Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company The Wasteland
“I think we are in rats' alley, where the dead men lost their bones.” – T.S. Eliot, The Wasteland
Yesterday,
Debt was such an easy game to play
Now it needs a place to hide away
Oh, I have too much debt to paySuddenly,
I’m not half the Dow I used to be
There’s resistance hanging over me
Oh insolvency, came suddenlyWhat’s a CDO I don’t know, but they couldn’t pay.
I’m long, something wrong now I long,
For Yesterday.
Yes, the verdict is official. The Dow has now fallen fifty percent from its previous high, set only seventeen months ago in the early autumn glow of October 2007. Remember that and have a good snort the next time somebody tells you “the market is a discounting mechanism.” Because what that really means in practice is that the market is simply drawing a straight line from what’s happening today into some nebulous future point. Sometimes it works, and sometimes it don’t.
We are indeed in bottomville, the Wasteland, make no mistake about it. One of the familiar features of the region is a sense of fatality, a feeling that all efforts are for naught and that there is no way out. Remember also that market bottoms aren’t signaled by traders becoming indifferent to bad news, as so many will tell you. True recession bottoms come when traders no longer care about good news, because they don’t believe anything can matter anymore. Their recession horizon stretches into infinity.
Another neighborhood landmark is when cynicism in the press reaches a certain saturation point and vindictiveness becomes commonplace. Business journalists don’t make the kind of money that the people they cover do, particularly on Wall Street, so there is a certain amount of French Revolution-style bloodthirstiness in the coverage when the woes of the investment community reach peak levels.
Doubts about the sanity of the government reach a crescendo as well, partly because they never go out of fashion, and partly because we Yanks are impatient and want things fixed by tomorrow if not sooner. What, there’s still a recession on? Wasn’t that supposed to be fixed already? What’s going on with those knuckleheads in Washington, can’t they find the switch? You can find those reactions going back through the centuries.
The economy is indeed in bad shape, as we have often pointed out. Yet things are unlikely to turn out as badly as the recent turn in press coverage suggests, which has now moved to the accepted wisdom that we are inevitably doomed. It’s unfortunate, but the press is usually as lemming-like as the industries that they cover. It’s only human nature: none of us are completely immune to the vibrations of popular opinion. It’s also a good contrarian signal.
It’s rarely brought up now, for example, that during the boom real-estate years, the prevailing wisdom in the media was that if investment banks or commercial banks did not acquire sizable real estate operations of their own, they were doomed to the fates of minnows. So they bulked up on the magic juice, and avoided being taken over or marginalized. Nope, instead they blew up. Let that be a lesson to you, A-Rod.
The most notorious example of piling on in the financial press is the Business Week cover. It is often said in the investment community that when a trend appears on the cover of said magazine, it’s become so overloaded that it is surely time to exit all positions before the collapse. A good example of the phenomenon came this weekend, when the news services prominently excerpted the comment in Warren Buffett’s just-released letter to shareholders that the economy would be in a “shambles throughout 2009”, and “probably well beyond.”
The remark less featured, though, was Mr. Buffett’s trenchant comment that just as risk had become underpriced, it is now overpriced. Nor was much made of his remark that he was mostly indifferent to the collapse of many stock and bond prices, as it now afforded an opportunity to buy things “marked down.” Few managers have the durability of a Buffett and the luxury to ignore short-term trends, but it’s worth noting that he has been a buyer for some months now.
As for our view of the economy, we’re no more sure than Buffet of what’s going to happen. Still, there are a couple of things to consider that might console you. One is our observation that “stuff runs out.” New orders and inventories have declined so dramatically in response to the credit freeze that a certain amount of reordering is going to be inevitable. Given the circumstances, though, it seems likely that it will start out cautiously and in small bites.
That would actually be a plus, because too much of a surge would probably be followed by another drop that the markets would take very badly. We can adapt to difficulties, but it’s the unexpected bad news that does the most damage on Wall Street.
The credit freeze itself has motivated us to use the metaphor of the economy as an anaconda. The anaconda, as you probably know, is that humongous slow-moving snake of the boa family, the kind that crushes its prey rather than poisoning it. It can swallow animals much larger than itself, thereby providing material for many a cartoon sketch.
Suppose, however, that you had never seen one of these cartoons, or an anaconda for that matter, and came upon one that had just begun to dine on its favorite dish of wild pig. Over time the pig will get digested and pass through the snake, but if you happened to see that massive, distorted bulge inside the snake for the first time, you would probably think that the whole mess was surely going to blow up.
So it might be with the credit freeze. The Lehman Brothers bankruptcy filing touched off the global counterparty panic and credit lock amidst a faltering economy. The common refrain amongst companies in the last quarter was that after September 30th, orders fell off the cliff. That started the adverse feedback loop that Bernanke referenced in his recent testimony: cancellations begat cancellations, begat margin calls, begat layoffs, begetting further cancellations and so on. We’ve all seen the headlines.
