03 Feb 2006 The Wall of Worry

The latest economic news further clouds the picture and investors have acted on that uncertainly by selling stocks.  We expected a sell-off early in the year, but wonder if it has gone a bit too far. 

The government reported today that the unemployment rate unexpectedly fell to 4.7%, the lowest level since July 2001.  The economy is growing fast enough to create new jobs and raise workers’ compensation which suggests that there will be more consumers on the way and that all consumers will have more money to spend.

However, as wages rise, so say some experts will prices rise.  Their concern is that both the worker pool and plant utilization are already near capacity.  Further tightening of either or both will result in inflation.  The remarkable increase in worker productivity over the past several years has enabled our economy to grow rapidly while remarkably free of inflationary pressures.  But the question of whether that trend will continue was brought into focus yesterday when the government reported that fourth quarter productivity unexpectedly dropped .6% after an increase of 4.7% the quarter before.

Investors worry that the Fed may view the latest unemployment and capacity utilization reports without rising productivity as indicative of future inflation, spurring them to continue raising rates.  They fear the Fed may overshoot their target as they have during most previous tightening cycles.  As interest rates rise, stocks become less attractive relative to bonds.  And if the Fed goes too far with rates, they risk smothering the expansion and sending the economy into recession.  While we do not know the mind of our new Fed Chairman, Ben Bernanke, we are pretty sure he does not want recession.  He will likely do his best to stop before doing damage, but we will have to wait and see just how far he thinks he can go.  Markets don’t like to ‘wait and see.’

The experts we follow believe that the productivity surprise in the fourth quarter was an aberration and that the 3% trend of growth remains intact.  They point out that strong productivity growth has been the driving force behind years of solid profit growth, strong consumer incomes and spending, and low inflation.  They expect the trend will continue throughout the decade.

It is evident that the global expansion is alive and well.  Commodities like copper, aluminum, and lead strongly suggest that demand is booming.  As more people around the world prosper, they need more commodities to make all the goods they want to buy.  Gold has also been on a tear lately due to demand for jewelry and electronic component uses, and to a lesser extent, as a store of value for those who fear global inflationary pressures will soon rise.  We believe that the significant consumption of gold in emerging economies such as India and China is just another sign of the increasing numbers of workers/consumers in those countries.  Taken a bit further, greater numbers of workers in the global economy put downward pressures on the costs of produced goods, not inflationary pressures as is currently feared in the U.S.

The recent volatility in stock prices has been due more to investor uncertainty about the future than negative reports.  We are in the middle of earnings season and about half of companies have reported their earnings.  Historical quarterly results have been largely as expected; they are up about 15%.  But the uncertainty has been heightened by managers’ downbeat outlooks for the coming quarters.

As we have pointed out in the past, we believe the recent dramatic effects of legal authorities like the SEC and the Congress under Sarbanes Oxley legislation, as well as the ever-present class-action lawyers have all but muted any enthusiasm or optimism in the forward-looking reports of companies.  Analysts are left to guess about future earnings with little guidance from management until the next quarter’s reporting cycle.  As a result, they may be further off the actual results than they used to be.  Investors are adapting to less candor from managers and the result is more volatility in the short run.

The ultimate peak in oil prices and in interest rates, the question of inflation or not, the question ofIran’s nuclear ambitions all have to be answered in the coming months.  Yes, they hold sway over stock prices – in the short run.  But, these uncertainties also keep “irrational exuberance” in check by not allowing investors to get too far ahead of reality.  It is earnings that move stocks over time, and there is little evidence to suggest a reverse in their trends.  It is said that bull markets climb a wall of worry.  At this point both the wall and the bull look to be in great shape.