U.S. stocks rallied Wednesday after an employment survey posted a huge print followed by the best service-sector reading yet for this recovery cycle.  While the employment number was viewed with a little skepticism (economists weren’t willing to boost their estimates for Fridays official jobs report by much on the news) and the service-sector gauge showed some deterioration within its internal indices, one can’t ignore that we’ve received much better employment and consumer readings of late.

The better-than-expected data led to a selloff in the Treasury market (though longer-term yields remain below the most recent highs hit in December and well below the peak for 2010).  The 10-year yield, for instance, leapt 13 basis points to 3.46%.  The economic data also caused crude oil to reverse early declines and move higher.  It certainly wasn’t because the weekly energy report was bullish as fuel inventories rose more than expected.  However, last week was a bad week by which to gauge things due to the snowstorms that hammered the Eastern U.S.  Gasoline and diesel inventories jumped as demand plunged 6% (gasoline demand down 5.8% and diesel down 6.4%). 

Financials, consumer discretionary and tech led the rally.  The S&P 500 index that track utilities was the only of the major 10 groups to close down during the session; basic material and consumer staples were also among the biggest laggards. 

The CRB rallied yesterday too, and with the Dollar Index up big that link (weaker dollar, higher commodities) broke down yesterday.  Agricultural and energy prices (crude back above $90) led the CRB higher. 

Despite, on balance, the improved data figures over the past several weeks, I’m sticking to the forecast that economic data is going to weaken in the months ahead.  My timing has certainly been off regarding the manufacturing sector -- most factory gauges continue to post strong results (although the capacity utilization rate remains 10% below normal and factory payrolls have declined for the past four months).  And while the jobs data is likely to show a really nice bounce off of November’s weak results, most of the best economic numbers we’ve received over the past two months are a function of rising stock prices (which as we know all too well can certainly turn and have the opposite effect on wealth) and the first holiday season in three years to benefit from a greater willingness among consumers to spend.  The problem is the improvements don’t appear to be coming from organic means, if you will.  Instead, the numbers have been engineered by massive short-term stimulus and I’m sorry to say that such artificially driven activity is not long-lasting (leading to additional rounds of weakness in the very short term, such as we saw mid-2010) and carries with it a huge payback effect when it comes time to unwind (regarding the intermediate term).

Market Activity for January 5, 2011

Mortgage Apps

The Mortgage Bankers Association reported that their applications index rose 2.3% in the week ended December 31.  This follows five weeks of decline that was largely a function of lower refinancing activity due to the rise in rates. 

Applications to refinance a mortgage did end its streak of decline in this latest week though, up 3.9%, as the average contract rate on the 30-year fixed mortgage slipped to 4.82% from 4.93% in the week prior.  Purchases fell for the third week in four, dipping 0.8%.

ADP Employment

The employment change survey from outsourcing firm Automatic Data Processing estimated that private-sector payrolls surged 297,000 in December (well more than the 100K expected).  This is the largest number the ADP report has ever printed, although the survey’s history is a short one as it only goes back to 2001.

The report estimated that goods-producing industries added 27,000 payrolls – 23K coming from manufacturing (if this is accurate it will mark the first payroll increase for the sector since July); construction payrolls were unchanged according to ADP, so the other 4K must have come from the mining sector.  The unchanged reading for construction payrolls ends a 42-month streak of decline.

Service-producing industries increased payrolls by 270,000 -- the report doesn’t break out the numbers from the individual sectors.

Large firms (> 499 employees) added 36,000 jobs; medium-sized firms increased payrolls by 144,000; and small firms (< 50 employees) added 117,000 jobs. 

ADP’s results underestimated private-sector payrolls every month this year, so we can expect something that is much better than the 170K expected (with a whisper number probably above 200K) for tomorrow’s official jobs report.  The market currently expects a total increase in payrolls of 150K, as economists expect a decline in government employment.  Could this be the sign that we’ll finally get that first 300K private-sector monthly payroll increase that accompanies nearly every labor market expansion cycle?

Let’s hope we’re on the road to something big, as we need a string (like a full year) of 300K-plus in monthly job growth to get the unemployment rate meaningfully lower in a reasonable timeframe and finally get the Fed out of the way.  At which point, we can return to fundamental analysis and find out exactly what this market is made of; what the economy is made of and its ability to withstand higher interest rates after the central bank has conditioned the marketplace to ultra-low rates. And just as important, the government’s ability to finance the explosion in debt we’ve incurred over the past three years. 

ISM Service

The Institute for Supply Management’s gauge of service-sector activity rose to the highest reading during this recovery cycle, up 2.1 points to 57.1 (expected to rise just 0.7 point to 55.7).  A reading above 50 marks expansion.

The new orders index jumped 6.5 points to the hot level of 63.5, the business activity index rallied 5.5 points to 63.5 and the inventory change index rose a point to 52.5. These were the readings that drove the composite index up to that reading of 57.1.  

However, the other sub-indices showed deceleration.  To wit, backlog of orders fell back to contraction mode, dropping three points to 48.5; supplier deliveries fell a point to 51.5; inventory sentiment rose 1.5 points to 61.5 (a higher reading is bad as it shows more respondents believe their inventories are too high); the employment measure fell 2.2 points to 50.5 (that may have dampened the euphoria from the ADP number of bit); and exports slipped 3.5 points to 56.0, although still a healthy reading.

Bottom line:  This is a good report from ISM, but a number of segments showed deterioration.  The average reading for December is 55.4 (excluding recessions), so this print is above average.  So long as new orders remain hot the composite reading will hold up.  The prices paid measure jumped 6.8 points to a reading of 70.0 (below the all-time high of 78.8 but well above the ex-recession average of 63.0.  Respondents noted that they are buying inventory ahead of pending price increases, so some of the inventory increase appears to be less due to sales optimism than it is dancing around future price increases. 

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Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900