Mutual Fund Investing - Economy Vs Market

In order to appreciate where the market stands now-and where it may be going-you have to think back to the last days of April, the whole month of May and the last half of June.

Over that period, stocks lost all their gains and more, showing a loss for the year as we entered July. Since then the market has dug itself out of that hole. The S&P 500 is now positive for the year. Since the low for the S&P 500 on July 2nd (1022.60), stocks have risen slightly more than 10%.

The European crisis... Before looking at what we think accounted for the turnaround and the market's recent strength, we need to consider what caused the May plunge. You know the answer very well. The European debt crises (Greece, Spain, Portugal, et. al.) shook the world markets. Worries extended as far as to whether the euro's value would collapse, with chaos to follow on the world's currency markets. Would there be a de facto devaluation of the euro, threatening everyone else's export trade? On and on went the worries, and down and down went the markets.

Here we are, about two months later, and Europe is still standing. On Monday, August 2nd, the Wall Street Journal reported that the "euro shot to a three-month high against the dollar." American tourists, dreaming of relief from hotel prices in Paris, will have to grin and bear it, not for the first time. As for the Euro area economy, it is looking fine right now. Germany, the heavy-lifter of the Euro-area, is extremely strong. The Euro-area bond markets are providing funds, even for Greece. Crisis, what crisis?

Europe is the one down. Whatever Europe's problems, they do not pose a crisis any more. Part of July's rally was simply restoring value that had been swept away in the selling binge of May and early June.

The U.S. economy... The one still to go is the U.S. economy. After the May plunge, stocks rallied for a while in June only to fall again (to new lows for the year). This second fall had nothing to do with Europe. It had everything to do with concern about the U.S. recovery, and that concern is with us right now. The concern is that the recovery has lost momentum, as becomes evident with every new indicator.

The market's late June plunge, and the data causing it, elevated the issue of a double-dip for the economy to major status. Given the market's behavior in July, and now early August, it appears that concerns over a stagnant to falling economy were already discounted by investors. The July economic numbers were certainly not robust, and yet the market rallied 9.2% over the month. What did the market (investors) see?

Two obvious factors have been driving the market, in our opinion. First, while the numbers keep saying "loss of momentum" the indicators have not been uniformly following the same script. Yes, retail sales have turned sluggish. At the same time, the indicators of business investment spending are encouraging. It is a mixed picture. Not inspiring, but at the same time not the prologue to a new downturn. We would posit that some who sold in June, or held back, are now cautiously moving in. The worst is not happening.

The other factor is earnings. The earnings reports for the last quarter have been very strong. We have seen estimates that earnings could rise by 36% with the top-line increasing by 9%. As Patrick O'Hare, Chief Market Analyst for Briefing Research reminded us the other day, the market sold off in the face of the earnings reports. Much of the buying we have seen then is a reversal of the bad bet on earnings made earlier.

Looking ahead, we find the implication of the earnings reports extremely positive. Consider that the economy overall was fairly sluggish last quarter, and yet companies were able to achieve strong earnings. This provides evidence that this recovering economy, with plenty of slack, will be able to generate continued earnings gains despite a sluggish environment. When activity picks up, as it will, we expect an earnings surge in first stage of the economy's revival.

Right now... The issue then is what about revival. We are the first to admit it is not at hand. What is at hand are the preconditions for revival. Take the consumer, for one. Consumer spending has turned sluggish, and the consumer is decidedly pessimistic. As a result the consumer savings rate has risen to a high 6.2%. Will the rate go higher? Maybe. But we doubt it. Considering income growth, we would expect to see consumer spending increase somewhat faster than it has. Exports is another sector where we expect to see improvement.

We remain encouraged by the resilience shown by the market. As we have been saying, the U.S. market is cheap. We continue to favor equities.

Walter S. Frank has been the Chief Economist and Chief Investment Officer for Moneyletter for the past 25 years. He has had a long and distinguished career as an economist, financial advisor, and money manager. Mr. Frank is a regular contributor to Barron's and The Economist magazine.

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