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Investing Specialists

A Lot of Smoke, Not Much Fire

We got a lot of information, but little light on the direction of economic activity this week.

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The S&P 500 Index broke its seven-week winning streak, falling about 1% this holiday-shortened week. Earnings news this week again dominated the economic data.

Although earnings news was generally positive, the reports were not quite good enough for investors, especially when it came to banks. However, news out of the tech and industrial sectors remained surprisingly strong. Businesses appear to be back in investing mode, spending on computers and industrial capital goods.

News out of the manufacturing sector continued to improve, at least based on the Empire State and Philly Fed manufacturing reports. Initial unemployment claims, thankfully, dropped back after last week's holiday-related spike, which should bode well for January's all-important employment report.

Housing data were mixed with good news on existing home sales but flat housing starts. And in the upside-down world where good news is bad news, China's announcement of GDP growth close to 10% in the fourth quarter spiked investor fears. Markets now worry that higher growth would lead to more monetary tightening and an eventual slowing in China's economy, the world's engine of economic growth.

In general, this week's data provided a whole lot of information but little or no light on the direction of economic activity. In fact, we'll have to wait until the first week of February to get the data that really count: employment and consumer incomes.

Bank Earnings Fail to Excite
The earnings news this week on balance was very positive, but investors are now setting a much higher bar for companies. Investors generally reacted poorly to a slew of bank reports that nevertheless basically met expectations. Internal growth remained extremely modest at most banks, and trading and European-related revenue streams were weak--hardly a surprise.

Reduced reserves for bad loans offset the negative factors but didn't exactly set investor spirits on fire. News of more layoffs at financial-services firms and the potential negatives of increased regulation didn't help matters, either.

Meanwhile,  IBM (IBM) and  General Electric  (GE) knocked the cover off the ball, indicating businesses were finally opening their wallets for expensive capital goods, typically the last part of an economy to rebound. And rebound they did. Both GE and  Parker Hannifin (PH), a major industrial producer, showed new order growth in excess of 20% on the equipment side of the house. Even IBM's global services business managed to show 18% bookings growth after three consecutive quarters of decline. These contracts tend to be for long-term projects with relatively big sticker prices. Therefore, strong signings should bode well for 2011 and beyond.

Regional Manufacturing Data Even Better Than It Looks
The Empire State Report on Manufacturing showed a slight improvement, while the Philly Fed data later in the week showed an equally modest decline. But those readings are based on one summary question (Are overall business conditions better, worse, or the same?) rather than a summation on data for production, orders, inventories, and so on. The subindexes this month were remarkably strong for both regions and look much better than one might guess from the summary question. The New York report showed new orders, shipments, and employment indexes all had meaningful improvement. Subindexes in the Philly Fed report were spectacular. Shipments and orders made five- and six-year highs, respectively. Even the employment part of the index managed a four-year high.

Existing Home Sales Jump Higher; Housing Starts Stuck in the Mud
While we continue to watch housing data, the segment remains too small to move the economic needle for now. Until the employment numbers improve, it's unlikely the housing sector will contribute much. However, if 2011 continues to show meaningful economic growth, 2012 could prove to be a great year for the housing industry with a combination of limited new supply and increasing demand as consumers regain their footing.

But the situation this week was mixed, with quite positive news on existing homes sales but housing starts that were still in the dumps. Existing home sales jumped 12%, to 5.28 million units, well ahead of expectations of 4.88 million units and an upwardly revised 4.7 million units the prior month (on a seasonally adjusted annual rate basis).

Our housing analyst Eric Landry tweaked me this week, pointing out that both the consensus and I would have come closer to the mark if we'd used year-over-year pending sales data to forecast closings instead of messing with the more-volatile sequential monthly data. Live and learn. Quietly, existing home sales have been up in five of the last six months. Even the inventory of homes for sale declined meaningfully, from 9.1 months of supply to 8.5 months. But Mr. Landry reminds me that inventories typically fall this time of year, so we shouldn't get too excited. As we warned in last week's video, if it looks too good to be true, it probably is.


