Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Fast Start
“The race is not always to the swiftest." - Ecclesiastes 9:11
By the first trading day of the year 2009, Friday the 2nd to be precise, a sense of invincibility to bad news had set into the equity markets. Two prior days of sizable gains, though built on very light trading volume, managed to conjure up some of that magic elixir known to traders as momentum. Equity traders have a built-in upward bias and are always looking for a wave, so with few profits to take and forced liquidations taking a rest, they began to get giddy and listen to their own chatter.
So what if the news is terrible, because - we already know that! We Are Looking Across the Valley Again (and ignoring all the corpses at the bottom). Talking heads beamed at the cameras with the new formula: new administration means new confidence, stimulus package means third-quarter recovery, and my last trades are up so the sky’s the limit. One fellow breathlessly announced that retail investors are just itching for the signal to jump in. Really? Perhaps he was thinking of the former clients of Bernie Madoff, who surely can’t wait to get back into equities. Or was it the stunned readers of the next batch of 401(k) statements?
As those who have gone too long without sleep begin to have delirium, so the market has begun to have its own hallucinatory vision: the worse the data, the better. You see, the bigger the declines in the incoming data, the more the government is forced to act (and if you don’t see that, you’re fully excused). That means less debate and more urgency, bigger stimulus packages (so buy those steel stocks) and more Fed purchases, so buy the leading economic indicator (oil) before it’s too late!
It may seem lunatic, but the market has embarked on bigger fantasies before. You may recall that the collapse in Internet stocks was nothing to worry about, because they were only six percent of the market, or that subprime mortgages didn’t matter, because housing was only six percent of GDP. In the spring of 1999, the markets rallied furiously on news of a plunge in employment, because the smart money knew that it meant that the Fed would have to lower interest rates. The cure was on the way, just like it is today.
The part that doesn’t quite fit is that the U.S. hasn’t had an infrastructure stimulus plan in seventy-something years, and the general consensus amongst economists is that it didn’t really do much at the time. It may have stopped things from getting worse, and we got a lot of useful infrastructure built (and some good books written too), but as far as reviving the economy, it didn’t. Mostly, it was World War II that did the trick. Yet the bulls, none of whom has ever been in this situation before, are cheerfully talking as if the fix is already in. It’s merely a question of which positions to add to in preparation.
To be fair, the stimulus program of the nineteen-thirties had central bank policies working in the opposite direction, which is not the case today. The Fed is being very aggressive in pushing money into the system and lowering the cost of money. Perhaps most importantly, the monetary base isn’t being shackled by how much of an industrially non-essential yellow metal has been hacked up out of the ground and put into government storage boxes (sorry, gold bugs).
And despite the fashion for endless comparisons with Japan’s lost decade and its failed stimulus programs, the Japanese situation differed in some key respects. Japanese assets reached far more inflated values than ours (at one time the real estate value of Tokyo’s Ginza district alone was worth more than the entire state of California), necessitating a larger wind-down.
That adjustment was further complicated by a custom of corporate cross-holdings and a cultural tradition of responsibility that taken together, made a speedy process simply impossible: most of corporate Japan would have had to simultaneously default and resign. Grafting capitalism onto cultures thousands of years old gets tricky sometimes.
However (and you knew there had to be one coming), there is still a catch. The above makes the case that our current downturn needn’t last a decade. We agree. But Wall Street is talking as if the alternative – indeed, the only alternative - to a ten-year recovery is the ten-month version. As London cabbies used to say to us, “not bloody likely.”
That brings us round to the income problem. A key factor in the timing of real estate’s fall from grace was the ratio of house prices to income. While the bubble was bound to burst in any case, the fact that median incomes remained stagnant as house prices rose made the bubble almost entirely dependent on itself, aggravating the blow-up to boot.
Without rising incomes, buyers were increasingly obliged (and encouraged) to resort to Alt-A and adjustable-rate mortgages, in order to afford increasingly unaffordable homes. Without rising incomes, one would expect that subsequent default rates would then accelerate to above-historical norms, and that is exactly what has happened.
The price-income ratio has fallen back to more typical levels, thanks to the record declines in home prices. But the income that was originally lost in the 2001-2002 recession has never been replaced. It was masked by the wealth effect of rising home prices and easy credit access, and partly offset by the rise in the real estate industry itself, along with its ancillary financial services. Those factors have all disappeared, and we are now back to the original problem: where is the income going to come from?
The incoming administration is talking about extensive tax cuts, including changes in withholding rates that will put extra money into consumers’ pockets. That looks like a good move to us, and energy prices have declined at least temporarily, offering another palliative. But it just isn’t that much more money, especially in the face of a rapidly increasing unemployment rate and a still-frigid credit market that has yet to confront the wave of defaults and bankruptcies that 2009 is going to offer us.
