Consumer's Purse Strings Tightening Like a Noose Around Stocks

Gateway's (GTW) earnings and revenue warning brought it all home: The American consumer is slowing down, and at a much quicker pace than many had reckoned.

If you are looking for a reason, look no further than Thursday's weekly jobless claims: The number of people applying for first-time jobless benefits rose to the highest level in more than two years. More than anything -- more than higher interest rates, than higher energy prices, than falling stock-market wealth -- it is the job market that determines how much we buy. It is not for nothing that as the unemployment rate declined from over 7.5% in the early '90s to the present-day 3.9%, measures of consumer confidence steadily climbed. And it is not for nothing that, with the labor market showing the first signs of softening, those same measures are beginning to deteriorate.

Vulnerable

"Job growth has slowed, and if job growth continues to slow, that's going to undermine one of the key cornerstones for consumer spending," says Morgan Stanley Dean Witter chief U.S. economist Richard Berner. "In an environment of much slower job growth, the vulnerability of the economy in general, and the consumer in particular, increases."

The bad news for companies whose fortunes are tied to the consumer -- retailers and consumer cyclicals like car companies, appliance manufacturers and, as has become increasingly apparent, PC makers -- is that it's probably going to get worse before it gets better.

Although there have been signs of slowing employment growth, the unemployment rate remains at its 30-year low. It will probably begin to creep higher when the November jobs report comes out next week, and will continue to creep higher until the Federal Reserve eases and the economy begins to reaccelerate. Even then it will take time, because employment tends to lag behind the economy. Berner notes that the unemployment rate didn't even begin to move higher until after the economy soft-landed in 1995.

Moreover, it may be that a higher unemployment rate is actually one of the conditions for the Fed to begin cutting rates.

Fire Away!

"Basically, the Fed wants to see the unemployment rate go up at least a couple of tenths," says Goldman Sachs director of U.S. economic research Bill Dudley. "That's probably the one thing that's holding them back. They're sort of in reactive mode." With a higher unemployment rate, the Fed could move to a neutral stance when it meets Dec. 19. That could pave the way for lower rates sometime in the first quarter of next year.

Now, the stock market is not about the present but the future, and with the possibility of the Fed easing in the first quarter, one could argue that now is the time to be buying the consumer-related stocks. Sort of looking across the valley at the promised land.

But remember that lag effect. Unemployment continues to rise even after the Fed begins to ease. It's fine to move into the consumer stocks before consumption starts to pick up again, but why not wait until the actual Fed ease rather than on the ease that may come several months out?

Simple and Plain

"It's pretty plain and simple," says Merrill Lynch quantitative strategist Kari Bayer. "The best time to buy consumer cyclicals is when profit cycle is accelerating and the Fed is easing. The Fed is not is certainly not trying to stimulate the consumer right now."

So for now, Bayer thinks the best stocks to own are the ones that offer a constant stream of earnings, no matter what happens to the economy. Everybody's gotta eat, and consumer staples -- foods and beverages -- continue to perform well. The pharmaceutical sector also tends to see its earnings grow at a consistent rate, and it, too, like the staples, has been one of the few things working in a tough market.

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