Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Catch a Wave
"You gotta catch a wave, and you'll be sittin' on top of the world." - Brian Wilson & Mike Love (The Beach Boys), Catch a Wave
You sure can tell springtime is coming. The markets put on a near-effortless rally of about three percent last week, greeting reports sundry and not with unbounded good cheer. You may or may not know that March has been a great month in equities for the last four years, or that April is the best month of the year overall. Well, trust us, traders do know.
For several years now, we have found ourselves writing a springtime column called “Hope Floats,” which has come out variously in late March or April. We’ve no reason to doubt that this year’s spring won’t see another edition. The markets may be a bit overbought at the moment, and likely to get more so this week, making us due for a bit of a pullback. But our guess is that unless the Chinese pull a stinker out of their hats, 1200 on the S&P 500 is in the bag this spring (it currently sits about six percent away at 1136), and it could easily go higher.
The Europeans are making the right noises about the Greek debt problems. Such crises usually take about a year to get to the point that they can no longer be ignored, so it may take until next winter before we discover that there is a country (or two, or three) deeper in the soup than we thought. But for now, the seas appear calm again, calm enough to pull out that long board and get tubular.
As we suggest below in The Economic Beat, we don’t think unemployment has “turned,” despite some of the hype in a business press forced to explain why the markets were up. The outlook for employment, housing and income is uninspiring at best. But it appears that we are in a restock process that could last a couple more months, and we have the waves of springtime ready to break in our favor. That will keep a favorable slant on the news flow.
Prices won’t go straight up, and the risk of an unwelcome intrusion of reality from the Far East or Europe remains. There is also the problem of bullish conviction getting too widespread and the market racing too far ahead of itself, inviting retaliation. But we are more likely than not to navigate those shoals, at least for the next six weeks or so.
The irony is that the main nemesis of the market for the next two or three months is itself. The way the modern market moves these days, as soon as some year-end target on the market starts to take hold in the popular imagination, traders are apt to try to get there as soon as possible. Why wait? But getting there too quickly will result in disappointment, because the economy simply won’t improve fast enough to support a valuation based on what the view might be nine or ten months from now.
Another problem the markets are likely to run into is their own success. If we’re able to get to 1200 or 1250 in the next two months, not at all implausible, such a run-up would make it more tempting for governments to get some dirty work out of the way. The Chinese might decide to get more aggressive with tightening, causing a bigger slowdown than is baked in.
Too much animal spirits could also inspire the Fed and/or the European Central Bank to withdraw easing faster than thought. Consider the ridiculous increase in oil prices, for example. Stockpiles are growing and demand is weak, but prices rally anyway. The increasingly strong correlation between equity markets and commodity prices make it quite plain that financial speculation is the marginal price driver in the asset class.
For the near term, until and unless some new regulations get passed, it isn’t possible for equity prices to rally without taking commodity prices with them. In this credit-starved world, the leveraged nature of futures contracts makes them a natural vehicle for leveraging performance bets. Thus, an extended rally in equities could quite easily take oil prices towards $100/barrel, despite the lack of demand (there are always oil fires and productions stoppages somewhere, so one can always talk up supply shortages).
The resulting price pressures would bother central banks and possibly backfire on the markets. Although talk of raising rates or other tightening can engender a knee-jerk rally in a market worried about growth, it doesn’t last, especially after a couple of months of hot numbers. Eventually fear would overcome complacency about growth.
That could provide another temptation to the Chinese. Faced with robust Western equity markets and soaring commodity prices, the country’s leadership might decide to get more aggressive about inflation and lending. That could blindside a rally that had decided that all must be well, or else why would prices be up?
There’s precious little money coming into the markets, making the rally more precarious. Yet as the time since last year’s abyss passes, a growing sense of safety at the corporate level is taking hold. Combine that with large stockpiles of cash at big companies, very low interest rates and investment banks desperate for a kicker, and the market’s cash supply is likely to be augmented by an active mergers market. Of course, that could result in the retail investor being finally tempted in again just as prices peak, but that’s tomorrow’s problem.
In any case, those scenarios should take time to develop. Although some pullbacks from overbought conditions would occur along the way, it looks to us like spring is here and the surf is up. If nobody blows up anything big, the market should put on its usual rites of springtime dance and fall in love with itself the way it usually does. Then we’ll get the usual hangover and regrets. Until then, enjoy the surf – while it lasts.
Much of last week’s surfing fever was centered around the Institute for Supply Manufacturing (ISM) and – naturally – the jobs report. We say “naturally” because the two reports that markets most love to rally over are the jobs report and the Fed statement. If either report does not present actual documented evidence of outbreaks of bubonic plague, the equity markets are nearly always overjoyed at such an unexpectedly favorable turn of events.
The ISM reports, and in particular the reaction thereto, were about what one might expect at an early stage of the recovery. That’s the good news (and a vital part of the “V” recovery narrative). The dark cloud attached to that silver lining is that they were also perfectly consistent with a rebound that has already passed its apogee and is beginning to ease (can you say, “new normal?”).
That has both bears and bulls claiming the field and amping up the sardonicism about the other side’s inability to read data. That is typical of early-stage recovery, enabling veteran bulls to lean back in their chairs knowingly in expectation of validation. It’s also characteristic of a short-lived spike: the bears and skeptics aren’t ready to run.
The manufacturing edition of the ISM posted a decent result of 56.5. It’s a good result, but despite the folks at Econoday using “strength” every few words in their summary, along with the adjectives “exceptionally strong” and “very strong” (twice), it was a point below consensus and represented a slowdown from the January reading of 58.4.
