Train Wreck in Slow Motion

July 26, 2009

The S&P500 moved up again for a weekly gain of 4.1%.  The VIX skidded again to levels not seen until just before Lehman blew up in September 2008.  The Dow crossed 9,000 regaining all the losses of 2009.

Economic data was light during this late July week.  Leading economic indicators came in slightly better than expected.  Initial claims jumped back up to 554K; continuing claims dropped again to 6.22 million.  Existing home sales came in at a rate of 4.89 million, about as expected.

The bigger news came from corporate earnings where, very much like in the prior week, many firms “beat” expectations.  But these analyst expectations were driven down so low that many firms miraculously “beat” them.  Never mind that most of these earnings expectations were far lower than the earnings from Q208.  Also, many prominent firms continued to shrink–they were losing sales and show few signs that this shrinking will end next quarter.

The technicals are, as expected, showing a positive rebound on the daily charts.  The monthlies are still in bear market territory.

A major consideration for any investor must be the choice of time frame within which to draw conclusions about the economy, the markets and individual firms.  This is important because the closer one gets up to a picture, the easier it is to get caught up in the minute details that can actually be nothing other than noise.  The other reason the choice of time frame is important is because it is perfectly plausible that in doing this analysis one can find a opposing forces at work: the tide can be going out (in the long term time frame) while at the same time, a counter wave can be coming in (in the shorter term time frame).

It appears that today’s global financial crisis and recession has created the possibility that such seemingly contradictory forces are fighting each other.

On the one hand, the root causes of the  massive credit and asset bubble burst that unleashed this recession at the end of 2007 are still not fixed.  Total credit relative to GDP is at record highs–a level that is arguably unsustainable.  Adding to this force is the massive contraction in private consumption and business investment, leading to unemployment that will easily exceed 10%; at almost 80% of GDP, this is the problem that the federal government alone is attempting to prop up. 

On the other hand, the reduction in the rate of decline of many economic indicators over the last three months has created the counter force that is leading many analysts to conclude that the recession is nearing an end.  Many of these indicators are rooted in the restocking of inventories that happens after inventories get depleted at onset of most recessions.

So the question becomes, which of these two forces will win?  And the answer seems astonishingly obvious:  the first is the tide, and it is still going out.  Not good.  The second is a wave, moving in the opposite direction of the outgoing tide.  Won’t matter.

The trick is not to be fooled by the desire to see good news in an otherwise depressing environment.  Make no mistake, our economy is still contracting; our people are not working; our corporations are shrinking.

It’s easy to be fooled by short term reports that suggest that things are getting better.  But just because the forces that are derailing our economy are happening in slow motion, doesn’t mean that the train will not get wrecked in the end.

Revenues vs. Earnings

July 18, 2009

The S&P500 jumped almost 7% last week, reversing much of the drop from the preceding four weeks.  Volatility fell, driving down the cost of insuring against a drop in the equity markets. 

Positive economic data did not drive the rally.  The Treasury’s borrowings came in worse than expected.  All inflation reports were within reasonable ranges–not too hot, not too cold.  Capacity utilization and industrial production continued their downward slide.  Initial claims were better than expected, BUT they were seasonally adjusted (to the positive) to account for the usual automotive layoffs that occur during this time of year.  They didn’t occur, so initial claims were distorted by the government; look for a return to more normal initial claims in the upcoming weeks.  Continuing claims dropped off, but not because the unemployed were finding jobs; more likely because their benefits were expiring.  Housing starts and permits were better than expected, but still near multi-decade lows, as one would expect when the housing market is still imploding. 

Technically, last week’s rally was not enough to reverse the weekly charts; they’re still weak.  The daily charts, clearly pointed up, but because the S&P returned to an overbought region (940), further upside movement is not a given.  The monthly perspective is still solidly in bearish territory.

So what sparked the rally?  One commonly cited reason was that Q209 earnings from several bellwether firms surprised to the upside.  If the economic recovery is happening, then one would expect earnings to beat consensus forecasts.  Some did.  All is good, right?

In a word, no.  First, many earnings forecasts (conjured up by the same sell-side, bottom-up analysts who were dead wrong about earnings in 2008) were set so low that beating them was not the great success that some in the mainstream media claimed. 

Second, and more importantly, while some major firms were beating estimates on the bottom line, they were failing miserably on the top line.  So these firms squeezed out more profits on declining revenues.

What’s wrong with this picture?  Simple logical extrapolation suggests that sooner or later, these firms will hit a wall with earnings.  If their businesses keep shrinking, they will eventually not be able to cut another employee, another lease, another capex project, etc. to be able to prop up profits.  Nobody can shrink their way to greater earnings.

And the top line erosion was scary: Alcoa (-41% yoy), GE (-17%), Intel (-15%), Marriott (-20%), IBM (-13%), Mattel (-19%). 

So the next time your financial analyst tells you: “the water is fine; go ahead, it’s OK to jump in”, ask the obvious question about earnings sustainability, over the next several quarters.  And be sure to ask about the core underlying problem of our great recession–the massive debt load carried by our private and public sectors and if it’s been fixed.

