23 March 2010

Economy and equity markets: are they disconnected?

saSince July 2009 I have been ambivalent with equity markets after their strong recovery from March low and continued weak economic data. The magnificent 7 indicators are all favorable and therefore tell us that there is nothing to panic about equity markets. But is this disconnected from the economic reality? So, let’s review a number of economic indicators. More than the numbers themselves, I will be looking at trends. In this analysis, I will neither review the situation of the financial sector nor the housing sector.
1. GDP breakdown
The second estimate of the fourth-quarter increase in real GDP is 0.2% higher than the advance estimate at 5.9% annualized, primarily reflected upward revisions to private inventory investment, exports and nonresidential fixed investment that were partly offset by an upward revision to imports and downward revisions to personal consumption expenditures and to state and local government spending.
The trend is definitely improving. The next 2 quarters will tell us whether we may get into a second dip recession. Today, I tend to give the GDP the benefit of the doubt.
The Conference Board Leading Economic Index increased 0.1% in February (+0.3% in January and +1.2% in December) pointing to a slow recovery, but a recovery nonetheless.
Ken Goldstein, Economist at The Conference Board: "The indicators point to a slow recovery this summer. Going forward, the big question remains the strength of demand. Without increased consumer demand, job growth will likely be minimal over the next few months."
2. Consumption
Personal disposable income has grown for 5 month in a row until it decreased in January due to an increase in federal non-withheld income taxes according to the Bureau of Economic Analysis. At the same time, the personal consumption expenditures went up for the 9th consecutive month in January (+ $52.4 billion). The personal saving rate decreased to 3.3% from 4.2% in December, but is now in solid favorable territory, even if I would like to eventually see it in the 7-8% region.
The trend is positive. In my opinion, pay checks given by the Bush and Obama administrations were used to repair households’ balance sheets during H1 2009, and now we are witnessing a non-subsidized consumption growth.
Household debt service payments and household financial obligations as a percent of disposable personal income have also decreased from 13.92% and 18.87% in Q1 2008 to 12.60% and 17.51% in Q4 2009 respectively.
All this translated into an improving picture for retail sales.
3. Unemployment
Unemployment seems to have stabilized with an unemployment rate of 9.7% in February and 14.9 million unemployed; the number increases to 16.2% and 24.9 million unemployed if we add part-time workers for economic reasons and discouraged workers, but slightly off the high reached a coupe of months ago. However, the number of discouraged workers continues to increase unabated to 1.2 million people (+65% compared to February 2009 and + 13% compared to January 2010) .
The employment situation, according to the establishment data, confirms this stabilization. Total non-farm employment went down 36,000 in February vs. -26,000 in January, -726,000 in February 2009 and -109,000 in December. Weekly hours worked also point toward a stabilization.
The diffusion index for the total private sector dramatically improved to 48.0 in February vs. 44.2 in January, 39.6 in December and 17.1 in February 2009 (50 percent indicates an equal balance between industries with increasing and decreasing employment). The diffusion index for manufacturing jumped to 54.9 in February vs. 40.9 a month earlier.

4. Banks’ lending
In February, banks continued to shrink commercial loans for the 16th month in a row, shedding an additional $17 billion; total commercial loans outstanding are back to the summer 2007 and $345 billion below the peak reached in October 2008 ($1,645.6 billion).
Whilst this is negative for growth as a whole since less credit is available, I take it as a favorable element in what was an economy built on over-indebtedness steroids, particularly at the household level, and the system has to be purged.

In addition, the rate of decline seems to be arriving at or near a trough.
5. Net export of goods and services
The balance of net export of goods and services dramatically improved, whilst higher again for the last two quarters, to represent a $449 billion deficit. This suggests that the US trade deficit will have a long way to really get any closer to being balance.
As soon as the economy will improve on a sustainable basis, energy and commodities prices will forge ahead and will add more weigh on the US trade balance. Any oil alternative like gas or shale gas, will take some time to gap the national output/consumption imbalance, but worth watching since it could change the ball game.
Equity markets have anticipated the economic recovery which is in its infancy. The important indicators are at worse stabilizing. Markets paused in July and again in January/February to go back to their previous high and extend to new post crisis highs.
As of today, market patterns are justified by economic data. However, on a simple valuation based on Shiller’s cyclically adjusted PER, the S&P 500 is becoming expensive at 21.3 x earnings on March 18 vs. 13.3 x in April 2009 and an average of 16.4 x. On a simple PER basis, the S&P 500 is trading at the top of its mid 30s - mid 90s range but well below its mid 90s – 2008 exuberance.
I conclude that equity markets are not disconnected from the real economy and there no reason, under the current circumstances, to fear a market collapse. The S&P is however no longer cheap and, despite a good earning season, I would continue to selectively buy on weakness quality stocks having displayed their ability to pay dividends. I would favor energy (oil in particular), technology and consumer companies with worldwide brands (P&G, Nestlé, Unilever, J&J for example) as well as “progressing” markets (terminology that I prefer to emerging) and stay wary of bank’s stock at least in the "regressing" world (i.e. developed).
Monetary policy will remain accommodative until the real estate market has fully recovered and don't forget, “never fight the FED”. As my friend, Jacques-Henri Gaulard, Managing Partner of Autonomous Research – a top notch independent research firm specializing on the financial sector -, says about interest rates : "we have moved from L4L to L4E – Low for Longer to Low for Ever…"


Bureau of Economic Analysis: National Economic Accounts

The Conference Board: Global Business Cycle Indicators

Bureau of Labor Statistics: Employment Situation

Federal Reserve Bank of St Louis: Economic Research

Yale Department of Economics: Robert Shiller Online data
FullerMoney: S&P 500 Graph

Markets & Beyond: The Magnificent 7 and Equity Markets
Autonomous Research