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Farrell: Could It Be "V"-Shaped?

Monday's collection of economic releases were all on the "green shoots" side of things: Construction spending was up 0.8%, which doesn't sound like much, but it was expected to be down. Residential construction actually increased a bit, which is another indicator that housing activity is close to bottoming out. The Institute for Supply Management (ISM) indexwas 42.8 (up from a truly dismal 32.9 in December 2008), still well below the dividing line of 50 that marks the difference between expansion and contraction. But the ISM said 41.2 marks the beginning of economic expansion, and the new-orders part of the index was a solid 51.1. Further, RBC Capital said that, in the past, a print better than 41 has "preceded positive GDP growth by one quarter 89% of the time." Wow! But remember that the ISM index has averaged 43.1 during recessions, so to call for a "V"-shaped recovery is a bit premature.

Personal income was up 0.5%, when expectations were for a decline. It was due mostly to government transfer payments (like social security) and the effects of the Obama tax cuts. But wages and salaries were up a tiny bit, for the first increase in 8 months. The savings rate has jumped to 5.7% from virtually zero a few months ago, and I suspect it will keep rising to the 8-9% long-term average (which will temper consumer spending). China's version of the ISM indexwas above 50 for the third month in a row, India's first-quarter GDP was better-than-expected at a positive 5.8%, and both the Euro zone's and the UK's purchasing managers' indices were better.

Corporate profits in the US for the first quarter were up $42.6 billion to $1.307 trillion. While that is off 18% from a year ago and off about 25% from the record $1.713 trillion recorded in the third quarter of 2006, $1.3 trillion is a lot of money. The gain, however, was due to the snap-back of financial profits (up 94%), and non-financial earnings were off—think the auto companies. It looks more likely to me that earnings for this year will be above the $50 level that I think is the median estimate. If the S&P were to earn, say, $55 for this year, the market at its current level of 945-ish would be at 17.2 times, which strikes me as fully valued.

I know that, at the beginning of recoveries, commodities have rallied—the Reuters/Jefferies CRB commodities index is up over 18% this year—and that bond yields have always risen. But I am worried that the rise in Treasury yields could torpedo a recovery. At 4.5% interest rates, every 30-year mortgage is theoretically refinanceable (from an interest-rate perspective -- the mortgage could be underwater). At 4.75% rates, Credit Suisse says 87% are refinanceable, but at 5.25%, the number drops to 43%. With the ten-year Treasury back to 3.7%, mortgage rates will be north of 5.5% and the hoped-for consumer reliquification will be stunted. Also, gasoline is back above $2.50, up 55% on the year, and the auto shutdowns are almost sure to cause a rise in unemployment claims.

And, where is the volume to support the wonderful move we have had in the market? I have been wrong (again!) to have turned cautious, but low-volume breakouts have often been sucker's bets in the past. A nice overbought rally does set the bar higher, though, and while I expect a consolidation, it will come from a higher level than I thought and the likely retest level will be higher as well.

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