02 Aug 2002 Recovery Much Slower Than Earlier Expected

Optimism is a wonderful trait, and we Americans seem to own the rights to it.  We are born with it in vast supply and our unique culture richly nourishes it.  Entrepreneurs, CEO’s, investors, and stock analysts are poster children of American optimism.  Problem is, it got out of hand in the late 90’s and we must now pay the price, as economic and company results fall relentlessly short of expectations.  In truth, the results aren’t really quite so bad as they seem; it’s our expectations that are too high. 

A great example of current optimism is the American consumer.  Almost in spite of the ailing corporate sector, the unflappable consumer continues to behave contrary to expectations.  Consumer confidence dropped more in July than at any time in the past eight months, but consumers continue to spend on clothes, cars, and houses.  These actions do not indicate they are afraid of losing their jobs or of big cuts in pay.  In fact, personal income increased by .6% in June, better than expectations of .5% and ahead of May’s .4% increase.  Unemployment data released this morning showed that the economy added 6,000 jobs and total unemployment remained at 5.9%.  That means a full 94% of Americans who wish to work, have jobs.  Could it be they are still optimistic about their future?

While consumers continue to wave the banner of optimism, the business sector of the economy struggles to find its way.  As companies report their second quarter earnings, we have actually seen improvement over expectations, granted they are reduced expectations.  According to First Call, 75% of the S&P 500 companies have now reported.  Extrapolating the remainder, the final results will be between 1% and 2% growth, not great, but in line with expectations at the beginning of the quarter.  More importantly, it is enough of an improvement to say that earnings are up on a year over year basis for the first time since the fourth quarter of 2000 and they are up on a sequential basis over the first quarter of the year.  So there is improvement, but the improvement is relative to reduced expectations.

It is likely that corporate earnings expectations will be managed down even more for the remainder of this year as our government has now considerably raised the penalties for CEO’s who falsely depict their company’s financial position.  The optimism that used to characterize their outlooks will undoubtedly be muted to inaudibility for quarters or years to come.  What’s more, Wall Street analysts, under their own pressures to show no conflicts of interest will likely be super-conservative in presenting their earnings estimates.  In fact, according to First Call, third quarter company earnings pre-announcements continued to run more negative than in recent quarters.  The ratio of negative to positive pre-announcements by companies is now slightly over two to one.  For the second quarter it was considerably better, at one to one.  First Call also notes that analysts’ reductions of earnings expectations are also running well ahead of normal.  These reductions will likely continue to put pressure on stock prices until actual earnings prove better than expectations on a consistent basis.

As noted earlier, the latest government reports on the economy were more disappointing than usual.  The disappointment comes largely because economists’ expectations were ratcheted up by the first quarter’s results, which were considerably better than expected.  However, the government has been busy revising downward results that were previously reported.  US real Gross Domestic Product grew at an annual rate of 1.1% in the second quarter, well below the consensus expectation of 2.3%.  Growth in the first quarter was revised down to 5.0% from the previously reported 6.1%.  Revisions showed that there actually were three consecutive quarters of negative growth last year (Q1-Q3), not one as earlier reported.  The economy is likely weaker than earlier expected, but it is still expanding.

“Climate is what we expect, weather is what we get.”  Mark Twain

Market conditions will likely continue to be sloppy for the next couple of months as expectations on most fronts continue to tumble.  You will recall our discussion of capitulation.  I think market capitulation is mostly behind us, but nervousness will keep a TIGHT lid on optimism.  A drop in rates by the Fed would be a good thing and they will likely do so in the coming days.  If not, no great loss, it means nothing of substance other than that they are watching and remain engaged.

Our market is now firmly in the hands of those who make money when share prices go down – hedge funds and traders.  Until long-term investors begin buying again in numbers and with consistency, the short-sellers will dominate the volume in stocks, both up and down.  Hedge funds, when employed to hedge portfolios against losses, perform a useful function.  But, the duration of this bear market has increased their popularity as profit vehicles, not just hedging vehicles.  As they attract new investors’ cash, they must broaden their ‘attacks’ on company stocks, driving them further down to excessive lows.  They have likely become the major force in market movements of the past few months; reducing stock prices as they short them and lifting them when they buy them back to cover their shorts.

Their influence will wane as long-term investors return to the markets.  How cheap stocks will get before investors return is the 6.4 trillion dollar question.  Will GE go back to the low 20’s, Pfizer to 25, or Duke Energy to 19?  Retailers bear the latest barrage from short-sellers as they bet the consumer will eventually buckle.  Our retail holdings, such as Best Buy, Bed Bath & Beyond, Action Performance, Chico’s and Charlotte Russe, have been knocked down well below their 9/11 levels, when investors thought consumers would literally hunker down in fear and quit buying.  That didn’t happen then and it’s not going happen this time.  In the months that followed 9/11, the retail stocks just mentioned, doubled in value.  It could certainly happen again as confidence returns.

We continue to position the portfolios for a plodding, prolonged recovery.  Our largest holdings are in retail, but recent additions have included high-grade corporate bonds (iShares Goldman Sachs High Grade Corporate Bond Index), commercial real estate (iShares Dow Jones Real Estate Index), high yield (Duke Energy), and defensive companies (Pfizer, UnitedHealth Group, and Dole Foods).  We will continue to watch, learn, adjust, and trim as needed.

Samuel Clemens was an unmitigated supporter of American Capitalism.  His words from Nook Farm: Mark Twain’s Hartford Circle are just as appropriate today as they were when he defended his Connecticut capitalist friends from the muckrakers of his time:

“as they acquired experience in an industrial culture, . . . attacked abuses but continued to assume that the good of the whole nation was being served by expanding capitalism. . . . The excesses in its exploitation by the unscrupulous were controllable.  Industrial democracy was a successful experiment.”  Samuel Clemens

Remain of good faith, the success of this great ‘experiment’ continues.