The Financial Commentator: Pre NFP Update


Investment letter – March 24, 2010


During the 1969 football season, New York Jets quarterback Joe Namath threw 15 touchdown passes, but had 17 interceptions. Hardly Peyton Manning or Drew Brees like numbers. But three days before Super Bowl III, Joe ‘Willie’ Namath boldly said, “We will win the game. I guarantee you!” And the Jets, 18 point underdogs, beat the Baltimore Colts 16 to 7.

The Labor Department will announce the employment report for March on April 2, and I guarantee you it will show a healthy gain in job creation. Although 25 of the past 26 months have experienced job losses, including 36,000 in February, a number of leading indicators suggest job growth is finally coming.

Temporary employment and the Household Employment survey are excellent forecasters of changes in the overall labor market. As I discussed in the November 2007 letter, when employers become concerned about a possible slowdown or recession, the first workers cut are temporary workers. In 2000, a decline in temporary employment began 10 months before the downturn in overall employment. I noted in the November 2007 letter that temporary employment had dropped every month since February 2007. Although the Household Employment survey is more volatile than the Establishment survey, the Household survey does lead at turning points in the labor market. In the November 2007 letter, I pointed out that through the first 10 months of 2007 the number of jobs created in the Household survey was 80% weaker than in the Establishment survey. It seemed clear to me that headline employment in the Establishment survey was soon going to turn negative given the decline in temporary jobs and the weakness in the Household Employment survey. The Establishment survey recorded the first job losses in the Great Exhale in December 2007.

Conversely, when the economy is emerging from recession, employers often add temporary workers. When they’re confident the recovery is for real, they add full time staff. Since last September, temporary jobs have increased every month, totaling 284,000, with 47,500 coming in February. According to the National Bureau of Economic Research, the 2001 recession ended in November. However, the unemployment rate rose from 5.5% in November 2001 to 6.3% in June 2003, which is why that recovery was labeled the ‘jobless recovery’. However, during this period, more than 2 million new jobs were created, according to the Household survey. Once those jobs filtered into the Establishment survey, articles about the ‘jobless recovery’ disappeared. In January 2010, the Household survey showed a gain of 541,000 jobs, while February jumped by 308,000. I would not take the size of these numbers at face value, but they do suggest improvement in the Establishment survey is forthcoming.

According to Challenger, Gray & Christmas, there were only 42,900 announced firings in February, the lowest for any month since February 2006. The pipeline of coming job losses is slowing substantially. In
addition, the Census Bureau will be ramping up hiring to conduct its decennial population survey. In February, 15,000 workers were hired, and counted as full time jobs. In reality, these are temporary jobs, but will add several hundred thousand jobs to the Establishment survey in coming months. Census Bureau temporary jobs will be marginally better for the economy than the ‘Cash for Clunkers’ and the first time home buyers tax credit. The ‘Cash for Clunkers’ program was intended to give the auto industry a lift, and promote the green agenda, as old models were replaced by more fuel efficient vehicles. According to the Department of Transportation, 690,114 dealer transactions took place between July 1 and August 24, 2009. Demand was certainly ‘borrowed’ from the future to achieve the bump in sales.
The Universities of Delaware and Michigan concluded that each new car cost the government $2,000, and increased fuel economy by less than .7mpg. I’m sure Al Gore thought it was money well spent.

The first time home buyers’ tax credit also borrowed demand from the future, as some fence sitters undoubtedly decided to buy sooner, and on the government’s dime. The Census Bureau hiring will at least provide work for unemployed workers, or underemployed workers. These jobs will put money into workers’ pockets, adding to demand in coming months, rather than incrementally lowering future demand as the ‘Cash for Clunkers’ and first time home buyers’ credit programs.

The Census Bureau jobs will boost job growth, and I doubt Wall Street will be bothered by the distinction between the economic benefit from a permanent job versus a temporary job. Wall Street is primed and ready to celebrate any job growth. Get ready for an onslaught of articles with one central theme and headline. “The Final Piece of the Recovery Is Now in Place – JOBS!” After the loss of 8.4 million jobs, job growth is good news. But a measure of perspective is always important. As discussed in prior letters, our economy needs to generate 113,000 jobs a month, just to absorb the average number of people entering the labor market. In effect, true job growth begins when more than 113,000 jobs are created in any given month (rather than zero), since that is what it will take to reduce the ranks of unemployed workers. Wall Street and the Administration are unlikely to point this out, since it might dampen the celebration.

