Filling The Gap

Includes: DIA, QQQ, SPY
by: Kevin Flynn, CFA

A month ago I was writing that the first-quarter top might not yet be in, and followed that up a week later with the assertion that a rebound to 1850 was still in the picture, even as the market was getting a pasting. Now we are in mid-February less than two percent away from completing the rebound, but I must confess that the route was odder than I thought it would be.

It wasn't any earnings report from Wall Street darlings that pulled stocks out of their spiral, nor an improved economic reading. It was just a good old-fashioned classic technical bounce from the 50% retrace of the trip from the October low to the January high. The move seemed to get added fuel from a jobs report that was confusing enough to revives hopes of a favorite Street parlay: either the report was better than the headline jobs number looked (which had already been given a weather pass) and growth is really fine - or it wasn't, in which case the Fed would cease tapering.

In the middle of this nice chart rebound came a few days blessedly free of major economic releases. Short-term momentum was tilted higher, and traders eagerly awaited testimony of new Fed chair Janet Yellen. The aura surrounding her remarks was reminiscent of 2007, in the sense that Yellen said nothing at all new, but the market decided that the revelation that the chair of the Federal Reserve didn't say anything bad-new means that all must be well in the world. At least for now.

Janet Yellen's performance was perfectly straightforward and broke no new ground - in itself, no doubt reassuring to traders. It would be a mistake, however, to overlook the remark that the market adored above all else, just as it would be a mistake to overweight its significance: In response to a question about what it would take for the Fed to slow its taper of quantitative easing, Yellen replied that a "notable change in the outlook" would be necessary. It was a textbook answer rather than a significant policy statement - the head of the Federal Reserve is not supposed to say that the bank intends to pursue policy with complete indifference to the economy. Not ever.

Yet what the market heard was, "Yellen put," a continuation of the so-called Greenspan and Bernanke puts: The Fed will rescue us (markets) if things get bad. I don't know if that's what Ms. Yellen intended with her words, but it's what markets wanted to hear in them, and so they did.

Thus the narrative has pivoted, along with prices. The morning news flow today was filled with stories of big rallies in emerging market currencies, reversing the melodramatic tales of recent weeks about emerging market quicksand. The silliest of these was no doubt the many rapturous remarks about the unexpected strength in the latest Chinese trade data, strength boosted by an early Chinese New Year (end of January, instead of last year's first week of February) and the usual Chinese practice of telling central government ministries how wonderfully everything is going.

The pivot isn't over, either, not in its narrative and not with prices, though both are set for a little pause. Indeed, a respite in the ascent may have started Wednesday when markets couldn't' hold early morning gains, and could find a little more extension Thursday on the back of what is expected to be a weak January retail sales report. Consensus is for a decline of 0.1%, for which the weather will justly get some of the blame (probably more than it merits), so it will have to be a real clunker to get the markets to sell off in reaction. That said, a decline isn't likely to inspire more buying or recovery talk either.

The flight of the recovery narrative should continue to gain altitude, though the trip may be a little bumpy, through a combination of the stock market's yearning to believe, future jobs reports that should belie the deceptive weakness of December and January, and some inevitable rebound from the weather when (if?) winter eventually ebbs.

Yes, I said it: The labor market is actually better than the December-January reports, though not as good as the November report. I don't know what's going on with the seasonal adjustment factors at the Bureau of Labor Statistics (BLS), but the essentials are this: the year-on-year rates of growth in the establishment survey's unadjusted payroll totals (estimated) through the ends of November, December, and January respectively are 1.85%, 1.71% and 1.74%. By way of comparison, the increase for all of 2013 is currently estimated at 1.69%.

In the case of the November and December seasonally adjusted totals, I would strongly suggest averaging out the two months combined, leading to a 175,000 monthly clip. That would resonate with the latest JOLTS (labor turnover) report for December, which showed better results in jobs hires and openings than the headline number of 75,000 net new jobs would imply - December 2013 was better on both counts in the latter data set than December 2012.

Assuming that January's real underlying rate is in the same 175K per month ballpark - a reasonable inference, looking at the unadjusted data - that would mean the most recent three months were below the 190K run rate that the BLS currently posits for all of 2013. Can the 15K/month difference all be attributed to weather? A guess would say "yes," while a hard answer can only be estimated: The real difference is unknowable. More importantly, it's not worth worrying about anyway, because the larger issue is that the labor market is not showing any core indication of a move towards a 3% real GDP economy.

