Consumer Spending: The Reality of Zero

You can slice it, you can dice it. You can even massage it and look on the bright side. But you still can't get blood out of a stone or, it seems, inflation-adjusted increases in consumer spending.

Real personal consumption expenditures were flat in April, down from a slight 0.1% increase in March, the government reported today. Meanwhile, as our chart below shows, the longer-term trend isn't inspiring.

Looking at the three major components of consumer spending--durable goods, nondurable goods and services--doesn't inspire either. As the second chart below reminds, inflation-adjusted spending looks tired by several measures.

At least there's no mystery as to what ails Joe Sixpack's spending habits. Higher energy and food costs, a general if still modest rise in overall inflation, and housing and job stress are collectively taking their toll.

That leads to the question of whether the stress testing has legs? By my reckoning, there's good news and bad news. The good news: the economic slump may not deteriorate into a full-blown recession. Yesterday's modest upgrade of Q1 GDP's growth is one clue. The bad news: the "recovery," when it comes, won't seem much like a recovery.

Why? For now, we'll simply say that the economic chickens are returning home and they're of a mind to roost.

What moves stock market

It is often enlightening to see what moves the market. At various times in the business cycle the market responds differently. To look at this question a simple correlation study was performed using ETFs as surrogates for various macro variables.

Correlations with SPY for the last 95 days:

Oil USO 12%
Gold GLD -10
Bonds TLT -53
TNotes SHY -72
Euros FXE -15
Yen FXY -65
Fincls XLF 88

All of the above relationships are coincident and therefore not predictive. However it is interesting to note that gold is negatively correlated with stocks. On the other hand oil is positively correlated, which is somewhat unusual. The relationship between bonds and TNotes is negative and very strong. It seems that the recent fair weather in the stock market has been punctuated by recurring flight to quality squalls.

The dollar seems to be a significant factor as well. However it is notable that stocks are much more strongly impacted by the yen than the euro. Finally the financials are strongly and positively correlated with the market as one might expect.

Is Big Pharma Bad Medicine?

The big pharmaceutical companies may be doing wonders to help patients in poor health, but they sure aren’t doing much in the way of helping investors create healthy gains. In 2006, it looked like these stocks would finally pull out of their slump. But already in 2007, it appears as if their illness is far from cured. And here’s the incredible part – the bigger the company, the worse the performance.

To be fair, the market didn’t really have the best Q1 either. Even a small miracle today or later this week wouldn’t mean a whole lot as we wind down the calendar quarter. As it stands right now, the S&P 500 is only up by 0.86% year-to-date. We can’t expect these pharma stocks to go like gangbusters in a tepid environment. The problem is, it doesn’t appear as if these stocks even deserve to move higher, even if the market environment were better.

The wrench in the works – and it’s a big one – is simply how these major drug makers still look solid when you take a snapshot of the fundamentals. The average large-cap pharma stock’s current P/E of 16.8 is reasonable, even though this group can and has traded less expensively. Better still, the forward-looking P/E of the average drug manufacturer stock is 13.3 – cheap by anybody’s modern standard.

So why can’t these names get any traction in the marketplace? Perhaps investors are watching the numbers a little more closely than these companies realize.

Things Just Don’t Add Up

In the interest of a complete picture, not all the major drug makers are losing ground in terms of revenues and earnings. Enough are, though, to potentially spoil the whole batch.

Johnson and Johnson (NYSE: JNJ) is a good example of how the numbers just don’t seem to make sense. The current P/E of 16.08 is nice, and the forward-looking P/E of 14.13 is even better. But, the current numbers aren’t suggesting the same progress is in store. The quarterly earnings growth of 3.5% is essentially keeping pace with inflation, while revenue growth of 8.5% isn’t a whole lot prettier. That anticipated 12.1% improvement in the current P/E ratio is going to take a little more than very modest top and bottom line growth.

The Merck & Co. Inc. (NYSE: MRK) message is even more mixed. Based on current stock prices, they’re expecting their 2008 year-end P/E to be 15.67, versus the current P/E of 21.65. Great! But, how in the world is that going to happen when earnings are actually shrinking (year-over-year) by 57%, have fallen the last two calendar years, and have fallen for at least three consecutive quarters? Investors haven’t found an answer either…at least not yet. The stock seems to reflect it.

And if you work your way down the list of pharma stocks, more often than not you’ll find a comparable scenario – the current results don’t quite fit with where the company says they’re going.