According to the quarterly Manpower Employment Outlook Survey, a net 5% of the 18,000 firms surveyed planned to hire in the second quarter, down from 6% for the first quarter. With 14.8 million Americans officially unemployed, there were 5.45 applicants for each job opening. Although down from the record 6.25 in November, the total number of job openings were 2.4% lower than a year ago, and down 44% from the 2007 peak.

The Federal Reserve of Atlanta estimates that small businesses accounted for 45% of the 8.4 million jobs lost during the Great Exhale recession. During the 2001 recession small business only accounted for 9% of the 3.6 million jobs lost. The National Federation of Independent Business said its sentiment index fell in February to 88. Half of the 10 components weakened, including hiring plans and their economic outlook. Credit availability remains tight for most small firms, as banks maintain high lending standards and credit card companies cut credit lines. Small businesses have historically created 70% of all new jobs. With credit tight and consumer spending tentative, small business job growth will remain restrained for some time. With small business absorbing so much of the job losses, this is not encouraging.

While the improvement in temporary jobs over the last seven months is a positive, the transition from a temp job to a permanent job may not occur at the same rate of prior recoveries. According to Kim Megonigal of Kimco Staffing Services, which has 40 offices throughout California, temps designed to become permanent workers have dropped 70% since the start of the recession. “It’s happening, but not at the rate it used to.”

The labor market is going to show improvement in coming months, which is good news. But let’s get real. If a net 200,000 jobs are created every month beginning in March 2010 (313,000 less the 113,000 needed to absorb new entrants), it will take 3.5 years to recoup all of the 8.4 million lost jobs.

Over the last twelve months, the majority of economic metrics have shifted from absolutely awful, to less bad, and gradually to growth. The most important metric – jobs is about to register growth. Many of the green shoots from a year ago have grown to become at least green saplings. With job growth finally added to the recovery story, most economists will forecast the saplings of today growing into a forest of trees in coming quarters. In every post World War II recovery, this has been the pattern, which is why investors are likely to interpret a resumption of job growth as an all-clear sign.

The following is a quote from my December 2007 letter. “In the last 25 years, banks have made a concerted effort to move as much lending as possible off their balance sheets through securitization, thus empowering the role of credit markets to create credit. As the credit markets supplied a greater proportion of credit creation to finance growth for our economy, the Federal Reserve’s capability to manage the credit creation engine has diminished. Most investors really don’t understand the credit creation process, and as a result, don’t comprehend the scope of this crisis, or the Fed’s limited ability to deal with it. It really is different this time.” Why is this still true today?

Every prior post World War II recession was not precipitated and deepened by a global financial crisis that severely impaired credit creation. It is remarkable that so few economists and investment strategists acknowledge this crucial difference as they formulate their forecasts. In their 2009 book This Time is Different: Eight Centuries of Financial Folly, Kenneth Rogoff and Carmen Reinhart show that financial crisis’ share many characteristics. Severe banking crisis take a long time to work through, housing prices decline for six years, unemployment remains high, which causes tax receipts to plunge, resulting in an explosion of government debt, as governments replace weak private demand with public spending. They also found that future economic median growth is reduced by as much as 1%, if government debt exceeds 90% of GDP.

The global nature of the current crisis has forced every developed country to respond with huge stimulus plans, resulting in gaping budget deficits. According to the International Monetary Fund, the G7 countries will run average deficits of 9.7% of GDP in 2010. Even if the plethora of fiscal stimulus programs are withdrawn by G7 countries by 2014, the government debt to GDP ratio will be close to or above 100% in Britain, France, Italy, Japan and the United States, with Germany closing in on 90%.
Collectively, the G7 nations represent almost 70% of world GDP. Rogoff and Reinhart’s analysis
suggests that as these countries cross the 90% threshold in coming years, world-wide economic growth will be significantly weaker beyond 2014. Historically, weaker global growth has opened Pandora’s box, ushering in a fertile environment for protectionism, revolution, and war. Change is coming.

A scholar agreeing with Rogoff and Reinhart’s research would recommend that each country change course, so such a miserable fate could be avoided. If reducing budget deficits are necessary to keep the debt to GDP ratio below 90%, G7 governments should raise taxes and cut government spending. Sound advice, except for one tiny detail. The recovery of the last year in G7 nations was almost totally dependent on deficit spending. For instance, in the United States the Washington Times found that transfer payments – unemployment, Social Security, Medicare, Medicare, food stamps and other forms of welfare exceeded $2.1 trillion in 2009. Meanwhile, individual taxes amounted to just under $2.1 trillion. “For the first time since the Great Depression, Americans took more in aid from government than they paid in taxes.” There is a real risk of aborting the fragile recovery, if budget deficits are narrowed too aggressively, whether it is from tax increases, spending cuts, or a combination of both.

