Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Double Jeopardy
“Baby better come back later next week, ‘cause you see I’m on a losing streak.” – Jagger-Richards, Satisfaction
It’s said that what goes around, comes around. Ten years ago this very week, the jobs report for May 2000 threw up a stunning clunker. Although the number was positive, thanks to 357,000 Census jobs (note the symmetry), private payrolls were reported to have fallen by 116,000, compared to a gain of 267,000 private sector jobs the prior month. How did the market take this completely unexpected turn of events? Why, the Dow rallied by a little over 140 points to cap off a 500-point week. What else?
The difference then, you see, was that the market – still in the last few months of a tech bubble that believed in paradise on earth - took this development as conclusive evidence that the Fed would be lowering interest rates. Ergo, we would all be saved.
Today we were not saved. Why not? Was it because the report hinted that we might be headed for a double dip, as the press suggested? Or at the very least, a growth slowdown? You might think that would be the logical answer, but we have to say (with our best Chris Rock voice), “not really.”
No, these kinds of big reactions are all about momentum and expectations. When the market rallied on clear evidence that the economy was starting to flag in May 2000, the positive momentum from the tech bubble was still intact. At certain times in the market, all news is good news, and that was the case back then (and many a time since). Right now, however, the momentum has been downward since the moment the books were closed on April.
The second punch in the one-two combination was that the market was flat out wrong-footed, caught leaning completely the other way. Traders were increasingly looking forward during the week to riding a big jobs-report fueled wave Friday morning. I wouldn’t exactly say that it rained, but the flat waters were a big let-down to people who’d been waiting for a surge.
We had no fast predictions about the report ourselves, but a good report did seem plausible to us. Though skeptical about the consensus predictions of 550,000 (you may now read that it was only 500k, but it was really the higher number), so long as private payrolls could print something over 100,000, we thought that the market would be off and running. Another clue to the magnitude of the disappointment is that most predictions for private payrolls were for something north of 150,000, compared to the actual result of 41,000.
Other indicators, particularly the consumer confidence report from the Conference Board, seemed to lean towards a decent result. The weekly claims data haven’t been encouraging, but state tax receipts have been picking up, a positive indicator notwithstanding. The Monster employment index increased and the direction in both ISM reports was positive.
It certainly didn’t help that Friday morning trade was off to a poor start before the jobs report was released. The Prime Minister of Hungary observed that a default (most likely some kind of restructuring) was a possibility for his country’s debt, and as everybody knows, as Hungary goes, so go Germany and China. Yes, we’re being cheeky, but in a world paranoid about contagion, one person walking into the room with spots on their face can be enough to send everyone sprinting for the exits.
Hungary isn’t in the Eurozone, its debt problem has been known for a long time, and the country’s central bank was critical of the new Prime Minister’s pessimism. Its deficit is less than half of Greece. They did borrow heavily in foreign currency, particularly Swiss francs, and the fall of the euro against that country’s currency (it just hit an all-time low) has been painful. Yet Hungary has already partially restructured via the IMF, and many suspect the new government simply doesn’t like its austerity program. The comments came at a bad time and rankled financial players as being irresponsible.
Although the weekend press approach took a view similar to ours regarding the double hit to the markets – we even considered titling the column “Double Whammy,” but the weekend Journal pre-empted any such notion by using it in its lead headline – their one-two was jobs and Hungary. We say it was momentum and expectations, because if the momentum had been positive, the Hungarian remarks would have been shrugged off.
We’ll go another step and say that the late sell-off in the market that essentially doubled its losses Friday afternoon could be traced to the euro-yen trade. One can attribute that partly to negative momentum in the euro, and partly to Hungary (though a non-euro country) giving those fears another push. A lot of leveraged money is in the euro-yen trade, and when the yen beats up on the euro like it did on Friday, the margin clerks start showing up in droves. We suspect a lot of forced selling. It’s that kind of market.
The market psychology has turned. First-quarter earnings were good, but the latest economic news is only lukewarm. Disappointment! But if you step back and think about it, that’s more likely than not very, very good for the framework of the global economy.
It isn’t good for those currently unemployed, and it isn’t welcome to a financial sector that is still too large and yearning for a return to pre-2007 days (though many would dismiss that comment as preposterous, the behavior of the Gang of Four big banks and the oversized financial sector tell a different tale).
However, a slower rate of recovery that allows the economy to restructure rather than borrow its way out has its advantages. One would be a suspension of the bubble cycle, which has been quite harmful apart from that element whose goal is to cash out two or three years of oversized, unmerited bonuses and then leave the inevitable losses for others to clean up.
Another is that it makes life much easier for the central banks, particularly our own, to exit its quantitative easing program without inflation. It was only two months ago that the majority view in the marketplace favored a certain year-end prediction of a 5.5% yield on the ten-year Treasury (currently around 3.25%). We’re willing to bet that that view has been deserted even faster than the euro.
Homebuilding isn’t coming back next this year, though the stocks will pop with every rally (it’s just a way to add juice). The barriers of rising foreclosures, stagnant employment and unusually tight credit (particularly for residential construction) simply can’t be overcome that quickly. The rate of home ownership remains above the long-term average, and there is too much supply ready to absorb any uptick in demand – which the recently expired tax credit has dried up for the next couple of months anyway.
However, at some point, hopefully before the end of next year, homebuilding is going to accelerate again. A slowly declining unemployment rate and the current very low building rates will eventually get us to a place where builders can start to build again at a rate more appropriate to the population. When that happens, employment will get a sudden boost, particularly in the ranks of long-term unemployed men. In many professional services, being out of work for a year or more can be a death knell, but that isn’t the case in construction.
