Spanish Flight


“We have all been here before.” – David Crosby

by M. Kevin Flynn, CFA

The markets have started to think about Europe again. Its recession is deepening – though the February EU industrial data proved surprisingly better, it was overshadowed by a raft of depressing Spanish data, worst of all being that the banking system is starting to get more than half of its funding from the ECB. Another crisis looms as: interest rates on Spanish government debt move higher, and insurance premiums against the debt defaulting top record levels.

Worries about a hard landing in China – which for it means GDP dropping to around plus five percent – grew. The markets were clearly put off by its first quarter GDP print of 8.1% (consensus was for 8.4%) and rumors were swirling from China to Wall Street that a reserve requirement cut – the Middle Kingdom’s preferred method for distilling monetary ease – would be imminent. When no news came from the West in the hours before trading opened, futures began to sag and the rest of the news took on a somber coloring.

The glow from the JP Morgan (JPM) earnings “beat”, heavily celebrated on its arrival by the Bloomberg newsreaders (when will they learn?), faded quickly under a steady diet of humorless questioning on the conference call. The bank did beat estimates, and on a more forgiving day – the Fed offering to buy more bonds, for example – the stock might have soared, despite the fact that net income was actually down from the first quarter of 2011. But with Spanish and Chinese banks coughing, the big pieces of income that came from reserve releases and mortgage trading looked more suspect. Dimon’s admission that he wasn’t really sure about the future of the recovery fell harder on investor ears.

One of those amusing little tidbits that we like to point out is that the two Gang of Four banks that reported Friday (the House of Morgan, and Wells Fargo (WFC)) were partly hoisted on their own petards. In a move similar to state jockeying for early presidential primary spots, Wells moved up its earnings announcement to the same day as JPM, instead of the traditional day or two afterwards. The latter responded by moving up its usual 8:30 AM (New York time) conference call an hour to 7:30 AM, setting off a scramble amongst analysts to listen to one call while trying to get ready for the next.

It all rather backfired when analysts had an extra hour to brood over JP results before the market opened. The customary flood of fast-money buy orders that hit an opening tape when estimates are beaten were undermined by pre-open anguish. The Wells Fargo results also beat estimates, and on higher year-over-year earnings too. But an earnings increase based on dramatically reduced reserve ratios and charge-offs on a day when markets are worrying about the health of the European banking system, and even the outlook for Chinese bank losses, just doesn’t have the right cachet. Swimming in the wake of the JP call ended up swamping the Wells stock price.

Nevertheless, this is still April and the real decoupling is between the real economy and liquidity: the markets may worry about the global economy, but they still live and die on the outlook for monetary easing. All the markets need is one whiff of that kickapoo joy juice known as central bank quantitative easing, and the race to the top will be right back on. Wednesday’s rebound was set off by an ECB governor’s remark that more bond buying was a possible response to Spanish woes.

Friday morning, we noticed one presentation that calmly informed us that China is not really slowing down, so there is no reason to worry. On the other hand, the analyst went on, if the country really is slowing down, then the country will loosen its monetary policy (cut reserve ratios), so there was no reason to worry. You can’t lose.

There is quite a bit of this attitude out there in investment-land, and it is by no means new. The phenomenon precedes just about every slowdown we’ve ever witnessed, large or small: keep buying equities, because it’s a can’t-lose bet. The economy can’t really be slowing because the stock market has been going up. And okay, even if the economy is slowing, the central banks will bail us out (the “Greenspan/Bernanke put”).

It can be dangerous to be ahead of the crowd in these circumstances. It was clear in the fall of 2006, for example, that domestic growth in the U.S. had come to a near-standstill, and that the housing market was imploding. “Global growth,” responded traders, and rejoiced that new homes were getting a much-needed inventory correction (!). There were some wobbles along the way, but the S&P still rose around 25% from July 2006 to October 2007.

In his book The Big Short, (still the best reading on the crisis, in our opinion), author Michael Lewis recounted how a California doctor-turned-investment manager named Michael Burry was the first manager to take a substantial short position on the housing market meltdown. As you can guess, Burry ended up making enormous profits from his positions, but not before being pilloried and harassed throughout 2007 by his Wall Street client base, infuriated that he was breaking even during a year the S&P was hitting new all-time highs. And they were supposed to be the “smart money.”

There is indeed much to be worried about, and in our opinion the six-month horizon has some serious dark clouds on it. The odds for a repetition of the 2010 and 2011 post-April letdowns are growing, and talk and memory of the accompanying sell-offs has grown. Are we in for a repeat?

It’s certainly possible. But there are a couple of truisms to keep in mind. One is that while central bank easing has certainly provided a cushion in the past, it has never once headed off a bubble from coming to grief. The Spanish housing bubble, which affects banks throughout the continent, will have its day in the end, as will the Chinese property bubble.

