Sunday, January 06, 2008

Fed in Tough Position

- Employment report confirms economic plunge, Fed & administration remain indifferent, market responds in kind
- Job creation not negative but it may as well have been.
- Fed is in a tough position, but doing nothing for fear of inflation definitely won't help.
- Positives: valuations are reasonable, fiscal stimulus will eventually pass, global economy will survive, and that equals a shorter economic hiccup.
- Market getting short term oversold as NYSE indices approach natural support at the November low, but a bounce is not likely to change the market's character.

The first three days are in the book and they are way down.

Futures were up ahead of the jobs report as stocks were going to try and build off of Thursdays push and rebound some in relief to the prior selling. Then the jobs report missed big with unemployment jumping to 5%, the futures tanked and so did the market when the bell rang. They were down, fell hard to midmorning, bounced toward lunch, then rolled over again and sold to the close. The action confirmed the market's weak technical positioning that it has built in since Q3.

On top of the jobs report China issues its quarterly statement that it would 'take measures' to 'slow' its economy. INTC received an analyst downgrade and it was clocked on the session, capping a week that saw it decline 18.5%. The ISM services topped expectations (53.9 versus 53.5 expected) but the impact was similar to a lone raindrop hitting hot pavement.

Investors were waiting on what Fed Vice Chairman Kohn and President Bush had to say about the economy and what Bush intended to do about the economy given the string of weaker data summed up by the jobs report. Kohn didn't even mention the unemployment report in his comments. It was classic denial. The WSJ ran a story for the Fed Friday indicating that price increases in food and energy may keep it from cutting rates at its January meeting. Kohn refused to discuss the jobs report as it flew in the face of the Fed's adamant position that inflation was the primary concern. As for Bush, he did not come out with anything with his meeting with Bernanke and Paulson. Most speculate he will do something at his state of the union address on January 28. He did say the economy had a solid foundation and the financial markets were strong. That was a punch in the nose to investors who know the stock and bond markets are signaling major trouble. You know the result: more fuel to the downside fire as investors realized they waited in vain.

Technically the action was crappy to crappier, at least looking at the major indices. They gapped lower and continued selling through the session. The size of the losses and the close at the lows signaled massive weakness.

Internals: Horrid as you would expect, matching the point declines. -4.4:1 breadth on NASDAQ and -3.4:1 on NYSE. NASDAQ foreshadowed this action as breadth was worse than NASDAQ on Wednesday and Thursday; NASDAQ was losing its relative strength. Volume surged to the downside of course, spiking above average on both NYSE and NASDAQ. After cracking the 200 day SMA on Wednesday and Thursday, big institutions were dumping NASDAQ shares as the growth model they need was formally laid to rest by the jobs report.

Charts: Nothing positive here, at least long term. NASDAQ took awhile to start its selling, but when it did it quickly surpassed the NYSE indices. It broke below its November low, the first of the three large cap indices to do that; again, NASDAQ quickly overtook the NYSE large cap indices when the dam broke. SP500 and DJ30 sold hard as well, but they remain above their November lows though barely. They both closed at this same level in August after that big spike lower intraday mid-month. Maybe they can form a double bottom here, but they will have to prove it and no one was ready to buy into that possibility just yet. One thing that this test of the November lows does is set up an oversold bounce after just over a week of selling.

Leadership: As we expected in the Thursday report, a weaker jobs report sent just about all stocks lower. Technology pretty much gave up. Despite the overall selling, energy, agriculture, heavy construction, metals - - the international plays, all held near support. Of course, so did defensive stocks such as JNJ, PG, MO. Nonetheless, if you look at their positioning you would not expect to see the indices tumbling down six straight sessions and crashing through support. With the market getting oversold and these stocks holding near support, a relief bounce should slingshot them back up. If it does not then when the relief bounce ends things are likely to get really ugly.


Jobs report manages to hold positive by a hair.

Given the weekly jobless claims a negative non-farm jobs report was a possibility. Thus the 18K jobs to the upside was almost a moral victory. Well, not almost. It was not really close. It was the weakest showing since August 2003. That was Q3 2003 and you may or may not recall that the economy grew at a 7.3% pace in that quarter. Cool. So this report means nothing, right? Not quite. At that time the economy had been in the toilet for over a year and one-half and was on the rebound. This time it is heading the other way.

November was written up to 115K from 94K. October was revised down to 159K from 170K. The missing link for December was the private service sector. It was 93K, well below the 152K three-month average. Of course it did not help that the usual monthly losers (construction and manufacturing) were lower as well.

Employment is a lagging indicator. The ISM reports, durable goods, retail sales, leading indicators all were heading lower in advance of this report. ECRI's annualized growth rate hit its lowest level since the end of the 2001 recession. Moreover, the market has struggled since the summer. When the jobs report finally caught up with the other indicators the market figured the die was cast. It was already lower and weakening and this data sealed up the package.

Fed is in a tough position but that is what it is there for.