Monthly data is a bit noisy, but December's year-on-year growth rate of 1.71% compares with 1.73% for December 2012. The current estimate for 2013 jobs growth of 1.69% stands in comparison with 2012's rate of 1.72% There's still time for the former to get another bump higher, but regardless of that there is no real change evident. Looking at the jobless claims data, a better coincident indicator than payrolls (a lagging indicator), there is no evidence of labor market gains beyond 2013's rate - if anything, the gains are slowing . Don't be misled by the big jump in the household survey either - it was pure catch-up. A month ago, the establishment survey's count of job additions in 2013 was a whopping 50% ahead of the household survey: 2.26 million vs. 1.46 million. All January did was narrow the gap between two series that are supposed to converge over time.

With the S&P fourth-quarter revenue growth rate running at just over 2% - and it's sales growth that drives hiring, not confidence surveys or EPS-friendly stock buybacks - there isn't any case for hiring to pickup beyond its current rate. Adding headcount before sales start to pick up means lower profit margins and a trip to the shareholder penalty box.

That's one side of it. Another is that one should not expect a measured, sensible tread from the herd. Instead, experience suggests that one is more likely to see great masses trying to follow each other to the same place at the same time. So when we see some resumption of normalcy in the weather, we should also see a pickup in data from retail sales and manufacturing. When we see some resumption of normalcy from the BLS, we should also a pickup in headline jobs numbers. The sum of all that will mean a resumption of normal abnormalcy in the stock market.

Since all of the foregoing economic measures are likely to beat estimates when they do occur, that should give rise to a certain amount of hysteria, along with chest-thumping bellows that the 3% outlook was right all along. But it'll just be noise. There's nothing out there that indicates that the core rates in the economy are suddenly improving. The current ratio of negative-to-positive guidance changes for the first quarter of 2014 is 4-1, for example, according to FactSet, and growth in just about any economic category you can think of was slower in 2013 than 2012.

Yes, there should be a little help from the budget deal and debt-limit extension, but in real terms, the 2013 budget is still smaller than the last budget of George Bush in 2008. There was also a much ballyhooed pickup in GDP in the third quarter of 2013 - the root source of all the recent hype about economic momentum - but it was mostly inventory-based. GDP decelerated in the fourth quarter, and the latest trade and inventory data suggests that the next revision to Q4 GDP may show further deceleration to 2.6%.

With January retail sales set to be about break-even, no discernible pick-up in February retail sales, over a million people still cut off from long-term unemployment benefits and more bad weather pelting the eastern part of the country, it's not as if there's any extra fuel on the fire for a pickup in the first quarter from last quarter. We're still running at the long-term trend rate of 2% real GDP, maybe a little less.

But don't expect sobriety to get priced in yet. The other pivot point is visible in the chart below:

That recent gap in the S&P 500 just begs to be filled, so far as traders are concerned, and they're going to need a better reason than a feeble January retail sales report -which comes with a built-in weather excuse - not to do the job. The market hasn't failed to close out a gap like the one above since last June, when the price tag for failure was a 2% decline morphing into a 5% decline. Then it did close the gap, as indeed it has not failed to do a single time in the QE-era. A failure to do so this time would be a major warning light.

Despite my still-intact prognosis for a return to the highs this quarter - and the speed of the rebound over the last week showed the latent possibility in such a move - should prices stall out at the present level for more than a few days, I would be leery of the growing possibility of a completion of a 10% correction. My apologies for sounding like I'm trying to have my cake and eat it too, but at the moment the markets are neither overbought nor oversold and predicting short-term sentiment is most tricky at such times. The market may want to go higher, but people haven't stopped looking over their shoulders, not after the January we had.

A potential catalyst for a move in either direction this month - now that the debt ceiling is off the radar - could come next week, with a good-sized slate of housing-related data on tap. It's too early yet to expect any rebound data from that sector, and indeed one would think that the weather could not have been a plus.

Next Wednesday will see releases of the latest FOMC minutes (afternoon) and another "flash" PMI from China (evening), followed by more flash PMIs from Europe and the US before Thursday's open. It could make for another little pivot point. Don't take the latest Chinese trade data seriously, but there was no denying the impact of the last Chinese flash PMI. Despite the sharp rebound in all things emerging-market related this week, that region is essentially still under house arrest so far as asset inflows go - another stumble and the exits will get jammed once again.

The very near term outlook - the next few days - may be positive for equities, but the intermediate outlook is apt to be volatile. If and when the gap does get filled, I'd use the occasion to scale a goodly chunk out of the asset class and leave it there. I don't like the long-term outlook at all.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.