Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Hit or Miss
“Bet your bottom dollar you can lose the blues in Chicago, Chicago.”- Judy Garland, Chicago
The first thing we should do in honor of last week is to say, “Thank you, Chicago.” Without its Purchasing Manager’s Index for July crossing the tape shortly after the open on Friday morning, we probably would have been in for a two percent sell-off in equities, ending the week and month on a down note.
Prices were sinking fast in the wake of a disappointing GDP headline, and the market was already down one percent in the first ten minutes when word of the report hit the tape (subscribers get the release shortly before it’s released to the general public). The unexpectedly strong result broke up the wave of selling, and the markets eventually struggled back to flat on the day.
Despite another week of good earnings results, a series of disappointing economic releases kept prices from moving much higher after an enthusiastic start on Monday. July’s rebound performance has lifted the S&P 500 back to an important pivot level, the 1100-1120 area. If prices can manage to get a decent push above that level, it would encourage momentum traders and techies (who make up most of the action of late) to pile in. The summer rally could then easily last into early September.
But if prices fail to get past that level, they’re likely to head back to 1050 or so, and thus the anxiety on the part of the traders. Naturally one doesn’t want to be too long going into a correction, and with the market struggling before the recent rebound, it feels right to keep a finger on the trigger. But if there’s any worse feeling on the Street than losing money, it’s watching a rally from the sidelines.
Hence last week’s ambivalent action. While companies were generally upbeat, including the Dow stocks reporting last week and leading indicators like shipping companies Federal Express (FDX) and (a week earlier) United Parcel Service (UPS), a batch of disappointing snapshots of the economy in the back half of the week (durable goods, the Fed’s beige book, second quarter GDP, all of which you can read about below in the Economic Beat) left traders anxious about whether the message was that it was time to cash in on the July move.
Had the advance estimate on GDP for the second quarter come in at something closer to 3%, we don’t doubt that traders would have gulped another can of Red Bull and kept right on going. But it didn’t, and while it was actually better than it looked (see below), it still looked like the sell-to-protect-profits play was next up on the rota. Indeed the selling was well underway when the unexpectedly good Chicago report came in and blurred the crystal ball again. So traders reversed field again and decided it was better to go home neutral and wait for next week.
And so here we are. In the space of a few months, the wise nod has gone from being directed at the premise of a strengthening U.S. and fading old Europe, to "the U.S is entering deflation" story and "Germany is leading Europe out of the ashes." The economic ship is a large one and usually moves ponderously, but the wise theories about them can move very quickly indeed.
Thus, the weekend Journal and Financial Times speculated about deflation, double dips and destocking. The bear version of events is that with the cursed inventory rebuild out of the way, the economy and profits will show their true colors again, which is to say black and blue. Consumers will be afraid to spend, banks afraid to lend, businesses afraid to mend, and so Japan, here we come.
This overlooks a few inconvenient truths, as Al Gore might say if he were an economist. Keep in mind, dear reader, that one of the few things you can count on from Wall Street is that most of its denizens are constantly talking their own book, in the jargon of the trade.
For example, while it’s true that the inventory-to-sales ratio is now higher than it’s been in months, it’s still in the basement. We were due for a pause, and while certain newspapers might be more than happy to print cautious-sounding quotes from business people, the reality is that sales levels are slowly creeping higher. They aren’t rebounding sharply, as they did in some of the post-war inventory recessions, but we aren’t in one of those. We’re in a post-credit-crunch, stair-step recovery, and each pause along the way will be accompanied by warnings that we are about to fall to our deaths. It’s the one thing you can count on.
Employment is going to recover slowly too. Political partisans will write furious articles blaming the slow employment growth on whatever legislation happens to be before Congress, be it health care, financial regulations, taxes, social security, or whether today should be National Indoor Flower Day or not. Above all, the slow pace will be the government’s fault.
