The Changing of the Season


“And with a drop of blood, you sign your name.” – Mephistopheles, in Goethe’s Faust

When the markets closed on Friday, the S&P 500 index had quietly finished giving back all of the gains since “Draghi-Day,” when European Central Bank (ECB) president Mario Draghi said that the bank was ready to buy “unlimited” amounts of short-term sovereign debt to cap sovereign rates and defend the euro. All you have to do is sign this parchment, Dr. Faust.

Alas, it would appear that several of Europe’s elite may have read Goethe, because no one has yet signed up to trade in their nation’s soul for bonds. As a result, at S&P 1428 we are now below the close of 1432 on that glorious day. Wasn’t there some other central bank action in the interim? I do seem to recall something, but the markets seem to have forgotten it.

The situation is simple. The pull on the markets from fundamentals – a slowing global economy, a slow US economy, near-zero corporate earnings growth – is downward. The tide is going out, as I wrote last week on Seeking Alpha. I might add that it started going out in March.

What has propped the market up since the weather-inspired delusion of the first quarter – we are now less than 1% above the first day of April – have been the twin chimeras of European rescue and central bank easing. Every story of a bailout or disaster averted in Europe has been good for a big rally in the markets, usually and conveniently located near the end of a month.

Notwithstanding these miraculous escapes, the EU economy keeps slowly sinking into the quicksand. Greece is in a depression by any definition of the word, and Spain is drawing nearer every day. Soon one or both will overthrow their taskmasters and refuse any more Faustian bond bargains. We came within a couple percent in the June Greek election. When the luck runs out, I cannot say for sure, nor can anyone else. But it will.

The other mythical beast has been central bank easing. First it was the promise of it – the ECB could do this, it might do that; the Fed might bring us more quantitative easing – and then it was the fact. After we ducked the Greek election bullet in June, it’s really been the sultry siren song of central bank money-printing that has kept the market oars pulling in the water.

Now the song has ended. The ECB has acted, the Fed has acted. There is little more left in the chorus book that the market will listen to. The ECB has a little leeway – it could throw off all conditions for bond-buying, or guarantee all EU deposits. That would be good for a rally, along with multiple cranial explosions in Frankfurt. It wouldn’t stop the recession.

For its part, the Fed is worse off. In this respect the FOMC may have miscalculated, because it really has no new song left to sing. I am sure Dr. Bernanke would disagree with me, and reply that the Fed could expand its purchase program if necessary. To which I would say that although Dr. Bernanke can surely solve for eigen-values in his models faster and better than I can, I may know the markets better than the good doctor. They would not react well to a doubling of asset purchases. In fact, I doubt that any related rally would last for more than an hour or two before turning into panic selling (and for the record, many of us market veterans would never have signed on either to allowing Lehman to file a surprise, unmanaged bankruptcy. There are better ways to dispose of the dying, Dr. B).

Now we may need to wait upon European rescue stories. I thought that there might be some last week, what with the EU finance ministers meeting on Monday and the IMF meeting in Tokyo on Tuesday. The markets did too. It didn’t happen, obviously. But with the ECB standing by as emergency backer, private money is suddenly snapping up Spanish and Italian debt. Ergo no bailout, ergo no contract with Mephistopheles, ergo no wire story to galvanize the black boxes into buying and thus rev up the high-frequency-trading (HFT) turbochargers. There was nothing but the banalities of sliding data and lackluster earnings.

There was a silver lining to the Lehman collapse. No, really. Consider that the private mortgage-backed securities (MBS) markets suffered cardiac arrest in August of 2007, when the two Bear Stearns MBS hedge funds went belly up and left Fannie and Freddie holding the bag. Markets peaked three months later (on the salvation of Fed action, no less) and the Great Recession started five months later.

The Lehman collapse was ugly, and a mistake, but it did avoid the European scenario of death by a thousand cuts. It suddenly became very clear that taking aspirin wasn’t going to do the trick anymore – the patient needed immediate triple-bypass surgery. Our restructuring was quite painful, but markets started to recover five months later and the economy began to improve about twelve months later.

Europe has been stuck at the figurative one mile an hour. The moneyed factions in the EU keep telling us that the disease can be cured with diet and exercise, while in the meantime the patient’s lungs are collapsing. The suffering in the periphery is being unduly drawn out, and the suffering in the core is just starting to take hold.

Looking ahead to next week, the markets are only mildly oversold after the failure of mega-banks JP Morgan (JPM) and Wells Fargo (WFC) to knock the ball out of the park on Friday with earnings results. The reports were perfectly respectable under the circumstances, I might add, but perhaps hopes were too high. I don’t have a lot of hope either for industrial earnings, which start in earnest next week, but neither does the market, an important distinction.

An unintended irony could develop next week with the industrials supporting the market with earnings that are weak so far as growth is concerned, but better than feared, while the much anticipated earnings growth from financial stocks is good, but not as good as hoped. The key will be the outlook. If the EU doesn’t provide some rescue news next week, we could be left watching the tide go out.

