As we head for September, historically the market's worst month, it seems like a good idea to review what we know and what we don't know.
At the top of the list of things we don't know is what the Fed will do at its September 19th meeting; at the top of list of the things we do know is that the asset markets - all of them - are obsessed with the Fed. September's returns should hang in the balance - after all, it's not like the month is doomed to negative returns. It often starts out cruising on the back of a late August rally, which took a hit this year when the real world intruded this week with talk of armed intervention in Syria.
We don't know what will happen in Syria, either, but markets traditionally sell off in fear of conflict and then rally after it begins, probably because its worst fears are never realized. While we're on the subject, I beg deference from the many SA readers who are already abreast of the situation to remind everyone that Syria's relatively minor oil production is not at issue: The threat of war always rattles markets, perhaps more so when it is in the Middle East. There doesn't seem to be any good way to enter nor in particular to exit Syria, with its more generalized menace of a Sunni-Shia conflict threatening metastasis.
That said, it wouldn't surprise me to see markets quickly become inured to the situation; in fact it would be quite typical behavior. In that respect, a word of warning about the perils of setting your sails by the stock market in these situations: Auction markets quickly lose interest in anything that seems extraneous to the auction itself, so while the loud bang of Syria might have rattled them for a day on Tuesday, Wednesday's rebound only meant that the world didn't end, not that the situation can't come back to bite. It can, but it will have to make a bigger noise the next time around.
After Wednesday's close, the S&P is down 3% on the month and about 4.4% since its brief episode of silliness on the first two days of the month. Yet it should rally over the next few days, barring waves of large metal cylinders taking a tour through Syrian airspace. The stock market is short-term oversold, and though Syria may have spoiled much of my outlook for the late August rebound, the technicals do favor a bounce.
Thursday morning will bring the first revision to second-quarter GDP, and it could be a win-win release. The consensus is for an upward revision to 2.1% (annualized) versus the original 1.7% estimate, and while the number is heavily dependent on a dubiously weak inflation rate of 0.7%, if history is any guide the latter will need a few revisions to climb back to a more plausible number. Should the datum arrive under 2%, the market may decide to treat it as another exhibit in the argument against tapering.
If the Middle East doesn't further intrude, the rally could last until my column next week. July's tally for new orders for durable goods was a dud, negative when it was supposed to be positive (overall and ex-transportation), particularly in the business investment category (-3.3%). The silver lining to that is that there appears to be a noticeable bounce this month.
The Kansas City, Dallas and Richmond Fed manufacturing surveys were all decently positive and above expectations over the last week, while the Markit flash PMI moved up to 53.9 as well. The Markit number has usually run ahead of the ISM survey it's supposed to signal, but in this case it may be on the money if the Chicago PMI delivers on Friday. All of that would produce a happy ISM manufacturing result on Tuesday, and the stock market always likes one of those - especially on the first trading day of the month.
We also know that the new home sales rate fell in July, and that the estimated decline was 13%. We know that shipments of durable goods were estimated to have fallen by (-0.3%) in July, and that with new orders down overall, ex-transportation, and in business investment, it suggests further weakness in August shipments. Finally, we know that the initial estimate for the month's retail sales growth was +0.2%. In sum, the long-awaited second-half rebound is off to a weak start.
If you want to protest that the ISM numbers suggest that the rebound is at hand, think again. These surveys use diffusion results, meaning they essentially measure the plus-minus difference, and over the short run can give quite weak indications of the level of activity.
One good example is the July ISM reading. At 55.4 (seasonally adjusted), it was the highest monthly reading in over two years and the press did not hesitate to gleefully report it as the fastest expansion of manufacturing over that time. The final tally, however, was that both shipments and new orders of manufactured goods fell in July, though not in every category. It was also the highest July reading since 2010, when Ben Bernanke was so alarmed by the prospects for the domestic economy and deflation that he proposed the first quantitative easing program the following month.
We do not yet know the results for the August jobs report (though the cutoff date has passed), but we do know that another number like July's 160K will produce a divided Fed and probably a token cut at best in bond purchases. We also don't yet know what effect a number over 200K would produce on the markets. It would be very unusual for stocks to decline on a relatively good jobs report, yet such a number would almost surely bring on some measure of the taper.
We don't know what will happen in the Middle East. We do know that the global economy is not well situated to cope with a sustained rise in energy prices. We know that European vacations end this week, but we don't know if that will mean further unrest for them next week or next month.
We know most of all that most or all of those concerns will fall in the shadow of whatever the Fed does decide next month. We know that long-term indicators show the stock market at very overbought levels - and that it stayed even more overbought for over 18 months at the end of the 1990s - the last time that P/E multiples were expanding as fast as they are now (though not nearly as high, thankfully).
I also know that the more the market worries about September (or any other impending doom), the less likely it will be down when it comes around. The media seems more preoccupied with a weak August this time around, but that phenomenon often leads to a September rebound.
In sum, we know that the market is oversold in the short-term, overdependent on the Fed in the intermediate term, and overbought in the long term. We know that nominal GDP has been falling, and that earnings growth was barely positive in the second quarter. Yet if the Fed does anything in three weeks time that the market sees as friendly, it will propel prices higher, perhaps to new highs. But then the policy elites are going to have to either fish or cut bait, because we are nearly out of time to justify those prices.