Another Payroll Cut Gutshot

November Employment Report
533,000 jobs were cut, which was far worse than the 335,000 expectation. This is the worst number in 34 years. 1.91 million jobs have been lost this year. You should've heard the collective "OOHHHH!!" on the Chicago Mercantile Exchange (CME) trading floor when this headline came out.

The unemployment rate rose to 6.7%, but was lower than the 6.8% expectation.

How could job cuts be worse-than-expected, while unemployment was better-than-expected?

Defining Unemployment
You're unemployed only if you're looking for work, but you can't find it. This has to be documented. So if you've been laid off, but you haven't told anyone that you're looking for work, then you're not considered unemployed.

Analysis of Unemployment
Some people have been laid off for a while. Most of you know how difficult it is to find a job in this economy. It's possible that some people have just given up looking for a job. Maybe they're planning on going back to school. Or maybe they're becoming heroine dealers. Or maybe they just don't want to collect unemployment. I know plenty of fresh graduates who've recently been laid off who also live at home. There are probably at least some bright, Ivy League grads without jobs who have too much pride (and probably money) to file for unemployment.

It's Getting Worse
In the first week of December, companies have announced another slew of job cuts. AT&T is cutting 12,000 jobs. Dupont is sending 6,500 to the unemployment line. 600 miners will lose their jobs at Freeport Mcmoran. Viacom's 850 job cuts will be focused on MTV. Also in media, GE told subsidiary NBC Universal to layoff 500. Avis Budget, the car-rental company, is laying off 2,200. And let's not forget about the financial sector. JPMorgan Chase is cutting 9,200, Credit Suisse is cutting 5,300, and State Street is cutting 1,800. It's gonna get worse. And who knows how many jobs are being cut by privately held companies?

The economy is in bad shape and it's gonna get worse.

Mortgage Rates Fall. Go Buy a House

Yesterday, the Federal Reserve said it would buy up $500 billion in agency debt (I'll explain this in a minute). This caused the average rate for a 30-year fixed mortgage to fall to 5.5% from 6.4% in just one day. This was the biggest one-day drop in seven years.

In other words, it just got a lot cheaper to buy a house.

Remember That $700 billion Bailout?
Just under two months ago, the $700 billion bailout plan, aka the Troubled Asset Relief Program (aka TARP), was approved with the intention of buying securities riddled with screwed up mortgage assets (e.g. subprime mortgages). This was supposed to convert banks' crap into cash. Instead, the Treasury used most of the TARP money to buy equity stakes in the banks. In other words, the gov't gave the banks cash but also became part owners. This was arguably a better move than just buying bank crap.

Different from the TARP
The Treasury's TARP was designed to buy troubled assets (e.g. subprime mortgages). The Fed's new plan is to buy agency debt securities, which consists of mortgages meeting strict Fannie Mae/Freddie Mac standards. These mortgages are given to people who can actually afford the modestly-sized house they are buying. In other words, these mortgages tend to get paid back.

Shock to the System
The Fed's announcement suggested life would come back into the mortgage-debt markets. This made mortgage-debt investors happy, which made mortgage rates fall.

Great Consequences For the Weak Housing Market
1) Housing prices may stabilize: Houses became more affordable. If you're in the market for a $200k house, then a 5.5% 30-year fixed rate will save you over $40k compared to a 6.4% rate. As bad as things are, there are still a lot of people in the market to buy a home who have been waiting for a more attractive opportunity to jump in. (This is called pent-up demand.) Things just got a lot more attractive.

Housing prices have been plummeting and inventory has been rising. According to the Case-Shiller home price index, prices in 20 major cities fell 17.4% year-over-year in September. This was the fastest pace on record. According to the National Association of Realtors, there was a 10.4 month supply of homes on the market in October. This compares to a 4.5 month average in 2005.

Home-buying activity will bring supply off of the market, which will help housing prices stabilize or even improve.

2) Consumer spending may improve: People can refinance their existing mortgages at an attractive rate. If you're sitting on a 6.4% mortgage on a $200k house, then refinancing at 5.5% would put an extra $115 a month in your pocket. That's extra money you can use to buy stuff, which is great for GDP growth.

Remember: 70% of GDP is consumer spending.

So, buy a house or refinance your mortgage
...if you can afford it, of course. Buying a house will help stabilize the deteriorating housing market. This should ultimately help all of those mortgage-debt issuers, including banks. If the banks' mortgage-debt values stop falling, then they will ultimately be willing to lend more money to consumers and corporations. In other words, this will help unfreeze the credit markets.

