Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
A Curious Incident
“”Excellent,” I cried. “Elementary,” said he.”- Sir Arthur Conan Doyle, The Memoirs of Sherlock Holmes
Was last week an example of the dog that didn’t bark in the night? Sherlock Holmes fans may recall the dog that did nothing and thereby made the famed sleuth so suspicious. Last week the market did nothing after a jobs report that was very far off the consensus. Suspicious stuff indeed.
Although the economy still lost jobs last month, the loss felt almost trivial. Equities rallied at first, but mostly came a cropper on a strengthening dollar and a wave of fear about whether the Fed might move sooner than expected. That had TV impresario Jim Cramer raging against the falsehoods spread by dastardly short-sellers, but the next day the Wall Street Journal carried an article wondering the same thing.
Well, it’s a natural reaction. Might the Fed move faster on interest rates? There certainly are reasons not to. Lending fell 3% in the third quarter, the largest such decline since tracking began in 1984. Ian Shepherdson of High Frequency Economics observed that $2 trillion in bank credit (loan and lease assets) are still to come out of the system. Gretchen Morgenson reported in Sunday’s New York Times that the Gang of Four big banks are still holding $440 billion of second liens and home equity lines of credit; we suspect that in a fair auction, those assets might possibly fetch something less than par.
That gives the Fed reasons to want to give the banks plenty of room to earn their way back into better capital positions. If rates stay near zero long enough, the banks may possibly even lend money at some point.
On the other hand, there’s the weakness of the dollar and the threat of too much money. Morgan Stanley (MS) worried last week about a UK sovereign debt crisis in 2010. The Fed surely wouldn’t like to find itself in that line of thought. More are calling for a pre-emptive rate rise to say, one percent, as a level sufficient to slow the dollar/risk-asset pair trade, yet still allow banks to make money (we support such an idea). The problem with every crisis is that they always appear to be contained at the beginning.
All of this has left the market off its usual feeding pattern for this time of the year. Ordinarily we should be winding up the first week of December gains over the next day or two, to be followed by a brief retracement that would set us up for the “Santa Claus” rally sometime the following week.
But last week went rather sideways, and many funds seem determined to do very little beyond protecting their gains until the end of the year. Futures indicate some bit of nerves as we go to press.
Even so, the only effect may be to shift the usual second-week pause by a couple of days. There is too much complacency in the market, but it’s difficult to overcome at this time of year and we doubt that the Santa Claus rally can be derailed. The market has had trouble breaking through 1120 (S&P 500), but we wouldn’t count out one last glorious rush towards self-affirmation.
We should mention a correction: last week we stumbled over the prone figure of our faithless copy editor and published that one in four mortgages were in arrears or in default, when the real figure is about one in seven. We knew this, but were regrettably thinking about a widely reported headline story that did concern one in four homes, namely a story by the Journal that estimated the proportion of American homes that are underwater. In other words, one in four are worth less than owed.
Once again we have threatened our copy editor with draconian punishment and cut off his YouTube privileges for a week. Alas, as in the past, he walked away with a smirk and a sly aside about the resolute nature of our strong dollar policy. Most disturbing. Thus, in the spirit of our grandstanding Congressional representatives, we will blame Treasury Secretary Geithner for the mistake, for it surely cannot be ours. We intend to question Chairman Bernanke about his role as well. After all, total economic illiteracy is a hot currency on the hill, and we want to spend our share.
It’s always nice to find a fall guy, isn’t it? Populist anger towards the government and mysterious big-money institutions comes with every recession, and the current version has made for some spectacular headlines and missteps. We feel for Chairman Bernanke, who has had to squirm under some rather pointed questions about the Fed’s role in the bubble and ensuing collapse.
It’s not to say we excuse the Fed in any way. We were growing anxious about lending standards way back in 2005, and waited in vain for the Fed to quietly suggest to banks that they keep reading the loan applications thoroughly, rather than just batch program vast stacks at a time for approval and then reship them elsewhere.
As for Lehman Brothers, our position throughout has been that it was the worst policy blunder since the Great Depression. Having Lehman disappear in its then-current form was probably unavoidable at the time it happened. But when one of the world’s largest global investment banks is about to plummet into an unmanaged bankruptcy in the middle of a rapidly escalating financial crisis, looking the other way and crossing your fingers has to go down as one of the stupidest decisions in financial history.
There’s an old saw on the Street, largely true, that holds that only really smart guys can make truly dumb mistakes. Lehman’s a good example of that wisdom. But it’s a rather large and unfair approach to put it on Bernanke’s shoulders. Like Secretary Geithner, he does have the unfortunate problem of still being in government service. That makes it mighty convenient for our political buffoons to haul them up into the stocks and pretend that our elected representatives had nothing to do with it.
But they did. Former Treasury Secretary Hank Paulson is a former chairman of Goldman Sachs (GS) (just in case you are one of the few who didn’t already know). In our minds, he is most responsible for the Lehman blunder. Had he told Bernanke that Armageddon would follow if Lehman blew up – not failed mind you, because like Bear Stearns, the guvvies could have made a deal for Lehman to be cut up and sold – then we are quite sure that Bernanke would have found something to do.
