Economic perspectives – November 2, 2009

Russell T. Price, CFA – Sr. Economist

Growth resumes but still no guarantees

• A sigh of relief: U.S. economy expands for first time in more than a year: The U.S. economy grew by 3.5% in the third quarter. It was the first quarter of growth since Q2-2008 and the fastest pace of growth in two years. While growth benefited from temporary government programs in the period, there were also signs of fundamental improvement in our view.
• Third quarter corporate profits coming in strong: For the second consecutive quarter, corporate earnings are exceeding expectations by a wide margin. Forward estimates have also been rising but we need to see a stronger consumer for earnings to maintain their improvement trend through 2010.
• Inventories provide a source of future leverage. Business inventories are becoming very tight and should offer a solid source of positive leverage over the next few quarters as producers ramp-up production simply to match current demand.
• Housing finally shows some life: The housing market continues to show encouraging signs of life. Existing single family home sales have been positive on a yr/yr basis for the last four consecutive months (the first time this has happened since 2005.)
• Rebound likely to be modest: Despite recent improvements, the pace of U.S. economic expansion through 2012 could be modest. We currently project 2010 U.S. Real GDP growth of between 2.5% and 3.0%. Since 1975, economic growth in the first year following a recession has been 4.4%.

Full steam ahead?

On October 29th investors cheered as the Commerce Department announced the U.S. economy's first quarter of growth in more than a year. The agency said economic activity in the third quarter expanded by a stronger than expected 3.5%, thus ending the longest consecutive streak of economic contraction since World War II. Growth benefited in the period from various government stimulus programs, but the underlying data also provided encouraging signs of life in key areas of the economy. Residential construction activity contributed to growth for the first time in three and a half years, and businesses spent more on equipment and software on a quarter-over-quarter basis for the first time since the fourth quarter of 2007.

However, not all of the economic data of late has been positive. The Labor Department recently said that another 263,000 jobs were lost in the month of September. More troubling was the fact that this was a more than 60,000 increase over the 201,000 jobs lost in August. A few days prior to the Employment Report, the Commerce Department had noted that New Orders for Durable Goods (manufactured goods meant to last three years or more) had dropped by a sizable 2.5% in August. The drop was much worse than the 0.5% gain in new orders forecasters were looking for and represented the worst month-over-month performance for this measure in more than six months.

No two economic downturns or recovery periods are every exactly alike. Most will share some high-level common threads but there are always differences that make each situation unique unto itself. There is, however, one constant that arises in virtually every economic downturn…the rebound that follows is never fast enough, strong enough, or clear enough for peoples liking. This is not a criticism, nor can we blame anyone for desiring the fastest possible return to good economic times. People are also right to question the path ahead at any time; certainly there are no guarantees and no one (that I know of) has a crystal ball. But on the other hand, we must also accept that periods such as the present, where conditions are "less bad" but still much weaker than they were, are a necessary stop on the path to recovery.

As we go through this process, there are bound to be some discouraging economic reports that cause people to question the legitimacy or robustness of the recovery. So while the third quarter GDP report was encouraging, the examples above illustrate that investors should not expect economic measures to show improvement on a purely linear or consistent basis. Over time, it is trends, not singular reports that are important in determining the most likely path forward. Fortunately, we believe fundamental economic trends do remain fully supportive of a developing recovery. In this month's report we take a look at some of these trends.

Non-farm payrolls

Is the economy truly improving? For the average American, the answer to this question will most often relate to how they feel about their employment prospects. Despite September's disappointing jobs report, the trend in non-farm payrolls remains decidedly positive. After peaking in January of this year when a net 741,000 jobs were lost (the highest number since 1949), monthly job cuts have been falling at a fairly steady pace. Some months are not as good as others, but the trend remains encouraging in our view with the 3-month moving average showing steady progress

Chart Source: U.S. Dept. of Labor, Ameriprise Financial.

