US Perspectives: The Market That Wants to Believe

Given the volatility in the Middle East and the many unknowns in Japan, the assumption of a quick return to normalcy is a relatively bold expectation.

Robert Johnson, CFA 23.03.2011
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Given unrest in Egypt (then Libya and Bahrain), gasoline close to $4 per gallon, and an unfolding disaster in Japan, it is nearly impossible to fathom that the S&P 500 is still within 4% of its recovery high of Feb. 17, 2011. At same time, first-quarter GDP estimates have moved from close to 4% to the range of 2.5%-3.0% and inflation has accelerated, yet the market continues to hang in there.


The indicators provided more of the usual news last week--real estate stuck in a rut, inflation accelerating, manufacturing burning up the track, and unemployment claims data limping back toward long-term averages. The consumer has not given up hope yet, either, as weekly chain-store sales continued to show year-over-year growth in excess of 3%, despite some incredibly tough comparisons with a year ago. The International Council of Shopping Centers weekly index is now at its highest level of the recovery. It seems to me that both the market and the consumer have become inured to all the world's crises.


From Panic, to Complacency, to Renewed Panic?

The stock market's reaction is not atypical to what has happened during past periods of economic difficulties or natural disasters. At the start of a crisis, the market does what it does best: It panics. Sell now, ask questions and get the details later. This time was no exception. The market experienced several drops of more than 100 points last week as the Japanese nuclear situation worsened. Given all the uncertainty, those market drops are not unjustified. Typically, when the worst-case scenario doesn't occur instantly, the market often flattens out or perhaps even rebounds. After the reactors in Japan didn't melt through the center of the earth and there were reports of many unharmed businesses, markets rebounded sharply later in the week. Following the panic, complacency settles in. Then, over time, as a full picture of the triggering event becomes clearer, markets often sell off more dramatically than the initial panic.


For example, Robert Rodriguez of First Pacific Advisors warned of the subprime debt at the Morningstar conference in June 2007. Although there were some initial reactions to these early reports and others like them, when the sky did not immediately fall, markets continued on their merry way. Then the bottom finally fell out of the market in the fall of 2008 when the problems could no longer be ignored.


Now I am not reasoning that our markets will fall off immediately and that we could complete another cycle of panic-complacency-market collapse. However, markets certainly seem to be assuming that the Middle East is likely to settle back into some type of normalcy and that what happens in a small corner of Japan is unlikely to stop the Japanese production machine. Given the volatility in the Middle East and the many unknowns in the Japanese situation, the assumption of a quick return to normalcy is a relatively bold expectation.


It's Too Early to Declare Mission Accomplished

Morningstar's analysts worked hard last week at the unpleasant and macabre task of determining who might be harmed and who might gain an edge in the Japan crisis. Initial reports seem to indicate that a lot of the most badly damaged areas were not large manufacturing centers, and many Japanese factories were able to restart last week. However, continuing radiation issues that could spread more broadly across the country, supply chains that stretch in all directions, just-in-time inventory systems, and infrastructure issues that may take a while to identify all seem like reasons for caution. This is especially true given the fact that Japan remains the third-largest economy in the world. Its size makes Japan an important customer to many multinational companies. Surprisingly, 13% or more of Coca-Cola's operating profits come from Japan.


Inflation: The Trend Is Not Your Friend

Last week's inflation news was not good. The consumer price index was up 0.5% in a single month; on a year-over-year basis, the number was well over 2%. Both figures have been accelerating for some time. Even worse is that both import prices and the producer price index both exceeded 1%. These increases often turn up in consumer prices months later, so things are clearly going to get worse before they get better.


Month-to-Month Increases in Inflation: CPI









Source: Bureau of Labor Statistics


Inflation is not getting any better around the world, either, as both China and South Korea have had to raise interest rates in an attempt to control inflation. Even Europe is entertaining the thought of raising rates as inflation moves above 2%. Outside of the United States and Europe, it's hard to find places where the rate of inflation isn't in excess of 3%.


To say that Europe and the U.S. won't experience sustained inflation because of high unemployment and low utilization rates seems to miss the point that we are all linked to the rest of the world. Other parts of the world are seeing labor shortages and production bottlenecks that are pushing prices higher in addition to the commodity-related increases that are driving a good part of inflation in developed economies. As the U.S. imports goods from these developing markets, U.S. prices will necessarily go up, too.


