The Departed


“Little strokes fell Great Oaks.” – Benjamin Franklin, Poor Richard’s Almanack

It was the week of the missing. Famed bond manager Bill Gross went missing a week ago today, having suddenly left his position as head of the world’s largest bond firm, the one he co-founded. Since that time there has been ample speculation over the break-up, which I will boil down to one weighty phrase: Things weren’t so good between him and them.

Pimco sent forth the usual reassurance rangers and mollifying missives that investment firms dispatch at such times, but Mr. Gross had not been heard from at all until Saturday morning’s release of a Barron’s interview, in which he had very little to say about Pimco beyond being “uniquely” pleased not to be involved anymore in company management. Period. Mr. Gross is no doubt more interested in courting old clients than reopening old wounds (for the curious, here is a link to a putative copy of his farewell email).

The stock market rally also went missing last week. At its low on Thursday, the Dow Jones came within a half-percent of being flat on the year. The widely quoted “seventh straight quarter of gains” for the S&P 500 (wouldn’t it be better to be buying after seven straight quarters of losses?), vanished the same day, only to be finally bailed out by the mid-day rebound on Thursday from the 150-day exponential moving average (EMA). It’s the same line in the sand where the late January/early February decline halted.

Some common sense went missing as well, as news of a surprise Ebola patient was partly behind the Thursday sell-off. We’ve all been informed of how difficult it is to transmit Ebola, but the story had been building for some time and the Dallas case was the first unexpected landfall here in the U.S. I don’t think it’s going out on a limb to say that by and large, people don’t put blind trust in government reassurances that all is well. Seven years ago this month, the markets made a then all-time high, and the subprime crisis was “contained.” One year later and six years ago this week, all hell had broken loose and the credit markets were frozen solid, leading to the sharpest downturn in nearly 80 years.

A major reason behind Thursday’s initial sell-off was another object gone missing: European Central Bank (ECB) President Mario Draghi’s quantitative easing plan. Draghi’s dispirited press conference (you can see the text and webcast here) made it fairly clear that the Germans are not budging from their opposition to broad-based bond buying. A smaller purchase plan was announced, and Draghi would not commit to a buy level.

Markets all over Europe plunged on the news. Even so, many economists and jurists in Germany were apoplectic at any plan at all, threatening legal action and claiming that the ECB would be filled with “nuclear waste.” All of this came against a backdrop of weak economic news spanning most of the eurozone. One suspects that the U.K. is feeling as pleased as ever with its original decision to opt out of the common currency.

The head of the Secret Service went missing after a heap of embarrassing revelations appeared. The ceasefire in the Ukraine went missing, but the terrorist group ISIL did not, posting another gruesome murder video and overrunning Turkish positions near the Syrian border. While the two conflicts went missing from Wall Street consciousness on Friday, I suspect that they will not stay so for long. As the price of oil plummets, fueled by a surprise Saudi statement that the country would compete on price instead of cutting production – and thereby undermining ISIL oil revenues – I find myself wondering how long it will be before the ISIL gangsters target Mid-East refineries in order to drive prices back up. Or we have to commit ground forces yet again in the region.

Hong Kong stock prices went missing after more than a week of demonstrations that were suddenly broken up by mysterious gangs of armed men – has the Russian army has been sending “vacation” videos to the People’s Army? Mohamed El-Erian wrote about a missing trio from the latest jobs report, while more estimated earnings disappeared: FactSet announced in its last pre-season earnings report (Alcoa (AA) kicks it off on Wednesday) that the latest consensus is 4.6%, below the 4.9% estimate that accompanied the start of last quarter’s earnings (and about 200 basis points lower than a few weeks ago). That implies earnings growth below last quarter’s actual 7.6% (not the inflated 10% that Bob Pisani keeps talking about on CNBC – I don’t know where he gets this stuff). The recent strength in the US dollar could lead to further guidance cuts from the many S&P 500 companies that derive a third to a half of their sales abroad.

