Good Evening: Much stronger than expected housing starts and what some are calling a successful retest of the November lows combined today to push stock prices higher. If the laws of economics have been repealed and housing supply can truly create housing demand, then perhaps this rally can keep going. Before we get too excited about how far it might carry equity prices, however, BAC-Merrill’s David Rosenberg has an updated S&P earnings forecast which just might sober up investors as they celebrate St. Patrick’s Day.
Early clues about just how resilient the major averages might be today after yesterday’s reversal were evident both last night and this morning. First, the disappointing news from Alcoa (a dividend cut cum secondary offering) was rationalized as specific to Alcoa and not applicable to others. Using this same train of thought, investors only punished Nucor when it guided lower this morning. Second, the economic data out this morning was deemed to be positive instead of negative. Housing starts were expected to fall in February from January’s depressed levels, but starts popped a surprising 22% (see BAC-MER’s take below). There may indeed be anomalous reasons behind this jump (weather, seasonal adjustments, etc.), but for me it was the reaction by market participants that represented the real anomaly. Home building stocks were sought and many analysts heralded the release as indicative of a bottom in housing. As for how more supply will somehow create more demand for houses, the analysts were understandably mute.
Equity investors decided not to question this logic and the major averages opened not far from unchanged. But when an early dip could reach no further than S&P 750, more than a few traders bought stocks in the belief that yesterday’s afternoon selling was just a mirage. The major averages began a persistent, saw-toothed rally that only stopped because the closing bell rang. The Dow (+2.5%) was the least frisky of the major averages, while the Russell 2000 (+4.5%) posted the largest gain. Treasury prices were once again on the weak side and yields rose between 3 bps and 6 bps. The dollar was off slightly against its major competitors, and commodity prices continued their recent roll. Though gold and silver were once again left behind, it should be noted that John Paulson’s firm bought 11% of AngloGold Ashanti. Just as he saw the subprime crack up coming months ahead of time, could it be that Mr. Paulson now sees a similar opportunity in the opposite direction for the gold miners? As for the here and now, crude oil’s challenge of the $50/bbl level and mostly firmer grain prices enabled the CRB index to close 1.2% higher today.
Perhaps I wasn’t paying attention during my many economics classes, but I thought I remembered learning that an item suffering from weak demand and ever weakening prices is in need of less — not more — supply. If building 500K more homes can solve a housing crisis where some 6 million already stand vacant, then we’ve truly discovered how to turn lead into gold. Heck, perhaps we can use this same economic alchemy to solve the entire financial crisis. Let’s just print as large a supply of new dollars as it will take to buy up every toxic asset and every vacant home! Supply creates demand and problem solved!
Bank of America-Merrill Lynch economist, David Rosenberg, is also worried about supply and demand. For him, though, the key to U.S. stock prices going forward has to do with our economy not being able to supply the earnings growth investors currently demand. His piece you see at bottom argues that we have yet to see the final low in equities because earnings expectations are still too high. Many laughed at him when he predicted last August that 2009 earnings for the S&P would come in around $63 on an operating basis. The consensus penned in $100 earnings estimates for the same period, giving the prevailing 1300 price for the S&P a very reasonable forward PE of 13. Now that the Great Recession is a reality, guess which of the two estimates is the current consensus?
Now that the consensus has finally joined him at $63 for this year and is making the same “market is cheap at 13 times this year’s earnings” call, Mr. Rosenberg has again broken from the pack in reducing his estimates down to $40 for 2009, which leaves the S&P at a less than cheap 19 times this year’s earnings. As reported earnings are even worse, but let’s cut the crowd some slack and exclude the bad stuff; expectations are still too high, in Mr. Rosenberg’s opinion. Furthermore, he notes that during each of the past few bear market rallies, financials led the bounce, followed by consumer discretionary stocks and materials names. During the March rally, we have the exact same leaders in the exact same order, so the current rally certainly seems to be reading from the bear market script as opposed to the brand new bull market one. Like Mr. Rosenberg, I concede that this rally could carry further, perhaps even another 10% if folks really believe that either the Fed or the Treasury Department can save us from further woe. But if Mr. Rosenberg is anywhere close to right with his new earnings forecast for the S&P 500, then we unfortunately still have some unfinished business to the downside. Despite this less than giddy outlook, I wish everyone a happy and safe St. Patrick’s Day!
— Jack McHugh