Insight Line—March 19, 2007

A standard plot in science fiction novels revolves around machines rising to control their human creators. Sometimes life does imitate fiction: Welcome to today’s Wall Street.

From the daily headlines, investors might believe that market activity follows a clear rationale, e.g. “Stocks End Mixed, Aided by Decline in Oil Prices,” or “Stocks Rally on Improved Earnings Outlook.”

Lost in such simple descriptions is the fact that a huge portion of the day-to-day activity scrolling across electronic display boards reflects no human interaction at all. Instead, these transactions represent nothing more than computer-enabled efforts to exploit the statistical noise of price fluctuations. So prevalent are computer-based trading strategies that a recently released analysis suggests that in 2006 the average holding period for a New York Stock Exchange listed stock is only seven months.¹

Computers, long embraced by Wall Street’s back offices for handling ever-increasing operational paperwork, have taken on a more important function. No longer merely recording the events of the market, computers are now driving a good portion of its activities.

Beginning with the 1997 Securities and Exchange Commission mandate that stocks trade in sixteenths rather than eighths and progressing through the 2001 conversion to decimal-based trading, Wall Street now has an entirely different reason to turn to the most advanced technology available. You see, a reduced spread differential essentially lowers transaction costs, thereby making previously cost-prohibitive transactions commonplace. Thus, anyone with a powerful enough computer can actively discover and exploit price discrepancies between stocks and stock-based derivatives.

Computer-assisted stock trading didn’t appear overnight. In fact, one form—program trading, or the simultaneous purchase or sale of 15 or more stocks worth at least $1 million—has been around for more than two decades. Only recently, however, has program trading volume skyrocketed. These computer-driven strategies, according to some sources, routinely represent more than 50 percent of the daily New York Stock Exchange turnover, compared to less than 25 percent only a few years ago.

A more recent offshoot of program trading, algorithmic trading, places the machines firmly in charge. Though originally designed to enable “stealth” trading patterns by large investors who did not wish to have their intentions uncovered, algorithmic trading spawned an even less human-reliant program: statistical arbitrage.

Statistical arbitrage, sometimes referred to as “black-box” trading, uses sophisticated computer programs to capitalize on liberalized short-selling strategies that exploit inefficient pricing between stocks, derivatives and exchange traded funds (ETFs) on any active exchange in the world.

So what does this mean to us as investors? As I see it, there is nothing sinister in all this hyperactive positioning, per se. After all, it is not as if program trading comes from one run-amok computer intent on market domination. What’s more, as the textbooks will tell you, speculators—whether machine or human— make for a more efficient market. Lastly, despite such increased trading activity, stock market volatility, as measured by actual price movements of the Chicago Board of Options Exchange volatility index known as the VIX is within striking distance of a 10-year low.² Nevertheless, the very size of computer-based trading activity calls into question the validity of daily headlines purporting to offer an explanation for the previous day’s activities.

All of which leads me to suggest that the late Will Rogers might have given today’s investors a bit of bad advice when he reportedly quipped, “Well, all I know is what I read in the papers.”

¹ “Wrong Way? Street Signs Point to Speed,” by Justin Lahart, The Wall Street Journal, February 26, 2007, page C1, ©2007 Dow Jones & Company.

² Ibid, Lahart

Factors Driving the Economy

Economic Acceleration

Economic Deceleration

Latest Available Information
(as of 3/16/07)

Employment
^{(Source: Bureau of Labor Statistics)}

Up

Down

February employment data fell victim to old man winter. Colder than normal temperatures across a large portion of the country drastically curtailed hiring in the construction industry, thereby resulting in total payroll employment rising just 97,000. That said, payroll employment of 137.4 million workers remained in record territory. Household survey data reported total job holders rising to a record 145.9 million workers. The unemployment rate slipped slightly to 4.5 percent. As such, I suggest the appropriate action on the table is to circle UP.

Personal Income
^{(Source: Bureau of Economic Analysis)}

Up

Down

Personal Income growth in January 2007, aided by bonus and Social Security adjustments, jumped one full percent to $11.225 trillion. Wage and salary levels moved up to $6.214 trillion. In essence, the personal income data suggests wage and salary growth are a more dominant influence on consumer spending patterns than ongoing weakness in home prices.
Please circle Up on the table.

