By Joseph Y. Calhoun
The stock market and the traders who rule it seem to have had a change of heart last week. Stocks were down over 2% with most of that coming Thursday with a 300+ point drop in the Dow Jones Industrial Average. The Dow - and small caps - are now down for the year although the S&P and NASDAQ are still in the green. As for the catalyst, that depends on whom you believe I suppose. Some pegged the source as the Argentinean default which seems a bit far-fetched considering their history and basic irrelevance to the global economy. Others pointed to the Banco Espirito debacle in Europe. Some cited an acceleration in the economic data based on the 4% GDP growth reported for the second quarter and a decent employment report Friday. The thinking seems to be that better growth means the Fed's morphine drip of easy money will come to an end sooner than previously expected.
That last explanation would seem to have some validity based on the open mouth policy of the Fed. Charles Plosser dissented from the FOMC statement Wednesday because he objected to the language stating that rates would stay low for a long time. He believes that the economy is close to the goals of the FOMC and that the Fed shouldn't promise something it can't deliver. Richard Fisher of the Dallas Fed has made similar comments recently going so far as to run a recent speech as the lead editorial in the Wall Street Journal. The speech made the case that the Fed's loose monetary policy has overstayed its welcome. Interestingly, he did not dissent from last week's statement. So, there are members of the FOMC who believe rates will need to go up sooner than the majority.
With Yellen running the meetings though it is far from assured that these hawks will prevail and that rates will head higher sooner rather than later. The idea that the Fed is behind the curve on inflation will, I believe, be proved wrong rather quickly. There was a lot of angst, at least according to observers like Art Cashen, about the employment cost index last week but what looked like a hot number was in reality merely a return to the previous trend that prevailed prior to the 1st quarter GDP contraction. The reason I see little reason to expect a surge in consumption - or investment for that matter - is that incomes are still stagnant. The employment report Friday showed a decent gain of 209,000 jobs but the wage component was flat and up just 2% over the last year. That is right in line with the inflation numbers meaning that workers have not seen a rise in their real incomes.
We already have numerous market indicators that support the idea that rates aren't going up anytime soon, most prominently the bond market itself. Meanwhile, a lot of the things that have pushed the inflation figures higher recently are already reversing, primarily energy and food prices. Anyone bothering to look at the commodity markets or the US Dollar index would see that natural gas prices are back below $4, oil is trading again below $100 - despite the turmoil with Russia and the ongoing Sunni-Shiite civil war in the Middle East - agricultural commodity prices have basically collapsed and the dollar is heading higher. In short, inflation isn't a problem now and the idea of cost push inflation from wage gains seems wishful thinking. The fact is that the data released recently shows an economy that hasn't changed all that much in recent months - or years for that matter.
The GDP report was better than expected and certainly better than the first quarter but those who see some escape velocity in the numbers are, I believe, seeing what they want to see. The fact is that the economy is and has been growing at 1.5 to 2.5% for the last few years and nothing in the most recent GDP report indicates that is changing, certainly not for the better. Much of the gain in the second quarter is attributable to inventory accumulation which could be a positive sign or negative one depending on how sales go over the next few months. Based on the recent consumption numbers I see no reason to believe that inventory will do anything more than it has done in the recent past, namely add for a quarter or two and then subtract as sales don't meet expectations. Final demand is still tracking at 2%; the acceleration in economic growth is a mirage.
While there doesn't appear to be much of a change in the economic trajectory, what may be changing is the market's perception of the central banks of the world. The Espirito Santo bank collapse in Portugal would seem to put a dent in the ECB's narrative that they have everything under control. While the collapse of a Portuguese bank may seem unimportant, the action in European financial stocks would seem to indicate there are worries that this might not be the only cockroach to emerge from the European financial cupboard. If there is additional capital needed in the banking system will the slow moving ECB be able to offset the drag that might create? The consensus last week seemed to be coalescing around no.
