“Who was so firm, so constant, that this coil would not infect his reason?” – William Shakespeare, The Tempest
It was indeed quite a Halloween treat on Friday. Just as the usual jitters that come in October pre-earnings season combined in mid-month with Ebola and a gloomy IMF growth outlook to pound stock prices, so at the end of the month came a fresh story of renewed central bank determination to pump them back up again. Japan’s buy-everything story hit the tape Thursday night in the US, sending futures prices soaring and riding the end of the traditional third-quarter earnings rally that makes the last four days of October amongst the best in the year, even during stock market crashes (in 2008, the S&P 500 rallied 14% over the last four days of the month of October).
Most mutual funds use October for their fiscal year, so a shrewd manager will dump losers during the traditional decline and switch into fresh names, not only cutting the tax bill but making the list of annual report holdings – which has to be disclosed in full – look a whole lot better. And since the tape makes the news, it always gives way to a fresh burst of stories about how great the emperor’s new clothes look.
That brings us to the tricky part of the tale – if, as stories jubilantly repeat, consumer confidence is at an all-time high, the economy is doing great, the stock market is at an all-time high, unemployment is below the historical post-war average (and I say we’re likely to drop to 5.8% or so in next week’s release), and claims are at their lowest percentage of the population since 1968, then how can Americans think the unemployment rate is closer to 30% and the sitting President be near record lows of unpopularity?
The short answer is just a repeat of the reality that the tape makes the news. When stock prices are overshooting to the upside, every positive-seeming item is heralded as yet another solid brick in the robust foundation of, well, robustness. Every negative item is immediately assigned one-off status and looked upon as a freak. Case in point: The first estimate of third-quarter GDP was released Thursday morning, showing an annualized, seasonally adjusted rate of 3.5%. Although some of the internals were weak enough to get forecasters to start lowering forecasts for the next quarter, by Friday night the story was flying around that the last two quarters of GDP growth were the best in over a decade.
The breathless tidbit casually omits the sharp 2.2% decline in the first quarter that led to the oversized 4.6% rebound in the second quarter. The first quarter, you see, was an aberration and so shouldn’t be counted, while the rebound was just more good stuff that we should all expect, right? Well, now that the third quarter is in, the four-quarter nominal growth rate stands at 3.9%. The average for the last four years? 3.9%. That’s some acceleration.
As for the booming numbers in employment, there are a couple of twists that get left out. Layoffs as a percentage of the population are at a 46-year low, yes. So is the percentage of the population that’s actually working. You can’t file for jobless claims if you have no job to begin with. There’s more below in the Economic Beat, but I’ll cheat with one more nugget: we still don’t have as many people in the insured work force (paying into the Social Security program) as we did before the recession, and aren’t on track to get there until sometime next year.
Part of the reason for the violence of Friday’s rally was fear – fear on the part of short-sellers. As soon as the news of Japan’s remarkable decision to add more QE (about $100 billion) by the Bank of Japan, on top of having the official pension fund buy more domestic and international equities, fears of a global short-squeeze began to spread rapidly. The yen plunged on the news, and suddenly Germany was in the cross-hairs. News of another rotten month in German retail sales crossed the tape even as its chief export rival in autos, precision machinery and other key industries was getting a currency boost. How could the eurozone delay QE much longer? The Germans would be forced to capitulate.
Frankly, I don’t think that more QE is really going to help the Japanese economy or the European ones – it feels like more of a desperation move than anything else. It also reminds me very much of what I believe to have been Denmark’s pension fund decision to reallocate (capitulate, really) towards tech stocks and venture capital at the end of 1999. Sovereign pension funds are fabulous at investing in what worked five years earlier.
But the stock market doesn’t care about such nuances in the short term, and I can’t say I blame the traders for fearing a short-squeeze. As Japan so clearly demonstrated, it’s impossible to predict policy decisions.
Before you cry “Excelsior!” though, there are still a couple of hurdles to cross before stocks launch into a one-way bet for the rest of the year. One is the post-season letdown that usually takes place in early to mid-November: despite the hype, earnings growth is likely to be about 7.3%-7.5%, below the second quarter’s 7.6%. Many of the big global industrials are clearly flagging, and while there are always excuses to be made, a struggle to keep up with the order book isn’t one of them. It’s a familiar late-stage phase.
There are some psychological hurdles to cross in the next week, beginning with the Tuesday election: Wall Street belief in a Republican Senate (for all the good it would actually do) was behind part of last week’s rally. Should the GOP fail to regain outright control, stock prices will pay the disappointment tab. And while I remain firmly afraid to guess what this coming Thursday’s European Central Bank (ECB) announcement might bring, two historical trends are undeniable, one of them being that the bank takes great care to appear as if its hand were unforced. It would be very like the ECB to decide on QE this week and then wait another month to announce it.
The other bit of historical evidence is that the Germans remain firmly opposed to most forms of QE, particularly the sort that involves buying any government bonds. The country isn’t exactly known for changing attitudes on a dime. If the Germans ever do come around, it’ll be because they are looking into one sort of abyss or another (or at least think they are), not because the U.S. stock market is at an all-time high and so they feel obliged to join the party. The name Lehman Brothers has hardly been forgotten in the corridors of power overseas.
Finally, there is Friday’s jobs report. I’ve been going out on a limb to say I expect a very strong number, possibly 300K or more, due to the very low claims numbers during the October measurement period. The Bureau of Labor Statistics may yet make me look like a fool, as it has so often done with so many others; its model is constantly tweaked. But should a very strong number come through, the market may suddenly find itself worrying about tightening again at a time when stocks are vulnerable anyway.
