What We Learned

As I was putting together my thoughts for last night’s post, I couldn’t help but note that my assertion that today’s BLS jobs data would be largely irrelevant may have struck many as strange.  Job creation, as we are repeatedly told, is the key to this economic recovery and, therefore, any data point that gives us a sense of this growth must, by definition, be an important, market-moving event.  Better-than-expected growth would translate to higher equity market prices, due to the resulting increase in consumption and, by extension, improved corporate earnings.  Less-than-expected growth would, as you might expect, translate to an equity price decline as the prospects for consumption and earnings growth would decline accordingly.  Pretty straight forward stuff you might say.  So why did I frame today’s jobs report in such a passé manner if the conclusions are so straight forward?

The reason for this has to with momentum and the effect it has on markets of all kinds.  In numerous past posts, I’ve alluded to the fact that market prices frequently do not reflect the true underlying fundamentals of their respective securities.  Examples of this abound.  The technology stock bubble at the end of the past century is one that immediately springs to mind.  During that time, valuations of the technology-related shares reached levels that had simply not been seen before en masse and had no basis in reality.  Because of the rampant growth associated with the widespread adoption of the internet, too many investors were willing to assume that those rates of growth could be expected to continue in near perpetuity.  However, anyone willing to take a step back and look at the bigger picture realizes that eventually the law of large numbers would cap, and subsequently decrease, the rate of growth.  Think about it terms of salary.  Is it harder for you to get a raise from $25,000/yr. to $50,000/yr. or from $100,000 to $200,000?  Putting aside all the constraints associated with a specific firm’s ability to pay the range of salaries, it is clear that coming up with an additional $25,000 is much easier than finding another $100,000.  The growth rate (100%) associated with each salary is the same, of course, but the likelihood of each increase occurring is VERY different.  Obviously the $25,000 raise will be much more likely than the $100,000 raise.  Unfortunately, though, this simple logic wasn’t applied during the tech bubble.  It wasn’t applied during the sub-prime-led financial meltdown.  It wasn’t applied during the railroad boom of the 1800s.  And it wasn’t applied during the Roaring ‘20s.  Could this be happening again?

To compare today’s market environment to the major bubble periods of the past is to greatly overstate our current conditions in my opinion.  However, I bring these comparisons to the forefront to spotlight how fundamentals, all too often, are meaningless in the ultimate direction of the market.  That’s why I viewed the absolute levels reported by the BLS today as largely irrelevant and looked to the reaction with much more interest.  While fundamental data points like employment levels, GDP growth, and manufacturing activity may be used as justification for a bullish or bearish bias, only supportive data will be considered while countervailing items are dismissed for a host of reasons.  And it is the manner in which markets react in the face of fundamental data that provides us with the best insight on where momentum currently lies.  Fundamentals, though, provide a sense of just how far momentum is moving market prices from reality.  Obviously, this creates a great deal of tension.  If fundamental data suggests things are overvalued, it would stand to reason that, as an investor, you would want to avoid buying in since prices are getting ahead of themselves.  But, on the other hand, knowing that momentum could, and frequently does, push prices significantly beyond that which fundamentals imply could suggest that there is still a fair bit of money to be made, thereby warranting entry.  So what does today’s reaction to the BLS numbers suggest is in the offing for the market since there is strong evidence that, fundamentally speaking, equity valuations are a bit rich?

With reported job gains of 192,000 in February and a corresponding drop in the unemployment rate from 9.0% to 8.9%, today’s report was largely consistent with expectations.  The decline in the unemployment rate was perhaps better than expected by most, but, again, this was consistent with a rate near 9% that most were expecting.  So with the data slanting slightly to the positive side of the ledger, it would have stood to reason that equity markets would have rallied through the session.  But as is too often the case, what seemed likely to happen ultimately did not come to fruition.  On the day, the S&P 500 fell 9.82 points (-0.74%) to 1,321.15.  To be sure, overly optimistic expectations that manifested themselves in the session leading up to today’s release contributed to the pullback, but, as I mentioned last night, concerns over the continued rise in crude oil prices and geopolitical unrest once again outweighed any positive sentiments that may have lingered.  This is evidence, to me, that the strength of the liquidity-induced rally since Q3 2010 is beginning to fade.  In periods prior (February most recently), an addition of 192,000 domestic jobs and a move in the unemployment rate below 9% would have been met with a HUGE spike in share values.  Clearly this was not the case today, hence my conclusion.  To be sure, the peripheral issues of commodity prices and geopolitics are contributing to the muted response, but the fact of the matter is that neither of these items were of concern to the market on Thursday as share prices rose sharply.  And with the commodity and global situations little changed since then, I find it hard to believe that the price action we saw today was driven by fundamental developments rather than a shift in investor sentiment.

