Correction or More?
The stock market is in the throes of a correction that has lopped 7% off the averages over the last couple of weeks and skittish investors seem to be taking the attitude of sell now, ask questions later. Earnings season has been surprisingly upbeat with roughly 3/4 of companies producing earnings better than the consensus. A nearly as robust number have reported revenues higher than Wall Street’s crystal ball gazers’ estimates. Politically, Congress looks headed for a year of trying desperately not to do anything really stupid before the elections in November - something politicians find hard to do in the best of times - and the seating of Scott Brown (R, Kennedy) increases their chances of accomplishing that goal. Economic news has been generally upbeat too and yet stocks just can’t seem to get any traction. Is this just a correction or the beginning of something more damaging?
Balancing the good news in the US has been the allegedly bad news out of Europe and the fear of potentially, someday getting some bad news out of China. Greece and Portugal are having budget problems and in normal times that wouldn’t even qualify as news, but in a world conditioned to see everything as interconnected, a default by Greece is somehow seen as an excuse to sell US stocks. The domino theory has made an unlikely comeback under the new moniker of systemic risk. A default by Greece leads to a default by Portugal which leads to Spain which leads to Italy which leads to Ireland which leads to the UK which leads to, I don’t know, Goldman Sachs bonus pool I guess and goodness knows we can’t have anything upsetting that apple cart. Frankly I find the whole thing a bit ridiculous. Greece and Portugal together represent roughly 3% of EU GDP and a little belt tightening there will not be the end of the world or the Euro for gosh sakes. Everybody have a shot of ouzo and calm down.
The other big worry that has developed over the last few weeks is that China, in trying to slow their economy, will be more successful than the world economy can handle right now. In case you haven’t heard, the commentariat has determined that China is the new bubble and while they believe the Fed should identify and proactively manage bubbles in the US they worry that the Chinese monetary authorities do not have the same level of sophistication as our own distinguished group of monetary mandarins. The worry seems to be that the authorities there will not be able to identify the magic level of lending that slows the economy just enough to prevent inflation but not so much that they stop buying commodities or Treasury Notes in bulk. Well, of course they won’t and pssst….the Fed can’t either.
I am not concerned about China’s growth, their inflation or their alleged undervaluing of their currency. The Chinese economy can grow at very high rates without inflation because it is still a very poor country and so has lots of room to grow and oh by the way, growth doesn’t cause inflation. I don’t worry about overbuilding in real estate because the average person in China is still living in what the average American would rate slightly less desirable than a tool shed. They might have too many apartments for a while but it isn’t like Miami where it will take us years to import enough fools to absorb our excess supply. There are still a lot tool shed dwellers in the Chinese countryside who desperately want to upgrade to a poorly constructed 500 square foot apartment in the city. As for the currency and the inflation rate, well those are inevitably tied together so if they aren’t allowing the Yuan to rise, they aren’t too worried about inflation. In other words, China is not the bubble - or the popping thereof - you are looking for.
What about the US economy? Could the market be downgrading the growth prospects of the US economy? The President just released his budget and if the administration’s projections for the future of the US economy are accurate, there is surely cause for concern. It is one of the most pessimistic assessments of future American economic performance ever produced by a politician hoping to one day be re-elected. The long term plan has deficits of at least $700 billion until 2020 and unemployment over 6.5% out to 2014. Growth over the next 4 years is penciled in at a 4% real rate but then falls steadily to 2.5% by 2020. Inflation, even with the large increase in government spending, never breaches 1.7% and the ten year Treasury note never trades with a yield higher than 5.3%. If the administration’s budget deficit projections are even close to accurate, inflation and/or interest rates that low are highly doubtful thus making all the other projections too optimistic.
So I guess if anyone were to actually read the budget document it could have made them more pessimistic about the prospects for US growth but it isn’t exactly a best seller and has zero chance of being enacted to boot. The Obama administration - and most people for that matter - underestimates the resiliency of the US economy. The assumption that the economy cannot recover on its own without spending assistance from government is one that suffers from a lack of empirical evidence. But even supposing that is true, don’t the deficits have to end at some point?
In fact, the US economy is on the verge of a robust recovery right now and the majority of the stimulus money hasn’t even been spent yet. The January employment report, despite a negative headline number, was actually one of the most positive economic reports we’ve had in quite some time. Among the positives:
- Employed rose by 541,000
- Unemployed fell by 430,000
- Labor Force rose by 111,000
- Employed part time due to economic reasons fell by 849,000
- Employed part time due to slack work or business conditions fell by 580,000
- Manufacturing jobs rose by 11,000
- Motor vehicles and parts employment rose 22,700
- Retail trade rose 42,100
- Professional and business services rose 44,000
- Temporary help rose 52,000
- Average weekly hours rose by 0.1
- Average hourly earnings up $0.04
That is quite a long list of positives and should not be minimized. Yes there were still some negatives but nothing that should surprise anyone. Construction lost jobs again and the revisions for the last year showed many more jobs lost than previously estimated but both of those were expected. Turning points in the economy are always times of high anxiety and this one is no different. Economic growth is accelerating and what we need most urgently from the political class is for them to overcome their urge to meddle. Unfortunately, the chances of that are pretty slim. In an election year they’ll want to pass something that shows they care about unemployment even if they can’t do much about it. Let’s just hope they do it quick and then hit the campaign trail where they can do little damage.
