How Strong are Retail Sales

Retail sales data were released today. At first glance, the number seemed disappointing -- retail sales fell by 0.4% (read article). There is, however, a quirk you need to know about when analyzing this number: it is a nominal value. Why is that a problem? Gasoline prices fell dramatically in September, giving the impression of retail weakness, when in reality that was not the case. To see this, recall that:

nominal retail sales = price x quantity

When a critical price falls dramatically, as that of gasoline did, we have a large drop in the price term, which tends to make the growth rate in retail sales low or negative, as was the case this month. Similarly, in months where gasoline prices rise, this will tend to push up the value of nominal retail sales.

So, at the present time, or any time when gasoline prices change substantially, gauge retail sales strength by focusing on retail sales excluding gasoline (and retail sales at service stations). For September, retail sales excluding sales at service stations rose by a respectable 0.6%. What a different perspective this gives!!

An important part of macroeconomics is knowing how to "read the tea leaves." The Carnes and Slifer book is very good for this (you should read the material dealing with retail sales). This is one more example of why it is important not to examine only overall indicator values without delving into greater detail.

Now, as the more meaningful real trend of retail sales indicates economic strength, the bond market sold off again today, pushing the 10-year bond rate all the way up to 4.8%. Read this story to see the details. It's safe to say that the bond market has dramatically changed its perspective from just one week ago. The likelihood of a Fed rate cut early in 2007 is somewhere between slim and none. Don't forget that the Fed Chair and several members also need to establish their "cred." Erring on the side of ease would be a major error they would suffer from for years to come. So, for them, it is preferable to err on the side of causing weakness than to risk higher inflation.

Employment Report Implications

Today, the September employment report was released. There was a weaker-than-expected employment change of 51,000. If the market's focus were solely on this number, interest rates would have fallen (lower inflation expectations due to slower expected growth), and the stock market should have risen as this is consistent with the "soft landing" scenario.

As it turned out, the stock market dropped slightly. But, the biggest story was that the 10-year bond rose by 9 basis points, all the way up to 4.70%! How did that happen?

First, the bond market, which subscribes to the "hard landing" scenario, had not only priced in that the Fed is finished raising interest rates, they apparently also presumed that the Fed would begin easing early in 2007. Wow! While the 51,000 payroll change would normally have made them happy, there was a sizeable upward revision to August's payroll number (+60,000), the unemployment rate dropped to 4.6%, tied for its lowest value in a while, and the government released a statement indicating that payroll employment gains have been understated through March of this year, by about 800,000.

So, taken together, this information says the economy has more strength than the bond market had presumed, and the likelihood of the Fed lowering interest rates early next year is now remote. What is the outcome? You guessed it, a bond sell off, pushing interest rates higher. Go to StockCharts.com and plot the 10-year bond ($TNX) to see that action for yourself. The chart shows the 10-year (click to enlarge).

Note the large bar for today. Using the Raff Regression Tool (sixth icon from the top right), I made the blue price channel and have indicated three resistance levels (think of these as R1, R2, and R3 as technicans would). I have also located support.

The other story is the recent strength in the dollar. I discussed in class today that when we see the combination of rising stock prices, rising bond prices (declining r) and a rising dollar, this indicates that foreign investors are bringing money into US asset markets. This happened earlier in the week. What about today?

With the threat of a nuclear weapons test by North Korea, the dollar strengthened. Once upon a time (translation: when I was a student), gold was the "safe haven" when indicents like this occurred. Today, gold only rose $1.50. The US dollar has now become the safe haven. And when the US dollar strengthens, US asset markets also become relatively more attractive to foreign investors. This bodes well for stock indices not falling too far too fast. When the US dollar strengthens, this also puts downward pressure on commodity prices. Check out the CRB Index ($CRB) to see this.

Finally, to see the international fallout (sorry!) from the possible nuclear weapons test, check out the Japanese Yen index ($XJY). Not a pretty sight!

Dow Jones Record

The Dow-Jones Industrial Average ($INDU) set a new record today, closing at its highest level ever. You can read about today's performance or explore its history. The real question is whether this upward move has "legs." Will resistance hold, and today be part of a failed breakout, or will we move toward even higher levels?

Applying technical analysis, there is reason to think that today's record will be met with a pullback in the near term, even though the RSI doesn't indicate that $INDU is oversold (based on the weekly data used). The chart below (click to enlarge) illustrates that the record -- as resistance from early 2000 -- was broken today. Why do I think some pullback is coming? Using the RSI, there is a bearish divergence: the $INDU has moved higher (it has higher highs) but this has not been confirmed by the RSI (it has lower highs).

