“The teeming autumn…like widow’d wombs after their lords’ decease.” – William Shakespeare, A MidSummer Night’s Dream
Fall is now officially here. If you want to know the reasons why the markets were so volatile last week, get out a notebook and get comfortable, because going through the entire list of suggestions is going to take some time. Or maybe I’ll just summarize the meanderings all over the road for you: algorithms, technicals, overseas, and the Fed. After all, isn’t it always about the Fed in one way or another?
The week began with losses that had some commentators mystified, but they may have just as well been asking themselves why equity markets were up by the same amount last week. I wrote at the time that the tape was headed for trouble, after prices rose in a narrowly-based rally based on ducking potential bad news and charts. Some of those problems remain intact, though some of the excess has worked its way off.
A number of Fed governors made a number of remarks during the week that made it fairly plain that the members of the FOMC (monetary policy committee) are not all singing from the same songbook. Some expressed urgency about getting the next rate move underway, others expressed urgency about making sure employment and the economy get a whole lot better first. The latter goals are certainly laudable, with the only catch being that zero interest rates aren’t making any positive contributions to them anymore. What some of the governors fear is that a move upward might rattle the financial system enough to bring the business cycle to an end (and leave them holding the bag, at least in the eyes of the public). Others fear the cycle ending in the next year or two anyway, and don’t want to arrive at that spot with little or no room to maneuver.
Overseas developments also pushed the tape around, ranging from a Russian legislator proposing to nationalize foreign assets, to Japanese inflation and ongoing worries about China. There is always bad news somewhere in the world, with the market’s reaction to it dependent on the calendar and the prevailing winds. Fall is usually a challenging period for equities, with small losses common and big losses coming in every now and then. The market’s confidence level has weakened in recent weeks as it confronts the end of quantitative easing (QE) next month and the possibility of rising rates coming closer on the horizon, making it easier for bad news to get more traction. The fall could have more bumpy weather ahead.
A noteworthy event without much news coverage was the plunge in S&P 500 earnings estimates as the end of the third quarter draws near. FactSet reported that the consensus now stands at 4.7%, down sharply from 6.2% the prior week. This kind of gaming goes on every quarter, at first noisily (look how much earnings are expected to grow this quarter!) and then stealthily – the rug gets pulled out at the last minute so we can all exclaim over how companies are killing estimates. It’s as certain as death and taxes.
The real interest lies in calculating actual implied earnings. With just under two weeks to go before earnings season starts to get underway, I’m guessing that we will see another typical round of cuts by next Friday, say about another fifty basis points. Then we’ll be entering the quarter with estimates at 4.2%, possibly lower. That’s lower than the second quarter projected rate at the same time. A good rule of thumb is to add about 2%-2.5% to the estimates to arrive at what analysts really believe, leading me to think that earnings growth could drop back below 7% this quarter (the second quarter was 7.6%). .
A big story at the end of the week was the seemingly out-of-the-blue departure of bond legend Bill Gross from Pimco, the Newport Beach investment firm he co-founded and helped build into the biggest private bond investment firm in the world. I have no inside nuggets to add to the frantic coverage, and wouldn’t trust them anyway. Having had a ringside seat in the past for this kind of thing, what I can say is that a lot of semi-hysterical and bitter remarks will follow in the immediate wake, most of them distorted and nearly all of them regretted a year or a two later.
I do think that a lot of assets will indeed follow Mr. Gross out the door, who will have a much better chance at putting up good numbers again with a smaller asset base. Pimco may brag about the size of its investment team, but in my experience, the larger the team, the more average the performance. The firm will survive of course, as it does have some good managers and the tactical advantage of Mr. Gross’s age – at 70, he isn’t going to take as much with him as he might have if he were still 55 or so.
There could be some added volatility in the bond market in the weeks ahead, though, as some of Gross’s very large positions inevitably get unwound and redeployed. That might feed into to volatility in the stock market. With the end of QE in a few weeks, the odds are starting to favor more gross decline for equities in the weeks ahead. We may finally see a test of the 200-day average on the S&P, which hasn’t happened for nearly two years, an unusually long stretch. It shouldn’t come as a surprise: when one looks at the economy, corporate earnings, and stock prices, only the last has been on a tear. With all of that said, though, we may only be in the warm-up stage for now, as larger declines have usually come in late October and early November. Usually.
The Economic Beat
I’m not sure what economic report could be said to have led the pack last week, but I’ll start with the latest revision of GDP. It was not significant in a numerical sense, but ideal in the warm-and-fuzzy department.