My assessment is that this is nothing more than the usual anxiety associated with this phase of an economic recovery. Greece and Portugal will not bring down the Euro and do not represent systemic risk. China will keep growing a lot faster than most of the developing world not to mention the entire developed one. The US economic recovery is starting to accelerate and the political environment is favorable in that the politicians will spend most of the year campaigning and talking about doing things rather than actually trying to do them. There might be more downside yet, but absent a really stupid policy decision by Congress or the Fed, it will likely prove temporary.
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Weekly Economic and Market Review
As stated above, the employment report released on Friday contained some pretty good news in my opinion. The remainder of the data for the week has to be classified as mixed since there was some good stuff and bad stuff, but I do think the bad stuff wasn’t terrible and the good stuff was pretty terrific. The week got started with Personal Income and Outlays with income higher than expected and outlays a little light. Actually the headline on this report was a little misleading. Income gains were confined primarily to proprietor’s income, mostly the farm component, while wages and salaries were only up 0.1%. Spending was a little less than expected but November was revised higher.
The best forward looking report of the week came later on Monday with the release of the ISM manufacturing survey which was positive in all respects. The total number was 58.4 but the underlying dynamics were positively smoking. New orders rose to 65.9 the third straight month over 60. A lot of the new orders by the way are in the exports sector. New orders are so hot in fact that the backlog number is now also over 50 and rising (56.0). The employment index was up 3 to 53.3 but that is still a little low for any significant job growth (manufacturing employment was up in the Friday report though). The inventory component rose to 46.5 which is consistent with flat conditions. Inventory restocking is right around the corner.
Construction spending disappointed again and I have no idea when it will pick up. Residential may be bottoming but non residential isn’t even close. Retail store same store sales were strong this week. The MBAs mortgage index rose 10.3% mostly on a 26.3% increase in the refinance index. Pending home sales were up slightly but nothing to get excited about after last month’s big plunge. Jobless claims rose a bit to 480,000 and I think was largely responsible for the Thursday selloff. Claims really need to resume the downtrend if the recovery is to accelerate the way I think it will. We need claims down under 400,000 to get some decent job growth.
Productivity rose 6.2% in the quarter while unit labor costs fell 4.4%. That’s good news for corporate profits and hiring. Factory orders were up 1%, much better than expected. ISM non manufacturing survey was up to 50.5% but is improving very slowly. With most of the US economy involved in services that isn’t good news. The best part of the report though was the New Orders index up to 54.7. Lastly, consumer credit contracted again last month although the rate of contraction has slowed considerably. The debt to income ratio has fallen considerably but should probably fall more. We don’t need expanding consumer credit for economic growth. In fact, we shouldn’t even want it; we should want this recovery to be investment led while the consumer continues to retrench and pay down debt.
Despite all the fireworks in the stock market last week, there wasn’t much net movement in the US market. The S&P 500 ended the week just 0.76% from where it started. Foreign markets did considerably worse with Latin America and Europe markets down 3-5%. The dollar was up again and that drove key commodities lower. Oil was down 2.3% while gold, after a 5% hit on Thursday, ended the week 2.8% lower.
Stock market sentiment has turned bearish very quickly with this correction. Bears outnumber bulls slightly in the AAII poll, but I’d like to see fewer bulls before getting aggressive on the buy side. Put/call ratios could also get a little higher. A VIX over 30 would also make me get a lot more aggressive. For now, I’m biased toward buying the dips but not aggressively.
Selected Charts
Commodity indices are dramatically oversold and at support.
Munis have had a good couple of weeks including high yield.
The late Friday rally formed what is known as a hammer on the candlestick chart for the S&P 500. Hammers are very bullish signs but a retest of the lows should be expected.
Regional banks actually held up pretty well in the correction and appear to be at support.
The healthcare stocks broke under the 50 day MA, but held above the trend line.
Alright, I admit it. I've doubted the dollar rally all the way up but at this point the trend is up until proven different. I still think the long term fundamentals favor a lower dollar but apparently not right now. Expect a pullback to the 78-79 area for consolidation.
