Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Cold Front
“The winds grow colder, and suddenly you're older.” - Judy Garland, The Man that Got Away (Harold Arlen)
What happened last week? After a pleasant tropical cruise in the first half of January, filled with warm breezes and tall drinks with little umbrellas, along came a nor’easter in the markets that by week’s end left the top decks empty. The passengers were locked below into their cabins, pestering the stewards for another dose of those seasick pills. For that matter, those of us in the Northeast and Midwest were light years away from thoughts of warmth and wondering when, if ever, we might take off the extra layer of winter woolies.
We were amused to see at week’s end how many denizens of the Street were reflexively pointing their fingers at the government for the market’s weakness. Isn’t that the credo these days? When financial sectors profits soar, it is due to the brilliance of its top people, and so they should keep most of it. Losses, as we have so plainly seen, are the responsibility of the shareholders and the government.
It follows then that when stock prices put on a good rally, it is must be due to our far-seeing gaggle of the gifted, and when they fall, it must be the fault of the feds. It stands to reason, after all. One does owe them credit for consistency.
To begin with, we’ll repeat our observation that the markets had gotten too complacent. The simpering in the mirror had gotten so pronounced that even some insiders were beginning to roll their eyes and think wistfully about banana peels. As one observer put it, the market was priced for a surplus of good news. When it didn’t get all of it, a little burst of reality went a long way.
There has been some good news too, after all. Profits are beating consensus estimates at a nearly eighty percent clip, compared to the long-term average of about two-thirds. We would put some of that down to the caution that has become standard in corporate suites, and some down to Street analysts who know that it is better for your companies to beat than to fail, but the percentage is still good.
There was caution spread throughout the outlooks, but many of the larger bellwethers were raising guidance nevertheless. The problem might be thought of as two-fold: reluctance on the part of corporate management to be as effusive as Wall Street has priced in, and the shadow of China.
For us, the wavering winds from the China sea are the principal reason for the recent change in weather. It’s become an article of faith for many on the Street that China is going to lead the world out of the wilderness and back to global growth (it’s one of the ironies of our business that it seems to be okay to place unlimited faith in the stimulus program of an economy centrally managed by the Communist party, while heaping furious scorn on an American one run by elected representatives who dare to stick their noses into the business world).
Many China pros were warning of problems by the end of 2009, but those warnings went largely unheeded until its government began to talk of excesses and tightening. In the wake of that turnabout, issues like jobless claims and increasing credit write-downs suddenly looked much more ominous than they might have otherwise. When a bit of sell-the-news syndrome set in with some of the most widely followed stocks, a sense of hesitancy about the market’s short-term direction enabled it able to spread more quickly.
As our readers know, we were among the voices saying that market valuations had risen to the point of leaving little margin for error. When you hear portfolio managers start to plead their case for an expansion of earnings multiples as a reason for prices to move higher, you can be fairly certain that reality is preparing a good-sized smack to the head.
All of this has brought us below certain sacred chart lines. Traders are now on watch for a further drop, say to 1020 or 1000 on the S&P, while a test of Dow 10,000 looks like a short march. We would say that sentiment is now evenly split between fear and greed, which may be a good thing. Some are urging a sell into any rally attempt, while others are gearing up to ride a bounce that they hope to be as vicious as they would like to make it.
Frankly, if we could tell you exactly which way the market was about to turn, we would be too busy figuring out how to spend all the profits from our futures trading to bother writing this column. One thing we can say with confidence, though, is that the market has fallen out of the zone of very optimistic valuations. They aren’t yet into pessimism, though, and therein lies the rub.
An important thing that did not occur in January was any indication of steady inflows of new money into the stock market. It’s a daily auction, the stock market, and when new money comes into an auction room every day, prices tend to stay high no matter what. Without that tailwind, the current market becomes more of a trading one than ever. The net result of the last three months has been essentially zero, which may surprise you.
Looked at from a trading point of view, the markets are oversold in the short-term and due for a bounce. However, the intermediate trends are suggesting that the prevailing wind is still from north-to-south (and if that seems too lyrical, then “down” will work). The problem with trading markets, though, is that people do tend to fixate on the charts, but only until something more interesting happens. At the risk of offending technicians out there, the graphs are mostly of short-term interest on the Street - fundamentals do outweigh them in the end.
It also must be said that news events get more oomph when the markets are either extended or directionless. The same story can generate completely different reactions, depending on what else has been going on. When China became a little cautious, for example, against a Western backdrop of utter confidence, it rattled us. The flip side of that is that the more the market weakens, the more likely it is that even the most harmlessly benign remark out of China could set off a massive riptide reversal, the kind that sets traders to targeting anything and everything that’s been sold short.
Against that, neither do we suffer from the kind of excess pessimism that demands that one start ignoring the indices and start buying individual names every day. Markets tend to swing too far, and while we’ve had a pretty good drop here, it isn’t yet more than a squiggle when looked at from the longer term. We are definitely still vulnerable, especially given the time of year, the lack of new money flows and the lack of truly compelling bargains. Oh, and did we mention the apparent lack of momentum in the economy?
As to the government, we would advise you not to put too much stock in the grousing. Businesses having been blaming their problems to the press on the government for as long as there have been newspapers. Not to alarm you, but there really isn’t very much that the government can do anyway to help this economy, not in the short run. It’s mostly up to us.
We’ll start this week’s review with the GDP report released on Friday. According to the Bureau of Economic Analysis (BEA), it rose in the fourth quarter of 2009 at an annual rate of 5.7%. This was well past the consensus of around 4.7%, though the burst of late calls the previous week for something close to 5.5% meant that the market had largely discarded the lower number.
