The economy is showing gradual signs of improving, said the Wall Street Journal, which is having a bit of bad luck with headlines this week - it led Monday's "Money & Investing" section with a headline proclaiming that "surging stocks put bears on heels," only to see the market take the biggest one-day drop in stocks since early November.
The recent drops and volatility are warning signs, but don't mean a stock market fall is imminent - depending on your definition of the word. If the time horizon is three to six months, then a fall is imminent, make no mistake. But it's three to six days, about the time span of a conservative trader, then no.
There are several reasons for the market to sell off within the next three to six months. To begin with, the calendar trade is usually weak in May and June. It doesn't have to happen - if the market has been unusually weak prior to that, it will usually reverse; if the economy is particularly strong, or perhaps the market is in a bubble, we may skip it, but none of the foregoing apply (though I have no doubt that many are frustrated by a bubble-style mentality that is pervading many of the current rallies, an issue I'll return to below).
We are in a program-driven market whose dominant theme is that central banks support and protect stock markets - so far as they are able. The limits on central bank magic, in the market view, consist of systemic failures, economic collapse, and high inflation. While there is a great deal of debate about the chances of one or both of the latter two outcomes, the markets are generally inured to them, as such debates are more or less permanent fixtures on the economic scene.
Without hard evidence of collapse or high inflation arriving in the very near future, the markets are rather like antelopes grazing on the African savannah. There may be lions lurking in the distance, but there are always lions lurking. One may as well keep eating and drinking, and leave off the leaping about, until the distance factor starts to become an issue.
Indeed, the systemic failure issue is similar in that respect. In the case of the EU, the lions are a little closer in the sense that a disorderly event is not too far off to be imagined. Over time, though, herds do develop a tendency for complacency in the absence of an attack. We were all aware last week that there were Italian elections scheduled, and that the Italian electorate is suffering by and large, but the prospect of a "disunity" government simply fell off the radar screen. The poll blackout certainly played a role, but there is also a certain amount of crisis fatigue, whether in the case of our budget battles or the EU's own long-running series of dramas. And let's not forget the market's love of its own momentum.
In the case of Italy, all that was needed was for Chairman Ben to show up with his feed bucket and reassuring smile in front of Congress, and the markets took right off again. Lions, shmions. Italy might need another round of elections, but nothing is going to happen this week. In the meantime, might as well keep eating and drinking.
A sell-off isn't imminent in the next few days or weeks because during this quarter, the default action is to buy, unless. "Unless" would be one of the three fears getting too close - in this case, it would almost certainly have to be an EU problem - or we get into May. The Stock Trader's Almanac is pretty clear on the subject of the statistical weakness of the May-November period, and we are in a trader's market.
What is more likely over the next few weeks is the proverbial marginal new high in the S&P 500 and the Dow Jones (the latter could happen any day now). Later on when we head into May, we will have to confront - again - the sad reality that the economy isn't really improving, despite the optimism of the Journal. Consider the graphic below of global GDP, courtesy of The Economist:
You don't need a magnifying glass or a degree in statistics to infer that the rate of global growth is in fact slowing. As for the US economy, it has been almost completely flat in the last three years, as measured by nominal GDP. Despite the excitement over housing going from the worst level since the Depression to the second-worst level since then, the fiscal changes - income taxes and budget cuts - are going to outweigh them, especially with Europe heading into another year of recession and the global trade picture steadily deteriorating.
A certain alchemy keeps the markets going at times like this, one that smells a bit like 2007. To begin with, the bond markets are easy. "Covenant-lite" loans are proliferating, everyone knows that junk-bond yields are at historic lows, and the banks are still tight.
Corporations are more interested in using their borrowed treasure chests to prop up share prices and earnings-per-share by buying in stock or paying dividends. Jamie Dimon talked his usual good game about how much money JP Morgan (JPM) might earn in the next few years, but the bank is also looking to eliminate 17,000 jobs. I don't call either of those strategies templates for growth, but as actions speaking louder than words.
Part of the alchemy is that the economy isn't going straight downhill, either. The rate of growth is slowly easing, but there are still up-and-down pulses that are the rhythm of any economy. When upward pulses occur in the first quarter, typically on the back of new budgets, the improvement is dialed into the trend for the rest of the year, the following year, and indeed the rest of the decade, in what has become an annual ritual. In recent years, it starts to become clear in the wake of first-quarter earnings and economic summaries such as GDP that by golly, this year isn't taking off like a rocket either. The tape news looks disappointing, the trading boxes take note of the date and the market pulls back.
Until that time, so long as the economy isn't in actual contraction, we are treated to an endless series of "new highs" in various measures. It might be a five-year high in the market (soon to be an all-time one, though not when adjusted for inflation), or a four-year high in new homes (still lower than the seventy preceding years), or the one mantra from the mutual fund industry that I find particularly irksome, "profits are at an all-time high." Yes, so is the national debt, the money stock, the population, and gross domestic product. It doesn't mean we're living in runaway prosperity.
As for the excitement in new-home sales, well, the increase was due to a blip upwards in the Western region; the other regions were relatively flat. Don't take me wrong, as I am aware that housing is recovering and that some markets are hot, such as California. But here is a look at new home sales in the Western region for the last 20 years:
source: Census Bureau, Avalon Asset Mgmt
As you can see, the number of homes sold in the West is still in a well-defined range that is also well below historical norms. There is no breakout yet, though that's not to say there won't be one later in the year. Given the improvement in commercial real estate credit conditions, I expect some spillover into residential construction credit, even though mortgage purchase applications have been declining in recent weeks. However, that will in turn depend on the EU lion not getting too close, and that is still difficult to predict.
There have been some prominent calls for a big equity decline in March, but big sell-offs (ten percent or more) almost never happen at this time of year (if one were likely, we would have seen a down January). When Bear Stearns failed in March of 2008, the markets wobbled, but then went on to recover as part of a rally from late January to early May. That's not to say that present conditions are like 2008, only that the Bear Stearns failure was a large and bright warning sign that the bulkheads were taking on water. The passengers on the upper deck went on dancing anyway, because of what else, the Fed. It arranged for the safe conveyance of the unsightly Bear Stearns body.
Whatever tensions that Italy might raise, ECB President Mario Draghi may very well defuse the market's concerns at the bank's announcement next week. I believe that he hinted at a rate cut with his recent oblique remarks about the exchange rate. With the recent weakness in EU economic news, he has a good case for shaving another 25 basis points off the rate. It could reignite European markets and would not be too difficult a sell to the Germans this time, as it might appear to be a way to head off any budding Italian crisis.
Between Draghi on the 7th and Bernanke on the 20th, I expect the potential for downward pressure on equities in March to be limited and for the antelopes to keep frolicking and playing. That same Journal article I remarked at the beginning of this article also cited - correctly, in my opinion - central bank pumping as the main support for stocks, and that is frustrating not a few fundamental analysts into making bitter remarks about the bubble mentality. But credit hasn't quite finished the trip from Easy Street to 2007 Bubble-Stupid Lane.
It's a time for continued patience and keeping an eye on the exits, though, rather than a time for new money. As the trading adage goes, it works until it doesn't. The calendar is in your favor a bit longer and the central banks are still handing out the feed buckets. Even so, the volatility is a warning not to get greedy. Even fast antelopes can get caught.
Additional disclosure: I am long SPY, MDY, and IWM, and have written call options against them.