The economic recovery remains vulnerable

There is so much wrong-headed thinking being bandied about, that there were seemingly endless alternative titles for this piece that came to mind. I will mention just a few as a synopsis of my current thinking.

Press reports of October employment are more fiction than fact.

The October BLS employment report reveals far more weakness than strength.

Markets are misguided in believing there will be a step-up in inflation any time soon.

Deflation remains a very real threat despite the Fed's planned buying of Treasuries.

Treasury yields are destined to decline.

The financial press trumpeted the 151,000 seasonally-adjusted increase in October nonfarm payroll employment as if this were proof positive that the economy is finally on track to not only a sustainable recovery, but to a significant growth in employment. Unfortunately, changes in the seasonal adjustment and other details are resposible for most of the seeming improvement in nonfarm payrolls in October and recent prior months. There is almost always a sizable rise in employment at this time of year, much of it temporary. In recent years the actual, not seasonally-adjusted, October rise was smaller than the seasonal adjustment expected, producing disappointing increases or declines in the seasonally-adjusted payroll data. Last year, for example, an 870,000 actual rise in October nonfarm payrolls was expected. Because the actual rise fell short it produced a seasonally-adjusted nonfarm payrolls October 2009 decline of 224,000. In an effort to avoid undercounting this year, the threshold for an October 2010 rise was reduced to 768,000, a cut of 102,000, boosting the seasonally adjusted October nonfarm payrolls by the same amount. But did they finally get it right? No.

Monthly nonfarm payrolls are also boosted by a fictional assumption that new small businesses that are not sampled, and for which there are no reliable data, hired additional workers. Excluding just these two variables, the entire October increase in nonfarm payrolls would disappear.

An even more convincing indicator of continuing employment weakness is provided by the Household survey, a particularly dependable indicator of employment in recoveries. In October Household survey employment plunged a startling 330,000. This huge decline calls the validity of the October rise in the nonfarm payroll survey as a correct indicator of employment into serious question.

There was also a 254,000 October decline in the Household survey labor force, as more unemployed workers became discouraged and left the labor force. Largely as a consequence,the unemployment rate remained unchanged at 9.6% in October rather than rising.

The Bureau of Labor Statistics Household survey is a far more reliable indicator of employment increases at the current stage of the business cycle because it is more attuned to small firms hiring, where much of the early cyclical job recovery occurs. In contrast, the payroll survey is limited to medium and large firms.

A still better measure of the true employment situation is the broader unemployment rate that includes those only marginally attached to the labor force, also called U-6. This unemployment rates includes the large number of discouraged workers who have given up looking for work and those temporarily employed part-time workers who were unable to find full time employment. This unemployment rate was 17.0% seasonally adjusted in October, down only marginally from 17.1% in September.

The various measures of the economy that provide evidence of recovery are benefiting from some temporary sources of strength that will soon be dissipating. This includes a rebuilding of inventories, which may have already (or soon will be) increased to excessive levels. That will remove roughly half of recent economic growth.Among new sources of economic weaknesss is a coming wave of foreclosures that will further depress housing prices, consumer confidence and spending. Many banks and other originators of packaged and securitized mortgages may soon be required to recognize losses on previously sold issues. State and local governments are likely to be further scaling back their spending and laying off workers as they respond to legaly mandated requirements to cut their fiscal deficits. And unless offset by new initiatives, Federal taxes will be rising. At best these trends will keep real GDP growth at a minimal rate next year of 2% or less.

The widespread concern that the Fed purchase of Treasuries will lead to an acceleration of inflation is misplaced. There are many ways to arrive at the exact same conclusion. The huge excess capacity to produce goods and services will prevent producers from exercising pricing power and disproportionately raising prices. The current 74.7% industrial capacity utilization rate is far from the 85%-87% area where bottle-neck pricing pressures typically even begin to emerge. The recent sharp trend decline in money volicity more than offsets the rise in the money supply. Even more significant, credit, a key determinant of economic activity and price pressures, is not expanding. The deleveraging of the credit expansion leading up to to the housing bubble still has further to run. Taken together these various appoaches to forecasting inflation point to at least a continuation of the recent 1% increase in consumer prices or (more likely) a further deceleration in consumer price inflation to or even below zero next and year and probably beyond.

Though the Treasury 10-year yield is already at a relatively low 2.53% (and it is likely rise with this week's Treasury borrowings), a further eventual decline to or close to 2.0% is likely. I recognize that such a forecast is difficult for most readers to accept, especially given all the press coverage of rising inflation projections and pronouncements that US Treasury prices are in a bubble. However, with a zero inflation rate increasingly likely, even a 2.0% ten-year US Treasury yield would still be high relative to the lows in Japanese yields and real US Treasury yields.

For the time being the outlook for equity prices appears bright. After the rapid rise in equity prices from their cyclical lows, especially in recent months, a price pull-back is probably long overdue. However, when the rise in the Value Line arithmetic index exceeds 4.0%, as it did last week, with a 4.1% increase, it has proven to be a relatively reliable advance indicator of further increases in the S&P 500 and other broad equity market indices. Indeed, past experience suggests that a long postion in the S%P 500 should be maintained until the Value Line index experiences a 4.0% decline,at which point the long position should be sold and a short position established. Though there have been exceptions, this investing approach has been sucessful over time. For more information on this relationship see The 4% Indicator Revisited by Michael J. Collins in the 2010 Annual of Technical Analysis of Stocks and Commodities.

This and prior reports can be accessed at philipbraverman.blogspot.com

Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport, New York 11731

I can be reached at philipbraverman@Gmail.com