Key Market Factors: Global Melt-Up, Consolidation or Correction?

Includes: QQQ, SPY
by: John Furlan

Thanks very much to followers and for comments. Factors and ratings below are my opinion of the equity markets’ current views, the “market’s mind,” how it responds to changing expectations of key fundamentals, not my personal views of them. Markets are very dynamic, and risk preferences, time horizons, etc., differ very widely; thus this article does not offer investment advice.

Market Status—With Global Production Set to Rise, Focus Shifts to Fed, Jittery Consumers This Week

My key market question remains the same as last week's, “can fundamentals start improving fast enough to keep up with markets, or are the latter increasingly at risk of running too far ahead of the former?”

In the U.S., the equity market continued to answer yes to the former, with SPX closing at a new post-Oct high, while China’s market may have started to say yes to the latter, with the Shanghai Composite on Friday closing down for a third day in a row for the first time since mid-May.

Global risk markets seem to be inching closer to a speculative melt-up which would place monetary authorities more in a bind, most clearly in China, where the stock market has been reacting to speculation about its “moderately loose” monetary policy. (See what the WSJ said on Aug 8 in “Hot Money on China’s Plate.”) In the U.S., traders will look for more clues on the Fed’s easy money “exit strategy” in the FOMC’s policy statement Aug 12.

With 2Q earnings season past, the market focused on economic data from China in the beginning of the week, its PMI holding steady, and from the U.S. at the end, its unemployment inching down to 9.4%. Both were viewed bullishly by the market, as employment losses of 247k were in line with whisper estimates and just low enough to eke SPX at Friday’s close past resistance at 1007.

So far, equity markets have moved up from their March lows (China much earlier on its strong stimulus plan) in tandem with leading economic indicators, such as ECRI WLI and OECD CLI, both of which showed continued strong increases this past week.

China is expected to report strong urban fixed investment (+34%) and weak exports (-23%) on Aug 11, and industrial prod (12%) and retail sales (15%) on Aug 12. China’s July money supply and loan growth is expected to be 29% and 34%, deemed “moderately loose.”

Small signs of change may be starting to appear regarding China, e.g. in lower bank loans in July, perhaps slightly less fevered property transactions, and the biggest decline in the Baltic Dry Index since late Oct.

Surprised by the strength of “cash for clunkers,” economists at a number of leading banks tried to catch up with the robust market rally by boosting their U.S. 3Q GDP estimates up from around 1.5% to 3% or more.

The market has long been discounting a manufacturing/inventory cyclical upturn, but personal income and consumer spending still appear quite weak in most countries, including the U.S. More data on the American consumer psyche when WMT reports, along with U.S. retail sales on Aug 13 and U of Mich consumer confidence on Aug 14.

As the economy picks up in 3Q, what will that do to interest rates, with the 10-year yield at 3.85% moving back toward its recent high of 4%? The treasury will raise another $75 b this week (though it has lowered its estimate of 3Q funding needs).

SPX closed the week at 1010, it has now rallied 52% off its Mar 6 intraday low of 666, the largest rally in 70 years. Professional money managers under-weighted in equities and caught by surprise by the strength of the post Mar 9-rally keep trying to buy a dip, making intra-day sell-offs extremely small, so far.

Key Market Factors: This Week’s Update

The info below is greatly condensed mainly from news sources, primarily Bloomberg. After the first five factors, the order of others' changes is based on market importance that week. If the rating changes, the previous week’s rating are in ( ). Charts are grouped at the end of the article. BTE is an abbreviation for better-than-expected, WTE worse.

+ Earnings: With 2Q earnings reports winding down, by the last tally I saw on Bloomberg, 75% of S&P companies beat estimates, up significantly from 1Q. CSCO reported last week in the typical BTE margins/mediocre rev pattern. Earnings from British banks (HSBC (HBC), Barclays (NYSE:BCS)) were also BTE, helping fuel financial stocks.

