Friday, October 3: Employment and Vote

This morning, the US Bureau of Labor Statistics released its September employment report. True to expectations, payroll employment fell by 159,000 relative to August. There were some revisions to earlier months, but these were very small (actually positive). The unemployment rate remained unchanged at 6.1% (I had expected this to rise), and average hourly earnings rose by 0.2%. Read this article about the report.

What reaction did markets have to such a disappointing report? The opposite of that expected. Stock market futures improved substantially. And, with this "bad news," interest rates rose, as did the US dollar. Perhaps the only expected result was the movement out of industrials, which are cyclically sensitive. What happened?

"Other things" were not even close to being equal. The weak employment report was perceived as increasing the likelihood of the passage of the rescue plan later today. Furthermore, credit crisis effects weren't even reflected in this report, so employment reports in future months should be even more disappointing. Thus, markets are also building in the presumption of Fed rate cuts, possibly today if the legislation fails to pass.

What about industrials? These are pro-cyclical, so with a slowing economy, you should expect these to decline. But, industrial companies also tend to rely substantially on externally generated funds. So, in light of the current and ongoing financial difficulties, even if the rescue legislation passes, there are questions about how far down industrials might fall in coming months. Where did the money exiting industrials go (rotate) to? Large banks, who have the money, even if they don't necessarily want to lend it. Graph XLI on Stockcharts.com and observe its behavior over the last few days and contrast that with today.

Let me reiterate that I continue to believe the Fed must lower interest rates. Remember, the Fed has a target of 2%, but the fed funds rate is a market rate that isn't always at its target. So, go back to the graph we did in class with real money demand falling due to a slowing economy and the Fed having a target of 2%. Were they to have kept the fed funds rate at 2%, the money supply would have been falling. But, all the injections of liquidity over the past few weeks have made the actual fed funds rate much lower than the 2% target. So, if the Fed decides to keep its existing 2% target and enforce it, they would have to undertake major withdrawals of liquidity, which would further exacerbate the current national recession (I continue to believe the US has been in a recession since January) and global weakness.

Finally, even if the rescue legislation plan passes (and I expect it will), DO NOT expect equity markets to go straight up from here. There is still a national recession, Europe and Asia are weakening, and global weakness will continue moving forward. And, last Monday when it was presumed the legislation would pass the first time around, the market was down about 3% even before the vote. There is an old saying in the stock market: Buy on the rumor, sell on the news. So, "the news" will be passage of the legislation. And, lots of money is waiting to sell any rally. So, don't be surprised if the market is down, maybe by several hundred points, for the day. And, if the legislation is passed, the anti-shorting ban will have a time table for expiration of a few days. What will happen when this is removed?

As I write this post (10am on Friday), the Dow Jones is up 136, NASDAQ is up 44, and the S&P 500 is 23 points higher. The 10-year bond is up 3 bp to 3.67%.

August Employment Report

On Friday, the government reported another decline in monthly (payroll) employment. This time the decline was 84,000. Weakness was greater than this number appeared to show, since prior months saw employment revised lower (ex: June went from -51,000 to -100,000, the first six-digit decrease since the recent declines began). Along with this the unemployment rate rose by a greater-than-expected amount, from 5.7% in July to 6.1% in August, its highest level in over four years.

As we haven't yet started with our topical coverage yet, I will refer you to an article dealing with this labor market report. Also, read the relevant chapter for this in the course text The Atlas of Economic Indicators. Finally, let me point out two things for you keep in mind as the semester progresses:

#1: When studying new data for an economic indicator, ALWAYS LOOK AT REVISIONS TO PRIOR PERIODS BEFORE EVALUATING THE CHANGE FOR THE CURRENT PERIOD (this puts the current change it into the correct context); and
#2: The overwhelming majority of media coverage from this report centered on the unemployment rate, which as I indicated on Thursday, IS A LAGGING INDICATOR.

I will leave it to you to figure out whether the media is actually basing its assessments of future economic activity on this lagging indicator.

An Economic Indicator is Born

This past Friday, there was a great deal made of the fact that for the first time ever, the number of customers visiting Starbucks declined. This had a very negative effect on Starbucks' stock (SBUX) and, more interestingly, the entire stock market reacted negatively to this news. Why would Starbucks' stock drag down the entire stock market?

