- The first quarter earnings rally has arrived.
- Interpreting the latest economic data.
- Be careful of central bank policy intentions.
The first-quarter earnings rally is upon us, though there may be complications along the way - Thursday is an options expiration day, Ukraine tensions could intrude, and early results have been a mixed bag, with some high-profile companies [IBM (NYSE:IBM), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), American Express (NYSE:AXP), Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM)] posting uninspiring results. The pivot point seemed to come on Tuesday, when the market did a double reversal that finished with a rally, the kind of move that technicians love.
The key, as ever, to successful navigation of the coming weeks and months is to properly manage one's expectations ahead of time and not fall victim to the fever of the herd. If possible, you want to profit from it to the extent your investment style and mandate permits.
Earnings seasons in recent years have typically gotten off to a erratic start. The economy hasn't been growing broadly and deeply enough for the largest companies to reliably post banner results. But as the season moves on, the estimate beat rate will rise, early weak results will be forgotten (at least for a time) and the momentum of rising prices and new highs will add a beguiling luster to events. Talking heads will sing ever-louder songs of praise while market organs issue manifestos about the invincibility of stocks and bull markets.
The economic data for March and April will indeed show some monthly improvement as the weather warms, and that will fan the flames. As the results come in, the extent of the improvement will be exaggerated, critical analysis will be largely forgotten and the usual shouting of the bulls will resume that a month or two's worth of minor rebound this time is the real thing. Even the Fed wants to blame the winter slowdown on the weather ("but my FOMC colleagues and I generally believe that a significant part of the recent softness was weather related" - Janet Yellen). It would certainly make the bank's job easier if its forecasts came true for a change and broke the perennial streak of the staff being obliged to revise them downward.
This week's data is providing an excellent example of the events to come, starting with March retail sales. The reported 1.1% increase beat estimates, and since the report's release, it has almost invariably been referred to as proof that it was all weather. Of course weather has played a role in recent data, as February was utterly miserable in much, but not all, of the country (California is the world's 8th largest economy, and did not suffer the weather that plagued the Northeast and Midwest).
But let's take a look at the longer-term trends. March retail sales are provisionally up 2.1% year-on-year, compared to the 2013 rate of 2.24% (not seasonally adjusted). The Easter calendar shift plays a role (March 30th last year), but the weather rebound was conspicuously not enough to offset that. First-quarter sales rose 2.08% year-on-year, compared to 3.02% a year ago. I'm perfectly willing to add back a percent for weather and Easter, but that still only leaves us at the same rate as last year. There is no evidence of an underlying upward shift in demand growth being concealed by the weather. The rolling twelve-month rate of nominal sales growth fell to 2.9%, the lowest it's been since September 2010. There are some offsets going forward that may limit bigger gains.
One is that auto sales didn't have a first-quarter setback, so there isn't much to rebound from. A second is that there is no wealth effect from rising stock prices so far this year, but from the sound of it, it's the first time people have paid taxes in several decades. That complaint isn't completely new, but I can't recall the last time taxes got so much blame for stock market weakness . Capital gains taxes are certainly larger this year than last, and since the well-to-do are largely the only ones with discretionary income, it could be a drag on consumption (and another excuse down the road). While there will always be an Easter effect, weekly chain-store reports haven't been showing much life so far this month. By all means, expect some rebound, but only back to the previous trend.
Now let's look at housing. I've been estimating that new home construction will improve by about 8%-10% this year, but we are not off to a good start so far. Housing starts are down (-2.4%) through the first quarter. The number is subject to revision, but at best we would be flat. Before you blame it all on weather, starts in the West are also estimated to be flat in the first quarter versus a year ago, with single-family homes even showing a small decline (though the first March estimate).
The larger problem is tight credit, and as Jamie Dimon's remarks made clear, you either get a GSE loan or you are rich enough to get a jumbo loan (or pay cash and bypass the banks completely). That isn't going to change this year, but what will change for at least a couple of months is the rate of improvement in starts. Even if we only achieve a 5%-8% improvement in starts this year, well below last year's rate and what most have penciled in for 2014, we will still need some big rebound months to get there - meaning even bigger amounts of hot air. Remember that.
