Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Some Like It Hot
“You’re not giving yourself a chance. Don’t fight it. Relax.”
- Sugar (Marilyn Monroe) in Some Like it Hot (screenplay by Billy Wilder & I.A.L.
Diamond)
After the previous Friday’s ugly sell-off, we wrote that the overwhelming sentiment on the market was that disappointment lay in store on earnings, the economy and prices. Such lopsided consensus is usually wrong, we said, so look for the market to get a lift from earnings.
One week and one hefty move upward later, we read renowned skeptic’s Dave Rosenberg’s opinion that the overwhelming sentiment on the Street is that the “overwhelming” consensus is for no double-dip and a summertime rally in equities. Do that many people read our column?
Probably not. If we were to guess, we would say it’s a question of perspective, and that the rally must have seemed more massive to a bearish Mr. Rosenberg than it did to us. The earnings came through pretty well, though, with lots of positive outlooks and hardly a lemon in the bunch. Amazon (AMZN) did take it on the chin, but its other-worldly valuation leaves little room for error (take heart, though, the Friday rally helped it bounce back, so there’s still time to get short on its margin shrink - like we are).
Another oddity during the week was a Wall Street Journal story about small businesses unable to get loans except by posting cash collateral in the amount of the loan. These “compensating balances” are in effect interest-free loans to the bank. Then the bank will lend you back the same money at interest. No wonder the banks say that loan demand is down.
Restricted cash, compensating balances, a little vigorish, it’s nothing new in banking, of course, but in normal times the amounts are a relatively small percentage of the loan. Why such a large amount now? Most of the banks contacted by the journal either had no comment or double-spoke to the same effect.
The banks don’t want to tell the Fed anymore that they are continuing to tighten lending standards. Either they can’t tighten them any further, as in the example above (lending you your own money back at interest is as tight as it gets), or they don’t wish it to be known. So they shake their heads and mourn the weakness of loan demand, while every small business owner in the country can tell you how difficult it is get any credit.
Cash flow analysis, retort the banks. What they don’t tell is that it’s really their own cash flow that they’re worried about. So long as they have to working off shaky loans – and the Gang of Four have plenty of them, be assured of that – they’re going to hunker down and work the guaranteed government yield trade until they’ve earned their way back.
This phenomenon has been around longer than we have. It may seem to some of you that we’ve been writing about it for just as long, too. Banks are members of the same species as the lemmings. In good times, they come off the sidelines at the end of a wave and throw money at people cashing out. They dutifully lose their shirts, and then wisely fix the problem by dismantling the departments involved and sitting in the corner, refusing to lend money at all.
After enough time passes, the brew of competitive pressure, bonus envy and fear of being taken over and having to work for somebody else will lead banks back into the game. Why the essential practice of knowing your customer and making decent loans is so hard for them to grasp is a subject too long for this column.
The banks will start to lend again, but probably not until the fourth quarter at the earliest and in our opinion, later than that. Until then we will have to read articles about “pushing on a string,” the depression-era phenomenon of financial institutions awash in liquidity yet refusing to lend. That thirties-style phenomenon isn’t going to repeat itself, only echo it, because things aren’t as bad this time. However you can be sure that we will hear that it could get as bad, because those kinds of stories sell, especially in an election year.
A loony idea that is getting traction of late is that it’s “Japan all over again.” We wonder if anyone who says this was actually of adult mind at the time of the great Japanese fade. And if they were, what exactly were they drinking?
Comparing our own situation to the Japanese one is very much like comparing the surf at Coney Island to a thirty-foot tidal wave. They are both made of water, aren’t they?
There were two key features of the Japanese system that prevented a timely recovery from the collapse of the real estate bubble. One was uniquely Japanese, and the other wasn’t, although the degree to which it was practiced was exceptional.
The latter problem was one of cross-shareholdings between the banks and their customers. During Japan’s short rise to pre-eminence, this system was often hailed as an enlightened model of common self-interest. However, under extreme conditions, funny things can happen. Light will bend. Space curves. Time passes differently. Housing prices go down, even nationally.
When the massive bubble that was the Japanese commercial real estate and stock market collapsed, the cross-holding system prevented the banks from writing down the value of their loans. Were they to do so, the book value of the bank shares would go to zero or its immediate vicinity. The bank shares held by their customers would be worthless, triggering default by the customers, triggering bankruptcy by the banks, triggering more customer bankruptcies. A single move could result in near-total domestic collapse.
