Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Fool's Gold
“Experience keeps a dear school, but fools will learn in no other." - Benjamin Franklin, Poor Richard's Almanac
Most would agree that this recession has been the worst post-war recession, or that it features the worst credit-crunch and largest loss of household wealth since the Depression. Nonetheless, your average trader and investment banker is right back on the sauce. Goldman Sachs’s (GS) quarterly results have everyone believing that with Lehman and Bear Stearns gone, thar’s gold in them thar hills, so everyone is rushing to make risky bets again. Analysts are back to marking their ratings to market, investment banks are back to pushing the hire-with-bonus button.
“It doesn’t matter what it is, if the market wants to go higher, it will find any piece of data to go higher…even if it’s negative news, it will say, “now the worst is behind us.” Doesn’t matter what it is, if it wants to go higher it will.”- Karen FinermanImpatient bulls tell us to ignore the fact that this August looks much like the last August and the August before, stock markets that rose on little more than high spirits, thin volume, a willingness to gamble and aggressive program trading. Oh, and the will to believe the excuses invented to justify the latest momentum trade.
“Not only does the emperor not have any clothes, I think he’s surrounded by a roomful of tailors.” – Rick Santelli, CNBC, August 14, 2009
In the wake of the forties, fifties and sixties, we had a generation of investors who thought that five percent was pretty fair return on your money and double-digits was exceptional. The higher interest rates of the seventies, eighties and nineties spawned a generation of investors who believe that a minimum of nine to ten percent annually is practically a birthright. Bernie Madoff promised investors they could even have it without any volatility, and they leapt for it.
The Fed, investors and advisers need to adapt to the fact that there is a big global money river out there now that moves across sectors and borders avidly and easily. Very low interest rates did not flood the banks with so much cash that they threw money into housing; that line is a popular myth. But they did cause the money river to chase leverage and risk in order to generate those magic ten percent returns. Today’s near-zero rates aren’t creating any new pots of money, but they do entice the existing ones to gamble.
A generation of retail investors may be licking its wounds over losses suffered in the tech wreck, but the fabled profits of the tech bubble still permeate the trader mentality. The modern Wall Street pro isn’t looking to emulate Peter Lynch or Warren Buffet, or build a deeply respectable money management business. No, they want to emulate John Paulson and cash billion-dollar paychecks by putting a huge stack of chips on the really clever bet.
The average hedge fund manager, a friend observed to us the other day, used to be a middle-aged guy who’d built a successful career in stockpicking. Now they’re just transplanted prop (proprietary trading) desks.
We would go further and say that the Greenwich, Connecticut-Manhattan corridor has come to resemble the area around Sutter’s Mill, California in the wake of the gold discovery of the mid-nineteenth century. Instead of thousands of prospectors and tents with pans and pick-axes, we’ve got thousands of traders with flat screens, smartphones and clever algorithms all trying to mine the data. The easy money is gone, but hope lingers on.
Such a mentality reinforces our fear that we may see a sequel to the markets of the nineteen-thirties. Unemployment shouldn’t reach the same peaks, thanks to better central bank policies and quicker interventions, but just as that decade saw a series of sharp rallies led by traders who had been permanently molded by the gushing markets of the roaring twenties, we could also see a succession of sharp, broken rallies that continue until all the two-and-twenty gold prospectors have gone broke and go home.
“This crisis is a mile wide, but an inch deep, and it’s basically in housing and autos, which make up about 8.5% to 9% of real GDP. If you’re a part of that inch or your business serves clients in that inch, this is a depression. But if you live a foot away, times are pretty good.” – Jim Paulsen, Wells Capital Management Oct 22, 2007
Who else isn’t making the transition out of the bubble days? Corporate CEO’s, it would seem. Gretchen Morgenstern pointed out in the Sunday New York Times how CEO’s are still trying to game the system towards tax-free stock payoffs based on short-term incentives with no performance hurdles. That kind of stuff leads to complete exasperation and bad regulations in the end, but they will only have themselves to blame.
In the club are energy companies and users loudly warning the government that the energy derivatives markets needs speculators to allow those actors to lay off risk. Undoubtedly they do, but we don’t think that energy markets have caught on to the fact that the oil bubble of 2008 – built on a pyramid of speculation and crowded bets - quite likely killed the golden goose. Our back-of-the-envelope calculations imply that the “cash-for-clunkers” program alone is going to cut 200 million gallons of annual gasoline use out of the U.S. market.
Throw in a newly thrifty consumer, rising unemployment, the new fleet standards for fuel economy and aggressive plans to deploy wind and solar energy and one ends up with a picture of oil demand taking quite a punch. None of the foregoing factors is big enough by itself to take out oil prices, but add them all up and even China may not be able to do enough, especially when they find themselves falling far behind the West in clean energy and (more importantly) dependence on foreign producers.
We reckon a fair chance that there’s still at least one oil mini-bubble left, to be fueled by the next rally in equities. Previous oil bubbles, though, have led to years of reduced consumption that has caused prices to collapse. Those complainers about regulating speculative trading in oil may rapidly find themselves with much bigger problems on their hands.
For that matter, the traders in fool’s gold are risking bringing their houses down too. One trend in banking that disturbs us these days is how aggressively banks are trying to stick it to their clients.
We’ve long resigned ourselves to the fact that commercial bankers are largely a pack of lemmings, with a predilection for aggressively jumping into the last days of a price bubble and then trying to gouge their losses back out of their retail client bases. Lately, though, the lengths to which banks are willing to go to shake down even large commercial customers has left us uneasy.
No doubt some bad habits were picked up during the heads-in-the-ground attitude of the past administration, and banks are justly famed for trying to close the barn door after all the horses have left. Yet we’ve been seeing a lot of unusually aggressive behavior these days. It makes us wonder how worried the banks still are about the assets on their balance sheets.
