U.S. stocks erased early-session losses after it was learned that the Securities and Exchange Commission’s (SEC) vote on pursuing a case against Goldman Sachs was not unanimous.  The vote came in at 3-2, which means the SEC pursuit of the way Goldman has allegedly conducted itself may not be as vigorous as previously expected. 

While many will say that it’s GS for the SEC not to pursue the case aggressively, the market also feared the short-term market ramifications of such action.  But we shouldn’t put our guard down, as Congress and state attorneys general are there, in all their populist fury, to go after the entire financial industry by way of a new regulatory regime. 

I do find it surprising the SEC voted this way, considering the several acts of serious malfeasance they missed over the past couple of years, or decades in terms of Madoff.   One would have thought they’d go after this case, maybe even to overdo it, just to make a statement.

The early slide was largely led by basic material shares.  China’s pullback on its stimulus, particularly on the loan front as they shift to more stringent credit standards and halt loans to those speculating within the housing market (third home buyers as they call them), has people worried about Asian demand a few months out. China’s very aggressive stimulus program, both in terms of outright government spending and in massive credit creation, has fueled the Asian economic bounce.  But the market’s mid-day rally gave life to the commodity trade and basic material shares bounced back.

In the end, all 10 major industry groups close up for the session.  Industrials were the laggard, essentially unchanged.  Financials, Friday’s big losers, was the best-performing group, up 1.10%.

Market Activity for April 19, 2010

Europe Versus The Volcano

The volcanic ash resultant from Mt. Whateveritsnameis continues to create havoc in Europe and beyond.   I noticed a couple of articles over the weekend commenting on how the fallout from this eruption threatens to kill the EU recovery.  Surely the cessation of flights is affecting everything from tourism to manufacturing to global trade, but the EU recovery is about as weak as they come and was going to fizzle out on its own anyway. 

For instance, the Eurozone’s largest economy, Germany, managed just two quarters of growth following four quarters of deep declines – and those positive quarters registered increased of less than 3% at an annual rate; and the most recent GDP print came in at zero.  France, the zone’s second-largest economy, mustered a GDP reading of just 2.4% at an annual rate in the fourth quarter.  Italy fell back into contraction during the fourth quarter after one quarter of growth and Spain has yet to see a positive GDP print as they have recorded seven-straight quarters of contraction.  For the Eurozone as a whole, fourth-quarter GDP registered zero after just one quarter of increase, and a weak one at – up 1.6% at an annual rate. 

So people can blame EU economic weakness on the volcano, but all it will actually do is shift things around.  It will make the current quarter looked worse that would otherwise be the case and the subsequent quarter will enjoy the bounce.  But the EU was in trouble to begin with and by 2011 most Western economies will show economic weakness set in again.  And as this occurs, Asia and the Pacific Rim in general, which has recorded the strongest growth over the last couple of quarters, will show the effects as well.

Leading Economic Indicators (LEI)

The Conference Board’s index of leading economic indicators, LEI, jumped 1.4% in March, marking the 12^th month of increase.  A reading of this magnitude is in a range of the strongest you see in a monthly LEI print, and the March number was influenced by more than just the Fed keeping the yield curve at a record wide – a huge positive slope between short-term Treasury yields and those on the long-end of the curve – and stock prices – which to some degree at the least has resulted from the Fed keeping rates floored. 

In March, the average workweek and the pace of deliveries accounted for 42% of the increase.  These are improvements we’ve talked about via the regional manufacturing reports.  When the pace of deliveries (from vendors to manufacturers) slows it means suppliers are having a tough time keeping pace with rising orders – and one can surmise that factories are becoming stretched and need to add workers.  A rise in the average workweek also usually results in an increase in workers.   Now we just need to see it occur.

But the other, what I’ll call artificial monetary-policy inflators, components that have been propping up the LEI index continued to contribute mightily.  The rise in stock prices and the massive upward slope of the yield curve accounted for another 42% of the rise in LEI last month.  Generally, one can view improvement in these components as a good sign for economic growth.  But as we’ve talked about in the past, relying on the normal indicators these days -- indicators that generally are very good at signaling a durable/long-lasting expansion is upon us – may prove deceiving.    

For stock prices, we know that the Fed’s ZIRP is pushing people into riskier assets, and if this is even partially due to the Fed’s stance then it means that some degree of this rally is abnormally short-lived.  Higher stock prices have certainly helped the consumer spending figures improve as more people feel better about their financial position.  If this is an especially short-lived jump in stock prices, however, then one can expect another round of consumer weakness – a proves that is already destined to occur because the household deleveraging process has not truly occurred, the only improvement in household debt levels has resulted from a massive increase in foreclosures – and I wouldn’t exactly call this improvement. 

For interest-rate spreads (the slope of the yield curve), this generally tells us that banks will aggressively boost lending – extending credit is certainly a very profitable endeavor when the rate banks charge for loans (dictated by the longer-end of the curve in many respects) is much higher than their cost of funds (dictated by the short-end of the curve).  But today we still find that credit continues to contract, the normal juice to economic expansion is not there.  Instead, the massively sloped curve in this environment of poor credit quality (which already has the banks uneasy to lend) has banks flooding into the Treasury market -- it’s much safer to borrow near zero and lend to the government at something considerable higher (and even 1.5% is much higher than zero).  That is, this credit is not getting to the private economy.  Yes, very large firms can borrow from the capital markets, investors are lurching for yield despite the risks attached because of what the Fed has done.  But small firms are essentially shut out of the credit markets, and small business provides for the majority of job creation. 

I think the artificially inflated nature of LEI can be seen via the way the leading index has overtaken the coincident index (another reading within the report).  The coincident index, which is meant to track the current economic state rather than what it may look like six months hence, removes the factors the Federal Reserve and federal government can massage in the short term.   Notice how the leading index has shot through the coincident index, which rarely occurs and certainly never with this vigor.  Then again, the Fed has manipulated the slope of the yield curve and stock prices like never before, and those are the components that have most influenced the leading index during this run. 

Also notice how the leading index bridged the gap and converged upon the coincident index earlier last decade – another time the Fed was aggressively easy.  This time it won’t take so long for troubles fostered by an unprecedented monetary easing campaign to show up.

Bottom line: So long as the Fed is at zero, the improvement in LEI is highly suspect.  These are comments that are maybe difficult for one to believe accurate as the stock market continues to rise and corporate profits have rebounded nicely, but a couple of quarters down the road and this analysis will be easier to accept. 

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900

www.acrinv.com