“With the old Almanack and the old Year, Leave thy old Vices, tho’ ever so dear.” – Benjamin Franklin (ed.), Poor Richard’s Almanack
The Chinese new year doesn’t start until next month, but worries about China helped usher in a new year for equities on our own calendar last week. A couple of traditional rules of thumb went the wrong way and another appears challenged: First, the perennial “Santa Claus rally” that should last about a week lasted but two trading days after Christmas before fading and then disappearing entirely during the ugly first two days of the new year. Then are the saws about as the first week of January goes, so goes the month; as January goes, so goes the year
Just as buying begets buying during bull market rallies, selling begets selling during corrections and bear markets. Dips that were avidly, feverishly bought transform into bounces that are anxiously and quickly sold. The issue is the underlying backdrop – what the foundation is for the market’s broad trend of optimism or pessimism.
The answer isn’t so complicated, though it is rarely given an accurate hearing. In equities, it’s as simple as whether things are thought to be getting better or worse. Often the market struggles to decide which is really true, but when it does, the moves can become pronounced. For the feeling that things will be better, the sine qua non is the conviction that profits and growth are rising now and will be rising six months down the road as well. Sometimes the basis for believing the latter is flimsy, true, but it has to be there. Of secondary consideration is money flow – whether it is getting tighter or looser and by how much.
It may not be easy, but equity markets can rise if the central bank seems to be bent on tightening, so long as it isn’t getting too tight and the growth-profit condition is intact. Similarly, prices can fall if the profit-growth condition is being met yet money is too loose – runaway inflation. Right now, the amount of “tightening” by the central bank is laughable – the short-term federal funds rate is about 0.35%, one of the lowest rates ever. Yes, the course is towards higher rates, but if the Fed ever gets to 1% this cycle (which I doubt), one can hardly call it tight money. Long-time once-chairman Alan Greenspan has often been strongly criticized for leaving rates that low in the early part of the 2002-2007 cycle. In the meantime the bank is maintaining a massive balance sheet and very importantly, still reinvesting all of its maturing Treasury payments and redemptions. Banks are in no danger of seeing their reserves involuntarily shrink and so forced to constrict credit.
The real basis for the current selling pressure is the fear of declining profits and growth. The S&P 500 had overall profit declines for the second and third quarters of 2016; it’s no coincidence that the index declined over the last seven months. The profit declines were modest and concentrated in energy – so were the declines in the index price. The fourth quarter is lining up to be the third consecutive quarter of decline, however, and that is worrisome.
So when radio and television analysts talked at length last week about why the Chinese stock market or the yuan shouldn’t affect us, they were missing the point. The market is being spooked by the pace of yuan devaluation not because of its direct effect on the U.S., but because it points to weakening growth in China at a time when there doesn’t seem to be much growth anywhere around the globe. Worse, the pace of the weakening growth might be accelerating. That is something to worry about.
The latest indicators of the U.S. economy are covered in depth below. In the short term, equity markets are deeply oversold and approaching levels that almost demand a bounce, but first they have to get past the anxiety of panicky sellers trying desperately to bail on any rebound at all. Not everyone is convinced that one has to bail, but they currently outnumber those with deep convictions about buying, at least in these conditions. Bear markets rarely get going in January, but it has happened.
A good reason for concern is that beyond technical reasons for a bounce, it’s hard to see where a week of good news might come from. For that reason, corporate outlooks will be very carefully watched in the upcoming earnings season. The upcoming retail sales report (Friday) might help, yet even last week’s bonny jobs number couldn’t turn the trick. I’ve been saying that equity exposure needs to be cut substantially, so I will hardly say it’s time to jump in, but we are getting due for at least a short-term bounce. Given current anxiety levels, it may take another few percent of selling first before the weak-growth narrative itself gets oversold, and then we may see the classic short-squeeze reversal.
The Economic Beat
A tumultuous week was capped off by a big number from the December jobs report, with the seasonally adjusted (SA) number of 292,000 blowing past what had been consensus estimates for about 200,000 (200K). The result had been tipped by a big increase in the ADP payroll estimate two days earlier from 211K (November) to 257K, raising unofficial guesses to somewhere around 250K. It was still a sizeable beat, and included upward revisions to October and November.
The equity markets seemed unimpressed, and once again the usual jobs day rally barely materialized. The unemployment rate remained level at 5.0%. One item that might have held back the cheering was that hourly earnings remained unchanged. It’s probably fair to say that there was some suspicion about the nature of the new employees, with veteran trader Art Cashin pointing out on CNBC that nearly all of the jobs in the household survey (+485K) had gone to teenagers and those over 55, strongly suggesting seasonal part-time work; only 16K of those jobs went to people in the 25-54 age group. The household survey is volatile and it wouldn’t do to read too much into one number – the survey also says there are 760K fewer part-time workers than last December – but the jury seems to want more evidence before voting. At any rate, it isn’t the kind of number that would make the Fed more reluctant to raise rates, nor does it address the currently trending concern about international growth.
