Bears Running Out of Ammunition

The week started out on a high note, with retail sales up 0.5%, excluding autos. Including autos, retail sales declined just 1.5%, versus an expectation of a 2% to 3% decline. Meanwhile, consumer prices continued in Goldilocks mode, not too hot and not too cold, with prices up just 2.4% on an annualized basis. The regional manufacturing reports were mixed, with New York showing exceptional strength while Pennsylvania was down. On the other hand, industrial production, one of the gold standard coincident indicators, showed surprising strength even after earlier months were revised upward. This marks the third month in a row of strong performance from this key metric. Inventories continued their downward trajectory last month, and they continue to decline at a healthy clip. That means the net positive effect of inventories will be more modest than I had anticipated during the September quarter, but more generous (and a nice tailwind) during the fourth quarter.

The week ended on a sour note, as the University of Michigan Consumer Sentiment Survey fell backwards for the mid-September period on the heels of a strong showing in August. This number doesn't sound any alarm bells with me. It's highly volatile, and not particularly predictive. Nevertheless, the market zeroed in on the sentiment numbers like a laser beam, skidding sharply after their release on Friday. So much for my earlier theory that corporate earnings season might finally distract the markets' gaze from the economic indicators.

Corporate News Better, But Not Perfect.
Speaking of corporate earnings, most of the reports, including  Intel (INTC),  IBM (IBM), and  J.P. Morgan (JPM), and  CSX (CSX), provided positive earnings surprises. However, the news and commentary from the C-suite was more muted. Consistent with the prior quarter, the upside surprises stemmed more from cost cutting and special credits rather than from eye-popping top-line growth. Intel and some of the other tech stocks did report stronger revenues, as computer manufacturers build inventory ahead of the introduction of the new  Microsoft M (SFT) operating system due on Oct. 22nd. However IBM is still worried about big data center computers and storage devices. Improved sales from its high margin software group and developing market sales helped to boost IBM's numbers beyond its earnings target.

 Google (GOOG) was another company that saw some revenue growth. The search engine giant's quarterly sales grew 8% versus the June quarter. This growth was particularly encouraging, especially given that its June-quarter sales were flat. It was enough to inspire Google chairman Eric Schmidt to declare during the company's conference call that "the worst is behind us". Now it's just a matter of determining the pace of the improvement. Likewise, CSX Corporation, operator of one of the nation's largest rail networks, also noted "the worst of the recession is likely behind us".

However, the news was not uniformly good from the corporations. Banks in particular did not excite investors. While their bottom lines looked okay,  Citigroup  (C) and  Bank of America (BAC) disclosed loan losses that were larger than expected, with revenue growth that was uninspiring.  GE  (GE) also came up a bit short in the revenue department despite exceeding bottom line projections, setting off some initial selling on Friday, with the Michigan survey taking the rest of the credit for Friday's sloppy performance.

Standing By My 3.5% Growth Forecast for the Second Half of 2009
Enough noise. The last two weeks of data is consistent with 3.5%-4.0% GDP growth in the second half, and more than 3% in 2010. The economy has come along way. In June, 2% growth seemed like a stretch, and the consensus was for 1% growth or lower, with even that modest number heavily weighted to the December quarter. At the same time, unemployment forecasts have held steady or gone higher. This means one of two things: Either employment is going to get surprisingly better in the short run, or corporate profits are going to show some sharp improvements (revenues up, labor costs down equals higher profits). I am rooting hard for some improvement in the labor markets, especially given that I saw some encouraging smoke signals in the labor market this week, too.

Better Signs on the Job Front
First, Google announced the end of their hiring freeze. Google had actually been reducing headcount for several quarters, but management announced during its recent conference call that the hiring freeze officially ended in August. Challenger Gray & Christmas reported that announced layoffs for September fell to their lowest monthly level since March 2008. The raw number was down 50% from September a year ago, and 13% from this August. It is also showing up in the initial weekly unemployment claims that continued to decline this week, declining by 10,000 to 514,000 well down from its peak of 641,000 and a non-recessionary number of about 325,000.

While the employment situation remains pretty bleak, employers are having difficulty filling job vacancies in select specialties. In healthcare there is an abundance of applicants for lower level jobs, but as one moves up the skill ladder, there are more job openings than there are unemployed people in those fields according to the Conference Board (see occupational highlights). So employers relying on the near record high 9.8% unemployment rate could be surprised by how fast the employment market could get tight. Almost half the job losses this recession were from construction and manufacturing sectors (despite the fact that these represent well under 20% of all jobs). Those sectors could continue to show weakness, but others could prove to be more resilient.

I also believe calendar year budgeting cycles could benefit employment levels, hasten the end of wage freezes, and accelerate the reinstatement of 401K matches. Often it is hard to change these variables mid-year (at least, it provides a good excuse). Now, with the recession over in my opinion, and executives speaking more often of improving conditions, next year's budgets could be more robust. Though the last Watson Wyatt survey was from August, it seemed likely the movement to lift salary freezes and reinstate 401K matches was building nicely, according to that survey.

Alternative Measures of Confidence Looking Up
As I mentioned earlier, the University of Michigan Sentiment Survey showed a decline in the mid-October Survey from 73.5 to 69.4. However, this number jumped sharply in September from 65.7 to 73.5, and is still way up from its low of 55.3. The change in this indicator (I believe that just looking at the level of the indicator or the month to month changes is not the best way to use this indicator) compared to a year ago is still quite large, and is usually consistent with year over year consumer spending growth of 3% or more. While the 3% level has yet to materialize, I am optimistic that it will. Despite the poor sentiment number, weekly chain store sales have strung together three consecutive weekly gains. That is probably a better indicator of consumer confidence than the Sentiment Survey, because people are voting with real dollars, not answering a survey the way they think they are supposed to.

I have one other odd factoid this week that might suggest higher consumer confidence. Our auto analyst Dave Whiston points out that motorhome order backlogs at Winnebago more than doubled from May to August. Given the relatively high price and the discretionary nature of motorhomes, larger order backlogs probably speaks well to building consumer confidence. I also understand that interest in flashy sports cars is beginning to pick-up at the Car-Max website which means that consumers are at least beginning to dream a little more.

Real Estate on Deck Next Week
Next week brings a couple of key real estate indicators, but not a lot else, leaving room for earnings news to dominate the headlines. Housing starts are still bouncing along the bottom, but I would expect some modest improvement again on Monday when the starts are released. Later in the week, we have existing home sales, which had shown several months of improvement before showing a surprise decline last month that spooked the markets. Given the news from pending home sales several weeks ago, I am optimistic that this number will turn positive again this month. That said, we are entering the time of year when seasonal weakness creeps into both the number of transactions and pricing of residences. The first time home buyers' credit is also due to expire soon, if Congress doesn't get around to extending it. So, in the months ahead, I will attempt to focus more on retail spending, incomes, and employment, and a little less on the real estate market, which should at least show some signs of stability going forward.

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