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Get Ready for a Growth Surprise

A smaller trade deficit would push the first-quarter growth rate higher than estimated.
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I interrupt today's regularly scheduled gloom and doom with this message: It looks like everything is falling into place for a growth surprise on May 26.

And that would mean that stocks, which interrupted the rally that began on April 20 by tumbling more than 100 points twice last week, are now buys on weakness.

I know it doesn't feel that way right now. In fact, the news recently has just seemed to go from bad to worse.

Escalating Worries

It all started on April 28, when the U.S. Department of Commerce issued its advance first-quarter report. It showed economic growth in the first quarter dropping to 3.1% from 3.8% in the fourth quarter of 2004 and 4% in the third quarter.

Suddenly, nagging concerns that the economy might be slowing -- fueled by a weaker-than-expected April retail sales report -- became full-scale anxieties. Retail sales climbed just 0.3% in March, well below the 0.8% consensus expectation and behind February's 0.5% rate.

Those worries were compounded this month when Standard & Poor's downgraded the debt of

General Motors



Ford Motor


to junk-bond status. Wall Street analysts, noting that the two car companies had $500 billion in debt out there, immediately began to wonder who was holding the bag.

Once again, Standard & Poor's pointed the way with credit downgrades on two complex types of derivatives known as collateralized debt obligations, or CDOs, and credit-default swaps. Both are products designed to provide insurance to a bondholder against a potential corporate default.

On May 10, Standard & Poor's lowered its credit ratings on about $80 million in CDOs sold by

Deutsche Bank


. The next day, Standard & Poor's downgraded more CDOs arranged by

BNP Paribas

. In addition to receiving a fee for managing the transactions, banks often keep a portion of some of the riskier pieces of each derivative, which also carry the highest yields, for their own portfolios.

Nobody was saying it out loud, but quietly traders worried that a financial institution had kept too much of a derivative that went sour. A big enough bet could put an entire seemingly sound company at risk of a default on its derivative contracts that would ripple through the financial markets.

And Wall Street knew that there was enough evidence coming in from hedge funds, some of the biggest purchasers of derivatives, to show that some players in the market were taking large and unexpected losses. A few European hedge funds had been telling investors that they'd taken losses of as much as 5% on some of their funds in April, and the fear was that May would bring even worse news.

Feeding the fear was the knowledge that some derivative products weren't performing as designed. Instead of providing insurance, they were actually adding to the losses suffered by investors.

A Vicious Cycle

Fears like these feed on themselves. In the financial markets, fearful investors decide to sell ahead of the bad news they expect -- and that creates exactly the selling and lower prices they anticipated. This, of course, generates more selling.

That kind of negative feedback even works with economic forecasts. A month ago, the 56 economists surveyed regularly by

The Wall Street Journal

were projecting 3.7% growth for the second quarter of 2005. The economists have grown much, much more pessimistic and are now projecting 3.2% growth. That's a big 14% drop in the projected growth rate. Is it the result of new data that show the economy is slowing, or just a reflection of the pessimism that grips the financial markets right now?

I'd argue the latter -- that the economists' pessimism is more a reflection of where we are than a projection based on new data for the future.

And I'd argue the data started to turn for the better May 12, the very day that the


published the economists' downgrade of the U.S. economy.

Good News Is Out There

Also on that day, the Commerce Department reported stronger-than-expected retail sales for April, which followed a soft March number. Retail sales climbed 1.4% in April, almost double the 0.7% growth rate expected by economists on and off Wall Street.

This is actually the second piece of unexpected good news on the economy delivered in the last few days. On May 11, the Commerce Department (again) released numbers showing that the March trade deficit was much lower than expected, if still a whopping $55 billion. Economists had been expecting a deficit near $61 billion. (The February deficit was revised slightly lower, too, to $60.6 billion from $61 billion.) The unexpectedly small gap was a result of a drop in imports of 2.5% and an increase in exports of 1.5%. The export number was led by a 3% jump in capital goods, a category that is often a key indicator of the level of growth in the economy.

But to me, the best part of the trade deficit numbers is that they just about guarantee that the growth rate for the economy in the first quarter will be revised upward when the Commerce Department issues a more complete report on May 26. The numbers on economic growth reported on April 28 were only the "advance" estimate. Since data from different parts of the economy flow in at different speeds, the number-crunchers at the Commerce Department have to make estimates of economic activity when they issue their first report. More exact data go into the "preliminary" estimate announced about a month later. (The final, final figures on first-quarter growth will come out around the time the department reports advance estimates for the second quarter in July.)

In their advance report, the statisticians used an estimate for the March trade deficit of $61.3 billion. When they do their revisions for the preliminary report on May 26, they'll use the actual March numbers (and the revised February data). The lower deficit, the smaller level of imports and the higher level of exports will all work to push the growth rate for the first quarter higher than the initial 3.1% estimate.

Watch for the Report

So May 26 is almost certain to produce a growth surprise. If it's a big enough surprise, it will get investors' attention. If it's big enough, it will end the worries about slower growth, at least for a while, and investors will decide that, as in 2004, the economy merely hit a minor soft spot. And if it's big enough, investors might actually notice that stocks are now a relative bargain.

On May 12, 2004, the

Standard & Poor's 500

stock index traded at 1097. Operating earnings for the trailing 12 months at the end of the first quarter of 2004 for the 500 S&P stocks came to $58.08, giving the index a price-to-earnings ratio of 18.9.

On May 12, 2005, the S&P 500 closed at 1159. Operating earnings for the trailing 12 months at the end of the first quarter of 2005 are estimated at $69.74 by Standard & Poor's. That puts the price-to-earnings ratio of the index at just 16.5.

What's happened, of course, in the year between May 12, 2004, and May 12, 2005, is that operating earnings have climbed better than 20%, while the price of stocks has gone up just 6%.

And we all know what happened in 2004 after May 12, don't we? From that date to the end of the year, the S&P 500 index gained better than 10% -- before dividends.

A Caveat

There's only one thing stopping me from turning all this analysis into a loud cry to load up the truck right now.

I don't know if the growth surprise I expect on May 26 is going to be big enough to get currently worried investors' attention. If not, we could replay a less pleasant aspect of the market history of 2004. May 12 didn't mark the low for 2004. The market didn't put that in until Aug. 12 at 1063. In between May 12 and Aug. 12, the market rallied to a high of 1144 on June 23 before slumping back to the August low.

I don't expect history to repeat itself exactly in 2005 -- as Mark Twain reportedly said, history doesn't repeat itself, but it sometimes rhymes. It's quite possible that the derivative scares of this spring are serious enough to put some serious hurt on the financial markets from current levels.

So I think an investor needs to build a portfolio that's balanced between stocks that will go up strongly if things get even dicier from here and stocks that will climb strongly if the growth surprise comes in strong.

I've got a fair dose of the first kind of stock in Jubak's Picks. Gold stocks go up when fear rules the markets. If we're headed for a financial dust-up over derivatives, I want to be in gold -- and cash.

But I'm short on classic growth stocks of the kind that go up most strongly when the market shifts from worrying about growth to cheerleading about growth. (Oh, sure, energy and oil-drilling stocks will do well if growth picks up, so I'm not dumping that sector, one of my favorites for the long term. But I think I can find a kind of growth stock that will do even better.)

At the time of publication, Jim Jubak did not own or control shares in any stock mentioned in this column.