The Worst Economic Week of 2010

by: Grant Dossetto

Friday saw a nice reflex rally off of the 1040 support. The Dow, Nasdaq, and S&P all jumped by over 1.5% with around 85% of all stocks showing positive gains for the day. The 2nd revision of GDP was not a severe as first believed, a -0.8% decrease to 1.6%, and Bernanke’s calming influence once again gave life to the bulls. Few things over the past 18 months have been as consistent as a green day when Maestro II speaks. Strength was particularly acute in financials and materials, the most volatile market sectors. At 1060 on the S&P we are towards the bottom of the trading range which developed in May after April’s year (and bull market) highs. Technicals suggest short term market strength with two bullish reversal days in the past three. That is false hope though. Bears have just sprung the best bull trap of the year and will realize great rewards over the next 5 trading days.

This week is heavy on economic data which should end the analyst illusions’ on Wall Street. From a note released by Morgan Stanley’s Richard Berner on the 27th, “We are downgrading our outlook for second-half growth to 2-2.5% from 3-3.5% previously.” The second half of 2010 will not show mediocre 2% growth at all, it will be negative this quarter. For June, personal income disappointed at 0% month over month. It was in July that we saw the first signs of deterioration in jobless claims. By the end of the month, claims were above 480,000. That deterioration has been confirmed in August. The four week moving average in claims is now at 482,500. We also know that the BLS released unemployment numbers for July below consensus at -131,000. The miss was most acute among private sector payrolls. The Street is looking for a 0.3% month over month increase in personal income. I wouldn’t be surprised if it was negative. We have seen an increase in the personal savings rate over quarter 2. There is little evidence that this should have changed. This would suggest outlays below the change in income. I am also looking for this to be negative. The weakness in jobless claims also portends a poor employment number on Friday. Not only will we continue to see job losses related to the Census, we may see private sector job losses as well. Consensus is for -80,000, I expect a number similar to that of July. A significant miss.

The ICSC same-store sales index was showing year-over-year growth of 3.8% for the week ending July 24th. Since then we have entered back to school season replete with weekend state sales tax holidays that are conducive to strong results. Reality has proven to be just the opposite. We have seen negative week over week sales for the past four weeks and the YoY growth rate is down to 2.3%. Several retailers have been cautioning on future outlook. A loss of 1.5% on the growth rate points to rapid economic deterioration, not simply stagnation. Chain store sales come out on Thursday. Look for more misses than beats. Motor vehicle sales will also be released. Steep model year end discounts resulted in a marginal unit sales increase for July. As the discounts end and car companies shift to 2011 models in the month of August, sales should be weak. The consumer is not in a strong enough economic position to carry the economy forward.

Lastly, I am looking for a sharp decline in the ISM manufacturing index. New orders slowed rapidly in last month’s report. This portends a drop in production this week from last month’s still strong 57. Another area of strength in last month’s report was employment. It jumped to a robust 58.6. That is unsustainable though as inventories increased four points to 50.2. Orders are dropping, production is still steady, and the newly manufactured goods have to go somewhere. High inventories into a weakening economy spells disaster for margins, the source of earnings beats for this year. To keep inventories in line, a sharp contraction in production must occur. That is already showing up, judging by regional Fed surveys. Philadelphia went negative for the first time in over a year. New orders went negative in the Empire State Survey. The ISM will be back into contraction, if not this month, by early October. Hardest hit, the Kansas City survey, where future production indexes fell by over 60% from 23 to 10.

This illustrates the second falsehood that goes for consensus in New York. The slowdown will not be temporary as Morgan Stanley suggests,

we don’t think this slowdown will last beyond H2, much less morph into a downturn. In his Jackson Hole speech, Chairman Bernanke seemed to agree that the current economic weakness does not augur a weaker outlook for 2011. We agree. Among the reasons: Downside risks probably will prompt policy actions, balance sheet repair will be more advanced, and we expect net exports to improve in the second half of 2010 and into 2011. In fact, we see no reason to downgrade 2011 and possible reasons to upgrade, especially if policy turns more stimulative.

A “stimulative” Fed has no power in deflation. Ben Bernanke has been reduced to the impotent Wizard, hiding behind the curtain. New home sales just came in at a record low, three months after the end of the latest homebuyer tax credit. Existing home sales fell over 5% in June, the last month of the tax credit. They proceeded to tumble another 27% in July. We know that the FHFA home price index declined by 0.3% in June. Case-Shiller, the most respected home price measure, comes out on Tuesday and should verify a price decrease. If a drop in home sales of 5% garners a loss in price at a 3.6% annual rate, what do a drop in home sales of 20% produce? The last time existing home inventory was at 11 months, home prices declined by nearly 20%. Existing home inventories are now at 12.5 months. Another bout of severe deflation in the real estate market, and on banks’ balance sheets, is on the way. Over a trillion dollars in quantitative easing to keep rates on the long end of the curve low and a de facto mortgage monopoly complete with the discredited practice of 3.5% down loans by the FHA have left us in a worse position than when the policies started. They have kept the economy from making the necessary adjustments to return us to organic growth. Today, we have growth created purely through record deficits. Amazingly, the economy is destroying capital faster than DC can borrow or print it. The Fed has no magic bullets. It cannot fix what ails us.

The most frustrating thing is that everyone outside of New York and Washington gets it. The most important issue in all polls for Americans today is the economy. They have given the current administration an F. Republicans now carry 50% on the generic Gallup ballot, that has never happened before. Both the House and Senate may change political leadership come January. The People know that what we are doing is breaking. They are voting with their money as well. Equity mutual funds have now recorded 15 straight weekly outflows. Retail investors have pulled out $50 billion from the market, a staggering sum. When Wall Street realizes the recovery is smoke and mirrors, there will be no one to sell to. Expect blood on the streets when reality hits. After the barrage of bad news this week, that time will be far sooner than many anticipate.

Disclosure: No positions