High Anxiety

“Stay at the hotel until it’s over.” – Gary Cooper, in High Noon

Timing can be everything in this business. Last week, the Wall Street Journal inaugurated the fourth quarter with a prominent story atop the front page of its “Money and Investing” section, “Investors See Reasons to Jump In.” The story led with the thought that “A resurgent dollar is remaking the investment landscape…many investment managers expect (it) will propel U.S. stocks to fresh gains.”

Since then, the S&P has shed about another 3.5% to go along with the 2% it had already lost at the time of the story from its mid-September peak. The Nasdaq is down nearly 5% this month alone, the Dow Jones is back in negative territory on the year (barely), while the Russell small-cap index is off nearly 10% on the year – almost 13% from its July peak three months ago.

That last part has had traders and others who mind the technicals worried. Not only is narrowing breadth a bad sign for market momentum, when money starts to cluster around the largest, less volatile companies, it tells you that there’s a lot of hatches being battened down. The small-cap development is also one that would seem to make no sense from the global economic point of view, as those companies have the least foreign exposure and the U.S. is widely thought to be the best-performing global economy.

But small-cap stocks were also the most expensive, broadly speaking, making for another example of a point I like to make – valuation isn’t a very good guide for when stocks will correct, but it is one for how far they will. Expensive stocks normally start to lose their mojo well ahead of everything else, when some investors start thinking it might be a good idea to get some of the horses back into the barn. The reverse is only true in a mania, like tulips or dot.com stocks, when people stop believing it will ever rain again (and if that sounds silly, believe me, last March we were all wondering if the ice around here had become permanent).

All well and good, you may think, but why are stocks going down? Every time I get asked this question, I’m tempted to reply, “well, can you tell me why were they going up so much in August?”

The point is that there is always a lot of bad news waiting to happen somewhere in the world. It most assuredly isn’t all equal, and rarely is it genuinely new, but neither is the market’s willingness to listen to it. Most of the headwinds for the market were either known or suspected back in August, but once stocks rebounded off their long-term trend line, light volume and the usual vacation-induced August apathy allowed them to fly to new highs. It’s only happened about ten million times.

Now the markets are listening. There are many fearful stories – Ebola, Ukraine, ISIS, China, Japan, but they all come down to one thing for stocks: what happens to growth? When growth goes away, so do earnings, and when they leave, prices are right behind.

War is never good for growth. But while we are very unlikely to go to war over the Ukraine, the sanctions have begun to bite. Russia is spending foreign reserves desperately to prop up the ruble, its stock market has cratered, and Europe is starting to feel the effects, especially Germany, a country at the forefront of global growth worries this week.

Ebola is weighing on the stock market. Most traders aren’t genuinely worried at all about a pandemic. But until the danger recedes, each fresh round of infections, however few, means a much greater impact on trade and travel. That is bad for growth, bad for earnings (Ebola could be a far more serious problem, I realize, but this being a newsletter about the market, I’m going to stop there and not contribute my own 2000 words of vaguely-informed opinion on the subject).

Global growth is weighing on the stock market. In case you didn’t notice, the International Monetary Fund (IMF) put forth an unhappy-sounding tome this past week entitled “Legacies, Clouds and Uncertainties.” The organization lowered its outlook for this year and next and talked gloomily about the increase in downside risks.

Monetary growth is weighing on the stock market. The Fed’s program of monetary expansion known as quantitative easing, or QE, is slated to end this month. Previous ends have been followed by stock market corrections, and we may well have started early this time. Japanese QE (“Abenomics”) is producing mixed results, while the European Central Bank (ECB) is running into heavy German resistance over plans to expand its own QE program.

Global markets are well aware that ECB President Mario Draghi is being stymied on what he would like to do, and are having doubts about how and when Germany might ever let him do it – if at all. Draghi has since been trying to air out both the German side – countries must get on with restructuring – and the side anchored by France and Italy, which essentially comes down to “enough austerity already, can you please see what the US has done and get on with it?” Each of the two sides thinks that the solution is for the other side to be more like them, both think they have already done enough in that direction, and neither want to budge further. It’s an auspicious position.

Dollar growth, as in the value of the dollar, is weighing on the stock market, despite the sunny outlook implied by the above-mentioned Journal article. Most of it is related to currency devaluations by Japan and the EU, but competitive devaluations have been a growing threat for over a year now. Japan is now worried the yen has fallen too far too fast. A falling euro benefits European exports, but the Germans are also worried about too much of a good thing.

