We’ll just have to wait and see if this move lower is something meaningful or another one of these sort of mini-corrections as they’ve been called (you can’t exactly call a paltry 6% slip a correction, terming them dips is more appropriate) that attracts subsequent buying. As you all know, I’ve felt this market is over-bought and sentiment is over-bullish for a few months now. Maybe investors are beginning to wonder if expectations got a bit ahead of realities. We do know that balance sheet, or credit induced, recessions are quite different than the typical cyclical downturn. Certainly, things take longer to play out as both households and institutions need to deleverage and as we’ve gotten to this level in stock prices traders kind of take time to look down and ask: Now what? I think this week will offer us a good indication of how the markets will trade over the next couple of months.
Tech, materials, energy and industrials led the session’s decline. Consumer staples, telecom and health-care shares were the relative winners, but all 10 major industry groups declined on Friday.
Commodity-related shares, what had been one of the hottest sectors, has corrected pretty nicely. Over the past few weeks, even though we like these areas (basic materials and energy) over a two-year horizon, we’ve caution about becoming too myopic with this trade. We’ve seen a lot of performance chasing here over the past couple of months, but you really had to build a position back in March and April of last year when few people were thinking about the inflation trade. We continue to like the inflation trade (basic material and energy) along with tech and industrials, the former on a two-year horizon and the latter for the next decade, but you’ve really got to pick your spots in this market – particularly so with regard for inflation trade.
For the week the broad market lost 3.9%, the S&P 500’s worst week since the one that ended on October 30. For January, the S&P 500 slipped 3.7%; the Dow Industrials lost 3.46%; the Dow Transports got hit by nearly 5%; the NASDAQ got whacked by nearly 5.4%.
Market Activity for January 29, 2010
Fourth-Quarter GDP – The First LookThe Commerce Department reported that the economy grew at a 5.7% real annual rate in the final three months of 2009 – much better than the 4.6% expected. This marks the second-straight positive reading as it follows the 2.2% rise in the third quarter. This first look at Q4 GDP is what’s called the “advanced” reading. That’s because we’ll get two more primary revisions to the number. We’ll watch those revisions with caution as the prior quarter’s reading initially came in at 3.5% but was revised all the way down to 2.2% by time of the final revision.
As we’ve been talking about, the reading was fueled by the change in inventories. The gross private investment component of GDP (of which inventories are a key part) jumped 39.3% at an annual rate, which means private investment accounted for 67% of the rise in GDP; inventories alone accounted for 60% of the GDP increase. Inventories did fall in the quarter but only by $33.5 billion. Since stockpiles fell $139.2 billion in the previous quarter (and for context they fell at a record rate of $160.2 billion in the quarter before that), the lower rate of decline added to GDP, massively. All it takes is for inventories to fall at a slower rate in order to contribute to growth.
If one likes to take inventories out of the equation to get a true look at domestic demand, GDP rose 2.2% -- that number is known as real final sales; its long-run average is
2.7% and normally runs at 4-6% coming out of recession.
In terms of contributing components:
Inventories led the way adding 3.39 percentage points (ppt). The next in line was personal consumption, the largest component of GDP, contributing 1.44 ppt of the 5.7% GDP reading. (Personal consumption continued to account for 71% of GDP. That number will be coming back down to the historic average of 65-66% as households begin in earnest to reduce their historically elevated debt/income ratios. The government is delaying this adjustment as transfer payments currently account for a record percentage of personal income. But this level of government spending is not sustainable and thus the adjustment will eventually take place and will weigh on economic growth a couple of quarters out.) Investment on business equipment and software added 0.81 ppt (we’ll watch to see if we get more than just maintenance business spending in the quarters ahead). Net exports (exports minus imports) added 0.50 ppt. Even residential fixed investment (home building) added 0.14 ppt.
Auto and parts purchases subtracted 0.57 ppt from the personal consumption segment; nonresidential structures (commercial building construction) subtracted 0.52 ppt from the private investment segment.
