Seventh Best September in 82 Years on Weak Economic Data

If September were to end today, September 2010 would go down as the seventh best September for the S&P 500 since 1928.  A mere three days into the month, the S&P 500 has risen 5.26%.  On only six other occasions – 1939 (start of World War II) +14.4%; 1950 (price/earnings ratio of 6.9x) +5.6%; 1954 +8.3%; 1996 +5.4%; 1997 (near resolution of the Asian Contagion) +5.32%; and 1998 (bailout of Long-Term Capital Management) +6.2% – has the market done better in September.

Near-term trading is all about newsflow and expectations. The past week offers evidence of this maxim up in spades.

The market soared this week not because the economic news was good.  It was not.  It was mediocre at best.  The market soared because it was not as bad as thought.  Jamming shorts into an illiquid market pushed the indices into the upper end of their four-month trading range.

The market was exceedingly pessimistic going into the month, with all sorts of chatter about a double dip.  Four pieces of data mattered, three of which caused the market to take off like a scalded cat and one that was ignored.

On Wednesday, the August ISM Manufacturing index handily beat expectations.  Perma-bear David Rosenberg detailed concerns about the ISM print, but the market would have none of it as the S&P 500 rose 3% and the Russell 2000 4% on Wednesday.

On Thursday, pending home sales unexpectedly rose 5.2% in July whereas economists were expecting a decline.  Sales declined 2.8% in June and a whopping 29.9% in May after the expiration of the homebuyers’ tax credit.  Whether or not the increase in home sales is a dead cat bounce remains to be seen, but for the moment, the market interpreted the data as the consumer having a pulse.

Friday was the jobs report.  Nonfarm payrolls in August declined 54,000, half of expectations.  Private payrolls rose 67,000, beating expectations of +40,000.  Perhaps more importantly, there were substantial upward revisions, with July revised from -131,000 to -54,000, and June from -221,000 to -175,000.

Interestingly, manufacturing jobs declined by 27,000, even though the jobs component of the ISM survey increased.  Prior to the release, David Rosenberg questioned the jobs component of the ISM, noting inconsistencies in the data.

An increase of 67,000 was the eighth consecutive month of positive private job creation.  However, job creation is still weak.  The prior seven months were; July +107k, June +61k, May +51k, April +241k, March +158k, February +62k, and January +16k.  Private job creation has been positive but August was below the year's average of +99k.  Over the past four months, private sector job growth has average +72k.  Private job growth has decelerated.

This is consistent with the claims data.  Initial jobless claims last week were 475k, above the 2010 average of 465k. The average of initial claims for August was 486k, the highest monthly average this year.  

According to the ISM non-manufacturing index, employment may even be contracting.  The broad index came in lower than expected at 51.5, signaling continued but slowing expansion.  (A reading above 50 implies expansion. A reading below 50 implies contraction.)  However, it was the lowest reading since January.  Given that the market went ga-ga over the ISM manufacturing index and ignored the services index, it should be noted that services are a much bigger part of the economy than manufacturing.

What was more interesting were the components of the index.  Business activity, new orders and order backlog all declined, while employment and new export orders were in outright contraction.  The reading for employment was 48.2, indicating that employment is falling in the services sector of the economy.  Also, inventory sentiment rose, indicating that managers think their inventories are too high.

Net net, the news releases were better than expected but weak in the absolute.  However, in a market where expectations were clearly negative, incrementally positive news can jam the market higher, especially when everyone is at the beach (except of course the machines that run the market, which never go to the beach).

The question now is whether or not the market can break through the fast approaching resistance levels.  My guess is that Tuesday will be up day, as Mutual Fund Monday is deferred because of the long weekend, pushing the market towards the upper end of the trading range.  I think the real test will come later in the week and into the following week as volume comes back into the market.  If volume does not come back into the market, be concerned, even if the market goes up.

