Weak Consumer Spending
The market has paused and is finding a range this week. The Fed spooked the market with the possibility of “tapering” the asset purchase programs. This concern translated into some selling pressure in both bonds and equities and we saw the 10-year yield break above the 2% area. Then we saw the mortgage market follow suit, with an increase in the 30-year fixed rates; the biggest jump and highest rate in over a year. The re-fi game seems to be running out of steam, as it is a finite market which has been going on for years (for those that can). I heard one economist make an interesting observation; he stated that low rates will certainly help but don’t solve the core problem, the debt and ability to pay. The re-fi market has certainly helped those that could already afford to pay, but how much is it really helping those that could barely afford it? Probably not too much. Is it just another can-kicking routine; what the economy really needs is a full deleveraging? The macro picture shows flat income growth and stagnant consumer spending, coupled with high (and in some cases rising) consumer debt – I guess lower rates in many cases just pushes off the mathematical inevitability that no one really wants to face.
Weak Consumer Spending
Austrian vs. Keynesian
One of the fundamental beliefs among Austrian and Keynesian economists is importance of consumer spending. Austrian’s take a more laissez-faire approach, but in broad terms savings is more important than unchecked spending. Keynesian’s are more focused on the NEED for consumer spending (regardless of how it is obtained) based on the assumption that is what makes the economy grow, creates jobs, and generates needed taxes for the government.
Great Music Video that gives a basic view of Austrian vs. Keynesian economics.
Decisions or No Choice?
My grandfather once instructed me about home ownership. His strategy was pay it down as quickly as you can, debt is bad, and never borrower against your home. It is an investment in your family; it is not a financial investment. He also valued savings far more than spending. It is a lesson that goes unheeded and mostly untaught in today’s economy. Keynesians, which champion consumption above all else, still rule the day. The Fed has taken this approach by lowering rates to zero and savers (ones like my grandfather) are punished for saving money. They are paid little to no interest and that forces savers to look towards alternative investments. I had a discussion with a friend of mine in his 70’s. He doesn’t want to buy any more stocks than he already has; he wants to buy fixed income – but it pays nothing. He said to me, it feels like the government is FORCING my investment decisions and I hate that and also don’t trust the government. He admitted that he starting buying more equity based products, but is sticking with dividend paying stocks. Still, he doesn’t like, nor want, the volatility – but what choice does he have?
The Fed’s monetary policy is working, if the goal of that policy was to drive investors out of fixed income (bonds) and into equities. It has given the market a powerful fuel injection sending it higher and faster than EPS growth, revenue growth, and profit growth. At some point this fundamentals vs. price will break down; the market is rallying for no other reason than it is the only game in town. I am not sure if we are there yet, but some indications have shown that we have approached that inflection point.
However, all the stimulus from the government, coupled with the Fed monetary policy, has not trickled down to where it is intended: the consumer. The unemployment rate remains high and job creation remains weak. We are also seeing very soft consumer spending and income levels. Perhaps Fed monetary policy works great for member firm banks and the stock market, but does little to really help the economy.
This morning the Commerce Department reported that consumer spending fell 0.2%, the weakest reading in a year. Last month wasn’t that great with a paltry increase of 0.1%. Consumer spending still accounts for 70% of US economic activity, but that, too, has been shrinking as government spending has been a larger and larger driver each year. However, all is not that bad, once we back in the government’s method of inflation, spending actually was up 0.1%. As the government’s method of measuring inflation continues to decline, it continues to boost the consumer spending results. I wonder what will happen when the government adopts the new C-CPI-U; perhaps it will be like rocket fuel and reflect a massive robust consumer spender. It’s amazing how a tweak here or there to a model can make the data look so much better.