In its third estimate for the second quarter (also the last standalone word on the subject), the Bureau of Economic Analysis (BEA) now says that GDP rose at a 4.6% rate, when annualized and seasonally adjusted. That looks like a nice jump from the 4.2% earlier rate, but needs to be put into perspective. The dollar amount of GDP output was revised upward by 0.1% – rounded up. It was actually less than a tenth of a percent. The four-quarter rate of real GDP growth moved up from 2.5% to 2.6%, while the annualized rate of growth over the last four years went from 3.84% to 3.86%. An up revision is better than a down, but this is not the kind of stuff to break out the cake and balloons, either.
Except on Wall Street. The report put up a Goldilocks-style not too hot, not too cold figure: up from the previous estimate, meeting consensus estimates, yet beneath the whisper estimate of 5%, a number that would have spooked a market increasingly jittery about the specter of a rising interest rate horizon.
The impact of the number will be lasting in Wall Street time. Until October 30, when the advance estimate for third quarter GDP is due, it will be quoted to death by asset gatherers and market promoters singing their songs about how great the economy is. However, the increase was centered in the volatile categories of nonresidential fixed investment and exports, with the latter hardly set to take off on the back of the strongest dollar rally in many years. Personal income, the key to sustaining higher growth, was revised up by only 0.03% in dollar terms. A number that accompanies the GDP report and flies below the radar is the NIPA measure of corporate profits – even after the second quarter rebound, it’s showing a net decline for the first half of 2014. It’s worth watching.
Another overblown figure was new home sales. The key to understanding this data series is an awareness of its volatility, very small initial sample sizes, and subsequent large revisions. Back in February, it looked like the January sales number was the highest annualized rate in years, but I was skeptical at the time for the same reason I’m skeptical of August – an outsized initial estimate in one region. The January number was later chopped way down, to not even as big as January 2013.
The headline initial estimate of a 504,000 annualized rate of new home sales rested on a near-50% jump in sales in the Western region, in turn coming from an estimated monthly increase of only 4,000 homes. Sometimes the figure is from a new development coming on to the market, but in any case such jumps rarely hold up. There was nothing unusual about sales in the other three U.S. regions, and the unadjusted 12-month total rose by only 2.3%, not the 18% that breathless newscasters and stock promoters raved about.
Existing home sales slipped in August, according to the initial estimate, leaving the 2014 sales rate 5.3% below 2013. The most notable aspect of the report is the rapid decline in investor purchases and the still-elevated number of all-cash buyers. The former has fallen to 12% of the total, the latter to 23%, the lowest rate since the end of 2009. There is talk that institutional buyers are starting to move on and even begin to unload supply. In any case, price appreciation has slowed: the median prices for existing home sales is up 4.8% nationally, while government mortgage agency data is showing a comparison of 4.4%.
The durable goods release was its volatile self again, with Boeing once again the culprit. July’s increase in new orders was 22.5%, thanks to a UK air show, so in August the numbers returned to earth with an 18.2% decline. Excluding transportation, the month came in with a gain of 0.7% and July’s decline was revised up to (-0.5%). The business spending category rose 0.6% (seasonally adjusted) after an 0.2% decline in July. The 12-month rate of change, currently 5%, has remained in a narrow band since March. It’s a good level, if not a great one. The best thing one can say about business spending is that it hasn’t been overdone.
At this point, retail sales look to be subsiding from August’s modest back-to-school bump. With one weekend left to go, there’s a risk of seeing a decline in non-automotive sales for the month of September, but predictions would be premature.
Looking at regional data, the Kansas City and Richmond Fed both reported upbeat manufacturing survey results for August, though as I wrote last week, these can have trouble corresponding with production. However, with clement weather and the auto manufacturers back on in September, the month should turn out decent manufacturing results. The August auto production holiday contributed to a decline in the Chicago Fed national activity index, but it’s another estimate prone to heavy subsequent revisions; I don’t read very much into the first releases.
Next week has the September jobs report on Friday. Consensus is for 215,000, and looking at weekly claims data that seems about right. We’ll get the usual advance clue on Wednesday from the ADP report.
The beginning of the month always brings the high-profile purchasing surveys from ISM, with manufacturing on Wednesday and services on Friday, also featuring the latest trade data at the same time as jobs. Regional reports include Dallas on Monday and Chicago on Tuesday. It’s really a loaded week, with personal income and spending on Monday, Case-Shiller prices on Tuesday, auto sales and construction spending Wednesday, and factory orders on Thursday. The week is also filled with purchasing surveys from abroad, notably China on Monday evening and EU countries throughout the week.