Tuesday, October 20, 2009

A Longer View of the Markets...

We at Sabrient are "market relative" meaning our buy rating equities outperform the market and our sell rated equities under-perform the market compared to its relative benchmark. In addition we do not try to time the market or even try to give more weights to up or down markets, but it is always with open eyes we need to see the current events and macroeconomic events with full knowledge. We understand that to win in markets it takes long term investment strategies like New York University economist Nouriel Roubini that so succinctly predicted the current crisis stated in Money magazine:
...Roubini himself hasn't bought or sold a thing in response to his own forecasts: He has all of his money in a diversified portfolio of index funds. "That's how I've invested for the past 20 years and how I'll invest for the next 20," he says. "I take the long-term view."

Mixed Signals or Structural Changes?
This blog post will center around the article from the Federal Reserve Bank of Dallas entitled: National Economic Update|October 8, 2009|Optimism Amid Uncertainty. That is definitely a theme that the newsletters from Sabrient ‘What the Market Wants’ has brought up. First the opening statement:
As we enter the final quarter of 2009, a number of important indicators are beginning to show expansion, suggesting that the trough of the current contraction may have come in the second quarter of this year. However, not all incoming information has been positive. Some data suggest that any optimism should be tempered, that this fledgling recovery has a long way to go before the economy achieves stability, and that the key word moving forward is “uncertainty.”

Uncertainty? Most certainly! Most recoveries also are marked by mixed signals as some of the signals may be sectors that are shrinking in overall importance and have more to do with changes in the structure of the economy than the marked level of growth. I already noted that there were some Shoots of Recovery??? in the late part of August and since then we have had more positive signals.
Manufacturing Up, but Job Losses Give Reason for Pause
An example of recent growth is the Institute for Supply Management’s Purchasing Managers Index for Manufacturing. In August, this indicator crossed the critical threshold of 50 for the first time since January 2008. And it remained above 50 during September with a value of 52.6. This typically signals expansion in the manufacturing sector. The ISM’s nonmanufacturing indicator also rose into expansion territory for the first time in a year, to a value of 50.9

Very good but manufacturing has not been a source of job growth from recoveries and the long term trends are down for employment in manufacturing. But this is not to say that manufacturing is dead in the USA like many pundits on TV state. An idea I have also had to try to correct in people's minds. But let us look at what the trend is with regard to the manufacturing sector which could be one of the shrinking sectors as sectoral shifts happen. The chart below tracks the Industrial Production Index (IPMFG) from January 2000 until August 2009 which would mark almost one decade. Data from Chicago Fed Midwest Manufacturing Index and U.S. Industrial Production.

{X-axis is months starting at January 2000 and Y-axis is the index measurement.} It clearly shows that the US will not get back to the level at the beginning of 2000 even if we are starting to see a positive numbers the last two months. It is worth noting that the index had a local high of 104.5 for July-August 2000 which took until May 2004 to recover from the recession and the 9-11 events. The index then had a nice steady growth spurt during which it reached a peak of 114.8 in December 2007 which marked the first signals of banking problems. Basically, a lost decade as far as manufacturing is concered. If you look the data more you can see that every decade was marked by increased levels of manufacturing even as far back as the 40s.

A Lost Decade for Manufacturing... What about employment?
Conversely, the job picture in September is no cause for excitement. During the month, the economy shed 263,000 jobs, and the unemployment rate rose to 9.8 percent (Chart 2). The story becomes somewhat more worrisome when looking at only private-sector jobs. As of September, the number of nongovernment jobs was just below that seen in June 1999, leaving the impression that 10 years of private sector progress has been lost through 21 months of labor market downturn.

Yes another signal of a lost decade and similar time frame for the losses noted above in manufacturing. Anyone follow the DJIA also? November 1, 1999 opened at 10,731.
There is some optimism to be found in the job market, however. Job losses in housing-related industries are now tapering off at about the same pace as in nonhousing-related activities, suggesting that the structural adjustment that this sector has been undergoing since roughly 2005 may be coming to an end.

Is Housing Spelled with a W?

