Thu, Sep 16, 2010 - 3:00pm

When trying to do an analysis of the financial markets as well as the overall economy, one is struck that it is a variety of fairy tales all smashed together. First up is an old favorite: Goldilocks. Her search for (Mr.) Just Right took her through various parts of the house, discarding those too hot/small, big/small or hard/soft. Let’s look at the data just released today for some examples of what I’m talking about.

First up is the weekly jobless claims figures, reported down a smidge from the previous week and save for a low reading in July, the lowest since early May. Over the last four weeks, the claims figures have fallen by 10% from their peak of 500,000. At that pace, we could see claims within a more normal range by the end of the year. Also, looking at the non-seasonally adjusted data for initial and continuing claims, those figures are either in “normal” ranges or at 2-year lows…the data looks “too hot”. The “too cold” would argue that little has changed in the initial claims data for the year and still above 400,000 on an ongoing basis and higher than what is considered “healthy” for a normal functioning economy. Others argue that many have dropped off the reporting structure and the low levels reflect those out of the job market or have extinguished their benefits. The financial markets reaction to the data today was merely a yawn.

There are data reports from the various Federal Reserve districts that until rather recently were overlooked as too volatile and too small a sample to put much credence in any one data point. That has changed as investors look for any new data point to help investors’ wanderings in the wilderness. Today, it was the city of Brotherly Love showing a bit of love for the economy. While still negative, it was up much better than expected (to nearly zero) and sets up for revisions to the monthly Supply Management report due the first week of each month, indicating that manufacturing is on better legs than earlier in the year. This follows a poorer report from the Empire State yesterday – a too cold report. So looking at the market reaction to the report, it can be argued that the Philly report was too hot as bonds have been declining since the report was issued.

Finally, sentiment is a key player in at least the short-term direction of the markets. Let’s look at the AAII weekly data over just the past couple of months below:

While the middle column has truly been neutral, the bullish/bearish column has been all over the place, with bearish sentiment hitting 50%+ twice and with the latest reading, now over 50% bullish. What makes the last four weeks interesting is a complete flip-flop from very bearish to bullish while the equity markets rose over 7%. This series has gone from too hot to too cold quickly and frequently over just the last few months and the equity markets have rose by less than 2% over that period of time with plenty of 100+ point daily swings.

Harry Truman’s frustration with economists (give me a one-handed economist!) is never more true today with a variety of high profile economists on nearly opposite camps when looking at the data and making some determinations of where we are in the cycle. As a result, many other economic indicators and analysts are getting a hearing. A few that are now being watched closely include ECRI weekly releases of their forecasting model and a daily look at “leading indicators” from Consumer Metrics Institute. While ECRI data is pointing to a weak economy, the CMI data has finally turned higher (and is at the highest level in 2 months) after pointing toward economic slowing well into the first quarter of 2011.

Unlike the Goldilocks economy of the 1990s, this Goldilocks has been spent much more time trying to find the “just right” situation, she has been flitting between the hot and cold scenarios much more frequently than in the past – driving investors nuts at the lack of consistent trends in both the economic data and the markets.

In keeping with the fairy tale theme, while Goldilocks is busy in the house, there is a wolf still lurking in the woods – debt and unemployment. No matter what the specific data release of the day might be, overarching all remains the high levels of debt held by consumers and the government. Debt will be the wet blanket that keeps the economy from truly overheating. What is left is a catch-22 in the economy: will a debt reduction “program” negatively impact employment or will an employment program increase overall debt (primarily at the federal level)? Unfortunately the economy and financial markets are caught between a rock and a hard place and guessing the next direction has been hazardous to investor’s wealth.

Finally, there seems to be a change in the tone of the financial markets that may be reflecting a “new” economic norm–interest rates are beginning to rise. The 10-year Treasury bond is now closing in on 2.8%–after making a trip to 2.4% a few weeks ago. Instead of watching stocks, the interest rate market could be the key to determining the overall direction of the economy and equity markets. If indeed the trend in rates has changed, we may see a reversal in the persistent flow of money that has been going into bonds that may find its way into stocks. It is at this time that the KISS principal is likely to work best. Know what you own and keep the quality high.

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Managing Director
pnolte [at] dearpart [dot] com ()