Summer Daze
“For he both pleases men and angers them” – William Shakespeare, “Much Ado about Nothing.”
by M. Kevin Flynn, CFAThe month of August 2007 ended last week with a spell of beautiful weather in the environs of the financial city-state of Manhattan Island. The relative calm in the credit markets kept the kingdom’s elite away and more or less off-duty for a second week. Their wirelessly tethered vassals, left in possession of the field, the tourists and the weather, would probably have gladly traded places, if not paychecks, with the tourists for a day or two as they were whipped around on their summer carnival ride.
The dips and lurches left not a few wobbly-legged and reaching for the little paper bags, but the final day of August actually left the markets in the plus column for the month, if not quite for the week (though the Nasdaq did eke out a small gain). In contrast to last year, though, when the markets entered September feeling quite smug about its chances of beating the September jinx, the only thing traders seem confident about right now is that the month will be another white-knuckle ride.
Despite the unusual back-to-back 200-point days that were, after all, mostly episodes of follow-the-leader that got out of hand, the main event of the week was Friday’s “Let’s Make a Mortgage Deal.” Eagerly anticipated and co-hosted by Messrs. Bush & Bernanke, the markets rose in anticipation of the show but in the end the reviews were mixed. Both men want the mortgage markets to settle down and not do any more damage to the economy, but neither want to be seen in the position of letting the current posterboy villains, those vile speculators, off the hook.
The President’s offer of help to suitably qualified homeowners was something of a letdown, being that the filter for qualified promises to produce a disappointingly small number. For his part, Bernanke plainly acknowledged the Fed’s concern about the uncontaining of the subprime problem and the potential for real harm to the rest of the economy, but stopped short of promising a rate cut. For now, it looks like we are stuck with another couple of weeks of market soothsayers cackling about the inside scoop on the real meaning of it all, at least until the Fed actually meets on September 18th.
Near term, both leaders will be trying to figure out how much pain the patient can take without going flat-line. The President appears to be constrained by an inner circle of advisors philosophically opposed to funding anything that isn’t related to arms, cops, spies or oil and coal. On the other hand, his party has been struggling of late, and heading into elections with Iraq tied to one leg and a recession and foreclosure flood on the other would risk massive defeat at the polls. For now, it looks as if the administration will continue its apparent policy of trying to look concerned while hoping that Ben & Co. manage to sort it out on their own.
The Fed, as anyone who’s been reading the business news has noticed, is in a tricky place. It looks like they’re getting the upper hand on inflation. They’d like to bleed some of the subprime offenders a little bit and put some more caution – “moral hazard” - back into the investment arena. On the other hand, though, they’ve been losing the containment battle and want to keep the markets from losing so much confidence that we slide into recession. The fall is usually a tricky time for markets and in the current climate of anxiety, it’s conceivable we could get to a place where simply not cutting rates would be problematic. They’ll need a bit of luck.
Longer term, the outlook is difficult. The main engine of domestic growth from 2002 through last year was the increase in asset prices resulting from the low cost of money. But the Fed’s rate increases gradually shut down much of that engine. The stock market continued to party on anyway, driven by its own momentum and relying on such props as currency-inflated foreign earnings and buyout pools emboldened by the lemming-like plunge in lending standards. But the truth is that aggregate earnings from domestic operations have been going nowhere for almost a year now.
The West has been engaged in an unholy trade for some years now of reallocating input factors of capital and labor to Asia, principally India and China, in exchange for cheaper goods. We sell them the production capacity, they sell us the finished product. They reallocate subsistence-level farm workers to goods production, and we reallocate our goods production labor to subsistence-level retail positions that sell us the imported goods.
This is not an argument against free markets. However, one result of the increasingly unchecked frenzy to cash in on equity-based executive compensation is that we have shipped a great deal of our production capacity abroad in order to maximize profits. In the process, we have stripped away much of our own earning power, at least at levels below the executive suite (median income has been declining). The easy-money policy that was needed to pull us out of the bubble-collapse recession led to an historic, once-in-a-lifetime spike in housing values. The conversion of those assets to cash enabled spending to be maintained, even expanded, in the face of that loss of earning power. But that spike is over.
The Street has been hoping that a combination of business reinvestment, especially in technology, and a continuation of foreign demand for U.S. products will stimulate demand enough to keep the economy growing. However, European demand for U.S. products is based on an Asian order book that is very much like our own. The rapidly growing Asian economies are providing the growth at the margin, but they are still much smaller than ours. One scenario that the Street has not wanted to think about is that in place of Asia-centered “global” growth stimulating U.S. demand, the slowdown in U.S. spending would instead begin to drag down Asia. That would be an unpleasant spiral.
