August seasonality arrived and along with it a flurry of negative headlines to accelerate the decline.
We knew the markets were going to weaken in August and that seasonality arrived right on schedule. Economic headlines, weak earnings guidance and geopolitical events combined to accelerate that seasonal decline. When investors are worried they will find a reason to sell and there were plenty of reasons last week. The markets posted their worst loss of the year and the odds are very good there will be more declines in our future.
Helping to push us lower was weaker than expected guidance from Wal-Mart, Macy's, Nordstrom, Kohl's and Joseph A Bank.
Wal-Mart, the nation's largest retailer reported same store sales that declined -0.3% compared to estimates for a +1.0% gain. They missed the revenue target of $118.47 billion by nearly $2 billion. The CEO said, "We have seen customers both in mature and emerging markets curb their spending. We believe that environment is going to remain through the end of the year." Customers were buying underwear, socks and toothpaste instead of video games, tablets and TVs.
Nordstrom (JWN) reported same store sales rose +4.4% and well below estimates of 6.8%. They cut full year sales growth estimates from 3-5% to 2-3%.
Macy's reported earnings that missed estimates and sales fell -1% for the first decline in four-years. The CFO said, "We believe that much of our weakness is due to the health of the consumer."
Kohl's beat estimates on earnings but profits declined -3.5% and they lowered their full year outlook on sales and earnings.
The slowing pace of retail sales produced fears of consumer exhaustion. With 70% of GDP coming from consumer buying a sharp decline in purchases would push the economy closer to a recession.
Those earnings were offset slightly by good news and rising sales at Michael Kors and Dillard's. Those upscale retailers command a much smaller market share while lower end retailers WMT, Macy's and Kohl's have 20 times the annual sales and better exemplify the average retail shopper.
On the economic front a six-year low in the weekly jobless claims suggests employment is rising and that could put the Fed on track to taper in September. That sent yields on the ten-year treasury to a two-year high of 2.85%. Yields have risen +75% since the bottom in May. That is the largest percentage gain in a similar timeframe since 1962. Good economic news is bad news for the market.
Ten-Year Yield Chart
However, bad news was also bad news when it came from the Philly Fed Survey and the NY Empire Survey. The Philly Fed survey collapsed from 19.8 in July to 9.3 in August. New orders and employment fell sharply and back orders remained in contraction for the seventh consecutive month. The NY Empire Manufacturing Survey declined from 9.5 to 8.2 and new orders fell from 3.8 to 0.3 and barely above contraction territory. Backorders remained in contraction for the seventh consecutive month. The employment component for the NY area did rise from 3.3 to 10.8.
Industrial production came in flat for July after only a +0.2% gain in June. Consensus was for a +0.4% gain. The average for the last four months is -0.1%.
Industrial Production (Source: Marketwatch)
Consumer Sentiment for August fell -5.1 points from 85.1 to 80.0. The prior month reading was a six-year high and analysts were expecting another gain to 86.5. The -5.1 point drop was the largest monthly drop since records began in 1999. The present conditions component fell from 98.6 to 91.0 and expectations component from 76.5 to 72.9. Both were the lowest readings since April. The sudden decline in sentiment with the markets at new highs and gas prices fading is troubling for analysts. Couple the sentiment readings with the slowdown in sales at the mass market retailers and trouble could be brewing. The headline number for August equates to annual retail sales growth of only +2.0%. That is borne out in the weak retailer earnings.
Housing starts rose +5.9% from 836,000 to 896,000 for July but analysts were expecting 925,000. This compares to the July 2012 level at 741,000 so we should not complain about the weak gains.
If you look below the headline number the number of starts for single family homes actually declined -2.2% while multi-family starts increased +26%. Housing permits, a preliminary to starts, fell -1.9% for single family and rose +12.6% for multi-family. Single family activity has fallen to its lowest level since November. This was the second consecutive monthly miss for starts.
Rising interest rates is tempering expectations by builders and they are cutting back on the number of new homes unless there are existing orders. Nobody wants to get caught overextended again if the economy begins to fade. Plus, a smaller inventory of new homes means they can charge higher prices.
The economic calendar for next week is headlined by the FOMC minutes on Wednesday. There should be nothing new in the minutes since nearly all the Fed heads have been making speeches trying to talk up their position on QE changes. However, with the market expecting a taper announcement in four weeks every piece of Fed data will be analyzed under a microscope.
The home sales data will be updated on Wednesday and Friday and assuming there are no major surprises the market reaction will be minimal.
