European Central Bank

How did German Chancellor Angela Merkel and French President Nicolas Sarkozy (“Merkozy”) manage to convert a really scary story into a happy tale that has been so wildly bullish for stocks and commodities during the month that ends with Halloween? That’s a very good question.

Perhaps the simplest explanation is that investors have concluded that the latest Grand Plan to save the euro fashioned by Merkozy is just as flawed as the one that was dead on arrival on July 21. So the inevitable solution to the Euro-Mess is to have the ECB clean it all up.

In other words, the mantra in financial markets is now, “Ease, Mario, ease!” Last week, in the October 25 FT, Martin Wolf led the chant in his column titled “Be bold, Mario, put out the fire.” He wants incoming ECB President Mario Draghi to implement a program of quantitative easing. The only problem is that Article 123 of the Treaty of Lisbon (2007) prohibits the ECB from doing just that.

Nevertheless, the ECB has started doing it again for a second time. The bank’s balance sheet rose to a record €2.3 trillion on October 21, up €440 billion from a 2011 low of €1.9 trillion on April 8. This expansion was attributable to the ECB increasing its loans to euro area financial institutions by €177 billion to €585 billion. In addition, the ECB’s holdings of euro area bonds rose €110 billion so far this year to a record €567 billion. In the ECB’s first round of QE, the bank’s balance sheet soared by €512 billion to €2.0 trillion during the four weeks through October 17, 2008.

Home Alone: Update on the Homestead Act

Everyone knows that housing was the epicenter of the previous recession and that it is the biggest drag on the recovery. President Barack Obama wants to help by allowing homeowners to refinance their mortgages at record low interest rates even if the values of their homes have fallen below the amounts they owe.

The majority of the FOMC wants to help too. That’s why they voted to implement Operation Twist at their meeting on September 20-21, despite the objections of three cold-hearted dissenters. Last week and early this week, three of the do-gooders on the FOMC said they are ready to do more good and are considering a third round of quantitative easing that would include purchasing mortgage-backed securities again.

I don’t understand why no one in Washington is pushing for more targeted policies that would simply reduce the huge overhang of unsold homes. Doing so would take the downward pressure off of home prices. Actually, it should boost home prices by convincing would-be homebuyers to stop waiting for better deals and jump in and buy a house.

That’s the objective of the Homestead Act that Carl Goldsmith and I proposed this past summer. It would provide a matching down payment subsidy of up to $20,000 for anyone purchasing a home as their principal residence for two million houses. It would provide tax-free rental income for 10 years to anyone who purchases a house to rent for another one million houses. That would eliminate the current overhang of unsold homes completely.

Carl and I reached out to various political leaders in Washington on both sides of the aisle. Congressman Gary Ackerman liked the idea well enough to instruct his staff to work on a bill. The problem is that our plan would lower the corporate tax rate on repatriated earnings to 10%, using the proceeds to pay for the subsidy. The Congressional Budget Office scores these tax revenues as though they will be raised at the 35% tax rate even though such a high rate has been a major obstacle for such repatriation. So, we’ve hit a road block, though we are still pushing for the plan as best we can.

Confidence & the P/E

Everyone is very depressed. Investors are very depressed, as evidenced by the latest Bull/Bear Ratio, which is 1.06 this week. Although that’s the first reading above 1.00 in seven weeks, it’s still very low. Yet the S&P 500 is down only 2.3% ytd and 9.9% from the year’s high on April 29. Consumers are also very depressed. Yesterday, the Conference Board released October’s Consumer Confidence Index (CCI), which plunged during the month to 39.8 from 46.4 in September. It is the lowest since March 2009. The expectations component fell to 48.7 from 55.1 last month. Yet retail sales have been remarkably resilient.

There is a close correlation between the forward P/E of the S&P 500 and the expectations component of the CCI. They have fluctuated in volatile cycles since 2008, rising together in response to the Fed’s numerous attempts to make things better, but then falling together on disappointment over the results. Unemployment remains high. Inflation-adjusted incomes are stagnant. Home prices are depressed. Profits are great, but the European financial crisis increases the risk of a global slowdown or even a double dip.

