Computer takeover confirmed

I wrote this article about a week ago for a publication and thought I would post it here on the blog. This is something to think about. The theme of the article begins about five paragraphs in.

Computer Takeover Confirmed

Traders and market-watchers kept waiting all week for something to happen – anything. But, something never came, and anything was nowhere to be seen. The market is usually good for one or more days of big swings and volatility, but there was none of that last week. A very late rally in Friday’s trading took the Dow up 40 points from a low of -70 points; this created the only 100 point trading range for the entire week. The primary reason for the lack of action in the stock market was the lack of action in euro trading as the currency moved little last week. There were several weak economic indicators from Europe, but it’s obvious that stock traders want to wait to see what the European Central Bank President Draghi has in store for them. As you recall he is promising to “save the euro.” His first lifesaver for the euro will not be thrown until September. This could keep stocks on an even keel until then regardless of the news.

The only market that was active last week was the bond market. For the second week in a row, the bond market showed noticeable signs of fatigue. This was apparent when the U.S. Treasury came with its monthly sales of longer-term debt. Demand for the issues was the weakest in about two years. It appeared that the 10-year note might break above 1.75%, and speculative traders were talking about a move to 2% was in the cards. But the selling stopped suddenly for no apparent reason, and yields rose only slightly on the week. Mortgage rates are roughly a quarter percent off the very lowest rate of this cycle. A move to 2%, should it develop, would boost mortgage rates at least another quarter percent. This is something to keep in mind if you’re shopping for a home or looking to refinance your home.

The lack of economic news last week will be made up for this week as several important numbers hit the tapes. Retail Sales will be released on Tuesday, and this is the biggest number of the week. After three consecutive months of declining sales (the first time this has happened since 2008), economists are expecting sales to turn higher. Most reports from major retailers for July indicated better sales as back-to-school buying kicked in. This is the report to watch.

We’ll also get Industrial Production, the inflation indexes, and Housing Starts along with a number of other minor indicators. After three months of generally weaker-than-expected economic data, the numbers this week will be critical. Surprises to the downside might confirm more than your garden variety seasonal respite. Of course stock traders won’t necessarily react to bad news. In addition to having the Draghi promise to look forward to, they also believe that Bernanke will kick off another round of money printing should our economic numbers continue to recede.

I’ve talked a lot in the past about how computer trading has taken over the short-term trading in stocks. News, economics, and fundamentals are irrelevant in the world of computers. Complex algorithms, seemingly currently tied to the euro, trigger trades that amount to 70-80% of the daily volume. Some of you might be skeptical of that viewpoint, but I heard someone last week in a position to know to verify that view. The CEO of one of the largest high-frequency trading firms was interviewed on CNBC last week regarding criticism of the impact on the markets by high-frequency trading. The CEO was surprisingly direct and strangely robotic in his answers, especially when the interviewer challenged his views. He reminded me of Hal in 2001 Space Odyssey, except for the fact that the CEO had a face. He mentioned but didn’t spend much time on the common claim that high-frequency trading provides liquidity to the market. That’s a farce, and everyone knows it.

To his credit, sort of, he cut to the chase and stated flatly that the individual investor has no business trying to trade this market short-term and should stop trying. He said the computers are in charge now and high frequency trading is only going to grow in its dominance. When challenged by one outraged interviewer, he said it’s okay if investors want to buy stocks for the long-run based on fundamentals. (Generous of him don’t you think?) He said the computer programs don’t recognize or factor in anything like economic or earnings data, but individuals can’t compete with computers in the short-term. Some of the questions got pretty intense as the interviewers were probably trying to shake him. After all, CNBC depends on individual investors tuning in daily in hopes of getting investment insight to make money. But there was no shaking this guy. He simply calmly restated his positions that computers are in charge now, and there is nothing you can do about it. I swear the guy was a robot or cyborg. He went on to say that the algorithmic programs “learn” as they trade and will always stay several steps ahead of human decision making. I give him an “A” for honesty but an “S” for scary.

