Avalon's MarketWeek

Leave the Cannon, Take the Blini.


“Leave the gun. Take the cannoli” – Clemenza, in The Godfather

For a while on Friday, it seemed like the near-unthinkable could happen: a down week in the stock market. But an oh-so-typical Friday afternoon surge had the market close instead at its high on the week. I should also note that the S&P 500 closed at an all-time high: It seems only fair, given that CNBC telecasters mentioned it about four or five hundred times.

Friday was actually a nifty little encapsulation of the last year in the stock market. Stock futures were down ahead of the jobs report – I can’t even honestly tell you why, but one guess is that the markets feared a good jobs report, and by extension, a potential end to Fed benevolence. However, when the all-important number was shown to be about 90,000 short of consensus – 142,000 versus expectations for around 230,000 – the market rallied back half of its losses. It stayed that way through mid-morning, then put on a big rally of 20 S&P points to close at the day’s high.

Some accounts will tell you it was about the jobs report, some will tell you it was about the Ukraine, but I doubt both reasons. A better reason is traders front-running Monday Merger Mania – a show that comes around in the late innings of pretty much every bull market – and while I think there is a lot to that, Friday afternoon reversals, rallies and late surges have been so commonplace the last couple of years that I can’t help but think that a lot of it is just pure tape-positioning, driven by algorithmic buying and enhanced with HFT trading.

If you want a reason for why three out of four mutual fund managers are underperforming the market, along with most hedge funds, you only have to look at Friday afternoons and the run-ups to Fed meetings. Most money managers disdain trading strategies that target buying at such times as mere day-trading, and are too steeped in analytic thinking to buy on such flimsy pretexts. The robot trading programs just don’t care. What’s more, I would estimate that about a third of the market’s gains come from gap-up openings spurred by the futures market. I guess the moral is that if you believe that the market will rise brainlessly upward, you want a brainless overseer of your funds – until the market goes down, of course. Then you can blame the government.

Watching the Seattle Seahawks dismantle the Green Bay Packers Thursday night in the American football season’s opening match, I was shifting between channels and my workstation, as is my usual wont. A movie channel was carrying a broadcast of The Godfather, the 1972 Francis Ford Coppola landmark film that I’m always ready to drop in on for a favorite scene or two. I came in right about the time Michael Corleone (Al Pacino) was volunteering himself as the gunman to dispose of a murderous rival gangster and his corrupt police captain bodyguard. A few moments later, Michael is in a basement with Clemenza (Richard Castellano), a loyal family capo (top lieutenant), trying out the handgun intended for the shooting.

As Michael and Clemenza discuss the violent consequences certain to follow the hit, Clemenza waxes philosophical, observing it’s an inevitable part of the business that they’re in. He suddenly compares the situation to Adolf Hitler at Munich (World War II was far more recent in 1972), saying it had been wrong to give into his demands over Czechoslavkia and that the Allies should have stopped him right then and there. I shifted uneasily on the couch as I watched the scene.

The Hitler-Czechoslovakia, Putin-Ukraine comparison had occurred to me and many others some months ago. But the movie inspired me to do a little more digging. Here is an eerily familiar excerpt from Hitler’s 1938 speech on the subject:

“I am asking neither that Germany be allowed to oppress three and a half million Frenchmen, nor am I asking that three and a half million Englishmen be placed at our mercy. Rather I am simply demanding that the oppression of three and a half million Germans in Czechoslovakia cease and that the inalienable right to self-determination take its place.”—Adolf Hitler’s speech at the NSDAP Congress 1938 (from Wikipedia)

The Czech president, Edvard Benes, was pressed by Britain, France et al. to give autonomy to the Sudeten Germans, the ethnic Germans who made up the majority in that part of Czechoslovakia (the Sudetenland). This Benes did, along with acceding to most of the other German demands. However, the German separatists continued to make trouble. In September, several months after the speech quoted above, violence broke out again. When the Czecho military tried to restore order, Hitler protested that the Sudeten Germans were being slaughtered. More familiarity. At the end of the month, the infamous Munich conference was held and the Sudetenland was conceded to Germany. In the aftermath, British prime minister Neville Chamberlain expressed a sentiment also eerily familiar today:

“How horrible, fantastic, incredible it is that we should be digging trenches and trying on gas masks here because of a quarrel in a far-away country between people of whom we know nothing.”

