Economy could shake off its torpor, but inflation could be a trouble spot. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth-management firm based in Philadelphia.

Summary The direction of earnings is an important component to stock price returns. Current consensus estimates for company earnings anticipate a relatively weak first half of the year and greater strength down the road. Much of the economic data we're seeing lately would seem to indicate that the economy is somewhat sluggish, but there are some early economic indicators that are pointing toward a revival in economic and earnings growth six to nine months from now. A short period of sluggish growth is probably good for earnings but bears some risks with regard to inflation. We conclude by considering the passion with which the Fowlers approach the game of baseball.

Review and outlook

Stock prices continued to move up boosting the markets for yet another week. The alleged rationale for this spring in stock prices was a number of better-than-expected earnings reports and a better-than-expected core inflation number. But the health of the market rests to a certain degree on some optimistic assessments of future earnings. According to consensus estimates, earnings growth will be flat in the first half of the year and then accelerate to double digit growth levels by year end.

Is Wall Street being too optimistic? Can flowers bloom in the fall as well as the spring? After being spectacularly wrong during the Internet bubble, Wall Street analysts have somewhat redeemed themselves. Their estimates, derided by many strategists as too optimistic, have been fairly accurate. There are some early indications that their optimism may be justified.

The S&P rose by 2.2% last week. Financials, which posted a 3.9% gain for the week, led the way. The Russell 2000 small-cap rose by just 1.2%. Year to date, large- and small-cap stocks have seen comparable gains of 5.2% and 5.6% respectively. International equities rose by 1.8% for the week with a weaker dollar accounting for 0.7% of the gain. Year to date, the EAFE index of international stocks is up 9.1%.

Can this bounty continue? A lot depends on whether earnings estimates meet or exceed expectations later in the year. Interestingly, much of the earnings growth that is anticipated this year will come in the third and fourth quarters.

S&P 500: Estimated/Actual operating EPS growth|image1|2002 Growth reflects the estimated impact of FASB 142 Sources: Glenmede Investment Research and FactSet (First Call estimates)

Certainly the news is good this quarter at least for larger-cap stocks. As of this point in the earnings cycle, 69% of companies have beaten their estimates and only 21% have come up short. The numbers are not quite as supportive on the small-cap side where the number of companies in the Russell 2000 with positive and negative surprises is evenly divided.

S&P 500: First quarter earnings surprises|image2| Source: Glenmede Investment Research and FactSet (reported EPS through 4/20/07)

Russell 2000: First quarter earnings surprises|image3|Source: Glenmede Investment Research and FactSet (reported EPS through 4/20/07)

Some skepticism is warranted. Wall Street analysts overestimated earnings through much of the Internet bubble. Could they be doing the same again? There are at least some early indicators that might say that the economy and, subsequently, earnings will pick up at the end of the year.

Though the industrial segment of the economy continues to shrink in importance, it's still a good early indicator of the direction of the economy. One of the best measures of that early strength is the Institute of Supply Management's (ISM) survey of New Order trends. As the graph below shows, the percentage of businesses reporting better new orders has been reasonably strong and, perhaps just as important, the percentage of companies reporting worse new orders is dropping to more normal levels.

New order trends have a positive bias |image4| Sources: Glenmede Investment Research and Haver Analytics

We also like to look at our proprietary model that forecasts industrial production nine months out. The Glenmede Leading Production Indicator previously forecasted a marked slowdown in industrial production -- and we're seeing it now. This indicator -- which takes in a lot of data, including numbers on credit-card quality, stock prices, household-savings levels, and employment costs -- has recently improved to a fairly positive level, indicating a move to a higher level of industrial production.

Leading production indicator (nine-month lead) April 2007 |image5| Sources: Glenmede Investment Research, Haver Analytics, FactSet, and MATLAB

Interestingly, although this data might be good news for the economy and corporate earnings, it isn't necessarily good news with regard to inflation. Inflation is still running at relatively high levels, and a weaker dollar, higher commodity prices, and building-wage pressures present some challenging headwinds. It's quite possible that a short period of slow growth doesn't keep inflation sufficiently in check. It's possible that we could be sitting here in the fall faced with the prospect of higher short-term interest rates rather than lower.

Sometimes, flowers that bloom in the fall are indicative of a growing season that has gone on a little too long.

A passion for the game

I enjoy watching sports, particularly baseball. My own athletic career, however, has remarkably few high points. Most sports require either an acceptable level of hand-eye coordination, a certain level of speed and quickness, or a somewhat intimidating level of height or bulk. Sadly, these were not attributes that were passed down through my family gene pool. The one sport that I did excel in -- cross country running -- only really requires the ability to run for a long time through the woods without getting lost.

There's probably a metaphor embedded in this observation that helps to explain why I ended up in investing. My eleven-year-old son, unfortunately, couldn't care less about metaphors. He's more incline to wonder why his mother couldn't have found a more athletically inclined mate who could have contributed some more helpful sports genes. Fortunately, he seems to have taken more after his mother's side of the family where there is a healthy level of hand-eye coordination and speed.

My daughter is a different story. She doesn't quite have her father's lack of athletic prowess, but let's just say that mastering any athletic task requires of her a considerable expenditure of time and practice. So I feel we share a bond. The three of us spend a fair amount of time in the back yard tossing baseballs and softballs back and forth. The ability to flip a ball at high speed across the yard seems to have come naturally to my son while my daughter has had to spend years perfecting a relatively accurate toss.

Generally, these are cooperative affairs. Occasionally though, my son, who has attended that special sensitivity training that all younger brothers seem to have absorbed, will hurl the ultimate epithet. "You throw like a girl!" he'll tell his sister.

This is not a welcome criticism.

"Daddy! Do I throw like a girl?"

"Sweetheart, you have a very good throwing motion."

"I throw like a girl!"

Getting to my daughter's softball games means leaving work early, so I'd been missing them. Recently though I decided to show up to at least one of her softball games and offer my support. I felt that I might even be of help in view of my own experiences on the athletic field. Again: a passion, tinged with pain, and that the two of us could share.

And so I stood the other week in the rain, the only parent from my daughter's school watching.

And what I saw suggested to me that, just as there may be hope for the economy and future earnings, there may be hope for my daughter's athletic career. She caught balls, made hits and scored runs.

But good news can also be too good. With reference to the economy, a shallow slowdown might not be enough to control inflation.

But the news about my daughter's athleticism only got better that drizzly day.

"Your daughter is a great athlete," her coach remarked to me. "Athletic ability must run in your family."

I winced inwardly: so much for that bond.

Ah well. At least she still likes watching baseball with her dad. -FWR

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