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Avalon Asset Management Company Back to the Future?
“The smiles returning to the faces" - George Harrison, Here Comes the Sun
Another week meant another five days of trading malaise as traders struggled to read the tea leaves at the bottom of their respective cups. The bad news was supposed to be all factored in, but there seems to be such an endless supply of it. It’s one thing to say that we should look ahead to the second half and talk about today’s great valuations, that seems like a fine idea, but just try to find a CEO who’ll say anything good. And these damn banks, are they ever going to stop finding more losses?
The week began and ended with losses, and not the little sort either. Alcoa (AA) reported its dismal tale on Monday, replete with salary and hiring freezes, layoffs of 15,000, and tales of unprecedented drops in pricing and demand. By week’s end, we were getting reports of staggering losses from Citigroup (C) and Bank of America (BAC), and over the weekend potentially the largest corporate loss in the United Kingdom’s history from the Royal Bank of Scotland (RBS). Circuit City (CC) announced liquidation and the impending loss of over 30,000 jobs.
Despite that, equities managed to trim their losses by putting on enough of a comeback in the last half of the week to avoid matching the dismal level of declines of the previous week. The rally had very little to go for it beyond technical factors, but those are as good as anything else in market environments as dreary as the current one.
After days and days of selling, the markets finally managed to generate a bounce by testing the Dow at 8000 and the S&P at the December low of 816 (the Dow actually got to 7995 on Wednesday morning). It wouldn’t surprise me a bit if traders had actually engineered the bounce simply by giving up and pulling the averages down the last few feet just to get the bounce. Stranger things happen on the Street all the time. For example, on Wednesday morning the news that Bank of America was getting more Fed money helped spur the rally in the market, yet by Friday that same news was driving down the bank’s stock.
Quite a bit of anger was ignited by B of A’s big Merrill-related losses and the simultaneous decisions to cut the dividend to a nominal one cent, take another $25 billion in TARP money, and get another couple hundred billion or so in guarantees. Citigroup, which had firmly stated that Smith Barney was not for sale and then sold it, decided to reorganize by week’s end into a good bank and a bad one. We had thought the one-stop financial supermarket idea dead at the end of the 1980’s, but Citi’s Sandy Weill revived it and everybody seemed to fall behind it again, if only to avoid being taken over themselves. Now we get to watch it unravel all over again.
There’s a lot of anguish over Citigroup and BAC, with good reason, and we’ve never been especially enamored of either of them. Nor have we ever owned a single share for a single second. All that said, though, an FDIC takeover, as some suggest, is not the solution. Neither is letting the banks go belly-up in order to teach the survivors a lesson, or letting the healing begin with a smaller number of banks, or rationalizing the industry capacity to more appropriate levels, or whatever else short-sellers who are desperately in need of a few more wins might suggest.
No, the United States has enough problems without making the rest of the world suspicious of doing business with us by letting one or two of its marquee banks fail. Nor do we believe that Ben Bernanke has the slightest intention of allowing a repeat of the Lehman experiment: that was enough excitement for this entire generation of governors at the Federal Reserve. We would suggest that being short of BAC at this point would be like selling the highest chair on the Titanic: if you manage to do the deal, you’re not going to have a lot of time to enjoy the money.
The $64 question remains - is this a pothole, or a sinkhole? The pothole crowd was emboldened by the Santa Claus rally at the beginning of the month, but the growing number of strategists and CEO’s starting to point towards recovery in 2010 began to drive spirits down into the sinkhole camp.
The pothole thesis is that although we are in a deep hole now, the large amount of governmental easing and stimulus will lead to a second-half recovery. The sinkhole scenario is that the magnitude of the credit freeze will stretch out the usual response time to monetary stimulus and keep us stuck and wallowing in our recession until 2010 at the earliest. Unfortunately, there wasn’t any financial news from last week to support the pothole over the sinkhole. It was rather the opposite.
Yet all is not entirely lost: the Federal Reserve is doing everything it can to push money into the system, and Treasury Secretary Hank Paulson retires on Tuesday. Those are hopeful data. President-elect Obama (who may well be President Obama by the time you read this) could bring a burst of confidence back to the country, along with an economic team that might be willing to try every magic spell ever conceived until one of them sticks. Both of those could give us a lift ahead of the schedule that the current pace dictates, though such tactics also carry more than the usual element of risk.
On the other hand, there is always the danger that the politicians might start to take seriously the usual lot shouting that the thing to do is clean the house and let all the banks fail, the faster the better, so we can root out the scoundrels and bad debts and get on with our new lives. Yes, and no doubt we should close all the hospitals too, so we can get rid of the sickly and concentrate on the benefits of a completely healthy population. We would like to think that nobody would take this kind of fantasy seriously, but then we remember Lehman Brothers.
