Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Sailing the Seven Seas
“If you can keep your head, when all about your are losing theirs and blaming it on you” – Rudyard Kipling, If
What a market. After seven straight down days on the Dow, prompting cries of Armageddon and sending smaller investors fleeing to the sidelines, prices turned around and climbed up for seven straight days. The venerable index came with a half-percent of making up all the losses from the downward slide before running out of gas on Friday.
Correction: it didn’t exactly run out of gas. No, it was more like it drove into a ditch and crashed. The gains of the week went with it, and fear again walked by our side. But don’t get too sour yet: this market could just as well go up for seven straight weeks instead of days.
No, we weren’t lying out in the sun too long last week, though we might not blame you for thinking so. One needs to consider the current setup. In April, for example, prices rose right to the end of earnings season, then abruptly corrected. That may have been disappointing, but it’s typical price behavior except in the best of bull markets. The outlook became so tautly confident that any prick would cause the balloon to burst, and it did.
We are fairly well down to the other end of the balance from April. Bearish sentiment indicators rose sharply last week. Further evidence of a growth slowdown fanned fears of dastardly double-dips. Gang of Four banks Bank of America (BAC) and Citigroup (C) reported revenues that were less than robust. Stories abound of small investors deserting the market.
Yet non-financial companies are likely to report good earnings, typified by last week’s reports from Intel (INTC) and Alcoa (AA). Frankly, we consider a positive report from Alcoa to be bordering on the divine. With the coming week’s economic data mostly confined to the housing sector, an area that’s been given up on again of late, there’s a fair chance that the markets will get a lift from positive earnings results.
We’ve been concerned of late that a rally into mid-July would end in grief, because that’s the usual way of pre-season rallies. That concern has been eased a bit by the sharp increase in skepticism about the quarter and the year, positioning the market much better for upside surprises. Rallies that find their footing in mid-July have a way of running into the first week of September, hence our thoughts that a seven-week rise isn’t out of the question.
Keep in mind that the overwhelming consensus sentiment of the moment is the conviction that earnings, growth and stock prices are about to disappoint us all. It’s important, because the universal consensus on Wall Street is nearly always dead wrong.
It’s neither the best nor the worst of times, a situation that frustrates the many market mavens who want a decisive outlook. Markets crave certainty.
Last week’s data continued the theme of moderating growth and a “stair-step” recovery. If you were feeling optimistic, you could dial in on Intel’s bang-up quarter and guidance; if double-dip deflation is your cup of tea, you could run with the price data.
We’ll start with business activity. The New York and Philadelphia Federal Reserve banks both reported July survey results that came up short of expectations, helping to end the market’s winning streak and preparing the way for Friday’s nasty sell-off. The Philadelphia result was 5.1, down from 8 the previous month and short of consensus for 12, while the New York reported an overall reading of 5.1, down from 19.6 the previous month and well short of estimates for 18.
Along with the Industrial Production report of a 0.1% increase for June, this is very much the picture of an economy moving mostly sideways for the moment. As we’ve said, it’s going to be a stair-step recovery, with cautious businesses ramping up more incrementally than in previous recoveries.
There were silver linings in all of the reports: industrial production was thought to have pulled back in June, but grew mildly instead, and both surveys still showed expansionary readings. Much was made of the sharp drop in the Philadelphia survey’s six-month outlook, but the outlook has value as a coincident indicator only. You would do all right trading the reports if you looked to short the most optimistic readings in the outlook and bought the gloomier ones.
Manufacturing output did fall by (-0.4)% in June, but it was the not the first drop since last year, as some reported: it also fell by (-0.3)% in February. Although the February dip was immediately followed by some strong months, and inventories are still low, it wouldn’t be surprising to see another month of calm before production picks up again. It’s the summer. Yet businesses are making equipment and capital investments, and Intel’s results make it clear that the corporate refresh cycle of workstations is real.
Sales fell more than expected in June, (-0.5)% overall and (-0.1)% excluding autos. While hardly robust, the data were nonetheless better than appeared. Excluding autos and gasoline, sales edged up by 0.1%.
