Riding the Train


“The trouble with you is the trouble with me, got two good eyes but they still don’t see.” – The Grateful Dead, Casey Jones

A month ago, our column title was “Jobs Jolt June.” It was tempting to double up on the alliteration this week with “Jobs Jolt July.” We might have, too, had the market sold off more than it did. It probably should have, and that’s a warning sign for bear and bull alike. When a stinker the size of the July report hits the market and the reaction is as restrained as it was on Friday, it’s either an oversold market too shell-shocked to care, or an overbought market too far gone into dreamland to wake up. It wasn’t the former.

What’s amusing – though maybe not so much to short-sellers – is that the media seems to keep biting on the story that the recent end-of-month, mark-em-up rallies miraculously rescuing prices for the last four months in a row are somehow related to Greece. If the Greek debt outlook was really priced into the market, the S&P would be about fifteen percent lower than where it is now.

It’s remarkable to read various market pundits talking importantly about strategy and perspective based on how the Dow and S&P are up eight or nine percent on the year, when almost the entire gain came over the last eight trading days! Seven really, being the last four days of June and the first three days of July. Pay attention, people. This trick is four months old now. The shorts, they did pay attention this time, and began running for cover the moment the horn blew on Monday June 27th, adding fuel to the move.

But wait, you might say. What about that Greek vote that week – wasn’t it really a relief rally? Don’t be naïve. Traders don’t believe for a minute now that the Greek situation is settled, and they didn’t believe it then either. What they did believe – correctly – was that the threat of immediate default was taken off the table at the beginning of rally week, for at least long enough time to get the game going again. That was all that mattered.

Newsletter writer John Mauldin wrote in his latest issue “the market does not get it.” When a friend brought it to our attention, our initial inclination was to agree – it seems the best explanation for bidding up prices in the face of visible peril. Now we are not so sure. It might be useful to step back and reflect on just who is “the market.”

Not the mutual fund managers, not anymore. Equity inflows into domestic funds have been virtually nil this year. The truth is that they are virtual prisoners of the market fluctuations, because they have so little influence. Fully invested, the best they can do is rotate from one sector to another and pray. They certainly aren’t going to complain about the month-end mark-ups that keep their funds in the black. If anything, they stand ready to add what little cash they have on hand to the buying when the time comes.

The Wall Street Journal ran a piece over the weekend (“Stocks: More Room to Rally?”) that covered the triumvirate of worries we have been fretting over in our annual and quarterly reports: the debt ceiling battle and its possible consequences, too much bad paper in Europe, the China bubble (good to see our reports are getting around). If the Journal is writing about it, you can be sure that every trader in Manhattan has at least heard of the situation.

We think that it’s quite possible that the market by and large does get it – including the pack of traders playing Liar’s Poker with prices at the end of every month. It’s been a typical Street mélange – traders playing daily momentum, traders specializing in the pain trade, hedgies and fund managers playing a little position flipping with their eyes glued to the charts and their ears glued to their traders. These risk-on, risk-off rallies have been low-volume affairs because they lack both money and real conviction. What they have is greed and a business need to publish positive month-end numbers for as long as possible.

It isn’t as if the Street is unaware of the risks. Longer-term valuation-style fund managers – the Einhorns and Paulsons, for example – are taking a beating in this market while they wait for one of the shoes to drop. They were the ones short subprime or the homebuilders (or just the market) in 2006 and 2007, taking some hard lumps along the way. Mutual and pension fund managers, whatever they may think, are captives of fully-invested mandates and a competitive structure that rewards relative losses as well as returns.

The rest of the action in these light-volume affairs is driven by traders who are undoubtedly aware of what’s going on. Their unifying belief is that it’s necessary to make as much money as possible until one of those big sirens go off. They aren’t investing, only renting stocks and other securities from day to day. The ones left holding the bag will be – as usual – the shareholders of those mutual and pension funds, and the day traders who thought they were wired in but weren’t.

Keep in mind that a great many Street players have no interest whatsoever in avoiding bubbles – on the contrary, they seek them out and help promote them. It’s possible to make fantastic profits from bubbles, both on the way up, and on the way down. All of them, right down to the day trader sitting in his or her basement den, think that they can get out in time. But momentum, greed and the power of the crowd always suck huge number of these self-styled cagey, cold-blooded pros into the fatal error of believing their own press clippings, and they get caught.

Another of our favorite metaphors has been making its way of late into mainstream business media – it’s the one based on the “chicken” race from Rebel Without a Cause, where two teenagers race their cars towards a cliff in a competition to see who has the nerve to stay in the car the longer before jumping. But one of them gets a sleeve caught in the door, and can’t escape.

This is no investor’s market. Prices aren’t telling you anything but the direction of this week’s news flow and whether or not one of the three “black swans” have been spotted yet. Don’t fall for the hype, and don’t get your sleeve caught in the door.

The Economic Beat

That jobs report that you surely read about was as bad as advertised. The best thing you can say about it is that it wasn’t negative.

Was it really weak across the board? Yes it was. Categories that are thought to be leading indicators, such as temp hiring and hourly earnings, actually were negative. Workweeks declined, overtime declined. Revisions to prior months, a good indication of the direction of the employment tide, were negative.

