2011 Q3 – The Economy This Fall – October Blues

On October 3rd, 2011, posted in: Economic News, Newsletter by


Investors expected something dramatic from the Fed in September. They had three options, cut or eliminate the interest rate the Fed pays banks on reserves. Next they could have introduced Quantitative Easing III (QE3) or finally they could try to bring down long-dated Treasury yields, referred to as Operation Twist.

QE1 and QE2 created $1.6 trillion in excess reserves. Banks are holding these reserves rather than lend them out, probably because the program was perceived as temporary. So when the Fed reverses quantitative easing, banks would then need to shrink their balance sheets and call in loans. This would not be catastrophic for business.

Since mid-2008, the Fed has boosted the monetary base by 207%, but M2 has grown just 20%.  M2 drives inflation, so the 125% rise in gold prices since mid-2008 has priced in about one-half of QE turning into M2. Many economists feel the Fed should cut the 0.25% interest rate banks pays on reserves (some even call on the Fed to charge banks a fee for holding them!). Banks would then shrink reserves and expand the money supply. If this happened, GDP and inflation would accelerate.

The Fed did not make this move. Instead, it announced it would sell $400 billion of shorter term Treasury bonds and buy $400 billion of longer term bonds by mid-2012. This is aimed at bringing down long-dated Treasury yields. It may actually do that, but only temporarily.

The big, important news was the Fed did no further easing of monetary policy.

As a result – gold has fallen 14% from its peak while the stock market has reacted negatively. Most think equity prices fell because many think the lack of real action on the part of the Fed means there is no substance to their actions. These commentators and investors believe QE 1 and 2 caused the rise in stock prices. But in reality, P/E ratios (price-earnings ratios) have fallen during this period, not the opposite. If Fed liquidity actually caused rising stock prices, the P/E ratios should have gone up as well.

Instead, the Fed chose to “badmouth” the economy to justify Operation Twist. They said there were “significant downside risks.” But the Fed looks at the same data all of the commentators and economists see and the most high-frequency data, like unemployment claims and chain store sales still say the US economy is not in a recession. Additionally, Edmunds and JD Power both say auto sales rose in September.

There is NO support for a more aggressive Fed action. A 0% federal funds rate is already too low and the Fed is already overly loose. Consumer prices are rising (up 3.8% versus a year ago) while “core” consumer prices, which exclude food and energy, are up (2.7% annualized rate) during the past six months. Nominal economic growth, which includes inflation, suggests Fed policy is accommodative. The end of QE2 does not change any of this. The Fed is still very easy.

Most think the Equity Market will shrug off last week’s news. The economy is not in a recession and while European problems are troubling, US banks have plenty of capital to sustain a Greek collapse or other crisis. Despite all the negative talk and market reaction, Gold is moving down. This suggests the Fed policy of easy money is at an end and a tighter fiscal policy will actually help the economy. Gold Investors should be wary. But, for equities, this is a good sign.

Personal income declined 0.1% in August (-0.3% including revisions to prior months) versus a 0.1% expected gain.

Personal consumption rose 0.2%, matching expectations. In the past year, personal income is up 4.5% while spending is up 4.7%.

Disposable personal income (income after taxes) was unchanged in August but down 0.3% including revisions in prior months.

Disposable income is up 3.2% from a year ago. The weakness in August was due to private-sector wages and salaries; small business income grew 0.6%.

The overall PCE deflator (consumer inflation) increased 0.2% in August and is up 2.9% versus a year ago. The “core” PCE deflator, which excludes food and energy, was up 0.1% in August and is up 1.6% since last year.

After adjusting for inflation, “real” consumption was unchanged in August (-0.1% including revisions to prior months), but up 1.8% from a year ago.


Implications:  Considering all the financial volatility in August, personal spending held up well, remaining unchanged even with inflation factored in. What matters is what comes next and auto analysts estimate that sales increased substantially in September. Given the loose monetary policy, expect inflation to worsen in the year ahead.

