Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company 'Tis the Season
“Follow me with merry measure...while I tell of Yuletide Treasure” – from the Christmas carol, “Deck the Halls” (anonymous)
December’s first week neatly recapitulated the market action since the long-gone halcyon days of August, when beautiful weather and sublime complacency prevailed in New York City and all along the Eastern seaboard. We wrote columns praising the sunshine and warning readers against believing in any rallies. Then along came September, and down went Fannie (FNM) and Freddie (FRE), Lehman and everything else.
And so it was that Monday the 1st ended the biggest five-day rally since 1932, by answering with the biggest first-day-of-the-month drop in the markets since 1929. It was the fourth-largest point drop ever in the Dow Jones. Since the September abyss, we’ve had no fewer than three thousand-point rebounds in the Dow Jones, and we are in the midst of one now (or have just completed one). Each rebound was punctuated by remarks that the bottom had been put in, and that the market and traders were now looking ahead. Each one has been followed by declines to new lows.
The last four days of the week were familiar. Bad news poured out in buckets, all of it worse than expected, and yet the markets held on stubbornly for the rest of the week. We had the usual frenzied gyrations in the closing hours, but by week’s end traders were sounding ebullient again. Yes, it’s time to look across the valley and grab that Santa Claus rally.
Once again as in olden days, the bad news is already priced in. So deck those halls and buy those homebuilders: commentator Jim Cramer was so pleased by the market’s resilience, that he took homebuilder Toll Brothers’ (TOL) CEO Robert Toll’s gloomy outlook as contrarian evidence that it’s time to move in to win. We were a little uncertain as to what make of this, as the homebuilders were accurately predicting at the beginning of 2007 that the housing market would go into the tank, while Wall Streeters accused them of being unduly pessimistic. It turns out they weren’t.
As to how much bad news is really priced in, our answer is that while that is certainly the case for some stocks, it’s instructive to compare the rally in homebuilder stocks with the layoffs at AT&T (T). The latter announced a cut last week of over 10,000 white-collar employees. At the same time, mortgage purchase applications bounced higher on a decrease in rates and refinancing applications rose higher still. We can expect a continuation if the government’s (rumored) plan to take rates down to 4.5% becomes reality.
Homeowners eager to lower payments will leap at the lower rates, which would lead to an increase in disposable income. Such low rates would also pull in a sizable number of would-be buyers who don’t want to miss out on lower prices, leading to a bump, or at least flattening out, in home sales.
As improved housing data start to arrive in January along with the arrival of the new president, hopes that the corner has turned may soar, along with the desire to ride any rally in stocks (and of course there is always the chance that traders will begin to anticipate this very scenario and jump the rally into this month).
The reality, though, is that AT&T’s massive layoffs were one such story among many this week, as evinced by the jobs number. As usual, our sheeplike corporate executives are all using the same playbook. The more recent fad of outsourcing and stock buybacks (to get the value of those stock options up), a little trend that did nothing at all to improve company product lines, quality or demand, has given way to massive layoffs and draconian cuts in capital expenditures. At least that has the virtue of consistency, because it has the same zero effect on quality of product or its demand.
In fact, in aggregate the new fad will lead to even more declines in demand. But by then our execs will have lots of practice in how to do ever more cuts in staffing and cap-ex. The net effect is that even though lower rates and foreclosure assistance will flatten out the decline in home prices and sales, the homebuilding industry is going to be swamped by unemployment and income effects.
In addition, while big banks are very happy to collect fees to refinance mortgages that can be sold to Fannie and Freddie, there is no indication that they actually want to lend money to anybody with less than a fifty percent down payment. We have said before that this cycle is not like the 2001-2002 recession, when homebuilders recovered early, but more like the 1990-1992 version, when home prices fell and the sector didn’t recover until the rest of the market did. It’s going to be a long, slow recovery.
