Taking the Market's Temperature

By: Michael Ashton | Wed, Apr 25, 2012
Print Email

Forget for a moment, if you can, the European drama - the falling of the Dutch government, the possible imminent failure of the French one, and the ongoing heated argument about whether Europe can stand austerity (and whether that means austerity for all, or just for the periphery). If you want to take the temperature of the U.S. market, we have other tests worth considering.

It was revealed yesterday that Wal-Mart is the subject of a U.S. criminal corruption probe by the U.S. Justice Department, resulting from allegations of bribery in its Mexican unit Wal-Mart de Mexico. The company had already announced an internal investigation, but a criminal inquiry is another matter. This is potentially a good test for the equity market. A bull market tends to shrug these things off; a bear market tends to accentuate them. On Friday, Wal-Mart fell $2.91 (4.7%); on Monday it dropped another $1.77 (3%). The early returns are that the market isn't taking it well.

The other proximate test is the earnings report for Apple, released today after the close. Apple reported great second-quarter numbers, handily beating estimates, but harshly revised its forward outlook lower. In bull markets, investors will focus on the current beat and speculate happily about how easy it will be to beat the lowered estimates. In a bear market, investors conclude that the beat represented sales pulled forward into the current quarter, don't therefore give the company credit for the beat, and push the price lower since the future earnings (which after all are a more important part of the current price than the current single-quarter's earnings) are expected to be weaker. Especially with interest rates (and therefore discount rates) low, this latter effect ought to be the dominant effect, but in my experience market reaction has had more to do with investor mood than analytics. With Apple, the shareholders form a virtual cult so expect to see many columns about how great it was that the company outperformed lofty expectations - and if Apple, already 13% off its highs over the last couple of weeks, cannot quickly stage a convincing rally (for more than one day!), it is a bad sign for the market as a whole.[1]

This is one way to take a market's temperature. In the same way the way a boxer takes a punch can reveal whether he has a glass jaw, the way a market takes a metaphorical punch (or even perceives that a punch has been thrown!) can reveal much about the underlying strength of the bid.

Whatever investor confidence is doing, consumer confidence isn't exactly buoyant. On the other hand, today's 69.2 print on the Consumer Confidence index also wasn't miserable: as recently as October, the index was at 40.9. Moreover, the critical "Jobs Hard to Get" subindex showed surprising strength, declining to 37.5 (see Chart, source Bloomberg) and giving hope that the recent Payrolls gains aren't as ephemeral as some had thought they may be. Still, as the chart also shows - we're a long way from a robust jobs market.

Jobs Hard To Find

On Wednesday, the Federal Reserve will meet for the second day and release their policy decision around 12:30ET. The only additional data point they will see is a Durable Goods number (Consensus: -1.7%/+0.5% ex-transportation). If the Committee was going to do something hawkish, such as reduce the "at least" time frame for the projection of low rates, the odds are certainly better after two months of pretty good (although partially weather-induced) data and with the stock market high and having risen for months. I doubt, though, that they want to upset the gentle growth they've recently seen, especially with tensions rising on the Continent again.

As I've pointed out recently, some thinkers inside the fed have begun to question the usefulness of a permanently-low rate regime and the risk of the steady rise in money, which has pushed core inflation higher in 16 of the last 17 months. But those are still peripheral thinkers, and even the hawkish-leaning policymakers seem willing to go along to get along. At the same time, I think the odds of a QE3 announcement, or even hint, at this meeting is quite small for the same reasons cited above.

Now, the members of the FOMC mostly arrived at this week's meeting by plane, and if any of them made their own reservations they may have noticed that domestic airfares have risen quite a lot recently. At least, I had noticed, and was not surprised to find that average domestic non-premium Y-class airfares reached a record $477 per ticket last month (see Chart, source Bloomberg, Airlines Reporting Corporation).

Y-Class Airfares

However, much of that record is due to jet fuel, which while near the highs of the last year is still 26% below the highs of 2008. The relationship between air fares and jet fuel is actually pretty interesting. From 1990-1998 or so, the gradual rise in air fares was decoupled from the jet fuel market, which was basically flat. After that period, but especially from 2004 onward, air fares more often moved in tandem with jet fuel prices (see Chart, jet fuel prices on right axis).

CPI-Airfare versus Jet Fuel

This point is actually made more powerfully by the following scatter-plot of the same data. Before 1998, air fares were essentially non-responsive to jet fuel prices. Since 1998, the variation in jet fuel prices explains 75% of the variation in the CPI-Airfares series (which is several levels down in the Transportation major group of CPI). Every penny rise in jet fuel prices causes a rise in air fares of about 0.09%.

Jet Fuel 1988-2012

The recent rise in airfares is somewhat beyond what would be expected from the recently-placid behavior of jet fuel, which raises the possibility that the increase represents other cost pressures, increasing profitability, or the influence of a general inflationary dynamic taking hold (also known as: our customers are expecting prices to rise, and we expect energy prices to resume rising, so let's go ahead and increase prices). Now, air fares only represent 0.75% of the CPI, so if the year-on-year rate of increase went from essentially flat as of the March CPI to +13% where it was one year ago and where the Airline Reporting Corporation data suggest it could be heading, it would only add 0.1% to headline inflation. But the ample variability of air fares tends to increase the salience of the information in our minds - which is to say that in our personal CPI calculation, we will tend to overweight the importance of air fares, like we do gasoline, because the volatility makes it noticeable, and makes it hurt more.

I doubt that it will hurt enough to turn the FOMC into a bunch of hawks, but - these also aren't the only prices that are rising visibly.


[1] By the way, I'm not necessarily a believer in bad karma, but if you are then you should be aware that at the end of the Apple earnings call the company played a strange saccharine song called "Happy." Read the story, and listen to the song if you must, here.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

Copyright © 2010-2017 Michael Ashton

All Images, XHTML Renderings, and Source Code Copyright © Safehaven.com