Some thoughts on today's numbers

Housing starts of 546K came in lower than expected, with decline in single-family houses partially offset by increase in multi-family homes. We note that today's number, although slightly lower than expectations, was higher than the previous month. However, such growth appears to be due mainly to the usual and significant revisions that we keep seeing more of. June's numbers were revised down to 537K from 549K. Not surprisingly, permits did decline in July compared to the original and revised June figures. Overall, as mentioned earlier this week, a decline in these housing figures is positive as it limits inventory growth. Such decline combined with a slowdown in foreclosures, which we have not yet seen, could actually create a tiny light at the end of the dark housing market tunnel.

Industrial production and capacity utilization for July were better than expected, which was surprising to us.

Capacity utilization of 74.8% was slightly higher than the 74.6% consensus. We note that this figure has slowly but surely declined since the 1970's. We do not expect it to reach 85.0%+, which means that employment recovery will take longer than many think.

Industrial production grew 1% from June. All components of this indicator showed growth, with manufacturing, mining and utilities, growing at 1.1%, 0.9% and 0.1%, respectively. Manufacturing growth was mainly driven by a 9.9% increase in motor vehicles and parts, which is not likely to continue. In our opinion, this is not an indication of expected strong auto sales going forward. We believe such growth is also driven by auto parts due to the upcoming maintenance season of the government-driven increase in motor vehicles sales earlier this year. In addition, historically, growth in motor vehicles and parts manufacturing has been between -5.0% and 5.0%.

Although inventory replenishment is close to end, we fear that many companies may have begun their fall and 2011 stock-piling too aggressively.

Lastly, ICSC (International Council of Shopping Centers) released its weekly chain store sales index. It declined 1.3% from the prior week. This was the third consecutive decline. The index was up 3.3% from the prior year, but then again, given last year's bad numbers, even a winter jacket retailer should show annual growth during the summer in California.  Maybe not, as WMT reported a decline in Y/Y same store sales in the U.S.  In addition, HD lowered its revenue guidance for the year.  We must say that both companies beat expectations on the bottom-line.  There is still no sign of strong and stable revenue growth and we are in the third quarter of the so-called recovery.  We are seeing minimal growth in non-government-aided consumption.  But let the stock market go higher.  The government has basically eliminated all other options for investors, except the one with a potentailly high reward and certainly much higher risk ... the stock market. 

Interesting quote and some other thoughts ...

Before mentioning the quote, we'd just like to point to the fact that the economy is moving in the wrong direction, and that's become clearer since the start of 2H '10 (as we've been discussing since Q3 last year). Recovery will take a while, although the equity market may remain over-valued (in our opinion) due to the government making risky assets more attractive (we must say that S&P500 is down more than 3% YTD). Its amazing that consumers are at a stage where they not only have to pay down their debt (which can be helped by actually saving more) but they are also being enticed or 'pushed' to allocate their limited and possibly declining disposable income (due to uncertainty of employment) towards riskier assets! There will come a time, when the Fed, Congress, the President and the market will realize that this economy cannot be turned around merely by enticing consumers to buy or borrow more.

In addition, as much as we hate to say it, as we consider ourselves 'supply-siders', the supply-side strategy will not work. This is due to lack of credit available for consumers. And we certainly are not blaming the banks. Again, consumers no longer have credit because they borrowed and borrowed and borrowed, which has been the driver behind US economic growth since mid-80's. That's no longer possible, unless the government decides to 'force' banks to lend, and promises consumers that they won't have to pay it back. Yes, it sounds unrealistic, but it actually is becoming more realistic everyday. Let's put it this way, in California, some long-time recipients of jobless benefits have begun to use those government checks at casinos, while at the same time not paying their mortgages waiting for government to provide more protection from the ‘ruthless’ banks, which the government bailed out. It all just goes round and round.

We've mentioned this before, for this economy to stabilize and maintain it for the long-term, it must transition back to more manufacturing/production. Consumption can no longer be the growth driver. We look for consumption growth to continue in Asia (incl. China and India) as it remains untapped compared with the US, which will likely be followed by demands for higher wages in those countries (as we're already seeing in China). This could once again make labor more attractive here in the US, which could drive the transition towards more manufacturing and in time, a more balanced production and consumption driven economy.

Quote

Now, after such a lengthy argument/explanation, here's a quote from someone whom CNN was interviewing - "All the people that helped perpetuate the bad loans are now perpetuating the rescue scams". Sounds like banks and their little 'made-to-look-local-and-consumer-friendly' side businesses; whether you're talking about mortgage loans or credit card debt.  We note that we are NOT marketing CNN or any other of the too-many cable news networks.

Week of 8/16 – 8/20

Some potentially market-moving indicators will be released next week.

We think last week’s jobless claims will be inline with the current 475K consensus as many of the now-jobless government temp workers will likely take a bit longer to file. Continuing claims will likely show increase given the latest uptick in the 4-week moving-average (MA) of initial claims, combined with minimal job growth in the private sector. Last week’s disappointing July employment figures (as we’d expected) support our belief.

July housing starts will likely be in-line with the 555K consensus (an increase of 6K from June) given June’s surprising higher than expected housing permits. However, we believe July’s housing permits figure will be disappointing (which is positive in our opinion) as we are getting closer to the end of the summer construction season. Although the equity market reacts positively to strong housing permit figures, we believe that more permits could once again push inventories higher in 3 – 6 months, putting more pressure on home values and the overall housing market.

We don’t expect July’s capacity utilization to surprise on the upside mostly because exports were likely disappointing in July as they were in June (reported last week).

Lastly, the Leading Indicators will likely come in better than expected. We note that the better figure is driven mainly by the stock market’s performance in July; S&P500 went up nearly 7%. Although we must paradoxically say that we believe the Leading Indicators is actually a lagging one; it weighs too heavily the stock market’s performance.

Comments on July's upcoming employment figures

Unemployment figures for July will be released next week. We believe the net jobs added figure (excl. government jobs) will be slightly below the 82.5K consensus. 

This year's first half earnings were very good. This was mainly due to - easier comparable first half of 2009 (1H '09), inventory replenishment after a state of paralysis in 1H '09, aggressive and certainly necessary cost cutting measures implemented within nearly every sector, and analysts' 'conservative' estimates and expectations. However, as we mentioned last year, the second half of 2010 may be a different story. The Y/Y comparison is not nearly as easy as it was in the first half. In addition, revenue growth, if any, remains very disappointing. Although some sectors reported stronger than expected revenue growth (Y/Y) and some companies have provided positive revenue guidance for Q3 or the entire 2010, strong revenue growth for most companies remains unlikely. For this reason, we believe the majority of companies remained hesitant in increasing their headcount in July. 

Management teams' main objectives include impressing Wall Street. The best way to do this is to beat Wall Street's earnings expectations and have impressive Y/Y bottom-line growth (knowing that an impressive top-line growth is not likely). That is why we believe companies have not and will not increase their payroll significantly until at least 12 months down the road. 

