What Is Not Seen

Well, almost.

Im currently on vacation in Paris, with limited internet connection I thought it be appropriate to comment on the recent market development.

The Dow Jones Industrial Average is by many seen as the back bone of the U.S economy. Looking at the “leading” blue-chip stocks today, they all seem quite tired. With the Dow down 9.4 % so far this month, we have to go back as long as to the Great Depression for a larger intra-month drop in June.

I have on many occasions mentioned the Bullish percent indicator, an indicator (contrarian) that gauges the current level of risk in the market, and has a great track record. On the 19th of May I wrote in “A Stock Market Correction” that we were in for a correction. The same date the Dow Jones index peaked at 13136.69 and the bear market rally was clearly over. Since then the index has plunged13,63 % to 11346,51 today.

Soon after the peak, the Bullish percent indicator switched to a column of “O’s, indicating that demand, once more had weakened and supply was taking over. At the moment we see the NYSE Bullish percent stands at 38 %, meaning that only 38 % of the stocks in the index is experiencing some positive momentum.

This development was also captured by the VIX index that some market analysts like to keep an eye on. The VIX index measures investors risk appetite by deriving 30 days expectations on market volatility from option prices. Since the middle of May we have seen a steady increase in the index, moving almost inversely to the broader market indices.

According to the often cited maxim, we are in a official bear market when stocks have fallen by 20 %. Even if we technically are not there yet, its only one tick away. Since the absolute bull market peak in October 9th last year when the Dow hit 14164.53 stocks are down 19.9 % of today.

However, official or not, there should be no doubt that both the U.S economy and the stock market both has been in a clear bear market for some time now.

Kieran Kelly, a derivatives expert, has done some very interesting work regarding the workings of the law of large numbers, and its implications for financial theory. By studying the impact of the reverse of the law of large numbers, he delivers a devastating blow to the almost omnipresent efficient market theory. From a FT article we read that:

The reverse of the law of large numbers, as its name suggests, describes the reverse effect of the law of large numbers, which crops up everywhere in the fields of mathematics, physics, engineering and the social sciences. Put simply, the law of large numbers, or LLN, says that the larger the sample, the closer the average will approach to the expected average. Rolls of a die, for example, fluctuate wildly around the expected average of 3.5 in a small sample, but converge on the average as the sample size increases…

…In his work Mr Kelly addresses what happens to the balance of expectations when so-called rational independent entities start copying each other. Since copying reduces the independence of individual entities, Mr Kelly designed an experiment to see what happens to the balance of expectations when the LLN goes into reverse and individual behaviour starts to merge into group behaviour.

The experiment focuses on a number of individual entities who are faced with a choice between two equally likely options – the market will go up or the market will go down. Given that the future is unknown, in an unbiased market, the likelihood of the next move should be a 50-50 bet.

“We first examined what was the most probable outcome of expectations when a large sample was all acting/choosing independently,” says Mr Kelly.

“Then, we gradually reduced the number of individual entities by allowing first one individual to copy another, then two individuals to copy a third (or one to copy another and a second to copy a different other) and so on. This progressed step by step to the ultimate extreme of everyone copying everyone else, so the market as a whole is acting as one.”

They found that as individuals move toward herd behaviour, the probability distribution changes from the normal bell curve, with expectations clustered around the 50/50 level, through a tipping point, where there is an equal likelihood of a balanced or unbalanced market of expectations, to a position where a market is almost certain to be unbalanced in its expectations. At this extreme, the whole market has the same view, so the balance of expectations is polarised one way or the other.

Austrian economists have already provided lots of counterexamples and, economic reasons why the efficient market hypothesis is deeply flawed (read more).

The work of Mr Kelly adds an additional dimension to this criticism. The idea of the reverse law of large numbers, provides insight how real market agents act and interact, contrary to the efficient market theory. By themselves, recent market bubbles should be evidence enough, that phenomenon such as herding- and crowd behaviour is present in determining asset prices.

Mark Faber in a Bloomberg video today, says that the Friday market sell-off was not over done, but was merely a delayed reaction to the fact that the U.S. economy is already in a recession. The rally since mid March has been baptized a “Sucker Rally”. I agree with Mark that equities are over valued (both from a technical point and a fundamental point ).

Also, recently, Relative Strength for stocks over bonds, measured by S&P 500 and Dow Jones Corporate Bond Index, have turned south for stocks, signaling weakness ahead.

In a couple of my earlier posts, I have argued that the manufacturing sector make up the largest part of the modern industrialized economy, especially the U.S economy. While the press keeps nagging about the fact that consumption constitute 70 % of GDP, manufacturing constitute totally 62 % of the whole economy! To quote from one of my earlier posts:

By looking at the broader statistic provided by the Bureau of Economic Analysis, Gross-Output, total spending in the US economy is approximately $24 trillion. With GDP of $13 trillion, industrial spending including spending on manufacturing can be estimated roughly to $14,9 trillion. This would infer that consumer spending constitute only 38 % of total economic spending not 70 % according to the GDP. The other 62% can be subscribed to spending in earlier stages of the production process, in particular manufacturing.