The Chicago Fed National Activity Index and the Kansas Fed Manufacturing Survey are two more bricks in the wall of worry over QE tapering in September.
Every piece of news last week was analyzed for its potential impact on QE. Analysts are pretty evenly split on whether it will happen in September or later in the year but almost all agree it will happen. A positive jobs number the week after Labor Day will be the nail in the QE coffin according to many analysts.
Another factor is the shrinking issuance of Treasuries. With the deficit for 2013 running in the $750 billion range compared to $1.2 trillion in 2012 the number of treasuries being issued is declining. If the Fed does not taper they run the risk of buying up the majority of the new issuance and dramatically impacting the treasury market. After the spike in yields last week that may be a good thing but the Fed has to be conscious of their impact.
Also, we saw in the international capital flows data on Wednesday that China and Japan, the two largest holders of U.S. debt were both sellers in June. Net sales were $66.9 billion and more than twice the $25 billion average over the prior two months. This was the largest sale of treasuries by foreigners in six years. This may be just a blip on the radar or it may indicate the increasing worry over the stability of the U.S. because the Fed is monetizing the debt. Think about it. How credible can a country be when the central bank is buying the majority of the debt at ridiculously low rates? Once the Fed halts QE it will be interesting to see if the overseas buyers come back to the market and at what yield they will be interested in investing. I would bet it is not 2.7%.
U.S. Securities Sales (Source: Reuters)
Hedge funds tripled their short positions against 10-year treasuries last week. According to the Commitment of Traders report (COT) the large speculators increased their net short position from 20,096 contracts to 66,432 contracts. This is the largest net short position since July 2012.
(Source Business Insider)
Bill Gross said last week, "We are in a war, a very bloody bond war." Also, "I think QE is changing and I think September is probably the time. We give it 80-percent and hereâ€™s the reason. We think the future fed policy will increasingly rely on whatâ€™s being called forward guidance as opposed to asset purchases or quantitative easing. To the Fedâ€™s way of thinking, that (QE) is a tired horse which has inflated asset prices but has done little to stimulate growth. In addition, according to some Fed numbers, it puts the Fed balance sheet at future risk with potential higher interest rates. This implies to us our reliance on future guidance and forward guidance which is a reverse type of twist from back in September of 2011. This is a reverse twist in which the fed wants the market to buy securities with the comfort of forward guidance and withdrawing the purchasing of 85% of the gross issuance of 20 year and 30 year treasuries."
My personal opinion is that the Fed will not change the QE program in September unless there is a very strong jobs number. The rest of the economics are simply too weak and nearly every Fed speaker has repeated over and over the taper will be data dependent. We will have another jobs report, GDP revision and Retail Sales for August before the September 17th FOMC meeting. Inflation also remains too low.
The Producer Price Index last week showed zero inflation in the headline number and only +0.1% in the core rate. Trailing 12-month core inflation fell to +1.2%. The Consumer Price Index headline number rose only +0.2% with a +0.2% increase in the core rate. The trailing 12-month core rate was only +1.7%. These declining rates of inflation should keep the Fed on hold unless jobs really spike higher.
The Fed may want to taper in September but the data does not support it. The market is acting like it is a sure thing and the Fed is going to slash QE immediately. I don't believe the Fed invested $2 trillion to push the market and economy higher only to jerk the rug out in September. The economy is just not that strong. Lastly, Bernanke has to be thinking about his legacy. He may not want to go down in history as tanking the market and economy just about the time it started to gain traction. There is far more risk in an early taper than there is in a few more months of QE. This is especially true because of the risk from the debt ceiling debate in September and the pending announcement of a new Fed chairman. The market normally declines on a change in Fed chairmen because investors don't know what to expect and the new guy may want to assert his authority and rock the boat as soon as he takes office. Analysts are afraid Larry Summers could do just that while Janet Yellen would maintain the status quo.
The precious metals market is in extreme rally mode. Silver rose +13% for the week and gold gained +4.8%. The reasons for the rally are many. The rise in violence in Egypt and news that Syria is hacking U.S. banks, newspapers and government websites contributed somewhat to the return of the Armageddon trade. The Syrian Electronic Army (SEA) hacked the Washington Post and readers were redirected to the SEA website. CNN, Time Magazine and the New York Times were also hacked. Various banks including Wells Fargo were experiencing repeated attacks. The SEA was more of a nuisance than a real threat but the headlines were the same.
The violence in Egypt is continuing with another 82 protestors killed on Friday and more than 800 arrested. Vigilantes at neighborhood checkpoints battled Muslim Brotherhood protestors as they tried to torch government buildings, police stations and riot against the general population. In the last week more than 800 people have been killed although the Brotherhood claims it was a lot more.
