The Hunt for Black October

“Damn the torpedoes, full speed ahead!” – Admiral David Farragut

It was a week of waiting last week, and that may be a short-term bullish harbinger for equity markets. Although the very mild three-week streak for the major winning streak came to a close, the market really hasn’t gone anywhere since it’s post-Brexit, we-didn’t-die breakout-rebound in July. It’s been sideways since that time, with bouts of volatility from time to time.

The coming weeks offer a good opportunity to break through that, despite the October reputation as a crash month. Although the latest jobs report (for more of which see below in the Economic Beat) resulted in a down trading day that was somewhat contrary to form – during bull markets, equities are supposed to rally on job Fridays – there wasn’t enough evidence in any direction to convince the market that either the Fed must act soon, or that the business cycle is ending this month.

The latter point is important. Despite the bravura talk about “Goldilocks” scenarios and outlooks that implicitly assume a business cycle that never ends, there has been growing anxiety below the surface of index trading about the state of the economy and by extension, corporate profits. GDP growth has slowed to minimal levels, jobs growth has slowed to low levels, retail sales have slowed to stall speed. It’s been quite a while since we’ve had a genuinely good earnings season. The bull market is old, and there is very little evidence of solid growth anywhere in the world.

All of the above could lead to new highs for the stock market this month (of course). As we enter the beginning of third quarter earnings season, not much is expected but there is a crucial difference – earnings growth. According to the latest FactSet, “it is likely the index will not report a decline in earnings for the third quarter.” Although the current top-down estimate for the S&P 500 is for a 2.1% loss, there is generally a cushion of around 300 basis points built into such projections, implying analysts expect a gain. Replete with the usual positive earnings “surprises,” of course, and with defiant optimists announcing we are now ready to begin “the next half” of the recovery.

We’re currently in a classic “wall of worry” phase, when stocks don’t need actual good news to rally, only the absence of the worst fears coming to pass. With a positive earnings season in view (however minimal), improving prospects for a Clinton victory in four weeks (the Street hardly loves the former Secretary, but it really, really doesn’t want her volatile and unpredictable opponent), and no Fed meeting this month, all we need is no meltdowns to grind higher. The FOMC is scheduled to meet at the beginning of November, but nobody expects them to pull any surprises one week before a presidential election.

The principal headwind the markets have to deal with in the coming weeks is the earnings and valuation conundrum – valuations are already uncomfortably high by historical standards, and earnings growth has been difficult to come by. A final tally of 1% isn’t much to get excited about, though many will claim to see signs of a major rebound. The coming retail sales report (Friday) seems to me to be set up to disappoint, and that could reignite growth fears, but even if that should come to pass, it would probably be drowned out soon afterwards by the usual palliative that “this will keep the Fed on hold” and the general din of earnings season. Corporate outlooks will be key.

Forget the argument about whether stock prices “deserve” to go higher – deserving has nothing to do with it. The game is still going to be on until it’s clearly over, and so long as the evidence is still mixed, Wall Street isn’t going to throw in the towel. The arguments for staying invested in equities may be getting thinner and thinner, but they won’t go away until it’s too late.

The Economic Beat

The report of the week was of course the jobs report. The reaction to September echoed the August reaction in many ways, principally in being a somewhat modest number (156,000) that was very much like the original August estimate of 151,000 (both numbers are seasonally adjusted, or SA). Both numbers were a bit below consensus for something about 20,000 (20K) higher. In the wake of both, Wall Street soothsayers hastened to get into print and onto the airwaves with the proclamation that the number was more evidence of the “Goldilocks” economy. It could not have been better, sir.

Average hourly earnings growth increased from 2.4% to 2.6% year-on-year (y/y), and average weekly earnings grew by 0.5% on the month, to 2.3% year-year. The comparisons benefited heavily from a weak September 2015 report, when hourly y/y earnings were virtually unchanged and weekly earnings declined. Other positives included something of a catch-up number in the household survey, where a 354K jump helped it get well ahead of the payroll survey in y/y gains: 3.0 million (mm) for the household survey, 2.4mm for the payroll category. The household survey is much more volatile, but the two do converge over time.

The unemployment rate did increase to 5.0%, though this was due in part to a drop in the category of people not in the labor force and an increase in the labor force that was slightly ahead of the increase in employed. The participation rate edged up to 62.9% from 62.8%, while the employment-population ratio edged up 59.8%, both about a half-point better than a year ago. Manufacturing lost jobs for a second straight month, with the service sector taking up the slack. The initial estimate for private sector growth of 167K (the government sector showed a net loss last month, unusual in the run-up to a presidential election) was not far from the ADP estimate of 156K. Revisions to the last two months – one up, one down – cost the seasonally adjusted total 7K overall, though it is worth noting that estimates of the unadjusted count fell for both July and August. Overall I would say look at the record lows in the last two weekly uninsured employment rates (1.3%, NSA) and conclude that we are at full employment, have been at full employment, and the jobs growth story is ending.

The ISM surveys were mixed, but Wall Street greeted them both. The manufacturing survey improved somewhat to 51.4, up from 49.4 and beating fears for another sub-50 reading. The improvement is quite modest and taking the months together would signal sideways activity, with the sector growth score still in contraction at 7 growing versus 11 contracting . New orders improved to 55.1, however, so perhaps better times are ahead. The non-manufacturing side reinforced the sense of well-being by rising to 57.1, with a good sector growth score of 14-4. Prices improved to a reading of 54.0, so there certainly appears to be a pickup from August.

Factory orders rose 0.2%, and the seasonally adjusted numbers for cap-ex spending are getting some rather misleading play as signaling a recovery. The numbers have been positive the last two months, but only because the year-year comparisons this year are not as bad as a year ago. They are still down not adjusted, just by not as much: August was down 1.3% unadjusted compared to a year-ago (-4.4%), but that’s not much of an improvement. It did improve the trailing-twelve-month (TTM) total to (-3.9%) from (-4.2%), but the former is still quite weak and the last two TTM months are the worst since May 2010, when the trend was moving upward. It looks to me as if the declines in the manufacturing sector are flattening in the last couple of months, but they are still declines and I expect further declines down the road after a pause.

Wholesale trade also posted a surprising rebound in August, with the initial seasonally adjusted estimate posting its first year-year gain in twenty months! The calendar may have played a role here, as the July NSA decline was especially sharp and the two months of July-August combined essentially canceled each other out. Shipping, strike, and seasonal considerations (August begins holiday ordering) may have also played a role. For now the TTM rate remains at (-2.6%) and the inventory-sales ratio at 1.33, about the same as a year ago this time and still too high. Ironically, the data mean no inventory contribution yet for this quarter’s GDP, although sales did improve.

Next week the big story will be retail sales and the beginning of earnings season, though we will have to wait until Friday for the former. Other reports on the calendar include the labor conditions index on Tuesday (little-watched, maybe even by its Fed-creators), the labor turnover report (JOLTS) on Wednesday, followed by the release of the Fed meeting minutes Wednesday afternoon. The latter could lead to a brief bout of buying or selling if traders think they are more hawkish or dovish than thought. That seems like an obvious enough statement, but the point is that absent some startling revelations, the reaction will almost surely be brief.

The week will round out with trade prices on Thursday and producer prices on Friday.

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