The Myth Of The Accelerating Economy

Includes: DIA, IWM, QQQ, SPY
by: Kevin Flynn, CFA

Wednesday was such a beatific day, wasn't it? A weak opening that reversed from the sound of the opening bell, finishing with style in a last half-hour flourish to new highs of the day, including a new high - all-time! - on the S&P 500, even as volume vanished. Amongst the sea of green numbers, newly-minted experts avowed that anyone not buying every dip is a sucker, and that the only direction is up. Even JP Morgan strategist David Kelly was moved to admit on CNBC that "it seems to a bit of a one-way trade right now."

Perhaps it is, but not because the economy is getting any better. Yes, I've seen the headlines, but the problem is that the headlines are all that most people have seen.

The most notable attributes of the GDP and jobs report headline numbers were that they beat estimates. Good for a lot of fanfare, but one needs to be aware of what is really going on. Four-quarter nominal GDP growth the last three quarters has been 3.08%, 3.1%, and 3.07%. The 2010-2012 period saw nominal GDP average 4%. Yet the same old trumpets blow the same old story of the "recovery gaining traction." It's been gaining traction for almost four years now, yet we are moving slower.

A quarterly GDP print of 2.8% is nothing new - as I pointed out in my own weekly column, 8 of the last 15 quarters have been at that level or better. Because the higher prints are mostly the result of inventory builds (like the most recent one), or perhaps a low inflation deflator, as with the second quarter, the numbers subside again within a quarter or two.

Given the inventory build of the last three quarters, GDP is apt to reverse again in the fourth quarter. The four-quarter rate of real GDP is 1.6% through the end of the third quarter - no, that's not a misprint, it really is a one-handle: See Line 1, page 13 of the latest BEA GDP report (you can find the link on this page). That's some acceleration. Should the fourth quarter accelerate downwardly (the recovery is always accelerating) in keeping with the pattern, we could end up with real GDP of less than 1.5% this year.

As for the jobs report whose strength was such that the weekend Wall Street Journal claimed in bold headlines that the Fed is now in a bind, regular readers of this space know that I have written several times this year about the phenomenon of the estimates from the Bureau of Labor Statistics (BLS) fitting so remarkably close to previous years: According to BLS data, the year-on-year job growth for the first ten months of 2011, 2012 and 2013 has been 1.47%, 1.46% and 1.47%. That is remarkably similar.

The upward revisions to the October jobs report came out of new seasonal adjustment factors that emerged from the preliminary benchmarking revision. The BLS estimate of September jobs was unchanged in adjusted form; that was good for an additional 15,000 in seasonal jobs. The 204.000 jobs that the BLS reported for October represents a 1.7% year-on-year increase, in the 1.62%-1.7% range that each of the last six months have been in - and every 1.7% initial result was later revised downwards.

While I generally leave the subject of the Labor Department's birth-and-deaths model well enough alone, this time I raised an eyebrow. The BLS October estimate was 126,800. Really? In the month of the government shutdown and impending debt default, new businesses created that many jobs? Four days later the small business confidence index came out and added fuel to my suspicions. The births-and-deaths model is inherently built on small business hiring, and yet there was the big drop in the October small business survey that notably included a big drop in hiring plans. Brand new businesses would not have been included in the survey, but even so.

There's another anomaly that bothers me - all of those eating and drinking jobs that seem to fill up the largest bucket in the BLS survey almost every month (53,000 in October for leisure and hospitality). The Labor department says that 29,200 of that total went to food and drinking, seasonally adjusted, though the raw estimate fell by 52,000. Okay, I understand the need for seasonal adjustments.

The part that bugs me is that the Commerce Department says that spending at food and drinking places was up 3.8% through the first nine months of 2013. The Labor Department says that this bump apparently necessitated a 4.8% increase in hiring in the same category (both figures are based on unadjusted data). If we reasonably estimate that about 1% of the 3.8% increase in dining-out dollars is from pricing (retail sales data is unadjusted for inflation), it means employers needed 4.8% more workers to handle a 2.8% increase in trade. Not very productive.

It could be that the Commerce Department is undercounting spending at food and drinking establishments. However, that doesn't jibe with the multi-decade lows in labor force participation and the employment-population ratio. The Fed likes to talk about demographics when it comes to the latter, but given the high participation rate by seniors trying to get by, there's more to this than baby boomers retiring. It might more likely be that a lot of people are holding a couple of part-time jobs (they would be counted twice).

Here's a look at the latest chart of National Activity from the Chicago Federal Reserve:

A few things stand out about this chart: one, the lack of evidence of the recovery gaining traction. Sideways would be a generous description. The second is of course the dramatic flight of the stock index while economic activity goes nowhere (note the resemblance to 2007).

I would like to say that the latter incorporates a still more remarkable phenomenon, that of the near-total conversion of the investment community to the notion that the Fed has bathed the stock market in the same Styxian waters as Achilles, rendering it all but invulnerable. There may be a susceptible heel somewhere, it is allowed, but it will be ages before anyone ever finds it.

Unfortunately, I have seen this enchantment before, in fact all through my investment career. In July of 1987 I sat in on an investment policy committee that was bullish down to the last toenail, despite a mass of data flashing danger. In the spring of 2007 the level of certainty was even more total - I remember a strategist challenging his clients to make a single bullish case that didn't involve the word "liquidity," a term that morphs into a euphemism for the river of greed that characterizes the peaks of bull markets.

Last week I warned against the complacency of the crowd, but since that time a broader review has made apparent the depth of its penetration. As usual, there are always a few skeptics warning of trouble, including cranks like yours truly and other slow-witted types like Buffett, Gross and Fink, to name a few. We are listened to politely for a brief moment, and then drowned out by the din of shouts that every dip must be bought, dismissed with a smirk for our feeble-minded belief that even a ten percent correction could happen, and thrown into the pit with the hard-money trolls.

You may think this is the point where I light the brimstone, but it isn't. I do not accuse Labor of cooking the books, as much as some may want me to - the truth is that the precision of the BLS data is an illusion, as even its own statisticians would tell you. They are doing the best they can to construct estimates from a limited amount of information, and the retrofit nature of the process means that it will always lag reality. The real point is that the clamor of estimates being beaten, whether with earnings or economic data, is being fueled by a tape that will always find its justification somewhere.

Don't let Wednesday fool you - we're still due for some sort of pullback. I bought more TZA, though the former may well end up falling into the bin of another dip to be bought (traded, if you ask me). It often happens that the market's own self-promotional aura becomes more real to it than any other meaning from the data. The myth of the strengthening economy could persist for some time yet, and even give way to another burst of insanity should a colder reality induce Janet Yellen to defer tapering yet again.

The bubble is building, but I cannot say with any conviction that the end is nigh - valuations have rarely brought down a market on their own. I can say that if the bubble is allowed to build much longer, the ending will be calamitous, perhaps leading to more devastation in some ways than the crash of 2008. Yet we may only be halfway through a blow-off top phase. Just don't make the mistake of converting to the brave new world - it's only the myth that's accelerating.

Disclosure: I am long TZA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.