I could go on with more missing items – the offensive line of the New England Patriots comes to mind – but then your patience might go missing as well. Turning back to the market outlook for the coming weeks and third quarter earnings season, I confess to a feeling of unease about the storyline. In the last few weeks, the stock market has actually run very much to form, believe it or not – a mid-September peak followed by declines into early October happens nearly every year. Usually it’s followed by a rally into earnings season, then a sharp, short slump into November, before Thanksgiving kicks off the end-of-year rally.

So while there was a lot of ominous talk that last week’s sell-off might not be over after Friday’s rally, the odds favor that it is – for the next two or three weeks, anyway. Equities have not failed to stage strong rebounds each time they have rebounded from the 150-day average, and our algo-driven market is not likely to fail this time either. Unless.

Unless what, you may wonder, and I wish I had the definitive answer. It’s ISIL, it’s the Ukraine, it’s fourth quarter guidance, it’s a feeling we’ve dismissed these and other concerns too easily (not including Ebola – if it aerosolizes, we have a far bigger problem than the stock market, but I don’t see why it should). If markets do run true to form, the S&P should climb to about 2100-plus by year’s end, but it’s the widespread certainty that we will that leaves me feeling uneasy. Don’t mistake last week’s messiness – the professional side of the market still believes overwhelmingly in a good rally this quarter, and if the world doesn’t intrude, algo-trading will make it happen.

But the trade is just too one-sided – fear is missing, and that always leaves me uneasy. The last time the S&P was up seven quarters in a row, it was followed by a steep correction (28%) that only the Fed and the internet frenzy were able to rescue. Back then an over-leveraged hedge fund couldn’t handle the Russian default and blew up the Treasury market. We don’t know who is over-exposed this time, and it would be very like the stock market to go up an eighth quarter in a row just because seven was the limit the last time. But the Fed’s room to cut rates is missing, and the only boom has been in stock prices and digging for shale oil. We may yet need to go down first before we can keep going up.

The Economic Beat

The jobs report took its usual place as report of the week, so we’ll start there. The operative word was “relief,” as the headline number of 248,000 was above the tentative consensus of 215,000. The claims data had tipped a good number, but the Street always likes a consensus beat.

I read two interesting reports that were polar opposites – the above-mentioned reaction from Mohamed El-Erian, whose missing trio correctly noted that there was no wage growth in the report and the participation rate fell from already multi-decade lows. The structure isn’t robust – the not-in-labor-force (NILF) population grew faster again than either the civilian population or the number of employed, thus explaining the drop in the unemployment rate. El-Erian also noted that long-term unemployed remained at about 3 million (which Barron’s recently blamed on laziness and government benefits, a theory that Charles Dickens would have readily recognized). The diffusion index, which measures how many industries are growing employment versus falling, fell overall and fell in manufacturing, the latter to a near-neutral 51.9.

The other report I read claimed the report was very nearly the best of all worlds, and predicted a drop in the unemployment rate to below 5% next year, below the Fed’s forecast of peak rates of 5.2%-5.5%, along with imminent wage pressure. I’m not going to reprint someone else’s report and then bore you with a one-sided rebuttal, but I will point out my own trio – a curious fact, an anecdote, and an analysis that supports El-Erian’s view that the labor market structure is still soft. 4% is not on the way.

The curious fact is the discrepancy between establishment payrolls and the insured workforce – those paying regularly into the unemployment system. The peak in the insured workforce came in the fourth quarter of 2008, at 133.9 million (mm). At that time, the establishment payroll count was about 137.2mm, for a difference of 3.6 million. The second quarter of 2014 ended with an insured count of only 132.1mm, which I expect to grow to about 133.7mm (still not as high as the last peak). That’s not the curious fact, though. What’s curious is that the current payroll count is 139.75mm, which should leave the insured vs. payrolls difference at about 6 million when the third quarter insured count is released in a few weeks. That’s far greater than the 3.6 million back in 2008. The payroll survey counts paychecks, while the insured workforce counts social security numbers. The implication is clear – more people are working extra part-time jobs to make ends meet.

