Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
The Spy Who Left Me
“Nobody does it better, though sometimes I wish someone could.” – Carole Bayer Sager (lyrics), The Spy Who Loved Me
Deep cover, that’s what was it all about. The Gang That Couldn’t Infiltrate was rolled up last week by the FBI and other government agencies, resulting in a spies-for-spies swap right out of John LeCarre. The suburban saboteurs were apparently still working on perfecting their Facebook persona and studying the art of the backyard barbecue mole when the feds decided enough was enough. It wasn’t quite enough to push a mountain of hype about a basketball player’s contract off the front pages, but within the States it was enough to further demote water cooler talk about the World Cup.
We’re a bit concerned that last week’s rebound, in particular the chest-pounding affair of three-percent-plus gains on Wednesday, was also something of a deep cover operation. To begin with, not so many chests were being pounded. True, there was a story about strength in the Australian economy that got the overseas markets going, and the prospect of an All-Europe World Cup final must have cheered markets there. It was exactly the kind of mundane stuff that we had said only last week could spark a turnaround in badly oversold markets.
But that should have been good for about a hundred or so points on the Dow, with maybe a modest follow-up Thursday and an orderly pullback on Friday ahead of the weekend. The rest of the move, however, looked very much like a staged affair. We suspect the familiar, quiet-yet-lethal hand of options dealers and their short-squeezing allies.
Due to the vagaries of the calendar, this month’s options expire early, Friday the 16th for practical purposes. As bearish sentiment ran up to very high levels in the preceding weeks, put protection became the name of the game. Short selling picked up as well, but as downward moves deepen, the more experienced sort of short-seller becomes more vigilant even as they bring down more prey. That’s especially true in the kinds of markets we’ve had of late.
The heavy-duty professionals in the options markets usually look to start making their moves on the Wednesday before expiration week. When one has been selling boatloads of a certain kind of option, the ledger looks much better if the market can move the other way before expiration. While the Wednesday immediately before expiration Friday is traditionally the day for professionals to rebalance positions, if the dealers can get the market moving the previous week, they will.
This isn’t to say that the options dealers run the markets. They don’t have that kind of money. But when conditions are right – light volume, aging trends – the dealers know how to get the tape moving in the right direction. Wednesday’s carefully staged pushes upward through technical levels were exactly the right moves to get wary shorts to cover and trading boxes to jump in. Thursday’s late surge upward was pure tape-painting.
We’re not against the market going up, certainly, and one would think we’d be in the mood for a victory lap after our exhortations of the previous week to start buying. But the kind of rally we had leaves us uneasy.
The stock market tends to have a certain rhythm, and earnings season is one of the best examples of it. Had prices continued to struggle for another week in the run-up to earnings season, that would have left lots of fuel in the tank for a sustained move upwards. Second-quarter earnings are going to be decent, but there are two Street aspects to reports: the actual numbers, and the mood in which they are received.
When good earnings hit a pessimistic, fearful market, the upside reversal is a fine sight to behold. We’d have been looking for a rally that could stretch through August into early September. However, a rally coming into earnings season is a dangerous thing, as April demonstrated so well. When the psychology of investors becomes one of confident conviction about the numbers, almost the only room left for stocks is to go back down.
If the market rallies again this week, we’d suggest preparing yourself to sell the news as the month wears on. For stocks to rally going into earnings season and keep going afterwards, companies need to report strong results and stronger guidance. That’s just too much to ask of company management this time around.
Guarded optimism when one is expecting the worst can bring the buyers in running, but when prices have already priced in good news, that kind of view by management – which is really all that we have a right to expect this summer – tends to be a big disappointment. Last week’s rally was more of a covert operation. Another week of prices rising on light volume and hot air will leave stocks dangerously exposed, so be careful.
Congratulations are in order for Spain on its World Cup victory, but it has to be said that it was one of the least aesthetic finals in recent memory. Perhaps the fervor for improved regulation in the financial markets can spill over into the exclusive antechambers of FIFA, the sport’s haughty ruling body, but like a rational stock market, that may be too much to hope for.
The short week saw little in the way of fresh economic data. Tuesday brought the ISM non-manufacturing report for June with a reading of 53.8, disappointing expectations for something closer to 55. Last week we groaned over the misreading of the manufacturing report, this week we can groan about the nonmanufacturing version.
“Business activity is at its lowest level since February, ” said one prominent economic reporting service. No, it isn’t. How can they report so sloppily? What they are trying to say is that the business activity index reading of 58.1 was the lowest in the months going back to February, when it was 54.3, but that is not the same at all as the level of business activity. It’s the rate of change that’s slowed.
