It’s been anything but a quiet summer

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Normally (if there really is a normal) financial market participants find summer trading patterns quiet and uneventful. This year almost every part of global markets has seen more volatility than usual due to the uncertainty over the current condition of most of the world’s economies. This week I will update my view on many of the most watched markets and the U.S. economy to give readers a game plan for the remainder of the year.

 U.S. stock market

The rally from the March lows has climbed the traditional wall of worry as it has dragged portfolio managers into the market out of fear of missing the move more than improving fundamentals. The one constant that has kept investors on the right side of the equity market for the past two years has been the tight correlation between the Australian dollar and the S&P 500. The Aussie led stocks lower in the 2nd half of 2007 then bottomed well ahead of the March 2009 low in the S&P. This year the Aussie has led US stocks higher and shows no sign of breaking this tight relationship. One of the keys to making $$$ is to always respect the major trend and not try and guess when it will change and the Aussie/S&P is one of the strongest trends we have seen in many years. We are just days away from September and that month has seen 32 stock price peaks in the last 80+ years so stops should ALWAYS be used for those playing from the long side.

Economists are celebrating a U.S. economy that is losing downward momentum but clearly we continue to lose jobs each month and consumers can’t spend what they aren’t earning. California’s unemployment rate for July rose to 11.9% after losing 35,800 jobs last month, the most of any state. (Imperial county has a 30.2% rate.) It has the fourth highest unemployment rate in the nation (Michigan is #1) and shows no sign of reversing despite so called experts call for a 3rd quarter increase in GDP. The key point to remember about the U.S. economy is that upside momentum does NOT always follow the end of a decline. The next jobs report (September 5) is expected to show a loss of approx 200M jobs and combined with an increase in the monthly population of 125-150M we will continue to see pressure on consumer spending due to a decline in personal income.

Long term interest rates

Seasonally the 2nd half of the year brings lower rates approx 75% of the time since the mid 1960’s. There is a huge tug of war between those betting on a resurgence of inflation due to the increase in government debt and those who believe inflation will remain dormant for many years. The 10 year Treasury remains in a wide trading range with 3.25% on the downside and 3.75% on the upside and probably won’t be resolved until the stock advance loses steam or the inflation component breaks above its early August high of 2.02%. Although everything points to lower inflation readings for the foreseeable future memories from the late 70’s and early 80’s have experienced investors ready to jump on the inflation wagon with bets that will profit if there any signs of an increase in inflation. The winter months are usually not good for stocks but are often the best for bonds and we may see that pattern unfold after the Labor Day holiday.

Fed policy

The biggest concern NOT factored into the markets may be the coming expiration of Fed Chairman Bernanke’s term in January 2010. Markets hate uncertainty and the longer President Obama waits to decide Ben’s fate the more the market will price an uncertainty premium into long rates. There is no reason to believe he won’t be reappointed and his speech this morning at the Kansas City Fed’s annual Jackson Hole conference was mostly about how the Fed went about saving the financial system from a complete meltdown earlier this year. Bernanke is clearly campaigning for an extension to his current contract but the decision is as much political as it is stability for financial markets. In the past 50 years decisions have been made based on market stability but this President doesn’t seem to care as much about that with his theme that those that make above $250,000 per year should support those that make less. Although the economy has lost downside momentum the Fed will NOT even consider raising overnight rates from the current 0.25% level for many months if not years. We would need to witness a period of sustained job growth and a declining unemployment rate before the Fed would take a chance on contracting credit especially since credit availability continues to be a problem for consumers, businesses and real estate investors. I expect short term rates to remain well below long term rates for a considerable period of time enabling banks and other lending institutions to earn a nice profit on the spread between their cost of funds and the rate they charge to customers.

Gold

The great hedge against inflation is a part of many sharp hedge fund portfolios but one must remember it is also a hedge against uncertainty which remains a big part of investor psychology. If inflation were to reappear it’s doubtful the Fed would stand back and not react especially if the rate rose to 5% or more. Deflation is hard to stop and the Fed would like to see some appreciation in price levels but the real estate bubble that just popped was a function of low borrowing rates accompanied by high leverage and yearly price rises. It’s doubtful the lenders will allow the leverage to return for many years and the market place is not going to allow negative real interest rates (nominal rates less inflation) out of fear of losing more money. The cost of holding gold is always high during inflationary periods because it doesn’t earn any interest so timing becomes a crucial issue for those betting on higher prices. A continuation of deflation should not inhibit gold’s ability to break the magic $1000 level but more uncertainty regarding Bernanke’s appointment might be enough to send the yellow metal soaring to new highs.

The BIG elephant in the room

Expectations of an economic recovery are growing each day the stock market rallies and today’s advance increases the confidence level of those profiting from the recent advance. BUT the Fed’s weekly H.8 report released this afternoon is MUST reading for anyone who believes that everything is progressing towards a return to sustained economic growth for the U.S.  Page one of the report is all that is needed to see that loans and leases in bank credit fell again last week ($13 billion) and have declined $175 billion since June. Banks are holding onto their reserves and investing them in Treasury and Agency securities (+ $29 billion last week) or in safekeeping at the Fed and earning interest. Banks also increased their holding of cash last week by $94 billion and it sends a clear message to the world they are terrified of loaning $$$ because the value of most of the collateral used for the loans continues to fall. If lenders are afraid of creating new credit how can borrowers expect to grow their businesses or seek new investment opportunities? They can’t and won’t until the Fed creates incentives to lend and stops paying interest on excess reserves. At some point the elephant in the room will be too big to hide and the government will be forced to recognize what is obvious to anyone who closely follows credit markets. Cash for clunkers and the next program of cash for appliances helps consumers in the short run but takes away from demand in the next year. Tax incentives to banks that lend or guarantees against loss will be needed to move banks away from their “non-risk taking” current stance and the sooner the government moves the better because a credit contraction is like deflation – the longer it is allowed to stay the more difficult it is to change.

