Somewhere Over the Rainbow

“Where troubles melt like lemon drops.” – E.Y. Harburg

by M. Kevin Flynn, CFA

No, the headline-roulette, quarter-end, window-dressing rally won’t last. But unless there are riots in Berlin over the weekend, it isn’t going to end on Monday, either.

Despite last Monday’s rocky start, markets began moving up as usual Tuesday for the time-honored, sacred quarterly ritual of Pushing the Tape Higher for the Benefit of the Rubes (uh, Customers). Any fund manager worth his or her salt knows to keep some cash on hand for this game. Things started looking rocky on Thursday when the EU summit looked like it wasn’t going to produce a single communiqué at all, not even the usual historic, groundbreaking agreement to continue talking about the problem.

Fortunately, the titans of the EU came together in the wee hours Thursday night on an agreement for a European-wide supervisory board. By the end of December. That will give Madame Merkel ample time to insist on plenty of restrictions and assure the German people that without central control, it won’t happen. She’s right about that, because every country has to approve.

The really hot news was that the EFSF (European Financial Stability Facility) can now directly lend money directly to troubled banks instead of having to go through the related country’s central bank first. So instead of lending the money to the country so they could lend it to the bank – which drove up the country’s deficit and potentially their interest costs – the EFSF can lend it to the banks directly, who can then lend it back to the countries (by buying sovereign debt that their central bank will count as risk-free). That takes the pressure off the countries, who will in turn fund the EFSF to lend the money. Wait a minute…

Surely it’s more important that the EFSF dropped its seniority claims, which have the effect of scaring off private investors. The idea of the stronger countries kicking in some of the money doesn’t hurt either. Perhaps most important of all is that the rally came on the last day of the quarter, after the market had given up on anything good at all being announced. Stocks that were down on the quarter were being pitched off the cliff on Thursday, while “safety” stocks like AT&T (T) were ramped sharply higher in the second half of June. It’s vital to make those statements look good, you know. But nearly all was forgiven on Friday upon the running of the shorts.

Three big events could keep the rally going next week. The most important fundamental is that Monday is the first day of the quarter. The playbook says you close your eyes and buy on the first day of July (up 18 of the last 22 years). If everyone else is going to do it, you might as well too, right?

Second, the European Central Bank (ECB) makes its announcement on Thursday. Now that they know that there is a promise to have a supervisory authority by December (I still get goose pimples thinking about it), why, the sky is the limit. They could follow up with some big liquidity operation announcement to greet the US markets, returning from closure on the American Independence Day (Wednesday; U.S. markets will also close early on Tuesday afternoon). Or not. In either case, it should be a volatile day of either jubilation or disappointment.

Finally, there is the jobs report on Friday. It’s all a guess, but if we were to get more liquidity from Frankfurt (home of the ECB) on Thursday and some half-decent jobs number on Friday, sheer momentum could rally the markets into late July. Who needs earnings?

Unfortunately, not much has changed for Europe. A supervisory authority isn’t going to fix its problems. They still need to write down all the bad the debt and recapitalize the financial system, something that will need Germany’s approval to work. It probably won’t be forthcoming, leaving investors with a dilemma. It is a step in the right direction, but the bank regulator and lending are a long way off.

Earnings estimates for the second quarter are now negative, on balance. The sages talk of waiting for guidance on the second half, but pretty much everyone is expecting weak guidance. The quarterly game to rig both the results and the outlook has been in earnest for several weeks now.

Meantime, the global economy continues to weaken, even with the long-sought promise of a supervisory authority. German retail sales in May fell (-0.3%) instead of rising by the same amount – could that have influenced Merkel’s decision? US data has been on a slow fade lately (see The Economic Beat, below). The EU banks that do need emergency funds are hardly going to be in a hurry to turn around and lend them out.

This is a slow process still getting underway with many obstacles to success, not least of which is less time than the EU thinks. A stock market rally will only prolong the agony by allowing policymakers to go back to sleep again, hoping that somehow, somewhere over the rainbow, everyone earns their way out of it. Japan followed a similar policy of hoping companies would earn their way out of bad debt, contributing to the expression “lost decades.”

