Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Fever Patch
“It provokes the desire, but takes away the performance.” - William Shakespeare, Macbeth
The air is getting thin up here, make no mistake about it. Another big week of gains has left the major indices dangerously overbought and major resistance points are coming into play. While such factors are admittedly short-term and technical in nature, often playing out in unexpected ways, it does mean that the risk-reward trade-off is not moving in your favor.
Yet a week of reasonable earnings and rising prices has also left many managers with a bad case of performance anxiety. Despite the increasingly silly enthusiasm in the press, this rally has not been widely embraced as the real deal in many corners of the investment world. Although competitive pressures have left fund manager cash levels at the ultra-low levels that presage a correction, many hedge funds and traders have been skeptical all along. That’s led to a steady drizzle of dip-buying that stymies most selling.
Earnings are good, but not as good as their headlines. Excluding the financial sector, revenue comparisons between the abysmal first quarter of 2009 and last quarter aren’t impressive. The perception of the gains has been exaggerated by widespread underestimation of results by the Street, whether by design or dullness.
Still, there’s no denying the momentum that’s gripped the market. It’s the kind of wave that we’ve never seen end well, but getting in front of it can be costly too. The billions that John Paulson made by betting against the subprime market are well known, but there were many who identified the problem as early as 2005. A lot of money was lost betting against the sector in 2005-2006.
We’re not ready to say that the end is near, but we’re certainly due for at least a hiccup. We may get one, too, with the Fed meeting this week (see the Economic Beat below). Issues like the sovereign debt problem or China could also spook the market suddenly, though we think the critical moment for both are likely to come later in the year.
One item in favor of the momentum is that not everything has become overpriced. While many securities, particularly small caps, have come roaring back with a velocity that admits little room for error, many companies remain at reasonable valuations. All things being equal, it could take some time before valuations reach the place of nowhere to go. It might also take until the end of July for the second-half slowdown to become too obvious too ignore.
It’s worth noting that the current issue of Barron’s is packed with warnings on its front cover: “Tap the Brakes,” reads the banner, while blurbs refer to “Raging Small-Caps,” or advice from Streetwise columnist Michael Santoli to “Beware a boom in bullishness.”
We don’t read the weekly until after our own column is written, in order to avoid “cross-talk,” i.e. having its thoughts show up in our own, however unintentionally. We didn’t this time either, but the steepness of the current rally had us curious to see if their cover wouldn’t reflect some anxiety. Obviously it did.
In the maximum-perversity world of Wall Street, though, that’s more likely to give the rally another nudge than anything else. Another week of positive earnings comparisons with the pits of the first quarter of 2009 is hardly likely to derail the momentum. It would be typical form for the current move to last through the first week of May – but that’s only the end of next week.
There’s nothing written in stone about these things, of course. Many traders believe that the last legs of a momentum craze offer the best chance for easy money. But investors should beware – betting on fever is a dangerous game.
That earnings dominated the tape last week was no surprise, what with a 13- month rally entering the heart of earnings season. The eccentric part was that the market seemed to be as distracted by overseas economies as our own, with the Greek drama on center stage.
A real eye-rolling spectacle was the sight of traders trying to whip themselves into a holy frenzy of singin’-and-a-shakin’ over the housing sector. One could have predicted six months ago that regardless of what happened in the meantime, home sales would get some kind of bump in March and April as the expiration of the tax credit drew near. A sixth-grade class wouldn’t have needed a single recess period to work that one out.
Yet the stocks reacted to the event more like an excited third-grade class, sending the homebuilder stocks on a parabolic rise that left the Spyder homebuilder ETF, the XHB, up over ten percent in a single week. The sight of a stock going up ten percent in a week is one thing, but to see an entire sector go up like that is quite an unusual event.
Part of the reason for the increase is sector rotation: there’s a widespread belief that the homebuilders have lagged the market. It was true in some ways, because on a one- or two-year basis, homebuilders had indeed underperformed the S&P 500. That isn’t true anymore, as last week’s phenomenal speculative surge pushed the sector up nearly fifty percent since the beginning of last November. That put it even over the last two years and ahead over the last twelve months.
Those year-on-year comparisons made for wonderful-looking headlines, but at this point the builder stocks are for speculators only, and we’d start scaling out if you’re involved in the space. There were more clouds than sunshine if you looked at the picture carefully.
