Gilda Radner’s Emily Litella on the Saturday Night Live of yore used to respond with a sheepish “Never mind” when proven wrong. That roughly approximates our reaction to this morning’s September employment report.
It turns out that the initial jobs report for August was wrong, and by more than a little. You may recall that the government’s first report for August showed the first net loss (-4,000) in nonfarm payrolls in four years. It wasn’t hard to jump to conclusions. But as we learned today, there was no loss in August, which actually posted a revised 89,000 gain. What’s more, the initial estimate for September showed a 110,000 rise in nonfarm payrolls–the highest since May.

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Inflation is a familiar subject on these digital pages. As a risk factor, however, it’s been mostly a non issue, or so the government’s official inflation numbers advise. We worry about inflation just the same. One reason arises from the possibility that commodities are in a secular bull market, energy in particular. We’ve discussed why that may spell higher inflation down the road. In the October issue of Wealth Manager, we looked into the topic in a bit more detail. Inflation may ultimately prove to be tame after all. But let’s not be hasty. Before you make a final decision, consider one of the risks that could derail the sunny outlook. To probe the darker side, read on…

Now more than an ever an upside surprise is needed.
Higher-than-expected earnings are always good news for the stocks market. But as third-quarter reports start rolling in the weeks ahead, another upside surprise would be extremely timely in the fall of ’07. Anything less may spell trouble above and beyond the usual risks.
Optimism has clearly been the dominant force of late. Despite the various financial blows that frightened investors in August and convinced the Fed to cut interest rates by 50 basis points two weeks ago, the stock market has more or less survived and even thrived. Equities are either at peaks or within shouting distance of all-time highs, depending on the index. The implication: the future looks rosy.
That’s a bold statement considering the lingering worries thrown off by real estate woes of late. Home sales, to cite one statistic, continue falling. There’s also the question of whether the labor market is set to contract, as suggested by the August employment report, which posted the first net loss in four years. Recession, in short, has been on the minds of many these past few weeks. But judging by the stock market, such worries are merely the stuff of overactive imaginations.
In fact, let’s not minimize the message emanating from Wall Street. The future looks damn good, equity traders are collectively shouting. “Equity investors clearly don’t see a significant risk of recession or a major slowing in corporate earnings,” Sal Guatieri, senior economist at BMO Nesbitt Burns, told The Globe and Mail on Monday.

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A casual observer of financial markets might have expected worse after August. Much worse. If you’ve been keeping up with the media reports, red ink looked like a sure thing for September.
In fact, the exact opposite graced September as all the major asset classes ran higher last month. One might reasonably be surprised at the outcome. After all, the Federal Reserve cut interest rates by an aggressive 50 basis points two weeks back, a decision in anticipation that the subprime/housing fallout would take a hefty toll on the economy and, by extension, the capital markets. Trouble may yet be coming, but as you can see from our chart below, everything was in the black for September.

If you weren’t reading the day-by-day analysis and instead looked only at monthly total returns, you might think that all’s well and by more than a little.
All was particularly well last month in emerging market equities, which was firmly in first place for September’s biggest gain. Indeed, EEM surged nearly 12% last month. Emerging market stocks have rarely performed better on a calendar month basis in dollar terms.
Commodities had an impressive month as well. DJP added 8% in September, driven by higher prices for oil and gold, to name but two of the more obvious climbers. In third place: EFA, a proxy for developed market stocks.

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Let’s get right to the point: the American consumer isn’t easily distracted. A recession may be looming, the housing market may be swooning, but Joe Sixpack isn’t easily discouraged from indulging in the great American pastime otherwise known as shopping.
As he has so many times in the past, Joe’s keeping the economy bubbling in 2007, as this morning’s update on personal income and spending reminds. In fact, the extraordinary staying power of the American consumer is that much more amazing as it comes in the face of lesser personal income last month. In theory, income and spending are joined at the hip. If you earn less, you spend less; earn more, spend more. No explanation needed. But that seemingly iron law only applies in the long run, and even then there’s room for debate in a world of easy loans and a myriad of innovations to keep shopping habits alive and kicking. And once you turn to the short term, well, let’s just say that logic and mathematical certainty are as ephemeral as the wind.
Consider the latest reading on consumer spending, which accounts for the lion’s share of GDP. The government today reported that personal consumption expenditures (PCE) rose 0.56% in August vs. July. As our chart below illustrates, that’s the highest monthly pace since April. Last month’s rise is all the more impressive considering that it was accompanied by a lesser rate of increase in disposable income.

