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Avalon Asset Management Company Hope Floats - and Floats
"It's been a long cold lonely winter." - George Harrison, Here Comes the Sun
There’s just something about the springtime, isn’t there? Two years ago our inaugural column was entitled, “Hope Floats.” It ran on March 23rd. One year ago, we wrote “Hope Floats Again” for the week of April 25th (see the archives). Now here we are with the third edition of floating hopes, and although we are less skeptical than the first two occasions, there is still reason to be cautious.
One reason would be that the supply of doubters in the current rally is finally beginning to dry up. Not that all are converted yet, but we noticed some bullish smugness creeping in by the end of the week. That isn’t a good sign. Murphy’s Market Law states that as sentiment builds towards harmony of outlook, the opposite becomes more of a dead certainty. We’re not quite there yet, but the air is starting to get rarified.
Another reason is quite simply that the economy isn’t up to it yet. The “demonic low” on March 6th (666 on the S&P) overstated how badly off the economy is, but it isn’t good enough either to sustain a genuine bull market. We’re in the region of fair value now, more likely on the high side. We think it would be excellent to go sideways from here and consolidate for a few months, but the movers and shakers of the modern market aren’t interested in flat charts. More likely we will over-reach, then over-react.
The good news is that last week gave some tentative credence to our hopes about what the economy ingested last fall, when the government decided to push a major bank off the roof to see what would happen (a very big splat and everybody running away. Wasn’t anybody in the administration old enough to have seen an episode of “Spanky and our Gang?”). In our economy-as-snake metaphor, we are hoping that it swallowed a water buffalo that makes a very ugly bulge for a couple of quarters, yet then returns to where it was, rather than blow up from the elephant that it might have eaten.
However, as the Pimco (the country’s best bond managers) people were quick to point out last week, where the economy had been going was not so great. Besides working our way through the housing decline and subprime mess, domestic demand had been largely stagnant for over a year and we had been steadily losing manufacturing jobs.
We are still fighting off a credit crunch that has small business owners keeling over (cf. Saturday’s Wall Street Journal, Credit Woes Hit Entrepreneurs). By the time the government gets around to slapping the credit-card companies around (if ever), we may have lost a great deal more momentum. To be blunt, we think that this is bad management by the lenders. One can’t expect staggering amounts of capital from the government on non-punitive terms – a structure we agree with, as necessary to restore the health of the system – and then run around dealing out harshly punitive terms and cutting off lending to customers with no more than a lot of terse “no comments.” That’s begging for payback, and management will have only itself to blame.
We don’t feel any warm glow either over the possibility of General Motors (GM) or Chrysler going through bankruptcy (n.b. - we don’t own any equity or debt of any carmaker). It’s not a great time for it. We understand that politically, the government doesn’t want to appear to be pouring money down a rathole. Yet the plain truth is that it is the government that is largely responsible for their dire situation. Sure, the carmakers should be further along building more fuel-efficient, high-quality cars, and we disliked the SUV boom as much as anybody (though the domestic consumer seemed to have loved them).
But as we heard a fellow on the radio last week say, “it ain’t that people don’t want to buy a GM car. People just don’t have money to buy cars.” Precisely. The auto industry (including the Japanese makers) is running at a staggeringly low sales rate of nine and-a-half million (domestically six and-a-half), a run rate that is something out of the nineteen-seventies and down forty percent from a year ago, because of the credit freeze brought about by the Lehman Brothers bankruptcy. You know, the one where the government stood aside and did nothing because “it might have cost billions of dollars?” That doesn’t look expensive anymore, in fact we’d say quite a bargain in comparison, and it wasn’t GM or Chrysler or Toyota that pulled that stunt, it was the feds.
There’s also a steady stream of people on the radio – mostly English, for some reason – cheerfully assuring us that all we need do is nationalize the banks, shrink them down, write off the bad loans and then kick them back out to the private sector again and we’ll be speeding along on the road to recovery. That reminds us of Karl Marx saying that all we need to do to get Communism working is the transformation of the proletariat. Simply put, short on details and in practice, quite literally an impossible, bloody mess. It was wonderfully arrogant to posit something that had never worked before by a man who was no more of a proletariat worker himself than the Pope.
We will go further and say that these nationalization proposals are simply the other side of the same coin of unbridled arrogance that got us into this mess in the first place. One assured us in dulcet, mellifluous tones that trust me, housing prices never go down, there are only fortunes to be made and no risk to be seen. The other now assures us in a similar key to trust me, it may never have been done before (not here, anyway) but it’s bound to work, I just know that it will. In fact, history is filled with examples of rulers trying in effect the same thing by abrogating banking institutions to the state, and it hasn’t worked. Perhaps they didn’t go to the right university.
