A bear market rally in equities

The equity market rallied last week on an unsustainable sense of relief that the earnings performance of a number of key companies was far better than feared, particularly after GE's disappointing report the week before. The market's positive earnings surprises included Google's report of a 30% jump in first quarter profits from a year earlier, almost double the 17% rise posted in the fourth quarter. IBM's first quarter profit spurted 26%, ahead of the 18% rise forecast for the full year. EBay's net earnings were up 22%, better than the market anticipated. While the reports indicted that the recession has certainly not yet powerfully slowed these companies earnings, the reports were not quite as positive as they at first appear.

Google indicated that clicks on its advertisments increased 20% in the first quarter from a year earlier, a slowdown from a 30% rate of increase in the fourth quarter from a year earlier. This could be a harbinger of a slowdown in the growth of Google add revenue in coming quarters.

Much of the IBM earnings gains was due to the appreciation of foreign currencies. The firms Asia revenue was up 14% with currency gains and 3% without them. The comparable IBM gains for Europe and the Middle East were 16% and 4% after adjusting for currency gains, and for the Americas 8% before and 6% after currency gains. Despite a substantial backlog of service contracts, new IBM service contracts fell 2%in the first quarter.

EBay's active users edged up a mere 1%, the least gain ever reported. The revenue gains of EBay's core business has slowed, while non-core business accelerated, making for a more mixed picture.

Though the psychological relief of the few relatively favorable earnings reports helped push equity market prices back toward their recent highs, this is not the beginning of a sustained cyclical rally. Not only were the positive reports not quite as positive as they seemed, they overshadowed less favorable earnings reports in both business and finance. Advanced Micro Devices posted yet another loss. Though Nokia reported a 25% earnings increase, it forecast a slowing market for the rest of the year. Citigroup and other financial institutions reported losses.

Housing starts plunged a further 12% in the latest month to the lowest levels since the recession of 1990-91. This is a clear indication that housing is still far from bottoming out. A rise in the CPI that pushed it up 4.0% from a year ago was troubling. However, a 2.4% rise from a year ago in core consumer prices, excluding food and energy, suggests that soaring food and energy has not yet spilled over significantly into other broad sectors of the economy. With demand in the broad economy not yet as depressed as it will be when the consumer and business retrench, the restraining impact on prices of the recession still lies ahead. That is why it is still prudent for the Fed to ease further. However, The step-up in inflation has increased market expectations that the Fed's late April easing will be limited to a one-quarter point reduction to 2.0%.

While the equity market is considered the most reliable leading indicator, it is not consistently infallable. The equity market is primed by typically spectacular price increases in the last three months of recession to eargerly over-anticipate the end of a recession. The incentive is that in recent recessions the average price gains of stock indicies are almost twice as large in the final three months of recession as they are in the first three months of actual economic recovery. Recognizing the financial advantages of buying three months ahead of the end of the recession, investors have a tendency to jump the gun and buy long before the appropriate time. But how can I be sure that this just another false start?

While nothing in life is certain, there are too many negative forces at work to believe the recession will be as mild as it has thus far proven to be or so short-lived to be ending at mid-year or sooner as the recent equity market rise suggests. The consumer and business and global economy have not yet materially reacted adversly to the constraints of the credit crunch, the housing debacle, the looming credit card bubble, surging unemployment and the cost squeeze imposed by soaring energy and food costs. The unemployment rate will leap higher and together with other pronounced negatives will turn the plunge in consumer confidence into a retreat in consumer spending. There is a virtual avalanche of mortgage resets coming that will produce further waves of forclosures, falling home prices and additional financial institution losses and capital writedowns. And a steep drop of 49% in China bubble stock prices suggest China's boom is likely to at least be scaled back, most likely in the fourth quarter, after the Olympics. That will produce a global recession, with additional adverse US economic consequences. In concert, that array of negative factors portends a longer and deeper US recession than widely anticipated.

Philip Braverman
Braverman Economic Consulting
One Hewitt Square #249
East Northport, New York 11731