A Ray of Pre-Holiday Sunshine

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[dropcap]T[/dropcap]he holidays are here. I love this time of year. The air is crisper and the already beautiful San Francisco becomes even more stunning as stores, homes, and office buildings hang colorful lights outside their windows. And aside from the occasional Black Friday shopping brawl, people even seem nicer. But with negative news out of Europe and China, is it really a time for cheer? Surprisingly, yes. The holidays are a good time to point out there are still many positive developments in the old US of A.

Let’s start with one of the biggest and most important: corporate earnings. Simply put, they continue to blow past expectations. According to Zacks.com, third quarter earnings for companies in the S&P 500 were up 14.9 percent year over year (17.8 percent if you exclude financials), and total sales were up 11.3 percent over the same period. More importantly, earnings growth was significantly higher than the 9.7 percent expected at the beginning of the season. These are stellar numbers, and even more impressive when you consider the turmoil erupting across the Atlantic. It appears the impact of Europe’s debt woes on U.S. business activity was fairly muted in the third quarter. Most of the gains occurred in energy, basic materials, industrials and consumer discretionary – all economically sensitive sectors and good barometers of business and consumer activity.

Granted, expectations are for single-digit growth in the fourth quarter, but positive growth nonetheless. Another quarter of upside earnings surprises would not come as a surprise. U.S. retail sales are already significantly outpacing expectations this holiday season. According to comScore, Black Friday sales increased 26 percent over 2011, and Cyber Monday sales of $1.25 billion were up 22 percent, making it the biggest online spending day on record. I guess the three spirits visited Scrooge a little earlier this year. …

And let’s not forget about GDP. Sure, revised third quarter growth of 2 percent was below previous estimates of 2.5 percent. But it’s still well above 1.3 percent in the second quarter and 0.4 percent in the first. Not only is growth positive, it’s accelerating! If we breakdown GDP further, we can see personal consumption expenditures were the largest contributor, while changes in private inventories were the biggest detractor. But is drawing down inventories necessarily a bad thing? Businesses are getting leaner, meaning any future uptick in demand can have a leverage effect on growth.

U.S. corporate balance sheets are also healthier than they’ve been in decades. According to a report by Robert Sadowski of the Federal Reserve Bank of Cleveland, corporations held 7.4 percent of total assets in cash as of September 2010. This is the highest it’s been since the 1950s – a bullish factor for multiple reasons. Companies can use this cash on capital expenditures, dividends, share buybacks, and M&A. All bode well for the economy and stocks.

Based on this data, one would think the business environment is fundamentally sound, maybe even strong in areas. But it certainly doesn’t feel that way, does it? Don’t get me wrong, there are still significant risks out there. Despite improvement in the latest reading, unemployment remains elevated. And even if we pull out of this soon there’s always potential for future inflation spikes given the massive liquidity pumped into the system. But all in all, we continue to see positive incremental developments. The same can be said even outside the U.S.. Germany now appears open to the ECB playing a larger role in stemming the debt crisis, so long as member nations abide by stricter fiscal responsibility. And China recently reduced its reserve ratio – a sign it is shifting focus back on growth.

Final Thoughts

It’s been a challenging year for markets and the general economy, but there are still many positive developments, and that’s something to be cheerful about. All we need is a little nudge to turn them into longer-term trends – a completely conceivable outcome. So grab that glass of eggnog – or my personal favorite a nice full-bodied Syrah – and take some time to relax and enjoy yourself this December. I know I will. Happy holidays!

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Brendan Erne, CFA
Brendan Erne serves as the Portfolio Management Team Leader with Personal Capital Advisors. He has over 15 years of industry experience, spanning almost all levels of the investment process, including several years at Fisher Investments as an equity analyst covering the Technology and Telecommunications sectors. He also co-managed a large cap growth portfolio and co-authored Fisher Investments on Technology, published by John Wiley & Sons. Brendan is a CFA charterholder.
Brendan Erne, CFA

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