Irrational Exuberance II


“How do we know when irrational exuberance has unduly escalated asset values?” – Alan Greenspan, December 5, 1996

“What was that all about?” Such was the question most of last Wednesday and its immediate aftermath, when the equity markets staged a seemingly magic rally out of nowhere on no real news to speak of.

Before I weigh in, keep in mind that most market observers try to justify whatever may be going on in the equity markets as more or less reasonable. As a rule, you are not going to hear stories about dubious machinations, because the safest rule of thumb is to allow that while they may occur from time to time, one can’t going around repeating a bunch of rumors that may be just that, or even counter-machinations, and in the end markets find their true value anyway, right? Of course they do.

With all of that said, the main reason for last week was a staged technical breakout fueled by a major overdose of “nuthin-but-blue-skies-ahead” optimism. The latter you ought to know about by know: despite the occasional warnings from the more sober types, the market is largely bent on seeing only the best possible outcomes from a change in the administration.

This good feeling is being aided in no small measure by a fervent desire to see prices continue to march higher into the end of the year. Bonuses, asset measurements and client happiness are at stake, thanks to our obsession with calendar-year measurement. It always happens at this time of year, no matter how bad the news may have been. This time around we are going from zero returns to up single digits, maybe even more, but when we have been in the middle of a recession and the markets were failing, prices have usually still found a way to march a good five or ten percent off of their lows. It’s just the way it is.

The day before the Wednesday breakout, the trading talk had turned to the possibility of the Dow Jones Transportation average possibly making a new high. The importance of this, excited traders noted, would be that it would confirm the new high in the Dow industrial average as valid and thus provide a major buy signal. What a surprise the next day that a group of traders suddenly started buying up the Dow Jones Trans right at the open, triggering a new high and leading to preprogrammed buying on no news at all.

It’s usually impossible to argue with a momentum rally until it has run its course. A relentless run of higher prices has a way of cowing skeptics until it’s over – who wants to look bad? Instead we try to dig up more explanations on why the market can’t be wrong. Strategists come under pressure from their sales departments to think of more buy-friendly outcomes. Bond market participants, who have little professional skim in the game, are free to maintain a chorus of doubts – as is the case now – but those rising-price headlines cast their own magic.

Right now the market is as short-term overbought as it’s been in years, and is trying to take out new degrees of being intermediate and long-term overbought. At any other time of year but December I would expect an imminent pullback of respectable size, but this month we may get no more than a pause. The current index options layout suggests a Friday close near 230 on the SPYder, or near 2300 on the S&P 500. We might get there.

It is indeed irrational exuberance all over again, but the most important difference between 1996 – when former Fed chair Alan Greenspan first made his infamous remark about irrational exuberance – is that 1996 was in year four of its expansion. We are now more than seven years into the current one, and nothing is more dependable in this world than the fact that business cycles do not last forever. You may not want to fight this rally, and understandably so, because it may well have more room to run. But it’s going to end up as another episode of “what was everyone thinking?”

The Economic Beat

Last week was a quiet one, with perhaps the most important news being the stock market’s own self-infatuation. The report of the week was probably the November ISM non-manufacturing purchasing survey. One doesn’t hear much about it in the regular news, but the survey showed a respectable increase to 57.2, where 50 is neutral, from 54.8 the month before. The sector score was a very good 14-2, but the responder comments seemed far more muted. Perhaps a month of rising stock prices will convince the participants that good times are inevitable. It bears repeating once again that the surveys have historically not been good indicators of future developments.

Factory orders reported a big increase of 2.7% in October, thanks to orders for new aircraft. Excluding transportation, orders were up 0.7%, but core business cap-ex orders were negative on a year-year basis, down by 4.2% from a year ago and the eighth consecutive month of negative comps. Were it not for the extra leap year day in February, every month this year would be negative. Year to date, the category is down 4%, while overall orders are down 2%.

The labor turnover survey (JOLTS) for October again showed openings down slightly from the prior month, slightly up year-over-year, but hiring down from a year ago. The growth in the labor market is nearly over. However, the Fed’s little-noticed Labor Market Conditions Index showed another positive number, the second in a row, at 1.5. The number is subject to large revisions. Wholesale sales improved in October on a year-year comparison for the third month in a row, mostly because last year was so bad – sales are still below 2014 levels. Inventories contracted slightly, but the inventory-to-sales ratio remained at very high levels for this time of year.

This Wednesday will be the day of the month. At 8:30 we’ll get the first estimate of November retail sales (also producer prices, though only a real surprise number will matter there), followed by industrial production at 9:15, business inventories at 10 and finally the piece de resistance, the Fed statement at 2 PM, replete with updated quarterly and annual forecasts.

The days leading up to Wild Wednesday will be quiet on the economic front too, with nothing scheduled for Monday and only import-export price data on Tuesday, along with the small-business confidence index. This is the pivot week for the month, though when we pass Christmas, prior news usually falls off the radar. Thursday and Friday are big days too, with both the Philadelphia and New York Fed banks reporting their monthly manufacturing surveys, the two most influential of the month. We’ll also get weekly claims, the consumer price index (CPI) and the homebuilder sentiment index.

The sentiment index is always followed the next day by housing starts, so Friday will see November starts prior to the beginning of “quadruple witching,” when quarterly S&P futures options expire along with monthly options.

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