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STOCKS AND BONDS BOTH HIGHER ON WEAK ECONOMIC DATA

Stock and bond prices are higher right out of the gate this morning following key economic reports that gave the markets a “three for three” confirmation of less inflation and slower growth to come. The Consumer Price Index came in slightly softer than expectations, U.S. home starts were weak, and industrial production was reported weaker than expected. All of the data came in before the opening bell for the New York Stock Exchange and worked to push stock index futures higher across the board. Nearly an hour into the trading session the Dow is 35 points higher at 11,265, the NASDAQ is six points higher at 2,121 and the S&P 500 is four points higher at 1,289. For the stock bulls, the key today will be to see if the broad averages can hold yesterday’s gain and build on it to close the S&P 500 above key resistance at 1,290. We are now looking at “contrary” stock markets on Wall Street that move higher on weak economic data, but also a sagging U.S. dollar as the economy on Main Street grinds lower with less stimulus from the housing sector.

Market expectations called for the headline CPI number to gain 0.4% with the core CPI higher by 0.3%. The headline number matched the forecast and core CPI rose by a softer 0.2%. This was the smallest rise in core CPI in the last six months, and was consistent with the muted inflation data in yesterday’s Producer Price Index. I believe these numbers are “managed” lower (index weighting, substitution, hedonic adjustments, etc.) to understate the true rate of inflation, but the markets seem to accept the data. According to an economist at Wells Fargo, Scott Anderson, “We’ve seen the core PPI trending down, so we think pipeline inflation pressures are beginning to moderate and will eventually play into slower core CPI inflation.” The problem I see here is the fact that we have a service-driven economy. Only 15% to 20% of our economy is driven by manufacturing. If inflation is slowing in the overall economy, it tells me we can expect wage growth to be weak to non-existent in the service sectors of the economy.

My suspicion that wage growth will become a problem is confirmed by the Labor Department today. They said year over year real weekly earnings fell 0.1% after wages were adjusted for inflation. This is the third decline in the last five months for inflation-adjusted earnings. If this trend persists, the consumer will have to bust-out the credit cards to help Santa Clause this November/December. Also remember we have some rather “political” elections coming up in November…the Fed has done their job and is now out of the way from causing any problems (more rate increases) before the November elections. The big trick is to see if the Spin-masters can keep stock prices elevated through election time and into Holiday shopping.

Investors (voters and shoppers) will want to be feeling good with a “wealth-effect” to re-elect the incumbents and shop ‘till they drop! Some analysts have even suggested that China jumps-in to buy U.S. equities in the fourth quarter so the “wealth-effect” will translate to increased export sales to the U.S. from China during the Holiday Season. In the three weeks just prior to the elections of November 2004, the S&P 500 index moved from 1,090 to 1,184…it worked for the incumbent and also helped to keep the money flowing for Christmas. Can the bulls repeat?

Industrial production rose 0.4% in July while the markets were expecting a gain of 0.6%. A quick look into some of the detail is bit alarming to me. According to a Bloomberg article, “Manufacturing, which accounts for about four-fifths of industrial production, increased 0.1% last month after rising 0.8% in June.” This was primarily due to a failing auto sector that fell 6.2% and overall consumer durable goods (autos, furniture and electronics) that fell 3.2%. The big gainers were electric and gas utility output due to the heat wave (higher by 2.0%) and non-durable consumer goods such as food, clothing and paper products (higher by 0.8%). Take away the gains from producing more electricity to run air conditioners and take away soft-consumable items, and industrial production is clearly weakening more than the soft headline number indicates.

An interesting contrast to our industrial production numbers came out of China just yesterday. Chinese industrial production rose 16.7% year over year in July. This was China’s smallest gain since April as their central bank begins to restrict bank lending via higher reserve requirements. The soft industrial production numbers reported today in the U.S. are consistent with the Empire State manufacturing data released yesterday that put the Empire State mfg. index down to a fourteen month low at 10.34 in June versus 16.58 the previous month. In the U.S., our industrial production numbers move higher due to a need for more power to cool our offices and homes. This is great for the energy companies, but to the rest of the economy I see the added expense for electricity as a drain on consumer discretionary spending and higher overhead costs for businesses.

Good for Bond Prices, Bad for the U.S. Dollar

Probably the most significant report hitting the wires this morning was the release from the Commerce Department that said housing starts fell 2.5% in July, the lowest level in nearly two years. Building permits declined 6.5% to the lowest level in seven years. According to a Bloomberg article, “Sales fell in June and the number of homes that were completed and waiting to be sold rose to the highest since record-keeping began in December 1972.” OOPS!! Declining sales and more unsold homes will put the brakes on rising home prices. Yesterday the National Association of Realtors reported median home prices rose 3.7% in the second quarter versus a 10.3% gain the previous quarter. With lower home appreciation rates we should see less equity extraction for consumer purchases as we move closer to the Holiday Shopping Season. I will be fascinated to watch consumer spending and retail sales numbers over the coming months.