The anecdote comes from Chicago Fed President Charles Evans, who remarked hearing stories about employers having positions open, but leaving them unfilled unless the “perfect” candidate comes along. That’s a buyer’s market, so far as employers are concerned. Any web search on “long-term unemployed” will tell you that employers won’t hire them.

A bit of analysis comes from me, beginning with the fact that job increases are loaded at the bottom of the pay scale. People work there because it’s all that they can get, not because of the classic model that better employers aren’t bidding enough for their services, and so will have to raise wages. With teen unemployment at 20%, the entry-level pool isn’t about to be pressured.

Labor is a lagging indicator. As every business cycle peaks, so does employment – in fact, employment peaks many months after the business cycle has turned. So at every cycle peak, we get a lot of dumb predictions that the economy will get better next year because employment is still rising, thus a better economy will mean even better employment. If it were true, there would never be recessions.

Claims data indicate that employment has already begun its peak phase. The length of peaks varies, but we have not had one in the last two cycles that lasted as long as a year. The current trend implications – trends, not absolutes – are that employment will peak at the end of 2015, meaning the business cycle will already have turned (for what it’s worth, the markets do start to price in the turn earlier than the public, but very slowly and not in a readily apparent manner. The big drops come when trouble is obvious to everyone).

In sum, last month’s report was better than the headline, just as I and many others wrote, but not the total aberration some claim it was. Nor is this month’s report as good as some of Saturday’s headlines (5.9%, 238K), or the perfect model for the perfect future that some claim it is.

Recently I’ve taken to writing more about the divergence between industry surveys and industry output; the surveys have become less reliable indicators of actual activity. With that in mind, the ISM people that administer the two big national surveys released their manufacturing and non-manufacturing reports last week. Manufacturing for September reported an overall index of 56.6, “down” a bit from the previous month’s 59.0, but still respectable and with a good score of 15-3 growth vs. contracting. Factory orders, however, fell 10.1% in August. That’s largely due to Boeing (BA), but new orders were still down 0.1% when transportation is excluded. The gain in business cap-ex was revised down from 0.6% to 0.4%.

Non-manufacturing reported an overall measure of 58.6, also down a bit from August and also quite respectable. The score was 12-5 growth vs. contraction, good but not great, with the very interesting fact of “Labor” being reported as a commodity in short supply – I can’t recall seeing that before, while at the same time the number of responses reporting “lower” on employment intentions jumped quite a bit. Dallas and Chicago also reported regional survey results well into expansion territory. Yet all in all, the surveys largely tell us what we already know – high or low, they remain poor guides to where either the economy or stock market will be in six months time. Ironically, the best indicator I know is the Philadelphia six-month forecast – it’s a great contrarian indicator that peaked in August, so I expect the surveys to soften into the end of the year unless the seasonal adjustment factors are rejiggered (it happens).

Construction spending fell sharply in the August initial estimate, (-0.8%) vs. an expected gain of 0.5%, but the category is subject to unusually large revisions and surprise outliers usually end up revised substantially the following month. The July increase of 1.8%, for example, fell all the way to 1.2%. Even so, the construction contribution to GDP looks to be smaller than anticipated. So does retail spending, after the last batch of weekly chain-store surveys and auto sales reports indicated a soft month in September.

Personal income (+0.3%) and spending (+0.5%) rose in line with expectations in August. There was nothing unusual about either category – the year-on-year change in nominal personal income is 4.28%, compared to the 16-year (about two business cycles) average of 4.29%. The interesting part is that per-capita nominal income has only grown at 2.5% over the last two years (compared to a nominal rate of 3.8%), highlighting the growing income gap.

There is a great deal of Fed activity next week that could well dominate the tape in what is otherwise a nearly dead week for economic data. I count nine different district Fed Presidents giving 12 speeches – and that doesn’t include a Washington appearance by ECB President Mario Draghi on Thursday. Coming in the wake of the jobs report plus the labor turnover survey on Tuesday, with the latest FOMC minutes set for release on Wednesday, it should be another Fed-dominated week unless something overseas pops up. The latter is quite possible in view of the elevated political temperature in some key areas, but always impossible to predict from one week to the next.

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