Clearly, there are a lot of issues that are affecting the marketplace right now so it’s hard to keep up with all that’s going on.  With so many headlines coming out of Libya and the Middle East, weekend news could really sway direction on Monday.  But, again, today’s reaction appears to warrant caution over the near-term.  I’ll stick with gold, some cash, and perhaps even a little Treasury bond exposure (short-term position for the Treasuries) until the dust settles.  At the very least, these issues will have an effect on subsequent economic data points, which will likely be used to further the bearish narrative that is now materializing.

Until Monday…..

Whoa, Dude…..

Well apparently the potential issues associated with higher commodity prices (namely crude oil), geopolitical unrest, and the residential and commercial real estate markets were solved overnight as the major equity indices jumped about 1.75% during today’s session.  To be sure, news of a reduction in initial jobless claims to 368,000 during the last week of February along with solid productivity gains (2.6% during Q4 2010) helped to underpin today’s move, but, watching the pre-market futures this morning, it was clear that the market was simply in the mood to trade higher (S&P 500 futures were about 12 points above fair value prior to the open of trading).  This is further evidenced by the number of people who are pointing to the weakness in crude oil prices throughout the day as a reason for the run up.  Interestingly, those noting the decline in crude apparently gave no attention to the absolute value of the commodity as prices remained firmly above $100/barrel at $101.88, down about $0.35 on the day.  This is certainly not the scale of move that will alleviate the negative impacts on the economy and I am somewhat surprised that so many commentators would accept this notion so quickly.  I guess it’s just another reason why we all need to take media reports with a healthy grain of salt.

Perhaps even more interesting than the suddenness of today’s equity rally was the relatively sharp drop in gold bullion prices, down more than $20/troy oz. to $1,416.  Having just put in a new closing high, gold bulls, like myself, would like to have seen a greater amount of follow through buying.  Obviously that has not materialized so far.  Somewhat hawkish comments from ECB chairman Jean-Claude Trichet regarding the need for higher interest rates may have triggered some of today’s selling.  However, these comments were made in a longer-term context and did nothing to sway the ECB’s decision to keep its benchmark rate unchanged, so it’s quite possible that there was a bit of an overreaction in the bullion market.  Having seen prices jump from the $1,325 level just over a month ago, it is also quite possible that there was a fair bit of profit taking implicit in today’s trade, especially given the lack of follow through in upward price momentum seen yesterday and today.  Only time will tell if this marks a true reversal or a temporary setback.  I think it’s worth noting, though, that prices could not hold above the previous resistance level of $1,430, which is a fairly negative technical development.

Despite this rash of euphoria that swept through the marketplace today, I think equity investors are setting themselves up for a repeat of the first week of February.  At that time, positive private sector job creation was reported by ADP (just as was the case this week) and the markets moved up sharply in anticipation of an equally impressive jobs report from the Bureau of Labor Statistics.  And as is too often the case, the correlation between the two reports proved spurious and the BLS numbers fell far short of the levels implied by ADP’s report.  I see this scenario as quite likely to happen again this month.  That said, this doesn’t mean that the BLS numbers will be negative.  In fact, I fully expect them to be modestly positive, which would be consistent with the slow, but deliberate growth in employment that is likely taking place.  But with most market watchers looking for a number between 200,000 and 240,000, I think the risk is clearly on downside as I believe companies continue to add positions in a modest fashion (Q4 productivity growth further supports this notion) that is inconsistent with recent economic cycles.

To confuse the employment issue even more, I wouldn’t be surprised to see the unemployment rate move up even if the reported job numbers meet or exceed market expectations.  If the job market is, in fact, improving in a manner consistent with current expectations, I think it’s reasonable to assume that workers, previously classified as discouraged (meaning they are no longer looking for work and, therefore, not counted as part of work force), would once again begin actively pursuing positions.  This expansion of the labor pool would likely offset many of the job gains during the period, thereby increasing the unemployment rate.  With so much subjectivity implicit in the calculation of the unemployment rate, predicting its ultimate direction is difficult at best.  But if the past six months have shown us nothing else, it’s that the reported job gains/losses often provide little to no insight on the unemployment rate.  As such, the question becomes one of market focus.  Is the unemployment rate more important than the actual reported position gains/losses? 

