Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
A Wandering Market
“A wandering minstrel I, a thing of shreds and patches.” – Gilbert & Sullivan, “A Wandering Minstrel I (The Mikado)”
Traders like to joke that the best time to trade is when Congress is in recess, and can’t do any damage. Perhaps another variation on the theme could be that when the World Cup is being played, distracted traders result in less volatility in the market. If that were to be true, then we would like to propose that the finals last the entire summer. We suspect that most of the European teams would heartily agree with an extended group round (though perhaps with a no-vuvuzela provision).
There was only one triple-digit day last week, as it happens the day that the United States came from behind to draw a heavily-favored English side. We won’t go so far as to claim a connection, given that most of the floor isn’t that deeply into the sport. But it certainly did involve players with shorts on, just not the ones on a pitch.
Options expiration weeks have a gravitational tidal pull that opposes the prevailing direction of the preceding weeks. Positions get squared, options for the current month are decaying rapidly, and options dealers are more than willing to apply pressure to the other side of their book: it makes the options that they sold more profitable. Real events can swamp the effect, just as a storm can raise water levels at low tide, but every pro knows that the tide is still there.
We thought that the previous Friday’s late rally was probably due to derivatives players starting to reposition the tape, and on Tuesday the effort came through. As the market punched through technical levels that everyone knew were there, a nice short squeeze developed to help matters along. It’s a tried and true formula, and we were long a few out-of-the-money calls ourselves. Lo and behold, they ended up in the money.
Thus viewers of Jim Cramer’s “Mad Money” show were treated to the odd spectacle of Jim urging viewers not to give up on tech stocks on Monday after a late reversal took prices back down, then angrily denouncing the tech-led rally as “fake” the next day (naturally the market rose the rest of the week, highlighting the perils of making short-term calls). Between a trader friend of ours chortling over the short squeeze Tuesday afternoon and Cramer’s turnaround a couple hours later, we had to wonder how many people got caught with their shorts up.
There wasn’t much more to the week, financially speaking. The pressure on the euro eased, helped by a successful auction of Spanish bonds that gave the market enough room to maneuver higher. The economic data was mixed, with good news in production and manufacturing being offset by weak results in homebuilding and unemployment. The latter had the virtue of being not unexpected, and while there was some stirring over the Philadelphia Fed survey, it was better than the headline number (see below).
Next week could be another story. To begin with, the United States has a chance to qualify to the round of 16 by beating Algeria. After a wretched referee call that cost the U.S. victory over Slovenia became a lead headline across the country – the beautiful replay of three American forwards being yanked to the ground in the penalty box was something anyone could understand – the Yanks are suddenly much more interested in the outcome.
On the other hand, if England fails to beat Slovenia, the Footsie (FTSE, or UK stock index) could get a beating. But we have to admit, the story of the week will probably be the housing sector. May home sales data are released next week, and they’re going to be rotten.
Whether the market has sufficiently discounted them will probably hold the key to the week’s action. Homebuilder Lennar (LEN) releases results on Thursday, and if they drop a depressing outlook on top of another grim batch of initial unemployment claims, then ignoring what happened to Cramer, we boldly predict that prices won’t push higher.
The Fed meets next week as well, but unless the statement is something out of character the market won’t be hanging on it much. Stocks are more or less in the middle of their trading range, with neither a steady decline or rally at stake.
No, we think it be largely charts and churning until the advent of earnings season a month from now. We could see an effort to push prices higher into the end of the quarter start to develop, but that’s a tricky path that will need a bit of luck. Let’s see, a win by the U.S. and the U.K., BP gets the oil spill under control, claims fall dramatically, or the home sales reports get lost or fouled. One of those might help.
The disappointment of the week was surely the weekly initial claims data, while the best reports centered on manufacturing and production. It’s a picture of an economy that is recovering, but not with all sectors at once. Until the markets can adapt to the understanding that housing is not going to recover this year, and what that means for the rest of the economy, we will have to cope with a steady flow of disappointment.
Start with the industrial production data for May. The report was a good one, with the index rising by 1.2%, the best result in months. Production of consumer goods rebounded nicely, business equipment put in another good month and capacity utilization rose smartly. The last category has now been above the last recession low for two consecutive months, so we are digging our way back.
Manufacturing utilization also continues to rise, but unfortunately has yet to recover to the lows of the last two recessions. The positive of that is the absence of inflationary pressure, as witnessed in the reports on prices.
The New York and Philadelphia Federal Reserve banks reported their monthly surveys last week, and they were both fine. The markets seemed to have trouble understanding either one, however. The New York report, came up a tad short of expectations (19.6 actual compared to consensus 21.0), but that narrow of a miss is just noise for day traders who prefer to shoot first and think later (if ever). New orders and inventories improved in both reports, which is the essential fact. The New York survey also showed strong intentions to increase capital spending, a positive sign.