The market is a discounting mechanism.  Perhaps the market action of the last three days is signaling that the economy is going to get stronger.  But the economy is going to have to show strength soon.  The data thus far has been weak, consistent with an anemic economy and a market in a trading range. 

 

Comments

[David]

I wouldn't say the market is "illiquid" just because volume is lighter in August than, say, September. I'm also not convinced the market wouldn't have gone up 5% (or even more) next week given the same data because, as you said, expectations have been so low. I recall back in 1990 that from 1926 the DJIA average p/e was around 13. We are now around 11. In the 2000s we were much higher so there has been serious multiple contraction making stocks look very cheap, in my opinion. Moreover, interest rates are very low as is inflation (factors which help determine p/e). Corporate profits are pretty good suggesting that even incremental increases in sales can have a major affect on the bottom line. Balance sheets are strong, companies are lean.

In my view, the market is a coiled spring waiting to break out of the trading range between 10-11K once economic activity picks up. As you noted, the market is a discounting mechanism and unemployment, for example, can remain elevated while the market moves higher. At times, economic data can look soft even during healthy expansions (e.g. regional indexes, ISM, etc.) because of noise or whatever. In my view, this past week was not due mostly to short-covering. As long as the train is moving forward there will be a creeping realization that the economy will not experience the dreaded double-dip and the arguments for a bear market will begin to look less solid. Given the enormous economic turmoil since 2007/8, its a given that the level of pessimism would rise appreciably and its evident in blogs like this. The U.S. is broke, the love affair with equities is over, the appetite for risk is much lower and so forth. Prior to the market's 80% climb from trough to peak beginning in March 2009, there was the same feeling recently that stocks would only go down. And they still may, of course. Maybe a double-dip is still in the offing. But as economists adjust their GDP forecasts downward for 2011, what if the economy surprises on the upside just as it did on the downside this year? I don't hear much chatter about that, which is another reason why I'm bullish.

Toro, I enjoy your blog. You do a nice job presenting your opinions.

[Toro]

David

I appreciate the kind words.

The house view here at Running of the Bulls is that we are and remain in a multi-year trading range. I do not know where and what that range is but it will be difficult for the market to advance much as economic growth remains below trend due to fall-out from the housing bubble, which will take years (2? 5? 7?) to work out. I do not subscribe to the dire views of Dow 1000, re: Robert Prechter, but I remain open-minded about it. I also remain open-minded that I may be wrong and this could be the beginning of a new bull market. I don't know. Being adaptive rather than dogmatic seems to me to be a better way of surviving in the markets.

The one point in your well-articulated post I would quibble with is the PE. My Bloomberg shows me that trailing reported earnings are $67 on the S&P500, which would put the market ~16x earnings. (Though, correct me if I'm wrong on that. I used to get the data straight from S&P but do not anymore, so maybe I'm looking at that wrong.) The market looks cheap on Wall forward operating earnings. This years estimates are $83 and next year's are $95, giving us multiples of 13x and 11x. I believe that Wall Street grossly overstates profitability by using operating earnings. In fact, over the past 25 years, on average Wall Street's operating earnings have overstated reported earnings by 20%. I wrote about it here.

http://runningofthebulls.typepad.com/toros_running_of_the_bull/2008/01/mistrust-operat.html

The long-term average PE based on next 12 months earnings is ~14x. Being generous and assuming that Wall Street's analysts are "only" overestimating reported earnings by 15% instead of 20% would put forward reported earnings at $80 two years out, meaning the two year forward PE of the market is ~14x!

Wall Street's assumptions also assume that profit margins will return to their record highs. Since 1945, reported net profit margins have averaged under 6%. Since the forth quarter of 1986, reported net profit margins have averaged 5.5%. At $95, Wall Street is assuming a return to near the record profit margin of 10%. Sales per share of the SP500 is $926. If one assumes trendline nominal economic growth of 6% (not a given in this environment), in two years, SPS will be $1040. At $95, that is a profit margin of over 9%. To assume that stocks are cheap here assumes that profit margins will stay this high indefinitely. Are we in a new paradigm where profits stay elevated forever? Maybe, but GMO has done work concluding that profit margins are one of the most mean-reverting data series. The model that I work from is that there has been a structural shift in profitability upwards from 5.5% to 7%, which would put the market at normalized PE of 16x.

