The Time is Out of Joint


“Your fingers on your lips, I pray.” – William Shakespeare, Hamlet

So here we are with the stock market selling off in disappointment over the likelihood of a makeshift, minimalist budget deal. Not because it had hoped for more – it wanted less, rather, on the grounds that more budgetary pain means more monetary morphine from the Federal Reserve. And whatever else you may think about the efficacy of the morphine, if everyone else seems to be buying into the idea that it makes buying stocks a no-risk proposition, why then, bring on the needle and we’ll worry about the long-term effects when they get here.

For someone like me, it’s an unsettling state of affairs and a warning to the Fed. I suspect that for the Fed, it’s just another sign of the lower stage of evolution that characterizes the denizens of the stock market, not to mention another perfect example of why the governors can’t possibly bother themselves with trying to make any sense out of them. Just, you know, give them a banana and pray they don’t become violent.

Suppose the governors do reduce the dose next week – will the patient go into convulsions? If they wait for another season, will the seizures only be worse later on? More importantly, will the Fed get blamed for them?

I wish I could tell you what the Fed’s monetary policy committee (FOMC) is likely to do, but I can’t. If the FOMC wants to leave the rate of bond purchases intact, it can use the latest inflation data as a pretext, as it is quite weak. In that vein ,the economy is still running below the level of potential output: The industrial production report due on Monday is likely to show industrial and manufacturing capacity remaining at rates still comfortably below their 40-year averages, even below the low of the 1990-1991 recession. The number of economists at the Fed worried about overheating can probably be counted on one finger.

The size of the Fed’s balance sheet, rapidly closing in on $4 trillion, and the nation’s soaring money supply are another story. If the FOMC shamans are justifiably worried about those items, along with the lack of remaining policy response ammunition available, they can use the latest unemployment rate, however flawed it may be, as a pretext.

In the near term, QE is all that asset markets across the globe are focused on. Worse than that obsession is that I don’t know what the FOMC will get up to, and even worse than that is that I can’t be sure of which way the market will turn in the aftermath. One would think that prices would sell off if the Fed initiates a reduction in purchases – also known as the “taper” – but I have seen stocks put on a defiance rally so many times in the face of tightening that I wouldn’t bet on anything (though bonds are almost sure to come under pressure).

If the Fed stands pat and is vague about its future plans, that would be the best of all worlds, and if it hands down a split decision – no taper now, expect one in March – well then who knows, but my best guess is that prices would rally, sell off, then rally again into the end of the year.

All of this feels rather foolish – shouldn’t an investment column be talking about earnings and growth rates? But that’s what we’ve come to – to ease, or not to ease, as Hamlet might have said, and a time so out of joint that traders fear running out of diseases that require opiate. I don’t think this situation ends well, but I’ll be surprised if December doesn’t pull something together to the plus side in one way or another. It would make perfect sense for the market to sell off another five percent or so over the last three weeks – and that is exactly why I don’t expect it to happen.

The Economic Beat

The main report of the week was November retail sales, so I’ll start with that. The reported monthly increases beat consensus, not surprisingly, both overall (+0.7% vs. +0.6%) and excluding autos (+0.4% vs. +0.2%), as well as excluding autos and gas (+0.6% vs. +0.4%).

Strong report, one would think, but it really isn’t, with some of the strength coming in seasonal adjustments, and some of it just a rebound. The rolling rate of 12-month change declined from 4.25% to 4.14% (unadjusted, since there is no need to seasonally adjust them in this case), and the year-to-date (YTD) rate of increase remained at 4.27%. A year ago, the YTD rate of increase was 5.7%.

The rolling 12-month ex-auto comparison fell to 3.2% , the lowest rate since August 2010, when it was climbing instead of declining. For comparison’s sake, you may want to note that the rate was 4.1% in November of 2007, two months before the recession began, and the rate didn’t fall below 3.4% until November 2008, after the Lehman crisis and in the middle of the stock market crash. For all that, the business press was still citing the report as further evidence of strength that may lead the Fed to taper on Wednesday. Chain-store reports for the first week of the month were soft.

