Avalon's MarketWeek

Waiting for the Fed Again


“When you taste honey, remember gall” – Benjamin Franklin (ed.), Poor Richard’s Almanack

Coming into the peak of earnings season, the stock market is in a bit of an odd place. On the one hand, the projected earnings decline for the quarter, after adjusting for the usual analyst cushion, is still about 5%. That doesn’t reflect weakness across the board, but it isn’t much to back up a rather rich valuation and the 15% ricochet-rally from February.

Yet the market held up well last week. Selling hasn’t gotten any real traction in weeks, and it’s difficult to escape the sentiment that trading programs want to march back towards the old highs (about 2135) on the S&P 500. Traders want to follow them. Despite the generally anemic performance in both earnings and the economy, the magic of rising stock prices is sprinkling its usual fairy dust into the eyes of many, feeding a growing conviction that perhaps things are really better than they look. At least for now. Or maybe about to be. After all, stock prices have been going up.

Then there is the strange kabuki dance between a Federal Reserve regime that seems as preoccupied with equity market reaction as any Fed in living memory, and those same equity markets obsessed in equal measure with every Fed policy twitch. The last part is of course not new.

So while the markets have been wanting to go higher, doing so inevitably emboldens the Fed into talking up another rate increase and heaven knows, maybe even implementing one that might take rates up to some punitive level, like 0.5%. How can the economy possibly survive if money costs 0.5% per annum? Or if oil goes below $40 a barrel? The oil link has weakened a bit of late, but by no means has it gone away.

It’s a conundrum. Stock prices have been rising on sentiment based on neither earnings nor the economy. The latter link can be like gravity – a weak force that takes its time, but eventually prevails. The bond market hasn’t been buying into it. The equity sentiment began with a technical and calendar rebound that has looked for a stronger sense of justification, settling on Fed hesitation and an oil rebound (the collapse fanned fears of global recession) as its just causes. However, at some point earnings need to support the rally, and they need to do so by doing more than beating estimates. Growth is needed, certainly more than we’re getting.

If stocks should keep rising, with or without earnings support, then the Fed will take steps towards a move. That could kick out more than the monetary softness leg, as another rate tick higher (or a sense that one is imminent) would start to send the dollar back higher and oil lower again. If the Fed doesn’t raise rates, it’ll be either because the data is too weak or the stock market is too weak. If it’s the former, stocks can still survive on sentiment for a time, but I wouldn’t want to be going into May hoping for weak data as the mainstay support of my equity positions. It isn’t as if turning the calendar flips a switch – and overly anticipated seasonal changes have a way of not happening – but it certainly isn’t another source of strength.

In the meantime, the economic data points lopsidedly towards the ending of the business cycle, with only employment holding up. It has admittedly held up very well in the classic sense, as claims remains low and job growth modest, yet still good enough, right in the stock market’s comfort zone. Employment is a lagging indicator, however. The shifting composition of our labor force – more services, less goods production – may have made it more so, prolonging the belief in a new plateau (there are none) and that this time is different. This time is never an exact copy of the last time, but that doesn’t mean new laws of economics.

For now, I still believe that all the market has really done is move back to the top of the trading range it’s been in for over a year. Prices could of course still move a bit higher, but the next big move is almost surely down.

The Economic Beat

A quiet week of economic releases favored the tape (quiet weeks consistently favor a continuation of the previous week’s trend) and left the stage to earnings. While housing news was the main theme, the surprise report of the week was the Philadelphia Fed’s business activity survey that mainly concerns regional manufacturing.

Although industrial production reports have been consistently weak for many months, recent survey reports had shown a lift from their own streak of bad news. The New York Fed surprised to the upside the week before with a report that showed a broad rebound (though we don’t know how deep it was), and that in turn followed reports showing better results from other regions – Chicago, Dallas, Richmond – as well as the most recent national (ISM) purchasing manager index (PMI) that had managed to climb back above the neutral level of 50.