The answer to this lies in assessing the overall strength of the US economy. Starbucks coffee is more expensive than its primary competitors nationally, Dunkin Donuts and McDonalds (it recently made a dramatic upgrade in the quality of its coffee). And, coffee at Starbucks is more expensive than both of these competitors. Furthermore, an important input for retailers selling prepared coffee is milk (and cream), the price of which has risen sharply of late, hurting its profitability.

So, the interpretation of the Starbucks situation Friday was that: (1) it is yet another company being hurt by rising costs; and (2) the deterioration in discretionary income resulting from higher food and energy prices has now spread to Starbucks, signalling the broadening of overall demand weakness. Thus, a new economic indicator was born on Friday: STARBUCKS AS AN INDICATOR OF DISCRETIONARY SPENDING.

How accurate is Starbucks as an indicator of discretionary spending and hence as a leading economic indicator? Has it been a very good indicator for quite a while and we didn't realize this until last Friday? For extra credit (due at the beginning of class tomorrow, 11/19), graph Starbucks stock price (SBUX) as a line graph in the same graph as consumer discretionary stocks (XLY). To do this, below the main graph under Indicators select Price. Enter the symbol XLY . Under POSITION, select BEHIND PRICE. Then make this a line as well. Add any annotations you think will illustrate your beliefs about the relationship between these two variables. Those annotations will serve as your discussion. Copy this graph and paste it into a Word document and bring it to class Monday.

Here is the link for an article written about Friday's events. Read it and critique it (you should begin doing this routinely).

Useful Links

It is very useful to have a blog post that provides URL's for reference information dealing with writing research papers in general. Here are several sources for you to consider:

A Step by Step List for Writing a Research Paper

Another Step by Step List (pardon the source's name!!). Click on each step of the process on the right of the page. Pay special attention to the section on Gathering Data.

A General Guide for Writing Research Papers . Look at Chapter 1 on outlines (as you page down). This is very relevant for next Friday's work due.


Here's a start for you. READ THROUGH EACH OF THESE. Bring any questions you have to me or other faculty members in our department.

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.

Sector Performance Before "The" Employment Report

Tomorrow we get the September employment report. This will be a market mover, but not in the traditional way. The stock market wants the Fed to keep cutting. So, if the employment gain is very good, the Fed will be less likely to cut at its next meeting, causing a market sell off. The same is true for a very bad report. Yes, the Fed would likely cut again, but this would signal the possibility that we might already be in the early stages of a recession, so the souring of profit expectations would overpower the effects of lower expected interest rates. Remember:

Stock prices = f(expected profit, interest rates)

So, when both factors change, the effect of one may well offset the other. That is the nature of forecasting! The ultimate change in stock prices will ultimately be determined by the changes in each factor and how sensitive stock prices are to those factors when their changes are that large (or small). This is a non-linearity -- the impact of each factor depends on its own level and how the other changes.

The next thing to look at is which sectors have performed well since the Fed rate cut in September. To do this, go to StockCharts.com. On the left side, click on Market Carpet. Under the heading Available Carpets, select S&P Sectors Carpet. You should see the image below (click to enlarge):

Step #1: Stretch the number of days bar on the bottom right (indicated in red typing on image). Move this to 13 days. NOTE: you can change both start and end date by dragging on either or both ends of this.

Step #2: When step #1 is completed (the days are correct), click on the button on the top left (indicated by the red typing in image). This will give a more aggregate overview, listing the sectors that have done best and worst over the time period you chose.


The result should be the next image (click to enlarge): NOTE THE PERCENT CHANGES IN EACH SECTOR (Highlighted in a reddish tint on bottom right).

There is a mixed picture since the Fed cut rates. The leading sectors are Materials, Technology, and Financials -- this signifies that the rate cuts have up to now apparently stimulated sectors related to growth. But Health Care, a defensive sector has done fairly well, while Consumer Discretionary, which we would have expected to be among the best performers is one of the slower performers (it was the only declining sector).

Note that on the left side of this Java Applet the sectors and their percent changes are noted over this period (which was summarized on the bottom left). If you double click on one of the gray headings you get a breakdown of that sector and the bottom right list shifts to the best and worst performers in that group.

Try double clicking on Consumer Discretionary. Let's see who has been holding this back, making its growth less than expected. Look at the bottom 5. What has been slowing this sector down to less than expected? How does this information alter you view (if at all) about growth prospects.

