June 6, 2005
Recession? Risks Developing, but Not Just Yet
With job growth of just 78,000, Friday's employment report was disappointing, but economists were right to point out that one report doesn't make a trend.
Of course, the "one report doesn't make a trend" defense assumes that all your information is coming from just one variable (in this case, the monthly employment report). If you only use one variable, and it has a certain amount of month-to-month variability or "noise," you probably are going to need a whole series of reports (a "time series") to isolate the true information from the random fluctuations. But come on. If that's your strategy, you might as well print "Master of the Obvious" on your business cards. By the time you get enough data from a single variable to be confident in your conclusion about economic conditions, the value of your conclusion will be zip.
If your information comes from noisy variables like employment data, interest rates, or stock prices, you've got a choice: a) sit in a lotus position repeating "one report doesn't make a trend" again and again, withholding judgment until a trend is obvious even to a blind monkey, or b) focus on cross-sectional evidence (movements in many variables at the same point in time) rather than just time-series evidence (movements in the same variable at many points in time). For instance, if you look at whole collection of very good measures of economic conditions, and they start simultaneously deteriorating or diverging in important ways, you don't need to wait for a whole series of reports - you've already got enough information to isolate the "signal" from the "noise."
As an example, a lot of mutual fund investors pay attention to the 200-day moving average of the S&P 500, defining the market to be in an uptrend if the S&P is above the moving average, and a downtrend if it is below. In effect, investors are filtering out the short-term "noise" by taking the average of 200 trading days. The problem is that following a time series of observations on a single variable is an awfully inefficient way of getting your information. By the time a new trend is obvious to you, you're probably not alone. As a rule, it's only useful to panic if you can do it before everyone else does.
When you're sick, having all sorts of symptoms, maybe even keeling over in pain, you don't sit there waiting for your temperature to hit 105. You examine all the symptoms together (or at least go to a skilled doctor that knows how to interpret those symptoms and make an accurate diagnosis). That's one of the reasons I spend so much time talking about the quality of market action across a wide range of measures. Various "divergences" and "internals" (interest rate spreads, volume, breadth, leadership, currency movements, etc) are extremely helpful in figuring out the "story."
Which brings us to the economy. Yes, last month's job number was disappointing. But if you look at prior recessions, they normally didn't start until job growth was even weaker - usually less than 1% growth in nonfarm jobs over the prior 12 months, and less than about 0.5% growth over the prior 6 months. At present, we've still got nonfarm payroll 1.5% over year-ago levels, and 0.8% over the level we saw 6 months ago. In terms of job numbers, an oncoming recession will probably announce itself with payroll growth averaging less than about 110,000 jobs a month over several months. So far, we've got just one.
That's not to imply that recession risks are of no concern. In my Brief Economics Primer, I list numerous indicators that have typically signaled an oncoming recession. Of these, there is a simple four-indicator "syndrome" - credit spreads wider than 6 months earlier, yield curve relatively flat, S&P below its level of 6 months earlier, and Purchasing Managers Index below 50 - that has been present at or near the beginning of every post-war recession, and not otherwise. Of these, the interest rate measures are already in place, the S&P is virtually unchanged over the past 6 months, and the PMI has been moving down relatively quickly toward the 50 level. So again, we've got legitimate concerns here, but they're still what I'd call "developing" risks rather than outright warnings.
The same goes for a variety of other measures, such as the consumer confidence spread, capacity utilization, and others noted in the primer. Suffice it to say that the overall economic picture is tending toward weakness. Which doesn't necessarily say much about the stock market - market declines tend to precede economic weakness months in advance, so even if the economy isn't about to roll over, there's no particular assurance that stocks won't. By our measures both valuations and market action remain unfavorable at present, though we'd quickly become modestly constructive if we observe a shift in that evidence.
