Inflection Point


“Who has deceived thee so oft as thyself?” – Poor Richard’s Almanack, Benjamin Franklin, editor

We don’t go this far out on the limb very often, but there are times it is called for. Example: in our column of March 6, 2009, we said that the bottom had been reached and that we were “in the deepest part of the trench.” We admitted to not knowing exactly how wide the bottom was, nor the exact deepest point, but proposed that the capitulation point was at hand. In the event, the bottom came the following trading day, Monday, March 9th.

We’re going out on a limb again and saying that we are at the high point of the current rally. Once again, we’re not sure of the breadth of it, nor the exact high, and we do not expect to be as serendipitous as the last time and see prices crest on Tuesday (Monday being a market holiday).

Tuesday is certainly possible, given the extravagantly overbought state of the market, but the lures are still out there – every morning’s lower open is bought as soon as traders decide that the selling lacks verve. Specific chart points are seemingly begging to be touched – the all-time high on the Russell 2000 is 856 and change, barely two percent away. In this market, that’s hardly a day’s work. One should expect a run at it next week, but should traders pull it off, our advice is to sell the sucker-trap.

Admittedly, we have succeeded in touching one Holy Grail without damage, namely the doubling of the S&P from the March 2009 intraday low: the infamous demonic 666. 3000 on the Nasdaq also beckons to the chart-minded, but a six-percent move higher may be too much to ask for in the short term. If we got there within the next two weeks, we would go all in short the market. It wouldn’t be a crowded perch.

The level of complacency in the market has hit the ridiculous zone and passed into infatuation. In much the same way that despair seemed limitless after the horrific start to 2009, all sentiment and all indicators seem to point in one direction today: nothing but blue skies ahead. The financial press, thoroughly cowed and frightened at the beginning of that March of two years past, now drops simpering bouquets everywhere, rushing to make excuses for any indifferent data point and fawning obsequiously over every point higher on the Dow.

Investing has become easy again – it’s just a matter of guessing which sector or momentum play will heat up next. Is it energy? Health care? What did Jim Cramer say last night? Maybe it’s the cloud stocks – they’ve all come roaring back from rather indifferent earnings on nothing but momentum mojo and move-that-merchandise analyst recommendations. Some of them are even trading at less than one hundred times earnings – what a steal!

Investor confidence is at exalted levels, and sellers have capitulated. Noted hedged fund manager Whitney Tilson’s infamous mea culpa letter on the horrors of shorting has rung a pretty loud bell, but the cattle have taken it to mean dinnertime as they placidly shuffle into line for the slaughterhouse.

If we sound offended, it’s because we are. Valuations aren’t as cheap as they are made out to be. The mantra that the market is only at 13.5 times next year’s earnings is repeated louder and more frequently every week. It’s a shame that it’s such an intellectually dishonest exercise.

What makes the market multiple cheap? Partly it’s the early-year top-down earnings estimate that almost never materializes. Partly it’s an S&P 500 multiple significantly pulled down by a financial sector that lacks believers, unlike the quarter-century leading up to the crash, and trading at around ten times. Then there’s the similarly priced jumbo-cap tech segment that totally lacks momentum mania – Microsoft (MSFT), HP (HPQ), Cisco (CSCO), Intel (INTC), and the like. In a capitalization-weighted index like the S&P 500, it makes a difference.

Much was made last week of the Fed’s research staff raising its latest forecasts, and indeed one would hardly expect a rising market to ignore supporting evidence. Yet there is a valuable lesson to be had from studying the FOMC minutes over time, with particular attention to the matter of those staff forecasts. They really aren’t useful. Keep in mind that the staff’s main goal isn’t to predict the economy, but to be conventionally appropriate. They ratchet linear regression lines up and down around the latest quarterly data, but the economy isn’t linear and the forecasts are never right.

If, for example, the stock market should continue to rise, then rising asset prices and in particular soaring commodity prices would set off inflationary pressures. The process has already begun. Yet last quarter’s preliminary GDP reading of 3.2% rests upon the fiction that inflation only grew at a 0.3% annual rate in the fourth quarter, despite all the evidence that it was about 1.0%. The forecast for the rest of the year rests upon the fiction that the economy can grow between 3.5% and 3.9% for the remainder of the year without any consequence of speculatively fueled inflation. Absent a drastic change in commodity market regulation, those trend lines will never get there.

