How to Invest Today

Wall Street is hoping for a strong economic recovery, but again and again investors are disappointed by signs that American consumers remain cautious and careful about opening their wallets. The latest evidence arrived Nov. 17, when Home Depot (HD) reported earnings.

Home Depot’s profits actually beat expectations, but what worried Wall Street was the picture executives painted of their customers’ moods. “There is still a great deal of pressure in the housing and home improvement markets, though there are some positive signs of stabilization,” Frank Blake, Home Depot’s chairman and chief executive said in a statement.

There are at least a few reasons for Home Depot to be upbeat. Many sales measures did improve from the second quarter to the third.

According to comments to analysts by Blake and other executives, Home Depot customers are happy to spend on simple home remodeling projects. Basic maintenance — plumbing repairs, for example — is still being done. Customers are also launching do-it-yourself projects, including boosting the energy efficiency of their homes. Finally, customers are updating the decor with new coats of paint or new carpet, or sprucing up their yards with better gardens.

What Americans aren’t doing, however, is launching major remodeling or expansion projects. Executives said lumber, hardware, electrical and mill work sales all underformed. The average customer’s sales ticket was down, a sign contractors are still spending a lot less at Home Depot, the world’s largest home improvement chain.

The caution from Home Depot on the consumer environment echoed comments from rival Lowe’s (LOW) when it reported earnings on Nov. 16. Lowe’s chairman and chief executive Robert Niblock said in a statement:

The broad-based pressures of the macro environment are clearly evident in our sales as consumers continue to delay large purchases until they feel better about the economic outlook.

Home Depot’s gloomy outlook sent share tumbling more than 3% lower by midday on Nov. 17. Lowe’s shares also slipped.

But focusing on one day’s stock performance might overstate the significance of current pessimism about the U.S. consumer. Home Depot shares are still up 7% in November, while Lowe’s shares have risen almost 10%. Third quarter results may discourage unrealistic investor expectations, but they don’t mean the U.S. consumer is hopeless in 2010 and beyond.

And, analysts praised Home Depot’s ability to cut costs. Morgan Stanley (MS) analyst Matthew McGinley wrote:

To the extent that it is sustainable, this [cost-cutting] reflects the potential to expand margins dramatically in a sales upturn. … [Home Depot] management deserves an award for cost control in 2009, but the stock may pause unless we see confirming evidence that 2010 [sales trends] will be positive.

“While the stock should give back some of its recent gains,” JPMorgan (JPM) analyst Christopher Horvers noted, sales and profit margins should improve. “We believe a longer view is appropriate.”

Robert W. Baird analyst Peter S. Benedict also saw the glass as half full. “Bottom line,” he wrote: “More signs of stabilization here, and we see improved trends going forward.”

The big question for Lowe’s and Home Depot is how long the U.S. consumer continues to put off major home improvement projects. Many Americans may be contemplating major addition to their houses or the construction of a new deck or garage. But they can’t be expected to make such major expenditures until their confidence — in their jobs and in their investments — truly returns.

Although municipal bond insurers have been on life support for almost two years, Ambac Financial Group’s (ABK) revelation in a Nov. 9 filing to the U.S. Securities and Exchange Commission that it might have to file for bankruptcy protection in mid 2011 should serve to remind muni investors of the need to be especially careful with what they buy.

Until early 2008, cities, towns and states across the U.S. were able to offer muni bonds at a nice premium if they were insured by Ambac, MBIA (MBI) or a handful of other companies. Now that it’s understood how insurance, once limited to munis, has been spread thinly across many riskier assets, the market has no illusions about insurers’ ability to cover losses in the event of another perfect financial storm, says Bill Larkin, a portfolio manager for fixed income at Cabot Money Management in Salem, Mass.

Despite the strong possibility that after June 2011, Ambac may not be able to fulfill its obligations, muni investors don’t have much reason for worry: bond prices have already factored in the increased risk of default, since investors no longer depend on insurance, say some bond fund managers. While it’s bound to be painful, municipal governments have no choice but to bring their spending in line with lower revenues, says Larkin. “States can raise fees, levy fees, auction off properties, lay [city workers] off. They can do some uncomfortable things, but the bond holders get paid.”