If It’s Not One Thing It’s Another

If you’re looking for a little evidence that birds of a feather flock together, just take a look at Pfizer Inc. (NYSE: PFE). The stock is down slightly for the year, and has been falling ever since September – entirely missing the big 2006 year-end rally (a red flag in itself).

The unfortunate piece of the puzzle is this…the stock looks well undervalued, and actually appears to have a legitimate shot at trading at its forward-looking P/E of 10.95. That’s a relatively cheap stock, but not even as cheap as the current P/E of 9.6 (both are well under industry norms).

Obviously the Pfizer company is facing huge problems, right? Well, no - not really. Revenue growth is flat, and even taking out a major one-time boon to the bottom line in fiscal 2006, earnings were still 36% better last year than they were the year before. Even with a flat earnings forecast, the valuation remains surprisingly low.

Yet, even Pfizer can’t draw any real buying interest. If a good company’s stock can’t get traction right now, do the weak ones even have a prayer?

Bottom Line

Most individual investors – and most pros for that matter – tend to have more of a ‘show me’ attitude. As of right now, most pharma accompanies haven’t yet proven they’re going to be able to deliver on their lofty plans. In fact, most of the current numbers show anything but that.

One of the trickiest parts about being an investor is deciding whether or not a stock will trade at what the company thinks it’s worth, or if it’s going to trade at what most of the market thinks it’s going to be worth. In most cases, ‘the market’ is right. It doesn’t appear as if investors think much of the drug-makers right now….and, maybe they’re right.

Random thoughts

) With a good heart I mention, regardless of whether one was long or short, but from the standpoint of the dispassionate observer, the Osbornian man from Mars, or the O'Brianesque or Ferberesque all-seeing eye, it was beautiful the way this holiday week ended. Completely the opposite of the Easter holiday as is natural, and with total fright of a repeat of the French Bank inside trades on Washington's birthday. The memory of the terrible beginning of the year, and predictions of the Palindrome and Sornette, and the weekly old timer, and what happened in the last June to July comes to mind. Who could have the courage over the weekend except those who trade all markets without commissions and make money 95% of all days by marketmaking to the public, and enjoying borrowing costs of less than 2.5%. It's a perfect recap of the year, and a warning that only the strong could possibly withstand giving the public a chance to lose so much more than they have any right to lose. And today's action was so similar to the meaningless Employment number of January 3. With a rise by a gnat's earlash preceded by a run of two grand terribles. Everything is designed to deceive, and prevent the weak among the public from capturing the full differential of 6% earnings return plus 6% growth, compared to 3% on Treasuries. There were so many beautiful touches. The four down opens this week following five up opens last week. the down 50 this week in S&P after up 40 the previous week. the fake decline of the ten year below 115 and then back up to 116, a situation repeated endlessly over the last months, but each time with gusto and real sincerity. And the weak closes on Thursday and Friday followed by down down to surprise, discombobulate and ruin the vacation of all those who like to fade it.

2) The sight of a commercial space on the southeast corner of Fifty-third and First, long ago the Mayfair restaurant, not rented out for five years on the grounds that rents will go up and they should wait, reminds me of the builder who doesn't work overtime to get the rents, and those who buy the two year but not the 10 year, on the idea that rates could go up. But how much do they have to go up over the subsequent eight years to equal the total return of the 10 year, and, similarly, how much do the 10 years have to go up 10 years hence to equal the 30 year? It's terrible to see.

NYSE Short Interest Back Near Record Highs

Last night after the close, short interest figures for the New York Stock Exchange [NYSE] were released and showed that short sales as of May 15th rose 2.34% since the end of April. Even though the S&P 500 closed at its highest level since January, short bets remain near all-time highs. This is in contrast to October when short interest was declining leading up to the market's peak, and indicates that many investors are skeptical of the current rally.

click to enlarge


The table below lists the twenty non-Nasdaq stocks in the S&P 500 (Nasdaq short interest figures will be released on May 27th.) with the highest short interest as a percentage of float. Like last month, Consumer Discretionary and Financial stocks are well represented on the list of stocks most heavily shorted. The list of stocks on the list of least shorted come from various sectors. In fact, eight of the ten sectors are represented on this list (no Materials or Consumer Discretionary).

The Market

The market reminds me of some very creative people we all meet (people like Hobo) who always amaze you with new ideas and inventions at every clip. What it's been doing last few days has happened once in a saint's death. The gold, crude and euro:dollar all up 1 % or more in conjunction with a 1% decline in stocks. Never before, perhaps once, but never with up afternoon. Similarly today. What always amazes most is how fixed income can go up and down on statement of commissioners of authority, as if when they said they were vigilant on inflation that was bad for fixed income.

