“Watch your back.” – Anonymous
Two weeks ago, we told you that the falling markets were on the verge of an upside reversal that could start as early as the next day. In the event, it began one day later than that. Despite the bad tone, gloomy headlines and ugly September finish, we concluded that there was nothing new in any of the news that was supposedly bringing the market down. What was more likely was that those who were set up to profit from a falling market had more ammunition than those who weren’t. But we reckoned that play was done.
Ten trading days later and here we are at the other end of the parlay. Markets have put on an incredible rally that included the S&P rising four percent and the Russell 2000 seven percent in the last forty-five minutes of the first Tuesday (and second trading day) of the month. By Friday’s close, the big-cap rally had reached 14% from that same day and small caps had recovered 18%.
And it’s probably about to turn again.
The media is playing its role well, so well that it’s at times painful to watch how much the business press can get taken for a ride by the Street. The same front pages that warned of the end of all things at the beginning of October are now bubbling with good news about the economy. Confident predictions are trotted out along with whispers of that famous fourth-quarter surge that will lift the boats all the way into the end of the year.
Not quite yet. Let’s begin by pointing out that just as nothing was new as the market sank to new lows, nothing has been new as the market came roaring back (on steadily falling volume, no less), with the exception of the Apple 4S and the lamentable departure of the late Steve Jobs. Europe is talking change, but not much more – while they did (finally) approve the new EFSF stabilization fund, it’s only an intermediate step to the real cure: write down the periphery debt, recapitalize the affected banks, and start over. A pre-packaged bankruptcy for the PIIGS is what’s needed, much like GM.
An EU do-over isn’t going to be an easy process, and there aren’t any guarantees it will get there. Rising markets aren’t going to help, either, as the political echelons probably need the cover of a meltdown crisis to serve up the medicine that needs to be taken. The higher stock prices go (or the lower CDS spreads), the more opponents will be emboldened to say or do something stupid.
On the other hand, the market’s bar for action has definitely moved, and that’s part of the problem. As prices sank lower and lower and stories kept talking about the bad things that might happen, the bar for what was genuinely bad got higher and higher. Worry fatigue set in and even mildly good news was a catalyst for traders to rush to the other side of the options boat and start burning up all the puts, not to mention the amateurs.
By the same token, as prices rise higher and higher and stories keep talking about all the good things that might happen, the bar for what is genuinely good gets higher and higher until anxiety sets in and even mildly bad news could be a catalyst for traders to play the same game in reverse.
For example, while it may have been a relief to hear EU officials say we’ll do what has to be done after the S&P had corrected 19%, if we go another couple percent higher it risks a letdown to hear the same officials say we’re still talking rather than doing anything. Not to mention that the amateurs are all bulled up and ready to be plucked again, going by the press and the latest polls.
The good news, such as it were, is that the surge could last a bit longer before markets reverse again. A backup could start this week, but it could also wait until the week after. The 200-day exponential moving average on the S&P is an inviting target overhead at about 1236, only a percent and-a-half away. The usual play in these circumstances is to have a breakthrough to higher levels for a few hours, days or points to finish roping in the unwary. Then the turn will come right about the time CNBC starts talking about how resilient the market is.
Looking ahead to next week on the economic calendar, the news is primarily manufacturing-centered. Going by the pickup in autos and aerospace, the sector ought to be okay. Housing has some reports too, but the sector can really only surprise to the upside.
So as we get into the meat of the season, the focus should be on earnings. Estimates have come down sharply from a month ago, so the usual façade of companies beating them shouldn’t be threatened (one can already see the beatific looks on the faces of the newsreaders). There is risk in several areas, though.
To begin with, the financial sector looks shaky and the tepid results last week from JP Morgan (JPM) weren’t a harbinger of great things. That said, the bar is set low so there is actually room to surprise to the upside. Keep an eye on Citigroup (C) on Monday.
Another challenge for S&P-type companies is the recent rise in the dollar. We don’t expect bad news from the IBM report on Monday, but it should give a clue to the currency challenge (expect companies to talk loudly about “core” earnings and to downplay any such effects). IBM has executed well and bought up tons of stock, so despite the recent rise in the stock traders may be willing to overlook the buck and keep riding the wave. Later reports may find them less forgiving.
