“October. This is one of the peculiarly dangerous months to speculate in stocks.” – Mark Twain (who added the other eleven months to be equally dangerous)
While the S&P was only down about 1.5% last week, it probably felt bigger. It should, because it’s down about 3% from the previous Thursday and 4% from the announcement of QE-infinity. Only a Friday afternoon rebound kept the index from falling below the Day of the Draghi (September 6th), when European Central Bank (ECB) president Mario Draghi said the bank would buy “unlimited” amounts of short-term EU sovereign bonds in order to cap their yields (with conditions, but the markets hardly cared about them that day).
Earnings season is wearing down the stock market, an event I have been predicting for many weeks. The cumulative effect of so many major companies coming up short in revenue, along with year-on-year sales declines and fourth-quarter estimates guided down has the market sagging.
But not reeling. While the Dow and S&P 500 indices have fallen five out of the last seven days, the Nasdaq four, prices have finished near their lows on only two occasions. Dip-buyers are still coming into the stock market, typical behavior at the onset of a correction. If you’re feeling bullish, you marvel at the resilience of the market; if bearish, you marvel at the lemmings running over the cliff.
Short-term trends are notoriously difficult to anticipate in the market. In light of all the weak outlooks and sales declines, you might think that the typical fund manager is fretting over which positions to sell. You would be wrong. The main concern in the land of institutional money management is making sure portfolios are positioned for one, the possibility of a Romney victory (a Democrat-to-Republican switch is always cheered by traders, though at times for very brief periods); and two, the Thanksgiving-to-Santa Claus annual price rally. Europe will muddle through, or at least not blow up this year, the thinking goes, and the larger concern is the performance derby that ends December 31st.
I will no doubt have occasion to return to this theme. For now I will simply say that the Thanksgiving-to-New Year’s Eve rally is not a law of physics. We did see it for five years in a row, from 2007-2011, which seems to have many convinced that it has in fact become one. Even 2007 and 2008 had them, though it ought to be said that being 100% cash on October 31st of either year would have easily outperformed any Thanksgiving-Santa Claus tandem. However, the trend in recent years – which have admittedly been difficult – for fund managers has been to manage the last two months on the basis of the firm’s competitive position. In short, go all-in and hope for the best; if something bad happens, it’s not my fault.
In the meantime, we have some rather large known unknowns coming up. The economic calendar starts light next week, which tends to favor the preceding week’s trend. That would suggest a down arrow. However, the Case-Shiller housing index comes out on Tuesday, and while it is not usually of keen importance to the markets, the notion has become widespread lately that one should hide out in stocks without overseas exposure. Housing is one of the only sectors with a hot hand, so regardless of homebuilder valuations, any good-sized price increase from the index would be given a warmer-than-usual reception from a market looking for anything to stop the bleeding by the end of the month on Wednesday. I would look for at minimum a one-day reversal effort over the next three trading days to salvage a little bit of the month.
Another popular theme is to go beta-neutral, which partly explains the dismal recent performance of high-flyers like Apple (AAPL) and Amazon (AMZN; though when it comes to earnings, Amazon seems to inhabit its own special universe). Beta measures the sensitivity of individual stock price to the market, so in a defensive environment low-beta can be a good thing. Next week has a lot of insurance companies reporting, which might help except for Hurricane Sandy. It’s also a big week for energy companies, a sector that has been under pressure and is unlikely to produce a cheery outlook for the fourth quarter. While commodity traders have been bailing lately, I wouldn’t expect complete disaster, as the unusually high price of third quarter gasoline probably helped out companies with “downstream operations” (e.g., refining).
The confounding part about which scenario comes to pass in the remainder of the year comes from the market being a herd. In the longer term, one can make many measurements and evaluations about where the herd will eventually end up, and if one does good, intelligent work, be rewarded. In the short term, what herds do best is keep running in the same direction until frightened. Then they run in another one.
The wild card next week is the October jobs report, due out Friday. A good report would ordinarily launch a rally after the recent blood-letting, while a weak one would be expected to open an artery. It’s a little less clear this time around with the presidential election just around the corner. Another good report might be shouted down in the heated partisan climate, and a bad report could conceivably be welcomed on the floor as setting up a Romney victory (exchange traders generally lean heavily to the right).
The global economy is still headed down, while the US economy is still muddling along (I highly recommend the Warren Buffett interview on the subject from CNBC). Europe only produced more weak data last week, with its PMI readings all deep in recession territory. The one bright spot was the UK, where GDP recovered to a 1.0% annual rate in the third quarter, effectively ending the country’s recession. It makes a good argument for monetary accommodation and having your own currency.
The main drivers of the stock market this year have been neither earnings nor the economy (though the first quarter did get some help from the warm weather), but rescue actions by either the two main Western central banks (the ECB and the Fed) or the EU. It bears repeating to observe that the ECB and Fed are effectively out of the game as market carrots, because they have already promised all that they have to give.
Nothing is imminent in the EU, at least not next week. Certainly a Spanish request for ECB aid would lead to a sucker rally much like the Day of the Draghi, but with the country’s funding nearly complete, the last bond auction reasonably successful, and the Friday publication of the country’s official unemployment rate topping 25%, it seems most unlikely that Prime Minister Rajoy would want to sign on for the stringent conditions that an ECB “aid” package would require. Not without a major crisis.
Frankly it seems unlikely that the rest of the EU will do anything sensible at all until extreme pressure forces them into making choices (which could conceivably go wrong). Greece should get an extension next month because it’s small and Germany seems largely resigned to a little more money as the price of avoiding a euro-crisis, but aside from that we should expect nothing without duress.
