Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Back on the Chain Gang
“We fall but we keep gettin' up" - The Pretenders
As the venerable Thing might have said, had he been of the trading floor rather than the Fantastic Four, “It’s sloggin’ time!” Beset by bad earnings and worse economic data, yet simultaneously lured on by the chance to surf reversal waves, the market muddled through another week of soft, sucking slippage that left boots muddied but prospects for the intangible intact.
That intangible would be the prospect of the big rip, a condition black reversal wave that will come out of nowhere and scatter the bears in terror while the big kahuna bulls ride majestically to shore on righteous waves of trading profits. Why exactly this might come to be is, like most mythical convergences of the cosmos, based upon a messy collection of ad-hoc justifications, self-interest and plain old greed. Doesn’t everybody want to win the lottery?
One could be pardoned for thinking that a week in which such luminaries as Microsoft (MSFT, first real layoffs ever), Johnson and Johnson (JNJ, projecting first sales decline in seventy-six years), Nokia (NOK, worst forecast ever), Samsung (SMSN, first quarterly loss) and General Electric (GE, 65% one-year drop in stock price to 1996 levels, dividend and triple-A rating in deadly peril) assembled together to make it quite plain that the economy was bad, really bad, and not only really bad but a lot worse than they thought a couple of months ago, would be a week to throw the bags overboard and abandon ship.
But that would be to mistake our hardy surfers for mere Sunday amateurs. You see, they already know that it’s stormy out, so it’s just a chance to catch some real rollers. Why worry about such trifles as the economy when there might be technical levels to catch?
Cheekiness aside, what is keeping the market from falling apart completely under the weight of so many busted stocks is primarily a lack of selling pressure. Most of the cash that needed to be pulled out of the market was converted by the end of the year. The larger players are neither buyers nor sellers, but are sitting on the sidelines in the wait for clearer signs. Right now, the clearest sign is “Do Not Enter.”
That leaves the floor to the traders and players, and the result is a lot of shifting back and forth through the mud with days like Friday and its rebound “rally” that “absolutely nobody believes in,” as MarketBeat's David Gaffen aptly put it. What traders believe in is the 8000 level on the Dow because it’s served as a useful trampoline - so far. It isn’t a question of valuation or earnings or outlook, it’s a question of a trade that manages to stay alive, with little else to choose from in the wake of 2008.
This churn is typical around market bottoms, although we are reluctant to say the final bottom has been put in. On the negative side are earnings and outlooks that are clearly worse than expected, and that point to an economy in greater peril than we would like to think.
On the positive side is nothing really tangible, although that isn’t necessarily fatal: there’s the general belief in a retest of the November lows, which in the perverse world of the markets makes such an event less likely, and a furtive hope that the Obama administration might pull something sensational out of its hat and launch the forty-foot reversal wave that traders are not-so-secretly dreaming about.
Maybe they’ll repeal taxes for a year. Even better, perhaps the new President will announce a program to put a Blackberry and MacBook into twenty million newly built homes financed at zero percent, each perched on a freshly repaved street with a new American car in the garage and a gift basket of semiconductors in the hallway.
The fantasy is clearest in the price of oil. Although the latest weekly production data clearly showed stocks ramping up much faster than expected amidst fading demand, prices managed to shake off the initial sell-off and struggle back into the black. The most amusing part of this is listening to traders try to pass off “rising oil prices” as positive indications about the economy. They must think that we were all born after last June. The prices aren’t rising on anything but demand for higher prices, and those aren’t signaling anything but the hopes of traders for a short squeeze and the big rip reversal.
In the meantime, the current markets and the barrage of bad news remind us of a cornfield with recordings of a barking dog: after a time, the birds adapt to the noise and decided to keep feeding until the real thing shows up. Whether it’s the equity or the oil markets, though, one real big-dog seller will have the bull-talking traders taking flight instantly.
Still, we have to admit that it can’t be easy for anyone with a sizable position in say, Microsoft, to be dumping the stock here at the seventeen level. The stock was called a buy at thirty, a buy in the mid-twenties, a buy at twenty and now here it sits at an eleven-year low with a single-digit P/E. The knife has to stop falling at some point, but in the interim the number of bloody fingers keeps growing. It’s emblematic of what’s keeping the market together more than anything else: it’s just not easy to sell these blue chips at single-digit P/E levels, and most of us have run out of other winners to sell.
Even stories such as Apple (AAPL) and Google (GOOG), though reporting earnings last week that were better than expected, are still more than fifty percent off their highs. Who would want to sell them here? That said, we have no sympathy for anybody who buys into last week’s budding notion of a tech rally. That the two companies are able to take share in declining markets is very good news for their stockholders, and makes them quite respectable growth stocks.
The notion, however, that their success says anything about the tech sector is just a lot of trading hot air. There is no early recovery going on in technology. Google is laying off employees. Sales of all device types are shrinking. The drastic shrinkage currently going on in the order book can’t go on forever, of course, and when semiconductor inventories begin to dry up there should be a decent resurgence. Their stocks could rebound by 40%. But will Intel (INTC) rebound from its current level of 13 back to 18, or will it be from 10 to 14? That’s the problem.
One thing that the new administration may want to fix quickly are the rotten 2005 bankruptcy laws, which were intended as a big gift to big lenders and have ended up exacerbating the current downturn. It’s virtually impossible for a company to reorganize in bankruptcy now, and the result is that Chapter Eleven has just become a brief stop on the way to liquidation.
