Marginal Cost


“How could you do this to us, after everything we’ve done for you?” – Mortimer Duke (Don Ameche) in Trading Places

“Margin call, gentlemen.” Those were the words famously uttered near the end of the movie Trading Places, right after the nefarious Duke brothers had seen their attempt to game the futures market in orange juice go brutally against them. Since it was a Hollywood movie, the Duke brothers’ firm failed and they were broke. How quaint, compared with what’s usually happened in the last decade.

Over the last two weeks we’ve seen two increases in margin requirements for gasoline futures, one for silver, and the fourth since February for crude oil. The increases led to some major downturns in prices, as speculation has been running wild in the whole complex for some time. The need for extra cash led to selling pressure everywhere and a little rattling of the risk-on credo.

It wasn’t a good time to own oil stocks, but money quickly raced into other sectors and the markets are only off a couple of percent over the last two weeks. That’s quite ordinary for the beginning of the month of May, though it may feel like a major correction compared to the complacency of recent weeks. After the usual April rise, though, there’s usually a bit of “sell first, ask questions later” behavior.

After Wednesday’s plunge in gasoline futures (7%), the Financial Times opined that the market recovered Thursday with the help of upbeat unemployment data. The writer guessed that the drop in weekly claims was bigger than expected, thought it wasn’t; while claims did drop, they were actually a bit higher than consensus. We won’t overly quibble the point – the drop was close enough to trend that surely a lower consensus could be found somewhere. It was still a bigger number than fits the bull case and the market opened lower on the morning’s disappointing lineup of data.

What saved the markets was the Angel of the Charts. Not long after the market opened, the Dow and Nasdaq both touched their 20-day exponential moving averages (exponential is much preferred over simple), while the Russell 2000 touched the 50-day and the S&P 500 came within a whisker of its 50-day. All at the same time. What a setup! Rally time!

Put it this way – the news Thursday morning may not have been great, but it wasn’t enough to terrify longs out of their positions, nor was it good enough to suck money in. The news Friday morning before the sell-off was really nothing special either – the drop was simply a fade from the technical bounce the day before. With higher margin requirements again meaning dollar shorts unwinding, it was no day for equities.

The fade was nudged along by news of further China bank tightening and worrisome euro developments, true, but let’s be realistic. The market has been ignoring both of those issues since last summer. There’s an old Street saying that the tape makes the news, and while it’s an imperfect observation, there is much truth to it.

For example, news of the housing bust began in the fall of 2006, and equities went up in a nearly unbroken straight line until May 2007. The Bear Stearns mortgage-related hedge funds went bust in August 2007 (freezing mortgages out of the credit markets), and the S&P 500 hit an all-time high two months later. Bear Stearns itself went bust in March of 2008, and six weeks later equities finished a ferocious spring rally that put the averages back to new highs on the year. Lots of alarms were sounded, but the herd thundered on heedless.

The most pivotal news in the last couple of weeks has been that tightening of margin requirements in some of the commodity futures markets. It caught a lots of folks leaning way over one side of the boat, and we think that the regulators were right to stop serving some of the more intoxicated patrons.

With said commodity volatility now on the front pages, we will doubtless be treated to breathlessly rendered accounts of the same everyday occurrences that these markets always experience – a mine opens or closes, a refinery comes back online or goes offline; there is a fire somewhere, there is no fire anywhere.

The financial press will act as if these events are shaping the market and traders will do little to discourage them. When the wind is at your back, every rumor helps and vice versa. There are supply and demand considerations in every commodity market, but the speculative flows of our sophisticated, modern, innovative era magnifies them to unrecognizable extremes – into bubbles and bursts. The regulators did us a favor in recent days by letting a little air out of commodities before things got even crazier, and the potential collateral damage more serious.

That doesn’t mean that the game is over, though. The hesitation in the market right now is over whether the Big Risk button is still on or about to come off, and that matters far more than some mine or refinery. While the signals are a bit mixed, history suggests that our herd will try to keep the stampede going until the cliff has been reached and there is no more ground beneath its feet. Some will still have those legs going as they plunge into the sea.

Not everyone plays this game. Some managers are quietly cutting back in the belief that the correction will come before the end of the year. It’s a good tactical point – cutting back in December can mean losing “permanent” ground in the annual performance race, so nobody does. Cutting back in the middle of the year, though, leaves plenty of time to step over the bodies of the fallen.

May is a funny month. It had a long run as being a great month, but in the late nineties it started to become ugly for equities. In recent years April has become more pronounced to the upside, so May has gotten choppier as a consequence. Big corrections are rare, though, and we will need a bigger headline than the ones we’ve been getting to take the market down more than a few percent. When traders are willing to step in and buy chart bounces, it suggests a lack of real concern (else heavy selling would break the buy attempts).

As for potential perpetrators, a big headline could come out of China. We firmly believe that there will be one this year or the next, but lean towards the position that it will come later rather than sooner. The tide is starting to go out on the property bubble, but our best guess is that the view of who is naked is still months away.

There will be a storm from Europe, and the grand denouement seems to be drawing nearer. Yet so long as the raindrops are still off in the distance, the race to harvest as much as possible remains. There ought to be one or two extend-and-pretend weekends left in the EU bag, even though the supporting role of the International Monetary Fund (IMF) suddenly become more problematic over the weekend with the arrest of its well-known head, Dominique Strauss-Kahn.

The lending and property bubble in China is churning out new millionaires and billionaires, mesmerizing Western money pros and sending demand for French and Italian luxury goods to new heights. The country’s appetite for German precision machinery (that they hope to copy and make for themselves) is also unabated. The meant some nice prints of first-quarter GDP last week for the Eurozone’s two biggest countries, but we think they go down from here.

