Ramblings of a Portfolio Manager

The Great Wrestling Match--Top Down vs. Bottom Up. Who Will Win? So Far it’s the Guy Fighting with the Rear View Mirror

Last week earnings season officially kicked off with reports from Alcoa, Intel and several banks. The results were dramatically different than expected…in fact they were much, much better than we or most of Wall Street had anticipated. Second quarter earnings came in as expected—stronger than expected (why does no-one ever mention the paradox in that oft-repeated phrase?)—but the guidance, which every market watcher had expected to be downbeat, was surprisingly strong. In fact both Alcoa and Intel, our two cyclical reporters, guided most of their financial metrics higher for the rest of the year. That was not what the market was expecting. The reports initially continued the market rally that had begun the week earlier: a rally which in truth had begun not in anticipation of such positive results but due to relief that Europe is not melting down and is addressing its myriad problems in a semi-rational manner (e.g. the bank stress tests). Alcoa and Intel were frosting on a cake that had already been baked. By the end of the week JPMorgan and Bank America had reported similar results with credit quality improving amid tepid loan growth and weak trading revenues. Not stellar results, but not the disaster the markets had been expecting, especially in the wake of the Financial Reform bill, which had threatened and distracted bank Management throughout most of the quarter.

The week was full of other positive news as well. BP appeared to have successfully capped its well in the Gulf (unexpectedly), Goldman Sachs settled its fight with the SEC for half of what was anticipated (unexpectedly), without having to subject itself to a show trial, and jobless claims came in lower than expected. With all this positive, unexpected news, the major indices ended the week down -1%+. Huh? Despite the prior week’s rally based, as we indicated, on bullishness on Europe, one would have expected a continued strong market. We didn’t get one and the answer lies in several economic indicators released during the week: the Empire State Manufacturers Survey and the Philly Fed Index. Both came in weaker than expected, indicating that the economy did indeed take a pause in June, and the markets decided to focus on those data points rather than the comments and outlook of company management.

With two conflicting sets of data to analyze, on which one should we rely? Let’s take a quick look at the two culprits behind last week’s decline. The Empire Manufacturer’s Survey is a very narrow survey in which New York manufacturing companies are asked to estimate the percentage changes in their sales and employment levels from year to year (2009 to 2010 in the most recent case)—both year to date and for the calendar year. In addition to being narrow, it’s a backward looking indicator, which largely reports what has happened in New York-based businesses over the last month with little commentary on expectations for the future. Last week’s survey indicated that conditions for New York manufacturers continued to improve in July, but that the pace of growth in business activity slowed substantially over the prior month (June). The new orders and shipments indexes were also positive but lower than last month’s levels and the employment indexes dipped as well, with the average work week index falling below zero for the first time this year. The future general business conditions index component was little changed, remaining close to its May and June levels but below the highs seen earlier in the year. Most of the other components of the index were also positive, but were below the peak levels reached in May. As for the forward-looking part, the median respondent reported that sales were up 7 percent for the first half of 2010 and were expected to be up 8 percent for the full calendar year, indicating continued positive growth. The release of this report on Wednesday dampened the continuation of the rally sparked by Intel and Alcoa.

The Philly Fed survey has been conducted since 1968 by the Philadelphia Federal Reserve Bank and questions manufacturers in the Third Federal Reserve District (Pennsylvania, New Jersey and Delaware) on general business conditions. It comprises a blend of manufacturing sectors and general businesses. The survey is conducted in the vein of the Purchasing Managers Index (PMI) report and has a rather high correlation with that report; it questions participants about their outlook on things such as employment, new orders, shipments, inventories and prices paid. Answers are given in the form of "better", "worse" or "same" as the previous month, and, as with the PMI, results are used to construct an index, only this index uses a median value for expansion of 0, rather than 50. The Philly Fed Report signals expansion when it is above zero and contraction when below thus a higher Philadelphia Fed Survey figure indicates a positive outlook from manufacturers, suggesting increased production. So what did Friday’s survey reveal that sent the markets down so sharply?

Results from the Survey released on Friday suggest that regional manufacturing activity continues to expand in July but has slowed over the past two months. Surveyed firms reported a decline in new orders this month compared with June. Employment showed a slight improvement this month. The survey’s broad indicators of future activity continue to suggest that the region’s manufacturing executives expect growth in business over the next six months, but optimism has waned notably in recent months. The future general activity index remained positive for the 19th consecutive month but fell to its lowest reading in 16 months. The future new orders and shipments indexes also declined notably, falling 22 and 13 points, respectively. For the 15th consecutive month, the percentage of firms expecting employment to increase over the next six months (30 percent) exceeded the percentage expecting declines (17 percent).

How do we rationalize these economic reports with what companies have said so far this quarter First, they all tell us something we already knew—that business conditions slowed in May and June. The combination of fears of a European meltdown, uncertainty surrounding the Government’s attack on financial institutions and the expiration of the Federal Housing Purchase Tax Credit, among other things, caused the consumer and some small businesses, at least, to temporarily put on the brakes. This information should have already been discounted in the markets’ 10%+ slide from its April highs. Secondly, and more interestingly, however, they show a dichotomy between what management is saying about the future in the survey responses versus what they are saying on earnings conference calls. The Empire State Survey is largely backward looking and thus says little about what its small collection of firms is thinking about the future. The Philly Fed survey, however, encompasses a larger number of firms from a broader spectrum of businesses and the outlook from this survey was somewhat more dour than what we have been hearing from company management. How do we explain that? There are several reasons, we believe. First, the Philly Fed Survey is still somewhat narrow in its geographic and business line focus versus the component companies of the S&P 500. Secondly, they are also somewhat smaller and have less foreign sales as well. Finally, the questions asked regarding the future are quite narrow versus the “free association” latitude given company management on conference calls. So what we are hearing from the survey respondents is still a narrow outlook as compared with the likes given by Alcoa, Intel or the banks. IBM and the rest of the technology companies, scheduled to report this week, will further broaden the economic commentary.

How does an investor make sense of this all? Should we believe company management, whom we all know can be promotional about their stocks, or the government reports, some of which encompass the very same companies that have given rosier outlooks on conference calls? Frankly, our money is on company management. First of all, the surveys contain a very large, rearward looking component to them. We all know that May and June were slow, as does a market down12% from its April high. Secondly, while management can say whatever they like to a government survey taker, they are making very public comments, to which they will be held, when they give earnings and sales guidance on conference call. Additionally, management teams have learned over the years that the game is to guide so as to set a low bar that will be easier to beat in the upcoming quarter. So, if anything, management guidance on conference calls to date has been conservative rather than promotional. If that’s the case, then the Q3 2010 may be even stronger than analysts have “estimated” already. Just remember, a rear view mirror may be a great way to kill the mythical medusa but given that markets are anticipatory beasts, it isn’t a good way to invest.