Trim the Sails

“A southwest blow on ye and blister you all o’er!” – William Shakespeare, The Tempest

The stock market may not have done much last week in terms of week-to-week price movement, but it was an interesting time nonetheless. Fed chair Janet Yellen’s testimony before Congress was sufficiently non-committal to allow some relief rally action (she didn’t guarantee a mid-year rate increase), but at the same time a factoid that had many fund managers buzzing was the negative outlooks for S&P 500 profit growth over the current quarter and next.

Those outlooks are currently negative, with FactSet currently showing estimates for a decline of 4.6% and 1.5% respectively in S&P 500 profits for the first and second quarters. It’s reminiscent of 1998, when a rising dollar and negative corporate profit rates combined to help set up the market for a 28% decline in the fall, after the Asian currency crisis broke. The Fed and the dot.com bubble saved the market then, but this time we may not be so lucky.

Coming on the top of rather sober economic news, such as the latest downward revision to fourth-quarter GDP (now estimated to be at a 2.2% seasonally adjusted annualized rate) modest news from housing and China, the picture is one of the same sort of disconnect as 1998. Asian markets were rallying over the weekend on yet another rate ease by China as its property market continues to collapse, but I am not comforted by the generally weak global environment that the putative magical cut is occurring in. While I don’t believe that the US is currently in a fatal slowdown, the disparity between the financial and real economies continue to grow, with metrics such as the Shiller P/E and the GDP-market cap ratio (the Buffett indicator) in nosebleed territory, the former now surpassing its 2007 peak.

Valuations don’t make markets correct. That said, lofty valuation levels are apt to clash with the basement profit levels, TINA (There is No Alternative to stocks) notwithstanding. The bull market may not quite be dead, as the summer currently rates to see better economic activity (see below) than the current quarter, but I’d be careful right about now. March often sees some heavy going in terms of price action, and the current wide divergence between the real and the financial economy has prices vulnerable in the absence of the once-reliable QE spigot. Any moves up over the next week or so – Russia, China and Iran permitting – should be a good source of dry powder for the sacred mid-April earnings season rally.

The Economic Beat

Apart from the Yellen testimony, the report of the week was the second estimate of fourth quarter GDP. The market impact was muted, though the new number of 2.2% was well below the initial estimate of 2.6%, because consensus was at 2.1%. There were fears as well that the number might even come in below the 2-level.

After the first revision, nominal (before adjusting for inflation) GDP for calendar 2014 now stands at 3.9%. To put that into perspective, the average four-quarter rate for the last three years is 3.9%, the average four-quarter rate for the last four years is 3.9%, and the annualized growth rate over the last three years is – 3.9%. The average annual growth rate is 3.93%. I think there may be a pattern here.

Nominal growth decelerated more sharply than the headline number indicates, the latter benefiting from one of those tiny price deflators (0.1%) the Bureau of Economic Analysis (BEA) throws out every now and then. Had the BEA used the CPI rate of 1.6% that prevailed at the end of 2014, inflation-adjusted (“real”) GDP would have been a mere 0.7%. The four-quarter growth rate did in fact fall to 3.65%, and may fall further if the first quarter ends up as anemic as it is setting up to be.

The real implication of all of this is that the intrinsic strength of the economy has never changed over the last several years. There have been rhythmic pulses around the same trend rate, pulses occurring largely in reaction to each other (the cycle of inventory stock and destock) and the weather. Wall Street and some of its prominent news organs made quite a fuss over the middle two above-trend quarters of 2014, an episode that I and many others predicted in advance would be the logical rebound to the weather-dampened contraction in the first quarter. Indeed, many of the same Street springtime heralds of the rebound seemed to have completely forgotten their predictions by the third quarter, preferring instead to talk importantly (for about the 80th time) about how the economy was now reaching escape velocity. Except it didn’t – for about the 80th time.

It matters to investors because the escape velocity talk was used as partial justification for the stock market (as measured by the S&P 500) being up about 12% last year, along with “record corporate profits.” Corporate profits are indeed at record levels, as should happen in any normal expansion, but with only 15 S&P 500 companies still to report for the fourth quarter, it doesn’t look as if total profit growth, currently standing at 4.7% for 2014, can get to the 5% level after all. What that tells you is how much QE has inflated asset prices compared to consumer prices, and that the fall rates to be large once it gets underway.

A number that helped the market sell off on Friday was the Chicago purchasing manager index (PMI) coming in at around 45, well below both consensus and the neutral level of 50. The Chicago survey has always been volatile and has become more so since it was taken over by a stock exchange, so one needs to take these things with a grain of salt. Other regional manufacturing indices were also on the light side, with oil-centric Dallas in negative territory and Richmond and Kansas City essentially neutral. The weakness in Dallas needs little explanation, while the other regions are likely suffering from the weather. It’s reasonable to expect a spring-summer rebound again; the national survey number (ISM) will be released on Monday.

There was better news in durable goods, where transportation led a 2.8% increase in new orders. Excluding transportation, new orders were up 0.3%. It was all rather modest, as January 2015 cap-ex spending was only 0.3% better than the frozen January 2014 and the intermediate growth rate continues to soften. Shipments for durable goods overall fell for the month.

Housing had a slew of numbers indicating modest activity. Existing home sales fell a surprising 4.9% in the month of January, and while the number may yet be revised upwards and comes in a highly adjusted month – January is not exactly a big month for home sales – the year-over-year change is still only a modest 3.2%. The median price fell, though the Case-Shiller price index the next day showed a modest improvement for December. New home sales appeared to fare a bit better – though they fell slightly to a seasonally adjusted 481K rate in January from 482K in December, expectations had been for something about 10K less. It should be noted that the January data is prone to big revisions. Pending home sales rose a provisional 1.7% in February, not exactly a huge rebound from the decline in January sales. Revisions are apt to change the tone a bit, but the overall picture is certainly one of modest activity.

The consumer price index (CPI) fell a sharp 0.7% in January, taking the year-on-year rate down to a minus 0.2%. It was all energy-related, not surprisingly, with the ex-food, ex-energy rate remaining at a stable 1.6% year-on-year.

Besides the ISM manufacturing survey on Monday, next week will bring one of the month’s main attractions, the monthly jobs report on Friday. That and the ISM surveys (non-manufacturing is on Wednesday) should dominate the week’s news on the economic side, but there are other important releases, including January personal income and spending on Monday, the Beige Book on Wednesday and the ADP payroll preview report on Wednesday. Other reports of note include construction spending on Monday, productivity and factory orders on Thursday, and finally international trade on Friday.