Will Santa Bring Coal To Traders This Season?

It's been a while since our last post, so I'm not going to go into great detail about all the economic numbers reported since early November. Suffice it to say that the inflation reports released before Thanksgiving were better than most expected and certainly good news for inflation watchers. I've created a link to the releases for both the PPI and the CPI if you want detail.

Yesterday (11/29/06) we got the first revision of 3rd quarter GDP. (There's one more revision on the way. Imagine trying to tell your boss you needed three tries to get your work right and keeping your job!) GDP was revised up to +2.2% versus the initial report of +1.6%. While it's clearly an improvement, 2.2% still represents a deceleration from the prior quarter. There was some good news on inflation in the report as core personal-consumption expenditure index rose 2.2% (yr./yr.) - down significantly from last quarter's 2.7% rise. This inflation number may still be high for some but at least it's heading in the right direction. And there was some impressive results on the corporate profit front with the government's number showing a 30% gain versus last year. Here's the link if you need all the gory details: Q3 GDP

Of course, all these numbers are measures of historical performance. And as investors, we're more interested in what happens next. We've seen a few numbers (Chicago PMI, new unemployment claims, and some of the housing stats, for example) that make us think that economic growth will remain subdued going forward. It's probably not a great environment to sustain the high profit growth we've seen recently but it's a good bet interest rates stay in their current range. So right now we're looking for some appreciation in stocks next year - just nothing out of the ordinary.

And what about a Santa Claus rally this December? With some of the market averages already up double digits, we somewhat concerned that Santa will have coal in his bag.

Employment Results Startle Analysts

This past Friday's employment report from the Labor Department has been the subject of much discussion among pundits. Not because non-farm payrolls rose a less-than-expected 92,000 in October, but because the prior two months were revised upward by a total of 139,000 jobs. September's figure alone was revised up by 97,000. (Remember how surprisingly small September's gain was initially?)

The household survey reported an impressive job growth number for October of 437,000. This was a huge increase over September's household survey number of 271,000 new jobs. And, the headline unemployment rate fell to just 4.4%.

So what should we make of these numbers?

• First off, it's tough to be overly pessimistic about the economy near term given these results. We suspect that holiday spending will be fine despite the problems with housing.
• Second, strong employment gains often hurt productivity over the short run and may account for some of the recent disappointment on that front.
• Third, there is a growing shortage of labor so wage inflation will be harder to keep in check, raising doubts about any Fed rate cut in the near future.

No Productivity Gains in the Third Quarter

The Labor Department released productivity figures for the third quarter and they aren't very encouraging. In fact productivity for the quarter was unchanged and the prior quarter was adjusted downward significantly (read the release here). As we mentioned in a recent post, rising productivity offsets rising employment costs and helps to keep a lid on inflation. So right now, companies are not able to offset rising labor costs with productivity improvements and will either try to raise prices (bad news for inflation) or take a hit to their profit margins (bad news for earnings growth). Either way, this is not a positive for stocks.

For the optimists in the crowd, we observe that the productivity numbers can be a bit flaky as the measurement of output in some sectors is quite difficult. How does one measure the output of the financial sector for example? So wait to early December for the report on nonfinancial productivity before jumping out the window.

More Evidence of a Slowing Economy

Today the Institute for Supply Management (ISM) released the results of their October survey of purchasing managers - the Purchasing Managers Index (PMI). At 51.2, the index points to further growth in the economy. (Remember that any result above 50 indicates economic expansion, while below 50 indicates contraction.) However, this result was below the prior month as well as expectations, and can be construed as further evidence of a slowing economy.

A look behind the headline number provides for some interesting reading (you can access the press release here). In particular, the ISM survey on prices indicates that purchasing managers are seeing lower prices. I'm not sure how much of this relates to energy, but this has to be a hopeful sign for inflation. And, the numbers on new orders and inventories seem to indicate the potential for some further slowing in economic activity.

The ISM survey is an important indicator of the direction of economic activity. It does not help much with gauging the magnitude of the change in GDP. So based on today's release, it looks like the economy will continue to grow but we still lack clarity on the rate of growth over the next several months.