This is not really a surprise if you’ve observed the markets over the last couple of years. It’s clear that rational human beings aren’t making these decisions. Now, if we can just get CNBC and business scribes to stop saying “investors bought today” or “investors sold today.” Investors have nothing to do with it. This is not to convince you to get out of stocks, but the cyborg trader has a point. Trading in the short-term has gone to the computers. The only reasonable way for individual investors to stay in the stock market is to invest in a diverse portfolio of funds or stocks that can stand the test of time over the long-term.

But make no mistake about it, short-term trading can impact the long-term. Big downswings in the stock market can undermine business confidence and can unnerve and drive away individual investors in stocks at just the wrong time. Big upswings in stocks for no good reason can also lure investors into the market at just the wrong time. Stock prices can also influence interest rates, even for short periods of time, which can impact your mortgage rate. The cyborg trader seemed to suggest we go about our lives and leave the stock market to them. It’s not as benign as he made it seem. Not only does the short-term influence the long-term, but as computers become even more dominant the risk of a repeat or worse of the “flash crash” of 2010. The regulators are the only ones that can fix this, but they seem unwilling to address the issue and are just hoping that nothing “bad” happens. In this regard, they remind me of the leaders of the European Union. They are just hoping nothing bad happens. Hope is good, but it’s not a solution.

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Mini- Housing Boom/Bust?

I haven’t posted anything on this blog in a while what with writing for dwightjohnston.com, the California and Nevada Credit Union Leagues, and Callahan, but I thought I would post a few thoughts on housing. The next few weeks will be very interesting. The crisis point in Europe I have been expecting could be in the early stages. All bets are off then on everything, including housing.

Last week we wrapped up the months various housing reports with Existing and New Home Sales numbers. Both of those continued the trend of modestly more positive news in housing. As I’ve written in the past, I believe this is the year we can finally say the housing market bottomed and began a slow, gradual turn. But the challenges ahead aren’t insignificant. Incomes are not growing and most mortgages require substantial down payments. Additionally we don’t know how much supply will hit the markets from foreclosures this year and the next. The landscape for housing in indisputably better, but I fear that some of the articles appearing now might be misleading and encourage people to leap into the housing without weighing all the pros and cons.

I had to check my calendar recently to make sure I didn’t travel back in time after seeming some stories on housing. Over the past couple of weeks several leading newspapers have written stories about bidding wars breaking out over houses. The stories divide into two camps. On one side, the wars are over the shrinking supply of distressed homes as investors try to top each other to buy these properties. While it’s a good thing to see inventory leave the market, more is coming and we don’t know for sure if the investor crowd will remain so ravenous. But, more importantly, these articles often leave a false impression of what is really going on. They fail to report that the wars are mostly all cash bidders, but more importantly they fail to point on the reality of the sale prices. Some articles cited gains of 20% or more in areas in Florida and Arizona. That sounds fantastic until you look at reality. As an example, one county in Florida reported the median home price rose from $90,000 to $111,000 in just one month! Fantastic, right? But the records show that the median home price in that same area was $294,000 in 2006. The articles fail to point that out. So beware the hype about percentage price gains. It’s easy to make the gains look good when they are coming off such a low base number. Don’t get caught up in the hype.

The second type of battleground for bidding wars is occurring in some the priciest areas of the country. In the Silicon Valley homes are bringing multiple offers as the latest round of high tech bubble money is flooding the area. Other areas, such as Beverly Hills, are also seeing the bidding war phenomenon return. These areas are still crazy expensive, but the current prices are considered bargains. Homes that might have sold in 2006 and 2007 for $5 million or so are going for $3.5 million. Get ‘em while they’re hot! Here is what got my attention. One very happy realtor said he had not seen this sort of frenzied investor activity for homes since 2006 and 2007! Hmm. Are bubble signs already popping up?

The point of this discussion is that we’re beginning to read articles that make it sound like there is a new housing boom going on, and you’re about to miss out. The articles read as if they have been written by realtors. The accounts do make good headline fodder after years of relentless negativity on housing, but don’t let these sunshine reports influence your personal decisions. Rates are very low, which is a huge plus, and if you need and can afford a home in your preferred area it’s not a bad time to consider it. But do not get caught up in the hype and live to regret it. That happened to a few million people just five or six years ago. The housing market is far from fully healed. Investor activity is disguising what is really still a market in a nascent recovery. The frenzy will run out of energy long before the market runs out of houses.