While we're at it, a paper in Nature says that there is a gene for leading a herd in humans, a long gene. Galton would have appreciated this, and looked for the comparable gene for being herded, a tendency he found particularly prevalent in oxen and humans. On a day like today with the market reacting to minutes of several weeks ago, with much new data in markets, and announcements by leaders of the pack, one would have hoped that the presumably short gene for sheep-like behavior would not have manifested itself in so many breaks below round numbers and trillions of wealth temporarily lost, with the herded ready to transfer so much wool and mutton to the big leaders who can borrow freely at the discount rate from their future colleagues.

P/E Divergence Between Growth and Value Stocks: The Wrong Way

Recently, growth and value stocks have seen a big divergence in valuations. One index has an as-reported P/E ratio of 33.66, while the other is at 18.92. The only problem is that it's the value stocks that have the 33.6 P/E, while the growth stocks have the 18.9 P/E.

Below we highlight a historical chart of trailing 12-month P/E ratios for the S&P 500 Growth and Value indices. As shown, the Value P/E has spiked significantly in recent months, as supposed value names that typically pay high dividends (financials, etc.) have seen a big drop in earnings.

This isn't the first time the divergence has happened, however. After growth valuations spiked during the tech bubble, value stocks followed with their own surge in P/E ratios in late '01 and '02. Ironically, growth stocks have held their value much better than value stocks have in 2008.

The Drifter

Housing drop

Subprime flop

Credit crunch

Belly ups

Bail outs

Fed puts

No recession

Jobs in session

GDP

Low inflation

High oil

Faked them out

Stocks up

Percentage of Stocks Above 50-Day Moving Averages

Currently, 77% of stocks in the S&P 500 are trading above their 50-day moving averages. As shown in the one-year chart of this indicator below, 77% is an overbought level and it usually doesn't last long without seeing a pullback.

On a sector basis, Energy and Telecom top the list with 89% of stocks trading above their 50-days. Technology is at 87% and just broke to a new one-year high. Healthcare and Consumer Staples currently have the lowest percentage of stocks above their 50-days, as investors have shunned defensive sectors over the last month or so.

Gray Man

The legend is that before big hurricanes and natural devastation in the Carolinas, a gray man appears . What is the gray man that appears before big devastations in the markets? I propose that yields in bonds going up a plethora is one such gray man, a throwback to the bond vigilantes, and there are stock vigilantes and gold vigilantes. The whole subject calls for quantification as I return from the Carolinas.

Economist Recession Odds Tick Lower

Bloomberg's monthly survey of economists was released on Friday, and the collective odds for a recession over the next 12 months dropped to 55% from 70% in April. Below we provide a chart of recession odds from the monthly Bloomberg economist survey versus the Intrade contract for a recession in 2008 going back to the start of the year.

The Intrade contract most recently traded at 27.3, which is down from a reading of 72.9 last month. It's noteworthy that the recession has to occur in 2008 for the Intrade contract, while it's over the next 12 months for the economist survey. But it still highlights that economists and traders have both become more skeptical of an actual recession, with traders more so than economists.

Twelve O’clock and All’s Well”

For the week the Dow lost -2.39%, the S&P 500 -1.81%, Nasdaq -1.27%, and the Russell 2000 -0.78%. The S&P 500 chart from my previous post does not need updating because on Fri the market did not move much. Markets around the world also offered dismal weekly returns with the one key exception in Russia which soared +9%. The top performing sectors this week will not be of any major surprise - oil & gas, metals & minerals, precious metals, specialty chemicals, and basic materials. The worst performers were airlines, generic drugs, regional banks, investment brokers, education & training services, department stores, and insurance.
The Treasury bond market is very close to completing a major reversal, and that would signal higher rates over the next 3 - 6 months in S&P analysts view. The 10-year Treasury yield is close to breaking key support at 3.96%, and if it does, a major double bottom in yields will be complete. Yields could then jump to the 4.4% to 4.5% range.

Commodities are still hot these days, and that will influence inflation and make life miserable for the equity investor, unless he/she is in commodity-related stocks. However, there are always exceptions to the rule and certain stocks, sectors will thrive regardless of the general economic pic.

The Baltic Dry Index is up 82% since bottoming in late January, which might be a sign that the global economic environment is not faring as poorly as many think.

