Economic perspectives – July 30, 2009

Russell T. Price, CFA – Sr. Economist

Could the "Great Recession" be nearing its end?

• The "Great Recession" may be nearing its end: We currently expect U.S. Real GDP to show slight positive expansion in the third quarter. Although recessions are no-longer measured solely on the basis of GDP performance, we believe the worst economic period in more than 70 years could well be nearing its end.
• Stronger than expected corporate profits: With the second quarter earnings release season more than half-way complete, a high percentage of companies in a wide range industries have reported better than expected results. Aggressive cost cutting has fueled these gains as it normally does at this point in the cycle.
• Housing finally shows some life: The housing market has shown some encouraging signs of late. New and existing home sales were each higher in the month of June and prices appear to be firming, in some cases even rising, in some of the country's hardest hit regions.
• Rebound likely to be modest: The pace of U.S. economic expansion through 2012 could be modest in our opinion. We have confidence in the economy's prospects for recovery but the harm that has been inflicted on the balance sheets of consumers, financial institutions, businesses and government has been significant and will take some time to repair.
• Not banking on the consumer just yet: We still expect the unemployment rate (a lagging economic indicator) to peak at about 10.2% by late 2009 /early 2010. Our research shows that stock prices have bottomed before the unemployment rate has peaked in every recession since 1945 with an average lead time of 8.3 months.

Key economic data

Economic estimates are consensus estimates as surveyed by the most recent Wall Street Journal survey * = Number based on average through May. ** = Number based on most recent rate
Historical data and Fist Call consensus estimates for the S&P 500 via Baseline

Are the gains justified?
Since its close on March 9th at 676.53, the S&P 500 has surged approximately 44%, while the tech-heavy NASDAQ Composite has registered an even larger 55% gain (as of 07/29/09). Have improving economic fundamentals really been strong enough to support such gains?

Economic trends have been improving lately but they are not the sole influence behind the market's recent swell. A portion of the equity market's strong recovery of the last 4 months may be attributed to a perceived reduction in specific threats such as financial sector health (which appears to have improved considerably), auto sector bankruptcy implications (which have now proceeded without much residual damage), and the potential for huge government indicted changes in the health care and energy sectors (the magnitude and scope of which appear to be easing). The primary fuel however, has been investor reaction to encouraging economic signals, and more recently, better than expected corporate profitability. In aggregate, we do believe underlying economic indicators, combined with forward corporate profit expectations, are supportive of current market valuations, as a slow yet sustainable improvement in economic growth seems to be taking hold.

In recent months we have seen improvements in a broad array of economic indictors. After very sharp declines in the second half of 2008, consumer end-demand appears to have stabilized; this combined with the inventory reduction efforts of the business community has equated to improving factory orders and production levels. Even in the housing sector, prices appear to have finally reached levels where they are re-stimulating demand. Existing single family home sales have risen in 4 of the last 5 months and new home sales hit an 11-month high in June. The stock market itself is also a leading economic indicator. Better than 50% of American households have direct or indirect stock market holdings; and although stock prices in general are still approximately 38% below their peak levels as attained in October 2007 (as measured by the S&P 500), the market's recent gains come as a very welcome development for investor wealth perceptions. According to Federal Reserve data, Americans witnessed a reduction of almost $14 trillion (22%) in their total net worth between Q2-2007 and Q1-2009. The recent surge in stock prices has allowed investors to not only breath somewhat of a sigh of relief when opening their financial statements, but the $3.5 trillion gain in total U.S. equity values since early March (according to Bloomberg data) has offset at least some of these losses.

Significant economic challenges remain but we believe many of the economy's imbalances enter the second half of 2009 in much healthier condition, and still making progress. We expect further economic improvements to emerge over the months ahead, particularly as allocations under the Federal Government's fiscal stimulus plan ramp-up in the second half of the year and into 2010. We believe the U.S. economy could see an end to its current recession in the current quarter (Q3). Good riddance.

Are economic fundamentals really improving? The evidence…

Leading Economic Indicators (LEI) suggest improvement on the horizon:
The Conference Board's Index of Leading Economic Indicators has risen for 3 consecutive months, thus bringing the overall index to its best level in 11 months. The LEI Index has not seen its 3-month annualized rate of growth expand this quickly since mid-2003.

Dramatic turnaround in Leading Indicators conference board leading index, % change

Charts source: Conference Board, Moody's economy.com

Consumer demand appears to have stabilized:
Consumer spending remains exceptionally weak but it has shown some signs of improvement over the last few months. Consumers are actively deleveraging as evidenced by falling credit balances and a rising savings rate, but factors associated with the Federal Government's stimulus plan recently provided most consumers with a few extra dollars to spend. Most working American's experienced a small payroll tax cut beginning in April, and approximately 55 million Social Security recipients received a one-time check for $250 in May. Our outlook for a resumption of U.S. economic expansion in the second-half of the year, however, is not dependent on the consumer. In fact, we expect consumer spending to remain fairly flat for a few more months at least. Over time, spending should slowly recover as confidence levels rebound amid improving economic fundamentals.

