Avalon's MarketWeek

The Wizards of Awe


“Professor Marvel never guesses. He knows!” – L. Frank Baum, The Wizard of Oz

It seems like a good time to repeat an old stock market adage, one I often like to cite: The tape makes the news. Though stocks were little changed during the week, it was nonetheless another record weekly close for the S&P 500, and so the inescapable conclusion must be – as evidenced by the AAII poll, the latest consumer sentiment readings, CNBC effusiveness, headlines in the business press – that all is well with the economy, profits and whatever else one might think of. Well, maybe apart from the weather.

The rarefied air up here seems to have cut off a certain amount of oxygen to a certain number of brains. It’s a common symptom of a late-stage bull market – sometimes all of the oxygen gets sucked out before the end, leaving nothing but buy-every-dip zombies wandering the fields, waiting for the inevitable cull.

While I do note the usual minority trying to call some attention to the fact that things aren’t really quite so rosy, the recent steep rebound from the suddenly fierce correction seems to have mostly converted the doubters of mid-October to a new level of mid-November fidelity. In turn, that spurs a surge in the brisk wizard’s trade of all-is-well talismans, presumed to be authentic and organic, usually man-made and well, not so authentic.

A piece of wizard’s gold I’ve already called attention to in the recent past and one that is probably not done roping in its quota of dopes is the “four quarters in five” gem that seems to have convinced much of the investing public (or maybe just the investing paparazzi) yet again that domestic growth is finally taking off in the good old U.S. of A.

“Four quarters in five,” in case you’re wondering, refers to the fact that four of the last five quarters have printed annualized, seasonally adjusted GDP rates of 3.5% or higher. The slogan distilled thereof is considered to be proof that the US economy is finally lifting off. The depth of naivet√© necessary to both acolyte and proselyte of this latter-day fragment of scripture is not only impressive, at times I even find it startling. Woven into the credo is the notion that the sharp drop in the first quarter of 2014 (-2.1%) was some kind of weather freak, and but for this rotten trick of nature it would be five in five.

It’s utter nonsense. Four-quarter nominal GDP growth – that is to say, gross domestic product for the trailing four quarters, not adjusted for inflation – was 3.9% at the end of the third quarter of 2014 (and if anything, will be lower after all revisions are in). The average for this rate over the last 12 quarters is 3.9%. The compound growth rate for nominal GDP over the last five years is 4.0%. Exactly what change are we supposed to be talking about here?

That’s not all (you knew it wouldn’t be). I have written in the past that since the recovery began, the economy has periodically thrown up a quarter with a four-handle on it (i.e., > 4%). Mostly due to inventory builds, these are then followed by two or three quarters of deceleration to something with a one-handle; rinse and repeat. I would estimate that the first quarter of 2014 was headed for about a 0% rate when the bad weather intervened and dragged it deeper to its eventual resting place of (-2.1%).

So yes, the weather did indeed pull the rate down in the first quarter. But without the winter trench dug by the weather, there is no 4.6% spring rebound that will ease to 3.2%-3.3% after revisions in the third quarter and perhaps to a two-handle in the fourth quarter. The weather didn’t change the underlying strength, as the Fed and others would also tell you, it just squeezed some of the business out of one quarter and into the two subsequent ones. The average real GDP rate for the first three quarters of 2014 is still 2.0%, and may well end up there – again – at the end of the year. Nine in ten fund managers will not tell you this.

There are other junk stones in circulation (and no, I’m not talking about Twitter’s (TWTR) junk bond rating). You may for instance read about the “surge” in October retail sales (+0.3%, and one of the most average months of October in the last twenty-odd years) that was partly a very mild bounce from a very mild September decline, the latter partly an artifact of the Labor Day calendar. The reality is that the trailing-twelve-month (TTM) growth rate of (unadjusted) retail sales through the end of October is 3.9%. The average TTM rate over the last twelve months: 3.9%. Every month in 2014 has had a TTM rate between 3.7% and 4.0% (note the very tight relation between retail sales growth, which is expressed in nominal terms, and nominal GDP). There is no surge, but there was the usual holiday sales promo in the Wall Street Journal.

The Financial Times has some junk for sale too. Thursday’s edition had a piece on how the drop in the price of oil is going to save us all, a theme I certainly do not trust. The piece took economists to task for not updating their forecasts: “we do not see any evidence that the growth rate is slowing down. There has been some slowdown in the eurozone, but this is offset by a rise in the growth rate in the US, while China has been fairly stable.” But the U.S. growth rate hasn’t risen, as I just showed above, and China’s production does continue to fall, as last week’s data releases showed.

The improvement in consumer sentiment is meaningless as an indicator of what may happen, but not so for the AAII investor survey. It has a reliable contrarian track record, as even the survey will tell you. Historical data suggests that AAII readings as bullish as this week are invariably followed by prolonged periods of little to no gains in the stock market.

