When the Economy and Stock Market Detach

In our latest "Week Ahead" copy, we warned that data due at the end of this week, specifically the ECB Policy Statement and press conference, and the Employment Situation Report, would likely paint a much less sanguine portrait of the economy than what the week ago flurry of favorable news brushed.

We told you to take your money and head to the beach for an Indian summer extended weekend. You would have been better off using your dollars to dry yourself with after a refreshing swim, than to have left your dough in stocks over the past couple days. Unfortunately, we were right; the news flow was dire, and stocks reflected the tone precisely. The S&P 500 Index trended lower all week, but took a steeper route on Thursday and into Friday morning. The S&P fell 3.0% on Thursday, but managed to recover 0.4% through Friday, despite a poor start.

So Let's Talk About the Drivers

Two of the most obvious drivers this week were the above mentioned reports. On Friday, the ECB kept rates steady, but what it had to say in its statement and press conference spoke decibels louder than its rate inaction.

First of all, the ECB chief was in a tough position. After all, his governing group, after months of threatening, moved to raise interest rates at their last meeting. This move was meant of course to stall HICP inflation, which was running at 4.0% in June and July. The most recent reading was still high at 3.8% for August. Since that rate hike, however, euro area Real GDP was reported to have contracted 0.2% in the second quarter, defying ECB expectations. As you’ll recall, the ECB acted on rates after noting first quarter GDP growth of 0.7%.

For the ECB to come out this meeting and cut rates would expose its last move as flawed. Doing nothing now allows the group a pivot point, from which it can move in either direction at its next meeting. Jean-Claude Trichet expressed "no bias" toward inflation or economic growth, which to be fair was his position at the date of rate hike. Thus, it seems clear that he understood this current environment to be a possibility his economic realm might incur.

The ECB lowered its growth forecasts for '08 and '09 and raised its inflation forecasts, both meeting the actual accounts of data that proved off the ECB's prior forecasts. In other words, they're not exactly looking credible right now. What's worse is that they're still anticipating a significant drop-off in inflation, and decent economic growth for '08. There may yet be further adjustments to their stubborn forecasts.

So, perhaps, in part covering is rear, the ECB chief stressed the importance of containing second round effects, those being embedded inflation driven by wage increases. In other words, the ECB believes inflation can be contained by disbelieving its existence. Don't give wage increases to employees, unions and citizens; let them bear higher temporary commodity costs themselves; and those costs will moderate as greater production meets lighter demand.

Now, I seem to recall Europe having a history of citizenry uprisings, riots, and burning of castles and overturning of kingdoms. If I have not already made clear my disbelief that the ECB can convince member nations to contain the wages of European citizenry, then consider this. This ECB action seems to naively write off Indian and Chinese development as short-term in nature, and economic decoupling as nonexistent. If inflation proves stubborn due to Indian and Chinese economic persistence, good luck keeping your head Jeannie.

That said, I agree that inflation control is critical for the ECB, since there exists that strong underlying demand from emerging markets. I believe wages should rise, however, to meet the secular change I see around the world - that change drives price increase as demand for limited resources increases. The right course of action to help the developed world digest this dynamic environment is to force China and India to play on fair ground, thus applying natural and fair drags to their development. These drags would be especially geared to impact foreign competitors that benefit unfairly at the market share cost of European and U.S. producers of goods and services.

Your Pain is My Gain

The handcuff that the ECB is wearing now, along with other factors elsewhere, have helped to strengthen the dollar, and also act as a positive capital flow driver toward US assets and away from European. This has likely aided American securities markets and even housing and commercial real estate, and made American companies more interesting for outright acquisition now as well. This has probably been the key driver of American share rise since mid-July, combined with collapsing commodity prices, which has added a second capital stream flow toward US securities.

Unemployment Rises Nonetheless

Despite the flow of capital into U.S. equities, as natural benefactor from flow out of Europe and commodities, or at least due to reduced capital draw from those competing markets, the U.S. economy and its key catalysts continue to deteriorate. Momentum is a strong factor that should never be discounted, especially in the size and form of ship that is the U.S. economy. While capital flow supports securities, it cannot manufacture synthetic demand for goods and services. Thus, an overwhelming negative factor and driver continues to outweigh fund flows.

While oil, gasoline and other commodity prices have eased, not much of that change is easily factored into the immediate spending destinations of consumer capital; that said, the decline of gasoline and unprocessed foods prices are notable and play an important role in restoring economic stability.

Still, these expenses of production were incorporated into processed foods and finished goods pricing as well, and they are typically removed at a much slower pace then at which they enter. Basically, it's an easier decision to raise prices than it is to cut them folks. In a competitive marketplace, however, price ease must ensue. Even so, all this takes time.

Meanwhile, companies remain stressed and continue to reduce workforce. Unemployment jumped in August, to 6.1%, up from 5.7% in July. This measure baffled economists, as they anticipated a level of 5.8%. Most of the 1.4% deterioration of the rate over the last 12 months has occurred within the last four.

