Stormy Weather
“When he went away, the blues walked in and met me.” (“Stormy Weather,” lyrics by Harold Arlen)
by M. Kevin Flynn, CFAWho went away? The low-grade credit buyer, that’s who, the market’s best friend of late, the trusting and good-natured brother-in-law who’s been placidly shoveling up all the dirt left on his lawn, no questions asked, since the beginning of the buyout craze. It seems he’s suddenly gotten stubborn about what’s really in all that dirt. For Pete’s sake, of all the times to start poking around a bunch of dirt and asking a lot of fool questions. Doesn’t he know there’s business to be done?
Or something like that. That hissing sound audible last week was not something coming from traders watching the market performance, but the takeover premium being let out of stock prices, to the tune of about 585 points from the Dow Jones. It was its worst week in nearly five years, accompanied by the S&P and Nasdaq going down 4.9% and 4.7% percent respectively. That premium began escaping when its chief supplier, our low-grade credit buyer, decided they didn’t need any more dirt and that now would be a great time to take a vacation. Annoying, but also ironic, since Wall Street’s own investment banks have a hand in it.
The problem goes all the way back to the market meltdown at the beginning of the decade, when the economy, equities and just about everything else except bonds cratered. The Federal Reserve cut interest rates to historic lows. Really, really low lows, so low the money faucet turned wide open. As the economy crawled out of the wreckage, people discovered that they could afford a lot more house with such low rates, and the real estate boom was born.
What was different about this bubble - er, boom - though, was the involvement of Wall Street. What used to be strictly a banking affair, the province of savings and loans and mutual banks, became a Street party. Investment banks provided the credit in buckets, and buckets of money were made The way it worked is that mortgage companies would go around making mortgages – i.e., lending money – and then sell them to the Street, who would in turn bundle up the mortgages into securities and sell them again. The Street gave the mortgage companies credit lines – called “warehouse” lines - to go make more mortgages. As real estate pricing shot up, Wall Street’s investment banks turned on the spigots. It was a virtuous circle for a while that made lots of people rich, until it got overdone.
Default rates on loans made at the end of the bubble, when standards were lowest and prices were highest, started popping early this year. Nervous investors began deciding that they didn’t any need more loans from the weaker end of the market, the “subprime” segment. The investment banks turned around and began shutting the window on the subprime mortgage companies, who were left holding securities that nobody wanted. Understanding the situation, the banks followed the old rule that to lose a client is human but to lose money is insane, and cut off their lines of credit. Some of the mortgage companies then blew up, contributing to the March meltdown of this year. The equity markets recovered, but the queasy feeling in credit-land stayed.
The collateral-based lending market followed the path of the mortgage market. The investment banks provide credit to lenders, who go around making loans and then bundle them up into securities for buyers again, often the same people that were buying mortgages. Hedge funds, in particular, were generating outsized returns by borrowing heavily to invest in higher-yielding, lower quality loans. The leveraged demand for leveraged yield drove interest-rate premiums on lower-quality paper to record lows this spring. Private equity and public corporations alike could borrow easily and inexpensively and they did, because there were huge fees and bonuses to be made from the simple act of moving a big pile of money from column A to column B.
But housing still hasn’t found a bottom, and the subprime problem never quite resolved itself. The Bear Stearns hedge funds failed, okay, well that was all junk mortgages anyway and the Fed says it’s contained. Then financial companies doubled and tripled loan-loss provisions. Hmm. When financial leader American Express (AXP) announced that it had tripled its loss provisions last Monday unease grew, but when Countrywide Financial (CFC), the country’s largest mortgage lender, spent three hours Tuesday talking about problems in the mortgage business and said they had spread to prime loans, that was the last penny dropping. There was a thud heard ‘round the country as high-yield buyers shut their windows and investment banks cut their credit lines. Time to rethink. Credit default premiums and spreads soared. Buyout loan deals, notably Chrysler, ran into the ditch. The problem with the credit markets is that most of it is over-the-counter and rather illiquid; it can hum along ever so smoothly and then turn on a dime and a rumor. The buyout game is suspended, and the premium it put on equities is fast disappearing.
Confident herds run through fences, nervous ones can pull up in front of every pothole. Therein lies the danger ahead. One of the few economic positives has been the steady upward march of the stock markets. A big correction could set off a further crisis of confidence, both here and abroad, that could have a self-destructive effect on spending levels. It was almost pathetic to see the commentators repeating “global growth” Friday as their shibboleth – the only things missing were crucifixes and necklaces of garlic - but a precipitous drop in markets could have a knock-on effect on that engine as well.
Now the recession word is being heard. There’ll be another in our lifetimes of course, you can be sure of that, just as you can be sure that it will be preceded by a gaggle of Wall Street geese loudly honking that one isn’t coming. I will spare you my line-by-line analysis of the economic situation here - partly because most of you wouldn’t read it anyway - and remark that while the economy is not as strong as most of Wall Street has been braying, nor is it as weak as some of Saturday’s headlines.
