Look For Equities To Rally Into Next Week

Includes: DIA, IVV, QQQ, SPY
by: Kevin Flynn, CFA

We got our rebound and sell-off last week; now it's time for another rinse and repeat. If that sounds like the European crisis, it's not that much of a coincidence.

The near-term direction of the market is typically made up of momentum; reigning directional perceptions and the comparison of real data versus the perceptions; and how far the market may be tilted towards one side.

Looking at economic events, the recent data has not been terribly encouraging. The global slowdown is widely built into investor perceptions, and there has been little to move them off that stance. Purchasing-manager data from the eurozone and Germany were worse than already-dreary estimates, and the latest earnings results from US companies such as Apple (NASDAQ:AAPL), Ford (NYSE:F), Caterpillar (NYSE:CAT) and UPS presented a consistent pattern of lowered guidance from management that centered on Europe and its effect on global trade. "Global headwinds" may be the phrase of the week.

The most recent domestic data has been mixed, allowing the major indices to stay within their trading range. All the companies referenced above, for example, reported respectable domestic results. The Chicago Fed's national activity index improved somewhat, though it is still negative, and the new Markit "flash" manufacturing PMI showed a manufacturing sector still hanging in there as slightly expansionary. Boeing (NYSE:BA) reported encouraging earnings and revenue.

Against that, the Richmond Fed business survey showed a sharp deceleration in activity, and home sales were softer than expected in both the existing and new home categories. The extraordinary tightness of credit continues to hang over the sector, and the headlines seem to be putting some additional caution into the buying public - mortgage purchase applications have been shrinking in recent weeks.

Despite this, non-economic events are going to favor stock prices in the short term. The equity market is in an oversold condition, the Treasury market in an overbought condition, and sentiment indicators are at levels that suggest imminent reversal. The end of the month approaches, and efforts to move back up to the top of the trading range could get start getting underway as early as today (Thursday). The Fed's FOMC policy statement is due next Wednesday August 1st, and sentiment is again shifting towards hope for additional accommodation. Even if the latter doesn't arrive, traders will look to play the lead-in rally. Any weakness in Thursday's jobless claims or durable goods reports will only fuel such hopes.

The most volatile hurdle to cross between now and the Fed meeting next week is Friday's release of the first estimate for second-quarter GDP. The estimate range seems particularly wide, ranging from 0.0% to 2.4%. The consensus appears to have fallen to about 1.2% (annualized) from 1.5% only a week ago. UPS CEO Scott Davis projected a second-half growth rate for GDP of just 1.0% during the company's earnings presentation on Wednesday.

Clearly, the bar has been set low. The headline number that the market will focus on is "real" GDP, or GDP adjusted for inflation. That calculation depends on the quarterly GDP price deflator, which periodically produces surprisingly low results (the deflator is a subtraction in the calculation).

Such results have usually come in the fourth quarter of recent years, but the second quarter of 2009 did produce a negative number. The price indices for personal consumption expenditures (PCE), which are also calculated by the Bureau of Economic Analysis (BEA), the agency responsible for the GDP estimate, have been falling for several months, leading to a consensus estimate of 1.6% for the second-quarter GDP deflator that closely matches the BEA's most recent PCE data.

However, the price of oil fell nearly 20% in the second quarter, and could be a major swing factor in the GDP deflator estimate. The PCE deflators do not always correlate with the GDP deflator - in the fourth quarter of 2011, for example, the average PCE price index was about 2.6% (annualized), but the reported GDP deflator was only 0.8%.

This leads us to infer a higher-than-usual chance for a surprise in Friday's initial estimate. The numbers most likely to produce a rally are either a low number of 1.0% or less - thus "guaranteeing" Fed action in trader eyes - or a high, positive surprise number close to 2.0% that indicates the economy is doing better than expected. Numbers in between are more difficult to handicap, with our thinking being that an intermediate number is likely to create an initial swing that could easily reverse.

The flip side is that a market rally is likely to produce the opposite of what traders want. Should the indices move back up near the top of the trading range, it will make a much better case for the Fed to wait, especially on political grounds, until September before making its next call. However, that potential disappointment is a problem for August, and until then the prices will be set by short-term tactical trading. Money managers will be very reluctant to go against the possibility of another month-end melt-up and be left behind in the performance derbies - they will not fade the rally.

The dynamic does leave the door wide open for another August fade, similar to last year. As we said, though, that is a problem to worry about later. If 2012 continues to imitate 2011's price action through next month and produce a significant drop, take consolation in the thought that at least it would create more pressure on central banks to act - and here we are really thinking of the European Central Bank - and most of all, on politicians both here and across the Atlantic. We fear that only sustained ugliness will be able to get them off the sidelines.

Disclosure: I am long F.

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