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Avalon Asset Management Company Dog Days
“Trouble with you is the trouble with me, Got two good eyes and we still can't see.” – Hunter-Garcia (The Grateful Dead), Casey Jones
Have a dog? We don’t mean one of the stocks in your portfolio. We already know you’ve got one of those (whether or not you want to admit it probably depends on how high your fees are). We’re talking about one of those four-footed, our-furry-friend kinds of dog. The reason we ask is that on Friday, during a brief time-out from the market love-fest, we had the chance to hear a radio station put a question to its listeners about the propriety of using public money to expand dog parks within existing public parks.
This is a simple debate, we thought. If you or your loved one owns a dog, the answer is undoubtedly going to be yes. If not, the answer is probably not. In short, are you long dogs or aren’t you?
Listening to some of the debate about the economy inspired by the jobs report on Friday, it occurred to us that the question about the recovery is similar. If you are long stocks, or even more importantly, long the selling and promoting of stocks, then a big second-half recovery is in the bag. If you are not long stocks, then the answer is probably not.
Well, maybe it isn’t quite that simple. We own some stocks too, but even so we remain neutrally positioned. While we’ve been saying for months now that the economy’s fall had to level off at some point, a phenomenon that seems to be finally happening, we’re also in the wide bottom school. The end of the current recession may well be upon us, but we think that stocks have left fair value well behind. Or as Jim Cramer put it during the week, there are now five competing outlooks, which he dubbed the “LUVMW” question: is your recovery version shaped liked an L, U, V, M or W?
Every week we pour over the economic data and write it up for The Economic Beat, of which more below. Before we come to that point, thought, we’d like to say that we’ve also been listening and reading to an awful lot of earnings reports lately. Believe us, that’s hard work. Let’s just say that not many chief financial officers left behind promising careers in entertainment to work in finance.
That issue aside, though, there is definitely something impressive about this season’s earnings presentations. Not so much with what management is saying, but with how it gets translated by the barkers and the boosters of stocks and shapes that take the form of a “V”. Sometimes we can’t help but think that that those mugs must be long an awful lot of dogs.
The homebuilders, for example, have rallied furiously in the last month, up 33%. You wouldn’t guess it by listening to management talk about business or looking at company earnings. You might come to that conclusion, though, listening to people who are excitedly promoting the current rally (“did you hear that folks? He said the worst is behind us! What more evidence do you need?”)
Ironically, June new-home sales, constantly and lovingly referred to as the keystone of this summer’s new era of good feelings, put on the worst showing for June new-home sales since records began in 1963 (sales in June 1982 were slightly lower on an absolute basis, but much higher on a per-capital basis). But they were up from May, which kept the latest June company by being the worst May since records began in 1963. Yet our May was the worst on a per capita and absolute basis, so June does mark progress. And when you think about it, there must be nowhere to go but up, right?
Now the IYR, a.k.a. the real estate ETF, has gone parabolic because all the property that they (and the banks) own are going to be worth so much more money. What else can one conclude from the evidence? There are over a million foreclosures in the pipeline for the latter part of the year, Fannie Mae (FNM) posted a huge, wider-than-expected loss last week while predicting further losses, idem for the mortgage insurance companies, and Standard & Poor’s reported that prime mortgage delinquencies rose nearly 14% in the second quarter.
Commercial real estate may have been downgraded last week, may be so overbought now that it yields less than corporate investment grade bonds, and may be worrying the Fed to death as the next shoe to drop, but it raised a lot of capital, so what else do you need to know? One might say that it’s really a short-squeeze gone wild with the usual hare-brained cover story, but then one might be accused of being anti-dog.
Has anybody else noticed that the Shanghai stock market has had a couple of serious hiccups in the last two weeks? Sure then, but they’re foreigners, aren’t they? How about the U.K. central bank saying that the recession was deeper than they thought and more quantitative easing was necessary? Ah, more foreigners. What about Royal Bank of Scotland (RBS) posting a weak quarter and saying that they didn’t see losses letting up until 2011? Well now it may be a global bank, but aren’t we really talking about foreigners again? Ignoring all the warning signs, now that’s American!
To be sure, Germany’s exports increased last month (although industrial production fell again), leading to excited speculation – and it is nothing more than that – that Germany will lead us out of recession and that international trade is back in the ascent. The latter fact would explain why container lines, the companies who actually carry the stuff of international trade, have empty bins sitting around the world with rates at rock-bottom lows and bankruptcies looming. Nowhere to go but up again!
A theme that we’ve been writing about, and will probably continue to write about for some time to come, is that people – especially those in established positions - are slow to adapt to shifts in their environment. Across the ages, established ways of thinking have been able to persist in the face of contrary evidence on a catastrophic scale.
In the last century, for example, the first World War (the “Great War”) featured a horrifying succession of bloody campaigns with staggering losses of life, as generals persisted in using tactics based on horses, muskets and swords, with armies employing machine guns, poison gas and tanks.