One of the lessons learned from the Great Depression was that the Federal Reserve erred in allowing the money supply to contract by 30%. As a student of the Depression, Ben Bernanke understood why it was so important to flood the financial system with liquidity, when the crisis exploded in September 2008. In 1936, John Maynard Keynes published, The General Theory of Employment, Interest and Money, which advocated active policy responses by the public sector to offset declines in aggregate demand during recessions. Since then, governments have used budget deficits to increase demand to keep recessions shallow and short. Unfortunately, most governments did not have the discipline to run surpluses during the good times to eliminate the government debt run up during recessions. The net result is that most of the G7 nations in the last 30 years have considered a debt to GDP ratio of 30% to 60% normal. This ratio of debt might not have weighed on economic growth over the last 30 years, but it did narrow the cushion below the critical 90% threshold, and leave G7 nations vulnerable to an unexpected economic shock.

Since December 2007, the Federal Reserve has been forced to take unprecedented actions to repair credit creation. It has expanded its balance sheet from $900 billion to $2.2 trillion, purchased $1.25 trillion of mortgage backed bonds, and $300 billion of long term Treasury bonds. And this is just a partial list. Back in December 2007, I noted that most investors didn’t understand the credit creation process, or the Fed’s limited capacity to repair it. Unfortunately, that’s still true, since most economists believe the crisis is over.
According to the Federal Deposit Insurance Corporation, U.S. banks posted a 7.5% decline in total bank loans outstanding in 2009, the steepest percentage decline since 1942. The FDIC also reported that 702 banks are at risk of failing, a 16 year high. More than 5% of all loans were at least 90 days past due, the highest in the 26 years data has been collected. Deutsche Bank estimates that banks will absorb $250 billion in losses on home mortgages. They also estimate that banks will need to book another $250 billion in losses for loans made to finance office buildings, shopping malls, and other commercial real estate. The combined $500 billion in additional losses is more than double banks’ current reserves against losses. As of December 2009, 42% of all commercial real estate loans were held by the 7,344 community banks with less than $1 billion in assets. The 100 largest banks with more than $10 billion in assets hold about 17% of total commercial loans. The ongoing pressure on bank balance sheets will continue to curb lending, especially to small businesses that rely on their community banks.

In 2007, banks provided about 35% of credit which was down from near 75% in 1980. By 2007, the securitization of mortgage and credit card debt and auto loans was providing 40% of credit. In 2006, issuance of asset-backed securities, not including residential mortgage backed securities, topped $700 billion, according to the Securities Industry and Financial Markets Association. It was $168 billion last year. In 2007, the commercial paper market, which is used by companies for short-term credit, was $2.2 trillion. In January 2010, it was $1.1 trillion.

As long as credit creation remains so impaired, the economy is missing one of the pillars it needs to create a self sustaining recovery. A resumption of job growth is important. But it is going to be more difficult for the saplings to grow into trees, unless credit becomes more available.

As noted last month, China and India are at a different stage of development, with different battles, and different monetary priorities and challenges than those facing the G7 central banks. The goal for the central banks in China and India is to maintain economic growth, so living standards are raised, and a broad middle class emerges over time. While G7 central banks are dealing with huge budget deficits, rising debt to GDP ratios, aging populations, and the real risk of deflation, China and India do have an inflation risk. Food comprises a far larger portion of the average person’s annual income in China and India, so changes in food prices are a major factor of daily life and inflation. In India, consumer prices have risen by almost 17% in the past year, primarily driven by a surge in food costs due to a drought. Wholesale prices are up 9.7%. In a surprise move between meetings, the Reserve Bank of India increased rates from to 3.25% to 3.5% on March 19. Given the spread between interest rates and wholesale inflation, more rate hikes can be expected in coming months. In China, inflation was up 2.7% from a year ago in February, the highest in a year, and headed higher.

