Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Waiting for Da Dough
“The world is still deceived with ornament.” – William Shakespeare, The Merchant of Venice
Tempers and dispositions took on a noticeably soured hue last week as January’s dreams of imminent glory began to crumble and fade. It really couldn’t be helped, given the market’s built-in tendency to rally on its own fantasies of islands in the sun, then sell off as soon as the first pictures become available.
So long as the government acknowledges that it may need to act without specifying the details, the market is free to construct a thousand dreams of what might be. Once any details become known, though, of necessity the dreams will vanish and leave us with reality. That state, you have probably noticed, pretty much bites these days. Therefore, one must honor tradition: buy the rumor, sell the news.
While the press seems mostly inclined to pursue the angle that it was Treasury Secretary Geithner’s lack of detail on Tuesday that caused the market to sell off – a view eagerly fanned by newly out-of-power Republicans delighted to be back in the audience throwing the rotten fruit, rather than being the ones on stage catching it – that’s a misreading. Equity markets had put on a trader’s rally in anticipation of powerful new magic coming from the new shamans, but it’s unlikely any spell would have sufficed for long. The magic dreamt of is far more powerful than anything that can be produced.
Suppose, for example, that Geithner had thrown out the reddest two pieces of meat that market lions have been clamoring for: an end to mark-to-market accounting, and a mega-bank that would instantly buy up all the bad assets on bank balance sheets. We’d have seen a violent move in equities, amped by a lot of short-covering, and for a day or three, the bears would have had to run and hide. But then the doubts would have started: did the government pay too much? What’s going to happen to the dollar? Why did/didn’t the government nationalize the banks? Why didn’t we arrest all the bank executives? Should we have shot them instead?
Most of the promise that accompanied the recent rally in stocks was invented by the market itself, as was the disappointment. The new administration promises to get to work as soon as possible. The situation is dire. Talk of the necessity of a “shock and awe” program becomes the latest wisdom on the Street. Wow, shock and awe, that alone makes you want to reach for the buy button, doesn’t it? The trade of the week is the bailout trade.
Geithner promised a statement by last Tuesday, mostly to try to defuse the daily clamor to Fix it All Now. Since the markets wanted shock-and-awe, ergo Geithner must be planning a shock-and-awe speech. Obvious, isn’t it? The scenario was neatly sketched out: bid prices up in anticipation, short-covering rally on the plan, sell off the next day or so.
But there was neither shock nor awe, not much more than a reiteration that we have a big problem and should probably think carefully about how to fix it. No S&A, no short-covering rally. Traders feel aggrieved, but few were really buying into the notion that the new administration had it all doped out only twenty-one days after taking office. They were buying into the trade first, the dream second.
The main problem that the markets have right now is that they are plain fed up with the financial sector. They want the problems to go away, and the sooner the better. Most of us can empathize. Yet the creeping fad on the Street for nationalizing the banks is nothing more than classic self-promotion, a.k.a. talking one's book. Traders long on tech and energy think that if they can just get the banks off the front pages, they can get that big rally going and make some big dough.
This creates pressure on the Obama administration to act too quickly or do something as stupid as nationalize the banks, a guaranteed disaster. We’re not arguing for the slowest possible approach, but by all means fellas, if you’re going to plan a big shock and awe program, take an extra day or two. Listening to the dreams of traders is as sure a road to perdition as we can imagine.
As Pimco’s Mohammed El-Erian observed the week before, the government is going to need private capital to help solve the problems of the financial system. It cannot manage it all on its own. Therefore, a market-friendly solution must be found. That precludes idiocies like nationalization or any other approach that makes banks radioactive to investors. It’s going to take us all a long time to get out of this mess, no matter what the new administration may try, but that is no reason to dig holes that will take us decades to climb out of. The pilot program for the stupid approach has already been tried. It didn't work.
The stimulus bill did pass late Friday, readying a $787 billion package for the new president’s signature on Tuesday. The fact that neither chamber of the Congress was really satisfied with the bill is probably a good sign that the compromise was on the effective side. That said, though, we will repeat, and not for the last time, that the stimulus package is not enough.
We don’t mean to fault the new administration for lacking ambition. Getting such a huge amount of money approved in such a short amount of time is quite a feat, and going for a much larger amount would probably be a mistake on several counts. It would be politically risky, to say the least, and even trying to appropriate larger amounts would probably outstrip the government’s ability to come up with an effective template. It’s also going to be a struggle to manage the actual money and keep corruption away from the effort.