If in fact the rebound had crested, or is cresting, one would expect a slowdown in new orders (leading) and a pickup in employment (lagging). That’s exactly what we got. The comment from the machinery sector that “the economy has killed new capital sales” correlates better with the actual January decline in new orders from private business investment than “very strong” and “exceptionally strong.”
Yet it’s still too early to call. For its part, the jobs report surmised that manufacturing employment was unchanged in February, despite some of the glowing descriptions about how strong the sector is. The services sector, though, reported an increase to 53 overall versus expectations for 51, which made the report suddenly more fashionable. New orders increased to 55, which is nice, but only nine of the seventeen industries reported growth, with the other eight reporting contraction. That was not so good.
One puzzle was the retail trade sector complaining that unemployment and housing continue to hurt business, though anecdotal evidence about the sector enjoying robust full-price business abounds. It looks to us as if there are fewer customers, but the ones who are less scared about the economy (especially those able to cash a good bonus check) are letting up on the purse strings a bit.
Snow was the villain of the week and may well repeat its role this week in retail sales, housing and unemployment. Despite the protests from retailers, who always blame weather, we are unconvinced. The Labor Department hasn’t blamed the weather for much of anything and opined that it had no impact on the employment situation.
Economist (and skeptic) Dave Rosenberg reminded us that the great snowstorm of 1996 turned out to have no impact at all. We would point out that although the Mid-Atlantic got much snow and even more snow publicity, February was a below-average month for snowfall in most of New England. The rural mountainous regions got plenty, but little fell in the more populated coastal regions.
It’s probably best to keep in mind that February is generally the weakest month of the year for retail and housing, and really isn’t important as an indicator (unless it generates a positive surprise, in which case it is important in the canyons of Wall Street). It’s a month of big seasonal adjustments in both sectors, as well as in the employment report. As an example of the latter, the unadjusted employment rate is 10.4%, versus the seasonally adjusted rate of 9.7%. The former, which eased from 10.6% in January, might explain why confidence indicators have been falling.
However, the equity markets aren’t known for deeply looking into nuances, and neither they nor the business press got bogged down in them in the wake of the February jobs report. Never before have we seen a monthly net loss of 35,000 jobs so triumphantly hailed as the rainbow we’ve been looking for. “Outlook Brightens for Jobless,” hailed the Journal, which blamed the snow for shortfalls, and “Jobless Data Boost Hopes for Recovery” proclaimed the usually more reserved Financial Times .
It was widely reported after the report how it had smartly bested the consensus estimate for a loss of (75,000) jobs, although we thought it curious that the number had only emerged as consensus after the fact. Prior to the report, the general consensus was for a loss of (50,000). We rather thought the report worse than expected, because the various teaser reports earlier in the week had indicated something smaller.
There was good news in the temp data, a leading indicator (in theory) that rose by 47,500 (maybe). But there was bad news in average weekly hours, which fell a tenth; in the aggregate weekly index, a coincident indicator that fell three-tenths; and in average weekly earnings, which fell a dollar. You didn’t read much about that, but it was easy to find that December losses were revised downward from (-150,000) to (-109,000). The part about those losses being originally announced as (-85,000) slipped off the page.
Let’s just say that the folks at the Liscio Report, who specialize in the analysis of employment and sales tax data, commented that “it looks like the hiring strike continues.” It seems that the probability of an unemployed person finding a job fell last month, to nearly its low point in the cycle. For them, the market is stabilizing, “but it’s not really turning around,” and there was “very little evidence” for a weather effect.
Pending home sales fell sharply in January, pointing to lower sales in February and March. Again the weather was blamed, and January was indeed a difficult month. However, mortgage purchase applications were lower throughout February, despite a rebound last week, so don’t look for an improvement soon. 15-year rates have fallen to 4.25%, which would be wonderful if it wasn’t only available to people who don’t actually need a mortgage to buy the house.
That report was ignored, along with the weekly claims report that 470,000 additional people filed new claims. We think the latter stinks, along with the jobs report, coming over two years into the recession and a putative seven months after the economy was supposed to have turned. But you probably already know that we think that, and that the market doesn’t care.
Factory orders were widely reported to have risen 1.7% in January, although they were up only 0.1% excluding transportation (less widely reported) and durable goods were revised downward (much less widely reported). We found it interesting that computer orders fell. It’s only one month in a volatile series, but we’ll keep an eye on it. In other January data, construction spending was reported to have fallen (-0.6)%. The year-on-year decline improved, though the comparison is more than a little suspect.
Motor vehicle sales came up short of expectations, but not for Ford (F), which has been riding a real wave of late. That may mean another fall in consumer credit, which rose in January for the first time in months, although credit card levels continued to decline. Still, the decline was light, indicating some stabilization.
Finally, the Fed’s Beige Book also blamed weather for holding back the economy in a report that characterized conditions as “mixed.” An aspect that the equity markets didn’t like so much was that loan demand was reported to be weak across the country, and that banks remain cautious.
Next week has the mid-month lull, a very light calendar with little of interest before Friday’s retail sales report for February. International trade will check in on Thursday morning and the University of Michigan will give its first consumer sentiment reading for March on Friday. Two inventory reports are due out for February, which should give a clue to whether restocking has finally begun.
Light calendars usually mean a continuation of the previous week’s momentum, meaning an up market. Abetting that is an outlook for mild weather in New York and a calendar of earnings reports dominated mostly by retailers, who have been pretty chirpy of late about their improved margins. Caveat emptor.
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