A Test of Forgiveness

“Oft expectation fails, and most oft there where most it promises” – William Shakespeare, All’s Well That Ends Well

A funny thing happened on the way to the 1525 level on the S&P 500 index Friday. The market had had its first coy flirtation in the morning at 1524, around the usual peak time of 10 AM. After the morose Europeans had closed up for the weekend and gone home, the markets had steadied and were moving higher into mid-afternoon towards their next date with the seemingly important psychological level.

Then Wal-Mart (WMT) happened. Bloomberg news reported that a vice-president complained in an e-mail that February sales were off to “the worst start to a month I have seen in my 7 years with the company.” The vice-president, who shall remain nameless here (no doubt he is getting enough of a beating this weekend), wondered where all the customer money had gone to. Together with retail sales (see below), it looks like the early returns on the payroll tax indicate it will not be a source of stimulus.

It being an expiration Friday, the market managed to right itself after about forty-five minutes of selling that resulted in a massive fifty basis-point correction, on the high side for these days. Calmer (greedier?) heads prevailed, and much like it did with Wednesday’s European-occasioned drop, the market quickly set about repairing the damage. It was up for the seventh week in a row.

Next week should be the test for February. Historically not a good month for the markets, a post-options expiration period of weakness often follows. But the markets more or less skipped the second-half January fade, and last year skipped the second-half February fade too.

Investor sentiment is bullish but the latest readings are not excessively so, and the slight pullback on Friday left the S&P less extended. The Dow Jones actually lost a few points on the week (thanks to Wal-Mart), though the Russell 2000 small-cap index remains in nose-bleed territory, a clear indication that aggressive traders are still very much in the game.

We are setting up for some kind of showdown between a small but growing group of alarmed strategists and managers, and an apparently growing group intent on playing the seasonal trade to the end, or at least confident about following the leaders. Mid-February has long been anticipated by many as the test.

As I have been writing in recent columns, I don’t really believe that this is about the economy or earnings, but about trading programs versus the headlines. In the absence of genuinely disturbing news, to me it’s questionable whether the indices can pull back much before mid-spring. A percent here or there, perhaps, or even a few percent in March if February manages to pull through unscathed.

There is always the possibility that the trade becomes so over-anticipated that it won’t happen, in classic Street fashion. However, there still seems to be about the requisite level of anxiety floating about. Absent something serious and unexpected on the policy front, it doesn’t yet appear to me as if anything but a sequestration crash has a chance to derail the indices’ march to their all-time highs this spring. As Clint Eastwood told Gene Hackett’s sheriff in The Unforgiven, “deservin’s got nothin’ to do with it.”

I wish a pleasant and long holiday weekend to all US readers, as all markets are closed on Monday, February 18th.

The Economic Beat

So far as the market was concerned, the economic highlight of the week was probably Wal-Mart’s inadvertent warning.

If things are slowing down, the question is by how much, and what passing effect the budget battle may have played. January industrial production declined by 0.1% (seasonally adjusted). The year-on-year increase has gone from 5% in 2011, to 3.4% in 2012 and 2.3% in 2013 (unadjusted). I don’t see the tax increases and spending cuts helping to reverse this trend in the near term.

The February New York Fed manufacturing survey seemed to suggest a rebound, when it came in at 10.0 versus expectations for no change. Along with a consumer sentiment survey that reported a number of 76.3, ahead of expectations for 75, that gave the market a lift in its chase for the targets that loom ahead. The sentiment survey from the University of Michigan tracks stock prices more closely than other surveys, such as the small business optimism index, which was little changed at 88.0 and below expectations. The Bloomberg consumer comfort index has shown very little change in the last month.

Looking at the historic data, I have my doubts about the significance of the NY Fed survey result. To begin with, the underlying raw numbers exhibit quite a bit of seasonality. Going back to the beginning of the survey’s data in July 2001, every February has been positive but for the 2008-2009 recession. The unadjusted number of 13.13 is below average for February, contrasting with a result of 21.2 last year and 29.03 in 2007. The adjusted result was also the lowest February number since 2009.

It seems to imply more than anything else a typical, new-budget, new-calendar-year pulse. It’s nice to be out of recession territory, but it looks to be a dampened peak in an ebbing cycle. March is always positive too, except for recessions, so next month’s result could fan more flames, assuming there is no sequester shock.

The weekly claims data seemed to improve, but as I detailed on Seeking Alpha, it was due entirely to a big seasonal adjustment factor. The year-on-year changes are far smaller than 2012 and imply a leveling off. The rising market has led to much excited talk about how soon the Fed may have to slow its purchases, but the start to 2013 doesn’t give me confidence that we are on track to get to 7% unemployment by year-end. We may have difficulty getting to 7.5% and staying there.

The retail sales report seemed to show the impact of the increased payroll tax if nothing else, up 0.1%. Gasoline sales were up 0.2% while pump prices were soaring, indicating one area where people are cutting back. The consumer inflation (CPI) report next Thursday may well show that sales rose less than inflation. The year-on-year January change of 6.24% was below last year’s pace of 6.47%, indicating a slower start than a year ago.

Import-export prices are still weak, particularly when factoring the speculation-fueled increase in oil prices (don’t take my word for it – check out the charts and data at the Wall Street Journal). The decrease in global trade is an ongoing cause for concern.

One might have thought that the dismal reports on European GDP would have been the news of the week, but markets shook it off after the merest of retraces. The data missed estimates, showed weakness across the board and confirmed a second year of recession with composite EU output of (-0.6%). Germany fell as well with a quarter of (-0.6%), the weakest quarter in two years, but most seem to want to concentrate on its widely anticipated rebound. Time will tell if it’s a genuine rebound, or just another short cyclical pulse.

Next week is a short week with the President’s Day holiday and all US markets closed on Monday. The focus will be on housing, with the homebuilder sentiment index due Tuesday and January housing starts on Wednesday. Existing home sales are on Thursday.

The other main report will be the Philadelphia Fed survey on Thursday. The consensus is for a very beatable 1.1%, though March has averaged about 15% over the last three years. Other data on Thursday, besides home sales and weekly claims (which will see a large downward shift in the adjustment factor), are the January Leading Indicators, the CPI, and the new “flash” purchasing manager’s index (PMI) reading from Markit Economics. It has usually run a point or two ahead of the traditional ISM survey – which also used to be known as the PMI.