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Avalon Asset Management Company It's Not Easy Being Green
"But green's the color of Spring, and green can be cool and friendly-like." - Kermit the Frog
How about that jobs report? When we lost 350,000 jobs last September, it was catastrophic. Flash forward nine months, and it’s considered too good to be true. Oh yes, yes, still an ugly number, no doubt, but the loss was expected to be over half a million. As early as the day before there were rumors of “problems” with the number. In the day following the report, verisimilitude trumped meaning for the top spot in the day’s usual debate.
The stock market rallied, of course, because it’s taken to rallying on every jobs report, regardless of how bad or good, because it’s never as bad as it could have been. It’s taken to rallying every Monday, too, apparently because Mondays are never as bad as they could have been. Come 9:30 the market has opened, and this amazingly reassuring turn of events has sent buyers sprinting into the auction hall.
Take last Monday, when the market put on another two-percent-plus rally in the face of the General Motors (GM) bankruptcy. Last fall, that would have taken a thousand points off the Dow. In the springtime, it’s not as bad as it could have been, right? They didn’t shoot anybody, after all. It’s about time those silly auto companies were restructured anyway, what with their terrible management and greedy unions. Good medicine for ‘em. What’s that, Toyota (TM) sales were down more than GM? Excuse me, I’ve to take this call.
An abundance of springtime optimism is nothing new on the Street, and neither is the sight of traders belligerently declaring there should be no end to this rally while they look over their shoulders and mutter buy orders for index puts. Whether or not the Labor Department may have been off by fifty or a hundred-fifty thousand is in truth, not that germane to the picture of the economy anyway. It does provide some fodder for people who make their living by shouting at other people on television, but the economic picture really hasn’t changed at all.
The credit-freeze plunged us into two quarters of severe contraction. We pointed out back in February that the then-current contraction couldn’t last (it might have lasted another quarter or two if we had ever tried to adhere to the gold-standard fantasy of some of the cultists that lurk on the fringes of finance – as Hunter Thompson once wrote, “when the going gets weird, the weird turn pro.”) Some kind of inventory bounce was inevitable, and the decline would eventually flatten out.
Aided by federal intervention – some of it no more than verbal - that process is underway. We will almost certainly get a positive bounce in GDP sometime before the end of the year, but that means little. We’ll have to, just to avoid a general depression (some would argue that we had one anyway because GDP fell by more than ten percent over the last two quarters, but there is a sense that depressions have to last longer to earn that moniker). The five-tenths percent unemployment leap of last month – the largest annualized drop in employment in over fifty years – will almost certainly mark the peak of employment decline.
As we scrape along the economic bottom, unemployment will level off somewhere north of ten percent. We’re pretty close already, so we can expect steadily shrinking increases in unemployment (more green shoots!) going forward: most businesses have finished the first stage of their triage drill, and are now in wait-and-see mode. There will still be some bleeding, but the hemorrhaging is done.
The monthly industrial surveys will hit fifty percent before the end of the year and in all likelihood much sooner than that. If they don’t, we’re in much bigger trouble than we thought. At that point, the recession will be proclaimed to be over. To which we say, big deal. What will matter is the aftermath. A change from the lowest-recorded capacity output ever to the second-lowest recorded capacity output ever may give us a positive change in GDP, but it isn’t going to do very much for earnings.
As last month’s personal spending report showed (see below), the consumer is still in retrenchment mode, and it’s easy to see why. Wage growth is at its lowest in fifteen years, energy prices have been driven up by trigger-happy speculators, house prices are still falling, and while confidence surveys are being driven higher by hopes that the future will get better, the consumer still isn’t impressed by current conditions. They’re in wait-and-see mode too.
The flight path of the economic decline is gliding onto a more level, albeit bumpy plane. The conventional bull position is that a market rally precedes the end of the recession and a return to positive GDP points. But that has already occurred: the S&P 500 index is up over 40% from its March 9 intra-day low. Now the market is being pushed less by the prospect of higher earnings than by a lack of investment alternatives, and the (temporary) feeling that the trend is your friend once again. The air is getting thin up here.