Unfortunately, I think the answer is that the equity market will focus on whatever number fits the narrative that is currently en vogue.  This was never more evident than last month when the unemployment rate fell to 9.0% despite a modest addition of 36,000 jobs that was far below consensus estimates.  Subsequent to that release, market chatter regarding the implicit seasonality of the job creation numbers and the ‘flaws’ in BLS methodology abounded as justification for why the numbers were so different from consensus estimates.  In previous environments, these same pundits made the case that it was more important to focus on the change in the numbers from period to period rather than their absolute levels.  Obviously, this is simply an attempt to fit the data to one’s opinion.  As such, the market, once again, chose to focus upon the unemployment rate rather than the actual job numbers since it was more consistent with the prevailing narrative.  This is what makes trading around the BLS numbers so difficult as it’s more about identifying which theme the market will run with rather than the actual economic outcomes that are implied by the reported numbers.

By this point, I’m sure you’re wondering why I’ve gone on and on about the BLS jobs report and its various flaws and issues.  I bring these items to your attention because I believe that tomorrow will go a long way towards telling us what the underlying mood of the market truly is.  Having run nearly straight up since September, it’s obvious that the bulls have been in control for some time now.  But over the past couple of weeks, it has appeared that fear and doubt have begun to creep back into the marketplace.  Coupled with a widening perception that the equity market needs to take a step back after such a powerful move higher, the table is certainly set for some kind of retracement.  Today’s price action, though, certainly threw some cold water on the bear’s case.  As such, the manner in which the equity market reacts to tomorrow’s numbers will be among the best indicators of underlying investor sentiment and intermediate term direction available.  As most bull markets roll over amidst a wave of positive (though backward looking) news, failure to rally through a better than expected number tomorrow would harbinger negative things to come and prove consistent with growing negative sentiments.  However, reluctance to selloff in the face of another set of disappointing numbers would clearly show that the party is ripe to continue for a while longer.  To me, this is the real value of tomorrow’s report; the numbers are nearly irrelevant.

Finally this evening, I want to apologize again for not getting a post written last night.  As I mentioned via the FT Twitter feed (@FundTechBlog), I was pretty sick last night and simply unable to provide any meaningful commentary.  Thankfully, I appear to be over the hump (though not totally in the clear as yet) and the interruption limited to only one night.  Additionally, with the start date of my new position quickly approaching, I wanted to take this opportunity to say thanks to Peggy Sherman (a former colleague) for her support and guidance during the past year as I worked through several career-oriented issues.  Your willingness to listen and share your candid opinions on a range of issues was truly invaluable.  For this I am truly grateful, especially since this level of generosity is becoming less and less common in the workplace.  I can only hope that my new colleagues prove as generous and selfless as you.  They’ve got some mighty big shoes to fill.

Until tomorrow…..

Crude Reality for Equity

Unsettling.  That’s probably the best way to describe today’s session if you’re an equity bull.  With the S&P 500 down more than 20 points on the day (-1.57%) and settlement near  the lows of the session, it seems clear that today’s downward bias may be more than a fleeting phenomenon.  Volume was average, so there’s no real indication of panic selling.  But when you consider that crude oil prices moved above $100/barrel again today and that numerous geopolitical issues remain unresolved, it makes sense that the equity market should back track a little.  And in many ways, today’s steady drift lower was merely a continuation of the selloff that began with the Egyptian unrest seen just over a week ago.  Gold prices also reflected this generally negative tone as bullion jumped over $23 to a new all-time closing high of $1,434.50/oz.  So despite some solid economic data today (manufacturing activity was up yet again), investors were simply unable to escape the broader concerns associated with higher energy prices and their ultimate impact on global economic performance.  As such, I view today’s move as confirmation of the fact that we are in the midst of a corrective phase in this equity market that will likely see the S&P 500 drop anywhere from 7 – 10% from its recent highs.  With the near-term price action in the gold, Treasury, and volatility index markets clearly confirming an improved demand for ‘safe haven’ assets, the ability to make a bullish case over the near term is getting tougher by the day and, therefore, warrants defensive posturing for the foreseeable future.  For reference, if the pullback proves to be consistent with my expectations, that would mean we could see the index move to the 1,200 level over the next month or two.

