A Sea of Confusion

May 10, 2010

On April 26 the Dow closed at 11,205.  If someone told you that on May 7, after numerous positive economic and earnings reports over the preceding two weeks, the Nonfarm Payroll report would show a job gain of 290,000, what would you expect?  Dow 11,500?  Dow 12,000?  I doubt if anyone would have guessed Dow 10,400. 

In the February 8, 2010 Longer-term Commentary titled “The Trade Puts Economy at Risk,” I discussed how the Greek debt crisis, which seemed to have been quelled at the time, threatened to morph into the next global financial crisis.  I tried to explain why Greece mattered and the danger the situation represented to the economic recovery.  In this issue, I will go deeper into the current debt crisis situation and talk about how Greece might be the 2010 version of subprime. 

Before I dive into the debt crisis issue, I believe recent economic developments here warrant more than just a cursory dismissal.  If the debt crisis quickly abates, there are enough positive developments to warrant confidence in a continued recovery.  Just don’t get too excited though.

Jobs – Yes!....Probably

April Nonfarm Payrolls rose by 290k.  This wasn’t too far out of the realm of possibility given that the Census Bureau was expected to add between 100k and 150k workers in April.  But the Census Bureau only added 64k jobs in April, leaving the private payroll increase at a very healthy 226k.  Oh, I just wish it was that easy.  But our friends at the Bureau of Labor Statistics added a record number of jobs into the total using the infamous ‘birth/death adjustment’ of smaller business openings/closings.  The BLS added a huge 188k to the payroll report reflecting theoretical gains from new businesses.  In March, skepticism was warranted when the BLS pushed the March number higher by an 81k birth/death adjustment.  But 188k in April?  That stretches all sense of credibility.  Adding the temporary census workers and the birth/death adjustment factor you find that 252k of the 290k job gain could be reasonably in question. 

The other nagging concern is that wages aren’t budging.  Wages were flat after rising .1% in March and 1.6% for the entire year.  That doesn’t even keep up with our low inflation rate.  The BLS also reported that the U-6 Unemployment rate rose to 17.1%.  This is the unemployment rate including discouraged workers and “marginally attached” workers.  I don’t know which of those two categories sounds worse, but together they mean that slower income growth will remain a drain on economic growth.

While there were several questionable elements to the report that looked so good on the headline number, let’s look at what was really good and hopeful in the report.  The first positive was, somewhat perversely, the rise in the Unemployment Rate from 9.7% to 9.9%.  I’ve mentioned in past writings that this can actually be a good sign that the job market has turned.  This is because the increase in the Unemployment Rate came from a big jump in those who recently declared themselves as eligible for work.  In other words, they have jumped into the pool of available workers.  Although they have not found work yet, the fact that the survey showed this increase in interest is indicative that jobs are being seen as more available.  To be completely realistic, some of the gains to the pool might be coming from workers who are seeing their unemployment benefits maxed out.  But, the overall picture is something to be positive about.

The second positive was the fact that all employment sectors, with the exception of state and local government workers, scored gains.  This even includes the construction sector, which gained 16k jobs for the first gain in about three years.  Manufacturing had its biggest single month gain (44k) in four years.  This sector has now added 95k jobs in the past four months.  Sadly. it is unfortunately worth noting that this sector has lost 2.8 million jobs since 2006.  Temporary workers continue to be added, and the workweek edged higher by .1 hour.  The .1 hour workweek increase is worth about 300k jobs on an income basis.   

As usual with any economic statistic, especially the complex payroll report, there are questionable segments and some nagging concerns, but I do view the overall report as something positive and something that the economy can build on.

Consumers Spending Again but for How Long?

Consumer spending in the first quarter outstripped most projections prevalent at the beginning of the year.  Some of the results look more impressive than they are since the comparisons are to an extremely weak first quarter of 2009.  But, the gains were generally solid and surveys of retailers have reported far more positive outlooks than negative. 

There are two factors that boosted first quarter consumer spending that will be fading as the year unfolds.  The first is that tax refunds were roughly $100 billion more this year than the same quarter in 2009.  Historical patterns suggest that money was spent.  Some also went for debt repayment, but the bulk flowed into sales.  Car sales also improved due to big rebates and 0% financing, but sales seem relatively stuck at the 11 million annualized pace.  That’s certainly better than the 9 million annualized pace in the first quarter of 2009, but it remains far below the old normal pace of 15 million. 