Furthermore, we are near a cyclical peak in our stair-step recovery. Unemployment is still very high and housing is still in the ditch, two significant brakes on a growth path. The marketing pitch is the virtuous circle of recovery, but the reality is that manufacturing growth will ease back again as inventory levels replenish and sales growth takes a breather. It’s perfectly consistent with the reality of the economy we’re living in, and would not be indicative of a double dip, but it isn’t the variant that the Street is selling.

“It’s all about earnings,” protest the fantasists, as if earnings growth never peaks. But it always has, and always will. We are well aware of the current surge in CEO optimism, taken as incontrovertible proof that earnings targets cannot help but be surpassed. Yet the level of CEO pessimism two years ago didn’t presage the recovery in the markets or economy. Study the six-month outlooks from the Philadelphia Federal Reserve bank surveys, for example, and you will find that the outlooks are excellent indicators of the present only.

A pitch of only a few months ago was that emerging-market (EM) growth would pull the rest of the world along with it. As EM central banks around the globe grapple with growth-slowing inflation measures, though, the money river is shifting out of EM equities and into developed-world equities. Decoupling strikes again.

We’re not saying that the world is about to blow up, anymore than we said prosperity was just around the corner two years ago. The pendulum has reached the other end of its arc, is all. At the beginning of March 2009, prices reflected a sentiment that nothing could ever go right again. Two years later, the market is acting as if nothing could ever go wrong again. But things do go wrong. China, Europe, the Middle East, the deficit, the end of stimulus programs. Structural problems in our economy that were covered up by the credit bubble haven’t gone away. The simple ebb and flow of inventory hasn’t vanished.

Don’t be taken in by the fact that we aren’t in a 1999-2000 style bubble, or that IBM isn’t selling at 40 times earnings. That comes along about once a century. The typical market correction comes along much more often, and we’re about to have one.

If you put new money to work now, be prepared for some losses. It’s true that the rally could rebound quickly from only a modest pause – history has shown that rising markets are usually able to sustain irrational fever longer than falling ones. You could find yourself feeling smug again within a week or two. But the flip side is that the longer a fever persists in the face of the evidence, the uglier is the aftermath. To those who think that they can call the dip that isn’t bought, or the day that the unexpected” headline triggers the exit stampede, we say good luck. You’re going to need a lot of it.

The Economic Beat

Last week was a week of excuses and mirages. We’ll start with the excuses.

Retail sales for January were reported to have risen 0.3% instead of the 0.5% consensus estimate. Excluding autos and gasoline, sales only rose 0.2%. December sales were revised down to 0.5% total and 0.1% excluding autos and gasoline. The excuse was the hard January weather (maybe some of the snow blew back into December, too).

We’ll allow that the January weather wasn’t good for sales, and that January isn’t a great barometer for spending. Yet we would also point out that retailers predicted a January slowdown in early December, well in advance of any meteorological phenomena. Most consumers also got a payroll tax cut in January that should have offset any weather effect. February sales have been modest so far. While it isn’t a good predictive month either, it seems to us that retailer predictions that a period of subdued growth would follow the aggressive bargain hunting and restocking of the holiday season are still sensible.

Next up are the inflation excuses. The Producer Price Index (PPI) rose 0.8% on the month, and 0.5% excluding food and energy. Those are high numbers, though there is some solace that December was revised down from 1.1% to 0.9%. The excuse is that a big part of the increase came from pharmaceuticals (+1.4%). Our observations are that energy prices rose even faster (+1.8%), and that when inflation starts to take hold, it isn’t a process of every category going up the same month. It starts with a spike here, a sector there. When every category is rising, it’s already established.

The Consumer Price Index (CPI) rose 0.4% in January, or 0.2% excluding food and energy. Both were higher than expected. The year-on-year rate rose to 1.7%, still low and a far cry from the 0.3% rate the BEA came up with for its fourth-quarter GDP estimate. It’s increasing slowly to a rate that is actually more comforting to the Fed – around 2% – and that really isn’t bad.