Declines in big-ticket categories, such as autos, furniture and building material were all easily predictable due to the expirations of incentives in the auto and homebuilding sectors. The sharp decline in gasoline sales was due to price decreases, which in turn were due to the fall in equity prices (oil largely tracks the stock market now, something we are not supposed to notice). Electronics, clothing and department stores all registered reasonable monthly gains.
May data on the trade balance showed increases in both exports and imports, an indication of improving demand. That was noted in the FOMC minutes as well, but the Fed nevertheless lowered its growth outlook for the remainder of the year. It’s probably still on the high side, but one should take heed of the reality that the Fed staff rarely gets any of its outlooks right: they largely draw a straight line forward from the most recent batch of data. If only the economy were so simple. Inventory growth edged up by 0.1% in May, but it was really due to falling sales.
One thing that will surely bug the Fed members in the next meeting is the price situation. Import and export prices fell in June, along with overall producer prices (the PPI was down -0.5%) and consumer prices (CPI: -0.1%). Although core prices rose in both the CPI (0.2%) and PPI (0.1%), the results still fanned deflation speculation. Year-over-year, the CPI is up only 1.1% total and 1.0% excluding food and energy. The PPI is up 2.8%.
We've read some deflationary hand-wringing. For example, intermediate- and crude-stage goods have slipped year-on-year, and food has fallen several months in a row. Before you go out and buy your zombie costume, though, keep in mind that the recent set of data is being heavily influenced by oil and housing.
Oil has slipped around ten percent, give or take, since mid-April, and that is due entirely to the retreat in the stock market. Food prices are heavily influenced by petroleum prices, as are the drops in more obvious categories like jet fuel and commercial electric power. A ten percent move up in equities would send oil prices back to $85 a barrel, and all of that data back into rising territory.
As for housing, we don’t have to tell you that the surplus has pressured both home prices and the homeowner-equivalent-rent category in price indices. Mortgage-purchase applications fell again last week to new lows, with the newspapers running stories every week about thirteen- or fourteen-year lows. That’s because the series only goes back to 1997.
We heard a story during the week in which a realtor opined that the real test would come in the fall. We imagine that the hope was that after a few months had passed since the end of the tax credit, maybe momentum would start to rebuild. There is no reason why it should. Rates will be low, but the number of qualified would-be buyers waiting on low rates as a reason to buy must be miniscule by now.
If you are recently back to work, you will need to either be wealthy or have Fannie or Freddie agree to buy your loan, because otherwise you won’t get one. The mortgage financing that was available in the last recession isn’t this time. Employment will have to improve steadily for over a year before that segment of the population can think about returning to the loan window.
Further price declines, which appear to be in the cards at this point, will not encourage the existing market to make a change. Lower buying prices for a new place mean lower selling prices too, so there’s little to no net incentive to trade up. Much of the existing market is underwater anyway.
Unless the government enacts new programs – and we’re not advocating that they should - there will be no respite this year in homebuilding or home sales. Look for more bleak news next week from the homebuilder sentiment index (Monday), housing starts (Tuesday) and existing home sales (Thursday).
The combination of the growth slowdown, declines in equity prices and home sales and lots of worrisome headlines took a toll on sentiment. The national small business confidence index fell in June, and the preliminary July reading of consumer sentiment from the University of Michigan plunged to 66.5, a low for the year. The largest threat remaining to the economic recovery is indeed fear. The banks hiding in their bunkers and refusing to lend is one obstacle, while consume retrenchment would be another.
Although we believe that the front pages (or home pages) have the biggest impact on sentiment measures, employment plays a strong role as well. The latter can’t be said to be helping matters of late. Although the Labor Department reported a decrease of 29,000 initial unemployment claims in its weekly report, the market didn’t get very excited about it. That’s because the unadjusted number rose by about double that amount, to a lofty 513,000.The seasonal adjustment is logical, because there is typically a burst of separations at the end of the second quarter. People file after the obligatory waiting period, hence the bump in the raw data. And it may even be, as the department apparently thinks, that the bump is less pronounced than usual. But real people losing real jobs have an unadjusted impact on things like consumer sentiment or retail sales.
Earnings will dominate next week, with little besides the housing news on the schedule. Thursday should get the most attention: besides the usually weekly claims report, leading indicators for June will come out at 10 AM alongside the existing home sales report.
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