Monday, August 17, 2009

Time for a correction?

We certainly have not participated in this great rally, and we must admit, we regret such misstep. However, we remain skeptical as although the economy has avoided the black hole, recovery is no where in sight. Unfortunately, in our opinion, the market has not yet realized such ... reality.


July unemployment numbers came in better than expected. Those figures included decline of 247k in non-farm payrolls (compared to the market's expectation of -325k), 33.1 average working hours, 0.2% higher average wages, and a 9.4% unemployment rate. In our opinion, these not so bad numbers were temporary and are misleading. Decline in non-farm payrolls was impacted by more government jobs (which we hope are only temporary as the last thing we need is further expansion of the government), higher payrolls in healthcare, and the seasonally expected higher payrolls in hospitality/leisure.

However, heavy declines in other industries such as manufacturing were alarming. Manufacturing employment declined by 52k. We note that this number was helped by a 28k increase in auto workers, which we believe is temporary and driven by the famous "cash for clunkers" program. Also, as stated by the BLS, these numbers were not that bad because there may not be any more jobs (and other costs) to cut in manufacturing. Professional and business services industries lost another 38k. And financial services shed another 13k jobs in July.

What caught our attention were the temporary help and part-time employment figures. Historically, those have been leading indicators of recovery. However, we did not see any improvement in those figures. We currently have nearly 9MM part-time workers. Temporary help, which is considered a segment of professional and business services, continues to fall.

Increase in weekly average hours of work was somewhat of good news. But then again, given the lack of stability in most positions within the workforce combined with continuing decline in employment, many are working harder just to keep their jobs. In addition, although total average weekly earnings increased slightly, we believe such movement was driven not only by more hours worked, but also partially by the increase in minimum wages which went into effect in late July. Of course higher minimum wages could impact weekly earnings more positively, but we believe it will also drive many companies to layoff more workers.

The July 9.4% unemployment rate was very welcomed by the market. Unfortunately, many overlooked the fact that such figure was due to many unemployed no longer looking for jobs. The BLS stated that the labor force participation rate declined by 20bps in July. The BLS excludes those when calculating the 'official' unemployment rate. Luckily, it also provides a rate which includes the discouraged workers. Unfortunately that rate increased to 10.2% in July from 10.1% in June.

Overall, the employment situation in the U.S. has not improved. Of course, the figures that we discussed are lagging indicators. However, the employment figures that we consider as leading indicators, such as jobless claims, remain very weak. Last week's initial jobless claims came in at 558k, approx. 14k higher than market’s expectation. Initial jobless claims have remained above 500k for approx. nine months.

Lastly regarding employment, some are comparing the current situation to previous recessions. As displayed by the graph below (provided by FAO-Economics), some believe that the similarities seen in the chart indicate that we are well on our way to a recovery. We must note several differences between this recession and the ones included in the graph. First, we believe this recovery will be another jobless recovery, similar to the last two recessions. As displayed in the chart, employment did not recover to pre-recession levels. However, we note that consumer debt levels were also lower in those recessions, which leads us to believe that employment may not be a lagging indicator during this downturn. In order for consumption to recover, consumers can no longer borrow more (although the government can!). For this reason consumption, which represents 70%+ of the economy, will not aid in recovery until there is some improvement in the employment picture.

Figure 1 (provided by FAO-Economics)


Consumption remains weak as shown by last week's retail report which indicated a 0.1% decline, worse than the market's expectation of a 0.8% increase. That figure was more disappointing when we exclude auto sales, which of course have been pumped up by the "cash for clunkers" government program.

In order for consumption to rebound, we need some stabilization in the declining consumer revolving credit, combined with increase in consumer confidence. However, both continue to decline (Figure 2). We note that week's preliminary University of Michigan consumer confidence of 63.2 was significantly below the 69.0 consensus estimate.

Figure 2

What we are looking for is a combination of deleveraging, higher savings rates followed by stabilization in unemployment, all of which represent a slow recovery. Unfortunately, this is not yet taking place.

Although we are seeing some deleveraging in consumer balance sheets, as the revolving credit continues to decline, we have not yet seen a correction in revolving credit as a percentage of disposable income (Figure 3). We believe this is mainly due to continuing rise in unemployment (Figure 4), which may not be a lagging indicator in this recession.

