Avalon's MarketWeek

The Return of the King


“I don’t know how he caught it. I don’t think he does.” – Tom Brady on teammate Julian Edelman’s sensational Super Bowl catch

The stock market is hanging in there. After a better-than expected jobs report, stocks reversed their losses on the week and finished with a slight gain. Is it worth it? For that matter, are today’s stock prices worth it?

According to FactSet, the S&P 500, the stock market’s proxy, has reported total earnings gains of 1.75% over the last two years, based on nearly completed reporting for 2016. Until the election, stock markets didn’t go anywhere either, but have rallied about 8% since on hopes of easier times – easy money, tax cuts, easy rules, more fiscal spending.

So far none of it has happened, though some of it surely will. But when? In the meantime, some progress has been made – the estimated earnings gain for the fourth quarter of 2016 now stands at 4.6% (year-on-year), thanks largely to the recovery in oil prices and the energy sector.

The current situation is a balancing act – the market still wants to go higher, it wants to believe, while at the same time so many unsettling developments are coming out of Washington that I remarked last week that investors ought to be thinking about running for the exits. It’s a sentiment that isn’t exactly unknown on the Street, and so we have the classic pattern of backing up a bit on things that don’t look good, then rallying forcefully on anything that doesn’t fit the doomsday scenario (like the jobs report).

Legendary investor George Soros may be short the market, but people can brush that aside as politically motivated (Soros is a progressive). It’s also true that he can afford to wait. Now another giant has joined the queue – lesser known in the everyday world, though not amongst the Wall Street cognoscenti and perhaps even more admired: Seth Klarman, whose note about “Investing in the Age of Trump” has become the hottest piece of reading on the Street.

To be sure, Klarman doesn’t advise investors to flee (though he wrote his letter before last week), but did observe “perilously high valuations” and a market “hypnotized by talk.” He also wrote about the things that could go wrong – trade wars, inflation, runaway deficits. Markets wouldn’t like that, and they are not priced for any of it.

I’ll add another – the market is priced very high, and the business cycle is very old. While most found succor in the latest jobs report, for me the latter confirms a pattern of the type of slowing growth that comes at cyclical ends (for more, see below). Valuations don’t make markets fall, but they do tell you how far they fall once they tip – and we are a long, long way from the ground.

In the near term, overbought markets should continue to trade on sentiment. Apart from policy moves that could fall out of the sky, there isn’t much on the calendar until the retail sales report in the middle of the month and February options expiration at the end of next week (the 17th). Current positioning suggests 2300 as the optimal dealer close, so I expect something very near that barring unforeseen – or is it unforeseeable? – developments.

On an entirely different note, congratulations to the New England Patriots, Super Bowl Champions for the fifth time in a game that was an instant classic. What a finish!

The Economic Beat

The report of the week was the January jobs report and its headline announcement of 227,000 jobs (227K), seasonally adjusted. That was above the consensus expectation of 175K, sort of, as the ADP report two days earlier – which attempts to anticipate the government’s Bureau of Labor Statistics (BLS) report – had reported an increase of 246K versus a similar consensus. The markets were expecting a number over 200K, but they celebrated anyway because it’s what traders do. The ADP was closer than it looked, because their estimate is for private sectors only, and the BLS estimated private sector jobs growth at 237K. Maybe that was the reason for the celebration.

That said, the report wasn’t all that great and continues a pattern of softening growth. We don’t know for sure yet if anything reasonably close to that number of jobs was really created, as the estimated raw payroll count shrinks by about 2% every January. It’s a combination of layoffs, retirements, and workers just being lost from the count as they change jobs. The January number is really more of a run rate, as it takes about 4-5 months for the unadjusted number of workers in the estimates to regain December levels.

The danger at this point is that the January number might reflect more a lack of firing than an increase in hiring. It happens at the ends of business cycles, but it usually takes until sometime in the spring to show up in the data. For now, the provisional year-year gain in January payrolls is 1.51% compared to the year-ago 1.86%, and that is the slowest January gain since 2013. If it’s later revised downward the way last January was, it could even be the smallest gain since 2011. The year-year pattern has been softening for months and looks more and more like the pattern seen entering 2007.

