Tipping Point


“It’s too close for comfort, this heat has got right out of hand.” – Bananarama, Cruel Summer

Here we are in mid-July, with the S&P 500 standing about where it did on February 7th. The increase in the market seems due to the rally that happened in the first six weeks of the year (the S&P rose nearly 7% between December 31st and February 22nd; since that day it is down 2%, and 3.5% since the end of April). What has really kept the market alive since then is a series of mark-em-up rallies at the end of each month.

Three things are uppermost in trader’s minds: the debt ceiling battle, earnings season, and the European monster. Both the bond and the stock markets have priced in a last-minute resolution, though the two sides haven’t been moving in that direction. Senator McConnell’s gambit, reminiscent of Pontius Pilate’s scene with the water bowl, may seems like black comedy, but it’s being taken seriously (in case you’re at a loss, the idea is to authorize the President to raise the debt ceiling at his own discretion. Then the House will vote to overturn it, the President can veto it, the Republicans will lack the votes to override and be able to say they all voted against it. What a circus).

If a bill hasn’t passed by Friday August 1st, then the markets will get nervous. Until then, so long as there is no final thumbs-down, they will prefer to focus on earnings season. It’s the party the market has been looking forward to since last month.

It’s a tough call, this earnings season. Earnings are expected to beat estimates, on average, by a little more than four percent. By strange coincidence, estimates have been lowered by four percent since May. It’s a game the Street never tires of, and just because it’s a rigged game doesn’t mean traders won’t be celebrating anyway. They might even start to believe it was really a surprise after a while; it wouldn’t be the first time.

It’s an overcrowded trade, to say the least. Usually such things come to grief, but the one exception is earnings season. If the market wants to have its earnings party, it’ll usually do so regardless of how contrived it may seem, the quality of the earnings or the lack of any real surprises. Companies will have to put up lots of disappointments and lower guidance to undo the proceedings. The caveat is that if the earnings really aren’t all that great, the rally will become a rout afterwards.

The two problem areas are the financials and semi-conductors. Revenues are down for the former and the early-reporting chips (semis) have been disappointing. With a growth-sensitive market prizing revenue growth as much as profits, if not more (they have to bet on something), these two key barometers of fundamental well-being look to be of little help. The rally may go on anyway, but it’ll be tough to stay long a market that isn’t supported by either financials or chips.

As for Europe, they’ve given us another stress test that had already lost considerable credibility before the results were even released. A German bank withdrew because it thought it would fail, the Spanish banks did their best to direct attention elsewhere and the general process continent-wide resembled a crowd of university students pleading their grades at the end of term. More funding plans won’t resolve the problem of too many bad loans, but nobody knows when this recognition will become official. Until then, we’ll just put on another rally every time the inevitable is rescheduled.

Earnings should be good, because they tend to lag the economy. In fact, one of the latest trading theories gaining traction is that the lack of hiring should reassure us, because it means profit margins will remain strong. Much will depend on guidance, but don’t look for companies to get too candid. If things seem a bit cloudy, management usually will stick to forecasts “based on what they can see,” wait until after earnings season to unload stock, and then ‘fess up later based upon “fresh” data.

We’re going to be in for some volatility. It’s impossible to know what will happen with either the debt ceiling or Europe, but it’s certain that the market will rally on any postponement of either problem, if only for a little while. If guidance isn’t poor, prices will rally on earnings too.

On the other hand, if either the debt ceiling or Europe come unglued, look out below. The economy has been slowing, so the chances that the earnings rally is completely wiped out in August are growing every day. The market could rally to the 1370-1400 level, which sounds great, but if happens this month, the payback later will be that much worse.

The market doesn’t really discount the future anymore; it rallies until disaster tips it over. The lesson most traders “learned” from 1999 and 2007 isn’t that one should pay attention to deteriorating fundamentals, it’s that one should make as much money as possible until the last pole of the tent collapses. The problem is that this behavior has been seriously undermining the economic structure it purports to represent.

But why should the markets face reality? The Europeans don’t – they administer stress tests that don’t include the possibility of sovereign default, a technical term for the fact that the continent is sitting on a mountain of bad debt that has to be restructured. A number of our own politicians won’t, insisting that a Treasury default will somehow be good for us. China won’t on any number of levels. To survive as an investor, you need to stick to the old axiom of buying what’s cheap and selling what isn’t, and don’t fall for the madness of crowds.

The Economic Beat

The most overlooked release of the week was the June Industrial Production report; the most misunderstood was weekly claims. Beginning with production, the month-over-month result benefited from one of those “met estimate” headlines when reality was something different. The consensus called for an increase of 0.2%, and 0.2% was the number printed, but it came on top of a two-tenths revision downward to the previous month. May was not up 0.1%, as it turns out; it was down 0.1%.

Rather than belabor one month, though, let’s look at some numbers over the recent months. The estimate for second-quarter industrial production growth is 0.8%, annualized. For the first half of 2011, the index rose at a 1.1% annual rate. Manufacturing rose from 89.6 to 90.6, a 2.2% annual rate, with most of the increase came from December to January; the annual rate for the last five months fell to 1.34%.

Perhaps the most interesting statistic is energy usage over the last twelve months. Electric production is off 1.4%, while natural gas is down 1.6%. That isn’t just weather and conservation – it’s a sign that industrial usage has been modest at best. Without autos (up 7.5% over the last twelve months), where would we be? But the American auto sector is smaller than it used to be and doesn’t punch the same weight in the economy anymore. The last twelve months also benefited the sector from climbing out of the trough; a similar gain for the next twelve months looks highly unlikely, given the sluggish labor market, weak income conditions and impending budget reductions.

