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Avalon Asset Management Company The Waiting Pool
"Letting "I dare not" wait upon "I would", like the poor cat i' the adage?" - William Shakespeare, Macbeth
A five-year chart of the S&P 500 index (the yellow line) shows that it has broken through its fifteen-week moving average (red line) to the downside. Looking at the last five years, index trips below this line have lasted from one to two months on the shorter end of the range, and took some much longer excursions after the end of 2007. The 20-day, 50-day and 200-day exponential moving averages on the Russell 2000 are all sloping downward again.
What does this mean? Is there more trouble ahead, or could the market be coiled like a spring, ready to leap back? Charts are only charts, of course, and are always trumped by fundamentals. While it’s true that technicals and program trading have indeed determined much of the action during recent weeks, earnings season looms and that drama will be the determining factor. If the market bounces back up next week, technicians can simply say that the breakdown wasn’t confirmed.
As for momentum, there isn’t any. The green-shoots movement seems to have taken a sabbatical, although that could actually help lift the market - earnings price moves are more about vivid headlines of affirmation or denial than they are about data analysis. While there are optimists and pessimists, in general we haven’t detected a lot of confidence about earnings season. A surprise packet of decent headlines could make the markets take off.
We don’t want to dampen your spirits, but it’s also quite possible that earnings season will just be more of the same muddle that we’ve been seeing of late. Chevron’s (CVX) good-news/bad-news update on Thursday showed the problems that integrated oil companies are having – “upstream,” or crude margins are up, while “downstream” or refined product margins are down. The stock sank in Friday trading.
In technology, it appears that stocks are poised to report encouraging results, but that seems to be widely expected. Some affirmation would by no means hurt the stock prices, but the surprise factor that can provide an extra boost is missing. Turning to financials, investment banks such as Goldman Sachs (GS) should produce strong results, but results from the Gang of Four, including JP Morgan (JPM), Citigroup (C) and Bank of America (BAC) should be quite a mix.
The investment banking operations at Citi should do well, but on Friday it already prepared us for more bad news in real estate by breaking out historical operations into “good” Citi, a.k.a. Citicorp, and “bad” Citi, alias Citi Holdings. Bank of America has been hinting at some hot results from its Countrywide and Merrill subsidiaries, but will undoubtedly have more problems in mortgage-related products.
How much attention will be paid to the real estate-related write-downs is a good question, and will probably come down to credibility versus the mood of the day. In any case, the reports from the two giants will be a cross-section of banking results for the quarter – good spreads from current operations, but problems with the older book.
Industrial companies rate to be a mixed bag at best. Alcoa (AA) rose initially on a loss that wasn’t as bad as expected, but when the short-covering ran its course, so did the rally and the stock price fell back to pre-announcement levels. We expect a lot of Alcoa-type stories from the industrial sector – better margins from cost cuts, some scattered pickup in orders here and there, but few signs of any real rebound. That could leave the market directionless again. If recession-duration fears get more traction, it could even lead to more downward pressure.
The government’s talk about a second stimulus program may be a bit of a trial balloon, but we would guess that it also signals growing unease from the administration’s council of elders about the state of the economy. Warren Buffett, known to have an ear or two in Washington, remarked at the media conference in Sun Valley last week that there aren’t any green shoots in the daily sales reports of his portfolio companies. We should probably be grateful that retailers don’t have to report earnings for another month.
Yet we believe that overall, the financial sector is poised to report some good numbers. The widened yield curve should help both trading and net interest margins. Banks will probably fudge and waffle the write-downs in order to protect their capital ratios, but regulators may not feel especially motivated to put any additional squeeze on them. If the narrative can get a little positive spin going, some short-covering could help boost financials into pairing up with technology to lead the market higher.
That’s a big if, of course. A plausible thesis for the secular bear-market group is that the economy never adjusted to the consequences of the tech wreck, and simply put the problems off for another day with another bubble. Now we’ve got two bills due instead of one. That’s not too cheery an outlook, we admit. But even secular bears have lots of bull rallies.