October should therefore finish in the red, perhaps quite handily. After that it will be a question of waiting on political developments, and it’s a guess as to where those will lead.
The Economic Beat
GDP (gross domestic product) was the report of the week. It came in at 2.0% annualized, above consensus for 1.8%-1.9% (since it was higher, you’ll hear the lower number quoted on the radio and television; had it come in lower, it would have been the other way around). Although data had been implying less than 2%, my sentiment was that the initial print would come in with a 2-handle, partly because the durable goods report on Thursday had suggested a big rebound in defense spending. Federal spending did indeed swing positive from quarter to quarter for only the second time in the last two years, and was the largest swing factor in the report.
Household services spending slowed, business investment slowed, and the trade deficit worsened. The September pickup in durable goods, led by autos and still subject to revision, meant a bump back up in personal spending. At a rate of about 2%, it’s below the 2.3% average going back to the beginning of 2010, but right in line with spending since the beginning of 2011, when the initial rebound from the recession began to level off. Domestic final sales rebounded to 2.3%, the best increase (by a tenth of a percent) since the end of 2010.
Perhaps the biggest surprise was the price deflator (or measure of inflation), which came in at 2.9% and is the highest such measure since the third quarter of last year. That meant nominal GDP grew at 5% (annualized), the fastest since the second quarter of 2011. In sum, it was a better quarter than the second, but not a great quarter and fairly in line with the 2%-ish rate of the last two years. Normally I might caution that the durable goods number might be revised downward to put it back into sub-2.0 territory, but the price deflator might easily be revised downward as well, canceling out the effect.
The aircraft rebound in September durable goods orders was off the charts, with Boeing going from one plane in August to hundreds in September. Shipments for the category were up nearly 13%, boosting GDP, while orders were up a ridiculous 2,640%. Defense orders were up as well, bringing the headline total to 9.9%, a number that didn’t excite the market due to the aircraft component. New orders for business investment were unchanged and are down year-on-year, while autos eased, so it didn’t produce jubilation. Excluding defense and transportation – the so-called “core” component – new orders were unchanged, and that is what the market mostly took from the report.
Housing news was mixed. New home sales for September boosted the homebuilder sector on Wednesday with a report of a 5.7% increase to a 389,000 annual rate, larger than expected. That said, news of a 389,000 annual rate in 2006 would have caused the sector to collapse and probably a stock market crash as well, but it’s all in the trend, isn’t it? A word of caution – while the year-on-year numbers show solid improvement, the unadjusted monthly data was less spectacular and the increase benefited from a downward revision to August.
The combination of warm weather, record low mortgage rates and the attendant headlines meant a decent surge in new home sales was a heavy favorite. Against that, pending home sales (which are based on existing homes) were barely changed. I would also add that investor participation in new homes as an investment has been something of a fad in recent months, leading me to question the underlying solidity of the trend.
Manufacturing displayed continued softness. The Richmond Fed survey was negative, the Kansas City Fed survey was negative and the lowest in three years. As noted above, durable goods orders were flat outside of defense and transportation (aircraft). Despite the widespread market conviction that Washington will somehow muddle through, it nevertheless appears that the fiscal cliff has already put the brakes on business. The Markit “flash” PMI, a relatively new report, was at 51.3 with some deterioration in orders. The influential national ISM survey of purchasing managers in manufacturing is due on Thursday.
There was very little change in the Federal Reserve’s statement after their meeting, which came as a surprise to almost no one. One interesting aspect was that a survey of primary bond dealers – who handle Treasury bond sales – was overwhelmingly on the side of the Fed adding Treasury securities to its buy list when Operation Twist ends in December. That came out on Monday, after one bad day in the market. Sentiment certainly is fickle – and demanding.
The Chicago National Fed activity index did rebound to zero in October, though the 3-month moving average remains mired in negative territory. I’ve been warning that stocks have always turned to follow this index into negative territory, and October appears to be bearing that out. There was no European rescue to defy gravity.
Apart from the heavy earnings calendar – mostly smaller companies if you exclude the energy sector – next week brings the next big milestone, the jobs report on Friday. After some technical issues, weekly jobless claims have settled back into their usual year-long pattern, implying the same trend for employment. It’ll be interesting to see if the claims snafus (California didn’t send in some data) affect the jobs total at all, which could have an impact on the election. As we go to press, consensus is looking for a gain of around 120,000, with a slight uptick in unemployment to 7.9%. It will doubtless be a politically charged result.
As I’ve written before, jobs growth and weekly claims have been quite stable all year, especially when looked at from the year-on-year aspect. The headline volatility has really come from seasonal adjustment factors. As noted, the claims data are still steady heading into next week, with the insured claims rate running at 4 1/2 year lows. My own work on unadjusted claims data shows mid-October with the biggest year-on-year drop in four-week claims totals since May, so there’s no indication of trouble there.
There has been a hint of slowdown in survey reports, though these do not always translate into hard numbers, and of course the election itself may be having a perverse wait-and-see effect on hiring. The ADP payroll number on Wednesday should give a clue.
The calendar next week is therefore back-loaded, with ADP Wednesday, ISM Thursday and employment on Friday. Personal income and spending for September is due on Monday, but that part is largely derivable from today’s GDP report. The other report of electoral interest will be the Consumer Confidence report on Tuesday.
Other reports include the Dallas Fed manufacturing survey on Monday, Case-Shiller home price data Tuesday, October auto sales and same-store sales on Thursday (the number of chains reporting is quite small now) along with construction spending. Factory orders for September are due at 10 AM Friday, but the report will likely be lost in the employment clamor.