Pass the Pipe


“Everything is the way it is because we’ve all agreed that’s the way it is.” – Charles De Lint, The Onion Girl

In last week’s issue, I wrote that the coming week should mostly be about geopolitical concerns, and so it was – mostly. The exception was over on the Nasdaq, where the so-called “FANG” stocks (Facebook, Apple, Netflix, Google) fell out of bed Friday on the heels of some analyst downgrades. The FANGers had been leading the charge in the equity markets so far this year as managers and traders poured into them because 1) everybody else is buying them; 2) the growth rates aren’t bad and the stocks are very liquid (unless everyone else is selling); 3) everybody else is buying them; 4) you don’t want to get left behind in the performance race; and 5) everybody else is buying them. May as well play along, why buck the crowd?

This kind of behavior has been around on Wall Street forever, from the roaring 20′s nearly one hundred years go through every post-war decade. Even the 1970s had its “Nifty Fifty” stock bubble until the1973 recession and then stagflation put the market on its back for years. The behavior does go with every bubble, but to be fair, it also happens without bubbles. It always happens in the last phases of a bull market, though its mere existence doesn’t necessarily signal the end of a bull market. What it does signal is a lack of conviction about the potential for equity appreciation based on traditional metrics. Instead, it’s a game of follow-the-leader(s).

So some market trading did roughly trace geopolitical issues – stocks rallied for a time on the testimony of former FBI director James Comey because he didn’t produce a smoking gun that would mean the immediate downfall of the president. Had he produced a smoking gun, the market would have also rallied, but over the prospect of getting the less volatile and more true-blue conservative Vice President Mike Pence. Similarly, the UK stock market barely blinked over the poor showing of the Tory party in the snap election called by Prime Minister Theresa May. In an election meant to reinforce the Prime Minister’s hand in Brexit negotiations with a firm mandate, the Tories suffered significant losses instead and saw May’s own political survival cast into doubt. Wouldn’t you think that the Brexit vote might have taught the Tory party a lesson about trying to govern by referendum? It did teach UK traders not to flinch, however, because the initial Brexit sell-off was followed by a quick rally. After all, the world didn’t end two days later, so how bad could it be (currency traders did not take the same view)? It works until it doesn’t.

Equities here in the U.S. are certainly overdue for some sort of pullback simply to return to a less overbought state – the FANG plunge managed to pull this off for the Nasdaq, but not the Dow or S&P 500. Even two days in a row of trivial declines seem to invite determined performance chasing, however. In the meantime, the yield on the ten-year bond has fallen by nearly half a percent from its recent March peak, and is slowly but surely working its way back to pre-election levels. A word to the wise is that equities usually follow, giving an excellent opportunity to get out. But the stock market in toto never believes such warnings and in practice always seems to take its own temporary defiance as proof that nothing is wrong.

Then the bottom falls out. But before we can get to worry about that, let’s all be dialed in on the coming Fed meeting because what else can we trade on? The roaring economy? In the meantime, don’t believe the old wheeze that earnings will grow into today’s sky-high valuations. It comes along in the late stages of every business cycle, has never happened, and never will. It’s just opium for the masses, as Karl Marx might have said about markets had he ever been a trader. Pass the magic pipe and caveat emptor.

The Economic Beat

A quiet week for data left the field to geopolitical news, as expected. The highest-profile report of the week was probably the ISM purchasing manager survey for the non-manufacturing sector. At 56.9, it was down slightly from the previous month’s 57.5, though the difference isn’t significant. 17 of the 18 sectors reported growth, a very good score, though the prices component of the survey – the most sensitive leading indicator – dropped to just below the neutral level, at 49.2, well down from the previous month’s 57.6. I would expect the energy patch is chiefly responsible. The services survey from Markit Economics was also nearly unchanged, at 53.6 vs. 53.1.

The Fed’s little-heeded Labor Market Conditions index enjoyed another good reading at 3.5, virtually identical to the previous month’s 3.6. The irony is that last year’s rate of job growth was slightly better than 2017 has been, yet the index languished at or below the neutral level of 0 most of the year. Jobless claims are lower, however, as is the unemployment rate. The latest labor turnover report (JOLTS) for April was further evidence, with the now-familiar theme of openings continuing to rise while hires are either down month-to-month or flat year-on-year.

Wholesale trade was a disappointment in April, as both inventories (-0.5%) and sales (-0.2%) were down on a seasonally adjusted basis. That’s going to mean a hit to Q2 GDP estimates. Sales excluding petroleum are still up year-over-year, albeit mildly so, and the inventory-to-sales ratio remains elevated at 1.28, better than April of the last two years but otherwise quite high for the month.

Next week picks up considerably, with not much the first two days, producer prices on Tuesday being the only real report of interest, followed by a blockbuster Wednesday and Thursday. Wednesday morning will see May retail sales alongside the consumer price index (CPI), and the afternoon will feature the latest Fed statement, forecast and quarterly press conference. Thursday brings manufacturing surveys from both New York and Philadelphia, import-export prices, industrial production for May, and the housing market index (homebuilder sentiment), which presages the monthly housing starts report on Friday. Friday is also a quadruple-witching expiration date.

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