Midday Musings: Watching the Expectations Grow

The news of U.S. casualties sustained in the latest offensive in Afghanistan is a stark reminder that we are still a nation at war with an enemy that has been beaten down but not vanquished. On a far less serious note, the disappointing results from Oracle (ORCL Quote) late Friday are a reminder that corporate earnings remain under pressure, despite evidence of the economy's recovery.

But the market's action midday Monday is a reminder that news only matters when it matters. That is to say, the market has a way of focusing on only what it wishes to focus on at any given moment. Currently, what the market -- and market participants -- wish to focus on are the factors that spurred last week's advance.

Specifically, they are focusing on the healthier economic reports -- culminating with Friday's better-than-expected report from the Institute of Supply Management -- that have prompted many market watchers to raise their expectations for earnings and the economy.

Case in point is Bruce Steinberg, chief economist at Merrill Lynch, who this morning lifted his GDP forecast to 3.5% for both the first and second quarters vs. 2% and 3%, respectively, previously. Steinberg left unchanged his forecast of 5% growth in the second half. On a year-over-year basis, he expects GDP to be up 4.3% in the fourth quarter.

"A stronger economy means better earnings," the economist continued, raising his forecast for S&P 500 operating earnings to $45 in 2002 and to $55 in 2003, each $1 higher than previous estimates. "Productivity growth is phenomenal, leading to declines in unit labor costs and wider profit margins, despite an utter lack of pricing power."

Two keys to Steinberg's optimistic view are the "resilient" consumer and prospects for improved capital spending.

From the consumer, he's expecting 3% spending growth this year, leaving "plenty of room for upside surprises." Regarding capital spending, Steinberg now expects 5% growth in the first quarter vs. previous expectations for a decline, with tech spending accounting for most of the gain.

Finally, even if the economy expands rapidly, the economist doesn't foresee the Federal Reserve being in any rush to tighten. The Fed expects growth of only 2.5% to 3% in 2002, which wouldn't be enough to prompt a rate hike, he suggested. "If our [more optimistic] forecast plays out, the Fed would tighten later in the year, but probably not until the fall."

Noting that inflation "has always declined in the first year of U.S. recoveries," Steinberg thus concludes that "any rise in bond yields this year is likely to be modest."

Continuing Friday's trend, the price of the benchmark 10-year Treasury was down 7/32 to 98 31/32 at midday, its yield rising three basis points to 5.01%, which is modest only if you're not long the note.

The market's midday gains, Steinberg's note, plus the page-one story in The Wall Street Journal about the economy's newfound flexibility, suggest that the concerns raised by Lakshman Achuthan, managing director of the Economic Cycle Research Institute, here last Thursday will prove prophetic.

In a nutshell, Achuthan warned that because the recession of 2001 appears to have already ended -- and with just one quarter of declining GDP -- champions of "New Era" theories would be reinvigorated. Achuthan doesn't foresee an exact repeat of the 1990s scenario but cautioned that there are potentially dangerous implications for investors who follow the lead of New Era economists.

Step one of the process appears to be unfolding right on schedule.

Speaking of Which...

Coincidentally, Richard Bernstein, chief U.S. equity strategist at Merrill Lynch, also issued a report this morning, noting that his sell-side indicator has risen to 69.6% as of Feb. 28, up from 69.1% at the end of January. There have only been five higher readings in the history of the indicator, which is based on the recommended equity allocations of Wall Street strategists, including Bernstein, who maintains a defensive recommendation of 50% stocks, 30% bonds and 20% cash.

"Wall Street strategists continue to believe that the current environment represents one of the best times to buy equities in the last 16 years, and remain unusually confident regarding the effectiveness of monetary and fiscal policy," Bernstein wrote. "We continue to believe that there is a disconnect between the actual profits recovery and the stock market's view of how strong and rapid that profits recovery might be."