Number of the Week: 5% Unemployment Could Be Over a Decade Away

By Justin Lahart

162: Number of months it would take at this year’s pace of job growth for unemployment rate to fall to 5%.

U.S. employers have added 757,000 jobs to their payrolls in the first half of this year. That actually wouldn’t be so bad if there weren’t so many people out of work. The June unemployment rate of 9.2% was well above the 5% it logged in December 2007, when the recession got under way.

What would it take to get the unemployment rate back down to 5%? Much stronger growth in jobs — or a whole lot of time. Here’s a back-of-the-envelope calculation:

The unemployment rate, based on a Labor Department survey of households, is the share of the work force (people with jobs plus people seeking jobs) who are unemployed. Out of a workforce of 153.4 million people, there were 14.1 million unemployed in June.

The Labor Department’s payroll figures are based on a separate “establishment” survey of employers that doesn’t include some workers, like farmhands, included in the household tally. To get around this, assume employment in the household survey increases at the same rate as employment in the employer survey did in the first half of 2011. That implies a gain of 1.2%, or about 1.6 million employed, over the next year.

Next, we have to factor in labor force growth. If we assume that it grows at the same pace as the Census projects the working age population – people aged 16 and over – will increase by about 1.4 million people next year. With employment growing just a smidge faster than the labor force, then, the unemployment rate would still be a disappointingly high 8.9% in June 2012. The October 2012 unemployment rate — the last one we’ll see before Election Day — it would edge down to 8.8%. And it wouldn’t reach 5% until December 2024.

There are caveats on our envelope. We only have a rough sense of how fast the population is going to grow. We don’t know how much of the population will want to work — plenty of people who dropped out of the labor force during the recession will probably come back as things improve, but an aging population is also pushing more people out of the job market. History says there will be at least one recession sometime in the next 10 years, which will knock employment lower.

But while it’s possible to fudge the calculation in one direction or the other, there’s no way to make this year’s jobs growth look anywhere close to adequate.

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NEW EVIDENCE OF A CHINESE HOUSING BUBBLE

by Cullen Roche

When people discuss the surge in Chinese real estate you’ll often hear that the issue is not broad and is instead contained to a few of the larger cities (sounds familiar – hello Miami, Los Angeles, NYC and Boston!), but new research from Professor Christian Dreger and economist Yanqun Zhang say the problem is more wide ranging and consistent with a bubble that threatens the Chinese economy:

“In recent research (Dreger and Zhang 2010), we use a dataset for 35 major cities to estimate the size of the bubble relative to the equilibrium level implied by the panel cointegrating relationship. We suggest that positive deviations from the long run might indicate the presence of speculative bubbles. However, many analysts have argued that a bubble has emerged only in recent years, probably spurred by the recent fiscal stimulus package (Wu et al. 2010). Hence, the evidence can be misleading if the cointegration relationship is considered over the entire period. In a first step, we estimate the long-run relationship only up to some point in time. The fundamentals include real per-capita income, real interest rates, real land prices and population. Cointegration between these variables and the real house price can be established. City fixed effects are embedded to control for unobserved heterogeneity.

In the second step, the house price evolution is predicted over the rest of the sample, i.e. the last two years, where perfect foresight is assumed with respect to the fundamentals. This gives an estimate of the fundamental development of house prices, and the size of the bubble can be addressed. As an exception, land prices are held constant throughout the forecasting horizon to reduce endogeneity problems.

Our results indicate the presence of a house-price bubble. In Figure 1it can be seen that increasing imbalances have emerged over the past two years. For example, real house prices in Shanghai have been 28% above the long run equilibrium in 2008, and 35% in 2009. While the evidence is similar for Beijing, the increase is more spectacular in Shenzhen. Compared to the cointegrating relation, real house prices are overvalued by 66% in 2009, after 23% in 2008. In general, the bubble is more pronounced in the special economic zones and the south-eastern coastal regions. Overall, the size of the bubble is 20% in 2008 and 25% in 2009, regardless of whether GDP or population weights are applied.”