Prices: A Lot of Ups, Not Many Downs

Highest Inflation Categories


Lowest Inflation Categories






Airline Tickets




Public Transportation




Natural Gas


Used Cars










Source: Bureau of Labor Statistics


The one real hope was that rising prices in commodities would restrain overall growth and cause prices of other noncommodity groups to decline, offsetting rising raw-material costs. Furthermore, rising commodities might slow growth, which would cause the demand and the price of those commodities to fall of their own accord. For several months, these arguments seemed to work; we saw a reasonable number of goods falling in price each month (or at least growing considerably below the average rate). This month, the price increases continued to be dominated by food and energy, but there was a broad group of other products that saw price acceleration in February. In fact, only a fluky apparel number and almost flat housing costs (that comprise in excess of 25% of the inflation calculation) kept the headline number from looking worse.


Industrial Production Numbers Are a Lot Better Than They Look

The headline industrial production shrinkage of 0.1% from January to February may have looked weak to some, but peeling back the onion reveals a different story. The volatile utilities sector shrunk 4.5% in February (following a 2% decline the previous month), sinking overall results according to Morningstar's industrials team. In fact, excluding utilities and mining, industrial production grew a respectable 0.4%.


Looking at the data on a year-over-year basis, industrial production was up 6.9%, its best showing since July. In general, industrial production was relatively weak from August through November and has shown sharp acceleration through the last three months, excluding the volatile utilities and mining sectors. Autos were by far the strongest sector, growing 3.5% from January, reflecting strong consumer demand recently.


Housing Starts Going in Reverse, Again

Morningstar's housing team was disappointed with this month's housing data as described below. Some of the relatively bleak numbers don't seem to square with more positive notes that our housing team is hearing from the field. As bleak as the news was, remember that new housing currently represents about 1% or so of GDP (down from pre-recession norms of 4%-6%). Therefore, even a relatively large change in housing starts isn't going to do much to GDP growth, although it will definitely suppress employment growth in the months ahead.


February housing starts sunk to a 479,000 annual rate, which was 20% below the year-ago figure and 23% below January. The sequential plunge was driven in part by a 40% decline in the five-plus unit category from a January result that was almost double December's annual rate. Needless to say, the five-plus category is volatile.


Single-family results were far from stellar, with 29% and 12% respective annual and sequential declines. The north region was down 38%, and the Midwest was down 49% sequentially, suggesting February's nasty weather had a part to play in the weakness.


Permits set an all-time low of 517,000 total pulled in February at an annual rate. The single-family rate of 382,000 in February didn't set a record low, but it was low enough to qualify for the team picture.


We're a bit puzzled by these results, especially considering comments coming out of the builder community of late. Much of what we've been hearing was modestly positive, and many of the large builders have been satisfied at their order trends thus far in the spring selling season. We'll have to see what happens over the next couple of months, but we wouldn't be surprised to see a large reversal in the near future and/or a material revision to February results. Now trailing along the very bottom of a mostly sideways trend for the past two-plus years, however, these latest results are a bit scary.


A Big Week for Housing Data and the Final GDP Revision for the December Quarter

Existing home sales, Case-Shiller housing prices, and new home sales are all due this week. I don't hold out much hope for any of the housing statistics this month. Falling pending home sales point to a decline in existing home sales. The consensus is for a fall in existing home sales to 5.1 million units (seasonally adjusted annual rate) from 5.3 million the prior month, which seems to be in range to me. I suspect the Case-Shiller numbers will be down again, albeit modestly. Our housing team's real-time data points to a rebound in the index this spring (the Case-Shiller numbers are a three-month moving average for the period ended two months ago (January), so we could see another month or two of decline in this metric.


GDP for the fourth quarter was originally estimated at 3.2% but revised down to a more meager 2.8% last month. Given some recent data revisions--especially to retail sales--there are expectations that the number may be revised upward to as much as 3.1%. I don't think the revision will have much of an impact. However, there is a chance that the new number will force analysts to pull out the sharp pencil for adjusting their first-quarter estimates, which got as high as 4%. The first few reports for the quarter are pointing to a much lower number. Soaring imports, a poor January consumption report, and rising inflation are all weighing on the first quarter's potential. However, even more recent data revisions and a reversal of January's horrible weather conditions make the first-quarter forecast a real moving target. Japan's issues could also reduce U.S. imports in March, potentially inflating GDP, while rising oil prices may well have the opposite effect.



This is an edited version. The article originated from Robert Johnson’s column at

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Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis with Morningstar.

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