“Thus does conscience make cowards of us all.” – William Shakespeare, Hamlet
What a predicament. On the one hand, it’s November and we have a market that badly wants to push higher. Some are calling for a “fall melt-up,” while others feel a certain sense of entitlement to a fourth quarter rally (November and December are historically the 3rd and 2nd best months of the year respectively for the stock market). The market’s earnings multiple isn’t expensive by historical standards (though that means less than what you may think), and the U.S. economy, while not robust, is still riding a certain sense of smugness in the market over a GDP print better than was thought to be in store a few months ago.
Yet there are many worries in the air. Number one remains Europe, whose default worries have entered a new dimension. There is the upcoming deadline for the US debt ceiling, with the super-committee report due the 23rd and little hope for a breakthrough. The third-quarter earnings season offered little in the way of positive guidance and was a mixed bag at best, despite the usual pious talk about beating estimates. There are worries about growth in China and indeed growth around the rest of the globe.
Equity markets, though, have begun to develop a certain sense of fatigue with these issues. One could easily see prices here rally over the installation of a new Greek government that agrees to do no more than not hold a referendum on the EU’s pound-of-flesh approach to its troubled finances. It wouldn’t make much sense, since the EU situation would be no different than it was two weeks ago: an agreement to ask someone else for bail money, a continent headed into recession and political leaders hoping for a miracle.
In fact it’s arguably worse in Europe, now that the Chinese have joined the list of nations saying ‘no’ to being Santa Claus, and the signs of decline have become more pronounced (further deterioration in the European Purchasing Manager Index, a lowered growth forecast from France followed by a new austerity program, deepening government turmoil in Greece and Italy).
As to our debt ceiling, there isn’t any expectation that much real progress will come out of the super-committee. Ironically, that’s precisely the kind of thing that can feed a rally: expectations low enough that anything short of a gun battle could get interpreted as a green light to keep buying.
Technically, the markets are delicately balanced, with much of last week’s trading action being a series of skirmishes between those trying to break resistance levels and trigger some automated buying, and those willing to fade the attempts and ride a retracement back down again. The S&P 500 index has risen back towards its 12-month moving average, a key level for chartists (and this is a chart-driven market). Look at the chart below of the S&P for the last fifteen years, with the smooth line being its moving 12-month average, and you can see why: every breakthrough of the average has been followed by a sustained rally in prices.
It’s one reason why some of the clever-boots have been trying to push prices higher during quiet periods in the trading day, whenever some wisp of good news appears or failing that, an absence of concretely bad news. At times like these (and especially in the fourth quarter of the year), the equities market can ignore deteriorating situations for prolonged periods. If you were to canvass the floor traders on the New York Stock Exchange, they would probably all tell you that Europe’s crisis isn’t over and that Greece will probably blow up. What they’re willing to go long on is that it might not happen before December 31st.
Yet there’s also a group that sees the current situation as a bear-market rally. While sentiment levels are about average and the market is only mildly overbought, there is an undeniable sense of complacency in the market about the “inevitable” fourth-quarter melt-up. Look again at the same chart above at the rallies in the second half of 2001 and the first half of 2008, and you can see that rallies that failed to break through the 12-month average were followed by sustained declines. Hence the willingness to fade the recent attempts.
Indeed, the current period reminds many observers, including this one, of the 2007-2008 period. Back then it was the U.S. financial system that was obviously degrading, with numerous signals along the way, yet the majority were willing to keep hanging in there and hope for some sort of deus ex machina. Failing that, well, so long as the cops are still on the way and not yet at the door, why, roll the dice one more time, Fred. Europe is obviously headed for a deeper crisis, but you know, maybe it won’t happen until next year.
From the fall of 2006 into the fall of 2007, traders repeated the mantra of global growth and decoupling – the good international economy would bail out the failing domestic economy. Now the idea gaining traction is that the modest U.S. growth –- 2.5% last quarter! – is going to render Europe and China irrelevant. It didn’t add up then and it doesn’t add up now, but the market isn’t always logical when it comes to rising prices. Anyway, the market narrative is often nothing more than a pretext for following the trend that everyone else is following – true belief is for suckers.