If refinancing your mortgage will save you money, then do it. More money in your pocket is means you're more free to buy stuff.

But We're Not Even Close to Being Out of the Woods Yet
The economy is still in terrible shape. I continue to believe things will get much worse before they get better. We will continue to lose jobs and unemployment will rise. This is just part of us becoming a more financially responsible economy.

However, in order for things to eventually get better, the housing market must stabilize and even improve. The recent decline in mortgage rates is a step in that direction.

From Bad to Worse and It'll Get More Worse

I'm literally surrounded by empty cubes and offices right now.

Crippled Economy Leaning on Broken Financial System
Nothing is working in our economy right now. Banks are not lending and corporate credit costs have shot through the roof. Companies have less access to money than before. Bank assets are rapidly losing value so they're becoming even less likely to lend. Lay offs will continue to roll out. No one is safe.

Deflationary Spiral
Falling costs were good for a while. Oil, gas and food costs are down. Things seemed cheaper. But now deflation is a threat. Companies can't keep prices stable, so they will fall. If those prices fall, your wages will fall.

However, your fixed payments won't move, effectively rising.

Lame-Duck
On top of that, we have lame-duck leadership in Washington.

It's Only Getting Worse. Period.
The economy was propped up on cheap credit and loose lending practices. Lenders and borrowers are now smarter. In order to adjust, GDP must fall. This includes major job cuts and a spike in unemployment.

The Unlikely, Only Solution
Lenders loosen wallets and people buy shit they don't need. But, that's not gonna happen. We've learned from our mistakes, and now we'll be cursed by the memory.

Changing the Rules of the Game, During the Game

Let's say you're playing a game of chess with a friend. You've positioned your pieces in such a way that you would have checkmate against your opponent in 3 moves. Then your mom comes by and looks at the board. She realizes your friend is about to lose, so she takes some of his captured pawns and puts them all over the board.

Looking Forward...
1) How are you supposed to employ a chess strategy when there is a chance that an authoritarian will unexpectedly change the rules in the middle of the game? 2) If you're the losing opponent, why should you put the same amount of effort into the chess game when an authoritarian will likely protect you from losing?

1) Regulatory Risk
Gov't Rescue: When considering investment opportunities, you'll probably avoid companies on the verge of bankruptcy. In fact, you might want to short (or bet against) those companies.

But companies haven't been allowed to go bankrupt lately. Bear Stearns, Fannie Mae, Freddie Mac, and AIG are examples of companies that would've gone bankrupt, if it weren't for government intervention.

Currently, the auto industry lobby is pressuring legislators for a bailout. They argue that bankruptcy would be extremely bad. In truth, it would be bad. But how can we position our portfolio of investments--even non-auto investments--if we're not sure whether or not the auto industry would be protected? We have no idea what, if any, the ripple effects would look like.

Gov't Rules: Back in September, the SEC enacted a temporary ban on short selling on around 800 companies. Not only did this create significant inefficiencies in the market, but many investors flat out got screwed. Many used short positions to protect themselves from declining investments. This was taken away.

Perhaps this explains why many hedge funds sold their stocks and are now hoarding cash. Hedge fund managers are extremely smart. They understand the rules of the game, and they exploit those rules. Now, those rules have changed, and may continue to change. Garry Kasparov and Bobby Fischer probably wouldn't play chess if they thought those rules might change.

Yesterday, Treasury Secretary Hank Paulson said the Treasury would no longer use bailout money as initially intended. In other words, they said they would do one thing, but now they're doing something else. Who would want to invest in this erratic regulatory environment?

When the markets are stable...

Regulatory risk isn't a major concern because you won't see dramatic rule changes. You don't have to worry about investment rules. You only had to worry about the businesses in which you were investing. Isn't that what investing is all about? Right now, I think we need a stable regulatory environment so that people sitting on cash will feel safe putting money back into the stock market.

2) Moral Hazard
This is the risk that behavior will change if one thinks he/she will be rescued by the government. Maybe this explains why Lehman Brothers went bankrupt. Bear Stearns, Fannie Mae, Freddie Mac, and AIG were deemed to important to fail. Most would agree Lehman was just as important. (In hindsight it was; Lehman's bankruptcy exacerbated the Sept/Oct credit freeze) I was shocked when they were allowed to go bellyup. I'm sure Lehman's management strategically positioned themselves for some sort of rescue, which never came.

