The August unemployment report carried both good and bad news. Those who were looking for jobs and couldn’t find them, rose to 9.7% of the work force, the highest in 26 years but only 216,000 jobs were lost which was an improvement compared with recent months. We all expect the unemployment level to stay high for two reasons. First, it is a lagging indicator and may remain near 10% even if the economy continues to recover. Second corporations know that increasing revenues is difficult in the current economic environment and are slow to add workers even as business improves. You can see that in the impressive increase in productivity. According to a Goldman Sachs report 46% of the companies in the Standard and Poor’s 500 beat earnings estimates for the second quarter by a wide margin but only 23% had a significant increase in revenues. Perhaps the most encouraging recent sign of a better economy was the recent report of the Institute of Supply Management which moved up to a reading of 53. Anything over 50 is an indication that an expansion is underway in manufacturing, but some of the recent rise may be related to an increase in automobile production as a result of the “cash for clunkers” program. Indicators of service sector improvement are not doing so well.
While there seems to be agreement that the recession around the world has ended, investors have little confidence that economic growth in Europe or the United States will be strong. The American consumer, accounting for over 70% of spending is overleveraged as we all know and thinking more about reducing debt rather than adding to the burden through increased spending. Corporations are in better financial shape, but sluggish sales will discourage ambitious capital spending programs. The financial sector, which has recovered from a near meltdown a year ago, still has substantial toxic assets on its balance sheets and, as a result, has been careful about making new loans. It will be hard for the economy to show sustained growth at 3% or more if credit is tight. The housing industry has bottomed and homes are selling again but nobody expects a strong rebound. So investors expect a slow improvement in the economy, perhaps 2-3% real gross domestic product growth and therefore are wary that the equity market which has already increased more than 50% from its March low can make much progress from here.
Adding to this suspicion is the recognition that the biggest moves of a bear market low usually occur in the first six months. Also insider selling in August reached $6.1 billion, its highest level since May 2008 when the market was topping. Perhaps those insiders who see what is going on within their companies believe investor enthusiasm has gotten ahead of reality and are taking advantage of the recent market strength to lighten up on some of their holdings. A Barron’s survey of both buy and sell side strategists showed them estimating year-end 2009 targets for the S&P 500 ranging from 930 to 1175 with the current level of index at 1047. Most of the estimates cluster below 1100, so these observers do not expect much in the way of market performance between now and the beginning of next year. The recent trade flap between the United States and China revives protectionist concerns which is another negative.
If you are looking for good news, you are more likely to find it abroad. The economies of Continental Europe, perhaps because of its social “stabilizers” did not seem to suffer as much as the United States and seem to be on a path of slow recovery. Both China and India are continuing to show growth near their targets, the former above 7 % and the latter above 5%. At the beginning of the year there was widespread belief that both countries would suffer because of reduced demand for their exports from the West, but demand from their own internal economies plus the rest of Asia would appear to have offset reduced buying from European and American customers. There are some who believe that China has artificially pumped up its economy. Banks there have been lending aggressively and virtually its entire $585 billion stimulus program has been spent in an economy whose total size is $5 trillion. Much of that has gone into infrastructure spending which has both short and long term positive implications. The United States stimulus package is $787 billion, but our economy is three times the size of China’s and less than one-third of the total package has been spent. The strength abroad has helped U.S. exports, but unfortunately this is not an important enough component of the overall economy to provide a major thrust to growth. Rising exports is a positive for our trade balance but this has been offset by the increase in the price of imported oil which has increased by more than 60% since the beginning of the year.
The rise in the price of gold may be a sign that investors are worried that excessive money supply growth in major economics around the world would lead to rising inflation or weakening currencies or both. Also low interest rates on the 10-year U.S. Treasury could be an indication that investors are looking for safety and are reluctant to move up the risk curve in a time of uncertainty. At the beginning of the year President Obama’s approval ratings were extremely strong with the Gallup poll approaching 70%. That reading has fallen to 52% and other polls have shown a similar drop. This fall in popularity reflects continuing problems in economic performance and high unemployment. A lack of meaningful progress in Iraq and Afghanistan and our continuing, and possibly increasing, military involvement there has also diminished confidence in the Administration. At the beginning of the year most Americans thought the idea of healthcare reform was a good one, but support seemed to decline as the possibility emerged that existing employer coverage might be changed in order to cover the uninsured. Close to 70% of voters believe they currently have good to excellent coverage and the number who believe the current healthcare system is good or excellent has improved from 29% in July of the last year to 48% this past summer. Healthcare reform is the top policy item on the President’s agenda and his difficulties in getting the legislation into a position where it can be passed has hurt him. Enthusiasm for Washington leadership would provide a positive background for the market, but Obama’s challenges with healthcare, the two wars in the Middle East, and the economy are hurting him.
But there are some favorable signs. Merger and acquisition activity is picking up around the world. A number of cross border and domestic deals have been announced. There has been a sharp rise in temporary employment which may be a precursor of an ultimate improvement in permanent job creation. Employment surveys in Latin America, Europe and Asia have improved. Car sales have almost doubled in China over the past year indicating that consumers there are starting to spend a little more rather than save. Exports in Germany and Taiwan are up. Corporate profits in Japan are up sharply and housing appears to be improving everywhere. Inflation is clearly under control in spite of rising commodity prices. Wages are flat and without some pressure from employees for higher compensation prices are likely to stay in line.
The September and October period has historically been a difficult time for the financial markets. With the market having done so well in the spring and summer it seems reasonable to expect either a correction or a period of consolidation. The market move since March has been characterized by lower quality speculative issues and this has been true in the bond market as well. This represents an opportunity for the indexes (composed of higher quality stocks) to move out of their trading range. Most observers believe the S&P 500 will have trouble moving above 1100 or below 900 so stock selection will be key to performance since the market itself will not provide much help. In the bond market higher yield securities have done particularly well over the past six months and many credit market investors believe it is time for some consolidation there as well. The consensus operating earnings estimate for the S&P 500 for 2010 is about $75, but if the economy is somewhat stronger than most observers expect, it would be easy to see operating earnings reaching $80. The long term average multiple of the index is 15 times, so this would mean that we could see a level of 1200 over the next year. There is considerable resistance in the form of supply at market levels above 1200, but if the fundamentals are stronger than expected, a move to that level is quite possible. The fact that few expect it makes it more likely.
There is a growing feeling that sometime in 2010 both the economy and the market will run out of steam. The stimulus program will have been spent and earnings may start to falter. This is creating a cloud of caution over equities. But near term fundamentals may prove sufficiently positive to convert that concern to something more constructive and that’s why I believe the next important move in the market is to higher levels. For some time I have had difficulty identifying the natural economic force that will sustain the market when the stimulus is no longer a factor. In the 1990’s it was technology, the cell phone and the Internet. In the current decade it was housing, consumer spending and easy credit. I can’t identify a set of drivers that will take over when government spending is no longer there. Perhaps one cannot see this before it appears. A lack of visibility keeps many on the sidelines. Whether the near term strength of the economy and the market will prove enough to draw them into the market as participants is uncertain. I think the news will be good enough to do that. Whether the economy maintains its strength through 2010 is less certain, but I believe we will see the market at higher levels before that becomes clear. If the economy flags next year, it is possible we will see a second stimulus round, but the market’s reaction to that and the additional borrowing that would go with it would probably not be positive.
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The Blackstone Group
345 Park Avenue
New York, NY 10154