We had remarked last week that when the holiday hiatus comes to an end, traders are likely to take stock of events that have unfolded over the past few weeks and possibly dictate the short term course of the front line indexes. 2007 ended on a bad note with all the front line indexes closing in the red; 2008 has begun on an even worse cue with all the indexes declining sharply this week amidst some very dire economic data. Ominously, S&P (SPY) is down 3.86% in the first three trading days of the year, its second worst start ever.
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The Nasdaq Composite (QQQQ) has lost 5.5% in the same period, its worst start ever. Intel suffered two downgrades this week on concerns that the strong growth in the PC market in 2007 will begin to temper this year and the high inventory levels that could extend through the first half of 2008, pushing the stock to its largest weekly decline in two years. Friday's remarkably sharp decline, although partly fueled by the dismal jobs data outlined below, was the largest one-day decline for the Nasdaq in almost a year.
Traders seem to be in a hurry to book their profits after seemingly holding themselves back for most of December – a move possibly aimed at postponing their capital gains until 2009. Not to be left behind, analysts seem to be entering 2008 on a bearish note as well. Back from their holidays, analysts have downgraded stocks all across the spectrum, to the extent that as on Friday, none of the S&P sectors had a positive number of net revisions.
The unrelenting selling pressure is taking its toll. We have explained previously how the small and midcap sub-universe would likely bear most of the brunt of a sustained credit crunch. That contention has come true with the small and midcap benchmarks witnessing milder recoveries and more severe declines. The Russell 2000 is now well below the August summer trough at a 15 month low.
The S&P 500, the commonly used benchmark for stocks in the United States, gave a 3.5% return in 2007 (before adjusting for dividends), less than the latest headline inflation number and less than the return given by a typical money market fund. However, a lousy stock market in 2007 may just look good compared to the predictions of an awful one in 2008. The weakening economy is now threatening to snowball into a full-blown recession sometime this year. Indeed, some like the revered Bill Gross of PIMCO believe that December may have actually marked the beginning of a recession. Why is this important? Every recession in post-war history has been associated with a stock market decline. The average peak-to-trough decline in stocks (distinct from the economic peak-to-trough that lags the one in asset prices) in a recession is a whopping 28% - an unequivocal proof that recessions and hard landings are associated with sharp, severe and sustained bear markets. As an aside, stocks are now beginning to look a bit cheap. Bear Stearns is now trading under book value, the first investment bank to do so in almost a decade. But as any old-timer would vouch, the bottom of a bear market can be quite elusive.
Recessions are also associated with sharp drops in earnings, of the order of 15-20%. The possibility of an earnings recession also seems to be coming true. Reuters' estimates for 4Q'07 S&P 500 earnings have swung wildly from a 11.5% growth at the start of 4Q to a 6.5% drop this week – the biggest quarterly move since Reuters began compiling analysts' forecasts in 1999.
For those not familiar with Chinese astrology, 2008 is the 'Year of the Rat', the first sign of the Chinese zodiac, a year of plentiful opportunities and prospects and relatively free of turbulence. Unfortunately 2008 beckons no such optimistic promises for the US stock markets. We will be battling a recession for most of the year and possibly succumb to it eventually. The Fed will try to do its bit of course. But will it succeed? Will 2008 instead be the 'Year of the Bear' for the U.S stock markets? We discuss all this and a whole lot more in the following sections.
Labor market turns
We have repeatedly pointed out the errors in the government reported data - be it, inflation figures, payroll data or the GDP growth numbers. Each of these economic spins has got systematically unwound over the past few weeks. The latest shoe to drop and the most powerful indicator in this series is the dismal jobs data released this week.
Non-farm payrolls rose by only 18,000 in December – or as BLS chose to report it, largely unchanged – versus a consensus expectation of 70,000. This is the lowest reading since August 2003 and capped the worst year for job creation since 2003. Excluding a gain in government jobs, payrolls actually fell last month for the first time since July 2003 hurt by losses in manufacturing, construction and retail.
The jobless rate shot up to 5% from 4.7% in November and a cycle low of 4.4%, its highest level in 26 months and the largest single month increase since April 1995. Although that is still well below its historical average of 5.6%, such a rapid increase is almost a defining characteristic of an economic recession. Since 1949 the unemployment rate has never risen by this magnitude without the economy already being in recession.
Worse still, the increase was exceptionally broad-based, with the unemployment rate for every single age group rising. Full time jobs contracted by a huge single-month total of 592,000. Part time jobs rose sharply but the Number of Persons At Work Part-time For Economic Reasons surged even more for a massive two-month gain of +264,000.
