Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
May Daze
“Doesn’t have a point of view, knows not where he’s going to, isn’t he a bit like you and me?” – Lennon & McCartney, Nowhere Man
“Tell me where the dollar is, and I’ll tell you where the market is.” Thus spoke a futures trader before Monday’s open. Later in the week another observer commented that the market was “just hedge funds trading with each other.” Both comments were largely true so far as the week’s price action was concerned, and both reflect one of the market’s habitual vacations from reality.
According to the Wall Street Journal, the “pro-growth” trade is now over. This was a momentum trade that tried to trade high-beta ideas such as commodities, materials or whatever else might be in favor as the play of the week. It’s plausible. While pretty much everything was getting dumped last week, previously fair-haired sectors such as small-caps and commodities were getting the worst of the beating.
It probably wasn’t investors that were selling, either. They aren’t prone to dumping their holdings and taking profits as soon as some magical technical line gets crossed. However, institutional investors had run cash levels down to very low levels of late, leaving them short of ammunition to try to buy the dip. That is, assuming that they wanted to, in the midst of the sea change in sentiment.
Every momentum trade needs a narrative. It’s not the basis of the trade, despite what the press usually thinks, but it does provide a kind of support system for attracting money to help fuel the trade. Eventually the narrative always breaks up, because nothing goes in the same direction forever, but the momentum trade doesn’t break up because the narrative breaks down. The trade simply gets old enough that eventually some excuse seems good enough for everyone to get out. The exit reinforces the excuse.
Such wavelets don’t drive the market in the longer term, but they do heavily influence prices in the short and medium term. Algorithmic trading, which has proliferated in recent years, tries to ride such moves and those trades tend to drive the day-to-day price action. Our best guess is that recent stresses in currency trades first caused traders to begin liquidating positions in other markets, and that begat the chain reaction that spread to commodities and then to stocks. First of all, though, we had had a long run that left the market overbought and ready for profit-taking.
So what’s next? The typical pattern for a May breakdown is for the market to flounder for a month or three. There’s a good chance that selling the rallies will take over as the prevailing theme in the near term; many are already promoting this view. The global recovery story has flagged, but the truth is that much of the hedge fund community never really believed it anyway.
Nevertheless, the reality is that the economy is improving. It’s improving slowly, though, such that we may not repeat the first quarter’s growth rate for the rest of the year. That will make it difficult for a growth story to grab the stage again quickly. Conversely, a trade that tries to build momentum off a double-dip story won’t last long either, because we will have positive growth this quarter that could even see certain sectors start to pick up again in June.
The question is to what degree fear and loathing manage to set in. If anxiety takes root and prices chop back and forth, then it could take until second quarter earnings results for the next leg up to get started again. By then expectations for the quarter would be too low, priming the market for a wave of positive surprises that would ignite a rally.
If, however, we get into a real fear-trade and the market trades significantly lower over the next few weeks, the negative momentum trade will probably break up by next month. That’s because excessive discounting of a sharp global decline would be undermined quickly by the fact that while the growth rate may be decelerating from last quarter, it isn’t turning negative either. Greece may eventually leave the Eurozone, but not next month and not this summer. The story will get old and fears will fade.
Don’t take the financial regulation story too seriously either. New regulations naturally cause a knee-jerk reaction to sell related stocks, but it isn’t as if the companies’ livelihoods are being threatened. Despite what they say, even their profits aren’t being threatened. One could justifiably say, “what profits?,” since so much of the pre-crisis profits wound up being paper fictions that vanished with the demise of the housing bubble.
Banks and credit-card companies were able to make money for decades without thirty percent interest rates or wildly leveraged prop trading desks. It probably isn’t possible to stop banks in a market-based economy from making stupidly aggressive loans at the peak of a cycle, but limiting their ability to do so will help their shareholders and the financial system. The ones who will really suffer are the CEOs who manage to cash out massive bonuses on profits that later turned out to be illusory.