One area that is showing real improvement is manufacturing. The latest industrial production figures and their revisions are a bit of a puzzle to me, with big spikes in February and pronounced slowdowns (though still good rates) in March. It's counter-intuitive. The year-on-year growth in manufacturing production leapt from under 2% in February to nearly 3% in March, though the ISM and New York surveys have shown more subdued results (Philadelphia, by contrast, had a good result). Capacity utilization is barely higher than a year ago. But the gains were broad-based and worth watching, though April and May data will be vulnerable to downturns in mining and utilities.
Then there is the Fed factor. It may not be as positive as the ultra-dovish characterizations in the business media, but it's enough to provide a good tailwind to the first-quarter rally. When Chair Janet Yellen spoke this week about the dangers of low inflation, it was reminiscent of Ben Bernanke talking up unemployment in 2010 as a way to prepare the ground for continued Fed accommodation. Lesson learned. Her remark that the economy might not reach full employment for two more years were interpreted as the Fed saying it wouldn't raise rates until then, when all it did was indicate that it might not. Or it might.
None of us know what the Fed will be saying a year from now, though the perceptions of what it might say does matter. But we can reasonably talk about what the Fed might be doing this month. If the quarterly earnings rally comes off as scheduled, then in two weeks the Fed will be looking at new highs in the stock markets and a batch of economic data that is clearly comfortable with the bank's view that any weakness was weather-related. There are some more housing reports in the pipeline, but the starts data were available before her remarks and one thing we will not see in the interim is a report of falling home prices. With no other major reports in the pipeline, there is no reason to expect anything but another continuation of the taper.
That leaves a window of vulnerability for the market before the next Fed meeting in mid-June. The volatility in the markets this year speaks to a greater-than-usual chance of a spring swoon in the latter part of the second quarter. Not only should the rotation out of high-fliers be telling you something, the last time the IPO channel was so stuffed with deals pricing below the initial range or suffering mediocre performance in the aftermarket was the spring of 2000. The fact that the excesses were greater then isn't the point - it's the inflection point that matters, not the degree of stupidity.
Other swing factors in the weeks ahead include most prominently the Ukraine and the global equity desire to believe in infinite stimulus. Should the European Central Bank (ECB) move to further accommodation at its meeting in early May, stocks will love it. The reaction to the latest GDP print from China was symbolic - GDP growth slowed, so the government must provide more stimulus.
So far as the Ukraine goes, even tanks rolling across the prairies might not be able produce more than a day or two of ripple in equities, not at this time of year. Crimea has come and gone (for good, apparently) and stock prices are now partly inured to the situation. But as to the central banks, you need to look below the surface.
China prints whatever GDP it wants to print. If expectations were for 7.3% and it released 7.4%, that isn't an accident. It doesn't tell me that more stimulus is on the way, but the exact opposite. What the government would really like to do is to weaken the yuan and revive the export sector, rather than let loose another wave of credit binging and excess speculation. Whether it succeeds remains to be seen, but I don't see stimulus plans coming in the immediate future.
In Europe, it isn't just the talk of deflation that have the Germans feeling a change of heart about quantitative easing. It's the euro, as President Draghi has repeatedly mentioned in recent weeks. It's too high, and the export-oriented German economy doesn't like it - exports declined last month for the second time in three months. With China bent on weakening the yuan, enough to get the U.S. to complain (while we are bent on zero rates for the visible horizon), the eurozone is feeling the pressure to respond. All of this raises something of a riddle - if the global economy is really poised to accelerate as much as the IMF and the like have assured us this year, then why are the three largest economic actors bickering over how weak their currencies ought to be and the equity markets talking about further stimulus?
A final note - I'm sure most of you know about the mid-term election effect. It's real, but rising prices will push it off the radar for the rest of the month. So while next week I'll most likely still be writing about further gains to come in equities, I'll also be warning you again that there is still a big air pocket coming afterwards. The way to profit from the next two or three weeks is to be long and longer equities, but don't fall in love with the move or the hype that will be dominant by late April or early May: Asset managers and long-only traders shouting in triumph about buying every dip. There's a much bigger one coming.
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.