Yet employment is growing, though at a lackluster pace. Home prices have mostly stopped falling. Energy prices are down from elevated levels at the beginning of the year. Borrowing costs are at record lows. Many business managers seem to be moving forward, and not letting the constant meddling of our political leaders get in the way of doing business.

The P/E rebounded during October as investors regained some of their confidence in the resiliency of the US economy. It also rebounded on hope that the Europeans would muddle along and avoid a financial meltdown. There should be more upside in the valuation multiple as long as investors expect that muddling will prevail over melting. That’s likely to be the case over the rest of the year. On the other hand, the upside for the P/E may be limited if consumers remain as depressed as they were in October. Are we having fun yet?

S&P 500 Earnings

We monitor quarterly and annual earnings expectations every Tuesday in our Morning Briefing. This is an especially interesting exercise during earnings seasons, allowing us to see how actual results are influencing future projections. Here is what has happened so far:

(1) During the week of October 21, the actual/estimated blend of earnings for the S&P 500 jumped to $24.91 per share from $24.43 the prior week. So the y/y growth rate rose from 12.3% to 14.5%. That jump was certainly boosted by a quirky accounting rule that lets banks book a profit on the falling value of their own debt. It accounted for nearly half of the profits gain for both Citi and JP Morgan Chase.

(2) The uptick in Q3 didn’t stop analysts from cutting their numbers for Q4 and all of 2012. The Q4 estimate was lowered to $25.38, which would be up 12.6% y/y. The 2012 estimate fell to $108.90, which would be up 11.5% from the latest estimate for 2011. Next year’s estimate has been lowered in 10 of the past 11 weeks.

(3) The V-shaped recovery in forward earnings, which powered the bull market since March 2009, is losing steam. Indeed, forward earnings has been flat for the past 10 weeks, with a slight downward tilt over the past six weeks.

Joe and I are still expecting that next year’s estimate will be lowered to $100 a share by the end of this year. Forward earnings will do the same since it is a time-weighted average of the current and coming year estimates.





The Fed & QE

We need to find something for Fed officials to do in their spare time. They insist on subjecting the economy to their new experimental monetary policy fixes that are extremely controversial and replete with dangerous unintended consequences. They refuse to believe that they’ve run out of policy tools. They insist they can do more to revive economic growth and lower the unemployment rate. That’s despite lots of evidence that record low interest rates and a second round of quantitative easing haven’t stimulated growth as they expected.

Although they started to implement their Maturity Extension Program (MEP)--a.k.a. Operation Twist--just last month, they are already having second thoughts about it. Rather than cease and desist, they want to do more, including a third round of quantitative easing and more “forward policy guidance.” Let’s review the latest developments:

(1) The minutes of the September 20-21 FOMC meeting, which were released on October 12, suggested that QE-3.0 is still on the table: “A number of participants saw large-scale asset purchases as potentially a more potent tool that should be retained as an option in the event that further policy action to support a stronger economic recovery was warranted.”

(2) Last week, Fed Governor Daniel Tarullo, who rarely comments on monetary policy, made headlines with a speech he presented on Thursday, October 20 in which he said: “I believe we should move back up toward the top of the list of options the large-scale purchase of additional mortgage-backed securities (MBS), something the FOMC first did in November 2008 and then in greater amounts beginning in March 2009 in order to provide more support to mortgage lending and housing markets.” One of the many benefits of doing so, he said, is that it should induce “investors to shift to other assets, including bonds and equities.”

(3) The next day, in a speech on Friday, October 21, Fed Vice Chair Janet Yellen seconded Tarullo’s consideration of another round of QE. She noted that while the Fed had only just recently implemented Operation Twist, it is a program limited by the Fed’s holding of short-term securities, and buying most of the outstanding long-term Treasuries might not be such a good idea after all since it “could potentially have adverse effects on market functioning.”

