The Search for Reason



“To-morrow every Fault is to be amended; but that To-morrow never comes.” – Benjamin Franklin (ed.), Poor Richard’s Almanack

Yes, the market did indeed turn in its first 1% down day since the election last week. Does that mean the Trump rally is over? Easy to say – the answer to that question is a firm, “who knows?”

Although the indices have been on a slow fade in recent days, in the short term it doesn’t mean much. The spring rally is just around the corner, and late March sell-offs are nothing new. It hasn’t been much of a sell-off, for that matter, being a matter of a mere two or three percent.

I don’t get a sense of capitulation by any means. We may have seen a bit of buyer fatigue, as traders lack convincing new reasons to keep marching higher, but despite the fright invoked last week by the failure to repeal and replace the Affordable Care Act (“Obamacare”), I would say that there is still a residual bid under the market. As we get to the end of the quarter, some buyers are going to step in to try to make up for being underinvested in a market trading at sky-high valuations with no good reason but sentiment.

Yes, earnings growth has returned, somewhat, thanks largely to the rebound in oil prices and the energy sector, which could both cycle out later in the year. Allowing for the usual discount to analyst overestimations, earnings growth can be roughly pegged at about 5% for 2017, though there is certainly hope out there that it will be more because you know, tax cuts and regulation are going to be magic, though neither staved off the end of the business cycle in the past. If earnings should grow by say, 6% this year, that means that they will have grown about 6% total for the last three years. This is something to pay a 25 times earnings multiple for?

As for the Obamacare fiasco, the stock market could care less whether it comes or goes, what it really has all its hopes staked on is those big tax cuts and deregulation. The GOP’s failure to put something together in health care to please all of its constituents isn’t really a surprise, given the fractious nature of a party grown accustomed to acting in opposition, but what rattled the market for a day or so was the fear that perhaps Washington is going to mess up tax cuts (“tax reform”) as well. The ultra-conservative Freedom Caucus wing of the GOP was opposed to any replacement at all for Obamacare, helping to sink the AHCA replacement bill. Since the Caucus has its roots in the Tea Party movement, it could pose a similar obstacle when presented a bill likely to be scored as sending the deficit soaring. President Trump’s proposed budget had draconian cuts in many programs to pay for more defense spending (and get rid of those damn do-gooders at the same time), but there may not be enough to cut if a trillion-dollar tax cut gets put up for review, not without too much pain in Congress.

That day of reckoning is still a ways off, however. The chief near-term risk in the market is the substantial overnight one of a political explosion coming out of the administration, but the stock market has never been good about worrying about such things for long and there is no sign that this time is different. Absent that – and politics are admittedly very difficult to predict – the market will probably march higher in April, possibly to new highs, on the usual charade of earnings “surprises” and the widespread knowledge that April, after all, is the best month of the year for stocks. All the recent softness has done is allow stocks out of their short-term overbought position with no real pain, setting things up for a nice move higher next month. Don’t look for reason from this market yet.

The Economic Beat

It was a mixed week for news that was on the light side and not really dominated by anything that wasn’t political in nature. The report of the week might have been the little-noticed Chicago Fed national activity index. Its result for February was the best in some time, up a whopping 0.34 (0=unchanged), which doesn’t look like much for headlines but is a good number. The moving three-month average rose to 0.25, its best showing since December 2014. Revisions will follow what is a preliminary estimate, but January was revised slightly upward and so there may not be any damage. As I have noted in recent weeks, the weather undoubtedly gave the month a lift. Weather has a way of giving back, of course, but it may not be right away.

The real longer-term key may lie in the price of oil. The Kansas City Fed’s regional survey rose to 20, quite high for that region and its best result in nearly six years. The Kansas City index spent most of 2015 and 2016 in the red as falling oil prices led to widespread production contraction and shutdowns throughout the oil and shale regions of the U.S. The recent rally has revived quite a bit of production activity that has also become more technologically efficient, and so lowering its cost of getting oil out of the ground.

It’s good news and bad news. High oil prices in the first half of the current business cycle meant a boom in oil exploration, drilling and production that was responsible for most of the growth in U.S. manufacturing for several years. The long slump in prices that followed oversupply translated into a prolonged decline – though not a crash – in national manufacturing activity, with regions like Dallas and Kansas City the worst hit. Now the rally has meant new multi-year highs for these regions, but being a commodity power comes with problems, as the Saudis and Russians (both economies having taken a big hit) can attest. The U.S. economy is at full employment but low growth mode, suggesting that domestic demand for oil is unlikely to move much higher, if at all, though there may be some market share to be won. The oil rally flattened out some time ago, though, and absent big production cuts somewhere – voluntary or not – it may be hard for demand to get ahead of the rapid response of U.S. production.

Housing is a mixed bag so far this month, with the pace of existing home sales slowing a bit to a 5.48mm annualized pace, a 3.7% monthly decline even as the year-year rate remains 5.4% higher. Tight supply has been an issue, but I suspect that mix is an issue as well with activity concentrated in the higher end. The new home sales rate rose by contrast to a seasonally adjusted 592,000 (592K), though the trailing twelve months rate (TTM) barely flickered from 562K to 566K. It’s the fourth consecutive month with a rate in the 560 range. Neither result was a surprise, as housing starts have been rising while pending home sales fell last month.

The Markit Economics purchasing manager indices have not been keeping pace with the regional or national surveys, and their flash March result on Friday showed some moderation in activity with its three indices all near 53, still decent but down from about 54 the previous month. That’s in keeping with the durable goods report, whose headline number was again buffed up by new aircraft orders: +1.7% overall for the month, but only 0.4% (below consensus) excluding transportation and more importantly, another anemic month for the business investment category. Outside of oil, U.S. corporations are not spending much on new plant and equipment, favoring financial allocations instead.

The coming week will bring more regional surveys from Dallas and Richmond, with not much real news until Friday, when personal income and spending for February are released along with the Chicago purchasing manager index. Another GDP estimate is due on Thursday, but the last one barely moved the needle and at this point the fourth quarter is getting to be old news anyway (though the stock market would surely fawn over any positive surprise – it has to, at these prices). The quarterly corporate profit update might be more meaningful.

The rest of the week has some scattered advance estimates in inventories, international trade and existing home sales. The real action gets going again the first week of April, when the jobs report and the national activity surveys are due.

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