The Consumer vs. The Investor

The economy is coming out of, or may be out of recession.  Would somebody please notify the market?  Positive economic news is becoming almost commonplace, but its market impact has been mostly counter-intuitive.  In a bear market bad news is bad news and good news is sometimes bad news.  Many of the favorable economic releases of late have been greeted with fears of inflation and higher interest.  Yesterday, Jack Guynn, Atlanta Fed. President and non-voting member of Greenspan’s inflation police, knocked the wind out of the struggling market’s sails when he said that the Fed stood ready to raise rates at the first sign of inflation.  The S&P 500 and the NASDAQ dropped 1% and 1.5%, respectively on his comments.  If Mr. Guynn’s understanding his counterparts’ positions is true, then the Fed has learned NOTHING about the productivity miracle of the 90’s.  I think they have and that Mr. Guynn doesn’t speak for the majority. 

More constructive comments came yesterday from Minneapolis Fed. President Gary Stern, a voting member, who said that the economy was poised to recover in the first half of this year; not the second half, as many had believed until recently.  He said that he didn’t see inflation as a problem and that it will probably stay in check for some time.  He predicted that inflation would stay in a range of 1.5% to 2% for the near future and mentioned nothing about rate changes.  (The Producer Price Index was just released.  The measure that excludes food and energy showed a .1% decline, better than economists’ expectations of a .1% increase.  This means inflation is NOT a problem.)

Our economy’s MVP, the consumer, has hardly wavered in the din of ‘experts’ and the media’s wailing and gnashing of teeth over the impending collapse in consumer spending.  The consumer has not succumbed.  Isn’t it refreshing when the real world doesn’t play along with the script handed down from the ivory tower?  This week retail sales (the barometer of consumer actions) rose by an amount that was considerably stronger than expected by the tower-dwellers.  The 1.2% increase in sales last month followed a 0.7% increase in December, which was revised upward from what the government reported a month ago, according to the Commerce Department.  The $223 billion level of retail sales, excluding autos, was the highest since the government began keeping comparable records in 1992.  Whether that demand will continue still remains a question, but the momentum is on the side of improvement.  Many of the influences that would normally slow consumer spending are likely past.  Unemployment claims appear to have peaked and are declining and wage pressures have eased.

According to Peter Kretzmer, senior economist at Bank of America Securities, “wealth, income, the price of goods, and interest rates are the fundamental determinants of consumer spending.  It looks like we are entering a period of monetary policy induced consumption strength.”  He means the tax cuts and low interest rates enable the consumer to remain engaged in the economy.  Housing and vehicle sales, for example, are closely linked to employment, which is the major source of income for most folks.  He adds, “that’s where the break came this time, spending on housing and autos continued apace even as job losses mounted.”  The reason: at 5.6%, the unemployment rate is closer to the best levels of unemployment reached in previous business cycles, not the peak as it is likely to be this time.  While the overall numbers of job losses have matched those of past recessions, they’ve been reached in a third the time, reducing the negative psychological impact on consumers.

Consumers have the means to keep spending.  Refinancing applications were at record levels in November, allowing Americans to use their homes as a source of cash.  And the government’s reductions in tax withholding rates became effective in January, boosting paychecks.  Personal incomes rose 0.4% in December, led by wage and salary gains.  Job cuts are slowing, too, as initial jobless claims have remained below 400,000 for five straight weeks, the longest such stretch since March of 2001.

A deeper recession continues in the business sector, but there are signs of improvement there too.  A record $120.6 billion decrease in fourth-quarter business inventories implies that factories will soon have to boost production to keep pace with consumer demand.  Business inventories fell in December to the lowest level in two years, reflecting declines at department stores and other retailers, factories and wholesalers, said the Commerce Department.  The 0.4% decrease in inventories, to $1.14 trillion, was the 11th straight month in a row of declines and that followed a steep 1.2% drop in November.  Stockpiles were down a full 6% in December from a year earlier.

Still, Investors Doubt and the Market Lumbers

As of yesterday’s close the S&P was down .5% and the NASDAQ was down 3.5% so far this February.  These results may suggest that investors doubt a recovery anytime soon or they are uncertain of the strength of that recovery.  But remember, emotion plays a huge role in the short-term market.  Enron’s scandal, concern regarding proper accounting practices of companies in general, the broadening terror campaign, and impasse on economic stimulus measures, have kept the market shackled.

While not a perfect indicator by any means, the market is the best ‘in-the-trenches’ barometer we have of investor sentiment and corporate earnings expectations.  As noted, the broad averages are retreating, but there is a better story beneath the headlines.

Some industries are showing promise in this market.  So far in February, the best performing sectors have been construction and engineering, gold mining, entertainment, and trucking.  Improvement in the stocks of these companies suggests that investors are expecting economic recovery.  In the last two weeks, wireless communications and information technology, in general, have been hurt the most as some ‘investors’ took their ‘profits’ after their dramatic run-ups in these stocks following September 11th.

Taking a slightly longer view, since September 24th, you can see in the chart below that many industries in the technology sector still retain significant gains; implying that investors continue to value their recovery potential.  The graph represents the best and the worst performing groups in the S&P 500 since 9/24.  In case the graph is difficult to read, the top five industries are; Internet software and services, up 79%, homebuilding, computers and electronics, semiconductors, casinos and gaming, up 59.5%.  The five worst performers are utilities, down 63%, wireless services, integrated telecom, gas utilities, and photo products, down 8%.

So, there is a tug-of-war going on in the market between two powerful forces; there is fear on the one side, fear that the consumer and the market will disappoint; and on the other, seasoned professional investors who are busily positioning their portfolios for the eventual recovery.  The latter group represents the ‘stock-pickers’ you hear about on the financial programs.  They understand that the business cycle will eventually respond to the Fed’s 11 interest rate reductions, low energy costs, low inflation, steady consumer demand, LOW BUSINESS INVENTORIES, oh, and LOW INTEREST RATES.  Please indulge me in a short digression to make a very important point: all pieces of the puzzle would come together beautifully if Washington would magically realize that lower taxes do more to foster job creation and economic growth than all the other forces combined.  It was Reagan’s tax cuts in the 80’s that prepared the way for the greatest economic expansion in US history during the 90’s, Mr. Daschle!

Actually, the market is quietly showing signs of recovery, in spite of the broad averages’ suggestion to the contrary.  Individual companies and industries’ stocks rise for a few days before succumbing to the selling pressures of holders who have waited for price strength to sell, or from the pressures of short-sellers.  With all the fears out there, innuendo and rumor are powerful tools for the bear side of the market, the short-sellers.  But, the bears will wither faster than Duke basketball opponents when investors, holding some five trillion dollars in cash, grow weary their low interest rates and they come back into the equities markets in search of better returns.

As I prepare to send you this note, the University of Michigan just published its Confidence Index.  The street was looking for a reading of 93.8, but was disappointed by a reading of 90.9, down from a 93.0 last month.  The indicator shows that the tug-of-war continues and the market bears gained a few inches on that pull.  On the news the NASDAQ declined 20 points, or 1% and the Dow 70 points, or .7%, but they seem to be holding there.

The weight and traction in this contest have clearly shifted to the side of economic recovery.  Sure, there will be missteps as the dual continues, like the Michigan confidence indicator, but so far the slips have been less significant than the gains made by the recovery side.  We will watch carefully for signs of more serious slippage, but the weight of evidence of late overwhelmingly favors recovery, albeit slower than we would hope.

Have a good long weekend – the markets and our office are closed for observance of President’s Day on Monday.