This morning’s ISM Services report missed estimates substantially.  Headline came in at 52.8 vs expectations of 57.  The underlying data was even worse.  New orders tanked 11.4 points to 52.7.  Unemployment fell to 51.9 from 53.7.  Meanwhile, prices, though falling, remain at very high levels.

The answers from respondents nicely summarizes the environment:

  • “Business conditions [remain] unchanged. No supply impact from the Japan earthquake/tsunami, but continue to track with the supply base.” (Management of Companies & Support Services)
  • “Revenues are picking up slowly, but the growth is positive as compared to last month and the same month last year.” (Real Estate, Rental & Leasing)
  • “Looking forward with reserved caution. Cost of goods by this fall are a big worry.” (Accommodation & Food Services)
  • “Continuing economic uncertainty will curtail or delay project spending for the immediate future.” (Educational Services)
  • “Fuel prices continue to be challenging and in addition to shipping, are influencing the cost of materials.” (Public Administration)
  • “We are seeing price increases in many areas, and the lead times are stretching out. Our business activities are improving at a moderate rate.” (Wholesale Trade)

So what we have is an economy that remains very weak where job’s growth is still muddling along and rising prices are hurting corporate profits.  Those who are finding solace in the idea that this weak report confirms QE3 might reconsider.  If anything, this report only confirms my findings that QE has had no meaningful positive impact on the economy.  In fact, you could easily argue that the cost increases due to commodity price speculation are the only meaningful result of QE2 and are having a negative impact on the overall economy.

What does it all mean?  Well, the good news is that the index is still expanding.  Although 52.8 is a big miss it is still an expansion.  So it’s not yet time to panic.  It is worth noting, however, that lower ISM reports have correlated very highly with equity returns (see here for more).  Although the ISM Manufacturing report remains robust at 60.4 it would be surprising to see the two indexes diverge permanently.  Because these are diffusion indexes we can likely expect the ISM Manufacturing report to decline in the coming months.  And as I discussed last month, that could be a significant headwind for equities – even though it doesn’t point to economic doom.

For now, I still believe the US economy is strong enough to maintain meager growth.  The risks still are exogenous – primarily foreign related as China eases their economy and Europe remains mired in a debt crisis.  Our balance sheet recession is very much alive, however, the government has done just enough to offset the negative impacts.  Unfortunately, the Fed appears to have added another risk to the scenario in commodity prices.  We should all hope that the price boom in commodities does not lead to a price collapse.   If anything, all of this only confirms the thinking that “hedge in May” is a good idea.


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • Anonymous

    “Unemployment fell to 51.9 from 53.7.”

    Surely this good?

  • Cullen Roche

    It means QE2 is working and that we need QE3, right?

  • Brandon Ferro

    It would be beyond ironic if there is one last leg to the Fed induced commodity rally and that this parabolic blow off does in fact lead to the bubble finally popping and ushering in the panic-like deflationary wave they were trying to avoid in the first place. As I think about positioning myself from a trading perspective, this is the outcome I think is most likely. One last run for everything over the next few months until the door slam shuts, and I really think it’s going to slam, not close.

  • George H

    I feel that we are in a similar situation just like April/May last year. ISM Service is at similar level and is in a dive.

    Not sure we will get a flash crash. But a significant pullback in equity is a high probability.

  • Anonymous

    Look at the current silver price movement as a rehearsal. Door slammed shut on a Sunday at -12%…


  • George H

    When one gets their mind twisted, they can argue the other way.

  • haris07

    Wrong in the conclusion, this report lends more credibility to market participants who think QE3 is coming (me included). This is because Bubble Ben is convinced that QE2 worked well (and more importantly that is the ONLY thing he knows to do). Housing double dipping, economic growth slowing + need to try to elect Obama => QE3 by end of the year or early next year. QE to infinity…

  • Brandon Ferro

    Agreed. I talk to folks on the sell-side that are ex-colleagues of mine. They go on marketing trips and visit institutional investors to discuss their industry lists. Their take-aways from these trips are that nearly universally buy-siders lack conviction and have lacked it for the entirety of the past year. That said, the same people have also felt like Bernanke has been daring them not to invest or to short and they had no option but to be invested. They all think exactly what we think but with the one caveat that they will be able to exist quickly and cleanly before the next joker who is thinking just like them about this ridiculous QE rally.

    If I think about that the latter, it suggests the market ecosystem is incredibly unstable right now, much like silver as you point to. Logically, this tells me nobody will be able toe exit as quickly as they think. This, in turn, suggests downside is going to come fast and will be harsh.

    I am not specifically highlighting the potential for a crash and if I were, I would not put it at greater than 10% likelihood. That said, I would just point out that the factors that caused both the 87 decline and the May 10 flash crash are very much still in place and probably more entrenched than they’ve ever been. The Fed induced speculation probably hightens this reality. As such, even a 10% “crash” probability seems excessively high to me.

    We’re near the end…

  • Cullen Roche

    Could be right. I think the evidence is becoming pretty clear that QE2 did not help and may have only hurt. Therefore, while QE3 might be on deck, it would only further hurt the recovery (though it could induce one more seismic shift in portfolios)…..

  • Brandon Ferro

    Haris07 – I’ve largely agreed with this logic for quite some time, but am beginning to part ways with it.

    I’ve always maintained what you maintain – QE to infinity and with it equities – with one caveat – that being we never get to infinity, much less QE3, should something outside Bernanke’s control limit his ability to pursue such a policy.

