GDP Report

Friday's report on Q4 GDP growth was both surprising and disappointing. Yet the stock market posted a very strong day in spite of this number. Why?

First for the GDP number. The reported growth rate, 1.1 percent, is much smaller than what was expected (around a 2.6% rate). But examination "below the surface" of this number reveals some trends that are either one-time in nature or just plain incorrect. Government spending fell at a double-digit rate from Q3 to Q4. What's the probability of that repeating? Not much. Also, the amazing car sales prompted earlier in the year by major discounts essentially "stole" sales from the end of the year, making the Consumption growth rate much slower than is realistic to expect for this year. Then there is the fact that Friday's number is preliminary, using ESTIMATED values for Net Exports and Inventories. These may also be revised in the next two relases of Q4 data.

So, why the stock market response? Other things being equal (which we spoke about in class on Thursday), this should have hurt stock prices. But "other things" are seldom equal. Housing data released the same day were encouraging. Several large companies reported strong earnings. But, in a sense, the GDP number itself was a "win-win" for the stock market. IF it is correct, then the clear implication is that the Federal Reserve will have almost no further tightening to do. This is beneficial to stocks, since rising interest rates are bad for stocks (we will go over the reasons in class over the next two weeks). But assuming this growth rate is too low, which is a very safe bet, this implies profits, which are a fundamental driver of stock prices, have remained strong going into 2006. And the stronger are profits, the higher stock prices tend to move (other things being equal, of course).

We will cover this topic in detail on Tuesday. Make sure you bring the Online Notes for GDP to class with you.

Employment Report

Yesterday morning's employment report was, at first glance, disappointing. While payroll employment was expected to show a net change of about 125,000, the actual change was only 56,000, less than half the expectation. A good story describing this is in Money.com. While the payroll employment change was disappointing, the unemployment rate fell slightly from 5.1% to 5.0%. All of this is detailed in the official report by the Bureau of Labor Statistics.

A few things to note. Virtually all newspaper/Internet articles describing this are WRONG -- they state that the 56,000 number was the addition to employment. It was actually the net change in employment -- the difference between jobs added and jobs lost. In a post-manufacturing economy like ours, job loss occurs every month (unfortunately). About 15 or 20 years ago, what the newspapers described would have been accurate.

Note also how much of the discussion about this report centered on the unemployment rate. Did you hear anyone say (or write) that the labor force fell last month? A falling unemployment rate caused by a lower labor force (the unemployed dropping out of the labor force) is little cause for celebration! More importantly, the unemployment rate is a lagging indicator.

One last point. Average hourly wages rose more than expected, providing fuel to "inflation hawks," part of a bond market sell off yesterday. I wonder how much of this is caused by the fact that a number of the persons no longer employed as the result of the hurricanes had low and below-average earnings (tourism workers, etc.). Hmmm.

Returning to the bond market, the 10-year bond rose by 1.3 basis points yesterday to 4.66%, the dollar strengthened, and the stock market continued its recent rally. As an extra credit exercise (due at the beginning of class on Tuesday), graph the ten-year bond using daily data for the last year. Add comments, support/resistance, and indicator information, etc. with the StockCharts annotation tools (Note: when adding comments, leave a space after the last character before closing the box). Then do the same thing with two years of weekly data on the 10-year bond. In a short paragraph (a Word document where you can also paste the two graphs) contrast what the daily and weekly charts are showing.

GDP Report

Friday morning, the preliminary Q3 GDP report was released. While the growth rate, 3.8%, was slightly higher than expected, the media has attributed the large stock market rally to this report.

