Midsummer Scheming


“That you have but slumbered here, while these visions did appear.” – William Shakespeare, A Midsummer Night’s Dream

by M. Kevin Flynn, CFA

Last week certainly played out to form. The markets began with a little wind at their backs from the bounce off the previous six-day losing streak. It was options expiration week, usually a positive in July, and the 1370 level on the S&P was beckoning on the charts as the top of the trading range. Earnings estimates had been cut and the season talked down to the point that very little was needed to provide a relief rally. It was classic trading stuff.

In the midst of the hopeful banter, little attention was paid to the reality that earnings are slightly down year-on-year, more than half of companies reporting are coming up short of revenue estimates, and that the quality of earnings beats is weak. Most of it is coming from draconian estimate cuts barely two or three weeks old, along with stock buybacks, accounting help, and more cost cuts.

The weakness in revenue gains led to a mighty mid-week rotation out of consumer staple stocks like Wal-Mart (WMT) and Whole Foods (WFM) into big-cap tech stocks like Google (GOOG), Amazon (AMZN) and Priceline (PCLN), the common theme being “proven revenue growers.” The minor detail that a company like Amazon fuels much of its growth by losing money on much of what it sells is for the small-minded folk lacking in vision. It isn’t clear either why people who can’t afford to buy food are instead going to bid on hotel rooms and plane tickets. But it’s a familiar enough scenario over the last half-dozen years.

Economic data left no doubt that we are in the midst of a slowdown, and the initial print for second-quarter GDP due next Friday might give an indication of how much. Personally we think that the number might come in higher than expected, not through a sense that the economy is doing better than what recent data indicate, but because PCE inflation data have hinted that the GDP price deflator could be quite low.

The consensus estimates that we are seeing for the GDP number are in the 1.2% – 1.4% range. However, the deflator is estimated to be around 1.6%, and we would not be surprised to see it come in at 1.0% or lower. The Bureau of Economic Analysis does this from time to time. The result would be to boost the real GDP headline number close to the nominal level of growth, in other words higher, possibly as high as 2%.

The release will come on a crucial day. Although markets are likely to begin the week under pressure, as we get towards the back half the usual fever to start marking up month-end prices should be getting underway. That move typically starts around the third-to-last day, which in this case is Friday. In addition, the day is also three days before the FOMC announcement, another time when markets start to trade up. Indeed, we could see an advance rally get going on Thursday afternoon.

Despite any earnings patter, what is really keeping equities alive is the eternal hope of more Fed easing and a lack of alternatives for the double-digit returns that investors crave. We suspect that many a trader is hoping deep down inside for a gruesome GDP number, the uglier the better, in the hopes it will spur the Fed into further action – and even if it doesn’t, a good-sized three-day rally that anticipates the same might serve just as well. What would happen with 2% is beyond our guess, but we suspect that a number of something like 1.7%-1.8% would disappoint markets in spite of beating the estimates by several tenths of a point, as it would be neither weak enough nor strong enough.

The problem for the Fed is that the sources of the slowdown are largely beyond its reach. Europe needs to save itself, and Friday’s Spain news was more of the same. Yes, they’ll give the country some money but the government is still on the hook for it and so back up went Spanish bond yields. Its economic outlook got cut again and by the way, the EU wants the government to produce more austerity. It’s so wearily familiar, but little else should have been expected this close to the August lull. We wonder if anyone at all can believe that Spain can possibly grow next year on its current path, but maybe that’s a problem we have to think about in the fall.

The impending fiscal cliff is a political problem that Fed policy has had the perverse effect of sustaining – so long as we are not looking into the abyss, Congress is content to pander to the ideological wings and leave the heavy lifting for another day. Better yet, leave it to someone else entirely. A ridiculous act of self-deception perhaps, but little different from what our European counterparts have been doing. An IMF senior economist resigned Friday with a note that blasted the Fund’s inability to get ahead of crises, particularly in Europe. Who will resign from Congress, we wonder.

