The Economic Data Is Better, But That’s Not Enough To Move Me Into The Bull Camp

We are seeing more and more encouraging data. Though definitely a positive, it’s not enough to move me into the bull camp.

The Economy Is RELATIVELY Better

One of the indicators I follow regularly is the ISM manufacturing index. In terms of “real-time” economic data, it’s about as close as we get.

Last month, the index reached its highest level since October. Though the survey still clearly suggests that the economy is contracting (April’s reading was 40.1; scores above 50 imply expansion), the pace of contraction slowed notably. Equally important, key components, such as new orders and production, showed sizeable improvements from March.

April’s job losses were the fewest in 7 months at 539,000. To put this number in perspective, nonfarm payrolls fell by an average of 700,000 per month between December and March.

Then there is Vegas, yes, that Vegas. The CEOs of MGM Mirage (MGM) and Boyd’s Gaming (BYD) used terms like “sequential increases in occupancy levels” and “signs of stabilization”. In layman’s terms, business doesn’t stink as much as it did during the first quarter.

Though casino hotel bookings are not what I would hinge my economic forecast on, combined with other data, they are a positive sign.

Keep in mind, however, that we are not out of the woods. The economy is still going downhill. However, the rate of deterioration is clearly slowing and that’s a big positive.

Earnings Estimates Are Also Looking Better

Brokerage analysts are far more optimistic right now than they were 3 months ago.

During the past 4 weeks, 5,120 full-year earnings estimates have been revised upwards. Three months ago, just 2,152 estimates were revised higher. That’s a 250% improvement.

Before you get too excited, understand that negative revisions still outnumber positive revisions (6,655 versus 5,120). Nonetheless, the revisions ratio (positive revisions divided by negative revisions) has improved for 16 out of the last 20 weeks.

Again, we’re not out of the woods, but there is definitely some sunlight shining through.

Why I Remain Cautious

I’ve been bearish about the markets and think we could see a pullback in stock prices. There are a few reasons why.

First, April was not nearly as good as the bulls made it to be. Yes, the Dow Jones Industrial Average (^DJI) surged 5.5% during the first half of the month. But, in the second half, momentum slowed with the average rising just 1.7%.

Even then, the statistics don’t tell the whole story. From the Apr 16 close to the Apr 30 close, the Dow gained a mere 43 points, or 0.5%.

That’s a big difference in return for someone who bought the Dow Diamonds ETF (DIA) on Apr 16 instead of just a couple of weeks earlier. (DIA is an ETF that tracks the performance of the Dow.)

Secondly, volume is not signaling a lot of conviction on the part of buyers. Throughout March, the SPDR S&P 500 ETF (SPY) experienced average volume of 400 million shares per day. In April, daily volume declined to 287 million shares.

Yet, during this entire time, stocks have risen. And the higher they go, the more the rally is losing steam. That’s not good.

Thirdly, I’m worried about the banks.

Yes, everyone passed the stress test, but it was a questionable test to begin with. Plus, Bank of America (BAC) and 9 others have lots of time to raise funds. But, foreclosures are still rising, credit card defaults will get worse and, despite all of the analysis, nobody still knows how to value the toxic assets.

The government might keep the large banks afloat, but their stock prices and earnings could still suffer. And that alone would cause problems for the stock market. Not to mention that financial stocks (and related ETFs such as Financial Select Sector SPDR (XLF)) are overdue for a pullback based on technical analysis alone.

Fourthly, as earnings season comes to an end, we should see fewer positive revisions to profit forecasts. The ratio of positive to negative revisions typically falls after earnings season, even during good times. I don’t see any reason for this to change.

A drop in positive revisions would be one less catalyst for stocks to go higher.

Finally, the General Motors (GM) situation remains unresolved. If bankruptcy proceedings turn messy, it will cause a big disruption across the entire automotive industry. This, in turn, could create problems for the market.

Be A Buyer, But A Cautious One

The improvement in the data is significant and should not be ignored. If you’ve been sitting on the sidelines, start looking at stocks closely.

What I wouldn’t do, however, is take unnecessary risks. Rather, look for industries with strong signs that business conditions are improving, such as rising earnings estimates on several companies.

And don’t be afraid to dollar-cost average. You still have plenty of time to gradually build new positions.

On the other hand, if you have large gains in risky stocks that you bought in March, consider Bernard M. Baruch’s infamous advice, “Nobody ever lost money taking a profit.”

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