Avalon's MarketWeek

Changing Seasons


“You ain’t seen nothin’ yet.” – Bachman Turner Overdrive

What a week, and it’s only the beginning. The sheer speed of last week’s downturn and rebound, not to mention its size, left a cluster of suspects in their wake and roused substantial vitriol from those who have been waiting to pounce on the stock market, Fed, or both. Voters and politicians can’t legislate the stock market (hello, Beijing) but, heaven help the Fed if it gets left holding the bag for the next bear market. Whatever timetable you may have for one, bear markets are inevitable, yet at the moment the Fed has managed to maneuver its way into being suspect number one for the next one. Heaven help us all if one of the consequences is a decision by Congress that it needs to get more involved in central banking. The very thought of it makes me shudder – ISIS could probably not do more damage to our economy.

It’s a widely-held misapprehension, particularly in the business media, that the business cycle only ends at the discretion of the Fed, when the latter decides to “jack up interest rates and send the economy into recession,” to approximate a certain national reporter’s phrase that has stuck in my mind. The corollary would be the nonsensical notion that the business cycle can be obviated by the simple act of never raising rates, or just keeping them at zero forever (the preferred solution of CNBC newsreaders). Problem solved!

Nevertheless, business cycles do end and as they do, trading tends to be dominated by speculation over the next Fed rate move. A very good reason for that is that corporate profit growth has largely ceased to be exciting by that point, certainly the case now, with quarterly profit growth for the S&P 500 estimated to be slightly negative. With only about ten companies left to report for the second quarter, FactSet has the index’s aggregate earnings growth pegged at (-0.7%). If you just take out energy, industrials and materials, though, earnings growth looks good. You gotta accentuate the positive. Aggregate revenue growth is worse, though, around (-3.4%).

All of the above tells you that the valuation base is weakening, a big reason for last week’s outsized volatility. Valuations themselves usually don’t influence the direction of prices, but the latter do need some sort of positive growth for fuel. When they don’t get it, support levels can collapse a long way.

When the longer trend starts to buckle, then short-term factors churn out more violent moves. Several factors were at work in last week’s action, including good old fear and cash. Institutional cash levels have been at record lows, making redemptions more problematic in a climate dominated by worries over global growth (China above all) and a year of stock prices stuck in neutral. Algorithmic and high-frequency trading amplify short-term moves anyway, so in a light-volume month like August, a surge of redemptions and margin calls can turn brush fires into something much bigger. Tuesday’s outsized selling looked very much to me like a slug of fund redemptions being electrified by the algos in a climate of low buying interest.

But the buyers aren’t out entirely, not yet. There is still money to be made trading the long side, and I expect periodic rallies that will try to take back the year’s previous highs. I plan to trade them myself. But the going won’t be easy, and moves back to the old highs will be good occasions to sell, whether they break through or not.

The Economic Beat

The report of the week had to be the second estimate of second-quarter GDP. It was a lifesaver. Coming in at a hefty 3.7% versus consensus estimates for 3.2%, it threw a lot of cold water on the growth hysteria that had gripped the market.

The latest number does look much better, but there were a few prominent weak spots in the upward revision, starting with an upward revision in private inventories. The latter are already quite high, and there is surely going to be some contraction down the road to balance them out. Last year’s long West Coast port strike left many retailers short of product for the holidays, leading many to move up delivery schedules this year and the subsequent inventory bulge. I’m not sure how the Bureau of Economic Analysis (BEA) is going to handle the seasonal adjustments for what will probably be atypical numbers in the last third of the year, but at some point there has to be a reckoning.

Another big jump came from government spending, but one never knows the future with that kind of number – there are always special factors with that category, it just depends on how big they are. One of the contradictions came in trade, with higher exports and lower imports in the face of what was supposed to be higher consumer spending. Dollars and energy aside, import prices have been falling faster (-10.4% year-on-year) than export prices (-6.1% y/y) and is isn’t because our good old American exports are doing great. Higher consumer spending is being heavily fortified by junk auto loan financing, the kind of thing that can (and does) disappear from one month to the next.

I’ll tell you two other problems with the alleged GDP rate of plus 2.1% for the first half. One is that gross domestic income was up only 0.6% . Without weighing in on the longstanding argument about which measure is better (the debate is usually ideological), the discrepancy does put an asterisk on the quarter’s GDP for me, at least for the time being. A second problem is corporate profit growth. Despite a second-quarter improvement, the official measure of after-tax corporate profits (with inventory adjustment) was negative in the first half of the year. Not by a lot, but it’s another big bright flashing yellow light that suggest not putting all of your money on the GDP read. That said, you can expect the reading to get a lot of attention in the coming weeks as incontrovertible proof of a robust company. Four-quarter nominal GDP now stands at 3.66%.

A similar misread comes from the latest reading on durable goods. The July reading showed a 2% increase in new orders (seasonally adjusted, or SA), 0.6% adjusted excluding transportation. The business cap-ex category came in for lavish praise, up 2.2% following a 1.2% increase (both SA). Words like “strong” and “solid” were in abundant supply and talking heads will cite them in often-puzzled fashion as they marvel at how people can overlook how good the data is.

Because the data isn’t good, for one thing. Lost in the noise about an apparent pop is that new orders for cap-ex were down in July on a year-on-year basis for the seventh month in a row. Durable goods orders are down 5.1% on a year-to-date comparison, (-2.0%) excluding transportation. Business cap-ex is down 3.4% year-to-date.

Apologists will blame energy, and it’s certainly true that spending on energy exploration and production has taken a big hit this year from lower prices. Yet it’s also true that energy had been most of the only growth in cap-ex before the oil storm hit. Beware of the phenomenon of every downturn of the last few decades: they have begun with one sector conspicuously weakening first while Wall Street investment banks proclaim that one must focus on the rest of the economy. GDP is not strong and neither are orders for durable goods. Regional monthly Fed surveys released last week include Kansas City with an ugly result of (-9) and Richmond with a no-growth read of 0 (zero is neutral in both cases). Dallas will report on Monday, and it will be a surprise if the energy-centric region isn’t negative too, meaning Philadelphia would be the only positive regional reading of the month.

The latest housing data was good but not great, and will probably stay that way until the business cycle is in an actual downturn. Federal mortgage-based data shows an annual rate of price increase of 5.6% through June, while Case-Shiller data reported that its rate had contracted to 5.0%. New home sales rose to a seasonally adjusted annualized rate of 507,000 in July, with 500K being about the rate sales have been running at for most of the year.

Personal income rose an estimated 0.4% in July and spending an estimated 0.3%, with year-on-year real disposable income at 3.3% and spending at 3.2%. The rates are decent and reflect full employment, but are not showing new trends.

The focus next week will be on any Fed remarks and of course Friday’s release of the August jobs report. Being the first week of the month, we’ll also get the latest ISM purchasing manager surveys, with manufacturing on Tuesday and services on Thursday. They’ll be preceded by two regional surveys on Monday, the private Chicago purchasing index and the public Dallas Fed index.

It’s a heavy week, with the preliminary construction estimate and auto sales also on Tuesday. Wednesday brings the ADP payroll estimate, factory orders, productivity and costs and the Fed’s Beige Book, the compendium of regional business reports. Thursday adds international trade and more information on current GDP. China and Europe will release purchasing manager surveys throughout the week.

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