“Only vaulting ambition, which o’erleaps itself and falls on th’ other.” – Macbeth, in William Shakespeare’s Macbeth
It shouldn’t be more than a week or so now, maybe two, before the markets finally get a slap in the face. Up seven weeks in a row, relative strength indicators flashing red, and complacency we haven’t seen since the spring of 2007.
An eye-opening moment for us last week was seeing a gallery of portfolio managers and strategists lined up on CNBC like so many smiling Buddhas. That’s perhaps unfair to the Buddha, though, since we can’t recall ever seeing descriptions of Buddha as “smug.”
And smug our gallery was. For them, the market outlook for 2011 is just a beckoning road to riches, with the only real issue being which sectors to favor. Although recent consensus estimates have been published subscribing to a 9 or 10% return on equities this year, don’t you believe it. The whisper number is 20%.
In this fantasy narrative, record profits, cash, and a resurgent manufacturing sector lead the country on through a year of 3-4% annual growth, aided by those ever-reliable bursting emerging markets and global growth, a term which we’ve begun to hear again of late.
We don’t doubt that the economy will grow this year, but it isn’t going to be the yellow-brick road that the straight-up rally of the last four-and-a-half months has made appear before so many eyes.
Looking at 2011, some large problems remain. Readers may be tired of hearing us repeat it, traders don’t like to think about it, and equity fund managers have reverted to their usual manifesto of treating evil thoughts as somebody else’s problem.
But Europe isn’t going to go away. So far, the European Central Bank (ECB) has succeeded in staving off liquidity problems with successive rounds of bond-buying and arm-twisting. Liquidity was a 2008 problem, though, when investment banks found that the slightest disturbance in the Force was enough to suck their massively over-leveraged balance sheets into a black hole.
The problem with Europe is too much debt and too much bad paper. Periphery countries like Greece and Ireland owe too much money, period. Not only are they not going to be able to grow out of it, but the Procrustean hangover medicine being described by the Bundesbank – oops there we go again, we mean the ECB – is keeping these countries in brutal recessions.
Spain is locked in one too, and while their ratio of public-sector debt to GDP may be manageable, the country was the epicenter of the European real-estate bubble. There’s just too much bad paper held by the banks, and some kind of reckoning is bound too arrive. All of these countries need to restructure, cleanse their balance sheets and start over. The day will arrive and we would be very surprised not to see it come this year.
China has been kicking up its reserve ratios and interest rates every other week, it seems. The country is so obviously wrestling with the effects of its financial bubble that CNBC should start readying their “Why Didn’t We See This” special right now. Yet scratch a commodities trader for why prices march ever higher and they will robotically answer, “China.”
Most of them know it isn’t China, of course, or at least they used to before they started succumbing to their own nonsense, the way every momentum bubble does. Commodities are just the favored mo-mo* trade these days of a global financial sector that has gotten much bigger and much faster. Too much money – leveraged money – chasing too few assets.
The gorilla in the room is how much emerging-market recovery is fed by Western financial speculators throwing money at commodities. We effectively transfer money to places in South America, Asia and the Middle East, and then pronounce ourselves astounded at how their economies are growing. In turn, they buy more mining gear and earth-moving stuff from the West and start bidding up prices on specialty chemicals and building chemical plants, and everybody runs around shouting, “global growth.”
But when the music stops and commodity prices go back down this year, all those countries will find themselves again moored with a lot of projects that suddenly look very expensive and profit outlooks that need to be reviewed. Then comes another dose of Big Ugly for the financial markets.
But – and this is a big but – nobody knows the timing or coming of that day and time. The current market not only looks very much like the market of late 2006 to mid-2007, many traders and strategists are betting on just that.
The deceleration in the U.S. economy and the disintegration of the housing market were plainly visible in the fall of 2006, but it was all to the good. The more bad news that homebuilders put out, the more traders rallied their stocks in a mindless frenzy that a little inventory correction was exactly what was needed.
The credit madness was plainly visible by the spring of 2007 (cf. our column of April 27, 2007 – or any column from that April), but the market rallied into the summer anyway.
So why bust your head worrying about some slowdown that the silly economists can’t pinpoint anyway? Ride the wave until it’s broken, and then step aside. Better yet, flip your bets and ride it down. Explanations are for the media.
The markets are due for a rest, and the calendar and odds very much favor some sort of breakdown as earnings season ends. The hope is that it will be a minor one, though, and we should probably first punch through 1300 on the S&P in a day or two. 12,000 also beckons on the Dow, along with the Holy Grail of 850 on the Russell 2000 and the possibility of a new all-time high on that index.
The last one may have to wait until March, though. Wait – a new all-time high on the Russell 2000? With the economy and problems we have, are we kidding? We most certainly are not, and would also add that the target is a magnet right now for traders who have lost their fear – another precursor to a fall.
The playbook: look for new highs next week that will help act as support levels when the rally starts to burn up by month-end. Ride the rebound rally into new highs in March-April, just like 2007. Maybe it’ll all work out. If it doesn’t, the traders and hedgies will flee with their money as fast as they can figure it out – which is never as fast as they think. There’s a good chance it’ll all happen, because the stock market is an auction market and right now the buyers are believers. Until they’re not.
Monday is Martin Luther King Day, a man whose speeches still send a shiver down our spine when we hear them. May he rest in peace. U.S. markets, banks and government offices will be closed.
