“So you’re scared and you’re thinking that maybe we ain’t that young anymore.” – Bruce Springsteen, Thunder Road
Well, that was a beating, and the natural question is, there more to come? It would be lovely to know for sure, but I suspect that an oversold market will probably stabilize in the short term. We may well get another air-pocket dip, but the real trouble is more likely to be down the road.
As to the causes for last week’s action, the easy answers were everywhere, beginning with China. Its stock market continues to be buffeted and a purchasing manager survey of the country threw up the wrong number at the wrong time, 47.1 (50 neutral) in a world already on edge about global growth. Falling oil prices were again prominent in a week in which many other commodities were also taking a growth-related beating. Vietnam and Kazakhstan both devalued currencies, the latter by a startling amount (nearly 25%) that revived fears of currency wars and the Asian currency crisis of 1997-1998.
All of those reasons matter as proximate catalysts, but miss the root: corporate earnings and their corollary, weak domestic growth. S&P 500 earnings growth is flat to down so far through the first half, and the hopes for a positive year rest principally on yet another fourth-quarter comeback, of the sort that hasn’t materialized in recent years, certainly not compared with summer expectations (though by the time January rolls around, expectations will naturally have been shaved down enough to allow for the traditional running of the estimate beats).
The results for the last quarter did not inspire. Yes of course, if we just eliminate the energy and materials sectors, okay maybe industrials too, why then earnings look pretty good. That’s how every downturn starts, with bulls and long-only managers announcing that we just need to concentrate on the rest of the corporate world and ignore those parts that aren’t doing well, because they’re less than ten percent of the economy anyway and so don’t really matter. Homebuilding, you may recall, was only about 6% of GDP going into the Great Recession. Internet stocks were only 6% of the market going into the tech wreck. If we just focus on what’s doing well and ignore the bad stuff, things aren’t so bad.
Until they are, that is. The Asian currency crisis was going on for about a year before it finally came home to roost in the fall of 1998. Corporate profit growth in 1998 was actually negative (using government measures) when the infamous hedge fund Long Term Capital blew up the credit markets in the summer and caused a panic there. That led to a juicy 25%+ correction in stocks before the Fed was able to cobble together a solution that involved getting the investment banks to backstop the fixed-income market along with interest rate cuts. Guess what Fed policy isn’t available to help this time around?
The S&P was trading at about 19 times earnings a month ago, on the back of zero to negative earnings growth for the first half. Valuations don’t make prices fall, but the latter is the kind of thing that sets markets up for a bad news tumble. That said, I didn’t expect this out-of-season August air pocket, because stocks are usually rising at this point regardless of the news. In fact, I still don’t believe that this is the end of the bull and think stocks will rebound, if only for a time. When the business cycle ends, so does the bull market, and I’ve been saying for most of the year that the cycle is running out.
Now many are worrying about global growth and are trying to come to grips with the China slowdown, but China’s biggest problem has been its own bubble and the lack of a miracle to rescue it from the inevitable. Even in centrally-managed countries with seemingly unlimited reserves and export ability, there are consequences to things like massive overbuilding and a lack of buying coming out of the rest of the world, in particular the West.
Keep in mind that the end of every correction (and this may be one), or even every run of four or five days of selling, is accompanied by the sentiment that there is nothing on the horizon that might stop the selling. It’s going to feel this way too, and it may take another central bank move to stop the bleeding, beginning with a cut in the reserve ratio that China hands are focused on. I don’t think that the real bear is here yet, though he certainly is growling. We’re paying the price for many months of complacency over a zero-growth (in aggregate) corporate world, yet oversold markets have a way of rebounding at astonishing speed. The lack of liquidity that is facilitating the downside can work in the other direction as well; just don’t try to catch the falling knife and you should get another chance to start your exit in more orderly fashion.
The Economic Beat
The release of the week had to be the FOMC minutes, though there was no economic information within that wasn’t already known for some time. What we did learn was that the FOMC has diverse opinions. Well, who would have thought such a crazy thing?
In terms of economic releases, perhaps the highlight of the week was existing home sales, up 2% in the month of July (seasonally adjusted) and up 10.3% over the last twelve months. 2015 has definitely been a rebound year from the more-sluggish 2014, but new home construction overall is not that different. Housing starts are up 11.4% this year versus the 2014 rate of 8.3%,, with single-family up a near-identical 11.2%. Therein lies the difference, as single-family was up only 4.9% last year. The homebuilder sentiment index remained strong with an August reading of 61 (50 is neutral), an elevated reading for the series.
Weekly claims also remain at peak levels, leading to the usual mistaken proclamations that strong employment will lead to further gains in income and a new leg up in the business cycle. If this were true, there would be no cycle at all – we would just get to maximum employment and keep raising ourselves up. Housing is also a lagging indicator most of the time, the exception being the bubble-crash in the last cycle, when it led the way down. Don’t look for the first indications of a recession to come from housing this time around.
On the wobbly side were some readings in manufacturing. The New York Fed August reading was a real dud, coming in with its lowest reading in six years, a dreary (-14.92). New orders were even worse, at (-15.7). Those are weak readings, to be sure, but they are also diffusion readings and could represent no more than a mild (if widespread) pullback. A level of minus fifteen now could go with a much higher level of overall activity than a minus fifteen reading during a recession. A clue to that was the Philadelphia Fed survey, which checked in with a better-than-expected result of 8.3, up from 5.7 the month before (zero is neutral). New orders were not as strong however, at 5.8 vs. 7.1 the previous month. The two combined seem to sum up the “flash” reading on the Markit purchasing manager index, 52.9 vs. 54.2 the month before. The choppiness is typical of the end stage of the business cycle, but doesn’t promise more than that, not yet.
Consumer spending seems to continue tracking its runway towards zero, as Redbook data is still around 1.6% year-on-year. With the latest CPI reading of 1.8% “core,” that implies flat or even down unit sales overall. The total result of 0.2% year-on-year is of course, just transitory.
The big reading next week comes on Thursday with the second estimate of second-quarter GDP. It may not be the most timely, but traders will focus on it for clues to the Fed’s September decision. It’ll follow another important release, July durable goods by one day, and precede July personal income and spending by a day. Durable goods may be the most sensitive indicator in terms of where the economy is going – a weak reading could cause big problems if the markets are still under pressure.
Other readings include the Chicago Fed activity index on Monday, new home sales and home prices on Tuesday, and regional activity readings from Richmond (Tuesday) and Kansas City (Thursday). The consumer sentiment measures next week will probably reflect some of the recent angst, but will not reflect the decline of the end of last week.