A Mighty Wind In The Markets

Includes: EWP, QQQ, SPY, VGK
by: Kevin Flynn, CFA

With a four-day rally underway in the market, a mighty wind has seized the media and punditry, especially the televised variety. The IMF-inspired gloom of last week has been forgotten, and we are being told that solid earnings and a booming housing recovery are driving the market higher and saving the US economy. All of this has transpired since last week, no less, when small-business optimism was down, the IMF lowered its forecast and imports and exports reported a decline. Those homebuilders sure work fast.

To borrow a metaphor from last week's column in Seeking Alpha, the tide is still going in the same direction. The difference between the two weeks is that last week we didn't get the European riptide, and this week we did. The market is riding the news of a Spanish bailout that sent futures soaring in Tuesday's pre-market and the IBEX Spanish market index up 6% in two days. It was what the market lacked last week to get the trading robots and HFT traders pulling in the same direction, and this week we got it.

What's more, you can expect this fever to continue a little longer. Thursday and Friday bring two days of EU summitry, and one thing that is reasonably certain to happen is an optimistic, economy-reviving communiqué on the "Single Supervisory Mechanism," or central banking supervisory agency for the EU. Not only will the report of a new agency further invigorate the stock market - the same place where the typical trader would tell you with veins bulging out of forehead that government agencies can't create jobs - but the notion of an EU banking supervisor should by itself suffice to revive profits around the globe. Sorry, no questions at this time.

Spain is due to hold regional elections next week, and Prime Minister Rajoy promised there would be no bailout. However, the country needs one, the markets want one, and even Italy wants Spain to get one. You can see the conundrum. The solution is a kind of "bizarro world" dance where Spain can informally do a few bailout-like steps without making formal application, and in turn, there will be no cash prize awarded, but a credit line made available instead, called the ECCL ("Enhanced Conditions Credit Line"). It's as if the Eurovision song contest is going to consist of lip-synching, with the contestants competing for lyric sheets.

It gets better. The German-led faction doesn't even want to pay for the lyric sheets. So the compromise, inspired by the dream that the mere threat of ECB bond-buying could be a perpetual panacea for sovereign interest rates, will be that the Spanish credit line won't be funded by the fund that was supposed to fund it, the European Stability Mechanism (ESM). It seems that Germany's chancellor Merkel needs to lip-synch that part as well, in order to get it past the tone-deaf German parliament.

So the latest EU brainstorm is that the ESM will put up a token amount only, with the rest of the credit line funded on an as-needed basis by the European Central Bank (ECB), which will somehow do what it said it couldn't legally do for Greece. Spain won't make a formal application, but sign a deliberately vague Memorandum of Understanding (MOU) instead. The MOU will promise good behavior, fiscal rectitude, use movable targets as goals and for good measure throw in two extra penalty kicks to Germany in the next European Cup.

Cheeky perhaps, but not as fantastic as this whole charade of Spain pretending not to ask, the EU pretending not to pay and Chancellor Merkel pretending not to look. It's a bit reminiscent of the "Super-SIV," that wonderful chimera from 2008. SIVs, you may recall, or Structured Investment Vehicles, were off-balance sheet ways for banks to get into huge trouble by borrowing short and doing leveraged lending long (their one redeeming feature was that "Structured" was later able to be modified to "Stupid" without changing the acronym).

The Super-SIV was going to work on the good-bank, bad-bank principle by vacuuming up all the bad SIVs from all the bad banks and put them into one bad entity for good investors. The problem was that neither the government nor anyone else was willing to back the Super-SIV, and none of the banks involved wanted to disclose how far the market value of their paper was from the accounting value. That is very much the situation today with Europe and all of the Spanish property-bubble debt owned throughout the EU, including in no small measure by German banks. No backers, no disclosers.

Cheeky I may have been and skeptical most certainly, yet I do not doubt for a moment that the markets will lap it all up, at least for a time. Not everyone will, of course; many hedge funds will try instead to figure out ways to bet on the eventual demise. But you can bank on the notion that the first reaction will be for prices to rally, and that will convince at least half the crowd that it must be working.

