As I listened to the comments after the job report today, it occurred to me we were hearing more of the same. The job number doesn't matter - what matters is the Fed's reaction to the number. Do you think maybe it's time to start valuing stocks based on the data and not on what is obviously a very ineffective and almost useless Fed monetary policy? I think so.
Fed policy isn't working to stimulate economic growth. It is working to some degree to inflate asset prices and it has kept rates artificially low, which helps keep the interest cost on the record U.S. debt at affordable levels. That said, there is really nothing the Fed has done that has impacted jobs growth, and that is without question the most important metric relating to continued economic growth, although economic growth is not relevant in today's stock market.
Corporate America has proven very adept at cost cutting and most of those cost cuts have been in the labor area. In the short term, that has proven to be a very successful strategy in terms of corporate profits. Longer term, the strategy can't work, as we need consumers with money in their pockets to buy what companies sell and we are destroying the consumer to the short term benefit of the elite.
Let's look at the market's response to the jobs number, which demonstrates the focus is not on the health of the economy, but on how the number might impact Fed policy going forward. By the way, the response it seems is a function of inflation expectations assuming that QE will continue and be inflationary or in the alternative - a simply market manipulation tactic executed by the algos and explained by the media as a response to more Fed printing. The second explanation seems more plausible, and the evidence seems irrefutable as I will discuss in a minute.
For now though, let's look at market response. Here is the 10 year (NYSEARCA:TLT):
Here is the US dollar (NYSEARCA:UUPT):
Each of these markets' knee jerk response indicates that traders deemed the jobs report inflationary, which will work to devalue the dollar. The reason - the Fed will just keep printing money. It may be true that the Fed continues QE at the same pace, but it is also true that Fed policy hasn't been effective, and therefore no consideration should be given to what the Fed may or may not do in coming months. The truth is, it just doesn't matter.
When markets continue to build in future expectations based on false assumptions, there comes a point where the truth comes into play, and the assets that moved higher based on these false assumptions rapidly recalibrate.
Here's what happened to Apple (NASDAQ:AAPL) when it finally became apparent that the company could not hold its competitive advantage in the iPhone market:
Momentum and irrational euphoria can trump reality in the stock market, and in fact we see that all the time. That is why it is so difficult to time peaks in the market. Apple is a perfect example of that phenomenon. The stock soared on the basis of a very flawed assumption - the assumption that Apple could maintain its short-term windfall advantage in iPhone sales which necessarily required a continuation of the high demand for the product and the added assumption that other companies wouldn't offer their own competitive product and at a cheaper price.
What's most astonishing is the abject lack of understanding that produces dead cat bounces in a stock that is probably pretty fairly valued at current levels. The idea is that the $700 price was reasonable and Apple is a good company so the stock will make its way back to the highs. It may do that someday, and it is reasonable to argue that Apple is still a good company, but the idea that $700 was a realistic valuation is based on a very flawed assumption.
Here is a look at gold - another example of a market that priced in assumptions that were horribly flawed:
Gold's rise was predicated on the high inflation expectations arising from an inflationary Fed policy. But we haven't had much in the way of inflation so - like Apple - gold traders finally recognized that the market move was based on a flawed assumption. In other words, the Fed's QE has not devalued the dollar, nor has it spawned inflation. Here is a look at CPI. It shows that inflation is not a problem and in fact the real problem is the possibility of deflation:
It's the nature of markets that they tend to get locked in on a premise, and once that occurs, the market seems particularly resistant to abandoning the premise. It happened with gold and Apple - just two examples. It is now happening with the broader stock market. The fact is, we desperately need modest inflation, and what we have is disinflation and very close now to deflation. Here is a graphic that shows what happens in a deflationary spiral:
Deflation does feed on itself, as the reaction to falling demand leads to cost cutting, and that means a reduced labor pool receiving a paycheck, which means a reduced consumption pool and a further decrease in demand and so forth. That is where we are today and gold seems to get it but not stocks - yet.
Back to the point of Fed policy - there can be little doubt that the market's response today was based on the assumption that the Fed would not taper, and the offshoot of that is that the dollar will fall and inflation will be the outcome. Well, we have had the Fed's policy of QE for over 5 years now, and the CPI chart shows that QE is not inflationary.