If it turns out that the desperate treatment of clients by banks had a basis in deteriorating assets, that would be bad news indeed for the stock market, the kind of thing that leads to prolonged trips southwards. In the end, exasperated government officials might agree with singed investors that it’s time to get tough with all the fools that keep burning up everybody’s money.
The twin highlights of the week, as predicted, were the FOMC statement and the report on July retail sales. Our prediction that the Fed would issue a cautiously optimistic statement (the core position of 99% of all central bank statements) came true, but not the part about the subsequent rally.
The Wall Street Journal – the Journal, no less! – ran a headline after Wednesday’s market rally that the market’s big rally was in response to the FOMC’s improving outlook. It’s a great newspaper, so we hope that nobody over there is too offended if we point out that the market was up 124 points immediately before the FOMC statement, and actually lost fifteen points in the hours after the committee’s verdict. Eager traders decided that rather than wait, they would borrow in advance on the usual FOMC rally.
What did the Fed say? “Information suggests that economic activity is leveling out.” Well, duh. The market gave up on the infinite abyss argument back in March, when we rallied back from the 666 level. Yet it was the key statement cited endlessly in the press, partly because it was such a dramatic change from the previous meeting’s analysis that “the pace of economic contraction is slowing.” Remember “the housing crisis appears to be contained?”
Retail sales weren’t quite the leveling expected, as they fell 0.1% in July instead of rising by the expected half percent. Excluding autos and gasoline, they fell 0.4%, compared to a (-0.1)% drop the previous month. Isn’t that the opposite direction from leveling off? Of late we’ve found ourselves frequently deconstructing the grimmer reality behind overly optimistic headlines about retail sales, but not this time. The headlines disappointed and the underlying numbers were weak.
Markets rallied anyway, though the weekly data showed continued softness and earnings reports from major retailers showed continuing weakness in sales. The rallying cry was again that earnings were better than expected, but retailers are playing a dangerous game. Lean inventories are usually a sign of good execution in style and purchasing, but in the current situation they are the consequence of near-panic cuts in ordering and stock. The new practice of carrying nothing on the shelves and offering to order everything for delivery in two weeks time is going to end by eroding sales by more than the weakness in employment.
Employment is continuing to weaken, by the way, as initial claims rose back to 558,000. Haven’t employers read the theory that they cut too much and have to hire back now? We find this high of a level this deep into the recession to be worrisome. Two months ago, we’d have said that claims should have dropped below the 500,000 level by now. The persistence of this weakness is ominous.
The trade balance showed a marginal deterioration, but the market was pleased that exports and imports both rose. More worrisome was that exports and imports of consumer goods both fell, while year-on-year declines in exports widened and stayed dramatically down (-31.1%) in imports. The increase in overall imports was due entirely to oil.
Wholesale and business inventories fell more than expected in June, which might have gotten the market excited about restocking if July retail sales hadn’t also fallen. With sales and inventories falling in July, the already baked-in increase in third-quarter GDP may require some further revision downward. If inventories are discovered to have fallen again in September and there is no rebound in retail sales, it could get ugly.
One good piece of news was that industrial production finally showed a bounce of 0.5% after months of decline. Overall, the report was slightly weaker than expected and consistent with a very mild reloading of goods, in particular autos. Capacity utilization edged off its record all-time low set the month. It’s still a weirdly low number, but the change in direction is something of a relief.
Price data reflects continued demand weakness. July’s import-export price data showed continuing falls in both categories, reflecting the poor conditions. The consumer price index (CPI) showed a year-on-year decline of nearly two percent for July, very rare indeed, while most of its components reported lighter-than-expected bumps. Total CPI was deemed to be unchanged from June, with core inflation up a mere tenth of a percent.
Oil stocks remain at twenty-year highs, and mortgage-purchase applications are still in the basement. The real-time picture of the economy isn’t particularly V-shaped. For that reason, perhaps, the consumer sentiment index from the University of Michigan showed an unexpected drop back to 63.2 for the first half of August, when a continued improvement to the sixty-eight level was expected. The markets weren’t terribly pleased with the news, despite the fact that the correlation with actual spending isn’t great and bulls telling us in the afternoon that the number was “wrong.” It still didn’t fit the narrative.
Next week will bring two regional surveys of business conditions, on Monday from the New York Fed and on Thursday from the Philadelphia Fed. These are overdue for neutral readings, but the market is staying very cautious, calling for a tiny gain in New York and a tiny minus reading in Philadelphia. Anything above that could set the markets off again.
We’ll get lots of data and excitement about housing, with housing starts on Tuesday and existing-home sales due on Friday. The consensus is to call for very marginal improvements in both categories, leaving lots of room to declare “unexpected surges” in both categories. Foreclosures rose last month; perhaps that will help the latter report. The housing market index, or homebuilder sentiment report, is due up first on Monday. Given its very low levels, any uptick can be reported as a big percentage gain.
Producer prices for July are due on Tuesday. They ran hot the previous month, so markets are looking for a retreat. If they don’t get it, the bond markets won’t like it and neither will equities. Leading indicators round out the week on Thursday, but the report of the week may be the earnings report from tech bellwether Hewlett-Packard (HPQ) after the market’s close on Tuesday.
StockWatcher will return in a later edition.
Avalon Asset Management Company is a Registered Investment Adviser
Avalon's MarketWeek is not intended as a market timing newsletter or service. No buy or sell recommendations are made for any of the individual stocks mentioned on the site, and neither Avalon Asset Management Company nor its officers, directors or employees make public stock recommendations. Please address comments to MarketWeek@AvalonAssetMgmt.com