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Avalon Asset Management Company One After 909
“Then I find I've got the wrong number, well." - Lennon-McCartney, One After 909
How many more wrong numbers can the market take? That is the question, as doubts crept in over the course of a week that saw traders returning their gifts from the “Santa Claus” rally of a week before. We already know about all the bad news, so there can’t be any more negative surprises, and prices are going up because the market is correctly anticipating the second-half recovery coming from that stimulus package that is Inauguration-day ready. Right?
Friday morning, we were treated to the sight of a confident floor trader who embraced that story with a smile, turn pale with the sickly cast of thought when an on-air reporter put that very question to him: “How much more bad news can the market take?” He admitted that it was a very good question. Yes, indeed.
Looking across at the country at California, it occurs to us that if the principal trading floors were located on the West coast rather than the East, the Dow Jones would probably be about a thousand points lower. Along with being one of the states worst hit by the housing crisis, California is looking at a staggering budget shortfall and talk of shortening the school year, furloughing state workers and other a host of other cuts and revenue increases to try to make up the difference. I don’t know that they can take any more bad news.
In the good news column, we are supposed to be excited that the stock indices were approaching their 50-day averages, inspiring talk of a breakout. We will point out that in the last twelve months, the indices have moved above their 50-day averages several times, with the S&P moving above its 200-day average in May. You would have done very, very well had you sold into each so-called breakout. The only move that had any legs, from April to May, “confirmed” by the 200-day breakout, turned out to be the perfect time to cash out and flee.
Another bit of news intended to cheer us was that the latest Investor’s Intelligence poll showed more bulls than bears for the first time since August 20th. Late August, that was a great time to get into the market, wasn't it? Then there was the rallying cry that it’s never right to bet on the end of the world. Very true, but one can also lose a lot of money betting on false beginnings too.
One often sees sharp rallies in bear markets based upon technical factors and a pause in redemptions; optimistic narratives will spring up like mushrooms out of the rot to justify what are little more than trading pushbacks. Be careful about which mushrooms you swallow.
The two new buzz-words for the month are “shovel-ready” and “cramdown.” The former refers to the uncomfortable reflection that while the incoming government may be readying a big stimulus package of infrastructure investments, it’s possible that said investments might not actually be breaking ground the day after Inauguration Day. How much of the pipeline, then, could really be ready to swing into action, or “shovel-ready?”
The answer is, probably nothing. In fact, Congressional leaders were voicing doubts during the week that the stimulus package could be signed off on by Obama’s target deadline of February 12th. Then the projects have to be put out to bid, go through the process and so on. There is likely to be a bit of a wait.
What will probably matter more than the stimulus package, though, is not the first response but the second. The same bad news that the markets welcomed as bringing on bigger and better stimulus has the Obama camp and the Fed worried. We think that after the initial burst of euphoria from the package wears off, we’re going to still be confronted with deteriorating credit and employment conditions, higher bankruptcies and more defaults. It will probably be an as-yet unannounced plan or move that really starts to turn things around.
Indeed, so far as the markets go, the stimulus package looks very much like an interest-rate cut to us: one buys the rumor and sells the news. While there is no stimulus package, traders are free to indulge their fantasies of how big and glorious it may be, but once it passes reality has to set in again, and what is there to look forward to? It isn’t going to be the next quarter’s GDP, and as for earnings, they are going to be best thought of in the abstract for some time to come.
While unemployment has been falling for a year, bankruptcies and defaults are just starting to warm up. The Madoff and Satyam (the Indian IT company whose CEO just admitted he’s been cooking the books) stories are just the first wave. Friday brought allegations of massive bid-rigging in the municipal bond market. It’s still early in the game.
Speaking of Madoff, here at MarketWeek we don’t have the same concerns as the big national media, so we’ll cheerfully dish you the inside scoop on the Madoff fiasco. It’s only fair, since most of the Street already knows (or at least, we think we know) how Madoff did it for so long.
The SEC investigated Bernie, so why they didn’t they find out what was going on? Because he didn’t commit the crime they were looking for, that’s why. It was just like one of those stories about the cop who lets the murderer go because he was looking for a pickpocket. Although no one will want to admit it – for obvious reasons - it was widely assumed, even in the advisory world, that Bernie was up to something to produce those relentlessly smooth returns.
That something was presumed to be front-running orders from the trading business for the accounts of the investment clients. That could produce reliable returns, and seemed to fit well with the other circumstances. Bernie had a trading business. Anyone doing such a thing wouldn’t want too many clients – and Madoff said he didn’t – because while one can get away with a lot of loose behavior on Wall Street, getting too greedy about it can bring in the feds.
