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Avalon Asset Management Company Happy Daze is Here Again
“But I can’t back down now because I pushed the other guys too far.” – Brian Wilson (The Beach Boys) & Roger Christian, Don’t Worry Baby
Yes, it’s summer in the city again. There are some things that we think you ought to know, or at least recall, about these Julian days before you slip off to the backyard to dig up your last stash of cash and fling it into the game. We do so hate to see people lose money.
The most important is that we are now fully into the summer holiday season. That is one of the principal reasons that volume has been so low as the market pulls off coup after coup in its rally. Many of the grown-ups are away, and however tethered the senior set may be to their smart phones, they are at best passive participants. The door is open to the junior set.
Thin markets are usually momentum markets, and the current edition is no exception. Any doubts that you may have had over the momentum parentage of this rally should have been completely erased by Friday’s price action, when the markets managed to eke out a neutral-to-positive day despite the very soggy blanket of disappointing earnings results released between Thursday’s close and Friday’s open. With luminaries such as Microsoft (MSFT), American Express (AXP), Amazon (AMZN) and Capital One (COF) providing varying degrees of discouragement, the over-extended market should have rolled right over.
It didn’t, and it may well not until valuations become ridiculous or the Hamptons empty out again. The market rallied quite smartly from mid-July to late August last year, adding about ten percent before the wheels came off in September. The stock market usually manages to put on some kind of summer fireworks around the time of earnings season, sometimes moving down but mostly upward, the natural bias of the market. The trend is anything but reliable.
Yet one of the most enduring features of the stock market is its tendency towards maximum perversity, or as venerable floor trader Art Cashin likes to say, the market loves to embarrass the largest number possible (an investment friend of ours likes to say the same thing, but with a different verb). Short interest rose again.
Most market professionals know that the market is overbought. Many expect a sharp pullback by the fall. Put-to-call ratios show an abundance of call options being bought, indicative of froth in individual equities but usually a negative sign in the case of index contracts (the normal posture of institutional investors is to be long stocks and hedge with index puts, so that more puts than calls are bought). The latter condition suggests that the bigger players are either shorting stocks and hedging with calls, or (more likely, we think), under-invested in equities and compensating with index call contracts.
With most available logic pointing towards down, that naturally improves the short-term outlook for continuing the rally. You just need to know that the higher this structure goes, the ricketier it gets. It could last another two days or another two months – and then look out below. As we heard all weekend, it’s the best two-week rally since the year 2000, which ought to have everybody running for the hills. But since we already know that, it should go higher anyway, right? After all, the trend is your friend – until the end.
One thing you have to say about the stock market is that it isn’t afraid of looking silly. The same analysts who had finally figured out to set their estimates to beatable levels are now racing to mark their recommendations and outlooks to market prices. It’s like screeching in astonishment at the surprise party that you yourself had planned.
Puffed up with its quarter and racing stock price, Goldman Sachs (GS) announced on Monday the raising of its year-end price target on the S&P 500 to 1050 (at the time, about a ten percent move). Not to be outdone, UBS raised its target the next day. The market acted like it was trying to get there by the end of the week. Why waste time?
We tend to the skeptical, as most of you know, a tendency that usually leaves us back in the pack when these so-called breakouts are staged. We don’t think the recent earnings are encouraging at all, and have found very little optimism outside of smart phones and semiconductors, where inventories had fallen to pre-transistor levels. Most CEO’s were mindful enough of the stock price to throw in some talk about “stabilization” and “signs of a bottom,” while carefully hedging their outlooks with talk about rising unemployment and difficult conditions.
Caterpillar’s (CAT) earnings release symbolized the week for us. A revenue shortfall with an earnings beat due to one-off items and extravagant cost-cutting, with the best parts being extrapolated to the next twelve months and a monster rally in the stock price. We were frankly dismayed with Cat’s sales levels, as the rebound in oil and commodity prices should have given Cat’s order book a much bigger boost. Apparently Cat isn’t the only one in the business that’s cutting costs.
What could derail the rally? Perhaps a GDP result like the U.K.’s, where optimism that the worst is over got a nasty shock when the country posted its worst year-over-year decline in GDP since 1955. It’s interesting to note that the U.K.’s housing crisis closely resembles our own.
A breakdown in technology stocks might do it, as tech has been the leading hope in this really. One might have thought that the Microsoft or Amazon results would have done the trick, but it appears that a lot more is needed is needed to convince our junior traders that the magic ride has ended.
The most likely event to reverse the tide, it would appear, is for the rally to get to those magic levels – 1000 on the S&P is practically a magnet at this point – and draw enough attention to convince the majority that it’s all real. When enough people are committed to being long, it will only take a breath of wind to blow the house of straw down.