Everybody is Expecting a Bailout
...because everybody thinks they're too big to fail. There's no question that a failure at GM, Ford, or Chrysler would be devasting. But should they be bailed out?

Short Term Politics vs. Long Term Prosperity
Here's what it comes down to. If an automaker fails, the U.S. would lose at least several hundreds of thousands of jobs. It would almost certainly push us into a deeper recession. This is very bad...in the near term. Also, politicians can't win votes if they allow this to happen.

But bad businesses must be allowed to fail. This is how capitalism works. Auto makers took risks by focusing on gas guzzling SUVs and pick up trucks. Now they're hurting. If you rescue a bad business, then it let's people believe it's okay to run a business poorly. This is an extremely bad precedent.

At the very least, the government should not intervene. You should not force honest, hardworking taxpayers to bail out failed businesses. If leaders in the private sector believe auto makers are too big to fail, they'll figure something out.

Deflation Isn't Good Either

Lower Demand Means Lower Prices
The weak economy is marked by unemployment, pay cuts, and investment losses. In other words, people have less money to spend. In response, your favorite stores are cutting prices to try to get you back into their stores.

Waste Some Money
So, if you have some extra cash, things are looking cheap. In fact, if you can, you should waste some money. This economy was largely built on wasting money. Even worse, a lot of that wasted money was borrowed money. The very reason why the economy is struggling right now is because we stopped wasting money.

Think about how many people havejob titles like Ford Excursion assembly line worker, Starbucks barista, Bose soundsystem engineer, Tempurpedic mattress salesperson, subprime mortgage broker, Super Sweet Sixteen party planner, and foie gras goose forcefeeder. They all offer crap that we want, but don't need. Demand for these things are falling, so now they're cheaper.

Stuff We Need
But it's not just discretionary items. Food and gas prices are also falling. Again, this has much to do with falling demand, which is sad when you think about it.

Before You Offend a Poor Person...
If you are able to buy these cheaper goods, you are part of the fortunate minority. These lower prices are still expensive for most people who are struggling to make mortgage payments, car payments, student loan payments, utility bill payments, and credit card payments.

The deteriorating demand coming from these people is the major reason why prices are falling.

Business Perspective
Of course, lower prices puts pressure on corporate profit margins. Fortunately, demand for goods is so low, that raw material and production costs are coming down. This is reflected in oil prices, which are down 60% from July highs ($147.27/barrel on July 11. $56.88 right now). Food, metals, plastics, paper, and other commodities have also seen sharp price declines.

The Problem of Deflation
As prices down, company revenue goes down. Lower costs may keep profit margins somewhat intact. Nevertheless, if revenue falls, absolute profits fall. This is bad for stock investors.

To fight falling profits, employees will get paid less or get laid off. What happens next? Just go back to the top of this post.

Circuit City, Chapter 11

For several years, Circuit City has been struggling to compete with Best Buy, Wal-Mart, and all of the low cost internet retailers. If I remember correctly, management once cut it's showroom salesforce in an effort to shed costs. But that led to significantly lower sales.

Internal Credit Crisis
A few months ago, a credit agency recommended that vendors not supply Circuit City with goods. Why? If you sent a truckload of TVs to Circuit City, there was a pretty good chance you might not get paid.

External Credit Crisis
This was followed by the global credit freeze we saw in October. Some vendors, who were willing to supply Circuit City, were now facing their own financial problems. Customers were now unable to finance those purchases.

Last week, management announced it would close 155 stores--20%--across the U.S. Today it filed for Chapter 11 bankruptcy protection.

Clock Is Ticking
Now they have to scramble to get their shit together. If they don't get it done, then keep your eyes and ears open for a Linens-N-Things-style liquidation sale.

Worse-Than-Expected October Job Loss

"Nonfarm payroll employment fell by 240,000 in October. Job losses over the last 3 months totaled 651,000. In October, the unemployment rate rose from 6.1 to 6.5 percent, and the number of unemployed persons increased to 10.1 million." -Bureau of Labor Statistics

Economists were expecting 200,000 losses in October and a 6.3% unemployment rate.

Worse Revision
By the way, remember the 159,000 drop in September payrolls? That was worse than the expectation for a 100,000 loss. Today, the BLS revised that number to 284,000.

Real Expectations
Believe it or not, it's possible that the investment community was expecting worse-than-expected data. This could be one of the reasons why stocks have fallen around 10% on Wednesday and Thursday.

Ultimately, expect a decline in stocks today. But don't be surprised if they actually rise.