Crosswinds


“There are times to make money. This is a time to not lose money.” – David Tepper, hedge fund manager

Taking my own advice from last week, I was trimming equity positions Monday and Tuesday as prices rose on the strength of little more than some leftover momentum from the prior week, momentum that took a hit with an underweight April retail sales report (see below). After finally poking its head above 1900 on Tuesday, the S&P was unable to hold that level into the close and subsequently lost ground to finish the week with its third try at the level rebuffed.

Yet even as the talking heads sagely observed the importance of the new high, equities remain vulnerable to further weakness. Prices are supposed to break through important levels on the third try, not fail. If it hadn’t been for an options-related rally Friday afternoon, the averages would have been down a percent or more on the week. Next week is likely to see a continuation of pressure, with the combination of the failed chart attempt, light economic calendar and weakened momentum likely to prove a drag. And I haven’t even mentioned the Ukraine yet.

Things could turn otherwise in the Ukraine, of course, and next week’s release of the latest Fed meeting minutes could push prices either way. The main problem remains, though: The prevailing winds of earnings growth, economic growth and Fed accommodation are barely blowing these days. With valuations at such high levels, that’s a problem that leaves the market vulnerable to lesser winds like the calendar and whatever worries might get blown in from overseas.

It’s more likely than usual that we’ll get continued pullback over the next few weeks, but it’s not certain. The market is vulnerable to some correction, and will get no protection from the calendar, but more catalysts besides valuation and weak earnings are needed to tug prices down more than a few percent. While anxiety-related selling could easily get some traction over the next week in the absence of a positive surprise from the Fed minutes or housing data, something bigger is still needed to cause real damage.

One such catalyst might come from the Russell 2000 index of small-cap stocks. It bounced off a support level on Thursday for the third time in six months, but many traders are professionally doubtful of triple-bottoms. The Russell nearly always takes its cue from the S&P 500, rather than the other way around, but in a time of heightened anxiety and little to no help from the big three of Fed policy, earnings growth and the economy, it’s possible that a breakdown past the 1080 level on the junior index could cause some trouble and get trading programs to cut equity exposure.

Another fright could come from the bond market. The ten-year Treasury bond also bounced off a six-month low, a yield of 2.47% in this case, a number that had any number of equity and bond pundits, traders and managers weighing in on what it all might mean.

Jim Bianco’s observation that the entire trading world was short the ten-year coming into 2014 was probably the most instructive remark of the week. That posture came in tandem with unanimous year-end Street surveys of economists that real GDP growth would surpass 3% this year. With nobody left to sell Treasuries, it’s understandable that a short squeeze might develop. Treasury issuance has slowed as the deficit has shrunk, so that the Fed is still buying the lion’s share of bonds every month in spite of its taper program. Pension funds and foreign central banks are holders. And the economy is showing no sign of 3% growth this year – the major investment banks have already started backing off that number for 2014 and are (as ever) pushing it back until 2015. It’s turning into “wait ‘til next year” for the economy for the fifth year in a row now.

Should the ten-year break through the 2.47% level, it could keep falling to around 2.25% before finding more sellers (falling yields equal rising prices). Such a breakdown could engineer equity selling by black-box trading programs. One can argue all day about whether or not bond prices are pricing in a significant economic slowdown or if the issue is really a supply-demand imbalance, but one point that seems clear is that they are not pricing in any obvious pickup in growth. Whether active traders might be buying the ten-year for safe-haven purposes, to cover short positions, or because algorithms are triggered to sell equities and buy bonds on technical grounds, it all ends in pressure on equity prices.

Right now it’s a long way until the next Fed statement in mid-June (the 18th). The market will remain vulnerable to selling air-pockets until that meeting unless there is a significant change in the winds in the meantime, be it the Fed’s posture, economic data or both.

On a final note, Monday after next (the 26th) is the last Monday in May, making it the day that the U.S. observes its Memorial Day holiday. That means this coming Friday will be marked by early closes in the bond markets and early departures by traders of every asset class as they hasten to get away for the long weekend.

