Hard Patch Coming?

Includes: DIA, IWM, QQQ, SPY
by: Denis Ouellet, CFA

I have been worrying about a soft patch since early December as auto and chain store sales seemed to be stalling and unsold inventories were mounting fast throughout the system right in the middle of the all-important selling season. Comments from various retailers, combined with significant widespread promotional activity, led to expectations of a very slow retail environment throughout the holidays.

The strong official retail sales numbers, as originally reported, were very puzzling. Fast rising online sales could have explained the apparent gap but when Amazon released disappointing growth for Christmas, downward revisions to the retail sales numbers became likely. This happened last week.

The January Advance Retail Sales Report shows that sales came in at -0.4% MoM, down from -0.1% in December, itself downwardly revised from +0.2%. Core Retail Sales (which excludes Autos) were unchanged at 0.0% MoM, down from 0.3% in December, also downwardly revised from +0.7%.

"Non-Auto Discretionary Sales" (core less food and gasoline) declined 0.3% in each of January and December and are down 0.4% over the last 3 months. During the 3 most important months of the year, nominal non-auto discretionary sales declined at a 1.1% annualized rate. We will get the January CPI later this week but we already know that Core CPI rose 0.3% during November and December. If January comes in at +0.1%, we could infer that real non-auto discretionary sales have dropped at a 2.3% annualized rate between November 2013 and January 2014.

This is a HUGE decline which will impact global goods production for many months. Add that car sales have been weak in recent months and you get a possible hard patch which nobody is really willing to see now.

Economists are tripping over themselves to adjust their Q4 and Q1 GDP estimates.

"Control sales", the components of retail sales that feed straight into the GDP calculation, rose 0.1% in November (from +0.4% originally), 0.2% in December (from 0.6%) and declined 0.3% in January. The substantial revisions materially change the picture from that of a very upbeat consumer (+6.2% annualized control sales growth for Nov.-Dec.) to that a very cautious consumer (+1.8% a.r. for Nov.-Dec., and zero for Nov.-Jan.).

The reality is that the monthly sales statistics were deceptively buoyant at the end of 2013, driving substantial upward revisions to growth expectations. These have just been totally deflated by the recent revisions. Yet, most economists and media blame the weather and keep their jolly mood.

But the weather is not the main factor since the weakness actually started in November and continued right through January and even February, judging from weekly chain store sales. In fact, on-line sales declined 0.6% in January.

The problem is more fundamental, "weather" you admit it or not: slow employment growth, low labour participation rate, tough lending standards and declining social security payments. You can rely on the top 10-20% only up to a certain point but the reality is that real household income for the mass of "ordinary folks" remains well below its past cycle peak and shows no upward movement. Furthermore, the recent sales weakness occurred in spite of a sudden spike in revolving credit in December, borrowings which will need to be paid down shortly.

To be sure, we have gone through periods of weak retail sales during this recovery and they eventually proved benign.

This one is more worrisome because it happened during Thanksgiving and Christmas and is leaving businesses with significant excess inventory entering the new year. Business inventories were up 4.4% YoY at the end of December, up from +3.1% in September.

The highly complacent conventional wisdom is pretty much the following:

For now, given improved household finances, we look for a healthy rebound in sales once this awful winter ends. (BMO Capital)

It is funny how things may look different from various lenses. Take household finances, for example. "Ordinary folks" may not be seeing their household finances as much "improved" as economists watching aggregate statistics do. The same for the weather as the WSJ reveals:

The average temperature in the 48 contiguous U.S. states in January was 30.3 degrees, just 0.1 degree below the 20th century average, according to the National Climatic Data Center's monthly climate report, released Thursday.

It was very cold in the eastern U.S. but warmer than usual out west, "resulting in an overall monthly temperature slightly below average," the report noted.

Precipitation was below normal last month. The average of 1.32 inches was 0.9 inches below last century's average, the lowest since 2003 and represented the fifth-driest January on record, the center said.