There may have been good reason not to get too excited about the improvements – after all, a very mild winter following two brutal ones should pose seasonal adjustment (SA) issues. In addition, until we get into recession itself, the surveys shouldn’t be expected to decline relentlessly until the end. However that is exactly what Wall Street has done, with many now calling for years more of expansion after some brief moment of weakness.

The Philadelphia reading of (-1.6) will not put an immediate stop to the talk, but it certainly undermines some of it for the moment. The report was weak almost across the board, though not disastrously so. It was followed the next day by the Markit Economics ”flash” PMI of 50.8 for April. Essentially flat (neutral = 50), it was a small decline from the previous month’s read of 51.4 and not what was hoped for. These readings could be confronting their own adjustment issues, as April 2015 was the start of a two-month rebound from a winter of record snowfall in the Northeast.

That comparison issue is going to affect the housing picture as well. Starts (-8.8% ) and permits (-7.7%) in March declined sharply from February on a seasonally adjusted (SA) basis, but on a year-to-date basis they are both running at double-digit levels ahead of last year, in the range of about 15% (single-family starts) to 22% (total). That advantage will fall off precipitously the next two months, as both categories experienced big rebounds last spring from weather-depressed levels. It looks to me like 2015’s 10% growth rate is still intact overall, however, despite the month-to-month volatility. Homebuilder sentiment remained unchanged at a solid 58 (above 60 is gangbusters). All of that said, activity is still well below previous decades.

In a similar vein, existing home sales rose comfortably in March (+5.1%, seasonally adjusted and annualized), doubtlessly helped along by the mild weather that left the first quarter with a near-5% gain. Year-on-year, however, sales are close to flat (+1.5%) and there will probably be comparison issues over the next two months.

Weekly jobless claims remain at remarkably low levels, with the last two weeks pointing to another strong jobs number for April. Once again, seasonality may be coming into play with the most recent data and the shifting composition of the labor force is doubtless making historical comparisons more difficult, with both a shrinking manufacturing sector (the quickest to lay off) and a higher concentration of entry-level health-care workers (the last to get laid off) affecting the data. Still, there is no overlooking that claims have been in the peak leg of the cycle for twenty months now, an exceptionally long period. Despite the old Wall Street adage that “trees don’t grow to the sky,” you can believe that the opposite sentiment is getting plenty of air play these days.

Next week will of course feature the all-important Fed policy meeting and statement, to be released to the millions of watchers and trillions of dollars waiting to see what to do on Wednesday afternoon. Will the Fed be hoist on its own petard? Will it really matter to the real economy? Only time will tell, but whatever the Fed says, don’t be surprised if the governors begin to fan out the next day so they can start pushing back on whatever the market concludes.

The week kicks off with new-home sales on Monday and durable goods orders on Tuesday. Don’t expect much more than monthly noise from the former, but a lot of attention will be paid to the durable goods orders for signs of any manufacturing rebound, or at least an energy-inspired respite.

The other big report is the first estimate of first-quarter GDP on Thursday, which the Fed governors will surely have seen. Consensus is for a rate of only 0.7%, while the Atlanta Fed was at 0.3% coming into the week. The latter will adjust after the reports on new-home sales, durable goods, and international goods trade on Wednesday. It was a soft quarter for which the weather can’t be blamed, so expect to hear plenty of people blaming the number as misguided instead. After all, the stock market can’t be wrong.

The week ends on Friday with March personal income and spending (and perhaps another quick-yet-small GDP revision to the first quarter), along with the (oft-revised) first estimate of the employment cost index for the first quarter. Weakness in the ECI would make it difficult for the Fed to talk tough. Regional activity reports are plentiful throughout the week, with Dallas on Monday, Richmond Tuesday, Kansas City on Thursday and Chicago on Friday. The Case-Shiller home price index is also due on Tuesday.

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