Thus, the bears were in charge last week. The S&P 500 lost 0.7% last week, performing relatively well on the back of a plunging euro and a brave buying spree late on Friday – the Eurostoxx lost 4.7% and Spain’s Ibex index lost 7.7%. Emerging markets also coped relatively well, with the MXEF index belatedly dropping 3.8% as the true extent of risk aversion became clear.

Gold looked jumpy too, selling in correlation with equities, as we have predicted previously. Anyone who bought gold to hedge sovereign risk will now have to suffer a volatile market-to-market.

The gold trade may eventually work out. But for now, the cash is sloshing from developed nation to developed nation, and from asset class to asset class in a fruitless search of safe yield. Much of it will wind up in the emerging markets, but that investment universe is not big enough to offer security on the scale required by developed-world investment capital. When the alternatives have been exhausted, gold may finally begin to re-price relative to global money supply.

Regular readers will be watching this market dynamic with a calm curiosity. MM’s Outlook & Review turned cautious two weeks ago, after Obama launched a necessary but destabilising effort to clean up the US banking sector. Markets were already ripe for a fall, now it appears to be underway. With that in mind, we might best direct our attentions to considering how far the correction could proceed.

Fundamentally things look bad, as the market remains highly valued on forward and trailing earnings. Technically too, there are reasons to wonder. The 200 Day Moving Average is only 4.6% down on the SPX, if that doesn’t hold then the potential for a rout increases substantially. No wonder nervousness is high.

But, it is worth remembering that this is no ordinary market: Free money is a great driver and most assets have shown surprising resilience over the last year, faking to the downside only to push higher. With this in mind, it would be brazen to presume a one-way bear trade.

Even the Vix Index offers limited guidance. Two weeks ago it rallied more than 50% over the week, a clear sell signal? It is true that the Vix is both mean-reverting and mean-fleeing: A spike in volatility might reasonably be expected to precede further volatility. But, as the chart below shows, this is not a given. Over the past 20 years, there have been six instances of the Vix moving by more than 50% over five days. In the following three months, the S&P 500 was as likely to rise as it was to fall. That said, using these six instances, the expected return three months after a 50% one-week Vix jump is negative (-0.7%).

Chart 2: S&P 500 – 3 Month Reaction Post Vix Rally

There are plenty of good reasons to stay out of the game for now then; or at least to be highly selective about what you buy. Short-term avoid high beta and consumer dependent equities, treasuries from over-leveraged nations will represent a great buy, but this trade is not for the faint-hearted. “Quality” government paper looks under threat too, how long before the market starts to price risk into US, UK and German paper?

By contrast, the emerging markets, which are certainly not risk-free, offer apparent economic stability. For those willing to accept that economic management has improved globally in recent decades, surplus nation bonds offer appealing safety. And emerging market equities ought to rebound faster than their developed world peers, look for chances to build positions if the crisis continues.

Of course, the free-money factor may win the day again. But the upside looks limited. If the rebound comes this week then I would not want to chase it. Many investors have their downside hedged, but sentiment is highly volatile and there is a growing consensus willing the market to let off steam properly.

Here are some of the key data points we are watching for over the coming week:

Monday
Europe – Investor Confidence (Feb). Improvement MoM is little consolation when the print is still expected negative.

Thursday
US – Retail Sales (Jan), Inventories (Dec). Sales are expected up MoM and YoY, still off the pre-crisis peak but clawing their way back quite persistently. Inventories are believed to have (finally) risen in December.

Friday
Europe – 4Q GDP, Industrial Production(Dec). GDP is expected at -4%, rising slightly from its bottom mid year. Industrial production is also expected negative, but off the lows.
US –  Consumer Sentiment (Feb). Expected to continue edging up.

This weekend’s G7 meetings offered an opportunity for developed world governments to catch up with each other and compare notes. Although the language was careful, it seems as if the so-called Tobin Tax found its way back to the discussion table too.

In the US, there is a well developed effort to tax the banking sector to recover funds lost in the bail out (0.15% tax on balance sheets of more than $50 bln). Technically this is not a Tobin Tax as it is proposed as a one-off move and targets size rather than liquidity. But unsurprisingly there are plenty of politicians ready to extend the tax. Given the state of government finances, who can blame them?

Yet, of all the regulatory moves on the table, a straight balance sheet tax looks of limited use, because uncontrolled it would pass directly onto bank customers, who are already sick of hidden costs and inefficient banking systems.

