The stock market is in the throes of a correction that has lopped 7% off the averages over the last couple of weeks and skittish investors seem to be taking the attitude of sell now, ask questions later. Earnings season has been surprisingly upbeat with roughly 3/4 of companies producing earnings better than the consensus. A nearly as robust number have reported revenues higher than Wall Street’s crystal ball gazers’ estimates. Politically, Congress looks headed for a year of trying desperately not to do anything really stupid before the elections in November – something politicians find hard to do in the best of times – and the seating of Scott Brown (R, Kennedy) increases their chances of accomplishing that goal. Economic news has been generally upbeat too and yet stocks just can’t seem to get any traction. Is this just a correction or the beginning of something more damaging?
Balancing the good news in the US has been the allegedly bad news out of Europe and the fear of potentially, someday getting some bad news out of China. Greece and Portugal are having budget problems and in normal times that wouldn’t even qualify as news, but in a world conditioned to see everything as interconnected, a default by Greece is somehow seen as an excuse to sell US stocks. The domino theory has made an unlikely comeback under the new moniker of systemic risk. A default by Greece leads to a default by Portugal which leads to Spain which leads to Italy which leads to Ireland which leads to the UK which leads to, I don’t know, Goldman Sachs bonus pool I guess and goodness knows we can’t have anything upsetting that apple cart. Frankly I find the whole thing a bit ridiculous. Greece and Portugal together represent roughly 3% of EU GDP and a little belt tightening there will not be the end of the world or the Euro for gosh sakes. Everybody have a shot of ouzo and calm down.
The other big worry that has developed over the last few weeks is that China, in trying to slow their economy, will be more successful than the world economy can handle right now. In case you haven’t heard, the commentariat has determined that China is the new bubble and while they believe the Fed should identify and proactively manage bubbles in the US they worry that the Chinese monetary authorities do not have the same level of sophistication as our own distinguished group of monetary mandarins. The worry seems to be that the authorities there will not be able to identify the magic level of lending that slows the economy just enough to prevent inflation but not so much that they stop buying commodities or Treasury Notes in bulk. Well, of course they won’t and pssst….the Fed can’t either.
I am not concerned about China’s growth, their inflation or their alleged undervaluing of their currency. The Chinese economy can grow at very high rates without inflation because it is still a very poor country and so has lots of room to grow and oh by the way, growth doesn’t cause inflation. I don’t worry about overbuilding in real estate because the average person in China is still living in what the average American would rate slightly less desirable than a tool shed. They might have too many apartments for a while but it isn’t like Miami where it will take us years to import enough fools to absorb our excess supply. There are still a lot tool shed dwellers in the Chinese countryside who desperately want to upgrade to a poorly constructed 500 square foot apartment in the city. As for the currency and the inflation rate, well those are inevitably tied together so if they aren’t allowing the Yuan to rise, they aren’t too worried about inflation. In other words, China is not the bubble – or the popping thereof – you are looking for.
What about the US economy? Could the market be downgrading the growth prospects of the US economy? The President just released his budget and if the administration’s projections for the future of the US economy are accurate, there is surely cause for concern. It is one of the most pessimistic assessments of future American economic performance ever produced by a politician hoping to one day be re-elected. The long term plan has deficits of at least $700 billion until 2020 and unemployment over 6.5% out to 2014. Growth over the next 4 years is penciled in at a 4% real rate but then falls steadily to 2.5% by 2020. Inflation, even with the large increase in government spending, never breaches 1.7% and the ten year Treasury note never trades with a yield higher than 5.3%. If the administration’s budget deficit projections are even close to accurate, inflation and/or interest rates that low are highly doubtful thus making all the other projections too optimistic.
So I guess if anyone were to actually read the budget document it could have made them more pessimistic about the prospects for US growth but it isn’t exactly a best seller and has zero chance of being enacted to boot. The Obama administration – and most people for that matter – underestimates the resiliency of the US economy. The assumption that the economy cannot recover on its own without spending assistance from government is one that suffers from a lack of empirical evidence. But even supposing that is true, don’t the deficits have to end at some point?
