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Market Sees Economic Glass as Half-Empty

The market is too focused on declines in lagging indicators and is missing the improvements in indicators that tend to lead us out of a recession.

The markets overreacted to the economic news this week, in my opinion. While the general tone of the economic indicators and analyst comments we focus on were positive, a number of the lagging and coincident indicators remained quite negative. The market chose to focus on the half-empty glass, particularly with regard to the employment numbers, and the Dow fell 1.9% for the week. I saw little reason to change my view that the second-quarter GDP will be more negative than most are expecting (though much better the first quarter). However, reduced inventories and an improving auto industry could set the stage for growth in excess of 2% in the second half of 2009.

The best news this week was a sharp improvement in the Case-Shiller Home Price Index, as discussed by our housing analyst, Eric Landry. Housing prices shown in the report slipped just 0.6% versus a decline of just over 2% for each of the prior two months. According to Landry, this was the sharpest improvement in the history of the index. Additionally, eight of the 20 markets measured in this index saw price increases, and an additional 11 markets saw a slower rate of price declines. This is all great news as we believe housing led the economy into the current mess and will have to at least stabilize before we can see substantial improvement. As prices firm, I expect to see sales volumes continue to improve as customers begin to fear that they will miss the bottom of the market.

This week's purchasing managers survey (PMI) from the ISM and last week's durable goods order numbers paint an improving picture for the hard-hit manufacturing sector for the upcoming months. The PMI has been trending positive since December. And although the new orders component of this widely watched index, which has been on a tear the last few months, flattened in June, the individual index components that had been lagging, such as employment and backlogs, looked much better in June. This is great news because the PMI and manufacturing orders have proven to be great leading indicators in past recessions. I've also heard from our metals team that they are now seeing some signs of a bottom in the steel sector. Analyst Min Ye reported that utilization rates at U.S. factories moved up from the low 40s to the high 40s and that U.S. steel manufacturers had raised prices by about 5% (albeit from very, very low levels).

Inventories, as reported in the PMI, continued their strong downward trend. While this is counted as a negative in the index (because theoretically if management sees weak conditions, they will hit the brakes on building inventory), I think the ever-declining inventories are a positive. I believe that this inventory will eventually have to be restocked so when the economy picks up even slightly, manufacturers will have to scramble to ship goods in a timely fashion. That is exactly what is happening now in the semiconductor industry. John Ayling, one of our semiconductor analysts, reported this week that Semiconductor Manufacturing International (SMIC) is raising its sales forecast for chips based on better demand in China and inventory restocking across its product line. John cautions that end-user demand is still uncertain but that restocking of inventories is a broad trend that is driving double-digit sequential gains in the semiconductor foundry business. Also, one of our industrial team members reported that one major manufacturer had to scramble to produce enough surgical masks to deal with the swine flu outbreak because inventories had been reduced to such low levels.

 

The week was bracketed with bad news from the consumer. At the beginning of the week, the Conference Board reported that consumer confidence declined in June after a couple of months of nice improvement. Given that the decline was small and that this data series is usually a concurrent indicator, I was a bit surprised that the market reacted so negatively.

At the end of the week, disappointing employment data threw the market into a funk. Job losses in June were worse than May and noticeably worse than expectations. Given my view that this is a coincident or lagging indicator and that the loss remains below its worst levels so far (781,000 jobs lost in January versus 465,000 for June), I am not terribly concerned.

Overall, I don't think the statistics were as bad as the Street seems to think they were. Eight of the twelve 12 we track in the report showed an improving trend (fewer losses). Embarrassingly for the Obama Administration, the Federal government managed to lose 49,000 jobs in June despite the massive stimulus program. Much of that up and down is tied to temporary workers setting up and concluding the first round of Census preparation.

Probably more important than total employment, initial unemployment claims declined last week after a brief pop up the prior week. The improvement here is glacial, but the positive trend has been in place since April. New reports from Watson Wyatt, the human resources firm, suggest that we are nearing the end of the layoff cycle and that a significant portion of corporations believe that we are at or near the bottom of the economic cycle and that hiring freezes will be lifted over the next six to 12 months. Challenger Gray and Christmas, a recruiting firm, reports that announced layoffs for June were at their lowest levels in 15 months.

All in all it was a mixed week, but I think the market's reaction to some lagging indicators, while difficult to interpret, was a bit overdone. The news flow over the next week is much slower, but I am looking forward some even better news on the housing front later in the month. I remain a believer that the economy has bottomed.

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