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The reduction in inventories is a good sign that the cleansing process is underway, but unemployment is on the rise and consumer spending is weak. Firms are using layoffs and are reducing capital investments in the struggle to remain or return to profitability. The latest Fed interest rate cut is unlikely to help, as mortgage and longer-term interest are increasing. While banks have lowered their prime-lending rate, fewer and fewer firms appear to qualify for this preferred rate as banks have tightened lending qualifications. The result is an increase in borrowing costs for most firms.
The increase in new home construction is not as positive as it first appears. New home construction is weather sensitive, and the warm weather to date is likely responsible for most of the increase. The next several months will tell us whether the increase in November moved planned future housing starts forward or if this is indicating a strong housing market.
Additional spending cuts and layoffs will soon follow as we have yet to feel the impact in the reduction of state budgets. State governments are struggling with reduced revenues and budget cuts. With a reduction in employment and program spending this will be the next bad news for the economy.
Congress continues to fight over the form of a stimulus package, but the length of the recession and the timing of the economic recovery will be dependent on what happens with oil prices, rather than any economic stimulus package from Congress. I see nothing in the proposed stimulus package that will help the economy in the short-term and much that will be a drag on the economy later. The proposed tax cuts, regardless of the form, put little money into the hands of those that are likely to spend but will add to future budget deficits.
If OPEC is successful in driving the price of oil higher, expect the recession to be longer and deeper. The recent drop in the price of oil put money into the hands of people who appear to be spending this increase in real income. An increase in the price of oil acts like a tax on the consumer, reducing their income and spending. However, this money is not available for spending by governments in the US so there is no offsetting spending. The economic impact of constantly changing oil prices results from a lack of a comprehensive energy policy. Congress could do more for the economy by developing an energy policy that makes the US independent of OPEC and other oil producers.
The Stock Market
The recent run up in stocks draws attention to the risk of trying to time the market. For a value investor, the level of the market cannot be supported by the economic outlook or projected profits. The overall level of the market would imply an increase of profits of over thirty percent next year and continued significant profit gains in subsequent years. The value of stocks in the “technology sector” implies even greater profit gains for this sector of the market.
For “technology” stocks to improve, capital investment, particularly in computer hardware, computer software and telecommunication equipment, would have to increase significantly. It is likely that the technology sector will lead the recovery. The surplus capacity in the telecommunications industry will take several years to be brought into a supply/demand balance. For the computer industry, the current installed hardware and software is more than adequate for most companies’ current and future needs. I would anticipate that these sectors will lag in profit improvements when the recovery occurs. There will always be some exceptions, as new technology will offer opportunities or as firms such as Microsoft diversify into markets that are more likely to lead in the recovery.
Stocks in the News
General Electric confirmed it will meet expected profits for the forth quarter and expects 17-18% increase in profits next year. They appear to be meeting these targets at least partly due to changes in expected pension returns. This will make it more difficult to meet projected gains in future years.
The Enron debacle, warm weather and the drop in oil prices have beaten down natural gas producers and pipeline companies. This is one area of the market that has long-term appeal at current prices as they offer a reasonable yield and reasonable profit expectations even if oil prices remain low.
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