Employment Report -- March

Yesterday the March employment report was released. To the surprise of many (including me), payroll employment rose by 180,000 over the February total. This was far above the consensus estimate of around 130,000. Ironically, there was no effect whatsoever upon the stock market. Of course, that's because the markets were closed the day the report was released. So, Monday should start off with a bang, as traders have had the entire weekend to think about their reaction to the report.

Part of the reason for a larger-than-expected employment gain was that when the February survey was undertaken there was a snow storm, which prevented some persons from getting to work during that week. THE EMPLOYMENT SURVEY IS CONDUCTED DURING THE WEEK THAT INCLUDES THE 12TH OF EACH MONTH. So, comparing to a month with snow storms leads to some distortions. February likely understated employment, and March, comparing to February, overstated employment strength. While the employment data are seasonally adjusted (a statistical smoothing that takes into account events that happen "normally" at the same point each year), atypical events -- like February's snow storm, often cause seasonal adjustment distortions. A very readable article describing seasonal adjustment in on the online syllabus. Access it here.

So, while we have to wait until Monday to see how the employment report will affect the stock and bond markets, there was a great deal of discussion about the report overall and its likely asset market effects on television Friday. One question that is emerging about "good news" is whether the stock market will react positively or negatively at the present time. Why? Because "good news" may signal the increased likelihood of Fed tightening. And, we saw earlier in the semester, that rising interest rates are bad for stock prices (often referred to as a "head wind"). But, a stronger economy means profit strength in the future, which is a plus for stock prices. So, which effect will predominate with investors? Stay tuned, we'll see. Here's a Friday article that discusses this. Let's see how accurate it proves to be.

Along with employment, the monthly labor market report also has information on the unemployment rate, which fell unexpectedly from 4.6% to 4.4%, placing us at full employment, an average hourly wage growth. Often this is taken to be an inflation indicator, but it really isn't that good at signaling future inflation (here's an article discussing that). Actual wage growth was 0.3%, the expected amount, so there is not likely to be any reaction to that aspect of the report. As I stated in class, there are composition effects to wage change, determined by the types of jobs that are added in a given month. If lots of "high wage" jobs are added, the wage gain will be substantial. If largely "low wage" jobs are added, the opposite occurs.

So, what is happening to inflation expectations? Has the employment report changed anything? I have shown a way to observe this using StockCharts.com and TIPS prices relative to bond prices. For extra credit, graph this ratio (which we have discussed in class before) using daily data (make it a line graph). Annotate this with comments, print it and add a paragraph of discussion, and hand this in at the beginning of class on Tuesday. I will not accept anything after the beginning of class.

So, Monday morning promises to be very interesting for the stock, bond, and currency markets. It would be very good practice for you to think of what "should" happen, based on economic theory.

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.

Big Drop in the Dow-Jones

This past week saw notable movements in the Dow-Jones Industrial Average ($INDU). We discussed much of this in class (thru Thursday anyway). Friday was not a good day. The DJIA closed down 120 additional points, ending at just over 12,100.

The DJIA has been in an uptrend for many months now (since August 2006), so some sort of correction was called for. Typically, these corrections range between 5 and 10 percent declines. The time frame is variable -- there is not a "typical" correction period. IF, however, a correction ultimately involves a 20% decline, the market is deemed to have changed to a "bear market."

After a week like the one we just went through, I recommend using weekly charts to view trends, etc. The chart shows $INDU weekly (click to enlarge it).

One thing to note: just as there is support for price in a main chart, you can use levels of the RSI to denote whether a trend remains in force. As you can see in the diagram, the uptrend remained in tact as long as the RSI (based on 9 periods) stayed at or above 50 (the demarcation point). Since July of 2006, until this past week, that condition was met.

Look at the large weekly bar, which closed near the low for the week. Not good!! Further note that this large drop occurred on large volume. Also not good!!

There is something that is visible on a weekly chart of $INDU that is not apparent from daily data: a bearish divergence. While $INDU was making higher highs since October of 2006, these were not confirmed by the RSI moving continually higher. Thus the bearish divergence.

