Smooth Sailing Now; Icebergs Ahead
01/22/2010 9:20 am EST
Many investors expect the economy to stay not too hot and not too cool, and they may be right about the year's first half. But trouble looms on the horizon.
The odds that the US stock market will win its current bet look daunting.
Investors who've been pushing up stocks are betting that the US economy will produce a big enough increase in earnings to keep stock prices headed higher, and at the same time, show enough signs of weakness to prevent the Federal Reserve from raising interest rates in 2010.
Seems like trying to get a camel through the eye of a needle?
Well, I think the odds are better than you might think—for the first half of 2010. Then they get progressively worse until, by 2011, the chances that the stock market will get the precise balance it needs are almost nil. (This column is an update of my article “How to Worry/When to Worry.”)
The key to my relatively optimistic view for the first half of 2010? Timing.
Earnings Collapse, Then Surge
For example, take a look at quarter-by-quarter earnings projections for the stocks in the Standard & Poor's 500 Index.
Operating earnings collapsed at the end of 2008. For the fourth quarter, the 500 companies in the index showed a total operating loss of nine cents a share. In the fourth quarter of 2007, these companies showed total operating earnings of $15.22 a share. I think that qualifies as a collapse.
For the fourth quarter of 2009, the one that companies are reporting now, Wall Street analysts are forecasting total operating earnings for the S&P of $16.08 a share. That's a huge swing, and explains, in part, why stocks have rallied so strongly since March 2009.
But watch what's likely to happen as 2010 moves along:
- In the first quarter, projections call for operating earnings of $17.12 a share, up from $10.11 in the first quarter of 2009. That's 69% earnings growth year to year
- Second quarter operating earnings are projected at $18.59 a share, up from $13.01 in the second quarter of 2009. That's a 43% jump
- Third quarter earnings are projected at $19.92, up from $15.78 in the third quarter of 2009. That's a 26% increase
See the pattern here? As stocks move further from the bottom in earnings at the end of 2008, year-to-year earnings growth slows because the year-earlier quarter was progressively less horrible.
That makes spectacular earnings growth pretty easy to come by in the first half of 2010 while making earnings growth in the second half of the year look increasingly ordinary (especially if stocks have kept moving up in price quarter by quarter).
So the odds that stocks will deliver the earnings needed to justify higher share prices look pretty good in the first half of 2010 and then decline as the second half progresses.
Of course, actual earnings could be way off projections. But here again, I think timing comes to the aid of investors.
Will the Economy Cooperate?
The big threat to those earnings projections is the real economy. Actual earnings could fall far below projections if the economy grows more slowly than the 3% most economists are expecting for 2010. With the official unemployment rate at 10%— and the full unemployment rate north of 17%—and forecast to remain stubbornly high into 2011, projections of 3% economic growth may seem ludicrously high.
But they're not, and I'll explain why.|pagebreak|
By this point in the recession and recovery, I think every investor knows that the unemployment rate is a lagging indicator. Long after the economy has started to grow after a recession, unemployment remains high. Employers are reluctant to do much hiring until they are convinced that the upturn in the economy is real. And then it takes time to find job candidates and interview, process, and train them.
The rule of thumb for recessions before the 1990-91 recession was that the peak in unemployment came about one quarter after the upturn in the economy. By that rule, with the US economy showing growth in the third quarter of 2009, the unemployment rate should have peaked in the fourth quarter, or at worst, will peak in the first quarter.
But the two most recent recessions haven't followed that rule. After the 1990-91 and 2001 recessions, the peaks in unemployment followed the upturns in the economy by a year or more. If this recession follows the pattern of those two recessions, we're looking at rising unemployment or, at best, no reduction in unemployment until 2011.
Wouldn't that be enough to put a huge dent in those earnings numbers? You might think companies couldn't generate profits like that if 17% of workers were officially unemployed, unable to find more than part-time jobs, or so discouraged that they'd stopped looking for employment.
But if you thought that, you'd be wrong. Initially, at least, high unemployment that stays high as an economic recovery begins is good for corporate profits. That's because when companies put off hiring even as an economic recovery brings in more business, employers wind up doing more work with the same shrunken staffs.
You can see the result in the productivity numbers from the Bureau of Labor Statistics. Productivity climbed at a low 1.8% annual rate in 2008 and was actually negative in the first and third quarters of the year. After a modest 0.3% gain in productivity in the first quarter of 2009, productivity soared 6.9% in the second quarter and moved even higher in the third quarter, rising 8.1%.
With hourly earnings up just 0.3% in October and 0.2% in November and December, most of the gains from that increase in productivity aren't going to workers. Instead, they're heading straight to corporate bottom lines.
That increase in corporate profits is one reason so many capital goods and technology companies are reporting an increase in sales and orders from their corporate customers in the current earnings season.
You can't build a long-term recovery if workers don't eventually get to share in the productivity gains and if companies don't hire. With about 70% of the US economy dependent on consumer spending, in the long run, any sustainable recovery has to include rising employment and rising incomes.
In other words, in the first half of 2010 we could get exactly the earnings growth Wall Street now projects, even if unemployment remains stubbornly high. But in the second half of 2010 and into 2011, it's hard to see how a sustainable recovery and continued growth in corporate profits can meet expectations without higher employment and income growth.
A Half-Percent Difference Matters
This takes us to the big debate right now over the long-term sustainable growth rate for the US economy.
Last May, Pimco's big guns, Bill Gross and Mohamed El-Erian, said that coming out of the recession, the economy would grow more sluggishly than in a usual recovery. Long-term economic growth would average just 2% a year, they forecast.
That call is by no means supported by the consensus of economists. According to a Bloomberg survey of 46 economists, growth in the recovery will match the average over the past 20 years. The median forecast in the study says the economy will grow 2.5% a year.
It matters which view is right. At 2.5%, the US economy would be $400 billion bigger in five years than if it grew at just 2%.
If the economy grows 2.5%, stocks will do fairly well and make the puny yields of bonds and dividend-paying stocks look even smaller. In this scenario, it would pay to reverse portfolio decisions that have moved big money out of stocks and into bonds. The problem is that however you grade the arguments—and I find the Pimco position convincing—we won't know the answer until we get much closer to the 2011-13 time period that economists are arguing about.
I suspect that as we approach the beginning of that period, fears of a slowdown in growth will increase.
It's just another reason to think that the first half of 2010 will be much clearer sailing for investors than the second half and 2011. Add in the probability of a Fed interest rate increase in late 2010, or more likely, in 2011, and some action by China to reduce runaway economic growth in late 2010 or early 2011, and investors will have plenty to think about.
In the first half of 2010, timing does indeed favor stock market optimists. After that, it'll be time to worry again.
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At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.