That doesn’t mean the rally can’t go on, though. Far from it. It will run until the markets finally get the idea that things really aren’t getting better, and that may or may not happen by Friday (jobs report) or earnings season (partly rigged). The biggest awakenings usually happen in the fall. Unless the ECB comes up with something pretty big on Thursday though, we won’t be trusting either the rally or August, not for a minute.

The Economic Beat

Mixed, that’s what this economy is. New home sales rose in May, though the rate is historically still remarkably puny. Pending home sales rose in May as well, but mortgage-purchase applications have fallen in June. Caution is setting in throughout the economy, though the homebuilder stocks are partying like its 1999: KB Home (KBH) was up 20% on the week, topped off by the news that it lost less money than expected in its latest quarter.

Lennar (LEN) did even better, posting a big $2 year-over-year earnings increase. We won’t spoil it by telling you that it came from a tax benefit, or that Lennar’s pre-tax earnings for the six months of 2012 are down about 6% from the first six months of 2011. That wouldn’t be fair, and you might wonder why the stock is up over 70% since then. That wouldn’t do at all.

Manufacturing is mixed. The Dallas Federal Reserve reported modest growth across the board in its district, although lower energy prices may mean a slowdown for next month. But Richmond and Kansas City reported declines, and the Chicago PMI (Purchasing Managers Index) was nearly flat for the first time in years. On the other hand, durable goods recovered somewhat after two months of declines. New orders reported a 1.1% monthly increase, well beyond the consensus estimate of 0.4%. Excluding transportation, though, they rose only 0.4% versus expectations for 0.8%. April’s number was revised downward, and the year-on-year rate for new orders excluding transportation fell sharply to a quite modest 3.8%. At least business investment spending picked up after two months of declines.

Yes, caution is spreading. The Conference Board confidence measure fell (62.0), the consumer sentiment index fell (73.2), and May personal spending was unchanged as income rose a mighty 0.1%. Perhaps the most interesting news was that the personal consumption expenditure (PCE) price index posted a rare (-0.2%) decrease in May. That could mean that we get another one of those GDP quarters where the BEA says there was no inflation and real GDP ends up looking great – until about a year later, when the BEA decides that there really was some inflation after all and quietly redoes the GDP calculation.

Whatever the BEA’s cuisine, the Chicago Fed’s National Activity index, a fairly good real-time indicator, fell sharply into negative territory, with its diffusion index negative for the first time in a year. That’s not so encouraging. The Philadelphia Fed’s Leading Index for the US in May was 1.1, better than April’s 1.0 but suggesting fairly modest times ahead. Reports from the two weekly retail sales trackers are not promising for June, and the fall in energy prices hasn’t encouraged consumption. It would appear that GDP for the second and third quarters is tracking back below 2% (though there is always the magic deflator).

Maybe another ECB liquidity-luau next week will put stocks on another goofy fun-ride similar to the first quarter and dispel some of the cautious atmosphere, but we wonder. It would surely keep the rally going, but the current market lacks the momentum carry-over the first quarter enjoyed, and has neither positive earnings, nor the absence of harsh weather, nor the psychological effect of a new calendar and fresh budgets to work with. Perhaps the sight of soaring energy prices (oil rose 9% on Friday) will motivate us all into working harder.

Next week is a holiday week with an early close in the US on Tuesday and all markets closed on Wednesday. But it’s still a busy calendar, with the ISM manufacturing index kicking things off on Monday. The recent “flash” estimate for the ISM, new from Markit Economics, was at 52.9, so of course consensus is set lower at 52.0 (don’t you love this business?). The ECB announcement on Thursday and the jobs report on Friday are the other key releases. The consensus for the latter is for a modest 90,000. We expect upward revisions to prior months.

That’s our own troika, but there’s much more: Construction spending on Monday, factory orders on Tuesday (largely implied by the durable goods report), the ADP payrolls report on Thursday before the open, followed by the ISM non-manufacturing report at 10 AM. The EU and Germany will be reporting data on PMI, unemployment and industrial production during the week, and China reports PMI numbers over this weekend.

We wish our American readers a pleasant 4th of July holiday and remind everyone that volume rates to be light in our markets. Some will be taking a long weekend leading into Wednesday, some coming out of it. That usually means higher volatility.