Based on the CPI, inflation rose just 0.7%, the smallest gain in almost 3 years. The newer model reflects a gain of only 0.3%. Perhaps next year they can come up with an even “better” model that will take inflation negative. The reason I hound on the CPI and the adjustments is that it just doesn’t imply the government’s model for inflation, but it is used in SO many economic data points that it further skews that data as well. Just like consumer spending, adjust it with the government’s inflation model and boom, consumer spending looks better than expected. Adjust Social Security with the government’s inflation model and boom, we don’t have to pay our elderly as much as we thought for their Social Security. I feel that it masks reality and as we continue to change the method and adjust it and revise it, all of which only lowers the results, we are impacting all sources of key economic data metrics that are important.
One of the key problems is that consumers, unlike the major corporations, are unable to deleverage themselves. They are still underwater on their homes, they still have consumer debt (for credit purchases), they have limited refinancing, they are unable to sell-off non-performing assets, and they are stuck. Thus they can’t save or have very little to save. Rather than save they spend. The Keynesians want them to spend and borrow in order to spend more. Because Keynesians believe it is spending that drives the economy, and while they may be right, it is important to know WHERE that spending comes from. Austrians prefer that spending to come from earned income rather than added debt and that debt is used in a limited and responsible matter. That is probably why Austrians have such a difficult issue with Congress and government’s massive deficit spending. To them (and me) it is irresponsible and creates larger, long-term problems which we may have significant problems resolving.
The weak consumer spending, even with it being “adjusted” for inflation, spells out the fundamental growth problem in the domestic economy and it could just be the wake-up call that brings MORE attention to the validity of the recent equity rally. Companies already told us in their recent earnings that top-line revenue is flat or declining. They’ve already told us that next quarter expects to see even further top-line revenue declines. This means that companies will have to CUT COSTS (perhaps cut jobs, or limit hiring) to keep margins higher and report profits. We have also seen a huge move in share-buy-backs by companies to reduce floats, which will certainly help EPS in the coming quarters. Hopefully that will mask the top-line revenue problems.
So today’s Commerce Department’s weak consumer spending report confirms corporate’s weaker top-line revenue. However, bad news could be good news. This may just be the data needed to justify MORE Fed asset purchases and my bet is the talk of “tapering” will be old news in a couple of weeks.
We could still have that melt-up. What happens when the Fed steps back into the bond market, pushing bonds higher and the 10-year below 2%? Do you think investors will still want to buy the 10-year for 1.8% or lower? Remember my friend who is buying more equities, not because he wants to, but because he doesn’t have a choice. If the market continues to move higher and the Fed makes bonds unattractive, it can certainly pull more people into the market.
I personally hate betting on a “melt up”; I believe the market SHOULD be seeing some correction to price back in fair value vs. fundamental growth; however, you can’t fight the Fed. If the Fed decides to ramp-up asset purchases (which Evans, Bullard, and Yellen have all indicated), we could see a continued rally.
Do you really think that the bond vigilantes have more money than the Fed? Of course not, the Fed can print as much as it want; and it has.
Do you really think the Fed would allow the 10-year to rally back up to 3% or 4%? Of course not, the government deficit spending can’t afford that rate; it would send mortgage rates higher and stall economic “consumer” growth. Consumer spending would slow.
The Fed currently buys over 70% of all gross US treasury issuance. Fed President Fisher said that will most likely hit 100% if rates remain the same by 2014.
We could see the market sell-off 5-10% in a couple of months, but not crash. We could see the bond yields move up to 2.5%, but not rocket to 4%. The Fed just won’t allow it, they are the biggest player in the bond market and adding in the circuit breakers in the equity market, it will be hard to see a 10% move in a day.
Time for Reflection
This week there was a pause in the equity market. It is a time of reflection of the recent rally. It is time to review those top-line revenue results and consumer spending. It is time to accept the Fed’s roll in the bond and MBS market. It is time to come to terms with the how and why and not just accept headline numbers.
We can’t fight the Fed and we shouldn’t try. We need to play the game, but we need to play it wisely. We need to also understand that at some point we face an inflection point in which the government’s intervention in the financial markets reaches a point in which it can no longer dictate market and economic conditions.