Maybe our thoughts regarding the state of employment no longer being a lagging indicator were correct. This topic was discussed again this weekend in an article on Reuters. Just remember that the 'trickle-down' theory will work only when regular middle-income consumers, including the ones unemployed, can use their credit cards or may still have equity on their home, or can still borrow from their banks. None of these is applicable to the current state of the economy.

Jim Cramer comments on this week's upcoming housing numbers

Before calling it a night, we read a CNBC article summarizing Jim Cramer's comments regarding this week's upcoming housing data. Similar to what we said early on Monday morning and what we have been saying for a while, Mr. Cramer expects the housing figures to disappoint.

However, Mr. Cramer is blaming such potential disappointment on economists that provide the housing estimates. He actually said, "thanks to the eggheads economists who've created absurdly bullish expectations." This is an interesting way of thinking about the housing numbers. It seems that he's basically trying to minimize their possible negative impact on the equity market this week, especially given the fact that he had made some bullish statements last week. We don't recall much criticism of the same economists by Mr. Cramer when their estimates were too low or too conservative. We assume criticism was not applicable or necessary as their low and inaccurate estimates partially helped drive the equity market higher.

Mr. Cramer is looking for home prices to rise when builders begin building fewer homes. In other words, when inventories decline, prices are likely to go up. Unfortunately, the tax breaks offered by the government delayed such necessary inventory adjustment by creating an artificial and short-term increase in demand for real estate.

One thing with which we certainly agree is Mr. Cramer's view that one of the main factors slowing down the housing recovery is the lack of recovery in employment, especially given the fact that households remain burdened with debt.

Mr. Cramer also stated that the housing market is not a big percentage of the economy. This may be true, strictly speaking. However, given average household's massive investments in real estate, any significant downturn in housing certainly impacts average household's purchasing power and consumption. Let's not forget that consumption is a big part of the economy.

On top of all of that, we sensed a bit of excess boastfulness when we read his quote saying, " ... remember that you have the real numbers from me, and you can rest assured that you have not only seen tomorrow's headlines today, but Thursday's as well, and it can't get any better than that."

We certainly do not have as much credibility as Mr. Cramer (and likely never will). Nor are we respected and experienced as he is. For this reason, his statements were a surprising, which is why we thought to comment on them.

Disappointing July NAHB

The NHAB housing market index was released this morning. And yes, it was disappointing.  We have been saying for a long time that the real estate market may experience a double dip, and latest data show that this may actually take place.

The NAHB for July was 14, a 12.5% decline from June. This index has not been this low since April of last year.

David Crowe, the NAHB Chief Economist said, "the pause in sales following expiration of the home buyer tax credits is turning out to be longer than anticipated due to the sluggish pace of improvement in the rest of the economy. That said, we do believe that favorable factors such as low mortgage rates, affordable prices, and demographic trends will help revive consumer demand for new homes this year, and that new-home sales will improve by 10 percent in 2010 from 2009."

We think that all of the factors cited by Mr. Crowe are valid, except for the fact that they will not help revive the market this year. Those factors are based on the state of employment in this economy, and that is certainly not improving. Lastly, the 10% annual improvement expected by Mr. Crowe, most likely has already taken place during the first six months, so it is still very likely that we will see another dip in the housing market for the rest of 2010.

Can we still apply the buy-and-hold strategy?

We thought that maybe we should take a step back and just see how well (or badly) certain indexes and ETFs have performed during the last 5 years. Below is what we came up with, or shall we say, it’s what the market came up with.

It is clear that the notion of buying and holding equities for the long-term is no longer applicable in this market, especially recently.  It is also clear that gold is ... well, its golden!  Here is some additional data: S&P500 is down nearly 30% during the last 10 years, while the volatility index (VIX) is up nearly 36%. These are the figures that casinos love to see - people gambling more (increase in VIX) and losing more (decline in S&P500).

We believe that the performance of stocks no longer necessarily represent the performance and/or health of a company or the economy. One may ask whether the stock is the chicken and the company is the egg, or the other way around. But merely the existence of such a dilemma or question is telling us that the performance of a company (in terms of growth, profitability, etc.) may now represent less than 50% of the performance and valuation of that company's stock. Simply put, fundamental analysis is now out the door, at least for the time being. Diversifying away stock specific risks is no longer applicable. Stock specific risks are now nearly impossible to identify, as again, we no longer place much emphasis on a company's or the overall economy's performance. And the systemic risk, we think the government has failed to minimize.

One may provide a rebuttal and propose that given such 'transition' in the market, investors must begin to adjust the way they value stocks and lower weight given to fundamental analysis of companies. We agree, if the objective is only to beat the market.  We agree, if the objective is to gamble just like one would when visiting Palms, Wynn, Caesar's and many other casinos in Las Vegas (or Macau). Well, as mentioned earlier, at least some figures demonstrate that the market is becoming a casino. But all of this will make the economy dependent on the stock market.  Excuse us, we just realized that this is already the case.  The economy is dependent on the stock market. The stock market is no longer an indicator of the economy.  The health of the economy is based on how high or how low those stocks go. Is this really the type of economy and equity market that we'd like to have? In our opinion, no.

There are many reasons as to why the market is becoming a casino (if it hasn't already). The one that stands out is the huge influence that large businesses and/or industries have over the government. The leverage that these lobbying groups have over our so-called lawmakers is unbelievable and it could surpass leverages historically demonstrated by the NRA, AIPAC, etc. And we're certainly not blaming the lobbying groups as they have a right to push for what's best for them and their clients.  The lawmakers and their 24/7 election concerns are what concern us.  From the day they get elected, they begin to think about their re-election campaign strategies, which certainly makes them more and more vulnerable to that cash and those promises and possibly threats they receive from lobbying groups. 

Basically, nearly every industry gets its way. All of this creates more red tape for other industries and this goes round and round, and creates a potentially very costly cycle. The red tapes create additional risks for the market. The red tapes induce many (mostly the quants on Wall Street) to design securities to get around them or to make money via them. By the way, we believe they have a right to do so.  This again adds to volatility.

The market will likely become more volatile, as we have seen (and as indicated in the table shown earlier). Volatility may be good for professional traders/investors and quants, but it is the worst for retail and Mom & Pap investors. And they are the people that drive this economy. They are the ones that consume, of which we have not yet seen enough. 

Besides our whining and complaining we think the market could take a further dive.  From a technical standpoint, if S&P500 goes below 1050, then 1000, or another 6% decline, could be next.  In addition, although the 100-day and 200-day moving average (MA) have not yet begun to trend down, another couple of flat to slightly down weeks could initiate the downward trend for those MAs, which would also make it more likely for them to cross. 

We note that as compared to 3 weeks and 5 weeks ago, when S&P500 was basically at current levels, VIX was between 9% and 33% higher than where it closed at on Friday.  This may somewhat lessen the fear in the market.  However, we believe this is mainly due to expectations of good earnings releases during the next few weeks.  Unfortunately, we also think that the good numbers will likely be followed by disappointing guidances.  Its during most earnings seasons that the market and investors realize that fundamental analysis of companies just cannot be ignored. 