Over the last nine months, total disposable income has grown by 3.9% but total consumer spending has declined 1.7%, thus enabling the personal savings rate to jump to 6.9% in May. As shown in the chart at left below, total consumer spending posted fractional gains in both May and June. Retail sales, which account for 45% to 50% of total consumer spending, also appear to have seen their worst. After a huge 10% drop in the second-half of 2008, retail sales have shown modest growth in recent months (see chart at right below). June retail sales were the second best of the year and represented a 1.7% increase over 2008 year-ending levels. Note: the charts below represent seasonally adjusted data and are sourced from the Commerce Dept. and Baseline.

Total Consumer Spending:

Total Retail Sales:

Tighter inventories offer a point of potential leverage: U.S. businesses have cut their inventory levels by approximately $143 billion, or about 9.4%, over the last 10 months (through May). Lean inventory levels can be a strong source of fuel for an economy once demand stabilizes and businesses look to replenish shelves that were previously taken down to the bare minimum.

Business Inventories, % change

Source: Commerce Department, Moody's economy.com

Manufacturing activity: In June, manufacturers responding to the Institute of Supply Management's (ISM) Manufacturing survey reported their first month-over-month expansion of production since August 2008. The gains for this national index are particularly encouraging given the temporary production shut-downs at Chrysler, General Motors and many of their suppliers during the month.

The ISM Manufacturing Index - Production component. This is a diffusion index, meaning numbers above 50 indicate month-over-month expansion while numbers below 50 indicate mo/mo contraction.

ISM Production Index July 27, 2009

Source: ISM, Baseline

Factory Orders: New factory orders were also higher on a month-over-month basis in both April and May (see chart at left below). The improvements represent the first consecutive month-over-month gains for the series since last July. The ISM's New Orders Index has provided confirmation to the growth in new order activity (see chart at right below). As with the chart above, this is a diffusion index, meaning numbers above 50 indicate month-over-month expansion while numbers below 50 indicate mo/mo contraction.

Factory orders % change month ago

Source: Commerce Department, Moody's economy.com

ISM New Orders Index July 27, 2009

Source: ISM, Baseline

Economic outlook: Could Q3 mark the end of the "Great Recession"?
We recently revised our Q2 U.S. GDP estimate to show a smaller contraction than previously forecast. We now estimate Q2 U.S. Real GDP to have contracted by about 1.6%, as compared to our prior estimate for a 2.2% decline. Better than expected data on trade, new home construction and, to a lesser extent, consumer spending contributed to our modestly improved outlook of economic activity in the period.

The trade balance issue is particularly noteworthy. The real U.S. trade deficit for May of -$36.2 billion was its lowest since December 1999. U.S. exports were down 24% versus the year-ago in May, but imports were down an even more notable 34% (these figures are on a constant dollar basis, thus they are not influenced by fluctuating crude oil prices). This is not a one quarter phenomenon. The improving trade picture added 2.2 percentage points to GDP growth in the first quarter of this year, and has averaged a 1.2 percentage point contribution to each of the last 10 quarters. By and large, these improvements reflect the lagging benefit of a weaker U.S. dollar.

Trade Deficit July 28, 2009 $ Billions, SAAR

Source: BEA, Baseline

Forward economic estimates: Consensus views of forward U.S. economic growth have improved slightly over the last month. The sharp inventory cuts seen in Q1, combined with the recent evidence of a bottoming process developing in the broader economy, have offered some positive implications.

Ameriprise Advisor Services GDP Outlook

Chart Source: Ameriprise Advisor Services, Commerce Dept.

Importantly, our forecast of a second-half improvement in U.S. economic activity is NOT dependent on a resurgent consumer. In fact, we expect consumer spending remain fairly flat in the third quarter before posting a paltry 0.3% gain in the fourth quarter.

Corporate profits: Corporate profits better than expected by a wide margin.
The Q2 corporate earnings release season is just past the half-way mark as of this writing. Thus far, results have been notably better than expected with outperformance seen across a fairly wide range of industries. According to Thompson Reuters, of the 263 S&P 500 companies to have reported results through July 28th, 76% have posted better than expected results while only 14% have come-up short. At this stage, profits are almost universally being fueled by aggressive cost cutting. This is a very normal development at this point in the cycle. Revenue growth will eventually come as the economy recovers but we believe investors could be making a mistake in placing too much emphasis on searching for signs of revenue expansion just yet.