Wow, is she already admitting that MEP was a mistake?! I think she is. So what does she want to do instead? More, more! She’s ready for QE-3.0: In her opinion, “securities purchases across a wide spectrum of maturities might become appropriate if evolving economic conditions called for significantly greater monetary accommodation.”
 

Apparently, Ms. Yellen doesn’t have any doubts about the effectiveness of quantitative easing despite plentiful evidence that QE-2.0 actually backfired. The chart above shows inflation-adjusted retail sales since 2008. After recovering solidly from September 2009 through November 2010, it’s been flat since then through September of this year.

In my opinion, after QE-2.0 was first mentioned by Fed Chairman Ben Bernanke on August 27, 2010 and actually implemented on November 3, 2010, it depressed the purchasing power of consumers by boosting food and fuel prices. QE-2.0 backfired. It clobbered consumer spending just as the economy was on the verge of transitioning to self-sustained expansion, without any help from the Fed.

Why did Fed officials rush to implement QE-2.0? They clearly failed to recognize that the soft patch in economic growth from May through July was temporarily related to the termination of tax incentives to buy houses and appliances at the end of April 2010. Despite having hundreds of economists working at the Fed, they completely misread the economy and meddled at the worst possible time. They seem intent on making the same mistake all over again now.

 

The second chart in our blog today shows the performance of the S&P 500 with overlays showing when QE-1.0, QE-2.0, and Operation Twist were in effect. Stock prices rallied during the first and second rounds of quantitative easing. They sold off as soon as both programs were terminated. They are rallying again under the influence of Operation Twist and talk of a third round of quantitative easing. Pushing up stock prices has been one of the main goals of the Fed’s experiments with untested monetary policy measures. How much longer will they succeed in boosting stock prices if they not only fail to boost economic growth, but actually adversely affect it?

China

In my opinion, China’s success of the past three decades is mostly attributable to the exploitation of Chinese workers. That’s right, the world’s largest communist country has been exploiting its workers! There are an estimated 120 million migrant workers in China. These are not people from other countries. They were all born in China, mostly in rural villages. Yet, they are restricted from living and working freely in their own country.

Many of them have no siblings because their parents were limited by the one-child population control policy instituted during 1978. When they were teenagers, they swarmed out of the impoverished rural areas to the urban centers on the east coast of China, finding jobs in the booming export manufacturing industries.

These migrant workers provided the cheap (exploited) labor that transformed China into the world’s top manufacturer and exporter. Their pay was low, and they received few, if any benefits. They were second-class citizens subjected to the household registration system known as the “hukou,” which defines where people are officially registered to live and whether they are considered urban or rural residents. The distinction is crucial, because rural migrant workers who move to cities to work in factories and on construction sites are not eligible for many social benefits, including education for their children.

Many migrant workers are now young adults, who are very unhappy about their status and their standard of living. They are starting to demand better treatment. The government responded at the beginning of the year by raising the minimum wages by 15%-20%, and by promising that the next Five Year Plan will focus on improving the lives of Chinese workers. The resulting jump in labor costs has been exacerbated by a shortage of young exploitable new entrants into the labor force as a result of the one-child policy.

Higher nominal wages and rising labor costs have pushed the CPI up by 6.1% y/y through September, led by a 13.4% increase in food prices and a 12.3% increase in fuel prices. Anecdotal evidence suggests that inflation may actually be higher than shown by the official data. That explains why monetary and credit authorities have been tapping on the brakes since early last year. M2 (in yuan) rose 13.1% y/y through September, the slowest since May 2001. Bank loans are up 14.3%, the slowest since November 2008.

Small firms are getting squeezed by rising labor costs and much tougher credit conditions. They are being forced out of business. The authorities are scrambling to provide credit to them, fearing that rising unemployment along with erosion in the purchasing power of recently raised wages will exacerbate social unrest. No wonder that the Chinese stock market is down 15.7% ytd, among the worst performing in the world.

