Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Goldman Whacks
“I am shocked, shocked to find gambling going on in this establishment!” - Inspector Louis Renault (Claude Rains) to Rick Blaine (Humphrey Bogart) in Casablanca
There we were, with the Dow up six days in a row and six weeks in a row. It was Friday, and the troops were warming up for their usual mid-morning counterattack, the time when the scoffers and the doubters are routed and the benighted driven from the field. It’s great theatre, really, just about the best stuff we’ve had since the days of the Colosseum.
But then those spoilsport feds came along. As we all know, the First Axiom of the stock market is that when markets go up, it is because of the brilliance of our hard-working free enterprise warriors. When they go down, it is because of inept, interfering and ignorant government bureaucrats.
Friday provided another demonstration of that lugubrious truth. The early morning weakness from Asian and European fears had nearly dissipated – aren’t those places really far away, after all? – and our knights of the Holy Order of Dip Buyers had readied the field for victory. Then along comes the SEC with its noxious complaints. What’s this? Goldman (GS) hath sinned? We are shocked I tell you, shocked!
You know the rest, at least so far as Friday went. It seemed as if that gigantic Icelandic cloud of volcanic dust had hived off a piece of itself, and sent it spinning over the canyons of lower Manhattan. Chart takeoffs were canceled and flights of fantasy grounded. Can you believe the injustice of it all?
We don’t mean Goldman, either. We mean that after slogging through that tedious streak of niggling quarter- and half-percent gains every day, falling asleep watching that silly volatility index, we finally got a triple-digit gain in the Dow. And wouldn’t you know, the feds threw it right back in our faces with a triple-digit loss. So, so unfair.
Does it really matter? Maybe, but maybe not. It certainly provided the first indisputable reason for taking some profits that we’ve had for some time. Traders had gotten bored with all those tiresome stories about Greeks and jobs. What does that stuff matter to the big recovery that is so firmly entrenched in the minds of the media? Some of the CNBC reporters have taken to chanting the nostrum “this strong economic recovery” so often that it’s starting to catch up with such touchstones as “global growth” and “home prices never go down.” Think about it.
Handicapping the match, though, we’d have to say that unless we can be provided with a fresh batch of cage-rattling revelations, and quickly, the market is likely to shake off its angst for now and go back to basking in earnings beats. True, the outlook from Bank of America (BAC) – itself a possible target after Dutch bank Rabobank alleged Saturday that Merrill Lynch had pulled the same stunt as Goldman - on Friday wasn’t so sanguine. The outlook from the banking sector is apt to be more mixed than what is priced in. But that won’t matter to the massive amount of tech and industrial results slated for next week.
Yet it will matter to Goldman, a company that right now may well be the most infamous house in that most infamous neighborhood, Wall Street. One of the first things that came to mind of many a veteran on Friday was the name Drexel Burnham Lambert. Although the one-time investment bank never reached the cachet of a Goldman, Drexel was the terror of corporate America in the nineteen-eighties.
Led by junk-bond king Michael Milken, Drexel’s “confident financing” letters struck fear into the hearts and minds of CEOs, because those letters meant that Drexel was ready to finance a raid. Whether it was an LBO, outright takeover or just plain “greenmail” (when a company’s management pays a juicy premium to buy out the equity position of a corporate raider, in order to make it go away), it was a rough game.
Those tactics made Drexel the most hated name in corporate boardrooms, but its bonuses were the envy of the Street. While the Goldman name has few problems in the executive suite, on Main Street it may rightly or wrongly be the least popular bank in America.
When Drexel got caught up in what Milken called “technical violations,” (an old Street euphemism for insider trading), a battle ensued between the SEC and the New York State Attorney General’s office to see who could administer the biggest thumping to the firm. Unfortunately, the prisoner died during the process. How unsporting of them.
On the day that Drexel suddenly shut its doors, such was its notoriety that few tears were shed outside of the firm’s headquarters. But they began to flow quite rapidly after that, because Drexel was the market maker for the gazillions of junk bonds they had sold to financial institutions around America.
Those firms had relied on Drexel’s staunch assertion that they would always make a market in the paper. But when Drexel died, the market for that paper went into cardiac arrest and prices fell to pennies on the dollar. That’s right, fire-sale prices. Sounds familiar, doesn’t it? Exit Drexel, exit its clients, enter the undertakers.
For that reason alone, we wouldn’t expect criminal charges to be brought against Goldman. The SEC doesn’t have criminal powers, and although the New York AG doesn’t work for any federal agency, you can be very sure that neither Tim Geithner nor Ben Bernanke nor even President Obama are in any mood for blowing up the world’s premier investment bank at this particular time. Drexel II would not be a hit with the global economy.