Well, we all know what happened. I hope you’ve all stayed with my jaunt through history, because now it’s time to wonder what, if any parallels might apply to today’s stock market. It’s easy to get bogged down in a comparison of the personalities – Hitler was for a greater Germany, Putin is for a greater Russia, but the former was a genocidal madman, the latter is a more moderate pragmatist. Or is he? The world didn’t know that Hitler was Hitler in 1938, but the leading democracies of Europe did know they were even more tired of conflict then we are today – the ubiquitous monuments in the villages of France and England are still testament to the slaughterhouse that was World War I. History has been very hard on Neville Chamberlain, but so far as the Ukraine goes, I’d say his statement accurately reflects American public feeling today.

But it’s not so much what we or the stock the market thinks about the “real” Putin – by now I doubt that anyone on the Street believes he’s going to let Ukraine be. The NATO countries are urging Ukraine President Poroshenko to put down the guns and go along – Ukraine cannot take on the Russian army on its own, and the country isn’t part of NATO (Czechoslovakia had no equivalent treaties either). After all, as I hear our National Public Radio commentators remind me every day, “Ukraine is in Russia’s backyard.” Right. So was the Sudetenland to Germany. Did I mention that Hitler also expressed great concern over the treatment of the Polish and Hungarian minorities in Czechoslovakia? Yes he did. He too was big on “humanitarian actions” – as wildly popular in Germany then as Putin’s are in Russia today.

No, the stock market doesn’t trust Putin at all, not while he cynically goes on averring that Russia is simply a compassionate bystander to the whole process, brazenly disclaims any Russian involvement at all, and brags at home about being a nuclear superpower. I would guess that just about every floor trader and Greenwich hedge fund office believes that he isn’t going to rest until the Crimean action is duplicated. The reason the market won’t sell off more for more than a few days at a time is because it believes that the West isn’t going to do much of anything about it.

Indeed, German Chancellor Merkel was already talking Friday about postponing further sanctions should the ceasefire hold. They’re bad for business, you see. We said similar things about Hitler – he’s a guy we could do business with. Sure.

Then there’s ISIL, and God only knows what those fanatics have planned. I won’t argue policy prescriptions here, but it’s worthwhile reflecting on super-investor Sam Zell’s comments to CNBC this week: “I don’t remember any time in my career where there have been as many wildcards floating out there that have the potential to be very significant and alter people’s thinking.” Caveat Emptor.

The Economic Beat

I have frequently written during the recovery about economic data not being as good as it seemed, but in the case of the August jobs report, the reverse is true. Looking at the adjusted and unadjusted data, it would appear to me that the main issue with the lower-than-expected headline total of 142,000 new jobs is in the seasonal adjustment factor. That includes the scary-looking downward revision to June.

It’s a good time to remember that the data points are only initial estimates, typically revised a couple of times in the subsequent months and then revised again in the February benchmarking. It doesn’t do to get too carried away with imprecise measurements. With that said, let’s get started.

The year-on-year change in total payroll jobs (unadjusted) in August is a provisional 1.84%, compared to the year-ago 1.79% and being the best August rate since 2005. The real problem is that the month-over-month change (unadjusted) from July to August was 0.24%. That’s really a decent number, the third-best since 1996, but the catch is that the two best such Augusts were 2013 and 2012. Last year’s gain was 0.31%, and while that may yet be revised away, it stands for now as the best monthly jump for August since at least sometime before 1981 (I don’t keep jobs data from before that year). 2012 was 0.28%, the highest since 1984. So while the August gain is well above the average of 0.1% for the month (since 1981), is better than any August in the last cycle, and is as good or better than any August in the 1990s but one, seasonal adjustment factors do give the strongest weighting to the most recent data. So the headline total, which reports adjusted figures, looks worse than the underlying increase.

Something needs to be revised, that’s certain. The CNBC cheerleaders quickly began slagging off the August report as an inferior reporting month that gets revised the most and has the biggest revisions. That may be, but I wasn’t comforted by the fact that the household survey (admittedly much more volatile) only showed a gain of 16K in employment. I do think that August stands a decent chance of being revised upward in both categories, but something is afoot. As for the June revision (-32K), it seems rather big compared to the unadjusted revision of only (-4K). The unemployment rate did fall, but that was due more to people leaving the labor force, as the participation rate fell by the same amount.

