“All is for the best in the best of all possible worlds.” – Voltaire, Candide
For a brief moment Friday morning, we had to wonder if the market would finally give way to a classic mid-August sell-off. Thursday had witnessed a triple-digit loss for the Dow, the biggest in many weeks, and markets again opened down Friday morning in the wake of a disappointing durable goods report.
Markets were also deeply concerned by the rumor that German chancellor Angela Merkel was taking strudel with her tea at her meeting with Greek Prime Minister Antonis Samaras. Equity traders began nervous selling on the premise that the Germanic pastry order was a clear slap in the face to Mr. Samaras about getting any help on his country’s debt woes. Fingers rested nervously on the sell button in case the worst should happen – would Madame Chancellor dip her strudel meaningfully into the tea?
However, when the news crossed the wire that Frau Merkel had instead accepted a slice of souvlaki, prices quickly rebounded. Europe was saved! Nearly at the same time, it came out that Fed Chairman Bernanke had acknowledged to Congressional representative Dan Issa that the Fed is in fact a central bank, and that it can print money, leaving traders beside themselves with joy. The Fed can print more money! Prices soared at this stunning new development, and the Dow soon finished up in triple digits.
We won’t ask your forgiveness for being a bit cheeky, as after all it is late August and the silly season for the markets is now upon us. More importantly, you need to save all of your merciful tendencies for equity markets that seem to have poured Drano™ directly into the brain pan.
Here’s the bull case in a nutshell. To begin, if the central banks do ease, buy equities and commodities and keep buying them until it becomes apparent that it hasn’t worked. When that happens, take profits until the central bankers are frightened into promising more easing. Then buy everything all over again; rinse and repeat.
Next, hope that the central bank easing – in particular, the buying of sovereign bonds by the European Central Bank (ECB) – will lower yields to sustainable levels for the periphery countries. This will suddenly induce the Spanish and Greeks to fire all of their civil servants and begin exporting them to China, thereby remedying their trade imbalances and budget deficits in one stroke. It was hoped that the thirty-cent mortgage loans being carried on European bank books at a dollar might also be exported to China, but it seems that the latter is currently in a surplus position.
The austerity budgets of the affected countries will then reverse the experience of economic history and grow the national economies into surplus, using an over-valued currency to boot. Just to show off, as it were. When part two fails, proceed to part one and begin again.
The global economy is slipping, and monetary policy won’t stop it. Europe is no closer to the grand bargain now than it was before (write down the debts and mutualize them, give up on austerity and realign the currency). All it will do is provide a chance for more short-term trading profits until the big bill finally comes due, wrecking a lot more retirement plans.
We wrote last week in Seeking Alpha that it doesn’t have to happen that way – that the thoughtful, intelligent elites might somehow put aside all of their differences and calmly reach a solution involving mutual support and sacrifice that will ultimately be beneficial to all – without ever looking into the abyss.
But don’t bet on it. Yes, the more clever traders will bet on risky assets if and when central banks print more money because they know others will too. The less clever ones will drink the kool-aid and believe it all. Our advice: it’s summer, and enjoy a good run with the crowd if you like. Do not, however, drink the kool-aid.
The Economic Beat
The report of the week so far as the stock market was concerned was new home sales: it beat estimates. The report of the week for us was the July durable goods report, which didn’t.
In the market’s attempt to go higher, stocks briefly jumped Wednesday on a premature release of existing home sales – they had risen 2.3% from June. The early release of the story didn’t mention that the rate was about 30,000 less than consensus, so equities lifted off as if astonished that there could be a gain. The increase wasn’t enough to make up for the June decline, but it was in line overall with the trend this year.
While the July new homes sales rate of 372,000 was over the consensus estimate of 362,000, a look at the underlying data left us a long way from giddy. Seasonal adjustments added a bit to the rate, which in real terms has been flat for months.
