Darkness at Noon


“There’s no more faith in thee than in a stewed prune.” – WIlliam Shakespeare (Falstaff), Henry IV

It’s time to start thinking about trading back into stocks. Mad, are we? Perhaps. But in our column of April 2nd of this year “Hope Floats, IV”, we derided the tidal wave of confidence about the strength of the economic recovery. The “V” was a done deal, the thinking went, and the majority of investors favored a prediction that the yield on the 10-year Treasury bond would rise to 5.5% (it has since fallen to less than 3%).

A sampling of the press coverage at the time: “Hope at Last,” on the cover of The Economist; “Factories revive economy” was the headline on the front page of the Wall Street Journal, while the Financial Times reported that the American economy was reaching “escape velocity.” As the rally wore on, we became more and more skeptical (e.g., for the week of April 23rd, we wrote that the markets were “dangerously overbought.”)

Well now, here we are at the end of a seven-day losing streak on the Dow, the longest since October 2008 (an eight-day event) and entering the kind of light news week that favors a continuation of the existing momentum – in other words, down.

The Economist ran a special 14-page section on credit that said in effect that the West is stuffed, the FT talked of the “flagging recovery” in the U.S. and the Journal reported that the “U.S. Jobs Picture Darkens.” Not to be left behind, last Sunday’s New York Times featured an article by Paul Krugman warning of the dangers of another depression.

Market prices collapsed on Tuesday when the Conference Board reported a correction in its Leading Economic Indicators for China Index for April from 1.7% to 0.3%, based entirely upon an error in the “Total Floor Space Started” Gee, wasn’t cutting down on commercial overbuilding an official government goal?

The June jobs report was slightly worse than expected, with private sector payrolls only up 83,000 instead of the expected 100,000. Bob Pisani observed on CNBC that the number was actually a relief, because for the last two weeks everybody on the floor was expecting a number worse than the consensus. Now, it’s a bit curious to call something “consensus” when the market is clearly expecting something else, but putting that aside, what does all of the above tell you about the current state of expectations? Could they get much worse?

Well, a little, perhaps. Momentum is a powerful force in the markets, and it’s currently downward. But it’s also nearly exhausted itself.

Consider for a moment that Dow Jones eight-day losing streak in October 2008 – one that going by today’s tea leaves, we are probably going to tie on Tuesday. At the time we were riding in the wake of a colossal policy blunder, the grandest of our lifetimes. The idiot-ological decision to not properly quarantine Lehman Brothers, but simply look the other way while it burst unleashed a massive financial panic around the globe. Order books vanished literally overnight, for fear of never getting paid. The financial system peered into the abyss. Earnings and GDP fell off a cliff in the ensuing months.

Contrast that with today. Corporate earnings are rising, as is GDP. Companies are confident in their results, as witnessed by behemoths such as 3M (MMM) raising guidance last week and Dell Computer (DELL) announcing plans to hire 5,000 employees over the next few years. Payrolls are rising, not falling.

The problem is that we aren’t growing as fast as our springtime fantasies. The market’s reaction to finding out that it isn’t getting the candy it dreamed of is a typical one. Pounding the floor, screaming and crying, wailing that the only alternative to a “V”-shaped instant recovery must be a recession. No, it isn’t.

When a springtime rally ends badly, it usually continues to chop its way lower until the end of June or middle of July. It’s more commonly the latter, because that’s when earnings can come along to bring the message that business isn’t going as badly as our worst fears – just as it wasn’t going as well as our fondest hopes.

The current slowing in the growth rate – a very modest one, at that – should not have come as a surprise. It isn’t as if MarketWeek was a voice in the wilderness crying out that growth rates would be milder than hoped. The illustrious (and we will grudgingly admit, somewhat better known) leaders of Pimco, Bill Gross and Mohammed El-Erian, continually warned of “sugar highs” in the equity markets and held steadfast to predictions of a “new normal” 2% real GDP.

But momentum makes the news. As the short-squeeze trade continued and prices rose week after week in the spring, the understandable desire to believe in the most positive outcomes got the better of the media and many others. Now the momentum is headed down, and we are getting the usual emphasis on the worst possible outcomes, when the real problem is one of deflated expectations.

