Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company All's Wells that Ends Well
"Oft expectation fails, and most oft there where most it promises.” – William Shakespeare, All's Well that Ends Well
What was it that Charles Dickens wrote – “it was the best of times, it was the worst of times?” That sounds about right for current days, as well as for that other time in 1933, back when the equity markets last enjoyed such a good run. There was no television then, so we cannot say whether or not traders beamed quite as joyously as they were doing at the cameras on Thursday night, but we haven’t seen such a burst of rapture in New York City since Grady Little left Pedro Martinez on the mound in the eighth inning of Game Seven.
A week of shuffling became a week of backing and filling, in market parlance, when mega-bank Wells Fargo (WFC) stunned the markets early Friday morning by announcing that it expects to post record first-quarter profits, largely due to its acquisition of Wachovia Bank and some brisk business in refinancing. That sent financial stocks soaring, the market roaring, and the pullback week became a record week instead.
Now is the time to arm oneself with a good stout stick. Not for protecting trading gains, for that you need only enough good common sense to know that trees don’t grow to the sky, and to take some money off the table. No, the stick is to be suitably prepared for the first members of “The Market is a Discounting Mechanism” chorus. As soon as they come onto the stage, we need to rush in and thrash them, lest they infect the multitude.
On Wall Street, the tail is at least as likely to wag the dog, if not more. Rising prices always find an excuse, but the narrative tends to come after the fact and more often than not is some self-serving rubbish as unoriginal as it is wrong. Traders make money by riding waves, not by explaining them.
Impressed by the majesty of the market move, we whipped out a few charts to find the last time the market was so overbought. The answer, we trust, will make you smile: the first week of April 2008. The favored refrain at that time was, “the market is a discounting mechanism.” Nearly every spring, the market becomes infatuated with second-half earnings. Last year at this time, fourth-quarter earnings were projected to rise 25%. Instead they fell by more than 10%. That’s a bit of a miss. Maybe what people really mean is, dat da market ain’t very good at dis countin’ business.
What really happens in most springs is a burst of sentiment. Of late, the speculative news flow has started to become more positive. Behavioral-algorithm trading programs pick this up and start to spit out buy orders. Other hedge funds pick up on the money flow and enter their own buy orders, causing more traders to jump on board. The tyranny of benchmarking obliges other asset managers to put some money into the game, lest they get called out by the consultants for falling behind. Shorts get squeezed, prices rise, the press comes calling, and nobody is going to say, “we’re all chasing the latest computer-generated move.” That might make the clients wonder.
Therefore, a narrative must be spun. The economy comes to the rescue, because in the absence of comet strikes or mass recurrences of bubonic plague, the economy simply cannot go down in every sector for very long. Things wear out and get used up, eaten, or otherwise disposed of. After inventories suffer the obligatory annihilation, more must be produced, and so there will be some positive data points. Using complex mathematical models, traders get out a ruler and pencil and draw a straight line from today’s data point into infinity.
The cruelest irony is that after a time, the market jockeys start to believe their own posturing. Thus we get such great new credos as the “new new” thing, the infinite Internet, home prices that never go down, covenant-lite financing, global growth, decoupling, and so on.
When reality intervenes, the jolt can be terrific. Last year’s spring fever blew right through the first quarter earnings season and all of its warnings, ostensibly because of those juicy earnings to be delivered in the fourth quarter (for reasons mostly unspecified beyond the mantra, “global growth”). It wasn’t until nearly the end of May that the markets started to sober up. We don’t have to tell you how accurate the discounting mechanism turned out to be.
All this is not to say that we are unhappy with the rally; far from it. We grimaced and bought, then grimaced and bought some more in early March, because we thought that the straight line connecting the S&P to the 500 level was based on fear rather than fact. We have said for some time that the inventory and production cutbacks were too severe and that some restocking would come to pass. That has taken place, and we believe that the market has returned to approximate fair value.
But the restocking is only that, a necessary bridge on the road of getting the economy to start to turn around, but still not a true change of course. That sets up the market for disappointment, because traders aren’t content to reach fair value and then sit back and read the newspapers for a couple of months. They want action.
