is released.  Why? Well, it’s based largely on negative housing-market fundamentals.  A new round of price declines (as the tax credit has run its course and we now deal with the hangover of that subsidy, which pulled activity forward) are pretty much inevitable in my view as sales will be insufficient to absorb the coming supply – distressed properties will jump and put additional pressure on prices.  This has implication for credit quality, which means banks will have to set aside more provisions, corporate profits will suffer and we’ll have firms becoming even more cautious.

And this caution, already apparent, is what has the IS ratio at record low levels.  Firms are not sure this recovery is long-lasting and they’ll remain chary with their cash if another round of housing weakness ensues.  In addition, European banks are heavily exposed to euro-zone government debt, which has the business community wondering if Europe can even contribute to global growth, and increased regulations and higher tax rates result in their own uncertainties.  This has implications for production and hiring.  I’m not prepared to say we’ll see an economic double dip by year end, but soon after. 

If this take on economic realities is inaccurate, then firms will find reason to boost inventory levels for another several quarters and this will help to offset the invariable drag from consumer activity and construction -- at which point we’ll still have debt problems to deal with and slow growth is not enough to fuel significant and prolonged employment gains. 

On the other hand, if this assessment is largely correct, we’ve got significant weakness coming a couple of quarters out -- whether GDP actually prints negative readings again by Q1 2011 or two-three quarter beyond hardly matters.  As GDP weakens, it will become even more obvious that this recovery is not normal, which means continued volatility for stocks and additional pressure to the downside.  Consumer activity (particularly from the well-off/affluent) is heavily dependent upon the direction of stock prices. 

Have a great day!

Brent Vondera, Senior Analyst