“What’s it all about when you sort it out, Alfie?” – Joss Stone, “Alfie”
by M. Kevin Flynn, CFA
A funny thing happened on the way to the end of last week. On Wednesday morning, the election results were in – the Republicans had retaken the House of Representatives but not the Senate. Although a couple of races were still in doubt, the outcomes wouldn’t be enough to tip the balance.
Yet though the GOP had done a bit better than consensus with the House, the whisper number of retaking the Senate hadn’t materialized. The net result was about what it was supposed to be, so the market didn’t react much.
Later that same day, Federal Reserve chairman Ben Bernanke and the Federal Open Market Committee (FOMC) announced the details of her majesty, QE II. We mean neither the ocean liner, nor a certain woman who takes her daily tea by the end of Buckingham Palace Road, but the reigning queen of the stock market: the second round of “quantitative easing” that has lately served as the true liege of the faithful. Definitely not the ocean liner, but if you want to be nautical about it, “Love Boat” wouldn’t be too far off.
The QE II program, as announced, was a wash as far as expectations went. It was a little more than expected ($600 versus $500 billion), yet a lot less than the more optimistic hopes ($1 trillion). Bernanke was careful to say that the Fed had pulled up the cannons, but on the other hand they might not fire them all. They would hold back on their ammo if it wasn’t necessary – or in other words, if the economy could manage not to suck.
It was all a bit too misty for our brave lads and lasses in the equity markets, fingers on the trigger, to know what to do. The hoped-for adrenaline rush of a mighty Senate victory hadn’t arrived, and there was more than a little confusion about the QE II numbers. Couldn’t Bernanke just give a “beat and raise” like everybody else? A conference call might have been nice too. Stocks went sideways.
Ah, but the pen is indeed mightier than the sword, as Thursday morning made so very plain. First there was the Wall Street Journal proclaiming in banner type, “Fed Fires $600 Billion Stimulus Shot.” Right below that, also in large type (but suitably smaller, as after all it was merely talking about the President, not the Chairman of the central bank): “Obama Concedes Shellacking.”
And just in case that wasn’t clear enough, Chairman Bernanke himself weighed in with a timely essay in the Washington Post on what it was all about. In case the market hadn’t quite got it, Lord B. spelled it out in black and white: “Easier financial conditions will promote economic growth…and higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
Well, that was clear. He did say, “higher stock prices,” didn’t he? That might earn him back the old moniker “Ben the Blessed” from the halcyon days of 2006-2007, when he ushered in an era of more transparency at the Fed and a series of carefully signaled interest rate increases that allowed stock prices to roar. Never mind all that backbiting about missing the credit bubble or credit derivative madness or subprime contagion.
Cast aside those evil thoughts about the sudden lack of transparency on who blew up Lehman in the middle of avalanche season. That was Ben the Bumbler (and a few other names that we cannot print here). This man wants stock prices to go up, he proclaims it right there, and you don’t fight the Fed. Above all, don’t fight the Fed when it looks like it could mean higher stock prices today and I have a long position.
Well, fight they didn’t and equity prices surged by over two percent, three percent on the week. Investors have now discovered about a gazillion new dollars of future profits to discount since the end of August. And you thought that finding the Chilean miners was a neat trick.
What now, you may wonder. It’s a fair point. The markets are ignoring some rather conspicuous problems. One is the dollar. Those of our readers who make their living in the investment business are probably well aware of the recent near-perfect inverse correlation between the dollar and the stock market. What began as a perfectly normal occurrence – people fleeing to the dollar during the crisis, then giving it back up again for riskier pursuits as anxiety waned – has become a mindless robo-trade.
That would probably undo itself in due time – the dollar going to zero won’t propel the stock market to new heights – but the situation in Europe is approaching a boil. The spreads on Irish debt are at new highs, with margin requirements suddenly going up on the trades and the government preparing fresh austerity measures in response. In Greece, failures to meet fiscal goals are going to present the government with an impossible choice between its own economy and the international debt markets.
Despite the politically inspired vogue for austerity, though, the programs aren’t doing any good for either the Irish economy or the Greek economy. Both are getting worse, not better. Did we mention Spain? The reactions don’t portend well for the euro (or the U.S. economy either if we pursue some ill-fated austerity program, an avenue that the Federal Reserve is plainly not pursuing). A dollar rally isn’t going to spur the stock market higher.
