Jack A. Ablin, chief investment officer over at Harris Private Bank in Chicago, is one of my favorite thinkers in the portfolio manager community. He put a good note out this week on employment that I would like to share with you because I think it’s accurate and helps explain my view on why U.S. stocks have an opportunity to work well this year unless they’re sidetracked by other problems.
Jack pointed out that at 9.9%, the U.S. unemployment rate is as at levels not seen in nearly 30 years. The spike from its most recent low of 4.4% in late 2007 is unprecedented. While the natural rate of unemployment is higher than the 5% level of the mid-2000s, it’s also become clear that employers cut too many workers in the latest downdraft and are set to hire over the next few months.
Jack said his recent conversations with corporate CEOs confirm that view. From late 2007 through the first quarter of 2009, there was no visibility on the financial system, let alone profit margins. Managers had to reduce costs by cutting inventories, shunning small suppliers and slashing their workforce. By the time they were done, companies had cut far more workers than actual business conditions merited. As a result, productivity, which is output divided by employees, spiked to 7.8% in the third quarter of last year, helping to fuel big earnings gains.
Companies always add to their staffs slowly at first after a recession, but then the pace picks up speed. They start by hiring temporary workers, so assessing the number of temps on the job provides an early indicator of a rebound in full-time employees. Jack said his researchers have found that the nation’s unemployment rate is indeed closely tied to temp hiring activity. The unemployment rate tends to track the six month change in temporary hiring activity lagged three months.
By running the regression formulas, his team has determined that recent temp hiring suggests that the unemployment rate could drop to 8.6% by July. Stronger temp activity could push the figure even lower later this summer.
Harris analysts suggest that strong employment reports over the next few months will likely spark investor enthusiasm and encourage the Federal Reserve to talk about tightening interest rates. And just as investors pessimistically once expected job losses to go much lower than they did, they will next start projecting them to go much higher.
The bottom line, Jack argues, is that higher employment will lead to higher wages and increasing consumer and business confidence, and thus higher earnings, equity prices and price/earnings multiples lie ahead in the autumn or winter after stocks shake out some problems over the summer.
More positive vibes? OK, sure. Everybody loves a deal, and the mergers and acquisitions machine is in full swing lately, lifting values of four medium-sized companies on Monday. This is a reflection of company treasure chests brimming with bond sale proceeds and cash flow. The biggie was Man Group of England picking up asset manager GLG Partners (GLG) for around four and a half bucks — a 49.8% premium to Friday’s price but still 70% off its 2007 level.
I cannot overstate enough how important these kinds of deals are to all asset prices.They keep short-sellers honest (no one wants to be short a stock with the potential to jump 50% in a day on a buyout offer), and generally provide an optimistic tone because they show that real buyers are willing to pay real money for real companies. The most important way that high cash flows keep share values higher occurs when companies buy back their own stock, which provides an automatic boost to earnings per share.
As long as there are deals, the bull cycle has a shot at surviving its many attackers. You’ll know when this bull cycle is over for sure, though, when one of these deals fails to be completed due to lack of financing. That was the death whistle for the market in late 2007, and it will happen again in this cycle eventually.
As for troubles to beware, there are many — and they are growing more intense.
Although all eyes have been tuned to Europe lately, as you can see on the right side of the chart below the decline in China is getting serious. Shanghai stocks have been declining rapidly, and the Chinese market has clearly entered a bear cycle by my definition, which is two consecutive months below a 10-month average.
Note that the start of the 2008 decline in Shanghai stocks looked just like the current chart. As bad as the slide in February 2008 was for Shanghai, conditions soon worsened and the index ultimately fell 70%. Faltering confidence in China leads to difficult times throughout the world, as so many economies are finely tuned to feed it everything from steel and coal to grain and machine tools. Do not ignore this situation even as the media spends more time fretting about Lisbon and Athens.
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