Now, according to the latest numbers, the manufacturing sector gained momentum during May. Looking at the ISM survey (Institute for Supply Management), released yesterday, we saw that PMI growth in manufacturing increased to 49.6 % in May, up from 48.6 %, in April (A number below 50 signifies a slowing manufacturing sector). The biggest positive change was found in production, new orders and prices, where production increased 3.2 % to 49.7 % and new orders 2.1 % to 51.2 %, sending an apparently bullish signal.

Also, today’s Census report on Manufacturers’ shipments, inventories and orders agree with the ISM survey, showing an increase in manufacturing with 1.1 % for new manufacturing orders in April.

Looking back on 2007, we see that manufacturing peaking in July. So, what then does these numbers tell us. Is the April readings possibly a through for manufacturing?

Not likely! While ISM new orders increased, we saw a sharp 5.5 % decline in order backlogs. Backlogs can be viewed as total value of sales orders waiting to be fulfilled. Thus, by merely looking at new orders compared to backlogs, we see that the gain in new orders is smaller than the decline in backlog. Keeping in mind that ISM is only a survey, the net effect indicates a slower overall demand for manufacturing goods.

Another important fact regarding new orders can be seen in the Census report. According to the headline number, new orders in manufacturing increase by 1.1 % in April. However, non-seasonally adjusted change during the month for new orders declined with -2.7 %. That is a positive adjustment of totally 3.8 %.

The case with ISM production, on the other hand, is not as obvious as with new orders. Looking at the downward trend since July 2007, when manufacturing peaked, the May production reading is likely nothing more than a short-term divergence from the long term-trend. According to economic theory, manufacturing in this stage of the business cycle should experience severe problems.

But what about the FED cutting interest rates? Since September 2007 the FED has cut interest rates by 3.25 %. While the rate cuts often have a direct impact on the stock market, they have a lagging effect on the economy.

First, a lower interest rate means lower financing costs for companies, as they now can borrow money more cheaply. This low rate environment creates an artificial boost to accounting profits as capital is allocated to the manufacturing sector.

Second, an artificially low interest rate creates monetary inflation. Eventually, this inflation results in higher prices. The recent surge in commodity prices, such as energy, metals and agricultural goods, is partially a consequence of prior rate cuts.

Looking at the ISM report, prices reached 87 % during May, the highest reading for the index since it registered 88 percent in April 2004. A surge I input prices directly affects capital intense businesses, such as manufacturing, resulting in lower profit margins.

At this point, it is too early to call for a new “bubble” in manufacturing. Although, the rate cuts still have a distorting effect, keeping malinvested capital from being liquidation. Surging input prices have put a cap on growth in manufacturing. As long as prices on energy and other input goods keeps on piling up, manufacturing will suffer. Hence, we should expect further weakness going forward.

Finally, to answer the initial question: What’s up with manufacturing? let us once again turn to the ISM survey to see what respondents are saying:

“Higher prices, tighter supply, longer lead times, shrinking inventory (same as last month).” (Transportation Equipment)

“Just two months ago we were cautiously optimistic, but now sales inquiries are coming in at a snail’s pace.” (Machinery)

“Ethanol-driven agricultural commodity increases continue to pose major hurdles.” (Food, Beverage & Tobacco Products)

“Pricing is skyrocketing for chemicals.” (Chemical Products)

“Current forecast flat for Q2 through Q4 after dip in Q1.” (Computer & Electronic Products.

Times Online U.K. has an interesting interview with Nassim Nicholas Taleb. Most famous for his recent book, The Black Swan, Taleb here gives his bearish outlook for the U.S. economy.

The sub-prime crisis is not over and could get worse. Even if the US economy survives this one, it will remain a mountain of risk and delusion. “America is the greatest financial risk you can think of.”

The problem with financial crises, is that they in fact reflect economic imbalances. When an economy experience recession, some of the prior missallocated capital is liquidated. These misallocations occures during the booming years, when entrepreneurial activity is misdirected by faulty markets signals, such as artificial low interest rates. When FED and gouvernment officials speak about providing measures in order to avoid recession, they are in fact just pushing the problem forward. As Taleb points out, should the U.S. economy artificially recover, without naturally redirecting capital to its highest valued ends, we can expect the next financial wave to hit the economy with a vengeance.

Taleb continues with more gloomy words:

Governments and policy makers don’t understand the world in which we live, so if somebody is going to destroy the world, it is the Bank of England saving Northern Rock. The biggest danger to human society comes from civil servants in an environment like this. In their attempt to control the ecology, they don’t understand that the link between action and consequences can be more vicious. Civil servants say they need to make forecasts, but it’s totally irresponsible to make people rely on you without telling them you’re incompetent.