The Philadelphia report was a bigger miss, 8.0 versus consensus for 20.0, but digging down into the details showed decent results in almost every category but employment. The biggest drops came in prices and in the answer to the general question about whether business is getting better or worse, a qualitative question that can be influenced by the headlines (oil spill, sovereign debt crisis, worst May for the stock market in decades). Numerical answers (new orders, inventories) fared better.
Manufacturing will continue to recover, especially with the inventory-to-sales ratio so low. However, the housing market will be moribund for the rest of the year (the Wall Street Journal ran a piece that housing will need job growth to recover. Good to know somebody’s been reading our column). Although the homebuilders are generally not financially threatened this year, new construction will languish. Starts fell ten percent in May, permits another six percent. As we predicted, the homebuilder sentiment reading reversed course, falling all the way back to seventeen again (neutral is fifty).
The declines will level off, but it’s already June. Essentially there will be no summer construction season in residential, and that means high unemployment will persist in the construction industry – and long-term unemployment will continue to set records.
Weekly claims rose again last week, confounding hopes for an ease. There wasn’t much difference between the adjusted claims number, a depressingly high 472,000, and the unadjusted total of 440,071 that rose even more sharply from the prior week. Continuing claims rose as well. Oddly enough, the four-week moving average fell for both, though not by much. The weekly revisions continue to be upward, not a good sign.
Some called for a “V”-shaped recovery, some for a “U,” others for a “W.” It looks to us now that it will be a stair-step recovery this year. Homebuilding won’t start to get traction until 2011. Manufacturers are cautious with adding labor. Production will run up a bit, pause, run up, and pause again, with incremental dollars favoring investment and marketing over hiring. Skilled trades should recover in stair-step fashion, but unskilled will probably be near-frozen for the rest of the year.
Government hiring is under pressure, but leisure and recreation could offset that as employment slowly improves and people continue to favor local vacations. A falling euro favors overseas travel, but that will be held back by high unemployment and sharply higher fares. The airlines have nearly ceased all competition on transatlantic fares, with each company making the routes the center of their margin improvement (there are no discount carriers operating in the market, although Virgin Atlantic has kept the London-New York route more honest - they must really hate Richard Branson).
Core inflation continues to be non-existent. Both the consumer (CPI) and producer (PPI) indices fell last month, pulled down by falls in petroleum, itself pulled down by the stock market. The core (excluding food and energy) both rose by an identical 0.1%. Similarly, import and export prices showed little change outside of petroleum and currency variations.
The big ugly next week will be the May existing home sales report on Tuesday. We expect drops in both existing and new home sales (Wednesday). It won’t catch the market by surprise, but the size of these drops isn’t going to give anybody a warm and fuzzy feeling. They may even overshadow the Federal Reserve’s Open Market Committee meeting, normally one of the two biggest reports of the month. We predict that the FOMC will say that the economy is slowly improving and not much else. What else could they say?
May durable goods orders report on Thursday, with a small decline expected. Looking over the industrial production report, though, we’d favor an increase outside of transportation. Friday will bring the last scheduled GDP revision for the first quarter (no change expected) and the last consumer sentiment reading for June from the University of Michigan. Besides Lennar,a smattering of earnings includes some retailers and two notable tech reports on Thursday, Oracle (ORCL) and Research in Motion (RIMM).
Time for another short idea from the StockWatcher, with the usual admonition that short selling is only for professionals. Being early on a long idea is an opportunity cost; being early on a short idea can bring a lethal visit from the margin clerks.
This time we are talking about the stock of sales and marketing software leader Salesforce.com (the ticker is CRM, short for Customer Relationship Management). It’s a typical Avalon short theme: good company, good product, insane stock price.
Besides being a good company with a good product, there are other reasons to fear being short CRM. It’s a momentum darling. Jim Cramer touts it as one of his favorite recovery stocks to buy on a correction. The company has what promises to be a very good product coming out soon, called Chatter (an obvious nod to Twitter). Chatter essentially allows a sales and marketing group, or even an entire company, to tweet, so to speak, internally about its customers. Beta reviews have been positive.
Good company, good product. But the stock price, are you kidding? At Friday’s close of $95.72, that’s over eight times sales for a company whose sales growth has slowed to under 20%. It’s over 100 times cash flow and 150 times earnings (but only 72x 2010 estimates – such a bargain!).
Trees don’t grow to the sky. Many say that you can’t short a momentum stock on valuation alone, and that may be true for short-term, in-and-out traders. For ourselves, we have never seen ridiculous valuations fail to come back to earth. They can get more ridiculous first, though, so you need to manage positions carefully. The brokerage community will almost never be early on these.
If the market corrects, this one will correct hard, so it’s worth thinking about if you want to hedge your technology holdings. At these prices, you don’t have to worry about takeover bids.
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