Friday's Employment Report

I had stated in class that the bond market anticipated a bad employment report. THE BOND MARKET WAS CORRECT. In anticipation of a larger-than-expected fall in employment (an actual fall of 263,000 -- much worse than the "consensus" estimate), and thus slower growth ahead, interest rates had been falling during this week. And, the actual number didn't do anything to reverse that trend. Here is a very short summary of the day's 10-year bond performance.


The chart (click to enlarge) shows the ten-year bond rate ($TNX). NOTE: the rate of interest is the listed value on the right axis divided by 10. So, 35 corresponds to a 3.5% rate, etc.  Resistance for the 10-year bond rate has recently been 3.5% -- you can see the rate bouncing off this level several times since August. Focusing only on this past week, we see a noticeable decline in the 10-year rate, in anticipation of a weak employment report.

As interest rates and bond prices are inversely related, note from the RSI indicator above the chart that rates are oversold, so a bond rally (on potentially bad news) has caused bond prices to be overbought.

There is one interesting thing about Friday after the employment release: the 10-year rate rose (and prices fell). And, while the rate hit 3.1% at one point during the day, the close was higher than the open. There was also a lower tail (remember: a possible signal of change of momentum). It is quite possible that the low on Friday may be a 10-year low for the short-term based on Friday's price bar. Keep in mind, though, that mortgage rates tend to be highly correlated with the 10-year bond rate, so it appears that we are going to see lower mortgage rates ahead (below 5% on 30-year mortgages). The real question is whether mortgage applications rise or fall ("other things" are not necessarily equal).

The stock market had a rough couple of days. After class on Thursday, the market dropped sharply. Friday, after the report, another sharp drop occurred until around mid-day when we came off the lows of the day. Here is a story about the stock and bond markets. For extra credit, due at the beginning of class on Tuesday, create a chart of the S&P 500 (daily) using "fill the chart" as the data range. Put the RSI in the same chart (not above or below it), paste this into a Word document. In that document, provide a brief summary indicating how the RSI signaled the recent stock market decline.

You should continue following the bond market throughout the remainder of this semester and beyond, noting what it is forecasting and contrast this with what the stock market is assuming. We will cover the stock market this week.

January Employment Report

Friday's employment report was very close to my expectations -- very bad. As I stated in class on Thursday, my expectations were for payroll employment to fall by 550,000 and the unemployment rate to rise to 7.7%. The actual employment change was -598,000 and the jobless rate rose to (only) 7.6 percent. Read a story about this report. Also, view a video, the Short View by John Authers of Financial Times.

Reaction by markets was very likely the opposite of what you had come to expect. I will focus on only the stock and bond markets in this post.

The stock market actually rose by 217 points. There are a couple of reasons for this. There is a formal expectation for major numbers and what is called a "whisper number" -- what markets really expect and have braced for. The whisper number for employment was a decline of over 600,000, so the actual number was not much of a surprise (or scare). The whisper number for the unemployment rate was around 7.8%. So, in a sense Friday's stock market rally was a sigh of relief -- we apparently have dodged a bullet. But there is another level of causation involved.

The January numbers were so bad that markets have now discounted for the fact that some stimulus package will definitely pass -- and soon. Furthermore, Treasury Secretary Geithner is expected to announce a new round for TARP funding, and as of Friday, markets reacted to the "rumor" (their visions of what will likely occur) as they so often do. But there is a very old saying in the stock market: Buy on the rumor, sell on the news. So, when the actual details of the Treasury program are eventually released, apparently on Tuesday, expect there to be somewhat of a letdown, as reality seldom matches expectations, potentially resulting in some stock market giveback.

Technical analysis tools help in evaluating the likelihood of this. First, the RSI(9) for the Dow-Jones Industrial Average ($INDU in StockCharts.com) just moved over 50 on Friday, a bullish sign, and nowhere near an overbought reading (at 70). But, a look at recent highs in late January indicates that there is resistance point not far from where the market closed for the week. So, we have a toss up based on technicals.

What about the bond market? Review the online notes from Thursday. Interest rates rose on the "good" news, which means the bond market sold off (lower bond prices). Persons sold bonds, which lowered bond prices and raised interest rates, and moved into stocks, raising stock prices. This is a very typical "rotation, the reverse of a flight to safety. The ten-year US government bond rate rose to almost 3%, which is stunning since about a month ago it was threatening to break below 2%.