On the other hand, it’s possible, even reasonable that some individuals get targeted. Quite frankly, a few perp walks would restore some balance to the Street. While most businesses are about making money in the end, the business of Wall Street is money, and therein lies temptation.
Consider the case of Alan Stanford. The latest embarrassing revelation is that the SEC believed that he was running a Ponzi scheme as far back as 1997, yet never opted to take action. He and Madoff are simply two of the more obvious examples of what happens when everybody decides it’s okay to turn your back (by the way, that leads us to wonder something else: the SEC may have the stomach now to go after Goldman, but does it have enough trading smarts yet?).
For those fatheads who still believe that there’s some kind of free-market good fairy out there who prevents these kinds of problems from happening, we have a suggestion. Seek out what you believe to be the world’s best casino, with the most enlightened management imaginable and the happiest, most devoted employees. Then try to sell it the self-governing concept of taking the cameras out of the rooms where the money gets counted. The roaring gusts of laughter might just be enough to break up that volcanic cloud.
Last week’s economic news was exactly the kind of thing that was widely predicted months ago. We couldn’t draw down inventories forever; sooner or later they had to be rebuilt and when that happened we’d get a lift in production statistics. This is what is happening now. Business inventories, for example, rose by 0.5% in February, the best jump in months.
Though the rest of the news is definitely mixed, the production rebound has largely turned the business press into drooling publicity flacks for the recovery. It’s being touted far more widely by the talking heads in the media than it is on the floor of the New York Stock Exchange.
The production news is indeed improving. The New York and Philadelphia Feds both turned in positive business surveys for April, with the former reporting a result of 31.86 (consensus 25) and the latter 20.2 (consensus 20, neutral is zero for both). While neither survey was quite perfect, the results did show broad improvement, especially in New York.
Those reports should bode well for the April Industrial Production report. The March data came out on Thursday and continued to show slow-but-steady improvement of 0.1%. That may not seem like much, but March’s balmy weather depressed utility consumption and thus the total; manufacturing actually rose by a pretty robust 0.9%.
That’s good, but lost in the excitement is that capacity utilization only crept up to 73.2 from 73.0, while for manufacturing it rose to 70.0 from 69.4. To put those numbers into perspective, consider that both readings are still below the cyclical lows reached in the last two recessions! Recovery yes, but “new normal” may be yes as well.
It was no secret that Easter came early this year, and that that would give a big lift to retailers. Add in favorable spring weather and a rising stock market, and it was easy to predict that March would get a boost. That was the case, as March sales rose an impressive 1.6% from the month before (revised upward from +0.3% to +0.5%), by 0.6% excluding autos, and by 0.7% excluding autos and gasoline.
That led to some rather embarrassing strutting about the recovery in the business press, whose ads and subscriptions, after all, do go up with the stock market. Put the numbers into perspective: the combined total for January and February of 2010 is still about seven percent below the total for the same period in 2008. Despite an early Easter, favorable weather and rising stock market, March 2010 was still 1.6% below March 2008.
Although the stock market is still rising in April, Easter is gone, the weather has gotten a bit cooler and the volcanic effect is here. Combined retail sales for March and April are going to appear less sanguine than March alone, and the jobs and consumer sentiment data are certainly pointing the way.
Sentiment, as measured by the University of Michigan, is falling unexpectedly and sharply in April, to a reading of 69.5 where an increase to 75.0 had been expected. That takes us back below the seventy level, and may have added to Friday’s sell-off in the stock market. Weekly claims also rose unexpectedly and sharply, to 484,000 where 440,000 had been expected and from 460,000 the week before. Both numbers point to fresh weakness in the labor market.
The previous week’s increase in claims had been largely written off as related to the Easter holiday, but the latest increase gave pause for thought. The unadjusted data showed a very sharp rebound of nearly 100,000, making the previous week’s adjustment suddenly look much more plausible. Continuing claims rose as well. Although the raw data did show a decrease in that category, the big new increases in initial and emergency claims (up an unadjusted 260,000 in the March 27 week) support the adjusted data.
None of this is as yet showing up in expectations for the April jobs number, still penciled in at a rosy 200,000 increase. However, the week just ended closed the measurement period for that report. If we see another elevated claims number come out of it this coming Thursday, expect to see the monthly estimates start to come down.
Housing is another category that appears to be about to disappoint overheated expectations. Mortgage purchase applications fell by a hefty 10.5% in the week ending April 9th, and a disappointed Econoday (two weeks ago they were hailing the rebirth of housing) complained that “much higher” mortgage rates were “a drag on housing demand.”
