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Investing Specialists

Buy the Rumor Sell the News

By the time all the data confirming an economic recovery comes in, most of the easy profits have been made.

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The indicators have been pointing to a stronger economy for some time, and the market has moved up accordingly. Depending on which index one uses, U.S. equity markets have gained more than 60% since March 2009. While earnings improved during the second and third quarters of 2009, much of that improvement got its gusto from cost-cutting, not from any meaningful revenue increase. Although company management comments were markedly better during the third quarter than the second quarter, they were still far from glowing. But hope springs eternal, and despite the hesitant tone, the market continued to plow ahead.

Now with the tendrils of fourth-quarter results emerging, I am beginning to see more positive revenue surprises, more bullish comments from management teams, and an economic recovery that has now become a foregone conclusion. So, what happened in the face of this good news?

Based on the S&P 500 Index, the market managed to decline just over 1% for the week ending Jan. 15. This is just another reminder that the market is a highly anticipatory device. By the time all the data confirming an economic recovery was in, especially from corporate sources, most of the easy profits had been made.

Watch Closely for Margin Pressure and Rising Costs
This week's economic data wasn't particularly illuminating. Corporate earnings news started out weak with bad news from  Alcoa (AA), but closed out on a stronger note with surprising results from  Intel (INTC) and  J.P. Morgan (JPM).

The corporate data was generally consistent with strong current economic growth and potentially even more growth in the first quarter. However, certain themes in some of the earnings releases, and our analyst comments, are worth considering. Alcoa raised the grim specter of higher raw materials and energy prices cutting into profitability. Morningstar's Eric Chenoweth, who heads up our energy team, seconded the notion that prices for some commodities are looking toppy even as input prices for raw materials, capital goods, and services are rising faster. Therefore, potential margin percentage improvement may be more limited compared with typical recoveries. In other words, Alcoa's surprising revenues but disappointing profits could be a trend that investors need to keep an eye on.

Looking backward, corporate earnings did far better than most analysts anticipated during the June and September quarters, as corporations restrained wages, labor force growth, and raw material prices, with a few exceptions. This caused margin percentages to fall substantially less than during previous recessions. If margins declined by a lesser amount, there is also less potential for those margins to rebound.

I guess all of this is a fancy way of saying that investors need to pay more attention to individual companies, as well as the relationship between revenue growth and cost growth. In other words, we're in the part of the economic cycle when it is more important to listen to what analysts and companies have to say, and a little less to what economists are forecasting.

On the other hand, analysts can get caught up in pulling apart corporate profitability levels, too. For example, Intel announced exceptionally strong growth in both revenues and earnings this week, far exceeding analyst expectations. This caused at least two analysts to publicly fret that Intel was already peaking for this cycle and that money might be better invested elsewhere. While margin percentages overall may be at the high end of their long-term potential, I really have a hard time believing that the total product of revenues and margins (that is, total earnings), have peaked. The full Microsoft Windows 7 rollout (which should drive computer and microprocessor sales) is just gathering steam, and the higher margin corporate computing business looks poised for much better revenues in 2010, more than offsetting the potential declines in margin percentages.

The China Syndrome
Another factor weighing on the market this week was the continuing efforts to restrain growth in China. This week, China's central bank raised reserve requirements 0.5%, to 15%, which will further serve to reduce the supply of credit.

Money placed into reserves can't be loaned out. With slower credit expansion, slowing growth in the Chinese economy can't be too far behind. This was not one random act, either, as the Chinese Central Bank also raised interest rates on selected financial instruments during each of the prior two weeks.

Fear that Asian growth would slow meaningfully broke the back (at least temporarily) of the boom in commodity prices. Even oil, with a little help from U.S. inventory data, closed below $80 this week. An anemic China is more likely to torpedo growth in Europe than in the U.S., which is less dependent on exports.

 

Inflation Looks Okay, But Could Be Sneaking Up
Inflation data looked relatively tame, and better than expected, with just a 0.1% increase for December (whether one includes food and energy or not). On a December-to-December full year basis, prices were up 2.7%, or 1.8% excluding food and energy. For some perspective, the full index was up just 0.1% in 2008.

For the full year 2009, energy and motor vehicles notched the biggest increases, while food at home saw a meaningful decline. Rents and shelter expense inflation were also very low, and close to flat for 2009. The housing category carries a very meaningful weight in the CPI index. Some economists are beginning to worry that the low shelter number may be obfuscating stronger underlying inflation.

Outside of food and energy, a quick perusal of the inflation-by-category list shows few items showing an increase of less than 3% (year on year), leading some credence to that view. Stay tuned.

Retail Sales Look Goofy But Better Than They Appear
The market correctly shook off news that retail sales from the Census Bureau declined 0.3% in December, while the consensus view was for 0.5% growth. Meanwhile, the two previous months of data were revised sharply upward. That basically means that sales weren't very far off the mark for December after all. That shows up in the year-over-year growth rate for retail sales of 5.4% that is more consistent than the credit card data and the same-store sales data I have analyzed in my columns of the last two weeks. This is just one more example of focusing on one piece of data--an often revised one at that.

Mixed Data in Manufacturing
Morningstar industrials group leader Eric Landry and I were disappointed with this week's industrial production number, which showed growth of 0.6%, in line with expectations and about the same as the prior month. While the headline number was fine, the bulk of the growth appeared to be in utilities. Non-durable goods showed a small decline while durable goods eked out a small gain.

Again, December isn't necessarily the best month in the world to be analyzing data because of all the seasonal noise that is embedded in the numbers. These numbers are also subject to revision, and aren't entirely consistent with the production component of the ISM purchasing managers survey that showed sharp improvement across the board.

Offsetting the weak December industrial production report was a surprisingly strong Empire State Manufacturing report for January. It sprinted to 15.9, up 11 points from last month. This marks the sixth consecutive month of improvement for this figure. Both the production index, which should bode well for this month, and new order index, which should have benefits several months out, showed strong improvement. Even the employment portion of the index moved into positive territory.

There was, however, bad news on the inflation front. Corporations reported that input prices and the prices they charge customers were both up considerably in the latest month. I should caution that this is just one region, but it does have a reasonable track record for predicting trends in the manufacturing sector that turn up later in the national survey and various government reports.

Slow Week Ahead
Next week should be relatively quiet. Given my inflationary concerns, I will be taking a strong look at next week's producer price index to check for further signs of degradation. Housing starts are also due next week, and it will be interesting to see if the renewed housing credit has kicked into gear yet. The off and then on again housing credit is playing havoc with the numbers, causing an unexpectedly large decline last month. The Philly Fed Index is also out next week. Let's see if that confirms the positive results out of New York this week.

A Word on Seasonality
Just as general note, I am growing a little uneasy about the disparity between the relatively positive data from private sources and corporate releases, and the relatively dour numbers coming of the government statistics mills. The data sources were pointing in opposite directions at the beginning of the recovery late last spring, as many government statistics turned positive while corporate managers were resolute in their conviction that the green shoots would die a very early death. Now, we have just the opposite. I am hoping (and watching like a hawk) that this time the government is wrong. Strong seasonal adjustment factors, including bad weather, work day/shopping day issues, and a recovery in a normally slow period are all combining in a frothy mix that makes clear statistical analysis nearly impossible in the short run. After a month of pretty sloppy numbers (employment, retail sales, and industrial production ex-utilities), it will be fascinating to see how the market reacts to real GDP growth that could be as high as 4%-5% when it is reported in a couple of weeks.

See More Articles by Robert Johnson

Robert Johnson, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.