Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Are We There Yet?
"I frown upon him, yet he loves me still." - William Shakespeare, A Midsummer Night's Dream
A seven-month high, sayeth the press, and indeed it is. In the mere space of five weeks, equities have succeeded in grinding out a magnificent 1.8% higher, which may not seem like a lot in absolute terms, but compared to money market funds, is about five or six years’ worth of work at the prevailing rates. It’s also a pretty sight better than the trailing twelve-month performance of equities, which stands at about (-38.5)%, as measured by the S&P 500 index.
It may not seem like a lot to those happy breed of investors that have been pouring money into mutual funds for twelve weeks in a row now. Those inflows seem to have had the effect of putting quite a bit more cheer and verve into the commentary of our broker-custodian, who also happens to have a sizable mutual fund business. Its views of the incoming data have taken on a decidedly sunnier tone of late, which is understandable, but one thing does puzzle us: with all that money coming into the market, who is taking it out the back way?
Make no mistake, dear reader, these are dangerous times for the equities market. The discussion in every corner of the financial press is the increasingly narrow range that we are trading in, and in which direction we will break out. The near-universal consensus is that we deserve to go lower, but will probably go higher. For ourselves, we too give the edge, but only a slight one, to the upside version.
Why the danger? Because the current arguments for the market to go up aren’t based on things like earnings or the economy, but on such deep financial analyses as “there’s a bid under the market,” or “the tape is telling you to stay long,” and “there’s too much cash on the sidelines.” Dangerous indeed, because while such markets do indeed have an upward drift, they have no solid foundation. They may drift upward for weeks or even months while investors argue about valuation, then come undone in a flurry.
Something will come along that undermines the narrative, setting off a very fast drop as everybody takes five steps back at once. Unlike the tragedies of ancient Greece, though, there is no chorus to fill us in as we build to the climax. Events won’t come neatly packed on consecutive days, making the situation plain to everyone. They’ll be spaced apart, giving the crowd a chance to retrace a few cautious steps forward, urged on by the die-hards (and the longs looking to get out at higher levels). The stair-step descent usually takes around a month or two, giving everybody a chance to lose money.
So why do we give the markets the edge to go higher first? Partly because it’s the nature of the beast: equity markets have a natural upward bias. Too, the momentum has been bullish for three months, and even when stretched and tired, bullish momentum usually needs to hit something hard to give it up. The S&P has been flirting around with 950 for weeks, and only needs some semi-believable pretext to close above the magic number and launch the final giddy push toward the 1000 level.
Then there’s the calendar. Springtime rallies usually fade in late May, but those that do make it to mid-June have a way of sticking around until July. It’s a behavioral quirk rather than a law, but it’s enough for us to give an edge to the upside breakout. Against that, of course, is the truism that making a market prediction usually immediately precedes the opposite result and is practically a guarantee of it. We are also troubled by being part of the majority view, as well as the general rise in bullish sentiment.
We therefore stand by our earlier advice to keep taking money off the table should the market keep rising. The economy isn’t strong enough to sustain the trend, however much the traders may like the latter, and if that isn’t enough to convince you, you may wish to consider that markets that are led higher by commodities and energy, as in the current case, usually have short life-spans and hard landings.
While we’re on the subject, did you happen to see the news on China? Its customs agency reported that exports fell 26.4% from April to May, a steeper pace than the 22.6% drop in April. Despite that, the near-mystic belief that China’s two or three months of stimulus spending will be enough to reinvigorate the entire global economy continues to infect the Street.
Much has been made of the fact that the Chinese have been buyers of raw materials the last few months. The common, though not universal, inference is that Chinese growth has resumed its righteously upward path to the stars and beyond. We happen to be in the camp that thinks China is merely taking advantage of lower prices to restock, and would also add that in so doing the country gets quite literally two bangs for its bucks: besides stockpiling on the cheap, the country effectively hedges some of its currency exposure by quietly pushing some dollar reserves into commodities.
