August 16, 2010

As the second quarter earnings season draws to a close, 75% of the reporting S&P 500 companies have exceeded analysts' estimates, while the average earnings surprise has been 10.6% above expectations, delivering the sixth straight quarter of positive earnings surprises. Despite this upbeat trend, the market tanked, due to some negative trade numbers and misguided guidance by top Fed officials. As a result, the S&P lost 3.8% last week.
 
What rattled last week's stock market the most was Wednesday's report by the U.S. Commerce Department that the June trade deficit grew to $49.9 billion, up from $42 billion in May. This was the largest monthly trade deficit in 21 months and the biggest increase in 11 months. Looking more closely at the components, June's imports rose 3% to $200.3 billion, while exports fell 1.3% to $150.5 billion. Since June was the closing month of the second quarter, this surprise statistic means that the initial second quarter GDP estimate of +2.4% will likely have to be revised down to 1.5%, or 1.2%, or perhaps as low as 1% (GDP adjustments will be released August 27). The reason for this revision is that output once thought to be domestically produced actually came from imports.
 
The global economic recovery remains strong, especially in China and Germany, while the U.S. appears to be a drag on the global economy. A closer look at July retail sales, for instance, reflects this trend. July's 0.4% rise in retail sales was mostly due to rising gasoline prices, up 2.3% in July. A rising dollar volume of sales disguised a real (after-inflation) decline, since sales at most retail stores fell in July. In addition, the Labor Department announced on Thursday that new jobless claims rose by 2,000 (to 484,000) in the latest week. The four-week average of new jobless claims rose by 14,250 to 473,500, the highest level since late February. Although this rise may seem small, any rise during a recovery is disappointing, reigniting fears of a double dip recession, due to stubbornly high jobless figures. In other news, The Wall Street Journal survey of 53 economists, released Thursday, showed that most economists are getting a little more pessimistic. On average, they expect the U.S. economy to add just 136,000 jobs a month over the next 12 months, down from their earlier forecast of 157,000 in July. In addition, these economists did not support the termination of the 2003 tax cuts. Only three of the 53 economists wanted these tax cuts to expire, while 32 economists said these tax cuts should be extended for everyone.
 
The Federal Reserve also contributed to last week's market fears, with their confusing language during and after last week's Federal Open Market Committee (FOMC) meetings. Specifically, the Fed's official statement said that a "more modest" economic recovery led the Fed to reinvest the proceeds of maturing mortgages in U.S. Treasury debt. Translated from Fedspeak, this means that the Fed will resume their quantitative easing (QE) by buying Treasury bonds, which will likely depress long-term Treasury rates. Although most economists anticipated that the Fed would resume its quantitative easing, due to slower economic growth rates, statements like "the pace of economic recovery is likely to be more modest in the near term than had been anticipated," and "lending by banks has continued to contract" seemed to rattle investors around the world. Many investors sold stocks due to the Fed's new language and policy actions.
 
The U.S. may be sputtering, but the global economic train continues to be driven by China and other nations. The main reason we are continuing to see a V-shaped recovery in earnings, despite a flat-line U-shaped economic recovery so far is that approximately 40% of the S&P 500's earnings come from overseas operations, where economic growth is far more robust than it is within the United States. Take China, for instance: On Wednesday, Wall Street was rattled a bit when it was announced that China's industrial output slowed in July, falling to a 13.4% annual pace, down from a 13.7% rate in June. Additionally, China's capital spending slowed to a 22.3% annual pace in July, down from 25% in previous months. Finally, China's retail sales in July slowed to a 17.9% growth rate, down from an 18.3% annual pace in June. Since Wall Street usually shoots first and thinks later, this China report added to Wednesday's market decline.  In Europe, strong Chinese demand continues to lift Germany's exports, which surged 16% in June vs. May. As a result, Germany's GDP rose an estimated 2.2% in the second quarter compared to the first quarter, an annualized GDP growth rate of 9.1%! Unlike the U.S., Germany has chosen not to engage in any trade wars with China, so they have not been hit with any extreme tariffs. Meanwhile, China has installed a 105% tariff on U.S. broiler chickens, due to our tariffs on their tires. Can you believe this, chickens for tires? I should add that the growing middle class in Asia, India and Latin America continue to create global demand and drive GDP growth. While exports are rising to these regions and helping to boost European GDP growth, the U.S. has been left behind, especially now that it has been revealed that U.S. exports actually fell in June. China's exports continue to soar, by a whopping 38.1% in July, and are now at their highest level in 18 months, while U.S. exports have contracted, due in part to the U.S./China trade wars.
 
On Wednesday, the Treasury Department announced that the federal budget deficit was a whopping $165 billion in July, marking the 22nd straight monthly deficit. Federal outlays rose to $321 billion, while tax receipts were only $156 billion, so the U.S. government spent more than twice what it collected in taxes. Is anyone surprised by this? 
Complicating matters is that after 48,000 state and local workers lost their jobs in July, and over 300,000 since August 2008, Congress reconvened for an emergency session to pass a $26.1 billion aid package to save more state and local jobs from financially troubled states like California, Illinois and New York. But in order to pass that $26.1 billion aid package, Congress took $12 billion from the food stamp program. Bottom line, with unemployment now apparently at the highest level in almost six months and Congress desperately raiding food stamp money to try to preserve more jobs, unemployment is likely to be the #1 issue for Congressional representatives running for re-election in the upcoming mid-term elections.
 
This brings up the best piece of good news I can offer at this time. Historically, the mid-term election-year rally begins in late September and lasts 26 months, all the way through the 2012 Presidential elections. If we see a major political shift this November, as we did in 1994, the next two years could be great, as 1995 and 1996 were, when the Clinton Administration worked well with the new Congressional leadership. I don't know if the tax cuts will really end this year, but I do know that 142 stocks in the S&P 500 have boosted their dividends so far this year. If federal taxes on dividends end up rising from 15% to 39.6% next year, then we will probably see companies front-loading their dividends before tax rates rise. If this happens, we'll see the favorable impact later this year when mutual funds list the reinvested dividends and cap gains. As long as the Dow yields more than Treasury bonds and more companies increase their dividends, the foundation for a sizable stock market rally could be brewing for the very near future. We shall see as all of this plays out through the November elections and Congressional discussions following those elections. Remember, elections have consequences so get out and vote in November.
 
Have a nice week.

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