One advantage of the present situation is that technological innovations have resulted in a smoother inventory cycle than we experienced in days past. Apart from housing, we don’t have an inventory problem. Another is that although incomes have become significantly more unbalanced, the employment picture is still relatively full. We can survive a bit of a slowdown.
Nevertheless, there are sufficient structural risks – we haven’t even touched upon the Chinese and Indian stock market bubbles - that the Fed may have no choice but to begin lowering rates soon, even if they would prefer to wait and appear unforced. Merrill Lynch (MER) recently put on its “sell” list the brokers, Wal-Mart (WMT) and the state of California (Countrywide (CFC), the builders and Safeway (SWY)). It makes you wonder what they know. (On an unrelated but still juicy aside, Credit Suisse is paying former banking employee and techbubble symbol Frank Quattrone’s $20 million-plus legal bill. Makes you wonder what he knows).
I have every sympathy for the Fed’s desire to prevent a restart of the carelessly risky behavior that became widespread over the last few years. But they are quite aware that in the patient’s current condition, the remedy could be worse than the disease. The dosage may have to come down.
The Economic Beat
The early part of the week was light on data and even lighter on news. Existing home sales were steady, but the supply of homes for sale hit the highest levels since the housing recession of 1990-1991. Consumer confidence levels declined as expected, but the number is not much of an indicator. The media gave it some attention Tuesday for want of other hard news, but the markets gave it the usual shrug. The Michigan version was released on Friday, showing little change and getting even less attention.
The second-quarter GDP number was revised upwards, as expected, but had little market impact. Much of the strength in the revision was due to higher export and lower import calculations. That kind of revision might get a benign greeting during happier times, but in the present circumstances there is more room to worry about consumer spending. Business investment was revised upwards and residential (housing) downwards. Probably the biggest factor in the number being a non-event was that the pre-meltdown quarter feels very far away now to market participants.
Friday, by contrast, had lots of interesting news, beginning with the personal income and spending report. The inflation part was good news, as the PCE component (Personal Consumption Expenditures) rose a modest 0.1 percent on both a core and non-core basis, putting the yearly core change at 1.9%, within the Fed’s comfort level.
Personal income came in at a higher than expected 0.5%, Before you break out the champagne, though, nearly half of the increase came from government transfer payments and an increase in dividend and interest income. Private wage growth actually slowed from the previous month. Expenditures, recovering somewhat from June, met expectations but the annual growth rate continues to decline. The government noted that second-quarter corporate profits rose, but domestic profits were up a mere 1.0%.
Factory orders came in above expectations, but were driven largely by strength in aircraft and defense spending. Overall, the economic picture continues to be one of weak growth. As Mark Zandi, chief economist of Moodys.com put it, the difference between a weak economy and a recessionary one is confidence, on the part of consumers, business and investors. The next few months will be critical.
This week’s ISM survey, to be released on Tuesday, should give us some insight into the credit market’s impact on business sentiment. The data of the week will be the employment report on Friday.
The over-valued stock of the week is Amazon (AMZN), whose last quarterly earnings report has helped it to a subsequent 15% price rise, net of the August drop. The stock is now trading at about seventy times cash flow, 180 times trailing earnings, eighty times current earnings estimates, oh it goes on and on. The stock is trading back to dot-com prices, though it hasn’t quite yet achieved dot-com multiples. It’s one of Jim Cramer’s “Four Horsemen” (of the Apocalypse?).
It’s a name to be careful of, because for two quarters in a row it’s beaten estimates by enough to catch its many short-sellers in a riptide. It’s more than tripled in the last twelve months, largely on the strength of the moves surrounding its last two earnings reports. Despite the extremely high valuation, analysts continue to shower the company with buy recommendations (hey, brokers need to make money too). It’s had its price target raised eleven times in the last month. That’s some momentum to watch out for.
I actually think that Amazon is a decent company. And I do believe that online retailing is going to continue to take market share from stores, though that rate is probably going to decelerate. That’s not why the stock is at $80. Those who own it don’t own it for its 24% gross margins or its 4% net margins. They own it because right now, Amazon’s stock is rocket fuel. The “smart” trade right now, we’ve been told over and over, is big tech. There are few big cap growth stocks around these days that are really growing sales at a rapid rate, and Amazon is one of them. Money has been flocking to that small group.
But at these levels, Amazon is running out of room for error. At the macro level, consumer spending is slowing. At the company level, Google’s (GOOG) stock price took a hit when its investments in growth began tugging at margins. Amazon has raised its margins by scaling back its investments, but they can’t play that game for long. The price is too high now, but if the market doesn’t crater it’ll probably get even higher in the near term, which would present a tasty opportunity.
The recent pattern for the stock is to run up to the end of the year as a Christmas bet, and then correct. There’s a good chance that you won’t have to wait until the end of December this year.
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