A measure of relief was the unintended humor that came out of the coconut crowd. The story went round that the seasonal adjustment factors were wrong, and that using last year’s factors would have put out a number in excess of 200,000. This theory was neatly demolished by the people at the Liscio report, specialists in employment and tax data. They pointed out that one, it was incorrectly calculated; two, there is no good reason for using old seasonal factors; three, if the old seasonal factors were calculated correctly, June would go up (to about 70,000) but May would go down by nearly the same amount.

The nuttier coconut of the day: the Obama administration had deliberately cooked the number, you see, in order to win support for a new bailout program that it would later credit for the recovery that would have happened anyway. Right. Well, what else could it be? Ergo, the slowdown is a misprint, or a mistake, or transitory or something, but give us back our rally!

We would also observe that one of the only sectors to consistently gain jobs has been health care. The local paper ran a headline last week noting that Massachusetts hospitals would lose significant funding if some of the contemplated Medicaid/Medicare cuts went through. While we won’t quarrel with the principle that health care costs need to be reined in, the first two things to go under some of the draconian cuts contemplated in health care will be jobs and care, with the burden of the latter falling on the elderly and indigent (the elderly rich will probably be okay).

Before you Joe Kernan-types start to have your head explode in righteous wrath as to why we are in this situation, we aren’t trying to make any polemical or even political point. It’s just what’s going to happen, is all. It’s already started: hiring in the sector slowed to its lowest number since January.

It was a bad jobs report, and the month was weak, that much is incontrovertible to all but the fringe set. The more important answers to seek are one, what happened with the ADP report that set the market on fire the day before (it estimated private payroll growth at 157,000), and two, how transitory is the current situation?

Diane Swonk, chief economist at Mesirow Financial and one whom we’ve always admired for a pragmatic approach, quickly put forth an interesting notion for the difference: ADP might be picking up hiring at newly public companies better than the Labor Department, which may not yet have added a Groupon (Swonk’s example company) to its survey. It sounds plausible, and would suggest that the real number lay between the ADP version – potentially distorted upward by a sample including Groupon – and the Labor Department, missing out hires in the Web 2.0 economy.

The explanation would have the added virtue of exciting the creative-destruction zealots, but it doesn’t quite cinch the matter. The household survey is supposed to better at picking up hiring at new and smaller businesses, and that side of the report wasn’t just a disappointment, it was flat out terrible – a loss of 445,000.

We would gladly be the first to say that the initial estimates from the household survey tend to be very rough indeed – revisions of over 100,000 aren’t unusual. But 445,000 is just too big of an elephant to conjure away. What’s more, the civilian labor force had an estimated drop of 272,000, an indication of rot rather than strength below the waterline. Had the unemployment rate increased due to people joining the labor force, we would say, just wait a bit, better times are coming, but this was the opposite.

The Labor Department’s version also correlated better with other indicators. Weekly claims were elevated all month long. Recent measures of consumer confidence and sentiment revealed higher levels of pessimism about the job market – and they do tend to correlate well directionally with hiring. The ISM non-manufacturing survey showed fewer firms increasing hiring and more firms decreasing – and non-manufacturing makes up 91% of employment. Layoffs increased a bit as well. One silver lining – the Manpower help-wanted index edged up, and that fits in with Ms. Swonk’s observation on IPO-firm hiring. The drawback with hiring driven by investor money is that the latter ends abruptly.

The main factor holding back employment is a lack of demand. The arguments about uncertainty are mostly self-serving polemics promoting a view; if anything, we would say the most concrete effect of uncertainty is companies hoping to game the system by holding off new hires, in the hopes that the government will bribe them to do what they would do anyway. But the larger problem is that demand is growing quite slowly, and companies that are able to expand their labor inputs outside of the country do so.

Coming back to the ISM non-manufacturing number, it declined from 54.6 to 53.3 in June. Not a significant decline, but slowing. Contrast the reaction to the manufacturing survey, which rose by 1.8 from 53.5 to 55.3: that change was treated as the Second Coming and conclusive proof that the so-called soft patch was over. The market doesn’t get it here. Nor did it get the employment reading, which seemed unchanged going from 54.0 to 54.1, but a peek underneath would have revealed the weakness noted above (less growing, more cutting). It could only have been seasonal adjustments that kept up the headline.

Other weakness in the ISM services number could be found in prices and imports. New orders also fell, but they are less important an indicator, as it doesn’t even apply to most of the sectors.

Looking over the rest of the week, factory orders rose 0.8% in May, a bit less than expected, while inventories increased by more than expected for the second month in a row. The warm weather and heavy discounting in June will have alleviated some of the retail inventory, as well as helping retailer sales comparisons (although margins are going to be disappointing). Consumer credit increased, with credit card balances up a second month in a row. That helped spark a slightly desperate reversal in the market Friday afternoon. Competition in the card market is heating up, leading to somewhat improved conditions, but so long as personal income is flat to down in real terms, this is no panacea.

Looking ahead to next week, Alcoa (AA) gets things going with its earnings report on Monday after the close. The outlook will probably matter more than the numbers, a dynamic likely to be the case throughout earnings season. Fed minutes are released Tuesday afternoon, but the real action happens Thursday and Friday. JP Morgan (JPM) reports Thursday morning, Google (GOOG) after the close. On the economic side, the Producer Price Index (PPI) and June retail sales will accompany the usual weekly claims, as well as business inventories.

Friday brings Citigroup (C) earnings, along with the Consumer Price Index (CPI), New York Fed manufacturing survey, June Industrial Production and consumer sentiment. It’s also expiration day for July options. Days that are this crowded tend to confuse the markets more often than not, and so usually move less than one would think.

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