Toil and Trouble

“Is it safe?” – Sir Laurence Olivier, in Marathon Man

When the trading squalls reversed direction yet again last week, this time turning headwind to tailwind and powering the Dow Jones Industrial Average to a near-300 point Friday gain (though still down on the week), it brought to mind Sir Laurence Olivier’s iconic Marathon Man riddle to Dustin Hoffman: “is it safe?” Hoffman’s graduate-student/distance runner character, “Babe” Levy, was a pawn in a high-level, high-stakes game of international intrigue, which is about how most retailing investors were feeling last week. As for whether “it” was or was not safe, Levy hadn’t the slightest idea what the menacing Dr. Szell (Olivier) was talking about with his insistent question. Perhaps it is in that spirit that I write this week’s column.

If asked, damage control would report that despite Friday’s rebound, last week’s storm nevertheless left the Dow Jones down on the year, along with the small-cap Russell 2000 index. The S&P 500 was briefly in negative territory a couple of times during the week, but managed to exit the week still clinging to gains of about two percent, similar to the Nasdaq.

If you want to know why we had so many swings of three to six hundred points (intra-day), and why the indices are where they are now, there were about three to six hundred reasons being offered up by the end of the week. I can say with certainty there was not one single factor, regardless of the usual outpouring of conspiracy cranks, government-haters, and “end is near” professionals who appear after the sound of every accident.

The sell-off had a mix of reasons, but one of the most important was also was one of the least-cited ones – valuation, as in, “quite elevated.” Don’t get me wrong, because in the short and medium term, valuation has little to no influence on whether stock prices will go up or down. It does affect how far they might go in one direction, however. The selling was not precipitated by any sudden revelations about earnings or their proper multiples, but awareness that the market engine had gotten long on altitude and short on helium while crossing the great October divide. The weather isn’t always rough there, but when it is, it can blow hard. This month it’s blowing hard.

One of the harder winds is fear of a global slowdown. The International Monetary Fund (IMF) cut its growth forecasts and issued gloomy remarks the previous weekend that came with a bundle of disappointing European data and obvious infighting-induced paralysis at the European Central Bank (ECB). Deflation and recession fears are growing in the eurozone, but the Germans refuse to budge from their horror of expansive monetary policy. The EU’s failure to adopt “burden-sharing,” or collective fiscal policy, may yet undo the union: anti-EU and nationalist-separatist parties are rapidly gaining ground in national polls and legislatures.

Ebola fears are playing a role. The first appearance on our shores of a transmissible disease with a fifty-percent mortality rate is bound to be unsettling, especially after one has first read that it is not easily transmissible and is then greeted with stories of newly transmitted cases. Stories about Dallas health care workers hopping onto planes and cruise boats after being exposed to a dying victim seem like something right out of Hollywood. Outbreak, another Dustin Hoffman movie, concerned an aerosolized version of – yup, Ebola. Beyond the visceral fear the stories inspire – two I read in the last 24 hours discussed the disease’s prospects for mutating into more easily transmissible forms – there’s the still-small-but-growing possibility of widening travel restrictions and quarantines before it’s all over. It won’t help the global economy.

October is playing a role. The market is more vulnerable to selling in the fall than at any other time. Though declines are by no means automatic, everyone is aware of the tendency, including the people who write the algorithms that do much of the daily stock trading. In the face of adversity, buyers will stand aside and sellers gain traction now more than the rest of the year because, you know, it’s October.

When pharmaceutical giant AbbVie (ABBV) announced early Wednesday morning that it was throwing in the towel on its acquisition of Irish-based Shire (SHPG) in light of the new U.S. rules designed to thwart tax inversions, the surprise news sent futures plunging. Then came the story of a fresh U.S. Ebola case. More selling. Then the September retail sales report missed consensus by a mile (though it was better than it looked, as you can read below), and the selling doubled. A few minutes after the open, the margin clerks – who always panic at bottoms – began selling out all the hedge funds that had the committed the dual sin of being leveraged up and owning the now-plummeting (-30%) Shire stock. The Dow fell nearly 500 points in the first quarter-hour and only partly recovered.

Monetary policy is playing a role. The Fed still looks set to end QE this month, and while there has been speculation to the contrary, three of the most wired Fed-watchers I know of – Larry Kudlow, CNBC reporter Steve Liesman, Wall Street Journal reporter and designated Fed print journalist Jon Hilsenrath – have all been outspoken that the Fed wants to exit the program and is not going to let a stock market tempest throw it off. One of the Fed Governors, St. Louis Fed President James Bullard, did help rescue the market Thursday when he speculated that the Fed might do otherwise, but Bullard has been something of a Fed wild card in recent times, now hawkish, now dovish, frequently throwing out statements that seemed designed to either reassure the markets or test their ability to handle a change of course. He’s not a current voting member of the monetary policy committee (the votes rotate amongst branch presidents).

Debates about the effectiveness of monetary policy aside, the sense that the central banks have their backs has unquestionably been a major prop for investor sentiment. To quote former IMF director and Pimco chief Mohammed El-Erian,

“…too many investors have been comforted by two intoxicating notions: that the global economy would continue in a low-growth equilibrium, thus avoiding both a recession and an inflationary boom, and that central banks would succeed in repressing market volatility, not just pre-emptively but also after the fact should an unanticipated event occur.”

