“He who died for soaring too audacious in the sun, where that same treacherous wax began to run.” – John Keats, Endymion
Fly high, or fly away? That seems to be the question weighing on the minds of investors as we enter another week of careening between the crises in North Africa and Japan.
Those are only the obvious crises. The not-so-obvious crises in China and Europe are still to come to fruition, but they will blossom in due time. The problem in both places is too much bad paper – the European periphery is full of it, while China is still creating it (the central bank raised its reserve requirements yet again last week). Post-crisis, far more will claim to have seen it then can be found now, but that is the way of such things. However we are telling you now, and we are short both the euro and the Hang Seng Index.
It is also the way of such things that prices move much more readily in response to the promise of prosperity than they do to the prospect of not-prosperity. It isn’t until a crisis is full-blown and obvious to all that prices move, and then they have a rather painful way of descending much more quickly than they rose.
In the meantime, though, there is money to be made on the Street, and by golly, money that needs to be made. Most of it requires a rising market as a proper backdrop, and to think otherwise is well, un-American.
For this reason and the fact that the long, six-month, this-is-easy rally is still visible in the rear view mirror, one should expect that there will be sharp rallies as the market continues its descent. After all, the American economy isn’t doing badly. It just isn’t doing quite as robustly as the equity rally would have you believe.
The eminent economist and near-perennial bear David Rosenberg wrote a column on Friday that we think presents an insightful picture into the current state of affairs. The link is available on our website, and we suggest that you read the article, because his excellent daily letter will cease to be free to the public after the end of the month. He wrote that
“So far, what has happened in equities has been treated as a financial event — just wait until the economic event follows suit. And it’s not only fiscal stimulus that is soon to subside. We still have that 86% correlation over the past two years between movements in the Fed balance sheet and the direction of the S&P 500 – this too will come home to roost before long, whether or not we end up seeing a resolution to the crises in Japan, Libya or Bahrain.”
Now, just as the typical Street strategist will torture a piece of data until it admits that skies are blue, Rosenberg has been known upon occasion to washboard an economic release until it confesses the opposing sin. In general, though, he is worth listening to and we think the case he is making here is correct, which is to say that while the markets may stage some vigorous, chest-beating rallies at signs of improvements in Japan, Libya et al, the underlying problems aren’t going to go away.
One of the problems is that we were already headed for a growth slowdown, as was China. Such an event is no catastrophe and is very much in the normal rhythm of the business cycle, though the latter is of little comfort to the large current number of unemployed. Continued upward pressure on oil and food prices will exacerbate any slowdown. The market isn’t yet prepared for that.
Should oil prices rise another ten percent from current levels, which given the volatility of the situation could happen in a week or a month, China could quickly find itself going from an attempted soft landing to a much harder one, and that isn’t priced into the market either. An overreaction would be typical.
Going by the Sunday New York Times, Japan is in a tough spot. Going by the business press and Western fund managers, its problems are practically over and the only question is at what point to buy and how much. One report we saw suggested that about 23 days after the first big dip would be a good start. Others professed an eagerness to get in should prices weaken any further.
This suggests several things. One is that a lot of managers are stuck with a lot of losing positions in Japan. Another is that the Japanese market is primed to rally further, because nearly any drop is good for a rebound. Such rally could be a great way to lose money, too, because unanimity in the stock market is almost always right in the beginning, dramatically wrong in the end, and the end always comes unexpectedly.
Think we’re too skeptical? Then consider that this is a marketplace that nearly one year on from the flash crisis has found nobody responsible. Two-and-a-half years after a tremendous financial crash from one of the great get-rich-quick Ponzi schemes of the last century, who has gone to jail or had to cough up a bonus from any of the firms at the center of the crisis?
The only chump who has gone to jail to date is some computer geek who had the nerve to try to steal proprietary trading code from Goldman Sachs. He got eight years last week for stealing from Goldman, while Goldman paid a couple-of-cents a share fine for failing to disclose it was suckering its clients. Steal from the Street and you go to jail, the Street steals from you and retires to the Hamptons. It’s a wonderful world.
The Economic Beat
It was a week filled with releases, brushed heavily in spin and gloss. Or was it dross?
We’ll start with manufacturing and production, because the data affords a fine opportunity to illustrate the difference between levels of real activity, and diffusion opinion surveys about the activity.
To wit, industrial production for February was reported to have fallen by –0.1%, instead of the 0.6% gain expected. Utilities were the biggest contributor to the drop, with “unseasonably warm” weather being incorrectly blamed. The weather certainly improved from a frigid snowbound January, but nobody living in the northern half of the country is going to agree that last month was unusually warm.
