Around the Street November 2, 2009, 1:00PM EST

Getting a Fix on the Fed

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Michael Englund, Action Economics

Upside surprises in U.S. reports [released Nov. 2] for the Institute for Supply Management's October manufacturing index and its employment component, alongside the 6.4% pending home sales surge [in September] and robust residential construction figures [for September], have prompted upward revisions in our fourth-quarter and first-quarter GDP estimates to 2.3% for both quarters. Residential construction now looks poised for 20%-25% growth in both quarters, following a comparable gain in the third quarter that should be revised to 22% from 23.3%. And the strong ISM data have capped the downside risk in the October jobs report, as well as the early factory sentiment figures for November.

Yet, all was not rosy in [the Nov. 2] reports, as surprisingly weak nonresidential construction figures suggest an ongoing downward spiral in this important investment component. And big downward construction revisions imply that third-quarter GDP growth will be knocked down to 3.3% from 3.5%.

Tony Crescenzi, Pimco

Fed data released [on Oct. 30] indicate banks increased their cash holdings by a record $160.6 billion to a record $1.344 trillion in the week ended Oct. 21, reflecting a renewed expansion of the Fed's balance sheet. Bank loans continue to move in the opposite direction as bank cash, with loans and leases at the nation's commercial banks falling for a 21st consecutive week, by $32.9 billion to $6.684 trillion. Thus far this year, the total amount of loans and leases outstanding has contracted $530 billion, a 9.1% annualized rate of decline. Commercial & industrial loans, which are a subset of the loans and leases figure, have fallen at an even faster pace of 17.3% year-to-date. The contraction in lending stands in sharp contrast to the trend in commercial bank holdings of securities, which have increased $210 billion thus far this year, or a 12.5% annualized rate of increase.

Weakness in bank lending is not unusual in the early stages of an economic recovery, because companies in the early stages can rely upon internally generated funds to finance their expansion. In fact, in six of the 10 recessions since 1948 a trough in bank lending did not occur until six months after the recessions ended. In two of the cases (1948-1949 and 1980), a revival occurred the same month as recession's end. Still, broken business models, overleveraged borrowers, capital-starved banks, and forthcoming increases in capital requirements and other regulations mean that the recovery in bank lending could take longer and be more restrained than usual.

Sam Stovall, Standard & Poor's

On Oct. 19, a few days after the Dow Jones industrial average closed above 10,000, the Standard & Poor's 500-stock index ended near the 1098 level, after peeking its head above the 1100 threshold on an intraday basis and registering almost a 4% month-to-date advance. Since then, however, it's been all downhill. However, S&P's Investment Policy Committee thinks the S&P 500 will close the year around 1055, based on its 12-month target of 1150. We believe the market is undergoing a digestion of the 25% advance experienced since the July 10 decline that shaved 7% off the market following the 40% surge since the bear-market bottom.

We believe the decline we are currently experiencing could be of a similar magnitude. Mark Arbeter, S&P's chief technical strategist, sees 1025 as the next level of support, which would equate to a 6.7% decline from the recent recovery high. In addition, our economic and fundamental core beliefs remain intact. Combined with our expectations for a pullback in share prices over the near term, rather than a deeper correction or even the end of this embryonic bull market, S&P's Equity Strategy group continues to lean toward the cyclical side of the sector ledger, with overweight recommendations on the Energy, Industrials, and Materials sectors, while underweighting Telecom Services and Utilities.