February Follies


“It wasn’t raining when Noah built the ark.” – Warren Buffett

by M. Kevin Flynn, CFA

Don’t fall for it. That’s really the most important thing we have to tell you this week. By “it,” we mean the patter being currently spun by headlines and talking heads, not to mention any part of the business media that needs a rising market to generate business. The stock market may be caught up in another momentum trade – it’s all it seems to know how to do anymore – and the roar of the stampede is exerting its animal pull.

But the economy isn’t doing any better than it was a year ago this time, at least not on a relative basis, and neither are the world, corporate profits, or true belief in this move. For every perma-bull that reporters were able to trot out last week, there are a lot more managers sitting around with growing apprehension about how big of an air pocket we’re going to hit. They’re just not going to go on the public record – and especially not on television- to talk about it. Not good for business, you know.

We are rolling our eyes at the current situation, but not in surprise. We’ve said for weeks now (perhaps tediously) that the market is getting higher and higher up on a ladder that isn’t of the soundest construction. The risk level is dangerously high, particularly for those who can’t sit in front of a screen all day and time their jump as the ladder collapses (even the trading pros can’t really do that – they just hope to make more on the way up than lose on the way down).

At the same time, the market is the market and we’ve freely acknowledged that it will try to keep climbing until it runs out of steps, or a good excuse to cut and run shows up. Stocks were already dangerously overbought a couple of weeks ago, but the nature of the little mini-correction that followed was a skit we’d seen before, so we reckoned that momentum would head immediately back to the danger zone. That it did, and there’s probably still another week left to squeeze out of this move.

We say that because the U.S. economic calendar is largely empty next week. There are some interesting tidbits coming from Europe and China, but we reckon that the seasonal factors are overstating European data about as well as ours, and official Chinese data is not something to bet the ranch on. Form for the empty week that comes every month is for the market to follow the previous week’s direction, and while we haven’t done any statistical studies, we’d reckon that holds true about 90% of the time.

The overbought heights do present some hazards. One should expect extra sensitivity to any letdowns from abroad, such as a dud industrial report from Germany or a scary inflation report from China. But neither appears as being odds-on to us just yet.

Then there is Greece and the eurozone debt problem. Just about everybody is aware of it and you may be as sick of reading about it as you are about the Super Bowl, but before your eyes glaze over and you go back to browsing YouTube videos, consider that the terrain underneath the situation has shifted in a dangerous way. The Dow Jones index has now reached its highest level since May 2008, and putting aside the thought that that month may not be the best of omens, there are deeper parallels worth a few minutes of reflection.

In that briefly merry May, the markets were putting the finishing touches on a rally that lifted prices into positive territory for the first time that year, leaving the S&P 500 a bit more than six percent higher than now. It was largely a seasonal effect: markets then dipped in the summer, only to be followed by another seasonal rally that ran from the end of the second quarter (our friend the calendar) into the middle of August. Worries about Fannie and Freddie, as well as AIG, conspired to give prices a wobble, but they soon recovered amongst confidence that the government wouldn’t do anything really stupid.

The U.S. was already in a recession by then, but one that most commentators refused to acknowledge. Though the housing bubble had burst and homebuilding executives had said that there was no hope in sight, traders kept trying to jump the gun on a homebuilder rally. The credit crunch was obstinately denied by most Street pundits, even though Bear Stearns had collapsed in March and Lehman Brothers was under severe pressure. It seemed that nearly every week we would learn of another exotic acronym of Frankensteinian financial innovation that the big banks had created, only to desperately wish it belonged to someone else.

In brief, though warning signs abounded, the markets held on. Prices are fundamentally set by humans (before being dutifully distorted by trading robots) and we tend to err on the side of optimism. More germane to the current situation, the markets had a strong case of crisis fatigue. So did the key policymakers – Treasury Secretary Paulson, Fed barons Bernanke and Geithner. The heads of the biggest banks were all worried about what might happen, but most refused to confide in any but a very select few – quite sensible, given the nature of their balance sheets and reliance on short-term funding.

There was no political will within the Bush administration to orchestrate any intervention for Lehman Brothers, not after the months of criticism it endured about Bear Stearns. Less well known is that there was little to no sympathy for Lehman either from the asset management community, an influential (and mostly conservative) community. Neither group likes to talk about it much, but the buyside has always looked down upon the sell-side, regarding it as riddled with hucksters and chiselers, intellectually and/or morally unqualified to work the investment management side of the street. To this day, many firmly believe that Bear should have been set on fire and left to burn.

There is no political will within Germany either for spending money on groups it considers to be cultural inferiors, gamblers beyond their means. Europe has another kind of divide, too: government elites have a deep disdain for the markets, regarding them as dismissively as our buy-side does the sell-side.

After the lengthy rallies that both U.S. and European markets have put on, the result is a dangerous mix that lends itself perilously close to the same kind of thinking that brought on the crash of 2008. Germany feels none of the pressure to compromise it would have if markets were plummeting; on the contrary, Merkel et al. have been emboldened by recent headlines to harden their positions. Hank Paulson decided upon a government takeover of Fannie and Freddie as a standin for guaranteeing their debt; now Germany wants to do the same with Greece.

In other words, time, fatigue, and a seemingly benign market are again burying the voices of pragmatic realism in favor of cant – there shall be no salvation for the wicked – and hubris: who needs these weaklings anyway?

Both the Greeks and the Germans are running out of patience. Going into Sunday night – that has a familiar ring to it – talks are on “a razor’s edge”, but we are all mostly certain that some sort of reason will prevail. Will it? We’ve no doubt that all involved are suffering from fatigue, both physical and mental, and would wager quite a lot of money (probably with no takers) that both sides are desperately longing to tell the other to get stuffed. Everyone thought a Lehman deal would get done too, us included.