However, other areas fell as well. Manufacturing rose by 0.4%, but only by 0.2% outside of autos, which have about peaked and would have slowed soon anyway, with or without the Japan quake. Promoters can’t seem to resist extrapolating the growth onto a straight line ever upwards, but it never works that way.
The ISM manufacturing survey registered a reading of 61.4 in February, the highest since May 2004. Yet manufacturing production itself only rose at half the rate it registered in December and January. Even allowing for an upward revision, it is unlikely to reach January’s increase of 0.9%. This points up the limitations of the survey: it is good for measuring the breadth of improvement, but the depth of improvement may be quite different.
Another problem with the manufacturing surveys, as we frequently point out, is that manufacturing is a smaller part of the economy than it’s been in many decades. The old correlation between manufacturing growth and GDP isn’t what it was. So despite the good readings registered by the New York and Philadelphia Fed surveys last week, the results are unlikely to translate into the economic strength that the press and brokerage community is wont to attribute to them.
The survey results were good: against a baseline of zero as no change, New York reported a result of 17.5, and Philadelphia a lofty 43.4 (versus expectations for around 28), the latter being the highest in over 25 years. The results were good across the board, with new orders registering a similarly high reading of 40.3. The two readings one would have wished to be lower were prices paid, a very high 63.8, and the six-month outlook, which rose to 63. The latter, unfortunately, is very much like the stock market surveys of investor bullishness, in that its peaks of optimism always immediately precede declines in activity.
Perhaps more revealing was the Philadelphia Fed’s index of coincident activity for January, released the same day. It showed a year-on-year increase of 2.5%, and that may be the most accurate summation of the overall increase in economic activity that we’ve seen. The nearly straight-up six month rally in the stock market lent a certain enchantment to the perception of economic data, but the rebound, while quite real, simply isn’t as glittering as most of its press clippings. It was moderate.
The enchantment extends to the reception of the weekly claims. All hailed another sub-400,000 reading as if the economy was on fire. It is a mild improvement, but looked at from a higher vantage point it is a maddeningly slow one. Only the worst recession peaks of the last twenty years have reported layoff levels as high as the March 12 week of 2011. The message that many want to believe is the one of “robust, self-sustaining,” but what the data are really telling us is that the slowness of this recovery is extraordinary.
Mortgage-purchase applications fell back again last week and the index remains mired below the 200 level (our estimate). The homebuilder sentiment index checked in at 17, a truly lousy number that was nevertheless reported as if was great news (we actually saw a news release that exclaimed about the “surge” from 16 to 17!). The index has languished between 15 and 17 for nearly two years, with an occasional outlier along the way. The proof was in the housing starts number, which reported a deep drop to a 479,000 annual rate, nearly 100,000 below the estimate.
It was the bad weather, complained the optimists, in some cases the very same ones who blamed the drop in industrial production on the good weather. But weather had nothing to do with the big drop in building permits, now down over 20% year-on-year. There’s a good reason homebuilder sentiment is so low, and there was no surge.
Nevertheless, the onset of spring should lead to a modest pickup in sentiment, similar to what we saw in 2010. At the current time, though, there is no indication from any data – employment, income, credit, construction activity, or reports from the publicly traded homebuilders themselves – that indicate any acceleration at all in homebuilding activity.
There is acceleration, however, in energy and food prices. The Producer Price Index (PPI) rose a scary 1.6% last month, and that does constitute a surge. The year-on-year rate rose to 5.8%. Excluding food and energy, the rate remained at a very manageable increase of 0.2% for the month and 1.9% year-on-year, but those energy bills still have to be paid. Similarly, the Consumer Price Index (CPI) rose 0.5%, but only 0.2% excluding food and energy. It sill adds up to a monthly decline in disposable income for the average family.
Import and export prices posted the biggest increases of all, with export prices up 8.6% year-on-year and import prices 6.9%. The two are heavily made up of food (exports) and energy (imports), which explains some of the disparity. The only way these prices will drop, unhappily, is if the stock market falls first. If the markets continue to rise, so will financial bets on commodities. In the case of oil, even that may not happen if the Middle East situation deteriorates.
For once, the FOMC (Fed) policy statement last week was a non-event. The committee’s statement was slightly more upbeat than the previous month, but the differences were non-obvious. There was a bit more muttering about inflation this time, but no real change in view.
Next week will give us the main update on the housing market, with the combination of existing-home sales (Monday), new-home sales (Wednesday), and the federal agency home price index on Tuesday (the more widely used Case-Shiller price index is a week later this month).
February durable goods are due on Thursday. The last GDP estimate for the fourth quarter (last until it’s revised again), along with the last March sentiment index, comes on Friday. Oracle (ORCL) reports earnings after the close on Thursday, and all ears will be listening to what management says about postquake activity in Japan.