Oh, the power of misinformation – and the price that gets paid in the end. I can hardly believe it, but here we go again.
For the stock market, the highlight of the week was the Fed meeting, the rough equivalent of Sherlock Holmes’s dog that didn’t bark (“that was the curious incident.”) When the FOMC (monetary policy committee) didn’t raise rates, stock prices joyfully leapt higher, in a manner reminiscent of 2007. Back then, every Fed meeting at which the central bank did not actually cut rates was occasion for ecstatic joy in the equity pits. That may seem counterintuitive, but every momentum market knows how to create its own reality.
In the 2007 edition, each deferral of action only increased the market’s frenetic certainty that the Fed would simply have to cut rates at the next meeting. The slogan was, “if you wait for the move, you’ll miss the move” and so the market would rally in eager anticipation of rate cuts that would never come. When the Fed finally did cut rates in October of that year, it was the beginning of the end: The stock market peaked two weeks later and took another year and a half to bottom, losing more than half its value in the process.
As I wrote during the week, the last-minute notion that the Fed might instigate a surprise rate increase was typical of any number of rumors of the most dubious origin I have seen over the years. The point of them is to spread some fear while simultaneously taking the opposite side of the trade, an old wheeze that goes back to the days of Daddy Warbucks and the Roaring Twenties – and to William Shakespeare, for that matter. When Ronald Reagan was president, the market that so adored him would also periodically kill him (psst! – the President’s dead!).
The jubilation over the Fed not raising rates – an event thought to have zero probability three weeks ago – obscured the fact that once again, the bank lowered its forecast for the current year to 2.1%-2.3% inflation-adjusted GDP, for a year widely predicted to come in at 3.5% or more this past January. As usual, it maintains its forecast for next year, and come September or December, the bank’s staff will no doubt rinse and repeat the second part of the process of the last four years: Start lowering the forecast for next year while raising it for the year after.
A similar ploy came along Friday, when an “equity strategist” from Wells Fargo was on CNBC talking about “event risk” as being the “only threat” to the stock market’s invincible, inevitable, divinely-ordained (surely?) rise. As an example of big negative event risk, he gave the possibility that come July, China might announce a 6.5% growth rate for second-quarter GDP.
To quote Mr. John McEnroe, you cannot be serious. The strategist knows as well as I do that 1) the Chinese government announces whatever GDP rate it sees fit to announce; and 2) that a minimum floor for GDP of 7.5% had just been announced by China’s Premier, Li Keqiang. The chances that the country will announce 6.5% four weeks after its Premier said 7.5% is the minimum are exactly zero – but don’t be surprised to see more attempts to push this inside-baseball “rumor” in advance of the release. It’s a farce.
Exhibit Three: FedEx (NYSE:FDX), neé Federal Express. The company announced its quarterly results Wednesday morning and I was rather taken aback to see a jubilant Jim Cramer uber-gushing over them on CNBC. Had I been missing something in the economic data? Surely the market would have discounted a certain amount of traffic rebound in a quarter ending May 31st, especially since FedEx itself had complained during our seemingly endless (though not on the West Coast) winter about the weather’s deleterious impact on business. Perhaps something big was afoot.
So I looked at the company’s numbers and went through the conference call. The first thing I want to say is that the company’s performance was absolutely normal and that it executed its plan well. The second thing is that while management was perfectly straightforward about the numbers, all, I repeat, all of the Wall Street hoopla thrown about in their aftermath is an absolute, back-of-the-medicine-truck load of utter nonsense that would have sent The Catcher in the Rye’s phony-phobic Holden Caulfield charging off his cliff. Any notion that the company’s results reflect some sea change in either the economy or its own business is a lot of nonsense, ebullient stories notwithstanding.
FedEx quarterly revenue was up 3.5% year-over-year. To be candid, I consider that to be less than special for a rebound quarter. The revenue increase was on the back of 2% growth in total package volume. That’s right, 2% growth, the same 2% growth rate that the company had for its entire fiscal year, the same 2% that real GDP has been growing at for the last two years.
This lede from CNBC: “Shares of FedEx shot up to an all-time high after the company reported its quarterly profits more than doubled last quarter.” More smoke and mirrors. Profits more than doubled because the just-ended quarter had none of the writedowns and special charges that the company took a year ago. FedEx was completely straightforward about that fact in the first paragraph of its release, using a figure of $2.13 as the base comparison to the latest quarter’s $2.46. That’s a long way from doubling, but even so 15% growth is pretty good, isn’t it? Sure, except that $0.12 of it came from share repurchases (that the company also plainly disclosed).
That still leaves us with 10% EPS growth. Oh, one more thing: the company has eliminated 3,600 positions in the last eighteen months. In fact, what we are left with is the national formula for S&P earnings growth: take volume growth of one to two percent. Add price growth of one to two percent until you have revenue growth of two to three percent. Sack employees and buy back shares until earnings growth is to taste (by the way, lowering FedEx book value by about 5% in the process). Why, just look at that earnings growth – the economy must be doing great! Yes, it’s growing at 2%.
Here’s another fellow waxing ecstatic over the company’s outlook (the EPS outlook fell exactly into the middle of Wall Street estimates, so it was hardly a surprise). In fact, if you dissect the company’s outlook the outlook for earnings improvement is based not on an acceleration in revenue or volume, but on buying back more shares and operational efficiencies (“yield”). It’s also qualified on no increases in fuel costs and no slowdown in global growth. In other words, it expects to grow unless the economy slows down and/or costs go up. Cause for celebration indeed.
