U.S. stocks recovered Friday’s mild losses as stock traders ask: “What jobs report?”    Bond traders on the other hand won’t forget the labor market situation so easily, and we’ll get into that below.  Stocks also brushed off a San Francisco Fed paper suggesting “the macroeconomic outlook is likely to deteriorate progressively sometime next summer.”  It would be nice if it took until then. 

Beyond this resilience, if you can call it that, I was surprised to see traders bid prices higher simple because we get an FOMC statement today (thought there’d be a wait-and-see approach), and unlike the past few meetings this one is going to get a lot of attention as most people seem to expect a language change at the very least.  Then again, who am I to try and call this market.  More than ever, it’s anyone’s guess – in the short term at least. 

Volume was absolutely pathetic, as it has been for past the three sessions – hitting just 63% of the six-month average yesterday.  Yes, it is August, and not many people aren’t around, but generally volume can muster 85% of the average and doesn’t really tail off until late in the month.

All 10 major industry groups gained ground yesterday.  Telecom and consumer discretionary shares led the advance, while health care and utility stocks were the laggards.

Market Activity for August 9, 2010

The Disconnect…Won’t Have to Wait Much Longer to Know Who’s Right

There is a massive disconnect right now as the bond market signals economic hell is here (0.54% on the two-year, 2.83% on the 10-year), yet stocks are behaving like the recovery has a reasonable shot of turning into actual expansion.  Stocks certainly aren’t going gangbusters, but relative to what’s occurred in the bond market traders appear sanguine. 

I recall a sort of equity/bond market disconnect occurring in mid 2003 as Treasury yields hit their cycle low while stocks had bounced 25% off the low within two months.  I was saying the stock market had it right back then, largely because we didn’t have the same structural issues we do today.  The jobless rate topped out at 6.3% (not 10%), household debt relative to after-tax income stood at 100% (not 120%) – it was high back then but more manageable with a better job market, home prices were rising at an 8% annual rate during the previous four-year period by 2003 (not down 5.6% annually as they are over the past four years), the Fed hadn’t gone completely native – although in hindsight they sure did royally jack things up, tax rates were on the way down (not up), and GDP was bouncing at a 4% plus rate after a very mild downturn (not barely hitting 3% even with unprecedented Fed action and off of the worst recession in the postwar era). 

So we’ll see which market is right in calling this one.  The bond market is signaling much weakness to come and stocks appear to be saying economic activity will trend higher, even if it’s at a below average rate. 

This Week’s Data and the Fed

It will be a big week, not just because we get the latest NFIB survey on small business confidence, the latest on consumer confidence, CPI for July (particularly interesting with all of the deflation talk), the weekly event that is initial jobless claims (increasing important these days with such lackluster job gains) and retail sales, but because we also have an FOMC meeting this week.  And it will be the most important meeting in quite a while as they are very likely to set the stage for further quantitative easing.

A statement follows these meetings, and it’s expected that the members of the FOMC will further downgrade their assessment of the economy and may say something regarding another round of QE.  As stated yesterday, I’m not sure they’ll go there just yet, not big bang at least, but expect something nuclear by year end.  At which point, even the blindly bullish will acknowledge that things are far from normal – such is the reality of a debt-led recession; the road to ultimate recovery takes longer than is usual and it’s made worse by politically reactive policy. 

For today’s statement, expect them to massage the wording of the statement to relay that the extremely low level of fed funds will remain in place for eternity (that’s a joke, but just barely) and at the least set the ground work for using  pay downs of their mortgage-backed securities to buy more Treasuries – such action won’t result in substantial easing but it will get the market ready for further action ahead.  Oh, and watch for Hoenig’s vote.  He has been the lone dissenter, wanting the exceptional low rates of fed funds for an extended period phrase removed.  If he gets back in line with the other members, it will signal something big is coming. 

When they do go big bang by year-end 2010/early 2011, I’m sorry to say the plan won’t work because only time can ultimately heal what ails.  Of course, good policy that incentives businesses to spend and hire can ease the economic damage (that’s the lesson from the early 1980s), but we’re nowhere near such action. Besides, this part of the strategy is out of the Fed’s hands, it depends on Congress and the WH -- and stimulating the supply side is seen as anathema to these people; boosting demand remains all the rage.

But back to the Fed, in fact the next round of meaningful QE could turn disastrous.   What happens to corporate profits when the decision encourages traders to bid commodity prices higher?   Higher input costs relative to selling prices isn’t exactly a good mix for profit margins.  What happens to the yields curve?  Long-end yields can come down much lower relative to the short end, which is all but floored.   What we ultimately need is strong and consistent job growth, but the Fed can’t do a darned thing to spur job creation.  This takes confidence and incentives, and that depends on tax and regulatory policy. 

Have a great day!

Brent Vondera, Senior Analyst