Avalon's MarketWeek

Still Flying


“A full Belly makes a dull Brain.” – Benjamin Franklin, Poor Richard’s Almanack

One down, one to go? The late-breaking Greek deal/extension/charade on Friday helped propel the S&P 500 index past the magic 2100 mark on Friday, a level that traders and the televised crowd have been eyeing since December. That leaves only Ukraine as the mote in the market’s eye, one that may or may not be removed over the coming weeks. Of course, the Greek deal may eventually circle back to the front pages, given the determination of the Germans to punish and the similar determination of the Greeks to throw off their yoke. How any of these competing aims might get accomplished in the end without upsetting the euro balance is difficult to imagine, which is precisely why the market rallied to a new high.

Seen this movie before? Time after time in recent years, markets have rallied on a reliable recipe of disaster averted and central bank liquidity, served up in a broth of non-negative numbers from U.S. gross domestic profit and/or corporate profits. If a Ukraine disaster can be avoided – by no means clear – then the U.S. economy should have enough momentum to keep sliding along with positive numbers for the next two or three quarters.

It’s telling that the only economic category really doing well these days is a lagging one, employment. With 90% of the S&P 500 having reported, FactSet has its constituent profit growth rate at only 3.5%. I expect we’ll still get past the four percent level, but that isn’t much of a number for an index trading at nearly 20 times earnings. 2014 is shaping up to come in at about 5% S&P profit growth. Before you dismiss it as an energy fluke, the impending revision to fourth-quarter GDP is probably going to be downward, dinging the annual rate of nominal GDP further below 4%, possibly even below the recovery average of 3.9%. Going by the weather and corporate outlooks from the recent reporting season, the first quarter isn’t going to be much better, though it does have the benefit of easy comps.

Such issues haven’t unduly troubled the market, where money is flowing more into broad targets like the SPY ETF (because there is no alternative) than individual stocks (because bond yields are so low). Negative profit growth would be a problem unless we can blame it on the weather, as would economic contraction or an East-West confrontation over Ukraine. Until one of those uglies comes to roost, the markets will want to work their way higher.

Note that I used the word “want” – in the absence of the Fed’s QE money-printing, the lower liquidity conditions are going to mean a bumpier ride. January looked like a second consecutive year of re-allocation away from equities to me, and indeed one story making the rounds is that hedge fund maven David Tepper (among others) had cut U.S. exposure, no doubt some of it in favor of the mythical European recovery that’s been happening next year since 2009, just like the fabled lift-off of the U.S. economy. In recent years, the Fed liquidity pump has allowed us to escape the usual first-quarter bloodletting that precedes the spring rally; in its absence, we may have to deal with some more serious dips.

Such pullbacks might not suffice to bring down the bull, but they would add more to the current topping pattern suggestive of a bull market is in its final stages. On the other hand, the severity of this quarter’s weather is likely to lead to another weather rebound down the road, one that coming on top of the usual April-May rally, could easily lead to more nonsense about escape velocity this summer. The irony is that such chatter might come just as the business cycle is coming to a close. That’s not a prediction, just an acknowledgement that the cycles never last forever, only the predictions that they will are immortal. This cycle is getting quite old, but I don’t see signs of imminent death quite yet.

Some claimed to see signs of rebirth, or perhaps of the mythical new plateau in Wal-Mart’s (WMT) announcement that it would ensure all of its workers make at least $9 an hour this year, with plans to up it to $10 the next year. The announcement is taken as a herald of a tightening labor market, accelerating incomes and the aforementioned plateau.

The extra billion may mean a lot to Wal-Mart and even more to its workers who were making the federal minimum of $7.50, but it’s a drop in the bucket of national income. I applaud the move and expect that there will be more gradual tightening up and down the income scale, but for this cycle it’s going to be too little too late. A higher floor will definitely be a plus in the next one, though.

The Economic Beat

The report of the week was probably the Fed minutes, though the market didn’t react all that much to any of the week’s reports, not surprising in view of the ongoing angst with Greece and Ukraine. The FOMC’s (monetary policy committee) extensive discussion of the ramp up of its reverse repo program as a tool for rate management neatly reflected the bank’s overconfidence in its ability to fine-tune not just rates but the economy, a posture that simply begs for a “surprise” bad ending. It’s worth nothing the bank’s perennially over-optimistic staff noted that “The risks to the forecast for real GDP growth were viewed as tilted a little to the downside, reflecting the staff’s assessment that neither monetary policy nor fiscal policy was well positioned to help the economy withstand adverse shocks” (emphasis added). No kidding, and I believe it’s one of the main reasons many committee members want to get on with the process of getting off the zero bound.

The Producer Price Index (PPI) was something of an eye-opener, with a monthly decline of 0.8% taking the year-on-year rate to (-0.1%). Energy played a big role, but the ex-food-and-energy index still fell 0.1% on the month and took the year-on-year rate down to 1.5%. The numbers were in the same vein as the previous week’s release of declining import-export prices. We can argue about what it really means, but it seems safe to say that one thing it doesn’t mean is that economic activity is lifting off, despite the benign employment data.

When the Philadelphia Fed survey’s six-month outlook was peaking near sixty last fall, I wrote at the time that given the outlook’s excellent track record as a contrarian indicator, we should expect the general activity index to be making its way back to zero over the coming months. The February report released on Thursday approached that level with an activity read of 5.2, versus consensus for about 8. The forward outlook plunged steeply, from about 50 to a shade under 30.

Winter is probably playing some role; the survey is seasonally adjusted, but perhaps not for record snowfalls (though last year we were having a record cold wave from the polar vortex in much of the country). I doubt very much it’s anything more than a reflection of the usual ebb-and-flow manufacturing rhythm that has prevailed in the new millennium. Don’t be surprised to see the survey cross zero in March, don’t be surprised to see a weather-aided rebound back to peak levels later in the year, do be surprised if the latest data turns out to be anything more than a rhythmic pulse. In a similar, somewhat less predictable vein, the New York Fed’s survey showed a mild retreat from 9.95 to 7.78 (I love the seeming precision of these hundredths of a point in a diffusion survey). New orders eased to near the unchanged level in both surveys – they are likely to hover there for a month or three before rebuilding.

Homebuilding activity seems to be maintaining a 2014 pace, though it’s a bit early to say. Starts fell somewhat from a warm December’s pace to a 1.065mm annual level, while the level of permit activity remained about flat, results reflected in a not-significant decline in the sentiment index to 55 from 58 (50 is neutral). January was up quite a bit over January 2014, but the month started off with much better comparable weather that has since turned quite difficult through much of the country. The current month ought to see a drop-off as a result of the record snow in the Northeast and ice and chill through much of the country. February of 2014 was a tough month for weather too, so comparisons may be easy in one sense yet provide a shaky basis for firm inferences at the same time.

Activity abroad remains mixed, the notable part being Japan emerging from recession with a positive quarterly GDP print of 2.2% released last weekend. The number was less than expected and the year-on-year rate remained negative at (-0.4%).

Next week will see the most important monthly housing news, with existing-home sales on Monday, new-home sales on Wednesday and Case-Shiller price data (from December) on Tuesday. There should be meaningful reports in new orders from durable goods (Thursday) and the first revision to fourth-quarter GDP (look for a decline from the initial estimate of 2.6%). The highlight will undoubtedly be Janet Yellen’s testimony on Capital Hill: she will answer questions from the Senate Banking Committee on Tuesday. The real fun comes Wednesday, when members of the House will have a chance to display their typically abysmal grasp of economics and finance.

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