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Weekly Update: Elevator shaft

As of 06-07-2013

OMG, this is it! The Fed is going to start to taper. Oh no, look at this ugly ISM manufacturing report (more below). This is it! You know this week’s jobs report is probably going to be bad. Worry. About what? Is it too hot or too cold? This morning’s jobs report was neither. Fed Chairman Bernanke said many times that he wants to see unemployment at least at 6.5%, and he may go lower if he doesn’t like the quality of employment. When have you ever seen or heard the word “taper’’ so many times in your life? “Taper’’ showed up more than 23,000 times in a Google search of the past few weeks’ news. Not too hot. Too cold? Evidence is gathering that suggests accelerating growth in the second half.

An astute advisor told me he was worried about the “elevator shaft possibility”—that is, a big move down resulting from all the interference by central banks and country leaders to manipulate markets upward. The Nikkei’s plunge—it’s been falling at a 90% annualized rate since May 22, more than reversing the year-to-date 81% annualized increase before then—is an uncomfortable reminder of this worry. U.S. hedge funds ploughed into the Nikkei in early April when the Bank of Japan launched its massive new QE program and Shinzo Abe pledged even more government stimulus. But unexpectedly, Japanese bond yields backed up, causing the hot money to exit as fast as it entered. The concern is that all this global QE is creating fake growth and market distortions. A new Institute of International Finance report warns financial markets are currently divorced from reality, benefiting from central bank actions even “as signs of potential underpricing of risk persist.” Kansas City Fed President Esther George, a new voting member and lone QE dissenter this year on the policy-setting Federal Open Market Committee, this week said the Fed’s “unconventional actions … increasingly appear to be viewed by markets and the public as ‘conventional.’ As a result, several sectors in the economy are becoming increasingly dependent on near-zero short-term interest rates and quantitative easing.”

Dudack Research notes margin debt is at its second-highest level on record, meaning liquidity could be a problem if stock prices were to fall dramatically. ISI technical analyst John Mendelson says this is the poorest liquidity he’s ever seen and blames it in part on the demise of the NYSE specialists, who were required to trade against the trend; a sharp reduction in block trading, eliminating another source of stabilization; and the exodus of most “Prop Desks,’’ where professional floor traders would often buy on weakness and sell on strength. There is nobody now on the other side of the trade,” he says. Illiquidity is not a one-way street. There can be melt-ups as well as meltdowns. The concern is the elevator shaft, i.e., if the market does start to move lower and there is nobody on the other side of the trade. This reminds me of what I experienced when I traveled after 9/11. Meeting after meeting, with the horror still fresh on all our minds, I would be asked when I thought the next terrorist attack would happen? And I would respond, “I don’t know.” We can only deal with what we handicap. Not to diminish the danger of the elevator shaft—we must remain vigilant. However, today, as a long-term fundamental investor, I see a market that is not too expensive and is consolidating as we said it would. I see inflation under control, political cans getting kicked down the road, earnings that are fine and fundamental economic growth in the U.S. and around much of the world. In the past few weeks, I’ve completed my parental duties with the graduation of my son from college and my daughter from high school, and the only thing I can think of now is, “Relax.” Relax.


Europe’s outlook improves Every country in the eurozone reported an increase in its PMI for the first time since July 2009, with the largest monthly gains recorded in Spain, France, Italy and Germany. Also, 75% of eurozone’s PMIs are above their year-ago levels, matching their highest reading since April 2011, which was just before the current recession started. None of the PMIs are in expansion territory, but a few countries, such as Germany, the Netherlands, and Austria are inching closer to the 50 mark. Greece and Spain's readings are around two-year highs, while France's is at its best level in over year. Also this month, the PMI has been greater than its flash estimate by the most since data began in 2006. Whenever the final reading has beaten the flash by at least a standard deviation, the economy and equities have typically outperformed.

