There was news last week of two negative indicators we haven't seen since the Lehman Brothers bankruptcy in 2008: the low level of the inventory-to-sales ratio – a key measure of future corporate profits – andretail sales falling, in February, for the third consecutive month.
We also learned the Atlanta Fed lowered its real-time 1Q GDP estimate to a moribund 0.6%, while jobless claims were back above 300,000.Lumber sales – animportant leading economic indicator – plunged, and technology bellwether Intel Corp (NASDAQ:INTC) lowered its revenue estimate for the first quarter by $1 billion on plunging PC sales.
On Thursday, March 12, just as we learned this discouraging news, thestock market saw its largest rally in months, with the S&P 500 jumping by 1.24% (25.31 points)….
Why is this not surprising?
In fairness, volume on the rally was pretty weak, with only 92 million shares of the SPDR S&P 500 ETF (SPY)trading on the day. In fact, "up" volume in the stock market has been weakening while "down" volume has been rising in the increasingly volatile early trading days of March.
During the first 9 trading days of March, there were 4 positive days and 5 negative days. The aggregate volume on the positive days on the SPY was 344 million shares while the aggregate volume on the negative days was nearly twice as much at 647 million shares. This suggests that despite some of the most bullish investor sentiment readings on record, stock market investors are increasingly keeping their hands in their pockets as the market flirts with new all-time highs.
In fact, after both the Dow Jones Industrial Average and the S&P 500 hits new all-time highs and the Nasdaq Composite Index breached the 5000 barrier for the first time since the Internet Bubble in 2000, the direction of the markets has been decidedly downward. Maybe the consistent stream of negative economic news is finally breaking through the thick skulls of investors.
The Dollar Delirium
The primary force moving markets now is the inexorable rise of the dollar. Last week, the Dollar Spot Index (DXY) broke the 100 level for the first time in the current cycle – as recently as last summer it was trading in the high 70s. In December, the DXY broke the all-important 95 level that breached a 30-year trend line. Technicians will tell us that it could rise as high as 125, a move that would be driven by increasing divergence between monetary policy in the United States and those in Europe, Japan and the rest of the world.
A likely interest rate increase by the Federal Reserve in either June or September of this year will only accelerate the dollar move, further rocking markets. The Japanese Yen just breached its own 30 year trend line against the dollar at 121, suggesting further Yen weakness lies ahead, while the Euro has collapsed from $1.20 at the beginning of the year to $1.05 today and is well on the way to breaking below parity ($1.00).
These currency moves will have enormous effects on stock prices, bond prices and commodity prices throughout the world for which investors are ill-prepared. Investors have been bidding up the S&P 500 while the companies in the index earn about 40% of their money from outside the U.S.Those earnings are going to get hammered by the strong dollar.
Commodity prices are going to remain under pressure due to the strong dollar, which will not only hammer the commodities themselves, but the stocks and bonds of the companies that produce them. Finally, dollar strength is enormously deflationary due to the fact that it depresses commodity prices.
Many pundits are arguing that the Fed should wait longer to raise short term interest rates. Regardless of what the Fed should do, I believe the Fed will start raising rates in June. While "official" inflation figures are weak, the cost of real-world goods and services continue to rise and the unemployment rate has dropped to 5.5%, making it increasingly difficult for the Fed to justify what are effectively crisis-era policies.
The deflationary effect of the a strong dollar, however, will suppress long-term interest rates even as the Fed raises short-term interest rates, leading to a flatter yield curve and possibly a recession. The strong dollar is also creating a drag on the U.S. economy by slowing exports (by making U.S. goods more expensive abroad) and pressuring corporate earnings. This is a dangerous brew for stocks that are already trading at extended valuations. Over the last couple of weeks, investors have started to show a bit of nervousness over these trends.
Beyond the Boom and Bust
Last week, stocks were extremely volatile and closed down for the third week in a row. After a big rally on Monday, stocks sold off hard on Tuesday. On Wednesday, markets took the day off (maybe they were too preoccupied preparing for Hilary Clinton's news conference) before rallying like fools again on Thursday after hearing a raft of terrible macro news. Then they began selling off again on Friday (only an end-of-day rally saved Friday from being a total disaster).
The Dow lost 108 points or 0.6% to close at 17,749.31 while the S&P 500 fell by 18 points or 0.9% to 2053.40. Both indices are now slightly negative on the year. The Nasdaq Composite Index lost 1.1% or 56 points to 4871.76 but is up for the year on the back of its largest component Apple, Inc. (AAPL), which at $123.59 per share is up 12% on the year though down from its recent closing high of $133.00 per share on February 23. All eyes are on the launch of the Apple Watch although the company would have to sell an extraordinary number of timepieces to move the needle on its financial results.
Next week, investors will once again hang on every word of Janet Yellenand the Federal Open Market Committee as it decides whether it will continue to be "patient" about raising interest rates. The rank absurdity of leaving the fate ofthe global economy in the hands of a bunch of former tenured economics professors – who have little real world or business experience – would be undeniable if markets did not buy into their every utterance. This is a group that has led the world economy from one crisis to another with its misguided policies, and wise investors know better than to heed their words and instead play the cycles of boom and bust they create. We are again at the peak of one of those cycles of overvaluation. Investors need to understand that and conduct themselves accordingly.