March 2003

Fear In Check?

Fear Factors...There is absolutely no question that significant equity bear markets bottom in the height of investor fear.  Fear that is often irrational.  Fear that is often an emotional mirror image of the lack of logical thinking that helps drive the euphoria seen at equity bull market tops.  As you know, there is a subset of technical analysis devoted entirely to the apparent study of human fear.  Tools such as options related volatility indices like the VIX, VXN, QQV, etc., put-call ratios, sentiment indicators, the commitment of traders report, specialist short sales, and the list goes on and on.  In the current environment, many a characteristic defining the moment such as declining volume, the clear downside bias of the equity averages, and collapsing consumer confidence is being rationalized as heightened near term investor "fear" over geopolitical events - specifically the Iraqi situation.  This rationalization leads many to the conclusion that once this source of fear is alleviated, uncertainty will give way to stability and renewed confidence.  As always, we suggest digging a bit below the blaring media bullhorn headlines of the day in trying to get an understanding of the nature of investor emotions at any point in time, whether characterized by emotional fear or euphoria.   

Where've You Been?  We've Looked For You Forever And A Day...For long time readers of CI, you know we've been looking for a collapse in consumer confidence at some point during the current cycle.  It's happened during every economic and significant equity market troughing experience of the last four decades at least.  Given the excesses of the immediate prior period, we simply could not see any other ultimate conclusion to the cycle of consumer emotion.  When the January Conference Board Consumer Confidence Index cracked 80 as of the January reading, we related in our discussions that never in the last thirty years has this confidence index broken 80 to the downside and not ultimately ended up in the mid-50 to mid-60 range shortly thereafter.  This go around, it happened post haste.  For a good while now we have been projecting a potential bottom in the mid-50 to 60 range, based largely on what you see below.  At long last, we've entered our target zone.  And it has seemed like it has taken forever and a day to finally arrive.
      

But it wasn't just the headline February consumer confidence number that was a show stopper.  The subcomponents of the report also speak to the constant that is historical cycle repetition.  The decline was broad based.  The expectations and present situation subcomponents fell to levels not seen in roughly a decade.  All age groups, all income categories and all geographic regions witnessed confidence declines.  Of course the irony in the report was that the number of folks planning to buy a home actually increased a tiny bit over the prior month.  Only fitting.

Many an optimistic pundit has argued that what we are witnessing in these numbers is merely a replay of the fear seen during the Gulf War experience early in the last decade.  When Saddam invaded Kuwait in the summer of 1990, the consumer confidence index in the prior month stood a hair above 100.  When bombs began dropping in January of 1991, the consumer confidence index temporarily bottomed at 55.1,a number much lower than last week's reading.  As we have mentioned to readers many a time, important equity market lows of the last four decades can be found in time periods coincident with consumer confidence readings between 50 and 65.  From a contrarian standpoint, is the public exhibiting the type of fear necessary to create some type of financial market and possibly economic bottom?  Although the jury clearly remains out for now, we have our doubts.  Especially regarding a potential bottom of significance.  As you can see in the chart above, the consumer confidence bottoming "process" in the early 1990's took years, not months.

Is the current plunge in confidence really being driven by near term events surrounding Iraq?  Although this may be a partial cause, we believe something much deeper in terms of the expression of fear is taking place.  As you know, the probability of conflict with Iraq has been a "known" and rising potential for some time now.  The military build up has been completely telegraphed day by day and month by month.  The increased potential for domestic terrorism has been a clear and present reality for well over a year.  Is it just in January that the American public is waking up to these possibilities and only now expressing these fears in the implicit message of the consumer confidence index?  We do think the American public is finally waking up, but to something much different than geopolitical tension.  Households may be waking up to something they have been ignoring for at least a few years now.  Recent evidence tells us that folks are slowly waking up to the fact that the economy and the financial markets are not recovering as promised.  As promised by the Administration.  As promised by Wall Street pundits.  And as argued in the media headlines for so long now.

Fear In Check?...We have produced a series of charts that we hope help explain what the American public may now be in the process of beginning to discount.  As you know, the American public has been walking away from equity mutual funds in slow motion fashion for a good seven or eight months now.  Yet they have continued to borrow and spend for homes, cars, etc.  In our minds, that borrowing and spending could not have occurred without a certain psychological conviction that the labor market would again revive in a relatively short term time frame.  It may just be that the current drop in consumer confidence is measuring a perceptual or psychological give up on the part of households relating directly to jobs.  Again, as you know, this has been a long time coming despite layoff pressure and continuing high levels of jobless claims data that has steadfastly refused to improve on what is going on close to two years now.
        

