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The gulf between investors and economists who believe in the Easter Bunny and those who believe she's buried under the New Jersey Turnpike with Jimmy Hoffa and Elvis has seldom stretched larger than it does today. And rarely have the stakes been higher for the group that's right.
On the one hand, we have sunny investment pros who think the Federal Reserve has pulled off the miracle of the century with its two-year campaign to lift interest rates: a "soft" landing for the fast-flying U.S. economy that has blunted inflation. On the other, we have skeptics who think the Fed has recklessly pushed the economy over a cliff toward a recession and botched its all-important battle with inflation.
If the optimists are right, break out the champagne: job growth and corporate profits will bend but not break over the next year. They'll just sort of pause a bit as the lagged effect of higher interest rates gains traction. Companies may try to raise prices, but they won't stick -- curbing inflation. Stocks will levitate, and there will be smiles all around.
But if the pessimists are right, higher rates and energy prices will lead unemployment to soar, corporate profits to tank and prices to spiral higher, a triple bogey of bad news. Bears foresee a return to 1970s-era "stagflation," a period of flat growth combined with inflation, that would end with a full-fledged recession. Stocks will stink.
I know it seems crazy that intelligent observers could have such divergent views, but that is the nature of a market. Smart people looking at the same data can come to different conclusions that depend as much on their own hopes and fears as unemotional analysis.
A good, cleansing recession?
Personally, I think the path forward is pretty clear: Put me in the cage with the Easter Bunny. Seventeen interest-rate hikes are a lot. They are going to take their toll. But U.S. manufacturing and service businesses will not plunge into an abyss. The recovery from the last recession, in 2001, is still under way. It will slip a gear, but its resilience will surprise people. After a short period of sub-par news on the economy, say around nine to 12 months, consumers and businesses will adjust and the worldwide growth engine will rev higher again.What's the evidence? Let's look at the data and compare it to the historical record.
Second-quarter corporate earnings growth was great. Higher rates and energy prices are not slowing the train. With 90% of all major U.S. companies reported, growth for the period came in at a stunning 16.3%, which was well above the 10.9% projected at the start of the quarter. This will go down as the twelfth straight quarter of double-digit earnings growth for the S&P 500 ($INX) companies, which is the second-longest streak ever. (The last was from the fourth quarter of 1992 to the fourth quarter of 1995.)
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Nearly 70% of companies reported a positive earnings surprise, and the median upside was 5%. Compare that to an average of 60% beats and 3.2% median surprises historically, according to Thomson Financial data. Homebuilders and transportation companies were relatively weak and electric utilities, consumer staples, health care and basic materials providers were relatively stronger.
Ultimately, higher interest rates probably will slow earnings growth, and the most recent period may be seen as a peak. But for now, a rolling four-week average of analysts' earnings estimates revisions is still positive. It's worth noting that shares of transportation companies, such as railroads and truckers, were the final cyclical sector to fall during the May-July collapse. And yet the transports, which fell an average of 9% from early July to early August, still have the strongest positive estimate revisions of any industrial sector.
More confirmation of surprising strength in the past few weeks include a decline in the four-week average of unemployment claims, strong retail sales in July and an improvement in the building of inventories. All told, the broadest measure of the U.S. economy is on track to advance about 3% in the second quarter, which is about average for the past few decades.
If growth peaks right around here as higher interest rates work their evil magic, then most studies suggest that inflation will top out as well, as suggested by recent data. That combination would keep the Fed at bay and hold rates at the 5.5% level, which would not be terribly burdensome for either consumers or businesses. Next we'll be talking about rate cuts instead of increases.
Easing off the accelerator
The combination of a pause in growth with a moderation of inflation could lead to one of the most marvelous scenarios that investors have ever seen. So get ready for talk of recession to be replaced with discussion of the fabled, and little seen, "midcycle slowdown."In past midcycle slowdowns, last witnessed in 1995 and 1985, the S&P 500 has risen as much as 40% as investors discounted a low in earnings and began to look toward the next peak.
Here's how it worked the last time: Gross domestic product growth advanced 4.1%, 5.3%, 2.3% and 4.8% in the four quarters of 1994, then sank to 1.1%, 0.7%, 3.3% and 3% in 1995. Now you might think that the market would have been strong in 1994 and weak in 1995, but it's a lot more perverse than that. Market returns were negative in 1994 as investors anticipated that strength was peaking, and then were very strong in 1995 as investors anticipated that weakness was troughing. Sure enough, 1996 was indeed much stronger, with quarterly growth of 2.9%, 6.7%, 3.4% and 4.8%. The same pattern emerged in 1984-1985.
