Stocks Always Anticipate Earnings - Not the Economy
09/15/09
August retail sales were much stronger than the consensus expected. Even excluding the sales resulting from the Cash-for-Clunkers-induced auto sales the 1.1% rise is the best showing in six months. The 2.7% increase in the overall number was the strongest in three years. Retail sales excluding auto, gasoline and building materials rose 0.7% in August, after a 0.3% decline in July. The strength of the data is likely to see economists revise up third-quarter GDP estimates. The new consensus estimate should center around 3% for the third quarter of 2009. Strength was seen in clothing, sports goods and general merchandise, which all rose more than 2% each. Furniture and building material sales remained weak, however. The data left the dollar weaker as always seems to be the case, when good or better than expected news come out. That in turn enticed buyers of commodities such as oil and copper back into the markets and the race was on, again. Strong (pardon me, better than expected) retail sales coupled with demand for commodities drove the shorts to cover their positions again. Adding fuel to the fire were more companies announcing that business was getting better. National Semiconductor showed confidence and Federal Express, the one representative of global flows of merchandise also said, that international business was looking better. Even Best Buy's revenue exceeded guidance. The consumer is down but not out, it seems. Furthermore, the above companies represent 3 different sectors with different customer bases, different product lines and different competitive headwinds or tailwinds. All three are seeing concrete improvements in their respective businesses. It seems that a recovery is no longer limited to green shoots in isolated areas. It is broadening and gaining strength.
Retail sales (first chart) climbed more than expected in August and the inventory to sales ratio declined further. Businesses continue to work through existing stocks and this will be the 11th consecutive monthly decline. Sooner or later we'll get a halt to inventory liquidation and the result will be a nice pop in gross domestic product.
The general tone of the economic releases the past few weeks has been positive and it has been accomplished without inventories being rebuilt. Most of us acknowledge that inventories forevermore will be lean and mean, but at some point they will have to be replenished. It's nice to see economic improvement without an inventory assist. Knowing that it will come bolsters the prospects for a better third-quarter and fourth-quarter GDP. Other indicators support this view. The Empire State Manufacturing Index surprised us with a nice jump in its monthly report. The index registered 18.9, up from 12 last month and a mere 0.6 the month before. It's the highest the index has been since November 2007. It shows, at least in the tech-focused manufacturing area covered by this survey, that this arena is showing definitive signs of life. If this was the only number we had to use, you could extrapolate an Institute for Supply Management reading of 55. The Institute for Supply Management's manufacturing index has, over the years, proved to be one of the best predictive indicators for overall economic health. Even though there are far more jobs in the service sector as opposed to the manufacturing sector, this index has caught the last four recoveries in a very timely fashion. The 52.9 reading was the eighth sequential increase and the highest since June 2007. If it's the only number you had to go by, this would translate to an annual gross domestic product of 3%. The ISM non-manufacturing index at 48.4 was in line with the consensus guess but it was up from 46.4 last month. It also was an 11-month high. While not as robust as the manufacturing number, the service sector also wasn't a focus of the stimulus program, such as "Cash for Clunkers" program. Regarding the stimulus, apparently only 20% of the money has been spent. While much more has been allocated, it has yet to be actually spent, so the effect is still going to be felt in coming months and quarters. The weekly leading economic indicator also continues to skyrocket. The growth rate reached its highest level in 30 years.
The stock market continues to confound all its critics by going up some more, each time good (or bad news) comes out. Earnings comparisons are the latest data point for the bulls. The third quarter this year and the third quarter of last year are are comparing very very favorably. To keep it simple, just consider this: Standard & Poors estimates 2010 operating earnings for the S&P 500 index to come in at $72.98. The S&P 500 Index is currently trading at 1.060. Dividing 1.060 by 72.98 we arrive at a Price-Earnings Ratio 14.52. Since we are talking next years earnings, we would have to assume that the index trades at 1060 at the end of 2010, Which is 14 months away. If we take a level of 1200 at the end of 2010, we would arrive at a P/E Ratio of 16.44. If we assume an S&P Index level of 1,300 at the end of 2010 it would amount to a P/E Ratio of 17.81. Even this P/E Ratio seems cheap if we apply the Fed Model. The Fed Model was shown in these pages before and it gives you for all its shortcomings at least an adequate comparison of risky versus "riskless" returns available in the marketplace. Indeed, stocks stack up well compared with bonds. The model compares the "earnings yield" on the S&P 500 based on projected profits in the next 12 months to the 10-year Treasury. (The earnings yield is the inverse of the S&P's P/E ratio.) Based on this admittedly simplistic model, the S&P trading at 1,300 shows an earnings yield of $72.98 / 1,300 = 0.056%. If we compare this earnings yield to the current 10-year T-bond yield of 3.50% then we can see that the S&P 500 could be called undervalued by about 36%. Naturally there are three factors that influence this calculation. Earnings over the next 6 quarters, bond yields over the next 6 quarters and the risk premium that market participants place on risky stocks versus riskless T-bonds. What I am saying here is not that the stock market is cheap. What I am saying, however, is that the stock market is only discounting good news that are still in store. Let there be no doubt that we are getting to the point where we are fully discounting everything good and nothing bad, that may come our way in the next year. Perhaps we are due for a rest after all. My bet is that October is going to give us the nasty shakeout that September was supposed to have in store for us.
Hermann Vohs
"The optimist thinks this is the best of all possible worlds. The pessimist fears it is true."
Robert Oppenheimer
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