In a world (Europe if you ask French Finance Minister Lagarde) where banks are allowed to keep their profiteering prop-trading operations, and banking sector profits are allowed to remain out-sized relative Main Street, yes a flat tax could be imposed – if coupled with (near impossible) regulatory oversight to ensure that it falls on the bank not the customer.

But, the more pertinent question is to what benefit such a tax? Considering the loss of tax income as a result of the recession in all major developed nations, the tax falls far short of compensating the costs of the financial crisis.

If ring-fenced and transparently managed, one might argue that it helps us to prepare for future crises. But, what is the chance of that? Governments are simply clawing for any tax revenue they can find, and banks (with healthy trading profits) are easy targets.

More worrying, the idea of taxing banks to compensate for the costs of future crises ought to be dead in the water for the simple reason that it explicitly accepts the fact that we are unable to avert future crises. While this may be reality, the capitalist system cannot get back to productive risk-taking until it has at least convinced itself that lessons have been learned and recurrences are not possible.

Taxing bank balance sheets is a cheap populist solution to the question of financial regulation. It will cost the customer, not the banks. Yet, it offers the politicians a chance to look tough and the banks an opportunity to role play at change, without tackling the underlying issues and without removing the profiteering risk-taking from the system.

It is also worth wondering at the whereabouts of other key nations. There has been little talk from key emerging markets about the need to follow the West’s lead on banking regulation. Some even voice that the crisis was Western made, and that emerging market banking systems are not in need of similar overhauls. This is simply not true. The key emerging markets may believe they can benefit from remaining laissez faire on regulation (as they have on tax) and arbitraging business away from the West.

That would be a mistake. If the developed world manages to sufficiently resolve these regulatory concerns, then it will remain a focal point for global capital seeking security. In that world, emerging markets will remain prey to highly volatile capital in- and out-flows, while the West will create a foundation for healthy and steady economic progress.

Establishment Survey

According to the BLS website, Construction employment declined by 75,000 in January, with nonresidential specialty trade contractors (-48,000) accounting for the majority of the decline. Since December 2007, employment in construction has fallen by 1.9 million. Housing still the black sheep…

On the other hand, temporary help services added 52,000 jobs and retail trade employment rose by 42,000. The federal government added 33,000 jobs, including 9,000 temporary positions for Census 2010 whereas employment in state and local governments, excluding education, continued to trend down

As for the revision, as I told you before, a figure of 800,000 additional job losses was expected. The US economy finally lost “only” 620,000 additional jobs in 2009 and 1.4M since December 2007.  An upward revision in November mostly explained the gap. Indeed, the nonfarm payroll in November showed an increase of 64,000 (a green shoot that might be only due to statistical error).  

The biggest downward revision occurred in March (-101K to 753 K total losses) and in November (-97 K for a total of 221K losses). I must say that I’m rather pleased with the latter. I was forecasting back then more than -200K, a bad call it looked, and worse, the revisions kept proving me wrong each time. I was having doubts on my forecasting abilities… Actually, I gave up forecasting after that; but now given the final number, I might also revise this.

So bottom line from the ES, the recession was worse than we thought and real improvement in the unemployment rate (i.e. outright job growth of more than 100,000) is still far way.  

But, wait a minute, the unemployment rate? It is coming down to 9.7 % from 10% according to the Household Survey! So, where is the catch? How do you square one with the other?

Household survey

So, first of all, one point does not make a trend and the US administration ought to take this number with a grain of salt.

Looking at the broad picture, employment increased by 540K and unemployment decreased by 440K, hence the substantial decrease from 10 to 9.7 %! But, the devil is in the details.

Last month, the weak point was the labor force participation rate which fell to 64.6%. As I noticed previously, it implied that 660K people left the labor force in one month, which is equivalent to what we observed in one year! (from Nov 08 to Nov 09 ). Now, in January, this rate was little changed at 64.7 percent. However, no change is still bad news, since those “desperate” people will come back and search for a job at some point. So, expect a higher unemployment rate down the road.

But now, without further ado, here goes today’s devil. Again, this is nothing but a statistical trick. Check the non seasonally adjusted numbers, and you’ll find that the unemployed people from December to January  increased by more than 1.3 millions, from 14.7 to 16.1 millions (employment increasing only by 1 million). If you redo the calculation given these non seasonally adjusted numbers, the unemployment rate is actually 10.6 %!   