As for the Federal Reserve, I remain of the opinion that the bulk of the attention on Fed policy is misplaced (see Why the Fed is Irrelevant). Based on the yield curve, inflation risks, and other factors, short-term Treasury yields are likely to move to about 3.75% in the coming months. The Federal Funds rate will probably do the same - a result that will probably have far more to do with the Fed's reaction to inflation "surprises" than a response to slower economic growth that is already widely recognized. Given that we've gone 2% of 2.75% in probable rate hikes and a ball game has 9 innings, I'd argue about being in the 8th inning - looks closer to 7th to me. But the bigger question is: So what? Market valuations, the abominable U.S. savings-investment balance and Chinese currency policy are the 800 pound gorillas here, not Fed Funds. The U.S. personal savings rate hit the lowest level in history last month with the exception of a single negative reading following 9/11, and yuan-dollar interbank spreads continue to climb, suggesting growing currency pressures (but no tipping point yet). Fed Funds are the least of our worries.
Long-term interest rates are more important, of course. Here, the reaction of the bond market reminds me a lot of what it did when Greenspan was talking deflation. We're seeing another overreaction, most likely because of duration hedging in the mortgage market, which exacerbates volatility (falling long-term yields move intermediaries like Fannie Mae to negative "duration gaps" since their assets - mortgages - get prepaid but their liabilities stay fixed, so they respond by buying long-duration assets like Treasury bonds to hedge, which magnifies the swing). At this point, a bet on long-term Treasuries is a bet on economic weakness without rising inflation, which we could get if the economy rolls over and we see rising credit defaults, or it's a bet on economic weakness, with inflation, but also with a move to negative real yields, which we could get in a dollar crisis. In either case, inflation protected Treasuries look at least as attractive as straight Treasuries here, with less risk.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and moderately unfavorable market action. On the hopeful side, market breadth (advances versus declines) continues to behave well. On the negative side, we're seeing dull volume on advances, expanding volume on declines, and a variety of other evidence of distribution.
While I don't have any particular affection for chart formations, I try to monitor the market in as many ways as I can. However one feels about charts, point-and-figure patterns, and so on, they can be useful tools to consider all the possibilities. The S&P 500 looks interesting on a number of fronts. As several technicians have noted, the daily chart since October looks like a huge head-and-shoulders pattern with current action working on the right shoulder. Personally, I'm more drawn to the action since late April - a classic "rising wedge" on diminishing volume. That's a fun one, because its standard interpretation - an unenthusiastically rising market encountering persistent distribution - meshes well with what we're actually observing from more, let's say, conventional measures. Finally, the point-and-figure chart since mid-May shows an uncorrected "high-pole" ascent. The resolution of those can be interesting, because they often reverse to uncorrected declines (which shows up as two long bars in opposing directions on a chart). On the other hand, a reasonable correction here, followed by a further advance, would suggest that the recent strength is something more than a knee-jerk rebound rally to clear the oversold condition we developed in April.
In bonds, the Market Climate is characterized by unfavorable valuations and relatively neutral market action. Unlike stocks, bonds tend to have much less potential for extended bubbles (since the payment stream is known with certainty), so market action has less ability to temper poor valuations than it does in stocks. At present, the roughly 2-year duration of the Strategic Total Return Fund remains primarily in Treasury Inflation Protected Securities.
Needless to say, it's a challenge to weigh all of the conflicting bits of evidence relating to the economy and market action, determining what new evidence is important, and using it to tell a cohesive story. At present, that story continues to have the following elements: an overvalued stock market, overbought technicals with evidence of persistent distribution, an overbought (and in my view also overvalued) bond market, and an overbought dollar, but at the same time, not enough evidence of risk aversion, inflation, or recession risk to conclude that the markets couldn't hold up for a while longer. In short, with valuations firmly unfavorable on every front, negative developments are less a question of "if" as "when." But "when" need not be now. While we clearly allow for further short-term strength in both stocks and bonds, the probable return/risk tradeoff still appears unfavorable. We remain defensive, but also patient, and open to new information that might change our evaluation of the risks.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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