However, the biggest drags on employment recovery are essentially out of the government’s reach. Number one, the more economically sensitive manufacturing sector is now only about nine percent of employment, little more than a third of what it was less than twenty years ago. The manufacturing recovery in employment is going to happen more overseas than here, because that’s where the S&P 500 has been moving its production.
Number two, the homebuilding sector, traditionally a provider of better-paying skilled labor jobs, is still in the recovery ward, and it’s not coming out this year. We added more houses and homeowners that the economy could realistically accommodate in the space of five or six years. We still haven’t worked off all the excess, and until we do, banks don’t want to lend money to buy a house. They only want to be the financial broker between you and one of the two government agencies, Fannie Mae and Freddie Mac (now both traded on the pink sheets).
Number three, we have something of a financing problem in commercial real estate. An awful lot of loans are up for renewal over the next twenty-four months or so, and the securitization market that facilitated them is a tiny fraction of what it once was. A lot of lenders are going to have to get creative with a lot of loans, and the most typical behavior of banks dealing with these situations is to hunker down and not make new loans (except to the government) until they’ve got a good idea of how much red ink is going to glow on the rest of the balance sheet.
As to deflation, we threw cold water on the Japan-redux argument last week. The only deflation that the U.S. has ever experienced in its post-gold-standard history came about when the Federal Reserve and federal government embarked upon premature programs of monetary tightening and spending cuts in 1936-1937, with the economy not yet really recovered and unemployment still above 14% (it’s tempting to point out the parallel between that disastrous path and what the modern-day Tea Party movement proposes, but we’ll not go down that road).
In sum, manufacturing will continue to recover, but it won’t rebound as fast as it once did and won’t hire back as quickly either, at least not domestically. It wasn’t a manufacturing-led recession, and it’s a smaller sector now. Homebuilding won’t start to add jobs until next year, and will be slow to come back. Autos are recovering pretty well, but will need years to get back to pre-Lehman levels. Why wouldn’t they? We were living in the biggest credit bubble since the 1920’s.
The economy is going to come back slowly, and there is no governmental magic wand to fix it, regardless of what political partisans on either side of the aisle want you to believe (after all, they are only talking their own book as well). The good news is that we are still coming back. It just won’t happen quickly enough to save us the trouble of too many crackpot theories wasting too much of our time.
Next week brings lots more earnings and lots more economic data. On the plus side is that earnings will be good, the weather outlook for New York City looks promising, and August is traditionally a benign month for equities. The main emotional hurdles to cross are the two ISM reports on manufacturing (Monday) and services (Wednesday) and the reigning big kahuna, the jobs report on Friday. As far as the rally goes, well, it’s not really about the data, is it? It’s about the hit or miss.
Contrarian, contrarian, that’s what we are. The second quarter GDP number was better than it looked, and we’re not on that side of the fence very often.
The report certainly had something for everyone. Members of the twilight-in-America set could point to the revisions that said the recession was deeper than earlier thought. Personal income had been lower too. We would say that such revisions furnish some additional explanation for the low levels of consumer confidence, which fell back to bleak levels again, but they really don’t have much significance going forward.
If you want to be a little bit more optimistic, the first quarter grew faster than originally proposed, without excessive help from a dubious price deflator (originally 0.6%, it has since been revised to 1.1%. The higher the deflator, the lower is real GDP) and real final sales grew by 1.3% in the second quarter, versus 1.1% in the first (though if you want to be a bear, you could thunder that those are low rates. Very true, but they’re still an improvement). Domestic purchasing picked up, but PCE (consumer spending) slowed.
We’re not going to dissect the report in detail for you, because it would take too long and we’re not sure it could be done conclusively anyway. We have to point out that two of the big minuses in the number were an increase in imports relative to exports, not really a sign of domestic weakness, and a big increase in the price deflator from 1.1% to 1.8% (though domestic price inflation was quite low). Many categories fared well, such as equipment, software and residential investment.