But that said, the economy is in a deep hole. The government is doing the right thing under the circumstances by passing a plan that will line the hole with padding, but there is nothing that can help us climb right out of it. The economy is just too big for that. The growing realization that not all of the $787 billion is going to steel and concrete, or that much of the money will take months to find its way into the economy, is starting to infect the outlook of floor traders. Poor things, they were dreaming of bigger glories.
In that respect, time is on the side of the opposition party and not the new president. In power for less than a month, the Obama administration is still talking up the mistakes of its predecessor, but is going to soon find that the public rapidly loses interest in what happened last year. No matter what it does, the economy will take time to turn around, and inevitably the bleak headlines will begin to stick to the sitting president.
The Republicans, still smarting from taking a drubbing the last election, are understandably anxious to right the ship, so to speak. Despite Obama’s call to abandon “failed dogmas,” the opposition isn’t about to line up behind policies that if successful, would only strengthen the hands of their adversaries. Years of gerrymandering have carved House districts so thoroughly conservative that most G.O.P. incumbents fear attacks from the far-right wing of their own party more than any discontent from the general voters of the district.
It makes for some odd developments. In most Western democracies, the opposition party would be complaining that they weren’t getting enough seats at the table, but in our own system we have the rather unique spectacle of the opposition insisting upon having none at all. Hence the zero vote for the stimulus bill from House Republicans, or the in-and-out episode of Senator Gregg, the would-be Commerce Secretary who suddenly withdrew. We suspect the much-vaunted (and feared) mass e-mail capabilities of the Republican National Committee behind the decision of Sen. Gregg, probably himself taken aback by the ferocity of the response.
In the early days of former President Clinton’s term, the incoming administration stumbled upon personnel issues, inexperience on the national stage and a lack of unity within its own party. Republicans were able to seize on the missteps and turn the centerpiece program of health care reform into a public relations disaster that was virtually dead on arrival. They parlayed that success into sweeping the Democrats out of a decades-long House majority in the next election. We suspect that the party hasn’t forgotten its victorious coup.
The momentum on the side of the Obama administration is that the economy should start up some kind of recovery by 2010. The question is, will the recovery be robust enough?
Stuff gets used up, and the business cycle has never been entirely repealed. Despite the seizure in demand, we are bound to see some re-ordering during the next few months. That will generate market rallies based upon the early indications of a turning point in the economy. Most of the early ones will fail, contributing to the sense of general malaise and strengthening the hands of the doomsayers. Gold may hit a violent peak.
In the end, though, there will be some recovery, although it is likely to be a tepid one. We never really finished paying the tab for the last recession, when many high-paying jobs were permanently lost or replaced by lower-paying ones. The Bush tax cuts didn’t do much beyond increasing the upper end’s share of the pie. Tax cuts are most effective when taxes are relatively high, such as when Reagan took office.
It’s a mixed blessing that Keynesian programs work best when the economy is in the hopper, where it is now. Nobody wants to be here, but at least it’s the right approach. We are also of the opinion that last week’s Fed plan to restart the credit-card securitization market with a significantly expanded TALF program will be a crucial part of the recovery. The Fed needs to get the program started, the sooner the better.
In the last recession, real estate became the only asset class still standing. Equities were out, and very low interest rates meant that leverage was necessary to earn any money in the fixed income market. It shouldn’t be a surprise that leverage in real estate securities turned out to be the winning formula. The success led to investors throwing money at the sector, further increasing returns; the trade got overcrowded, and we know the end result.
The investment-led boom, like the tech bubble before it, generated a considerable amount of employment and increase in household wealth that evaporated when the supply of new money dried up (kind of sounds like Madoff, doesn’t it?). It doesn’t seem likely that we are about to embark on a third bubble. More likely, we are in for the period of protracted adjustment that we ducked the last time ‘round. There will be some winners and some losers, but no riptide that raises all the boats, not for a while. We may well be better off for it, because the constant swarming for the big dough seems to inevitably lead to the big crash.
A quiet week for data featured disquieting news on employment and inventories, and a report on retail sales so surprising that the market essentially dismissed it. A contraction was expected in January retail sales, but the census bureau said that they actually rose by one percent. Given the widespread declines in chain-store sales and motor vehicles, the disbelief that greeted the report was not a surprise.
Certainly the raw data showed steep declines in every category but gasoline sales, which benefited from a rebound in prices. However, after the bureau’s adjustments for seasonal variation and “holiday and trading-day differences” were factored in, sales were up. Or so they said, but we have to admit to being skeptics as well. It may not have been deliberate, but it seems unlikely to have been accurate either. Perhaps the hardest part to believe was that although automakers reported very weak results for January, the report claimed that motor vehicle sales actually rose.
