Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Seven-Eleven
“All is for the best in the best of all possible worlds” – Voltaire, Candide
“Extra froth, please” may well become this month’s slogan. As the markets tossed another effortless one-percent-plus weekly gain onto the pile last week, we decided that the froth bug was finally beginning to infect our glorious springtime rally.
This was particularly true on Thursday, when the Dow put on a 100-point reversal and turned a short-lived dip at the open into another buying opportunity. There were plenty of reasons to take some profits off the table, too: the long extended run in stock prices, a hot weekly jobless claims result, concerns about the Greek debt situation.
Yet buyers threw themselves into the dips anyway. There may not have been a lot of buyers, but there seem to be even fewer sellers, and that’s enough of a formula to do the trick. Now we have seen the Dow rise from below 7,000 at its low last March to over 11,000 for a brief time Friday afternoon. It should finish the job this week.
There are some other warning signs, such as too-bullish sentiment readings and an options market where hardly anybody is buying puts these days. Yet those readings may correct with only a mild pullback of two or three percent.
We have been saying for some time that the news flow coming into earnings season rated to be market-friendly. The inventory restock is clearly here, and while It may have been late, that should mean it will end a little later too. We happen to think that the real crisis in sovereign debt is still to come, but these things have a way of taking time to rot sufficiently before they start to burst.
There’s nothing hard and fast about these crises, but in our experience they never ripen as quickly as the first lurid headlines might indicate. Inevitably, a period of promises and programs follows that will placate market fears for a time (such as the Eurozone’s latest weekend program for Greece). The situation could go wrong earlier, but it probably won’t.
Earnings season kicks off with some high-profile reports next week (see the Economic Beat below) and then gets into full gear the week after. One thing you might want to note is that there have been very few warnings about earnings shortfalls. So even though we are extended technically, a brief pullback could simply reposition the market for further gains as we go through the season.
Our guess is that the weak sister of the sectors is going to be the financials. There probably won’t be much that could be considered really ugly, but their environment has become a bit less benign. That probably won’t be enough to seize the narrative back from the bulls, though. A more likely consequence is that the market will prefer to focus instead on industrials, technology and other beneficiaries of the inventory rebound.
There are other warning signs around the globe, such as the weekend news that China became a net importer for the first time in ages. Even with a little pullback, though, any subsequent rally would still leave the market badly overbought – and the bar is getting set higher and higher in terms of expectations.
The structure is getting more rickety and hence more vulnerable as it gets higher, but we continue to believe that the markets will punch through to marginal new highs in the major indices. 1200 (the S&P 500), 700 (the Russell 2000) and 11,000 on the Dow, we are nearly there on all of them and the likelihood is that earnings seasons will not derail the bullish narrative. Performance fears are going to keep up the pressure to hold rather than sell.
We expect that sometime between now and the end of July, when the second quarter earnings season ends, we are going to get a sizable correction. But although market vulnerability is growing along with the age of the current move, we continue to believe that the odds favor the market talking its way higher, on balance, for at least another couple of weeks. All the news will be for the best, because this is the best of all recoveries – until it isn’t.
Last week was about as quiet it gets for economic data, yet there were a couple of releases of note that appeared to be tailor-made for the market’s case of spring fever. Since they were so widely misreported, they could also help continue setting the market up for a strong case of disappointment.
The first release was the ISM non-manufacturing survey for March. It was a good report, showing an expansion reading of 55.4. Business activity increased to 60.0, and employment nearly stopped contracting.
However, it seems the business media still has problems understanding the report. Perhaps only cub reporters get the assignment about writing about economic releases; once they begin to understand them, they turn to writing books and columns. Depending on whom you read, it showed the strongest level of non-manufacturing activity in three years (the Financial Times) or four years (the Wall Street Journal).
Whether it was three years or four, that would be great if only it were true, but it wasn’t. The ISM indices have no relation to the level of economic activity. They measure the rate of change from the previous month, using a diffusion process. The reading of 55.4 may have been the highest reading since 2006, but it could just as well have come the month after half the planet finished dying from the bubonic plague. It did show fairly broad growth from the previous month, but diffusion measures are a better measure of the breadth of change rather than the rate.
