The Merry Month of May

“Love, whose month is ever May, spied a blossom passing fair” – William Shakespeare, Love’s Labour’s Lost

As has happened so often through the years, the stock market is baffling onlookers by ignoring the economy that exists. Negative GDP for the first quarter? No problem. Spending declines in April? No problem. What the markets are currently looking for is the magic elixir of central bank easy money. Trading programs are fervently inserting central banking replacements for the Federal Reserve, and appear to be quite ready to plug in the successors without bothering to wait for any acceptance speeches.

The other side of the recent melt-up in equities is the multi-year high in short positions that existed in the middle of May. Readers would be well advised to remember the similar event from this time a year ago – short interest at a multi-month high, people expecting a post-earnings season pullback, and wham! – the European Central Bank (ECB) wheels out the easy money artillery on May 2nd. Result: Massive short-squeeze, prices go parabolic, day traders exult that central banks make buying equities risk free. It’s so crazy that Ben Bernanke gets nervous and drops the “taper is over in six months” bomb. Equity markets take their beating, but what catches Ben unawares is how much leverage the bond market has on – bonds around the world get an even bigger whipping.

Roll forward one year, short interest at multi-year high, the ECB is promising something big on June 5th. As the market creeps higher on low volume, more and more shorts are squeezed into covering – and the squeezers are very much aware of it. Retail investors, as usual, are getting sucked into believing a rally that is about to end, while others seem anxious to recreate the magic 2013 formula that central bank money cures all. But while last year’s action by the ever-so-deliberate ECB was a surprise, the only possible surprise this year is if they don’t do something big. I would not be at all surprised to see the recent move start to break apart right after the much-anticipated meeting on Thursday (cf. “buy rumor, sell news” in your investor encyclopedia).

The economic news was mostly tepid all week, with the exception of weekly claims (down, but nothing extraordinary) and the Chicago PMI (see below), the latter having zero immediate impact on the market. That hasn’t mattered – tepid will do just fine, thanks. Just ask the bond market. Anyone in the stock market afraid of tepid must have gotten out a year ago. Everyone expecting worse this month – perhaps lured by dire correction warnings – sold their (often borrowed) shares, but worse failed to show. “Wait ’til next year,” on the other hand, is a permanent resident.

Some say that the bond market is correctly worried about the Ukraine, while the stock market is ignoring it at its peril. While the latter could be true and entirely characteristic of stocks – like pigeons, they jump at the first cocked arm and then ignore the rest – I’m not sure the bond market is going through anything more than a short squeeze and some fast trading. True or not, the bond market is definitely not worrying about accelerating economic growth, psalms sung by the equity shepherds notwithstanding.

Friday was the last trading day of May, so it may yet turn out that selling that day will turn out to have been a sound move. Business television and media, not surprisingly, go to work every year lambasting the old “sell in May” maxim before we’re even out of April (they do the same thing again at the end of the summer with September), but what the adage refers to is the fact that the six months from November to April have remarkably outperformed the six months from May through October through history (most of last year’s gain came in the designated months – the November 2012 to April 2013 move was especially strong).

There has never been an insider secret that equities start to fall off the cliff the first week of May – June is actually the more dangerous month, and from 1985 to 1997, May was up every year, not to mention being the best-performing month over that stretch. But the media loves to charge after straw men, and are encouraged in the task by traders far more cunning than the newsreaders they whisper to.

The market is overextended and the low-volume rally is apt to break up at any time, though the carrot of the ECB meeting Thursday might keep things afloat until then. A year ago you might have watched in disbelief, but once the Fed chickened out in September there was no stopping the stock market. We’re not going to rerun 2013 this year, though, however much the mini-squeeze may have dazzled the unwary.

The Economic Beat

The most prominent report of a week when the market paid little heed to them was the first revision to first-quarter GDP. Coming nearly two months after the end of the quarter, it is admittedly a backward-looking piece of data, but the size of the number (minus one percent) was eye-opening. It was the first negative quarterly rate since the first quarter of 2011.

Apologists and market acolytes rushed forward in the wake of the release to either discredit it (“the polar vortex”) or insist it set the stage for an even better second quarter. Not surprisingly, many were in both camps. There were some misguided attempts to try to highlight the strength of consumer spending (rising at a 3.1% annualized rate), but the number was inflated by somewhat involuntary spending on medical care and home heating. Spending on goods was estimated to rise at only a 0.7% rate.