Bull/Bear Ratio

The good news for the stock market is that sentiment remains very bearish, which is bullish. Despite the huge rally in the S&P 500 since 3:10 p.m. on October 4, the Bull/Bear Ratio (BBR) compiled by Investors Intelligence remained under 1.0 for a sixth consecutive week. It was 0.87 this week. Last year, it also dropped below 1.0 just when the market bottomed in early July and continued on to have a great yearend rally. At 41.0%, the percentage of bears is down from last week’s high of 46.3%, but remains as high as it was in early 2009 just before the start of the latest bull market.

There is a good correlation between the four-week average of the BBR and the expectations component of the Consumer Confidence Index, which is compiled monthly by the Conference Board. The fit between the two has actually improved since the start of the financial crisis in early 2007. Recently, I’ve explained the strength in retail sales during the summer in the face of plunging consumer confidence by observing that when Americans are depressed, they go shopping.

In the past, whenever the BBR fell below 1.0, it was a great time to go shopping for stocks. That seems to be the case again now. The consensus is so skeptical that the Europeans will actually solve their debt crisis that sentiment isn’t getting a lift from the powerful rally in stocks. Who is doing the buying? It might be the high frequency traders. It must also be value buyers, who are trained to load up on stocks when bearishness is so widespread.

World Trade



It’s always important to look at the big picture. I do so focusing on the various data series for world trade. The latest data show that the global boom has turned into a soft patch. Evidence of an imminent double dip in the world economy is scarce and flimsy. Let’s have a closer look at the big picture, which we update regularly in our World Trade chart book. 

(1) The volume of world trade has stalled. The Netherlands Bureau of Economic Policy compiles a monthly index on the volume of world trade. It rebounded smartly from the recession of late 2008 and early 2009 to a new high in March of this year. Since then, it’s been stuck between 165 and 170. It is highly correlated with the OECD’s index of global production (i.e., for the 30 OECD countries plus the six largest emerging ones). The production index has also stalled this year, but managed to edge up to a new record high during July. (See Figure 6.)

(2) In current dollars, the value of world exports has also stalled. This series is compiled by the IMF, and has been hovering around $18 trillion, at an annual rate, from March through July. Not surprisingly, it tends to be highly correlated with the CRB raw industrials spot price index, which is down 15.5% since its record high on April 12. That’s one of the few signs that the soft patch is getting softer. However, the CRB index still exceeds its previous cyclical (and record) high of early 2008 (Figure 9).

(3) The exports of the G7 countries rose to a new cyclical high during August. The total was $6.08 trillion (saar). There were strong surges to new cyclical highs in Germany, France, the UK, and Japan (record high). On the other hand, American and Italian exports flattened during the month, Canada edged down during the month (Figures 11-13). Over the past 12 months, the G7 countries accounted for only one-third of the value of world trade, down from 50% in 1996 (Figure 8).

(4) Exports have stalled near record highs in many emerging economies. Actually, exports in some countries are starting to look a bit toppy, especially in India, Malaysia, South Korea, Taiwan, Brazil, Russia, and the Ukraine. Still making new record highs are Singapore, Argentina, and Columbia.

(5) China’s export engine seems to be sputtering just a bit in the EU and the US. I’ve saved the most interesting trade story for last. China’s exports have flattened around $1.8 trillion (saar) for the past year. Not surprisingly, the weakness is in exports to the EU and the US. You can see this in Figures 13-16 of our China chart book. Today’s charts show the y/y growth rates of Chinese exports to the EU and the US. In September, the former was up 10.4%, while the latter was up 12.3%. Both growth rates are relatively low and remain in their downtrends of the past two years. Both are highly correlated with their respective manufacturing purchasing managers indexes (M-PMIs), which have been heading down most of this year.

Our World Trade and China chart books are available to subscribers of our research services.

Profits & Retail Sales

It’s too soon to tell whether the Q3 earnings season will be full of positive or negative surprises. Last week, Alcoa and JP Morgan disappointed, while Google beat expectations. I expect more disappointments in Materials and Financials. However, there should be plenty of beats among Retailers, Industrials, and IT.

