Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Get Shorty
"But we are spirits of another sort." - William Shakespeare, A Midsummer Night's Dream
Take one drifting market, add weeks of soft sinking, then soak in fearful charts. Shake about the head and shoulders, and then shorten liberally until all the dough is on one side. When stretched taut, add a pinch of Whitney’s special upgrade sauce and ignite. Stand back.
So it was that in one short week, the markets upended a long month of gnawing anxiety over the direction of the economy. Although acknowledgement had been building for days that uber-bank Goldman Sachs (GS) would report bang-up (bank-up?) results, when leading bank analyst (and enduring pessimist) Meredith Whitney upgraded the stock to buy before Monday’s open, the day before the company’s report date, it nevertheless caught the market leaning the wrong way and set off a week of relentless short-squeezing.
Ms. Whitney also raised her estimation of near-term performance for the banks in general, observing as she did a few months ago that the banks would have the advantages of some strong tailwinds in interest rates in the quarter to go along with a bevy of special-items opportunities to boost profits and capital ratios. She estimated that the sector could produce trading gains of ten to fifteen percent (excluding Citigroup (C), of course). Given her record of negative calls the last two years, the positive switch was the perfect pivot point for a market that had been filling up on short-selling and bearish sentiment.
Goldman’s results, as you probably know, did indeed deliver on hopes and it reported earnings well beyond expectations, something the bank had been accustomed to doing until last year. Gang of Four banks Citigroup, JP Morgan (JPM) and Bank of America (BAC) also reported, with the quality of their results running to form: JP led the pack, while Citi’s one-off profits at the other end were a result of spinning off crown jewel brokerage unit Smith Barney to Morgan Stanley (MS) (Citi retains an interest).
Yet Whitney’s estimation of the quality of the results appeared to be on the mark. JP Morgan CEO Jamie Dimon was less than effusive about the economy and warned of growing problems in commercial real estate. The results at B of A and Citi left many analysts skeptical that either would make any more money for the rest of this year. Embattled Bank of America CEO Ken Lewis tried to shift attention to 2010, while bank BB&T (BBT) complained about the environment being too difficult to make any predictions. Nobody was willing to say that credit losses had peaked.
If things had been left to the financial sector, the week might indeed have not been so glorious, but fortunately for the longs, technology came to the rescue. Bellwether Intel (INTC) reported results Tuesday evening that, although down nearly 40% from the prior year, went well past expectations and set tech stocks and equities on fire Wednesday. The rest of the week, traders could ignore Google (GOOG) in favor of IBM, or anticipate Apple’s (AAPL) report next week.
An impending decline on Thursday was helpfully reversed by a wire report that “Dr. Doom” analyst Nouriel Roubini had turned bullish on the economy, a turn that Roubini took some pains to deny. He did allow that the worst is behind us in terms of the steepness of decline, and that the recession would probably end by the end of the year. Of course the worst is behind us, the question is where we are headed.
The banks assured investors that the worst is behind us, so buy their stocks. On the other hand, if you are the government, then the worst is yet to come, or it is if you’re going to pose a lot of annoying questions about credit card rates and lines of credit. But if we’re talking about TARP money, well then, the worst is behind us again, for the compensation committees say that the best is yet to come - provided that the feds aren’t around. It’s a wonderful world.
One of the success stories last week was Johnson and Johnson (JNJ), whose earnings beat led the stock price higher. We own JNJ ourselves, so we’re not complaining, yet the company also reported that U.S. sales fell seven percent. For that matter, B of A expects credit losses and bankruptcies to continue to go up while house prices continue to go down. Even CNBC was brooding last week over the differences between the headlines and the details. Against that, though, the “Fast Money” traders from the same channel were positively slavering last week over technology, energy, and emerging markets. In short, all the familiar “more beta is better” bets. What’s the disconnect?
In the classic recovery leg of the recession cycle, the first post-bottom quarter will exhibit exaggerated profit growth as companies benefit from their restructuring efforts. Although revenues may compare quite modestly, profits can jump. In the second post-bottom quarter, the continuation of profits begins to reassure lenders, and credit starts to flow again. Competition spurs these efforts on, and the economy recovers. Many are using this playbook and are trying to position themselves in whatever they believe to be the right early-stage sectors – apparently technology, energy, financials and emerging markets.
