Rhapsody on Two


“It was the epoch of belief, it was the epoch of incredulity.” – Charles Dickens, A Tale of Two Cities

The current market environment seems almost a tale of two cities these days, with stocks poised to make a run past their old highs, yet European worries (Ukraine, Greece) are getting fresh legs. A jobs report (“boffo,” NPR called it) emerged Friday at the other end of the dial from reports on spending. The latest earnings insight from FactSet shows a blended earnings growth rate of only 3% for the S&P 500 in the fourth quarter (it will surely be called anywhere from 6%-10% in most corners of the Street) with about 60% of the index having reported. That rate should rise, given the normal built-in cushion for estimates, but a final result of more than 5% seems a big stretch.

Profit struggles aren’t all just energy, either, as some energy companies reported good growth in the quarter. Consumer staples, utilities and financial sectors are all also showing negative growth at this point. Whatever excuses might be made, weakness in financials is never a good sign.

But look at that boffo jobs number, one that the Wall Street Journal pronounced “ripe for lift-off.” Aren’t we finally about to take off in this recovery?

Lift-off? You’ve got to be kidding me. Let me begin by observing some iron-clad facts: The business cycle has never been repealed, and it never will be. Higher levels of employment do not lead to endless levels of expansion in economic activity – a lagging indicator, employment grows for many months after recessions have begun and contracts for many months after the onset of recovery. If higher employment was all that mattered, we would never have had any recessions.

Here are two more maxims, one from Bob Farrell’s famous rules of investing, and one from yours truly. The Bob Farrell rule is that there are no new plateaus, not in the stock market, not in the economy. A corollary might be that every market cycle brings another prediction of a new plateau.

A second maxim is one you may find surprising – the business cycle does not depend on Fed rate policy. I would guess that most investors presume the reverse, but it just ain’t so. Monetary policy is a blunt instrument – it can cushion, but it does not protect. The last recession that was actually engineered by Fed policy was the 1980-1982 recession, when Paul Volcker hiked short rates towards 20%. That’s how blunt of an instrument it is.

Certainly the Fed lowers rates in the early stages of recessions, but that has never stopped the economy from going down anyway. As the expansion cycle matures, the Fed then tries to move away from below-normal rates towards what it thinks is some kind of normalized level of rates that won’t facilitate further speculation. ’80-’82 aside, higher rates don’t kill speculation, either – only the collapse of the market cycle does that. Higher rates may cut off one source of alcohol, but believe me, the market knows how to keep getting drunk until it falls over anyway.

All well and good, you may wonder, but what does it all mean for 2015 – and this quarter, for that matter? Is it time to head for the hills, a theme that had a lot of currency during January’s darker days and what many emails are warning me to do on a daily basis, or is it time to reload and re-enlist for the next big move, as last week’s rally and the jobs report seemed to promise, and what every equity fund manager believes anyway?

If I could give those kinds of exact answers, I’d be writing this missive from my yacht. What I can tell you is some observable facts and some things that concern me. One, the market is expensive on just about any numeric metric, though I’m sure some busy Street strategist is hard at work on finding ways that it isn’t. Two, economic growth has not changed, neither for better nor worse. It was no different in 2014, though corporate profits grew at a slower pace – about 5% overall for the S&P, even as the broad index rose more than double that rate. Three, it’s late in the cycle for both the market and economy. Expensive, late-stage markets in low-growth economies may not simply up and die, but they are ill-placed to withstand adversity.

You may wonder why a modest economy should contract, but that’s missing the point – there’s plenty of excess, it just happens to be concentrated in the 1% economy, where most of the growth has been. There’s no economic law that unemployment has to fall below 5%, once thought to be the floor – that level may well be the limit again this time around. I don’t like the long-term chart of the market, I don’t like that we’ve started off with a down January two years in a row, I don’t like how many companies are still struggling to move product. The good news is that my economic analysis suggests that the business cycle still has about a year left to run, the market’s ever-hopeful spring season is not far off, and we might see some half-decent quarters again later in the year. The key is how long “about a year” for the cycle ends up being. I’m not rhapsodic, but I’m not exiting quite yet.

The Economic Beat

Jobs were of course the highlight of the week, with the robust-looking report of 257,000 net additional jobs beating consensus for 230,000 and whisper numbers for something lower after the ADP report had come in at 213,000 two days earlier. January is always a benchmark revision number, so excuses and caveats were being made right up until the release of the report. and some afterwards as well. The report also came with strong-looking revisions to November and December, adding 86K overall to the two months, leaving November with a whopping increase of 423K and the last three months with an apparent net addition of just over one million. The Wall Street Journal (see the link above) boasted that “the economy created more than a million jobs over the past three months.”

Except it didn’t. One might gather otherwise from the BLS report talking rather piously about how such matters as, “construction continued to add jobs in January.” No, it didn’t, nor did the sector add jobs in December. Rather, the sector’s usual winter cutbacks were somewhat less than a year ago, as was the January loss of 2.8 million from the estimated count of total payrolls. Based on the initial estimate, the percentage loss was 1.95%, in line with the long-term average of about 2% and the average of the last four years (2%), including a rate of 1.94% in 2012, based upon the revised data.

