Investors, if you think US fortunes continue to drive the world economy, keep your money out of this market. But if you expect Asia and South America to lead the recovery, jump in now.
U.S. and global economic data have begun to diverge so greatly in recent months -- with sustained weakness here and a surge of strength overseas -- that it's a wonder we're all on the same planet.
The differential is more than just a matter for academics to discuss at the faculty club, because investors large and small need to decide, pretty much immediately, which set of data to believe.
Those who believe that American consumers, banks and factories are still the main engine of growth in the world are taking profits on recent gains in stocks, shying away from risk and husbanding cash. Those who believe instead that rising consumption and industrial might in Asia and South America are more important are going in the opposite direction, diving into risk with abandon.
We'll know who's right in the fullness of time, but in the near term, investors do not have the luxury of waiting. They must anticipate the future based on limited data, act now, and prepare to face the consequences if they're wrong. That makes this summer one of the most intense stretches of soul-searching for professionals in the past two years, as it will make and break careers, reputations and fortunes for years to come.
In a moment I'll tell you why data and psychology now favor bulls, but let's look at the story from the perspective of active practitioners rather than economists -- two private wealth managers who actually have to make decisions on behalf of clients, rather than just spout off with no consequences.
Worries and economic warts
- A prolonged U.S. retail sales slump, highlighted by a same-store sales plunge of 32% last month at Abercrombie & Fitch (ANF, news, msgs), shows that consumers are in no mood to buy goods even if factories were ready to make them. A plunge of 5.1% reported by U.S. shopping malls in June was worse than the dire 4.5% forecast.
- Unemployment is not just the worst since 1983 -- 29% of the unemployed have been looking for work more than six months; the number of people taking unemployment benefits has reached a record 6.88 million; and six people are looking for work for every job opening, a fourfold increase from just a year ago.
- With consumers on the sidelines, U.S. industry is on the brink. Factories used only 68.3% of available capacity in May 2009. The lowest prior level since the Depression was 70.9% in December 1982.
- Despite the recent uptick in construction, new-home sales are down 73% from their 2005 high, and the cumulative loading of rail cars is down 19.2% from 2008's depressed levels.
- Price/earnings multiples on U.S. stocks, reflecting investor sentiment, fell only to a multidecade average at 16 rather than to the single-digit lows seen in prior deep recessions.
Sprott concludes by listing three scenarios for his clients: If S&P 500 earnings stay constant at $63.03 and price-to-earnings multiples hit cycle lows at 6 due to worsening sentiment, he sees the Standard & Poor's 500 Index ($INX) falling to 378. (It closed at 987 on Thursday.) If earnings are halved, as they have done three times in the past 30 years, and the P/E stays constant at 16, the S&P 500 would fall to 506. If earnings are halved and the P/E hits cycle lows, he gets an S&P 500 value of 189 -- a true, old-school depression.
Sprott says only buoyant investor sentiment is keeping the market up, as earnings have not improved. "Keep it simple, stupid," he says. "Investing is and always has been about the real economy, and this market is ignoring the hard data."
Globalization's other face
Helton believes bears like Sprott are selecting only the data that make their points and missing noncorroborating evidence. He points out that P/Es have indeed come down by more than half, so what's the problem? Corporate earnings are stabilizing and show signs of going positive in the fourth quarter, and that's even more clear when you look at the S&P 500 without the volatile results of the banks and energy producers. And while more people are out of work, those who are working are enjoying rising real incomes because of low inflation and improving wages.
Don't focus just on struggling retailers, which always have troubles forecasting demand, Helton says. Look at networking equipment titan Cisco Systems (CSCO, news, msgs), whose chief executive last week said he predicts 12% to 17% growth and sees productivity for the nation overall rising up to 3% annually, which would potentially equate to gross domestic product growth rising to around the normal rate of 4% by 2011. "The bears are always squawking about dangers at inflection points," Helton added. "But they're just projecting the recent past into the future," he said. Three months from now, he suspects, data will force the bears to reconsider.
If Helton is right, and I suspect he is, it's going to be in large part because U.S. companies are getting a huge boost from their international operations. Most North Americans don't pay enough attention to this data, but a quick synopsis from ISI Group analysts from the past week can shed some light.
The improvements, in many cases due to government stimulus, make your eyes bug out: Global vehicle sales are up 21% in the past seven months; steel production is up 15%; China's electricity production is up 14%; Korean GDP is up 9.7%; Japanese exports are up 20%; and Taiwan export orders are up 45% and industrial production is up 50% in the past five months. It's not just Asia, either: French consumer spending is up 3.4% in the past four months; Canadian retail sales are up 2.5% in the past five months; the Brazilian unemployment rate has fallen to 7.9% from 8.6%; and the Mexican unemployment rate has fallen to 5.7% from 6.2%.
This is not a trivial travelogue. These countries' companies are buying more Caterpillar (CAT, news, msgs) and Cisco equipment, organizing their sales databases with Oracle (ORCL, news, msgs) software and charging purchases on MasterCard (MA, news, msgs). Last summer, I wrote a column headlined "Warning: Worldwide wipeout ahead." Now the opposite seems likely, as the U.S. has an opportunity to follow the rest of the world out of recession.
Room to run
Now that unprecedented levels of worldwide fiscal and monetary stimulus have blunted the credit crisis and parried the recession, companies are doing well enough to beat analysts' panic-inspired earnings expectations. And those improvements in stock prices and the tone of hopefulness are likely to make consumers more optimistic, and thus more likely to spend in the third and fourth quarters of this year.
Even bulls are not calling for another rip-roaring move higher now to complement the 45% advance off the March lows that has already been recorded. But with so many investors still on the sidelines or short, paralyzed with disbelief and anxiety over having missed the initial move, you can probably count on an advance for the rest of the year even if it's punctuated with more 10% to 15% corrections such as the one just seen in June.