One ominous development is that on Friday, the US Treasury reported that corporate tax receipts were down 5.4% y/y in the 12 months through September. The growth rate is highly correlated with the comparable figure for the S&P 500 quarterly earnings, and is the weakest since May 2010. It’s possible that the weakness in corporate tax receipts is related to the strength in capital goods orders in recent months. Corporations may be rushing to take advantage of the 100% depreciation allowance that expires at the end of the year.

When Americans get depressed, they go shopping! How else can we explain why retail sales rose 1.1% during September, while the Consumer Sentiment Index (CSI) was near previous record low readings at 59.4 during the month, and fell to 57.5 during the first half of October? In addition, August’s retail sales were revised upwards to 0.3% from flat, and July’s figure was nudged up from 0.3% to 0.4%. That happened even though the CSI expectations component fell in early October to 47.0, the lowest reading since March 1980, when Jimmy Carter was depressing the nation.

Retail sales rose to a new record high of $3.95 trillion (saar) during September, up 18.6% since their most recent cyclical low of $3.33 trillion during March 2009. It is puzzling, though, that over the same period (through August), personal disposable income is up only 8.5%, with wages and salaries up 7.1%. On the other hand, rebounding strongly along with retail sales is the 12-month sum of individual income tax receipts, which is up 28.9% from its January 2010 low of $846.8 billion to $1.09 trillion through September of this year. This suggests that personal income may be revised up eventually.

 

That all sounds very good and certainly doesn’t support the dire warnings of the double-dippers. However, the picture isn’t quite as rosy for inflation-adjusted retail sales. While I estimate that they were up 1.0% during September, real retail sales are no higher than during last November. Real retail sales have been essentially flat since then for the past eleven months. They are also still 5.2% below the record high during December 2006.

S&P 500 & the Blue Angels

The chart above shows the S&P 500 from 2007 to now and compares it to six series calculated by multiplying the weekly forward earnings data for the S&P 500 by whole number multiples from 10 to 15. These series look like the vapor trails of six Blue Angel jets flying in formation. The S&P 500 has been flying within these vapor trails like a stunt plane. It’s a neat way to visualize how changes in the S&P 500 are driven by changes in forward earnings expectations versus changes in the forward P/E.

The chart confirms the obvious: Much of the short-term volatility in the stock market is attributable to the volatility in the P/E. Earnings expectations don’t bounce around very much from week to week. They tend to be inertial and autoregressive. In other words, they tend to move in the same direction they moved just recently. When they are rising, they tend to keep rising. When they are falling, they tend to keep falling.

 

Almost all of the recent plunge in the S&P 500 occurred between July 21 (1345) and August 8 (1119). Since then it’s been moving between the August 8 low and the September 1 closing high (1218). Yesterday, it tested the top of that range, but backed off a bit to close at 1207. The chart in our blog shows that the plunge from July 21 through August 8 was almost all attributable to a plunge in the forward P/E from 12.7 to 10.4. Forward earnings have edged down over the past five weeks. However, all of the recent volatility in the market has continued to be attributable to the volatility in the valuation multiple.

 

 

The chart below shows a similar analysis for the S&P 500 from 2000 through 2006. Back then, the S&P 500 peaked at 1527.46 on March 24, 2000 and fell to 776.76 on October 9, 2002. This bear market was mostly attributable to the sharp decline in the forward P/E from 25.4 to 14.2 from the peak to the trough of the S&P 500. Earnings actually held up surprisingly well back then. There was a particularly bad break in the P/E from 19 down to 15 during July 2002, as a result of WorldCom’s accounting scandal.

If recent history repeats itself, then the valuation multiple should recover partially again. It already has done so, from a low of 10.2 on October 3 to 11.2 yesterday. I’m not sure there is much more upside over the rest of the year, but there should be more upside next year.

Add caption

Valuation & the Bond Yield

Are stocks undervalued? They certainly seem to be, especially relative to bonds. Very often in the past, falling bond yields were associated with rising valuation multiples. This time seems to be different. Or is it just a temporary divergence, and a great buying opportunity? Let’s analyze the data:

(1) The forward earnings of the S&P 500 dropped for the fifth week in a row through last Friday to $107.59 per share. This is the time weighted average of the latest consensus estimate for 2011 ($97.80) and for 2012 ($110.53).

