Bad Omens

“In the most high and palmy state of Rome, a little ere the mightiest Julius fell, the graves stood tenantless and the sheeted dead did squeak and gibber in the Roman streets.” – William Shakespeare, Hamlet

Friday was one of those great, truly fat-headed days for which Wall Street is justly infamous. It wasn’t so much that the market reversed more than a percent from a weak opening – after several days of weakness, conditions were ripe for a classic trap of suddenly soaring short positions.

No, the wonderfully Homer Simpson moment came from the croaking of the Lost Bull Patrol, that group that by dint of being either far too long in a market less benign than promised, or incapable of believing in anything but rising prices (mutual fund managers and a certain breed of floor trader), are always happy to try to turn fool’s gold into, well, more fool’s gold.

One of the chief chump tales being peddled was the notion of how great the earthquake in Japan would be for that country and by extension, equity prices. Why, the damage alone would generate a rebuilding effort that would kick-start GDP! Time to buy construction stocks! Get ‘em while they’re hot! Golly, If only the country could produce another quake and perhaps a typhoid epidemic or two, why, it’d be time to go all in on Japanese equities (oddly enough, the Japanese themselves seem to see things differently: their market is plunging).

It brings to mind such great infatuations as the homebuilder rally of 2006 (new home sales are plunging – great news, it’ll reduce inventories!), the unemployment rally of 2000 that signaled the recession (great news, the Fed will cut interest rates!) and any number of interest-rate cut rallies (don’t fight the Fed!) that always turn out to be based upon the gloomy realization (months later) that the Fed acted because the economy was slowing down, and one round of cuts is never enough.

It was indeed a fool’s rally, but something very important must be kept in mind: you can lose a lot of money trying to fight such a move. We’ll leap upon the opportunity to cite again our favorite Keynesian maxim: the markets can remain irrational far longer than you can remain solvent. Homebuilder stocks kept trying to rally for many months after the fall of 2006, and equity prices burned with idiot fever in the spring of 2007 (as our forward-looking stock market “anticipated” the recession). The list goes on – you can look back at the end of every momentum market and marvel at how the signs went unmarked for months.

We don’t want to be equally guilty of over-exaggerating the negative consequences to the economy of the events in Japan. Clearly the human cost, already tragic, is much worse than initially believed, and the outlook for damage to the nuclear plants has grown more perilous by the minute as we go to press. They are not yet a certain catastrophe, however, and the effects of a quake on a mature economy tend not to be long-lasting. They do indeed generate rebuilding activity.

But let’s be clear. Earthquake damage is not the solution to the problems around the globe. Japan may indeed rebound in a couple of quarters, but to what? More negative GDP (it contracted last quarter)? Yes, it will mean increases in public spending, but Japan’s massive infrastructure programs of the 1990s did little to nothing so far as GDP was concerned (or equity prices).

A further slowdown in Japan probably isn’t going to be beneficial to Southeast Asia. By that logic, the rest of the world should have caught fire after the U.S. crash of 2008, but it conspicuously didn’t, mostly following our lead instead. China is still slowing down, either by happenstance or design (officials talked up more interest rate increases over the weekend to combat rising inflation).

The situation in the Middle East appears to be less stable than a week ago, despite Egypt getting off the front pages for a few days. We got reminders last week that the European debt situation hasn’t been fixed, although the full acceptance of that unhappy equation has yet to take place. Greece’s debt rating was cut to junk, Spain’s rating was cut, the new Irish government will not bow to German Chancellor Angela Merkel’s wishes, and Portugal’s situation isn’t improving either. That pot is going to boil over.

But the market hates to give up, as Friday’s rally evidenced. It’s clear that growth is going to slow to a rate lower than what the recent rally had baked in, but we don’t yet see it contracting, either, making the outlook murkier and giving the growth true-believers something to hang on to a while longer.

Ergo, we’d be careful about fighting any rallies next week (if indeed there are any). It could work out, but it would be a risky strategy. Every dying bull move produces a number of counter-rallies that can be painful to be on the wrong side of. You might find it a little easier to cope with the situation in the near term by simply lightening up on long positions during any rallies that come along. You could sleep better in the bargain, too.

We’re not going to say much more about what might happen in the ensuing weeks; there are too many unknowns, and they happen to be rather large in scope. The situation is certainly pressurized, that much is certain, and so we do feel safe in saying that a sharp move is in store.

The markets will either concede a slower growth rate, in which case another five to ten percent will come out of prices, or it will mount an in-your-face counter-rally that seeks to shout down the doubters with its own move. They are both plausible, so far as we can see, so avoid making big bets. The Ides of March are upon us, and Caesar should have indeed heeded the warnings.

