U.S. stocks got a boost at the open from overseas manufacturing data as both Chinese and UK factory gauges showed an acceleration in activity – it was the second-straight month of acceleration in terms of Chinese factory output and the first in Britain since May.  However, the rally began to fizzle about an hour into trading as the S&P 500 closed in on the 1200 mark, and then slid into negative territory in the final hour. 

Beyond running into technical resistance, the early gains really began to evaporate on news that JP Morgan Chase improperly allowed a hedge fund to choose assets in a mortgage-securities product (a collateralized debt obligation) that it also invested in – actually betting against what was the riskiest segment of that CDO. (You may remember when Goldman Sachs got into trouble over the same issue several months back; they paid a fine and it was done.  In my view the housing market mess and overall loan quality are much bigger problems for JP Morgan and the banking industry in general.)

The overseas factory data was followed by our own national factory activity gauge, which showed the sector remained pretty hot – manufacturing is holding up much better than I’ve expected, but weakening business spending activity will not be helpful in coming months, particularly since the latest boost is derived from very short-term holiday-season restocking.  A troubling aspect of the factory data is the rise in input prices; if this fails to abate then margins will deteriorate and that means, if not the end to, a significant slowdown in the business-spending cycle.

Telecoms, tech and energy were the only groups to close higher for the day.  Utilities, consumer staples and basic materials (another very strange grouping of safety stocks and high cyclicals) were the day’s worst hit. 

The dollar gained some ground on a little safety-trade after reports that the ECB pumped roughly $360 billion into Ireland and the IMF may soon need to get in and offer a bailout.  Despite a little dollar strength, and it was slight, the CRB (commodity index) held above that 300 level we’ve been talking about.

Volume was weak as trading activity came in 17% below the six-month average.

Market Activity for November 1, 2010

Personal Income & Spending

The Commerce Department reported that personal income fell 0.1% in September (first decline in 14 months and expected to rise 0.2%) after a downwardly revised 0.4% (previously reported at 0.5%) for August.  Spending also missed the mark, coming at 0.2% (expected to rise 0.4%) after August’s upwardly revised 0.5% increase. 

The main private-sector gauges, compensation and wages & salaries, were unchanged in September.  Proprietors’ income rose 0.5% (on the back of another big increase in farm income, up 9.6% for the month) – nonfarm was up a paltry 0.1%.  Rental income continues to rage forward, up 1.2% for September – up 9.7% y/o/y.  Personal income via assets fell for the third-straight month, down 0.3% -- dividend income rose 0.8%, while interest income (thanks Fed) fell 0.9%.

Looky here, government transfer payments fell a meaningful 0.9% in September; no wonder the overall reading declined, which is precisely the problem.  Unemployment insurance slid 18.2% in September. 

Excluding transfer payments, personal income was flat for a third-straight month and remains 5.6% below the peak hit in 2007 – a level of deterioration that has never been recorded in the past 49 years; this data goes back to 1961. 

As a result of spending outpacing income for the month, the savings rate (the cash savings rate) slipped to 5.3% of disposable income from 5.6% in August. 

ISM Manufacturing

The Institute for Supply Management’s gauge of national factory activity accelerated in October to 56.9 from 54.4 in September – this borders on hot activity and is completely disengaged from what’s going on in the overall economy via the GDP reports.  (The level that ISM has averaged year-to-date is believed to correspond with 5% GDP – we’re running at half that rate.)

The internals continue to look really good, for the most part, as new orders jumped 7.8 points to 58.9; supplier deliveries slipped a bit but remain in mild expansion mode; employment improved to 57.7 from 56.5 (although it’s too bad this isn’t reflected in the official jobs data as factory employment has declined for two months); and export orders jumped 6 points to a reading of 60.5. 

The only weakness in the report continues to be the backlog of orders category, which fell a half point to 46.0 – it’s been in contraction mode for two months as production continues to outpace new orders.  This means there is little room for weakness in new orders.

I think these numbers are the last hoorah for this manufacturing cycle and will begin to deteriorate over the ensuing months.  Although, I need to admit that I believed the weakness would show up in September yet the sector continues to carry on.  Again, we’ve seen business spending trend lower and if that trend continues then factory orders are going to feel the effect.  Also, factories are receiving a seasonal boost right here as retailers stock for the holiday season. 

Further, the price gauges continue to show that margins are getting squeezed – and that is precisely why I question the durability of the business-spending cycle.  The prices paid reading within ISM has bounced back to 71.0 (up from 57.0 in June).  This is meaningfully above the long-term average of 58.0, but remains below the peaks hit in previous years.  The problem right now is that firms lack pricing power like never before, at least in terms of the postwar era.

This is a higher input cost problem and a direct result of unprecedented Fed easing policy that has played a key role in boosting commodity prices. 

Construction Spending

Construction outlays rose 0.5% in September on the back of government spending.  Private spending on construction projects was unchanged, but the public sector component rose 1.3% during the month. 

Total construction spending is down 10.4% over the past year and down 34% from the peak hit in 2006.  But it would have been worse without the big increase in government projects (I’m not saying that this is necessarily good for the economy outside of the very near term, in fact I believe such policies carry with them large payback effects) as the public sector now accounts for 39.9% of all construction spending. 

When this government support wanes the industry is left to reality.  And if the support continues, then it diminishes private sector activity in other areas of the economy (a dollar in government spending is a dollar sapped from the private sector).  This is what history teaches; apparently we must learn it again.

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Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900