The Moor’s Last Flight

“Though Birnam Wood be come to Dunsinane, and thou opposed, being of no woman born, Yet I will try the last.” – William Shakespeare, Macbeth

It looks like we were lucky in the timing again last week, when we flatly said that the stock market was about to correct and it was no time to put in new money. Equities sold off heavily on Tuesday and weren’t able to stop the bleeding until Friday.

That the market had its worst weekly decline in months (since November for the S&P 500, August for the Dow) isn’t much of a surprise. Equities were badly overbought and ripe for a pullback. Nor was the Friday (low-volume) rally a surprise. A feature of every rising market is its unwillingness to leave the tables when the game is up. Strategists and TV commentators (who want and need you to be spending money on equities) refer to this as “resilience.” When the cops walk into the room and bust you, though, “resilient” usually isn’t the term people use to describe how they feel.

In the long term, the stock market is a good measure of economic performance. In the short term, the stock market is above all a herd that likes to run in the same direction. That makes it subject to silly infatuations, manic depressions, and wild-goose chases. The herd survives, but there are many broken legs and bodies over the cliffs along the way.

During times of prolonged winning and losing, the market really does resemble some sort of gambling table where all are mesmerized by the action itself. When players hear the police cars down below coming to break up the game, most simply don’t want to believe it. There’s got to be time for one more bet. Maybe the cops are going to another party. Maybe it’s just pizza delivery. Hey, did anybody here order pizza?

So when potentially negative – or genuinely, unquestionably negative – developments arrive in the market, traders usually give it anywhere from five minutes to a couple of days to end the world. If we’re still alive after that, then it must not be really serious and let’s get back to the game (“you need to be in the game!”).

The present situation in the Middle East is a good example of what we’re saying. We don’t know what will happen, and doubt that anybody does, given how rapidly events have unfolded and caught nearly everyone (including the participants) off guard. The Libyan situation could go any number of ways – perhaps Gaddafi goes quietly, or at least quickly. Oil prices could plummet, then rocket again if the aftermath proves difficult. Unrest in the rest of the Middle East might subside, or it could grow.

The point is that there is great uncertainty in a part of the world that supplies the critical part of the oil. We are not predicting what will happen to oil prices, but given developments so far, it would appear that there is a substantial possibility for a disruptive episode. The real surprise about last week’s decline was not that prices fell about 1.7%, but they fell so little. That it was the largest drop in so many months speaks more about the market’s current self-infatuation than about how limited the damage might be.

We would guess that the possibility for spreading political unrest in the Middle East is somewhere between one in four and one in two. That implies a 25%-50% chance that the price of oil may see a substantial spike, with negative consequences for the global economy.

Oil isn’t just about gasoline and heating, but a vital industrial component that is a critical part of the world food chain. Skyrocketing food prices are behind much of the unrest in the Middle East and tensions elsewhere in the globe, including China. Food and energy are indeed non-core components when it comes to measuring classic inflation from general demand and productive supply tensions, but they are very core when it comes to spending power and political instability.

Current equity prices don’t reflect this possibility. At its current level of about 1320, the S&P is pricing in a risk of disruptive oil price movements at less than one in twenty. That appears to us to be dangerously disingenuous.

We aren’t predicting disaster; we aren’t predicting anything, perhaps, but more surprises. One thing we are sure of as market veterans is that traders would love to stage a big, virile, self-affirmation rally that would “crush the shorts,” have Jim Cramer running around his studio shouting and whooping, and generally validate the current trend (and their long positions) as soon as they are given any flimsy excuse for doing so. Such behavior always precedes a bigger fall, and is no good indicator of good times ahead.

Nor is such behavior of imminent destruction, either. While the recent doubling of the S&P from its bottom is the first such occurrence since 1936, the subsequent collapse of the market in 1937-1938 didn’t happen for another year, so why flee now? The cops won’t be here for hours!

Our advice is to stay prudent, and sit this one out. The people who lose the most money in the investment business are the ones who stick around to try to squeeze out the last month, week, or few percent of the rally. An article in the Saturday edition of the Wall Street Journal observed how people who sat out the rally since March of 2009 are now coming back into the market, illustrating an old Street truism: as bad as you may feel when you’ve lost money on something, watching from the sidelines while others clean up can feel even worse. It can tempt you into an indiscretion. Relax, don’t do it.

The Economic Beat

A hard look at last week’s data leads us to the conjecture that the economy may be headed for an episode of deceleration. Not a double dip, but a growth rate below what many have penciled in, including certain economists and strategists who capitulated quite recently to the rising prices in the stock market (perhaps their clients became offended that they lacked enthusiasm).

Our picture is based upon housing, employment, manufacturing, inflation, and political instability. Taking them in order, housing is clearly still a drag on the economy. Although mortgage-purchase applications picked up a bit last week, they remain near historic lows. Credit is lethally tight, as was made apparent by last week’s existing home sales. January chalked up a new record for percentage of all-cash sales (32%), and distressed sales made up 37%. Those factors weighed heavily on prices: both the average and median price fell around 5%. The Case-Shiller index for December showed a decline of about 1% and deterioration in the year-on-year decline.

