Really Good News . . . for the economy

The second most closely watched economic statistic right now is the Labor Department's weekly report of the number of Initial Unemployment Claims as reported by the state unemployment agencies.  (The monthly employment report is the most anticipated report). The number of initial unemployment claims is considered a "hard" almost "real time" statistic.  However, there is a lot of "noise" in the data due to normal seasonal fluctuations during the year.

One of the major seasonal fluctuations is the annual shut down of the auto plants for retooling in July.  As I understand it, GM did not shut down this year which distorted the seasonal adjustments.  The auto workers typically file for unemployment during these shut downs.  When they didn't file in July it made the numbers look better than expected because of the seasonal adjustments to the data series.

The seasonally adjusted data series has looked worse in August for the same reason.  Brian Wesbury at First Trust Advisors compares the seasonally adjusted with the unadjusted data and shows that the actual number of new claims for unemployment is the lowest that it has been since September, 2008.  If you look at his chart you will see why seasonal adjustment is necessary.  However, there are times when the raw data needs to be examined as well.  This is one of those times.

Why I'm Not Hiring

Micheal Fleischer, president of Bogen Communications in New Jersey, spells out some of the barriers to hiring new employees.  I have been making the case that the barriers to economic growth are increasing in the form of:

• higher marginal tax rates (reduces after-tax return on capital investment),
• increasing regulatory burden (increases cost of production and thus reduces after-tax return on capital investment), and
• increasing trade restrictions (reduces the market's ability to price efficiently and thus reduces after-tax return on capital investment).

Is it any wonder that we are not getting the growth in hiring and investment we would like to see in this recovery? 

Many supply side economists continue to highlight marginal tax rates as the problem when higher marginal tax rates are only a portion of the problem.  Increasing regulatory burden and increasing trade restrictions don't get the press, but they are equally as important (if not more important).

Even with the passage of landmark legislation, it remains to be seen what the actual regulatory burden will be in financial services and health care (not to mention the impact on other industries).  Despite thousands of pages of legislation, the regulatory agencies still need to write tens thousands of pages of regulations.  Then, those regulations will need to be read and digested.  All of this will take some time and will prolong this period of uncertainty and slow job recovery.

Having said that, the GDP numbers should look pretty good for the remainder of 2010.  GDP or Gross Domestic Product measures the total value added in the national economy.  By definition, its mirror image is National Income.  With marginal tax rates set to increase on January 1st, those with the flexibility to advance income into 2010 and delay expenses into 2011 will do so in order to minimize the impact of higher tax rates.  Those with that flexibility are also those with the most income so their shifts have significant impact on the National Income and Product accounts (GDP and National Income).  We've seen this movie before; it happened in the first half of the 1990's, the last time marginal tax rates were increased.   As I said, the remainder of 2010 should look better than it really is and the first part of 2011 should look weaker than it really is.

The Soak-the-Rich Catch 22

Arthur Laffer shows in the Wall Street Journal that the top 1% of income earners pay more in taxes as a percentage of Gross Domestic Product than the bottom 95% of income earners.  If tax rates go up, it is the top 1% that has the abilityl to hire the lawyers and accountants to make sure that their average tax rate stays the same even though their marginal rate has increased.

Marginal tax rates need to remain low so that capital will be employed to create jobs.  Higher taxes on income and capital mean that fewer jobs will be created.  Fewer capital projects will be profitable after tax and thus business investment will be lower than it would have been at the lower tax rates. 

Higher tax rates in concert with a higher regulatory burden mean that the economy will not create as many jobs as it has in the recoveries of the last 30 years.

Without Stable Money There Can Be No Trust

I have mentioned a number of times that the focus of government policy ought to be lowering the barriers for producers to produce.  If the goal of government policy is increase employment then the government ought to do things that incent employers to grow their business.  Unfortunately, government policy has had the (unintended?) consequence increasing the barriers to employment growth.  (see the post of June 16th).  Even a neutral policy would be welcome at this point.

Unfortunately, one major barrier to business growth has been the decimation of the value of the dollar.  John Tamny lays this out beautifully in this Forbes.com opinion piece.

If we can't trust the currency, how can we trust any other government institution?  Jude Wanniski wrote "A Gold Polaris" back in the 1990's.  In it he attributed much of the social pathology that began in the 1970's after the Nixon administration broke the link between the dollar and gold. 

Technical versus Fundamental Analysis

There are two basic ways to look at the stock market.  In evaluating a stock most people look at the attributes of the company, the industry or the county’s economy to determine whether the stock represents good value.  They might ask, “is demand for the company’s products accelerating and will that acceleration lead to growth in earnings and dividends?”.  This type of analysis is called “fundamental” analysis.  Often you hear analysts on CNBC or Bloomberg speak of a company’s ”fundamentals”.  The theory is that higher earnings and dividends will lead to higher stock prices over time.

The other type of analysis looks not at the supply and demand for the company’s products but at the supply and demand for the company’s stock.  These analysts look at the historical price and trading volume to discern patterns of accumulation and distribution by the so called “smart” money (also known as “the herd”).  This type of analysis is called “technical” analysis, a misnomer, but one that has been around for 75 or 100 years.  There are traders who make money with a myriad of “indicators”, but sadly, most do not.

However, there is formation of stock/market index prices that has stood the test of time.  It is called a “head and shoulders” formation for a reason that will become obvious.  It comes about in the following manner.

1. The stock/index is in an uptrend.  The price cycles up and down, but each high point in the cycle is higher than the previous high point.  Each low point in the cycle is higher than the previous low point. 
2. However, there comes a time when the pullback from the last high matches the previous low.  What has formed at this point is a potential left shoulder and head in the head and shoulders formation. 
3. If the subsequent rally fails to make a new high and pulls back to the previous two low points then we must respect the potential for a trend reversal.
4. If the price goes below the previous two low points (known as the neckline) then we have to assume that the price trend is down and the lows in the cycle will be lower and the highs in the cycle will be lower.
5. Ideally, volume will be highest under the left shoulder, a lower level under the head and even lower under the right shoulder.
6. The larger the distance between the “neckline” and the peak in the “head” the bigger the subsequent decline.  As a rule of thumb, many say that the predicted decline from the neckline would be the same number of points as the distance between the peak and the neckline.  Translation:  a break below the neckline would indicate that we are only half way through the pain.

Currently, the major indices in the U.S. have traced out potential head and shoulders formations.  See the chart of the S&P 500 shown below.  A close below 1050 would put in play completion of a head and shoulders with a working target of 884.

The comparable numbers on the Dow Jones Industrial Average are 9,816 for the neckline and 8,428 as a working target.

One caveat:  there are times when the market will make a slight break below the neckline and then rally to new highs.  There are no sure things in this business.  Someone has said that the market will do whatever it takes to make the maximum number of investors look foolish.

Prices below are daily through the close price on June 28, 2010.