May Is The New April, But Is The ECB The New Fed?

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


The weather rebound came a month later than anticipated.

Can last year's ECB-inspired multi-asset rally be repeated?

The stock market tries to guess what lies behind doors one, two and three.

Though I like to write my SA columns Wednesday evenings, now and then circumstances intervene - this week, I found it impossible to do so. Half of the stock's market recent advance could be traced to hopes for the ECB meeting, which loomed as momentous. It's unusual for American markets to be reaching overseas for support, though not unheard of. In the past this has not been a good sign for the longer term, though having little to no significance for the short term.

But first let's do the US side of things. Two weeks ago, I wrote on SA that "the delayed improvement in the weather suggests May is the month that will see the rebound in spending," adding that "it'll be just a rebound, but would still run against correction fears and get its share of aggrandizement from investment bank equity strategists."

Sure enough, here's a UBS economist on CNBC (egged on by the newsreader). It's just a sample - I hear the same thing all day long after every "estimate beat" - the big escape is at hand. Weekly chain-store data during May pointed to a weather rebound, and monthly auto sales data from the manufacturers seemed to have confirmed it. The two ISM surveys also reported broad recovery, with 17 out of 18 industries reporting growth in each report, an unusually large percentage (note that the surveys do not report level of activity, only direction). I expect the monthly retail sales report, due out next Thursday, to also reflect the rebound that April did not have (plus only 0.1% for a month including Easter).

After the ADP payrolls report, I wanted to wait for the jobs report to lend weight to my thesis that the month is simply a rebound (has anyone noticed what a useful service the ADP report is providing equities? Its consistent lowball numbers make the BLS report and subsequent "estimate beat" and rally so much easier). I will cover the report in more detail on my own website (see the link above), but the first look at the numbers confirmed my belief that there is no real sign of change. The rate of year-over-year payroll growth was unchanged, weekly hours were unchanged, and the growth in hourly earnings remains at about a 2% annual rate. Household employed counts lagged the payroll count again, suggesting that the phenomenon of holding several part-time jobs continues to grow.

Those who want the stock market to go up come what may insisted that the jobs number was a good one, those on the other side of the trade took a different view. From my own point of view, the number is good but not great, and in any case, employment is a lagging indicator, not a leading one. There are definitely signs of a weather rebound in the collective economic data, but it does not appear to be an unusually large one, nor are there signs of the "breakout growth" that many have been trying to get us to accept on faith for quite some time.

For my money the pivotal moment for the stock market came from overseas with Mario Draghi and the European Central Bank he presides over. It's instructive to consider the differing reactions of the two main financial asset classes, stocks and bonds. The former rallied, though US traders seemed to be busy selling the news until hedge fund manager David Tepper pronounced that all was well again (are we back to that again?). Mr. Tepper notwithstanding, the melt-up in equities had been aided in no small way by the anticipation of more stimulus.

Bond markets in both countries were unimpressed - or at least not frightened. Prices rose instead and yields fell. The European markets were perhaps inspired by the thought of the bank guarantee of sovereign bonds appearing to become more entrenched, not to mention the pure price momentum that has taken some of the periphery country yields to low, otherworldly levels. Both markets may have taken comfort in the recent US experience, where aggressive policy in both conventional and unconventional areas has led to neither inflation nor accelerating growth. One can and certainly should contend that other factors than monetary policy have been at work, and it's possible that the economy would have decelerated in the last couple of years without the Fed's aggressive help.

However, the only thing that has really gone higher is the price of assets, as more money competes to buy the same things. The bond market is probably going to quickly shake off Mr. Draghi's bravura performance, on the very reasonable supposition that it will do little to change the growth trajectory of the member countries. Mr. Draghi himself admits that the risks remain to the downside. I agree with that, though I also consider current ECB posturing to be an interesting example of the dance between the Germans and the bulk of their EU colleagues. The Germans are plainly going along because they've been alarmed by the effect of the euro's strength on their export-based economy. Outside of Germany, the weakness in eurozone lending has been a challenge (it did tick up in the first quarter after a rotten fourth quarter).

The latest eurozone inflation data of 0.5% has mollified the Germans to go along (finally) with taking monetary measures to weaken the euro and try a little-pump priming. It doesn't hurt the German side that much of Mr. Draghi's program remains theoretical: The ABS (asset-backed securities) market has been steadily contracting in Europe, and while one can offer three-year funds to banks, they are not obligated to take them. The effects of the negative deposit rate may be the most significant, as ending the mostly failed sterilization efforts should have little effect.

The question remains of where the reserve money will go. One cannot force banks to lend when they are afraid, as both the Depression and current excess reserves in the US clearly show, and one cannot stop them from lending when they have the fever, as the many busts over the decades have demonstrated. Another financial market may absorb excess bank reserves instead of them going to non-financial uses - sovereign bonds (including Treasuries) and inter-bank loans come to mind. Aggravating all of it is that demand is weak - the biggest incentives for companies to hire and expand capacity in aggregate is always going to be sales growth, still noticeably lacking.

Mr. Draghi managed to talk yields down a year ago without spending a penny. Can he talk the euro down in the same way, or is it only going to succeed in more asset inflation?

Equity investors are looking at a different set of choices. Behind door number one is the September 2007 "trader's dream" Fed action of cutting rates by a full half-point. It led to another market top the following month, but that was the bull's last bellow. Behind door number two is last year's "whatever it takes" remark by Mr. Draghi, which briefly drove asset markets crazy and sent stock prices into a parabolic spike that triggered an end-of-the-taper alarm by Ben Bernanke three weeks later.

But what lies behind door number three? Although leverage has passed 2007 in some important respects, many current economic measures are better, even if GDP isn't one of them: The economy isn't headed for recession in two or three months time. Door number two's Draghi remark of last year not only caught markets by surprise, it was in the context of QE-infinity. giving the upper hand to traders singing the song that central banks had turned equities into risk-free investments.

We are currently in neither of those places. Despite the markets approaching severely overbought levels, we've been there before. Short-term traders may be willing to keep squeezing sellers until the Fed finally feels compelled to say something, as the Wall Street Journal's Jon Hilsenrath (the Fed's preferred media interlocutor) signaled this week. The bank's next statement is still twelve days away, and in the meantime there could be attempts to whip up Chinese stimulus fever. CNBC couldn't stop repeating "record highs" and "Goldilocks" all day long. Is door number three September 2012 and the Fed's massive QE-3 rally?

The natural direction of the stock market is up, established bear markets aside. Several weeks ago, disappointment and anxiety over first-quarter growth and earnings got a little help from geopolitics to push short positions to a multi-year high; the damage might been impressive had a catalyst come along, but one didn't. Prices began squeezing ever higher until the impending ECB meeting came into view. Now that it's past, one would typically expect the selling to start near Friday's close.

We have arrived to the inverse side of the middle of May, with trader ebullience and investor enthusiasm at dangerously high levels. There will be payback, but whether it comes before or after the Fed meeting is hard to say- the stock market doesn't naturally trend down, so a mirror-inverse of May is less certain. Should the market maintain its present course, the Fed is more likely to dump a bucket of cold water on it two week's time - but that's a lifetime for a short-term trader. The net of it all is that the market is running on liquidity dreams more than liquidity itself (forget about earnings). It's a dangerous place to be, either long or short, but I cannot believe that we can keep this up much longer, or that door number three leads to another six-month rally.

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.