It has been awhile since we published our last Economic Update and now that earnings season is largely over, the time is right for one.
At the end of October, the markets began to weaken with many stocks – outside of Amazon – responding poorly to their earnings releases. In a blog entry at that time, we made the following now paraphrased comments:
“The double dip drum has been beating once again given the recent pullback in the markets. While any pullback is worth monitoring, corrections are actually quite common. In fact, we’ve had several 5% plus peak to trough corrections since the recovery began in March.
During June: The S&P 500 “corrects” from 948 to 870, an 8% decline.
During August: The S&P 500 “corrects” from 1035 to 990, a 4 decline.
During September: The S&P 500 “corrects” from 1070 to 1020, a 5% decline.
During October: The S&P 500 “corrects” from 1100 to 1040, a 5% decline.
As the data suggests, each correction has been followed by higher subsequent highs. Alot of money is still on the sidelines and these corrections have provided opportunities to buy rather than sell. I believe the pattern will hold.”
Now, two weeks later, the S&P 500 has reversed course and is resting at 1100 once again, pondering its next move. We believe the markets will resume their upward march over the next two to three quarters, but also recognize that some positive news may be necessary to catalyze a sustained breakout above current levels.
So, the logical question is what might be the source of a positive surprise?
With earnings now behind us, the likely source of positive news may come on the macroeconomic front. And since the greatest concern over this recovery’s sustainability seems to rest on the outlook for employment, it stands to reason that a recovery in employment could be and perhaps should be the source of that very surprise.
Before we discuss our thoughts on the employment outlook, however, it probably makes sense to provide a quick summary of our thoughts from the third quarter’s earnings season just ended, thoughts which we’ve collected from reviewing forty or so earnings call transcripts as well as summaries of many more.
Earlier this week, JP Morgan provided a top down analysis of earnings results. Of the 440 companies in the S&P 500 that had reported their results as of Monday, 80% posted earnings that were ahead of expectations, the largest figure on record. In addition, 60% of these companies also reported revenues ahead of expectations, which may help offset concerns that recent gains have been solely a function of cost cutting.
From our own bottoms up perspective, technology companies have been the most bullish in their outlooks. Cisco Systems, in particular, declared the first quarter as the trough for results, the second as the tipping point, and the third just ended as the start of a worldwide economic recovery.
The bullish outlook from technology companies can also be supported by the large number of M&A deals in the space, including last night’s announced acquisition of 3Com by Hewlett Packard. We would also add that technology tends to be a sector with early cyclical characteristics as many companies try to delay the need for new hires by transitioning to next generations of productivity enhancing technologies first.
While the outlook from technology companies has taken the next step forward, I would characterize the outlook from other sectors of the economy as remaining “cautiously optimistic”. In spite of their more tentative outlook, free cash flow generation is reaching historical highs for many sectors of the economy. In fact, it remains well above reported earnings, as a function of reduced production, leaner inventories, falling receivable balances, and lower employment levels.
A Rockwell Collins executive may have summed up the outlook best by saying “you can delay painting your house, but you can’t not paint your house forever.” Double negatives aside, spending may remain restrained for a time, but it can’t be restrained forever.
In simple terms, our macroeconomic playbook reads something like this. Almost all economic recoveries begin with cost cutting. After the cost cutting, revenues eventually stabilize and pick back up as a function of overshooting production on the downside and a more stable demand environment. The final step in the recovery begins when companies start the process of “painting their houses” once again. As confidence returns, corporate spending will pick back up and along with it, employment.
Of course, this takes money, but on this front there is good news, given high rates of corporate profitability and cash flow generation, as discussed earlier. It is also worth nothing that while bank lending standards may still be tight, corporate debt issuance has been at record highs and spreads remain constructive.
Already, there are twelve countries outside the United States experiencing improving employment, including Australia, as reported by ISI Group. Within the United States, continuing claims have stopped increasing and in spite of a record unemployment level not seen since the early 80’s, the four week moving average of weekly unemployment claims just declined for the tenth consecutive week.
The unemployment rate is generally viewed as lagging indicator since it has historically peaked well into the earlier months of an economic recovery. As we look to the winter and spring months ahead, we believe the biggest surprise will therefore be the employment outlook. (Note that the unusually high worker productivity level just announced – 9% – is likely unsustainable and may be a function of cutting payrolls too much.)
Of course, an improving employment outlook would be a major surprise in an investment environment that remains so skeptical of that very thing. But in spite of such skepticism, the recovery to date, has been far more textbook that most would care to admit. While there are always those who would say “this time it’s different”, in my experience, these words have invariably accompanied very poor investment decisions.
Tactically, we have been paring our significant gains in early cyclicals, particularly consumer discretionary stocks purchased a year ago when the death of the consumer was loudly proclaimed. We’ve been redeploying these gains into later stage cyclical stocks more recently – areas that should outperform as the recovery matures; primarily energy, industrials and materials.
If time proves our forecast correct, an improvement in employment should be on the macroeconomic agenda at some point in the next two or three quarters, setting the stage for continued outperformance as we enter 2010.
That’s the picture we’ve painted. Now it’s time to sit back and watch the paint dry.