Subpar economic recovery underway

The major [U.S.] market indices finished last week lower on concerns that the rally in stock prices has outpaced the still developing economic recovery. Seasonal influences may have also been at work as the end of the third quarter approaches. Prior to last week’s slump, the major indices had advanced by over 16% and traders may have been locking in some of those gains ahead of quarter end.

Essentially, I believe investors are now waiting to see if the government-induced stimulus will transition to organically derived growth. In other words, I believe investors fear that once the government takes its foot off the “gas pedal,” the recovery will run out of steam. At some point, fundamentals will also need to start showing up. The third quarter earnings season—which kicks off in a couple of weeks—will be instrumental in providing investors with clues as to whether the uptick in economic activity is beginning to filter through to the corporate space. The focus will clearly be on revenue generation as opposed to cost-cutting efforts as the primary source of earnings growth. Corporations over the past several quarters have aggressively cut costs, creating significant amounts of operating leverage. If topline growth begins to resume, the bulk of it should fall straight to the bottom line.

While I continue to believe the economic recovery remains intact, but feeble, data points last week provided a stark reminder that the road to recovery is very rarely a straight line and often presents potholes along the way. This was most evident in housing-related data with both existing and new [U.S.] home sales falling short of economists’ expectations. While on a multi-month basis the trend in housing statistics remains higher, the numbers last week seemed to catch economists off guard. A recovery in the housing sector remains a prerequisite for an overall turn in the economy. While affordability, due to declining home prices and low financing rates, remains at near-record highs, the housing market will continue to face headwinds from high/rising unemployment and tight lending standards.

Despite the slump in housing reports, the Mortgage Bankers Association reported that U.S. mortgage applications jumped to their highest since late May as interest rates on the benchmark 30-year fixed mortgage dropped below 5%. Overall applications rose by 12.8%, driven by solid gains in both the refinancing and new purchase components. The decline in mortgage rates and the stability in pricing should help keep affordability at high levels. In addition, there have been rumblings that the $8K first time home buyers credit, currently set to expire at the end of November, will be extended into next year. At a minimum, the combination of high affordability and government incentives should limit downside risk in the housing space, in my opinion.

After gaining almost 60% off the March 9 lows, the [U.S.] markets seem poised for a period of consolidation. The gains have pushed the markets into “overbought” territory and generally have left the major indices “priced for perfection.” This overbought state has raised the odds that data points or news flow that goes against the “bullish grain” will likely result in corrective periods. I continue to believe that ongoing pullbacks—which have been generally absent as of late—are healthy in the sense that they help keep expectations in check and weed out excesses that tend to get built into stock prices. I also believe that these consolidation periods generally allow for the digestion of gains and set the stage for the next phase to be higher.

U, V?
There seems to be a growing split opinion among economists on the speed and shape of the recovery. Generally, most feel the recovery will be weak and shallow and develop in the shape of a “U.” However, there seems to be a growing chorus of economists looking for stronger rebound, more akin to a “V” shape. The latter group refers to historical precedents as a guide and commonly cites the “Zarnowitz Rule”, named for the late economist Victor Zarnowitz. Mr. Zarnowitz, who was a member of the National Bureau of Economic Research (NBER), the official arbiters of dating the start and conclusion of recessions, observed that deep recessions are almost always followed by rapid rebounds.

While anything is certainly possible, I believe given the large amounts of slack in the economy, rising savings rates, the huge amount of wealth destruction over the past several quarters, the threat of higher taxes, and banks’ general reluctance to lend money, the economic recovery will likely be sub-par.

Oil slides
Oil, as measured by the New York Mercantile Exchange (NYMEX) WTI Crude Futures, closed at the lowest weekly level since mid-July and has now pulled back over 11% from the year-to-date high reached on August 24. The weakness is likely a reflection over concerns over the strength of the global economic recovery and the resulting level of energy usage. Last week demand concerns were raised following the weekly inventory report from the Department of Energy. The report showed that crude inventories during the week ended September 18 rose by 2.85 million barrels, well ahead of the expected draw down in inventories of 1.4 million barrels forecast by analysts.

