On Friday I questioned the validity of relying on a single, relatively unreliable and untested measure as a leading indicator. At the risk of sounding like an economist that is not to say I disagree with the conclusions made.

Indeed watching the UK consumers’ response to their emergency ‘austerity’ budget may be a useful predictor for the likely US retrenchment, whenever Obama decides (or more likely, is forced) to follow suit.

Though rather than being a function of the consumer, there is a case to be made that the next major index movement will come from a government’s inability to pay it’s bills and hence stopping the stimulus-led consumer ‘growth’ story in it’s tracks.

Debt Induced Recession

First off is an article from Sunday’s Telegraph that points out the cost of hedging against Greek default is more expensive now than at any time since the current crisis began. And that’s with massive European intervention.

Then there is the US itself, where in California alone spending must be reduced by a sum greater than Greece, Portugal, Ireland, Hungary, and Romania combined. 45 other US states have budget deficits to cut by this time next year. Obama at the surprisingly low key G20 summit appeared to bow to pressure from other world leaders to move to cut budget deficits by half inside 3 years.

Does anyone really believe this will happen?

Gross American debt is predicted (by the government) to hit 100% of GDP by 2011 – over 15 trillion dollars. The painful fiscal tightening that any attempt to reduce this – no matter how hollow – will when taken with similar tax objectives from individual states, likely precipitate a substantial fall off in GDP growth. Hastening such a scenario is the ending of the existing Bush-era stimuli such as extended benefits in July. Housing has already been shown to have retrenched following the New Home Sales tax credit scheme shutting down.

Lack of demand points to deflation and this points to more expensive debt servicing and a final slip from recession into acknowledged depression. But the longer Quantitative Easing is pursued, the longer the money is printed, the bigger this final reckoning will become. Ultimately the Fed’s unwillingness to accept the Business Cycle is the chief obstacle in this war against the inevitable.

But all the signs are there that the market thinks we’re closer to that tipping point than is currently being reported.

I don’t read too much into Mark Hulbert’s commentary over at Marketwatch. Although a contrarian he chooses to place a large emphasis on correlations that simply do not stack up imo.

Take for example the Dow Theory, a dated system that makes judgements based indicators one of which is divergence of Dow Transports Index from DJIA – begging the question why would Transports nowadays have advance knowledge of the market demand any more so than the producers they service? Producers have whole departments dedicated to forecasting demand for their goods. By the time a profits warning comes in at Transports you can be sure producers have already given appropriate guidance on their expectations. It’s part of market listing regulations.

Obviously when the Dow Theory was being developed markets were not quite as developed. So why use it today? Smacks of column filler rather than serious financial insight.

However he’s completely correct when he calls out the current chorus of praise by analysts for a leading indicator known as the ECRI WLI. It’s not the value itself that’s being lauded as ‘prescient’ by the investment community but the growth rate – which currently stands at -4.7% with a value of -10 a near certain sign of recession (and in this market’s parlance, the advent of the 2nd downer in the double dip).

Never mind the fact only 3 out of the last 7 -10 readings has the WLI actually succeeded in being a leading indicator of government recognised recession, Hulbert makes a more pertinent point. That relying on a metric that only has been backtested 7 times is completely useless in a statistical analysis. It’s one of the fundamental problems with market analysis today. The other – seeing correlation in numbers regardless of relationship – being Hulbert’s main weakness, but more about that another day.

Half way through last week a nation erupted; the Republic of Ireland football team crashed out of the World Cup at the hand of Gaul, that of a certain Thierry Henry. A Facebook group was established. It took on something of a life of it’s own – over 300k users inside the first 24 hours.

“Something has to be done”.

FIFA made no mention of the incident in their official match report. It was edited several times, each time the Magnum PIs on Twitter reporting to the world the latest breach of instant populist moral values and punch-drunk notions of democracy. Avatars may not have been coloured green, but the online social network air was turning a particularly dark shade of blue and the feedback loop of increasingly agitated noise fed into itself, reaching a deafening cresendo online while steadily losing touch with reality.

Of course the same old predictable new media rubbish was trotted out the next day. Sky Sports News ran with the facebook group, the Guardian ran with the usual ‘Twittersphere exposes FIFA duplicity’ bollocks and generally everything was very ‘the power of the web this’, ‘online social network that’.

And then… nothing happened. The irate fans presumably sobered up and went back to whatever they were doing had the South not qualified and the ludicrous calls from the FAI and bandwagon jumping politicians had officially fallen on deaf ears at FIFA.

