Market Outlook – 12 December, 2003(A)

While we have argued for months that the economy and corporate earnings would surprise investors on the upside, we really weren’t prepared for the steady stream of superlatives flowing from the headlines recently.
The first glimmer of good news came with the report that 127,000 jobs were created in the month of October, the first real sign of life on the employment front in nearly three years. You’ll recall that the doomsayers only weeks before had been lamenting the so-called “jobless recovery” and pointing to this fact as a harbinger of bad times ahead.
Then in mid-November third quarter economic growth was estimated to have run at a blistering 7.2% pace; that figure was later revised to an even more torrid 8.2%, the fastest growth since the roaring ’90s. Productivity likewise knocked the lights out in the third quarter, surging over 9% as corporations squeezed every penny of profit from their operations. Now we hear in the first week of December that US manufacturing activity during November shot up at the quickest pace in 20 years, presaging more job creation in the months ahead.
Against such a strong economic background, corporate earnings soared 30% in the third quarter. This caught shell-shocked, too-cautious analysts by surprise and sent them scurrying to revise upward their earnings expectations for the coming year. All of a sudden, the stock market’s sharp rise off of its March lows appeared rational and prescient, which is exactly how the market is suppose to operate.
Back in the dark days of January we argued that the economy and the stock market would recover in 2003 and would do so, in part, for political reasons. We noted that 2003 is the third year of President Bush’s term and that the market last declined in the third year of a president’s term in 1939. In that year the S&P 500 fell less than 1%. We also noted that the median return for the S&P 500 in the third year of a presidential term is 23%. This sort of regularity is no accident and the reasons for it are as obvious as they are cynical. Presidents do whatever it takes to insure a happy electorate come year four, when voters’ pocketbooks determine which levers they pull behind the curtain.
True to form, the Federal Government’s entire arsenal of economic stimuli has been put to work over the past year: a tidal wave of deficit spending is goosing the economy; tax cuts have filled consumers’ pockets with extra cash; the lowest interest rates in 40 years are keeping borrowers borrowing (and thus spending); and a weakened dollar lures overseas buyers for U.S. exports that are now cheaper in world markets. In short, the incumbents have gone all out and the results are precisely as ordered. The question now becomes: How will the economy and the market fare once they’re weaned from these unsustainable stimuli?
The bull case holds that once these artificial measures jump-start the economy, it will feed on its own momentum and become self-sustaining. Rising manufacturing will bring rising employment, which in turn will create greater demand, which will spur more manufacturing, etc. A virtuous cycle.
The bear case argues that once interest rates rise, the tax cuts are spent, the federal deficit gets too big-that is, once the artificial stimuli are removed-economic momentum will wane and with it the stock market’s vigor.
We think the odds are on the bulls’ side in this debate, at least for the next year. One thing recent headlines have made eminently clear is the Feds have put enough wood in the boilers to keep the economic engines humming well into 2004. While we may not favor the political outcome such a rosy outlook predicts, we have to say the path of least resistance for stocks over the coming year leads up.