“To everything, there is a season.” – Ecclesiastes 3:1
No doubt we can all remember the fun house rides of our youth. As fun as they looked – and we had many friends who loved them – alas, our inner ear was not amused at the ones that spin people around in violent arcs and circles. It would share its displeasure with the semi-circular canals, and the end results were unpleasant. We found it hard to justify queuing up and paying money for dizziness and nausea, when there was a cheap substitute readily available in the evening news.
Last week took us back again. Judging by the flood of mutual fund redemptions, it took a lot other people back there too. It seemed to take newsreaders and editors back as well, judging by the sensationalist reporting and the somewhat embarrassing comportment of many of them, who seem positively thrilled, if not downright pleased, at the carnage in the markets.
It’s the way of the world – bad events attract more attention than good ones. Not only that, but the relationship between the Street and the business press tends to be one of mutual disdain, built upon an inequality of income and expertise.
The current situation is not like 2008, as so many stories led off with last week. In fact it is mostly quite different, with the main commonality being the clueless tin ears of our legislative discourse. In the fall of 2008, we had a massive debt bust gathering speed, an economy already in the grips of recession, and an overvalued stock market still desperately holding out hope for a “goldilocks”-type landing.
We also had a still-entrenched band of stubborn laissez-faire ideologues who fatuously thought that private markets live in a magic fairy world, where all that happens is for the best and whose purity government can only corrupt (then-Treasury secretary Hank Paulson predicted that stock markets would rally on the “certainty” gained from the news of Lehman’s bankruptcy. Forrest Gump couldn’t have gotten that one as wrong). It was a rude awakening.
But this year’s rude awakening is quite different, and has much more in common with two other panics, the ones of 1998 and 1987. The former had a bond market and sovereign debt panic, while the latter had an overvalued market that ended up getting ambushed by its own financial innovations.
We were very much around in 1987 (we started working at the age of five). The innovation of the time was something called “portfolio insurance,” a popular concept for limiting risk (funny how such concepts usually end up going the other way). It involved automated selling of stock futures and baskets of stocks as a hedge against downside volatility. The “overlooked” problem was that it worked best if nobody else was doing it. But it was such a great marketing pitch (no downside volatility was Bernie Madoff’s calling card) that everybody was in on it.
Suppose you took a training class on how to quickly exit a burning building. You’d have a real advantage over the others in your building – unless a few thousand people took the same training class and executed the same escape plan. That’s what happened in 1987: too much money tried to take the same route out of the same building at the same time. At computer speed.
The stock market subsequently put in trading restrictions designed to brake automated activity, and indeed all activity, if certain limits were breached. Since that time, though, some of the restrictions have been relaxed, and more “innovations” that serve a few at the expense of the many have come back to plague us.
First amongst these is high-frequency (HF) trading, which can and does execute thousands of trades per second. Since the NYSE became a public corporation, it has shamelessly courted the volume revenue that HF traders bring, offering to put HF-trader network servers next to its own (known as “co-locating”) in order to minimize the number of nanoseconds it takes to communicate price information.
HF trading especially amplifies the impact of large orders. While it’s true that it amplifies movements in both directions, the larger impact is to the downside, because when investors are redeeming funds, large orders flow in from funds to meet redemption needs. They tend to bunch at the end of the trading day, when institutions know how much cash they’re going to need from the volume of requests. The real volume of selling is then swelled dramatically by HF traders trying to profit from the trend (it was reported that HF volume tripled last week).
It’s an old truism in the markets that the main cause of higher prices is higher prices and the same for lower prices: buying begets buying and selling begets selling. That’s nothing new, but when certain innovations – such as portfolio insurance or HF trading – can greatly speed the selling pressure, it’s time for the referees to step in. The HF firms claim that they provide liquidity, but this is like the Mafia claiming they provide protection – others are simply afraid to meddle. Of course, the HF firms will also claim that any changes will “cost jobs” (unlike the economic damage caused by last week’s plunges). Why haven’t drug dealers used this ploy? Everyone else does.
The crisis is also reminiscent of 1998’s currency-sovereign debt crisis, which culminated in the Russian default, the collapse of a big hedge fund (Long-Term Capital) and a generalized panic in fixed-income trading that ended up knocking 22% off the value of the S&P in only 8 weeks. The good news was that once a policy fix was in, it only took 7 weeks for equities to recover. We see a similar possibility this time, with Europe and in particular Germany only agreeing to stop dancing around the inevitable (a full-blown restructure of periphery debt and recapitalization of any banks needing it) when pushed to the brink. Then markets would rocket back, and so would the European economy.
