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What’s Next?

The markets might just be going through a mild jittery patch, or it might be something a bit bigger. Certainly, the PIIGS situation is something which is likely to be a concern over a longer period of time, but it isn’t completely clear whether it necessarily must end with a bang rather than a whimper (although many, including on Friday noted economist Martin Feldstein, feel that the Euro “isn’t working” or in some cases fundamentally cannot work). It certainly isn’t clear whether, even if it is going to end with a bang, that the bang will be now, and given the predilection among equity investors for riding the roller coaster until the very moment when it is leaving the tracks and is difficult to exit, it may be that we can steer past these jitters.

It doesn’t help when the jitters compound, though, and the news on Friday that China hiked reserve requirements again makes some people nervous. It doesn’t really do that for me, since although China is among the fastest-growing of decent-sized economies it isn’t growing in a sustainable way and it is better in the long run if she slows down and works off some of the speculative froth. (There are those, too, who think it’s too late for that speculative froth to be brushed away without a bubble popping, but this is something we will find out.) At least, it is interesting to see a monetary authority actually try to deflate a bubble rather than insist it doesn’t exist.

Still, the investors of the world are doing a reasonable job of skimming past these issues without looking like the Wide World of Sports “agony of defeat” guy. On Friday, the March TNote rallied 10 ticks and the S&P slipped a mere 0.3%. Yawn.

I think the market is also a little jittery because some recent reports have ceased getting better, and some (Initial Claims, for example) have suggested that a period of somewhat worse growth might be returning after the first post-stimulus steroidal surge wears off. Personally I wouldn’t read too much into the weakness, but then I also didn’t read too much into the prior strength and I think the true picture of the economy is of one that is limping along absent government stimulus. I don’t think that the jump start provided by the stimulus money has yet turned the engine of growth over into a self-sustaining rhythm, and so I rather think that the equity market is on some thin ice at the moment as we see whether the folks who survived round 1 in 2008 can ride out round 2.

But the real vulnerability of the market isn’t to changes in the true underlying trajectory of growth – which as I said is rather banal and boring and flat – but to changes in the perception of that underlying trajectory from the “liftoff” suggested by gussied up Q4 numbers to, instead, a sputtering, coughing, wheezing, limping economy. Expectations don’t have to become negative, that is, to threaten the stock market. They just need to come back to the underlying reality.

(As an aside and to people who haven’t read my columns for very long: I think the most common error made by professional and amateur forecasters alike is that the data are taken as truth rather than as “experiments” that should be interpreted in terms of their error. That is, a data point only is useful in the context of the null hypothesis, and it can only reject that hypothesis by deviating substantially from what would be expected from that experiment if that null hypothesis were true. If Pr(this data point is produced | Ho is true) is sufficiently low, then we can reject the null and accept the alternative hypothesis. This is all a very long-winded way of saying that ‘Claims being high or low only matters if you can tell me what you were thinking beforehand and whether this is different enough to change your hypothesis. Because investors do not usually interpret data in this way, they usually overreact. In most cases, data doesn’t tell us much in any one release but gradually accumulates to affect one’s view of the trend rate of economic activity).

The coming week promises several more data points to inform that view. On Tuesday the Empire State Manufacturing Index is projected to rise to 18.0 from 15.9 last month. This is a good test, since the January figure represented a big jump from 4.5 in December, and the consensus forecast is looking for a continuation of that jump to something more reminiscent of the post-cash-for-clunkers spike last fall, rather than a retracement to the weak December level. Empire is a pretty volatile series, which means that by itself it can almost never tell us anything, but weakness here would be another small twig on the camel’s back.

Housing Starts and Industrial Production on Wednesday, and Philly Fed on Thursday, are also useful releases. Part of the problem with all of these, though, is that almost anything looks good compared to what it was at the nadir of the crisis. It was that euphoric realization – that the abyss didn’t swallow us all – that propelled equities from the bottom; the baton of the bull was handed off to stimulus-induced improvement; and here we are wondering “what’s next?”

One of the things that is next is CPI on Friday. Tomorrow, I will talk a little about why the CPI number is really a pretty well-done number and how we can feel pretty comfortable that the government isn’t “fudging the number” as many people seem to believe.

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