The official numbers only count the dead at hospitals and morgues. Hospitals and morgues are no longer releasing bodies unless the family accepts a death certificate claiming death was from some other cause like suicide, fall, illness, accident, etc, because the government does not want the "official" count of deaths from the military to go higher. In Muslim countries bodies are supposed to be buried immediately for religious reasons and families are accepting the "other than military" cause of death in order to comply with the rules.
Friday's battles took a serious turn for the worst as armed civilians joined the military in the conflict against the Brotherhood. Protestors claimed they were ready to die for the cause and began writing phone numbers with markers across their chest so the next of kin could be notified. Commercial buildings were set on fire by the protestors. This could easily spiral into a full civil war with a lasting impact. Dozens of churches were attacked and numerous Christians were killed. Morsi supporters have accused the Christian minority of siding with the military against the Brotherhood. Companies all across Egypt closed up shop and began evacuations of personnel. Analysts continue to worry the violence will spread to neighboring countries and possibly spark other rebellions.
The return of the Armageddon trade was just one reason for the spike in precious metals. The dollar fell sharply on Thursday after the unemployment claims. A falling dollar pushes commodities higher.
Many gold bulls announced last week they had exited their positions. John Paulson with a billion dollar position in the GLD sold half of his position. Dan Loeb said he closed his 130,000 share GLD position. George Soros said he closed his GLD position of 530,900 shares and all of his 2.67 million shares in the Gold Miner ETF (GDX). With the bulls leaving the game the shorts had nothing more to hope for. If you are short in hopes of a big downdraft when the bulls leave and suddenly you found out they left already there is no further reason to be short.
Gold and silver have been heavily shorted for most of 2013. Those shorts were getting killed last week. The low price of gold has caused a buying binge around the world. India said gold purchases rose +71% in Q2 and China's purchases spiked +87%.
Lastly the paper gold market is exploding. Paper gold is where you buy some instrument that says you own gold but you really don't. Banks and major dealers are leveraged as much as 100:1 on paper gold. That means they may have a ton of gold in their vaults and own hundreds of futures contracts but they have sold or pledged 100 tons. The paper gold market exploded over the last decade as gold prices soared. Investors may have a certificate saying they own gold and that was ok until the Internet started filling up with stories about empty vaults. More and more retail investors are demanding delivery of physical gold and that is squeezing the banks and dealers to buy gold to cover their short positions. I would not be surprised to see some big firm go belly up and that will cause an even greater buying panic.
Silver has broken above several levels of resistance including the 50 and 100-day averages. If this short squeeze continues next week it could really accelerate with a move over $24.50. Investors who have been putting off buying silver in hopes of getting a lower price have suddenly found themselves chasing the price higher. Those of us that have been buying physical coins every week are celebrating.
Gold has surged nearly $100 since the $1275 low on August 7th. Current resistance is now $1400 and $1420. Over $1420 the short squeeze should accelerate but $1475 is major resistance.
I have mentioned several times that China's government produced economic numbers are a farce. We now have proof of that fact. Christopher Balding, associate professor at Peking University's HSBC Business School decided to study the matter and found that China's GDP is overstated by as much as $1 trillion. He said through "significant and systematic irregularities" China is overstating their GDP by 8% to 12% or roughly $1 trillion.
Balding looked at the data between 2000-2011 and found that inflation numbers had been systematically manipulated in a way that distorted other data like GDP. Balding said, "If inflation data is not accurate, or is willfully fraudulent, as appears to be the case, it will impact many other areas of economic and financial data leading to large disparities over time. It is disturbing that a statistical body would so obviously manipulate and produce blatantly fraudulent data."
Everyone knows of the bubble in China's urban housing prices. We have seen those prices more than double over the last five years. However, China's reported inflation data for urban housing was a gain of only +0.53%. Rural home prices were pegged at a gain of +1.67% even though rural home prices are imploding as people move to the city and abandon their rural properties. To assume that rural home prices rose three times faster than urban homes is blatantly false. "Claiming that the housing component of the CPI grew by only 8.14% over the prior 11 years is nothing less than comical" according to Balding.
Balding claims the real GDP growth number in China today is closer to +6% than +7.5% as they reported. Now the real question is whether or not the market will care. I doubt it since most investors are headline readers only and don't actually understand economics.