However, the economy wasn’t in a classic overproduction stage, such as it was leading up to the 2001-2002 recession, nor taking an inflation beating nor suffering a lot of other overheated symptoms. Certainly credit and the housing market had been overheated, but that correction was well underway and the fall in housing is nearly complete.
Production in many industries, including homebuilding, is running well below the replacement rate. In theory, that could last much longer, but it probably won’t. For example, as the people who are employed begin to buy houses again, the people without jobs will start finding work again.
Credit is the key. The banks are still frightened to death and the fixed income markets largely dysfunctional. The latter is essential to getting things going again, and the Fed’s strenuous efforts to push money through the system are slowly bearing fruit. Investment-grade bond issuance is booming and the spread between corporate and Treasury bonds is shrinking. The market is tilted to quality issues, but that’s to be expected. Eventually the market should broaden.
So the question is, what did the anaconda swallow? More than a pig I’d day, more like a water buffalo. But was it an elephant? That remains to be seen. We are probably going to get two of the nastiest back-to-back quarter declines since the depression (see below). That argues for the water buffalo at least, but then it could pass.
Right now, the two biggest stones around the neck of the economy are the credit markets and sharply increasing unemployment. The Fed is working night and day on the credit markets and some signs of thaws are discernible (the process, however, will not be straight up). The stimulus package isn’t going to cure unemployment, but it’s trying to slow down the decline. Unemployment will peak after the economic turn, but there’s a good chance that the rate of increase is probably peaking now, from the impact of those back-to-back quarters (try to remember that when next Friday’s jobs-bomb lands).
We were never of the mind that global growth or China or the emerging markets were going to save us. However, right now many commodities (except gold) are underpriced. At the first signs of economic life, money will flow back into that sector, partly because they are oversold and partly because the investment world is fretting over inflation. There will be plenty of people around to promote and sell – out of pure altruism, no doubt - the buy-commodities-before-the-great-inflation school of frenzy.
An increase in commodity and energy prices won’t seem so great to the average consumer here, and some of it will again be momentum-driven hot air, but it will reignite the resource-rich countries, such as South America, Russia, parts of Asia and the Middle East. The latter had been one of the top export markets for our own country, as well as for Europe and China. As exports to the resource-rich countries resume, trade around the globe should pick up. When that happens, the larger banks should be in a position to offer trade credit again. Some kind of return to stability and moderate growth should follow.
That’s the theory, anyway. More could still go wrong, and I nearly passed out Friday morning when I read that as part of the latest government aid, Citigroup was suspending preferred dividends. That was the headline, but the reality was that the trust-preferred is still paying distributions. That’s a relief, not because I own anything Citi-related – I wouldn’t go near it – but because you really don’t want to see the government start to blow up the preferred stock in the financial sector.
Most people don’t know or care what preferred stock is (and yes, we do own some), but in the investment world it’s kind of a sacred cow, like a money market fund N.A.V. If some starts to fail, fear will grip the markets and the price of all the bank preferred will go to pennies. That would keep the banks frozen out of the private capital markets, in the sights of the short-sellers, and on the front pages of the newspapers for the wrong reasons. We will again cite Pimco’s El-Erian: the banks need market-friendly solutions and the help of the private sector. The government cannot do it all by itself. So please don’t blow up anything else (no nationalizations, regardless of what trendy business school economists say), and for pity’s sake, could we please have back the uptick rule?
The markets could yet fall more, though at the moment equities are oversold and due for a rally. At the beginning of the year, our reply to a survey included the observation that the S&P could possibly fall to 650 and the Dow look at 6000 – from underneath. That event wouldn’t help confidence or unemployment. It might not happen either, but markets do overshoot. If it’s any consolation, the more likely outcome of such an event would be catharsis and a catalyst to a genuine reversal and the end of the bear market. But it wouldn’t feel warm and fuzzy.
This is obviously one nasty recession, but we are not yet of the opinion that it should evolve into the D-word. An awful lot more would have to go wrong. The world’s central banks are lining up correctly this time and not worrying about defending some dubious gold standard (sorry goldbugs, but that’s the way it is). The more likely outcome is that we are in for a long rebuilding period, the one that we skipped from the last recession by juicing up on housing. Yesterday’s problem may have come back to today, but we can fix it over time.
There wasn’t anything good in last week’s roundly disappointing headline data, but beneath the surface lurked a glimmer of hope in weekly chain store sales. They are still showing yearly declines, but have been steadily improving this month. This is mild support for our thesis that “stuff runs out,” i.e. that we will begin to run out of things and have to replace them.
In retail, this is surely in part pent-up demand from consumers who cut back quickly in response to the disastrous fourth-quarter headlines, but are now drifting back to the stores. That is encouraging, though the effect of this week’s wretched headlines on that small comeback remains to be seen.
