Last Week’s Lessons For This Week
by Cliff Wachtel, Global Markets
The Rally: What’s Driving It, What Will Stop It?
- A recap of each day’s prime market movers last week;
- Our conclusions about:
- What’s driving this rally
- Its obstacles
- What’s likely to sustain
- What’s likely to stop it
- What to do
There was no major market moving news. Data was inconclusive, caution ahead of Asian earnings reports plus Asian indexes being so high and near long term resistance brought some profit taking. Europe and the US were mixed-to-flat, although entrenched long term upward momentum suggests markets want to test higher to their all time highs. For example, the bellwether S&P 500 is already at 1500, only about 50 points from its all time high, and that is tempting for momentum and other short term traders.
All three global market regions closed higher on positive earnings news, with US housing data and positive China PMI reports and comments from China’s top think tank outweighing weak consumer confidence figures. This is a classic case of how when a trend is strong, when facing news events of equal significance but opposite outcomes, markets will pay more attention to the event that confirms the trend.
Asian indexes were all up strongly on hopes that various government policy moves in Japan and China would support higher stock prices.
Europe and the US were overall lower on a combination of some disappointing earnings reports and US Q4 GDP. Many were quick to dismiss the Q4 contraction as a likely aberration (see here and here), hence the pullback in US risk asset markets was minimal.
However the very bearish recession signal of the sub-2% annual GDP growth for 2012 went largely ignored. See our conclusions and lessons section below for more on that.
Worth noting is that the FOMC meeting made clear that the Fed’s policy remains unchanged. They’ll continue their $85 million/month asset purchases and to keep rates low because the US economy hasn’t improved enough to justify any changes.
All three global regions lower on a combination as caution ahead of US jobs reports, European earnings and earnings misses, prompt mild profit taking. That European stocks closed lower was interesting because the EURUSD continued higher, despite the risk-off mood being augmented by the US GDP miss.
The US pullback was minimal, perhaps because the Chicago PMI was strong, particularly its jobs component, which is considered to be one of the best leading indicators of Friday’s jobs reports, so that lent some countervailing optimism.
Asia on good China manufacturing data and continued optimism that China’s slowdown was over and that higher growth was coming.
Europe and the US were also solidly higher, aided by the good news from Asia, with additional support from good German and EU PMI reports, positive US manufacturing data. Although the US jobs report missed forecasts on the headline numbers, the details suggested no material change in the US employment picture, and thus fed hopes for continued stimulus, thus markets were overall higher after the report.
CONCLUSIONS AND LESSONS
So what did we learn from last week for the coming week and beyond?
RISK ASSETS CONTINUE TO MARCH TO DECADE HIGHS DESPITE UNSUPPORTIVE FUNDAMENTALS
We ended yet another week in which risk asset price continue their steady march to decade highs despite growth, jobs, earnings , and other key fundamentals data that are far worse than they were when markets hit these peaks in late 2000 and 2007.
For example, briefing.com noted in its review of the past month:
Economic Data Paints Bleak January Picture
Of the seven January reports, five fell short of expectations.
- The Empire Manufacturing Index, NAHB Housing Index, Philadelphia Fed Survey, Michigan Sentiment, and Consumer Confidence reports all missed expectations.
- Meanwhile, the ADP Employment Change and Chicago PMI surprised to the upside.
The advance fourth quarter GDP reading was a headline disappointment, as a 0.1% contraction was recorded for the final quarter of 2012. However, the report was not as weak as it appeared.
- The biggest drag on quarterly growth came in the form of a 6.6% decrease in government spending. This was largely due to a 22.2% decline in defense spending which followed a 12.9% increase during the third quarter.
- The change in private inventories also subtracted 1.27 percentage points from the change in real GDP.
- Personal consumption expenditures, which constitute more than 70% of GDP, rose 2.2%, which was the largest increase since the first quarter of 2012.
- Business investment rose 12.4%, which was the largest uptick since the third quarter of 2011.
Mixed Earnings Unable to Derail Rally
The second half of the month saw the start of the fourth quarter earnings season.
- Most companies have beaten on the bottom line per usual, hurdling estimates that had been lowered in many cases by analysts ahead of the reports. Revenue growth is still weak, but similar to earnings, most companies have exceeded depressed top line growth estimates.
- Cautious guidance has been a common theme as many companies see headwinds in the first half of the year, although the default opinion is that the second half of the year should look better.
Q4 GDP CONTRACTION: ABERRATION OR WARNING?
About that US Q4 GDP miss (a 0.1% contraction instead of the forecasted 3.1% increase in GDP), while the consensus was that the contraction was an aberration, there was a darker side to the report.
First, UBS analyst Art Cashin, quoting Bloomberg’ Rich Yamarone noted:
The year-over-year change in real GDP was 1.5 percent. There has never been a time since measurement commenced in 1948 when the annual pace of real GDP has fallen that low without the economy ultimately slipping into recession. Sub-2.0 percent readings are historically the warning signal.
In other words, while the quarterly result may be a short term aberration, it means 2012 annual GDP has now flashed a new, historically reliable recession signal. This may be the most under-reported important story of the week.
Second, the blame for the surprise contraction, as noted above in the briefing.com quote, was a big decline in government spending, particularly in defense spending.