It’s an important point. The BLS publishes totals that might better be called “annualized run rates,” because of the seasonal adjustment work that goes into them. Arriving at those run rates means a lot of data comparison (I suspect much linear interpolation) and projections. There are actually fewer people in the payroll count than three months ago – a lot fewer, and that’s usually the case. The truth is that the BLS doesn’t really know yet how many of them are really not working, and how many simply went uncounted. It can do some reasonable inferences from claims data and statistical analysis, but it takes until the spring to get a better handle. It’s one of the reasons the season can produce surprise duds in the employment report.

That said, the process works pretty well overall. Other important categories get seasonally adjusted as well, such as retail sales (some), GDP and personal income (a lot). One things that isn’t adjusted, though, is corporate profits, though they have their own intrinsic adjustment by analysts looking at year-over-year comparisons. The trick is not to try to extract too much true wisdom from a fuzzy number – the January jobs number, along with the months preceding it, is something of a guess whose accuracy isn’t revealed for some months to come. The good news is that the department’s newly revised data show impressive year-on-year comparisons in its monthly unadjusted totals, suggesting that job growth was indeed good.

But not as good as the headlines would have you believe. Using other BLS data, my estimate is that upwards of a third of those jobs consisted of part-time work and second (or third) jobs. I heard National Public Radio enthusing over the best three months for jobs in 17 years, except that it really wasn’t, because the population has grown in the meantime. 2014′s increase of 1.94%, based on preliminary data, would make it the best year for job expansion since the year 2000. Okay, I’m quibbling over a couple of years, but the years 1994-2000 added jobs at rates over 2% every year, something that absent a very big revision, the current cycle still hasn’t managed. My estimate is that rather than “lift-off”, as the Journal headlines would have it, 2014 will end up being the peak year for job additions in the cycle. Time will tell.

Another plus in the report was the hourly earnings rose 0.5%, but I would caution against reading too much into this number. There were some weak months preceding it, and the year-on-year gain rose to only 2.2%, a level we have been at many times in this cycle. The average for the last five years is 2%, and the average for the last 8 years is 2.4%, so it’s presumptuous to call it a breakout. Mix may be playing a role as well, as the jobs seem to be either entry-level positions or highly-paid ones fueled in part by the bubble in private equity. There is certainly wage pressure in the Silicon Valleys and Kendall Squares of the world, but not much elsewhere. The unemployment rate for college graduates edged down to 2.8%, the lowest since the crash and marking the first time in the recovery of consecutive monthly rates below 3% (December was 2.9%).

Personal income grew the expected 0.3% in December, raising the year-on-year rate to 4.6% (thanks mostly to the drop in the price deflator), and the annual rate to 3.9% for 2014, or 2.4% in real terms. Spending was restrained, falling 0.3% on the month to a 3.6% year-on-year rate and leaving 2014 with real spending growth of 2.5%, compared with 2.4% in 2013.

The ISM purchasing manager January surveys did not reveal much. The manufacturing diffusion number eased to 53.5 from 55.1 the month before, though the ratio of expanding-to-contracting sectors, at 14 to 2, remained healthy. The non-manufacturing survey result was virtually unchanged at 56.7 (December 56.5), though one item that stuck out was the expansion-contraction number falling to only 8-8, or half and half. It’s only one month, and even a second and third month might only signify an ebb-tide quarter rather than general economic anemia, with much of it related to the drop in energy prices. Still, it’s something to keep an eye on. With both surveys showing less enthusiasm this month and a lot of stormy weather in the Northeast, we may be in for another sub-3% GDP quarter.

In that vein, factory orders for November were revised downward and are estimated to have fallen again in December (-3.4%), dragged down by declines in defense and aircraft spending. Durable goods orders were slightly positive when excluding defense and civilian aircraft, but shipments declined. When combined with the international trade data, the data point to downward revisions in Q4 GDP; I’m seeing new estimates of only 2.1%. At least construction got a minor bump up for November (from -0.3% to -0.2%), and a rise in December (0.4%), though the first estimate for a month of construction spending is prone to deep revision.

Trade data showed that imports rose more and exports declined more than expected in December, which means additional downward pressure on the Q4 GDP reading. It’s an oddity of the number that when Americans scrimp on buying foreign goods because of difficult financial stresses, it puts misleading upward pressure on the GDP number. and vice versa. The rising dollar is going to pressure exports, while we get less output benefit from falling oil prices due to our higher mix of domestic production.

Retail sales for January is the highlight for next week’s calendar. Looking at the Redbook report, a burst in the final week may not have been enough to save the core sales number from a second month of negative territory. Although the auto industry reported good sales comparisons for January, the annualized rate (computed separately) fell from December to January, raising the bar for the report to avoid negative territory. The red zone is already baked in, with consensus calling for a drop of (-0.5%), a result that would surely baffle the “lift-off” crowd.

In a notable late-breaking development, Chinese trade data for January showed sharp drops in exports and especially imports. Chinese data is mysterious and oft-manipulated; in this case the report may be influenced by the country’s impending New Year celebration, crackdowns on bogus export reporting, oil prices, currency values, and internal matters. If the government decides the numbers were too dramatic, they may well reverse the next month. My practice is to take the direction of the numbers as more or less legitimate, so I believe there is some decline. The extraordinary drops in import categories like oil, coal, and iron ore (40%-60%) are telling us a story of deceleration of big projects at the very least, regardless of the calendar and currency.

Tuesday will bring two important numbers, the labor turnover report (JOLTS) and wholesale trade for December, which will add some more refinement to the last GDP estimate. Business inventories complete the picture on Thursday, and import-export price data is on Friday.

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