Despite the Wall Street Journal’s optimistic headline the next day about it being the fastest growth rate in six years, there were a couple of problems with the number, as evidenced by the market’s failure to get excited about it. One problem, as the Journal pointed out, was that the increase was driven largely by slower inventory liquidation. Another problem, from our point of view, is that we don’t believe it, and we think you shouldn’t either.
The headline numbers for GDP are for real GDP, that is to say, after adjustment for price inflation. For several quarters, the BEA has posted remarkably low price deflators for GDP: 0.0% for the second quarter, 0.4% for the third and 0.6% for the fourth. Yet other inflation indicators have generally run in the neighborhood of 1.5% on an annual basis, with higher rates in the fourth quarter. The BEA’s own statistics from the same GDP report claimed an inflation rate of 2.1% in the fourth quarter for domestic purchases, and 2.7% for the so-called Fed favorite, Personal Consumption Expenditures (PCE).
Regardless of whether you are tempted by experience to take a skeptical attitude towards revisions – third quarter GDP was first announced as 3.5%, yet currently stands at 2.2% - we think that there are very strong grounds to doubt that real GDP was above 5% in the fourth quarter.
However, a number closer to the original consensus of 4.7% would still be a very respectable jump, as well as perhaps closer to reality. But the early indications from corporate earnings guidance aren’t backing a continuation of that rate, lending weight to the view that the inventory adjustment is already easing. The Street has not wanted this view, nor has the market been priced for it.
Another market-weakening datum came from the weekly unemployment claims. Although they did recede from the previous week, 470K versus 478K, the consensus was much lower, at 440,000. We’ve been hammering the point anyway that that’s too high, two years after the putative onset of the recession, and this time it was also too high for the market’s mood.
The durable goods result didn’t cheer the market either. The headline number of a 0.3% increase in new orders in December fell well short of the consensus view of 1.6%, but you can throw that one out anyway, as it was yanked by a monthly swing in the always-lumpy commercial-aircraft order book. There were some positive aspects that optimists dipped into heavily to paint a more positive picture, such as an upward revision to November’s decline, a December increase in private business investment spending of 1.6%, or a 0.9% increase in new orders excluding transportation.
Here’s the real problem, though. Take out transportation spending, and we are still left with two sobering realities: new orders in December of 2009, the tail end of our “fastest quarter in six years,” were less than one percent higher than December of 2008. That particular month came during the time that businesses were throwing everything overboard, liquidating stocks and payrolls. Yet a year later, in the midst of our big recovery, we’re not even one percent higher (+0.7%)? Private business investment spending actually fell on the year-ago basis. Maybe it’s not such a big recovery.
The week got off to a shaky start with news from the housing sector. The verdict on December was that existing home sales fell (-16.7)% and new home sales fell (-7.6)%. Both of these results were far below consensus. The disappointment was tempered by awareness of the distortion caused by the tax credit that was going to expire in November, and the fact that December isn’t a big month for sales anyway.
Some tried to talk up the increase in average sales price in existing home sales, but ignore it: it was strictly a case of mix. For example, the federal housing price data released on Tuesday showed an increase in average price for November, while the Case-Shiller housing index showed a slight decline. It was widely expected that the supply of homes at the bottom end of the price scale would get cleared out first, and that’s what has happened. It pushes up the average price, but try telling a homeowner with a house for sale that the price is going up.
Refinancing applications are so feeble that the Mortgage Banker’s Association wondered if the pool of would-be refinancers is shrinking. It was most likely meant as a hint to the Fed to push rates back down below five percent (everybody is against more government spending, it seems, unless it involves themselves) but the banks are shrinking the pool on their own.
The consumer confidence measures for January (which we put in reverse order in last week’s column) rose marginally, but slightly ahead of expectations. That led the business press to get over-excited, using terms such as “surge” and “spike” to describe movements that were quite mild. The results also came on the heels of the early January surge in the market, when the indices were marching up almost every day. Without a big reversal soon in the markets, those surges and spikes will have to be returned to sender. Weekly retail sales data again showed consumers spending less, not more.
The FOMC met and issued its statement last week, with almost no change. There was a comic effect, as the news that there had been a dissenter inspired the markets into a rally, based upon the notion that the dissent translates into improved prospects for growth that the Fed can see, apparently, but wants to keep hidden. That deep analysis did not address the problem of why the statement also reported that bank lending is contracting.
Next week’s data should be fairly big in its impact, beginning with the ISM national manufacturing survey for January on Monday and concluding with the monthly jobs report on Friday. Last Friday’s Chicago PMI reported a very encouraging result of 61.5, which is certainly expansionary. It may be influenced by the auto sector, but it was still a good report. The other regional surveys also point to a good result, so expect positive news there.
The ISM report on Monday will be reported after personal income and spending for December, and alongside of construction spending. The ISM non-manufacturing survey will come out on Wednesday, but before that we’ll get reports on big-ticket sales Tuesday: pending home sales and motor vehicle sales (January). Wednesday will be crowded with Treasury funding results and early reports on the January job picture (layoffs and ADP payrolls).
Thursday is another heavy day, what with January chain-store sales (expect some drops), December factory orders, fourth-quarter productivity (look for a ridiculously high number due to job losses), and of course weekly jobless claims, which are likely to retain their high profile for some time.
Friday will present the enchilada grande, the jobs report. The current consensus is for zero, which might seem low in view of the claims data, but the latter began to move higher after the cut-off date. At any rate, market expectations will likely have shifted considerably based upon the reports coming earlier in the week, so the fact that it is zero as we go to press means little for Friday. Any bit of a surprise should set the market’s tone for the first half of the month.
Avalon Asset Management Company is a Registered Investment Adviser
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