Grand View- Is the recovery here?

The US economy has continued contracting in the soon to be completed first quarter. Current estimates suggest the US economy as measured by Gross Domestic Product (GDP) contracted by close to 6%. The initial release will be issued April 29th. This following final fourth quarter GDP numbers of -6.3%. Recently the Federal Reserve released its new forecast for economic activity. They look for 2009 GDP to range from -.5% to -1.5%. So, after a severe contraction in the first quarter, they expect the healing process underway to begin in the second quarter and continue throughout the remainder of the 2009. Further the Federal Reserves 2010 estimates for GDP suggest a return to growth of 2.5%-3.3%. The numbers coming out of the Federal Reserve on Inflation remain promising also with estimates of 1%-1.5%, well within their targeted range. They estimate unemployment ranging between 8-8.8% for both 2009 and 2010. Chairman Bernanke testified before congress in late February that he anticipated the current recession to end this year and the following year to be one of resumption to growth, dependent in no small part, upon stabilizing the financials.



There is the potential for significant improvement in GDP growth in the second half of the year. The recovery should be a continuation of the gradual improvement currently underway. To see this improvement we need to take a step back and search for this evidence over the course of a period of time. First let us look at the National Manufacturing Purchasing Managers Index. While the February release came in at 35.8 well below the 50 number that would reflect an expanding economy. If we take a step back we see that February’s number was .2 better than January and 2.9 ahead of December’s reading of 32.9. Next we look at Industrial Production (IP), again the recent February release came in at -1.4%. Again, taking a step back we see that as being an improvement from January’s -1.9% and December’s -2.4%. What we are searching for at this point is stabilization. We must stabilize the economy before we can resume a growth trajectory. So, as you can see, while not a resumption to growth, definite signs of improvement worth monitoring. Now a look at one of the most troubled areas of our economy, housing. February existing home sales came in at a surprising +5.2%. New homes sales followed lock step coming at +4.7%. The Commerce department reported a surprising jump in construction of new homes of 22%. The first time housing starts increased since June. Meantime the Mortgage Bankers Association showed an increase of 30% from the prior week in Americans applying for home loans. While one month does not indicate a trend, it is worth monitoring.



There are promising signs outside the US boarders as well. The China growth and decoupling story has taken a beating over the course of 2008 and into 2009. Could the global economy recover without the US growth engine in tact? Or the US consumer in retrenchment? The answer is still not conclusively there yet. One area to look is the Chinese Purchasing Managers Index (CPMI). The latest release rose to 49 up significantly from January’s 45.3 gaining for the third straight month. While the 5th straight month the index is below 50, the estimates for March show the Chinese economy back in expansion mode at 54. Outside of China’s expectations of growth exceeding 8%, India anticipates the measures already taken should lead to 2009 annualized growth to range between 6.5%-6.7%. Should both of these two developing economies be successful in stimulating domestic consumption and be less reliant on the US, would be viewed as significant and applauded. We’ve also witnessed significant rallies in emerging market stock indices, which would suggest a return of risk appetite from investors.



Back to the domestic side of the equation. The US market has rebounded smartly off the March lows. There continues to be a battle being waged between the “top down” and “bottom up” analysis for earnings. Top down looks at the market from 10,000 feet above. Looking at the macro economic environment on down, while the bottom up starts from company specifics on up. Due to the extreme contraction in the availability in credit and the ensuing ripple effect, the estimates are so wide as to drive a truck through it. Estimates for earnings on the S&P 500 index range from $45.00 to $75.00 a share. Taking that a step further, being in a low interest and low inflation environment utilizing a 14 to 20 price earnings multiple can be and is being arguably made. The divergence in estimates lie primarily, in my opinion with the financials. Will the financials be neutral to earnings or continue being a detractor to earnings? If we can finally believe the CEO’s of the major money center banks, “The first 2 months of the quarter have been very profitable”, financials could actually add to earnings. There is reason to finally believe these CEO’s. The many programs the Federal Reserve has implemented, most recently TALF-Term Asset Backed Securities Lending Facility should help thaw the securitization markets. The Federal Reserve may expand this programs ability to purchase a broader array of securities. Further the announcement to purchase longer dated Treasury bonds and Mortgage backed securities. This current lending environment where institutions can borrow at virtually 0% and lend at 4 ¾% on new mortgage originations and 8%, 14% and in some cases 25% on credit cards should allow banks to recapitalize their balance sheets through actual earnings. Now onto the Geithner plan. Finally. While we’re not sure exactly what prices investors will pay, or which sellers will participate, we’ve got the plan. In short, investors, (hedge funds and private equity) will be given access to cheap funds with significant protection to set up SPV’s (special purpose vehicles) to buy those ‘legacy’ assets from banks. While not perfect, at the minimum the taxpayer has an opportunity to participate in any profits, at the margin banks get to relieve themselves of bad investment decisions. This allows for banks to free up reserves against held against potential losses which can be redeployed for investment and loans directly into the economy. Also, for those banks that have aggressively marked down these assets on their books may be able to book profits on these sales or simple “mark-ups’ instead of the unending mark-downs we’ve become accustomed to during this crisis.



Where are we? While there is still enough negative news abounding in the markets, there are feint signs of stability as evidenced by the PMI, CPMI and IP. There are also conflicting signs in the commodities arena. In the midst of a global economic contraction you wouldn’t expect to see a spike in commodities, specifically copper and the stabilization of the CRB index (Commodities Research Bureau). While short term encouraged by the recently announced aggressive plans put in place by the Federal Reserve and Treasury ( exiting these plans will take the skill of a surgeon) the full effects and ensuing restoration of confidence is down the road. The plan of the Fed and Treasury in unleashing the potential pent up demand for housing, automobiles and economic expansion by artificially depressing lending rates should be effective, but will take some time. Akin to a turning of an oil tanker. The new captain and crew, President Obama, Geithner and Summer, have seen the iceberg and the turn has begun. I would conclude the rally has been significant and expeditious and mainly technical in nature. We were extremely oversold, by any measure. Now taking a pause, allowing for the underlying fundamentals (economic and corporate earnings and outlooks) to catch up, confirm and justify the next move higher is warranted. While still looking for a 12 month target range of 1050-1100 on S&P 500 it will be a challenging journey fraught with major rallies followed by rounds of profit taking. Prudent investors need to be alert and recognize the signs of a bear market rally or the emergence of the the next raging bull.

Cheers
James