US Perspectives: Not All Labor Markets Are Dead

Building on the monthly employment report, weekly initial unemployment claims improved yet again, though I am a bit suspicious that a holiday-shortened reporting period may have helped keep claims artificially low. Then, just as thing were looking up, tech bellwether Cisco laid an egg as the company meaningfully reduced growth estimates for the upcoming quarter, although expectations were met for the just-completed quarter. New concerns about the European debt situation, with a special focus on Ireland and Portugal, certainly did not help markets on Thursday, either.

Capping this not-so-wonderful week was news out of China that its consumer price index jumped to 4.4% in October. This immediately ignited fears that China would raise rates or reserve requirements to slow growth. This in turn caused a dip in Asian and Australian markets as well as a meaningful decline in commodities ranging from gold to oil. The drum beat of bad news drove the S&P 500 down by 2.2% last week.

Google's Salary Boost Shows Not All Labor Markets Are Dead

In a positive note for all of us working trudgers, out of the clear blue, Google announced it would give every one of its 23,000 employees an automatic 10% salary increase beginning in January. While recent defections and tight competition with neighboring Facebook make this a special case, it pours cold water on the theory that every labor market will remain weak just because the national rate (or even the California rate, for that matter) remains so elevated. In an article that will surely get pasted to human resources cubicles across the land, management noted a Google survey indicating employees had a preference for salary increases over bonus and equity awards, and Google was granting that wish.

The Trade Report Shows Modest Improvement

The trade report for September came in better than expected at $44.50 billion, lower than August's $46.5 billion level and well below June's $49.8 billion disaster. Just as importantly, when the Bureau of Economic Analysis estimated the September trade number to prepare its third-quarter GDP estimate, they incorrectly assumed the trade deficit would worsen. Instead the deficit fell. This should add at least a couple of tenths of percent growth to the already better than expected 2.0% GDP growth rate for the third quarter when the next revision of the GDP is released on Nov. 23.

I have been watching the trade balance report like a hawk because it single-handedly took almost 3 percentage points off of what otherwise would have been an excellent June-quarter GDP report. Consumers have been willing to spend more than what many analysts give them credit for; unfortunately, many purchases have been imports. Consumer imports were one of the real bright spots in September; imports of consumer goods fell by $1.9 billion, and auto imports fell by $1.5 billion. Export growth was not as exciting, but as I suspected, agricultural and food exports picked up due to crop failures around the world. Unfortunately, the food category probably won't prove large enough to make much difference in the overall trade statistics. Overall, the falling dollar should bode well for trade figures in the months ahead. A falling dollar makes U.S. goods more competitive in foreign markets.

Cisco Earnings--End to the Tech Boom, or a Special Situation?

As an economist, I usually view Cisco as an important bellwether for technology spending specifically and corporate investment spending more generally. The analyst community seemed divided on whether Cisco's projections that revenue growth would drop from the high-teens range in the most recent quarter to single digits for the January 2011 quarter meant an end to the boom in tech spending or whether it was an unfortunate combination of special circumstances.

For the record, Morningstar analyst Joseph Beaulieu was in the "special situations" camp with earnings hurt partially by weakening public sector demand, slowing demand from service providers (cable and telecom companies), and hefty exposure to weak European markets. Furthermore, the current tech boom seems a bit more focused on computer hardware and software than the more telecom-related products Cisco produces. Nevertheless, the report raised a caution flag for companies that sell extensively to government agencies and to slower-growth European markets.

China May Tighten with Heightened CPI

China reported an increase in its consumer price index from 3.6% in September to 4.4% in October. That would make it increasingly hard for China to stay under 3% inflation for all of 2010. Without some type of intervention, it looks as though inflation forecasts could exceed 4% in 2011. Increasing food prices, which make up a relatively large portion of the index, helped drive the CPI to its highest rate in more than two years.

