“Show me the money!” – Rod Tidwell (Cuba Gooding Jr.) in Jerry Maguire
Shall we review September? It began with a sub-par jobs report. The ISM manufacturing report posted its lowest reading in three years. The Chicago Purchasing Manager’s Index (PMI) posted its first contraction reading in three years. The Philadelphia and New York Fed surveys both fell – again. The August industrial production report posted a sharp contraction. The August durable goods report was comically low. New home sales fell, pending home sales fell, Chinese manufacturing contracted for the eleventh month in a row, and the European PMI fell deeper into contraction.
The transport sector was littered with earnings warnings and shortfalls, from Fedex (FDX) to Norfolk Southern (NSC), and the IYT (Dow Jones Transport Index) fell 2.5% for the month and over 6% for the quarter. Leading indicator Jabil Circuit (JBL) got taken to the woodshed for a 20% drop when it missed on earnings, reported no annual revenue growth and lowered guidance for 2013.
Conclusion? The markets rise by 2.5% to a post-recovery high. It was all about money-printing: European Central Bank (ECB) President Mario Draghi threatened to buy short-term sovereign bonds in “unlimited amounts” and Federal Reserve chairman Ben Bernanke said that the Fed would buy mortgage-backed securities (MBS) indefinitely. In other words, crank up the printing presses.
Yet the markets faded after the Fed’s announcement, back to about where they were before. If it hadn’t been for some knee-jerk buying Thursday on the wondrous rumor that Spain was going to pass another austerity budget in the midst of its recession, thereby qualifying for possible bond-buying and more money-printing, we might be back to the price levels of Draghi’s “unlimited” day.
Several things suggest themselves in the wake of the quarter. The first is that Europe is going to keep getting worse before it gets better. Spain is now facing the Hobbesian choice between an austerity program that risks taking the country into depression – the Bank of Spain warned on Wednesday that output is falling at a “significant pace,” even while unemployment is already at 25% – and insolvency if it refuses austerity. Greece’s economy needs help more than ever, as Mohammed El-Erian warned. Both countries witnessed violent demonstrations during the week.
Another reality is that earnings are going to be weak. The only silver lining is that they are universally expected to be weak, so there’s a lot of room for upside. The hard part will be trying to ignore lowered guidance from management.
A third thing is that for some months now, the market has been living almost exclusively off hopes of more central bank liquidity. Now that the ECB and Fed have announced their programs, the lure of more action is largely gone. In the summer, markets would sometimes rally on bad news because it would bring the Fed back in. Now what?
It removes an important prop from the market. One thing that’s become evident is the feedback loop between trading robots and High Frequency Trading (HFT) programs. The robots that analyze news flow – no, I’m not wearing a tin foil hat, this is real stuff and has big money and bigger computers behind it – are clearly programmed to buy stories and words about easing, liquidity, bond buying and the like. In the words of the Wall Street Journal’s Heard on the Street column, “right now markets respond more to central banks and government intervention, rather than straight economic signals.”
The HFT order-flow sniffers – computers executing millions of buy and sell orders a minute – act as a kind of accelerant on the robotic (algorithmic, if you prefer) buying. The result is exaggerated price movements on low volume that leaves veteran floor traders scratching their heads, normal hedge-fund managers reaching for the antacid and mutual fund managers looking up at the indices, wondering whatever happened to fundamental analysis. As retail investors continue to pull money out of stock market funds, the influence of these little trading tornadoes increases. The rest of the market volume has been disappearing.
However, accelerants on the upside can also be accelerants to the downside. Somewhere over the next six weeks or so, we are likely to witness a serious give-back in equity prices. As we wrote in Seeking Alpha during the week, though, the month is still likely to see a move higher in the first half of October. We have a fake Spanish bailout to look forward to, FOMC minutes to fondle with their pillow talk of infinite easing, and a jobs report that probably won’t be any different than recent ones but for one detail: estimates are lower. Ergo, the magic phrase “better than expected” has a good chance to appear on the tape. The cold rain of earnings won’t really get going for a couple of weeks, so there could be lots of trading-robot buy words between now and then.
A reckoning looms for all of this, much like the last big high in October of 2007. Besides the drop in the transports – cheerfully dismissed in Barron’s as outdated thinking, the way earnings multiples were dissed during the dot.com bubble – you might have noticed that oil is falling this month. Oil goes up when traders believe the economy will pick up, and falls when they don’t. It also goes up when traders are convinced that more money-printing is going to crush the dollar. It doesn’t go up when traders are sufficiently convinced that demand is going to be weak enough to overrule the liquidity. You can always sniff out an equity rally without legs when oil isn’t going up with it, and it’s been selling off ever since the FOMC announcement. The joke is on the consumer – gasoline prices are still going up. Caveat emptor.
The Economic Beat
The Chicago National Fed Activity Index led off the week, and while it doesn’t get a lot of buzz on the Street, it’s a number worth paying some attention. The three-month moving average hit its lowest point (-0.47) since June of 2011, and that was followed by quite a deceleration into the third quarter of that year (GDP fell from a 2.5% rate to 1.3%). It has been negative for six months in a row as the stock market has risen, and when that has happened in the past it has been followed by a downward turn in the market each time.