Stock prices are still holding up as we pass through the noon-hour. The weak economic data and soft inflation figures have convinced the stock bulls that the Fed is out of the picture for another rate increase at their next meeting on September 20th. The big question to ask is which market is correct: the stock market or the bond market? The Treasury complex is getting a bid across all maturities moving bond prices higher and yields (interest rates) lower. The Fed funds target rate is now set at 5.25%, but the two-year note yield has moved down to 4.88%, ten-year yield down to 4.87% and the thirty-year bond fetches a whopping 5.00%. If the economic slowdown is truly here, I expect the exuberance with stock prices to diminish and we should see bond prices remain fairly firm relative to stocks. More money moving into bonds will help to keep long-term interest rates lower which will help the Fed orchestrate their soft-landing for real estate prices. Stock prices can come down, but falling Treasury prices (higher interest rates) will also cause a further deterioration in the housing sector. As long as the inflation data consumed by the masses remains “subdued,” bond prices can remain artificially high thereby keeping long-term yields in the area of 5% to maintain a soft floor under home prices. If the bond market gets hammered, housing and the dollar will also get pounded!

Perma-Bulls Hit the Street

In my opening paragraph I mentioned the S&P 500 Index working to close above resistance at 1,290. It will be significant from a technical perspective as we move through the second half of the year, because if broken decisively, the area between 1,280 and 1,290 will work as support moving forward. Remember that just three months ago the S&P 500 touched a five-year high of 1,326. At 1,290 we are less than 3% away from making another multi-year high. The Perma-Bulls on Wall Street (fund managers and brokers that will “paint the tape” to make their year-end bonuses) are salivating to push the broad indexes higher.

I guess I always seem to get a bit suspicious and skeptical whenever the mainstreamers parade Abbey Joseph Cohen of Goldman Sachs out on CNBC to tell everyone where stock prices should be. Bottom line…she says stock prices should be 15% higher than they are today. If she is correct, the SPX should move from 1,290 to 1,483. It may sound far-fetched, but that’s her story and she’s sticking to it! Realizing the consumer is all but tapped-out, Ms. Cohen believes the driver to move stocks higher will be increased capital spending from corporate America and increased export sales due to a lower dollar and increased economic activity from overseas. Thanks Abbey, but I think I’ll stick with the resource sectors (things people need) because understated inflation is baked in the cake!

Here is where I believe she came up with the notion that stock prices are undervalued by 15%. If you look at stock prices relative to inflation, stocks are clearly underperforming. The S&P 500 Index moved through the 1,300 mark back in March of 1999. We are now more than seven years down the road and the index is once again approaching 1,300. Just to break-even against inflation, the index would need to stand at 1,483 to represent the same value it did back in 1999. The number is actually higher, but I base it on inflation adjusted numbers through 2005 provided by the Inflation Calculator at http://www.westegg.com/inflation/. I plugged in the data and the calculator reported as follows:

What cost $1300 in 1999 would cost $1482.68 in 2005.

Also, if you were to buy exactly the same products in 2005 and 1999,
they would cost you $1300 and $1139.83 respectively.

The S&P 500 needs to run 15% higher from where it is just to keep pace with inflation. Earlier I made the point that wages are actually negative relative to inflation, and now you can see that stock prices are also negative when adjusted for inflation. Most commodity prices are 200% to 400% higher than they were just a few short years ago, but wages and stocks are flat to negative. Higher mortgage rates, higher energy costs, record high debt burdens, and slowing home price appreciation are taxing the consumer’s discretionary spending. I can clearly see where the Perma-Bulls would like to take this stock market, but to see it happen we will need to see corporate America increase capital spending in the face of a slowing economy. We will also need to export some real goods to the rest of the world rather than simply continuing to increase our export of debt paper.

The Bulls could get their way with some improvements to the economic data, while at the same time maintaining the notion that inflation is not a problem. Frankly, I’m actually expecting just that between now and election time. “The economy is slowing but stable, and inflation is under control,” will be the mantra as we move into the Fall Season. Hey, crude oil even came down again in price today…no inflation with crude back down to the bargain price of $71.80! Politics and Wall Street spin are still ruling the roost in the financial markets as we move through these most uncertain and turbulent times.

The gains on Wall Street stuck like glue as Main Street begins to feel the crunch of a slowing economy! Just a couple weeks ago the Bears were telling everyone to be prepared with their crash helmets. Now we get some solid weakness in economic reports and the markets rally higher! The crash helmets have covered and today we see the Dow Industrials pounding higher by 96 points to 11,327, the NASDAQ Composite closed 34 points higher at 2,149 and the S&P 500 closed above key resistance with a gain of nine points to 1,295. The next few days should tell us if this is the beginning of the ramp-job into the elections, or if it’s just a nasty head-fake higher to flush-out the shorts! The Bears have a great case to present, but for now I wouldn’t underestimate the salesmanship of Wall Street Spin-masters to move stock prices higher.

Have a Great Evening!!

Mike Hartman

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