It's always amazing to see the extent to which a rising stock market can beguile minds. The mistakes of the past are forgotten - hence the Reinhart and Rogoff book, This Time is Different, by no coincidence the market's frequent rallying cry against the lessons of history.
Evidence doesn't only get ignored, it gets rewritten. Consider the story in Tuesday's Wall Street Journal, claiming that "the longer-term picture is of businesses steadily increasing spending," dismissing the February pullback (it fell 2.7%) as inconsequential and dwelling on the fact that the three-month moving average has risen since October. Indeed it has, though as it goes up and down all the time with the rhythms of stock and destock, it doesn't mean that much. Of far more weight and interest is the year-on-year change in annual (trailing twelve-month) spending.
source: US Dept. of Commerce, Avalon Asset Mgmt
Note that the last time it went negative was January 2009, in the middle of the recession. Does it mean we're headed for one now? Nothing is inevitable, except perhaps the business press making a mess of the data. But it is no long-term picture of, "businesses steadily increasing spending."
Or take the latest survey from the Dallas Federal Reserve. It beat estimates and was reported in glowing terms. Yet like most of the other data this quarter, it was weaker than that from a year ago.
Dallas Fed Business Index
First 3 Calendar Months
When the Conference Board reported Tuesday that consumer confidence took a steep plunge, instead of rising the way it was supposed to, the press immediately trotted out the usual quotes about spending not really correlating with spending. Had it risen by as much, the citations would have been raves about the glowing prospects for increased consumer spending.
It might be tempting to dismiss such stories on the grounds that the great majority of people aren't reading papers the Journal every day. The tone spreads, however. I often find myself wincing at end-of-day market and economic news summaries on public radio stations. As the consumer confidence number suggests, people may not take such reports at face value. But they have a cumulative effect on the narrative. When any market has been on a prolonged rise, those who aren't in it start to develop anxiety over missing out on the easy money.
Like housing, for example. But is it the pre-bubble rush, or the post-bubble? Reporters have been tearing out their hair and beating their breasts at the 8.1% January increase in the Case-Shiller index, the largest since 2006. I'm not sure why a comparison to the last inning of the great housing bubble is supposed to be so wonderful, but consider this chart of Case-Shiller prices:
When you look at it from a somewhat longer view, it's harder to see what the excitement is all about. It's nice to get a rebound off the lows, and I too believe that longer-term structural factors support higher levels of housing activity. I also happen to believe that other structural factors, like weakening per-capita income, recent college graduates working for low hourly wages and a still-tight credit market are going to combine to keep the sector from running away. It wasn't news that pending home sales fell, but I was intrigued by Larry Yun, the National Association of Realtors' normally ebullient chief economist, remarking that "little change is likely in the pace of sales over the next couple months." We're coming into the high season.
Then there are the poor memories. It would appear that the robust pre-Cyprus European markets have, once again, also lulled its political elite into thinking that they have but to raise their hands in command, and the seas will part. Although every half-awake economics student learns about Gresham's Law, "bad money drives out the good," an apparent belief in the sanctity of the moral (or social) high ground can lead the political elites into disastrous illusions about their exemption from economic and market principles. It very often needs the chaos of a falling market to cow them back to reality.
Quite a few others remembered the Gresham spirit last week, even if the EU financial ministers thought it more convenient to forget it. A couple of good examples include The Economist and Seeking Alpha's own Inflation Trader. I myself was moved to immediately roll camera in despair Sunday night at the undercutting of an already weak European banking system. The gist of everyone's remarks is that it will weaken faith in weaker banks, causing deposit flight towards wherever people may think their money is safer.
Don't think it's just Italian or Spanish banks that might come under pressure. The largest French bank, BNP-Paribas, is leveraged over 30 times, and German colossus Deutsche Bank over 60 times. Lehman Brothers' last annual statement showed leverage of about 31 times. I compare the Cyprus solution to the Bear Stearns failure, in that a major consequence of the Bear collapse was an erosion of the ability of stressed financial firms to access capital markets for funding. That was the eventual rock that Lehman Brothers finally broke on.
All of the above said, economists tend to make lousy traders because the market is generally not in tune with the economy, or even corporate earnings. Being a reflection of our own human behavior, it normally has a structural bias towards the upside, and in the short term is nearly always running in some sort of momentum drive or another. I have written some articles of late on Seeking Alpha that worry about a later spring correction, or an eventual episode of uglier payback that comes when the stock market has to eventually bow to gravity.
But I've also steadfastly maintained that, absent some geopolitical surprise, the markets would try to move higher through the end of this quarter. I don't know if the all-time high on the S&P 500 will be taken out today or next week, but I expect it to be broken.
April is a tricky month. Historically, it's been the best month for equities in the post-war period. That doesn't mean it's bullet-proof, of course. Occasionally, there is some serious volatility early in the month that can leave traders desperately trying to decide if it's something serious or the last dip to be bought. Unfortunately, there is no magic rule. For what it's worth, real springtime corrections tend to start at the end of first-quarter earnings season, not before.
Next week could go a long way to determining April, because the ECB has its announcement on Thursday and the March jobs report is on Friday. They will have far more influence in determining near-term prices than the Cyprus solution. The latter is going to lead to an eventual credit fissure in the EU's structure that will cause havoc in the fixed income markets, and that is one problem that equity markets never, ever ignore. It's for that reason that I say that the bell has rung on equities. We're moving towards the final denouement.
But it's not a fire bell. It's a signal to start moving towards the exits, and it's one that most people will not heed. Mistakes like Cyprus take time to mature. Lehman Brothers was still able to raise money after Bear Stearns went under. Mario Draghi might light a fire at any time with one more cut in interest rates. It will be too little too late, yet equities will trade higher first. It's just the nature of the beast. Indeed, if one passed around a crystal ball on the exchange floor that the EU is going to break apart in say, September, leading markets to crash, traders would mark their calendars to start exiting on August 31st.
If you're a quarterly investor, I would suggest reallocating sharply downward in equities for the second quarter. April is unlikely to fall apart, but as the market moves higher on its own helium, the probability of the ten-to-twenty percent flight correction grows. Don't be greedy, or overly alarmed if April manages to tack on another percent or two. On the unlikely possibility of an EU miracle, you can always get back in. Investing on the expectation of a miracle is a losing strategy.
If you're a regular short-term trader, I would be careful about managing current exposure. Rising prices inevitably generate a certain amount of hubris about one's ability to manage the exit. I haven't abandoned equities either, but as the market rises higher into thinner air, I am moving closer to the ground and cutting my allocation exposure. Nearly everything is overbought.
The most important things to keep in mind are one, don't fall for the media hype. The U.S. economy isn't pulling off some miracle; most of the data suggest that this year's usual first-quarter upward pulse in activity is lower than the previous two years. Two, equity markets always ignore the first big warning signs. They may tremble briefly, but then the credo that "what doesn't kill us makes us stronger" takes over and the final burst of irrationality prevails.
Three, the markets will try to believe in the U.S. exemption from the near-certain eventual EU crash for as long as possible. The most serious threat to your portfolio isn't missing the last few percent, it's your own fear of not being one of the select group high-fiving the last victory. When the last bell does ring that everyone in the city can hear, it's too late. You should have already left.