To Worry, or Not To Worry

“To take arms against a sea of troubles, and by opposing end them?” – William Shakespeare, Hamlet

A funny thing happened on the way to last week’s easy, low-volume rally – somebody had the audacity to file a discouraging geopolitical story on a mid-August Friday during trading hours. Don’t these people know about three-day weekends?

The resulting volatility was typical for a very low volume week marked by run-ups and reversals. As I noted last week, August is a month when a determined group – and that includes groups of trading programs – can move the tape in either direction without much resistance. At the beginning of the week, the tape was set up for one more leg down, but every day of relative calm was another chance to squeeze both shorts and expiring options, and by Friday morning the S&P was headed for yet another episode of a chart classic – the inverted head-and-shoulders “breakout” trade that has been one of the hallmarks of the two last QE-3 years.

Alas, the real world intervened. So unfair. The days ahead will be marked by strenuous proclamations that the Russia-Ukraine situation will have no effect on the U.S. economy and should have no effect on stock prices, but that is a most mistaken view. Any episodes of good-cop by Mr. Putin will provide a big lift to prices. As for his bad-cop days, the most likely menace of Russia-Ukraine is not one of world war, but the Morton’s Fork he presents to Europe in choosing between appeasement and recession. In the likely eventuality of a Russian occupation of either Ukraine or some eastern portion thereof, Europe will have to elect either the morally repugnant and politically treacherous route of looking the other way and going on with business as usual – the road taken by most of the West with the pre-1939 Adolf Hitler – or stiffening their backs and seeing trade with one of their largest partners plunge as a result.

The day before the crisis flared anew, Hungary and Slovakia were petitioning for an end to the sanctions on Russia, and it wasn’t because they’re fans of a Russian Ukraine. Their economies are taking a beating, and indeed the latest GDP figures from Europe this week were largely disappointing, with heavyweight Germany posting a slight decline. The chances of Putin coming away from the imbroglio with at least a part of the Ukraine seem quite good, yet how can Europe look away in the wake of the murderously downed MH-17? The denouement of all this is impossible to foretell and could change at the last second, yet one cannot overlook the possibility of a Russian-EU trade freeze that ultimately fractures the unity of the latter. Were that to happen, they’d probably start building shrines to a newly-canonized Saint Vladimir in Russia.

Do not think I’m being fanciful. Putin’s current approval ratings in Russia are in the upper 80s, mirroring the extreme popularity of Hitler when he “resurrected” and remilitarized Germany against the predations of its neighbors – or so it was seen within the latter borders at the time. Germany had been humiliated and nearly destroyed economically by the Great War, the Versailles treaty and its aftermath, and its sense of aggrievement over lost eminence and unfair, treacherous foreigners isn’t far from the sentiments of post-USSR, post-superpower Russia, a land where suspicion of the West has been accompanied by a sense of unfair treatment for over a millennium. Occupation of the eastern Ukraine could spark dancing in the Moscovian streets.

Such a move would lead to considerable price volatility, of course, and talk of the big correction finally arriving. It would all be carefully attended by the usual swarm of overeager bulls who believe that such dips are for suckers and to be bought as soon as the selling appears to subside. The possibility of a subsequent recession is not an issue for traders who only trade today’s news and charts – they are only too happy to let someone else worry about a month down the road. Every day of calm next week (I’m making no predictions here) will be seen as an opportunity to try to push the tape higher.

Investors could and should be legitimately worried, because a European decline would have effects around the globe, but we would first have to endure the usual denials based on the familiar denial theories of decoupling, protests that “it’s so far away,” and the beating to death of the freshly revived metaphor that the U.S. is the cleanest dirty shirt in the hamper.

I would agree that the U.S. economy is in an advantaged position relative to most of the rest of the world, but putting aside the many looming problems, there are two immediate drawbacks. One is that our relative advantage would appear to be already priced into a richly-valued market, leaving far more room to the downside than up. Sightings of the 10% earnings-growth illusion quieted down by the end of last week as FactSet reported that the second quarter’s growth rate had eased to 7.6% with 31 companies left to go from the S&P 500. Should that hold, the rate for the first half would be less than 5% for a market priced at nearly 20 times trailing earnings. It was 7% last year.

