Summer’s End


“Oh, how shall summer’s honey breath hold out against the wreckful siege of battering days” – William Shakespeare, A Midsummer Night’s Dream

It was an interesting week for discussion in the investment world, less so for clarity. The markets rose a bit, but not more than they usually do in the September expiration week (“quadruple witching”). The merits of the new Fed quantitative easing program dominated the discourse, but probably few minds were changed. The verdicts on whether the newest addition to money-printing will lead to rising inflation, currency and trade wars, fiscal irresponsibility or the heartbreak of psoriasis are probably a long way off. Too long for the attention span of traders.

Or are they? It’s important to remember an oft-overlooked truism about the market: the tape makes the news. The common misperception is that daily market rises and falls are grounded in the economy, but that is because the business press labors to explain it that way. When prices are rising, reporters decide that the news of the day must have been good, and vice versa. Prices do follow the economy in the long run, but the chief cause of higher prices on a day-to-day basis is the sentiment that prices are rising, with the same going for falling prices.

Right now, there is a widening disconnect between the economy – which is slowing – and the stock market, which is rising. While the behavior of the latter has much of the press talking up how great housing is (hardly anything else is getting better), and isn’t it wonderful that the Fed is saving the economy, there has been a fair amount of dissension about “QE-infinity” in the investment community. Up or down, every market trend has its detractors, but the prominence of many of the critics hasn’t escaped the notice of traders.

More importantly, the critics have gained a bit of credibility from the markets. Yields on long Treasuries spiked in the wake of the FOMC announcement, but quickly recovered most of their losses. It’s never comfortable to see bonds heading the other way. Oil prices sold off. The sharp decline in transportation stocks was eye-catching for market veterans: Federal Express (FDX) cut its earnings projections amidst a dour outlook on global trade and China. The credit rating for competitor UPS was cut. The rail stocks got a prominent downgrade and Norfolk Southern (NSC) followed up by pre-announcing an earnings miss.

Transport stocks are thought to be more cyclically sensitive, which is why they are a cornerstone of “Dow Theory.” Whatever the fearless 35 year-old Whartonite fund manager may think of such ancient chants, Dow Theory gets a lot of respect on the trading floor, particularly with market veterans.

That said, it’s fair to say that the level of worry chatter is about average. The stock market was still up last week, is still technically overbought and there is still much complacency. Despite the fretting above, many are convinced that all will be trumped by fearful hedge fund managers leading a general buying charge in the last quarter by institutional managers worried about underperformance.

The week following expiration is usually a down one (Friday’s late sell-off was probably pre-positioning, along with the drop in oil prices), so that should ease the market out of its overbought stance. The issue of complacency and the performance race are different matters.

Trends in market sentiment have a knack for defying rational behavior. Market momentum should be enough to carry prices higher in the early part of October, but slipping past what is going to be a dismal season for earnings is going to take some conjuring. On the side of the magicians are operating margins near all-time highs, and the usual Wall Street practice of quietly making draconian estimate cuts in the two or three weeks leading up to quarterly reporting season. This ensures the usual ratio of upside earnings “surprises.”

They will have to contend with the gloomy number of companies that are going to report revenue and earnings declines from the third quarter of 2011. You’d be surprised how well the Street can slip past such pesky numbers (“we’re looking forwards, not backwards”). The real danger comes from management guidance. Cuts in next year’s outlook are much harder to deal with, as will be a lot of executive frustration with trade and government. That the Street is too high with its 2013 projections is nothing new, because the Street is always too high this time of year. It’s one thing for management to nod and say, well, we’re going to try to get there, but another for them to declare business just won’t be as good.

Over in Europe – the other source of rallies – Spain is said to be working on some kind of bailout deal that can avoid the dreaded troika, Greek discussions took a time-out and its yields fell below twenty percent (such a bargain). Portugal is in the news with divisions over pension reform. If any of the foregoing can avert immediate disaster, then markets can rally off the miss, though none of it will do anything to help the deepening European recession. France’s economic decline is worsening, leading Prime Minister Francois Hollande to plead with German Chancellor Angela Merkel for pro-growth policies. The grand restructuring bargain Europe needs to get out of its hole is not yet visible.

The Fed and the ECB have largely emptied out their kits, removing a key source of optimism for the stock market. There’s no more easing carrot left to dangle. Any doubling down on QE going forward is only going to frighten the markets (a big disadvantage of no end-date for QE-infinity is that it takes away the possibility of a fresh fix – whether it would work or not, it’d be something to trade on). We need some crises to avoid, or stocks are going to take a tumble next month.

