Avalon Asset Management Company Lexington, Massachusetts Investment Management
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“If it be now, ‘tis not to come, if it be not to come, it will be now.” – William Shakespeare, Hamlet
It’s April, and the markets are higher. That is the normal order of things, and is to be expected. We are not surprised to see the Nasdaq extend its winning streak to seven weeks, nor by the broader markets recovering most of Monday’s losses, nor by Alan Abelson (Barron’s) scoffing at all of it. That’s a flat month, seasonally adjusted.
What surprised us last week was the teapot tempest over the interrogation of Bank of America (BAC) CEO Ken Lewis by New York Attorney General Andrew Cuomo. We get Cuomo’s motivation, and grant that half of it is probably for the benefit of his own political ambitions. Despite the dutiful headlines by the press, though, with obligatory shock levels implied, we have to wonder if anybody really is surprised or even cares much about it, including whether or not Lewis found himself in a federal headlock.
If we understand things correctly, when investment bank Merrill Lynch was conveyed into B of A’s hands that fateful weekend last September, it was done with some federal nudging and promises of support. No surprises there, nor complaints. Things shouldn’t have been allowed to sink as deeply as they did, but at that point the grand rule of laissez-faire had to be junked before the free market could freely fall on Main Street and freely crush them both. Mr. Lewis, who tends to be thin-skinned, hasn’t been very reticent since then about his federal guarantee and pro bono publico benevolence.
It’s been known for some time that as Merrill’s positions worsened in last year’s brutal fourth quarter, Lewis had some second thoughts and said as much to the federal government. That doesn’t come as much of a surprise either: Lewis is not known to be generous at the deal table, and would probably have wanted at least a bigger and better guarantee from the feds. Most CEOs in his position would have done the same. He may only have intended his threat to walk away as a negotiating tactic, but it wouldn’t surprise us if he was indeed ready to walk.
Now it appears that either Paulson or Bernanke or both may have told Lewis, “over your dead body,” when he threatened to renege on the deal. Our first reaction is to say, “so what?” but upon patient reflection, we should add, “well done.”
Does anyone think it would have done the markets or financial system any good to have Bank of America walk away from Merrill at that point? Or to have said in September, “we wouldn’t have touched that dog without help?” Ken Lewis isn’t exactly a virgin at this kind of thing. He probably has more heads of former bank presidents on his office wall than anybody in America, the latest one being that of John Thain, Merrill’s former CEO. Lewis reportedly told Thain that if he wanted to be in line for the top slot, he had better withdraw his bonus request. As Lewis has so often done before, shortly afterwards he then sacked him anyway. Ken plays to win.
So if the top fed dogs had to bare some teeth and bark at Ken to back away when he wanted more, well, that’s life in the pack sometimes. For now, it seems to us that the main point of these revelations is to protect the tenure of Mr. Lewis and further the dreams of Mr. Cuomo. Just another day in Manhattan, we’d say. Our prediction is that in a year or two, B of A will end up kicking Merrill back out again at a big profit – possibly assisted by more federal arm-twisting.
There’s no need to cry for B of A’s shareholders, though, for they will come out well ahead when all is said and done. The cries of aggrievement will come from those players who were short Merrill’s stock and debt and were either late in doing so, or tried to stick around for that Master-of-Universe rush of watching it go all the way to zero rather than take the big gain and get out. Those cats will be the most scalded of all, and you can count on them to yowl to the press.
The brinksmanship game seems to be the current modus operandi as well with the U.S. domestic auto industry. The government has given Chrysler a deadline and let it be known that it will allow the company to be flushed into the bankruptcy sewage pipes. The strategy seem to pay off over the weekend when the UAW agreed to further concessions for the auto company, which has a May 1st deadline for restructuring.
For its part, General Motors (GM) has a deadline of June 1st to restructure or face a bankruptcy filing. We still don’t like the idea, nor are we keen on a Chrysler filing. The administration has been preparing the market in the hopes of not repeating the Lehman shock wave, but that only addresses one part of the problem.
Everyone seems to be fixating on their favorite tree in this game, because it doesn’t seem as if anyone is even trying to see the forest. The economy is in a deep recession. Putting huge employers like General Motors and Chrysler into bankruptcy is a very risky move, even if they are managed, pre-packaged situations. The authorities badly underestimated the fallout from Lehman Brothers – as did many other pundits – yet now seem to be confident that tipping huge manufacturers into bankruptcy in the midst of the worst recession in seventy years will work out just fine.
