Coming to the Inflection Point


“Many foxes grow grey, but few grow good.” – Benjamin Franklin (ed.), Poor Richard’s Almanack

A year or so from now, people are going to be wondering what happened to the economy. Most will be looking for someone to blame for why an economy that was doing so nicely tanked so quickly. Probably the Fed will get the majority of the blame, if the central bank ever manages to squeeze in a couple of puny hikes before the cycle has ended. Most likely the Obama administration will get the lion’s share of what’s left, if the election lines up right (and it probably will). Politics being what they are, many will try to give the outgoing administration the majority of it, but that comes with the territory. Taking too much credit for the good times and getting too much blame for the bad is right out of the presidential handbook.

“Shoppers Splurge in Spring Spree…” read the headline in the Wall Street Journal. You have got to be kidding me. Avid investors, even casual ones, may be inured to this type of endless it’s-all-good optimism that prevails on CNBC, but when the Journal runs this kind of garbage (only 99.44% pure), it gets repeated on drive-time radio everywhere. One of the great downsides of the availability of “free” Internet content has been the reduction of news analysis to a handful of sources – domestically the Journal, the New York Times, and a few wire services. Most industry participants have long eliminated all or most of their in-house news staff in favor of recycled news from the remaining handful.

So yes, May retail sales had a rebound (see more below in The Economic Beat), and the jobs report offered up the prior week beat consensus with a reasonable initial estimate of 280K. But retail sales are in no splurge or spree, and the economic data is rife with indicators indicating a business cycle that is slowly turning over. Republican or Democrat, low interest rates or high, every cycle turns over in the end, and Wall Street will go on acting as if it won’t happen until it’s impossible to deny.

There was a time when the stock market might take fright that the cycle was ending well in advance of recession, often multiple times. An old saw from the late great economist Paul Samuelson was that the stock market had predicted “nine of the last four recessions.” It’s also true that corporate earnings growth flattens out as the cycle ends, sometimes declining before the onset of the official recession date, and the stock market will usually take note of it.

For good or ill, however, our central bank has gone from being a sphinx-like institution that rarely spoke, to one that is verbose to the point of having governors that don’t seem to know when to shut up. The rest of the federal government now collects and disseminates far more key economic data than it did thirty years ago. Let’s not forget algorithmic and other computer-based trading, either, that no one in this business doubts as having had the effect of strengthening trends.

The net of it is that instead of the historical guessing at what a few bits and pieces of data might mean to the economy and to the central bank’s never-telegraphed next move, we now have an investment community permanently fixated on Fed policy as the key to everything – partly because everyone believes it’s what everyone else believes, so why buck the crowd? Equity managers like to excuse valuations detached from any reality of earnings fundamentals by saying, “don’t fight the Fed,” but the real message is, “don’t fight the crowd.”

What are the markets most thinking about (when Greece isn’t back on the screen)? The next Fed move, of course. So every bit of data, large or small, tends to be seen in that light. Since the house organs of the investment world never want the cycle to end, they tend to spin things for the better, and the journalists read really cool wire-house research that similarly couches things in favorable terms. So in 2007, stocks hit the peak of their cycle in October (thanks to a Fed rate cut) with a recession less than three months away (no, it did not start after Lehman failed). There was plenty of economic evidence available that showed the economy was grinding to a halt, in particular the housing sector that had been at the center of the cycle, but it was all dismissed as secondary to Fed policy.

In fairness to equities, they did begin a steady decline after the October 2007 top, once the long-awaited Fed move had become reality rather than rumor (it was in fact a double-cut, more than the market expected). One can make the case that since stocks usually rally after the first rate increase (very true), and with said rate increase being most unlikely until September, then the market should be safe until at least the fourth quarter, possibly longer.

It’s a reasonable point, one of the ones that keep me thinking that the market top for this cycle is probably not in yet. It also helps keep some of my immediate anxiety in check: Retail sales are in fact weak this year, with year-to-date sales growth of 1.86% (unadjusted), by far the weakest since the recession. The spring is no better – even April-May of 2008 had better year-on-year growth than April-May 2015. The annual rate of growth in wholesale sales, at 2.2% through April, is the weakest since the recession. Business cap-ex spending is the weakest since the recession. Only the lagging indicator of employment continues to do well.

