Economic Notes – October 29, 2012


Written by: Jon McGraw

Durable goods orders rose more than expected in September, up +9.9% versus a consensus forecast of +7.5%. The underlying components, however, were mixed, as the transportation component (mostly aircraft orders) made the largest contribution to results. Ex-transportation, orders were up +2%, and the ‘core’ capital orders measure was flat on the month. Shipments were relatively weak, with those for core goods only rising +0.9% and revised down a bit for earlier periods.

The Richmond Fed manufacturing index came in weaker than anticipated for October, at -7 versus +4 for September and lower than the forecast similar level of +5. The report’s composition was also softer, mostly in the areas of new orders and shipments; however, wages were improved slightly. Inflation also jumped to the highest levels in almost a year, a reflection on commodity price increases.

New home sales rose +5.7% to 389k for September, higher than an expected +3.2% gain, although a few prior months were revised downward. The Southern U.S. drove the bulk of sales in the month, the Northeast and West contributed a bit, while sales in the Midwest declined. Pending home sales, on the other hand, were a bit weaker than expected, with a month-over-month-gain of +0.3% for September, which lagged the forecasted improvement of +2.5%. Regionally, the composition was similar to that of the new home sales report, with gains in the West, Northeast and South, while the Midwest lagged. This offsets some of the good news in the new home sales report and continues to demonstrate a choppy, slow-moving recovery.

The Thomsen Reuters/University of Michigan consumer sentiment index rose to a five-year high in October, up 5.5 points from last month to 82.6. Falling gas prices and better employment prospects appeared to be catalysts.

Initial jobless claims came in at 369k for the week ending Oct. 20, which was just 1k or so below forecast, and 23k lower than the previous week. This result was right in line with the four-week moving average. Continuing claims for the Oct. 13 week were 3,254k compared to an expected 3,260k reading.

The Federal Reserve Open Market Committee met last week and the result wasn’t too unexpected—per our note earlier in the week. The policy outlook continues to favor accommodation and rates kept low through mid-2015 (despite the continuing dissent of Richmond Fed President Lacker, who disapproves of the use of timing language—and we wouldn’t disagree necessarily). The underlying fundamentals since the last meeting haven’t changed dramatically, either—as we continue to plug along at a slow pace, but just fast enough to keep ourselves out of trouble.

Speaking of growth, the advance/initial estimate for the 3rd quarter Gross Domestic Product was published, and it was a bit better than expected—a reading of +2.0%, versus an anticipated 1.8%. Private consumption expenditures and residential investment showed strength; however, business investment in structures was weaker while equipment/software came in unchanged. The biggest surprises in the report appeared to be a slowing in private inventory accumulation (lower inventory stockpiling is usually a positive), as well a much stronger government spending (+13% growth in defense spending in the quarter), but these offset to some degree. The price index component rose +2.8% compared to an expected +2.1%, showing that some inflation has indeed crept its way in. The core price index was up +1.3%, right in line with target.

Other than that, the report was not out of line with forecast. We’ve been in a period of positive, but slow growth, and a 2% quarter is right in line with this. Expected growth for the fourth quarter is about the same 2%, based on estimates from several firms, so we don’t expect radical improvements or deterioration for the rest of this year. This pace isn’t slow enough to ‘stall’ and push us into further deceleration and possible recession fears, but not fast enough either, at least enough to get job growth going at a faster rate (what the government would ultimately like to see). While a high-profile report from a news standpoint, this may be a draw in terms of its election impact. Obama is certainly hoping for the strongest possible numbers as evidence of success in boosting economic growth, while Romney (as would any challenger to a sitting President) may benefit from continued weakness—as it plays into a theme of current policies not working and needing change. It is no surprise that domestic economic conditions and employment play a big role for voters, since the livelihood of households takes precedence over foreign policy and other matters not as close to home.