Screen the media in a situation like this. Everyone knows that Q3 is history and Q4 growth will be slower than the Q3 value. Why the stock run-up then? Partially it was a short-covering rally, where shorts, persons who are betting that the market and individual stocks will be declining, sell borrowed shares of these stocks from their brokers. IF all goes as planned, and the stock prices decline, they can then purchase the shares of these stocks to replace their borrowings at a lower price, giving them profit. On rally days like yesterday, stock prices rise, meaning they will have to pay more to buy the replacement shares, either limiting profit or resulting in an outright loss. So, they often "pull the trigger" and purchase the stocks, leading to further increases. If you graph the Dow-Jones Index ($INDU), you will see two major resistance hurdles for the next couple of weeks: the 50-day MA at 10,437 and the 200-day MA at 10,500. Beyond this, the declining resistance line is at 10,640. Will another bounce off this resistance occur? Stay tuned.

Look at the dollar on days like this. The dollar was higher, and both stock and bond prices rose. What does this indicate? A capital inflow from overseas investors whose overall fears about the future course of the US economy were temporarily pushed aside (remember, they are still unsure about Fed Chair designee Bernarke).

Read about the Q3 GDP report, and remember the "tricks" I showed you about how to summarize all of this data. Look for the significant changes in items from last quarter (Table 1 is % changes, Table 2 notes contributions of individual elements). Remember: this is a preliminary report, where inventories are estimated (September data is not in yet). The same is true for Net Exports.

Keep an eye on Government -- its contribution rose significantly in Q3 as Gulf Coast relief efforts began. This will intensify in Q4, helping that quarter's final value. For durable goods, especially auto sales, sales were higher in Q3. I doubt they will do as well in Q4 as the big discount programs are largely over and they "borrowed" some sales that would have occurred in Q4.

Assignment #1 Answers

I will provide a brief overview of questions #1 and #2.

#1) The MPC falls, so the MPS rises. This causes AE to be less steep, lowering the equilibrium value of Y. Also, the multiplier falls. With a flatter AE curve, monetary tightening, which raises r and lowers autonomous C and Ip, will cause smaller declines in equilibrium Y.

#2) As foreign income rises relative to that in the US, this stimulates US exports to these countries. At the same time, US equities become relatively less attractive, depressing equity prices here. This results in the dollar depreciating relative to foreign currencies (whose economies are growing more rapidly than the US). The capital outflow will also affect fixed income markets here, resulting in a sell off, and higher interest rates.

Inflation and Earnings

Today on CNBC I saw something very interesting. In light of high inflation rates implied by both the CPI and PPI (today), Steve Liesman noted (correctly) that publicly traded companies generally report earnings, etc. without taking inflation into account (translation: they report NOMINAL values not REAL values). I have been saying this for years in my MBA class. I guess when earnings growth is far above inflation, it isn't so bad to overlook real values.

Still, remember what we talked about in class: WHEN WORKING WITH DATA OVER LONG PERIODS, NEVER RELY ON NOMINAL VALUES. ONLY REAL VALUES ARE COMPARABLE OVER SUCH A TIME SPAN.

So, with inflation currently running around 2.5%, any company whose year-over-year (nominal) earnings growth (or revenue growth, etc.) is below 2.5% is experiencing a decline in its real earnings or revenue.

How Strong is the Economy?

There are many ways to gauge the economy's momentum. GDP reports are important, but dated -- we won't have the data for Q3 for another month, and that will be a "first pass." There are other indicators used: the Index of Leading Economic Indicators; Consumer Confidence; Retail Sales; and many others.

A very good real time read on this is given by the Cyclicals Index ($CYC). We have discussed ways to look at short-term and intermediate-term trends. How can we determine the long-term trend? The way I will suggest here is to look at daily data using a very long moving average. How long? Long enough to capture the current trend without having many "bounces" below or above in the short-term. In the diagram of Cyclicals, the MA that works for this is the 400-day (=80 weeks).

The potentially startling result using the 400-day MA, is that the long-term trend has just recently turned negative (early October). Note this on the graph. Also, short-term support has also been violated in the past few days. So, no matter what you hear on CNBC, or Bloomberg, the rosy picture painted by my fellow economists is not shared by asset markets. The message of the Cyclicals is that we are already experiencing a "soft patch." And, as asset markets are leading indicators, this paints a not-so-rosy picture for the upcoming months. Note that this is consistent with what the bond market has been saying for some time now (the bond markets are saying the Fed is tightening too much).