Things economic usually look bleak at this stage, with unemployment continuing to rise along with bankruptcies and business failures. It’s the “darkest before the dawn” sort of thing, yet at the same time it’s well-known that much of the best gains in equities come during the exit from the recession leg, so traders and truebelievers soldier on. That’s the bull case in a nutshell.
Will it work out that way? The current housing and credit crisis is much worse than the 1990-1992 period (also a housing decline). At that time it was possible to amputate the troubled S&L’s from the rest of the economic body, repackage their healthy remaining assets and then fling them all back out at an eventual profit to the government.
That kind of experience motivates a lot of calls today for nationalization of troubled banks, in order to speed up the process of flushing out bad debt and handing out clean balance sheets to allow lending to live again. Yet trying the same kind of amputation process now would lead to something similar to the wiggling torso in the Monty Python Search for the Holy Grail movie. No arms or legs, if you recall.
The drop in production and increase in unemployment is similar to the 1980-1982 period, but this time there is no magic interest-rate buzzer to press. In fact, the last economic period that combined such dramatic production cuts, financial crisis, frozen credit and staggering unemployment was in the nineteen-thirties. We won’t revist those depths for some very good reasons, including a more accommodative central bank, not being chained to a hard money standard, and much less of a manufacturing-based economy.
But the slump could still last longer than people think. An enduring characteristic of human endeavors is that people have difficulty adjusting their way of looking at the world. Problem resolutions are often hampered by managerial and administrative echelons whose framework was set twenty or thirty years earlier.
Thus the conflicts of the nineteen-sixties were hampered by views set in the second World War. It took thirty years for economists to start to accept that Keynesian economics might not fix every problem; now the current elder statesmen of the supply-side movement that blossomed nearly thirty years ago are in the same position. They can’t or won’t change their minds, only fade from the scene in one way or another.
Stock market investors in the nineteen-thirties had the same problem. Having lived through a period of roaring prices, they put on several sharp rallies in the expectations that “normal” times would return. Of course there were policy mistakes that helped prolong the Depression, but there are always policy mistakes.
Today’s investors may also have trouble coping with an economy that doesn’t recover rapidly. Almost anyone who’s traded for less than ten years, perhaps even twenty, is impatiently waiting for the sharp rebound to get going – or believes that it has already begun. Only the newest and oldest investors are worried, the former because they’re not really sure how much things do bounce, and the latter because they’ve been around long enough to know that once in a while, a bad bounce can get right up in the face.
We don’t believe in the global collapse or Depression scenarios, but until they happened, we wouldn’t have believed in such massive pyramid bubbles as the tech wreck – with the S&P trading at forty times earnings – or the housing bubble either, with its $50,000 bungalows going for ten times that amount.
One thing we are sure of is that there are lots of traders and investors firmly believing that the markets will behave as they “always” do – i.e., for the last fifteen years or so. They are ready to jump on the next rocket ship. Another is that a recession such as the current one, with the biggest production declines in sixty or seventy years and the worst demand, housing and credit collapses in seventy years is quite unlikely to behave like the last ten or fifteen years. That doesn’t mean, however, that the markets won’t try to.
We are used to hearing economic events be misreported in the national media. It’s the nature of the beast: harried reporters are grabbing headlines from about a hundred different categories and trying to put together a reasonable hook and story-line. Yet at times we have to wonder how many toes can be shot off the foot and one can still keep walking.
Retail sales for June were probably the data of the week, although the market didn’t react as if they were. National news outlets dutifully carried the story with the “unexpected jump” and “more than expected” tags, which may have left some casual market observers wondering why stock prices didn’t react better that day.
The reason is because the retail sale weren’t better than expected; in fact, they were worse. While the headline of 0.6% (seasonally adjusted) was better than the consensus guess of 0.5%, the foundation and mix was all wrong. Ex-autos, a number which got much less publicity, sales rose 0.3%, which was below the 0.4% consensus estimate.
