The Virtue of Patient


“All I can promise you is blood, sweat and tears.” – Winston Churchill

We are not, as Winston Churchill famously said, at the end of the beginning, though he was talking about the Battle of Britain rather than the stock market. Nor are we at the beginning of the end, not unless one takes a very broad view of what an end stage might be. I confess that it feels rather odd for me, an avowed market skeptic, to be insisting that the market is still more likely than not to go on to new highs this year, but my task is to catalogue the beast, not tame it. One can no more cajole the stock market into rational behavior than convince a lion to be vegetarian.

Despite a lugubrious (and volatile) three-week losing streak that has nudged the S&P 500 a tad back into the red for the year, the index is still only about three percent off its all-time high. The message from last week’s volatile trading ought to be clear enough: the level stock prices of is all about Fed magic. The hilarious part is that hardly anyone outside of the Fed genuinely believes in the magic, they just think that everyone else does.

Can we have any clearer proof than the last two major economic releases? When the jobs report was released on the 6th, stock prices were pummeled on fears that the above-expectation headline data would invite a mid-year tightening that traders had started to talk themselves out of. When the February retail sales report last week reported a second consecutive unexpected monthly decline, markets rallied furiously, helped along by the usual short-squeezing. Too bad the mood turned sour again on Friday when the euro and oil prices resumed their grim descents.

All of this came against an oft-noted backdrop of estimated profit declines for the first and second quarter. The usual cushion built into Street estimates suggests that the quarters are still expected to squeak out narrow gains, though not across the board. Still, that certainly isn’t much for a market trading at scary-high forward multiples, and one no longer running on the QE turbocharge.

Sky-high valuations don’t make prices come down, they only tell you how far they have to travel to get back to the ground. The real catalyst for the descent is going to be, as ever, the end of the business cycle, not interest rates at fifty basis points. That said, the current tandem of lofty valuations and anemic profits certainly makes for a more instable ride in the absence of QE liquidity and its concomitant conviction that the Fed has the market’s back. If the FOMC has the nerve to remove the word “patient” from next week’s statement, signaling that a rate increase is possible (though not promised) within two meetings, stock prices may finally find the 10% correction that many have been awaiting for over a year. If the word stays in, it’ll make for a terrific rip-reversal.

Yet even if the Fed should excise the magic “patient” word, the markets are likely to recover. There is always anxiety ahead of every Fed tightening cycle, and the current episode is no different. Since the stock market usually tries to keep moving higher until an economic downturn is undeniable, the likely second-quarter rebound in economic activity should encourage markets to recover any losses and resume the onward and upward trek.

The real challenge for the Fed will be not to get caught with ultra-low rates when the current business cycle ends. Yet the central bank often acts as if its mandate depends on slipping out of its zero-interest policy without discomfiting markets in any way at all, a nonsensical approach that has somehow managed to prevail. The seventh anniversary of the crash is in six months, and yet here we are with rates still at zero percent and most unlikely to be significantly different this fall. One wonders if the Fed has fallen for the old market myth that “this time is different.”

Churchill’s promise of blood, sweat and tears is likely to apply to current markets for a time as traders try to figure out if (and when) there is life after tightening, but prices should regain their footing. The larger battle of what to do with sky-high price levels and a fading cycle is yet to come.

The Economic Beat

The report of the week (weak?) was of course the February retail sales number, whose weakness inspired the one-day no-Fed-tightening turnaround in the market. The results were a wide miss in every category: monthly total sales fell 0.6%, seasonally adjusted (consensus was for a gain of 0.3%), ex-auto sales fell 0.1% (consensus +0.5%) and ex-auto, ex-gas (“core”) fell 0.2% (consensus +05%).

Attention: retail sales are not as bad they have looked the last couple of months. January did have a seasonally adjusted decline, partly a result of having 9 weekend days instead of the 8 in January 2014. But the growth rate for trailing twelve-month (TTM) sales has not wavered in the last three months: December 4.02%, January 4.1%, February 4.07%. Indeed, the rate has hovered around a trendline of 4% for nearly two years now. The ex-auto rate has been at 3% over the same period. February sales were up 1.2% year-over-year, below the 20-year average but about in line with the previous two years.

The growth rate in TTM ex-auto, ex-gas sales has increased – at 4.33% in February, it’s a full percent higher than a year ago, and began ratcheting back up around the time oil prices began their plunge. What’s amazing is how few seemed to have glommed on to the essential fact that lower energy prices change the mix of spending, but cannot change the total. For the total to grow, one needs either more income or more borrowing. It is NOT like a tax cut, making me wonder if Yellen says things like that to Congress because it’s politically useful to do so and she knows that they lap it up, or whether (like many top economists, I am afraid) she is so busy with travel and meetings that half of what she says is based on headlines and little else.

Wholesale sales and inventories for January were on the weak side, with January sales unchanged from January 2014 (a negative quarter for GDP, you may recall) on an adjusted basis and down 3.4% unadjusted, presumably due to the extra weekend day in January 2014. The inventory-to-sales ratio rose to a very high level, 1.37 unadjusted and 1.26 adjusted, compared to a year-ago 1.24 and 1.19 respectively. That is going to mean weak inventory accumulation in the first quarter and put downward pressure on GDP.

Price weakness is evident in many places these days, perhaps nowhere more son than in import-export prices. Import prices fell again and are now down 1.8% excluding petroleum (-9.4% with petroleum), while export prices are down 5.9%. The strengthening dollar has aggravated the situation, but import-export price changes have been flat long before the greenback started to take off. Producer prices are up only 1% year-on-year excluding food and energy through the end of February (-0.7% overall), and that isn’t due to dollar strength. Lower energy prices and static demand are the two key factors.

Employment remains steady, with claims in the same range they have been for many months and a labor turnover report (JOLTS) that signified nothing new in hiring.

A notable overseas development besides the weakness in the euro was continued weakness in published Chinese economic data. One cannot take the data at anything near face value, but the government does signal strength or weakness with changes in trend. The latest releases in industrial production and retail sales both showed slower year-on-year growth to 6.8% and 10.7% respectively, both figures representing multi-year lows. The reaction in the Wall Street Journal and Bloomberg seems to largely be confined to excitement over the prospects for more stimulus.

Next week brings the center of market attention, namely the Fed meeting and its Wednesday statement. March being a quarterly meeting, it will come with press conferences and updated forecasts, so it seems safe to say that more volatility is likely. Preceding the Fed’s crucial hours in the sun are the New York Fed survey on Monday, along with the national industrial production report, and then housing starts on Tuesday (homebuilder sentiment the day before). The Philadelphia Fed survey is Thursday, and quarterly-plus-monthly options and futures expirations (“quadruple witching”) are on Friday.

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