The government is supposed to start reviewing results of its stress tests this week, and we’d urge some common sense there too. In the first place, as Bank of America’s (BAC) Ken Lewis put it last week, “what makes you think we haven’t already been through a stress test?” Banks have just come through the worst credit freeze since the Depression and the two worst back-to-back quarters of GDP in fifty years. They’ve been stressed.
It isn’t going to do us much good now to force the banks to protect themselves against something that’s already happened and put handcuffs and shackles on them going forward. Hey, have some show trials and throw some bodies in jail if you like, but the economy needs lenders now, not a bunch of frightened misers all trying to gouge the small consumer because the latter is too small to take them on. Remember the law of unintended consequences.
If the government doesn’t do anything to scare us in the meantime, the lack of news on tap for next week will tend to keep the markets moving in the same direction, meaning up in this case. Anything short of a death rattle by Alcoa (AA) on Tuesday will probably rally the markets Wednesday morning. Even so, we are already overbought and a pullback becomes more likely with each passing up-day.
We wish our readers a Happy Easter, or Happy Passover, as the case may be, and if you’re in the investment business, may you enjoy our one three-day weekend when everybody else works.
Last week we observed that the bar was set so low for most reports that beating them wouldn’t be unduly difficult. In turn, that could help the market talk its way past what was sure to be a dismal jobs number. That turned out to be the case, but a healthy dose of cheerleading was needed to put some of those reports into the “beat” column.
Perhaps the best example of what we mean was the report on factory orders. The crowd-pleasing 1.8% increase broke a six-month string of declines and beat the consensus of 1.5%. That was fine, but for one problem: they weren’t up 1.8%, they were up 0.08%.
The extra 1.7% came from a downward revision to January’s orders report. Originally reported as $351.9 billion, it was revised downward to $346.1 billion. If the consensus had been right, new orders would have come in at about $357 billion, or about five billion dollars more than the $352.2 reported. There’s a reason that these estimates are done in percentages rather than dollars. If the February data follows the recent pattern and are revised downward again next month, then even the percentage beat will disappear – but by then the market will have moved on.
Sideways economic movement is what we have been calling for, and it’s certainly better than another decline. But shipments fell again and inventories appear to still be too high, pointing to further declines ahead. If we revert to 2008’s feeble pre-Lehman pattern of up one month and down the next, that is an improvement from the current situation, but the markets may have promised themselves something much better.
We think that the production data were disappointing. Although the Chicago PMI was largely overlooked by a market that had quarter-end mark-ups on its mind, the reading of 31.4 was a new low since the 1980-82 recession. The ISM national manufacturing squeaked out a very marginal beat of the consensus (36.3 actual vs. 36.0 estimate, a meaningless difference), but we had hoped for something better. The new orders index did improve to 41.2, the first time it’s been over forty in seven months, and that led to much of the “less bad” talk that circulated through the week.
We’ll say it again: the surveys only measure changes from the previous month. In terms of total output, a reading of 40 can come in a month that has higher output than one with a reading of 65. Rates in the thirties represent severe declines, and simply can’t go on forever – some things get used up and have to be replaced. If the economy were really starting to move sideways, we’d have seen better numbers in either the manufacturing or non-manufacturing series. Maybe we’re just being too picky. Nevertheless, the report on the larger services sector showed widening declines from the previous month, with new orders dropping back into the thirties.
A scenario that’s plausible is that the economy is still deteriorating at about the same rate, but reloading some of its exhausted supplies. That would be reflected in results of modest improvement in the manufacturing numbers while the service economy tanked, dragged down by the worsening employment picture. Next month’s data might clarify this possibility. Backing that hypothesis is that the manufacturing survey reported some participants seeing positive signs, while the non-manufacturing report did not.
The news on housing was weak, but overlaid with the same veneer of “less bad” that was the flavor of the week. This was chiefly due to the uptick in the pending home sales index, which rose 2.1%. An odd bit of irony came from how the Case-Shiller price index and the National Realtors group reported the same data. The former showed steepening rates of decline in pricing (over 19% year-on-year), which the latter joyfully noted as an improvement in affordability. Yep, they’re getting more affordable all the time.
Construction spending was also “less bad” but really wasn’t: it fell 0.9% where (-1.5)% had been looked for. That sounds all right and sent the homebuilder stocks off on another rally, but private residential construction – i.e., homebuilding – fell 4.3% in February, with the year-on-year decline unchanged from January. That might explain why Toll Brothers (TOL) CEO and founder Robert Toll unloaded 200,000 shares of stock last week. Yeah, we know, there are lots of reasons for insiders to sell stock, but it’s an old saying on the Street that not one of them is a belief that the price is about to go up.