The second positive transient factor is harder to quantify but without a doubt a significant element in not only retail sales but in better consumer debt delinquency numbers.  There are now 4.8 million homeowners 60 days or longer delinquent on mortgage payments.  Some of these are “strategic defaults,” but in all cases this means that the borrower is making out no payment of any sort for living quarters.     

I remain convinced that the U.S. consumer has undergone a secular change.  Consumers have entered a long period of paying down debt and increasing savings.  Despite the year-long rally, Wall Street’s erratic behavior is no comfort to those in retirement or nearing retirement.  For those still in the wealth-building stage, they have to wonder just what to do to build wealth.  They thought their parents had it all sewed up with home equity values and steady investing.  Now they see that those long-held investment truths were only true for a different age and time.  Safety first is the new theme.  Assuming jobs can be created at a reasonable pace, consumer spending can continue to recover.  But this will be a long-term process.  The first quarter was not a preview of the future.  It was a very nice reprieve and provided reasons for businesses to feel more confident about the future.  But businesses have to look realistically at the future.  They cannot look at the past to predict the future.

The Greek Story – A Classic Revisited?

The current Greek story will likely play out more like the Iliad, the long epic poem covering ten years, rather than the two hour movie Mamma Mia!  The markets are currently recovering, yet again, from immediate fears of a Greek failure.  As previously mentioned, the potential default of Greece was merely the first default feared.  The markets had begun to fear a meltdown of numerous euro zone debtors, which would ultimately lead to enormous banking losses and a worldwide financial meltdown.

Last week, stock markets were plunging and credit spreads of all forms of debt were blowing out.  There were huge money flights into the safety of gold, the dollar, and U.S. treasuries.  Over this past weekend, the European Union leaders knew they had to come up with something beyond anything they had imagined just a few weeks ago.  The nearly $1 trillion in a support package has temporarily at least put out the fires in the markets.  It seems that trillion has now become the new billion.  Just throwing around billions no longer works.  To get the market’s attention, it takes trillions.

Maybe this will work.  Perhaps the crisis has been averted, debt markets will re-stabilize, and the world can continue the economic healing process.  I fear it won’t be that easy.  What has the EU actually accomplished by this bold move?  They have merely used a paper guarantee to insure some big investors and their banks against losses in speculative debt investments (Greece, Spain, etc.) that those investors bought with cheap money - leveraged.   So, once again, it appears that speculation with 0% money is being rewarded.  The EU ministers are currently strutting around and spouting macho-like phrases about “defeating the wolf pack,” “all-in,” “shock and awe,” etc.  What the EU ministers really did was continue to reward speculators by guaranteeing them against losses.  Those EU ministers also made certain that any losses will be borne by taxpayers – not investors.  The wolf pack is laughing all the way to the bank.

In the meantime, the debt bubble will continue to grow and the ability to pay that debt back will become more remote.  The weak-sister countries in the EU will have to play some sort of austerity game, and their economies will weaken.  This will in turn weaken all of Europe.  Our economy will suffer to the degree that our biggest export buyer will buy less due to weakness and the strength of the dollar.  There will be more government turmoil ahead in Greece, and regime changes are likely.  That will spread to other countries eventually.  This saga will play out over the next few years, not weeks.  The world remains an over-leveraged accident waiting to happen.

You might recall that way back in 2007, credit markets really started to worsen after Bear Sterns was forced to shutdown some mortgage-related funds in July of that year.  Other hedge funds and the like soon folded, and credit spreads generally started to widen substantially.  The Fed then acted in September and opened liquidity facilities and started cutting the fed funds rate.  Traders celebrated.  The Dow, which had fallen from 14,000 to 12,800 between July and September, rallied back to over 14,000 in October.  Yet, what went unnoticed for those rally months was the fact that the underlying debt problem, mortgage-related values, was worsening.  After a brief but dramatic tightening of spreads, credit spreads started to widen again.  And of course you know how everything played out from that point on throughout 2008 and 2009.  I think this is where we are in the current version of the Iliad.  I also hope I am dead wrong.  Rather than focus on stock market moves over the next few months, the more important markets to watch will be the credit markets.  Monitoring credit spreads and bond values will be a far more valuable tool than relying on news from the casino on Wall Street.

