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The stock market charged higher on Thursday, erasing its entire decline from the early portion of the week. The S&P 500 spiked 1.5% while the Nasdaq Composite (+1.8%) outperformed.

The broad-based rally in the U.S. followed an overnight session that featured dovish comments from two European Central Bank members, setting expectations for more monetary easing from the central bank. This started with Vitor Constancio who spoke in Hong Kong, joining the chorus of voices calling on the Federal Reserve to delay its first rate hike while Ewald Nowotny said that more needs to be done by the ECB in light of soft inflation data.

The dovish remarks from two ECB policymakers weighed on the euro, sending the single currency lower by 0.8% against the dollar to 1.1383. To be fair, the Dollar Index (94.46, +0.47), which gained 0.5%, spiked to highs after the release of today's economic data, which included a 42-year low initial claims reading (255,000; Briefing.com consensus) and an in-line CPI report (+0.2%).

In addition to the flurry of economic data, investors received a fair batch of quarterly reports that were mostly in-line with expectations.

All ten sectors ended the day in the green with financials (+2.4%) leading the way. The influential sector was powered by Citigroup (C 52.97, +2.25) and Goldman Sachs (GS 184.96, +5.45) as the two heavyweights rallied 4.4% and 3.0%, respectively. Citigroup delivered a better than expected quarterly report while Goldman Sachs matched estimates.

The financial sector held the lead throughout the session while other groups shuffled around as the session wore on. When the dust settled, telecom services (+2.3%) and health care (+1.3%) ended not far behind financials with the health care sector rallying behind biotechnology. The iShares Nasdaq Biotechnology ETF (IBB 314.76, +13.18) surged 4.4%, masking a 1.6% decline in the shares of UnitedHealth (UNH 59.33, -0.70), which followed a one-cent beat.

Elsewhere, the energy sector (+1.8%) finished among the leaders despite showing relative weakness in the early going. The early underperformance and the subsequent recovery followed the price action in the oil market as WTI crude was down more than 2.0% after the latest Energy Information Administration storage report showed that inventories remain near levels not seen at this time of the year for more than 80 years. However, the energy component staged a full recovery, ending the pit session lower by 0.6% at $46.38/bbl before returning to unchanged in electronic trade.

Also of note, the top-weighted technology sector (+1.3%) ended in a position of relative strength despite having a brief power outage in late morning action. That brief swoon was brought on by a pullback in chipmaker names following yesterday's M&A speculation. That being said, the PHLX Semiconductor Index still ended higher by 1.0%.

Treasuries ended the day on their session lows with the 10-yr yield rising four basis points to 2.03%.

Today's session generated the largest volume of the week with more than 933 million shares changing hands at the NYSE floor.

Economic data included Initial Claims, CPI, Empire Manufacturing, and Philadelphia Fed Survey:

• The initial claims level declined to 255,000 for the week ending October 10 from a downwardly revised 262,000 (from 263,000) while the consensus expected an increase to 269,000
  • The claims level has returned to its mid-July mark, which represents the lowest level since November 1973
  • The continuing claims level fell to 2.158 million from an upwardly revised 2.208 million (from 2.204 million) while the consensus expected a decline to 2.200 million
• The CPI declined 0.2% in September after decreasing 0.1% in August, which is what the consensus expected
  • The decline in prices was the result of a sizable drop in energy costs with total energy prices falling 4.7% in September after declining 2.0% in August
  • Gasoline prices declined 9.0% while food prices increased 0.4%
  • Excluding food and energy, core CPI increased 0.2% and ended two consecutive months of 0.1% gains. The consensus expected an increase of 0.1%
• The Empire Manufacturing Survey for October registered a reading of -11.4, which was above the prior month's reading of -14.7, but below the consensus estimate, which was pegged at -8.0
• The Philadelphia Fed's Business Outlook Survey increased to -4.5 in October from -6.0 in September while the consensus expected an increase to -2.5
  • While the headline index improved, nearly all of the sub-indices within the survey deteriorated on a month-to-month basis
  • Business managers claimed that activities were slightly improved in October, but stated overwhelmingly that trends in production, orders, and employment were worse off

Tomorrow, September Industrial Production (consensus -0.2%) will be reported at 9:15 ET while August Job Openings and Labor Turnover Survey and the preliminary October Michigan Sentiment Index (consensus 88.4) will be released at 10:00 ET.