It was an exclusive club – or so people thought - and like getting entrance to a swank speakeasy during Prohibition days, one doesn’t disturb the host by asking a lot of questions about the setup. Lay a finger on one side of the nose, wink and accept the hospitality. The SEC tried to find evidence that Madoff was front-running – which, like insider trading, is often very difficult to prove - and didn’t. Bernie was too crafty, or the SEC too naïve, or whatever suited you, but nobody thought to look for a curtain marked “Ponzi” because they already knew what the scam really was. Ironic, isn’t it?
Perhaps the greater irony is that, but for the once-in-a-century ferocity of the market collapse, Madoff might have gone undetected to his grave. But the collapse created such liquidity demands on his clients that Madoff was overwhelmed by redemption requests. His clients were unmotivated by any concerns about him, they just needed cash. As it turns out, so did he.
Yet there are some positives. GE’s finance subsidiary, GECC, sold one of the largest 30-year issues in years last week at a yield of about seven percent, without any government guarantees. There is some appetite returning for something that isn’t a Treasury. It’s a very high spread, and a triple-A credit, but it is without a doubt an improvement from the last couple of months.
Mortgage markets are steadily improving, with “cramdowns” introducing the latest bump. Cramdowns are the principle that judges will be given the right to cut the principal balances of mortgages for homeowners in Chapter 13, thereby cramming lower balances down the throats of the lenders. The main advantage is that there are too many parties these days to a mortgage: the originator, the servicing agent, and the investor. Judges can in theory speed the process and put homeowners into affordable payment streams with principal balances that aren’t underwater, putting fewer foreclosures into the market.
We’re still seeing some continuity in the market, too. Outgoing Treasury Secretary Hank Paulson still said last week that the feds couldn’t have prevented the Lehman failure, and there is still nobody who believes him. Maybe thirty years from now he’ll allow that things might have worked out better. Surprisingly enough, the Obama administration still hasn’t made any attempt to recruit him.
The operative mood at the beginning of the week of ring out the old, and ring in the new, required some contortions, but the markets never have a problem coming up with a narrative to justify rising prices. Thus, a better-than-expected report on construction spending (-0.6% versus expectations for –1.3%) was warmly greeted on Monday, while a worse-than-expected drop in factory orders (-4.6)% from November was sniffed at on Tuesday as being “old” data. You gotta play smart: the construction report was from November too.
There were some interesting bits nevertheless. Private residential construction fell sharply again, which is what the homebuilders have been saying. The total number was held up by increases in public spending and surprising increases in industrial construction (power generation and manufacturing). When one breaks down the categories, though, it’s hard to make a case for any increases going forward, with the exception of public spending.
The factory orders number wasn’t as bad as the total seemed either, being dragged down by price drops in energy non-durables. New orders for durable goods fell (-1.5)%, a downward revision from the previously reported estimate of (-1.0)%. Looked at on a diffusion basis, however, the picture was more disturbing, with large decreases in many categories. Shipments fell sharply as well.
The report on pending home sales didn’t bring any solace to investors looking for signs of stabilization in housing. The indicator fell (-4.0)% in November versus expectations for a decline of about a percent, with October downwardly revised as well. Still, the realtors’ association was quick to point out that November’s data didn’t include any effect from lower mortgage rates in December.
That is a fair point, and mortgage purchase applications have been increasing of late, including the last two weeks. The surety that home purchases “must” pick up substantially as a result of lower rates has led to another gathering of the lemmings, but there are some grounds for looking before leaping off that particular cliff.
Two very large obstacles standing in the way of a housing recovery are credit and employment. It’s difficult to really get housing purchases going in the face of sharply rising unemployment. Easy credit might work, as it did in the 2001-2002 recession, but that’s obviously not coming to the rescue this time, with a shrinking pool of lenders and credit availability at historic lows. The outlook for when credit thaws is a guess that doesn’t include the word “soon.”
Banks are going to take more losses in real estate, especially as financial centers such as Boston, New York, Philadelphia and San Francisco experience a second dip in 2009. Both residential and commercial losses are going to increase in these areas, and the balances due are going to be larger. This will not lubricate the wheels of mortgage lending. Banking analyst Meredith Whitney surmised last week that banks will need more capital.
The large urban markets are heavily dependent on jumbo financing (loan balances above the federal guarantee limit), and it’s shut for now. The banks are sitting on a huge inventory of homes that don’t show up in the record level of listed homes for sale, a figure that also excludes the homes of people who want to sell just as soon as the market recovers. Housing analyst Ivy Zelman predicted last week that housing isn’t going to improve before 2010.