Chances are your advisor won’t even understand the questions.

Calm Before the Storm?

July 12, 2009

The S&P500 dropped almost 2% last week.  And this drop makes it four weeks in a row, the longest weekly stretch of losses since February.  Volatility (VIX) crept up for the second consecutive week, the longest weekly stretch of rises since January.

Last week was a quiet one for economic data.  Consumer credit continued dropping–not surprisingly as people (consumers) keep losing jobs and fail to secure new ones.  Initial claims fell under 600,000 but that happened during a holiday shortened week (July 4) so it’s hard to conclude that unemployment claims are falling off sharply.  Continuing claims spiked however–to a record 6.88 million.  The trade balance improved, but another takeaway is that trade for the U.S. (and the rest of the world) is shrinking–hardly a positive sign.  Michigan sentiment fell, when a small rise was expected; this surprised many analysts who argue that our consumer led economy is on the mend.

Technically, all time frames are pointing down.  The daily charts suggest that a major support level around 880 has been violated.  Since the middle of June, after peaking at 956, the S&P500 has initiated a weak downtrend.  The weekly charts also point to a breakdown and weakening of the uptrend that began in mid-March.  On the long-term monthlies, the predominant downtrend is still firmly in effect.

The green shoots rally is beginning to fade.   All of the price jump from March 9 to June 11 rested on a multiple expansion, not the growth in earnings.  This means that at some point, the earnings must start to expand.  And the market seems to be implying that that point is imminent. 

What’s eerie is that the equity markets adopted a similar psychology about a year ago, with most analysts expecting a major rebound in corporate earnings in Q408.  We all know what happened.

Other similarities include a rising, and then suddenly falling commodities market.  Oil, for example, ran up strongly this year and peaked in June at about $75 per barrel.  Like last year, oil peaked in the summer and then started falling rapidly–it is now at $59 and falling. 

The Yen and the U.S. dollar are also rising as investors seem to be seeking out safe havens.  And the dollar’s rise is occurring despite the well publicized ballooning of the U.S. fiscal deficit.

And ominously, just like last year, financial stocks are selling off.  Citibank is melting back down into the $2 range.  Larger regional banks, like Regions, are almost back down to their March lows.  And commercial lenders such as CIT are nearing bankruptcy.

Equity market volumes are eroding on a daily basis–not what you’d expect in a true bull market.  And the VIX, which traditionally bottoms during July, is creeping back up after touching levels (25) last seen before the Lehman blowup.

Market risk appetite appears to be fading.  The stars seem to be lining up for a strong sell-off.  It’s not clear if this sell-off will start next week, or the week after.  But between now and the early fall, a lot of signs are pointing to another storm in the equity (and credit) markets.

It’s calm now, but dark clouds loom on the horizon.

June Jobs Report….Not a Good Sign

July 4, 2009

From sputtering to breaking down.  The S&P500 last week ended on a down note–falling 2.5% for the holiday shortened week.  Volume fell as can be expected in early July, but the VIX jumped which usually doesn’t happen in the sleepy summer months.

The weekly data added more evidence that the green shoots theory may have been overblown.  Consumer confidence fell, when it was expected to rise.  The ISM index came in slightly weaker than expected.  Auto sales (except those from Ford) were horrible.  And the big downer was the jobs data.  Non-farm payrolls fell by 467K, almost 100K more than expected.  Unemployment (U-3) rose to 9.5%, the highest level since 1983.  Hourly earnings were flat, not rising 0.2% as expected; and the average workweek fell to 33.0 hours, not 33.1 hours as expected.  Also, initial claims came in at 614K and continuous claims were 6.7 million, virtually at record highs.

The technicals are pointing down on the daily charts.  After three straight weeks of dropping, the weekly charts are showing signs of a weakening uptrend, and the monthly charts of the S&P500 are still in firm bear market territory.

After the jobs report came out, Jeff Frankel (professor at Harvard University) posted some interesting insights on his blog.  He started by de-emphasizing the importance of the unemployment rate, mainly because of the the difficulty of measuring who exactly is looking for a job.

Instead he focuses on the employed people (less debatable) and notes that as a percentage of the entire population (also not very debatable), the fraction of the people with jobs has declined to 55%.  That’s well below the peak reached in 2001 at 64%.  Not a good sign.

But because employment is a lagging indicator, Mr. Frankel highlights another measure: the total hours worked in the economy.  And these hours are driven by the length of the workweek.

Why is this more of a leading indicator?  When the economy slows, firms will cut back on hours worked (the workweek) before laying people off.  When the economy grows, firms will bump up the workweek of existing employees before they hire new people.

This last jobs report told us that the workweek is still falling and setting new lows (33.0 hours).  This is pushing total hours worked down as well.

So as a leading indicator, this data is suggesting that the economy is still not recovering.  In fact, this data suggests that more (many more) layoffs are possibly on the horizon.

Not a good sign.