To gauge just how bad this number is, consider this: the economy needs to add 150,000 new jobs a month just to account for the growth in population. By that token, the cumulative 1.33 million jobs added in 2007 looks anemic, falling short of this barely neutral figure.
Further, as we have remarked before, the BLS' adjustment for birth and death of corporations only skews the data further. The birth-death (BD) adjustment necessarily will underestimate the jobs added when an economy is recovering from a recession, while overestimating them when the economy slows down. This happened in 2003-2004 when economists thought that a jobless recovery was underway, only to realize later that jobs were indeed added in this period. The converse may just be happening now, with the birth-death adjustment overestimating the jobs created.
The BD adjustment has added 1,305,000 jobs since Feb 2007, virtually accounting for all of the NFP jobs created in the whole of 2007. For December, the BD ratio accounted for 66,000 jobs, i.e. 48,000 jobs more than the headline number. The BD adjustment also indicates that the financial services industry added an unrealistic 17,000 jobs last month.
Clearly the flaws in the adjustments and the frequent large revisions have rendered the employment data largely meaningless. Nonetheless this report, coupled with elevated figures for initial and continuing claims for unemployment benefits over the past few weeks, confirm that the last straw that had supported a slowing economy and a debt-ridden consumer is now finally faltering. This makes a recession very likely. To twist Harry Truman's timeless quote, its a slowdown when your neighbor loses his job; its a recession when you lose yours!
Manufacturing takes a hit
The consumer is not the only one pinched. The Institute of Supply Management's PMI, the benchmark gauge of the health of the manufacturing sector, unexpectedly dropped to 47.7, the lowest reading since April 2003 and way below a median estimate of 50.5. Readings below 50 indicate that the economy is generally contracting. Not only was the headline number dismal, but the internals showed significant weakness as well. Of the six components of the report that go back to at least 1970, three of them went from expansive (above 50) to contractionary (below 50) in December. Since 1970, this is only the fifth time that these many categories of the ISM have turned negative simultaneously.
This Institute of Supply Management diffusion index gives us a glimpse into about one-fifth of the US economy. But that is the part most sensitive to interest rate levels and the one needing a great deal of help from the FED. History shows that the Fed has always cut rates when ISM is below 50 and falling. Thus a FED rate cut at the January meeting is now a near certainty.
The ISM report follows others that show a weakening of the manufacturing sector. The Philadelphia Federal Reserve's business gauge for December contracted for the first time in a year, while the Richmond Fed's measure also turned negative. The manufacturing slump also seems to be spreading internationally with the JP Morgan Global Manufacturing PMI slipping in December to a near four-and-a-half year low.
The coming consumer recession
The economy is in a tight spot. Several recessionary signals are evident – an unrelenting housing slump, faltering cap-ex spending by corporates, continuing credit and liquidity crunch, crude topping $100 and forward looking indicators of supply such as the ISM report above indicating contraction. But the optimists argue that as long as the consumer stays on his spending spree, a recession could be avoided. That contention is justified, with consumption being over 70% of aggregate demand.
But now that argument is falling flat on its face. Until now, the consumer was saving-less and debt-burdened and at the receiving end of several shocks – falling home values and hence reduced home equity withdrawal and the incident reduction in the wealth effect, rising costs of debt servicing due to ARM resets, stubbornly high gasoline prices and most recently reduced stock market wealth. With the pillar of support from jobs and income generation slipping, the consumer is on shaky ground. It is thus no wonder that the holiday shopping season has turned out to be the weakest in five years.
With the labor market faltering, a recession is increasingly becoming the most likely outcome. The debate is now shifting from a hard vs soft landing to how hard the landing will be.
The Fed's dilemma
The Fed is in a tight spot. It is already behind the curve despite cutting rates by a full 100 basis points in three meetings. While rate cuts will help in an overall sense, it will not help ease the credit crisis. It will not magically bring back the confidence in the sub-prime market. It will not reverse the housing price declines overnight. These are problems we simply have to work our way through.
The Fed is flirting with a recession. As much as the Fed wants to get ahead of the curve, it is still somewhat hamstrung by elevated inflation with oil touching $100 a barrel and gold marking new lifetime highs being proof of that. A 50 basis point cut is now quite likely at the Jan meeting. The Fed funds futures contracts are now indicating a 68% chance of a 50 basis point rate cut, up from 34% before the jobs report and virtually zero a week back. According to this graph from the Cleveland Fed, the options of Fed fund futures indicate that the implied probabilities of a 50 bps rate cut at the Jan FOMC meeting have shot up over the past few sessions coinciding with the above economic releases. The Fed could, however, decide to take it slow until it becomes clear that we are in a recession and/or the slowing growth takes care of the inflation. The equity markets will not welcome that for sure.