Earnings reports for Q2, which were announced over the last month, were outstanding!  Net income grew 42%, revenues grew 11.8% and 75% of firms beat expectations.  Not surprisingly, stocks soared 7% in July, taking the S&P 500 back to unchanged on the year.  No carry forward of price appreciation so far in August.  With daily price swings in the range of 1%, stocks are down 2.3% on the quarter and down 2.4% on the year.  Why can't investors focus on the generally rosy outlook for corporate earnings for more than 24 hours?
 
Housing, state spending and jobs - bogeymen for rest of 2010
With each passing year, it seems that fewer and fewer investors are actually researching individual companies.  Instead, the focus revolves around the "macro picture" of economic growth, money supply, inflation or deflation, and the risk of a "double-dip" recession.  The prevailing narrative is that jobs growth will remain flat to negative, housing will start falling as the current stimulus ends, and plunging state spending, driven by plunging tax receipts, will offset any remaining federal stimulus.
 
These concerns are not unreasonable.  Excess housing investment over the last ten years created a lot of well-paying blue-collar jobs in construction, and additional well-paying white collar jobs in finance and mortgage lending.  People have taken comfort from the recent upturn in prices but our forecast remains flat real estate prices at best for the next 10 years.  Compared to the rally in housing prices that lasted from1997 through 2007, the rally that ended in 1989 was modest.  Even so housing did not rise to new levels until 1999.  At present, supply remains well above demand for the foreseeable.  Even though mortgage rates are low, a return to basic lending standards means that many people no longer qualify for a mortgage.  About 25% of homeowners have negative equity in their homes (the balance on their mortgage is higher than the current value of their house.)  Plenty of those owners are willing to abandon their properties, which end up on the foreclosure market.  Other owners are looking for the slightest rise to get clear.  Finally, home building hasn't stopped.  Housing starts are down by 75% since 2006, but ample permits are issued at the rate of 565K units/month.
 
Federal spending surged in 2009-10 (tax credits for first time home-owners, direct grants to states for infrastructure spending, the TARP rescue of the banking system.)  However, state spending, which is governed by balanced budget legislation, is plummeting as tax revenues fade.  Federal stimulus peters out this fall, but the real impact of state cuts won't be felt until this winter. 
 
State spending grew about 60% over the last 10 years, so some discretionary spending can be cut easily.  Social programs, however, face increased demand from stressed families.  Another burden on states: pension plans are dramatically underfunded after the market selloff last year and because projected investment returns are sharply lowered. 
 
There's no easy solution for these problems; states have to muddle through as best they can until tax revenues turn up.
 
The jobs situation remains bleak.  There's no chance that construction spending will return to pre-recession levels.  States should use this opportunity to launch infrastructure projects of their own, but lack the funds and Federal support to do so.  We estimate that every high paying construction job generates 2-3 low-paying jobs - everything from retail and fast-food jobs, to manufacture of construction materials.  Meanwhile, corporations, between increasing health care costs and fear of the "double-dip" are pushing overtime to the max without taking on new workers.
 
This chart shows that the rate of jobs growth coming out of this recession is on par with the post- 2001 recession - the so-called "jobless recovery."  Projections from the Bureau of Labor Statistics show total employment not reaching a new peak until 2012, possibly 2013.  To bring unemployment down to 5%, jobs growth would have to average about 250K/month, which is well above the projected 125K/month. 

 

The Eurozone countries have adapted to permanent unemployment in 8-10% range, and the US may well be headed in that direction.

 
Strategy
Net, a contraction in spending in both construction and at the state level means poor jobs growth means reduced consumer spending means continued high unemployment.  There isn't a magical way to break out of the vicious cycle; American simply must wait until the excesses of the last decade are washed away.  So does that mean we should abandon all stocks and invest only in bonds (and gold, and canned goods?)  No!  As we have said time and again, US corporations derive 60% of revenues from overseas operations, which remain strong.  In times of stress, large publically traded corporations take market share from smaller private corporations, and the current environment is no different.  Interest rates remain locked at 50 year lows.  Granted banks are reluctant to lend right now, but credit issues are easing for most corporations.
 
Lastly and most important!  The time to buy stocks is when the economic forecast is grim.  If you wait until the forecast looks great, stock prices have already moved higher.  Right now, the stock market feels like a pressure cooker on the boil.  Growth in earnings, which continue to impress, is the heat source.  However, fears of a double-dip recession, which leave most investors bearish, have kept a lid on stock prices since April.  What happens to net short investors if the risk of recession recedes?  As we have seen, short-covering rallies are usually explosive to the upside.  We continue moving cash into stocks as there are plenty of companies with great prospects and reasonable valuations.
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