The Labor Department says it may have underestimated payroll gains from March 2010 to March 2011 by 192,000 or 16,000 per month. Labor issues an estimate like this every year based on analysis of jobless claims.

On the housing front, pending home sales, which are contracts on existing homes, declined 1.2% in August. The biggest decline came in the Northeast, where flooding may have temporarily deterred homebuyers.

The best news is the Chicago PMI, which measures manufacturing activity in that region, increased to 60.4 in September from 56.5 in August. The consensus had expected a decline. The sub-indexes for production, employment and new orders all soared above 60. Above 50 means the economy is expanding.

Real GDP growth in Q2 was revised up slightly to a 1.3% annual rate from a prior estimate of 1.0%, slightly beating expectations of 1.2%.

Commercial construction and net exports were also revised upward. The largest downward revision was for business investment in equipment & software. Inventories were also revised downward.

The largest positive contributions to the real GDP growth rate in Q2 were from business investment and consumer spending. The weakest component of real GDP was inventories.

Additional evidence the economy is not slipping into a double dip recession is the growth of chain store sales. In September, same-store sales were up 3.4% versus a year ago according to the International Council of Shopping Centers and up 4.1% according to Redbook Research.


What this means:  Forget about the GDP report. The big news during the last month, was that initial claims for unemployment benefits fell 37,000 to 391,000, the lowest level in almost six months. Unadjusted claims were 325,000, which is 13% lower than a year ago. Meanwhile, continuing claims for regular state benefits fell 20,000 to 3.73 million.

In other words, these claim report are a clear sign the US is not in recession.

In other economic news – New orders for durable goods slipped 0.1% in August, slightly better than the expected decline of 0.2%.  Overall new orders are up 12.3% from a year ago, while orders excluding transportation are up 7.8%.

The government calculates business investment for GDP purposes by using shipments of non-defense capital goods excluding aircraft.  That measure rose 2.8% in August and even if unchanged in September, will be up at a 17.7% annual rate in Q3 versus the Q2 average.

Unfilled orders rose 0.9% in August and are up 8.1% from last year.


What this means:  This is not what a recession looks like. And while new orders for durable goods slipped a little in August, shipments of “core” capital goods, which exclude aircraft and defense and which the government uses to calculate the business investment part of GDP, increased a robust 3.3% (including upward revisions for July). This is the fourth straight monthly gain for core shipments, which are now at a new all-time record high.

Meanwhile, corporate profits are at a record high. As a result, the odds are stacked in favor of a substantial increase in business investment over the next few years.

In other recent news, the Richmond Fed index, a measure of manufacturing activity in the mid-Atlantic, increased to -6 in September from -10 in August.  Chain store sales were up 4.2% versus a year ago according to Redbook Research and 2.7% according to the International Council of Shopping Centers.


On the housing front, the Case-Shiller index, a measure of home prices in the 20 largest metro areas, was unchanged in July (seasonally-adjusted) and down 4.2% versus a year ago.  However, prices were up in nine of the twenty areas.  The biggest losses in July and the prior three months were in Phoenix, San Diego, San Francisco, Las Vegas, and Los Angeles.

New single-family home sales fell 2.3% in August, coming in at a 295,000 annual rate versus the expected pace of 293,000. Sales were down in the Northeast, West, South, but up in the Midwest.

At the current sales pace, the months’ supply of new homes (how long it would take to sell the homes in inventory) ticked up to 6.6. Inventories fell slightly, but so did the pace of sales. Inventories are at their lowest level on record, dating back to 1963.

The median price of new homes sold was $209,100 in August, down 7.7% from a year ago. The average price of new homes sold was $246,000, down 8.5% versus last year.

What this means:  New home sales may have declined slightly in August but remain in the very narrow and depressed range they have been in since May 2010. New home sales face a number of strong headwinds. Credit conditions remain tight even as mortgage rates decline. Also, builders are competing against like-new existing homes selling at steep discounts, including foreclosed properties and short sales.