Yet while the Fed is correct in its assessment that a little inflation is a sign of a healthy economy, and that capacity slack is still too great in this country for classic demand-pull inflation, we’re not sure if Bernanke is willing or able to understand that if asset prices continue on their trajectory, a surge of cost-push inflation will follow.

We understand the theoretical basis for excluding food and energy from measures of core inflation, but rising food and energy prices still eat into the pocketbook and threaten to cancel out the payroll tax cut. Export prices rose 1.2% to a 6.8% 12-month rate, and import prices rose even faster, by 1.5% to a 5.3% 12-month rate. Pressure is building.

That could be seen in the Philadelphia Fed February business survey. Prices paid showed a dramatic increase and mismatch, with 67% reporting higher input costs and only 21% reporting higher selling prices. It’s going into translate into pressure on either margins or finished prices. The overall activity index rose to a stunning 35.9, but it was a mirage. New orders were the same as the previous month, the difference being a shipments spike that should disappear next month.

Industrial production rose only 0.1% in January. We see it as a sign that manufacturing may level off for a time. The overall number was pulled down by mining and utility output, numbers that tend to bounce up and down, and manufacturing production rose by a reasonable 0.3%, led by a healthy 0.9% increase in business equipment. Yet capacity utilization dropped a tenth, and the manufacturing utilization rate of 73.7% is still well below its long-term average.

There has clearly been strength in autos (automotive products up 3.0%), but that too should begin to level off. It won’t mean that the economy is stuck, but that auto production will not climb a straight line to 2007 levels. Why should it? Inventory levels and the inventory-to-sales ratios are also showing mild increases typical of a budding pause.

Another entrant in the mirage category was housing starts. The homebuilder stocks rallied as usual on the headline increase, but that’s a Pavlovian reflex to be sold immediately. Single-family starts were actually down from December and are down 20% year-on-year. Permits fell as well. Some of the fall was exaggerated by a December surge that was related to building-code changes in the West.

Still, the homebuilding sentiment index remains near rock bottom at 16, and that should tell you what is really going on homebuilding. The increase was all in multi-family units (apartment buildings) and as we observed last week, at this time of year one or two projects can drive the numbers way up. Mortgage rates have jumped of late, and while they are still low by historical standards, lending standards are ferociously tight and purchase applications have been steadily eroding back toward the all-time lows set in the wake of the tax-credit expiration.

Looking at actual claims data for the last twenty years, last week’s number of 421,000 (unadjusted) is still too high for an economy with the number of unemployed that we have. The four-week adjusted average has crept up, and the excuse for that is the weather. The divisor for the seasonally adjusted number swings much lower in the coming weeks, and that could lead to the reported number climbing back up again.

Were that to happen, with some sort of pause or correction in stock prices imminent any day now, we could see a stretch where stock prices fall (net) for a month, bond yields retreat and spreads contract (bear with us now), claims increase and the sum of it all pushing down the Leading Indicators, which rose by only 0.1% last month. Combine that with some normal inventory ebb, throw in a Middle East wild card or two, and we’ve got the makings for some fear returning to the market.

Next week is the same week that the 2003-2004 recovery rally went on hold for six months. History may yet rhyme again. The economic data will contribute the rest of the housing picture, with Case-Shiller price data on Tuesday, existing home sales on Wednesday and new home sales on Thursday.

The consumer will be represented by the monthly confidence index on Tuesday, and the final sentiment estimate on Friday. One would expect an increase at least in the former, given the rising stock market. Gasoline and heating oil prices have been rising too, but natural gas prices are falling as an offset, so the nod should go to the stock market effect. Manufacturing will put up the Richmond Fed index on Tuesday – not a market biggie yet – and durable goods on Thursday. The first revision on fourth-quarter GDP arrives Friday.

Earnings are led by Dow Jones stalwarts Hewlett-Packard, Home Depot (HD) and Wal-Mart (WMT), momentum darling Salesforce.com (CRM) and a slew of retailing and health-care names.

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