Buffett v. Gross

In case you missed it, there was an epic smackdown last week between Warren Buffett and Bill Gross of PIMCO fame. It wasn’t actually a smackdown, but on the same day it was revealed that Bill Gross had ramped up the holdings of U.S. treasuries in his mega-bond fund to 38% of assets, Warren Buffett said that treasuries was the most “dangerous” asset class in investments. Warren has a point. At this level of rates, the price risk in longer-term treasuries is huge. Investors can buy high-quality dividend stocks at yields well above bond rates and can participate stock rallies. I am certainly not one to argue with Buffett, nor am I a huge fan of Bill Gross. But Buffet is forgetting one thing.

After the double knock-out blows of stock market and home equity meltdowns, for many investors it’s all about return of principal, not return on principal. You’ve probably heard that before. Many individuals, especially those in or near retirement, simply cannot afford to risk money on stocks. At least with bonds, you know you will get your money back on a fixed date. That’s simply not true for stocks. It’s entirely conceivable, given the European risk, that stocks could fall by 40-50% from this point. And, there is no guarantee that stocks would bounce back this time. Consider Japan. Over twenty-two years ago the double collapse of stocks and home equities struck, and today the Japanese stock market index remains at roughly 25% of its peak and the 10-year note rate in Japan has been stuck near 1% for over a decade. Bond investors are actually earning more on a deflation adjusted basis. Investors at first resisted switching to all Japanese bonds for the first ten years, but surrendered to staying in bonds after countless false starts.

It’s not just individuals who opted for return of not on principal. Global institutions and central banks also gorged on our mortgage backed bonds. Today those entities still want the safety of U.S. assets but not the risk. Those huge funds have flowed into treasuries at the sacrifice of returns. Pension funds could be next, but there will have to a revolution in re-writing pension benefits first.

We are likely in a different world in which a once in a lifetime secular event has taken place. In the Buffett/Gross smackdown it’s awfully tempting to bet on Buffett, but this could be a Gross world.    

Individual Results May Vary

I wrote this for a publication at the beginning of the year. Thought you might enjoy it.

Individual Results May Vary

Hopes for a big ending to 2011 faded last week as the euro was hit and prices of distressed European bonds fell. Traders did manage to put in one positive day on the week which kept the major indexes from straying too far from unchanged. For the year the narrow Dow 30 stocks rose by 5.6%, but the broader S&P index was astonishingly unchanged for all of 2011. That seems incomprehensible given the tumultuous year. Of all the surprises in 2011, perhaps closing the year absolutely unchanged was the most surprising.

You are no doubt familiar with the ad disclaimer “Individual results may vary.” Those are most common at the end of ads for the latest weight loss miracle cure. How did that guy lose 70 pounds when you only lost 10? Individual results may vary. That same disclaimer can be used in investing. While the broad S&P index ended unchanged, your investments might have performed much better or much worse. If you followed a conservative path of cash, high quality bonds (no high yield bond funds), and quality dividend stocks, congratulations! You beat Wall Street. If, on the other hand, you heeded the Wall Street advice at the beginning of 2011 you might want to toss your 401ks when they hit the mailbox this month. At the beginning of 2011 Wall Street had a very strong consensus that stocks would move higher by 15-20%, investors should move money into foreign markets (especially emerging market stocks), buy commodities, and avoid U.S. treasuries like the plague. Stocks were flat, foreign stock markets fell by 15-20% generally, the broad commodity funds all fell on the year after the bubble burst in April, and U.S. treasuries was the best performing investment in 2011.

The Wall Street consensus for 2012 is less concrete than at the beginning of 2011, but Wall Street expects stocks to rise 15-20%. Wall Street always expects stocks to rise. Selling you stocks is their business. They wouldn’t have anything to gain by telling you that their product was going to stink for the coming year. But the consensus is a bit more divided and for good reasons.

