Double-Dip Fears Overblown - Market Analysis

My view of the economy has long been in-sync with the former, i.e., I expect the economy to continue on its expansionary trajectory, with some moderation in the growth momentum due to global headwinds and continued domestic issues. This view comes from an objective reading of the economy; be it recent developments in the labor market, on the interest rates front, or the manufacturing/nonmanufacturing sides of the economy.

My sense is that we are close to the stage where this view will take hold, helping the markets find their footing. The second-quarter earnings season, just days away now, should help us get there, particularly if management teams are able to reassure about the level of consensus earnings expectations. The current expectations of corporate profitability, if confirmed by management teams on the second-quarter earnings calls, would allay the double-dip fears.

Labor Market Weak, but Still Growing

There is no denying that the economy's job-creating performance has been sub-par in this recovery, particularly when viewed against the extent of job losses suffered since December 2007. With about 7.3 million fewer people working compared to the onset of the Great Recession in late 2007, we need a much faster turnaround in the labor market to make a dent in the jobless rolls.

And simply put, we are not getting that type of a robust labor market turnaround. Leaving aside the headline numbers, the payroll data for each of the last two months has been weak; with June adding 83,000 and May accounting for about 33,000 private-sector job creations. The numbers in March and April were much stronger.

If we look at the first half of 2010, we find a slow and steady positive trend in private sector job creations. The gains in hirings and income have been broad based, supported primarily by a strong turnaround in corporate profitability. As long as those profitability measures remain intact, as referred to earlier, the turnaround in the labor market will remain sustainable.

Lower Treasury Yields Don't Reflect Double-Dip Fears

The yields on Treasury bonds have dropped sharply in recent weeks, with the benchmark 10-year yield now under 3%. The gap between the yields of the 2-year and 10-year Treasury bonds has compressed to its lowest level in months. This is viewed as one of the signals from the bond market of an imminent recessionary relapse. I beg to disagree with that assessment.

My view is that the increased demand for treasury bonds, and the resulting compression in yields, is a direct result of the global headwinds, particularly the European sovereign debt crisis. Moderating economic growth and well-anchored inflation expectations, not deflationary fears, are also at work here. My sense is that as stability returns to the global financial system, particularly if no outright European defaults materialize, the treasury yields may start moving higher. But that is some way off for now.

We look for continued low short-term rates, given the Fed's well choreographed intent to keep rates low for an 'extended period', which in my view means at least through the middle of next year. As such, the interest backdrop should continue to remain supportive.

Momentum Slowing, but Economy Still Growing

Recent economic reports show a faltering growth momentum in the economy, but interpreting this to mean the onset of a double-dip is a stretch, in my view. We saw that with consumer confidence and the manufacturing ISM survey. Today's nonmanufacturing ISM tells a similar story.

The nonmanufacturing ISM Index for June, which essentially reflects a survey of purchasing managers in the U.S. services-related businesses, showed a reading of 53.8 for June, down from 55.4 in May. This index averaged 53.0 in the first quarter and 49.4 in the fourth quarter of 2009. The growth momentum thus far has mostly been on the economy's manufacturing side, which has benefited from inventory restocking and global demand. But last week's manufacturing ISM index reading was a drop from the prior month as well.

But manufacturing is much smaller than the service sector, in terms of its contribution to the U.S. economy. And we haven't really seen the type of growth in the service sector as we have seen on the manufacturing side. But we should keep in mind that readings of 50.0 and above, on both the indexes, indicate economic expansion. And we remain above that level in both places.

Putting it all together, I expect the current uncertain economic outlook to linger some more. But the second-quarter earnings season should start providing clarity and visibility, particularly with respect to the earnings outlook for the second half of the year and also next year. Assurances on current earnings growth expectations would go a long way towards allaying the worst of the fears.

Portfolio Update

We made six changes to the portfolios last week; adding two stocks and deleting four. We added one each to the Focus List and the Growth & Income portfolios, while three of the four deletions were from the Growth & Income portfolio. There were also changes to the Timely Buys list.

We added two insurers last week - Assurant (AIZ) to the G&I and Meadowbrook Insurance (MIG) to the Focus List - to gain exposure to a relatively stable sector in the current turbulent environment. Both companies offer solid earnings momentum and attractive valuations at current levels.

Our sole Focus List deletion was Maidenform Brands (MFB) to lock in our attractive 55% gain in the stock in the face of fast-emerging weakness in this retail-centric name. The company's fundamentals look good and we wouldn't be averse to reconsidering it a later date.

Our exit from L-3 Communications (LLL) followed weak guidance and its inability to win a government contract. We suspected that the Zacks Rank would follow the recent negative estimate revisions.

The other deletions - Alcon (ACL) and T. Rowe Price (TROW) - were prompted by Zacks Rank moves to #4 (ACL) and #5 (TROW). We always exit positions that have fallen to a Zacks #4 Rank ('sell') or Zacks #5 Rank ('strong sell') to remain consistent with the Zacks investment framework.

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