Finally, there remains the issue of guidance and European sales. The latter seems headed for recession, and caution on the part of its corporate sector could pose a problem for certain technology and software companies. Traders are prepared to deal with a little prudence, but not a lot. As for guidance, it may come down to how far corporate management is willing to stick out their collective necks to support the stock.
A typical outcome would be for prices to keep rising on enthusiasm and optimism into the middle of earnings season, and then begin to fade under the weight of mediocrity (there is also a chance that disappointment begins to set in quicker if the financials come out weaker than lowered expectations).
For all that, Europe’s financial dilemma remains the deciding factor until its final denouement. The next round of meetings doesn’t begin until next Saturday, on the 23rd, but whether or not its leading players can manage to keep their mouths shut until then is another story. We wouldn’t bet on it. Even if they did, there is always the chance that the Financial Times will throw a few more late-in-the-day news bombs if the rally wears on. But in which direction, we couldn’t tell you.
The Economic Beat
The report of the week was surely the retail sales report for September. Not only did it beat estimates, it was a decent number, period. Sales were up 1.1% including autos, and 0.5% excluding autos and gasoline. That came on top of a good-sized upward revision to August (+0.3% versus 0.0%). The report looked fairly clean, with the only weakness in food, of all things. The ex-auto, ex-gas number closely tracked the 0.6% increase in aggregate payrolls reported for September.
Until then, really not much had happened on the economic front. Second place in the sweeps were the FOMC minutes, which revealed a bit more aggressiveness on the part of some of the members to get back into the asset purchase business. The notion that another round of easing could be there to fall back on bolstered trading to the upside. Whether or not it would work doesn’t matter, what matters is the belief that some kind of rally would inevitably follow.
Small-business optimism index crept up, probably bolstered by the stock market, but consumer sentiment fell, despite the increase in sales and payrolls. Maybe the poll came before the rally had gotten traction? A partial explanation could be the labor market, where jobless claims are inching up again. Don’t believe the misreport, as claims didn’t fall last week and the rise will show up in next week’s revision. You have to compare apples to apples, revisions to revisions.
The trade balance came in on target, with exports making a good showing. Export and import prices continue to show worryingly high inflation, with food driving the former and petroleum the latter. The Producer Price Index (PPI) and Consumer Price Index (CPI) come out Tuesday and Wednesday and should give us a better look at the domestic picture. Business inventories rose 0.5% in August, in line with sales.
Next week has more on tap, but the reports rate to be overshadowed by earnings. Monday morning kicks off with the New York Fed manufacturing survey for October and the September industrial production report. Thursday has the Philadelphia Fed survey. The consensus for both is negative, which seems a bit dubious to us, so there could be upside from those two reports.
Housing checks in with three reports: the homebuilder sentiment index on Tuesday, housing starts on Wednesday and existing home sales on Thursday. As we said, the sector can only surprise to the upside and credit availability remains extraordinarily tight.
Rounding out the calendar will be the Leading Indicators on Thursday, expected to remain in their current uptrend. However, the ECRI (Economic Cycle Research Institute) index has been persistently negative and fell to its lowest level in over a year. The ECRI has a fairly good track record, and while nothing is perfect, we admit to finding this worrisome. We don’t see the economy in double-dip territory yet, but a European accident or another debt-ceiling standoff could get us there.
The rest of next week is about earnings. Monday’s lineup features Wells Fargo (WFC) and growth darling VMW in addition to Citigroup and IBM.
Tuesday morning completes the Gang of Four reporting with Bank of America (BAC), seen as the weakest, before the open. It’ll be joined by Coca-Cola (KO) and Johnson and Johnson (JNJ). The big enchilada that day, though, will be Apple (AAPL) after the close. Don’t be surprised to see them carry the tech tape into the next morning. Joining Apple are Intel (INTC) and Juniper Networks (JNPR).
Wednesday has Morgan Stanley (MS), United Technologies (UTX) and American Express (AXP); Thursday features AT&T (T), Nokia (NOK), Phillip Morris (PM), Microsoft (MSFT) and Sandisk (SNDK). Friday has a big lineup too: General Electric (GE), Honeywell (HON), McDonald’s (MCD) and strong>Verizon (VZ). If you want our advice, it’s sell into strength and be ready to flee.