Consumer confidence dropped significantly last month. The Conference Board measure declined from 62.7 in May to 52.9 in June. The University of Michigan Consumer Confidence Index, which is one of the Leading Economic Indicators (LEI), dropped from 76.0 to 66.5 from May to June. Housing data has turned negative. Housing starts declined by 10% from April to May and are likely to show an additional decline of 7% in June. And the last couple of months have been difficult on labor market statistics. Average hourly earnings were -0.1% in June.
The LEI, after climbing off the March 2009 low, have rolled over in the second quarter. Furthermore, the Economic Cycle Research Institute’s Weekly Leading Index (WLI) is flashing warning signs that often precede further declines in the Purchasing Managers’ Index. Among developed countries, it declined somewhat in Canada, Japan, the United Kingdom, and the United States. It also declined in important countries in Southeast Asia, namely, China, Taiwan, Singapore, and India. Importantly, these indices are still above 50, a positive benchmark. However, the recent declines in WLI are not consistent with buoyant earnings estimates.
Analysts call for an increase of 35% in earnings this year and 18% next year. Recent market jitters reflect investors’ concerns that global growth is slowing. Yet, consensus estimates have not been reduced in any meaningful way. An interesting McKinsey study shows that over the last 25 years analyst’s forecasts have on average been almost 100% too high. When economic growth accelerates (typically after a recession) the size of the forecast error declines. We do not see accelerating economic growth.
While the US paid lip service during the recent G-20 Summit in Toronto to reducing the deficit, we have not seen any discussion of reductions in spending. The implication is that taxes will move significantly higher. Higher taxes will reduce consumer spending. Consumer spending at over 70% of GDP is the heart of the US economy and a proxy for US growth. Labor income reflects corporate costs. When consumer spending rises faster than labor income, corporate profit margins increase. Over the past year, consumer spending went up by 4.6% while labor income increased by only 1.0%. This support for profit margins is beginning to erode. In the past six months, consumer spending has been increasing 3.8% (annually), and labor income has been going up 4.1% (annually). Federal incentives (“cash for clunkers”, new home buyer’s credit) are waning. Consumer purchases may have been front-loaded, and the savings rate will likely increase.
Consequently, there a number of reasons to question market valuations based on projected earnings. Equity valuations are vulnerable when investors expect strong earnings growth. When earnings are anticipated to grow more than 15%, total returns decline by 12%.
The encouraging signs of economic recovery that we have seen since last summer are beginning to show weakness. The recent change in trends, which we anticipated, warrant a particularly conservative investment policy. The second half of 2010 will provide many challenges to investors