Then there is the debt ceiling and the budget battle. That looming crisis may be the first to blow. In theory, the ceiling is reached next week, but the Treasury seems to have some levers to pull to keep things going until around August. Certainly the markets have been showing zero concern, evidently believing either that some deal will be made or that it’s just too early to worry. The crisis could come in June, though, as it’s a good month for it, often difficult for equities. With the debt ceiling still at an impasse – as it surely will be – and QE2 running out, traders could get nervous.

Gillian Tett wrote an astute article in the Financial Times on Friday that remarked how surprisingly successful the much reviled bailout programs have been in restoring GDP (if not a level playing field or common sense) in the United States. In a vein similar to Churchill’s observation that “Americans will always do the right thing, but only after they have tried everything else,” Tett went on to point out that Congress turned down the TARP program at first, refusing to do anything until the markets crashed and forced them to act. Her suggestion that it may take another crash to get them to behave this time could turn out to prescient indeed.

We are in a spot familiar to veterans of the last fifteen years or so. The market is no longer trying to anticipate at this stage, only trying to celebrate the last bits of news as long as it can. Earnings growth has peaked, but actual earnings are less important at this stage than the act of beating estimates and raising guidance. Probably the most common sentiment on the Street is that the market is currently overshooting its way into a big correction. Time to get out, then? Not on your life.

Bailing now would mean missing the overshoot (true). And, since nobody really knows where the cliff edge is (also true), might as well stay long until you’re there and then try to minimize the damage (which is why you will see bulls still moving their legs as they fall to their fate). And if the cliff edge gets you, well, as Mr. Loaf once sang, two out of three ain’t bad.

The Economic Beat

The report of the week might have been the retail sales report for April. There were some attempts to buff it up a little, but the Street largely saw it for what it was, a disappointment. The good news was a pretty strong revision upward for March (+0.4% to +0.9%), but that was tempered by the news on the month’s core rate (excluding gasoline and autos), which only rose an additional tenth, from 0.6% to 0.7%.

The part that the Street didn’t like (for good reason) was that the core sales rate only rose 0.2% for April. That matched the increase in the Consumer Price Index (CPI) core inflation rate and suggests that unit sales were flat over the previous month. That’s not supposed to happen for a month that has the entire Easter season in it. It was the first flat month of the year for core sales; overall the numbers did rise by 0.5%, driven by increases in food and gas.

The other reports from Thursday were also disappointing, with the Producer Price Index (PPI) for April rising a bit more than expected, 0.8% versus the 0.6% consensus. The core rate was also a little warm, rising 0.3% instead of the expected 0.2%. More worrisome was that the year-on-year increase rose sharply to 6.6% (6.8% unadjusted).

That continued some disconcerting data from Tuesday, if a bit less prominent: import prices rose 2.2% (11.1% y/y) and export prices by 1.1% (9.6% y/y). Although the pressure is from food and energy, there is leakage. Fortunately, the CPI did come in as expected at 0.4%, but the core rate did edge up to 0.2% from 0.1%. The year-on-year rate remains a very tame 1.3%.

So if producer and trade prices are hot, and consumer prices cold, that suggests pressure to make it up somewhere. It may be that companies are responding by lowering their main input cost: labor. The stock market view has been that companies can’t cut anymore, but the weekly claims figures have been belying that perspective ever since the first quarter ended.

Auto sales have been lackluster for the last two months, due in part to supply problems out of Japan, and some of the central manufacturing states have reported layoffs in that sector. It could well just be a logistics-related pause that goes away on its own. Manufacturing has been steadily adding jobs, and we don’t see any real evidence of that changing. Still, other sectors have been seeing elevated layoffs, obviously, and it could be that some companies are responding to cost pressures with layoffs. They’re supposed to be adding jobs, not subtracting them. Don’t they read stock market reports?

We’ll get some clues to the matter next week from the two manufacturing surveys, New York (Monday) and Philadelphia (Thursday). Small business optimism fell in April, so the game seems to still be for S&P 500 companies to sell as much as possible abroad while hiring as little as possible as home. That won’t hurt earnings near term, but if commodity prices don’t stabilize soon the emerging-market order book will suffer.

The remaining March inventory data came out, and it was generally better than first thought, which will add to the first quarter GDP revision. But the trade gap rose more than expected, and that will subtract from the revision. Another sign of sales weakness was the decline in consumer good imports. Not such a big deal by itself, but adding consistency to a picture of slower spending.

Notwithstanding that, consumer sentiment rose a bit, measured by the University of Michigan. It’s still at low levels and down from the fourth quarter, but any increase is helpful. It may have been related to the previous week’s debacle in commodity prices, but probably the biggest factor was the bin Laden news.

Besides the manufacturing surveys for next week, we’ll get April’s Industrial Production report. Consensus is for an increase of 0.4%. There will be a broad slate of news on housing, with the homebuilder sentiment index on Monday morning, April housing starts on Tuesday, and existing home sales on Thursday. Listening to homebuilder presentations, we doubt that there will be much happening in sentiment or starts.

The Fed’s Open Market Committee (its policy-making group) meeting minutes are due on Wednesday afternoon, and analysts will peer inside to try and guess at any changes. Leading indicators are out on Thursday, followed by the last day for trading May options on Friday. That deadline will bump up against a couple of expensive stocks (with rich options premiums) reporting earnings on Thursday, Aruba Networks (ARUN) and Salesforce.com (CRM). Network equipment supplier Brocade (BRCD) also reports that day.

Perhaps the main earnings report of the week, though, will be Hewlett-Packard (HPQ) on Wednesday evening. There are also a slew of retailers throughout the week, and their results will be important to the week’s tone. Traders will be watching to see if the companies were able to overcome the tepid-looking April retail sales report.

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