Is the Market Right?

The S&P has risen five of the past six days or 3.3%, as investors demonstrate more optimism about this country’s economy.  Investor optimism continued to be fueled this week with several positive economic reports.  The first came on Tuesday as the Conference Board reported that consumer confidence in theU.S.rose in May to its highest level in six months.  The confidence index rose to 83.8 in May from 81 in April, the second consecutive monthly increase as energy prices fell and the stock market rose.  An index in the report that measures consumers’ attitudes about conditions six months from now rose from 84.8 to 94.4, the highest level since September of last year.  

Also on Tuesday the Commerce Department reported home sales unexpectedly rose 1.7% in April to 1.028 million at an annual rate, the fastest pace this year.  The National Association of Realtors reported that April’s sales of previously owned houses rose 5.6% to 5.84 million at an annual rate from 5.53 million in March.

Even Wednesday’s disappointing Durable Goods Orders report failed to slow the market’s advance.  Orders placed withU.S.factories for durable goods fell in April by the most in seven months on fewer bookings for automobiles and business equipment, according to the Commerce Department.  The 2.4% decrease to $168.9 billion in orders for items made to last at least three years followed an increase of 1.4%.  Greenspan told Congress last week that companies still appear hesitant to spend and to hire, “and we need to remain mindful of the possibility that lingering business caution could be an impediment to improved economic performance.”

Yesterday the government reported its revised growth rate for theU.S.economy in the first quarter.  According to the Commerce Department theU.S.economy grew at a 1.9% annual rate in the first quarter (over a 1.6% rate reported last month), faster than reported a month ago, boosted by consumer spending and a narrower trade deficit.  In the final three months of last year, the economy expanded at a 1.4% rate.  According to Bloomberg’s sampling of economists, economic growth needs to accelerate to at least 3% to reduce unemployment, which now matches an eight-year high of 6%.  Gross domestic product increased an average 3.6% a year during the country’s record expansion from 1992 to 2000.  Initial jobless claims fell by 9,000 last week to 424,000, the Labor Department said.  Claims have remained above 400,000 for 15 straight weeks, suggesting a weak labor market.  According to economists quoted by Bloomberg, sustained claims below 400,000 would be a sign that companies are starting to hire again.

Rising productivity keeps companies profitable while concurrently restraining their need to hire additional workers.  Companies are producing more with fewer resources.  Worker productivity has risen 2.3% in the past 12 months ended in March, faster than the economy is growing.  The economy must grow faster in order to bring those displaced workers back into the job place.

Aided by hints from the Fed talk of deflation can be heard almost daily.  Deflation is a general fall in the price level associated with a fall in the stock of money.  Carolyn Baum of Bloomberg quotes Jim Grant, editor of Grant’s Interest Rate Observer, in her latest article and says that Grant exposes the fallacies about deflation that have entered the vernacular.  For example, “falling prices are the fruits, or an effect, of deflation.  In theUnited Statestoday, there is some of the effect, but none of the cause.  Some prices are falling (and, to be sure, some are rising), but no contraction in money or credit is evident.”  The broad monetary aggregate M2, which includes demand deposits, savings deposits, time deposits and retail money market funds in addition to currency, is up 8.1% in the year ended May 12.  On a 13-week annualized basis, M2 is growing at close to 9%, according to Baum.

Given the huge over-investment of the 1990s and excess capacity the economy is left with today, and deflation rhetoric is in full bloom, according to Baum.  Joe Carson, an economist at Alliance Capital Management, summarizes by saying that “excess capacity, technological improvements and declining import prices are often cited as concrete sources of potential deflation.  Deflation and inflation are purely monetary phenomena.  They are not created solely by business conditions, but through the relationship between those business conditions and the concurrent monetary conditions.”  In short, deflation is not a present concern for this economy.

What is a concern is the continued strength of the consumer.  Today’s Personal Spending showed a slight negative on that front as it declined by .1%.  Economists had expected an increase of .1%.  The Easter holiday causes unevenness in this number so economists generally take an average of March and April.  Spending averaged a better .4% for the two months.  Nevertheless, the consumer must stay engaged long enough to sustain moderate growth in the economy until business spending picks up.  Today theUniversityofMichiganrevised their Confidence index down modestly from 93.2 to 92.1.  The index was still well above April’s reading of 86.  It appears that the ending of the war has had a positive effect on consumers.

On Wednesday President Bush signed his third tax cut bill designed to rev-up this economy.  It is capable of adding some much needed stimulus in the short term and is expected to improve both consumer spending and job creation in the small business sector.  Don’t be surprised to see the Fed cut rates again at or before their next meeting on June 25th as more monetary signals point to it.   Additionally, this month, they stated more concern about the economy than they had in previous months by moving from a balanced bias to one of weakness.

We believe that economic recovery has taken hold and that government and corporate reports should, on balance, continue to support the thesis.  So far business profits have come from cost cutting and improved productivity, but there are signs of increased spending in pockets of industry.  Manufacturing in Chicago unexpectedly expanded in May as the Chicago Purchasing Manager’s Index, just released showed considerable improvement in many areas.  The index came in at 52.2, over last month’s 47.6 and economists’ estimate of 49. Readingsover 50 indicate that business is improving.  According to Bloomberg, before the war, business at Chicago-area factories had shown improvement for four straight months, adding credence to the argument that the war was the primary impediment to business expansion.

The fundamentals required for continued consumer spending are firmly in place.  Low interest rates should continue for the foreseeable future, energy prices are visibly falling at the pump and in utility bills, the trend in job losses is declining, and productivity continues to help those employed earn more as they produce more.

The best forward indicator of all, the stock market, continues to advance with today’s good news.  Could it be that the market might just be right this time?