Where'd the Rally Go? 5 Signs to Watch Now
So much for the second half of the year getting off to a strong start. The market plunged 2.5% in one trading session just two days into the third quarter. Blame the selloff on the Labor Department, which reported Thursday that the economy shed another 467,000 jobs last month. Earlier estimates pegged the losses at 365,000.
All is not lost, however. May factory orders came in better than economists' forecast, housing prices edged down at a much slower rate in April and oil fell back well below $70 a barrel. Indeed, these so-called "green shoots" of economic recovery (as Federal Reserve Chairman Ben Bernanke would say) may still be a bit wilted and patchy, but it's becoming clearer that the freefalls in earnings, GDP, unemployment and housing have been arrested. To be sure, lots of critical indicators are still in decline, but at least the rate of decline has slowed.
"Factory orders have been better the last couple of months and home sales look like they are starting to stabilize," says Richard Moody, chief economist at investment and research firm Forward Capital. "But any improvement — or any slower rate of deterioration — is really put at risk by what is going on in the labor market. That puts a downside risk on any outlook for the second half of the year."
Investors have an obstacle course of data and projections to contend with as they poise their portfolios for what promises to be a bumpy second half. Here, then, is a look at five critical areas — and what they portend for the next six months.
Corporate Earnings: Baby Steps Toward Recovery, but Don't Get Too Excited
The second-quarter earnings season is almost upon us and it's shaping up to look a lot like the first quarter: bad — but getting better. In the aggregate, S&P 500 second-quarter earnings are forecast to drop 35% year over year, according to Thomson Financial. However, not only is that projected drop a slight improvement over first-quarter results, but analysts' average forecast actually trended up in June, something that hasn't happened since 2007.
Investors have been pricing stocks for this "less bad is good" earnings environment throughout the rally that started in March, possibly setting themselves up for disappointment. "The market expectation is that earnings are going to be better in the second quarter than in the first," says Don Humphreys, president of Voyager Wealth Management. "If they don’t come out better, then the market is going to have to pull back."
On a positive note, the ratio of negative to positive second-quarter earnings pre-announcements for the S&P 500 is below the long-term average, according to Thomson Reuters. That helps bolster the case that analysts' estimates are on the mark and that the second quarter, as bad as it may prove to be, will indeed come in better than the first.
Energy Prices: Oil Prices Apt to Stay at Current Levels
"Oil prices are the wild card here, the big unknown," says Robert Brusca, chief economist at Fact and Opinion Economics. A weak economy doesn't bode well for energy demand, however, and the U.S economic recovery isn't exactly getting off to the races, he says. Indeed, GDP is forecast to grow just 0.6% in the third quarter, according to The Wall Street Journal Economic Forecasting Survey, and only 1.9% in the fourth. The European recovery looks to be weak as well, Brusca says. That argues against oil prices going much higher.
Of course, traditional theories of supply and demand don't always apply in the case of oil prices, says Brusca. "I wouldn't be surprised if oil prices stay where they are, move a little bit higher or even fall 10 or 20 bucks a barrel," the economist says. But one thing is for certain: The last thing cash-strapped consumers need is $4-a-gallon gas again.
Jobs: The Worst Won't Exactly Be Over
Employment numbers tend to lag behind other indicators in any recovery, and the current recession is no exception. "The bad news is that unemployment, which is watched very carefully by many Americans because it does affect us directly, will keep growing," says Dan Seiver, a finance professor at San Diego State University. "It’s quite conceivable we could hit 11% before unemployment actually peaks out," he says. Unfortunately, that peak may not happen before the end of the year, he says.
Even worse, the average American will keep an eye on the job market – and will likely not start spending freely until it shows some signs of improving. A tight job market, combined with essentially flat hourly wages, “bodes very poorly for consumer spending,” says Forward Capital's Moody.
"A lot of people are arguing that the stimulus is going to kick in over the second half of the year and that will provide some support," he says. "But with consumer spending remaining weak, business spending might remain weak."
