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.           

Global Economic Revisions

The sharp decline in global stock markets last week was in large part attributed by the financial media to economic warnings issued by the Federal Reserve and the International Monetary Fund (IMF). The reports spawned a rash of recession forecasts as markets tumbled. A closer look at the press releases of these institutions, however, reveals a far less ominous outlook of continued albeit more modest growth. 

Financial markets were well aware before last week that the U.S. and European economies were weakening and that there was a rising risk of further deterioration. It was the Fed’s language that startled investors. Their September 21 policy statement asserted that “there are significant downside risks to the economic outlook, including strains in global financial markets. ”This was a sterner warning than the Fed’s August 9 alert that “downside risks to the economic outlook have increased.” 

Investors evidently overlooked the positive growth forecast in the Fed’s statement: “The Committee continues to expect some pickup in the pace of recovery over coming quarters” and anticipates a gradual reduction in unemployment. Indeed, three members of the ten-member Committee believed the economy was not in imminent peril and voted against the Fed’s new “operation twist” policy on the grounds that they “did not support additional accommodation at this time.” 

In its semi-annual global economic report released last week, the IMF alarmed investors with the opening statement: “The global economy is in a dangerous new phase. Global activity has weakened and become even more uneven, confidence has fallen sharply recently, and downside risks are growing.” In the introduction, Executive Counsellor Olivier Blanchard pointed out that “fear of the unknown is high” and concluded: “In light of the weak baseline and high downside risks, strong policy action is of the essence.” 

The actual growth projections in the IMF forecast are more encouraging. Global GDP growth is expected to be 4.0% in 2011 with an additional 4.0% in 2012. The U.S. will avoid recession with 1.5% growth in 2011 and 1.8% growth in 2012. The Euro Area is projected to slip but remain positive: 1.6% growth this year will slide to 1.1% in 2012. The emerging and developing economies will continue to drive global growth with gains of 6.4% in 2011 and 6.1% in 2012. China and India will maintain their torrid pace with 2012 gains of 9.0% and 7.5%. 

 Supporting these forecasts of continued GDP growth this and next year is the consensus outlook of economists polled by The Economist. The U.S. is expected to grow 1.6% in 2011 followed by a modest rise of 2.0% in 2012. Euro Area growth will remain positive but slump from 1.7% this year to 1.0% next year. The widening gap between the developed and the emerging economies, so pronounced in the IMF forecast, is also reflected in the consensus outlook: China is predicted to slow only modestly from 9.0% to 8.6%, whereas economists foresee India’s GDP will rise from 7.9% to 8.2%. 

 In review, the broadly accepted, probable scenario projected by professional economists is that the U.S. and Euro Area will muddle through with the support of continued strong growth in the emerging economies. Even though the economists do not believe recession is likely, they acknowledge that the global economic outlook has dimmed, the risk of a further deterioration has risen, and a further reduction in estimates may be necessary. All eyes will focus on the policy makers to take decisive action to raise consumer and investor confidence and restore healthy growth.

U.S. Economy: The Good and The Bad

Investors over the past few weeks have been beset by a strong dose of volatility in both news reports and stock markets. Economists disagree on where the U.S. economy will go from this point forward and their forecasts seem to get increasingly divergent by the day. A recent Bloomberg article, “It’s the Dog Days of Summer, Shall We Take a Double Dip?: The Ticker,” discusses varying views on the likelihood of a double dip recession. The article enlightens both the optimistic and pessimistic sides of the issue. Their conclusion indicates that although the U.S. and global economies are clearly moderating, the consensus scenario is that recession will be avoided.

The Bad:

Polls conducted recently by the Wall Street Journal and USA Today reveal that the consensus on the likelihood of the U.S. entering another recession has risen to 30%, twice as high as a few months ago. Economists generally accept that U.S. growth will be slower and unemployment will remain inflated for a longer period of time than previously thought. On August 22, Citigroup, Goldman Sachs, and JPMorgan Chase cut their 2011 and 2012 GDP projections. Finally, the need to reduce government spending will handcuff legislators from adopting stimulus measures and the Fed has few tools left to jump-start growth.

The Good:

The consensus on the likelihood of entering another recession is still below 50%. Bob Doll, the chief equity analyst at BlackRock, states: “Stocks have fallen 15% or more in the past few weeks, but since the Great Depression there have been 30 market declines of 15% -- but only two of those predicted a recession.” Even with their reduced U.S growth outlook, Citigroup will projects a 20% stock increase over the next 12 months. The jobs picture is discouraging, but is still strong enough to avoid recession. To be sure, the 12-month data regarding new jobless claims has improved and bank lending conditions have eased. Credit flows, an indicator of reinvested savings, continue to be adequate. Corporations are generating strong profits and carry record cash holdings. Recessions are usually associated with having a negative bond yield curve (whose short-term rates rise above long-term rates), and right now the U.S. has the opposite. Schwab economists sum up these positives with the observation that the U.S. will avoid recession “due to continued positive leading economic indicators, an improving jobs picture, solid corporate balance sheets and a still-steep yield curve.”

The slowing U.S. economy is expected to have only a limited impact on global growth. For example, Morgan Stanley recently cut global estimated GDP growth in 2011 to 3.9 percent from 4.2. The dramatic fall of world stock markets in the past few weeks, which we consider excessive, discounts a much greater than 0.3 percent drop in global growth. For a more in-depth view of Marietta’s opinions on this issue, please refer to earlier posted blogs “Clouds Gathering on the U.S. and International Economic Horizon” and “Financial Market Turmoil.”