U.S. Equity And Economic Review: This Is Not A Market That Wants To Move Higher, Edition

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Includes: DIA, QQQ, SPY
by: Hale Stewart

The Institute for Supply Management (ISM) released its monthly manufacturing and non-manufacturing report this week. Although manufacturing increased .2% to 48.2, this was the fourth consecutive month of contraction. But new orders and production were both above 50, indicating we could see slightly higher numbers next month. And the anecdotal comments were surprisingly positive:

  • "The oil and gas sector continues to be challenged by low oil and gas prices. Risk of suppliers filing for bankruptcy and reducing their workforce is becoming an increasing risk. Our company workforce is also declining." (Petroleum & Coal Products)
  • "Business this month [is] better than last month and better than this period last year. Reduced oil and basic chemical prices providing favorable margin comparisons." (Chemical Products)
  • "Huge rollout in wireless in 2016 across all markets. We should be very, very busy." (Computer & Electronic Products)
  • "We are a bit slower, but staying busy." (Fabricated Metal Products)
  • "Business is still strong, but slowing." (Transportation Equipment)
  • "2016 starting off with strong orders." (Primary Metals)
  • "Market is sluggish to start the year." (Wood Products)
  • "Medical device continues to be strong." (Miscellaneous Manufacturing)
  • "Overall demand is higher than expected for post-holiday season." (Plastics & Rubber Products)
  • "Much worldwide macroeconomic uncertainty affecting our business. Business confidence seems low." (Food, Beverage & Tobacco Products)

While some comments mentioned a "slowdown" and there was a specific reference to the weak oil market, other comments reported strength and increasing orders. The overall tenor plays more to the positive new orders and production numbers than the bearish headline reading.

The service sector continues to expand, but the 53.5 headline number was below consensus. 8/18 sectors reported contraction, which is a larger-than-desired percentage. The activity reading dropped sharply from 59.5 to 53.9. New orders also declined, but by a smaller margin (58.9 to 56.5). But as with the manufacturing report, the anecdotal comments were surprisingly strong:

  • "We have experienced a slight increase in business activity since the start of the new year. Our new job orders have increased about 10 percent and the job awards about 12 percent." (Professional, Scientific & Technical Services)
  • "Healthcare requirements in several states changing, which will [affect] our business directly." (Health Care & Social Assistance)
  • "Research funding expected to increase during 2016 and will result in higher employment when compared to calendar year 2015." (Educational Services)
  • "Protein commodities all lower due to strong U.S. dollar. Trade imbalance in exports and embargos with certain foreign nations." (Accommodation & Food Services)
  • "Sales have improved. We are feeling more optimism, but remain concerned about the impact of global unrest." (Retail Trade)
  • "Watching economic slowing in other sectors, but not affected yet." (Management of Companies & Support Services)
  • "We continue to see record low key commodity prices driving product cost down. Record low oil prices are putting extreme pressure on exchange rates for key export markets Canada and Mexico. Falling prices [are] pushing margins down as many are forced to drop prices to meet the competition. Extreme weather conditions this season are adding additional challenge[s] to both retail and wholesale sales volume regionally." (Wholesale Trade)

In general, orders are up and input costs are down; both are positive developments.

While personal income increased .3% in December, personal consumption expenditures were up .1%. Durable goods purchases dropped .7% while non-durable goods purchases decreased .2%. This release continues a trend of slightly overall negative consumer expenditures figures. The weakness is especially concerning because it occurred during the holiday shopping season.

However, new car sales were "up about 5% from January 2015, and up about 1.4% from the 17.2 million annual sales rate last month." As the following charts show, this key figure of consumer demand and sentiment remains strong both from a short and long-term time horizon:

Click to enlarge

And finally, we have the employment report. Although the headline number was light (at +151,000), the drop is easily explained. As I noted on Twitter: "-30,000 construction, -20,300 transportation/warehousing, -25,200 temp. employ." While we've seen a nice continued increase in construction employees since the end of the recession, this segment of the labor market is seasonal; winter and early spring are times of weather-related weakness. Transportation declined because of a slowing industrial sector. Weaker industrial production means fewer raw materials are transported to factories for conversion into goods and fewer goods are subsequently transported from factories to their respective markets. December's temporary employees figure was an increase of 25,100, meaning January's drop could be nothing more than the firing of seasonal employees. Seasonal adjustments are theoretically supposed to smooth out some volatility. But also remember there are numerous adjustments to employment data over the years. This is not to say that we shouldn't be sensitive to the weaker number. But we should also remember this is a very volatile figure, subject to numerous revisions.

The report contained other solid internals. From my co-blogger:

  • average wages rose smartly
  • aggregate hours also rose smartly
  • wages and hours for December were revised upward. This means that real aggregate wages had a big increase, probably over 1% in just one month.
  • part time for economic reasons declined
  • the employment population ratio for prime working ages 25-54 rose by 0.3% and has finally made up more than 1/2 of its loss from the Great Recession.

Overall, the report was nowhere near as bad as the resulting market sell-off implied.

The Atlanta Fed's GDP forecast now is 2.2%; Moody's high frequency number is 1.2% and the Atlanta Fed's interest rate model is 1.9%. The NY Fed's recession prediction model shows a 4.56%; The Atlanta Fed's model is 10% while the Cleveland Fed's model is 6.19%.

Economic Conclusion: This week, we learned manufacturing continues to contract, while the service sector continues expanding (however, manufacturing employment has been remarkably resilient). Although the headline ISM service dropped more than forecast, the anecdotal comments were mostly positive, new orders grew and backlogs ticked up a bit to a position of moderate expansion. Consumer news was mixed. Incomes increased, but spending was stagnant. However, January car sales were positive. Finally, the employment report showed positive wage gains.

Market Overview: The market is expensive. The current and forward PEs for the SPYs and QQQs are 21.40/15.87 and 20.85/17.12, respectfully. One could argue the market is becoming attractive on a forward basis, but that would assume the revenue and earnings picture is improving. According to Factset.com, it isn't:

The blended revenue decline for Q4 2015 is -3.4%. If this is the final revenue decline for the quarter, it will mark the first time the index has seen four consecutive quarters of year-over-year revenue declines since Q4 2008 through Q3 2009. Six sectors are reporting year-over-year growth in revenues, led by the Telecom Services and Health Care sectors. Four sectors are reporting a year-over-year decline in revenues, led by the Energy and Materials sectors.

.....

The blended earnings decline for Q4 2015 is -3.8%. If this is the final earnings decline for the quarter, it will mark the first time the index has seen three consecutive quarters of year-over-year declines in earnings since Q1 2009 through Q3 2009. It will also mark the largest year-over-year decline in earnings since Q3 2009 (-15.5%).

This week, let's look at the SPY's P&F chart, because it really explains the market's current situation:

Click to enlarge

In April 2015, the market hit the 210-212 (it says 2008 on the P&F chart) level. It remained there until September when the index sold off sharply. The market rallied strongly in October, but, again, couldn't move above the 210 level. We had a second large sell-off in January that coincided with the Chinese sell-off. A counter-rally ended in February, with the market now in a slight downtrend.

There are a few key takeaways:

  1. The market twice rallied to the 210-212 area and couldn't move higher.
  2. We've now had two sharp sell-offs from these levels.

These moves have coincided with

  1. A declining revenue and earnings environment.
  2. A sharper sell-off in the more risk-oriented averages such as the IJHs and IWCs/IWMs
  3. A post January 4 treasury market rally.

This is not a bullish equities environment.

Hale Stewart, XE.com