In the Great Depression, the stock markets put on several stupendous rallies over a period of years, with one rebound topping one hundred eleven percent, because traders were so eager not to miss the resumption of the boom markets of the “Roaring Twenties.” Yet that period didn’t resume for another sixty or seventy years, depending on whether you want to use the tech bubble or real estate bubble as your starting point. Today’s traders appear to have the same symptoms.
Despite the public fury with a compensation system that might charitably described as heavily tilted, today’s banks in the U.S. appear determined to resume as quickly as possible a compensation structure that throws tens of millions of dollars at ‘geniuses’ whose chief talent lies in being lucky enough to take on excess risk while standing in the right place and time.
Such genius is coincidentally supported by the knowledge that there appears to be very little individual risk involved in playing with somebody else’s money. Hasn’t it occurred to anyone from these companies that such behavior is practically begging for retaliation from the government officials whose intervention they so profess to fear?
Maybe not. Investment bank Goldman Sachs (GS), sometimes called “Government Sachs,” has come under wider suspicion than usual in recent times for the apparent depths of its connection with the government. Yet late on Thursday, there was the bank telling its clients hours before the jobs report that it was taking its estimate of job losses down to 250,000. The next morning, the jobs report reported a loss of 247,000. Wow, those guys are good, aren’t they? Fearless, too.
In the summer of 2007, markets soared when the Fed assured them – and this is no joke – that growth was not too strong: Now traders are speculating on when the Fed will have to raise rates as the economy begins to accelerate. In October 2007, we wrote a column titled, “Up, Up and Away,” observing that stocks were rallying upon every piece of news, while analysts responded by raising their price targets. Last week CNBC’s Fast Money exclaimed “this is a market that can’t go down,” equity analysts raised all their price targets and market strategists raised their GDP estimates.
One year ago this week, the markets were rallying on technology stocks and an increase in pending home sales. Knowledgeable wags wisely observed during the month that the market turns up before the economy does, that the rise in stock market prices would restore confidence and encourage spending, that the economy would recover with the stabilization of the housing market (!), and that there would be cash coming in from the sidelines. This was last year, not last week.
You know, sometimes you just can’t teach an old dog new tricks. Skeptics we were, and skeptics we remain.
Last week led off with the ISM manufacturing report, so we’ll cover the two ISM reports first (besides, if we talked about the jobs report first, you might not finish the rest of the report).
The ISM manufacturing report finally got to a neutral monthly comparison in exports, imports and backlogs, while new orders and productions showed expansion. The industry comments were still on the subdued side, with ten of the eighteen sectors reporting further declines. There was some talk about inventories being at the bottom of the cycle, and that was the part that the Street is absolutely running with.
The ISM overall number was reported to be 48.9, the seventh month of “improvement” in a row. On the other hand, we keep imagining some B-school student twenty years from now saying, “but wasn’t anyone concerned that after three consecutive quarters of contraction in GDP, the manufacturing survey was still declining for the eighteenth month in a row?” Wonder what the answer will be.
Nevertheless, market strategists rushed to increase their GDP estimates for the third quarter based upon the inevitable increase in inventory restocking. That leads us to imagine the same student wondering, “but didn’t people notice that the inventory-to-sales ratio in June of 2009 (1.42) was the highest it had been in June since 2001?” We wonder what the answer will be on that one too. Did anybody else notice either that the ISM stood at 49.5 this time last year, for the fifth month of “improvement” in a row (in other words, lessening rate of decline)?
The ISM non-manufacturing survey, conversely, fell from June to July, though very marginally so (47.0 to 46.4). The rate of decline didn’t change in the services sector, which is twice the size of the manufacturing sector but generally thought to be less reliable as a leading economic indicator. It was the tenth consecutive month of decline, and respondents’ comments reflected on balance “a sense of uncertainty and cautiousness about business conditions.” Perhaps they don’t have as many dogs.
Construction spending was reported to have risen three-tenths of a percent between May and June, although a decline of five-tenths had been forecast. This was supposed to be another sign of a bottom in housing. Perhaps it is, but we wonder what the people in the census department, which collects the data, must be saying to the people in the Labor department, which reported that employment in construction fell by about seventy-five thousand for the third month in a row. “Laggards?”
In the not-so-green shoots department, personal income in June was reported to have fallen by 1.3%, mostly related to drops in government transfer payments, while consumer spending rose due to higher gasoline costs. That might help explain why weekly chain-store sales comparisons continue to be relentlessly negative, and why July same-store sales comparisons were generally weaker than expected (and negative). Disposable income had a slight fall, and the year-on-year decline in income widened considerably.
