Summer Lull


“Deep summer is when laziness finds respectability.” – Sam Keen

I may not like to say it, but it was probably once again the case last week that the Fed was the most important factor in the markets. Equities were able to pull off but one more day of follow-through from the previous week before sagging through a stretch of light data that featured a couple of Fed governors (Fisher, Lockhart) dropping more hints on Tuesday that a reduction in the buying of Treasury bonds was on tap. “The worst week since June” (which was only five weeks ago), ran the headlines, with most blaming the Fed.

Other than that it was a textbook first week of August. Second-quarter earnings season has been a dull affair yet again, with the main feature being even smaller earnings growth (currently around 2%) than last year at this time. Naturally the market multiple is at a four-year high, as it simply has to be that earnings growth has nowhere to go but up. It’s a no-brainer.

Still, a 1.5% loss in the market isn’t exactly huge. Depending on next week’s retail sales report, the calendar suggests one more week of softness before we hit the stock market’s “silly season” and rally for no apparent reason into Labor Day. Europe is on vacation and our own President hits the beach this weekend.

There are always some grounds for worry. The administration is treating the threat of a potential terrorist attack somewhere in Africa as very real, and Sunday is the 11th of the month. The markets remain fairly complacent, with below-average bearish sentiment readings and the VIX struggling to move back above the 13 level after dropping to a very, very low below-12 reading on Monday.

Yet bonds, which had an historic sell-off in late May after Fed Chairman Ben Bernanke first broached the subject of “tapering,” or easing back on Fed purchases of Treasury bonds, rallied this time around, so maybe some investors were a little concerned after all. Even gold managed to bounce back after getting trounced in mid-week.

While it’s only anecdotal, it feels like the penalty for earnings disappointments seems to have gone up lately. In normal times, it might be anywhere from two or three percent to five or ten, but lately I’ve been seeing haircuts of twenty-five percent and up, with not-exactly-high-flyer American Eagle (AEO) being one of the more prominent muggings.

Experience suggests that when nuts-and-bolts type companies like AEO get that kind of pounding, not just sky-multiple momentum plays, doubts about the health of the market have crept in. Take heart, though, for if it is the beginning of the end of the bull market, it will usually come months later, rather than days or weeks. Indeed the top is often yet to come, and I suspect that to be true this time as well.

As the debate heats up over who will replace Ben Bernanke – who has apparently had enough – as Fed chair in January, one wonders about the ramifications of that potential sea-change to the eventual chosen one. The leading contenders are San Francisco Fed governor Janet Yellen, the current vice chair, and former Treasury Secretary Larry Summers, the Jason Bourne of intellectual heavy-hitters. Running a somewhat distant but still plausible third is former governor and vice chair Donald Kohn.

All are qualified, and Yellen would be the first woman to serve as Fed chair, making her the sentiment choice of many, including a number of Democrats who have already signed a letter in her favor to the President. The problem is that whoever consents to donning the mantle may find themselves being left a rather large bag to hold with it.

The Economic Beat

The ISM non-manufacturing survey led off the week with an above-consensus result of 56.0. The report looked fairly good across the categories, with the exception of employment, and business activity posted 60.4%. Since services make up about 70% of the economy, it’s a fair question to ask why the market didn’t seem to take it more to heart.

One is that the non-manufacturing survey isn’t much of a leading indicator. It usually doesn’t signal weakness in the cycle until the recession has already begun, and didn’t drop below 50 in the last cycle until after the Lehman bankruptcy. The average for the last 40 months of the older “business activity” index has been 57.5, while the newer NMI index has averaged 54.6 since the beginning of 2012. So the numbers were decent but not earth-shattering, and the part about employment might have been a damper.

International trade occasioned some excitement, by contrast, with the revelation that imports rose less than estimated – mostly due to energy products – and exports rose. That will be a positive factor in the next GDP revision. I don’t believe in getting excited about falling imports, GDP or no GDP, but the trading boxes just trade the tape stories.

A partial offset to the trade balance will be inventories. Wholesale inventories fell instead of rising in the largest quarterly drop since the third quarter of 2009, Growth in orders has slowed as well. The silver lining is that with inventories falling for three months in a row and the inventory-to-sales ratio at a below-average 1.17, there’s a good chance that some inventory replenishment will help out the third quarter. Even so, I worry about the weak trend in wholesale sales.

The most market-moving report of the week seemed to be the Chinese trade report. Why exactly it caused so much excitement is a bit puzzling. I get the part about it beating estimates, but even so – here is what I read on Econoday:

On a seasonally adjusted basis, July exports were down 1.2 percent on the month after gaining 2.1 percent in June. Imports slid 3.0 percent after gaining 3.2 percent in June. On the year, seasonally adjusted exports were up 2.0 percent while imports were 6.6 percent higher.

This is a reason to buy commodities?

There are a couple of other little problems with the release. One is that it came out about seven days after the month ended. Two days earlier, the US published its trade balance report – for June, or about five weeks after the month ended. How does China, with its 32 provinces and billion-plus population, manage to count its data so quickly and accurately (especially in the case of GDP, but that’s another issue)? For that matter, industrial production also came out with a good-sized jump that was apparently driven by steel and heavy industry.

The markets also seemed most encouraged by a resumption of import growth. After the terrific cash crunch in June, it seems to me that this should have been less of a surprise. The other puzzling aspect was why industrial production would be driven by steel. Have the Chinese resumed building empty structures, or are the data being massaged as needed (or both)? Neither outcome would be welcome, except perhaps for traders in need of a fresh momentum play (iron ore, for example) and they duly responded. Faked momentum plays have painful endings.

You may have noticed quite a bit of giddy elation last week over July PMI surveys in Europe in the range of 50. They get reported as “surges to their highest levels” in activity in some number of months, but that isn’t how diffusion surveys work.

Diffusion measure the breadth of changes in activity, not its depth. One more purchase order counts as much in the answer as one hundred. Breadth and depth aren’t entirely unrelated, but if Europe has a series of readings between 50 (which means no change from the previous month) and 50.5 for the next twelve months, the continent is in for more trouble. It would only mean stagnation at depressed levels of activity.

A closer look at some of this week’s data tells you why it’s too early to break out the champagne. France reported a drop of 1.4% in June industrial production. Some of that was energy-related due to cool temperatures, but one would normally expect a mild rebound in the following month at this stage of the business cycle, not fresh evidence of an uncontrollable downward spiral. In addition, the latest uptick in German manufacturer orders – also much celebrated – was juiced by the Paris Air show, which should have led to more aircraft-related business throughout the Airbus and European aircraft region. Orders for German consumer goods declined, by contrast.

Next week’s principal report of interest should be July retail sales on Tuesday. It could get a run for its money from housing starts on Friday, and the inflation indices are always potential wild cards, though I don’t expect anything dramatic next week. Import-export prices are out Tuesday, producer prices Wednesday, and consumer prices (CPI) Thursday.

Thursday will be a busy day. In addition to the CPI and the usual weekly claims report, it will have manufacturing surveys from the New York and Philadelphia Feds, two of the highest-profile regional surveys. July industrial production will also be released. Usually the three reports are spread out over three separate days, and I couldn’t tell you why not this time. Maybe the sequester is at fault. The homebuilder sentiment index also comes out Thursday morning.

The EU will have its own industrial production data out earlier in the week, and its first estimate of second-quarter GDP on Wednesday, along with initial estimates for Germany and France.

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