What is wrong with the stock market? Part I

Global stock markets went through two weeks of very bloody, gut-wrenching sessions. The Dow Jones Index (DJI) lost almost 2000 points in 3 weeks. Going through the last 10 sessions was like fumbling your way through a multi-level deep dark tunnel. As soon as you thought you saw the end of the tunnel, you stumbled into a deeper, darker hole. Triple-digit deep red figures were intertwined with only two very small greens. To make it worse, DJI stumbled over 600 points (5.5%) yesterday, sending the market into a full-blown panic. VIX, a gauge of fear, surged to 48, a level unseen since the flash crash.

"Is this the bottom?"

This is the multi-trillion question that is on the mind of every other person, be it someone who is enduring pain in the stock market or who has plenty of cash set aside waiting to invest. For a few days, yesterday may have found the bottom for the market. In fact, if the Fed Chair, Bernanke can give a little bit more than just a rhetoric like the one given by President Obama, the extremely oversold market may very well recapture 300-500 points in a couple of days. However, the development beyond a few days is far more difficult to conjecture. It all depends on what kind of rabbits the Fed and hopefully, the government, pulls out of their hats.

"What is the problem? "

What is more worrisome than not knowing the answer is not knowing the question. Not many people out there can tell exactly which problem is at the core of this precipitous fall. Therefore,  one cannot tell whether it is a bottom until he knows which rabbit should be pulled out of the hat to be a solution.

There are three problems that are cited by most as causing the sell-off. The list may expand.
1. Europe debt crisis
2. The worry that the US economy maybe  heading at a double dip, and bringing the world with it.
3. S&P downgrade of US government debts

Which one is it? Until we ask the right question, we cannot hope for a right answer.

Economic Slowdown?

July manufacturing and non-manufacturing survey released by the Institute of Supply Management (ISM) pointed to a worrisome  outlook of the economy.

On August 1, 2011, the market took a sharp dive soon after the debt-deal relief rally. The sharp dive coincided with a shocking ISM manufacturing index for July that came in at a disappointing 50.9 vs a 55.3 reading for June. Although any reading above 50 indicates monthly expansion in business conditions but the reading  is now at the slowest rate so far of the recovery. Most troublesome are new orders and backlog orders data. New orders at 49.3, a little below break-even 50, indicated a contraction. This is the first sub-50 reading since June 2009.Backlog order dropped to the territory of contraction to 45.0 for the lowest reading since April 2009.These two figures pointed to more slowdown in manufacturing in coming months.

The ISM non-manufacturing pretty much echoed the
 manufacturing counterpart.A second month of slowing
in new orders and deepening contraction in backlog orders undercut strength in the ISM non-manufacturing composite index for July that edged only slightly lower to a 52.7 level that indicates moderate monthly expansion compared to June. New orders, which were in the 60s as recently as March, fell nearly two points to 51.7 and are now testing the monthly breakeven level of 50. Backlog orders are already well below 50, down 4-1/2 points in the month to 44.0. Weak orders do not point to overall strength in the months ahead.

The Timeline of The Fed's Exit Strategies

From the June FOMC meeting minutes,

Step 1: cease reinvesting some or all payments of principal on the securities holdings in Special Open Market Account (SOMA).

Step 2: modify its forward guidance on the path of the federal funds rate and will initiate temporary
reserve-draining operations aimed at supporting the implementation of increases in the federal funds rate.

Step 3: begin raising its target for the federal funds rate, and from that point on, changing the level or range of the federal funds rate target will be the primary means of adjusting the stance of monetary policy.

Step 4: Sales of agency securities from the SOMA will likely commence sometime after the first increase in the target for the federal funds rate.


Step 5: The pace of sales is expected to be aimed at eliminating the SOMA’s holdings of agency securities over a period of three to five years, thereby minimizing the extent to which the SOMA portfolio might affect the allocation of credit across sectors of the economy.

Step 6: The Committee is prepared to make adjustments to its exit strategy if necessary in light of economic and financial developments

Manufacturing is in contraction

Two important regional manufacturing indices this week reported contractions in manufacturing.
For the first time since November 2010, Empire State Index that was released by the New York Fed fell nearly 20 points in the June reading to minus 7.79 in what the report describes as a "steep" decline. New orders fell nearly 21 points to minus 3.61. Shipments are even worse, down nearly 35 points to minus 8.02.

Philly Fed survey echoed the Empire State survey. Philly Fed general business conditions index came in at minus 7.7 for the first negative reading since September 2010.  New orders are minus 7.6 with unfilled orders at minus 16.3. Shipments and employment both rose in the month but at a slower rate.  Declines in orders are likely to point to slowdowns, if not contractions, in shipment and employment.

Business sentiments deteriorated quickly. The six-month outlook as what were once expectations for very solid growth are now turning into expectations for only marginal growth. Much cited in recent weak economic data reports has been Japanese supply effects. However. transportation equipment, where Japan effects is the most pronounced is not a dominant industry in either the Mid-Atlantic or New York regions. This week's two reports raise the risk of contraction for the ISM's national report on manufacturing to be posted at the beginning of July.  