As recently as a few months ago, more than half of the industries in the survey were still reporting contraction. As they stop contracting, that sends the numbers back over fifty (the neutral line), but it doesn’t correspond to a level of output. The directional change is indeed good, but the press and markets are overlooking the fact that the levels of activity are still relatively subdued. That is most likely going to lead to disappointment.
Same-store March sales for chain stores were reported on Thursday, with the average coming in around nine percent. The data was widely hailed and helped the markets reverse some early weakness and march ever higher for another week. We frequently read how it was the biggest monthly increase in over a decade.
Some retail analysts tried to dampen the enthusiasm shown by the press, but the latter weren’t going to let boring details get in the way of a good headline. What the retail analysts were trying to point out was that March of 2009 was one of the worst Marches ever recorded. Start with the easiest comparison in decades, and then throw in the fact that Easter moved up three weeks, and you will get a sharp bounce. The comparison effect is going to get more and more difficult as the year moves on, however.
We still think that the combined March-April period – a better measure – will show an increase, partly because the increase in the stock market and the perception of greater stability has relaxed spending constraints in both the wealthy and the employed. The phenomenon is likely to flatten out by summer, however.
One measure that the stock market didn’t like so much is that weekly claims rose again, back to 460,000. That helped the market open weaker – for about twenty minutes, before traders came to their senses and started buying again. What were they thinking?
Still, it must be said that while the Easter holiday might have messed up the adjustments a bit, it wasn’t a lower number either and is still high. We’re also aware of the argument that employment is a lagging indictor and we’re tired of it, because we are long past the average time for employment to have started growing again. Another couple numbers like last week and we will need a whole boatload of census jobs to match the March number.
Another, smaller data point that disappointed was the contraction in consumer credit, which fell by $11.5 billion in February. Netting out the January upward revision of $5 billion, that still represents a net loss of $6 billion or so, and revolving credit was down in both months for an $11.2 billion contraction overall. That seems to belie the hopeful headline in mid-March in the Journal: “Credit Markets Spring to Life.”
Perhaps they are springing in another way: mortgage rates jumped 27 basis points as the Fed dialed back its purchases of mortgage-backed securities. It’s unclear that the trend will continue, as there have been anecdotes of fixed-income managers waiting to step in to replace Fed buying – but probably only after they feel reasonable certain that the adjustment has stabilized.
Mortgage purchase applications were flat last week (+0.2%). That surprised us, given that the tax credits are supposed to be expiring soon. We estimate that the level of activity is about 20% lower than it was in early October, when it was believed that there was only a month left.
Wholesale trade inventories were reported to have risen 0.6% in February with an upward revision to +0.1% for January. That’s good news, and shows that the inventory restock has indeed been happening for some time now. Business inventories will report on Wednesday.
Next week will see a pickup in activity, weighted towards the latter half of the week. The first couple of days won’t see much more than data in international trade and price inflation, but by Wednesday we’ll be moving at speed. Two big reports will be the CPI and retail sales reports on Wednesday, with the sales reports almost certain to get the most attention. With the early Easter, how can the retail sales number not look good?
Thursday will bring lots of information on output. The New York and Philadelphia Fed surveys are both due, along with the March industrial production report from the central bank. Look for the rebound to continue in all of them. Friday will bring housing starts for March and the first April report on consumer sentiment from the University of Michigan.
Yes, and first quarter earnings season begins next week as well, with a big lineup. Alcoa (AA) starts off the season after the close on Monday. Intel (INTC) follows after Tuesday’s close, with JP Morgan (JPM) following before the next open on Wednesday morning. With retail sales, CPI and Morgan’s earnings report, that should make Wednesday the day of the week.
Google (GOOG) reports after the close on Thursday, while Friday will see heavyweights such as Bank of America (BAC), General Electric (GE) and Mattel (MAT). Next week should be very telling on whether the market’s momentum love affair can squeeze through the rest of April.
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