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Morning Notes For September 17th 2010

The following is a guest post by a buy-side analyst working in a US asset management firm. The author's comments are in italics. I welcome your feedback in the comments:

  • Unemployment, as measured by Gallup without seasonal adjustment, increased to 9.4% in mid-September from 9.3% in August and 8.9% at the end of July. This finding makes it far more unlikely that there will be a significant decline in the U.S. unemployment rate prior to the midterm elections. – Gallup – on the other hand, the unemployment rate may get a boost if the labor force shrinks (chart below)

hopeful finding job in next 4 weeks Sep 2010

  • Basel capital rules worse than the headlines indicate; while the headline numbers call for an increase of tier-1 from ~2% to ~7%, based on changes to the definition of capital, the real increase is more like from ~2% to 10%, a dramatic increase – FT
  • HPQ – co said to be close to naming Hurd successor; HPQ's board leaning towards naming an internal candidate; decision could be announced in the coming week (Bloomberg)
  • Obama reaches out to Wall St, hoping to calm rising tensions w/senior industry execs; NY Post
  • Gold up $5 to $1,280; Copper up 1.5%, slightly off highs

Gold Spot $/oz – monthly chart back to 1975
gold price long term chart Sep 2010

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Here's a rather rare message from personal development guru, Tony Robbins on the stock market:

Source: Tony Robbins blog

Most of the content about the economy and the stock market should be old hat to my readers. While Tony doesn't name the person he has been mentoring, from the description of this trader's success in the 1987 crash and his profitability during the past few years it can only be Paul Tudor Jones II.

This is an educated guess on my part. We know from the 1987 PBS produced documentary "TRADER: The Documentary" that he was heavily short the S&P 500 using Elliott Wave analysis. As well, we know from his more recent comments that he is bullish on gold and bearish on equities (generally speaking).

By the way, the documentary is extremely rare but I have a copy and to be honest, I was shocked to learn that Tudor Jones's home-run during the 1987 crash was underpinned by Elliott Wave analysis.

If we assume that Tony is speaking accurately from his recent conversations with Paul Tudor Jones II, then he is saying that while he was bullish on March 2009, now he is bearish and expecting a waterfall decline sometime into late 2010 or early 2011.

Make of that what you will.

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In an attempt to present a balanced view, below are 10 reasons to be bullish and a single (big) reason to be bearish. The bullish case is built by James Altucher, who I consider to be a smart guy. He feels that he is 'all alone' in being super bullish. How else would you describe a guy who expects the S&P 500 to rally 50% to reach the previous all time highs?

He outlines his reasons the S&P 500 should hit 1500:

  1. Large Cap US Valuations
    While the general market isn't cheap, the largest capitalization companies are selling for very compelling valuations. Many have already pointed this out, most prominently Jeremy Grantham's call for "high quality" US stocks - a notable position for someone who is more inclined towards the bearish camp.

    Also, this weekend's Barron's edition had a short article about the valuation skew, going as far as comparing it to the famous "Death of Equities" cover story from the 1980's. The article included this interesting factoid:

    Oppenheimer strategist Brian Belski recently noted that the gap between the earnings yield on the S&P 500—earnings divided by the index's value—of 8% is five percentage points above the 3% yield on the 10-year Treasury note. Belski's research shows that, historically, when the gap has been this wide, the average one-year return on the S&P has been 26.7%. The last time the gap was so wide was in the late 1970s.

    If you've been reading the blog recently, that should sound familiar: A Case for Undervalued Equities: Earnings & Interest Rates.

    Forward earnings are looking good and unless they fall off a cliff, the price earnings ratio is looking relatively inexpensive:

    SP500 forward PE Jul 2010

  2. European Sovereign Debt Fears
    As for the major concern of a default or reorganization in the European currency and/or sovereign debt market, Altucher points back to the mass defaults of Latin America in the early 1980's. I might also point out that a few years after that there was the Savings and Loan financial crisis which was, at the time another major shock to the US economy and lead to very similar soul searching regarding regulation, debt, the lobbying of government agencies and congress (Keating Five) and questions about nurturing "moral hazard". In the end, the world not only went on, the bull market accelerated.
  3. Unemployment - "Jobless Recovery"
    Altucher says that the labor market has improved for 6 months and that in any case, such hand-wringing over a "jobless recovery" is what we hear at the end of every single recession since the 1960's. He also believes that this will continue to trend positive.
  4. Corporate Profits
    Since they have not yet started to hire, bringing employment back to normal trends, companies are simply operating as normal with less labor costs. This means that more flows to the bottom line, improving their profit margins.
  5. Hourly Pay
    Altucher also points out that hourly pay has been growing at a rate that makes up for the lack of a robust job recovery. Again, this is following the script from previous recessions where hourly pay growth leads employment gains.
  6. Consumer Spending
    This higher hourly rate has pushed consumer spending to a new high - higher than the last quarter before the start of the recession.
  7. Cash on Balance Sheets
    US corporations are now flush with cash and they will use this eventually. When they do, it will be destined to MnA, share buybacks (which they already have ramped up) or capex. All of these will increase demand and improve the economy and either indirectly or directly translate to higher stock prices going forward.