As for the miraculous powers of the "Single Supervisory Mechanism," the magic central regulatory body that will fix all of the EU's problems, I would point out that the relationship of regulations to the financial system is that of vaccines to disease. Their purpose is to prevent sickness; they do not cure it. The U.S. passed a vast body of regulatory legislation in the wake of the stock market crash of 1929 and the Great Depression. The new rules cleaned up the industry and prevented another bubble for sixty years, but did nothing at all to palliate the Depression itself.

Then there is the economy. Despite the enthusiasm bursting from media talking heads that really ought to know better by now, or business journalists still being taken for dupes by the industry (I will not name names to protect the guilty), the economic data is not much better this week, and earnings are anything but solid.

Shall we talk about retail sales? The year-on-year change in actual September sales - not seasonally adjusted numbers, but real - fell to 3.0% in September. That is the lowest increase since August of 2010; the 20-year average for September is 4.5%. If year-on-year inflation is 2.0%, as the latest CPI data showed, and retail sales (which are reported in nominal terms) rose 3.0%, that suggests real annual growth of 1%. GDP shouldn't be far off, not with exports falling and business investment slowing.

Hold on though, the consumer is "brightening," says the Wall Street Journal, apparently going by last week's Michigan sentiment survey and the housing starts data. Is 1% annual real growth brightening? And why are retailers talking down Christmas already?

The same article also noted that business sentiment is less optimistic, and that much is true. The New York Fed survey came up with another dismal contractionary reading. September industrial production, with an increase of 0.4%, was reported to have bested estimates of 0.2%, but that was a mirage. The extra two tenths was all due to August being revised downwards by the same amount. The report actually showed a weak rebound from Hurricane Isaac, and even the normally ebullient Econoday admitted that "manufacturing is now sluggish and not providing the engine of growth as earlier in the recovery."

Well then, it must be housing, right? Wrong. Housing has turned a corner, yes. It is a long way off from being a boom. New home construction is less than 1% of GDP. The new and exciting level of new home starts is still at the level of the early 1960s - and not one of the good years, either. That's an improvement from the 1940s level of last year, but it's not going to send the economy soaring.

There's a reason why homebuilder sentiment inched down last month, instead of inching up. Real permits (not seasonally adjusted) were down by 10%, not the seasonally adjusted +15% reported. It may have been a good number for September, but homebuilders have to pay their bills in real dollars, not seasonally adjusted ones. What's more, September benefited from two rather large tailwinds: Above-average temperatures (again), and the FOMC decision that immediately drove down mortgage rates.

The rate plunge spiked a wave of refinancing that is already easing. The spike in starts may very well suffer the same fate, for two reasons. One is that winter is coming, and the other is that while there is no doubting pent-up demand for housing, the pool of buyers eligible under the current stringent lending criteria is not as large as it would like to be. The numbers were good, yes, but you should be wary of the market's tendency to extrapolate any number it likes into the infinite horizon. The number of actual single family starts has been in a tight range of 49,400-54.400 for the last five months, and September's figure of 52,500 lies easily within that range. Given the weather and FOMC, it should have come as no surprise at all.

As for those "solid" earnings, both IBM and Intel (NASDAQ:INTC) reported 5% year-on-year revenue declines and lowered forward guidance. JP Morgan's (NYSE:JPM) revenue was down 1.5% year-on-year and Bank of America (NYSE:BAC) down 5%, while Citigroup (NYSE:C) was up 2.7%. At least Wells Fargo (NYSE:WFC) was up 8%. The key is that IBM and Intel getting crushed are not signals to get excited about the rest of the earnings season.

There will be some earnings winners, certainly, and prices will be more sensitive to Europe for another week or so anyway. I'm sticking to my call for a new top in October, and am holding onto my SPY, EWP and VGK, though with very little conviction (watch out for options expiration on Friday). The weight of weak earnings and negative sales growth is still going to take a toll, and a correction should begin to set in by the end of the month. However, the dimensions of it will depend on the political winds, not the economic ones. My crystal ball stops there.

Disclosure: I am long SPY, EWP, VGK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Also relevant for QQQ.

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