Nine and a Half Weeks


“It never occurred to me to call it pathological.” Elizabeth McNeill, Nine and a Half Weeks, A Memoir of a Love Affair

Well, we made it. We got to the October top talked about since the springtime, poking through the 1750 level I wrote about last week and coming to rest in the 1755-1760 trading target noted in the weekly video (see the MarketMinute at right, or on YouTube). With 9 1/2 weeks left to go in the year, what happens now?

What’s likely to happen next is a slow fade all the way into Thanksgiving. We had a flirtation with 1760 on Friday, but the market is overbought and earnings are not doing the job, despite some of the high-profile stories you may have read about. It still looks like 3%-4% year-on-year earnings growth on the back of 2%-3% revenue growth, with guidance coming down across the board.

That doesn’t mean head for the hills, only that we are likely to see the market reverse into a technically oversold condition sometime over the next month. The S&P should fall back to about 1700, a little more than three percent lower than Friday’s close; whether or not it’s able to pierce that support floor will depend on the news flow. I wouldn’t look for anything sensational next week – the market should settle for a few days, have the usual brief rally for the Fed meeting and the first of November, then sag. It might tack on a new high in the process, and it might not. Whatever extra it tacks on next week, if any, is likely to quickly disappear.

As for the top staying in October, I’m going to hedge my bets. An important parameter has changed since the springtime, namely the supposition that the Fed would begin dialing back on its quantitative easing program in the fall. It seems quite unlikely now that any such thing will happen in calendar 2013, given the current softness in the economy, another impending budget-debt battle around the turn of the year, and the likely reluctance of the outgoing Fed chair, Ben Bernanke, to pre-empt his heir presumptive, Janet Yellen. The consensus for a change in Fed policy has shifted to March.

The base scenario now looks like a fade back towards the 1700 level in November (or lower if something untoward happens), followed by the inevitable Thanksgiving-to-New Year’s rally. The latter has become one of those events where everyone buys because everyone else is buying, though it often takes some time off in mid-December. It’s possible that favorable political news that month – which these days, means any decision not to burn the country down to the ground – might tempt traders to force a new high before the end of the year. It’s also possible that another burst of DC funk emerges from the December 13th deadline for agreeing a budget framework, but it would have to be a fairly nasty one – the market certainly isn’t about to expect any real progress.

There is a wild card to keep in mind, though the odds are against it being played. Should something reasonably ugly come to pass in the remaining 9 1/2 weeks, the selling might surprise you. The market is quite complacent, with traders comforting themselves by saying not everyone is complacent, just as they did in 2007-2008. Most are nevertheless convinced that the magic potion of no taper-talk, no government meltdown and performance pressure will keep anything really bad from happening. Buy every dip. Who knows, maybe next week’s Fed meeting will fuel a sense of invincibility and another shot at going parabolic, as happened at the beginning of May.

But if something untoward should happen, one might see a bigger rush for the exits than the performance-chasing protection theory admits. As we get to the end of the year, hedge fund managers will be less worried about which quartile their performance falls into and more worried about the disappearance of their 20% cut of the profits. Mutual funds and institutional mandates will have very little cash left with which to bail out the market.

Ah, but banish those unworthy thoughts. That nothing bad can possibly happen, not this year, is the received market wisdom, and when has the market ever been wrong? The momentum is admittedly such that it will take more than rumors of government dysfunction to break up the rush to the finish line. I still say be careful about leaping into the first dip next month, and be even more careful about next year. But that’s 9 1/2 weeks away, a lifetime on Wall Street.

The Economic Beat

The jobs report wasn’t anything special, but didn’t need to be. So long as the number isn’t some sort of lightning bolt, the market will keep rallying on job reports until the bull market is over. If the number is weak, it means more accommodation from the Fed; if the number is strong, it means the recovery is here. I’m not being smug, because it’s exactly what the market has done for all of 2013. At some point there will be a major surprise that signifies a turning point, but nothing about this week’s data indicate such a surprise is imminent.

Although the print of 148,000 was below consensus for about 175,000, it is still consistent with the rest of 2013. Most of the year has shown monthly year-on-year growth in a tight range of 1.57% to 1.67%; September’s rate was 1.66%. I broke down more of the numbers in my Seeking Alpha column, but the highlights are that the labor market is still soft, despite improvements in the rate that are due as much to the faster relative growth of the number of people classified as not in the labor force (and so not measured as unemployed) as they are to the slow-but-steady pace of hiring. Real after-tax hourly wage growth was negative over the last twelve months.

