The press reports attributed the very mild market decline Wednesday to the GDP number and the Fed's assessment on risks to the downside, but I don't believe that either had much to do with it. The S&P 500, after all, was in the green mid-morning, hours after the GDP report. It was really just another classic trading day of buying the market up to the Fed report, then selling it afterwards.
The market is still overbought and so vulnerable to a little end-of-month selling that is actually a bit overdue for January. As hard to believe as two down days in a row may seem, I would like to draw your attention in particular to a weekly claims number that has a chance of showing a big increase Thursday morning. I dislike and try to avoid making such predictions as a rule, as guessing an individual number is such an easy way to look silly. However, in the case of the claims data, there is more than meets the eye.
I wrote last week about the seeming anomaly in recent claims data, with the last two weeks showing higher unadjusted levels than their year-ago counterparts, yet being reported as substantially lower on an adjusted basis. Thursday's release will be the first in three weeks with a seasonal adjustment factor lower than the year-ago week (99.5 vs. 113.1).
Last week did include the Martin Luther King holiday on Monday, meaning that government offices were closed, and that should affect the number. However, if the comparative trend of actual claims remains in place, we could see a spike in adjusted. The previous two weeks both had adjustment factors far above the previous year, which may lie behind the sudden drops reported. Ergo, there is more risk for the last day of the month.
The release of the first estimate for fourth quarter GDP did produce a rumble, but not in the stock market. It was from pundits and economists rushing forward in an unruly mob to disavow the number of (-0.1%). One motivation might have been that the miss was so large, with no estimate below 0.5%.
It was said to be the fault of the government, the drought, Hurricane Sandy, and possibly the lack of supersize sodas in New York City. Since none of the preceding factors had escaped the attention of the media in recent months, one wonders why they seemed to have come as a surprise to the forecasters. I particularly remember reading about Hurricane Sandy. The reconstruction efforts were going to add half a point to GDP.
I would not be surprised to see the initial estimate revised upward. Last year's initial estimate of Q4 GDP was 2.8%, and the Bureau of Economic Analysis (BEA) now tells us that the rate was really 4.1%. Clearly there's room for improvement. I don't consider the 4.1% number to be accurate, though, as it depends on a price deflator of only 0.1%. Inflation by all other measures runs about 1.5%-2.0% annually, yet every four to six quarters the BEA comes up with some off-the-chart deviation. The latest deflator was only 0.6%, which suggests to me that the economy indeed was flat in the quarter; PCE inflation measures ran between 1.5% and 1.7% annualized.
Current-dollar GDP was only at a 0.5% run rate, and while I do expect that to be revised upward, even another half-percent upward would suggest that the underlying real rate was about unchanged. Yes, there were special factors, but there are always special factors. The one that is truly unusual is the contraction in government spending. It's a drag on growth, as they are discovering in the UK, where they are faced with the prospects of a triple-dip recession. I've no intention of starting (or joining) a discussion on the political merits of government spending, but only want to point out that with the impending sequestration battle, we are likely to be in for more of the same drag in 2013. Goldman Sachs economist Jan Hatzius voiced a similar opinion.
I saw one economist on Bloomberg straight-facedly proclaim that the number actually revealed "a lot of forward momentum" in the economy. What nonsense. The optimist case is that consumer spending, as measured by the PCE component, rose from a 1.6% rate in the third quarter to 2.2% in the fourth. I believe there's a holiday called Christmas in the fourth quarter. People are known to spend money for it.
Another write-up I saw extolled the large increase in durable goods orders (+13.9%) as a sign of consumer confidence and spending momentum. Also nonsense, as durable goods spending is always lumpy. Last year's fourth quarter saw the exact same increase, followed by a typical deceleration over the next two quarters (Q2-2012 is now reported as having fallen 0.2%).
A better picture of the trend of consumer spending comes from non-durable goods, which fell to a 0.4% rate (initial estimate) in the quarter. That is closer to domestic final sales, which slowed from 2.4% to 1.1%, or gross domestic purchases, which fell from 2.6% to 0.1%, though I am optimistic that the latter will be revised upward.
One of my favorite indicators is the trend in imports - they will usually rise strongly in good times and fall sharply in bad. The fourth quarter showed a drop of (-3.2%), which also boosted the GDP result by 0.56%, since imports are subtracted in the GDP calculation. It was the first time since the first half of the recession year of 2009 that imports fell two quarters in a row, though it ought to be said that the recent decrease was far milder.