Speaking of fantasy, one of the odder notes that struck us last week was noticing that one of the most emailed articles in the Wall Street Journal was a piece touting the importance in these troubled times of reading Ayn Rand and her maladroit best-seller, Atlas Shrugged. What makes it odd is that here we are staggering towards perhaps the worst economic decline in seventy-five years, much of it the result of libertarian policies that consisted largely of sticking one’s head in the sand when it came to regulation, all the while citing Rand and assuring all and sundry that alchemic forces would bring about the required transformation of dross to gold.
Rand’s books were a piece of her times, and perhaps a necessary antidote to the sort of glassy-eyed head-in-the-sand dreaming that Milan Kundera characterized as the “belief in the Grand March.” The war-inspired final revulsion at the centuries-old European class system led to some dubious flights of fancy, quite notably a widespread infatuation with the old Soviet Union and its satellites. It used to require a great deal of pretense and hypocrisy, not to mention having to buy a lot of posters with wrench-wielding laborers.
Rand’s ham-handed expose of the so-called “workers’ paradise” as a state consisting mostly of soulless bureaucrats straight out of Kafka and Chaplin (with the serious failing of insufficiently privileging the high-IQ caste that Rand belonged to) was a popular counter-thrust to the “Grand March” set. Her capitalist superheroes, as imaginary as the workers’ paradise wrench-wielders, had the advantage of being rich and admired for their brainpower, quite the appealing fantasy for geeks.
Yet here we are fifty years later with people still passing this stuff around like it’s a template for serious economic policy. It’s as if we decided to base our foreign policy on the history of dealings between Elves and Men in MiddleEarth, J.R.R. Tolkien’s imaginary world. I mean, Tolkien is a fine writer (and certainly more adept than Rand) who’s made his share of pithy observations and MiddleEarth is a cool place and everything, but I don’t think the Lord of the Rings should be the background material for dealing with Vladimir Putin, do you?
While we’re being cheeky about the Rand set, we have to admit to an embarrassing addition to the “oops” department ourselves. Last week we thought we were being rather clever and daring by giving you the dirt on how Bernie Madoff worked his magic. In a nutshell, we said, it was thought to be an insider’s dirty little secret that Bernie was front-running trading-desk orders for the benefit of his advisory clients. People who thought that they were in on the scam turned out to be the victims of quite a different one.
Imagine our embarrassment later in the week when, while catching up with the previous weekend’s reading, we came across a lengthy two-page essay in the Sunday edition of the New York Times called “The End of the Financial World as We Know It,” by Michael Lewis and David Einhorn. Not only did it make the same point about the front-running a week earlier, we suspect that the Times just may be more widely read. Did we also mention that Messrs. Lewis and Einhorn are a tiny bit better known than ourselves? Ah, the dangers of not staying current.
Coming back to the markets, we are unlikely to duplicate the massive sell-offs of October-November because of the lack of forced redemption selling. However, while the lack of minus-700 point days is better than the proverbial sharp stick in the eye, it doesn’t translate into a market afraid to test the lows again. The general consensus for next week is that the Obama inauguration will fire up a rally, and that worries us. It’s usually the case that when something is widely accepted as inevitable in the markets, it doesn’t happen.
Whatever the case, we want to salute the new President and wish him the best of luck, because he is going to need it in great quantities. It is especially fitting that his inauguration follows the day after the celebration of Dr. King’s birthday. We are not alone in remarking this, obviously, but we stand and applaud nonetheless.
The week began slowly, with the usual lack of major economic releases on a Monday. Alcoa (AA), however, got the earnings season off to a poor start with its disheartening release and outlook after the close.
The next day brought news on international trade, and the sharp drop discouraged analysts and led to gloomy headlines on the decline in global trade. Although the drop in imports will help fourth-quarter GDP figures (imports are subtracted, so when they go down GDP goes up), nobody was kidding themselves that it was good news. Japan reported its largest monthly drop in trade ever, China the biggest in a decade, Germany much the same.
The severity of the trade fall in November was a reaction to the October spending and credit collapse brought about by the Lehman failure. Not only did demand implode after September 30th, but trade financing was frozen as well, leaving goods stuck at their destinations.
Since the government has decided to stop experimenting with blowing up global financial institutions, it’s highly unlikely that we’ll see another drop of this magnitude. That is, unless the incoming government gets carried away with “punishing fat cats” and makes the similar error of thinking that ideology will somehow trump money. Our advice to the next administration in that respect would be, lock up all the individuals you want, but keep the institutions going.
Since the speed and magnitude of the October collapse probably won’t be repeated, we can expect some improvement going forward in the changes in monthly trade. This will give traders another opportunity to get it wrong and rally prematurely on the “improvement,” only to find out that leaving the maelstrom isn’t the same as smooth sailing. Markets can be so cruel.
The trader frustration level increased when retail sales data for December were released Wednesday morning. The drop of (-2.7)% was much larger than the expected (-1.2)%, and the excluding-autos figure of (-3.1)% didn’t provide any solace. That sent equity prices spinning further downwards, leading traders to complain that people should have known that the data wouldn’t be good.
