Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Eyes on the Exit
“Men must endure their going hence, even as their coming hither. Ripeness is all." - William Shakespeare, King Lear
Many things were coming to an end last week in the Northeastern part of the country – August, warm summer weather (Tropical Storm Danny arrived with buckets of cold rain on Friday), and the life and times of Senator Edward Kennedy, whose passing we note with great sadness. Since this is a market report, we will add short-sellers to our list of endings, as well as the impending demise of the silly season.
The Financial Times reported that short-selling fell to its lowest levels since October 2007 (a market top), as the momentum of the season chased short after short. In golf, the silly season comes late in the calendar year, when the regular tour has ended and offbeat events spring up in exotic locales. In the stock market, it’s the second half of August into sometime in early September, when the arrival of Labor Day and school classes enforces the return of families from vacation idylls to the mills of vocation.
The peak of our silly season is usually this week and next. One notes with understanding that the four most active stocks on the New York Stock Exchange of late, accounting for about a quarter to a third of daily volume, have been such solid, blue-chip names as AIG, Fannie Mae (FNM), Freddie Mac (FRE), and Citigroup (C).
What do these companies have in common, besides being wards of the government and having further losses to report? Big short positions for a start, and in the case of the latter three, stock prices below five dollars. That latter quality can make short positions problematic, even miserable, due to the margin requirements associated with such levels. That has imbued them with another sharing, namely a doubling and tripling of the stock prices in the last few weeks. There has been no news to justify these events, just momentum day trading, short-squeezing and the usual bulletin-board rumors of men from Mars.
The press has largely gotten into the spirit of the season. The rally that was greeted with considerable skepticism and bitterness in July has now more or less been embraced. It seems that we need to build confidence and pull ourselves back up, and so reporters can feel a twinge of patriotism as they paint the latest economic release in ever-warmer hues.
This reversal of form led to some befuddlement last week when the market failed to react to journalistic hyperbole. Having formerly grumbled at the market leaping ahead on the faintest rays of hope, the press found itself largely alone in the vanguard last week when it trumpeted the latest results, only to turn around and find traders still lagging behind in the trenches, and showing little inclination to do otherwise.
We would like to say that the market has caught on to some of the real weakness of the reports, but that would be wishful thinking. The reality is that a certain amount of boredom has set in with the better-than-expected shtick, earnings reports have gotten thin, short-sellers are getting scarce, traders are starting to look over their shoulders, and day-traders have preferred to dial in on individual names with enough short interest left in them to still get some pop.
Had August been a sideways month, we might have gotten a good setup for September, which is to say that we could have talked about how dangerous the latter is for two or three weeks and thereby given ourselves a good shot at a rally. Still, the main thread of conversation has been the relentless march upwards, which leaves a continuation of the rally as the most perverse – and therefore typically quite possible - outcome. But with profits to protect, potential sellers coming back from the beach and valuations anything but cheap, it’ll be tough.
In these modern, innovative times, one always has to ask, where will the money river flow? In the early part of the decade, ultra-low interest rates and a discredited stock market lured money first into real estate, then into leveraged bets on real estate. Now those same rates have diverted money into corporate bonds and equity markets around the world. The question is, is the river willing to keep flowing into equities for lack of better yields, or will it flee again from risk as it did in the fourth and first quarters? Or seek new areas for returns entirely?
We don’t know the answer, but enough money has been made in equities and commodities that we suspect a good portion of the river is willing at least to go into temporary hiding, should the occasion present itself. There’s still a few more days left in the season, but we smell the beginnings of a shift from ‘looking for an excuse to buy’ to ‘looking for an excuse to sell.’ It doesn’t seem to quite be here yet, but there’s a whiff in the air.
We leave you with the interesting contrast presented by two companies that reported earnings last week, spirits maker Diageo (DEO) and Tiffany & Co. (TIF), of the blue box fame. Diageo, whose fortunes depend largely on selling a lot of premium scotch and other spirits, reported that volumes fell eleven percent in the Asia-Pacific region. You know, the region where growth is supposed to be raging again. Tiffany’s, by contrast, reported that same-store (like-for-like) sales comparisons grew five percent in Asia excluding Japan (where unemployment just hit its highest rate in half a century).