The notion that the economy may be bubbling more than some think also finds support in yesterday’s initial jobless claims report. Last week’s new filings for unemployment benefits fell to a four-month low, which implies that the outlook for economic momentum still looks healthy. Then again, this encouraging news was tempered by Thursday’s report on new home sales for August, which confirmed what was already obvious: the housing market remains mired in a slump. Indeed, sales of new homes fell in August to the lowest annualized rate in seven years.

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In search of economic signs confirming or denying the gathering weakness, this morning’s durable goods report for August extends fresh support for the fear that the forces of darkness are indeed approaching. As our chart below shows, August witnessed the biggest monthly drop in percentage terms since January. It’s also the first decline since May. If you ignore defense orders, new orders dropped by an even steeper 5.9% last month.

It’s hard to put a positive spin on the latest durable goods report. The aura is that much gloomier when you couple today’s news with yesterday’s update on existing home sales, which tumbled more than 4% last month to the slowest annualized rate in five years.
It would be folly to dismiss the signs that the economy’s weakening. On the other hand, all’s not lost, at least not yet. Consider our second chart below, which puts today’s weak durable goods report into broader historical context. As you can see, the latest dip, while troubling, is hardly definitive proof that recession is imminent. We’re still within the range of volatility that’s prevailed in recent years.

But let’s be clear: the pressures are building and from the evidence in recent weeks it’s only prudent to expect that the news will get worse before it gets better. That, at least, is our guess. But the economy is still standing and, despite all the hits continues to hold up, as far as we can tell at this point. If there’s a deciding factor that will tip the balance one way or the other, that will probably be consumer spending, which accounts for more than 70% of GDP.

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Commodities have enjoyed a renaissance in recent years as a strategic tool in portfolio design. The allure boils down to the low correlation between the prices of raw materials and stocks and bonds. Adding commodities to a conventional investment portfolio enhances the overall expected risk-adjusted returns. But what looks good in an optimizer can get messy in the real world. Yes, there are a number of mutual funds and exchange-listed securities that offer investors one-fund solutions to owning commodities broadly defined. But when you buy one of these funds you’re buying commodities futures rather than raw materials proper. There’s nothing wrong with futures, and in fact they’re a reasonable proxy for commodities. Then again, futures contracts are quirky animals and they introduce an additional layer of risk as well as opportunity over and above those dispensed by the underlying commodities.
A recently launched ETN seeks to exploit those risks and opportunities while still providing broad, passive exposure to the asset class. On the surface, the S&P GSCI Enhanced Commodity Total Return Strategy Index (NYSE: GSC) looks like one more fund tracking the Goldman Sachs Commodity Index. And to an extent, it’s just that, considering that GSC stays true to its benchmark by weighting the various components as per the underlying index. Where GSC differs is in its management of the futures contracts. The idea is that GSC will outperform GSCI by taking a more proactive approach to exploiting opportunities and minimizing risk inherent in futures. Will it work? Kochis Fitz, a San Francisco wealth management shop, thinks so. In fact, the firm, which partnered with Goldman Sachs in GSC’s design, initially invested $70 million in the new fund as a vote of confidence. Is the bet likely to pay off? In search of an answer, your editor recently interviewed Jason Thomas, chief investment officer at Kochis Fitz. To learn more, read on….

It’s probably just coincidence but it’s a striking one just the same.
Frederic Mishkin, a voting member of the Federal Open Market Committee, has a new research paper that considers the evidence that monetary policy has become more science than art over the past generation. By Mishkin’s reckoning, nine “key principles” form “a set of basic scientific principles, derived from theory and empirical evidence, that now guide thinking at almost all central banks and explain much of the success in the conduct of monetary policy.” First among the nine he cites: Milton Friedman’s widely repeated observation that inflation is always and everywhere a monetary phenomenon.
Against that backdrop we turn to the latest money supply numbers from the Fed, which brings us through September 10. Considering the 50-basis-point cut in Fed funds earlier this week it comes as no surprise to learn that a bull market prevails in M2 money supply, the broadest measure published. In fact, in late August, the 52-week percentage change in M2 topped 7% for the first time in nearly four years, as our chart below shows. Although the surge pulled back in the last two weeks, the ascent remains intact. Until and if the Fed gives reason to think otherwise, a prudent observer of monetary trends would do well to assume M2’s pace will go higher still.