The list of potential road bumps in 2012 is long but of course starts with Europe. Wall Street mavens say the euro will survive, and the worst of the possible market unrest will be over by mid-year. Wall Street experts also believe that the economy will then begin to advance more strongly for the balance of 2012. Generally, the consensus is that the few months of 2012 will be unstable and volatile but followed by several months of growth and stability. In other words, stocks down early in the year but roaring ahead later.

I’m not taking a contrarian stand just to be contrary to Wall Street’s view, although that’s usually the best bet, but I expect a different outcome. If you haven’t totally blocked from your mind what happened in 2011, you’ll remember that the biggest stock market rallies came after the multiple euro rescue efforts following each crisis. The first three months of 2012 will present similar opportunities. There will be endless summits, “secret” meetings, and numerous proposals to save the euro from extinction. I expect those events will actually help stocks early in 2012.  But reality will settle in that nothing positive will be forthcoming from the tumult in Europe. Most importantly to us, regardless of what “solutions” are achieved in Europe, the European economy will suffer. Remember that the combined European Union economy is actually larger than that of the U.S. The U.S. will suffer mostly the backside of the storm. Europe will be more of a drag on South America and Asia, but the resulting weakness in those economies will hamper our prospects as well. I think our best economic numbers of 2012 will be early in the year, not later. This week in fact we should have two positive reports, one manufacturing index and the monthly Nonfarm Payroll report. I believe the U.S. can avoid a recession, but the risk for the economy is to the downside not the upside.

There are wild cards aplenty. A China economic meltdown on a crumbling real estate market? Another surge in oil prices brought on by strife in the Middle East? A surprising plunge in Russia’s economy that leads to a civil unrest? What we don’t know we don’t know? (That last one was courtesy of Donald Rumsfeld.) The point is we just don’t know what will become the issue of 2012. You’ll notice I did not mention the 2012 election. That’s because it is simply irrelevant for the 2012 economy and market performance. The government will not be a factor this year; that will come in 2013. It is certainly logical that Europe will top the list for the second straight year, but you can never be certain.

One thing that does look certain is that interest rates on the long-end of the market will not fall as much as in 2011. If they were to do so, the U.S. 10-year Treasury note yield would end 2012 at 0.50%. Not impossible mind you, just not very likely. I expect rates will stay very low again in 2012. With the uncertain global economic picture, I cannot make the case of a significant rise in rates. For those of still on fence about buying a house or re-financing your mortgage, that’s good news. Time is on your side. For those savers among us, well, we’re getting used to paltry returns.

If you enjoyed the volatility in the markets in 2011, chances are good you are going to love the volatility in 2012. I can see reasonable prospects for a trading range on the S&P of as low as 900 to as high as 1400 or so. It’s also possible that the market will end 2012 unchanged again, but guessing on the stock market isn’t the point. If the twists and turns in the markets were unsettling to you last year and made you question your retirement plans, etc, you need to take action now. No more excuses. Get help from trusted and qualified sources, and get educated. Do not blindly follow Wall Street’s annual marketing pitch for certain wealth. Individual results may vary is a warning, not just a disclaimer.

Tapas Anyone?

Tapas Anyone?

The first week of November the markets had a feast of Greek dolmas (stuffed grape leaves). Greece appeared to be in a meltdown only to be revived at the end of the week. Last week the markets dined on cannoli as the collapse of the Italian bond market moved the crisis from Greece to Italy. In both cases, a change in leadership temporarily caused the markets to surge and recover the big losses that started each week. We now have two new leaders in Greece and Italy who will ultimately prove just as ineffective as the two ouster premiers. When debt problems are so overwhelming and the structural flaws of the political and financial systems are so deeply embedded it’s just a matter of time before the endgame must be played regardless of the quarterback. Once again it appears the endgame has been delayed until 2012. But with the rapidly moving scenarios playing out across Europe, the opening whistle to the endgame could blow at any time.

