08/04/10   Profits Now, Deflation Later

Editor’s Corner

Investor Heat Map 8/4/10

Profits Now, Deflation Later

Ron Rowland

Corporate profit reports continue to surprise on the upside, which probably says as much about the analysts as it does about the companies.  We don’t doubt that the earnings are real.  The bigger questions are where the profits come from, who is receiving them, and whether they are sustainable.  With second quarter GDP coming in weaker than estimated and national output the past three years all revised downward, the picture is not nearly as rosy as some forecasters suggest.

Take a look at a few economic headlines from the last few days: Personal Income and Spending Were Flat, Pending Home Sales Dropped, Chain-Store Sales Fell, Consumer Confidence Cooled, and Factory Orders Shrank.  Monthly unemployment numbers come out on Friday.  ADP estimates that private employers added 42,000 jobs in July, which is better than a drop but hardly enough to make a dent in the growing ranks of long-term jobless people.  We think this relates back to corporate earnings.  Much of the profit growth is driven by cost-cutting, and people are a big part of the cost structure at most businesses.  Eventually the loop will be closed as consumers cut their own spending enough to leave businesses looking for revenue.  This may be why companies that can afford it are building up large cash reserves: they expect to need liquidity in the near future.

From that perspective it may seem hard to be bullish on stocks, but many people are.  Today, traders seemed cheered by reports from China that banks will be subjected to a stress-test under the assumption of home prices declining as much as 60%.  We don’t doubt that there are parts of China where such losses are possible.  Exactly how does this help the U.S. economy?  For better or worse, China is now thought to be an indicator of world economic strength.  If the Chinese can keep their growth rates up, then surely the U.S. will be okay, too.  We shall see if this line of thinking makes sense.

Recent price trends may seem a bit confusing at first.  The stock market rally still has momentum but is bumping up against resistance.  Gold and commodities have been rising while the dollar plunges even as Treasury bonds look more bullish.  The yield on ten-year notes is back below 3% again, ending today at 2.95%.  Is all this action related?  Yes, and it suggests that deflation is still a greater threat than inflation.  The fact that interest rates are so low during a time of record government borrowing tells us that private lending activity is still anemic.  Liquidating the debt overhang will take time, and the process has only just begun.


Telecom took the top spot in our sector rankings this week.  Materials edged into second place, displacing Utilities which is now #3.  The big mover of the week was Energy, however, which climbed all the way from #9 up to #5.  Higher crude oil prices and an apparently successful capping operation in the Gulf of Mexico were helpful.  Health Care is still on the bottom and is the only category still in an intermediate-term downtrend.


The Style rankings flattened out to one of the narrowest spreads we’ve ever seen.  Only 10 points now separate the top of the list from the bottom.  Remarkably, the best-ranked Style category only matches the “average” sector category.  One might think that dividing up the domestic equity market should, on average, produce about the same result either way.  The flaw in that logic is that the three strongest sectors (Telecom, Materials and Utilities) are actually the three smallest sectors in terms of capitalization.  Meanwhile the four largest sectors happen to be last on the list.  In other words, stock market “leadership” is extremely thin right now.  This makes the relative Style rankings of limited usefulness for the moment.  The rankings could change dramatically at any time.


Britannia once again rules the waves in our Global rankings, which have the United Kingdom leading other world markets.  This may catch some people by surprise; we have not noticed many CNBC pundits pounding the table for U.K. stocks.  Part of the strength can be attributed to gains in the Pound.  CurrencyShares British Pound (FXB) has climbed from around 143 in mid-May to over 158 today – a better than 10% gain in less than three months.  This gives U.S. investors a 10% boost to any gains in the underlying U.K. stock prices.  Europe as a whole is now #2 in the Global ranks.  The former leader, Emerging Markets, slid to third place but still looks strong.  Canada, Japan, and the U.S. still occupy the bottom of the list but are all in slight uptrends.


The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

“When people expect falling prices, they become less willing to spend, and in particular less willing to borrow.”

Paul Krugman, economist, 8/2/10


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