Premium spirits are an aspirational good; Tiffany sells luxury goods. What this suggests to us is that the average mug mightn’t be doing so well in the region, but those who had lots of money to put into the stock market (or in the case of China, flipping commodities and property in addition to stocks) have prospered. In other words, could a global asset mini-bubble sparked by government liquidity have risen, and be concealing the real state of the global economy? Oh, come on now, that never happens, does it?
In an example of how most of the press has caught the market’s momentum fever by now, the eyebrow-lifter for us last week was hearing an NPR reporter earnestly follow up her upbeat assessment of the first GDP revision (unchanged at (-1.0)%) with the observation that “in further evidence that the economy is recovering, jobless claims fell 10,000 from the week before.”
If claims would only fall as much as the weekly announcement, a lot more people would have a job. But every week the previous week’s claims are revised upward. We will learn next week (although it will go unreported) that claims didn’t fall by 10,000. In fact, the only time weekly claims have fallen by more than 10,000 this year was last month, when the labor department was struggling to cope with unseasonal employment patterns in the auto sector. Given the subsequent sharp rebound, however, there is doubt about whether those drops ever really happened either.
In any case, if weekly claims at the 570,000 level - to be revised back up to 575,000 next week - are evidence of an economic recovery, then we are in worse shape than generally thought. The fact is that claims continue to run worse than expected, indicating more disappointment ahead in the August employment report due next Friday. The consensus for that report ranges from a loss of 200,000 to a loss of 240,000. We lean towards the latter figure, but the department’s well-known adjustments could easily kick it lower.
Another example of spun sugar last week was the new home sales report. There were a lot of superlatives thrown around the 9.1% “surge” and “solid” result, which is odd considering that it was the worst July for new home sales ever reported by the government. No, really. Going back to 1963, the only months of July in the last forty-six years to report lower sales totals were in the 1980-1982 recession (in ‘81 and ‘82), when mortgage rates were climbing towards seventeen percent and the population was twenty-five percent smaller. On a per capita basis, July 2009 is the clear loser as the worst July ever.
In an indication of how much the homebuilding business has come to a near standstill, the number of homes for sale fell to 269,000, while the median number of months needed to sell a new home surged to nearly twelve and a half months. Yep, a hot market, although one thing that isn’t surging is the refresh rate. Toll Brothers (TOL) reported another big loss (though excluding all of the assets it lost money on, it made money. Got it?), but noted a slight uptick in orders at reduced prices.
Perhaps, as Robert Toll said, now really is the time to get into the market. However, mortgage purchase applications remain stuck at very low levels, despite the impending expiration (maybe) of the first-time homebuyer credit and record low mortgage rates. This suggest that although they don’t always do so, sales will probably follow the typical pattern and fall off from July to August, and continue to fade into the fall unless the government comes up with additional help. There doesn’t appear to be any assistance coming from the banks: delinquencies are at an all-time record (going back to 1972).
As we predicted last week, the Case-Shiller report showed a moderating rate of decline, with most of the major cities reporting some monthly improvement. That is to the good. However, some analysts have made the case since early in the year that a shift in mix would produce this very result, as the ravaged subprime sector was swept out. The thesis is that prices in the upper ranges are still falling, but that trend will be obscured or even contradicted by the exhaustion of transactions in the bottom tier. Time will tell.
New orders for durable goods rose 4.9% in July, said the headlines, versus the consensus for an increase of 2.5%. However, that lift was due mostly to a new order for Boeing (BA) and an increase in defense hardware; excluding defense and transportation, orders fell by a small amount, as did private investment in capital goods. In a more positive sign, shipments rose again and revisions to the prior month were upward. Inventories fell again, which comes as a contrast to the restocking that’s supposed to be boosting GDP this quarter.
Consumer confidence was given a lot of play during the week from the news that the Conference Board’s survey rose well past the consensus estimate of 48 to 54.1, after falling for two straight months. Unfortunately, fifty isn’t the magic border between negative and positive, as it is with the business surveys. This particular survey usually reads in the nineties, and is still below its year-ago, pre-Lehman reading of 61.
The current conditions components of the Board’s survey were essentially unchanged, with the improvement all coming in future hopes, a result we put down to the headlines about the stock market. The University of Michigan’s final sentiment reading for August did improve a couple of points to 65.7, about the same as July, but its assessment of current conditions fell several points. Neither of the reports shows the consumer feeling better. The press does, though.