(2) The forward P/E edged up to 10.7 from 10.5 the previous week. That’s not much above the previous low of 9.3 in December 2008, which was a 23-year low. Monday’s rally lifted the P/E to 11.0. That’s still well below 15.0, which is widely believed to be about the normal valuation multiple during normal times. Actually, using monthly data, the average forward P/E for the S&P 500 since the start of the data during September 1978 has been 13.6.

(3) Today’s charts compare the forward P/E to the 10-year Treasury bond yield and to expected inflation in the 10-year TIPS yield. The close positive correlation among these three variables since 2007 has been remarkable.

However, it isn’t surprising. Since 2007, the yield and expected inflation have fallen when the economic outlook seemed to be worsening as the financial crisis intensified. When the crisis seemed to be abating, yields and expected inflation rose. The same cycle of fear and relief that’s been behind the volatility in yields and expected inflation has been driving the stock market’s valuation of earnings.

In other words, lower bond yields are bad for stocks, while higher yields should be good for stocks. It’s not clear how Operation Twist might alter this relationship. It is the latest monetary stimulus program that reflects the Fed’s lack of confidence in the economy’s ability to grow without massive policy intervention. The problem is that investors have lost their confidence that such intervention is helping the economy. Indeed, some believe it is actually counterproductive.

I’m in that camp. Nevertheless, stocks are cheap. So I don’t see much more downside for the valuation multiple. However, it may take some time for it to move back up to its norm. That will happen when the financial crisis is finally behind us.

European Recession?

Is Europe falling into a recession? It seems to be heading in that direction. Let’s review the latest business indicators:

(1) Europe’s manufacturing PMI is under 50. The EU’s manufacturing purchasing managers index (M-PMI) dropped to a 25-month low of 48.5 in September, the second straight reading below 50.0. Only Germany saw its M-PMI hold above the breakeven point, but barely, with its index at a two-year low of 50.3. Italy was the only EU country to show an increase in its M-PMI in September, but at 48.3 it was the second sharpest contraction in two years, with August’s the steepest at 47.0. The UK saw a moderate expansion in manufacturing activity last month, as its M-PMI climbed to 51.1 from just under 50.0 in both July and August.

(2) Europe’s non-manufacturing PMI is also under 50. Markit’s euro zone non-manufacturing purchasing managers index (NM-PMI) fell from 51.5 in August to 48.8 last month, its lowest reading since July 2009 and below an earlier flash reading of 49.1. September is the first month that the index has been below the 50 mark that divides growth from contraction, since August 2009. Germany showed activity close to stagnation, while in France the rate of growth slowed to a 26-month low. Italy's service sector contracted for the fourth month and at a faster pace than expected, while Spain's shrank for the third straight month.

(3) Ditto for the composite PMI. The composite PMI--combining the services and manufacturing data--fell from 50.7 in August to 49.1, its lowest level since July 2009.

(4) European production indexes held up during August, when  factories are mostly closed. Actual production indexes were mostly higher during August. That’s not saying much, since the data are boosted by seasonal adjustment factors to reflect the fact that many factories are closed during the month. So for what they’re worth, August industrial production edged down by 1.0% in Germany, rose 0.5% in France, jumped 4.3% in Italy, and unexpectedly increased 0.3% in Spain.

Monster Employment Survey & Railcar Loadings

So far, there isn’t much evidence that Europe’s troubles are slowing the US economy. There’s no recession in my forecast for the US, just “muddling” growth. I continue to expect that real GDP will be up by about 2% during both Q3 and Q4. While I expect that there may be earnings disappointments in the coming reporting season for Q3 results, I also see some industries that should have good news:

(1) Construction equipment and farm machinery industries are rolling along. Shipments and exports in US capital goods industries are a bright spot for the US economy. Much of that strength is attributable to construction equipment and farm machinery. Orders for these goods along with heavy trucks rose 70% (saar) during the three months through August (using the three-month moving average). That’s the best growth rate in the history of the series dating back to 1992. It augurs well for the Q3 profits of these industries.