The FedEx story is no surprise at all, but an all-too-familiar one that gives rise to editorials like the one Stanley Druckenmiller (successful hedge fund manager) and Kevin Warsh (erstwhile Fed governor) penned this week in the Journal, “The Asset-Rich, Income-Poor Economy.” As the article says, “corporate chieftains rationally choose financial engineering—debt-financed share buybacks, for example—over capital investment in property, plants and equipment.” Or increased hiring, for that matter.
In the interim, the curiously closed world of the investment community whips itself into an ever great lather over asset prices. Not earnings or economic growth, mind you, but asset prices that rise out of any proportion to the first two until it’s taken on faith that the latter must be growing in a way we can’t see, or can’t see yet but surely will, or – in the latest artful dodge – really quite handsome in spite of their homely appearance. Most of the talking heads on CNBC seem content to play the role of cheerleaders these days (aided and abetted by nearly any equity mutual fund manager that can get onto the show), prattling twenty times a day (at least) over the latest “new all-time high.” Oh, for the days of the late uber-skeptic Mark Haines and his unflappable co-host, Erin Burnett.
The problem is not rising stock prices. It’s that when prices have been rising out of any proportion to the underlying fundamentals of real earnings, those prices inevitably do not rise to they sky, but return back to earth. And it won’t be the governors of the Federal Reserve that pay the price for that yawning crater, nor the money managers and their fawning acolytes who insist that the only logical future is to invest more into a market that must surely go up. It’s everyone else watching their 401K plan, their IRA plans and their jobs suddenly disappear at an age they can least afford it. But don’t worry – Janet Yellen says there is no bubble, and the Fed would never misinform us. As Marc Antony once observed, they are all honorable men.
The Economic Beat
The highlight of the economic data, apart from the lowered GDP forecast from the Fed, was the current manufacturing rebound, which owes as much to the warming weather as the earlier downturn did to the cold, though the latter got far more attention in the investment world. The lowlight was housing, where weak housing starts and declines in mortgage activity led to a wave of downgraded growth estimates for the sector.
Industrial production rose 0.6% in May, according to the Fed’s initial estimate, a decent rebound from an April not as bad as feared, being revised from (-0.6%) to (-0.3%). The year-on-year rate benefited from an easy comparison and will do so a bit longer, as production eased last summer: May 2014 shows a 4.3% annual rate (seasonally adjusted), with manufacturing up 3.6%.
The rebound was also reflected in the two regional Fed business surveys, from New York and Philadelphia. Both showed decent breadth of improvement and were above estimates, with New York coming in at 19.28, virtually unchanged from the May reading of 19.01, while Philadelphia reported 17.8 versus the month’s prior level of 15.4. My usual caution: the surveys report diffusion results, not volume of depth of activity. The higher the number, the broader is improvement, but the amount of improvement is unknown.
The key number this month was in the Philadelphia six-month forecast, which happens to be a very reliable contrarian indicator for short-term activity (you can see the chart here). Given the seasonal and weather factors, I suspect at least one more month of gain in this number and possibly two, depending on the strength of the May durable goods orders to be released next week. Then activity will undergo a normal cyclical pause, which may come as a shock to the perennial cheerleaders for the ever-elusive second-half rebound.
Housing starts were a clear disappointment, with the seasonally adjusted number showing a 6.5% month-on-month decline. What really matters is the comparison with 2013, since that trend will decide housing’s contribution to annual GDP in 2014. Through the first five months, starts are up 6.5% compared to the same period in 2013, with single-family starts up only 2.5%. To give you some context, starts grew at a 19.8% clip in 2013; my own estimate of 7%-10% for 2014 now appears to be in jeopardy – and I had been leaning towards the high end.
After mortgage purchases had a dismal week, dropping back to a minus 15% comparison year-over-year, the Mortgage Banker’s Association threw in the towel and lowered its forecast for home sales in 2014 to predict an annual decline of 4.1%. Interestingly enough, the investment market for non-performing mortgages is apparently now overheated as the reach for yield continues.
The report that might have sparked the most controversy – after all, the Fed behaved exactly as expected – was the latest consumer price report (CPI). The index rose more than expected, by an estimated 0.4% from April to May and leaving it 2.1% (1.9% excluding food and energy, which no one really needs) higher than a year ago. Janet Yellen’s take on the issue during the press conference was somewhat non-committal, characterizing monthly data as “noisy.” True enough.
The price increases in food and energy are more supply-related, as some difficult weather has led to diminished harvests, and geo-political tensions (along with commodity speculation) are largely responsible for elevated oil prices. Housing is definitely getting more expensive, however. The two main problems for the Fed’s is that first, its 2% long-term target (it uses a different measure than the CPI) wasn’t really expected to be hit this year. Not only that, it was supposed to be generated by higher levels of economic growth, not coming in the wake of a negative GDP quarter. The second problem is that there is a veritable host of monetary hawks who strongly disapproved of the recent quantitative easing, one that stands ready to scream and leap at any hint of inflation.
Looking ahead, next week brings a substantial slate of data, beginning with existing home sales on Monday and new home sales on Tuesday. Consumer confidence also comes out on Tuesday, though I consider those surveys to be soft and not especially useful, in addition to being backward-looking. The other big reports include May durable goods on Wednesday, released alongside the second revision of first-quarter GDP, and personal income and spending on Thursday. A string of housing numbers that are consistent with the weakness in last week’s releases, combined with another potential downgrade to the GDP estimate, might rattle the markets in what is often a difficult week for stocks (June post-expiration). The income and spending number will surely be looked at in light of the Druckenmiller piece.
A number of Fed banks will also issue reports during the week, beginning with the national activity index from the Chicago Fed on Monday and regional reports from Richmond (Tuesday) and Kansas City (Thursday).