Hot Stuff


“Some like it hot, and some sweat when the heat is on” – Robert Palmer, Some Like It Hot

by M. Kevin Flynn, CFA

We had to double-check our eyes, but the major indices were all up last week, despite the six-day losing streak that Friday’s little party brought to an end. Some of them barely squeaked by – the Dow was up 0.04% – but the short-squeezing flurry at the close, ahead of expiration Monday (see below) pulled us over the finish line. Now what?

Regardless of what the press might have said, it wasn’t relief over the Chinese GDP print of 7.6%. Their official numbers aren’t taken that seriously, and the figure was expected. There was some relief around JP Morgan’s (JPM) earnings release, true, but again, it was expected. The market had gotten oversold and was ready to go, and all that was needed was the absence of bad news for another goofy rally on below-average volume that has been the trademark rebound of the last three months.

You’re probably thinking that next week will be at risk because of earnings. If so, then you haven’t been paying attention this year. It’s a possibility, we admit, but the market is apt to rally more likely than not next week, at least until Friday.

The press will try to explain next week that earnings are coming in better than expected, or that housing starts beat estimates, or some other pretext for the masses. Fuhgeddaboudit. This is New York, fellow citizens, and during options expiration week we trade up in earnings season. We did in January (when earnings turned in a poor report card versus expectations), we did in April, and you should expect us to do so in July. That is the gravitational pull of the market, and it’s going to take a lot more than complaints about the stronger dollar hurting earnings to throw out the trader’s playbook in a traders’ market.

Admittedly, it probably won’t be a huge week. But if the big banks can manage not to screw up their earnings reports – and going by the accounting practices featured last week, it looks like that’ll be the case – then the markets will take it as permission to have their scheduled move higher. Nothing is guaranteed of course, and if the news gets bad enough the jig will be up. But the markets trade more on expectations than reality, and the bars have been set low enough that it will take some pretty big stumbles to have the market lower going into Friday. Some companies will miss, and there will be more than enough cautious guidance to go around, but the payback for that typically comes the week after.

There is a European Central Bank (ECB) meeting next week, but it isn’t one of the policy announcement meetings. However, the financial ministers do meet on Friday regarding Spain, and for that we should expect a lot of spin and the potential for heightened volatility leading up to it. Our guess is that by Wednesday at the latest, the S&P will be looking to test 1370 again, little more than a percent higher from Friday’s close. As usual, Thursday presents a tougher obstacle, being heavy with influential news and earnings, but the swing factor may be the rumors and stories about the Spain meeting.

It’s the unexpected that will matter. We just came off a six-day decline and a trunkful of news stories about weak earnings and the likelihood of another summer swoon. Ergo, in the absence of comets hitting the Earth, markets should rally.

It’s after next week that you should be worried about. It isn’t good to put too fine a point on these things, mind you, and it’s certainly possible for next week’s data momentum to put a hole below the waterline, but given that the economy has really been moving sideways and estimates have been cut dramatically, the odds favor the playbook.

Things look much less promising afterwards. The fall from expiration week into mid-August has been pronounced the last two years, and there is good reason to expect it again. Earnings may beat estimates, but guidance is going to come down. There is some debate as to whether a weakening market could provoke the Fed into action with a slow fade, but we rather doubt that it will happen soon. After Friday, the S&P is back to being up nearly 8% on the year, the Nasdaq even higher.

The most likely scenario is that at least two of the indices (the S&P and the Nasdaq) are still positive when the Fed meets at the turn of the month, even if the week after next does run into bad weather. There are only two more jobless claims reports before then, and no jobs report. The seasonally unadjusted data for both series are simply not ringing any alarm bells, whatever disappointed traders may say.

Even if a couple of economic reports do come up short, without some dramatic externality it’s simply wishful thinking to make a case for Fed action at the upcoming meeting. Indeed, the Fed may very well feel that as the heart of the problem is overseas, buying US mortgage bonds would have very little effect at present. Better to keep something in reserve against the day that the EU simply can’t stick another patch on the tire anymore, or gives into some German-Finn fantasy that allowing markets to clear will do the job (it’ll do a job alright, we won’t contest it).

Of course, there is a decent chance that the growing LIBOR scandal worsens, but it would be unusual to see it erupt quickly. The usual protocol calls for at least a few more weeks of blanket denials (“I am not a crook.”) Afterwards come the limited denials (“however, it’s possible that the guy next to me was”), followed by the usual erosion to resignations for the common good, then a wish to put the matter behind me, and finally guest accommodations at Dartmoor.

