Economy and Stock Market Detach

By The Greek:

In our "Week Ahead" copy, we warned that data due at the end of this week, specifically the ECB Policy Statement and press conference, and the Employment Situation Report, would likely paint a much less sanguine portrait of the economy than what the week ago flurry of favorable news brushed.

Article interests AMEX: DIA, AMEX: SPY, AMEX: SDS, AMEX: DOG, AMEX: QLD, Nasdaq: QQQQ, NYSE: NYX, AMEX: IPF, AMEX: XLF.

We told you to take your money and go to the beach for an Indian summer extended weekend; but did you listen?! You would have been better off using your dollars to dry yourself with after a refreshing swim than to have left your dough in stocks over the past couple days. Unfortunately, we were right, the news flow was dire, and stocks reflected the tone precisely. The S&P 500 Index trended lower all week, but took a steeper route on Thursday and into Friday morning. The S&P fell 3.0% on Thursday, but managed to recover 0.4% through Friday, despite a poor start.

So Let's Talk About the Drivers

Two of the most obvious drivers this week were the above mentioned reports. Yesterday, the ECB kept rates steady, but what it had to say in its statement and press conference spoke decibels louder than its rate inaction.

First of all, the ECB chief was in a tough position. After all, his governing group, after months of threatening, moved to raise interest rates at their last meeting. This move was meant of course to stall HICP inflation, which was running at 4.0% in June and July. The most recent reading was still high at 3.8% for August. Since that rate hike, however, euro area Real GDP was reported to have contracted 0.2% in the second quarter, defying ECB expectations. The ECB previously acted on rates after noting first quarter GDP growth of 0.7%.

For the ECB to come out this meeting and cut rates would expose its last move as flawed. Doing nothing now allows the group a pivot point, from which it can move in either direction at its next meeting. Jean-Claude Trichet expressed "no bias" toward inflation or economic growth, which to be fair, was his position at the date of rate hike. Thus, it seems clear that he understood this current environment to be a possibility that his economic realm might incur.

The ECB lowered its growth forecasts for '08 and '09 and raised its inflation forecasts, both meeting the actual accounts of data that proved off the ECB's prior forecasts. In other words, they're not exactly looking credible right now. What's worse is that they're still anticipating a significant drop-off in inflation, and decent economic growth for '08. Despite the commodity price factor, there may yet be further adjustments to their stubborn forecasts.

"Now, I seem to recall Europe having a history of citizenry uprisings, riots, and burning of castles and overturning of kingdoms."

So, perhaps, in part covering his rear, the ECB chief stressed the importance of containing second round effects, those being embedded inflation driven by wage increases. In other words, the ECB believes inflation can be contained by disbelieving its existence. Don't give wage increases to employees, unions and citizens; let them bear higher temporary commodity costs themselves; and those costs will moderate as greater production meets lighter demand.

Now, I seem to recall Europe having a history of citizenry uprisings, riots, and burning of castles and overturning of kingdoms. If I have not already made clear my disbelief that the ECB can convince member nations to contain the wages its European citizenry, then consider this... This ECB action seems to naively write off Indian and Chinese development as short-term in nature, and economic decoupling as nonexistent. If inflation proves stubborn due to Indian and Chinese economic strength, good luck keeping your head out of the guillotine Jeannie.

"The right course of action to help the developed world digest this dynamic environment, is to force China and India to play on fair ground, thus applying natural and fair drags to their development."

That said, I agree that inflation control is critical for the ECB, since there exists that strong underlying demand from emerging markets. I believe wages should rise, however, to meet the secular change I see around the world - that change drives price increase as demand for limited resources increases. The right course of action to help the developed world digest this dynamic environment, is to force China and India to play on fair ground, thus applying natural and fair drags to their development. These drags would be especially geared to impact foreign competitors that benefit unfairly at the market share cost of European and U.S. producers of goods and services.

