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US Economy

Heightened Risk, Emerging Opportunities

By Elliott H. Gue, on Jun. 14, 2013

In each of the past three years, US economic activity has softened in the spring and early summer, prompting some pundits to forecast impending recessions. Needless to say, these growth scares catalyzed significant pullbacks in the S&P 500–and buying opportunities for patient investors.

The resultant pullbacks weren’t modest declines or short-term bouts of profit-taking. In 2010 the S&P 500 dropped by more than 17 percent from its April high to its early July low, and in 2011 the index endured a 21.6 percent decline between May and October. Last year, the selling pressure was more subdued, but the almost 11 percent dip in the S&P 500 between May and June still shook plenty of investors out of stocks.

I don’t have an unblemished record of correctly forecasting the path of the US and global economies–in my experience, any analyst or economist that claims to have a crystal ball or an infallible, proprietary indicator is either naïve or lying.   

But investors who have heard me speak at investment conferences or have followed my work know that I have been correct in one regard: I identified each of these downturns as a short-term slowdown, not the beginning of a new recession. Although I can’t claim to have called the timing of the market’s lows precisely, I did correctly flagged these pullbacks as buying opportunities.

Economics is far from an exact science. With the barrage of economic indicators that come out each week, investors often find themselves paralyzed by information overload. To add to the confusion, many of these data points give conflicting signals about the direction of the economy.

Rather than focus on dozens of obscure indicators, I believe in keeping it simple and focusing on a handful of economic data points that have proved their value over the long term. This approach doesn’t always yield a crystal-clear outlook, but it does reduce the potential for bias and the temptation to confirm preconceptions about the economy by seeking out supporting data points.

My top-down investing style starts with a thorough analysis of big-picture economic conditions, then drills down into specific industries and culminates in detailed research into individual stocks. This inaugural issue of Big Picture lays out my current outlook for the US economy and its implications for the stock market through the end of 2013.

The 2013 Soft Patch

For the fourth year in a row, the US economy lost momentum in the second quarter. This softness appears set to extend into the third quarter. Much of this weakness stems from the immediate spending cuts involved in the US Congress’ resolution to the so-called fiscal cliff.

Excluding car dealerships and gasoline stations, US retail sales grew at an average monthly pace of about 0.3 percent through May 2013, compared to about 0.5 percent per month in the back half of 2012. On an annualized basis, automobile sales are roughly flat over the past six months.

Recent trends in the Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI) on manufacturing are more worrying. The headline index recently dipped to 49, its lowest reading since 2009, when the US economy was emerging from the Great Recession.


Source: Bloomberg

ISM bases the PMI on a survey of purchasing managers at major US manufacturing firms. Index values less than 50 indicate that activity in US manufacturing sector shrank, while readings greater than 50 indicate expansion. Historically, however, a PMI level below 45 or 46 suggests that the economy has slipped into recession. Fortunately, the current reading and other economic data suggest that an extreme contraction doesn’t isn’t on the horizon.

A deep dive into the PMI for manufacturing is also instructive.

The New Orders Index, for example, serves as a useful leading indicator of manufacturing activity; when survey participants report an uptick in orders, a corresponding increase in manufacturing output is usually only a few months away.

When this component holds up better than the headline PMI index, this implies only a modest or short-term slowdown in manufacturing activity. But this sub-index currently stands at 48.8, which is roughly in line with the PMI for manufacturing. However, the ISM Report on Business New Orders Index has tumbled at a faster rate than the main index, falling from a high of 57.8 in February 2013–a sign of additional weakness in manufacturing.

We also monitor the Inventories Index, which surged in the first few months of 2013 before tumbling in recent months. We expect this destocking trend to continue in coming months because of weakness in manufacturing activity and order intake.

This scenario could set the stage for the US economy to enjoy a growth spurt in the final months of 2013; if inventories become too lean and order activity picks up at year-end, manufacturers may look to step up production.

The recovery in residential housing has been one of the bright spots for the US economy this year.


Source: Bloomberg

Housing starts and sales of new and existing homes have all picked up in 2013, reducing the overhang of unsold homes and bolstering residential home prices. The latest reading from the S&P/Case-Shiller 20-City Composite Home Price Index indicates that sales prices in the largest US metropolitan statistical areas have increased at an annualized rate of 11 percent–the fastest pace since mid-2006.

Although the recent uptick in yields on 10-Year US Treasury notes has pushed up mortgage rates slightly, borrowing costs aren’t far from multiyear lows and buying a home is still attractive relative to renting. We expect the housing market to weaken only slightly this summer; the longer-term recovery in the US housing market has legs.

The US economy grew at an annualized pace of about 2.4 percent in the first quarter of 2013, but recent weakness in retail sales and manufacturing activity points suggests that gross domestic product may have expanded by less than 2 percent in the second quarter. This softness will likely persist into the third quarter.

Economic growth should strengthen toward the end of 2013. Fiscal shocks to an economy tend to fade over time, once consumers adjust to tax hikes and spending cuts. Meanwhile, relatively robust housing and stock markets should help to boost consumer spending and confidence; rising asset values make individuals feel wealthier.

Salient Differences

Although the US economy has encountered its summer soft patch, the stock market has only suffered a few minor pullbacks. Three major reasons have held off the usual selloff: aggressive monetary easing, a reduction in systemic risks and a relatively modest contraction related to lower government spending and higher taxes.

The Federal Reserve has continued its quantitative easing (QE) campaign, buying about $85 billion worth of bonds each month. This policy tends to bolster asset prices and has provided a welcome tailwind for stocks. And although the Fed hinted at the possibility of tapering its bond-buying campaign in May, we wouldn’t expect the central bank to pursue such a course until year-end, at the earliest; most Fed members will be unwilling to curtail QE when the economy appears vulnerable.

In summers past, investors could expect a flare-up of concern about the EU sovereign-debt crisis, but the European Central Bank’s willingness to buy bonds issued by Italy, Spain and other fiscally weak nations has relegated this formerly frightening prospect from the front page. Moreover, Europe has put the worst of its austerity measures behind it, alleviating this impediment to growth. A number of indicators suggest that the EU could exit recession later this year.

The bottom line: Risks of a short-term correction in the broader market are heightened this summer, as US economic growth appears set to disappoint. But the outlook is more sanguine heading into 2013, supporting further upside for stocks over the next six to 12 months.

Taking Action

In the inaugural issue of Capitalist Times Premium, I highlight my top picks in the current market. At present, consumer staples and other defensive sectors appear overly expensive, while cyclical groups appear undervalued. As the US economy bottoms out and strengthens into the back half of 2013, I’m looking for a major rotation in favor of cyclical groups such as energy, basic materials, technology and financials. 

Elliott H. Gue is founder and chief analyst of Capitalist Times Premium and Energy & Income Advisor.

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