Back in the real economic world though, the news has continued to get better and this is probably the best reason to treat any pullback in prices over near term as a great long-term buying opportunity, particularly in the economically-sensitive sectors of the market including the resource, industrial and technology stocks. Many of the copper, iron ore, coal, agricultural and auto stocks have sold off sharply over the past few weeks and are looking like good entry points again for adding to positions. The economic data continues to support the positive outlook for earnings in these sectors. German industrial output and economic growth came in well ahead of expectations this week while the US consumer data is also improving rapidly, with consumer confidence levels returning to pre-recession levels, a good signal for retail sales and the important employment reports coming in later this week (March 4th). While the industrial sector has had a sharp recovery in North America, the all-important service sector, which represents over 70% of the economy, is also looking good. The chart below shows the ‘Non-Manufacturing ISM Index’ for the US, which is basically a survey of managers in the service sector on the current conditions and outlook for their industry. Any reading above 50 indicates expansion while a number below 50 indicates recessionary conditions. The chart clearly shows how quickly the service sector has recovered after the sharp drop in 2008. The index is now back to the strongest levels seen in the 2003-05 period, when the last expansion was well underway.

In addition to the strong economic data, the earnings reports continue to come in exceptionally well. Over 75% of US and Canadian companies beat earnings expectations again for the 4th quarter of 2010, the 7th straight quarter where over 70% of earnings beat expectations. Over 70% of the reporting companies also showed revenue growth ahead of expectations, another sign that the underlying economic background continues to improve and support higher stock prices. Another measure of the strength in corporate earnings is the Earnings Revision Ratio (ERR), compiled by Merrill Lynch. The ERR is simply the ratio of the number of stocks being upgraded by analysts versus the number of downgrades. The chart below shows the ERR over the last 23 years, during which time the average level has been around 0.8 (meaning that 8 stocks were upgraded for every 10 that were downgraded on the month). After dropping to an all-time low of just over 0.2 in 2008, the ERR has recovered sharply and has stayed above 1.0 since early 2009 (around the same time as the bottom in stocks was seen). The ratio recently popped up into the 1.2 range due to upgrades in the Industrial, Technology, Materials and Auto sectors as 4th quarter earnings came in well above expectations for companies such as Deere, Caterpillar, Cliffs Inc., GM, GE, IBM, Apple, Intel, Dell, DuPont and a host of other multinationals that have the common factor of selling primarily into the emerging markets.

In addition to the superb earnings recovery that the market has witnessed since the economy hit bottom in early 2009, it is also worthwhile to note the exceptionally strong financial position that most North American companies are in currently. Following the shocking meltdown in the economy in 2008, corporations were forced to deal with a radically weaker business environment as well as restrictive capital and lending markets that were a threat both to existing operations as well as to growth plans. Not knowing if you would be able to access capital markets, or even knowing if your bank would be in business, motivated senior management to make draconian cuts to expenditures and restructure operations to improve profitability, conserve cash and reduce the need for external financing. The result was a recovery in corporate profits unlike anything we have ever seen once the economy stabilized. The strength of that recovery can be seen in the chart above when looking at the ERR during 2009. The other consequence of this restructuring was a build-up in cash at most North American companies, who were suddenly generating much stronger corporate profit margins and making active commitments to conserve the excess cash being generated in case capital markets stayed constrained. Cash levels have continued to build, as shown in the chart below, such that they are now at 54-year highs. Cash holdings at the S&P500 companies has built up to over US$900 billion, over 50% higher than the prior peak seen back in 2007, prior to the last recession.

These cash balances are now giving companies much more flexibility to choose growth plans as the economy and capital markets continue to recover. Some more mature companies are increasing dividend payouts and many managements have decided to increase share buyback plans while the growth-oriented companies are taking advantage of acquisition opportunities in the market to expand or just adding facilities through capital spending. This is also leading companies to increase payrolls as well to support larger business operations. This growth in employment should also start to support stronger levels of consumer spending which will lead to further growth. The normal multiplier effects of expansion are now starting to come into play and this should continue to support global economic growth, irrespective of the shorter-term risks from the political issues taking place in the Gulf region.

1 2 3