Lastly, given the lack of artificial high provided by the government for the real estate market, the market appears to be dispplaying withdrawal symptoms, similar to many drug addicts.  We think basically the housing market, the auto market and the rest of the economy has become addicted to government help.  Once aid from the government is no longer available, the markets get off of their artificial highs.  We're seeing this with the real estate market.  Next week's building permits, housing starts and existing home sales figures will likely be disappointing, even with the more conservative estimates.  In addition, we think initial jobless claims will increase as last week's reported decline may have been due to the shortened 4th of July week.

Jobless claims extension defeated in the Senate

Extension of jobless benefits was defeated again in the Senate late Thursday night by a filibuster.

Accordingly, about 900K claimants will lose their eligibility by the end of this week, which is now upon us. This means that next week's EUC 2008 number will be drastically lower, as we mentioned earlier on Thursday morning. It could also mean lower consumption by the ones that were receiving those benefits. With consumption already not very inspiring, this will likely further cut into consumer spending.

This is exactly what the economy does not need. Its a perfect example of a drug addict facing difficulty in first quitting the drug use and then actually recovering from the addiction, if possible. The government made the economy dependent on these stimuli and now the economy is begging for more and more. Although the equity market has had a rally the last few days (driven by technical indicators as we mentioned before), it may begin sweating in the future, nearly as much as the economy has already begun to. Maybe the economy should attend some SA (Stimuli Anonymous) meetings.

The Philadelphia Fed Survey says ...

A bit late, but we thought to say a few things about the Philadelphia Federal Reserve survey, which is viewed as an indicator of the health of the manufacturing industry in that region.  It was released this morning and came in significantly below estimates. It was 8.0 for the month June versus May's 21.4 and analyst estimates of 22.0. 

What stood out was the number of employees and average employee workweek indices, both of which declined into negative territories, suggesting contraction in June. 

In terms of how those manufacturers view everything six months from now, they remain hopeful. The future index increased from 37.0 to 40.2. We must note that the number of employees index declined to 19.5 from 30.1, indicating the manufacturers' unwillingness to increase headcount. Of course they are more than willing to squeeze as much work out of their employees as they can, indicated by the average employee workweek for the next six months going up to 25.2 from 14.6. Lastly, capex will not be growing during the next six months as much as the manufacturers had indicated in May. The capex index for the next six months declined to 3.0 from 7.0. 

The possibility of a slower, weaker and potentially contracting 2H '10 is increasing.

Initial and continuing jobless claims disappoint

It appears that the employment situation is not really improving.  Initial jobless claims for the week of June 12 came in much higher than expected. The 472K figure was above the average estimate of 450K. Seasonally adjusted continuing claims for week of June 5 were also higher, up 88K to 4.57MM.

We touched on the EUC 2008 and extended benefits figures in our earlier post. Extended benefits (provided by state/Federal 50/50) increased slightly. However, we saw a big dip (-191,103) in EUC 2008. This is not an indication of jobs found by those claimants. You see, the government has not passed an extension to the EUC 2008 program, so that number will continue to decrease as many reach their limits and are basically no longer included in that figure. The last week for the EUC 2008 program was May 22.  This program was initially intended to be temporary, but the state of the economy and political incentives forced our law makers to extend it for a long time.  The economy has not realized any return on this, but those politicians certainly have ... for now.

CPI was in line with expectations, supporting the PPI and capacity utilization stats and, for now, quelling fears of higher inflation.

Housing starts, building permits and FDX outlook disappoint

As we mentioned, capacity utilization came in better than expected, but did not indicate rising inflation.

Housing numbers disappointed big-time, with housing starts of 593K falling short of the 655K consensus. Building permits came in at 574K, below the 631K expectation. 

Although we did not mention PPI in our previous post, we note that it did not decline as much as many had expected with -0.3% for May being a bit less than the -0.5% average estimate. Core PPI (PPI excl. food & energy) did increase by 0.2%, which was more than the 0.1% consensus. Rising PPI, however, when combined with the capacity utilization data, does not indicate inflation rising too much. We'll see if the CPI data supports this tomorrow. 

On another note, FedEx (FDX) a bellwether, disappointed with its annual guidance. We'll see if anyone will pay attention to this as fundamentals appear to have been pushed aside for a long time.

Give Props to the Technicians ...

Well, S&P 500 did not break below the 1,050 level, and in turn, literally burst through the 200-day average of 1,108.25, which as displayed by the market, convinced technicians to make that 180 degree turn from bearish to bullish ... at least for the day. As we mentioned last week, continuance of the latest downturn or correction would take place if S&P 500 had gone below 1,050, which of course did not occur. At the same time, the latest downturn short-term partial recovery did strengthen the 1,050 base level.

If the market turned upward and excluding significant downward movements, the 200-day average is likely to trend further upwards and maintain such a trend. This is mainly due to the fact that the market experienced a big upturn, 18%+, since late August '09 until late April '10. The turn of the 200-day average could drive similar change of direction in the 50-day average at least through the next 2-3 weeks, which do include the April highs. So, at least in the short term, from a technical standpoint, the market appears to be leaning more towards the bullish side.

So technicians may be looking for the 10-day to cross the 200-day on the upside, or the 200-day crossing the 50-day on the upside. The downturn and/or bearish mentality may conquer the market again, if the faster declining 50-day crosses the flat 200-day.

As usual, we believe the fundamentals tell a different story. With many upcoming key economic indicators, the battle is now between technicians and the other more fundamental-based traders, meaning volatility may be around the corner.

For the rest of this week, some potentially disappointing economic indicators include May housing starts and building permits (due out tomorrow morning).  The end of the latest home buying incentives has very likely driven down demand for not only buyers but also the builders.

Capacity utilization will likely be positive or better than expected, but not at a level demonstrating strong expansion or instigating inflation fears.

We look for initial claims to be in-line with the 450k current estimate. In addition, although the total continuing claims may be lower (likely around 4.5MM), we recommend for everyone to view the Extended Benefits and the EUC 2008 (Emergency Unemployment Compensation) figures in the weekly initial claims report. The decline in continuing claims, we believe, is more likely due to the 26-week expiration of benefits for many unemployed. Yes, a small, very small portion may be due to some job findings, but after the 26 weeks are over and the initial continuing benefits run out, those unemployed are no longer included in the continuing claims figure. For this reason, again, we believe many should view the Extended Benefits and EUC 2008 numbers, which together, will likely be higher than the prior week. All in all, the current burst in government hiring may have helped to slightly, only slightly, ease the lingering unemployment fears. But once the Census project is finalized, we don’t expect the majority of Census workers to find FT jobs.

Lastly, the Leading Indicators figure could be in-line or worse than expectations, negatively impacted mainly by the 9%+ drop in stock market values during the month of May.

