U.S. stocks rallied the most since …no, I’m not going to go there – it was just May 10 when the S&P 500 jumped 4.4% after four days of rather deep declines.  But don’t you just love how the media headlines things in this way, as if it’s been years since such a move has occurred.  When the markets are stuck in a range and volatility is running fairly strong, relatively large moves are frequent – and man do these numbers look familiar, kind of feel like you’re the Griswolds on the roundabout.  “Hey look kids, there’s Big Ben, Parliament.” http://www.youtube.com/watch?v=iAgX6qlJEMc

Seriously though, it was a strong day as advancing stocks trounced decliners by an 18-to-1 margin and even volume was decent at 1.4 billion shares traded on the NYSE, but then we are just ahead of a holiday weekend, so volume shouldn’t be any weaker than that.  One would like to see a bit more conviction, but we know by the activity over the past month that there’s none of that. 

The broad market finished yesterday nearly 1% above Wednesday’s intraday high – remember the market fell apart late in that session.  A Financial Times article suggesting that China’s SAFE (State Administration of Foreign Exchange) was going to reduce their euro-zone bond holdings appeared to be the primary reason the market erased Wednesday’s intraday gains late in the session.  Yesterday morning, however, SAFE issued a statement saying they will maintain their European investments, calling the report “groundless.”  So, traders pushed prices back to levels prior to that FT report.

In Thursday’s letter we explained China wouldn’t begin to reduce euro-denominated holdings by broadcasting it to the world, thereby crushing the $630 billion in European government bonds they currently hold.  The point of the statement is to explain that the market turned lower on what should have been seen as a bogus report.  What it signals is the jumpy nature of the old stock investor these days, even if a story sounds ridiculous people aren’t waiting around and taking any chances, whatsoever.  Hold onto your hats!

All 10 major industry groups ended in the black.  Financials led the way, up a whopping 4.45%, erasing the prior week’s losses (but still 12% off the recent peak).  Energy, basic material and tech were also among the top performers.  Health-care and consumer staples were the laggards, but they too were up nicely – nearly 2%.

Market Activity for May 27, 2010

First Revision to Q1 GDP

The Commerce Department revised their first-quarter GDP reading lower to show the economy grew at a 3.0% real annual rate (it was expected to be revised up to 3.4%), after initially estimating last month to have grown 3.2% via the government’s first look.  The main reasons for the revision was a slightly lower increase in personal consumption (although this component, the largest for GDP, still came in very strong), a larger than previously-estimated decline in commercial construction, a slightly lower boost from business spending, and a bit more drag from government spending (state and local governments are in a world of hurt, as I repeat yet again, and it’s overwhelming the increase in spending on the federal side).

So let’s not re-hash the minutia of this report, as we went over this all last month when the initial estimate was released.  Instead, I’ll focus on a few larger picture items that pop out. 

Personal consumption was strong (considering the consumer headwinds), even if it was a bit milder than initially estimated, accounting for a whopping 80% of first-quarter GDP.  This component had made up 70% of GDP over the previous few years, a level that was already unsustainable.  It will eventually return to its long-term average of 65%, a reality that the economy will not be able to escape due to the heightened degree of household debt levels, high joblessness, a decline in wealth and flat incomes (in fact, take away the temporary stimulus of transfer payments and real personal income has declined 2.83% per annum over the past two years).  The eventual reduction in personal spending will pressure GDP even if durable and substantial job growth ensues, which is quite the “if” at this stage.

The government component is likely to continue dragging on GDP as states and localities must rein in spending.  Their largest issues are state and local employee pension plans that are also unsustainable.  The fight to bring these outlays to levels that make sense will result in a major political fight, but reality will eventually win.  Increasing states’ financial woes is the recently passed health-care legislation that will force these governments to fund millions more in Medicaid rolls – states fund about 50% of Medicaid payments. 

Q1 GDP was revised lower even as inventories were revised higher.   The inventory dynamic is something we’ve talked about for nearly a year now, and it can provide a very nice boost to economic growth over short periods of time.  However, it is discouraging that other aspects of the report overwhelmed the higher revision within the inventory component.  And real final sales, GDP minus inventories (which is meant to show the underlying demand within the economy), came in even lower due to the upwardly revised inventory reading – down to 1.4% from the previously estimated 1.6%.  Real final sales normally hits 4-5% coming out of recession, yet the best number we’ve seen during this three-quarter stretch of GDP improvement has been 1.7%. 

GDP is not showing the normal power that follows deep recessions.  Another fact we’ve harped on for a while now is that following the three prior worst recessions of the postwar era, GDP had averaged 7.75% roughly a year after those recessions ended.  This time we’re on pace to average about 4.2%.  There is something wrong with this picture. 

Jobless Claims

The Labor Department reported that initial jobless claims remained stuck above the 450K level, falling 14,000 to 460,000 in the week ended May 22 – economists had expected these claims to fall to 455K. 

We need initials to fall to 400K, which is the level that always accompanies sustained job growth.  (While we’ve seen job growth pick up over the past couple of reporting months, we’ll need a long period of consistent monthly employment gains just to bring the jobless rates below 9%.  Monthly job increases of 208,000 for at least a year are needed just to keep up with labor force growth – the labor force will jump over the next year; it is reasonable to expect one million re-entries, and the traditional 1% per year population growth will boost it by another 1.5 million.)

The four-week average of initial jobless claims rose 2,250 to 456,500.

The improvement in continuing claims remains in place, falling another 90,000 last week – traditional claims were down 49K and emergency extensions (EUC) fell 41K.  However, with initial claims still elevated (net firings elevated) and the long-term unemployment figures at record levels, one has to believe that this decline is due more to benefits expiring than the result of job growth.  Oh, and with Congress planning to pass (today) their latest iteration of jobless benefit extensions, we are likely to see EUC claims rise again.

Have a great Memorial Day weekend!

Brent Vondera, Senior Analyst