Again, East and West were at odds. "Dry conditions dominated much of the western and southern United States, with severe-to-exceptional drought engulfing much of California and Nevada," the report noted. "Numerous winter storms impacted the central and eastern United States, bringing above-average snowfall but closer-to-average total precipitation."

The previous month, though, was the 21st coldest December on record and the chilliest since 2009.

The November temperature was 41.6°F, 0.3°F below the 20th century average, ranking near the median value in the 119-year period of record.

By the way, if you think we've seen all of the bad weather for the year, like most people assume, the Browning Newsletter might discourage you, whether you live on the East, Central or West USA:

In 80% of similar years, late winter remained cold in the Eastern and Central US through February. In 60% of these years, there was little to no slowing of the eastward sweep of storms, so while temperatures were cold, they were not as extreme as they were in mid-winter. (…) At the same time, in 80% of similar years, more cool air and precipitation entered the Pacific Northwest and Western Canada. (In 40% of these years, some of this precipitation even hit California.)

Here's the bad news. This shows sign of being one of those 20% of years where the drought lasts all winter! Even though it has been more common during the past
century for the infamous "Ridiculously Resilient Ridge to fade in late winter - allowing a "Fabulous February" or "Miracle March" to break or at least alleviate the Western drought - meteorologists don't think it is likely this year. The High in the atmosphere is showing no sign of leaving.

Weather blaming has thus just begun. The 2014 blame game is not exclusive to economists as Obamacare and, now, the Olympics are demonstrating:

  1. Sochi Olympics: U.S. Takes the Overall Lead in Excuses
  2. Soft Snow is Hard on Team USA
  3. U.S. Speedskating to Drop Controversial Under Armour Suits

In the hours after gold-medal favorite Shani Davis finished nowhere near the podium, the U.S. speedskating team pored over data through the early morning Thursday, questioning everything from race strategy to skate blades.

After an equally disastrous outcome in the women's 1,000-meter race later on Thursday, a suspect emerged: the high-tech racing suits the team adopted for the Winter Olympics.

These suits-designed by apparel sponsor Under Armour and billed before the Games as a competitive advantage-have a design flaw that may be slowing down skaters, according to three people familiar with the U.S. team. (…)

Under Armour developed the skintight aerodynamic suit for the Sochi Games and it was pretested for specific conditions, including the sea-level altitude, that athletes would face there. The company billed the so-called Mach 39 outfit as "the fastest speedskating suit in the world." The suits, made from five synthetic fabrics, went through 300 hours of wind-tunnel testing and incorporated the design expertise of Lockheed Martin's aircraft engineers, the company said. Even the zippers were a special design. (…)

Never mind all the testing etc. It's got to be the Under Armour (NYSE:UA) suits.

Or, maybe, the problem is more fundamental, being simply under the armour:

Brittany Bowe, the world-record holder in the 1,000 meters who finished eighth behind Ms. Richardson, said "other countries are just getting really fast."

The hard patch fear is amplified from the other fact that eurozone retail sales also heavily disappointed at year end, even though the media seem to have totally missed the miss which I reported on Feb. 5:

Total retail volume dropped 1.6% MoM in December in the EA17. Over the last 4 months, retail volume is down 1.8%, that is a 5.4% annualized rate! Core sales volume dropped 1.8% in December and is down 1.5% since September (-4.6% annualized). Real sales dropped 2.5% in Germany (-2.4% in last 4 months), 3.6% in Spain (-6.0%), 1.0% in France (-1.2%).

There again, recent revisions require everybody to curb their previous enthusiasm (chart on right from NBF). We seem to be in a generalized consumer strike engulfing North America and Europe. By the way, how's the weather in Europe?

Perhaps it will wake politicians up to the reality that the top 10-20% remain but a minority which cannot, all by itself, pull the economy forever.

The weather is a nice scapegoat, but weather or not, the excess inventory is real and needs to be worked out. Perhaps, as DB's economist Joe LaVorgna wrote

Eventually, though, we should see some impressive weather-related snapback in economic activity.

Eventually, sure! Let's all pray it happens sooner than later.

