Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
It Happens Every Time
"It happens all the time, this crazy love of mine." - Poco, Crazy Love
It’s one of the enduring enigmas of the investment business. We really can’t explain how and why it happens every time, but it does. Perhaps it’s just a manifestation of an old phrasing of Murphy’s Law: the perversity of the universe tends to a maximum at all times.
We are talking about why the market rallies every time the Fed begins to reverse its monetary policy. In the period leading up to a tightening, for example, the market takes a fearful header on every hint that the central bank might do just that. When the event finally does come to pass, you might think that the market would sell off. After all, it really isn’t good for equities.
But it doesn’t. It didn’t on Friday, when we really got nothing more than a whiff (albeit an unmistakable one), and it never does. It always rallies. One could say that it’s just another example of the Street’s fondness for going one way on the rumor and then reversing on the news, the way it usually does. There’s a lot to that; traders love to turn and burn positions that got comfortable with a trend (day-to-day momentum is one thing, but bets on a periodic event getting similar results are treacherous).
Yet whenever the Fed moves in, there is one market reaction that’s a constant: “The Fed is on the job. It’s going to be okay.” So when it begins to loosen, as it did in 2007 for the same reason it’s loosened for the last twenty years or so - the economy is slowing down – it should have been a clear signal to start lowering equity exposure. Instead, the market went for the Goldilocks theory: it’ll all turn out “just right.”
When it actually begins to tighten, as opposed to dropping hints, we of course have to have a rally. Usually it’s because see, the Fed is on the job, isn’t it great, we’re going to have a soft landing. Or maybe inflation will stay tame. Or, we’re going to squeeze the rookies out of their short positions. On Friday the theme du jour was hey, the economy must really be growing, right? Great news! Although one might have thought that with the Street expecting 38% earnings growth this year, that part was already priced in.
Tighter money really isn’t a reason to celebrate. Of course, last week’s bump upward of the discount rate had nothing at all to do with the usual soft touch to the brake pedal. Despite the Fed staff’s latest set of chirpy predictions for growth, there is no evidence from Bernanke that he thinks we’re out of the woods. Away from the abyss, sure, but Friday’s news of a drop in the CPI core rate – the first in nearly three decades – could not have reassured a man who has reason to be worried about deflation.
The Wall Street Journal applauded the news as good for investors also, though that may well have been a case of trying to explain why the market was up. A backup thesis for the approach that the economy is growing is that the first initial foray into withdrawing super-stimulus conditions went well. Bernanke carefully telegraphed that some kind of move was imminent, then proceeded with a light touch to show that while the bank really will dial back on the money motor, it means to cut the throttle lightly. Very lightly.
It was well done, we are sure. But is it a reason to celebrate, even after a few days of the latest technical rebound (always on much lighter volume than the drops) had managed to turn story lines positive again?
One school of thought, more widespread than you might think, is convinced that it is. In their view, the classic v-shaped cyclical recovery is definitely on. According to their view, the gradual withdrawal of the stimulus is smoothly meshing with the arrival – perhaps a bit tardy - of the inventory restocking phase.
They point to the regional business surveys that are starting to show positive changes in inventories, indicating that destocking has finally come to an end. Companies are beating earnings estimates and raising guidance at a healthy clip. The hefty profit leverage from the recession’s massive cuts in input factors will spur companies to re-invest in productive capacity. Recovery may not be all that clear yet, but it’s always murky at this stage.
But such leading lights as the Pimco crowd remain unconvinced, steadfast in their opinion that as the stimulus eases we will see a return to real growth rates of around two percent. Infamous bank analyst Meredith Whitney was back in the spotlight again last week, warning that the financials have diminished earnings power. The recent track record of beat-and-raise for the quarter may look pretty good, but when compared with the last quarter of 2008 – a real ugly duckling – almost no one has anything to brag about. Revenues rarely show any increases.
Many traders are agnostic and will try to have it both ways, hoping to surf any big waves of optimism caused by an inventory restock, and then jump off at the first sign of the big correction. Not such a bad idea, except that knowing in advance which dips are the ones to buy and which one is the start of the big one is a bit tricky to get right.