Employment is key to any economic situation and especially important to an economic recovery. However, the jobs market is a classic lagging economic indicator where we typically see non-farm payrolls turn positive a quarter or two after a recession has ended. In the interim, we have seen some improvements in consumer spending of late. Right now these improvements largely reflect improved confidence and slightly higher spending on the part of the majority of Americans that are still employed and possibly feeling a bit better about their employment status. For these modest improvement trends to continue however, we believe the economy needs to start generating actual employment growth within the next two quarters.

New unemployment claims

New claims for unemployment insurance also remain uncomfortably high; but when compared against prior recovery periods we get some comfort from seeing a common trend. Actually, the pace of improvement in new claims has been very similar to that of the last two recessions. Through the week-ending October 24th, it has been 36 weeks since new claims for unemployment insurance hit their peak for the current recession (at 674,000 in the week ending March 28th). Since that time, initial claims have declined by about 21%. Following the 2001 recession, initial claims had made a 27% improvement 36 weeks after peaking, and following the 1990—'91 recession initial claims were just 13% better by this point.

Chart Source: U.S. Dept. of Labor, Ameriprise Financial

Manufacturing activity

Manufacturers have seen a notable improvement in new orders. According to Institute of Supply Management's (ISM) Manufacturing Survey, new orders hit a better than four and a half year high in the month of August. The strong reading for August was followed by a small pull-back in September, which is often the case following sharp one-month improvements, but the trend in this series still bodes well for production activity going forward.

Note that this is a diffusion index meaning that numbers above 50 indicate month-over-month expansion and numbers below 50 indicate contraction.

Chart Source: Institute of Supply Management, Thomson Baseline

Housing

After several difficult years, the worst of the housing sector downturn finally appears to be in the rear-view mirror. Residential construction activity actually expanded in the third quarter of this year after 14 consecutive quarters of decline.

On a year-over-year basis, existing home sales have been positive in each of the last four months through September (for the first time since late 2005.) Sales could also continue to benefit under Federal Home Buyer tax credits as Congress appears close to extending and possibly expanding the program as of this writing. Prices, however, are likely to remain under pressure a bit longer due to the weight of distressed sales.

Chart Source: Census Bureau, National Association of Realtors, Ameriprise Financial

Retail Sales:

Overall consumer spending remains exceptionally weak, but retail sales, which account for 45% to 50% of total consumer spending, appear to have seen their worst. After a huge and sudden 10% drop in the second-half of 2008, retail sales have stabilized and have even evidenced some modest growth. In the chart at right we show total retail sales excluding autos on a seasonally adjusted basis. We excluded autos as to avoid any message confusion stemming from the temporary benefit of the "cash for clunkers" program. According to the International Council of Shopping Centers (ICSC) weekly same-store sales activity appears to have remained on a modestly positive trend through October.

Economic Outlook:

The U.S. economy expanded at a 3.5% pace in the third quarter. Although not as strong as we would like to see following such a deep recession, it was still the first quarter of expansion since the second quarter of 2008, and the strongest pace of expansion since the third quarter of 2007. In other words…we'll take it. Our estimate and the consensus estimate (as compiled by Bloomberg) were both looking for growth of 3.2%.

There were a number of positive surprises in the report that held favorable implications for forward growth. We were very encouraged to see that business spending on equipment and software actually grew during the quarter. This improvement comes sooner than we believe most forecasters were expecting and it represents the first qtr-over-qtr expansion for this component since Q4-2007. It also suggests rising business confidence and aging equipment, a combination that bodes well for further business spending gains in the months ahead. Residential construction activity also grew during the quarter - for the first time in three and a half years. New home sales could subside a bit in the near-term unless Congress extends the Federal government's New Home Buyer Tax Credit program beyond its current expiration date of December 1st. Even without an extension however, inventory levels in the space are near record lows and we believe the housing sector has likely seen its bottom.

Consumer spending was also a bit stronger than we expected. The "cash-for-clunkers" program was a boost to spending in the first two months of the quarter, but overall spending does not appear to have dropped off much in the final month of the period. Overall, we estimate that the cash-for-clunkers program added about 1.0 percentage point to the Q3 GDP figure.

