- After scant 0.1% (preliminary) GDP growth in 1Q14, the second quarter should be a different story.
- Strong economic data coupled with solid earnings growth has been insufficient to move the stock market significantly so far in 2014.
- As long as the market outlook remains uncertain, we would expect continued concentration in mega-caps and would be wary of false "all clear" signals for small caps.
The advanced 1Q14 GDP report indicated that the U.S. economy grew a scant 0.1% in the first quarter. That number does not fully jibe with other data, most notably employment gains. Still, revisions in the preliminary and final 1Q14 GDP tallies are likely to be modest. The second quarter will be a different story; in addition to core strengths in the economy and the usual spring bounce, the economic data will likely reflect at least some pent-up demand carried over from 1Q14. We think GDP could advance at approximately a 3.5% pace in 2Q14, with potential upside to 4.0% if inventory accumulation accelerates.
Strong economic data coupled with solid earnings growth has been insufficient to move the stock market significantly so far in 2014. And the preliminary 2Q14 GDP release will not be available until July. We can analyze some of the data that will go into that report, however, in order to get a sense of the economy's strength coming out of the first half and heading into the second.
Stagnant Stock Market or Base-Line Consolidator?
The stock market is certainly sending mixed messages. Defensive groups such as Utilities lead the market year to date. Another group of inflation-beneficiary sectors with commodity exposure - including Energy, Materials, and Industrials - are also top performers. Some of the strongest sectors in recent years, most notably consumer discretionary and financials, are market laggards, both impacted by the cooling-off period in housing after white-hot activity in 2012 and 2013. In the current uncertain environment, investors are crowding into mega-caps and dumping mid- and small-caps.
Broadly, confusion about where the market is heading stems from a peculiar circumstance: the major indexes finished 2013 at or near all-time highs. Thus, it only takes a basis point of advance this year to establish new highs. If the stock market had peaked in November and finished the 2013 year five percentage points below its highs, the inch-worm gains this year would be seen plainly for what they are.
Instead, we are getting two conflicting messages this year. The financial press trumpets, "Stocks hit new highs!" But investors reading their account statements wonder what happened to the market mojo of last year.
When markets conclude a clearly defined and sustained trend in either direction with a sideways-trending pattern, we see a greater likelihood for the market to break in the opposite direction from its long-prevailing trend. But the stock market can equally use such side-winding periods to consolidate gains and form a consolidation base-line for further advance.
In particular, if the market has broken a clear trend because of a clear change in economic circumstances, the likelihood of a trend break to the opposite direction is much higher. The stock market flat-lined between March 2000 and August 2000, as die-hard bulls fought to sustain the fabulous 1990s stock gains. But much of the 1990s bull market had been predicated on an internet economy that delivered much less than its advocates had forecast. The promise of ubiquitous broadband choked on last mile dial-up modems. It would be a decade before that promise began to be fulfilled. In the late-2000 through late-2002 period, investors paid for the false premise.
This time around, we are not seeing signs of any great unraveling such as occurred in technology in 1999-2000 or housing in 2006-07. True, the housing economy has cooled. But housing is not beset with the huge imbalances that doomed it in the middle of last decade; in fact, this cooling-off period likely strengthens the housing sector for a more sustainable expansion in coming years.
The technology sector has seen several of its high-flyers crash to earth. But these are a select few, most of which were hugely overvalued. Unlike in 2000, technology sector business activity is accelerating, not contracting. And mainstream technology is engaging in an unprecedented round of shareholder-friendly capital allocation programs that signal confidence in the sustainability of innovation and growth in cash flows.
The stock market tends to follow its own mind, and we won't know what it is thinking until it moves decisively. We can say that conditions are not ripe for a significant trend break based on steady or sudden deterioration in the fundamentals. In fact, the fundamentals have rarely been healthier.
Consumer, Industrial Economies on the Move
Argus Chief Investment Strategist Peter Canelo points out that the high-frequency (weekly) indicators - money supply, credit, commodities, and unemployment claims - are universally improving. Inflation shows signs of breaking out. Trailing three-month core and all-items producer price index is grown at a 2.3% rate. Median CPI also signals a trend change. No one is certain why the bond market is ignoring all this; but bonds cannot ignore inflation in particular for very long.
The economic data from the second quarter to date shows some moderation, particularly on a month-over-month basis, but overall signals indicate an economy operating at a relatively high level of production. The industrial economy currently appears stronger than the consumer economy, which led in 2012 and 2013.
Regionally, the ISM Milwaukee survey fell below the 50 level signaling expansion; but the Chicago Purchasing Managers' survey roared to 63.0, crushing the 57.0 consensus call. Business activity in Chicago, still shaking off its frigid winter, expanded at its fastest pace in six months. The New York Empire State index was three-times higher than expectations, led by new orders growth, work hours, and six-month general business conditions.
Nationally, the Institute for Supply Management reported a third straight month of acceleration in April, as the ISM manufacturing index rose to 54.9% - the highest level since December 2013. ISM non-manufacturing, which covers services (a much bigger swath of the economy), rose to 55.2% in April, which was the highest level in six months.
Like the market itself, the consumer is searching for direction. For the consumer, spending begins with confidence. The Thomson Reuters/U of Michigan Consumer Confidence survey for April reached a nine-month high and rose from a four-month low in March, and showed consumers the most optimistic about current conditions than at any time since July 2007. But in mid-May, the preliminary reading on that same consumer confidence survey again yo-yoed lower.
The Commerce Department's retail sales report showed a 0.1% gain, which as a headline number was regarded as a disappointment. But March growth was revised to 1.5%, the biggest gain in four years. Thus, April's fractional move higher actually indicated fairly good activity at the malls and online. The National Federation of Independent Businesses (NFIB) straddles the consumer and commercial and industrial economy, so its reports send signals on all parts of the broad economy. In May, the optimism index from NFIB reached 95.2, representing its highest reading since October 2007.
Despite the flowers busting out all over, we are not ready to declare a thaw in the housing market. Still, the April starts data was encouraging. Housing starts jumped 13.2% in April, led by Multifamily structures (up 40%). While single-family starts are still contracting, the overall seasonally adjusted annual rate (SAAR) climbed back above one million, to 1.07 million SAAR for April. Building starts rose 8% to a 1.08 million SAAR.
Theories abound as to why stocks have not moved much (in either direction) this year, and as to why bonds are rallying with inflation knocking at the door. We continue to regard this as a stock-picker's environment. As long as the market outlook remains uncertain, we would expect continued concentration in mega-caps. We would be wary of "all clear" messages regarding small caps; several such pronouncements have proven premature. We would remain over-exposed to inflation beneficiaries such as materials and energy. And throughout the market, we would look for the available bargains in high-quality names.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.