Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Circling the Drain
“Do not go gently into that good night. Rage, rage against the dying of the light.” – Dylan Thomas
Oy, what a week. It was bad enough to start off with a four-hundred point loss in the Dow. It was even worse after a diet of steady erosion put market losses up over six percent on the week. Perhaps worst of all, though, was that the steadily increasing whining coming from the trading floors had started to gain currency by week’s end, threatening to provoke the government into even further stupidities.
What began as trader’s disappointment to Treasury Secretary’s Geithner speech the week before last – they wanted a miracle that he failed to deliver – has taken on a bizarre life of its own. When Geithner didn’t pull the rabbit out of his hat that would stop the financial stocks from falling, thereby pulling down the rest of the market, the grumbles about the sector grew into a clamor. We are sick of these banks, said the traders. Can no one remove these irksome stocks from our sight?
The original grumble was that the government should just take over Citigroup (C) and be done with it. In the bizarre logic that characterizes momentum moves on the Street (one might also call them waves of mass hysteria, but that would be impolite), when an original rumor derives a second, the original one becomes taken for granted. Then the second derives a third and the second is taken for granted, and so on until the first whispers are the facts that everybody knows and the only question is which particular flavor of cheese the moon is actually made of.
So it was: if Citigroup, why not Bank of America (BAC)? If not Bank of America, why not Wells Fargo (WFC)? By the weekend half of the banks were starting to trade at bankruptcy prices and the more gullible members of the media had taken the bait, right down to the New York Times. Yes, yes, said the chorus, remove the offending members from our sight. Let us wipe the slate clean and let the healing begin.
What an absolute load of rubbish. Nationalization of the banks would not save us, it would likely be the crowning blow of stupidity that began with gutting Fannie Mae (FNM) and Freddie Mac (FRE) and then letting Lehman collapse into bankruptcy. Nationalization would not save us from the Japanese-style “lost decade,” it would give it to us. Please, please, no more deer-in-the-headlights blunders, no more gentle falls into the long dark night, and above all, no more falling for the Wall Street rumor mill. Did it work on the way up? Conspicuously not. Can anyone explain to me why it should work on the way down?
Wall Street, the center of the free markets, has taken to pining for government intervention and then roundly criticizing it, like a starving man criticizing the wine list. Why does anyone take it seriously? Remember the mantra, “housing prices never go down?” Remember the wildly overpaid CEOs that just resigned in disgrace? Remember decoupling, global growth, peak oil, junk bonds, Long Term Capital, the Dow at 30,000, the tech bubble? Am I missing something here?
Yet now, nationalization of our largest banks, a Wall Street grumble-and-gamble destined to produce nothing more than a one-off, one-day trading reversal, is being seriously discussed. Why? The government’s job is to supervise banks, not run them. We need to restore the faith of investors in the banks, not wipe it out. This growing chorus of “fire all the managers, wipe out all the shareholders, start with a clean slate” resembles nothing so much as an angry lynch mob hunting down the doctors because they have the flu.
If the government wants to stop the carnage in the financials, the first thing is to restore the uptick rule. Don’t ban short-selling, it doesn’t work. Restore the uptick rule, right away, now. The second thing is a temporary requirement that all credit default swaps (CDS) trades be reported to the SEC immediately and to the IRS quarterly.
Why the IRS? Well, maybe the government will want to levy an excise tax on CDS transactions that do not involve an owned bond position. That would cause howls of pain all over Fairfield County, but we got by without CDS for centuries. We can live a little while with a diminished CDS market until a regulated clearinghouse is established.
Neither of these measures will erase bad debts from anybody’s balance sheets. On the other hand, the main cause of the latest crisis of confidence is first, the falling stock prices themselves and second, the lack of the Obama administration’s ability to decide on which magic wand to wave in thirty days. I can understand why the administration wants more time to get it right, but I can’t understand why they didn’t reinstate the uptick rule and threaten to get tough with the CDS market.
Some are profiting from the fall in the banks stocks and will make gobs of money if they fall further. It’s everyone for themselves on Wall Street, and the hedge fund era is not the market of the seventies, eighties or nineties. I hope that Treasury’s planned update next week includes at least one, if not both, of these measures. In case you’re wondering, we’re not long any of the common equity of any of the ten or even fifty largest banks. We don’t like Citigroup’s model and never did. But we are long the U.S. economy, and to that we do confess to talking our book.