Your Pain is My Gain

The handcuff that the ECB is wearing now, along with other factors elsewhere, have helped to strengthen the dollar, and also act as a positive capital flow driver toward US assets and away from European. This has likely aided American securities markets and even housing and commercial real estate, and made American companies more interesting for outright acquisition now as well. This has probably been the key driver of American share rise since mid-July, combined with collapsing commodity prices, which has added a second capital stream flow toward US securities.

Unemployment Rises Nonetheless

Despite the flow of capital into U.S. equities, as natural benefactor from flow out of Europe and commodities, or at least due to reduced capital draw from those competing markets, the U.S. economy and its key catalysts continue to deteriorate. Momentum is a strong factor that should never be discounted, especially in the size and form of ship that is the U.S. economy. While capital flow supports securities, it cannot manufacture synthetic demand for goods and services. Thus, an overwhelming negative factor and driver continues to outweigh fund flows, with regard to economic impact anyway.

While oil and other commodity prices have eased, not much of that change is easily factored into the immediate spending destinations of consumer capital; that said, the decline of gasoline and unprocessed foods prices are notable and play an important role in restoring economic stability.

Still, these expenses of production were incorporated into processed foods and finished goods pricing as well, and they are typically removed at a much slower pace then at which they enter. Basically, it's easier to raise prices than it is to cut them folks. In a competitive marketplace, however, price ease must ensue. Even so, all this takes time.

Meanwhile, companies remain stressed and continue to reduce workforce. Unemployment jumped in August to 6.1%, up from 5.7% in July. This measure baffled economists, as they anticipated a level of 5.8%. Most of the 1.4% deterioration of the rate over the last 12 months has occurred within the last four.

This rapid rate of increase in unemployment is characteristic of the last phase of the business cycle, in my view. It is representative of capitulation in the corporate environment. At this point, the disbelievers of recession are long fired or otherwise silenced. Now, free reign is given to the Armageddon types, and under the pressure of tightening profit margins and job insecurity, managers are cutting away.

Nonfarm payrolls fell by 84,000 in August, worse than was expected and greater than the 51K shed in July. The number of long-term unemployed increased by 163K. This is disturbing because the longer you are unemployed the more you eat into your nest egg, and the less positive influence you have on the overall economy. In English, you can't spend what you don't have anymore.

That group I like to monitor as an offbeat measure of what's going on, part-timers who lost their full-time job, was about unchanged in August. This could signify that part-time jobs are filled to capacity, and capacity decreases after the summer. Fortunately, much of the nation's part-time position demand decreases as well as teenagers and college students return to school.

Here's an amazing statistic: the number of multiple job holders increased by, get this, 298,000 in August. So some 5.5% of you who are employed, are also working two jobs. There is a statistic the presidential hopefuls need to get a hold of.

Jobs were lost across the board, except in education and health services, for obvious reasons. I think that's enough piling on bad news to deliver the message. The unemployed don't spend money, and that's true whether gasoline prices are above $4 or below. Oh, sure, when you first lose your job and are collecting the government handout, you relax a little. You take that vacation you always wanted, and you drink more beers on Wednesday afternoons at the ballpark. But, that false comfort fades fast, and these folks are not going to be spending in the second half of '08.

Thus, stocks had plenty of reason for despair this week. But, their resiliency on Friday, heading into the weekend, was a clear positive for valuation and perhaps an early signal that stocks have some sort of solid footing. There's something called erosion though, and never forget today's solid footing could give way tomorrow.

We're at a tough point in this business cycle. At this point though, stock market forecasting might be completely detached from economic forecasting. Therefore, we may be at the six month lead leg, where stocks start to precede true economic expansion. It's always bleakest here, and this time is no different. That one unique factor remains though, Iran, and the war I see approaching. It remains very well capable of throwing a monkey wrench into the business cycle, and must be discounted into forecasts for both stocks and economies.

Please see the great changes we've made to the site, by clicking on our banner below. Also see our disclosure at the Wall Street Greek website.