The Economic Beat

The argument for the market to go higher certainly isn’t the economy. The New York Fed survey is down two months in a row, the Philadelphia five, with the market rising all the time, something that hasn’t happened before. One argument going around since Uncle Ben dropped the big one is that the economy will simply turn and follow the stock market. Silly me, I thought it was the other way around.

The Philadelphia reading wasn’t as negative as August, with to a relatively small decline of (-1.9), and new orders a positive 1.0. In other words, both readings were close to unchanged, with the overall index slightly negative. These are diffusion indices. so no change from August means no rebound either. It’s a bit worse than it may appear.

As the recovery has leveled off into a low-growth state, it has translated into somewhat more volatile numbers from modern just-in-time inventory management. Rather than being indicators of accelerating growth, spikes in production have been restocking episodes. Sharp drops have been inventory runoffs. The steep decline in August industrial production ought to imply positive September numbers for both surveys – if we are still running at the same trend, then a spell of reloading should follow the plunge.

The Philadelphia number does appear to reverse on the chart, as it is less negative. Wholesale sales growth and inventory build rates have declined to the lowest levels of the recovery, yet inventories were on the high side in July. That partly explains the August slowdown in manufacturing (-0.7%) as a rebalancing of stocks. Even with 1.5%-2.0% GDP growth, we will soon need another period of restocking, yet the Philadelphia survey previewed no improvement for the fourth quarter.

The survey did show optimism for six months out, which fits in with manufacturer expectations that the pressure to refresh will build. That it won’t happen until the new year is probably based on a combination of both a calculus of inventory runoff and a sense that the fiscal cliff issue will be resolved one way or the other by then. While the six-month outlook isn’t terribly accurate as a rule, the reality that inventories are running low in certain areas seems to be supported by the data.

I don’t see this as evidence of a recovering economy, but a non-collapsing one. So long as we aren’t falling off a cliff, there are inevitably going to be episodes of inventory replenishment, even running at zero growth. That the New York and Philadelphia numbers are negative in September, even if the Philadelphia decline is small, is ominous after the sharp August drop in industrial production. The Markit “flash” PMI showed a reading of 51.5 again, which suggests that the national ISM (PMI) should come in right around neutral again (the Markit flash number has averaged about a point or two higher than the actual ISM).

What was notable about the Markit report was the continued weakness in exports. For that, look no further than Europe. China is importing less from us as well – around 70% of the trade deficit comes from China (though we’re buying less from them too). The growth in global trade is unusually low now, and threatens to push our stall-speed economy into a mild recession in 2013. There won’t be much either presidential candidate can do about it – the core problem is in Europe.

Next week’s batch of regional industry reports (Dallas, Richmond, Kansas City and Chicago) should help clarify the situation. The market will probably pay more attention to August new orders for durable goods, but it may not be as timely a clue for where we are headed going into the fourth quarter. 45% of the Philadelphia Fed respondents predicted deceleration heading into the fourth quarter, and another 20% saw no change.

Playing in counter-point to manufacturing is a mild improvement in housing. With the market up on the year, the strength of the recovery is getting exaggerated reviews in a press that needs a better-sounding excuse than central bank money-printing. The real level of housing starts and sales has been steady the last four months, with the improvement noise coming from seasonal adjustment factors.

While the improvement in housing is undeniable, it has also been undeniably slow and undeniably boosted this year by homebuilding executives with an eye on the stock price. Not only is the level of starts this year still below the recession level of 2008, it is below every other year before that going back to at least 1959 and probably World War II. Starts were up in August, though not as much as expected, while existing home sales exceeded expectations.

Mortgage availability remains very tight, and there has been more weakness of late in purchase applications. The Fed has said it’s buying mortgage-backed bonds to keep rates low and homes affordable, but we would add that it’s quite likely that it is also trying compress profitability for the banks, thereby pushing them into relaxing lending standards. More loans would be one way to make up the loss of margin. Next week will deliver the Case-Shiller price index on Tuesday, new home sales on Wednesday and pending home sales on Thursday.

With the stock market putting in a good performance of late, Tuesday’s consumer confidence report is expected to post a good gain. For that reason, it may get more media attention than any other report. The durable goods report and GDP revision on Thursday are of interest, but if they are not up to expectations they can be easily dismissed as pre-QE data. It all depends on the market’s mood. We would say that the key reports are the August personal income and spending report on Friday, followed by the Chicago PMI. It’s also the last business and trading day of the quarter.

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