We have made the point since last year that zero interest rates will in the end lead money to take greater risks in the search for returns, even moderate ones. The risks are not always apparent, as was the case for investors around the globe who bought supposedly safe mortgage-backed securities. They weren’t trying for home runs, merely a little pick up in what was supposed to be AAA-rated paper. The salespeople omitted to tell them that it had become the most overcrowded trade in the world.
That search for returns led to last month being the best single month for returns on commodities since 1974, at the advent of double-digit inflation. At the risk of tiring our regular readers, we repeat the observation that this has nothing to do with industrial demand or cost-push inflation. The economy may or may not pick up, but its collapse has been taken off the table.
With that underpinning, futures contracts offer the best way to make leveraged investments, because leverage is very difficult to come by otherwise. Banks and prime brokers aren’t doing credit lines right now. Fringe theorists, hard-core monetarists and right-wing opportunists try their best to pretend otherwise, but very few take seriously the argument that inflation or booming credit demand is imminent. Those stories are offered up on an as-needed basis to justify the betting. One buys commodities because the trader’s playbook says, ‘buy commodities at the turn.’
This has led to something of a pickup in inflation. It isn’t the case of too much money chasing too few goods, but too much financial money chasing too few alternative returns. It’s an indirect by-product of zero rates: in the classical model, zero rates invite a surge in credit demand and the system is flooded with money, leading to goods-chasing inflation. It’s not happening now, because the credit actors are hiding in the basement and the velocity of money is practically zero.
But as the fear of systemic failure has ebbed, investment money has started looking for somewhere to go. As Pimco’s Bill Gross observed on Friday, savings rates aren’t going to do it for them. The traditional correlation is that too much money will chase too few commodities, so commodity prices rise. The new correlation is to buy what everybody else is buying, whether you believe in it or not. Thus have energy prices risen, and thus is inflation a little bit hotter than it should be. But only a little, and it could come right back down again.
A friend of ours asked last week what the catalyst might be for a market downturn, and our reply, in a word, is disappointment. The capacity of economic data to disappoint was suspended when we got to the point of fearing the worst. When anything less than the worst transpired, we rallied. That move is played out, and we are now shifting to a stance of expecting better days. The disappointment will come not from a surfeit of bad, but from a dearth of better. It won’t be easy for the shoots to stay green.
The item of the week – and the mystery as well - was without doubt that bad old jobs report. The Labor Department surprised everyone, including possibly itself, by reporting a loss of 345,000 jobs where something more like 530,000 had been expected. Adding to the mystery was the report that the unemployment rate surged more than expected, a full five-tenths of a percent to 9.4% (the consensus was 9.2).
Economists tied themselves into knots trying to figure this one out. We should note that in the April report, the department reported a loss of 530,000 jobs in the payroll survey, compared to a loss of about 560,000 in the household survey. This month, the two went in opposite directions: the household survey loss widened to 780,000 (a gain of 200,000), while payroll losses shrank by nearly the same amount.
One explanation would be that both the household survey number and the unemployment rate jumped from an influx of younger entrants, that is, kids finishing school for the year and unable to find a job. That would be the colleges, because high schools are not ending in May. The unemployment rate for adult men and women rose “only” four-tenths of a point compared to the five-tenths rise in the overall rate and a 1.2% increase in the teenage rate. This was a popular theme for green-shootists, but the participation rate (the proportion of active workers and searchers to the general population) was unchanged.
Allowing some boost from new entrants (though the data are supposed to be seasonally adjusted), it isn’t exactly encouraging to know that it’s nearly impossible to get a job. It’s also hard to square the payroll survey with the weekly unemployment claims data, whose four-week moving average is unchanged from one month ago. Weekly claims did improve during the week to “only” 621,000, and the four-week average is down 30,000 from two months ago, but the size of the drop still seems a little suspect.
The ADP report estimated a loss of 539,000 and the Monster help-wanted index declined, but the Challenger layoff report showed a distinct moderation. The ISM manufacturing survey for May showed no change in the employment picture, while the non-manufacturing survey showed a small improvement in the rate of decline. It didn’t really add up, and the market clearly didn’t trust it.
