The Seatbelt Light is On


“There aren’t enough lifeboats. Someone is going to die. So you might as well enjoy the
champagne and caviar.” – Jamie Dimon (JP Morgan CEO), on the eve of the Lehman
bankruptcy

Attention, ladies and gentlemen, this is your captain speaking. The crew informs me that we have just crossed the 200-day moving average (exponential) on the S&P 500. I wish to congratulate all of you for coming along for the ride. They all also tell me that the close of 124 on the Spyder (SPY; SPDR S&P 500 ETF) was perfect for burning the maximum number of options. You may have heard a whoosh in the last couple of minutes, but it’s nothing to be alarmed about: it was only the options dealers parachuting out of the plane.

I’m pleased to tell you that as it was the dealers that took all your money for this flight, we are now free to go wherever you wish. Please remain in your seats with seatbelts securely fastened while the crew distributes destination ballots, as severe turbulence is approaching. You may experience some discomfort while co-pilots Merkel and Sarkozy try to decide the best way through the storm. In the meantime, I’d like to thank you again for flying Forever-and-a-Day airlines. Does anyone here speak German?

Kidding aside, our prediction of last week that the markets should manage to work up another week of gains certainly got off to a shaky start, but the last-day rush on Friday managed to pull prices over the finish line. For our money, this was mostly about options dealers getting their own back, as the investment world was buying put options in epic numbers on the way down to S&P 1030 a couple of weeks ago. A study of outstanding option interest in the SPY last weekend suggested to us that dealers would try to pin it between 122 and 124, with 124 being optimal – above that, big slabs of call options would have started to come into the money. It was masterfully done.

Lest you think we’re aggrieved, we weren’t and aren’t. Options market-makers aren’t non-profit corporations, and have as much right to make money as the next trader. If you didn’t know that dealers are busy at every expiration time trying to push prices towards their own advantage, then you shouldn’t trade options. Nor is it all a fix – dealer capital is limited, and determined market moves can leave them with big losses. The best setups are low-volume markets without clear direction, and that’s what we had last week. For ourselves, we were happy to be taking money off the table.

In sum, there is no reason to believe the usual pundit-pulp and rubbish about European optimism and encouraging earnings. To be sure, the markets did catch some tailwind from Wednesday afternoon’s late story that France and Germany had cooked up a two-trillion dollar plan to fix everything once and for all. Though the story was probably a plant from some London-based hedge fund (and if we were them, we’d give it up, because the regularity of these bogus, warmed-over news bombs coming out of London late in the US trading day has started to attract a lot of attention), it did leave a kind of warm and fuzzy glow.

But now the market is in a show-me state again. At the bottom two weeks ago, anxiety had reached such an extreme that something concretely awful had to happen to justify it. When nothing did, markets reversed. Now we are at the opposite extreme, and without a real, credible European solution this week, we will see another reverse.

As to earnings, the reality is that they have been mixed. You may read that 66% of companies are beating estimates, but keep in mind that 66% is the long-term average, because estimates are made to be beaten – they were considerably lowered just a month ago. On top of that, in a good earnings season the first week has a much higher beat rate. From our point of view, 70-75% would have been a good number last week; 66% is at best fair and looks sub-par.

Some good names have done well, and that is encouraging. For ourselves, though, we can’t remember a good earnings-season rally that followed on the heels of IBM getting crushed on its earnings report, not to mention names like GE and the major financials. True, the latter rallied on the Europe play at the end of the week, but those gains have no conviction at all behind them. Has anyone seen the Nasdaq take off in the last ten years after an Apple (AAPL) earnings
miss?

Nevertheless, stocks will rally further if Germany and France can make it hand-in-hand to the Emerald City, which is to say have a credible agreement that can stand the test of time. We would love to see it. Absent a real bone-rattling crisis, though, we say the odds are against it, despite some of the numbers being thrown around in the press. The problem goes beyond Greece, after all – the other troubled periphery countries will want debt write-downs too, and if they don’t get them they will come under siege in the markets almost immediately. Many private banks are still sitting on huge real estate losses, and many large banks will require substantial capital in the event of sovereign write-downs.

All of the above can be done, and it may happen in the end, but we don’t reckon that it will happen in this go-around. What is needed is a good-old fashioned Anglo-Saxon-style Chapter 11 bankruptcy filing for the periphery, with most of the debt wiped out and a fresh start. In the abstract it’s do-able, but it goes against German culture and French financial interest. If either are seen to be unduly violated by their respective domestic constituents, Sarkozy’s re-election would be doomed and Merkel would simply be dismissed – right after the deal was roundly rejected by the German Parliament.

What is more likely is either another impasse or a partial solution that tries to buy more time and put off the most bitter medicine. There may be more money coming, but we doubt it will be enough – the Germans won’t want to spend it, and the French won’t want to lose their AAA-rating (a useless trap, in our opinion). It would be typical form to see a big relief rally of a few hours (there’s a deal!) to be followed by a bigger sell-off as the details sank in (you call this a deal?).

Our advice is to stay in your seats with belts secured and wait. Chances are that only the brink of collapse will compel the EU actors to make the necessary compromises. If they can find a way to get it done first, so much the better. Missing the first few percent in the markets won’t kill you. But if they mess it up, it’s a long, long way to the ground. Getting out a day early might cost you a few quid in opportunity profits, but getting out a day late, you won’t want to know.

The Economic Beat

The Philadelphia Fed’s October manufacturing survey gets our vote as the report of the week. Our assessment last week that the manufacturing survey would look alright got a bit tarnished on Monday when a weak survey from the New York Fed and a tepid industrial production report was weaker than hoped.