This left the organiser of the original page on Facebook – by this stage 400k strong – to lead a merry band of 150 people with nothing better to do on a Saturday afternoon to the French Embassy in Dublin. Ably assisted by Dustin the Turkey.

I guess I’m not doing a complete hatchet job on online campaigning here. There is a kind of potential value in online networks, but in each case until a method is found to unlock it, it remains just that – potential. After all the hullabaloo generated in the RoI football case a conversion rate of just .04% (with some generous rounding on my part) to partake in some form of action highlights what surely is the case for a majority of internet based issues – that they struggle to make the leap into anything meaningful in the physical world.

Certainly in PR terms it has a discrete value – albeit one that is more difficult to control. By saturday, realtime opinion regarding the protest march – the same medium that had elevated the issue to frontpage news only two days before – had largely reduced it to a laughing stock:

try living in Ireland – there’s a march on the French Embassy today. In this weather. I’m hoping all the idiots drown.
SpodoKomodo twitter update

While the usual sources of financial infotainment were puzzled at the pullback – citing an absence of negative macroeconomic news – this is in fact a telegraphed “the rally has run out of steam” message. Trader sentiment changes as a function of time, and it is this inability to read the same data consistently that has the greatest impact on market direction beneath the long-term trend. So people have had enough of drinking the government-led recovery Koolaid for now.

What we then look to are combat indicators giving us signs of whether indeed everyone sees this and are still prepared to presevere with a contrarian rally – “climbing the wall of worry”. In such an event watch for a sharp drop as sellers get out quick followed by an equally sharp rebuttal as traders look to get in on the next leg of the rally.

The 2nd scenario is that this is indeed the end of the current rally, whether it then plays out to be a bear market one or the first phase of a recovery would remain to be seen.

So keep an eye on this throughout the week, my thinking at the moment is we’re seeing the beginnings of a summer pull back based on low volume and lack of strong recovery numbers.

Anyway on the subject of blogging on the markets in general, it’s not often I allow myself the opportunity to comment on the daily financial noise, so when I do it’s with the intention of pointing out that the general short term outlook of those who should know better is more or less completely at odds with long term, set-in-stone realities.  And it seems even those who do know better are unable to see any other way out of it:

The rise in debt eventually will lead to slower economic growth and diminished standards of living in the U.S

Allan Sinai, chief economist Decision Economics

Nevertheless he supports the Obama stimulus plan.  I have a ‘meh’ attitude to all the political hubris surrounding the market today, but I can’t understand all his talk of building for the future when his policies will result in a poorer US tomorrow.

Another noteworthy individual coming from the ‘knows better but doesn’t appear to think there’s anything else for it’ stable is George Soros.  He has been expounding exactly what circumstances the US finds itself in, but his solution seems to be to throw more public debt at it.  Puzzling.

To put this into perspective, take a look at the ‘Some Inconvenient Truths’ paper causing a stir amongst the more savvy market commentaries.  A depression of between 3 – 7 years.  Note the FT writer covering the story was equally unable to decide on the state of the economy – the two tags she decided on to accompany the story?  Depression and recession.

Once the debt has been drawn down, which will happen, will the 10s become the new 80s?  Much more recognised voices than mine can articulate the cycle that may produce it.

And is Brazil, largely seen as immune (insofaras an economy can be immune from a global recession) to events elsewhere, merely being set up as the last domino to fall?

But last night the penny dropped, albeit in the form of disappointment over the automakers bailout. That in itself may prove to be unsuccessful even if it passes the senate eventually. The Whitehouse is now looking to use some of the bailout loot reserved for the banks instead. Either way it’s messy and the outcome will be highly uncertain at best, a waste of money from the outside at worst.

The Dow came out of it’s benign hibernation to finish down 200pts. It’s also poised for a triple digit decline today, although just how bad may be tempered by the news that retail sales came in not as bad as expected. Barring a high profile pre-Xmas bankruptcy, I’m looking to find support around 8,200 or if a bankruptcy occurs, somewhere around the mid to upper 7,000 (ie no lower low for the time being).

There’s an awful lot of money on the sidelines that needs a new direction for 2009, recession or not. As much as I hate the term ‘window dressing’, it’s very difficult to ignore basic market concepts such as this, especially seeing as the market has been showing all the signs of finding a range it is comfortable with since the end of the November carnage, at least for now. Then we can worry about what 2009 has in store.