An Oily Exit?

“Admiration is the daughter of ignorance.” – Benjamin Franklin, Poor Richard’s Almanack

by M. Kevin Flynn, CFA

We understand the set-up – bonds look way overbought, Europe looks shaky, China is slowing down, money returns nothing, where are you going to go? We get the big herd move into U.S. equities.

We also get that it doesn’t matter – at least for a little while – if the crowd is right or not. Whatever the real value of that object up on the auction stand, when everybody in the room needs to buy something and there isn’t much else to spend it on, the price of the object is going to go up. Buyer’s remorse is for
another day.

We also get the common notion that if only everyone would all feel a little more confident, then you know, things really could get better. There’s a will to believe out there that’s perfectly understandable.

But at the risk of boring you with our repetitiveness, though, we’ll say it again – things are not as good as the headline factory is saying. Earnings growth is slower than a year ago. Economic growth is slower than a year ago. The ECRI was chiming in last week saying much the same thing we’ve been saying, only more so. We compare the current rate of change with that of a year ago and say, this quarter isn’t really as good as the first quarter of 2011. The ECRI is gloomier.

They have a point – year-on-year real disposable personal income has been negative for months. Year-on-year real spending, or PCE, has been declining for four months. Perhaps we’re due for a bounce, yet we haven’t really seen it in the data yet. We gave considerable heed to the Safeway (SWY) conference call last week, partly because the company is so close to the ground on spending habits, partly because management stuck with its 2% GDP call last year at this time when the Street was running half-drunk with 4% predictions. For them, the “bifurcated” recovery continues: the upper income consumer is fine, while all else struggles.

We’ve also spent a deal of time looking at industrial ordering, and while there is no doubt that it’s up at the moment, the increase is smaller than a year ago – no doubt due in part to the changes in accelerated depreciation – and there is no indication from recent historical ordering patterns that suggest that this is anything but another restocking pulse.

The market has climbed higher on what has been called a “stream-of-anecdotes” news flow. The economic data is being judged on comparison with Street estimates rather than on its own. That game works for a time, but not a very long one. Nearly absent from mainstream reporting is the fact that all of these economic “surprises” reflect growth patterns weaker than a year ago.

Oil prices are soaring, turning into the latest can’t-miss-parlay. First, the Mideast: trouble in Syria, trouble in Iran, they won’t sell oil to France! The fact that the EU already voted in an Iran embargo months ago is conveniently forgotten. Besides, maybe Iran will fire some shots in the Gulf, that ought to be good for five bucks a barrel. Or Israel tries to take out Iran nuclear production facilities: ten to fifteen bucks a barrel.

Second, if growth really is accelerating around the globe, then the demand story is good for a trade. If in fact it’s slowing down, as the EU, IMF, China and the World Bank say is the case, why then there will be more quantitative easing, more central bank money pumped out and so you have to buy commodities.

Third, short covering in the euro means weaker dollar, weaker dollar means buy more oil. Last but not least, the casino just increased everyone’s credit line at the tables: the CME cut margin requirements for oil contracts. Against all logic, oil prices shot up faster afterwards. We’re sure there’s no connection.

The usual suspects are making the usual arguments for why “this time will be different” for surging oil prices: we’ll use natural gas instead (tell that to the airlines, trucking, chemical and delivery companies); Americans don’t really care if gas is $4 a gallon (that must be why consumption is falling); it’s a reflection of strong emerging-market growth (as PT Barnum said, there’s a sucker born every minute).

The adjustment will come any day, and the sooner the better. If we get the chart “breakout” past 1370 on the S&P 500 and get to 1400 first, the fall afterwards is only going to be steeper. That won’t stop the April rally, but it means bigger payback afterwards.

The Economic Beat

We’re going to start with the latest Chicago Fed’s National Activity Index (NAI) that was released last week. It’s made up of 85 monthly indicators and, like the Philadelphia Fed’s coincident and leading U.S. indicators, seems to us to paint a better picture of overall economic activity than some of the reports more celebrated by the market, such as the ISM surveys or the jobs report.