Housing: Signs of Stability Ahead
The housing market got us into this mess, so investors and analysts seeking signs of a recovery are jumping on any housing data the second it comes out. That may prove to be a waste of energy during the second half of the year, however.
Recent numbers show a slowing rate of decline in housing prices and suggest that some regions could be bottoming out over the next few months. Those are promising signs, but unfortunately a stabilizing housing market won’t drive the recovery.
"When the jobs situation stabilizes, the housing situation will stabilize," says Fact and Opinion Economic's Brusca. "Housing isn't really a threat anymore. It could still decline. But we are not in a situation where housing is a key. The economy is key to housing, not the other way around."
Interest Rates: Short- and Long-Term Rates Should Stay Low
The next meeting of the Fed on Aug. 12 will offer a chance to see where short-term interest rates are heading – and how optimistic the Fed is about the overall health of the economy. For now, though, the Fed will likely continue to pursue a near zero-interest-rate policy in order to jumpstart the economy. However, the agency needs to be watchful of any sign of inflation. "Their big thing is to make sure to pull back on the liquidity in time, so as not to get a ‘double-dip recession," says Don Humphreys of Voyager Wealth Management.
Humphreys says he doesn’t expect inflation to be an issue for quite a while — at least until some real economic growth kicks in. That should also help to keep a lid on long-term rates and tame the so-called bond vigilantes, who sell bonds in the belief that the Fed will have to raise short-term rates to stifle inflation, causing bond prices to fall, says Brusca. (When interest rates rise, bond prices fall.) The recent selloff in long-dated Treasurys pushed longer-term interest rates higher — a situation that, if it continues, would eventually threaten any hopes for recovery.
But after coming very close to the psychologically significant 4%-yield mark, 10-year Treasurys are back at 3.5% "The bond vigilantes recognized that if you're not going to have a strong recovery, you don't have to be a vigilante about the interest rates going up," Brusca says.
So much for the second half of the year getting off to a strong start. The market plunged 2.5% in one trading session just two days into the third quarter. Blame the selloff on the Labor Department, which reported Thursday that the economy shed another 467,000 jobs last month. Earlier estimates pegged the losses at 365,000.
All is not lost, however. May factory orders came in better than economists' forecast, housing prices edged down at a much slower rate in April and oil fell back well below $70 a barrel. Indeed, these so-called "green shoots" of economic recovery (as Federal Reserve Chairman Ben Bernanke would say) may still be a bit wilted and patchy, but it's becoming clearer that the freefalls in earnings, GDP, unemployment and housing have been arrested. To be sure, lots of critical indicators are still in decline, but at least the rate of decline has slowed.
"Factory orders have been better the last couple of months and home sales look like they are starting to stabilize," says Richard Moody, chief economist at investment and research firm Forward Capital. "But any improvement — or any slower rate of deterioration — is really put at risk by what is going on in the labor market. That puts a downside risk on any outlook for the second half of the year."
Investors have an obstacle course of data and projections to contend with as they poise their portfolios for what promises to be a bumpy second half. Here, then, is a look at five critical areas — and what they portend for the next six months.
Corporate Earnings: Baby Steps Toward Recovery, but Don't Get Too Excited
The second-quarter earnings season is almost upon us and it's shaping up to look a lot like the first quarter: bad — but getting better. In the aggregate, S&P 500 second-quarter earnings are forecast to drop 35% year over year, according to Thomson Financial. However, not only is that projected drop a slight improvement over first-quarter results, but analysts' average forecast actually trended up in June, something that hasn't happened since 2007.
Investors have been pricing stocks for this "less bad is good" earnings environment throughout the rally that started in March, possibly setting themselves up for disappointment. "The market expectation is that earnings are going to be better in the second quarter than in the first," says Don Humphreys, president of Voyager Wealth Management. "If they don’t come out better, then the market is going to have to pull back."
