At the beginning of 2010, the market moved up the first six days consecutively. The underlying fundamentals in the US economy continue to improve, but these have been trumped by global macroeconomic concerns over potential Sovereign Debt defaults by Greece, Spain and Portugal…sending the markets to a 10% correction Friday before bouncing back over 2% from the lows. Technically speaking, this market correction should be over.
Just to address the Sovereign Debt issue in Europe. We do not believe the European Union (“EU”) or the European Center Bank (“ECB”) will allow a default to occur because it would mean the end of the EU itself. Rather, we think that the economic powers, Germany (primarily) and France will use this opportunity to bail out these countries and increase their power within the EU. In recent times, it has been the coalition of Spain and Poland, which thwarted the Franco-German duos attempt to foist their control upon the rest of the EU through a constitutional agreement that would cement the EU under their leadership.
From a fundamental perspective, we have had six months of consecutive increases in the median price of housing. This has occurred primarily as buyers have been more aggressive at the low end. Though the continued supply of foreclosed homes is likely to keep a lid on new home construction, this is still a positive. According the ISM (Institute for Supply Management) industrial activity increase for the sixth straight month and in yesterday’s employment report, we saw the first increase in manufacturing employment since December 2007. From the ISM:
“The manufacturing sector grew for the sixth consecutive month in January as the PMI rose to 58.4 percent, its highest reading since August 2004 when it registered 58.5 percent. This month’s report provides significant assurance that the manufacturing sector is in recovery. Both the New Orders and Production Indexes are above 60 percent, indicating strong current and future performance for manufacturing. This month, 13 of 18 industries reported growth, up from nine industries last month, and this is a good indication that the impact of the recovery is expanding.”
Another positive factor was revealed in the fourth quarter earnings reports, not only did 74% of the S&P 500 surpass their earnings estimates, but 71% surpassed their revenue estimates. Overall sales growth rose 7% in the fourth quarter. And that included the auto industry which had two terrible months following the “cash for clunkers” stimulus promotion. Add to that the continued strong same store sales in January and we believe we are seeing the gradual cyclic recovery that we have been talking about in the past months.
The unemployment and underemployment problem is likely to be with us through the end of 2011. There have been several structural changes, like the shift of manufacturing jobs overseas and the creative destruction of the print media business by the Internet. This is likely to keep growth in the second half of 2010 to the 2-2.5% range, which may be a drag in the equity markets. We are also facing some major upheaval in the commercial real estate markets. These markets respond more to unemployment than to economic growth. Exacerbating this problem is the huge leap in productivity that we are seeking. US productivity increased 5.1% in 2009, but these figure were released before the February 5th employment report wherein job losses in 2009 were increased by 900,000. Effectively that means the 2009 productivity increases were probably north of 6%. This is outstanding for corporate profits.
To summarize, we believe the Sovereign Debt issue in Europe will be solved this week and will be a non-event, and the US economy is slowly strengthening. Without any “outlier events” the impact on the markets should be modestly positive, yielding annual gains of 6% to 10%, or about 14% to 18% higher from here. Bonds should maintain their range as there is little reason for the Fed to change policy.