• Nasdaq +2.8% YTD
• S&P 500 -1.7% YTD
• Dow Jones Industrial Average -3.8% YTD
• Russell 2000 -3.4% YTD

In May of 2014, the Federal Reserve began discussing a newly designed labor market index to help support their claim that employment conditions in the U.S were improving. This was an important facility for the Fed which needed support to raise interest rates. My good friend Doug Short has a complete discussion on the LMCI, which is worth reading for context. As he defines:

"The Labor Market Conditions Index (LMCI) is a relatively recent indicator developed by Federal Reserve economists to assess changes in the labor market conditions. It is a dynamic factor model of labor market indicators, essentially a diffusion index subject to extensive revisions based on nineteen underlying indicators in nine broad categories.

 

The indicator, designed to illustrate expansion and contraction of labor market conditions, was initially announced in May 2014, but the data series was constructed back to August 1976."

Unfortunately for the Federal Reserve, the index has not supported the Fed's claims that employment is growing at a rate strong enough to withstand a tightening of monetary policy. In fact, as shown in the chart below, the LMCI index (smoothed with a 12-month average) has been a leading indicator of future weakness in employment. The recent downturn in the LMCI suggests that employment gains may more muted in the months ahead.

Therein lies the problem for the Fed. If the LMCI is indeed forecasting weaker employment, then the Fed's ability to raise interest rates is negated. However, as shown in the chart below, the Fed has ALWAYS been late to the game when hiking interest rates. Each time the Fed began hiking interest rates was at the point the LMCI had effectively peaked. 

The Fed is once again very late to the game in hiking rates. The problem is that with the economy growing at less than 2% annualized, there is very little wiggle room for a policy mistake.

Retail Sales Decline

While the weakness in the LMCI is suggesting more disappointing employment growth ahead, retail sales are suggesting that the economy is likely much weaker than headlines suggest. 

Given all the massaging of data through seasonal adjustments, the chart below using the NON-seasonally adjusted data smoothed with a simple 12-month average. This gives a much more realistic look at what is actually happening with retail sales in the economy that makes up roughly 40% of total personal consumption expenditures. I have also provided the SA adjusted data to show the correlation between the two series. 

As shown, when retail sales have fallen below 4% growth it has historically been a leading indication of the onset of a recession. While there has been no official recession call as of yet by the NBER, it is important to remember that much of the economic data is subject to rather large annual revisions. It will not be surprising to see economic growth revised lower next year. 

The chart below shows the annual rate of change in "control purchases" which is more closely related to the actual activity of average consumers. I have overlaid the analysis with a simplistic economic cycle. Again, as shown above, control purchases are also suggesting that the economic environment is, in fact, very weak. 

The weakness in retail sales will feed into the personal consumption component of GDP which comprises almost 70% of the economic equation. This will be a problem for the Fed. 

What Inflation? PPI Declines Again

Of course, let me once more remind you why the Fed raises interest rates - to SLOW economic growth and QUELL inflationary pressures in a potentially OVERHEATING economic environment. 

With Q3 economic growth rates closer to 1% than 2%, there is little danger of an overheating economy currently. Furthermore, as shown in the composite inflation index below (average of both PPI and CPI), there is absolutely no worry about spiking inflationary pressures.

Of course, this is why the Social Security Administration just announced there will be NO INCREASE to social security payments this year. Unfortunately, for those recipients there will be no offset for sharply rising healthcare costs, property taxes or insurance payments. 

For investors, the deflationary decline will erode corporate profitability and ultimately stock prices. As shown in the chart below, sharp declines in inflation have generally been associated with negative annual rates of growth in the financial markets. 

Weakness in the financial markets ultimately weighs on consumer confidence which is why the Federal Reserve has been focused on supporting higher asset prices. A collapse in stock prices will quickly turn in to a negative feedback loop for the economy.

The Federal Reserve is quickly becoming trapped by its own "data-dependent" analysis. Despite ongoing commentary of improving labor markets and economic growth, their own indicators are suggesting something very different. 

As I have stated previously, while the Federal Reserve may hike interest rates simply to "save face," there is indeed little real support for them doing so. Tightening monetary policy further will simply accelerate the time frame to the onset of the next recession. Of course, the Fed knows this which is why they recently floated the idea of "negative interest rates" out into the markets. In other words, they already likely realize they are screwed. 

