Silence of the Lambs

“Pay no attention to Caesar. Caesar doesn’t have the slightest idea what’s really going on.” – Kurt Vonnegut, Cat’s Cradle

It’s a tough business sometimes, this musing of the market outlook. Two weeks ago, I was writing on Seeking Alpha that “the springtime correction is upon us.” I did allow that markets might move up another “percent or two,” and sure enough they did. More than two, even (though not by much).

However, allow me to say that I’ve seen this movie before. It was in the spring of 2011, when from mid-April to the first week of May, the S&P rose about 5%. Traders rushed into high-beta stocks for a trade and a short-squeeze, even as earnings failed to live up to expectations, particularly in cyclical stocks. On May 13, 2011, I wrote that “probably the most common sentiment on the Street is that the market is currently overshooting its way into a big correction,” but that people were afraid to sell because “bailing now would mean missing the overshoot.” By August, the market was 20% lower.

Hang on, you say, this time is different. Or perhaps, that time was different. Of course it was (is). They’re always different in some ways. Two years ago it was a combination of whispers about trouble in China, Europe (no chance of that happening again), and increased commodity margin requirements that helped bring the market down. Given the recent bleeding in commodities (which had been going the other way in 2011), the last isn’t likely to recur.

Some things are the same, though. One is that the market is ridiculously overextended. My indicators say that the last time the market was this overbought on an intermediate basis was mid-February – of 2011. That was followed by a garden-variety 5% correction, in turn followed by the obligatory triumphant reversal march to a marginal new high in April. And that was that.

Markets correct (as opposed to crash) primarily because of an excess of sentiment. It may seem like it’s always because of some unexpected bad news, but as a rise climbs giddier heights, it becomes more fragile to any news that doesn’t fit the prevailing narrative. What constitutes “bad” news to a bunch of scared trigger fingers becomes increasingly amorphous. The essence is that the rise becomes a sentiment stampede, and the sentiment tires out for one reason or another. One can never quite pinpoint the moment or nature of buyer exhaustion in advance, but with a bit of experience, one gets a feel for when a critical stage has arrived. Like right now.

There are, of course, exceptions to the infatuation rule and these are known as bubbles. 1929, 1987, 1999. They lead to horrible, gut-wrenching crashes, but the early stages of bubbles always feel grand. Traders don’t fear the onset of bubbles, either. They fear the end of them.

I don’t think that the current period will rise to bubble stage. Mini-bubble clearly, as we are already there. But the current rise isn’t being fed by a massive influx of retail money, like 1929 or 1999. It’s being pushed around by various trading strategies, and one big difference is that trading strategies bail out far quicker than the retail public ever does. Some are even precisely timed to a certain event.

For example, Wednesday’s rise was fed by a sudden influx of buy orders around 11 AM, partly designed to trigger more buy orders set to execute on a break above the previous day’s high. Typical up-market stuff, right out of “Moving the Tape 101.” Curious that it came on expiration Wednesday.

Example two came about 2 PM Friday. Another barrage of buy orders, this time designed to break the S&P above its three-day top of 1660 after three failed attempts, which would of course trigger more buy orders.

Not coincidentally, it also pushed a considerable amount of expiring options contracts deeper into the money and a much larger amount out of it. The open interest on the S&P 500 1600 call strike alone – nearly 120,000 contracts – was more than nearly all of the puts between 1600 and 1660.

But before you get to feeling bad for the options dealers (or wonder how they could let such a thing happen), you need to wait ’til the end of the movie. The retail-oriented SPY ETF had a massive imbalance in puts below the expiring May strike (i.e., out of the money) – over two million, by my estimate, including more than half a million between 163 and 166 alone, all of which were worth serious dinero a week ago and exactly zero at 4 PM on the 17th (the SPY closed at 166.94). That compares to less than 200,000 calls in the same strike range.

Talk about leading lambs to the slaughter. It was total carnage, a complete wipeout. Game, set, match and championship to the options dealers. Oddly enough, I predict the epic massacre will not be on the cover of Barron’s, or featured on NPR’s “Only a Game.”

Tonight and tomorrow’s news accounts on radio and the press will talk about investors being cheered by the latest batch of positive economic news, namely the University of Michigan sentiment index – which peaks when stock prices do – and the Leading Economic Indicators. Neither report is ordinarily good for more than five or ten minutes attention on the tape. No, it was nothing more than another springtime sidewalk hustle – albeit epic in scale – with the dealers once again filling up the bars late Friday afternoon and early evening with their customers’ money. Those Ocean’s Eleven guys were children in comparison.

The Friday evening futures market was trading up another significant amount as I write, but I wouldn’t put too much stock into it. The market is set to reverse, and you should hope that it does. Corrections are healthy, but bubbles burst. Ask the lambs – they’ve seen how it ends.

The Economic Beat

The week led off with an April retail sales report that confirmed the sluggishness of the sector, yet was given a pass because it beat consensus. The ex-auto, ex-gas number was plus 0.6%, which has now been crowned a trend. A good number is now an upward inflection point, you see, while a weak number is “just one number.”

However, the rebound strength in categories like building materials was weather-related. If you recall, cold weather was given much of the blame for weak March sales. Weather should get credit for the rebound too – although building materials were indeed up 1.5% from March and 7.7% from a year ago (unadjusted), the March-April combined total was only up 1.5% year-on-year.

