Recovery Persists, Indifferent To Federal Follies

Includes: SPY
by: Jim Kelleher

The stock market continued to push to new highs as stocks entered the final full trading week of October. After the uncertainty in the month's first half, investors are engaging in what might at first seem to be a relief rally. But it could equally be a calendar rally.

We are seeing an uncommonly broad advance in the wake of the budget and debt-ceiling settlement. In 4Q13 to date, amid 4% appreciation in the S&P 500, no sector is negative. The sector advance is tightly bunched, from the lowest (Consumer Discretionary, a surprising laggard with a 3.1% gain) to the highest (Telecom Services, a surprising leader with a 5.6% gain).

Market bulls have two things going for them: seasonal strength, and the dwindling time to year-end. The fourth quarter is historically the best time to be in stocks. Since 1980, the S&P 500 has averaged capital appreciation of 4.1% in 4Q, which is the best performance of any quarter.

The market's proclivity to go up most years, despite bearish growling, is why momentum generally builds into year end. The market, as we know, is not made by blog-posters ranting about O'Bumbler or the Rob-publicans. It is made by private wealth managers and institutional investors cognizant that if they deeply lag their competition, their jobs are at stake. Thus, the closer we get to the end of any rally year, the more the hard-core bears must capitulate and chase the rally, or risk presenting their clients with even worse returns as a result of being out of or betting against the market.

The accelerating pattern of monthly appreciation across the final quarter makes this crystal clear. Since 1980, capital appreciation on the S&P 500 has averaged 1.21% in October, 1.60% in November and 1.93% in December. While there have been 11 down Novembers vs. 22 up Novembers since 1980, there have been just seven down Decembers vs. 25 up Decembers in that span.

The only thing the market has to fear, seemingly, is the sense of its own invincibility. That, in our view, is the biggest cause for concern.

Data Still Positive

The fourth quarter began amid partisan intransigence in Washington. Companies and individuals with direct ties to the federal government's cash flow endured two weeks of missing paychecks, most of which will be recouped, and lost cash flow, which may never materialize. But the broad economy showed it could get along quite well without Washington.

As October began, hard data from the government became scarce, and market-watchers turned to the various sentiment and diffusion indexes. Most showed a downturn from recent highs, on the presentiment that the politicians would once again walk the economy right up to the brink.

We surveyed economic reports, both government and non-government, from the final weeks of September, as well as the more limited data set available since the government shutdown. For the latter period, we were necessarily more reliant on data from non-government entities. This limited data set does show some signs of tempered activity and weaker demand. Some of the data reflects a slow seasonal recovery at end-of-summer. But some data points - sentiment most notably - are experiencing direct impacts from the fiscal follies in our nation's capital.

Walking back from the most recent data, it is little surprise that the Empire State Index fell to 1.5, a five-month low, in October from 6.3 in September. Although the index measures manufacturing activity in New York State, it also draws on sentiment from Northern New Jersey and Southeastern Connecticut - areas with a heavy reliance on the salaries of Wall Street's commuters. As the dwindling days brought markets ever closer to the unthinkable brink of federal default, concerns in the bond market worsened to the first hints of panic. In a related report, the New York ISM reading dropped to 53.6 in September from 60.5 in August.

But there were positive signs even within the broadly negative Empire State index reading. The measure of new orders increased to 7.8 in October, up from 2.4 in September and representing the highest reading in seven months. As they did in July 2011 and again in December 2012, the folks who drive the economy - the manufacturers, truckers, warehouse operators and service providers - have had to move to the sidelines while political battles risked stalling the economy. On the assumption that a budget accord will be reached and the debt ceiling raised, the six-month outlook from New York area manufacturers was a highly positive 40.8 - the best reading since April 2012.

The toll of the budget and debt-ceiling impasse is being felt most directly in consumer sentiment and confidence. In October, consumer sentiment as measured by the Thomson Reuters/University of Michigan index fell to 75.3, a nine-month low and a decline from September's 77.5. Once again, however, data points beneath the headline number were encouraging. The U. Michigan's Current Conditions gauge, which measures consumers' view of their personal financial situation, rose to 92.8 in October from 92.6 in September. Personal finances country-wide are benefiting from the jobs recovery, the rise in home values, and the rise in financial asset values.

The National Federation of Independent Business (NFIB) Optimism Index, regarded as the best reading on what small businesses are thinking, declined to 93.9 in September from 94.1 in October. The three-month low in the index reversed a portion of the gains won across the first half of 2013. Despite a few silver linings - sales are expected to increase, according to NFIB survey participants - few business owners expect conditions to increase over the next six months. For these pragmatic entrepreneurs, living with Washington dysfunction is just part of the job.

In the absence of the monthly nonfarm payrolls report (subsequently reported at a below-consensus 148K for September), the weekly unemployment claims number has taken on added significance. Claims ballooned by 66,000 to 374,000, for the week ended October 5. A California computer glitch contributed half the gain, but the other half likely came from federal workers starting the process in case the shutdown extends past the hoped-for end date of mid-October.

The National ISM-Services survey, which covers much more of the economy than ISM-Manufacturing, fell to a three-month low of 54.4 in September, from 58.6 in August. Despite the decline, this reading is sitting right about at its 54.7 average for 2012 and the 2013 year to date.

In contrast to the cautious reports from NFIB and ISM-Services, reports from the consumer economy show continued high levels of activity. But there is tempering in consumer activity as well. New vehicle sales slowed slightly as expected in September, while remaining at high levels. The seasonally adjusted annual rate (SAAR) was 15.28 million vehicles in September, down from the 16.09 million SAAR in August. Actual September unit sales of 1.14 million vehicles declined year over year, for the first annual decline in two years.

Ford (NYSE:F) surpassed Toyota (NYSE:TM) in actual September domestic vehicle sales and almost caught GM (NYSE:GM). Both Ford and GM have more domestic content in their vehicles than Toyota, in what we regard as a positive for the domestic parts-supplier community and thus jobs and economic activity.

The look-back at the end of September is interesting, because even at that late date there was optimism that Washington would get its act together. Regional Fed reports from Chicago and Milwaukee were rising, consumer spending was on the rise, and new home sales activity was on the upswing even amid rising mortgage rates.

The two sides in Washington usually see the world and the country in starkly different ways. Both sides agree, nonetheless, that the Federal government needs to be solvent and not spend so much more than it takes in. In that regard, both sides are getting some degree of what they want. The budget deficit just ended fiscal 2013 is not yet fully calculated - another casualty of the government shutdown. But the deficit was about $750 billion with one month remaining in fiscal 2013, compared with a deficit of $1.164 trillion at the comparable time in fiscal 2012.


Despite the subtraction of this $400 billion in government "stimulus" in FY13 compared with FY12, the economic recovery meanders on. The economy is not roaring ahead. But neither is it stalling, whether Washington is working or not working - and at this juncture, it is hard to tell which is worse.

(Jim Kelleher, CFA, Director of Research)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.