Take the Cannoli


“Leave the gun. Take the cannoli.” – Clemenza, in Mario Puzo’s The Godfather

by M. Kevin Flynn, CFA

Last week we wrote that trouble is brewing, and this week our assessment is that trouble is here. Equities are overbought, and the narrative has taken an it’s-all-good turn: either the economy really is doing well, in which case equities are the obvious choice, or it actually isn’t doing so well, in which case equities are the obvious choice because the Fed will ease.

How’s that? We can’t tell you which assertion was more common last week – the one with the economy taking off, or the one with the Fed having to step in with more quantitative easing. A glaring contradiction, one might think, but only for the infidels. The Fed won’t buy long bonds this time, you see, but will buy mortgage-backed bonds instead, in order to jump-start housing. So it does count as easing for betting purposes, but as it’s not “true” quantitative easing, the Fed will have the political cover to do it. Thus, the markets can bet on weak-growth central bank accommodation at the same time they celebrate increasing growth. It’s a wonderful world, especially in light of the fact that housing is supposed to be exhibit “B” for the case that the US is recovering.

Not to be outdone is the putative European miracle. Don’t worry about Greece, because “they” will find a solution at the last minute. They always do, you know, so better to get your bets down now. Not only that, but the ECB (European Central Bank) is providing more liquidity, making for another twin parlay. All the risk is in missing the upside breakout.

There are two contradictions at work. One is the classic equity market contradiction of rallying on an easing central bank stance. It’s been a consistent reaction through the years, and the way you should think of it is that it in the short term it is usually right to go along, because everybody else is doing it. However, it is always wrong longer term, because central bank easing only begins when a downward economic trend has been firmly established – and changes in monetary policy can’t turn the economy quickly enough to avoid it.

The markets don’t turn quickly either. The first step is euphoria: the (fill in name of central bank) is on the job. Buy equities! The next step is denial: don’t worry, there’s going to be a soft landing. The last step: trip and fall into the rowboat, then head for shore before the ship sinks.

A good warning can be found in the beginning of this quarter’s earnings season. Estimates for the quarter were cut dramatically in the remaining weeks of 2011, and of late the market has been playing its usual game of celebrating the “earnings beats.” Well, estimates are supposed to be beaten. The Street is not interested in seeing the companies they follow come up short. In the second place, the beat rate is running quite low.

Take IBM for example. The stock rallied, partly in relief, but the salient fact is thatits revenue was up 1.6% in 2011. Earnings per share did better than that, thanks primarily to buying back shares. IBM’s mix also improved, along with the company doing a good job of managing expenses – we’re not knocking it by any means. The point is simply that revenue growth is slowing across the board, and while that fact may be temporarily obscured by some of the earnings estimate “beats,” the market can’t and won’t hide from it for long.

We think that equity prices are about to step down. The wild card, as ever, is the European situation: if a deal with Greece is announced, we could see a wild one-day rally. If so, fade it to your heart’s content, because it’ll provide an excellent opportunity to take your money and jump into that rowboat. As soon as the Greek deal falls off the front page, Portugal, Ireland and Spain are queued up and waiting. They will all need a debt restructuring, and Germany has yet to face up to the heavy lifting it’s going to take to save the eurozone. The European recession is going to get worse before it gets better.

Don’t fall for the usual early-year elation. This market is running on low-volume momentum, the worst kind, and it’s strictly a trading affair. If you can’t trade full-time and don’t have the cynicism necessary to abandon equities at a moment’s notice, stay on the sidelines. Better yet, take your goodies and go.

The Economic Beat

No one report stood out last week, but housing and manufacturing were well represented with three reports each.

Housing was more intriguing, both because of its new can’t-miss status and because of some of the anomalies within the data. The markets got all shook up on Wednesday with the latest homebuilder sentiment report (“Housing Market Index”). It showed a substantial increase, to 25 from 21, and was the highest reading in over four years.

However, 50 is the neutral line for the survey, so 25 is quite a low reading. One can’t expect to close the gap in one or two reports, of course, and progress should still be respected, but we wouldn’t get too excited yet anyway, for several reasons.