There are two more observations in this sea of gloom: the two GSEs (government-sponsored enterprises), Fannie Mae and Freddie Mac, have both been tightening standards. Although this is one of the best times ever to lend money to homebuyers, and 2005-2007 was the worst, the banks are behaving the way they usually do: lending all the money they could during the worst period, and not wanting to lend any during the best. By and large, comparing banks to sheep may be unfair to the latter.

Think about it for a minute: sheep may eat the grass short, but don’t lay waste to the neighborhood. Wolves are the natural enemies of sheep, while banking seems to eagerly invite them over to eat their fill – which they do, leaving the bank carcasses behind. Upon reflection, we owe an apology to the sheep.

Coming back to housing, it appears likely that the foreclosure process will begin to pick up again. Although that would give another bump up in existing sales, good for the usual sucker’s reflex-rally in the homebuilder stocks, it wouldn’t be a sign of a recovering housing market. The national rate of ownership is still above the long-term median, and should slowly trend down. Falling prices act as a curb on buyer appetite.

New home sales fell in January to the bottom of the estimate range, at 284,000. That’s down nearly 20% from last January and near the all-time low of the series. Some of the weakness may be attributed to the December expiration of tax credits in certain states, in particular California. One might also consider that January and February are light months, weak indicators of the year to come. But even a rebound would leave sales at historically low levels.

When set against the last twenty years of data, last week’s claims level of 391,000 (384,000 unadjusted) isn’t as bonny as the drop below 400,000 seems. For the week in question, only the recession years of 1991-1992 and 2009-2010 had higher claims levels. We’re supposed to be out of a recession, yet claims are still higher than the equivalent weeks during the recession period of 2001-2002. The 1990s data are worse, because of the smaller population, but the current covered work force (the “official” work force that actually pays unemployment insurance) is smaller now than the 2001-2002 period. Some progress.

Nevertheless, some rebound is expected in the estimate for February jobs, due next Friday. The consensus is for 180,000 new jobs, which seems too high to us but for the snapback effect from the January storms. The report has disappointed four months in a row now, and so perhaps is due for a positive surprise, but we’re not predicting one. Only manufacturing is doing much hiring, and the sector is hardly more than a third of its size twenty years ago. Excluding health care and leisure and hospitality, most sectors are still under pressure.

The Richmond Fed manufacturing report produced another in a series of strong results for Fed manufacturing surveys, so everyone, us included, anticipates a strong national ISM manufacturing report on Tuesday. We also expect, however, that either this month’s report or the next will mark a peak and the ISM will begin to ease afterwards. It rarely stays above sixty for long, and given the political and pricing pressure in the rest of the world, we expect some slowdown in new orders. The Chicago PMI will give the last advance peek on Monday.

The latest estimate for fourth quarter GDP was released, and it came in well below expectations at 2.8% (consensus was 3.3%). The deflator was raised to 0.4%, a rate that we expect to be raised in the fullness of time to something roughly double that. That implies that real GDP ran at about 2.5% or less. Ergo, the economy had less momentum coming into the year than previously indicated. Although some pickup should be expected for the current quarter, the growth rate will probably slow again in the second quarter. If oil prices should fail to retreat soon, there’ll be more pain.

Durable goods rose in January, helped by airplanes. Excluding transportation, they fell, as did non-defense capital goods excluding aircraft (business investment). However, goods have been in a pattern for some time now of beginning the quarter with a pullback and then rising again. We expect that February will show a recovery. The next revision of January durable goods will come in the factory orders report due next Friday.

Another factor in our estimation that the economy is beginning a deceleration phase is the Chicago Fed’s “National Activity Index” reading for January. It showed some decline from December (+0.18) to January (-0.16). Some of the decline is doubtless related to the durable goods pattern and to the weather, but down is down. The sharp rise in energy prices is on the verge of canceling out the payroll tax-cut effect, overriding the weather issue.

Consumer confidence and sentiment rose to new multi-month highs, as measured by both the Conference Board (70.4) and the University of Michigan (77.5). Both of these measures tend to be over-parsed and their readings more a measure of recent newspaper headlines than anything else. Recovery readings should be above 80. The last peak of June 2010 was followed by several months of disappointment that the economy didn’t lift off the way the stock market promised; we see it as more likely than not that both readings will decline again next month.

Food and energy inflation have accelerated in recent weeks beyond what the latest CPI and PPI readings were able to pick up. Besides eating into disposable income, this is also creating problems in the emerging markets. We’ll be paying close attention to the price components of the two ISM reports next week, the manufacturing edition on Tuesday and its non-manufacturing cousin on Thursday.

Rounding out next week’s reports are pending home sales and personal income and spending for January. Pending home sales have been running at much higher levels that actual sales, an indication of the tight credit environment. Besides the ISM report, Tuesday will put up January construction spending and February auto sales.

Wednesday brings the jobs report teasers (layoffs and ADP payrolls), along with the Beige Book (compendium of regional Federal Reserve reports). Same-store sales for February are due on Thursday, but more companies dropped out last month and at this point the survey has a heavy survivor bias (stores with consistently strong sales are happy to keep reporting on a monthly basis, others drop out, leaving a distorted sample). Productivity and costs come out Thursday.