Stocks and Bonds Are Bullish on the Economy

While unemployment remains high and the housing market weak, many large corporations and the stock market are roaring back to life, a sign to some analysts that economic growth next year may be stronger than expected. About 80 percent of companies in the Standard & Poor's 500-stock index that reported third-quarter results as of Oct. 27 have exceeded analysts' per-share profit estimates, helping stocks return to near their 2010 highs. "Equities are a leading indicator," says Thomas Lee, the chief U.S. equity strategist at JPMorgan Chase (JPM) in New York. "We've added $1 trillion to household equity. There's an intangible benefit to business confidence as well. The stronger we finish in 2010, the more optimistic we're going to feel about 2011."

Bond investors are growing less concerned about deflation and the prospect of a double-dip recession. Instead, they are betting that inflation will pick up as the Federal Reserve acts to bolster the economy. On Oct. 25 the Treasury sold $10 billion worth of inflation-protected securities at a negative yield—the first time that has ever happened. The investors who bought the bonds will only make money if consumer prices rise. About 90 percent of respondents to a Citigroup (C) survey said they expect another round of large-scale asset purchases by the Fed, a tactic meant to boost the economy known as quantitative easing, after the central bank's meeting on Nov. 2-3.

Robust earnings and market enthusiasm run counter to pessimism about the U.S. economy ahead of Nov. 2 congressional elections, in which Republicans are expected to take control of the House of Representatives. While the bad data keep coming—the unemployment rate was 9.6 percent and foreclosures reached a record in September—the markets have a different take. "The market is telling us it's not all doom and gloom," says Nariman Behravesh, chief economist at IHS (IHS), a consulting firm in Lexington, Mass. "Earnings are very good in many parts of the economy."

Economists surveyed by Bloomberg News in October forecast an average 2.7 percent growth in gross domestic product this year and 2.4 percent in 2011. Corporate performance fueled by increased productivity and exports may spur economists to raise their estimates for next year, says Joseph G. Carson, director of economic research at AllianceBernstein in New York. "The recovery that started out very narrow is beginning to broaden," he says.

Auto Shipments

Automobile production is aiding the recovery, CSX (CSX) Chief Executive Officer Michael Ward said on Oct. 13. Jacksonville (Fla.)-based CSX, the second-largest publicly traded American railroad, reported third-quarter profit that beat analysts' estimates as a 44 percent increase in auto shipments boosted rail volumes. Ford Motor (F) reported its best third-quarter earnings ever in October. General Electric (GE) is optimistic even after a 5 percent third-quarter sales drop. Higher airline traffic, rail loadings, and cargo freight miles all are positive signs, Chief Financial Officer Keith S. Sherin said in an Oct. 15 interview.

Manufacturing activity in the Federal Reserve's 10th district, which includes all or parts of seven Midwestern states, rebounded in September, and producers' expectations for future activity improved, the Kansas City Fed says. Parker Hannifin (PH), a Cleveland-based maker of valves and pumps, saw sales in its industrial North America division rise 36 percent in the three months ended in September from a year earlier. The company raised its annual forecast after fiscal first-quarter earnings more than tripled. Cargill, the Minnetonka (Minn.)-based grain distributor, said on Oct. 12 that first-quarter profit rose 68 percent. Sales climbed 6 percent, to $27.8 billion.

There are even signs the American consumer may be starting to shop again. Retail sales rose 0.6 percent in September, following a 0.7 percent gain in August that was larger than previously estimated, according to the Commerce Dept. Wal-Mart Stores (WMT), the world's largest retailer, may have "positive" fourth-quarter sales at U.S. stores open at least a year after five consecutive quarters of decline, CEO Michael T. Duke said during an Oct. 13 investor conference. Kohl's (KSS), the fourth-largest American department store chain, plans to hire about 40,000 people this holiday season, 21 percent more than last year, to prepare for a projected increase in sales.

For ING Investment Management's Paul Zemsky, strength in transportation stocks is especially telling. United Parcel Service (UPS) raised its annual profit estimates in October after posting an 80 percent gain last quarter on higher international shipments. Shares of the world's largest package delivery company are up 22 percent since July, while FedEx (FDX), the world's biggest cargo airline, has seen its shares climb 23 percent. "You need those stocks to do well for an economic recovery to be durable," says Zemsky, the New York-based head of asset allocation for ING, which oversees $550 billion. "People who are counting the U.S. economy down-and-out are making a mistake."

The bottom line: Gains in the stock market, plus strong corporate earnings, may indicate that the economy will do better than forecast next year.

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