Capital Spending Whoa

Lately, I’ve been writing about the market’s latest push toward the highs as a false rally. Maybe it’s just my nature to scrounge around looking for evidence to support my contrarian views, but I am adamant about backing up my opinions. Most recently I said the reaction to the FOMC policy statement was overblown as traders and investors misread the policy to the effect they saw a rate-cut in the near future. To the contrary, the statement had obviously stated that it plans to maintain the current fed funds rate at 5.25%. The markets react and anticipate, yet sometimes they anticipate incorrectly. This is why we are so fascinated with financial markets and this is why things can become ugly in a hurry.

I don’t believe things will get ugly, but I do think the markets have been overlooking certain aspects of the economy that are suggesting weakness, yet are captivated by other aspects in order to keep the “Goldilocks Scenario” alive. Eventually, according to efficient market theory, all information will be accounted for and the market will price accordingly. That said, the markets should currently be pricing in a modest economic growth of 2-2.5%, slower corporate earnings, higher energy prices, a slowing housing economy (which by the way pushed economic growth for the past several years) and a federal funds rate of 5.25%. However, I don’t think we have seen this. The market is sitting within 1-2% of their 6 year highs and nothing is being discounted. An extremely optimistic market will sooner or later catch up with the real information being released leading to less optimistic markets with a sense of risk.
One of the aspects of the economy the market has simply overlooked is the slowdown in capital spending. Capital spending is the capital spent to acquire or upgrade assets. Think buildings, computers, planes, trucks, equipment and other machinery. Before providing the numbers, let me explain why capital spending is important. When businesses are growing (and the economy expanding), they need equipment and machinery to let their business flourish. Orders are placed with vendors to provide the products and then the businesses begin producing their goods for consumers. If they decide to not invest in their infrastructure then they are not producing more goods; therefore, the economy has fewer goods on the market and it slows the overall business cycle. This is an elementary crude explanation, but it should do for now. On to the numbers.
This morning, the numbers for February factory orders were released. They did nothing to make me believe that the downtrend will be interrupted by a sudden surge of new orders being placed. The first quarterly decline in capital spending in nearly four years was posted in the fourth quarter of 2006, but it passed with hardly a mention. Although Feb. orders were up 1.0%, this was well below the consensus estimate of a 1.9% gain following a -5.7% drop in January orders.
This doesn’t bode well for the overall expansion of businesses growth. Take a look at the chart below. You can see that the drop has the look of the drop in orders from the last recession in 2000.
The drop in capital spending is happening at a time of near-record corporate profits. It has been known for some time that CEOs remained cautious in their spending
Factory Orders

Factory orders consist of durable and non-durable goods. Non-durable goods include items like food, clothing, and tobacco products. Durable goods are products that maintain non-durable goods such as washers and dryers, computers and machinery.

plans, yet they have spending all those profits on share buybacks. That creates some shareholder value, but how does that help an economy that is beginning to show more signs of weakness?
Ben Bernanke has taken notice of the lack of spending by businesses hoarding cash as he gave his testimony to the congress last week adding that there was “an additional downside risk” to the economy if the weakness in business investment continued. I know we have ignored some weaker data points along the way to these multi year highs, but this is not something that we want to ignore.
The lack of spending may have similar effects on the economy as a weaker housing market. It will take some time to see, but as early as next month more capital spending data will be released. Another quarterly decline would mean two consecutive quarterly declines in capital spending at the same time the economy is modestly expanding. Take note that the market has yet to account for this and it again overlooks a vital piece of forward-looking information reflecting the state of the economy. I have not forgotten the 6.5% drop near the beginning of March; however, it took the market no more than ten trading days to recover almost all that was lost during that “correction”. That is not convincing enough for me and the wall of worries is continuing to grow. Maybe I am overly cautious, but I doubt it.
Charlie Santaularia
Managing Director
Parrot Trading Partners, LLC

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