Looking for Direction

“And there shall be a great confusion as to where things really are.” – Monty Python, The Life of Brian

The stock market is handing out more warning signs these days. The problem is that divining exactly what they mean has always been a tricky art.

When stocks got off to a weak start in January, I wrote that the phenomenon mattered as an indication of changing sentiment in what had been a sentiment- and liquidity-driven market. Last week’s price action followed classic earnings-season form for the first four days of the week, the indices floating up a bit higher every day. Then Friday arrived and sellers gave most of it back. Like January’s decline, that kind of move isn’t a signal that the bottom is about to fall out – then, as now, I expect prices will try to continue their upward climb. But it does provide another indication that the base of sentiment has weakened.

There were a variety of reasons on offer for Friday’s decline. Worries about Russia and the Ukraine, another Amazon (AMZN) earnings result resulting in a sell-off, a little bit of profit-taking. They are all valid reasons, but the latter two were more indications of a market out of sync with its 2013 swagger. It was the second quarterly result in a row that Amazon earnings actually beat estimates and sold off significantly afterwards – the stock is down 25% from its late January high. That the stock should correct after earnings is nothing new, because the company hardly ever reports a profit. But the stock price was able to triple from 2010 to 2014 in the face of an endless string of earnings misses and lack of profits. Sales growth was all that mattered.

The sea change in the market isn’t that the market has suddenly decided that sales growth doesn’t matter anymore, an easy conclusion to reach when confronted with the beating that stocks with lofty price-to-sales ratios have been taking this year. Nor is it the tortured logic that some CNBC presenters have been trying out for us, the idea that people are selling growth stocks because they feel the economy is about to accelerate and so they would rather have real earnings, making it the first time in memory that investors had decided to pile into utility stocks in anticipation of an economic upturn.

No, what we are continuing to see is investors getting out of high-beta, high-valuation issues and into low-beta, low-valuation issues as a defensive measure. Much like the early going in the year 2000, it reflects less of a philosophical shift in the desire for real earnings and more of a concern that prices the previous year went too far on a liquidity boom that appears to be drying up. Investors will keep throwing money at momentum stocks, regardless of valuation, if they think others will. Experience has shown, though, to keep an eye on the money river, because once it looks like it’s starting to abate, high-flying stocks fall the furthest and you don’t want to be left holding the bag.

It remains to be seen whether growth in 2014 can finally live up to its advance billing, or like the last few years be postponed yet again to the horizon. Perhaps more important than the question of 3% GDP this year or next is how much longer the current expansion can last and whether or not an uptick could be the final leg – business cycles still don’t last forever. The data is unclear on this point, but one thing that seems reasonably clear is that the FOMC has no good reason yet to turn aside from its intended path of tapering. That doesn’t mean it won’t – policy decisions are unpredictable, to say the least, and the Fed has shown signs of succumbing to hubris about its ability to steer the economy. But if it does stay the course, that source of liquidity is going to keep drying up, putting not just the high-fliers at further risk, but last year’s multiple expansion as well.

The Economic Beat

The report of the week was probably the one on March new home sales, which reported a surprise decline in the seasonally adjusted annual rate to 384,000, well below expectations and the year-ago rate of 443,000.

The good news is that it was only one month’s data, and new home sales will probably bounce back as the selling season gets into full swing. The bad news is that the sector may have trouble getting above the 500,000 annual rate (actual) during this cycle. Historically, that’s an extremely low level.

The problem is supply and demand. The Fed’s QE policy has inflated the prices of assets beyond stocks and bonds – new home sales prices are up over 12% year-on-year. The median price of $290,000 is at an all-time high (partly a mix issue). Sales, however, are down over 10% from the year-ago month and down 2% from the year-ago quarter.

Quantitative easing has been unable to address two other problems – low to non-existent wage growth, and the credit cycle. The first is a fact that monetary policy cannot address (not in real terms), and the latter is unlikely to reset its historical pattern just to suit the Fed.

I’ve said it many times – banks are lemmings. They all chase the same things at the same time. Whether it’s trading derivatives or making energy loans, a successful sector invariably gives rise to a flood of new money that eventually drowns it. Oddly enough, this usually happens long after prices and terms have risen to the point that they make no economic sense other than the possibility of selling them immediately afterwards to a greater fool. Competitive greed and the fear of being left behind are powerful forces.

What usually kills a sector is running out of fresh meat – borrowers, in other words. The reason I make this distinction is to illustrate the point that sectors don’t rise and fall on pricing alone, but on the number of willing participants. In bank lending, the classic historical pattern is that once a sector is overfinanced, it takes at least two credit cycles to recover. The reasons are simple enough – after a blow-off cycle, the banks get religion and end up sacking most of the people responsible while subsequently enduring years of losses sitting on the books. One doesn’t get ahead in the banking world by using the subsequent credit expansion cycle to advocate a fresh plunge into the morass that nearly brought down the institution. It takes time, loss of institutional memory and years of minimal credit-loss experience to re-establish the sector’s acceptability

Home lending is not going to recover to historical levels this cycle. Mortgage rates may be relatively low, but credit standards are monumentally tight. The banks may have earned their mountains of fines with an era of sloppy paperwork and an if-it-breathes, give-it-a-home-loan attitude, but a byproduct of their punishment is an ongoing reluctance to give a mortgage to anyone not directly related to God or Mark Zuckerberg (and even the latter has to sign a 500-page agreement). I am hopeful that the situation will ease in the next credit cycle, but it isn’t going to happen in this one.

Existing home sales echoed the story. The annualized rate of 4.59 million fell again in March and is now down 7.5% year-on-year, even as prices are up 7.9%. Mortgage-purchase applications dropped to a new 2014 low with an 18% year-on-year decline.

Manufacturing showed some life, with a March increase of 2.6% in new orders for durable goods (2% excluding transportation) and a long-awaited rebound in capital spending of 2.2% (seasonally adjusted). The twelve-month growth rate of 4.8% was the best for the latter since September of 2012. The Kansas City and Richmond districts reported decent manufacturing survey results, while the Market Economics initial PMI reading was fairly level at about 55. The Chicago PMI is next Wednesday and the national PMI reading is on Thursday.

An increase in capital spending wasn’t enough to save the economy in the first half of 2000, and it may not be enough now. Weekly retail sales figures were disappointing, considering that the week in question was Easter week. Year-on-year results will look better, but the monthly sales figure could be weak apart from motor vehicles.

Next week will bring the two main events on the calendar, the FOMC statement on Wednesday the 30th and the May employment report on Friday the 2nd. It’s possible the latter could breathe some new life into the market: weekly claims are down 7% year-to-date, but were down a much-larger 13.5% year-on-year during the April measurement period. Though I suspect that the claims weakness has much to do with the simple fact of hiring fewer workers earlier in the year, it should nonetheless give the Labor Department’s seasonal adjustment factor a boost and could make for a satisfying headline print. Consensus is for 215,000.

The week is jammed with other big reports, not least of which is the first estimate for Q1 GDP growth on Wednesday morning, Consensus is for 1.1% – could a low number influence the Fed’s decision? They’ll also see pending home sales data on Monday, Case-Shiller prices on Tuesday and ADP payrolls that morning – though presumably the FOMC members will already have Friday’s jobs number in hand. The Chicago and national PMI numbers come out Wednesday and Thursday, personal income and spending (mostly known in March from the GDP report) on Thursday along with construction spending and April auto sales, topped off by factory orders on Friday. The market’s focus will be on the big three of the FOMC statement, the GDP report and the jobs report.