Retail Sales
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

The nation’s measure of retail sales activity in February 2007 succumbed to less than ideal weather conditions. Total retail sales of $370.5 billion, essentially unchanged from January 2007’s level, reflected drops in building materials, clothing and restaurants. Encouragingly, year-over-year growth rates ticked higher, but have yet to reach the point needed to meaningfully influence the overall contribution to gross domestic product (GDP) growth in the first quarter of the year. As such, I suggest the appropriate action is to circle Down on the table.

Durable Goods
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

New orders for durable goods, heavily influenced by swings in net aircraft orders, declined a larger than expected 5.6 percent in the January 2007 data. In a troubling development, January shipment data, key to GDP calculations, was revised from a 0.2 percent increase to a 0.5 percent decrease. Granted the unfilled order book remains at a record high $695 billion; however, the negative reading presents a serious challenge to keeping the appropriate circle on UP.
Please note, barring a major swing in the February data released later this month, the circle will move to DOWN in the April 2007 edition of Factors Driving the Economy and the Markets.

Inflation
^{(Source: Bureau of Labor Statistics)}

Low

High

Inflationary pressures remain evident but not elevated. The Federal Reserve’s preferred measure, Personal Consumption Expenditures excluding food and energy price changes, suggests inflation remains within the range of 2.0 to 2.25 percent for 2007 forecasted by Federal Reserve Chairman Ben S. Bernanke during his Monetary Policy Report to Congress on February 14, 2007. That said, Federal Reserve Board members along with Federal Reserve district bank presidents continue suggesting inflation as their primary concern. Therefore, to reflect this heightened awareness I suggest the appropriate circle to remain HIGH.

Government Spending
^{(Source: Congressional Budget Office, U.S. Treasury)}

$In

$Out

The most recently released monthly statement from the U.S. Treasury reports some sobering numbers, if viewed in isolation. The federal government ran a budget deficit for February 2007 of $120 billion, a record for the month. Yet for the first five months of the fiscal year, which began October 1, 2006, the Treasury estimates the federal budget deficit running 25.5 percent below a comparable point last year. Simply put, if the trend, identified in the Factors update months ago remains, the federal budget deficit will more than likely fall when expressed in percentage terms to the overall economy from that recorded in fiscal 2006. I suggest circling $IN on the table.

Monetary Policy
^{(Source: Board of Governors, the Federal Reserve System)}

$In

$Out

The Federal Reserve Open Market Committee (FOMC) continues to set the overnight inter-bank lending rate at 5.25 percent. In that the Committee convenes its next meeting (March 20-21) two days post publication of this Insight Line, readers will gain additional knowledge that can serve as guidance until the next regularly scheduled meeting on May 9, 2007. That said, concerns over the growth path of the economy and the unwinding of excess leverage in the sub-prime mortgage markets gives me cause to continue suggesting a softening in the FOMC’s stance sooner than anticipated by consensus analysis. While I doubt a rate cut is forthcoming on March 21 (I hold out some hope) it is not unreasonable to argue for a neutral policy directive. Therefore, I now suggest that the appropriate circle on the Factors update shifts from OUT to IN as investors may soon price policy change into their intermediate forecasts.

Yield Curve
^{(Source: Bloomberg, LP)}

Positive

Negative

The difference between the three-month Treasury bill yield and the 10-year Treasury note yield was -65 basis points on March 16, 2007.
The inversion in the most popular measure of the yield curve, the discount yield on 90-day U.S. Treasury bills and 10-year U.S. Treasury notes, remains a point of observation but has yet to reach the point where odds of a recession in the coming year move beyond a 50 percent probability. As a cross-check, my read of corporate credit spreads does not suggest new levels of financial stress, which are usually evident prior to recessionary periods. Please continue to circle NEGATIVE.

Gross Domestic Product
^{(Source: Bureau of Economic Analysis)}

Above

Below

Though I have no certainty of knowledge, I believe enough anecdotal evidence on inventory, consumption and net exports suggests that economic growth in the first quarter of 2007 is not expanding meaningfully from the 2.5 percent annualized rate recorded in the fourth quarter of 2006. Granted, weather is playing a disproportionate role in the observed data, but I sense it is not sufficient enough to argue for a dramatic rebound in the second quarter. In that trend real GDP growth over the last five decades has centered around 3.3 percent. I continue positioning the appropriate circle as BELOW.