The fact is Keynesian economics only work until they don’t. The government can’t control free markets or the laws of supply and demand. They can slow the flow or delay it, but in the end it can’t change it. Unfortunately for Keynesians they never learn this lesson until it is too late. Many of them are blind to the problem. Remember the housing bubble?, the Keynesian, even when the housing market was collapsing could NOT come to terms with it. Bernanke (Keynesian Soothsayer) stated it was first only a small correction; then it was just a sub-prime thing; then it was limited to a few sectors; never did he come to terms with reality until it was too late. Even then he thought they could save it. They bailed out all the banking and financial institutions; they nationalized the GSEs; the Fed started buying (and continues to buy) Mortgage Backed Securities (MBS). They can’t let it fail or allow participants in the game to fail, because if they did they would have to admit to themselves that their Keynesian philosophy has failed.
So to keep the Keynesian belief alive, the Fed continues to buy $85 billion a month in bonds and MBSs; the government continues to deficit spend; some companies continue to get bailouts and special funding through the discount window; and now the government is changing several ways in which we measure the health of the economy, because the reality is that it is not going as well as Keynesian theory would have us believe.
The Keynesians rule the roost and regardless of our ideology, or belief that they are wrong or right, or even the MATH – for now you can’t beat them, can’t fight them, and must just accept the rules of the game. That game is Fed QE and for now that is the single largest driver in the equity and bond markets.
Support & Resistance
This remains a short-term support level which we could test. We may break below it and we could very well get a small correction in the market. I am not sure how fast or how much the Fed will step in, but I suspect they would. The market is over-heated, but if the Fed and Admiration can spin economic data optimistically and the Fed can continue to keep a lid on rates, we can see this rally continue.
This remains the Gamma Straddle Strike. I suspect some trading action higher or lower, implied volatility is cheap relative to my volatility forecast in this index.
This is the short-term support level. I think the market may visit this level, but if we come in Monday with some optimism, we could see a rally of these levels. The VIX is edging higher, now in the high 14′s, but I think has room to go higher. The VIX is telling us it expects a small correction (2-5%).
RUT 975 – 1000
There is still strong order flow into equities; however, I believe the RUT will be the tell-tale sign as to whether we see a small correction or continue to march higher off these supports. The 10-year yield rose above 2%, but that is based on the “tapering” concerns.
The market is moving based on LIMITED CHOICE and FAITH; certainly not on fundamentals. The limited choice has been driven by the government and Fed, making equities attractive relative to non-yielding government bonds. The Faith is that these Keynesian policies can continue to work and that we will not implode in the future.
I have talked with many market professionals over the last month. There are two schools, the active traders have been doing well, mainly because implied volatility has been low and they can take cheap deltas. These people are in and out of positions in 20-30 days tops. They go home flat deltas, or if they take deltas they have gamma. I don’t know too many traders that have been net short volatility; it has just been too cheap to take the risk.
The other school is the investor friends. Some of them are doing very well just staying long, but as a whole many of them have not been increasing their long positions because they can’t fundamentally get their head around it. They look at the economic and earnings data and it all tells them the market is going up too fast. I only know a couple that increased their long equity portfolio in Jan; most started trimming their longs each month or just riding the train with what they have. A few of them have told me they want to get off this ride, but don’t know where else to go. They are concerned they could see a short-term correction that could wipe out 20-50% of their unrealized gains. Yet their firms continue to peddle the stay long and get longer mantra. More assets under management and continue to get long.
There is also the case of the “melt-up”, in which I think many traders will do extremely well (if they own extra tails and some gamma). However, a “melt-up” could suck in lots of investors who only know how to buy and could get stuck in a long position when the “melt-up” ends.
I would continue to roll-up my hedges as the market rallies; I would expect a “melt-up” as much as I would expect a short-term correction of a few percent. I also expect the Fed to keep the status quo, because they have no other option. My concern continues to be long term.