(2) The auto industry is back on the highway. During September, retail auto sales totaled 13.1 million units (saar). That’s up from a recent low of 11.5 million units during June, and back near its high for the year of 13.2 million units in February. The industry’s production is recovering from parts shortages following Japan’s earthquake during March. In addition, the national average pump price of a gallon of gasoline was back down to $3.50 a gallon during the final week of September from a high this year of $3.96 in mid-May. That might explain why light truck sales jumped to 6.0 million units during September, the best rate since March 2008.

(3) Retailers doing well despite weak consumer macro numbers. September saw strong sales as the 23 retailers tracked by Thomson Reuters reported a 5.1% y/y rise in stores open at least a year for the month, beating expectations, for a gain of 4.6%. Both large discounters and high-end retailers beat expectations. This may reflect survivor bias, as they have less competition. The average vacancy rate at malls in the top 80 US markets ticked up to 9.4% in Q3 from 9.3% in Q2, according to data released Friday from real-estate research company Reis Inc. The vacancy rate marked the highest that Reis had on record since the firm started tracking mall data in 2000. September’s Monster Employment Index of online job ads showed the retail industry’s index edging up to the best reading since September 2008 (chart above). Retailers’ payrolls rose 13,600 during September.
 

(4) The transportation and warehousing industries are preparing for a good holiday season. September’s Monster Employment Index showed the transportation and warehousing index rising to the highest since October 2007. Payrolls were little changed during September in these two industries. Railcar loadings rose to a new cyclical high during the week of October 1, led by a new record high for intermodal containers (chart below).

(5) Help is wanted in the IT industry. The macroeconomic indicators on orders, shipments, and production for the Information Technology industries are mixed. During August, orders for computers and electronic products remained in a flat trend, which started late last year. Industrial output of computer and peripheral equipment during the month rebounded back to the record high at the beginning of this year. However, production of both communications equipment and semiconductors have been flat for several months. Yet September’s Monster Employment survey showed a sharp increase in the IT industry’s index, to the best reading since October 2008.

US Purchasing Managers Indexes

It’s official: The next recession hasn’t started yet. It certainly didn’t start in September based on the latest available batch of economic indicators. Most encouraging is that private-sector payrolls rose 91,000 during the month, according to ADP. While the non-manufacturing purchasing managers (NM-PMI) edged down from 53.3 in August to 53.0 in September, that’s still a positive sign. September’s survey of nonmanufacturing purchasing managers shows that the new orders index for this sector increased for the second straight month to 56.5. That contrasts with the comparable M-PMI index, which remained under 50 for the third consecutive month. The NM-PMI business activity index (production) rose to a six-month high of 57.1. The backlog of orders index recovered to 52.5. The bad news is that the NM-PMI’s employment index slumped to a 17-month low of 48.7, the first reading below 50 since last summer.

US Auto Sales



In recent weeks, the ECRI Weekly Leading Index has declined sharply. It did so last  summer too, supporting the dire forecasts of the Double Dippers. But it recovered during the fall, and the economy continued to grow albeit at a slow pace. The ECRI’s warning on Friday that a recession is imminent doesn’t jibe with the monthly indicators that have been coming out for the third quarter. Indeed, many of them suggest that real GDP should be up by around 2%. That’s not strong enough to lower the unemployment rate, but it beats a recession.

Among the strongest sectors of the economy right now is the auto industry. Auto sales rose during Q3, averaging 12.5 million units (saar), up 2.5% from Q2’s pace of 12.2 million units. That doesn’t seem like much, but it is boosting production. More importantly, sales ended the quarter very strongly at 13.1 million units. If they hold at that pace during Q4, then auto sales will also boost the current quarter’s real GDP. They might even do better given the decline in gasoline prices. That seems to be boosting demand for light trucks, which rose to 6.0 million units (saar) during September, the best pace since March 2008.

