Q1 Earnings

By the end of last week just over half of the companies in the S&P 500 reported earnings and so far Q1 profits are expected to fall around 14%. Not good, but better than the 24% decline we saw in Q4 ‘07. On a positive note, companies from the energy, technology, and industrial sectors are reporting the biggest profit increase for Q1, and if you take out the financial sector, profits are actually expected to be up around 8.6%. Firms with a strong international presence are also benefiting from overseas growth and a weak dollar.

Some in the media are proclaiming the worst in the credit crisis induced market sell-off is behind us, but with only $250 billion of an expected $1 trillion (courtesy of the IMF) in sub-prime write-offs behind us, more bad news form the credit market is likely. We may never hear about many of the write-downs held at pension funds and sovereign wealth funds but more debt downgrades from the rating agencies are likely to hit the banking sector. More telling, there is little evidence banks have started lending to each other again as LIBOR rates jumped up around 20 basis points in the last week moving the TED SPREAD further into negative territory.

On top of credit market issues, a deflating residential real estate market and higher energy and food prices have the U.S. consumer in a foul mood. Confidenced readings are very very low.

It is hard to imagine stocks advancing much from this level but there may be a few pockets of opportunity.

Ongoing globalization may be able to help deliver some positive returns in 2008. Raw material demands from emerging markets have put pressure on commodity prices and some of the industries closely associated with commodities (agriculture, mining, energy) are experiencing a favorable business climate as a result. But the commodity price link between these investments can introduce an additional element of risk and a global economic slowdown would likely reduce demand for raw materials. Also, the pricing pressure for food and energy cost are likely to send inflation numbers higher globally, eroding real returns.

One commodity that is under pressure is gold. It continues to decline from its March sell-off, on a strengthening dollar and increased risk appetites by investors.

When comparing international stocks with U.S. stocks in the short term, the Vanguard Total Market Index (VTI) for the U.S. has declined 10.19% from the October 2007 highs while the Vanguard All World Ex-US (VEU) is down only 8.18% during the same period. Interestingly, since the March ’08 bottom the VTI is up 9.52% while the VEU is up 11.41%. Below is a one year chart of the two indexes.

With emerging countries strengthening their economies and instituting improved financial systems, it is possible a U.S. slowdown will have a smaller effect on other parts of the world.

As is usually the case, there is conflicting data to contend with in terms of investment opportunities. Given uncertainty in credit markets, the real estate and economic slowdown in the U.S., and the grumpy U.S. consumer, I believe a defensive bias in portfolios has merit.

Stocks Take The Lead

World Markets

Stocks asserted their leadership over other asset classes during the past week gaining just over 4%, as measured by the S&P 500. Last week also saw the DJ-30 and NASDAQ break through resistance levels; the S&P 500 and NYSE have yet to do so. U.S. stocks saw several market leaders emerge, a positive development. Volume did pick up but still came in below average.

U.S. REITs turned in a strong performance followed by stocks in emerging and other developed countries. IBD reported the Shanghai Index is down 41% so far in '08 and 49% since October '07 highs, possibly presenting an opportunity for patient investors. Commodities also saw small gains, bonds fell for the week.

This coming week a broader representation and larger number of companies will report earnings. MarketWatch reported the overall earnings outlook has only weakened slightly from a 14.1% decline to a 14.6% with 157 companies from the S&P 500 having reported. Companies with a larger percentage of business overseas are benefiting, as expected, from a weak dollar and stronger economies internationally.

World Economy

A slightly better than expected report from U.S. retailers was followed by weak reports from manufacturers and the housing market. Industrial production in the Euro Zone appears to be holding but the ECB warned a slowdown could be coming. The WTO expects world trade growth will slow to a 6-year low of 4.5% in ’08, versus 5.5% in ’07 and 8.5% in ’06. LIBOR rates spiked mid-week causing the spread between LIBOR and Treasuries to widen, a sign of continued tight lending conditions between banks.

Inflation Data

Higher wages in the Euro Zone has the ECB on inflation alert. In the U.S. producer prices jumped 1.1% in March, double forecast. Core inflation hit 2.7%, its highest level in nearly 3 years. Still, the Economic Cycle Research Institute reading on future inflation continues to signal we are in an inflationary cycle downturn.

Summary

At this point we have an intermediate term rally underway. It remains to be seen whether it can mature into the start of a new bull market for U.S. stocks. For a nice combined market/economic summary, check out this story on MarketWatch, Five signs the market has bottomed.

Without Conviction

I mentioned that last week's divergent development may represent a positive tone for stocks, which by chance, played out. Stocks surged on Tuesday and held higher ground for the balance of the week. Some stock investors appear to believe the worst of the credit mess is behind us and any U.S. recession will be mild.

World Market Summary

U.S. stocks turned in a good performance for the week with the S&P 500 delivering a 4.2% gain. The NASDAQ 100 was the big winner for broad indexes, up 5.56%. REITs also performed well adding 6.99%. Emerging country stocks added 5.37% and international developed country stocks were up 4.41%.

Top sectors included current leaders Metals & Mining and Steel. Home builders also topped the list up 57% (that not a typo, check out ITB) since early January 2008 but is still down 50% from January 2007 highs. International sectors were led by finance, up 6.82% and materials, up 5.67%.

Asian and Latin America countries continue to represent the top performing emerging markets and Australia followed by Italy and U.K. topped developed countries.

Price action for stocks was constructive during the week. Stock leadership broaden and more successful breakouts materialized, both positive developments. However, volume has been lighter than average over the last two weeks. By comparison, the early 2003 market recovery shows a much higher level of market activity. The market is trying to tell us we have heard the worst from big banks and any U.S. recession will be shallow; but not convincingly.

World Economy Summary

U.S. manufacturing continues to be weak, unemployment is up, and retail sales are down. We are hearing more frequently from international monetary authorities regarding their concerns about inflation. Big banks continue to work through credit related issues and Lehman Brothers did successfully raised $4 billion in new capital but the TED SPREAD (3-month T-Bill – LIBOR) only narrowed a bit during the week as banks continue to be hold their cash.

Is The Worst Over?

During the next couple of weeks we are going to have a much better picture of how the current credit conditions, slowing economy, and rising commodity prices are impacting corporate earnings. Earnings season officially kicks off today and by the end of next week a good portion of the warnings should be issued. By some P/E estimates stocks are no bargain, even at current prices.

By most accounts we can expect more large credit-write downs from banks in the coming quarters.

It is entirely possible the worst of the market decline is behind us but mini-rallies in correcting markets are part of the process.