The good news in these reports was the inventory of new homes for sale fell to the lowest level on record yet again in August. Notably, although the inventories of completed homes and those still under construction continue to fall, the inventory of homes not yet started increased the most in almost five years.

This fits with other data suggesting that home building is at, or is very close, to an upward inflection point. The median price of a new home is down 7.7% versus a year ago while average prices are down 8.5%.  However, in other recent housing news, the FHFA index, a price measure for homes financed by conforming mortgages, increased 0.8% in July after a 0.7% rise in June.

In the past three months the index is up at a 7.4% annual rate, the fastest pace since early 2006 before the housing price collapse began.  Still, prices are down 3.3% versus a year ago.

On the Existing homes front, sales rose 7.7% in August to an annual rate of 5.03 million units, easily beating the expected pace of 4.75 million units. Existing home sales are up 18.6% versus a year ago. Sales in August were up in all major regions of the country. Almost all of the increase in overall sales was due to single-family homes. Sales of condos/coops rose slightly.

The median price of an existing home fell to $168,300 in August and is down 5.1% versus a year ago. Average prices are down 4.0% versus last year.

The months’ supply of existing homes (how many months it would take to sell the entire inventory at the current sales rate) fell to 8.5 from 9.5 in July.  This drop in monthly supply was due to both the faster pace of sales as well as a smaller inventory of homes for sale.

What this means:  The rebound in August was well above expectations and beat the forecast of over 74 economic groups that made predictions. What makes the 7.7% gain to a 5.03 million annual pace even more impressive is it came in the face of financial volatility in August as well as a hurricane that hit the eastern seaboard late in the month. It would not have been surprising if these factors temporarily depressed sales. Buyers could have pulled out, concerned about a double-dip recession. Despite these potential pitfalls, the strength in sales was widespread, increasing in all major regions of the country and for both single-family homes and condos/coops.

Even so there’s no clear evidence of a sustained recovery, and neither monetary nor fiscal policy seem capable of giving the economy a boost.

We’re due for another employment report in early October , but it is likely to be more of the same.

Summing it all up:  There don’t appear to be any game changers on the horizon.  Remember the seven years of famine in Genesis? If we mark the beginning of the “seven lean years” as 2008, then there are still a few more years to go, before things really improve.



The markets reacted mixed to the barrage of economic data above and the end of the third fiscal quarter.  The Dow [+1.32%; -5.74%], S & P 500 [-0.44%; -10.04%] and the NASDAQ Composite [-2.73%; -8.95%] didn’t do much.  All three are still well into negative territory for the year. So if the third year of the President’s term is going to continue the historical trend of being positive, it had better get going. Past performance is no guarantee of future results. Indexes are not available for direct investment.

Maybe there is some reason for market optimism in in the coming quarter, despite the general economic chaos. One reason might be the pessimism most analysts has showed for corporate earnings. The downward revisions have been substantial, so there could be some “earnings surprises” in the coming days.

I attended a luncheon recently where the principals were discussing the advent of computer trading. How the various firms were vying for access to the internet and quicker information to gain an edge on trades. It was interesting to hear the efforts firms would go to, to gain this advantage.

Last week was a good example.  A pattern is emerging where the markets are up early in the day, but give back much of the gain in the final hour of trading.  This is what happened during the day trading heyday. Active traders went home each night with zero positions on their books. This has been referred to recently as “high frequency trading” – but the results are the same.  Institutions are now following suit, not just the lone cowboys who lurked in the corners of internet cafes. This added volatility will discourage long-term investors from getting into the market. They are still on the sidelines in zero-yielding money-market funds.

Treasury yields rebounded after the earlier dramatic decline in early September. The market is starting to absorb the Fed’s “Operation Twist,” strategy, shifting the Fed’s portfolio from short- to longer-term issues.