Another policy fix we would want to put in besides regulating HF trading and getting the EU to face the music would be to raise margin limits in the commodity pits, in particular for oil. As we never tire of pointing out, equity prices can’t get going without oil prices rising even faster. Forget the smokescreen of supply-demand arguments, the main driver of oil prices above $100 was financial speculators seeking leveraged bets unavailable in the equity and bond markets.
Of course, at the first whisper of putting the brakes on, the main trading desks would call the oil companies and shriek hysterically that the latter won’t be able to hedge production anymore. In turn, the companies will dutifully complain to Congress (more jobs lost! more PAC contributions lost!). It’s all baloney – the main losers wouldn’t be the oil companies or their customers or our jobs, just a few big bonuses on a few trading desks – and of course, OPEC.
One more thing, as Steve Jobs likes to say – restrict credit default swap (CDS) purchases to owners of the underlying bonds. A few exceptions could be carved out, but generally speaking, it’s CDS trading that ignite cascading downward spirals in equities. The European countries banning short-selling of equities are targeting the wrong practice – without the CDS trading, they wouldn’t have much short-selling to ban. But like CDOs, banks make huge upfront margins on such trades and are loathe to abandon them – and like CDOs, cross their fingers that they won’t go bad, because they won’t have the money to pay them off.
The economy isn’t plunging and stocks are no longer overvalued. They could get cheaper, but the bulk of the damage has been done. Don’t mistake our meaning, though – while all of the above have been contributing factors, the main reason for the downturn in equity prices was the belated discovery that economic growth in 2011 wasn’t going to be what it was cracked up to be.
It’s an overreaction. The major data points of recent weeks – the ISM surveys, weekly claims, the jobs report – have all been positive and some have surprised to the upside, albeit mildly so. But the same kind of senseless optimism that pervaded the tape at the beginning of the year and in April has now found its opposite in senseless pessimism.
Left to its own devices, the economy will see another round of inventory build in the last three or four months of the year that could see us finish on a comparatively decent uptick. But not if we engage in a wild game of who can cut more, and not if we have another ugly contest in December when the next phase of the budget ceiling is due. The main cause of the deficit is the recession and its anemic recovery, not government spending, and a reckless pursuit of austerity will put us in the proverbial position of fixing the roof in the middle of a storm. By the time the job is done, the house is lost.
In the meantime, we feel sorry for the retail investors who realized their losses by panicking last week. Selling after a big correction makes it extremely difficult to get back in and recover your losses. Despite the real possibility that we could still make a lower low, this is really a time to be selectively buying. We make the downside risk to be about another five percent down from last week’s low, while the upside is about twenty percent higher from where we are now.
But perhaps it’s not the time to be betting on the fortunes of Standard and Poor’s (S&P), now caught in a ridiculous downgrade spiral as it lowers ratings by the bucket load after questioning the political will of the US to pay its debt. Unless S&P can justify the downgrades by panicking others into creating a financial collapse (itself instigated by S&P), it risks burying itself. That’s what happens when you ride the roller coaster.
The Economic Beat
It only makes sense that the most important release of the week also generated the least volatility. We are talking about the July retail sales report, which surpassed expectations with an increase of 0.5% and included an upward revision to June. Sales excluding autos and gasoline rose 0.3%.
Given the gyrations in the market, it’s fair to say that the positive retail sales print did more than lead the market to a gain. It also broke the near-death spiral of massive swings – we don’t doubt for a moment that a weakish number of say, 0.1% or so, would have led to another big lurch downward.
The University of Michigan’s consumer sentiment measure, by contrast, fell to 54.9, its lowest level in over 30 years. While it’s true that that sentiment doesn’t correlate very well with actual sales – the latest weekly Redbook sales tally was good – such a low reading does give pause: the ICSC-Goldman weekly tally was not so good. Sentiment readings do tend to reflect financial headlines and the recent direction of the stock market more than anything else, so traders do take them with a grain of salt, despite the press pouring on the melodrama.
The larger cause for concern is the effect that the headlines may have on business decisions. The small-business (NFIB) sentiment index fell for the fifth month in a row to a level of 89.9. That’s below average for the recovery, though still well clear of recession trough readings. The problem, though, is that most businesspeople are good at other things than macroeconomics. They tend to be poor forecasters with as many, if not more, crackpot theories about the economy as any other group.