Clearly, I’ve been an equity skeptic for some time now, so it would be fair to say that I’m merely continuing my bearish mantra in an effort to eventually be proven correct.  That’s a fair criticism, I guess, but the fact remains that I have honestly disliked this equity market (on both an economic and valuation basis) for nearly six months.  And were it not for the monetary policy interventions of the Federal Reserve providing the justification for investors to buy shares during this time, I believe the negativity that we are beginning to see would have crept into the market much sooner.  In retrospect I should have followed the old Wall Street mantra of not ‘fighting the Fed’.  But the fact remains that most objective assessments of the domestic economy’s performance note the significant portion of economic growth that has been predicated on federal stimulus, both monetary as well as fiscal.  And with these ‘drivers’ coming to a deliberate end in the not-too-distant future, the realization that the U.S. economy will have to generate sustainable, self-derived growth amidst an environment of rising energy prices, constrictive Chinese monetary policies, and geopolitical unrest is finally beginning to hold in investors’ minds. 

To be fair, I am trying not to read too much into today’s price action since, as I’ve stated many times previous, one day does not a trend make.  But unlike previous periods when I noted similar mood swings in the market place, there appears to be no Federal Reserve stimulus plan at the ready to alleviate the growing mood of pessimism that appears to be taking hold.  In fact, reading between the lines of Federal Reserve Chairman Bernanke’s Congressional testimony, it seems clear that the increased threat of inflation (which is something the Fed has been deliberately attempting to orchestrate) coupled with an improved internal economic forecast for 2011 has largely negated any desire to add additional stimulus to the economy at this point.  To my mind, this opens the door for a more ‘normal’ ebb in the equity markets as the Fed put will be off the table for the time being.  To be sure, any sustained sell off of meaningful scale will get the chatter going fairly quickly, but, for now, a more fundamentally-based trade can take hold, which is something that really hasn’t been seen in six months (or three years for that matter).  And as I noted in last night’s post, valuations are stretched and primed for some sort of recalibration.

So If I’m correct that we are in the midst of a pull back, the question becomes one of next steps.  As you may recall, I’ve said that the continued strength of corporate earnings has compelled me to be a buyer on dips.  I am still firmly of that opinion, but with one major caveat.  China.  As noted previously, the reliance upon China and the Asian region for corporate earnings growth over the past few years has only increased.  This is part of the reason why earnings have been able to disconnect somewhat from the overall performance of the U.S. economy.  But with China grappling with internal strife (as always) and clearly attempting to stem the effects of commodity inflation through more constrictive monetary and banking policies, it seems evident that the earnings growth engine of the last decade may be primed for a slowdown.  This is why I’ll be weighing the relative health of the domestic economy with that of Asia when share prices near that 1,200 – 1,225 range.  But assuming no material change from the conditions we are seeing today, my bias will be to add equity exposure.  Granted, there’s a fair bit of ‘show me’ that’s going to have to materialize between then and now, but proof is all I’m asking for.

Looking to tomorrow, keep an eye on both crude oil and gold for signs of a continuation of the fear trade.  Also, as I Tweeted this morning, look to shares of Goldman Sachs (GS) for signs that the recent implication of a board member in the Galleon insider trading scandal is having a meaningful impact on share value.  With the SEC having stated previously that there would be a rash of ‘big name’ firms coming to light as a result of recent investigations, GS could prove to be the canary in the coal mine for the entire financial sector.  And as the last few years have proven, yet again, as go the financials so goes the markets.

Until tomorrow…..

At Long Last

As I've intimated a few times over the course of the past two months, Fundamentally Technical has not been terminated, but merely on a temporary leave of absence.  Since leaving my previous employer, Briaud Financial Advisors, in late December, my focus has been on finding another position that would fill the void that caused my departure from the firm.  Because of that, I was simply in no place, mentally, to provide any coherent analysis of the markets.  But with this process now complete (I have accepted a Senior Financial Analyst position with Suddenlink Communications’ CAO group to do merger and acquisition due diligence and strategic asset valuation.), I am pleased to report that things are getting back to normal and, therefore, FT will once again publish the daily commentary and insight that you have come to expect.  My sincerest thanks to all of you for your patience during this trying time.  I’m excited about this new opportunity and look forward to working with a great group of people.  And along with this change in position, I am excited to have FT back in focus.  I know the coming months will see some of my best work come to fruition and I’m excited to have you along for the ride.

Now on to the meat and potatoes…….

Without delving too deeply into all that has transpired since my last post, suffice it to say that the euphoria of December 2010 has followed through in an unabated manner into the new year.  So far this year, the S&P 500 is up nearly 6.0% as corporate earnings and domestic economic indicators continue to improve.  But just as I suggested prior to my hiatus (and a couple of months leading up till then), valuations are suggesting that the equity prices are getting ahead of themselves.  According to Standard and Poors, the S&P 500 earned $76.97/share during 2010.  This translates to a trailing twelve month price to earnings ratio of 17.24.  With a historical average closer to the 12 -15 range, it is clear that the current market environment is not conducive to adding equity exposure.  This is not to say that prices can’t move higher, of course.  If the past three months have shown nothing else, it’s that momentum is a real phenomenon in the marketplace, which makes reconciling fundamental issues with market prices all the more difficult and frustrating.

