Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Falling Leaves
"Hiring man says, 'Son, if it was up to me.'” - Bruce Springsteen, Born in the USA
It’s become something of an annual ritual in recent years for traders and mavens to start passing the time in late August by talking about how dangerous September can be for the markets. The point of this little exercise is to try to defang any problems in advance by talking about how really, really bad things can get and thus ward off frights at anything short of Armageddon. Duly prepared, the market can more confidently brush aside most problems and keep up its bull momentum.
Last year, the market was busily rising right up until Lehman Monday, ignoring the collapse of financial stocks along the way. Oops, Armageddon. What has become something of a cliché in recent times is that the markets emerge from September on a run that ignores everything but its own momentum, putting off the bill until October. The October game is to try to defer reality until January, but it hasn’t been as successful.
The fade in the economic data that began two weeks ago with a report on listless August housing starts has now spread throughout the broad areas of the economy. A thorough review of the economy’s moving parts has led us to believe that September was a lot worse than the market seems to want to believe. True, we’ve had two down weeks in a row – and investigations into such a scandalous development are underway – but the damage is pretty minimal in view of the gap between reality and expectations. Or put another way, estimates and prices.
Take mutual fund managers. For them, the real estate brokers of the investment world (it is always a good time to buy mutual funds), the jobs report was apparently a parlay that could not lose. A good report would have validated the “V”-narrative and sent a clear signal to buy stocks. The weak report, however, gave them the dip to buy that they have been fretting over. All outcomes led to buying stocks.
That kind of thinking always precedes a correction, but naturally there’s a catch: the markets can live with that kind of contradiction for longer than you think. It usually takes some time for the market to finally give up its beloved momentum. The fact that traders know this tends to make the momentum trade tenacious, self-reinforcing, and punctuated by steeply sudden blow-offs.
Fund managers were quick to jump on Pimco chieftain Bill Gross’s remark that the jobs report would keep the Fed on hold for quite some time as an added justification to buy, while eliding the part about the reason being very low growth. Traders happily followed them into the market, and then dumped their positions going into the close.
These weak closes of the last few days are generally not good omens for prices, but everyone could still feel good at the end of the day. Traders had benefited from another quick flip, fund managers could pat themselves on the back for buying near the lows, and everyone could talk about how resilient the market was at the local watering hole. It looks to us like the market can handle another two or three percent down before the dip-buyers would start losing their nerve.
Should they do so, the traders would quickly chuck everything to protect the year’s profits, adding to the damage. The final tally? Well, for you remaining hardcore efficient-market holdouts, consider that it could depend upon the time of day. We currently have a large crowd milling around the ten percent correction line as the cue to jump back into the market and start buying with both hands.
That’s the plan, anyway. The reality is that if the market were to hit the ten percent line in the first hour or two of trading, then in the absence of any surprise shocks to the system (you know, like an investment bank bankruptcy filing) there very likely would be a fierce snap-back rally as the ten-percenters piled in and professional traders jumped on for the ride. But if we were to hit that magic line in late afternoon trading, say after 2 PM, it’s more likely that participants would simply stand aside and wait to see how bad it got. As Louis Armstrong liked to observe, it’s a wonderful world.
If you think that’s ironic, then chew on the lifeline that Goldman Sachs (GS) threw the market on Thursday in the last hour of trading. At the beginning of the week, Goldman had been estimating a loss of (-150,000) for the jobs report, but suddenly switched to an eleventh-hour estimate of (-250,000).
The change of heart could have come from the ADP payrolls estimate released Wednesday morning, but in any case most market participants believe that Goldman has a wire on these reports (did Mr. Beeks arrive in time?) and so there was little sting left in the remarkably close number of (–263,000) the following day. Had that jobs number instead burst upon the market late the previous Friday, without warning, the damage would most likely have been quite ugly.
Fortunately, though, the warning sirens blared in time and another iceberg was avoided. Easy stuff, this cruising through the icy waters, isn’t it? Just like it was in September 2008, or September 1987. Don’t worry, though, the bull strategists tell us that it’s always a bit rough in the early going.
Time will tell if September was indeed just a stutter-step on the road to recovery or another dot to connect in the L-shaped scenario. The weekly data in the second half of September showed mortgage purchasing applications steadily weakening, retail sales weaker than the first half, and jobless claims rising at the end of the month. That doesn’t sound like we hit the fourth quarter running.