Chairman Bernanke’s remarks last week reassured us: he doesn’t believe in nationalization. At his appearance before the Washington press corps last week, that issue was raised along with the inevitable one of what happened with Lehman. The chairman is understandably somewhat limited as to what he can say, as are all Fed chairpeople, and it wouldn’t do for him or for the Fed for him to say, “we blew it.”
But he’s getting closer, as he allowed that Lehman’s unmanaged failure could not be repeated and that a structure needed to be put into place to ensure that such events could not recur. We still think Paulson led him down the primrose path on that one, but will give Ben partial blame for falling for it. He has otherwise been creative and knows that the key is continuing the unlock of the credit markets, not putting our largest banks in the hands of an already overstretched government. Stay the course, Chairman Ben.
Bernanke was also hopeful on inflation. We certainly can’t see any signs of it emerging from the demand side, or at least, not from industrial or consumer demand. The demand for trading profits may be another story. Whether or not the Fed is correct in its estimation that it can withdraw money from the system as the crisis eases, thus easing the impact of money supply on prices, the markets may have other ideas.
We don’t like to interfere with free trading, but as the investment sector has become more developed, the tendency for the herd to stampede into a sector and wreck things – technology, real estate, oil – has become more and more pronounced. The current fever for gold probably won’t do any harm, except for those poor souls who get in too late and end up holding the bag, but the distortions from another stampede back into commodities and oil could create big problems for the larger economy.
The authorities may want to think now about tightening up things such as margin, delivery and reporting requirements. Hedging and speculation are knotty and touchy subjects, so best to tackle them now while prices are still subdued and not many players have loaded up. However gratifying it was to see the peak oil theory blown to bits and our disbelief validated, we would gladly have skipped the whole thing, especially $4 a gallon gasoline and soaring food prices.
As an aside, I’m sure most of you noticed that the food companies all shrank their packages last year, rather than raise prices, in response to rising costs. Has anyone else noticed that although oil has since fallen by more than $100 a barrel, the packages have stayed the same size? Curious, isn’t it.
Thursday morning’s Wall Street Journal carried a story on the public reaction to President Obama’s plan to help the mortgage and housing sector. The reaction was chiefly criticism from people who did not stand to benefit directly themselves from the plan. Later that morning, CNBC commentator Rick Santelli staged a hammy recapitulation of those arguments and was enthusiastically joined by futures pit traders wondering the same thing: what’s in it for us?
We suspect that Santelli was caught off-guard by how much publicity he got, including direct references from the president’s press secretary. But why is anybody surprised? We admit that a bunch of high rollers suddenly getting up to grouse that they’re not getting anything out of it wasn’t a very pretty picture, but in the first place, these are the trading pits, and in the second, their reactions largely mirrored those in the Journal article. This isn’t a wave of populism, it’s us. We get money from the government, we’re happy, somebody else gets it, we’re not. It’s one of the oldest trends, not the newest.
As we bring this week to an end, consider the following lugubrious data: Japan’s quarterly GDP (-12.7 annualized decline) was the worst in 35 years, and foreign investment in China fell for the fourth straight quarter, down 33% in 2008. Here in the U.S., for the first time ever in over 80 years of data, the S&P 500 reported a quarterly loss. We are all linked.
Yet that is also grounds for hope. All the governments are starting to row in the same direction. Rates are falling around the globe, while governments enact stimulus measures and guarantee their banks. We have no Smoot-Hawley trade war, no central banks working at cross purposes (the ECB will keep cutting rates, of course, but as Chairman Trichet is French, he must first show the world that he is doing so at his own discretion and above all not under Anglo-Saxon influence). The lack of a v-shaped bounce may be maddening for Street traders accustomed to easier times, but a slow recovery is in the cards over the next twelve months.
