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Avalon Asset Management Company God Rest Ye Weary Gentlemen
“But I heard him exclaim, ‘ere he drove out of sight, "Happy Christmas to all, and to all a good-night!"”- Charles Moore
It is said that there is an old gypsy curse that runs along the following lines: “May you live in interesting times.” As 2008 winds to a close, we can say without equivocation that the year has been an interesting one.
Yes, although we would have gladly done without it, the market crash of 2008 will pass permanently into the history books as a seminal event, one of the great bear markets in financial history. It will also be bracketing the left end of a severe recession. What the markets would really like to know now though, is what is going to be on the right end? Is it to be the recession of 2008-2009, the recession of 2008-2010, or something even worse that begins with a “D”?
That’s a question that the Fed is desperately working on as well. Last week’s FOMC action to cut rates to the near-zero range, the lowest in our history, may have rallied the markets for a day, but it also appeared to indicate a certain degree of anxiety about the current direction.
The interest-rate cut wasn’t that big of an event, though the zero figure made for lurid headlines and the larger cut made traders bulls for a day. Of late, the effective Fed funds rate had been running barely above that level, at about eighteen basis points. The wider measures that the Fed intends to take are more significant, in particular its willingness to buy up more kinds of debt and extend lending terms in order to restart the moribund securitization market.
That market, which chiefly involves the bundling up of car loans, credit card balances and mortgages, and packaging them as bonds to investors, needs to get going again to head off a larger liquidity crisis. Without sales, the auto business can’t get going again. Without confidence, few are willing to buy a house or car, especially if they find themselves without a job. Without credit, there is no confidence and no sale. It’s a nasty circle.
For all that, the equity markets seem determined to keep their year-end rally going, the so-called Santa Claus rally, and there is a good chance that they will succeed. Trading volumes will dry up dramatically between now and the end of the year; most books are closed and there is no new money coming into the market. Redemption pressures have eased, at least until next month, and there are probably more buyers than sellers for the moment. In such circumstances, relatively small amounts of money can push prices higher, lessening the sting of a brutal year for performance.
As a “Fast Money” trader put it early in the week, “this market wants to go higher,” so bad news doesn’t matter. Many pundits have made this claim in the last few weeks as the markets have generally risen despite poor data about the economy and earnings. But there is nothing new about such a phenomenon, especially at year-end, when self-interest lends itself to a little padding. Despite the bravado, though, the markets can only take so much bad news before they begin to crumble again.
In the interim, battles are raging over responsibility for the housing mess, the auto industry, the central bank’s aggressive monetary policies. Republicans are understandably anxious about not suffering the fate of Hoover’s party, which found itself locked out of the White House for the next five elections after the demise of the Roaring Twenties. Thus there is a growing movement on the right to try to shift the genesis of the housing crisis onto former President Clinton’s tenure. In reply, the New York Times featured the culpability of the Bush administration as its lead story on Sunday.
Both administrations tried to help housing along, and we can’t think of one that didn’t. During the recent boom years, however, there was a willing suspension of lending standards and sound practice, generated mostly by Wall Street’s desire for profits and abetted by a federal reluctance to intervene with tighter standards. There are plenty of villains to cast in that drama, but we would remind everyone that any move to tighten and curtail during the boom years of 2004-2006 would have been about as popular as increasing levels of nuclear radiation.
The auto rescue package rages on. Last week the Treasury did the right thing in our opinion, by raiding what was left in the TARP cookie jar to extend some credit to our domestic automakers. That was made necessary by the recalcitrance of southern senators who saw a free vote against bailouts of vile northerners, knowing that the president would pull their votes out of the fire as needed.
We watched one blonde basilisk come on television to rant that the whole thing was a setup to allow the Democrats to pay off the UAW for its presidential campaign support. Indeed, many conservatives see a once-in-a-lifetime chance to get rid of a group that has long been a major contributor to its adversaries. This may prove to be more than a little shortsighted, as autoworkers were heavily represented in the Reagan Democrat group, but it does remain true that Michigan autoworkers can’t vote down in Alabama.
Yet the woes of the auto industry are sales, not costs. The current run rate of auto sales in this country is about 11.7 million vehicles per year, compared to a typical run rate of 16-17 million vehicles per year. If that rate keeps up through 2009, the foreign automakers will be closing all of their U.S. plants as well, and simply wait for better days.
Should the automakers restructure to an 11.7 million rate? That is highly unlikely to last long, unless we get a depression. Should they restructure to the capacity that is likely to recur sometime over the next twenty-four months? Not easy either, because doing it properly would require more governmental funding, meaning more yelling and screaming. What the government would really prefer is to get sales going to a level where it can avoid some truly ugly choices, on topics such as retiree health benefits and increased job destruction.
As to the Fed’s quantitative easing, we are in uncharted territory. It is generally agreed that liquidationist and tight-money policies helped the turn the 1930’s recession into the Great Depression. The current credit crunch is the most severe one that we have faced since that time, so it’s understandable that the Fed and Ben Bernanke should roll the dice a bit to get the patient breathing now and worry about the side-effects later.
Many worry about the inflation that may follow, or the damage to the dollar. Yet we suspect that the latter is going to be limited by the even greater weakness of most of our trading partners, in particular Europe and its Euro.
A more immediate danger might be a possible unintended consequence of the governmental guarantees of certain private-sector debt: it may inadvertently create a two-tiered market, one that has no government guarantee and no liquidity, and one that has both. That could lead to pressure to guarantee a much broader spectrum of debt, leading to a deeper strain on our currency and financial system.
