U.S. Economy: When Good Is Bad And Bad Is Good

Includes: SPY
by: Eric Parnell, CFA

These are strange and interesting times indeed for the U.S. economy and the markets that are supposedly dependent on it.

On Friday, the Bureau of Labor Statistics will release its latest employment figures for the month of May. Investment markets are awaiting this release with baited breath. Since the beginning of the year, net new job growth has been steadily decreasing from 275,000 jobs added in January to just 115,000 in April. Heading into the report for May, economists are predicting anywhere between 95,000 and 206,000 new jobs were added. It will be interesting to see come Friday morning at 8:30AM.

Now in a normal world, investment markets would cheer a stronger than expected jobs report. This would imply that the economy is improving and suggest an increase in GDP growth, which is the key driver of earnings growth that is a primary factor to drive stock prices higher. But, as we all know by now, this is far from a normal world we've been living in over the last few years since the outbreak of the financial crisis. After all, the stock market soared by as much as +13% earlier this year in the face of these deteriorating employment numbers along with a host of other economic readings that fell short of expectations.

Ironically, the stock market (NYSEARCA:SPY) may actually recoil at a stronger than expected jobs number on Friday. This is because the stock market, even after its recent pullback, is trading far above its fair value level given where we are in the current economy. For example, we still need to add 3.2 million net new jobs before we even return to the employment levels of September 2008 just before the financial crisis fully erupted (and when the stock market was trading considerably lower than it is today). And none of this includes the 8.6 million people that have been added to the list of those "Not In The Labor Force" over the same time period, many of which would likely be employed or at least looking for a job if current economic circumstances were better. Thus, a jobs number on Friday even 100,000 above the consensus range only begins to scratch the surface in resolving an employment issue that is likely to take years to repair and play out. And none of this even begins to consider the underlying pricing instability that remains a genuine concern.

Instead, many investors are hoping for a worse than expected jobs number on Friday. Why? Because they need their latest fix of monetary stimulus, particularly in an environment where the U.S. and Asian economies are slowing and Europe is accelerating their slide toward full blown crisis. So if the latest employment figures come in worse than expected, some believe that this will provide greater flexibility for the U.S. Federal Reserve to step in with another stimulus program perhaps as soon as their next FOMC meeting on June 19-20. Conversely, if the jobs number comes in better than expected, it may force the Fed to wait before taking action.

First, the Fed is likely to remain on hold during their upcoming policy meeting in June regardless of what the employment report says this Friday. While the economy has certainly deteriorated, it has not slowed to the point where it would justify further aggressive policy action by the Fed. Moreover, the Fed is now in a politically more complicated position just five months before the next U.S. Presidential election. Having already suffered wilting criticism and threats to their independence from numerous members in Congress, the last thing the Fed likely wants is to draw any unnecessary attention to itself with a preemptive policy action.

Instead, the Fed likely needs the stock market to deteriorate markedly from current levels before it has the required visual evidence to justify additional policy action. While I strongly disagree with the reliance on stock market as an indicator of economic activity and the need for policy response given how grossly distorted it already is from previous actions since the beginning of the financial crisis, it likely still remains a primary focus for policy makers on whether further support is needed.

But regardless of whether the Fed opts to provide additional stimulus or not in the coming months, the fact that investors could potentially get excited about bad news and drift on good news highlights the still dysfunctional state of the stock market over three years after the outbreak of the financial crisis. While the short-term high of stimulus is great for the stock market and most of us will respond accordingly to try and participate while the fleeting burst to the upside lasts, the long-term issues remain unresolved and in many ways are being compounded by delaying the inevitable.

At some point markets are going to have to adjust to the reality that the economy is not strong enough to support stocks at current levels. And given the fact that we are supposedly no longer on the brink of the full-blown collapse that presented itself in late 2008, the sooner we allow markets to find their true equilibrium price the better. For once we do, capital markets can finally stabilize and investors can begin to assume a more constructive long-term view instead of being forced to maneuver the high volatility and unpredictability that accompany each new stimulus cycle. In the meantime, the market bubbles only grow bigger, the marginal impact of stimulus becomes less, and the subsequent stock corrections all the more violent. Certainly not the capital markets backdrop to encourage companies to hire people back to work.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.