Another negative is a big decline in the six-month outlook as what were once expectations for very solid growth are now turning into expectations for only marginal growth. Japanese supply effects may be at play to some extent but transportation equipment is not a dominant industry in either the Mid-Atlantic or New York regions. This week's two reports raise the risk of contraction for the ISM's national report on manufacturing to be posted at the beginning of July. 

CPI figures mean no more QE3?

The consumer price index in May grew at a 0.2 percent rate. The core CPI, that excludes energy and food prices, jumped 0.3 percent. Both measures were worse than analysts and expected. Year-on-year, inflation worsened to 3.4 percent (seasonally adjusted) from 3.1 percent in April. The core rate bumped up to 1.5 percent from 1.3 percent in April on a year-ago basis.

Although energy prices came down 1.0 percent, following a string of strong gains including 2.2 percent in April, food prices rose 0.4 percent, matching the boost in April.

There are signs that  inflation in agricultural products and energy may have been passed along to products. Apparel, shelter, new vehicles, and recreation all contributed to the acceleration in the core CPI, rising more in May than in April.

One of the two primary goals of the Federal Reserves is to maintain price stability and full employment. With the year-over-year core CPI so close to the Taylor rule of "2%", does it mean we can pretty much sweep QE3 underneath the rug?

A Dismal Job Report

In the last 2 days, one question that lingered in market participants' minds has been whether the market has priced in a poor job report schedule today following an anemic ADP private payrolls report on Wednesday. The market gave a resounding answer this morning,  "NO. Not this much." The market opened down with triple-digit loss again in the Dow Jones Index with a dismal Employment Situation Report.

Nonfarm payroll employment in May grew a modest 54,000, following a revised 232,000 jump in April and a 194,000 increase in March, far lower than analysts' revised forecast for a 170,000 expansion.  Private nonfarm payrolls advanced 83,000 in May, following a 251,000 increase in April, also far lower than the median forecast of a 180,000.

From Wall Street Journal,

Sluggishness in payroll jobs was broad based...................................

Goods-producing jobs edged up 3,000, following a 38,000 rise in April. Manufacturing jobs dipped 5,000 after a 24,000 advance the month before. However, construction nudged up 2,000 after a 5,000 increase in April. Mining gained 7,000, following an 11,000 boost in April.

Private service-providing jobs slowed to an increase of 80,000 after a 213,000 jump the prior month. There was not much to write home about as the biggest component gain was for professional & business services with a 44,000 increase in May. Health care rose 17,400 for the latest month. On the down side, retail trade fell 8,500 while leisure & hospitality dipped 6,000.

Government jobs contracted 29,000, following a 19,000 dip in April. This latest decrease was largely local government, led down by local government education.

On a positive note, wage growth improved in May as average hourly earnings rose 0.3 percent, following a 0.1 percent uptick in April. May's number topped the median forecast for a 0.2 percent increase. The average workweek for all workers in May held steady at 34.4 hours.

On a year-ago basis, overall payroll jobs in May eased to 0.7 percent, down from a 1.0 percent pace the month before.

Turning to the household survey, the unemployment rate nudged up to 9.1 percent from 9.0 percent in April. Household employment actually rose 105,000 for the month but was outpaced by a 272,000 gain in the labor force.

The big question is whether the May numbers are a temporary soft spot or a new trend.

ISM Data Shows Significant Slowdown

From Wall Street Journal

Monthly growth slowed very significantly in the manufacturing sector during May, according to the Institute For Supply Management whose headline composite dropped 6.9 points to a much lower-than-expected 53.5. Importantly, new orders slowed a very significant 10.7 points to 51.0, still over 50 to indicate growth compared to April but well under April to indicate a much slower rate of growth. Manufacturers drew heavily on backlog orders which fell 10.5 points to 50.5.

Other readings show a significant slowing in production, a moderate slowing in hiring, and decreasing delays in delivery times that are consistent with slowing conditions. Inventories interestingly contracted in the month, suggesting that manufacturers were quick to keep levels down given slowing demand. It also perhaps reflects supply shortages tied to Japan.

The ISM manufacturing index (formerly known as the NAPM Survey) is constructed so that any level at 50 or above signifies growth in the manufacturing sector. A level above 43 or so, but below 50, indicates that the U.S. economy is still growing even though the manufacturing sector is contracting. Any level below 43 indicates that the economy is in recession.

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ADP Data Confirms a Slowdown?

A 2% loss day of the Dow Jones Index coincided with disappointing ADP and ISM data. ADP estimates private payrolls rose only 38,000 in May which is far below expectations for 210,000. The ADP national employment report is computed from a subset of ADP records that in the last six months of 2008, represented approximately 400,000 U.S. business clients and approximately 24 million U.S. employees working in all private industrial sectors. The data are collected for pay periods that can be interpolated to include the week of the 12th of each month, and processed with statistical methodologies similar to those used by the U.S. Bureau of Labor Statistics (BLS) to compute employment from its monthly survey of establishments. (Definition of Wall Street Journal)

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