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The laggard economy

Second-quarter earnings have been far better than expected, and the stock market has barely budged over the past six weeks. But that is not necessarily a bad thing. By Martin Wolk.
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With the second-quarter earnings season largely behind us, the nation’s biggest companies have reported results far better than analysts expected — and the stock market has gone basically nowhere. But considering the remarkable run-up in stock prices from March through June, a pause in the action is nothing to feel bad about.

Investors have been buffetted by the cross-currents of strong financial results, mixed economic signals and a wrenching plunge in bond prices. The bond market rout has send long-term interest rates soaring, which generally makes stocks a riskier and less attractive investment. But with a strong surge on Friday, the Dow ended the week within 50 points of its recent June 18 high, reflecting the underlying bullishness of institutional investors.

Sung Won Sohn, chief economist for Wells Fargo, said the stock market is caught in a “tug of war” between strong earnings, which tend to drive stock prices up, and higher interest rates, which tend to drive them down.

“It’s probably a good idea for the stock market to pause for a while, and I’m pleased that it has,” he said. “Any further rally will have to be supported by actual earnings. Especially in tech, stocks have gone too far, too fast.”

Not that actual earnings have been so terrible for the second quarter.

“Before it’s all over, it’s going to be a terrific quarter relative to expectations,” said earnings guru Chuck Hill, research director for Thomson Financial First Call. With two-thirds of the results already reported, Hill said second-quarter operating earnings are running 6.2 percent ahead of expectations, equal to the record first quarter pace and far better than the 2.8 percent average of the past nine years. And he estimated earnings would end up 9 to 10 percent better than last year’s second quarter.

Perhaps more importantly, analysts have been boosting their estimates for second-half earnings, which Hill said is unusual at this time of year, especially considering the unenthusiastic tone of many executives who have ventured to comment on near-term business prospects.

The problem is that the stock market, by surging more than 25 percent over three months, had anticipated every bit of the strong earnings news and then some, said Hugh Johnson, chief investment officer of First Albany.

“Earnings are better than expected, but they’re not good enough,” he said. “They need to be a lot better to justify current valuations.”

If the yield on the 10-year Treasury bond was still 3.1 percent, as it was when it bottomed out June 11, current price-earning ratios would be justified, Johnson said. But as bond prices have fallen, the yield on the long-term benchmark has surged to 4.18 percent.

Such a sharp movement in bonds generally would reflect a strong economic outlook, and certainly analysts and investors are banking on improvement after a long downturn. But bond prices also have been whipsawed by signals from Federal Reserve officials who first raised the possibility of deflation and then seemed to downplay it.

In fact the long-awaited economic rebound is still the missing piece of the puzzle, although the past week brought some modestly encouraging data, including a surge in orders for durable goods. New claims for unemployment benefits came in at the lowest level since February, but analysts cautioned that the weekly figures are highly volatile. Analysts generally expect the labor market to show no improvement when monthly figures are next reported Aug. 1.

Richmond Fed President Alfred Broaddus specifically focused on the labor market when he gave a cautionary assessment of the economy Friday.

”(T)he relatively favorable outcome in the consensus forecast is by no means a sure thing,” he said in a speech to bank executives. Broaddus noted that strong increases in productivity allow U.S. businesses to meet the current relatively weak demand without adding workers.

“The risk, of course, is that sluggish job growth — or worse, continued job losses in the near term — could undercut the apparent recent revival of consumer confidence, since confidence depends in no small measure on people’s perceptions about their job prospects, whether they are currently employed or not.”

Because of the weak labor market, many analysts are highly skeptical about the economic rebound, despite massive stimulus including $13 billion in child tax credit checks that the Treasury began mailing out Friday.

“I don’t think were going to have a strong recovery,” said Sam Stovall, chief investment strategist at Standard & Poor’s. He pointed out that the 2001 recession, now officially in the books, ranks as one of the mildest on record, meaning a likely modest rebound. And there are signs that the rising long-term bond rates already may be starting to weaken the housing market, long one of the economy’s strongest sectors.

Johnson, of First Albany, also is among those who believe the performance of the economy — and corporate earnings — are bound to disappoint. But as chief strategist for a company that manages $1 billion in investors’ funds, he cannot afford to resist the momentum of the stock market and shifted to a more bullish stance about a month ago, allocating more money to technology, consumer cyclicals, and stocks that are likely to show greater volatility.

“But because of our worries about valuation we have decided to do it in stages,” he said. “We’re waiting for weakness, quite frankly.”

But Johnson said investors who look at Frist Albany’s relatively large cash position are unhappy, and are turning up the heat on him.

“The market is arguably overvalued, but it’s not giving ground because of investment behavior,” he said. “Nobody likes to get left out.”