Our thoughts on some of today's economic indicators

It appears that consumers were not consuming as much as the government and/or economists had expected. The May retail sales monthly decline of 1.2% was below the consensus of a 0.2% monthly gain. This was a bit surprising as we thought consumers may still have some of their tax refunds to spend in May. This is the largest monthly decline in eight months.

Consumer confidence, on the other hand, is increasing as indicated by today's Reuters/University of Michigan Consumer Sentiment Index. It came in at 75.5, higher than the 74.5 consensus, and 1.9 points higher than the previous month. Then again, this index had also increased by 1.4 points in May, a month in which retail sales actually declined big. So, we'll see if consumers will actually put their money where their mouths are.

Both the index of expectations and of current conditions rose. According to the report, there is less fear regarding unemployment. We must note that although there has been some improvement in the employment picture, its mostly from the Census temp jobs. Let's hope that all of those Census workers will be able to find a FT job after the government is done with them.

Let's combine the smiling consumer sentiment data with the not so happy ECRI's Weekly Leading Index (WLI). The latest figure of 123.2 was lower than last week's 124.0, making this the fifth straight weekly decline. Its also the lowest level since the last week of July '09. We're not saying that this indicates the end of the world, but it does say that this economy is still not in good shape and that things are not improving as well or as quickly as many think. All of this may say that the market at these levels just may be expecting too much.

We still believe this recovery is losing steam. We wonder just how much more money the government can throw at this. With Bernanke in charge and his 'mothership' (this is what Dan Patrick calls his ex-employer, ESPN), Goldman Sachs, facing what at least on the surface appear to be some serious charges, we think everything will be thrown at this economy, even the Fed's kitchen sink, to at least make it look like its recovering and to keep that consumer confidence rising. Hopefully then consumption will get going, people will start working, government will begin generating huge tax revenues and will start paying off its debt. Be positive, think positively, have high hopes and good things will happen.

Will the latest market correction continue?

S&P500 is down 4.5% since we labeled Bernanke as the official silencer of bad economic news. It appears that these days, no matter what Bernanke throws out there, the market has realized that a much quicker and stronger recovery was already priced in.

As we’ve mentioned a few times before, the second half of this year could be tougher than what we’ve experienced the last 12 months. Year-over-year comparisons will be much more difficult for many companies during the last six months of 2010. There are no indications of any steady top-line growth for companies across most industries. Most companies have cut their expenses to the bone, resulting in impressive margin expansion. However, we continue to believe that this cannot continue.

With the topic of sovereign debt now on the front pages worldwide, it appears that the government will find it slightly more difficult to continue its so-called stimulus programs. Thanks to those Europeans, our lawmakers may finally begin to take into consideration the long-term negative impact(s) of their programs. Maybe they can think of something better than programs that are to stimulate the economy just long enough (between 2 and 4 years) so they can re-elected.

The employment picture doesn’t look that great either. Yes, the government is hiring but all of this hiring is temporary. Well, maybe the government is hoping that with some extra money earned by the temp Census employees, consumption would increase enough to convince small businesses to hire again. Unfortunately, this just may not work out for the government, as most consumers and small businesses no longer trust the government or the overall system. ‘Conspiracy theorists’ are no longer the ‘few’, they are becoming the majority; and that’s for very good reasons.

We’re glad to see the consumer revolving credit not increasing significantly. In fact, it declined by $8.5bil in April (last reported month). Declining revolving credit certainly doesn’t indicate any significant or steady comeback in retail sales growth. Of course, thanks to the government’s free money programs, the non-revolving credit balance appears to be increasing. But again, for how long can the government pay us to consume? Wow, I just said that the government is paying us to consume! Socialism, welcome back!

Consumers have continued to deleverage their balance sheets, which has lowered their debt payments. Consumption remained flat in April (last month reported) compared with March, but was up Y/Y at a meager 4.6%. This figure is not impressive as April ’09 was also a weak consumption month. The May figure may be slightly better as our consumers may have put their tax refunds to good use. Unfortunately, we believe a better use would be savings, which was again at a low 3.6% rate in April. Overall, the economy would benefit more from higher savings in the long-run. But the government is doing everything it can to prevent the hard working families from saving.

Housing is not looking good either. This week, even with rates remaining at their lowest levels, refinancing declined. Of course, no surprise as the purchase index declined for the fifth consecutive week; again while rates have remained at low levels. This is another example of how well these government programs work, only for the short-term. Let’s hope the home builders didn’t think that this government-induced ‘high’ would last longer. If they do, we can expect another jump in inventory levels during the next few months. The optimists or green sh*ters may point to the latest decline in foreclosure (from the latest RealtyTrac report) rates as an indication of a turnaround. Well, sorry to tell you ‘greenies’ but such decline is accompanied by huge jump in the number of homes that banks have begun to repossess. You see, the banks, for the time being, are ignoring the late-payers in order to take away the properties of the truly non-payers. Banks had been wishing that over time, many of their foreclosures would work out, but unfortunately they haven’t. At this time, banks have no choice but to try and control home inventories. It appears that the best way to do so is to forget about the new foreclosures and try and tackle the old ones. We wish the banks and other lenders a lot of luck.

With all of this said (and we do have a lot more to say as we basically omitted discussion of the latest oil disaster), the market (S&P500) has entered its correction phase, down more than 13% from its high in late April. We continue to believe there is more room for the market to decline. In addition to some things mentioned above, from a technical standpoint, if S&P steadily breaks the 1,050 level, the 1,000 level is doable. If the market dips below 1,000 on heavy volume, then the 950 – 975 level would be realistic.

Hopefully if the market behaves the way that we are anticipating, because then we will likely begin to publish our thoughts on specific soon-to-be under-valued companies. Until then, we remain bullish on gold. As mentioned in our previous note, hopefully our simple strategy will be successful so that we can begin vacationing in the now much more affordable Greek islands for a long, long time.

Benny Always 'Silences' Bad Economic News

The equity market reacted to the housing market data as if we were back in late 2005. Disappointing new home sales of 309K (annualized), significantly below the 354K consensus, was disappointing enough to send the S&P 500 up nearly one percent! Of course, we cannot forget the fact that Mr. Bernanke testified today and said exactly what he knows his ex-colleagues at Goldman Sachs and the equity markets love, "low for an extended period." Add to all of this, last week's very disappointing jobless claims and the very high new homes inventory of 9.1 months (highest since last May) and one would not expect the market to shoot up 1%.

We concede that this type of movement would be understandable if it was believed that we were at the 'bottom' with no where to go but up. However, we ask - weren't we at the bottom in March '09? And given the 63%+ increase in S&P 500 since, combined with the not so greatly improved economy, is a continuing rise in the equity market really justifiable?

Well, it may be, as it is clear that the government, which can justify virtually anything, has been the driver behind such movement. Here is another example - the passing of today's jobs bill in the Senate. This is something that can cost over $13 billion during the next ten years. Tax exemptions are for social security payroll taxes. Given the indirect, but potentially very significant, impact of this on social security benefits, we are just amazed. Add to that a $1,000 income tax credit to businesses for every new employee that they retain for more than a year, and you have nothing but the government influencing the participating businesses' strategies.