Another strong sector is the capital goods industry, where orders, shipments, and exports rose to new cyclical highs in August. Orders for machinery rose to a new record high during the month, led by construction & farm machinery. Also rebounding strongly are civilian aircraft orders and mining, oil field, and gas field machinery shipments. On the other hand, orders for electrical equipment have been stalled around cycle highs since late last year.

Selected Stock Market Indexes

That was a bad break yesterday. The S&P 500 dropped 32 points, or 2.89%, to 1099.23. That’s a new closing low for the year, breaking below the previous 2011 low of 1119 on August 8. That increases the likelihood that last year’s low of 1022 on July 2 will be retested. There are many stock markets around the world that have already dropped below their 2010 lows and seem to be heading towards retests of the lows of the previous global bear market in early 2009:

(1) European bourses plunged without any hesitation through their 2010 lows during August as investors concluded that the July 21 rescue plan was badly flawed. The MSCI Europe stock price index is down 17.5% since then, led by a 26.2% drop in Germany’s DAX. The major European indexes are getting closer to their March 2009 lows: Germany (46.6% above), France (16.2), Italy (16.0), and Spain (17.7).

(2) Among the major EM stock indexes, the following are trading below their 2010 lows: Hong Kong, Taiwan, and Israel. Currently retesting their 2010 lows are China, South Korea, India, and Russia.

(3) Financial stocks are also rapidly heading towards their previous bear market lows in early 2009. The FTSE Eurofirst 300 Banks Euro Index is down 33.6% ytd, and only 47.8% above its March 9, 2009 bottom. In the US, S&P 500 Other Diversified Financial Services and Investment Banking & Brokerage are down 46.3% and 47.4% ytd, respectively. The former is 76.8% and the latter is 34.3% above their respective previous bear market lows.

European markets have been slammed by concerns that the failure of European leaders to clean up the Euro-Mess will cause a recession over there. That scenario would be bad news for emerging economies that export goods and commodities to Europe. The S&P 500 has held up relatively better since early August because consensus earnings estimates have remained resilient. That may be starting to change.

2012 Earnings Estimate For Financials & Materials

Earnings and guidance are likely to be disappointing during the upcoming reporting season. Real GDP rose only 1.3% (saar) in the US during Q3, with consumer spending edging up just 0.7% (also an annualized rate!). European economic growth might have turned negative during the quarter after stalling close to zero during the first half of the year. The yield curve has flattened in recent weeks. Industrial commodity prices fell 10.8% from the end of June through the end of September. The price of a barrel of Brent is down 8.0% over this period.

Odds are that there will be lots of disappointments in the earnings season ahead, most likely led by the Financials and Materials sectors. Of course, the bad news for the quarter may have been discounted already. However, there could also be lots of cautious guidance about Q4 and 2012. Industry analysts are already trimming some of their earnings estimates for next year, particularly in the Financials sector.

As of the week of September 22, the Financials sector’s 2012 earnings has fallen 9.8% since the start of 2011, led by a 23.0% drop for Investment Banking & Brokerage (ETFC, GS, MS, SCHW) and a 17.2% drop for Other Diversified Financial Services (BAC, C, JPM). These earnings estimates have been mostly falling since the beginning of the year, but have been doing so at a faster clip recently.

 

 

The sector that is most likely to provide lots of negative earnings surprises is the S&P 500 Materials sector, where 2012 earnings have risen 10.6% since the start of 2011, led by a 17.5% increase in Diversified Metals & Mining (FCX, TIE). That’s a stretch given the recent plunge in the price of copper. Steel (AKS, ATI, CLF, NUE, X) has risen 14.0%, though Aluminum (AA) has edged down by 0.7%. The forecasts for Diversified Chemicals (DD, DOW, EMN, FMC, PPG, up 9.9%) and Specialty Chemicals (ECL, IFF, ROH, SIAL, up 1.9%) may be more realistic because the cost of their feedstock is dropping along with the price of oil.