We hasten to point out that the drop was aggravated by a fifteen-plus percent drop in gasoline sales, brought on by a combination of lower prices (retail sales data are unadjusted for inflation) and slowing demand. Without gasoline, the damage was only (-1.5)%, which may translate to relatively flat on a unit basis. But this is December, the holiday season, coming on top of five months of declines, and even with massive discounting, spending was unable to get going. Excluding vehicles, the year-on-year comparison of (-6.7)% gives a better picture of the deterioration.
Weekly data didn’t provide any solace. Chain-store sales continue to show year-on-year declines, indicating a record seventh month of declines is in the offing (though the records only go back to 1992). Mortgage purchase applications fell back sharply, perhaps an indication that not that many people were waiting on the sideline for lower rates. The lower rates did, however, lead to a hefty increase in refinancing applications. That will lead to better balance sheets and more disposable income down the road, but those seeds are unlikely to bloom before the fall at the earliest.
Initial unemployment claims surged back up to 524,000, which seems to be the current trend level when the holiday weeks are excluded. We were actually relieved not to see a larger number that could have pointed to bottlenecks from the holiday season, or just flat-out panic. Although continuing claims fell back a bit, it reflects people falling off the list by virtue of exhausting their benefits. If we continue at the current trend, the total will continue to work its way higher in a sawtooth pattern, then get another sharp lift when the extended benefits envisioned in the stimulus plan become available.
Nearly all the December monthly price data came out last week. Import-export prices were more or less in line with consensus estimates, and import prices in particular continue to benefit from the collapse in energy. Even so, import prices excluding petroleum declined for the fourth month in a row and export prices excluding agriculture fell, increasing concerns about falling demand and deflation.
The PPI, on the other hand, fell a little bit less than expected, though the core rate showed an unexpected monthly tick upward of 0.2% when 0.1% was expected. In another time and place, you might have heard at least one person fret about stagflation (and quite possibly the gold-bugs did on their blogs), but in the current circumstances it was understandably construed as a hopeful indicator about demand.
The story was much the same with the CPI: it fell a bit less than expected. The monthly core rate was unchanged, a tenth short of estimates rather than a tenth over. The report had little impact on the market, but it’s interesting to note that the year-over-year change in the CPI was 0.1%. In other words, consumer prices rose by one-tenth of one percent in 2008! But it was a wild ride, led by the fourth quarter collapse in energy prices (-76.6% annualized) and total prices falling for the third month in a row in December (-0.7)%. The latter fall was slower than the previous two months, easing deflation fears.
The industrial sector was represented by regional surveys from New York and Philadelphia, and the national Industrial Production report. As we wrote last week, the estimates on the surveys were so low that it would have taken a real bomb to produce a negative surprise. Both reports showed contractions – the New York at (-22.2) and Philadelphia reporting (-24.3) – that were accompanied by downward revisions to the previous month. In other words, we are still declining steeply, and from levels that are even lower than originally reported. But the rate of decline softened. Lucky us.
The Industrial Production data should have shaken the market, but that was a difficult task on an expiration Friday focused on keeping all of those puts on financial stocks out of the money. It was a scary report. December production fell (-2.0)%, twice the expected (-1.0)% rate. November’s drop was doubled as well, being revised to (-1.3)% from (-0.6)%. That brought the fourth quarter run rate to (-11.5)%. That’s not bad, it’s terrible. The year-on-year drop for December was (-7.8)%. I cannot recall ever seeing such numbers, though I suspect that the 1980-1982 recession is still the champ.
I’m not sure why the equity markets pay so little attention to the Industrial Production reports, because they’re a fairly good indication about the strength and direction of the overall economy (and earnings). Unless traders are on pins and needles about a possible interest rate change, though, they rarely give much heed. Capacity utilization fell steeply, manufacturing production fell steeply, our hopes for the first half fell steeply. Yet the market is a forward-looking, discounting mechanism, and so was looking far off into the future, next Tuesday to be precise, and the hoped-for Inauguration Day rally.
There was a consumer confidence report on Friday, but it was essentially unchanged from the previous month. Low, but not as low as the terrifying days of October. Beyond that it had no useful information.
Next week is another holiday-shortened week, with markets closed on Monday. The economic calendar is nearly empty, with the only monthly reports being the Housing Market Index on Wednesday and housing starts on Thursday. Perhaps the promise of the stimulus bill has lifted the housing index out of single digits.
The focus will be on earnings, then, and some of the leading companies reporting are IBM, Johnson and Johnson (JNJ) and CSX on Inauguration Tuesday, United Technology (UTX), Apple (AAPL) and major airlines on Wednesday, Google (GOOG) and Microsoft (MSFT) on Thursday and GE, Schlumberger (SLB) and Xerox (XRX) on Friday. Thursday will also see a big slug of banks reporting.
Expectations have come down quite a bit in the last month and in the financial sector, Citi and B of A have set the bar even lower. Nobody is expecting anything but gloom from company executives, yet the drumbeat of bad news has still rattled investors. They should be rattled, so maybe the market will put on a “Braveheart” rally instead.
StockWatcher is still in hibernation.
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