On the one hand, there’s still a lot of money left over from the easy-credit era (though a lot of it has migrated to low-wage regions and oil-producing countries), corporate balance sheets are good and the economy is still growing, albeit slowly. Interest rates still aren’t high by historical levels. But the liquidity choke-off at the high-risk end (you mean there’s risk?) could spread. There are rumblings of increasing losses in commercial construction lending, which until recently was humming, and talk of evil spirals in the credit markets. You can blow up commodity funds by the dozen and the Street will stifle a yawn, but credit breakdowns are seriously bad mojo.
I wouldn’t look for the white knight of sovereign wealth funds to come riding to the rescue either, though many were passing its holy image around for a reassuring rub on Thursday and Friday. The Journal ran a story early in the week on the trillions of dollars of reserves being held abroad in those same low-wage and oil-producing countries, and the story quickly metastasized into a belief that these trillions would inevitably bail us out. That would explain the rush to buy ten-year Treasury notes, I suppose. They were trying to help the equities markets, you see, but just pushed the wrong button on their speed dialer.
There are two things that you can make book on. One is that last week is not going to bring the missing retail investor rushing back to equities. The other is that countries, the worst market timers of all, only come in big when confidence is universal, i.e., a market top. What would you guess confidence levels to be about now? The Street may be yearning for its favorite pigeons to show up at the last hour and keep the game going again, but after last week’s fire alarms, don’t count on seeing them anytime soon.
Right now the X-factor is the possibility of July markdowns causing a hedge fund death spiral, beginning with withdrawal pressures, then credit problems, then the margin call-collateral meltdown that ends in another “Dear Valued Client” letter. In the current conditions, even rumors of problems could start a death dive. Don’t buy into soothing statements about the economy being fine, because the stock market hasn’t been trading on the economy, it’s been trading on liquidity and momentum. When they got crushed last week so did the market. Friday’s closing action was ugly, but we still haven’t had a capitulation yet. It probably would have been better if we had.
Yet sentiment could turn quickly again, so keep your seat belts fastened. Traders haven’t forgotten the rebounds of last March or last August, and most institutions are still overwhelmingly bullish in the intermediate term. Thursday’s earnings reports were actually pretty good. Next week brings the new month’s influx of money and the jobs report, which has been a Street favorite in this rally. Keep an eye out for real bargains, as opposed to chart ones: there may still be a sun up in the sky. But nobody would blame you if you sat out August in cash and on the beach.
The Economic Beat
The news from housing last week was reminiscent of Dr. Seuss’s Mr. Grinch: Stink, stank, stunk. Even equity floor traders are beginning to think that there’s a problem. Whatever you may have heard, the sum total was worse. New home sales were down much worse than expected, existing sales sank, and all the builders that reported had the market wishing they hadn’t.
Events last week, especially the Countrywide Financial conference call, have made it plain that the bust leg of the mortgage sector has arrived. It’s a cycle that never fails to repeat: when a sector starts making headline profits, competition and greed drive lending to flood levels and standards go out the window. After the tide turns and problems start to make the headlines, everybody pulls back and even God can’t get a loan, which of course only makes things worse. We never seem to learn. The homebuilders are telling us not to look for any relief from housing this year and probably not next year either. Given the current conditions in the lending market, it’s hard to argue with that prediction.
In the middle of the week we got a disappointing report on durable goods. They were up, but when you took out Boeing’s orders, they were down. The key category is non-residential fixed investment excluding transportation – a mouthful that translates into how much the regular business sector is investing – and it was down. The market has been baking a second-half pickup into its outlook, based largely on business spending. It’s not happening yet. Given that Europe tends to coast on neutral through the August holidays, I wouldn’t look for much pickup in next month’s data either.
Optimists are trying to emphasize Friday’s above-consensus GDP number of 3.4%, but you can take that report with a very large grain of salt. Some of the quirks in import and export data that made the first quarter number too low reversed field and boosted the second quarter. A better reading would be to average the two quarters out. The slowdown in consumer spending caused some concern, though. It was anticipated, yet the pickup in business investment that was also anticipated is struggling to appear. Some economists are starting to move their second-half growth estimates downward.
Next week brings a lot of key data, in particular the income and spending numbers on Tuesday and the jobs report on Friday, with factory orders and the ISM surveys in the middle. Look for the jobs and inflation data to remain within recent ranges, though the markets may be jumpy about variations. Any surprises are more likely to come from the manufacturing data or the income and spending report. The sound you’ll hear Friday afternoon will be a sigh of relief as the August exodus takes flight from Wall Street and the stormy weather is left behind – they hope.
Quite a bit of stocks began showing up at bargain prices at Friday’s close. It may not be the best time to be plunging in, though, because in the current conditions the market could easily sell off a good deal more.
With that said, here are some of the names on our radar screen: Liz Claiborne (LIZ), (trading near a four-year low), Dress Barn (DBRN), Hartford Financial Services (HIG), Kaiser Aluminum (KALU), Hershey (HSY, near a three-year low), Safeway (SWY) and Waste Management (WMI). We hope to be featuring them all soon.
Avalon Asset Management Company is a Registered Investment Advisor
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