Last week we suggested that traders might try to push prices higher into the end of the month and quarter, but unwittingly left out the caveat, “unless external events intervene,” which they did in the form of worries about China. Nostra culpa.

We’re still set up for a test of 1000 on the S&P, and momentum will probably carry us a bit lower than that before we can start to reverse. But with companies such as HP (HPQ) and IBM (IBM) trading at less than ten times earnings, it’s time to start edging back into equities (we own them both). The mood is so poor at this point that the market is nearly to the point where anything resembling an improvement will launch a rally. Get ready.

The Economic Beat

Woe is me, said the tape. But the data didn’t paint a picture of woe and double-dip recession, only a picture of a mixed recovery and things that we’ve told you to expect – that manufacturing would still grow, but not leap off the mat quite as fast as the first quarter, that housing is comatose this year, and that employment gains will come in installments. In short, a stair-step recovery.

We’ll come to the jobs report, but most of you have already seen a good chunk of it splashed all over the front pages (albeit with the usual characterizations ranging from lazily misguided to amusingly fatheaded). Let’s start where the week began, with the personal income and spending report.

This one was actually rather good. Personal income is growing at a steady clip of 0.4% per month, and April was revised higher to 0.5%. The consumption side of the report showed an increase of 0.3%, led by autos. Those who are working are willing to spend a bit, or they wouldn’t be running off to buy new automobiles.

On the other hand, June auto sales were a bit of a disappointment, coming in below the estimated rate. We don’t mean to be apologists, but would caution against a misreading of results that appeared respectable to us. Recessions tend to turn everybody into a bargain hunter, such that the presence and absence of incentives have an outsized impact on sales and blur the seasonal adjustments’ fit with underlying demand.

Anecdotal evidence does suggest that bad headlines about the financial world have made some consumers cautious, but that is typical of recessionary times. Sales of pickup trucks are doing quite well, which we see as a positive leading indicator. The U.S. automakers are gaining share with fewer incentives, while Toyota (TM) is having trouble moving vehicles without them.

Traders and the media that swim in their wake will keep getting too excited by better months and unduly depressed by weaker ones. As much we’d all love a nice 45-degree upward slope of recovery, we’re not going to get one. But that doesn’t mean that we’re all going to the dogs; it just means more doomsayers on TV and the covers of magazines.

In the first quarter of 2009, we made a point of reminding people that the dour headlines of the moment had nothing on the nineteen-seventies, a truly rotten period. Although unemployment was lower at the time, the climate was such that predictions of economic apocalypse and the imminent breakdown of civilization were staples for years. They erred.

When times are frothy, we may get books about the Dow hitting 30,000, but you might be interested to know that only a few years before that piece of wisdom appeared, certain prominent technicians were predicting three hundred on the Dow just over the horizon. Academics tend to eat this world-to-hell stuff up, partly because they are astounded that people who are clearly their intellectual inferiors (a group that comprises most of the known universe to any self-respecting professor) can be so ignorant and yet earn more money. Caveat emptor.

However, a key difference between the seventies and our current era is the much-diminished role that manufacturing plays in our economy. A look at Labor Department statistics can tell you that entering the 1973-1975 recession, manufacturing comprised 23.9% of total non-farm employment. At the end of that recession in late 1975, it had slipped a little to 21.8%, but remained stable thereafter for some years. Thus, entering the 1980 recession, manufacturing employment remained at 21.34%, and five years later it was 21.37%, or virtually unchanged.

But then the great outsource began, accompanied by a decades-long hiring expansion in financial services that further altered the mix. At the outset of the year 2000, manufacturing employment had fallen all the way to 13.3% of total non-farm rolls. Eight years later, with the 2001-2002 recession behind us and another about to begin, it had fallen further to 10%. It now stands at only 8.9%, less than half that of 1985.

The classic post-war recession was an inventory recession, with too much stuff on the shelves. Once the imbalance was worked off, employment could recover quickly as manufacturers revived production. Union seniority rules ensured that laid-off middle-aged workers returned to work first.

Work rules may not have changed much, but manufacturing’s piece of the twenty-first century American pie is much smaller. Compounding the problem in the trade sector is that its last boom was in residential construction: an excess of homes takes a lot longer to work off than an imbalance in autos or televisions. It’s going to take another year or two at minimum before homebuilding can resume something resembling normal conditions.