The good part of the recent decline is that more and more good companies are selling further and further below fair value. They could still go down even further, no doubt about it, but the longer-term risk-reward ratio is definitely turning in favor of investors. It’s a good time to have some dry powder to put to work, though you may need a bit of nerve. The market will provide another narrative, don’t you worry.
We didn’t think that last week’s scheduled releases would have much impact on the market. That turned out to be correct. We thought that instead of the releases, earnings would have the bigger impact. That turned out to be not so correct. What mattered the most were fear, technicals and the quant program routine of the day.
It’s usually the case that news is interpreted according to a particular week’s momentum. Take for example last December, when the market sun was shining benevolently. The prevailing outlook was that the Fed would soon be dealing with rampant inflation, so the news that the Producer Price Index (PPI) or Consumer Price Index (CPI) had fallen by a tenth of a percent from the previous month would have been greeted with wild enthusiasm. It will keep the Fed on hold!
But last week we had a market eclipse. Ergo, the news (for April) was bad and evidence of deflation because the economy is weak, do you hear me you fools, weak! Run for your lives!
Thursday’s Journal proclaimed in its page one banner that inflation was the weakest in 44 years! To which we would like to say, after the biggest recession in seventy-five years and an underemployment rate of over 17%, you were expecting what maybe? A surge in demand?
Oddly enough, the overall PPI rate was up two-tenths of a percent, more than expected. However, that was due mostly to automakers pulling back on incentives, which sent their prices zagging back up again after they had zigged down in March. An interesting contrast between CPI and PPI looks set to come next month, because while oil prices have plummeted by nearly fifteen dollars a barrel in the last three weeks, the twenty percent drop in oil and unleaded gasoline futures has meant virtually no change in pump prices. Time to buy the refiners?
There are two good points to take from the price index data. One is that prices are behaving as they should, which is good news (unless you’re a gold bug). The Fed is correct in its estimation that the slack in the economy is trumping the amount of monetary easing in the system. It may very well be able to inch its way back out of quantitative easing with little or no damage from inflation. That will outrage the hard-currency nuts, but since outrage is a normal state for them, think of all the righteous blogging they can look forward to.
The other point is that whether the data had missed a tenth to the high side instead of the low side hardly mattered. When the market is going bad, all deviations from expectation are bad news. When it’s afraid, even a butterfly is a potential enemy. If, however, you start to read in the media that butterflies are threatening to fly off with your pet cat, you can take it with a grain of salt.
A piece of news that certainly contributed to the negative mood of Thursday’s sell-off was a startling jump in weekly initial unemployment claims. The general thinking has been that a big drop in claims has been waiting just around the corner, so the hefty spike of 25,000 in the other direction was a very unwelcome development to the “strong and robust” camp.
Yet the spike may have had more to do with last year than this one. The raw data for last week actually showed a drop of 1,819 from the previous week. Our guess is that the adjusted data is being thrown off by last year, which saw a steep surge in claims to over 700,000. That turned out to be unsustainable, thank goodness, and by this week last year claims had fallen to the 540,000 level.
Claims this year have been on a much flatter trajectory, however. The gap between this year and last year had been closer to 160,00, but last week the difference was only 140,000. Claims were almost a third higher a year ago than they are now, but fell on a steep trajectory from the spike. This year unadjusted claims have declined slowly.
So the current data got a 25,000 adjustment boost despite falling by nearly 2,000. That is probably a better indicator of the limitations on using trends to make adjustments. The weak decline in claims is entirely consistent with the premise espoused here and elsewhere (Pimco, most prominently) that the economy is recovering, but only slowly.
That will be a source of disappointment to a more optimistic narrative, but the economy itself is not experiencing the dreaded “double dip.” The dip is coming in share prices. If those prices overshoot enough to the downside, though, economic actors will again become cautious, and that could indeed throw a temporary brake on things. We believe that the overall trend of slow recovery will stay intact, however.