What’s ahead? It’s clear that no one knows. While the markets celebrated the end of the Berlusconi reign, there is no guarantee that the bond market in Italy will cooperate. The plunge in prices in Italian bonds was arrested by the change, but the debt of Italy remains in a very fragile state. The conditions that caused the bond debacle are still present; only the name on the Premier’s office changed. Unfortunately, even if Italy and Greece manage to avoid further disruptions for a few weeks, Spain could be next in line in the unlimited buffet of debt problems in Europe. The debt of Spain has been trading better than that of Italy, but the Spanish bond market is following the same pattern as Italy’s. In fact, some of the concerns about the true nature of Spain’s banking system (with potential losses unaccounted for) are more troubling than those in Italy. Tapas might be next on the menu.

The perplexing aspect of all of this is that the stock market in the U.S. is virtually unchanged on the year. While it’s always possible that the European debt crisis will be solved in an orderly fashion, it’s also not realistic. At best, the various components of the European Union bailout plan will result in a recession in Europe that will have be a drag on the global economy. At worst, the debt fiasco will end badly and result in a few weeks of market chaos and then a global slowdown.

As I’ve mentioned in the prior weeks, Wall Street traders, et al, just want to end the year in rally mode in order to bank some more bonus checks. To most of us, logic would dictate a cautious approach with some many unresolved issues ahead, but that’s just crazy talk on Wall Street. The 3rd quarter was a terrible quarter for Wall Street and especially hedge funds (big accounts that take big risks with borrowed money). Most of us would be reluctant to take on more risk after that experience. But these guys play a different game – big risk for big reward. There is no middle ground. What some recent numbers and anecdotal information have revealed is that hedge funds actually ramped up risk after that the 3rd quarter debacle. Wall Street mavens are saying that the market has taken on all the bad news and remains unshaken, and this means the market is a “buy.” Perhaps. But, it could also mean that the market is an illusion if not delusional and not at all reflecting any future outcome other than the optimal.

While Europe has been and will continue to be the dominant force, our own economy continues to chug along at a sluggish pace. We should get more evidence of that this coming week. You will be reading about Housing Starts, Retail Sales, Industrial Production, and the Consumer Price Index. All of these should reflect an economy that is cautiously moving ahead. As mentioned in last week’s column, businesses are being cautious in these uncertain times. The pace of economy and level of business and consumer confidence reflect more an appropriate response to the events this year and the risk ahead. Wall Street’s throw-caution-to-the-wind attitude is fine for the big, short-term risk takers, but that attitude doesn’t work for those in it for the long haul.

For some of you the last few weeks (months) of volatile trading has led to several bouts of indigestion. As I’ve said before, the real test of whether or not you have the right investment mix is whether you can sleep at night. It’s really hard to get a good night’s sleep if you have indigestion. Delusional or not, the market continues to give you opportunities to think long-term about your needs and whether or not your current investment profile is really right for you. Eating at an all-you-can-eat buffet when your system can’t handle it is bad for your health.

 

Get a Grip!

The following are some thoughts I had on the markets Thursday and Friday, which I posted on my service web site. At the end I added my two cents on the S&P downgrade.

After an absurd day with a 400 point swing in the Dow, the Dow closed with a gain of   points 61 points. The S&P closed almost unchanged and just decimal points below 1200. The NASDAQ closed down 1%. Volume was huge! (Read updates for reasons) For the week the Dow closed lower by 700 points. At the beginning of the week, with the debt ceiling bill passage, I reminded everyone that after the 2008 TARP passage the Dow was 1,000 points lower thirty days later. At the low this morning, the Dow was in fact down 1,000 points in just one week. The S&P lost 7% this week, and the NASDAQ gave up 8%. The all-important Nonfarm Payroll number was forgotten after the first 15 minutes of trading.

A day like today makes you want to sell every stock you own and never buy stocks again. We have some serious problems, but I’ll just give you two. First, the credit crisis in Europe will eventually overtake everything. If the EU follows through with bond purchases next week the crisis will be postponed but remain inevitable. They have no long-term answers, and their short-term answers have shrinking credibility. It’s like tossing doggie bones at traders. Stock trading today alone tells you this will be a problem for the market. The Dow went from +170 to -230 at least partially on Europe. The news of purchases caused the Dow to go from -230 to +150 points. That ain’t right folks. Plus, at least half of the entire recent downturn in stocks was Euro based. Money was fleeing European banks, and my bet is that we haven’t seen the last of that.

