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"The quickest way to double your money is to fold it and put it back in your pocket.” – Will Rogers
The market has a bid in it that I don’t understand,” a floor trader told the cameras last week, and we can sympathize. The financial press is struggling to come up with plausible justifications for a market that seems to treat every bit of news as an occasion to lean on the gas pedal. "It’s stability in the housing market," will say one reporter. "Financials are leading us out," says another. "The stimulus package is improving the outlook for second-half earnings," decides a third.
Dear readers, it’s really none of those reasons. Certainly the outlook for the second half isn’t worsening due to the stimulus package, and financials are largely the hot sector. But it has very little to do with any new-found faith in the strength of the economy. It’s a play on the tape, one with a new wrinkle, but a momentum trade nonetheless.
For a stretch in the first quarter, the downside momentum became so firmly established that the market actually inverted its usual posture of buying stocks and hedging with puts. The put-to-call ratio theory suggests that when market participants are buying relatively few puts, bullishness is overdone and the market is ready to correct. Conversely, if participants are buying more puts than usual, bearishness is overdone and the market is ready to rise. But last quarter, the posture swung to shorting stocks and buying calls as a hedge. The put-to-call ratio fell for the wrong reasons.
This was not due to professional investors abandoning the market. The long-term investors have been largely watching and waiting all year, allowing trading strategies to drive the market. When the feds put together a series of market announcements that made shorting too risky, the trading posture began to swing to the long side, where it remains. The economy hasn’t recovered enough to encourage fundamental investors into the market beyond putting on a little extra exposure to the rally, nor is it good enough to make bearish investors give up.
Disappointment could come later – at the current rate it almost certainly will – but for now the government plans are still too new to be graded, and in the interim there is the risk of further new policies that could cause a short squeeze. Some kind of restoration of the uptick rule looms, and the Wall St. Journal reported that high-frequency traders have caught on to gaming the leveraged ETFs for fun and profit. So the prevailing wind for the most active traders is to play from the long side, and it will remain so until a crisis arrives or the market’s benign view is punctured.
But this does not mean that a new bull market is imminent. That proposition looks doubtful, even beyond another few weeks. The economy isn’t about to turn enough to sustain such a move. We have talked of the current sideways move in the economy for some time, and we expect it to continue for a while longer. Yet it’s more likely that the economy will follow with a soft decline before any recovery really gains traction.
We are just beyond fair value on the broad indices now, and markets being what they are, are likely to overshoot the current area into a region above 900 on the S&P. At that point many of the optimists will have convinced themselves that there is a recovery in process because the markets are higher and the markets are collectively wise. You might think after the last few years that there would be more recognition of a trading move, but the markets love trends more than anything else, for the simple reason that it’s easier to make money.
If the markets do break through 900 in the next few weeks, they will enter a zone where there is no margin for disappointment. The economy cannot deliver on such a premise. As the restocking period fades and unemployment continues to mount, fears of a “double-dip” recession will be voiced and the market will stage a retreat. Then it will probably overshoot again to the downside - maddening, but it’s what markets do.
The mystery of the week to us was Goldman Sachs (GS). They delivered a decent quarter and beat estimates by a mile, all well and good. The thing that puzzles us, though, is that Goldman talked about having roughly $165 billion in “excess liquidity,” yet ran a $5 billion offering of its stock last week in order to help pay back $10 billion to the government. Why didn’t the company just write a check out of that $165 billion? Do they really have the cash or not, and if they do, why dilute the equity? We can think of some plausible explanations, but it was an odd thing to do.
Despite the improving tenor of the financial companies’ earnings, we don’t think that the banks are entirely out of the woods yet. They should be able to earn their way out of the current crisis by and large, but Citigroup (C) still looks pretty shaky to us and all of the banks have stepped up their foreclosure activity. It may be that the major banks are taking advantage of the current generous yield spread and government to accelerate write-offs. But that exacerbates capital and housing problems in the short term, and will not speed an economic recovery.
Meantime, despite talk about skepticism about the rally, it looks to us like the trading crowd is quite happy with the move. The number of prominent managers suggesting it could be the real thing is growing all the time. It may be just as risky to say that the new bull is not here as it is to proclaim its arrival, but we’re not ready to take the great leap forward.
The economic data released last week presented a mixed picture, which on the surface sounds like what the market has been hoping for. Yet the mixture was not one so much of decline giving way to improvement, as one of sharp decline dribbling to slower decline. The lack of consensus about what comes after – a rebound, plateau, or a further decline to a lower plateau (or even rebound) – keeps the trading volatile.
Industrial output, for example, was a distinct disappointment. It fell 1.5% in March, nearly double the decline that the market was expecting. Capacity utilization, at 69.3%, hit an all-time low for a series that dates back to 1967. It was outdone by factory capacity utilization, which set a new all-time low (65.8%) going back to 1948. Those are low numbers. The annual rate of output decline in the first quarter was 20%, the worst since the recession began.
The paradox of such a decline is that it practically guarantees some sort of bounce. The steepness is essentially unsustainable in the absence of a greater calamity, as the surveys from the New York and Philadelphia Federal Reserve banks suggested. We have been saying of late that the surveys, which represent monthly changes in activity rather than absolute levels, would inevitably start to drift back towards neutral levels.
