Mid Term

“We hold these truths to be self-evident” – American Declaration of Independence

At the end of the June 23rd week, I found myself with two paragraphs of economic news and one about the market. Looking ahead to the July 4th holiday, when I customarily put out a shortened “holiday” issue, I decided to reverse the usual order and instead put out a combined two-week issue. There was much more to say about economic data, thankfully, and a bit more on the markets.

Some of the market action is worth talking about. The Nasdaq took something of a beating as the month ran on, in part due to the inevitable quarterly rebalancing that follows a prolonged run-up like the one tech stocks have certainly enjoyed. A lot of money has been drawn into Nasdaq 100 stocks as the momentum place to be as well as to park money you don’t know what else to do with. If you can’t beat ‘em, join ‘em.

With so much money being run on a quant basis these days, a little bit of market mojo can turn into a lot more price action, so it isn’t surprising to see some of the retrenchment. A lackluster economy, an uncertain Washington, a very old bull market, it isn’t much to get excited about. So you’ve got be on your toes and be prepared to run from sector to sector these days. That, at any rate, is what many managers believe, and they are making most of the recent price action.

Then there is the Federal Reserve, which seems to be quietly, oh-so-quietly coming around to the notion that valuations might be really, really high. Fed governors aren’t allowed to say any such thing, of course, and even hints that some sectors might be rich (e.g., Janet Yellen’s biotech remarks) invite far too much reaction, along with bitter criticism from those on the wrong side of the trade. Valuations are stretched, no about it, with a lot of long-term metrics looking pretty outrageous. Valuations aren’t what moves stock prices, of course, but the Fed does have to worry about containing the aftermath of their regression to the mean, which is always and ever only a matter of time.

The obvious way to do this is to start removing the props to the financial sector. The price of money has been very cheap for a long time now (to those who can get it), held down by both the Fed’s interest rate policy and its large bond portfolio. Although the Fed ended its policy of making net portfolio additions some time ago, it has steadfastly rolled over maturing principal and reinvested its coupon payments. With aggregate holdings over $4 trillion, this has meant a large and steady buyer in the bond market. Exiting the positions (with exaggerated care, no doubt) will have some effect on depressing prices (and so raising yields), chiefly by removing a big buyer, especially at the long end of the curve.

A steady increase in yields could invoke an occasional bout of panic selling in the bond markets, which in turn could spill over into equities. Too much panic, and the Fed will simply postpone its plans to let the balance sheet run off. I’m of the opinion that the Fed is a good year behind on this program, as it will not want to be selling Treasuries when recession starts. The end of the business cycle has been looming for some time. Since any rapid selling to get back to zero might well hasten the end of the cycle, the central bank has to figure out the appropriate slow, measured pace that can maybe shrink its holdings to an optically acceptable level before the next downturn hits. I’m guessing that the governors would be quite happy if they were to succeed in taking the portfolio down by half before the next downturn can hit, with the hope that the extraordinary measures in the wake of the financial crash might not have to be repeated (i.e., no more QE). My gut tells me that they won’t make it to unloading half.

Technically speaking, the equity markets have worked off their overbought short-term condition, but remain overbought over both the medium and long term. The S&P 500 hasn’t had a sniff at its 200 day moving average since early November, and that is a long, long time to not touch ground. We could get some rocky sailing ahead, but if there is too much put buying ahead of this month’s expiration, the combination of options dealers pushing back and quarterly earnings season could bail the month out. Yes, I know, what about fundamentals, but prices haven’t been about fundamentals for a long time. I hope you all had a great holiday on the 4th.

The Economic Beat

A slow June 23rd week for economic data didn’t get going until Wednesday’s release of May sales of existing homes. The rate picked up to a 5.62mm annualized rate, ahead of expectations. The beat of consensus led to some typical chest-beating about how suddenly glorious the housing market is and by extension the economy, but it was one month’s data that was well within the range of the last six months. Friday’s report of sales of new homes looked better, with upward revisions to the previous three months and an increase in the estimated annualized rate to 610K. The actual trailing-twelve-month (TTM) rate rose to 591K, and the year-year growth rate remained stable at 14.3%. That was at the low end of the range over the last four months (14.3%-15.9%), but the difference isn’t great and is still subject to revision. The following week saw the rate of pending home sales estimated to have fallen 0.8% in May.

The rate of growth in home prices also moved up smartly during April in the federal mortgage database, from 6.4% (y/y) to 6.8%. However, that was followed a few days later by the private-sector (and more widely followed0 Case-Shiller report that showed a slowdown in the year-year rate to 5.7% from 5.9%, partly on the strength of a large downward revision to March (+0.5% vs. +0.9% originally estimated).

The only other real economic news of the prior week was the little-watched Kansas City manufacturing survey, which rose from 8 to 11 (0=neutral). Regional Fed surveys released the following week were generally positive, with Dallas at 15 (down a tad from the previous month’s 17.2) and Richmond at 7 (up from 1). The volatile Chicago survey, which like the national purchasing manager surveys uses a baseline of 50, soared to a very high reading of 65.7 (from 59.4).

All of the foregoing surveys were sound enough the previous month, with only Kansas City suffering a lowered reading. Yet the Chicago Fed’s index of industrial activity in May showed a sharp decline to (-0.26), pulling the 3-month moving average down to 0.04. The Chicago index does get big revisions from time to time, so it isn’t inconceivable that the negative result be erased, but at first glance it appears to be yet another instance of the survey bias that has prevailed since the election.

May orders for durable goods fell 1.1% on a seasonally adjusted basis, but orders were up 0.1% excluding transportation, which suffered another big swing in the always volatile commercial aircraft segment. Business capital goods orders fell 0.2%, seasonally adjusted. Looking at the trailing-twelve-month (TTM) data, the TTM total is down only 1.6% from a year ago, the best it’s been since June 2015, when oil prices were plunging. That said, the TTM total is still at 2011 levels, even lower in real terms.

Another revision to first-quarter GDP was released that saw the estimate raised from a 1.2% seasonally adjusted annualize rate (SAAR) to 1.4%. However, the difference came not from any changes in output, which was virtually unchanged, but a recalculation of the inflation rate (from 2.2% to 1.9%) that boosted the headline number. The estimate for consumer spending did see an increase (0.6% to 1.1%) that was offset in other areas. The NY Fed estimate for the just-completed second quarter is 1.9%, while the Atlanta Fed – which of late has started high and finished low – is at 2.7%. The estimate for corporate profit growth in the first quarter was revised downward from 12% to 11.5%.

May personal income and spending data seemed to confirm a current pattern of weak spending growth, as the spending was estimate to have risen but 0.1% (SAAR) for the month. Income rose 0.4%, though the data was skewed by non-salary & wage categories.

Could it be related to slowing employment growth? We’ll find out on Friday the 7th, when the June jobs report is released (consensus 170K). It’ll easily be the highlight of the holiday-shortened week. Other highlights will include the latest ISM national surveys of purchasing managers, with manufacturing scheduled for Monday and non-manufacturing on Thursday. The latest factory orders data are Wednesday with the Fed meeting minutes late in the day, and international trade is on Thursday.