“I like the truth sometimes, but I don’t care enough for it to hanker after it.” – Mark Twain
Well, that was an interesting day. After nearly two months of negligible volatility, the markets broke out to the downside on Friday in a big way, not so surprising, as moves after long periods of calm tend to be large. The S&P 500 index fell nearly 2.5%, the biggest single-day drop since the Brexit sell-off.
The market started selling off in reaction to remarks by Boston Federal Reserve president Eric Rosengren, though to be fair he didn’t say anything revolutionary. He did allow that a policy of “normalization” (translation: higher rates), might be “reasonable,” and added some fretting over commercial real estate prices and lending. The latter is the kind of stuff that Fed governors say when they’re raising rates at the end of the cycle, and might have added some octane to the selling in the afternoon.
The odds of a September rate increase jumped to 40% in the bond futures markets, but that spike may have had as much to do with short-covering as anything else. Like most observers, I don’t believe that the Fed will raise rates before the election. It does sound, however – for one day – that they are more determined to do so later.
CNBC reacted frantically, parading out an interview with another Fed governor, Dan Tarullo (also a voting member), who struck a more cautious tone than Rosengren and talked about wanting to see more inflation first. CNBC referred to it throughout the day in a seeming effort to put the brakes on the selling, but it was to no avail and the sell-off peaked at the close, never a good short-term indicator. It didn’t help that Rosengren had until recently been consistently dovish throughout the cycle, making his switch more ominous.
Some perspective is in order. The post-Brexit stock market rally was a fairly silly bit of business, built on a technical break-out, the failure of immediate disaster to materialize and the perennial conviction that you have to “be in to win,” or stay invested in equities. As is usually the case with such trades and indeed the Brexit vote itself, there’s the herd feeling that if the guy in front of me didn’t fall off the cliff, there must not be any cliff at all.
So valuations had gotten silly-high, and while they are still too high, they are now not quite as high as a month ago. Valuation alone does not make stock prices go up or down, of course, but the more extreme the valuation, the bigger the move when hard news comes along that doesn’t fit the accepted narrative, in this case the familiar “Goldilocks” claim that the economy would keep chugging on (forever, maybe) in a growth mode that wouldn’t be quite high enough to invite Fed action – except maybe a couple of years down the road when the recovery really takes off, and that is why you should be loading up on cyclical stocks today, sir. You see, there is no more business cycle, just an unlimited horizon of low growth that will keep central banks pumping money into the system forever. Did I mention that housing prices never decline?
I recently rewatched The Big Short, a movie I recommend to anyone and especially those who have money invested in the markets. Some of the enduring truths of the financial world include the very strong pull of the herd that we are all subject to, the irrational belief that if the stock market is at new highs that all must be well with the world (overlooking the fact that bear markets do not begin from new lows), and the willingness to lazily assume that the headlines you read must be telling you everything you need to know. Or that they are all based on honest analysis.
The Big Short (which I read as soon as it came out) features lots of what psychologists call “cognitive dissonance,” or the willingness to filter out information we don’t want to believe (it even leads with a Mark Twain quote to that effect, along with some humorous reminders). Two eye-poppers in cognitive dissonance occurred Friday, one being a note that amongst other things extolled the 0.8% year-year gain in weekly Redbook sales as a nice positive. It was the biggest gain in two months! But this is the heart of the back-to-school season, and quite frankly, anything under 1% this time of year sucks. It was the lowest back-to-school result in six years. This was from somebody whom I generally give a “B” or better, too.