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Rantly McTirade said:
Payroll employment was a weak report, plain and simple, in particular for one that’s 10 months beyond a major equity market bottom and 6 months beyond what so many econohacks claim was the business cycle low-go to the Hussman Funds site and look under their research(not weekly comment) list for a recent evaluation of the 4 indicators used by NBER to determine business cycle turns-employment is the weakest by far and behaving much worse than it has after typical cycle lows in the past. Finally, the report showed how statistical finagling results in final output that’s simply unhinged from reality. It claims that 42k retail jobs were added in January-retail jobs never rise in January as seasonal help goes, some retailers close & others reduce staff via evaluation as they’ve passed their busiest time of year. The payroll model ‘knows’ this and therefore throws in an totally assumed # of retail jobs as a ’seasonal adjustment’ offset. This year, with seasonal hiring the lowest in decades and with large #’s of retail stores-and entire chains-closing over the prior 18 months, the actual # of job losses in retail was in fact relatively(only) modest vs prior history & current job levels but the seasonal adjustment factor still toosed in a big ‘assumed’ offset job # and, shazam!, 42k in new retail jobs. In reality, no, retail jobs declined in January just by fewer than prior history would expect-that’s the equivalent of ‘boom’ these days.
Also, ISM is a month over month diffusion index with no information at all about magnitude of change or, especially, absolute level-the latest # was the biggest month/month gain, in terms of breadth, in several years but it in no way indicates that manufacturing activity is at levels equal to that of a few, or even several, years ago. Given the utter collapse of manufacturing that occured from mid-’08 through spring ‘09, a a good sequential rebound-in breadth terms at least-over the next several months is unsurprising. Oh, and the strongest subindex of the overall index was, er, prices-commodity price strength, most likely.
Anthony Di Carlo said:
Employed rose by 541,000?
How many were private sector? Isn’t that the more important number?
Joseph Y. Calhoun, III said:
Rantly: I agree that there were weak parts of the establishment survey but I was mainly looking at the household survey. In the past, the household survey has been more useful at turning points, rising before the establishment survey at the beginning of the recovery and falling before the establishment survey at the beginning of the recession. I would also point out that I date the beginning of the recession later than the NBER and the beginning of the recovery later as well. The stock market generally bottoms when the recession hits its nadir not after recovery begins. The ISM is a great indicator for pegging the bottom of the stock market. The stock market and the ISM tend to rise together from the worst part of the recession.
I am also aware of the rising price index in the ISM as I’ve been warning that inflation will be higher than expected all year. We had a brief deflation in the 4th quarter of 2008, but that is long gone. And no, manufacturing is not back to where it was yet, but it is moving in the right direction. Of course with rising productivity we will not see manufacturing employment recover to its previous level but that isn’t news. Manufacturing employment has been falling for years but the US is still the largest manufacturer in the world.
So, of course you are right, the economy is not great right now. So what? What matters is the future not the present and I do not believe it is different this time. Double dip recessions are very rare (the Great Depression and the 81-82 being the only ones in the last century) but the fear of them is not. As an investor I don’t think it makes sense to invest on a low probability outcome. Unless the Fed or Congress does something really stupid - not out of the question by any means but less likely in an election year - the recovery will likely proceed as past ones have.
Anthony: I don’t believe the household survey (which is where that number comes from) breaks down the numbers between private and government employment but we know from the establishment survey that while the federal government added 33,000 jobs (9,000 for the Census), local and state governments continued to lose jobs so the total was a loss of 8000 jobs in government.
Rantly McTirade said:
NBER has not yet said the recession has ended. The mentioned link,
at hussmanfunds.net, reviews the 4 indicators used by NBER(and no form of GDP is one of those)and, using the assumption that the recession ended in midsummer,compares their performance to how they have performed on average in the months following the actual end of prior recessions since WW2. Only one of the four(IndProd) is tracking the average recovery path, one is improving at a weaker than average rate, one is basically flatlining(no more decline but no improvement-much less ‘typical’ improvement) and one(payroll employ) has diverging further to the downside. Again, ISM indicates one month change in breadth; manufacturing is now roughly on a steady 10 month improvement streak but absolute activity levels are far below 2006-7 levels-no surprise given the ~9/10 month massive collapse(like a shorter 1931-2) from summer ‘08 to late spring ‘09.
We may look back a year from now and say that a strong, sustainable, ORGANIC economic upcycle developed and even accelerated throughout 2010-but at the moment there’s nothing close to a preponderance of hard evidence that would indicate that as a likely outcome.
Joseph Y. Calhoun, III said:
Rantly: I am fully aware of the four indicators the NBER places high emphasis on when considering whether the recession has ended. You can read what they say about recession dating here: http://www.nber.org/cycles/recessions.html
You should also be aware that there are a lot of forward looking indicators other than the ones cited by the NBER. The Treasury spread model used by used by the NY Fed is quite helpful. Credit spreads are also a great indicator of recovery and recession. Compare Baa to Aaa yields; if they are narrowing risk tolerance is rising and the recession is ending. With that spread under 100 basis points, the bond market is predicting a strong recovery.
