U.S. stocks fell yesterday after the latest data on housing showed prices declined in July.  There also appeared to be some confusion out there with regard to the Fed that may have played a role in the market’s decline – the decline among the major indices was pretty slight though so I wouldn’t make too much of these issue just yet.  

The Federal Housing Finance Agency’s Home Price Index posted a 0.5% decline for July (on a month-over-month basis) and the way data has been revised down lately next month we may find the drop was worse – June’s decline, initially posted as -0.3% was revised down to show a slide of 1.2%.  On a year-over-year basis, this measure of home prices has posted eight months of decrease. 

With regard to the market’s reaction to the Fed, there were two things going on – and when I make these statements I’m going off of press reports that quote traders.  One camp appeared to doubt whether the Fed’s statement really signaled they’ll be implementing the next round of quantitative easing.  The negative tone of the statement seemed to worry others that may have been holding out for evidence that the past three months of weak data was nothing but a transitory slump. 

I don’t believe either of these camps are on the right page.  The next round of QE2 is coming and the weaker economic data is not some statistical fluke, or a so-called mid-cycle slowdown (which is a ridiculous thought in and of itself – one only wishes we were in a mid-cycle stage since that would mean we’d have enjoyed a couple of years of 3%-plus growth by now and a much much lower jobless rate). 

Four of the 10 major industry groups closed higher for the session, led by utility shares as safe-havens outperformed – but not totally. 

Again, finding sector themes is incredibly difficult, if not futile thanks to the Fed, in this environment as the highly cyclical sectors have had a tendency to move in tandem with traditional areas of safety.  As the Fed is prepared to go even more unconventional, you see this combination of safety/dividend stocks (plays on the low interest-rate/weak economic environ) mingling with commodity-related stocks (fueled by the Fed signaling they’ll work to manufacture inflation via dollar depreciation).  But one has to be very careful because if the data trends lower from here you’ll get smack silly by the cyclical trade. 

Market Activity for September 22, 2010

Mortgage Apps

The Mortgage Bankers Association reported that their applications index fell for a third-straight week, down 1.4% for the week ended September 17 -- even as the average contract interest rate on the 30-year fixed mortgage fell back to 4.44%. 

Both refinancing activity and purchases drove the index lower as refis slipped 0.9% (after the prior week’s 10.8% slide) and apps to purchase a home fell 3.3% (following the slight 0.4% decline in the prior week).

The applications index is indicating that existing-home sales for the next three reporting months will fail to bounce.  The trend in apps appear to be signaling that home sale will come in flat-to-down for August (a report we get this morning), rebound by the September report, but fall off again in October (assuming the final two weeks of September apps don’t rebound in a big way). 

The consensus estimate is for sales to rise 7.2% in today’s August report, following July’s record 27.2% plunge, but apps in late June and July don’t signal such a move.  Apps picked up again, on a relative basis, over the previous couple of weeks and that bodes well for the September sales report yet this latest apps reading doesn’t augur well for the October report. 

I should mention that it is very tough to gauge the timeline of contract signings to closings, and thus how the monthly sales reports will turn out based on applications activity.  (Previously-owned home sales are counted when the contract closes.)

In general though, sales are floored and have no chance of really picking up until substantial levels of job creation ensue.

How Cheap Are Stocks?

The answer to this question obviously depends upon the future trajectory of profit growth.  The conventional wisdom is for S&P 500 earnings per share to grow 15-18% in 2011 to $90-$95.  This would put the multiple (P/E) on the S&P 500 at 12-13 times earnings based upon the current price of the index.  That’s historically cheap relative to the long-term average of 15.5 times earnings and the currently very low level of interest rates – even it is logical for stocks to trade cheaper than the historic average valuation in this environment (the risk of financial shock is elevated and there’s only one way for interest rates to go from here once we get out of this period of economic malaise).

But is it really that reasonable to believe the profit cycle has legs from here?

Look, there are very experienced strategists who believe the profit cycle will continue – and most seem to think it will continue at a furious pace. I believe some of this experience will come back to haunt those that are so confident in the trend this go around as they are being too myopic (basing things only on profit-cycle behavior over the past 30 years rather than adjusting their outlook for the after-math of a debt-led recession, which we currently find ourselves).

Just as all of those economists out there who believed the recovery would be v-shaped and followed by the normal multi-year expansion were dead wrong, so too are most equity-market strategists – it’s due to an unwillingness to view the world outside of normal business-cycle activity.  This recession was very different than “normal” and the profit cycle was driven by massive cost-cutting on the payroll front rather than revenue resurgence.  Without job growth, and businesses still show no desire to meaningfully add to payrolls, I don’t see how firms will find the final demand necessary to drive a sustained profit cycle.

And then, there’s the pretty good indicator of after-tax NIPA profits (what’s known as economic profits via the National Income and Product Accounts within the GDP reports, or after-tax profits from current production).  This profits measure has slowed to flat (up just 0.15% last quarter) from double-digit growth during the previous five quarters.  This gauge of profits has a tendency to lead accounting profits by two-three quarters, which says we should receive another very good earnings season for the third quarter, but tail off by the fourth and likely have run its course by Q1 2011. 

All of this said, I do believe a massive opportunity will once again present itself for the long-term investor.  Firms are streamlined like never before and as time eventually heals the debt problems and policy moves from a position of inhibiting this healing process to one that speeds the time of convalescence this economy will take off and profits and stock prices will come along for the ride (this comment on the direction of policy is key, the longer the shift takes the deeper we fall into this malaise and the time to pull out of it extends).  The problem is we’re not there yet, in my view, and the intermediate-term time period may still prove very tough to bear – one that puts pressure on stock values again and diminishes annualized rates of return, based on the current level of equity prices. 

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Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900