Avalon's MarketWeek

Waiting for Mario


“Why, man, he doth bestride the narrow world like a Colossus” – William Shakespeare, Julius Caesar

It seems a good idea about now to recall the stock market of January 2014, a market also characterized by a bumpy start and a sudden drop that puzzled market followers spoiled by the easy, Fed-fueled returns of 2013. The prior year’s disproportionate gains led to quite a bout of portfolio rebalancing as institutions adjusted equity exposure driven into the red zones by rising prices.

2014 wasn’t quite half as good as 2013, but it was nonetheless enough to set off another wave of portfolio rebalancing. Mix in some legitimate fears about slowing economic growth with the fears that falling prices usually awaken, and we again have a fright about what the year will bring. Similar to last year, the stock market failed the “first five days test” (thought of as a harbinger for the year’s performance) and is also headed for a negative month, though neither of those omens proved accurate in 2014.

Not every year’s rally is brought up short by calendar rebalancing, but the current market is missing some of the high-octane fuel that keeps markets going around the annual turns. Valuations aren’t cheap, despite the perennial equity fund manager protestation that they’re “reasonable.” Most of all, the fall of 2014 lacked the spark of boundless optimism that new programs of quantitative easing have set off in previous years. Nor did it have another surprise about-face from the Fed, like the one in September 2013 that launched the market back on its way to half of that year’s gains.

In fact, this January lacked any momentum at all, as even the perennial Santa Claus rally faded at the finish and left the S&P 500 index with a rare (though minimal) December decline. Small wonder that smaller gains could still lead to rebalancing and help fuel modest losses at the outset of the year.

Other factors are at work of course, not least of which is the confidence-damaging plunge in oil prices. Lower energy costs are generally an economic good, but like a falling currency the benefits can take time to work their way into the economy. The current 45-degree plunge, another example of a one-way trade run amuck, has had its initial effects by fanning fears about fading economic growth and failed bond principal payments. Waves of job and budget cuts in the energy sector are following, such as Schlumberger’s (SLB) decision last week to axe 9,000 workers. The energy sector and energy-related activity has been one of the few sources of decent new jobs in the current U.S. recovery, particularly in manufacturing.

The supply-demand picture in oil isn’t as out of balance as the recent momentum would have it, nor was it in 2008, when surging prices hit $150 a barrel. At that time every story of a refinery fire or unplanned shutdown – both common occurrences in a dirty, dangerous industry – would immediately set prices on another spike higher. Now every story of increased supply or pause in demand that might have been welcome a year ago is another fright for traders.

Put Wednesday’s release of December retail sales – a big decline with a miss of consensus – into this volatile environment and you have an easy-to-understand story about anxiety selling, even if the logic is a bit confused (the month’s sales were much better than the headline number would have you think, as you can see in The Economic Beat below). Friday’s rally didn’t have much logic either, being based primarily on the less-than-fundamental reasons of 1) breaking up a 5-day losing streak; and 2) fresh hopes for central bank liquidity, namely the promise-hope that President Mario Draghi will finally emerge from another European Central Bank (ECB) meeting with a new QE program this coming Thursday.

Certainly the fourth-quarter earnings season isn’t helping much. The current “blended” earnings rate for the quarter, according to FactSet, is a very meager 0.6%. The blended rate, a mix of estimated and actual results, is at this early stage almost entirely based on estimates. Earnings aren’t really expected to be quite that low, of course, as the necessary “positive surprise” factor requires a cushion of 300-400 basis points. But it’s the lowest expectation since the results for last year’s weather-scarred first quarter, one not helped by last week’s string of disappointing results from the big banks. 2014 could end up with less than 6% earnings growth overall (the current FactSet estimate is for 5.1%). The estimate for the first quarter of 2015 is for only 1.8% growth with three months still to go, strongly implying the Street is actually expecting it to be negative.

Weak earnings growth isn’t a wonderful foundation for rising stock prices, yet the next two weeks could see some rally attempts notwithstanding. To begin with, the market is technically oversold – not as much as it before Friday’s rebound, not so much that it makes further declines improbable, but enough that traders will still be looking for a reversal opportunity. In the second place, there are two important central bank meetings before the month is over – the aforementioned ECB event, and the Federal Reserve’s get-together the last week of the month. It’s mad to bet on policy decisions, as the maladroit surprise move by the Swiss central bank showed (“we changed our mind about the currency. Sorry.”). I freely admit that I don’t know what the ECB will do, though it’s pretty obvious that the Draghi camp wants to do one thing and the German group doesn’t.