Tomorrow "the" report on employment is released at 8:30. I encourage you to see how the above results change. In general, when a major release occurs, read about it in the Carnes and Slifer text (Atlas of Economic Indicators), and check out the sector patterns to discern any rotations. What do these rotations indicate about growth expectations?

Finally, it is important to keep in mind that all of this note has pertained to the stock market only. To see how the bond market is viewing the world, look at the yield curve and how it has changed (go to Bloomberg.com for this or go to the Links for this blog under my picture). Has it steepened or flattened (or possible inverted)? Finally, check out the dollar's exchange rate with other countries and its index ($USD). What does the world think about how this report has altered growth prospects here? You can also check out www.dailyfx.com for exchange rate information.

This weekend I will post a follow-up note after the employment report has been released.

Fed Aggressively Cuts Rates

The Fed lowered interest rates today but farther than many (included myself) had expected. Recall, I had anticipated the combination of a 25 basis point fed funds rate cut and a 50 basis point discount rate cut. Along with this, I expected a statement that indicated further rate cuts would be forthcoming as needed.

Recall there are currently two problems facing us -- a slowing economy, which the fed funds rate impacts, and a liquidity/credit crunch crisis that the discount rate addresses. And, there is the question of how much the US economy will slow in upcoming months. Nobody knows this for sure (no matter what they pretend). And, the two "dangerous ingredients," the slowing economy and credit crisis might possibly combine and become very "explosive," meaning cause a more severe slowdown and/or recession. Apparently, it is this potentially explosive combination that the Fed reacted to. And, given the lags in monetary policy changes (6-9 months), the Fed HAD TO BE PROACTIVE. Remember, Ben Bernanke has not been the Fed Chair for very long, so he still has to establish his "Fed Cred," or credibility. And, all the press play for former Chair Greenspan's book probably influenced the magnitude of the move somewhat (this Fed can't allow itself to possibly be "behind the curve" of this slowdown.

The result TODAY: the stock market got what it hoped for, so there was a major increase, +335 points for the Dow Jones, a full +70 points for the NASDAQ, and +43 points for the S&P 500. Shorter duration interest rates fell, a very healthy sign (we will discuss this in the next week it has to do with the yield curve) for future growth prospects. And, the exchange rate picture was mixed: the US dollar rose against the Japanese Yen, but fell against both the Euro and British Pound.

The chart shows Cyclicals ($CYC) for the past three months (click to enlarge). Note how, over this period, the 50-day moving average was originally support (until late July), then became resistance. Today, after the Fed's rate change, there was a very large increase. Note how tall today's bar is and that the close was at the day's high. More importantly, today's close broke above the 50-day moving average. Also, look at the RSI(9) above the cyclicals. It has recently moved into the bullish range, above 50. Finally, the price relative, comparing cyclicals to the stock market (in terms of the S&P 500) has turned up recently. Part of today's large increase was the result of "short covering," where persons had sold shares of various stocks betting that their prices would decline. When the news came out, they hurried to buy back the stocks (covering their shorts). This added demand was an important contributor to today's large run up in prices.

What about tomorrow? Now that the markets got what they wanted, there will no doubt be further deliberation and possibly second guessing of the Fed's decision. Was the large rate cut a sign that the Fed thinks things are actually worse then they have led us to believe up until now? Will today's breakout be sustained, or will something else come to the forefront, making today a "one day wonder," or in technical terms, a failed breakout. Keep following cyclicals through the rest of this week into next week.

August Employment Report

The August employment report came in with a bang. While the consensus prediction for payroll employment was around +110,000 (I had figured around +50,000), the figure released by the Bureau of Labor Statistics was -4,000 -- the first month-to-month decline in four years. Ouch!! You can read about the report.

As I stated in class, this would clearly be one of those "other things are not equal" situations. On the one hand, a weak employment report further fuels the expectation that the Fed will lower rates at its next meeting on 9/18, possibly by 50 basis points (1/2 of a percentage point). That is a positive for the stock market (which is driven primarily by profit expectations and interest rates).
But, weak employment signals less spendable income in future months, which will cut into profits, a negative for stocks. Which effect would dominate? As the morning unfolded it became readily apparent that the negative aspects were more than offsetting the positive factors.

