Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Hurd on the Street
“No it isn’t very pretty, what a town without pity can do.” – Gene Pitney, “Town Without Pity.”
My, my. There was a time – a rather long one, at that – when the larger-than-life set was largely assumed to have larger-than-normal appetites. Politicians, titans of industry, athletes, movie stars, it seemed taken for granted that the prodigious fire that motivated them carried over into other prodigious appetites.
Going a little further, a glance at some of the trendiest television shows of recent years, such as Desperate Housewives and its many offspring, or Mad Men, one might be tempted to conclude that the hoi polloi had joined the club. Americans seemed to fall into two groups: those who were fooling around, and those watching them with envy.
A lot has changed in recent years. The press doesn’t bury that sort of story anymore – just ask Elliot Spitzer or Bill Clinton. In the corporate world, the threat of major legal liability has itemized most of the behavior that people love to watch in Mad Men into a catalogue of the explicitly forbidden and is now grounds for instantaneous separation. Just ask Mark Hurd, the once and former king of Hewlett-Packard (HPQ). His nebulous relationship (not to Mark, presumably, but to the rest of us) with a female vendor led to his posterior being unceremoniously deposited on the street late Friday afternoon.
We’re going to stay well away from any social or moral commentary on the incident: this is an investment column and our readers can sort out those issues for themselves. The question that came immediately to our mind on Friday was, is Mark Hurd worth more than $11 billion to HP? Because that was the amount of market cap being shaved off the company in Friday’s after-market trading. Given the somewhat disapproving tone of the discussion of Hurd’s former and future compensation, we would have to say that there was something of a disconnect. If his contract paid him too much, how could he be worth all that market cap?
Our opinion is that while HP seems to have done well with Hurd at the helm, he’s no $11 billion-dollar man. Nothing personal, but he’s not the Steve Jobs type. Quietly efficient and competent, apparently yes, at least until Friday. But $11 billion, gee whiz. So it was that, already long HP stock, we leapt into the Friday aftermarket waters and cheerfully took some of the stock off the hands of people who apparently thought he was worth that much. We don’t think it’ll be there Monday morning.
We’re not sure how much longer the story will be there either. While this kind of story is ideal August weekend fare, the fact is that vacation time has arrived on Wall Street. That means lighter volumes, a more benign attitude, gossipy stories, and oh yes - a very short column the next two weeks from Avalon’s MarketWeek.
It was three years ago this August that the news of two Bear Stearns hedge funds going over the edge rattled the markets for a week or so. Some shrugged it off, though we didn’t, because when credit funds blow up – they were invested in mortgage-backed securities – it is always something to take seriously. Nevertheless, the market soon shook off the bad news and went back to happier thoughts. It’s the nature of the season.
This doesn’t mean that August is a bullet-proof month for investors, as some serious blood has been shed in the past. But the month does tend towards the benign, so despite the surge in gloomy stories over the weekend inspired by the July jobs report, the market could recover quickly (along with HP’s stock) and keep floating higher the next few weeks. It’s the nature of the beast.
There are a couple of clouds looming. Depending on where you sit, they may feel to be directly overhead, or they may still appear to be off in the distance. One is the current state of the recovery, and the other is the question of what happens in the fall.
So far as the recovery goes, as our readers know, we’ve deemed it a stair-step kind of situation, where generally cautious attitudes will lead businesses and consumers to move incrementally. The bulls have dubbed the current slowing in growth “the pause that refreshes.” That seems to really irritate the bearish camp, which sees it as an inexorable step towards the dreaded double-dip.
We don’t see the economy as double-dip bound, but there is a danger that falling confidence could lead to a self-destructive spiral that takes us there. We suspect that the Federal Reserve worries about this too – it’s reminiscent of the 1930s, a period on which the chairman is one of the world’s leading analysts. It’s also possible that we get a quarter of below-zero GDP that in the end doesn’t amount to anything more than a blip.
Another Depression-inspired cloud is the prospect of premature policy tightening. The monetary and fiscal tightening moves of 1936-1937 took unemployment back up from around 14% to north of 20%. Now seen as colossal mistakes that only the remilitarization of the second World War rectified, the prospects of the November elections bringing in a group of tightening ideologues bent upon the same course has many of the country’s best professional money managers deeply anxious.
Elections elsewhere are a concern too. Europe faces the prospect of social unrest next month, when returning vacationers often decide that the world needs a serious makeover. Given the current austerity regime, things could get more tumultuous than usual. Greece is facing its own elections in November, and the impending process could roil Europe all over again. We think it will.
