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The economic reports last week continued the trend of reports showing a drop off in growth. Worse actually since several of last week’s reports were just plain bad and indicated outright contraction rather than just a reduction in growth. The market held up fairly well until Friday as good earnings offset bad data, but by Friday the data and some iffy reports from Bank of America and Citigroup allowed sellers to gain the upper hand and push the averages down around 1% on the week. Throw in the passage of financial regulatory reform heavily influenced - or to be more factually accurate, written by - lobbyists along with a wet noodle wrist slapping of Goldman Sachs and one can see why the average investor might find the appeal of the stock market somewhat lacking.
I have been accused of incurable optimism and I suppose that is true to some degree but even I had trouble finding anything positive about the economic data released last week. The Redbook and Goldman retail sales reports were weak with the Goldman report showing a week to week drop in same store sales of 1.5%. Sales are still rising at over 3% year over year but unless we are about to see a surge in job growth even that anemic rate of growth seems unlikely to continue. The official retail sales report was also weak although I did find a few glimmers of hope hidden in the details. Most of the headline drop of 0.5% was due to a drop in auto sales and if you exclude autos and gasoline, sales everywhere else were actually up slightly. Furthermore, the negative trends were most readily apparent in - guess what - housing related retailers. On the positive side, sales at electronics and appliance, miscellaneous, non store (internet and mail order), health and personal care, clothing and department store retailers were all higher.
Business inventories rose last month at both the retail and manufacturing levels as sales were down more than production. This build in inventories is a bit of mixed blessing. A small rise such as this could indicate an increase in confidence although based on recent business surveys that seems unlikely. In this case jittery businessmen seem more likely to react to a rise in inventories with more caution. Retailers are already deep into discounting to clear out old inventory and certainly do not want to add to the problem. For production and hiring to continue on the current pace at the manufacturing level, sales will need to re-accelerate and that is in turn dependent on the jobs market which has so far done nothing but disappoint.
The trade report on Tuesday did show some positives but because it represented May data it really did nothing to change the perception about the current economy. Both imports and exports rose but imports more so the deficit rose. And for a change it was the non petroleum portion that made the difference. On the export side, capital goods were the leader while - no surprise - import increases were primarily in consumer goods. The rise in exports was particularly welcome since the previous months report had shown a drop. Again though, this report is old news and did nothing to refute the idea that the economy is slowing.
Manufacturing has led the recovery to this point but several reports last week pointed to a recent sharp slowdown in growth. Both the Empire State and Philly Fed reports showed broad reductions in growth with some components falling into negative territory. The Empire survey showed negative readings in unfilled orders, workweek and delivery times and a sharp drop in new order growth. The Philly version showed an actual negative on new orders in addition to the other negatives. Couple those with a weak industrial production report and falling capacity utilization and you get the sinking feeling that the one area of the economy that has been doing pretty good is peaking and may in fact be rolling over. The double dip crowd gained a lot of momentum last Thursday.
We also got producer and consumer price reports last week both of which showed drops in overall prices due to lower food and energy prices. Core prices were still higher and year over year overall still show positive inflation but the trend is definitely toward slower increases in prices. The recent public discussion of deflation and all its alleged attendant evils means these “deflation” headlines could have a negative impact on psychology. Indeed the consumer sentiment survey Friday may reflect some of that angst. Fears of a double dip recession can also be discerned in Google search trends which show a big recent spike in searches for the phrase. Of course the sentiment levels are back to those that prevailed at the bottom of the market and the economy last year so maybe this is as bad as it gets. Or at least that’s what an optimist would say.
One potential piece of good news came in the jobless claims report Thursday which showed a significant drop in new claims. Unfortunately, the drop appears to be a seasonal adjustment issue related to auto production retooling so it may not mean much. Auto makers usually shut down this time of year to retool for the new model year but for some reason GM hasn’t done that yet so we might get a catchup when they do. In addition, continuing claims were up big. We’ll have to see how this works out over the coming weeks but initial claims are at 429k and approaching the 400k level I’ve been aiming for all year. For now though, I think you have to go with the pessimists and assume the numbers last week were at least a bit of a fluke.
Stocks held up on good earnings early in the week and the consensus seems to be that the selloff Friday was a result of the accumulation of weak economic data through the week capped by the consumer sentiment report Friday. That’s a mighty convenient narrative for the bears but it doesn’t make a lot of sense to me. If weak data were the culprit, Thursday would have been the day to get more negative with all the weak manufacturing reports. I think the real reason for the sell off Friday was the passage of financial regulatory reform and Bank of America’s revelation in their earnings conference call that it would cost the firm some $10 billion in revenue over the next year. There are good reasons to think that a reduction in financial firm revenue is a good result over the long term but with so many saying that the bill wouldn’t do much harm the size of the reduction reported by BAC Friday probably shocked the hell out of some bank investors.
Frankly, I don’t know how much the bill will effect financial firm revenue or earnings and I doubt Bank of America does either since we don’t really know what all the rules are yet. Much of the bill leaves the specifics to the regulators. What should really scare the pants off everyone is that the estimate given by Bank of America on the conference call only encompassed the things that are already known. It seems a very good bet that the actual impact will be even worse. Not only that but considering the scope of the rule writing task the uncertainty surrounding the reform - like the health care version - is just beginning. We won’t have a clear view about financial company earnings for many quarters to come. Given the known loss of revenue and the uncertainty about regulator actions, there is no chance that financial firms will be increasing lending any time soon. So if you believe, as so many seem to, that more lending is the key to recovery, you had to get a lot more negative with the passage of “reform”.
The markets are now pricing in a pretty negative economic outcome and sentiment is quite negative. It would be quite easy to just join the crowd, sell risk and embrace the comfort of the bond market. It would be easy and I think most likely dead wrong. I’ve been doing this for some time now - parts of three decades - and more often than not the most profitable investments are also the ones that are the hardest to execute. For that matter, the ones that generate actual contempt and laughter are the ones that yield the greatest reward. We aren’t quite to the point where being bullish on stocks or the economy elicits guffaws but we aren’t far from it.
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