Are You Ready For The Market's Test Of Nerves?

Includes: EEM, IWM, QQQ, SPY, VGK
by: Kevin Flynn, CFA

Last week I wrote that the markets were set for a third week of gains, and after some near-heroic late Friday trading, they managed to rise a second week. Equities then came out of the gate fast Monday morning, poised to finally stage the breakout above the 1420 level that had eluded it the previous three days when the ISM Manufacturing survey hit at 10 AM with a surprise disappointment reading of 49.5.

Not only did this fly under the consensus estimate of 51.7, it also flew in the face of the Markit Economics PMI of 52.8 that had been released only 90 minutes earlier. The relatively new Markit number has been tracking closer to the traditional ISM number, and its final reading was not only a small improvement over its initial flash estimate of 52.4, it fanned hopes for an ISM that might be above consensus as well. The disappointment was keen.

The Markit explanation for the divergences focused broadly on two issues, one being that the two surveys are nevertheless moving closely in tandem when using rolling three-month periods, and the other the use of differing sample weights and survey size. Markit says that its survey panel is nearly double the size of the ISM, and claims its weights lead to better correlation with official production data. Another guess I might hazard is that the ISM survey tends to focus on large firms, which are more export-sensitive (exports have been contracting for six months in a row), though I don't know the size breakdown of the Markit survey.

A leading characteristic of recent economic data is that they never seem to be as bad or as good as the headline numbers suggest. That wasn't the case with ISM manufacturing, though. As close as 49.5 is to neutral, it wasn't better than it looked. Six industries reported growth, compared to eleven in contraction. Seven industries reported growth in new orders, nine contraction.

Yet there were silver linings in the data. One report I saw repeated many times in the media, usually couched in ominous tones, was that respondents weren't blaming Hurricane Sandy. That is so, with only one industry (primary metals) referencing the storm. The theme that did come through was caution induced by the fiscal cliff.

Combined with a decent result Wednesday for October factory orders, which included an upward revision to durable goods, the manufacturing picture is one not of slipping into classic demand or inventory recession, but of a watch-and-wait pause as we get to the late innings of the cliff chicken match. In fact, the low ISM inventory reading suggests that any resolution is going to kick-start production.

The ISM non-manufacturing survey result of 54.7 beat estimates and came as a welcome relief on Wednesday. The business activity/production index rose sharply from 55.4 to 61.2, the highest reading for November since the decade-high reading of 62.8 eight years ago in November 2004.

The ADP payrolls number was a mixed picture. The result of 118K was below the consensus estimate of 125K, but well above my own fears of a Sandy-induced drop to below 100K. In addition, economist

Mark Zandi did some work

with ADP and estimated that Sandy had lowered the total by about 86K, which implies a woulda-been number of 204K. Granted that employment is a lagging indicator, it would still make for a decent number.

The consensus through Wednesday for the BLS November jobs number on Friday is 80K, which seems to leave hope for an upside surprise of over 100K. I worry about the effect of Sandy jobless claims peaking during the BLS measurement period, but should we get a number over 100K, it would allow the week to close out on a high note.

The data Wednesday morning was market-friendly, starting with some hopeful overnight nuggets from China. The reports might have been enough for the S&P 500 to challenge 1420 again but for the California-based fruit company located in Cupertino, California.

Apple (NASDAQ:AAPL) took a terrific shellacking on Tuesday for no apparent reasons other than margin requirements had been tightened after the stock had failed to break out to 600 on Monday, and perhaps most of all that a great deal of Apple stock is in weak hands right now. Google (NASDAQ:GOOG) went through this problem in 2006-2007 when it was the high-priced darling stock of its day. The implication is that Apple could have several more quarters of gut-churning volatility ahead of it before fast-money wannabes have lost enough money that they give up on trading it for good.

The economy is making slow progress, as even short-seller Jim Chanos allowed. There are still obstacles to confront, clearly, with the lack of income growth being a particular structural difficulty, but the rough annual average of 2% GDP growth seems to still be intact.

A couple of hopeful developments Wednesday included the market starting to ignore the dueling press-conference shtick of going on air to say that the other side is hopeless and standing directly in the way of America's path to truth, justice, and the American dream. There was even news on hopeful developments in Republican flexibility.

However, two ominous stretches of turbulent air lie ahead for equities in the coming week (depending on the jobs report, the stretch could begin Friday or next week) that will test your nerves. The first bout should come, not surprisingly, from the cliff process.

The dark side of the markets getting inured to dueling press conferences is that it incites the noisier members of both sides to try something louder and more dramatic. This week's default position is that the other side hasn't made a realistic proposal yet. Next week's essential book may be that the other side is led by heroin-addicted slave traders in the pay of North Korea.

Ever since the election, I have thought that the calendar favored a peak of hostility next week, when both sides would seek their last chance to ham it up for the cheap seats before having to sit down and do something serious. If the market exits this week thinking that some movement towards compromise is underway, a return to melodrama next week could lead to sharp disappointment.

That would dovetail with another familiar trading phenomenon, the bout of flu that the equity markets seem to catch around the second week of nearly every December. It's rarely fatal, clearly, or December wouldn't be the second-best month of the year for equities. It can however be difficult to keep one's Zen perspective when the market slips into a funk and loses a quick three or four percent in the matter of a few days, especially when the business organs start to warn that the end of all days is yet again at hand. I suppose we should all expect Peter Schiff to be back on CNBC within the next week or so.

I do confess to having some sympathy for the plight of both sides in the cliff debate. What many fail to appreciate is that redistricting (gerrymandering) since the last census has left many Republican representatives in districts that are largely Democrat-proof (the Democrats have been just as guilty in the past of this sin). Any political threat to their re-election is more likely to come from some fire-breathing hard-core type accusing them of being tax-raisers and traitors in the employ of the Democratic National Committee. National and state results don't matter to these reps, at least not insofar as getting re-elected.

For that reason, many of them may see their best strategy as allowing the taxes part of the cliff to expire. That way they can later claim victory with a vote that lowers the temporarily raised rates that they can blame on Obama. On the Democratic side, many are chiding President Obama for not sitting down more with Speaker Boehner, forgetting that the President was regarded as a loser - by the very same people - for pursuing exactly that strategy during last summer's crisis. Other Democrat leaders, flush with election victory, are advocating going over the cliff to put those nasty GOP reps in their place and reclaim the high ground.

No doubt it is frustrating to score up a largely positive election result and find the other side not being your humble servant, but it usually doesn't work that way. I would also caution our earnest technocrats to keep in mind that the strategy of sitting back and letting the rotten structure fall was tried without success in September 2008, when it was applied to a struggling investment bank named Lehman Brothers.

For all that, the impending weakness doesn't rate to last. If there are pullbacks in the SPY, IWM, VGK, or EEM next week, I would buy them - in careful increments - on the grounds that the second half of the month usually finishes well. The QQQ is riskier due to the Apple volatility, but clearly that could work to your advantage as well.

If an extension is reached before year-end, equities could finish very well. Since there isn't certainty about any deal package at all happening, though, I would look to keep some hedges on hand until such day as some deal is struck, particularly if the market makes a run to 1450 before anything is in hand.

Disclosure: I am long SPY, EEM, IWM, 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: I have a call position in Apple and my SPY and IWM positions are hedged.

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