The problem with the short-term is that the long-term isn’t looking so good. This rally could last a bit longer, as fast starts certainly aren’t uncommon at this time of year. Traders are aware of the very light volume and that underpinnings of the current move are weak, but part of the game is trying to talk more money in off the sidelines. If they succeed, so much the better; if not, they are ready to run. You should be too.
Armed with the shield of ignorance, meaning in this case a license to ignore bad news, the equity markets shrugged off some truly rotten data last week. The perversity of late that posits that the worse the news gets, the more government is then obliged to act, is thought to be good for equities. Thus, the sharper the economic decline, the sharper the stock market rally. You know, if only we could get universal unemployment, then the market could really take off.
Let’s cover the usual suspects. Housing? Rotten. The average year-on-year decline in home prices is now nearly at twenty percent, with many of the former boom cities at thirty percent. That clearly must be a bottom, so let’s move on (and throw a few homebuilder stocks into the basket).
Manufacturing was worse than housing. The Chicago Purchasing Manager’s Index was approximately unchanged, but new orders fell steeply, foreshadowing Friday’s national ISM (Institute of Supply Manufacturing) index reading of 32.4. The latter was one of the lowest readings ever, reminiscent of the 1980-1982 or 1973-1975 recessions. New orders, however, fell to 22.7, the lowest reading in sixty years, and that only because the series doesn’t go back any further. It’s a stunning fifty percent drop since July.
To economists and number-crunching types, these new order declines indicate a re-acceleration of the decline in the economy. But to traders, it’s like so obviously a buy signal, dude. If the reading is the lowest ever, then it has nowhere to go but up, right? How much more obvious can that be, my friend? You must learn to understand investing.
In another indication of deflation induced by collapsing demand, prices paid also plunged to the lowest level since 1949. Employment readings fell to worsening levels, while the report quoted a machinery executive as saying that “Asia – in particular China – has virtually shut down.” Didn’t anybody tell China that they are bailing us out? Or maybe that machinery executive needs to listen to stock market strategists, rather than clients, in order to properly understand demand.
Consumer confidence took another big hit, with the Conference Board reporting that the November bounce is over and consumer confidence hitting a new recession low of 38.0, well below estimates. Just more proof of a bottom, dude. A report suggesting that this is the worst Christmas season since 1970 was ignored by traders (more bottom evidence); compare that to the talking head who thrust his jaw out and boasted that a decline of between two and four percent in sales was miraculously good compared to his expectations of a fall of between eight and ten percent. According to his thesis, retail is doing much, much better than expected (and if you want to buy retail stocks, he just may know a seller).
The latest weekly jobs data showed a surprising drop in initial claims below the five hundred thousand level, but the holiday-adjusted results were even doubted by the Labor department. In an all-too-familiar pattern, though, continuing claims ended their pause with another leap upward, in this case over 4.5 million and the highest level since the 1980 recession.
Next week will bring the December jobs report on Friday. The consensus estimate is for a loss of five hundred thousand, with estimates ranging as high as seven hundred and fifty thousand. Although we recently wrote that another huge negative number would not be welcomed by the market, the recent euphoria has left us uncertain that a nice round number of say, a loss of one million, might not actually be welcomed.
If that seems hard to grasp, consider that in the market’s bizarro-land, it could be seen as solid grounds for a stimulus package that was mega, mega-stimulating. Can’t you hear the traders now? “This loss removes any doubt that Congress has to act, and as you know the market hates uncertainty.” Yep, if we could only just lose a few million more jobs, we’ll really be sitting in clover.
The week will lead off with motor vehicle sales, with estimates of declines in the thirty to forty percent range. It doesn’t really matter what they are to the market, as for now traders believe that the government will keep them afloat regardless. Construction spending is expected to have fallen between one and two percent in November.
Tuesday will bring the report on November factory orders, along with the ISM services industry report and news on pending home sales. The ISM non-manufacturing number is at its lowest level since the number was first assembled in 1997. Another buy signal.
Chain store sales for the month of December will come out on Thursday. With expectations set as low as they are, companies that do not actually file for Chapter Eleven bankruptcy on Thursday will probably see their stock prices rally. The reckoning will come later, when companies start to report no earnings - though we already know that - but no visibility either.
We continue to recommend that readers have a look at the ETF ProShares Ultra-Short Real Estate Fund (SRS). The current situation in commercial real estate reminds us of this time a year ago, when a certain residential housing CEO opined that the residential market “sucked,” and would do so every day of the year. He was right, and the traders who shrugged him off as unduly pessimistic were wrong.
We believe that the same is in store this year for commercial real estate. Falling profits, rising unemployment and unusually tight credit don’t translate into higher rents, yet the markets are once again acting as if the crisis is nearly over. It isn’t.
Avalon Asset Management Company is a Registered Investment Adviser
Avalon's MarketWeek is not intended as a market timing newsletter or service. No buy or sell recommendations are made for any of the individual stocks mentioned on the site, and neither Avalon Asset Management Company nor its officers, directors or employees make public stock recommendations. Please address comments to MarketWeek@AvalonAssetMgmt.com