One might even go so far as to say that a record low in mortgage rates – down to 4.61% for a 30-year fixed loan – really ought to be inspiring more activity than a lousy 2.1% uptick in pending sales. True, that report is for February and so not up to the minute, but there has been no increase in weekly mortgage purchase applications. The perception and reality that prices are still falling, and that loans are hard to get, has yet to be overcome.
An area where the data really is less bad is in spending. Last week reported the best week of the year for chain-store sales, while the decline in motor-vehicle sales moderated ever so slightly. Well, if you can’t buy a car or a house, maybe you’ll buy something that’s cheaper. That’s still some help to the economy. As is usually the case, though, spending and consumer confidence don’t go hand in hand: the Conference Board’s consumer confidence survey showed almost no change from last month’s record low. The outlook for the future seems to be especially suffering from the crashing labor market.
Initial unemployment claims rose yet again – now there’s a report that regularly beats the consensus. The rise to 669,000 was well beyond estimates, yet worse was the news that continuing claims moved up to 5.7 million. We’ve now completed the circle we predicted earlier: five million jobs lost, and five million in continuing claims. The next stop is six and six: we should hit six million in continuing claims by the end of April, and six million jobs lost within two months at most.
That brings around to the jobs report. It was telegraphed by a poor ADP payroll estimate two days before, so by Friday morning anxious CNBC commentators were reassuring us that unemployment is a lagging indicator. Yes, one week of less-bad and the economy has turned the corner. It seems that denial on the Street is not just a problem in the executive suite.
There are a lot of ways to look at the report, starting with the estimated loss of 663,000 jobs. One can be optimistic and say that it wasn’t far above the estimate of 650,000. One can be pessimistic and say that given that January was originally reported as a loss of 598,000, then revised the following month to a loss of 651,000, followed by another revision this month to a loss of 741,000, we ain’t seen nothing yet.
One can be optimistic, like the floor traders who were pleased that February’s results were not revised downwards, but we think we’ll be cynical and wait a month or two. One could take heart that the unemployment rate of 8.5% – the highest in 26 years – was at least exactly what the market was expecting. Or one could be a little sour and note that when all the people are counted who have “left the labor force” (they haven’t reported to the unemployment office that they’re still looking for work, usually because when the benefits run out, they don’t bother coming by to get counted), or who are working part-time for involuntary reasons, the full-time unemployment rate is 15.46%. Ouch.
Yet we will agree on one thing: the economy does look like it’s starting to turn. We expect this, because the decline of the last two quarters was so severe that some amount of restocking is necessary. However, it will not turn on Wall Street time, and it will take a good six to nine months at least before it’s really pointed in the right direction. Then the GDP numbers will be up, but that will mask a much weaker overall level of activity.
In the meantime, unemployment is not going to be lagging indicator, but a boat anchor on the neck of the economy and consumer demand. Work-week data point to more weakness ahead in production. We reckon that unemployment will most likely start to truly lag sometime over late fall or next winter, but the market’s “discounting” (i.e., “false start”) mechanism will try to look ahead several times – and go into the ditch - before it gets it right.
That’s not to say that the Fed hasn’t primed the pump, or that the G-20’s trillion-odd dollar stimulus package (voted for, but not yet funded) is going for naught. It will all bring benefits in time. But global economies don’t move fast as Wall Street traders. Many a politician has learned most painfully that it isn’t hard to bring an economy or currency down: as the poet said, the descent to hell is easy, and the gates of the underworld stand open night and day. But to find one’s way back to the surface, “hoc opus, hic labor est” (that is the great task, that is the real work).
Next week is practically devoid of news. Aside from the usual weekly data, there really isn’t anything of note beyond the reports on international trade balances and prices (Thursday). Probably the main thing to take note of is that the U.S. financial markets are closed on Good Friday, April 10th, and the bond markets will close early (2 PM) on Thursday. Many European markets will be closed on (Easter) Monday.
On a side note, the relevant body (SIFMA) announced on Friday that it was eliminating seven of the twelve annual early closes for the bond markets. The one that surprised us was the elimination of the early close on the day before Thanksgiving. Given the long-standing tendency in the investment business to leave at lunchtime and not return until Monday, we wonder why they bothered.
The earnings season is supposed to officially kick off next week with Alcoa’s report on Tuesday after the close. You can put us into the cynic column on that one, as that company has missed badly so many quarters in a row that unless it files for Chapter 11, the stock will probably go up. A few retailers and shippers report during the week as well, but we will probably be trading mostly on technicals and momentum. The FOMC minutes come out on Wednesday, and for lack of anything else might provide some excitement.
StockWatcher returns in a later edition.
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