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"We hold these truths to be self-evident, that all men are created equal" - The American Declaration of Independence
As June drizzled to a close in the environs of New York City, neither the bears nor the bulls seemed to be able to get a grip on a narrative that could drive the markets. The V-shaped recovery of the bulls has stalled up about halfway up the rightward leg of the “V”, leading many to predict a “W” in its place.
The joy over backing away from the abyss in March faded by the end of May, giving way to a June that saw-toothed through a very narrow range. If you timed it perfectly and sold out on the right day in May and went away, you came out ahead. Even without such timing, though, anyone who exited shouldn’t be any worse than break-even.
The bulls still have cyclicality and the inevitable restocking on their side, along with time and possibly money, if they can manage to convince a herd that is frantically searching for the next big move. Money desperate for returns is crowding high-beta areas such as emerging stocks, technology, commodities and materials. Corporate yields may be well and good, but they aren’t going to make up for last year’s losses anytime soon, not when you can’t leverage them up anymore.
The bears point to rising unemployment and a credit market that is utterly adrift at every level but the corporate one. One can sell bonds, but borrowing for autos, homes, or even Best Buy (BBY) is still incredibly difficult - its credit lender just raised finance rates. The bear narrative got a boost last week when the only really definitive piece of economic news was a downright dreary jobs report that not only missed expectations by a mile, but pointed to more weakness ahead.
With rising unemployment, falling workweek hours and weak income as a base, the ongoing adjustment to higher savings and lower consumer spending is for now another millstone on the neck of the economic recovery. It should give us a healthier economy in the long run – but as Keynes ironically observed, in the long run we are all dead.
Credit isn’t coming to the rescue anytime soon. The major banks are using the grace period that Congress gave them for new credit-card reform measures to try to gouge their retail customers out of every nickel possible until then. It puts us in mind of the old saying that if one should owe the bank a thousand bucks and can’t come up with it, it’s big trouble for you, but owe them a million dollars and it’s the bank that’s in trouble. The fragmented nature of the retail customer base means that it has no bargaining power, apart from the voting booth, and that is a slow-moving mechanism.
We might take this occasion to mention one more time that the rates that the banks are currently charging used to be flat-out illegal. But years of double-digit inflation in the nineteen-seventies led Paul Volcker to push short-term rates to the high teens. That put credit-card lending into a situation where it couldn’t make money, because interest rates were generally capped at around twenty-one percent. Anything above that was usury (those were state laws). As default rates rose in the 1980-1982 recession, retail lenders were trapped in an impossible situation, so the states took pity and largely removed the usury prohibitions. After all, the free market would check any abuses, right?
It wasn’t foreseen that the then-fragmented card business would end up being rolled up into five big banks, all too big to fail, with seventy percent of the market. Some of the concentration came from laissez-faire attitudes that saw no reason to limit it, some from the financial supermarket-as-Titanic model, and the rest of it from sudden shotgun financial marriages in the wake of the Lehman collapse.
There is no competition amongst The Gang of Five, except to see who can raise rates the fastest and still get away with it. It might not appear to make much sense to gouge your customer base in such a manner, because it should drive them away, but credit is so tight right now that the Gang isn’t worried about it. They feel free to piously intone that if a customer is unhappy with new terms, he or she can “opt out” and choose to pay off the entire balance and go elsewhere, knowing full well that few of the nine million-plus people working part-time on an involuntary basis, or the seven-million plus that are entirely unemployed, are in any position to make that choice.
The other serious flaw in the banks’ approach is that it drives the default rate much higher much faster. Isn’t losing the entire balance (or perhaps settling on a fifty-percent haircut) less profitable than getting a few extra fees up front? It isn’t just credit cards either. As Gretchen Morgenstern pointed out in this Sunday’s New York Times, banks are taking the same approach to mortgages.
Rather than make real modifications on problematic loans, the banks prefer an approach of adding missed payments back onto the balance, throwing in a workout fee and then restarting the clock. The interest rate hasn’t changed and the principal has gone up, but the banks call it a modification anyway, though the only thing that has been modified is the eventual foreclosure date. When the loan predictably goes bad shortly afterwards, the solemn verdict from the banks is that “modifications don’t work.”
