Shave and a Haircut

“Despair ruins some, presumption many.” – Benjamin Franklin, Poor Richard’s Almanack

You could hardly have helped noticing that the third quarter of 2011 ended with a thud. A similar-sounding headline led most of the business press and was a front-page story virtually everywhere, right down to the use of the word “thud” (an old Street favorite). Comparisons to other losing quarters and dismal streaks made the rounds.

As the Wall Street Journal summarized, investors were anxious about a slowing U.S. economy, European debt, and a slowing China. All very true, and we’ve been featuring these issues in our own quarterly reports and from time to time in this column. Yet none of this was new last week, and only China might be said to have taken a turn for the worse – really it was the news flow about the latter that became grimmer, chiefly based upon accounting-related fears.

We don’t want to minimize any of the above issues, given how often we’ve tried to draw attention to them. But that said, we don’t think that last week’s price declines were related either to new information or new perceptions about any of them. We would say rather that the camp of people who could profit from falling prices last week had more ammunition than the camp of those who would benefit from rising prices.

Indeed, the first half of the week saw multiple attempts to rally the market, and by mid-day Wednesday the S&P looked as if would surely regain the 1200 level by Friday, if not that day. It was mostly window-dressing and marking the tape, to be sure, but it’s a rare market that tries to step in front of such action.

But last week’s market did. The morning rallies were defeated by afternoon selling, with the latter persistently aided by a steady flow of timely news frights emanating from London-based media (see the Economic Beat below).

Understand that most of the time prices get pushed higher towards the end of a reporting period, it isn’t that there are so many buyers as it is that there are fewer sellers. In short, the larger part of the market is benefiting from the rising prices, and so while there may be relatively few actually trying to bid up stock, there are even fewer who want to do anything to disrupt the process.

Why didn’t this happen last week? There were indeed repeated attempts to rally the market higher, but in a rare turn the attempts fizzled out. Our experience tells us that it wasn’t because big-money investors were suddenly fleeing the market over news that Chinese shell companies had dubious accounting practices – that story has been running in Barron’s all year. It wasn’t the U.S. or Europe either, which actually had more good stories than bad running last week.

We would say that, like the bonfire that started in the wake of the Lehman debacle in 2008, the decline started with hedge fund redemptions. When commodity prices started plunging recently, it didn’t take long for the word to get around that certain hedge funds were under redemption pressure. The downturn in commodity prices, a highly leveraged corner of the market, in turn led to margin calls and a downward spiral, putting even more pressure on certain funds. In the mad spring of 2007, the Street circulated takeover lists; last week it was circulating lists of stocks held by hedge funds thought to be under cash pressure.

It’s quite likely that all of this led a large chunk of momentum money to go for the throat in recent weeks, and they in turn were standing readier to take the tape down last week than those who were hoping to see it rise. The markets ignored some positive developments in both Europe and the U.S. last week that, rightly or wrongly, would have led to higher prices at another time.

But the quarter is over, and while there are still nervous sellers, the big money to be made by pushing down prices ended at the closing bell on the 30th. Don’t be surprised to see a sharp rally develop in the very near future, perhaps beginning as early as Monday. Sentiment is nearly washed out, the shorts have done their jobs, booked their quarter and are ready to leg it at any whiff of an upturn. The Chinese stock market is closed all of next week.

There is still risk in the market, because there is still risk that the E.U. – principally Germany – might repeat the Lehman experience by choosing fantasy over reality, as our own government players did with the ill-fated bank. But there is little chance of being surprised by it. Prices already reflect gloomy outcomes, sentiment measures have been showing steep levels of bearishness for weeks, put-to-call ratios reflect near-Armageddon outcomes.

It may seem counter-intuitive, but the pain trade is most likely to be upward this month, and while there is still a good chance that we haven’t made the final bottom, we might not be able to get there without a rally first, for the simple reason that crashes come from a height. The market is not high, and we have been awash in anxiety. Those reasons aren’t enough for a genuinely sustainable rally, but they could be enough to surprise a lot of faces to the upside. All bets are off if real news is significantly bad, of course, but we’re at a point now where even the mildest good news could go a very long way. It’s been that kind of year.

The Economic Beat

The report of the week may well have been one that came out of London. The market was well on its way to its usual quarter-end mark-‘em-up rally on Wednesday when the Financial Times suddenly ran a story in the late afternoon about seven EU countries wanting banks to take a bigger haircut (write-down) on their bonds. It wasn’t exactly news, but a European bond-scare story was just the thing to take the wind out of the rally.