FOMC meeting
As expected, the Federal Open Market Committee (FOMC) ended last week with no change to interest rates. The federal funds rate was maintained at a range of 0.00% - 0.25%. While the after meeting communiqué was similar to the meeting notes from the last FOMC gathering, the tone was slightly more upbeat. The Federal Reserve Board (the “Fed”) signalled that economic activity is picking up (in the August statement the Fed reported economic activity was “levelling out”) and that housing activity was increasing (in August housing was merely showing “signs of stabilising”). The Fed also acknowledged that inflation is expected to remain “subdued for some time” and that they are in no hurry to tighten rates. A look at the Fed Fund Futures shows that traders are currently betting that the Fed will remain on hold through at least the first quarter of 2010.

Market viewpoint

Maintain positive outlook
While my bias is for the market to continue on an upward trajectory over the intermediate term, the most likely path for the markets in the near term will be a choppy, sideways range. With that said, I think March 9 represents the [U.S.] market’s low. Also, because of the high levels of cash on the sidelines and what appears to be a growing level of risk taking, a “buy-the-dip” mentality will provide a downside buffer, in my opinion. In other words, any pullback in the market will likely be short and shallow.

Stocks will likely resume an upward tendency with the emergence of further signs of economic stability, in my opinion. This includes signs that banks are making progress in ridding their balance sheets of “toxic assets,” further stabilisation in the job market, and a continuation of economic progress.

Potential risks/wildcards
My expectation that stock prices will trend higher over the next 6-12 months assumes an economic recovery continues to progress, a stable to moderately declining price environment (no extended periods of deflation and/or hyperinflation), and the eventual recovery of earnings growth. A delay of any of these events could ultimately prolong the market’s recovery period.

Performance for week ending 25/09/09
The Dow Jones Industrial Average (Dow) lost 1.6%, the Standard & Poor’s 500 Index (S&P 500) fell 2.2% and the Nasdaq Composite Index (Nasdaq) shed 2%. Sector breadth was negative as all 10 of the S&P sector groups finished lower. Materials (-4.8%) was the worst performing sector while Telecom (-0.18%) was the best. The Canadian market, as measured by the S&P/TSX Composite Index, finished off 2%.

Definitions
Standard and Poor’s 500 Index is a capitalisation-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally defined as the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.

The Nasdaq Composite Index is a broad-based capitalisation-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market. The index was developed with a base level of 100 as of February 5, 1971.

The S&P/TSX Composite Index is a capitalisation-weighted index designed to measure market activity of stocks listed on the Toronto Stock Exchange (TSX). The index was developed with a base level of 1000 as of 1975.

The Mortgage Bankers Association (MBA) is the national association representing the real estate finance industry, an industry that employs more than 370,000 people in virtually every community in the USA. The mission of the Washington, D.C.- based association includes, but is not limited to, investing in communities across the nation by ensuring the continued strength of the nation’s residential and commercial real estate markets; expanding homeownership and extending access to affordable housing to all Americans and supporting financial literacy efforts.

The National Bureau of Economic Research (NBER) is a private, nonprofit, nonpartisan research organisation dedicated to promoting a greater understanding of how the economy works. The NBER is committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.

New York Mercantile Exchange (NYMEX) WTI Crude Futures - Crude oil is the world’s most actively traded commodity, and the NYMEX Division light, sweet crude oil futures contract is the world’s most liquid forum for crude oil trading, as well as the world’s largest-volume futures contract trading on a physical commodity. The contract trades in units of 1,000 barrels, and the delivery point is Cushing, Oklahoma, which is also accessible to the international spot markets via pipelines. The contract provides for delivery of several grades of domestic and internationally traded foreign crudes, and serves the diverse needs of the physical market.

Indices do not include any expenses, fees, or sales charges, which would lower performance. Indices are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

The individual companies mentioned in this piece were for informational purposes only and should not be viewed as recommendations.

The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes. This document contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Information in this report does not pertain to any Claymore product and is not a solicitation for any product. This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy.