Hazy Daze in May

“And these does she apply for warnings, and portents, and evils imminent.” – Caesar, in William Shakespeare’s Julius Caesar

by M. Kevin Flynn, CFA

The waters are muddying again as more spring-like weather returns to the environs of Wall Street. Trading seemed odd all week, from a slight rebound on Monday in the face of disruptive European election results, to a surprising rebound on Friday after a brace of disappointing economic reports from China and an embarrassing mea culpa from JP Morgan (JPM). The latter attempt faded away in afternoon trading, however, bringing the correction from May 1st to 4.65%. That’s about the level where many avowed last quarter that they would eagerly step in to buy.

Indeed the market is somewhat oversold on a short-term basis, and appears to already have readied itself for a lot of negative outcome. The reason equities didn’t sell off on Monday is that they had already done so the previous Friday, as both a Socialist victory in France and a dysfunctional outcome in Greece were widely accepted before the event. On the Friday just past, rumors that left-wing attempts to form a coalition might fail (thus avoiding an official government repudiation of the EU bailout pact) led to the reversal attempt off the disappointing inter-session news. When support failed to develop for either the rumors or JP Morgan, the oncoming weekend suggested it was time to fold up and wait for another day.

So the market is oversold and arguably due for at least another rebound attempt. We can all see the specters of a slowing Asia, recession in Europe, and a possibly inevitable Greek exit. In these types of situations, any whiff of something to the contrary easily ends up first launching the usual mad scramble to cover short positions until the dust settles, and second putting a little bravado back into the souls of those who swore that they would buy the next dip.

Despite the likelihood of an attempt to play the rebound, though, there were some unsettling developments during the week that appeared to weaken the ground underneath. Cisco (CSCO) reported earnings, and though the company put on a rather decent first quarter, it rattled the cages with a diminished outlook and talk of a slowing European order book. It was one of several high-profile stocks that got hammered with 10%+ declines during the week (JP Morgan’s decline extended into 10% in after-hours trading on Friday). While Cisco isn’t quite the bellwether it once was – Intel (INTC), for example, said its European business is just fine, thank you – the many names getting the double-digit haircut last week is a sign of a market that’s getting hollowed out.

Market sentiment is a tricky thing anytime, and never more so during trading markets like the one we’ve been living through the last year and a half. One of the more reliable dynamics of any market is that the unanimously believed trade almost never works. Coming into the spring, it seemed to us that the fears of a “three-peat”, or a third consecutive summer swoon, had become so widespread as to render it unlikely. Indeed, the big counterattack that flattens the widespread prediction of doom is perhaps the Street’s favorite trading rally.

Yet a funny thing has happened on the way. A disturbingly confident swell of opinion has risen up over the last month that any sizable sell-off has now been definitively ruled out. To our way of thinking, that brings the possibility of a decline back into play, since disappointed expectations are usually the strongest driver of any sell-off.

The JP Morgan news caught markets by surprise, certainly, and took some luster off banking stocks, in particular the Gang of Four. Can anyone really know what the behemoths are up to, it was asked, when JP’s 10-Q (quarterly financial filing) is 150 pages long? We won’t need to repeat what’s already been widely said, but we would observe that many assume that press accounts of the London positions at the heart of the bank’s problem are what brought it to an ignorant management’s attention. Afterwards, the story goes, a surprised and chastened CEO Jamie Dimon shut it down.

However, it may be that the press account itself was a key catalyst to wrecking the bank’s position. It’s tricky enough to have a large position at any time in trading; when the whole world knows about it, it isn’t good for the ones holding the bag. It’s especially bad when the market wasn’t that liquid in the first place. Obviously it’s the bank’s fault for allowing its position to get to the size it did, but the losses may have really only started to mark down when it pulled back and belatedly realized that the rest of the market was now waiting with sharpened knives.

We’ll give Dimon credit for not making the blunder of trying to blow out of the whole position immediately and making the losses permanent. After all, if the credit situation in Europe or in fixed income should hit any kind of freeze, the positions will swing back into the money regardless of the waiting adversaries. We think it likely that between Asia, Europe, and the fiscal cliff, something is likely to come up to test credit market nerves.

On the other hand, we also view it as another example of systemic flaw inherent in the giant universal bank model that we have disliked since the nineteen-eighties. It didn’t work then, hasn’t worked since and never will. As cold-blooded financial analysts, our belief is that the cultures of investment banking and commercial banking are intrinsically different enough that if they are both working well, they cannot work well together. If by chance they do briefly work well together, then one of them is bound to be working poorly.