That type of rate would upset Chinese consumers and force the government into action. Given that China is the price setter in a broad array of commodities and a leading importer of European goods, the market did not take kindly to the news on Friday. The news was particularly disappointing as previous reserve requirement boosts and rate increases earlier in the year have failed to stop the inflationary train.

Using 10-Year Average Earnings the Market Looks Elevated, on 2011 Earnings Not so Much

Previously I got a lot of questions on the 10-year price/earnings ratio; I'd mentioned that the market valuations might be looking a little rich at 22 times earnings versus a long-term historical average of just under 17. The price/earnings ratio I cited was developed by Yale's professor Robert Shiller. The index uses a 10-year average of annual S&P earnings and compares those earnings to the current level of the S&P 500. Professor Shiller kindly produces new readings each month on a public website.

Using a 10-year average tends to remove some of the extreme earnings volatility issues involved with just one year's worth of data. To give you some feel for how volatile the annual data can be, annual earnings have been as high as $84.92 and as low as $6.86 in just the last 10 years. By consistently using 10 years' worth of data, we tend to capture at least one whole economic cycle, not just one weird peak or trough year. Also, using 10-year historical data removes the need to forecast future data. Removing the need to predict short-term future earnings is a very good thing; the range of estimates is generally wide and generally too optimistic at peaks and too low at bottoms. One might question the use of historical data, but long-term growth of S&P earnings is surprisingly stable (at about 6%, by the way). If earnings grew 1% in one decade and 10% in another, using historical data would prove a bit more risky.

That said, the measure might not be perfect. There's nothing particularly magic about a period of 10 years. It might not even capture one complete economic cycle, or it might capture more than two cycles. It might catch a peak at the beginning of the 10-year measurement period and a peak at the end, or combination of peak earnings and trough earnings. This time, near-zero earnings during the financial crisis are weighing particularly hard on the 10-year measure. In round numbers, the 10-year average of S&P earnings is $55. On that level of earnings, the market looks expensive at just under 22 times earnings. But looking at forecast S&P earnings of approximately $75 for 2010 and $90 for 2011, the market looks much less expensive at 16 and 13 times earnings.

Morningstar's Price/Fair Value Estimate Stands at 1.03

By way of comparison, Morningstar' proprietary price/fair value index also shows that the market is relatively expensive at 1.03 times Morningstar's fair value estimate. However, the track record of this metric is relatively short, with just about 10 years of data. From 2001 to 2010--our entire track record--that metric has ranged from a high of 1.14 to a low of 0.55.

I am detouring into a discussion of market valuations because I am feeling pretty good about the economy again, especially given the week before last week's employment report and last week's balance of trade report. However, a lot of that good news may be at least partially embedded in market prices.

Retail Sales, Inflation Data, Real Estate Data, and Manufacturing Data on the Docket

I expect good news on the government's retail sales report, but so does everyone else. Previously announced same store-sales reports from individual stores and nicely improved auto sales could drive retail sales as high as 0.7% according to consensus forecasts. That would beat September's already elevated 0.6% growth rate.

By far the most important number for this week is the consumer price index. Consumer incomes have begun to show some decent growth, and I'd really hate to see that improvement eroded away by the effects of renewed inflation. The results lately have been a bit jumpy with a couple of months of 3.6% annualized growth this summer before a fall back to the 1.2% level for September. The consensus calls for another 0.3% jump (3.6% annualized), which seems a little high to me.

Housing starts are also due, and I remain hopeful this metric will stay flat or show modest growth. Mortgage moratorium issues with existing homes may begin to drive potential housing buyers to consider a new home as a plausible alternative. Again, as long as the number doesn't fall off a cliff, I wouldn't worry much about either a small increase or decrease.

There will be a lot of manufacturing reports this week, including industrial production and two regional purchasing managers' reports. I suspect industrial production may be relatively flat, which may disappoint a few analysts looking for better growth. The regional PMI reports should be pretty flat, too, as auto production remains relatively flat. At this stage of the recovery, I am not particularly worried about the manufacturing sector.

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