But how could this be? If the Fed will be lowering interest rates soon, and the unemployment remained unchanged, why so negative a reaction by the markets? That's where it is necessary to read the details of the report. First, let me state a rule for judging reports: NEVER PLACE TOO MUCH WEIGHT ON A SINGLE MONTH'S VALUE. Actually the markets didn't. As it turned out, the employment totals for the prior two months were revised sharply lower. This brings me to a second rule: ALWAYS LOOK AT REVISIONS TO PRIOR TIME PERIODS BEFORE JUDGING THE CURRENT VALUE. So, instead of having an average monthly employment gain of around 110,000 over the past three months, the average (with revisions) becomes only +44,000. In addition to this, a further examination of the unemployment rate is called for. While the unemployment rate remained unchanged at 4.6%, the labor force dropped sharply. Had the labor force participation rate (% of population in the labor force) remained the same as it was last month, August's unemployment would have surged to 5%. Now it should become more apparent why the negative reaction occurred.

It is important to keep in mind that the primary factor determining whether a recession is upcoming is whether housing weakness is "contained." The dominant view has been that as long as employment remains strong and the unemployment rate doesn't rise too much, persons should generally be able to afford their mortgages, limiting housing damage. Well, in August, employment fell and the unemployment rate should have risen (with the same participation rate as last month). So, it is not clear how much "containment" will exist going forward, raising the likelihood of a recession (my estimate this entire year has been 45%, well above the consensus until very recently). Add to this the fact that a very large number of mortgages will be "resetting" to higher interest rates in October, and you can see the basis for the stock market selloff. Here's an article highlighting whether a recession is likely.

While we haven't covered it yet, another big reaction to the weak employment report was a sharp drop in interest rates. The 10-year government bond, which is linked to mortgage rates, fell from 4.50% to 4.37%, a 13 basis point drop in one day!! Bonds are fixed (nominal) income assets, meaning they pay fixed amounts of income per year. "Bad news" about the economy, like this employment report, is good news to the bond market as it implies less of an inflation threat in the future (inflation lowers nominal income). And, we will see (later this coming week) that bond prices and interest rates move in opposite directions. So, on Friday we had a stock market sell off and a bond market rally!! Finally, not unrelated to all of this was a sharp rise in gold prices. See if you can figure out gold prices rose. (Hint: it is related to interest rate changes.)

All of this should demonstrate the point I made the first day of class: if you understand macroeconomics you tend to think in terms of sequences (sets) of variable changes, not just what is happening to a single variable. The ability to do this takes practice. Judging by the way this semester has started, you'll be getting lots of practice!

Inflationary Expectations are Rising

Recently the Fed affirmed its worries about rising inflation. If you want to read a good article about this, click here. And today the Producer Price Index (PPI) report for March was released (click for article). How can we examine inflationary expectations without waiting until a CPI, PPI, or GDP deflator report is released? The answer is to examine the ratio of TIP prices (Treasury Inflation-Protected Securities) to nominal bond prices. I have found it useful to use the ratio of 20+ year bonds. In StockCharts.com, the symbols for these are TIP and TLT. So, to examine the ratio, use TIP:TLT. Also, switch to viewing this as a line graph and remove moving averages, etc. but keep the RSI (use 9 periods). The resulting chart is given below (click on the image to enlarge it).

A critical technical formation has appeared with this ratio: a double bottom. Recall from Stikki Stock Charts that a double bottom is a reversal pattern. This price ratio has failed to break below a support level twice, which often (BUT NOT ALWAYS) signals an upward move is forthcoming. According to technical analysis, it is possible to determine a likely upside price target assuming a reversal does occur. To do this, form a neckline connecting prior recent peaks (i.e., resistance). In the present example this is at 1.148. Subtract from this the value of the bottom, which is 1.121, which I will round to 1.12. Then add this difference to the neckline value to arrive at the price target:

TARGET Change = Neckline - Bottom
= 1.148 - 1.12 = 0.028
TARGET VALUE = Neckline + Target Change
= 1.148 + 0.028 = 1.176

So, should this double bottom play out as a reversal, we would expect to see the ration TIP:TLT rise to around 1.176. The graph contains this information with a horizontal line drawn at this value. Notice anything interesting? The price target move us almost exactly to a prior level of support from June of 2006!

How likely is it that we will actually reach 1.176? Note from the RSI that it is not yet overbought, so there is room to move up. It is not far from the overbought reading of 70, however, so there will likely be a short-term downward move before that target would actually be reached. I suggest that you consider a support for the upside rally of a value of 50 for the RSI. As long as the RSI(9) remains at or above 50, don't rule out the possibility of reaching the upside target.

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.