It looks to us that a mentality of buying the dips is coming back into vogue, meaning that the current rally could keep going until most are convinced (or at least, afraid to be publicly skeptical) that it’s real. Right about the time that bullishness is crowned the new king, the economic data will disappoint again, the pain will be real again and the new king will be unseated once more.
The IMF and World Bank have both estimated global output to be down somewhere between one and three percent for 2009. Global trade is plummeting, and European manufacturing is falling off a cliff. Talking heads crow over the extra money consumers are getting from refinancing, while ignoring the money being taken out of the other pocket in the form of higher credit card rates, higher unemployment and frozen lines of credit.
The Chinese have taken advantage of cheap commodity prices to restock, and oil has crept back up again, to Russia’s great relief, causing stock markets in both countries to roar back. Naturally, China has been re-anointed the savior, and emerging markets are rapidly witnessing the rebirth of the infallible investment doctrine. Yet consider that most all of this spreading halo is due to a few American bank CEOs saying that first-quarter earnings would be alright.
Stock markets do rally before the economy turns. Lots of times. They get it wrong over and over, but it’s the only the last one that people remember. That last rally is also accompanied by lots of doubt, anxiety and skepticism, which doesn’t make it easy to differentiate it from the others, but if it were easy, we’d all be rich. We just read about a local couple buying a house because they figured houses have bottomed and “in four or five years we’ll make a nice profit.” They may be in for a surprise.
We believe that the bottom has been put in for financials, but the rest of the economy is going to take a lot longer to catch up. For that reason, the pivotal rally is more likely to come in the fall. If it comes early, well then, all’s well that ends well. But if it doesn’t, don’t say we didn’t warn you.
The data point of the week last week was of course the early earnings outlook by Wells Fargo. A very light calendar whose highlight was a set of gloomy Fed minutes left the market wallowing in the mire for most of the week, but the Wells announcement was like one of those magic bottles of tonic that used to be sold off the back of a tinker’s wagon. It cured everything.
It didn’t cure unemployment, though, which continues to rise. Weekly claims fell somewhat from the previous week, but were still at a very elevated 654,000 (in reality probably more than 660,000, as every week the previous week is revised higher). Continuing claims continue to soar, now at 5.84 million. Another week or two should put us up over six million, and we expect more layoff announcements as earnings season heats up.
The surprise data point of the week was the trade report, which showed a much smaller deficit than expected. Import sales plunged, which will make the GDP report more misleading than usual (imports are subtracted from GDP, so the dramatic cutback in spending on imports will somehow mean the economy is “better.” That’s some pretty cheesy lipstick on that pig). Exports rose, somewhat surprisingly, but the year-over-year change worsened.
Prices for imports and exports fell, at least when oil was excluded (export prices falling either way). The irony of oil prices is that demand continues to fall, but prices have climbed back up over $50 and are staying there. In a little echo of last summer, prices are being propped up by traders again, this time betting that prices will rise because equity prices are up. We would say that at least ten dollars of the current price per barrel is speculation.
There’s no belief that the oil supply-demand curve has improved over recent months, only a belief that extra profits can be made by playing high-beta sectors like commodities and homebuilders in a rising stock market. A real problem is the huge amount of oil that has been bid for storage. It’s offsetting OPEC cuts and is turning into a potential glut that could swamp prices at some point. The global economy isn’t doing well enough to absorb it, the springtime stock market rally notwithstanding.
Another sign of sideways improvement could be found in the report on wholesale inventories, which fell a big 1.5%. It was the biggest percentage drop in 17 years, created by slowly improving sales (less negative than before) and continued production cuts. Weekly chain-store reports continue to improve, but the ever-shrinking set of monthly same-store sales didn’t impress us. Despite favorable press coverage (the stock market rose, ergo the reports must have been good, right?), retailing looks to be quite weak.
Wal-Mart (WMT) sales, for example, came in below guidance. Outside of the deep discounters and the odd teen retailer (i.e., The Buckle (BKLE)), those stores still reporting – which aren’t many – were generally below expectations. Some retailers raised earnings guidance on the back of better inventory management, others talked hopefully about the calendar shift and better foot traffic, but while those factors may be a help, they aren’t going to offset the rapid increases in unemployment. We could get a deceptive picture next month, though, as the late Easter, delayed spring and pent-up demand could combine to give sales a transitory boost.