Support appears to be around 12,000 (look at the chart). If we fall below this, things will get very interesting. How likely is it that we will move below 12,000? Fairly likely, since even after the horrible week, the RSI is not yet in oversold territory. Ugh! Stay tuned, let's see how this week plays out.

In situations like this, you should look to see if any major (i.e., potentially market moving) economic data will be released this week. The answer is yes -- the labor market numbers for January will be released this Friday. What kind of employment report would lead to further price declines? Increases? Also, don't forget about the bond market.

Today's Employment Report

This morning, the January employment report was released. The consensus estimate for job change was +150,000, partly related to what was considered to be warmer-than-normal weather nationally in January. When the number was initially released, it appeared that employment change was slower than expected: +111,000. BUT, prior months were revised up significantly higher, RULE: ALWAYS LOOK AT REVISIONS TO PRIOR DATA BEFORE ANALYZING THE MOST RECENT DATA POINT. Here is an article about the report that you should read.

Along with employment change, the government released the January unemployment rate (slight rise to 4.6%), hours worked (slight decline), and the change in average hourly wages (+0.4%).

When the employment report is released, market participants attempt to gauge the implications for growth and inflation. As we will see this week, nominal interest rates are a function of both of these, so interest rate implications are critical when this report is released. And, it took a while for the markets to "digest" all that was going on with this report. The graph below shows this, focusing on the 10-year bond rate. It is from MarketWatch.com and has OHLC bars for 15 minute intervals to show more immediate and ongoing reactions. The double vertical line in the middle of the graph denotes the end of trading on Thursday. To the right is Friday (today) and the reaction to the job report. Can you see the obvious manifestation of initial confusion by the market for the 10-year bond rate.? Actually, the relevant question is how can you miss it?

The inflation implications of the report are derived from the behavior of the unemployment rate (it relates to resource utilization) and the hourly wage change (which could put upward pressure on prices when it rises "a lot"). In general, when the unemployment rate falls, this is taken to signal tighter labor markets and upward pressure on wages and prices in the future. Translation: higher future expected inflation. How inflationary depends on where the rate is and how much it changes. The lower the unemployment rate, the more inflationary will be the impact of declines. Similarly, the more rapid is growth in the average hourly wage, the more inflationary is it taken to be. We will see later in the course that productivity should also be taken into account to make a more proper determination of this (called Unit Labor Cost), but productivity data are only released quarterly.

Follow the 10-year rate for the remainder of the day. What ultimately happened? Compare the daily bar in StockCharts.com to the prior day. Also, look at the 10-year on a weekly chart.

Big Story: Sharp Interest Rate Increases Last Week

This coming week we will be discussing and modeling interest rates. Ironically, during the first week of class, the 10-year bond rate went all the way from 4.77% to 4.88%, an eleven basis point increase. That might not sound like much, but it is significant, especially since mortgage rate changes tend to be highly correlated with movements in the 10-year bond rate. Expect to see higher mortgage rates reported next week. Read this story to see more about this.

What we will see this coming week in our model of interest rates is that stronger economic growth pushes interest rates higher (other things being equal). That is what happened Friday, with stronger-than-expected reports on Durable Goods and New Home Sales. There was strong economic data earlier in the week as well.

You can plot the 10-year bond rate on StockCharts.com using the symbol $TNX. Follow the handout material I distributed on Thursday, switch to OHLC bars, but customize the time period (change RANGE) to Select Start/End, and use the time period Jan 22, 2007 through today (that will be Friday). Click on UPDATE. You will see the following graph (without the comments embedded). Click on the graph to enlarge it:
















Q: Is this week's run up in the 10-year bond rate due for a pause, or will it just continue?
A: Use technical analysis to provide an answer to this. Note in the graph how the "interest-rate bulls" (which we will see are actually bond market bears, since higher interest rates mean lower prices) dominated this market from Tuesday - Thursday, as the close each day exceeded the open. On Friday, things reversed, as close > open. So, a momentum shift occurred on Friday. We can also use the RSI indicator to help with this (see handout I gave). First, change the default value on RSI from 14 to 9. I highly recommend that you use 9 in the future. As of Friday, we can see that the momentum had shifted, based on the above discussion, AND the RSI was in the overbought range (RSI > 70). This indicates the likelihood of a short-term pause. IT DOES NOT GUARANTEE ANYTHING, HOWEVER!! We will see if this is what occurs next week.

