Monday, February 1, 2010

Thoughts on the latest and Upcoming Economic Indicators and the President's Latest Strategy

The market (S&P 500) declined 3% since we posted our Is it Time to Take a Break from that Great ‘Recovery’? blog. Q4 earnings reports have not been disappointing, but we believe a sense of fundamental-based valuation of the market and companies is beginning to creep back in. Most companies' impressive EPS have not been accompanied with at least the hope of top-line growth, which we believe is necessary for this economic recovery to continue.


Friday's preliminary Q4 GDP report of 5.7% was certainly better than the 4.7% consensus. However, PCE growth was responsible for only 25% of the reported growth. In addition, it accelerated at a slower rate in Q4 than it did in Q3; an indication of the continuing absence of meaningful growth in consumption, which is a necessity for this economy to recover.

In addition, inventories contributed approx. 67% to the growth. This is good news and bad news. It can be viewed as slowing inventory burn with replenishment on the horizon, showing that businesses are expecting some recovery in consumption. Inventory growth in calculating GDP has been positive for only two quarters (Q3 and Q4) after negatively contributing to the GDP for seven consecutive quarters. The question is - will companies actually produce more because of growth expectation or just partially replace the drastically cut inventory? We continue to believe latter to be the case.
Although imports grew for the second consecutive quarter, we noticed its smaller contribution to GDP than the prior quarter. This indicates that demand here at home remains weak, and companies remain hesitant to make growth investments or to fully replace inventories cut since Q4 ‘07.


This morning's positive news, better-than-expected Jan. ISM PMI, drove up the market nicely. Although most of the components of the ISM were positive (except inventories), we note that prices increased more than any other component with no industries indicating that they faced lower prices in Jan. In addition, growth in imports remained weak. We believe the excellent ISM figures represent only the upcoming inventory replenishment, which is slightly positive for the economy, but may not be sustained after Q1. Lastly, the employment component of ISM was also positive at 53.3, but we think this may decline after Q1 as inventories may no longer require replenishment. However, in the short-term, this could be a positive indicator for the upcoming Jan. unemployment data, which will be released on Friday.

Consumer Confidence

What drives confidence is comfort brought forth by the ability of a consumer to have money in his/her pocket for consumption of goods other than mostly necessities. The government can print more money and/or place the cash in the consumers' hands for only a short period. The results have been such that not many have found a job, and many could be taking additional risks regarding investments of their minimal and nearly extinguished savings.

Last week’s consumer confidence survey showed slight improvement and came in higher than the consensus. However, overall, it appeared that consumers remained pessimistic.

While more consumers responded that business conditions were good (9.0% from 7.5%), even more viewed those conditions as bad (46.1% from 45.7%). Consumers expecting improvement in the short-term declined (20.9% from 21.2%) and more believed the conditions will worsen in the future (12.7% from 11.8%).

Regarding the employment situation, less consumers believed jobs are “hard to get” (47.4% from 48.1%). We believe this is driven merely by short-term ‘enthusiasm’ which is expected as the New Year has begun. We note that only 11.8% said that jobs are “plentiful”, down from 12.7%. In fact, less expect more jobs to be available in the future (15.5% from 16.4%).


savings increased slightly in December to 4.8% (from 4.5% in Nov.), it remains significantly below the 6.8% historical level. Uncertainty and fear due to lack of jobs, are driving consumers to save more. We believe higher savings and further deleveraging of balance sheets will in time bring back consumer confidence. Of course, the government and the Fed (not much difference between the two these days) are creating barriers by keeping rates low and attempting to convince consumers to again take more risk.


We have mentioned this a few times before, and it is very basic - in order for the economy to recover, the issue of unemployment must be addressed; not by the government, but by the market itself. Unemployment is no longer a lagging indicator as households no longer have multiple credit cards to tap into and continue to spend. With jobless claims remaining over 400k, solid improvement in unemployment, therefore meaningful growth in consumption, remains a few quarters out.

