A wide array of statistics and policy actions were reported last week that failed to satisfy the gloom and doomers. Economic statistics, while weak, are generally not falling off a cliff, and continue to support my view that we can avoid an economy wide recession. It’s still too early to declare victory over the gloomy ones, but many parts of the economy are looking stable, and in fact, looking up.

One big report covered first quarter GDP, showing a first quarter rise in real GDP of 0.6%, matching the fourth quarter increase. Not a big increase, but also not the decline typically associated with recession. The employment report for April showed a small drop in payroll employment of 20,000, but it also showed a reversal of prior rises in the unemployment rate, falling to 5% from March’s 5.1%. Certainly not the kind of big gains associated with vibrant economic growth, but also not the nosedive I would associate with a slide into recession.

We got another read on inflation. The broadest measure of inflation, annualized change in the GDP price index, showed a rise of 2.6% in the first quarter with the “core” (excluding food and energy) GDP price index up 2.0%. Both inflation measures are lower than in the fourth quarter. Continued low inflation gives the Federal Reserve room to cut interest rates, and they did, dropping the fed funds rate to 2% on Wednesday. They also announced further actions to shore up bank balance sheets today.

As I have said before, I still remain very concerned about the direction of oil prices and the dollar exchange rate. Oil prices well about $100 per barrel continue to place a heavy burden on U.S. consumers. They are responding by cutting back, with gasoline use, compared to last year, down the last three months. But consumers are also slowing other purchases. The dollar may be bottoming; it hit a record low in mid-March and, like the equity markets, subsequently moved higher. Lower oil prices and continued dollar gains would, I think, be very beneficial to the economy and financial markets.

On the company earnings front, with 371 of the S&P 500 companies having reported, total earnings are down 14% compared with Q4 2007, but the decline is concentrated in the financial sector, where earnings fell 69%. Eight of the remaining nine sectors show increases, ranging from a high of 23% in Technology to a low of 4% in Health Care. (The other earnings decline was in Consumer Discretionary.) Adding it up, the entire non-financial group was up about 10%. Forward earnings expectations are for another overall decline in Q2 (more financial sector write-downs) and then gains in Q3 and Q4; the Q4 2008 earnings growth expectation is a rise of 53%. That huge rise is mainly due to the very depressed earnings level in Q4 of 2007, but it does show how large the financial sector hit has been.

All in all, it has been a pretty good couple of months for equity markets, earnings and the economy. While we are still down about 1.9% on the Dow and 4.0% on the S&P500 year to date, we are up a fair amount from the lows in mid-March. We are near the end of the first quarter “earnings season” for S&P 500 companies and are again seeing a major divergence – excluding financials, company earnings look strong. I will continue to watch all of these indicators closely, but for now at least, I think things are looking up. As always, please call me with any questions or concerns.

Financial markets continue to be roiled by sub-prime mortgage concerns. And a number of doom and gloom prognosticators are saying we are in a recession or predicting recession. I continue to disagree with these gloomy assessments of the U.S. economy. I am confident we are not in a recession, and I do not expect a recession this year.

Yes, housing construction and home prices are down, but other sectors of the economy are taking up the slack – notably U.S. exports which are rising at an 8% growth rate in real terms and are 3½ times the size of residential construction. The consumer is hanging in there, behaving rationally. Real consumer spending excluding energy (taking out gasoline, heating oil and the like) rose 2.6% last year, while spending on energy slowed to 0.3% (and fell outright in the fourth quarter). Makes sense to me given outrageously high energy prices. Business fixed investment is chugging along at a steady 7.5% growth rate in real terms. Inventory investment was soft all year and fell in Q4, but I consider that to be a positive this year – no inventory glut to clear out. And government spending is doing what it always does – rising – at a steady 2.5% rate in real terms.

Income and interest rates look okay. Real after-tax personal income is chugging along at a 2.1% growth rate. The personal saving rate, while low, is in positive territory. Outside of these sub-prime related write-offs at a bunch of big, dumb banks, company earnings look pretty good. With 439 of the S&P 500 companies having reported, non-financial company earnings are up about 14% over the last four quarters. There were big gains in Technology (good volume, better pricing), Energy (sky-high oil prices), Healthcare (demographic tailwind) and Industrials (exports). And the Federal Reserve is cutting, not hiking, interest rates.

What I worry about are rising oil prices and/or further dollar declines. Another big rise in oil prices might do enough damage to tip us into recession, and further dollar declines would erode international investment in U.S. financial markets. And oil prices have moved back up to $90-100 per barrel range. Unfortunately, energy policy has not helped. Starting last September, with oil prices around $75, the Energy Department began adding oil to the Strategic Petroleum Reserve! Over the same time the private sector reduced inventories and petroleum use fell. So, on the margin, it appears that the U.S. government was the big marginal buyer helping push prices from $75 to $100. Not smart… However, the Energy Information Administration is forecasting a deceleration in global demand for oil and a rise in supply. So there are some grounds to expect lower oil prices.