The Fed has to deal with some issues that its predecessors did not, mainly some modest but persistent inflation left over from Greenspan's low, low interest rates that were left too low way too long. Thus we keep seeing some issues with consumer prices, mainly outside of the core, but within the core prices are quite well contained and the inflation pressures, the things that drive prices in the future, have waned. Indeed, ECRI's future inflation gauge fell to a 31-month low. It is very good in predicting inflation and this report indicates inflation just is not the problem.

What we are seeing as inflation is the rise in food and in energy. Of course, it seems everyone but the Fed knows that the ethanol mandate is what is pushing our food prices higher: a food chain based upon corn syrup will rise in price if corn prices rise. As corn is an inefficient feedstock to make ethanol, it takes a lot of corn to produce a gallon of fuel. Thus we are competing with fuel when we go to the store to buy food. This doesn't even account for the massive amounts of water it takes to produce one gallon of ethanol, another cost we are paying.

The irony of this ethanol folly is that it is doing nothing to dent oil or fuel prices. US consumers and businesses are not pushing prices higher; they are part of it, but it is a world effort, along with a lot of worry and speculation that is keeping a premium in oil prices. The Fed cannot change this unless it can bring down all world economies and thus reduce oil demand. It is as if the energy market knows we are not going to produce enough ethanol to make a difference. If we planted every open space in the US we might have enough to impact energy prices, but all of the fertilizer used and water wasted, not to mention the leveling of all open spaces to plant, are much more costly than the price increases in oil. There is already empirical evidence of the fallout of this planting: along the Mississippi river there is so much planting of corn and a corresponding increased use of nitrogen and other fertilizers, the runoff has killed fish in a 175 mile stretch of the river. We go to all of the expense to clean up our water and then pass a scientifically unsupportable government mandate that provides the incentive to pollute again. Nice, well thought out planning. Instead, energy prices keep climbing, almost mocking this effort.

Unfortunately the Fed is being pressed by the gold bugs and other central banks into maintaining a hawkish stance, one that places inflation fears above growth concerns. On Friday that WSJ article was the Fed attempting to prepare the way for a 'no action' meeting in January. Talk about ill-timed. Did they bother to look at the jobs data that they did have ahead of its Friday release? Worse, did they have it and still run that 'let them eat cake' article? The Fed Funds futures contract has basically priced in a 50BP rate cut in January post-jobs report. Does the Fed still maintain its position post-report as well? It cannot change oil prices by raising rates. It cannot lower food prices by raising rates; indeed, you can track the rise in our food prices to the mandate to produce more ethanol. Raising rates is not going to lower food prices.

So we have a Fed that does not want to cut rates needing desperately to do so as well as continue injecting liquidity into the market. Problem is, it can hack rates 50BP in January and again in February and still not make a difference. Not because that would not finally provide an environment of easier money, but simply because the Fed is too late to the game.

Needed: some fiscal policy stimulus.

Monetary policy cannot solve the issues. The Fed has waited too long as it did in 2000. It cut rates from over 6% to 1% and the economy went steadily lower. It was not until the fiscal stimulus, and specifically the second round that provided investment incentives, that the economy recovered. Right now the economy needs fiscal stimulus.

And aren't we lucky. Friday President Bush met with Bernanke and Paulson to discuss options. He commented after the meeting about the strong markets and solid economic foundation, but gave no details of what he has or doesn't have in mind. Speculation is that he will wait until the State of the Union on January 28 to announce any possible stimulus. As with the Fed action, that is too late.

Of course it will still need to get through a hostile Congress, and with that situation about all that tends to pass, particularly for lame duck President in his last year, is a 'rebate' program such as the first tax cuts in the last recession. They had zero impact. Of course they did. Every time this cheap, politically expedient 'incentive' is used it does nothing. What is needed is a change in corporate tax rates, say down to 0%. Also, some assurance that the dividend treatment will be extended as well as the investment incentives would give certainty and thus capital investment once more. There is some momentum to reduce corporate tax rates and to provide the middle class a tax cut or make those currently in place for the middle class permanent. The latter likely would not have much impact at all, but it is doable. That is a sorry commentary on the current political climate. We hear the democrats are working on a stimulus plan of their own as each party tries to beat the other to the punch in an election year. You can bet that will be targeted at those who don't pay taxes and the dubious benefits that provides the economy. We also hear, however, that a corporate tax cut is another democratic proposal in the offing. Some sow's ears, some pieces of gold.

There is thus potential for some fiscal action, but it has to be the right kind, and unfortunately the parties are philosophically opposed to one another as to what kind of stimulus they will agree to. We all know what works: proposals that incent capital investment. Sadly, what we know works often falls victim to political games, and in an election year where half of the candidates (on both sides) are railing against corporate greed (do they know that most corporations are considered small, i.e. family corporations?), providing the right kind of tax cuts as stimulus is about as likely and the process about as pleasant as passing a quarter-sized kidney stone.

By: Jon Johnson, Editor

Jon Johnson is the Editor of The Daily at

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