Was the last twelve months all a dream? It may have been for the stock market, which followed a steep twenty-percent swoon last summer with an improbable six-month momentum rally of twenty-six percent, topped off by the strongest first quarter in fourteen years. Yet for all that, we are right back to where we were a year ago: on May 10, 2011, the S&P 500 closed at 1357.16; one year later, at 1354.58. We hope you pocketed some dividends along the way.
It's no wonder that retail investors are flocking to bonds. We noticed not a few equity fund managers last quarter confidently proclaiming their eagerness to buy any 5% dip, and they're getting their chance. Wednesday's close represented about a 4½% drop from the April 2nd high of 1419 (of course, the managers might not have meant a drop from that level. Maybe they really meant from 1390, or some other, similar mid-March level). That is, if they can, as the Investment Company Institute reported yet another outflow from stock funds in the first quarter, this time to the tune of $8.6 billion.
Besides the mediocre jobs report, there was another unexpected development last week. The pattern for months has been for a persistent bid to show up on weakness, but last Tuesday's first-of-the-month rally was met with an uncharacteristic fade, and punters faded the tape again on Friday when the jobs disappointment led to losses becoming steeper as the day drew to an end.
Much of that could and should be tied to Europe. The markets didn't ignore the outcome of the European elections on Monday - they already sold the results in advance on Friday, leaving us with the worst week of 2012. Anxiety about Europe may have been linked to the Tuesday fade as well, as a steady stream of weak economic data continues to emanate from the continent.
Remember when banks were coughing up one hairball after another in 2008? One of the bigger ones that appeared on the pavement were the "off-balance sheet" SIVs, or Structured Investment Vehicles. Another brilliant way to over-leverage the banks to mortgage-backed paper, one of the highest profile sinners was Citigroup (C). A proposal was floated for a "super-SIV," a kind of good-bank bad-bank entity that would be stocked with sinning SIVs and sold off to investors. It never got off the ground.
Spain might do well to review the episode as bond yields rise and it begins to hack up its own detritus. The country has been talking up a similar solution for the disturbingly weak mortgage book its banks have, with the notion that, perhaps like the Fed's "Maiden Lane" vehicles, all that bad stuff could be put into one place and later sold. The goal would be the same: build a firewall around the bad banks.
But the reason the super-SIV failed and the Maiden Lane entities worked is that the super-SIV, like the Spanish solution, envisioned a pool of SIVs from various banks and then selling it to private investors. The banks ran into intractable problems, though, the first being the realization that putting in existing SIVs at anything approaching fair market value would backfire when the market was faced with proof of how cheap the paper really was - and by extension, how stressed the balance sheets were. Then there was the problem of valuing my paper versus your paper, how to sort out gains and losses, and the fact that the Fed wasn't interested in guaranteeing losses in order to sell it while the profits would revert to the banks.
The Fed's Maiden Lane vehicles, by contrast, involved single companies - first Bear Stearns, then AIG - and the central bank keeping the details close to its vest, indispensable for avoiding further panic. But the Spanish government buying the bad loans or otherwise guaranteeing them, voluntarily or not, is precisely what the market fears. Putting an arms-length market price on the paper in order to entice private buyers would raise the same problem that the Citi consortium faced. We're sure plenty of traders remember.
We're sure you remember Friday's jobs report, too. Not only was it weaker than expected, but ironically it was not weak enough either. As we pointed out last week, a really big miss, something in the low five figures, would probably have induced a rally on the grounds that QE-3 was in the bag. Those kinds of rallies are beloved by traders, not only because they crush the spirit of short-sellers and catch many others wrong-footed, but after a decent interval one turns around and sells it all back to the suckers.
Ah, but while the Fed can cushion, and lubricate, or slow, it cannot create prosperity. It can try to create the conditions for it, but it can't hire a nation and put it back to work. Like our elected leaders, it does have the capability to bring on disaster, but that's the nature of the beast - creating a panic in a room is much easier than ensuring that everyone is happy, So it goes with the financial system.
The job market is following a pattern remarkably similar to last year, which is exactly what many are worried about. The change in unadjusted non-farm payrolls from December 2010 through April 2011 was plus 2,000. The change in 2012, pre-revision, is also plus 2,000. Even with a positive revision, it's likely that the percentage change would remain identical (in case you're wondering - in real terms, about 2% of the workforce separate from their positions in January and the vacancies are refilled over the ensuing months. Seasonal adjustments smooth out the volatility). Weekly claims improved, but the drop in actual claims from the first week (reflecting end-of-quarter layoffs) to the final week of the month was almost identical to April 2011. That's a lot of similarity.
Positive revisions were a plus in the April report, with 19,000 added to February and 34,000 to March, though that further undermines the case for QE-3. Some commentators instantly assumed a similar revision was already in the bag for April, and that the consensus of 165,000 would eventually prove to have been right, with some of the difference being warm-weather payback and the rest added later.