There’s always a bit of noise in these surveys – for example, the widely publicized MarketBasket (regional supermarket chain) worker walkout here in upper New England led to a drop in retail workers that will be reversed in September. The household survey also stands in a rather weak juxtaposition with the payroll report, an anomaly that will probably give the Federal Reserve something to think about. The above-average increases in the “not in labor force” category (NILF) continue as well – August 2014 clocked in at 2% higher than August 2013. The long-term average since 1948 is 1.15%.

Many blame the increases on the baby-boom generation retiring, but I have some problems with that argument, beginning with the recession. From 2008-2009, the NILF growth rate soared from 0.96% to 2.71%. The first wave of boomers were born in 1946, so unless everyone is retiring early, the number of 65 year-olds should have started to accelerate in 2011 and kept going. However, the growth rate in NILF has actually been slipping since 2009, though not yet below 2%, the first time since WWII (when records start) that we have had five consecutive years of NILF growth above 2%. This year will probably be the sixth, as the rate usually picks up in the fourth quarter. Add to that the zero growth in weekly hours and the 2.1% annual growth in weekly earnings (nearly zero when adjusted for inflation), and you can see why the Fed still worries about slack in the labor market.

In sum, the number will likely be revised upwards, but not as far as 200K, bringing the string of 200+ months to a close. I don’t want to make too much of the 142K print, but it is possible that we’re seeing the end of a post-winter hiring surge that itself followed the winter lull. We’ve also had several of these streaks in recent years that haven’t led to something more, so more of the same might be the safest inference. The ADP payroll report, at 204,000, was also below consensus, while weekly claims data have been fairly steady around the 300K mark since early July.

Two numbers that stood out during the week came from the monthly ISM surveys of purchasing managers in manufacturing and service industries. The manufacturing survey reported an overall index of 59.0, with new orders rising to an elevated 66.7, while the services sector registered a similar number at 59.6. As usual, popular media outlets described these numbers as showing the “strongest growth since” some date, when they don’t mean that. They mean improvement was the broadest across the sector, but they don’t tell you how strong that growth was. The August manufacturing reading was the best since March 2011, but the economy was so mediocre that year that former Fed chairman Ben Bernanke launched the second round of quantitative easing that fall.

The sector scores in the surveys were very good – 17-1 growth vs. contraction in manufacturing, and 15-2 in services. The manufacturing report was a bit at odds with the Fed’s Beige Book report, though, which reported that “District reports on manufacturing were mixed–divided almost evenly into one of three characterizations of the sector’s activity: expanding, contracting, or unchanged.”

Some have suggested that responses from purchasing managers in weak areas have been eliminated, either through attrition or as deliberate policy – the Chicago PMI has started charging for access to all of its data, while the ISM is now charging for historical numbers. Perhaps the thought is that people are more willing to pay up when the data looks good. For myself, I suspect that the auto industry’s influence over the number has grown as other industries have sent manufacturing abroad; there may indeed be attrition from weaker sectors. Autos did do a banner business during August, a month that should turn in a good-looking retail sales figure next Friday.

Factory orders turned in a great-looking number for July, 10.5%, though it didn’t cause that much excitement in the investment community. For good reason – besides missing the consensus for 10.9%, tipped off by the big durable goods number released the week before, the result was actually a loss of 0.8% when transportation orders were excluded. The culprit was Boeing’s (BA) order book at a European air show, and while that sounds good, it won’t mean anything to current production and shipments. The wait on new planes is years long, and orders often cancel before delivery.

Construction spending appeared to have rebounded in July with a gain of 1.8%, but I can’t think of another series that regularly gets such large revisions. A good example is June, originally released as a loss of 1.8% and now thought to be a loss of only 0.9%, with the year-on-year change revised from +5.5% to +7.0%. July is at 8.2%, but don’t take the number to the bank yet. The strength in the initial report was from public sector spending.

Retail sales will be the highlight of next week, coming on Friday, though I expect that Tuesday’s release of the labor hire-and-fire report (JOLTS) will be in for more scrutiny than usual after the surprise in August payrolls. Unfortunately for the discussion, the release only covers July. Wholesale trade data is out Wednesday and import-export price data is Friday; international trade data released this week showed increases in exports as well as imports, along with a record monthly trade gap with China. The latter may well have been influenced by solar panel manufacturers stuffing the channel ahead of tariffs announced on July 25th. I don’t doubt that the tariffs were deserved, as China generally tries to get away with whatever it thinks it can get away with, and considers it all part of the game. It’s probably one of the reasons Chinese authorities have stepped up anti-trust and health actions against American companies in recent weeks.

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