Considering that the European markets had been closed for hours and most of the press in London and Europe had gone home, it was rather odd that the FT would run a story like that ninety minutes before the U.S. close. One has to wonder what motivated the decision to run an essentially stale story at that point, as they could hardly be ignorant of the fact that it could rattle the markets.

It would also be interesting to know who decided to feed the story (again) to the paper in the middle of a sharp run-up in U.S. equity prices. Gordon Gekko, maybe. It was common knowledge that that an attempt to rally prices into the end of the quarter was underway, and that the principal obstacle to the attempt would be fresh bad news out of Europe. However, given all the negative news stories that seemed to radiate from London news bureaus all week, one can hardly help wondering how certain London-based hedge funds might have been positioned.

Outside of that, one might have guessed by looking at the reports and not the tape that either the weekly jobs claims numbers or the Chicago PMI would take the prize, and that the market had rallied.

Weekly claims fell to 391,000, a number which should stay below 400,000 even with the inevitable revision (as we noted in last week’s column, the previous week’s “decline” of 9,000 turned out to be ephemeral – after all revisions were counted, there was no decline at all). The Labor Department was quick to say that seasonal adjustment factors might be awry and throwing the number off.

It’s a bit odd for the Department to be so quickly playing down good news. We checked the data going back to 2000, and while the seasonal adjustment factor (SAF) for the third week of September has indeed crept up over the years, most of the change came from 2000-2005. Using the mean SAF for the last six years still prints a number at about 396,000. It may have been that Hurricane Irene did indeed inflate claims.

There is also some uncertainty (shared by the Department) about the relationship between claims at the end of the third quarter and claims in the fourth quarter. Claims usually lighten at the end of the third quarter and then pick up again in the fourth as companies do their year-end shuffle, but in recent years the ramp-up has gotten steeper. The SAF is supposed to take out such effects, so they may be wondering if it should go back in the other direction. Let’s hope that it was indeed Irene and that layoffs have actually lightened.

The improvement in claims won’t help the jobs report due on Friday, because it came after the cut-off. But we can tell you that there was some improvement in job survey results that do correlate with an improved claims outlook. The Conference Board’s monthly confidence measure did show more pessimism about the current job market, but in contrast more optimism about future conditions. The University of Michigan showed improvement in both respects.

Of course, both of them reported very low numbers – 45.4 for the Conference Board, 59.4 for Michigan. But much of that, if not most, is attributable to the headlines about the stock market, Europe and the bitter government divide. The good news was that every region reporting last week – Dallas, Richmond, Kansas City, and Chicago (the first three being regional Fed surveys) – reported increased hiring in manufacturing. We gutted our manufacturing base in the late nineties, so the pickup doesn’t help as much, but it helps.

Manufacturing surveys were mixed last week, with Dallas and Richmond reporting declines and Kansas City and Chicago reporting growth, and the latter in particular posting eye-popping numbers overall (60.4) and in new orders (65.4). The gains seem to be coming primarily from autos and aerospace.

Durable goods eased in August, as expected, but the business investment category gained 1.1%. On the housing front, there wasn’t much movement: new home sales are still drifting around the 300,000 level, with the August estimate at 295k. Prices weakened again, with the silver lining being the continuing fall in supply to new lows every month. Case-Shiller data showed no change for existing home sales, so the weakness in new home sales pricing may be due to mix. Pending home sales fell for a second straight month in what is undoubtedly a reflection of the ever more fearful banking sector: purchase applications have been showing some mild improvement.

The personal income and spending report gave another reason for the low consumer survey numbers: income fell, though spending rose. Real disposable income fell for the second straight month. The big decreases were in the services sector and personal transfer receipts: Medicaid and unemployment insurance. It would seem that more people have exhausted their benefits.

Next week has two numbers of major import: the ISM manufacturing survey on Monday, and the jobs report on Friday. In between come the ADP payroll teaser and the ISM non-manufacturing report on Wednesday.

Certainly expectations are low for both the ISM and the jobs report, with consensus expecting another neutral reading for the ISM and an increase of 65,000 for the jobs report. It’s safe to say that the Street is primed for declines in both (in the ISM, that’s below fifty). We think that the first number is primed to surprise, but the jobs number will be a challenge.

The rest of the week will include August construction spending and September auto sales (Monday), August factory orders on Tuesday (mostly tipped by the durable goods report), the ISM services report Wednesday (the one that matters more to current-quarter GDP), September same-store sales Thursday (weekly numbers looked weak). We’ll also get some August inventory data on Friday along with consumer credit.