The solution would have been for something like a Resolution Trust Company, the vehicle formed to mop up the S&L debacle of the early nineties, or other governmental agency to come in and help extricate the banks and their clients from their involuntary death tango.
However, to do so would have meant widespread admissions of failure across the entire upper stratum of the Japanese society. Tradition would have demanded the resignations of nearly every chief executive and top ministry official in the country, as atonement for the losses. Although it’s less true today, there were genuine grounds for concern that such an event would have unleashed not just chaos amongst the country’s elite, but widespread “honor” suicides as well. It’s not the most attractive thing to recall, certainly, but that was the real situation.
The supposed equivalent today is that domestic American banks, above all our beloved Gang of Four, are also sitting on wads of losses that they don’t want to write down. Hence we are in for a decades-long period of banks carrying and hiding real losses that prevent them from lending.
The Gang hasn’t written down all of its losses, true, but it isn’t especially unusual behavior for banks to stretch out loan-loss recognition over a period of time. It’s only been about eighteen months since the end of the fatal fourth quarter of 2008, and the Gang has taken off quite a bit. What’s more, recognition of the losses doesn’t imperil their clients. The fact that Citigroup’s (C) book value is only seventy-five cents, or that its share value is about four bucks, doesn’t impair the balance sheet of its corporate customers.
We’re not in for a Japan redux, but we are in for a lot of silly comparisons and reporting. Another example of the latter can be found in analyses of the latest bank earnings. A year ago, it was widely written that the banks were a great deal with respect to future earnings because their loan-loss provisions were so huge. The valid premise was that twelve months later, the much smaller write-offs would mean big boosts to earnings.
So here we are twelve months later with the predictions coming to pass, and the same business press is fretting over it, writing that the smaller loan-loss provisions call into question the quality of the earnings. Sometimes you just can’t win.
The new consumer-protection agency, which will work under the Fed (a Senator Corker (Republican – Tennessee) compromise that we believe is a good one) has many an institution fearing publicly for its life. Don’t you listen to the posturing.
Nobody except the sharks themselves have an issue with a crackdown on the nastier forms of predation, so we’ll pass on that side of it. As to the rest, it’s true that the agency could go off the rails, and that’s a danger. The banks have nobody but themselves to blame. For decades now, every time they’ve lost big bucks on foolish commercial lending and see-no-evil credit practices, the banks turn to trying to jack up fees on that part of its clientele that has the least leverage with the bank.
It won’t do any good for a bank to reprice that $200 million loan tranche it bit off, because it’s not getting paid anyway. So it tries to make up the difference by trying to stick up the small customer with fees: late fees, over-limit fees, just-in-case fees, 30% interest rates and just about everything but sending over a couple of knuckle-dusters to repo their possessions.
This isn’t good business practice, not just for moral reasons but because it drives the clients into bankruptcy quicker, and eventually the credit line goes unpaid. But that’s a problem for another quarter down the road, let’s just try to make the numbers on this one. It’s the same kind of mentality that got them into SIV’s, CDO’s and other brilliant ideas.
The problem with trying to hose the small customer is that while it works for a while, there are a lot more small customers than there are bank lobbyists. The customers vote. Making enemies out of them can be risky.
Rounding the turn into the end of the month, good news from Germany (business investment sentiment) and the U.K. (better-than-expected GDP) helped allay the global slump fears. It’s the biggest earnings week of the season, and the bias is upward. If the market can slip by the new home sales report on Monday, and it should, we could put in another decent week leading up to the second quarter GDP report on Friday.
“Housing Market Stumbles,” said the headline on Wednesday’s Wall Street Journal. Say what? To paraphrase Private Hudson’s line from “Aliens”, maybe you haven’t been keeping up with current events around here, pal. The story might better have read, “Housing Market Still Lying on the Ground.” But that’s not as flashy a headline.
It’s no news at all that the housing market is moribund, but I guess the Murdoch version of the venerable business paper does go for sirens flashing. Well, we’re here to set you straight.
To begin with, the fact that the Housing Market Index, which is the homebuilder sentiment index, fell to 14 (from 17 the previous month) is really of no import. The index has been thrashing around at these levels for over a year, and whether it zigs up one month by a point or two or zags back down a month later is meaningless. Maybe a homebuilder or two had a beer this month (or maybe a Prozac) while filling out the report, and we wouldn’t blame them, but whether it’s 14 or 17 or 19 is of no significance. They’re not building homes this year.