0 Technical/Sentiment: ACWI, ETF of MSCI All Country World Index, whose rally since May 1 was its largest over that period since its inception in 1970, was flat the past four days. SPY closed the week up from Monday’s pop, but international EEM, EFA down. The Shanghai Composite, global market leader, was down the last 3 days for the first time since the week of May 18, with MACD, RSI negative divergence on Aug 4 high. The U.S. market remains overbought, with nearly 90% of S&P stocks over 50-day ma, and keeps going up, with SPX closing the week above 1000 and Nasdaq exactly at 2000.

Since July 22, financials have led and QQQQ has flattened, with some beaten down financials having huge moves on huge volumes this past week, AIG, C, CIT, FNM and FRE, MTG, PMI, etc. Since the latest leg of the rally began near the beginning of earnings reports after the July 10 close, the XHB homebuilders ETF has risen 42%; IYR REIT ETF 39%; XLF financials 29%; XLB materials 24%; IWM small cap 19%; EEM 18%; SPY 15%; QQQQ 14% (ultras of course much more, e.g. UYM 61%).

Carl Swenlin, still riding his Mar 17 trend-following buy signal (see my Aug 4 article, “Trend Following: Hussman vs. Swenlin,”), notes in his Aug 7 “Chart Spotlight” the bullish implications should an overbought S&P break to the upside of its ascending wedge chart pattern.

0 Valuation: SPX is currently trading at 13.5x 2010 consensus EPS of $75.

0 (+) Interest rates and credit: 10-year T-bond yields rose this week from 3.50% to 3.85%, the June 11 rally high was 4.01% (Bloomberg consensus of economists for year-end is 3.67%), as bond buyers factor in a stronger economic forecast and heavy Treasury sales of $75 b more this upcoming week. Treasury to sell more TIPS in response to China. Treasury cut its projected 3Q borrowing from $515 b to $406 b, up from $343 b in 2q (lower than $361 b original forecast). Treasury holdings by de-leveraging individuals and banks have significantly increased. One bank estimate that net new issuance of corp debt after redemptions should fall to almost zero in 2H. Both might put lower pressure on l-t rates. BOE extended the bond purchase program. Pimco said Bernanke won’t raise rates before 2011.

BX, the private equity leader, was up 27% last week and 64% since July 10. Leveraged loan prices reached Sept 26 highs. YTD corp bond sales in Europe exceed the 2007 record for the whole year. EM bond sales already exceed all of 2008's total. Gauges of financial market conditions/stress based on various spreads, etc. continue to improve at least to levels of pre-Lehman Sep 15 bankruptcy, often much longer. According to Moody’s (NYSE:MCO), high-yield spread narrowing and market re-opening allowing for re-financings will lower peak default rates. According to Fitch, the value of corp bond downgrades declined significantly in 2Q.

++ Leading indicators: These have provided key support for the rally, with ECRI’s Weekly Leading Index (WLI) bottoming Mar 6 along with SPX. (see my July 26 article, “ECRI vs. Roubini, Round Two"). WLI, released every Fri, increased strongly for the 2nd straight week, with its annualized growth rate (AGR) making another five-year high, ECRI saying “prospects for U.S. economic growth have brightened significantly.”

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OECD area Composite Leading Indicators (CLI), also released this Fri, mth-mth chg was both positive and increasing for the 4th straight mth through June (still useful despite the lag as the data looks out about 6 mths). OECD moved its assessment of the entire OECD, U.S., Euro area, China and India from “possible trough” in May to “trough” in June. (China has a higher bar due to its much higher trend growth.).

- Employment/Income: U.S. July payrolls fell by 247k, the unemployment rate dropped to 9.4% from 9.5%. The market viewed the former as a mild positive, about in line with the whisper est., rallying modestly on the news Friday morning and holding it during the day. The day before, the 4-week moving avg of initial jobless claims fell slightly to 555k, continuing claims rose slightly to 6.31 m. Wages and salaries in June fell 4.7% from a year ago, the largest drop since records began in 1960 (a flip side of BTE corp earnings due to cost cutting). Personal income fell 1.3% in June, the largest decline in 4 years, adj for stimulus plan -0.1% in June and flat in May. Savings rate fell to 4.6% from 14-year high of 6.2% in May.

