TGIF


“Everyone’s hopin’ it’ll all work out.” – Loverboy, Working for the Weekend

by M. Kevin Flynn, CFA

If you’re feeling bullish, you can make the case that the market has had a steady series of higher highs and lows in the S&P 500 going back to the beginning of June. It is climbing the wall of worry, so to speak, given that the number of down days has outnumbered the up ones going back to the end of April.

If you’re a skeptic, welcome to the club and take heed that the market is back to where it was four months ago. The kick-the-can-inspired cycle of rallying on the absence of meltdowns has us barely above the level of April 2011, and we will probably be back below that before the end of the month – unless it’s on a Friday: the June 29th, July 13th, July 27th and August 3rd counter-rallies are responsible for more than half the market gains this year.

If you’re bearish, you take comfort in the last statement and note that neither the eurozone nor the European Central Bank (ECB) has come up with a genuine plan to pull Europe out of its spiral. For good measure, you might add that more
central bank action can only cushion Europe’s downturn and cannot take the place of needed structural adjustments. In the meantime, economies around the globe continue to sputter, and the supply of Fridays is limited.

And if you’re a trader, you are (hopefully) simply riding each wave as it comes with the understanding that until Europe comes up with the big fix, nothing is permanent, neither rally nor decline. The risk of sudden catastrophic error is as large as ever, so you keep your bets limited and go with the flow. Oh, and don’t short the Thursday close.

Friday’s rally was classic contrarian stuff and the sign of a market desperate for the rally it had promised itself. Wednesday came and went with no talk of imminent action from the Fed, but by Thursday morning traders had begun to convince themselves – yet again – that Fed Chairman Bernanke had signaled imminent action at the next meeting. A market rallying on the hopes of Fed action that never comes is classic stuff.

Thursday came and went with no action from ECB president Mario Draghi, not even the rate cut widely presumed to be the bare minimum. There was only talk of further studies and the fruitlessness of doubting the euro (though he stayed away from the subject of which countries might still be using it a year from now).

A possibility that we pondered on Seeking Alpha last week is that German central bank (Bundesbank) president Jens Weidmann and ECB chairman Draghi reached a kind of Faustian bargain whereby Weidmann conceded some technical grounds for action in exchange for a) Draghi holding off on further action a bit longer; b) more learned debates on what will and won’t work; and c) not appearing to cater to the scoundrels that run the stock markets.

When the job market report finally came in with a positive surprise for guns that had been cocked for three days (markets wanted to rally on the 31st as well), it was no surprise when the shooting started. Ergo, yet another low-volume, disproportionate rally that involved the usual shaking out of the weak hands and squeezing of the shorts.

A light calendar next week means one of two likely scenarios will prevail. The first is that markets work themselves higher in a kind of nonsensical frenzy to hit the May S&P 500 high of 1420, only 2% higher than Friday’s close. It won’t be easy to get there next week on its own power, however.

What is needed to really shape the markets now is some kind of European statement. A positive one from either Draghi or the Germans will provide the fuel for a move towards 1420. A negative one will see us quickly head back to 1340.

Monetary policy alone will not fix what ails Europe, China, or the United States. The danger for investors is that traders will act as if it will – until it doesn’t. The sugary liquidity lure could provide the octane for a sawtooth rally towards an October high, with a move towards 1420, 1450 or even 1500, all based upon nothing more than one school of momentum prevailing over another. Perfect fuel for a crash.

On the other hand, monetary policy could end up providing the balm for a rebound as stock markets reel from one of many strong possibilities, including 1) another downgrade of the U.S. credit rating; 2) a downgrade of the ECB credit rating; 3) another Grecian stumble, with exit still a possibility; 4) a showdown between one of the larger weak sisters (Spain, Italy) and the ECB and/or German-led bloc that provokes a crisis; 5) an Asian surprise, probably from
China; 6) a policy blunder in the name of ideology; and 7) the other likely scenario: traders wake up to the lack of earnings and growth.

The global economy continues to stagnate, and monetary policy alone cannot solve its problems. There is still time for a grand bargain to address the structural problems, but it is running out. We do not rule out the possibility of the grand fix and would be delighted by its arrival, but history suggests that only a crisis will convert words to action.

The Economic Beat
The good news about last week’s data releases is that they weren’t as bad as the market’s fears. The bad news is that they in fact show a weakening economy and really aren’t supportive of a sustainable rally. That a fearful market rallies on data that isn’t as bad as feared is nothing new, but is very different from the bad-but-getting-better kind of news that can light a sustainable rally and invite one to go all-in.

Make no mistake about it, the economy is slowing from the first quarter into the second quarter and into the third. Weekly retail sales numbers were not pretty in July, despite the usual monthly ritual of some of the bigger chains beating estimates designed to be beaten.