But Paulson didn’t tell him that. He was the expert on financial markets, not Bernanke. It’s legitimate to argue about whether it was wise to choose an academic such as Bernanke in the first place, but another Greenspan was clearly not wanted at the time. In any case, it might not be possible to have a chairman who is both thoroughly grounded in central banking and a veteran market insider at the same time. Bernanke’s understanding of what to do once the fall occurred may have no equal.
The Bush administration won its election. They were our elected representatives. After the Bear Stearns rescue, it came under attack from within from a loosely knit group of ideologues and laissez-faire wing-nuts who have a unifying belief that any government intervention must be wrong (unless possibly it involves using our military to beat people with a stick). When Lehman’s number was up, the administration decided to try the ultra-laissez-faire approach. It did not work.
Instead, it nearly caused the entire global financial system to collapse. But we got the policies that we asked for. Not everybody, perhaps, and certainly not the results, but the free-market movement had come to reign supreme and its song was number one. The majority re-elected a group that promised more prosperity.
But we got another group, one that was busily hijacking free-market capitalism – which we approve of – in its pursuit of a deluded vision of laissez-faire extremism. They more closely resemble a kind of religious cult than a group of thinkers in the way we understand the term. Many still work the Street and the halls of various “free-market” institutes, and are still furious that the government intervened at all with Bear Stearns, or after Lehman Brothers. Like the Khmer Rouge, these ferocious warriors stand ready to sacrifice as many of their fellow men and women as necessary in pursuit of purity. After all, they have plenty of gold salted away.
Look back, and you can be sure that the principals involved would leap at the chance for a do-over: Chairman Bernanke, Treasury Secretary Paulson, President Bush. Given a second chance, they would be only too happy to ignore the strident yammerings of the self-appointed high priests and do the practical thing. They would (horrors!) intervene in the markets, find a way to carve up Lehman, stabilize the death spiral. We wouldn’t have avoided the recession – we were already in one – but we could have avoided stepping off the cliff.
The conclusion is that appointing another regulator or weakening the Federal Reserve is pointless. The Fed is, and always has been, a political institution. Its various chairs and governors are very aware of what any administration thinks and wants. They listen. They’re not at the whim of Congress or the President, but nobody but the propeller-hat set would want that.
We could pass a hundred new rules now, create a new risk czar, shuffle the birdcages all around, but it wouldn’t help anything. Mainly it would cause a lot of confusion and anxiety. We had enough rules and laws ten years ago. But the prevailing thinking was that enforcing rules was blasphemous, so there was no enforcement. For ten years, Capitol Hill and the White House unwound sixty and seventy year-old rules about banking, short-selling, leverage. The SEC studiously pursued a policy of disdain for itself and focused on reading the lobby room magazines while providing career paths to Wall Street and Capitol Hill. Enter bubbles, Bernie Madoff and the Great Recession.
Some sixty or seventy years from now, after every adult who was an actor on the scene has passed away from the stage for good, we will once again start to listen to the tunes of a Pied Piper. It won’t matter if there are agencies and laws created to prevent us from listening again, because human beings are responsible for them. Maybe we’ll repeal the rules, or decide they are too antiquated to take seriously, but if we want to hear the music, we’ll make sure that they let us listen. Time to take down the tents of the blame-fantasy carnival and get on with the real problems.
The jobs report left the market curiously unmoved at the same time as it dominated news outlets. The reported loss of only (11,000) was much lower than the consensus for (-125,000), which had itself been moving up stealthily. At the end of last week, it called for a drop of 100,000. By Tuesday, it had gone to (-125,000) and on Thursday I heard an expansive fellow broadly smile and shrug that he thought the consensus of (-150,000) was probably right. So the whisper number was probably (-175,000), given additional impetus by the ADP payrolls report that estimated a loss of (-169,000).
I reckoned by Thursday evening that it would take a print worse than (-200,000) to rattle the market. A loss of 100-175,000 would probably have generated one of those counter-intuitive rallies that the markets loves – in this case, it would have meant that the Fed is probably on hold for the rest of 2010! But could that possibly happen after adjustments?
Apparently not. The labor report showed continued weakness in goods production, but health care still adding workers, with large increases in home health care, hospitals and social assistance. Also in the plus column were state and local hiring for education, temp workers and custodial hiring. Not quite the best-paying jobs.
The gains were strongest in temp employment, which did benefit from big seasonal adjustments. We would advise not listening to the Street economist who crowed that the report clearly shows that companies are looking to expand payrolls. If that’s the case, then why, on a non-seasonally adjusted basis, did the losses in goods production accelerate from October to November, going from minus 140,000 in October to a loss of 172,000 in November?
Frankly, we doubt the numbers are very close to the truth, but the direction is unmistakably better. The upward revisions to previous months were sizable, and key indicators such as the average workweek and the aggregate weekly hours improved (although the latter is still below the second quarter average and virtually unchanged from the third).
