It Is Not All Clear


“And the whole world will sing, when they sound the last all-clear.” – Charles-Elton, When They Sound the Last All-Clear

There’s trouble brewing in this market, of the sort that will only exacerbate the ongoing outflows by retail investors.

On the one hand, we have had a massive surge in complacency in certain quarters that is being used as a kind of cover story for the markets. In brief, the mantra is that the US has all this wonderful economic news; Europe is going to muddle through; China is going to ease; and it’s a presidential election year. Returns of twenty percent or more are pretty much in the bag this year, and it’s just a question of outrunning the rest of the pack, leaving all the cautious chumps behind.

This cover story, which isn’t really believed outside of the lands of long-only and trend-chaser, has sucked in the latter to the extent that the AAII indices of individual investor optimism are at peaks. Helping the story along is low volume and more importantly, less selling. The long corner of the investment world has been putting money to work. After taking a beating last year, European investors have been desperately looking for reasons to get the new year going in a positive direction.

Yes, somebody has been buying. The last eight trading days in a row, the US equity markets have opened lower, only to find a bid within an hour or so of the open. The only time this year the market hasn’t closed higher than its lunchtime level was the first day, when it gapped so steeply at the open – nearly three percent higher after ninety minutes of trading – that traders felt obliged to take some money off the table.

In other words, the market is being supported, but by whom? We can’t tell you, but we are sure of one thing – it isn’t the kind of money that sticks around when trouble comes. It looks to us like the goal is 1325 or the middle of February, then see you later.

Suppose the cover story is true though, you may say. Why shouldn’t the market go higher? Let’s look at the U.S. part of the equation. Last week we remarked Nomura Security’s assertion that certain economic reports had been off the mark in recent years. Due to the 2008 crash and the two quarters of contraction that straddled it, the fourth quarter of ’08 and the first quarter of ’09, we’ve had seasonal adjustment factors that were overstating activity in quarters four and one, then understating them in the second and third quarter.

Subsequently the Philadelphia Fed, whose survey had been cited by Nomura, has revised its figures downward for 2011, and indeed that was the case. The numbers released during the first quarter of 2011 weren’t as good as advertised, and neither was GDP. The dip in the middle of the year was also overstated, and of most relevance today, the fourth quarter wasn’t quite as robust as the first blush. We’re cruising for a disappointment.

There’s more below, but first let’s have a look at Europe. Its liquidity crisis has been deferred, maybe indefinitely, by the new LTRO facility that allows banks to get three-year funding from the ECB with all manner of collateral. That takes a sudden failure of the sort that finished Bear Stearns and Lehman Brothers off the table.

That’s a definite plus, but what it does is stretch out Europe’s problems in a different way. The problem of all the bad debt hasn’t been touched, and the recession that has started is going to get deeper. Perhaps this is what is meant by “muddle-through:” so long as there is no overt risk of overnight systemic failure, a willingness to bet on risky assets.

We think that the latest manifestation of the Greek crisis will get smoothed over again, perhaps setting off another market rally, but all of this just postpones the inevitable. The periphery countries have too much bad debt in the system, and keeping them afloat on more debt-and-punishment programs only prolongs the agony and the impact on the rest of the global economy.

As for China, no property bubble anywhere has gone unpunished and it will have its day of reckoning. The authorities may or may not succeed in pushing it off to 2013. We don’t share the common belief in their omnipotence, but easing will usually buy a few extra months and it’s reasonable to expect the attempt.

Last year the markets rallied in a near-unbroken line from the end of the summer to the middle of February. This year the move started one month later, at the end of September. It’s been a little choppier, but the essential fact to keep in mind is that the current move is led by trading money that is only trying to slice itself a similar piece of profit. It probably has no belief whatsoever in the solvency of Europe or China, the strength of the US economy, or much besides central bank liquidity. It’s here for the trade only.

So you should know as well that there is no all-clear yet, whatever is being peddled in the marketplace. The markets will probably open higher on Tuesday, despite the fresh European worries, because the markets nearly always rally the first day of options expiration week in January (such resilience, the talking heads will exclaim!). It’s just a trade. Take prices for what they are, including any “breakout” to 1325 or environs thereof – signals from a trading game run by agnostics who have more money than you.

When Europe truly confronts its debts, it will be time to invest again. Until then, the prices that you see are for trading only.

The Economic Beat

The economic news was not good last week. It wasn’t terrible, but it certainly should have done more to shake the recently complacency that has suddenly permeated much of the investment world. Ten days ago, we were reading reports proposing that fourth-quarter real GDP would come in at 4% annualized. We’ll be surprised if it isn’t less than 2.5%; that’s what the noise of the stampede can do to the Street.