This rapid rate of increase in unemployment is characteristic of the last phase of the business cycle, in my view. It is representative of capitulation in the corporate environment. At this point, the disbelievers of recession are long fired or otherwise silenced. Now, free reign is given to the Armageddon types, and under the pressure of tightening profit margins and job insecurity, managers are cutting away.

Nonfarm payrolls fell by 84,000 in August, worse than was expected and greater than the 51K shed in July. The number of long-term unemployed increased by 163K. This is disturbing because the longer you are out of work, the more you eat into your nest egg, and the less positive influence you have on the overall economy. In English, you can't spend what you don't have anymore.

That group I like to monitor as an offbeat measure of what's going on, part-timers who lost their full-time job, was about unchanged in August. This could signify that part-time jobs are filled to capacity, and capacity decreases after the summer. Fortunately, much of the part-time labor supply decreases as well as teenagers and college students return to school.

Here's an amazing statistic: the number of multiple job holders increased by, get this, 298,000 in August. 5.5% of you who are employed, are also working two jobs. There's a statistic the presidential hopefuls need to get a hold of.

Jobs were lost across the board, except in education and health services, for obvious reasons. I think that's enough piling on bad news to deliver the message. The unemployed don't spend money, and that's true whether gasoline prices are above $4 or below. Oh, sure, when you first lose your job and are collecting the government handout, you relax a little. You take that vacation you always wanted, and you drink more beers on Wednesday afternoons at the ballpark. But, that false comfort fades fast, and these folks are not going to be spending in the second half of '08.

Thus, stocks had plenty of reason for despair this week. But, their resiliency on Friday, heading into the weekend, was a clear positive for valuation and perhaps an early signal that stocks have some sort of solid footing. There's something called erosion though, and never forget today's solid footing could give way tomorrow.

We're at a tough point in this business cycle. At this point though, stock market forecasting might be completely detached from economic forecasting. Therefore, we may be at the six month lead leg, where stocks start to precede economic expansion. It's always bleakest here, and this time is no different. That one unique factor remains though, Iran, and the war I see approaching. It remains very well capable of throwing a monkey wrench into the business cycle and must be discounted into forecasts for both stocks and economies.

Disclosure: none

Comments

[investor88:]

Good point about possible Iran war. Nobody thinks about this except once a while when oil price spikes then subsides. Since nobody thinks about it, at least not the markets, then a war with Iran would be a outlier event of significant impact on the equity markets.

2008 Sep 07 08:25 AM

[whidbey:]

You must be living somewhere else, perhaps the EU, but not in the USA. The markets hesitated last week to see what the tawdry little meet between the Treasury and Fed would bring forth for the GSE. After all it is the harbinger of the next eon in American Financial History.

Will, the news is bad, we just nationalized a debt of about 14 trillion more or less hoping that no one would notice it is all smoke and mirrors with little or no substance. Like Dr. Pangloss "they are my words and only I can say what they mean" (literary license), the Treasury has spoken: we have taken over the GSE and all is well.

Not quite! You have made admissions against your interests that will be used against us all to refuse credit, bash the dollar and run inflation up. This is the modern version of Dante. Abondon hope all ye who enter on nationalization (or the gates of hell). It is just too easy, when one of national institutions (private or just GSE) goes to hell, we just say, it is OK, we will swear they we will pay for them. But the evidence is otherwise. We pay for little, lay up debts and lie about what we will do to pay our creditors. This is the gate to hell and we should be very reluctant to do the GSE deal and another others remotely like it. But the monkeys in Congress will see this the wave of the future and with one of the clowns running for president leading we will venture into the center of hell to gaze at the devil himself. Make no mistake about war is it just one of the fixes politicians use to divert national attention. The decoupling was between not market and economy, but between character and sanity.

2008 Sep 07 01:34 PM

[carey_jim:]

We tend not to believe our pundits who tell us that the American democracy is manipulated into what Walter Lippmann first called "Manufactured Consent" in the 1920's and does not function as the Founding Fathers wanted it to function.

Just as unions distort labor markets, advertising and other forms of manufactured consent distort financial markets.

It's like the road runner in the cartoons. When he runs off a cliff, it takes him a long time to realize that he is suspended in air, a thousand feet above the valley floor. When he finally sees where he is, gravity takes over and he falls.

In the same way, the laws of economics and finance, as obscure as they admittedly are, take over once the body politic has time to realize that it is suspended in air, thousands of feet above economic reality.

It took the Soviet Union a long time to realize where they were but once they did, they fell to the ground very quickly, just like the road runner in the cartoon.

We aren't as far off the ground of economic reality as the Soviets were (hopefully) but it looks like we've got a huge drop in our future.

We investors need to find parachutes, in my opinion.

2008 Sep 08 12:41 PM