Tendril Movement

I am exploring the concept of circumnutation and tendril movements as a model of universal spiral movement in all parts of the plant world and markets, and found an article that is a good jumping off point. I would be interested in your ideas on the horizontal and vertical aspects to which markets cling and go around in clockwise and counterclockwise direction.

James Sogi replies:
After a tendril winds up high and breaks and falls on its own weight more than some percentage of its height, it might take a day or so of random waving around before it finds some support towards the end of the day and can try climbing back up.

One thing these tendrils that fall down to the ground in Hawaii do is if they touch the ground is they start to send out roots and morph into a new plant. A gardener can to take that new start and grow some new plants and reap some fruit. After January's big fall, the markets fallen tendril was able to grow some roots and some fruit into the spring.

Asparagus roots grow foliage, gather energy, and produce edible shoots, but after some production, run out of energy and need to recharge. Seems to be a common natural cycle.

Phil McDonnell adds:
We grow a vegetable garden with many diverse varieties. I am always amazed at the strategies different plants seem to use to survive. In particular the legumes seem to particularly favor circumnutation and tendrils. Most peas and beans are grown on some sort of support like a pole or trellis. For the really tall pole beans that grow to six feet I have learned to use their natural circumnutation to advantage.

One form of this is the tendency of the tendrils to wrap themselves around some convenient support. But there is another form of circumnutation this gardener has learned to use to advantage. It is well known that many plants turn themselves toward the sun: heliotropism. Clearly this is an adaptation to maximize their light gathering ability but it also allows them to compete with neighboring plants and potentially block them out. One aspect of this is that the stems bend toward the sun in the morning and tend to track it as the day proceeds finally bending to the west at night. Curiously at night the stem proceeds to bend back through what is nearly a full circle so as to face the rising sun in the morning. One can use this type of circumnutation to train the plant to wrap itself around a pole. Each day another wind on the pole will be added.

The smaller bush varieties of legumes tend to rely more on their tendrils. Effectively when they are planted densely the tendrils connect to the other plants and form a complex structure of multiple stems with cross connected supports from the tendrils. Together the complex is stronger than the individual parts.

When the market is in an uptrend it seems to spiral around its basic trend channel. Clearly this resembles the helix like structure of circumnutation. One is struck by the similarity to other similar patterns. For example in a fluid flow in a cylinder there is a natural tendency to spiral inside the fluid channel. This behavior is predicted by the differential equations which describe this process. In a similar analog the Earth Moon system causes the Moon to describe a helical structure as the system orbits the Sun. One wonders if there is a common model which underlies all of these processes.

Commodities Vs. Equities: The Battle Continues

If the markets seem a more than little indecisive at the moment, one of the reasons is that ongoing sector rotation has muddied the waters with respect to what is hot and what is not. A lot of the sector rotation churning, on the other hand, is merely asset class trickle-down, as investors try to decide at a much higher level whether they want to make a substantial commitment to equities and the possibility of a resumption in the recent bull market – or whether the hard assets of commodities are a more attractive option in light of natural resource shortages and concerns about inflation.

The commodities vs. equities battle has been tilting in the direction of commodities in recent months, but since the March lows the consensus has unraveled. In the chart below (click to enlarge), the ratio is of the Rogers International Commodity Total Return Index (RJI) to the SPX. [RJI is an ETF linked to the Rogers International Commodities Index that has a broad weighting, with less emphasis on energy than most commodity indices.] The ratio chart shows indecision over the past six weeks, with the symmetrical triangle pattern awaiting resolution. I am not sure which side will win the commodities vs. equities skirmish, but when we can declare a victor in this battle, we should know a great deal about the future of the markets over the next few months.

When Central Bankers Were Men

I've been re-reading parts of two terrifically enlightening books on the Federal Reserve this week, "The Creature from Jekyll Island" and "Secrets of the Temple".

In the course of my review, I was reminded of a gentleman who once was the head of the Federal Reserve System who believed in sound money and hard banking, William McChesney Martin. Appointed by Truman in 1951, Martin would last through 5 Presidents, finally retiring in 1970 during the Nixon administration. A Yalie that had concentrated in English and Latin, McChesney Martin had deep family ties to the Federal Reserve. His father, William McChesney Martin Sr., had been both the Governor then President of the St. Louis branch of the Fed as well as helping to craft the original Federal Reserve Act of 1913. Junior himself was instrumental in the 1951 Accord, the agreement that is seen as re-establishing the Fed's independence.

