Readying the Next Bumper Crop of Money
It has now happened twice in the last few weeks that equities have blasted off, seemingly on nothing or next-to-nothing, before trading sideways for a couple of days in a moderately disinterested fashion. After the last episode, earlier this month, a final spike was followed by a series of somewhat-alarming slumps to erase most of the surge.
Bulls will take solace that the slumps only erased most of the surge, and not all of it, before another series of staccato jumps pushed the market higher.
There seems to be a growing belief that the monetary authority is behind the equity rally. The theory is that Bernanke has said quite clearly that the wealth effect from the stock market rally (a) has been very important and (b) was one of the things the Fed hoped to provoke with QE2; is it really that hard to believe the Federal Reserve is actually bidding up equities?
That is a really attractive theory, but unnecessary to explain the rallies. I also think that, although in 2008 the Fed cut some corners and bought assets that it was technically not allowed to buy, they took advantage of a clause that gives them much wider latitude when disaster is about to strike. It would be very difficult for the Fed to actually buy equity securities (and where would they hide them?) directly, especially if the world isn't actually ending. So I'm not on board with this conspiracy although I completely understand that it feels suspicious!
And we don't need it to explain the rallies. While there is no solid, good reason that stocks ought to rally, there are a number of plausible reasons they could rally, at least a little.
For one thing, there have been some companies beating earnings estimates. To be sure, in some cases these estimates were not very aggressive estimates, but Apple, Intel, IBM, Novartis - there is no question these were beats. The counterargument is that there have also been some big misses - Bank of America's $8.8bln loss leaps to mind. Cisco is laying off workers, and Goldman missed estimates. Some banks are doing well, but the ones that are beating estimates are doing so mainly on "decreased costs to cover bad loans," and there is only so long that game can last (especially with Europe about to explode). Then again, the financials are dead money anyway so arguably the market is right to focus on the Apples and the Intels.
The market also got a bit of a goose yesterday from the jump in Housing Starts to 629k, besting estimates. There's nothing particularly exciting about that in the context of where Starts are (see Chart), but it was a positive surprise.
If all of these housing charts look about the same, it's because they ARE all about the same. Down, then flat.
Counterbalancing this was the weak Existing Home Sales report today; home sales also remain in a range, but inventories rose again.
There was also the glimmering of a deal to cut the deficit and raise the debt ceiling. The outlines of the deal involve a tax hike of around $1 trillion and spending cuts of around $2.7 trillion over the next decade. Does anyone want to place bets as to which of these components will be rolled back next year? Hint: more people benefit from government spending than are hurt by paying taxes, and 2012 is an election year.
Now, I am trying to be generous about the couple of pops we've seen recently in equities, but honestly I'm not buying it. There are reasons, and more importantly there are lots of people trying desperately to inflate the importance of those reasons. But the road ahead doesn't get smoother, rather it grows bumpier.
Thursday brings Initial Claims (Consensus: 410k vs 405k) with the question of whether last week's surprising drop was the start of a return to lower levels or an aberration from a current run-rate closer to 420k. Economists are voting with their estimates that most of the drop to 405k from 427k, 432k, and 429k the prior three weeks represents real improvement. I think that's aggressive. Then we have the Philly Fed index (Consensus: 2.0 vs -7.7), with economists suggesting that last month's drop was a complete aberration and a bounce to near May's 3.9 is expected. But that would mean that the weak showing from Empire a couple of days ago was the outlier. For both of these data, economists are quite optimistic against pretty weak evidence that they ought to be. I'm all for optimism, but I don't see the sudden rebound they see.
We'll also be treated to more Bernanke chit-chat as he testifies on the Dodd-Frank anniversary. Seriously, we're going to celebrate anniversaries of legislation now?
Some investors say that the stock market could get a spur from Leading Indicators (Consensus: +0.2%). Stone & McCarthy are forecasting 0.5% as a result of the jump in M2. If it is the case that economists haven't incorporated the rise in M2 into their estimates, there may be a surprise, but market participants don't generally pay any attention to LEI because the component data - the indicators themselves - have already been released and therefore there is no new information.
But then there's the niggling detail of the European summit tomorrow, at which a grand plan for saving Greece, or the banks, or the Euro, or all three is supposed to emerge. I find the market's sanguinity about this summit to be incredible. The Greek Prime Minister has said that his country has sacrificed about all that it can, and that it needs money immediately. European banks and the ECB itself is at great risk if no agreement can be reached, and it isn't like it's an easy call. The EU is reportedly discussing using the European Financial Stability Facility to extend credit lines to tottering countries, but that implies there must be a triage debate going on: save Greece, or let Greece go and try to save everyone else, or try to do a little bit of everything. I don't hear anything that sounds like a solution, although surely tomorrow just after lunch we will hear of some grand plan (or a little plan, made to sound grand). I just don't know how they can get enough done before they all take off for vacation during the month of August. And I doubt very much that the market will hear the marvelous results it seems to expect.
Right about the time the summit releases a statement, bids will go in for $13bln of 10-year TIPS. The lessening of the cacophony around European bond markets the last couple of days - Greek 10-year yields fell 63bps today; Portuguese yields dropped 64bps, Irish yields 59bps, and Italian yields 14bps - lessens the need to de-emphasize Italy in the global inflation-linked bond indices. The when-issued (WI) 10y TIPS are yielding 0.48% right now. At that yield, I think there will be a pretty sloppy tail although as usual the issue will clean up well once the landscape becomes clearer. In the meantime dealers will be forced to hold a lot of the event risk, and right now holding extra risk is not high on the list of things that the head of the desk wants to do.
Finally, let's not forget that Thursday afternoon produces the money supply numbers, which have been positively buoyant recently. I expect that we will see some retracement, but the upward surge is now a few weeks old and it may be that no retracement is coming. That would be amazing, and frankly a little scary. The translation of M2 into inflation is not automatic, and it isn't instant. But it works exactly the same way that it works if there is suddenly a bumper crop of tomatoes so that there are now four times as many tomatoes compared to apples as there were previously. In that case, the price of tomatoes relative to apples will fall. If there is a bumper crop of money, then the price of money compared to apples (and gold, and copper, and coffee, and gasoline, and everything else) goes down - or, since we take the value of money to be constant, the price of those other things will tend to rise.
So this is one thing of which we don't want any more record harvests. And yet, at the same time, it seems the one crop for which the weather is always perfect. Whatever comes from Europe, it will include more money!