The Stock Market's Cruel Summer

Economists are beginning to worry that investors are expecting too much out of the U.S. economic recovery.

"This is not a normal recovery," Michael Englund, chief economist at Action Economics, says of recent economic releases. "There are headwinds that are delaying the growth process."

After strong economic data earlier in the year, recent numbers have disappointed:

On June 29, the Conference Board's measure of consumer confidence dropped to 52.9 from 62.7 in May.

Retail sales fell 1.2 percent in May, following a 0.6 percent rise in April.

Also in May, nonfarm private payrolls rose just 41,000 after increases of 158,000 in March and 218,000 in April.

U.S. new home sales dropped 32.7 percent in May.

The consensus on Wall Street is too optimistic about the U.S. economy and, in turn, about U.S. corporate profits, says Standard & Poor's equity strategist Alec Young. "If we continue to get disappointing numbers, analysts will be cutting their earnings estimates."

According to Bloomberg's survey of analysts, earnings of the broad Standard & Poor's 500 index are estimated to rise 34.1 percent this quarter. Alcoa (AA) starts the second-quarter earnings season on July 12.

June Jobs Report

A crucial test of the market's view of the economy will come on the morning of July 2, when the June report is released. "So much is going to depend on job creation," says Prudential Financial (PRU) market strategist Quincy Krosby.

According to Bloomberg's survey of economists, U.S. nonfarm private payrolls are expected to rise 110,000 in June. A weaker number could sap the morale of a market already in negative territory for the year. "If the numbers disappoint on Friday, this market is going to break down," Young says.

The S&P 500 closed down 3.1 percent at 1,041.24 on June 29, and is off 6.6 percent since the beginning of 2010.

Based on how the last two recessions ended, a "soft patch" is not unusual during an economic recovery, says Michael Sheldon, chief market strategist at RDM Financial Group. The difference this time is the severity of the recession and the high levels of debt still plaguing the economy. "There are a number of structural issues that will take time to work through," he says.

Englund believes many observers got "overly enthusiastic" based on better-than-expected March and April data that got an artificial boost. Bad winter storms in January and February led to a "post-weather bounce" in the following months. Now, he says, "some lofty expectations have been trimmed."

Stimulus from the Federal Reserve and U.S. government spending helped spur the economy, but that is waning, says Keith Hembre, chief economist at First American Funds. "We've come off a sugar high from stimulus," he says. The U.S. House of Representatives failed to approve an extension of U.S. unemployment benefits on June 29, and a broader jobs bill failed the previous week.

Earnings Season

When it comes to the economy, one thing that could help reassure investors is a good earnings season—even if better-than-expected profits failed to help the market last time.

During first-quarter earnings season, S&P 500 earnings beat analyst estimates by 14.1 percent, according to Bloomberg. Yet since the start of the last earnings season, the S&P 500 is down 13 percent.

This time, because stocks and expectations have fallen, investors might be more easily impressed. "It could pave the way for a bounce if we get [positive] surprises," Krosby says. Also reassuring would be commentary from CEOs about future sales, earnings growth, and the strength of the economy. "Earnings guidance is taking on an increasingly significant role," she adds.

3M (MMM) said in a statement on June 28 it expects sales of $6.6 billion to $6.75 billion this quarter, more than the $6.56 billion that analysts had estimated according to Bloomberg. 3M Chairman and Chief Executive Officer George W. Buckley told analysts on June 29 that he expects a "pretty good year" in 2010, according to Bloomberg News.

"If we get more comments like 3M's, that could improve investor psychology at least on a temporary basis," Sheldon says.

Unfortunately for anyone trying to make predictions, more is affecting U.S. stocks than the domestic economy and earnings. Global worries—including a growth slowdown in China and debt concerns in Europe—are dragging stocks lower. "The key still is uncertainty over in Europe," says Schaeffer's Investment Research equities analyst Ryan Detrick.

Even if the U.S. economy regains its footing this summer, it could still be slammed later by economic and financial problems from overseas. That signals challenging times ahead for equity investors.

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