If there was something in last week’s data that may lead the Fed to postpone tapering, it was more likely in the inflation reports. Export-import prices continue to be weak, with export prices down (-1.6%) over the last twelve months and import prices down (-1.5%). The producer price index (PPI) came out with a story similar in tone, a monthly decline of (-0.1%) in the headline number and only +0.1% excluding food and energy, the so-called “core” rate. The latter dipped on a year-over-year basis to 1.3% from 1.4% in October. The total rate did increase from 0.3% to 0.7% year-over-year, but that is still quite low. The consumer index (CPI) comes out Tuesday as the FOMC begins its meeting; its annual rate dropped below 1% last month, at 0.9%.

Weekly claims surged, but this was really a catch-up effect from the previous few weeks of holiday-affected data. The moving four-week average of unadjusted claims (which soared to their highest reported level since last December) remains comfortably below the rates of year ago – the decline is about 15%. Claims data is more sensitive than the monthly jobs report, but they’re both still lagging indicators – the claims data were looking great just before the 2001 and 2008 recessions. There doesn’t seem to be any inflection point despite the spike, and that’s good news. The labor turnover survey (JOLTS) showed that most of the dynamism in the labor force is concentrated where the hiring is – at the bottom of the pay scale. The quit rates in manufacturing and construction are down from a year ago, despite our wonderfully improving job market.

Next week is one of those overloaded weeks that tend to overwhelm the market, in a way making it even easier for the Fed policy statement on Wednesday to dominate and set the tone for the rest of the year. That may not be immediately apparent from that afternoon’s price action, because markets tend to sell off after an FOMC statement, but this one in mid-December at the end of a big year rates to deviate from the pattern.

Manufacturing surveys, housing data, another GDP revision, triple-witching on Friday – it all makes for a big week, and the Fed will get much of the most sensitive data before the of its meeting. Monday starts off the industrial side with the New York Fed manufacturing survey and the Markit Economics “flash” purchasing manager index, accompanied by the latest productivity and costs information and followed by the report on November industrial production.

Those are followed by reports on Tuesday and Wednesday that might be very influential, especially if the Fed is as divided in private as it appears to be in many of the governors’ public speeches. The latest CPI comes out Tuesday morning and is followed by the homebuilder sentiment index; luxury homebuilder Toll Brother’s (TOL) latest earnings report was positive, but its outlook was on the restrained side. More important is the next day’s housing release – three months worth of housing starts, including the shutdown-delayed September and October reports.

If consumer inflation is low and housing starts are as restrained as the Toll Brothers report – that is, the year-on-year increases are still good, but at a moderating pace – the FOMC may find itself sufficiently divided to opt for simply postponing any major changes in direction until 2014 and Janet Yellen’s imminent accession to the chair. That said, Bernanke has zigged when I thought he would zag so many times that I have given up any hopes of anticipating his actions. I don’t think I would make a trading bet on next Wednesday if he confided his thoughts to me over dinner this weekend. The meeting’s statement will be followed by a quarterly press conference, his last one as chairman of the Federal Reserve.

There is still lots to come after the Fed’s announcement – the Philadelphia Fed has its survey release on Thursday, though you can be sure that the FOMC will have everything but the write-up for its meeting. The report on existing home sales for November comes Thursday, and it’s quite possible the committee will know its contents as well, though the data comes from the private sector. The sales pace has fallen for four months in a row, though it is still at a respectable level (5.1mm annualized).

The week will wrap up with another installment of leading indicators on Thursday and revisions to third-quarter GDP and corporate profits on Friday.

There’s also some news of interest on the foreign side – China’s “flash” PMI comes out Monday morning (Sunday evening in the US) and the EU, which had a slew of soft industrial data last week, starts off with fresh purchasing surveys on Monday followed by a batch of inflation data throughout the week.

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