The number was also pulled down by inventory contraction, as has been the case on a periodic basis,. An enduring pattern of the recovery has been an inventory rhythm that features a rebuild quarter coming about once a year. It lifts quarterly GDP growth above 4% and produces the same excited declarations every time from Wall Street boosters that this time the economy is reaching escape velocity. After the restock peaks, the “escape” quarter is followed by several quarters of diminishing contributions from inventories until they turn negative again – also about once a year. The latter occurrence is invariably dismissed by the boosters as a one-off correction that will most assuredly be followed by more growth. And it is – eventually, for about a quarter, and then the pattern repeats itself. The net of it all is has been that every year, annual nominal GDP remains at about 4% (even that rate has been slipping), real GDP at 2%, and the boosters keep promising – nay, insisting – that a bigger number is just around the corner.

The second quarter is indeed likely to be positive, although it is off to a mixed start. At the other end of the spectrum from the GDP report was Friday’s release of the Chicago PMI, with a very high reading of 65.5. The details of the report are no longer released to the public, but it does seem to me that the Chicago PMI has been running hotter ever since it was taken over by the stock exchange operator, Deutsche Borse. Certainly it has been running well ahead of every other manufacturing survey – Dallas and Richmond were both positive in May, but less so than the prior month.

I don’t know what the Chicago unadjusted data says, but the part of the report that was publicly available (click on the link above) raised my eyebrows with its deeply bullish spin from the MNI (Deutsche Borse) economist, blaming the first quarter squarely on the weather and declaring that “growth is becoming more entrenched.” The Chicago report didn’t feature that style of commentary in the past, nor does one see it in other manufacturing surveys. One would hardly ever guess that the report was written by a group whose fortunes are tied to the stock market.

April wasn’t the warmest of months, something that showed up first in the retail sales report and now again in the personal income and spending report. The latter showed a contraction in its PCE (spending) category of (-0.1%) for the month, or (-0.3%) in real (inflation-adjusted) terms. Much of the effect was due to a pullback in items like automobiles and heating, so I don’t consider it the beginning of the end, but declines in nominal personal spending are infrequent, with only four in the last four years. The money didn’t go elsewhere, either.

Though the spending result was well below consensus, it didn’t bother the market. Personal income rose 0.3% on the month, also less than the expected 0.4%. Real disposable income grew 2% year-over-year, which doesn’t make much of a case for the still-celebrated (on Wall Street) 3%-plus rate in GDP that we are supposed to enjoy this year. The Street keeps claiming it will come from employment growth, but the compound annual growth rate for personal income is 1.8% for the last four years and only 1.5% for the last three – and it’s the last three in which employment has grown.

April also got off to a weak start in business spending, with new orders for durable goods in that category falling by a seasonally adjusted (-1.2%). I happen to believe that the warmer month of May is going to see the real weather rebound, but even so the second quarter is off to a weak start. The headline number for durable goods rose 0.8% in April and March was revised higher, mostly from seasonal adjustments. But the former was only up 0.1% excluding transportation, and shipments – the part that factors into GDP – slipped (-0.2%).

Housing, which through the first four months of the year is running below 2013 in both new and existing sales, was apparently still tepid in May with only a 0.4% increase in pending home sales from April. The mortgage process remains very onerous and investor interest seems to be backing off. The increase in home prices eased slightly, with the Case-Shiller report showing the March year-on-year increase at 12.4%, down from 12.9% the month before. The federal mortgage database showed the year-year increase also declined by a half-percent down to 6.4%, which clearly indicates the strength concentrated in the upper end of the market (the federal database tops out under $1 million). The National Realtor’s Association estimated that $1 million-plus sales rose nearly 8% in March on a year-on-year basis, while the low end of the market (below $250K) cratered.

The real highlight of next week is not the jobs report, as one might ordinarily think, but the ECB meeting on Thursday. Consensus for the jobs report is for a little over 200K, not as strong as the April report, not weak enough to turn the Fed aside from its taper path, and the market is likely to accept anything in the 175K-250K range. It’ll be preceded by the ADP payroll report on Wednesday.

Other reports in a very busy week include the ISM surveys on Monday (manufacturing) and Wednesday (services), construction spending on Monday, April factory orders on Tuesday, the Beige Book regional economy survey on Wednesday (along with international trade), and May sales for autos (Tuesday). A raft of overseas manufacturing surveys are also on tap, starting with China on Sunday night.