The Federal Reserve of Ben Bernanke and Janet Yellen has grown steadily more solicitous of the financial markets, and its policy committee (the FOMC) seems to have fallen into the trap-notion that it really can steer the markets and the economy. Hence any further selling that might get set off by another ECB admission that it’s still stuck on the can’t-agree-on-anything-but-further-thinking stage, weak earnings and/or falling oil prices might provoke the FOMC into issuing another ultra-dovish communiqué designed to soothe the troubled waters. Our central bank can’t get away with this kind of thing forever, but like most traders, it seems inclined to keep pushing the button until it doesn’t work anymore.

It’s a good time for caution. I don’t think the equity bull has been killed quite yet, though these things are admittedly difficult to discern in real time, and the stock market and the business cycles aren’t getting old, they are old. Such creatures may not die of pure old age, but they certainly don’t get new life from it either. Yet bear markets almost never take hold in the spring, and a couple of benign central meetings could be all that it takes to have the S&P at 2100 and people talking about Fortress America again.

The Economic Beat

The report of the week was surely the retail sales report, coming as it did with a result of (-0.9%) that was far short of the consensus for a mild decline of (-0.1%) overall and a gain of 0.6% excluding autos and gas – the latter result also coming up far short with a loss of 0.3%. Revisions to November were downward.

The December report was actually much better than it looked. The seasonally adjusted numbers were not good and shouldn’t be ignored, but the December and quarterly year-on-year comparisons for unadjusted numbers were both fine, if not awe-inspiring. The November-December total was in line with previous years. Sales growth should be approximately 4% in 2014, compared to 4.1% in 2013. There hasn’t been any change in the trend (for further details, see my report at Seeking Alpha).

As I said at the time, November retail sales weren’t as good as they looked, but the release of a provisional +0.7% versus an estimated +0.4% set stocks on fire. Now that number has been revised back to 0.4% and though December sales weren’t as bad as they looked, the report sent the market plunging. The tape giveth and the tape taketh away. The S&P closed at 2026 the day before the November report, and a month later is now at 2019.

December industrial production was reported out with a slight decline of 0.1%, pulled down by utilities (-7.3%) but also consumer goods (-1.1%), while construction put in an improbable gain of +1.4%. A balmy December was clearly at work, and the seasonally adjusted results might be taken with a grain of salt – look for a typically big rebound from the utility sector in January. Manufacturing was up a reasonable 0.3% on the month, finishing the year with a respectable 4.9% gain, the same as the total index.

Results were also mixed on the industrial survey side. Philadelphia reported a weaker-than-expected result of 6.3; zero is neutral and the consensus was for 20.0. If the survey follows its historical pattern, it won’t reverse its weakening trend until it dips below zero again. New York reported a similar result of 9.5, the main difference being that the expectation was for a result of 5.0. As these surveys are rough measures, one shouldn’t make too much of the odd point or two.

There doesn’t seem to be any inflation pressure, going by the producer (PPI) and consumer (CPI) price indices for December. “Disinflation,” the middle ground between inflation and deflation, is now the operative word. The PPI reported 2014 at +1.1% overall,+ 2.1% excluding food and energy but with goods having a reading of (-1.1%). CPI showed the year’s reading at only +0.7%, with the “core” rate (excluding food and energy) at +1.6%. The numbers are subject to some revision, and the plunge in oil prices put downward pressure on them that may reverse later in 2015. That said, there certainly isn’t any impetus from that nook of the data for rate increases from the central bank.

That fall in energy prices led to boffo sentiment numbers, with the University of Michigan consumer measure at an eleven-year high of 98.4 and the small business optimism number at an eight-plus year high of 100.4. All of these sentiment measure are a better measure of the path we’ve been on than the one we’re on. So long as energy prices remain low, in particular gasoline, we should keep seeing good sentiment results.

The labor turnover survey showed that job openings rose to a new high – prominently reported in the media – but that the rate fell, almost completely unreported. Weekly claims showed a little bit of lift, both results probably being influenced by weakness in the energy sector. It’s too early to draw any conclusions.

Next week stars the ECB meeting and announcement on Thursday as the week’s highlight. It may seem odd for that to be the pivotal U.S. event, but central bank liquidity has after all been the defining credo of the cycle, and it might also make better reading than U.S. profit growth. The rest of the week should be dominated by earnings, with housing news leading the way on the economic data. The latter should get a boost – probably an exaggerated one, given the frigidity of December 2014 – from the warmer-than-usual weather last month. The homebuilder sentiment index is Tuesday, followed by housing starts on Wednesday and existing home sales on Friday.

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