Reich Is Right: Watch Your Wallets

The recent rally in equity markets has been quite impressive. The Nasdaq had a run of twelve straight days in the black, which will in all likelihood come to an end Friday as Microsoft (MSFT) is down big after disappointing earnings. This is the longest streak of positive days in the Nasdaq dating back to 1992, and so much of the bullishness can be attributed to a second straight quarter of better than expected corporate earnings results. While we are not complaining that the Dow has reached the 9000 level again, there are real concerns about the foundation of this rally; the enthusiasm spurred by “better than expected” yet still weak earnings. The theme of this earnings season has been cost savings, which help corporate earnings rebound from bad sales results.

Former United States Secretary of Labor Robert Reich had a very interesting blog post on Thursday about this very topic. Here are some of the key points,

“What’s pushing the stock market upward? Mainly, unexpectedly positive second-quarter corporate profits. But those profits aren’t being powered by consumers who have suddenly found themselves with a lot more money in their pockets. The profits are coming from dramatic cost-cutting — including, most notably, payroll cuts. If a firm cuts its costs enough, it can show a profit even if its sales are still in the basement.

The problem here is twofold. First, such profits can’t be maintained. There’s a limit to how much can be cut without a business eventually disappearing — becoming, in effect, a balance sheet in space. Secondly, when businesses slash payrolls to show profits, consumers end up with even less money in their pockets to buy the things businesses produce. Even if they hold on to their jobs, they’re likely to fear that they won’t have the jobs for long, which causes them to retreat even further from the malls…Operating income for companies in the S&P 500 that have reported so far has been almost 29 percent lower than last year, more than 80 percent lower than 2007, according to Standard and Poors. Ouch…

Keep your eye on the real economy, where unemployment and underemployment keep rising. It’s not as much fun as cheering and investing right now, but it’s far safer.”–Robert Reich

The market has grabbed a hold of this “better than expected” sentiment with gusto, and the economy does seem to be headed towards growth rather than the meltdown we faced just nine months ago. However, we are still treading very carefully in this newly overbought market. The market is not attractive from a valuation standpoint, nor do we believe that the economy has worked through all of the potential stumbling blocks. The housing market has stabilized, but we have observed commercial real estate showing signs of significant strain. Consumption is the largest driver of economic growth, and with unemployment rising and consumer credit shrinking we don’t see that improving before 2010. Once this bubbly sentiment wears down and we realize that growth in an environment of double digit unemployment may be slower than hoped, the market could be vulnerable to a reversal.

Original post

Comments

[whidbey:]

Thanks any time Robt Reich says anything rational I want to hear it, and I do appreciate his analysis on this issue.

On the other hand he has some very odd ideas about Health Care which only a man from the Golden State could love and understand. I liked it better when he in New York and CNBC thought he was a fire Hydrant, or was it the dogs in the city? Anyway, he was all wet most of the time and everybody knew it.

Jul 24 04:30 PM

[Long Silver...:]

I read an article last fall that South Korea had a culture where layoffs were shunned. Instead, everybody took a pay cut but kept their jobs. I wonder how Korea is doing now, compared to the US? Anybody following that story?

Jul 24 07:30 PM

[Adam855:]

Tough to argue with what Reich has to say. This particular rally could easily extend into the fall, but I'd tread very carefully since the fundamentals of the economy are still extremely shaky. I suspect the market will be heading downwards again in the October time frame.

Jul 24 09:37 PM

[RatWatcher:]

'Consumption is the largest driver of economic growth, and with unemployment rising and consumer credit shrinking we don’t see that improving before 2010.'

The first part of this doesn't require -US- consumers. Exports also drive economic growth. If (when) the USD begins its inevitable free-fall, those holding them will naturally get rid of them via spending. Their final destination must be US products, real estate, or intangible property such as copyrights and patents. When the dam bursts, the flood will come....

Jul 25 01:52 AM

[john12345:]

Reich is correct but in a narrow argument. The US just can't continue to have consumers and government borrow and spend just to keep the economy and China happy. What's wrong with saving instead of spending and borrowing?

Jul 25 08:38 AM

[seethrudanoise:]

normally Reich is a bag of hot air liar...so what does he really want besiedes his overpaid position?

Jul 25 12:10 PM

[Doc 224899:]

Reich is the guy who wanted to make sure that stimulus money didn't wind up going to skilled workers or white males.

Is he an appropriate target for the term "bonehead"?

Jul 25 02:41 PM

[Doc 224899:]

"Consumption" as an economic driver, MUST be replaced by something real, like "Services".

Even Obamanomicists recognize that!

I say the foundation of a service economy should be healthcare, as a broadly defined sector. The last thing we should be doing now is capping healthcare profits, clogging it up with regulations and more complex bureaucracy, putting non-clinical government wonks in oversight and regulatory positions, and laying it more open to the ravages of trial attorneys.

Jul 25 02:46 PM

[bartpr:]

it will be interesting to see what kudlow and his troop have to say tomorrow night. i just love to see reich take the supply siders on.

Jul 26 01:13 PM