JC Penny and Bill Ackman have agreed to an uncontested divorce. Ackman and JCP have agreed on a share sale method to allow Ackman to sell his 39 million shares. The deal was a condition relative to his resignation from the JCP board. Ackman will be able to register and sell a portion of his shares up to four times during the agreement. Each time he will have to offer more than 5 million shares. The agreement ends when his 17.7% stake falls below 5%. Under the agreement JCP can also impose blackout periods of up to 90 days. There cannot be more than three blackout periods in a 12-month period. The board could determine that a major share sale could interfere with company plans to sell its own shares, make an acquisition with shares or interfere with a "material transaction" and impose the blackout. Apparently Ackman is calling it quits on his attempt to restructure JC Penny and is willing to accept his losses. Reportedly his cost in those JCP shares is around $25.
There was very little stock news on Friday. For an option expiration Friday volume was light at 6.5 billion shares. Volume was 3:1 declining over advancing despite the averages flirting with positive territory late in the afternoon. There were 386 new 52-week lows and 70 new highs, 5535 decliners and 1252 advancers.
This was the worst week of the year for the major indexes and the odds are very good we are going to see additional new lows in the weeks ahead. The S&P closed at 1655.83 and slightly below the 50-day average at 1657.40. On three of the last four dips since November the 50-day average has been support and a rebound occurred. In June the S&P fell -58 points below the 50-day before a rebound appeared. In theory this should be support but there are extenuating circumstances.
At the risk of repeating myself twice a week for the next month there are some very negative headlines in our future. The debt ceiling debate will begin on Sept 9th when the House returns from the August recess. However, hardly a day goes by now that the coming battle is not discussed in the news. Investors remember how destructive the August 2011 battle was and that will cause investors to move to the sidelines ahead of the event.
The September 17th FOMC meeting will also be a serious hurdle. Regardless of how many analysts are saying taper or no taper there will still be a lot of angst ahead of that meeting.
Add in the potential for fund managers to take profits ahead of these market moving events and the next several weeks could be very volatile.
Noted bull Ralph Acampora has been predicting new market highs for months and saying buy, buy, buy. He changed his tune last week and is now expecting a -15% decline, which would take the Dow to 15,333. Since Ralph has mixed success in picking market direction for more than a week I would not normally put much faith in his prediction. However, he arrived at the number by analyzing each of the individual stocks on the Dow and predicting their future levels. He then calculated the impact to the Dow. I actually think this is a worthwhile endeavor. I routinely go through the individual Dow 30 stocks and try to determine market direction so I am familiar with the process. Today there are a lot of "heavy" charts. That means there are a lot of Dow stocks that have negative patterns and are currently in a decline or about to decline.
I am not going to predict a 15% correction but I do believe we could see a return to the June 24th lows. On the S&P that is 1560 and a decline of -149 points or -8.7%. The 100-day average is 1631 and the 200-day average is 1550.
Depending on the weekend headlines I would expect the S&P to rebound from the 50-day average on Monday but the rebound should fail and we eventually go lower.
The Dow lost -344 points for the week to close at 15,081. That was below the 100-day average of 15,103. That is a decline of -577 points since the closing high at 15,658 on August 2nd. The Dow has already broken both the 50 and 100-day averages and could easily retest the June lows at 14,551 for a decline of -7%.
Given the events in our future a decline of 7% on the Dow and 8% on the S&P would be easily justified. That is just a hiccup in the greater scheme of things.
The next most likely target for the Dow is 14,880 followed by 14,600 where I believe the decline would end.
Like the S&P, assuming there are no major headlines over the weekend, I would expect the Dow to rebound slightly from the 100-day average but the rebound should eventually fail. Nothing says we have to rebound but the bulls may find some added confidence by Monday. Volume will be very light so any buying could push it higher.
The Nasdaq gapped down on Thursday to close at -3606 and failed to venture too far from that level on Friday. The index used round number support at 3600 all day and traded in positive territory by late morning. Late day selling pushed it near the lows for the day.
Next level support is 3575-3580 and that is sure to be tested next week. Resistance is now the Thr/Fri high at 3620-3625 and then 3650.
The Russell 2000 declined -2.3% for the week and broke below critical support at 1040. The Russell is now in free fall territory with the next material support at the 1000 level. The 50-day average at 1018 has not been support on the last two tests but the 100-day average at 986 has produced rebounds. Once the Russell index broke 1040 support the trend should continue lower. Maybe not lower on Monday not over the coming weeks.
Russell 2000 Chart
S&P earnings for Q2 were up only +3.3%. However, bank earnings were up +27%. If you subtract the bank earnings the rest of the S&P saw earnings decline -1.2%. Bank earnings are done going up as mortgage originations are declining, the bond market is also in decline and onerous regulations are rising. That means Q3 S&P earnings could be even worse than Q2.