A phenomenon we’ve noticed lately is the dearth of inventory in many stores. That suggests to us that retailers will also report this month a quarter of better margins and earnings than anticipated, and revenues somewhat lower than expected. In retail especially, though, this kind of bump from cutting goods on the shelf to the bone is a mirage. You can go out of business in a hurry with falling sales and great gross margins.
After the earnings euphoria wears off in the retail sector (“not as bad as expected”), you may want to sharpen your short-sale pencil on some of the companies. A massive slug of unemployment claims is scheduled to begin expiring this fall, and we wonder if the administration will be willing or able to get the votes and money for another extension.
As you surely must have seen in the news, pending home sales had an increase last month of 3.6%, which had many a news commentator and stock trader in awe. Pending home sales experienced even larger increases last August, December, and April, with no discernible effect at all on levels of existing home sales (new-home sales have fallen), but very noticeable effects on stock prices.
What we really like about the National Association of Realtor’s number is that it’s an index; levels can’t be determined. So the NAR can observe that it’s the first time since 2003 that pending home sales have risen five months in a row – when home sales had already been booming – without giving any clue to the level of sales. We think that the combination of the expiring tax credit and distress-sale prices is producing a blip that will subside.
The NAR also boasted about how great its affordability index is now. The irony of this is that when this index was in the basement (meaning houses were unaffordable relative to income), it was nevertheless easy to buy a house, because one didn’t need a down payment or even documented income. Now affordability is in the stratosphere, but it’s so much harder to buy one.
The association bragged how a median income family making $60,000 can now afford the payments on a $289,000 house, much higher than the $181,000 median. There’s just one catch: the twenty percent down payment. How many families making sixty thousand dollars a year have another sixty thousand in cash sitting in the bank? The association did allow that affordability is lower for first-time buyers with smaller down payments. Very true, especially when you consider how few of them can get a loan.
Getting in step with the times, the Mortgage Bankers’ Association took the unexplained and startling decision to stop listing its weekly index values and only report percentage changes instead. That will make activity comparisons far more difficult, which is probably the point. We can still say that purchase applications continue to go nowhere and remain stuck at very low levels, despite the hoopla. However, maybe if the Association reports percentages instead of hard data, it can suck people into believing something is happening.
Consumer credit fell more than expected, which briefly put a shadow over the market’s starry eyes on Friday. It didn’t fall in the 1980-1982 or 2001-2002 recessions, though it did fall in the 1990-1992 recession, when savings and loan banks imploded along with the junk bond market. The unemployment rate peaked at only 7.8%, however.
That brings us to the jobs situation. New unemployment claims fell back to the 550,000 level, although continuing claims increased again. We are suspicious about the seasonal adjustments of both categories, but we do believe that in any case both levels should continue to ease. It won’t mean the job market is improving in any meaningful way, rather that the pace of claims is bound to ease up as businesses take stock of already large reductions and continuing claims begin to run out of time in larger numbers.
Along those lines, the Labor Department reported that only 247,000 jobs were lost in July, compared to consensus estimates of about 275,000 (the day before) and 350,000 (the week before). There was some suspicion about leakage, given the number of revisions in the days leading up to the report and President Obama’s improved disposition the night before the report.
There was also some suspicion about the accuracy of the number, as it benefited very strongly from the elimination of 422,000 from the labor force. The unemployment rate got the same help, as its reported drop from 9.5 to 9.4% was helped by a drop in the “participation rate,” meaning people were dropped from the labor force. The Monster Employment Index fell, the Challenger layoffs report showed a widening loss, and the ADP payroll report indicated a loss of 377,000. Stock prices went up, though.
Some of these factors surely led Laura Tyson, an adviser to President Obama, to murmur about seasonal adjustments and decline to change her view that the unemployment rate will continue to rise for the balance of the year. To that point, the unadjusted unemployment rate remained at 9.7%, the same as the month before.
For us, the report was strongly suspect, with the only real good news being that the revisions to previous months were positive. We too believe that the unemployment rate will continue to trend higher, but the fear we have isn’t whether or not the rate peaks at ten or eleven percent, but for how long it might stay highly elevated. It could be much longer than what the markets think.
Next week the focus will be on the Fed, when it delivers its statement on Wednesday, and on the July retail sales report to be distributed Thursday. We say that the Fed will take no action on rates while making some cautiously hopeful comments. The latter are likely to whip the market into a frenzy.
Retail sales are expected to have increased by a scant 0.1% excluding automobiles. Anything less might provide an excuse to take some profits. Earlier in the week, the employment cost index comes out on Tuesday and the international trade report on Wednesday. Neither is ordinarily a market mover, but the market is apt to be pretty jumpy next week. Business inventories for June are due on Thursday, and will be looked at more carefully than usual for clues to restocking potential.
Friday is packed, with the Consumer Price Index and Industrial Production reports for July coming out before the open, and the first University of Michigan sentiment number for August due later in the morning. We’re not looking for surprises from any of these.
StockWatcher will return next week.
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