Weekly Update: Impending doom
I traveled to New York City this week, where clients at both breakfast and lunch meetings shared a nagging nervousness. I’ve been hearing this for months. It’s hard to put a finger on—many end clients aren’t even aware of the pending “fiscal cliff,’’ nor do they seem all that wrapped up in what’s going on Europe. But generally, they are almost universally suffering from a sense of impending doom. We’re coming off a month in which the Dow declined 17 out of 22 days, or 77% of the time. Since 1900, only four previous months have had such a large percentage of down days, the most recent being January 1968! Looking at history, subsequent market action has been modestly positive, with the Dow up one, three and 12 months later by 1.1%, 3.9% and 6.6%, respectively. (Not exciting, is it?) Wolfe Trahan notes many investor sentiment readings are at post-Lehman lows, and Dudack Research’s proprietary work shows that, before Wednesday’s rally, the market reached an oversold level that was the deepest since August 2011 and June 2010 before that. In both instances, the market experienced a near-term rally of 5% to 8%, followed by a retest of lows. And in both cases, the S&P 500 eventually fell to a lower low, but with less selling volume, representing an excellent entry point for investors.
Wednesday’s strong rally—the S&P had its biggest one-day gain on the year—was the first positive sign of accumulation this market has seen since last year’s fourth quarter. Volumes expanded, but most importantly, breadth was impressive, with advances outnumbering declines more than 7 to 1 on the NYSE. I think the rally was fed by a very dovish speech from Fed Gov. Janet Yellen that raised hopes for more quantitative easing, by increased speculation that the Bank of England will enact more QE on its own, by the growing sense that there is progress in helping Spain, and by Wisconsin’s election results (in which Republican Gov. Scott Walker easily beat labor’s effort to recall him over policies limiting union bargaining and public pensions). But at this writing, the midweek rally has stalled, with the markets seemingly in a holding pattern. (Not exciting, is it?)
While it’s pretty unusual to have a momentum signal similar to the one experienced on Wednesday fail, it’s not clear the market has yet bottomed. On the one hand, the VIX has yet to reach the 30 to 40 level that typically signals capitulation, in which equities have discounted much of the worst case. Of the prior 21 times the VIX hit 25 (it hit 27 this earlier this week), only four times saw it peak below 28—meaning 80% of the time, a peak was at a higher level. Using just medians of the precedent 21 cases, the S&P likely reaches its trough around 1,245-1,265. That would put it in line with the 13.5% correction that Leuthold Group notes is typical in a calendar year. (Not exciting, is it?) On the other hand, since late March, corporate guidance has improved sharply. Since March 2011, the ratio of U.S. corporate earnings guidance upgrades to downgrades has led ups and downs in the equity market by 12 weeks, suggesting much of the sour corporate outlook has been priced into the market. Strategas Research also observes that, historically, the ratio of negative-to-positive earnings pre-announcements has been a fairly reliable contrarian indicator of market performance during the reporting season. When the ratio, as it is today at 3.4:1, has been greater than the series’ long-term median 2.1:1, stocks have rallied during the peak reporting month. It could be that we don’t need the same level of investor capitulation this year as last year because we never had the same degree of optimism. Meanwhile, there’s a pervasive sense of impending doom. Wouldn’t Mr. Market laugh and laugh if in the end, it wasn’t exciting at all?
This should help consumer spending U.S. wholesale gasoline prices have collapsed from the peak of 330 cents at the end of March to around 260 cents now, and year-over-year gas prices are seeing their first decline since 2009. The previous times gasoline prices were down from the prior year were in ’98, ’03, ’06 and ’09, and each case marked important turning points in consumer spending. Speaking of consumer spending, May retail sales could surprise. The consensus is for a flat month, but Thomson Reuters notes same-store sales rose 3.9% year-over-year in May, beating expectations. Annualized car sales did slip below 14 million for the first time this year, but it was still the best May for sales in four years and, year-over-year, sales jumped 26% with all automakers reporting gains.
Not all the news on jobs is bad Although May payrolls disappointed, most leading indicators of employment are at or near multiyear highs. With nonfarm productivity plunging from a post-recession high of 6.1% annualized in Q1 2010 to 0.4% after this week’s revision to Q1 2012, businesses will have to meet any increase in economic activity with more hiring, particularly in light of stagnant labor force growth. This is reflected in the latest Duke University/CFO Magazine Global Business Outlook Survey, which despite a gloomier outlook (more below), sees domestic full-time hiring growing 2.5% over the next 12 months, up from 2.1% in the previous survey.
It’s premature to worry about a recession … The ISM non-manufacturing composite index remained at a level consistent with moderate growth, edging up in May contrary to expectations for a decline. It marked the 29th straight month the service sector has expanded, further reducing the odds the economy is slipping into a recession. The Fed’s Beige Book exhibited no significant change in tone regarding activity versus its early April survey, describing overall growth as “moderate’’ with 11 of 12 districts in expansion mode. And May’s heavy truck sales jumped a record 16.4% to five-year high, suggesting small business activity is improving in part on a pickup in construction.
… but this is why there is talk about it A month of generally downside economic surprises, capped by May’s jobs report, may be weighing on businesses. The latest Duke/CFO survey found confidence in the economy has cooled, prompting a reduction in capex plans—over half of the companies continued to prefer to hoard cash than invest, in part because of weak consumer demand. Elsewhere, the Sentix survey slipped to its lowest level this year as European investors were less positive about U.S. economic conditions. A decline in current conditions also caused the RBC Consumer Outlook Index to slip by the most in 10 months, though the average consumer was little concerned with either the European crisis or the approaching fiscal cliff. Discover’s U.S. Spending Monitor also fell for the first time in five months as fewer respondents felt their financial situation was improving.
Factories may be slowing April orders unexpectedly slipped for a second month and have now fallen three of the last four months. Nondurable goods orders declined the most since July 2009, and nondefense capital goods orders ex-aircraft slipped a second month in a row, suggesting a pullback in factory activity—particularly given that more businesses told the ISM that their inventories are getting too high. Ward’s says Q3 vehicle production is scheduled to decline, albeit after four quarters of double-digit increases.
Trade disappoints The trade deficit narrowed less than expected in April, with both exports and imports declining, reflecting not only falling petroleum prices but stagnant demand. This is a slight negative for Q2 GDP growth, though this morning’s separate support on wholesale inventories could offset trade’s drag. Led by durable goods, inventories rose well above consensus even as the inventory-to-sales ratio held steady.
Election watch No president has been reelected with an approval rating below 50% at this point of the reelection year and every president with an approval rating above 50% has been reelected. Obama is currently at 47%, which is above previous losers and below previous winners. There is a strong inverse correlation between his approval rating and the unemployment rate. The current trajectory suggests that he needs a 7.6% unemployment rate to hit the 50% approval rating. But the best predictor of reelection may be real per capita income, and this number remains below the critical 2% year-over-year growth rate historically needed for reelection.
Pulling a Clinton Political analysis firm McBee Strategic Insight says there is now a 60% chance that Washington will avoid the fiscal cliff through a temporary deal kicking the can to early-to-mid 2013. One reason is that Democrats are showing cracks in party unity over whether to extend Bush-era tax cuts and for whom. Former President Clinton went off-message this week by suggesting that cuts get temporarily extended into mid-2013. The markets would love some progress in avoiding the fiscal cliff.
If only Atari had listened Next Friday, Sotheby's will auction four pages of instructions handwritten in 1974 by Steve Jobs. The document, in which Jobs suggests improvements for Atari arcade game World Cup, is expected to fetch as much as $15,000.