As discussed last month, China’s far larger problem is the real estate bubble that has developed in most 5
major cities over the last year. In 2009, a record $560 billion of residential real estate was sold in China, an increase of 80%. The housing price-to-annual income ratio in many large Chinese cities is over 20 to 1. The highest in the U.S is in Honolulu, which is 8.2 to 1. The surge in real estate values was fueled by an unprecedented increase in bank lending, which was mandated by the Chinese government, in part to replace the plunge in exports to G7 nations during the second half of 2008. Prior to the collapse of the global economy in 2008, exports comprised more than 40% of China’s GDP. In 2009, Chinese banks lent almost $1 trillion, or about 25% of China’s $4 trillion GDP. In addition, the Chinese government launched a $570 billion stimulus program, which amounted to 14% of GDP. The Chinese economy certainly benefited from this extraordinary stimulus, but there is no question that a significant portion of the lending has been responsible for real estate speculation. History has shown that excessive real estate speculation never ends well, and this episode in China won’t end well either.

Local governments in China are prohibited from going into debt, unlike cities and states in the U.S. In the U.S., state and municipal governments are allowed to issue bonds for specific needs. The amount of debt issued and owed by state and local governments in the U.S. is known by investors. That’s not how things work in China. In order to circumvent the laws prohibiting local governments from going into debt, local governments set up off balance sheet companies to borrow from the banks. When I first read about this I had to laugh, and wonder, when did Citigroup, one of the masters of off balance sheet accounting begin to advise local Chinese governments! Victor Shih, a professor at Northwestern University, estimates that off the book borrowing by local governments could total as much as $1.7 trillion, close to 40% of China’s GDP.

Although I can cite no official figures, I suspect that some of the lending surge also increased China’s industrial export capacity. Economic growth in the G7 nations in 2010 and 2011 will be weaker than prior to the financial crisis, especially if governments get really serious about reducing their large budget deficits. If they withdraw them gradually, so the risk of another economic dip is less, at least 5 of the G7 nations’ debt to GDP ratio will exceed 90%. History suggests median economic growth will be at least 1% slower for years, as the U.S., Japan, Britain, France, Italy, and potentially Germany, struggle under their debt burden. Japan’s debt to GDP rose above 90% back in 1999, and economic growth during the last 10 years has been anemic. G7 nations’ proportion of global GDP is 70%, while China’s is about 9%. While G7’s proportion of global GDP will shrink in the coming decade due to slower growth, China’s dependence on exports will remain high. A recent analysis by the IMF estimates that for China to maintain its 8% annual growth rate, its share of world exports will have to double by 2020. That is not going to happen, since many of its trading partners will be importing fewer Chinese goods.

The significant contribution to growth from exports has enabled China to create millions of jobs for farmers emigrating from rural areas into cities, which has helped keep unrest under control. But it’s obvious that China’s trade success is sowing the seeds of protectionism, and not just in the U.S. Last week, 130 members of the House sent a letter to the Commerce Department to impose countervailing duties on Chinese imports to protect American manufacturers, if China refuses to allow its currency to appreciate against the dollar. And five Senators introduced a bill that would compel the Treasury Department to cite China for manipulating its currency. With an election around the corner in November, this issue is not likely to go away, even though protectionism is understood to be bad economic policy.
The one investment theme that garners widespread advocacy is that China will continue to grow far faster than any of the developed economies, and for that reason deserves a place in any well diversified portfolio. Whenever an investment theme becomes widely accepted, like the tech stocks in early 2000, or housing in 2006, I know it is time to begin looking for cracks in the ‘story’. The People’s Bank of China is walking a tightrope between maintaining strong growth, and curbing real estate speculation and rising inflationary pressures. The lending spree in China last year inflated a real estate bubble that will lead to a decline in real estate prices, and losses for Chinese banks. As export growth slows, China will have a problem with excess industrial capacity that will be tough to replace with domestic demand. If China’s economy is unable to maintain its 8% annual growth rate, there are going to be social problems, as the ranks of unemployed workers increase.

As I discussed last month, my analysis approach combines economic fundamental data and technical analysis. The synergy of both of these disciplines is superior to simply relying on just fundamental analysis or technical analysis. In the August letter, I discussed at length, “How Technical Analysis Can Improve Fundamental Analysis”, and showed how the combination helped identify the top in the U.S. stock market in October 2007, and the low in March 2009. It is noteworthy that as the stock market in the U.S. and all the other developed economies in the world were making new recovery highs in January and March, the Shanghai Composite, the China Shanghai 50, and the DJ-CBN China 600 were all making lower highs. I think it is time to short China. The easiest way is to short the China ETF FXI above $40.40, with a stop at $42.00.