Q: If the 10-year rate does decline, where is it likely to move to?
A: SUPPORT.

Note that by not just following the close each day, but looking at the high, low, open, and close, we are provided with a great deal of added information and insight. While Friday's close was higher than that of Thursday, the fact that on Friday, the close fell below the open, provides a critical insight that you just can't see by restricting focus (as so many persons do) to closing value only.

British Pound Nearing Record

The dollar has weakened against several major currencies over the past week. One of the most important currencies the dollar has depreciated against is the British pound ($XBP). The US dollar - pound exchange rate is now approaching $2. Using technical analysis, is there any basis to conclude that the current high values will continue to move higher?

First, it is important to establish whether the value the pound is approaching, $2, is a resistance level. To do this, remember the basic rule: Look left. What I have done is to extend as far back as far as my subscription allows (to the late 1980s). When going this far back, it is necessary to use monthly data so the graph doesn't get very messy.

When doing this, first, clear off the moving averages that are on the StockCharts.com graphs (the 50 and 200 period). Experiment with values and find a period that fits the most recent upsurge very well. In the present context, the 48-month moving average does this, as the graph shows (click to enlarge).

Examination of the graph shows that $2/pound is a very long-term resistance level that dates all the way back to the early 1990s. So, I have drawn a horizontal line to designate this fact. Support is the 48-month Moving Average.

Is it likely that the pound will break above its long-term resistance? The answer is yes, in the near-term, though. Note that the RSI is not yet at or above the overbought reading of 70 yet, so this indicates there is more upside possible. Also, below the main graph I have added a graph that shows how far the actual values of the pound are from the 48-month Moving Average. Apparently, 20 is the resistance level for that divergence (note: this is 20 cents). At present, the divergence graph below is not yet at 20, so this also appears to confirm that there might be further upside for the pound.

Remember, this is a likely outcome, not guaranteed. And, if the pound does move beyond its long-term resistance at $2, it will become overbought fairly quickly thereafter, as the RSI is very close to 70. So, whether a move above $2 can be sustained after it occurs is open to question.

As I have stated in earlier posts, use economics to determine whether the move after $2 (if it does occur is up or down). To do this, you must essentially formulate a forecast of the pound. A key factor is US monetary policy. Also, will the European Central Bank raise rates for the Euro zone? If so, relative US interest rates will fall (as the Fed is on hold with rates for now), causing the pound to appreciate further. See if you can identify other factors that will determine likely future values of the pound.

Post Election Info

The election is now over (thank God!!). A sharp market sell off that some had feared failed to materialize. Interest rates have come down about half way from their gain after the employment report last Friday.

There is an excellent article I want you to read by Michael Kahn dealing with political cycles and the stock market. The interesting question he explores is whether the market will be strong for 2007 and 2008, or just 2007. In other words, will a historical pattern hold?

Today, we received the most recent balance of trade data. The September trade deficit fell sharply. Why? Because this is a nominal value, and the price of oil dropped sharply over the period covered by this report. So, while short-term fluctuations in the balance of trade often result from changes in relative US income change (as I noted in class), at times when oil prices rise or fall sharply, large changes occur. Read this article on the balance of trade figure.

Perhaps the most important implication of the balance of trade figure is that it indicates the likelihood of an upward revision to Q3 GDP growth. That's because the initial number we received (+1.6%) uses an approximation (i.e., guess) of the balance of trade deficit, which likely included an overestimate of the value of imports. Remember, imports get subtracted from GDP, so lower imports (due to a drop in oil prices) will add to GDP growth figure.

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.