The tax exemption will be in effect only until the end of Congress' 2010 calendar year, which is Sept. With no indication of strong improvement in consumer or business demands within this economy, why would businesses, any businesses, risk increasing their headcounts for no return? We actually forgot, that return is provided by the government, which means that as soon as it is shut off, so are the working hours of the newly hired employees of participating businesses. Even with low rates, businesses are not willing to borrow to expand. Will incentives such the ones mentioned above help this situation significantly enough to start a long-term job and economic recovery? No.

Of course, the government's actions and policies all come with good intentions, as it hopes that one day the real economy, the consumers and small businesses will jump on the 'bandwagon' (in addition to all lawmakers getting re-elected). When such phrase is used in sports regarding specific teams, we know we should not be placing much money on those teams when in Las Vegas.

Regarding some other economic data released today, the Case-Schiller Housing price index came in very slightly (1bp) better than expected. But let's be realistic, those figures were for the month of December, nearly three months ago. With indications of higher inventories and foreclosures, we envision continuous lower housing prices.

Given our consistent 'whining' and complaining about the current state of the economy and about certain steps taken by the government, what do we propose? Nothing. We propose that the Fed and the government do nothing. We propose that the Fed allow the market to determine the interest rate. We propose that with higher rates, individuals increase their savings. We propose for the government and the Fed to allow banks to patiently wait until higher savings increase their capital. After which, not only would consumers have some money to spend (creating demand), but banks would also be loaning money, their clients' money (not the government freebies, the supply of which appears endless, which in the long-term will make them useless).

Regarding tomorrow's jobless claims figures, we expect something slightly lower than the current 460K consensus, which the government and the market will likely take as good news. We expect lower numbers as we think staying home during the bad weather motivated more people to file for initial claims 1.5 weeks ago, rather than last week. However, we believe tomorrow's figure will remain above 430K and close to 450K, which is not positive no matter how one may look at it. We do expect continuing claims to be up for the 2nd week in a row.

January durable goods orders will also likely be better than expected, due to some New Year optimism demonstrated by some businesses in early January. With these in mind, it wouldn't surprise us if the market hit another "high" tomorrow. Such movements are mere but yet very important, short-term highs. If S&P 500 does not hover around 1100 long enough, the risk of another and more significant pullback increases, each day as it moves further above 1100, in our opinion.

For Friday, we expect a slightly lower second estimate of last year's Q4 GDP growth, which we do not believe will impact the market too much. In addition, existing home sales for January may not be disappointing as both some sellers and some buyers may have too quickly hit the market fearing that buying homes this cheap is a chance of a lifetime. However, Friday's likely disappointing Chicago PMI and University of Michigan's consumer sentiment, combined with the market moving up on Wednesday (and possibly on Thursday), will likely push the market down a bit, giving us a taste of what may happen next week with possibly three very important indicators (ISM, ISM Services and unemployment) being disappointing .

Lastly, we thought to mention something regarding the US’ ever expanding debt, to which any new jobs bill will add. There may come a time when, unfortunately, the government will no longer be able to help everyone due to high debt. At that point, many may begin protesting and demanding support from the cashless and/or dollar-valueless government, similar to what the Greeks are doing these days. We hope that at that time, we, along with many others, will be vacationing on one of those beautiful Greek islands.

Fed's Consumer Credit report ... worrisome.

We thought we should provide some initial comments on the Fed's consumer credit report released on Friday, as we believe it may have contributed to the equity market's turnaround from triple-digit losses mid-day to a slight gain at the close.

Decline of $1.7billion in credit was much less than the $10.0billion decline expected by analysts. We believe this was driven by Christmas shopping and various government 'incentives.'

It is safe to assume that many consumers, now a bit more confident than last year, decided to treat themselves or loved ones to more or better gifts during Christmas season. In addition, the very slow improvement in the employment situation (although may not be maintained) and the government's lovely gifts for additional consumption (such as cars), may have convinced many to tap into their unbalanced balance sheets and, temporarily, slow down the deleveraging process.

To make it simple, we compared the Dec. '09 results to 2005, which was when the housing market peaked. Dec. consumer credit balance remained above the 2005 level. More specifically, the $2,456.8 billion was 7%+ more than the 2005 balance. The revolving credit balance remained 4%+ above 2005. In addition, the non-revolving balance is above that of 2007! This is alarming and demonstrates just how much further consumers levered themselves in only 24 months, 2005 – 2007, before attempting to correct their actions. We believe many are determined to reduce their debt further, but cannot do so while unemployed.

Thanks to the government and the lower rates, the average amount financed for a car continued to rise in Dec. to $30,598, from $30,506 in Nov. and only $24,133 in 2005. Of course part of this is explained by the fact that consumers were borrowing more for their homes in 2005, and that today's rates are more than 40% lower than rates in 2005. However, with lower unemployment and overall income per household, such increase in auto loans, in our opinion, is unsettling.

In addition, the loan-to-value ratio of such loans stood at 92 in December, significantly above 2005's 88 and only slightly below 2007's 95. Combined with not much growth in overall consumption and continuing decline in the housing market, this ratio demonstrates 1) consumers likely did not have more cash to put towards those loans and 2) the government’s success in convincing consumers to borrow more at the great low rates. We wonder what would happen if the Fed was forced to exit such 'stimulus' phase of the economy (or plainly - money printing) before any meaningful improvement in jobs all around the country. We must also note that although the average length maturity of these loans is 64 months (higher than 60 months in 2005), the more time for the borrower, the more likely that the borrower will hit the high-inflation phase of this great recovery (likely within the next 24 months).

Simply put, we believe that the lower decline in consumer credit in Dec. was only for the short term. We hope we are correct, because if not, then, with the help of the government's stimulus programs, we are only delaying the significantly negative impact of high debt. Actually, so is the government.

Highlights and Lowlights of the Jan. Employment Report

As we expected, the 'official' unemployment rate was better than the consensus, and BLS reported a loss of 20k in non-farm jobs, compared with analysts' expectations of a gain of 5k. Of course, BLS refers to such state of non-farm employment as "essentially unchanged". It appears that BLS never fails to disappoint. In order to support a positive or negative reaction to this morning's report, one must look at the details.

Long-term unemployed continued to increase. There has not been yet any sign of reversal in this upward trend. Let's put it this way, the number of long-term unemployed in Jan. was 6.3MM, up from 6.1MM in December. Approx. 200k additional people became long-term unemployed in the month of January. This figure was 2.7MM and 5.9MM in Jan. and Nov. (respectively) of last year.

2.5MM people not included in the 'labor force'. As we had expected, the number of people in the labor force, as viewed by BLS, declined further. More specifically, total not in the labor force was 2.54MM, up from 2.49MM in Dec. Discouraged workers made up 42% (1.1MM) of the non-labor force figure, up from 38% (929k) last month. What a combination - more workers quit looking for jobs, and overall, additional workers continued to lose their jobs. When including the non-labor force figure results in an unemployment rate of 11.1%.