Offsetting the positive surprises mentioned above was another larger than expected $130 billion in business inventory cuts. This also holds positive implications for forward growth. It is important to think of inventory cuts in their simplest form: under-production versus demand. This can not continue indefinitely. Eventually when the customer looks to buy, there will be nothing on the shelf — a lost sale. The U.S. economy's business inventory to sales ratio, as published by the Commerce Department, is falling at a very rapid pace and is on track to hit a new all-time low within the next few months. As inventories become too low, production will have to ramp-up rapidly just to catch-up with demand. Such a scenario bodes well for future economic growth, as the longer this situation continues the more the production equation is slowly being spring loaded.

Corporate profits: The lynchpin between the economy and stock prices

We are past the half-way point in the Q3 earnings release season, as of this writing. Thus far, corporate reports have been coming in well ahead of expectations. According to Thomson Reuters, of the 344 S&P 500 companies to have reported results for the period, an exceptionally strong 80% have reported better than expected results, while just 14% have come in below estimates.

Many companies have also been reporting modest revenue improvements — a factor many skeptics noted was lacking from Q2 results. As we have noted in past commentaries, this is very much the typical pattern at this point in the economic cycle. Early in an economic recovery period sharp cost cuts fuel early sequential earnings improvements. As the economy stabilizes and begins to grow, revenue gains can be leveraged off of the prior cost reductions to provide further profit margin improvements.

S&P 500 earnings for the third quarter were expected to post a year-over-year decline of approximately 18%. With results coming-in so much ahead of expectations, however, this number is likely to be significantly better in the finally tally. Analyst estimates beyond the third quarter have also been moving higher as companies outperform and provide higher guidance. Estimates for S&P 500 Q4 EPS results are now forecast to be 39% higher than year-ago levels (versus 36% last month). Estimates for Q1-2010 meanwhile are currently looking for a yr/yr gain of 35%, while for all of 2010 S&P 500 earnings are currently forecast by First Call to be 25% higher yr/yr.

The 39% yr/yr gain forecast for Q4 may appear overly-optimistic at first blush, however, there are legitimate factors which we believe should boost results on a yr/yr basis. 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 U.S. companies took charges and write-downs totaling a massive $243 billion. By comparison, charges and write-offs dropped to $102 billion in Q1-2009. Energy sector profits should also recover somewhat in the second half of this year as oil commodity prices are trending to be notably higher than year-ago levels in Q4 and Q1. Additionally, companies in a broad range of industries should continue to benefit from 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 $57.06 by third quarters' end (we will reference this figure later in our S&P 500 discussion) — a 38% decline from the cyclical high of $92.25 as attained in Q2-2007. By year-end, trailing twelve-month earnings are forecast to be $61.91.

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.

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 chart above) 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: $57.06 * (10.7 * 168% = 18.0). These numbers suggest a possible value for the S&P 500 of 1027 at third quarter's end (modestly below the third quarter's actual ending value of 1057). Taking these assumptions out to Q4 ending values, however, suggests a possible 1114 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 1060 — equating to an estimated year-ending P/E of 17.1 assuming First Call full-year S&P 500 earnings estimates are correct. Also, the graph and table below are for illustrative purposes only and implied S&P 500 Index levels may not match our official targets.

Summary

Our confidence in the U.S. economy's intermediate-term outlook has grown in recent weeks. Most economic indicators have continued previously started improvement trends while other metrics have just recently turned to a more optimistic tone. Employment however, holds the key. Most employment related metrics have been heading in the right direction but we still need to see this develop into actual employment gains at some point over the next six months. Currently we estimate non-farm payrolls should turn positive in the first quarter of 2010. This would be generally consistent the pace experienced in past recessions. And as we stated at the start of our report, this is all part of the process. Conditions simply have to transition through a period of "less bad" before we can reach expansion territory.

Like everyone else however, we are impatient and will be somewhat nervous until job growth resumes.

Risks

Significant economic challenges remain but we believe many of the economy's imbalances enter the final quarter of 2009 in much healthier condition and still making progress. Clearly however, some issues remain, and a rising Federal government debt position poses longer-term challenges. These issues are likely to weigh on growth prospects over the intermediate-term rather than send us back into recession, in our opinion.

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.