Regional manufacturing surveys were mostly downbeat, not a good sign for the National ISM manufacturing index due out on Monday. Looking at the Fed surveys, the Dallas index fell by (-0.9), Kansas City declined from 5 to 2 and Richmond posted a gain of four, ending a series of declines.
Although Dallas fell by only a small amount, it should have seen more of a lift from the post-Isaac rebound. The report that was disturbing was the Chicago PMI and its result of 49.7, the lowest in three years. Looking at the report in detail, it would appear that business is flat-lining (better than falling off, it should be said), something that was signaled last month by the decidedly mixed tone of responder comments. This month’s batch of comments looked about the same, so we would guess that there will still be no change (which is what 49.7 amounts to) next month.
The concern is the Chicago decline in new orders (47.4 seasonally adjusted, 50.0 is neutral). With five weeks to go before the election and three months until the fiscal cliff, it isn’t likely that we’ll see a national burst of decisiveness from business management. That suggests more weakness ahead.
There is a silver lining. Looking at inventories and backlogs in Chicago and elsewhere, it looks like the first quarter of 2013 is lining up once again for another episode of inventory replenishment. I suppose we’ll have to listen to a rerun of nonsense about the economy reaching “escape velocity” again that was all the rage back in March and April. Yes, it escaped alright – from 2.0% annualized GDP growth in the first quarter to 1.3% in the second.
Thursday’s third estimate of GDP, one that might have shaken a less diabetic market, was based principally on downward revisions in exports, consumption and a big drop in fixed non-residential investment, a problem that Alan Greenspan drew attention to over the summer. It looks like he was right. Given the weakness in domestic final sales (1.4%), the likelihood that exports will remain under pressure from China and Europe and fixed investment under pressure from the fiscal cliff, I’d guess that GDP is going to stay the same or weaken in the third quarter. Our best hope is for imports to decline – hardly a sign of prosperity, but it can boost the number.
Personal income rose a meager 0.1%, the same as July after a downward revision to the latter. The difference was that real disposable income fell by 0.3% in August. The year-on-year rate in income picked up, but that is due to soft comparisons with last year. Spending did pick up by an expected 0.5%, due to the back-to-school season, higher energy prices (gasoline is up 47 cents a gallon from July) and the many state sales tax holidays during the month. The number that really stood out in this report though, was the drop in real disposable income and the sizable revision to July income (from 0.3% to 0.1%). That isn’t going to be a tailwind for spending going into the fourth quarter.
Employment growth may be slowing. We also wrote in Seeking Alpha last week that there’s a reasonable chance for a good headline print for next week’s jobs report, depending on the seasonal adjustment factors. We based that estimate on the facts that the first two weeks of September (when the data is collected) have seen the lowest number of real claims since November of 2007 (the end of the third quarter is always low tide for claims), while the underlying trend of real job growth has been fairly steady all year. The year-on-year improvement in claims looks like it’s running at about the same rate as it’s been all year, though, despite the latest adjusted low number (going by past experience, the latter should get about a 5,000-6,000 upward revision next week). To top it all off, the estimate of about 100,000 net hires in September (at this writing) is on the low side.
That’s the positive side of the ledger. On the negative is that surveys seem to indicate a bit of weakening in hiring intentions. We’ve been reading quite a bit about big layoffs and cost-reduction programs (mostly in labor) of late, but those probably won’t start to hit until January. It may be some bias from manufacturing: low natural gas prices have slowed that sector down while taking coal down as well, which has also suffered from weakening Chinese demand. Perhaps the service sector will make it up in the “eat, drink and get sick sector” (last week we heard an NPR participant remark that we’ve gone from a service economy to a “servant” economy – ouch!).
As mentioned above, the durable goods new orders number for August took a spectacular fall (-13.2%) that was tied to a near-goose egg in aircraft. Excluding transportation, the fall was only (-1.6%), and the business investment category actually rose by 1.1%. However, there were downward revisions to July, which was already negative excluding transportation. It’s another item that doesn’t bode well for quarterly GDP.
Housing news was somewhat disappointing. The Case-Shiller price index rose 0.4%, but that was well short of expectations for something close to 1%. The new home sales rate fell from July to August while the number itself was short of expectations, and to top it off pending home sales for September fell. The week saw a slew of downgrades to homebuilder stocks in the wake of the news.
The good news was in sentiment surveys, which of course tend to track the stock market, and whose peaks tend to precede downturns. Maybe this time will be different. At any rate, the Conference Board confidence number rose to 70.3, the highest since February, and the University of Michigan sentiment number came in at 78.3. The latter number is slightly more timely than the Conference Board number, which was sampled the day the market skyrocketed on “QE-infinity.”
Next week will bring the once-mighty jobs report on Friday – can it regain importance over whispers of monetary easing? Before that, we’ll get a look at the two ISM surveys – manufacturing on Monday along with construction spending, and non-manufacturing on Wednesday, shortly after the ADP payrolls teaser. Thursday has August factory orders and the latest FOMC minutes, the latter often good for a ridiculous flutter on any words that suggest more money-printing. Same-store sales for September come out that morning.