Whether or not the revision arrives, the employment market is easing. Additions to non-farm payrolls for the first four months of the year are, in thousands, 279, 259, 154 and 115. It would obviously take a very large revision to raise April past March. The household survey - the one that everyone likes to talk about when it's higher than the payrolls number - actually showed a decline of 169k.
The average workweek has barely moved: 34.5 hours in April, the same as March, down a tenth from February and up only one tenth from April 2011. No pressure there. Average weekly earnings are down from February, and goods production eased to a gain of 14,000 in April, the lowest since November and lower than the year-ago month (39k).
The declining participation rate - the lowest since 1981, on the off chance that you haven't read that scandalous fact already - is a problem. It is partly a reflection of demographics, and partly a reflection of how difficult it is for the longer-term unemployed and the never-yet-employed to get hired. The former group is stagnant, the latter grows naturally, and so the participation rate falls.
Personal income rose a bit more than expected in March but spending a bit less, the latter helping to keep a lid on the market on the last day of the month. That said, growth in real personal income in the first quarter was only 0.4% against 2.5% in Q1 2011, and real disposable income grew only 0.1% versus 0.3%. It's going to be difficult for a consumption-dominated economy to accelerate with such sluggish income growth. The weakness in real income growth is one of the main reasons that the ECRI (Economic Cycle Research Institute) is sticking to its call for a recession within the next six to twelve months.
Productivity fell in the first quarter, leading many to hopefully speculate that employers will be forced to hire, but please take that idea with a grain of salt. The fall had more to do with a slowing of output that was not immediately matched with a cut in labor, and is likely to be a transitory effect. Employers hire because sales are growing, period. It isn't because productivity ratios are falling, or any other excuse made up to advance a theory about how the world ought to work. It's only when employers need the extra inputs.
We don't see the jobs report as pointing to recession; our view for some months has been that the employment market has largely been in low-growth equilibrium. The pulses around the central tendency are meaningful only insofar as they overexcite the markets (though that is hardly new), or make the Fed staff look bad with endless wrong revisions to their outlook. While GDP should plod on, eventually leading hiring to shift a gear up again, it's likely such increases will remain transient.
There are some clouds, though. April same-store sales were on the disappointing side. It's a shade ominous, as the small group remaining that still reports (only 18 companies) is upwardly biased: most chains stop reporting after comparisons become challenging. The combined March-April increase (balancing out Easter) was lower than a year ago (4.5% vs. 6.4%). The weekly reports, though, were completely at odds, so perhaps it'll turn out to have been an average month when the Commerce Department reports next Tuesday.
Last week's non-manufacturing report was a clear miss at 53.5, down from 56 in March and the lowest since October. Be careful with diffusion reports, as the economy could grow nicely for a long time at 53.5; the number was no disaster, despite its bad timing for an anxious market. The part that concerned us most was not the drop in new orders, which aren't that significant in services, but the major drop in prices, a more sensitive indicator of demand. Though the category is volatile, a ten-point fall (63.9 to 53.6) is a rare sight for any category.
The March wholesale sales report was released Wednesday, and it was food for thought. Given the size of the first quarter increase (7.9% in unadjusted terms), our analysis suggests that the second quarter is likely to produce another round, albeit mild, of inventory accumulation. That would be a positive contribution to the quarter's GDP, all to the good. However, if form holds, a second half of flat-to-down sales would follow such an increase - making us worry about that ECRI view.
Contrary to last week, the first three days of this week saw a weak open followed by a reversal. It's tempting to think that we've had our five percent correction (Tuesday's intra-day low equaled a drop of a bit more than five percent from April 2nd), and that the fund managers are being true to their word. That would be nice, but we're not convinced it isn't just traders playing technical bounces.
It isn't clear where fund managers would be getting the extra cash, and won't growth managers - not to mention all the closet indexers out there who bought Apple (AAPL) out of fear of being left behind again - need to have some money for the Facebook (FB) IPO?
The tape action looks to us like the players with serious fun money - the ones who buy index ETFs in increments of $10-$100 million - have been showing up in mid-morning again to bid prices higher, but haven't looked all that committed in the afternoons. The S&P 500 is somewhat oversold on an intermediate basis, but not on a long-term one, and the first peek at the 1340 resistance level produced a quite typical rebound, suggesting a lack of real panic. The tension over Europe is to the point where a piece of fluff could produce a quick snap-back rally, and traders know it.
Yet Cisco's (CSCO) outlook after Wednesday's close certainly lacked oomph and wasn't exactly sunny about Europe and China either, opening the door to fresh worries and an orderly step-down to the 200-day exponential moving average, currently sitting at about 1313. The 150-day average is at 1328. We say watch the news out of China Thursday night, when the country releases monthly data on inflation, retail sales and industrial production. That should tell you whether or not we're about to test the 200-day - and how orderly it might be.
Additional disclosure: Also a put position in Apple (AAPL).