China’s dollar strategy will become a little clearer when the Treasury releases its report on the same on Monday. As to the rest, if the daily reversal that we've been seeing in the last hour of trading isn’t enough reason to make you distrust this market, then try the market’s increasing sensitivity to the success or failure of Treasury auctions: an equities market that leaps at a 2.7 bid-to-cover ratio and panics at 2.3 isn’t a dream to us.
The item of the week was retail sales. The good news was that the previous month was revised upward a couple of tenths. The bad news was that excluding autos and gasoline, real sales fell. The 0.5% headline increase for May was led by the speculation in oil trading, which resulted in a large increase in gasoline prices. Excluding gasoline and motor vehicle sales, sales were up 0.1%. Since we already know from the previous month’s report on spending and income that the monthly core PCE rate is running between 0.2 and 0.3%, the conclusion has to be that real spending is still falling.
Despite the lift from changes in tax withholding, retail sales may continue to stay weak. Consider that the Federal Reserve reported that household net worth fell an additional $1.3 trillion in the first quarter. Not the kind of stuff that motivates spending. The current quarter’s rise in the stock market helps, but the ongoing drop in home prices is offsetting much of that gain.
Jim Keegan of Ridgeworth Funds has been making the point for a couple of months now that with 77 million baby boomers heading towards retirement with damaged balance sheets, the savings rate will have to increase. Ergo, consumer spending seems certain to decline from its current rate of 70% of GDP to its long-term average of 65%. With massive cuts (in the trillions of dollars) in household credit lines and overall conditions still extremely tight, a return to trend seems impossible to avoid.
A look at retail categories reinforces the view. Discretionary categories such as furniture, electronics, sporting goods and others fell. Spending rose on food, clothing, health care and home and garden (home maintenance, or sellers dressing up homes, perhaps). Auto sales and parts showed an uptick, but are still running at depressed levels.
What the market will have to contend with is that the trend is unlikely to be smooth. We are bound to get a positive monthly change in real sales at some point, which could very well launch the market into an ecstasy of straight-up extrapolation. When the rainbow fades with no pot of gold, the disappointment could be expensive to late-comer investors.
After retail sales, the Fed’s Beige Book, or regional business survey, probably commanded the most interest. It didn’t have much good to say. National conditions are weak, with only five of the twelve districts reporting that declines were moderating. We’re off the steep part of the slope, but don’t seem to be going anywhere else.
The sluggish view is also reflected in trade balance figures, which showed exports falling faster than imports in April. Imports of consumer goods did show an increase, but not enough to help China, evidently. One has to wonder what the aforementioned return to trend for U.S. consumer spending would mean to Chinese GDP. Weekly retail sales reports showed accelerating year-on-year declines. We do believe that the comparisons are distorted by last year’s tax rebates and by Wal-Mart’s (WMT) decision to stop reporting monthly sales. We also believe that sales are weak, period.
In the nutcake world of financial speculation, though, prices of energy and commodities keep being bid up, partly on fantasies about global trade being up someday, somewhere, somehow, and partly because the trend has been up: from the trading point of view, somebody might pay more tomorrow than what I paid today. Thus, import and export prices rose uncomfortably in May, by 1.3% and 0.6% respectively. The increases were led by the speculation in commodity prices, despite our current abundance of oil and wheat.
Another headline-grabber was the drop in jobless claims, a drop exaggerated by the usual phantom 5,000 or so (every week the previous week is revised higher, yet the press duly reports a phantom larger drop that never occurs). Back down to “only” 601,000, or when revised next week, the same as the first week in May (605,000). Last week’s reported drop in continuing claims was also revised away, such that we still have an uninterrupted increase every week this year. They now stand at 6.8 million.
As GM and Chrysler shed workers, in the near term that will put upward pressure on the weekly claims numbers. The closure of the four thousand or so auto dealerships will put additional pressure on claims and on local economies, as each auto dealer forms a kind of mini-economy with its advertising dollars, local purchasing and community support.
