July Jazz

“We go forward, only forward” – Stannis Baratheon, Game of Thrones

The stock market marches on. We’re into earnings season, and the stock market always rallies during earnings season, even during recessions. It’s just the way it is.

That’s not to say that earnings aren’t good for the second quarter. They’re actually decent on a year-over-year basis for the first time in years, thanks mainly to the recovery in oil prices. Defenders of the stock market talk importantly about double-digit earnings growth, but most of that is coming from the energy and utility sectors – in other words, from higher oil prices. Take out those two sectors and earnings are running about 6%-7% year-year growth, which still isn’t bad, but not so great when you consider it’s taken about three years for the S&P 500 to get that earnings growth. The increase in stock prices has been more than triple the earnings increase over that period.

The main driver of higher stock prices is higher stock prices, Vanguard founder John Bogle likes to say, and I have never quarreled with this remark. In the last issue, I pointed out that the stock market has been trading primarily off of its own trend lines. The most important factor supporting the trend lines isn’t the promise of tax cuts or moderate Fed policy, though those certainly help, but employment data. So long as jobs aren’t contracting, the stock market won’t either. It doesn’t believe any other evidence of recession, and usually has trouble accepting the start of job losses too.

Jobs will contract some day, of course, as the business cycle hasn’t been repealed. Tax cuts won’t stop the end of the business cycle either, not if history is any guide. Most of the enthusiasm for tax cuts coming from corporate America is personal – tax cuts will mean more money for the people in the corner suites, at least on the surface. In theory, it should present more money for dividend payments and stock buybacks – key parts of executive compensation – along with direct executive compensation (salaries that would also be theoretically taxed at lower levels). However, the current corporate base rate of 35% is simply one ingredient in the stew that makes up corporate tax bills, with most S&P 500 companies already paying between 20% and 30%. At this point no one knows what other reforms will in fact happen, including me, and anyone who thinks that they do is dreaming. A very simple plan to cut the base rate from 35% to 20% with no other alterations would certainly benefit many companies, but is that likely? The Republican majority is slim, particularly in the Senate, and a big negative deficit number from the Congressional Budget Office, bound by law to score these things, would cause discord.

As an example of this uncertainty, FactSet recently estimated that earnings calls that mention administration policy have fallen from about half of S&P 500 companies in the first quarter to about one in eight in the second. That’s quite a decline. I’ve no doubt that Congress will want to tackle the subject after Labor Day and try to get something done, if only for symbolic reasons, but what that may end up being is just a near-random guess. One guess I would make, going by recent efforts in the health care area, is that the cuts would likely be phased in over time rather than immediately. That way the headline damage to the deficit and talk of corporate giveaways would be mitigated, giving proponents a chance to claim that increased growth down the road is going to offset the losses.

In the meantime, this market is getting tired. Technically stocks are quite overbought, but a minor pullback of a few percent could take care of that. We’ve also gone an abnormally long time without a 10% correction, but the kicker isn’t just the length of time – we’ve gone several years in the past (including the last cycle) without such a correction coming along. The trick is that past such periods have started mid-cycle or earlier, while the current correction-free 18 months have come as the current business cycle is approaching 100 months, making the latter the third-longest ever and within spitting distance of second. Yes, it’s a well-worn saying on the Street that bull markets don’t die of old age, but it’s also one that gets more frequent repetition as the cycle is in fact wearing out. This one is close.

The Economic Beat

The main fortunes of the economy haven’t changed much so far this year, with the most notable developments being an uptick in oil-related business as the wellhead price has recovered, and a slow but steady softening in auto manufacturing. That said, some of the brash optimism that seemed to be inspired by last year’s election results seems to be finally be fading from the manufacturing surveys – a development that may have just as little to do with actual manufacturing activity.

The New York and Philadelphia manufacturing surveys came out in the July 14th week, with both showing appreciably more subdued results. The New York survey checked in with an overall number of 9.8, about half of last month’s 19.8. The Philadelphia index did not slow as much, but still came in below consensus at 19.5 (zero is neutral for both) versus the previous month’s 27.6 (“slow” being a relative term, as the surveys do not measure amount of output). The New York number has jumped around quite a bit this year and the latest result falls into about the middle, but the Philadelphia survey had been in the stratosphere most of the year without any corresponding results in measures of actual activity. So it may be best to think of the latest results as continuing to be more from the gut than the ledger, more reflective of negative headlines about Washington drama and stalemates than of any real changes in economic activity.