Leading indicators started off the warm-and-fuzzy feelings with the third increase in a row, again led by an increase in long-term bond yields. We’ll repeat what we’ve said before, which is that this particular indicator is behaving differently in the current environment. In the conventional model, long-term yields rise as the economy exits from recession and prospects for growth improve. Investors begin to dump bonds in favor of equities, and prospects of growth-induced inflation push up the longer end of the curve. Prices for long bonds fall as demand falls and interest rate risk increases.
In the current economy, there has been a move towards equities as valuations rebounded and the flight-to-safety trade abated. That is conventional. Yields have also risen due to the massive amounts of Treasuries coming on to the market, and that is not conventional. The only growth that’s being priced by bonds is in the amount of dollars being put into circulation by the government.
Another potential false indicator is in supplier deliveries, which have slowed. Usually this is a sign of more goods in the pipeline. Although the rate of production decline has generally slowed, however, there has certainly been no increase as of yet. Any delivery lags are more likely due to customer requests and diminished delivery capabilities (for more on this, see the current “Off the Charts” column in the New York Times).
The coincident-to-lagging indicator ratio turned up, and in the past that has been a reliable precursor to the end of recession. We expect that it is again, but the end is going to be followed by a very mild rebound that may require several starts before it can gain traction. In the interim, the coincident indicator is still falling. The turn is nigh, but it isn’t quite here yet.
Existing home sales came in about as expected, but the news services called it “better-than-expected,” and it was, barely: 4.89 million annualized, versus expectations for 4.85 million units. Not much of a beat, but the percentage increase was inflated by a downward revision to the previous month. In fact, the National Association of Realtors seems to have learned the government’s knack of how to manage news flow, because they’ve gotten into the habit of overestimating sales every month – which gets people excited – and then quietly revising them downward the following month, when nobody pays attention.
How much has housing actually recovered? Using the latest NAR figures, from February to June, the existing-home sales rate rose a grand total of 3.6%. Using an estimate of about 30,000 for the average downward revision, that implies that the revised figure will result in a four-month change of 3.2%, presumably within the survey’s margin of error (although the association’s website doesn’t specify what that might be. Well, they are realtors).
If one were to link the announced monthly changes together, the net result would be a sales increase of 9.2% for the quarter. We estimate that the actual rate was about 6.8%, or thirty percent less. How well is housing doing? Over the last year, prices have fallen between 15 and 20 percent nationally, mortgage rates are down about 100 basis points, and yet existing home sales are still down from amazingly low to incredibly low levels.
But the Financial Times ran a story saying mortgage applications had “swelled for three weeks running.” Excuse me? The mortgage purchase index for the week fell over the three weeks from June 26th to July 17th, the latest such period for which data is available. Something swelled all right, but it wasn’t mortgage-purchase applications.
New-home sales come out on Monday, and we confess that we have little idea as to what to expect. Homebuilding is still in a bottom, constrained by massive oversupply of inventory, extremely tight credit and rising unemployment. While the problems will certainly be overcome eventually, it won’t be this year. That said, seasonal adjustments are the joker in the deck this year and anything could come out of the Census department this Monday. If the headline number is the least bit attractive, this momentum market will almost surely be infatuated with it.
Weekly chain-store sales continue to show deterioration, at least as reported by Redbook. The ICSC-Goldman index is also reporting year-on-year deterioration, but at a milder rate. Weekly initial unemployment claims rose back to the 550,000 level, with the Department of Labor fretting over what would happen as its auto-layoff adjustment period winds down. Continuing claims fell if seasonally adjusted and rose if not; it is widely accepted that expiring claims are responsible for the drop. Here in Massachusetts, the government was only two days from dropping nearly 100,000 workers from the rolls before it came up with an emergency extension.
The University of Michigan’s final report on consumer confidence for July showed a slight tick upward. Up is better than down, but the market ignored the minor variation anyway. Closer attention will be paid to the release of the Conference Board’s monthly confidence survey this Tuesday. The consensus is for an unchanged level, leaving the door open for the recent floating market rally to goose the results.
Monday’s new-home sales report for June will be followed on Tuesday by the Case-Shiller report on housing prices for May. It should make for an interesting tandem. Durable goods data for June come out on Wednesday, and new orders are expected to have fallen about a half of one percent. The Fed’s Beige Book, its regular survey of regional business conditions, comes out Wednesday afternoon.
The first estimate of second-quarter GDP is due out on Friday, the last day of July, and the consensus is somewhere between –0.7% and –1.5%, depending on who you listen to. Personally, we don’t think that the headline number is terribly significant, but it should have a market impact on a summer day. The Chicago-area Purchasing Manager Index (PMI) will come out later that morning. Any shift towards neutral could help ignite equities on the last trading day of the month, which typically has an upward bias.
We should also point out that the minimum wage in the U.S went up on Friday. Doubtless this will give rise to a lot of pulpit-pounding, some price increases for fast foods, and a one-off bump in personal income. Time to buy the homebuilders, no doubt.
StockWatcher still has a new name in progress and will really, really present it next week.
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