A Change of Seasons

“Where are the songs of Spring? Ay, where are they?” – John Keats, Ode to Autumn

Two problems loom large for this current stock market. One is that the market is coming to believe in the inevitability of testing the support lines of the August 2015 low (about 1867 on the S&P 500) and – conveniently near on the charts – the October 2014 low, which was a nearly identical 1862 on a closing basis but was an ominous 1820 on an intra-day level (the S&P closed Friday at about 1931). The growing sentiment that a test is inevitable is making buyers scarce.

The other problem is earnings. While attention tends to be focused on what the Fed may or may not do, S&P 500 earnings are at risk of being flat to down this year, not exactly an argument for paying an above-average multiple. Second-quarter earnings appear to have declined about 0.7%, according to FactSet, approximately offsetting the first-quarter gain of the same amount and leaving growth about flat for the first half. The third quarter is setting up for another negative comparison, leaving the fourth quarter to do the heavy lifting. It’s no wonder that a few – though only a few – hardy souls are broaching the “R” word.

There are some positive effects still to come, such as the end-of-year rally that starts around Thanksgiving and runs (roughly) through the turn of the year. There is also the possibility of the lift any Fed inaction may give to markets. But if earnings can’t start showing some growth, it’s going to be difficult for prices to get above current levels, Fed or no Fed, rate raise or no. The inevitable end-of-year rally could end up being only a partial rebound from 52-week lows.

You mightn’t think earnings were the problem with a market that was preoccupied last week by the papal visit, a surprise resignation by House Speaker John Boehner, and a speech by Fed chair Janet Yellen (“this time we really, really promise that we might raise rates. If we want to. Okay maybe we will, but maybe we won’t. Clear on that?”). Then there are worries over Chinese growth, European growth, emerging markets, commodities and oil. Hey, wait a minute, is this beginning to sound like the dreaded “R?” Or that other kind of stock market that begins with “B?” Belief in that other kind is starting to attract converts, helped along by the central problem of no earnings growth.

Several things are worth keeping in mind. One is that the beginnings of bear markets are very difficult to discern in real time. Another is a point that I have been making for some months now, namely that the business cycle is nearly over. Alas, the beginnings of recession are even more difficult to discern in real time. For what it’s worth, my best guess is that one would not arrive before the first quarter of 2016, which may seem startlingly close to most of you. From my perspective, though, it’s more of a question of how much longer the economy can hang on.

It’s only fair to say that one of my major indicators suggests that a bear market in stocks has indeed begun. I don’t trust any single indicator, however, so I’m not going to go out on that limb yet, though I am fairly certain that we have entered the sideways phase that comes between the bull and bear. Indeed, there is a good case that that we have already made the stock market highs for this cycle. I had long thought that we would breach 2200 on the S&P before it was all over, but that is starting to look more and more difficult. As worries over growth build and another weak earnings season looms, there may be too many sellers waiting near the old highs.

For what it’s worth, the markets are getting increasingly oversold, and while we are likely to face selling pressure through the end of the month and quarter, common to the third quarter and with more motivation than usual this year, the pressure for a rebound is building at the same time. The question is from what level. I believe the case for support in the 1820-1860 level, but sometimes the markets do something else. You can still believe in the end-of-year rally – I do – and my analysis suggests that if we hold to form, the fourth quarter should show improvement in retail spending, enough perhaps to convince prices to move back past the 2000 level on the S&P and leave most of us wondering what the fuss was about. If so, it’ll make a good flight square.

The Economic Beat

The week led off with housing, in the form of existing home sales for August. The 5.31 million annualized, adjusted rate was a dip from July’s reading of 5.58mm. It’s certainly too early to say anything about a one-month drop-off, and it may well be nothing but a blip, as new home sales appeared to rise smartly in August, to a rate of 552K that is still low by historical standards. July new home sales were revised upward, always a good sign. The stock market’s bumpy ride may be having a negative effect on sentiment, however, as the University of Michigan index dropped sharply in the last two months, though still at a good level (87.2). Consumer sentiment measures don’t correlate with spending very well, but they do tend to move in rhythm with the cycle and stock market headlines. Some small amount of caution may have crept in. Agency home mortgage data showed an increase in the year-on-year rate of home price appreciation to 5.8%.