The Fed is winding down, interest rates cuts are an impossibility both here and in Europe, doubts about more QE are widespread (many believe that news of yet another extension would rally the markets only briefly before giving away to a bigger sell-off), the current bull market is getting elderly – none of these are new, but as time passes, it becomes more and more difficult for the market to look away. The plunge in oil prices should help profitability in the corporate sector going forward – unless it’s signaling a harder global slowdown. Demand forecasts have been coming down.

The good news is that the end is not yet near; the bad news is that the end is not yet here. No, I didn’t flunk my drug test; the first end is that of the bull market – despite the current pain, I think the bull should still run well into 2015 (further than that, I have some doubts). We will have a year-end rally. The second ending is attached to the current episode of “re-pricing of risk,” to use a popular, learned-sounding euphemism for the dash for the exit. One thing missing from last week was the cathartic “thud,” the kind of selling blowout that tells you all the weak hands have been shaken out. Wednesday’s volume came close enough to say that it might be over, but real shake-outs are characterized by massive selling at the close, something the day avoided.

That doesn’t mean we must have a thud, but it does leave the door open wider to one within the next few weeks. Early to mid-November would make a good candidate on historical form. Next week starts the heart of the earnings season, though, and it would be a very unusual season indeed that could report growth (probably about 6%-7% overall) and not have a rally from all of the estimate “beats.” The week after continues the process, with the added twist of an FOMC meeting on the 29th. While that could mark a dividing line, investing based on policy guesses is a mug’s game. After that come the mid-term elections, with the Senate in play and probably some large moves after the results are in. Keep your seat-belt fastened, dear reader, because it doesn’t quite look safe yet.

The Economic Beat

The report of the week was the retail sales report for September. It was part of a trio of bad news that morning (Ebola, the cancelled AbbVie-Shire deal) that crushed the stock market and briefly sent the 10-year bond yield to 1.9%.

But were sales really so bad? Certainly the headline numbers missed consensus, particularly the ex-auto number, with a loss of 0.2% versus expectations for a gain of 0.3% (the overall total fell 0.3%, seasonally adjusted). The estimate itself was flawed, as I wrote for Seeking Alpha – the weekly reports from the Redbook research service had pointed to a decline. Yet the combined months of August and September (not adjusted) had year-on-year growth in line with the 20-year average and only a little down from last year’s increase. Sales for the quarter grew faster in 2014 than 2013. The tale of a monthly decline could not have come at a worse time, though, for a market on edge from fears of a global slowdown.

The retail sales report was released at the same time as the New York Fed manufacturing survey and the producer price index (PPI). Both of the latter contributed to the fear from the same culprit of estimate misses. The New York survey showed a reading of 6.17 (zero is neutral) which is actually not at all bad, but a big drop from the previous month (27.54) and a big miss of consensus (about 15). The PPI was negative for the first time in over a year (-0.1%), but once again consensus might have sussed it out from the drop in petroleum prices. It didn’t help that the release parachuted into a bonfire of worries about EU deflation. Later that afternoon, the Fed’s monthly Beige Book compendium of regional conditions seemed more subdued than its last iteration.

The news got better on Thursday: Weekly jobless claims fell to an adjusted 264,000, the lowest such total since October 2000 (reported with nary a trace of irony over the recession that began almost immediately afterwards). The older, more influential manufacturing survey from the Philadelphia Fed reported a surprise beat of consensus with an activity index of 20.7 against expectations for 20.0. The difference is meaningless, as is the decline from the previous reading of 22.5, but I do expect the index to continue to fall through the end of the year.

One report that missed on Thursday was the homebuilder sentiment index, which fell back to 54 (50 is neutral), but was still positive and the decline may have meant little. The housing starts number the next day was heavy on multi-family, but single-family did pick up to raise the year-to-date comparison to plus 3.8% (unadjusted). Initial housing reports from the Commerce Department have small sample sizes and are subject to large revisions, with this one also looking like a candidate for downward revision. Time will tell; in the meantime permits (+1.5% adjusted) were a bit light of consensus.

Business inventories (+0.2%) were also light in August – in combination with the September retail sales report, expectations for the third-quarter GDP print have started to come down a bit. However, September industrial production, aided by big pushes from utilities and mining, rose a solid 1%; manufacturing rose 0.5%. The first read on GDP comes the week after next, one that will mainly feature existing home sales (Tuesday) and new home sales (Friday). The consumer price index (CPI), due out on Wednesday morning, might provide excitement if it comes in too low.

The week’s biggest news could come from China, which releases reports on GDP, industrial production and retail sales Sunday night. Since Premier Xi has said that growth won’t fall below 7.5%, I fully expect the print to be at least 7.5%. The data has to be taken with a heavy dose of salt, particularly GDP, but consider also retail sales, which feature double-digit year-on-year growth every month while consumer inflation falls below 2%. Okay, boss. The market may pay more attention to the initial Chinese PMI reading Wednesday night.