But, for some reason, January is one of the months with the largest seasonal adjustment up in jobs. That’s to say that the seasonal adjustment factor decreased the unemployment figure from 16.1M to 14.8M while increasing the employment numbers by 500K. You understood me well, with a simple tap on a keyboard, the BLS erased the 1.3 people who lost their job from December to January !

Now, I agree on the fact that seasonal adjustment is indeed necessary to get rid of fluctuations due to weather changes, holidays, and schools opening/closing. But, to trust those numbers, one should really understand the BLS methodology, and I don’t (I’ll try again at some point). But if you know please, can you explain to me how this is really done, and how you can decrease a monthly figure by 1.3 millions? Plus, is January so different from December regarding those conditions?

Moreover, if I plug the 1.4 million revisions from the Establishment survey into the seasonally adjusted unemployment rate, the figure is more in line with the unadjusted figure (even reaching 10.7 %). I tend to trust more this type of manipulation…    

The market seems puzzled by the discrepancy between the Establishment survey and the Household survey. I already pointed out some seemingly conflicting results. But when you dig into the numbers, these surveys are actually both pointing toward the same direction: North.

I’ll be still sitting in front of my PC next month, watching the inconvenient truth officially revealed.

Why not?

Yesterday, Jim Chanos on CNBC: “Greece is always said the country of my ancestors has long been a society of many chiefs and no Indians as someone once said. They’ve got some real problems that they don’t even want to fess up to themselves. Whether the EU does anything to help them out, I don’t know.”  He is right. Almost. I think the world (see pessimistic reports from Mauldin et al) underestimates the power of Brussels. All the years of structural reform debates about the Lisbon treaty have not only breeded a new generation of political leaders in the first, second and third row, for which the European Union became just a natural added layer to their national responsibilities. They also strengthened the political integration of the union up to a level, on which tough love became a possible option amongst neighbours. Looking only ten years back, strong intervention in national politics (remembering the 10y-anniversary of the counter-productive sanctions against Austria) was far less accepted amongst the member states. Things have changed. Since the EU, especially the currency union, became a refuge for non EU members (Iceland, Croatia, …), the perception and the practical value of the Union and the Euro changed to the good.

Brussels is playing the Greek case exactly right. Supportive enough to let the country breath, tough enough to push for the initiation of long-overdue structural reforms.  If the EU would have offered an easy exit (money supply) the precedented case would have opened the gate for ie Portugal, Spain and Italy to bet on bail-outs, instead of doing their homework. On Wednesday, Joaquín Almunia, outlined a challenging recovery road-map for Greece. It´s an ambitious plan, requesting tough choices from the Greek government. The Commission aims to reduce the budget shortfall to below 3 percent in 2012 from 12.7 percent in 2009. We will see soon if the government is willing and able to execute.

Is it doable? Yes it is. Comparing Greece with Ireland, like some other commentators did, ignores the fact that both countries start their ambitious jorney from completely different plateaus. For instance, Ireland can easily cut public service wages by 20%, having raised it before to one of the highest levels in Europe. Furthermore, Ireland did it´s homework of reforming the country to a modern 21st century-service economy before the crash. Greece can be better compared to the Hungarian case two years ago.

Since then, a new prime minister, together wit the help of the IMF and Brussels initiated a series of serious reforms:

• Government changed pension indexation with anticyclical effects for the subsequent years;
• Government modified the conditions of early retirement with the pension benefits included. Retirement before the statutory age shall involve lower pension benefit;
• Retirement age will gradually increase from 2012 by six months each year until 65 years of age both for men and women;
• Government restructured the too generous housing subsidy scheme including the elimination of interest subsidies and social policy aid replaced by a narrower new subsidy scheme;
• Energy price subsidies will be phased out of the social policy system in 2010;
• Government changed the method of sick-pay disbursement with a general rate lowered by 10 percentage points;
• Entitlement criteria of family allowance were modified. Now it is available only until the lower limit of age,
• Government changed child-care subsidies with shorter periods of eligibility for both child-care allowance and child-care aid;
• Headcount stop entered into force in government agencies from the summer of 2009;
• Nominal wages were frozen for those employed in the public sector;

Hungary is back on track for positive GDP numbers in 2010, catching up with its peer group in productivity and convergence. Obviously in both cases, structural reforms can not be fully executed within 2-3 years. But once on track, their tendencies can be measured, trajectories calculated. CDS spreads are a good indicator for that.

