Deficits and Small-Cap Stocks

Initial unemployment claims again trended lower, falling to 502,000 from 514,000 in the prior week. Although initial claims have spiked occasionally since late July, the numbers suggest that the pace of layoffs has slowed significantly as companies achieve staffing equilibrium.

Continuing claims declined slightly from a sharply upward revised 5.77 million to 5.631 million, but expect the pace of the decline to remain sluggish, especially now that President Obama signed a fourth benefit extension into law last week.

Under the provisions of the extension workers who have exhausted all of their federally funded benefits or are about to will be eligible for an additional 14 weeks of payments. If they live in one of the 29 states where the unemployment rate is over 8.5 percent, they will receive another six weeks for a total of 20 weeks of benefits. That extension is the largest contributing factor to the sharp upward revision and should lead to further markups as more workers are notified and enrolled.

Government assistance programs are straining the US budget and the credibility of the US dollar. In October the US budget posted its thirteenth consecutive deficit and fifth largest on record, widening to to a $176.4 billion shortfall after running $155.5 billion in the red in September. The trade deficit also widened to $36.5 billion from $30.8 billion, as petroleum imports rose. Taken together, that kept the US Dollar index relatively flat, while the price of gold continued its relentless upward march.

Markets were boosted this week by surprisingly strong third quarter results from a variety of retailers; Wal-Mart Stores (NYSE: WMT), J.C. Penny (NYSE: JCP) and Abercrombie & Fitch (NYSE: ANF) all reported earnings that beat analysts’ expectations. Nordstrom (NYSE: JWN) was the sector’s loser of the week, missing analysts’ estimates by a penny.

Although I doubt retailers will post record earnings in the fourth quarter and, in fact, expect results to be weak, the recent bit of good news coupled UBS (NYSE: UBS) increasing its profit outlook for the S&P 500 over this year and next helped to drive markets higher. Analysts at the banking conglomerate raised their third-quarter earnings estimate for the index to $16.70 from $16.15.

One interesting point to note this week is the continuing divergence of small-cap stocks from their large-cap brethren, with larger names solidly outperforming this week. It’s looking as though the run in small caps may finally be losing steam; investors appear to be favoring larger multinationals that should continue to generate dependable earnings, particularly if inflation kicks up. It’s increasingly looking as though we’ve reached the point in the recovery cycle where speculative small-cap names are beginning to lose their luster.