November 26, 2002
Bear’s Take a Bite Following Gross Domestic Pricing-Power
NABE President Tim O’Neill said today, “It’s not Goldilocks, but certainly there is no expectation we will see a second recession.” Mr. O’Neill was referring to economist expectations for GDP growth in 2003, which stood at 3.2% two months ago and stands at 2.8% today. O’Neill added, “The flight plan is the same, but the altitude is going to be a little bit lower.” Clearly he is not referring to the stock markets, which are up strongly over the last two months even as the economic flight plan has been adjusted lower.
That economists do not expect a recession is, of course, irrelevant. After all, O’Neill and the gang missed calling the 2001 recession, the 2002 recovery, and will likely miss calling the next… Furthermore, that economists slashed their 4Q01 growth estimates (currently at 1.4%, or almost half of the previous projection) is also irrelevant. What is relevant you ask? That economic growth estimates are trending lower as the stock market trends higher. To be sure, these trends tend not to coexist for an extended period of time. To simplify, either the markets will fall as the economic estimates continue to be hacked lower or growth estimates will stabilize (enlarge) and the markets will rally.
With this in mind, and taking into account that the markets are devoid of earnings news, each economic report has become extremely important. We caught a glimpse of this last week, or when a weekly jobless claims number (usually not a number considered that important) catapulted the markets higher, and we caught another glimpse of this today when three reports – GDP, new home sales, and consumer confidence – helped take the markets lower. Tomorrow is durable orders, jobless claims, personal income/spending, the Fed’s Beige book, and Chicago PMI. The conference board’s help wanted index (Oct) is also due out.
Key Turning Point?
Immediately following the GDP release the future markets turned slightly positive. However, by the opening bell futures signaled that the rally had been completely snuffed out. That the markets reacted so poorly to what was, on the surface, good news, could mark a turning point for the markets.
Incidentally, theorizing that today was a key turning point for the markets is pure speculation. However, after being bombarded with ‘this is the bottom!’ commentaries in July and October one has to wonder why more people are not speculating ‘this is the top!’ Investors don’t think the 20% bear bounce is going to last – do they?
Following the GDP report the markets awaited two other reports – consumer confidence and new home sales. When both of these reports came in below expectations the markets began to sell off aggressively.
* Prior to the confidence and housing reports the Dow was clinging to 8,800 and the Nasdaq was gunning for 1480. These levels are worth keeping in mind should the markets attempt another rally before the end of the week. If indeed today was a turning point these new levels would serve as resistance for any such rally.
4% GDP not all Roses (Excel)
A 4 handle on 3Q02 GDP was above what economists expected. However, within the revisions rest some interesting tidbits:
- A $15.5 billion increase in business inventories padded the overall number by 0.45 points. Building inventories could be a signal that demand is not picking up as quickly as businesses would like.
-- After tax corporate profits, not reported in the initial GDP release, were up by 2.1% compared to 2Q02. However, year-over-year after tax profits were actually down by 1%.
-- Business spending on facilities and equipment, which originally reported as having climbed, fell in the latest revision.
What is most worrisome about the GDP data is the fact that companies built up inventories at a rapid pace in 3Q02 ($4.9 billion annualized increase in inventories in 2Q02). If the U.S. economy is really turning around and if businesses are soon going to start spending, why are inventories being built up? What impetus is there for businesses to enact new capital expenditures if they are building inventories??
In order for companies to gain pricing power either consumers must spend more rapidly, the Fed must deflate the dollar, and/or or inventories must decline. Suffice it to say, sorting through exactly how and why companies will find the need to spend more money is a dicey subject, especially when mention of a declining dollar, which would inflate import prices, gets thrown into the mix.
Regardless, and this has been worth reiterating for all of 2002, economists and Wall Street expect companies to begin spending, but companies are not showing any signs of increasing their spending right now. Furthermore, it is not as if a slight increase in profits automatically means that companies will spend, spend, spend. Rather, companies can use excess cash to sure up their balance sheets, to pay out dividends (dividends were up smartly in 3Q02), to buy back stock, to pay for severance packages, to replenish under funded pensions, to bribe SEC officials, etc.
In sum, 3Q02 GDP highlights the fact that companies have not met capacity constraints necessary to justify increases in spending. Companies built inventories up in 3Q02 at their fastest pace since 4Q00. This is not to suggest that inventory build ups suggest economic recession (as the build up in inventories during the final quarter of 2000 did). After all, economists currently anticipate 4Q02 growth will be a robust 1.4%. The U.S. economy may be weakening, but Santa Clause and Mr.G will ensure it stays above water…or so the story goes.
Speaking of Santa, the weekly retail sales numbers came in weak. Apparently these numbers are meaningless, as economist contend that consumers are saving themselves for this Friday -- when Christmas spending season begins.
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