But all that is on hold for now, sort of. It’s been a grueling year for the investment community (unless you were in long-dated Treasury strips. The universal worst bet at the beginning of the year, it’s wrong-footed almost everyone, as the big consensus view usually does). Many are glad to take a respite for a few weeks. Earnings season was favorable and beaches beckon.
Friday’s late action is what you really should have heard on the Street. The market sold off on the jobs miss, as anybody could have told you it would. But the big reversal in the last hour, inspired by a better-than-expected consumer credit report, tells you which way this market wants to go. In August, it’s hard to convince it otherwise.
Shall we start with the job report, or are you already sick of it? There are two essential aspects of the report that we will bring up first, since you probably won’t read them elsewhere - unless you’re a serious investment wonk, in which case we apologize.
Point number one: the market didn’t sell off because the jobs report scared traders about the state of the economy. It sold off because it was a miss. The market has been having itself a pretty good time of late, but not so much that people are ready to give up on the notion that this is a trading market. Ergo, the average trader is now agnostic (trading-wise, anyway) and simply buys a beat and sells a miss.
Not only does that approach work most of the time, it’s a comfort when the market feels as directionless as the current one. With the mavens of the world scratching their heads and in not much agreement about anything, why try to be a hero?
Point number two: the jobs report surprised hardly anybody trading the markets. It may not have been as good as the bulls wanted nor as bad as the bears would have liked, but it was close enough to recent data not to surprise. The private sector added fewer jobs than expected, about 70,000 instead of 90,000, but that’s a pretty close miss in the land of the jobs report, where revisions can be mighty large.
In fact, we would say the report was very close to expectations, if not hopes. Manufacturing is hiring, but at a subdued rate; local governments are shedding people as the new fiscal year gets underway, and the census workers got laid off. Construction was down, but there was a strike and nobody thinks construction is taking off this summer.
The parts that perhaps weren’t completely in the script were details such as temp jobs declining, a negative; manufacturing added more than expected, a positive; weekly earnings increased and the aggregate weekly index of hours worked hit a sixteen-month high, good coincident indicators, but workforce separations continue (people dropping out of the labor force), a bad coincident indicator. June took a big revision downward, with half of the losses coming from the government.
It adds up to a weak recovery, in the words of the authors of the Liscio report. Yet there are some glimmerings of hope. The three latest supply manager surveys, Chicago and the two national ISM surveys (manufacturing and services) released since last Friday, have all showed improved employment readings. Two of them are manufacturing-based, and while that sector has been steadily adding jobs, it’s smaller than it used to be. But the 50.9 reading in the non-manufacturing ISM survey, hardly robust, benefited from a drop in the number of industries cutting back on employment. Are things stabilizing?
They might be. The latest release of the weekly initial claims report prompted us to do some number crunching, because we were curious about the gap between the headline seasonally adjusted number and the unadjusted basis. The headline number of 479,000, which is what traders see on CNBC as it goes across the tape, represented an increase of 19,000 from the week before. The unadjusted number, though, which is rarely talked about, fell by over 14,000 to a level of 399,000.
So we looked at the July claims data for the last ten years (going back further might be less representative). At first glance, all seemed in order, because we did indeed confirm that claims fell by an average of about 49,000 during the last calendar week of July. That would make last week’s fall of some 14,500 below average, and so seasonal adjustments would “normalize” it to an increase.
But in looking at the data, a bit that caught our attention is that the last Friday of July doesn’t always conveniently fall on the last calendar day. What’s more, while there is usually a sharp drop in claims in July, it doesn’t always occur in the same week. Since the week of July 23rd had indeed shown a sharp drop in claims in the raw data, we decided to look at claims behavior during the last half of July for the last ten years.
One thing that’s clear is that July claims accelerate in the first half of the month (many use a June 30th fiscal year), and then decline in the second half. Our analysis showed that going back ten years, the mean decline in claims in the second half of the month is about 127,000, while last month’s decline was about 106,000. But throw out 2000-2002, and the average drop in claims falls to 115,000, with the median being very near 112,000.
We’re not tilting against seasonal adjustments, and the BLS surely uses a more sophisticated model than ours. But we do want to point out raw claims fell about 106,000 in the last two weeks of July (although last week’s total may yet be revised), that that is very close to being normal, and so it may be that weekly claims are a bit better than reports indicate. Such a condition would be consistent with the recent supply manager surveys, yet would not have shown up in the jobs report, which measures through the second week of the month.