The Economic Beat

Many of you have probably noticed that MarketWeek sometimes goes to press during the wee hours of Monday morning. This occasionally leads to the assistant editor nodding off at critical moments.

So it was that during the composition of last week’s issue we looked at the right week, but wrong month (February) for the upcoming economic calendar, and so missed that retail sales and consumer sentiment were due on Friday the 11th. We also had the day right (Thursday) for the Fedex (FDX) earnings report but the wrong week (this week, not last). It happens. We would sack the assistant editor, but it’s tough to find good help who will work for peanuts. Really, just ask any other CEO. It’s the biggest complaint out there.

That aside, it still wasn’t much of a week for news. Apart from those Friday releases, there was little of note beyond the trade deficit (balance) on the monthly calendar. So far as the domestic economy went, retail sales had the stage to itself.

It was a fairly good report, although a little below consensus expectations. Total sales increased by 1.0% (seasonally adjusted) in February and by 0.6% when auto categories are excluded. The ex-autos number was boosted by gasoline prices, but the details revealed broad-based gains across most categories. That said, February is one of the lightest months of the year for sales and gets a fair amount of seasonal adjustment. It isn’t a great indicator. As for March, it will suffer this year from the late Easter (April 26th) compared to last year (April 4th), so year-on-year chain-store sales comparisons are apt to suffer.

Events caught up with consumer sentiment this month, as it downshifted with a loud bang from 77.5 to 68.2. That’s quite a drop for one month, with rising gasoline prices and falling stock market prices largely responsible. Sentiment and spending don’t correlate much, so the report really doesn’t represent much of an inflection point for the economy. But it does highlight the fragility of the consumer psyche and by extension, the underlying real economy. Spending could pull back quickly, especially under the pressure of escalating energy costs and discouraging market news.

Small business optimism rose moderately in February, from 94.1 to 94.5, but this month’s events are likely to push it back down again. The last leg of inventory data came in for January, and it was promising: inventories rose, but sales rose faster and the inventory-to-sales ratio fell. It’s something in the way of old news at this point, with most of the data already known, but it does represent a good start as far as GDP is concerned. Inventory build data can be deceptive, though, and our suspicion is that an equally good, if not better February will precede a slowing March.

Offsetting the positive GDP effect from inventories was the January trade deficit (“balance”). It rose considerably more than expected, due mostly to a spike in imports. Some of it was energy-related, but we suspect the tax credit at work: this year’s favorable tax treatment for business investment has unleashed a torrent of capital expenditure, and the biggest part of the surge in imports was for capital equipment. It’s one of the contradictions of GDP: healthy import demand translates into a weaker reading.

Claims spiked back up again during the week, and the Labor Department’s latest JOLTS measure of employment conditions made it clear that the job market is no rising river, stock market propaganda notwithstanding, but a sluggish swamp.

As usual, the third week of the month (next week) is the opposite of the second and the calendar is quite crowded. To begin with, Friday is a quadruple-witch day, with the expiration of futures along with monthly and quarterly options and index options. That usually lends some odd behavior to the week’s trading (although what constitutes “odd” on the Street anymore is a valid question).

We’ll get a full suite of news: inflation, housing, manufacturing and the Fed. The first of these will come via import and export prices on Tuesday, the Producer Price Index (PPI) on Wednesday and the Consumer Price Index (CPI) on Thursday. Import-export prices in particular have been rising fast.

Housing data will be in the form of the homebuilder sentiment index on Tuesday and February housing starts on Wednesday. Don’t expect much from either category. Mortgage-purchase applications rose sharply last week (12.5%), but for many months now there has been a pattern of a week or three of gains being followed by steady declines that are at times heavy.

The net result is that purchase applications remain deep in the basement and have never really threatened to break out. The recent spate of headlines about the GSEs (Fannie Mae & Freddie Mac) toughening mortgage requirements may engender a get-it-while-you-can surge of buyer attempts, but it won’t last. The banks aren’t of a mind to lend for housing and won’t be until next year at the earliest.

The New York Fed presents its latest manufacturing survey on Tuesday, with the Philadelphia Fed presenting its particular edition on Thursday. The central bank will release February Industrial Production on Thursday also, but of more interest to the stock market will be its latest policy statement Tuesday afternoon.

Rounding out the other data will be the latest Leading Indicators report on Thursday (consenus 1.0%). Of course this is also the week that Fedex really will present earnings. With tensions heightened, its results should get a lot of attention. They may be justifiably overshadowed by geo-political events, but it’s worth the trouble to parse the details.

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