It Can’t Get Any Worse?
On Friday, shortly after the release of the payrolls report, we asked half in jest whether the time had finally come for the market to interpret bad news as bad news, and not as an opportunity to speculate on more central bank largesse. As someone remarked to us later: “You had to ask”.
Photo credit: Paul Cross
Apparently a slightly later released news item informing us that “factory orders hit the skids” was taken as a buy signal of the “it can’t get any worse” sort. Normally it is considered bullish when the market rises on ostensibly bad news – and very often, this is actually the correct interpretation of such market action. However, one must be careful when the fundamental backdrop is subject to severe deterioration. Readers may recall that commentary on the markets was brimming over with the same type of argument in late 2007 and early 2008. In October 2007, the market in its unending wisdom priced the shares of Fannie Mae at $73 for instance.
The point is this: Although as a trader one must always respect market action, especially in the short term, one must at the same time avoid to ascribe to the mass of market participants a degree of wisdom they simply don’t possess. The market very often “knows” nothing and frequently tends to get things completely wrong. If that were not so, there would never be any buying or selling opportunities, but plenty of those obviously exist.
The “Throwing of the Light Switch”
Anyway, over the weekend we caught up a little on our reading, and inter alia came across an article at Wolfstreet a friend had pointed out to us, which discusses the recent weakness in US manufacturing data.
What struck us was a comment made by the CEO of a manufacturing company in the context of the latest Kansas manufacturing survey release. As Wolf street notes, according to the survey, “the future composite index and the indexes for the future production, shipments, and new orders all dropped to their worst levels since 2009”. Here is what the CEO said:
“It feels like someone just flipped the switch to ‘off’ without any concrete reasoning,” one of the executives commented.
We immediately recognized that phrase – we have heard it twice before, and it has stuck with us ever since. In fact, we have mentioned it a few times when occasion demanded in past articles. The first time we heard this phrase was in late 2000, in an interview with the CEO of a telecom equipment provider. Paraphrasing: “It’s as if someone had just thrown a light switch – orders have suddenly disappeared”.
The next time we heard the phrase uttered was in late 2007 – this time in connection with a mortgage credit company. Ever since, we have filed it away as an anecdotal reference to the onset of recessions. And lo and behold, the phrase is popping up again in a district manufacturing survey.
Over the weekend we also looked at the latest EWI financial forecast (a monthly publication focused on US markets). In one section, the authors discuss the recent prevalence of individual stocks and corporate bonds crashing even while the market as a whole seems to be holding up relatively well. They also ponder whether certain corners of the bond market that are lately attracting funds from those fleeing the junk bond market for their perceived safety are really as safe as is widely assumed. The following turn of phrase stood out to us in this context:
“Our view is that Glencore’s “flash crash” will turn out to be one of many “light-switch” declines, and not just in commodity-related businesses. Already, a plethora of stocks in a wide range of industries have quietly crashed over 50% this year. The industries range from specialty retail (Aeropostale, -78%) to coffee (Keurig Green Mountain, -67%) to semiconductors (Micron Technology, -61%) and the Internet (Groupon, -61%).”[and further below, in the discussion of corporate debt]:
“As the charts of Glencore’s stock and its credit default swaps illustrate, the “light switch” moments are starting to appear.”
So there you have the same phrase again, only this time in connection with financial market behavior. As the accompanying chart shows, junk bond spreads are exhibiting a distinct similarity to how they looked just ahead of the most recent recessions and bear markets:
This synchronicity in this turn of phrase is of course not a coincidence – both the sudden disappearance of manufacturing orders and the “quiet flash crashes” of individual stocks from a wide range of industries coupled with persistent weakness in junk bonds, are symptoms of the same underlying phenomenon.
When we see the phrase about a “light switch suddenly being flipped to ‘off’” or a variant thereof popping up in reports about the economy or descriptions of market behavior, our ears are perking up. Admittedly, a sample of two is not exactly the mother of all sample sizes. Then again, anecdotal evidence is by its nature not statistical, but rather reflects the perceptions of people, in this case people intimately involved with the underlying businesses or markets.
We tend to believe that such evidence is actually important. Both in 2000 and 2007 we encountered this phrase shortly after the stock market (in the form of the S&P 500) had put in an all time high or a retest of an all time high. Even the very first time in 2000 it struck us as significant. The reason in this case was that only half a year earlier, there had been much talk of “equipment shortages” and even (hold on to your hat ) “DRAM shortages”.
When manufacturers see their orders suddenly dry up, something is very wrong in the economy already (note also, this tends to happen before any material effects on employment become evident. A sudden rise in initial claims would definitely cinch it). In light of this, stock market rebounds, even impressive ones, should be viewed with a healthy dose of skepticism.
Charts by: StockCharts, Elliott Wave International