According to Birinyi & Associates the trailing PE for the major indexes is far in excess of what earnings are projected to be over the next 12-months. That even includes the fact that earnings for future quarters are still projected to be much better than past quarters. Q4 earnings growth is still projected to be in double digits. The last three quarters have seen estimates cut by two thirds from the prior quarter. Guidance for Q3 has been so bad the estimates are dropping like a rock but Q4 is still projected to be a double digit blowout.
The Russell 2000 small caps led the rally for most of the year and it has gotten way ahead of reality. Estimates for Russell earnings are so bullish that the Price to Earnings ratio (PE) is expected to drop by more than 60% if they come true. Saying that in another way, it means that earnings are expected to more than double over the next 12-months. Do you believe that earnings for small caps are going to double over the next 12-months especially with sharply rising interest rates? I seriously doubt it.
Birinyi PE Table
Scott Minerd at Guggenheim Partners said, "The trailing 12 month earnings for S&P companies rose only +2.4% for all of 2012 and another +2.5% for the first seven-months of 2013. That is the slowest earnings growth in non-recession years since 1998. Without renewed earnings growth, a continued rally in stocks driven by multiple expansion may not be sustainable."
Nominal GDP growth over the last year has been the slowest ever recorded outside a depression. This comes at a time when monetary stimulus is the highest ever recorded and is being practiced by central banks all around the world. Trees don't grow to the sky and QE will not go on forever. Eventually these central banks will have to stop injecting their crack cocaine into the financial markets and the withdrawal symptoms are going to be extreme and without the benefit of a movement limiting strait jacket.
Since 1952 the U.S. has averaged a recession about every five years. They typically come after stock market peaks. Will the end of monetary stimulus allow a new recession to form? With GDP already declining i would not bet against it.
S&P-500 Chart - Monthly
The markets today are more worried about how long QE will last than earnings growth. When QE ends and earnings growth returns as the primary market indicator the results are going to be ugly. While I am not a fan of QE I certainly hope cooler heads prevail at the Fed to keep the money flowing until actual economic growth and earnings appear.
The end of prior QE programs has produced serious market volatility. Why would this time be any different especially at our current market levels?
S&P-500 Chart - Weekly
If anyone does not believe the Fed has created this multi-year rally with its QE programs they only need to look at this chart. The red line is the S&P and the black line is the Fed balance sheet. What do you think will happen when that QE support is taken away? Chart is from StreetTalkLive.com
There is also the presidential cycle to contend with. In the second year of a presidential cycle the markets tend to decline because the administration is doing things that are not very popular. This is especially true of the second year in a second term. The last two years of the four year term are typically bullish because the party in power is doing everything they can to get reelected. The giveaway mentality takes over and consumer sentiment rises. The chart below is from TheChartStore.com via AllStarCharts.com. It is a composite of the last 21 presidential cycles dating back to 1928. For a larger chart click HERE.
Presidential Cycle Chart
Fewer and fewer stocks are holding up the market. The percentage of S&P stocks trading over their 200-day average fell to 81.8% and those over their 50-day average fell to 52.4%. Translation = market strength is declining.
Percentage of S&P over the 200-Day average
Percentage of S&P over the 50-Day average
In a 13F filing George Soros disclosed he had increased his shorts using puts on the SPY from 2,618,700 shares to 7,802,400 shares. These reports come 45 days after the end of the quarter so he could have even more by now.
The current bull market is in its 53rd month. The average since 1962 has been 48 months according to Birinyi & Associates. September is historically the worst month of the year for the market even when there is not a heavy calendar of potentially negative headlines.
The market collapsed last week when 10-year yields went over 2.7%. When the Fed halts QE the real yield on the 10-year will return. Historically that has been about 2% over inflation, which is currently 1.2%. If the Fed is successful in returning inflation to the 2.5% target that will push 10-year yields to 4.5%. Using basic math that will reduce the value of stocks by 30% or more. The bond market has done the math and they see the QE writing on the wall. Once stock investors begin to see the non QE value ratios returning the equity market will not be so attractive.
We need to be cautious with long positions and keep our stops tight. Traders can remain bullish as long as they are aware of the risks and plan accordingly.
Enter passively and exit aggressively!
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"The only thing to do when a person is wrong is to be right, by ceasing to be wrong. Cut your losses quickly, without hesitation. Don't waste time. When a stock moves below a mental-stop, sell it immediately."