That’s not to say that employment is doing well, only that it might still be creeping up in spite of the weekend’s many laments. The Challenger layoffs people opined that the layoff situation seems to have bottomed out. The Street likes to bounce back and forth between the binary outcomes of double-dip recession and strong V-recovery because simple answers appeal, but a slow growth recovery should look like something in between. That will frustrate gun-slinging traders and hedge fund managers who want to make killer all-in bets – too bad. It will also frustrate the unemployed, a group that we do have sympathy for.
On the plus side of the ledger, the two ISM surveys turned in better-than-expected results, with the manufacturing side reporting an index of 55.5. Some bemoaned the drop from June, but we would gladly take a 55 reading from here on out. A bit more troublesome was the slowdown in new orders, but upon closer examination, perhaps better than appeared.
Of the five manufacturing sectors that experienced a decline in new orders, three appear to be special factors, and two related to new construction: furniture, which is to be expected given the end of the tax-related house-buying bulge in the spring, along with non-metallic mineral products (sand, gravel etc). The other is chemicals, which is probably experiencing a letdown in the wake of BP’s oil rig being finally capped. Machinery declined also, though, confirming at least a pause in corporate cap ex.
On the non-manufacturing side, not only was the result also better than expectations (54.3 vs. 53), but an increase from June. Yet both surveys maintained a tone of caution in responder comments. We think the June headlines took a toll on confidence – will August show any improvement? The month’s initial reading from the University of Michigan comes out next Friday, but the jobs report headlines may keep a lid on any improvement.
The good news from the ISM was tempered by a weak report on June factory orders. May orders were revised downward, along with the June durable goods result from last week. Pending home sales fell again the same day, surprising few but nonetheless an uncomfortable reminder. Mortgage-purchase applications ticked up feebly by 1.5%, but remain mired near historic lows.
June auto sales were a bit lighter than expected, and chain store sales results were mixed. The two of them suggest that the July retail sales report, due next Friday, could be at risk. Construction spending for June got a positive print from a big downward revision to May, but the next day’s latest report on personal income and spending seemed to catch more eyes, given that it was flat across the board – no change in income, spending, or the core price index. That fueled more warnings from the deflation team.
Next week brings us the FOMC statement on Tuesday. No change is expected in the current interest rate stance, but there should be intense scrutiny of the wording. Friday will be the other big day, with the June CPI accompanying retail sales before the open, followed by consumer sentiment, and then business inventories.
We’re going to leave you with four names for the rest of the summer – and they’re all short ideas (full disclosure: we’re already short all of them). All should be treated carefully, because they are momentum stocks, which have a way of going up for no other reason than the market is open again that day.
Our four anti-horsemen are, in no particular order, Amazon (AMZN), Acme Packet (APKT), Salesforce.com (CRM) and VM Software (VMW).
All are good companies with bad stock prices. The valuations are actually quite ridiculous, with all but Amazon selling at nine times sales and up. The latter is no bargain either, at 43 times cash flow and operating margins of four percent.
Yet so long as the market keeps going up, these stocks will go up more. They are darlings of retail brokers and will remain so until the day they blow up. So why go short? Doesn’t Cramer love these names?
The answer is that one, they should also go down more when the market does go down, and two, trees don’t grow to the sky. If you are long technology, or long equities in general, you can’t know the day that the next bout of anxiety will overtake the tape and we embark on another ten percent fun ride south. But if you keep scaling into these names a little at a time, we think you will be glad to be short them when the next correction comes. It might help to think of them as pair-trades (and if you don’t know what that means, you probably shouldn’t be reading this section).
Although we cannot ever recall seeing a nine-times-sales valuation pay off, keep in mind that such stocks are rarely broken on the first gap down. If the market is crashing, they usually crash harder, and when earnings disappoint, it gets ugly.
However, true believers and story traders keep coming back for longer than you might think possible. We’ve been in and out of these names before, and wrote about some of them in earlier StockWatcher reports. We think it’s time to get back in again. But once you get into the black on your position, it’s essential to set a cover stop as soon as the downward momentum begins to flag.
The other thing to keep in mind is that shorting stocks is not for people who check their screens a couple of times a day. If you are not in this business fulltime, then our advice is that you avoid these names completely.
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