    I think the current slowdown in macro-econ data points, all of which seem to be due to the commodity bubble, is “that” event that’s going to preclude more QE unless we get a dramatic recession / equity sell-off.

    Ultimately, the vast majority of the world, including institutional investors, is coming around to the idea that the most noticeable effect of QE has been a rapid rise in global input prices. Add into the equation the fact that central bankers everywhere are tightening, with the Fed doing the opposite, and the hurdle for more QE is just WAY TOO HIGH than it used to be.

    Game over, for now…

  • Witt

    I like to think of it as a chain reaction based implosion. And though I agree with you here, we all need to think what that means… is there even a bottom? What happens to the notional value of derivatives (mainly CDSs) towering about 25X the worlds GDP? See, I think they went to such lengths to avoid that, but it’s inevitable. But we’re talking about a the whole financial order collapsing on its own weight. How do we come out of that? What power struggles ensue? Who gets saved; who’s thrown to the wolves? I don’t think we understand the full gravity of a major sell-off and economic contraction were it to occur right now…

  • haris07

    Brandon, Agreed in general that this time around the bar is higher for QE3. But I still think that as the S&P falls (say 20%), Obama panics and so does Ben. Since fiscal stimulus is out, Ben turns on QE3 (and the financial establishment will support him full force). I expect that this will “work” for a smaller duration and lesser magnitude than QE2 prceisely for the reasons you outlined – more and more people around the world are going to be convinced that it won’t work (which it clearly doesn’t). HOWEVER, my take is that Ben has no choice but to do it…nothing else works (which it won’t) and he has to try and help Obama. I think QE3 will likely be the final nail in the coffin for the USD and US Treasuries….and that any other QE will be unlikely, but I am not so sure. Ultimately, Europe is going to tighten because of the hyperinflation ghosts but Fed is going to loosen because they are haunted by the depression ghosts. And ultimately, they are both going to be wrong! After reading Ben’s paper from 2002 and his utterances, I am quite convinced of QE3…albeit delayed a little for now.

  • George H

    What does QE3, …, QEn have in common with?

    Gambler’s mindset. Double down. By probability, you will win at some point, which will make up all your losses.

    If you are still alive, that is.

  • eludog

    I’d be surprised if QE3 does not happen at some point. It simply has to. Maybe after a 20%-30% correction, but it will happen at some point.

    I actually expect something to take place beyond the current powers of the FED. It seems inevitable. We need to somehow induce inflation. That is what drives any bullish belief at this point and I think they will make it happen somehow. A significant stimulus package could kickstart it. The downside to not do anything is so severe I just can’t see it as an option.

  • Brandon Ferro

    You guys are probably right – more QE3 will come, but not until something bad happens.

    Also, I don’t think it has the effect at that point it has had so thus far.

    If the commodity bubble explodes it suggests a new economic cycle/paradigm is going to come about – the last decade has been EM growth and with it, commodity prices. The two are inextricably linked. If the latter ends, it will coincide with or be caused by the former.

    I’m not sure what happens when this occurs but I think it will be of greater significance than anything Ben or QE can do at that point…

  • blacklotus

    Unemployment rose. Technically the index is called “Employment” so when it falls, unemployment rises…

  • El Viejo

    Speaking of Exogenous, how long till a Greek Default? 6 weeks? 6 months?

  • Nemesis

    QE stoked a speculative blow-off by encouraging leveraged carry trades that pushed up stock and commodities price again 10 yrs. ahead of fundamentals while pulling in the production frontier from the future to the present.

    Note that adjusted for the US$ (US$ Index and trade-weighted majors) and CPI, the SPX is at the levels of Mar. ’09, lows of ’02-’03, and ’96-’97. Not coincidentally, the latter date is approximately when the US economy ceased growing in real per capita terms (private employment and industrial production have not grown since).

    Corporate profits have been maintained during the past 11-15 years by labor cost reductions, growth of gov’t transfers, and price and currency effects; but this phase is coming to an end post-Peak Oil and an acceleration in the decline of per capita net energy returns.

    Now gov’t spending has to be frozen (or cut in real per capita terms), bank lending will continue to contract, US supranational firms’ investment will soon be cut in China-Asia, and US$’s will come rushing back home.

  • Greedsgood

    Anyone have a view on the USD and where it moves versus the Euro, Pound, Yen and other dev market currencies? Since the currency “race to the bottom” is a zero-sum game, my theory is that we are at or at least close to some push back from other dev market countries who would like to see their currency weaken or stabilize vs the USD to help their own economic growth driven by exports. I’m shocked that Euro countries are not more concerned about currency impact on exports and economic progress considering the current anemic growth rate.

    Given the high correlation between the weak dollar and commodities/equities, it would appear that the set up is in place for a pullback.

  • Gatti

    Brandon Ferro- I appreciate your wisdom and thoughts. We’ve lined up fairly similiarly. I won’t go into what our investments are but I do fear my timetable of pulling the trigger is very close to the populace.

    I am looking into when to switch to those countries who are trying to slow. The current interest rates seem very appealing both in terms of fixed income and equities(now taking it on the chin).

    Cheers Brandon…good luck

  • B Ferro

    Thanks Gatti.

    Surprised you’re looking into EMs right now – those equities really seem to be struggling from a price action standpoint and it looks like all the chart breakouts that occurred last month are in the process of failing miserably….

  • Quark

    You not anticipating the crash yet the end is near yet you don’t think that there is virtually no chance of a 10% correction. Huh?

  • Chris of Stumptown

    no, unemployment fell. That is what employment > 50 means.