The trading market lives, and we certainly are impressed at the efforts that are going into keeping it alive. It reminds us of two other years: 2007, and 1987 (the latter estimate being shared by Marc Faber of the "Boom, Doom and Gloom Report"). It feels like 2007 to us because of the similarity in trading patterns, and indeed we wouldn't be at all surprised to learn that some of the same firms were redeploying those strategies.
Much like 2007, we have an extended rally, with eyes on exits, news flow that regularly fails to support the myth that all is well, yet no obvious, hit-you-in-the-face disaster yet (though clues abound). So a story that is less than encouraging may cross the morning tape, and nervous traders start to take some money out. Yet nearly every morning around 10:30 AM, after trading volume has subsided, certain traders start to step back in and drive the market higher during the light conditions.
If things are lagging, someone may fire a big ETF order, say on the order of $50-$100mm, and suddenly prices are looking up again. Maybe the game will be varied by hitting the tape with multiple smaller orders instead (we've all read "Liar's Poker)." It's even easier now than in 2007, because volume is lighter. We watched in amazement then, and we're watching it happen again.
In other ways it does feel like 1987, in the sense that the market is on a runaway train and the investment fund community is overwhelmingly overconfident. The bond market started signaling that things were going wrong in the spring of that year, yet prices drove past every danger sign in an orgy of self-infatuation. You can object that the Black Monday collapse was partly driven by portfolio insurance, and that circuit breakers have since been instituted, both true. Yet today we have high-frequency-trading instead, and there was a singular benefit to that wild day twenty-five years ago this October: the correction finished in one day. It took a couple of weeks for everyone to recover their nerves, true, but it wasn't nearly as wrenching as the drawn-out post-Lehman collapse that took six months to find a bottom.
The sugarcoating that goes on now is certainly stronger than it was in 1987, partly because the financial sector is bigger and partly because it has more dedicated media outlets now. The way many of the news sources we track strain to describe how well the emperor is dressed would be surprising and even embarrassing, if we hadn't seen this movie before. We're used to it, even if still manages to raise our eyebrows.
If a Fed governor gave a speech expressing confidence that another bond-buying program would soon begin, or that the economy had finally reached escape velocity, what do you think would happen? The markets would go ballistic, of course. Instead, New York Fed governor and FOMC vice chairman William Dudley - the guy who oversees the central bank's trading desk branch and monitors the Street - gave a different take on Monday night.
In his remarks on the national economy, Dudley noted that "it is far too soon to conclude that we are out of the woods" and that "the economic data looked brighter at this point in 2010 and again in 2011, only to fade as we got into the second and third quarters." He noted the unusually warm weather and that most of the fourth quarter's growth was due to inventory accumulation (a point we have also been repeating), that growth in final sales was "actually quite weak," and that big inventory quarters are typically followed by inventory slowdowns.
As for that booming labor market that the press has bought into, Dudley noted that
had the labor force participation rate not declined from around 66 percent in mid-2008 to under 64 percent in February, the unemployment rate would still be over 10 percent.
That speech didn't get much play at all, though noted economist and near-constant bear Dave Rosenberg took notice. However, the February existing home sales report released on Monday was dressed up quite nicely. It was slightly below consensus, a miss small enough that we consider it meaningless, but what got the most attention was the upward revision to January and the fact, duly trumpeted by the realtor's association and repeated on radio the rest of the day, that year-on-year sales were up over eight percent. That sure sounds good.
In the end, it may indeed turn out to be so, but you will have to excuse us for taking this glowing appraisal with a very large grain of salt. You see, one year ago this month the January data were also revised upward, only to a 5.4 million sales rate. Many months later, that rate was revised again - to about 4.54 million. The first January 2012 revision is actually 16% below the first January 2011 revision, and the initial February 2012 run rate of 4.59 million is 6% below the initial February 2011 estimate of 4.88 million.
Well, maybe the association has dramatically improved its early estimates, but we're going to wait and see. In other respects - median home prices, percentage of distressed sales (around a third), cash sales (ditto), January and February of 2012 are virtually indistinguishable from their 2011 counterparts, and all of this despite the favorable weather. For that matter, we looked at the housing starts unadjusted numbers, and while permits are certainly up compared to last year, construction isn't, which may explain why the homebuilder sentiment index didn't move last month. Warm weather may have pulled some sales forward (in apparel as well), but it's too early to tell, because the first two months of the year are small in real numbers and the housing totals we get are heavily adjusted.