The narrative surrounding the Fed may also be changing. The improvement in the recent economic figures - or at least the perception of an improvement - has allowed the Fed to continue its tapering project with another $10 billion cut at last week's meeting. And Yellen has said that it would take a major change in the economy to stop the march to the end of QE. In addition, the prevailing attitude for the last few years has been that stocks are the only place to be and the Fed has your back so buy all you want. With Yellen's version of the irrational exuberance speech a couple of weeks ago, that might be changing. No longer can you buy just anything - particularly in the credit markets - and expect the Fed to react to every little drop in price. It seems to be dawning on the market that the Fed in fact would be pleased to see some of the froth come out of junk bonds, leveraged loans and yes, stocks.
It may also be that the institutional memory of the end of past QEs is starting to move to the top of stock trader's worry list. It takes nothing more than a review of the charts to realize that the end of QE1 and 2 saw pretty significant moves down in stock prices. Whether that was due to the end of QE or some other external factors - the European crisis was just getting underway at the end of QE2 but was that a function of the end of QE2 or just bad luck? - probably doesn't matter. If the widespread belief is that QE = higher stock prices and NO QE = lower stock prices, that may be enough to put us in correction mode as we get closer to the end of QE.
Another factor that may work against stocks here is the widespread indexing that has captured investors' hearts over the last decade. There is nothing so common on Wall Street as a good thing taken too far and indexing would seem to fit the bill. Indexing, at least the capitalization weighted version that is the most popular, is nothing more than a momentum strategy dressed up in academic clothing. Stocks with a rising capitalization - or in the case of the Dow just a higher stock price - get more of the future index dollars while those with a falling capitalization see less capital flows. That's how we ended up with technology and financials making up so much of the S&P 500 in the last two bubbles. The point is that momentum is not something that will only work in one direction. The stocks that captured the momentum on the way up will reap the whirlwind on the way down.
There are a lot of investors in the stock market who are not really comfortable, who really don't want to own stocks but feel they have no choice. Any inkling that stocks are about to reverse direction and these people are pushing the sell button. And when they do they are increasingly hitting it for the entire market rather than just one stock. Just as it has been hard to interrupt the bull market on the way up, it may be difficult to reverse a decline once it gets started. Was last week the beginning of the long awaited correction or God forbid, a bear market? Only time will tell, but there are some disturbing technical signs. As noted above, the Dow and Russell 2000 (small cap stocks) are down for the year and the small cap index is trading below its 200 day moving average, a widely accepted indicator that the trend has shifted. If small caps are leading indicators - and they did indeed lead the market on the way up - then there is likely more downside to come for their larger brethren.
I suspect that the narrative of an improving economy leading to quicker rate hikes will fade pretty fast. If the economy is so hot, if inflation is an emerging worry, why aren't bond yields heading higher? We did see a small rise of about 15 basis points last week on the GDP and ECI numbers but by Friday yields were back near their recent lows and the downtrend intact. Conversely, junk bonds parted company with Treasuries at the end of June and are now down almost 3% from their highs. That might not seem like much but at the highs that wasn't far from a full year's worth of interest payments. I would also note that defaults in the high yield market have recently turned higher, not something expected of an improving economy.
I have been thinking recently (thanks Eric) about George Soros' idea of reflexivity, the idea that it is markets that change the economy rather than the other way around. That theory doesn't appear to have been very useful on the way up - higher asset prices don't seem to have had a material impact on growth - but then we don't know the counterfactual. On the way down though it might be more obvious. If the junk bond market goes into hibernation that will have an effect as marginal companies get cut off from credit. If leveraged loans lose favor, that will have an effect on the liquidity needed to keep fueling the M&A boom. With growth already at a low level, it would not take much to push the economy over the edge and back into contraction. Could it be that the traders who push the market lower in fear of accelerating growth and inflation actually produce the opposite? For now, despite the change in perception, the economy itself hasn't changed much. If last week was just the opening move of a bigger correction, that might change.
One last thought: If the Fed was right about the wealth effect on the way up and behavioral economics has any validity - losses have a greater psychological impact than gains - the effect on the way down will be larger. Stay tuned.