09 Aug 2002 Recovery Any Slower and We Back Up
July was the worst month for the S&P 500 since September 2001. Few stocks were spared abuse. Most of the best performers were stocks bouncing off oversold bottoms as telecommunications and technology stocks were among the leaders. As mentioned in last weeks’ Brief, short covering accounted for most of the gains in stocks. Lately, though, market specialists say they are seeing some real buying. It may be due to money managers re-balancing their portfolios towards equities as bonds have become over-weighted during the past couple of years.
The question on so many investors’ minds is whether we are headed for a double-dip recession. We learned last week that last year’s recession actually began in early 2001 and lasted three quarters, not just one. We know now that the NASDAQ market was correct in calling the recession last year. The question on everyone’s mind now is, are we in for another one? This week’s economic data, on balance, continued last week’s momentum in pointing to that conclusion. But conditions are still favorable for a recovery, if only a modest one. Labor costs are low, inflation is tame, interest rates are low, and production materials are cheap. Cash flows can improve as companies rebuild inventories that remain historically low compared to current sales.
A Bright Spot Among the Clouds
Today’s announcement of productivity, one of the best indicators of economic performance and profits, was quite good. U.S. second quarter productivity rose 1.1%, twice the expected rate and 4.7% higher than it was during the same three months last year. It represents the strongest gain since 1983. In reporting their surprisingly good earnings this week, Cisco credited higher worker productivity as part of their success. As companies produce more per worker, both profits and the standard of living rise. In his recent testimony to Congress, Mr. Greenspan said the following about productivity:
“Despite the recent depressed level of investment expenditures, the productivity of the U.S. economy has continued to rise at a remarkably strong pace. The magnitude of the recent gains would not have been possible without ongoing benefits from the rapid pace of technological advance and from the heavy investment over the latter half of the 1990s in capital equipment.”
Many experts are now suggesting that the Fed will shift its neutral stance on the economy toward a weaker economy and a diminished threat of inflation. Some are even calling for a cut in the discount rate. It might happen, but will mean little more than a cheer from the sidelines.And the Stock Market?
After removing the predictions of double-dip, accounting scandals, global tensions, short-selling and covering, and the rest of noise from stock price movement, second quarter earnings have had only minimal impact. Through the end of July, 85% of the S&P 500 had reported second quarter earnings. On average, the results were in line with projections, but fewer companies missed expectations than normal and more companies met or exceeded consensus, according to First Call. Analyst’s expectations are becoming more realistic and companies are providing better guidance.
Tom Galvin of CSFB points out that because the S&P 500 index is market cap weighted, a few bad apples have spoiled the bunch. Excluding the ten worst declines, earnings would be up 7% to 8% for the quarter compared to the same time last year. The forecast looking forward remains somewhat foggy. Negative pre-announcements have been on the rise again for the third quarter reversing positive trends in the first half of the year, with particular weakness in consumer cyclicals and technology shares for which First Call has posted three negative pre-announcements for every positive one. The new penalties of jail time for CEO’s and CFO’s also likely mute any optimism that might otherwise be expressed.
As hedge funds and traders continue to dominate the markets, volatility remains at historic levels. You don’t need me to remind you of market volatility. But it is noteworthy to mention just how recent volatility stacks up with history. The VIX, an indicator of the options volatility trading on the Chicago Board of Options Exchange suggests very extreme levels of volatility for the second time in as many years. September 11th brought the last wave. Since 1986 when the VIX was created, it has only reached highs near or above 60 on six occasions. October 1987 was the first such occurrence followed by 1989. The last four have occurred in the last five years. Each of the historical occasions was followed by major upward moves in the market.
There are indeed numerous uncertainties facing investors. The likely outcome is continued ‘bottom-building,’ with volatility declining. People are taking a ‘show me’ attitude toward stocks now. We may not see market improvement until actual earnings begin to beat expectations and the economy shows signs of stronger recovery. Markets traditionally anticipate economic recovery months in advance of the data, but this time is different for one of at least two reasons. One is, investors are tired of the repeated punishment for believing in a recovery that does not materialize. Two, the market may be signaling another recession. As stated earlier, the latter outcome is less likely given the extremely accommodative stance of both Fed and fiscal policy. While further fiscal stimulus couldn’t hurt (capital gains tax cut, new business start-up incentives, and acceleration of the existing tax cuts), the recovery will likely continue, albeit tortuously slowly. The market can rise under either scenario.