All currency transitions carry certain costs of adjustment, regardless of direction. A stronger U.S. dollar makes oil cheaper for us, as well as commodities and other foreign imports (and of course, those ever-dwindling trips to Paris). That’s good for inflation, but less inflation is about the last thing that the Federal Reserve wants right now. It also hurts our exports. A growing chorus of stock market voices have noted that while the third-quarter effects should be minimal, a higher dollar is going to have the all those global S&P 500 companies lowering earnings outlooks.

Time to head for the hills, then? Not quite, though some buying caution is also in order: Fear is always hard to gauge. The current correction may not be over yet: The S&P closed a hair above its 200-day average (the simple average; the Street-preferred exponential moving average (EMA) is another five points lower) on Friday, and while we could yet pivot from it, it may have taken took too long to get there for a quick bounce to hold. Traders have been rattled by all the volatility, and the 95% conviction of a few weeks ago to buy at the 200-day seems to have seriously weakened. The trend-line from November 2012 appears to have been violated.

That leaves the S&P’s 52-week average, last touched in 2012, as the next support level (1880-1881). With a catalyst we could certainly go even further – the 1700 level representing the post-crisis trend-line comes to mind. It’s a long way off yet, but even that would only be a 15% correction, not a bear market.

You can get mini-bear markets from certain things – an outbreak of war, the Long-Term Capital crisis of 1998 – but true bear markets only result from economic downturns and their loss of earnings. In other words, a recession, and we are not there yet.

So yes, you can start thinking about buying stocks here – the S&P is oversold on an intermediate basis for the first time in two years. But do it like the smart money does – ease in a little bit a time and forget about trying to go all-in at the bottom. No one knows where that is ahead of time, only a few do when it happens, and most not until well afterwards. Most retail investors get whipsawed in corrections by jumping way too early at their long-awaited great chance, then panic and sell after their losses deepen instead. When the bottom happens, they refuse to believe until the new high is reached – and then the trouble starts all over again.

The Economic Beat

It was a very light week for economic data, though I wonder if a busier calendar would have made any difference to the market’s overwhelming obsession with central banks. The Tuesday release of the IMF report sent markets into a big tailspin, while the Wednesday release of the Fed minutes and their conspicuous absence of early tightening attitude put up a big rip-reversal, short squeeze and all. Draghi’s subsequent downbeat appearance on Thursday next led to an even bigger loss.

Apart from those, the report that seemed to get the most attention was weekly jobless claims, which put up another low number (287,000, seasonally adjusted). It’s a hopeful sign for another good jobs report, but the pattern of claims is also suggesting that employment growth is in the late innings.

That possibility was echoed by the JOLTS (labor turnover) report for August, that showed a new high in openings at the same time as hires fell sharply. Perhaps some revisions are in store, but the fall in hires does mesh with the August jobs report. The month did end five weeks ago, so one would think that a revision should be modest.

The wholesale sales and inventory report for August showed an unexpectedly large increase in inventories that left the inventory-to-sales ratio at an unexpectedly high level for the month, 1.19 seasonally adjusted (1.18 unadjusted). Autos might have been the culprit, and may be a problem in September as well, going by the automotive sales report. An inventory build is something that would give a lift to third quarter GDP but then take it back in the fourth quarter; the first estimate is due in a couple of weeks.

Looking at the Redbook reports for September, the retail sales report due up next Wednesday might be in trouble from a combination of the auto sales decline and weakness in chain store results. The other weekly report, ICSC-Goldman, was more optimistic. My experience is that while neither are perfect, when the two reports run in different directions the monthly report is usually closer to Redbook. I suppose the proof will be in the estimate anyway, as the markets seem to pay the most attention to the number in the light of consensus.

Import-export prices were both down in August, though close to the flat-line when the petroleum effect is taken out. Imports were up 0.7% year-on-year excluding petroleum. The latter feeds right into agricultural prices that lowered export prices by 0.2% for the year but were otherwise unchanged. I cannot think of another cycle that has had such weak trade prices during a period that’s supposed to be a recovery. Perhaps there is more deflation pressure than I have realized.

The real news was from overseas, where Germany was posting some rotten numbers in factory orders and exports that inflated EU recession fears. Declining trade with Russia is partly to blame, though that should hardly come as a surprise at this point. Some German statements left the impression that their sense of sanction-related sacrifice is hardening attitudes against Draghi’s programme to buy bonds.

Next week is busy again, with the key reports being Wednesday’s retail sales and industrial production on Thursday. The New York Fed reports its survey on Wednesday, Philadelphia on Thursday, and the Beige Book is also released on Wednesday afternoon – that and industrial production should come in for heightened scrutiny. The homebuilder sentiment index is Thursday and the first estimate of September housing starts is Friday.

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