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Avalon Asset Management Company The Silly Season
"Go on, take the money and run.” – The Steve Miller Band
In the United Kingdom, the Parliament usually goes into recess around the beginning of August. Since the 19th century, this has been known as the “silly season,” a time when the media struggles to come up with things to talk about. In this country, as near as we can make it, professional golf popularized the term on television with offbeat, made-for-TV events between the end of the regular season in the fall and the start of the new season in January.
There are of course other trades that make use of the term, including our wonderful world of Wall Street. Our silly season is the latter part of August, when “everybody” takes vacation. Trading volume drops to the levels only seen at Thanksgiving and Christmas, the backups have strict orders not to do anything stupid, and the press struggles to provide rational explanations for carnival-like trading.
Last week ended in almost exactly the same manner as August 2007 – a couple of near-200 point days characterized, as we wrote at this time last year, by “episodes of follow-the-leader that got out of hand.” The main difference this year is that we’ve gotten inured to the 200-point swings: a fifty-point move in the Dow nowadays counts as virtually unchanged.
So we’ve had some silly stories. Television tried to pitch Friday’s sell-off as the market reacting to Senator McCain’s surprise choice of a vice-presidential candidate. Ridiculous. The problem was that Dell messed up its quarter, was cautious with its outlook and the market was up two days in a row going into a long weekend. Time to take the money and run, as the traders who’d been buying Fannie (FNM) and Freddie (FRE) securities all week did when they unceremoniously dumped them on Friday.
That was how the week started as well. The markets had been up three days in a row, so when Monday hit with prominent worry stories in the Wall St. Journal and New York Times and insurer AIG was battered with another analyst downgrade, that was all the excuse necessary to hike up the kilts and leg it.
It’s fear and greed, remember. Market goes up a little, time for some fear, market goes down a little, time for some greed. The S&P 500 index finished August in almost exactly the same spot it was on July 23rd. Five weeks of flopping around and the media is stuck with trying to pretend there’s a deeper reason for it all.
There isn’t. This isn’t an investing market, it’s an agnostic one. Even short positions have diminished. Every day, traders have a look at the headlines and rumors, decide which way the wind is blowing and place their bets accordingly. After the market’s been open long enough to provide sufficient data, the black-box trades kick in and take over the action until the close. Then we reset for the following day. It being the silly season, the grown-ups are gone and the swings are bigger but with less meaning.
The Fannie and Freddie debate continued without any clear resolution. Given the stories circulating in the press, it would appear that Treasury Secretary Paulson is inclined neither to outright nationalization, nor to appeasing the laissez-faire wing in the White House. Several Street brokerage houses opined that neither agency is in any immediate need of help and can muddle through for an indeterminate time. So long as the debt auctions proceed satisfactorily, the government will probably stick to contingency planning and keeping fingers crossed.
JP Morgan (JPM) announced that it held $1.2 billion par value in GSE preferreds that it had written down by 50%. That announcement heightened the growing awareness that many banks hold GSE preferred as part of their capital base, and that the equity wipeout that was being taken for granted in the press as inevitable might have some ugly consequences. Well, duh. One already ominous sign: China has cut back on its agency debt by 25%.
The administration had better be extremely careful that it doesn’t jeopardize U.S. debt ratings or set off a global financial panic in pursuit of some chimerical goal of ideological purity. The silver lining for now is that the public is largely unaware of the danger, and at bottom, for now, this is a confidence issue. Ironically, the two agencies are enjoying the most profitable spreads in their history on current mortgages, which are probably about as airtight as mortgages have ever been.
The battle will go on, however. We heard one commentator fantasize that (as usual) the government was necessarily the intrinsic problem, saying that the markets couldn’t correct more quickly (as they did in the Great Depression) because “the politicians want house prices to go down more slowly.” The politicians, is it? Funny, I can’t recall even hearing of anyone complaining that that the value of their house isn’t going down fast enough. Maybe I’m just not getting out enough. Or is it the silly season?
Last September was a dulcet time for the market, as the storms of August (begat by the Bear Stearns hedge-fund meltdowns) gave way to the typical initial market reaction: the Fed is on the job, so there’s nothing to worry about. In classic market fashion, the dangers of September (usually weak for equities) were talked up so incessantly that prices did the opposite, and we had a rally that lasted right into October.
This year the environment is different. While very much on edge, the markets are still dying to go up and the urge to be first to call the turn is evident everywhere. Unfortunately, that’s usually not what precedes the turn. There’s an awful lot of slippery ground to tread next month, ranging from the next employment report to earnings reports from the investment banks to retail sales reports. Next week the silly season will be over and traders will be returning in force, which should give us a better clue to the seasonal direction.