Trading prices may tell us that the trend still lives, but it's a day-to-day affair that is about itself and not about the economy or earnings. It's about the trend. In its early days, a trend draws strength from the repudiation of the old trend; in its last days, it lives off the denial of its own end. A classic sign of a trend approaching the end are news events starting to acquire a rather comic aspect, as bits of fluff are dramatically promoted in significance and thunderclaps are ignored (until the lightning finally strikes).
But it's useful to reflect upon what prices are saying from an investment point of view, though, rather than that of the trader. It's a view that isn't always heeded, even by those who are paid to do so; the pull of the stampede can mesmerize more than you may think. The investment valuation is like gravity - though it may be a comparatively weak force, it is persistent and nearly always prevails in time.
For the investor right now, prices are starting to say that nothing can go wrong this year. That isn't likely. Facing the slowdown in China and perhaps the rest of the emerging markets, the recession in Europe and its disintegrating periphery, the quite modest nature of the U.S. recovery, the debt burden hanging over the developed world, impending budget battles and automatic spending cuts, oil prices that will realistically recede only if traders believe that the economy is turning down - it simply isn't possible that the market can sail through all of these perils untouched. That was partly Marc Faber's thesis.
Yet those obstacles are not the province of the trader. One or more of them will be before the year is out, certainly, but not now, not yet. Traders concern themselves first with what might happen tomorrow, less with the day after, and so on until anything more than a week out is rarely considered (we're not knocking traders, incidentally, just reiterating that it's important to distinguish the two approaches).
The market has rallied on some real fluff lately, whether it was another Greek non-default story or the denial of the rumor that the US was considering releasing strategic oil reserves onto the market (yes, it drove a reversal on Friday). European markets rallied on the news that investor sentiment about the future (though not the present) had improved in Germany. Their market is up over 15% already this year, how could it have been anything else? That is like 2007.
Most US banks passed their stress tests - another rally. Yet we didn't notice the least shred of doubt beforehand about the results; indeed the whole affair had been well off the radar screen. When necessary, though, any non-negative can become a major positive development. We did think it ironic that JP Morgan (NYSE:JPM) chose to celebrate its newly acquired seal of capital approval by deciding to immediately weaken its base with an increased dividend and stock buyback program - and providing a big boost to executive compensation.
The Fed also said that the recovery was "moderate" instead of "modest" in its monthly statement. This was interpreted as a major upgrade to the outlook, and by the weekend, the press was treating it as such. We suggest checking Mr. Dudley's text - the Fed habitually gives texture to FOMC statements with follow-up speeches by governors . Rather than focus on the central bank's semi-permanent default position of cautious optimism, focus on what it does: the policy is still to keep interest rates near zero for over two more years, and there was no change in its current "twist" policy of using maturing debt to lean on long-term rates.
Yes, the failure to hint at the next round of quantitative easing certainly shook bond traders who had come to expect it. The reaction was understandable and yet curious at the same time. The bond market has conspicuously not been surfing the recovering economy story, and there was something of an overabundance of hope that Professor Dumbledore - er, Bernanke - would unveil another miracle of quantitative easing with his invincible wand. Prices moved sharply as an overcrowded trade unwound, though some pundits tried to sell the re-allocation as the bond market buying into the recovery theme. Yet had the Fed announced another round of QE, equity prices would presumably have taken another trip skyward and bonds would have sold off from that re-allocation. Perhaps the real conclusion is that bonds were simply overbought.
The Philadelphia Fed business activity index now stands at 12.5, with new orders barely positive; a year ago at this time it was 29.8 (revised) with new orders over 20. The New York Fed manufacturing survey stood at 20.21 in March, little changed from February 2012, a little better than February 2011 (16.16, revised) and with new orders down both month-on-month and year-on-year. Industrial production was unchanged in February.
We're not going to quibble about a couple of points in diffusion surveys; they're not precise enough for that anyway. But the data support Dudley's and our own point of view that the economy hasn't yet reached escape velocity and that we may simply be repeating the rhythm of the last couple of years (likely, in our view). The year-on-year increase in actual retail sales excluding gas and autos - that is, not adjusted for anything - from February 2010 to February 2011 was 5.61%, while the year-on-year increase from February 2011 to February 2012 excluding autos and gas, was - after adjusting for the extra leap-year day - 5.62%. Some escape. In fact, the year-on-year rate fell for total sales, from 9.2% to 6.5%.
Only the stock market seems to be reaching escape velocity. We've seen this episode before.