What will matter to markets for now, though, is whatever the Fed says next Wednesday and whatever trouble that Greece manages to get in or out of. Both events could lead to explosive (if short-lived) moves in either direction. As for me, I’m still not buying any dips.

The Economic Beat

The report of the week was the May retail sales report. In an oddity not atypical of this business, the business media (and so the news that most people hear on drive-time radio, including NPR) raved that it was a great report, the first-quarter weakness is over, the economy is solid and so on.

Some quotes from Econoday include “the long awaited rebound from the soft first quarter is here” and “the consumer showed a lot of life in May.” The New York Times ran a glowing Associated Press story that noted sales have risen a “solid 2.7%.”

The talk could hardly be farther from reality. 2.7% over twelve months is not solid, but a bright yellow flashing light – when trailing twelve month (TTM) sales fall below 3% in the latter half of the cycle (as opposed to rising above it in the first half) it’s a big warning sign that the cycle is on its last legs. The year-over-year monthly comparison was weak too (1%), the worst May comparison since 2009. TTM sales on an unadjusted basis slipped from 3.7% to 3.4%, the latter being the weakest since August 2010.

The 1.2% monthly gain (seasonally adjusted) may look like a big number, but as catch-ups go it was nothing special. It didn’t even meet the consensus guess for 1.3%, though the “core” (ex-auto, ex-gas) increase of 0.7% did sail past the consensus estimate of 0.5%. It was indeed a rebound, but it was just one monthly number, one that only looked good next to the previous three months, without negating their weakness. The intermediate and longer trends continue to deteriorate (along with the reporting).

The lack of global growth is reflected in inflation data. Import-export prices rebounded in May, thanks to the bounce in the price of oil, but year-on-year export prices are down 5.9% (-4.6% excluding agriculture, heavily influenced by energy prices) and year-year import prices are off 9.6%, or (-2.2%) when excluding oil. Producer prices are down 1.1% over the last year through May, up a mere 0.6% excluding food and energy. I don’t how all of these people can go on CNBC and say with a straight face that the economy is fine. Maybe they’re reading the Journal.

As warning indicators, May wholesale sales and inventories are more of the same. In the wake of the report I tweeted that monthly comps for wholesale sales were down for the fourth month in a row, for the first time since 2009. Four down months in a row screams as a leading indicator of a generalized slowdown. “That’s just energy-related” some would say, perhaps the same ones who said in 2007 that “housing is only 6% of the economy” and that tech companies were only 6% in 2000. Yet the inventory-to-sales ratio is still too high – there’s going to be a big pullback in inventories soon, affecting GDP in the second or third quarter. The same excuse was made for European industrial production, which eased to a 0.8% year-on-year rate. If you just take out energy from the report…and non-durable consumer goods…and one or two other things…

The labor turnover survey (JOLTS) came in for its share of mis-reported hype. Everywhere I looked, Street economists and news stories bragged about the number of job openings being at the high of the series, which goes back 15 years. So is the population. The openings rate is at a high, which is just what you would expect near the end of the cycle (employment lags the cycle), but the actual hire rate is unchanged from a year ago. Claims data are fine, however, and there is no signal of an imminent slowdown there (though claims will be nearly the last indicator to flash yellow). Consumer sentiment, the most unreliable and lagging indicator of all, rose. Of course it did.

Next week brings more Greek news of one sort or another, probably another kick-the-can but I make absolutely zero predictions about policy. Other than that, the FOMC meeting should dominate, with the market’s short-term trading focus remaining fixated on prospects for a rate increase. We’ll get the Fed’s second-quarter forecasts, which should include the usual downgrades to this year and next, along with an ever-optimistic pickup somewhere on the more distant horizon. Just follow the yellow-brick road.

The week starts off with production data, first the manufacturing survey from the NY Fed, then the industrial production data from the central bank. The homebuilder sentiment index tops off Monday morning, followed by housing starts the next day. On Thursday we’ll get the Philadelphia Fed survey, and Friday brings quadruple witching. It should mean a lot of volatility.

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