I don’t need to tell you that credit is different this time, but what’s unusual about this recession is the lack of tide-you-over money. In other recessions, private equity and vulture funds step in and bottom-fish companies that weren’t in such great shape, but had brand value. With some cash to tide them over and some restructuring, the companies slimmed down, got better and lived to fight another day.
It isn’t happening this time, because there is practically no lending available. Companies will go out of business that probably shouldn’t, for the primary reason that they cannot roll over debt or borrow money. Linens ‘n Things, to take a recent example, had to shutter for lack of financing. Many familiar names are going to disappear in the next two or three quarters – along with their payrolls.
Additional pressure may come from the credit-card sector. Banking analyst Meredith Whitney, whose dour predictions on her sector have been consistently on the money, fretted on Tuesday (causing a closing sell-off) that the larger banks – the top five now do seventy percent of credit card issuance – may cut or pull credit lines by the end of the year, thereby dealing another rabbit punch to the consumer. We have to agree that the effect would be devastating.
In the face of all the facts, it seems illogical for the markets to have been rallying and traders to have been beaming by week’s end. Yet last week reminded us very much of the market’s rally in the first week of April. Then as now, an absence of selling allowed day-trade-type buying to move the markets higher. The redemption pressures that have plagued the markets of late have eased, although in our opinion it’s only a pause.
Eight months ago a wave of complacency engulfed the markets that the worst of the news was past and the second half would bring recovery. Last week, the idea that the economy recovers in the second half of 2009 was rapidly becoming gospel. Massive write-offs by investment banks in April invoked the “kitchen sink” theory now back in vogue, and their stock prices rallied on the news.
Throw in the belief in a seasonal rally - April is one of the best months for equities, while the “Santa Claus rally” is a popular notion on the Street – and you have ingredients for a move higher. The economic calendar is mostly empty the next few days, which could help traders fuel a climb in prices. Treasury bond yields are at record lows, with the two-year Treasury note trading at just over eighty basis points and the ten-year yielding about 2.55%. At those yields, traders are hesitant to keep buying into what may be a bubble. That makes stocks more attractive.
Yet any second-half recovery is far from assured. If the big card issuers do move en masse to cut credit lines at the turn of the year, you can forget about a recovery in 2009. Likewise if the government messes up the automaker relief package and opts for a bankruptcy experiment, although economist Mark Zandi’s assessment before Congress last week that such a course would be “cataclysmic” for the economy seemed to stun lawmakers into backing away from such an action.
Even so, some kind of pre-packaged bankruptcy solution is getting a lot of airplay. It’s an idea based in politics, however, not in economic reality. The political solutions that have been tried so far – Fannie, Lehman, the first AIG solution – have worked out quite badly. Yet like eighteenth-century doctors bleeding a patient to death, befuddled Ayn Randians keep wanting to apply more leeches. We’re not out of the woods yet.
One often hears that stocks will begin a sustained rally before the economy actually recovers. It’s true. One also hears that unemployment peaks after the economy has turned; also true. What one doesn’t hear about is that stocks rally many times before the economy recovers. Each succeeding rally blows up, until by force of repetition and an eventual economic turn, one sticks. Being only human, we like to remember the one that worked and forget about the others.
On Friday, market participants seemed quite pleased that the market had managed to rise in the face of a historically bad employment report. It’s all very well but for one thing – we have seen many a stock market rally in the face of a bad jobs report, both in the current recession and in earlier ones. We cannot recall a single one that didn’t come to grief.
We wish a happy feast of Saint Nicholas to our European readers.
In last week’s column, we wrote that the coming week would provide a stern test of the market’s “new new” thing, namely the feeling that since prices already discount worst-case scenarios, we can cast a steely eye upon more bad news.
Those steely eyes were glassy at the end of a week of reports that widely missed every estimate to the downside, none more so than the jobs report. The stunning loss of (-533,000) led the front page of every newspaper in America, if not the Western world. It was the largest such loss since 1974, although it must be said that the 1974 loss was a much larger percentage of the actual workforce.
