St. Patrick, Save Us


“May the the road rise to meet you.” – from an old Irish prayer

by M. Kevin Flynn, CFA

The trading market lives! It’s an important distinction to make when looking at prices. Trading prices are based on recent momentum: as Vanguard’s John Bogle likes to say, the main driver of higher prices is higher prices. What last week’s rally tells you from the trading point of view is that in its narrowly circumscribed universe, the noise of positive surprises outweighed the negative.

Note that we are referring to the noise of the news rather than the supply or its meaning. That the tape generates the news is an axiom that is true in almost any market. Whether markets are rising or falling, traders will focus on the news that supports the trend and tend to ignore the rest. The filtered result is repeated to inquiring journalists and duly reported in the business and mainstream press, thus reinforcing the price-induced sense that either all is well or all is lost.

What trading prices are telling us now is that the trend still lives, but it’s a day-to-day affair that is about itself. It’s not about the economy or earnings, it’s about the trend. In its early days, a trend draws strength from the repudiation of the old trend; in its last days, it lives off the denial of its own end. A classic sign of a trend approaching the end are news events starting to acquire a comic aspect, when bits of fluff are dramatically promoted in significance and thunderclaps are ignored. Last week had several good examples of both.

But before turning to those events, it’s useful to reflect upon what prices are saying from an investment point of view, rather than the trade. It’s a view that isn’t always heeded, even by those who are paid to do so; the pull of the stampede can mesmerize more than you may think. The investment meaning is like gravity – though it may be a comparatively weak force, it is persistent and prevails in the end.

For an investor right now, prices are starting to say that nothing can go wrong this year. That isn’t likely. Between the slowdown in China, the recession in Europe and its disintegrating periphery, the quite modest nature of the U.S. recovery, the debt burden hanging over the developed world, impending budget battles and the automatic spending cuts, oil prices that will realistically recede only if traders believe that the economy is turning down – it simply isn’t possible that the market can sail through all of these perils untouched.

Those issues, however, are not the province of the trader. One or more of them will be before the year is out, but not now, not yet. Traders concern themselves first with what might happen tomorrow, less with the day after, and so on until anything more than a week out is rarely considered.

What drove prices on Tuesday’s mini-reversals wasn’t the retail sales report, which was about was expected (as a trend gets extended, it becomes increasingly necessary to be better or worse than consensus). Rather, it was several bits of theatre, including a Wall Street Journal report about Fed bond-buying. The story was nothing more than one reporter’s speculative account of options the Fed could pursue if it wanted to embark upon further easing, yet was misleadingly headlined as an actual plan, despite a follow-on story (conveniently posted at midnight) by the reporter emphasizing that it was only speculative. By week’s end it was still being quoted as a factual event.

Second, the market rallied further upon news that Greece wasn’t defaulting. That may seem hard to believe, but we can assure you that traders figured out long ago that any news of a Grecian non-default was fuel for another leg up. Though most analysts not working for official European institutions would agree that the Greek situation is untenable and cannot last in present form, we can assure you that traders will continue to buy non-default news until the end. It isn’t as if traders don’t know the real Greek story, but they also know that the short-term trade is to buy non-default until the end (and even hard-nosed floor traders are capable of falling for their own illusions).

An even earlier driver of “the best week of 2012” was improved German investor sentiment about the future, though not about the current situation. It’s really a non-event, because expectations are founded on what stock prices have been doing recently. Such survey readings are probably the best contrary indicators that we know.

A much bigger driver was the news that most US banks had passed their stress tests. We certainly didn’t see any shred of doubt beforehand about the results; indeed the test was well off the radar screen. When necessary, though, the obvious can become a major development. We did think it ironic that JP Morgan (JPM) chose to celebrate its newly acquired seal of capital approval by deciding to immediately weaken it, with an increased dividend and stock buyback program.

The Fed also said that the recovery was “moderate” instead of “modest” in its monthly statement. This was interpreted as a major upgrade to the outlook, and by the weekend, the press was treating it as such. All the statement consisted of was the banal obvious, and we don’t know how anyone in their right mind would expect that the Fed would do anything else. Its default position is cautious optimism; pessimism comes when we are already in trouble. Watch what it does, not what it says: policy remains that it still expects to keep interest rates near zero for over two more years, and there was no change in its current “twist” policy of using maturing debt to lean on long-term rates.

Yet the failure to hint at the next round of quantitative easing shook traders who had come to expect it, including those in the bond world. The reaction was understandable and yet curious at the same time. The bond market has conspicuously not been buying the recovering economy story, and there was something of an overabundance of hope that Professor Dumbledore – er, Bernanke – would unveil another miracle of quantitative easing with his invincible wand. Prices moved sharply as an overcrowded trade unwound, though some pundits tried to sell the re-allocation as the bond market buying into the recovery theme. Yet had the Fed announced another round of QE, equity prices would presumably have gotten legs for another trip skyward and bonds would have sold off from that re-allocation. Perhaps bonds were overbought, period.

We thought that the mid-week silliness might signify a market top, but when Friday gave us another piece of vaudeville with the denial of a rumor, all we can say is that we are in a topping period. Prices started to sell off that morning, precipitated by the whisper that the US might release strategic reserves onto the oil market. When it was denied, oil prices rebounded, and equities rose again.

This kind of nonsense is typical of a stretched trend and tells you that the end is near, but “near” can be a day or a half-year off. Sooner is better for the investor and the health of the market, but later is better for the trader – until it isn’t. Saints preserve us!

The Economic Beat

The news last week centered on inflation and manufacturing. The only real news of the Fed statement, as ridiculously overanalyzed as ever, was its lack of news about quantitative easing.

Industrial production was estimated to have been flat in February, though the flat reading from January was given a substantial revision upward to +0.4%. The revision was manufacturing-centered, specifically autos, which was more consistent with the month’s auto sales. The weather that is forgotten when reporting jobless claims was brought forth for the weakness in production (mining and utility production declined).

The New York Fed survey came in about as expected at 20.2, but looking at the diffusion subcomponents the last two months, we think that the strength of the number is misleading. New orders slowed, as well as in the Philadelphia survey, which also came in about expected at about 12.5. The Philadelphia reading in February 2011 was 33 and change – we think the usual first-quarter bounce is more subdued this year than last, despite the chatter.

On the inflation front, import, export, consumer (CPI) and producer (PPI) prices all increased at a 0.4% rate. The domestic core rates were subdued, running at 0.1%-0.2%; and year-on-year total inflation is running about 3%-4%. These are tolerable numbers, but if oil prices keep rising it will be problematic.

Retail sales rose 1.1% in February, 0.6% excluding autos and gasoline. However, the year-on-year increase in actual retail sales excluding gas and autos – that is, not adjusted for anything – from February 2010 to February 2011 was 5.61%. The year-on-year increase from February 2011 to February 2012 excluding autos and gas, was – after adjusting for the extra leap-year day – 5.62%. That isn’t much of a difference. In fact, the year-on-year rate fell for total sales, from 9.2% to 6.5%.

This week’s data will be centered on housing: the homebuilder sentiment index Monday, housing starts (February) Tuesday, existing home sales on Wednesday, federal loan-based priced data on Thursday, and finally new home sales on Friday. There will be some European purchasing manager data in mid-week as well, but Europe is also caught in the momentum trend. Despite having much more bad news to ignore, its markets are also managing to fasten onto whatever positive shreds it can find.

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