Traders are beginning to believe that the jobless recovery has turned into a jobloss recovery instead. The economic numbers on Friday did not help improve sentiment despite some positive signs under the hood. The markets closed the week with a loss despite a barrage of good numbers over the last several days.
The Consumer Sentiment improved slightly to 90.9 from the preliminary 90.3 for July. The expectations index fell from 86.4 to 83.7 but the present conditions index jumped to 102.1. This surprised some traders as it was different to what the Consumer Confidence showed earlier in the week. What it did not show was a marked decrease in sentiment to confirm the confidence numbers. Instead the gain in the present conditions was the biggest in a decade. Analysts think this is related to the higher take home pay, tax credit checks and recent market gains. Clearly it was not due to higher interest rates and analysts think the next report could show a drastic drop.
The Nonfarm Payroll report added to the frustration with a loss of -44,000 jobs when +18,000 were expected. The June number was also revised down to -72,000 and more than twice the -30,000 initially reported. The May number was also revised down and this makes the sixth consecutive month of job losses. The unemployment rate dropped unexpectedly to 6.2% from 6.4% simply due to 500,000 workers dropping out of the job market in disgust without finding jobs. Sounds like a summer vacation to me. 9.06 million workers are currently officially unemployed if you don't count the -556,000 dropouts. Had there been no dropouts the unemployment rate would have been 6.5%. March was the only other month this year with a drop in the workforce at -64,000. If those workers return in September after the summer vacation then the unemployment rate could be even higher. The average workweek for manufacturing fell to 40.1 hrs and 33.6 for nonmanufacturing. Conditions may be slowly improving but so slowly that employers cannot afford to hire more workers and are continuing to layoff workers to cut costs. Temporary hiring picked up as employers replaced full time employees with part time and added part time to replace workers on vacation. This too shall pass when the summer is over.
I went back to the 8/2/2002 report to see what had changed in the last 12 months. In 2002 the report made these points. "The unemployment rate remained unchanged in July at 5.9%. However, part of this is the result of a contracting labor force and unemployed workers see few opportunities in the labor market and drop out." No change there. "Manufacturing losses continue to abate. Only 7,000 jobs were lost in July". Big change here with -67,000 manufacturing jobs lost in 2003. "The labor market added 6,000 in July, but the gains for the previous months were revised up to 66,000, nearly double." Big change here as well with six months of losses in 2003 instead of the four months of gains in August 2002. There were 8.1 million unemployed in Aug-2002 and 9.06 million in Aug-2003. Investors have to ask themselves, Are things really better now than they were in Aug-2002? The Dow traded in a 305 point range on the report Friday in 2002 with a high of 8508 and a low of 8203, closing at 8313. Interest rates on both the 10-year and 30-year were lower on the 2002 report date and dropping.
Contrary to the negative picture above the ISM posted a number over 50 at 51.8 for the first time five months. This does indicate an expansion. It was yet another positive in a week of bullish economic reports. This was inline with expectations. New orders jumped to 56.6 from 52.2 and the third month for that component over 50. This report indicates that a recovery is in progress but at a snails pace.
Personal Income rose by +0.3% in June despite falling hours and wage pressure from job competition. Personal Spending also rose +0.3%. Depending on which numbers you look at they were not buying cars with the increase in wages. Compared to last July the automakers reported drops in sales. GM -5.7%, Ford -11.5%, Daimler Chrysler -7.5%. Compared to last month sales rose to 17.3 million in annually adjusted terms. GM rose +5.3%, Ford +3.3%, DCX +2.0%, Honda +1.5%, Toyota +1.9%. Sales are limping in on the backs of incentives but the drop in mortgage refinancing is going to impact those numbers.
Construction Spending came in flat for June compared to +0.5% estimates. Construction has either been flat or down since February. The market is still in turmoil with low mortgage rates a drag on new apartment construction. A high vacancy rate in commercial office buildings is depressing rents and convincing investors to wait for a change before building new office projects.
Overall the reports were not bad other than the Jobs report so what happened to the markets? Friday was an ugly day and when combined with Thursday it was a two day bear market. While there was no really big drop on Friday there was almost zero interest in buying. There was a strong rumor buoyed by some truth that Saddam was cornered in a farm house in Tikrit. The truth, U.S. forces surrounded and raided two houses in Tikrit capturing two Saddam associates. The initial reports of the attack had Saddam in the house. The market barely budged with only a +30 point bounce at 1:15. Last week this would have been good for a +100 point spike. Considering it came on a Friday it is even more amazing that nobody rushed to cover with the potential for a weekend capture. The Dow ended with a close at 9153, only 15 points above the low for the day but the volume was very low.
