August 16, 2012

Today’s market not driven by fundamentals – so be careful

Posted in Banking, Economy, Europe, Federal Reserve, Finance, Foreign, investment banking, investments, Italy, Spain, Uncategorized tagged , , , , , , , , , at 8:45 PM by Robert Barone

The Past
 
The stock market always has been considered a “leading” They are “administered” by central banks (the Fed, the European Central Bank, the Peoples’ Bank of China, the Bank of Japan, etc.), which set and manipulate the rates. When interest rates are determined by other than market forces, you can be assured that scarce resources are inefficiently allocated. We need only look to the long period of administered artificially low rates under the Greenspan Fed to realize that such a policy was a major contributor to the housing bubble last decade.

Expectations

Given the recent collapse in basic, fundamental worldwide economic activity (consumption, orders, employment), one must be skeptical of an equity market that continues to, apparently, defy gravity. Investors, or more accurately, speculators, await the next Fed or ECB policy-easing move, not wanting to “miss” the inevitable market updraft that they hope occurs. (Of course, they could be hugely disappointed, as were the initial investors in Facebook!) Could it be that market expectations of such moves already have driven prices up, and the policy-easing moves themselves will be anticlimactic? In market parlance, this is known as “buy the rumor, sell the fact.”

Recent market reactions

Sooner or later, markets will come back to valuations based on the underlying fundamentals. This isn’t the first time that the markets have exhibited extreme sentiment. And it won’t be the last. So, let’s examine some of the recent “policy” issues and data releases in light of market sentiment.
 
• On July 26, ECB President Mario Draghi (“Super Mario”) said, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” adding later, “Believe me, it will be enough.” The market interpreted this as a pledge that the ECB would directly purchase the debt of Spain and Italy, thus reducing pressure on interest rates in those countries. The Dow Jones rose 3.2 percent during the next two days. On Aug. 2, when the ECB met and didn’t announce
anything major, the Dow sold off .7 percent, only to begin a rise again on Aug. 3 when the market realized that Spanish and Italian two-year rates, which is where those two countries are selling new debt, were now falling. Apparently, the markets now believe Super Mario’s words.
 
Nevertheless, no amount of liquidity can resolve the solvency problem that exists in Europe’s southern nations. No matter what these politicians do, short of an unlikely fiscal union, the euro will be pulled apart. The northern countries — Finland, Denmark, Germany — have attitudes toward work, debt, inflation and socialism that are diametrically opposed to the attitudes in the Mediterranean countries.
 
So, Europe likely is to remain in a recessionary/slow growth mode for the foreseeable future, and debt issues there will continue to impact capital markets worldwide.
 
• On July 27, the Department of Commerce’s Bureau of Economic Analysis reported that the real GDP grew at an annual rate of 1.5 percent in the second quarter. (The measurement methodology of the price deflator is questionable as it biases the real GDP number significantly upward. While every other indicator of economic activity is declining, it doesn’t seem logical that this one is rising.)
 
The markets had expected a worse report, and breathed a sigh of relief, advancing 188 Dow points that day (1.5 percent). But, even a cursory analysis of the underlying data reveals that the private sector remains in stagnation. In the second quarter, nominal dollar GDP grew by $117.6 billion or by $1.29 billion/day. However, the federal government added $274.3 billion in new debt ($3.01 billion/day). Thus, it took $2.33 of new debt to increase GDP by $1. Would anyone in their right mind sign up for a loan of $233,000 if the lender was only going to fund $100,000?
 
• The Aug. 3 employment report was “stronger” than expected, according to the media, with the Establishment Survey showing new job growth of 163,000. (June’s 80,000 job growth was revised downward to 60,000.) The headline “unemployment rate” went up to 8.3 percent. It was widely reported that the rise of the unemployment rate was due to the fact that fewer people were discouraged and more people entered the labor force. After all, how else could the unemployment rate rise when 163,000 jobs were created? The answer is, after all these years, the media doesn’t know that the headline unemployment rate is calculated using a completely different survey. The Establishment Survey queries 141,000 businesses, while the Household Survey queries 60,000 households. The Establishment Survey adds in a residual factor of about 50,000 jobs per month, created out of nowhere, from what is known as the birth-death model (the BEA assumes 50,000 more new small businesses are created every month than are closed; this is clearly an historical artifact and doesn’t exist in today’s world, but it is still added to the data). The Household Survey actually showed a decline of 195,000 jobs (all of which were full-time jobs) in July, and because the labor force declined by 150,000, the unemployment rate went up. The labor market is nowhere near healthy.