Housing Market Hints at Steps Toward Normalcy

Taken together, existing-home sales and new housing starts give the impression that the housing market may have finally bottomed out (Chart 3). It’s possible that the apparent stabilization has been artificially induced, in part, by the temporary tax credit for first-time homebuyers, something that will become clearer when the tax credit expires in December. Even so, the improvement in housing market conditions is apparent in the flattening of home prices during the three months of second quarter 2009—the first time in six quarters that prices have declined by less than 3 percent. Unfortunately, this too could give way to additional price declines once the large foreclosure inventory on banks’ balance sheets hits the market.

Good news about the job market as well as the glut of houses that were foreclosed to have been absorbed into the market including the new homeowners that took advantage of the tax credits. But that could all be for naught if the rumors of the vast amounts of foreclosed homes may come on the market in another wave. I won't go into all the nuances here but this article seems to cover most of the important ones. Letter of the day? W Housing could take double dip down in 2010. And now back to the National Economic Update article.
Perhaps the most persuasive evidence that the housing downturn has halted comes from the indicator of five-month-moving-average, single-family housing permits, which we use in gauging the housing cycle. According to this indicator, the housing downturn that started in December 2005 may have ended in April of this year, making it the deepest in magnitude and the third-longest on record (Chart 4).

Just because it has been deeper and longer than most others, does not indicate that it may last even longer and deeper. It may also be marked by the double dipping in the W shape as noted above. The worst position to be in would be a vicious cycle of rising unemployment leading to further weakening of the housing market caused by increases in foreclosures as the article Mountain of modifications Industry tries to keep up with avalanche of troubled mortgages indicates.

What Factors Lead to the Housing Crisis?
The last section brought up the issues of what caused the housing meltdown at least with regard to macroeconomic factors. Maurice Obstfeld and Kenneth Rogoff provide some insights into these factors in the PDF paper "Global Imbalances and the Financial Crisis:Products of Common Causes" and a portion of their introduction:
This apparently favorable equilibrium {strong economic performance} was underpinned, however, by three trends that appeared increasingly unsustainable as time went by. First, real estate values were rising at a high rate in many countries, including the world’s largest economy, the United States. Second, a number of countries were simultaneously running high and rising current account deficits, including the world’s largest economy, the United States. Third, leverage had built up to extraordinary levels in many sectors across the globe, notably among consumers in the United States and Britain and financial entities in many countries. Indeed, we ourselves began pointing to the potential risks of the “global imbalances” in a series of papers beginning in 2001.2 As we will argue, the global imbalances did not cause the leverage and housing bubbles, but they were a critically important codeterminant.

What about some more good news and how are consumers doing?
Before getting back to National Economic Update article let me provide a few more shoots of recovery:
U.S. CPI up 0.4% in August on higher gasoline prices Core inflation rate rising at slowest pace in five years
U.S. Q2 GDP down 0.7% vs 1.0 prev est
Spending soars to highest in eight years on clunkers' Real disposable incomes off 0.2%, marking third monthly decline in a row
U.S. Sept. ISM services highest since May 2008
Trade gap narrows on drop in crude imports
Consumer prices rise 0.2% in September Home-ownership costs fall for first time since early 1990s
Except for autos, U.S. Sept. retail sales healthy
U.S. Sept. industrial production up 0.7%
Consumer Fears Ease and Prices Remain Subdued
The pervading unease that has typified consumer spending seems to be gradually lifting as well. Headline retail sales climbed 2.7 percent in August, the biggest monthly advance since January 2006. The monthly gain remained solid—1.1 percent—even after excluding products benefiting from the cash-for-clunkers program. In addition, the University of Michigan’s indexed consumer confidence indicator has risen 15 points since the end of last year, when it hit low levels comparable with those seen in the first- to third-quarter 1980 downturn.

Finally, changes in prices have remained relatively subdued. In both July and August, year-over-year CPI inflation was between –1.4 and –1.9 percent, while core CPI inflation remained about one point below its average over the past decade. Long-term inflation expectations, as implied by forward rates, similarly remain close to historical levels.

The positive aspect throughout the crisis has been that inflation has always maintained low levels. Even when food and gas prices were rising which caused the headline inflation rates to increase, core CPI numbers stayed low. The pundits were dead wrong about stagflation.

Hot Money Flows into {out of} the USA?
Financial Indicators Provide Market Optimism
On the financial side, a host of indicators used to assess the stress of credit and securities markets are returning to historical levels, reinforcing the view that markets are beginning to heal. That is certainly the message coming from the three-month LIBOR–OIS spread. After a period of uncharacteristic elevation, the spread is quickly approaching levels seen well before the current downturn started (Chart 5).