Conclusively, I consider the political avenue Brussels and the Greek government walking along as highly constructive for both objectives, Euro stability and the need for structural reforms in Greece. Once constructive reform steps are taken and Greece might need some liquidity injection on its way, I am convinced that Brussels will find some additional money in its structural & coherence funds.  The only real deal-breaker could be, if this or any future government (in case current one has to step down due to the pressure of the street – which wouldn´t surprise me) is not strong enough to deliver the structural reforms needed. But we are still far from this point. Let´s give them some time and a chance to prove that they are reliable and credible partners.

Looking ahead then, the picture is rather murky. Sentiment is weak but funding conditions are supportive, and this week there is plenty of data due, which should provide further guidance:

Monday
US – Personal Income & Spending (Dec), ISM Manufacturing (Jan), Construction Spending (Dec). Manufacturing and construction may have eased, but spending should have continued to grow.

Tuesday
Europe – PPI (Dec). Possibly edging back toward flat YoY.
US – Motor Vehicle Sales (Jan). Expected down MoM.

Wednesday
Europe – Retail Sales (Dec). Watch this volatile number for guidance about European economic sentiment, although strong consumer expansion seems unlikely.
US – ISM Non Manufacturing (Jan). Expected up moderately on December.

Thursday
US – Factory Orders (Dec). Continuing to increase, albeit slowly.

Friday
US – Non-Farm Payrolls (Jan), Unemployment (Jan). Consensus is for flat payrolls, and for unemployment to have inched higher. With consensus at zero, surprise here will move markets.

If US GDP were a business, its marketing department would not be pleased. Already mired in a credibility crisis – it is simply too volatile – the latest reading is a last blow to the significance of this statistics. At 5.7% quarter over quarter – the highest increase in the past six years – GDP growth seems to be so out of touch with reality that not even the stock market was fooled. After rising 120 points, the Dow lost steam and finished the day down 53 points. The S&P 500 lost 1% for the day, breaking the1087 support level decisively.

So is GDP growth a broad measure of economic activity, or rather a bad statistics?

According to the textbook definition, a country’s gross domestic product, or GDP, is the market value of all the final goods and services produced within that country in a given time period. This is true.

There are several ways of measuring it. The Final Demand or Final Expenditure Approach calculates GDP as the total market value of final sales in that country, in a given period of time, and therefore GDP measures aggregate demand in an economy. But that is not true.

It is not true because part of the thousands of miles of fiber optic cable produced in 2000, where never sold, neither in 2000 nor later. They were part of year 2000 GDP, but they were never part of final demand, or of final expenditures. And part of those thousands of miles were kept in inventory and sold years later, perhaps after Global Crossing filed for bankruptcy, in January 2002. Eventually they became part of final demand, but not in 2000.

Therefore, year 2000 GDP was misleading as a measure of final demand: a glut of high tech gear found its way into GDP, overstating demand and clouding economic analysis. To be sure, over multi-year periods, final production will approximately equal final expenditures. This is because if I buy a computer this month, this computer might have been produced last week or last year. If it was produced last year, it was kept in inventory, and it boosted 2009 GDP. But my 2010 demand is going to boost 2010 production – and therefore, indirectly, 2010 GDP – because computer producers will want to be able to meet final demand, and therefore will probably produce one more computer to replenish their inventories.

This is reasonable. But it is also misleading if you are looking for evidence of coincident economic activity. GDP provides a fairly accurate measure of average final demand during multi-quarter periods, but it can easily confuse today’s production with tomorrow’s expenditures. This is exactly what happened with Q4 2009 US GDP, which was inflated by a large “inventory restocking.” In other words, business inventories had gotten very low – because businesses have been very cautious given the very weak final demand of the past year, and kept production to a minimum – and were forced (in the last quarter) to increase production to bring inventory levels closer to normal levels. Will these newly produced goods become final sales in the current quarter, or will they languish in storage for several quarters? The latest GDP reading doesn’t tell us.

This is only one of the many misleading aspects of the GDP indicator. I’m sure we will have ample opportunity to explore more of its vagaries in upcoming posts. A particularly revealing critique of GDP was included in John Mauldin’s December 11, 2009 Thoughts from the Front Line.

As the Bureau of Economic Analysis said in a press release:

“The change in real private inventories added 3.39 percentage points to the fourth-quarter change in real GDP after adding 0.69 percentage point to the third-quarter change. Private businesses decreased inventories $33.5 billion in the fourth quarter, following decreases of $139.2 billion in the third quarter and $160.2 billion in the second.

