“It seemed like the real thing, but I was so blind.” – Blondie, Heart of Glass
by M. Kevin Flynn, CFA
You really knew what kind of market it’s been of late on Tuesday, when a clunker of a number on consumer confidence came out. Yes, yes, we all know that data doesn’t correlate well with spending, but equity prices are known for reacting to the Conference Board numbers, especially ones that are such wide misses of estimates. Nine times out of ten, a dud like last week’s result would have sent prices reeling and traders leaping into basement shelters.
But the market stayed steady until late Thursday, when the usual quarter-end window dressing finally shaved a little skin off prices. “Stocks rose as traders bet the fed would have to take further steps to prop up the economy,” said one headline. Marking the tape and momentum chasing, we’d have said. We’ve seen this movie before.
The notion of bidding up stocks on weak data because it impels the Fed to support the economy is a story that can last longer than you think. It shouldn’t last more than a day or so. In practice, though, it can last months, especially when dovetailing with the parallel idea that if the data is good you have to buy equities as well, because they’re too cheap. Though we don’t like these contrived episodes, some do, because there is nothing a trader loves more than trading an up momentum market beset with doubters.
The concern that the aftermath could be ugly isn’t a momentum guy’s problem. Their job is to stay in until the last possible moment, then abandon ship as fast as possible. In the meantime there’s money to be made, so get out of the way. The long-term horizon of the typical Street denizen is next February’s bonus check, and for those who care about the truly long-term, it’s the one after that. Apres moi, it’s somebody else’s problem.
It’s not the kind of environment that suits the long-term investor, but attempts to get these kinds of momentum markets going do often fail. The last time we had a runaway market, our little mid-February to April frenzy of this year, it ended with the flash crash and a bitter taste in the mouths of retail investors that hasn’t left.
That legacy is ignored in most of the canyons of Manhattan, though. It’s a problem for the rubes, not them. The flash crash has been traced to a particular trade that was heavy for the system, but the problem of why the system has become so vulnerable won’t be an easy one to resolve, and one the exchanges would rather people didn’t talk about. When people are making money off of something, no matter how dangerous it may be, they quickly come to see themselves as entitled to it, not to mention necessary to the fate of the planet.
Looking back at the waning days of the last bull market in late 2006 and the first half of 2007, the markets kept surging in the face of warning signs. Many were puzzled, including this author. We wondered about why government authorities were still doing the hear-no, see-no, speak-no evil routine. Yet we also observed during those times that there was a sizable contingent of traders still angry about Greenspan’s famed “irrational exuberance” remark in 1996.
Events proved that Greenspan was right, but early. What ticked off traders so much was not that Greenspan might have been on to something, but that he was trying to spoil the party. The bubble was able to grow to such tremendous proportions first; there was so much money to be made! What’s Nosy Parker doing by coming along and trying to wreck our game with his busybody, do-gooder notions? Government should stay out of private affairs!
Now, we don’t want to exaggerate the current market – it’s still a ways from that mentality. It seems plausible to us that economic data more benign than anticipated last month caught hedge funds with no sellers left to play with. It also had the effect of turbocharging a technical bounce that was tightly coiled to spring, and while it was surely not inevitable, the bounce needed a steady diet of worse news to keep it down.
The shortfall in performance may have convinced a posse of managers that they needed to get longer. We can think of a variety of reasons, but probably most important is that as the end of the year draws near it’s time to start putting up some outperformance or risk losing client assets.
With the flow of funds data indicating that most retail investors have been pouring money into fixed income, that would leave a lot of wealthy people finding themselves up a modest amount on the year in their own accounts, yet down or trailing in their hedge fund investments.
That’s a lethal situation. We’ve been in this business for over twenty-five years, and even though every last one of us knows that a genuine performance horizon is at least three years, that’s not the way people behave. A couple of quarters of underperformance and even clients who have worked decades in the investment business – in other words, they should know better – start to second-guess and fly the coop.
So our guess is that there could be a persistent, yet provisional bid in the markets for a while as hedge funds come around to a slow-growth view that entails buying dips. It would explain why the markets are developing a bull-market tendency to explain away weaker developments, such as last week’s confidence data or all-time highs in the two-year bond, and cluster around events that tend to confirm a positive view, like the recent China PMI.
That could leave the markets more vulnerable to sharp declines – one can’t be really disappointed until one’s expectations have been raised high enough. The real question for the fourth quarter, though, is whether something can come along sufficiently real and sizable to shake newly converted investors out of a belief that all lines converge on equities.
It mightn’t be that difficult. A parallel view is that the beneficial calendar effects overstated the amount of real belief that it’s time to buy equities. Big market events, like the IPO wave of the tech bubble, or the subprime mortgage meltdown, tend to leave behind a kind of doppelganger image of investors looking to replicate the last hugely successful headline strategy. We don’t know if the market has yet run out of hedgies looking for the next big short.
