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Recovery Seen in Second Half—but Will Stocks Care?

Published: Friday, 26 Jun 2009 | 8:26 PM ET

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By: Patti Domm
Executive Editor

Stocks enter the second half of the year with trepidation, despite the fact that the economy may finally start to show real signs of recovery.

The coming week marks a turning point for the market, which so far shows a solid gain for the second quarter of about 15 percent for the S&P 500 and nearly 20 percent for the Nasdaq. The Dow is up about 11 percent. If the quarter closes out at these levels Tuesday, it will be the first time since fourth quarter, 2003 that all three indices scored double digit gains and the first time since third quarter, 2007 that they finished positive. All but the Dow have gained on the year.

The week also bridges the tail end of the second quarter and the first days of the third quarter, which economists mostly expect to be markedly better than the second quarter and some even see turning positive.

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A few key pieces of economic data are due, unusual for the typically quiet, holiday-shortened Fourth of July week. The June employment report is likely to show unemployment creeping closer to double digits when it is released Thursday. ISM manufacturing data, consumer confidence and monthly auto sales for June are also expected.

There will be little earnings news, but analysts say it is possible some companies could pre announce their second quarter reports. Not a market mover, but of big interest Monday will be the sentencing of ponzi scammer Bernard Madoff.

Stocks could stay stalled next week in continued light volume trading, traders say. "If you've got a mindset by a majority of the market participants that we've got to see a pullback before you put new money to work, what we've got to see is significant positive catalysts, either in the economic data or earnings reports," said Art Hogan of Jefferies. "I would argue we're going to go through an earnings season where corporate America comes out and sees an outlook that's much more robust."

Traders at New York Stock Exchange.
Oliver Quillia for CNBC.com
Traders at New York Stock Exchange.
Economic data in the past week included some positive surprises, including the durable goods report which showed an increase of 1.8 percent, instead of an anticipated decline. Yet, the stock market had its ups and downs but was mostly sideways on the week as traders worry the economic recovery will be weak at best and could even tilt downward again.

"Typically, the market is forward pricing and looks out six months. Now, it's not. It's looking about three months at best," Hogan said.

Economists expect to see the loss of about 370,000 nonfarm jobs and an unemployment rate of 9.6 percent when the government employment report is released Thursday. ISM is expected to come in at 44.9, compared to 42.8 in the prior month.

"We're expecting negative 400,000, and it's partly technical," said Citigroup economist Steven Wieting of the nonfarm payrolls. "For one thing, you have both the auto makers substantially not producing in the month of June, incrementally down from the month of May, and you have the temporary census workers rolling off, so the two are about 80,000."

But Wieting said other data expected in the next couple of days could start to show that the economy is beginning to turn, and he and other economists see a pick up coming in industrial production

Wieting said ISM, to be reported Wednesday, will be very important. "The surprising thing about the ISM report in May is the fact that, in the face of the auto industry cuts, you saw the new orders above 50," he said. "The fact the orders continued to improve in the face of this industry hit was constructive."

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"I think we're going to see better readings by July. I'll put myself out there and say July will be a better month than June for a lot of economic data," he said. "We are seeing a lot of things. There is an auto maker taking production back up. Orders data for the past two months is a lot better than shipments."

Chrysler Monday is reopening manufacturing plants and Wieting said restarting auto production is one thing that will help give the economy a kick, but it's not the only thing. "You're going to see the first industrial production gain in 2009 in July," he said.

Wieting said the early signs of improvement mean that third quarter GDP could actually be positive. "From what we're seeing, we think the third quarter will have to be up some," he said. He forecasts a 0.5 percent growth rate.

"Broad employment is highly correlated to the production cycle...only one third of it is manufacturing jobs. We don't think production gains are going to be profound. you can still lose jobs while we are growing production," he said.

JPMorgan economist Bruce Kasman, in a note, pointed to the expected annualized increase in Asian production of 30 percent for second quarter, the sharpest jump ever in his 15 years of history for the data. "We are now projecting U.S. and Euro area industrial output to rise at an 8 percent and 4 percent pace, respectively in 3Q09." Kasman expects a 2.5 percent rate of GDP growth and a further drawdown of inventory through the summer months. However, in order for manufacturing improvements to be sustainable, they must be accompanied by real improvement in final demand.

Whither Stocks

Barry Knapp, Barclays Capital head of U.S. equity portfolio strategy, said he thinks the stock market could stay range bound for a bit longer. He said there could be a move higher with some good earnings improvements and a decent pickup in industrial production, but it's likely to finish the year around current levels. For the most part, he expects to see a weak earnings recovery.

"We might be in a little bit of a dead spot, between when the economy bottoms out and when it starts to pick up. It might be middle to late third quarter before it starts to pick up," said Knapp.

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The stock market's performance since early March has been typical of a recovery rally, with gains in small caps and financials and consumer discretionary stocks taking the lead. Since 1973, the average 12 months earnings recovery for the financials and discretionary stocks have been 55 and 64 percent, respectively, said Knapp.

However, he said investors may want to look elsewhere for gains after big run ups in the two sectors.

"We've been getting increasingly cautious on the (consumer discretionary) sector. I think before too long, you get neutral or even cautious. Without evidence of top line growth, I think investors are going to be disinterested. We've seen a lot of interest in shorting the sector by hedge funds and others," he said.

Knapp said his favorite sector is tech. "The story with tech is cyclical and secular. Inventories are under control. Balance sheets are pristine," he said. He also likes health care. "Generally speaking, health care looks cheap, and I like the idea of betting the government will be ineffectual, and grandiose change won't happen," he said, adding the sector does have its problem areas, like the insurers.

Four of the top five performing Dow stocks year-to-date are tech companies: IBM [IBM Loading... () ], Microsoft [MSFT Loading... () ], Cisco [CSCO Loading... () ] and Intel [INTC Loading... () ].

He said he is flat in industrials and underweight right now in energy and materials. "We've gotten about a 10 percent pull back in industrials, materials and energy and that could continue. I'm calling it a mini growth scare," he said.

"Our commodities guys think a lot of the surge in commodities in the first quarter was attributable to China stockpiling," he said. "...If there's going to be another leg higher in commodities, it's going to be from recovery in the U.S. and Europe. It's going to be highly correlated to when industrial production improves in the U.S. and in Europe."

In fact, Potash [INTC Loading... () ], one of those in the commodities-related group, cut its second quarter outlook late Thursday. It blamed weaker sales volumes as a result of dererrals of purchases by customers around the world.