Wall Street has spent much of the past month worrying that trouble on the other side of the Atlantic, and the weak jobs picture in the U.S., will combine to force a nasty double-dip recession and a new bear market.
Given the proximity to our own scary financial crisis, it’s no surprise to see concerned investors flee from risk, wiping out 14% of the value of the S&P 500 in just six weeks.
But what if, after all, those double-dip fears are overblown?
The bulls argue the U.S. economic recovery remains on track, the euro has reached a short-term bottom, earnings will continue to impress and companies’ balance sheets are fortified with enough cash to withstand a little turbulence along the way.
“I do think we will see an expanding economy and, in general, we should see further gains in the stock market as the market looks ahead of these headwinds that we’re definitely facing,” said Gus Faucher, director of macroeconomics at Moody’s Economy.com.
The U.S. economy should grow at a pace of just 2.5% during the second half of this year, but then reaccelerate to 3% during the first half of 2011, and hit 4% for the full year, Economy.com forecasts.
Will Debt Crisis Mirror Lehman Fiasco?
The bears scoff at that outlook, pointing to the scary debt crisis gripping Greece, Portugal, Spain and other debt-ridden European nations, which have implemented austerity measures that could further hurt growth. They would also point to the anemic private-sector job growth revealed in May’s U.S. employment report and a surprisingly steep drop in a regional manufacturing report that was released on Thursday.
Yet Economy.com sees just a 20% chance of a double-dip recession, which is commonly defined as two consecutive quarters of negative growth.
While trouble in Europe’s economy and a stronger U.S. dollar will knock about 0.2 percentage points off 2010 GDP, “other parts of the U.S. economy are strong enough that we should be able to get through it,” said Faucher. “It would take something major to push the economy back into recession.”
Worries that the trouble in Europe was a repeat of the Lehman Brothers collapse that ignited the financial crisis in 2008 sparked a wave of risk aversion on Wall Street that left the Dow Jones Industrial Average at seven-month lows on June 7. Since then, the markets have stabilized and bounced off their 2010 lows.
“The markets have heavily discounted the weakness in sovereign debt. There are clearly policies being implemented that are aimed at cutting debt, cutting spending and getting the financial house in order,” said Peter Kenny, managing director at Knight Capital Group. Alluding to the $1 trillion rescue unveiled by the European Union, he added that as “policy has been crafted to address the specific needs of each issue, the risk aversion has become less and less urgent.”
As recently as the end of May, the Organization for Economic Co-operation and Development forecasted global economic growth of 4.6% this year, including a jump of 11% for China, the world’s economic engine.
“Obviously, the economists at the OECD aren’t expecting that the euro mess will lead to a repeat of the global wipe-out that followed the collapse of AIG (AIG: 37.54, -0.2, -0.53%) and Lehman. Neither do I,” said Ed Yardeni, president of Yardeni Research.
Some would say the markets have even overdone it, discounting losing Europe as a trading partner altogether.
“We will trade with them during tough times and during good times. It will slow, but it’s not like it will go away. Our economies are interconnected,” said Marc Pado, U.S. market strategist at Cantor Fitzgerald.
Earnings to Brighten the Mood
Aside from the thinking that the European fears have been overblown, the bulls have a strong case to be made that U.S. corporate earnings are likely to remain impressive. As earnings season begins to heat up, the spotlight will likely shift from the trouble overseas to the relative strength at home, especially in the wake of heavy cost-cutting that has made companies much leaner.
Earnings “have been outstanding across virtually all sectors,” said Kenny. “That’s the rebound story. Companies are delivering on the earnings. That at the end of the day is what’s driving pricing.”
The pessimism on Wall Street hasn’t caused analysts to lower their forecasts yet. S&P 500 forward earnings rose to a new cyclical high of $88.51 a share during the week of June 11 — the highest level since Nov. 2008, notes Yardeni. Consensus annual forecast for 2010 EPS rose to $82.15, but slid for 2011 to $96.52.
At the same time, companies have socked away billions of dollars on their balance sheets as a rainy-day fund. Once they feel more confident about the economy, they are likely to use this cash for acquisitions, stock buybacks and special dividends.
“As an economy, I think we’re lean and mean right now and we’ve got the cash on hand to weather any storm,” said Pado.
The markets have also fretted that the austerity measures laid out by European nations and expected to be enacted at home will serve as a drag on economic growth.
“That’s a seemingly good point made by Keynesians. However, there is an alternative view emerging — that fiscal discipline can lead to prosperity rather than ruin,” said Yardeni.
Warning Signs Bulls Are Wrong
While the bulls feel the double-dip fears have been exaggerated, they are keeping an eye on several indicators that could signal trouble ahead. For example, Yardeni said he doesn’t like what he’s seeing in high-frequency indicators, specifically industrial spot prices, the price of crude oil and the Baltic Dry Index.
“If they continue to fall in coming weeks, we’ll have to reassess our sanguine view,” said Yardeni.
Faucher said he’s watching for signs that businesses or customers have been “spooked” by the trouble overseas. A significant drop-off in consumer confidence figures from the University of Michigan could provide a good gauge of any spill-over effects.
Kenny said he’ll be watching to make sure governments take “extremely constructive measures” to cut government spending. “The headwinds the spending represent are going to be insurmountable in the next 24 to 36 months,” he said.
For now, the bulls look to scoop up beaten-down stock prices while many other investors remain jittery.
“Right now I think we’ve overdone it to the downside and I’m looking for a recovering rally for the rest of the summer period,” said Pado.
By Matt Egan – foxbusiness.com
Add A Comment