20k non-farm jobs cut. Unlike what most analyst's were expecting, what was a growth of nearly 5k jobs in Jan., net 20k additional people lost their jobs.

Most of the losses came from construction (-75k) and transportation and warehousing (23k courier and messenger jobs were cut). Approx. 42k positions were added in retail. Net manufacturing was negative, 11k job cuts, however it included some bright spots such as 23k more jobs in car manufacturing. A temporary boost brought forth by the government.

The number of temp positions increased by 52k, which can be viewed as positive, for now. During most recoveries, temporary jobs grow before permanent ones, as employers remain uncertain regarding the stability of the recovery. However, in this case, with lack of consumer demand, lack of an upturn in the housing market, continuing deleveraging process of consumer balance sheets, and increased productivity per worker, we believe many employers may realize that they do not need to replace the temp workers with full-time employees.

And of course, one cannot discuss employment without mentioning the federal government, as it added 33k jobs in Jan. Nearly 9k were for the upcoming 2010 Census. Let's hope those employees can weather the emotional storm when conducting the census.

Net result of BLS' revisions is negative. This might not appear as significant. We just wanted to point out the 1k job-loss net result of BLS' data revision for Nov. and Dec. Nov. revision of job growth, +64k from +4k, was more than offset by the Dec. revision of job-loss, -150k from -85k. Here is the most alarming figure - net results of BLS' revisions over all 12 months in 2009 was additional job cuts of 579k. In other words, during 2009, BLS initially (monthly) under-reported job cuts by more than half a million.

9.7% unemployment rate. This is self-explanatory, but we'd like to again point out that including the people 'marginally attached to the labor force' (as referred to by BLS), the unemployment rate would be 11.2%. It is a slight improvement from Dec.'s 11.4%.

Overall, we believe a full recovery in the state of employment will continue to take some time, which will delay the overall economic recovery. We do not consider unemployment as a lagging indicator in this recession. As we expected, the Jan. figures were not necessarily disappointing; however, we believe they were also impacted by the Christmas Season. We look for continuing job cuts in manufacturing in Feb., driven mainly by construction and automobile. In addition, we believe that a sizable number of temporary workers will begin to respond to surveys by saying they no longer expect to find a full-time job, which depending on how BLS' views it, they will be excluded from labor force calculation or will be part of net temp job count. We look for similar results in the retail sector in Feb. All of this may result in net job cuts (again) for Feb.

Another break from the 'recovery'?

It appears unemployment is not improving as much as the market's upswing (prior to today) had indicated, providing support for our view that the market is (and soon to be 'was') over-valued. Initial jobless claims of 480k for the last week of Jan. came in higher than expected and highest since the Nov. 14, 2009 reading of 501k. In addition, continuing claims for the week of Jan. 23 increased slightly. As we have noted before, declines that we had seen in continuing claims had been suspect as it is likely that many of the 27+ weeks unemployed are no longer, or cannot any longer, claim unemployment benefits. However, if initial claims continue to rise (if so, at a minimum rate and certainly not as much as they did in the prior year), and if many of the unemployed decide to receive extended benefits, then we will likely see an increase in continued claims, as we did this morning.

Although initial claims is viewed by many as a leading indicator, we still expect the Jan. unemployment rate to be in-line or better than the 10% consensus. However, we also view the expected gain in non-farm jobs as unlikely. We believe this was indicated by the ADP employment report yesterday. Unless the unemployment rate and the non-farm jobs figure come in significantly better than expected, we do not foresee a significant one-day bounce (after the market's current dive; S&P 500 is down 2%+).

The volatility for which we had hoped going into Friday's numbers (benefiting the SPY or S&P 500 futures straddle trading suggestion) has certainly been there.

The productivity figure also released today is another sign that it will take a bit longer for the employment situation to improve. With such high unemployment and a rather flat consumer demand (compared to normal economic conditions), it appears that companies still have room to cut and/or implement additional policies to make their operations even more efficient than what they have done during the last 12-18 months. This basically implies that the state of the economy must change drastically before companies feel more at ease to hire additional workers. Higher productivity is likely due to the large amount of fear that the currently employed have about possibly losing their jobs. Such incentive has driven them to work hard and produce much more than they or their employers expected.

High unemployment combined with increased efficiency is not positive for the economy, unless we finally realize that this economy is in a transitional state, and government policies intended to artificially boost consumption will likely backfire in the future.

Lastly, factory orders came in better than expected, but combined with the initial claims and productivity data, it could result in too much inventory going into 2H'10 ... again.

Let's wait and see just how well the BLS will craft and present the Jan. unemployment data tomorrow. One never knows, the BLS, the government and the main media can pitch anything to create some confidence. It has not worked yet.

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.

GDP

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.

ISM

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

Although 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.

Unemployment

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.

Is it time to take a break from the great 'recovery'?

It appears that the economy may not be accelerating as quickly as the equity market expected or is expecting. Although we have seen improvements in different parts of the economy, the numbers remain disappointing. However, the market continues to climb higher, until today. Could reality set in at some point? Could it be that many expect the government to continue to feed everyone, including the Haitians?

Although early Q4 earnings have been mixed, we do expect overall S&P 500 earnings to come in-line or better than the current consensus. However, as we mentioned previously (a long time ago!), strong top-line growth must accompany good earnings at some point. Only top companies in the tech and defense sectors will likely be able to accomplish this as both have become necessities, literally; some through natural and habitual evolution and innovation, while others through government’s great story-telling talent.

Intel (INTC) certainly had a great quarter and provided very positive guidance. Unfortunately, JPMorgan (JPM) could not accommodate its excellent earnings with solid revenues. Other big players likely had a good Q4, but given the slightly more stable market, it makes you think whether or not companies such as Goldman Sachs (GS), very dependent on trading revenues these days, could have impressive top-line growth in 2H’10. But again, S&P 500’s 4Q’09 earnings will likely come in in-line or better than expectations.

Going back to the economy, inventory replenishment may have given some life to the economy, but will it continue? The answer of course is based on consumption, of which we have not seen much improvement, as indicated by yesterday’s retail report and this morning’s consumer sentiment.

In addition, although initial jobless claims, viewed as a leading indicator, have declined slightly, they remain well above historical pre-recovery levels. Again, Thursday’s report (1/14) supports this view.

Of course, continuing claims has been declining a bit more rapidly, but does that really make sense given that unemployment has remained high and jobless claims have stayed above 400k? The logical explanation would be that there are many more people giving up looking for jobs than there are finding jobs. Certainly, many companies have already cut down to the bone in terms of reducing headcount. As it is well-known, the continuing claims figure does not include the number of unemployed that have basically said 'no mas'. We assume those figures would be different if everyone had the attitude that those Green Bay Packers displayed last week against the Arizona Cardinals. They fell behind big but came back to make that game 'one for the ages.' Then again, that's just a game, and the football players get paid no matter what.

