The Enemy Of My Enemy Is My Friend

6/15/2009


At street level, consumers and businesses can become adversaries.

Individual consumers often presume that when they gain the upper hand in negotiating a wage increase or filling their grocery cart with nothing but sale items, the business suffers. Conversely, executives often cite today’s layoffs as a likely cause of tomorrow’s profit growth.

At the level of the individual consumer or business, such sentiments are often correct. But investors should focus on the forest rather than the trees. Consumers account for roughly 70% of gross domestic product, with businesses providing about 12% and the government the rest. Forces that are good for business also tend to be good for consumers. To illustrate this point, let’s refute two commonly held beliefs:

Layoffs do not lift the stock market. Yes, individual stocks may rise on job-cut news in the near term. But many fail to consider that layoffs translate into unemployment, which is not good for stocks. Over the last 48 years, the S&P 500 Index has tended to perform poorly for as long as 12 months after periods of rising unemployment.

Corporate profits do not increase as a result of layoffs. Cost cuts may boost the bottom line for individual companies. But, marketwide, fewer workers means less production, which means less profit. Since 1962, total U.S. corporate profits have tended to fall during periods of rising unemployment. Some might suggest that profits should rise after periods of rising unemployment as the cost cuts take effect. A logical assumption, but also incorrect, as the weakness in corporate profits persists for periods of up to 12 months after bad news in the labor market.

As both a consumer and an investor, you should be concerned about the rise in unemployment, as well as the prospects for higher inflation. But the news is not all bad. While unemployment continues to rise, the pace of layoffs slowed in May. In addition, you can take heart from some better news on the industrial side. Construction spending and factory orders for April came in above expectations. Even residential spending rose slightly, the first gain since August. Both construction spending and orders are still sharply down from a year ago, but the recent improvements suggest the economy may not be getting any worse.

These days, you take your good news where you can get it. Remember, stocks typically rebound long before the economy is firing on all cylinders. Both the Conference Board and University of Michigan consumer-confidence indexes have risen since March, showing that a strong stock market can cover a multitude of ills.

A near-term correction in the stock market would not be a surprise. Unemployment seems likely to keep rising in the near term, and the problems in the housing market are far from resolved. But we may have seen the nastiest piece of the storm.

What to watch
Investors should pay particular attention to oil prices, bond yields, the consumer price index (to be updated June 17), data on durable-goods orders and the gross domestic product (June 25), and a statement from the Federal Open Market Committee (June 26).


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