I also look at TIPS breakeven inflation rates to get an indication of growth and inflation. Looking at TIPS, the value of the dollar and commodity prices gives a real time market view of monetary policy. The 5 year breakeven is now around 2% which is comparable to where it was prior to the recession. I would expect to see a lower breakeven (or outright deflation as we did in the fall of 2008) if the market were expecting lower growth. In fact, I wouldn’t mind seeing that breakeven rate at 2.5% right now. It would make me a bit more comfortable. I can invest in an inflationary environment; deflation is much harder to deal with.
As an investor you can’t wait for a “preponderance of hard evidence” before investing. You have to use market indicators and history as a guide. You also have to be flexible. Right now, the indicators I watch tell me to expect a strong recovery. If those indicators turn negative, I have no problem reversing course and admitting I was wrong.
We’ll see how this comes out in due course, but I do think I’ve got history on my side.
By the way, I have tremendous respect for Hussman. I’ve quoted him on my blog frequently and linked to his weekly commentaries.
alex west said:
…
mong the positives:
Employed rose by 541,000
Unemployed fell by 430,000
Labor Force rose by 111,000
Employed part time due to economic reasons fell by 849,000
Employed part time due to slack work or business conditions fell by 580,000
Manufacturing jobs rose by 11,000
Motor vehicles and parts employment rose 22,700
Retail trade rose 42,100
Professional and business services rose 44,000
…
blah blah blah..
#labor
in 2009 US lost 4 mln jobs.. ( look at un-adj data).. period
unmpl benefits up 100 % (yes 100)
#taxes
pers income taxes down 18 % 4 month 2010 fin year.
corp taxes down 33 %
sales taxes (state) down 11 %..
so where’s recovery viriginia ??
alex
see
cbo.gov
daily treasury statement
Joseph Y. Calhoun, III said:
alex: Look at forward looking indicators such as the ISM or the Treasury curve or credit spreads. Look at corporate profits, particularly of the financial companies which benefit enormously from the steep yield curve. There are plenty of positive indications out there if you are willing to consider them. Your comment is similar to ones I’ve noted on other sites such as the Big Picture, Barry Ritholz’ site. It almost seems as if some are so wedded to the US in decline scenario that they become almost irate at anyone who dares to challenge their view. That’s a dangerous attitude for an investor. You have to remain open to the possibility that things are not as you perceive them to be. I certainly am.
Rantly McTirade said:
I was speaking in an economic forecasting context(generally not so useful), not a portfolio management one; the correlation is often uncertain.
The US has been in relative decline for 40 years; completely normal given the massive relative advantage it had @ the end of WW2. Trying to avoid or reverse that inevitability, instead of intelligently dealing with it, has brought unnecessary travails.
On ISM again, it typically has been a good directional indicator for the US economy, though again the magnitude of change has had a clearly looser link. This is because the manufacturing sector has been the ’swing’ factor in the US economy for decades as the service sector has generally ploughed ahead at a very steady pace with minimal swing in pace in either direction. However in the current cycle, we’ve had a what looks to be permanent elimination of service sector activity, notably in a) financial services(I’ll skip detail; its obvious) and b) retail(again, we’ve had a huge drop in retailing with multiple small-medium chains closing completely-as well as lots of individual stores- and store closures by nearly all major retailers as well. This has left a ton of excess capacity out there, primarily in retail and office(for financials) space and in unemployed people; I think one big reason the ‘reemployment’ process has been so hard is that retailing was the ‘fallback’ job source for those who lost jobs in previous recessions, especially the last couple. This overhang is going to be a drag on economic upside for some time; ISM services has seen a much less vibrant sequential rebound so far than the manf. one-since services is a good 4-5x bigger than manf., I wonder why the financial media hasn’t pointed this out more(sarcasm drips). And since manf. remains in a very long term trend of shrinking employment, even a semirenaissance in US manf-which I think has a good shot of occuring in the coming decade-will not provide a significant job boost. To use a wrestling analogy, a NCAA champ @125 lb probably can ‘fireman carry’ , at least for a while, a quality 150 lb class wrestler;whether he can do it to a Sumo champ who’s flat on top of him is different.
Joseph Y. Calhoun, III said:
Rantly: You’ll notice that I haven’t said anything about the duration of the expansion I expect. I have a lot of the same concerns as you concerning the durability of any recovery. Having said that, I think you have to wait to see how policy changes. Personally, I think we have to embrace the rebalancing of the global economy. The US has a place in the big scheme of things but it isn’t on the consumption side. Our days as consumer of last resort are over. We should be changing policy to shift the tax burden to consumption and away from capital and income. We can’t restore the status quo and we shouldn’t be trying.
Avery Zelaya said:
Thanks for another fab article - I
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