The Big Casino

Finally, a brief recap of what happened in the stock market last Thursday when the Dow went through the bone-chilling 998 point drop.  By this time if you hadn’t already heard of high-frequency trading, you have now.  This trading, controlled by a very few, very large players of both unknown names and known names like Goldman and Citibank, is computer-based trading using highly complex trading models and strategies.  But they all rely on generating millions of trade every day for very small increments of money at a single time. 

We know that individual investors have not returned to the stock market since the 2009 debacle.  Yet despite the lack of new money, the stock market staged a huge recovery.  I’ve often written that the market often seemed to be trading up on thin air.  That air was the volume of high-frequency trading.  Over the past year, high-frequency trading represented 60-70% of the total volume in stocks.  Those programs work fine as long as there is no significant volume of trades coming for “real” investors.  Last Thursday, real sellers showed up for the first time in over a year.  That selling triggered the programs of those high-frequency trading houses to go into sell mode.  The basic system was overwhelmed when those huge orders found illiquid markets.

The issue is that trading in stocks is now fragmented among many venues.  Stocks are no longer traded on a single exchange.  Almost all stocks can now trade on multiple platforms.  Once the NYSE decided to halt trading to investigate a few questionable trade reports, those computer programs defaulted to smaller platforms without liquidity.  The problem is that there are no consistent trading rules or circuit breakers on the various platforms.  The computers only knew that their programs said to sell a certain number of shares regardless of price. 

Currently all the exchanges and SEC officials are “investigating” what happened.  There is no mystery here.  There are numerous officials claiming shock this could not occur.  They are either woefully uninformed or just plain lying.  It’s been known for some time that a day like Thursday wasn’t just a possibility but a certainty.  The flaws were not secret.  The New York Times, among other publications, has published articles as far back as July 2009 about the flaws in the high-frequency trading mechanism that would cause exactly what we saw last Thursday.  One CEO of a large trading firm admitted they knew that the programs had this fault.  This should be an easy fix.  The SEC can assemble all parties and hammer out consistent rules.  They can also demand that high-frequency traders have some failsafe mechanism to effectively pull the plug on their computers when something has obviously gone astray.  As I said, this should be an easy fix, but nothing seems to come easy in the financial markets. 

While investors, including the lowly individual and 401kers, are breathing a sigh of relief about the quick rebound in stocks, the last two weeks will do nothing to rebuild confidence in the world’s biggest casino.  This pattern will only reinforce the secular trend of saving more and spending less.  The NASDAQ is still off more than 50% from the 2000 peak.  The Dow and S&P remain roughly unchanged since 1999.  Individual investors are no longer rewarded for patient, steady-as-you-go investing.  All they have seen is that the big-money controlled markets can now destroy in a heartbeat what takes months or years to build. 

I don’t have the answers for what could make the markets a safer place to build for the future.  It seems that a few big players have taken control of all markets.  We have huge leveraged players playing a game of chicken with the world’s governments while relying on those same governments to provide cheap money.  Then we have the huge equity gamblers, tweaking their virtual reality computer programs, without any concern about how the smallest of tweaks can impact huge numbers of real people.  

I’ve said probably far too often that the stock market is not the economy.  It’s merely a reflection of the collective optimism or pessimism of traders at any one particular point in time.  Throw in ample amounts of greed or fear, and you have stock prices – not a forecast for the economy.  Unfortunately, the stock market has begun to reveal more and more signs that some sort of rigged game is being played.  That might not be the case at all, and I’m not one of those people who believe in conspiracy theories. But, seemingly inexplicable market behaviors and inexplicable government responses to the outcomes of those behaviors, can lead to a general public mistrust of all financial markets and institutions as well as the government.  That matters.  The lack of trust can produce big behavioral changes on the part of individual consumers, investors and savers.  Lack of trust leads to ever increasingly defensive actions.  That does matter to the economy. 

After reading this upbeat tome, some of you might believe I am being far too negative.  I certainly hope I am.  I will be very grateful to be dead wrong.  Perhaps the current relief in the markets, along with the positive economic signals I wrote about, will manifest into a full-blown optimistic result.  We have faced very long odds in the past when confronted by a gathering of storm clouds, and each time the end result was far better than the worst-case scenario.  Maybe the EU’s action could be the first step in averting a worst-case outcome.  If so, I’ll be the first one to say, Opa!

Dwight Johnston