Average workweek hours fell slightly, along with the aggregate index, showing little inclination by employers to increase output or hire. More than anything else, we are simply running out of downslope. Wages and salaries were flat in April. Personal income surged from an increase in unemployment insurance benefits, but personal spending declined an additional tenth of a percent, which is what you might expect.
Weekly chain-store sales are still sluggish and pointed to a down month of May, echoed largely by monthly chain-store sales reports (which have an upward survivor bias). The indications for May’s retail sales reports point to another negative month, but there are a couple of chances: increases in energy prices will help the headline report, and the Commerce Department’s seasonal adjustment model has been out of synch with current conditions for some time.
The ISM manufacturing index was widely cited in the press as being bullish, though we don’t agree. If this were anything like a normal cycle, we should have gotten a better number than the 42.8 we did get. New orders finally dragged themselves back above 50, to 51.1 – it’s about time - but keep in mind that 51.1 now is nothing compared to a 51 in say, 2006. After a ten percent contraction in GDP and seventeen straight months of declines in new orders, having a just-barely positive comparison to last month is like a batting average that jumps from .150 to .160: it may be an improvement, but it isn’t getting the job done. Five out of eighteen industries reported growth.
The non-manufacturing survey didn’t fare better. Six out of seventeen industries reported some growth, but the 44 result showed the same slope of decline as the previous month, and in contrast to manufacturing, new orders fell. Neither survey showed any improvement in general trade, as exports and imports continued to decline at roughly the same rate.
New factory orders were alleged to improve, but that was another case of over-reporting. They were supposed to increase to $347.8 billion from March’s $345.3, but fell instead to $344.4 billion. Thanks to the magic of revisions, though, March was taken down to $341.1 million, resulting in a gain (for now) for April. The original above-expectations March result of a loss of (0.9)% turned out to be a worse-than-expected drop of (1.9)%, but so what? We already rallied on the March report and we’re not giving it back. Yet.
Pending home sales for April were reported to have leapt by 6.7%, spurred on by the first-time homebuyers credit (and distress prices in distressed areas). That is good, but it’s old news. Weekly mortgage-purchase application activity continues to be very weak in the peak part of the season, while higher rates are hitting refinancing activity. If the weekly data isn’t amiss, the March-April uptick in purchase activity is only a short-lived bump. The market won’t like getting that news.
The market did rejoice over an increase in construction spending (0.8%), though private residential spending continues to fall and construction is only five percent of GDP. The increase was led by home-improvement spending, which we guess to be attributable to a combination of refinancing (lower monthly payments), the warmer weather, and the flood of houses for sale on the market. There’s a lot of competition out there right now.
Motor vehicle sales were something of a bright spot. Although May’s annual rate of 9.9 million is still remarkably low, it is less ridiculously so. Car sales are definitely going to lift off at some point, if for no other reason than to offset the losses from scrapping. That is promising, but though the increase will look nice for a time, it may still be a couple of years before we return to a more normalized rate.
Productivity and costs both showed improvement, but we attribute it entirely to the massive job cuts of the first quarter. Those results may not hold after inventories are rebuilt. Consumer credit contracted very sharply in April, meaning that those inventories may have a longer shelf life than normal. That would lead to another fall in output and a reversal of the productivity and cost improvement.
Next week features the retail sales report for May on Thursday, and that one should be influential for the stock market. The other newsmakers after retail sales ought to be the Beige Book, the Fed’s compendium of regional reports, on Wednesday and the University of Michigan’s initial June read on consumer confidence on Friday. The latter should show continued improvement from the stock market rally, and show continued lack of correlation with actual spending.
There will also be data on international trade sales on Wednesday and prices on Friday. If imports continue to fall faster than exports, that will lead some to rhapsodize about the improvement to GDP, and in turn spur us to make snide remarks about the value of GDP as an economic indicator. Business inventories for April may be of interest on Thursday, but could easily be overshadowed by the 30-year bond auction later in the day.
Stockwatcher will return in a later edition.
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