What's Priced In?

This morning's Breakfast with Dave is another good one. Rosenberg discusses the ISM, car sales, housing, and most importantly "What's Priced In?"

Yesterday was an exclamation mark on just how much is priced in because ISM surged to 52.9 (see more below) and pending home sales soared 3.2% MoM (best level since June, 2007, no less) — though construction spending in June did dip 0.2% as declines in nonresidential and public construction overwhelmed the recovery in the residential sector. And there was also the news that global chip sales rose in July for the fifth time in as many months — by a ripping 5.3% (though still down 18.2% YoY). Not only was the stock market down 2.2% yesterday, but it was on higher volume to boot (+19% on the NYSE) — distribution days are never very good signposts.

As everyone knows, we have been very busy working hard to identify what the markets are discounting in terms of future economic growth and came to the conclusion months ago that the equity rally in particular was leapfrogging the outlook. It’s one thing to price out the recession, which is what a 20% rally suggests, but once you surge over 50% from any low the market is usually in year two of the recovery phase. Even if the economy does better than we think it is capable of, the reality is that the stock market has discounted a whole lot of growth — from our lens, two year’s worth. We can debate the macro outlook, to be sure, but the market does look now as though it is going to sit and wait for the fundamentals that have been priced in to come to fruition.

From a purely technical standpoint, which is beyond our purview but must be addressed since so much of the bear market rally was technically-based, a 50% retracement would imply a corrective phase to 840-850 on the S&P 500, which would imply that the market is back to pricing in a 2.0% growth trajectory for the coming year (precisely where the corporate bond market is in terms of its embedded outlook for growth).

Presently, it is still unclear whether or not we are going to necessarily undergo this correction — so many times in this bear market rally buyers have come in after the type of giveback we have endured, which has been just 3.2% thus far from the 1,030.89 interim peak on August 27. A break below the most recent low of 979.73 back on August 17 would probably be very meaningful in this sense, and again, what is different this time is that we just came off a week with some new information — Mr. Market is no longer rallying on good news. And, this is exactly what the tell-tale sign was back in 2002, when after a huge rally, the S&P 500 failed to rise on the day that the ISM broke above 52.0 as it did yesterday (when the March 2002 data were released on April 1 of that year) — that was an early sign to take profits because the market slid more than 30% over the next six months.
Similarly for the bond market, it would be critical for the yield on the 10-year note, now at 3.37%, to “take out” the interim July 10 low of 3.32% — if that happens, a break towards 3.00% is very probable.

Besides the VIX index being at its highest level since July 9, Baa spreads have stopped tightening and have widened back to levels seen a month ago. High-yield spreads have widened roughly 50bps from their recent tightest levels of just three weeks ago and are back to where they were at the end of July — when the S&P 500 was at 987. Keep your eyes on the credit market — it tends to “lead” equities.

ISM – A HISTORY LESSON

The ISM came in above expected at 52.9 in August, up from 48.9 in June and has risen now for eight months in a row after hitting bottom at 32.9 last December. This is the best result since October 2007.

The proverbial fly in the ointment is the fact that there still appears to be no sign of any renewed inventory cycle taking hold — in fact, at 34.4, the subindex is suggestive of continued de-stocking on the part of manufacturers. The last time the ISM production component was at 61.9, employment was at 54.3 (8 points above where it is today) and inventories were 48.1 (14 points higher than they are today).
It still seems as though the story is one of a rebound in auto production, which had sunk to levels that were well below even the depressed quarter-century lows in vehicle sales before the Cash-for-Clunkers gave spending activity a near-term boost.

Next question comes down to what is priced in. The fact that the equity market sold off is a clear sign that a super-sized ISM index had been priced in long ago even as the economists went ga-ga over the prospect that it was heading for a 50+ print.

The current landscape is eerily similar to what happened in late 2001 and early 2002 when green shoots were everywhere and the Nasdaq rallied over 40% and the S&P 500 by over 20%. Back then it was all about autos — 0% financing and a massive production runup: Auto sales soared at a 65% annual rate in 4Q of 2001 and in the first quarter of 2002 we saw auto production ramp up at nearly a 20% annual rate and that kick-started real GDP to a 3.5% annual rate. According to the consensus, the recession was over and a V-shaped recovery was under way. Well, it was half-right. The lesson learned was recessions that are followed by listless recoveries do not end bear markets in equities. We also learned that inventory improvement that is not backed by higher final demand results in an economic relapse — who exactly believed at the start 2002 when the ISM index was surging above the 50 threshold that we would finish the year with 0% GDP growth and the stock market struggling at new cycle lows? The consensus is early 2002 for fourth quarter growth was 3.6% and ended up f-l-a-t.

The reason we think it is important to talk about this is because it was precisely at this point in the brief ISM cycle in late 2001/early 2002 that the S&P 500 peaked — at 1,170 even though the index had three months to go before peaking out. And the decline was serious — down 34% and the falloff in bond yields to the lows was 230 basis points.

There's lots more in Rosenberg's four-page article about the ISM, Housing, the FHA, and historical comparisons. The most important take-away is "Keep your eyes on the credit market — it tends to “lead” equities."

I had similar thoughts in Corporate Bond Spreads Key To Continued S&P Rally.

I have been meaning to do a followup post on credit spreads, and will try and get to that later this week.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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