Let it be said right here that we do not share this confidence. No, not in the least, no matter how many business school professional ideologues – er, professors - can be produced to tell us how good the poisoned cup will taste.
There are problems with the domestic auto business. There’s a lack of fuel-efficient cars, although the American consumer wasn’t particularly interested in them until gasoline prices soared last year. That infuriates the left. The auto workers are heavily unionized, relatively well paid and have a legacy pension and health care structure that was agreed to in better times (sounds like the public transport unions). That infuriates the right. The autoworkers vote mostly Democratic since Reagan, which infuriates the right even more.
Yet the auto business is not on the brink of bankruptcy for any of those reasons. The entire American auto business, whether foreign-made or domestic, can barely sell a car due to the credit crunch. That crunch was precipitated by the Lehman bankruptcy filing that sent a massive shock wave through the credit markets, brought lending to a standstill and put global trade into a nearly paralyzed state. The government’s doing, not the auto industry.
The main reason that Ford (F) isn’t on the brink of bankruptcy isn’t because they have a flotilla of fuel-efficient cars or altruistic employees not interested in compensation. It’s because Ford went to the credit markets in a massive preemptive round of liquidity financing well before the credit freeze. The company mortgaged every last lug-nut and wheel while the credit markets were still working. They are burning cash like Chrysler and GM, but they aren’t on the brink of insolvency like those two because they stocked up on cash ahead of time. N.B. - they didn’t do it because the business was going so well.
We readily concede that if GM or Chrysler had been outperforming Toyota all these years, they would have been in better financial circumstances when the storm hit. We also readily concede that Japan would never, ever allow GM and Chrysler to build plants in Japan and not have their workers receive prevailing wage and pension benefits, as the South and Senator Richard Shelby have so gladly done for the Japanese automakers, who would all be bankrupt if they had had to survive on the sales of cars like the Prius.
Yet the fact remains that our automakers had been working at restructuring for years while trying to satisfy a number of different constituencies. It certainly could have gone better. It’s been years since Detroit wowed the world. The second-hand Buick we had in high school was the last GM car we ever bought, and we’ve never owned a Chrysler or the equity or debt of either GM or Chrysler. Even so, they might have pulled through but for that fateful weekend in September.
The last game of brinksmanship we will mention is the one being played by the bulls and bears in the stock market. Although the rally is supposed to be climbing over a universe of skeptics, it seems to us that the bull camp has been growing much faster of late.
In favor of a longer rally are momentum, the springtime and the residual skepticism in the market. Yes, there are some green shoots, but the current valuation already reflects them. We don’t see the economic outlook as being strong enough to sustain a continued run-up in valuations.
However, the aggressive trader these days is going long and buying dips. That is significant, because the traditional long-term buyer is still mostly watching and waiting. That gives the smaller camp more leverage in the short term, but makes the foundation of the rally more ephemeral. You can date this rally, but don’t marry it.
On a different note, we note that our favorite Wall Street Journal columnist and “MarketBeat” dean David Gaffen appears to have left the paper. He will be missed.
A week mostly characterized by earnings that “could have been worse” did offer up some data on housing in an otherwise sparse week. The bright spot was supposed to be sales of new homes for March. As has been the case for earnings, the bar was on the floor and so the result beat consensus – with upward revisions for January and February! Time to buy the homebuilders for God only knows which time.
The problem with that logic is it overlooks how difficult it is for new home sales to possibly get any worse. The new home sales total for March is the lowest total for the month ever recorded, going back to the beginning of the series in 1963. The population of the country is more than fifty percent higher since that time. In fact, the only months that the March total tops are the credit-frozen months of the winter that just ended (some of our Minnesota readers may dispute that latter observation as premature).
An analysis of the sales data is revealing. Despite the lowest mortgage rates ever recorded, sales of new homes still fell on a seasonally adjusted basis in the Northeast and Midwest. They were level in the South, where about 60% of sales occurred, and the West showed an increase. Sales were concentrated in the sector of completed-construction homes with a price range of $150,000 - $200,000.
In other words, some bargain-hunters are indeed picking up some of the empty-home glut in the South and West. Here in the Boston area, the local press is writing up fire sales in the Ft. Meyers, Florida area, where intrepid Red Sox fans are scooping up landing areas near the baseball team’s spring training location for twenty and thirty cents on the dollar.
