The Stock Market: Economy over Earnings

Morris Segall      aborted stock market rally, consumer sentiment, oversold stock market rallies, peaking in corporate earnings cycle, pessimistic Fed outlook

In our July 6th website article, “Economic and Capital Markets Update”, we concluded our bearish forecast with the advice, “we would use an anticipated market rally in July from good second quarter corporate earnings to move towards our intermediate-longer term strategy”.  Despite our negative assessment of the economic data of the last two months and our downgraded economic forecast for next year, we expected the combination of an oversold stock market and strong second quarter corporate earnings reported in July, would produce a strong equity market rally that we would use to sell equity positions in favor of the re-allocation we advocated for the intermediate-longer term. As if on cue, the equity market rally we were expecting arrived the next day, July 7th, as the major U.S. equity market averages rose approximately 3%. Over the next five trading sessions, the major averages added another 3%-4%, peaking on July 14th on the backs of strong earnings from major bellweather companies like Alcoa, CSX and particularly Intel. However the economic news released last week continued a string of weak reports including retail sales and industrial production for June, a pessimitic Federal Reserve economic outlook and finally another collapse in consumer sentiment, this time in the University of Michagan survey reported on Friday. The weakening economic data and outlook  undermined the earnings rally and accompanied by weak operating earnings from major international banks, the stock market rally of July 7-14 reversed with a 3% decline in the major averages on Friday. Importantly, the rallies in virtually all of the major U.S. equity indices failed at or around the 50% retracement from the June market lows, a key development for market technicians and traders who now believe the aborted rally at such a key technical level spells the end of the July rally and a resumption of the market decline begun this past May.

From a technical standpoint they may be right. From an economic standpoint they could also be right. The stock market is a forward looking mechanism and the increasingly weak economic data being reported look like it is corroborating our stated belief that the economy is stalling. The Fed’s downwardly revised economic outlook and the huge decline in consumer sentiment in both the Conference Board and University of Michigan surveys portend the kind of economic retrenchment we warned about in our July 6th website article. The consumer sentiment readings are particularly worrisome because they reflect a deep level of pessimism that can be a self fulfilling contraction in consumer spending, already weak in this recovery. We still expect a summer spike in consumer spending from increased vacation travel and we think it may provide another oversold rally in the equity markets when reported in August and September. However, the stock markets could be at or below the June lows when the news hits and the economic outlook for late this year and next could have eroded further.  This week will be crucial to see whether Q’2 earnings can halt the market reversal and give investors a better exit point. We still believe stock market rallies in July or later should be sold into. The stock market uptrend from March, 2009 is over.  Current earnings no matter how strong cannot outweigh a deteriorating economic outlook that portends a peaking in the earnings cycle over the next four quarters.

Morris R. Segall, CFA, CIC

June Unemployment: More Bad News

Morris Segall      recovery cycle, stock market, unemployment

Friday’s unemployment report for the month of June was weaker than economists had expected and weaker than the surface numbers show. It also was the latest in a series of weaker and disappointing economic data reported last week. Last week saw a continuation in weak consumer spending  in May for the second month in a row despite healthy gains in consumer incomes over the April-May period. The consumer savings rate increased in May for the second month in a row to 4% reflecting consumer caution. Also, last week, the Conference Board reported consumer confidence in June fell dramatically from 62.7 to 52.9. Clearly the stock market declines in May and June are depressing consumer attitudes but respondents are also again expressing difficulty in getting jobs and are increasingly pessimistic about both current conditions and future expectations. We have repeatedly stated in our economic presentations, since the economy began recovering last year, that the absolute level of consumer confidence in this survey have been well below levels normally seen in postwar economic recoveries and indicated to us a muted consumer reaction to the economic recovery.  Rounding out last week’s economic reports were: a greater than expected decline in the ISM purchasing managers index reflecting a pause in the upward trend in orders and shipments seen since last year and a decline in hiring  by respondents; an increase in first time unemployment claims for the last week in June, taking first time claims to over 470,000 for the third time since May and well above the level of 350,000 seen in previous economic expansions; and finally, factory orders for May dropped for the second consecutive month after rising steadily since last spring. 

But the June employment report contained cause for concern despite the expected decline in census worker jobs and a reduction in the unemployment rate for the first time this year. The number of discouraged workers at 1.2 million is up by over 400,000 from last year. The number of people in the work force, as measured by the Household monthly data,  is down by over 1 million workers since June of 2009 and despite that drop in the labor force, the employment participation rate is down to 64.7% from 65.7% in June, 2009. A full year after the economy began recovering, the average workweek is only at 33.4 hours versus 33.0 hours in June, 2009. Over the last twelve months, average hourly earnings are up by only 1.7%, less than the 2% annual rate of inflation as measured by the CPI through May of this year. The private sector created only 83,000 jobs in June, below an expectation of approximately 100,000+. Of that 83,000, approximately 21,000 were in temporary help services and 37,000 were in leisure and hospitality. A number of leisure and hospitality jobs, 28,000, were in amusements, gaming and recreation that may be seasonal hires to cope with a very active vacation season. Other professional and business services added another approximately 25,000 jobs and healthcare added approximately 17,000 jobs. Most of the remaining sectors in goods producing, services and governments cut jobs in June. The June numbers follow a downwardly revised estimate of 33,000 private sector jobs created in May and establishes a pattern of weak private sector hiring for the two month period when empirical and other evidence should be creating the opposite result.

Tomorrow we plan to publish our updated economic and capital markets analysis and forecast on our website, www.spgtrend.com. It will extend the theses we have articulated in our blog articles since May. That is the expansion cycle in the U.S. equity market has reversed because of the international credit alarms caused by sovereign debt issues in Europe and these developments are having a negative impact on the U.S. economic recovery cycle. The economic data of last week, particularly the monthly job report, lead us to believe the U.S. economic recovery is  pausing while businesses and consumers assess the outlook for the remainder of this year and next.  We are afraid businesses in particular are already starting to plan “cutbacks” in anticipation of a weaker economy going forward.

Morris R. Segall, CFA, CIC