A rose may be a wonderful sight to behold, but if you were told that an enormous greenhouse with a windfall budget took a year to produce one rose, your celebration would be tempered a bit, don’t you think? New housing sales in March of 2010 were at an annual rate of 411,000, making it the third-lowest March since records began in 1961. The only two that were worse came last year, when it was believed that the world was ending, and back in 1982, which on a per-capita basis was far better than last month.
For many this is a bullish sign, as a friend reminded us. It can’t get any worse, right? And the cyclical recovery is coming, so it’s just a matter of time.
But the cyclical recovery is probably not coming in homebuilding, at least not in the time that prices have factored in. Ivy Zelman, who has been the best housing analyst for at least the last decade (she now has her own firm), warned that the recovery isn’t going to be here for another three years, in 2013. If the usual Street metric is to buy a sector a year ahead of its recovery, that makes last week’s rally about two years ahead of schedule.
We can point to a few things that support Mr. Zelman’s position. Consider that the greenhouse that nurtured this third-worst-ever March combined the lowest mortgage rates in generations, courtesy of the nation’s central bank, with a Treasury department paying people to buy a house.
Yet those payments are ending next week, and the central bank has now left the mortgage market. Home prices are still falling by almost every metric. The FHFA, which tracks government-backed purchases (over 90% of the market), showed another decline in February. The median price for new home sales fell in March. Prices as measured by the Case-Shiller index have been steadily declining, though seasonable adjustments had masked the effect. We say “had” because the Case-Shiller people themselves disavowed the adjustments last week, advising people to focus on the raw data instead.
One thing in favor of real estate, at least for the moment, is that we still have a very large financial sector, and once again it is looking for yield. A certain amount of complacency has come back into the financial world about making can’t-lose investments, leading to an environment that encourages throwing money around again. That can support pricing, and many feel that the Fed is indeed tacitly encouraging asset reflation. But trying to create demand with easy money is perilous – just ask the Japanese.
The Leading Indicators rose sharply in March, led as usual by the steep yield curve and the rising stock market. We’re not predicting a double-dip, but when the inventory rebuild levels off, many of the categories – factory workweek, stock prices, jobs – could reverse. It wouldn’t necessarily mean recession, but the fear of it would be bad for stocks.
As to the labor market, initial claims retreated to 456,000. This was supposed to be a good thing on the theory that the rise in the previous two weeks could be blamed on seasonal factors. Our take is that while the bulge may have been created by the calendar, the fact that people can think of 456,000 weekly claims in month twenty-eight of the recession as a reasonable level is evidence of widespread blindness.
The PPI produced its biggest monthly gain in some time, but this was largely written off by the market as oil- and food-related, two things that nobody really needs. In the case of food, the spike isn’t as production-related as apologists would have you believe. Energy prices are locked in tandem with the stock market (translation: speculation) and feed directly into food prices. One consolation is that when the stock market finally does correct, it will take oil prices down with it.
In other indicators of this “strong and solid” recovery, weekly sales are coming down from the Easter period and the money supply fell by $36 billion. Mortgage-purchase applications put in their expected rebound from the previous week as the expiration looms, but remain at subdued levels.
Next week has the all-important Federal Open Market Committee (FOMC) statement, the boys and girls that decide where interest rates should be headed. Given the sharp rally in stock prices, this makes for a trickier hurdle than usual.
We don’t expect any real shift from the FOMC, but the rebound in equities has to be an invitation to throw in a word or two about withdrawing accommodation, or some other such hint. That could trigger a massive run for the exits. Oddly enough, such a move could actually help extend the rally into the summer, as a drop that shaved off a few percent without causing more serious damage would probably embolden traders and dip-buyers. The verdict comes on Wednesday.
Home-price data from the Case-Shiller people are due on Tuesday, and it will be interesting to see if they have made any revisions on the back of their disavowal of previous seasonal adjustments. It could cause a quiver in the market. The Conference Board’s April reading for consumer confidence comes later that morning, and the market will be watching closely to see if it tracks the drop in the University of Michigan’s index.
The last day of the month is usually supportive of stock prices, but this one could be volatile. It’s the end of the week as well and has quite a bit on tap. Initial estimates for first-quarter GDP are due from the Bureau of Economic Analysis (BEA), along with the employment cost index (and perhaps yet another revision to the fourth quarter of 2009). The consensus estimate is for 3.4%. Any significant deviation from that will likely cause an explosive move in stock prices.
The Chicago PMI and the University of Michigan’s second April reading on consumer sentiment will cap off another week from the heart of earnings season. Expect the week to start slowly, but then move sharply over the last few days, led by the FOMC and GDP.
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