Just something to think about.

One of the main reasons why the BLS has been massively overestimating job creation ever since great financial crisis, is due to the well-known birth-death adjustment, aka the CES Net Birth/Death Model, which quantitatively is shown on the chart below, has resulted in the "addition" of some 5.3 million jobs, that don't actually exist, but are merely modeled by the BLS which continues to assume the same new business creation/destruction dynamics that existed before the crisis.

 

The is a big problem with this core assumption, which has follow through effects not only for domestic fiscal policy, but also monetary policy (and explains why despite a 5.1% unemployment, there is zero wage growth, thus keeping the Fed pushing the ZIRP accelerator pedal years later), for the simple reason that as of this moment it is dead wrong.

Here is what Gallup CEO, Jim Clifton, wrote several months ago looking at the trends in new business creation and destruction in the US.

We are behind in starting new firms per capita, and this is our single most serious economic problem. Yet it seems like a secret. You never see it mentioned in the media, nor hear from a politician that, for the first time in 35 years, American business deaths now outnumber business births.

 

The U.S. Census Bureau reports that the total number of new business startups and business closures per year -- the birth and death rates of American companies -- have crossed for the first time since the measurement began. I am referring to employer businesses, those with one or more employees, the real engines of economic growth. Four hundred thousand new businesses are being born annually nationwide, while 470,000 per year are dying.

As Clifton adds "you may not have seen this graph before" and for good reason: it destroys the most sacred assumptions held by the BLS' cubicled actuaries and various tenured economists locked up in their ivory towers: namely that the number of US business startups outnumbers the number of failures. This is no longer true!

 

Here is what the above chart shows: until 2008, startups outpaced business failures by about 100,000 per year. But in the past six years, that number suddenly turned upside down. There has been an underground earthquake. As you read this, we are at minus 70,000 in terms of business survival. The data are very slow coming out of the U.S. Department of Census, via the Small Business Administration, so it lags real time by two years.

Gallup adds that business startups outpaced business failures by about 100,000 per year until 2008. But in the past six years, that number suddenly reversed, and the net number of U.S. startups versus closures is minus 70,000.

 

So what is causing this historic shift in US business creation.

The are various answers, the most obvious of which is that the US never actually left the 2007 depression, whose effects continue to be papered over, literally, with some $13 trillion in global central bank liquidity, which have made life for the richest 0.1% better than ever at the expense of the middle class. 

But the biggest culprit is also the one which over the past 7 years has become America's latest credit bubble, last checkrising to $1.3 trillion in debt: student loans.

This is what Gallup finds when looking at the future of collapsing U.S. new business formation:

... the country can't look to people coming out of college to reverse this trend because too many of them are strapped by student loan debt. Results of the 2015 Gallup-Purdue Index -- a study of more than 30,000 college graduates in the U.S. -- provide a worrisome picture of the relationship between student loan debt and the likelihood of graduates starting their own businesses.

 

Among those who graduated between 2006 and 2015, 63% left college with some amount of student loan debt. Of those, 19% say they have delayed starting a business because of their loan debt. That percentage rises to 25% for graduates who left with more than $25,000 in student loan debt. According to the National Center for Education Statistics, nearly 16.9 million bachelor's degrees were conferred in the U.S. over the past 10 years -- a time frame that mirrors Gallup-Purdue Index analysis of recent graduates between 2006 and 2015.

Putting these sad statistics into numbers, Gallup calculates that over 2 million graduates have said they have delayed starting a business because of their student loan debt. If even a quarter of them had done so, we would quickly recoup our average surplus of 120,000 new businesses annually.

It would also mean that the BLS's Birth/Death model would once again be accurate. However, as a result of record student debt, which is increasing at an accelerating pace of over $100 billion per quarter, not only is the birth/death adjustment wrong, but its "contribution" to the total number of jobs should be inverted.

Which, incidentally, would reflect far more accurately the woeful state of the US labor market.

Finally, we know we are spot on right with our assessment that student debt has become the primary culprit holding back the jobs (and businesses) recovery, because two days ago none other than Ben Bernanke said Bthat "student debt no threat to U.S. financial system."

And that is all you need to know why the biggest threat to the US financial system is none other than student debt (after the Federal Reserve itself, of course).