Real final sales of domestic product – GDP less change in private inventories – increased 2.2 percent in the fourth quarter, compared with an increase of 1.5 percent in the third.”

From the same BEA press release, we read:

“The acceleration in real GDP in the fourth quarter primarily reflected an acceleration in private inventory investment, a deceleration in imports, an an upturn in residential fixed investment that were partially offset by decelerations in federal government spending and in PCE.”

The decelerations in imports and in PCE (personal consumption expenditures) are not what you associate with green shoots or any thaw in consumer end demand. It is worth remembering that the National Bureau of Economic Analysis has yet to call the end of the Great Recession, the recession that started in December 2007.

In other words, the Fe d will be in no rush to start hiking rates: not if macroeconomic releases are as underwhelming as this one. Economic activity is expanding at a tepid pace, and this despite the unprecedented amount of stimulus that has been pumped into the economy. If feasible at all, stimulus will continue. It is only a statistical recovery out there.

For their part, the bank defenders, which surprisingly included the FT editorial, argue – correctly – that the proposed legislation would have made no difference during the credit crisis. Prop trading divisions did not fail, and have even helped banks through the crisis, providing a means of diversified revenue in the market rebound. While this argument is technically correct, it shirks the essence of the proposed legislation, and the deeper problem with the banking sector.

The justification, indeed moral obligation, for separating out prop trading is not tied with the immediate banking issues that made the bail-outs inevitable. It is tied with the broader de-regulation of the financial sector that allowed banks to outgrow their utility status without surrendering their government guarantees. Prop trading contributed directly to the over-sizing of banks and the decline of banking transparency. It inevitably enjoys advantages of knowledge, timing and deal flow that divert investment rents from genuine risk-takers to de facto insider opportunists. And it goes a long way to explaining the outsized bonuses that rightly anger so many on Main Street.

There is nothing wrong with traders taking huge risks and reaping exceptional rewards. But prop-trading has been benefiting from reduced risks and subsidised funding. As a result, as well as enriching a small elitist population, it has inflated the banking sector beyond the scope of the real economy in many developed nations.

In the trailer for Oliver Stone’s much awaited Wall Street sequel, the infamous Gordon Gekko reflects on the change that has taken place in the banking sector since he was imprisoned in the late 1980s: “Someone reminded me that I once said greed is good. Now it seems it’s legal.”

This point is excellently demonstrated in a chart by Jim Reid of Deutsche Bank. While considering this chart, it is worth reading this 2008 blog post, which traces the break down of the Glass-Steagall Act during the 1980s and 1990s. Is the FT editorial genuinely of the opinion that the credit crisis/banking sector bail-out was unrelated to the rapid expansion of the banking sector? Perhaps the timing is coincidental?

Deutsche Bank’s Famous “Mean Reversal” Chart

Certainly it is true that financial innovation would have continued with or without the deregulation of the financial sector. And the point here is certainly not that financial innovation is bad. Nor to contest that a deep, stable and liquid financial sector is essential to healthy economic growth. Quite the opposite. As Niall Fergusson has argued in The Ascent of Money, financial innovation has contributed immeasurably to the development of modern society.

Yet, who can honestly argue that the ascent of banking profits, the credit crisis and the deregulation of the financial sector – which unleashed leverage and vertical integration through the embracement of overlapping business lines – are unrelated? Elizabeth Warren, the chairwoman of the congressional oversight panel on TARP, elucidated the links excellently on a recent episode of John Stewart’s Daily Show.

Goldman Sachs was one of the last remaining private partnerships on Wall Street, but it listed in 1999, to publicly take advantage of the transforming financial sector. Since then, it has done that very well, rewarding employees and shareholders alike. But, it is far from clear that the public good has been well served by either the bank or those rule changes that unleashed it. After all, the Goldman continued to package and sell securities based on dodgy mortgages long after it decided that they were unattractive assets to hold.

It is thoroughly predictable that the banks push back hard to defend the deregulation that allowed them to profit so incredibly. And it is true that prop trading was not the weak link that led to the bailouts. But it is dubious to argue that the deregulation of the banking sector has been of benefit to modern society at large. Banks are simply pursuing their interests, and they are wealthy and influential enough to threaten even the US president’s efforts to impart reasonable controls.

This will be a tough battle then. But surely society has the stronger hand. And if one recalls that the banking sector might have failed if left to its own devices, perhaps even the banks can grasp that the sector needs policing for its own benefit. As John Mack said last year at a Bloomberg conference: “We cannot control ourselves. You have to step in and control the Street.”