If this third midcycle slowdown occurs on schedule and the economy blusters through the Fed's tightening cycle without a recession, analysts at ISI Group suggest that three to five years of growth without inflation may lie ahead, e.g. from 2008 to 2010. And even then, a recession might be remarkably mild compared to the past, as the last four -- in 1973-1975, 1980-1982, 1990-1991, and 2001 -- were increasingly mild, with GDP falling, from peak to trough, 3.1%, 2.9%, 1.3% and 0.4%, respectively. This makes sense when you consider that the U.S. economy is a lot less cyclical than it was in the past, with so many more service companies than manufacturing companies. That is, a lot more people go to work at Starbucks (SBUX, news, msgs) shops than at 3M (MMM, news, msgs) plants today: 115,000 vs. 69,000, at last count.
Considering all the negative press that the Fed has received recently, you should know that a key factor behind the economy's strength is the central bank's radical decision to launch a pre-emptive strike on inflation with rate hikes rather than wait for it to bust out. It took advantage of a period of strong corporate profitability. That stands in contrast to the Fed's decision to raise rates in 1990 and 2001 as profits were already weakening.
ISI points out that scary recessions occur when the Fed is trying to kill a wage and price inflation spiral. That's not what we have today, as wages, sorry to say, are not moving a lot higher. ISI notes it's a lot easier to kill "demand pull" and "energy pass-through" forms of inflation -- which is what are what we face now -- especially when Asia is exerting a damper on inflation by lowering the cost of goods and the developing economies of Brazil, India, Eastern Europe and Russia are providing U.S. companies with new sales frontiers.
So why do stocks tend to rise during midcycle slowdowns? While the Federal Reserve is raising rates, price-earnings multiples -- which are the incredibly important and hidden lever behind stock values -- decline. In the current case, P/E multiples have compressed for 11 straight quarters. When it becomes clear that the Fed is done, ISI observes, multiples start to expand, kicking off an explosion in prices. To show you how this works, during the 1985 and 1995 midcycle slowdowns, earnings advanced at a single-digit rate but the S&P 500 rose almost 30%. The X factor was higher multiples.
Winning the slowdown race
The top-performing sectors during the 1985 and 1995 midcycle slowdowns were financials, aerospace/defense, restaurants, health care, office equipment, transportation, beverages, home builders and telephone carriers. The worst performers were steel, paper containers and gold. If it works out that way again, here are some major companies in the best sectors that have suffered multiple compressions in the last year and are top-ranked by the MSN StockScouter rating system. Nibble on them now if you wish, but you should have a better chance to buy them cheaper in October and November after the usual autumn swoon.| Name | Sector | P/E now | P/E one year ago | YTD % chg. | 8/14 price | StockScouter rating |
|---|---|---|---|---|---|---|
Transportation | 13.1 | 23.8 | 16.1 | 59.79 | 10 | |
Health Care | 28.2 | 46.3 | 4.8 | 47.19 | 10 | |
Health Care | 30 | 42.9 | 18 | 62.9 | 10 | |
Capital Goods | 8.7 | 11.6 | 29 | 117.72 | 9 | |
Capital Goods | 10.4 | 13.7 | 18.3 | 55.8 | 9 | |
Finance | 12.6 | 13.1 | 1.4 | 54.39 | 9 | |
Public Utilities | 12.8 | 14.9 | 18.8 | 39.86 | 9 | |
Finance | 13.4 | 22.2 | 10.7 | 44.14 | 9 | |
Basic Industries | 16.8 | 27.7 | 5.5 | 72.63 | 9 | |
Health Care | 17.2 | 49.8 | 3 | 47.54 | 9 | |
Health Care | 17.4 | 22.4 | 5.6 | 63.94 | 9 | |
Health Care | 17.5 | 23.5 | 8.5 | 27.22 | 9 | |
Basic Industries | 17.8 | 22.1 | 14.9 | 25.34 | 9 | |
Capital Goods | 19.2 | 28.2 | 1.8 | 61.7 | 9 | |
Consumer Services | 19.9 | 23.1 | 22.8 | 29.76 | 9 | |
Capital Goods | 20.3 | 24.3 | 13.6 | 65.12 | 9 | |
Consumer Services | 20.3 | 23.8 | 3.6 | 23.84 | 9 | |
Health Care | 22 | 36.7 | 1.1 | 67.08 | 9 | |
Health Care | 24.2 | 24.6 | 10.4 | 67.57 | 9 | |
Health Care | 25 | 32.5 | 8 | 56.02 | 9 | |
Finance | 31.9 | 40 | 15.1 | 54.43 | 9 | |
Finance | 38.9 | 44.8 | 21.4 | 83.74 | 9 |
Fine Print
To learn how recessions are officially defined, visit the Web site of the National Bureau of Economic Research. … To learn more about ISI Group, read here. … Learn how the Congo election turned out here or here. (I wrote about Congo's mines in this column.)Jon D. Markman is editor of the independent investment newsletters Strategic Advantage and Trader's Advantage. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Jon Markman owned shares of Starbucks.
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