June 2007
The US stock market, as measured by the S&P 500 index, is now up about 28% from its June 2006 low posted almost exactly one year ago. Of course, just before that low was recorded, the stock market was experiencing quite a bit of valid nervousness following its 8% swoon from only a month earlier. Remember, gas prices were spiking, oil hit $75 per barrel, inflation was perking up and investors started rapidly fleeing the emerging financial markets in droves. It was ugly, but ever since that June 2006 low, it has literally been off to the races. Why and was it justified?
These are important questions to ask since it has a direct bearing on how an investor might prudently position their portfolio today. I must say, especially after a 28% run that has been nearly straight up, it won't surprise many to sense our continued cautionary tone.
The US economy is a good place to start our analysis of today's market conditions. Everything that comes out of nearly every bullish commentator's mouth should be prefaced with the following disclaimer/oath:
"I solemnly swear that I believe, with all of my heart and mind, that the real estate recession has bottomed and the consumer, whose spending is key to the health of our great nation's economic activity, will not miss a beat. Further, I also swear that I do not believe that the consumer will feel financially pinched by their declining home equity or the record cost of filling up their gas tanks. It is with these beliefs, and other unmentioned risks, I feel that my bullish commentary is firmly based on robust analysis rather than simply hope for continued good things to come."
U.S. 1st Quarter economic growth came in at a revised 0.6% change versus the 4th Quarter of last year. This was the slowest growth posted since early 2003. The blame was placed on corporate inventory drawdowns (not making as much stuff to sell and allowing spending to bring down inventory levels) and increased imports (again, we're not producing as much). It is important to note, the 2nd Quarter is likely to show a reversal of those two headwinds and growth is likely to be closer to 2% or even more.
Is this the beginning of a sustained up trend or is this a quarterly blip in a generally slow growth economy?
The housing market is also to blame for the 1st Quarter economic slowdown as overall existing home sales have dropped 10% from a year ago and home prices are just posting their first ever annual declines in history. It has been said that the drag from new home construction, which has fallen about 20% from a year ago, has dragged the overall GDP down by 1%. Fed Chairman, Ben Bernanke, just remarked today that they have indeed underestimated the duration of this drag and that investors should expect the slowdown in residential construction to last for a while. By the way, the largest, publicly traded national homebuilders have been saying that for some time now.
Is this new home construction recession all we should concern ourselves with or is the more important existing home market slowdown going to finally affect consumers' appetite for spending?
It is getting a bit old to mention, but one of the newest inventions of the early 2000s was the amazing adoption of easy-to-do home equity withdrawals. Most consumers are aware of how simple it has been to call your local bank and say you want to refinance your mortgage or get a large home equity line of credit. In a blink, consumers can basically start tapping their greatest savings vehicle known to man! What most people don't realize is that when home prices plateau or even start to fall (a once unheard possibility but actually happening on a national level), the home equity begins to dry up and the banks naturally get a little more careful about extending credit on that kind of collateral.
Are we starting to see this happening with the sub-prime mortgage issue? Is the quite large drop in home equity withdrawals going to affect spending negatively as it affected spending positively in years past?
It is important to remember that about 70% of our economy is driven by consumer spending and a good chunk of that is related to retail spending. This brings up another point and question. Overall retail sales have fallen quite abruptly since mid-year 2006.
Is the consumer's wallet healthy enough and will overall job growth and, more importantly, general income growth be enough to shelter the economy from this affect?
While nobody knows the future, one clue that has typically helped glean the direction of the economy has been the "index of leading economic indicators". This is an index made up of ten prime measures that tend to predict future economic activity. So, what is the index telling us? Ever since mid-2004, just one year after the stock market perked up from its 2000-2002 doldrums, the index of leading economic indicators has fallen. And it hasn't stopped dropping yet.
Does this measure have any validity anymore or has it lost its ability to help predict what is ahead?
Now, on the flipside, there are some things working for the financial markets. Spending has not slowed (quite surprisingly). Job growth has not been that weak, all things considered. Interest rates are still historically low and inflation appears to have peaked after last year's spike. This fact alone might give the Fed license to lower interest rates if an economic slowdown does appear imminent. All negatives become positives?
Add to the mix that profit margins are already at multi-decade record highs with labor's share is at multi-decade record lows. Not to mention that increasingly important European and Asian economies appear quite strong even as the US weakens. This global balance is pushing many to reconsider the old rules. Finally, it is hard to downplay the mood lifting affect of private equity buyouts and mergers & acquisition activity that seem to be announced everyday now. The combination of the above has given investors (is that too strong a word?) quite a rush in the past year.
Will this flurry of good news continue to outweigh the bad? Have stock prices already reflected the good and do current prices protect investors from the possibility of worsening economic conditions? Is it natural to feel protected by the (not so easy to explain) actions of others or should investors just hunker down and think for themselves? Finally, as for the 1st Quarter slowdown, was that all there was to it?
Here is a flippant answer to the last question, I'm not quite yet willing to just shut my eyes, tap my heels three times and say, "There's no place like home. There no place like home... "
Jason P. Tank, CFA
jason@frontstreet.com