There are other issues. China is behaving erratically. Our banks may have another round of major losses to write down from flawed mortgage loans. Market operators are trying to punch the XLF (financials ETF) through breakout levels in order to keep the rally going until the end of the year (and earn bigger bonuses), but that game requires a co-operative news flow. Not a great one, but not one that involves more losses either. In favor of the operators is that one can expect the banks to deny a problem for as long as possible.
The economy is in a recovery, a view we’ve held consistently throughout the year. But it is “disappointingly slow,” according to the Federal Reserve. We still hold to our stair-step recovery view, and are pleased to see the recent pickup in some of the data – that last pause was starting to get a little too long. By next year, the expansion should get a further boost from companies that are forced to expand labor and capital inputs from the very lean levels of the recession. That will be good for the economy, but not for profit growth, which is rapidly slowing.
For the true believers, there are two paths to the end of the year. A mild pause or correction that happens any day now, followed by another climb to the end of the year, or a straight climb to the end of the year. Our system is still set up to favor the latter, despite the abuses and problems of recent years, but some caution might prevail. Neither view allows for anything to go wrong, but something always does. It won’t be long now.
The Economic Beat
Lost amidst the good data from last week were a couple of flat notes at either end of the week. Personal income and spending for September were a distinct disappointment and couldn’t have cheered the Fed: income fell (-0.1)%, while spending grew a muted 0.2% versus expectations for about double that rate. The Fed’s preferred measure of inflation, the PCE measure (Personal Consumption Expenditures), was unchanged, bringing the year-on-year rate to 1.2%. The Fed stated two days later that 2.0% was its comfort zone.
Friday’s problem child was the pending home sales report, which showed a September drop of (-1.8)%, where a gain of some two or three percent was expected. Housing is going to stay moribund for a long time.
That’s a problem for the job market, despite the happy number posted on Friday. The increase of 151,000 was well beyond consensus and higher than most top-of-range estimates, including our own. Homebuilding is one of the last skilled trades left in the country that pays a decent wage and can’t be outsourced.
The strength in the jobs report was entirely in services. Goods-producing sectors added a net total of 5,000 jobs, while manufacturing contracted. The ISM surveys (see below) point to expansion there – let’s hope they’re right. Manufacturing may get revised upwards, as the revisions to August and September were strongly positive.
But the service jobs weren’t great service jobs. The big hiring was in low-paying areas such as bars and restaurants, admin and janitorial staff, health care support staff. Such jobs will do little to lift national income, and certainly not income inequality.
On the brighter side, though, was that it was the best report in months. The indices of aggregate weekly hours and payrolls increased (the former is finally back above the 2002 level), weekly hours and earnings increased, and temp hiring picked up again.
Against that is that weekly claims have begun rising again. The November report may be less sanguine. The U-6 under-utilization rate is still at 17%. Real claims will be under pressure from now until the end of the year, and while the headline numbers will be seasonally adjusted, the effect on income and consumption in an already fragile economy won’t be. No wonder Bernanke wants stock prices to go up – he needs the employed to start doing some major spending.
The stars of the week were the ISM purchasing manager surveys. The manufacturing sector posted a strong rising index number of 56.9, while non-manufacturing came in at an improved rate of 54.3. Oddly enough, the services sector posted a jobs number that was nearly unchanged, yet that was where all the jobs growth was in the BLS report. The manufacturing report showed a strong employment reading of 57.7, though Labor showed a net loss for the sector.
Further bright spots for manufacturing were that new orders rose strongly to the 58.9 level, and factory orders for September rose 2.1%. The latter number was skewed by the aircraft industry: non-defense capital goods without aircraft fell by (-0.2)%.
Elsewhere, September construction spending posted a gain of 0.5%, much better than expected, same-store sales for October were mixed (with some worrying weakness in teen sales) and auto sales for October picked up. The latter helped offset another downturn in credit card debt in September.
Looking to the week ahead, the G-20 group of developed countries will meet next week, so look for some more discomfort over the dollar’s fall (though if the euro crisis begins to return, the subject may be pushed back off to the sidelines). An exceptionally quiet U.S. schedule is highlighted by Friday’s report on consumer sentiment – that’s how slow a week it is.
The real (scheduled) interest of the week is that one, the U.S. finally sets its clocks back over the weekend, and two, Thursday is a government and bank holiday in many countries, including the U.S. Our stock market will be open, but the weekly claims report will be a day early, in deference to the holiday.