“It’s deja vu all over again.” – Yoga Berra
How predictable is the current market? It’s been a trading market for so long that it seems to have given up any pretense of being anything else, content to keep putting its feet in the same traces in the snow. It’s safer – most of the time, hopefully – and familiar.
So how long does the current rally last? It fell off a bit last week, as we said it almost certainly would, but now it looks as if traders want to head for the end of the second week in February, same as last year. We’re listening to the same hype about the same overblown data (inflated the same way as last year by the same over-compensating seasonals), and should have the same letdown when we reach the same unsupported heights.
Of course, the tango duo of Germany & Greece could move things off track. German finance minister Wolfgang Schauble strongly hinted on Sunday that the best thing Greece could do for itself would be to turn over management of its financial affairs to the Germans. He’ll step down from that in a day or so, of course, after the requisite Greek indignation. But the message is still pretty clear – we could really be better off without your bungling.
So the Greeks will bluster, and Schauble will say he didn’t really mean it, while fully expecting them to put on another hair shirt and kiss his ring in exchange for the latest round of noblesse oblige. The markets will roar higher in happy appreciation, and you can begin shorting European stocks at the close of that day. Greece could definitely use the debt relief, but it is only the small tip of a larger iceberg, with Portugal, Spain, Ireland and a large number of private banks right behind them.
If the spat turns up into a full-scale dustup, unlikely but always a possibility, then of course markets will react quite badly. However, the base case is for some sort of patch-up (though it was for Lehman Brothers too, so don’t stick your neck out too much). Should form prevail, then we expect the following parlay to prevail: first, the manufacturing survey reports next week, exaggerated by seasonal factors; second, the usual bid-‘em-ups that surround the turning of the month.
Next there’s an empty week of data following the current one such that, barring a jobs report disaster, momentum should allow traders to extract one more week from the trend; and finally a break above the trend line that runs from the July 2007 high to the 1325 area. The robot buying that will be triggered by the marginal new high is the perfect place to begin dumping long positions to marks chattering about the “volume breakout.” Of course it is, dear. Have another cookie.
How predictable is the market? So predictable that in the face of an outlook so dolorous from the Federal Reserve Bank that it felt obliged to promise easy money for another two years and lower its forecast for the rest of the year, the markets staged a sharp reversal on the good news of more liquidity. So predictable that in the immediate wake of the Fed’s announcement, hedge funds began pouring money back into commodities in the hopes of a rerun of the last announcement in August 2010.
We have to admit, we don’t have the greatest faith in the Fed’s forecasts. Like most such official outlooks, they tend to be better indicators of the present state of affairs than any future one. But that ought to tell you something too.
We’re rerunning a stage of the market that should be familiar to observers by now: many months deep into a trend, with seasonal effects in the second half of their run, and – in the present case – a steady rise in prices that has turned the average punter into a true-believing, self-styled “long-term investor.” In the meantime, the trading guys with all the real money to spend have their coats on and an eye on the door.
Yes, the base case is for the rally that began in September to stick out a couple more weeks, though some backing and filling should be expected along the way. But it’s a rickety structure that could disappear overnight. Watch your step, because a plunge is about to happen all over again. Picking the day in advance, though, can’t be done. All we can tell you for sure is that the higher we get first, the more we will end up giving back.
The Economic Beat
Since we doubt the GDP estimate, we’ll start there. It was something of a disappointment as announced, coming in at 2.8% against consensus estimates of 3.1-3.2%. But we don’t think it was even as good as 2.8%, and believe that the final revision will show that GDP grew less than 2.5%, as we suggested some weeks ago.
GDP for the fourth quarter of 2010 was first estimated as 3.2%. It fell all the way to 2.3% in its final revision. The third quarter of 2011 GDP was similarly estimated at 2.5%, only to be subsequently revised downward to 1.8%. We’ll let you guess what direction lies in wait for the current GDP estimate.
One reason it’s going to be downward is the price deflator, which is used to adjust nominal GDP to the real GDP figure that is used as the common currency. In quarters one through three, the price deflator’s annual rate ran between 2.6% and 2.7%. In the fourth quarter of 2011, the deflator plummeted all the way to 0.4%, far outside the consensus estimate of 1.5% and well below the bottom of the range.
A flattening out in energy prices in the fourth quarter did affect overall price inflation, true, but inflation didn’t fall to a 0.4% annual rate that quickly, we can promise. Regular readers know what we have taken the BEA to task several times over the last few years for putting up the occasional sharp discontinuity in its inflation estimates. None of these oddball numbers have survived the test of time, and have generally ended up about half a percentage point higher in the final estimate (though it has often taken many months and done with no fanfare). We think that Q4 2011 will end up being 2.2%-2.3% instead of the initial 2.8% estimate.
Consumer purchases and final sales were much weaker than expected in the estimate, yet the worse is still to come. Retail sales have fallen sharply through the first few weeks of January, and there is no reason to expect that the last week produced a miracle comeback. It’s the same thing that happened last January – after rising up for Christmas, consumers went back to being frugal.
New orders for durable goods rose by 3.0% in December (2.1% excluding transportation), sending the business media into near-ecstasy over the economy’s momentum and leading many to publicly doubt the Fed’s downbeat assessment of the economy. The business investment category (non-defense capital goods excluding aircraft) rose 2.9%!
These bursts of excitement bring to mind a certain crusty old Latin teacher who used to look at the class balefully and admonish, “wrong, wrong, wrong!” In the first place, we’re talking a simple inventory restock. We get one of these every few quarters, and every few quarters Wall Street economists rave about the accelerating momentum. This is followed a quarter later by a big correction in the stock market when the acceleration turns out to have been – yet again – just another inventory restock. The business capital goods category fell in October and November – mild destock – then rose in December: mild restock.