Figure 1. House price bubble in major Chinese cities

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BULL MARKET HAS WEAK LEADERSHIP

By Carl Swenlin

While this bull market has rallied +105% from the 2009 low (basis the S&P 500), I have had a sense that there was something “squishy” about it. One thing was the absence of convincing volume, something analysts have been complaining about since the bull market began. Recently, when looking at our Blue Chip 152 Top 10 Index, I found some surprising evidence of just how dysfunctional this bull has been.

The Blue Chip 152 is a list of stocks that includes the stocks in the S&P 100, the Dow 65, and some Nasdaq favorites. Some years ago I got the idea to track the top 10 relative strength stocks, believing that this would provide a a short list of stocks that would always be upside winners. Boy was I wrong about that. Just look at the chart.

While the Top 10 have tended to perform better than the SPX in bull markets, they perform far worse during bear markets. The reason is simple. Market leaders tend to retain their leadership in bull markets — once a stock rotates into the Top 10, it will stay there quite a while until it is forced out by a stronger stock, which in turn persists in its leadership position.

In bear markets the story is very different because the majority of stocks are are in decline. Stocks with high relative strength are just not declining as fast as other stocks. As a stock enters the Top 10, it is likely that it is peaking, rather than being in the middle of a strong up move, so the Top 10 stocks as a group are more likely to be moving into accelerated down moves.

Here are some charts of the Top 10 and the S&P 500 which allow us to compare bull market gains and bear market losses. Note that during the 2002-2007 bull market the SPX gained +105% versus +336% for the Top 10. Now compare that with with current bull market gains of +105% for the SPX (already equal to the last bull market) and +119% for the Top 10 (way behind its performance during the last bull market). While the Top 10 is ahead, it is really lagging its normal performance. The reason for this is that there is faster rotation in and out of the Top 10, which is caused by weaker than normal performance of the leaders.

Bottom Line: I your impression of this bull market has been that it doesn’t “feel right”, your impression is not without basis. The Blue Chip Top 10 Index shows us that the leadership has been weak and lacking in persistence compared to the previous bull market

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DEJA VU ALL OVER AGAIN?

by Cullen Roche

A little datamining never hurt anyone. And here’s a fine piece of it. The market has troughed during the summer in each of the last two years. And to be fair, summer is a notoriously poor market period on a historical basis with the end of the year being one of the better seasonal periods. But American Century Investments recently noted that the performance this year is eerily reminiscent of both 2009 and 2010. Will this year be the same? Should we prepare for both higher yields AND higher equity prices into year-end? Via ACI:

“The mid-year U.S. economic slumps of the past two years can be shown graphically, reflected in the declines of benchmark stock indices and Treasury yields over the period. The graph below shows the behavior of the S&P 500 index and the 10-year U.S. Treasury yield in 2010 and 2011 year to date through June 30. Note the similar dips in all four lines within the shaded second-quarter period for both years “:

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PortfolioMatters: When Good Funds Having A Bad Time

By Charles Rotblut

Even good mutual fund managers can have bad quarters. Such was the case last quarter for Bruce Berkowitz of Fairholme (FAIRX), which ranked among the worst-performing domestic stock funds covered by our Quarterly Low-Load Mutual Fund Update.

FAIRX lost 7.3% last quarter and is now down 9.5% year-to-date. Disappointing results, but they follow years of comparatively strong performance. Fairholme topped its domestic peers on an annual basis for nearly all of the past decade.

Chart Source: Yahoo Finance (added by EconMatters)

When looking at a mutual fund with a good long-term record but lackluster recent performance, the first question to ask is “has anything changed?” The answer often rests on one of four characteristics: management, objective, size and external factors.

An actively managed mutual fund’s performance is often tied to the talent of its managers. Any time a successful fund manager departs, future performance needs to be scrutinized more closely. Some funds enjoy a successful transition and others do not.

A change in a fund’s objective can give a manager more flexibility for picking investments, but it can result in different return characteristics. Investors need to read their fund’s prospectus annually to check for any changes.

Size can create headaches for a fund following a specific strategy. This occurs when assets under management (AUM) exceed the amount a manager can effectively deploy. It can be a problem for funds that target certain foreign markets, specific industry groups or smaller companies with less trading volume.

