Rate of Change

Today, the very orders that make HFT a beneficial trading strategy and one worth the massive capex, are controlled by the exchanges.  That's the difference between this form of "technological advancement" and those of the past, the direct ownership of the critical intersection between information processing and order execution.

Tax refunds, which can be an important source of cash flow for consumers early in the year, have totaled $20bn less year-to-date than refunds in 2012. Goldman Sachs notes that this is the equivalent of nearly 1% of disposable income over that period, and some consumer-oriented businesses have attributed lackluster sales in late January and early February to lower refund payments. Balancing the possibility of a small amount of additional catch-up with the possibility that some of the decline versus 2012 is fundamentally driven by the effects of tax law changes or other factors, the upshot is that Goldman believes the cumulative gap of around $20bn looks likely to persist. Since the current rate of change in tax refunds looks similar to last year's, this should not weigh further on consumer cash flow. However, it also implies that we should not expect the consumer to receive much of a tailwind from delayed tax refunds in March or April. It does make one wonder a little if this marginal cash-flow is the reason for the extremely unusual cyclical strength and weakness we have seen in macro data for the last few years.

Central bankers have been counting on "the wealth effect" to lift their economies out of the post-2009 global meltdown slump. The wealth effect concept is simple: flooding the economy with credit and zero-interest money boosts the value of assets such as housing, stocks and bonds. Those owning the assets feel wealthier, and thus more inclined to borrow and spend more money. This new spending creates more demand which then leads employers to hire more employees. Unfortunately for the bottom 90% who don't own enough stocks to feel any wealth effect, the central bankers got it wrong: wages don't rise as a result of the wealth effect, they rise from an increased production of goods and services. Despite unprecedented money-printing, zero interest rates and vast credit expansion, real wages have declined.

This recent release of the manufacturing and industrial production data added further support to our view that the much touted economic recovery has yet to manifest itself.  The latest data showed that manufacturing in January fell back but after strong gains in December and November.  However, it is important to remember that the gains at the end of 2012 were driven by the effects of Hurricane Sandy and the "Fiscal Cliff."  That ramp up in November and December is likely to leave a void in demand in the coming months - so January's weakness is likely a return to a more normalized trend. What is clear, however, is that the economic data is not markedly improving.  While monthly data points will remain volatile it is the trend of the data that is most telling about macroeconomic future.  Currently, that outlook remains one of a "struggle through" environment at best. The belief, currently, is that the economy in the U.S. can decouple from the rest of the globe and act as an island of economic prosperity.  With 40% of corporate profits tied to international exposure it is unlikely that the U.S. can remain decoupled from the rest of the global community for long. 

The ongoing message from the mainstream media, analysts and most economists is that the economy has turned the corner and we are set for substantially stronger growth in the coming year.  While that sounds great on the surface the economic data has yet to hint at such a robust recovery.  What is worrisome is that CNBC has started using the term "Goldilocks economy" again which is what we were hearing as we approached the peak of the market in early 2008.  As David Rosenberg pointed out in his morning missive: "Maybe, it's just this:  so long as there is a positive sign in front of any economic metric, no matter how microscopic, all is good.  After all, you can't be 'sort of in recession' - it's like being pregnant... either you are or you are not." The bottom line is that ex-artificial stimulus, and other fiscal supports, there is little in the way of an economic recovery currently going on.  In order for the economy to reach "escape velocity" it will be on the back of sharply rising employment and wages which are needed to prime consumer spending.  This is not happening as the the gap between wages and rising cost of living continues to drive the consumer to shore up that shortfall with more debt.  

There have been several articles as of late discussing that the next great secular bull market has arrived. However, the reality is that this cycle is currently unlike anything that we have potentially witnessed in the past.  With massive central bank interventions, artificially suppressed interest rates, sub-par economic growth, high unemployment and elevated stock market prices it is likely that the current secular bear market may be longer than the historical average. No matter how you slice the data - the simple fact is that we are still years away from the end of the current secular bear market. The mistake that analysts, economists and the media continue to make is that the current ebbs and flows of the economy are part of a natural, and organic, economic cycle. If this was the case then there would be no need for continued injections of liquidity into the system in an ongoing attempt to artificially suppress interest rates, boost housing or inflate asset markets. From market-to-GDP ratios, cyclical P/Es, misconstrued earnings yields, and the analogs to previous Fed-blow bubbles, we appear near levels more consistent with cyclical bull market peaks rather than where secular bear markets have ended.

No problemo....

Things change fast in the technology world. 

The personal income and spending report Friday morning left a lot to be desired for those expecting a stronger economic environment soon.  However, the report fell well in line with what we have been expecting over the past several months as the drag on real wages and incomes have weighed on the consumer; and with personal consumption making up more the 70% of the economy, changes to employment, incomes or credit has an immediate and significant impact to growth. When it comes to the economy, and particularly the ongoing recession watch that has nearly become a sporting event, it is real (inflation adjusted) incomes that matter.  In the most recent report we see that real personal incomes declined for the month from $11,546 to $11,532 billion for the month reflecting a -.12 change. Economic expansion since the last recession has been hovering around a flat line for the past seven months. The next couple of months will be very telling about the strength of the underlying economy.  The manufacturing data continues to point to further economic weakness, hiring plans have deteriorated and the main drivers of economic growth have all stagnated. While we can hope to get lucky that things will work out for the best - "hope" rarely works out as an investment strategy.

