New Decade, Same Playbook


“What has been done will be done again; there is nothing new under the sun.” – Ecclesiastes 1:9

Was Monday the first day of the year? Indeed it was. And did the markets properly rally? Indeed they did. Despite some of the fuzzy misreporting about the sequence of events, the Dow was up over 100 points in the first thirty minutes of trading, before a single piece of news had crossed the wire.

It’s a New Year, my lads and lasses. Squawk boxes across the land welcomed the troops back from vacation with the same message – well done (to those who remain, anyway), hope you enjoyed your ski trip, but now let’s hit the ground running and write some tickets! We’ve got new quotas to meet, new goals to exceed! Upgrades poured out of the canyons of lower Manhattan like fake watches out of Asia, while traders rushed to pour beta into their tanks.

But that was about it. Had you cashed out around 11 AM Monday morning and gone back to trying get the snow off your New York City street, you’d have done fine. Better than the markets, too. Although ADP’s big head fake on jobs growth (see below) got the market to a higher peak on Wednesday, by Friday’s close we were back where we started. Not that that was so bad, still up a percent or so for yet another week in the black.

It’s a funny place, Wall Street. Doubtless you may have heard about the rise of mathematics on the Street. It’s true. The firms develop ever-more complex models and equations for pricing things on the fly, such that your average bank head really has no clue on the validity of many of the prices.

Then there’s the economy. It has far more variables and unknowns than your average structured product, so you would be forgiven for thinking that the math would be correspondingly more complex. And you would be wrong. The main economic tool method on the Street remains the straight line, and its widest implementation is connecting two data points.

Thus, we are being treated to forecasts of 2011 that largely consist of the month of December being repeated for the next twelve months. If the model is sophisticated, it may go all the way back to three months ago, but only if the results look better that way.

We’re not going to join the group making predictions for the end-of-year S&P 500 index, because we don’t have to, but we will say this: neither the economy nor the market will go up in a straight line.

Some of the immediate problems: equity markets that are overbought; traders who have forgotten fear; a European debt situation that continues to deteriorate (but so long as it happens slowly, that’s a problem for sometime later); a Chinese financial bubble that the authorities aren’t sure they know how to unwind; the next panic attack in the stock market from the next pause in manufacturing; and a new Congress that may stumble badly if it goes too far in trying to impose ideological purity on impure markets.

That aside, the prevailing view in the market seems to be that we will soon suffer a minor correction of a few percent or so that will not derail a mighty momentum wave before March. This is not a new page from the trading playbook, as the November-March rally is a pretty familiar sight on the Street.

Hope that we don’t keep a straight-line rally going into March. That may seem strange to say, but if we do the payback is going to be bigger. One big problem: since commodities are now a preferred beta trade, an equity rally into March is going to mean another mini-bubble in oil prices that will more than offset any benefit from the payroll tax cut. We’ll be back to $4 gasoline and narrowing profit margins everywhere but the oil industry. Food price tensions will erupt again.

One thing that we do agree with is that the market is overbought. We’ve been saying so for weeks, while acknowledging at the same time that end-of-year conditions would mean no possibility of a correction without something really ugly happening.

But now the Santa Claus rally pages have officially turned, and we are about to enter the first quarter earnings season. Alcoa (AA) kicks off the season on Monday after the close, to be followed by heavyweights Intel (INTC) after the close on Thursday and JP Morgan (JPM) before the open on Friday. Valuations have a high bar to scale at this point, but management traditionally is optimistic in the first quarter. It should be interesting.

The Economic Beat

As usual, the highlight of the first week of the month was the jobs report. If you worked for Wall Street or the White House, you dwelled on the big change in the unemployment rate (from 9.8% to 9.4%) and ignored the details. Detail number one would be that half of the drop in the rate came from people leaving the labor force. Not a triumph.

Detail #2 would be the percentage of the labor force that is working or trying to do so, the participation rate. It fell to a 28-year low. Detail #3 would be that the result of +103,000 came in much lower than the consensus, which had been raised to 175,000 in the wake of a gaudy payrolls report from ADP two days earlier. That was the official number, but many were expecting, either openly or covertly, something in the 200-plus region.

There were even fears that a blowout number – say, in the neighborhood of 300,000+ – could be in the pipeline, threatening the Fed’s easing stance and the market’s rallying stance. That fear evaporated quickly.

Economists whose bonuses don’t depend on rising stock markets took a more measured view. Capital Economics called the report a “bitter disappointment,” while the people at the Liscio report, who put these things through a fine-toothed comb, also characterized it as a disappointment, but offered some notes on the bright side: “no major ugliness hidden under the surface” and total employment rose above the level it was at when the recession ended for the first time.