But we could wreck it. In the nineteen-seventies, New York City came infamously close to defaulting on its debts and declaring bankruptcy. Then-President Gerald Ford, a Michigan Republican, was inclined to take the advice of his advisors and let the city float down the Hudson. The Prime Ministers of France and Germany, Valery Giscard D’Estaing and Helmut Schmidt, however, told Ford that such an event could possibly touch off an international financial crisis and diminish the creditworthiness of the U.S. Ford bucked his advisors and reversed course.
The nationalization of even one of our top banks in the current climate would only spread the malaise: the market would immediately switch its focus to which one is next and not stop. Nationalizing Citi and B of A would cause an endless string of follow-on nightmares and result in more banks failing rather than fewer. It would diminish our standing around the world and frighten the global financial system for a decade.
It’s a recipe for a quick collapse, not a quick fix. Do not gentle into that night, Mr. President and Mr. Secretary.
One can see why the market had such a crummy time of things. The Empire State manufacturing survey started us off with a new record low of (–34.7), a very wide miss of the average guess of (–22.0) and narrowly missing the most pessimistic estimate (zero represents no change from the previous month). New orders fell to a record low, though if it’s any consolation, the data only go back to the last recession.
Thursday’s Philadelphia Fed manufacturing survey, however, goes back further. It lined up right behind the New York survey, reporting a deeply negative number (-41.3) that surpassed even the worst estimates and widely missed the consensus for something in the (minus) mid-twenties. An optimistic Bloomberg reporter remarked that “at least it’s only the lowest number since 1993 or something” and not the lowest number ever (it was the lowest since October 1990), but failed to notice that shipments and employment did fall to their lowest levels since 1968, which is when the survey began.
There was some hopeful talk about the six-month outlook improving, but as can be seen from the chart below (courtesy of the Philadelphia Fed) the indicator is a poor one of performance six months out. It’s a better one of a near-term rebound.
We agree that there will almost certainly be a rebound, and soon. Shipments have fallen to practically nothing and everybody is destocking. But this recession isn’t a classic inventory one, it’s due to a financial panic precipitated by the failure of a “systemically critical actor” (Bernanke’s words) in the midst of an economy that was already weakened, but not collapsing. We weren’t overproducing, except relative to an impending credit freeze that could not be predicted, but could have been avoided.
Even with rising unemployment that is probably already at eight percent, we’re going to run out of stuff soon, probably by the spring, summer at the latest, and that will turn the survey results back upward. That is good news, but brings its own set of problems.
The reload could spark the race to load up on commodities, driving up inflation as we indicated above. The demand would be driven not by the velocity of money, but by the velocity of traders rushing to plunge into the hottest trade. Given that nothing but gold has performed this year, there’s a good chance that the mob will be unrulier than usual.
As prices rise, pushing up the headline data, libertarians and gold holders will smugly inform us that they predicted it all, even though monetary policy will have had nothing to do with the increases in prices. That would not stop the thundering from the pulpits about reckless government policies, however, nor shake the sales pitch and cover story for plunging back into commodities. Predictions for $10,000 gold could resurface.
However, if the manufacturing improvement turns out to be only a brief reload – and there is no compelling reason to rule out that possibility – then we could get a final capitulation and the harder landing that comes from dashed hopes. Traders will bitterly complain that everything the government has done is for naught. Eventually the shock waves will settle, corporations will have finished reloading in the debt markets and the economy will lurch back on its way. The bear will take a long nap or quite possibly leave, and the rebound will be nice – but from what levels?
The January Industrial Production report furnished a good explanation for the dismal survey results. We can start by telling you that capacity utilization fell to 68.0%, which means that our production capacity is running at the lowest rate since 1948, when the series began sixty-odd years ago. The year-on-year decline in the total index widened to (–10.0)% from December’s (-7.8)%, while manufacturing fell (-12.9)% over the same period. These are spectacular numbers.
The monthly total decline of (-1.8)% was pulled up by utility output, as we predicted (we thought mining output would increase too, but it fell slightly). December was revised substantially downward, from (-2.0)% to (-2.4)%. Consumer durables fell by (-10.5)%. It may be the ugliest IP report that I’ve ever seen.
The good news in housing was that the housing market index rose 12.5% from December. The bad news was that the index rose from its all-time low of 8 back to its previous record low of 9. Fifty is neutral.
