Weekly Update: Here's the situation
They say the market climbs a wall of worry. The theory's never been truer. While the major indices continue to press toward fresh four-year highs, the reasons to be bearish seem to grow larger every day. German business owners are nervous and are less active than they should be in spending money on capital projects, hiring more employees and creating new orders. The problem is that the policymakers, the elected politicians, are not giving them confidence that everything is going to be OK. It is hard to commit capital when you don’t know what tax policies and labor laws are going to govern you. Just like in Europe, here in the U.S., business owners don’t know what their health-care costs are going to be next year. They don’t know what their taxes are going to be. They don’t know what labor laws are going to look like. There is too much uncertainty to jump in with both feet. Stocks are OK; profits may not be. Meanwhile, the VIX is below 16. Increasingly it seems like more and more people have resigned themselves to the futility of fighting European and Fed policymakers. Expectations of more aggressive policy action has continued to fuel the risk-on trade.
Global stock market action is still frighteningly light, even for August, with very thin volume and liquidity that are likely to get thinner these next two weeks, among the most popular vacation periods of the year. Yet the market continues to grind higher. The S&P 500 touched 1,426 this week, surpassing the cyclical high of 1,422 on April 2 and just 9% below its record high on Oct. 9, 2007, even as earnings are 7% higher now than they were back then. Oppenheimer notes there have been two important inflection points for equities thus far this year: the intermediate S&P high of 1,422 and the intermediate low of 1,266 on June 4. Unlike the rallies in the previous two years, the relief rally since June 1 has been led entirely by the forward P/E on the S&P, which rose from 11.5 on June 1 to 12.8 currently even though forward estimates, at around $111, have been virtually flat. It is possible that margins may be boosted in this year’s second half if companies, worried by the uncertainty of the fiscal cliff (more below), stop recruiting and cut back on investment. The World Bank’s annual survey on employment rigidity finds the U.S. to be the world's least rigid economy, meaning firms are able to rapidly reduce head count in the face of weaker revenue growth, such as they did in 2008’s fourth quarter following the Lehman bankruptcy and could do again if/when we hit the fiscal cliff.
But job cuts in a labor market where job growth continues to be weak could thwart economic and earnings growth. With the exception of May and June, net earnings revisions for the S&P have been negative since September 2011, following 26 consecutive months of positive readings. During August, they fell 11.3%, the worst since April 2009. Revenue estimates for the current quarter have been revised down 12 of the past 13 weeks, and the expected year-over-year earnings growth rate is now at -2.9%. ISI Global proprietary readings suggest renewed deterioration. Moreover, S&P revenues are highly correlated with manufacturing and trade sales in the U.S., which grew in Q2 at their slowest pace since Q3 2009. Investors remain skeptical of the rally. A TABB Group survey found that market confidence has fallen to its lowest level in year, and Bank of America said its clients last week were net sellers of U.S. stocks for the first time in six weeks, even though the S&P reached its highest level since April. But until price proves it wants to go lower, betting heavily on the short side of this market still seems premature. The Rydex Asset Ratio, one of the best indicators from regression testing, is signaling that often-wrong-at-extremes traders are now at their most bullish stance of the last few years. You have to go back to 1998 and 2000 to find them with more bullish sentiment. That’s not good. Still, for now, the pain trade remains to the upside.
Housing a contributor New home sales rose above expectations in July, offsetting June’s drop-off, to match a two-year high. However, the inventory of new homes fell to a new record low, which could deter growth for lack of supply. Sales of existing homes also rose, putting the year-over-year annual sales pace above 10% and dropping the seasonally adjusted months of supply on the market to its lowest level since February 2006. Prices were mixed in the two reports—they slipped on new homes but rose on existing homes by nearly 10% year-over-year. FHFA’s separate purchase-only price index rose more than expected in June and has now been up seven of the past eight months, further evidence that the sector is now firmly in recovery.
To QE3 or not to QE3 Minutes from the latest Federal Open Market Committee meeting show policymakers were more dovish and suggested a third round of quantitative easing is likely at next month’s meeting. The minutes did not reveal how FOMC members' views have changed in response to the somewhat better tone of data over the past three weeks. But few would argue the data have signaled a “substantial and sustainable strengthening,’’ which is what Fed policymakers say is needed to prevent further stimulus. The stage appears set for Chairman Bernanke to expand easing discussions at Jackson Hole next weekend. One quandary: The Fed has indicated it will not launch Q3 so long as stock prices are high, yet the stock market is high because it anticipates QE3.
More reasons why it’s too early to worry about recession In addition to the generally better tone of recent data on jobs and housing, the Markit U.S. flash PMI rose in this month for the first time since April, beating expectations and taking some of the worries off disappointing regional Fed readings. Still, like so much of the recent data, the PMI reflects improvement, not robustness—it still remains well below levels experienced in the first quarter.
That’s a mighty steep cliff The Congressional Budget Office warned the U.S. is headed into recession if lawmakers do not prevent a series of tax increases and spending cuts from automatically taking effect in January. It predicts that the economy would shrink by 2.9% in next year's first half if the so-called “fiscal cliff” were to occur, pushing the unemployment rate to 9.1% by the fourth-quarter of 2014, and scored the hit to the private economy at $5.2 trillion without counting any slowdown effect! On the reverse, the CBO says if current policy were maintained, the economy would grow by 1.7%. I was happy to see this, as I’ve been discussing the “fiscal cliff” for months and the odds of falling into recession next year, but the vast majority of individual investors were not familiar with the phrase.
Pocketbook inflation hitting consumers Overall price pressures may appear subdued, but households are starting to feel the pinch. Gasoline prices have jumped 12% since July 1—this past Monday’s average national price of $3.72 a gallon set a record for that date—and both the International Monetary Fund and the World Bank are warning the world to prepare for higher food prices in the next few months as food production has been hurt by unfavorable weather in the U.S. and Black Sea regions. The United Nations Food and Agriculture Organization's food index climbed 6% in July, reaching a higher level than in 2008, when food and oil prices drove millions into poverty.
These confidence gauges are troubling Sixty percent of Americans participating in a new Gallup poll said the nation’s economy is getting worse. Their feeling that the economy is going downhill has increased in each week since January 2008, when tracking of the confidence level began. Another weekly poll of confidence, the Bloomberg Consumer Comfort Index, fell a sixth straight week to its lowest level since December, with consumers’ assessments of the economy and their personal finances at their lowest levels since January and November 2011, respectively. Some of this likely has to do with the state of the middle class’s finances: A new Pew Research Center study found that the median income for the middle class fell 5% over the past decade, the first drop since WWII.
Oh Canada! This week, I returned to Michigan, visiting more good friends and finding the one spot in the U.S. where you look south onto Canada. Our neighbor to the north has a distinctly powerful demographic profile. It will be one of the very few developed countries that will be able to announce that it has a growing population in the year 2050. It has managed to compensate for a birth rate that is below replacement by increasing the pace of immigration, most importantly by attracting immigrants who are skilled workers or persons interested in starting a business.
This is one long Greek drama (but is it a comedy or a tragedy?) A senior lawmaker within Chancellor Angela Merkel’s majority party in Germany told the press that “concessions are possible” for Greece, as long as the government shows a willingness to meet the agreed-upon targets. (LOL.)
Convention watch With the Republican Convention kicking off next week, we note that since 1964, the average bounce that a candidate has received after the party convention has been 5 points, according to Gallup. Also, there is a rumor that at the Democratic Convention the following week, the president will announce that Hillary Clinton will be running as his vice president. I better get a case of popcorn; this election season promises to be very interesting!