Second, high frequency traders have not gone away. We haven’t heard much about them as they pulled back after some scrutiny. They were obviously still lurking on the street corner. While most of the activity today was from leveraged traders who were forced to sell and from big bargain hunters, we saw instantaneous 100 point swings. That can only come from those high frequency computers. One of these days, those computers might get stuck on the sell signal. The economy is the least of our worries.

No one knows what we’ll walk into Monday. European markets were closed when the news of the bond purchases broke. Those markets should open up huge. But, if European traders get any whiff over the weekend that the bond purchase plan is not completely credible, the markets could be in a freefall. What a choice.

 

If I ruled the world (I’ll be happy to just start with the U.S.), I would tell everyone “Get a grip!” Every television and radio newscast, website, newspaper etc. led Thursday night with dire stories of the stock selloff. The most common headlines were “America in Crisis” and “Global Meltdown.” Hey, so stocks have sold off for a few days. Big deal. In the U.S., the markets are down just slightly on the year. Many of the articles written said that governments needed to do something to avert another recession. Really. Is that what you want? Government and central bank tinkering has done nothing but put band-aids on wounds that need open air to heal.

This hardly qualifies as a crisis. More importantly the economy isn’t in crisis either. Yes, the economy has slowed, but we’re not burning up jobs at 500,000 jobs per month, and our financial institutions aren’t under attack. The stock market was simply breathing thin air and living on QEII money, and traders weren’t thinking clearly. Leverage amplified everything. Now, some of that has come out. Could it get worse? Yes. And I believe there will be a “real” crisis sometime in the next twelve months in Europe, but I don’t believe this will lead to another economic meltdown in the U.S. The economy will slow again and stock prices will fall. This is just the cycle we’re stuck in. Relax.

Finally, a couple of thoughts on the S&P downgrade. First and foremost, this will mean nothing to interest rates for a variety of reasons. Frankly the world cannot do without our huge market to use as a giant liquidity pool. Plus, where the heck would they put all those dollars they have? Rates will move on fears or lack thereof, economic conditions, and inflation. The world knows we can pay our debt. We have a printing press.

Second, S&P is looking pretty dumb on this one – even dumber than usual. These are the same guys who never saw the mortgage crisis coming. While that is their most spectacular failure, the history books are littered with corporations and municipalities that S&P had highly rated just before the entities dove for the cheap seats. The S&P also admitted they had missed estimates by $2 trillion, but that made no difference to them. They ended up claiming the big reason was they didn’t like our political atmosphere after witnessing the debt ceiling fiasco. Well who does! No one. But it’s hardly S&P’s place to base financial analysis on their limited view of politics.

S&P also rates France AAA, but it’s clear to everyone that France’s own social program costs will be much worse than ours in the years ahead. They have the Germany and France AAA although those two will be taking huge hits on Greek debt et al, as Germany and France are the primary funding source of the ECB purchases of bad debt. And, by the way, S&P still rates Italy and Spain AA although their numbers are looking more like junk bonds. S&P seemed determined to make a political statement regardless of facts. I don’t like our fiscal outlook either, but I know the U.S. will pay although the process of getting there is ugly.

S&P needs to take a hard look at itself and clean up its own house before it gossips about the U.S. having the messiest house on the block.

Mood Ring

The stock market is not the economy. I’ve offered this reminder for years, and I’m sure the phrase has been used by others. The stock market is nothing more and nothing less than the collective optimism or pessimism of traders/investors executing at any particular point in time. The market’s performance after last Friday’s horrific jobs report is proof positive of that theory. While stocks did close down on Friday, the decline was mere peanuts given the nature of the jobs report.

Coming into last week traders were dreaming of new highs for the year. The indexes were just a few points shy of those goals at the close Thursday. In fact, a new 2011 high for the NASDAQ would also be an almost eleven-year high for that index. That still leaves it short 2,000 points of the year 2000’s high , but that’s not even in the discussion. When the jobs numbers came out, the markets did drop sharply with the Dow down about 150 points. But by the end of the day the index was down only 63 points. This token decline after the worst economic data we’ve had in a full year, tells us that rampant optimism on Wall Street still rules.