Before you start applauding the free market at work, though, listen to that banging sound up the street. It isn’t the snowbirds, it’s the local bank branch office hammering extra boards over the mortgage-lending window on the off chance some lunatic wants to come in and borrow money for a home. It may come as a surprise to some on Wall Street, but when a bank lets go of another foreclosure at a big loss, it doesn’t put on a dinner to celebrate the free market at work. It strengthens its resolve not to put any more money into an area where prices are falling every month.
Existing home sales fell in March at a rate (-3.0%) that was below consensus, while February sales were revised further downward. We thought that the rate might have been flat or even higher, given the continuing falls in mortgage rates and prices. Prices rose a few percent, apparently due to mix, and that provided a reason for the stock market to have another drink. The rate of foreclosure sales rose to fifty-one percent, a new high, despite the partial moratorium on foreclosure sales that is now being put aside.
We think that the rate speaks to what real estate financier Donald Trump observed on Thursday, namely that regardless what the banks may say on television, they don’t want to give anybody a loan, no matter how much money or income they may have. Trump is given to exaggeration, of course, but bank analyst Meredith Whitney echoed his remarks when she remarked that liquidity is leaving the banking system at an accelerating pace. It’s a problem. Banks are always reluctant to lend into a recession, the current one is one of the worst ever, and few want to volunteer to carry more money into the radioactive sector.
Given that the banks will probably have another round of losses to report this quarter, home prices are still falling, and the shoe is still to drop in commercial real estate, the logical conclusion is that consumer and real estate lending standards will continue to tighten for at least another quarter, if not two or three. The combination of lower prices and rates during the spring selling season should firm up sales for a time, but we fear that another period of weakness looks difficult to avoid.
Durable goods orders were reported to have fallen 0.8% in March, a drop less severe than the (-1.8%) prediction, but that improvement was tempered by the downward revision to the February data. Once again, the markets cheered an improvement that never happened: based upon the original February data, durable goods were expected to fall to a pace of $162.6 billion. They fell to an estimated $161.2 billion, a drop of 2.6% from the February report. The data were in fact worse then expected, but reported otherwise.
Looking at weekly data, mortgage purchase applications continue to fall while refinancing applications continue to rise. We will keep repeating it: the lower payments will help consumer budgets, but will not be enough in aggregate to offset the decline in consumer credit lines. The market will ignore the fact of the latter until it isn’t possible anymore.
Initial jobless claims rose back to near the previous trend line, while continuing claims rose to a new record of 6.2 million. At the moment, it looks as if seven million in continuing claims isn’t too far off. We seem to be losing jobs at a stable rate. Weekly retail sales softened somewhat, but the tailing off from the Easter effect complicates matters. Sales have certainly lifted from the fear levels of January and February, but further improvement must face credit and employment headwinds.
Oil prices fell at the beginning of the week, when the fall in equity prices took out the economic recovery premium, but regained most of the decline by the end of the week. Although soaring inventories in crude and distillates are signaling the exact opposite, speculators keep throwing money at the sector as a bet on economic recovery. As a day trade, such moves may be profitable and we can respect such as playing on the market mood, but as investments, such plays appear foolish.
Next week lifts the pace. Tuesday will bring the Case-Shiller home price index, followed by the Conference Board’s April report on consumer confidence. The latter should surely see at least a small gain from the stock market, especially from the extremely low levels it has been visiting of late.
The first estimate of GDP for the first quarter is due out on Wednesday morning, and the consensus is for a rather low (-5.0%) decline. The steep fall in imports could push the number up a little, but in any case take the number with a grain of salt, as revisions have been large of late. More current looks at output will come from the Chicago PMI on Thursday, the ISM manufacturing index on Friday and factory orders (for March, pre-empted by durable goods data) later the same morning.
Personal income and spending is due out on Thursday, though the March data will be discounted by the GDP report the previous day. We’ll also get data on employment costs, which have been running at the lowest rate since 1982 (when the series started). The University of Michigan kicks in another April reading on consumer sentiment on Friday.
The big reading on central bank sentiment comes on Wednesday, when the Fed’s Open Market Committee (FOMC) meeting comes to a close and the learned group offers up its assessment of the economy. That will be the focus of the market, which certainly doesn’t expect any change in interest rate policy, and rightfully so. We predict that the Committee will see some signs of recovery along with further downside risk, and that the markets will focus on the former after a brief quiver about the former.
StockWatcher will return in a later edition.
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