And yet on Friday, we listened to National Public Radio talk about the “firm” retail sales report and “surprisingly strong” jobless report. If that is the stuff of good news, then we are in for some disappointment ahead. The RBC CASH index (Consumer Attitudes and Spending by Household) fell back sharply in May to 34.3, below where it stood a year ago.
Even so, jobless claims should start to see some significant moderation by the end of the summer. Claims will rise at first in response to the auto sector conditions, but then should drop substantially. It won’t be so much because the economy is getting better, but because the current rate simply isn’t sustainable. Wholesale and business inventories fell again sharply in April, by 1.4 and 1.1% respectively, well outpacing the declines in sales. A pause in factor cuts is inevitable.
The University of Michigan’s mid-month June look showed only a very slight improvement from May, in practice a statistical tie. That disappointed the stock market somewhat, which had been hoping for something a little better. The trading boys and girls had been on something of a roll the previous afternoon when the 30-year Treasury auction went better than expected.
Next week has a lot of data on housing, output and pricing. The market is probably still most sensitive to the former, but we wouldn’t put much stock in next week’s releases of what are essentially homebuilder reports, the Housing Market Index (a homebuilder sentiment survey) on Monday, and May new housing starts on Tuesday.
Homebuilding is in an extended bottom right now, and there is simply no good reason for builders to be adding to inventory. The shock is over and so they may be a little less pessimistic, but small variations are just statistical noise these days. Mortgage purchase applications are still dead in the water.
We would pay attention to the output data. The New York and Philadelphia Fed report their June manufacturing surveys next week, and given the April inventory declines reported last week, it’s reasonable to expect some improvement in both. Industrial production for May is due from the central bank on Tuesday, and another small decline is expected. We’re getting overdue for a monthly bounce in output, but the automaker bankruptcies may put it on hold for another month or two.
The consumer and producer price indices both report next week, and we will probably see some big numbers in the monthly changes for both, at least at the headline (total) level, thanks to our bubble boys in commodities. Core prices will probably remain quite subdued, but that isn’t going to help the dollar or real spending very much.
Leading indicators for May come out on Thursday, and even though many of the factors are fizzling at the moment, another improvement is expected, courtesy of the stock market rally, a slight improvement in job losses, the improvement in consumer sentiment and the widening in the yield curve.
It and all of the other reports could be outweighed at the trading level in the markets by the quadruple witching on Friday. Dollar volatility could also be big next week, courtesy of the inflation reports, the commodity trade, the Treasury capital report on Monday (are Asians still buying our Treasuries?) and the current account report on Wednesday. Other wild cards include the five- and seven-year Treasury note auctions on Thursday and Fed Chairman Ben Bernanke’s speech on Wednesday.
It may not be much of a stock, but it could be a pretty good investment. The latest nod goes to a closed-end municipal bond fund, of all things, the Morgan Stanley Insured Municipal Trust (IMT). Our apologies, but it’s just too hard to recommend putting new money into equities at this particular moment.
Municipal funds have come under a little pressure of late, partly because bonds needed to take a breather, and partly because the return of the risk trade has meant exiting munis to buy stocks. As good contrarians, we’ve been taking advantage to do some buying in municipals.
IMT is rated four stars by Morningstar, and 80% of its holdings are rated “A” or higher. It uses leverage, about 29% levered at last count, and at last look had as its largest position a short position in U.S. Treasuries, which seems like a sensible hedge to us. Its current yield of 6.77% is about a 9% taxable equivalent for those in the 25% tax bracket, and the fund currently trades at about a 9% discount to net asset value.
As for the fact that it’s not a real common stock, console yourself with the thought that its current ten-year annualized rate of return is 5.22%. Though it won’t always be the case, at the moment that’s a whole lot better than what equities did.
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