No Job Growth for Small Business Spurs Recovery Doubt

Small businesses are becoming the Achilles heel of the U.S. recovery by limiting growth and job creation.

Companies with fewer than 500 employees, such as Phoenix Technologies Ltd. and Sonic Corp., helped lead the economy out of the four recessions since 1980. This time, they continue to cut capital spending and dismiss workers, eliminating 3,000 jobs in January, according to Roseland, New Jersey-based Automatic Data Processing Inc., the world’s largest payroll processor.

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Improvement in the unemployment rate, which fell to 9.7 in January from 10 percent in December, may stall later this year if these firms aren’t hiring, and growth likely won’t meet the median 2.7 percent annual rate forecast for 2010 by 67 economists in a Jan. 14 Bloomberg News survey.

“Will you have a sustainable recovery a few years down the road without getting some small-business spending? No,” Cary Leahey, senior managing director at Decision Economics Inc. in New York and a former White House economist, said in an interview. “Wall Street gets it.”

The Russell 2000 Index of small-cap stocks has risen 4 percent in the past six months, lagging behind a 6 percent increase in the Standard & Poor’s 500 Index. Coming out of previous recessions, shares of companies with market capitalization between $250 million and $1 billion generally led markets higher.

Stock Performance

The Russell Index gained 17 percent in the six months following the end of the 2001 recession, compared with 0.2 percent for the S&P 500. Futures on the S&P 500 were little changed today at 1,059.10 as of 11:09 a.m. Singapore time.

The U.S. economy expanded at a 5.7 percent annual rate in the fourth quarter, the fastest pace in six years, after a 2.2 percent increase in the third quarter, buoyed partly by capital expenditures for equipment and software by large companies such as Dallas-based Texas Instruments Inc. Growth may be difficult to sustain if smaller firms continue to pare spending and staff.

“It suggests that a V-shaped economic rebound is even more unlikely than suggested by many standard economic indicators,” said Andrew Tilton, an economist at Goldman Sachs Group Inc. in New York, which sees gross domestic product growing 2.3 percent this year.

The National Federation of Independent Business’s index of small-business optimism has been near historic lows for 15 consecutive months, declining to 88 in December from 88.3 in November, the federation reported Jan. 12. During the four prior recessions, it dipped below 90 only once.

Optimism ‘Stalled’

“It has been a very difficult year, and 2009 did not end on an uplifting note,” William Dunkelberg, chief economist for the federation in Philadelphia, said in the report. “Optimism has clearly stalled, in spite of the improvements in the economy.”

Twenty-two percent of the group’s members reduced employment in December, while 10 percent added workers. The federation will release its January data tomorrow.

Investors shouldn’t assume there’s value in small caps during this recovery, according to Robert Olstein, who manages the $14 million Purchase, New York-based Olstein Strategic Opportunities Fund, which focuses on small businesses.

“Smaller startups are having a really hard time,” Olstein said in an interview. “We’re looking for companies that have great balance sheets that have run into some kind of temporary problems.”

Portfolio Holdings

His fund, which is up 61 percent in the past year, owns shares of Indianapolis, Indiana-based shoe retailer The Finish Line Inc.; Nash Finch Co., a Minneapolis, Minnesota-based food purveyor; and surgical-instrument maker Conmed Corp. of Utica, New York.

Because few economic reports capture small-business statistics, some economists say investors are being misled about the strength of recovery from the longest, deepest recession since the Great Depression.

Recent numbers suggest “the official data are too heavily weighted towards bigger companies, which are doing better than credit-constrained smaller firms,” said Ian Shepherdson, chief U.S. economist at High Frequency Economics Ltd. in Valhalla, New York. “The latter employ half the workforce.”

The Institute for Supply Management’s manufacturing report and the index of leading economic indicators are two such measures, Shepherdson said. The Tempe, Arizona-based institute’s factory gauge rose to 58.4 in January from 54.9 the previous month, the fastest pace since August 2004. The New York-based Conference Board’s index of the outlook for the next three to six months gained 1.1 percent in December, the ninth consecutive increase.

‘Spot On’

The unexpected drop in the U.S. unemployment rate during January to 9.7 percent shows those indicators “have the direction of the recovery spot on,” Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ in New York, said in an interview. “The wheels of the economy are turning. The improvement in the employment data does match the increase in GDP the last two quarters, so it’s not a fluke.”

Rupkey’s view is seconded by Dean Maki, chief U.S. economist at Barclays Capital Inc. in New York and the most accurate of 60 forecasters in the Bloomberg News ranking of GDP projections for the first three quarters of 2009.