If we assume, as is quite possibly the case, that interest rates have bottomed, then bond prices will be falling from this point forward. If you were an investor, how could you "play" this expectation? There are inverse Exchange Traded Funds (ETF's). For bond prices, the symbol is TBT, the double inverse (i.e., ultra short) for 20+ year bonds. Check this out and graph it on StockCharts.com. Is there a trend? If so, which direction? Where is support? Resistance? What do the RSI and relative strength indicate? Please note: I AM NOT RECOMMENDING THE PURCHASE OF THIS ETF.

As I finish this post (11:30pm Sunday night), the Dow-Jones futures are signalling an opening that is down about 92 points from Friday's close. This might well change. But keep an eye on markets after the Treasury announcement on Tuesday.

GDP Report

On Friday, the preliminary GDP estimate for Q4 of 2008 was released. The number indicated a decline of 3.8% (versus Q3 -- an annualized change). This is well below my expectation of -4.5%, and the consensus figure of -5.5%. However, the preliminary (first-pass) number is based on estimates of inventories and net exports (exports and imports).

Interestingly, both inventories and net exports made positive contributions to the Q4 number. Personally, I believe these will be very different when the second pass number is released in a month, so I am sticking with my expectation of -4.5% to -5%.

What did the stock market do in reaction to the GDP number? After a brief and weak rally early, the stock market closed down. The Dow-Jones Industrial Average closed right at 8,000 (a fall of 148), which is a support from a few months ago (think of this as Support #1). Will that hold? Next Friday the employment number for January will be released, and it promises to be UGLY!! So, it is likely that we will test Support #2 of 7,962 from mid-November, especially since the RSI is not yet in oversold territory.

The bond market likes weakness (remember from class: bad news is good news in the bond market), so rates dropped slightly (this was not much of a surprise to bond traders). Commodities (in terms of the CRB Commodities Index) rose slightly, as did Oil and GOLD.

In my mind, the most significant trend from intermarket analysis is that in spite of Friday's result, the bond market might have already turned up (rising interest rate trend, falling bond prices). As Murphy discusses in his text, historically, BONDS LEAD STOCKS (and Commodities). So, if the bond rates have bottomed, we might see a stock market bottom by the fourth quarter of this year.

If you have not done so yet, purchase and read all of Stikki Stock Charts, download my handout for getting started with StockCharts.com, and try out the things in the handout. I will hand out material to you on Tuesday.

After "The" Employment Report

As you know from class, the September employment change was essentially in line with expectations. Payroll employment for the prior two months (July and August) was also revised significantly higher. Most notably, the original employment change for August, a 4,000 decline, was erased. The revised August employment number is an increase of 89,000. Along with this, the unemployment rate rose slightly to 4.7%, and average hourly earnings rose by a greater-than-expected 0.4%.

Hopefully, you took the time to perform the practice exercise in advance of this report. The markets viewed this as a strong employment report. The perceived (key word!) likelihood of a recession dropped noticeably as the result of today's data.

- The stock market liked the report a great deal. It was not too high as to preclude further Fed rate cuts, but not so low that it might have indicated we were in the early stages of a recession. Read a story about this.
- The bond market didn't like this at all -- both significant employment gains and the "hotter" than expected wage gain raised the inflation flag. Here is a story about this. Examine the yield curve to see how the bond market ultimately reacted. Clearly, the yield curve got steeper, indicating the expectation of stronger upcoming growth and inflation.
- The oddity today was the foreign exchange market. Normally, we would assume that the greater perceived economic growth and higher interest rates would both strengthen the US Dollar. However, by day's end, the dollar had weakened further. Read about this. It might have been profit taking by currency traders and the overall perception that the direction for the US dollar is still down. Where is the bounce (support)?

Following what I did in yesterday's posting, I revisited the Market Carpet at StockCharts.com. This time, I looked at the most recent 10 days (not the entire time since the Fed rate cut). The "carpet" below is what pertains (click to enlarge):
Now look at the sectors that have performed the best over the period of this carpet, the last 10 days. All (no exceptions) are cyclically sensitive sectors (look at the bottom right). The leader is Financials. This sector had taken a beating after the financial worries in August. But, with recent data showing that the commercial paper market is improving and possibly stabilizing, there was some "make-up" momentum. Generally, however, it is desirable to see both the Financial and Consumer Discretionary sectors outperforming other sectors.
So, over the past 10 days, the equity market has signaled expectations for an improving level of economic activity. None of these sectors would have performed so well had there been substantial recession concerns. For extra credit (due at the beginning of class on Wednesday), replicate this market carpet (look at yesterday's post for how to do this) but for the 14 days since the last rate cut. Print out the carpet and bring it to class.

Finally, look at the sectors that underperformed: Utilities; Health Care; and Consumer Staples. All of these are defensive sectors, that outperform when recession worries accelerate, but underperform when recession fears abate, as has been the case recently.

