Avalon's MarketWeek

The Guns of August


“Summer’s lease hath all too short a date” – William Shakespeare (Sonnet 18)

It’s not the first time I’ve borrowed the title of Barbara Tuchman’s celebrated book on World War I, but it may have been the most appropriate one. In some ways it was a typical early August week, with the near-daily 100-point-plus swings in the Dow and big swings in sentiment.

If I look dispassionately at the charts, prices are well set up for one more down leg before the selling is done, though that doesn’t mean it has to happen. The selling volume suggests that a small dip could be over, but there was not enough of it to feel safe that a big wave had been exhausted. As to whether we actually get one, from a purely technical basis the implied next step would be down and the Thursday bottom, when the S&P had a brief flirtation with the 1900 level (1903 and change) doesn’t look like a firm one. I wouldn’t bet my life on either direction.

Short-covering (and squeezing) jumped back into the fray Friday afternoon when it appeared that Russian czar Vladimir Putin had switched positions again in his game of push me-pull you with the Ukraine. The level of paranoid dialogue coming out of the country continues to mount, and while I always advise against trying to guess policy, it’s hard to believe that Putin will simply walk away from the situation after putting in a token blockade of food imports. However, as I’ve often remarked, crisis news needs to constantly worsen in order to keep stocks in sell mode, and any days of calm could lead to further attempts to squeeze the shorts.

In the meantime, there is also the Middle East for distraction. No predictions there either, only that the situation is tense and any signs of de-escalation will also be instantly welcomed by stocks. In every situation, be it the Ukraine or somewhere in that troubled band that runs from the eastern end of the Mediterranean to the mountains of the Hindu Kush, any period of calm does run the risk of setting prices up for a harder fall down the road. Though most crises do play themselves out without real trouble, making the reaction of the market understandable, the current number and temperature of these hot spots is a bit disconcerting.

The bond market is not as sanguine as stocks. The yield on the ten-year fell for the week to 2.42% (2.415) after rebounding from a 52-week low on Friday of 2.37%. Much of that is safe-haven buying and some of it is short-squeezing, because everyone in the world has known since the beginning of the year that rates are supposed to be rising this year, especially in the second half. Beyond the haven factor, we’ve seen a continued inflow of money into bond funds, a lack of conviction in the bond market that growth is really going anywhere (along with a lack of data to prove otherwise), while steadily dwindling Treasury borrowing needs have offset the effects of the Fed’s taper program and its deeply obscure hints about rates. The shrinking budget deficit has meant little new Treasury bond supply coming onto the market that the Fed isn’t swallowing one way or another, and of course there are never enough Treasuries in a panic.

Over in Europe, one of two disturbing developments is that sovereign bond yields in much of Western Europe are at multi-century lows. That should be telling you something about growth. Italy just printed its second straight quarter of negative growth (with admittedly mild declines), and now it looks as if Germany may be headed that way too, with the help of the Russian sanctions. All of that has led to the FTSE European stock index breaking many long-term trendlines: the one extending from May 2012, the 12-month moving average, the 60-week moving average, the 200-day moving average. I heard many fund managers come on CNBC and complain that it all means nothing to the U.S. – oh, we’re back to decoupling, are we?

European equities are certainly oversold in the short-term and an actual schedule of QE purchases announced by ECB president Mario Draghi, as opposed to talking about preparation, could cause a violent rip-reversal. But multi-century lows in bond yields are a big warning bell nevertheless, even if partly underwritten by implied central bank guarantees. I seem to recall Fannie Mae and Freddie Mac having implied government guarantees too.

Draghi is absolutely right when he talks about the need for fiscal and structural reform as being more important than another rate cut. The problem is that his own bank’s aggressive easing posture has had the same result as the Fed’s program here – it’s allowed just enough recovery for legislative bodies to completely avoid making any hard choices.

And in China, rally-desperate traders bid up equities Friday in response to the latest trade report. I could hardly believe that Bloomberg would run a story “suggesting the U.S. and European recoveries will help sustain expansion.” Oh yeah, they’re booming over in Europe, haven’t you heard? If anything, I would suggest it’s the opposite – weakened consumers in Europe could be increasingly turning to cheaper Chinese-made goods. It doesn’t hurt either that the yuan has depreciated over the last year, but did Chinese exports really increase by 17.3% year-on-year to Europe, as reported? The country is notorious for inflating its export data. Whatever the case, I cannot take seriously the idea that a European recovery is helping to sustain Chinese expansion.

It’s still August, a time of light volumes and big swings. The reluctance of traders to make any real decisions could allow a determined group to push the tape around in either direction without much resistance. Earnings are getting their usual exaggeration – last week I complained that some were claiming 10% earnings growth despite FactSet’s compilation of a 7.5% rate. This week it moved up the rate moved up to 8.4%, and so naturally a strategist from Morgan Stanley upped the ante and claimed they were really 11%! At the rate we’re going, by year-end the Street will be fondly recalling that 20% growth back in the second quarter. At least the suns of August have been equally generous.