I agree with the popular Street view that inventories should see some rebuild, but some commentary is a little ahead of itself in that respect. Inventories aren't all that low - the year-on-year rate of wholesale inventory change in September through November was well above the preceding four months and November, at 7.02%, was above the 20-year average of 4.9% and about equal the November 2005 rate of 7.18%. The domestic final sales number in the fourth quarter suggests demand is weakening, and this is also hinted at by weak data from January weekly retail sales reports and consumer confidence, quite likely both suffering from the restoration of the payroll tax.
The accelerated dividend and bonus payments in December, meant to dodge the tax man, led to a huge increase in disposable personal income (+8.1%) in the fourth quarter. Before you conclude that it must inevitably lead to higher spending, Trim Tabs suggested on Seeking Alpha that much of it went into the stock and bond markets, which fits with the fact that higher-income earners save and invest more of their marginal income.
In addition, much of the increase in personal income came at the expense of the first quarter, in the form of income that was pulled forward. The missing dividends, bonuses and extra taxes in Q1-2013 should all produce a spending drag that may more than offset any increase in capital spending, since spending is 70% of GDP. And if spending is weak, not every business is going to want to expand capital spending, regardless of the outcome of the budget process next month.
However, none of this may matter until mid-February. The trading part of the market is clearly trying to push the S&P 500 index to the magic Fibonacci number of 1510 and made two runs at it in the last two days, with the second attempt topping out at an agonizingly close 1509.94. Indeed that may count as close enough for some of the technical high priests, but I suspect that the hoi-polloi are going to want a print above that level. The classic scenario would be to push forward to the marginal new high before reversing, and let's not forget the Dow's need to print above 14,000, either.
Friday's jobs number could play a big role in that, especially as it comes on the first day of the month and is followed later by the ISM manufacturing number. The ADP payroll survey did report an above-consensus number of 192,000, but that has to be weighed against their initial December number of 215,000 (now revised down to 185,000). Not only does that represent a decline in initial estimates, but their first December number was 60,000 ahead of the initial Labor department number. Consensus for the latter is 185,000, though that may change by Friday morning.
I'll confess to having no idea about Friday's number. January is the most heavily adjusted number of the year, since in the real world, end-of-year terminations and transfers mean that the actual count of employed workers shrinks by about 2% every January. It's also worth noting that Friday's report includes the annual benchmark revision, which can stretch over several years of data.
For me, neither the weekly jobless claims series nor the personal income data point to big revisions for 2012. Having said that, though, large revisions have occurred in the past and the updating of seasonal adjustment factors could conceivably produce some headline-making swings. January 2013 was much colder than January 2012, and I wouldn't want to accuse Labor of having a deft touch when it comes to accounting for weather.
In short, I see Friday as a roll of the dice. We could see a big surprise in either direction, and a positive one would probably be enough to propel us past S&P 1510 to perhaps 1525 by mid-February. A negative one would obviously have an opposite effect, but while February isn't a great month historically and we haven't had a good February swoon in a few years, they usually follow a weak January. It would be quite unusual to see a strong January market give up in early February, and if it did - which I don't expect, absent an external geopolitical event - that would be a bad sign.
You may note that I have said nothing about earnings, and the reason is simple - they haven't really mattered to the broader market. Clearly they have to some individual names - Apple (NASDAQ:AAPL) and Netflix (NASDAQ:NFLX) come to mind - but markets have largely overlooked management guidance that has been uninspiring, going so far as to reward cuts in outlook from names like Caterpillar (NYSE:CAT) and Amazon (NASDAQ:AMZN) (I wouldn't touch any of those four names with a ten-foot pole on the long side). One report that I will be looking forward to on Thursday is MasterCard (NYSE:MA). I have no position there, but I am looking forward to deciphering their views on spending.
The market has been fearless of late, chasing technical levels and round numbers with impunity, and pride goeth before a fall. However, just because a lack of fear has descended doesn't mean it has to go down right away. I think the odds favor only a mild pullback before the rally resumes into mid-February. There are many contrary indicators about, including the flow of funds, hedge fund positioning, economic surprise, and capitulation buying, but most of them take weeks and months to play out, not days.
Markets seem to me to be as much of a prisoner of seasonal patterns as I can ever recall, and it will take something big to alter that course. But the upside is limited, and it's not a time to be guessing with your 401k money. Don't be the last to the party, and don't worry about missing the last percent. If you see 1525 on the S&P this month, hit that bid.