Employment Report Effects

The February employment report was released yesterday at 8:30 am. The stakes for the markets were high: too low a number and recession fears would re-emerge, which would hurt the stock market but help the bond market; too high, and the opposite would be a problem, with a reduced likelihood of the Fed easing in the near term.

The payroll employment number that emerged was +97,000, which was high enough to remove recession fears, but not so high that worries of overheating would emerge. This scenario has come to be called the Goldilocks Scenario. Read the following article about all of this. Also, read the chapter on the employment report in the Carnes and Slifer text (The Atlas of Economic Indicators).

The stock market began the day with a healthy rise but gave much of this back by the end of the trading day. This often happens when markets get what they were hoping for (this is a variant of the old saying: Buy on the rumor, sell on the news). So, SUPPORT AND RESISTANCE BOTH HELD.

The principle items that caused a reaction in the bond market were a higher-than-expected rise in average hourly wages and a decline in the unemployment rate to 4.5%. In addition to these, the prior months' employment numbers were adjusted upward (this has been occurring for a while now). So, it is very likely that today's somewhat tepid payroll employment increase will be revised higher with the release of next month's data. All of these factors heightened inflation fears, causing a bond market sell off. The 10-year bond rate rose to just under 4.6%, an increase of 8 basis points for the day. Clearly, the bond market wants the Fed to lower interest rates, and the employment report dashed those hopes (for now at least). I guess the bond market's view of the world should be referred to as "The Three Bears," given the stock market's view.

So the "wildcard" for now is the mortgage market. How far will weakness in the sub-prime market reach higher tiers? It has already impacted the "Alt A" market, and with the tightening of lending standards, it will very likely creep somewhat into the market for prime mortgages. The different perceptions of the future state of the economy held by the stock and bond market centers largely on the answer to this question. For now, at least, it appears safe to say that "all's quiet on the carry trade front." Stay tuned.

An interesting article for you to read is by Jeremy Siegel. He attributes part of the recent volatility in stock markets to "trend following" by technicians. These traders (myself included) often place automated "stop loss" orders below the trend so they can insulate themselves from potentially large losses. Here's how a stop loss order works. You choose a price level at or below which you want to get out of a stock (or index like an ETF). Hopefully your choice is based on where support is. You should place the "stop" a bit below support, so that if a false breakdown occurs you don't get "stopped out," after which the stock begins to rise again. You then place an order stating this with your brokerage account. To automate this, specify the time frame for your order as "Good Till Cancelled," or GTC. Normally, this will remain in effect for several months. If, instead, you specify market day, you are only covered for that trading day, after which the order no longer exists. Specifying GTC thus automates this process so you don't have to remain in front of your computer all the time.

So when trendlines are finally broken in sustained uptrends, many of these stop orders kick in, potentially causing large sell offs, and magnified price declines. Hence the volatility aspects. I doubt that stop loss orders played the major role in the large Tuesday sell off, but they were certainly part of it.

A recommendation when you buy stocks: USE STOP LOSSES, but leave room below support in case a false breakdown occurs. Remember, capital preservation should be a primary factor for you.

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.

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.

Bond Market

Today we discussed the bond market in class and how bond prices and interest rates move in opposite directions. This can be seen vividly in today's news. Existing (median) home prices declined relative to last year, a rare event. This is bullish for bonds since it implies that inflation should come down a bit, and the inflation measures we use (like the CPI) will likely drop as well. Remember: bullish for the bond market means higher demand and higher bond prices -- which causes lower interest rates. You can read about this in an article from MarketWatch.com.

To further understand what is happening, remember our basic model of nominal interest rates (r):

r = f(expected inflation, economic growth, monetary policy)

Today, the news caused expected inflation (and actually expected growth) to moderate, causing nominal interest rates to fall. Remember: you can also explore this by using the ratio TIP:TLT in StockCharts.com, or take a look at the TIPS spread from Bloomberg.com (the link is: http://www.bloomberg.com/markets/rates/index.html ). You should bookmark this link.

When at Bloomberg.com above, page down to the graph. This is today's yield curve. Then, click on the tabs for different countries. Compare the interest rates (say 10 year) for the different countries listed.

Finally, oil prices bounced off support at $60 today. Graph $WTIC in StockCharts.com. Look to the left from today's values to see where support lies. You will see a $60 support point from early March of this year. Had this support not held, the prior support of just under $58 that I mentionned in class would be the relevant level. There was a bullish divergence in effect which makes today's move not entirely surprising. Oil price was falling while the RSI was making higher lows.

The question now is how long this upward move will hold. How far might it go? Resistance, remember?