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Today's Market WrapUp 06.06.2007 Mon Tue Wed Thu Fri Puplava Archive
Everyone was looking for what would break the equity rally that began after the February sell-off that arose after the Chinese Shanghai index corrected. The consensus thinking was that it would be the Chinese market once again as it accelerated even higher and was overdue for a correction. Well, the Chinese market began correcting last week and was down 21.5% from the high seen on March 29th (4335.96) as of yesterday before staging a rally. The sell-off didn’t rattle the markets as it did back in February, but what appears to be the straw that broke the camel’s back was rising interest rates, which also contributed to the sell-off that was seen in May of last year. Figure 1
The 10-year UST yield broke its downtrend that had been in place since last June, the beginning of the equity rally that saw the S&P 500 rise nearly 24% while the 10-year UST fell 15% from a high in the yield of 5.23% to a low of 4.43%. However, since the May low the 10-year UST rose from 4.65% to nearly 5% and broke its downtrend at the same time, and yet the markets marched ever higher. There seems to be a disconnect between Wall Street and Main Street that continued to ignore the signs around it as the markets have also continued higher despite rising energy prices, dwindling small business optimism, and falling consumer confidence. Wall Street may now be catching up with Main Street with the recent slide in equity prices. Figure 2
Figure 3
Figure 4
The markets were being driven upwards with private equity deals and mergers and acquisition (M&A) deals while ignoring negative economic news and a continual deterioration in the housing market. The White House lowered its forecast for economic growth this year with a release today that put their estimated growth at 2.3% this year, down from their previous estimate of 2.9%. Fed Chairman Bernanke has continued to reassure the markets that the economy remains strong despite first quarter GDP coming in at a meager 0.65%, the worst showing in more than four years. Bernanke, in a speech by satellite, said yesterday that the economy will recover from its recent feeble performance despite ongoing weakness in housing, which he said could drag on the economy for longer than anticipated. Though housing has clearly been a drag on GDP, Bernanke said that "We have not seen major spillovers from housing onto other sectors of the economy.” Tell that to Bed Bath & Beyond (BBBY) who announced their earnings release late Monday. Bed Bath & Beyond Investors Take a Bath In a statement issued late Monday, Chief Executive Steven Temares said a dropoff in consumer spending was a major factor in the company's first-ever earnings shortfall since it was publicly listed in 1992. "Based upon what we have experienced and has been reported by others, the overall retailing environment, especially sales of merchandise related to the home, has been challenging," the CEO said. Bed Bath & Beyond leads retail index lower The home-furnishings retailer pared its first-quarter profit projection to a per-share range of 36 cents to 38 cents. That's below the 39 cents a share forecast reached by analysts reporting to Thomson Financial. Bed Bath & Beyond said its same-store sales would rise about 1.6% compared with the 3% to 5% original forecast. That prompted Goldman Sachs analyst Adrianne Shapira to downgrade her rating on the stock to neutral from buy. "While Bed Bath & Beyond has historically been able to buck the trend, the convergence of a tough housing sector, aggressive competition, and rising oil prices has proven tough to overcome," she said. Bernanke’s call for a rebound in economic growth appears hard to swallow when the vast majority of economic data reveals decelerating trends, not accelerating. For instance, though employee compensation is growing, the rate of change of growth continues to decelerate with retail sales along with it. Employment trends are the largest contributor to income trends, and both appear to be rolling over. Figure 5
Figure 6
In terms of assessing economic strength, employment trends are one of the key factors from a top down approach as greater employment means greater incomes, which then translates into greater consumer spending and higher GDP. As mentioned previously, the year-over-year (YOY) rate of change in employment has decelerated and has contributed to weaker economic growth as seen by durable goods shipments which display a strong correlation to employment trends. Figure 7
To see where the strength and weakness lies within employment, three key sectors are shown below. Manufacturing (blue line, Figure 8) has not decelerated sharply as it has in the past leading up to recessions, though it still is currently growing at a negative YOY rate of change as more manufacturing jobs are shipped overseas, with manufacturing playing a smaller role in the current economic expansion than in the past. The two key areas of the current economic expansion have been the U.S. consumer (retail) and housing (construction). Retail employment (orange line, Figure 8) peaked at just under a 2% YOY rate of change in the middle of 2005 and decelerated sharply along with the housing bust, though recently it has peaked back up, currently up 0.4%. This pick up in retail employment is likely to be temporary as railcar shipment data does not corroborate the trend in retail employment as railcar shipments continue to plunge, indicating a weakening, not strengthening, economy and U.S. consumer. Figure 8
Figure 9
The other key area of employment has been construction employment (green line, figure 8 above), which peaked in the middle of last year at 7.1%, and has fallen off a cliff in short order and turned negative at -0.35% currently. Ignore those that continue to say that the housing recession is not spilling over into other areas of the economy, as the trend in employment speaks otherwise. Coinciding with falling construction employment on the heels of a housing recession are strong weakness present in manufacturing industries geared towards housing. For example, strong weakness is present in the wood and furniture products industries, both of which are sharply contracting with wood product employment down 7.1% and furniture and related product employment down 5.5%. Figure 10
