It looks like conditions favor the current rally for another calendar week and change. The rally got its start in the usual way, from the kind of sell-off that compresses valuations and sentiment to levels that provoke recoils. It has since been able to continue largely on three factors - earnings, news flow, and the calendar.
The heart of the quarterly earnings season, which featured a largely anemic revenue performance by S&P 500 companies, has dwindled in the rear-view mirror. Those companies are usually global endeavors with significant exposure to European woes. Once the bulk of the season largely ended, the flow of disappointments ended with it. Since then, other high-profile companies such as Home Depot (HD) and Cisco (CSCO) helped reverse the tide somewhat with more positive reports.
News flow has been modestly constructive. It isn't good enough to have the S&P 500 at 1600, certainly, but it's been enough to confound fears of the worst and help a market that wants to rally. The market context of news is critical. Domestic economic releases may not be ripping, but they are good enough to support the move back up, as well as positioning US equities in a relatively favorable light. The political news has also been constructive, even if not ideal.
Three key components of the news that I was counting on to help the market are playing out as expected. None of them were surprises, simply the sort of things that can be forgotten when the media and disappointed electioneers are shrieking about the end of the world.
First, the Greek problem hasn't been solved (at all), but it was effectively tabled until next year. Second, the budget deadline in the US has benefited from constructive comments by both sides. The grand bargain is unlikely to come this year, to put it mildly, but the sides seem to be thawing enough to keep the market happy about the prospect of a pre-deadline extension and multi-part deal.
Third, the Fed has come forth as expected and suggested it will continue the long-Treasury bond aspect of Operation Twist. That news actually came a bit early, but the next Fed meeting could provide another psychological boost.
Then there is the calendar. December is historically the second-best month of the year, and the rally usually starts around Thanksgiving week. If managers had been ripping the cover off the ball, there'd be good reason to worry about defensive strategies, but my sense is that anything that looks like the fiscal cliff is going to be successfully managed is going to send money pouring into the markets. A lot of business was lost last year by managers trying to stay sensible and prudent through the last week of December.
At some point in early to mid-December, you should expect some pessimism to resurface and break the spell. There is no real reason to expect the budget process to move smoothly to an agreement without some bluffing and counter-bluffing along the way. All deals involve give-and-take, and the bigger the deal, the more likely the grandstanding.
This week Senator Reid was the saber-rattler and Speaker Boehner poured oil on the troubled waters. That sets the stage for the Speaker to get tough later and Senator Reid to stand down, allowing the GOP to claim some victory points. It is politics, after all. Before it's all over, there will be tantrums and threats to sink the whole thing.
Indeed, impresario Jim Cramer was busily predicting failure of the process on his show Wednesday, but I believe his analysis is somewhat misguided. He correctly points out the dilemma that many Republicans face in trying to achieve a deal, and that many will opt for no compromise over the career-suicide action of being called a "tax-raiser." The mistake is in saying that the budget process will blow up in a few weeks and take us all over the cliff.
Both parties know that the real December goal is not to achieve major tax reform in the few remaining weeks, or even agreement on the expiring Bush tax cuts. It's to avoid sequestration (the automatic budget cuts), and that's the part of the deal that will happen.
Of course incumbent Republicans don't want to be painted as tax-raisers, and there will doubtless be some artful dodging in 2013 as we go from deal to no-deal to deal back on again. But incumbent Republicans don't want to be painted as the patron saints of layoffs either, especially in the defense-heavy South. Thousands of pink slips won't help anyone's election chances. Sequestration-avoidance is the deal that gets done in 2012, with 2013 set to host the featured heavyweight bout on taxes.
Turning back to the economy, let's look at some of the data. All of it can be interpreted for good or ill if one is so inclined, but for me the most important feature of it is that the unambiguously down-position that S&P 1340 represented on the morning of Friday the 16th has not been borne out.
A good example is the durable goods report for October. If I wanted to be bearish, I would point out that the year-on-year change in business investment orders (non-defense capital goods excluding aircraft) was minus 7%, and then dig up a chart showing that this has historically signaled a recession. I would leave out the fact that orders in the fourth quarter of 2011 were juiced by an expiring investment tax credit, or that orders in the second half of 2012 have been suppressed by uncertainly about the next fiscal regime.
More pragmatically, the October increase in monthly business investment orders does not support a thesis of orders falling off a cliff. One month does not a reversal make either, but it is consistent with a notion that business has slowed down ordering in deference to federal fiscal concerns rather than to plunging conditions - and that 2012 corporate budget money still needs to be used up. I wouldn't look for any significant improvement until the federal budget impasse is resolved, but once that happens, there will be some catch-up spending.
The Wall Street Journal bemoaned the "uneven" housing recovery after September new-home sales were revised sharply downwards, but I don't see it that way. The small monthly revisions added up to big changes in the annual rate, but the real discrepancy had been in a reported September surge that probably never occurred.
That makes sense, because the original September datum was an anomaly in a string of stable sales levels (unadjusted) going back to February. The revised September data and the initial October data are both consistent with the prevailing 2012 pattern of year-over-year improvements. In addition, mortgage-purchase applications have been on a healthy upward trend in recent months. The improvement is real enough, the mistake is to infer some sort of parabolic change or return to 2005 levels is imminent. It isn't, not for years yet to come. That doesn't mean the sector isn't healing.
The Chicago Fed National activity index took a steep drop last month, but the big cut was in production, and that should be Sandy-related. Last week's flash PMI reading of 52.4 is mildly encouraging, yet not as good as the current Richmond Fed manufacturing report (+9). The Dallas Fed report did show a decline, probably more related to the fall in oil prices than anything else, yet the respondents retained a sense of optimism. The drop in its headline number was not due to a surge in people saying conditions were worse, but to a shift in people saying that conditions were the same, rather than better. It will be interesting to see if automotive conditions have revived enough to lift the Chicago PMI back up on Friday. If so, it will help markets go out with a bang.
Thursday morning should bring a positive GDP revision and another small increase in pending home sales. If jobless claims can manage one more drop to near pre-Sandy levels, that should allow the markets to get on with the important task of rallying into month-end, unless the Friday data is simply disastrous.
For that matter, the way looks relatively promising for prices to keep moving up into the end of next week. If last week's PMI flash was accurate, then an improving ISM national manufacturing survey number on Monday - the first trading day of the month - could give markets another lift. Next week's jobs data, starting with ADP on Wednesday, will be the next hurdle. I have to admit to being a little uncomfortable with the high consumer confidence number this week, as these types of peaks tend to come before market downturns. But at least it doesn't suggest sudden weakness in the labor market.
There probably will be an equity downturn somewhere in the middle of December; there usually is, which makes Mr. Cramer's prediction of a 10% drop a little safer (if it's 5%, he can still declare victory). It's even more likely if the markets break out past 1410 - which could happen over the next two days - and we get to the 1425-1440 zone by the end of the next week.
That would take stock prices into an extended posture and ripe for a run back to 1380 or so on budget cage-rattling, or just because traders worry it's time for the usual mid-December weak spell. But let's not get too far ahead of ourselves - in the current market environment, more than two weeks is practically an eternity.
Disclosure: I am long CSCO.