In the face of all this uncertainty, there are a couple of things you can count on. One is that a rising market will put off any attempts to seriously engage with problems. The EU, and in particular the Germans, may do the right thing in the end, but only when pushed to the brink of the abyss. The same goes for our own Congress. That means that when the crisis comes, prices will be at a much higher level to fall from and many more players will be foolishly over-extended than now. Just what we all need.
Finally, Europe’s crisis isn’t about if, when, or whether Greece defaults. It’s about too much bad debt across the continent. Like subprime mortgages and Internet stocks before it, Greece is only the most vulnerable part of a much larger problem. Don’t be taken in by its size relative to the whole – Internet stocks were only six percent of the US market cap, while housing was only six percent of US GDP. There’s more to the iceberg than what you can see sticking up out of the water.
The Economic Beat
Per our usual custom, we’ll begin with the jobs report. There was a time when a report like the October 2011 edition would have rattled the markets and started talk of a recession. Now expectations are low, so for many it’s proof of a slow (but sturdy!) U.S. recovery that will outperform the rest of the West.
For us, it’s evidence of an economy that is still treading water and not much more (but not worse, either). There were good bits and bad bits, starting with the upward revisions to August and September. So while the initial estimate of 80,000 (104,000 private) was a bit below the consensus, one can hope that there will be another upward revision to October (though that is not the pattern for 2011). The aggregate payroll index rose by 0.3%, the unemployment rate ticked down by 0.1% and the number of long-term unemployed fell (though the details on that one are unclear). All on the positive side of the ledger.
The worse bits were that the increase in temp jobs, a leading indicator, fell for the third month in a row, while the goods-producing sector lost jobs and manufacturing appears to have plateaued. Almost half of the increase came from health care and the leisure-hospitality categories, and the U.S. economy isn’t going to reignite by consuming more health care. Furthermore, these are low-paying jobs that are likely to keep exacerbating the roughly one hundred year-high in income inequality. The U-6 measure of labor underutilization fell back to 16.2%, but that is only even with June, July and August. The number of employed is only 1.2 million more than a year ago.
Of more concern to us were the two ISM reports on the manufacturing and service sectors. While both numbers showed mild expansion – 50.8 for manufacturing, 52.9 for services (fifty is neutral) – there were some worrisome signs. Although new orders rose somewhat in manufacturing, it was largely due to seasonal adjustment. More disturbing was the growing-contracting sector score for both surveys: only eight-six growing versus contracting sectors in manufacturing (a deficit of eight-nine in new orders), and an eight-eight tie in services. One likes to see a two-digit number of growing sectors and a ratio of 2-1 or better in favor of growth.
Another sign of impending weakness came in the price categories. The manufacturing prices index fell by fifteen points, the most since June 2010. That was part of a period, you may recall, that inspired deflation fears and quantitative easing (“QE-2”) by the Federal Reserve Bank. Prices are a highly sensitive leading indicator, and they also slipped in the non-manufacturing survey. The bright spots were in employment, which showed expansion in both surveys.
The bad news from the Fed was another lower round of forecasts for the economy (but don’t take it too much to heart, as they aren’t the most accurate), and the good news – so far as the stock market was concerned – was that Fed Chairman Ben Bernanke did not rule out another round of quantitative easing. Ergo, Ben and the Fed must be standing by, waiting in the wings.
Factory orders fell in the U.S. in September, led by transportation, but the business investment category rose by 2.4%. The Chicago purchasing managers’ index rose again though the rate of increase slowed, and October chain-store sales were something of a disappointment. That’s only the continuation of a trend that has been going since last year: Americans are willing to step up for certain kinds of purchases – Christmas, Easter, back-to-school – but are otherwise being careful. Christmas should be all right for the retail sector, given the deliberately tight inventories.
Productivity rose, thanks to an absence of wage growth. The celebration was muted. Motor vehicle sales rose a bit more than expected, showing once again the difference in credit availability compared to housing. Construction spending rose in September. In sum, the picture seems to be of an economy that regained some traction in the summer, yet looks to be mildly easing again.
Next week is a light week for economic data, with the biggest reports probably being weekly claims Thursday, together with the trade deficit and import-export price data. Of more may interest may be Fed Chairman Ben Bernanke speaking on Wednesday, and Cisco (CSCO) earnings after the close that same day.