But a couple of weakish months won’t mean either that stuff doesn’t run out and have to be replaced, or that we’re all going to the devil. The economy has to start walking before it can run, after all, and Wall Street time hasn’t even been in the same dimension as the economic cycle for over a decade. It just means prices got ahead of themselves a bit, and would require some adjustment.
Should that happen, be prepared for some fairly loud weeping and wailing, especially from the financial press. Having stayed bearish for months after the rally began, they have only recently been coming around to the bullish camp and will not take the reversal kindly. But you can’t stop the changing of the seasons.
The data last week painted a fairly uniform picture of a rebound that is flattening out ahead of the schedule the rally gave it. The market hates to give up on momentum, so the excuse-me phrase of the week is “bumpy start,” which has a soothing reassurance about it. The report that caused the most excitement was the upward revision to second quarter GDP, from a loss of (-1.0)% to one of (-0.7)%, although that outdated data point was the least important of the week. It did have the key virtue of being up, however.
The hodgepodge of adjustments that went into the revision was led by help from the price deflator: the current-dollar estimate of GDP (-0.8)% is still unchanged from its first look months ago. Looking at the details under the hood, the most encouraging note from the point of economic activity was that imports didn’t fall as far as estimated. Otherwise the trends in sales, profits and cash flow didn’t look so good to us.
Manufacturing and employment reports were sharp disappointments, at least if you live in the real world. If you’re a fund manager or brokerage strategist, they were good, because they keep the Fed on hold (!). We wish that we were making that part up, but we’re not.
The best part of the manufacturing news was the ISM was unchanged from the month before, at 52.6 versus 52.9 (the tenths really don’t matter), pointing to slow-but-steady expansion (of course, another possibility would be, “feeble bounce”). It fell about a point short of official estimates and at least two or three points shy of the whisper numbers coming out of the weekend, but the regional survey from Chicago the day before had jolted expectations back downward.
That particular result, known as the Chicago PMI (for Purchasing Manager’s Index, which is at least closer to the “National Association of Purchasing Managers” name that the ISM used to call itself) was a stiff disappointment. The contracting indicator of 46.1 (50 is neutral, expectations were for 52) wiped out the good feelings generated earlier that morning by the revision to secondquarter GDP.
The silver lining of the Chicago news was that it readied the market for the shortfall in the national number the next day. The bad news in both reports is that the trend in new orders weakened, though still remained positive, while employment stayed weak and inventories showed little improvement. Prices paid are remaining firm, with one ISM respondent complaining that suppliers are using any order increases to try to raise prices. Normal enough behavior, when one considers that the market has been rewarding stock prices for higher margins while overlooking falling sales.
The depressing last word on manufacturing came from the factory orders report, which showed a fall of (-0.8)% for August when they were expected to rise by a percent. The number was led down by a downwardly revised drop in durable goods, but that category was still returning to normal after a big July airplanes order for Boeing (BA). Things weren’t looking so bad outside transportation, but the problem is that they weren’t looking so great, either. The non-durables increase was due mostly to price increases in oil and coal. This economy is not doing much.
A big reason for the feeble economy is the consumer. Confidence, as reported by the Conference Board, fell last week back to 53.1 from 54.1. That may not seem like much, but it was supposed to rise to 57 if not higher, following the improvement in the University of Michigan survey (which tends to track stock market movements more closely). The long-term average for this survey is in the eighties. Poor employment and income prospects are dogging the consumer, according to the Board, and that is going to crimp demand.
The personal income and spending reports for September clearly illustrate the current situation. Despite the “better-than-expected” monthly increase of 0.2% that was at times inanely praised in the financial press, disposable real income fell again (-0.2%) and the year-on-year decline widened slightly from the previous month. Market commentators tried to portray it as good news and dutifully echoed the current pablum about inflation being so weak (1.3% over the last twelve months) that it will “keep the Fed on hold.”
But the consumer isn’t feeling better about income. Inflation is weak because demand is weak and the last thing the market should be worrying about now is the Fed raising rates. Auto sales fell so dramatically in September (except for Ford (F)) that the whole cash-for-clunkers program was called into question. Weekly retail sales are doing better this month, but not by a lot and the seasonal bounce seems to be losing momentum.
