“I’m back in the USSR.” – Lennon-McCartney
It was another odd time last week, and while the market was up, one is tempted to say that if you string enough of these odd periods together, you have the makings of a sea change.
Despite the usual blather, most of the price action was taking its cue neither from the Ukraine nor the various economic releases. It was really about the FOMC (Federal Reserve monetary policy) meeting on Wednesday and the quadruple witching (futures and options expiration) on Friday. The latter was textbook – a big bid before the open to position the futures, followed by selling all afternoon to wipe out the options. The 125,000 SPY 188 call options that were worth $0.45 at one point in the morning (a value of about $5.5 million) finished the day at a nice round zero (there were far more at higher strikes).
Besides the ridiculous IPO froth (signaling retail frenzy) and the gathering rotation out of high-beta tech and biotech stocks into low-beta names (signaling institutional fear), some of the things to be concerned about include the disproportionately higher selling volume and yes, the Ukraine. The markets tend to ignore the latter type of event after a first initial fright, but for me it’s a little reminiscent of the Three Mile Island meltdown, with its sequence of headlines that went “Problem?” / “No Problem” / “Really, Really No Problem” and ended with, “Thousands Flee.” I’m still worried that we’ve only seen the beginning of this stare-down.
I’ll get the Fed meeting out of the way first: It was no big deal. The truth is that the Zero Interest Rate Policy (ZIRP) really isn’t doing any good anymore, nor is quantitative easing, except perhaps to enhance the psyche of leveraged traders in the financial markets. From an economic point of view, there is all the liquidity in the world and whatever incremental benefit the increase in stock market prices may have had on employment and corporate confidence faded long ago. Were the Fed to declare five more years of ZIRP, the main impact right now would be corporations issuing more five-year bonds at 1% to buy back stock and increase dividends.
Chairperson Yellen did hint that the Fed might start raising rates sometime next year, causing no real impact beyond a lot of hot air. Certainly if the Fed were to raise the federal funds rate to 1% tomorrow, it would roil financial markets and crush a lot of leveraged positions, make no mistake. It’s also clear from recent remarks by Fed governors that concern about the latter and speculative excess is gaining ground. But raising rates to the 1% level by the end of 2015 or mid-2016 will have a negligible effect in most places. The markets always adapt to gradual increases, and are more likely to rally on them on such theories as “only 25 basis points,” or “maybe they’re done for this year” than sell off. Rising rates won’t be so great for long-term bondholders, but it won’t be carnage either, not after the initial volatility and wailing dissipates.
We are a long, long way from Fed interest rate increases causing any sort of recessionary problem for the economy. Don’t mistake my meaning – that’s very different from saying that the bull market is guaranteed until then. Equity valuations are very extended (do not heed for even a moment the perennial idiocy about how some promised pot-of-gold earnings will make it all worthwhile) and the market is very, very overbought on a long-term basis.
But those two factors alone are only a weak force, so it isn’t as if a bear market must immediately follow upon their heels. They are persistent ones, however, and they do eliminate our safety cushion, such that when something does precipitate a downward turn, the decline is apt to be uncomfortably large. The longer it gets put off, the bigger the final due bill.
Rising rates can eventually cause credit expansion to cease and finally contract, precipitating a recession, true. But it’s also true that business cycles don’t last forever, and a rate increase can be one of several events that simply act as a catalyst for ending speculative excess. Borrowing at 1% instead of 0.25% should make virtually no difference to funding a project that expects a 15% return – unless you realize that the prices you’re paying to invest are so elevated that the 15% return requires perfection. People do fool themselves into believing in perfection, especially if it means a big paycheck this week or a big bonus this year – but it never lasts. The reality is that you can’t get rich by buying high and selling low – but the people who sell you high can.
The Economic Beat
The persistent theme of aggrandizing beats of persistently understated estimates – while ignoring underlying weakness – continued through last week. Exhibit A is housing starts, which were greeted with billing and cooing because permits beat estimates and January starts were revised upwards.
The January revision was the result of shuffling some sales out of December, so there was no extra strength there. The underlying weakness, as I pointed out in my Seeking Alpha column, is that starts are running 6.4% lower year-to-date (YTD) than a year ago, when they should be running 10% higher (my estimate) or even 15%-20% higher (general consensus). That’s a little too much to blame on the weather. Permits were up a over 16% in 2013, but slowed to about 10% the last six months of the year; through the first two months, they are up 4.7%. If we adjust for weather by doubling the last two months, that’s still under 10%. Permits also run ahead of starts, putting even my own modest estimate for starts at risk, and perhaps explaining why the homebuilder sentiment index is still at 47 (50 is neutral). .