Other than that, the week began with a thud and ended with a larger one. The smaller noise came from the Conference Board’s report on consumer confidence, which fell to levels that can only be described as surreal. The stunning reading of 25.0 (versus expectations of about 35) was accompanied by plunges in the outlook on jobs and future conditions. It’s an all-time low, of course, going back over four decades, but one that also moves us to say that we are in a trough unlikely to be seen again in my lifetime.
In between, the news on housing continued to disappoint. Prices continue to fall steadily, with the Case-Shiller indices showing yearly declines near 19 percent overall. Existing home sales data echoed the declines with an accelerating fall in median prices in January: the year-on-year decline in that report fell to about 15%. The sales total was discouraging, as hopes for a slight rebound came to grief amid a drop of over five percent instead. It was the lowest annual sales rate since 1997.
Last December, a sudden Fed-driven drop in mortgage rates pulled in a group of would-be buyers off the sidelines, leading to increases in mortgage-purchase applications and pending home sales. The group proved to be smaller than initially hoped, as applications fell off quickly and remain at very weak levels. But the fall in completed sales points to a high transaction failure rate (as well as making our prediction for an uptick look bad).
One proposed explanation for the increased failure rate was that buyers might have walked away from falling prices, but we suspect that financing is the problem. Anecdotal evidence of extremely tight lending requirements suggests that fearful banks continue to pull back from real estate lending. The perverse effect of that, of course, is that it increases the strain on existing loans, but try telling that to the banks.
The press made something of the fact that months of housing inventory increased, but the actual number of homes for sale fell: the increase in inventory months came from the lower sales rate. The latter is bound to pick up sometime this year, but as it does hidden inventory will likely come in off the sideline. The key is how quickly the deterioration in employment can be stabilized.
A similar increase in the supply figure bedeviled new home sales, where the number of new homes for sale fell, but months of supply moved up from the lower sales rate. Sales fell nearly ten percent from the previous month and the annual rate hit a new all-time low. Prices fell sharply; perhaps we will soon reach the magic clearing number.
Durable goods were ugly, as we predicted, but the market didn’t seem terribly surprised by the news. The (-5.2)% fall more than doubled the consensus, but the reaction was softened by several factors. For one thing, the report didn’t exceed the worst estimates, and had been telegraphed by related weakness in last week’s Industrial Production report. For another, the total was pulled down by weakness in military orders, which the market generally doesn’t get excited about. On the other hand, non-defense orders excluding aircraft – i.e., private business investment – did fall (-5.4)%. The six months of consecutive declines is a record, but the series only dates to 1992.
The weakness in overall output was driven home by the readings from the Chicago PMI, weekly initial claims, and the revised fourth-quarter GDP. The Chicago index ticked up a bit from the previous months, mostly due to an increase in production, but remains at a weak 34.2 (fifty is neutral) and new orders were unchanged. Employment fell, however, and that was in line with the positively gruesome increase in weekly claims. Those leapt to 667,000 from the previous week’s 631,000, and as usual the latter number was revised higher from the week before.
Continuing claims soared to 5.1 million, giving us the five-and-five we talked about last month: more than five million jobs lost in the last year, more than five million in continuing claims. At least the federal government is helping with its safety net. Next Friday’s jobs report will surely be horrific.
The week closed with revised numbers for fourth-quarter GDP and the University of Michigan’s final consumer confidence number for January. The latter didn’t change much, but the former was drastically revised down from a drop of (-3.8)% to a nearly double (-6.2)%. The market’s reaction was muted though, for a couple of reasons. One is that few had taken the original number seriously. Another is that the original estimate of a slight build in inventory was revised to a sharp drop, lessening fears about how bad this quarter’s inventory cutbacks will be.
For now, the sentiment is for the current quarter to come in at about the same rate as the previous quarter. If that holds true, it will be the worst two-quarter downturn since the strike-related years of 1957-1958. Nice to live in record-breaking times, isn’t it?
Perhaps we will see some more records next week. The two ISM reports are due next week, starting with the manufacturing survey on Monday. The recent Philadelphia survey implied that a very poor number might lie in store. The non-manufacturing version appears on Wednesday, and may matter more to the markets. It’s larger, and the recent regional manufacturing surveys have already discounted a weak report in that sector.
Personal income and sales for January will be reported Monday morning, followed by the ISM number and construction spending. On Tuesday, pending home sales for January are reported and on Thursday, same-store sales for February (although more chains drop out every month). Productivity and cost data comes out the same day, but the market isn’t usually paying much attention to this report unless it’s an outlier.
After a couple of warm-up reports, the February jobs report will arrive on Friday, more likely than not with a bang and a crash. Initial claims are running at 2.5 million a month, so we could see quite a whopper of a number. The labor department will add its usual make-up number to account for births and deaths, then revise the total lower again the following month.
Anything less than a million mightn’t shake the market, but the real total may well have been in excess of that. Last week’s new post-1982 record for claims won’t enter into the measurement period, so March could still be worse. If the unemployment rate doesn’t hit 8% officially, it probably will on the revision. Will April be the cruelest month? It’s hard to tell in the wasteland.
StockWatcher will return in a later edition.
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