I think it's worth looking at the Fed's 2 mandates - price control and employment - to see how effective the policy has been. Actually we've already looked at inflation. Using the CPI as a measure, we are just a breath away from deflation as the chart above shows. Now let's look at the employment situation.
I prefer to look at the numbers of employed - not the unemployment level - as that is the number that represents the consumption pool, and the consumption pool is what drives GDP, and therefore, top-line sales and profits. We have made some progress since the beginning of QE but not much. We are as a practical matter back to the levels of 1999 and still well below the pre-recession high. Here is a look at the same data expressed as a percentage change number:
What this number demonstrates is that QE is simply not getting the job done. We have been relatively flat in terms of jobs growth for about 2 years now. Here's my point - I am fine with stocks moving higher based on earnings, but find it troublesome that stocks move higher on the "bad is good" theory that is expressed as the Fed will continue to increase unused excess reserves, and therefore stocks should go higher. In other words, the fact that we are not getting anywhere with QE means that we will continue to not get anywhere with QE, but we will continue QE nonetheless, and therefore stocks should go up.
While we are looking, we might as well look at GDP. It is not one of the Fed's mandates, but it does help to connect the dots:
I drew a horizontal line across the chart at the level of the current read to illustrate that no point dating back 70 years has shown a GDP print this low except during periods of recession, as reflected by the areas shaded in gray. Again, this isn't one of the Fed's direct mandates, but virtually everyone expects effective monetary policy to produce positive GDP growth, and that is clearly not what we are seeing.
While we are looking, we might as well look at corporate sales and profits. Here is a chart of the S&P 500 earnings growth rate:
The nominal growth rate for the S&P is a minus .95%, and the trajectory is decidedly down. The real earnings rate growth chart has the same appearance as the one above, but the inflation adjusted real growth rate is -2.63%.
So one has to ask - are things improving? And one who looks at the situation objectively has to answer - no, not at all. Should that matter? I think so, as the sad truth is we have driven stocks to all time highs based in part on the fact that profits have been pretty good and based in part on the fact that the Fed's policies will cause profits to continue to grow, thereby justifying the multiple expansions we have seen this year.
Here is one more chart just to illustrate where we are in the long term on PE ratios:
The chart above is the 10 year inflation adjusted PE or CAPE. I drew a horizontal line across the chart to show that there are only 3 instances dating back to 1880 where this metric showed a print as high as we are today - the first was the 1929 crash, the second was the dotcom crash and the third was 2008-09 crash.
Another point worth mentioning is that the PE ratio can spike when earnings fall sharply followed by a sharp sell-off in stocks. What occurs is a big spike in the PE ratio as the stock price is slower to react than the earnings side of the equation. Such a scenario could occur again if we see a sharp drop in earnings before stocks price in the earnings contraction.
The following excerpt from FactSet.com suggests we may be seeing just such a scenario in the making:
Blended Earnings Growth is 1.7%, but Falls to -3.4% excluding the Financials Sector
The blended earnings growth rate for the index for Q2 2013 is 1.7%. If this is the final growth rate for the quarter, it will mark the third consecutive quarter of earnings growth for the index after reporting an earnings decline in Q3 2011. But, it would also reflect the third-lowest earnings growth for the index in the past four years. Five of the ten sectors are reporting higher earnings relative to a year ago, led by the Financials sector. On the other hand, the Energy, Materials, and Information Technology sectors are reporting the lowest earnings growth of all ten sectors for the quarter.
The Financials sector has the highest earnings growth rate (27.2%) of any sector for the second consecutive quarter. It is also the largest contributor to earnings growth for the entire index. If the Financials sector is excluded, the earnings growth rate for the S&P 500 falls to -3.4%.
The following chart - again courtesy of FactSet - breaks down data by sector:
Q2 2013 Earnings Growth
The truth is, we just aren't gaining much ground from monetary policy, but we sure seem to believe we are, as reflected by the S&P 500 chart (NYSEARCA:SPY):
Here is another view of the same data but presented in logarithmic scale:
Using this scale, the detail from a similar period - the mid 60s to 1975 - compared to today's chart, becomes clear. If history repeats itself, then we are headed a lot lower and very soon. The January, 1973, high monthly close was 121.74 and the July, 1974 close was 62.52 - not quite a 50% drop, and the 3rd move down forming a 9 year wedge pattern. If history does repeat, then we have one more major leg down to complete a similar wedge pattern, and the next leg down will actually bring the price below the other two legs.