Maki sees unemployment falling to 9 percent by the end of 2010, because “business-equipment spending is bouncing, signaling an expansion in the corporate sector that is starting to turn the labor market,” he said in a Feb. 5 note to clients.

Gains in Growth

The economy still needs a contribution from small companies, or growth and employment gains won’t be as fast as they could be, Rupkey said. “ISM and leading indicators are probably overestimating the recovery speed.”

The nation’s monthly payroll figures are inflated because the Labor Department model that estimates small-business hiring has overstated the number of jobs added during the recession, Shepherdson says.

According to the model, small companies created an average of 113,000 jobs a month from February through December — a period when total employment fell by a nonseasonally adjusted 3.7 million, Labor Department statistics show.

The model “is creating jobs out of thin air that are not actually being generated,” Joshua Shapiro, chief U.S. economist at MFR Inc., an economic-consulting firm in New York, said in a Feb. 4 note to clients.

Payrolls would have contracted between 1980 and 2005 without the employment created by business startups, the Census Bureau reported this month.

‘Difficult Environment’

Small businesses “in many parts of the country, in many sectors of the economy, are still facing a very difficult environment,” Treasury Secretary Timothy Geithner told reporters in a Feb. 2 conference call.

President Barack Obama said the same day that he wants to create a Small Business Lending Fund with $30 billion transferred from the Troubled Asset Relief Program. He also has endorsed $33 billion in tax cuts for small companies and incentives for hiring and wage increases.

Small businesses are “the places where most new jobs begin” and will be at the forefront of new hiring as the economy recovers, Obama said in his weekly radio and Internet address on Feb. 6.

Consumers are cautious, and that’s keeping owners of small firms on the sidelines, said Holly Wade, a National Federation of Independent Business policy analyst, in a telephone interview from Washington.

‘Still Apprehensive’

“They’re still apprehensive about hiring people, because they’re not seeing enough customers to translate into another worker,” Wade said.

Revenue at Phoenix Technologies, a maker of computer- communications software, fell 10.3 percent to $15.6 million in the most recent quarter from the year-earlier period, the Milpitas, California-based firm reported Feb. 4. The company, which has a market value of $110 million, cut 9 percent, or about 45 people, from its workforce last year; it had 462 employees as of Sept. 30, according to data compiled by Bloomberg. Shares are down 8 percent to $2.80 since August.

Much of the U.S. economy’s improvement has been stimulated by government programs that have helped larger companies without trickling down to smaller ones, especially those in the housing and construction industries, said John Silvia, chief economist at Wells Fargo Securities, a unit of San Francisco-based Wells Fargo & Co., the largest U.S. home lender.

Traditional Recoveries

“Given that we’re not getting the traditional housing recovery, maybe we’re not getting the traditional small-business recovery,” Silvia said in a telephone interview from Charlotte, North Carolina. New-home sales fell 7.6 percent in December, according to the Commerce Department.

Red Bank, New Jersey home builder Hovnanian Enterprises Inc., with a market capitalization of $301 million, cut about 1,000 workers, or 38 percent, of its employees in the past year. Shares have fallen 20 percent to $3.55 in the past six months. Hovnanian had 1,750 employees as of Oct. 31, Bloomberg data show.

Lack of access to credit is also affecting small businesses disproportionately. The Federal Reserve reported Feb. 1 that banks were continuing to tighten standards for loans to small firms, while standards for large companies were unchanged.

Growth in 2010 “is going to be a challenge if the credit markets stay tough” and potential licensees aren’t able to borrow funds to open new restaurants, Sonic’s Chief Financial Officer Stephen Vaughan told investors in a Jan. 11 conference call.

Drive Ins

Sales at the Oklahoma City-based operator and franchisor of more than 3,500 drive-in restaurants fell 26 percent to $136.5 million in the most recent quarter, compared with the same period a year ago. The company’s stock is down 28 percent to $8.19 in the past six months. Sonic had 350 employees as of Aug. 31, according to data compiled by Bloomberg.

So far, there are few signs of improvement. PayNet Inc.’s Small Business Loan Index, which tracks loans of $1 million or less, was 8.6 percent lower in December than a year ago.

“In the first half of 2009, the average monthly decrease was about 20 to 25 percent, so it’s clearly a step in the right direction,” said William Phelan, president of the Skokie, Illinois-based company, which offers credit reports for banks that lend to smaller firms. Still, “demand for expansion loans for small businesses is 35 percent below its peak in 2006. That’s another indication of how far we have to go to climb out of this recession.”

“Things don’t seem to be getting any worse, but they aren’t getting any better,” the NFIB’s Wade said. Small businesses “are in a kind of survival mode. We just haven’t seen anything indicating a change.”

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