The NAI reported a value of +0.22, down from 0.54 in December, but “positive for the second straight month for the first time in a year.” Aye, and there’s the rub, at least from our perspective.

The NAI in January 2011: +0.27, against the current +0.22. The current three-smonth moving average: +0.14, versus January 2011′s reading of +0.15. In short, it seems to us that the economy is doing very much the same thing it did a year ago, which is to say getting a boost from new budgets and an inventory replenishment episode, but not a huge boost and one that will ebb again.

New home sales came out on Friday, and the details were illuminating. The latest run rate of 321,000 is still anemic, and while December did get an upward boost, its rate of 324,000 is hardly different.

December and January are of course low-water marks for building activity during the year, and perhaps not the best indicators. Even so, a look at year-ago activity suggests that there has been no real change in the industry, with the exception that it continues to slowly get rid of old inventory and come into balance.

Unit sales were up from a year ago, but a look at the underlying unadjusted data tells you that all of the increase came from a small bump up in the South, from 11k to 13k. If one had said in November that one of the mildest winters in the last century would produce an increase of exactly 2k starts in the South (and a decline of 1k for the rest of the country), would anyone have been impressed? The median price fell sharply year-on-year, from $240,100 to $217,100, suggesting both a mix shift and probably some price-cutting to get rid of unwanted inventory. The average price also fell, from about $276k to $261k.

We’re not saying housing is getting any worse; it’s hard to see how it could. Supply-demand conditions are the most favorable they’ve been in ages, and new construction is running well below the household formation rate. But financing is still extraordinarily tight and buyers still fearful of falling prices. Some economists think it may take a generation for attitudes towards home purchase to fix itself, à la Great Depression. We hope not, but those who keep looking for a sudden renaissance in homebuilding may be in for a long wait.

Existing home sales showed the same story. The sales rate is anemic at 4.57 million units annualized, and in the case of January below expectations. The median price fell, the average price fell, and the year-on-year price changes for median and average are, like new home sales, in the negative single digits. We are hopeful that 2012 will see some stabilization, but this bottom is a wide one. The latest pending home sales data come out on Monday, and Case-Shiller price data on Tuesday.

Consumer sentiment as measured by the University of Michigan rose a bit to 75.3, but once again it’s retracing the same pattern of a year ago. The stock market headlines and “better-than-expected,” weather-boosted data are giving a false impression about how well things are going, obscuring the fact that this quarter’s pickup is actually not as strong as it was this time a year ago. We’re also about to hit a harder speed bump in the form of soaring oil prices, and no Virginia, it isn’t different this time.

We are beginning to worry about the claims data. Looking at the unadjusted data over the last ten years, the last few weeks are not above-average except when compared with the two or three worst years of the decade. It doesn’t look as if employment is growing significantly; rather it looks as if the job attrition rate has hit equilibrium. When adjusted for one of the mildest winters in the last century, the claims data looks unchanged. The worry is that when spring hits, it’s going to look higher than expectations.

The February jobs report comes out next Friday. Our sense is that the headline number is going to benefit once again from the weather and adjustment factors. We are adding jobs, which is good, but adding them at a below-par rate whose underlying trend rate hasn’t really changed, despite a couple of months here and there that exaggerate gains and losses. It raises the final disappointment potential for the current momentum trade.

Next week is indeed a big one. In addition to the usual market excitement around month-end and the big-kahuna jobs report, there is the durable goods report on Tuesday and the ISM manufacturing survey on Thursday. There are three regional manufacturing surveys, Dallas, Richmond and Chicago preceding the national report, not to mention the Fed’s Beige Book compendium of regional branch write-ups on local economies.

Then there’s the more market-popular Conference Board consumer confidence report on Tuesday, to be contrasted by the January personal income and spending report on Thursday. Besides being the first day of the new month – always a bullish fundamental – Thursday also has construction spending, chain-store sales, new car sales, and of course weekly claims to accompany the ISM report. The German and EU PMI (purchasing manager) reports will be out before the open, so it could be quite the busy day. There’s another Q4-GDP revision out the day before – we look for another bump downwards.