As you will see in the following charts, there is a clear sense of historical rhythm in directional movement between labor market data and coincidental consumer confidence readings.  Simplistically, there has been a very high degree of symmetry between consumer confidence data and the help wanted index over the past twenty five years:
      

In like manner, directional movement between confidence readings and rate of change experience in actual payroll employment data has also been quite coincidental as you'll see below.  Oddly enough, it's really only over the past six months or so that this relationship has begun to diverge a bit.  But although year over year rate of change in payroll employment has turned up from negative territory recently, absolute 12 month rate of change experience is flat.  In essence, it's not getting any worse for now, but we certainly have not seen growth.  Households have a perfect right to be questioning near term labor market conditions:
      

Could it be that now two years into a labor market experience that can at best be characterized as flat, at least as is seen in the jobless claims data chart above, that households are just now starting to lose the faith in the potential for job recovery?  From our perspective, that is the exact message we believe the current consumer confidence numbers are portraying.  The jobs component of the consumer confidence report is nothing short of crystal clear in what it is telling us.  The jobs "hard to get" reading is today much higher than at any time in the recent post recessionary period, let alone being much higher than readings in the months following 9/11.  The "jobs plentiful" reading tells the same story, only in reverse.
      

The suggestion by the headline media that geopolitical events of the moment have single-handedly caused the recent significant downturn in consumer confidence is misleading.  For ourselves, it seems pretty obvious that households are finally beginning to address their employment prospects in a serious and sober manner.

Unfortunately for the immediate future trend of confidence readings, recent employment anecdotes are not exactly encouraging.  The latest Manpower Employment Outlook index just recorded its largest tumble in seven quarters.  Manpower tracks ten job related categorizations.  Only mining and construction were positive in the recent results.  All four regions of the country tracked by the report showed declining numbers.  It just so happens that correlation between the Manpower report and subsequent payroll employment experience isn't exactly shabby from a historical perspective.
      

Is the consumer finally starting to retrench both psychologically as well as in the reality of economic action?  We've been waiting forever and a day for this portion of the overall cycle to arrive.  The anecdotes continue to mount that this potential retrenchment is indeed picking up steam.  Two months of absolute dollar contraction in consumer credit outstanding now followed by a significant month over month drop in the consumer confidence reading into our long awaited trouble zone suggest either of these occurrences alone is not some type of fluke.  In terms of the equity market, household credit and now labor market conditions, are households becoming "more aware" by the day of the economic realities of the moment?  In every cycle there comes a point of recognition.  Maybe in this cycle it's simply one point at a time or a series of points in terms of self realization.

The last comment we will make on the fear expressed in the consumer confidence report is how this reading may relate to retail sales ahead.  Much like the employment data, real retail sales and consumer confidence have maintained a certain coincidental rhythm over the past quarter century.  Simply stated, the chart below tells us that either consumers are about to get a whole lot happier in the near term, or retailers are about to get a whole lot less happy.  It's either one of the two.  You don't need us to explain the potential implication for the broader economy.
      

We take the message of the consumer confidence index quite seriously.  Especially as it relates to the similarity in labor market related data over time.  IF we are correct in our assumption that households are beginning to become worried about their employment prospects, the ramifications of this will be felt not only in consumption, but in the credit and equity markets as well.  Monitoring the near term trend in consumer credit will be a worthwhile exercise.  Maybe more importantly, if households are starting to seriously worry about paychecks, we can't help but believe household complacency regarding the equity markets is about to give way.  As you may know, redemptions of equity mutual funds in 2002 summed to less than 1% of the total market value of the domestic equity mutual fund complex in its entirety.  Redemptions of this magnitude are among the smallest of historical calendar year redemption experience seen over the last thirty years.
          

We have been convinced that the public has remained faithful to equities throughout the bear market largely because week to week paychecks have remained intact for a large number of folks.  If the perception regarding paycheck certainty is changing, we have the sneaking feeling that public perceptions regarding equities may be in for deeper change ahead.  Change possibly well beyond what we have already seen in equity fund data over the last half year plus.  Can households keep their investment fears in check while their fear regarding paychecks appears to be heightening?