Daily Insight

U.S. stocks rallied on the first trading session of the year as traders returned to work with a sense of euphoria. Oh, and a speech by Fed Chairman Bernanke on Sunday to the American Economic Association suggested that the easy-money train will roll on for quite a while. Barton Biggs summed it up well while explaining his bullish fervor: “I don’t know what’s going to happen in the second-half of [2010]. I’m just saying that in the next three to six months the economy is going to keep recovering and stocks are going to go up again.” The bulls may be more short-sighted than anytime in the past 30 years.

Yesterday felt a lot like the final three quarters of 2009 as the same trades prevailed: stock, commodity, Treasury prices all up; the dollar down.

The day’s economic data was mixed as the latest manufacturing report posted its fifth-straight month in expansion mode, while the latest construction-spending reading fell for a seventh-straight month.

Crude oil rose well into the $81 handle yesterday on a combination of events: very cold weather across the country, an array of pretty strong global manufacturing reports and the Bernanke speech.

(I found it interesting that the Shanghai market closed lower by 1% during their Monday session even after another good factory report from that country – another sign that what’s good is bad as stock prices around the globe are being fueled by rock-bottom interest rates. This conditioning, also particularly true for the housing market, may just cause more troubles than would otherwise be the case when rate rise even mildly from these levels.)

Market Activity for January 4, 2010
Maybe the 2012 Prediction Isn’t So Crazy (No not that the world will end, the other prediction)

As mentioned above, Mr. Bernanke delivered a speech this past weekend in which he stated that regulations must be used to prevent bubbles, Fed tightening is just an “option.” Does this mean he’s setting the tone for the Fed will wait a very long time before they begin to unwind the unprecedented monetary easing policy that remains in place? Does this give credence to Federal Reserve Bank of St. Louis President Bullard’s prediction that the FOMC (also an estimate by Goldman Sachs) won’t raise fed funds until 2012?

He certainly denied that interest rates were the cause of the housing bubble, not the first denial as he’s stated this before. If interest rates didn’t cause the housing bubble, or more appropriately termed the debt bubble, I don’t know what did. He says it was a lack of regulation and the monitoring of this regulation but while some regulation is necessary it has never stopped crises. Besides, the lack of lending standards follow borrowing excesses, they don’t cause them. Undoubtedly, very easy credit certainly exacerbates things but extremely low interest rates for a long period of time is the origin. It is a very low interest-rate environment that gets the ball rolling.

The Fed needs to understand that human nature goes wild when incited by bad policy decisions by the FOMC – like consumers and institutions are not encouraged to take on more debt when fed funds is below the rate of inflation? Please. Everyone wants in when money is “free”, and it was essentially free when one could get an ARM at close to zero in real terms.

And it would be wrong to let Congress off the hook. Rolling the dice, to paraphrase Barney Frank’s now famous words, with Fannie and Freddie and many years of prodding lenders to extend credit to high-risk borrowers is another major cause of the problems we now face. The alternative mortgage products that Mr. Bernanke cites as “quite important” and “a key explanation” for the housing mess were created in response to pressures from Congress to boost home ownership. Congress had absolutely no problem with loans that minimized payments to the detriment of principal and dispatched the down payment, in fact they encouraged it…until home prices began to fall and these mortgages (turned into investment securities) became toxic. Again though, without super-low interest rates there is no incendiary device.

The fact that the Fed fails to understand this (or is it just that they are unwilling to raise rates even a smidge because they know the additional burden that will result with regard to servicing the massive debt the government is incurring) means that they should be stripped of their interest-rate mechanism; the market needs to determine rates if the Fed is going to deny such obvious connections. There is no doubt that debt bubbles, misplaced assessments of risk and commodity-price spikes are directly associated with excessively easy monetary policy. To deny this reality is like obstinately arguing the universe is geocentric. Of course, Galileo was eventually vindicated; the universe is indeed heliocentric. It’s only a matter of time Mr Bernanke.

ISM Manufacturing

The Institute for Supply Management reported their gauge of manufacturing activity accelerated to 55.9 in December from 53.6 the month prior. This marks the fifth-straight month in which the index has remained above 50, the line of demarcation between expansion and contraction. The six-month average is 53.3, a level that some say predicts GDP growth of close to 4% if it holds there for another six months. The question is whether it can hold this level once stimulus spending begins to wane in the 2H 2010.

The internals continue to look good-to-strong in most cases. The new orders index jumped to 65.5 from an already hot 60.3 in November. Backlog orders slipped to 50.0 from 52.0, but remains at that cut line – this is one of those readings we’ve been talking about needs to remain in focus; if it fails to remain in expansion territory for an extended period it will signal current factory workers are not stretched and thus there will be no need to hire additional workers. Supplier deliveries, another gauge of resources becoming stretched, accelerated to 56.6 from 55.7. The employment index rose to 52.0 from 50.8, now three months above 50.

The worse aspects of the report were the inventory gauge, prices paid and eroding breadth.

The inventory reading remains negative. It rose in December, but only from a depressed reading of 41.3 and the 43.4 print for December does not show business confidence has improved much – the six-month average is 40.3. One shouldn’t expect this reading to blow through 50 but until it moves to the high 40s it will signal a lack of business confidence. (When firms become confident they will happily boost inventory levels.)

The prices paid index moved to 61.5 from 55.0; the six-month average is 60.8 – this will put pressure on profit margins and thus force managers to stretch existing work loads more than would otherwise be the case.

Lastly, I can’t help but notice that among the 18 industries that ISM tracks, the number reporting growth has declined for two months – down to 12 from 13 in November and down to 9 from 12 in this latest report for December.

Construction Spending

The Commerce Department showed that construction spending fell for a seventh-straight month in November, down 0.6% for the month. Private-sector residential construction fell 1.6% for the month and the commercial side was down 0.2%. Public-sector spending was of little help for the month as federal and state spending on commercial projects slipped 0.4% -- public-sector residential construction rose 1.2% in November, but this is segments accounts for just 1% of the total number. (For clarity, private-sector residential spending accounts for 30% of all construction spending; private and public commercial outlays makes up roughly 69% of the total number -- 35% from the private sector and 34% from the government.)

Many have counted on residential construction to contribute nicely to fourth-quarter GDP based on a 4.5% jump from the private sector in October. These latest results reduce that good start to the quarter. The housing starts data for November suggest a good reading for December, but with the weather we’ve run into it doesn’t look like this will come to fruition.

Have a great day!

Brent Vondera, Senior Analyst