The lack of dynamism was born out in the labor turnover (JOLTS) August survey, which measures job openings, hires and separations. Compared to August 2012, the hire rate is the same (3.3%), the separations rate is the same (3.2%), and only the job openings rate showed some life (2.8% vs. 2.6%). The quits rate, a theoretical indicator of labor confidence, did improve to 2.3% from 2.1%, with about two-thirds of the change coming from the two categories of retail trade and health care-social assistance. The quits rate fell in manufacturing, a sector with almost no jobs growth from a year ago. I would guess that the Fed was hoping for more when it launched the current QE program in September 2012, but it was probably also hoping for more from our elected leaders – monetary policy is no cure-all.

The August durable goods and wholesale trade data were finally released on Friday, and there were some interesting inferences to be drawn from the data. The headline number for durable goods new orders was above consensus at +3.7%, but it was all in aircraft: Excluding transportation, new orders were down (-0.1%). In the closely watched category of business investment spending, they fell (-1.1%).

That was the fourth month in a row that the three-month moving average (not seasonally adjusted, or NSA) for business cap-ex was negative, at (-1.9%), but also the fourth month in a row that the trailing twelve months expenditure increased. Recall that spending grew quite cautious in the face of the looming default-sequester showdown last year, with the result that monthly new orders in the category declined five of the last six months of 2012 (NSA). Spending isn’t robust this time either, but it’s better than it was.

Wholesale data showed the inventory-to-sales ratio dropping to 1.136, the lowest it’s been since May 2012. It may be counter-intuitive, but this has not led to a subsequent increase in sales the next month for restocking, not in recent years. Rather the opposite has taken place, as it’s been a harbinger of slower sales that bring up the ratio instead.

The August wholesale sales figure was bothersome on two counts. The NSA sales increase from July to August was quite mild by historical standards – about $5 billion compared to $27 billion in 2012 and $38 billion in 2011. That’s because August is the time when vendors start building inventories for the Christmas selling season. This year’s meager increase clearly suggests something is awry, with the most obvious suspect being that retailers aren’t expecting much for Christmas.

It could also be that an outlook for warmer temperatures left apparel vendors with a lot of unsold fall inventory – that seems clear enough from the numerous warnings last month – and they went lean in order not to get stuck again in the winter. That could be perversely good news for retail stocks, as stores would be able to move all of their winter inventory at full price should temperatures turn cold before the end of the year. It’s a lovely theory, and apparel sales were indeed off, but not enough to account for the total. The weakness was widespread and included petroleum products, autos and electronics.

Another explanation is that business was cautious in the face of the government shutdown. We won’t know until the October data shows up, which won’t be until December, and it’s quite possible anyway that the slowdown was due to a combination of all of the above . The other aspect of the August number that baffles me is that the seasonally adjusted increase in sales was $2.8 billion, compared to $2.4 billion in August 2012. Yet the non-adjusted increase in 2013 was five times smaller, or $22 billion less. That’s some adjustment.

International trade was about unchanged in August, with exports slipping fractionally and imports flat in the first estimate. I’ll have more to say about the data in a later report, as this week’s economics section is rather long already. On the manufacturing side, the Richmond and Kansas City surveys showed modest improvement for the month, while the Markit “flash” PMI estimate suggested the rate of growth was slowing, with production actually down slightly. The markets seemed willing to accept the decline as Washington-based, and for the moment it’s as good an explanation as any.

The pace of existing home sales moderated in September, along with home price appreciation: Prices rose 8.5% year-on-year in the federal data, down from an original 8.8%, revised down to 8.6%. Once the government had shut down, tax returns could not be verified, which surely slowed some transactions, but August sales had no such issues and were revised downward to no change. There seems to be some sort of stand-off developing in the sector between would-be buyers and sellers trying to recoup pre-crisis prices. Credit in the sector remains very tight.

Construction spending reported a consensus-beating gain of +0.6% for August on top of an upwardly revised 1.4% for July, both led by private residential construction. September might be more of the same, as the jobs report showed a sudden surge in new construction jobs: +20,000 after months of miniscule gains. Consumer sentiment slipped downward, no doubt another victim of Washington.

Next week continues a heavy slate of earnings and another batch of catch-up data. September industrial production is scheduled for Monday, along with pending home sales. The biggest reports ought to be the September retail sales report on Tuesday and the FOMC (Fed monetary policy) announcement on Wednesday. I’m concerned that sales were soft, but seasonal adjustments make these things difficult to estimate with any confidence. The Fed announcement seems unlikely to surprise, so maybe it will, though the latest jobs report could hardly have inspired the FOMC to pull back from its purchases.

The manufacturing sector starts off with the Dallas survey on Monday, continues with Chicago on Thursday and ends with the national ISM (purchasing manager) number on Friday. October employment will be delayed until the following Friday, although the ADP report will be right on schedule Wednesday. The two price indices, producer and consumer, were also delayed and come out Tuesday and Wednesday. We’ll be drowning in data. Did I mention Case-Shiller housing data on Tuesday and monthly auto sales on Friday? The sum of it all is a bit much for the markets to digest in one go, so typically most of the reaction comes later.

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