Nonsense. To begin with, the similarity between this month and last September, the first tax-credit expiration month, is remarkable. In the second calendar week of April, applications fell -10.5%, in the second calendar week (9/11) of September 2009, they fell by -10.3%. On April 9, 2010, the national average for 30-year mortgage rates was 5.17%; on September 3, 2009 the average was 5.08%. Both of these rates are very near multi-decade lows; they are no drag on anything.
After the big drop in applications the second week of last September, the numbers zigzagged the following two weeks until closing with a double-digit flourish of a gain during the expiration week. That’s probably what you should expect for this month, but there is one very telling difference: the level of purchase applications is running nearly twenty percent lower than it was in September of 2009.
As it did in September 2009, the Housing Market Index (homebuilder sentiment) rose back to 19. It was a bigger jump this time, from 15 instead of 18, meaning that this time it gets to be called a “break-out” instead of “sustained improvement.” You need to take this with a very large grain of salt: the neutral reading is 50, and after September the index subsided again. Since we’re coming into the warm weather, it may hold up better this time, but as Barry Sternlicht of real estate hedge fund Starwood Capital observed last week, “there is absolutely no money for building.”
That’s one of the reasons that single-family starts fell about 1% in March. Starts rose overall by 1.6%, but the increase was concentrated in apartment buildings (five units or more). Permits did rise by about 5% for single-family homes, though. An interesting feature of the data was that starts are down significantly year-over-year in the Northeast and Midwest, yet up strongly in the South and much higher in the West, though the latter declined from February.
As far as inflation goes, there seems to be nothing to talk about. The CPI rose by 0.1% in March, while the core rate was unchanged. Year-on-year, the core rate fell to 1.2%, which is lower than where the Fed would like it and inching closer to deflation. The PPI comes out next Thursday.
The trade deficit came in about expected, but exports slowed while imports increased. That’s going to be a negative for GDP calculations. Prices rose about 0.7% for both imports and exports, primarily due to rising energy prices.
Next week the economic calendar is light and the earnings calendar packed. The Leading Indicators come out on Monday, but the main attention away from earnings will come Thursday and Friday, with jobless claims and existing home sales on the former, durable goods and new home sales on the latter. Thursday will also see the PPI and the federal mortgage home price (FHFA) index. It easily looks to be the day of the week, so loaded with economic and earnings data that it may be too much to digest.
As for those earnings, every day is packed with major companies. Some of the highest-profile names include IBM and Citigroup (C) on Monday; Goldman Sachs and Apple (AAPL) on Tuesday; Qualcomm (QCOM) and United Technologies (UTX) on Wednesday; Amazon (AMZN), American Express (AXP), Microsoft (MSFT) and Ford (F) on Thursday; Honeywell (HON) Friday.
It's been tough to run StockWatcher of late. Being careful buyers, we try to get our positions at least started at reasonable valuations before we write them up here. In more normal markets, this isn’t too difficult, but when prices are going up nearly every day it becomes a challenge to find opportunities either to buy or to discuss.
With that in mind, we want to bring up network storage and Ethernet company Brocade (BRCD). It’s a play off of our recurring thesis that the migration towards more complex web-based structures – cloud computing, smart phones, tablet computing, and so on – means rapidly increasing demand for the suppliers to the movement, even within a framework of subdued overall industry growth.
The billions of iPhone applications and rapid growth of mobile video translates into lots more bits that have to be stored and shipped from central devices to individual users. Obviously that is going to benefit such companies as Cisco (CSCO) as well, but Cisco is so large it’s harder to move the needle.
Not so with Brocade, which has recently been the recipient of upgrades from various investment banks and even television guru Jim Cramer.
Here’s what you need to know: Brocade is selling into one of the hottest sectors in technology right now. They aren’t as big as Cisco, but with a market cap of less than $3 billion (compared to $150+ billion for Cisco), a little growth is going to go a lot further. At $6.35, we make the current price to be less than twelve times FY 2010 (October) estimates of $0.55; with the Goldman mess looking to be good for a bit longer as we go to press, you’ve got a good chance to pick it up for less than that.
The company’s Ethernet business missed on its last quarter, hence its decline to more affordable levels. Nothing we’ve seen indicates to us that the situation is dire. The Ethernet business is going to grow, sometimes a little more than the Street thinks, sometimes a little less, making for opportunities to buy and sell.
Above all, there is cash. It looks to us that the company should have at least sixty to seventy cents of free cash flow this fiscal year. That makes it attractive. Even with a slowing second half, we think that the stock can get to ten dollars by year-end. That’s a decent living.
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