That is very much indeed positive signs and no geopolitical tensions has changed this recently. But this spread could easily widen if there is greater uncertainty perceived or real in the global economy including how the global imbalances become resolved.

Obstfeld and Rogoff stated that China "has plenty of room to take the lead and should." But it was noted that there is a lack of incentives for the individual players and nations to change their policies in the short run that leads to longer term lack of changes. I find it hard see much "hot money flows" entering the USA right now or more broadly as a rising exchange rate for the US dollar as was experienced between April 2008 to March 2009 with a 16.4 % increase.

They also note that the "The dollar is likely to depreciate quite a bit further as adjustment proceeds, although the process will be slower to the extent that major U.S. trading partners, notably China, resist the appreciation of their own currencies." One more passage from Obstfeld and Rogoff:
Are today’s somewhat compressed external imbalances still a problem? Perhaps one could hope that the current pattern is sustainable and will require little further adjustment. A number of considerations suggest, however, that global imbalances remain problematic, both for the U.S. and the world:
• The large private foreign purchases of U.S. assets that helped finance the U.S. deficit in past years have, for the moment, contracted sharply. Given the prospect of much larger U.S. public-sector deficits down the road, with no clear and credible timetable for their reduction, U.S. external borrowing will be prolonged and investor faith in the dollar cannot be taken for granted. Recent research on crises suggests several avenues of vulnerability as U.S. government deficits and debt grow, including self-fulfilling funding crises and currency collapses once fiscal fundamentals enter a danger zone. Given the multiple equilibria involved, the timing of such events is inherently impossible to predict. It is even conceivable, if the fiscal regime comes to be perceived as non-Ricardian and therefore not self-financing over time, that inflation expectations lose their customary monetary anchor, thereby making inflation control by the Fed more difficult.35 In short, the prospect of dollar instability remains.

Most recent developments.
The equity markets and currency markets got a little choppy as the news of the PPI and housing starts figures were released including the Euro reached a high vs. the dollar since August 2008.
Dollar moves choppy after weak U.S. PPI/Housing data
U.S. PPI has declined 0.6% from August to September, while it dropped 4.8% sin the last twelve months, a well larger decline than the -0.2% monthly and -4.1% yearly drop expected by the analysts. Excluding food and energy, the Core PPI Index edged down 0.1% in September, and rose 1.8% year on year.

Furthermore, U.S. housing Starts increased 0.5% in September to a seasonally adjusted annual rate of 590,000 units, too short of the 2.0% increase forecasted by market analysts.

The drop in PPI is significant and the markets reacted in knee jerk fashion but the Core PPI is something that needs to be looked at even more closely. In this case the last month was down but only slightly and the past years numbers are quite in line with maintaining low but positive inflation levels which is good for strong economic growth going forward.

Housing and construction in general also does not seem to be sector that will lead the USA out of high unemployment as the overhang of foreclosed homes and resets mortgages may create a huge surplus of housing units on the market.

What does this mean?
I think I still come back to what Max Lichtenstein and Jessica Renier entitled their National Economic Update as "Optimism Amid Uncertainty". But along the way, we have explored some issues including the insightful paper by Obstfeld and Rogoff about the convergence of factors that lead to the financial crisis caused by the housing sector. And whether some of these sectors could be the impetus for a bain or boon going forward. We also looked at some data that showed a "lost decade" in both employment and the manufacturing sector.

Obstfeld and Rogoff ask what will happen "if the U.S. is no longer the world’s borrower of last resort." But for the mean time, do not expect the global imbalances to be corrected...
Euro touches $1.50 vs. dollar for 1st time since August 2008
Henri Guaino, a top aide to French President Nicolas Sarkozy on Tuesday, said the euro at $1.50 "is a disaster for European industry and the economy," Reuters reported.

A day earlier, French Finance Minister Christine Lagarde, speaking to reporters after a meeting in Luxembourg of euro-zone finance ministers, said officials needed to remain "disciplined" in their message calling for a stronger U.S. currency.

"We want a strong dollar; we need a strong dollar," she said, according to news reports.

And European Central Bank President Jean-Claude Trichet on Tuesday repeated his endorsement of calls by U.S. officials for a strong dollar.



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