Spartan Times


“One more such victory will undo me!” – Pyrrhus, victorious Greek general at the Battle of
Asculum

by M. Kevin Flynn, CFA

As we go to press on Sunday, the Greek parliament has voted in acceptance of another ruinous austerity program amidst globally televised images of riots in the Greek capital. We wish we knew what was going to happen as much as anybody else does. Our base scenario is the same as the one in the markets – some sort of ugly is patched together and victory is declared. But will the Greek people accept the deal, or rebel? And if the latter, when? We wish we knew the answer.

The deal isn’t anything but another postponement of the day of reckoning. Some feel it will start to come undone as early as next month, while luminary George Soros thinks it could buy another six months of quiet – at least so far as Greece is concerned. He doesn’t believe it will ultimately solve anything either.

Given the unrest in Greece, one has to wonder if Germany and the EU will still buy into the deal. There’s a chance of the Germans balking yet again, but they’ll probably go along. A continued rise in markets, though, might temp them into an indiscretion.

Back here in the U.S., although the markets wobbled on Friday, leading to the first weekly decline of the year, U.S. futures are rallying in anticipation of another victory parade celebrating the decision to pretend-and-extend again in Europe. If the vote pulls through, we reckon the rally will resume for another week.

To begin with, the calendar is heavy next week with industrial data. Given the warm weather and the normal first-quarter order patterns, unless something is very wrong the Federal Reserve regional surveys should look quite positive. We’re a little more skeptical on the outlook for January retail sales and industrial production (see below), but seasonal adjustments may rescue them as well, and manufacturing (though not utility output) should have gotten a boost from the weather.

Another supporting factor is that Friday is the expiration date for the current monthly options, and call activity has been very heavy. Look for call buyers to try to support prices. It should be pointed out also that Friday is the one-year anniversary of the day that the 2010-2011 fall-to-February rally broke. That may not cause traders to flee the following Tuesday (markets are closed on Monday the 20th), but they’ll certainly be aware of it, and another week higher will have left the markets dangerously ripe for correction anyway.

Against that, there are a couple of non-negligible dangers to keep in mind in this trader’s market. One is that the ill will between the Greek populace and German elites erupts into something serious enough to call the deal into question. The markets wouldn’t like that, regardless of how superficial the agreement might be.

Another is the effect on the CDS (credit default swaps) market. Will the Greek haircut trigger a payout, and if so, how large will it be? We think that they’ll try to sweep it under the rug again, but it’s just a guess. The process could develop in unexpected ways.

Then there are the other PIIGS countries, in particular Portugal. One theory gaining currency last week was that the draconian tactics by the Germans and EU officials were partly an effort to discourage other heavily indebted countries – i.e., Portugal – from seeking some debt relief of their own. Plausible, even likely, but one can’t help but wonder about the wrinkle that Portugal still can’t afford its debt in any case.

S&P announced the downgrade of 34 Italian banks last week (out of 37), while the European Banking Authority (EBA) decided to postpone another round of stress tests until next year. It seems that many European banks are planning to meet capital requirements by making outsized profits between now and then. Perhaps the central thrust of EU actions is to buy the banks more time to prepare for the inevitable, but markets have a way of operating in ways unsanctioned by financial ministries.

Keep an eye on China, too. The country has put out some surprisingly weak monthly data of late that is all being laid at the door of their New Year holiday, which began January 23rd. We’re not sufficiently experienced with Chinese data to draw our own conclusions, but Nomura Securities, for one, wouldn’t buy the seven percent drop in electricity usage as being all due to New Year’s. Time will tell, but we found it curious that China started talking about the need to help Europe with its debt problems as reports circulated about the first drop in Chinese exports in two years.

The Economic Beat

The quiet week for domestic data brought little in the way of contrast. A couple of numbers were a bit worse than expected, but the shortfall in the University of Michigan consumer sentiment reading, for example, was trivial. The December trade deficit was a bit larger than expected, which will put downward pressure on the Q4 GDP revision, but December inventories were slightly higher, providing a partial offset.

The more interesting aspect of the wholesale inventory report was that on an unadjusted basis, wholesale sales fell in the fourth quarter. The sales-inventory ratio is about the same as a year ago, so nothing alarming is going on, but the decline offers two clues to the larger picture. One is that it offers a partial explanation for the subdued nature of S&P 500 earnings for the fourth quarter.

The other pertains to the calendar rhythm of business. Fourth-quarter declines aren’t so unusual, given the nature of said calendar, and we wouldn’t use them as an economic indicator except in extreme cases. But they do tend to be followed by larger-than-average increases in subsequent first-quarter sales, which isn’t hard to understand. Excluding recessions, first-quarter sales always have healthy increases – it’s the start of another year, with new budgets. That they tend to ramp up more than average when the fourth-quarter was a little lower than average shouldn’t require much explanation.

A little more context is necessary, though. The largest increases in actual (that is, unadjusted) wholesale first-quarter sales come when they are following a two-quarter period of weakness. In other words, the usual calendar effect gets an additional boost from restocking. If the restocking has already started in the fourth quarter, as it did in 2010, then the first quarter tends to be really good, as was the case a year ago. Again, it isn’t hard to understand – good fourth quarters can mean a looser grip on budgets.

Since the last three quarters of 2011 showed a decline in the (unadjusted) sales rate, we should therefore expect a better-than-average increase in first quarter sales: calendar-plus-restock. That should be pleasant enough, but the caveat is that it’s just business rhythm. In fact, really strong increases in wholesale sales are, not surprisingly, usually followed by two or three quarters of weakish sales. Restock, relax, restock.

The restocking rhythm isn’t much of a clue at all to the long-term trend of the economy, though, not anymore. Modern lean methods of production and management mean that an inventory expansion that might be counted on to last a year or two thirty years ago now last a quarter or two. That, of course, may partly explain why the early-year effect in equity prices has become so pronounced in recent years.

Next week will bring the January retail sales report, which is expected to show a healthy month-on-month increase. Weekly sales rates declined considerably throughout the month, though, so we confess to being a bit puzzled. Perhaps it’s another effect of the weather.

We will also see three influential reports on manufacturing: the New York Fed survey on Tuesday, the Philadelphia Fed’s edition on Thursday, and the central bank’s report on Industrial Production in between on Wednesday. All are expected to show healthy increases, particularly industrial production (which may tie back to our comments about wholesale sales, above).

The homebuilder index (Wednesday) is expected to keep improving, and should offer a clue to housing starts on Thursday. The Producer Price Index (PPI) and Consumer Price Index (CPI) come out Thursday and Friday, but the markets aren’t thinking much about inflation these days. Other reports include the FOMC minutes on Tuesday and the Leading Indicators on Friday.

Of course, what happens in Europe may overshadow everything. We’ve no predictions to make there, but do have some observations to offer: the late-quarter weakness in European data is being given a free pass, thanks to improving survey data, with expectations of a first-quarter rebound firmly in place. The rebound could well happen, but would need a pretty snappy New Year holiday rebound in China as well. And it will take a lot more than votes in the Greek parliament to solve the debt problems of Europe.

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