We could see more defense spending cuts of a similar magnitude for Q1 2013 given the currently scheduled sequestration due to hit at the end of the month.
TWO BIG QUESTIONS
So the two biggest questions investors face appear to be
- What’s driving markets higher to decade highs?
- In view of our answer to #1, is there still time for new long positions in risk assets?
1. What’s Driving Markets Higher To Decade Highs?
The consensus appears to be that risk assets continue to move higher on a combination of
- An ongoing relief rally after fiscal cliff deferred, which in turn helped feed…
- Technical momentum, which has brought the leading global stock indexes in the US and elsewhere to near decade highs. That in turn has whet traders’ appetite to test those decade highs
- Short Term Focus: Continued complacency about the biggest market threat, the EU, as well as the next austerity battle in the US. Looming unresolved deleveraging issues just aren’t a factor.
- All of the above allow the abundant stimulus printed cash to continue chasing yield to continue into equities and other risk assets, ongoing contraction and weak earnings be damned.
In sum, unless we get some new kind bearish catalyst, markets seem set to test those highs.
Beware however that they aren’t far. For example, the S&P 500 closed the week at 1513, only 4.3% below its all time high of 1552.87. That puts it at the outer edge of most 2013 forecasts, as we noted here.
2. In view of our answer to #1, is there still time for new long positions in risk assets?
There is no clear consensus, although there are many who believe the rally may have a few months yet. See here for one example.
Now read the follow-on discussion below.
What Could Halt The Rally?
Obstacles to the current rally include:
- Stronger technical resistance as major global stock indexes hit decade highs should leave markets vulnerable to profit taking, especially from those who entered late and are sitting on small profits. Combine that with exceptional bullish sentiment and an ongoing global contraction and we’ve a market primed for some kind of sell off once those highs are hit.
- Sequestration spending cuts scheduled for March could again send US GDP down for the second straight quarter and put the US into official recession. Good luck keeping markets at decade highs in that case.
- Payroll tax increases have hit consumer confidence, and should hit consumer spending, 70% of US GDP.
- The next EU anxiety outbreak: Outside of Germany, the major economies of the EU, including # 2 France, #3 Italy, and #4 Spain continue to contract. German PM Merkel is up for re-election in September, so her flexibility to continue obligating her voters to yet more bailout funds and a more debased EUR may be more limited until then. Cyprus needs a bailout soon, but German cooperation may be harder to get considering Cyprus has become a haven for German and other EU tax evaders.
- Japan’s current moves to weaken the JPY risk igniting a new race to debase currencies with their competitors like Korea, China, and Germany.
- Simmering geopolitical issues from Mideast tension (most likely involving Israel vs. Syria/Iran, though internal Egyptian or Syrian unrest are also possible bearish catalysts) or from Asia (Korean Peninsula or South China Sea conflicts, most likely involving China and Japan).
What Can Sustain It?
In addition to the ongoing mix of stimulus cash and yield hungry investors gone numb to the risks in the EU and elsewhere that have kept stocks and other risk assets rising regardless of weak growth, jobs, and earnings, what else is there?
GREAT ROTATION: MUPPETS IN, SMART MONEY OUT?
One explanation for the recent rally in stocks and other risk assets is that investors are rotating out of bonds into stocks in search of yield.
Businessinsider.com’s market summary for Tuesday noted here:
Skeptics are worried that stocks can’t continue this huge rally. But there are also plenty of strategists who see plenty of reasons for more gains
As John Hussman noted here, the whole idea of the great rotation out of bonds and into stocks is flawed because there are two sides to every transaction. If retail investors are buying, someone else is selling. Guess who? The smart money. For example, here’s a note from Seeking Alpha’s Monday market currents:
$55B poured into equity mutual funds and ETFs this month, according to TrimTabs, the largest amount since the epic peak of the tech bubble in February 2000. Corporate treasurers and insiders are selling, with a net $11.9B in share offerings and insider sales. (Emphasis mine) Garnering the bulk of flows in the ETF space are emerging market (EEM, VWO) and global stock funds.
So perhaps a more accurate name for the inflows into stock funds might be: the great rotation from bonds to stocks by the dumb money as the smart money sells. That sounds like yet another setup of the small investor, who will once again “assume the (long) position” at precisely the wrong time.
New long positions in risk assets are only for short term traders who can monitor positions closely.
For longer term investors we can’t make a case for a sustained uptrend, yet we would not advise shorting a trend that remains intact, or even selling existing positions, especially if they pay an income and you’ve significant capital gains. Instead, have some kind of stop loss, fixed or trailing, as partial protection.
Meanwhile, use the time to work up a list of new longs and entry levels for them.
For a variety of reasons, we’re watching the EURUSD for new short entries, and USDJPY for new longs.
If Most Of Your Wealth Is In USD, JPY, EUR, or GBP, Time To Start Diversifying
One trend that shows no sign of letup is the ongoing debasement of these currencies by their central banks. Japan’s central bank is the most recent one to begin active verbal or actual intervention.
See here or here for the most up to date guide for lay investors on simpler, safer ways to get that diversification for lower risk and better returns, than generally found in guides on forex or foreign investing.
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DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.