The good news this morning is that the 2nd estimate of the third quarter (3Q) GDP was revised up from 2.0% initially to 2.7%.  This is up sharply from the 2Q print of 1.3%. However, the combination of rising levels of unsold goods (inventory), slowing sales growth and declining incomes all point to weaker GDP growth in Q4 and into the early quarters of 2013.  Look for GDP growth in the 4Q to decelerate to 1.5% to 1.7%. While there is currently not an official recession in the U.S. economy, as of yet, the details of the current economic growth are not ones of robust strength. If we are correct in my assumptions the economic underpinnings will continue to negatively impact fundamental valuations as profit margins continue to be compressed. While most of the media, and mainstream analysts, continue to focus on the state of the economy from one quarter to the next - the trend of the data clearly shows the need for concern.  Of course, this also why Bernanke is already considering QE4.  As we stated previously, while economic growth did pick up this quarter it is the makeup, and more importantly the sustainability, of that growth is what we need to continue to focus on.

In a recent article at the NYT entitled 'Incredible Credibility', Paul Krugman once again takes aim at those who believe it may not be a good idea to let the government's debt rise without limit. In order to understand the backdrop to this, Krugman is a Keynesian who thinks that recessions should be fought by increasing the government deficit spending and printing gobs of money. Moreover, he is a past master at presenting whatever evidence appears to support his case, while ignoring or disparaging evidence that seems to contradict his beliefs. Krugman compounds his error by asserting that there is an 'absence of default risk' in the rest of the developed world (on the basis of low interest rates and completely missing point of a 'default' by devaluation). We are generally of the opinion that it is in any case impossible to decide or prove points of economic theory with the help of economic history – the method Krugman seems to regularly employ, but then again it is a well-known flaw of Keynesian thinking in general that it tends to put the cart before the horse (e.g. the idea that one can consume oneself to economic wealth).

Because not one Wall Street analyst could have possibly factored in the impact of Sandy into their expectations of the month's Industrial Production, which in October declined by -0.4% to 96.6 from 97.0 in the Fed's index, well below consensus expectations of a 0.2% rise, and down from last month's 0.4% increase, it is only logical to blame it all on Sandy. Sure enough, this is what the Fed just did: "Hurricane Sandy, which held down production in the Northeast region at the end of October, is estimated to have reduced the rate of change in total output by nearly 1 percentage point." So let's get this straight: Sandy - which hit on October 29, or with about 94% of the month of October done and impacted New York and New Jersey, not the entire US, is responsible for 250% of the entire October 0.4% drop?  Can we please get back to the "It's all Bush's fault" excuses already. At least those were idiotic and funny. Blaming everything on Sandy is just the former. And yes, capacity utilization for the entire USA which came at 77.8%, the lowest since November 2011, and well below expectations of 78.3%, was obviously crushed by a tropical storm that impacted New York and New Jersey for 3 days in the month. Brilliant.

So much for last week's aberration initial claims print of 339K (revised higher of course to 342K). With expectations of an increase to 365K, the DOL just came out with a whopper of a miss, the largest in three months, at 388K, an increase of 46K in one week, which was also the highest print in three months. Remember: this number will be revised to 391K next week. So much for single print indicative of a recovery. As the chart below shows, the rate of change was a 13.45% from last week: the highest in five years! So far, there has been no explanation from the BLS or DOL for last week's outlier print. And no, last week's print was not due to  California, which the DOL reported just decreased by 4,979 in the week ended Oct 6, not the required 49K. What is however worse, is that it is becoming increasingly clear that nobody at the DOL knows what is actually going on following a statement by the Labor Dept that "it appeared that state-level administrative issues were distorting the data", and numbers are simply picked out of thin air. Finally, in truly amusing news, those on Extended Benefits have once again started to rise, after dropping to virtually 0 following expiration of state benefits. 

The recent release of the final estimate of Q2 GDP, and the September's Durable Goods Report, confirmed that indeed the economy was far weaker than the headline releases, and media spin, suggested. While the media quickly glossed over the surface of the report there were very important underlying variables that tell us much about the economy ahead. The problem is that there is little historical precedent in the U.S. as to whether maintaining ultra-low interest rate policies, and inducing liquidity, during a balance sheet deleveraging cycle, actually leads to an economic recovery.  This is particularly troublesome when looking at a large portion of the population rapidly heading towards retirement whom will become net drawers versus net contributors to the economic system. The important point for investors, who have a limited amount of time to plan and save for retirement, is that "hope" and "getting back to even" are not successful investment strategies.

Much has been written on the fading efficacy of the Fed/ECB grand-monetization schemes over the past few years. The following chart clarifies the market's apparent 'getting-religion' moment and that since QE1 - and the wake-up call that indeed the Central Banks of the world will inflate their way out of this mess - the market has increasingly front-run (and therefore removed) much of the actual balance sheet expansion efforts of the monetary overlords. One thing is sure, the latest ramp in stocks is absolutely front-running 'something' big from the Fed/ECB and for now, they are late! Does the Fed need to re-instill some discipline in order to regain its omnipotence?