It may also be that bad news is good news again! After all, the Fed and the ECB backstops are still firmly in place. The problem is that "whatever it takes" Dragui can keep banks afloat and make investors buy sovereign bonds simply moving his lips, I doubt he can make people spend more than they can. In the U.S., newly at bat and cautious Janet Yellen also seems to blame the weather:

"I was surprised that the jobs reports in December and January, the pace of job creation, was running under what I had anticipated. But we have to be very careful not to jump to conclusions in interpreting what those reports mean," Ms. Yellen said. Recent bad weather may have been a drag on economic activity, she noted.

Asked what would cause the Fed to alter its course, Ms. Yellen responded it would take a "noticeable change" in its outlook for growth, employment or inflation.

In any event, she can buy all the bonds she wants, she also can't influence ordinary folks, the ones really missing in action now.

The fact that commodity prices have not risen in the face of rising economic optimism should concern investors. Here are a few rather interesting charts from Ed Yardeni:

Obviously, commodity prices do not seem to share the overall optimism. Harsh winter? Oil prices are not moving on this. And what about the so-called tight relationship with QEs. Could it be that commodity markets are no longer influenced by central banks' financial heroin? What's to blame? Here are some suggestions:

A surprise fall in industrial production in January provides further signs that the US economy is going through a tough spot as harsher than usual winter weather causes widespread disruptions.

Other than winter weather, there are these other facts on U.S. IP:

  1. Manufacturing output has been revised downward for each of October through December. The revisions are not insignificant and result in an annualized gain between October and January of only 0.6%. From another angle, manufacturing output grew by 0.47% monthly on average between August and October 2013, 0.3% in each of November and December, before the 0.8% drop in January. Part of January's decline is admittedly weather-related but the basic trend was clearly slowing.
  2. Production of Business Equipment fell for the third consecutive month (-4.9% a.r.)
  3. Production of construction supplies dropped 1.0% after a 0.6% drop in December. These require lead time and must be related to the housing slowdown which is clearly more interest rate related than anything else. Recall that most economists negated the impact of rising mortgage rates until it became obvious.
  4. The production of automotive products fell 5.1% in January. Weather-related or due to excess inventories?

Since mid-December last year, China's domestic industrial product prices have fallen, indicating that the real economy has once again lost momentum. In the week following the Chinese New Year, industrial product prices continued to soften. The direction of industrial product price movements corroborates with the decline in the headline PMI reading. (CEBM Research)

External trade was the weak point (…) Many in Japan have seen a weak yen as an economic cure-all, and the currency's decline of more than 20 per cent has indeed boosted profits at global manufacturing groups such as Toyota. But it has done so mainly by increasing margins on goods that companies sell overseas - and, increasingly, produce there too - while having relatively little effect on export volumes.

How's the weather in Japan and China these days? And in Brazil? Or throughout the EMs. Did you notice the Sochi weather lately? And we have not talked about California yet.

Weather blaming is not about to go away. The first quarter earnings season, to begin in about 6 weeks, will include an overdose of weather excuses. If the winter causes Ms. Yellen to wait for more clarity, perhaps investors will do the same and not run for the fences if results are below expectations. In fact, the blame game has already started.

The word "challenging" appeared frequently in the latest Bloomberg compilation of conference calls. While lackluster performances, weaker demand, reduced outlooks and softer growth were blamed on inclement weather, at least one food company found the snow to be a positive influence as consumers ran out to purchase in bulk ahead of the storms. Currency headwinds took a toll on many multinational companies.

If economists say it's the weather, it must be the weather. In the meantime, analysts are getting busier and somewhat more cautious as the Q4'13 earnings season comes to an end. Factset reports:

In aggregate, companies are reporting Q4 earnings that are 3.3% above expectations. This surprise percentage is equal to the 1-year (3.3%) average, but below the 4-year (5.8%) average. The blended earnings growth rate for the fourth quarter is 8.3% this week, above last week's blended earnings growth rate of 8.1%. The Financials sector has the highest earnings growth rate (25.4%) of all ten sectors. It is also the largest contributor to earnings growth for the entire index. If the Financials sector is excluded, the earnings growth rate for the S&P 500 falls to 5.0%.

