U.S. Stock Market Rally Supported by Economic Data and Corporate Profits

The 11.7% rally of the S&P 500 Index in the 4^th quarter through November 11 is part of a global stock market advance that includes Europe and the emerging economies. Most market observers attribute the gains primarily to developments in Europe, where policy makers have made progress in containing the sovereign debt crisis. Not to be overlooked, however, is the contribution made by encouraging economic data and strong corporate profits in the U.S. and by signs of ebbing inflation in some of the leading emerging countries, especially China.  

U.S. economic reports in October and thus far in November have been surprisingly good, especially in relation to the rising fears in September of an imminent and severe double-dip recession. Last week’s news, for example, reveals that small business optimism ticked up, consumer confidence indices rose, weekly initial unemployment claims continued to fall, mortgage applications rose, the trade gap narrowed, consumer credit expanded, and import prices declined. Despite a faltering Euro-Area economy, the U.S. economy continues to grow, although at an anemic pace.

U.S. corporate profits have also defied pessimists’ forecasts. Over 90% of companies in the S&P 500 have reported earnings so far this quarter, and over 70% have exceeded Wall Street estimates. International Strategy and Investment (ISI), a widely respected research firm for institutional investors, reports that S&P 500 earnings are running 5.8% above projections, and they are expected to be up about 18.3% year over year when the remaining companies report.   

We pointed out in our October 4 Outlook that global stock markets were “very oversold.” At the time, the markets reflected a recession-level collapse in economic growth and corporate profits despite a significantly more positive consensus forecast of economists. We view the market’s recent rally as only a partial adjustment to this oversold condition. During the last year, when S&P 500 profits soared about 18%, the S&P 500 Index rose only 4%. As a result, the P/E ratio of the S&P 500 Index based on consensus 2011 earnings estimates is now 13.1x, which is still below the past recession average of 13.7x. The consensus estimate of a further 7% profit advance in 2012 would further improve the market’s valuation.

Our conclusion is that if the U.S economy continues to avoid recession, as most economists expect, then the U.S market is still oversold.           

Small Business Confidence Rising; ISI Remains Optimistic

We share the view of most economists that the major deterrent to a strong and sustainable U.S. economic expansion is the lack of healthy job growth. High unemployment and underemployment has dampened consumer confidence and spending, and is clearly having a serious negative impact on stock prices. The key to employment gains in this as in past economic recoveries will be small businesses. According to the U.S. Small Business Administration, its members represent more than 99% of all U.S. employers and have created 64% of all new jobs in the past 15 years. The problem is that small business owners have been very reluctant to hire in the current economic recovery.

The announcement on June 8 by the National Federation of Independent Business that their small business optimism index increased from 90.6 to 92.2 in April, which marks a 20 month high, is a very encouraging sign. 7 of 10 components in the index rose, led by a significant gain in expectations for business conditions six months down the road. Most noteworthy is that job creation plans registered the first positive reading in 19 months. Other positive responses include an improvement in profits, plans to increase capital spending, and an expectation of easing credit conditions.

A caveat is in order: even with April’s advance, the Index trails levels reached in past economic rebounds. On the other hand, a pick up in hiring led by small businesses would be a powerful antidote to the currently fashionable thesis that the U.S. economy is heading into a double-dip recession.

Separately, The International Strategy and Investment Group (ISI), highly respected and influential among institutional investors, has taken a strong stand against the prospects of a double-dip. On June 7, ISI distributed their forecast for U.S. GDP growth of 3.5% in 2010 with an additional 3.0% in 2011. Key to this forecast is their weekly survey of companies, which last week rose to a new high and indicates that “a powerful, broad-based recovery is unfolding.”

ISI is well aware of the headwinds: the Eurozone economy is likely to see a double-dip, U.S. tax rates are headed up, U.S. state and local budget cuts and tax hikes are likely, and they foresee a slowing in China real GDP to 7.5%. Despite these and other negatives, they cite continued strength in manufacturing, strong corporate balance sheets and profit growth, lean inventories, low inflation and interest rates, and an accommodating Federal Reserve in addition to their company surveys to support their positive outlook.