Why the Economy will Stumble—Guaranteed

The S&P500 slipped about 0.2% last week in a relatively quiet trading week.  Supporting the price drop was the small jump in volatility–the VIX index crept up by almost 4%.  The week’s price behavior is suggesting that the strong movement in early September is getting exhausted.

The week’s economic data were mixed to weak.  Consumer confidence was much worse than expected.  Second quarter GDP growth, at 1.7%, was a bit better than expected, but still highly indicative of an economy that’s slowing dramatically.  Initial jobless claims were still stuck above 450,000.  Personal spending hit projections, and personal income was slightly higher than the consensus estimate.  But the majority of the increase in income was the result of government provided unemployment benefits–benefits that are not sustainable.  ISM manufacturing was slightly worse than expected, but as the analysis below will show, the underlying components of ISM were far uglier.

Technically, the upward momentum of early September is clearly petering out.  The US stock market, while oversold, is showing multiple hints of an imminent pull back–on a daily charts.  The weekly charts are also not strongly bullish.  The 50 day moving average is still below the 200 day, and the signs of weak or limited upside are numerous.

So what drove the big September rally, despite the clearly poor economic fundamentals? 

Simple, the Fed, and promises of another round of quantitative easing.  Perversely, market analysts became bullish on stocks precisely because economic data got worse.  Why?  Because the more the economy stumbles the more likely the Fed will print dollars (electronically) to pump into the capital markets, which will be supportive for stocks.

So what could go wrong? 

Well if it were so easy, the Fed would never have allowed the devastating crash of 2008 to happen.  But it happened, despite the market’s hopes for a Fed rescue.

What can and very likely will overwhelm the efforts of the Fed is the the imminent downturn in the US economy–an unexpected downturn is exactly what led to the crash in 2008.

Consider this:  starting in August of 2010, between 500,000 and 1,000,000 people who’ve been collecting unemployment benefits for almost TWO years (99 weeks to be precise) will lose their benefits. 

Typically, a person collected something around $2,000 per month.  This “income” will either disappear or downshift to $400 per month, if people apply for and qualify for welfare benefits.

Consumer spending, which makes up 70% of the economy, will hit a wall beginning this fall. 

What will businesses do?  Well, last week’s ISM report offers a clue.  Beneath the headline number, several key components collapsed.  New orders plunged.  Inventories piled up.  And prices paid spiked.  All together, this means that businesses will be hitting the brakes–laying workers off, cutting back on production and suffering from lower profit margins.

The bottom line?  The economy looks like it’s about to hit another wall.  Corporate profits will follow.

Could this be the reason why Obama’s vaunted economic team has been running for the hills, by quitting in droves?

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