Although we cited the March'09 lows as the bottom, we certainly did not expect such strong recovery in the stock market. We believe that the market is currently over-valued. In addition, given the market's recovery, the notion of 'buy anything' is no longer applicable. With volatility declining (although VIX is up nicely today), we believe fundamental analysis may be rearing its logical and realistic head. We’re using the word ‘rearing’ as fundamental analysis is the last thing traders want to hear about after a great 2009.

So, let's look at valuation for a bit. The S&P 500 is at approx. 20x 2010 GAAP earnings, which could be considered fairly valued given the expectation of a 22% Y/Y growth in earnings. With not much improvement expected in consumption (although the 2010 GDP Y/Y growth consensus is near 4%, thanks to government spending and inventory build-up assumptions), we believe earnings growth for the year could disappoint and come in less than 20%. As mentioned earlier we’re confident that S&P 500 companies’ earnings would be in-line or better for Q4 and 1H'10. However, the second half of the year could be different. If companies are not successful at growing revenues, it appears that they may not be able to expand margins Y/Y further by cutting costs, making the overall 22% 2010 earnings growth a bit too optimistic. Based on a 17.5% earnings growth assumption, a 17.5x earnings multiple (PEG of 1.0), which represents S&P 500 at 1,000.00, would be more appropriate. Of course, government intervention, or that quick and short term high, could prove us wrong again. Trading along the lines of government's continuing intervention has and may continue to pay off for some time, but at some point even the government may be forced to say 'enough is enough'.

Time for a correction?

We certainly have not participated in this great rally, and we must admit, we regret such misstep. However, we remain skeptical as although the economy has avoided the black hole, recovery is no where in sight. Unfortunately, in our opinion, the market has not yet realized such ... reality.

Unemployment

July unemployment numbers came in better than expected. Those figures included decline of 247k in non-farm payrolls (compared to the market's expectation of -325k), 33.1 average working hours, 0.2% higher average wages, and a 9.4% unemployment rate. In our opinion, these not so bad numbers were temporary and are misleading. Decline in non-farm payrolls was impacted by more government jobs (which we hope are only temporary as the last thing we need is further expansion of the government), higher payrolls in healthcare, and the seasonally expected higher payrolls in hospitality/leisure.

However, heavy declines in other industries such as manufacturing were alarming. Manufacturing employment declined by 52k. We note that this number was helped by a 28k increase in auto workers, which we believe is temporary and driven by the famous "cash for clunkers" program. Also, as stated by the BLS, these numbers were not that bad because there may not be any more jobs (and other costs) to cut in manufacturing. Professional and business services industries lost another 38k. And financial services shed another 13k jobs in July.

What caught our attention were the temporary help and part-time employment figures. Historically, those have been leading indicators of recovery. However, we did not see any improvement in those figures. We currently have nearly 9MM part-time workers. Temporary help, which is considered a segment of professional and business services, continues to fall.

Increase in weekly average hours of work was somewhat of good news. But then again, given the lack of stability in most positions within the workforce combined with continuing decline in employment, many are working harder just to keep their jobs. In addition, although total average weekly earnings increased slightly, we believe such movement was driven not only by more hours worked, but also partially by the increase in minimum wages which went into effect in late July. Of course higher minimum wages could impact weekly earnings more positively, but we believe it will also drive many companies to layoff more workers.

The July 9.4% unemployment rate was very welcomed by the market. Unfortunately, many overlooked the fact that such figure was due to many unemployed no longer looking for jobs. The BLS stated that the labor force participation rate declined by 20bps in July. The BLS excludes those when calculating the 'official' unemployment rate. Luckily, it also provides a rate which includes the discouraged workers. Unfortunately that rate increased to 10.2% in July from 10.1% in June.

Overall, the employment situation in the U.S. has not improved. Of course, the figures that we discussed are lagging indicators. However, the employment figures that we consider as leading indicators, such as jobless claims, remain very weak. Last week's initial jobless claims came in at 558k, approx. 14k higher than market’s expectation. Initial jobless claims have remained above 500k for approx. nine months.

Lastly regarding employment, some are comparing the current situation to previous recessions. As displayed by the graph below (provided by FAO-Economics), some believe that the similarities seen in the chart indicate that we are well on our way to a recovery. We must note several differences between this recession and the ones included in the graph. First, we believe this recovery will be another jobless recovery, similar to the last two recessions. As displayed in the chart, employment did not recover to pre-recession levels. However, we note that consumer debt levels were also lower in those recessions, which leads us to believe that employment may not be a lagging indicator during this downturn. In order for consumption to recover, consumers can no longer borrow more (although the government can!). For this reason consumption, which represents 70%+ of the economy, will not aid in recovery until there is some improvement in the employment picture.


Figure 1 (provided by FAO-Economics)

Consumption

Consumption remains weak as shown by last week's retail report which indicated a 0.1% decline, worse than the market's expectation of a 0.8% increase. That figure was more disappointing when we exclude auto sales, which of course have been pumped up by the "cash for clunkers" government program.

In order for consumption to rebound, we need some stabilization in the declining consumer revolving credit, combined with increase in consumer confidence. However, both continue to decline (Figure 2). We note that week's preliminary University of Michigan consumer confidence of 63.2 was significantly below the 69.0 consensus estimate.


Figure 2

What we are looking for is a combination of deleveraging, higher savings rates followed by stabilization in unemployment, all of which represent a slow recovery. Unfortunately, this is not yet taking place.

Although we are seeing some deleveraging in consumer balance sheets, as the revolving credit continues to decline, we have not yet seen a correction in revolving credit as a percentage of disposable income (Figure 3). We believe this is mainly due to continuing rise in unemployment (Figure 4), which may not be a lagging indicator in this recession.

Figure 3


Figure 4

We note that we may see some sequential improvement in consumption in August, which would be due to seasonality (back-to-school spending) and not necessarily consumers wanting to spend more.

Lastly regarding consumption, the bulls are now widely using the phrase "pent-up demand" (we no longer hear or read the "green shoots" phrase too often) and believe it will drive the economy to full recovery in 2H09. In order for consumers to meet their pent-up demand, they must have income, credit and/or other assets. Unfortunately, currently that is not the case. Many also state that consumers have profited from the latest rally in equities. Unless consumers are the institutional funds, we must disagree. Unfortunately, it is more likely that the average investor jumps in at the peak of this rally, which of course is bad news. We note that approx. 25% of the population is in the 45 - 64 year age bracket; and this figure continues to increase every year. We believe that with so many risks and uncertainties associated with the economy, the job market and the equity market, which all significantly impact retirement savings, it is unlikely that most individuals in this age group jumped in (after getting out in late '08 and early '09) and benefited from this rally.

Housing Market

We have seen some improvement in the housing market as June sales of existing and new homes increased 3.6% and 11.0% sequentially. However, we believe this has been driven by the great 'gift' that the government provides for first-time buyers. We wonder how the housing market will behave after such 'gift' expires by the end of November.

