Further Weakness in the US Economy

By: Paul_J_Nolte

The worst quarter since the first half of 2002 will be in the books at the close today, and not a day too soon. The news of the week included still poor housing data, although a few glimmers of hope in that the declines were less than originally estimated. Too were the refi and new purchase activity, reported by Mortgage Bankers Association, jumped as mortgages rates moved modestly lower. This week will be loaded with the usual first week data, including employment, which will likely show another contraction in payrolls, further fueling those sitting on the fence that we are indeed in a recession.

Further weakness in construction spending, factory orders and the ISM report on manufacturing are also like to be seen during the week. We are expecting more poor economic reports in the week's ahead, confirmation that we are in a recession – we should expect poor reports. Also in the docket is a proposal for larger oversight by the Fed in areas that it currently does not control. In the wake of the Enron mess, we saw added regulation in the form of Sarbanes-Oxley that was supposed to provide investors better information on earnings. However, the added costs have actually forced some companies to go private and many would argue that the information is actually worse today. Unintended consequences indeed!

The long-term technical picture of the markets has improved, however the short-term indicators are in jeopardy of beginning a new decline that could negate the long-term view. One of our long-term and relatively simple looks is looking for a combination of higher stock market yields and lower interest rates on bonds.

This quarter could mark the first time since 2002 that dividend yields are up enough combined with lower interest rates to generate a “buy”. As with any mechanical system, there are imperfections. Two large quarterly losses were realized, one in 2002 (just before the steady rise) and one in 1975, just before a 20% 6 month return. On average, when the conditions are similar to today's, the markets return 5% per quarter and have positive returns just over 70% of the time (data goes back to 1960). This compares to an average of 2% quarterly return and positive returns generated 64% of the time for the entire data series. The negatives? Volume continues to be a worry, with expanding volume on the declining days and less volume on rallies – still indicating that investors are more interested in selling this market than actually buying. While our “buy” signal is 3 months ahead of our expectations, we will be watching the markets closely for an entry point.

The break in the commodity markets may provide a boost to an already low interest rate environment. With the CRB index falling over 5% in the past two weeks, another 5% decline in commodities would provide additional support to ever lower rates as the Fed tries to get the loan market moving. The repairing of balance sheets has begun as the yield curve is above 3 full percentage points (the difference between 30 year and 13 week treasuries).

While many will point to the steep curve as a reason to buy financials, history suggests that the curve is likely to remain this steep well into next year, so there will be ample time to buy banking issues. The rapid steepening of the curve is very similar to the '00-'01 period when it took 9 months to widen vs. the 12 months this time to get 300 basis points steep.

By Paul J. Nolte CFA
http://www.hinsdaleassociates.com
mailto:pnolte@hinsdaleassociates.com

Copyright © 2008 Paul J. Nolte - All Rights Reserved.
Paul J Nolte is Director of Investments at Hinsdale Associates of Hinsdale. His qualifications include : Chartered Financial Analyst (CFA) , and a Member Investment Analyst Society of Chicago.

Disclaimer - The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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