Ramblings of a Portfolio Manager

What More Does the Market Want?

We just ended a second consecutive week during which an enormous amount of potentially positive market moving data was released. Two weeks ago we got strong earnings and forward guidance from the likes of Alcoa, CSX, GE and Intel, heard of a Goldman Sachs settlement with the SEC and learned that BP may have successfully capped its leaking well in the Gulf. Last week we saw continuing positive news: the Financial Regulation Bill was passed by the Senate and signed into law by the President, relieving much of the uncertainty surrounding the bill especially when in the final analysis the rules may take up to a decade to be implemented by which time affected firms will have adapted to or circumvented them; the results of the European bank stress tests were released, results that were much, much better than expected both in terms of the number of firms that passed and capital that needed to be raised; housing start data was in line with expectations but new permits were better than expected; weekly jobless claims came in more or less in line and the Senate approved an extension of unemployment insurance, restoring benefits to 2.5 million people; Fed Chairman Bernanke testified on Capitol Hill that the Fed does not see a double dip and maintains its 3%+ GDP growth forecast but is in no rush to hike rates and is ready to implement “QE2” should growth slow; General Electric hiked its dividend earlier than expected, a sign that they see strength in their business going forward and, finally, the string of strong corporate earnings and raised forward guidance continued with the who’s who of the Fortune 500 reporting including IBM, Microsoft, American Express, Coca Cola, Apple, UPS and Ford. The markets responded positively to this data with the Dow and S&P 500 both rallying about 2.3% over the last two weeks. This rally, however, was very choppy (markets initially dropped over 1.5% on Bernanke’s testimony) and still leaves us negative for the year with the Dow down 1% and the S&P 500 just below the flat line.

With all the positive news and dissipation of uncertainty during the last two weeks, the major market indexes still sit in the red for the year. What will it take for investors to feel comfortable enough to get back into the market and move us higher? Last week we opined on the dichotomy between the economic data and company reports. A more accurate depiction, it now appears, is reality vs. the forecasts of economists—i.e. the view from the trenches vs. that from the Ivory Tower. We reiterate our belief that the best prognosticators of the Country’s economic future are its CEOs and not politically (or otherwise) motivated egg heads, most of whom have never held a real job. Still, with all the positive chatter coming out of Corporate America, the markets languish. What more do they want?

We believe that there is one remaining piece to the puzzle, or conundrum in Alan Greenspan speak, and that is jobs. Though companies have painted a rosy outlook for their future profits, most have done so with the assumption of no new hiring. Clearly, for the markets to advance, unemployment must come down, which means these companies must incorporate additional staffing into their forecasts. Two factors are going to cause them to do this: first, their businesses must improve to the point where they cannot possibly grow Earnings Per Share fast enough to meet Wall Street expectations without brining in new workers—i.e. capacity utilization must increase to the point where productivity gains alone (i.e. using more technology or working existing employees harder) will not suffice to drive earnings higher. We believe that many companies are getting to that point right now. Just this morning Federal Express hiked its guidance, saying that they expect volumes to grow 20% this year. Given that their planes are already nearly full, they will have to add new planes, and people to fill and fly them, to meet this growth. We’ve heard similar reports from other industries, who are also beginning to ramp their capacity utilization.

The second factor that will spur hiring feeds into the first, and it involves the reduction of uncertainty regarding Government policy—both on taxes and regulation. Companies will hire when business improves but only if they are confident in estimating the marginal cost of those hires. Right now, given the uncertainty over the cost of health care reform, new taxes in 2011 and any other fiat of regulation that Congress decides to ram through between now and November, that marginal cost of hiring is almost impossible to estimate. For the future to be sufficiently clear to give CEOs the green light to hire, we are going to need a radical change in policy/behavior on Capitol Hill and the only way to achieve that is to get some good old fashioned gridlock, or better yet complete regime change, in Congress. Poll any CEO and it is highly probable that you will hear the belief that we currently have the most anti-business Government in this nation’s history occupying our seats on Capitol Hill. This isn’t necessarily our opinion—it’s a message we have consistently heard from virtually every earnings conference call we have attended—and it is a line of thinking that doesn’t encourage Managements to hire. Fortunately, the mid-term elections are only a little more than three months away and we will be getting early data from the political polls very soon. Given that markets are discounting mechanisms, this means that if the polling data shows CEOs will be getting their wish this election, then we can see continued equity gains through the fall. Let’s just hope that the “dead men walking” on Capitol Hill don’t pull the same tricks as the Corzine administration did to New Jersey just before it was ejected on its ear last fall—that is, ramming through more tax and spend policies at the 11th hour. Hopefully, those soon-to-be lame ducks will start thinking about their futures in the private sector and exercise some spending restraint for a change.