On a positive note, the ratio of negative to positive second-quarter earnings pre-announcements for the S&P 500 is below the long-term average, according to Thomson Reuters. That helps bolster the case that analysts' estimates are on the mark and that the second quarter, as bad as it may prove to be, will indeed come in better than the first.
Energy Prices: Oil Prices Apt to Stay at Current Levels
"Oil prices are the wild card here, the big unknown," says Robert Brusca, chief economist at Fact and Opinion Economics. A weak economy doesn't bode well for energy demand, however, and the U.S economic recovery isn't exactly getting off to the races, he says. Indeed, GDP is forecast to grow just 0.6% in the third quarter, according to The Wall Street Journal Economic Forecasting Survey, and only 1.9% in the fourth. The European recovery looks to be weak as well, Brusca says. That argues against oil prices going much higher.
Of course, traditional theories of supply and demand don't always apply in the case of oil prices, says Brusca. "I wouldn't be surprised if oil prices stay where they are, move a little bit higher or even fall 10 or 20 bucks a barrel," the economist says. But one thing is for certain: The last thing cash-strapped consumers need is $4-a-gallon gas again.
Jobs: The Worst Won't Exactly Be Over
Employment numbers tend to lag behind other indicators in any recovery, and the current recession is no exception. "The bad news is that unemployment, which is watched very carefully by many Americans because it does affect us directly, will keep growing," says Dan Seiver, a finance professor at San Diego State University. "It’s quite conceivable we could hit 11% before unemployment actually peaks out," he says. Unfortunately, that peak may not happen before the end of the year, he says.
Even worse, the average American will keep an eye on the job market – and will likely not start spending freely until it shows some signs of improving. A tight job market, combined with essentially flat hourly wages, “bodes very poorly for consumer spending,” says Forward Capital's Moody.
"A lot of people are arguing that the stimulus is going to kick in over the second half of the year and that will provide some support," he says. "But with consumer spending remaining weak, business spending might remain weak."
Housing: Signs of Stability Ahead
The housing market got us into this mess, so investors and analysts seeking signs of a recovery are jumping on any housing data the second it comes out. That may prove to be a waste of energy during the second half of the year, however.
Recent numbers show a slowing rate of decline in housing prices and suggest that some regions could be bottoming out over the next few months. Those are promising signs, but unfortunately a stabilizing housing market won’t drive the recovery.
"When the jobs situation stabilizes, the housing situation will stabilize," says Fact and Opinion Economic's Brusca. "Housing isn't really a threat anymore. It could still decline. But we are not in a situation where housing is a key. The economy is key to housing, not the other way around."
Interest Rates: Short- and Long-Term Rates Should Stay Low
The next meeting of the Fed on Aug. 12 will offer a chance to see where short-term interest rates are heading – and how optimistic the Fed is about the overall health of the economy. For now, though, the Fed will likely continue to pursue a near zero-interest-rate policy in order to jumpstart the economy. However, the agency needs to be watchful of any sign of inflation. "Their big thing is to make sure to pull back on the liquidity in time, so as not to get a ‘double-dip recession," says Don Humphreys of Voyager Wealth Management.
Humphreys says he doesn’t expect inflation to be an issue for quite a while — at least until some real economic growth kicks in. That should also help to keep a lid on long-term rates and tame the so-called bond vigilantes, who sell bonds in the belief that the Fed will have to raise short-term rates to stifle inflation, causing bond prices to fall, says Brusca. (When interest rates rise, bond prices fall.) The recent selloff in long-dated Treasurys pushed longer-term interest rates higher — a situation that, if it continues, would eventually threaten any hopes for recovery.
But after coming very close to the psychologically significant 4%-yield mark, 10-year Treasurys are back at 3.5% "The bond vigilantes recognized that if you're not going to have a strong recovery, you don't have to be a vigilante about the interest rates going up," Brusca says.