The non-event of the week was that second-quarter GDP was unrevised, though it was expected to have fallen an extra half-point. Final sales were revised slightly higher and inventories lower, leading to a lot of bullish fever about a big jump in third-quarter GDP (if that does come to pass, it will lead to a lot of sucker talk about a “return to trend”), supposedly from increasing sales and inventory restocking. However, inventories of durable goods fell in July, as did retail sales, and chain-store sales continued to fall in August.
Personal income and spending was weak in July as well, with income unchanged and real disposable income falling slightly. Consumer spending increased 0.2% despite the cash-for-clunkers program, a bit less than expected as we had feared last week, but not enough of a miss to motivate real selling. Purchases for nondurables fell and barely moved for services. Aren’t these people listening to CNBC? Or perhaps they are, as many traders expressed worry last week about the latest rise in the market.
We will certainly get an awful lot of data to think about next week, possibly sparking a final melt-up before reality sets in. Four major surveys are due out, beginning with the Chicago Purchasing Manager’s Index (PMI) on Monday, the national PMI (now known as the ISM) for manufacturing on Tuesday, non-manufacturing on Thursday, and ending with the employment summary on Friday.
Despite all the positive talk about inventory restocking this quarter, consensus estimates are set quite low for most of the surveys, with only the ISM manufacturing survey sporting a growth estimate – and at 50.5, by the barest of margins (fifty is neutral). Why would the Street ever do such a thing?
We couldn’t say, but we can observe that it certainly leaves a lot of room for upside “surprises.” Combined with the usual turn-of-the-month upward bias from the flow of funds, that could – strictly by coincidence, you understand - propel the markets higher. It’s not a done deal, though, as traders have started to show a tendency of late to want more from economic releases than low-quality triumphs over lowball estimates.
Construction spending for July is due on Tuesday, and has provided surprise upward movements in two of the last three months (consensus for July is for no change), despite the sector continuing to shed jobs at a fast pace. No doubt stimulus spending is playing a role in the data, as private non-residential construction has remained weak. Pending home sales for the same month are due later that morning, and should receive a boost from buyers trying to slip through the first-time tax-credit window before it shuts.
Sales data will come in the form of August motor-vehicle and chain-store sales reports, to be released on Tuesday and Thursday respectively. Productivity and cost data are due on Wednesday, and should show large gains from the massive cuts in employment, probably giving rise to more excitement about v-shaped corporate profits. Factory orders also come out Wednesday, and should show an increase from the above-mentioned transportation and defense sectors.
We’ll get the usual clues during the week about the Friday jobs report, which is expected to show smaller losses than the July report and another uptick in the unemployment rate. Perhaps the department will simply eliminate more people from the labor force instead. More patriotic that way.
We’ll come clean and admit that we’ve been holding out on a buy candidate until the rally comes back to earth (and we can buy our position at lower levels). However, a short-sell candidate that you may want to cast your eyes upon is a stock we noted above, luxury goods maker Tiffany & Co (TIF).
There is no need to rush into this one, despite the stock’s ten percent rise on Friday and its seriously expensive valuation. The silly season isn’t over yet, and so the stock could move up another five percent or so. It doesn’t go ex-dividend until September 17th, and if you’re short, you’ll have to pay that one.
But here are some reasons why you should think about selling: the company beat by thirteen cents on the latest quarter, sparking the rise, but five cents came from a sharply lower tax rate and revenues were down sixteen percent on the year. The company thinks declines will improve the rest of the year, but admits that it’s mostly due to easier comparisons. The stock sells at about thirty times trailing earnings, a zone that it has historically entered just as it tops out.
During eight of the last ten years, Tiffany’s stock price has reversed from the summer into the fall. In other words, summer dips were followed by fall rallies and vice versa. The exceptions were 2003 and 2005, when it didn’t reverse until late fall (if you sold short in September you had to wait until March or so to get it back, but then it was very successful). The stock has more than doubled since last April.
Finally, if you want a more fundamental reason, we think that as soon as the global stock markets correct, Tiffany sales are going right down with them, and the stock price even faster (the beta is 1.7). Do you believe in the mini-bubble? If so, then hold the stock. But if you don’t…
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