Saturday, March 03, 2012

Stocks Ignore Economic Woes as Apple Drives the Indexes

The following commentary is derived from a Special Report distributed to subscribers of the Forbes Special Situation Survey on March 2.

So far, 2012 is turning out to be a great year for stocks. Through Friday, March 2, the NASDAQ Composite Index was up 14.2% year-to-date and the S&P 500 was up 8.9%. Of course, both indexes benefit greatly from their inclusion of Apple Inc., which is up 34.6% year-to-date. Apple, which has a market capitalization of more than $500 billion, is about one-fourth larger than Exxon Mobil, the second largest stock in the S&P 500. Because both the NASDAQ Composite and the S&P 500 are cap-weighted, they got a big boost from Apple's outstanding performance. On the other hand, the Dow Jones Industrial Average, which does not include Apple, is up just 6.2% year-to-date. This demonstrates just how influential Apple has been to the other two indexes.

For the most part, the corporate sector of the economy is doing well. Companies have benefited greatly from low interest rates and years of cost-cutting. Profits and balance sheets are strong. Many companies are using cash to increase dividends, repurchase shares, and pay down debt (or at least refinance existing debt with cheaper debt). Yet three critical legs of the economy remain troubled.

Employment – On the surface, there appear to be significant improvements in the employment market. The unemployment rate, which peaked at 10% in October 2009, has gradually declined to 8.3%. Weekly initial jobless claims improved from 659,000 in March 2009 to 351,000 for the week ending February 25, 2012. Nonfarm payrolls increased by 243,000 in January, marking the 16th consecutive month that the economy added jobs. There is no question that these trends are good. They certainly indicate that the jobs market is moving in the right direction. However, the improvement in the unemployment rate is largely an aberration because discouraged workers, who are many, are not counted. Furthermore, initial jobless claims are still higher than they should be in a recovery, and job creation is still much too anemic. Take a look at the employment participation rate to see just how troubled the jobs market remains. This figure is calculated by dividing the civilian labor force by the civilian non-institutional population. This critical measure, which hovered above 66% before the financial crisis of 2008, is now down to just 63.7%. In other words, a smaller proportion of the population is taking part in the labor force. If you think there isn't much difference between 66% and 63.7%, you will probably be shocked to learn that had the participation rate remained at 66%, the unemployment rate today would actually be 11.8% instead of 8.3%. As bad as it is, the unemployment rate looks better simply because fewer people are participating in the jobs market. Also, don't forget that if the jobs market truly strengthens, the unemployment rate should initially rise as more people begin to look for work.

Housing – Warren Buffett argues that the housing market is near bottom. He says that over the long term, the number of housing units must rise in line with the number of households. Today, household formation is outpacing the increase in housing units. That doesn't help the housing market in the short term because there is an oversupply of homes. In the long term, however, more houses will have to be built. Furthermore, because interest rates are low and housing prices are so depressed, the cost of buying a home looks extremely attractive compared to the cost of renting. Buffett is right that the housing market will eventually improve. Of course, the critical question is when? Unfortunately, the latest S&P/Case-Shiller numbers show that we aren't there yet. Housing prices are still falling. In fact, they are almost 35% below the 2006 peak. On average, homes today are worth what they were back in early 2003. Many people who purchased a house after that date are underwater.

Energy – According to the AAA Daily Fuel Gauge Report, the national average price of regular gasoline has reached $3.74 per gallon. In some parts of the country, it is well above $4.00 per gallon. Just one month ago, the national average price was $3.45 per gallon. This 8.4% increase in a month is largely due to the rise in crude oil prices. The oil market has been particularly sensitive to rumors. For example, any talk that Israel is about to attack Iran in order to destroy that nation’s nuclear capabilities causes prices to rally. A recent rumor that a pipeline in Saudi Arabia exploded caused another spike in oil prices. Interestingly, that rumor, which turned out to be false, appears to have originated in Iran. That may not be surprising, yet the reaction showed just how nervous oil traders are. Demand for gasoline, which has been depressed since the start of the financial crisis, was starting to pick up. Higher gasoline prices, however, are likely to reduce demand again, which is not a good development for the economy. Higher gasoline prices could also fuel inflation. One energy bright spot is natural gas, which is plentiful, cheap, and not imported. Maybe it's time to start thinking more seriously about alternative sources of energy, such as T. Boone Pickens' idea of converting long-haul trucks to natural gas.