From our point of view, it was no surprise. Despite the clear strength in recent manufacturing surveys, it’s a much smaller part of the economy now than it was in the 20th century. Coming out of the 80-82 and 90-92 recessions, manufacturing was around 25% of total employment. According to the latest Labor Department figures, it currently makes up just under 9%.

Consider also a company like Furniture Brand Networks (FBN), one in which we happen to have a position in the stock. The relatively small company (annual sales of around $2 billion) announced last week that it will open a cut-and-sew facility for making new upholstery, with 150-200 new positions. In Mexico.

Until companies large enough to outsource their labor needs begin to look within our own shores again, most of the hiring will come from service positions, not from manufacturing. That was the case with the December report, as nearly all of the hiring came from service positions, chiefly leisure-hospitality and health care. Positions that we can’t outsource.

In the case of leisure and hospitality, no doubt the heavy snowfalls in the West and Northeast helped out the ski industry, but how many of the positions will remain after the holiday is in doubt. The ISM non-manufacturing survey showed essentially no change in hiring intentions from November.

The market’s post-recovery focus on the job market notwithstanding, jobs are still a lagging indicator. They rate to be even more lagging in this recovery. Weekly claims ticked back up again to 409,000, with the unadjusted number up to 577,000. These are high levels. It’s a problem for the economy.

The problem will be more structural than cyclical for some time to come. The unemployment rate amongst adult over-25 workers with college degrees or better is a very manageable 4.8 %. These consumers have resumed spending in tandem with the improvement in the headlines.

In the absence of a broader recovery, though, manufacturing is going to continue to proceed in a stair-step fashion, with episodes of inventory restocking followed by production plateaus. With each change of course, the financial markets will redraw a straight line from the latest data into infinity – they seem incapable of doing anything else – with an end result of higher volatility in the financial markets.

Homebuilding took over from manufacturing in the last decade as a provider of skilled-labor employment, but although the industry may show a flicker here and there in 2011, it is years away from being able to fill that role again.

The December report showed little to nothing in terms of improving income. The average workweek was unchanged, suggesting little input pressure, and average hourly earnings barely budged. Still, the weekly payroll index managed to rise another 0.3%, the October-November revisions were positive and the diffusion index improved. The market is getting better, but will continue to confound eager talk of “virtuous circles” and “strong and self-sustaining” for many months to come.

As to the ADP report and its skyscraping prediction of 297,000 additional jobs, they have doubtless gone back to the drawing board. Perhaps the revision next month will show a result in between the two. The Challenger layoffs report fell to its lowest level in years, but the Monster online hiring index fell again.

The employment diffusion result from the ISM manufacturing December survey, like its services cousin, also declined, though at 55.7 it’s still a decent result. While the headline result of 57.0 was actually a bit short on consensus (and definitely short of a whisper number near 60), it’s still a solid result, bolstered by very impressive readings in new orders (60.9) and production (60.7). Sixty-plus readings are big.

Some quibbles: only eleven of the eighteen sectors in growth, one up from October but one likes to see a reading in the teens; prices paid rose to a dangerously high level of 72.5; trade slowed (both exports and imports were lower); backlogs continue to contract. It’s a good report, but there were indications of a potential plateau forming.

The ISM services (non-manufacturing) report beat consensus, rising from 56 to 57.1 (consensus 56.1). Business activity and new orders were both very strong, at 63.5 and 63.0 respectively, and an impressive fourteen of eighteen sectors reported growth. But there was that weakish reading in employment (50.5, or flat) and a big spike in prices (mostly due to the rise in the stock market). The ISM is effectively a large company survey, so could be missing smaller-business hiring.

Factory orders for November were a pleasant surprise. No change was expected, but orders rose by 0.7%, thanks to a big revision upward in durable goods. The business investment category was unchanged from its previous level of plus 2.6%.

Another positive surprise was November construction spending, which rose by 0.4% against the consensus of 0.1%. It was all on the public side, as private spending declined by 0.1%. One of the ironies of the report, released at the same time as the ISM manufacturing report, was the headlines the next day attributing the day’s rally to the strength of the two reports. Prices were higher before the release.

The FOMC minutes really had nothing new to add. Consumer credit rose in November, thanks to auto sales, credit cards continue to fall. Mortgage-purchase applications are flat.

Next week is of the backloaded variety, with very little until the end. Nothing of note happens until Wednesday, when we get the December Beige Book (regional compendium of business activity) and import-export price behavior, followed by trade data on Thursday. The Producer Price Index (PPI) also comes out Thursday.

But Friday is the big day. At 8:30 there’s the CPI and Retail Sales for December, with consensus for the latter at a healthy 0.8% increase. These are followed by Industrial Production at 9:15, the first consumer sentiment report of 2011 at 9:55, and finally business inventories at 10:00 AM.

Added to the mix will be the market reactions to the Intel report from Thursday evening and the JP Morgan report before Friday’s open. It could mean overload, but that usually leads to a mixed day. Usually.

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