The government component was not a player, actually subtracting 0.02 ppt. Non-defense spending rose a large 8.1% at an annual rate, but it was weighed down by a 3.5% decline on the defense side and a slight decline in state and local government spending. Many are expecting government to be a big contributor to the economy, and I suspect we’ll see a big quarter here from the public sector over the next couple of quarters. But we shouldn’t forget that reductions in state and local spending will loom large over the next year or two. For now, most of the money the federal government is pumping into state and locals is helping to fill budget gaps. But when this money runs out a couple of quarters down the line, they will be forced to engage in austere spending restrictions – unless Washington chooses to engage in yet another massive “stimulus” program and delay the inevitable that much longer.
So a 5.7% print is good, but it is quite shy of the growth level that has been recorded coming out of the prior three worst recession of the postwar era. One quarter removed from the 1957-58, 1974 and 1981-82 recessions (and this latest GDP number is one quarter removed from the last negative print, which was the second quarter of 2009) GDP averaged 8.6% at a real annual rate. So by comparison, this is a weak reading. To get to the 7.8% growth rate, which is the average 12-month growth one-quarter removed from the worst postwar recessions, we need 8.5% GDP readings for the next three quarters. But 5.7% is 5.7% and since we endured four-straight quarters of negative GDP, the longest recession in the postwar era, we’ll take it without much complaint.
Chicago PMIThe Chicago Purchasing Managers Index showed that factory activity in the largest manufacturing region was pretty hot, beating expectations by 4.3 points and the highest reading since November 2005. The January reading for Chicago PMI came in at 61.5 after a downwardly revised 58.7 in December – initially posting 60.0. A number above 50 marks expansion.
New orders accelerated to 66.4 from 64.4; order backlogs rose to 54.3 from 52.0; inventories jumped 10 points to 48.7; employment rocketed to 59.8 from 47.6 (the sector needs this in a big way); suppliers deliveries fell to 55.3 from 57.0 – but who cares with these other solid-to-strong readings.So here we go, the economic bounce we’ve been talking about is here; enjoy it while it lasts. My view is that this will be a transitory expansion, lasting no longer than 4-5 quarters. I’ve explained why I feel this way on several occasions; the most in depth explanation was laid out in the first letter of the year, but here are a couple main reasons.
This looks to be purely an inventory led recovery as firms must restock after the record slashing that has taken place over the previous quarters. But with businesses likely to remain cautious, a function of high uncertainty with regard to future tax rates and coming regulations, a meaningful job-market recovery will be unusually dilatory – hence, a durable increase in end demand will prove challenging. Also, it is going to be tough for credit to expand. Even when loan demand rebounds a bit, very poor credit quality and the likelihood that home prices will endure another leg down (doing additional damage to the non-performing loan scenario) will hamper the supply of loans.
But even if we forget about real estate and loan quality realities and assume something spectacular occurs: the government comes out and states that the top federal income-tax bracket (60% of which is small business ) will not increase in 2011; the capital gains and dividend tax rates won’t increase by 86% and 166%*, respectively; the tax deferral on overseas profits will remain in place; and private equity isn’t burdened (the passive income tax) with the proposed tax rate increase to 35% from 15% -- hence, this weight of uncertainty is removed from the economy’s shoulders. Even if the spectacular were to occur, Washington gets a clue, we still have the Fed in front of us.
Bernanke & Co, as if anyone needs reminding, has the fed funds rate floored at unprecedented low levels. Say the economy were to vigorously bounce in the coming five-six quarters, the FOMC will have to raise rates in an aggressive manner. And Fed tightening almost always results in recession – the only exception is 1995 when the economy barely escaped a negative GDP reading. But that period saw the Fed raise fed funds from 3% to 6% and household debt/income stood at 85%, not the present 125%. This time they will go from effectively 0 (which means the banking sector has been subsidized like never before) to who knows what under the best growth potential scenario. This may explain why I’m skeptical of a durable recovery under either a weak or robust economic circumstance.
* Those 86% and 166% increase numbers I mentioned with regard to capital gains and dividend income are based on the latest leaks from policymakers that they are thinking about raising the cap gain to 28% (which jibes with their constant talk of returning to 1990s tax rates) and 39.6% on top rate incomes – if the Bush tax rates are allowed to expire the tax on dividend income will rise from a straight 15% to the investor’s marginal income tax rate.
Have a great day!
Brent Vondera, Senior Analyst
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