Hesitant Beginning


“And thus the native hue of resolution is sicklied o’er with the pale cast of doubt.” – William Shakespeare, Hamlet

Well, it’s done – 2013 is in the books, with one of the most improbable rally years ever. In a year in which nominal four-quarter GDP steadily fell from 4.8% in the third quarter of 2012 to 3.3% in the third quarter of 2013, and likely something lower in the fourth quarter, and in which the rate of corporate profit growth declined again to roughly half of what was estimated at the beginning of the year, the equity markets rose about 30%.

As an aside, it should be of interest that corporate profit growth actually declined in 1998, a year that saw a 28% fall correction in equities before the Fed stepped in and steered them back to a 26.7% annual gain, one that fueled the most massive surge of we-are-invincible irrational exuberance since the late 1920s.

At some point in the not too distant future, there will be plenty of discussion and wringing of the hands over how investors and the Federal Reserve could have been so blind – a $4 trillion dollar balance sheet (it’s now official), the 90% correlation between equity prices and the growth in said balance sheet, the latest wave of excess in the credit markets (record levels and flows of corporate bonds, junk bonds, covenant-lite bonds, leveraged loans, payment-in-kind (PIK) bonds – PIK bonds above all signaling the Dionysian orgy stage of every credit boom). How, the books will wonder, could they have missed it again only six years later?

One explanation can be found in the mortgage market. One of the earliest practical lessons I learned in the investment business was that banks are the lemmings of the financial world. Though the image of lemmings marching off cliffs into the sea may be a myth in the natural world, it is cold reality in the financial world. Whenever a sector heats up, the banks will herd together in a way that would make lemmings envious, throwing massive amounts of loans at the new sure thing until it is so leveraged up that a loud cough will start an avalanche of default.

The banks always react the same way – get rid of everyone (the CEO and board excepted, of course) responsible for lending to whatever the horrible treacherous sector was, batten down the hatches and then wait for the next siren song to begin. It becomes nearly impossible to borrow money in the tainted sector, and ridiculously easy to borrow in the new favorite. The result will be that the tainted lending will have standards so tight that the default rate drops to zero for the next five years, while the favored book becomes so loose that the banks run out of live bodies to lend to. And then it crashes.

It’s so difficult to get a mortgage now, five-plus years after the crash, that interest-rate risk aside, it’s practically the safest paper around. Meantime, the paper that’s supposed to be next door to guaranteed, high-yield and leveraged loans (hey, the economy is always going to get better next year, so what’s to worry?) will be so massively overborrowed that the next sneeze could start a wave of virulent tuberculosis.

It could be something as simple as one lousy quarter of returns from rates moving up. Investors might start to panic and dump their holdings, and suddenly borrowers can’t roll over their principal anymore because no one wants to even hear about junk bonds. So borrowers start to default, not because the economy is bad, but because they can’t make payments they were expecting to refinance. And then the virus becomes a plague: Lehman Brothers filed bankruptcy when it couldn’t obtain short-term financing anymore, and in a heartbeat every bank was afraid of every other one.

Such events will always be characterized by the perpetrators as due to an unknowable and foreseen chain of events, while the CEOs will go around blaming the government. The investment community isn’t going to blame itself for trying to extract every dollar possible out of the craze – they’ll blame the Fed, Obamacare, the minimum wage, wind power, sunspots, or whatever else might attract financing from rich cranks with an axe to grind.

Some worry about China – very legitimately, in my opinion – as posited by George Soros (he’s worried about Europe, too). I am quite sure that China is inevitably headed for one of those speculative collapses that the US periodically went through in its 19th-century adolescence (bankrupting many a European family in the process), but the country is opaque enough that the timing is nearly impossible to predict – much like the US busts were when easily-manipulated news traveled by horse and telegraph.

The Middle East is a perennial source of concern, so much so that markets have learned to ignore it until troops can be seen marching onscreen, but the Sunni-Shiite conflict in the region is not only spreading, it’s gaining some real momentum of late. That could be a nasty turn of events.

For myself, I worry about a year like 1973, one that began with a big pickup in GDP and the ten-year yield slowly marching higher (not so slow for those days) as an era of loose Fed policy began to backfire. The performance of the market in 1972 was quite similar to 2013 – not a single day in either year finished below the previous year’s close – and the market started falling steadily in January (the oil embargo that finished off the economy didn’t start until October).