It’s hard for the consumer to feel much better when the so-called “true” unemployment rate (the Labor Department’s “U-6” rate, which counts discouraged workers and part-timers who can’t get full-time work) has risen to 17%, or more than one in six Americans able and willing to work – which itself is shrinking as more people get discouraged and drop out. The record number of long-term (more than six months) unemployed workers is a problem that isn’t going to solve itself with a quarter of inventory profits.
Not only did job losses reverse course and worsen in September, but weekly hours fell back to their all-time low, the coincident indicator of weekly aggregate hours fell back, and the manufacturing workweek fell despite the ISM positive reading. It was a horrible report and the market would surely have reacted worse if the unemployment rate had gone to 10 percent rather than the 9.8 reported, but what saved us was the number of people kicked out of the labor force. It wasn’t any flattening out of losses.
Unemployment is worse than that 9.8 number, and the market simply hasn’t come to grips with how bad it really is.
The department’s preliminary estimate of its annual revision to the data is a staggering additional loss of 824,000 jobs, or around 100,000 a month so far this year. That isn’t far from the phantom number added by the department’s “births-and-deaths” model (not people, but small businesses) that we have been taking to task all year as not suited to years like the current one (not a normal distribution year). Apparently small businesses died off in massive numbers in the first quarter.
The current recession has encompassed the worst decline in employment since the end of World War II, when demobilization suddenly took millions of men out of uniform and put them back into the labor force. The Liscio report, an economic service that crunches and sifts through the details of government statistics, commented on this decade’s employment picture by saying it had “never seen anything remotely like that kind of carnage in seventy years of monthly stats.”
Oh well, jobs are a lagging indicator, right? So we shouldn’t worry that weekly claims rose back up to 551,000, a figure that we would have given no credence three months ago. That was when the recession was supposed to have ended, remember, and so jobs are supposed to be improving now. They aren’t. Citing the Liscio people, post-financial crisis recessions “are typically anything but the V-shaped affairs that many observers are dreaming of.” True, but at least the Fed will be on hold.
Turning to housing, it’s still at the bottom and isn’t moving. Mortgage purchase applications fell again and are back to levels of a couple of months ago. August pending home sales rose 6.2%, but the July increase in pending sales failed to translate into any increase in actual sales. Some were talking up that result as a potential one-off, but our prediction is that in the absence of an extension to the tax credit, home sales are going to retreat again just as auto sales did. Given credit and seasonal conditions, even an extension might not do the trick.
The Case-Shiller number reported a third month of increases in monthly home prices for July, though they are still down about thirteen percent compared to July 2008. But housing is seasonal and August data indicated some weakening; we think that the only thing that can save the Case-Shiller number from taking a seasonal dip is a change in sales mix. That could happen, but whether it does or not, this industry isn’t getting better yet, just not getting worse, and the homebuilders are going to be in for a long winter.
The most distorted report of the week was the “increase” reported in construction spending for August. It was actually $17 billion below the originally reported figure for July, but both June and July had whacking big revisions taken to them and ended up being much less than first reported. The real estate area in general this year has been the subject of a seemingly endless number of phantom improvements that are subsequently (and quietly) revised away. Going by the headlines, one would think that the area is steadily perking up, yet the revised data say it’s steadily declining – as do the figures on construction employment and homebuilder revenues.
Next week will be as light as last week was heavy. After the ISM non-manufacturing index on Monday – estimated to be finally unchanged, at fifty – there is little else. Consumer credit comes out Wednesday afternoon, but the market cares little about it or the international trade figures on Friday. Currency traders may use the latter to justify whatever is going on in the dollar, but only if it helps the trend.
Chain store sales for September are due on Thursday and though there are few remaining chains that report publicly, that should get the lion’s share of publicity. The weekly sales data suggest some mild improvement over last September – which wasn’t exactly a happy time – and if that should be the case, it will provide some ammunition for bulls.
Discount retailers Costco (COST) and Family Dollar (FDO) add to the picture with earnings results on Wednesday, and aluminum giant Alcoa (AA) officially kicks off the third quarter earnings season with its results after the close on Wednesday.
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