Consider bond markets and gold prices. They are making fresh parallel highs every week. That’s just not compatible with rising equity prices, because they simply can’t all be right at the same time. It can look that way for a while, though, because momentum makes a lot of people unshakable believers in the rightness of their genius. Then one day they find out they’ve been suckered, and the money is gone. As Alexander Pope might have written, had he been born a couple of centuries later, “a little outperformance is a dangerous thing.”
The Economic Beat
We had a little trouble talking this week, as our mouths are still full of the hats we had to eat last Tuesday upon the release of the Conference Board’s consumer confidence report. We threatened to dine on them if the survey didn’t follow the stock market up. It did not. It didn’t follow the increase in stock market prices, nor income nor spending. It went down hard, the other way. Nothing of 2009 vintage, mind you, but 48.5 is still on the ugly side of the street. Big ugly.
Unemployment benefits came back – a big reason for the increase in August personal income and spending – stock prices came back, the headlines got better. Why did confidence weaken so much?
We think that the thesis put forth by the folks at briefing.com was as good as any, namely that the hue and cry of the November elections campaign – a campaign, we would add, that has grown increasingly nasty and apocalyptic – has gotten people feeling pretty anxious. In fact, we’d say that the polarization of rhetoric and enmity has gotten so deep that increasing numbers of people are scared more than anything else of the inevitable Armageddon that will ensue if their opponents win. They can’t both be right.
Motor vehicles sales were decent in September, and the University of Michigan’s final edition of September consumer sentiment rose above estimates, though remaining at weak levels. That would seem to bely the confidence number, but motor vehicle sales may have benefited more than usual from the calendar and a late Labor Day weekend.
The first half of the week had little to offer, apart from the Conference Board result that should have sparked a sell-off and didn’t. Mortgage-purchase applications rose a small amount after a couple of weeks of decline, but really it’s the same comatose pulse. Of more interest was that refinancing applications edged down yet again. Is the pool of qualified applicants starting to run dry, as we speculated next week, or are the banks shrinking it every week on their own with policy changes?
Manufacturing was positive, although mixed. The Chicago regional purchasing report was strong, with both the overall total rising smartly (62.8 vs 59.8) and new orders (66 vs. 59). A slowing of employment growth and some weakening in inventory and production, though, raised concerns about manufacturers running down stocks.
That was echoed in similar declines the next day reported by the national ISM survey, which though still at a decent overall level (54.4), showed lower rates of growth in new orders (51.1, barely above neutral), backlog and production. Despite some cautious comments, though, we are still impressed by the fact that eighteen sectors reported growth and only three contraction.
The regional surveys have been very much a mixed bag of late, reflecting the rather halting nature of the recovery. That might be seen in the speed-up in price increases in manufacturing, where a greater number of commodities are being reported in short supply or up in price. Some markets, like coca, are suffering from financial speculation and the lust for the next big killing, but we suspect also that steady growth linked to extremely cautious capacity increases has led to the odd shortage.
Personal income and spending did indeed increase in August, though much of it could be traced to the resumption of extended and emergency unemployment benefits. It still helps spending, and an increase is better than a decrease, but it may throw off the September data. A story about midnight benefit-recipient shoppers in the Wall Street Journal made it clear that life is still quite difficult for many. Next week’s release of September same-store chain sales (for those who still report) should add some light.
Perhaps next Friday’s jobs report for September will add some light too, although the revisions can be so large that caution is advisable. We thought the raw data for weekly claims to be generally encouraging last month, as the September weeks were the lowest such totals since the Lehman bankruptcy two years ago. We don’t expect hiring to be strong, but with manufacturing continuing to add in small amounts and service data seeming to hang around neutral, the behavior of individual sectors may give a better clue to the hiring trend. The consensus is for no change.
Construction spending improved for August, but the increase wasn’t what you would like. July was revised downward, and private construction spending fell rather steeply (-0.9%). The increase was all in public construction, much of it on highways and roads (remembering August traffic woes, it sure seemed that way in our neck of the woods). In another respect, though, it perhaps did highlight the benefit of having a public spending offset to the weakness elsewhere.
Next week’s center of attention will of course be the jobs report, unless a bit of nastiness from Europe comes our way. Although Monday is often an empty day, it should be on the lively side this time with both August factory orders and September pending home sales coming out at 10 A.M. The latest durable goods data was good, making a benign factory orders number (excluding transportation) more likely (though the revisions can be deadly).
As to pending home sales, the consensus is for a small increase of a percent or so. The weekly mortgage data is still in Bottomsville and by no means pointing to anything but weakness, but the run rate has been so low that one cannot rule out little squiggles upward (which could turn into big trading squiggles).
The ISM services index comes out Tuesday and wholesale trade Friday, but we suspect that unless one of the earlier numbers throws something wild, the market’s main attention will be on the usual lead-up numbers to the jobs report, in particular the ADP report on Wednesday. It’s the last jobs report before the election, so expect a lot of spin.