Market upswing will go on, 2-3% Q3 growth: Interview with Jacob Hurwitz

Jacob Hurwitz is an independent Minneapolis-based financial advisor. Formerly he was a principal at Kenwood Capital Management, which managed small and mid-cap U.S. equity portfolios for institutional and individual clients. Previously he was senior vice president and portfolio manager at the Hartford-based Travelers Investment Management Co.

Harlan Levy is a business reporter and columnist at the Connecticut daily newspaper the Journal Inquirer.

H.L.: Has the continuing stock rally since March gotten ahead of the economy?

J.H.: Absolutely not. By all indications, the economy is clearly on an upswing. Federal Reserve readings on the pace of the economy released last week show all 10 geographic regions of the United States on a strong recovery led by autos, pharmaceuticals, semi-conductors, and, importantly, temporary employment.

Consumer confidence continues to rise. Importantly, maybe most importantly, it’s quite evident that the global recovery is V-shaped, except for the U.S., where the rebound has been less dynamic. In the second quarter, 10 countries reported positive gross domestic product, and these were not just emerging countries.

It’s also close to a certainty that the third quarter economic growth in the U.S. will be positive, likely in the 2 to 3 percent range, due to the federal stimulus package and the “Cash for Clunkers” program, rising sales of new and existing homes, improving retail sales, less negative employment trends, and rock-bottom interest rates. Estimates for corporate profits are rising sharply, reflecting the huge operating leverage in the U.S. economy. Additionally, almost 40 percent of the S&amp;P 500’s earnings are sourced overseas and will benefit from the strong global recovery.<

In conclusion, the market has been discounting the probability of a much brighter U.S. and global environment well into 2010. Therefore, it’s no surprise that the market has risen as sharply as it has, given that the global economy did not come to an end, as the market was discounting last winter.

H.L.: The going trend in the stock market seems to be that you don’t sell strength; you buy strength. What do you think of that?

J.H.: The market is now in a well-established uptrend, and it’s likely that that uptrend will continue into 2010. The returns to holding cash are almost zero, and longer-dated bond returns will likely be negative as interest rates edge up. U.S. equity valuations are reasonable, especially given the probability of sharply higher corporate profits over the coming quarters.

Many individual and portfolio managers have been underinvested over the last six months, and on the institutional side in particular it has proven difficult and painful for these portfolio managers to miss the rally. There’s a bias, therefore, to buying stocks and not selling them, and this is likely to continue over the coming months.

H.L.: It seems as if stock prices rise as the dollar weakens. What do you think of that, and is a weak dollar a good thing?

J.H.: A weakening dollar benefits companies that sell products into the global market and benefits in particular commodities producers, such as those in the field of oil exploration and production and basic materials such as copper, steel, and aluminum. The stocks of companies operating in these industries have been beneficiaries of the weaker dollar. Stocks in more defensive sectors, such as healthcare, consumer staples, and utilities are less exposed to currency fluctuations.

A managed weakness or gradual weakening in the currency can be absorbed by the market over time. However, a sharply lower dollar would prove very problematical for the U.S. equity markets and our economy as a whole, because it likely would produce, or even be the result of foreign investors bailing out. We need their capital.

H.L.: Do you see a correction in the stock market any time soon?

J.H.: There still is a healthy amount of skepticism regarding the U.S. equity markets among all investors. That’s a bullish factor. This doesn’t preclude a 5 to 10 percent correction at any time. We are heading into third-quarter earnings season. While it’s likely that in total these earnings will surprise on the positive side, you shouldn’t expect either every report or every trading day to be positive.

H.L.: What are the prospects on the labor front, especially in light of the fact that the true number of jobless may be a lot more than the unemployment rate recognizes, since many workers have stopped looking for work, and they don’t go into the data?

J.H.: The pain inflicted on the American labor force through this recession cannot be underestimated. There are some indications that if we apply the same methodology to calculating the jobless rate as was in effect 30 years ago the rate today would be closer to 15 percent, not the current 9-to-10 percent. It’s obvious that a lot of disillusioned workers have stopped looking for work. However, the pace of job cuts has lessened.

Some forecasters believe that the cuts will be behind us around year-end. I’m not quite that optimistic. At some point in the first half of 2010 I expect the economy to be adding jobs. However, it should take the creation of almost 10 million jobs to absorb those who have lost work in the last two years. I believe that the reported jobless rate will peak very close to where it is now.

H.L.: Are our banks as healthy as they seem to be saying?

J.H.: The banking system is not out of the woods. Emerging problems in the commercial real estate sector – shopping centers or office buildings, for example – will continue to grow over the coming year and will likely lead to another round of write-offs by the banks. Improving profitability in the banking system should finance internally much of this problem, but the problem itself will continue to pressure our banking system for some time.

Credit is still difficult to obtain, but lending surveys are showing an improved willingness to lend, if only to the most creditworthy borrowers. This is good, but it needs to get better.

Much of our economic growth over the last 20 years was financed by bank lending against assets of all kinds, including autos, houses, commercial real estate, student loans, for example. The banks then immediately turned around and packaged these loans in the securitization process and sold these packages to individual and institutional investors, as well as other banks. The market for securitized loans evaporated last year and is not likely to come back for some time. This will mute both bank lending and overall economic growth in the coming years.

H.L.: How do you view the housing problem?

J.H.: Housing is getting better, and foreclosures will probably peak by the end of the year. That said, as has been the case coming out of prior periods of housing weakness, you should expect flattish home prices for anywhere from two to five years. Much of the nation’s economic growth this decade came from rising home prices, so flat prices obviously won’t drive stronger economic growth. If you’re looking for growth, you have to find it someplace else.