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Is Past Prologue

After a 16% slide in the stock market between April and July, equities have rebounded about 10% since their early July trough. Yes, Virginia there is once again a summer rally. The rally reflects generally a more sanguine feeling about growth. Recall since late January and more recently in May and June, investors were worried about growth outside the U.S., whether it be Europe or China. They were also concerned about growth in the U.S.: witness recurrent speculation about a double dip in the economy. More recently, worries about economic and financial conditions in Europe have eased, while in the U.S., fretting about a double dip in the economy has subsided. Meanwhile, most companies have reported both favorable bottom line and top line growth for the second quarter. Consequently, this confluence of macro and micro economic trends suggesting better than expected prospects for growth has provided the catalyst for this year’s summer rally. At this point one should ask whether this confluence of favorable developments is past or prologue.

In case it has not been noticed, a deceleration of growth has set in the U.S. economy. After 3.2% growth over the previous four quarters, the rate of expansion moderated to 2.4% in the second quarter. Looking forward, gains in growth are likely to be more moderate than in the past year as the economy came off its bottom. Moreover, much of the recovery to date has come from rebuilding inventories. For further inventory growth to occur in the future, final sales will have to pick up. At this time there are few signs that consumer demand is about to materially strengthen. The savings rate has climbed to over 6%, the highest level since 1993; however, more important to potentially sustainable final sales growth is the expansion of employment and incomes. In an economy expected to grow 2.5 to 3% into 2011, there is little likelihood that the workforce will grow very much. Capital spending, especially for technology, is an area of strength. But imports are a drag on the economy and little incremental stimulus from all levels of government is expected in the foreseeable future. While monetary policy is supportive of growth, more stringent requirements imposed by the banking system are a constraint on growth. Overseas, we believe growth will be relatively slow in much of the developed world, including Europe.

Given that the U.S. economy seems to be transitioning from its recovery phase to a more sustainable growth phase of 2.5 to 3%, it is appropriate to ascertain what this transition portends for profits growth. Corporate operating earnings grew 53% in the first quarter thanks to gains in margins. Second quarter results may rise in the neighborhood of 45% helped by improvement in revenue growth. For 2010, corporate profits are estimated to rise over 30%, implying a continued deceleration in growth over the remainder of the year. The early expectation for profits growth in 2011 is for 6 to 7% to $86.00 for the S&P 500. Sales may grow 3 to 4% if history is any guide. Meanwhile, the Financial Times recently indicated that the consensus of bottoms up estimates for profits in 2011 is over $95.00, compared to the $86.00 estimated by strategists.

We recently expressed some caution about the outlook for the equities’ market. Despite the summer rally which might carry to 1200 on the S&P 500, we believe that investors’ perceptions about the growth of profits may moderate in the months ahead as earnings growth estimates come down for 2011. Despite an environment of low interest rates, investors may find that any reduction in earnings growth estimates over the next twelve months could produce higher valuations than now perceived. Moreover, increased uncertainties about government intervention in the economy are not the stuff of which higher valuations for stocks are produced. It still seems a bit early for a secular bull market in stocks to resume. The best we can reasonably expect is a continuing trading range setting.

A. Marshall Acuff, Jr., CFA
Managing Director
Director of Research
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC

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