What the Numbers Say

by Paul J Nolte CFA, Dearborn Partners. July 19, 2006

The key data has made it to the markets this morning, and in general the numbers were received well. Following on the data, Fed Chairman Ben Bernanke made his required testimony in front of Congress – answering questions about why the Fed is persistent in their raising of interest rates. The financial markets cheered it all and jumped 1.5% quickly. Questions from the various Senators centered around the lag effects of the prior rate increases as well as the fact that a pause in the rate cycle has now been elevated to something very special vs. the normal course of business (we had two pauses in the '99-2000 rate hike cycle). Whether the specter of a pause is the engine behind the market jump or that oil prices have come down some from recent peaks or that interest rates have moderated from their recent peaks, investors don't really care, but that the recent decline seems to be over has caused them to jump back into stocks. While the daily movements of the markets are relatively hard to discern real reasons (higher oil prices helped the S&P 500 to rise on one day, higher oil prices hurt stocks another), we are trying to look at the longer term views that will assist us in being on the right side of the markets over the long-term and not worry as much about the daily noise.

So what are the numbers saying? Fresh data this morning point to a still weakening housing market as the home builders association numbers are now at lows not seen since the '90-'92 recession. If we use that period as a guide, we can see housing weaker still and not fully recovered until sometime in 2008. The housing market "collapse" is indicating that economic growth is likely to be in the 2% range for the second half of the year – in our view pointing to an imminent interest rate cut either late in 2006 or early '07. We have been watching lumber prices as a key leading indicator of housing – and after peaking two years ago, lumber prices are now at levels last seen in late 2003, and getting to within hailing distance of 2000-'02 lows. Industrial production, however, has been stronger (and is the only strong economic reading of the last two weeks) and we may be seeing an inventory build that would allow the sales to inventory levels to rise slightly in the months ahead. Finally, the much discussed (and argued) data regarding inflation was generally in line with the consensus views and the markets did little once the data was available. Questions are arising about the usefulness of the CPI data as the imputed rent factor has been adding to the CPI data – this in the face of a weakening housing market. However, if we were to use gold as an indicator of market views of inflation – their collapse yesterday and jump today might indicate that inflation is not really a concern, as gold continues to trade well below recent peaks. Is gold still in a corrective mode or is there more weakness ahead after the parabolic rise in prices – especially in the face of a weakening economy.

When we look at our rankings within the 100+ industry groups that we follow, those sectors that are scraping bottom include the housing market, but too many of the housing related stocks like the home improvement "stores" (HD and LOW) and furnishings. Comments from other retail companies are demonstrating that what is ailing HD is beginning to fan out to the rest of the consumers as higher oil prices, higher minimum credit card payments and higher equity loan payments are all beginning to have their effects upon a consumer who is not seeing the wage growth to match the rising costs of living. It is this particular situation that leads us into the camp of these items acting as a tax upon the consumer instead of the tinder for rampant inflation. Listen to the earnings reports from Corporate America and their discussion of costs and margins. Much of their focus is on the rising input costs (see energy prices) and moderating margins (see lack of pricing power). One way that we look at the world is via the sales per share component of corporate earnings. What we have seen over the years is a relatively flat top line growth of generally less than 5%, while the bottom line has been expanding at 15+%. This situation is not something that can persist forever and we believe with this economic slowdown (or recession – although it is too early to make that call) we will see additional pressure on margins and earnings that may force S&P 500 earnings to actually decline on a year-to-year basis. Following on still high market multiples for the recent 12 months of earnings, we still can see a market below current levels by the election. Our forecast has been for a flat year at best, and likely 10% lower by yearend.

Going back to our rankings, the more defensive sectors of the markets have been improving, although not yet at the top, their persistent rise indicates to us that investor's appetite for risk may be waning – take a look at international indexes as well as small/mid cap indexes over the past six weeks. Investors have also added dollars to short funds as well as buying puts on the markets, so we could see another few days like today of sharp increases that squeeze some of the negative speculation out of the system prior to embarking upon a very choppy decline into the fall. While we take great care in developing our economic and company models for how we believe the world works, the geo-political world will trump all – so we still remain concerned about the tenor coming from the Middle East.

Today's Market

Stocks, bonds and gold were big winners in today's markets upon hearing that Bernanke may make this rate cycle more like those in the past by actually pausing. Whether this actually is a good thing for stocks over the long-term remains an open question (we think not). Oil fell as inventory levels continue to grow, much to the chagrin of analysts (supplies are near/at 7+ year highs). After struggling through last week, we may be seeing a relief rally that may be little more than a short squeeze. Obviously time will only tell whether the second leg lower will break the recent lows, but our "big picture" views of the economy and markets indicate that a failure at those lows is only a matter of time.

Paul Nolte

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