Factory orders were in the negative column for June, though why estimates were for a positive number after last week’s durable goods release is a mystery. The larger significance could be in the downward revisions to the declines in durable goods and business capital goods. We wouldn’t draw the usual straight Wall Street line into infinity on the small downward revisions, but a negative direction of revision is never anything to cheer about.

The weakish momentum going into the third quarter was also reflected in the ISM manufacturing index. Although the value of 49.8 is essentially no change from the month before, some of the underlying data showed hollowing out of the legs. The seasonal adjustments are masking significant weakness in areas such as new orders and production, while backlogs are falling at a non-negligible rate. The Dallas Fed survey showed a nastily sharp contraction to (-13.2), where a
positive read had been expected.

Yet all is not lost. ISM employment readings are steady, and while that is admittedly a lagging indicator, prices did creep up a bit, and they are the most significant leading indicator. Some areas, particularly those related in some way to automotive manufacture, are seeing steadily strong business, echoed in a reasonably good Chicago PMI report with an overall reading of 53.7. Responder comments in both surveys were a mosaic of strong and weak spots, with the national ISM comments more optimistic than its reading would appear, and the Chicago comments more pessimistic. The Dallas region is probably undergoing a needed breather from a long expansion fueled by oil and gas drilling.

The employment data, as noted above, hit a market starved for a positive surprise after being let down by Messrs. Bernanke and Draghi. Like the manufacturing report, it contained both good and parts.

The good parts aren’t easily seen from the headline numbers of 8.3% unemployment and the seasonally adjusted number of +163,000 jobs. The unemployment rate ticked up a tenth, as did the U-6 “under-employment” rate (15.0%), which tracks both the unemployed and the underemployed (anyone who wants to work full-time but doesn’t). Both rates are nevertheless significantly better than the year-ago rates of 9.3% (overall) and 16.3% (U-6).

In the case of July 2012, the Labor Department’s seasonals may be the best of the year so far. In the real world, July is rarely a month of actual net additions to the labor force; the end of the second quarter is actually the second-largest labor cliff of the year in terms of separations, exceeded only by the end-of-year decline that comes after December 31st. When analyzing the data, what matters is not the absolute cliff but the relative one.

Comparing the July preliminary results against workforce data since 1980, and using the actual data instead of adjusted, yields some good insights. The average loss of jobs in the month following the end of the second quarter is (-0.95%) of the total workforce since 1980, or about one percent (January is roughly double that). In 2012, it was (-0.98%) of the workforce, which is very close to the mean and the best number since 2007.

Most of the separations at the end of the second quarter are replaced in one form or another in the ensuing months, at least in a good year. The mean change in actual jobs from the end of December to the end of July is (-0.15%) since 1980, a figure that shouldn’t surprise given that it contains the two largest declining months of the year. It hasn’t been positive since 2006. In 2012, the figure for the first seven months was (-0.11%), a number slightly better than the mean and also the best number since 2007.

If you’re wondering why jobs aren’t recovering faster, forget all the polemics about taxes, regulations, health care and whether it’s the year of the goat or the year of the rat. It’s because our manufacturing workforce is little more than a third of the size it was in 1980, and the production of goods is what rebounds fastest from recessions.

Employment is recovering, but slowly. The unemployment rate for the college-degreed remains at a low 4.1% – again, think of the smaller manufacturing base. But there is no pressure in the demand for labor. Average weekly hours are stuck, virtually unchanged from a year ago. Average hourly earnings are up 1.6% over the same period, barely in line with inflation. Anyone over 50 or under 20 can tell you how difficult it is to find work. The participation rate of 63.7% is a decline of (0.3%) from last year, and that is behavior rarely seen in a recovery.

So while we’re hanging in there and consumer confidence edged back up a bit and the data isn’t the stuff of plunges, at the rate we’re going we will end up losing a few more tenths of a point of GDP this quarter. The key components of personal spending and business investment are dragging. Government spending is a negative every quarter and won’t change before the first quarter of 2013 at the least, if at all. The mild rebound in construction and housing has been nice, but no game-changer. Stall-speed remains a danger, and the effects on global trade from the Chinese and European slowdowns continue to matter. Unemployment in the EU is now at a record high since 1995 (when first kept).

The biggest data scheduled for next week is probably from China, which releases figures on retail sales, industrial production, inflation and the balance of trade next week. Germany will feature releases on manufacturer’s new orders and industrial production. That matters because the country may need to start feeling a lot more economic pain before its people can wake up to the dire reality of the continent’s situation.

In the U.S., a very light schedule includes consumer credit on Tuesday (moved mostly by student loans), labor productivity and cost data Wednesday, and trade figures on Thursday and Friday (balances and prices). Any market-moving items are likely to come from politicians, as random a guess as ever.

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