Ditto for housing starts, the datum that set off the Journal’s headline. They fell again, this time to a 549k rate and the lowest June ever (check). Single-family permits fell to another low too. So what? It isn’t news that housing is in a bottom. What many have had trouble grasping, it seems that this bottom is wide. Make that a double wide.
Will starts and permits keep going down? No, though they might ease off a little bit more. The tax credit squeezed out almost every marginal buyer who could get a mortgage, so we’re in the Death Valley part of the desert. But upon the exit from Death Valley, one is still in the desert.
We’re not getting out of said desert this year, either. Out of the Valley, yes, and it may feel a bit better. Maybe the sentiment index will go even go back up to 19 again. But anyone who thinks homebuilding will revive this year is either trying to sell you homebuilder stocks or living in another plane of reality.
The good news is that you don’t have to think about the sector at all until next year at the earliest. Just ignore next Monday’s report on new home sales, because it’s going to be another dud. Both the National Association of Realtors and the federal lending agencies reported price increases in June, but it’s strictly a case of mix. If an August rally lifts the stocks again, then you should consider shorting them with glee.
Existing home sales also fell in June, but not by as much as expected. Sales should continue to drift lower the next few months, but the main outlook for the year is similar to homebuilding – to use a sporting term, the housing sector is on the disabled list this year. Sometimes the data will beat estimates, sometimes they won’t, but there won’t be any real improvement in the trend this year.
There is always the possibility of discovering a massive oil field or vein of gold somewhere in the country, and that would of course change the demand for housing equation. However, we suggest you do not plan this into your investment strategy. We aren’t.
The Leading Indicators were bleeding last month. An optimist might point to the terrible June in the stock market as a factor set to reverse this month. A pessimist might point out that the big yield curve spread prevented the reading (- 0.2%) from being several tenths worse. On the other hand, if the earnings rally goes for another week – a distinct possibility – then the good July performance and widening yield spreads will give July an increase. What’s it all mean? That the recovery isn’t straight up.
In weekly data, chain-store sales are holding fairly steady at a year-on-year rate of plus 3%. Jobless claims are a bit all over the map, as the auto sector nonshutdown continues to result in eccentric seasonal adjustments. Last week the number of raw claims fell, but the seasonally adjusted total rose. The previous week saw the reverse, with the adjusted number showing a decline in the face of a big jump in the raw number. Maybe we won’t get real clarity for a few weeks more, but the unadjusted data of the last two weeks are lingering in the 500,000 level, not a great number.
Ben Bernanke fretted about the economy, but pronounced himself pleased with the financial-sector overhaul signed into law by President Obama last week. Both areas are going to recover slowly. When the chairman admitted that this was so in his Congressional testimony last week, the market plummeted.
We shed no tears at all for the financial community and its regulatory concerns. For years it lobbied hard for a removal of all restraints, because its enlightened self-interest would mean intelligent self-policing. Yup. They finally got the keys to the Porsche, and proceeded to drive it straight off the cliff. Well done, lads. You’ll have to go back to walking instead. The good news is that we’ll all be safer. The hard part for Washington will be the smaller contributions from the phony profits.
Looking ahead to next week, the calendar is very busy again. To begin with, it’s the heaviest earnings calendar of the season. It’ll be difficult for the market to know what to focus on, so the five Dow stocks that report next week should get a lot of attention: Dupont (DD), Boeing (BA), Chevron (CVX), Exxon Mobil (XOM), Merck (MRK).
On the economic calendar, after the new home sales report on Monday, we’ll get the Conference Board’s consumer confidence result for July on Tuesday morning. A slight decline is expected, yet either a rebound or a bigger decline would probably trigger a big move in equity prices. Case-Shiller home prices for May come out before the open.
We see the more important reports as coming towards the second half of the week, beginning with the June durable goods report on Wednesday morning; any increase would be welcomed (the consensus is +1.0%). The Fed’s Beige Book, or regional activity compendium, comes out on Wednesday afternoon. It’s often overlooked in more normal times, but something dreary could cause trouble.
After the weekly claims data on Thursday, Friday will bring the first estimate of second quarter GDP. The consensus we see is for something around 2.5%, although Barron’s chose to feature Barclay’s estimate of 3.0%. That looks high to us, but anything 2.8% or above would probably be tinder for a big end-of-month rally. The influential Chicago PMI comes out later that morning, along with the final July reading from the University of Michigan consumer sentiment poll. An improvement in either would be welcome.
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