In the Land of Milk and Honey


“The eye sees not itself, but by reflection, by some other things.” – William Shakespeare (Brutus), Julius Caesar

Have you heard about the latest circuit-breaker installed at the stock exchanges? It seems that any time the Dow or the S&P 500 fall by fifty basis points (one-half percent), the needles are suspended, a few discreet calls are made, and dip-buyers are summoned in sufficient amount to reverse course again.

Cheeky, perhaps, but about the state of things. While the Wall Street Journal was glowing over the 10-day winning streak on the Dow Jones average (brought to an end Friday; Senate inquiry scheduled to convene on Monday), little was said about the fact that on 8 of those 10 days, markets moved lower in the first half hour before recovering. Any retrace at all has been bought, including Friday’s temporary baffling lapse that saw the S&P weaken nearly a percent from Thursday’s failed attempt at the record close. Despite the need to expire many call options out of the money and a surprise plunge in consumer sentiment reading, order was partly restored.

Friday’s mini-drop may actually help the averages out for the rest of the month. While long-term indicators still remain in nosebleed territory, the modest retreat pulled short-term indicators out of the danger zone. With a Fed meeting to look forward to next week, there should be a floor under the markets for the next few days.

Nevertheless, those long-term indicators are implying a good-sized correction soon. The only time markets have escaped a subsequent 10%-plus decline in recent decades from levels as high as the current one was the tech bubble. The devil is in the detail of “soon,” because the subsequent corrective bottom has come anywhere from two to six months later, often preceded by one last move up, even another five percent more. It’s the kind of thing that drives market-timers and technicians crazy – not to mention those who finally thought the water was safe again.

Not to sound like a broken record, but the economy just isn’t doing that well. That doesn’t mean the stock market has to get crushed, but corrections do tend to happen after there’s been a sharp rise cloaked in a narrative that gets discredited. The current data in the economy hasn’t shown any type of breakout, just another variation of the typical upward pulse that usually occurs in the first quarter. The data suggests the pulse is more muted than the last two years, indicating the recovery is gradually settling to flat-line.

Exhibit “A” would be the fourth-quarter GDP estimate that currently sits at +0.1%; Exhibit “B” may be a similar reading in the second quarter. Most of the investing world is waiting for housing to set the country on fire in the second quarter, when the weather favors building again, but hopes may be running a little too high. Housing is certainly up over last year and faces very easy comparisons in 2013. But on an absolute level, I have doubts that it can offset the effects of the payroll tax and sequester. Perhaps the latter will be set aside or modified in a market-friendly way, but the modifications still have yet to happen.

A more likely outcome is that another favorable starts number or two creates a noisy mob sense of belief that housing is going to lead us into the promised land, where we will all dine on milk, honey, and record prices for stocks. Doubters will extrapolate the step-up already embedded in current data and prices into something much larger, so as not to be seen as falling too hopelessly behind equity prices (in much the way analysts will keep upgrading a stock because its price keeps going up). Then the numbers will subside and the disappointment hangover will follow.

The next budget deadline is just under two weeks away, on March 27th. The number of amendments to the latest Senate spending bill (99 at last count) suggests that lawmakers are desperate to avoid embarrassing stoppages. But House Republicans also have to worry where to draw the line in the sand on restoring spending cuts. Too much cutting could be a political embarrassment, but too much spending restoration would be problematic as well. They’re going to have a delicate line to walk – just like the market.

The Economic Beat

The data highlight of the week for the market was the retail sales report. It bested expectations, perhaps more of a credit to Street economists than to economic strength. It did not, as some claimed, discredit the possibility that the payroll tax restoration might be a drag on spending. The year-on-year increase, which I discussed on Seeking Alpha, is part of a pattern of declining year-on-year increases. February 2013 was the weakest annual gain for the month since 2010.

The industrial data was the same song. The New York Fed manufacturing survey beat consensus – easily done – with a reading of +9.2. That was half the increase of February 2012 (+18) and the weakest since February 2009. The year-on-year increase in industrial production was 2.4% (seasonally adjusted), compared to 4.8% in February 2012 and the slowest February since 2010. The first two months of 2013 have grown at a slower rate than the first two months of 2012.

Weekly claims eased again, and the last couple of weeks have reversed a three-month trend of the year-year improvement leveling off. Much of the variation is still coming from California, though, and in very large numbers, and it still isn’t clear to me why. The sudden decline in the University of Michigan consumer sentiment reading doesn’t resonate with employment strength, or the stock market. The sequester got much of the blame, but one has to wonder how much people have really seen so far in the way of effects. By contrast, the small business optimism index jumped up nearly two points to 90.8. Maybe they were long the market.

An answer may lie in the latest inflation readings, with identical 0.7% jumps in both the producer (PPI) and consumer (CPI) indices. The “core rates” that exclude food and energy were a modest 0.2% for both, but high gasoline prices and the sharply higher cost of staying warm – a much colder winter combined with a surge in heating oil and natural gas prices – had to have affected a lot of households. Since the GDP deflator tends to be energy-sensitive, that doesn’t bode well for first quarter GDP results.

Import-export prices were the same story. Sharp increases due to higher food and energy costs, while the rest of the spectrum was flattish. EU industrial production fell more than expected (-0.4%); the ongoing EU recession has been a drag on global trade. Chinese imports were weak (though distorted by their Golden Week) and the Hang Seng Index is down 10% this year (the Shanghai is flat). Import weakness is the proverbial canary for domestic demand.

Next week brings the all-important report of the Fed’s Open Market Committee (FOMC) meeting. It will include fresh forecasts (probably with downward revisions) and a press conference with Bernanke. I really don’t expect much in the way of change, but the markets will be paying close attention to Bernanke’s answers to see if he betrays any signs of changes in QE policy. The markets usually move up in advance of the meeting and then give it back afterwards, but any real difference could give rise to a violently different reaction.

The FOMC will have some fresh housing data to look at: The homebuilder sentiment index comes out on Monday, followed by housing starts the next morning. The rest of the housing data comes later, with existing home sales and federal agency price data on Thursday. Later that morning we’ll get the Philadelphia Fed’s manufacturing survey.

The March 2012 Philadelphia result was announced as 12.5, and that’s the best basis for comparison. It was later revised downward (again) to 8.6, but you have to compare apples to apples, or in this case, initial releases. Last month was a surprisingly weak (-12.5), so don’t be surprised to see a positive reading “surprise” an expert consensus carefully set in negative territory.

I would also keep an eye on the “flash” estimate for Chinese PMI, due Wednesday night. China is now struggling to come to grips with its property bubble, a development that is being ignored here in much the same way its stock market crash was ignored in 2007. If fear ever touches the credit markets, the party will end very abruptly.

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