A proposal to review regulatory requirements in the energy derivatives markets brought out all the little rally caps turned backwards last week. A coalition of worried industry executives, Ayn Rand diehards and right-wing attack dogs – that’s a coalition that’s loose by definition – came to life last week when the new Commodity Futures Trading Commission (CFTC) head Gary Gelsner decided to solicit views with a likely eye to tightening up the derivatives markets.
In an area as politically sensitive as the oil markets, one expects some nonsense from both sides. But the most disingenuous arguments are the bitter complaints that prices will only be allowed to move in the “right” direction. For example, take the self-serving nonsense that restoring the uptick rule to equities trading is not an attempt to keep markets orderly, but a heavy-handed government attempt to have prices only go up (the loudest complaints being sourced by “black-box” traders who would find an uptick rule inconvenient – but we are sure that they are all honorable men).
In a similar vein is the whine that tightening oil-futures markets is an attempt to make sure that prices can only go in the politically-desirable down direction. The sugar-sauce heaped onto these complaints is made up of dark warnings that if we keep an eye on speculation, the markets won’t be able to function in the perfect manner (!) of their custom. This is akin to complaining that if morphine is regulated in any way, your dying grandmother won’t be able to get the injection that she needs.
Companies in the energy business are right to worry about restricting access to customized derivative contracts, and of course the writers of the contracts need the ability to lay off the risk. The problem is the money river and the asset-allocation mania that has swept the institutional landscape for the last couple of decades.
There is nothing wrong with diversifying assets, but the American consultant-institutional investor tango has become pretty lethal. Perfectly legitimate studies will bring up some interesting performance feature, such as venture capital outperformance, or low volatility in real estate, or the low correlation of commodities with equities. Some bolder institutions take notice and have some success, and the next thing you know the consultants are running from shop to shop touting the new wisdom.
We don’t know why there aren’t more studies showing what happens when the new-new thing gains universal acceptance, and the trade or sector is flooded with new money. We can tell you, though. It blows up. Venture capital blew up, technology blew up, residential real estate blew up. Credit, oil, commodities, all blew up, as did portfolio insurance, junk bonds, one-decision growth stocks, and so on all the way back to Dutch tulips. Perhaps the consultants should be discussing this correlation, but there is so little glory in promoting common sense over the latest toy.
The commodities problem, one that we’ve frequently raised in our column this year, is that any time there’s even a whisper that the economy might get better, speculative money pours into those highly-leveraged futures contracts. Not only speculative money, but also asset-allocation money mesmerized by the move. Every market has a breaking point for how much new money it can handle without getting stupid, and the physical commodities markets are not at the high end of the range.
The readiness of the money river to race into commodities poses a hurdle to the recovery of the current economy, a problem for inflation, a problem for the dollar, and destroys true supply-and-demand price discovery. It’s no wonder that the administration wants to take a closer look and bring in some grown-ups.
The sensible thing to do is increase margin requirements when money gets too hot, and make sure that the business doesn’t end up with overloaded underwriters like AIG or overloaded daisy-chains like credit default swaps. Just as over-leveraged banks lead to spectacularly expensive failures, so do over-leveraged commodities markets. As ever, though, when there’s some real money being made on the other side, they won’t want to go quietly. For a good, colorful look at the problem, check out financial guru Jim Cramer’s verdict.
Errata: Last week we reported that Chevron would report quarterly earnings, but it was only an update. The company reports its earnings at the end of July.The week started with the Institute of Supply Management’s (ISM) survey results on the non-manufacturing side of the economy in June. There was a time during the last bull market when stocks would soar upon receipt of a favorable number. After all, the service sector makes up two-thirds of the economy. Before Monday’s number could even arrive, though, it was being talked down as not as good an indicator of real health as the manufacturing survey.
Thus, the NMI (or the PMI to us old-timers) weighed in with a result (47) that was largely ignored. The consensus was for something between 46.5 and 47, so the result met expectations. The ratio of sectors with monthly declines is still about twice that of improvements (eleven to six), but there were some encouraging details.
New export orders, for example, rose above the magic fifty mark. It’s one of the fuzzier subcomponents – three quarters of the respondents answer “N/A” because they either don’t have export business or don’t break it out – and frankly we’re not sufficiently well-versed enough in the report’s arcana to know what is driving the increase in the Arts or Entertainment and Recreation categories. But we are sure that up is better than down.