At the mid-point of the first quarter, analysts have lowered earnings estimates for companies in the S&P 500 for the quarter. The Q1 bottom-up EPS estimate has dropped 3.0% (to $27.45 from $28.28) since December 31. During the past year (4 quarters), the past five years (20 quarters), and the past ten years, (40 quarters), the average decline in the EPS estimate during the first half of the quarter has been 2.6%. For Q1 2014, analysts are now expecting earnings growth of only 1.2%.

+1.2%! And winter is not over just yet … Do you realize how close to zero 1.2% is?

Of course, one can remain jolly and share the eventual earnings rebound that will come with the eventual economic snapback that will stem from the eventual great spring and summer weather. For my part, I keep the discipline of using trailing earnings and I get nervous when earnings stop rising. Say what you want, earnings are the main and most dependable fuel for equities. They are the tail winds without which the navigation gets a lot more iffy, being subject to all kinds of cross currents that are often difficult to anticipate.

When earnings stop rising, higher P/Es are needed to lift equity prices. When P/Es are already on the high side, everything must be right to keep investors happy and hopeful. What do we need to keep the faith other than better weather?

  1. Tame inflation, to keep purchasing power reasonable and interest rates low.
  2. Stable or lower oil prices.
  3. Lower mortgage rates and/or rising house sales.
  4. Good car sales to keep factories humming.
  5. Faster employment growth.

The consensus is so one-sided towards continued low inflation that we need to watch this carefully. I share David Rosenberg's view that the labour supply has actually tightened due to secular trends. Also, we are seeing more signs of higher prices here and there. House prices, rents are rising. Natural gas and propane prices have skyrocketed. Trucking rates are rising due to fewer trucking companies competing. Amazon Prime will get boosted along with USPS prices. Prices are rising in Asia to cover sharply rising costs. Suddenly, import prices are rising in the U.S. There again one has to dig below the headlines:

Under the tame January headline numbers, nonpetroleum import prices rose 0.4% in January, the largest increase since May 2011. Last month's strength in nonpetroleum prices reflected a 0.8% rise (4.9% y/y) in foods, feeds & beverages costs as well as a 0.7% gain in nonauto consumer goods prices.

By the way, the U.S. imports a lot of foodstuffs during winter, even more so when drought-ravage California can't produce. FYI, California produces 35% of the nation's fruits and vegetables. Higher food inflation does not feed into core CPI but it sure eats into real disposable income, which will itself be impacted by the drought which, by the way, extends far beyond California:

Federal agriculture officials in January designated parts of 11 states as disaster areas, citing the economic strain that the lack of rain is putting on farmers. Those states are Arkansas, California, Colorado, Hawaii, Idaho, Kansas, New Mexico, Nevada, Oklahoma, Texas and Utah. (NBC)

As to the other economic variables, I fear that the positive momentum that became apparent late last fall was fuelled by deceptive and now deflating statistics. The very poor retail sales in both Europe and the U.S. during the most important selling season are not solely weather induced. For the most part they are real income induced.


We are all driving blind, still. Janet Yellen hopes that things will be clearer in a few months, but this may prove to be wishful thinking. In nearly 40 years of investing, I have learned that things rarely get much clearer. And when they do, watch out! You may be looking with your eyes wide shut.

This is a game of odds. Playing your hands against that of other investors on a table that changes constantly, even retrospectively! You thought you had a winning hand and bang, a joker!

  • The economic table was described above. It is murky. It could "eventually" get clearer, but not necessarily better.
  • The valuation table, provided by the Rule of 20 Barometer, is not totally uncomfortable but it is not compelling.

  • The technical table is inviting with the S&P 500 Index above its 50, 100 and 200 day m.a., all of which are rising.
  • The sentiment table is shaky, highly unstable.
  • The seasonal table looks good for another 10 weeks through April after which the odds are better fishing Atlantic salmon.

In all, the recent retail sales data are very destabilizing, to say the least, but people seem frozen in their hopeful tracks. Complacency makes me cautious. This could well be the winter of discontent.

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.