The Pause Before


“O, how shall summer’s honey breath hold out?” – William Shakespeare (Sonnet 65)

When the stock market came into last week overbought technically on every time horizon, it was little trouble to find an excuse to take some trading profits in the beginning of the week. Wednesday saw the semi-automatic Fed minutes rally (the market doesn’t need to find some unexpected goody, just no unexpected slug in the leaves). Thursday had the markets start off rattled by strife in Israel, Portuguese banking problems and weak European economic data, but the ease with which traders were able to negotiate a bounce off the S&P’s 20-day exponential moving average (EMA) settled matters and prices cruised home on autopilot the rest of the way. It was business as usual.

Perhaps the most notable event of the week (outside of the Middle East) was the added conviction the release of the FOMC minutes lent to traders that the bank is intent on backstopping the market. The many references to maintaining stability in financial markets came a week after chair Janet Yellen’s speech incorporating the same concerns. That air of trader certainty has not gone away, and will do battle with the aforementioned off-shore concerns and on-shore earnings season as the latter gets busy in the coming days.

Yet there is some uncertainty as well. I would expect at least an attempt to rally stocks as we get into the heart of earnings season, simply because rallying into any earnings season is the percentage bet. Whether or not there is much actual growth in earnings tends not to matter until the end, as the initial attention will focus on those companies that do beat estimates and then begin to shift towards the inevitable two-thirds rate of companies beating them. With Dow 17,000 nearby, not to mention 2000 on the S&P and recent all-time highs for both, it wouldn’t be like our stock market to not at least have a go at the round numbers.

That said, stocks are still in an overbought posture on most horizons. Despite the usual blatantly self-serving efforts of recent days to talk down earnings as the season approaches (quietly buying at the same time to take advantage of subsequent “surprises”), much of the good news may already be priced in. FactSet’s latest consensus estimate for the quarter is for 4.6% earnings growth, implying real expectations of about 6%-7%. The latter may prove a difficult target. The retail sector is clearly struggling, and financial sector earnings are going to weigh on the total: Wells Fargo (WFC), widely expected to be the best of the big four, reported 3% year-on-year growth Friday morning.

So the question will be, if earnings season is indeed modest and the market starts to sell off in late July – a common occurrence – will the Fed feel obliged to make soothing remarks and promises at its end-of-month meeting? I suspect traders will be counting on just that, so much so that unless the Fed specifically says something to the contrary, whatever they do say could be interpreted in the most hopeful manner. Not that the stock market ever does such things, of course, but the first quarter’s weak earnings results (and guidance) were indeed rescued by a very dovish Yellen in the first week of May.

Going by recent remarks, the current Fed would appear to still be traumatized by the events of May 2013, when Bernanke reacted to stock prices behaving in lunatic fashion by reminding all and sundry that unlike diamonds, QE was not forever. The seemingly out-of-the blue statement that QE might end in September 2013 rattled markets around the globe, particularly overly complacent fixed-income markets, and had the central bankers of many smaller countries fuming over the damage done to their bond markets.

It says here that that was exactly what Bernanke should have done, and he reaped exactly the desired effect: put some fear back into markets. A Fed that keeps traders at least a little off-balance is a Fed that keeps markets and their positions from getting overly complacent (read: leveraged). A confident Alan Greenspan rattled bond markets back in 1994 with unexpected tightening and rattled equities in 1996 with talk of “irrational exuberance.” That may not have thrilled traders, but the central bank’s job is NOT to guarantee all of today’s trades, as most of today’s traders appear to have come to believe.

Alas, the one-time maestro was never the same after the storm of criticism that ensued in the wake of his irrational exuberance talk. After the central bank’s Long-Term Capital bailout in 1998, Greenspan went along quietly when the talk of a new economic era began to dominate in 1999 and stayed mum about the ridiculous valuations (the S&P 500 included) of the tech bubble.