Yet the so-called strength of the report is belied by the ADP report, the Monster employment indicator, consumer sentiment data and the business surveys. The picture seems to be one where jobs continue to be very difficult to find but layoffs are at least slowing down. That seems to be a necessary step in a recovery.
But that is contradicted by the weekly claims data. We are aware that the BLS is reporting smaller numbers, but the fact remains that the unadjusted number of initial claims is still rising. Last week they were 543,000, yet the department took it down to 450,000 or so. We don’t think an improving economy would be laying off well over half a million workers a week two years into a recession, and do think that the seasonals are bogus in this case.
Three business surveys reported last week, with mixed results. The Chicago regional ISM report started it off on Monday with a positive result of 56.1 that was better than expected, as well as benefiting from a chunky seasonal adjustment. The theme of the report was stabilization, as most categories (including employment) saw a pronounced convergence away from stronger or weaker activity into no change.
However, the national ISM manufacturing report released the next day was not as good as hoped for. It was still in the expanding category, with a result of 53.6 (all the ISM reports use 50 as the neutral line). But unlike the Chicago version, the national report showed pronounced drops in answers that indicated higher levels of activity, along with nearly identical rises in the number of surveyants reporting lower activity. Twelve of the eighteen industries reported growth, but only six reported an increase in employment.
The non-manufacturing report that came out on Thursday caught us by surprise. Like most, we thought that the surveys would show mild improvement throughout the quarter. Instead the services sector reported a contraction (48.7). New orders held steadily in expansion mode, but the slightly better October new orders result failed to translate into November expansion. The employment reading continued to be weak.
One of the puzzles that arose out of the week’s data was that the manufacturing sector had an employment reading that was slightly positive (50.8), while the services sector produced a clearly weak reading (41.6). Yet the losses in the jobs report were concentrated in goods-producing industries, while all the gains came in the services sector. That’s quite a contradiction.
Robert Ore, the ISM chairman for manufacturing, was careful on Tuesday about the sector’s employment prospects. In a televised interview, he observed that if one respondent plans to cut 100 jobs and another plans to hire one person, the two answers cancel each other out. He further pointed out that the jobs question is essentially posed in contingent terms: would your firm hire if there were need? “Yes” answers don’t necessarily indicate that hiring is imminent.
Factory new orders improved by 0.6% in October, a positive surprise to the consensus that called for no change. But there was little sign of pipeline pressure – durable goods still fell, unfilled orders fell and inventories rose. Weekly retail sales moderated, leading to disappointing same-store sales reports on Thursday. The last estimate we saw was that same-store sales only rose 1.0% overall in November, quite a weak showing given the comparison with 2008. The retail sales report due next Friday is hoping for a 0.9% increase from October, helped by motor vehicles sales that while still weak, showed another month of improvement.
Pending home sales were reported to have risen 3.7% in October, which is good, but a definite slowdown from the previous month’s pace. Only about half of pending home sales of late have translated into existing home sales, so it will be revealing to see if this trend continues.
Construction spending did something in October, but we don’t know what. It was reported to be unchanged, but September’s original 0.8% boost was revised all the way down to a 1.6% loss. That’s an awfully large swing. There was some chest-beating over the 4.4% rise in private residential spending, but before you celebrate, you might wish to consider that the original September increase of 3.9% was revised to a fall of 1.8%!
Productivity for the third quarter was revised downward, but to a still pretty good clip of 8.1%. Output and labor cost readings were both milder than thought. The Fed Beige Book was once again a non-event, telling us that conditions had mildly improved, but the economy remains mixed.
There isn’t enough evidence in yet, but there appear to be two possible paths the economy is traveling. One is the straight-line recovery scenario favored by many Street strategists, with the degree of speed the chief subject of debate. The other might be thought of as the bouncing-ball model, with the initial high rebound from the plunge followed by successively weaker bounces. For ourselves, we have a sensation of a slight slowdown in November, but the inventory rebound might still come to the rescue, at least for a while. It hasn’t been much of anything so far, which leaves the door open for some improvement in the first quarter.
Next week will shed very little light on the subject. The calendar is almost completely empty, with nothing of real note until the November retail sales report on Friday. That usually indicates a continuation of the previous week's momentum, but of what? The price action was quite indecisive.
Still, there is a consumer credit report on Monday afternoon that, while not a traditional market-mover, in these credit-starved times comes in for a lot more scrutiny. Results have been a disappointment for months. Fed chairman Ben Bernanke will give a speech on the same day to the Washington Economic Club at lunchtime. It will probably hold no surprises, but one never knows what word the markets may fasten upon. That’s why Greenspan was so deliberately obscure.
Besides the retail sales report, the week will wind up with the international trade report on Thursday and trade price data on Friday, along with the first December consumer confidence reading and an October report on business inventories, which appear to have fallen. The earnings calendar is light and features mostly retailers, notably Costco (COST) on Thursday.
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