The Independent Market Observer

1/29/14 – Less Good Is Not Necessarily Bad

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 29, 2014 9:35:30 AM

and tagged Commentary

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In the past couple of weeks, there have been several indications of a slowdown in the U.S. recovery, and international markets have shown weakness. Over the past week, we’ve seen that translate to drops in U.S. interest rates and declines in the stock market. Since we ended last year, thinking there was nothing but blue skies ahead, clouds have rolled in. Should we be worried? And if so, about what?

Let’s start by looking at the U.S. economy. The first cloud was the shockingly weak jobs number three weeks ago: only 74,000 jobs were reported as created, against an expectation of around 200,000. I analyzed that figure and concluded, based on other data, that it was a false signal, due primarily to severe weather. Nonetheless, I saw it as something that should signal caution.

Since then, auto sales have disappointed; the Bloomberg Consumer Comfort and University of Michigan Consumer Sentiment indices dropped; building permits and housing starts decreased; business capital expenditures appear to have slowed; new home sales fell; and, most recently, capital goods orders dropped.

This list, as depressing as it looks, is misleading—I cherry-picked these negative data points from an even longer list of positive ones. The idea, though, is that there are now more negative data points out there. The balance of positive to negative is shifting, certainly not to overall negative, but to a more mixed tone. This is arguably a good thing; expectations had probably become too positive, and this is a necessary correction.

I think, though, that it also reflects very real constraints on the U.S. economy that we have to be aware of. My estimate of 2014 real economic growth, at 2.5 percent, is now somewhat below many others, and it takes into account these emerging areas of negative news. I still expect the U.S. to do well in 2014, but perhaps not as well as some of the more cheerful analysts out there.

Another reason for caution is the rest of the world. While the U.S. is doing relatively well, other countries are in weaker situations. The current emerging market fears are a good example of this. The U.S. has benefited from strong export growth to these countries, among others; as they are forced to adjust to more expensive money, and lower capital flows, that tailwind to the U.S. economy will subside. At this point, most of these countries are in much better financial shape than they were in 1998, so a crisis doesn’t look likely—but the adjustment will nonetheless be real and painful. The substantial drop in the value of Argentina’s peso and the sharp rise in Turkish interest rates are just two examples of how tough this might be. In addition, China just negotiated a potential default on a “wealth management product” similar to many of the U.S. subprime bond issues, which one commentator dubbed a “Bear Stearns moment.” Clearly, there are risks out there.

Europe also isn’t out of the woods. Although a slow recovery seems to have taken hold, the fundamental imbalances between countries remain. Unemployment, particularly of the young, remains at crisis levels. This is an ongoing story, and we will see many more potential crisis developments ahead, especially on the political side.

Again, my intent isn’t to ignore the many positive developments, but rather to recognize that the view is much cloudier than many investors expected at the end of last year. The fact that investors are dialing back their optimism is reflected in the recent declines in U.S. stock prices. This has been driven in part by disappointing earnings caused by the factors mentioned above, as well as the recent drop in U.S. interest rates, as investors rediscover the virtues of a safe-haven investment.

Looking ahead, this is a necessary and even healthy readjustment of expectations to the facts. While caution is always appropriate, technical and fundamental factors aren’t flashing red at this moment. The U.S. stock market has declined by less than 4 percent, which hardly counts as a correction. The fact that we notice this as exceptional speaks to how placid the market has been over the past couple of years. In historical terms, it is totally normal.

That said, longer-term concerns remain, and shorter-term concerns could emerge if stocks test various technical resistance levels. As of right now, we don’t see this, but it could happen.

The verdict for today, then, is the news is less good, but not bad. Caution is appropriate, as always, but panic is not. 2014 should continue to be a good year for the economy, and the stock market should maintain its current level—barring, of course, unforeseen developments.

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