I will continue to watch the economy and these data closely and report back to you. For now, I remain optimistic that we will avoid recession and return to faster growth and rising financial markets. As always, please call me with any questions or concerns.

The media is now worried about recession. Doom and gloom is everywhere, and the stock market is off to an awful start this year. The Dow is down 6.0% as of last week, and the S&P 500 is down 6.5%. Some (the optimists!) are comparing the current “credit market crisis” with 1998, when we had emerging market debt defaults and a big hedge fund named “Long-Term Capital” blew up. Back then, the S&P 500, which had been showing big gains, dropped about as sharply as it has lately and then recovered for nearly two years as the “credit crisis” faded.

I understand the point being made and consider it to be legitimate, but I would go further. Back in 1998, some corporate CFO’s were pumping up earnings, and earnings “quality” suffered. Today, I think companies are for the most part much more careful in their reporting, given new legislation. Back in 1998, companies and investors were punch drunk on the internet, and fiber optics cable was being laid everywhere. Today, I think investors are much more cautious, and generally, companies are very cost conscious. For example, back in 1998 payroll employment was growing at about 2.5%, versus 1% this year. In 1998, business capital spending rose 11% in real terms, versus 5% now. And inventory investment hit all-time record highs in both 1998 and 1999, versus a near record low (excluding recessions) today. So I see no excessive hiring or plant and equipment investment or inventory overhang that needs to be eliminated. Yes, we did have a huge overbuild in the housing market, but that correction is, in my opinion, largely complete. From the peak at the end of 2005, real residential investment has already dropped 24% – the biggest fall since the 29% seven quarter drop in the 1982 recession. Housing starts are already down 56% from their peak 23 months ago, the largest 23 month decline since 1975.

So I do not see the excesses that still “need” to be corrected with a recession. Also, back in 1998 the S&P 500 Price/Earnings Ratio (the P/E) on the stock market was much higher. On trailing earnings the P/E on the S&P 500 was about 30, and on forward earnings estimates it was about 23. Today it is about 18.7 on a trailing earnings basis (with the big hit on financial earnings) and about 13.3 on forward earnings estimates. To me, the lower P/Es take a lot of risk out of the market. Also, back then the credit crisis took the plain vanilla AA corporate bond yield above 8% in 1999. Today the AA yield is about 5.2%. Back then, total U.S. non-financial corporate balance sheets liabilities (debt) exceeded financial assets by about $1 trillion. Today, financial assets exceed liabilities by about $1.4 trillion. So I see record low balance sheet risk for aggregate non-financial companies.

Finally, I think this time around we have the Federal Reserve (the Fed) headed in the right direction. Starting out in September, the Fed has cut the fed funds rate from 5.25% to 4.25% currently, and I expect another ½ percentage point cut this month. So I think we will avoid recession, but I sure would like to see lower oil prices and a rising dollar exchange rate. As always, please call me with any questions or concerns.

I expect a positive 2008 for both the economy and financial markets. Aside from the hit on home construction, home sales and the sub-prime mess, the U.S. economy is in pretty good shape. The typical set of problems that precede a recession are not in place. Before most recessions, businesses usually spend too much on inventories, plants and equipment, have too many workers, and pay too-high wages. These expenditures push up costs and force businesses to raise prices (“cost-push inflation”). The Federal Reserve (the Fed) takes notice and starts hiking interest rates. Meanwhile, consumers balk at the price increases and cut spending. The combination of rate hikes, slowing real sales and sharp declines in profit margins throws business decision making into reverse with inventory liquidation and capital spending cuts, leading to falling production and employment. This process snowballs into recession.

However, right now I do not see these factors in operation. Businesses have been generally careful in controlling costs. Investment in inventories has remained low, capital spending has been moderate, employment growth has been slow and labor cost increases have been contained. So I do not see cost-push inflation developing and the Fed has been able to cut interest rates rather than hike them.

However there are risks to this outlook. As I have noted before, in prior years we had a big headwind from the rise in oil and commodity prices and the decline in the dollar. But easy credit market conditions provided a partial offset. Now, tight credit markets provide yet another headwind. Easier monetary policy — Fed rate cuts — helps offset tighter credit markets, but a swing from rising to falling oil prices and from a falling dollar to a rising dollar sure would help. So far, my outlook that these shifts would begin has proved to be wishful thinking. Oil prices briefly touched $100 a barrel yesterday and the dollar is back down near the record low. If oil continues to rise and the dollar fall, we may be in for a recession this year and global investors may look elsewhere for their financial investments. Not a very cheery possibility…

I will be watching economic and financial market conditions closely to try to see which way we are headed this year. One final thought – there is only one investment where I can guarantee you an after-tax double digit return. Pay off your credit card balances! All the best in 2008 and, as always, please call me with any questions or concerns.