In the second place, the accelerated depreciation tax credit expired in December. I don’t think that the durable goods data changed the Fed’s thinking one bit, because it’s more reasonable to think that the number should have been higher, given the rundown in inventories and the expiring credit. Let’s put the increase in business capital goods spending in perspective: last December it rose by 3.9%, a full point better than the 2011 edition, and yet there was no “significant acceleration” in the following quarter – except for Wall Street hype.
In the third place, seasonal adjustments and a warm winter are overstating the strength of the manufacturing sector. The markets rose sharply on Tuesday when the Richmond Fed’s manufacturing survey (since when has the Richmond Fed been a bellwether?) reported a “better-than-expected” reading of 12 (versus consensus estimates of 6). “Significant acceleration (is) underway,” reported one popular site. But the Richmond Fed’s index last January was 17. It also produced 24 in February and 16 in March, yet GDP for the quarter ran at a 0.4% annual rate only.
For that matter, the ISM manufacturing national index produced readings last year of 60.8, 61.4 and 61.2 in the first quarter. It’s part of the point we’ve been making for weeks now (and Goldman Sachs has now joined the parade): the seasonal factors are off, overstating production in quarters four and one, and understating them in quarters two and three. Those robust first-quarter readings from the ISM helped fuel a rally in the stock market, but GDP barely moved. The third quarter readings of 50.9, 50.6 and 51.6 coincided with a sharp sell-off in stock prices, but GDP was actually rising from 1.3% (annualized) in the second quarter to a 1.8% rate in the third.
So we expect the national ISM reading on Wednesday to beat consensus, which is for a modest 54.5. Maybe it’ll even come in at 60, causing paroxysms of joy amongst Wall Street strategists. But we’ll say this – the comments we saw last week extolling the “solid momentum” in the economy all came from Wall Street economists. But we haven’t heard the same from company management during conference calls – in fact, most of them were talking about first quarter weakness and hopes for the second half (excluding Apple (AAPL) of course, with its blowout report, but that company makes its own music).
That was true in the housing sector reports we listened to as well. Housing stocks have been in a terrific rally this month, but we heard a lot of caution from homebuilders in recent weeks. As it happens, pending home sales declined by (-3.5%), and the existing home sales rate also fell in December. The problem remains the same: while mortgage rates may be at a bottom, so is credit availability. The warm weather has encouraged traffic, but the financing capabilities of the homebuilders are limited and the banks don’t care what the temperature is.
For what it’s worth, we think that over time the success of smaller banks in the mortgage market will get the bigger banks to loosen up. But banks are very slow to re-enter markets where they’ve made big losses, and even slower when they are still holding some of those losses on the balance sheet. The bottom in homebuilding may be in; indeed we think it is. The problem is that the credit bottom is likely to be much wider, and the exit slope much shallower, than the current rally in the sector would have you believe.
Gains in the inventory rebuild helped produce the first positive reading in months for the Chicago Fed national activity index, but the three-month average fell due to the destocking in October and November. When combined with the sudden surge in energy prices – prompted mainly by the surge in stock prices – we are headed for another big step down in first-quarter real GDP. Consumers are pulling back, despite the increase in sentiment reported last week in the Michigan survey (wait until the January retail sales report comes out), and the price deflator will rise sharply again. You have been warned.
However, next week will bring a bushel of reports that could give the rally a couple more weeks of life. There is the aforementioned ISM report on Wednesday, which we expect to comfortably beat estimates (if it doesn’t, look out below). The even bigger jobs report comes out on Friday, though we don’t expect much validation from that particular number. There have been a substantial number of big layoff reports since the first of the year, and while we don’t expect them to have had much of an impact yet, it doesn’t suggest that employers are hiring freely, either. The consensus estimate of 135-150k looks about right to us.
The stars should line up on Wednesday, too – not only is the ISM likely to be a tape-booster when it comes out at 10 AM that morning, but it’s the first day of the month, which many buy because the first-day rally is so ingrained in the market culture. On top of that, the ADP payroll report comes out Wednesday morning, and it’s been on the high side of late. Construction spending (due out at the same time as the ISM) should have benefited from the mild winter, and auto sales are due the same day.
Barring a Greek accident, the markets should be in a good mood following Tuesday’s data as well. The Chicago PMI comes out that morning, another survey that will appear better than it is, and the Conference Board’s consumer confidence report comes out right after it. The consensus is for a bump up to 68 or so, but given the length of the stock market rally, the warmer temps and the Michigan trend, we could easily see a number above 70. The only downer of the day should be the Case-Shiller report on home prices, unlikely to produce any good news.
Indeed, it looks to us as if the end of the week will decide the market direction for the next ten days, because the following week is nearly devoid of new information, which usually translates into a continuation of whatever the previous week’s trend happened to have been. Thursday will see chain-store same-store sales reports, and even with the warmer weather and the inherent bias (because when companies start to struggle with same-store growth, monthly reporting is one of the first things to go), the weekly data aren’t optimistic. Fortunately, last January saw similar conditions, so the year-on-year comparisons might not look bad.
The swing factor ought to be the jobs report, then. It hasn’t had much luck in generating a rally in recent times, so perhaps lower expectations will help. But those will partly depend on what ADP says and whether the market was able to keep rallying -as prices continue to rise, not only does the EU get more complacent, but the bar for staying in gets higher too.