The Economic Beat

It was a quiet week in the US for data, but what there was had some interest. The first release of the week was the NFIB Small Business Optimism survey, which inched down instead of bumping back up as expected. There was some small improvement in expectations for better days ahead, but a downturn in hiring plans. As has usually been the case, the number one concern was weak sales.

The wholesale trade and inventories report came out, leading some journalists who probably should know better to exclaim with pleasure over the first increase in three months in sales. It wasn’t a great report, as the year-on-year change in sales (unadjusted) decreased from July to nearly unchanged levels in August, while the year-on-year increase in inventories fell again. It’s been falling since June of 2011.

The Beige Book, or compendium of regional Fed business summaries, was released, and gave markets a brief blip by saying that activity “generally expanded modestly.” In the world of Fed-speak, that doesn’t say much. Consumer spending was characterized as flat to slightly up, which doesn’t point to a big September retail sales number on Monday. The weekly retail reporting services were somewhat at odds again over the month, which usually doesn’t lead to an upside surprise. But there are always the seasonal adjustment factors. The book did note that loan demand was “steady to stronger” and residential real estate was widely better.

The trade data was interesting. Exports fell faster in August than imports, which doesn’t help the GDP calculation. As usual, China was more than half the deficit. Export prices rose 0.8% in September, led again by food prices. They rose 1.0% (revised) in August, but the Bureau of Economic Analysis (BEA) reported that exports fell over 1% in dollar terms. That would indicate that exports are falling faster in unit terms. While both import and export prices are down year-on-year, energy increases have pressured them in recent months.

The big increase in energy showed up in a larger-than-expected reading for the Producer Price Index (PPI), which came in with a monthly 1.1% increase for September. Excluding food and energy, the index was only up 0.1% . The increase in food prices slowed to 0.2%. If something exciting happens in the Middle East next month, we could be looking at more energy spikes. The Consumer Price Index (CPI) is due out on Tuesday.

The University of Michigan consumer sentiment index rose sharply and unexpectedly to a reading of 83.1, the highest level in five years. Was it a follow-on to the news about the unemployment rate falling to 7.8%, or another Chicago conspiracy (not far from Michigan, is it)? We think the September market rally and jobs report are largely responsible. The survey was at 83.4 in September of 2007, shortly before the bottom started falling out, so it isn’t much of a leading indicator. It has, however, increased for three months in a row. It wasn’t enough to outweigh the JP Morgan and Wells Fargo reports. Both reported improving mortgage demand, which was expected, and purchase applications have risen back to June levels. Clearly the FOMC announcement had an effect, but it remains to be seen how long-lasting it is. By contrast, the Bloomberg “consumer comfort” weekly index fell back and remains mired in deeply negative territory.

It appears that “those Chicago guys” – you know, the ones that fixed the jobs report – found their passports and went to Europe, too. The EU August industrial production report showed a surprising gain of 0.6% when another loss had been expected, in this case about (-0.5%). The press said, “surprising strength,” we say, “seasonal adjustment factors.”

There are two good clues in the Eurostat database that indicate why. The first is that the year-on-year change in industrial production fell to (-2.9%), a new low for the year. The second is that the “workday-adjusted” index, as opposed to the “seasonally adjusted” index, showed a very large drop. I couldn’t be sure of all of the terminology late Friday night, but it definitely points to a seasonal adjustment issue. My calls to the EU office went unanswered, a sure sign of guilt. Skeptics might note the hour was 3AM on Saturday morning in Europe, but they don’t know the power of conspiracy. In any case, the year-year drop doesn’t show promise, and the German production number was negative.

Did Chicago get to the claims data too? Take the latest report with a grain of salt, as it appears that California didn’t submit all of their data. Claims have been stable all year with the exception of last week’s report, which showed a year-on-year change of about double the pace of the rest of the year. A calendar shift may have played a role too; we’ll be surprised (and impressed) if there’s no rebound and revision next week.

We should get Chinese inflation data over the weekend. Trade data for September arrived overnight, showing a surprise increase in exports and imports. It may have benefited from an easy comparison; it may also have benefited from the impending leadership change next month. Monday will bring us the aforementioned September retail sales data, along with the New York Fed manufacturing survey and earnings from Citigroup (C).

It will be a very busy week next week, with the earnings season hitting stride and a big slate of data from housing and manufacturing. For the former, there’s the homebuilder sentiment index on Tuesday, housing starts on Wednesday, and existing home sales on Friday. For manufacturing, after the NY Fed on Monday, there’s September industrial production on Tuesday and the Philadelphia Fed survey on Thursday. China will report industrial production, retail sales and GDP in the middle of the week.

The CPI comes on Tuesday as noted above, along with earnings from Coca-Cola (KO), Goldman Sachs (GS), Johnson and Johnson (JNJ), United Health (UNH), IBM and Intel (INTC). Wednesday has Bank of America (BAC) and American Express (AXP).

Thursday will see reports from Morgan Stanley (MS), Verizon (VZ), Google (GOOG) and Microsoft (MSFT). Friday includes General Electric (GE), McDonalds (MCD), Honeywell (HON) and Schlumberger (SLB).

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