The reports bookended an upbeat earnings report from Toll Brothers (TOL), the publicly traded homebuilder that caters to the higher end of the market. Toll beat estimates and reported strong percentage gains, apparently leaving many observers in a near-delirious rapture about the sector and its single-handed revival of GDP.
We don’t want to appear hypocritical – we’ve been saying all year that housing has bottomed and should gradually improve. But we fear that the market is getting ahead of itself in terms of how quickly it may come back. We don’t mean to seem naive – it’s certainly standard practice for equities to rise quickly at the earliest stages of any cyclical move. And we were writing well before Warren Buffett said it that housing needed to come back for employment to return to normalized levels.
But the current rate of new home sales is still at the levels of the early 1980s – when the country was in a wrenching recession and the population much smaller. Yes, there is pent-up demand and the supply of new homes is limited. This should help drive profitability in the homebuilders. But the easiest comparisons are nearly over, and two things Toll Brothers executives repeated should be kept in mind – one is that the industry is still five or six years away from being fully recovered (their estimate), and another is that homebuilding is a slow process. It isn’t like adding a shift at the auto plant. A lot of inventory is permanently damaged goods, and the process of permitting and developing land isn’t one that happens overnight. During the boom, money was available to throw big developments into the deserts of the Southwest and the wetlands of Florida, but those times aren’t coming back anytime soon.
In the meantime, the economy is slowing. The durable goods data for July was a disappointment, coming in with a decline of (-0.4%) for orders ex-transportation where a gain of 0.4% was hoped for. It was good that orders rose 4.2% including transportation, driven prominently by aircraft, but one ought to set that against the $8.5 billion cancellation that Boeing (BA) just received from Qantas (AU:QAN).
Autos were a positive, but the statistic that caught our eye was the weakness in the business investment category, which goes by the catchy phrase, “new orders for nondefense capital goods excluding aircraft.” It fell (-3.4%), a sharp fall and the third in four months, on top of a downward revision to June. Most of all, it’s down (-6.2%) from July 2011. We shouldn’t be seeing year-on-year drops in a recovery. Weakness in shipments is going to pressure GDP for both the second and third quarter; a second-quarter revision is due this coming Wednesday.
Retail sales have been surprisingly tepid this month. We expect a pickup as back-to-school gets going in earnest, but it’s already late in the game. The Bloomberg consumer comfort index has been falling steadily and significantly – it doesn’t suggest a boom is at hand.
Had you asked, we could have made the easy prediction at the beginning of the year that, absent a European meltdown, the lowest number of layoffs since the crash ought to come in late August and early September. It’s usually the lowest ebb of the year, and last week’s unadjusted total of 310,000 was indeed the lowest number of layoffs since November of 2007. Seasonal factors translated this to an increase, but this time we’re not arguing. We track the year-on-year comparisons on both a weekly and rolling four-week basis, and the gap between 2011 and 2012 has narrowed of late. It isn’t significant enough yet to get alarmed, but it does suggest something of a leveling off. Given the caution that seems evident in retail sales and business investment, we would not be surprised to see a slowdown in real August hiring (the seasonal number could be a different story).
Next week starts out slow and finishes big. The first meaningful report for the market will be the consumer confidence report on Tuesday morning. It will follow the Case-Shiller home price index, which should show a modest improvement, much like the pending home sales index the following day (though pending sales have poorly correlated with actual sales in recent times). Wednesday will also see another revision to second-quarter GDP in the morning, along with the Fed’s “Beige Book” in the afternoon, an anecdotal diary of conditions around the Fed regional districts. Traders will look at both reports through the “ease or not to ease” lens.
Thursday will bring July personal income and spending, and Friday has the Chicago PMI, the most important of four regional business surveys during the week (the others being Dallas, Richmond and Kansas City). July factory orders also come out on Friday, but none of that will matter to the markets as much as Bernanke’s Jackson Hole speech at the annual monetary symposium that begins that day.