State unemployment data released Friday for the month of April showed broad improvement, with 34 states reporting declines in unemployment rates. Manufacturing continued to improve, albeit at a slower rate. That was reflected in the May surveys from the Philadelphia and New York Federal Reserve Banks, which showed slowing rates of growth in new orders. The New York index surprised the markets with its sharply lower (though still expansionary) reading.
The slowing growth is consistent with our proposition that the current improvement is a rebound that will slow soon, rather than Wall Street’s straight line (the only kind of outlook that ever gains wide currency there). Before you step out onto the ledge, though, such a development contains positive possibilities.
Inventory replacement has improved, but is still running below sales. Ergo, it will either have to pick up soon or run for a longer cycle than normal. A slower recovery path will be disappointing for job-seekers and momentum traders, but it may result in a more stable rate of growth.
The housing story is largely unchanged. It’s still dragging along the bottom, but perhaps a bit higher up the side of the trench. As we predicted, the homebuilder sentiment survey finally broke back over 20, for the first time since September 2007. Housing starts rose more than predicted for April. On the other hand, building permit filings fell sharply during the month, and mortgage-purchase applications plummeted by a startling 27% last week, taking the latter index to its lowest level in over a decade. Ouch.
Existing home sales are due out Monday, and should report a better increase than the conservative estimate of a 5.6 million annual rate. As the permits and purchase application data clearly show, however, the expiring tax credit pulled some sales forward, so you can expect a drop for May.
It won’t be the end of the world, but the simple fact is that with credit and employment conditions improving so slowly, housing just isn’t going to get much better this year. It won’t get worse, and there are spreading signs of improvement. It just won’t get better very quickly.
Leading indicators declined in April by (-0.1)%, surprising both us and the market. We didn’t think that things were so robust, but with the yield spread intact and the stock market gains for the month, we though it would lead to another easy gain. However, the big drop in building permits turned the tide, along with the known softness in initial claims, money supply and supplier deliveries. The Conference Board posited that growth would come “at a more modest pace in the near term.”
The latest FOMC minutes were released on Wednesday, and for once they didn’t seem to attract much attention. The staff upgraded its forecast for the year to 3.2 to 3.7%. When second quarter GDP comes out, though, they will lower it again. The staff’s forecasts aren’t especially good. Like most forecasters, they seem to be content with linear projections in a non-linear world.
Next week has some interesting wrinkles. Although Friday is only the 28th of the month, it will be the last trading day, as Monday the 31st is a national holiday in the U.S. Some markets will closer early Friday afternoon. The stock market will keep regular hours, and we could see some interesting late action. Many of the human traders will hope to leave early, and if they do so, that could leave an already over-automated market even more in the grip of the trading robots. Another last-hour big move is probably a good bet.
Besides the existing home sales report Monday, housing will offer up the latest price data in the form of the Case-Shiller and FHFA indices for March on Tuesday. April new home sales follow on Wednesday. Given the looming expiration of the tax credit and an associated increase in activity, it isn’t unreasonable to expect improvement in all four reports.
On the manufacturing side, durable goods for April come out on Wednesday, with all signs pointing to a good increase. The Chicago PMI (regional version of the ISM) survey comes out Friday. The Chicago survey is strongly influenced by conditions in the auto industry, so any sign that the automakers are dialing back on production would show up there. A decent number is expected.
Another GDP revision (first quarter) is due on Thursday, and from what we’ve seen, we’re leaning toward a small tick upward. However, were the GDP price deflator to fall in line with every other inflation measure, we could even get a tick down. Don’t bet on it.
We’ll also get reports on first quarter corporate profits (Thursday) and personal income and spending for April (Friday), but the report of the week should be the Conference Board’s consumer confidence report on Tuesday. It’s the sentiment report that the market heeds the most, and the recent red ink in stock prices and weekly unemployment claims may have dragged it back down this month. The market won’t like that, but if the decline is small it may beat expectations.
On the earnings front, it will be mostly retailers, including luxury goods maker
Tiffany’s (TIF) on Thursday. Homebuilder Toll Brothers (TOL) comes out
Wednesday, and if the market is looking for direction, Toll could be influential.
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