It isn’t that much different with the rallies that come from the Fed changing course. The rallies invariably turn out to have been misguided, because the perfect ending never does happen. Then why, you may wonder, do these kinds of moves usually last for months? We could go on at length about that one, but the simplest answer is probably best: because more people like to be long than short.
There were some positive developments to help last week’s largely technical rally. The regional business surveys from the New York and Philadelphia Feds both produced decent results, particularly the former, which rose smartly to 24.9 versus expectations for 18. The inventory reading in New York finally leveled off to zero, while the Philadelphia number showed another gain. We would be remiss though, if we didn’t note that the market was a little disappointed by the Philadelphia result. Although it met expectations (17.6 versus a conservative 17.0 outlook), the New York result had raised hopes for a bigger beat.
Industrial production showed another decent increase in January, rising 0.9% versus expectations for 0.8%. It was a fairly clean number, with manufacturing also rising by 1.0 percent. Capacity utilization is still running far below normal, at 72.6%, but it did rise somewhat to meet expectations.
The home sector was nothing to write about. The homebuilder sentiment index rebounded a couple of points from 15 to 17, but as we said about the drop last month, it’s all meaningless noise. It’s been in the mid-teen range for a very long time, wandering a point or two up or down. It’s in a bottom, getting neither worse nor better.
New home sales “beat expectations,” so that was the headline repeated by newsreaders. It’s a bit of a laugh, really. January and February are weak months that are highly adjusted. January 2010 improved over January 2009 by a bit less than ten percent using unadjusted data, but the “seasonal adjustment” nearly doubled that increase. Go figure. In any case, they’re still low numbers that point to little recovery. Mortgage purchase applications fell back again last week, but the real takeaway is that they remain stuck at very low levels of activity. Will the Fed really be able to stop propping up the market?
Jobless claims rose again, disappointing the market briefly. It’s true that the Labor Department is guessing a bit more these days to try to account for all the heavy weather in much of the country. Adjusted or not, the numbers aren’t great and contributed to a slowdown in the Leading Indicators report, which fell back to an increase of 0.3% from an increase of 1.1% the previous month.
The rest of the news was mostly about inflation, with mixed results. Import and export prices showed unexpected heat, which isn’t good. However, the increases are mostly driven by commodities, which in turn are being driven by financial speculation rather than demand. That led the Producer index (PPI) to hotter-than- expected readings of 1.3% jump in total prices, and a 0.3% increase excluding food and energy.
Consumer prices, however, were reported to be weaker than expected. The headline number rose only 0.2%, and the core number actually fell by (-0.1%), the first negative reading since 1982. That probably doesn’t please Chairman Bernanke, who has intensely studied the deflationary spiral of the 1930s. He’s due to give testimony on Wednesday of this week.
But the FOMC minutes showed that the Fed is still talking up the unwinding of monetary stimulus. What they will actually do in the event is still open to question, but the talk was reassuring to the financial markets – just as the Fed knew it would be.
Next week will have put the focus back on housing. The Case-Shiller report on home prices comes up Tuesday, new home sales are due on Wednesday and existing home sales come out on Friday. The government will report its own GSE price index on Thursday.
Friday should be the day of the week, what with the existing home sales report, the first revision to fourth-quarter GDP (consensus is for no change, we expect a downward revision), the Chicago PMI and the second reading on consumer confidence from the University of Michigan. The last one will be preceded by the Conference Board monthly reading on Tuesday, which counts more among traders.
Durable goods comes out on Thursday, as do jobless claims, and Chairman Bernanke will still be speaking. Any surprises there could end up setting the tone for the week. Still, there are foreign considerations that remain. Greece may have fallen off the screen with its 30-day timeout, but China will be coming back from its lunar New Year celebrations and could shake things up in either direction. Over the weekend, bank officials were talking tough on loans again. Some time this year, both regions are going to shake us up.
Avalon Asset Management Company is a Registered Investment Adviser
Avalon's MarketWeek is not intended as a market timing newsletter or service. No buy or sell recommendations are made for any of the individual stocks mentioned on the site, and neither Avalon Asset Management Company nor its officers, directors or employees make public stock recommendations. Please address comments to MarketWeek@AvalonAssetMgmt.com