US Equity and Economic Review; A Slightly Weaker Environment

The ISM manufacturing index increased 1.3 to 49.5, which is still a contraction. However, the internals were hopeful. New orders were 51.5; production increased 2.6 to 52.8 and employment rose 2.6 to 48.5. But new export orders decreased.  The anecdotal comments provided the best news:

• "Low oil prices and reduced activity continue affecting our business." (Petroleum & Coal Products)
• "U.S. business demand is solid; international demand is soft." (Chemical Products)
• "Mobility spend is up." (Computer & Electronic Products)
• "Business has to get better. And it appears it is. Healthy backlog for 2016." (Fabricated Metal Products)
• "Very strong demand for product. Material availability very good and commodity pricing continues to be depressed." (Machinery)
• "Airlines are still ordering planes and spare parts for plane galleys."(Transportation Equipment)
• "Market is beginning to trend up with spring season on its way." (Wood Products)
• "Not seeing impact from global economic volatility or oil prices. Business is strong and growth projections remain the same." (Miscellaneous Manufacturing)
• "Orders are coming in stronger than expected." (Furniture & Related Products)
• "Still a bit sluggish." (Food, Beverage & Tobacco Products) 

With the exception of comments related to the oil market and a few points about international softness, the comments are positive.  Hopefully, this will translate to a reading above 50 in the next few months.

The service sector is still increasing; the ISM services number decreased .1 to 53.4. The report contained mixed internals. While the 3.9 point jump in production and 8 point increase in new orders were positive, employment slid into negative territory with a 49.7 reading. In contrast with the manufacturing report, the anecdotal comments were a bit more mixed:

• "Overall business is increasing." (Health Care & Social Assistance)
• "Business and revenue holding steady with optimistic future aheadfor [the] rest of 2016." (Information)
• "Economy still in very slow growth mode — some additional work scope to current projects helping to maintain current level of business." (Professional, Scientific & Technical Services)
• "Local markets are very competitive." (Finance & Insurance)
• "Industry is being hit with commodity pricing at over 12 year lows." (Mining)
• "Lower food commodity cost of goods due to strong dollar, crude oil glut, Fed interest rate and demand lowering for U.S. exports." (Accommodation & Food Services)
• "Overall business transaction volume and inventory levels up year-over-year. Dealing now with more operational capacity issues, both inhouse and with providers, and difficulty sourcing R&D resources like design, engineering, and sample creation. All good indicators of demand and growth." (Transportation & Warehousing)
• "Continued pressure on commodity prices, low oil prices and resulting impacts on currency exchange continues to cause anxiety for wholesale customers. This is resulting in cautious ordering and shorter commitments on purchase forecast." (Wholesale Trade) 

While some industries are still growing strongly, several mentioned weak commodities prices and a slightly cautious tone on the part of some clients.  These aren’t fatal, but they do indicate a level of concern that would at minimum lower sentiment.

Auto sales were positive:

February's selling pace, estimated to have hit a seasonally adjusted annual rate of more than 17.5 million vehicles, marked a 16-year high for the month,but failed to live up to the 18-million-plus rate of demand that was hit three months in a row late last year. Researcher IHS Automotive said low interestrates, employment gains and inexpensive gasoline likely would lead U.S. sales this year to 17.8 million, higher than last year's 17.5 million.

As this chart shows, they are still near record highs:

However, incentives are accounting for an increasing percentage of sales; some analysts believe this may signal the sales trend has matured for this cycle.

And finally is Friday’s employment report, which had a solid headline rate of 242,000. December and January were revised higher by 30,000. Wages were the only problem:

In February, average hourly earnings for all employees on private nonfarm payrolls declined by 3 cents to $25.35, following an increase of 12 cents in January. Average hourly earnings have risen by 2.2 percent over the year. In February, average hourly earnings of private-sector production and nonsupervisory employees were unchanged at $21.32.     

This month’s drop in wages can be viewed as a claw-back from the large January increase.  And the 2.2% 12-month rise is still positive.  

The Atlanta Fed’s GDP now model predicts a 1Q16 growth rate of 2.2% while forecasting a 10% recession probability. The Cleveland Fed’s interest rate model predicts a 1.9% 1Q growth rate and an 8.82% recession probability. Finally, Moody’s predicts a 1.5% 1Q16 GDP growth rate and 4.56% recession probability.

Economic Conclusion: everything is holding steady, but a few cracks may be emerging. While the manufacturing sector is still contracting, the reports internals are encouraging.  The service sector is still expanding, although there is some underlying weakness probably due to weak oil prices.  The consumer continues to spend and employers are hiring robustly.

Market Outlook: the weak earnings environment has been one of my primary concerns over the last 12 months. Remember that earnings fuel market rallies.  When earnings stall or fall so does the market. 

Several stories this week added depth to the weaker financial picture of US corporations, starting with the increased use of adjusted rather than GAAP accounting methods for reporting.  From Bank of America Merrill Lynch:

“We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of lessearnings power.

Consider that when US GDP growth was averaging 3% (the 5 quarters September 2013 through September 2014) on average 80% of US HY companies reported earnings on an adjusted basis. Since September 2014, however, with US GDP averaging just 1.9%, over 87% of companies have reported on an adjusted basis. Perhaps even more telling, between the end of 2010 and 2013, the percentage of companies reporting adjusted EBITDA was relatively constant and since 2013, the number has been on a steady rise.

We are increasingly concerned with this trend, as on an unadjusted basisnon-commodity earnings growth has been negative 2 of the last 4 quarters, representing the worst 4 quarter average earnings growth in a non-recessionary period since late 2000.”

It’s easy to think accounting is an exact science.  In fact, companies and accountants have a large amount of leeway regarding how to present and report financials. It appears they are doing just that.

Second and third are these two charts from the blog Political Calculations:

The top chart shows that analysts continue to lower their earnings projections while the bottom chart shows dividend cuts are increasing.

Here is the conclusion from these three points: companies are increasingly trying to obfuscate their earnings, are increasingly cutting their dividends while analysts are continually lowering their earnings forecasts.

These are negative developments that add to downward price pressure.