Disappointing Week

Stock markets struggled this week, beset by weaker-than-expected employment numbers as well as other disappointing economic reports. We predict a slower-than-expected recovery and a near-term decline in stock prices.

US stock markets closed lower Thursday, in a holiday-shortened week marked by large swings in the major averages. The Dow Jones Industrial Average ended the week at 8280.74, down 223 points on the day and 188 lower (1.9 percent) for the week. The S&P 500 Index finished at 896.43, off 2.9 percent for the day and 2.4 percent for the week.

On Thursday, the markets were reacting to a surprisingly weak employment report. The Labor Department reported that the economy lost 467,000 non-agricultural jobs in June, compared to a revised loss of 322,000 jobs in May. Economists had predicted a loss of only 367,000 jobs in the month.

The employment numbers, and the market's reaction to those numbers, were disappointing given the fact that the markets had just completed their best quarter in more than ten years. During the quarter, the Dow gained 11 percent, while the S&P rose more than 15 percent. But the market's performance over the past three weeks has been less than sterling, with both indices down more than 5 percent in that time frame.

"Green shoots" - indications that the recession may be mitigating - had been the primary factor driving the "bull" market earlier in the quarter, but solid evidence supporting the so-called "shoots" has been lacking lately, and investors are now not only asking if the bull market can continue, but whether there is really an economic recovery on the near horizon.

In this article, we will take a closer look at the numbers and try to provide our own prognosis for both the economy and the markets.

Background

Earlier in the year, both the Obama administration and the Fed (as well as other central banks) seemed to be making all the right moves in engineering a recovery. The Treasury, in cooperation with the Fed, had finally come up with what appeared to be a workable plan for repair of the banking system. Congress quickly passed a $787-billion stimulus package. Fed Chairman Ben Bernanke, a student of the Great Depression, seemed to be pulling the right wires in order to avoid a repeat of that event. And the economic numbers, while not exactly demonstrating a turnaround, at least were not falling as precipitously.

There were other hopeful signs. Global shipping rates have jumped over 400 percent in the first six months of the year. Commodity prices have doubled.

China, last November, passed a stimulus package of its own, worth $586 billion. Economic reports out of China showed solid growth in the first quarter, and people began to talk of a Chinese-led global recovery.

India also showed promise: the Congress party scored solid gains in May elections, presaging positive economic results and this week the government was expected to forecast that GDP could possibly expand by 7 percent this year.

But there are storm clouds as well. The banking system still faces a mountain of questionable debt that has to be either sold off or written off. A number of analysts believe the government's much-ballyhooed stress test only papered over the real problems. The government has yet to attack the toxic-asset problem and only this week is expected to announce the participants in its partnership program.

The threat of inflation, and the central banks' reaction to the threat, raising interest rates prematurely, could choke off the recovery. However, there is still talk of deflation. Prices in Japan, for example, have fallen sharply and the Eurozone also recently recorded its first drop in prices. Officials in both areas, however, have said that deflationary conditions are not a real problem, only a fleeting occurrence. (Deflation becomes a threat to the economy if consumers and businesses, fearing deflation, decide to wait for lower prices and put off spending.)

Some economists believe that any improvement in the economy as been the result of the administration's stimulus package and the Fed's massive easing, that neither condition is sustainable. This week, administration officials began to talk about the possibility of a second stimulus package, if necessary. But, given all the talk lately about the Federal deficit, and the public's apparent aversion to deficits, we believe another stimulus package may be difficult to come by. And, inflationary concerns may limit the Fed's hand in coming months.

In the meantime, consumers and businesses are not spending. Household, business and even government balance sheets are extremely over-leveraged. Consumers and businesses are extremely concerned about their debt and are likely to continue to de-leverage before they resume their spending.

Some analysts also believe that a recovery may be led by inventory-replenishment - a shortage of inventory, caused by companies working off available stocks before producing new supplies - could provide a boost for the economy. So far, however, there does not seem to be any evidence of this happening (more on this below).

 

The Numbers

US economic numbers this week were, on balance, disappointing.

The Conference Board's index of consumer confidence, released Tuesday was 49.3 for June, a drop from the 54.9 registered in May. Economists had expected an increase in the index to 57.0, so the release came as a shock to traders, and stock markets traded lower on the news. Consumer spending accounted for almost 70 percent of GDP growth prior to the onset of the recession (it is much lower now) and spending would have to regain that percentage for the economy to recover any semblance of its former self. With consumers currently engaged in a massive amount of de-leveraging, as they try to rebuild their balance sheets, the Conference Board index reading doesn't bode well for the consumer sector.

The second key number to confront the markets this week was the Institute of Supply Management's manufacturing index, released on Wednesday. That index recorded an improvement in June to 44.8, from the 42.8 registered in May. The June reading was its highest level since August 2008. Despite the fact that the index doesn't turn "bullish" until it exceeds a reading of 50 (reflecting the fact that more than 50 percent of the respondents are bullish), and even though the reading was slightly less than the 45.0 expected by economists, investors still hailed the number as encouraging for the market and the market staged a nice rally in response.