The fall in the euro has been bad for the market because of the money tied to the euro-yen trade. Yet losses and margin clerks will eventually take out what trades are still on there, and the market will simply stop reacting. In the meantime, it’s good for European exporters, whose biggest destination is China (chiefly due to Germany and France). China has the world’s largest dollar reserves outside of the U.S. itself, and having all those dollars to spend on European goods that have gotten much cheaper isn’t going to sadden the Chinese.
Finally, a restructuring of certain Mediterranean debt – and it says here that barring a miracle, Greece will go that route before the end of the year – would cause some short-term turmoil in the markets, but be a big plus for the growth prospects of the countries involved. Once it does happen, the markets can stop worrying about it.
But that’s all the longer term. In the short term, we’re still on a downward slope. It could stay that way into July. Whatever model pundits may be using to decide if the market is over- or undervalued, to us it appears that the list of good companies that are undervalued is much bigger than the list of overvalued ones.
Last week we thought that the market could be up on the week if the jobs report came through; it didn’t. The calendar is light next week, a situation that tends to favor the direction of the previous week. Fear and momentum could shave another ten percent off the indices, don’t you doubt it. If it does, load up on equities. The economy is better than the weekend headlines.
Was the jobs report really all that bad? On a disappointment level, yes. The number was considerably lower than April’s 218,000, with the biggest drop coming in service employment (+37,000 versus +156,000). In goods production, most of the change was centered in construction (-35,000 against +14,000). Manufacturing is still adding jobs, but the rate slowed.
Individual states have been citing construction layoffs in the May weekly claims reports. Contrast that with last week’s announcement that construction spending rose 2.7% in April, a number much better than expected (consensus was for no change).
If we put those reports together with other pieces such as new home sales, the homebuyer tax-credit expiration, April construction employment (the first increase in years), mortgage-purchase applications and the jobs report, a plausible explanation emerges. Conditions led to a surge in building smaller homes (below $200,000) in March and April. Such homes can be quickly completed, leaving those workers to be steadily laid off in May as the surge halted. We feel confident that declines in May home sales will support this view.
For their part, the two ISM surveys for May both showed improvement in employment. The manufacturing edition’s subcomponent rose to 59.8, which is the best reading since May of 2004. The survey is a better indicator of breadth, rather than depth, however, so although manufacturing did add jobs in the BLS survey, it was only 29,000 jobs. The April total was 40,000, so our guess would be that May gets revised upward.
The non-manufacturing survey showed employment finally climbing back up over neutral to 50.4. It was barely positive (neutral is 50), not much changed from April (49.5), and boosted entirely by fewer sectors shedding workers rather than increases in hiring, but it was the first fifty-plus reading in 28 months.
That was the good news, but the headlines about it being the “strongest reading in over two years” were unfortunate. It’s the best directional reading, yes, but the ISM surveys only measure monthly change. What it really showed was that service employment finally stopped declining from the previous month after 27 months in a row. That’s good, but it doesn’t produce much in the way of new jobs.
Both of the surveys reported decent results, very little changed from the previous month: 59.7 for manufacturing compared to 60.4 in April, while services (nonmanufacturing) stayed level at 55.4 (above 50 is growing). New orders for manufacturing stayed at a strong 65.7 and edged down only a little to 57.1 in non-manufacturing, where they are less significant. More important to the latter is the business activity measure, which rose to a very respectable 61.1.
There were some scattered signs of slowing, something for bears to hang onto: the employment component in transportation and warehousing fell for the second month in a row, not a positive indicator, but the BLS survey showed a big positive swing in the same category. It could be explained by hiring at a large company such as Boeing (BA), which had strong orders in April. In manufacturing, the number reporting worse conditions rose in both new orders and production. That could just as well be random fluctuation as the start of a trend.
Pending home sales in April rose by more than expected (you may thank the analysts for low-balling this one), 6.0% versus a consensus around 5.5%. It definitely helped an oversold market climb back that day, but not many outside the marketing department and the general media took it very seriously. Mortgage-purchase applications fell for the third week in a row to fresh all-time lows (the series goes back to 1997), so May results are going to be plug-ugly. But there’s still time to flip a few trades: the first May sales data won’t show up until the 22nd (existing home sales).
Factory orders were a disappointment in percentage terms, but it was another case of expectations management. In March, analysts raved about a result of plus 1.2% versus an expected decline. This time orders only rose 1.2% versus expectations for 1.8%, and fell by 0.5% excluding transportation. But March orders were revised much higher to show a gain of 1.7%. The April dollar amount was good, but the percentage was wrong and so the market sold off.
Retail sales were a mixed bag, and chain-store sales results on Thursday reflected that. There were many factors that went into a slower May, including the ten percent correction in stock prices, but sales did decelerate from the pace of March and April. The monthly report is due on Friday and is the biggest report of the week. The consensus is for a gain of 0.4%, 0.2% ex-autos. That’s not much of an increase, but it’s still at risk.
The rest of the calendar is light. Given the state of the market, some of the lesser reports will get extra attention. Two good examples are consumer credit, due out Monday afternoon, and the NFIB Small Business Confidence index on Tuesday. The Beige Book comes out Wednesday afternoon, and that will probably get more publicity than usual.
International trade is due on Thursday, and while it used to be a market-mover, it’s rarely the case these days. The first consumer sentiment reading from the University of Michigan for June comes out Friday morning. We’ll be watching two reports closely: wholesale and business inventories, due out on Wednesday and Friday. The inventory-to-sales ratio is still too low, and as long as that continues, production will have to increase to pick up the slack. That’s a silver lining.
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