The second truism, though, is that every US equity market always buys the easing. It may be as simple as doing it because everybody else does it. It may be because so long as the possibility exists that the inevitable has been postponed, there is still money to be made. Funds are always going to stay fully invested, because it’s their mandate. Investment committees and consultants are supposed to make decisions about pulling back from markets, and take it from someone who lived in that world: 99% of them are afraid to do anything but follow the crowd. Finally, one has to watch out for the universal-consensus factor: if the market becomes certain that we’ll see a May swoon, a rally is odds-on.

Last Thursday, Google (GOOG) thought it was 1999 again, and announced plans to issue a tracking stock. They may call it another class of stock, but we would absolutely love to issue a few hundred million shares that pay no dividend, have no voting rights and therefore no real ownership of anything, but do offer a cool name. A tracking stock is a tracking stock, and when companies start to try to pull off this insult to the intelligence, it isn’t a promising sign. Nor is it when one stock – Apple (AAPL) in 2012, Microsoft (MSFT) in 1999 – is propping up an index on its own.

In the meantime, though, April is April and regardless of whether the markets sell off another day or two, an army of hunters is waiting with fingers on the trigger at any sniff of central bank action. One hint from either the ECB or the Fed that more bond-buying is on the way, and it will be game-on again in violent fashion. The markets will instantly chuck out any worries about some far-off thunderstorm that may never get here, regardless of the fact that nobody can remember a time when it didn’t. That’s a problem for next month/quarter/year. Besides, we have a whole industry that has to put its money somewhere.

The Economic Beat

The most significant piece of economic news last week was the proverbial dog that didn’t bark in the night: there was no announced change in bank reserve requirements in China after the disappointing GDP print.

Industrial production and retail sales data were above consensus, and actually fairly good – up 1.2% on the month for both – but industrial production just isn’t one of the sexier data. We will get our own retail sales data next week, on Monday, and expectations are running high for that report also, given the warm weather and early Easter. A shortfall will extend Friday’s losses, certainly, but the consensus is fairly low and our guess is that the news is fairly good – the weekly chain store reports have been encouraging.

The timing of news can be everything, leaving journalists frequently baffled. Last week’s jobless claims spiked higher, with a prior week revision of an extra 10,000, much larger than the usual few thousand. You might think that would take equity markets down, but when it came on the heels of dovish-seeming remarks by Fed Chairman Bernanke and Vice Chairman Dudley, it seemed to only reinforce the market’s belief that another bout of quantitative easing was close enough to taste.

Similarly, Wednesday’s rally sprung out of a hint by ECB governor Benoit Coeure, in response to the deepening Spanish troubles, that the bank could always buy more bonds. Shortly after ran a Goldman Sachs (GS) upward revision to its estimate for first-quarter GDP. That negated the weakness in the small business optimism index the previous day and built on a feeling that the traditional April reversal (weak start, big finish) might be at hand.

The Goldman revision was based on weakness in February import data, which isn’t a good sign and is one of the chief drawbacks of GDP as a measure of economic health: net imports are subtracted. If the trade balance improves because of a surge in exports, that is indeed good, but when it gets better because we’re buying less stuff, that’s an illusion. Nevertheless, we heard bewildered reporters try to explain the move as being based on an “improving trade balance.” Exports rose by 0.1%.

The Producer Price Index (PPI) recorded a net of no change on the month, but the core showed a hotter 0.3% increase. Import and export prices also rose more than expected, 1.3% and 0.8% respectively on the month, and Friday’s release of the Consumer Price Index (CPI) showed an increase of 0.3% overall, 0.2% excluding food and energy. Though neither the CPI nor PPI were alarming, neither did they indicate any deflation on the horizon. They are both running comfortably over 2.5% over the last year, making it harder for the Fed to make another case for quantitative easing that goes beyond supporting stock prices.

It terms of bad timing, the University of Michigan consumer sentiment first take for April was of really no significance, but the trivial miss (75.7 vs. 76.2) landed on a weak market that had in addition been snacking on too much sugar about how much confidence is improving.

In addition to retail sales next week, there is a busy schedule. We’ll get a big helping of industrial and manufacturing reports, with the New York Fed manufacturing survey on Monday, national industrial production on Tuesday and the Philadelphia Fed survey on Thursday. There’s also the first big installment of monthly housing data, with the homebuilder sentiment index Monday, housing starts on Tuesday and existing home sales on Thursday, which also has the Leading Indicators report.

It’s a big week for earnings, too. Citigroup (C) on Monday, Coca-Cola (KO), Goldman, Johnson & Johnson (JNJ), IBM and Intel (INTC) on Tuesday, and American Express (AXP), Qualcomm (QCOM), Texas Instruments (TXN) and VMWare (VMW) on Wednesday.

Thursday will see Bank of America (BAC), Morgan Stanley (MS), and Phillip Morris (PM), and the last day of the week has General Electric (GE), Honeywell (HON), (JCI) and McDonald’s (MCD).

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