Weekly claims were reported to have fallen to 405,000, and we heard NPR call it the biggest weekly drop in a couple of years. If only it were true.

The previous week received an extra-large revision upward, 9,000 higher. That exaggerates the size of the drop. Every week since April, the previous week is revised higher, making the current week appear better. That’s why every week the four-week moving average is reported to have fallen, yet remains unchanged from a month ago and is still higher than April.

On top of that, raw claims rose by 75,000 (unreported everywhere but by the Labor Department). A seasonal adjustment factor is appropriate for quarter-end because layoffs always spike at these times, but this one is above average to account for US auto industries doing summer shutdowns. Except that they’re not shutting down this time, because of the catch-up from Japanese parts shortages. The number is flawed.

Weekly claims go into most leading- and coincident-indicator models. The adjusted number is used, of course, so models that incorporate the number over the next few weeks are going to present false hope for the July jobs report. Given that raw claims were only 40,000 less than the equivalent week a year ago when factories did shut down, it suggests the labor market remains weak.

Retail sales were reported to have risen by 0.1% in June, unchanged when excluding autos. This beat the estimate of a drop of 0.1%, but even so wasn’t as good as it seemed. Gasoline purchases fell, despite the much-overhyped easing in prices (they’re still a dollar higher than last summer). The increase in food sales (+0.3%) was mostly due to inflation (+0.2%). What mainly helped the number was the late arrival of warm weather in the northern half of the country (the South is baking in a drought) and some massive inventory-clearing by apparel stores. Don’t look for an apparel repeat next month.

Despite the drop in energy prices, core inflation in both the CPI (consumer) and PPI (producer) price indices increased by 0.3%. However, thanks to the energy drops, headline inflation fell 0.2% in the CPI and 0.4% in the PPI. The year-on-year rates remain elevated for both the PPI (7.0%) and CPI (3.4%).

That seems to have been lost on the trigger-happy traders who went ballistic over Fed Chairman Ben Bernanke’s pronouncement that the Fed would be ready to intervene if necessary, fanning the flames caused by the release of Open Market Committee minutes in which some of the Fed governors wondered whether more stimulus might be necessary (and some said the opposite).

In the first place, does anyone expect Bernanke to answer that if the economy weakens, there’s nothing more the Fed can do? That would cause a major panic. For the same reason, the Treasury secretary always replies that he favors a strong dollar, regardless of what he may think – to say otherwise is simply not part of the job description.

Bernanke also qualified the Fed’s help with the proviso that inflation be contained. As he was speaking, the price of oil was simultaneously surging on the possibility of more Fed easing. Unless regulators decide to intervene in the commodity markets, the first effect of any more such easing would be to send commodity prices soaring, especially oil. Bloomberg reported that speculators piled into commodities in the week ending July 12, with the biggest increase since last August. A good part of the increase went into gold and silver as anxious investors took out protection against our fearless leaders in Washington, but agriculture bets soared as well.

No, there are unlikely to be any easy choices for the Fed, and the larger problem is that there is a limit to what any central bank can do for an economy. The Fed has already done about as much as it should, and another round of easing anytime this year would not only be politically risky, but touch off a round of commodity inflation that backfires both home and abroad. It’s time to stop hoping the Fed’s wand can wave our problems away.

The trade deficit soared in May, with rising energy prices and falling exports the culprit. The energy bill will reverse direction for the June report, as import prices were reported to have fallen led by a drop in energy. However, the drop in exports is something to worry about. Prices increased only 0.1% in June, but the yearly rate rose to a stiff 9.9%, led by an eye-popping 31% increase in food. That is real inflation. Year-on-year import prices were up a sobering 13.6%.

Two other reports that were largely overlooked were the New York Fed manufacturing survey and the first July consumer sentiment measure. The former posted the second month in a row of contraction with a (-3.76) reading, confounding the consensus guess of plus 8 (zero is neutral). New orders fell for the second month in a row, along with backlogs, inventories and prices. Consumer sentiment hit a two-year low of 63.8, with expectations dropping to 55.8. That’s a low number.

Next week is all about earnings, though there are some economic releases. The bulk of it is housing-related, with the homebuilder sentiment index Monday, housing starts Tuesday and existing home sales on Wednesday. Last month’s sentiment index slipped to the bottom of the range and mortgage purchase application activity has remained weak, but the advantage the sector has is that it’s almost impossible for it to disappoint anymore. The federal home price index for May rounds out the week for the sector on Thursday.

Thursday will also bring the Philadelphia Fed business survey for July, originally expected to rebound but New York’s negative result will reset expectations. It will come out at the same time as the home price data and the latest Leading Indicators. They will probably all be drowned out by the parade of earnings that day: AT&T (T), Ford (F), and Microsoft (MSFT) highlight the list.

The earnings week (and season) warms up in earnest on Tuesday, with Bank of America (BAC), Coca-Cola (KO), Goldman Sachs (GS), Johnson and Johnson (JNJ), Wells Fargo (WFC), Apple (AAPL), VMWare (VMW) and Yahoo (YHOO).

Wednesday has United Technology (UTX), F-5 (FFIV), and Qualcomm (QCOM).

Friday has Caterpillar (CAT), General Electric (GE), Honeywell (HON), McDonald’s (MCD), Schlumberger (SLB), Verizon (VZ) and strong>Xerox (XRX).

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