We wrote last week in Seeking Alpha that markets rated to fade into the end of July, but we took our eyes off the calendar. Absent central bank action, it is still quite likely to be lower by mid-August than it is now, and a better-than-usual possibility remains that earnings overcome the gravitational pull this time around. All that said, the markets will be looking to go higher next week. Since we also said it’s a good time to lower your exposure, take advantage should prices rise.

The Economic Beat

The release of the week didn’t even involve data. We’re speaking of the FOMC minutes, of course, which so disappointed a market trying to live on not much more than promises and dreams of central bank easing. Perhaps the second-most important release of the week, so far as the market was concerned, was the news that JP Morgan didn’t announce a bigger loss from their bad trade, instead announcing a second-quarter earnings beat and a first-quarter restatement (though the beat involved some heavy-duty accounting work and some serious reserves release).

One might have thought that the big drop in jobless claims (from 376k to 350k) would have been the story of the week, but coming as it did with Labor Department seasonal disavowals, it was quickly thrown into the bin and forgotten. Even so, the lack of summer shutdowns for auto factories isn’t a bad thing for their regional economies. It may help offset the Midwestern drought that, beyond getting commodity traders excited, doesn’t seem to have penetrated Street consciousness.

Sentiment indices fell again, with the small-business index giving up its gains on the year and falling back to the levels of October 2011. The University of Michigan’s sentiment index also edged downwards, to a reading of 72.0.

The essential fact of sentiment survey readings is that they are backward-looking. As we have often remarked, one could do reasonably well in the stock market with a simple strategy of investing at sentiment bottoms – in particular, when forward expectations are lowest – and exiting at tops. October of last year, for example, would have been a very good time to get into the market.

Surveys also provide the opportunity to torture data into confessing a variety of differing stories. That said, the small-business readings did corroborate several trends in the economy. Employers have slowed down on hiring, but are not increasing layoffs. The level of capital investment remains weak – Alan Greenspan observed during the week that the level of fixed non-residential investment to cash flow is the lowest it’s been in the U.S. since 1935. That was also echoed by wholesale sales, whose year-on-year rate has been falling for eleven months in a row. The biggest problem cited by small-business respondents is poor sales.

The liquidity trap in the 1930s was partly due to everyone waiting for everyone else to spend – in particular, waiting for employment to improve before taking any risks. We would say that in this particular episode, we are mostly waiting to see what is going to happen with Europe. Despite the stock market’s big oscillations around the notion of whether Europe is about to get better or worse, the broad EU economy continues to steadily deteriorate. This is in large part because EU actions over the last two years have been almost entirely aimed at staving off a specific collapse, while broader dysfunctions continue to be matters for discussion only.

Warren Buffett was interviewed by the usual suspects around his appearance at the annual Sun Valley confab for media moguls last week, and his comments that Europe is seriously weakening of late, while US data indicates sideways progress (except for housing, which is continuing to improve off a low base), are a good indication of what is going on. As we get into the latter part of summer and the heart of the European vacation season, the odds of EU action before the fall continue to diminish.

It looks like the Fed won’t have to worry about price inflation in the fall. Import and export prices have both been falling and are now sporting negative year-on-year declines of between two and three percent. Producer prices unexpectedly rose a tenth in June, but we suspect that the huge 9% rally-cum-short-squeeze in oil on the last trading day of the month distorted the result. The year-over-year change is less than one percent (though with little rain on tap for the Midwest, food prices are going to start moving). Consumer prices are up next on Tuesday.

June retail sales are out on Monday, with consensus projecting an increase of 0.2%. There are broad slates of industrial and housing data next week as well, with the former including the New York Fed survey on Monday, Industrial Production on Tuesday, and the Philadelphia Fed survey on Thursday. Housing has the homebuilder sentiment index on Tuesday, housing starts on Wednesday, and existing home sales on Thursday. Leading indicators are also due on Thursday.

The wild cards are the Beige Book on Wednesday afternoon and Fed Chairman Ben Bernanke’s semi-annual testimony to Congress on Tuesday and Wednesday. We don’t expect surprises from either, just the usual painful spectacle of Congress revealing how little its finance committee members understand finance.

Earnings and options expiration week should be the larger factors next week. The July expiration Monday is up about 90% of the time, so it will take a real shocker in retail sales to stop a continuation of Friday’s rally. Citigroup (C) reports before the open.

Tuesday brings Goldman Sachs (GS), Coca-Cola (KO) and Johnson & Johnson (JNJ) before the open, with Intel (INTC) after the close. The S&P has been largely held up by big-cap staples and tech, so good reports from that quartet are mandatory.

Wednesday brings the last of the Gang of Four banks, Bank of America (BAC), with American Express (AXP, and one of the Dow leaders this year) and IBM after the close. Thursday has Morgan Stanley (MS), Google (GOOG) and Microsoft (MSFT), with Friday featuring General Electric (GE).

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