Bonds continue to press the issue and there was some buying after the ISM report but it was very light. The rumors continued that there is a big bond fund in trouble and that is keeping pressure on bonds. If somebody is in trouble then the sharks will eventually sniff them out. There is also a strong and persistent rumor that overseas investors, pension funds and other governments are selling bonds by the boatload. They are responsible for more than half of the U.S. Treasury debt and the spiraling deficits are scaring them. Japan holds more than $400 billion, China $125 billion. They see the 60% drop in refinancing applications in the last six weeks, rates making a two year move in six weeks and the prospect that the government could be forced to sell $1 trillion in bonds in the next 12 months to support the deficit and the war.
High yield bond funds saw outflows of $1.06 billion in outflows last week and the single week record is $1.4 billion. The swap spreads soared +20 basis points in two days which is unheard of. The carry trade, where banks and hedge funds borrow Yen from Japan at 1% or less to leverage into dollar-linked bonds, is collapsing. The Yen is gaining on the dollar and dollar bonds are falling through the floor. As the trend continues the squeeze becomes painful and companies are racing to liquidate positions before huge losses pile up. Another problem is the pension shift. Whenever yields hit 4.5% and we hit 4.59% Friday, conservative pension funds shift out of risky stocks and into the safety of bonds. This could have been the problem on Friday. Stocks were being sold and bonds being bought by pension funds. Also, AMG data said that equity funds saw the first week of outflows in a month for the week ended on Wednesday.
There are massive forces at work here that we do not see on the surface. Hedge funds and bond junkies always over leverage when bonds appear to be headed in one direction. With bonds hitting a 45 year high there had to be a large number of over margined, over leveraged funds. With the bond disaster there has got to be casualties and those casualties have not come to the surface yet. If you doubt the rumors of an impending failure look at the chart for FRE, which is only about $1 from a multiyear low. LEH and BSC, both big bonds firms are falling off the cliff as investors fear an imminent disclosure. Even if they are not in trouble financially they are probably going to take a hit. Don't forget gold. The same traders who leveraged bonds to the moon thinking the economy was going in the tank were doing the same with gold. It hit a two week low on Friday. Sometimes when it rains it pours.
The GDP showed a +2.4% Q2 rate. Unfortunately 44% of that jump came in government spending for the war. As Art Cashin said several times on Friday, unless there is another war scheduled for the fourth quarter that burst in spending is not going to happen again. Another factor depressing the markets is the impending Fed meeting on Aug-12th. The fed funds futures are showing a zero chance of another rate cut. Zero! There is nothing for traders to speculate on or to get excited about. The Fed speak has been a constant, "slow recovery in progress" and "over accommodative stance" which means don't even think about another rate cut. The threats of other nontraditional stimulus have been taken off the table and the Fed has effectively neutered itself. It will have to start talking the talk and walking the walk to get investors attention because the walk softly and carry a big stick only works when your stick is bigger than 100 basis points. With a stick the size of a toothpick you won't get much respect.
The interest rate pressure is killing the homebuilders and the related industries. The drop in mortgage applications and rise in rates has finally popped the building bubble. The soaring builder stocks, which trade at absurdly low PEs of 8-12 are getting cheaper by the day.
Despite all the problems the selling for the week was not that bad. The S&P is on a streak of five winning months that it has not had since 1998. The -18 point drop for the week was hardly a drop in the bucket. The Dow closed at 9153 and is still well above support levels it has defended successfully since the beginning of June. The Nasdaq closed over 1700 despite the selling. The sell off only seems worse due to the 52-week highs hit on Thursday. When compared to those numbers and considering the bullish economic data the outlook becomes more cloudy. The most negative event was the failure of the 50 DMA on the S&P-500 at 985. This is the first close under the 50 since March 14th. If this holds on Monday it could setup some serious technical selling.
As I mentioned on Thursday, August has been the worst month of the year for the markets for the last 15 years. That is during good times and bad times. The first week of August is typically the worst week. Considering we did not get the typical end of July decline for reasons including Udai, Qusai and Saddam, the market could just be tired. Add in the ticking bond bomb and traders are ready to take some profits. The bulls are worried. They got the great economic news in every report but the Nonfarm Payrolls but the market died. Saddam was thought to be trapped in a farmhouse in Tikrit and the market ignored it. The market rallied on every piece of bad news imaginable for months and failed miserably on the first really concrete evidence of a recovery. Now I am bullish. Confused?