*”mo-mo” = “momentum moron.”
The Economic Beat
Last week’s light calendar helped maintain the momentum mania into and through the mostly disappointing data that came at the end of the week.
But let’s start with the good news. Industrial production rose by 0.8% in December, well ahead of the 0.5% consensus. Naturally, it was the data point that the Street most wanted to talk about, repeat, extol and promote.
It wasn’t as good as all that, though. A large part of the increase came from the big weather-related surge in utility output, up 4.3% on the month. When the weather moderates, there’ll be payback.
Manufacturing rose by 0.4%, the third good month in row, and consumer goods ended a four-month string of declines with a 1.0% increase. However, that still leaves it short of July. Capacity utilization put another increase, this time by 0.3%. At the rate of increase of the last six months, it will take another four years to reach its long-run average. The stock market could price that in by March.
Then there was the not-so-good news, beginning with inflation. The headline numbers for both the Producer Price Index (PPI) and Consumer Price Index (CPI) were hotter than expected or desired. The PPI total rose 1.1% for the month, nearly as much as the previous twelve months for prices excluding food and energy (1.4%). The CPI rose 0.5%, its largest jump in over a year and a half.
The core rates of both indices moved little, however, with CPI up only a tenth of a percent and the PPI up two-tenths. Therein lies a problem for the central bank, regulators and the economy, both global and domestic.
The core rate is an important measure that tracks the pulse of classic demand inflation: too much money chasing too few goods. Classic problems call for classic solutions: the central bank takes steps to reduce the supply of money, in turn damping the demand for goods.
With so much labor and industrial slack in the economy, those inflationary pressures are absent. However, commodity-fueled inflation still poses problems. It means reduced purchasing power for the consumer and pressure on business costs. Both are a drag on the economy, but the latter will eventually force its way into general price rises for goods.
The pressure on commodity prices isn’t coming from China or global growth, despite the nonsense that is steadily fed to the press. Every frenzy comes with its patter, and the volume of the latter increases in proportion with the money thrown around. It’s coming from financial speculation, as we keep pointing out in the column. The amount of speculative positions in oil contracts by financial players is at an all-time high, higher than the price bubble of 2008.
Gasoline demand is up a little more than one percent from a year ago, yet prices are ten to fifteen percent higher. Don’t fall for the line about Chinese demand – oil prices have marched higher in lockstep with the stock market. Oil-related inventories are either unchanged (gasoline) or higher (crude, heating oil) than a year ago.
In an effort to head off more problems with food and energy prices, the government is finally talking about imposing important new restrictions on commodity trading. You can be sure that phones are ringing off the hook at the offices of the media and the natural participants (producers and major users) in the commodity markets, threatening the end of their livelihoods if anybody tries to break up the party. The obligatory threat of job losses is, of course, automatic.
An illustration of the problems of “headline” inflation can be seen in the retail sales figures for December, which came up two-tenths of a percent short of estimates for both total sales (0.6%) and sales excluding autos (0.5%). With CPI inflation up 0.5% and retail sales up 0.5%, it implies that overall unit sales were flat. Higher food and energy prices crowd out other purchases. Weekly sales are falling quickly from last month.
The speculative fever shows up even sharper in import and export prices, which are heavily influenced by swings in food and energy. Import prices rose a steep 1.1% for the month, export prices 0.7%.
The end-of-year romantic fantasy about the job market being robust took another hit last week. First the JOLTS (Job Opening and Labor Turnover Survey, the Labor Department’s analysis of the job market) showed fewer job openings in November than October. Jobless claims spiked higher, particularly the unadjusted figure (770,000).
The calendar means that the number of actual claims will begin to ease now, but the elevated levels of recent weeks – prettied up by equally elevated adjustment factors – are motivating the recent deterioration in consumer confidence and sentiment, along with the rises in food and energy costs. The University of Michigan reported an unexpected decline in its first January reading on Friday.
Inventory building slowed down, as business inventories rose 0.2% in November (consensus 0.7%) and wholesale inventories contracted (-0.2)%. It was amusing to contrast press accounts extolling the overall strength of the quarterly build, juxtaposed against stories hailing the weaker data as promising more rebuilding. Apparently it doesn’t matter if inventories go up or down these days, because it’s all good. So long as the stock market is open, anyway.
While the Fed’s Beige Book showed lightly improving conditions around the country, one thing we’d highlight is the improvement in the auto industry, and improvement that owes a great deal to the return of credit for the sector.
Next week will bring some depressing housing data, and January doesn’t promise to be any better: mortgage-purchase applications have been weakening yet again. The homebuilder index comes out on Tuesday, December housing starts on Wednesday and existing home sales on Thursday. The consensus for start is for a slight decline, for sales a slight gain. The numbers are heavily adjusted at this time of year, so with levels so low, little regional blips can distort the results.
We’ll get a look at January manufacturing conditions with the New York Fed survey on Tuesday and the Philadelphia Fed survey on Thursday. Leading indicators also come out on Thursday.
All of those results are likely to be overshadowed by the earnings calendar. Next week isn’t quite the peak of the season in volume terms, but with Citigroup (C), Apple (AAPL) and IBM (IBM) reporting earnings results on Tuesday (the latter two after the close), Wells Fargo (WFC) Wednesday, Morgan Stanley (MS) and Google (GOOG) Thursday, Bank of America (BAC) and General Electric (GE) Friday, it will be highly influential.