The other major subcomponents are all still declining (except for prices), but flirting with the neutral level. New orders and production declines eased and were nearly unchanged from the previous month. Even employment showed some encouraging deceleration in its rate of decline. As we said last week, we are getting nearer to getting some neutral comparisons (fifty) in these reports, and that will help confidence. On the other hand, the very slow approach to those readings suggests a flight path to recovery that will likewise be slow to gain any altitude.
Weekly retail sales continued a weak pace that was echoed in a poor showing by chain-store reports for the month of June. The weakness was widespread, with surplus discounter TJ Maxx (TJX) being one of the only companies to report a gain. We still don’t know what Wal-Mart (WMT) got up to, while Costco (COST) domestic results fell one percent after factoring out gasoline. Retail sales for June are due on Tuesday, and unless the Commerce Department can come up with some creative adjustments, look set to disappoint the consensus estimates of an increase of about a half of a percent.
Mortgage purchase applications rebounded somewhat, as did refinancing applications. Had they fallen again, the market might have really tanked, as equities were already on edge, but the week’s recovery soothed nerves a bit. The overall level remains quite low anyway; the weekly data just kicks around a bit. Next week will see the homebuilder’s sentiment index on Thursday followed by June housing starts on Friday. Don’t expect much from either.
Weekly jobless claims fell below 600,000, a drop that was anticipated by many besides ourselves. Although the drop to 565,000 looked good, the understanding of the role that the American Independence Day holiday had played was something of a damper. More importantly, continuing claims rebounded sharply higher again to another new record of nearly 6.9 million. Even so, the automaker factory restarts could keep a lid on claims this month and we think another sub-600,000 number is in the cards – though the job market will be just as tight – unless state government layoffs explode. Unfortunately, that could happen.
Wholesale inventories fell again in May – will destocking never end? The trade balance was reported to have shrunk in the same month, thanks to rapidly shrinking imports and a small rebound in exports. This was good for the dollar, and a good opportunity to print a lot of hopeful nonsense about the economy. When will they learn?
Imports are dropping fast because we’re not spending. When this hits retail sales, we call it bad, but when it hits imports some try to fluff it up as good because of the GDP accounting quirk: imports are subtracted from GDP. So when we’re too broke to buy imported goods, GDP “improves” and we’re told that things must be better. Not really.
A lot of hope was also attached to the increase in exports. Unfortunately, the process operating there isn’t really the best for us either. When oil prices spike, as they did in April and May, the Middle East and North Africa - the two drivers of the increase and home of most of the foreign oil that we buy – will buy more heavy equipment from us. In fact, when most any commodity price soars, the same effect ensues. We send them an extra ten bucks to pay for the same amount of commodities, and they return the favor by throwing a couple of our own dollars back our way with some purchases to help them increase output.
We’re not tilting against international trade – we’re in favor of it – and it’s nice to see some of our oil money come back in the form of something besides Treasuries. But it’s a pretty expensive way to build exports, don’t you think?
Helping the market slump on Friday to its weekly loss, the University of Michigan echoed the Conference Board’s recent decline in consumer sentiment with its own drop in consumer confidence. The markets didn’t like it, but it only reflects what is really happening as unemployment and housing losses mount, while credit and earnings weaken.
Next Tuesday will be the day of the week: Goldman Sachs reports earnings in the morning, expected to be wonderful, while retail sales come out before the open amidst fears that they will not be wonderful. If the latter does run to form, we wonder if even Goldman’s good news will matter. Intel (INTC) reports after the close, and good things are expected there too.
The Producer Price Index (PPI) is also expected Tuesday morning, and both the CPI (Wednesday morning) and the PPI are expected to show sizable overall increases (thanks to rising energy costs) for June, with very little increases in the core rate. Import and export prices have risen sharply, but the increases were centered in those non-core categories of food and energy.
We will get a large helping of information on production, with the Chicago Fed reporting its monthly business outlook on Wednesday, followed by the national Industrial Production report later that morning and the Philadelphia Fed survey the next day. Earnings season really starts to kick into high gear – besides the companies we mentioned above, IBM, Google (GOOG) and General Electric (GE) also report results. You can expect the trading action to be a lot more pronounced next week.
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