I am always early. I am still expecting a decline below 9000 but I think the time is growing short. July earnings are over and we are a third of the way through the 3Q. Man, does time fly. In about two weeks we will start seeing the mid quarter updates. In four weeks we will start hitting the earnings warnings. But, the pump is primed. There was a significant number of companies that said business was improving. They probably lied hoping the 3Q would rescue them but that is not the point. The reports are actually showing a jobless recovery and that was expected. It could be mid 2004 before the jobs picture really picks up. However the manufacturing picture is improving. We are showing a serious decline in inventories across the board. This will have to be replenished before the 4Q or the holiday season will flop. Intel said it best this week. CEO Barrett said "IT spending will probably remain flat for the rest of 2003." But, Intel cannot afford to wait for business to pick up and they will be buying 35,000 PCs to replace their outdated equipment. They are expecting others to wait but they cannot afford to wait for the rush. There are countless others in the same shape with Y2K computers slowly dying. Unfortunately he also said he only expected a growth rate of 15% over the next 5-10 years IF the economy cooperated. Probably being a little cautious there and talking down future analyst estimates.
On Thursday Merrill Lynch went bullish on chips saying the demand was rising and orders were starting to stack up. On Tuesday Bear Stearns raised their projected computer sales for 2003 from 6% to 9% and said notebooks could grow to +22%. We will get the Semiconductor billings for June on Monday and that is expected to increase for the fourth consecutive month. Right or wrong traders will be buying the dips on techs expecting a positive surprise in October.
Copper and aluminum prices have been rising and that is commonly seen as a leading indicator of economic growth. Almost every hard product made has those metals inside. Add the wire and cable for new construction and the metals touch almost every sector. Cyclical stocks have been rocking. Check out the charts on MMM, BCC, IP, IR and DOW just to mention a few.
Now before everyone gets carried away I may be bullish on a long term basis but the next few weeks could be rocky. We are entering the three most volatile months of the year. They are volatile in good times and bad times. There are any number of reasons for this which I will not go into today. Just check some historic charts and take my word for it. That means the huge gains made on paper over the last several months are still at risk. Many funds will be adjusting their portfolios over the next three months. They will be selling the losers, picking more winners and positioning themselves for the fourth quarter run. The current external market factors like an impending bond disaster could accelerate those moves. If you thought there was another Long Term Capital about to explode over the front page and take a thousand points off the stock market would you be in a hurry to take profits?
In July of 1998 with the Dow at a new high of 9350, Long Term Capital, a hedge fund with assets of $4.8 billion and liabilities many time in excess of that, imploded. Highly over leveraged in bonds and derivates and in hundreds of deals with other banks it was facing a $250 million a day loss due to rapidly declining bond markets stimulated by the Russian default initially and then by the smell of blood as the rumors began to fly. With dozens of deals over $500 million to other banks like JP Morgan, Salomon, Citigroup, Goldman Sachs, etc, a default by LTCM would cause massive liabilities to ripple through the investment community and endangered the current financial system. The Fed later organized a multimillion rescue to protect the system but the stock market fell to 7400 from the 9350 high when the problem came public. -2000 points on a bond default from a $4.8 billion hedge fund. How much would we get today if it was FRE, LEH or BSC? For a complete history of LTCM: http://riskinstitute.ch/146490.htm(copy and paste this link into your browser) In another bond collapse one trader working for Barings, a 200 year old English bank, leveraged into over $60 billion of bonds and futures using only $615 million in capital. The company failed and the assets were sold for $1. Is it possible there is a ticking bond bomb? Absolutely.
Everybody with big money knows that October is planting time. August and September are harvest time. You reap the profits in Aug/Sep and reinvest them by planting in the October furrows. This year I fully expect that time table to be accelerated as eager fund managers try to beat the crowd to the punch. When? Who knows? We can only speculate that the next 90 days will be like a roller coaster in a hurricane. There will be peaks and valleys and dangerous cross currents but when we come out of October we should be in good shape if the recovery is still on track. Assuming the bond market gets back on track without a disaster the race to beat the crowd could begin quickly as long as economics continue to improve. Just like every roller coaster ride you have ever been on, they scare the hell out of you in the middle but the end of the ride is always smooth and level. We need to step up to the ticket counter and get ready to pay our money because the ride is about to start.
Enter Very Passively, Exit Very Aggressively!