However, the base reading masked some disturbing underlying numbers. That same report showed that inventories were down 2 percent from the previous month, to 30.8 percent, a 27-year low. In addition, new orders declined 2 percent also, to 49.2. Economists had been predicting that the economic recovery could be led by inventory rebuilding as firms, having run their inventories to rock-bottom levels, were forced to begin rebuilding stocks. Based on the ISM report, that isn't happening yet.

The third area of concern this week was the employment situation. On Wednesday, ADP reported that its survey of employers (taken as a harbinger of the government's employment report) showed employers shedding 467,000 jobs in May, down from 532,000 in May, but still an imposing number. Then, as cited above, the Labor Department reported its larger-than-expected drop in non-farm payroll employment. Investors had been hoping for at least the beginning of a trend of improvement in the labor situation, but that too doesn't seem to be happening.

There were some glimmers of hope among the numbers released this week. The Case-Shiller index of house prices in 20 major cities reported that home prices only fell 0.6 percent in May, compared to April, and were down 18.1 percent from a year earlier. This was a slight improvement on the previous month's reading. In addition, pending home sales were up 6.7 percent in May, from May 2008. Economists cited falling home prices and government tax incentives as the primary reasons for the increase. And, on Thursday, the government reported that factory orders rose 1.2 percent in May, on top of a 0.7 percent increase in April

 

The International Situation

Those investors looking for help overseas had to be somewhat disappointed as well.

Purchasing managers' indices in the UK, the Eurozone and China all showed improvements in the latest readings. But those improvements had to be considered pyrrhic victories. China's PMI recorded the best reading, rising to 53.2 in June, from 53.1 in May. But PMI readings in the UK and Europe remained below 50, with the UK PMI rising to 47 in June, from 45.4 in May (albeit better than expected), while Europe's rose to 42.6, its 4th consecutive monthly increase and a 9-month high. Nevertheless, with the exception of China, all the readings remain under 50, signaling only that the recession may be abating, not that a recovery is underway.

Earlier in the week, the UK reported that its GDP declined 2.4 percent, quarter-on-quarter, in the first quarter, revised from a previously-reported decline of 1.9 percent. The 2.4-percent drop was Britain's largest in 50 years.

Also during the week, Japan reported its Tankan index rose to a reading of minus-48 in the April-June quarter, up from minus-58 in the January-March quarter. Although an improvement, economists had been forecasting an improvement to minus-43. Japan also reported that industrial output rose 6 percent in May, the same increase it reported for April. However, the increase was less than expected (+ 8.8 percent) and industrial production was still down 29.5 percent year-over-year. Next week, the government is expected to predict that GDP will grow between 0.5 and 0.6 percent in the fiscal year beginning April 2010, compared to a forecasted 3-percent decline for the current fiscal year (private forecasters predict Japan's GDP will decline 6.6 percent this year).

Prognosis

We believe that the recovery in the economy will be much weaker than many investors hope for and that the recovery period will be much longer than expected. As a result, we think the stock market will continue to struggle and could undergo as much as a 5-to-10 percent decline from current levels.

Economic numbers will continue to be less than robust. In addition, we think that the recent run-up in commodity prices, instead of being a result of economic improvement, could actually be due to Chinese stockpiling of supplies (on Friday, the Financial Times reported that the spike in oil prices on Tuesday, was due to massive oil purchases by a rogue trader at a London commodity firm, not fundamental factors). We look for commodity prices to back off somewhat in the next few weeks.

China's stimulus may not carry over to the global economy, as hoped. The stimulus package has been mostly directed toward state-owned firms and infrastructure spending, which may not have much lasting impact on its economy. Exports continue to decline.

Global banking will continue to be a problem. We think that the government will not address the toxic-asset problem in a sufficiently aggressive manner. Until banks are forced to recognize and write-off these assets, the lending needed to foster economic recovery will not occur. And, the banking situation in Europe is even worse, especially in Eastern Europe and Russia.

Consumers and businesses will continue to de-leverage, until they regain the confidence in an economic recovery. This week's consumer confidence report shows that resumption of confidence is some distance off.

Finally, we believe the inflation/deflation question is a non-issue, We have faith that Bernanke will be able to negotiate the right course, regarding monetary policy.

Indian Markets

Indian stocks gained this week, on expectations the government will revise its forecast for GDP growth this year to seven percent. Short-covering ahead of next week's budget added to the rally. The Bombay Sensex Index closed Friday at 14,913.05, up 1.7 percent for both the day and the week. We look for the market to move higher next week. The Indian Rupee finished the week at 47.920 Rupees per Dollar, virtually unchanged on the week. We expect the Rupee to lose ground vs. the Dollar next week, as traders run to the safe haven of the Dollar.