It’s a little awkward as well that sales and production figures from the auto industry itself showed declines in June, but then, they don’t seasonally adjust. The least-publicized result, namely the one excluding autos and gasoline stations, was that sales fell 0.2%. That number was indeed noted in the business press, however briefly, and wasn’t lost on some Street traders. For those of you wondering how to reconcile the retail sales data with the weak June chain-store sales results released the previous week, the answer was in the details: unadjusted sales excluding autos and gasoline fell 3.5%, about in line with the chain-store average.
We don’t think that the government is really trying to cook the books, though many believe exactly that. The real problem, as we’ve said before, is that the government models aren’t built to capture recessionary times, which are infrequent, especially not the kind that come up every seventy years or so. The best-fit additions to the working labor force that the Labor Department has been conjuring up in recent months may have the virtue of being consistent practice, but nobody believes them.
The sales increase isn’t real either, but when it’s revised, nobody will notice. Last year’s June result was reported as an increase of 0.1%, which came as a relief. Now the Census department says that they actually fell 0.2%. Does anyone care now? If there is political influence, it’s that there is no political will to insist upon better data that might make perceptions worse (though shouldn’t there be some on the right who wouldn’t mind having the extra ammunition?).
In a similar vein, we heard an excited BBC announcer breathlessly announce the “bigger than expected” (by two-tenths) rebound in China’s GDP (reportedly 7.9% for the second quarter) and wonder if China wouldn’t lead the globe out of recession. If its economy is so great, then why is electricity consumption down? Maybe it’s a cool summer.
We believe that the Chinese mini-bubble will in time show the benefits and limits of stimulus spending. The government has been handing out money for cars, infrastructure and above all lending, with much of the last item apparently quickly finding its way into the stock market. They’ve gotten the requisite blip, but there are rumblings of problems beneath the surface. Here’s a tip: net exporting nations don’t lead the world out of recession. Here’s another: you can lose a lot of money betting against bubbles, and even more being in them when they break.
One of the odd things about China is the mystical level of belief held by many in the Western world in its invincibility to the global economy. Awed whispers and reverence about a one-party, centrally planned, avowedly socialist state with a determined interventionist approach come from right-wing supply-side extremists who espouse a shotguns-and-survival-shelters approach to life. Next time you hear somebody wonder how much lipstick can be put on a pig, just reply with the baseline answer for nearly every bullish strategist these days: “China.”
Coming back to production in our own land, the landscape shifted again. By the end of last week, the accepted wisdom was that “less bad” data was no longer good enough. “Good” was now required. Ms. Whitney changed all of that with her pre-market call on Goldman and the banks, and “less bad” was quickly returned to its number-one spot in the rotation. Less bad is plenty good enough again, above all when so many were caught short.
Thus, the New York Fed’s business survey and the central bank’s national Industrial Production results for the month of June were greeted as good declines, rather than bad declines. The former nearly hit the neutral level of zero (-0.55), and was for all intents and purposes unchanged from the previous month. New orders finally turned positive, as did shipments. In the national results, the decline was “less bad” again, falling (-0.4)%, with capacity utilization dropping to new all-time lows, but not as much as expected (consensus was for a fall of 0.7%). Who cares if the year-over-year decline widened?
We can thank the weather, because the rising temperatures in much of the country finally pulled up utility output, the only category to have risen (and no, it wasn’t due to factories restarting – their utilization rate fell again to a new record low, in a series that goes back to 1948). The less-bad narrative took a hit from the Philadelphia Fed’s June report, which showed an increased rate of decline from the previous month. But the decline in new orders improved! They improved in May as well, yet actual shipments worsened in June. Some of that is certainly a lag effect, but some of it is also cancellation.
Employment and work hours in the Philadelphia report fell, as did the six-month outlook. We bring up the latter two because they are important coincident indicators (our regular readers know that the six-month outlook has no predictive value, but is a good coincident measure). This survey is usually thought to be the best clue amongst the regional reports to the national measures (known as the ISM) set for release next month.