Harry S. Truman thought that by appointing Martin Jr. to head the Fed, he could over-ride the agreement. Despite being a Democrat and growing up in the bosom of the private-public power duopoly of NYC and Washington D.C. elites, William Jr. did not play ball. Instead he ran monetary policy in a strong, counter-cyclical manner and was very mindful of inflation - refusing to return to the practice of debt monetizing as Fed Chairman Eccles had been apt to do.

He was a hard-nosed real money man who lectured Congress sternly on what he saw as excesses in spending and a growing lack of appreciation of the two-sided nature of capitalism. In August of 1957 he told the Senate "We are dealing with waste and extravagance, incompetence and inefficiency; the only way we have in a free society is to take losses from time to time. This is the loss economy as well as the profit economy."

50 years hence the man that occupies the seat at the head of the Fed's table is completely devoid of such character. Instead of warning Congress that inflation causes mal-invest, encourages excess speculation (NASDAQ, real estate), and particularly afflicts "hardworking and thrifty… little man on the fixed income who could protect neither his income nor the value of his savings. Often, he was also the unemployed victim of the collapse", B.S. Bernanke recommends easy money and opening the spigots of government largess.

The history of the Fed is intriguing and insightful, giving generous lessons to those that would heed such knowledge. The obvious message today is that the current Fed is much like that of Arthur Burns or George Miller, men who would quickly acquiesce to the whims of politicians. In stark contrast to William McChesney Martin, Benjamin Bernanke wants to be loved and accepted and is willing to commit grave errors in monetary policy to achieve that aim. Speculators and pensioners beware!

Yield Curve

Lest we make the same mistake as everyone else, let us look at prices as signals rather than looking at past seasonally adjusted random numbers about announcements, anecdotes, et al. Note the 15% drop in last 2 weeks in gold and most commodities, and the comparable rise in the dollar, and consider whether the markets see less inflation or more inflation ahead, with all the finger pointing, imprecations, and critiques of the putative inflationary bias of recent activities.

Let us also look at the slope of the yield curve and calculate expectations going forward since 1960 or so when the curve was upward like this, the same way that doomsdayists would look at downward sloping to predict recessions, (as if that was bearish for stocks).

Many forms of dynamic behavior can be modeled by difference equations that reach a fixed point. I hypothesized that after a market hits a fixed point, where the change in the last 10 days is less than 1/3 of the moves in the previous 10 or 20 days, that a new equation might develop with trend following working much better. After testing this with various parameters I concluded that there is not much to it, except that the market doesn't like small moves, i.e. the old idea that rates of return are highest when risk is highest gets one more instantiation.

We had an interesting talk last night by Ed Hudgins of Atlas Society about measuring economic freedom. They have this down to a pretty rarefied state now, and consider most things that people might consider, like property rights, service rates, regulation, corruption, and time and ease of starting business. They conclude that freedom is responsible for everything good from gdp to growth to peace to longevity. However, like The Stages of Growth, all the stages and attributes are retrospective, tied in with past gdp, or expectations for the future thereof, and non-predictive. Their work in trying to measure economic freedom by state might be of investor interest, and things similar to Laffer's efforts in this field might have investment merit. Hutchins himself wants now to measure an index of individuality cross country wise and this brings to mind Sam Otis's remark in Johnny Tremaine, well worth reading for any kid or adult, that the simple reason for giving up life and liberty was " the ability to stand tall ". I believe this the key to economic prosperity also.

Highs: Financials Showing Improvement

While today's rally in the market has brought the major indices to their highest levels since early January, the average stock still remains well below its 52-week high. In the chart to the right, we calculated how much the average stock is trading below its 52-week high. Overall, the average stock in the S&P 1500 is currently trading 27% below its high over the last year. While small caps have been the hardest hit with an average decline of 31.1%, large cap stocks have held up the best with a more modest decline of 23.1%.

On a sector basis, it comes as little surprise that Consumer Discretionary stocks are the furthest below their 52-week highs (-35.0%) given that many of the market's problems can be traced back to the consumer. Somewhat more surprising, however, are the Financial stocks, where the average stock is 29.2% below its 52-week high. While the Financials were among the hardest hit late last year and early this year, there are now three other sectors (Telecom Services, Consumer Discretionary, and Technology) where the average stock is down by a larger margin. Additionally, the average stock's decline from its 52-week high in the Financial sector is only 220 basis points more than the average overall decline of 27%.