About That 1% Drop

It’s amazing the attention a 1% stock market pullback gets but I guess when it’s the first one in more than 3 months it gets noticed. More importantly of course are the reasons behind it and because the rally since the election has been all about hopes for lower taxes and a pronounced time out called on the regulatory state, yesterday’s decline reflected a true naivete that somehow things get done smoothly in Washington. Do they ever? Never but that said, markets have given themselves no room for error if the obvious policy initiatives get delayed by a pronounced amount of time.

Yesterday though was more than just healthcare vote worries. The retailer etf, XRT, closed at the lowest level since June 2016 on worries about the border adjustment tax that Kevin Brady yesterday repeated will definitely be part of the House tax reform bill. There is no question this sector was secularly challenged anyway but the industry is still the largest private sector employer in the country.

I do have to add this other possibility as a backdrop (that I keep harping on) but not a direct cause for the market weakness. That being the main 4 central banks that are or will slowly be removing accommodation this year. For the Fed, the stock market had a tantrum after QE1, QE2 and around the time QE3 ended. It plunged after the first rate hike and while it was bailed out on the 2^nd one on December 14^th because of Trump’s victory, the Russell 2000 is just 1 pt from the lowest level since December 5^th and the Transportation index closed at the lowest level since 2 weeks after the election. Now that we’ve got a 3^rd hike, the yield curve is now flattening which in turn is impacting bank stocks negatively. Looking overseas, because of ECB, BoJ and BoE QE and rate cuts, the Fed reduction in accommodation was offset. But, yesterday saw inflation pressures build not only for the UK consumer but also on the BoE to respond (but is paralyzed by Brexit). We are also just one week away from a 25% cut in ECB QE. And, the BoJ has started a slight taper even though they won’t admit it.

In terms of actual economic activity, as we heard yesterday from Ally Financial, we’re on the cusp of a hangover from the easy money generated post recession boom in auto sales. If you didn’t see this one coming, you never learned anything from the mid 2000’s or what the true concept of Fed easing tries to accomplish (encourage one to lever up and buy now, not later). After the sugar high, we’re still stuck with the leverage and less need to buy. Now we have an excess of cars coming off lease, a drop in used car prices which then creates a large pool of cars that are worth less than the loans on them and all eventually impacts the pricing and sales of new cars. And higher short rates don’t help either. Thank you Fed for never letting an economic cycle run its own natural course. This was so obvious an outcome to everyone but them.

Let’s add the bubble in certain parts of commercial real estate to the inevitable list of hangover outcomes which Fed President Eric Rosengren reminded us of last night. “We must acknowledge that the commercial real estate sector has the potential to amplify whatever problems may emerge when we at some point face an economic downturn…Commercial real estate capitalization rates are very low by historical standards.” Anyone who follows real estate already knows this and has known this for the past few years. The importance of the comments however is that it means that every bank who is in the real estate lending business is getting (and has been) a tap on the shoulder for regulators to reign it in. Try to get a real estate loan for that development project of yours, it ain’t easy now.

With the average 30 yr mortgage rate holding at near a 3 year high, mortgage applications fell w/o/w after last week’s rise. Purchases fell 2.1% w/o/w but remain up 5.1% y/o/y notwithstanding the uptick in rates and persistent rise in prices. Hopefully millennials and their first time household contingency are becoming more open to buying a home. We see existing home sales at 10am but that figure is a bit dated. Refi’s were down by 3.3% after 3 weeks of gains and are down 26% y/o/y.

After a few weeks of declines, Investors Intelligence said the number of Bulls rose to 56.7 from 53.4 and Bears remain almost non existent at 17.3 vs 17.5 last week. It is no coincidence that the extreme level of bullishness seen over the past month plus has coincided with a much choppier trading tape.