It also has the potential to be a problem for funds like Fairholme that hold a limited number of stocks (FAIRX holds just 20 stocks and seven bonds), but you need consider the average volume of each holding (aka liquidity) before viewing a concentrated portfolio as a red flag.

External factors are market and economic changes that work against a fund manager. Several gold funds, including U.S. Global Investors World Precious Minerals (UNWPX) and Midas (MIDSX), posted double-digit percentage declines last quarter because mining stocks fell in value. It does not matter how good a manager is; if the category he invests in performs poorly, his fund’s returns will suffer.

The most important factor is to think about why you bought the mutual fund in the first place. Most mutual funds, including Fairholme, are intended to be held for the long term. There are some that are intended for tactical, short-term speculation, such as Direxion Monthly Dollar Bull 2x Investor (DXDBX) and Rydex Investor S&P 500 2x Strategy (RYTPX).

The two types of funds should not be confused. If you own a fund that follows a long-term strategy and nothing significant has changed (e.g., objective, management, size, etc.), you should not be worried by a short period of poor performance if the fund has a lengthy record of good returns.

On the other hand, if you are buying a fund for purely short-term trading, be prepared to sell it quickly and do not treat it as a long-term position. Countless investors have hurt their portfolio’s performance by entangling short-term speculation with long-term investing.

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Another Commodities Bull Run By QE3?

By Commodities Now

The dark cloud over the US economy has had a small silver lining for commodity prices in the form of renewed expectations of yet another bout of quantitative easing from the Fed and a lower dollar. However, Capital Economics think it is far too soon to expect QE3. What’s more, there is only so much that monetary policy could do to offset weakness of final demand for commodities, according to Julian Jessop of Capital Economics.

Commodity prices have held up rather better than might have been expected given the recent run of bad news on the US economy, which has hit equity markets much harder. The resilience of commodity prices has been supported by gains in agriculturals, notably sugar and soybeans, due to renewed supply concerns. But even the prices of commodities which are more sensitive to the economic cycle, such as oil and copper, have edged down recently.

The most likely explanation is speculation that the US Fed will be forced to implement a third round of Treasury purchases (QE3), or at least that it will keep interest rates near zero for longer than others (although not Capital Economics) had previously anticipated.

Ultra-loose monetary conditions are, of course, particularly helpful for commodity prices because they minimise the opportunity cost of holding assets that do not pay any interest, while increasing demand for hedges against inflation or further dollar weakness. This argument is often backed up by variations on the Chart, which at face value at least imply a strong relationship between the Fed’s holdings of Treasuries and the level of commodity prices.

However, we are unconvinced for three reasons.

First, it seems premature to anticipate further QE. The US economy has slowed, but it has not collapsed. Some of the headwinds, notably the previous spike in gasoline prices and the disruption to supply chains from the Japanese earthquake, should fade in the second half of the year, allowing growth to pick up again. In the meantime, core inflation, although low, is ticking higher.

The Fed’s decision to launch QE2 was hugely controversial, even among some FOMC members, and it will take a lot more weak data to prompt serious consideration of a third round of Treasury purchases. Indeed, the prospect of another surge in commodity prices might be another reason for the Fed to pause before implementing QE3.

Second, in the conditions when the Fed might be willing to ease further, demand for commodities from end users is likely to be very weak. The US would probably have to be sliding back into recession, or facing an imminent threat of a slump as fiscal policy is finally tightened. The global economy would presumably be struggling too.

It would then seem unlikely that the institutions selling government bonds to the Fed would readily reinvest the money in much riskier commodities, or that others would be eager to increase their exposure to commodities either (the safest havens like gold excepted).

Third, even if the Fed does launch QE3, the dollar could still rebound. For now, shifting expectations for monetary policy are driving the US currency lower. But this would change if, as we expect, the financial crisis in the euro-zone deepens and the dollar benefits from a revival of safe haven demand.

Overall, whether or not the Fed launches QE3, we continue to think that financial conditions will remain favorable for commodity prices for a long time yet. However, this will not be the whole story if, as we also expect, the world economy faces several years of sluggish growth and the dollar recovers.

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