First there’s that sentiment report. The largest part of the improvement came from the Northeast, which through December had been enjoying one of its warmest winters in decades. It’s hard to accurately measure the impact, but it’s certain that it wasn’t a negative for industry. The other jump came in the West region, and the anomaly is that the housing starts report the next day showed virtually no change in single-family starts from the previous December for either the West or the Northeast. What’s more, single-family permits were down substantially year-on-year in the Northeast, and declined in the West as well.

The biggest improvement in starts remains the apartment area, whose financing comes from the construction and commercial lending areas. The single-family sector still depends on individual bank mortgages, where the twenty-percent down payment still rules and credit remains very tight. There were rumors again over the weekend of a wide-ranging settlement plan involving the Gang of Four mega-banks and mortgage problems during the housing bubble. The price tag being tossed around is $25 billion, perhaps $30-plus billion if more banks join in. Although the equity markets might welcome the relief aspect of a settlement, we can promise you that a $25 billion charge, well-deserved or no, isn’t going to loosen up mortgage lending at the country’s largest banks.

To underline that point, the report on existing home sales – which was a bit less than expected at a 4.61 million rate – reported that the first-time buyer percentage has declined from 33% a year ago to 31%. It’s not a big move, but it doesn’t support any notion of a surge in homebuilding either. Existing home prices fell another 2.5% in 2011; single-family sales were reported to be up 3.9%. Given the mild weather, the reported sales pace should have been better and may turn out to have been lower, since the National Realtor Association has had a tendency to over-estimate sales data.

Turning to manufacturing, we think that the mild weather again played an underappreciated role. The data is all seasonally adjusted though the weather was unusually warm, equating to no shutdowns and no days missed but getting credit for them nevertheless. Industrial production was reported to rise by 0.4%, led by manufacturing (+0.9%). Some pointed to the drop in utility production (-2.7%) as masking a better quarter, but you can’t blame the weather with one view and ignore it with the other. What’s more, the 0.8% increase in business equipment was probably juiced by the last month of the 100% accelerated depreciation credit.

The regional Fed surveys both reported moderately good activity, with the New York survey reporting a better-than-expected reading of 10.3, and new orders similarly improving to 9.7. Once again, though, we would say that the warm reception given this number was due mainly to the consensus estimate, rather than the number itself. A year ago, the (revised) index stood at 17.3, during a January that was much more difficult weather-wise. It’s all part of the stampede fever – half the crowd crowing about how good the economy is, the other half eagerly anticipating more easing to revive it.

Weekly claims also got an extra-big seasonal adjustment, one that was almost surely bigger than necessary, and inflated by storms from last year. The same week a year ago produced an unadjusted number of about 550,000 claims, versus about 522,000 this year. Using the 2011 adjustment factor, the reported number would have been 394,000 for the week, not much different than the week before. But this year the weather is mild. Still, it all adds up to buying equities: if the number is right, then the economy is accelerating; if the number is wrong, then the Fed will ease more, got it? Right.

The inflation data for December was given the same benevolent view. The Producer Price Index (PPI) fell by a tenth of a percent (+0.3% excluding food and energy), while the Consumer Price Index (CPI) was unchanged (+0.1% ex-food and energy). Pundits rejoiced – with a straight face, and often in the same breath – that the rest of the economic data was all positive, while the inflation data would simultaneously encourage the Fed to ease.

It just doesn’t work that way. The market is clearly trying to pull another rally rabbit out of the hat with this nonsense, and nonsense is what it is. The Fed isn’t going to embark on another round of quantitative easing without very good reason, either deflation or the economy clearly sagging. The biggest impact of the last round of easing was to raise commodity prices. That’s not to say it’s out of the question, but it will be if the stock market is steadily rising. That’s the catch.

Next week has a heavy calendar of both economic news and earnings. For manufacturing, we have reports from the Richmond and Kansas City regional Federal Reserve districts, along with December durable goods on Thursday. Certainly the latter should have benefited from the warm weather situation, along with pending home sales (Wednesday) and new home sales (Thursday). Leading indicators are also out Thursday.

The two most important releases for the market should be the FOMC statement Tuesday afternoon, press conference included, and the first estimate of fourth quarter GDP on Friday. But earnings should dominate, and will be hard-pressed to support this market.

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