Even the worst-fears whisper estimate of (-500,000) that surfaced Thursday afternoon – a kind of just-in-case protective insulation – came up short. The revisions were massive as well, with the addition (or should it be subtraction?) of another two hundred thousand to the losses in September and October.
That brings the tally to a loss up to over 1.2 million in the last three months alone. In the last twelve months, we have lost more jobs than the entire 2001-2002 recession. It looks as if the National Bureau of Economic Research (the official arbiter of such things) is right: it announced that we are in a recession that began last December.
The part of the jobs report that didn’t fit was the unemployment rate, which comes from the household survey. The 6.7% reported rate, better than the expected 6.8%, was due to a huge drop in the number of people looking for work. That was doubtless good for the nerves of the market, but many, including ourselves, wonder if the true unemployment rate isn’t running about a hundred basis points higher.
It won’t be the producing side of the economy that comes to the rescue next month. The ISM manufacturing survey reported its worst reading (36.2) since November of 1982, with new orders falling to the lowest levels since 1980. The drop in the price level was the largest since 1949. We do seem to be nearing the top of the list in the record books. The survey was echoed by a drop in factory orders of (-5.1)% that included a drop in capital goods spending of (-4.3)%. It was the third big monthly decline in a row.
Things weren’t any better on the services side. The jobs report showed a loss of (-370,000) in the service industry, while the ISM non-manufacturing survey hit a new all-time low of 37.3. New orders fell even further. Overall, this was one of the weakest ISM months since the nineteen-forties. Every sector is contracting, although education, health services and government are all still hiring. A year ago we were derisive of this trend, now we are grateful that anybody at all is hiring.
Although those sectors are hiring, most are firing. Weekly unemployment claims are still running over five hundred thousand, the four-week moving average is up over 524,000 and continuing claims ratcheted back up (as predicted) to nearly 4.1 million. Those are levels not seen since the 1980-82 recession.
Some data did beat 1980-82: retail sales. Same-store sales turned in their worst performance in about thirty-five years. However dismal that news, it came with its own otherworld kind of weirdness as equity markets congratulated themselves that the declines were largely in line with estimates. The party line was that it validates the immune-to-bad-news theory, but we can’t help but wonder something: if sales fell the most in thirty-five years while unemployment is still accelerating, what’s going to happen to sales after a few more weeks of layoffs? Initial claims are running at a rate of two million a month!
The renewed weakness in construction spending in October – a fall of (-1.2)% - probably accelerated in November. This is weak for employment and quarterly GDP, but in the perversity of economics it does help clear the decks for an eventual rebound. Or so we hope. One of the immediate reactions to Friday’s labor report was the expectation that it should lead to a larger stimulus package from the next government, if not the current one. That should lead to some improvement in non-residential construction spending; it’s not clear that any is needed yet in residential construction.
That economics is the dismal science was illustrated by the improvement in productivity and costs: it was due to employment falling faster than output. More improvement like that, and we’ll soon all be productively unemployed. At least it’s good for inflation, leaving the Fed extra room to get creative with its quantitative easing policies.
Next week will bring what is likely one of the worst November retail sales reports ever. That report, due on Friday, ought to further aid prospects for the larger stimulus package. Besides the pending home sales out on Tuesday, there isn’t much else of interest in the first half of the week, although we suspect more interest than usual in the weekly mortgage activity report.
Thursday brings the monthly tidings on international trade, and the Producer’s Price Index (PPI) will be released at the same time as the retail sales report on Friday. The latter two might conceivably bring an end to a rally, first because the lack of data in the first part of the week is likely to encourage one, second because the PPI report may well revive deflationary fears, and last because the retail sales report is going to be horrific.
From here it looks like a Friday exodus should be the order of the day, but seven hours is far too long to try and predict the markets these days, let alone seven days.
StockWatcher still recommends that you wait for the auto rescue package to be worked out before buying individual names. Be wary of rallies.
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