The Achillean Heel

“When sorrows come, they come not single spies, but in battalions.” – William Shakespeare, Hamlet

by M. Kevin Flynn, CFA

The worst week for equities since November left the S&P 500 index below the 1300 level for the first time since mid-January and down nearly 4% from a year ago, despite the mammoth five-month fun-run from the day after Thanksgiving to the beginning of April. The historic, double-digit, first-quarter gain that amazed nearly everyone (and eluded nearly everyone as well, apart from fund managers) has largely evaporated. The Dow Jones Industrials and the Russell 2000 small-cap index are both barely up a percent on the year, while the S&P 500 still clings to a gain of a few percent, thanks only to Apple (AAPL).

The market is oversold; short-term indicators are plain about that. Just how oversold is a matter of some dispute. Some data-miners are digging up reasons to say it’s worse than anything since the crash, or worse than the crash, or the worst in years, or whatever. The longer-term indicators that we use don’t appear unduly strained, though, certainly not as bad as last August-September and nowhere near the crash levels. Just as the first quarter showed that an overbought market can get more overbought, an oversold market can get more oversold, too, and there’s nothing new about either.

The market is also teetering on the verge of sink or soar. Pulling it towards further meltdown are of course the Greeks, the Greeks and the Germans, worries about JP Morgan Chase (JPM) and its burgeoning trade loss (now scheduled for further uglification on Capitol Hill), worries about a slowing China and the whole BRIC complex breaking down, a Facebook (FB) offering that seemed to expose buyer exhaustion, and just about any more weak data that might step on frayed nerves.

In favor of a rebound are the oversold state of affairs and the possibility that sharply falling markets will prod policymakers into action; they had become predictably complacent during the first quarter rally. CNBC veteran Bob Pisani remarked a sea change last week that we had also noted – after many months of buying every dips, including efforts the week before, traders had thrown it in and were now selling rallies. That doesn’t sound very promising, admittedly, but it is the kind of thing that precedes capitulation.

The tone is going to continue to be set by Europe, obviously, and the possibility for a financial system meltdown if the situation goes into a chaotic spiral. It’s as if 2007 and 2008 have been compressed into a single year, with the first quarter sailing along 2007-style, only to be followed by a 2008-sense of standing at the foot of the volcano again.

Quite honestly, we can’t say whether the volcano is going to erupt again or not, and we don’t think anyone else can either. Some native hue of resolution coming out of the G-8 summit this weekend at Camp David could stem the tide a bit, and indeed Friday’s mild rebound in the euro was surely in preparation for potentially euro-encouraging headlines.

And of course, there are the central banks. Equity traders are always happy to see more dovish intervention, if for no other reason than everyone else buys it too. The problem is that the banks need more grounds for acting first. The Fed is not going to come running in for every minor decline, and the European Central Bank (ECB) is only marginally more likely to act in the absence of danger more clear and present than European equities having given up their gains on the year. An operation similar to the December launch of the Long-Term Refinancing Operation (LTRO), which pretty much reliquified the entire European banking system, would surely be welcomed. It wouldn’t be enough to overcome a Greek tragedy.

But 2008 was filled with hopeful reversals, and this time may be no different. There’s an EU growth dinner scheduled for next weekend, and a summit meeting in June, which is also when the next formal Fed meeting is scheduled. Indications, even hints of accommodation, or perhaps just less austerity, might reawaken the market’s waning sense of confidence. Maybe Greek opinion polls will show a change of heart.

In any case, it’s going to take more than some easing or polls to solve the periphery debt mess, of which Greece is only the most vulnerable part. We shuddered last week when a Bank of American strategist opined that markets are prepared for a Greek exit, and could even stage a relief rally. It’s exactly what Hank Paulson said about the Lehman bankruptcy. For our money, it would be better to have Germany leave the euro and allow the currency to devalue as a way out, but that probably won’t happen. It makes too much sense.

The Economic Beat

Was the Philly Fed report all that bad? It wasn’t a disaster, and diffusion reports don’t measure activity levels, but it was discouraging. The good feeling that the New York Fed survey had generated vanished in its wake.

While the New York Fed is the higher-profile regional bank, highest in the system due to its oversight of the financial system, the Philadelphia Fed survey is older and is considered a better indicator of economic trend. Still, when one considers that they are only about 90 minutes driving time apart, the difference in the two reports is remarkable.

But the Philadelphia report was weak all across the board. The overall index dropped into negative territory, new orders were negative (though the swing was small), unfilled orders and delivery time plunged, and prices both paid and received fell even harder. There really was nothing to like in it, and it weighed hard on sentiment.

The New York Fed report was all right, particularly the index on general business conditions. New orders remained moderately positive and shipments rose. The only blemish was that price increases, the most sensitive leading indicator, slowed substantially.

The Empire State’s survey seemed to be echoed by the April Industrial Production report that came out the next day. The latter showed a strong monthly gain of 1.1%, yet it probably isn’t a good idea to get too excited about it yet. For one thing, the revisions to February and March were unusually large: As of last month, both had been estimated to be 0.0, only to change to +0.4% and -0.6% respectively. It makes you want to wait for another month at least to be sure. For another, the change was led by a big weather-related swing in utility output.

Manufacturing posted a good gain, and capacity utilization rose to a new post-crash high of 79.2 (though that is still below the post-war average). It all makes the Philadelphia report more surprising, even if there is no mistaking its weakness. The Philly let-down was accompanied by a surprise decline in the leading indicator report. The indicators aren’t much of a market mover anymore, but the timing could hardly have been worse and the decline ended a long string of gains.

April retail sales did show a slowdown. The gain of 0.1% was the same with autos, without autos, and core, and while it was at consensus and a post-Easter slowdown was expected, the markets weren’t really thrilled by a tie of what was thought to be a conservative estimate. The Redbook weekly retail report twenty-five minutes later seemed to emphasize the fade when it predicted a decline for May retail sales.

Housing starts came in a bit better than expected, but permits were a little worse and by the end of the week homebuilder stocks were under pressure. We’ll get the rest of the monthly picture next week with existing home sales on Tuesday and new home sales on Wednesday. More of the manufacturing picture will fill in with the Richmond Fed report on Tuesday and the more significant durable goods report on Thursday. A good rebound of 0.5% is expected for the durables report.

Let’s not leave out overseas: Although the European economy managed a surprise 0.0% initial estimate for first quarter overall GDP, thanks to a strong German showing and a French 0.0%, industrial production declined more than expected in April. The weaker euro hasn’t hurt Germany, at least. China’s latest PMI is due out next Tuesday night and the European PMI Wednesday morning before the open, and those two numbers could have considerable sway over Wednesday trade.