Notions of positive economic surprises are spreading. Along with them go the corollary that if they stop, it won't matter because then the Fed will act and save equities. The irony is that the surprises aren't really happening, much like those that happened (but didn't really) in the first quarter.
Yet the market is trying to trade as if they are real, helped along by the usual insistences that this time is different, that the fear in Europe is overdone and concealing great values, that this time is the same as the bull market during the first four years of the reign of Julius Caesar, and so on. The U.S. economy is spun as doing better than expected because the latest results are beating estimates, even when the same strategist had already lowered them three times this year.
The global economy is weakening, and it is taking a relatively stable U.S. economy with it. Unemployment in the periphery European countries isn't soaring, it has already soared and simply gets worse every quarter. Bit by bit, the weaker governments are dragging the stronger ones down, by transmission methods both direct and indirect. Not only do the struggling countries buy fewer expensive goods from the stronger countries, they also buy fewer goods from the cheap Asian exporters, who in turn buy fewer capital and luxury goods from places like Germany and France.
Governments try to cope with austerity budgets and currencies that are significantly overvalued for the weaker countries, yet undervalued for the stronger ones. Despite the trade advantage that has accrued to countries like Germany, it isn't enough when customers are feeling a pinch start to bite. The currency may have provided a significant boost to the exporting members of the EU, but the offset is eroding. Like many such compensatory factors, it will only be widely appreciated when it has stopped working.
Coming back to the U.S., consider the "positive surprise" retail sales report for July 2012. The Commerce Department reported that sales rose +0.8%, leading the Econoday website to report "major gains sweep the…report," while allowing that the month benefited from an easy comparison. The consensus estimate for the sales gain was 0.3%, so we can put this one right into the plus column for the economic surprise index.
The report didn't line up with the July weekly reports earlier put out by Redbook or the ICSC, which were reporting mostly slowing rates of sales. It must have come as a surprise as well to the management at bellwether retailer Staples (SPLS), which reported negative year-on-year comps for the second quarter. Bad execution by them, perhaps, or losing share to online vendors such as you-know-who?
The truth is that retail sales did not increase in July. Actual retail sales fell by about one percent. The seasonal adjustment factors for June and July have widened the gap this year compared to those two months in 2011; without the widening, there would have been no surprise. Retail sales used to rise from June to July in the first part of the decade, but since 2006 have been falling. As the older years drop out, the weighting of recent years grows stronger, and the decline from June to July looks better. But they're still declining where they used to improve, and GDP and company earnings count real sales dollars, not seasonally adjusted ones.
The revisions in the Fed's Industrial Production report have grown large enough that we're going to refrain from commenting on the current release. However, the New York Fed survey was negative for the first time in nearly two years. New orders in the survey registered a second consecutive month of contraction. If the Philadelphia Fed survey comes in negative again Thursday, we're going to think that maybe Berkshire Hathaway (BRK.B), Warren Buffett's firm, was right to have sold all of its Intel (INTC).
Last week's report on wholesale sales and inventories shows a continuing steady decline in year-on-year growth in wholesale sales for a year now, a pattern that always precedes a recession (though it does not always promise one). In short, business order patterns are deteriorating.
Despite all this, as Doug Kass pointed out, the market is rising in a helium-like way that ignores deteriorating fundamentals. The trading robots take note of the "positive surprises" and bid on stocks anyway, with the lowest volume month in nearly five years making for an easy time to move the tape.
As the 2006-2007 period clearly showed, the markets are capable of rising on weak data for extended periods on the theory that it invites central bank action, the magic elixir that fixes all economic miseries, large or small. We think that the current rally has the market in an extended state that will pull back imminently, even if we take one last stab at 1420 on the S&P 500. That said, be careful about digging in against the market's infatuations, for said pullback might not get much traction and it looks as if the markets will attempt a fall high, so long as Europe can stay out of the obituary pages.
But don't buy into the new positive data surprise notion either, because it isn't happening. As we have written elsewhere, the jobs picture has been fairly steady all year, with the exception of a brief warm-weather stretch in the middle of the first quarter. The conversion of the raw data has led to much excitement, but the unadjusted numbers have shown a remarkably similar pattern of subdued improvement all year long.
Corporate guidance for the second half has mostly translated into consistent downside revision. Europe and China are getting worse, and the U.S. is being gently but steadily pulled down with them.
We may trade the market, but we are keeping the larger part of our portfolios in cash. Keep your eyes on real data and real earnings, and remember the instructions that should come with each trading wave and fad on the Street - it works until it doesn't.