As I discussed in the December 2009 letter, if there is to be any surprise that has the potential to kick off another phase in the financial crisis, it will not originate in the U.S. “The biggest surprises are likely to come from overseas. Banks in Europe employed leverage of 40 to 1, versus the merely ridiculous 30 to 1 leverage of their U.S. counterparts. European banks have also been slower to acknowledge losses. As we all know, major banks in the U.S. were brought to their knees by sub-prime mortgage loans and the overall decline in home prices. Most of the European banks were affected by the same malady. Where they differ is their large loan exposure to Eastern Europe, Russia, Dubai, and Greece. This exposure is their version of sub-prime lending, and it has the potential to be as unsettling.” The ECB decided to kick the Greek credit problem down the road last month, when they chose to wait 30 days. This bought Greece some time, and they were able to sell $6.8 billion of bonds on March 4, with a yield of 6.37%. The 30 day window is closing, and Greece must sell $31 billion in bonds during April and May. It would appear that the ECB is now willing to allow the IMF to provide Greece assistance. People in France and Germany do not want to have their tax dollars pay for Greece’s profligate spending. However, this resolution may not happen until after a bit more fireworks in the foreign exchange market. This suggests that the Euro is nearing an intermediate low between 1.30 and 1.32 in the next few weeks. I will send out a Special Update when the decline appears over. If correct, the next phase of the financial crisis is still a number of months away.
In last month’s letter, I wrote, “In the next two weeks, Greece will attempt to float a bond offering of $7 to $8 billion. Greece is the G in PIIGS, and I can’t imagine that Greece, the ECB, and the IMF will not try to put on whatever lipstick is necessary to facilitate this upcoming auction, since it is in everyone’s interest that it goes at least OK. If it goes as expected, the Euro will get a lift, and the dollar will correct lower, possibly into a range of 77.75 – 78.70 cash. I expect the dollar to trade higher after this correction, which could last 3 to 5 weeks.” As noted, the auction did go off OK, the Euro bounced, and the Dollar correction lasted four weeks. But the Dollar only dipped to 79.50, before it quickly reversed, and has now made a new high as expected. The correction was just not as deep as I expected. The Dollar should trade up to 82.70 to 83.50 cash, before it tops.
If the Dollar is approaching a multi-week high, Gold should then be able to hold above $1,060, and the GLD above $104.00. Gold rallied about $100 after making its low in early February, so a similar rally could take Gold above $1,140, and possibly above $1,162. Go 50% long GLD below $105.80, and add below $104.50, using $103.80 as a stop
Although the 10-year Treasury has not broken out above 3.92%, as cited in the last two letters, it looks like it is getting ready to move higher. A positive employment report on April 2 could be the catalyst. Since it has not officially broken out, we will try to buy TBT, on a pullback to $47.89, using $46.55 as a stop. Note: this is the short 10-year Treasury ETF, so it goes up as yields rise, and employs 2 to 1 leverage.
In the Special Update on March 14, I wrote, “If the economy does not produce the expected sustainable recovery, I think the technical action of the market will weaken before the fundamental economic news softens. Since most economists and money managers do not pay much attention to technical analysis, they will not see it coming.” The healthy technical condition of the market at this point suggests the day of reckoning is further down the road. As long as the S&P holds above 1,044.00 on an intraday basis, and does not close below 1,056.00, I will remain bullish, and consider the primary trend to be up.

I also expected the S&P to breakout above 1,150, and climb to 1160-1180. I advised selling into this strength, and become a bit more defensive. Since that Update, the S&P has pushed to 1,174.72. Over the next handful of days, the S&P could dip to 1,141-1,153, before another push to higher highs occurs. If I’m right about a positive jobs report on April 2, the market should pop when the market opens on April 5, since it’s closed on Good Friday. The .618 retracement of the decline from October 2007 (1,576) to the March 2009 low (666) is 1,228.00. If the S&P does make this run up to 1,210-1,225, it will do it on higher volume, which will make the technicians happy. A good jobs report will make the economists happy too. When everyone is happy, it’s time to get nervous, and I will likely send out a Special Update. Everyone’s good cheer may be tempered, if the 10-year Treasury yield makes a run at 4.1%. Higher mortgage rates won’t help housing, which has been fading a bit. The next few weeks promise to be very interesting in all the markets.

E. James Welsh

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