The unemployment rate rose to 4.8%, partly for good reasons as the participation rate rose to 62.9% and the not-in-labor-force category shrank: more people entering the labor force in search of work. However, the household survey (used as the basis for calculating the unemployment rate) only showed a gain of 31K jobs and has been soft the last two months. That’s not cause for immediate alarm, as the household survey is pretty lumpy and often catches up in a single month, but it’s something to watch. Other aspects showed less strength too, from the shrinking annual increase in average hourly earnings (2.5%) to the smaller (and shrinking) increase in average weekly earnings (1.8%). That’s partly a mix issue, as the majority of new hires occur in lower-paying service sector jobs: 46K in retail, 34K in leisure and hospitality, 32K in health care and social assistance.

There’s a bit of tendency on the Street to call any report that is ahead of consensus – but not so far ahead as to invite the wrath of the Fed – a “Goldilocks” report. Looking at the year-year numbers doesn’t leave me with that sensation. I’m also skeptical of the big jump in retail jobs, as it doesn’t square with the soft-looking weekly retail sales reports from January. We will see.

Surveys are still showing sentiment running ahead of activity. The national purchasing manager survey (ISM) showed a slight improvement of 56 versus last month’s 54.5. 56 is a good score for the survey, and the number of growing industries was 12 versus 5 contracting, a good if not great score. The comments cited were positive, though perhaps not glowing, while new orders had another very good score (60.4) even as backlogs shrank, a bit of a conundrum. The Chicago regional index the day before was rather different, dropping from 54.6 to an unchanged level of 50.3. The Dallas survey, however, showed renewed gains (22.1 vs. 17.7). On the non-manufacturing side, the headline number was nearly identical at 56.5, nearly identical to its previous month. Here the comments seemed more restrained, even as survey numbers were better.

Factory orders did rise by a seasonally adjusted 1.3% in December after a drop of 2.3% in November, though, and business capital goods orders were positive (unadjusted) in December year-on-year (+1.4%). That’s notable after nine consecutive months of negative comps that is really twelve, as the tiny February bump was due entirely to the added leap-year day. However, end-of-year bumps in the last few years were not sustained – the December 2014 increase of 1.2% was followed by ten months of negative comps, and the November 2015 increase of 1% was followed by virtually twelve months of year-year declines. It’s also worth noting that you have to go back to December 2010 to find another December with lower order volume.

Year-on-year employment costs eased slightly to 2.2% in the fourth quarter, while labor costs rose 1.9% in the separately measured productivity report, which reported a disappointing 1% gain in 2016. It’s partly a mix issue, reflecting the higher proportion of job increases in lower output jobs such as home health care and leisure and hospitality. Underinvestment has been a problem. Disposable personal income (DPI) took a drop in December (year-on-year), falling to an estimated +2.1% (inflation-adjusted) even as spending (PCE) stayed level at +2.8%. Total DPI growth slowed to 2.7% in 2016 from 3.4% in 2015.

Over in housing, pending home sales rose 1.6% while Shiller-Case home prices rose from 5.1% year-year to 5.3%. Construction spending is thought to have fallen by 0.2%, despite the strong sales above and the demand to not live in the city. The series is heavily revised, though, so it wouldn’t be wise to count on the first estimate.

Finally, the Fed met during the week and took no action, nor did it add anything new to its outlook. The important part, from the market view, was that it provided a relatively soothing backdrop to the jobs report’s consensus beat. Had the Fed sounded hawkish, markets might have responded less favorably on Friday, instead of staging a big rally.

The coming week is a quiet one, with the labor turnover report (JOLTS) top of the charts. I’ll be looking closely at the wholesale trade report on Thursday, with the week rounded out by international trade on Tuesday and import-export prices on Friday.

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