Thus, I don't think the market is cheap. I think some stocks are cheap, particularly high quality stocks, but not the market.

However, I could be dead wrong. My object is to make money, not to be dogmatic. If I think we are going higher, I will turn on a dime and go all in.

T.

[dacian]

Hello

"The market is a discounting mechanism."

Well, that is a saying coming from very smart people; I think even Warren Buffet says that. Now it's not me a poor guy who's gonna oppose thats statement :) but it is my feeling from the last years developments and thinking at the internal structure of the market (as far as I can understand) that waiting for the market to discount anything is naive; today markets run on liquidity more that ever and not on anticipation of future state of affairs.

[dacian]

T., btw, are u still short? You change your mind lately quite often ;-)

[David]

Hi Toro,

Thanks for your response! You make some good points. Perhaps I was mixing oranges and tangerines when I mentioned the market p/e of 11. I was looking at the 2010 p/e for the DOW based on the average of analyst EPS projections for this year.

What makes stock market investing interesting is that its hard to get a consensus what the forward p/e really is. I just did a quick google search and came up with the follow:
"The early September surge contrasts with the month’s historically poor performances. However, heading into September stocks had become oversold amid considerably bearish sentiment. That led to attractive valuations, such that the S&P 500 traded with a forward P/E of 11.9x, which many viewed as attractive in light of the forward P/E of 11.1x that was seen at market’s multiyear low in March 2009, when the economic backdrop was arguably much more dire."

Also, this one which dovetails your point...
"What is wrong with the P/E? In short, the "e" can't be trusted. The Standard & Poor's 500-stock index's average P/E has dropped to 12.3 times earnings based on analyst forecasts for the next four quarters, below the 52-week average of around 14.3." [sorry, I couldn't post the links]

As you noted, analysts tend to overly optimistic. Interestingly though, in the recent quarter most companies beat expectations in spite of the slow down in the economy. Analysts/Economists tend to be behind the curve so when the economy starts to look weaker than expected from six months prior, forecasts come down which makes the adjusted forecast more reasonable in the short-term but possibly too pessimistic 12 months out. In other words, usually the forecast is for high growth, decent growth, slow growth or recession. It never seems to be good growth for two quarters, slow growth for the next quarter, another quarter of decent growth, two more quarters of anemic growth...you get the idea. Economists have been whipsawed in recent years.

My two cents is worth just that. Back in January I expected a 30% rise in the market this year even though I tend to be a conservative investor (nb: The year's not over! ha ha). That said, I still feel the economy will do better next year but that it doesn't have to be quite as robust as previous economic recoveries for companies to grow earnings in the low-double digits. Moreover, I feel the market is attractive if interest rates remain low. Low interest rates, low inflation, high earnings yield, reasonable p/e, that used to be a great environment for stocks. To be sure, structural changes are occuring, especially in housing. But I've been encouraged by what I've seen companies report so far in spite of the difficult macro-economic environment and if things do get better next year then fears should start to dissipate and the stock market will respond accordingly.

Toro, I periodically visit your site because you do your research and look at things objectively. You don't make extreme projections like some pundits might do to grab headlines, and I respect your reasoned opinions. I was too optimistic about this year and probably am about next year too. If we are in a multi-year trading range - something that I may need to come to terms with - I'm going to have to be much more patient with my stock holdings than I anticipated because I'm not a good trader.

Good Luck!

[dacian]

Hello David

"...in the recent quarter most companies beat expectations in spite of the slow down in the economy"

you hit the nail; that was based on cost cutting, no real sales; the question is, can this continue? for how long? hoping the real demand will pick up? will it be so easy to cut until that exact point in time?