One other meme that puzzles me – though I admit, maybe it shouldn’t – is the steady parade of exclamatory stories about things like jobless claims being at their lowest level since the summer of 2000, or sentiment being its highest since the summer of 2007. In other words, those prior levels came just before the ends of their concomitant business cycles – and bull markets. Now that relationship may be something that should awe you, but somehow the wizards never mention it.

The Economic Beat

It feels a bit awkward to say so, but the message from the week’s releases of U.S. economic data was that nothing has changed. It’s awkward because after spending hours poring over the September wholesale data, September labor turnover (JOLTS) and October retail sales, I don’t know that any of it is telling us anything new and different about the economy, or at least something we didn’t already know.

Wholesale inventories came out of September a bit higher than expected, and that will add a little back to third-quarter GDP estimates, which took a hit after the September trade balance was released (exports down + imports up = GDP down). As the chart below shows, sales growth weakens in the post-recovery stages of the business cycle, but then seem to build up rapidly just before the end, perhaps a contributing factor to the end of the cycle (i.e., too much inventory). The current gap between year-on-year sales growth and inventory growth suggests that the latter could start to tail off soon. Whether or not that happens in time for fourth quarter GDP I couldn’t say, but there doesn’t look to be any urgency about building them further. The seasonally-adjusted inventory-to-sales ratio is on the high side coming into the last quarter.

I think the main message of the JOLTS data is two-fold: There isn’t enough of it to give any reliable cyclical clues, and skilled labor continues to be gutted. I expect to publish a piece next week on the dramatic change in employment composition for Seeking Alpha, so stay tuned (or follow me on @kf_avalon).

The JOLTS data series itself only began at the end of 2000, and may not tell us any more than what we know from the rest of the employment data (it may also be we haven’t been clever enough to find it yet). The recovery is happening: The September hires seasonally adjusted annual rate crested 5 million for the first time since the end of 2007, and the year-to-date growth rate of 6.4% is the best since 2005. The recovery is modest: Total hire levels are still below the levels of 2005-2007. The adjusted hire rate for the private sector improved to 4.0% for the first time since 2007, but remains below the September 2001 rate of 4.2%, when the economy was at the end of a recession (the unadjusted data is quite similar). The same is true of the quits rate. The biggest changes are in the skew towards lower-paid occupations: we are becoming a nation of burger-flippers, as one equity fund manager recently fretted.

Weekly jobless claims are showing nothing new either. They rose during the last week, but it would appear to be mostly week-to-week noise. At 1.6% (unadjusted), the insured unemployment rate is still in the peak zone.

The retail sales data may have “surprised” to the upside with its provisional estimate of a 0.3% monthly gain compared to the 0.2% consensus, but at the aggregate level there is virtually nothing new happening. Trailing-twelve-month (TTM) growth remains in a very narrow range – it has averaged 3.9% for the last twelve months, exactly where October came in and right about the level of 4% nominal GDP that has prevailed over the last five years.

The composition of sales changed a bit – gasoline sales fell in dollar terms, department store sales are down, auto sales rose and online retailing continues to grow at about 10%, give or take a couple. The TTM for sales excluding autos and gasoline went from 3.63% to 3.66%. Falling gasoline prices should help purchases of other items, such as going out to restaurants and bars (up 0.9% in the month) and seasonal purchases (leisure purchases up 1.2%), but it’s a mix change – the sluggish pace of income growth constrains the ability of the total to grow.

One thing that hasn’t changed is the hype: October was a very run-of-the-mill month for sales, yet I read wide-eyed assurances that the “solid rebound” and “surging consumer sentiment” would take care of any inventory issues, which in the retail sector are pretty full up at the moment. But consumer sentiment measures don’t tell you how much people are going to spend – they tell you where the stock market, price of gasoline and unemployment rate have been lately and not much else. With the exception of the most extreme readings (good contrarian indicators), they say nothing about where sales or the economy are going, and so I rarely write anything about them.

Overseas, Chinese data continues to soften, with year-on-year growth in industrial production and retail sales at multi-year lows. Chinese stock prices keep moving up, however, partly because of the new Shanghai-Hong Kong “link,” partly because the deteriorating data convinces traders that the good old central bank must come to the rescue. But can it rescue anything but short-term traders? Over in Europe, Germany, France, and Greece eked out narrow escapes from GDP recessions; Italy did not.

Next week has a respectably full slate, starting off with the New York Fed manufacturing survey and the national industrial production reports on Monday morning. A first look at the October housing market comes with the homebuilder sentiment index on Tuesday, starts data on Wednesday and existing home sales on Thursday. Producer price inflation (or lack thereof – import and export prices are both negative year-on-year) comes Tuesday and consumer price changes on Thursday. The influential Philadelphia Fed survey is Thursday.

All of which should take a back seat to the release of the Fed minutes Wednesday afternoon. Will they or won’t they raise rates (to a still-ultra low range), and when will they do or not do it? You’ve gotta trade on something, I suppose, and there’s not much excitement in the economy. That’s why we have wizards.

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