In fact, the US economy is on the verge of a robust recovery right now and the majority of the stimulus money hasn’t even been spent yet. The January employment report, despite a negative headline number, was actually one of the most positive economic reports we’ve had in quite some time. Among the positives:
- Employed rose by 541,000
- Unemployed fell by 430,000
- Labor Force rose by 111,000
- Employed part time due to economic reasons fell by 849,000
- Employed part time due to slack work or business conditions fell by 580,000
- Manufacturing jobs rose by 11,000
- Motor vehicles and parts employment rose 22,700
- Retail trade rose 42,100
- Professional and business services rose 44,000
- Temporary help rose 52,000
- Average weekly hours rose by 0.1
- Average hourly earnings up $0.04
That is quite a long list of positives and should not be minimized. Yes there were still some negatives but nothing that should surprise anyone. Construction lost jobs again and the revisions for the last year showed many more jobs lost than previously estimated but both of those were expected. Turning points in the economy are always times of high anxiety and this one is no different. Economic growth is accelerating and what we need most urgently from the political class is for them to overcome their urge to meddle. Unfortunately, the chances of that are pretty slim. In an election year they’ll want to pass something that shows they care about unemployment even if they can’t do much about it. Let’s just hope they do it quick and then hit the campaign trail where they can do little damage.
My assessment is that this is nothing more than the usual anxiety associated with this phase of an economic recovery. Greece and Portugal will not bring down the Euro and do not represent systemic risk. China will keep growing a lot faster than most of the developing world not to mention the entire developed one. The US economic recovery is starting to accelerate and the political environment is favorable in that the politicians will spend most of the year campaigning and talking about doing things rather than actually trying to do them. There might be more downside yet, but absent a really stupid policy decision by Congress or the Fed, it will likely prove temporary.
If you’d like to receive this weekly commentary by email, click here.
Weekly Economic and Market Review
As stated above, the employment report released on Friday contained some pretty good news in my opinion. The remainder of the data for the week has to be classified as mixed since there was some good stuff and bad stuff, but I do think the bad stuff wasn’t terrible and the good stuff was pretty terrific. The week got started with Personal Income and Outlays with income higher than expected and outlays a little light. Actually the headline on this report was a little misleading. Income gains were confined primarily to proprietor’s income, mostly the farm component, while wages and salaries were only up 0.1%. Spending was a little less than expected but November was revised higher.
The best forward looking report of the week came later on Monday with the release of the ISM manufacturing survey which was positive in all respects. The total number was 58.4 but the underlying dynamics were positively smoking. New orders rose to 65.9 the third straight month over 60. A lot of the new orders by the way are in the exports sector. New orders are so hot in fact that the backlog number is now also over 50 and rising (56.0). The employment index was up 3 to 53.3 but that is still a little low for any significant job growth (manufacturing employment was up in the Friday report though). The inventory component rose to 46.5 which is consistent with flat conditions. Inventory restocking is right around the corner.
Construction spending disappointed again and I have no idea when it will pick up. Residential may be bottoming but non residential isn’t even close. Retail store same store sales were strong this week. The MBAs mortgage index rose 10.3% mostly on a 26.3% increase in the refinance index. Pending home sales were up slightly but nothing to get excited about after last month’s big plunge. Jobless claims rose a bit to 480,000 and I think was largely responsible for the Thursday selloff. Claims really need to resume the downtrend if the recovery is to accelerate the way I think it will. We need claims down under 400,000 to get some decent job growth.
Productivity rose 6.2% in the quarter while unit labor costs fell 4.4%. That’s good news for corporate profits and hiring. Factory orders were up 1%, much better than expected. ISM non manufacturing survey was up to 50.5% but is improving very slowly. With most of the US economy involved in services that isn’t good news. The best part of the report though was the New Orders index up to 54.7. Lastly, consumer credit contracted again last month although the rate of contraction has slowed considerably. The debt to income ratio has fallen considerably but should probably fall more. We don’t need expanding consumer credit for economic growth. In fact, we shouldn’t even want it; we should want this recovery to be investment led while the consumer continues to retrench and pay down debt.
Despite all the fireworks in the stock market last week, there wasn’t much net movement in the US market. The S&P 500 ended the week just 0.76% from where it started. Foreign markets did considerably worse with Latin America and Europe markets down 3-5%. The dollar was up again and that drove key commodities lower. Oil was down 2.3% while gold, after a 5% hit on Thursday, ended the week 2.8% lower.
Stock market sentiment has turned bearish very quickly with this correction. Bears outnumber bulls slightly in the AAII poll, but I’d like to see fewer bulls before getting aggressive on the buy side. Put/call ratios could also get a little higher. A VIX over 30 would also make me get a lot more aggressive. For now, I’m biased toward buying the dips but not aggressively.