The other drawback is that the “where else can you go” argument may be a reasonable one for fund managers who have a mandate to stay fully invested, but a great way to lose money for individual accounts. The former group never, ever acknowledges that the game is up until the whole world knows it – and then they blame the government anyway. Keep that in mind when you’re reading your next fund letter.

The Economic Beat

The report of the week was July retail sales, which disappointed hopes with a preliminary estimate of overall sales being unchanged from June. Excluding autos, sales were up 0.1%. The year-to-date rate is running at about 3.7%, or about 2% in real terms, in line with much of the last four years. I would take the report to indicate that the weather rebound is over so far as consumption is concerned, though that is not to say that sales will flat-line the rest of the year – August should show its usual back-to-school strength.

Every time there’s any break in gasoline prices, you can always count on some Street denizens to rush forward and start gushing about what a wonderful break the consumer is getting and how it’s going to mean a big pick-up in spending. The other thing you can count on is that the pick-up won’t happen.

We came into the 4th of July with gasoline prices at record seasonal highs, and now they’ve backed off about 20 cents a gallon. This is supposed to excite people? If gasoline prices should drop another dollar to the $2.50 neighborhood, that would likely induce people to start buying more gas – but then it would also hurt domestic oil production, unless we could somehow sell it all abroad at higher prices. Oil exploration and production has been one of our few bright spots, largely because American corporations can’t outsource it to the Philippines. Should it dim without a domestic energy substitute to take its place, the economy would probably grind to a halt again,

Longer term, the 12-month rate of retail sales growth continues to slow. The age of the recovery is part of the reason; if the economy stays on its current path, sales growth should stabilize near current levels (3.7%), or about 2% in real terms. If the annual rate of growth starts to fall below 3.5%, I’d be worried.

There isn’t much buying pressure in the world of imports either, where prices fell about (-0.2%), bringing the year-on-year rate back down to 0.8% (0.7% excluding petroleum). Just about everyone but the U.S. is trying to weaken their currencies, in particular China and the EU, so I wouldn’t expect the phenomenon to change in the near future. Export prices are up only 0.4% over the last twelve months.

Manufacturing was rather anemic in 2013, but is helping to offset this year’s lack of consumption growth with a pretty good showing so far, led by autos, the oil business, and a big month in July. The Fed said that industrial production rose 0.4% during the month and manufacturing by 1.0%, leaving the latter with a jump in the year-on-year rate to 4.9% and the overall rate at 5.0%. That broke a string of three months of 0.3% increases, about in line with the recovery’s long-term rate of growth. It’s all come against a backdrop of declines in utility production, now down 1% from a year ago. A note of caution is that the auto channel seems to be getting stuffed rather full – any inventory headaches could lead to sudden cuts in production. I have yet to see an auto cycle where the business wasn’t eventually caught overproducing after the peak.

The New York Fed’s manufacturing survey index fell from a four-year high reading of 25.6 to a still very decent 14.7 in August. On the other hand, the future outlook index rose to its highest level in 2 1/2 years, and that’s a warning sign – like its Philadelphia cousin, the peaks in the forward outlook are contrarian indicators.

On the lagging side was employment, with the most prominent example being the latest labor turnover survey (JOLTS) showing June hires at a 13-year high (the age of the series). That fits with the June jobs report, but the data is now six weeks old. The real question is whether or not it’s at or nearing a cycle peak, or an inflection point to the “virtuous circle.” Hire rates are still well below the last cycle’s peak.

Next week’s focus will be on the FOMC minutes (Wednesday), anything emerging from the central bank conference in Jackson Hole, Wyoming that begins Thursday, and housing. The homebuilder sentiment index comes out Monday followed by July housing starts the next day. Existing home sales for the month come out on Thursday. The consumer price index (CPI) for July is released Tuesday morning.

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