That said, my negativity on equity at this point is largely driven by valuations rather than economic concerns, though there are issues in the intermediate-term outlook.  GDP, PMI, manufacturing activity, and a host of other economic reports continue to paint a picture of a domestic economy that is continuing to heal itself, albeit with a great deal of help from the Federal Reserve.  The bigger question, of course, is whether or not this economic recovery will be able to continue apace as federal interventions begin to wind down and the economy is forced to stand on its own two feet.  With QE2 slated to expire in June, the liquidity beer keg that has intoxicated the financial markets for the past three years will finally begin float.  And just like a party goer that’s had a little too much fun, the question isn’t whether or not there’s going to an economic hangover, but rather how much will it hurt.  If economic growth has truly been organic and self-sustaining during this time, the effects of a draw in liquidity should be relatively minor.  Unfortunately, though, I’m concerned that we’re going to need more than a couple of aspirin to stave off the headache since any conversation with your neighbors is likely to include commentary on a friend/family member who has lost a job or been unable to find a job.  Such anecdotal evidence is highly suggestive of an economy that still has fundamental issues to work through.  And even if such stories are more rooted in perception rather than reality, the fact is that the very presence of such concerns among a majority of Americans will have lingering negative effects on economic performance.

Further clouding the economic forecast has been the recent run up in commodity prices, especially in the energy and agricultural sectors.  Clearly, uncontrolled inflation is a concern for both policy makers as well as individuals.  And while overall inflation remains under control (though creeping up), a sustained rise in energy and agricultural prices will inevitably constrict the U.S. economy’s performance.  So how likely are the recent moves to remain in place?  With respect to crude oil prices, there’s not a lot of fundamental support for $100/barrel prices since inventories are fairly high.  However, optimism over global economic growth and instability in the Middle East has added about $15 to $20/barrel to prices.  I don’t see this premium as sustainable unless things really get out of control on the geopolitical front.  It’s a possibility, but not very probable in my opinion.

Agricultural commodities, especially cotton, corn, and wheat, have seen their prices move in historic scale over the past six months.  As with crude oil, concerns about dwindling supplies due to improving global economic performance are underpinning much of the recent of spike.  Adding additional fuel to the fire is the momentum effect.  Investors are clamoring to buy up commodities in an attempt to capture some of the impressive gains that have been seen of late.  This has brought a wave of capital that is disproportionately large to the markets they are buying into.  Whether they are ETFs, managed future funds, or hedge funds, this crush of new money into the agricultural markets has been largely focused on the buy-side of the ledger, thereby giving each market an inherently upward bias.  As such, prices are simply disconnected from fundamentals.  In many ways, this is the same phenomenon that we saw in crude oil a few years ago.  And just like crude prices dropped sharply after their historic run, so too will this be the case with the ags.  I have no idea when this reversal will take hold, but it’s clear to me that there’s a lot more danger associated with owning agricultural commodities than there is staying away from them.  Aggressive folks, of course, could play this from the short side, but momentum is a tricky beast and very adept at running shorts from their positions.

Since I’ve talked a lot about what I don’t like, here’s one market I do like: gold.  After being negative on the yellow metal for so long, I finally came around to the bull camp in mid-January.  Having held numerous technical levels, gold’s price action has been nothing short of impressive and, as the last few weeks have shown, it is still among the markets that investors turn to when things get dicey.  Considering the growing threat of inflation within this uncertain environment, gold is primed for another round of investor euphoria.  In months/years past, it is possible that U.S. Treasury securities could have garnered a significant portion of the ‘flight to quality’ trade, but with the general direction of interests rates looking up and QE2 efforts winding down, it seems likely to me that investors will opt for gold rather than Treasuries, thereby adding additional fuel to the bullish fire.  I like using a security like GLD or IAU for gold exposure since they are directly tied to bullion prices and, therefore, little tracking error.  Some would suggest that buying shares of gold miners would be the preferred way to gain exposure, but, in my experience, these shares often trade more in-step with the general equity market rather than with bullion prices.  As such, there’s a level of risk that’s not worth taking on by owning the miners.

And with that FT is back.  It’s been too long since I last said……

Until tomorrow……