04 May 2007 Healthy Slowing Continues

One of the last holdouts in the slowing economy story – employment – has now fallen in line.USjobs grew at its slowest pace in more than two years last month, according to the government. And almost all of the gains came from health care and government while the job losses spread beyond homebuilders and manufacturers. Unemployment rose slightly as well from 4.4% to 4.5%. The good news is that inflation pressure from wages appears to be on the decline. Workers’ average hourly earnings rose just 0.2% after a 0.3% increase in March. Earnings were up 3.7% from April of last year. Easing inflation will give the Fed more room to loosen the money supply if needed to boost economic growth.

The engine of our economy, the consumer, might be slowing some. Last week’s report from the Department of Commerce showed that personal consumption expenditures increased only 0.3%, well below economists’ projections and below January’s and February’s rates of 0.6% and 0.7%, respectively. Higher gasoline prices and the prospect of lower home prices may be having some effect. But if job and wage growth continue to rise even slightly, there should be enough momentum to sustain consumer spending, sufficiently bolstering the broader economy. 

Corporate earnings for the first quarter have so far come in well ahead of earlier estimates. Expectations are that the quarter will show a 5.25% year-over-year increase compared to only a 3.3% increase suggested a week ago. With a fourth of the S&P 500 companies reporting so far over two thirds have beaten analysts’ estimates and fewer than 18% have missed.

Earnings can suggest whether a stock market is a good value or not. A widely used  measure compares the ‘yield’ of stocks (earnings divided by price) to the percentage yield of the 10-year US Treasury. The graph to the right demonstrates that valuations are somewhat extraordinary. Today’s spread of earnings yield over the 10-year Treasury is well above the prior two peaks in 1996 and 1982. This gauge is useful only when inflation is tame. If the trend for inflation continues down, expect to hear more about attractive stock valuations.

After Mr. Greenspan posed the risk of recession in theUSas one in four, investors continue to look over their shoulders at economic and anecdotal data for some clues as to whether we will sink into recession or experience the preferred “soft landing.” 

Liz Sanders, Schwab’s Chief Investment Strategist uses the graph on the left to show that the Purchasing Managers are not currently suggesting a recession is approaching. The four dips below the red line coincided with four recessions. But today, we are well above the level of 42 that indicates sufficient economic expansion to avoid recession. 

Alternatively, the graph below suggests a different outlook. If you believe that rapid declines in home prices bring about recessions, the latest plummet provides a compelling argument for your case. However, numerous experts including Fed Chief Ben Bernanke say that the housing problem is contained and will not poison the greater economy.

The Dow Jones continues to make new highs and the S&P 500 is closing in on its all time high of 1552. While attractive valuations keep a virtual floor under the market, indices continue rising on a bevy of company buyouts and the belief that the Fed will soon reduce rates. Ample liquidity in the world support the idea that buyouts will continue, but the Fed will likely remain on hold for several months to come.

Times like this suggest that investors remain true to their long-term strategic allocation of stocks, bonds, cash, real estate, and international exposure. From a tactical or short-term perspective caution is recommended.

We are moving more of our equity allocations toward defensive sectors like consumer staples, healthcare, and utilities. Also, given our view that energy prices will continue rising and shortages are likely we are overweight the oil and gas services industries in our growth portfolios. Given that interest rates may still rise a bit before inflation measures decline, we are maintaining maturities of five to seven years and shorter. Further, in our income portfolios attractive stock valuations discussed earlier keep us in dividend-rich large-cap companies.