Guess Again

“Another one bites the dust.” – Queen

by M. Kevin Flynn, CFA

The awakening is beginning, and we are afraid it is likely to get ruder. But first, if you took our advice last week and sold on Monday, well done. If you were clever enough to close out on Tuesday or even Wednesday afternoon, even better. Despite Thursday’s ugliness, it probably won’t hurt to put another toe in the water in the early part of next week. The end-of-quarter window-dressing period will line up neatly with the EU summit, and we have no doubt at all that “breaking news” will be strategically leaked from Europe in sufficient quantities to move the tape in the proper direction.

That ought to give you a chance to exit with a smile, while setting the market up nicely for its eventual leg down. That’s not to say it’ll all end on Monday July 2nd , because the first day of the month is usually up, 18 of the last 22 times, says the Stock Trader’s Almanac.

But a rude awakening is brewing. Most of the best volume days have come on stock market declines. Eleven of the last twelve times that the Spyder (SPY) ETF tracker for the S&P 500 has traded over 200 million shares have been to the downside. Volume precedes price, it is said, and we have set to see any signs of capitulation.

The economy is slowing, and Europe is unable to pull itself out of its endless vaudeville of death by a thousand cuts. The good part about the economic slowing is that much of it is being brought on by caution, more specifically the lack of confidence engendered by the European Union’s (EU) inability to get going on lasting solutions. The rest of it is mostly being brought on by the EU’s wretched approach of more austerity as the cure to every ill. Global trade is suffering, and a New York Times report about dressed-up Chinese electricity data would bear out Marc Faber’s assertion that the country is doing worse than generally believed.

The bad part is that the odds of the EU doing anything significant next week to arrest the slowing are slim. The chances are very good that they announce something, call it a major step forward and make the financial amounts (all theoretical) sound as large as possible. In other words, more of the same. The EU structure isn’t set up to move quickly, the Germans prefer an incremental approach, and the grander problem of how to reboot the financial system remains on the shelf.

It could be done quickly. First, do the equivalent of a pre-packaged Chapter 11 filing: Give up on the bad loans and recapitalize the system. But the EU system is too loosely put together to reach an agreement on payment issues in anything resembling due speed. The process could quite literally take over a decade, with many of the actors hoping every step of the way that the banks and countries would eventually earn their way out instead and obviate the solution. It will take a major crisis to burst this dream.

Second, allow the currency to devalue. The Germans would never agree to this, however, which is why we have written elsewheres that the country needs to either acknowledge the trade subsidy it gets by using the euro (and pay for it), or else exit the currency union and go back to the Deutschemark (or a new currency shared with those whose religions also forbid devaluation). Once again, it isn’t likely except in extremis.

Thursday night, the Moody’s credit rating agency cut the ratings of 15 global banks, many of them by a couple of notches and Credit Suisse (CS) by three. The banks replied with the usual statements of the downgraded – the agency doesn’t understand our business, we’re making great strides, pay no attention to that man behind the curtain and besides, everyone knew we were going to get downgraded anyway, so we’re moving on.

The fun part came after the downgrade, watching the stocks of the banks rally in its wake. It brought to mind how the homebuilding stocks would rally in the year leading up to the crash on the back of each fresh announcement that the order book had taken yet another hit. “We already know that,” was the rallying cry. Can’t help but go up from here, was the thinking. But they didn’t.

It’s only fair to say that US banks appear to be in much better shape than four years ago, that credit agencies do lag the market, and the downgrades were indeed widely expected. “Buy the rumor, sell the news” is one of the Street’s oldest dictums. But it would also be fair to say that all of the big global banks lack transparency, and that many managers, ourselves included, would not want to be holding them in any kind of crisis.

Despite all of the above, though – the weakening economy, a punchless earnings season looming, an EU summit that will probably do no more than agree to keep talking – there is a chance for the markets to avoid a summer collapse. One factor is the usual market earnings game – estimates are quickly being brought down in order to rig the news flow and allow the usual percentage of companies (about two-thirds) to beat estimates. Managing lowered guidance will be trickier, but the Street is capable of ignoring the unpleasant for longer than might seem possible.

Markets also like to punish the overloaded trade. Goldman Sachs (GS) went so far as to talk about shorting the S&P last week. If short interest builds strongly in advance of earnings, the tape could be ready to jump on EU press releases or anything else that seemed new and different, however vaguely worded or funded.

The wild card, though, and potentially the biggest factor is the European Central Bank (ECB). This week it announced looser collateral rules, and it has a regular meeting set for the week after next. The bank could undertake another big liquidity operation, like the Long-Term Refinancing Operation (LTRO) it did last year. That was a central pillar of the first quarter’s lunatic equity rally, and hopes for a redux could start getting traction as early as next week, similar to the trade in advance of the Fed meeting.

The LTRO didn’t stop Europe from sliding into recession, and another one wouldn’t do anything to reverse the current one. ECB President Mario Draghi complained last month that EU leaders must come up with their own solution and the bank can’t be expected to keep fix things on its own. All very true, but he may nevertheless feel compelled to do something to stop the recession from getting worse. What he will do is a guess, and the tape misguessed on Bernanke. A similar rally into the ECB meeting could end up undermining itself the same way.

