Keep Your Feet On The Ground As The Market Flies

Includes: DIA, SPY
by: Kevin Flynn, CFA


What do investors - or even the Fed - believe?

Economic growth rates remain unchanged, and so do predictions that they will get better.

The showdown between the Fed and traders is drawing nearer.

One of the ongoing struggles I see investors having in this late-stage bull market is knowing what to believe. Though one can hardly dispute that the current market is at least a mature bull - 64 months and counting - many would nevertheless dispute that it is even late-stage at all, despite the age and classic late-stage symptoms like merger mania and the increasingly shrill shrieking of perma-bulls insisting that everyone not all-in is a sucker or worse.

It appears to me that the Fed governors are also uncertain about what to believe. When I listen to Janet Yellen, I still get the sense of a chairperson fighting very hard against the last crisis, with an extreme reluctance to raise rates, heavy emphasis on banking capital and reserves, and even a willingness to let some air out of the tires with references to bubbly valuations in biotech and social media in the Fed's latest report to Congress. One has the impression that she knows exactly what to do to head off 2008, and is keeping very busy going about it.

Still, interpreting official phrasing is a challenging art. While disgruntled traders and analysts predictably rushed forward to berate Yellen for practicing sector analysis without a license, it didn't seem to me that that was at all her point. My immediate reaction was that it was a textbook central bank maneuver: We're not going to acknowledge a bubble, because that could tank stocks and get us in hot water. But gee, have you looked at what's going on around the corner? I for one doubt that Yellen really cares all that much about biotech stocks, and more likely had been provided with two high-valuation sectors that some of her staff felt relatively safe in using as poster-child bad boys.

Freshly installed Vice Chair Stanley Fischer, by contrast, made a couple of pointed reminders in his maiden speech when he said that there will always be another financial crisis, and that the next one will not look like the last one. I have to agree there - I don't see banks blowing themselves up again in this cycle. It's usually about 10-15 years between binges, and each one is followed by heavy regulatory scrutiny of the very sector that the banks don't even want to think about anymore.

Consider the utterances of Dallas Fed President Richard Fisher. If you're reading an article on Seeking Alpha, you're virtually certain to know that the last two days saw the release of June retail sales and industrial production. After I duly updated my spreadsheets and charts, I was surprised to hear Governor Fisher say Wednesday in an NPR interview (it's a good one) that things had recovered more quickly than the FOMC had expected. Really? Yet downgrading the US forecast at mid-year and again after the third quarter (while raising it for the following year) has become routine at the Fed in recent years.

No doubt Fisher is trying to push his end-QE agenda, and I was pleased to hear him argue for the cessation of rolling over the coupon and maturing principal payments the Fed receives. But the economy isn't recovering any faster: Industrial production is currently pegged at growing 4.08% year-on-year through June, versus an average of 3.91% since the beginning of 2010. Retail sales grew 3.6% through the first half of 2014, versus 3.8% through the first half of 2013. Ex-auto ex-gas sales growth has been remarkably flat for over a year.

But what about employment, you may say? What about it indeed. Ms. Yellen took pains to highlight both the progress in the labor market - the drop in the unemployment rate, June payroll workers finally surpassing the 2008 peak - while also showing the elevated nature of other unemployment indicators. In other words, Mr. & Mrs. Representative, we've been saving the bacon, but we aren't done yet.

There's a catch, however. Five years into the recovery, and the official number of insured workers is going to show - after the second quarter update comes out in a couple of weeks - that we are still about 1.9 million workers short of the last peak. I think we may catch the number by the middle of next year, but that may also come just as the expansion cycle is fading. After the tech wreck, it took about two years for the economy to recover its previous high-water mark in insured workers. The end of this year will make it six years and counting - while the stock market has tripled.

Indeed, how can you believe the markets? There were stocks rallying this week because of merger mania and trading programs that say you buy Fed testimony even as Chair Janet Yellen was getting hit with some nasty grilling from that haven of civic discourse, the House of Representatives. JP Morgan (NYSE:JPM) reported declines in earnings and revenue and was rewarded with a bump up in its stock price because it beat expectations. Bond yields have edged back down this week, but equity traders remain convinced that the Fed has their back - something Fisher alluded to as well - even as Yellen and Fischer (Stanley) have started dropping hints about not so much. They can hint all they want, but they markets won't stop believing it until they have absolutely no other choice.

How about the mystery of China, about which Bloomberg and others had the audacity to brag up its "accelerating" growth rate (from 7.4% y/y to 7.5% y/y in the second quarter). That the estimates were at 7.4% is slightly scandalous, because the Chinese premier basically told markets a month ago that GDP would be 7.5% at minimum. I'll repeat what most China hands in the investment community have known for many years - the government prints the GDP it wants to print.

It's a wretched game to guess policy decisions, be they coming from the Fed, or China, the Ukraine or the Middle East. I can say, however, that earnings season so far is on the disappointing side, despite the usual fanfare. I don't expect that to matter as the market carries out its holy ritual of the earnings-season rally - helped out by fresh, short-sucker headlines about corrections worries - but it will start to matter by the end of the month.

We could be in for a mini-growth scare by the time the Fed churns out its latest statement on the 30th. The S&P has been easily rebounding from any moves towards its 20-day EMA, driven by traders convinced the central bank has their back. Yet the noises from the bank suggest that it is going to try to ignore anything less than a good-sized beating. That isn't likely to happen before the meeting - indeed, I would guess a test of S&P 2000 is on many a trader menu - but we may finally see a test-run back to at least the 50-day if Ms. Yellen doesn't blink.

The grand illusions about the accelerating economy ("next year") and the you-can't-lose stock market aren't likely to end this year - and more's the pity, because the longer the party goes on, the bigger the final tab. But the ride looks like it might start to get a lot more interesting soon.

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