As for one month’s number, year-to-date retail sales are up 2.4% over 2012. According to the CPI figure released Thursday, half of that is inflation (retail sales data aren’t inflation-adjusted). Frankly, a one-percent gain is nothing more than a pimple. If you’re clinging to the notion that the economy is picking up and has escaped the springtime slump, consider that the April 2011 retail sales report showed an ex-auto, ex-gas reading of 0.7%.

The trend is that consumer sales growth is slowing to near zero (where it can keep the growth in S&P 500 sales company: either zero, -0.2% or -0.4% in the first quarter, depending on whose number you pick). It could pick up, of course – but why?

“Housing” is the answer on everyone’s lips, and housing starts have indeed continued at their trend rate, though April missed consensus by a wide mark. The miss isn’t really worth a fuss – year-to-date, single-family starts are still up 27% over last year, about in line with the pick-up that began in January.

There’s been a lot of builder talk lately, some of it featured in the Wall Street Journal, that homebuilders intend to keep new home growth on a leash. The reasons cited are pricing discipline, labor scarcity (?) and a rise in input costs, but I have to wonder if another reason, one that doesn’t sound quite so boffo in corporate presentations, isn’t that growth is still credit-constrained. Much of the single-home sales financing is being done by the builders themselves, in concert with the FHA. Banks have been playing a small role. I suspect builders may be aware of the limits on the size and growth possibility of that credit pipeline. Their sentiment index remains pessimistic.

Permits rebounded from the previous month in what should be the peak month (though possibly June) of the season. The real question is whether commercial credit conditions loosen enough to allow for another big surge in multi-family housing. If so, the cyclical end is approaching in construction, though the market traders won’t see it until it’s too late (and it could be six to eighteen months until there’s an explosion large enough to get everyone’s attention).

On the manufacturing side, there was no good news at all, zip, zero, none. So, that must be just one month’s data.

Not in the case of the New York and Philadelphia Fed surveys, both of which were negative at (-1.4) and (-5.2) respectively. Both surveys followed up their weakest March reading since 2009 with the weakest April reading since 2009. Both reported negative numbers in new orders and shipments, with rises in inventories directly tied to precipitous drops in the latter. Industrial production fell (-0.5%) in April, with every category but mining down. Manufacturing capacity utilization slipped to a six-month low.

Yes, but sentiment is up. The University of Michigan sentiment index climbed to 83.7. Although this index closely tracks the stock market, Econoday actually had the temerity to claim that it offered “a very upbeat indication for May’s economic data, hinting at significant gains for jobs and consumer spending.” Perhaps they should have actually read the report, which said that the gains were concentrated in upper-income brackets. Presumably they are already employed. The index’s last peak of 82.7 was followed by a November jobs report of 146,000 and a fourth quarter GDP rate of 1%. The previous peak, in July 2007, was followed by a recession. You have to admire their chutzpah, if not their logic.

Leading indicators were up 0.6%, “more than expected,” though not more than expected, since the difference was in building permits two days before. The gains were led by the April stock market surge and the sudden improvement in weekly claims.

Yet the improvement in claims may disappear. I have observed from time to time that the claims data this year is more volatile than a year ago, a phenomenon I have tentatively ascribed to California (which makes up 1/6 of all claims) contributing lumpy data by alternating estimates with hard data. There is also speculation that Hurricane Sandy reconstruction efforts are temporarily suppressing claims (the tri-state area of NY, NJ, CT makes up another 10% of the national total).

The plausible-sounding latter factor may or may not be at work, but I suspect the former reason more. Over the winter, the year-year improvement in claims dropped to about 5%, or about half the level of 2012. Then it picked up again, only to recede again. In an effort to better see the prevailing trend, I compared actual claims for the first 18 weeks of 2013 (i.e., the year to date) versus the same period in 2012, and came up with a rate of improvement of about 5.5%. That indicates that the trend that began in the fourth quarter of 2012 is still intact, and that the LEI will drop again next month: permits, stock prices, and claims should all reverse, even if not dramatically.

Inflation is admittedly a lagging indicator, but how one can brag about an accelerating economy in light of the latest Consumer and Producer Price indices (CPI, PPI) is a bit of a mystery. The trailing 12-month consumer rate is 1.1%, with the producer rate at an even lower 0.7%. A recent drop in energy means that the core rates are higher, at 1.7%, but some of that drop can be attributed to traders taking off global growth bets on crude oil.

Do not get me started on the annual Street analyst charade of falling gas prices being good for the consumer. The current national average is about a nickel cheaper than a year ago. That may mean a lot to national truck fleets, where every penny counts (diesel is down about a nickel too), and airline corporate profits (jet fuel is down about 15%!), but a nickel isn’t making anyone rush down to the mall to buy furniture or jewelry – if they even notice the difference.

For the market, next week’s highlights begin on Wednesday with the release of the FOMC minutes, unless existing home sales prints up some wild number earlier that day. Several Fed governors and one Journal article have hinted at slowing asset purchases in the last week – could the Fed have been softening up the market for what was in the minutes?

The other big numbers come Thursday, with new home sales, and Friday, with April durable goods orders. I’ll be interested in the Chicago Fed’s national activity index on Monday, though it is no market-mover (yet). A clutch of “flash” PMI data comes on Thursday, and Friday will have some EU data of interest, including German GDP estimates and the investor confidence survey. Traders will begin leaving in droves at lunchtime for the long Memorial Day weekend.

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