The waters are muddy now, as spring has returned to the environs of Wall Street. The correction that began May 2nd has now stretched to 5.6%. That's about the level where many managers avowed last quarter that they would eagerly step in to buy. Perhaps they bought during the middle of the day yesterday - the market again closed near its lows.
Short-term, the market is oversold. Rebound attempts last week seemed to signal that equities were already steeled to a slowing Asia, recession in Europe, and a possibly inevitable Greek exit. In these types of situations, the usual playbook is to look for any whiff of something contrary that might launch a short squeeze, and maybe put a little bravado back into the souls of those who swore that they would buy the next dip.
Despite the attempts to play the rebound, though, there were some unsettling developments during the week that appeared to weaken the ground underneath. One was a lot of names - obviously including Cisco (NASDAQ:CSCO) and JP Morgan Chase (NYSE:JPM) - getting a double-digit haircut. When reactions to the downside are violent and positive surprises produce little effect, it's a sure sign of a market getting hollowed out.
Market sentiment is a tricky thing anytime, and never more so during trading markets like the one we've been living through the last year and a half. One of the more reliable dynamics of any market is that the unanimously believed trade almost never works. Coming into the spring, it seemed to us that the fears of a "three-peat", or a third consecutive summer swoon, had become so widespread as to render it unlikely. Indeed, the big counter-attack that flattens the widespread prediction of doom is perhaps the Street's favorite trading rally.
Yet a funny thing happened on the way. A disturbingly confident swell of opinion rose up over the last month that any sizable sell-off had therefore been definitively ruled out. To our way of thinking, that brought the possibility of a decline back into play, since disappointed expectations are usually the strongest driver of any sell-off.
The JP Morgan news caught markets by surprise, certainly, taking some luster off banking stocks and further weakening a financial sector that has faded after rallying strongly in the first quarter. Can anyone really know what the behemoths are up to, it was asked, when JP's 10-Q (quarterly financial filing) is 150 pages long?
We don't want to repeat what's already been widely said. An overlooked dynamic, so far as we can tell, is that whether or not the original news accounts came as a surprise to CEO Jamie Dimon, they were probably a key catalyst in wrecking the bank's position. It's tricky enough to have a large position at any time in trading; when the whole world knows about it, it isn't good for the ones holding the bag, especially when the market wasn't that liquid in the first place. Obviously it's the bank's fault for allowing its position to get to the size it did, but the losses may have really only started to mark down when it pulled back and belatedly realized that the rest of the market was now waiting with sharpened knives.
Chase may get out of it yet - we think it likely that between Asia, Europe, and the fiscal cliff, something is likely to come up to test credit market nerves. It's nevertheless another example of systemic flaw inherent in the giant universal bank model that we have disliked since the nineteen-eighties. It didn't work then, hasn't worked since and never will. As cold-blooded financial analysts, our belief is that the cultures of investment banking and commercial banking are intrinsically different enough that if they are both working well, they cannot work well together. If by chance they do briefly work well together, then one of them is bound to be working poorly.
The shareholders don't benefit, the customers don't benefit, and it's pretty clear by now that the financial system doesn't benefit either. A few top managers get outsized bonuses for a limited time, perhaps some magazine covers and coveted social posts to additionally buff a few outsized egos, yet the rest of us are always left with cleaning up the inevitable mess. There is no good reason to keep allowing elephants into the china shop on the grounds that someday they will be ballerinas. They will still be elephants, the china will still be china, and it's folly to believe that whispering soothing words about free-market magic into elephant ears is going to mean that this time is different.
Another problem that emerged Friday was the news from China. Despite the rather mild immediate market reaction, it made for disturbing weekend reading. Retail sales and industrial production data were both sizable misses, with the latter nearly unchanged on the month, and notching the weakest yearly growth rate in three years.
We thought that weak numbers would help the S&P 500 descend to its 200-day average; we are headed there. The latest European ideas are not working, whether it's the Spanish bank plan, any Greek government, the German austerity program or the EU's endless economic projections of around-the-corner upturns that never materialize.
Yet the weekend business press was filled with talk of bargain hunting in the old continent. Bottoms aren't accompanied by cheerful talk of bargains to be had, but by dreadful tales of nowhere to go.
Still, the VIX volatility index is back at levels (22-23) from which the market has reliably rallied since the beginning of the year. Unfortunately we're in May now, and the trading robots may not be so anxious to step in here. Strategists are suggesting big cutbacks to equities, which many take as contrarian support. Traders are fleeing to Treasuries: the iShares long-bond ETF, the TLT, closed over 122. It has traded above 122 for more than a day at a time only once, and that was for two days in the post-crash fourth quarter of 2008. Some kind of relief, even if only temporary, seems inevitable.
But that relief will be short-lived if events overseas swamp those in the U.S. The lowering of reserve rates in China doesn't seem to be having any impact on lending: the country already has an overabundance of unoccupied property developments, and its European customer base is in pretty rough shape (a fact duly noted in the country's export report).
India also reported an unexpected decline in production, and the news out of the subcontinent has been running much weaker of late. It isn't immediate bad news for American company profits, but if the biggest components of developing Asia are slowing rapidly, it's going to create some challenges. Part of their problem, of course, is that their export-based economies have to deal with struggling customers.
Some of the news here in the U.S. isn't so bad. The New York Fed survey produced a decent reading, though price pressure was noticeably absent. The industrial production report for April reported a surprising 1.1% increase, led by increases in utility output and autos. Yet the revisions to February and March were so large (last month both were estimated at 0.0, this month recalculated to be +0.4 and -0.6) that it seems best not to get carried away with the news.
But while manufacturing looks like it's doing reasonably well, the rest is a mixed bag. The April retail sales estimate of 0.1% seems to confirm the same pattern for consumer spending that we've had since the crash: we'll spend for special occasions, but not much else (Redbook is currently forecasting a May decline). Housing starts improved, but permits fell off again. The recent easing in still-elevated gasoline prices will last only as long as the weakness in stock prices does.
Now, the recent increase in the consumer sentiment index to 77.8, that's something to worry about. Traders seem to love this kind of stuff, but the reality is that you could do a lot worse than follow a simple strategy of selling high readings and buying low ones. By contrast, Bloomberg's weekly consumer index slipped into recession territory, echoing the drop in the AAII investor group survey, which is itself notoriously contrarian. Investing is so easy, isn't it?
Expect rumors about Europe - some of them probably planted - to fly in the next few days, along with some vicious moves to go with them. For omens, consider that newly-elected French President Francois Hollande's maiden flight to visit German Chancellor Angela Merkel on Tuesday was forced to return when it was hit by lightning. The second flight was greeted by pouring rain. It feels like a long wait until June 20th and the FOMC's next statement.
Disclosure: I am long CSCO.