Although the consensus was for an increase of 2.5%, we think a lot of hopes were out there for something higher, and many were hoping for something in the range of 3.0%. The market would likely have rallied strongly on anything that was 2.8% or higher, but the miss had the opposite effect.
Yet as noted, Chicago saved us with a bang-up PMI report. Its overall reading of 62.3 was a big hit, given that consensus called for 56.0. Sixty-plus readings are unusual and show broad acceleration. New orders shot up along with backlogs, and even employment showed a reasonable gain. It was a good report, and is a hopeful indicator that Monday’s national ISM report could have a positive surprise.
The durable goods report for June came out on Wednesday, and was a disappointment. It combined with a restrained Beige Book later in the same day to inspire some profit-taking and arrest the upward trend. While the durable goods reading of (-1.0)% came as a distinct disappointment to consensus hopes of an increase of 1.0%, it was nevertheless a classically volatile durable goods report, led lower mainly by defense and aircraft. Although the business investment category (non-defense capital goods excluding aircraft) didn’t exactly roar with a 0.6% increase, it was still respectable after a strong May.
The Fed’s Beige Book, or regional compendium of district business reports, didn’t seem to contain much news to us. Real estate and lending are weak. Well, those two items are kind of joined at the hip, aren’t they? Is there anybody in this business who didn’t already know that they’re not doing well? Ditto for the news that manufacturing and retail sales continued to improve.
The laugh of the week, surely, was the press saying that new home sales “surged” in June. Oh, please. We already ranted about this last week, so we’ll spare you the rerun, but there was no surge. The newly revised total for May showed it to be the weakest month since 1963 – which it already was when it was first announced as 300,000. However, the sharp revision down to 267,000 made it the first official sub-300k month since that year, when records first started being kept.
As for the “surge” to 330,000, leaving aside the question of whether that number gets a later haircut as big as the previous month, as we’ve said before, sometimes the data will be a hit, other times a miss, but there is nothing going on in housing this year. 330,000 isn’t a basement rate, it’s subterranean.
Weekly claims fell, which did help the steady the market a bit. It was another heavily adjusted number, but one bright spot was that the unadjusted number fell steeply, down to 411,000 from 500,000 the week before. It isn’t unusual for claims to drop at this time of year, but the fact that they did is something that hasn’t happened much of late. It could be the start of a bright spot, relatively speaking (and we do mean relative). It’s not going to affect the July jobs report, but if it keeps up the August number would benefit.
Working against said jobs report is the end of the state and local fiscal year, which usually occurs on June 30th. The risk is that a lot of staff has been cut back or eliminated, which could show up mainly in the July report, or spill over into August. A negative print is expected on Friday, due to the loss of census workers, so the emphasis should be on private payrolls first, and such measures as hours-worked second.
In the runup to the jobs report, the ISM reports on Monday and Wednesday will tell traders whether or not to keep going long. It’s not as if the reports are likely to change many minds, but a beat in either report (especially the manufacturing number) will simply give traders the signal to bid prices up, while a miss will tell them to sell our recent rally. Is everyone really a macro maven these days? No, but in a trading race it’s better to watch what the other boats in the water are doing. If they’re wrong, you’re wrong too, but you’re not going to appear alone and ridiculous.
Pending home sales are out Tuesday, and construction spending Monday, but the sector isn’t very important to the Street right now. However, a beat is a beat, so if there’s good news from either report, it will come at the right time. Chain-store sales for July are due on Thursday; the weekly reports have been fairly steady.
Factory orders are due out Tuesday, but have been partly pre-empted by durable goods last week. Ditto for personal income and spending for June, which was mostly built into the second quarter GDP report.
If the ISM reports behave themselves, then prices could keep running up and traders will look to the ADP and Challenger reports as clues to Friday’s jobs report. If the rally continues, though, look for some pullback Thursday afternoon (getting square before the jobs report) and there will be quick exits should jobs disappoint.
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