If another LTRO gets launched, the EU economy would not get better. The global economy would not get better. But equity prices would probably take off again, if for no other reason than traders always bet on liquidity and it would be the maximum pain trade. Regardless of how skeptical they might be, few money managers would take the risk of being left behind. They would likely opt instead for the classic hold-your-nose trade. The EU decision-making process would go back to sleep, and the awakening might have to wait until the fall – when the falls get harder.

The Economic Beat

It appears that manufacturing is easing throughout the globe as worry takes a toll on international trade. In China, the private sector PMI declined from May to a seven-month low after the 8th consecutive month of contraction readings. The German PMI declined for the 5th month in a row to its lowest level in 3 years, with the last 4 readings showing contraction and the latest worse than expected. The Philadelphia Fed survey posted a rotten result of (-16.6), the sharpest decline since last August. You may recall that as being an unhappy time for equities.

There was a bit of silver lining. Markit Economics launched a “flash” version of the ISM manufacturing index and reported an expansionary result of 52.9. How well this will compare with the real thing remains to be seen, but it’s hopeful. The Leading Indicators also showed an increase of 0.3%, but you should probably think of it as only 0.1%, because about two-thirds of the increase came from the yield curve. With the Fed’s various operations and the frequent safety-flight takeoffs and landings, the old curve just ain’t what it used to be in predictive value.

There was little good in the Philly survey. Declines were steep in new orders, prices, shipments and workweek. The size of the index decline was about the same as the New York survey, which had managed to stay barely positive. Philadelphia’s reported number of employees did stay about the same. On that subject, weekly claims edged up again (though the media misreports it every week). The constant life-or-death struggle in Europe has to be taking a toll on corporate planning – why would you hire up in advance of an election too close to call (Greece), whose outcome might have induced a global financial panic?

Our own analysis of real data doesn’t suggest any sea change yet in employment trends yet. Claims are varying a bit, but the intermediate and longer-term comparisons with a year ago remain remarkably stable. The monthly jobs data has been better than the adjustment factors have made them appear. However, employment is a lagging indicator and it’s quite possible that claims could remain relatively stable as hiring tightens in the face of the headlines. One analyst characterized corporate CEOs as “terrified” and predicted weak jobs reports on tap for June and July.

It’s more likely to be a pause than a structural decline, but it isn’t going to be a pause that refreshes. The US isn’t over-inventoried or overstaffed, balance sheets are good and banks aren’t stuffed with junk (except, perhaps, for our global champions who need to lose money trading derivatives, in order to compete internationally with the other foreign banks losing money trading derivatives).

The housing news wasn’t new. Homebuilding remains steadily better than a year ago, yet still at historically depressed levels. It isn’t accelerating and it isn’t fading. Next year should be better, but not by a lot. The credit outlook is unchanged: tight, and easing only gradually. Existing home sale data remain bunched around a tight line, and it’s a mistake to make much out of the dispersion.

The one notable datum from the existing report is that home sales in the five-figure range are starting to dry up – it would appear that vulture investors are starting to run low on carrion (this also had the effect of increasing the median price). There is upward pressure from employment and household formation, yet there is resistance from negative-equity sellers and formidable resistance from still-wary banks.

And of course, there was the Fed. It extended Operation Twist and reduced its forecast for this year and next. Take the forecast in stride, as the Fed’s record in this regard is less than stellar. It did not launch the dreamed-of QE-3, nor did it hint that it was imminent, leading to the hope-rally giveback and the 2nd biggest sell-off of the year on Thursday.

Continuing Operation Twist was to be expected, both because to do otherwise would have been a de facto tightening, and because Fed governor Charles Evans had tipped it the week before. While there are risks in continuing the Twist program, the risks from tightening in the face of a likely European mishap are surely greater. The Fed’s action was correct.

Other indications of congealment: domestic trucking tonnage fell for the second month in a row. A survey of CEO confidence showed a decline. Architectural billings shrank for the second month in a row, gaining speed in the downturn. The popular ECRI growth rate, an economic cycle measure, hit a four-month low. Recent corporate earnings and announcements are all guiding lower into the second half, with every sector noting cautious customers and an uncertain macro environment. Oil futures, the favored toy of growth speculators, have been steadily falling and are off over 20% on the year.

Next week rounds out the monthly housing dataset with new home sales on Monday, the Case-Shiller price index on Tuesday and pending home sales on Wednesday. We’ll get to see a lot of regional manufacturing data, with reports from Dallas, Richmond, Kansas City and most importantly, the Chicago PMI on Friday. The national report is durable goods on Wednesday. That category is due for a rebound, so if another decline is seen it’s time to start worrying (though the worry may take time to show up in stock prices).

On the consumer side, the Conference Board reports the results of its monthly confidence survey on Tuesday (we’re guessing it won’t be up). That’ll be followed by the final University of Michigan June sentiment reading on Friday, which also sees the release of May personal income and spending data. There’s another first-quarter GDP revision on Thursday.

The spotlight, of course, will be on the EU summit meeting the 28th and 29th. Soothsayers will be in great demand, both before and after. That first-quarter GDP revision isn’t of much relevance anymore as we hit the end of the second quarter, but you never know – throw in a tenth of a point upward along with quarter-end mark-ups and a bit of EU fantasy trading, and markets could really dance. If there is a big bounce, do get your bags packed and ready.