Imagine a gasoline tank with a hole punched in it: the gas will rush out at the beginning and then eventually slow to a trickle. Factory utilization sitting at what is essentially a seventy-year low (in other words, since the United States began to rearm for World War II) is the empty tank.
The surveys still showed declines, and the Philadelphia result (-24.4) in particular was still quite ugly. That it was “better” than the consensus estimate of about (-30) is more of a testament to the Street’s predilection for handicapping results to ensure a winner. We have to be quite near a trough in manufacturing, not because the economy is necessarily getting better, but because the cuts in inventories should eventually catch up with the cuts in sales. Business inventories were reported last week to have fallen sharply in February, and should show another sharp fall in March. But by May or June (April data for inventories), we should show a pickup in activity as goods run off shelves.
That’s the idea, anyway. The adverse feedback loop didn’t break during the Depression, mostly due to misguided policies by the Treasury department and the Fed, but also because of the gold standard. The aggressive policies now being pursued by the government, Treasury and the central bank should begin to push the spiral into a neutral direction, possibly even a small uptick, by next month or the month after.
That’s the good news, and will lead to more excited talk about “green shoots,” a phrase that has now displaced “zombie banks” as the hippest utterance in financial argot. The brief reign of the latter phrase terminated with the currency of such absurdities as “wipe ‘em out and start over (the banks),” a notion equivalent to one’s doctor advising you to rip out your heart and “start fresh” with a clean slate. The green shoot movement is now rapidly headed into foolishness of the other extreme, as evidenced by the reaction to last week’s housing data.
The housing market index, it seems, “shot up” in April, the “biggest gain in five years.” That helped set the stage for a wild day in homebuilder stocks the next day, when housing starts badly missed estimates. At 14, the homebuilder index set a new record for the lowest April reading ever. It’s lower than any reading during the S&L-fueled housing bust of 1990-1992 and only back to the level of last October. Fifty is neutral. Yet “now is the time to act,” said the chairman of the homebuilders’ association. No doubt, just as it was back in August, when the association said the same thing, calling the bottom to boot.
Housing starts and building permits plunged anew in March, falling to levels nearly fifty percent below a year ago. If you want to know if the current rally is real, the answer can be found from the release day’s action (Thursday). The homebuilder’s ETF, the XHB, soared on a new volume record and the hoary theory that “this is good for inventories” was wheeled out, a joke we hadn’t heard since the fall of 2006. “Signs of stability” were duly reported in the press because single-family starts were unchanged – sort of. The reality was that February starts were revised downward by five percent to the level of March starts.
Be that as it may, the tone of the market’s response can’t be ignored. Returning to our question of whether the not the rally is real, the answer has to be yes – but only in the short term. When the markets rise on such news, it’s clear that the cause-and-effect is not the market following bullish news, but the tenor of the news taking its direction from a bullish market. You can lose a lot of money trying to fight momentum on the Street.
Despite the dynamic of the green-shoot fad suggesting that the rally still has some legs, though, it says nothing about the outlook for more than a few weeks. Any bit of hard news too big and bad to be ignored would still pull the wheels off the market’s go-kart in a hurry. Absent that, the current trend does look to have the potential to be a typical spring rally of the kind that can last well into May. If it does, we will probably be endorsing the same dictum as last year – sell in May and go away.
Retail sales fell a bit more than a percent in March, which should have been the week’s main disappointment, but an excuse to ignore was found in upward revisions to February and January. Despite much lower prices, gasoline sales are down 34% year-on-year. That says a great deal that the market is choosing not to hear. Overall, sales were weak across the board. Still, the weekly results for April were showing improvement as Easter neared.
The other over-hyped shoots (excluding earnings reports) included weekly initial jobless claims and the Fed’s Beige Book. The former fell pretty sharply last week, though the holiday period and seasonal adjustments generated more than a little doubt amongst those as silly as to want to be rational rather than rich. Continuing claims, however, leapt again, passing the six million mark ahead of schedule. We don’t see any other signs that employment is improving.
The Beige Book, the Fed’s collection of regional branch reports, suggested that the pace of decline is slowing, as we have predicted it would. That’s good. The pace of decline should level out for at least a time, then fall a bit more before we return to the pace of last year before-the-freeze. But that pace wasn’t much, and we will be “growing” from much lower levels with much higher levels of unemployment. Not so good. Consumer confidence rose, which we had thought overdue for a boost due to the market rally. It’s still at historically low levels.
Finally, there was inflation, or rather the lack thereof: the PPI, largely ignored, showed drops in total inflation for the trailing month and year with a 3.8% increase in the year-on-year core rate. In sum, not inflation, not deflation. The CPI, also mostly ignored, showed surprising drops in monthly and year-on-year total inflation, with modest increases in the core rate (1.8% for the trailing twelve months). That was good enough for the markets.
Next week will begin with earnings on center stage and only the Leading Indicators report to distract us until Thursday. Thursday and Friday, though, will bring the Existing Home Sales and New Home Sales reports, along with Durable Goods on Friday. We think the former will show signs of stability and the latter will be weak, and the market will probably celebrate both. Low rates, lower prices and the spring should combine to give us a little lift in home sales – little on Main Street, but writ large on Wall Street.
Credit remains tight, especially for new construction. Employment is going to keep rising for several more months at a minimum, and the recent increase in foreclosure activity at major banks will create more pricing pressure. Any increase is apt to be a short-lived bump rather than the real recovery.
StockWatcher will return in a later edition.
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