Less manufacturing and no impetus from construction means a much bleaker picture for the current middle-aged skilled worker in the trades. High unemployment is going to linger, and we have to tell you that there really isn’t that much the government can do about it.

People may argue about whether to tilt more money to corporations or to people, depending on their political bent, but neither approach will alter the fundamental problem that we have to go through a structural adjustment. Another stimulus program would cushion the effects – we said over a year ago that a second one would be necessary – but it would only be a cushion, not an engine. In theory it would help warm the engine and thus speed a recovery, but the possibility of policy blunders is always a risk.

That said, we see the reports on manufacturing and employment as respectable in view of the circumstances. The Chicago PMI reported a good reading of 59.1, with a sharp improvement in employment and consistent strength in new orders. The national ISM manufacturing reading was 56.2. New orders fell by over seven points and exports by more than six, however, causing much hand-wringing on the Street and wailing about the excessive strength of the U.S. dollar.

Regular readers know how much we bemoan the misunderstanding of the ISM surveys and their regional kin. They are monthly diffusion reports of rates-of-change that have very little relation to absolute levels of economic activity. One could have a high ISM reading two months after a global nuclear Armageddon, so long as the production of bows and arrows went from two to three, while an economy running flat-out at full capacity would be doing very well indeed to stay at a neutral reading of fifty.

It’s nearly impossible for such readings to stay above sixty for long. To news reports that say that the ISM fell to its “lowest reading in months,” we say, so what? The industry would instantly accept an order book that produced readings of 54 for the next two years, let alone 56. The surveys aren’t much of a leading indicator of either the economy or the stock market. New orders were at 58, which is good coming on top of previous readings.

We look upon the report as evidence that manufacturing is continuing to improve. However, as pointed out, the sector is now a much smaller part of the economy. The sector only added 9,000 jobs in June, according to the BLS, its smallest gain in some time, but we have been saying that there would be a pause.

Construction recorded a second consecutive month of job losses. That was echoed by the April report on construction spending (a loss of 0.2%, actually better than expected), and by May pending home sales, which dropped by 30%! Not so remarkable if you had noticed that purchase applications fell by 27%. You can now officially ignore the spin that tried to explain the drop in sales on bank delays in processing foreclosures: purchase applications were even lower in June than May. The Case-Shiller reported that prices rose in April, but this time at least it was understood as a one-off.

The slowdown that led the stock market to take fright and post such a lousy quarter with many alarming headlines clearly affected consumer attitudes. The confidence report took a sharp drop from 63.3 to 52.9, the size of the dip surprising us. Although it’s well-known that the reports don’t correlate well with actual spending, the poor outlooks on employment and spending plans shouldn’t be ignored.

The high level of weekly claims is obviously a problem. It’s clear from the various reports that employers are being cautious, and that improvement will be painstakingly slow. Weekly aggregate hours ticked up a tenth in June, a plus, but average weekly hours, hourly and weekly earnings all edged down. A very large number (625,000) left the workforce, cutting the unemployment rate in the worst of all ways.

Still, the pickup in manufacturing should continue at a steady pace, nourished by the need for goods replenishment. Business capital spending turned in a decent rebound in May with a 2.1% increase in non-defense capital goods excluding aircraft. Transportation and warehousing hiring is showing steady, if not sizable, improvement, but the drag in government employment is working against the
recovery.

The Monster employment index rose, however, and the local market here and elsewhere in financial services seems to be improving. All is not lost. One of the factors distorting seasonal adjustments in employment is that construction should usually be taking off at this time of year, but it isn’t. It won’t start to improve until next year’s building season, either, and quite modestly at that. Employment will recover more slowly than the optimists predicted, but that doesn’t translate into 1000 on the Dow (cf. this week’s business section in the New York Times).

Looking ahead to next week, the calendar is light in the holiday-shortened week. The ISM non-manufacturing report on Tuesday is the most noteworthy report, but the market may care more about weekly claims and June chain-store sales reports. The latter will probably be up year-on-year, but mixed. We would not be surprised to see overseas reports – or fears, or hopes – take center stage.

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