Where will the Dow-Jones go from here? To answer that question, economics is needed (see the prior post for an example of this).

stock prices = f(expected profit, interest rates)

Put these together and you get the present discounted value of expected future profits. Here are the types of questions that must be answered to arrive at an answer (which, bye the way, is a forecast):

(1) Has the Fed finished raising interest rates?
Will they actually lower rates next year (as the bond market presumes), or will inflation remain in the problematic range?
(2) Today, oil prices fell below $59/barrel. Will this continue? If so, this will moderate inflationary expectations and the inflation premium in nominal interest rates). What about declining gasoline prices? This will help consumers, but with a lag (it takes time to replenish the spending power lost over all these months with $3+ gasoline prices.
(3) How much damage to economic growth will be done by housing sector weakness? Have declining interest rates placed a bottom on the decline in housing, or is there quite a ways (down) to go yet? Look at a few home builder stocks. These appear to have bottomed. Is that a leading indicator of what is to come for the housing sector? Business construction (in the GDP accounts) have begun to rise. Will this be able to offset home construction weakness?
(4) Consumer debt has piled up -- largely through the use of home equity. What will power spending in the next several quarters if home equity can't? Job growth and income gains are critical here.
(5) Will business spending (Equipment and Software) be able to pick up the slack from weaker growth (or actual declines) in consumer spending? Judging from the most recent quarter's GDP report, no. But was the decline in this category an anomaly?
(6) Will growth in Europe continue to pick up and that of Asia remain strong? If so, this bodes well for export growth and profits to firms that have international sales.

This is not necessarily the entire list. But for a forecast of stock prices, like any forecast, you must identify what the relevant factors will be in the next 6 months or year, predict what each of these will do, then put all of this together to arrive at a conclusion.

Technical Analysis Applied to a Stock Pick

Today, Barron's Online had an article (subscribers only) with a strong recommendation to purchase Texas Instrucments (TXN), the maker of computer chips for computers and cell phones. While I have no doubt that just this recommendation led many to run out and purchase TXN, persons who know the tools we are using in class would have held off. Clearly, the "fundamentals" of TXN are very good, so the stock passes and important test. But should one buy it when a recommendation occurs? For persons who don't believe in technical anaylsis, the answer is a resounding "yes." They would likely point out that as a long-term investor, if the stock should fall in the near-term, it will surely rise later based on its strong fundamentals. Let's look at an annotated chart of TXN (click on it to get an enlarged version).

The first thing to determine is how close TXN is to resistance. It is apparent that resistance is at 34 (from April). It failed a breakout above 34 in late April and early May. That resistance recently held as well. Note from the Relative Strength graph (bottom) that TXN has failed to outperform the overall stock market since mid-August. So purchasing this stock now is a wonderful illlustration of my handouts in class -- how persons often tend to buy when a stock is close to resistance (i.e., price is high).

Why not wait until (or if) TXN clears resistance, then purchase it, or better yet, purchase at support? That is what I would recommend. Consider the "fundamental" investor. Should TXN drop to $30 from $34, assuming they purchased it at $34, they would need to recoup a 13.3% loss just to break even (=$4/$30). What they won't do, and that I recommended that you would do, is to consider purchasing at support -- this is the equivalent of "buying low."

The motto of the story: I often see buy recommendations for stocks given at a time when the technicals of those stocks are not "right." Use technical analysis with stop loss orders to manage gains and losses, and don't just "resign yourself to fate" in terms of whatever the stock price does, as the fundamental investors do.

Enter economic analysis: Is it likely that TXN will test resistance or fall to support? (As practice for you: Where do you see support here? Where would you think of buying this stock?) Since stock price is largely determined by expected profits (and interest rates), what is likely to be true of future profits for chip makers? Will electronics and computer purchases slow down as the year ends or will this get stronger? THIS WILL BE DETERMINED BY THE MACROECONOMIC OUTLOOK. What a coincidence, that's what ECN 327 is all about!!! The products TXN's chips go into are part of discretionary spending, which is highly cyclical. So, if the bond market is correct, that a sharp slowdown is coming, prospects for TXN's stock price are not very bright, in spite of its present fundamental strength. If the stock market is correct, that we are headed for a "soft landing," then the prospects for TXN are brighter, and this might be a stock to keep track of. So, look at the graphs of cyclical stocks ($CYC) and discretionary goods (XLY). What is the real-time information from these graphs telling us? Is the Fed done raising interest rates? Will housing's fall not be sharp (due to falling 10-year bond rates, etc.)? These are the questions to consider.