01 Nov 2002 Baby Steps

Roughly three quarters of companies have reported their earnings for the third quarter.  First Call tells us that the actual earnings are running 3.1% ahead of the final estimated earnings for S&P500 companies.  But these earnings expectations have been cut several times by analysts in the weeks leading up to reporting season.  At the beginning of the second quarter of this year earnings growth was expected to be over 16%, but by the start of the Q3 reporting season expectations had been cut to just under 5%. 

Big positive earnings surprises (over 25%) came from companies like Nextel, Electronic Arts, Amazon, Xerox Corp., Hilton Hotels, CheckFree, Alaska Air, Expedia, Computer Associates, IBM, Microsoft, AT&T, United States Steel, Lifepoint Hospital, Audiovox, Yahoo.  What these companies all have in common, in addition to being mostly technology companies, is that they represent industries that have been particularly hard hit by the economy.  That they are now beating analysts’ estimates is a good sign, even if the expectations were low.

IBM CEO Sam Palmisano said on Wednesday that the global economies may have reached ‘bottom’ and that his company plans to invest  $10 billion to increase sales of on-demand computer services, similar to the way electricity is sold to utility customers.  Companies buy processing power and computer storage as they need it.  IBM says it will be particularly useful for financial services companies, pharmaceutical developers, and automakers.

There is little evidence of a double dip ahead for the economy, but the speed of recovery has many worried.  To counter the trend, it is likely that the Fed will announce a rate cut at their meeting next Wednesday.  We think the cut could be as much as ½% given an outlook for low inflation and the Fed’s recent willingness to move boldly when they think it necessary.  It is also likely that the Administration and the returning Congress will move quickly move (as the politics of the elections will have passed) to enact fiscal stimulation measures designed to spur capital investment and job creation.

This morning, we learned that the U.S. unemployment rate rose to 5.7% from 5.6% in September, but less than the expected 5.8% level.  Consumer confidence reports and Durable Goods reports showed weakness too.  Personal income rose .4% while spending dropped -.4%, twice the expected -.2%.  Taken out of the context of the larger picture of recovery, these numbers could foretell trouble.  But we must remember how difficult the July – September timeframe was for consumers with war talk with Iraq, corporate and accounting wrongdoing, and the worst stock market performance in recent memory.  It is reasonable to expect some setbacks consumer numbers after such an intensely negative period.

Surprisingly, the next couple of months could be quite good for equity investors given the expected positive moves from the Fed and from Washington.  NYSE short interest (stocks borrowed and sold with the expectation of buying them back cheaper) is at a record high 2.3% of stocks outstanding.  This level of negativity is actually an intermediate-term positive for the market.  These positions must eventually be bought back and market rallies tend to stimulate the repurchase of shares.  A ‘supercharged’ effect can take place as short-sellers rush to buy and cover their positions.  Short interest has risen in the financial and consumer discretionary industries indicating some investors are betting on a double dip in the economy.  But information technology and telecom stocks have seen their short interest decline rather substantially in the last month, indicating the early stages of recovery for their businesses.

While the near term in markets is random, we think that odds favor market improvement in the coming months.  There will most certainly be an interruption in the market’s recovery if we go to War with Iraq, but the decline would be short-lived if the outcome of the war was known relatively quickly, as expected.  We believe that an objective reading of the economic data suggests that recovery continues, but is very fragile.  We think that the government will act promptly with simulative measures to spur capital investment and job creation.  We think the consumer is still engaged and that this will be a pretty good Christmas – not as bad as the recession of 1990 as some predict.  As we have seen in the past several weeks, small positive surprises have caused big moves in stock prices.  The signs point to more progress ahead.