Fade This Rally

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


False economic positives from February.

The weakness in current economic and profit data.

It's just another bounce before the end.

In February, we witnessed a series of economic "false positives," from retail sales to durable goods to GDP tracking forecasts that all played an important role in the current bounce in equities. The change in narrative coincided with the bounce from the long-term trend line of the S&P 500 (in the 1800-1820 range) in mid-February. The improving atmosphere put considerable spine back into the regime of corporate stock buybacks, notoriously a group ranking amongst the worst market-timers and currently approaching the record set at the end of the last bull market, in 2007. The Federal Reserve bank has helped things along by backing away from more hikes for the time being.

The February personal income report took the Atlanta Fed's GDP estimate all the way down to 0.6% - it had been 2.7% in January - but that had more to do with poor forecasting of what would happen than with the actual data that had been reported. I was writing at the time that the forecasts for an inventory build and for stronger consumer spending looked doubtful, and so they were. Perhaps there was a bit too much hope built in.

While the downward revision to January income and spending and a mediocre February report may have dashed those hopes, apart from the forecast changes there was very little in terms of actual change in the categories. The year-on-year growth (based on annualized, seasonally adjusted data) in the rate of February personal income is currently 3.99%, something of a slowdown from the monthly average over the last two years (4.4%) but dead average for the period going back to 2002 (4.0%).

The interesting bits were in real per capita income and the spending category called personal consumption expenditures, or PCE. The year-on-year change in real per capita income has fallen to below 2% for three consecutive months now, in contrast with the average of 2.75% that had prevailed over the prior twelve months. It's too early to tell if that's a real trend or just intermediate volatility, but it could be a byproduct of a change in hiring mix, with more new jobs going to lower-paying slots (a notion supported by the weakness in aggregate wage growth). PCE, for its part, has been quite stable, with the latest year-year rate at 3.76% through February, compared with the five-year trailing average of 3.83%. Given the measurement limitations, those results are virtually the same.

So spending has not in fact accelerated as originally estimated (hoped), nor has income, nor have inventory rebuilds, nor has business spending. This has led to gross domestic product ("GDP") tracking estimates for the first quarter to tumble from the high 2's in January to recent estimates below 1%.

GDP recorded two quite weak first quarters in 2014 and 2015, blamed first on bitter cold, then on record snow, and finally on flaws in the estimation process. The first quarter of 2016 was warm with below-average snowfall through most of the country, so it will be interesting to see how the current one turns out in the absence of those weather headwinds. Given the weakness in Q1-2015's nominal GDP (only 0.19%), one would think it should not be surprising if four-quarter nominal GDP - which has been about 3.1% the last two quarters - were to pick up, due to the easier comparison.

Yet if the Atlanta Fed's current tracker holds at 0.6%, or even comes in at 1%, that would imply perhaps greater structural weakness than the last two years, given the lack of a weather excuse. Inventories are still too high and the international goods report for February made it clear that exports are still suffering. The February durable goods report last week put an end to the flawed idea that business investment spending was suddenly recovering. The foregoing suggest no improvement is imminent in four-quarter GDP, though the final number may yet climb higher, given that manufacturing surveys seem to be seeing a distinct pulse higher after many months of deteriorating conditions. Whether the GDP number ends up 0.6% or 1.6%, it's still stall speed for me.

For the stock market, the last six weeks have been another example in a very long stream of historical episodes that stock prices do not correlate very well with GDP (though the former do go down in recessions). If tomorrow's jobs report is at or over consensus, the chances for a strong start to April (it's also the first day of the month, often a good day for stocks) are enhanced. After that, however, the stock market is headed for turbulent weather.

To begin with, corporate stock buybacks will be on hold until after reporting season is over. That absence was certainly felt during the January correction. And while April is historically the best month of the year for stocks - and you can be sure black-box algos have that programmed in - the traditional pattern is also for stocks to rally into earnings season, beginning right after tax day (April 15th) on hopes of earnings improvement, then sell off later when the hopes prove to have been too optimistic, one of the reasons for the "sell in May" adage. This year, however, earnings forecasts are quite pessimistic, and my guess is that the consensus two weeks from now, when the rubber starts to hit the road, will be for a quarterly decline of over 10% for the S&P 500. Given the size of the cushion built into recent forecasts, that would seem to imply an expected actual decline of 5% for the index as a whole.

And therein lies the rub. Equity prices are pretty good at ignoring GDP data, but they are not very good at ignoring profit declines. The Bureau of Economic Analysis estimated last week that fourth-quarter after-tax corporate profits fell by 3.6%. That's a problem that looks set to worsen in the first quarter. The dollar index is down from a year ago, so it's one excuse that isn't going to hold much water next month.

Given this mix, it seems clear to me that all stock prices have really done is return to near the top of the trading range they have been in since the break last August in the bull market's take-no-prisoners leg (a.k.a. a "Sornette wave") that began in November 2012. An enduring feature of the ends of bull markets is to trade in such a range for anywhere from six to eighteen months. Once the long-term trend has broken - and it hasn't yet - the bear market will become evident, but until then we will have the usual series of this-is-it-now frights and what-me-worry rebounds.

Given the ongoing economic weakness that continues to undermine corporate profits, I look for the next fright in equities to begin quite soon, though if I had to guess (and I'm glad I don't) it won't be the backbreaker quite yet. As Americans, we all want the best deal and tend to suffer terribly if the market goes up for one week without us, but don't confuse short-term noise with what is really going on. Even though this rally may not be the last one before the long-term trend breaks - and I can't tell you if it is, but I can tell you all bull markets end in time and the current business cycle is on its last legs - unless you're a professional short-term trader, it's a guess you don't need to take. It's a gift that you should be selling.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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