June Dance

“O, while you live, tell truth, and shame the Devil!” – William Shakespeare, King Henry IV

After a move that was more painful than previewed, MarketWeek is back after missing its first issue in nine years! The surveillance of the market never ceased, but the time to write about it did.

When the equity markets sold off steeply on Friday, May 13th, due to the supposedly lethal combo of Fed minutes that were more hawkish than anticipated and then, Lord save us, a retail sales report that wasn’t lousy, I couldn’t help but thinking – really? Are we back to this inane notion again that good news is bad and bad news is good?

Since then, the thinking has come around a bit to something more common to late-cycle markets, namely the notion that a rate hike must be okay, since it means that one, the Fed is on the job; and two, the economy must be doing pretty good. By the end of May, perma-bulls were practically shouting from the rooftops about the second-quarter rebound, but as we go to press the Atlanta Fed has just downgraded its GDP forecast to 2.5%.

The upward revision to first quarter GDP (from +0.5% to +0.8%) was much smaller than it seems to have appeared to one public-radio commentator who was heard to exclaim it had been revised to “nearly one percent!” – as if one percent is anything to write home about (maybe it is over in Europe, but not here, not after seven years of expansion). Very small amounts of dollars (small to the economy, that is) can move the annualized needle in GDP: the most relevant fact is that four-quarter nominal GDP went from 3.24% to 3.29%. Not much of a revision.

In the final, pre-recession stages of the economic cycle – the one we’re in now – economic growth has waned, profit growth has flat-lined or declined, valuations are high, and so the obsession with the nuances of Fed policy dials up to the maximum. The market can’t buy on growth and earnings themes because there are hardly any to go around, so the narrative switches to variations on the cycle not being over yet, things could be worse, short-squeezing the early bettors on a downturn, and the inevitable wishful thinking that you know, maybe the current cycle could be good for a couple more years yet (at the bottom of the economic cycle, it doesn’t really matter what the Fed says or thinks, because the bank is already all-in on easing and the depths of recession are one of the few times that equity markets understand the limitations of monetary policy).

It’s a crazy game – apart from a few die-hards, traders mostly know at such times that the end of the expansion is nigh, regardless of the eternal optimism of buy-side managers and their strategists. Many will simply move to the sidelines or reduce their positions, and so the action becomes dominated by short-term traders speculating on the next zig-zags of policy. The lure of trading volatility is ever-present on the Street, and while it may well be that more lose at the game than win, it doesn’t stop people from trying.

A couple of weeks ago I wrote that most commentators missed the real story of the stock market’s rebound – that as it sold off, what rescued the market was not some piece of Fed-speak or warmed-over economic news, but traders simply stepping back and letting the S&P 500 bounce off of its 50-day exponential moving average (EMA). The traders let the black boxes jump in and then trade with them on the way back up. I also noted that it was probably temporary, as breaches of the 50-day typically invite a subsequent test of the 150-day EMA (unless the market is in a strong upward trend, which it isn’t).

And so Thursday the 19th, when the market sold off again, traders stepped back and let the S&P bounce off its 150-day, a bounce aided by the fact that the sweet spot for Friday’s options expirations would be in the 2050-2060 range (the index closed that day at 2052). I would suggest to you that a test of the 200-day moving average for the S&P looms, except for one thing: at the moment, the 150-day, 200-day, 52-week and 12-month moving averages are all bunched in a very narrow range between 2025 and 2030, and the 150-day and 200-day averages virtually overlay each other at the present.

If you’re an optimist, you may see this as strong support (it’s certainly inviting to trade on), and for the moment that argument seems to be carrying the day, but as a realist I have to caution you. The market rode its rebound with some benign data and silly headlines, but the early part of June is typically a difficult time for equities. I would say that the odds favor another test of the above-named averages, one that is likely to incite a big drop, as there is no clear support before the 1900 level and indeed a case can be made for another test down to the 1820 level seen in February.

Until then, the rebound has happily highlighted news that is better than expected and rationalized away the bad, the way markets do. Some sales reports were better than expected, though not as good as they looked. My advice is to keep selling the rips, and don’t buy the dips, because none of us know in advance which one will be the one that gives way to the descending cascade that comes at the end of the bull market. Don’t be misled by a few positive-looking blips that get the business press into writing stories about recoveries that will stretch on forever (in the case of the current one, many have been writing for the last two years or so as if the now seven-year old recovery is just beginning). Every business cycle begins its ending with the economy running at full employment – it doesn’t recede from a bottom, as I constantly remind people, but from a top.

Employment, income and related activity are lagging indicators. One can and should expect scattered pops in spending activity, even though the overall growth rate may be nearly gone. It leads to the same scene being replayed at the end of every cycle – early warning signs of slowing growth lead to investor anxiety about an impending end, but then a few last gasps lead many Street voices to declare that it was all a mistake, that there is nothing to fear and the cycle will run on for at least another few years. The more unsteady the foundation, in fact, the louder some will bellow that there is nothing to see here.

I don’t know if the data will lead the Fed to raise rates in June or not, but by then the tenor may have shifted again and the central bank could be afraid to raise rates. The market seems to be emotionally pricing in a Fed raise, so another blink by the bank (if the market sells off, for example) could set off a rebound rally from what it likely to be some enhanced volatility in the first half of the month.

On the other hand, if the market manages to claw its way back to near its all-time high, it will not only be a wonderful opportunity to sell into a sucker’s move, it will probably push the central bank into raising rates again, leading to payback in investor sentiment, even if it isn’t immediate. The curious part is that it really doesn’t matter that much to the real economy if the Fed raises rates or stands pat, because the cycle is going to end anyway and short rates of fifty basis points can’t possibly scare anyone out of making capital investments.

A rate hike will matter – in the short term – to the financial economy and quite a bit more to short-term traders. Unless you’re one of them, I suggest your equity investments begin a long summer vacation immediately. Of course you might miss some last-gasp top, but so what? Investing isn’t about trying to go all-in at precise tops and bottoms, an approach that is strictly for paper portfolios and board games. As the famous Baron Rothschild famously said, he got rich by selling too early.

The Economic Beat

The Beat will return in its usual full format next issue, but for now let me just highlight a few things.

One is that manufacturing is still struggling, even if an April jump in industrial production (led by utilities) led many to declare that the sector’s troubles were over. The regional manufacturing surveys of the last two week were uniformly weak and weaker than expected. Today’s ISM reading was about neutral and the comments were okay, but the sector is going sideways at best.

The second is that retail sales are not as strong as some have proclaimed (note the drop-off in May auto sales). While it was nice to see some economic lift in April, it was most likely exaggerated by year-ago comparisons with a weak start to 2015. The trailing twelve-month rate (unadjusted) has picked up the last two months to 2.7% from 2% in January, but that is due more to the poor sales of last year’s miserable winter. Below 3% is still stall-speed for this category, which is not inflation-adjusted.

The third is that employment growth continues to ease. I don’t have any prediction for this month’s jobs report, but it does look as if employment is flattening. Meantime we are running at full employment and consumer debt is soaring, so expect an occasional bit of good news in spending, even if the growth story is really over. We’re living on borrowed time, quite literally.

The big report this week is of course the jobs report. If it keeps up in the same trend as last month, around 160K, then the Fed may have a bit of a quandary, increasing the chance of a blink and a knee-jerk rally in the financial markets. Consensus is cautious, staying close to last month. It’s no time to gamble.