A jobs report that is neither too hot nor too cold Today’s report on May jobs mildly surprised, with the 175,000 gains for the month coming above expectations  but downward revisions to April and March bringing the three-month gain in line with consensus. As has been the case, private payrolls led the gains as government jobs fell slightly. Notable for the markets was that May wasn’t a negative surprise, as the market had been  expecting, and unemployment rose a tick, putting to rest for now concerns the Fed may start to taper (23,001 Google mentions!) as early as summer.

ISM services surprises The index rose to 53.7, slightly above consensus expectations, indicative of continuous growth in services activity since January 2010 and continued moderate growth for the economy. May’s increase was led by stronger readings in new orders and business activity, although the index was below levels historically indicative of meaningful job growth. Price pressures also remained low as the prices index edged down to the lowest level in nearly a year. Perhaps no Fed tapering yet (23,002 Google mentions!).


ISM manufacturing surprises It unexpectedly fell to a contractionary 49.0 in May, its worst reading of the recovery, continuing a trend reflective of a weakening sector. On the plus side, customers' inventories remain too low and allow for an aggressive replenishment if demand improves. For the past two years, manufacturing has moved sideways and has been close to stall speed since last summer. Another concern—the number of industries reporting growth fell from 14 in April to 10 in May, and the strongest growth was in relatively smaller industries. However, several automakers say they are putting off plans to idle plants this summer because of rising sales—total vehicle sales rose to a better-than-expected 15.2 million annual rate in May, an early and positive sign of consumer spending intentions and an indicator that manufacturing’s lull may not last.

Tight-fisted companies hold back construction spending It rose by less than forecasts in April, with strength continuing in private residential construction spending, which has risen at a 22% annualized rate over the last three months. Public sector construction spending remains a drag, as does private fixed investment on nonresidential structures. Companies are cash rich but have been loath to boost investment spending, and the overall trend in capex does not appear to have been boosted by the Fed’s attempts to depress long-term borrowing rates.

More blah The Fed’s June Beige Book suggested overall economic activity increased at a “modest to moderate” pace across all but one district (Dallas, which was “strong”), somewhat softer than the “moderate” pace that was reported in its April Beige Book. Separately, April’s trade deficit widened less than expected, although the previous month’s deficit was revised upward, putting the 12-month total trade gap at its lowest since December 2010.

What else

Mortgage-rate watch Mortgage rates have surged the past few weeks, pushing the average 15-year rate above 3% and the average 30-year rate above 4%, their highest in more than a year. ISI says it’s too early to worry about the impact on housing, however. It says assuming solid employment gains, rates aren’t likely to negatively impact sales until they enter the 5.50% to 6.00% range.

How does this make sense? The total number of people in the United States receiving federal disability benefits hit a record 10,978,040 in May, according to newly released data from the Social Security Administration. In December 1968, 1,295,428 American workers collected disability and, according to the Bureau of Labor Statistics, 65,630,000 worked full-time. Thus, there were about 51 full-time workers for each worker collecting disability. Now there are only 13 Americans working full-time for each worker on disability.

I really hate casinos I spoke this week at a casino in Bethlehem, Pa., with a large group of CPAs. Now, as a CPA who is married to a CPA, I can say with authority that we are a serious group. The same could be said for the group at the casino, which is lucky, because we were talking about serious issues, and although slot machines’ “ding, ding, ding, ding, ding” could have been distracting, I did not lose my audience. These CPAs loved talking about dividends; they recognize that investing is not a casino (though we were in one), and that the ding, ding, ding we are hearing is the steady flow of dividends.

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.
Japan's Nikkei 225 Stock Average is a price-weighted index comprised of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange.
The Eurozone Purchasing Manufacturers Index (PMI) of manufacturing is a monthly gauge of the level of manufacturing activity in the euro zone.
The Institute of Supply Management (ISM) manufacturing index is a composite, forward-looking derived from a monthly survey of U.S. businesses.
The Institute of Supply Management (ISM) nonmanufacturing index is a composite, forward-looking index derived from a monthly survey of U.S. businesses.
Federated Equity Management Co. of Pennsylvania
Copyright © 2014 Federated Investors, Inc.

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