From the vantage point of history, economic performance is also in line with previous episodes of recovery in this type of ‘special situation.’ Based on the work of Goldman Sachs and other academics in studying 200 business cycles in 14 nations over 140 years, ‘normal’ recessions have tended to result in a 2% drop in real GDP in the first year, followed by a catch-up back to that starting level in year 2 and marginal growth of 1.5% for the few years following. However, for more severe recessions after debt busts (as we just experienced), the initial drop in GDP is much larger for the first two years, and it takes us about five years to get back to the starting point. We appear to be following this track, so the slow speed in crawling out of this ‘bust’ isn’t entirely surprising.


We witnessed a rough week for equities, as poor results for blue chips DuPont and 3M early on and disappointing results from Apple later in the week led indexes lower, the latter due to its especially large weighting. The growth sectors of health care, technology and consumer staples led with the smallest declines, whereas materials and energy fell the most last week.

We are in the midst of earnings season in the U.S., and although we wouldn’t expect this stat from the fear-oriented headlines, as revenue and earnings estimates have continued to be revised downward, especially in the info technology sector, over 70% of 273 S&P companies that have reported so far have beaten their earnings estimates (while roughly only a third have beaten revenue expectations). Interestingly, in last quarter’s season, S&P stocks tended to outpace non-S&P stocks on earnings release days; however, we’ve seen a bit of a reversal this season, as investors have favored non-S&P names. This has been most pronounced in the materials and technology areas.

In the emerging market world, news from China has improved, as better-than-expected export and industrial production numbers alleviated fears of a deeper slowdown and uncertainty surrounding a political transition next month. Emerging market stocks performed negatively, in line with most broader indexes, but Asian stocks (with trade ties to China) tended to fare a bit better.

Treasury interest rate spreads were virtually unchanged for the week, but long bonds gained due to the duration effect. ‘Credit’ tended to lag on the week, with negative performance for high yield and foreign debt generally.

Just a simple and quick example for those who think bonds are always a foolproof safe haven from volatility… Say, rates fall a relatively minor 0.03%, multiplied by the long-bond’s rough duration of 18 years = bond prices would rise about +0.5%. Of course, this also works in reverse. For the sake of argument, imagine economic growth is much higher than anticipated, so rates shoot up 0.50% (not unrealistic based on what’s happened several times over the last few years) x 18 year duration = bond prices drop -9%. This is a risk that’s likely somewhat higher than many think and is worth protecting against. Floating rates and shorter duratons is a couple of ways we can do that.

Asian REITs gained on the week, presumably due to the better sentiment in China (urban Hong Kong is a big part of that index). European and U.S. REITs were generally negative, with U.S. industrial and retail bringing up the rear—on par with an economic ‘risk-off’ week.

Commodities in general were down for the week, in line with other risk assets. Economically sensitive energy and industrial metals were down -3%, while agricultural commodities and precious metals suffered less.

What determines how much we should pay for stocks? Are they still a good buy at this point?

Looking at a variety of metrics, including a top-down ratio and bottom-up dividend discount model analysis, says yes. The P/E of the overall market is about 14 (based on the current level of 1412 and 2012 earnings of roughly 100… a fairly simple calculation this year). Looking at earnings expectations of roughly 107 for 2013 gets us to a forward-looking P/E of just over 13. Considering the median P/E for the S&P is about 16 for the last 8 decades, that puts us at a discount of 12% and 18%, respectively. Warranted? Perhaps. But the market doesn’t really ‘care’ about why the ratio is what it is. History tells us that below-market P/E’s give us a better probability of success.

From the dividend discount model perspective? This is more sensitive to inputs like future growth rates and risk premiums, but we get a number here of approximately 15-25% undervalued. Again, this isn’t an exact science, but it does give us a general guideline for whether stocks are in a category of ‘overvalued,’ ‘fairly valued,’ or ‘undervalued,’ and a bit of a hint of how much. We may have room to go in this market recovery if historical precedent is any guide. Investors giving up on risk assets because they don’t feel good about the fiscal cliff or election results could be making a mistake. A place where valuations look even more compelling is the developed foreign world (namely Europe), but we will save that for another discussion.

We wish our East Coast friends a safe few days in the midst of the extreme weather in that part of the country!