A Time of Change


“Thou see’st the twilight of such day, as after sunset fadeth in the west.” – William Shakespeare, Sonnet 73

Midway through October, there is a lot of happy talk about it being the best month for stocks in years. Don’t count on it. October has a history of rallying up until the options expiration Friday (last week), helped along by the usual rally into earnings season and a market-friendly Fed statement.

The rest of the month isn’t as friendly, and this month is unlikely to be any exception. There may be talk about rallies based on weak data staving off a Fed rate increase, but rallies without a positive earnings tailwind usually crash and burn soon afterwards. Earnings have been broadly disappointing so far for the third quarter, and we are on track for another quarter of year-on-year decline.

The casual observer may think that last week’s rally means all is well now, while the dyed-in-the-wool bull hopes it is so. The former may be forgiven for being deceived by the price action, but not the latter.

The upward pull on prices last week was from, in no particular order, the calendar, options expiration, and the raft of weak economic news (see below). The market usually does well in the first half of the month, as noted above, and a week of mostly disappointing news on the economy has many now convinced that the Fed will not raise rates this year. Part of that group is also convinced that the business cycle hangs on an interest rate increase of 25 basis points. That is not true. A jump-raise to one percent would certainly jolt financial markets and so is to be avoided, but as a cost of money one percent would mean little. It seems that most fear that the financial party may end as soon as the Fed raises rates, and while the former notion about a raise ending the business cycle is completely wrong, they may be right about the latter ending the financial cycle. The possibility that the Fed doesn’t raise rates at all this cycle, or never past the range of 25-50 basis points, is also growing steadily – keep in mind that both cycles are bound to end anyway. .

I am convinced that the cycle is in fact ending, but there are a couple of things to think about before you run away. One is that while the market is apt to run into some hard times over the next four weeks, the end-of-year rally is pretty sacred, even in bear markets. I suspect that stocks will also get some help from holiday sales. The growth rate of retail sales is in the danger zone and flashing red, but employment is still at peak levels and very few yet believe in the possibility of recession. Historically that has meant respectable holiday sales, and I can imagine the markets and even the Fed falling for the head fake, leading to a symbolic rate increase in December as a kind of token victory. Unfortunately, that last burst of holiday cheer has never done anything to change the real momentum of the cycle.

Only one thing could give the cycle an extension, and that would be a surge of money flows from some combination of credit and/or investing. I don’t see a burst from either on the horizon; indeed I would say instead that we are recently past the peak of credit issuance. Crazy deals were still getting done in the first half of the year, but things have gotten much tougher of late. As for investing, while the markets may indeed rise later on, there is no indication that everyone wants to suddenly get long equities. On the contrary, the prevailing mood is one of caution, not that a fortune lies waiting in stocks. It may be cautious optimism or pessimism, take your pick, but it’s definitely one of caution.

It’s possible that a few years from now, those who study such things (the Bureau of Economic Analysis) may come out and say that the expansion ended in the third quarter of 2015. We won’t get the first read on the quarter’s GDP until the end of the month, but right now it is tracking at about 1% (N.B. – official recession dates usually don’t begin with declines in official GDP, so that’s not a GDP prediction for the current quarter). Some may be counting on the notion that a weak number will keep the Fed on hold and thereby lift stocks, but it is likely to be cold comfort for another punk earnings season. It’s more important that the Fed can’t cut rates any further – not raising rates at a time of declining earnings and economic activity is hardly a cure for anything.

Calling the markets short-term is devilishly tricky, but that said I’d be on the sidelines for now. Some companies will surely do well this month, but a reporting season of declining quarterly earnings for the S&P 500 is no time to be moving into stocks. Wait this one out.

The Economic Beat

The report of the week was September retail sales, which were up a meager 0.1% and down 0.3% when excluding autos. An overlooked aspect of the report is that the trailing twelve-month (TTM) growth rate fell to 2.7%. Historically, declines below the 3% level have signaled an imminent end to the business cycle. The quarterly growth rate (year-on-year) was only 2.33% (unadjusted), the previous quarter below 2%. Employment levels are high enough to allow for decent fourth quarter sales, but such numbers can be deceptive, as noted above. In the early going, the last two recessions have seen fourth quarter bursts that featured good comparisons.

The news in manufacturing was decidedly weaker. The two leading regional Fed surveys, New York and Philadelphia, both reported negative readings at (-11.36) and (-4.5) respectively. More troubling were the cliff-diving plunges in new orders with both reports falling to around the minus-20 level (zero is neutral). New York has reported negative readings for five months in a row. That weakness could also be seen in the September industrial production report, with the headline index number falling by 0.2% to a year-on-year rate of only +0.4%. August was revised upwards thanks to mining and utility boosts (both would be weather-related), but the result is still two straight months of declines for both the overall and manufacturing indices. None of it can be blamed on adverse weather. The usual excuse-culprit is the dollar, but the weak economic data now has the market betting against rate increases and thus the dollar.

Inflation data was also helping to fuel the last wave of bets on soft monetary policy. The producer price index (PPI) declined by 0.5%, taking the year-on-year rate to (-1.1%), or a “robust” +0.8% when excluding food and energy. The consumer index (CPI) fell by 0.2% to a year-year rate of zero, though still at 1.9% excluding food and energy. The increase in rental costs is probably being understated in the latter, but that would be a worry if we were early in the cycle, or even at the mid-point. As the cycle ends, rents have a way of plunging.

The labor turnover survey (JOLTS) was steady, perhaps even showing an inflection point as openings declined slightly while the hire rate remained steady. Finally, the Fed’s Beige Book did its usual “modest to moderate” report, but I thought that the overall tenor was a bit weaker than recent months.

The big September reports are out of the way now, with weak growth in both employment and retail sales as the economy decelerates. FactSet reported that earnings estimates for the fourth quarter have now fallen into the negative territory. Estimates for the third quarter are for a loss of 4.6%, and while that has some cushion built into it, it presently looks like we are headed for the first back-to-back quarterly declines in S&P 500 earnings since 2009.

Next week will be mostly about housing, and while the sector isn’t booming this cycle, I don’t expect the same rate of weakening and expect that new home sales will hang in until the bitter end. The homebuilder sentiment index comes out on Monday, as usual followed the next day by the monthly housing starts report. Existing home sales are due on Thursday, along with the leading indicators report and the Kansas City regional survey. Kansas City was the Fed district to report a decline in the Beige Book. The European Central Bank has its latest statement earlier that morning.

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