Sentiment still seems a tad too complacent to us, although bull-bear readings are about even on balance. There are just too many people trying to jump the gun on a recovery rally for us to feel comfortable. It may be best to respect the current trend, such as it is, and stay ready to take profits quickly. You know, take the money and run. Happy Labor Day.
Housing data dominated the early part of the week, with reports on existing home sales, new home sales, and the Case-Shiller housing price index. The picture is largely the same. Sales are weak, pricing is weak and analysts argued for the nth time over whether or not the bottom is in yet.
Existing home sales came first. The five million annual rate was higher than expected, but it didn’t inspire the Street. The increase was largely due to batch foreclosure sales in distressed areas. Prices fell while inventories rose, this time to an all-time high of 11.2 months. New home sales didn’t fare any better. They were below consensus and fell from last month again – except they didn’t, but only because the previous two months were revised sharply downward. Prices fell and unit sales were down 35% year-over-year, but a virtual halt in building resulted in a drop in inventories.
As one economist put it, “data for July offer no substantial hope that conditions are bottoming.” Ivy Zellman, thought by many to be the best housing analyst and now running her own firm, offered the outlook of no bottom in prices until 2010 at the earliest, then two more years of flat conditions. Fed governor Lockhart offered his opinion that prices might decline another 15 percent nationally. Even so, the usual suspects claim every month to discern signs of bottoming in the market. For his part, TV host Jim Cramer, perhaps the best-known face of the Street, proclaimed that the bottom would come a year from now.
Mortgage applications remained at very weak levels, supporting the view that the uptick in sales was largely due to scavenging. Chain-store sales picked up a bit from a weak start, but as reports from retail stores such as J. Crew (JCG), American Eagle (AEO), Dillard’s (DDS), and Sears Holdings (SHLD) made clear, consumer demand is soft. Unless one is wealthy, as Tiffany’s (TIFF) demonstrated.
Durable goods came in surprisingly higher, with a lift of 1.6% versus an expected 0.1%. Excluding the transportation category, orders were up 0.7%. It was encouraging that the category of “non-defense capital goods excluding aircraft,” that wonderfully simple name representing business investment spending, is up 4.2% year-over year. That seems a bit puzzling in view of what companies have been reporting, but a careful look at the data showed weakness in IT and consumer-related categories and strength in machinery and primary metals.
That would suggest that the strength is coming out of the agricultural and oil & gas sectors, two areas that have been booming this year. Both categories have seen big price increases. That would make for a consistent picture: companies such as Caterpillar (CAT) and Deere (DE) have reported strength in current orders, but uncertainty about the outlook going forward. Deere has been aggressively raising prices for its farm equipment (its input prices are going up steeply too). But if commodity prices continue to ease, which Fed chairman Bernanke is counting on, that will mean that Cat and Deere sales are going to take a hit.
It’s really quite simple. If inflation is going to fall, then so are export orders. The market doesn’t like to think about such things when the mood is good, but that kind of ignorance has a way of coming back to bite people.
Speaking of inflation and export orders, one of the biggest government fiction pieces since the Warren report was released Thursday with the second estimate of second-quarter GDP. It was revised upwards, all the way from 1.9% to 3.3%. We wondered last week if the government would adjust its price deflator for real GDP. It didn’t. Nominal GDP was reported to have grown by 4.6% and the price index for gross domestic purchases was reported to have grown by 4.2%. Ergo, you might be tempted to conclude that there was minimal real growth. However, the implicit price deflator used to calculate real GDP was only 1.3%.
This is the lowest reading for the price deflator since 2003. Does anybody on the planet believe that inflation is at its lowest in five years? Conspiracy theorists could be tempted to link the release of the puffed-up GDP number to the same-night telecast of Obama’s acceptance of the Democratic nomination (roll your eyes, but Republicans have claimed for years that the Dems deliberately pulled the opposite trick on George Bush Sr. back in the election campaign of 1992, by releasing weak economic data that was later revised upwards). We’ll content ourselves by saying that the model has obviously failed to capture inflation.
Imports suffered the largest drop since the third quarter of 2001. As I recall, we later discovered that that period was a recession, but all the headlines talked about last week was the export-driven U.S. economy. I wonder if the export totals accurately capture the effect of food inflation (food export prices were up 33% year-on-year in June), but in any case the import totals point to collapsing U.S. demand. Traders bought retail stocks and homebuilders (!) on Thursday on the back of the GDP data; for their sake we hope they exited their positions Friday afternoon. It is indeed the silly season.