What's different today?
There are some significant differences today from past periods, and it is necessary that they be explained in order to understand why the markets are so resistant to a sell-off. I have asserted time and again that market price action is not based on the idea that bad economic data is being interpreted as good based on the idea that the Fed will keep printing. That's the story the pundits ascribe to the euphoric and giddy nature of stock traders that keep pushing stocks higher in the face of deteriorating economic data but I reject that notion.
The real reason the markets continue to defy gravity has to do with what the stock market has morphed into in recent years. Here is an excerpt from an article I wrote on HFT's that appeared in the September, 2011 issue of the Hedge Fund Journal:
Recently, many observers have assumed that price discovery has improved. But evidence to support this is limited. For example, HFT market makers need not just learn passively from observed order flow, but can also strategically set quotes to induce the revelation of information, potentially distorting short and longer term formation.
Lest you question the truth of this phenomenon, I would like to direct you to an article on Zero Hedge that establishes that this is going on and in fact that it occurred just prior to the release of the jobs report on Friday, resulting in the halting of trades through a circuit breaker action.
Here Is Today's 482 Millisecond NFP Leak, The Subsequent Gold Slam And Trading Halts In Treasurys And ES
What was more amusing was the action after the NFP release in both the eMini and the T-Bond futures, all of which had to be halted for a whopping 5 seconds until the algos, selling everything at first, got the memo out that good news today was in fact good news, and promptly ramped risk to the moon. Either that, or someone called in a code Red, made it so all selling was literally prohibited, and with the only path of no resistance up, resulted in today's epic melt up on what was initially a very bearish kneejerk response to the NFP print.
First: September 2013 T-Bond Futures trades and quote spread. The deluge of selling hits 482 milliseconds before the NFP release, leading to a 5 second circuit breaker and halting the OTR future contract of the world's largest bond market. Abe would be proud.
The more relevant question isn't whether or not this is happening, but who is doing it. Here is how Zero Hedge explains the "who is doing it" part - again from the same article referenced above:
Fear not though: the CFTC is on top of it. You see, when bond trading is halted two times in three months alongside of the most important monthly economic release, someone has a fit, and they scream at the CFTC. The Goldman-alumnus headed CFTC. So what does the CFTC do? They "review" it. From Reuters:
CFTC probing Treasury futures trading that led to halt at CME
U.S. futures regulators are reviewing trades that triggered a brief halt in trading at CME Group's markets for Treasury futures just as the U.S. government was poised to release key data on the jobs market.
"We are aware of it and will be doing a review of the trades, which is standard operating procedure for something like this," Commodity Futures Trading Commission commissioner Bart Chilton said in response to a query from Reuters.
CME Group halted trading in some Treasury futures for five seconds, beginning just before the 8:30 am ET (1230 GMT) release of the monthly jobs report.
Large trades in 10-year and 30-year Treasury futures were made just prior to the release of the report. Such trades and large market moves can trigger automatic stops in CME markets. ______________________________________________________
Of course, once the CFTC and CME both discover the ignition originated either at Liberty 33, at its proxy Citadel, or Goldman/JPM, the "review" will promptly fade into obscurity, or at best, the CFTC will "discover" that nothing actually happened contrary to irrefutable evidence to the contrary.
Here's what I think - the markets have not worked to produce real price discovery for some time, but the ramp from the November lows is the most blatant distortion of the markets I have witnessed in over 40 years. And the most recent ramp off the June lows is the most contrived segment of this most blatant distortion.
We have been reduced to trying to figure out where the algo operators - Goldman (NYSE:GS), JPMorgan (NYSE:JPM), etc. - want the markets to go. Nothing else matters today. The assumption of course is that they want the markets to go higher but do they? At some point, my guess is they turn this whole charade on its head and become aggressive sellers. The only question we must answer is when, and unfortunately most of us don't have that inside information.