We are seeing a continued slide in Long-term mortgages rates and the conventional, 30-year rate almost broke through the four-percent level.  If this happens, there will likely be a flood of refinancing applications. Don’t expect this to help new home sales or the housing sector in general. No one is expecting the mortgage market to return to near normal until foreclosed and underwater properties are absorbed. That is going to be awhile.

September saw the U. S. dollar strengthen versus the Euro (€), closing out at €1 = $1.3388. This is where the two currencies sat in January. A strong dollar helps American buyers (consumers, tourists, and investors), but hurts exporters (manufacturers), whose goods are now more expensive for Europeans to purchase. As a result, the balance of payments will continue to widen as the US imports more and more goods.

Haven’t heard much about oil, but its price was up slightly. Gas prices moved lower partially because of gasoline inventories held by the U. S.  We haven’t heard much about the decline in gas prices either. Interesting what sells in the media.


There was a business recently where the keynote speaker was the President of one of the nation’s twelve Federal Reserve banks.  His talk included some public thoughts about the economy and why he voted against Operation Twist.

It was his opinion the US is in for “a long, slow slog” as far as economic recovery is concerned.  There are no quick and easy solutions to spark a rapid turnaround, create lots of jobs, and reduce high unemployment.

Here are some of his reasons:

  1. Unforeseen weather patterns and catastrophic earthquakes and tsunamis.  These have all impacted the supply chains worldwide and they are slow to recover.
  2. The drop in consumer spending caused by high gas prices.
  3.  The atmosphere of pessimism caused by gridlock in Washington and their inability to deal with the debt.
  4. The European capital markets and the looming defaults in Portugal, Italy, Greece, Spain and Ireland.

It was his considered opinion; President Obama has had to lower his expectations for growth in the U. S. economy from 3.0%-3.5% to under 2% for 2011.  He also expressed hope next year might increase to 3.0%.

On the unemployment front, he was not optimistic the problem would be improving any time soon. He thought that today’s level of about nine percent would fall to near eight percent by the end of 2012.

So why was he not supportive of the Fed’s actions to stimulate the economy?  Having voted against the Fed’s actions at the last three meetings of the FOMC, what were his reasons?

First, he felt Operation Twist would have little or no impact on the economy.  He didn’t think it would lower long term interest rates by more than .20%. (twenty basis points). Also he did not see it having any impact on consumer rates such as credit cards and mortgages. So, if there was no benefit, why do it?

As a result, Operation Twist would not do much to “spur businesses to hire, or consumers to spend, given the nature of the structural adjustments occurring in the economy.”

His other reason for opposing the strategy was the impact this could have on the Fed’s reputation. He felt it would “undermine the Fed’s credibility by giving the impression that we think such policies can have a major impact on the speed of the recovery.”  He was also concerned there was a risk this strategy would cause inflation to accelerate and possibly keep unemployment rates high.

All in all, his comments only reinforced the general mess the US is facing under the current administration. With no clear tax policy, no budgetary constraints and no certainty for Obamacare and other programs the government has been pushing, business is just treading water. This will likely be the case until after the election in 2012.


www.cbo.gov – website for the Congressional Budget Office. If you want to see the nation’s budget deficit, go onto the site. For the past twelve months it will be about $1.28 trillion.


According to the Securities and Exchange Commission, the number of RIAs (registered investment advisers) has declined for the first time in 10 years.  However, the assets they manage have increased sharply.  As of May 1, 2011, there were 11,539 registered advisers, a decline of 104, or 1% over the past year.  But assets under management, increased from $38.6 trillion to $43.8 trillion, a 13.7% increase. This is a growing segment of the distribution system.


This information is compiled by Guy Baker from an assortment of news feeds including First Trust, Yahoo Finance, Bloomburg and others. This information is intended to be informational only. This newsletter contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Investing involves risk, including the potential for loss of principal. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.



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