At the other end was manufacturing data, which was not good. The Richmond (-5) and Kansas City (-8) Fed surveys joined New York and Philadelphia in the negative column, with only Dallas and Chicago left to report. You can be sure the energy-centric Dallas region (reports this Monday) won’t be positive, leading one to think that the ISM survey due on the first of the month (Thursday) will be negative as well. However, the ISM survey employs different methodology and respondents, so the purchasing manager index may yet be positive. A very tentative 50.5 (50 is neutral) is the consensus for the ISM. The Chicago purchasing index the day before may be a better clue, though it has been volatile of late. The Markit “flash” estimate was still positive at 53.

Manufacturing weakness can be partly seen in new orders for durable goods, which are down 2.3% on a year-on-year basis through August, the latter recording a monthly decline of 2% that was flat when excluding transportation. New orders for non-defense capital goods excluding aircraft, the proxy for business cap-ex spending, were negative year-on-year for the eighth month in a row. The weak market headlines aren’t going to help confidence.

Two numbers that got a lot of attention for the positive side of the ledger were weekly jobless claims and the latest revision to second-quarter GDP. The latter was boosted up from 3.7% to 3.9%, occasioning a fair amount of celebratory rhetoric, but we are talking about a very small revision in dollar terms, less than $2 billion in a $17 trillion economy. Annualizing it makes the change seem larger, but four-quarter nominal GDP went from 3.66% to 3.67%, for practical purposes unchanged. The rebound from the tough winter of 2014-2015 (in the eastern part of the country) has been much smaller than the rebound from the polar vortex winter of 2013-2014, which fell further but also rebounded higher in real terms. The Atlanta Fed is tracking third-quarter GDP at about 1.5%, though most economists are estimating 2%-2.5%. The Chicago Fed national activity index is closer in tone to the Atlanta Fed, with the former showing a drop in August to (-0.41) and the three-month moving average at zero the last two months. With only a few days left to go, those numbers don’t sound like 2% to me.

Jobless claims may have bottomed for the cycle, if my judgment is correct. Employment entered the peak phase in August 2014, and the average duration is about a year. September is always the lightest time of the year for claims, so I don’t expect any sudden change, but the trough period of the claims rate – which we have just entered – usually doesn’t last long, typically about six to eight weeks. Big layoff announcement the last two weeks from Caterpillar (CAT) and Hewlett-Packard (HPQ) may be a harbinger of things to come.

I can’t predict any disturbance in the jobs report due this Friday, however. One reason is that I don’t even try to predict it (and for good reason), another is that while a low level of claims doesn’t necessarily mean hiring is robust, a low claims rate can boost the initial estimate of payroll growth. In any case, employment is a lagging indicator and restaurant and hotel business (where hiring has been strong) seems to be holding up well, thanks in part to low gas prices.

For that matter, I can’t even predict the effect of the jobs report. A low number at other times might cause the market to rally on hopes of more Fed accommodation, but markets are surely spooked by low growth prospects right now. A high number might make the Fed’s increase threat more plausible for this year, yet reassure the growth worriers. It’s a tough call and only time will tell.

Other reports due next week include personal income and spending on Monday, along with pending home sales and the Dallas Fed index. Tuesday has the Case-Shiller home price report, Wednesday the ADP payroll teaser and the end of the month and quarter for stocks. Besides the ISM on Thursday, we’ll see construction spending at 10AM, September car sales throughout the day (can it really be almost October?) and factory orders after the jobs report on Friday morning. All in all, this market needs to see better economic data for reassurance.