Although results are outperforming estimates, corporate profits are still substantially below year-ago levels. A blend of actual results for S&P 500 companies that have already reported, and estimates for those yet to report, shows Q2 earnings estimated to be down about 31% yr/yr. Estimates for the third quarter currently look for a 18% yr/yr decline while corporate profits for Q4 are expected to show a strong 34% yr/yr gain.

The forecast for Q4 may appear overly-optimistic at first blush (and we do expect it may come-down a bit), but there are legitimate factors which we believe should boost results on a yr/yr basis by year-end. First and foremost, the huge losses taken in the banking sector during the fourth quarter of 2008 will make for very easy comparisons in this year's final quarter. According to Bloomberg data, write-offs and charges in the financial sector peaked in Q4-2008 as companies took charges and write-downs totaling a massive $243 billion. By comparison, charges and write-offs dropped to $102 billion in Q1-2009, and look to be much lower still in Q2. Energy sector profits should also recover somewhat in the second half of the year on stabilizing commodity prices, and companies in a broad range of industries should be seeing the benefit of recent drastic restructuring actions. Should these estimates for the year hold true, it would place trailing twelve-month S&P 500 earnings at a low of $53.75 by third quarters' end (we will refer to this figure later in our S&P 500 outlook) – a 42% decline from the cyclical high of $92.25 as attained in Q2-2007. By year-end trailing twelve-month earnings are estimates to be at $57.99.

Current estimates for the S&P 500 and its components:

Year-over-year Operating EPS growth Estimates:

Chart Source: First Call via Baseline Financial, data as of 07/28/2009

Stocks typically bottom long before the economy:
We have highlighted the following data in the table below for the last few months. We believe this historical view of stock performance during economic turning points offers valuable insights for investors at this stage so we intend to re-publish it for a few more months as well.

Our research, as reflected in the table below, shows that in almost every recession since 1960 stock prices have hit bottom about 9 months prior to the eventual bottom in corporate profits. The lone exception to this was the recession of 2001 when stocks had much more to "give-back" from a valuation perspective.

Recessions and stock performance: A historical perspective.

Data as of 06/29/2009
* Prior to 1947 U.S. Real GDP available only on a yearly basis
** Ameriprise Advisor Services estimate
TTM: Trailing Twelve Month basis
Source: AASI, BEA, Baseline, economy.com, National Bureau of Economic Research (NBER)

How to read the above table:
Taking the recession of 1990-1991 as an example: from peak to trough Real GDP in the recession of 1990-'91 declined by 1.3% and there were two quarters between said peak and trough. Corporate profits meanwhile fell 37.5% from their peak to their trough during this period and there were 37 months between these highs and lows. The S&P 500 declined a total of 14.8% from its high point to its low point during the period (based on month-ending values) and there were 4 months between these occurrences. The stock market hit its low 24 months before corporate profits saw their low for the period and unemployment rose by 2.6 percentage points, from a low of 5.2% to a high of 7.8%. Stock prices also bottomed 21 months ahead of the eventual peak in the unemployment rate.

Putting this data to work:
As investors, how can we use this information and apply it to the current cycle? We also went back and looked at how valuation multiples performed during prior cycles. Given that our research (as outlined in the previous chart) indicated that stock prices typically begin to move higher 9.3 months ahead of the eventual bottom in corporate profitability, it equates that valuation multiples have historically also hit their low at the time of the stock market low. In other words, if this past February's month-ending close for the S&P 500 of 735.09 was indeed the low for this cycle, then we would expect the P/E ratio at that time to have also been the low for this cycle (i.e. because the denominator, earnings, are still falling). The P/E ratio at the end of February was 10.7. Historically, we have found that by the time corporate earnings did reach their lows (9.3 months later), P/E multiples were 68% higher on average. Excluding the 2001 recession when valuation multiples were still well above their historical norms, the average cycle low for the P/E metric was 11.3 with P/E ratios rising to an average of 18.3 by the time corporate profits hit their low. Thus, from these historical averages we can get a sense of where stocks prices could be headed. If we assume that the third quarter of this year will indeed mark the low in the current corporate profit cycle, and that current forward estimates are close to correct, we can follow the resulting math: $53.75 * (10.7 * 168% = 18.0). These numbers suggest a possible value for the S&P 500 of 968 at third quarters' end. This is slightly below current S&P 500 levels (975.15 close on 07/29), however, taking these assumptions out to Q4 ending values suggests a possible 1044 level at year end. In these examples the resulting P/E ratio equates to 18.0 – slightly below the historical average. Our Senior Market Strategist, Marc Zabicki, CFA, currently forecasts a year-ending level for the S&P 500 of 980 but this estimate is currently under review. Based on First Call full-year S&P 500 earnings estimates this equates to an estimated year-ending P/E of 16.8.

