The Correction Cometh - And Everything You Need To Know About Why

by: Kevin Flynn, CFA

The Greek parliament voted in acceptance of another ruinous austerity program on Sunday, amidst globally televised images of riots in the capital. Our base scenario is the same as the one in the markets - some sort of ugly is patched together and victory is declared. But will the Greek people accept the deal, or rebel? Given the unrest, one has to wonder if Germany and the EU will still buy into the deal. The continued rise in markets may already be tempting them into an indiscretion: the latest rumor has some of the northern members deliberately raising the bar until Greece gives up and leaves on its own.

The deal wouldn't be anything but another postponement of the day of reckoning. Some feel it will start to come undone as early as next month, while luminary George Soros thinks it could buy another six months of quiet - at least so far as Greece is concerned. He doesn't believe it will ultimately solve anything either.

The fading rally could hang on a few more days, true. To begin with, rumors of Greek acceptance (strategically released yesterday just before the U.S. close - do the authorities ever wonder at such remarkable timing?) erased most of the U.S. losses in the last fifteen minutes of trading, losses that had more to do with a disappointing retail sales report than Greece.

Despite the retail sales disappointment, the warm weather and the normal first-quarter order patterns should be good for the manufacturing data coming out the next few days. Unless something is very wrong, the Federal Reserve regional surveys should look quite positive. Industrial production (though not utility output) should have benefited as well from the weather and seasonal adjustments.

Another supporting factor is that Friday is the expiration date for the current monthly options, and call activity has been heavy. Buyers may well try to support prices. It's also the one-year anniversary of the day that the 2010-2011 fall-to-February rally broke. That may not cause traders to flee next Tuesday (markets are closed on Monday the 20th), but they'll certainly be aware of it, and we are dangerously ripe for correction anyway.

Against that, there are a couple of non-negligible dangers to keep in mind in this overextended trader's market. One is that the ill will between the Greek populace and German elites erupts into something serious enough to call the deal into question. The markets wouldn't like that, regardless of how superficial the agreement might be. The situation is practically hour-to-hour, and we're no longer sure of good intentions.

Another is the effect on the CDS (credit default swaps) market. Would the Greek haircut trigger a payout, and if so, how large will it be? We think that they'll try to sweep it under the rug again, but it's just a guess. The process could develop in unexpected ways.

Then there are the other PIIGS countries, in particular Portugal. Another theory that's gained currency recently is that the draconian tactics by the Germans and EU officials are partly an effort to discourage other heavily indebted countries - i.e., Portugal - from seeking some debt relief of their own. Plausible, even likely, but one can't help but wonder about the tiny little wrinkle that Portugal still can't afford its debt.

S&P announced the downgrade of 34 Italian banks last week (out of 37), while the European Banking Authority (EBA) decided to postpone another round of stress tests until next year. It seems that many European banks are planning to meet capital requirements by making outsized profits between now and then. Perhaps the central thrust of EU actions is to buy the banks more time to prepare for the inevitable, but markets have a way of operating in ways unsanctioned by financial ministries. We can guarantee one thing - the EBA didn't cancel the stress tests because it was sure everybody would pass.

Keep an eye on China, too. The country has put out some surprisingly weak monthly data of late that is all being laid at the door of their New Year holiday, which began January 23rd. We're not sufficiently learned in Chinese data to draw our own conclusions, but Nomura Securities, for one, wouldn't buy the seven percent drop in electricity usage as being all due to New Year's. Time will tell, but we found it curious that China started talking about the need to help Europe with its debt problems as reports circulated about the first drop in Chinese exports in two years.

Back in the U.S., the December trade deficit was a bit larger than expected, which will put downward pressure on the Q4 GDP revision, but December inventories were slightly higher, providing a partial offset.

The more interesting aspect of the wholesale inventory report was that on an unadjusted basis, wholesale sales fell in the fourth quarter. The sales-inventory ratio is about the same as a year ago, so nothing alarming is going on, but the decline offers two clues to the larger picture. One is that it offers a partial explanation for the subdued nature of S&P 500 earnings for the fourth quarter.