Unemployment numbers are due out this Friday, and they represent a significant catalyst for the equity market to either bounce back (as it may have begun today) or decline a bit further. Although the market had already declined 3% the last 1.5 weeks and prior to today, given certain bearish technical indicators, a miss on the unemployment rate figure can still have a significant negative impact on the market. Of course, all of this depends on how the BLS (Bureau of Labor Statistics) decides to present the data.

We looked at the relationship between initial claims, continuing claims and the official unemployment rate. As expected, all three are highly positively correlated. Initial claims and continuing claims are no longer accelerating. In fact, from a monthly standpoint, it appears that initial claims are now trending down. Under 'normal' conditions, we would easily identify this as a sign of a recovery in employment. However, we believe that it only indicates a deceleration in unemployment, not necessarily a recovery or job creation.

We note that the long-term unemployment figure (jobless for more than 27 weeks as reported by BLS) has been trending up and increasing for a long time, indicating no jobs found by the current unemployed, and no 'job creation' (as the politicians love to say) by the market or the government. We would look for the long-term unemployment figure to continue to trend upwards.

However, the official unemployment rate may come in slightly better than expected as initial claims (although they do not represent any type of job creation) may be trending down at a higher rate than the declining labor participation force figure (basically the denominator of the unemployment rate), resulting in a lower unemployment rate figure. Today’s ISM report also provides some support for possibly a better unemployment figure on Friday. Earnings reports this week will take a back seat to the upcoming unemployment data. Today's performance could be an indication of higher volatility going into Friday's news, which means that a long straddle strategy on SPY or S&P 500 futures might work.

President's pitch is not the solution

The President is attempting to address the unemployment issue by making the government's very 'visible hand' more visible (possibly by putting on one of those Michael Jackson gloves) and even bigger. The tax incentives for businesses based on additional hiring proposed by Obama do not resolve the economic issue at hand. Such strategy is only a short-term solution which carries the risk of creating inefficiencies within companies.

The hiring that such an incentive might create is not long-term. In addition, we believe that companies will concentrate on hiring lower-wage and easily dispensable employees while benefiting from this great government incentive.

Such proposals also carry the risk of possibly veering companies off of the 'efficiency' track, on which they have been forced to stay by current market conditions. These risks, we believe, illustrate the President's political motivation behind such a solution. While we are not affiliated with any political party, we have to state the obvious - after losing the MA election, the Democrats are throwing everything at the wall, hoping the one that sticks will help them maintain their majority seats in both the House and the Senate.

Payroll tax cuts make sense; however, we believe that many businesses will view it only as a short-term policy. Given the continuing increase in the deficit (unbelievable figures released today by the White House), the Obama Administration will have to increase taxes at some point (more likely than cutting spending), increasing the likelihood that this policy is only temporary. With this in mind, many businesses may not want to take the risk of increasing their headcount at a lower cost, only for that cost to increase again in the future.

As we have mentioned before, the government (both Democrats and Republicans) appears to be doing everything now - spending to keep the GDP growing, giving money to people hoping to increase consumption, giving money to banks so they can easily take risks with it, and telling the unqualified homeowners that what they and their banks did was ok. These incentives, these tax credits, are good only for the short-term. They continue to delay the deleveraging of US households and that of the government, which we think must take place before we can have a more stable and long-term growing economy. Unfortunately, politics make everyone basically blind.

We believe the long-term solution is to increase interest rates a bit in order to 1) lower the risk of future inflation (due to all of this great money printing); and 2) provide incentives for consumers to save and deleverage their balance sheets. More savings means more capital for banks to lend out, which means possibly more businesses borrowing, which means those businesses may hire more based on higher demand as consumers actually have some money to spend. This very slow process (very slow especially given the politicians' 2 or 4-year-only time horizon) could bring back consumption and job creation.

Overall, in our opinion, whether this Friday’s unemployment report will provide a boost for the market or not, one thing remains clear - the market remains over-valued and traders and investors may start giving a second look to the long-lost fundamental analysis and valuation of the equity market.

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