Back in February, nine industries reported growth and eight contraction; not exactly robust. In the months since then, at least two sectors have been in contraction every month, and that was the case in June as well. The score for May, when the activity index was at 61.1 (its best reading this year), was sixteen in growth and two in contraction. For June it was fifteen in growth, with still only two in contraction.
The change was due to three percent of the respondents moving from the “higher” category to the “same” category. There was no change in the number of respondents reporting “lower” activity: it stayed at its lowest levels of the year (nine percent). Yes the rate of change eased off, but only mildly. Apart from employment, which continues to hover around the neutral mark, the report was reasonably good.
The next piece of poorly reported and broadly misunderstood data was the weekly claims data. News outlets around the country led stories about the day’s market rise being founded on improving employment conditions. What a load of nonsense.
It’s true that the upward revision game was at work again. Every week, the previous week’s claims are revised higher, providing a convenient lift to the weekly rate of change that falls back out – unannounced – the following week. The previous week’s claims were bumped higher by three thousand, providing a useful headline of “fell by more than twenty thousand” when they almost certainly did not.
Where there were increases in layoffs, it was primarily due to school closings and construction, which is usually hiring at this time of year. For the school issue, we can make the educated guess that many districts were eliminating staff at the end of the June 30 fiscal year, due to widespread budget shortfalls.
However, one thing that it isn’t readily apparent is why the increase of 22,560 in the unadjusted data merited a seasonal adjustment to a decrease of 21,000. We looked at the same week going back several years, and there is nothing of recent vintage that suggests a big bump at the end of June is a typical calendar effect in need of smoothing. The department may have misguessed on this one.
Chain-store sales results for June were mixed, as we said they’d be, but probably not as bad as the market had come to fear. Hot weather in the last week of June gave the July 2nd week a big lift in sales, more or less rescuing a still-unspectacular month. A fine example of the rarefied air that Wall Street breathes, though, came on CNBC in the wake of the reports, when a prominent Street analyst on the retail sector lamented that the fear of prospective tax increases next year were going to hold back retail sales the rest of this year.
As President Reagan liked to say, “there you go again.” The tax increases in question are the restoration of prior tax rates to households with adjusted gross income of more than $250,000. The notion that the $250k+ crowd is primarily responsible for light same-store sales at chains like Target (TGT), The Gap (GPS) or Costco (CSCO) is at best highly improbable and more realistically, nuts.
We’re well aware of the state of lamentation in the offices of Wall Street over the impending increase. It must be a cruel topic this summer, what with people finding themselves forced to think about renting the Tuscany farmhouse for one less week this year, or at least not flying over the cook, the nanny and the gardener. The fall of the euro has to rub salt into the wound.
But hurting retail sales in June? For what it’s worth, Porsche sales are up 14% year-over-year through the end of June, and Ferrari opened a New York showroom two weeks ago. That’s some cloud of fear.
Perhaps we are wrong, though. It may be that the Street is simply seeing a deeper connection. For example, the Manhattan financial crowd could be concerned that lower Christmas bonuses for household staff – thanks to those nasty tax hikes – will hurt spending at place like Target or Costco or Wal-Mart, or wherever it is that the little people go to buy things. Our take is that nobody likes to pay higher taxes, perfectly reasonable, but do try to keep some perspective.
Wholesale inventories rose slightly, about as expected, though April was revised downward. The important thing is that the inventory-to-sales ratio stands at a very low 1.14, compared to 1.13 in April. We should see another uptick in production soon.
Next week will see the beginning of the quarter’s high season. There is plenty of data on the board, and earnings will begin to roll in as well. Thursday should be the day of the week: the usual weekly claims update will be accompanied by the Producer Price Index (PPI) and Industrial Production reports for June, along with the July business surveys from the New York and Philadelphia Federal Reserve banks. Mega-bank JP Morgan (JPM) reports earnings before the market opens, and Google (GOOG) after the close.
However, retail sales for June come out Wednesday, with Intel (INTC) reporting Tuesday evening, so expect some action that day too. The bar is set fairly low for retail sales, with the consensus set at (-0.2)%. Import-export prices and business inventories are also on tap.
Alcoa (AA) officially kicks off the earnings season after Monday’s close. The company usually makes a mess of things, so a positive surprise from it could be an important pivot point for the market. International trade data is due the next morning.
Finally, the week will go out on a bang on Friday. To begin with, it’s the options expiration day. The economic data in store includes the Consumer Price Index (CPI) for June, and the first July reading on consumer sentiment from the University of Michigan. Market bellwethers Citigroup (C), Bank of America (BAC) and General Electric (GE) all report earnings before the open. It should be lively.
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