Yet despite the gloomy numbers, take heart, for the destocking/restocking cycle is playing out, albeit later than expected. Semiconductors have obviously rebounded. Current levels of industrial activity are so low that neutral-to-positive monthly comparisons are ever more imminent, a point we’ve been making for some time. Frankly we are surprised that it’s taken this long, and to our thinking that doesn’t bode well for the economy.
However, the stock market is an entirely different situation. The Leading Indicators are due Monday, and many will be watching the ratio of coincident-to-lagging indicators as the signal that recession’s end is imminent. We think that in the technical sense, the end of the recession is indeed nigh, at least as defined as contraction of output. How low can we go, after all? However, the end of the slump as a long and dreary period still appears to be far off. As last week clearly demonstrated, though, there will be lots of attempts to guess the recovery, and more orgiastic benders in stock prices.
Oil prices spiked again this spring with the stock market rally, and they will spike again before the year is out, whenever it looks like the recovery narrative can be played again. Those movements are financial bets, not supply-and-demand reactions. Wage and demand pressure are at near-zero, along with real inflationary pressure.
Homebuilding still isn’t going anywhere, despite the post-Whitney prompt upgrades and the twenty percent bottom-fishing rally in the homebuilder ETF (XHB). We actually saw the latest sentiment reading described as “badly needed good news.” The sentiment index for the last four months: 14, 16, 15, 17 (neutral is fifty). It stood at 16 a year ago and 17 last September. The low in the 1990-1992 housing bust was twenty, and we’ve been sitting below that level for fifteen months in a row. And the good news would be...?
Housing starts improved beyond a lowball consensus, but the market wasn’t quite thrilled with that news, as it is now widely accepted that the last thing wanted in real estate is more supply (of buildings, that is – supply of credit, they could use). It’s an approach that helps the market cope with the ongoing bottom. Completions also rose from the post-war low set the previous month. However, builders know they are in for more of it – starts are down 50% from a year ago – and complained that a quarter of new-home sales are failing due to financing issues. Homebuilding has indeed bottomed, make no mistake, but that bottom is a wide load. Actual new-home sales will be released a week from Monday.
Last of all, we touch upon the Federal Reserve Bank meeting minutes. The authors of the Fed report have now left behind its previous working stance of “wow, things are really crazy, so don’t blame us if we have to do some wild stuff.” The delivery has returned to the more typical posture of not rocking the boat and gently hoping for the best, the preferred stance of any central bank.
The market was fairly elated that the Fed staff raised its GDP outlook for next year and the year after, but we feel obligated to point out that the staff did the same thing this time last year. It was a forecast that didn’t work out especially well, but we bear no grudge. A well-behaved central bank is limited as to what it ought to do and say, and we have heard the fire alarms go off more than enough to know what they sound like. There isn’t any need for fresh reminders.
Given the vanishing usage of the special programs to support commercial paper and investment banks, it doesn’t appear as if any new weapons will be called for in the near future. Thus the Fed needs to start showing a little cautious optimism, or else it would risk prolonging the slump. As to the staff forecasts, you can do your own linear extrapolations of the last three months, for they rarely do much more than that.
Looking at the weekly reports, retail sales fell again last week, and mortgage applications turned back down again as well. As we’ve been predicting, weekly claims stayed down in the low 500’s again, but we’re not so sure we deserve a victory lap. Unadjusted claims rose by over 80,000 to over 667,000; the automaker layoff schedule has been unusual this summer and may have thrown the seasonal adjustments out of whack. It’s been a tough year for estimates.
Next week will give full stage to earnings reports, with about a third of the S&P 500 and Dow reporting. Economic news will be at a useful minimum. Besides the usual weeklies, there’s the leading indicators Monday, existing home sales for June on Thursday and another consumer sentiment data point for July comes Friday from the University of Michigan. Another massive schedule of Treasury auctions will have the potential to stir things up.
StockWatcher has a new name in progress and will present it next week.
Avalon Asset Management Company is a Registered Investment Adviser
Avalon's MarketWeek is not intended as a market timing newsletter or service. No buy or sell recommendations are made for any of the individual stocks mentioned on the site, and neither Avalon Asset Management Company nor its officers, directors or employees make public stock recommendations. Please address comments to MarketWeek@AvalonAssetMgmt.com