The other pertains to the calendar rhythm of business. Fourth-quarter declines aren't unusual, given the nature of said calendar, and we wouldn't use them as a leading economic indicator. But they do tend to be followed by larger-than-average increases in subsequent first-quarter sales, which isn't hard to understand. Excluding recessions, first-quarter sales always have healthy increases - it's the start of a new year, with new budgets. That they tend to ramp up more than average when the fourth-quarter was a little lower than average shouldn't require much explanation.

A little more context is necessary, though. The largest increases in actual (that is, unadjusted) wholesale first-quarter sales come when they are following a two-quarter period of weakness. In other words, the usual calendar effect gets an additional boost from restocking. If the restocking has already started in the fourth quarter, as it did in 2010, then the first quarter tends to be really good, as was the case a year ago. Again, it isn't hard to understand - good fourth quarters can mean a looser grip on budgets.

Since the last three quarters of 2011 showed a decline in the (unadjusted) sales rate, we should therefore expect a better-than-average increase in first quarter sales: calendar-plus-restock. That should be pleasant enough, but the caveat is that it's just business rhythm. In fact, really strong increases in wholesale sales are, not surprisingly, usually followed by two or three quarters of weakish sales. Restock, relax, restock.

The restocking rhythm isn't much of a clue at all to the long-term trend of the economy, though, not anymore. Modern lean methods of production and management mean that an inventory expansion that might be counted on to last a year or two thirty years ago now last a quarter or two. That, of course, may partly explain why the early-year effect in equity prices has become so pronounced in recent years.

Turning back to the consumer and January retail sales, the most important feature was the downward revision in ex-auto sales for December from (-0.2%) to (-0.5%). The revisions will put more downward pressure on estimated Q4 GDP. Given that the implicit price deflator used for the fourth quarter was something of a fairy tale at 0.4% (annualized), it's likely that annualized real GDP will have turned out to have run at less than 2.0% in the quarter (and the resulting payback in the Q1 2012 deflator is going to be a you-know-what, given the sharp spike in energy prices).

The revision also means that the miss was bigger in dollar terms than the announced percentage (+0.7%) implied, because the base was lowered. February sales have also been running at modest rates thus far, with a spike in gasoline prices again cutting into real disposable income.

It ought to be acknowledged that January and February are the two least important sales months of the year, and aren't necessarily barometers of what will happen later. The fact that consumers are being careful is the same story as last year. But the fact that the ex-auto and gas category fell (-0.5%) in the biggest retail month of the year, that's important. It supports what we've been saying: consumers may open the wallets for our kids on special occasions - Christmas, Easter, back to school - but the rest of the time, we're still being careful. Why wouldn't we be, when real disposable personal income (DPI) growth has been running at zero.

Despite the good things happening in first quarter business orders, the consumer is still 70% of the economy and doesn't appear to be doing anything to lift GDP above 2%, let alone the 5% fantasies we've seen recently. It's no recession, mind you, and better than the proverbial poke in the eye. But a path for forty-five degree stock price appreciation, it isn't.

We'll offer a consoling thought, though - although a correction of around five percent or so should start by next week, even as early as this morning, it isn't likely to be more than that, not when all is said and done. Wobbles in February and March are commonplace, but really big corrections are as rare as July snow. Not even the March 2008 collapse of Bear Stearns could keep the market away from its appointed April rally. The market is just too wedded to its springtime rhythm.

Of course, what happens in Europe may overshadow everything. A signed deal would give us a great one-day rally, a blown one a great excuse for profit-taking. We've no predictions to offer, but do have some observations: the late-quarter weakness in European data is being given a free pass, thanks to improving survey data, with expectations of a first-quarter rebound firmly in place. The rebound could well happen, but would need a pretty snappy New Year holiday rebound in China as well. And it will take a lot more than any vote in the Greek parliament to solve the debt problems of Europe. Treasuries, anyone?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.