The irony is that if a deal is done, it will elicit one last roar of approval from the equity markets. The 1370 level (the 2011 intra-day high) will immediately come into play as the next target on the S&P 500. But the European recession won’t go away, and the Greek one will only get worse. Portugal, Spain, Ireland – they’re right behind, with more bad paper than anyone wants to admit, just like 2008′s miscreants. And don’t even get us started on China.

But why worry? The May correction is still months away, and in a trader’s market, that is light-years distant.

The Economic Beat

In case you’re wondering why we haven’t leapt on the raging-economy bandwagon, we have lots of data for you. As regular readers know, we have been steadily persistent in our point that both weather and seasonal factors are inflating data adjustments. One would expect the exceptionally mild winter to give a boost to the economic data anyway – fewer missed days, easier to shop, and so on – but the impact this time is positively hormonal.

The ghost of the crash of 2008 continues to hover over quarters one and four. It decimated the fourth quarter of 2008 and the first quarter of 2009, and so we get seasonal adjustments that compensate by overstating what goes on in those quarters and understating what goes on in the others.

Here’s an easy case in point: weekly claims. The press triumphantly reported everywhere about how weekly claims fell “more than expected” to a 367,000 annual rate. Besides the fact that the drop is partly fictitious – it gets exaggerated every week by comparing an upward revision to an always-light current estimate, annoying us every week – it isn’t what it appears to be. If you applied the 2011 seasonal adjustment factor to the actual number of claims, the result would have been 378,000. Apply the 2010 factor, and you get 384,000. Use 2009, and it comes out to 392,000, which upon revision, would come out to something between 395,000 and 400,000. Still sure about that?

And as far as the employment report goes, well, we don’t quite believe it. Not as a harbinger of robust acceleration in the U.S. economy, which is what’s being peddled on the public way, and not even as an accurate assessment. “Fellow economist” Dave Rosenberg thought he also smelled something funny (Mr. Rosenberg has a Ph.D. in Economics and we do not, but we are still econ types at heart). We can tell you what we didn’t like; you’ll have to subscribe to Dave’s report to get his take.

Let’s start with the 19,000 department store hires. It reminded us of a remark about ADP’s estimate of the finance sector adding 9,000 jobs: in which country? The weather is playing tricks on the Labor department here and elsewhere, because department store sales were generally below plan and retail sales fell off sharply in January (though discounters were above plan).

Same-store sales had very easy comparisons this month. In January 2011, I returned from a trip to find a completely snowbound house, fully icebound doors included. This year there was barely a dusting the entire month. Bad for winter apparel and related margins yes, but good for store traffic. January is generally the lightest shopping month of the year – yet department stores added 19,000 workers after a disappointing December. I don’t think so.

Because we think that the seasonal effect is so pronounced this year, we’ll highlight some year-on-year comparisons for you. According to the BLS, the participation rate (workers and would-be workers) was 64.2% a year ago, and 63.7% in January 2012, or a drop of 0.5%. The employment-to-population ratio was virtually unchanged, from 58.4 to 58.5 (which is good, at least we’re not going backwards). There was a good jump in goods-producing jobs (an increase of 45k year-on-year), but nearly all of it (42k) came from construction. Warm weather again.

Manufacturing was actually 2k less than a year ago, call it a tie. Health care added 30,000 and leisure & hospitality – mostly restaurants – kicked in another 44,000. Temp hiring did pick up from December, which is good, but once again we’re a little hesitant. A year ago, the heavy weather led to a sudden drop of 11k in temp hiring, later revised to an adjusted increase of 16k. The actual drop in temp workers was about 234k in January 2012 and 244k in January 2011, such that the apparent 10k improvement swung the initial adjusted estimate by about 31,500. We’re not saying it’s wrong, but we’re not taking it to the bank either.

And for what it’s worth – there was a big surge in the layoffs report, and it went virtually unnoticed (though big layoff announcements have been widespread this month). The ADP estimate was smaller than its December estimate, and the Monster employment index fell by five percent. We can argue about them, but none of these numbers corroborate the BLS seasonally adjusted estimates.

The ISM manufacturing index was 54.1 for January 2012, but 59.9 in January 2011. New orders, which should increase with the new year, went from 63.8 a year ago to 57.6 this year, and the increase over December shrank from 4.8 last year to 2.8. Nine industries reported growth versus seven reporting contraction last month; that is just barely above the neutral line in our opinion.

The non-manufacturing (services) ISM survey reported an overall index reading of 56.8 versus 58.3 a year ago; business activity checked in at 59.5, also down from last year’s 62.4. At least the services index really did beat consensus, unlike the manufacturing index, which came in a bit short (but was heard to be reported as better-than-expected on both television and radio by the end of the day). Here’s a good quote from the survey to sum up what we think is really going on: “New fiscal year, new budgets – expecting to show an increase in the first quarter.”

The economy isn’t contracting, and we would love to see job acceleration. But we think that the real gains are smaller than advertised and reality is much closer to the most recent view put forth by Mr. Bernanke and the Fed, than the one being put forth by the media and implied by the current momentum rally. The ratio of companies beating earnings estimates this season – estimates that were cut in half in the fourth quarter – was running at just under 55% through the end of last week. That is unusually low. Normally, 65-67% is something you can absolutely count on. Revenue misses are even more common, in our own estimation.

No, we think that this is another case of misleading data and a market that will pay the price again for buying into it. And cross your fingers that the latest Eurodebt snafu ends with another decision to keep Greece on life support, because it’s the only ending currently priced in. The irony is that Europe is going to have another leg down, regardless of whose view prevails.

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