As for the stimulus program, as announced it isn’t going to put housing into a V-shaped recovery. It may keep it from getting worse, but there is only so much the government can do. Cramdowns, tax credits, it will all help, and we will come out of this at some point, but we still have a massive overhang and rising unemployment. If the feds can flatten things out by the summer, that will be quite a victory, but it’s going to be at lower levels of economic activity.
The ISM non-manufacturing number showed some improvement from the previous month with a reading of 40. Although still in recessionary territory, the rate of decline slowed in most categories, which is a good thing. Even so, one executive’s remark showcased the current difficulties: “Credit from suppliers is becoming an issue even with a perfect payment history. Everyone is scared.”
The employment statistics did not appear to fit neatly together last week, but the picture is clear enough: 7.2% unemployment, the most since 1993, and the most jobs lost in one year since 1945. The latter statistic made for a lurid headline on the front pages of most major newspapers, without the mention that the population has more than doubled since that year. Still, it wasn’t good and we’ve no doubt that the fault lies in not enough tax cuts for the wealthy, who apparently have lost interest in creating more jobs. They’re a busy lot, you know, and without enough incentives just can’t be expected to always be stepping up.
A second consecutive week of initial claims came in below the five hundred-thousand line. The market has been mostly suspicious of these holiday-week reports, and press accounts emerged on Friday that local governments simply hadn’t kept up with the claims applicants. That could prove embarrassing to those who saw signs of a bottom in the data, but time will tell.
Although those weekly reports weren’t part of the same reporting period as the monthly jobs report, the latter was definitely telling another story. The ADP folks rattled the markets on Wednesday with an estimate of 693,000 jobs lost in December, which sent the whisper number ever higher. By that evening, one million had been mentioned, presumably to inoculate the market against the worst possibility.
It wasn’t in the million zone, but the Labor department’s report was a disappointment. To begin with, the revisions to October and November were massively downward, raising the possibility that the ADP number may prove to be right in the end. Worse, the reported figure of 525,000 was neither too dreadful, raising hopes of bigger stimuli, nor too good, raising hopes of a recovery.
It may seem hard to believe, but in the wonderful bizarro-world of the Street, a number at the high end of the range – say, 800,000 or so – would have touched off a big rally. Traders were ready for a new narrative of massive stimulus and mega-cuts in taxes, the government’s hand forced by historic losses, the V-shaped recovery story crushing any shorts foolish enough to think they could logically sell the number. All they got was consensus and more tedious decline. Dang.
Tedious decline was the pattern of motor vehicle sales too, as December sales reports showed year-on-year declines ranging from thirty to forty percent. Was I the only one that smiled at the news that only Chrysler exceeded Toyota’s decline, while GM was at the front of the pack? Perhaps Congress should call in the Toyota execs and demand to know why they’re not building enough fuel-efficient cars.
The Fed released its minutes from last month’s FOMC meeting, and the devil was in the details. The Fed now expects GDP to contract for 2009 and has pushed off the recovery until 2010 (although on Friday Richmond Fed President Lacker claimed – for the third year in a row - to discern a bottom in the housing market). The Fed staff opined that GDP would fall much more sharply in the first half than anticipated, something worth heeding to those trying to look across the valley: the other side is going to be lower than you think.
Monthly sales reports for December were rotten, but despite the headlines it wasn’t the declines that bothered the market. Nobody cared that Saks (SKS) declined nearly twenty percent, because it had already been written off, but Wal-Mart’s (WMT) announcement of lowered results and guidance came as a big disappointment. That should lower expectations for next Wednesday’s report on December retail sales.
The week will start slowly again, with eyes turning towards the beginning of earning season and Alcoa’s (AA) report after Monday’s close. International trade comes out on Tuesday and business inventories on Wednesday.
The reporting will be heavy on pricing and manufacturing data, with the import-export price report on Tuesday, the Producer’s Price Index report on Thursday and the Consumer Price report on Friday. Prices are expected to have fallen nearly across the board, with the only question being the size of the declines.
The New York and Philadelphia Feds will report their December manufacturing surveys on Thursday, and the central bank will weigh in with national industrial production data on Friday. Expectations for the surveys are deep in the basement, so don’t look for negative surprises there. December industrial production is expected to show a decline of about a percent.
The Beige Book regional report is due Tuesday afternoon, giving a look at business executive outlooks, while the University of Michigan will offer another look at consumer confidence on Friday.
StockWatcher returns next week.
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