There is a tide in the markets, and it's the global economy. It's weakening, though not plunging, which ironically makes for a more treacherous investment environment. There are quick deaths and slow ones in the market, and the current situation is like the turn of 2007-2008: the economy is slowing, rotted pilings are starting to appear as the tide goes out, yet a mystic belief that the magic waters will return persists. Or in today's case, the black box trading programs will keep buying the same news formulations shown to provide alpha until there is an anomaly.
The riptides spring from the European Union (EU) and the two main central banks. A lot of theories have begun to circulate in the last couple of days as to why the markets are falling in spite of QE. Was it the downward IMF revision? Looming inflation? No, and no. Those both presume a classical market environment, and we aren't living in one. We're living in a trading market, characterized by net outflows from traditional long-term investors such as mutual funds, with trading programs filling the void.
The main drag on the market has been the absence of the riptides, which is to say European rescue stories and the tease of central bank action. The big disappointment on Tuesday wasn't really the IMF forecast, which has often been ignored by the market. It was the lack of an announcement from the EU financial ministers meeting on Monday, or the troika and Angela Merkel on Monday or Tuesday, or some EU minister somewhere leaking a tasty tidbit on what the next great leap forward will be. In that void, the IMF word did take on some extra weight, but it can quickly be forgotten.
Consider that in September, the S&P 500 was up 2.4%. On Thursday, September 6th, European Central Bank (ECB) president Mario Draghi said that the ECB was prepared to buy "unlimited" amounts of sovereign bonds to cap sovereign interest rates (so long as certain conditions were met; no buying has been done to date). On Thursday, September 13th, the Fed announced its latest round of easing, dubbed QE-3 by some, though we prefer the Seeking Alpha usage of "QE-infinity." On the four days of "statement Thursday" and the trading day after, the S&P gained 4.4%. The rest of the month, it was down 2%. It's also down over 2% since the day-after flourish of Friday, September 14th.
Those are the riptides, including any story that hints at closer EU union or a (successful) bailout of Greece, Spain, or whoever else is in the queue. Trading programs buy the story because the disaster-averted scenario has shown to be good for equity prices in the last few years. Admittedly, it has a strong element of auto-correlation, but so long as it makes money, it will keep repeating. One day soon, probably over the next six to nine months, the EU will find itself in a place that more communiqués cannot remedy, and that will be ugly for equities. Then the data will be back-analyzed for warning signs and the programs tweaked, but until then, welcome to the Matrix.
To be sure, there are myriad signs that the tide of the global economy is heading out. The early news and earnings from the industrial sector have been dismal. In what promises to be a model for the third quarter, Alcoa (NYSE:AA) reported earnings Tuesday night that every market-dependent news outlet was quick to summarize as beating on the top and bottom line. You had to dig down a lot further to see that Alcoa's revenue was down 9.1% year-on-year, and that net income was down 86%, the latter before special items that are arguably not so special. Guiding analysts below actual results was the easy part.
Alcoa also lowered its outlook for next year. Cummins Engine (NYSE:CMI) lowered its outlook for this year. These are early indicators for earnings season. We were surprised to hear Jim Cramer say that results at Costco (NASDAQ:COST) and Wal-Mart (NYSE:WMT) are reflections of the strength of the Fed's new QE program and the confident consumer. I see it as pricing pressure driving more consumers to the big-box megamarts, where they can buy cheaper gas (both Wal-Mart and Costco sell gasoline, though not at all locations) and then stock up on the trip to justify the extra drive. Wal-Mart claims it has a 17% pricing advantage over local grocery stores, where the consumer would be if he or she felt flush, rather than make long hauls to Costco or Wal-Mart. The Fed's Beige Book noted that retail sales were "flat to slightly up," hardly a barn-burner in the Fed's lexicon.
Business investment is declining, a point I have made several times in recent months. David Rosenberg looked at the three-month moving average of the business investment category, new orders of non-defense capital goods excluding aircraft, and found it in decline, which he calls a sure sign of impending recession. The market got a brief lift Wednesday morning from news that August wholesale sales had lifted after three months of decline and the inventory-to-sales ratio had fallen back to 1.2, but that was misleading. The year-over-year change for August sales (not seasonally adjusted) was a mere 1.76%, which is about the rate of inflation. Bearing out Rosenberg's point, the year-over-year change for the last three months of reported wholesale sales is the lowest since the fourth quarter of 2009 (there is a silver lining, in that by the first quarter of 2013 if not sooner, we should start to see pressure to restock).
Spain's credit rating was cut to BBB- by S&P, with a negative outlook. That's one step above junk. Not that it should be news to anyone, but S&P noted that "rising unemployment and spending constraints are likely to intensify social discontent," and cited "doubts over some eurozone governments' commitment to mutualizing the costs of Spain's bank recapitalization." The OECD leading indicator composite for the EU fell to its lowest level in three years, while its total composite fell to its lowest level in a year. Not to worry, all Spain has to do is agree to more budget cuts and tax increases. Then a bailout can be announced and Spanish stocks will soar again - though not for as long as the last time.
A piece in Business Insider (it's worth looking at just for the charts) demonstrated that the market is between 33% and 51% overvalued, based upon several metrics including the Q ratio and cyclical (trailing 10-year) PE. These metrics aren't useful as timing indicators, but they are an indication of the direction that gravity is pulling in.
The QQQ has broken down past its 50-day exponential moving average, and the S&P is just above its own at 1425 (futures are trading just above it). Yet for all that, markets aren't likely to tank quite yet, not without some bad news from Europe. To begin with, markets are a bit oversold, with the S&P relative strength indicator at its lowest level since June. The classic pattern is for it to test the 50-day first with a one- or two-day drop below the line before rebounding; it rarely slices through without looking back. We could see another down day if claims look bad (there isn't any real reason to suppose that they will be) or if trade numbers fall off a cliff Thursday morning.
Friday, however, both Wells Fargo (NYSE:WFC) and JP Morgan (NYSE:JPM) report earnings, and the conference calls for both should be on the positive side. The following week starts off with retail sales on Monday. It's a tough one to call, so I won't, but I don't expect a disaster either. Citigroup (NYSE:C) reports the same morning, with the same tailwinds and a lower bar of expectations. Many more financials report next week, which could help support the market. We just need IBM (NYSE:IBM) and Google (NASDAQ:GOOG) to stay out of trouble. That, or any positive-sounding bailout.
If we are to get into a 5%-10% correction, it's more likely to come from the cumulative weight of earnings, which tends to happen towards the back half of the reporting season. Then the tidal pull of earnings will be at its peak. It's important to note also that one source of riptides has been taken out of the picture - with both central banks having gone all in and shown their hands, a big enticement to put more money in the pot has been eliminated. The way to a 5%-10% pullback has gotten a little easier.
Additional disclosure: I have an options spread position in Google.