As the mortgage modifications go down, foreclosures go up. Why, Morgenstern wondered, are the banks choosing to eat an average loss of 65% of the loan balance in foreclosure sales, rather than modify the loan? Our guess is that the banks, as ever, are simply managing quarter-to-quarter earnings.
If a bank chooses a genuine modification, they have to recognize a current loss on the loan larger than any workout fees they can charge. That’s a hit to net income. Taking the pseudo-modification route, the loss gets deferred to a later quarter while the extra workout fees get packaged into this quarter’s income. Let another quarter or another year worry about the eventual, if not inevitable, default. For now the loan can’t be delinquent for at least another ninety days, one hundred and twenty if the consumer manages to scrape together that first payment. Banks desperately want to maximize earnings now to absorb the writedowns that will keep coming.
It’s obvious that this is an accounting shell game. In the case of credit cards, higher rates may hasten a default, but that too is a problem for another quarter. Higher rates now mean higher percentages of payments get pushed into current income, raising capital ratios now. If capital ratios go up and some extra dollars can be printed on the net income line, then maybe some more capital can be raised to absorb the losses that are coming. Who knows, maybe the economy will even get better next year.
In addition, if a bank were to collect a higher minimum principal every month while the payments stayed the same, it would change the interest-income mix and reduce current earnings. Not acceptable. Therefore, rates must be raised. Come to think of it, better raise rates on all the customers, because the way we’re bulldozing people into default, we’re going to need all the money we can get to absorb the losses coming down the road. In the meantime, pay back that TARP money so we can collect the bonuses appropriate to our stations in life on the paper profits (uh-oh - am I becoming cynical?).
Desperate times beget desperate behavior, and banks are desperate (unofficially, of course). Yet we admit, there is a kind of method to their madness. Putting off the day of reckoning is a tactic being tried all over America. The problem for the rest of us who have no balances or mortgage issues, though, is that we are not left unscathed by the Gang’s strategy. The higher default rates and higher foreclosure amounts will mean more losses to absorb. That means credit markets that take longer to recover, an economy that takes longer to recover, higher levels of unemployment and so on. We all pay the price, whether we have a credit balance or not.
However, in the short-term the market narrative will be reset by the impending earnings season. The reaction, as always, depends on expectations, and they seem to be fairly low again. While last week’s weakness in the markets may seem to be pointing downward, so many people are expecting a ten percent correction that one has to wonder if it’s still possible to get one. Banking analyst Meredith Whitney warned in April that the banks might put out some inflated earnings for the first half, but hot air may seem better to many than the big chill.
Last week was only a three-day week as far as economic reports, but packed with so much data that the market could barely keep up. They’ll get a chance next week, which has little to say after the ISM services June survey on Monday.
The production data was more of the same – the declines seem to be nearing an end, but when will the end finally get here? A telltale sign of the severity of this recession is the fact that we’ve gone for so long without a bounce. It should be at hand, at least as far as the ISM survey magic fifty number is concerned. The June survey reported a reading of 44.8, which was just shy of the consensus guess of 45.
From the ISM’s point of view, 44.8 and 45.0 are virtually the same, but from the stock market’s point of view, the small shortfall was something of a disappointment. Optimists rightly talked up the increases in production and deliveries, along with drops in inventories, and the tone of the survey respondents was markedly better than it’s been in the last year. But new orders declined, and the Chicago PMI released the day before was a similar disappointment (Purchasing Manager’s Index, the former name of the ISM survey). As with the national survey, the small shortfall (a tenth of a point) was meaningless, but the markets wanted a beat at that point and didn’t get it.
Looking at the inventory data, the only thing that prevents us from assuring you that July will finally poke its head back up over the magic fifty level is the weak sales data. The weekly retail chain store sales reports for June were terrible, and while the exclusion of Wal-Mart (WMT) is clearly having an effect, it’s hard to see the retailer making up the difference for everyone else. Motor vehicles sales fell unexpectedly, though automakers were more confident that the bottom is in.
But production cuts can’t last forever. Even if production went to zero, we’d still get a fifty reading the following month, because the surveys are comparisons to the previous month. A fifty reading may indeed signal that the end of the recession is upon us, because the recession will be deemed to have ended when production grows again. That won’t mean the economy is healthy again, though the stock and especially oil markets seem quite ready to take that line. In the meantime, we’ll have to wait until the week after next to get better data on June’s output.