That said, the PMI surveys from Markit economics showed – in the July flash versions – some slight improvement from last month. The manufacturing flash rose from 52 to 53.2, while the services sector showed a similar gain, from 53.0 to 54.2. The Richmond Fed survey also rose, showing a better gain from 7 to 14 (zero is neutral). The Chicago Fed’s national activity index also posted a gain, regaining positive territory to 0.13 from a downwardly revised (-0.30). The three-month moving average improved from a downwardly revised (-0.04) to a positive 0.06.

Housing data jumps around from month to month, but the overall story seems to be about the same – existing home sales are modest, while new home sales are growing but at a slower pace. Homebuilder optimism remains strong with a new result of 64 – neutral is 50, anything above 60 is very strong – and starts did indeed jump back up in June to a 1.215mm rate, no doubt it part thanks to more benign weather. New home sales, for their part, also rose and are up about 11% year-to-date, 9.1% over the last twelve months. I would look for a little growth burst in the sector as builders and buyers try to rush in before rates get higher and the cycle ends.

The pace of existing home sales did slow in the first June estimate, to a 5.52mm rate that also represented a slowing of the year-year pace, from 2,7% to 0.7%. It’ll probably pick up again next month. The federal mortgage-based home price gauge stayed steady at 6.9%.

Import and export prices both fell 0.2% in the first June read, as last month’s import drop was revised up from (-0.3%) to (-0.1%) and exports revised from a drop of (-0.7%) to (-0.5%). The culprit this month was oil, as prices excluding petroleum (imports) and food (exports) were unchanged. Year-year, import prices are up 1.6% while export prices are up 0.6%. Look for an oil-related bump in July prices.

It hurts my head sometimes to hear all the drivel about the latest GDP data. The first estimate for the second quarter posted a headline number of 2.6% (seasonally adjusted and annualized, or SAAR) for real (inflation-adjusted) GDP. That has had the effect of inspiring no end of comments about how healthy the economy is and how it’s “picking up speed,” or, “the recovery is finally getting traction.” I suppose it’s because of the estimate for first-quarter GDP, which was originally 1.4% (SAAR) but now revised downward to 1.2%. So, first quarter GDP was one-something, but now we’re at 2.6%, oh yeah, the economy is definitely picking up.

Never mind that the summer GDP bump has been a feature of recent years without ever going anywhere (nominal GDP in Q2 2016 was actually higher). The main difference between quarters one and two this year is the price deflator, which adjusts GDP from reported dollars to inflation-adjusted dollars. In the first quarter, the (annualized) deflator was 2.0%. For now, the estimate for the first quarter is all the way down to 1.0%; the lower the deflator, the higher is “real” GDP.

The underlying reality is that the economic run-rate has been completely unchanged this year. Real GDP is important to know, no question, but apart from times of high or volatile inflation, the best representation of GDP output is the change in four-quarter nominal (i.e., not inflation-adjusted) GDP. Relatively tiny dollar changes in a single quarter can get annualized into a rather misleading picture of what is actually happening. As for the price deflator, it’s a necessity, but the relatively smooth annual path can look pretty jumpy on a quarterly basis when the numbers are seasonally adjusted and annualized.

Here’s what you really need to know about GDP this year: four-quarter GDP stands at 3.72% through the second quarter. The average of four-quarter GDP over the last three years is 3.69%, or in other words, virtually identical. The trailing five-year average is 3.65%, also virtually identical.

Durable goods orders were up 0.2% (SA) in June, excluding transportation (new aircraft orders make for big swings in the overall index, have very long lead times and are prone to cancellation). Business investment new orders were down 0.1% (SA) for the month, but were still up 4.5% year-over-year, while the trailing-twelve-month rate continues to improve and is now down only 0.5% from a year ago. That’s the best it’s been since early 2015.

The following week begins August and so features the jobs report and a slew of surveys, with two national purchasing manager surveys each from ISM and Markit Economics, along with regional surveys from Dallas and Chicago. Other reports of note include pending home sales, personal income and spending, and construction spending.