The year-on-year growth rate in payroll jobs has been remarkably stable in recent months – 1.92% in September, 1.96% in October, 1.91% in both November and December. The participation rate edged up to 62.6% (not better than the year-ago 62.7%), and goods-producing jobs edged up as well, from +39K to +45K (SA). Hourly earnings are up 2.5% over the last twelve months.
The size of the payroll increase was something of a surprise, though claims data has been reliably firm. The main criticisms seemed linked – earnings weakness could be a mix issue if the lion’s share of jobs was really going to holiday part-time help. Despite the big number, though, there just didn’t seem to be much to say about the report. It’s late in the cycle and the markets are getting increasingly skittish about signs elsewhere of fading growth, something easy to do when stocks are taking a beating the first few days of the year. The unemployment rate has been flat the last five months and unchanged the last three, and while hourly earnings are weak, that is old news. Employment is a lagging indicator – the rate was 4.5% in the month before the last recession started – and I am more focused on the results from the coming two quarters.
The economic week started off pouring gasoline on the Chinese fire. Equities were already deep in the tank when the ISM survey of manufacturing purchasing managers came out, so one can’t blame the blizzard on the few flakes of snow that showed up later. However, they don’t help, either. The ISM result was below the 50 neutral line for the second month in a row with a reading of 48.2, compared to last month’s 48.9 and consensus for about 49. The selling did deepen after the report was released, but not significantly so and recovered soon after the Europeans left for the day.
The survey readings were weak, with a growth-contraction score of six versus ten and a new orders reading of 49.2, also in contraction but a little better than last month’s 48.9 (the difference isn’t significant). The comments from respondents were in line with a slowdown, not a collapse, and featured an interesting mix between those complaining that low oil prices were bad for business (fabricated metal products, for example) and those happily noting lower energy costs (plastics and rubber). The ISM survey is by no means an infallible leading indicator, but as noted last month, readings this low that come this late in the cycle are something to worry about. The much-less followed Markit PMI survey was directionally similar with a decline to a still-above-neutral reading of 51.2.
The usual anxious faces appeared following the manufacturing survey with the admonition that manufacturing is only about 10% of GDP, and that services are far larger. That is true, but manufacturing owes its closely-watched status to its role as a more-sensitive leading indicator, not to its weight in the economy. I don’t know that post-WWII manufacturing has ever been above 25%. It’s certainly been true that non-manufacturing surveys tend to turn much later, only going below 50 when recession has actually arrived. The latest such survey showed further easing in December, from 55.9 to 55.3.
That decline is small and not large enough to be truly significant, but the reading was the lowest of the year and missed consensus at a time the stock market wasn’t in the mood for such news. The business activity index actually ticked higher from 58.2 to 58.7, based on seasonal adjustments. The growth-contraction score was a still-respectable eleven in growth versus five in contraction. Good if not great.
Reflecting the mixed picture, factory orders in November fell 0.2% in November, with October getting a downward revision to 1.3%. Year to date, they stand at (-4.2%).
I try to report most construction spending data with the caveat that the data is heavily revised, but the November report was a revision whopper. October was cut from 1% to 0.3%, September was cut to 0.2% from 0.6% and a data processing error was cited that affected monthly numbers all the way back to last January! November itself showed a drop of 0.4% versus expectations for a gain of 0.7%, a miss so large that the chances for an upward revision seem good. The year-on-year rate is still a respectable 10.5%, very close to the year-year rate of housing starts (11% overall, 10.5% single-family).
International trade for November was a good news/bad news report, with the good news being an upward adjustment to the running estimate for Q4 GDP, thanks to an improving trade balance. The bad news was that both exports (-0.9%) and imports (-1.7%) fell, with the improvement due to faster weakening in imports. Domestic demand falling faster than foreign demand is not the way one wants to see a country improve its trade balance.
Wholesale trade data disappointed, with sales comping negative (-2.0% year/year) for the eleventh month in a row. Inventories fell as well (-0.3%), leading to downward revisions for current GDP and some excuse-making about inventory corrections being normal and transitory. That’s true. It’s also true that big inventory corrections are called recessions and they too are transitory, so I’m not sure what the consolation is. The inventory-sales ratio is dangerously high, implying further downward pressure – this isn’t going to be a matter of one month or two to clean up the overhang, not with the ongoing weakness in sales.
For once a release of the FOMC meeting minutes went almost unnoticed. The principal takeaway was that “some members observed that their decision to raise rates was a close call,” perhaps more deliberate verbal soothing from the Fed. On the other hand, Vice Chair Stanley Fischer later went on CNBC with the “bad cop” approach, saying markets were underestimating the path of rate increases. I don’t think the Fed makes it to 1% before it has to reverse course, but I’m sure the bank will be wishing it had more room when it does.
Weekly chain-store sales were good in the last two weeks of the month, a good sign for the December retail sales report due out at the end of next week, the highlight of the coming calendar and the main feature of a very busy day (Friday). The end of the week will also see reports on producer inflation, the latest New York Fed survey (results have been terrible of late), December industrial production, and business inventories. Retail sales and inventory data will firm up Q4 GDP forecasts. Other reports include the labor market turnover report (JOLTS) on Tuesday, the Beige Book (regional Fed business conditions reports) on Wednesday, and import-export price data Thursday.