You’ve probably already read quite a bit about the number, but I want to highlight the worst of the worst. The paltry 18k gain would have been even worse had the Bureau of Labor Statistics (BLS) not added almost 150k phantom jobs through the birth/death adjustment of businesses. This is an economic modeling assumption, not based on actual data. There are approximately 14 million workers unemployed, with half of those unemployed for more than twenty-six weeks. There are another 7-8 million workers that simply aren’t counted any longer due to classifications by the BLS. The true Unemployment Rate is 16.2% or possibly even higher. Temporary workers declined for the third straight month. This category typically signals trend changes. If so, the trend is not your friend.

Wages and hours worked fell. Wage growth is now roughly 1% below the inflation rate on a year-over-year basis. The hours worked decline is not a good omen for businesses adding workers. I think you get the drift.—a poor job market accompanied by low wages.

While Wall Street mavens and pundits expressed surprise and disbelief at the number, the fact is that this weak report is in line with what we’ve been seeing in other numbers over the past two months. Almost every indicator, other than one recent manufacturing report, has been signaling slowdown. The day before the Unemployment Report the ADP payroll service predicted jobs would increase by more than 150k. Traders rejoiced at this projection. Yet, at the same time, a highly respected survey of small businesses said that small businesses added fewer jobs in June than in any month in more than a year and businesses were planning for weak hiring the rest of this year. But Wall Street’s traders completely ignored that report. It clashed with the pretty picture they were painting.

The U.S. is supposedly two years into the recovery, but we’re still short 7 million of the jobs lost during the recession. Wages are going nowhere, consumer confidence is shaky at best, and the housing market has at least one more year in purgatory. I don’t believe the economy is ready to fall off a cliff without a shove from Europe or some strange action in Washington. But the very long process of unwinding the credit bubble has years to go and leaves us vulnerable to shocks.

Does this mean that stocks are ready to tumble? Not necessarily. With this much optimism in the market, warranted or not, traders are not going to give up easily. Additionally, there are some developments that might help a bit in the next few months. As mentioned last week, I’m hopeful that commodity prices continue to decline and allow consumers to spend more in discretionary categories. There is also some validity that the Japanese tsunami did more economic damage than thought to the supply line, and a rebound is likely as the supply line is restored. Business inventories are low, and any renewed confidence should cause an increase in production to build inventories. Finally, corporate earnings are still good. Most are good because of cuts to operating costs, but some businesses have found ways to expand business.

The paragraph just above lays out reasons for hope, but the paragraph just above that one lays out how things are. The markets are trading on hope, not reality. Perhaps we should be thankful for blind optimism.

This coming week you’ll hear virtually nothing about the awful jobs report. This is the beginning of earnings season. In case you’re not familiar with the “season,” this is when most companies release quarterly earnings. It’s also one of four times a year when companies, stock analysts, and traders all come together to play a game. The game is that companies and stock analysts tell us that earnings for a company will be X, knowing full well that earnings will be X-plus. Traders know this too, but they pretend shock and delight at the prospects of companies beating expectations. The only real surprise comes in those rare releases that only match or fall short of expectations. It’s a dumb game, and most everyone knows the game is rigged. But everyone seems willing to play along, especially when optimism is so extraordinarily high.

Just remember my basic premise. The stock market is a reflection of collective optimism or pessimism. We’re currently in the stage of optimism to the extreme. The market has been telling us that even through the very modest selloff in May and early June. There is no way to predict when optimism will give way to pessimism. Fortunately, periods of optimism last far longer than pessimism. But I’m throwing up the caution flag. Not the red flag, just the yellow one. The basic drivers of the economy are still broken; at best they are merely functioning with short term patches. Given the overwhelming consciousness of optimism, I worry what things will look like when that morphs into pessimism.

Wall Street loves to claim that the stock market is the Great Anticipator of future events. That’s a lie. If it were true, the Dow would not have been at 14,000 just prior to the credit meltdown. It also wasn’t true at the Dow’s 6,500 just before the recovery began. The stock market isn’t the Great Anticipator. The stock market is the Great Mood Ring.