China’s problem is more of a problem for China and its region than the United States, though it is something of an albatross around the neck of all the strategists and managers loudly talking the country up at the beginning of the year. The psychological effect isn’t positive, we’ll grant that, but the Fed buying bonds isn’t going to erase the piles of coal, steel, and empty buildings that litter the country.

On top of everything else, if the S&P is back to the 1370 level again by the time the Fed meets, a most realistic scenario, we don’t see how the bank can possibly stick its neck out three months before the election. But the end of next week is likely to trade as if it will anyway. Take note, though, that when traders are fleeing the financial sector to bet on tech, the way they were last week, it doesn’t bode well for the road ahead.

On a final note, we note with regret the passing of famed strategist Barton Biggs, whose work we enjoyed for many years. He will be missed.

The Economic Beat

The report of the week may have been this month’s Philadelphia Fed survey. It came in a little worse than expected, at (-12.9), with new orders down at (-6.9) and shipments shrinking with a (-8.6) read. All of the readings were less negative than the prior month, but there was some better consolation than that. Prices are the most sensitive indicator, and both paid and prices received were higher after contracting in June.

The New York survey, by contrast, had a positive overall reading with weaker subcomponents, with new orders dropping into negative territory and unfilled orders drying up at a faster rate. Prices paid also slowed considerably.

Industrial production rose by 0.4% in June, with manufacturing reversing June’s loss despite a negative contribution from utilities. The production index rose to a new post-crash high of 97.4. Though it is still short of the 100 reading of the 2007 reference year, we are nearly back to August of 2008 (97.9).

In sum, manufacturing is slowing but not crashing, much as was the case in June. The bad news might be the six-month outlook for the Philadelphia Fed survey. It’s a great contrarian indicator, and is still hanging in there at around the 20 level. A reading closer to zero would be a more investable bottom. The only time the overall index has rebounded with the six-month level this high was in August of 2010, when the Fed launched its first program of quantitative easing.

A good indication of how much the market wanted to go up on expiration Monday came in the wake of the June retail sales report. Despite the unexpectedly weak result of (-0.5%) that quickly led to lower estimates for second quarter GDP, markets managed to finish nearly flat on the day. Sales may have been better than reported, as the drop in auto sales did not match manufacturer figures. The year-on-year change in second-quarter sales (unadjusted) was right about average for the data going back to 1993, but the sharp drop in June’s year-on-year sales wasn’t. In the last twenty years, the only drops of similar magnitude came in 2001 and 2009, hardly encouraging. Everyone is cautious.

Housing news was mixed. Homebuilding has definitely improved, with the builder sentiment index taking another big jump upward. The downside is that it is still at 35, and 50 is the neutral level. That the trend was improving was reflected in June housing starts, which rose above consensus to a 760,000 annual rate. That is still well short of the one million-plus rate we need to be at for a healthy industry, but is a positive step. It may also be close to the peak of activity level for 2012, as permits eased and the end of the construction window for the northern half of the country approaches.

Existing home sales fell last month. The drop was pronounced in the low end of the market, where investor buying seems to have run down the supply, at least until banks start letting go of more property. The phenomenon also had the effect of driving up the median price, but house prices aren’t lifting off. New home sales are due on Wednesday.

We didn’t see anything in the Beige Book’s latest edition that makes a case for dramatic action from the Fed. The report was dominated by words like moderate and tepid, with a general sense of mild easing but nothing alarming. Weekly claims rose back to what appear to be the levels that they had been tracking prior to the 4th of July holiday week. The leading indicator report backed the notion of a slowdown with a (-0.3%) reading.

Next week the earnings season gets into top gear. Though many of the prominent names have already reported, the volume is heaviest next week, with names like McDonald’s (MCD) on Monday, Apple (AAPL) on Tuesday, Ford (F) on Wednesday, Exxon (XOM) and Amazon (AMZN) on Thursday, and Chevron (CVX) on Friday.

The economic calendar is light until Thursday, when June durable goods orders are reported. Above all is the GDP print on Friday. A mix of the lesser regional Fed surveys are scattered through the week, and housing will report new home sales on Wednesday and pending home sales on Thursday.

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