I wrote this update relatively quickly last night; it is perhaps a little too deep for general distribution as an Economic Update.  Seeing that I didn’t want it to go to waste, I thought it might be a perfect post for the blog.  If nothing else, it should help you get some sleep tonight.


Last Spring, I was in the office of an important client. Things were going really well for the markets and our firm and so when the client asked me what I thought about the problems in Greece and how they might affect things, I pretty much dismissed them as unimportant, commenting as someone else had recently that Greece’s economy was no larger than something like the state of Rhode Island. I don’t recall exactly what was said, but in essence, the concern had been mentioned previously, but the markets had plowed through them as a non event.

This view, however, only lasted a few short weeks, perhaps even days as I may have remembered it, as all of a sudden the Greece concerns became the de facto curse on the markets. Not only was Greece in trouble, but the entire continent of Europe and their ill fated currency, devoid of a common political will. These concerns were quickly joined by the BP Oil fiasco and for most of the rest of the summer, nothing really mattered, including the strong corporate profits.

This week, once again, the contagion fears are rising but their effect seems to be miniscule. Spain, Portugal just don’t seem to have the impact on the outlook that tiny Greece did at least at one point over the summer. This got me thinking about why the interpretation of contagion events can at times be dismissed as inconsequential and at other times monumental. In hindsight, I think I might have discovered a correlation, with the only caveat being that I am doing the dangerous and extrapolating only the most recent observation.

Last spring, at about the same time that the Greece fires started to have more bite than bark, the leading economic indicators of the economy also started to turn down. Mind you, the ISM’s leading indicators – a survey of purchasing managers – were still in expansion territory, but all of a sudden instead of improving, they were starting to roll over. As a leading indicator of the economy in terms of purchase and hiring activity, this subtle sudden second derivative shift in momentum may have explained the source of the bite in the bark all of a sudden. The markets for most of the summer were never the same but perhaps it was the economy, not the contagion.

In recent days, the markets have been soaring, dismissing renewed concerns over European contagion. While the tone from contagion was initially negative, China’s and North America’s leading indicators were released today and were positive and generally better than expected, leading to a strong market bounce that continued today. As long as things are fundamentally moving in the positive direction – at least in the eyes of purchasing managers – contagion is trumped by leading indicators, or so it would seem.

Of course, one other difference may be the advent of QE2, but that has largely been known since September, likely contributing to the markets rally since then. Another interesting data point is that payrolls have now improved month over month for three months in a row. Recently, I had a strategy firm we respect take a look at the performance of various market sectors following a definitive improvement in payrolls. Not surprisingly, the consumer oriented sectors tended to move up the most aggressively, along with what I would call hyper-cyclicals -the semiconductors, transports, and commodities. In analyzing the data, it also became a question of what might constitute a “definitive improvement” in employment, and upon closer inspection of the data, I saw a pattern in that three months of improvement tended to signal a trend change.

So, at least for now, I submit the following observations. The markets have been rallying in the face of contagion because the economy tends to trumps contagion. As long as this remains the case, it will likely climb further. With the exception of Cisco, most corporate managements remain positive in their outlooks, but earnings may tend to be coincident rather than leading, as the purchasing managers survey is. At the same time, I also see tremendous problems for the public sector, both state and federal, as it succumbs to the shock waves of recession; the original waves it missed almost entirely simply because government has no competition except when it comes down to regime changes which are determined by calendar votes rather than the constant variable of competition over time.

One odd thing about QE2 is that rather than causing interest rates to fall further, it has caused them to rise. While I may be reading far too much into it or even giving Bernanke and crew too much credit, perhaps higher interest rates are the medicine necessary to heal the financial sector once and for all. Financial stocks sure did well today! By increasing the expectations for inflation, nominal rates rise, improving the profit margins associated with making loans. The profitability of lending no longer becomes a disincentive to lending but an incentive. Ditto for waivers on fees like money market funds, which have plagued organizations like Schwab recently.

While we can debate whether or not the real incentives for economic activity have changed, it appears that the markets will chase the nominal over the real, at least for a time. As long as leading indicators of economic activity remain elevated, contagion fears may take a back seat. And as long as employment trends can improve month over month, the markets may begin to reestablish themselves. Of course, this could all come crashing down as it quickly did last spring once the leading indicators reversed course, but for now, it really does seem to be “the economy stupid”.

So far, the sectors that have been doing the best are consistent with an economy on the mend. As always, time will tell, but that’s the story for now.