The first two days of 2014 caught traders by surprise, with a sell-off the first day that broke a skein of five years. Some tax-related selling was expected, but the expectation was also that a flood of fresh retirement plan money would overwhelm the former. It didn’t happen, and then a spate of rather aggressive Fed governor comments Friday afternoon seemed to suggest that the bank is pretty intent on tapering, leaving markets wondering where the rally was – the S&P and Nasdaq fell a second day in a row (partly pulled down by Apple (AAPL), while the Dow and Russell 2000 managed a mild bounce.

Two days do not a month make, nor does one month make a year. It’s true that weak Januarys often precede weak years, and weak debuts usually precede weak Januarys, but the relationship is only a tendency, not a law. Still, it’s a situation worth watching, and the reaction to next week’s employment report may be the best clue to where sentiment is going. Happy New Year!

The Economic Beat

The dominant theme of this week’s slate of economic data was the lack of change from the previous month. It was one of those times where nearly every measure was as it had been on the previous go.

Pending home sales for November led off the week with a number showing a 0.2% increase from the month before. That’s well within the margin of error, so we could label even an unrevised number as being unchanged. The level is a bit lower than was thought, since the October data was revised downward by half a percent. High prices are cutting into sales – the latest Case-Shiller data showed another increase in the year-on-year rate from 13.3% to 13.6%.

The week had a slew of manufacturing surveys that also showed no real change from the previous months. These diffusion surveys are generally not well understood by journalists, who tend to report on them as if they were production meters, instead of a collection of better/same/worse answers that are often answered finger-in-the-air style by harried subordinates.

So the Dallas Fed reported a mildly positive 3.1 (zero is neutral), up from 1.9 the month before – or in brief, it went from 2 to 3. The production index wasn’t as strong as the previous month. Further up north in Chicago, the reported Purchasing Manager’s Index (PMI) December result was a decent 59.1 (50 is neutral), down from a string of plus-60 readings. The Markit Economics PMI for the US was at 55, up slightly from the previous month’s 54.5, but again, really no change. Nor was the much-better known (and better-followed) national ISM PMI survey, which “declined” from 57.3 to 57.0. Such changes are virtually meaningless, and the latter number could represent either higher or lower absolute levels of production. I suspect the former, given that 15 of the 18 industrial sectors reporting said conditions were better.

Jobless claims were little changed, and the last batch of December weekly sales data implied no change from November as a whole. The rate of growth in construction spending remained the same, which was rather encouraging, given that October reported a gain of 0.9% and November was at 1.0%. However, construction data is subject to outsized revisions. The year-to-date comparison is currently 5% higher, while the year-on-year figure is 5.9%.

Car sales changed to the downside, with the annualized rate coming up short of expectations and the major dealers falling short as well. One month of data isn’t a trend, but the manufacturers were aggressive with incentives in October and November, and subprime auto loan activity has been even more aggressive. It was a decent month for December, but analysts will be looking at the next batch of monthly results closely for signs of the trend flattening out.

Next week brings the big kahuna on Friday, the December jobs report. The weekly claims data suggest no change in trend, so my guesstimate is that the headline number will remain in the 180K-220K band, though as usual I won’t make any bets on it. The ADP payroll number two days earlier will give us the usual tease as to the final outcome.

The week gets off to a bang with November factory orders opposite the ISM services survey at 10 AM, but before the open we’ll get a batch of European PMI data. There’s been a lot of commotion lately over numbers there barely above 50 (the neutral line), but while it’s true that one has to cross 50 on the way to expansion, a long string of 50-51 readings could have characterized the black plague as well.

Things will slow on Tuesday with the international trade report (the market tends to overlook the importance of the import-export trends), and then Wednesday could be a rattler of a day, what with ADP in the morning and the release of the Fed minutes in the afternoon. After Friday’s anxiety, analysts and traders will be carving up the entrails of the minutes with their sharpest knives for clues to the will of the gods.

Ten years ago, the monthly same-store sales reports were eagerly awaited; these days the sample size is so small that it gets little attention anymore, apart from the odd heavyweight here and there. After this Friday’s jobs report, wholesale trade data will come out for November, and while it will no doubt be obscured by the glare of the former, I and my fellow geeks will be looking at it closely.

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