Wholesale and business inventories were reported to have fallen in December, but sales in both categories fell much faster. That meant a higher inventory-to-sales ratio and raised the likelihood of a first-quarter contraction in inventory (and thus GDP). Oil supplies also rose due to weak demand, while gasoline supplies were cut by refiners running at reduced capacity.
The recent divergence between crude oil prices, which have fallen to fresh lows, and gasoline prices, which have risen about twenty percent over the same time period, led puzzled CNBC reporter Erin Barnett to ask Marathon Oil (MRO) CEO Clarence Cazaolot for an explanation. He ducked the question, but the answer is that refiners have cut production very quickly, driving the crack spread (oil-gas price differential) sharply higher since the beginning of the year.
Mortgage purchase applications fell steeply again. For now, it seems our observation that low rates might pull only a small group of buyers into the market has proven to be correct, as applications have fallen to their lowest level since the year 2000. The trade deficit for December came and went with little fanfare. It shrank, although not by quite as much to expected, with the contraction coming mostly from plummeting global trade rather than improving composition. Both imports and exports fell, with the former getting some help from falling oil prices.
Consumer sentiment broke down again in February, according to the University of Michigan, probably in reaction to the recent parade of bleak headlines about the economy, layoffs, the stock market and the banks. The 56.2 reading was well below consensus (61.0), but a heedless market had bigger things to worry about. Sentiment didn’t seem to have any noticeable impact on weekly chain store sales, which are still running negative year-over-year but didn’t show any change from the previous week.
Next week is a short week with the President’s Day holiday on Monday, but it’ll be packed with potential market-moving data. The crucial housing sector will give us the housing market index on Tuesday morning, followed by housing starts the next day. Wal-Mart (WMT) will also report earnings on Tuesday.
On the industrial side, the N.Y. Fed will release its manufacturing index on Tuesday, and the Philadelphia Fed follows with its report on Thursday. Not much change is being expected in the very low levels of either survey. The central bank reports national industrial production on Wednesday. It’s expected to decline, but could get some help from the effects of January’s low temperatures driving up utility and mining output.
We’ll get a fairly complete look at pricing trends, with import and export prices coming out on Wednesday, the Producer Price Index on Thursday and the Consumer Price Index on Friday. A small decline is expected for import prices, while the latter two are expected to show small rebounds from January declines. Continued declines in the producer or consumer index would surely ignite deflation fears, but the January rebound in refined oil product prices should keep the headline numbers out of minus territory.
The Leading Indicators report is due on Thursday, and is expected to show no change, although it’s been propped up recently by changes in the money supply and flight-to-safety widening in yield spreads. The FOMC minutes are due on Wednesday, which besides dealing with housing starts, import prices and industrial production will have to confront post-stimulus-bill reaction. Another quiet day, no doubt.
The government didn’t unveil that much last week that was new, so we are going out on something of a limb here. A valuation and defensive play that we happen to like right now anyway is grocer Safeway (SWY).
To begin with, at Friday’s close of $20.75, Safeway is trading at less than five times annual cash flow and about eight or nine times management’s earnings guidance for 2009. That’s a big discount from its usual multiple of about fifteen times, and a cheap stock period. Those earnings will benefit this year from a reduction in cap ex, which had been elevated for some time due to the chain’s extensive remodeling program. The company also estimated that free cash flow would be something north of a billion dollars for 2009, meaning that the company is trading at eight or nine times free cash flow. That is seriously cheap.
The general fear factor surrounding Safeway and similar chains is that rising unemployment could cut into sales and a race-to-the-bottom price war could cut into profits. At these valuations, it’s built into the price.
There are some interesting forces at work with Safeway. Although Wall Street has generally cast a disapproving eye on the remodeling program because of the profit impact, we like the remade stores. We think that longer term, it will help with sales.
People always have to eat. We expect that something good to eat will become a popular affordable luxury this year. The main headwind, unemployment, will be offset to some extent by the extended federal safety net. The trade down to less expensive private labels cuts into the top line, but helps the bottom line. Grocers are very happy to trade sales of expensive branded products for their own less expensive versions, because the margins are so much better.
Refinancing, mortgage cram-downs and rewrite procedures will all help disposable income in distressed households. The large presence by Safeway on the West Coast and in some of the most distressed areas of the Southwest has cut into sales, but will also give it a leveraged rebound effect. The dividend isn’t much (the current yield is 1.6%), but it certainly beats T-Bills.
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