Fumes


In case you missed yesterday’s comment (it came out quite late), a link is here. It was both lengthier and pithier than today’s offering.

On Tuesday there was a very mild disappointment from Retail Sales, which clocked in at +0.3% on the aggregate and ex-autos number along with a downward revision to the prior months. Economists blamed the weather, which is probably right…but it is interesting that no one jumped to blame the weather when Initial Claims surprised on the strong side last week. And I am not sure how the weather can explain the downward revision to December. On the other hand, the Empire Manufacturing number was on-target, so nothing in today’s reports should be considered a show-stopper.

And that includes the UK CPI release, which put headline inflation in the UK at 4.0% year/year. This produced lots of anguished cries for monetary tightening, but core inflation is only at 3.0%. Yes, 3% is much higher than the BOE’s target, but it has been in that range since early last year. To be sure, the BOE doesn’t want inflation that high, but the money supply (M4) is already contracting in Britain (two years ago it was +17.5%), and with unemployment around 8% there it seems unlikely that the BOE is about to get aggressively hawkish. The money supply contraction already means relative disinflation is in store for late 2011 or in 2012. Our quant model has a serious underweight in inflation-linked Gilts, which makes sense since the 10y UK II Gilt yield at 0.85% doesn’t give a lot of protection against the declining relative inflation implied by the tight monetary conditions.

I keep saying “relative” inflation there, however, because we must always remember that liquidity is fungible. Banks and companies can borrow in a rainbow of currencies in the global capital markets. If the Fed and the BOJ add enough liquidity, then prices in general will rise although currencies of countries with more-prudent monetary policies will be more likely to appreciate and help to keep inflation in those countries comparatively lower.

The UK merits a comment today because so little seems to be happening domestically. Obama’s budget will cause an ugly battle but doesn’t affect the day-to-day ebb and flow of the market. Indeed, not much seems to be affecting the daily ebb-and-flow. Today marked the 10th consecutive trading day in which NYSE volumes have not reached 1 billion shares. That happened only once all of last year, and not at all in 2005, 2006, 2007, and 2008. Year-to-date NYSE volumes are down 15% over the same period last year, and -36% compared to the average of the last five years. Perhaps the stock market continues to rally because “fumes” are lighter than air.

The problem with many kinds of fumes is that they ignite easily. While there seems to be no catalyst to send equity prices sharply lower, the diminished volumes suggest that there are not a lot of buyers committed to these higher prices. The real test will be when a good break comes and we find out if volumes are light because everyone missed it and is waiting desperately for lower prices to get in, or because no one trusts these levels or the market as a whole and investors will remain on the sideline cheering when prices decline. To me, the fact that higher prices do not seem to be resulting in swelling volumes suggests the latter is more likely. But for a test, we will need an ignition source and I see nothing immediately obvious.

It need not be immediately obvious, of course! The impact will be greater if it comes as a surprise, either because no one saw the particular event coming or because no one thought it would be significant. For example, something as innocuous as a 4% 10y note rate could in principle trigger a movement into bonds from stocks in asset allocation models. It would certainly be surprising if that was a big event. No one is looking for a jump in CPI, and a bad surprise there may serve as a catalyst no one was worried about. Obviously, I don’t know. I’m curious about what the readers of this article think are the most-serious potential catalysts for an equity correction.

Bonds probably don’t need much of a catalyst to keep going down. Weak data and Fed buying may keep them treading water, but tomorrow’s Housing Starts data (Consensus: 540k) is unlikely to trigger a rally even if weak – this is January data and it would be a bit surprising if it didn’t show signs of weakness. Besides, we already know housing is weak. PPI (Consensus: +0.8%, +0.2% ex-food-and-energy) isn’t a candidate because, after all, it’s PPI. Industrial Production and Capacity Utilization (Consensus: +0.5%/76.3%)? No one really worries about these series when they are at middling levels. And, while FOMC minutes from the January meeting will be released tomorrow, there isn’t going to be a surprise there.

No, the better chance is for Thursday’s CPI release. I expect we’ll have another day of fumes on Wednesday.

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Categories: Stock Market, Trading
  1. Dr George Franco
    February 15, 2011 at 5:00 pm

    All past recoveries included housing as a basis…this year housing will only get worse in terms of price and the number of foreclosures. We cannot remain a consumer driven economy long. The current recovery of the consumer is mainly from those who earn >$50K the average guy on the street is struggling and will do so…so I think the “kicker” will be future dispointting retail sales in the summer and fall

  2. Jim
    February 16, 2011 at 6:22 am

    As a regular reader of your articles ( which are great by the way) I thought I would respond to your request that readers nominate their most-serious potential catalysts for an equity correction. I can only see four possible areas that could result in a correction these being:
    1. Middle East crises – probably only if the existing Saudi Arabia regime looked like falling.
    2. European debt crises – however even if Spain should run into problems I see the Europeans resorting to the printing presses and this seems to have satisfied everyone to date.
    3. Poor US economic data. However given the current mood to see even poor data in a positive light I suspect it would have to be at least three major turns in indices before there would be much impact so perhaps – increase in initial claims+ slump in housing prices + falls in commercial property .
    4. China. Again I don’t see any one issue causing the market to fall but if they had increased inflation+ dumping US treasuries+ lower growth/political instability then you could see a drop in equity markets.
    Of course the scarier scenario is not that the markets fall but they continue to rise – not without an eventual fall (as all markets will) – but for an extended period of time. What then? Once the previous high is taken and say the Dow goes to 15000 points what happens? Would that be a good thing or not and would it matter that the gold price was $5000 or $1000 at that point? Given that so many US companies derive a significant part of their earnings from outside the US perhaps US corporations will get ‘rich’ (esp in US dollar terms) but the citizens remain unemployed and ‘poor’.
    The only answer to the questions is that I have no idea.

    • February 16, 2011 at 7:07 am

      Thanks for your thoughts! It always amazing to me that most people believe a higher stock market is “good.” This may be true if you’re near your distribution phase, but it’s exactly wrong for young investors and even for older investors it isn’t a good thing if the big rallies are punctuated by collapses since personal expenditures will tend to ratchet up with bullish markets and leave personal deficits in the wake of the crashes.

  3. Lee
    February 16, 2011 at 12:20 pm

    The surprise government shutdown – and it lasting awhile?

    • February 16, 2011 at 12:34 pm

      Wait, is that bearish or bullish?!? 🙂

      • Lee
        February 17, 2011 at 8:36 am

        Tradingwise bearish, philosophically bullish – but nothing really changes until we get rid of patronage and lobbying money.

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