Little Improvement in Housing Starts
Eric Landry shares my opinion that current housing starts and permits data are still abysmal, but hope for 2012 remains strong:

Last month's 4.3% sequential and 8.2% year-over-year decline in housing starts to 529,000 SAAR indicates residential construction remains mired in a generational-sized slump--no surprise there. We've said many times that we'd be surprised to see an increase in activity before this coming spring, if even then. Activity remained within the narrow range to which it's been confined for the past two years. Fluctuations inside the 500,000-650,000 total start range are not as meaningful as sustained activity above or below the aforementioned limits. Total permit activity (which leads starts and new home sales) picked up in December, with total permits increasing 17% from November levels, but remained 7% below December 2009. Here again, investors shouldn't get very excited, as some if not all the sequential increase can be attributed to changing building codes (for instance, California is instituting its "Green Building Code" this month). In all, the latest data do nothing to change our opinion that housing activity will remain subdued for at least the next couple of months. We hold hope that the spring selling season will usher in a modest increase in activity and that the housing market can start to approach normal levels late this year or in 2012. Inventory of new homes remains extremely low, meaning that housing production will at some point enjoy a kicker from increased demand in addition to some inventory restocking.

Friday's Fourth-Quarter GDP Growth Could Approach 4%
Despite a large part of the data being available, the spread of GDP forecasts still ranges from 3% to over 4%. Based primarily on strong consumer numbers and export numbers, I suspect that GDP will come in at the high end of the range or even exceed it. The open question is the issue of inventories, which have been a big plus in previous quarters. Various accounting adjustments and a large number of estimates that go into calculating inventory make this category particularly hard to pin down. It certainly appears that the rate of growth of inventories is slowing, which could potentially mean that inventories could be a small negative to the GDP calculation (although not the most likely case). A potential offset is an increasing level of brokerage commissions from existing home sales, which will be far greater in the fourth quarter than the third.

Although GDP estimates have been rising for some time and whispers of 4% growth have been building, I believe a 4% growth number would have a strong positive psychological impact on both consumers and business leaders. I think a 4% GDP growth rate might just be a wake-up call to business leaders that it is safe again to invest their piles of cash. A 4% growth rate would be the second highest of this six-quarter recovery. The highest growth rate was 5% in the fourth quarter of 2009, but that jump was largely from the restocking of inventories. This time most of the growth will be from consumers, with consumer growth approaching 4% and contributing nearly two thirds of GDP growth this quarter. And unless I made a mistake in my calculations or my forecast is drastically off, real GDP will finally have recovered everything that was lost (4.1% in total, not annualized) in this recession and then some. However, that wealth is now spread across several million more people.

Housing Prices Likely Another Downer
Last month's Case Shiller Home Price Index fell 1.0%, and based on some real-time listing data tracked by Morningstar's housing team, those price declines could accelerate modestly for the three-month average ending in November (expected to be released Tuesday). Continued small declines are not ruinous to my GDP forecasts in the short run, though I 'd still like to see some increases when we move into the spring selling season. Also I think we could begin to see some disparity by region both this month and into the new year as states with smaller inventory levels begin to outperform the "sand" states (Arizona, Nevada, and Florida, for example) with larger inventories and more foreclosure issues.

New Home Sales and Pending Home Sales Also Due
I suspect that new home sales will be flat at 290,000, painfully near record lows. A combination of poor weather and weak starts data over the last several weeks is the cause for my pessimism. Again, no need to panic. Pending home sales (homes under contract but not closed) are due, and I use this input to forecast existing home sales. I am hoping (not forecasting) a continuation of the multimonth improving trend in pending home sales. However, the weather and the holiday season could still muck up the data.

Durable Goods Due for a Bounce
Durable goods orders showed a small decline (down 0.3%) in November, and I expect improving data for December--growth of 0.5%. My optimism is based on strong order data in the National purchasing managers' report as well as the two strong regional reports this week.

Robert Johnson, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.