The Economic Beat

The week led off with its biggest report, retail sales for April. I wrote a week ago that the market would need a big number to keep moving higher, and it didn’t get one – the result was plus only 0.1% (seasonally adjusted). While the year-on-year increase of 4.8% reflected Easter coming in April instead of May, it was not impressive compared to April 2013′s 4.4% year-on-year increase, not after factoring in the late Easter and the weather. First-quarter retail sales rose by only 2.2% year-on-year after revisions, and the rate of 12-month sales growth remained under 4%.

How to explain this lack of consumption? Obviously the weather played a role in the quarter, with elevated heating costs in much of the country handing off smoothly to rapidly rising gasoline prices as the temperatures finally turned. But the cold didn’t affect the West coast, nor did it affect the eastern part of the Southeast. The winter of 1983-84 was worse than 2013-2013, but didn’t receive near as much blame for slowing the economy. One reason is that an economic recovery was getting underway 30 years ago, while we are now nearing the end of what has been a very modest recovery cycle. Let’s be clear – we are living in diminished times.

Many economists dialed up an increase for consumption in 2014 based upon annual raises not being eaten up by an increase in social security taxes, as happened in 2013. But wage growth continues to be weak, and over a million people stopped receiving long-term unemployment benefits in January. The group seems to have largely dropped out of the labor force, if you believe that the similarity between that number and the not-in-labor-force increase this year is not coincidence. It’s a reality that is being largely overlooked, either for partisan reasons – business newsreaders generally subscribe to the pre-Dickens theory that unemployment benefits make people too lazy to work, and so naturally want to avoid contrary evidence – or out of ignorance and/or excess optimism.

In any case, disposable personal income growth is running at 2.2% through the end of the first quarter, so it may be that consumption is exactly where it should be. Anemic. At least retailers are adjusting, with their inventory levels essentially unchanged from the month before.

Industrial production took a header in April, but was belied by May regional surveys showing improvement. A decline of (0.6%) left year-on-year production at 3.2%, up from 3.1% a year ago, while manufacturing is at 2.9%. Capacity utilization eased back to 78.6. Both the New York and Philadelphia surveys showed strength, though only New York had hinted at last month’s decline with its April reading of 1.29, while Philadelphia had reported a reasonable 16.6. It’s a good example of why swings in diffusion surveys need to be treated with caution, as their indicative qualities work best when showing sustained readings over time. In the event, New York rose sharply to 19 in May, leading Econoday to effuse (yet again) over a possible breakout, while Philadelphia was about the same as the month before at 15.4.

The housing market index is usually a good clue to the starts data that follows in the next day or two, so it was a bit of a surprise when sentiment first declined to 45 (it was supposed to go up), and then starts data followed with an estimate beat of 1.072mm April starts (seasonally adjusted, annualized) versus consensus for about 980K. But the strength was in multi-family construction: year-to-date permits for single-family homes are down slightly from 2013, while single-family starts are up less than 2% year-to-date. Sales of new homes in April will be released next Friday.

Inflation is picking up, possibly. Certainly food and energy costs have been up, leading to a 2% year-on-year increase in the consumer (CPI) index, 1.8% excluding food and energy, while producer prices (PPI) had a sharp aggregate increase in May (0.6%) that produced a 2.1% year-year increase. Import-export prices, though, remain weak, with import prices still down year-on-year (-0.3%) and export prices virtually unchanged.

China released data showing year-on-year industrial production decreased to plus 8.7%, while retail sales growth slowed to +11.9%. Personally I have long found these levels a bit suspect, as the country churns out double-digit growth in retail sales month after month while claiming inflation is about 2%. Nor do I trust its GDP data. However, I do believe that the directional indication is significant and that both retail sales and industrial production growth rates have indeed declined. So of course Chinese stocks rose on the hopes of further stimulus, despite the government’s indications that it does not want to add more credit to an overleveraged economy.

Next week is a slow one with little data in the first half and housing data the main data in the back half, which could spell further trouble for stocks entering the week with negative momentum. The highlight, though, will be the release of the latest FOMC (Fed policy committee) minutes on Wednesday afternoon. After that we’ll get April existing home sales on Thursday and new home sales on Friday. Leading indicators and the “flash” manufacturing PMI are also out on Thursday, but they are usually not market-moving data. Bond markets will close early Friday and equity traders will start leaving at lunchtime in anticipation of the long weekend.

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