One year ago, the second-quarter GDP was also revised upwards, also due to an improvement in net exports. While the export position has helped cushion the economy from other problems, it hasn’t proved to be a reliable indicator of domestic spending, income or employment. What’s more, exports may be running out of steam.
Corporate profits have been weakening. Lost in the hoopla over the GDP number was the corporate profit data included in the same report. Profits declined, said the BEA, and apparently at a greater rate than the first quarter. We say “apparently” because the report said that the profits of non-financial companies fell, while the profits of financial companies rose. Oh, really? ‘Tis the season, we suppose. As Mark Twain might have said, there are lies, damn lies and then there are government statistics.
The personal income and spending data on Friday took some shine off of the GDP headline. Income fell by (-0.7)% compared to expectations for (-0.2)%. A drop-off was expected from the declining rebate-check effect, but the very wide miss makes us wonder if there isn’t an upwards revision in store. The inflation data wasn’t good either, with the PCE showing headline increases of 0.6% and a continued increase of 0.3% in the core rate. The net result was that real spending declined in July by (-0.4)%. That doesn’t sound like a “surprisingly strong” economy to us, but maybe we’re just cynics.
The Chicago PMI turned up with a quite respectable number of 57.9, showing a healthy increase when a slight decline was expected. New orders and production surged. It looks like another part of the mosaic formed by the durable goods and export data. More than half of the increase in the durable goods number came from airplanes, and the rest was centered on machinery and metals. As it happens, Caterpillar, Deere and Boeing (BA) are all headquartered in Illinois. Somewhat less appealing was the contraction in employment and another red-hot increase in inflation. The market, though, dwelled on the fact that the July inflation reading, though extremely high, was not as high as June.
As expected, the drop in gasoline prices led to boosts in the consumer confidence data reported by the Conference Board and the University of Michigan. Both numbers came in ahead of very low expectations, and both numbers were very low by historical standards. Still, an up trend is better than a down trend. The jobs outlook in the Conference report fell, however, and with another high initial claims number (425,000) reported, it points to weakness in next week’s jobs report.
That jobs report will crown a very busy week of data. After the Monday holiday, on Tuesday we’ll get reports on the ISM manufacturing survey and on construction spending, coming against a background of hurricane Gustav being disaster or dud (as we go to press, Gustav has been upgraded to a Katrina-level category 4, New Orleans is evacuating and tropical storm Hanna is following in Gustav’s wake).
Factory orders will come out Wednesday. Given the July strength in aircraft and machinery, and the price increase in the PPI, we look for an easy beat of the consensus. The Fed’s beige book, the regional branch survey of business conditions, will come out Wednesday afternoon. Thursday will bring us the ISM non-manufacturing (services) report, but first we’ll get chain-store sales data, weekly claims and the latest report on productivity and costs before the open. The jobs report will finish out the shortened week on Friday.
This is a trader’s market, not an investor’s market. Not everybody can be a trader, though, so with that in mind, we present Alaska Communications Systems Group (ALSK).
ALSK is Alaska’s ILEC, in other words, the big-fish local telecom. Like many of its kind, it’s had to navigate the transition away from fixed wireline acess to wireless usage. The loss of fixed lines has also resulted from competition, in the form of General Communications (GNCMA).
The company is leveraged with about 3-to-1 debt to assets, has had relatively flat revenue and recently lowered earnings guidance for the rest of the year. So what’s to like?
First, the company is nearly finished with some expensive capital expenditures. It’s made an acquisition and invested in fiber optic cable links to the lower 48 states. The stock reflects that, being not only at a 52-week low but a 2½-year low. It’s upgraded its wireless network and has a deal with AT&T (T; think iPhone). The company also rolled over to a national wireless plan that meant a one-time hit to ARPU, but is making that up on the data side. Enterprise revenue is increasing at over 40%.
A big reason to like the stock is the dividend. At Friday’s close of $10.52, it was yielding an extremely healthy 8.18%. The cash flow appears to be adequate to cover continue paying the dividend at its current rate.
ALSK is also a counter-cyclical play. The Alaskan economy, not surprisingly, is benefiting from higher oil prices and doing quite well compared to the rest of the country. ALSK could run into problems if oil was to drop back to $50 a barrel, but that wouldn’t be a problem for the rest of your portfolio.
Lastly, there is the drilling variable. There is talk in both presidential campaigns of doing some increased drilling, and the McCain campaign is specifically targeting the Alaska region. Any expansion of drilling in the region would be a further impetus to the local economy and ALSK would be one of the beneficiaries. At 8.2%, we think you’re getting paid well to wait.
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