The Economic Beat

It was a light week for data, leaving the market freer to gyrate on things overseas. The highlight of the week domestically was the ISM non-manufacturing survey, which checked in with a reading of 58.7. Being the highest such reading since 2005 – assuming it isn’t revised downwards – led many a journalist and reader astray, who talked of the “fastest” and “strongest” growth since then, when the survey means neither of those. Diffusion surveys like the ISM are at bottom yes-no questionnaires that subtract negative answers from positive and throw in some seasonal adjustment. There is no indication of how much better business is, and recent years have demonstrated this weakness: Despite an average reading of just under 55 over the last four years for the survey (which makes up most of the economy – manufacturing jobs are less than 10% of all employment), real growth has remained at a very modest pace throughout.

Certainly the sector score was good, much like the manufacturing survey released the week before. 17 of the 18 sectors reported growth, a wave that I partly attribute to good weather and the knock-on effects of the second-quarter rebound. Despite the seasonals, this survey has often registered above-trend numbers in the warmer months (and seen them revised downward later). The “strategists” running around this week talking about what a great number it is are setting themselves up for having to talk around lower numbers in the fall.

But let’s not be too dark. Weekly jobless claims also improved, leaving the seasonally adjusted four-week moving average at its lowest level in over eight years. The insured unemployment rate remained at 1.9%. Taken together, the data suggest that claims are nearing a cyclical bottom – the last cycle hit its moving average low in the same month, February 2006, with an average only10K lower – even as the employment rate has further room for growth. A linear trend of improvement could bring the insured unemployment rate down to 1.5% by next summer, which is about as low as the rate gets and may even be too much of a reach for this cycle – the last one bottomed at 1.6%. The fact that the 4-week average nearly matches the last cycle low while the unemployment rate is still a ways from the previous cyclical bottom suggests that employers aren’t doing much hiring or firing. It also fits in with my ongoing hypothesis that the expansion cycle ends in 2015. Take heart, though – usually the first months following the turn of the cycle are met with denial that any such thing is taking place.

Wholesale sales were up 0.3% in June, a bit below consensus, along with inventory growth of 0.3% also below consensus for 0.7% and including a downward revision to May. That net effect may cancel out whatever benefit the GDP number may have received from a lower-than-expected estimate of the June trade deficit, as quarterly inventory growth was nearly a percent below average (seasonally adjusted). Looking at the longer trends, the good news is that the 12-month growth rate in both sales and inventories picked up to the best in about two years. The bad news is that inventory-to-sales ratio doesn’t suggest a big build is coming in the third quarter, though the relationship isn’t always strong. Another year of 2% real GDP still appears to be a good bet.

Second quarter data for labor productivity and cost were released Friday, and as usual one should heed the year-on-year rates rather than the quarter-to-quarter numbers, which are quite volatile. There was a huge surge in first-quarter employment costs – over 11%! – but the year-on-year rate after the end of the second quarter is a tame 1.9%. Productivity rebounded after the first-quarter drop – the downward revision to the first quarter made for a bigger-than-expected second quarter, but it was all a wash. The year-on-year rate is at 1.2%.

Factory order data for June were released, with June showing a nice 1.7% bump after two straight months of declines. Econoday was one group going wild over the report, exclaiming that “this is a very solid and very balanced report that confirms manufacturing as the economy’s leading sector,” while admitting that month-to-month data could be “bumpy.” Particular attention was paid to the proxy for business investment, non-defense capital good excluding aircraft: “The outstanding area of strength in the report is core capital goods where a big 3.3 percent jump for nondefense capital goods excluding aircraft points to solid business investment which reflects solid business confidence in the long term outlook.” I guess they think it was solid.

I don’t know what’s in the water over at Econoday. The number was a catch-up, is all. The year-on-year rate of increase in the category is 3.0%; a year ago, the same rate was 2.9% and the year before that was 5.3%. In other words, the growth rate plateaued a couple of years ago and has remained steady since. For that matter, the current rate of growth in non-defense capital orders as a whole shows a slight decline of (-0.5%). Shipments this year are up 2.6% year-to-date, better than the 1.1% rate of a year ago, but that followed on the previous year’s rate of 5.8%. It’s the same story, month in and month out, of people trying to convince you that one good data point is some fabulous turning point in the recovery (there is also a much smaller group persistently arguing that any monthly data decline is the final nail in the economy’s coffin – you can ignore them both).

The next big report due up is July retail sales, coming our way on Wednesday the 13th. As usual, the two weekly chain-store reporting services have data going in different directions, implying a modest gain. The labor turnover report (JOLTS) comes on Tuesday, import-export prices on Thursday, and then the week finishes up with a crowded slate of July producer prices, the New York Fed manufacturing survey, and July industrial production.

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