Things are likely to get worse with the housing sector due to the current trend in interest rates that Wall Street is just finally starting to pay attention to. The trend of falling interest rates from 1990 to the lows of 2002 spurred one of the strongest and longest housing bull markets in the last one hundred years. Even though rates bottomed in 2002, purchase applications, as measured by the Mortgage Bankers Association (MBA), continued to climb until peaking in the middle of 2005, with rising interest rates displaying a lag on mortgage demand. Figure 11
The recent rise in interest rates may be a major development, marking a secular turning point in interest rates as the 30-year UST bond yield has broken a downtrend that has been in place for more than two decades, which would be a very negative development for the housing market with trillions worth of mortgages that will reset at higher rates over the next two years. Figure 12
Figure 13
If interest rates continue to rise, the slump in housing may worsen as more homeowners with ARMs are unable to make their payments. This will put further pressure on the housing sector with housing still having a long way to go in terms of bottoming as residential fixed investment as a percentage of GDP is not even half way to the level of previous bottoms. Figure 14
The overhang of housing on the economy will continue to weigh down economic growth for the foreseeable future as the housing slump has spilled over into the economy. If you aren’t convinced, take a look at the directional similarity of Bed Bath & Beyond with the Philadelphia Housing Index (HGX). Figure 15
Related to the housing and domestic industry, and also interest-rate sensitive, the consumer discretionary, financial, and retail sector have all failed to surpass their February highs and have severely lagged the S&P 500. In contrast, globally exposed sectors surpassed their February highs in concert with the S&P 500 as global economic growth remains strong while U.S. growth is anemic. Figure 16. Domestic Related Industries
Figure 17. Globally Exposed Industries
The current equity slide may continue as Wall Street readjusts to Main Street reality amidst a rising interest rate environment and continued housing slump despite CNBC constantly suggesting a possible bottom. It’s anyone’s guess how far and long the markets will correct. But one thing has remained constant over the past year, and that is the market's ability to surprise to the upside. Private equity deals and M&A activity may put a floor under the markets, but this is less likely to be the case with rising interest rates that reduce their profit projections by raising the cost of borrowing debt to fund their deals. It seems as if all eyes have now turned from watching the Fed and China to watching interest rates, and movements in the Treasury markets may be the key indicator to determine when the correction in the markets may subside. TODAY'S MARKET The markets continued their decent from yesterday’s sell-off after a release of downwardly revised nonfarm business productivity from 1.7% to 1.0% in the first quarter, and a large upward revision to unit labor costs, which were adjusted to 1.8% from the preliminary estimate of 0.6%, stoking inflation concerns. Additionally, as mentioned above, the White House revised down their economic growth forecast from 2.9% to 2.3% (Q406/Q407). Adding further to the negative news, the National Association of Realtors (NAR) trimmed its sales forecast for the fourth straight month and said it now expected sale prices would drop more sharply than it previously forecast. The NAR revised existing homes sales down to 6.18 million units for this year from their previous estimate of 6.29 million units, and changed their median sales price decline estimate for the year from 1.0% to a 1.3% slide. The negative news led to a triple decline seen in the Dow, which fell 129.79 points to close at 13465.67 (-0.95%), with the S&P 500 down 13.57 points to close at 1517.38 (-0.89%), and the NASDAQ slid 24.05 points to close at 2587.18 (-0.92%). Investors purchased Treasuries today with the 10-year note yield at 4.97%, falling 0.6 basis points. The dollar index was down on the day, falling 0.01 points to close at 81.88. Declining issues represented 78% and 66% for the NYSE and NASDAQ respectively, with down volume representing 84% and 74% of total volume on the NYSE and NASDAQ, reflecting a strong sell-off in the markets. Energy prices were mostly up on the day despite a strong build in gasoline and distillate inventories seen in the petroleum inventory release, with the 3-2-1 crack spread falling 2.92% and the one month contract on gasoline down 0.77%. Precious metals were relatively flat after staging a late afternoon rally with gold finishing in the green today at $671.05/oz (+0.15%) while silver was down $0.03/oz to close at $13.73/oz (-0.22%). Base metals were mostly down with tin putting in the only positive performance (+0.17%), while zinc displayed the weakest performance (-2.97%).
Overseas markets were mostly down with Germany’s DAX putting in the weakest performance (-2.4%), while a few select Asian markets finished in the green, with the Korean Kospi (0.26%) and Chinese Shanghai index (+0.24%) putting in the strongest performances.
The sell-off in the markets was broad based as all ten of the S&P 500 sectors were down on the day, with the materials and utility sectors leading the decline, down 1.39% and 1.38% respectively. The greatest strength was seen in telecommunication service sector and consumer staples, down 0.29% and 0.55% respectively.
Chris Puplava Copyright © 2007 All rights reserved.
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