Two things to keep in mind: First, starts and permits should indeed rebound when warm weather finally arrives – but when it does, we may still be looking at a 10% growth rate at best through the first six months. Credit has eased somewhat in commercial and industrial lending, but remains very tight in residential. I guess the loan officers haven’t forgotten the bust yet – and their bosses haven’t had a chance to forget all the record fines. Existing home sales are down over 7% year-on-year, with the percentage of all-cash buyers rising to a very high 35%.
Second, a lower-than-expected starts rate isn’t going to be bad for the bottom line of the homebuilders. They’re more interested in margin and pricing discipline right now than some sort of market share war, and with the general push towards building at the higher end of the price scale, should still show very good profit growth.
A similar dynamic obtained on the manufacturing side. I hear fund managers talk ebulliently every single day about how manufacturing is taking off. When surveys modestly beat modest estimates, it seems to become true to people, even though it isn’t actually happening.
The New York Fed’s manufacturing survey was a bit lower than expected: 5.6 vs. 6.5 consensus. Frankly I consider this to be a tie, but more important is the grand scheme:
Does this look like acceleration?
On Thursday the Philadelphia Fed survey beat expectations with a result of 9 versus a dubiously low estimate of 3.0, a stunning development still being talked about on CNBC the next day.
I don’t see trend changes happening here either. I would say that since peaks in six-month forecasts are (obviously) great contrarian indicators, current activity hasn’t quite completed its trip to the downside yet.
Then there was industrial production, a bit hit with a 0.6% increase in February (consensus 0.3%) and manufacturing up 0.8%. But it was only a recovery from January – year-on-year, manufacturing is up a lousy 1.5%. The year-on-year rate for overall production has been level for the last four months, and if we took away utility production (+8.1%), it would look worse. That’s not to say industrial production is signaling recession – it isn’t. It’s only signaling the same anemic growth we’ve been enduring the last few years.
Initial jobless claims were 4.2% lower in the week ending March 14, the week that the Labor Department will use for the March jobs report, than they were in the year-ago week. However, claims are running 4.5% lower YTD. This suggests that the March headline jobs number might be in for a smaller adjustment factor.
Over in retail, most chains continue to report disappointing sales, while the weekly chain-store reports remain soft. With Easter coming so much later this year, the year-on-year totals are going to look even worse. It doesn’t look like we’ll get a decent monthly result until mid-May, when April sales are released.
There isn’t much else to say about the Federal Reserve’s statement. It was a typical episode for the stock market – rallying into the report, then selling off afterwards. Traders usually talk themselves into overly dovish hopes, sell the news, and then start over afterwards. The Fed was universally expected to cut another $10 billion out of its monthly purchases in April, and duly announced that plan. That still leaves a lot of lolly on the table – $55 billion in April, to be precise. But should the taper continue on its path of a fall exit by the Fed, then by mid- to late summer the Fed’s smaller presence in the marketplace should lead to some upward creep in rates – including mortgage rates. Think about it.
There were a few noteworthy items besides new chair Janet Yellen talking about eventually raising short rates, which wasn’t new, just not the eternal ZIRP remark that markets have become accustomed to hearing. The comic part was all the hot air afterwards about how the Fed must recalibrate its communications policy so as (in effect) not to surprise any trader anytime, anywhere – the unspoken premise being that the Fed’s real job is to support trading profits.
Ms. Yellen also allowed that the Fed might have been too optimistic in January. No kidding. The Fed’s long-term outlook is perpetually too optimistic, and as usual the Fed staff was busy paring back its forecasts again. It’s still predicting 5.5% unemployment in 2016 – or the longest post-war peacetime expansion ever. I realize that there are institutional constraints on what the bank can say, there always have been always will be, but even so I just have to say – when pigs fly.
Next week finishes up housing with pricing reports on Tuesday (Case-Shiller, federal agency) followed by new home sales. Thursday brings up the rear with pending home sales. The manufacturing side is represented with many regional Fed reports, including Richmond (Tuesday), Kansas City (Thursday), and the Chicago branch reporting its national activity index on Monday. There’s also another flash PMI from Markit Economics.
The report of the week should either be durable goods on Wednesday or the next GDP revision on Thursday, and I’ll be curious to see the latest personal income and spending data on Friday, especially the latest on disposable real income. A couple of meaningless consumer sentiment surveys round out the US week.