As long as the old new law remains in effect, shutdowns and the resultant mass layoffs will continue to wreak havoc on the economy and employment. There is a yearning to believe that last quarter’s dramatic fall in demand is largely past, but so long as the Circuit City’s of the world continue to put workers on the street at 30,000 a pop, we’re going to keep getting hammered from the demand side. The credit markets are extremely tight for those without problems; for those faced with vital debt negotiations, they are virtually shut. So long as that situation persists, we’re still slogging away on the chain gang.
Last week was of course dominated by earnings news, or in many cases the lack thereof. What news there was eroded the protective barriers of discounted anticipation put up by traders. Yeah, they knew it would be ugly. They even knew it would be really ugly, but when you see it and it’s really, really ugly, that feels different, doesn’t it?
The new housing reports were so comically bad that it’s a quick, inevitable leap to the realization that they can’t get much worse. Moreover, the nearly completely dead pulse of the homebuilding industry is an advantage so far as inventory is concerned. Despite that silver-like lining, though (calling it silver just doesn’t seem right), the reflex leap into the homebuilders seems less appealing than ever. It’s hard for common equity to rebound from bankruptcy.
Last week we wondered if the historically low sentiment index for the builders could dig its way back out of single digits due to the drop in mortgage rates. Well, it didn’t. The housing market index actually dropped from nine to eight. The neutral level is fifty! Since zero is the limit, it obviously can’t get much lower, but the possibility of a more protracted period of pain is beginning to dawn on traders.
The housing starts and permits data released on Thursday explained that eight reading. Housing starts fell another fifteen percent, the second such decline in a row, to a lowest-ever annual rate of 550,000 that was below even the most pessimistic estimates. It’s also well below the theoretical replacement rate of around 750,000 to a million, so when unemployment stops rising there is no doubt that homebuilders will get a sharp rebound. Before you take that investment leap, though, there are a couple of thorny hedges to leap: which homebuilders will still be alive by then, and from what levels do they rebound?
Unemployment shows no signs of relenting. The claims numbers ratcheted sharply higher again, to 589,000 on initial and 4.6 million on continuing claims. Both numbers represent the highest since the recession of the early nineteen-eighties. Looking over the layoff announcements from the current earnings season, it seems likely that we will top – or is it bottom? – those lugubrious records.
Weekly chain-store sales readings continue to decline, with readings in the minus two percent region. Mortgage-purchase applications recorded a small increase, though to still-low levels, while brisk refinancing activity may have helped push rates back up again. Given the indications, it seems that more price declines are in store.
We don’t usually bring up the weekly energy report, but the startling size of last week’s builds in crude and gasoline inventories seem worth mentioning. The builds were well beyond expectations, and would seem to belie the idea of trading into energy as the early rebound trade. The physical demand figures say otherwise. Some are reading the recent oil price bounce as an early indicator of an economic comeback, but to us it’s nothing more than a pitch for a comeback. As far as prices being economic indicators, remember the summer of 2008.
Next week the calendar will pick up again. The housing picture from December will be completed by the existing home sales report on Monday, the Case-Shiller home price analysis on Tuesday and the new-home sales report on Thursday. All are expected to show further declines.
The manufacturing side will be represented by December durable goods data on Thursday and the Chicago PMI release on Friday. The Conference Board chips in two reports, with Leading Indicators on Monday and consumer sentiment on Tuesday. The latter report will be echoed by another reading from the University of Michigan on Friday, though the preliminary fourth-quarter GDP figure due that day will probably take center stage. The consensus is for a drop of around five and-a-half percent, with whisper numbers reaching as high as seven percent.
The FOMC meets next week and will deliver its verdict on Wednesday afternoon. There won’t be any hopes for a rate cut this time around, what with nothing left to cut, but there is a decent possibility of new credit-market relief measures. The official statement and its near-term prognosis will be scrutinized as well.
Most of us already know what that outlook is, but traders will look for the faintest glimmer of hope for a change down the road. We don’t think that they’re going to get it this time; if anything the Fed staff is likely to be more worried than ever. But then, they’re not traders.
Groundhog Day is still ten days away, but we’re going to stick our heads up anyway and declare that, at the risk of seeing another six weeks of winter, there should be some spring arriving this year in the stock of General Electric (GE).
This isn’t a trading call, but the rarest of creatures this winter, an investment call. We’re not going to drag up the hoary cliché that “the bad news is already in the stock,” because when we look at the economic trends, it’s perfectly possible that there is more non-discounted bad news in store for everybody.
The company reported earnings on Friday, and managed to hit its reduced target with the aid of a tax benefit. The quality wasn’t great, but then again, neither were IBM’s, whose declines in sales and gross profits were masked by a number of items such as expense reductions, share count reductions, tax benefits and a few other items. That didn’t keep IBM from rallying, but you know, it’s a tech stock, so it gets special dispensation.
GE, on the other hand, is trading at less than seven times trailing earnings and cash flow. Yes, we know that the market is worried about the dividend, but so what? If it gets cut in half, it’s still going to yield five percent and the stock would probably go up on the news. Ditto for the triple-A rating. In fact, you may want to ask yourself how many double-A companies are out there yielding five percent and sporting seven multiples.
GE has a massive order book that will likely see some cancellations. It can afford them. It’s still a fundamentally sound company whose financial affiliate, GECC, was recently able to place a large thirty-year bond issue at seven percent. Its commercial paper is good in the marketplace. We will take the occasion to remind you, not for the last time, that the bond market is a much better indicator than the stock market.
The price could still come off to ten dollars or so, a twenty percent decline. For that matter, so could the rest of the market. But from a three-to-five year perspective, this looks like a downside of two or three dollars and an upside of twenty or more. We can live with that.
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