Figure 3

Figure 4

We note that we may see some sequential improvement in consumption in August, which would be due to seasonality (back-to-school spending) and not necessarily consumers wanting to spend more.

Lastly regarding consumption, the bulls are now widely using the phrase "pent-up demand" (we no longer hear or read the "green shoots" phrase too often) and believe it will drive the economy to full recovery in 2H09. In order for consumers to meet their pent-up demand, they must have income, credit and/or other assets. Unfortunately, currently that is not the case. Many also state that consumers have profited from the latest rally in equities. Unless consumers are the institutional funds, we must disagree. Unfortunately, it is more likely that the average investor jumps in at the peak of this rally, which of course is bad news. We note that approx. 25% of the population is in the 45 - 64 year age bracket; and this figure continues to increase every year. We believe that with so many risks and uncertainties associated with the economy, the job market and the equity market, which all significantly impact retirement savings, it is unlikely that most individuals in this age group jumped in (after getting out in late '08 and early '09) and benefited from this rally.

Housing Market

We have seen some improvement in the housing market as June sales of existing and new homes increased 3.6% and 11.0% sequentially. However, we believe this has been driven by the great 'gift' that the government provides for first-time buyers. We wonder how the housing market will behave after such 'gift' expires by the end of November.

Inventory remains high as the months-to-sales figures for both existing and new homes remain significantly above historical average and prior recessions. June's month-to-sales ratio came in at 8.8, which was a significant improvement from May's 10.7. However, we believe such improvement is temporary and, again, based on government's gift to first-time-buyers. Increase in new home construction, which many believe is positive, will add to the market's inventory dilemma.

There are many questions regarding the housing market, such as - what will happen once the government no longer induces many to buy? Have employment, credit and savings improved enough to maintain the slight upward movement that we have seen during the last two months? Has the average investor profited from this latest rally in equities in order to put his/her gains towards a new home, a transaction which now will likely be based on higher mortgage rates? We believe answers to these questions clearly point to continuing weakness in the housing market. Although, again, we note that the government's assistance could artificially create additional upside during the next couple of months.

Of course, this government could continue to run the economy (and not the country), and may not only extend its housing 'gift' policy, but also provide more so-called incentives for people to spend while they are in debt and/or unemployed. Mortgage rates are higher but home sales are also increasing, while income is declining and job losses continue. What does this mean? It means again that the only factor behind the recent higher home sales is the 'gift' policy, which again could be 'wrapped up' by the end of November. Adverse impact of such policy, besides not allowing the housing market to correct itself, is that it could lure many sellers to take their homes off the market. Some sellers could begin thinking that 'hey, maybe I should wait. Prices are slowly going up, so I'll wait to get a higher bid.' If this occurs, we can expect additional increase in inventory.

July housing starts and existing home sales figures will be released this week, which we believe will likely be in-line or better than expected. But again, we believe this is temporary.

Q2 earnings season has ended

Pessimism which lowered expectations and drove many analysts to post very low Q2 estimates, was certainly helpful for many public companies during the Q2 earnings season.

However, we note that as of last week S&P 500 Q2 operating earnings actually came in lower than expected. According to the latest S&P numbers, Q2 earnings were $13.94/share, lower than the $14.31/share estimate that we saw in late June. We note that the latest S&P figure is based on approx. 91% of S&P 500 companies’ earnings.

Although the market has spiked up approx. 50% since the Match lows, we expect continuing pessimism as estimates across the board have been adjusted lower. Q3 and Q4 estimates are now 4% lower than they were in late June. For 2010, Q1 and Q2 projections have been adjusted lower by 2%, Q3 by 3% and Q4 by approx. 0.5%. In our opinion, these numbers indicate that the market just may be ahead of itself.


We believe that the state of the economy has not improved as much as the equity market currently indicates. Given where the S&P 500 closed at last Friday, it appears that the market expects a rapid or 'V' shaped recovery, although the S&P 500 operating earnings estimates indicate otherwise. Given continuing weakness in employment, consumption and the housing market, we believe the economy has a long way to go before recovering. For this reason, the market is overvalued and we expect a correction within the next couple of months, more specifically, before the start of the Q3 earnings season.