There's Just One Catch

Includes: DIA, IWM, QQQ, SPY
by: Kevin Flynn, CFA


The near-term market outlook appears benign, albeit bumpy.

Central bank faith.

Keep your eyes on the ingredients, not the packaging.

"All Gaul is divided into three parts," wrote Julius Caesar in his famous history of the Gallic wars, setting the stage for thousands of years of furrowed brows on young Latin students wondering why the Romans couldn't seem to write like everyone else.

One might add that the stock market is divided into three parts: the short-term, medium-term and long-term, which has caused centuries of pain to traders wondering why the first part is so often at odds with the third.

Looking over the very short-term that consists of the last month of December, I reluctantly admit that I have no great worries - reluctant because saying that kind of thing tends to invite meteor strikes and bubonic plague. Superstition aside, however, I do believe that the calendar effect is likely to prevail through the rest of the year. Be forewarned, however, that although December is indeed the second-best month of the year and many are talking as if the last few weeks are merely a matter of sitting back and watching the profits roll in while you shop online, it ain't so easy.

December performance tends to be backloaded. More often than not, the market is in the red with about a week to go before Christmas, often by two or three percent, and then it makes it all up with a flourish over the last trading days of the year. Be ready for some heavy weather. With the market being so complacent the last couple of weeks, it's nearly inevitable.

The chief prop of the global equity market has been central bank policy, and their recent strikes have left many sellers cowering in bunkers. First there was the Bank of Japan's Halloween ambush, then China's cut of about ten days ago. It was a move that seemed aimed more at the currency than anything else (and mounting loan losses), but in these days of central bank devotion on the part of investors, however, China's move was immediately followed with predictions of entire programs of stimulus, stimulus, stimulus. After all, the European Central Bank (ECB) is about to feed the beast on Thursday, so China will simply have to go along. Won't it?

To be honest, I don't believe that the ECB is going to do anything on Thursday but say they're getting really, really ready this time to do something really, really soon. I also don't believe that I'm any better than flipping a coin at predicting policy decisions. In fact, I'm probably worse, given that I cannot seem to shake the habit of attributing common sense to our august temples of finance - despite the evidence - while not assigning anything but random chance to the penny toss. I may have it the wrong way around. At any rate, the sovereign bond kabuki dance between the Draghi and German wings of the bank doesn't seem quite ready to declare a victor.

As I struggle with indigestion that stems not from Thanksgiving leftovers (my turkey was delicious, thank you) but from the myriad puff pieces about the economy appearing in investor quarterly reports and the business press, there are a couple of cases of bogus goods circulating that investors should know about.

The economy is booming:

No, it isn't. The revision to the seasonally-adjusted annualized rate (SAAR) of GDP for the third quarter was pleasant on the surface, but really came down to a few extra billion dollars in a $17 trillion economy. At 4.05%, four-quarter nominal GDP is still virtually even with the 4% rate that has prevailed the last four years. The former is on track to ease back to the 3.9% five-year compound growth rate. The worst scammers are the many media types that run around braying about the second and third quarters being the best six-month stretch in decades, while pretending that they are completely unrelated to one of the worst non-recession quarters ever. But the math is very simple: no minus 2.1% in Q1 means no 4.6% rebound in Q2. They are joined at the hip. The current quarter is tracking at 2% real GDP, meaning 2014 is tracking to be about 2.1%. 2012 was 2.3% and 2013 was 2.2%. Some boom.

The fall in oil prices is a big tax cut for the consumer:

No, it isn't. A tax cut puts more money in your pocket. A fall in gasoline prices allows the consumer to spend the difference elsewhere and can thereby benefit other categories, but there's a catch: it does not and cannot change the total amount of retail spending. A tax cut can. In the current episode of this hoary old wives tale, one thing that's been completely omitted by the cheap-gasoline bulls is the blast of cold air most of the country had to endure in November. Right now I would call it about even - the money saved on automotive gas has been burning instead in our furnaces. Natural gas prices have been rising.

The fall in oil prices will be great for the economy:

Inexpensive energy costs are definitely a boon for the economy. There's just one catch: nearly all of the improvement in industrial activity has come from two categories: oil and gas exploration and production (E&P), and aviation manufacturing. Not as much money spent by the consumer on imported oil, however, does mean more money available to spend on apparel and tech gear. The catch is that nearly all of it is manufactured in Asia instead of the Middle East.

The truth is that business is the biggest beneficiary of lower energy prices. That's still a definite plus for the economy, but there's a snag: It takes about four to six quarters for the drop in costs to benefit broad economic output. I won't hazard a guess as to how long the current oil weakness will last, but I have heard and seen remarks by industry executives that skewed price episodes usually last about a year. The inference is that the benefit could end before it really gets any traction. As for the impact on our oil sector, while we can argue about the effects of $60/bbl oil - and I don't buy that it's immediate Armageddon for U.S. activity - one thing is certain: that kind of price isn't a big incentive for more shale oil.

Manufacturing is leading the way:

Not either. A typical example is this puffery from the Monday's Wall Street Journal, which declared it our "forgotten economic engine." Yes, the ISM manufacturing surveys have been fairly good of late. But they haven't corresponded very well to industrial production or new orders and shipments of durable goods. The second-best industrial growth is coming from the aviation industry, which has long lead times during its replacement cycles (and quick cancellations during hard times). General manufacturing activity remains below long-term averages.

The return to full employment will take us to the long-awaited next level of growth:

If only this were true, we wouldn't have a business cycle. But we've already harvested most of the benefit from this cycle's employment rebound - at this point, we're not likely to have more than a few tenths left to go on the unemployment rate. Employment peaks after the business cycle is already over.

Far more important than any mythical gasoline tax cut is the meager growth we've been experiencing in personal income. With October's release, the growth rate in personal income over the last seven years fell back below 3% (2.99%, to be exact). That's nominal income. The annual growth rate since 1985 is 5.04%. It's going to be very hard to get nominal GDP going above 4% when income is stuck at 3%. You can cut your way to short-term profits, but not to prosperity.

The stock market will keep going up anyway:

More likely than not, but not forever. These days it feels to me like late 2006, but in reverse: instead of the myth of a slowing U.S. economy being rescued by global growth, it's the same thing the other way 'round (implying a cyclical market top in 2015). Stories of the slowdown in China are proliferating, and while I'm in the camp that's been writing about it for a couple of years, the broader investment public is starting to take it seriously. Keep in mind that the Fed's rate cuts in 2007 couldn't rescue our mountain of bad debt, though equities cheered them on anyway.

Some key commodities besides oil are engaged in similar market-share battles in the face of burgeoning supply and slumping demand. The generalized slump in commodity prices isn't a bad thing for U.S. manufacturers, but it isn't telling you much is good about the global economy, either. Falling commodity prices and falling high-yield bond prices (about 20% of the high-yield market is in energy) usually precede credit events, which tend to inflict mortal wounds to aging bulls.

One other thing will keep going up: the number of stories telling you that this cycle is different. Indeed, I cannot remember a market plunge that wasn't preceded by a growing general consensus that a new plateau of prosperity had been reached. There's a good catch here, though - I can't recall a market rebound either that wasn't preceded by the certainty that no bunker would ever be deep enough to hide in.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.