Avalon's MarketWeek

March Moonshine


“Stupid is as stupid does.” – Forrest Gump

One week ago the stock market was on a three-week losing streak, one of nevertheless modest proportions, that inspired me to remind readers that this was not the beginning of the end for the bull market in equities. Last week’s roller coaster ride seemed to confirm the fact as Fed-besotted traders and their programs sent the major indices to new highs, leaving the Nasdaq just a few ticks short of its all-time bubble high set in 2000.

Yet it was last week that was more indicative of a bull market in its waning stages. For many years now, the fiercest rate-related rallies have always come in the last year of the bull, based not on actual moves by the Fed itself, but by sudden shifts in the market’s convictions about what the central bank must do in the face of weakness. The Fed-inspired rip-reversal was the classic episode of people rushing from one overloaded side of the boat to the other. Never mind that the boat cannot carry so many people or that there is a small leak – the essential is that everyone is now on the safe side of the boat.

The Fed’s monetary policy arm, the FOMC, and its chair Janet Yellen, may be in something of a self-congratulatory mood right now, as it would seem that they pulled off a very neat threading of the needle with their statement and press conference last week. I had written that should the committee leave the word “patient” in its latest statement, it would occasion a furious rip-reversal in equities. Yellen and company seemed to have it both ways, simultaneously removing the sacred word while convincing the market that it would nonetheless remain at least kind of patient: no cut in April (barring a miracle) and seriously undermining the case for any increase later in the year.

We will depend on the incoming data, sayeth Yellen over and over again, both building a case against any Congressional rate-making rules (one can imagine the current House passing a resolution that forbids rate decreases under Obamacare, or ties them to immigration rules) and strengthening the case against raising rates by lowering the target range for unemployment while downgrading forecasts for inflation and growth. Ergo, just let the BLS keep putting out those job reports that we said would make us end ZIRP (zero interest rates). We’ll simply lower the jobs banner that we put up when we needed to make the case for QE, and raise the inflation one instead. That dual mandate sure comes in handy.

For many investors and onlookers, it seems simple enough to say why not? Why should the Fed be raising rates when the economy isn’t that great anyway and it’s so obviously good for the stock market? One may as well ask why one should be taking the patient off the morphine drip when it is clearly keeping him or her happy. The answer of course is that morphine does not cure anything, is not natural to the body, and prolonged administration will both delay genuine recovery and increase addiction levels. All of which all applies to our economy and stock market.

“Overall measures of equity valuations are on the high side,” repeated Yellen, “but not outside of historical ranges. By this she must mean, “not in the ’99-’00 bubble range,” because the stock market is outside of every other historical range but that one and the one prevailing in 1929. 1929 is far away and antique and so doesn’t apply, don’t you know, and we all know (don’t we?) that we’re not in another dot-com boom, so move along folks, there’s nothing here to see.

Now, it isn’t recommended for Fed chairs to proclaim that markets are too high (too low is okay), so I don’t expect anything in that regard from Yellen or anyone else in her position. In fact, one could make the case that Yellen’s statement itself is on the high side for Fed warnings, while still remaining within historical ranges, and the markets are ignoring that aspect at their peril.

The problem is that Fed policy, too fearful of doing anything to upset the financial markets, is feeding delusional hopes that trees can grow to the sky this time. The financial economy is already at a dizzying height above the real one, and whether one calls it a bubble or not is a pointless distraction. Business cycles do not end with a burst of growth that allows the real economy to catch up to the financial one, a recurring market chimera that every evidence indicates the Fed itself now believes in as the chief hope for the future. Markets always revert to the mean over time (Bob Farrell’s investing rule #1), and the longer the Fed is afraid of the market’s shadow, the more epic the reversion is going to be.

This cycle is getting old, and if our central bank doesn’t stop trying to be too clever by half with parlor word games and start getting itself out of its self-administered paralysis soon, it is going to catch the lion’s share of the blame for the inevitable crash and find a different charter waiting for it on the other side of the chasm. It gives me no pleasure to say that on its present course, it will have earned its fate.

The Economic Beat

The likely candidate for report of the week was February industrial production, coming in at +0.1%. While that was only a little short of consensus expectations for growth of 0.3%, the news was in the hefty downward revision to January, all the way from plus 0.2% to minus 0.3%. That took the year-on-year rate all the way back to 3.5% (it had been sitting above 4%). Manufacturing declined (-0.2%) for the third month in a row. One can blame it on special factors like the weather (which is fine in the western part of the country) and energy, but the weather was also responsible for a very sizable increase in utility production, without which the total number would have been quite negative.

The stock market loved it, for the additional point of weakness (GDP estimates for the first quarter are now edging below 2%) seemed to increase the chances of the Fed being on hold, a rapture that seemed to be confirmed by a Fed statement on Wednesday that included the annual lowering of this year’s forecast. The latter is now back to 2.3% to 2.7% real GDP. Reading the tea leaves in the lowered forecast for 2017, one guess is that the Fed expects the business cycle may in fact end one day. Unfortunately, such endings are always predicted to be at least another two years away, until they are plainly upon us.

The excitement over weak industrial production (classic late bull-market stuff) carried over to weaker-than-consensus readings from the New York (+6.9) and Philadelphia (+5.0) Fed surveys. Though the readings for both were trivially changed from the previous month, new order readings were weak, with New York registering a decline. I expect both readings will warm up again with the weather and the usual resumption of inventory accumulation.

Housing starts appeared to ease, with the sentiment index inching back towards neutral (50) in recent months, though not quite there at 53. The readings are being skewed by the weather, with a snow-free January registering a big increase and a snow-laden February a rare decrease. It’s too early to make any definitive statements about the year, but modest growth does seem to be ahead. Both jobless claims and retail sales are tracking their recent range.

Next week will bring another slug of housing data, and perhaps more importantly a slew of fine-tuning remarks from various Fed governors. Should equities continue to rally, look for some admissions that a June rate increase is still on the table; if they sell off, we will hear about the possibility of no increase until next year. A market-moving event may come on Tuesday, if the consumer price index (CPI) comes in weaker than the expected 0.2%, equities may stage another Fed rally.

Existing home sales are Monday, new home sales are Tuesday, and February durable goods are Wednesday. The next revision of fourth-quarter GDP is due on Friday, with the consensus looking for an upward revision to 2.4%.

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