For every Jamie Dimon, there are a hundred corporate CEOs at the other end of the scale who get most of their economic thinking from the headlines, political party emails and the golf course. We don’t mean to pick on them; it’s just that other skills matter so much more in getting to the top – e.g., organizational, engineering and sales abilities. We don’t think CEOs will mimic the panic in retail investing, but what macroeconomists do worry about is whether too many will go cautious at the same time. It’s the classic trap of self-fulfilling prophecy.
That isn’t showing up yet in weekly claims, which may finally have fallen below 400,000 last week. Two weeks of announced drops below 400k have subsequently been revised back up above that level, but the size of the upward revisions have been getting smaller, an encouraging sign. The latest estimate of 395,000 may actually hold up. Hiring hasn’t taken off, nor does it appear about to, but it is growing nonetheless and this is not the time to whack it.
The first estimate for French second-quarter GDP came in with a disappointing unchanged reading, but the wider miss was in EU industrial production, which fell a nasty (-0.7)% in June. This is a direct consequence of the austerity programs being flogged all over the continent, beginning with the periphery countries and now being talked up in France and Italy. You can’t cut your way to prosperity.
The more difficult the times, the more people gravitate to extreme solutions and the more a kind of general hysteria can set in. The global depression of the 1930s produced massive failures of common sense, from the me-first tariff wars that helped ruin the globe, to the economy-crushing attempt to balance the U.S. budget in 1937, to the rise of Hitler, Mussolini and Stalin. We don’t want to get up on the roof in the middle of the storm.
Our measure of productivity and costs fell (-0.3%) in the second quarter, due mostly to the slowing economic output. Another contributing factor is the widespread reinstatement of workforce benefits such as matching 401-k contributions after two years of omissions and freezes. Those incremental additions will drop out of the measure over time. Aggregate wage income growth is running at or below inflation.
The trade deficit worsened in June, with both exports and imports dropping. As usual, the biggest culprits are China and OPEC, i.e., cheap labor and not-cheap energy. A weakening Europe is not going to help our export growth.
Inventory growth was smaller than expected in June, a development that we welcome. Our belief is that inventory growth was exaggerated in the first quarter, partly by favorable tax treatment for capital investment, partly by excess optimism (particularly in retail) and partly in response to the Japanese earthquake, which led to considerable over-ordering in technology. We are currently working our way through the excess and with any luck will see inventory production shrink further in July, even August (although not in apparel, for obvious reasons), before giving way to a welcome resumption in the fall.
Next week will be crucial to the August markets. We have three industrial and manufacturing reports: the New York Fed (“Empire State”) manufacturing survey Monday morning, the Philadelphia Fed edition Thursday, and the July Industrial Production report sandwiched between them on Tuesday morning. Nerves are on edge, and bad news from these reports could reignite the downward spiral.
Yet we are hopeful that the resumption of auto production will give conditions a little boost. The danger of the surveys is that they are just that, quickly filled out by less-than-top executives with other things to do. They don’t say much about the level of activity; the Philadelphia survey, for example, was at near-record levels in March, yet first-quarter GDP was less than 1%.
There is also a big bucket of home sales data, but housing hasn’t moved the meter in a long time. That wouldn’t be the case if we saw a strong uptick, but mortgage-purchase activity hasn’t shown any improvement. The homebuilder sentiment index comes out Monday; it will be a good clue to July housing starts due out the next morning. Existing home sales for June follow on Thursday.
It’s also a big week for inflation data, which might move the markets but probably won’t unless they put up some pretty bad numbers. Import-export prices are Tuesday, producer prices Wednesday and consumer prices Thursday. So far the drop in oil has had very little effect on gasoline prices.
Rounding out the week are Leading Indicators on Thursday and a host of retail earnings reports, including Home Depot (HD) and Wal-Mart (WMT) on Tuesday. Last week’s Cisco (CSCO) report helped revitalize the tech sector, can Hewlett-Packard (HWP) do the same this Thursday? The expectations for the company are already very low. The company will be joined after the close by chipmaker Marvell (MVL) and the very expensive cloud darling Salesforce.com (CRM).
With Friday being an options expiration day, we could see more big movements in prices, and we wouldn’t be surprised to see them to the upside. All the recent put-buying means the options dealers will be in there buying away, and even mildly adequate reports from the tech trio could add more fuel.