Avalon's MarketWeek

Hot Air


“Wouldn’t you like to ride in my beautiful balloon?” – the Fifth Dimension

The market’s disconnect with reality continued last week. With 91% of S&P 500 companies reporting, the year-over-year decline in overall earnings remained steady at (-3.5%). It will be difficult at this point for the needle to get above (-3%). It will also mark the fifth consecutive quarter of declines, the first such streak since the Great Recession (the declines are milder, though). So naturally, the three major stock market indices are all at record highs, the first time since 1999. How’s that for a good omen?

You may very well wonder how we ever got there. The “melt-up” has its genesis in the Brexit rebound, and since then has thrived on options trading, technical breakouts, low volume, chart-chasing and “better-than-expected” earnings. That last development is one of the most ominous. As a cycle ends, fears about the end grow, even if apparently unacknowledged in prices. When news is weak but not as weak as expected, prices grind higher, making illogical valuations more insane and giving rise to the classic “blow-off top” phase that we are in now.

Yes, we’re in one now. Many strategists would disagree with this assessment, on the grounds that it isn’t like 1999. But neither was 2007, and in all probability neither will the next few tops be, either. 1999 was a once-in-a-lifetime mania.

The market is chasing its own breakout to no small extent, and same thing usually happens at the ends of bull markets. A marginal new high is accompanied by a chorus of “I told you so” from the die-hards. Familiar arguments pop up as earnings growth disappears – it’s time for a multiple expansion (a polite way of saying prices should go up anyway when earnings don’t); the ship will right itself in a couple of years; the market is looking ahead to the recovery in earnings x quarters from now, and my personal favorite, “there’s too much cash on the sidelines.” There’s been too much cash on the sidelines for about 15 years now, going from what I hear emanating from the Street, but I hear it said quite a bit in 2007. Could it be that some are just getting out early?

People who look at hard data (including yours truly) have started exiting the market this year and advised others to do the same, prominently including heavyweight investors like Carl Icahn, Jeff Gundlach, Bill Gross. David Tepper and others. This gives the opportunity for the true heavyweights, the self-styled expert day traders that populate comments columns and lunchtime television shows to now look importantly at the cameras and sneer at them. After all, prices can’t be wrong. Who cares if earnings are going down? They’ll come back someday. There’s no visible reason for stock prices not to go up.

A big part of the problem is that when one looks at earnings and economic data in a cold light, the message is pretty clear. But that’s not how these things get looked at on Wall Street, which tends to overly focus on relative expectations. For example, on Friday traders and pundits sang the praises of Nordstrom’s (JWN) earnings – the retailer beat expectations! By this week, you will doubtless be hearing daily about the “very strong” earnings coming out of the retail sector.

But Nordstrom’s sales and earnings are down year-over-year, in fact earnings are down quite a lot. So is the stock price, even after the near-20% rally since the earnings release. Revenue missed expectations too, but the market got better earnings than its darkest fears and so the inevitable hype follows. There’s been a lot of that going around, especially with earnings and economic releases. You can a lot of trading mileage out of a dying cycle when the death isn’t as gory as feared. The trouble, it’s still dying

So far this month, prices have held up surprisingly well, in part helped along by a jobs report that isn’t much more than an educated guess. That said, I look for the S&P to pull back slightly this week, to around the 2170 level. The market is considerably overbought right now, and while August does tend to march to its own eccentric beat, I wouldn’t count on it hanging in much longer

The Economic Beat

The report of the week was retail sales, one of the two monthly heavyweights (the Fed doesn’t meet every month, so its statement isn’t included). The lack of market reaction clearly showed how the market focus is now on two things only – the jobs reports and the Fed statements.

The initial estimate of July sales was that they were unchanged on a month-over-month, seasonally adjusted basis. Consensus had been for a 0.4% gain. On a year-over-year, unadjusted basis, monthly sales were up 0.7% over July 2015. Allowing for some inflation implies that in real terms, sales were down slightly.

One month does not a trend make, but the trailing twelve-month (TTM) trend isn’t particularly great either. In fact, it isn’t even good. The latest TTM read is for a growth rate of only 2.48%, the lowest since February. For historical perspective, in the last two business cycles sales only fell to those levels many months after a recession had begun. The rate is close, however, to the TTM increase in weekly earnings of 2.3%. We are running at stall-speed.

A fresh example of tape-influenced news was last week’s release of the labor turnover (JOLTS) survey for June. I have heard about a hundred times at least since then about job openings being up at all-time highs. What you don’t hear about is that actual hires in June were down from June 2015. The difference is small, leaving the rate unchanged, but that doesn’t suggest employment growth. It suggests that employment growth has slowed, something we will probably find out in the fall when the actual data catches up with the seasonal guesstimates. Productivity was negative in the second quarter (-0.5%) for the third quarter in a row, a tie for the longest streak ever. It’s partly a reflection of how so much of the growth in the labor market has come in the form of low-paying service activity that don’t add much to total output.

I read a wild piece of misinformation over the wholesale sales report for June. A nationally prominent economics site bragged over the “stunning” surge in sales, even though they were down year-over-year for the 17th month in a row on a seasonally adjusted basis (and down on an unadjusted basis as well) and talked about inventories being “too lean.” Too lean?? The inventory-to-sales ratio did ease from 1.35 in May to 1.33 in June, as it does at the end of every second quarter, but that said, it is well above the level of June 2015 (1.297) and is the highest June reading since 2001 (1.345), when we were in a recession. What a load of something, but as I like to remind, the tape makes the news.

Prices were up somewhat in June, as the year-on-year change in import-export prices eased to (-3.7%) and (-3.0%) respectively, the best they’ve been in some time. Producer prices fell, however, in a significant shortfall of consensus, with a (-0.4%) overall decline taking the TTM rate down to (-0.2%) overall. The “core” TTM rate (excluding food and energy) is still positive at 0.7%, but it’s a big drop from last month’s 1.3% rate. Consumer prices (CPI) are due out on Tuesday.

The big report for next week is the release of the Fed minutes on Wednesday. They won’t say much and probably nothing at all that is new, but we’ll still fuss over them beyond all reasonable merit. I’ll be looking more at Tuesday’s release of the industrial production report (Tuesday); along with the New York Fed manufacturing survey (Monday) and the Philadelphia edition (Thursday), we’ll get a look at where manufacturing activity really is, as opposed to stock market hype. The other main report is housing starts on Tuesday, with its teaser sentiment report the day before.

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