The interesting thing now is to see if the markets are right or whether the optimistic TV "talking heads" are correct.

Q: What do you think is the likelihood of being invited to Larry Kudlow's 5:00 show if you believe what the Cyclicals chart is saying?
A: DUH!

A Troubling Combination

Over this past week, we have observed several days where stock prices fell, interest rates rose, and the US dollar index also fell. From our discussions in class, this should be part of a reasonable and easy to understand sequence -- foreign investors moving some of their money out of US asset markets.

If foreign investors see better investment opportunities elsewhere, they will liquidate some of their US investments. This causes a selling of US stocks and bonds. As a result, stock prices fall as do bond prices. Recall that lower bond prices mean higher interest rates. As these foreign investors then convert their dollar balances into other currencies, the US dollar weakens. Thus the combination we have been witnessing.

Will this continue? Think of what will make US asset markets attractive, as well as the likely changes in interest rates that will be occurring.

CPI Release

At 8:30 the CPI numbers were released. While the overall number was a bit of a surprise (+1.2%), the highest rate in 25 years, the core inflation rate (which excludes both food and energy) was very tame (+0.1%). A good reference for market reaction is at MarketWatch.com. An article on the report itself is also at that site. The initial reaction by the fixed income market was very favorable -- the 10-year bond rate fell by 5 basis points.

As I watched CNBC, I was amused by the reaction to the CPI number by both Mark Haines and Becky Quick -- both refused to believe the number. They cited how high the levels of prices have become, and cited the obvious examples in their lives. Steve Liesman, the economics person (but not economist) correctly pointed out that inflation reflects the rate of change in prices, not their level. This is a critical and often midunderstood point. So, if prices rise to a "high" level and remain there, the inflation rate from that point would be 0%!

The critical issue here is called "pass-through." While the core inflation rate nets out the direct changes in food and energy prices, the overall effects of energy and food prices can and do spill over into core inflation. Note the recent price hikes by shipping companies (UPS and FedEx). The Federal Reserve pays the most attention to pass-through. They are betting that there is enough underlying strength in the economy to allow them to fight the inflationary effects in motion (pass-through) without causing a recession. I have some serious reservations about their strategy. Read about today's release on Industrial Production -- hardly cause for celebration. The Consumer Sentiment Index also showed weakness.

For the Fed, they still see a problem because they want to contain core inflation at below 2% annually. Even with the favorable report this morning, core inflation is running around 2.1%. Remember from our multiplier discussion yesterday, that there are lags in monetary policy. So, as spending is hurt by monetary tightening, it takes time, about 2-3 quarters, for the multipliers to work. This means that for the Fed to head off future inflation, it must act ahead of time. This fact is what confuses so many people.

Before the CPI Release

A look at the stock market yesterday revealed some depressing techncial trends. The major markets were all trading below their 200-day moving averages (MA). For the Dow Jones Industrial Average ($INDU), the 50-day moving average moved below the 200-day moving average. That is a very negative development. For the NASDAQ and the S&P 500, the 50-day MA is still above its 200-day MA, but both are trading below these two MA's.

In general, when a market (or stock) is trading below its 50-day MA, its short-term trend is negative. When it is below its 200-day MA, the intermediate term trend is also negative. For some large institutional buyers, a movement of a stock or index below its 50-day MA is a sell signal.

RECOMMANDATION: before making a final determination on trends, EXAMINE THE WEEKLY CHART.

For the Dow-Jones, the weekly chart is far less negative than the daily chart. $INDU has just recently moved below its 50-day MA, but remains above its 200-day MA, so while the short-term trend is negative, the intermediate-term trend remains positive. More importantly, the price relative (to $SPX) has just turned up -- so on a weekly basis the Dow-Jones is beginning to outperform $SPX.

Post announcement reaction by 10-year bond (click to enlarge).

Post-announcement 10-year bond market (click to enlarge). Graph courtesy of StockCharts.com