To begin with, December retail sales laid an egg. The consensus was for a rise of 0.4%, but the whisper number was really 0.5% and many were hoping for even more. The actual number of +0.1% was a surprise, but could be partly excused by an upward revision to November (October was also revised up a tenth of a percent). But the ex-auto number actually fell by (-0.1)%, and sales excluding autos and gasoline were flat. That resulted in immediate cuts to fourth-quarter GDP estimates.

On a combined November-December basis, sales were still up 4.1% year-on-year, so retailers could claim that the season still met expectations. It’s clear from the many warnings emanating from most of the apparel vendors, however, that sales gains came at the expense of margins. What’s more, the first week of January sales showed sharp deceleration. It could be a one-off, but it would be in keeping with 2010 and 2011, when consumers would open their pocketbooks for special occasions (Christmas, Easter and back-to-school) and were cautious the rest of the time.

Another hit to GDP estimates comes from the international trade balance report for November. The deficit expanded by more than expected, with imports rising on account of rising energy prices and exports falling. Net imports are subtracted from GDP, ergo the number goes down. The energy part of the equation weakened in December, as import prices fell (-0.1%), hopefully lowering the amount of money we sent abroad. However, export prices fell even more (-0.4%), and judging from the many earnings warnings, the amount of goods we sent abroad slipped as well.

A third negative sign was a spike in weekly jobless claims. One week isn’t that much to get excited about, and there is usually a spike at this time of year. However, since 2000, only 2009 and 2010 have seen higher levels (unadjusted) than last week’s number. We expect another week of elevated levels as the seasonal help hired for December gets pink-slipped and processes their new claims.

Finally eurozone industrial production weakened to a (-0.3)% rate year-on-year in November, and there is plenty of anecdotal evidence that the weaker EU members didn’t improve their lot in December. It appears increasingly likely that the eurozone entered into recession in the fourth quarter, and the first quarter appears to be worse.

We probably ought to mention business and wholesale inventory reports for November as well – the mild data reported points to no inventory boost to Q4 GDP with one month to go. Consumer sentiment, as reported by the University of Michigan, rose to its highest levels since May, which also came upon the heels of a stock market rally and turned out not to be a harbinger of anything but yesterday’s headlines.

When sentiment numbers are low, market observers like to stress the poor correlation between sentiment and spending. They are right. When numbers are rising, though, all one hears about is how it’s another sign of a great economy. The most important driver of spending is income growth, whether from higher wages, increasing employment, or both. The most recent trend in income is that annual growth in real disposable income has been on a negative trend the last few months. The anemic retail sales report underscored that.

The big pop in consumer credit in November reflected consumers dipping into savings (or credit resources) to finance Christmas spending. It was the biggest jump since 2001, in the aftermath of 9/11, and in a sadly misguided piece of irony, the folks at Econoday completely missed the significance of this and instead construed it as a “significant plus” for the economic outlook. Perhaps they ought to look back at the episode more closely, given that it came during a recession (yes, it came at the end of the NBER-dated period, but the stock market fell for another year).

What it reflects is crisis fatigue. Consumers get tired of being fearful and will bust out and do a little spending from time to time to feel better. In tough times, they do it for the holidays and the kids. As economist Laura Tyson pointed out in the New York Times on Saturday, deficit spending by households is “neither healthy nor sustainable.” The problem remains weak demand, both here and abroad.

Next week the focus will shift to earnings, as the season gets underway in earnest. Tuesday will see two more reports from the Gang of Four: Citigroup (C) and Wells Fargo (WFC) both report results before the market opens. The New York Fed reports its January manufacturing survey an hour before the open as well.

Continuing with the financials, investment banks Goldman Sachs (GS) and Morgan Stanley (MS) report Wednesday and Thursday, while remaining Gang of Four member Bank of America (BAC) also reports Thursday. The latter will doubtless be facing questions about that downsizing report mentioned above. American Express (AXP) reports after the close.

On the non-financial side, Thursday is the biggest day: Google (GOOG), IBM, Intel (INTC) and Microsoft (MSFT) all report after the close. As usual, General Electric (GE) will follow on Friday morning.

Turning back to economic releases, December Industrial Production comes out Wednesday and the Philadelphia Fed survey Thursday. Housing has a big week too, with the January homebuilder sentiment index Wednesday, December housing starts Thursday, and December home sales on Friday. Enjoy the Monday holiday, because the rest of the week will be intense.

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