Conclusions

As I said earlier, sooner or later, the markets will come back to what the fundamentals say. I don’t know when that will occur, perhaps after the elections, or maybe not until sometime in 2013, depending on who wins. As I said in a previous column, policy issues are important for markets. Clearly, today, policy appears to be not only the most important factor but the only factor.
 
Because sentiment on Wall Street can change in an instant, investors should remain very cautious. Depending on your own situation, perhaps some profit taking is now in order. Short duration bonds continue to look safe given current underlying economic conditions and likely policy moves.
 
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.
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August 2, 2012

Equities: Is a bear market inevitable in this economy?

Posted in debt, Economic Growth, Economy, Europe, Finance, government, investment banking, investments, payroll tax reductions, recession, Stocks, Uncategorized, Unemployment tagged , , , , , , , , , , , , , , , , , at 7:40 PM by Robert Barone

All of the data and the trends in the data indicate that it is possible that a recession might already have begun.

• Job creation has been dismal in the second quarter, with little hope for improvement soon; jobless claims are, once again, on the rise.

• Retail sales have fallen three months in a row; this has never occurred without an ensuing recession. What is of greater concern is that this has occurred while gasoline prices have been falling.

• While market pundits have cheered small gains in housing data, it is clear that housing is still bottom bouncing. Changes in foreclosure laws have caused supply constraints that have made it appear that home prices are rising again.

• Industrial production, the one bright spot in the economy, showed a decline in May before recovering somewhat in June.

• The drought has caused raw food and commodity prices to spike. These will soon translate into higher food and raw input costs. (Is anyone now questioning the wisdom of the congressional mandate to produce increasing quantities of ethanol from corn instead of sugar?)

 • Consumer confidence continues at levels below those seen in past recessions . Much of this is due to uncertainty surrounding fiscal policy and taxes.

• In the June Philadelphia Fed Survey, manufacturers were asked to list reasons for slowing production; 52 percent cited uncertain tax policy and government regulations.

• Real incomes are falling. The downward bias in the inflation numbers produced by the government inflates the reported GDP numbers. It has been my view that, as a result of the biased reporting, the recession never really ended, and real GDP is much lower than reported.

 Equity market up for year

 Nevertheless, despite all of the poor data, the equity markets have held up. At 1,338 (the closing level on July 25), the S&P 500 is still 6.4 percent higher than it was at the beginning of the year. This is strange, given that every other major market in the world is down 20 percent and in bear market territory. Here are a couple of possible explanations:

• The equity markets used to be a leading indicator of the economy. Severe market corrections (20 percent or more) usually meant recession was either imminent or already here. But, with the advent of computerized trading, the market now appears to be more of a coincident indicator. In late 2007, when the last recession began, the market was only off 5 percent from its October peak.

• Europe: There is such financial chaos in Europe that a flight to the dollar is continuing. Because higher quality bond yields are so low, some of the funds have found their way into the U.S. equity markets, thus keeping them buoyed.

Neither of these two reasons should give investors any confidence that U.S. markets can hold up. Besides the poor internal economic data within the U.S., worldwide data have been weak. In addition to the obvious problems in Europe, China is in a much slower growth mode, as is Japan, the rest of Asia, and even the commodity producers like Australia and Canada.

European soap opera
 
Europe is a whole other issue. American markets have benefited from their financial issues, but when panic and contagion show up over there, markets behave poorly over here. We have seen this time and again as the European drama (really a soap opera) has unfolded. It would be far better for the European politicians to come up with an
orderly plan for countries to exit the monetary union than to deny that the union isn’t in any danger of falling apart.

 

Solvable “fiscal cliff”

Finally, the approaching “fiscal cliff” in the U.S. is another wild card that could have a significant impact on capital markets. The good thing about the “fiscal cliff” is that it isn’t an outside force being imposed. The cliff is avoidable and completely under the control of Congress and the president.

With all of this going on, is a bear market inevitable? While I think that the confluence of events (worldwide economic slowdown, slowdown in the U.S., European financial chaos, “fiscal cliff”) make it likely, as I indicated in my last column, the application of “business friendly” policies could prevent it.

Until visibility into policy becomes clearer, investors should continue to be extremely cautious. They should remain liquid.

 Finally, the U.S. economy is so fragile that any external shock, like a financial implosion in Europe, is certain to have negative impacts on U.S. markets. Policy responses to economic slowdown or financial chaos (e.g., printing of money by the European Central Bank or QE3 by the Fed) are likely to have a positive impact on the value of precious metals and commodities. And the ongoing drought will definitely move food and commodity prices upward.

Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.