Housing market update:
The housing market has actually shown signs of life over the last few months. New and existing home sales were both higher in the month of June, and home prices in some of the worst hit geographies across the nation appear to be firming. New residential construction activity also seems to be firming sooner than we had anticipated with new starts rising for three consecutive months through June. As we have pointed out in recent reports, the number of new homes available for sale on the market has declined substantially and is now below historical support levels. Though we expect new home construction to bottom this year, we still expect average selling prices for existing homes to decline into 2010.

As shown in the associated charts, builders have cut back substantially in their new construction activity over the last 3 years. This has allowed the number of completed new homes for sale on the market to fall back near historical lows – and in recent months, below historical lows. Inventories are a key to correcting the prior imbalances of the housing sector. New home inventories hit their historical support level in April and the pace of existing home sales should see further support from distressed sales. Home prices however, will likely not see their bottom until 2010.

First and foremost, builders must eliminate excess inventory before the sector is likely to see a legitimate bottom. Fortunately, we believe strong progress is being made on this front. During the month of April, builders started construction on the fewest number of new homes for any month since 1959, when records were first compiled.

Monthly housing starts
(seasonally adjusted annualized rates)

Source: Ameriprise Advisor Services, Inc., Commerce Dept.

Over the last thirty years, the number of new homes available for sale has rarely fallen below the 300,000 level, regardless of economic conditions. We also note that the chart at right has NOT been adjusted for population growth (U.S. population has grown by approx. 50% over the period shown). Inventory levels broke below the 300,000 unit mark in April and ended the month of June at 282,000 (over the last 6 months inventory levels have been dropping by an average of 11,700 units). We believe a moderate overcorrection is likely on this measure, but given the growing population and household formation we believe pent-up demand is building and thus will aid a recovery for the sector in the years ahead.

New Homes Available for Sale (inventory)

Chart source: Ameriprise Advisor Services, Inc., U.S. Commerce Dept.

Summary:
We expect the U.S. economy to resume an expansionary pace in the second half of the year. We believe the growth drivers in the second half will come from a variety of factors. First, the vast bulk of spending under the Federal government's recently enacted stimulus legislation is slated to be allocated in the second half of 2009 and into 2010. Secondly, businesses have been cutting inventory levels aggressively and such actions will provide leverage to any improvement in demand. Third, consumer pent-up demand is building. As an example, U.S. light vehicle sales have been running at an average annualized pace of about 9.5 to 10.0 million units over the last several months. By comparison, the United States scrapped 13 million light vehicles in 2007. Fourth, many consumers will face lower monthly mortgage costs due to recent mortgage refinancing activity, while higher stock prices should also help rebuild consumer confidence and perceptions of wealth. Fifth, consumers should enjoy comparatively lower energy costs in the months ahead. Notably, home heating bills should come as a welcome surprise to consumers next winter based on the recent collapse of natural gas prices (utility supply contracts are typically negotiated in the late Spring). Finally, corporate restructuring actions should boost corporate profitability in the quarters ahead, and leverage profits when demand improves.

Risks:
While we have confidence in our economic outlook, we recognize that serious economic and financial market challenges remain. Recent credit market turmoil has widely been seen as the greatest risk to the global financial system in a generation. Despite what we believe are signs of improvement in this space, notable risks remain evident and the improvements could unexpectedly reverse due to any number of unforeseen circumstances. The ongoing correction in the U.S. housing market also raises the risk of a prolonged or deeper than expected economic contraction especially if consumer access to credit remains constrained. Commercial mortgage default rates are also rising and could pose yet another hit to the financial system in the quarters ahead. Given these uncertainties, stock prices are likely to remain volatile over the intermediate-term. Terrorism and geopolitical turmoil are also significant factors capable of producing negative economic shocks.

Director of Research Lyle B. Schonberger
SECTOR ANALYSTS	PORTFOLIO STRATEGY ANALYSTS	FIXED INCOME LIAISON Marc A. Zabicki, CFA
Consumer Goods and Services Patrick Diedrickson, CFA	Economic Strategist Russell T. Price, CFA	ADMINISTRATIVE ASSISTANT Robert Engle
Energy / Utilities Leze Thaqi	Market Strategist Marc A. Zabicki, CFA
Financial Services Lori Wilking	Model Portfolio Strategists Matthew J. Koellner, CFA Steven F. Shepich, CFA, CPA
Health Care E. Eugene Robinson	PACKAGED PRODUCT ANALYSTS
Industrials / Materials Frederick M. Schultz	Mutual Funds & Exchange Traded Funds (ETFs) Anthony M. Saglimbene
Technology / Telecommunication Justin H. Burgin

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