All these reasons but no one is actually buying! I assume that Altucher is thinking of the buyer strike that has been ongoing for more than a year in retail equity mutual funds. Somebody certainly has been buying since October 2008 when most individual stocks bottomed out.
Continue reading '10 Reasons To Be Bullish & 1 BIG Reason To Be Bearish'

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Last week's nonfarm payroll numbers were credited as the catalyst of a major sell off. While the payroll increased by 431,000 in May, expectations were much higher. May's numbers were a very good month - being the largest monthly increase since March 200. But it was skewed by the government hiring of 411,000 temporary census workers. Private payrolls increased just 41,000 after rising 218,000 in April.

Stepping back from the minutia of monthly fluctuations, we can get some perspective on the US job market:

nonfarm payroll long term chart of the day Jun 2010
Source: Chart of the Day

The long term regression line going back to the 1960's shows just how few jobs have been created since 2001. So the recent data point is really nothing new. As the lower pane shows, during the last economic recovery, job growth was not able to recover to its long term trendline.

But what really has me concerned is not the unemployment rate but the duration of unemployment. That is the mean number of weeks that people are unemployed. I first showed this chart last summer. And since then, it has just gotten even more terrifying:

average mean duration of unemployment Jun 2010
Source: St. Louis Fed

As you will notice from the grey recession bars, the Fed is suggesting that the recession is in fact over (as of July 2009). According to the established historical pattern, the current mean duration of unemployment is continuing to go higher, even after the recession is officially over. But this is beyond unprecedented. Even the U6 rate of unemployment has topped out but this keeps rising.

The only silver lining I could find is the recent survey results from the weekly "Job Creation" Gallup poll. This is the net result of a sample of survey respondents, subtracting the percentage of workers who say their employer is reducing the size of its workforce from the percentage who say their employer is hiring new workers and expanding the size of its workforce. The best we can say is that it has flatlined rather than continued to fall:

job creation index Jun 2010
Source: Gallup

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It has been a while since I looked at the yield curve. The last time was around this time in 2007 as I noted that the yield curve was flat. That was among many cautionary signals that are clear as a bell in hindsight (isn't everything?).

If you're wondering when the Fed will move, it is useful to look at the yield curve. This chart from CitiFX, dubbed "the best interest rate chart in the world", shows the yield curve for the past 25 years by looking at the yield differential between the 5 and 2 year US Treasury yield:

5 yr bond yield minus 2 yr bond yield curve Apr 2010

The six major inflection points correspond to major turning points for the economy and the equity markets. The inverted yield curves occurred in:

  • 1989: Almost immediately the Fed started an easing cycle (from 9.75% to 3%)
  • 2000: Within about 2 months the Fed started on a sharp easing cycle (from 7% to 1%)
  • 2006: The Fed dragged its feet, easing in August 2007 (from 6.25% to basically zero)

Then we have three instances where the yield curve was steep:

  • 1992: The Fed started tightening in early 1994 (from 3% to 5.75%)
  • 2003: The Fed waited until June 2004 to start tightening (from 2% to 6.25%)
  • 2010: With the steepest yield curve on the records, the Fed continues to stand aside.

According to the CitiFX report, based on their track record in previous cycles the Fed will key off real estate prices (the largest indication of inflation/deflation in the US economy), the changing yield curve, as well as the unemployment rate.

Another way to look at this is to consider the 5 year US Treasury bond yield relative to the 2 year bond yield (that is the ratio of the two). This also shows a similar picture with the yield curve once again turning down from an extremely accommodative position.

Click graph to see a larger version in a new window:
5 yr bond yield relative 2 yr bond yield curve Apr 2010

You can see the complete report here. But remember that even when the Fed inevitably does start to raise interest rates, that is not necessarily a death-knell for stocks.

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