Housing starts fell to their lowest level (466,000) since 1959, maybe even before then, but the series only goes back to that far. Considering that the population has more than doubled since that year, on a per-capita basis it must be a post-Depression record. At least we are dropping further below the replacement rate: there has to be a rebound some day, doesn’t there?
The largest decline came in multi-family units, where financing has mostly dried up. Permits continue to decline, meaning the rebound isn’t imminent, but we’re due for at least a weather bump this spring. On the other hand, buyers seem stuck on hold: although mortgage purchase applications crept back up last week, helped by an improvement in rates to below five percent (for those that can get them), they remain at very low levels.
The price data was curiously mixed, with a little something for everybody. The pace of import price declines slowed to about one percent, and export prices stabilized, showing no change apart from a spike in agricultural prices.
The Producer Price Index jumped back up 0.8%, more than the market expected, led by rebounds in energy, gasoline and food. Even the core PPI was up a more than expected 0.4%. Yet many of the increases seemed to be one-off annual ones, and those worried about deflation had something to talk about: intermediate and crude good prices both declined.
The Consumer Price Index was more reassuring. It rose an expected 0.3%, due largely to a rebound in energy prices and some expected rebounds in other categories, such as apparel. Year-on-year, the needle barely moved from the previous month: a (-0.2)% decline overall, versus (-0.1)% in December, and an identical 1.7% annual increase in the core. A whiff of inflation here (the core PPI was up 4.2% y/y) and deflation there (both indices declined from last January). It wasn’t very clear, so traders largely decided not to bother with any of it.
The markets didn’t ignore the endless bad news in employment. Weekly claims stayed at a very elevated 627,000, with revisions always upwards. The four-week moving average is now nearly to 620,000, with continuing claims just a hair under five million. The February jobs report is going to be ugly, but at least it’s another two weeks away.
The leading indicators rose a surprising 0.4%, although the coincident-to-lagging ratio continued to fall. Most of the increase was due to an increase in the money supply, but an interesting sidelight was in consumer goods. The Conference Board estimated that they rose 0.1% in January, yet the Fed reported that consumer goods production fell (-1.8)%. We’re inclined to go with the Fed’s version on this one. As for the money supply, it still doesn’t seem to be going anywhere. Eventually the velocity will pick up, but when?
Driving miles suffered the biggest drop in 2008 since 1942. Was it because of gas rationing in 1942? No, it’s because that’s when they started keeping records. Miles driven fell again in December and gasoline supplies rose unexpectedly again, extending a sharp fall in prices this week (though not at the pump, where they have stabilized).
Next week will bring us more consumer confidence reports, from the Conference Board on Tuesday and the University of Michigan on Friday. Expectations are low, so absent a sudden increase or something off the charts, they won’t matter much to the markets.
The second leg of the housing market news will check in with the Case-Shiller price index report on Tuesday, followed by existing home sales for January on Wednesday. The latter figure is on balance expected to tick up, although many are also expecting a decline. Our guess is to the upside, based upon the December spike in mortgage applications. It’s winter data either way, which can be suspect in housing. New home sales will complete the monthly picture on Thursday; they will be low.
The balance of the data will be on output, with durable goods on Thursday, and Friday seeing the Chicago PMI and the first revision of fourth-quarter GDP. Looking at the Industrial Production data, it looks like new orders for durable goods will be pretty ugly. As for GDP, the market is leaning towards a revision down to the minus five percent level, so anything better than that might be a small relief. If it’s unchanged, though, it’ll probably reinforce both disbelief and fears that the current quarter is the worst. It may well be.
There are still some important earnings reports coming out, notably Dell on Thursday and a flock of retailers in mid-week. The biggest news will probably come from government officials, though. President Obama addresses Congress on Tuesday, while the Treasury department has promised to cough up some more developments on its plans for the financial sector.
The pressure on Treasury to deliver a miracle is tremendous, and despite its efforts to manage down expectations on what news it will bring, the markets remain in a most unforgiving mood. Crackpot ideas and theories are flourishing. The time is ripe for a big market reversal, yet it is also ripe for a disastrous misstep. We are crossing our fingers.
StockWatcher will return in a later edition.
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