At the risk of sounding Pollyannaish, though, the New York report wasn’t as bad as the headline. While there was no improvement in the gloomy overall index – a contracting (-8.48) versus (-8.82) in September, virtually unchanged – the leveling in new orders masked a big increase in respondents reporting higher orders. Shipments increased substantially, as did employees. However, prices weakened, both paid and received, never a sign of increased activity.

Industrial production did pick up two-tenths of a percent, matching the consensus estimate, but capacity utilization was unchanged and is still well below springtime levels. Mining and utilities offset each other, but manufacturing is still inching up.

The Philadelphia report, though, showed a healthy increase of that went well past expectations of another negative reading. The reading of 8.7 compared with a (suspiciously low) consensus estimate of (-9.7). Strength was in overall business activity, new orders, shipments; employees inched up with no change in firms cutting back. The one drawback was that prices paid continue to strengthen with no reported increases in prices received. It may be a perceptual flaw by respondents (we can’t seem to raise our prices, but it feels like our costs are always going up), or it could reflect the strong increases seen in import-export prices (pressure on export prices is mostly food-related).

Housing had three reports, starting with a homebuilder sentiment index that had the media bamboozled. The reading of 18 (only 15 was expected!) started a reflex sucker rally in homebuilding stocks; after all, it was 30% higher than September! Yes, but the sentiment index has been stuck in the same range for years, mostly 15-17 but occasionally 14 or 18, even a 19 once. When we tell you that neutral is fifty, you can appreciate how far off 18 is from any real good news.

The sentiment index is a good clue to the housing starts report that always follows the next day, and it showed an increase bigger than expected, thanks to a surge in multi-family homes. Single-family homes barely ticked up and the increase could easily be revised away; in any case permits fell, signaling a slowdown next month. The annualized rate of 658,000 is still half of what a normal rate might be.

Existing home sales were less than expected, falling to a 4.9 million annualized rate and showing both mean (-3.1%) and median (-3.4%) price decreases. The Northeast improved, however.

Prices were a mixed bag, with producer prices (PPI) rising a very sharp, energy-related 0.8% (+7% year-on-year) for the month, although only 0.2% when the trivial food and energy categories are excluded. Gasoline rebounded strongly, matching the rebound in the stock market. Consumer prices (CPI) were subdued, thankfully, with the headline rate up a modest 0.3% (3.9% year-on-year) and core up 0.2%, matching the PPI core rate. Bond prices reacted little, being mostly driven by safe-haven considerations.

The latest Beige Book (regional Fed reports) was something of a disappointment with its talk about tepid to no growth, and cast a pall over the market for the rest of Wednesday. Leading indicators were positive, at 0.2% versus an expected 0.3%. And once again, claims were reported to have fallen even as they rose. Last week’s reported decline of (-1,000) was revised to an increase of 5,000 (originally 403k vs. 404k, now 409k vs. 404k) and the current underestimate of 403,000 will probably rise to 408,000 by next week.

Next week has a report of high interest – the first official estimate of third quarter GDP (doubtless accompanied by yet another revision of the second quarter). The consensus estimate of 2.5% seems improbably high to us, and we wonder where it’s coming from – retail sales reports? At any rate, we’ll be more than pleased with anything north of 2%. The September durable goods report is due on Wednesday, and that should tighten the estimates. You might also want to have a look at the Chicago Fed’s national activity index Monday morning.

The rest of the week has news on sentiment, housing and regional manufacturing. For the last, there’s the Richmond district report on Tuesday, followed by Kansas City on Thursday. Housing starts off with two price measures, the influential Case-Shiller index on Tuesday morning at 9 AM followed by the federal GSE data at 10 AM. New home sales for September come Wednesday morning, with pending home sales for October on Thursday. Credit tightness has induced a certain indifference to the pending home sales data, though, and only big outliers attract much attention. Which, come to think of it, is true of most of the housing data.

Sentiment weighs in twice, beginning with the monthly consumer confidence index on Tuesday from the Conference Board. But the market has largely given up on hearing any good news from this direction. The consensus is essentially a punt calling for no change, much like the University of Michigan sentiment number due on Friday. The end of the week also has personal income and spending for September, but most of the data will be known from the GDP report the day before. It’ll be accompanied by the employment cost index for Q3.

That brings us to earnings, which are running in and out of the spotlight and will almost certainly be interpreted in tandem with European developments. In other words, if the EU looks goofy again, then earnings won’t look so hot either, but if something really good happens, you’ll hear a lot of talk about earnings beating estimates again. It isn’t very rational, true, but what trading market is?

Caterpillar (CAT) reports before Monday’s open, and if we see yet another selloff there then we suggest you take to the lifeboats for the rest of the earnings season. By the same token, a good report would go a long way. Texas Instruments (TXN) reports after the close.

Tuesday will open with 3M (MMM), oil giant BP and trader favorite Coach (COH). The big report of the day for most might be the overhyped Amazon (AMZN), which seems to have made a virtue out of losing money so long as one grows sales. Isn’t that what went wrong back in the tech bubble? It’ll be joined by momentum stock F-Five (FFIV).

Boeing (BA) reports Wednesday morning, along with Ford (F) and oil giant Conoco-Phillips (COP). Visa (V) is in the afternoon. Thursday is a full day, with consumer giant Proctor & Gamble (PG) and top-giant Exxon Mobil (XOM) the most prominent names. Indeed, next week is the heaviest week on the calendar, but we are restricting ourselves to the most prominent names, such as Chevron (CVX) and Merck (MRK) on Friday.

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