If we haven’t cheered you up enough already, keep in mind that if the five largest banks end up curtailing credit card limits to the tune of one to two trillion dollars, as feared by banking seer Meredith Whitney, it would dwarf the effects of any stimulus program that the new president can get going.
In sum, though we will be as glad as any to close the books on this year, we are not yet believers that the Fed’s magic wand can make Oz re-appear in the second half of 2009. Even if we do manage to catch sight of the towers of the Emerald City, the recovery may start from a level that is much further down the valley than the one we occupy. It looks like more interesting times ahead.
MarketWeek wishes its readers a Very Merry Christmas, in keeping with the circumstances – and a pleasant Boxing Day as well!
The market tried to stay ebullient in the face of the economy last week, but the new Fed policy that launched Tuesday’s big rally actions led to lingering doubts. As many an economist pointed out, if the Fed was ready to empty out all of its remaining ammo, it might just be that the governors think they have some good reasons for doing so. Even noted hawk Richard Fisher, the Dallas Fed president who’d been busy all last year voting for rate increases, has completely thrown in the towel. That got a trader or two to blink.
Maybe the Fed governors were just reading the daily newspapers. France and Germany business surveys hit new lows, with the worst German recession since the Second World War now part of the forecast. Russia is devaluing the ruble a few days a week, the Ukraine can barely pay its bills, Japan is in recession. Over in the U.K., governmental borrowing had its biggest monthly increase since 1993 (when monthly tracking began), while net mortgage lending is expected to be negative in 2009.
Here at home, the banks formerly known as investment banks Goldman Sachs (GS) and Morgan Stanley (MS) reported nasty losses (but beat the Armageddon whisper estimates), provoking downgrades by the companies formerly known as rating agencies. Layoff announcements are multiplying – Caterpillar (CAT) is laying off the first big batch of workers since the beginning of the decade. Management doesn’t seem to be heeding the traders who’ve bid the stock up 25% in three weeks, but they’re always the last to know.
Best Buy (BBY) said in its earnings report that it believes there has been a "dramatic and potentially long-lasting change in consumer behavior." That doesn’t sound promising. Year-on-year sales reports at the national chains are running negative. The governors may also have noticed that some of our states – such as California, one of the world’s largest economies – are about to go broke.
In the event, the Fed cut the target rate to a range of zero to twenty-five basis points, the lowest rates since the bank was created and its first target range ever. They announced themselves ready to buy just about anything, and in another effort to get the securitization market going again, extended the term loan structure for asset-backed collateral to three years from one. You can put the autoworkers on bread and water, but if people can’t get car loans they’re still not going to buy any cars.
As for the housing market, it is going nowhere fast – except of course for the stock prices. The latest index reading remained at its all-time low of nine (breakeven is fifty) with traffic at seven. Mortgage purchase applications fell again to very low levels, and housing starts fell off a cliff. November’s rate was the largest monthly drop in twenty-five years, and the lowest run rate in fifty years. Maybe the Fed is onto something.
Manufacturing continues to sink, but the Street managed to shrug it off by lowballing estimates. The New York Fed and Philadelphia surveys continue to point to deeply declining conditions, but the market seems content to treat them as earnings announcements that beat estimates. But they’re not earnings, nor price levels that have improved from the previous months. They’re steep declines piled on top of steep declines.
Industrial production in November fell (-0.6)%, slightly better than expected, though the Fed cautioned that even that decline was heavily masked by recoveries from the hurricanes and the Boeing (BA) strike. The market ignored it, even cheered October’s upward revision, when all that amounted to was simply shuffling some hurricane damage out of October and into September. Leading indicators fell another (-0.4)%, with the ratio of coincident to lagging indicators declining alongside.
The CPI (Consumer Price Index) may well have given the Fed’s Mr. Fisher a scare. The November total rate showed a larger than expected (-1.7)% change from October with no change in the core, while the year-over-year total rate has fallen to 1.0%. With energy prices still plunging (oil hit a five-year low on Friday), we may well end up with negative inflation in the year-on-year next month, also known as de-, de-, umm, deeply interesting.
Employment continues to disintegrate. Another week of big claims, 554,000 at first look, pushed the four-week moving average up to a new post ’80-’82 high. Continuing claims backed off mildly, but that’s no grounds for hope: its yearlong pattern is mild pauses followed by much bigger increases. The December jobs report is shaping up to be another record-breaker. Here’s a prediction: if the next number explodes at the same rate as the last, there won’t be any rally in equities this time around.
Next week is a short one, of course. We’ll get the last scheduled revision of third-quarter GDP on Tuesday morning, and I’m sure we’ll all be on pins and needles for that one. Later that morning, though, will come news of genuine interest in the form of existing and new home sales. The University of Michigan will also give us its first look at December consumer confidence; a relaxation from recent ultra-lows wouldn’t surprise.
Wednesday morning, Christmas Eve, is packed with goodies: November durable goods, personal income and spending, weekly jobless claims and both weekly energy reports. The markets will close early, at 1:00 PM EST; Merry Christmas to all, and to all a good night!
As we believe that the commercial real estate market has plenty of heavy weather ahead of it, we suggest that readers take a good look at the inverse ETF ProShares Ultra-Short Real Estate (SRS). We like this below $60, and it closed Friday at $58.76. This ETF attempts to duplicate two times the opposite of the direction of the Dow Jones Real Estate Index. Thus, a bear market in commercial real estate would lead to an increase in the price of SRS.
Be warned that this is a highly volatile security, and will usually move in the opposite direction of the broad markets.
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