+ China: China said it will scrutinize stock market gains, without much elaboration on how. Official July PMI rose slightly to 53.3 (from 53.2), electricity output 8.4% yr-yr in 2nd 10 days of July, indicating June industrial upside momentum continues. 1H earnings will be reported in Aug. Bank loans are starting to fall, about 500 bi. yuan in July from 1.23 tr mth avg in frenetic 1H; Shanghai Composite fell the last 3 days of the week, its first 3-day decline since week of May 18, on traders' focused on whether China will tighten its “moderately loose” monetary policy, e.g. raising capital adequacy ratios, in response to increasingly speculative equity (individual investors opened more than 700k accts last week, the most since Jan 2008) and property markets (sales up 45%, prices in major cities 30% ytd). Housing transactions may be slowing slightly. Details start emerging on what may be China’s largest ever bank fraud in Guangzhou. Everbright Securities' first brokerage IPO in almost 7 years. GM's best July car sales ever, up 78%. China may top the U.S. as the world’s largest mfr by 2015 according to IHS Global Insight.

0 Housing: Incremental news is still being viewed very positively by the market, reflected in a 42% rise in the XHB homebuilder ETF since July 10, the latest being pending home sales index up 3.6% mth-mth in June, the 5th straight increase, May revised up. Existing home sales are now expected to increase to about 5 m rate, driven by better affordability index (159.2, down from record 178.8 in April), including tax incentives. 30-year mortgage rates rise to 5.53%. Prime mortgage dollar vol in some stage of deliq or default rose 14% between Mar and Jun. Sign of “new normal,” avg new home size 2,065 sq ft, smallest since 2000.

+ U.S. Economy: Economists in at least six major banks revised up their 3Q GDP forecasts from around 1.5% to around 3%, due to strength of “cash for clunkers” and a positive swing in inventory cycle at auto mfrs (July sales over 11 m., Aug may hit 13 m, vs 9.1 m at Feb low, vehicle prod up 60% in July from June), homebuilders (new homes down to 8.8 mths supply, from peak of 12.4 mths in Jan). Non-defense capital goods orders up 2.6% in June after 4.3% in May. But adj real disposable personal income down 1.8% in June, real consumer spending down 0.1%. Retail sales still weak. ISM mfg BTE 48.9, 11th mth high; ISM non-mfg WTE, 46.4, down from 47.0 in June. Stimulus spending still slow, may not get under way before northern winter halts construction.

+ Other developed: Eurozone July composite PMI index highest since Aug 2008; German June mfg orders beat forecast; Japan coincident index rose for 3rd mth. But German June retail sales fell -1.8%, (prev week, Japan retail sales fell -3%, 10th straight decline).

+ Emerging markets: Like China, India’s Sensex had a small sell-off the last 3 days of last week, losing 5%, holding above support at 15k. India GDP 2009 6%, 2010 7%, as Markit PMI shows ind prod BTE offsets moderately WTE ag due to disappointing monsoon. Continue to watch Mexican peso.

0 Financial sector: XLF led market last week. Some large non-U.S. banks reported BTE qtrs, Mistubishi (Japan’s largest), HSBC, Barclays, BNP, UBS. 8 mtg investment co’s recently filed reg statements. According to WSJ, many large banks added less loan loss reserves in 2Q. KKR (KFN) said to be readying 6 cos for IPOs.

+ Cyclical sectors: CAT analyst meeting 75% chance of normal cyclical recovery. Couple of banks make favorable comments about stocks exposed to commodity structural supply shortages

+ Technology sector: QQQQ lagging XLF since July 22. Handset market 1.1 b in 2009, 1.2 b in 2010, down than up 8%, smartphones 180 m and 224 m. China Mobile will launch a GOOG Android 3G phone. Notebook demand limited on Windows 7 coupon promotion. SIA 3-mth avg semi sales WTE -20%.

0 (+) Oil/Commodities/Gold: Oil price closed $70.93. Baltic Dry Index down -17%, worst week since end of Oct, -35% from June 3 high, China coal and iron demand slowed. LMEX metals index further accelerating price trend, 84% gain since Feb low. IEA chief economist said global oil production peaking in about 10 years.

0 Dollar: Index closed at 78.97, same comment as last week: would breaking key support around 78 be bullish sign of less risk aversion for safe haven trades, or put Fed in tighter spot on its easy money policy?

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