Inventory remains high as the months-to-sales figures for both existing and new homes remain significantly above historical average and prior recessions. June's month-to-sales ratio came in at 8.8, which was a significant improvement from May's 10.7. However, we believe such improvement is temporary and, again, based on government's gift to first-time-buyers. Increase in new home construction, which many believe is positive, will add to the market's inventory dilemma.

There are many questions regarding the housing market, such as - what will happen once the government no longer induces many to buy? Have employment, credit and savings improved enough to maintain the slight upward movement that we have seen during the last two months? Has the average investor profited from this latest rally in equities in order to put his/her gains towards a new home, a transaction which now will likely be based on higher mortgage rates? We believe answers to these questions clearly point to continuing weakness in the housing market. Although, again, we note that the government's assistance could artificially create additional upside during the next couple of months.

Of course, this government could continue to run the economy (and not the country), and may not only extend its housing 'gift' policy, but also provide more so-called incentives for people to spend while they are in debt and/or unemployed. Mortgage rates are higher but home sales are also increasing, while income is declining and job losses continue. What does this mean? It means again that the only factor behind the recent higher home sales is the 'gift' policy, which again could be 'wrapped up' by the end of November. Adverse impact of such policy, besides not allowing the housing market to correct itself, is that it could lure many sellers to take their homes off the market. Some sellers could begin thinking that 'hey, maybe I should wait. Prices are slowly going up, so I'll wait to get a higher bid.' If this occurs, we can expect additional increase in inventory.

July housing starts and existing home sales figures will be released this week, which we believe will likely be in-line or better than expected. But again, we believe this is temporary.

Q2 earnings season has ended

Pessimism which lowered expectations and drove many analysts to post very low Q2 estimates, was certainly helpful for many public companies during the Q2 earnings season.

However, we note that as of last week S&P 500 Q2 operating earnings actually came in lower than expected. According to the latest S&P numbers, Q2 earnings were $13.94/share, lower than the $14.31/share estimate that we saw in late June. We note that the latest S&P figure is based on approx. 91% of S&P 500 companies’ earnings.

Although the market has spiked up approx. 50% since the Match lows, we expect continuing pessimism as estimates across the board have been adjusted lower. Q3 and Q4 estimates are now 4% lower than they were in late June. For 2010, Q1 and Q2 projections have been adjusted lower by 2%, Q3 by 3% and Q4 by approx. 0.5%. In our opinion, these numbers indicate that the market just may be ahead of itself.

Summary

We believe that the state of the economy has not improved as much as the equity market currently indicates. Given where the S&P 500 closed at last Friday, it appears that the market expects a rapid or 'V' shaped recovery, although the S&P 500 operating earnings estimates indicate otherwise. Given continuing weakness in employment, consumption and the housing market, we believe the economy has a long way to go before recovering. For this reason, the market is overvalued and we expect a correction within the next couple of months, more specifically, before the start of the Q3 earnings season.

Is Alcoa a bellwether for the US economy?

It is becoming pretty tough to answer yes to this question, especially after Alcoa's Q2 earnings release.

We won't go through the earnings results as everyone is aware that they came in better-than-expected, driven by cost reduction and strong demand in China. Another pleasant surprise was the Company's revenue figure, which was nearly $300MM higher than what the analysts were looking for.

With that said, from a macro standpoint, nearly everything else mentioned on the call was negative. It appears that the Company's well-being is in China's hands. We do not view the better results as a signal for an economic turnaround in the U.S. anytime soon.

According to CEO Klaus Kleinfeld, global aluminum demand projection for 2009 has not changed. It remains at -7.0%. However, without China, that figure slides down to -10.0%. The Company's projection for various end markets is provided below:

Source: Alcoa analysis

Obviously, when it comes to North America, we're not seeing any good news in the table above. And who knows how significantly this could change in 2010, given the lack of consumption, unemployment, and higher savings; all of which are indications of no demand, resulting in less manufacturing and construction.

China is the only region in which Alcoa expects to see some growth. According to Kleinfeld, the fact that China's stimulus plan has strong infrastructure components, or is "shovel ready", is helping Alcoa. In addition, given China's average domestic savings rate of 40%, the government is pushing the Chinese to lower that rate, open credit card accounts and consume. Unfortunately, that is not the case with us, nor can we afford to do that.

Kleinfeld did mention that the automotive industry in the U.S. may be stabilizing in 2H09, but then again, we do know that such stabilization is nothing but inventory replenishment, demand for which is not yet clear. And we must say this may also be partially driven by the 'cash for clunkers' government policy, which will not positively impact auto demand in the long-run. As a reminder, June auto sales (announced last week) came in below expectations, below 10.0MM and below sales in May.

Overall, even though Alcoa's Q2 results beat expectations, we do not view it as an indication of a turnaround in or stabilization of the U.S. economy. Cost reduction and strong demand from China were behind those results. We do not yet see significant increase in consumption, stabilization of the unemployment rate, decline in savings rate nor an end to the deleveraging that nearly every household continues to execute.

The fantasy-to-reality consumer transition will take time

It appears that it will take some time for consumption to rebound in the U.S., which could lengthen the recovery of this latest recession.

In order for consumption to rebound, we need some stabilization in the declining consumer revolving credit, combined with increase in consumer confidence. However, both continue to decline. We note that the increase in consumer confidence since April '09 is likely due to what we believe to be a non-warranted 33% increase in the equity market since the March lows.
What we are looking for is a combination of deleveraging, higher savings rates followed by stabilization in unemployment, all of which represent a slow recovery.

Although we are seeing some deleveraging in consumer balance sheets, as the revolving credit continues to decline (Figure 1), we have not yet seen a correction in revolving credit as a percentage of disposable income (Figure 2). We believe this is mainly due to continuing rise in unemployment (Figure 3), which we do not view as a lagging indicator in this recession. We also believe that more and more of the currently employed consumers are becoming cautious as they may be next. This also explains the continuing increase in savings rate.

Figure 1





Figure 2

Figure 3

Higher credit card default rates, decline in home equity loans (as the housing market has yet to hit a bottom) also provide support for our view that consumption recovery will not begin in Q3, nor in Q4.

We would like to see savings rate climb to 8% (from 6.9% in May), the level at which it stabilized in the late 80's. In addition, although it may sound extreme, we would also like to see revolving credit as a percentage of disposable income to decline to 4% - 6% (from 8.5%), where it was in the late 80's. During the mid-to-late 80's, we believe consumers were 'wowed' more by credit cards. Unfortunately, over time, the increased awareness of credit cards, changed American consumer behavior and started the enormous leveraging for which we are now paying. Of course, although we are hoping for consumers to once again become realists, the federal government's policies and unfounded optimism may lengthen the fantasy-to-reality transition.

Lastly, the Fed will provide an update on change in consumer credit on Wednesday at 3pm (ET). The current consensus stands at -$7.5 billion, which we hope will be met. We note that although this data is somewhat lagging, again, the trends we see will provide us a clearer picture of a maybe-recovery.