Turn and Turn and Turn

Today's employment data truly exhibited some encouraging signs. The unemployment rate unexpectedly declined to 9.4% from 9.5%. Average weekly hours came higher at 33.1 hours versus a prior 33.0. This was due to businesses replenishing depleted inventories and the restarting of shuttered auto plants (which made the numbers look better than what they were). Is this the beginning of the end? Probably not, but it could be the end of the beginning.

What should we expect over the next twelve months? The next two quarters should exhibit positive GDP growth as businesses rebuild their inventories. However, when that is over, we could see GDP flat line or remain moderately positive. Why won't it go straight up? A good portion of consumers will remain on the sideline. Actually, before the days of easy credit, these consumers had been on the sidelines. Economic growth cannot return to levels seen during the last bubble if a quarter of consumers are not consuming much above subsistence levels.

Is there a way to get these consumers back in the game? Yes, but that may do more harm than good in the long run. One way is to make credit available in way which is similar to what was done during the housing bubble. That is probably not a good idea. The other way is to increase employment. However, unless employment growth is due to fundamental economic expansion, the gain will be short-lived (I.E. the tech bubble). Government hiring won't do the trick either as that would result in higher taxes. Essentially, money would be taken from one consumer, in the form of taxes, and given to another consumer in the form of wages, but it is a zero-sum game. Worse even, it could result in two consumers being able to purchase inexpensive or small-ticket items instead of higher-priced, big ticket items. Last time I checked, the U.S. economy was more dependent on the sale of big-ticket items.

Growth will come, but we all need to manage our expectations. What we have here is what I call the great correction. Since the Paul Volker Fed, we have had shallow, short-lived recessions as the economy recovered from the malaise and policy mistakes of the 1960s and 1970s. With the Fed having to resort to quantitative easing and lending practices returning to more prudent standards that correction is done. Barring poor economic policy or mass insanity among lending officers, the U.S. economy should begin a gradual march higher, but don't discount the poor policy or insanity scenarios.

Assuming that prudence and sanity prevail, what will keep growth modest? Higher taxes (they are coming), anti-business legislation (it is being mentioned) and higher interest rates. The latter is inevitable. That will make credit more expensive for those who can still qualify for loans. This should not discourage investors from participating in the markets. However, investors should manage expectations. With some exceptions, companies which provide goods and services that people need will be better investments than those which provide goods and services that people want.

There is an interesting development happening in the fixed income markets. Now that credit spreads have tightened, retail investors are pouring money into preferred securities. What they may not realize is that preferred credit spreads to benchmark treasuries are approaching or have reached their historical range versus treasuries. Many of preferreds, especially those of high quality telecom and utility companies and banks which have paid or are about to repay TARP funds will follow long-term interest rates in almost lock-step fashion. This means that more price depreciation may be on the horizon. If you own a preferred trading over $26, sell it. Its call feature will prevent it from rising much farther. Also, remember that a company only calls in a preferred or bond when it is economically advantageous for them to do so. This means that it is done when it is economically disadvantageous for investors. LIBOR-based floating rate preferreds may present opportunities, but remember that they perform best when the yield curve flattens. This is due to their short-term coupon reset benchmarks (LIBOR) and their long-term trading benchmarks (long-dated U.S. treasuries.