Then I heard CNBC’s Steve Liesman extol the wholesale inventory data. Now, Liesman seems like a decent guy and isn’t a partisan fanatic like some of his fellow CNBC presenters, but to me he has always seemed prone to a kind of wire-house pollyanish mindset. I don’t how he could possibly think that there is good news in the latest inventory data unless he just read some one-line victory lap from a brokerage house. What the report did say is that wholesale sales comped negative for the 18th month in a row. The inventory “build” is due to falling sales, not business confidence – the inventory-to-sales ratio for July is 1.34 (seasonally adjusted), the highest July reading this century, higher than even the 2001 inventory recession. That is not a sign that we’re entering some period of confident rebuilding, it’s a sign that demand stinks, stank, and stunk, to quote Dr. Seuss. But people will still be talking next week about that hopeful news in inventories – until reality hits them over the head with a brick about it.
So will Friday’s sell-off continue? I’m of a mind that the Fed was once again engaged in a bit of verbal tightening, and will start to walk it back next week if the selling doesn’t quickly abate. I don’t expect Monday to open up and would ordinarily expect a second day of selling (what I am positioned for), but since we’re trading on meaningless verbal gestures and there are three more Fed governors slated to speak on Monday, anything could happen. Just remember that at some point talk alone isn’t enough.
The Economic Beat
The report of the week might have seemed like Rosengren’s remarks, but the economic release that mattered the most was the ISM non-manufacturing survey. The market has become quite used to the ISM report churning out a steady stream of numbers in the mid- to upper fifties (50 is neutral), taking comfort in it as the manufacturing sector continues to struggle – the latest manufacturing survey, released the prior week, had fallen into contraction again (hadn’t those silly manufacturers heard all the strategist reports that the “manufacturing mini-recession is over”?).
The survey clocked in with a read of 51.4, well short of consensus. It was the lowest reading since February 2010, but that doesn’t mean activity is at the same depressed level now, only that it’s the first time in over six years that the respondents mostly said, “no change.” The expansion-contraction score was 11-7, nearly the inverse of manufacturing, but not the kind of 14-4 type readings we’ve been mostly accustomed to. Prices, the most sensitive leading indicator in the service sector, were slightly over 50 at 51.8, effectively unchanged from the previous month (51.9). Coming as it did on the heels of the below-consensus jobs report only added to the sense of economic disappointment.
The other reports from a light week didn’t attract much interest. The Fed’s Labor Market conditions index slipped back into negative territory (-0.7) for the seventh time in the last eight months, though it could get revised upwards later. The other labor market report, the labor turnover survey (JOLTS) showed something of an improvement for July, as hire levels finally picked up after a few months of negative year-year comps. Though the rate (3.6%) was unchanged from a year ago, the estimated actual number was up about 0.5% (5227 vs. 5084). The media tends to brag about openings, but what really matters are hires. Openings are free, hires cost money.
The Fed’s Beige Book continued its “modest to moderate” mantra, but what caught my eye was the report of soft retail spending. Not every district was down, but the “little changed” phrase used to describe overall sales does not seem to have penetrated most of Wall Street, where everyone keeps talking about the increase in consumer spending this quarter. Said increase is mostly relying on forecast rather than actual data, and every quarter this year has started out with retail spending forecasts that have overestimated the final result. I guess they’re bound to be right at some point, but I don’t think it’s this quarter.
Weekly claims remained consistent with their 2016 average of about a 5% decrease from 2015. The other report to catch my eye, though, was the one on wholesale inventories. It’s been nothing but weakness for a long time and the unadjusted sales data was bleak.
Next week is meaningless because the Fed doesn’t meet until the week after, right? Well, maybe not, because the data might give clues to what the Fed thinks it should do. Or what the market thinks the Fed ought to think. We’ll definitely have some more data to chew on, most prominently the August retail sales report due on Thursday. The consensus is for no change, despite all the talk on the Street about the strong retail spending this quarter. Has New York City already legalized marijuana?
Three other reports that will certainly factor into the Fed’s outlook are the producer price index (PPI) on Wednesday, its consumer counterpart (CPI) on Friday, and the industrial production report on Thursday, which has the New York Fed manufacturing survey as well. Import-export prices are also released on Wednesday, but the Street only heeds big surprise numbers from the category.