Traders were burbling with glowing remarks about housing on Thursday, yet the Fed doesn’t seem to think that the recent lift has any staying power. Its minutes made it clear that it still sees more risk to the downside in the economy and that the housing sector isn’t going anywhere soon. That “nice profit in four or five years” may be elusive. The Fed also remarked that existing home sales have suffered much less than new home sales.
Next week is as busy as last week was empty. Monday is a quiet start, with no major releases scheduled and a holiday in many European countries. After that we will get a bargeload of data on pricing, housing, sales and manufacturing.
Tuesday swings into gear with the Producer Price Index, to be followed by the Consumer Price Index the following day. Tuesday morning will also see the retail sales estimate for March (along with the February revision). Weekly chain sales have been creeping up in recent weeks, although the strength has been concentrated at lower price points. The focus should be on the ex-auto number.
General business activity for March will show up in the Federal Reserve’s Industrial Production report Wednesday morning, followed by its compilation of regional activity reports known as the “Beige Book” (guess what color the report cover is) in the afternoon. The April manufacturing outlook will show up in the New York and Philadelphia Fed regional surveys, on Wednesday and Thursday respectively.
The homebuilders’ end of the housing market will report the Housing Market Index, a measure of homebuilder sentiment, on Wednesday afternoon, followed by housing starts the next day. Both measures have been at or near stupendous lows of late, so any pickup at all has to be a realistic possibility. Even so, given the large inventory of homes on the market, the homebuilder segment may well lag a recovery in the broader housing market.
The spring selling season is starting to get underway in residential real estate, and the latest batch of mortgage purchase application data did see an increase. A likely scenario is that the combination of low rates and weather will lift home sales for a time, causing a great deal of excitement with Wall Street traders.
However, with unemployment continuing to rise sharply, a bump in housing could well be a passing phenomenon that does very little to ignite new home orders. This is going to be a slow recovery, and those who are trading homebuilding stocks with memories of 2002-2003 in mind are going to lose money. Purchase applications are still at low levels. Low rates are pulling in refinancing applications and the spring will pull in some buyers, but the labor market is going to keep a lid on activity. We may have reached a bottom in home sales, but the homebuilding recovery is still a ways off.
The impact of the stock market rally on consumer sentiment should start to show up in Friday’s consumer sentiment reading from the University of Michigan. The first of the April readings, it will go up against the deteriorating labor market. The previous week’s Conference Board reading appeared to have gotten no help at all from the stock market: it was a disappointingly small uptick from an all-time record low. By the end of last week, though, the press was talking hopefully about the recent rebound in confidence. It looks like traders aren't the only ones with spring fever.
On the well-worn market theory that if you liked something at a certain price, one must like it even more after the price has plunged (or is that what doesn’t kill you makes you stronger?), we present you with the redux of Kohlberg Capital Corporation (KCAP).
We wrote about KCAP last June, when the market price was around $12 and it was sporting a then-current yield of 13.7%. At Thursday’s close of $3.94, it’s now yielding 24.4%. You could have gotten it even cheaper, too, as we did back in the early days of March when the price fell below $2.
Like so many other companies, KCAP's stock price was decimated by credit fears. The company is a Business Development Company (BDC) in the leveraged loan business, which has not been the flavor of the month for some time. A bigger catalyst came in September when management balked at renewing its revolving credit line on terms it considered too disadvantageous. The usual fears of insolvency followed.
Since that time, the company has been amortizing its credit line, which doesn’t expire until September 2010, and continuing talks with lenders. We suspect that well before that time, the credit markets will have relaxed enough that the company can reach a respectable arrangement either with the current syndicate or elsewhere. In the interim, the dividend keeps getting paid, the default rate on its loan portfolio is less than one percent and the company recently observed that prepayment activity in its portfolio continues to be strong.
For what it’s worth, the company carries a book value of nearly twelve dollars. Yes, financial book values aren’t always what they appear, but the company has no asset-backed obligations. In the meantime, the Fed is pushing a great deal of money into the system and the credit system is slowly but surely thawing out. The market cap may be too small for many, but we think there’s money to be made here.
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