Last week I wrote about the V-shaped trading pattern that would be sucking in money until the market reached new highs – and the V busted its way through, though Japan pushed it up a day or two earlier than I thought likely. But we’re not out of the woods yet. I suspect I’ll be writing instead about a cup-and-handle pattern in a few weeks’ time – but that’s a treat for another column.
The Economic Beat
The trick or treat theme did indeed play heavily in the week’s economic releases, in particular with the first estimates of third-quarter GDP (+3.5%, seasonally adjusted annualized rate) and September personal income (+0.2%) and spending (-0.1%).
The initial estimate of GDP did beat the consensus guess of 3.1%-3.2%, but the result also had forecasters lowering growth estimates for the fourth quarter. Big boosts in the third quarter came from military spending (+16% annualized) and the trade balance. Given events in the Middle East, the former category seems likely to maintain its current level this quarter and even increase, but not jump much. Exports rose 7.8% and imports fell 1.7%, both unlikely to repeat due to seasonal reasons and the recent strength in the dollar.
Real spending slowed to 1.8% from 2.5%, while gross domestic purchases fell from 4.8% to 2.1%. Inventories fell slightly, but were still elevated through the end of August – it’s hard to say yet how much might have been worked off in September. It’s difficult to predict inventory builds anyway, and in the modern economy a build one quarter often ends as a draw-down in the next anyway.
The first estimate of GDP is only that, of course, and it would be rash to read too much into a number that often gets changes of between a half and a full percent. What caught my eye more than anything else about the release is the constancy of the economy – four-quarter nominal GDP growth actually fell to 3.9% from 4.3% in the third quarter, but is dead on with the average four-quarter rate of 3.9% that has prevailed since the end of 2011. The 3.5% third-quarter rate also got a boost from the inflation deflator, as the nominal quarterly growth rate fell from 1.7% to 1.2%.
There were plenty of explanations for the monthly drop in September personal spending, ranging from Ebola to the Middle East (it’s all people talk about in Wal-Mart, I am sure), but I’ll put forth three more sensible reasons: 1) Labor Day came early, pushing back-to-school purchases into August; 2) the compound rate of growth in real per capita income the last seven years is 0.01%; 3) with typical monthly noise, you’re going to see more months registering below zero in an economy with such slow nominal growth.
The maddeningly wrong “gasoline is a tax-cut” story keeps circulating more and more, however. The drop in gasoline prices doesn’t affect personal consumption totals, only the mix: If you had $100 to spend last month (or seven years ago), you still have $100 to spend this month. Some of it may go to apparel or food instead, but the $100 is still $100.
Every week I see ebullient statements on how employment growth is going to move us into a new stage of accelerating growth, making me wonder if the speakers are ignorant, lazy, or just – well, something else. Though I do expect a big number for the October jobs report, we are already in the peak zone of the insured unemployment rate. Far from being a perpetual-motion engine of ever higher growth, employment always peaks after a recession has started. While the party surely doesn’t figure to end in the next few weeks, it most certainly isn’t going to last a few more years, either. Even one more year would be unusual. Moreover, lost in all the self-congratulatory Street talk over employment is the fact that the number of insured workers still hasn’t caught up with the last peak. If employment gains stay on course, we will catch up with the previous peak by the end of the first quarter of next year – and may not have too long to enjoy it, as employment is a lagging indicator.
A report that had the Street buzzing on Friday was the release of the employment cost index for the third quarter. It rose 0.7% in the last three months, a result that beat consensus for 0.5%. Predictions of strong wage growth and dangers to inflation immediately followed. To which I say, “nonsense.” The current 2.2% rate of annual growth surfaced earlier in the recovery (second quarter 2011) and represents only the second time we have reached even that level since the crash – a level well below the last cycle (2002-2007) and even below the entire recession year of 2008. That’s not to say that it won’t go higher, only that we are already close to a much lower peak.
On the manufacturing side, the news was mixed but on balance positive. The Dallas and Richmond Federal Reserve banks posted solid survey readings, and the Chicago-area purchasing manager’s index put up another rocket number, 66.2 where 60.5 had been expected. That last result didn’t get nearly as much attention as it might have a year ago – as I’ve written earlier, the Chicago PMI data has gotten far more volatile since it was taken over by a privately held exchange firm (Deutsche Bors). I don’t take it as seriously as I once did, and it would seem the Street doesn’t either. New orders for durable goods in September did significantly miss consensus, falling by 1.3% instead of rising 0.9%, with orders excluding transportation also falling. I didn’t think that the number was really bad, though, as the year-on-year rates were unchanged.
Home sales data remained in its modest 2014 trend, with pending home sales up 0.3% (consensus 0.8%) and the year-on-year increase in the Case-Shiller home price index falling to 5.6%. Consumer confidence was the highest since October 2007 – the same month of the last cyclical peak in the stock market. Whoever said consumer confidence was a contrary indicator?
Next week is the first week of November, therefore filled with market-moving reports, including the two ISM surveys, with manufacturing on Monday and non-manufacturing on Wednesday. Then there is the biggest report of all, the jobs report on Friday. I’m guessing that all will show strong results (though the surveys are only surveys), but less so for construction spending (Monday), factory orders (Tuesday) and productivity (Thursday). Some retail sales will also be released, including auto sales on Monday and Tuesday and the very small sample of same-store sales Thursday. Watch for the ECB announcement on Thursday morning.