No one should be shocked. M2’s flight skyward has had a long and steady takeoff over the past several years and the Fed’s now operating on the assumption that the economy’s slowing. Trying to juice growth, as a result, is priority one and the weapon of choice is pumping up liquidity.
The question is what a strategic-minded investor should do? Some are opting for a hedge by voting with their wallets and converting paper into gold, the traditional store of wealth and insurance policy against the inherent risks of fiat money. Indeed, the precious metal yesterday had another big day, rising nearly $14 to almost $736 an ounce. That’s the highest price for gold since the early 1980s.
In a related move, the dollar plumbed new lows. The historic inverse relationship between gold and the buck is alive and kicking, feeding off one another like gasoline and fire.
Ironically, the clear inflation warning emanating from the gold and currency markets finds no sympathy in the official inflation statistics published by the United States government. On Wednesday, the Bureau of Labor Statistics reported that consumer prices fell in August by 0.1%. Rarely has gold run up so quickly and sharply in the face of officially stated deflation. For the moment, at least, this divergence is in the running for the mother of all statistical disconnects in the field of economics and finance.
It requires no great insight to realize that someone’s wrong about future inflation. CPI and gold can’t both be right. One side or the other’s headed for a massive dose of attitude adjustment. No one can be sure who’s going to get stuck, or when, but we have our suspicions.

The August employment report, which posted the first monthly job loss in four years, is considered the leading smoking gun that convinced the Federal Reserve to cut interest rates on Tuesday. The worry, of course, is that a recession’s coming. Why, then, is there no confirmation in the initial jobless claims so far this month?
This morning’s update on new filings for unemployment benefits through September 15 shows that the trend through September’s first half has been unmistakably down. As our chart below illustrates, new filings fell to 311,000 last week. That’s the lowest since late July and slightly below the year-earlier level of 322,000.

It’s too soon to declare that the risk of recession has passed, but today’s jobless claims report raises another clue suggesting that maybe, just maybe, the Fed acted a bit too hastily. Indeed, you don’t have to look too far to find a dismal scientist to argue that jobless claims in the low 300,000 level is considered normal in the context of an expanding American economy in 2007.
Of course, it would be foolish to read too much into this one number. Next week’s report could deliver a stinging reversal of fortunes. Jobless claims are volatile, which is why the smoother four-week moving average offers a somewhat better picture of the larger trend. But as you can see from the above chart, the four-week average is trending down as well.
Ultimately, the true state of the economy can only be known ex post, which is to say after the data’s published, scrubbed and confirmed. As such, the definitive word on the economy today will arrive some months down the road. For those who can’t wait, the alternative is to look at every number as it comes off the statistical assembly line while trying to keep the big picture in mind. Good luck.
In sum, observers of the economic scene must choose either timeliness or accuracy, but you can’t have both simultaneously. Yes, the choice is a thankless task for mere mortals– and perhaps central banks too.

Maybe the cut was justified, maybe not. But now that it’s a done deal, investors are left with the job of deciphering the implications.
The immediate reaction on Wall Street: yee-hah! Stocks across the board surged in the wake of the Fed’s bold 50-basis-point cut yesterday. The S&P 500 jumped 3% by Tuesday’s close.
But there’s more than one bull market unfolding, and therein lies the potential for trouble down the road. Indeed, it’s hardly irrelevant that crude oil closed at a new high yesterday. Ditto for the ascent of gold prices, which climbed to over $720 on Tuesday.
But not every market’s celebrating. The beleaguered buck took another hit on the news that the Federal Reserve lowered the price of money. The U.S. Dollar Index slumped half a percentage point yesterday, leaving it at a record low.
The falling dollar’s not-so-subtle implication: higher inflation. One only has to look at the bull market in oil to understand the risk. The United States is the world’s biggest importer of crude. It’s safe to assume that foreign exporters of oil aren’t insensitive to receiving payment in a currency that’s falling in value. One way to offset the forex risk is to charge more for oil in dollar terms.
Yes, oil’s a global commodity and its price is set internationally and so price-fixing is difficult if not impossible. But the next best thing is limiting production. OPEC will no doubt give that prospect serious consideration if the dollar keeps dropping.
Part of that consideration includes the issue of investing today to lift oil production tomorrow. Most if not all OPEC members are in need of technological upgrades to boost production to keep pace with rising global demand for the years ahead. But that takes money, and lots of it. Suffice to say, it’s a hard choice. Will a sinking dollar make the choice easier to delay such investment? If so, how will that affect the price of oil?
Then again, the man who heads the Federal Reserve has a paper trail arguing that a bull market in oil doesn’t necessarily bring higher inflation. The rationale is that oil prices are largely statistical noise and so they should be ignored when making monetary policy choices. Our guess is that notion will be put to the test big time in the coming months and years. The Fed, in short, will be proven right or wrong on the issue of whether higher oil prices can bring higher inflation. The question for strategic-minded investors then becomes: Is the potential risk worthy of hedging? That’s another way of ask: How much confidence do you have in the central bank? Judging by the dollar’s descent of late, there’s no doubt where forex traders stand.