Summary

Investors should be cautiously optimistic because the Fed will continue to make sure markets have enough liquidity to function each day. Financial market performance has been much improved in the past four months but banks remain fearful of performing their normal function of lending and support from the Fed will be needed for the next few years. Ultimately banks will be able to repair their badly damaged balance sheets but asset values will not rebound enough to give them the confidence needed to extend new credit. Until the government steps in with incentives any economic rebound will be short lived and four more years of flat economic performance with many jumping on board on a train that is not ready to leave the station. Cash should be the prominent vehicle in most investors’ portfolios awaiting better opportunities at a later date.

Will fewer lay-offs be followed by new hires?

In 6 days I will present my first ever investing principles webinar on Wednesday August 12th at 6pm (PST). I have spent the past 40+ years (200,000+ hours) analyzing economic, investment and interest rate trends and will spend the evening teaching participants how to achieve profits each year from your investment portfolio.  Can you really afford not to register for the webinar?

Today’s job report sent stock market bulls and bond market bears rejoicing as it appears the recession has ended and the U.S. economy is on its way back to the prosperity seen in the early and mid part of this decade. As usual we dig under the surface to find the nuggets that will help lead the way to unraveling the economic puzzle. The headlines tell us that “only 247,000” jobs were lost in July and the unemployment rate “fell” to 9.4% from last months 9.5%. The auto sector contributed 28,200 jobs as it prepared for the cash for clunkers program giving it the biggest job improvement in July in the past 11 years. Unfortunately people don’t quickly consume cars and this demand will result in a decline in auto demand later this year. Many “experts” are stating that the demand for autos is a sign of pent up demand but it’s nothing more than Economics 101 where demand increases when the price drops dramatically. Temporary help jobs fell by 10,000 and if employers saw a boom in business activity they would be adding to this category before even thinking about increasing permanent workers. The seasonal adjustment number obtained from the BLS “birth/death model” added 32,000 jobs and represents the largest July increase in 10 years as it subtracted from the total in half of the previous years. State and local government payrolls were flat in July and without education continued the decline that began last year. Finally only 30.1% of private sector businesses increased employment last month up from 28.6%.

The unemployment rate is computed from a separate survey and fell 0.1% more because 422,000 left the workforce than people finding new jobs. When the number of workers losing their jobs is less than the number leaving the workforce the unemployment rate falls giving the impression that the economy is rebounding and more jobs are on the way. Those seeking employment are becoming discouraged with an average duration of unemployment rising to 25.1 weeks in July from 24.0 in June. The biggest problem with the unemployment rate is that the participation rate fell again last month to 65.5% while the employment to population ratio declined to a 25 year low of 59.4%. Unless the U.S. population begins to decline (doubtful) the unemployment rate will continue higher. Since the consumer has led every U.S. economic rebound and over 2 million jobs have been lost in the past two years it appears the federal government is hoping that demand from China due to a weaker dollar will replace U.S. consumer demand.

Gold

Many believe gold is the best hedge against an increase in inflation but it can also be used as a play against dollar depreciation. Gold continues to move higher and readers have been long and buyers on any sharp pullback awaiting a move to $1000 and beyond. Although inflation is doubtful over the next few years more government involvement in business and less risk taking by the private sector should lead to higher gold prices on the realization the economy will NOT grow without lower taxes and more fiscal discipline.

The Fed and interest rates

Next week’s FOMC meeting is not expected to bring a change in current short-term interest rates as the Fed understands lending rates MUST remain low until businesses and consumers begin to borrow $$$ that is currently being printed but being kept at the Fed for safekeeping. Low interest rates will also insure the dollar does NOT appreciate driving foreign demand to cheaper destinations. Normally long-term rates fall in the 2nd half of each year and I expect them to decline later this year but for now money is leaving bonds and chasing the recent stock rally. Until the equity market slows down long rates will continue in a broad trading range and supported by the recent Fed Treasury and mortgage purchase program. The “key” 4.00% level should hold the 10-year Treasury note but investors should closely monitor the inflation component (nominal rate less tips yield) for any indication of inflation worries by long-term investors. The rate is currently near 2.00% and the high for this year was 2.09% on June 10th. During recent testimony before Congress Fed head Bernanke stated the Fed closely monitors inflation expectations and would take action IF this rate rose above current levels. In the past that action was usually in the form of higher short-term rates but because of the current weak employment situation and contracting credit the Fed could use other tools to reduce future inflationary expectations.

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Consumer credit

Today’s report by the Fed showed a continuation of the credit contraction as total credit fell by $11.3 billion with $5.3 billion coming from credit cards. This follows the $5.4 billion decline in May and is now $76.5 billion less than the peak in 2008. If consumers don’t have jobs and can’t borrow $$ how can they increase their spending? They can’t unless the federal government creates a “cash for deserving consumers” program giving them $$ to spend on needed goods and services.

Summary

The economy is bouncing back from levels that would have led to a 1930’s style depression but my theme for 2009 and 2010 is the U.S. economy is NOT binary and if we slow the rate of decline it will NOT lead to a sustainable advance. Credit continues to contract, banks don’t want to lend, jobs are NOT being created and businesses do NOT want to take risks and expand. It’s the beginning of a four year period of slightly up and slightly down where the federal government insures things don’t get worse but can’t create incentives for things to get better. The winners will be those earning less than $250,000 per year (especially those earning minimum wage) and the losers will be those who own assets on leverage that need appreciation (and inflation) to produce profits.