The housing picture is unchanged: the bottom is still in place. Pending home sales were unchanged (plus 0.1%), the realtors’ association’s conviction that now is the best time to buy a house is unchanged, the rate of decline in housing prices was virtually unchanged, as least as measured by the Case-Shiller index. Some metropolitan areas are showing stability, but mortgage applications fell again. Rates edged down a bit, but the steep fall in refinancing activity suggests that that particular boomlet has ended. Right now, lack of credit and employment trump any hoopla about rates and affordability, or realtor whining about unfair appraisals (in other words, not high enough).
The precursor to Thursday’s jobs disappointment was Tuesday’s consumer sentiment report from the Conference Board. Last week we said that the market probably wouldn’t react well if it flattened out (because that wouldn’t fit the recovery narrative). It did worse than flatten, though, falling back noticeably instead and dragging equity prices down with it. The indices for current and future conditions both fell, and the number of people saying that jobs were hard to get rose.
Construction spending totals for May were released, and showed a sharp decline (-0.9%) on top of a downward revision to April’s increase The data were mostly overlooked by markets trying to digest employment reports (ADP, Challenger), pending home sales and the ISM report, but the chart below does suggest some kind of bottom. It just isn’t a pretty one.
And of course, there was the unemployment picture. Most of the related data leading up to Thursday’s dud pointed to a worse-than-hoped-for drop: the employment component of the Conference Board sentiment index, the Monster Employment index, the ADP payroll report, weekly claims. The Challenger layoff report showed a decreasing rate of layoffs, matching the improvement in the ISM manufacturing survey, but it didn’t catch the drop in government payrolls.
The report was weak across the board, and a disappointment in every respect save the unemployment rate. Last week we suggested that the market should be able to withstand anything better than a loss of 500,000 jobs and a rate that stayed below ten percent, but that was too cynical, perhaps. The actual number of 467,000, 100,000 worse than the estimate, was a definite statement that the recovery is not happening as quickly as traders would like.
The details were discouraging. The workweek fell to 33.0 hours, an all-time low (since 1964) and an indication that hiring will not pick up soon. Weekly earnings fell, temp employment weakened, and the unemployment rate would have been higher if the employment force had remained stable as a percentage of population (discouraged workers aren’t counted). The so-called U-6 rate rose to 16.5% (percentage of all adults not working full-time who want to). That’s one in six. The only bright spot was that the May revision was positive, though the April revision was negative.
Yet all is not lost. We still believe that weekly claims will benefit in July as layoffs weaken – indicated by the Challenger report – and the auto sector layoffs and plant restarts work their way through the data. The ongoing turmoil in state and local government finances could offset some of the improvement, but a drop below the psychologically important 600,000 level in weekly claims should happen soon. It could even happen next week, thanks to the holiday.
That won’t signify an improvement in employment conditions, unless one counts as an improvement the fact that cuts in labor inputs are being exhausted. It will still be a start towards improving business confidence, though only a start.
Factory orders rose in May, as expected after the previous week’s durable goods report, but the news was lost in the wake of the jobs report. Actual shipments fell for the tenth month in a row, and unfilled orders fell for the eighth month, suggesting that the eventual June report will weaken in a way similar to its labor counterpart. The inventories-to-shipments ratio was unchanged, a sign that restocking hadn’t gotten any traction yet.
Next week doesn’t offer much for data. The aforementioned ISM nonmanufacturing report comes out on Monday morning, and there are no further major reports until June chain-store sales (now excluding Wal-Mart) on Thursday. Consumer credit will come out on Wednesday and wholesale trade on Thursday. The week will be filled with Treasury auctions, and the international trade and prices reports on Friday mark the other major reports. The last report of the week will be the University of Michigan’s first read on July confidence.
The earnings season will officially kick off with Alcoa (AA) reporting on Wednesday. There seems to be little if any optimism about the company’s results. However, Chevron (CVX) reports on Thursday, giving us the first look at the rebound in energy prices on oil company profits. If Chevron can pull out some good results on top of a holiday-induced drop in weekly claims, the markets may get frisky again and blame any June chain-store weakness on the weather.
StockWatcher will return in a later edition.
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