Stocks Suggest Economic Improvement

The US stock market as measured by the MSCI US Broad Market Index is up 2.4% for the week. The S&P is up the same and the Dow is up 2.3%. Various economic reports released this week proved considerably stronger than expected, boosting the outlook for stocks. Wednesday was a particularly good day, when it was reported that private employers added more jobs in November than previous months and the Fed’s Beige Book report of regional economies concluded that “the economy continued to improve, on balance” from early October to mid-November. Today’s jump in the unemployment rate so far, has not stemmed the advance. 

This morning, the government reported that the unemployment rate unexpectedly increased to 9.85%, the highest since April. With this report, the Fed’s $600 billion purchase of US Treasuries known as QE2 (Quantitative Easing – round 2) gains credibility despite recent criticism, both at home and abroad. Jobs are critical to a sustainable recovery, and the recent trend suggests greater challenges ahead.

For now though, the consumer is gaining confidence. On Tuesday, the Conference Board reported that, despite continued pessimism over the labor market confidence rose more than four points to 54.1 in November. The strongest component was expectations, which points to overall improvement in future months. The lack of meaningful improvement in the current situation reflects frustration over jobs. Those saying jobs are harder to get rose slightly to 46.5% while those saying jobs are plentiful rose a half percentage point to a still miniscule 4.0%.

Consumers appear to be acting on their confidence. Redbook reported a spike in same-store retail sales during the November 27 week, at a plus 4.9% on-year rate. It reflects the strongest rate of the whole recovery and compares to a steady seven-month trend at just below plus 3.0%. Month-to-month, the report suggests a 0.6% gain for November in what is a positive indication for the ex-auto ex-gas category of the monthly retail sales report.

The ICSC-Goldman Retail sales index confirmed Redbook as it moved higher in the November 27 week by half a percent weekly and 3.5% annualized. The annual rate is at the top of trend. The report notes that 34% of consumers, or 81 million, shopped on Black Friday or on the weekend. Still, the report suggests consumers are lagging behind last year’s pace, which Goldman says bodes well for the coming weeks. 

Cars are doing well too. Sales of US-made vehicles held unchanged in November at a 9.1 million unit annual rate. The results suggest the motor vehicle component, which surged in October following a big jump in September, won’t fizzle in November as many had feared. Anecdotal reports on used car sales point to strength as do indications on sales at auto-parts chains as reported by Bloomberg. Motor vehicles make up 18% of total retail sales. 

Housing, however, remains on shaky ground. Case-Shiller’s adjusted index fell for the third month in a row and fell very steeply, down 0.7% in September for the composite 10 index. At only plus 1.5%, the adjusted on-year rate extended its weakness. Unadjusted data, showing a 0.5% month-to-month decline and a plus 1.6% on-year rate, show similar results. Weakness is no longer concentrated in the West or Florida with declines sweeping across regions.

Housing did get a boost from the pending home sales index report yesterday. The index jumped 10.4% in October, indicating improvement for existing home sales. At 89.3, the index is up 18% from its post-stimulus low in June. Low home prices and rates are stimulating demand.

Manufacturing continues to be a bulwark of the economy. The Fed’s Beige Book, prepared for the December 14th FOMC meeting gave the economy a modest upgrade. Significant positives were the manufacturing, certain services, and consumer sectors. Especially encouraging were reports of a pickup in hiring. The report said “manufacturing activity continued to expand in almost all Districts, with relatively strong growth seen in metal fabrication and the automotive industries. Reports also showed steady to increasing activity for professional and nonfinancial services.” The report also noted price declines in several major markets including New York, Philadelphia, Atlanta, and Kansas City and said overall that “prices of final goods and services were fairly stable across Districts despite rising input costs, especially for agricultural commodities, metals, and fuel.” The bottom line is the economy is showing slow but steady improvement and inflation is not a problem.

Another healthy sign for inflation is that productivity remains high. Companies continue to squeeze more output from their current workforces instead of adding to their payrolls. Non-farm business productivity for the third quarter was revised up to a 2.3% from the initial estimate of 1.9%. Year-on-year, productivity was up 2.5% in the third quarter-down from 3.7% in the second quarter. Growth in unit labor costs for the third quarter was unrevised compared to the original estimate of an annualized 0.1% decline. Year-ago unit labor costs moved up to an annualized minus 1.1% from minus 1.9% in the second quarter. Inflation is definitely not a problem any time soon with shrinking labor costs.

Construction outlays jumped .7% in October, following a 0.7% rebound the month before. The Strength was in multifamily housing. Anecdotally, conversations with real estate brokers and apartment developers next door to us reinforce these trends as they say the rental market is booming. For the latest month, the multifamily component advanced 3.2% while the single-family component slipped 1.2%. On a year-ago basis, overall construction outlays improved to minus 9.3% in October from down 10.9% in September.

As for the outlook for the stock market, Cambiar Investors’ Brian Barish has some interesting things to say. He notes that “the structural issues affecting the US and European economies that led to the ‘new normal’ prediction by Pimco are more of a bond buyer’s problem than an equity buyer’s problem. If the whole stock market were a bunch of commercial real-estate investment trusts, they’d have a great argument. But we shouldn’t confuse the stock market with the US economy. Particularly outside the US, a lot of structural issues just aren’t there, and US companies get a lot of their revenue from outside the country.”

We couldn’t agree more with Mr. Barish. Many in the global economy are doing quite well. As the middle classes in China, India, and Brazil expand, they dramatically increase the markets for American goods and services. Barish says there will be a “multi-speed” market in 2011. Stocks in industries such as energy, consumer products and agriculture advance because “the revenue profile for those businesses has snapped right back to where it was before the great recession.” Financial and real estate companies will suffer because “it takes years, if not sometimes decades, for the economic landscape associated with bubbles to recover.”

Unfortunately, jobs and housing will continue to drag on the US economy, perhaps for years to come. However, the stock and bond markets, which power our savings, must not be rolled into the same depressing mix. There’s no reason to believe that capital market returns will not be sufficient to meet planning goals in the coming years. For instance, our Balanced Model which is 60% equities and 40% 7-10 Year US Treasuries has averaged a 4.72% annualized return since the market’s top in October of 2007. Alone, the S&P 500 remains down an annualized 5.4%. By monitoring the funded status of one’s plan and avoiding unnecessary risk through proper portfolio allocation, investors can confidently meet important goals, even through difficult economic times such as these.