Farrell: What Monday Meant

The early word on the Street Monday was that the Shanghai Composite Index was plummeting because direct foreign investment in China fell for the 10th straight month. That could well be. Then Japan became the third straight G-7 country (following France and Germany last week) to announce better-than-expected GDP, with an annual advance of 3.7% for the second quarter. But that wasn't enough even though it was the first positive quarter in five. The Japanese market fell, but I think it was more than just failing to meet expectations. Part of the strength in the Japanese GDP report was from the export segment, as part of German and French strength was from the export side of the equation. Not every country can rebuild its economy from growing the export trade. Someone, somewhere along the line, has to be willing to import. I think the world markets are beginning to recognize that the key to the whole thing is still the American consumer, who is decidedly in a funk for a lot of reasons (unemployment, stagnant wages, a housing debacle, and limited access to credit, and a newly-found propensity to save and not spend).

So while the futures market was allegedly reacting downward to the fall in the Shanghai and the Japanese markets, I think Monday's decline was really predetermined by U.S. economic news at the end of last week. As I mentioned in an earlier note, despite the addition of cash for clunker car sales, retail sales fell last month. U.S. consumer prices also fell for the year ended July (but encouragingly turned back up for the last three months). A decline in retail sales and a fall in consumer prices alerted the world that the threat of deflation has not disappeared.

The stock market consequently had a very tough day on Monday despite reasonably good news. The New York Empire Index registered a surprising 12.1 vs. a -0.6 last month. This was the first time this index poked its head above zero since April of 2008, and it is up from a -38 in March 2009. If this were the only number you had, you could read across, say the folks at Capital Economics, and project an annual gain of 3% for GDP.

In the early afternoon, the National Association of Home Builders (NAHB), a closely-watched gauge of housing demand, scored an 18, which was the third month in a row this index has been up. JP Morgan, Bank of America, and American Express also reported that credit card delinquencies are improving.

None of it mattered, as the realization that a 50% gain from the March 2009 lows might not be completely supported by the economic data. I believe my pal Doug Kass is correct in saying that March marked a generational low. But a 50% gain from that level needs to have follow-on economic data that can generate earnings. Monday saw a flight to safety as the 10-year bond fell to a 3.46% yield even though we know the Treasury will announce this Thursday a whole slate of bond offerings for next week (expect a 2-, 5-, and 7-year auction). As we speculated in Friday's note, inflation-sensitive sectors might be the most vulnerable, and indeed financial stocks (-4.2%), material stocks (-3.8%), and energy stocks (-3.3%) led the way down. I have been expecting a 1/3rd correction of the market's advance for some time. Where I have been wrong is the level the correction would start from. If this is indeed the beginning of a correction, a 1/3rd retracement of the advance would bring us back to the lower 900's on the S&P against Monday's close of 979.

Tuesday we'll be looking at numbers for Producer Prices and housing starts. The general consensus for the PPI is a gain of 0.5% and about 550,000 housing starts. With the glut of existing homes for sale, we don't need a lot of new housing starts (unless you own the housing stocks.)