Monday, 4 September 2006

If the US economy is slowing, the stock market's not showing

Most economists think that the United States economy is slowing. Some even think it is headed for a recession. Stock investors, though, appear unconcerned.

Last week, the Standard & Poor's 500 Index gained 15.01 points or 1.2 percent to close at 1311.01, the highest level since May 10 and just over one percent below its high for the year.

Apparently, fears of an economic slowdown -- or even a recession -- are being brushed aside by stock investors.

Economic data released last week generally indicate that the US economy slowed over the past few months, although at a gradual pace.

Second quarter GDP reported by the Commerce Department confirmed a slowdown in the growth rate from that in the first quarter, but the rate was revised up to a 2.9 percent annual pace from the 2.5 percent rate initially reported. Tellingly for stock investors, the growth rate of corporate profits also fell to 2.1 percent, well down from 14.8 percent in the first quarter.

Another Commerce Department report, however, showed that consumer spending actually picked up pace at the beginning of the third quarter, personal consumption expenditures rising 0.8 percent in July. Sales reported by retailers so far indicate that retail spending largely held up in August, but auto sales were down.

Consumer confidence deteriorated in August, which does not bode well for consumer spending. The Conference Board's consumer confidence index fell to 99.6 in the month from 107.0 in July while the University of Michigan's sentiment index fell to 82.0 from 84.7.

The manufacturing sector also showed some slowing. Another Commerce Department report showed that factory orders fell 0.6 percent in July. The Institute for Supply Management said its manufacturing purchasing managers' index slipped to 54.5 in August from 54.7 in July while the new orders index fell to 54.2 from 56.1.

The data from the housing sector continued to show weakness, with the Commerce Department reporting a 1.2 percent fall in construction spending in July and the National Association of Realtors reporting a 7.0 percent fall in pending home sales in the same month.

On Friday, the Labor Department reported that employers added 128,000 jobs in August, somewhat moderate, but about the same rate as previous months. More ominously perhaps was that average hourly earnings rose only 0.1 percent while the length of the average work week dipped by 0.1 hour.

Another piece of data released last week was the PCE price index, which was reported by the Commerce Department to have increased 0.3 percent in July. This is about the same rate as the previous months' average, while the core PCE price index, excluding food and energy, increased just 0.1 percent.

So on the whole, the picture is one of a slowing economy with inflation contained, if not quite falling yet.

The fixed income market is telling a similar story. 10-year Treasury yields fell 6 basis points last week to end at about 4.73 percent. Since the beginning of August, it has fallen about a quarter of a percent.

The yield on the 10-year Treasury note is now significantly below that of the 3-month Treasury bill, which is at about 5 percent. This points to at least a slowdown.

And yet, the stock market is near a high.

One possible explanation for this apparent anomaly is that investors think that the stock market weakness from May to July already reflects all the economic slowdown that is going to occur. The current strength in the market might even be anticipating the economic recovery that is expected to follow the slowdown. Since from peak to trough, the S&P 500 fell less than 8 percent over its period of weakness, this means that the market is expecting a relatively mild slowdown, at least from a corporate perspective.

However, another possible explanation is that the stock market is still adjusting to incoming data and may see renewed weakness once the evidence of a slowdown becomes more apparent.

In any case, saying that the stock market is not pointing to a slowdown is probably an overstatement. After all, although the large-cap S&P 500 has recovered almost all of its losses from its peak, the small-cap Russell 2000 is still 7.7 percent below its peak, having recovered only about half its losses since then.

This leads to an interesting comparison. Back in 2000, the S&P 500 had shown similar resilience. Having reached an all-time high in March, it fell sharply in April. However, it soon recovered and was back to around its high by September. The Russell 2000, on the other hand, after having reached its peak in March, fell and stayed down, not even coming close to its high again until well into the next bull market four years later.

As we now know, it was the Russell 2000's performance in that year that proved to be the better forecaster. The Russell 2000's weakness was sustained over the next few years, the S&P 500's resilience was not, and the US economy went into a recession.

Will things turn out the same way again six years later?

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