The shareholders don’t benefit, the customers don’t benefit, and it’s pretty clear by now that the financial system doesn’t benefit either. A few top managers get outsized bonuses for a limited time, and perhaps some magazine covers and coveted social posts to additionally buff their outsized egos, and then the rest of us are left with cleaning up the inevitable mess. There is no good reason to keep allowing elephants into the china shop on the grounds that someday they will be ballerinas. They will still be elephants, the china will still be china, and it’s folly to believe that whispering soothing words about free-market magic into elephant ears is going to mean that this time is different.

Two things to ponder this weekend: the latest European ideas are not working, whether it’s the Spanish bank plan, any Greek government, the German austerity program or the EU’s endless economic projections of around-the-corner upturns that never materialize. The markets are very aware of this, yet the business press is filled with talk of bargain hunting in the old continent. It suggests another one of those maddening periods where markets want to rally up to the edge of the cliff, a feature of equity markets as long as we’ve been in the business. It’s perhaps another argument for an imminent bounce, but keep in mind that bottoms aren’t accompanied by cheerful talk of bargains to be had, but by dreadful tales of nowhere to go.

The S&P 500 is still up about 8% on the year, while long Treasuries are up over 10% since March. One of them is bound to be wrong, and this time is never different: caveat emptor.

The Economic Beat

The most notable data in a sparse week came from China. The country’s inflation data was more or less on consensus and not elevated – producer prices were reported to have declined (-0.7%) over the past year. However, the retail sales and industrial production data were both sizable misses, with the latter nearly unchanged on the month and notching the weakest yearly growth rate in three years.

Despite the pre-opening jitters in the futures market, though, the news had little impact on equities. That wasn’t in keeping with recent experience, and strongly suggests that the market has built in a two-way view on the situation. That China must have been already expected to slow is evident, but really the more important inference is that markets are clearly expecting additional easing in monetary policy, probably in the form of lower reserve requirements, with the inflation data providing necessary cover.

The country already has an overabundance of unoccupied property developments, and its European customer base is in pretty rough shape (a fact duly noted in the country’s export report, which we take to mean that Intel wasn’t asked). It isn’t clear who would want to be stepping up to take advantage of the increased lending capacity. Developers trying to stave off bankruptcy would certainly be willing, but we rather doubt that such loans would turn around the declines in the production rate. On the other hand, there is little reason to doubt that equities would eagerly embrace another round of easing. At least oil and the Australian dollar had the decency to fall on the news.

India also reported an unexpected decline in production, and the news out of the subcontinent has been running much weaker of late. It isn’t immediate bad tidings for American company profits, but if the biggest components of developing Asia are slowing rapidly, it’s going to create some challenges. Part of their problem, of course, is that their export-based economies are having to deal with struggling developed-world customers.

Turning back to the States, the week was bookended by survey data from the National Federation of Independent Business (NFIB) and the University of Michigan. The former, usually called the small business optimism index, rose higher than expected. While 94.5 is still well below the baseline of 100, the rebound from 92.5 may have reflected the same conditions that led to the increase in the ISM manufacturing reading. In the same vein, wholesale sales for March were released and the adjusted monthly increase of 0.5% accompanied a 7.9% unadjusted increase for the entire quarter. Our analysis suggest a further, though milder increase should follow in the second quarter, and the other two data points support the idea.

On the other hand, the increase in the consumer sentiment index to 77.8 is something to worry about. Traders seem to love this kind of stuff, but the reality is that you could do a lot worse than follow a simple strategy of selling high readings and buying low ones. By contrast, Bloomberg weekly consumer index slipped into recession territory, echoing the drop in the AAII investor group survey, which is itself notoriously contrarian. Investing is so easy, isn’t it?

Next week will feature the retail sales report for April and the usual mid-month chunk of industrial data: the industrial production report for April, plus the New York and Philadelphia Fed business surveys. The consensus for sales is a cautious 0.1%,
but the industrial data are expected to show healthier increases. Homebuilder stocks have been on another little mini-tear lately, so next week’s releases of the sentiment index on Tuesday, along with starts and permits on Wednesday, should have them either peaking or deflating (the stocks usually start to fade by June). The FOMC minutes come out Wednesday afternoon.

Before any of the U.S. news begins, though, we will have learned first about any progress or failure on attempts to form a Greek government, plus the latest read on EU industrial production (Monday pre-open) and estimates on French, German, and EU GDP (Tuesday pre-open). It could very well set the tone, with a positive surprise launching a vicious counter-rally, or the more likely continuation of bleakness meaning a little more wobble before the rebounders can find some traction.

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