The central bank’s emphasis began to switch from preventing excess (“taking away the punch bowl”), a perspective that still prevails at the Bank of International Settlements (BIS) (the so-called “central banker’s central bank” – it’s not just an expression – cf. see the latest annual report here) to cleaning up the damage afterwards. That way the markets will get blamed and not the bank, a coincidence I am sure. When the housing bubble burst, Bernanke deflected questions about the Fed’s invisibility during the period by pointing the blame at hidden positions and non-bank lenders. You know, people the Fed had no relation with, like Bear Stearns and Lehman Brothers.

These “traumas” have produced the Federal Reserve we have today – a bank fearful of the Scylla of disturbing the party as well as a Charybdis of excess leverage. In its hopes to avoid all financial market volatility and criticism, it will signal everything a million years in advance and issue endless, perhaps overwhelming, amounts of guidance, interviews, speeches and chit-chat. The plan for controlling leverage will involve increased and as yet undefined “macro-prudential” regulation, an approach that incoming Vice Chairman Stanley Fischer (who taught many of today’s central bankers) has admitted the bank doesn’t really know much about: “we have relatively little experience in the use of such measures in recent years.”

The Fed is digging its own grave with this all-finesse approach. Last week the US House introduced a bill for a “rule-based” Fed. It won’t pass, but it is a shot across the bow. Should a bear market be in place at the time of the 2016 elections – the calendar alone makes that a very real possibility, given the age of the current bull market – it could sweep in a set of “reform-minded” legislators determined to cripple the bank and place it under more legislative oversight, an even bigger nightmare.

As for the other concerns, Portugal and the rest, keep in mind that such matters require a steady stream of frightening headlines to keep up pressure on prices. Otherwise stocks will try to reverse-rally on any and every hint of improvement. Failing that, there is always the old bull market standby: shut your eyes to bad stuff and forget about it entirely.

The Economic Beat

For market impact, the report of the week was the release of minutes from the last FOMC (Fed monetary policy committee) meeting. The minutes had nothing new, and that is the standby reason for a stock market rally.

Probably the most noteworthy report of the week was the weekly jobless claims report. It’s too early to make the call and the data for the July 5th week may have been affected by the holiday weekend, but if the subsequent week turns out even modestly in line with the week of the 5th, there’s going to be a big seasonal adjustment factor for June employment (whether it’s real or not is another issue, but may not be known for quite some time and even the unadjusted estimates are affected). The decline in claims for the July 5th week versus the equivalent 2013 week was much larger than the year-to-date average, so the subsequent claims week (which will comprise the cutoff date of the 12th) doesn’t need to do much to produce another jobs number in the high 200K range, possibly higher.

The claims report didn’t get as much attention as the monthly labor turnover (JOLTS) survey for May, with much mention being made of a higher number of job openings. However, the hire rates (3.8%) are the same as a year ago, and would have been weak without the retail sector.

Wholesale sales (+0.7%) and inventories (+0.5%) for May were reported, with both numbers coming in below consensus. Neither number was bad in any absolute sense, but the combined April-May total means that June is going to have do the heavy lifting for inventories to make a positive contribution to second-quarter GDP. It could be a close call, as the inventory-to-sales ratio is on the lean side. That favors a rebuilding month, but public companies may try to keep inventory levels under tight control for their quarterly filings. There is still room for the ratio to get leaner.

Europe reported some surprising misses in May industrial production, with declines in Germany, Italy, France and the UK, despite optimistic May purchasing surveys. Chinese data came in below expectations largely across the board, though the country isn’t so crazy as to publish truly weak data, whether or not it reflects reality. With China one pays attention to the directional clues, and they were soft. No global growth this year? Oh well, it’s sure to arrive next year.

Next week sees the pace of data releases pick up again, led by the June’s last big report, retail sales on Tuesday. There will also be the Fed manufacturing trio: the New York survey Tuesday, the national production report Wednesday, and the Philadelphia survey on Thursday. The June housing market will see its initial reads from the builder sentiment index on Wednesday and housing starts and permits on Thursday. China’s second quarter GDP is scheduled for Tuesday night, along with monthly industrial production and retail sales. Next week also sees the second quarter earnings season get into high gear.

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